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emerging/innovative research session

    Pam Rouse
    Visualizing Cash and Accrual Accounting
    emerging/innovative research session posted August 4, 2011 by Pam Rouse, last edited February 10, 2012 
    3460 Views, 7 Comments
    title:
    Visualizing Cash and Accrual Accounting
    author(s), affiliation(s):
    Pamela J. Rouse, Anne S. Kelly, J. Christopher Stump
    date:
    August 10, 2011 9:30am - 11:00am
    session description:

    Research Interaction Forum - Informal discussion of experiential learning tools and its impact on learning.

    abstract:

    One of the key learning objectives for the introductory accounting courses is to understand cash and accrual accounting. Introductory accounting students often stumble when they attempt to distinguish between cash and accrual accounting in
    both the financial and managerial courses. The revenue recognition and the matching principles cause confusion for
    students in financial accounting.  This lack of clarity is apparent when students use financial information to prepare
    a company’s set of financial statements, specifically the Income Statement on the accrual basis and the Statement of Cash Flows.  In managerial accounting, this misunderstanding resurfaces when students are taught budgeting and they are
    asked to prepare the cash budget and the budgeted income statement.  Although the following discussion describes
    some of the issues associated with cash and accrual accounting in both introductory course settings, the teaching example presented here is used primarily in an introductory managerial accounting course.  It specifically combines two experiential learning techniques as supplements to the accounting textbooks so that students can visualize the difference between cash and accrual accounting which enhances their understanding of accrual accounting.

    Comment

     

    • Pam Rouse

      The banner that was posted provides an overview of the two experiential learning techniques used in the study. Additional detail can be provided during the presentation.

    • Robert E Jensen

      A Case About Cash Flow Versus Accrual Accounting

      From The Wall Street Journal Accounting Weekly Review on December 16, 2011

      Diamond Payments Questioned By Growers
      by: Hannah Karp
      Dec 12, 2011
      Click here to view the full article on WSJ.com
       

      TOPICS: Auditing, Cash Flow, Fiscal Year, Inventory Systems, Mergers and Acquisitions

      SUMMARY: Diamond Foods, Inc., may have been attempting to reduce its 2010 costs for nut purchases and shift them into 2011 in order to maintain a sufficient stock price for use in purchasing the Pringles chips product line from Procter & Gamble. The related article indicates that Investigating the payments has led to a delay in filing the company's fiscal quarterly financial statements with the SEC.

      CLASSROOM APPLICATION: The article is useful in discussing cash versus accrual based accounting and when cash payments subsequent to a fiscal period may indicate that liabilities were in existence at a financial statement date. The discussion also can be used to discuss the impact of purchases of direct materials on the calculation of cost of goods sold.

      QUESTIONS: 
      1. (Introductory) What is the discrepancy between Diamond Foods, Inc.'s description of payments to walnut growers and what the farmers themselves say the payments are for?

      2. (Advanced) In this case, how does shifting the timing of cash payments help to shift the period in which costs are expensed by Diamond Foods, Inc.? In your answer, explain what item of cost is being paid for by Diamond.

      3. (Advanced) Does the time period for cash payouts always match the period in which expenses for the item in question are recorded? Explain your answer

      4. (Advanced) How have questions about these payments impacted Diamond Foods planned acquisition of Pringles snack chips from Procter and Gamble? In your answer, address how reducing Diamond's 2010 costs would impact the planned transaction given its structure as described in the WSJ article.
       

      Reviewed By: Judy Beckman, University of Rhode Island
       

      RELATED ARTICLES: 
      Probe Delays Diamond Foods' Report
      by Hannah Karp
      Dec 13, 2011
      Online Exclusive

      "Diamond Payments Questioned By Growers,"  by: Hannah Karp, The Wall Street Journal, December 12, 2011 ---
      http://online.wsj.com/article/SB10001424052970204336104577092701009641444.html?mod=djem_jiewr_AC_domainid

      Some walnut growers have challenged Diamond Foods Inc.'s explanation of mysterious payments to them, further tangling an accounting question that has delayed the snack maker's planned $2.35 billion acquisition of Pringles from Procter & Gamble Co.

      Diamond Foods has said a sizable payment to its walnut growers in September was an advance on their 2011 crop.

      But three growers said they told the company that they didn't intend to deliver their 2011 crops to Diamond, yet were assured by company representatives that they could cash the checks anyway. The three said they were told the checks were to top up payments for their 2010 crops.

      The company is the subject of shareholder suits that claim Diamond may have used the payments to shift costs from the fiscal year that ended July 31 into the current year, padding earnings for the previous year.

      The checks to the growers, what the company called momentum payments, are the subject of an investigation by Diamond's board and have become a sticking point in the company's deal to buy the Pringles snack brand. Diamond plans to pay in part with its stock, which has dropped 56% since late September, shortly after the company reported fiscal-year results.

      Diamond said its agreements with growers are confidential.

      Many growers, who harvested their 2011 crops last month, said they had never seen momentum payments before. Some growers also had grumbled over what they said were insufficient payments from Diamond for their 2010 crops.

      Mark Royer, who has grown walnuts for Diamond for the past 10 years, said he hadn't decide whether to deliver his 2011 crop to the company when he received his momentum check in September. He said he called his Diamond field representative to explain "what the mysterious payment represented."

      "I made the assumption it would have to be 2010 compensation, because the delivery-to-date pricing was almost 40% under market," Mr. Royer said.

      He said the representative told him Diamond executives "were not committing" about which crop the payment was for. "He simply said that he knew that certain growers were cashing their momentum-payment check with the understanding that they didn't intend to deliver in 2011."

      Mr. Royer said he then decided it was safe to deposit his check.

      He said he won't deliver this year's crop to Diamond. "I've kind of washed my hands of the matter," he says.

      A grower from Sacramento, Calif., said he was unsatisfied with his final official payment this summer for his 2010 crop. "It was grossly under what other growers had received," he said.

      He was pleased to get another check, for $90,000, several days later, he said.

      But he said he had been concerned that accepting the payment would require him to deliver his fall harvest to Diamond. He said field-service representative Eric Heidman, in Stockton, Calif., assured him that the check was the last payment for the 2010 crop.

      Mr. Heidman didn't return calls seeking comment.

      Another grower in Northern California said his field representative told him the momentum check was for 2010, and that he had told Diamond he wouldn't deliver this year's crop to the company. He said he had his lawyer send Diamond a letter, confirming that the grower wouldn't deliver this year's crop and would cash the check.

      Diamond began an investigation into its accounting practices last month after the chairman of the board's audit committee, Edward Blechschmidt, received complaints about the payments from someone outside the company.

      The investigation delayed Diamond's cash-and-stock purchase of Pringles from P&G.

      Continued in article

      Bob Jensen's threads on cash flow versus accrual accounting analysis ---
      http://www.trinity.edu/rjensen/Theory02.htm#CashVsAccrualAcctg

    • Robert E Jensen

      How could this be if the Matching Principle is dead?

      September 1, 2012 message from Scott Bonacker

      If you need an example for a class, here is one about how third party developers and the way they offer products through Intuit  is being changed -

      At a high level, the current changes are the result of revenue recognition requirements as determined by the Intuit auditors. The short story is that if Intuit sells the QuickBooks desktop product, they are required to recognize the revenue over the time period that the customer receives services related to that product. For example, if a customer is using QuickBooks 2010, and Intuit is providing support for the sync manage for that product, then (in theory) the time period for the revenue recognition is not when the software was sold. The revenue should be allocated over the time period that Intuit is incurring costs for that product. In this case, if they provide support for the Sync Manager until the product is sunsetted, then the time period could be 3 plus years as compared to recognizing the revenue in the year of purchase.

      More in the article

      http://www.sleeter.com/blog/2012/08/intuit-app-center-changes-and-how-they-affect-you/

       

      "Global Financial Reporting: Implications for U.S.," by Mary Barth, The Accounting Review, Vol. 83, No. 5, September 2008 ---
      Not free at http://www.atypon-link.com/AAA/doi/pdfplus/10.2308/accr.2008.83.5.1159

      This paper identifies challenges and opportunities created by global financial reporting for the education and research activities of U.S. academics. Relating to education, after overviewing the relation between global financial reporting and U.S. GAAP, it offers suggestions for topics to be covered in global financial reporting curricula and clarifies common misunderstandings about the concepts underlying financial reporting. Relating to research, it explains how and why research can provide meaningful input into standard-setting, and identifies questions that can motivate research related Go topics on the International Accounting Standards Board’s technical agenda and to the globalization of financial reporting.

      . . .

      Globalization of financial reporting is becoming a reality. However, many challenges remain. There are many around the world unfamiliar with independent standard-setting and an investor focus for financial reporting. They are struggling with the changes but are learning. No change is universally popular, and revolutionary “big bang” change is very difficult. Evolutionary change is somewhat easier to implement and absorb, although changing multiple times is costly. We also have not yet fully resolved the issue of individual country modifications to standards, which stand in the way of truly global financial reporting. Outside of the U.S., there is a concern that the U.S. will dominate. This concern relates not only to our thinking about issues, but also to the way the standards are written. In particular, there is a concern that the U.S. tendency to provide considerable detailed guidance will manifest itself in global standards. Inside the U.S., there is a concern that IFRS lack rigor and, thus, are not high quality. There also is a concern that the standards are not specific enough and enforcement around the world is not strict enough to ensure consistent application. Clearly, there is a tension. However, progress in the last five years toward global financial reporting has been breathtaking, and it continues apace. The SEC permitting use of IFRS in the U.S. would be a major step forward.

      The implications for U.S. academics are profound. The U.S. is deeply involved in and will be affected by global financial reporting. U.S. academics need to educate first themselves and then their students to be able to participate in a global world. There also is a myriad of open questions for research that U.S. academics can address. The capital markets are demanding a single language of business. They are demanding that the single language of business be developed internationally, not solely in the U.S. This demand for a single global language of business will be met. The market forces are too great to stop. The question is how, not whether, it will happen, and how, not whether, U.S. academics will participate.

      On Page 1166 Mary flatly asserts:

      First, there is no “matching principle.” That is, matching is not an end in itself and matching is not an acceptable justification for asset or liability recognition or measurement. The conceptual framework explains that matching involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events (FASB 1985, para. 146; IASB 2001, para. 95). Matching will be an outcome of applying standards if the standards require accounting information that meets the qualitative characteristics and other criteria in the conceptual framework. Matched economic positions will naturally result in matched accounting outcomes. However, the application of a matching concept in the conceptual framework does not allow the recognition of items in the statement of financial position that do not meet the definition of assets or liabilities (IASB 2001, para. 95). Thus, there would be no justification for deferring expense recognition for an expenditure that provides no future economic benefit or for deferring income recognition for a cash inflow that will not result in a future economic sacrifice.

      But matching still seems to prevail even though there is no more "matching principle according to the IASB and the FASB. The answer is that revenue can be deferred when there will be "future economic sacrifice." Sounds like matching to me. Neither domestic nor international standards allow early realization of revenue before it is legally earned. The standards just do not allow automobile inventories to be written up to expected sales prices until those sales are finalized. Carrying the inventories at something other than sales value is part and parcel to the "matching principle" eloquently laid out years ago by Paton and Littleton. Both international and domestic standards still require cost amortization, depreciation, and creation of warranty reserves. These are all rooted in the "matching principle" which has not yet died when defining assets and liabilities in the conceptual framework. In most instances the historical cost is still being booked and spread over the expected life of future economic benefits. Even if a company adopted a replacement cost (current cost) adjustment of historical cost of a depreciable asset, those replacement costs still have to be depreciated since old equipment cannot simply be adjusted upward to new, un-depreciated replacement cost.

      Paton and Littleton never argued that the "matching principle" for expense deferral applies to assets that have "no future economic benefits." In that case there would be no benefits against which to match the deferred expense.  Hence there's no deferral in such instances. I do not buy Barth's contention that there is no longer any "matching principle." If there are potential future benefits, the matching principle still is king except in certain instances where assets are carried at exit values such is the case for precious metals actively traded in commodity markets and financial assets not classified as "held-to-maturity."

      The Matching Principle lives on when there are expected "future economic sacrifices."

      September 1, 2012 message from Scott Bonacker

      If you need an example for a class, here is one about how third party developers and the way they offer products through Intuit  is being changed -

      At a high level, the current changes are the result of revenue recognition requirements as determined by the Intuit auditors. The short story is that if Intuit sells the QuickBooks desktop product, they are required to recognize the revenue over the time period that the customer receives services related to that product. For example, if a customer is using QuickBooks 2010, and Intuit is providing support for the sync manage for that product, then (in theory) the time period for the revenue recognition is not when the software was sold. The revenue should be allocated over the time period that Intuit is incurring costs for that product. In this case, if they provide support for the Sync Manager until the product is sunsetted, then the time period could be 3 plus years as compared to recognizing the revenue in the year of purchase.

      More in the article

      http://www.sleeter.com/blog/2012/08/intuit-app-center-changes-and-how-they-affect-you/

    • Robert E Jensen

      Teaching Case on the Allowance for Doubtful Accounts accrual accounting (under the Matching Concept) Versus
      the Cooke Jar Accounts accounting (under the Profit Smoothing Concept)

      Either the banks are illegally using the Allowance for Doubtful Accounts ledger inappropriately as cookie jar reserves or there is something that I'm not aware of that suddently allows USA banks to use cookie jar accounts apart from accounting rules and regulations for other companies.

      The Allowance for Doubtful Accounts ledger accounts were never intended to be cookie jar income smoothing accounts.

      The bottom line is that I do not understand the article below by Michael Rapaport.

       

      From The Wall Street Journal Weekly Accounting Review on November 1, 2013

      Reserve Funds Pad Profits
      by: Michael Rapoport
      Oct 26, 2013
      Click here to view the full article on WSJ.com
       

      TOPICS: Allowance For Doubtful Accounts, Bad Debts, Banking, Earnings Management, FASB

      SUMMARY: The article focuses on bank loan loss reserves, but the parallel to income effects from any reduction in bad debt provisions can be highlighted to students. At the end of the article, the FASB's proposed changes to an impairment model for loan losses-looking to future expectations of realizable cash flows rather than only past collectability of receivables-is discussed.

      CLASSROOM APPLICATION: The article may be used to cover banking or any loan loss allowance. It also may be used to cover the FASB/IASB project on Financial Instruments--Credit Losses.

      QUESTIONS: 
      1. (Introductory) What area of bank reporting has the Wall Street Journal analyzed for this article? How are bank regulators also looking at this issue?

      2. (Advanced) What are loan loss reserves? What alternate term does the accounting profession use in place of "reserves"? In your answer, contrast this term with the word "provision."

      3. (Advanced) Summarize the accounting for allowance for uncollectable accounts. How is an allowance for uncollectable accounts (or allowance for bad loans or receivables) established? What happens when an uncollectable account is written off?

      4. (Advanced) What happens when an allowance for uncollectable accounts is reduced because of improving economic conditions leading to better collectability of receivables? Specifically address the statement in the article that "accounting rules allow the money to flow directly into profits."

      5. (Introductory) What is the concern with the timing of banks improving profits with the "release" or reduction in allowances for uncollectable loans?

      6. (Advanced) "Bankers say current accounting rules essentially compel them to release reserves when loan losses ease..." Explain this statement.

      7. (Advanced) "Rule makers at the Financial Accounting Standards Board have proposed changes..." in a project on Financial Instruments-Credit Losses. Access the summary of this Proposed ASU on the FASB web site at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176160587228 Summarize the reasons for the project.

      8. (Advanced) Again return to the FASB proposed ASU. How does an impairment model consider future cash flows better than traditional methods of establishing an allowance for uncollectable accounts? To answer, describe the process of determining an impairment of an asset and compare to the description you wrote in answer to question 3 above.
       

      Reviewed By: Judy Beckman, University of Rhode Island

      "Reserve Funds Pad Profits," by Michael Rapoport, The Wall Street Journal, October 26, 2013 ---
      http://online.wsj.com/news/articles/SB10001424052702304682504579155931092819234?mod=djem_jiewr_AC_domainid

      Federal regulators have warned banks to be careful about padding their profits with money set aside to cover bad loans. But some of the nation's biggest banks did more of it in the third quarter than earlier this year.

      J.P. Morgan Chase JPM -2.02% & Co., Wells Fargo WFC -0.95% & Co., Bank of America Corp. BAC -1.41% and Citigroup Inc., C -2.21% the nation's largest banks by assets, tapped a total of $4.9 billion in loan-loss reserves in the third quarter, up by about a third from both the second quarter and the year-ago quarter after adjustments. All the banks except Citigroup showed significant increases compared with the second quarter.

      Accounting rules allow the money to flow directly into profits. In all, it made up 18% of the banks' third-quarter pretax income excluding special items, the highest percentage in a year, according to an analysis by The Wall Street Journal.

      The moves come at a time when banks are being slammed by revenue slowdowns. Big commercial banks have suffered from a double whammy of plunging mortgage lending and trading activity. Third-quarter revenue for the four banks dropped an average of 8% from the previous quarter. The KBW Bank Index has declined 2% in the past three months, while the S&P 500 stock index has gained 4% over the same period.

      The accounting maneuvers show how banks can prop up earnings when business hits a rough patch.

      "You've seen reserve releases improve the stated numbers," said Justin Fuller, a Fitch Ratings analyst. "Going forward, I think there's fewer levers to pull for the banks."

      Investment banks are feeling the squeeze as well. Goldman Sachs Group Inc. cut the funds it set aside for compensation in the third quarter, a move that bolstered its results in the face of a 20% revenue decline from the same quarter a year earlier.

      Such moves are "very emblematic of what's going on," said Charles Peabody, partner in charge of research at Portales Partners LLC, a financial-services research firm. The degree to which the banks' earnings rely on loan-loss reserves "exposes the lack of growth" in their traditional businesses, he said.

      The banks justify the releases. They cite improvements in credit quality and economic conditions—which make it less necessary for them to hold large amounts of reserves as a cushion against loans that go sour—and they say they are following accounting rules that require them to release funds as losses ease.

      A Bank of America spokesman said "the significant impact in credit quality we've seen in the last 12 months" has driven the reserve releases. J.P. Morgan, Wells Fargo and Citigroup all pointed to previous comments their top executives recently made indicating that reserve releases were merited because of factors like improving credit quality and the recent increase in housing prices.

      But the Office of the Comptroller of the Currency, which regulates nationally chartered banks and federal savings associations, is reiterating warnings to banks about overdoing it.

      In a statement to the Journal, Comptroller Thomas Curry said the OCC is monitoring banks' loan-loss allowances "very closely" and that "we continue to caution banks not to move too quickly to reduce reserves or become too dependent on these unsustainable releases." He didn't comment specifically on the banks' third-quarter releases, but said OCC examiners "will continue to challenge allowances on a bank-by-bank basis if necessary."

      If the regulator finds problems with a bank's reserves, it can issue a "matter requiring attention," a specific finding of a deficiency that a bank must address, an OCC spokesman said. The agency has thousands of such findings outstanding on a variety of subjects, but the OCC spokesman wouldn't say how many, if any, were related to banks' reserve releases.

      Mr. Curry has been vocal on the issue for more than a year. In September 2012, he called it a "matter of great concern," warning banks that "too much of the increase in reported profits is being driven by loan-loss-reserve releases."

      Last month, Mr. Curry said in a speech that when economic growth is slow, as it is now, banks might take more risks to maximize their returns, and so it is "particularly important" they maintain appropriate reserves. While some level of reserve releases is "certainly warranted," he said, the ease of boosting earnings through the practice "has proved habit-forming" at some banks, though he didn't single out any specific institutions.

      Mr. Curry said his previous concerns initially seemed to get banks' attention, and reserve releases temporarily eased, but that was "an anomaly." Since then, he said, the releases have increased again, despite "loosening credit underwriting standards" that suggest banks are facing higher risks.

      The OCC isn't alone in its concern. Last year, Federal Deposit Insurance Corp. Chairman Martin Gruenberg said the trend of earnings driven by lower loan-loss provisions "cannot go on forever." An FDIC spokesman said Friday, "We will continue to evaluate and confirm the ongoing adequacy of reserves during our regular examinations."

      Other banks are releasing reserves, as well, though the amounts drop off drastically below the top four. In the second quarter, the most-recent period for which industrywide figures are available, nearly 40% of all FDIC-insured banks released reserves, according to the FDIC. As of June 30, the industry's bad-loan reserves had fallen to their lowest level as a percentage of total loans since before the financial crisis began, according to FDIC data.

      J.P. Morgan released $1.8 billion in the third quarter, including $1.6 billion from its consumer and community banking unit, accounting for 19% of its pretax income after the bank's giant litigation expenses in the quarter are excluded. That is higher than in recent quarters, though the bank's nonperforming assets have declined 18% over the past year, helping to justify a larger release.

      Bank of America released $1.4 billion, comprising 29% of pretax income, and Wells released $900 million, or 11% of pretax income, its biggest release in more than two years. Citigroup released $778 million, down slightly from the second quarter, and the release amounted to 18% of pretax income. At all three, the percentage of pretax income was up from the second quarter, and nonperforming assets have fallen at all four banks at least 18% compared with a year ago.

      Continued in article

      Jensen Comment

      This teaching case will be very confusing to accounting students learning from traditional textbooks. In those textbooks the Allowance for Doubtful Accountants ledger account has nothing to do with cash in reserve funds, cookie jar accounting, or profits smoothing funds. The Allowance for Doubtful Accounts is simply a contra account to receivables assets in the accrual system that forces companies to currently expense the portion of receivables that is estimated will not be collected. It is a way to anticipate bad debt losses that are anticipated will not be collected. Bad debt losses are not to be estimated in advance only when there is no reliable statistical basis for estimating them in advance such as when a company has only a few customers (like Boeing) as opposed to millions of customers (like Sears). Sears can statistically estimate with great accuracy what portions of credit sales this year will not be collected in later years.

      The key issue that will be confusing to students is what triggers a debit (reduction) in the Allowance for Doubtful Accounts ledger account.
      Our USA textbooks teach that this Allowance for Doubtful Accounts ledger account deibt (reduction) comes when an account is ultimately written off as a bad debt. The expense for this was estimated in an earlier year of a sale under the Matching Concept that tries to match expenses in the same year that those expenses are associated with the revenues they helped generate. Hence current revenues and profits are not reduced due to bad debt write offs from sales made on account in prior years.

      Cookie Jar Reserve Funds for Income Smoothing Rather Than Bad Debt Accruals
      One difference in the past between USA accounting and European accounting (especially in Switzerland) was that USA GAAP discouraged having rainy day "cookie jar" reserve accounts that were set up to smooth profits rather than merely satisfy better matching of revenues and expenses under the matching concept.
      Bob Jensen's thread on Cookie Jar Accounting at
      http://www.trinity.edu/rjensen/Theory01.htm#CookieJar

      Question
      What is cookie jar accounting and why is it generally a bad thing in financial reporting?

      Answer
      Cookie jar is more formally known as earnings reserve accounting where management manipulates the timings of earnings and expenses usually to smooth reported earnings and prevent shocks up and down in the perceived stability of the company. European companies in the past notoriously put deferred earnings in "cookie jars" so as to picture themselves as solid by covering bad times with deferrals out of the cookie jar that mitigate the bad news and vice versa for good times. The problem with too much in the way of a good time (in terms of financial reporting) is that accelerated growth rates in one year cannot generally be maintained every year and it may be a bad thing, in the eyes of management, to have investors expecting high rates of growth in revenues and earnings every year.

      What's wrong with cookie jar reporting is that it allows management wide latitude in discretionary reporting that is a major concern to both investors and standard setters. Accounting reports become obsolete when they mix stale cookies from the cookie jar with fresh sweets and lemon balls of the current period.

      Also see http://en.wikipedia.org/wiki/Cookie_jar_accounting

      You can read more about FAS 106 at http://www.fasb.org/st/index.shtml
      Scroll down to FAS 106 on "Employers' Accounting for Postretirement Benefits Other Than Pensions"

      Now let's consider the following article:
      "Reserve Funds Pad Profits," by Michael Rapoport, The Wall Street Journal, October 26, 2013 ---
      http://online.wsj.com/news/articles/SB10001424052702304682504579155931092819234?mod=djem_jiewr_AC_domainid

      Federal regulators have warned banks to be careful about padding their profits with money set aside to cover bad loans. But some of the nation's biggest banks did more of it in the third quarter than earlier this year.

      Jensen Comment
      Firstly, in USA textbooks we teach that money (cash) is not usually set aside for the Allowance for Doubtful Accounts. Presumably cash could be set aside that is earmarked for future bad debts, but this result in the opportunity loss on what that cash could earn when invested in more profitable operations rather than being stored in a savings account.

       

      "Reserve Funds Pad Profits," by Michael Rapoport, The Wall Street Journal, October 26, 2013 ---
      http://online.wsj.com/news/articles/SB10001424052702304682504579155931092819234?mod=djem_jiewr_AC_domainid

      J.P. Morgan Chase JPM -2.02% & Co., Wells Fargo WFC -0.95% & Co., Bank of America Corp. BAC -1.41% and Citigroup Inc., C -2.21% the nation's largest banks by assets, tapped a total of $4.9 billion in loan-loss reserves in the third quarter, up by about a third from both the second quarter and the year-ago quarter after adjustments. All the banks except Citigroup showed significant increases compared with the second quarter.

      Accounting rules allow the money to flow directly into profits. In all, it made up 18% of the banks' third-quarter pretax income excluding special items, the highest percentage in a year, according to an analysis by The Wall Street Journal.

      Jensen Comment
      In USA textbooks we teach that money does not flow directly into profits when receivables are declared bad debts and written off against the Allowance for Doubtful Accounts contra account. Firstly, there's usually no cash that's been set aside for such purposes. Secondly, the bad debt expense was estimated and written off earlier in the year that the loans were made so that profits were not overstated in those earlier years.

      It would be a violation of USA GAAP if a bank used the Allowance for Doubtful Account reduction for anything other than a legitimate admission that a receivable must be at last deemed as uncollectable. It is the uncollectablity of the account that triggers the write down of the Alllowance for Doubtful Accounts. This contra account should never be a cookie jar account for the purpose of smoothing profits independently of actually writing off of uncollectable accounts.

      Either the banks are illegally using the Allowance for Doubtful Accounts ledger inappropriately as cookie jar reserves or there is something that I'm not aware of that allows USA banks to use cookie jar accounts apart from accounting rules and regulations for other companies.

      Didn't Fair Value Accounting for Financial Instruments Eliminate the Matching Concept and the Allowance for Doubtful Accounts?
      Yes and no.
      If JP Morgan bought $10 million worth of Greek bonds, USA GAAP dictates that the value of those bonds should be written up and down for their estimated value in the financial markets. (Rules for this have recently changed, but I will not go into all of that here.)

      But if Sears has 25 million accounts receivable on the books, including the account of Bob Jensen, it is beyond comprehension that Sears will will track the current fair value of the $29.18 that Bob Jensen currently owes Sears or the current fair value of each of the other tens of millions accounts receivable. Instead Sears with set up an aging schedule for the millions of  active accounts and estimate what portions of all accounts in each age class will eventually be written off as bad debts. Then in the year of sale those estimates will be expensed and credited to an Allowance for Doubtful Accounts ledger account under the Matching Concept just as literally all the USA accounting textbooks have explained for decades.

      Similarly, JP Morgan and other large banks will use fair value accounting for large-account financial instruments but will not use fair value accounting for 33 million small loans of under $500 to customers. Thus even though fair value theorists would like to kill and bury the Matching Concept, this concept is alive and well due to the total impracticality of tracking fair values of millions and millions of small accounts receivable and small loans by banks.

      But the Allowance for Doubtful Accounts ledger accounts were never intended to be cookie jar income smoothing accounts.

      The bottom line is that I do not understand the article above by Michael Rapaport.


      "Banks Need Long-Term Rainy Day Funds: Accounting rules prevent banks from building loss reserves until shortly before a bad loan is actually written off. That's just too late," by Eugene A. Ludwig and Paul A. Volcker, The Wall Street Journal, November 16, 2012 ---
      http://professional.wsj.com/article/SB10001424127887324556304578120721147710286.html?mg=reno64-wsj#mod=djemEditorialPage_t

      Governments around the world are taking bold steps to minimize the likelihood of another catastrophic financial crisis. Regulators and financial institutions already have their hands full, so the bar for adding anything to the agenda should be high.

      However, one relatively simple but critically important item should move to the top of the list: reforming the accounting rules that inexplicably prevent banks from establishing reasonable loan-loss reserves. If reserve rules had been written correctly before 2008, banks could have absorbed bad loans more easily, and the financial crisis probably would have been less severe. It is now time, before the next crisis, to recognize that reality.

      Loan-loss reserves get far less attention than capital or liquidity requirements, which are subject to specific government regulations. Nevertheless, the "Allowance for Loan and Lease Losses" should be an essential part of assessing the safety and soundness of any bank. The ALLL—not Tier 1 capital or even cash-on-hand—is the most direct way a bank recognizes that lending, including necessary and constructive lending, entails risk. Those risks should be recognized in both accounting and tax practices as a reasonable cost of the banking business.

      However, banks are now only allowed to build their loan-loss reserves according to strict accounting conventions, enforced by the Securities and Exchange Commission. Reserves have to be based on losses that are strictly "incurred," in effect shortly before a bad loan is written off. Bankers have been prohibited from establishing reserves based on their own expectations of future losses.

      The practical result is that in good times real earnings are overrated. Conversely, the full impact of loan losses on earnings and capital is concentrated in times of cyclical strain.

      Why have accounting conventions created this perverse result? Some accountants claim that giving banks flexibility with their reserves is bad because it lets bankers "manage earnings"—that is, to raise or lower results from quarter to quarter to look better in investors' eyes. This is a weak argument, because the ALLL reflects a banking reality, and the allowance itself is completely transparent.

      No one is misled when sufficient disclosures exist. The size of the bank's reserve cushion will be on the balance sheet, and it would need to be recognized as reasonable by auditors, supervisors and tax authorities. Importantly, from a financial policy point of view, reserves will tend to be countercyclical, likely to discourage aggressive lending into "bubbles" but helping to absorb losses in times of trouble.

      Capital is vital to the safety and soundness of banks. It is the ultimate and necessary protection against insolvency and failure. However, permitting a more flexible allowance for loan-loss reserve, an approach that gives banks and prudential regulators the right to exercise reasonable discretion to build a more flexible cushion in case of loss, is a must. Accounting rules need to change to permit this to happen.

      Mr. Ludwig, the CEO of Promontory Financial Group, was Comptroller of the Currency from 1993 to 1998. Mr. Volcker, former chairman of the Federal Reserve System, is professor emeritus of international economic policy at Princeton University.

       

      Bob Jensen's threads on where fair value accounting fails ---
      http://www.trinity.edu/rjensen/Theory02.htm#FairValueFails

       

      Jensen Conclusion
      Apparently it's not too late under the current wild west accounting our our big USA banks.

    • Robert E Jensen

      Special Problems in Accounting for Law Firms

      "ABA urges federal lawmakers to NIX draft provision requiring law firms to adopt accrual accounting." by Martha Neil, ABA Journal, January 16, 2014 ---
      http://www.abajournal.com/news/article/ABA_urges_federal_lawmakers_to_nix_draft_provision_requiring_law_firms/?utm_source=maestro&utm_medium=email&utm_campaign=weekly_email

      • The American Bar Association is urging federal lawmakers to rethink a possible plan to require businesses to use the accrual method instead of traditional cash accounting in the discussion draft Tax Reform Act of 2013.

        Accrual accounting would be more complex and expensive, the ABA's president writes in letters to lawmakers, than the system currently used by many law firms, which recognizes income and expenses for tax purposes when money is actually received and paid out, respectively. A number of others also have objected to forcing businesses to adopt the accrual method, which could require companies and law firms to pay tax on income they not only haven't received but may never receive, according to the ABA and The Hill's On the Money blog.

        "Although we commend you for your efforts to craft legislation aimed at simplifying the tax laws—an objective that the ABA and its Section of Taxation have long supported—we are concerned that Section 212 would have the opposite effect and cause other negative unintended consequences," President James R. Silkenat wrote in Jan. 13 letters to leaders of the Senate Finance Committee (PDF) and the House Ways and Means Committee (PDF).

        "This far-reaching provision would create unnecessary complexity in the tax law by disallowing the use of the cash method; increase compliance costs and corresponding risk of manipulation; and cause substantial hardship to many law firms and other personal service businesses by requiring them to pay tax on income they have not yet received and may never receive," Silkenat continues. "Therefore, we urge you and your committee to remove this provision from the overall draft legislation."

        The potential law in its present form would apply to businesses with annual gross receipts above $10 million.

        Jensen Comment
        The FASB requires cash flow statements as supplements to accrual accounting financial statements. Accrual accounting for revenues (apart from mark-to-market accounting for financial instruments) recognizes revenues when they become legally earned irrespective of the the timing of payments. Cash flow accounting without accrual accounting as well is frowned upon because management can manipulate (manage) earnings by simply writing contracts that time collections in advance of or after legally earning revenues.

        There can also be misleading matchings expenses against cash flow revenues. For example, in one year firms can take an "earnings bath" by timing cash outflows for the purpose of next year showing an enormous jump in cash flow earnings because so many expenses were deducted the year before the revenues they helped generate are realized in cash.

        Accrual accounting is generally required for firms that sell their stocks and bonds to the public. It is also generally required for firms that borrow money from financial institutions. Law firms are different in that partners of a law firm can usually choose most any accounting method they want since outsiders are less impacted by "misleading" financial statements.

        Law firms have special problems with accounting.
        Most of the expenses are for relatively high priced labor. Many of the cases have great uncertainties as to when and if they will generate revenues. Whereas medical and accounting firms are relatively assured of collecting fees for cases, it's sometimes very hard to over many years to account for pending law firm cases that are still open on the books. Capitalized (accumulated prepaid expenses) cases are soft assets that are not as a rule traded among law firms like pending oil wells can be traded among oil firms.

        I suspect there's a history of student projects and term papers focused on accounting for law firms. If not, now is a very good time to consider such projects that demonstrate how memorized bookkeeping in textbooks can become difficult to apply in the real world.

        Bob Jensen's threads on accrual versus cash flow accounting are at
        http://www.trinity.edu/rjensen/Theory02.htm#CashVsAccrualAcctg

        Bob Jensen's threads on earnings manipulation are at
        http://www.trinity.edu/rjensen/Theory02.htm#Manipulation

    • Robert E Jensen

      Accounting History Corner
      Matching Principle --- https://en.wikipedia.org/wiki/Matching_principle

      A nice timeline on the development of U.S. standards and the evolution of thinking about the income statement versus the balance sheet is provided at:
      "The Evolution of U.S. GAAP: The Political Forces Behind Professional Standards (1930-1973)," by Stephen A. Zeff, CPA Journal, January 2005 --- http://www.nysscpa.org/cpajournal/2005/105/infocus/p18.htm
      Part II covering years 1974-2003 published in February 2005 --- http://archives.cpajournal.com/
      The module for 1940 is as follows:

      1940
      The American Accounting Association (AAA) publishes Professors W.A. Paton and A.C. Littleton’s monograph An Introduction to Corporate Accounting Standards, which is an eloquent defense of historical cost accounting. The monograph provides a persuasive rationale for conventional accounting practice, and copies are widely distributed to all members of the AIA. The Paton and Littleton monograph, as it came to be known, popularizes the matching principle, which places primary emphasis on the matching of costs with revenues, with assets and liabilities dependent upon the outcome of this matching.

      Comment. The Paton and Littleton monograph reinforced the revenue-and-expense view in the literature and practice of accounting, by which one first determines whether a transaction gives rise to a revenue or an expense. Once this decision is made, the balance sheet is left with a residue of debit and credit balance accounts, which may or may not fit the definitions of assets or liabilities.

      The monograph also embraced historical cost accounting, which was taught to thousands of accounting students in universities, where the monograph was, for more than a generation, used as one of the standard textbooks in accounting theory courses.

      1940s

      Throughout the decade, the CAP frequently allows the use of alternative accounting methods when there is diversity of accepted practice.

      Comment. Most of the matters taken up by the CAP during the first half of the 1940s dealt with wartime accounting issues. It had difficulty narrowing the areas of difference in accounting practice because the major accounting firms represented on the committee could not agree on proper practice. First, the larger firms disagreed whether uniformity or diversity of accounting methods was appropriate. Arthur Andersen & Co. advocated fervently that all companies should follow the same accounting methods in order to promote comparability. But such firms as Price, Waterhouse & Co. and Haskins & Sells asserted that comparability was achieved by allowing companies to adopt the accounting methods that were most suited to their business circumstances. Second, the big firms disagreed whether the CAP possessed the authority to disallow accounting methods that were widely used by listed companies.

      Continued in article

      "Global Financial Reporting: Implications for U.S.," by Mary Barth, The Accounting Review, Vol. 83, No. 5, September 2008 
      On Page 1166 she flatly asserts:

      First, there is no “matching principle.” That is, matching is not an end in itself and matching is not an acceptable justification for asset or liability recognition or measurement. The conceptual framework explains that matching involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events (FASB 1985, para. 146; IASB 2001, para. 95). Matching will be an outcome of applying standards if the standards require accounting information that meets the qualitative characteristics and other criteria in the conceptual framework. Matched economic positions will naturally result in matched accounting outcomes. However, the application of a matching concept in the conceptual framework does not allow the recognition of items in the statement of financial position that do not meet the definition of assets or liabilities (IASB 2001, para. 95). Thus, there would be no justification for deferring expense recognition for an expenditure that provides no future economic benefit or for deferring income recognition for a cash inflow that will not result in a future economic sacrifice.

      Jensen Comment
      But matching still seems to prevail even though there is no more "matching principle according to the IASB and the FASB. The answer is that revenue can be deferred when there will be "future economic sacrifice." Sounds like matching to me. Neither domestic nor international standards allow early realization of revenue before it is legally earned. The standards just do not allow automobile inventories to be written up to expected sales prices until those sales are finalized. Carrying the inventories at something other than sales value is part and parcel to the "matching principle" eloquently laid out years ago by Paton and Littleton. Both international and domestic standards still require cost amortization, depreciation, and creation of warranty reserves. These are all rooted in the "matching principle" which has not yet died when defining assets and liabilities in the conceptual framework. In most instances the historical cost is still being booked and spread over the expected life of future economic benefits. Even if a company adopted a replacement cost (current cost) adjustment of historical cost of a depreciable asset, those replacement costs still have to be depreciated since old equipment cannot simply be adjusted upward to new, un-depreciated replacement cost.

      Paton and Littleton never argued that the "matching principle" for expense deferral applies to assets that have "no future economic benefits." In that case there would be no benefits against which to match the deferred expense. Hence there's no deferral in such instances. I do not buy Barth's contention that there is no longer any "matching principle." If there are potential future benefits, the matching principle still is king except in certain instances where assets are carried at exit values such is the case for precious metals actively traded in commodity markets and financial assets not classified as "held-to-maturity."

      The Matching Principle lives on when there are expected "future economic sacrifices."

       

      The Matching Principle Revisited
      SSRN, April 8, 2016
      http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2766630

      Authors

      Aleksandra B. Zimmerman,  Case Western Reserve University; Northern Illinois University - Department of Accountancy

      Robert Bloom, John Carroll University

      Abstract

      This paper reassesses the significance of the concept of matching expenses to revenues as an accounting principle. We compare and contrast the historical views of authoritative bodies and the various scholars and practitioners who analyze this subject, drawing implications for future standard setting. Through this historical retrospective on matching, which includes a review of more contemporary research and thought, we find that matching as an approach to income measurement can be helpful in forecasting earning power. Consequently, we conclude that matching should be retained as a long-standing fundamental accounting principle in standard-setting and in practice.

      Conclusion
      Accounting theory professors should not simply declare the matching principle dead!

    • Robert E Jensen

      From the CFO Journal's Morning Ledger on August 29, 2016

      FASB issues cash-flows standard
      The Financial Accounting Standards Board on Friday issued a new standard for reporting cash-flow statements, in an effort to streamline reporting and clarify aspects of generally accepted accounting principles that are unclear or absent, the Journal of Accountancy reports.

      Which is More Value-Relevant: Earnings or Cash Flows?
      http://www.trinity.edu/rjensen/theory02.htm#CashVsAccrualAcctg