Accounting Tricks and Their Impact on Valuation Chapter

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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.

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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….....

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