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Economics 4 / Management 4 Financial Accounting
Accounting Policies &
Earnings Management
Updated 09/02/16
Ugly Puppy Periods 1 - 3
Analyzing Accounting Choices Analysis is a systematic process of comparison.
Using a simple business model, we will systematically compare the financial reporting
results of: • two separate sets of accounting policies for … • one set of business events. This will demonstrate FORM (different reports) over
SUBSTANCE/REALITY (one transactions)
What is the role of Policies?
• Policies are guidelines for dealing with events.
• Policies tell us what we ought to do in general - be nice to others, or in particular - drive slowly around children.
• Policies are especially important when things get confusing or when unusual things happen.
Policies, continued • One’s policies should be evident from
one’s actions.
• Parents teach policies and sometimes even follow them.
• Dating is a process of learning another person’s policies.
• Donald Trump doesn’t seem to have any policies; Hilary seems to change hers’ frequently.
What is the role of an Accounting Policy?
Accounting policies are guidelines for: a) Making estimates – because accurate
measurements are difficult & expense; b) Analyzing & Interpreting transactions – because
some transactions are complex; c) Communicating contingencies (what if’s and
maybe’s) – because life is mostly about dealing with if’s & maybe’s; and
d) Recognizing Revenues & Expenses – answering: when is something completely “earned”.
Our illustrative firm has a Business Model that proposes several Profit
Centers.
1. Consulting services;
2. Retail Sales (of T-shirts);
3. Celebrity appearances and, maybe …
4. … an Instagram Account
What accounting policies do …
Accounting policies (which are adopted by
management) will tell the accounting
department how to measure and classify day-
to-day transactions.
Implications of accounting policies …
• Accounting policies will influence the firm’s financial reporting results;
• Two firms with different accounting policies, even though experiencing the same business activities & transactions, will report different to Sales, Expenses, Profits, Assets, and Liabilities.
Specific Accounting Policies:
1) What costs are Capitalized or Expensed.
2) How “capitalized costs” are Amortized.
3) In what order do “inventory costs” flow through
COGS.
4) How “contingencies” are reported. 5) How strictly is the earnings process is
measured.
6) How “bad things” are reported.
A firm can report different financial results, meaning different Profits, simply by
modifying its accounting policies.
Form versus Substance
Form = Reported Effect
Substance = Cause
Period 1 Ugly Puppy Events 1) Issue 200 shares of stock for $1 each. 2) Acquire an Ugly Puppy for $100, cash. 3) Buy T-shirts in three successive cost layers as: 4) 10 shirts @ $1 each, cash. 5) 10 shirts @ $2 each, cash. 6) 10 shirts @ $3 each, cash. 7) Consult 40 clients and 30 pay the $1 each; 10
promise to pay later. 8) Sell 10 T-shirts at $5 each, cash.
Capitalizing and Amortizing the Puppy’s Cost
Cost is $ 100
If this Cost is Capitalized, i.e. classified as an Asset, then the Cost must be Amortized. This involves two decisions: 1) What is the expected resale value or disposal
cost of this asset? 2) Over how many periods can we expect this
asset to be useful in the firms current business model?
Capitalizing and Amortizing the Puppy’s Cost
Expected cost recovery is $ 0; thus, Amortizable Basis is $ 100 - $ 0 = $100.
• AGG gives the amortizable basis a 4-period life
• CON gives it a 3-period life.
Amortization Schedules:
Period 1 2 3 4
1. AGG $ 25 $ 25 $ 25 $ 25
2. CON $ 33 $ 33 $ 33 $ 0
As we sell T-shirts, we need to expense (as COGS) the cost of “some”, not necessarily “those” specific T-shirts. This is a “cost” issue, not an “item” issue.
Management decides a policy that tells the accounting department what costs to expense.
Inventory Cost Flow Policies
FIFO means First In, First Out The first costs we pay ever, are the first costs that we expense.
LIFO means Last In, First Out The last costs we pay in any accounting period, are the first costs that we expense. Just think about how people get on-and-off an
elevator floor-by-floor.
The Cost Flow policy options? FIFO or LIFO
Use FIFO as the Aggressive choice.
• The $ 1 cost layer goes to COGS first, thus the $ 2 and $ 3 layers are LISH, ending inventory.
Use LIFO as the Conservative choice. • The $ 3 cost layer goes to COGS first, thus
the $ 1 and $ 2 layers are FISH ending inventory.
We sold 10 T-shirts
We consulted forty customers, but ten customers who did not pay the $1 fee.
However, each of those customers promised to pay in the future.
We will report $10 in Receivables.
Credit Sales
When a firm makes a credit sale, it sells on-account, it is holding a customer’s debt. • Will the customer pay the debt? • All of it? • When? How should the firm communicate the risk of not getting paid ?
Reporting (or not) the reality of collecting a debt.
A contingency means that A is related to B happening in the future.
• You getting your UCSD diploma is contingent on you passing all of the required courses.
• You getting a job is contingent on someone making a positive hiring decision in your favor.
• You getting married is contingent on someone falling into your trap.
Contingencies
Many of the book values reported on a firm’s Balance Sheet are unlikely to result in exactly
that value in cash.
This is a Book Value versus Market Value question: are we likely to collect the $10 value of the Receivables as $10 in cash?
The correct answer is “it depends”, or “maybe”.
When Reported Values are Contingent?
• How do we say “maybe” in Accounting? • Do we always want to say “maybe”?
Allowances are accrual accounting’s way of
quantifying maybe.
An Allowance is the amount by which we believe that the eventual Market Value of an Asset might
fall below the currently-reported Book Value.
Putting a number on “maybe”?
Layer COGS Layer COGS
$ 10 ( $ 10) $ 10
$ 20 $ 20
$ 30 $ 30 ( $ 30)
Inventory Cost Flows AGG CON
FIFO / LISH LIFO/FISH
The 1st Period - Aggressive policies Starting Rev 90 COGS (10) GP 80 G&A ( 0) EBITDA 80 DA (25) EBIT 55 I ( 0) EBT 55 T ( 0) NI 55
200
0
( 0)
0
0
0
0
(0)
0
0
0
0
200
0
120
10
( 0)
50
0
0
100
(25)
0
0
0
0
200
55
The 1st Period - Conservative policies Starting Rev 90 COGS (30) GP 60 G&A (10) EBITDA 50 DA (33) EBIT 17 I ( 0) EBT 17 T ( 0) NI 17
200
0
( 0)
0
0
0
0
(0)
0
0
0
0
200
0
120
10
(10)
30
0
0
100
(33)
0
0
0
0
200
17
Comparisons
• Period #1
Profits Assets Liabilities
Aggressive $ 55 $ 255 $ 0
Conservative $ 17 $ 217 $ 0
A Few Observations
We have:
a) Two sets of Financials.
b) One business.
c) Two reporting forms
d) One (substance) set of events.
e) One asset, CA$H, that cannot be altered by Accounting Policies.
Period 2 1) Acquire a 2nd Ugly Puppy for $100 cash 2) Borrow $100 @ 7% interest on an interest-only
basis with interest due in subsequent periods 3) Purchase 20 T-shirts @ $4 each, pay cash for 10
and take 10 on-account. 4) Purchase ten 10# bags of dog food for $5 each,
$50 total cash. 5) Take both puppies to a Vet and pay $24 cash. 6) Consult 40 clients and 30 pay $1 each; 10
promise to pay later. 7) Sell 20 T-shirts at $5 each, cash.
Capitalizing or Expensing the Vet & Trainer Costs
Cost is $ 24. This is an accessory to the “puppy”.
Is it betterment or repair? Betterment gets capitalized and amortized; repair gets expensed.
If capitalized, then the usual treatment: • What amount of the cost is recoverable? • What life do we give the cost?
AGG Capitalizing the Costs • Give the 2nd puppy’s cost a 4 period life. • Give the Vet cost a 4-period life.
• AGG Amortization Schedule: • Period 1 2 3 4
$ 100 $ 25 $ 25 $ 25 $ 25 $ 0
$ 100 $ 25 $ 25 $ 25 $ 25
$ 24 $ 6 $ 6 $ 6 $ 6
Total $ 25 $ 56 $ 56 $ 56 $ 31
CON Capitalizing & Expensing the New Costs
• Give the 2nd puppy’s cost a 3 period life. • Expense the Vet Cost in SG&A.
• CON Amortization Schedule: • Period 1 2 3 4
$ 100 $ 33 $ 33 $ 34 $ 0 $ 0
$ 100 $ 33 $ 33 $ 34 $ 0
Total $ 33 $ 66 $ 67 $ 34
Puppy Food
We purchase 10 bags of dog food. $5 per = $50
• Book the food in Supplies; expense it in SG&A.
We don’t want to count, measure, etc how much food each puppy consumes each period - far too complicated for an accountant’s simple life. So we estimate.
• Let’s say one bag per puppy per period.
There really isn’t an AGG versus CON issue here.
Inventory Cost Flows AGG CON
FIFO / LISH LIFO/FISH
Layer COGS Layer COGS $ 10
$ 20 ( $ 20) $ 20 $ 30 ( $ 30) $ 80 $ 80 ( $ 80)
The 2nd Period - Aggressive Starting Rev 140 COGS (50) GP 90 G&A ( 10) EBITDA 80 DA ( 56) EBIT 24 I ( 7) EBT 17 T (0) NI 17
120
10
( 0)
50
0
0
100
(25)
0
0
0
0
200
55
176
20
( 0)
40
0
40
224
( 81)
0
40
7
100
200
72
The 2nd Period - Conservative Starting Rev 140 COGS (80) GP 60 G&A (44) EBITDA 16 DA ( 66) EBIT (50) I ( 7) EBT (57) T ( 0) NI (57)
120
10
(10)
30
0
0
100
( 33)
0
0
0
0
200
17
176
20
(20)
30
0
40
200
( 99)
0
40
7
100
200
(40)
Comparisons
• Period #2
Profits Assets Liabilities
Aggressive $ 17 $ 419 $ 147
Conservative ($ 57) $ 307 $ 147
Period 3 Pay the Payable and the Accrued Interest. 1) Purchase three periods of Advertising for $33
cash; 2) Purchase 10 T-shirts @ $4 each, cash. 3) Consult 40 clients and all pay $1 each, cash. 4) Collect $10 in outstanding Receivables. 5) Sell 25 T-shirts at $ 6 each, cash. 6) Purchase 10 T-shirts @ $5 each, cash. 7) Encounter a person who agrees to $100 for a
celebrity Puppy appearance – next period – and pays $50 cash now with balance due on performance.
8) Declare $ 50 in dividends.
Layer COGS Layer COGS $ 10 $ 20 ( $ 10)
$ 80 ( $ 80) $ 40 ( $ 20) $ 40 ( $ 40) $ 50 $ 50 ( $ 50)
Inventory Cost Flows AGG CON
FIFO / LISH LIFO/FISH
The 3rd Period - Aggressive Starting Rev 240 COGS (100) GP 140 G&A ( 21) EBITDA 119 DA ( 56) EBIT 63 I ( 7) EBT 56 T ( 0) NI 56
136
20
( 0)
80
0
40
224
(81)
0
40
7
100
200
72
226
10
( 0)
70
22
30
224
(137)
0
0
7
100
50
200
( 78)
The 3rd Period - Conservative Starting Rev 190 COGS (100) GP 90 G&A ( 11) +10 EBITDA 79 DA ( 67) EBIT 12 I ( 7) EBT 5 T ( 0) NI 5
136
20
(20)
30
0
40
200
( 99)
0
40
7
100
200
(40)
226
10
(10)
10
22
30
200
(166)
50
0
7
100
50
200
( 85)
Comparisons
• Period #3
Profits Assets Liabilities
Aggressive $ 56 $ 435 $ 157
Conservative $ 5 $ 322 $ 207
