Accounting Methods and Quality of Earnings

Financial statements are prepared in conformity with standards that have been established over the years called generally accepted accounting principles (GAAP). Rarely, if ever, would you come across financial statements of a business prepared according to accounting methods other than GAAP. The minor exceptions to this general comment are not worth mentioning. (Financial statements of non-profit organizations and government entities follow somewhat different accounting principles and practices). Audits by independent certified public accountants (CPAs) are precisely for the purpose of making sure than GAAP have been followed in preparing the financial statements.
 
In short, anytime you pick up the financial report of a business you are entitled to assume that its financial statements have been prepared according to GAAP. The fundamental idea is to provide a well-defined set of general accounting methods and practices that all businesses should follow faithfully for measuring their profit and for presenting their financial condition and cash flows.

The twofold purpose is to have all businesses play by the same accounting rules regarding how they keep score financially and to make financial statements of different businesses comparable with one another. You can imagine the confusion if every business were to choose its own unique accounting methods. For instance, one business may use historical cost basis depreciation and another may use current replacement cost basis depreciation.

The six basic steps in the accounting process of a business are as follows:

  • Identify and analyze all transactions and operations of the business during the period.
  • Determine the correct accounting method for each basic type of transaction and operation according to GAAP.
  • Record and accumulate the transactions and operations of the business during the period, using the correct accounting methods, of course.
  • At the end of the period assemble the accounts for sales revenue, expenses, assets, liabilities, and owners’ equity, and make sure their ending balances are up-to-date and accurate.
  • Prepare the financial statements for the period and write the footnotes for the statements according to the prescribed rules of presentation and disclosure. (Include the CPA’s report if the statements have been audited).
  • Distribute the financial report to everyone entitled to receive a copy.

This post focuses on the above step 2nd—which, to be more precise, should say choose one of the alternative methods allowed under GAAP for each basic type of transaction and operation of the business.

Suppose, purely hypothetically, that a business employs two equally qualified accountants and neither knows of the other’s presence. Suppose both accountants keep the books, entirely independent of one another. This company would have two sets of books but only one set of transactions and operations during the year to account for.

Now the critical question:

  • Would both accountants come up with the same net income (profit) number for the year?
  • Would their ending balance sheets be virtually the same? Would their footnotes be the same?

You can probably see what’s coming here. Read on…

The two accountants, in all likelihood, would come up with different net incomes for the year. One or more of their expenses would be different, and their sales revenue for the year also might be different. This means that their balance sheets would be different. Sales revenue and expenses cause increases and decreases in assets and liabilities. So, if expenses are different, then assets and liabilities will be different. And, if net income for the year is different, then the retained earnings balance in the ending balance sheet will be different.

Does this mean that one of the company’s accountants is wrong and has made mistakes in applying generally accepted accounting principles?

No, assume not; neither has made a mistake.

Then, how can the two of them come up with different accounting numbers?

The answer is that for many expenses, and even for sales revenue, the GAAP rule book does not prescribe one and only one accounting method, but allows two or three alternative methods to be used.

Financial accounting would seem to be like measuring a person’s weight on a scale that gives correct readings, wouldn’t it? But, as a matter of fact, financial accounting according to GAAP allows a business to select which kind of scale to use—one that weighs light or one that weighs heavy.

We can think of the GAAP set of rules as an official cookbook for financial accounting that has more than one recipe for many dishes (expenses and sales revenue). For example, cost of goods sold expense and depreciation expense can be accounted for by different but equally accepted methods. Company’s choices of accounting methods for these two key expenses are disclosed in footnotes to the company’s financial statements.

The financial reporting game can be played using different methods of scorekeeping. Virtually every business has to pick and choose among different accounting methods for several of its expenses and perhaps for recording its sales revenue as well. For most businesses the profit result is the dominate factor in choosing among accounting methods. “How will net income be affected by the choice between accounting methods?” This is the main question on the minds of most business managers. Read on…

 

Business Managers and GAAP

Many deplore the “looseness” or “elasticity” of accounting methods that are permitted under the umbrella of generally accepted accounting principles (GAAP)—but not business managers by and large. For one thing, business managers know from experience that almost every law, regulation, guideline, benchmark, standard, or rule is subject to more than one interpretation. Business managers, in other words, are accustomed to operating in a fuzzy world of shades of gray; they don’t expect to find clear-cut, black-and-white distinctions very often. I would surmise that the reaction of most business managers to the earlier discussion of GAAP’s diversity probably is—”So, what else is new?”

Second, business managers probably welcome having a choice of accounting methods. In fact, they might prefer to have even more choices for their accounting methods and disclosures. The evolution of GAAP over the years has been in the direction of narrowing the range of acceptable accounting methods and reporting practices. Accounting methods have been tightened up over the years.

Nevertheless, the Financial Accounting Standards Board (FASB) still issues pronouncements that permit more than one accounting method or more than one manner for disclosing certain matters in financial reports.

The chief executive officer (CEO) of the business as well as its other top-level managers should make certain that the company’s financial statements are fairly presented, especially that the accounting methods used to measure the company’s profit are within the range of choices permitted by GAAP. If its accounting methods are outside these limits the company could stand accused of issuing false and misleading financial statements. The managers would be liable for damages suffered by the company’s creditors and stockholders who relied on its misleading financial statements. If for no other reason than this, managers should pay close attention to the choices of accounting methods used to prepare their company’s financial statements.

The chief executive officer of the business and its other top-level managers should decide which accounting methods and policies are best for the company. They have to decide between conservative (cautious) versus aggressive (liberal) profit-accounting methods, which means whether to record profit later (conservative) or sooner (aggressive).

The accounting choices have to do with the timing for recording sales revenue and expenses. The sooner sales revenue is recorded, the earlier profit is reported; and, the later expenses are recorded, the earlier profit is reported. If a business wants to report profit as soon as possible it should instruct its accountants to choose those accounting methods that accelerate sales revenue and delay expenses.

On the other hand, if a business wants to be conservative it should order its accountants to use those accounting methods that delay the recording of sales revenue and accelerate the recording of expenses, so that profit is reported as late as possible. The accounting methods selected for cost of goods sold expense and depreciation expense are two main examples of conservative versus aggressive methods for recording profit.

Business managers may prefer to avoid getting involved in choosing accounting methods. I think this is a mistake. First, as already mentioned, there is the risk that the financial statements may not be prepared completely in accordance with GAAP, especially if the financial statements are not audited by independent CPAs. Second, top-level mangers should adopt those accounting methods that best fit the general policies and philosophy of the business. The CEO should decide which “look” of the financial statements is in the best interests of the business.

Somebody has to choose the accounting methods—if not the managers then by default the company’s controller. The controller, being the chief accounting officer of the company, should work hand-in-glove with the CEO and the other top-level managers to make sure that the accounting methods being used by the business are not working at cross-purposes with the goals, objectives, strategies, and plans of the organization.

 

Consistency of Accounting Methods

Once a business chooses which accounting methods to use for recording its sales revenue and expenses, the business sticks with these methods. A company does not flip-flop between accounting methods. The Internal Revenue Service and the Securities & Exchange Commission take a dim view of switching accounting methods one year to the next. Furthermore, CPA auditors have to mention such changes in their audit reports. Changes may be needed in certain circumstances, but the large majority of businesses don’t change their accounting methods except on rare occasions.

Consistency of accounting methods from year to year is very important. As mentioned earlier, the difference between accounting methods has to do with when sales revenue and expenses are recorded.

Year-by-year, the annual amounts of sales revenue and expenses differ between accounting methods, and thus bottom-line profit will differ. The amounts of these differences can be very pronounced in the early start-up years of a business, or during years of rapid expansion or drastic decline. However, for a mature company that is not experiencing rapid growth or deep decline, the end result in terms of annual net income may be minimal—although it’s hard to know for sure.

GAAP do not require that a business determine and report how much different its annual net income would have been if the company had used alternative accounting methods instead of the methods it actually used. Conservative accounting methods can have a very pronounced effect on the cost values reported in a company’s balance sheet for its inventory and fixed assets. If inventory cost is materially less than current cost values, then a business discloses the difference between the balance sheet cost value of its inventory and the estimated current cost of the inventory.

 

Massaging the Numbers and Cooking the Books

Beyond choosing between alternative accounting methods, business managers can go two steps further in manipulating recorded profit:

 

Step-1: Massaging the numbers or income smoothing

Business managers can control the timing of some expenses and sales revenue to some extent and therefore boost or dampen recorded profit for the year. In this way managers ”put a thumb on the scale”, the scale being net income for the year. When managers cross the line and go too far it’s called cooking the books. Cooking the books constitutes fraud and is probably illegal.

The most common way of massaging the numbers involves the discretionary expenses of a business. Consider repair and maintenance expenses, for instance. Until the work is done, no expense is recorded. A manager can simply move back or move up the work orders for these expenditures, and thus either avoid recording some expense in this period or record more expense in the period. In this way the manager controls the timing of these expenses.

There are other discretionary expenses of a business. Two come quickly to mind—employee training and development costs, and advertising expenditures.

Managers control the timing of discretionary expenses, it is thought, to smooth profit from period to period. Instead of permitting the profit numbers to pop out of the process of the accounting system, and letting the chips fall where they may, managers ask the company’s controller to let them know in advance how profit for the period is shaping up, to get a preview of the final profit number for the year.

The profit lookout for the year may be below or above expectations. The look ahead at profit may indicate a unacceptable swing from last year. In these situations the manager may decide to nudge the profit number up or down, and the best way of doing this is to manipulate discretionary expenses. Or, the manager can control the timing for recording revenues. Sales can be accelerated, for example, by shipping more products to the company’s captive dealers even though they didn’t order the products. The business is taking away sales from next year to put the sales on the books this year.

 

Step-2: Cooking the books, is very serious stuff, and goes beyond massaging the numbers or doing some profit smoothing.

It’s fundamentally different from taking advantage of discretionary expenses to give profit a boost up or a shove down. Cooking the books is not just “fluffing the pillows” to make profit look a little better or worse for the period. Cooking the books means that sales revenue is recorded when in fact no sales were made, or that actual expenses or losses during the period were not recorded.

Cooking the books requires falsification of the accounting records. To put it as bluntly as I can, cooking the books constitutes fraud—the deliberate design of deceptive financial statements. CPA auditors search for any evidence fraud. But they may not find it when managers are adept at concealing the fraud.

 

Quality of Earnings

More and more often you see the phrase quality of earnings in the business and financial press. Reported net income is put to a quality test, or a litmus test as it were. This term does not have a precise definition that I’m aware of, but clearly most persons who use this term refer to the quality of the accounting methods used by a business to record its profit.

Conservative accounting methods are generally viewed as high-quality, and aggressive accounting methods are viewed with more caution by stock analysts and professional investment managers. They like to see some margin for safety, or some cushion for a rainy day in a company’s accounting numbers. They know that many estimates and choices have to be made in financial accounting, and they would just as soon a business on the low side rather than the high side.

Professional investors and investment managers are especially alert for accounting methods that appear to record revenue (or other sources of income) too early, or that fail to record losses or expenses that should be recognized. Even though the financial statements are audited, the professionals go over them with a fine-tooth comb to get a better feel for how trustworthy are the reported earnings of a business.

And, they pay a lot of attention to cash flow from profit (operating activities) because this is one number managers cannot manipulate—the business either got the cash flow or it didn’t. Accounting methods determine profit, but not cash flow. If reported profit is backed up with steady cash flow, stock analysts rate the quality of earnings very high.

To think that financial reports issued by businesses are pure as driven snow is naive. People are people, after all; we’re not all angels. As my father-in-law puts it, “There’s a little larceny in everyone’s heart”.

Just because a few cops accept bribes doesn’t mean all police are on the take. Clearly the large majority of businesses prepare honest financial statements. But there are some crooks in business, and they are not above preparing false financial statements as part of their schemes.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

One thought on “Accounting Methods and Quality of Earnings”

  1. I’ve read other articles by Putra and like always found the information to be on point the extremely helpful. This article provides a good starting point for my research. Very good description of the difference in methods and the affects.

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