Reference no: EM13879282

This case demonstrates the flexibility management has in determining Net Income under Generally Accepted Accounting Principles (GAAP).  Most courses dealing with Financial Accounting present the student with technical material, and focus on applying GAAP as though management exercises no subjective input in the process.  The present case forces students to re-think this assumption and to learn how much leeway management really has in applying GAAP rules.  After completing this case, students see that there is a substantial range of potential reported Net Income amounts, depending upon the estimates and assumptions they select.

INTRODUCTION

Do earnings lie? An unequivocal "YES" may seem too strong an answer, but there are many grey areas surrounding management's choice of the timing and amount of items reported on their company's Income Statement and Balance Sheet. These choices can lead to very different outcomes, even though such accounting is perfectly legal and is in accordance with Generally Accepted Accounting Principles (GAAP).  Many investors assume that financial accounting has rules that are set in stone, and that it is an exact discipline with only one correct answer.  In reality, this statement cannot be further from the truth. 

GAAP allows management to choose between methods of accounting for certain assets (e.g., LIFO vs. FIFO inventory method, alternative depreciation methods for fixed assets, and lease-accounting).  Furthermore, there are many areas where management must make estimates (e.g., the allowance for bad debts for products sold on credit, estimation of useful lives of long-term physical assets for depreciation, and impairment of intangible assets with indeterminable useful lives).  Collectively, the estimates, assumptions and accounting choices made by managers can lead to markedly different reported Net Income numbers, and different carrying values for assets, liabilities and equity, all of which can misrepresent/mislead financial statement users as to a company's financial situation or how well it is performing (Easton, et.al., 2011, p.1-19). 

It is fairly well established that corporate management is under pressure to deliver the kind of results that impress different company stakeholders.  Share prices react strongly to the sign of the change in earnings, managers are under pressure to ensure earnings increase and/or meet beat analysts' forecasts for their own personal wealth gain (Nichols and Wahlen, 2004).  Shareholders, for instance, want a good (realized) return on equity number that surpasses their marginal required return on equity.  Wall Street Analysts, who provide buy/sell/hold recommendations for the stock, in part base their analyses on corporate financial statements and what they imply for share-pricing.  The impressions of each of these groups influence share prices and thereby affect managers' performance evaluations and wealth as well as the firm's cost of capital. Credit rating agencies monitor a number of company financial indicators obtained from the financial statements to develop their ratings of outstanding corporate debt.  These ratings have direct consequences for determining the future cost of borrowing for the company and, ultimately, its future capital investment spending and growth.

This case presents a teaching approach that is more comprehensive than what commonly appears in accounting textbooks.  The aim is to have students experience how a situation that appears to involve clearly- and unambiguously-stipulated GAAP, can result in more than one method of application with more than one correct answer leading to very different end results and conclusions about a company's financial performance.  To understand the demonstrations given in this case, students are expected to possess a basic understanding of concepts learned in Intermediate Accounting I and II, which accounting majors typically take in their junior year.  The case demonstrates that even in a relatively simple context, there is no one correct "answer" but rather a multitude of potential correct income values.  This wide dispersion of answers leads to equally diverse implications for the perceived financial performance of a company.  An additional benefit of the case is that students can treat it as a simulation tool in which they vary assumptions and estimates, and witness firsthand how all variables, individually and collectively, affect the reported bottom-line Net Income number.  The points illustrated in this case are very often overlooked or mentioned in passing in textbooks that seem more interested in teaching GAAP rules in a static environment rather in a dynamic and interactive one.

DEVELOPMENT OF THE CASE

 

In this case, students acting in two contrasting roles, make decisions regarding the selection of accounting methods and estimates.  The first role is that of an aggressive manager who wishes to increase income, the second a conservative manager who wishes to avoid overstating income.  The case at hand requires students to make decisions about: (a) estimates of uncollectible accounts, (b) useful lives of physical assets,  (c) selection of inventory valuation methods (LIFO versus FIFO), and (d) selection of depreciation methods (straight-line versus declining balance),.  The case is conducted in a dynamic and an interactive way that imparts realism to the exercise.  We believe that this case offers students very useful and interesting insights, and proves to be a valuable learning tool not only for undergraduate accounting majors, but also for students pursuing a Master's in Accounting or an MBA with an Accounting concentration. 

Below is a hypothetical Unadjusted Balance Sheet and Income Statement for the year ended December 31, 2012.  Additional information is provided allowing students to prepare both an Adjusted Balance sheet and Income Statement making decisions under different sets of assumptions based on their assigned role:

 

BALANCE SHEET

AT DECEMBER 31, 2012 (UNADJUSTED)

ASSETS:

 

LIABILITIES:

 

Current  assets:

 

Current liabilities:

 

  Cash

$19,740

  Accounts payable

$50,468

  Accounts receivable (less allowance)

24,039

  Unearned revenue

10,000

  Inventory

1,569,500

 Total current liabilities

60,468

  Prepaid Insurance

24,000

  Long-term liabilities:

 

Total current assets

1,637,279

  Notes Payable

250,000

 

 

 Total Liabilities

310,468

Long-term assets:

 

 

 

Property and equipment

500,000

STOCKHOLDERS' EQUITY:

 

  Less: accumulate depreciation

-0-

Common stock, no par

251,676

Total long-term assets

500,000

Retained Earnings

1,575,135

 

 

Total Stockholders' equity

1,826,811

TOTAL ASSETS

$2,137,279

TOTAL LIAB. AND EQUITY

$2,137,279

 

INCOME STATEMENT

FOR THE YEAR-ENDED DECEMBER 31, 2012 (UNADJUSTED)

Sales

$2,233,109

Less: selling and admin expenses

655,974

           Rent expense

2,000

  NET INCOME

$1,575,135

 

Additional Information:

* Prepaid Insurance was paid on January 1, 2012.  The policy offers coverage for two years.

* Unearned Revenue represents a deposit received from a customer on December 20, 2012.  The customer has received part of the order.  One item costing $2,000 is on backorder and has not been shipped to the customer yet.

* A one-year Note Payable for $250,000 was obtained on September 1, 2012.  The interest rate is 8%.  All principal and interest are due on September 1, 2013.

* The gross amount of Accounts Receivable totaled $24,039.  (The firm's credit policy requires payment within 60 days). Industry guidelines indicate uncollectible accounts are generally in the range of 1 to 12% of the ending accounts receivable balance. (Note that management very often sets percentages based on an aging schedule, not just on the total accounts receivable balance, but for ease of presenting solutions these percentages will be used).

 

* The company uses Straight-Line Depreciation for its Plant and Equipment.  Plant and Equipment costs consist of the following:

            Building          350,000 (range 30 to 40 years)

            Furniture         130,000 (range 10 to 20 years)

            Computers         20,000 (range 2 to 5 years)

            TOTAL           500,000

 

 

* Inventory costs are as follows:

Purchase Date

Units

Unit price

Total price

1/1/12

500

385

192,500

3/1/12

400

415

166,000

5/1/12

700

450

315,000

8/1/12

500

490

245,000

10/1/12

600

525

315,000

12/1/12

600

560

336,000

 

3,300

 

1,569,500

Units sold

2,900

 

 

Units left

REQUIREMENTS OF THE CASE

Task:  Prepare an adjusted Income Statement and Balance Sheet.  Use a statutory tax rate of 35% to record income taxes payable and income tax expense.

If you are an aggressive manager you should use aggressive estimates and attempt to report the highest Net Income possible since:

            •           Management may receive higher bonuses based on favorable financial results.

            •           If reported Net Income is above analyst's expectation of net income, then share price may increase and management's stock options and stock holdings will increase in value.  However, if reported earnings are below expectations investors are disappointed and stock prices may fall (Brown and Caylor, 2005).

            •           Management may have minimum ratios to maintain according to debt covenants in their borrowing agreements.  This gives them an incentive to manage income in order to avoid debt-covenant violations.

If you are a conservative manager you should use conservative estimates and attempt to avoid overstating results for shareholders and potential investors since:

            •           The market may value more conservative earnings numbers.  Aggressive earnings management is unsustainable in the long run.

            •           The new CEO may be shifting costs to the current period from the future periods in order to record less expense and report higher income in future years. This allows the new management to blame poor current performance on prior management and take a "big bath" (rid the Balance Sheet of costs that would otherwise be experienced in the future).