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Accounting Choices and Earnings Management

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.

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Accounting Choices and Earnings Management

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  1. Accounting Choices and Earnings Management

  2. 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.

  3. 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.

  4. . • 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.

  5. 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.

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

  7. 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?

  8. Companies make profits. But managers report them

  9. 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.

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

  11. 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)

  12. Aggressive AccountingChoices • Revenue recognition based on liberalinterpretation 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.

  13. Conservative AccountingChoices • Revenue recognition based on strictinterpretation 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.

  14. 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.

  15. 1st Period Events • Sell 200 shares of stock @ $1 each; • Buyan Ugly Puppy for $100 cash. • Buy T-shirts in three successive cost layers as: • 10 shirts @ $1 each. • 10 shirts @ $2 each. • 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.

  16. 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?

  17. Amortizing the Puppy’s Cost 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.

  18. 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.

  19. The 1st Period Books w/ Conservative choices 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) 200 0 0 0 0 (0) 0 0 0 0 0 0 0 0 200 0 200 (50)

  20. 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.

  21. The 1st Period Books w/ Aggressive choices 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) 200 0 0 0 0 (0) 0 0 0 0 0 0 0 0 200 47 200 0

  22. 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.

  23. 2nd 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.

  24. Conservative Cost Layers on LIFO 10 @ $1: 10 @ $2: 10 @ $3: 1st COGS 10 @ $4: 2nd COGS Aggressive Cost Layers on FIFO 10 @ $1: 1st COGS 10 @ $2: 2nd COGS 10 @ $3: 10 @ $4: Cost Flow Assumptions:COGS & Inventory

  25. The 2nd Period Booking with Conservative choices Starting Rev 90 COGS (40) GP 50 G&A ( 70) EBITDA ( 20) DA ( 0) EBIT ( 20) I ( 10) EBT ( 30) T ( 0) NI ( 30) 250 10 (20) 30 0 0 (0) 120 10 (10) 30 0 0 (0) 50 0 10 100 0 0 0 0 200 ( 80) 200 (50)

  26. Capitalizing the Vet & Trainer Costs • 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

  27. The 2nd Period Booking with Aggressive choices Starting Rev 140 COGS ( 20) GP 120 G&A ( 0) EBITDA 120 DA ( 53) EBIT 67 I ( 10) EBT 57 T ( 0) NI 57 120 10 ( 0) 50 0 100 (32) 250 20 ( 0) 70 0 160 (86) 0 0 10 100 0 0 0 0 200 104 200 47

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