Effects of Accounting Policy on Market Share Price - Essay Example

?Effects of accounting policy Effects of accounting policy on market share price Introduction There have been concerns that changes in accounting policies and methods proposed by accounting regulatory bodies has had effects on the financial statements of companies and consequently affected the market value of the companies’ share price. This study will use a case study from Lev Baruch’s essay in the Accounting Review Volume 54, No.3 p485-503 which is a study of the oil and gas industry’s reaction to change in accounting policy. This study aims at investigating the effects of accounting policies on market value of firms and investor decisions. Discussion In 1977, the Financial Accounting Standards Board proposed to change the accounting methods used in the oil industry from full costing (FC) to successful efforts (SE). The FSAB through the Exposure Draft received great opposition from oil companies because the change in accounting method could adversely reduce the market share price and earnings at the same time. From an analysis carried out, 64% of the oil companies will have their earnings decreasing by 5% or more and 74% of the companies surveyed could have a 5% or more decrease in the market share price if they changed the accounting method from full costing to successful efforts (Zeff, 1979). On average, it was established that the industry’s market share price and earnings decreased by 4.5% in three days after the release of the Exposure Draft (Lev, 1979). The financial accounting standards board put forward two method used to account for oil and gas exploration cost. These include the full costing method and the successful efforts method. The two methods differ in the way they treat exploration costs (Myers, 1979). Successful Efforts method Under this method, the costs are incurred in unsuccessful exploration are charged as current expenses and therefore not carried forward as assets. Under the SE method, costs are capitalized by collection if the costs directly end up in the development of proved reserves. Costs not resulting in proved reserves are expensed as are incurred or as a determination of verified reserves is made. Simply, within a cost group, wells that are explored and found dry are expensed and wells that are successfully explored and developed are capitalized (Lev, 1979). Full Costing Method The FC method, on the other hand, treats all costs that oil companies incurred in exploration oil and gas reserves as assets subject to a limitation that the total amount carried forward does not exceed the approximated value of the reserves, anywhere the well is located either within the country or across any continent (Lev, 1979). Under the full cost method, all charges of discovering and evolving wells are capitalized regardless of the fact that they are proven or not. After which, depletion is done using the units of production technique where the all the proven oil and gas reserves are taken into consideration (Myers, 1979). Fundamentally, all of the costs of developing gas and oil reserves, both successful and unsuccessful are depleted as output units which are recovered from the successful wells (Myers, 1979). This method is permitted by the Securities Exchange Commission but not favored by the FASB and is proposed as an inducement for the investigation of further oil and gas assets since charges related to failed exploration can be expensed over time rather than as incurred (Myers, 1979). The Securities Exchange Commission was in charge of regulating the oil industry as per the Energy Policy and Conservation Act of 1975. Shortly before this act, FASB had expressed interest of setting accounting standard to be used in the oil industry. For this reason, SEC relied on FASB for setting accounting standard for the oil industry. FASB then came up with the Exposure Draft the proposed to change the accounting method used in the industry (Lev, 1979). According to FASB, the full costing method was inappropriate as it did not reflect uniformity in the oil industry. FASB and the supporters of SE held that the SE was more adequate that FC (Lev, 1979). In support of SE, it was held that uniformity in the oil industry was necessary to upset the inconsistencies, non-comparability and the misunderstanding that existed in the capital markets (Tehranian & Reza, 2010). The result of this was perceived to boost competition for capital allocation. The FASB also held that many of the small players in the oil industry had used the SE method and did not seem to harm their ability to source for capital in the capital markets (Lev, 1979). The oil and gas companies reacted by spelling out the effects this change will have on the operation of the companies (Grove, Sunder & Mock, 1979). According to the stakeholders, the following were perceived as the effects: (i) A change to SE method will seriously depress the earnings and equity reported by the companies. The companies’ earnings could drop as a result of treating unsuccessful explorations as costs therefore profits were likely to decrease. The change was perceived to have an effect on investor decision due to decreased earning. (ii) The volatility of earnings could significantly increase over time. This would be observed from the FC method’s capitalization method where the earnings series is smoother. (iii) The change in accounting method to SE could encourage risk aversion in places where risks could have been taken. Firms will develop fear in exploring highly risky well as failure to get oil and gas could lead to big costs and decrease reported profits (Tehranian & Reza, 2010). The oil companies also perceived the change as unfavorable for smaller players in the industry as their ability to raise more capital from the capital markets would seriously be hindered. The small oil companies consequently could reduce their new exploration activities. This was likely to lower their competitive advantage in comparison to the well-established and bigger players in the oil industry (Tehranian & Reza, 2010). This change has no observable effect on the cash flows of companies as it does not directly affect operating activities, financing activities or the investment activities which form the components of a company’s cash flows (Lev, 1979). As early explained, a shift in the accounting system from full costing to successful efforts method could reduce the market value of companies’ earnings and share price. These two are the factors used to determine the value of the company. Hence a change in the cost accounting method is likely to reduce the market value of the company as a whole. LIFO-FIFO analysis LIFO Stands for Last-in-First-Out. It is an inventory accounting method where the last received inventory is sold first. FIFO on the other hand stands for First-In-First-Out. This is the reverse of LIFO. In this method, Goods received last are the first to be sold (Kokemuller, 2013). These two accounting method has an effect on cash flows as demonstrated in the example below: Take a company with inventory of 1000 units at $10 per unit as at 1st December. During the month purchases worth $14000 were made. This comprised of 2000 units at $7 per unit. 2300 units were sold during the month. Using FIFO method; cost of goods expenses account will be $19100; that is the opening stock worth $10000 + closing 1300 ? $7 per units for the purchased stock. Closing inventory will be 700 units at a cost of $7 = $4900. Using LIFO method; cost of goods expanse account will be $17000; that is 2000 units of the purchased stock at a price of $7 = $14000 then add the remaining 300 units at $10 per unit of the inventory in hand at 1st December = $300. The two methods will result in two different figures in the cash flow statement of the company involved due to the differences in the cost of goods sold expense account. The difference will lead to a different amount of profit or loss and therefore different amounts of tax will be paid depending on the costing method used. For a company shifting from FIFO to LIFO, it will be at an advantage of paying less tax due to lesser profit. For companies using FIFO, they will enjoy higher profits but pay more taxes (Johnson, 2013). Therefore, Shifting the between LIFO and FIFO has an effect on both the cash flows of a company and taxes paid compared to the sift form FC-SE which has no effect on the two (PWC, 2004). Why market value decreased Oil and gas companies using FC anticipated a real effect on their ability to fulfill their debt obligations, for instance, those that involved the debt-equity ratio. It was perceived that a swap from FC to SE could facilitate a write-off of investments and will thus reduce the firm's equity and hike the debt/equity ratio. FASB’s survey on companies' revelation in relation to the potential influence of the switch to the SE procedure, six FC users out of 92 players asserted that existing liability and other affirmations will require renegotiation (Tehranian & Reza, 2010). Other firms perceived the change to have had a real effect on their dividend policy. They held that volatility of earnings may require companies to increase ration of retained earnings and dividend payout rations in a bid to secure the company’s position against future losses (Grove, Sunder & Mock, 1979). The downward shift in stock prices was also attributed to the investor reaction from the information they received. Investors were informed by FC companies that the shift to SE had negative implications on future exploration activities. This had an effect on future high-risk explorations as companies could be required to expense all costs of unsuccessful explorations under SE. if this proposition could materialize, it was perceived to affect cash flows of oil and gas companies (Grove, Sunder & Mock, 1979). Earnings management is the manipulation of financial statements by managers within the accounting flexibility regulations (University of Southampton, 2013). Accounting policy changes may restructure the flexibility lengths and therefore affect the level and mode of earnings management (Martin, 2002). In some other cases, earnings management may be ruled out by new accounting policies with the view that it may provide misguiding information to investors (Zhou, 2006). Conclusion FASB is the accounting body responsible for setting accounting standards. Accounting policies are prepared in a bid to make transaction recording easier and enhance uniformity across the industries. As discussed in this paper, the accounting policy chosen seems to have an impact on both the financial records and the market value of the firms. Accounting policies may be seen to change the way historical transactions are recorded but they have been proved to hurt other business operations. Like the Exposure Draft, other policies set by FASB and other accounting regulators should first be analyzed through feasibility studies to determine their effectiveness. Evidence therefore has shown that different accounting policies affect the market value of firm’s share price and earnings and also affects earnings management. References Grove, D.H., Sunder, S. & Mock, J.T. (1979). “Response from The Exposure Draft On Qualitative Characteristics”. American Accounting Association. [online] Available at: http://faculty.som.yale.edu/shyamsunder/Research/Accounting%20and%20Control/Published%20Articles/17.Response%20to%20the%20Exposure/17.AAASubcom.Qualita.Charact.CommFinancialReport17.pdf (Accessed December 8, 2013) Johnson, J. (2013). “Impact on Financial Statement When Switching to LIFO form FIFO”. Chron . Available at: http://smallbusiness.chron.com/impact-financial-statements-switching-lifo-fifo-51234.html (Accessed December 8, 2013) Kokemuller, N. (2013). “What Are the Implications of Using LIFO and FIFO Inventory Methods?”. Chron. 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[online] Available At: http://www.google.co.ke/url?sa=t&rct=j&q=&esrc=s&source=web&cd=7&ved=0CGoQFjAG&url=http%3A%2F%2Fwww.lby100.com%2Fly%2F200806%2FP020080627325798658107.pdf&ei=iPqiUq--F-r_yAOUmIFo&usg=AFQjCNFsje5HQu3oFVLTND4JDZO7gP63VQ&sig2=cbcPtzaRhxkqEA61WfutzA&bvm=bv.57752919,d.bGQ (Accessed December 8, 2013) Read More