Playing by the Rules

Conceptual framework allows non-financial manager to appreciate value of accounting

principles
Perfect measure of firms profitability: once firm ceases business and sells off all of its assets
True profitability: difference between cash generated by firm during its lifetime and the costs it
incurred in generating this cash
o Works in theory, but in reality profit info needed annually for tax, investment, and
management purposes
Accounting earnings : numbers calculated each year is best guess of the performance of the
firm in that year
o Guided by accounting principles
Usefulness of accounting conceptual framework
o appreciate value of accounting principles
Patience is key to measure profitability of a firm
Revenue recognition principle: certain conditions be met before revenues are recognized
o Revenue recognized when seller acquires right to receive payment from buyer
Matching principle: costs should be matched with the revenue generated through incurring
those costs
Earnings Management: active manipulation of accounting information to create altered
impression of firms financial performance as measured by its earnings
General Accounting Principles
o Strength: manager has great latitude in exercising his/her judgement which he/she may
make choices in calculating best earning #
o Weakness: may manipulate info in opportunistic ways
Managers choose to manipulate earnings
Potential investors/lenders use the info
May want to decrease interest rate charged on loans
Managers manage earnings based on market expectations
o May recognize revenue prematurely/ push expenses to further period
Managers compensation contract based on earnings #
o May receive bonus(manipulate)
Consequences of manipulating earnings
o Reversals of fortune: manipulation done at the expense of future years
o Artificial increase in current years earnings result in decrease in future earnings
o Loss of credibility
Ethical codes of conduct developed to ensure credibility/usefulness of
accounting earnings is maintained