Synthesis: Significance and Implications of Alternative Accounting Principles

Learning Objectives

Web

Refer to Figure 1. Circle A indicates the universe of possible accounting principles. The dashed line represents the dif-

ficulty of defining the relative size, or boundaries, of possible accounting principles. Circle B represents the set of account- ing principles designated as generally acceptable by standard-setting bodies. Circle C represents the particular accounting principles that a firm selects to prepare its financial statements. This reading discusses the narrowing from Circle A to Circle C. Anyone who understands the significance and implications of alternative GAAP can read and interpret published financial statements more effectively. This reading uses the terms accounting principles, standards, and methods interchangeably.

Establishing Acceptable Accounting Principles

A standard-setting body within each country typically has authority to select the accounting principles that firms must fol- low in preparing financial statements within that country. Chapter 1 discussed several issues regarding the selection and operation of this standard-setting body:

1. Should a governmental body or a private-sector body set acceptable accounting principles?

2. Should standard-setting bodies require uniform accounting principles for all firms, or should they allow firms a degree

of flexibility to choose the accounting methods that most effectively measure the economic effects of their activities?

3. Should standard-setting bodies follow a rule-based approach in setting accounting standards, or provide general princi-

ples that provide firms with more latitude in the way they account for various transactions?

1

Synthesis: Significance and Implications of Alternative Accounting Principles 2 FIGURE 1 Structure of Accounting Principles

A B

C

Universe of Possible Accounting Principles

Generally Accepted Accounting Principles

Accounting Principles Employed by

a Specific Firm

Standard Setting in the United States

Congress has the ultimate authority to specify acceptable accounting principles in the United States. It has delegated its authority in almost all cases to the Securities and Exchange Commission (SEC), an agency of the federal government. The SEC has indicated that it will generally accept pronouncements of the Financial Accounting Standards Board (FASB) as constituting acceptable accounting principles. Although this delegation of authority suggests that the standard- setting process resides primarily in the private sector in the United States, in reality the SEC and the FASB communicate continually as reporting issues arise. The FASB, at the SEC's urging, formed the Emerging Issues Task Force (EITF) to deal with new reporting issues when the FASB has not yet issued statements.

Firms in the United States have varying degrees of flexibility in choosing their accounting principles. In some instances, the specific conditions associated with a transaction or event dictate the accounting method used. For example, the method of accounting for investments in common stock of other firms depends primarily on the ownership percentage. In other instances, firms have wider flexibility in choosing among alternative methods, such as in selecting a cost flow assumption for inventories and cost of goods sold and in selecting depreciation methods. One might characterize the range of acceptable accounting principles in the United States as one of constrained flexibility.

The delegation of authority to the SEC and the FASB to set accounting principles in part recognizes that the informa- tion needs of users of financial accounting reports differ from the government's need to raise tax revenues. Thus, with the exception of the LIFO cost flow assumption for inventories, firms need not use the same methods of accounting for finan- cial reporting as it uses for tax reporting.

In selecting accounting principles, the FASB follows a process that incorporates both deduction from general princi- ples and, in some cases, a detailed rules approach. Figure 1.4 in Chapter 1 summarizes the FASB's conceptual frame- work. Chapters 2 through 4 discuss more fully the concepts of assets, liabilities, revenues, expenses, and cash flows. The FASB uses this conceptual framework in guiding its selection of acceptable accounting principles.

The conceptual framework does not always give the FASB clear guidance when it considers alternative methods to account for a particular transaction or event. The conceptual framework includes broad financial reporting objectives and general concepts. Standard-setters often logically deduce more than one accounting method from such a framework. Fur- thermore, preparers and users of financial accounting reports often lobby for other methods to account for a transaction or event. They sometimes argue that they cannot cost-effectively apply accounting methods under consideration by the FASB or that the methods will seriously disrupt firms' decisions or capital markets. Refer, for example, to the discussion in Chapter 12 on the accounting for employee stock options. The FASB initially proposed an accounting method that would have required firms to recognize additional expenses, thereby lowering net income. Intense lobbying against the proposed accounting standard bombarded the FASB. The FASB at the time settled on a standard that allowed firms to disclose the earnings effects of stock options in notes to the financial statements instead of in the income statement. Subsequent pres- sure from regulators, analysts, and academics led the FASB to reconsider the accounting for stock options and to require the market value method. Such lobbying shows the political nature of the standard-setting process and illustrates the diffi- culties that standard-setting bodies encounter when moving from Circle A to Circle B of Figure 1.

Standard-Setting in Other Countries

Until recently, the standard-setting process varied widely across countries. Governmental agencies played a major role in establishing acceptable accounting principles in some countries. Examples include Germany, France, and Japan. The meth- ods of accounting that firms used for financial reporting closely conformed to the methods of accounting used in prepar- ing income tax returns. Ownership of common stock in these countries typically resided in a few wealthy families and in large corporations and financial institutions. These shareholders closely monitored the activities of the businesses that they owned. Thus, there was less need to use financial statements as a source of information for assessing operating perform- ance and financial position. The need to raise income taxes in an efficient manner and the desire to use the income tax sys- tem to achieve certain public policy goals had a major influence on establishing acceptable accounting principles.

Synthesis: Significance and Implications of Alternative Accounting Principles 3

Other countries followed a standard-setting process similar to that of the United States: a private-sector body set acceptable accounting principles. Examples include the United Kingdom, Canada, and Australia. Broad public ownership characterizes stock ownership in these countries. Financial statements serve as a major source of information for share- holders to monitor the activities of firms in which they invest funds. The accounting principles that firms use for financial reporting often differ from the methods used for income tax purposes.

These different approaches to setting accounting standards resulted in different accounting principles across countries and a lack of comparability of financial statement information. The International Accounting Standards Board (IASB) and its predecessor organization, have endeavored since the early 1970s to achieve greater uniformity in accounting prin- ciples. The IASB has no legal authority to set accounting principles within individual countries. Its process has been to encourage IASB representatives to obtain their countries' acceptance of pronouncements of the IASB. Firms in the Euro- pean Community must prepare their financial statements according to IASB standards beginning in 2005.

Review of Generally Accepted Accounting Principles

This section summarizes the major currently acceptable accounting principles in the United States and as set forth by the IASB. Various chapters in the book have discussed these GAAP.

Revenue Recognition

A firm may recognize revenue

1. at the time it sells goods or renders services (typical under the accrual basis of accounting), or

2. at the time it collects cash (installment method or cost-recovery-first method), or

3. as it engages in production or construction (percentage-of-completion method for long-term contracts), or

4. perhapsnotuntilthecustomernolongerhastherighttoreturngoodsforarefund(suchaswhenafirmgivescustomers

the right to return goods for a specified time after purchase).

Recognizing revenue at the time of production or construction reports the largest cumulative income statement earn-

ings and balance sheet assets. Recognition at the time of sale reports the next-largest cumulative income and assets, fol- lowed by recognition at the time of cash collection or at the time the refund period expires. However, the revenue recognition method that produces the largest earnings for any particular accounting period depends on the growth charac- teristics of a firm. Growing firms generally report the largest earnings each period when they recognize revenue at the time of production or construction. Declining firms generally report the largest earnings each period when they recognize rev- enue at the time of cash collection. When firms neither grow nor decline, the income recognition methods usually report similar earnings amounts each period. To repeat a theme of this book, over long time periods, cumulative income must equal cash inflows minus cash outflows other than transactions with owners. Different revenue recognition methods, and different accounting methods generally, affect only the timing of recognition, not the amount of revenue.

To recognize revenue, a firm must have

1. performed all, or most, of the services it expects to provide, and

2. received cash or some other asset, such as a receivable, susceptible to reasonably precise measurement.

The generality of these criteria provides firms with flexibility in choosing their revenue recognition method. Most firms recognize revenue at the time they sell (deliver) goods or render services. Firms that conduct operations using multiyear contracts, such as construction companies, generally recognize revenue throughout the contract period using the percent- age-of-completion method.

Uncollectible Accounts

A firm may recognize an expense for uncollectible accounts in the period when it recognizes revenue (allowance method) or in the period when it discovers that it cannot collect specific accounts (direct write-off method). The allowance method results in the smallest cumulative earnings and assets on the balance sheet because it recognizes bad debt expense earlier than the direct write-off method. The method that produces the largest earnings for any particular period depends on the growth characteristics of the firm and on the amounts judged uncollectible during the period.

GAAP require firms with predictable uncollectible amounts to use the allowance method in financial reporting. Income tax laws require U.S. firms to use the direct write-off method for tax reporting under all circumstances.

Synthesis: Significance and Implications of Alternative Accounting Principles 4

Inventories

A firm generally reports its inventories using the lower of acquisition cost or market value method. When the firm cannot (or chooses not to) specifically identify which goods it sold, the firm makes a cost flow assumption. Allowable cost flow assumptions include FIFO, LIFO, and weighted average, although the IASB expresses a preference for FIFO or weighted average. FIFO generally provides the largest earnings and assets valuations when acquisition costs increase and the lowest earnings and assets valuations when acquisition costs decline. LIFO usually provides the smallest earnings and assets valuations when acquisitions costs increase and the highest when they decline. The weighted-average cost flow assump- tion provides earnings amounts between those for FIFO and LIFO but with expense, income, and asset valuation amounts more similar to those under FIFO than under LIFO.

The extent to which net income and assets differ under FIFO, LIFO, and weighted-average cost flow assumptions depends on three factors: the relative magnitude of acquisition cost changes, the rate of inventory turnover, and the pres- ence or absence of a LIFO layer liquidation. Relatively small changes in acquisition costs cause minor differences in earn- ings and asset valuations, whereas larger changes magnify the differences. A rapid rate of inventory turnover reduces the difference in effects of the three cost flow assumptions, whereas a slower rate magnifies the differences. If a firm must dip into old LIFO layers priced at acquisition costs significantly higher or lower than current costs, generalizations about the effect of LIFO on earnings and assets will not hold.

Firms have some latitude in selecting a cost flow assumption for financial and tax reporting. A U.S. firm must, however, use LIFO for financial reporting if it uses LIFO in tax reporting.

Investments in Securities

A U.S. firm accounts for investments in the common stock securities of other firms using the market value method or the equity method, or it prepares consolidated statements, depending on its ownership percentage. IASB standards also permit the use of the lower-of-cost-or-market method. These four accounting methods provide different financial statement effects as follows:

Accounting Method Income Statement Balance Sheet

Market Value

Lower of Cost or Market

Equity

Consolidation

Dividends received or receivable and realized holding gains and losses for securities available

for sale and realized gains and losses for trading securities

Dividends received or receivable, unrealized holding losses, realized holding gains and losses

Share of investee's earnings

Subsidiary's revenues and expenses minus minority interest in net income of subsidiary

Market value

Lower of cost or market

Acquisition cost plus share of investee's earnings minus dividends received

Subsidiary's assets and liabilities minus minority interest in net assets

of subsidiary

Net income reported by the equity method equals that reported in consolidated statements, although individual revenue and expense amounts differ. Total assets and total liabilities in consolidated statements usually exceed those under the equity method, but total shareholders' equity is the same under the two methods.

The accounting method used for financial reporting depends primarily on the owner's ability to significantly influence the investee company, with presumption of influence based on the percentage of outstanding shares held. U.S. firms hold- ing less than 20 percent of another firm's outstanding shares generally use the market value method. Firms in most other countries use the lower-of-cost-or-market method. The equity method applies to holdings between 20 percent and 50 per- cent. Generally, firms must prepare consolidated financial statements when the ownership percentage exceeds 50 percent. Firms must use the equity method when owning less than 20 percent if they can exert significant influence over an investee and must not use it, even when owning more than 20 percent, if they cannot exert significant influence. Firms do not con- solidate a majority-owned subsidiary if they control it only temporarily. For example, a firm would not consolidate a sub- sidiary if it intends to dispose of its controlling interest soon. A firm would also not consolidate a subsidiary if it cannot exercise majority control. For example, a parent company would not consolidate a subsidiary in bankruptcy, and therefore under the control of the courts, or a subsidiary in a foreign country that does not allow the parent to withdraw cash or other assets from the subsidiary.

Synthesis: Significance and Implications of Alternative Accounting Principles 5

Derivatives

Firms often acquire derivative securities to hedge the risk of changes in interest rates, exchange rates, and commodity prices. Firms revalue both the derivative security and the item subject to the hedge to market value each period. Unrealized holding gains and losses on both the derivative security and the item hedged appear in net income each period for fair value hedges. The unrealized holding gain or loss on cash flow hedges appears in other comprehensive income for cash flow hedges until the firm settles the item hedged. At this time, the unrealized gain or loss becomes a realized gain or loss and the firm transfers the amount from other comprehensive income to net income. GAAP treats derivatives not deemed hedges as marketable trading securities, with the accounting similar to that for fair value hedges.

Machinery, Equipment, and Other Depreciable Assets

Firms may depreciate fixed assets using the straight-line, declining-balance, sum-of-the-years'-digits, or units-of-produc- tion methods. In countries where tax reporting historically played a major role in establishing acceptable accounting prin- ciples, such as Germany, France, and Japan, firms tend to use accelerated depreciation methods for financial reporting. In countries with a history of using different methods of accounting for financial and tax reporting, such as the United States and the United Kingdom, firms tend to use the straight-line method.

The straight-line method usually provides the largest cumulative earnings and asset valuations, followed by the sum- of-the-years'-digits method and then the declining-balance methods. The financial statement effects of the units-of-produc- tion method depend on the intensity of use of the asset. The straight-line method usually results in the largest earnings for any period when a firm increases its depreciable assets and the smallest earnings when a firm decreases depreciable assets. When acquisition costs of depreciable assets remain stable and firms maintain their level of investment in such assets, the depreciation methods produce similar earnings and balance sheet effects.

Firms can choose any of these depreciation methods for financial reporting. Firms will frequently use different esti- mates of service lives for similar assets, partly as a function of the intended intensity of use and the maintenance or repair policy. Income tax laws specify the depreciation methods and service lives for various types of depreciable assets. The depreciation rates incorporate declining-balance depreciation methods. Income tax laws in most countries do not require conformity between financial and tax reporting for depreciable assets, but there are exceptions.

Firms must test depreciable assets periodically for impairment when an event occurs suggesting that the fair value of the asset has declined below its book value. The test for an asset impairment in the United States compares the undis- counted cash flows anticipated from the asset with its book value. If the book value exceeds the undiscounted cash flows, an asset impairment has occurred. The firm then measures the amount of the impairment loss by comparing the fair value of the asset (market value or present value of expected cash flows) with the book value. The excess of the book value over the fair value is the amount of the impairment loss.

Corporate Acquisitions

Firms account for the acquisition of another firm using the purchase method. The purchase method results in reporting the assets and liabilities of the acquired company at the market value of the consideration given to execute the acquisition. When the acquisition price exceeds the market value of identifiable assets and liabilities, goodwill appears as an asset on the post-acquisition consolidated balance sheet.

The market value of the consideration given in most acquisitions exceeds the book values of the assets and liabilities of the acquired firm. The purchase method will report lower future earnings because future expenses derive from the ini- tially higher asset valuations. Firms in the United States cannot amortize goodwill and other intangibles with indefinite lives. Instead, firms must test goodwill and other intangibles with indefinite lives annually for impairment. Firms in most other countries must amortize goodwill over some number of future years. The IASB sets 20 years as the maximum amor- tization period unless a firm can justify a longer period.

Leases

A firm using property rights acquired under lease may record the lease as an asset and subsequently amortize it (the cap- ital, or finance, lease method) or the firm may recognize the lease transaction only as the company uses the asset and must make lease payments each period (the operating lease method). Likewise, the lessor (the provider of the property rights under lease) can set up the rights to receive future lease payments as a receivable at the inception of the lease (the capital, or finance, lease method) or can recognize the lease only when the lessor becomes entitled to receive rental payments each period (the operating lease method).

From the lessee's perspective, total expenses over the life of a lease do not depend on the accounting method. Remem- ber: total expense ultimately equals total cash outflow. Depreciation and interest expenses under the capital lease method usually exceed rent expense under the operating lease method during the early years of a lease. The operating lease method reports higher total expenses during the later years of a lease. By the end of the lease term, expense totals will equalize. Lessees with growing lease activity will likely show higher expenses each year using the capital lease method than they would show using the operating lease method because more of their leases are in the early years of the lease period. Firms

Synthesis: Significance and Implications of Alternative Accounting Principles 6

with a declining level of leases should experience earnings effects just the opposite of those for a firm with a growing level of leases. The choice of accounting method for leases causes major differences in balance sheet amounts. The capital lease method includes the leased asset and the lease liability on the balance sheet, whereas the operating lease method does not. Because of the lessee's increased debt-equity ratio under the capital lease method, many managers prefer operating lease accounting.

From the lessor's perspective, total revenues over the life of the lease do not depend on the accounting method. Remember: total revenue ultimately equals total cash inflow. Because lessors often recognize a gain at the inception of a capital lease (equivalent to gross margin in a sales transaction), cumulative earnings for the lessor using the capital lease method generally exceed those of the lessor using the operating lease method until the final year of the lease. Lessors tend to report slightly higher asset valuations under the capital lease method.

Under the capital lease method, the balance sheet shows the lease receivable, which declines as the lessor receives cash.

Under the operating method, the balance sheet shows the asset itself, which declines in amount as the asset depreciates.

Whether a firm uses the capital or the operating lease method for financial reporting depends on which firm, the les- sor or the lessee, bears the risks of the leased asset. Risks include uncertain residual values of the leased asset at the end of the lease period, due either to excessive use or obsolescence, changes in interest rates, changes in the demand for goods produced or services rendered with the leased asset, and similar factors. Comparing the life of the lease to the life of the leased asset and the present value of the lease payments to the market value of the leased property at the inception of the lease determines which entity bears the risks. The capital lease method applies when the lessee bears most of the risks, and the operating lease method applies when the lessor bears the risks. The facts of each lease agreement determine the appro- priate method. The lessor and the lessee generally use the same method for a given lease because they apply the same cap- ital-versus-operating lease criteria. There is, however, no requirement that they coordinate their decision about the accounting method. The criteria for a capital versus an operating lease for tax purposes differ somewhat from those used for financial reporting. Thus, firms may account for the same lease using different methods for financial and tax reporting.

Employee Stock Options

A U.S. firm compensating its employees by granting them options to purchase its shares must value the options at market value and amortize their cost over the expected period of benefit.

Summary

The preceding discussion does not list all of the alternative GAAP in the United States and as provided by the IASB. Advanced courses in financial accounting consider additional reporting areas involving differences in accounting princi- ples. Firms must disclose their accounting principles in a note to the financial statements.1

Firms enjoy considerable latitude in applying GAAP for a particular item. For example, firms using the allowance method for uncollectible accounts base their periodic provisions on judgments of the amount of bad debts. Firms using the straight-line depreciation method base their depreciation calculations on judgments of useful life and salvage value. Thus, uniformity in the accounting principles used by two firms does not necessarily result in comparable earnings and asset valuations for these firms. Firms seldom disclose sufficient information about their application of particular accounting principles to permit financial statement users to assess the degree of comparability between firms.

Firms can also manage their reported earnings by timing their expenditures. Recall from earlier chapters that firms must generally expense, as incurred, expenditures on research and development, advertising, and maintenance of depreciable assets. Firms can accelerate or defer their expenditures, however, to achieve higher or lower earnings for a particular period.

Thus, an assessment of the effects of alternative accounting principles must consider not only the principles themselves but how firms apply those principles.

An Illustration of the Effects of Alternative Accounting Principles on a Set of Financial Statements

This section illustrates the effects that the use of different accounting principles can have on a set of financial statements. We constructed the illustration so that the accounting principles used create significant differences in the financial state- ments. Therefore, do not try to infer from this example the usual magnitude of the effects of alternative methods.

1 Accounting Principles Board, Opinion No. 22, "Disclosure of Accounting Policies," 1972.

Synthesis: Significance and Implications of Alternative Accounting Principles 7

The Scenario

On January 1, two identical corporations establish merchandising businesses. The two firms carry out identical operations and differ only in their methods of accounting. Conservative Company chooses the accounting principles that will minimize its reported net income. High Flyer Company chooses the accounting principles that will maximize its reported net income. The following events occur during the year.

1. Both corporations issue two million shares of $10-par value stock on January 1, for $20 million cash.

2. Both firms acquire equipment on January 1 for $14 million cash. The firms estimate the equipment to have a 10-year

life and zero salvage value.

3. Both firms make the following purchases of merchandise inventory:

Date Units Purchased

Unit Price

@$60 @$63 @$66

Cost of Purchases

$10,200,000 11,970,000 13,200,000

$35,370,000

January 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . May 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . September 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total .........................................

170,000 190,000 200,000 560,000

4. During the year, both firms sell 420,000 units at an average price of $100 each. The firms make all sales for cash.

5. During the year, both firms have selling, general, and administrative expenses, excluding depreciation, of $2.7 million.

6. The income tax rate is 35 percent.

Accounting Principles Used

The following sections describe the methods of accounting used by each firm and the effects that each choice has on the financial statements.

Inventory Cost Flow Assumption Conservative Company makes a LIFO cost flow assumption, whereas High Flyer Company makes a FIFO assumption. Each firm uses its chosen method for both financial reports and income tax returns. Because the beginning inventory is zero, the cost of goods available for sale by each firm equals the purchases during the year of $35,370,000. Both firms have 140,000 units in ending inventory. Conservative Company therefore reports a cost of goods sold of $26,970,000 [= $35,370,000 - (140,000 x $60)], whereas High Flyer Company reports a cost of goods sold of $26,130,000 [= $35,370,000 - (140,000 x $66)]. Income tax regulations in the United States require a firm to use LIFO in its financial reports if it uses LIFO for its tax return. High Flyer Company does not want to use LIFO in its financial reports and therefore forgoes the tax savings opportunities from using LIFO for tax purposes.

Depreciation Conservative Company decides to depreciate its equipment using the double (200 percent) declining- balance method in its financial statements, whereas High Flyer Company decides to use the straight-line method. Conser- vative Company therefore reports depreciation expense of $2.8 million (= 2 x 1/10 x $14,000,000), whereas High Flyer Company reports depreciation expense of $1.4 million (= 1/10 x $14,000,000) to shareholders. Both companies compute depreciation for tax purposes using a seven-year life, the double declining-balance depreciation method, and the initial half-year depreciation convention. Depreciation on both tax returns equals $2.0 million for the year.

Comparative Income Statements

Exhibit 1 presents comparative income statements for Conservative Company and High Flyer Company for the year ending December 31. For each company, the revenues and expenses (except for depreciation) reported in the financial statements equal those in the income tax return.

Conservative Company reports $800,000 (= $2,800,000 - $2,000,000) more depreciation in the financial statements than in the tax return. The $800,000 difference causes taxable income to exceed income before income taxes for financial reporting. Income tax expense of $3,335,500 equals the income tax rate of 35 percent times income before income taxes. Income taxes currently payable equal the income tax rate of 35 percent times taxable income. The difference between income tax expense of $3,335,500 and the income tax payable of $3,615,500 results in a deferred tax asset of $280,000 on the balance sheet. This account reports the future tax savings that Conservative Company will realize when it deducts the $800,000 additional depreciation for income tax purposes in later years.

High Flyer Company reports $600,000 (= $1,400,000 - $2,000,000) less depreciation in the financial statements than in the tax return. Income before income taxes exceeds taxable income; therefore, income tax expense exceeds income tax currently payable. The firm recognizes a deferred tax liability for the future taxes payable of $210,000 (= 0.35 x $600,000). Note in this illustration that High Flyer Company reports significantly larger net income and earnings per share than Conservative Company. Other management choices could magnify the difference. If both firms had issued stock options to employees as compensation in lieu of cash, with Conservative Company expensing faster than High Flyer, the Conservative Company would report lower income than High Flyer.

Synthesis: Significance and Implications of Alternative Accounting Principles 8

EXHIBIT 1

Comparative Income Statements Based on Different Accounting Principles for the Year Ending December 31 (all dollar amounts in thousands, except for per-share amounts)

Conservative Company

Financial Tax

Statement Return

High Flyer Company

Financial Tax

Statement Return

SalesRevenue........................................

Expenses:

CostofGoodsSold .................................. DepreciationonEquipment ............................ Other Selling, General, and Administrative. . . . . . . . . . . . . . . . . . . ExpensesbeforeIncomeTaxes ..........................

NetIncomebeforeIncomeTaxes........................... IncomeTaxExpensea .................................. NetIncome ......................................... Earnings per Share (2,000,000 shares outstanding) . . . . . . . . . . . . .

$42,000.0

$26,970.0 2,800.0 2,700.0 $32,470.0 $ 9,530.0 3,335.5 $ 6,194.5

$ 3.10

$42,000.0

$26,970.0 2,000.0 2,700.0 $31,670.0 $10,330.0

$42,000.0

$26,130.0 1,400.0 2,700.0 $30,230.0 $11,770.0 4,119.5 $ 7,650.5

$ 3.83

$42,000.0

$26,130.0 2,000.0 2,700.0 $30,830.0 $11,170.0

a Computation of Income Taxes:

Credits to Income Taxes Currently Payable on Balance Sheet

0.35x$10,330.0 ............................................ 0.35x$11,170.0............................................. Credits (Debits) to Deferred Income Taxes on Balance Sheet Dr.=0.35x$800............................................

Cr.=0.35x$600 ............................................

Total Debit to Income Tax Expense on Income Statement . . . . . . . . . . . . . .

$3,615.5

(280.0)

$3,335.5

$3,909.5

210.0

$4,119.5

Comparative Balance Sheets

Exhibit 2 presents comparative balance sheets for Conservative Company and High Flyer Company as of December 31. Merchandise inventory and equipment (net) as well as total assets of Conservative Company have lower valuations than those of High Flyer Company. Cash represents the only real difference between the economic positions of the two compa- nies. The difference in the amount of cash results from the payment of different amounts of income taxes by the two firms. Note that Conservative Company's higher cash results from paying smaller amounts of income taxes. Some analysts, including us, believe that Conservative Company has a stronger financial position than does High Flyer Company.

The differences in the amounts for merchandise inventory and equipment (net) result from the different accounting methods used by the two companies. Conservative Company reports smaller amounts than High Flyer Company because Conservative Company recognizes a larger portion of the costs incurred during the period as an expense. Conservative Company also shows a Deferred Tax Asset of $280,000 arising from temporary differences in depreciation for financial and tax reporting, whereas High Flyer Company reports a Deferred Tax Liability relating to the same temporary differences.

EXHIBIT 2

Comparative Balance Sheets Based on Different Accounting Principles, December 31 (all dollar amounts in thousands)

Conservative High Flyer Company Company

ASSETS

Cash.............................................. MerchandiseInventory ................................. Equipment(atacquisitioncost) ........................... LessAccumulatedDepreciation ........................... DeferredTaxAsset ....................................

TotalAssets .......................................

LIABILITIES AND SHAREHOLDERS' EQUITY

DeferredTaxLiability .................................. CommonStock ....................................... RetainedEarnings ....................................

TotalLiabilitiesandShareholders'Equity. ...................

$ 6,314.5 8,400.0 14,000.0

(2,800.0) 280.0 $26,194.5

$20,000.0 6,194.5 $26,194.5

$ 6,020.5 9,240.0 14,000.0

(1,400.0)

$27,860.5

$ 210.0 20,000.0 7,650.5 $27,860.5

Synthesis: Significance and Implications of Alternative Accounting Principles 9

Note the effect that the use of alternative accounting principles has on the rate of return on total assets, a measure of a firm's operating profitability. Conservative Company reports a smaller amount of net income but also a smaller amount of total assets. One may expect the rate of return on total assets of the two firms to approximate each other more closely than either net income or total assets individually. One still observes significant differences in the ratios for the two firms in this illustration, however. The rate of return on total assets for Conservative Company is as follows:

26.8 percent = $6,194,500/[($20,000,000 + $26,194,500)/2]

For High Flyer Company the rate is as follows:

32.0 percent = $7,650,500/[($20,000,000 + $27,860,500)/2]

Note that neither firm uses debt financing, so there is no need to add back interest expense net of tax saving in the numer- ator of the rate of return on assets.

Comparative Statements of Cash Flows

Exhibit 3 presents comparative statements of cash flows for Conservative Company and High Flyer Company. The amount of cash flow from operations for Conservative Company exceeds that for High Flyer Company. The difference of $294.0 million (= $314.5 million - $20.5 million) results from the difference in the amount of income taxes paid. These compa- nies paid different amounts of income taxes because they used different cost flow assumptions for inventories on their tax returns. The following schedule shows the cause of the difference in cash flow:

ConservativeCompany:LIFOCostofGoodsSold................................ HighFlyerCompany:FIFOCostofGoodsSold ................................. DifferenceinCostofGoodsSoldandTaxableIncome ............................ MultiplybyTaxRate .................................................. DifferenceinCashFlowfromOperations(=$6,314.5-$6,020.5) ...................

$26,970 26,130 $ 840

x 35% $ 294

Note that the use of different depreciation methods by these firms on their financial statements has no effect on the statement of cash flows. As long as both firms use the same depreciation method on their tax returns (double declining- balance method in this case), cash flows related to depreciation will not differ.

Comparative Statements of Cash Flows for the Year Ending December 31 (all dollar amounts in thousands)

EXHIBIT 3

OPERATIONS

NetIncome ......................................... $ 6,194.5

Additions:

DepreciationExpense .................................. 2,800.0 IncreaseinDeferredTaxLiability .......................... Subtractions:

IncreaseinDeferredTaxAsset ............................ (280.0) IncreaseinMerchandiseInventory ......................... (8,400.0) CashFlowfromOperations ..............................

INVESTING

AcquisitionofEquipment ...............................

FINANCING

IssueofCommonStock................................. NetChangeinCash ................................... Cash,January1 ...................................... Cash,December31....................................

Moral of the Illustration

Conservative Company

High Flyer Company

20,000.0 $ 6,314.5

$ 7,650.5

1,400.0 210.0

(9,240.0)

$

314.5 (14,000.0)

$ 20.5 (14,000.0)

20,000.0 $ 6,020.5

$ 6,314.5 $ 6,020.5

Effective interpretation of published financial statements requires sensitivity to the particular accounting principles that firms select. Comparing the reports of several companies may necessitate adjusting the amounts for different accounting methods. Previous chapters illustrated the techniques for making some of these adjustments (for example, LIFO to FIFO

Synthesis: Significance and Implications of Alternative Accounting Principles 10

cost flow assumption). The notes to financial statements disclose the accounting methods used but not necessarily the data needed to make the appropriate adjustments.

Assessing the Effects of Alternative Accounting Principles on Investment Decisions

Previous sections of this chapter emphasized the flexibility that firms have in selecting and applying their accounting principles and the effects that the use of different accounting principles has on the financial statements. We now examine two related and important questions:

Do investors accept financial statement information as presented, without noticing the differences in accounting methods that underlie the statements?

Or, do they somehow filter out all or most of the financial statement variances that result from differences in the selection and application of accounting methods?

Suppose that investors accept financial statement information as presented, without adjustments for the methods of accounting used. Then, two firms that are otherwise identical except for their accounting principles might raise capital at different costs or raise unequal amounts of capital. Then, the use of alternative accounting principles leads to a misalloca- tion of resources in the economy. The managers of a firm might have an incentive to select those accounting principles that place the firm and its managers in the most favorable light rather than to select those accounting principles that most accu- rately measure the economic effects of transactions and events.

Those who believe that alternative accounting principles can mislead investors make the following arguments.

1. Most investors do not understand accounting well enough to make adjustments for differences in accounting principles.

2. Financial statements and related notes do not provide sufficient information to permit the user to understand how firms applied the accounting methods selected, much less provide sufficient information to allow the user to adjust for alter-

native accounting principles.

3. The financial press frequently reports on firms whose market prices fall dramatically when reports about their misuse

of specific accounting methods hit the market.

Those who believe that alternative accounting principles rarely mislead investors make the following arguments.

1. Capital market prices adjust quickly and appropriately to new information. Sophisticated security analysts, who domi- nate the pricing of securities through their buy and sell recommendations, have the necessary skills to make adjustments for alternative accounting principles.

2. The financial statement effects of differences in accounting principles can be sufficiently small that adjusting for them does not justify the effort. For example, the financial statement effects of using FIFO versus LIFO cost flow assump- tions for inventories and cost of goods sold are small when prices do not change significantly and inventory turns over rapidly. Differences in depreciation methods do not cause serious financial statement distortions when acquisition costs remain relatively stable and firms do not grow rapidly.

Both of these positions have support in empirical evidence. Most of the evidence for the position that alternative

accounting principles mislead investors relates to individual firms. Most of the evidence for the position that alternative accounting principles do not mislead investors relates to aggregate market effects. Thus, evidence that capital markets in general react appropriately to financial disclosures by firms does not preclude the possibility that the market may react inappropriately to the financial disclosures of particular firms for a particular period.

Quality of Earnings Revisited

Security analysts examine a firm's quality of earnings when using earnings information in valuing the firm. Assessments of a firm's quality of earnings involve examining the choices a firm makes in

1. selecting its accounting principles from among alternative GAAP,

2. applying the accounting principles selected, and

3. timing business transactions to temporarily increase or decrease earnings.

Throughout, the book emphasizes that net income over sufficiently long time periods equals cash inflows minus cash out- flows other than transactions with owners. Firms, however, measure earnings for shorter, discrete time periods. Revenue recognition often precedes the receipt of cash from customers. Firms must therefore estimate at the time of sale the amount of uncollectible accounts and sales returns to measure earnings. Expense recognition often follows the cash outflows for goods and services acquired, sometimes by many years, as in the case of fixed assets. Expense recognition may also

Synthesis: Significance and Implications of Alternative Accounting Principles 11

precede cash outflows, as occurs with warranty services. The longer the time that elapses between revenue recognition and cash receipts and between expense recognition and cash expenditures, the more opportunity a firm has to bias its reported earnings and therefore lower its quality of earnings.

A concept related to quality of earnings is quality of financial position. The choices a firm makes in reporting rev- enues and expenses also affect assets and liabilities on the balance sheet. Analysts use balance sheet amounts in assessing a firm's profitability (for example, balance sheet amounts affect rates of return on assets and shareholders' equity and asset turnovers) and its risk (balance sheet amounts affect current, quick and debt ratios).

The next section reviews the impact of various financial reporting topics on assessments of the quality of earnings and the quality of financial position. Although we examine each reporting topic separately, assessments of quality must consider the net effect of all areas in which firms make reporting choices.

Revenue Recognition and Receivables Most firms recognize revenues at the time of sale, or delivery, of goods and services. Firms that collect cash from customers at the time of sale (for example, fast-food restaurants, movie theaters) have a higher quality of earnings, at least with respect to revenues, than firms that must estimate the amount of uncol- lectible accounts. Firms that sell to many customers, have historical data on the collectibility of receivables, and collect cash within one to three months after the sale (for example, department stores with their own credit cards) generally have higher-quality earnings than firms that sell to just a few customers, have limited historical data on collectibility, and per- mit customers to stretch out payments over many months or even years (for example, sellers of restaurant franchises, sell- ers of undeveloped residential real estate). Firms that provide customers with liberal rights to return products (for examples, sellers of products by mail or over the Internet) or that sell products requiring additional services before cus- tomer acceptance (for example, new computer software) must estimate the likely amount of returns and other after-market costs in order to measure earnings, thereby affecting earnings quality. Each of these choices that affect the measurement of revenue simultaneously affects the measurement of accounts receivable on the balance sheet.

Firms that recognize revenue on multi-period contracts as work progresses, such as construction companies, must esti- mate the degree of completion and the expected amount of total revenues and total expenses in order to measure earnings each period. The need to make such estimates before completion of the construction work affects the quality of earnings and the valuation of Contracts in Process on the balance sheet.

Cost of Goods Sold and Inventories Most firms choose either a FIFO, LIFO, or weighted-average cost flow assumption for inventories and cost of goods sold. LIFO generally matches more current cost with revenues than does FIFO and leads to higher-quality, sustainable earnings. Firms that dip into LIFO layers, however, match some older acqui- sition costs with revenues and negatively influence the quality of earnings. Whether a firm dips into LIFO layers is par- tially at the discretion of management. During periods of rising acquisition costs, dipping into LIFO layers can increase net income. LIFO provides, for inventories, balance sheet amounts that may reflect acquisitions costs of many years ago, when the firm created the LIFO layers. FIFO provides balance sheet amounts more closely reflecting current costs and therefore results in higher-quality measures of financial position. Thus, accounting methods that increase earnings quality may provide lower-quality measures of financial position.

Depreciation and Fixed Assets Firms with a high proportion of depreciable assets, such as manufacturing firms, have a lower quality of earnings, at least with respect to the measurement of depreciation expense, than firms with lower proportions of fixed assets, such as service and retail firms. Firms with depreciable assets must estimate the length of the period during which depreciable assets will provide services and the residual value at the end of that period. Such firms must also choose a depreciation method. These choices provide firms with opportunities to manage earnings in their favor.

Firms can measure depreciation using the straight-line method or an accelerated method. Because analysts often sus- pect that firms overstate rather than understate earnings, they view accelerated depreciation as providing higher-quality earnings. The vast majority of U.S. firms use the straight-line depreciation method. The depreciation method choice is therefore not an important source of difference in earnings quality between U.S. firms. Firms in countries such as Germany, France, and Japan frequently use accelerated depreciation methods for financial reporting. Thus, the deprecia- tion method choice does affect assessments of earnings quality in cross-national comparisons.

Most countries require acquisition cost valuations for fixed assets. The longer the time period a firm holds fixed assets, the more out-of-date these acquisition cost valuations become. When the fair values of fixed assets decline below their book values, GAAP require firms to recognize an impairment loss. Thus, the book values after recognizing the impairment loss will equal the fair values of the assets and provide high-quality measures of financial position. When the fair values of fixed assets increase above book values, GAAP in most countries do not permit firms to write up the assets. Thus, the reported amounts for fixed assets will understate the financial position of the firm. Measuring the fair value of fixed assets, particularly those uniquely suited to a particular firm's needs, is not a precise process. Thus, opportunities to manage earn- ings exist in both the timing and measurement of impairment losses.

Amortization and Intangible Assets Firms that acquire intangibles in external market transactions must capitalize their costs as assets and subsequently amortize those with limited lives. Firms that develop intangibles internally must gen- erally expense their costs in the year incurred. The immediate expensing leads to more conservative measures of earnings and, in the view of most analysts, a higher quality of earnings. Immediate expensing also eliminates the need to estimate the expected life and to choose an amortization method, actions required of firms acquiring intangibles in external market

Synthesis: Significance and Implications of Alternative Accounting Principles 12

transactions. Firms that develop intangibles internally, however, have discretion regarding when they expend resources and therefore can manage earnings in their favor in a particular year by delaying or accelerating expenditures.

Corporate Acquisitions The purchase method of accounting for a corporate acquisition reports assets and liabilities of an acquired company at the acquirer's acquisition cost, which equals the market value at the time of the acquisition. Firms using the purchase method must allocate this aggregate purchase price among each of the assets and liabilities acquired and then subsequently amortize those with limited lives. The initial allocation and subsequent amortization pres- ent firms with opportunities to manage balance sheet and earnings amounts. Thus, the analyst must consider the possible impact of the purchase method on quality assessments.

Warranties Firms that promise to provide future warranty services on products sold must estimate the expected costs of warranty claims and recognize that amount as an expense in the year it sells the products. When the warranty period is short, such as one year, and the firm has historical data on warranty claim costs for similar products, opportunities to man- age earnings and measures of the warranty liability are more limited than when the warranty period extends for many years and historical data on similar products are lacking.

The earnings and balance sheet amounts for insurance companies present quality issues similar to warranties. Insur- ance companies recognize revenues each period from insurance premiums and investments. They must recognize an expense for the expected costs of claims arising from insurance in force during each period. The claim period may be rel- atively short, as in the case of damage to automobile and buildings, or much longer, as in the case of liability or life insur- ance coverage. Insurance companies encounter difficulties estimating the timing and amount of claims, particularly from events that do not occur in predictable patterns (such as hurricanes) and events for which insurance companies do not have historical data.

Leases Lessees usually prefer the operating lease method because it permits them to keep the lease liability off the bal- ance sheet. The operating lease method provides lower-quality measures of financial position than the capital lease method because the lease obligation is, in economic substance, similar to reported liabilities. The operating lease method also keeps the leased asset off the books and understates the resources under the control and responsibility of management.

Employee Stock Options The market value method for stock options requires firms to make assumptions as to stock price volatility, dividend policy, discount rates, and other factors in valuing stock options. Firms must also make assump- tions about the expected period of benefit. The need to make these assumptions provides management with opportunities to manage earnings.

Investments in Securities Firms might vary their ownership percentage in other companies to achieve a desired income statement or balance sheet result. Firms that invest in start-up companies may keep their ownership percentage below 20 percent to avoid having to accrue a share of the net losses expected during the early years. Firms investing in companies with high proportions of debt in their capital structures may keep the ownership percentage below 50 percent to avoid having to consolidate the debt into their balance sheet. Analysts must assess whether legitimate business reasons explain the ownership percentages or whether firms are gaming GAAP to their advantage. Ownership percentages of 19.9 percent and 49.9 percent arouse suspicion.

Derivatives Firms purchase derivative contracts most often to hedge other items. If the derivatives are not hedges, then they are likely trading securities, which provide minimal opportunity for earnings management. For derivatives acquired as hedges, the firm must generally designate them as either fair value hedges or cash flow hedges. In both cases the deriv- ative and the item hedged appear at market value on the balance sheet. Unrealized holding gains and losses on fair value hedges flow through to net income each period, whereas unrealized holding gains and losses on cash flows hedges flow initially to other comprehensive income and only when settled do they affect net income. Firms have some latitude in des- ignating particular hedges as fair value versus cash flow hedges and can thereby manage earnings accordingly.

Timing of Transactions and Events Perhaps the aspect of earnings quality most difficult for the analyst to assess is the impact of the discretionary timing of transactions and events. A firm may reduce expenditures for maintenance in a par- ticular year, for example, stating that facilities were in less need of repair than in prior years. The analyst must assess whether the firm can sustain the increased earnings in future years. Firms may increase the depreciable lives of buildings and equipment, explaining that they were too conservative in their original estimates. Analysts must assess whether the longer lives seem reasonable, given the depreciable lives used by other firms in the industry, or whether a firm may have changed the depreciable lives to boost current earnings. Firms may experience decreased earnings in a particular year because of a weak economy. Because capital markets expect lower earnings, firms might take advantage of that expecta- tion by writing down or writing off assets, a phenomenon frequently referred to as the big bath. Firms managing earnings in this fashion will recognize losses from asset impairments in an otherwise weak earnings year. Firms hope that investors will view the charge as nonrecurring and will ignore or deemphasize it. By writing down or writing off assets, the firm will report larger earnings in future periodsby recognizing a loss now, the need to recognize expense later disappears. Firms hope that investors will forget that part of the reason for increased earnings is the earlier write-down of assets that would otherwise now be part of expenses.

Synthesis: Significance and Implications of Alternative Accounting Principles 13

Summary of Earnings Quality Assessing the quality of earnings and the quality of financial position is among the most important and yet the most difficult tasks of the analyst. This assessment requires the analyst to ask:

1. Does the firm have valid business reasons for the choices it makes, or does enhancing reported earnings or financial position appear to be the chief aim?

2. Whichareasofchoicehavethelargestimpactonaparticularfirm'sincomestatementandbalancesheet?Afirm'schoice of accounting principles may appear conservative, for example choosing LIFO or accelerated depreciation in measuring cost of goods sold and depreciation expense. Yet if the firm is not growing rapidly and acquisition costs are not chang- ing significantly, these choices have relatively little impact on earnings. Delaying maintenance, advertising, or research and development expenses might have a much larger effect and should be the focus of the analyst's energies.

3. Do the firm's choices enhance the quality of earnings at the expense of the quality of financial position, or vice versa? Firms using LIFO or accelerated depreciation may enhance their quality of earnings but may provide, for inventories and fixed assets, balance sheet amounts that significantly understate their current values.

4. Doesthefirmdisclosesufficientinformationtopermittheanalysttorestatereportedamounts,ormusttheanalystinject an intolerable level of subjectivity in order to improve the quality of earnings or balance sheet information?

The Firm's Selection of Alternative Accounting Principles

We next address the following questions:

1. Which accounting principles from among those prescribed as generally accepted should a firm choose in preparing its financial statements (that is, how should a firm move from Circle B to Circle C in Figure 1)?

2. Which accounting principles should it select for income tax purposes?

Financial Reporting Purposes

A firm's reporting strategy or objective might guide its selection of accounting principles for financial reporting. This sec- tion considers four possible strategies or objectives: (1) accurate presentation, (2) conservatism, (3) profit maximization, and (4) income smoothing.

Accurate Presentation One might judge the usefulness of accounting information by assessing whether it provides an accurate presentation of the underlying events and transactions. A firm could base its selection of accounting principles on accuracy of presentation. For example, previous chapters define assets as resources having future service potential and define expenses as the cost of services consumed during the period. In applying the accuracy basis, firms would select the inventory cost flow assumption and the depreciation method that most accurately measure the pattern of services con- sumed during the period and the amount of services still available at the end of the period.

This approach has at least one serious limitation as a basis for selecting accounting methods. The accountant can sel- dom directly observe the services consumed and the service potential remaining. Without this information, the accountant cannot ascertain which accounting principles lead to the most accurate presentation of the underlying events. Accuracy of presentation serves primarily as a normative guide for firms to use in selecting their accounting principles.

Conservatism In choosing among alternative generally acceptable methods, firms might select the set that provides the most conservative measure of net income and assets. Considering the uncertainties involved in measuring benefits received as revenues and services consumed as expenses, some accountants suggest providing a conservative measure of earnings, thereby reducing the possibility of unwarranted optimism by financial statement users. As a criterion for selecting account- ing princip