Alternative Methods of Accounting - Article Example

The accounting profession was formally founded in 1494 when the Father of Accounting, Luca Pacioli, introduced the double-entry system in the textbook Summa de Arithmetica, Geometria, Proportione et Proportionalite (Weygandt & Kieso & Kimmel, 2002). Accounting has always been a self regulated profession. After the 2nd half of the 20th century changes in accounting occurred due to the influence of private organizations such as the FASB. In the United States accountants followed the generally accepted accounting principles (GAAP) to guide their every day work. Accounting is a discipline that is very strict in its ways and does not welcome change well. In the aftermath of the Enron and WorldCom scandal the government had to force change with the creation of the Sarbanes Oxley Act of 2002 due to a lack of trust in financial information. Accounting is currently another challenge because many scholars and economist believe that accounting net income is not representative of actual reality. This paper discusses the advantages and cons of using alternative methods to determine the net income of a corporation. The efficient market hypothesis states that securities are typically in equilibrium and that they are fairly priced in the sense that the price reflects all publicly available information on each security (Besley & Brigham, 2000). Based on this theory investor’s look at all information to make their decision, thus the information on the financial statements is not the main source stakeholders focus on prior to making a decision. Despite the existence of this theory the truth is that people mostly look at the financial statements in order to make decisions concerning a common stock investment. The financial statement that people placed the most emphasis on is the income statement. This implies that net income is extremely important for making decisions. From an internal point of view the manager also places a lot of importance on net income. Stakeholders groups such as lenders, investors, business partners, and labor unions utilize net income as an important variable for decision making purposes. One of the problems with this metric is that most of the bonuses and additional compensation executives received are correlated with the net income. This scenario creates a conflict of interest and managers are tempted to manipulate accounting numbers by performing income smoothing. The solution many scholars believe is the best to solve the problem is to replace the traditional income statement with a statement of economic profit. Economic profit refers to the business profits minus the implicit costs of capital and any other owner provided income (Hirschey, 2006). Economic profit differs from net income in that it takes into consideration the cost of acquiring equity. The accounting profession does not place a cost on the acquisition equity, thus it does not take into consideration opportunity costs. An opportunity cost can be defined as a measure of the economic costs of using scarce resources to produce one particular good or service in terms of the alternatives thereby forgone (Credo Reference, 2010). The use of economic profits has helped managers improve their decision making. An industry that been positively influence by the use of economic value added (EVA) is the banking industry (Kimball, 1998). EVA is a metric that calculates the economic profits of a business. In the article The Transformation of the Corporation: Employee Capitalism the concept of EVA is presented as a way to measure the added value of investing in human capital. According to Peter Drucker economic value added provides companies with a measure of total factor productivity (Steward & Schonburg, 1999). The metric is utilized by financial analyst to evaluate the common stock price of a company. Economist believe that EVA is a better indicator of common stock value than other metrics commonly utilized by accountants such as return on equity, return on assets, and operating income. The mathematical formula to calculate EVA is EVA = NOPAT - capital charge or EVA = [Turnover –operating expenses – (average capital – cost of capital)] (Steward & Schonburg, 1999). Creating awareness and educating the employee about EVA can help companies meet their goals. A creative manager can create incentives based on EVA results to motivate employees to achieve a higher level of performance. “A proper calculation of EVA values spending on R&D and employee training; the kinds of long-term investments that help companies over time” (Geoff, 2010). The traditional metrics accountants have used such as ROE have given erroneous data to investors and managers that relied on the metric as an absolute truth. A few years ago Lehman Brothers had a very impressive ROE, but the company went out of business because executives over borrowed managing for ROE (Geoff, 2010). Two accounting concepts that are been used by scrupulous managers to manipulate income are bad debt reserves and deferred taxes. Both of these practices undermine the credibility of the accounting profession. The bad debt reserve is an allowance that is created to estimate the amount of uncollectible account receivables a firm will have during a year. Managers utilize this mechanism to inflate or deflate earnings at their convenience. The existence of bad debt reserves is a redundant practice that should be eliminated immediately. Bad debt should be treated as direct write-offs once they occur. Deferred taxes are another accounting practice that does not help improve the reputation of the accounting profession. The existence of deferred taxes occurs because there are different taxing rules that apply when filing a governmental tax return. Deferred taxes are an asset in a company’s balance sheet that can be used to reduce future income tax expenses (Investopedia, 2010). There are companies that every year keep accumulating and growing the deferred taxes account and never actually use it. The deferred tax asset increases the value of a corporation, but if the company never plans on using the deferred tax privileges then the asset in reality is worthless. A practice that is viewed as controversial by Mr. Steward is the utilization of the traditional straight-line depreciation method. The straight-line method divides the value of the equipment by the expected useful lifetime. The argument against the use of this method is based on the fact that most equipment suffers greater depreciation during its first years of use, thus normally depreciation is understated during the first years which increase net income. I don’t agree with Steward on the straight-line depreciation issue because managers do not make purchasing decisions to gain advantage from depreciation irregularities. Straight line depreciation is a simple and practical method whose purpose has never been to manipulate data. Depreciation also does not affect the cash flow of the firm. There are business projects such as strategic investments which cannot be properly evaluated using outdated financial metrics. A strategic investment is a project that produces insufficient earnings to cover the cost of capital in the early years, but will produce higher income in future fiscal years. The use of EVA is much better at accessing the value of these types of projects. A movement to switch from net income to economic income could have negative consequences. Investors currently believe a lot in the value of net income. According to Steward (2002) in the year 2001 the accumulative net income of the top 1000 public corporations in the world was $96 billion, a figure that if converted to economic profits could be $194 billion in losses instead. The majority of the users of financial information could not comprehend the existence of such losses. People are used to the traditional information they receive in the four basic financial statements. The revelation of an alternative view that depletes the value of the performance can cause chaos among investors. When the investor lost faith in the work of accountants after the revelation of various financial scandals at the turn of the century the only way people gain faith in the system was by the government intervening through Sarbanes-Oxley Act. In the theoretical scenario economic profit became norm instead of accounting if the public reacted against it there nothing the government could do to stop the panic. Thousands of investors could go on selling frenzy based on the new figures that deplete the income figures of public corporations. One of the proposals mentioned by Steward is to change the treatment of research and development from an expense into an investment. There is a reason why accountants do not believe research and development expenses are classified as an expense. The author’s claim does not make any logic based on the fact that companies invest millions of dollars a year on innovative ideas that never pay off. In the pharmaceutical industry for example it cost nearly $800 million to develop a new drug and only a portion of those drugs succeed in the marketplace. It would be unwise and improper to categorize R&D as an investment since so many of these types of disbursements end up being sunk costs. Currently the accounting disciple recognizes the value of innovation in the long run through a mechanism called goodwill. Goodwill is only quantified when a company is sold. Another similar proposal the author mentioned which made sense was giving value to intangibles. Intangibles that should be recorded as investment include training and development expenses, advertising of new products, and signing bonuses to recruit new talent (Steward, 2002, p.17). For example if a training program that cost $10,000 increases the sales of the company by $30,000 the training investment was worth triple its value. A controversy that exists in the accounting field is the treatment of stock option plans due to the fact that accounting treats this event as if it did not exist. The reason many businesspeople and scholars are so disgruntled as this event is that one of primary beneficiaries stock option are the chief executive officers and other top executives of corporations. The reality is that stock option grants should be expensed once exercise rights vest. Some companies have already taken a step forward towards brining changing to the accounting rules by voluntarily expensing stock option grants. Two of these corporations are Coca-Cola and The Washington Post (Steward, 2002). Currently the generally accounting principles state that information about stock option grants should be included as footnotes to the financial statements. I think it would be very beneficial for the profession to expense stock option plans. It is highly likely that the pay of corporate executives would go down if there was greater awareness about how a lot of these overpaid employees are benefiting. Excessive pay to executives is a major problem in corporate America. In the year 2000 the average CEO received 531 times more compensation than the average worker (Reh, 2010). The current practice of hiding stock option grants is overstating the income of corporations. Change is a part of life and in the business world it is constant that must be considered by managers in order to stay ahead of the competition. In the accounting profession change does not come easy. It took the world’s largest bankruptcy case and a series of other scandals in order for the governing bodies and the government to recognize accounting had major governance issues. The accounting profession must adapt to the realities and the needs of the managers and stakeholders of the 21st century. Traditional accounting profit is no longer a viable metric due to its inability to consider the cost of acquiring capital. When companies issue new shares of stock there is an opportunity cost of acquiring the capital that accounting is currently not measuring. There are also several other deficiencies in the accounting system such as treatment of bad debts, stock option plan treatment, and the existence of deferred taxes. A new metric that is better suited to evaluate the performance of companies is EVA. EVA can be used to calculate the economic profits of a business. Economic profits should be the new standard the accounting profession adapts to substitute net income. A change to economic profits will benefit all the major stakeholder groups. The change will increase the credibility and accountability of the accounting profession. References Besley, S., Brigham, E. (2000). Essential of Managerial Finance (12th ed.). Fort Forth: The Dryden Press. Credo Reference (2010). Opportunity Costs. Collins Dictionary of Economics. Retrieved February 9, 2010 from Credo Reference database. Geoff, C. (2010). “Many performance ratios lie about a company’s health. A new metric has emerged that can’t easily be gamed – and savvy investors and managers check it out.” Fortune 161 (1), 22. Investopedia.com (2010). Deferred Tax Asset. Retrieved February 11, 2010 from http://www.investopedia.com/terms/d/deferredtaxasset.asp Hirschey, M. (2006). Economics for Managers (India Edition). Australia: Thompson South Western. Kimball, R. (1998). Economic Profit and Performance Measurement in Banking. New England Economic Review. Retrieved February 10, 2010 from http://www.bos.frb.org/economic/neer/neer1998/neer498c.pdf Reh, J. (2010). CEOs are Overpaid. Retrieved February 11, 2010 from http://management.about.com/cs/generalmanagement/a/CEOsOverpaid.htm Steward, B. (2002). Accounting is Broken: Here’s How to Fix it. Stern Steward Research. Evaluation 5(1). Steward, S., Schonburg, J. (1999). The Transformation of the Corporation: Employee Capitalism. Stern Steward Research. Evaluation 4(1). Weygandt, J., Kieso, D., Kimmel, P. (2000). Accounting Principles (6th ed.). New York: John Wiley & Sons. Read More