There’s No One Right Answer In the Math of Business Finance
By ANDY FIXMER
Staff Reporter
When it comes to accounting, science can take a back seat to art.
Hand three accountants the financial minutiae of a company or individual and you could easily get three different results and each could be correct.
That’s because in accounting, there are few cut-and-dried rules and multiple choices abound for just about every situation.
“There is no one answer to accounting earnings or (tax) returns,” said Kenneth Merchant, the Deloitte & Touche chair in accounting at USC. “There are lots of gray areas.”
If a company is aggressive in its accounting policies, Merchant said it will likely set a high depreciation level for its assets, maintain low cash reserves and make optimistic assumptions about its inventory.
All of which can be done with proper accounting methods, and at the same time boost a company’s bottom line and still fall within the confines of Generally Accepted Accounting Principles, the complex set of codes that all accountants abide by.
Here are two scenarios used in the classroom by local accounting professors.
The year-end bonus
Situation: As the fiscal year is coming to a close, a company’s chief executive realizes earnings will be short of the point that he qualifies for a bonus.
Option: The executive could shift money out of the company’s reserve, boosting earnings.
Alternative: The executive shifts the company’s factories into a 24-hour operation, creating more products and boosting sales in the current quarter.
Discussion: Either choice has its drawbacks. With the first example, earnings are only made to appear higher by borrowing from future earnings that will be needed to replace reserves. In the alternative, increased sales will likely cannibalize business in the next fiscal year.
“In the accounting, both are correct if you’ve logged the sales and the assets properly,” Merchant said. “But what you’ve really done is stolen sales from the future and borrowed profits from the future by putting them in this year’s financial statements.”
After running through the scenario, Merchant said he likes to poll his classes on which, if either, they feel is the right answer. “It’s always interesting because you get so many different answers,” he said, “but they’re usually split.”
The side deal
Situation: A company secures a valuable contract to sell its gadgets to another firm, but it is contingent upon the buyer being able to resell all of the delivered product. For every unit that goes unsold, the manufacturer has to refund that portion of the transaction.
Option: Add the contingency as an amendment to the contract.
Alternative: An agreement for the contingency that is separate from the original deal.
Discussion: Adding the contingency agreement will lessen the overall value of the deal, because the refunds must be factored into sales. Creating a side arrangement allows the company to get the full value of the deal. However, if the side arrangement is obscured from auditors, this can be illegal.
USC accounting professor John Larsen said in the constant pressure to make a company’s financial status look as rosy as possible, it’s common for companies to enter into side arrangements that aren’t part of the original deal.
These arrangements can undermine the deal by promising buy-backs or dividends that make the original contract less valuable.
“Typically, there would be a side agreement that if you can’t sell this to your customer, your purchaser, then we’ll reimburse you for it,” Larsen said. “But it doesn’t constitute a sale technically. And a side arrangement that didn’t appear in the main agreement isn’t something independent auditors would likely find.”
In the end, Larsen says he tells his students to follow the straight and narrow path, to use conservative accounting rules and always be up front about the numbers being presented. “Stick with the rules,” he said. “What it takes to succeed in the professional accounting area is a lot of spine and spunk.”
