Question

If operating income could be manipulated by allocating over-or underapplied overhead, why don't GAAP always requires allocation?

Answer 1

Financial statement manipulation is an ongoing problem in corporate America. Although the Securities and Exchange Commission (SEC) has taken many steps to mitigate this type of corporate malfeasance, the structure of management incentives, the enormous latitude afforded by the Generally Accepted Accounting Principles (GAAP) and the ever-present conflict of interest between the independent auditor and the corporate client continues to provide the perfect environment for such activity. Due to these factors, investors who purchase individual stocks or bonds must be aware of the issues, warning signs and the tools that are at their disposal in order to mitigate the adverse implications of these problems.There are a host of factors that may affect the quality and accuracy of the data at an investor's disposal. As a result, investors must have a working knowledge of financial statement analysis, including a strong command of the use of internal liquidity solvency analysis ratios, external liquidity marketability analysis ratios, growth, and corporate profitability ratios, financial risk ratios and business risk ratios. Investors should also have a strong understanding of how to use market multiple analysis, including the use of price/earnings ratios, price/book value ratios, price/sales ratios and price/cash flow ratios in order to gauge the reasonableness of the financial data.