2.

4 DEPARTURES FROM GAAP

Financial reporting that departs from GAAP can generally be considered low quality. In such
situations, earnings quality is likely difficult or impossible to assess because comparisons with
earlier periods and/or other entities cannot be made.

(When we say low-quality financial reporting kasi, this contains inaccurate, misleading, or
incomplete information. So yung extreme lapses o yung matinding pagkalugi in financial
reporting quality e nagresulta ng rise to high-profile scandals na hindi lang yung investor losses
yung apektado but also in reduced confidence or diminished the trust in the financial system.)

( GAAP departure is actually ay isang sitwasyon wherein yung financial statements deviate
from the established accounting criteria. Kumbaga hindi nila sinunod yung naestablish na
accounting standards. For example, a company that uses an incorrect accounting method faces a
GAAP departure.)

EXAMPLE : The auditor noticed that the inventory of ABC Company faces a write-down due
to obsolescence. However, the company refuses to write down the inventory. In such a scenario,
a GAAP departure reservation is made. Since only the inventory and cost of goods
sold accounts are incorrect, a qualified opinion due to a GAAP departure would be issued.

In Required Departures from GAAP under the American Institute of Certified Public
Accountants or AICPA’s Code of Professional Ethics under Rule 203, - Accounting Principles,
a member must depart from GAAP if following it would to a material misstatement on the
financial statements, or otherwise be misleading.

(So sa departure, the member must disclose, if practical, yung mga dahilan kung bakit yung
compliance with the accounting principle e magreresulta sa isang misleading financial
statement.)

An example of improper accounting was Enron (accounting issues revealed in 2001), whose
inappropriate use of off- balance- sheet structures and other complex transactions resulted in
vastly understated indebtedness as well as overstated profits and operating cash flow.

(So based on my research. Enron Corporation was a US energy, commodities, and services
company based out of Houston, Texas. In one of the most controversial accounting scandals in
the past decade, it was discovered in 2001 that the company had been using accounting
loopholes to hide billions of dollars of bad debt, while simultaneously inflating the
company’s earnings. Yung issue na yun nagresulta sya sa mga shareholders losing over $74
billion dahil yung share price din ng Enron e nagcollapsed from around $90 to under $1 nalang
within a year.
So yung SEC investigation nireveal nila na yung CEO ng Kumpanya na si Jeff Skillings, and
former CEO, Ken Lay, had kept billions of dollars of debt off the company’s balance sheet. In
addition, they also pressured the company’s auditing firm, Arthur Andersen, to ignore the
issue.)
Another notorious example of improper accounting was WorldCom (accounting issues
discovered in 2002), a company that by improperly capitalizing certain expenditures
dramatically understated its expenses and thus overstated its profits.

(WorldCom naman ay isang American telecom company. WorldCom was one of the largest
long-distance providers in the United States. Mas nakilala pa to lalo na nung nasangkot pa sa
one of the largest accounting scandals in the country, which is parang kagaya ng Enron
and Tyco frauds. So lumabas lang yung issue nato nung nareveal na yung company e involved
sa manipulating of financial data para mainflate yung revenue nila at madeflate yung mga
expenses in order to pump up its profit. Involved din yung Worldcom sa isa sa mga largest
bankruptcies tas ayun nagrebranded nalang sila at yung mga network assets nila ay ibinenta sa
Verizon.)

the quality spectrum, fabricated reports portray fictitious events, either to fraudulently obtain
investments by misrepresenting the company’s performance and/or to obscure fraudulent
misappropriation of the company’s assets. Examples of fraudulent reporting are unfortunately
easy to find, although they were not necessarily easy to identify at the time. In the 1970s, Equity
Funding Corp. created fictitious revenues and even fictitious policyholders. In the 1980s, Crazy
Eddie’s reported fictitious inventory as well as fictitious revenues supported by fake invoices.
In 2004, Parmalat reported fictitious bank balances.

2.5 Differentiate between Conservative and Aggressive Accounting

Aggressive accounting choices in the period under review may decrease the company’s
reported performance and financial position in later periods, which creates a sustainability issue.

(So it says here na ang aggressive accounting choices daw ay may possibility to employ
more creative techniques na magreresulta ng overstated financial performance. The use of
these aggressive accounting choices in a company’s current reporting period can cause a
decrease in the company’s reported performance and financial position sain later sa mga
sumusunod pang panahon. This creates a sustainability issue.)

Conservative choices do not typically create a sustainability issue because they decrease the
company’s reported performance and financial position, and may increase them in later periods.

(On the other hand, conservative choices, they decrease current performance daw and
increase future performance. Even though conservative choices do not affect
sustainability, tit affects naman yung predictive power of financial information. While
yung mga ibang investors mas gusto nilang mag put up ng investments sa mga companies
na nagsstick sa conservative choices kasi mas easy daw to digest a positive surprise than a
negative one. However, unbiased financial reporting neither aggressive or conservative is
most useful.)
In terms of establishing expectations for the future, however, financial reporting that is relevant
and faithfully representative is the most useful.

(A common presumption is that financial reports are typically biased upward, pero hindi
naman laging ganun yung nagyayari. Although yung accounting standards ideally
promote unbiased financial reporting, yung iba paring accounting standards may
specifically require a conservative treatment of a transaction or an event. Also, yung mga
managers ay pwedeng pumili to take the conservative approach when applying standards.
Kasi essential din na yung isang analyst ay cinoconsider yung possibility of conservative
choices at mga effects nito.)

At its most extreme, conservatism follows accounting practices that “anticipate no profit, but
anticipate all losses” (Bliss, 1924).

But in general, conservatism means that revenues may be recognized once a verifiable and
legally enforceable receivable has been generated and that losses need not be recognized until it
becomes “probable” that an actual loss will be incurred.

2.5.1 Conservatism in Accounting Standards

The Conceptual Framework supports neutrality of information: “A neutral depiction is without

bias in the selection or presentation of financial information.” Neutrality— lack of upward or
downward bias—is considered a desirable characteristic of financial reporting. Conservatism
directly conflicts with the characteristic of neutrality because the asymmetric nature of
conservatism leads to bias in measuring assets and liabilities—and ultimately, earnings.

(In financial reporting, neutrality means avoiding bias of any kind, therefore they
should prevent any bias or error in accounting, in order to provide faithful information in
financial statements.)

(Sa kabila ng initiative para ipromote ang financial reporting that is impartial o walang
kinikilingan, meron paring conservatively biased standards na umiiral. So yung standards
across jurisdictions ay pwede paring magbago on the extent of conservatism embedded
within them. Therefore, yung analyst dapat aware sya sa mga implications ng accounting
standards for the financial report.)

Both IFRS and US GAAP specify an impairment analysis protocol that begins with an
assessment of whether recent events indicate that the economic benefit from an individual or
group of long- lived assets may be less than its carrying amount(s). From that point on,
however, the two regimes diverge:
  Under IFRS, if the “recoverable amount” (the higher of fair value less costs to sell and
value in use) is less than the carrying amount, then an impairment charge will be
recorded.
(kasi diba yung Impairment of Assets seeks to ensure that an entity's assets are not carried at
more than their recoverable amount)
 Under US GAAP, an impairment charge will be recorded only when the sum of the
undiscounted future cash flows expected to be derived from the asset(s) is less than the
carrying amount(s). If the undiscounted future cash flows are less than the carrying
amount, the asset is written down to fair value.
(Dito naman marerecord palang yung impairment charge kapag yung kabuuan ng undiscounted
future cash flows ay inaasahang galing sa assets na mas mababa ang value kesa sa carrying
amount.)

Common examples of conservatism in accounting standards include the following:

 Research costs. Because the future benefit of research costs is uncertain at the time the
costs are incurred, both US GAAP and IFRS require immediate expensing instead of
capitalization.
(So kaya kasali yung reseach costs sa example ng conservatism ay dahil kailangan sya talaga
maconsider to determine whether they should be capitalized o di kaya i-expensed as incurred.)

 Litigation losses. When it becomes “probable” that a cost will be incurred, both US
GAAP and IFRS require expense recognition, even though a legal liability may not be
incurred until a future date.
(Litigation Losses mean any and all damages, losses, claims, liabilities.)

 Insurance recoverables. Generally, a company that receives payment on an insurance

claim may not recognize a receivable until the insurance company acknowledges the
validity of the claimed amount.

(Accounting conservatism affects the quality of figures reported in the balance sheet, income
statement, and other financial statements. In the event of increased investment, this principle
leads to relatively lower reported earnings than other liberal accounting options. However, the
unrecorded reserves created by the lower earnings give the flexibility to report more earnings in
the future. A company can inject more funds in reserve to increase investment, thereby reducing
earnings.)

(Accounting conservatism is also used to record and report revenue. The principle requires that
revenues and related expenses are matched in the same period that they occur. The revenue
cannot be recorded if it is not realizable. It is premised on the fact that no revenue may be
recognized if a transaction does not create a claim to an asset or exchange of cash.)

Watts (2003) reviews empirical studies of conservatism, and identifies four potential benefits of
conservatism:
  Given asymmetrical information, conservatism may protect the contracting parties with
less information and greater risk. This protection is necessary because the contracting
party may be at a disadvantage. For example, corporations that access debt markets have
limited liability, and lenders thus have limited recourse to recover their losses from
shareholders. As another example, executives who receive earnings- based bonuses might
not be subject to having those bonuses “clawed back” if earnings are subsequently
discovered to be overstated.
(Most notably, it encourages management to face optimism or exaggerated uncertainty in its
decisions. It also means that there is a higher margin of security against distressed outputs.
In addition, accounting conservatism also leads to objective book values that are prepared based
on the Generally Accepted Accounting Principles (GAAP), making it easier for investors to
compare performance across different markets and periods.)

 Conservatism reduces the possibility of litigation and, by extension, litigation costs.

Rarely, if ever, is a company sued because it understated good news or overstated bad
news.

 Conservative rules may protect the interests of regulators and politicians by reducing the
possibility that fault will be found with them if companies overstate earnings or assets.

 In many tax jurisdictions, financial and tax reporting rules are linked. For example, in
Germany and Japan, only deductions taken against reported income can be deducted
against taxable income. Hence, companies can reduce the present value of their tax
payments by electing conservative accounting policies for certain types of events.

Analysts should consider possible conservative and aggressive biases and their consequences
when examining financial reports. Current- period financial reports may be unbiased, upward
biased through aggressive accounting choices, downward biased through conservative
accounting choices, or biased through a combination of conservative and aggressive accounting
choices.

2.5.2 Bias in the Application of Accounting Standards

Any application of accounting standards, whether the standard itself is neutral or not, often
requires significant amounts of judgment. Characterizing the application of an accounting
standard as conservative or aggressive is more a matter of intent rather than definition.

One example of biased accounting in the guise of conservatism is the so- called “big bath”
restructuring charges. Both US GAAP and IFRS provide for accrual of future costs associated
with restructurings, and these costs are often associated with and presented along with asset
impairments.