Ever
since the unethical actions of some employees of Enron Corp. first came to
light, ethics in accounting has been in the news with increasing frequency. The
unethical actions of the employees essentially involved their selection of
certain accounting policies for the company.
In
many instances, GAAP does allow firms some flexibility in their choice of
legitimate accounting policies. This is true, for example, in choosing an
inventory cost formula. However, the company’s choice of policies may ultimately
be influenced by several specific factors.
Instructions
State
three of these factors and explain why each of them may influence an accounting
policy choice.
1. Management
incentive plans. In many large
companies, management remuneration packages provide a salary, cash bonuses
based on net income or other performance variables, and stock incentives based
on share price performance. Common shares are offered to managers based on
share price performance to try to align the long-term interests of the firm’s
shareholders and managers. The cash bonus is often based on a percentage of
income once a target is reached. In some cases, once net income rises above a
certain ceiling, no further bonus is paid. This practice provides a great
incentive to keep income between the target and the ceiling. That is, managers
of units with income above the ceiling would be motivated to pick accounting
policies that carry forward “surplus” earnings to the next period.
2. Lending
covenants. Long-term lending contracts often include
covenants to protect the lender from observable actions by the borrower that
are against the lender’s interests, such as additional borrowing or excessive
dividend payments. Covenants are often based on ratios such as working capital,
times interest earned, debt to equity, and so on. Violation of a debt covenant
puts the borrower in default of the loan contract; the lender can demand
repayment or, more commonly, renegotiate terms and conditions, including
interest rates. Firms affected by these covenants try to select accounting
policies that improve critical ratios.
3. Political
motivation. Is it possible to report too much
income? If a firm is politically visible (usually because of size, the nature
of the business, or because of a government-awarded monopoly), high levels of
return are potentially undesirable. High profits attract attention and may
create enough dissatisfaction and political unrest to cause the government to
regulate some aspect of the business or intervene in another fashion. Such firms
would rather minimize reported accounting income at levels that provide
(barely) satisfactory levels of return to creditors and investors.
4. Taxation. Reduction of income to lower tax payments is an
obvious motivation for accounting policy choice. Remember, though, that there
are extensive provisions in the Income
Tax Act requiring the use of certain accounting methods for tax purposes,
regardless of the accounting policy choice made for external reporting; thus,
firms may have little room to manoeuvre.
5. Contracts. Legal agreements often refer to data (numbers) in
(audited or unaudited) financial statements. For instance, an agreement may
specify that “net income” is to be allocated in a variety of ways or that “book
value” of equity (or a multiple thereof) is to be used to establish a buy-out
price when a partner retires or a new partner admitted. In these circumstances,
there is considerable contractual motivation to manipulate income and book
value. How can the contracting parties make sure that manipulation does not
lead to inappropriate valuation? Specifying that GAAP must be followed is a
first step. However, there are areas of accounting policy where GAAP allows for
acceptable alternative methods.
