Transcript Chapter 14, Significance and Implications of Alternative

Chapter 14 – Significance and
Implications of Alternative
Accounting Principles
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
12th Edition
Clyde P. Stickney and Roman L. Weil
Learning Objectives
1. Review the process through which
standard-setting bodies establish
acceptable accounting principles.
2. Review the generally accepted
accounting principles discussed in the
text, emphasizing the effects of
alternative principles on the financial
statements and on the assessments of
the quality of earnings and quality of
financial positions.
Learning Objectives
3. Consider the effects of alternative
accounting principles on investment
decisions and market values of firms.
4. Understand the factors that firms
consider in choosing their accounting
principles from the set of acceptable
accounting principles.
Chapter Outline
1. Establishing acceptable accounting principles.
2. Review of generally accepted accounting
principles.
3. Illustration of the effects of alternative
accounting principles on a set of financial
statements.
4. Assessing the effects of alternative accounting
principles on investment decisions.
5. The firm’s selection of alternative accounting
principles.
Chapter Summary
Establishing Acceptable
Accounting Principles



Accounting standards are the rules of the
road for financial reporting.
Without any rules, it would be impossible
to interpret financial information.
So standard-setting bodies propose rules
which may be followed voluntarily or
imposed by law.
Establishing Acceptable
Accounting Principles
Four issues:
1. Should the government or a private
body set accounting rules?
2. Should rules be uniform for all firms?
3. Should the same principles apply to
financial reporting and to tax
reporting?
4. Should rules be supported by a broad
theoretical framework?
Standard Setting in the U.S.






Congress has ultimate authority for accounting
rules in the U.S.
Congress delegated its authority to the SEC.
The SEC generally accepts pronouncements of
the FASB.
U.S. GAAP allows flexibility in selecting
alternative rules.
Financial reporting rules are separate from tax
reporting rules (with a few exceptions mandated
by the IRS).
There is a conceptual framework for U.S. GAAP
but it is not as formal as some would like.
Standard Setting in Other Countries



Until recently, the standard-setting
process varied widely across countries.
Governments in other countries were very
active in setting accounting rules.
Many countries required the same or
similar rules for tax and financial
reporting purposes.
Standard Setting in Other Countries



Recently the IASB, the successor to the
International Accounting Standards
Committee (IASC), is gaining authority as
the international standard-setting body.
The IASB seeks to have individual
countries adopt its rules or write rules
that conform.
The IASB allows flexibility and differs
from tax rules.
Review of Generally Accepted
Accounting Principles

Revenue recognition.

Uncollectible accounts.

Inventories.

Investment in securities -- derivatives.

Machinery, equipment and other depreciable
assets.

Corporate acquisitions.

Leases.

Employee stock options.
Revenue Recognition

A firm may recognize revenue:
– At the time it sells goods or renders
services
– At the time it collects cash (installment
or cost-recovery-first methods)
– As it engages in production or
construction, or
– Perhaps not until the customer no
longer has the right to return goods for
a refund.
Revenue Recognition

To recognize revenue, a firm must have:
– Performed all, or most, of the services
it expects to provide, and
– Received cash or some other asset
susceptible to reasonably precise
measurement.
Uncollectible Accounts

A firm may recognize 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 is consistent with the
concept of accrual based accounting in that
expenses are matched to the revenue with which
they are associated.
The direct-write-off method is required for tax
purposes.
Inventories

A firm may record inventories based on
1. Acquisition cost
2. Lower of cost or market
3. Standard cost, or
4. Net realizable value (limited to
precious minerals and a few other
applications).
Inventories

In addition, the firm must select a flow
assumption:
1. LIFO
2. FIFO, or
3. Weighted average.

The IRS will allow LIFO for tax purposes
only if it is also used for financial
reporting purposes.
Investment in Securities

Depending on the percentage of ownership, a
firm may record investments in common
securities of other firms by:
1. The market value method.
2. The equity method.
3. Preparing consolidated financial statements.

The IASB allows for lower of cost or market.

Generally, if ownership is
– Less than 20%, the market value method,
– Between 20% and 50%, the equity method,
– More than 50%, consolidated financials.
Machinery, Equipment and other
Depreciable Assets

A firm may depreciate fixed assets using
1. The straight-line method,
2. Declining-balance method,
3. Sum-of-the-years’-digits method, or
4. Units-of-production method.

In countries where tax reporting is linked
to financial reporting, firms tend to use
accelerated methods.
Machinery, Equipment and other
Depreciable Assets

Tax reporting in the U.S. is separate from
financial reporting and uses the Modified
Asset Cost Recovery System (MACRS)
which rigidly specifies the depreciation for
types of assets.
Corporate Acquisitions


A firm may account for the acquisition of
another firm using the purchase method.
The purchase method puts the assets and
liabilities of the acquired firm on the
books of the acquiring firm.
Commonly, the purchase price will exceed
the net assets and goodwill will be
recognized for the difference.
Leases

A firm using property rights acquired
under a lease may
– Record the lease as an asset offset by
a liability and amortize the liability and
depreciate the asset (capital or finance
lease method), or
– Recognize only lease expense as
periodic lease payments are due or
with end of period adjusting entries
(operating lease method).
Leases

Depreciation and interest expenses under
the capital lease method generally exceed
lease expense under the operating lease
method for early years of the lease.
Employee Stock Options

A firm compensating its employees with options
to purchase its shares may
– Disclose the cost of those grants in the
footnotes,
– Charge the cost as a expense for the period
when the grant is made.


The “merely disclosing” option never records an
expense.
Total shareholders’ equity will be the same, but
the cost of the options reduces retained earnings
in the expense method but reduces additional
paid-in capital in the case of the disclose
method.
Illustration of the Effects of
Alternative Accounting Principles

The scenario

Accounting principles used

Comparative income statements

Comparative balance sheets

Moral of the illustration
The Scenario
Two identical merchandising firms:
1. Both issue 2 million shares of $10 par stock for
$20 million cash.
2. Both acquire equipment on Jan 1 for $14
million.
3. Both make identical purchases of merchandise.
4. Both sell 420,000 units at $100 each.
5. Both have selling, general and administrative
expenses (excluding depreciation) of $2.7
million.
6. Both pay 35% as an income tax rate.
The two firms differ in choice of accounting rules.
Accounting Principles Used
Depreciation
Method
Inventory
Cost Flow
Assumption
Conservative
Company
High Flyer
Company
Double
declining
balance
Straight
line
LIFO
FIFO
Comparative Income Statements



Conservative Company reports more book than
tax depreciation. This results in a temporary
difference between taxes payable and tax
expense which (at the marginal tax rate) gives
rise to a deferred tax asset of $280,000.
High Flyer Company reports less book than tax
depreciation, which gives rise to a deferred tax
liability of $210,000.
High Flyer also reports significantly larger net
income and EPS than Conservative because of
depreciation expense and cost of good sold.
Comparative Balance Sheets



Cash represents the only economic difference
between the two companies. The other
differences are timing recognition effects, which
will balance out over the long run.
Differences in amount of inventory and net
assets result directly from the different
accounting methods.
Note the effect of these differences on financial
ratios such as the rate of return on total assets.
Moral of the Illustration




Effective interpretation of published financial
statements requires sensitivity to the particular
accounting principles that firms select.
Comparing the reports of different companies
may necessitate adjusting the amounts for
different accounting methods.
Comparing the reports of one company over
time may also require adjustments if the firm
has changed its accounting methods.
This problem is even more severe in analyzing
foreign financial statements where the
accounting methods may vary greatly with U.S.
GAAP.
Effects of Alternative Accounting
Principles on Investment Decisions

Two related and important questions:
– Do investors accept financial statement
information as presented without
noticing the differences in accounting
methods?
– Or, do they somehow filter out all or
most of the variances and effects of
different accounting methods?

In short, just how smart are investors?
“Investors Do Not Make Adjustments
for Different Accounting Methods.”
1. Most investors do not understand
accounting well enough to make
adjustments for differences.
2. Financial statements and notes do not
provide enough information to support
add adjustments.
3. Market prices of firms drop with reports
of misuse of accounting methods
indicating that investors were surprised
by the news.
“Investors Make Adjustments for
Different Accounting Methods.”
1. Capital markets adjust quickly and
appropriately to new information.
Sophisticated security analysts have the
necessary skills and influence (or even
make) the market prices.
2. Many effects are small except for rapidly
growing (or shrinking) firms and tend to
stabilize and even out over time.
Quality of Earnings Revisited

Security analysts examine a firm’s quality of
earnings by examining the choices made in:
– Selecting accounting principles.
– Applying accounting principles, and
– Timing business transactions to temporarily
increase (or decrease) earnings.

Analysts then adjust their willingness to buy or
sell the firm’s securities for their assessment of
the firm’s quality of earnings.
The Firm’s Selection of
Accounting Principles

In selecting accounting principles, a firm must
answer:
– Which accounting principles should be
chosen for financial reporting purposes?
– Which for income tax reporting purposes?

In general in the U.S., these decisions are
independent except for some restrictions
imposed by the IRS (such as the restriction on
the tax use of LIFO).
Financial Reporting Purposes

A firm’s reporting strategies or objectives might
include the following:
– Accurate presentation,
– Conservative presentation,
– Short-term profit maximization, or
– Income smoothing.


There are moral considerations including what is
in the best interests of the shareholders.
Unethical management might attempt to deceive
the shareholders.
Income Tax Reporting Purposes
 For income tax purposes, firms should
select accounting procedures that
minimize the present value of the stream
of income tax payments.
 The IRS recognizes the objective of
paying the least legal tax -- there is no
assumption that it is desirable or noble to
pay more than the minimum legal tax.
 If the law allows for abuses, it is the
responsibility of Congress and the IRS to
fix the system.
Chapter Summary


This chapter has emphasized the
differences that may appear in financial
reports due to the choice of a set of
accounting rules among allowable
alternatives.
If the choice of the decision rule is
disclosed, then investors may be able to
estimate the effect of the choice and
compare firms with different sets of rules.