The Accounting Policy - Essay Example

The Accounting Policy Choice Literature Introduction Accounts are the only source of statistical data related to performance of an enterprise during an accounting period. So there has always been a lot of emphasis on proper choice of accounting policies, since an alteration of accounting policies can have drastic impact on the Balance Sheet of an enterprise. Balance Sheet happens to be the only document available with external stakeholders of an enterprise, thus any shift in accounting policies which may radically alter the face of the Balance Sheet have always been under the scanner of experts in financial field. Over the years, experts have observed how opportunistic alteration of accounting policies have been done in areas of contract and political costs and how these opportunistic policy changes have been effected to favor either the management or the organization as a whole. Opportunistic Choice of Accounting Policy in Contracts Watts and Zimmerman (Watts, R. and J. Zimmerman, 1986) did semantic studies in opportunistic choice of accounting policies adopted by management to alter Balance Sheet figures to suit specific objectives and it must be mentioned not all of which are always geared towards maximizing shareholder wealth. The most glaring example of such opportunistic choice of accounting policy is found in the zone of contracts. A contract is made between an agent and a principal and if the outcome of financial results has a direct bearing on the income of an agent, there is every possibility that the agent might try to modify the financial result in such a way that increases the agent’s income. Two forms of contracts that depend entirely on financial information are management remuneration contract and those entered into with banks and other financial institutions while signing a loan agreement. One must appreciate that it is impossible to foresee all possibilities and build in preconditions which will effectively preclude any opportunistic choice of accounting policies in future to provide undue advantage to any of the contracting parties. Managerial Remuneration Contracts Holthausen and Leftwich had done extensive empirical studies (Holthausen, R.W., & Leftwich, R.W., 1983) to draw a conclusion that more often than not mangers are more prone to make an opportunistic choice of accounting policies or show creativity in accounting, as Kamal Naser preferred to describe it, if such creativity increased their personal wealth in place of the shareholders’. If management remuneration includes a clause of profit sharing, then, other things remaining constant, managers are more likely to include future earnings in current year’s income. Also the timing of declaration of financial results has a big role to play in determining management bonuses. A glaring example of such “creativity” was on display in January 1991 when Westinghouse announced massive unaudited earnings of $1 billion for the year and top management helped themselves to huge bonuses. Then, right in the next month, the company announced an equally huge write-off of $975 million of bad debts thus reducing audited profits substantially. There was nothing illegal in it, but top management furthered its own interest at the cost of shareholder wealth and is till date one of the classic examples how opportunistic top management might be. (Schroeder, M. and Spiro, L.N., 1992) While on the issue of contracts, another example may be cited to further highlight how creative accounting policies are adopted to deny rightful share of stakeholders in organizational profit. Several film companies in USA have gained infamy for excessively increasing expenditure related to a film if it becomes successful in box office. Such a hike obviously decreases accounting profit and thus all the other stakeholders of the film as the actors, scriptwriters, lyricists whose contact include a share of profit end up with hardly anything. The accountants of those film companies are known to charge excessively high depreciation rates, drastically reduce the value of closing inventory and even include contingent liabilities while calculating expenditure. (Grover, 1991) Debt Contracts (Bank Loan Agreements and Debenture Trust Deeds) Debenture Trust Deeds Let us first discuss how choice of opportunistic accounting policies can affect Debenture Trust Deeds. Here the debenture holders assume the position of principal while shareholders, rather managers working on behalf of shareholders, assume the role of agents. The total value of a firm is dependent on the sum of debt and equity and by ‘trading on equity’ a manager can legally increase the earnings per share. Trading on equity is not that complicated a procedure. A manager increases the quantum of debt in the capital structure of firm and as interest on debentures is a taxable expenditure, records a low profit. But the number of equity shareholders is also low. So, even if the numerator becomes less, the denominator also remains less and the earning per share, calculated by dividing the residual profit with number of equity shares, returns a higher figure. But such an increase of debt gives rise to another problem which is discussed in Bank Loan Agreements section below. Bank Loan Agreements Almost all bank loan agreements lay down a limit to the quantum of debt present in the capital structure of a firm. Managers, in an effort to trade on equity and increase earnings per share, often hover around the danger mark. In such situations, mangers tend to choose accounting policies which attempt to include estimated future income stream in current year’s earning. Or, in extreme cases, even arrange for finance which will not appear as liability in the Balance Sheet. While on this topic, it would be worthwhile to recall an incident where change in accounting policies caused several firms to face immense problems with loan agreements. When FASB in USA decreed income from extended warranties should be spread over the duration of warranty period instead of considering it at the time of sale, consumer electronics retailers who had built up huge stocks through bank loans just did not know how to conform to the financial ratio requirements stipulated by bank loan agreements. Political Costs Too high a profit obviously attracts government and regulatory attention and almost always results in higher taxes or levies. In USA, pharmaceutical companies have been closely scrutinized right since 1992 Presidential campaign as healthcare became an ever important agenda for candidates from both Republican and Democratic camps. High profits of pharmaceutical companies have become a hot topic of discussion since then. These companies have felt the heat of high political costs and have resorted to abundant creativity in trying to reduce profits. Pharmaceutical companies have tried out various inventory valuation methods in their efforts to reduce the value of closing stocks. The most common weapon used by them was the variance between LIFO and FIFO method of valuation, choosing the one which suited them most at that particular juncture. They also altered their accounting policy of recognizing a debt as bad and increased the volume of bad debt expenses in Profit and Loss Account. The other policy change was the method by which depreciation was calculated. By shifting from written-down-value method to the straight line option the quantum of depreciation was increased and that was not the end. The assets were revalued upwards and their useful life was reduced, thus ensuring a sizeable lowering of profits. It might be mentioned it is not only the pharmaceutical companies but also the oil giants and even cable TV companies have felt political heat in recent times. Profit Smoothing Profit smoothing has been resorted to by almost all corporate houses at some point of time or the other. It is a general tendency of companies to report a smooth increase in profits year after year rather than showing high profits in good years and not so good results during rough periods. This also helps shareholders as share prices tend to be high for those companies who report steady profits year after year – investors as a clan are averse to volatility. This is achieved by creating large provisions for liabilities and also asset values during good years and reducing those provisions in years where the going is not so good. Microsoft also resorts to profit smoothing just to ensure profits forecast by the management at the beginning of the accounting period tally with actual profits. This not only creates an aura of invincibility around the organization but also helps it in predicting future profits with a high degree of accuracy. What the company does is to create large provisions for possible upgrades and customer service costs that might occur in future. This is a perfectly legal accounting policy and in keeping with the time honored tradition of accounting conservatism. (Fox, 1997, July) Big Bath accounting strategy This is a strategy adopted by some corporate houses when the going is particularly rough. If the financial results are not good in a particular year, and managers whose incomes are related to profits realize no amount of creativity can improve the situation, they do something which is exactly the opposite. Instead of trying to shore up the profits, they reduce it even further (it really does not matter by how far the target has been missed while bonuses are calculated) and make the picture look worse than it actually is. The idea behind such an action is to make even modest future profits look much better than they actually are. References Fox, J. (1997, July). Learn to play the Earnings Game. Fortune , 31. Grover, R. (1991). Curtains for tinsel town accounting? Business Week, 3 June , 138. Holthausen, R.W., & Leftwich, R.W. (1983). The Economic consequences of accounting choice: Implications of costly contracting and monitoring. Journal of Accounting and Economics, 5 , 77-117. Schroeder, M. and Spiro, L.N. (1992). Does everything add up at Westinghouse Credit? Business Week, 11 May , 80-83. Watts, R. and J. Zimmerman. (1986). Positive Accounting Theory. New Jersey: Prentice-Hall. Read More