Accounting Methods Used to Manage Earnings

Investors should be mindful of how the choice of accounting method can affect financial reporting. The accounting methods selected do not have to involve complex accounting standards to significantly impact the timing of revenue and the resulting financial reports. This notwithstanding, the higher the quality of the financial reporting, the more useful the information users of financial statements will have. The information at their disposal will enable them assess the effects of accounting choices.

Accounting Methods That Manage Earnings, Cash Flow, and Balance Sheet Items

Several accounting choices can be made which will allow company managers to give the impression that a company’s earnings, cash flow, and balance sheet items look better than they really are. These choices include the ones discussed below.

Cost Flow Assumptions

Choosing a cost flow assumption can affect profitability. For example, companies oftentimes assume that their inventory is sold to customers on a first-in-first-out (FIFO) basis. This would suggest that the remaining inventory reflects the most recent costs. Alternatively, it may be assumed that inventory is sold to customers on a weighted-average cost basis.

When prices are changing, the FIFO cost assumption provides a more current picture of ending inventory value, and the balance sheet amounts will, therefore, be more relevant to investors. Under the weighted-average cost assumption, however, the balance sheet will have a mix of old and new costs. Additionally, the more current costs will be shown in the cost of sales, which will make the income statement more relevant than under the FIFO assumption.

Accrual Accounting vs. Cash Basis Accounting

Cash basis accounting shows only the cash transactions that have been conducted by a company. In this case, a lot of financial information remains hidden. Accrual accounting, on the other hand, attempts to show the effects of all economic events on the company during a specified period. Relying on estimates about future events, revenues will reflect all transactions which occurred, irrespective of whether they were transacted on a cash basis or credit-extended basis.

Accrual accounting provides a better picture of what transpired during a reporting period than cash basis accounting. Accrual accounting, however, may tempt managers to manage the financial figures rather than the business.

Deferred Tax Estimates

Deferred-tax assets may arise whenever a company reports a net operating loss based on tax rules. This results from the company’s expectation that its current net tax operating losses will offset expected future profits and reduce the future income tax liability. Accounting standards, however, require that deferred tax assets be reduced by valuation allowances which account for the possibility that a company is unable to generate sufficient profit to use all of its available tax benefits.

The value of the deferred tax asset primarily results from a company management’s outlook for the future. Managers may take a more optimistic futuristic view and keep the valuation allowance artificially low if they need to stay in compliance with debt covenants.

Depreciation Method

Managers may choose to depreciate long-lived assets either using (i) a straight-line method, with each year recording the same depreciation expense; (ii) an accelerated method, with greater depreciation expense being recorded in the earlier part of an asset’s life; or (iii) an activity-based depreciation method, which allocates depreciation expense based on units of use or production. Depreciation expense is also affected by the estimate of salvage value.

The choice of depreciation method can significantly affect reported income.

Capitalization Practices

When classifying payments, a company management must determine the category in which a payment will fall. The payment can either benefit the current period, in which case it would be an expense, or benefit future periods, and thereby be classified as a cost to be capitalized as an asset.

The classification depends on the judgment of the management which can be biased based on the significant impact that the choice can have on current earnings.

Acquisitions

The fair value of  acquired assets has to be estimated. This estimation may, however, be biased downwards for the values of depreciable assets to keep future depreciation expenses low.

Goodwill

Goodwill estimates may depend on projections of future financial performance. To avoid a goodwill write-down, these projections may be biased upwards.

The Preparation of the Statement of Cash Flows

Company managers may be able to improve the appearance of cash flow from operations without actually improving it. For example, managers can deliberately lengthen the accounts payable credit period to make the cash flow from operations look better on the balance sheet date. Furthermore, in cases where net income is significantly greater than the cash flow from operations, it is likely due to management’s use of an accounting method to ‘artificially’ raise net income. It is equally noteworthy that misclassification of operating uses of cash either into the investing or financing sections of the cash flow statement can make cash flow from operations better than it really is.

Additionally, the choice of operating or financing cash flow for the placement of interest and dividends received or paid provides an opportunity for managers to select the presentation method which gives the best appearance of operating performance.

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 serve to reduce 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. Appply 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 affects the income statement and the balance sheet only.