The selection of accounting principles occurs at two levels. First, the FASB determines which principles constitute GAAP. In a number of instances, however, the FASB allows the use of more than one method. Thus, corporate managers also make accounting policy decisions. Which criteria are used by the FASB and corporate managers to select accounting principles?
The FASB’s primary objective is to select accounting principles that provide useful information to financial statement readers. However, businesses incur costs to generate the information required by the FASB. Thus, the FASB attempts to balance the costs and benefits of its rulings.
Some members of the financial community suggest that corporate managers act in the same way. For example, in choosing an inventory method, managers balance the costs of implementing each method with the quality of the information that each method yields. A more sophisticated view recognizes that accounting principles have economic consequences to managers and their firms, and that these consequences are considered by managers when choosing accounting principles. Beyond implementation costs, accounting principles can affect the wealth of managers and firms via
- Compensation plans
- Debt contracts, and
- Political costs
Many corporations pay their top managers a fixed salary plus an annual bonus, which is often a percentage of reported net income. A number of bonus agreements include a floor and a ceiling on the bonus. The floor requires that net income must exceed a predetermined amount before the bonus is activated. The ceiling places a limit on the size of the bonus; once the annual bonus reaches the ceiling, additional increases in net income no longer increase the bonus.
Bonus plans are intended to align the interests of managers and shareholders. Managers frequently face alternative courses of action, where one course is in their best interest, and another course is in the shareholders’ best interest. For example, a manager’s career might be aided by expanding the business (empire building), even when such expansion is not particularly profitable and is not in the shareholders’best interest. Expansion may result in more prestige and visibility for the firm and its managers, thus enhancing a manager’s employment opportunities. Because (1) bonus plans motivate managers to make decisions that increase net income and (2) increased net income is usually in the shareholders’ best interest, the goals of these two groups come more in line when a manager’s compensation depends on reported net income.
Given that managers’ compensation is tied to reported accounting earnings, how would we expect managers to select accounting principles? Most managers probably consider the effect that different accounting principles have on net income, and consequently on their compensation. In particular, bonuses often motivate managers to select accounting methods that increase reported net income.
Lenders are concerned about limiting their risk and maximizing the probability that principal and interest will be paid. Debt contracts between borrowers and lenders can help accomplish this. Many of these contracts impose constraints on the behavior of borrowers. For example, some contracts limit the total amount of debt a borrower can incur. In such cases, measurement of the borrower’s debt is based on the liabilities reported in the balance sheet. As another example, some contracts limit the cash dividends a borrower can distribute. This limitation is defined in terms of retained earnings, a component of owners’ equity that appears on the balance sheet.
Penalties exist for violating debt contracts. These include
- an interest rate increase,
- an increase in collateral (assets pledged to secure the debt),
- a one-time renegotiation fee, and
- an acceleration in the maturity date.
Because these contracts are defined in terms of financial statement numbers, the use of accounting principles that increase reported net income can reduce the chances of contract violation. Accordingly, the likelihood of violating debt contracts is another influence on managers’ accounting policy choices.
Federal and state governments have the power to regulate many operations of a business. Pollutant emissions and employment practices are just two illustrations. Governments also have the power to tax corporations. Because regulation and taxation are costly to firms, managers can be expected to take actions that minimize these costs. Because these costs are imposed via the political process, they are referred to as political costs.
Some accountants suggest that highly profitable firms are more exposed to political costs than less profitable ones. Relatively profitable firms are more likely to be the target of antitrust investigations or special tax assessments. For example, in the mid-1970s, firms in the oil industry earned unusually high profits due to a steep rise in oilprices. As a result, Congress enacted the Windfall Profits Tax, which subjected these companies to an additional tax on their earnings. More recently, Microsoft, Inc. has been the target of intense scrutiny by federal regulators because of its dominance in the computer operating system market and its resultant profitability.
Some accountants also argue that larger firms are more susceptible to regulation and taxation because their size attracts more attention. Accordingly, the managers of larger firms are particularly motivated to undertake actions that minimize political costs. One of these actions is the selection of accounting principles that reduce reported net income. Note that compensation plans and debt contracts motivate managers to select accounting principles that increase reported income, whereas political costs have the opposite effect.