Accrual accounting seeks to temporally match expenses to revenues. That is, it corrects for time differences between when the cash from revenues is actually received by a business and when expenses are paid out by that business.
For example, in selling a product, firms frequently pay out cash for the manufacture of a widget and then pay to house that widget in a warehouse or retail location that was built at some earlier time. Cash from the sale of the widget sometimes comes in well after its manufacture date. Accrual accounting attempts to calculate those future earnings relative to the cost to produce them. Additionally, accrual accounting tries to quantify the cost of the wear and tear on equipment (i.e., depreciation) so that the value lost through usage is matched to the revenues earned by the product manufactured. And so on for many other business activities.
Given its philosophical underpinnings, accrual accounting, not surprisingly, relies on abstraction and human judgment. As it relates to the latter, accrual accounting is complex because it asks for judgment from the business executives themselves as well as their auditors, and, of course, from the research analysts and portfolio managers who are trying to assess the accuracy of those judgments. Throw in the economic incentives handed out to business executives, and you have a built-in impetus to nudge and fudge financial numbers in a preferred direction.
All of this, of course, raises the question of our recent CFA Institute Financial NewsBrief poll: How accurate is accrual accounting in capturing actual business reality? Since many investing decisions depend on the accuracy of accrual accounting, this is a vital question.
How accurate is accrual accounting in capturing actual business reality?
Reassuringly, three quarters of the 568 respondents believe that accrual accounting captures at least half of the reality of a business, while the smallest category of poll participants (7%) believe that it is accurate a quarter of the time or less. Whew!
But many respondents recognize that the accrual accounting lens is a bit greasy, as the second smallest segment of respondents (8%) believe the image shining through the accrual accounting lens is at least 90% accurate. About two in three participants understand accrual accounting provides a less-than-perfect image of business reality (i.e., the combination of the groups ranging from 50–89%), but that, at the very least, half of what they are seeing is real. That is, they are at least 50% confident that accrual accounting represents real business activities. What was surprising to those of us inside of CFA Institute — who had placed our bets on the 76–89% category — is that the largest group of respondents picked the 50–75% range. So accounting standard setters, are you listening? Readers of CFA Institute Financial NewsBrief feel there is some work to do.
These results raise a natural question: What would help make accrual accounting more accurate? More thorough audits? Better internal accounting software and controls? Inclusion of economic, social, and governance (ESG) factors so the actual footprint of the business was better represented? Unified global accounting standards? Less complex businesses? And so on. We promise to revisit this question in a future poll.
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30 Comments
Hello Warren,
Thank you for your extended and continued contributions to this post!
Yours, in service,
Jason
"The boards propose that the objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers.
The objective of financial reporting is the foundation of the conceptual framework. Other aspects of the framework - qualitative characteristics, elements of financial statements, recognition and measurement - will build on that foundation with the aim of ensuring that financial reporting achieves its objective."
This is the stated purpose of financial reporting under IFRS. Presumably there is a similar statement of purpose under US GAAP. So in the absence of framing your comments against the purpose of financial reporting, might it be fair to say that more work needs to be done here? There is no stated purpose of accuracy. Accuracy is tempered by materiality. Those who expect accuracy do not have a clear understanding of the stated purpose of financial reporting under GAAP (US or IFRS).
Hi Jake,
Thank you for your comment. I think that you may have backed yourself into a corner here. If we take your premise as true, then those that make use of financial statements can only do so if their use is in accord with the intentions of those creating them. I gotta reject that notion. Just as it is legitimate for a lover of opera to reject Rihanna as being of a different substance than Maria Callas, it is also okay for research analysts (i.e. "Rihanna fans, in keeping with the analogy) to still use (listen to) financial statements (opera), even if the audience of the creators (i.e. "opera fans") ends up being different, and having a different opinion. In other words, it is okay for research analysts to complain about accrual accounting as being slightly less than what they would want it to be. Just as it is fine for a CPA true believer to argue that accrual accounting is the only substantive form of financial reporting. Same material, different goals and contexts = now we know why setting accounting standards is difficult.
I wonder if the CPAs commenting on this post have an explanation for the poll results, other than that investment professionals "just don't understand?"
Yours, in service,
Jason
Investment professionals just don't understand. I don't believe that the debate should be about whether or not they are "accurate". They were never intended to be accurate. So you have the wrong end of the hockey stick.
The question in my opinion properly phrased is do we have the right objective/purpose for financial reporting? Once you decide what the purpose is then you can discuss whether or not they were accurate. Otherwise I think that you are just being critical without offering a solution.
Hi Jake,
This was exactly why the end of this poll's write up asks and then states: "These results raise a natural question: What would help make accrual accounting more accurate? More thorough audits? Better internal accounting software and controls? Inclusion of economic, social, and governance (ESG) factors so the actual footprint of the business was better represented? Unified global accounting standards? Less complex businesses? And so on. We promise to revisit this question in a future poll."
Look for the follow up poll around the beginning of March, if memory serves.
Also, regarding models that CFAs use...no doubt, was anyone offering up the models of a Chartered Financial Analyst as a scion of accuracy? If anything, the famous concept of a 'Margin of Safety' is explicit acknowledgment that the models are inherently imprecise. One growth manager's DCF is a 'sell', while a value manager looking at the same numbers says it is a 'buy.' In fact, I think almost every research analyst and portfolio manager would tell you that they get paid for their opinions, fully recognizing the variability in their opinions relative to the competition. But they would also say, given all of that variability, that their accuracy in assessing the reality of a business, the economy, and of financial markets is what they hope will keep them employed.
Yours, in service,
Jason
Hi Jake,
I am not sure if you are an accountant, or not, but did you just state that accounting was never intended to be accurate? I think that is true in the modern era with the Corporationus Giganticus, but I certainly hope that my small business software can handle my eBay business with some accuracy. I think the creators of accounting absolutely wanted accurate insight into the activities of a business. I think that is probably what business people themselves want, too.
Regarding your proposed question...different audiences are still going to want different things from them. That could be a bank considering lending to the firm to shore up the pension plan, or the regulator wanting to build a case that management has misrepresented certain aspects of the business, to the college professor wanting to compare and contrast Coke with Pepsi. I think it is a legitimate question to ask how accurate accrual accounting is in capturing business activity.
Yours, in service,
Jason
You continue to look at things from a non-accounting perspective. Let's just agree to disagree. Accuracy is a subjective term not an objective term. You as a CFA should know that.
Are your valuation models accurate? Perhaps you should have a poll on that. DCF and NPV and the like are mathematically accurate but in application not accurate at all.
Your perception of accounting is bookkeeping, and not accounting. As long as you continue to take that view, I'm afraid that the discussion will go in circles.
If you ask over simplistic questions you should not be surprised if you get overly simplistic answers.
Hello Jake,
Actually I was on record earlier in this thread as saying I was a believer in accrual accounting and that I thought it was about 75% accurate. I also said that was good enough for me. I think it is always appropriate to ask if our models are reflective of reality, don't you?
Regarding DCF and NPV, you asked me to take a position on an issue that you raised. I know that these things are inaccurate, and I do not hold them, or accrual accounting up to a standard of perfection. Show me where in this thread, or in anything that I have written where I held that accrual accounting would be 100% accurate, or even 90% accurate. At no point have I said that was the standard. However, when a group of people that subscribe to our Newsbrief poll find that the range is 50% to 75%, I think that means that there is room for improvement. Or do you find accrual accounting good enough, as is?
It seems to me as if you are staking this out as a research analyst vs. accountant debate, and am not sure what set you off in this polarized position. Also, I don't recall having agreed that this discussion was about DCF/NPV as perfect vs. accrual accounting. Those were the arms you took up. I am guessing that you expected that to be a valid point, but I don't defend those models as perfectly accurate either. Where did I indicate that?
The spirit of the question about accrual accounting is a valid one. And the results are what they are. There is no need to agree to disagree. What I agree with is that it is okay to ask about the accuracy of a model, any model, a DCF/NPV, a quant's algorithm, and certainly an accountant's accrual accounting, and any model. Are you saying that accounting is not big enough and safe enough in its quality to stand a little scrutiny? I am guessing that you feel that some scrutiny is warranted, as well as improvements along the way to reflect the ever-changing nature of business and business activity. It was in that spirit that the question was asked.
Yours, in service,
Jason
By the way, here is a definition of accurate. Do you honestly believe that accounting under any circumstances can meet every part of this definition?
free from error or defect; consistent with a standard, rule, or model; precise; exact.
Now Jason, we really do need to be more careful in defining the terms we use when we ask a question, don't we? By definition accrual accounting is consistent with a standard, rule or model. You seem to be using the term as free from error or defect. Precise, exact. Because of the way the question was asked, the answer became a self-fulfilling prophecy.
I modify my comments and argue then that accrual accounting is accurate as it meet the standard, rule or model as in GAAP.
Jason, I'm both a CFA charterholder and a CPA. But I'm an extreme outlier in the distribution of the latter.