Question

Consider two manufacturing companies of electrical devices with identical business fundamentals. Everything is the same for these two companies (same operations, same economic fundamentals, same suppliers, same customers and same managers). The only difference is in the way the two companies choose to report their
financials.
Company A follows a conservative financial reporting strategy by choosing accounting policies that report the lowest revenue and assets and the highest expense and liabilities.
Company B follows an aggressive financial reporting strategy by choosing accounting policies that report the highest revenue and assets and the lowest expense and liabilities.
Required:
(a) Explain how you can discover information that one company is being conservative in financial reporting and the other company is being aggressive in
financial reporting. You are required to give specific examples that are directly relevant to the context of these two companies being manufacturing companies of electrical devices.
(b) Explain how you could use this newly discovered information that a company is conservative or aggressive in reporting in active investing.

Answer 1

A. This can be identified by comparing Gross profit and net profit ratios of both companies. Since the businesses are similar and have similar costs and revenues these ratio figures should approximately match, it there is a significant difference then it can be considered to be due to type of accounting barring extraordinary events.

Specific examples of agressive accounting:

-Capitalizing advertising and marketing expenses instead of writing them off.

-Capitalizing research and develpoment costs which do not bring future benefits.

-Lower booking of warranty, bad debt expenses as compared to normal rates.

-Booking revenue for a sale before it has been finalised.

- Issuing and capitalizing trade discounts instead of directly reducing them from revenues even in situations where capitalization is not prudent.

-Using a lower rate of depreciation than actual usage of the asset.

-Overstating the amount of overhead applied to inventory like including indirect expenses, therefore increasing inventory value and reducing COGS(cost of goods sold)

B. I can use this information by determining the actual profits of a company in cases of agressive reporting and comparing it's actual performance to peers who use conservative accounting to get a clearer picture of the company's actual performance. Hence I would invest based on knowledge of actual profits and net worth, not just the figures stated in the financials.