ACC 650
Dr. Ken Lorek
Chapter 4: Distortions in Historical Costing Accounting
There is the potential for management bias to be induced into the financial statements. Proponents of agency theory would suggest that managers are simply acting in their own enlightened self-interest when they inject this bias: (Please note that advocates of conservative accounting GAAP are also subtly injecting a counter-bias into asset valuations and income determination).
· Compensation via bonuses. It is common for bonus agreements to be framed around EPS targets. Lower limits and upper limits of the bonus range certainly provide incentives for managers to fudge the data.
· Compensation via stock options. Managers typically believe that smooth upward trends in EPS have a positive effect on the firm’s security price.
· Contractual Obligations. Debt covenants and bond indenture agreements may stipulate certain cash flow requirements, ratios, and EPS levels which, if violated, might trigger negative financial consequences for the firm.
It is an analyst’s job to try to undo any bias that is evident in the balance sheet, income statement, or cash flow statement. See tables 4-1 to 4-3 for the template that Palepu and Healy have decided to employ for the financial statements henceforth in our book. Adoption of a common template will facilitate:
· Time-series analysis of financial statements
· Cross-sectional analysis of financial statements
Bias may be injected by management with respect to asset, liability and equity distortions (as well as revenues, expenses, and cash flows).
· Some examples of asset distortions:
o Leases (ownership issue)
§ Operating Leases
§ Capital Leases
§ Inclusion/exclusion on the balance sheet
o Research and Development Costs
o Goodwill
§ Impairment versus amortization (SFAS #141 and #142)
§ Why is purchase versus pooling of interests still a consideration for analysts?
o Asset Impairment
§ Undiscounted cash flow argument
§ Lower of cost or market rule
· Inventories
§ Allowance Accounts
· Uncollectible Receivables
· Some examples of Liability Distortions
o Pension and Post-Retirement Benefits
§ Managers must estimate mortality rates, interest rates, worker salaries, attrition rates, etc.
o Deferred Tax Liabilities
o Warranty Costs
· An Example of an Equity Distortion
o Stock Options
§ Intrinsic Value Method (APB #25) No compensation expense is reported IFF exercise price is equal to or greater than the current market value of the company’s stock
§ Fair Value Method (SFAS #123)– firms have the option to recognize the fair value of stock options granted during the most recent period.
§ FASB SFAS No. 123R (2005) FASB mandates expensing of stock options on the income statement using the Black-Scholes Option Pricing Model.
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