1-Accounting

1)- Distortions due to accounting

Accounting principles are full of available alternative methods and estimations. Each of these can be challenged as a potential distortion, and similar companies do not necessarily use the same accounting alternatives or estimates.

In Russian traditional accounting there is much less variations between firms than in Western accounting because accounting is very tightly regulated. For instance, almost every possible asset is assigned a useful life by government promulgation. But there is actually much more distortion in Russian earnings because many events are not recorded in accounting at all, as it was shown in Chapter 6.

a)- Revenue recognition was discussed in Chapter 9 with a conclusion that just one method is often adopted by firms in one industry, but departures are possible.

b)- Cost of goods sold was also treated in Chapter 9. One will recall that the potential for distortions comes from inventory methods, and that this potential for distortions is substantial. Choice is available between standard costs and full absorption costs, between LIFO, FIFO and average costs, and between adjusting for lower of cost or market or not. LIFO is recommended in high inflation, and FIFO when inflation is moderate. But when should a firm switch from one method to another? That is up to each management. Moreover, when manufacturing is present, numerous expenses can justifiably be looked upon as either direct or overhead costs. Think of all the mixed costs, such as electricity, maintenance, cleaning expenses, to name only a few. Should keeping lights on in the workshop be considered a period cost (e.g. because lights have to be on anyway), or assigned as part of unit cost of production in that workshop? Both are right. It is up to management and accountants to decide.

Naturally, all costs reduce earnings regardless whether they are classified as direct or overhead, and whether they are capitalized in inventory or expensed as current year general overhead. But what needs to be investigated is whether a company that has lower cost of goods sold is actually more efficient in production, or is its unit cost the consequence of its accounting methods. Likewise, the question is whether the company with the higher cost really manufactures a better quality product that customers will prefer.

c)- Depreciation is another major source of distortions. First because there are different methods: straight line, declining balance, double-declining balance, sum-of-year digits. Although, straight line is preferred by most firms for financial statements and accelerated depreciation for income tax purpose, any firm can choose to use accelerated depreciation for financial statements. Second, useful lives of equipment are estimated by each firm with only scant guidelines from accounting rules. Moreover, depreciation depends on when the equipment was purchased. For instance, if one company replaces its equipment while another continues to use fully depreciated machines, the first one will have much lower earnings. Lastly, one recalls that recording fixed assets at their original cost causes a major understatement after a few years if inflation is present, and this carries over naturally to depreciation. On top of all that, different depreciation methods are used for different fixed assets, and neither the financial statements nor the explanatory notes ever give a breakout of the depreciation calculation. This makes depreciation one of the most - if not the most - accounting numbers to interpret. Does a higher depreciation relative to sales or assets really mean better equipment, or is it just the by-product of a more tax saving accounting strategy?

d)- Pension costs in the United States are calculated with two possible methods (discussed in Cahpter 11). In one of the methods (i.e. defined benefits), current year pension expense is based on a value of the assets in the pension fund and several estimates (e.g. retirement age, life expectancy). Even without any fraudulent intent, the estimates for retirement age, life expectancy, future return on fund assets and future salaries can be higher or lower than they should be. When different companies are compared, there is no reason to expect that each of the pension funds invests its assets in the same manner, or that employee vesting rights are defined in the same way. That means that the pension costs will vary.

Here again, one must question whether the company that has a relatively higher pension cost is actually provides its employees with a retirement security that the employees can appreciate, or is it merely an accounting artifice. An artifice that still has potential consequences on reported profits and therefore stock price. Both of these aspect deserve investigation.

e)- Discretionary expenses are numerous and give rise to possible errors of judgment or opportunity for income smoothing (which is dealt with later). Discretionary expenses are all the items that are not dictated by commercial reasoning, production requirements or accounting rules. Here is a partial list of some discretionary expenses
- provisions for bad debt, litigation or other potential losses
- employee bonuses, employee training, stock option plans
- charitable donations
- writing-off of equipment depreciating faster than expected, unsalable inventory, and many other prior year costs
- maintenance and repair
- insurance other than that for key employees and major assets
- research and development
- general and public relations advertisement

See review questions Q-13A1.1 through Q-13A1.16.

See research assignments R-13A1.1 and R-13A1.2.

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