How Managers Select Accounting PrinciplesThe selection of accounting principles occurs at two levels. First, the FASB determines which principles constitute GAAP. In a number of instances, however, the FASB allows the use of more than one method. Thus, corporate managers also make accounting policy decisions. Which criteria are used by the FASB and corporate managers to select accounting principles?

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This post overviews factors that effect corporate manager’s decision in selecting accounting principles they implement. Follow on…

 

The FASB’s primary objective is to select accounting principles that provide useful information to financial statement readers. However, businesses incur costs to generate the information required by the FASB. Thus, the FASB attempts to balance the costs and benefits of its rulings.

Some members of the financial community suggest that corporate managers act in the same way. For example, in choosing an inventory method, managers balance the costs of implementing each method with the quality of the information that each method yields. A more sophisticated view recognizes that accounting principles have economic consequences to managers and their firms, and that these consequences are considered by managers when choosing accounting principles.

Beyond implementation costs, accounting principles can affect the wealth of managers and firms via:

  • compensation plans;
  • debt contracts; and
  • political costs.

Read on…

 

Compensation Plans

Many corporations pay their top managers a fixed salary plus an annual bonus, which is often a percentage of reported net income“. A number of bonus agreements include a floor and a ceiling on the bonus. The floor requires that net income must exceed a predetermined amount before the bonus is activated. The ceiling places a limit on the size of the bonus; once the annual bonus reaches the ceiling, additional increases in net income no longer increase the bonus.

Bonus plans are intended to align the interests of managers and shareholders. Managers frequently face alternative courses of action, where one course is in their best interest, and another course is in the shareholder’s best interest. For example, a manager’s career might be aided by expanding the business (empire building), even when such expansion is not particularly profitable and is not in the shareholder’s best interest.

Expansion may result in more prestige and visibility for the firm and its managers, thus enhancing a manager’s employment opportunities. Because:

  • bonus plans motivate managers to make decisions that increase net income; and
  • increased net income is usually in the shareholder’s best interest, the goals of these two groups come more in line when a manager’s compensation depends on reported net income.

 

Given that manager’s compensation is tied to reported accounting earnings, how would we expect managers to select accounting principles? Most managers probably consider the effect that different accounting principles have on net income, and consequently on their compensation. In particular, bonuses often motivate managers to select accounting methods that increase reported net income.

 

Debt Contracts

Lenders are concerned about limiting their risk and maximizing the probability that principal and interest will be paid. Debt contracts between borrowers and lenders can help accomplish this. Many of these contracts impose constraints on the behavior of borrowers.

Example:

  • Some contracts limit the total amount of debt a borrower can incur. In such cases, measurement of the borrower’s debt is based on the liabilities reported in the balance sheet.
  • Some contracts limit the cash dividends a borrower can distribute. This limitation is defined in terms of retained earnings, a component of owners’ equity that appears on the balance sheet.

 

Penalties exist for violating debt contracts. These include:

  • an interest rate increase;
  • an increase in collateral (assets pledged to secure the debt);
  • a one-time renegotiation fee; and
  • an acceleration in the maturity date.

 

Because these contracts are defined in terms of financial statement numbers, the use of accounting principles that increase reported net income can reduce the chances of contract violation. Accordingly, the likelihood of violating debt contracts is another influence on managers’ accounting policy choices.

 

Political Costs

Governments have the power to regulate many operations of a business. Pollutant emissions and employment practices are just two illustrations. Governments also have the power to tax corporations. Because regulation and taxation are costly to firms, managers can be expected to take actions that minimize these costs. Because these costs are imposed via the political process, they are referred to as “political costs“.

Some accountants suggest that highly profitable firms are more exposed to political costs than less profitable ones. Relatively profitable firms are more likely to be the target of antitrust investigations or special tax assessments. For example: in the mid-1970s, firms in the oil industry earned unusually high profits due to a steep rise in oil prices. As a result, Congress enacted the Windfall Profits Tax, which subjected these companies to an additional tax on their earnings. More recently, Microsoft, Inc. has been the target of intense scrutiny by federal regulators because of its dominance in the computer operating system market and its resultant profitability.

Some accountants also argue that larger firms are more susceptible to regulation and taxation because their size attracts more attention. Accordingly, the managers of larger firms are particularly motivated to undertake actions that minimize political costs. One of these actions is the selection of accounting principles that reduce reported net income. Note that compensation plans and debt contracts motivate managers to select accounting principles that increase reported income, whereas political costs have the opposite effect.

 

The Two Roles of Financial Accounting

At the beginning of this chapter, the informational role of financial accounting was emphasized. From this perspective, both the FASB and corporate managers select accounting principles that yield the most useful information. However, as shown above, accounting principles also have economic consequences. These consequences arise in several ways:

  • First, accounting serves as a basis for contracting. That is, some contracts (compensation plans and debt contracts) are based on accounting numbers. Because different accounting principles result in different accounting numbers, the choice of accounting principles can modify the terms of these contracts.
  • Second, accounting principles may affect a firm’s exposure to political costs, such as taxes and regulation. Finally, the costs to implement different accounting principles vary. Some accounting principles are quite complex and costly, whereas others are rather simple.

 

For all these reasons, accounting principles can affect the wealth of a firm and its managers. The managers have an obvious incentive to select the principles that increase their wealth. Such an incentive may conflict with the notion that managers select accounting principles to provide useful information. This implies that financial statement readers must carefully evaluate the accounting principles used by a firm.The selection may not result in the most useful financial statement information.

 

The Political Nature of Accounting Standard Setting

Economic incentives associated with accounting principles might motivate an additional element of managerial behavior. As mentioned in an earlier section, the FASB conducts an elaborate due process procedure prior to issuing an accounting standard. This process provides corporate managers an opportunity to lobby the FASB. What underlies their comments to the board? Again, two possibilities exist. The comments may reflect managers’ assessments of which principles generate the most useful financial statement information. Alternatively, their comments may also reflect, perhaps in a disguised way, how the various accounting principles will affect their wealth.

Some observers believe that the FASB has been overly responsive to the latter arguments. Of course, others believe that the FASB is not sufficiently sensitive to the effects its pronouncements have on individual managers or firms. Thus, accounting standards setting is now widely recognized as a political process in which various parties argue for the selection of the accounting principles that further their own self-interest. Some accountants believe that self-interest arguments have had a negative effect on the usefulness of the information required by some FASB rulings.

 

Lessons to Learn

Accounting principles not only affect the quality of the information contained in financial statements, but they also affect the wealth of various parties. Accounting principles have economic consequences because of implementation costs, compensation plans, debt contracts, and political costs. Managers therefore have certain preferences for accounting principles that are not necessarily related to the inherent quality of the resulting information. Accordingly, care must be taken in interpreting both financial statements and manager’s recommendations about accounting standards.