Factors Influencing Accounting Quality

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There are three potential sources of noise and bias in accounting data:

  1. the noise and bias introduced by rigidity in accounting rules
  2. random forecast errors
  3. systematic reporting choices made by corporate managers to achieve specific objectives

Each of these factors is discussed below.

ACCOUNTING RULES: Accounting rules introduce noise and bias because it is often difficult to restrict management discretion without reducing the information content of accounting data. For example, the Statement of Financial Accounting Standards No. 2 issued by the FASB  requires firms to expense research outlays when they are incurred. Clearly, some research expenditures have future value while others do not. However, because SFAS  No. 2 does not allow firms to distinguish between the two types of expenditures, it leads to a systematic distortion of reported accounting numbers. Broadly speaking, the degree of distortion introduced by accounting standards depends on howwell uniform accounting standards capture the nature of a firm’s transactions.

FORECAST ERRORS: Another source of noise in accounting data arises from pure forecast error, because managers cannot predict future consequences of current transactions perfectly. For example, when a firm sells products on credit, accrual accounting requires managers to make a judgment on the probability of collecting payments from customers. If payments are deemed “reasonably certain,” the firm treats the transactions as sales, creating accounts receivable on its balance sheet. Managers then make an estimate of the proportion of receivables that will not be collected. Because managers do not have perfect foresight, actual defaults are likely to be different from estimated customer defaults, leading to a forecast error. The extent of errors in managers’ accounting forecasts depends on a variety of factors, including the complexity of the business transactions, the predictability of the firm’s environment, and unforeseen economy-wide changes.

MANAGERS’ ACCOUNTING CHOICES: Corporate managers also introduce noise and bias into accounting data through their own accounting decisions. Managers have a variety of incentives to exercise their accounting discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting:

Accounting-based debt covenants: Managers may make accounting decisions to meet certain contractual obligations in their debt covenants. For example, firms lending agreements with banks and other debt holders require them to meet covenants related to interest coverage, working capital ratios, and net worth, all defined in terms of accounting numbers. Violation of these constraints may be costly be-cause it allows lenders to demand immediate payment of their loans. Managers of firms close to violating debt covenants have an incentive to select accounting policies and estimates to reduce the probability of covenant violation. The debt covenant motivation for managers’ accounting decisions has been analyzed by a number of accounting researchers.

Management compensation: Another motivation for managers’ accounting choice comes from the fact that their compensation and job security are often tied to re-ported profits. For example, many top managers receive bonus compensation if they exceed certain pre specified profit targets. This provides motivation for managers to choose accounting policies and estimates to maximize their expected compensation.

Corporate control contests:  In corporate control contests, including hostile takeovers and proxy fights, competing management groups attempt to win over the firm’s shareholders. Accounting numbers are used extensively in debating managers’ performance in these contests. Therefore, managers may make accounting decisions to influence investor perceptions in corporate control contests.

Tax considerations: Managers may also make reporting choices to trade off between financial reporting and tax considerations. For example, U.S. firms are required to use LIFO  inventory accounting for shareholder reporting in order to use it for tax reporting. Under LIFO, when prices are rising, firms report lower profits, thereby reducing tax payments. Some firms may forgo the tax reduction in order to report higher profits in their financial statements.

Regulatory considerations:  Since accounting numbers are used by regulators in a variety of contexts, managers of some firms may make accounting decisions to influence regulatory outcomes. Examples of regulatory situations where accounting numbers are used include antitrust actions, import tariffs to protect domestic industries, and tax policies.

• Capital market considerations:  Managers may make accounting decisions to influence the perceptions of capital markets. When there are information asymmetries between managers and outsiders, this strategy may succeed in influencing investor perceptions, at least temporarily.

• Stakeholder considerations: Managers may also make accounting decisions to influence the perception of important stakeholders in the firm. For example, since labor unions can use healthy profits as a basis for demanding wage increases, managers may make accounting decisions to decrease income when they are facing union contract negotiations. In countries like Germany, where labor unions are strong, these considerations appear to play an important role in firms’ accounting policy. Other important stakeholders that firms may wish to influence through their financial reports include suppliers and customers.

• Competitive considerations: The dynamics of competition in an industry might also influence a firm’s reporting choices. For example, a firm’s segment disclosure decisions may be influenced by its concern that disaggregated disclosure may help competitors in their business decisions. Similarly, firms may not disclose data on their margins by product line for fear of giving away proprietary information. Finally, firms may discourage new entrants by making income-decreasing accounting choices.

Limitations of Accounting Analysis

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Because the mechanisms that limit managers’ ability to distort accounting data them-selves add noise, it is not optimal to use accounting regulation to eliminate managerial flexibility completely. Therefore, real-world accounting systems leave considerable room for managers to influence financial statement data. The net result is that information in corporate financial reports is noisy and biased, even in the presence of accounting regulation and external auditing.

The objective of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business reality and to “un-do” any accounting distortions. When potential distortions are large, accounting analysis can add considerable value.

External Auditing

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Broadly defined as a verification of the integrity of the reported financial statements by someone other than the preparer, external auditing ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable. In the U.S., all listed companies are required to have their financial statements audited by an independent public accountant.

The standards and procedures to be followed by independent auditors are set by the American Institute of Certified Public Accountants (AICPA). These standards are known as Generally Accepted Auditing Standards (GAAS). While auditors issue an opinion on published financial statements, it is important to remember that the primary responsibility for the statements still rests with corporate managers.

Auditing improves the quality and credibility of accounting data by limiting a firm’s ability to distort financial statements to suit its own purposes. However, third-party auditing may also reduce the quality of financial reporting because it constrains the kind of accounting rules and conventions that evolve over time. For example, the FASB considers the views of auditors in the standard-setting process. Auditors are likely to argue against accounting standards that produce numbers which are difficult to audit, even if the proposed rules produce relevant information for investors.

Generally Accepted Accounting Principles

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Given that it is difficult for outside investors to determine whether managers have used their accounting flexibility to signal their proprietary information or merely to disguise reality, a number of accounting conventions have evolved to mitigate the problem. Accounting conventions and standards promulgated by the standard-setting bodies limit potential distortions that managers can introduce into reported accounting numbers. In the United States, the Securities and Exchange Commission (SEC) has the legal authority to set accounting standards. The SEC typically relies on private sector accounting bodies to undertake this task. Since 1973 accounting standards in the United States have been set by the Financial Accounting Standards Board (FASB). There are similar private sector or public sector accounting standard-setting bodies in many other countries. In addition, the International Accounting Standards Committee (IASC) has been attempting to set worldwide accounting standards, though IASC’s pronouncements are not legally binding as of now.

Uniform accounting standards attempt to reduce managers’ ability to record similar economic transactions in dissimilar ways either over time or across firms. Thus they create a uniform accounting language and increase the credibility of financial statements by limiting a firm’s ability to distort them. Increased uniformity from accounting standards, however, comes at the expense of reduced flexibility for managers to reflect genuine business differences in a firm’s accounting decisions. Rigid accounting standards work best for economic transactions whose accounting treatment is not predicated on managers’ proprietary information. However, when there is a significant business judgment involved in assessing a transaction’s economic consequences, rigid standards are likely to be dysfunctional, because they prevent managers from using their superior business knowledge. Further, if accounting standards are too rigid, they may induce managers to expend economic resources to restructure business transactions to achieve a desired accounting result.

Delegation of Reporting to Management

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While the basic definitions of the elements of a firm’s financial statements are simple, their application in practice often involves complex judgments. For example, how should revenues be recognized when a firm sells land to customers and also provides customer financing? If revenue is recognized before cash is collected, how should potential defaults be estimated? Are the outlays associated with research and development activities, whose payoffs are uncertain, assets or expenses when incurred? Do frequent flyer reward programs create accounting liabilities for airline companies? If so, when and at what value? Because corporate managers have intimate knowledge of their firms’ businesses, they are entrusted with the primary task of making the appropriate judgments in portraying myriad business transactions using the basic accrual accounting framework.

The accounting discretion granted to managers is potentially valuable because it allows them to reflect inside information in reported financial statements. However, since investors view profits as a measure of managers’ performance, managers have an incentive to use their accounting discretion to distort reported profits by making biased assumptions. Further, the use of accounting numbers in contracts between the firm and outsiders provides a motivation for management manipulation of accounting numbers. Earnings management distorts financial accounting data, making them less valuable to external users of financial statements. Therefore, the delegation of financial reporting decisions to managers has both costs and benefits. Accounting rules and auditing are mechanisms designed to reduce the cost and preserve the benefit of delegating financial reporting to corporate managers.

Building Blocks of Accrual Accounting

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One of the fundamental features of corporate financial reports is that they are prepared using accrual rather than cash accounting. Unlike cash accounting, accrual accounting distinguishes between the recording of costs and benefits associated with economic activities and the actual payment and receipt of cash. Net income is the primary periodic performance index under accrual accounting. To compute net income, the effects of economic transactions are recorded on the basis of expected, not necessarily actual, cash receipts and payments. Expected cash receipts from the delivery of products or services are recognized as revenues, and expected cash outflows associated with these revenues are recognized as expenses.

While there are many rules and conventions that govern a firm’s preparation of financial statements, there are only a few conceptual building blocks that form the foundation of accrual accounting. The principles that define a firm’s assets, liabilities, equities, revenues, and expenses are as follows:

  • Assets are economic resources owned by a firm that (a) are likely to produce future economic benefits and (b) are measurable with a reasonable degree of certainty.
  • Liabilities are economic obligations of a firm arising from benefits received in the past that are (a) required to be met with a reasonable degree of certainty and (b) at a reasonably well-defined time in the future.
  • Equity is the difference between a firm’s net assets and its liabilities. The definitions of assets, liabilities, and equity lead to the fundamental relationship that governs a firm’s balance sheet:

Assets = Liabilities + Equity

While the balance sheet is a summary at one point in time, the income statement summarizes a firm’s revenues and expenses and its gains and losses arising from changes in assets and liabilities in accord with the following definitions:

  • Revenues are economic resources earned during a time period. Revenue recognition is governed by the realization principle, which proposes that revenues should be recognized when (a) the firm has provided all, or substantially all, the goods or services to be delivered to the customer and (b) the customer has paid cash or is expected to pay cash with a reasonable degree of certainty.
  • Expenses are economic resources used up in a time period. Expense recognition is governed by the matching and the conservatism principles. Under these principles, expenses are (a) costs directly associated with revenues recognized in the same period, or (b) costs associated with benefits that are consumed in this time period, or(c) resources whose future benefits are not reasonably certain.
  • Profit is the difference between a firm’s revenues and expenses in a time period.

The Institutional Framework for Financial Reporting

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There is typically a separation between ownership and management in public corporations. Financial statements serve as the vehicle through which owners keep track of their firms financial situation. On a periodic basis, firms typically produce three financial reports:

  1. an income statement that describes the operating performance during a time period
  2. a balance sheet that states the firms assets and how they are financed
  3. a cash flow statement (or in some countries, a funds flow statement) that summarizes the cash flows of the firm.

These statements are accompanied by several footnotes and a message and narrative discussion written by the management. To evaluate effectively the quality of a firm’s financial statement data, the analyst needs to first understand the basic features of financial reporting and the institutional framework that governs them.

Applying Corporate Strategy Analysis

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Let us apply the concepts of corporate strategy analysis to Amazon.com, a pioneer in electronic commerce. Amazon started operations as an online bookseller in 1995 and went public in 1997 with a market capitalization of $561 million dollars. The company grew rapidly and began to pose a serious threat to the dominance of leading traditional booksellers like Barnes & Noble. Investors rewarded Amazon by increasing its market capitalization to a remarkable $36 billion dollars by April 1999.

Flush with his success in online book-selling, Jeff Bezos, the founder and chief executive officer of Amazon, moved the company into many other areas of electronic commerce. Amazon claimed that its brand, its loyal customer base, and its ability to execute electronic commerce were valuable assets that can be exploited in a number of other on-line business areas. Beginning in 1998, through a series of acquisitions, Amazon expanded into online selling of CDs, videos, gifts, pharmaceutical drugs, pet supplies, and groceries. In April 1999, Amazon announced plans to diversify into the online auction business by acquiring LiveBid.com. Bezos explained, “We are not a book company. We’re not a music company. We’re not a video company. We’re not an auctions company. We’re a customer company.”

Amazon’s rapid expansion attracted controversy among the investment community. Some analysts argued that Amazon could create value through its broad corporate focus because of the following reasons:

  • Amazon has established a valuable brand name on the Internet. Given that electronic commerce is a relatively new phenomenon, customers are likely to rely on well known brands to reduce the risk of a bad shopping experience. Amazon’s expansion strategy is sensible because it exploits this valuable resource.
  • Amazon has been able to acquire critical expertise in flawless execution of electronic retailing. This is a general competency that can be exploited in many are as of electronic retailing.
  • Amazon has been able to create a tremendous amount of loyalty among its customers through superior marketing and execution. As a result, a very high proportion of Amazon’s sales comes from repeat purchases by its customers. Amazon’s strategy exploits this valuable customer base.

There were also some skeptics who believed that Amazon was expanding too rapidly, and that its divers ification beyond book retailing was likely to fail. These skeptics questioned the value of Amazon’s brand name. They argued that traditional retailers, such as Barnes & Noble, Wal-Mart, and CVS, who are boosting their online efforts, also have valuable brand names, execution capabilities, and customer loyalty. Therefore, these companies are likely to offer formidable competition to Amazon’s individual business lines. Amazon’s critics also pointed out that expanding rapidly into so many different areas is likely to confuse customers, dilute Amazon’s brand value, and increase the chance of poor execution. Commenting on the fact that Amazon is losing money in all of its businesses while it is expanding rapidly, Barron’s business weekly stated, “Increasingly, Amazon’s strategy is looking like the dim-bulb businessman who loses money on every sale but tries to make it up by making more sales.”

Investor concerns about Amazon’s corporate strategy began to affect its share price, which dropped from a high of $221 dollars in April 1999 to $118 dollars by the end of May 1999. Still, at a total market capitalization of about $19 billion dollars, many investors are betting that Amazon’s corporate strategy is likely to yield rich dividends in the future.

Sources of Value Creation at the Corporate Level

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Economists and strategy researchers have identified several factors that influence an organization’s ability to create value through a broad corporate scope. Economic theory

suggests that the optimal activity scope of a firm depends on the relative transaction cost of performing a set of activities inside the firm versus using the market mechanism.

Transaction cost economics implies that the multi product firm is an efficient choice of organizational form when coordination among independent, focused firms is costly due to market transaction costs.

Transaction costs can arise out of several sources. They may arise if the production process involves specialized assets, such as human capital skills, proprietary technology, or other organizational know-how that is not easily available in the marketplace. Trans-action costs also may arise from market imperfections such as information and incentive problems. If buyers and sellers cannot solve these problems through standard mechanisms such as enforceable contracts, it will be costly to conduct transactions through market mechanisms.

For example, public capital markets may not work well when there are significant information and incentive problems, making it difficult for entrepreneurs to raise capital from investors. Similarly, if buyers cannot ascertain the quality of products being sold because of lack of information, or cannot enforce warranties because of poor legal infrastructure, entrepreneurs will find it difficult to break into new markets. Finally, if employers cannot assess the quality of applicants for new positions, they will have to rely more on internal promotions, rather than external recruiting, to fill higher positions in an organization. Emerging economies often suffer from these types of transaction costs because of poorly developed intermediation infrastructure.

Even in many advanced economies, examples of high transaction costs can be found. For example, in many countries other than the U.S., the venture capital industry is not highly developed, making it costly for new businesses in high technology industries to attract financing. Even in the U.S., transaction costs may vary across economic sectors. For example, until recently electronic commerce was hampered by consumer concerns regarding the security of credit card information sent over the Internet.

Transactions inside an organization may be less costly than market-based transactions for several reasons. First, communication costs inside an organization are reduced because confidentiality can be protected and credibility can be assured through internal mechanisms. Second, the headquarters office can play a critical role in reducing costs of enforcing agreements between organizational subunits. Third, organizational subunits can share valuable non tradable assets (such as organizational skills, systems, and processes) or non divisible assets (such as brand names, distribution channels, and reputation).

There are also forces that increase transaction costs inside organizations. Top management of an organization may lack the specialized information and skills necessary to manage businesses across several different industries. This lack of expertise reduces the possibility of realizing economies of scope in reality, even when there is potential for such economies. This problem can be remedied by creating a decentralized organization, hiring specialist managers to run each business unit, and providing them with proper incentives. However, decentralization will also potentially decrease goal congruence among subunit managers, making it difficult to realize economies of scope.

Analysts should ask the following questions to assess whether or not an organization’s corporate strategy has the potential to create value:

  • Are there significant imperfections in the product, labor, or financial markets in the industries (or countries) in which a company is operating? Is it likely that transaction costs in these markets are higher than the costs of similar activities inside a well managed organization?
  • Does the organization have special resources such as brand names, proprietary know-how, access to scarce distribution channels, and special organizational processes that have the potential to create economies of scope?
  • Is there a good fit between the company’s specialized resources and the portfolio of businesses in which the company is operating?
  • Does the company allocate decision rights between the headquarters office and the business units optimally to realize all the potential economies of scope?
  • Does the company have internal measurement, information, and incentive systems to reduce agency costs and increase coordination across business units?

Achieving And Sustaining Competitive Advantage

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The choice of competitive strategy does not automatically lead to the achievement of competitive advantage. To achieve competitive advantage, the firm has to have the capabilities needed to implement and sustain the chosen strategy. Both cost leadership and differentiation strategy require that the firm make the necessary commitments to acquire the core competencies needed, and structure its value chain in an appropriate way. Core competencies are the economic assets that the firm possesses, whereas the value chain is the set of activities that the firm performs to convert inputs into outputs. The uniqueness of a firm’s core competencies and its value chain and the extent to which it is difficult for competitors to imitate them determines the sustainability of a firm’s competitive advantage.

To evaluate whether or not a firm is likely to achieve its intended competitive advantage, the analyst should ask the following questions:

  • What are the key success factors and risks associated with the firm’s chosen competitive strategy?
  • Does the firm currently have the resources and capabilities to deal with the key success factors and risks?
  • Has the firm made irreversible commitments to bridge the gap between its current capabilities and the requirements to achieve its competitive advantage?
  • Has the firm structured its activities (such as research and development, design, manufacturing, marketing and distribution, and support activities) in a way that is consistent with its competitive strategy?
  • Is the company’s competitive advantage sustainable? Are there any barriers that make imitation of the firm’s strategy difficult?
  • Are there any potential changes in the firm’s industry structure (such as new technologies, foreign competition, changes in regulation, changes in customer requirements) that might dissipate the firm’s competitive advantage? Is the company flexible enough to address these changes?
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