Accounting Tricks and Their Impact on Valuation

¶ … forecasting, there are a litany ethical dilemmas, decisions characteristics, problems, or frameworks that may impact the financial statements of Home Depot and Lowe's. The most egregious of which is management assumptions regarding future performance. In many instances, with the exception of cash, nearly every line item has some form of assumptions involved. Accounts receivable is often reported net of the allowance for doubtful accounts, which is a management assumption (Alexander, 2005). Management has the ability to dictate if the company will report inventory using LIFO of FIFO accounting rules.

With LIFO, assuming rising prices in an inflationary environment, Cost of Goods Sold will increase thus reducing Net Income. However, the reduction in taxes paid will actually make the company's cash flow from operations increase on the cash flow statement. FIFO will have the opposite impact. From a shareholder perspective reporting under LIFO would be more to the shareholders advantage as more cash is retained in the business. Depreciation is another expense that management has considerable discretion over.

Management can elect to use accelerated depreciation, straight line depreciation, or even the units of production method. Each method will have a different impact on the financial statements and subsequent perception of financial performance (Berezin, 2005). In regards to forecasting, this is important as an analyst most adjust future earnings for accounting tricks and gimmicks. A common example is off balance sheet debt in the form of operating leases. In an analyst doesn't account for this in his projections, the company may appear more solvent than it actually is.

This was notably the cash during the most recent financial crisis, when financial companies had more off-balance sheet debt than investors anticipated. As a result, many companies including Lehman Brothers, Bear Sterns, Long-Term Capital Management, and others, faced financial ruin (Gilchrist, 1976). Another problem that will impact financial forecasting is the overall framework of accounting and the overall emphasis on earnings per share. Management may engage in questionable activity to increase EPS, which is counter to the interests of shareholders. A common example occurs with acquisitions.

Acquisitions are almost always accretive to earnings in the short-term, but often fail to realize the promised synergies that management believes will occur. For example, HP and Compaq where brought together after the collapse of the tech bubble in early 2000. Compaq created and developed personal computers for individual consumer use. The PC industry however suffered from terrible fundamentals and economics. Rapid innovation, strong buyer power, low pricing power, oversupply, and lack of growth were all headwinds for the PC industry.

HP acquired the company, and immediately, EPS increased due to accounting rules and frameworks. However, HP had to impair the acquisition, and has subsequently broken itself up, in an effort to increase profitability. In fact, since the acquisition, profitability in its PC business has declined substantially. Management that initiated the acquisition is long gone, with existing shareholders having to deal with the aftermath.

Accounting rules emphasize EPS without regarding the actually economic earnings that a business generates In regards to forecasting, this is important because an analyst must be cognizant of management motivations and assumptions when forecasting future growth. In management acquires a company at a high price and subsequently impairs the acquisition, then shareholder value is destroyed. Management effectively overpaid for a business that is substandard. Analysts must take these impairments into account when forecasting future earnings of a business.

Finally, in regards to forecasting dilemmas, analysts must make numerous adjustments to the financial statements to arrive at the true recurring earnings of the business. Businesses, in many instances have non-operating items included in operating items on the income statement. For example, one time charges may be included in cost of goods sold. An analyst must adjust out these one-time charges to better determine the underlying, recurring value of the business. To properly do this, the analyst must thoroughly read the financial footnotes that accompany the financial statements.

The notes often contain the most important information within the entire filing. Impairments, non-operating costs hidden in operating costs, off-balance sheet items, and contractual obligations are all included in the notes. Without properly forecasting the footnotes, the analyst cannot arrive at the true value of a company through forecasting. In fact, it is quite possible that the analyst will arrive at the wrong figure, when he or she does not take into account information from the financial footnotes (Astrid, 2006). In conclusion, with regard to forecasting,.