LOS H requires us to:
describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items
Some of the important methods are:
1. Revenue Recognition
a. The recognition of revenue may differ from firm to firm based on the timing of its recognition. The firm may enter into a contract with the customer with terms of free-on-board (FOB) at either source or at the destination. If the contract is to provide FOB at source, the ownership of the goods sold transfers to the purchaser at the source itself, and revenues are recognized sooner, otherwise, it transfers at the destination.
b. In order to manage the timings of revenue recognition, a firm may also resort to channel stuffing, where the firms offer end of season’s discounts to encourage sales. It may also overload the distribution channel by shipping the goods without order.
c. The company may also reduce or increase the allowance for sales return, which is easy to justify but difficult to question.
d. The companies may also enter into bill-and-hold transactions. Under these transactions, the companies invoice and sell the goods, but do not ship the same to the customers. These transactions may be undertaken at the year-end to increase the recognizable revenues during the reporting period.
e. The companies may also have an alternate presentation of revenue to be recognized by changing the estimates of rebate fulfillment or allocation across multiple deliverables.
f. By taking such steps, the companies may defer the revenues during the high earnings periods. This is also called earnings smoothening, which reduces the volatility of earnings.
2. Depreciation Policies of Long-Lived Assets
The companies may choose alternative useful lives, salvage values, depreciation methods, etc. to manage their earnings.
3. Capitalization Policies Relating to Intangibles
a. The companies may choose between capitalizing a cost versus expensing the same.
b. At the time of acquisition, the companies may choose low fair values to value the assets, this will result in lower depreciation in the future years and higher goodwill (which is not generally amortized).
c. The goodwill may not be acknowledged for impairment.
4. Inventory Cost Methods
a. The companies may choose to change the reserves for obsolescence of inventory to manage earnings.
b. During inflationary periods the companies may go for LIFO liquidation to decrease the profits.
c. The companies may choose from amongst the different methods for valuation of inventories according to their needs (as discussed in the chapter on inventories).
5. Deferred Tax Assets & Valuation Account
a. For deferred tax assets to be carried on the balance sheet, there must be a reasonable expectation of its recovery (i.e. there should be possibilities of positive earnings in the future).
b. The management’s commentary may be altered to assure such ‘reasonable expectation’.
6. Others
a. The companies may alter the amounts of reserves for warranty etc. to manage their earnings.
b. The companies can also use related party transactions to absorb their losses.
7. Choices Affecting Cash Flow Statement
Some of the choices that may affect the cash flow statements are:
a. misclassifying the cash flows (in operating, investing, and financing activities),
b. stretching the payables (especially at the year-end),
c. taking full advantage of available flexibility.