--%>

Discretion can distort results

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

E

Expert

Verified

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.

   Related Questions in Corporate Finance

  • Q : What is Project Budget Project Budget :

    Project Budget: Collecting all costs related with completing a project is budget process. The Project Management Institute states that "aggregating the predictable costs of individual actions or work projects (establishing) an authorized cost baseline

  • Q : Explain Straddle and Strangle Straddle

    Straddle & Strangle: In the case of shorting butterfly spread, it can be seen that the gains are limited. However, there exists another strategy known as straddle which produces unlimited gains. This strategy benefits when the trader expects that

  • Q : DCF Analysis AB Corp. is in the

    AB Corp. is in the business of making white-board markers. They are computing the potential of investing in some new equipment that will enhance their manufacturing process.  The initial cost of the latest machinery is $470,000 plus a one-time installation cost o

  • Q : Who explained market-neutral delta

    Who explained market-neutral delta hedging?

  • Q : Standard deviation of portfolios returns

    Assume that you have $50,000 which you want to invest in two companies, XYZ Books and ABC Audio. XYZ has a return of 10% and standard deviation 15%, while ABC has return of 15% with a standard deviation of 20%. The correlation coefficient between them is .5. Your port

  • Q : Is PER an excellent guide to investments

    Is PER an excellent guide to investments?

  • Q : Expected return for a portfolio What is

    What is the expected return for a portfolio consisting of 200 shares of Nike, 200 shares of Home Depot, and 400 shares of Intel if their expected returns are 10%, 8% and 12% respectively, and their current prices are $25, $50, and $25 per share respec

  • Q : Understand and interpret financial

    Our purpose this week: learning how to understand and interpret financial statements. Assignment: The class should discuss all of the questions listed below as they rel

  • Q : Provide three examples of mutually

    provide three examples of mutually exclusive projects?

  • Q : Purchaing or leasing problem Crawford

    Crawford Corporation is planning to lease a machine for the next 4 years for an annual lease payment of $3,000 paid in advance, plus a non-refundable initial fee of $3,000. There is a 1-year delay for the tax benefits of leasing. Crawford may buy the machine, deprecia