Pergamon Computers ind. Engng Vol. 27, Nos 1--4, pp. 335-338, 1994

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An Empirical Analysis on Built-In Bias Factors of Financial Accounting System

Masayuki Abe and Junsei Tsukuda

Musashi Institute of Technology

Tamazutsumi 1-28-1, Setagaya-ku, Tokyo 158, Japan

Abstract Existing system that measures corporate perform-

ance is in actual the financial accounting system.

However, it is not so designed as to measure an

objective corporate performance since it involves

some allocation procedures which cannot be limited

to only one. By allowing the management to select

an accounting policy or method from a set of op-

tions, financal accounting system resultantly al-

lows to select an amount of profit from a range

of profit amounts which could be computed. These

facts introduce some biases into corporate perfor-

mance measured by the financial accounting system

compared with objective corporate performance. The

study aims to investigate the actual effects of

bias factors built in the financial accounting

system empirically using 1,014 Japanese firms' fi-

nancial data. Through sequential improvements

using a heuristic approach a useful method of em-

pirical analysis was found. Results of analysis

indicates that nine bias factors out of eleven are

actually effective with statistical significance.

They are recommended to be categorized into two

groups.

Key words: Financial Accounting Systems, Built-in Bias Factors, Empirical Analysis

1 Introduction Needless to say, measuring objective corporate

performance is essential in decision-makings such

as lending money to firms, selecting firms for

investment or for sale on credit or analyzing

effect of employing a specified strategy. A system

that measures corporate performance or economic

outcome of corporate activities is an accounting

system, which in actual is the financial

accounting system. Viewing from its measuring

procedure ,however, financial accounting system

is not so designed as to measure an objective

335

curporate performance. That nature of financial

accounting system comes from that it contains many

allocation procedures in itself, which in turn

comes from that it has some stress put on its

measurement of a fair distributable income for

each year. As allocation procedure cannot be

limited to only one, selection from several pro-

cedures is allowed in financial accounting. Thus

financial accounting system, by allowing the

management to select an accounting policy or

method from options, is as a result allowing to

select an amount of profit from a range of profit

amount which could be computed. These facts

introduce some bias into corporate performance

measured by the financial accounting system

compared with objective corporate performance.

The bias is produced by some factors built-in the

financial accounting system. The factors are

called as Bias Factors.

In order to measure an objective corporate

preformance all allocation procedures shold be

excluded. If the aim is not the measurement of

annual profit, allocation procedure or cost

matching income principle in financial accounting

system is not necessary to be employed. Although

computing economic outcome without allocation

procedure is not practiced in performance measure-

ment, it is employed in measurement for planning.

It is the computation of net present value or net

~inal value which is accepted as a rational

measure of advantage of ~, vestment item in capital

budgeting decisionmaking. Here the aim of

:~:umputalon is to measure a long-term econom:c

outcome for overall period of investment life.

Therefore, no allocation procedure is employed

here and the measure for investment item is di-

rectly calculated from recelpts and disbulsements.

if the same ;:inc~ple as that used in this

calculation is employed, an objective corporate

performance could be measured, unlike the

financial accounting system, We have developed a

measurement system along this policy (Takahashi

1983, Fukukawa Takahashi and Abe 1991), and the

336 Selected papers from the 16th Annual Conference on Computers and Industrial Engineering

,=,',st TIn-OPERATING-( MATERIAL + LABOR + OUTLAY +COST of CAPITAL of MANUFAUTURING ASSETS) CAPITAL RECOVERY . . . . - ' INCOME ~EXPENDITURES EXPENDITURES EXPENSES

[.- MANUFACTURING ASSETS * RATES of COST of CAPITAL

I I - - COST of CAPITAL / Total INVESTED ASSETS

' I

L MANUFACTURING 4- FINANCE ASSETS ASSETS

~ COST of BORROWED CAPITAL + COST of CAPITAL of NET WORTH

I L NET WORTH * Long- term Prime Lending Rates

1 I L MANUFACTURING ASSETS + FINANCE ASSETS - BORROWED CAPITALS

Notes : Assets and liabilities are that of the beginning of the term.

F i g - 1 C a l c u l a t i o n o f C A P I T A L R E C O V E R Y V A L U E

corpocate performance resuled ~rom this system is

named as CAPITAL RECOVERY VALUE. As the computation

procedure for CAPITAL RECOVERY VALUE does not

contain any allocation, the VALUE corresponds to

the objective corporate performance.

2 Purpose of the study

By contrasting with this CAPITAL RECOVERY VALUE

the characteristics of financial accounting profit

is made explicit. To know the characteristics of

financial accounting profit is useful in reading

financial accounting information adequately in

case that an objective corporate performance is

needed for purposes mentioned above but not avai-

lable. We are interested in showing by empirical

analysis how the built-in bias factors of

financial accounting system behave or what

characteristics the corporate performance measured

by financial accounting system has. We wish to

make its characteristics clear empirically by

knowing in actual how and in what situation the

financial accounting profits are affected by

built-in bias factors.

The reason why the empirical analysis is needed

here as follows. The bias factors producing

differences between financial accounting profits

and CAPITAL RECOVERY VALUE can theoretically

be derived from the difference between the two

systems. However intensely affecting factors or

frequently occuring combinations of factors could

not be derived theoretically. Knowing such a

theoretical bias factors does not directly mean

knowing ones that exist in actual. They could not

be made explicit until actual data are analyzed

through an empirical reserch.

3 Method of Sequential Analyses The method of empirical analysis to be used in

this case is not known yet. Although the method of

empirical analysis is to be established finally,

at the first step an effective method of empirical

analysis is needed to be heuristically detected,

where an appropriate direction to the best method

is to be found. Three analyses were carried out

through sequential improvements.

CAPITAL RECOVERY VALUES of 1,014 Japanese

manufacturers were calculated for 15 years (from

1976 to 1991) as shown in Fig-i using data from

anual securities reports. Costs of capital (of

MANUFACTURING ASSETS) are added back to CAPITAL

RECOVERY VALUES in order to make it correspond to

operating profits.

ANALYSIS-I: In order to examin the relationship

between the two performance values, a scatter

graph of 1,014 firms was drawn by plotting them on

the surface with CAPITAL RECOVER VALUES plus Cost

of Capital as x-axis and operating profits as

y-axis on 15 years average base (Fig-2). In this

scatter graph, there are 980 firms whose CAPITAL

Milhon'~ZN I -(P~si~vc)6 t to 2

27 14 [ 64 64 2

I 1 l 1 t5 61119 81 3 1 t 2 I 2 7 151 153 2

I I i4 7 70 120 2 I [ I [ 13 35 8 I

1 3 1 5 2 1 I ] 2 (Pt~itivc c)

k)g(CAP~AL RECOVERY VALUE ~ega~v~) ~ plus o ~ of ~pi~lD ........... 4 ..... 3 ........ v ......... ~3 .... {4 .... ~5 ..... ~6 •

I I II

2 2 2 1 2 1 2

I 3 2 3

I 4 ~cg.tivc)

~ g - 2 C o r p o m t e p e l ~ n n a n ~ o n f i f t e e n y e n m a v e m g e ~

Selected papers from the 16th Annual Conference on Computers and Industrial Engineering 337

RECOVERY VALUES plus Cost of capital and operating

profits are both positive (Quadrant I), 5 firms

whose values are both negative (Quadrant Ill), 14

firms whose operating profits are positive and

CAPITAL RECOVERY VALUES plus Cost of capital are

negative (Quadrant If), and 15 firms whose ope-

rating profits are nevative and CAPITAL RECOVERY

VALUES plus Cost of capital are positive

(Quadrant IV). Firms plotted in Quadrant IV are

the firms whose operating profits are less than

their objective corporate performances i.e.

CAPITAL RECOVERY VALUES plus Cost of capital.

On the other hand, firms plotted in Quadrant I

are calculated as positive in both corporate per-

formances. A statistical test (Wilcoxon's Rank sum

test) was performed regarding averages of two

groups of firms, one of which consists of these 15

firms in Quadrant IV the and other of which

consists of their courterparts each of which is

plotted in Quadrant I of which, operating in the

same industry sector by NIKKEI'S classification as

that of the corresponding firms in Quadrant IV and

having similar amount of CAPITAL RECOVERY VALUE.

Items used for test are the same as shown at the

left hand side of Fig-4. From this analysis, no

significant item was found of these eleven items.

ANALYSIS-2: From the results of Analysis-l,it was

noticed that the reason why no significant item

was found in statical test based on fifteen year's

average is that time horizon of fifteen years

might be too long to articulate the effects of

No. Bias Factors / Firms

1 Trade Receivables / Sales

2 Inventories / Sales > >

3 Costs Of production in its period / Sales >

4 Costs of goods sold / Sales

5 Sales and admin, expenses / Sales I > >

6 Depreciation expenses / Sales >

7 Allowance for doubtful debts / Sales >

8 Reserve for retirement / Sales > >

9 Reserve for retirement per employee

1977 78 79 80 81 82 83 84 85 86 87 88 89 90 91

I I

I I

F

F

Fig-3 Time horizons Dr test in ANALYSIS-2.

bias factors. That is, some significant item might

be found if the shorter time horizon was taken.

Therfore, the same tests as in Analysis-i was done

using the same items but in several shorter time

horizons on average basis of various number of

years (see Fig-3). In these tests, two factors

were found significant in three periods of seven

used. The factor were No.4 and NO.7 in Fig-4, i.e.

Cost of goods sold and Allowance for doubtful debts.

ANALYSIS-3: Examining result of Analysis-2, 15

scatter graphs were drawn, one for each firm. Each

graph contains 15 points, each of which represents

two economic performances for one year measured

by two accounting system. Of these graphs nine,

i.e. nine firms, were found with five or more

points in Quadrant IV and 15 years average also

falling in Quadrant IV. Statisical tests were done

of groups of points in the two Quadrants regarding

Firrp No.I 1 2 3 4 5 6 .7 J 8 9

Industry Textile Textile Textile Rubber Steel Machine Machin Machine Others

< > >

>

>

> > > >

<

10 Prepaid expenses ( Sales

11 Accrued expenses / Sales

>

> > > > > D D

> >

> >

Notel : >> means that values in Quadrant IV are geater than those of Quadrant I at 1% significance level and > at 5%

significance level. << and < means values in Quadrant IV are less than Quadrant I at 1 and 5% significance level respectively.

Note2 ~ Since Firm-8 and Firm-9 have only three points in Quadrant I, they were tested at only 10% significance level.

Fig-4 Results of test (detail)

338 Selected papers from the 16th Annual Conference on Computers and Industrial Engineering

eleven items whlch are seemed to be relevant to

negativeness of y-axis value. Numbers of groups of

points in two Quadrants were taken equal with

relatively non corresponding points exclued. Of

eleven items tested nine were found significant

in 22 firm-items in total (Fig-4). The results were

extremely improved relative to the prior two

analyses.

4 Discussion

Fig-5 shows results of tests depicted in Fig-4

summarized in terms of bias factors The numbers

in the Fig-4 are the number of firms whose values

of bias factors are significantly different in two

periods plotted in Quadrant I and IV, For instance

"7" in Total column of Cost of Goods Sold row re-

presents that there are seven firms each of which

has significant differnces in Cost of Goods Sold

between periods in which economic performances are

plotted in Quadrant I and those in Quadrant IV.

Here the bias factors are rearranged in descending

order of numbers in Total column. From Fig-5 we

know that firms in total whose three bias factors,

i.e. Costs of Production, Costs of Goods Sold and

Inventories, in total have significant differnces

amount to 12 of 20, or 60%. Thus these three fac-

tgrs are rather important among eleven bias fac-

Bias Factors / Significance level 1% 5% 10°~ Total

Costs of goods sold 4 1 2 7

Costs of production 3 3

Inventories, 1 1 2

Sales and admin, expenses Z *l 3

Depreciation expenses 2 2

Trade Receivalbles 1 ,1. 2

Reserve for retirement it 2 2

Allowance for doubtful debts 1 1

Prepaid expenses 1 1

Accrued expenses Not significant.

Reserve for retire, per employ.

Total 10 11 2 22

* Note: Unlike the others, in these cases value in Quadrant IV is less than Quadrant I.

tots and in addltlon have high mutual dependences.

In firms No.3 and 5 of Fig-4 a greater Cost of

Production in a period brought about a greater

Cost of Goods Sold, which in turn led to a less

operating profit of the period, which made the

performances of the period fall into Quadrant IV

rather than Quadrant I. Whereas in firm No.I

greater Costs of Production was absorbed into

greater Inventories which resulted in no signif-

icant difference of Costs of Goods Sold.

From these findings it was proved that theoreti-

cal bias factors, when they are discussed, need to

he grouped into following two categories:

(I) Those factors of which greater value in a pe-

riod contributes to make corporate performances

fall into Quadrant IV rather than Quadrant I,

where the contribution is independent of other

factors:Trade Receivables, Reserve for Retirement,

AllowaDce for Doubtfull Debts, Prepaid Expences and

Accrued Expenses

(2) Those factors having high mutual dependences:

Costs of Production, Costs of Goods Sold and In-

ventories

5 Conculuding Remark A better method for empirical analysis of bias

factors involved in financial accounting system

was detected thruogh sequential improvements using

a heuristic approach. The type of method in Analy-

sis 3 above was proved to be useful. Along this

line the method for empirical study on bias fac-

tors should be improved hereafter.

Theoretically derived bias factors that affect

the negativeness of operating profits in account-

ing periods having approximately the same amount

of positive CAPITAL RECOVERY VALUE PLUS COST OF

CAPITAL are recommended to be categorized into two

groups. Second group of factors related to Cost of

Goods Sold are to be further investigated and

tested with additional items.

References:

Fukukawa,Tadaakx Kichnosuke Takahashi

and Masayuki Abe(1991), "A Study on Economic

Performance of Equipment Investment - An

Empirical Analysis for 1980's in Japan", (In

Japanese) Autumun Conference of Japan Industrial

Manegement Association, pp.93-94.

Takahashi,Kichnosuke and Junsei Tuskuda(1983)

"An Objective Measuremnt of Long-Term Corporate

Performance of Japanese Firms", Proceedings of

the VIIth ICPR(Windsor Canada).

Fig-5 Result of test (summarized)