Discretion can distort results

Question

Discuss how management’s discretion in applying accounting rules can mislead investors. Provide three examples and how the discretion can distort results?

Answer 1

If there were no accounting standards and no law to dictate the accounting principles and policies then there would not be a single financial statement without any manipulation.

If the management has their own discretion in applying accounting rules then they would always prepare accounts in a way which will be beneficial for them. They will prepare accounts so as to mislead stock holders, investors, lenders and can pocket huge amount.

Suppose if a company is following straight line method of depreciation then if they were no restriction on applying a method consistently then, the management could have a good opportunity to apply different method of depreciation each year as per their requirement either to increase profit or decrease profit. They would identify the method which is beneficial for them in the given situation and would apply them and no one can make out this fraud going in the company.

Secondly, for example if a company is following accrual method of accounting it has to follow accrual method only. There can be an instance where management has  purchased huge stock irrespective of the need of the company ,may be for his own interest, and he can then apply cash method of accounting and can show purchases as per the requirement of the company and can adjust cash somewhere else.

Another example is in the valuation of inventories, if a company is using First in first out method or last in first out method or weighted average method then it has to use it consistently. Otherwise, management is always in the possession to manipulate accounts in their favour, thereby misleading, users of financial statements. Incorrect value of inventories, cost of goods sold can change the profit actually earned by the company.

A financial analyst should be aware that different accounting methods employed by different firms and by the similar firm in different years complicate comparisons. Financial ratios, for illustration, will differ whenever different accounting methods are employed, even when there are no dissimilarities in attributes being compared. Investors and Creditors also need to be alert to instances in which companies change accounting methods. Managers try to compensate for downturn in the actual performance by changing the method which will help them to increase the profit.