Question

FINANCIAL ACCOUNTING

Earnings management is a potential problem for many companies and occurs when the statement of comprehensive income numbers are manipulated by the choice of accounting policies/methods to show a particular income. Sometimes a manager will want to increase the net income to increase the bonus they will receive. In other situations, a manager may want to lower net income to lower the company's taxable amount owing or to encourage the government to impose tariffs and duty on competing companies' products.

Questions:

1. Using the concepts of inventories in financial accounting, how could a company show a higher net income in periods of rising inventory prices?
2. Would the above actions be ethical? Is it ever acceptable for a company to change its inventory method?

Answer 1

(a) The International Accounting Standards 2 provides for Valuation of Inventories at Cost or Net Realisable Value whichever is lower.

(b) There are various methods to arrive at the cost of Inventories like the (a) Weighted Average method (b) FIFO (c) LIFO (d) HIFO.

(c) The closing stock valuation is an off-balance sheet exercise done at the end of every financial year and the values are then brought to the books of account.

(d) In a rising prices scenario, the management can value the stock at FIFO basis since he fist stock would have gone out or sold off and what would remain the latest stocks obviously which would have been purchased at high prices. Hence, the final closing stock value can be high which would in effect increase profits of the company.

(e) A change of inventory method should be explained by the management why it is done and such explanations should be clearly mentioned in the Notes to Financial Statements. Hence does come under ethical considerations.

(f) However, if the management does the same frequently, then the company would come under the scanner of the Tax Officials and subsequently the shareholders of the company.

(g) Detailed calculations of the same to be mentioned in Notes to Accounts.