A company starts operations with no inventory at the beginning of a fiscal year and makes purchases of a good for resale five times during the period at increasing prices. Each purchase is for the same number of units of the good.
The purchases, and the cost of goods available for sale, appear in the following table. Notice that the price per unit has increased by 140 percent by the end of the period.
Accounting Choices and Estimates 355
Units Price Cost
Purchase 1 5 USD100 USD500
Purchase 2 5 150 750
Purchase 3 5 180 900
Purchase 4 5 200 1,000
Purchase 5 5 240 1,200
Cost of goods avail-
able for sale USD4,350
During the period, the company sells, at USD250 each, all of the goods purchased except for five of them. Although the ending inventory consists of five units, the cost attached to those units can vary greatly.
1. What are the ending inventory and cost of goods sold if the company uses the FIFO method of inventory costing?
Solution:
The ending inventory and cost of goods sold if the company uses the FIFO method of inventory costing are USD1,200 and USD3,150.
2. What are the ending inventory and cost of goods sold if the company uses the weighted-average method of inventory costing?
Solution:
The ending inventory and cost of goods sold if the company uses the weight- ed-average method of inventory costing are USD870 and USD3,480.
3. Compare cost of goods sold and gross profit calculated under the two methods.
Solution:
The following table shows how the choice of inventory costing methods—
FIFO versus weighted average—affects the cost of goods sold and gross profit.
Cost Flow Assumption FIFO Weighted Average
Cost of goods available for sale USD4,350 USD4,350
Ending inventory (5 units) (1,200) (870)
Cost of goods sold USD3,150 USD3,480
Sales USD5,000 USD5,000
Cost of goods sold 3,150 3,480
Gross profit USD1,850 USD1,520
Gross profit margin 37.0% 30.4%
Note: Average inventory cost is calculated as Cost of goods available for sale/Units purchased =
$4,350/25 = $174. There are five units in ending inventory, yielding an inventory value of $870.
Depending on which cost flow assumption the company uses, the end-of-period inventory is either USD870 (under the weighted-average method) or USD1,200 (under FIFO). The choice of method results in a dif- ference of USD330 in gross profit and 6.6 percent in gross profit margin.
The previous example is simplified and extreme for purposes of illustration clar- ity, but the point is important: Management’s choice among acceptable inventory assumptions and methods affects profit. The selection of an inventory costing method is a policy decision, and companies cannot arbitrarily switch from one method to another. The selection does matter to profitability, however, and it also matters to the balance sheet.
In periods of changing prices, the FIFO cost assumption will provide a more current picture of ending inventory value, because the most recent purchases will remain in inventory. The balance sheet will be more relevant to investors. Under the weighted-average cost assumption, however, the balance sheet will display a blend of old and new costs. During inflationary periods, the value of the inventory will be understated: The company will not be able to replenish its inventory at the value shown.
At the same time, the weighted-average inventory cost method ensures that the more current costs are shown in cost of sales, making the income statement more relevant than under the FIFO assumption. Trade-offs exist, and investors should be aware of how accounting choices affect financial reports. High-quality financial reporting provides users with sufficient information to assess the effects of accounting choices.
Estimates abound in financial reporting because of the use of accrual accounting, which attempts to show the effects of all economic events on a company during a particular period. Accrual accounting stands in contrast to cash basis accounting, which shows only the cash transactions conducted by a company. Although a high degree of certainty exists with reporting only cash transactions, much information is hidden. For instance, a company with growing revenues that makes the majority of its sales on credit would be understating its revenues for each period if it reported only cash transactions. On an accrual basis, revenues reflect all transactions that occurred, whether they transacted on a cash basis or credit-extended basis. Estimates enter the process because some facts related to events occurring in a particular period might not yet be known. Estimates can be well grounded in reality and applied to present a complete picture of the events affecting a company, or they can be management tools for achieving a desired financial picture.
To illustrate how estimates can affect financial reporting, consider sales made on credit. A company sells USD1,000,000 of merchandise on credit and records the sale just before year end. Under accrual accounting, that amount is included in revenues and accounts receivable. The company’s managers know from experience that they will never collect every dollar of the accounts receivable. Past experience is that, on average, only 97 percent of accounts receivable is collected. The company would esti- mate an amount of the uncollectible accounts at the time the sales occur and record an uncollectible accounts expense of USD30,000, lowering earnings. The other side of the entry would be to establish an allowance for uncollectible accounts of USD30,000.
This allowance would be a contra asset account, presented as an offset to accounts receivable. The accounts receivable, net of the allowance for uncollectible accounts, would be stated at USD970,000, which is the amount of cash the company ultimately expects to receive. If cash-basis accounting had been used, no revenues or accounts receivable would have been reported even though sales of merchandise had occurred.
Accrual accounting, which contains estimates about future events, provides a much fuller picture of what transpired in the period than pure cash-basis accounting.
Yet, accrual accounting poses temptations to managers to manage the numbers, rather than to manage the business. Suppose a company’s managers realize that the company will not meet analysts’ consensus estimates in a particular quarter, and further, their bonus pay is dependent on reaching specified earnings targets. By offering special payment terms, or discounts, the managers may induce customers to take delivery of products that they normally would not order, so they could ship the products on FOB shipping point terms and recognize the revenues in the current quarter. They could even be so bold as to ship the goods under those terms even if the customer did
Accounting Choices and Estimates 357
not order them, in the hope that the customer would keep them or, at worst, return them in the next accounting period. Their aim would be to move the product off the company’s property with FOB shipping point terms.
To further improve earnings in order to meet the consensus estimates, the compa- ny’s managers might revise their estimate of the uncollectible accounts. The company’s collection history shows a typical non-collection rate of 3 percent of sales, but the managers might rationalize the use of a 2 percent non-collection rate. This change will reduce the allowance for uncollectible accounts and the expense reported for the period. The managers might be able to justify the reduction on the grounds that the sales occurred in a part of the country that was experiencing an improved economic outlook, or that the company’s collection history had been biased by the inclusion of a prolonged period of economic downturn. Whatever the justification, it would be hard to prove that the new estimate was completely right or wrong until time had passed. Because proof of the reliability of estimates is rarely available at the time the estimate is recorded, managers have a readily available means for manipulating earnings at their discretion.
ConAgra Foods Inc. provides an example of how the allowance for uncollectible accounts may be manipulated to manage earnings.21 A subsidiary, called United Agri-Products (UAP), engaged in several improper accounting practices, one of them being the understatement of uncollectible account expenses for several years. Exhibit 16 presents an excerpt from the SEC’s Accounting and Auditing Enforcement Release.
Exhibit 16: SEC’s Accounting and Auditing Enforcement Release Regarding United Agri-Products
Generally, UAP’s policy required that accounts which were past due between 90 days and one year should be reserved at 50%, and accounts over one year past due were to be reserved at 100%.
… In FY 1999 and continuing through FY 2000, UAP had substantial bad debt problems. In FY 2000, certain former UAP senior executives were informed that UAP needed to record an additional $50 million of bad debt expense. Certain former UAP senior executives were aware that in FY 1999 the size of the bad debt at certain IOCs had been substantial enough that it could have negatively impacted those IOC’s ability to achieve PBT (profits before taxes) targets. In addition, just prior to the end of UAP’s FY 2000, the former UAP COO (chief operating officer), in the presence of other UAP employees, ordered that UAP’s bad debt reserve be reduced by $7 million in order to assist the Company in meeting its PBT target for the fiscal year.
… At the end of FY 2000, former UAP senior executives reported financial results to ConAgra which they knew, or were reckless in not knowing, overstated UAP’s income before income taxes because UAP had failed to record sufficient bad debt expense. The misconduct with respect to bad debt expense caused ConAgra to overstate its reported income before income taxes by $7 million, or 1.13%, in FY 2000. At the Agricultural Products’ segment level, the misconduct caused that segment’s reported operating profit to be overstated by 5.05%.
Deferred-tax assets provide a similar example of choices in estimates affecting the earnings outcome. Deferred-tax assets may arise when a company reports a net operating loss under tax accounting rules. A company may record a deferred-tax asset based on the expectation that losses in the reporting period will offset expected future
21 Accounting and Auditing Enforcement Release No. 2542, “SEC v. James Charles Blue, Randy Cook, and Victor Campbell,) United States District Court for the District of Colorado, Civ. Action No. 07-CV-00095 REB-MEH (17 January 2007).
profits and reduce the company’s future income tax liability. Accounting standards require that the deferred tax asset be reduced by a “valuation allowance” to account for the possibility that the company will not be able to generate enough profit to use all of the available tax benefits.22
Assume a company loses EUR1 billion in 2012, generating a net operating loss of the same amount for tax purposes. The company’s income tax rate is 25 percent, and it will be able to apply the net operating loss to its taxable income for the next 10 years. The net operating loss results in a deferred tax asset with a nominal value of EUR250 million (25% × EUR1,000,000,000). Initial recognition would result in a deferred tax asset of EUR250 million and a credit to deferred tax expense of EUR250 million. The company must address the question of whether or not the EUR250 million will ever be completely applied to future income. It may be experiencing increased competition and other circumstances that resulted in the EUR1 billion loss, and it may be unreasonable to assume it will have taxable income against which to apply the loss. In fact, the company’s managers might believe it is reasonable to assume only that it will survive for five years, and with marginal profitability. The EUR250 million deferred tax asset is thus overstated if no valuation allowance is recorded to offset it.
The managers believe that only EUR100 million of the net operating losses actually will be applied to the company’s taxable income. That belief implies that only EUR25 million of the tax benefits will ever be realized. The deferred tax assets reported on the balance sheet should not exceed this amount. The company should record a valuation allowance of EUR225 million, which would offset the deferred tax asset balance of EUR250 million, resulting in a net deferred tax asset balance of EUR25 million. There also would be a EUR225 million credit to the deferred tax provision. It is important to understand that the valuation allowance should be revised whenever facts and circumstances change.
The ultimate value of the deferred tax asset is driven by management’s outlook for the future—and that outlook may be influenced by other factors. If the company needs to stay in compliance with debt covenants and needs every euro of value that can be justified by the outlook, its managers may take a more optimistic view of the future and keep the valuation allowance artificially low (in other words, the net deferred tax asset high).
PowerLinx Inc. provides an example of how over-optimism about the realizability of a deferred tax asset can lead to misstated financial reports. PowerLinx was a maker of security video cameras, underwater cameras, and accessories. Aside from fraudu- lently reporting 90 percent of its fiscal year 2000 revenue, PowerLinx had problems with valuation of its deferred tax assets. Exhibit 17 provides an excerpt from the SEC’s Accounting and Auditing Enforcement Release with emphasis added.23
Exhibit 17: SEC’s Accounting and Auditing Enforcement Release Regarding PowerLinx
PowerLinx improperly recorded on its fiscal year 2000 balance sheet a deferred tax asset of $1,439,322 without any valuation allowance. The tax asset was mate- rial, representing almost forty percent of PowerLinx’s total assets of $3,841,944.
PowerLinx also recorded deferred tax assets of $180,613, $72,907, and $44,921, respectively, in its financial statements for the first three quarters of 2000.
22 See Accounting Standards Codification (ASC) 740-10-30-16 to 25, Establishment of a Valuation Allowance for Deferred Tax Assets.
23 Accounting and Auditing Enforcement Release No. 2448, “In the Matter of Douglas R. Bauer, Respondent,”
SEC (27 June 2006), www .sec .gov/ litigation/ admin/ 2006/ 34 -54049 .pdf.
Accounting Choices and Estimates 359
PowerLinx did not have a proper basis for recording the deferred tax assets.
The company had accumulated significant losses in 2000 and had no historical operating basis from which to conclude that it would be profitable in future years. Underwater camera sales had declined significantly and the company had devoted most of its resources to developing its SecureView product. The sole basis for PowerLinx’s “expectation” of future profitability was the purported $9 million backlog of SecureView orders, which management assumed would gen- erate taxable income; however, this purported backlog, which predated Bauer’s hiring, did not reflect actual demand for SecureView cameras and, consequently, was not a reasonable or reliable indicator of future profitability.
Another example of misstated financial results caused by improper reflection of the realizability of a deferred tax asset occurred with Hampton Roads Bankshares Inc. (HRBS), a commercial bank with deteriorating loan portfolio quality and com- mensurate losses in the years following the financial crisis. The company reported a deferred tax asset related to its loan losses; however, it did not establish a valuation allowance against its deferred tax asset. This decision was based on dubious projec- tions indicating that the company would earn the necessary future taxable income
“to fully utilize the [deferred tax asset] DTA over the applicable carry-forward peri- od.”24 Over time, it became clear that the earnings projections were not realistic, and ultimately the company restated its financial results to include a valuation allowance against almost the entire deferred tax asset. Exhibit 18 presents an excerpt from the company’s amended Form 10-Q/A containing the restatement.
Exhibit 18: Excerpt from Hampton Roads Bankshares, Inc. Form 10-Q/A filed August 13, 2010
NOTE B – RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS Subsequent to filing the Company’s annual report on Form 10-K for the year ended December 31, 2009 and its Form 10-Q for the three months ended March 31, 2010 the Company determined that a valuation allowance on its deferred tax assets should be recognized as of December 31, 2009. The Company decided to establish a valuation allowance against the deferred tax asset because it is uncertain when it will realize this asset.
Accordingly, the December 31, 2009 consolidated balance sheet and the March 31, 2010 consolidated financial statements have been restated to account for this determination. The effect of this change in the consolidated financial statements was as follows (in thousands, except per share amounts).
Consolidated Balance Sheet at 31 March 2010
As Reported Adjustment As Restated
Deferred tax assets, net USD70,323 USD(70,323) —
Total assets 3,016,470 (70,323) USD2,946,147
Retained earnings deficit (158,621) (70,323) (228,944)
Total shareholder’s equity 156,509 (70,323) 86,186
Total liabilities and shareholders’
equity 3,016,470 (70,323) 2,946,147
24 Accounting and Auditing Enforcement Release No. 3600, “In the Matter of Hampton Roads Bankshares Inc., Respondent,” SEC (5 December 2014), www .sec .gov/ litigation/ admin/ 2014/ 34 -73750 .pdf.
Consolidated Balance Sheet at 31 December 2009
As Reported Adjustment As Restated
Deferred tax assets, net USD56,380 USD(55,983) USD397
Total assets 2,975,559 (55,983) 2,919,576
Retained earnings deficit (132,465) (55,983) (188,488)
Total shareholder’s equity 180,996 (55,983) 125,013
Total liabilities and shareholders’
equity 2,975,559 (55,983) 2,919,576
Another example of how choices and estimates can affect reported results lies in the selection of a depreciation method for allocating the cost of long-lived assets to accounting periods subsequent to their acquisition. A company’s managers may choose to depreciate long-lived assets (1) on a straight-line basis, with each year bearing the same amount of depreciation expense; (2) using an accelerated method, with greater depreciation expense recognition in the earlier part of an asset’s life; or (3) using an activity-based depreciation method, which allocates depreciation expense based on units of use or production. Depreciation expense is affected by another set of choices and estimates regarding the salvage value of the assets being depreciated. A salvage value of zero will always increase depreciation expense under any method compared with the choice of a non-zero salvage value.
Assume a company invests USD1,000,000 in manufacturing equipment and expects it to have a useful economic life of 10 years. During its expected life, the equipment will produce 400,000 units of product, or USD2.50 depreciation expense per unit produced.
When it is disposed of at the end of its expected life, the company’s managers expect to realize no value for the equipment. Exhibit 19 shows the differences in the three alternative methods of depreciation: straight-line, accelerated on a double-declining balance basis, and units-of-production method, with no salvage value assumed at the end of the equipment’s life.
Exhibit 19: Alternative Methods of Depreciation
Year
Straight-Line
Method Double-Declining Balance Method Units-of-Production Method Depreciation
Expense Balance
Declining Balance Rate
Depreciation Expense
Units Produced
Depreciation Rate/Unit
Depreciation Expense
1 USD100,000 USD1,000,000 20% USD200,000 90,000 USD2.50 USD225,000
2 100,000 800,000 20% 160,000 80,000 USD2.50 200,000
3 100,000 640,000 20% 128,000 70,000 USD2.50 175,000
4 100,000 512,000 20% 102,400 60,000 USD2.50 150,000
5 100,000 409,600 20% 81,920 50,000 USD2.50 125,000
6 100,000 327,680 20% 65,536 10,000 USD2.50 25,000
7 100,000 262,144 20% 52,429 10,000 USD2.50 25,000
8 100,000 209,715 20% 41,943 10,000 USD2.50 25,000
9 100,000 167,772 20% 33,554 10,000 USD2.50 25,000
10 100,000 134,218 20% 26,844 10,000 USD2.50 25,000
Total USD1,000,000 USD892,626 400,000 USD1,000,000
Accounting Choices and Estimates 361
The straight-line method allocates the cost of the equipment evenly to all 10 years of the equipment’s life. The double-declining balance method will have a higher allocation of cost to the earlier years of the equipment’s life. As its name implies, the depreciation expense will decline in each succeeding year because it is based on a fixed rate applied to a declining balance. The rate used was double the straight-line rate, but it could have been any other rate that the company’s managers believed was representative of the way the actual equipment depreciation occurred. Notice that the double-declining balance method also results in an incomplete depreciation of the machine at the end of 10 years; a balance of USD107,374 (= USD1,000,000 − USD892,626) remains at the end of the expected life, which will result in a loss upon the retirement of the equipment if the company’s expectation of zero salvage value turns out to be correct.
Some companies may choose to depreciate the equipment to its expected salvage value, zero in this case, in its final year of use. Some companies may use a policy of switching to straight-line depreciation after the midlife of its depreciable assets in order to fully depreciate them. That particular pattern is coincidentally displayed in the units-of-production example, in which the equipment is used most heavily in the earliest part of its useful life, and then levels off to much less utilization in the second half of the expected life.
Exhibit 20 shows the different expense allocation patterns of the methods over the same life. Each will affect earnings differently.
Exhibit 20: Expense Allocation Patterns of Different Depreciation Methods
US Dollars 250,000
200,000
150,000
100,000
50,000
0
3
1 2 4 5 6 7 8 9 10
Year Units of Production
Double-Declining Balance Straight Line
The company’s managers could justify any of these methods. Each might fairly represent the way the equipment will be consumed over its expected economic life, which is a subjective estimate. The choices of methods and lives can profoundly affect reported income. These choices are not proven right or wrong until far into the future—but managers must estimate their effects in the present.
Exhibit 21 shows the effects of the three different methods on operating profit and operating profit margins, assuming that the production output of the equipment gen- erates revenues of USD500,000 each year and USD200,000 of cash operating expenses are incurred, leaving USD300,000 of operating profit before depreciation expense.