How Accurate Is Accounting?

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.)