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In addition, the firm must select a flow assumption: 1. LIFO 2 ... The allowance method is consistent with the concept of accrual based accounting in that expenses ... – PowerPoint PPT presentation

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Chapter 14 Significance and Implications of
Alternative Accounting Principles
  • 10th 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, emphasizing the effects of
    alternative principles on the financial
  • 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.

Chapter Outline
  • 1. Establishing acceptable accounting principles.
  • 2. Review of generally accepted accounting
  • 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

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.

Figure 14.1 -- Structure of Accounting Principles
Universe of Possible Accounting
Principles Generally Accepted Accounting
Principles Accounting Principles Employed by a
Specific Firm
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?

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.

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
  • The IASB seeks to have individual countries adopt
    its rules or write rules that conform.
  • The IASB allows flexibility and differ from tax

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

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,
  • 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.

2.b. Uncollectible Accounts
  • A firm may recognize expense for uncollectible
  • 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
  • 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

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
  • 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.

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.

2.e. Machinery, Equipment and other Depreciable
  • 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.

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

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.

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
  • 2. Charge the cost as a expense for the period
    when the grant is made.
  • The merely disclosing option never records an
  • 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

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

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
  • 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
  • 6. Both pay 35 as an income tax rate.
  • The two firms differ in choice of accounting

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

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
  • Note the effect of these differences on financial
    ratios such as the rate of return on total assets.

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.

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
  • In short, just how smart are investors?

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.

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.

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.

5. The Firms Selection of Accounting Principles
  • In selecting accounting principles, a firm must
  • 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).

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.

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

Chapter Summary
  • This chapter has served as a review and
  • 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.
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