Accounting Choices and Earnings
Management
Accounting Principles
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Accrual accounting is principles-based.
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Review the “accounting principles” in the
course Reader.
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Use these principles to analyze
transactions and justify your classifications.
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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.
.
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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.
1st Period Events
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1.
2.
3.
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Sell 200 shares of stock @ $1 each;
Buy an 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
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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
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:
1. $ 33
2. $ 33
3. $ 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 contraasset to Receivables.
• Fund the Allowance by recognizing a Bad Debt
Expense.
The 1st Period Books w/ Conservative choices
200
0
0
0
0
(0)
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)
0
30
0
0
0
0
0
(0)
200
(50)
Inventory Cost Flow?
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Use LIFO as the Conservative choice.
The $ 3 layer goes to COGS first, thus
The $ 1 and $ 2 layers are in Inventory, FISH.
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Use FIFO as the Aggressive choice.
The $ 1 layer goes to COGS first, thus
The $ 2 and $ 3 layers are in Inventory, LISH.
The 1st Period Books w/ Aggressive choices
200
0
0
0
0
(0)
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)
0
50
0
0
0
100
0
( 33)
200
47
A Few Observations
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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.
2nd Period Events
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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
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1.
2.
3.
4.
Conservative Cost
Layers on LIFO
10 @ $1:
10 @ $2:
10 @ $3:
1st
COGS
10 @ $4: 2nd COGS
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1.
2.
3.
4.
Aggressive Cost
Layers on FIFO
10 @ $1: 1st COGS
10 @ $2: 2nd COGS
10 @ $3:
10 @ $4:
The 2nd Period Booking with
Conservative choices
120
Starting
10
(10)
30
0
0
0
0
0
0
(0)
200
(50)
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)
50
30
0
0
10
0
100
(0)
200
( 80)
Capitalizing the Vet & Trainer
Costs
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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?
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Arguments?
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1.
2.
3.
4.
Apply 3 period straight-line amortization to get $20 per.
Adjust the Depreciation Schedule:
$ 33
$ 33 + $ 20 = $ 53
$ 34 + $ 20 = $ 54
$ 0 + $ 20 = $ 20
The 2nd Period Booking with
Aggressive choices
Starting
120
10
( 0)
0
50
0
0
0
100
0
(32)
200
47
Rev
COGS
GP
G&A
EBITDA
DA
EBIT
I
EBT
T
NI
140
( 20)
120
( 0)
120
( 53)
67
( 10)
57
( 0)
57
250
20
( 0)
0
70
0
0
10
160
100
(86)
200
104