© 2000 John Petroff
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© 2000 John Petroff |
2)- Impact of prior or future period events on current earnings, and excessive balance sheet items
The accrual method of accounting
reduces greatly the number of distortions that would come from
expenses that belong to prior or future periods. But there are
plenty that remain. In part that may be due to an accounting prohibition
of capitalizing expenses other than known prepaid expenses. But
for most part it is simply due to the impossibility of predicting
in which year a given expense will generate revenues, and consequently
assign the expense to that particular year. Many of these are
the same discretionary expenses just reviewed above, but here
they are listed for the amount that exceeds or falls short of
what is deemed necessary for the current year
- public relations advertising
- research and development
- maintenance and repair
- employee training
- write-offs
It is not suggested here that any of these expenses is not wise. In fact, these very same items will be further scrutinized for their impact on future earnings power later. But it is undeniable that earnings will be distorted compared to other companies that do not record similar expenses.
Another example of transfer of expenses
from one year to another is that of recognition of a significant
prior year adjustments. For very minor errors and omissions, the
corrections can be done through retained earnings without affecting
the income statement. When the adjustment is substantial, it appears
in the current year income statement, (even though for comparative
purposes prior year restatement would have been preferred). Here
are a few examples
- change in inventory accounting method requiring restatement
of some inventory items
- change in pension cost method increasing the liability of the
company
- collection of a substantial debt written off in a prior year
Recognition of prior year adjustment
is an admission that assets and liabilities should be other than
what appears in a given year balance sheet. To the extent that
the balance sheet items can be detected to be distorted (other
than by the mere effect of inflation), income statement items
will also be distorted. The following covers most cases.
a)- If liabilities are understated,
expenses will also be understated. For instance, if raw material
was purchased at an erroneously low price, account payable will
be understated, and so will cost of goods sold. Naturally if liabilities
are overstated, so will expenses and that would probably be of
greater concern.
b)- If current assets are understated,
revenues will be understated or expenses overstated, and visa
versa. For instance, a company that increases sales by selling
to insolvent clients, will show inflated revenues and accounts
receivable (i.e. an overstated current asset), but will also experience
larger future bad debt expense (i.e. an understated expense).
c)- If fixed assets are understated,
depreciation will be understated, as was previously noted. This
is also applicable for other depletable or amortizable assets.
See review questions Q-13A2.1 through Q-13A2.6.
See research assignment R-13A2.1.
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