I. THE FUNDAMENTAL ACCOUNTING CONVENTIONS
A. Going Concern- assets and liabilities are valued and stated on the presumption that the enterprise will continue in business
1. implies that financial statements do not represent a company’s worth if its assets were to be liquidated, but rather that the assets will be used in future operations.
2. allows businesses to spread (amortize) the cost of an asset over its expected useful life.
B. Liquidation as Proof and Periodic Reports – accountants assume that they can divide the business’s economic activities into artificial time periods (usually 1 year). Tradeoff between reliability and shortness of time period for report.
C. Consistency (year to year) – Accounting entities must give economic events the same accounting treatment from period to period.
1. Example: if one method of depreciation has been used in one annual report, a second report will be more easily comparable (and more useful) of it also uses the same method of depreciation
2. Rationale: accountants want to have some faith in trend lines
3. Distinguished from comparability – looks at an investment against another investment
D. Historical Cost – asset values are present at their original cost less certain reductions (i.e., depreciation, depletion) but without any recognition of increases in value
1. Increases in value occur because of (1) inflation and (2) economic changes
2. Failure to recognize these results from a general inability to precisely measure the change
E. Realization – Revenues are recognized when they are earned or realized. Realization is assumed to occur when the seller receives cash or a claim to cash (receivable) in exchange for goods or services.
1. This concept is related to conservatism in that revenue (income) is only recorded when it actually occurs and not at the point in time when a contract is awarded.
2. For instance, if a company is awarded a contract to build an office building the revenue from that project would not be recorded in one lump sum but rather it would be divided over time according to the work that is actually being done.
F. Conservatism – requires understating rather than overstating revenue (income) and expense amounts that have a degree of uncertainty. The rule is to recognize revenue when it is reasonably certain and recognize expenses as soon as they are reasonably possible.
1. The reasons for accounting in this manner are so that financial statements do not overstate the company’s financial position.
2. Accounting chooses to err on the side of caution and protect investors from inflated or overly positive results.
3. Creditors are primary beneficiaries of conservatism
4. Instances when Accounting is Too Conservative:
a) Historical cost – nobody cares about old data; what investors need to know has much more to do with FMV
b) Unwillingness to list self-developed intangible assets on balance sheet (all expenses to develop intangibles are immediately expensed)
(i) Ex: Microsoft values its intangible assets as ZERO on the balance sheet (doesn’t even include the costs of self-developed intangibles)
(ii) Income statements and balance sheets are interrelated, so misstatements on one cause errors in the other
(iii) Other side of argument – valuation problem
G. DeCaprilles – In most businesses, it is not possible to wait for complete liquidation before determining profits/losses. This means that exact measurement must be sacrificed and that the accounting process must seek to make reasonably defensible estimates of the profits or losses at periodic intervals.
H. Materiality: FASB Concepts No. 2 – materiality judgments are primarily qualitative in nature: Is this item large enough for users of the info to be influenced by it?
1. Only need to be as accurate to the extent that it would make a difference to investors
2. General rule of 5%, but not reliable
3. Exception: fraud is always material
I. McConnell Analysis (75-80)
1. Quality over Quantity – qualitative considerations may cause misstatement of quantitatively small numbers to be considered material
2. If intentional – it’s material – even small misstatements are material if they are intentionally undertaken to “manage earnings”
3. Potential for more Volatility – enforcement of materiality standard will make it more difficult to squeeze the last half penny when trying to meet analyst expectations
J. Purposes of Financial Accounting – Accounting is for outsiders who have no power to order customized reports, so they must make do with what management offers them.
1. The outsiders do not have uniform motives. Therefore, there is a fundamental conflict of interest about what the numbers should be:
a) Creditors want the reports to anticipate bad news
b) Selling shareholders want the reports to be optimistic (indicia of future good news)
c) Buying shareholder want to hear about good possibilities, but they also worry that sellers are puffing up value
2. “Stewardship accounting” – instead of asking what the value of the firm is, it focuses on informing management of where it spent the money; puts the responsibility on the outsider to determine value (including PV and risk)
II. ILLUSTRATIVE FINANCIAL STATEMENTS
A. Merrill Lynch, How to Read a Financial Report – attitude of this report is that we could sit down in Austin, TX and figure out what is a good stock
1. Not enough info in F/S to tell difference between a good stock and bad stock
2. Ratios don’t give you much info
3. Footnote 5 – Contingencies (pending asbestos litigation)
a) Purpose – to disclose info without having it be comprehensible
b) If more likely than not to occur—has to be booked as a loss
c) If not more likely than not to occur – disclose in footnotes
d) They didn’t book loss because not reasonably estimable
4. A few ratios:
a) Current ratio – is the firm going to have cash flow problems?
(i) Current Ratio = Current Assets/ Current Liabilities
(ii) Working capital – excess current assets over amount needed to pay the current liabilities
o Current Assets
o – Current Liabilities
o Working Capital
(iii) Debt-equity ratio – how much equity company has to satisfy debt
o Total Debt
o Total Equity
(iv) Return on Assets – ratio of income to the underlying assets
o Net Income
o (Beginning + Ending Total Assets) / 2
(v) Return on Equity – how much money company is generating with shareholders’ money
o Net Income
o Equity
(vi) Earnings per share – measure of how management’s performance (GPA of the company)
o Earnings available to C/S shareholders
o Average # shares outstanding
(vii) Price Earnings Ratio – interest concept except ratio is turned upside down
o Current market share price
o Earnings per share
B. Johns-Manville Report – “FOOTNOTE 5 IS A TIME BOMB WAITING TO EXPLODE!”
1. Tough to know what any set of F/S mean except in context of competitors/industry
2. Big piece of info not given – market price; impossible to say whether a good investment if not given info on price
3. Accountants love ratios! (Garbage In, Garbage Out)
4. Balance sheet is supposed to be a wealth s
stitute of Certified Public Accountants
c) SEC – Securities and Exchange Commission
(i) Federal authoritative body that oversees the securities market
(ii) Only statutory authority
(iii) Required disclosures for Public Offerings
d) GAAP – Generally Accepted Accounting Principles
(i) SEC requires that CPA’s comply with GAAP for audit
e) APB – Accounting Principles Board
(i) Previous private rule making body now replaced by FASB
f) FASB – Financial Accounting Standards Board
(i) Quasi-regulatory
(ii) Rule-making body that basically says to follow GAAP with a few SFAS remarks
g) FAF – Financial Accounting Foundation
(i) Charity oversight organization for FASB
h) FEI – Financial Executives Institute
(i) One of the trustees to FAF; has huge influence over FASB for the benefit of companies
2. Conservatism for the banks – banks were earliest outsiders to need accounting→ lent money to an enterprise and had to make assessment of safety of loans. Banks get paid first, but then do not participate in profits – conservatism – the fundamental rule of accounting is to anticipate all bad news, but no good news, and that is the kind of system needed by a bank that participates in bad news, but not in good news.
a) Banks have other ways of protecting themselves so that they do not need to know all that much about S-T business results. Investors who need to know a price to buy or sell stock need a lot more information on a very timely basis and the rule of conservatism does not work when want to know real value in buying and selling.
3. Public accounting – “public” accountants are those who audit a firm for the benefit of outside creditors, passive investors, or distant owners. Started in America after the Civil War at the behest of distant British investors using Scottish accountants to check up on frontier enterprises (railroads).
a) Auditing public accountants will spot check both the law (accounting standards) that was used by management to compute income and also the facts claimed by management. In theory must be loyal to outside investors and creditors, but are chosen and paid by the audited firm – divided loyalty and deep conflict as to who the client is.
b) AICPA – professional group that represents the public accountants.
4. Income tax – accounting standards have been heavily influenced by the 1909 decision to tax corporate income. Many accounting rules are best understood as tax minimization techniques and tax has shaped accounting terminology. On many issues, tax and financial accounting have gone separate ways.
5. SEC
a) Mandatory disclosure of financial statements to shareholders and potential shareholders is a direct product of depression-era SEC legislation. A prospectus must contain financial statements, which must be audited by CPAs and certified as prepared in conformity with GAAP. (Act of 1933).
