Accounting Methods Used to Manage Earnings

Accounting Choices and Estimates

Management’s accounting policies and decisions don’t always involve intricate accounting standards. For example, even straightforward choices, such as the shipping terms for delivered goods, can significantly impact revenue timing. For instance, if a company ships a certain value of goods to a customer on the last day of the first quarter under “free on board (FOB) shipping point” terms, the customer assumes ownership and risk when the goods leave the seller’s dock. Assuming there are no issues with the collectability or return likelihood, the seller can recognize the revenue and profit in the first quarter.

Conversely, if the shipping terms are changed to “FOB destination,” the customer assumes ownership and risk when the goods reach their destination. This change means the seller cannot recognize the sale and profit until the goods arrive, which would be in the next quarter. As such, such a change in shipping terms can affect whether revenue and profits are reported in the current period or deferred to the next. These terms can also influence managerial behavior.

To meet targets, managers might prematurely ship products under FOB shipping point terms to maximize reported revenue. Alternatively, if orders exceed expectations, management might prefer not to surpass analysts’ estimates by too much.

Moreover, to moderate investor expectations, management might delay revenue recognition by using FOB destination terms, thereby shifting the recognition to the next quarter. If customers demand FOB shipping point terms, the company might delay shipment until after the quarter ends.

The above example highlights a challenge for investors, where companies might use accounting to manipulate reported earnings.

Effect of Accounting Choices and Estimates on Earnings and Balance Sheets

Inventory Cost Flows

Assumptions about inventory cost flows illustrate how accounting choices can impact financial reporting. Companies might assume that their inventory items are sold on a first-in, first-out (FIFO) basis, meaning the remaining inventory reflects the most recent costs. Alternatively, they may use a weighted-average cost basis. The choice of an inventory costing method affects profit and is a policy decision that companies cannot change arbitrarily. This choice influences both profitability and the balance sheet.

In periods of price changes, FIFO provides a more current picture of ending inventory value, as the most recent purchases remain in inventory, making the balance sheet more relevant. Under the weighted-average cost method, the balance sheet shows a blend of old and new costs. During inflation, inventory value may be understated under the weighted-average method, as it does not reflect replacement costs. However, this method ensures that the cost of sales shows more current costs, making the income statement more relevant than under FIFO.

Trade-offs exist, and high-quality financial reporting should provide enough information for users to assess the impact of these choices.

Accrual Accounting and Estimates

Estimates are prevalent in financial reporting due to accrual accounting, which aims to reflect all economic events in a period, unlike cash basis accounting that only shows cash transactions. While cash basis accounting is more certain, it hides much information. Accrual accounting, with its estimates of future events, provides a fuller picture of a period’s activities but also poses temptations for managers to manage numbers rather than the business.

For instance, if managers realize they will miss analysts’ estimates and their bonuses depend on meeting earnings targets, they might offer special payment terms or discounts to induce customers to take delivery of products early. They might even ship goods without orders, hoping customers will keep them or return them in the next period. This can allow revenue recognition under FOB shipping point terms. Managers might also revise their estimate of uncollectible accounts to improve earnings. By using a lower non-collection rate, they reduce the allowance for uncollectible accounts and the period’s expense. Justifying the change can be easy, but its accuracy is often unverifiable until later, making earnings manipulation possible.

Deferred-Tax Assets

Deferred-tax assets arise from differences between accounting and tax rules, such as net operating losses. Companies record deferred-tax assets expecting future profits to offset current losses and reduce future tax liabilities. Standards require reducing deferred-tax assets by a valuation allowance if it’s unlikely the company will generate enough profit to use all tax benefits.

Management’s outlook on the future drives the value of these assets and can be influenced by other factors, such as the need to comply with debt covenants, leading to a potentially optimistic view to keep the valuation allowance low.

Depreciation Methods

The choice of depreciation method for long-lived assets also affects reported results. Managers can choose to depreciate assets:

• on a straight-line basis, with equal annual expense;
• using an accelerated method, with higher early-life expenses; or
• using an activity-based method, allocating expenses based on use or production.

Depreciation expense also depends on estimates of salvage value, with a zero salvage value increasing expense under any method compared to a non-zero value.

The company’s managers can justify any of these methods as each one may accurately reflect the manner in which the equipment will be utilized over its anticipated economic life. This assessment, however, is inherently subjective. The selection of depreciation methods and estimated useful lives can significantly impact reported income. These decisions are not definitively validated or invalidated until much later, yet managers are required to estimate their effects in the present.

Capitalization Practices

Capitalization practices offer another example of how choices affect financial statements. Management must decide if a payment benefits only the current period, making it an expense, or future periods, leading to capitalization as an asset. This judgment, predicting future use, significantly impacts earnings. Every amount capitalized as an asset is not recognized as an expense in the reporting period, affecting both the balance sheet and income statement.

Acquisition Allocations

In acquisitions, management must allocate the purchase price to various acquired assets based on their fair values, which might not be objectively verifiable. Lower estimates for depreciable assets can reduce future depreciation expense and increase the amount classified as goodwill, which is not depreciated. However, goodwill must be tested for impairment annually, with write-downs required if the fair value is unrecoverable. Projections used in this testing can be biased to avoid impairments.

Understanding these accounting choices and estimates is crucial for evaluating financial reporting and earnings quality. Choices exist in both presentation and calculation, and managers can influence financial results to meet expectations. High-quality financial reporting should provide transparent information for users to assess the impact of these choices.

Accounting Choices Affecting Cash Flow Statement

Recall that the cash flow statement is divided into three sections: operating, investing, and financing. The operating section shows cash generated or used by operations, the investing section shows cash used for investments or generated from their disposal, and the financing section shows cash flows related to financing activities.

The operating section is often scrutinized by investors as it is seen as a “reality check” on reported earnings since earnings generated solely through accrual accounting but unsupported by actual cash flows might indicate earnings manipulation. While some believe cash from operations is less susceptible to manipulation, it can still be managed to some extent.

Also recall that, the operating section can be presented using either the direct or indirect method. The direct method reports major classes of gross cash receipts and payments, leading to the net cash flow from operating activities. On the other hand, indirect method, reconciles net income to cash provided by operations by adjusting for non-cash items and changes in working capital accounts.

Despite its encouragement, the direct method is rarely used, and thus many companies opt to use indirect method.

Managers can improve the appearance of cash flow from operations without actually improving it. For example, delaying payment to creditors by USD100 million can artificially increase cash flow from operations by the same amount. Investors should examine changes in working capital to detect such manipulations. Comparing a company’s cash generation performance to industry norms or competitors can also highlight discrepancies.

Examining the Composition of Operations

Investors should scrutinize the composition of the operations section of the cash flow statement. If not closely examined, manipulations may go unnoticed. By studying changes in working capital, unusual patterns may be revealed, indicating potential manipulation of cash provided by operations.

Comparing Cash Generation with Industry Standards

Investors should compare a company’s cash generation performance to industry standards or similar competitors. Cash generation performance can be evaluated in several ways:

1. Cash Generated by Operations vs. Net Income: Cash generated by operations that exceed net income indicates higher quality earnings. Conversely, if net income consistently exceeds cash generated by operations, it might suggest the use of aggressive accounting methods to inflate net income rather than reflect actual financial performance.
2. Cash Generated by Operations vs. Financial Obligations: Comparing cash generated by operations to debt service, capital expenditures, and dividends can highlight discrepancies. Significant differences between a company’s cash generation and its benchmarks warrant further investigation and a careful examination of changes in working capital accounts.

Managing Working Capital Accounts

Managers may manipulate working capital accounts to present a more favorable cash flow picture. This can be done by delaying payments to creditors or altering the timing of revenue recognition. However, there are other methods as well.

Misclassification of Cash Flows

Managers may misclassify operating cash uses into the investing or financing sections to enhance the appearance of cash generated by operating activities. Another area of flexibility is interest capitalization, which creates differences between total interest payments and total interest costs.

Example: Interest Capitalization

Assume a company incurs a total interest cost of USD50,000, comprising USD5,000 in discount amortization and USD45,000 in interest payments. If two-thirds of this amount (USD33,333) is expensed and one-third (USD16,667) is capitalized, the company might allocate USD30,000 (two-thirds of USD45,000) to operating outflows and USD15,000 (one-third of USD45,000) to investing outflows. Alternatively, the company could offset the entire USD5,000 of non-cash discount amortization against the USD33,333 treated as an expense, resulting in an operating outflow as low as USD28,333 or as high as USD33,333, depending on how the non-cash discount amortization is allocated. This flexibility in allocation can lead to a distorted picture of cash flows.

Flexibility in IAS 7

IAS 7, Statement of Cash Flows, provides flexibility in the classification of certain items. Paragraphs 33 and 34 of IAS 7 allow interest paid and interest and dividends received to be classified as operating, investing, or financing cash flows. This flexibility allows managers to present the most favorable picture of operating performance:

• Paragraph 33: Interest paid and interest and dividends received are typically classified as operating cash flows for financial institutions. For other entities, these may be classified as operating, financing, or investing cash flows.
• Paragraph 34: Dividends paid may be classified as financing cash flows or as a component of operating cash flows, depending on the intended presentation.

By allowing these choices, IAS 7 allows managers to select the presentation that best enhances the appearance of operating performance.

Accounting Choices Affecting Financial Reporting

The following are some of the pertinent areas where choices made can affect financial reports

Revenue Recognition

• Timing of Revenue Recognition: Is revenue recognized upon shipment or delivery of goods?
• Channel Stuffing: Is the company overloading distribution channels with more products than they can sell, possibly through unusual discounts or price increase threats? Are accounts receivable unusually high, indicating potential channel stuffing?
• Sales Returns: Are there unusual activities in the allowance for sales returns compared to historical data?
• Days Sales Outstanding: Are there collection issues that might indicate the shipment of unneeded or unwanted goods?
• Bill-and-Hold Transactions: Does the company engage in transactions where goods are purchased but retained by the seller? This can allow fictitious sales.
• Rebates: How significantly do rebate estimates affect net revenues, and are there any unusual changes in rebate history?
• Multiple Deliverables: Does the company separate revenue arrangements into multiple deliverables, and are there reasonable explanations for how revenue is allocated?

Depreciation Policies for Long-Lived Assets

• Asset Life Spans: Do estimated life spans of assets make sense, or are they unusually short compared to industry standards?
• Changes in Depreciable Lives: Have there been changes in depreciable lives that positively affect current earnings?
• Asset Write-Downs: Do recent write-downs suggest a need to reconsider asset life policies?

Intangible Assets: Capitalization Policies

• Capitalization Practices: Does the company capitalize expenditures related to intangibles like software or R&D?
• Comparison with Competitors: How do the company’s capitalization policies compare with those of its peers?
• Amortization Policies: Are the amortization policies reasonable?

Allowance for Doubtful Accounts/Loan Loss Reserves

• Allowance Additions: Are additions to allowances lower or higher than in the past?
• Collection Experience: Does the collection experience justify any changes in provisioning?
• Industry Difficulties: Is there a possibility that lowering the allowance is due to industry difficulties or meeting earnings expectations?

Inventory Cost Methods

• Costing Methods: Does the company use a fair costing method, given its environment? How do its methods compare with industry standards?
• Obsolescence Reserves: Does the company use reserves for obsolescence, and are there unusual fluctuations?
• LIFO Liquidation: If using LIFO, does LIFO liquidation occur through inventory reduction programs, potentially generating earnings without supporting cash flow?

Tax Asset Valuation Accounts

• Valuation Allowance: Are tax assets stated at a reasonable value, and does the allowance reflect realistic future operations and tax payments?
• Management Commentary: Are there contradictions between management commentary and the allowance level?
• Changes in Valuation Account: Look for changes in the tax asset valuation account that might indicate a need for an earnings boost.

Goodwill

• Impairment Assessment: Are goodwill balances assessed for impairment annually based on subjective estimates like future cash flows and discount rates?
• Disclosures: Do disclosures suggest that impairment tests were skewed to avoid charges?

Warranty Reserves

• Reserve Additions: Have additions to warranty reserves been reduced to meet earnings targets?
• Actual Costs: Do actual costs charged against reserves support or contradict warranty provisioning activities?
• Product Quality: Do costs indicate the quality of the products sold?

Related-Party Transactions

• Management Benefit: Do transactions disproportionately benefit management?
• Control Over Destiny: Does one company have control over another’s destiny through supply contracts or other dealings?
• Dealings with Non-Public Companies: Are extensive dealings with non-public companies under management control, potentially absorbing losses to make the public company’s performance look better?

By monitoring these areas, analysts can better assess the quality and integrity of financial reports.

Question 1

If a company’s management desires to make, the current period’s financial position look more attractive, which of the following steps is it most likely to take?

1. Capitalize a payment.
2. Recognize a payment as an expense.
3. Either capitalize or treat a payment as an expense, as it doesn’t matter.

Solution

The correct answer is A.

Capitalizing a payment will reduce the current period’s expenses, thereby improving the current period’s financial position.

Question 2

In an inflationary market with low production, which of the policies below could managers follow to increase the reported cash from operations?

1. Apply straight-line depreciation only.
2. Use straight-line depreciation and apply the FIFO method.
3. Apply the FIFO method only, with no regard to the depreciation method.

Solution

The correct answer is A.

Depreciation is a non-cash expense that does not affect the statement of cash flow. The cost accounting method is also a non-cash expense since the company pays cash for the actual prices at which the inventory has been bought. The cost of goods sold accounting method only affects the income statement and balance sheet.