Chapter 14: Highlights
1.
The independent accountant expresses an unqualified opinion on a firm's financial
statements by stating that the statements follow generally accepted accounting
principles (GAAP). In the United States, Congress has ultimate authority to specify
acceptable accounting principles. Congress has delegated this authority to the
Securities and Exchange Commission (SEC).
The SEC generally accepts
pronouncements of the Financial Accounting Standards Board (FASB) as constituting
acceptable accounting principles. In reality the SEC and the FASB communicate
continuously as reporting issues arise. The delegation of authority to the SEC and the
FASB to set accounting principles in part recognizes that the information 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 financial reporting as for tax
reporting. The FASB follows a process in selecting accounting principles that
incorporates deduction from a broad theoretical framework (conceptual framework)
and induction from the information needs and preferences of its various
constituencies.
2.
Firms in the U.S. have varying degrees of flexibility in choosing their accounting
principles:
a.
In some instances, the firms have wide flexibility in choosing among
alternatives, such as in selecting a depreciation method or inventory cost flow
assumption.
b.
In other situations, specific conditions dictate the methods used; thus, there is
little flexibility. An example is the accounting for investments in the common
stock of other firms, which depends primarily on the ownership percentage.
3.
Until recently, the standard-setting process varied widely across countries. In some
countries such as Germany, France, and Japan governmental agencies played a major
role in establishing acceptable accounting principles. Financial reporting methods
closely conformed to the methods used in preparing tax returns. Other countries,
such as United Kingdom, Canada, and Australia, followed a standard-setting process
similar to the United States in which a private-sector body set acceptable accounting
principles. Different approaches to setting accounting standards resulted in different
principles across countries and a lack of comparability of financial statement
information. The International Accounting Standards Board (IASB) endeavors to
achieve greater uniformity in accounting principles. Having no legal authority, the
IASB encourages standard-setting bodies within various countries to obtain approval
within their countries of pronouncements of the IASB. The accounting principles
developed by the IASB are similar, with a few exceptions, to those discussed in this
book. Progress has been made but not to the point where IASB pronouncements
carry the full weight of accounting principles set within individual countries.
4.
Although a particular firm does not have unlimited flexibility in the selection of
accounting methods, the partial listing below of some of the more significant
currently acceptable accounting principles should give an impression of the wide
flexibility that does exist.
a.
Depending upon the situation, a firm may recognize revenue at the time it
sells goods or renders services, when it collects cash (installment method or
cost-recovery-first
method),
as
production
progresses
(percentage-of-completion method for long-term contracts), or perhaps not
until the customer no longer has the right to return goods for a refund. Over
long time periods, cumulative income must equal cash inflows minus cash
outflows other than transactions with owners. Different revenue recognition
methods, and accounting methods generally, affect only the timing of its
recognition. Most firms recognize revenue at the time they sell (deliver)
goods or render services.
b.
A firm may recognize bad debt expense in the period that it recognizes
revenue (allowance method) or if the amount uncollectible is unpredictable, in
the period when a firm determines that specific accounts are uncollectible
(direct write-off method). GAAP requires firms with predictable uncollectible
accounts to use the allowance method. Income tax laws require firms to use
the direct write-off method.
c.
Firms record their inventories using one of several bases: acquisition cost,
lower of acquisition cost or market, standard cost, or in some situations, net
realizable value. If a firm uses acquisition cost, it may select from several
acceptable cost flow assumptions. Allowable cost flow assumptions include
LIFO, FIFO or weighted average. Firms have some latitude in selecting a cost
flow assumption for financial and tax reporting. However, a firm must use
LIFO for financial reporting if it uses LIFO for tax reporting.
d.
A firm accounts for investments in common stock using either the market
value method or the equity method or it prepares consolidated statements.
The accounting method used depends primarily on the investor’s ability to
significantly influence the investee company, with presumption of influence
based on the percentage of outstanding shares held.
e.
Firms using derivatives to hedge the risk of interest rates, exchange rates, and
commodity prices revalue both the derivative security and the item subject to
the hedge to market value each period. The unrealized gain or loss resulting
from the revaluation is reported in income each period for fair value hedges.
For cash flow hedges, the unrealized gain or loss appears in other
comprehensive income until the firm settles the item hedged or when the firm
transfers the gain or loss to net income. GAAP treats derivatives not deemed
hedges to be marketable trading securities, with the accounting similar to that
for fair value hedges.
f.
For financial reporting firms may depreciate fixed assets using straight-line,
declining-balance, sum-of-the-years' digits, or units of production method.
Firms will use different estimated service lives depending on intensity of use,
maintenance, or repair policy. Income tax laws specify the depreciation
method and service lives for various types of depreciable assets. Income tax
laws do not require conformity between financial and tax reporting for
depreciable assets. Firms must test depreciable assets periodically for
g.
h.
i.
j.
impairment. The asset impairment test compares the undiscounted cash flow
anticipated from the asset with its book value. If the book value exceeds the
undiscounted cash flows, an asset impairment has occurred. An impairment
loss is then recognized for an amount equal to the difference between the fair
value of the asset and its book value.
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. Firms need not amortize
goodwill and other intangibles with indefinite lives. Firms must test goodwill
and other intangibles with indefinite lives annually for impairment.
A firm may set up as an asset and subsequently amortize the rights to use
property acquired under lease (capital lease method) or give no recognition to
the lease except at the time that lease payments are due each period (operating
lease method). Whether a firm uses the capital or operating lease method for
financial reporting depends on criteria such as the life of the lease relative to
the life of the leased asset and the present value of the lease payments relative
to the market value of the leased property. 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 a particular lease differently for
financial and tax reporting.
A firm compensating its employees by granting them options to purchase its
shares must value the option at the time of the grant and amortize it over the
expected period of benefit.
The items above do not represent an all-inclusive list of acceptable accounting
principles. The list merely provides the reader an idea of the alternatives that
do exist in different situations. Firms must disclose their accounting
principles in a note to the financial statements.
5.
Effective interpretation of published financial statements requires sensitivity to the
generally accepted accounting principles that firms use. Comparing the reports for
several companies may necessitate adjusting the amounts for the different accounting
methods used. Even though two firms may be alike in nearly all respects, they may
present materially different reports due to their use of different accounting methods.
6.
If investors accept financial statement information in the form presented without
adjusting the information for the different accounting principles used, one of two
firms otherwise identical might receive a disproportionate amount of capital funds.
Thus, the use of alternative generally accepted accounting principles could lead to a
misallocation of resources in the economy. If investors make the necessary
adjustments in analyzing the financial statements of various firms and invest
accordingly, perhaps the concern over the variety of acceptable accounting principles
is excessive. If the investors do make such adjustments, then increased disclosure of
the procedures followed may be more important than greater uniformity in accounting
principles.
7.
The question of determining the effect of alternative accounting principles on
investment decisions has been the subject of a extensive research and debate. Some
argue that the current flexibility permitted firms in selecting accounting principles
misleads investors and results in a misallocation of resources. Others present
evidence to the contrary.
8.
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:
a.
Selecting its accounting principles from among alternative generally
acceptable accounting principles;
b.
Applying the accounting principles selected, and;
c.
Timing business transactions to temporarily increase or decrease earnings.
9.
A related concept to quality of earnings in quality of financial position. The choices a
firm makes in reporting revenues and expenses also affect assets and liabilities on the
balance sheet. Analysts use balance sheet amounts in assessing a firm's profitability
and its risk. Assessment of quality of earnings and quality of financial position must
consider the net effect of all areas when firms make reporting choices.
10.
There are several possible strategies or objectives for financial reporting; each of
which might dictate the selection of a different combination of generally accepted
accounting principles.
a.
b.
c.
One might judge the usefulness of accounting information by assessing the
accuracy of the presentation of the underlying events and transactions. In
applying this criterion, the firm would select those principles that most
accurately measure the pattern of an asset's services consumed during the
period and the amount of services still available at the end of the period. This
objective has an important limitation. The accountant can seldom directly
observe the services consumed and the service potential remaining. Accuracy
of presentation serves primarily as normative guidance in directing firms to
select their accounting principles.
In choosing between alternative generally accepted methods of accounting, a
firm might choose those methods that minimize asset totals and cumulative
reported earnings, thereby providing the most conservative measure of net
income and assets. The use of conservatism as a reporting objective is
intended to reduce the possibility that users of financial statements will
develop overly optimistic assessments of a company. It is conceivable,
though, that statement readers might be misled by earnings reports based upon
conservative principles especially if earnings reported on a less conservative
manner might have led to a different investment decision effect.
An objective having the opposite effect of conservatism is profit
maximization, which is an extension of the notion that the firm is in business
d.
11.
to generate profits. Using this criterion as a reporting objective suggest that
the firm should select accounting principles which maximize cumulative
earnings and asset totals, keeping within the confines of generally accepted
accounting principles.
A final objective of financial statement reporting might be income smoothing,
which suggests the selection of accounting methods that result in the
smoothing of earnings over time. Advocates of this objective suggest that if a
firm minimizes fluctuations in earnings, it will reduce the perceived risk of
investing in its shares of stock and, all else being equal, obtain a higher stock
price.
In selecting accounting procedures for income tax purposes, firms should choose
those methods that minimize the present value of the income tax payments over time.
The operational rule, sometimes called the least and latest rule, is to pay the least
amount of taxes as late as possible within the law. The means of accomplishing this
objective are to recognize expenses as quickly as possible and to postpone the
recognition of revenue as long as possible. This policy may need to be adjusted
somewhat if the tax rates are expected to change in future years or if the firm has had
losses in earlier years and can carry those losses forward to offset taxable income of
the current year.