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How Accurate Is Accounting?

The Public Perception

The general public’s perception of accounting seems to be that accounting is a very precise system of nearly incomprehensible rules that are used to produce equally precise and mystifying financial reports that can be fully decoded only by other accountants. A bit of an exaggeration perhaps, but probably not too far afield.

The precision that most people perceive as accounting is really bookkeeping. Bookkeeping is an important element of financial reporting that records transactions and stores data, which is summarized and organized later in the form of financial reports. The entire bookkeeping process is based on a simple but essential equation (the “accounting equation”) and is subject to a conventional, commonly accepted process, so there is certainly precision in bookkeeping. Nevertheless, as exact as this process is, it is nothing more than recording numerical transactional data into specified categories and locations in a predetermined manner. The method might seem mysterious at first, but only because it is unfamiliar and uses unfamiliar terminology, which one learned, remains constant. Bookkeeping, however, does not evaluate the proper categories (“accounts”) to select, or determine the correct values to be used, the proper time periods in which to record the accounts and values, or how to report the information to users of financial information. These four responsibilities are much bigger and more complex jobs. They are what accounting does, and what sets accounting apart from bookkeeping.

The Student Perspective

In school, students learn the difference between bookkeeping and accounting. A college level first course in accounting, depending on the course type, covers bookkeeping to a lesser or greater degree, but spends most of the time introducing financial accounting concepts and principles. In the United States, the accounting guidelines that address the four responsibilities above are called generally accepted accounting principles (“GAAP”). GAAP continually evolves as new issues are addressed and old issues are reexamined. A course textbook incorporates the GAAP guidelines as it discusses key ideas and the established principles and procedures to address the issues.

GAAP is very extensive and sometimes complex, and incorporates both principles and procedures. Principles are policies or general rules that describe what should be done in a given situation. Procedures are specific rules and methods that implement the principles. In the authoritative GAAP literature there are both “broad GAAP” that apply to many financial events and circumstances and are like general traffic laws. There are also “specific GAAP”, applicable to narrowly-specified events or circumstances. At times, GAAP guidelines may even include procedures.

Several years of serious study are needed in order to acquire an understanding of the essential GAAP guidelines and how they affect the reported condition of a business.

There is, however, a side effect to all of this rule studying. Students can easily acquire the idea that when GAAP principles are properly followed, financial reporting becomes unbiased, uniform, and “accurate”. It is easy to fall into this trap without the mentoring and thoughtful reminders of worldly-wise faculty, particularly ones who have been practitioners, and who understand the variations and “wiggle room” allowed by GAAP. Without this help, an accounting student, even one who clearly understands the difference between bookkeeping and accounting, will enter the professional world naïve about the precision of financial reporting.

Why? And Some Examples

GAAP frequently allows choices and allows - even requires - estimates. Choices and estimates mean different outcomes happen even when circumstances are the same. Of course, the intention of having choices and estimates is to create all the tools necessary to make financial statements as accurate as possible given the nature of the operations represented. Unfortunately however, the result can also be financial statements that are not comparable between similar businesses, or that can be “managed” strictly for the purpose of making a business appear more successful that it really is. Although often this is not strictly fraud, such ethics are clearly questionable. In either case, there are many possibilities here. Here are a few examples.

Revenue recognition: “Recognition” in this context means a sales value being recorded into a company’s books. Investors attach a great deal of importance to total reported revenue because it is a major indicator of business viability and potential profitability. GAAP is especially rigorous in addressing revenue recognition constraints; revenue can be recorded only when it is earned. Even so, how much is “earned” can be a matter of judgment and choice of method.

  1. Sales returns/allowances/credit card losses: Companies such as merchandise retailers that can have material amounts of product returns and related events must make an estimate of the probable returns and related items, and then offset these amounts against gross sales in order to calculate net sales. A higher estimate reduces net sales revenue (and therefore net income). A low estimate has the opposite result. Remember, management makes the estimate.
  2. Internet transactions: Have you ever used the Internet for discount hotel or travel reservations? To make merchandise purchases? Suppose a company books a hotel room for you for $800. The cost of the hotel room to the Internet company is $600. Should the company report $800 of revenue with $600 of cost of sales? Or should it just report $200 of revenue? GAAP uses almost a dozen different indicators to decide this question, and a business is free to structure the transaction in a manner that could result in either outcome. But which way do you think makes the company look bigger and better to investors...?
  3. Percentage of completion method: Long-term contracts that span several accounting periods usually report revenue using a percentage of completion method. For example, if a company estimates that 20% of the estimated project costs are completed, then 20% of gross revenue would be recognized. The percentage completion estimate is decided entirely by management.
  4. Collection uncertainty: If there are significant doubts about if/when cash can be collected, revenue recognition changes and must be delayed until the cash is collected. This decision is based completely on managerial judgment.

Expense Recognition: Expenses are subtracted from revenue and reduce net income. Expenses occur when resources are consumed for the purpose of creating revenue. But when and how much of the resources are consumed?

  1. Depreciation: Depreciation expense is the allocation of the cost of a long-term asset such as equipment or a building. In order to calculate depreciation, management must estimate an asset’s useful life, estimate residual value, and choose among alternative methods that typically give different results during the intervening years of an asset's life. In fact, GAAP allows any method that is “systematic and rational”.
  2. Warranty expenses: Many companies offer warranties on the products they sell. When a customer utilizes a warranty, a business incurs expenditures to repair or replace the product. GAAP requires that a company estimate the warranty expenses and match these expenses against related revenues. Of course, the estimated amounts and timing are at the discretion of management.
  3. Leasing: Many companies lease assets instead of buying them outright. However, the terms of a lease can be designed so that the lease rental really becomes a financed purchase, not a rental. This means that instead of recording a rental expense for a lease, a company would record an asset on its balance sheet along with a liability, as the lease payments are recorded as loan and interest payments. GAAP has a checklist of several criteria that determine which outcome results, but a lease can very easily be structured to meet or not meet the criteria, however the parties wish to represent the transaction.
  4. Inventory methods: When a business sells a product, it records both the sales revenue and the cost of the product, called “cost of goods sold”. Cost of goods sold is usually a very large expense on the income statement of a company that sells products of any kind. However, the cost of goods sold depends entirely on the method used to record the cost of inventory sold; when prices have been changing these costs can be very different. A company can use a system that selects the first acquired costs, the last acquired costs, or various averaging systems of costs, all of which result in very different cost of goods sold. This can make comparisons between companies difficult.

Asset valuation: Assets, which appear on a balance sheet, are economic resources whose values represent the wealth of a company. “Wealth”, however, is a subjective word. The FASB Statement of Financial Accounting Concepts identifies five different values: historical cost, replacement cost, current market selling value - often referred to as “fair value”, realizable (collectible) value, and present value of cash flows - which in practice may be weighted by probabilities... OK, enough already!

Actually, this is not meant to provide lifetime employment for accountants, but rather to try to show a conservative value, under normal business conditions, that is best determined by the nature of the particular asset being measured and that eventually could be collectible in approximately that amount or more of cash. This is a balancing act. What makes understanding and comparing these values really difficult is that not only are there different types of assets in a constantly changing environment, but all these values, except historical cost, require estimates and allow alternative calculation methods. Here are just a few examples:

  1. Accounts receivable: GAAP requires that accounts receivable be shown at their collectible value (some receivables go bad), so an estimate of bad receivables must be calculated. There is more than one way to do the estimate, resulting in different values. The resulting estimate reduces the receivables and creates an expense on the income statement. Furthermore, companies have the ability to overstate the write-off in good years and understate in bad years, thus creating a “smoothing effect” on net income that management knows investors like to see. This can be done with certain other assets as well.
  2. Inventory: GAAP requires that inventory values as calculated by one of the methods (above) also be checked against their replacement cost - what it would cost to replace the inventory as of the balance sheet date, subject to certain adjustments. There are at least three common procedures to do this, usually resulting in different values. If the inventory value is too low, it must be written down, thereby lowering net income by some amount. (Write-downs cannot be recovered later.)
  3. Financial assets: The great credit crisis of 2008 - remember? Large financial companies had balance sheets that included hundreds of millions of dollars of financial assets that later lost most of their value. A major factor that contributed to this disaster was the lack of understanding of the complexity and potential subjectivity of the various GAAP methods used to determine complex financial asset values and the classifications of the assets. Very few investors understood the potential difficulty (and necessity) of determining fair (market) values, even in a crashing market, which can change unpredictably. Also not widely understood were rules for which financial assets were or were not subject to particular methods of value determination. (Management decides which financial assets are “trading”, “available for sale”, or “held to maturity”, with different rules applicable to each category.)

IFRS

“IFRS” stands for “International Financial Reporting Standards”. At the present time approximately 100 countries use these standards, while the United States uses GAAP. In 2002 the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) agreed to begin a project that would unify the separate standards into a single comprehensive system. Although much of U.S. GAAP would be retained, some GAAP would be modified or dropped and replaced by IFRS, which is often less rule-based than GAAP, and which allows greater flexibility. One outcome of this more flexible "principles-based" approach could be even less reporting uniformity than under GAAP, due to a greater tolerance of transaction interpretation than presently allowed by GAAP.

Summing Up

Financial statements really do not act as precise indicators or measuring devices that are uniformly calculated. When prepared with care, GAAP-based financial statements are fair and reasonable representations of the condition and operations of a business; however, the methods available do not have to produce uniform results, and the opportunities for bias clearly exist. In many respects, financial statements should be viewed as more like dashboard lights rather than as precision gauges. Furthermore, financial statements are not real time; they are rear-view mirrors. Both students (when learning the rules) and investors (when reacting to earnings per share) might find this idea useful to keep in mind.

By Greg Mostyn, Mission College

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Worthy & James Publishing is a provider of basic accounting books covering fundamental accounting principles, business accounting, and business math. Topics in financial accounting and business accounting covered include generally accepted accounting principles (GAAP), the accounting cycle needed to prepare financial statements such as the balance sheet, income statement, statement of cash flows, statement of stockholders’ equity, and financial statement analysis using ratios and other procedures. Internal control and cash budgets are included.

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