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

1. 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

2. 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.

3. 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 firm’s selection of accounting principles. Chapter Summary

4. 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.

5. 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

6. 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?

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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

19. 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.

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

21. 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.

22. 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.

23. 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.

24. 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?

25. 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.

26. 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.

27. 4.c. Quality of Earnings Revisited • Security analysts examine a firm’s 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 firm’s securities for their assessment of the firm’s quality of earnings.

28. 5. The Firm’s 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).

29. 5.a. Financial Reporting Purposes • A firm’s 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.

30. 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.

31. 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.