Why is Harry Malone concerned about relying on NuWare's reported performance? If NuWare follows the generally accepted accounting principles (GAAP), shouldn't the company's reported financial statements be reliable?
Generally Accepted Accounting Principles (GAAP) is defined as 'the standard guidelines of accounting rules for financial accounting and to prepare financial statements for private companies and the companies trading publicly in United States'.(4)
A financial statement following GAAP needs to be relevant, reliable, consistent and comparable. There are further four more basic assumptions made namely : Economic Entity Assumption, Going Concern Assumption, Monetary Unit Assumption, and Periodic Reporting Assumption.
GAAP exercises four basic principles to implement and achieve the objectives. (5)
Historical Cost Principle - The acquisition costs should be considered and not their fair market value for liabilities and assets.
Revenue Recognition Principle - Accrual basis accounting is preferred.
Matching Principle - This allows greater evaluation of actual profitability and performance, since the expenses are matched with revenues.
Principle of Full Disclosure - Information disclosed in the financial statement is enough to make a judgment while keeping all costs reasonable.
However GAAP provides tremendous leeway for companies to make assumptions. Let us consider a few choices made in financial statements which make it unreliable in spite of it following GAAP.
Depreciation
To state an example, deprecation of a 10$ fleet of cars over 10 yrs by the straight line method will reduced company earnings by only 10million. But another firm might consider the depreciation period to be 5 years and thus a deduction of 2$ million from the earnings. Similarly increasing the period of depreciation will boost current earnings
If we take the example of Nuware and R.P Stuart, both use straight line depreciation method but uses a longer depreciation period and has a significantly lower deprecation deduction than R.P Stuart.
Revenue recognition
As per GAAP it is critical to recognize when a sale count as a sales. Do we make an entry when the contract is signed or when the payment is received. To record revenue, a company must have pretty much fulfilled its obligations and be reasonably certain that it will get paid. Nuware recognizes revenue upon customer receipt or delivery which is ideal. Sales under deferred payment promotions are on Company's propriety credit card. Allowances have been made to provide estimates for merchandise returns. However a high in deferred revenue balance might indicate inefficiency delivering goods and services. (10)
Expense estimates/Reserves.
Most companies are required to set up reserve accounts for potential future expenses/bad debts. The potential for manipulation begins in good years, when high future payout estimates can be used to stock large amounts of money. In bad years, we can adjust the estimates downward, freeing up the money to compensate for a shortfall in profits. Reserve estimates are judgment calls and are highly susceptible to simple mistakes, as well as outright manipulation. The fall of reserves in balance sheet of Nuware is from $16410 in 2002 to $9438 in 2003, which is a subject of scrutiny.
Inventory
Inventory is the largest and probably the most important asset for many manufacturing and trading corporations. Inventory is probably the lowest liquid asset in the category of current assets. No wonder why stakeholders such as Credit rating agencies, Banks, Corporate and Individual Inventors are known to place such high importance on the valuation of inventories. The value arrived as the closing inventories directly affects the Gross profit, Operating cycle, the Current ratio, Inventory turnover; all of which are key determinants of the profitability and the short term liquidity position for any organization. Hence the valuation method used to arrive at the closing inventory balance gains significant importance.
GAAP requires that all inventory reserves be stated and valued using either the cost or the market value method - whichever is lower. If the cost of inventory exceeds the market value, an adjustment must be made to the inventory value entry on the balance sheet. If the cost of inventory exceeds the market value, an adjustment must be made to the inventory value entry on the balance sheet. (http://www.investopedia.com/ask/answers/05/070105.asp#axzz2JDoQDuRX)
GAAP allows firms latitude in selecting a cost flow assumption. Some firms use FIFO, others use LIFO, and still others use weighted-average.
During periods of rising prices and stable or increasing inventory levels (as is generally the case), firms reporting under US GAAP prefer to use LIFO because it results in higher Cost of goods sold, lower net income and consequently lower taxes. Paying lower taxes improves the firm's operating cash flows. On the other hand, LIFO uses older prices to value inventory. Therefore, in a period of rising prices and stable or increasing inventory levels, LIFO results in lower Closing Inventory and consequently lower current assets on the statement of financial position. (11)
Nuware uses a LIFO system of evaluation. LIFO makes it possible to "manage" earnings when inventory costs are rising. Firms can accelerate inventory purchases at the end of a "good" earnings year so that COGS rises and delay inventory purchases toward the end of a "bad" earnings year so that COGS falls when old LIFO layers are liquidated.
All such possibilities of manipulations even while following GAAP principals, makes it very plausible for firms like Nuware to have unreliable financial statements.
