FINANCIAL ACCOUNTING

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Chapter 14 Significance and Implications of
Alternative Accounting Principles

• FINANCIAL ACCOUNTING
• AN INTRODUCTION TO CONCEPTS,
• METHODS, AND USES
• 10th Edition

Clyde P. Stickney and Roman L. Weil
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Learning Objectives

• 1. Review the process through which
  standard-setting bodies establish acceptable
  accounting principles.
• 2. Review the generally accepted accounting
  principles, emphasizing the effects of
  alternative principles on the financial
  statements.
• 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.

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Chapter Outline

• 1. Establishing acceptable accounting principles.
• 2. Review of generally accepted accounting
  principles.
• 3. Illustration of the effects of alternative
  accounting principles on financial statements.
• 4. Assessing the effects of alternative
  accounting principles on investment decisions.
• 5. The firms selection of accounting principles.
• Chapter Summary

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1. 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.

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Figure 14.1 -- Structure of Accounting Principles
A B C
Universe of Possible Accounting
Principles Generally Accepted Accounting
Principles Accounting Principles Employed by a
Specific Firm
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1. 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?

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1.a. Standard Setting in the U.S.

• Congress has ultimate authority for accounting
  rules in the U.S.
• Congress has delegated its authority to the
  Securities and Exchange Commission (SEC).
• The SEC generally accepts pronouncements of a
  private body, the Financial Accounting Standards
  Board (FASB).
• U.S. GAAP allows flexibility in selecting among
  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.

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1.b. 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.
• Recently the International Accounting Standards
  Board (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 differ from tax
  rules.

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2. Review of Generally Accepted Accounting
Principles

• a. Revenue recognition.
• b. Uncollectible accounts.
• c. Inventories.
• d. Investment in securities -- derivatives.
• e. Machinery, equipment and other depreciable
  assets.
• f. Corporate acquisitions.
• g. Leases.
• h. Employee stock options.

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2.a. Revenue Recognition

• A firm may recognize revenue
• 1. At the time it sells goods or renders services
• 2. At the time it collects cash (installment or
  cost-recovery-first methods)
• 3. As it engages in production or construction,
  or
• 4. Perhaps not until the customer no longer has
  the right to return goods for a refund.
• To recognize revenue, a firm must have
• 1. performed all, or most, of the services it
  expects to provide, and
• 2. received cash or some other asset susceptible
  to reasonably precise measurement.

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2.b. 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.

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2.c. 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).
• 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.

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2.d. 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.

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2.e. 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.
• 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.

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2.f. 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.

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2.g. Leases

• A firm using property rights acquired under a
  lease may
• 1. Record the lease as an asset offset by a
  liability and amortize the liability and
  depreciate the asset (capital or finance lease
  method), or
• 2. Recognize only lease expense as periodic lease
  payments are due or with end of period adjusting
  entries (operating lease method).
• Depreciation and interest expenses under the
  capital lease method generally exceed lease
  expense under the operating lease method for
  early years of the lease.

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2.h. Employee Stock Options

• A firm compensating its employees with options to
  purchase its shares may
• 1. Disclose the cost of those grants in the
  footnotes,
• 2. 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.

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3. Illustration of the Effects of Alternative
Accounting Principles

• a. The scenario
• b. Accounting principles used
• c. Comparative income statements
• d. Comparative balance sheets
• e. Moral of the illustration

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3.a. 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.

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3.b. Accounting Principles Used
Conservative High Flyer Company Company
Double declining balance
Straight line
Depreciation Method Inventory Cost
Flow Assumption
LIFO
FIFO
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3.c. 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.

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3.d. 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.

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3.e. 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.

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4. Effects of Alternative Accounting Principles
on Investment Decisions

• Two related and important questions
• 1. Do investors accept financial statement
  information as presented without noticing the
  differences in accounting methods?
• 2. 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?

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4.a. Argument 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.

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4.b. Argument 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.

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4.c. Quality of Earnings Revisited

• Security analysts examine a firms quality of
  earnings by examining the choices made in
• 1. Selecting accounting principles.
• 2. Applying accounting principles, and
• 3. Timing business transactions to temporarily
  increase (or decrease) earnings.
• Analysts then adjust their willingness to buy or
  sell the firms securities for their assessment
  of the firms quality of earnings.

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5. The Firms Selection of Accounting Principles

• In selecting accounting principles, a firm must
  answer
• a. Which accounting principles should be chosen
  for financial reporting purposes?
• b. 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).

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5.a. Financial Reporting Purposes

• A firms reporting strategies or objectives might
  include the following
• 1. Accurate presentation,
• 2. Conservative presentation,
• 3. Short-term profit maximization, or
• 4. Income smoothing.
• There are moral considerations including what is
  in the best interests of the shareholders.
• An unethical management might attempt to deceive
  the shareholders.

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5.b. 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.

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Chapter Summary

• This chapter has served as a review and
  recapitulation.
• It emphasizes 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.