Question

When analyzing financial statements it is important to recognize that accounting distortions can arise. Accounting distortions are those things that cause deviations in accounting information from the underlying economics. Which of the following statements is not correct? Accounting distortions: can arise as management may deliberately manipulate financial statements arise often through application of (correct) accounting principles can affect the quality of earnings arise because the stock market is not efficient

Answer 1

Answer : Can arise because the stock market is not efficient.

Accounting distortions do not allow the users of the financial statement to get a true and fair view of the operating results and the financial position of the business.

Accounting distortions often arise due to financial statement manipulations by the management, e.g changing the valuation methods of inventory from LIFO to FIFO or vice-versa, changing the depreciation method, overestimating or underestimating the useful lives of assets, treatment of contingent liabilities, preponing recognition of revenues, postponing recognition of expenses ets.

Accounting distortions can also arise due to application of accounting principles. For example, some competitors may be using the LIFO cost flow assumption for valuation of inventories, while others may be using FIFO.

Accounting distortions would affect the quality of earnings too. Quality of earnings is said to be poor if the earnings are not stable from one accounting period to the next, or if most of the earnings are not convertible to cash, i.e there is a large difference between net income and the operating cash flows.

However, accounting distortions cannot arise because the stock markets are not efficient, simply because accounting is done of historical cost basis, and not on the basis of current market values of stock. Therefore, if a company has issued 1,000 shares at $ 20 per share, the book value of the stock would be $ 20,000, and not $ 15,000, even if the current market value of the stock is only $ 15.