8(a). Procedures Based on Choice, such as Accounting for Inventories and Depreciation
[Context] Meeting of the Investor Discussion Group on October 16, 1992. When discussing the types of information they use to achieve their objectives, investors were specifically asked about reducing accounting alternatives that are based on free choices.
Committee/Staff/Observer
That's a very good point about accounting alternatives. At a meeting of the subcommittee on current model enhancement in Chicago yesterday, one of the things we talked about was elimination of alternatives. The subcommittee is considering asking the standard setters to eliminate LIFO because of comparability. We also spoke about recommending the elimination of any accounting method other than straight-line, not because it is better, but because we hear from users that they want more comparability. Is eliminating alternatives really what you want? [TI 10/16, p. 32]
Participant I-7
Are you suggesting the elimination of LIFO both for reporting and tax purposes? [TI 10/16, p. 33]
Committee/Staff/Observer
No. Forget tax purposes. [TI 10/16, p. 33]
Participant I-6
As far as eliminating alternatives, I think that would be a major step in the right direction but I would put a big caveat on it. I wouldn't want to see everybody doing this because the needs of one industry may be completely different than another. For example, what is good for retail probably isn't good for basic industry, or what the users of a basic industry's financial statements want isn't the same as a financial services' users would want. Maybe what we have to do is to have specific types of accounting practices for an industry and no alternatives. [TI 10/16, p. 33]
Participant I-11
I think all of us from time to time will make all or most of these adjustments. The issue of comparability is one that arises frequently and is perhaps the most common reason I make adjustments to financial statements. But I am against a real strong stand by the accounting profession on doing away with choices. I'm thinking specifically of the decision made in the interest of comparability that nonfinancial companies had to consolidate their finance subsidiaries. Now when I look at a company, I don't know what I'm looking at. I think that was a terrible decision because it has reduced the amount of information available to me. So, I think we are all for comparability but I'm not sure it's universally good. [Also included in 1(b) and 2(c)] [TI 10/16, p. 33]
Participant I-9
The problem with LIFO is not LIFO versus FIFO, it's the year end adjustment. The fact that you can be surprised on that when you settle up at the end of the year. The accounting profession could give us a notice as to what that expected settlement would be. [TI 10/16, p. 34]
Participant I-8
It's a function of prices at the end of the year; I'm not sure the accountants could help us on that. [TI 10/16, p. 34]
[Context] Meeting of the Investor Discussion Group on December 9, 1992. Part of the meeting was devoted to the topic of alternative accounting procedures.
Committee/Staff/Observer
The last group of questions are unrelated but involve projects that are now being studied by subcommittees of the Special Committee. The first question . . . relates to alternative accounting procedures. By alternative procedures, we mean accounting methods whose use is essentially at the discretion of management, such as inventory and depreciation methods. Our question is: do you agree with the four paragraphs in the middle of page 14 of the meeting materials? If not, what changes would be needed to make the statement accurate? In effect, what those paragraphs say is that we should eliminate alternative procedures because we hear so much from users that you want comparability. Should we eliminate alternatives so that every company should follow the same basic accounting standards? [TI 12/9, p. 41]
Participant I-6
In the pure sense of it, I would argue for one set of books, tax and public reporting, but that's not the question. I think there should be standardized methods in inventory and depreciation, but I would not go so far as to say that everybody should use the same methods; I would standardize along industry guidelines. But more standardization would be better. [TI 12/9, p. 41]
Participant I-8
For example, if you prescribe FIFO for everybody, forgetting the requirements of analysts for more comparability, in an inflationary period, you would have some gross overstatements of earnings. So you're not reflecting the true economics of the organization. I don't think that does anybody any good. [TI 12/9, p. 41]
Participant I-7
LIFO would negatively impact earnings in a period of rising costs. [TI 12/9, p. 42]
Participant I-8
Right and that's a better reflection of the real economics of the business. [TI 12/9, p. 42]
Participant I-7
Because of the differences in the companies that we all follow, and even within the same industry, I don't necessarily require my companies to standardize. What I want is disclosure; then I feel it gives me a level-playing field. [TI 12/9, p. 42]
Participant I-12
I'll vote for that one. There are a lot of situations; for example, there is trade date and settlement date accounting for securities firms. The differences can be enormous. But if I know which method a company is using, I can make my adjustments my way. I'm all for disclosure but I don't think we ought to lock all American companies into the same principles because it might not be appropriate in a number of cases. [TI 12/9, p. 42]
Participant I-4
I don't think it's really correct of us to presume that we can set standards that everyone has to follow. I don't have any problems with alternative uses as long as the methods used are clearly enunciated. [TI 12/9, p. 42]
Committee/Staff/Observer
[Participant I-12] let's go back to your example of trade versus settlement date. Assuming you have two firms in basically the same business, and one uses one method and the other the other method, how is that useful to the investor when they look at those financial statements? Wouldn't it be better if the company did the adjusting for you and adopted one method? Wouldn't you get a more accurate result if everyone used settlement date, for example? [TI 12/9, p. 42]
Participant I-12
The difference between the two I believe is 5 days of float. It's a one-time difference. Is there a need for making major adjustments? Probably not, other than to recognize the existence of the difference. There's a material difference on the date you adopt the method or make the change, but not material differences afterwards. What I'm saying is that there's plenty of room for differential accounting if we know the methods that are used. [TI 12/9, p. 43]
Committee/Staff/Observer
To follow on with that question. In situations where the amounts are not easily identifiable in the financial statements, for example in the case of depreciation, how would you go about adjusting the information? Where do you get the information? Said in a different way, if disclosure is an acceptable substitute to mandating one-size-fits-all, then how would you get the information to true up different entities to the same basis? [TI 12/9, p. 43]
Participant I-7
My companies will generally give in the annual report the LIFO accrual provision, so I can tell from that source. [TI 12/9, p. 43]
Committee/Staff/Observer
But, for example, maybe in the case of the successful effort versus full cost, when there is not a discrete number in the footnote or the balance sheet, how would you go about doing that, or how do you go about that, or do you? [TI 12/9, p. 43]
Participant I-7
If it were significant, I would have to ask the company. [TI 12/9, p. 43]
Participant I-8
I have a lot of companies where that difference is the deferred tax item, for example in the case of depreciation accounting; if it's not that, then you have to ask. [TI 12/9, p. 43]
Participant I-6
I disagree. I have asked some of my companies time and time again what's the difference between successful efforts and full costs and it's huge and all of a sudden they have a huge write-off. For inventory accounting, it's pretty simple but you get beyond that and it's not that simple. [TI 12/9, p. 44]
Participant I-7
In my industries, I tend to find that a discussion about FIFO or LIFO or straight-line or sum-of-the-digits never comes up with my clients until there is a problem. For years, I had a major company in the industry telling every analyst about how conservative their accounting was and they had consistent profit problems and they were never rewarded for it. [TI 12/9, p. 44]
Participant I-9
On the inventory side, I don't think there's much of a problem; there aren't that many accounting standards used and they are well understood. What you worry about in the inventory is the age of the inventory, whether it's obsolete or not. The problem on the depreciation is not straight-line versus sum-of-the-digits, it's that I don't have any confidence on the useful life selected for depreciation. Whichever method you use is less relevant than having the right number of years to depreciate. [TI 12/9, p. 44]
Committee/Staff/Observer
[Committee/staff/observer] asked a very key question. For inventory, you get the difference between methods in the disclosure, but in depreciation, you don't get the difference between an accelerated method and a straight-line method. I think that working backwards from the deferred tax footnote is an oversimplistic answer and may not really be true. So the question [committee/staff/observer] is asking is do you even care or how do you go about doing it? Is it something that is not important to you? [TI 12/9, p. 44]
Participant I-6
It's important to me in the natural resources industry. [TI 12/9, p. 44]
Participant I-4
I think to some degree it's a question that can't be answered with disclosure and it highlights the idea that accounting presentation is only one part of the work that we do. Accounting information highlights the questions that we need to ask to management. I don't know if this could properly be shown in a disclosure item. [TI 12/9, p. 45]
Participant I-7
I don't want all the companies to fit in the same box. I want full disclosure so that I can make my mind up. I'll say it again; until there is an earnings problem, no one asks about the differences between LIFO and FIFO. [TI 12/9, p. 45]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of alternative accounting procedures.
Committee/Staff/Observer
Can we turn to page 21 [of the meeting materials]? Looking at the first part of the question 11, it walks you down through a question and an answer thing that we want to impose on each one of these topics. If it is a problem, what do you do to solve it?. That is, do you make a change, yourself? Is it a problem that you think needs to be limited to only one answer that's good for everyone? Or is it an answer that has to be imposed on individual industries? And if the answer is no, it's a problem but I don't want to see any change. Then does that mean that it's not a problem that's not surmountable in anyway in user analysis? We'll try this on the first one. Alternative procedures. Inventories can be FIFO or LIFO. And depreciation can use a variety of different methods. And you can get very complex accounting that goes around from, say, full cost to successful efforts or in the investment business trade date versus settlement date. In some cases, the footnotes have the information that if you wanted to recast you could, either directly because the footnotes tell you the alternative number. Or indirectly, because the footnotes basically allow you to extrapolate back to what the number probably is or close to it but in other cases there's no clue to unravel what it looked like if we used the other approach. So where there's a choice of accounting methods, should we eliminate that choice and prescribe one method? [TC 2/2, p. 35-36]
Participant C-14
As a matter of policy, comparability of financial statements should have a really high priority. In some areas, I guess, you could make arguments for why some companies do it one way versus another. For the most part I guess I prefer that they have disclosure rather than eliminating choices. [Also included in 2(c)] [TC 2/2, p. 36]
Committee/Staff/Observer
When you encounter a company that is using a choice, do you do something? [TC 2/2, p. 36]
Participant C-14
We won't recast our entire financial statements. We kind of adjust the numbers so that they're more comparable to others in the industry that may be using a different method. Because a lot of the analysis is getting into profitability, core profitability, and once you're using the same principles you can see the competitive position. [TC 2/2, p. 37]
Participant C-7
Looking at the segment that we service, lot of these decisions are driven by the tax consequences. A typical owner wants to maximize after-tax cash flow. That's the reason for the selection of LIFO or FIFO or accelerated depreciation method. I don't see in our analysis that we run into any surmountable difficulties in dealing with these. [TC 2/2, p. 37]
Committee/Staff/Observer
So are you saying that living with the status quo in a multi-choice world is fine with you? [TC 2/2, p. 37]
Participant C-7
In our environment, for the type of customers we're servicing, yes. [TC 2/2, p. 37]
Participant C-5
We do make some conversions, primarily the inventory conversion. But I think the concept of consistency among financial statements is important. And I think it will become increasingly important over the next five years. [Also included in 2(c)] [TC 2/2, p. 37]
Committee/Staff/Observer
My understanding is that the analysts might be more interested in what capital expenditure is going to be and what repairs and maintenance might be, as opposed to what is the precise difference between the straight line and the sum of the digits or a straight line and some other accelerated method. [TC 2/2, p. 37]
Participant C-5
Yes. [TC 2/2, p. 37]
Participant C-17
Public companies want to show profits. If I took the same company, private and public, looked at the bottom line, private guy, he's going to show as little as he can. Because he's not reporting to a shareholder. I understand that, whereas a public company is going to try to balance the two. So this doesn't trouble me in terms of having to make those adjustments. I think the world's so complex that I think to try and mandate a vanilla standard is impractical. [TC 2/2, p. 37-38]
Participant C-13
Philosophically, I'm in favor of one measure of accounting. What [participant C-14] said about comparability, I couldn't agree with him more. [Also included in 2(c)] [TC 2/2, p. 38]
Committee/Staff/Observer
Within the same company? [Also included in 2(c)] [TC 2/2, p. 38]
Participant C-13
No, within the industry, between other alternative investments. What the institutional investor is doing is choosing between a broad range of alternatives, not looking at one individual lending decision. When you're lending, you're not deciding whether you're going to lend to this company or that company. And to the extent that you have comparability, direct comparability between the statements of one or the other, it makes the job easier. You don't have to make the various adjustments. Now, in the case of full cost and successful efforts, there isn't enough information on the statements in order to make those kinds of comparability judgments. You've got to get behind it and find out. I do think of the four that are mentioned, I don't think we'd have any problem about trade date and settlement date. [Also included in 2(c)] [TC 2/2, p. 38]
Participant C-11
A very important point to make is that the methods which are being used should be disclosed. That is, the importance of it is that the analyst, not the accountant, but the analyst is then in the position to know what adjustments to make. For example, if somebody is aggressively depreciating, or definitely under depreciating, then you can at least think about the industry that you're dealing with. Think about the fact as to what if somebody has got an impaired asset future because they didn't properly depreciate or vice versa. They're, in effect, hiding all kinds of wonderful cash flow. Of course, the cash flow statement deals with that; the important thing is that you know what's going on, which isn't always easy. [TC 2/2, p. 38]
[Context] Responses to the postmeeting questionnaire to the February 2, 1993 Creditor Discussion Group meeting.
QUESTION 7-Inventory Methods
With respect to alternative inventory accounting methods, FIFO or LIFO, please indicate your preference with 1 meaning most preferred, 2 meaning next preferred, and so on to 5 meaning least preferred (use a number only once).
1-2,2-2,3-2,4-2,5-2 No change in accounting is needed; companies should continue to have free choice of which inventory method to use as long as each disc loses which method it uses
1-3,2-3,3-4,4-0,5-0 Companies should have a choice of method, but if LIFO is chosen, supplemental disclosure on a FIFO basis should be provided
Participant C-18: These are not alternatives.
1-2,2-4,3-4,4-0,5-0 Companies should have a choice of method, but if FIFO is chosen, supplemental disclosure on a LIFO basis should be provided
Participant C-18: These are not alternatives.
1-2,2-0,3-0,4-1,5-7 Only FIFO should be permitted because (check all that you believe are appropriate)
2 FIFO better reflects the way inventories are managed and thus better reflects inventory costs and gross profits on sales of inventory.
4 LIFO can artificially boost profits through decreasing units on hand at year-end.
2 Need for comparability outweighs whatever conceptual merits LIFO may have.
1 Other. Please describe
Participant C-18: None of these reasons are appropriate - limiting to FIFO only would distort F/S - very bad idea.
Participant C-2: Generally, (but not always) offers a better approximation of inventory value for collateral margins on the balance sheet.
1-2,2-1,3-1,4-6,5-0 Only LIFO should be permitted because (check all that you believe are appropriate)
4 LIFO dampens the effects of inflation on gross profits
Participant C-2: Is becoming far less critical.
4 LIFO can be used for tax purposes only if used for financial reporting as well
3 Need for comparability outweighs whatever conceptual merits FIFO may have
Other. Please describe
Participant C-18: Again, choice is key to reflecting differences (one situation to another). But this method is better (if only one choice) then FIFO.
Participant C-2: Make estimation of values other than LOCOM (book) a little more difficult (or a lot more difficult in some cases!)
[PMQC 2/2, p. 14-15]
__________
QUESTION 8-Depreciation Methods
With respect to alternative depreciation methods-
Please indicate your preference with 1 meaning most preferred, 2 meaning next preferred, and 3 meaning least preferred (use a number only once).
1-6,2-5,3-2 No change in accounting is needed; companies should continue to have free choice of which depreciation method to use as long as each discloses which method it uses
1-4,2-7,3-2 Companies should have a choice of method, but if other than straight-line depreciation is chosen, supplemental disclosure on a straight-line basis should be provided
1-3,2-2,3-6 Only one depreciation method should be permitted, and that method should be
2 Straight-line depreciation, because (please check as many as are appropriate)
1 Need for comparability outweighs whatever conceptual merits accelerated depreciation may have
1 Most companies already use straight-line depreciation, and there is little or no reason for a small minority to be different
Other. Please describe
Participant C-17: I cannot assign a rating as long as I know the effect of depreciation on cash flows, I am indifferent to the one and three options.
Participant C-15: Different methods are appropriate for different industries.
5 Accelerated depreciation, because (please check as many as are appropriate)
4 Accelerated depreciation better reflects the way plant and equipment assets wear out
4 Accelerated depreciation is widely used for tax purposes, and its use in financial statements would decrease the differences between reported net income and taxable income
Other. Please explain
Participant C-17: Same as above.
Participant C-14: Management decisions on asset purchases/sales reflect the tax incentives.
Other method. Please specify
Participant C-17: Same as above.
3 Either straight line or accelerated depreciation. Only one depreciation method should be permitted because of reason(s) below (please check as many as are appropriate), but I am indifferent about which method is chosen
Participant C-2: Can work with either.
3 Need for comparability outweighs whatever conceptual issues may be involved
1 Other. Please describe
Participant C-17: Same as above.
[PMQC 2/2, p. 16-17]
[Context] Responses to the postmeeting questionnaire of the December 9, 1992 and January 13, 1993 Investor Discussion Group meetings.
QUESTION 13 - Inventory Methods
With respect to alternative inventory accounting methods-
FIFO, the first-in, first-out method (including for our purposes its equivalent for fungible inventories that are physically mixed-the weighted-average method), which attributes the oldest costs to cost of goods sold and the most recent costs to inventory on hand
LIFO, the last-in, first-out method, which attributes the most recent costs to cost of goods sold and the oldest costs to inventory on hand-
Please indicate your preference with 1 meaning most preferred, 2 meaning next preferred, and so on to 5 meaning least preferred (use a number only once)
1 2 3 4 5
No change in accounting is needed; companies should
continue to have free choice of which inventory method
to use as long as each discloses which method it uses 3 1 1 2
Companies should have a choice of method, but if LIFO
is chosen, supplemental disclosure on a FIFO basis
should be provided 1 5 1
Companies should have a choice of method, but if FIFO
is chosen, supplemental disclosure on a LIFO basis should
be provided 1 2 3 1
Only FIFO should be permitted because (check all that you
believe are appropriate) 2 2 2
FIFO better reflects the way inventories are managed and
thus better reflects inventory costs and gross profits on sales
of inventory 2
LIFO can artificially boost profits through decreasing units
on hand at year-end 1
Need for comparability outweighs whatever conceptual merits
LIFO may have 1
Other. Please describe
Participant I-11: LIFO has no conceptual merits- it is purely a tax device. It also offers opportunities for
easy manipulation by varying period-ending inventory when prices are high. 1
Only LIFO should be permitted because (check all that you
believe are appropriate) 1 3 1 2
LIFO dampens the effects of inflation on gross profits 2
LIFO can be used for tax purposes only if used for financial reporting as well 2
Need for comparability outweighs whatever conceptual merits FIFO may have 2
Other. Please describe
Participant I-9: I prefer LIFO generally but in some industries it does not make much difference whether
LIFO or FIFO is used.
Participant I-12: Another choice: must report using same method as internal management ( a twist on
current practice)
[PMQI 12/9 and 1/13, p. 25-27]
QUESTION 14 – Depreciation Methods
With respect to alternative depreciation methods—
straight-line depreciation methods, which report the same amount of depreciation for each year, each unit
of output, or each hour of use constituting the useful life of an asset
accelerated depreciation methods, such as sum-of-the-years'-digits or double-declining-balance, which
report a declining amount of depreciation as assets get older—
Please indicate your preference with 1 meaning most preferred, 2 meaning next preferred, and 3 meaning
least preferred (use a number only once)
1 2 3
No change in accounting is needed; companies should continue to have free choice of which depreciation
method to use as long as each discloses which method it uses
Participant I-12: Information on classes of assets and/or average
lives would be helpful. Especially for data processing and high
tech items. 2 1 4
Companies should have a choice of method, but if other than
straight-line depreciation is chosen, supplemental disclosure
on a straight-line basis should be provided 3 4
Only one depreciation method should be permitted, and that method
should be (check one of the following boxes: straight-line
depreciation, accelerating depreciation, other method, or either
straight-line or accelerating depreciation) 2 2 3
Straight-line depreciation, because (please check as many
as are appropriate) 1
Need for comparability outweighs whatever conceptual merits
accelerated depreciation may have 1
Most companies already use straight-line depreciation, and there is
little or no reason for a small minority to be different
Other. Please describe
Accelerated depreciation, because (please check as many as
are appropriate) 4
Need for comparability outweighs whatever conceptual merits
straight-line depreciation may have 2
Accelerated depreciation better reflects the way plant and equipment
assets wear out 3
Accelerated depreciation is widely used for tax purposes, and
its use in financial statements would decrease the differences
between reported net income and taxable income 3
Other. Please explain
Other method. Please specify and explain why it should be adopted
Either straight line or accelerated depreciation. Only one depreciation method should be permitted
because of reason(s) below (please check as many as are appropriate), but I am indifferent about
which method is chosen
Need for comparability outweighs whatever conceptual issues may be involved
Other. Please describe
[PMQI 12/9 and 1/13, p. 22-26
[Context] The papers are a summary of a committee and staff members' discussions with selected sell-side analysts from Goldman Sachs.
[One analyst] believes accounting should strive to avoid volatility in earnings and he stated that the pooling concept makes numbers hard to compare. He believes there should be one standard for accounting and specifically mentioned his unhappiness with the choice of either of LIFO or FIFO. He tends to look at five years back and projects two years forward. [Also included in 1(a), 1(b), and 7(c)] [GOLDMAN, p. 3]
__________
From what has briefly been described of the [foreign] financial analysts' work, there results a series of requirements with regard to accounting data, which are but insufficiently met at present. We have broken them down into . . . major categories. [Also included in 1(b), 2(c), 2(d), 3(c) 4, 5(a), 5(c), 6, 9, 11(b), 11(c), and 15] [BETRIOU, p. 1]
It is likely that the objectives of all accounting data users do not coincide. As far as they are concerned, [foreign] financial analysts essentially need data which reflects the economic reality of entities they examine (groups or companies). Further progress is still required and we have broken this down into . . . categories: [Also included in 1(b), 4, 5(a), 6, 9, and 15] [BETRIOU, p. 3]
[L]easing should be entered in the assets and liabilities on the balance sheet (and not off the balance sheet which distorts the meaning of debts and fixed assets). Standardization at the European level would be useful. [Also included in 1(b) and 15] [BETRIOU, p. 3]