Financial Reporting Quality: Biased Accounting Choices

With the many choices of acceptable accounting methods under GAAP, choices can be made that may not really represent an accurate picture of the company’s performance. These are considered to be __biased accounting choices__. While you may think that only aggressive choices can be biased, conservative choices may also be biased.

Incorrect. It is not an aggressive choice as it results in lower income in the current period.

No. The choice may be biased because it is not a reflection of the usage utility of the tractor, but aggressive choices result in higher income in the current period.

Yes. The choice is a conservative choice as it will result in higher depreciation in the current period, lowering income, but it is biased because it does not represent the expected actual usage utility of the tractor.

In order to provide financial reports that would be higher on the quality spectrum, what do you think Hunter Farms could do?

No. Hunter Farms would be required to disclose information regarding depreciation methods regardless of the quality of the reports. Disclosure does not eliminate the bias in the choice.

Absolutely. Using straight-line depreciation eliminates the bias because it represents the true expected economic utility of the tractor and will depreciate it equally over the 10 years.

No. Expensing the entire tractor in the year of purchase not only is not a reflection of economic circumstances but is not in conformance with GAAP, which would lower the report on the quality spectrum.

Companies may have several motivations for choosing biased methods of reporting, such as attempting to disguise poor performance. On the other hand, companies may be motivated to use biased practices to delay recognition of excessive profits until a later time. Investors prefer companies with a steady growth of income, and in a year of high performance, the company will want to delay (or bank) extra profits to a future year to show continued growth. Assume Billy Bob’s Cattle Company is experiencing growth in excess of expectations. The company received several large contracts to supply equipment. Billy Bob’s already received payment on the contract and recorded it as unearned revenue. Billy Bob’s shipped the goods on the last day of the fiscal year to meet the contract specifications but sent them FOB destination in order to delay revenue recognition until the beginning of the new fiscal year. What do you think of this choice?

Incorrect. The method is acceptable under GAAP.

Correct. GAAP indicates that revenue recognition depends on the shipping terms. Shipping FOB destination delays recognition until the goods are received by the customer, thus delaying revenue recognition for the contract until the new year. The choice is biased, motivated by the desire to delay recognition.

No. Although the choice is acceptable under GAAP, the company had substantially completed the earnings process and could have shipped the goods FOB shipping point but chose to delay the revenue recognition intentionally.

Companies use biased practices to try to show a more positive future outlook. This includes things like burying expenses with a discontinued operation to give readers the impression that the company will do well in the future. __Earnings smoothing__, also called "income smoothing," is simply a way that companies use either aggressive or conservative accounting choices to avoid showing very high income in one year and low income in the next or vice versa.

Hunter Farm purchases a tractor for USD 100,000. The tractor is expected to last the company 10 years and provide an equal amount of service over those 10 years. Hunter Farm decides that they want to use double declining depreciation for the tractor because of the increased depreciation expense in the earlier years, thus lowering income. What do you think of their choice of depreciation method?

For example, assume that Break-a-Leg Ski Company is experiencing a decline in sales in the current year due to economic conditions. Break-a-Leg uses LIFO for inventory, and cost of the skis has been increasing steadily for years. Break-a-Leg typically keeps 500 sets of skis on hand at all times. The company decides to decrease inventory to only 100 sets of skis. What do you think the effect of the reduction of inventory is going to have on earnings?

No. Reducing the inventory will result in lower costs assigned to cost of goods sold than if the company had maintained inventory and assigned the higher more recent costs.

No. Reducing inventory will result in goods being sold that have lower costs assigned under LIFO.

Right! Under LIFO, the reduction of inventory will result in lower costs assigned to the goods that are being sold, rather than if the company maintained inventory, the more recent higher costs would be assigned. The result is higher income with the reduction of inventory.

Another way that companies can smooth earnings is to increase production. Assume that Break-a-Leg Ski Company produces skis. The company has USD 100,000 in fixed costs and each set of skis requires USD 25 in variable costs. The company is experiencing a decline in sales in the current year, and expects to sell only 1,000 sets of skis for USD 300 each, as compared to 1,500 sets in the previous year. Rather than producing only the 1,000 sets needed for sales, the company produces 2,000 sets of skis in the current year and puts 1,000 into inventory. Why do you think this makes a difference in earnings since they can only sell 1,000 sets?

Incorrect. Increasing inventory will result in more fixed costs assigned to products in inventory.

Incorrect. The costs for the additional goods produced are not expensed but rather carried in inventory.

Excellent. Increasing production to increase inventory will result in the fixed costs being spread out over 2,000 units rather than 1,000 units, thus delaying the recognition of half the fixed costs until those goods are sold. This will increase income in the current year compared to only producing the 1,000 units that can be sold.

In summary: [[summary]]

Increasingly, companies have used Non-GAAP disclosures and reporting metrics to provide more information to analysts. However, this poses a challenge to analysts. Many times these measures, like non-GAAP earnings, hurt comparability across financial statements because the adjustments made to calculate non-GAAP earnings aren't uniform across all companies. So using these metrics in analysis must be done on an individual company basis.

Use straight-line depreciation

Disclose the choice of depreciation method

Expense the entire $100,000 in the year of purchase

The choice is not an acceptable method under GAAP

Although acceptable under GAAP, the choice is biased

The choice reflects proper application of GAAP and is unbiased

Aggressive and biased

Conservative and biased

Aggressive and not biased

The reduction of inventory will have no effect on earnings

The income will be lower than it would be if the company maintained inventory

The income will be higher than it would be if the company maintained inventory

It doesn’t make a difference in earnings

Earnings would be reduced because of the increased cost of production

Earnings will increase since the fixed costs are spread out to more products

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