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How accounting rules give companies control over the bottom line

Financial reports always look certain and objective. After all, they’re filled with cold hard numbers, right?

Six accounting tricks of the trade

Accounting rules provide a reporting company a lot of discretion in how you can report depreciation, inventory valuation and other items. Here are some examples of methods companies used this discretion:

FUTURE TAX PAYABLE

Canadian Natural Resources Ltd. last August reported a second-quarter loss by taking an upfront $579-million “deferred income tax charge” to take into account a hike within the provincial corporate tax rate to 12 per cent from 10 %. This specific charge was prudent given that the company will need to face the higher tax rate. However the move shows the way a company can exercise its discretion on this point.

REVENUE MATCHING

This was one of the problems that got Nortel Networks Corp. in trouble. Based on the U.S. Filing (SEC), Nortel “accelerated” revenue for 2000 by declaring it had received revenue for work it was contracted for but hadn’t yet completed. Nortel paid US$35 million to settle the SEC case in 2007 without admitting or denying the regulator’s charges.

ACCRUALS

The RCMP in 2008 charged three former executives from Nortel of using “earnings management” to rearrange the company’s finances so they could trigger bonuses. Specifically, prosecutors said hundreds of millions of dollars in accrued accounting provisions were improperly accustomed to recognize severance costs, contract liabilities along with other financial risks. After a year-long trial, they were ultimately acquitted of fraud by an Ontario judge in 2013. 

INVENTORY

In a proposed class-action lawsuit that is still in a very early stage and it is according to unproven allegations, plaintiffs claim BlackBerry Ltd. improperly used “sell-in” accounting to book revenue when BlackBerry 10 devices were shipped to distributors, rather than “sell-through,” which would have held off on booking the revenue before the devices were sold to end-users. BlackBerry later changed its inventory calculation accounting method to sell-through.

DEPRECIATION

Back in 2002, the SEC brought and settled a case that alleged Microsoft Corp. misstated amounts between July 1994 and June 1998 because, partly, it accelerated depreciation for some assets without a properly substantiated basis.

AMORTIZATION

There was plenty of accounting fraud in the Livent Entertainment Corp. of Canada case that ultimately sent company founders Garth Drabinsky and Myron Gottlieb to jail. Within the largest part of the scheme, Livent classified pre-production expenses as “capital investments,” then amortized them over time. The manipulations specified for to move expenses to specific reporting periods so as to overstate the company’s income.

But accounting rules give reporting companies lots of leeway in how they report certain numbers, such as depreciation, allowances for future taxes and inventory valuation and the effect isn’t small.

“The magnitude of the typical misrepresentation is very material – about 10 cents on every dollar,” say four U.S. professors who surveyed 375 chief financial officers relating to this issue. Their study, published in the newest issue of monetary Analysts Journal, also discovered that the CFOs believe 20 percent of companies in any given year intentionally fudge the numbers, albeit legally.

This isn’t always a bad thing, but it’s something all investors should understand, particularly those following a good investment strategy that connects a company’s stock price using its earnings performance.

“The issue with accounting is much more in how it’s understood by a less sophisticated user who may not know very well what it truly means,” said Aaron Wright, a charted professional accountant at Collins Barrow in Halifax.

Discretion over some items is needed to notice that sometimes their precise value isn’t available when companies prepare their financial reports. It’s easier to fill the space by having an estimate rather than disregard the item completely.

Sophisticated investors and market analysts are very well conscious of the issue. This is exactly why you’ll see stock analysts focus not on a company’s bottom line profit, but on its EBITDA – earnings or profit before subtracting tax, interest, depreciation and amortization.

Consider that tax number, for instance. A business will never find out what its actual tax liability is perfect for confirmed quarter or year until it has submitted its tax return and received an assessment back from the tax collector.

To the healthy skeptic, however, discretion opens the door to abuse. Take a look at those cases when a business has run afoul of regulators or been targeted inside a class-action lawsuit, and you’ll probably see that the issue boils down to allegations that the company took advantage of the rules.

Academics even have a term with this: earnings management.

In 2011, a professor at Washington University in St. Louis studied the financial outcomes of 20,000 U.S. companies and found evidence that number fudging continues to be rising over recent decades.

“You have to give managers some discretion plus some leeway for judgment so they can convey what’s really relevant concerning the company,” said Dan Thornton, who holds the Chartered Professional Accountants of Ontario Professorship at Queen’s University in Kingston, Ont.

“But whenever you provide them with that discretion, leeway and judgment, you open up the possibility that there’ll always be several bad apples who’ll abuse the privilege and then try to manipulate things for his or her own personal benefit.”

Experts are convinced that in the vast majority of cases, companies and accountants understand it properly. There may be differences of opinion on whether a business used the best accounting technique in a given situation, but those working with clean hands should have grounds to justify their decisions.

“You’ve got to notice that it’s human judgment,” said Errol Soriano, a md at Campbell Valuation Partners Ltd. in Toronto. “It can run from doing the very best you are able to but coming to a different number, to trying to manipulate your result when you are very aggressive in your interpretation of the rules. That’s the spectrum.”

Accounting rules are rooted in something called the matching principle. Managers who prepare financial reports are supposed to match the revenue the company receives with any related expenses, which is not as easy as it seems.

“Sometimes when you’re preparing statements for any given period, you’re attempting to give recognition to costs that you don’t have concrete numbers for yet,” Wright said. “You desire to make your best estimate of the items that cost is likely to are available in at, because maybe you’ve recognized revenue in this period and you just haven’t yet recognized all the related costs.”

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