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.
If you liked this post, don't forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author's employer.
30 Comments
Hum? A theoretical discussion? Perhaps that is all that it should be here, and an uneducated reader could walk away learning something valuable depending on what form of accounting is necessary for them and depending on their needs. But accrual accounting rocks! And it must be understood completely, to see if it's the right art to practice and if there's a worthwhile benefit. It's been a while since I considered this question thoroughly, but it's always out there in the subconscious, and a great question, and I wanna stir the pot of thought a little. Why not just accecpt the fact that there are various points of view with regard to "accounting" and the information collected and presented by many different professionals for many different purposes. Follow the money. Accounting is an art, not a science, although it could be an exact science, and may be in several yeas as Artificial Intelligence progresses. Be careful, the robots are coming. So why is the so much confusion? I'm not confused. Different people hope to use the numbers for different purposes, so imagine an eloquent system where one could flick a switch and have the acutal correct numbers change for different purposes. I remember the concept of objectivity (and other accounting principles/concepts), and believe in it theoretically, but it's proven to only be a theoritical concept. In actual prictice, hum? People are motivated by different things and needs, as one previous writer here wrote - he's got it right!!, and because they have to be. Materiality is also very important, in the right time and place. So you can see, there are conflicts built into the system. But GAAP must be followed in the right environment! No if's and's or butts.
I leave with this. Don't trust the analysts on Wall Street. I listen to what they say and do the opposite. Very profitable. Don't get me started. And don't solicit me, thats illegal as far as I'm concerned.
:-)
La Place got it write, but its impossible.
"If you know the velocity and the position of every particle in the universe, you can predict every future event". With that, think about the possible honesty of financial statements.
For Jerry, above. Wow! In all the years that I have had my opinion in the public domain, that is the single greatest response to anything I have written. Well done! Drop the mic, Jerry!
Well put. There are conflicts built into every system. Those criticizing should in my opinion offer a solution. In the absence of that, well it's just being critical. Many of the models that CFA's use have embedded conflicts, limitations and bias (DCF, NPV, Payback). We need to educate ourselves as to what those are and then come to our own educated conclusions.
As a CPA myself, I respectfully disagree with your assertion that "Accounting is an art, not a science." In my view, accounting is neither.
Accounting is a 'craft'. The best accountants are neither artists, whose output is highly personal and generally unpredictable. Nor are they scientists, whose output follows known factual principles and is both rigorous and logical.
The only way to get good at a craft is do it. Assuming that one is not just going through unthinking and automatic-pilot-type motions, the more one does a craft, the better one gets.
Jake you are so far off the mark as to be almost absurd. The ultimate goal of financial reporting is to "fairly" (read accurately) represent the results of the operations of a business, etc. I agree with some of the comments about the complexity of GAAP etc. which I too agree is the result of the influence (lobbying) of Wall Street and the largest accounting firms who are totally lacking independence.
I do not understand the comment about materiality. Materiality and accuracy are related and the relationship is an important aspect of financial reporting today where we deal with such large numbers.
I also disagree with Michael about the new AICPA framework more accurately reflecting accrual accounting. The new framework is a weak approach to the basic complexity of standards and the differences in financial reporting for large and small businesses today. I do want to say that at least the AICPA has tried to address the problem with large and small GAAP which the FASB has failed so miserably at.
I believe that the poll is skewed due to confusion of accrual accounting and GAAP. GAAP, in my opinion, is too complex for most businesses today and there is such a large area now in GAAP where "judgements" about transactions and events are not consistent and are used to distort results for purposes seen or unforeseen as Jason so accurately related in his example.
Everyday you read about the big accounting firms being fined and penalized due to accounting irregularities in financial reporting. We have made financial reporting inordinately complex under GAAP and provided opportunities for those who are lacking ethical and moral standards to take advantage of. .....but we all have to live with what we have until we have better solutions to this hubris of those at FASB and others in our profession.
Hello Rusty,
Your answer is thoughtful and well-considered, in my opinion. Thank you for sharing it with folks.
Undoubtedly the financial profession has lobbied/does lobby for changes to accounting standards. I am a fan of mark-to-market, but only as a complement to earlier standards. Due to mark-to-market accounting there are anecdotal reports of financial institutions managing the end of the quarter balance sheet in conjunction with shadow banks and hedge funds inr oder to present the prettiest of pictures. Clearly, this has brought a level of absurdity to financial statements. However, I also know that the firm for whom I dedicated my portfolio management years, along with many others, felt that stock options were an expense and so should appear in the income statement. So the lobbying hasn't entirely been misguided, in my opinion.
Again, thank you for sharing your point of view,
Jason
Once one gets below current assets and current liabilities on the balance sheet, fair-value accounting (FVA) is the greatest hoax since one-size-fits-all. Start with the fact that FVA is highly judgmental because there are seldom active markets for long-lived assets. (Seldom, but not never.) So, invariably it's a Level 3 measurement (something just this side of pure fiction, no matter how 'precise' it may appear). That goes in spades for intangible assets.
Besides that, two other aspects of fair-value accounting trouble me. The first is that the people being asked to compute fair values on long-lived assets tend to be accountants. Value is prospective. Accounting looks backwards. And, frankly, other than an annual budget, ne'er the twain shall meet for accountants. If my CPA and non-CPA colleagues wanted to deal with the kind of ambiguity that we who do work under ASC 805 routinely embrace, they would have never become accountants. And, unfortunately, based on my anecdotal inquiries of professors around the country, accounting education on the college campus seriously lags what those of us reading this blog often have to confront.
Exercising the kind of judgment that is required to make Level 3 calls in the fair-value hierarchy will give most accountants migraines. Embracing the lack of precision and the softness of 'fair-value rules' is not why most of my colleagues became bean-counters. (I'm an extreme outlier in the distribution, which, I trust, is obvious.)
The second and arguably more troubling aspect of fair value is the incentives it creates: because fair value is an "exit price"--what it might be worth, rather than what was paid for a long-lived asset--the incentive is to trade assets ("The bazaar [bizarre?] is open!"), NOT to create unique capabilities that generate annuity streams of free cash flows that create real value for companies through returns that far exceed a company's cost of equity capital. Except in an article I wrote for the August 2008 edition of the IMA's "Strategic Finance" magazine ("The Fatal Flaw in SFAS 157"), I've not seen any substantive discussion of incentives in the context of FVA. I also argued strongly against FVA's assumption of homogeneity among both long-lived assets and the values thereof.
Along with that is the truly bizarre implementation of FVA: If a company gets a downgrade in the creditworthiness of long-term debt, well, that debit to funded debt has to have an offsetting credit somewhere--it really is helpful to understand the debits-and-credits side of accounting, folks. Under fair-value, that offsetting credit juices up the bottom line of the P&L. So, get a credit downgrade, and boost the bottom line. Terrific.
Bear Stearns did that in Q2 of 2007. They even managed to keep from laughing hysterically about it when they discussed it during the earnings call. Of course, less than year later, they were out of business. But writing down debt and pumping up the P&L is stark-raving nuts.
But then, so is fair-value, IMHO. Accrual accounting based on historical costs is far from perfect, but it has the rigor of real transactions, as one of our colleagues already observed, standing behind it. That alone makes it a helluva lot better than anything related to FVA applied to long-lived assets and liablities. As a former CFO, too, I cannot imagine having to sign off personally on Qs every quarter. I'd sooner take up cordless bungee-jumping.
FWIW, I believe that, with 'big GAAP', the FASB is trying to move towards balance sheets that reflect the market value of invested capital. It's not just a futile idea. It's a horrific idea because value is subjective. It always has been, and it always will be.
Fair-value accounting is a textbook case of the dreadful things that can happen when 65 really, really smart people--this particular group is in Norwalk, Conn., but they could be anywhere--have far too much time on their hands. They don't understand the wisdom of the old adage, "Don't just do something. STAND THERE!"
Thanks, Jason.
Hello Warren,
What an extended and thoughtful reply, thank you. I learned something, too, about accounting for the first time in years and years. Namely, the bit about Bear Stearns. Thank you. I have a Masters in Accounting, though am not a CPA. So, the incremental knowledge bits are rare. Woohoo! You have made my night!
Regarding "fair value" - I think the original intention was probably correct - to better reflect the actual value of the assets. In retrospect what is likely better is to simply provide transparency as to the nature of the assets (many of the assets are contractual in nature) so that the diligent and interested analyst can agree or disagree with the assumptions to calculate her own estimate of the fair value of the assets.
Again, thank you!
Jason
Thank you for your kind words, Jason. Since obtaining my charter at the ripe old age of 62--I did it to escape the embarrassment of having to pay dues to the AICPA--I have strongly believed that Level I of the CFA regimen doesn't put nearly enough emphasis on the nuts-and-bolts of accounting. I know that the mechanics of debits and credits don't do much for one's intellect, but they are a real godsend when it comes to understanding bad ideas such as FVA.
In addition, accounting professors have done neither their students nor the potential employers of those young people any favors with how they now teach the basic "Accounting Principles" course. That is "course," not "courseS," the way it was decades ago when I was an undergraduate. That's right, they devour a 1,200-page book in a single semester. Why? Well, as a recovering academic, I'd bet a bunch of money that it was because accounting professors hated teaching a "boring" subject such as the principles courses, so they compressed it into a single semester. That is why I advise some of the young people that I mentor to take that course at a community college, not at a four-year institution. At the junior college, it is still a two-semester course. The pace of doing it that way ensures that they will actually learn a lot, not to have to memorize-and-regurgitate on tests a mountain of information that they probably don't understand.
In addition, when the professors jammed the two-course regimen into one, they also--conveniently, I would argue--ditched the 'Practice Set' project that capped off the two-semester principles courses. This was a soup-to-nuts exercise near the end of the second semester that required students to create a chart of accounts, make the opening entries for a new company, and then record transactions for several months with a month-end "closings," including accruals and reversing entries. Students also had to present a balance sheet and a P&L; back in those days, there was no Statement of Cash Flows, unfortunately. (If one holds a gun to my head and tells me I can have only one of the components in the financial-statement package, I'll take the SoCF every time because that's where the chickens from the accounting games played on the balance sheet and the P&L come home to roost.)
Just 2-1/2 years out of my undergraduate degree, I landed a job as the first Controller in the then-59-year history of a retailer and wholesaler of engineering supplies and art supplies; it employed 93 full-timers. And it had, for all practical purposes, no accounting system. (It did have an outside CPA who did the tax returns and who had been slumbering for many years.) I saw before the end of my first day on the payroll that it had no system, so, on my second day, I brought my accounting textbooks and my old 'Practice Set' to the office and set out to design a soup-to-nuts accounting system.
Wonder of wonders, the damned thing worked. . .on the first try. That was in 1978, a year of high inflation. I also published monthly "Expense Summaries" by department. The department managers screamed bloody murder. But a funny thing happened: SG&A went down that year. The cash-register system at the flagship retail store, which had been more than $5,000 "short" in 1977, was $7.18 long in 1978. . .on $1.5 million in sales. Of course, the guy that ran that store was also making cash advances to sales people. . .out of the cash drawer. I stopped that practice the second day I was on the payroll. But I couldn't have changed a thing--because I wouldn't have known how to change it--had I been forced to injest that gargantuan accounting principles textbook in a single semester--without the 'Practice Set'.
Luckily, various iterations of Practice Sets are available for purchase now on Amazon. I have recommended to several of my proteges that they buy one of those and work through it because it will be a learning experience that does more to prepare them for their later professional lives than any other. Several have let me know early in their careers that the Practice Set knowledge stayed with them in numerous fortunate ways.
One last comment in this vein: I think it is borderline criminal for universities to allow young people majoring in finance to graduate with only two or three semesters of accounting courses. I think they need at least five (5), including the two intermediate courses. Substantive--serious--accounting knowledge is a key requirement of careers in corporate finance or securities analysis. It is also essential, I believe, to have a gut-level appreciation of what attracts certain people to accounting as a career. IMHO, the best way to do that is to require five or six accounting courses for finance majors. I took seven of them, including four (4) (Intermediate II, Corporate Income Tax, Advanced, and Auditing) in my last semester of undergraduate school. Looking back, I don't know how I did it, but I also know that I didn't give myself a choice.
Segue: I agree with your idea about disclosure and descriptions, Jason. However, unless I am mistaken, that can be done only with intangible assets that are not already on the balance sheet. I infer that is what you meant by your reference to "contractual in nature," but I thought I'd seek clarification just in case. I should also mention that "contract-based" is one of five broad classifications of intangible assets cited in ASC 805. The other four are marketing-related, customer-related, artistic-related, and technology-based.
Hope these comments are helpful.
Holy moley, Warren!
Thank you for the extended discussion. Yes, nothing helps more than learning that approximates reality.
In answer, to your questions, yes, you understood what I meant by 'contractual' in nature. An example is bond covenants lay out exactly what is exchanged for capital by a company. With the covenant in hand a smart investor can do prospective analyses given her assumptions about future economic states, business conditions, the shape of the yield curve, and so on. If there is something contracted, then let's have some detail, and then let's let the research analysts contribute their value add to the understanding of the company's prospects.
Yours, in service,
Jason