Accounting Choices and Earnings Management

Accounting Principles

• Accrual accounting is principles-based.

• Review the “accounting principles” in the course Reader.

• Use these principles to analyze transactions and justify your classifications.

• • • • Managers make accounting choices, which means that … Managers have the opportunity to select the manner in which certain transactions will be classified.

These choices change can alter the income statement and the balance sheet relative to alternative choices, thus ...

Reported profits across similar companies might differ just because accounting choices are different.

• • • • .

Accounting Standards are both rules and guidelines for measuring & classifying certain activities/transactions.

Managers make accounting choices in consultation with their auditor.

Auditors are expected to be “independent”.

The Enron scandal suggests that investors cannot always rely on a firm’s auditor for unbiased behavior.

The firm’s Managers make its accounting choices and auditors review them

• Manager might use the opportunity to enhance the appearance of financial performance, i.e. report higher profits?

This is called “Earnings Management”

.

• It’s not performance, it’s performance appearance.

What if you could decide your professor’s grading policy and style it just for “yourself”?

Managers frame the interpretation of the firm’s transactions

• What gets recorded & reported (or doesn’t).

• How transaction amounts are measured.

• The classification of those amounts: Revenue or Gain?

Asset or Expense?

• And when this is reported. This period, or next period?

Companies make profits.

But managers report them

Revenue Recognition Recognize revenue when it is realized:

(a) the service is delivered; (b) buyer & seller agree on the price; and (c) when cash is collected or its collection is reasonably certain.

Expense Recognition

• Associate (using the “matching principle”) costs with revenue generating efforts : a) Directly – e.g. COGS b) Indirectly – e.g. Advertising c) By Period – e.g. Rent

Booking Costs-of-Goods Sold “COGS”

this is a

Cost Flow Choices

• LIFO - last costs IN first costs “out”, i.e. COGS • FIFO – first costs IN first costs “out”, i.e. COGS LIFO implies FISH (first in still here) FIFO implies LISH (last in still here)

Aggressive Accounting Choices

• Revenue recognition based on

liberal

interpretation of the Realization Principle. • Shifting expenses to future periods or taking them during bad times.

• FIFO for COGS – usually the lower costs.

• Capitalizing – and Amortizing - big costs.

Conservative Accounting Choices

• Revenue recognition based on

strict

interpretation of the Realization Principle.

• Booking expenses when they are incurred. • LIFO for COGS – usually the higher costs.

• Expensing, not Capitalizing, costs that are uncertain as to helping create Sales.

Same Treatment?

• Interest expense.

• Most routine costs will be recognized as ordinary expenses, i.e. direct, indirect, or periodic expenses, e.g. rent, advertising, office-related, travel, wages & salary, maintenance & repair. • Pre-paid expenses.

• Purchasing inventory for sale.

• Paying vendors, employees, banks.

1

st

Period Events

• • •

Sell

200 shares of stock @ $1 each;

Buy

an Ugly Puppy for $100 cash.

Buy T-shirts in three successive cost layers as: 1. 10 shirts @ $1 each.

2. 10 shirts @ $2 each.

3. 10 shirts @ $3 each.

• •

Consult

40 clients and 30 pay $1 each; 10 promise to pay later.

Sell

10 T-shirts at $5 each in cash.

The Ugly Puppy’s Role in this Firm

• ?

• ?

What is the business nature of the puppy?

How does the accounting choice reflect Management’s view of the business nature of the puppy?

Amortizing the Puppy’s Cost

• • • 1.

2.

3.

•

Cost is $ 100.

Expected recovery of that cost is $ 0, thus • Amortizable Basis is $ 100 - $ 0 = $100.

Give the amortizable basis a three-period life.

Apply straight-line amortization

So $100 / 3 gives this Depreciation Schedule: $ 33 $ 33 $ 34 This will be our periodic Amortization expense.

Receivables and Bad Debt Customers often buy on-account, i.e. credit instead of cash, and the selling firm books a Receivable.

Most, but not all customers pay later. Since, some Receivables might never be collected, the firm may want to reflect this uncertainty in its financials. This is called an Allowance.

• Create an Allowance for Bad Debt. A contra asset to Receivables.

• Fund the Allowance by recognizing a Bad Debt Expense.

200

0 0 0 0 (0)

The 1 st Period Books w/ Conservative choices

0 0 0 0 200 0 Rev 90 COGS (30) GP 60 G&A (110) EBITDA ( 50) DA ( 0) EBIT ( 50) I ( 0) EBT ( 50) T ( 0)

NI ( 50) 120

10 (10) 30 0 0 (0) 0 0 0 0 200 (50)

Inventory Cost Flow?

• • •

Use LIFO as the Conservative choice.

The $ 3 layer goes to COGS first, thus The $ 1 and $ 2 layers are in Inventory, FISH.

• • •

Use FIFO as the Aggressive choice.

The $ 1 layer goes to COGS first, thus The $ 2 and $ 3 layers are in Inventory, LISH.

200

0 0 0 0 (0)

The 1 st Period Books w/ Aggressive choices

0 0 0 0 200 0 Rev 90 COGS (10) GP 80 G&A ( 0) EBITDA 80 DA ( 33) EBIT 47 I ( 0) EBT 47 T ( 0)

NI 47 120

10 ( 0) 50 0 100 ( 33) 0 0 0 0 200 47

A Few Observations

• We may have two sets of Financials, but • We have only one business !

• Thus, we have created a reporting form • That is different from the substance of events – does this matter? How?

• The one reported item that cannot be altered by Accounting Choices is CA$H.

2

nd

Period Events

• • • • • • Purchase 10 T-shirts @ $4 each, pay cash. Borrow $100 @ 10% interest on an interest-only basis with interest due in subsequent periods.

Take the puppy to a Vet and a Trainer and pay $60 cash. Consult 40 clients and 30 pay $1 each; 10 promise to pay later. Sell 10 T-shirts at $5 each in cash.

Encounter a person who agrees to $100 for a Puppy appearance – next period – and pays $50 cash now with balance due on performance.

Cost Flow Assumptions: COGS & Inventory

• Conservative Cost Layers on LIFO 1. 10 @ $1: 2. 10 @ $2: 3. 10 @ $3: COGS 1 st 4. 10 @ $4: 2 nd COGS • Aggressive Cost Layers on FIFO 1. 10 @ $1: 1 st COGS 2. 10 @ $2: 2 nd COGS 3. 10 @ $3: 4. 10 @ $4:

120

10 (10) 30 0 0 (0)

The 2

nd

Period Booking with Conservative choices

Starting Rev 90 COGS (40) 0 0 0 GP 50 G&A ( 70) EBITDA ( 20) DA ( 0) EBIT ( 20) 0 200 I ( 10) EBT ( 30) T ( 0)

NI ( 30)

(50)

250

10 (20) 30 0 0 (0) 50 0 10 100 200 ( 80)

Capitalizing the Vet & Trainer Costs

• • • • • • 1.

2.

3.

4.

Cost is $ 60. Just an accessory to the L.L.A. “Puppy”.

Expected recovery of that cost probably $ 0.

What life for the $ 60? Same as the $100 “Puppy” cost?

Arguments?

Apply 3 period straight-line amortization to get $20 per. Adjust the Depreciation Schedule:

$ 33 $ 33 + $ 20 = $ 53 $ 34 + $ 20 = $ 54 $ 0 + $ 20 = $ 20

120

10 ( 0) 50 0 100 (32)

The 2

nd

Period Booking with Aggressive choices

Starting Rev 140

COGS ( 20)

GP 120 0 0 0 G&A ( 0) EBITDA 120 DA ( 53) EBIT 67 I ( 10) 200 0 EBT 57 T ( 0)

NI 57

47

250

20 ( 0) 70 0 160 (86) 0 0 10 100 200 104