21.2 Analytics

Question 1

What are the main economic motives for changing accounting methods?

Answer 1

The main economic motives include:

Political costs: Large companies attract more attention from regulators and legislators, often leading them to adopt accounting methods that reduce reported income to avoid scrutiny.

Capital structure: Companies with high debt-to-equity ratios may adopt accounting methods that increase income to avoid defaulting on debt covenants.

Bonus payments: Companies may select accounting methods that maximize managers’ bonuses, linking performance to income.

Smooth earnings: Companies aim to maintain smooth earnings, making significant changes in income less likely to raise concerns from shareholders or other stakeholders.

Question 2

How do companies use accounting methods to manage political costs?

Answer 2

Larger companies that attract more political and regulatory attention may adopt accounting methods that reduce reported income.

This strategy helps companies avoid increased taxes or being viewed as having monopoly power, thus minimizing scrutiny from regulators and other stakeholders.

Question 3

How does a company’s capital structure influence its choice of accounting methods?

Answer 3

Companies with high debt-to-equity ratios may choose accounting methods that increase reported income to avoid violating debt covenants.

For example, companies may capitalize interest instead of expensing it, or use the full cost method for exploration costs in industries like oil and gas.

Question 4

What role do bonus payments play in the selection of accounting methods?

Answer 4

Managers whose bonuses are tied to reported income may prefer accounting methods that boost earnings and lead to higher bonus payouts.

This can incentivize the use of accounting methods or estimates that maximize income.

Question 5

What is the concept of “smooth earnings” in accounting?

Answer 5

“Smooth earnings” refers to a company’s practice of managing earnings to avoid large fluctuations.

Managers may prefer consistent earnings over time to reduce investor concerns and avoid the perception of volatility or financial risk, even if actual financial performance varies significantly.

Question 6

What is meant by “economic consequences” in accounting?

Answer 6

“Economic consequences” refers to the idea that accounting choices can influence the behavior of investors, creditors, competitors, and management.

Companies may make accounting decisions based on their potential economic impact rather than purely on conceptual or regulatory standards.

Question 7

What is the principle of neutrality in accounting standard-setting?

Answer 7

Neutrality is an aspect of reliability and faithful representation in accounting.

It means that accounting standards should be assessed based on their conceptual merits, without regard to their economic consequences or the behavior they may influence.

Question 8

How do accounting changes impact financial statement analysis?

Answer 8

Accounting changes can make it difficult to develop meaningful trend data because they may shift earnings from one period to another.

This often results in no change in the company’s cash position but can convert operating cash flows to investing or financing flows.

It is essential to review disclosures in financial statements for accurate analysis.