Current Assets
Ratios that measure short-term liquidity risk depend on the proper measurement and reporting of cash, short-term investments, accounts receivable, and inventories
Cash
Cash usually does not have significant measurement problems. Even cash amounts in foreign currencies can be readily estimated and measured in their U.S. dollar (or corporate home country currency) amounts. However, inclusion of cash as a current asset requires that it be available to satisfy current obligations, and you should carefully read the notes to the financial statements to ascertain whether there are any restrictions on the company’s use of cash for that purpose. Cash restricted for longer-term disbursements (e.g., bond sinking funds, plant expansions, etc.) should be reported as noncurrent
Short-Term Investments
Short-term investments are usually measured with readily available market values and thus are of less concern relative to measurement issues in accounting for accounts receivable and inventories.
Accounts Receivable
Accounts receivable are initially measured at the fair value of the exchange in a credit sale or service arrangement. At the balance sheet date, accounts receivable are adjusted downward by management’s estimate of the amount of uncollectible accounts arising from customer defaults or customer returns. Accounting quality for receivables is thus determined by the company’s revenue recognition policy and the quality of management’s uncollectible account estimation. If revenue is recognized too early or if it is recognized fraudulently, then accounts receivable will be overstated on the balance sheet. If the revenue comes from a product sale, then inventory is understated as well. Thus, the numerator of the current ratio (a key liquidity ratio) is overstated by the amount of the profit margin on the sale. Further, accounts receivable are overstated if management underestimates uncollectible accounts
Because balance sheets and income statements articulate, low-quality accounts receivable measurement also affects earnings quality. Aggressive recognition of receivables from sales and services will lead to overstated revenues and likely overstated net income. Underestimating uncollectible accounts receivable will give rise to understated bad debt expense and likely overstated income.
Inventory
Inventory is initially recorded at the original cost incurred to obtain the inventory. There are two primary asset measurement issues for inventory that affect accounting quality. The first is the choice of inventory method. LIFO is a popular method for inventory valuation under U.S. GAAP (but not allowed under IFRS).28 LIFO assumes that goods purchased more recently (generally at a higher cost) are sold first. LIFO generally yields higher earnings quality because most recent costs are matched with most recent revenues, earnings better capture the economist’s definition of income (based on replacement costs of goods sold), and earnings tend to be more persistent. However, LIFO results in far more conservative estimates of inventory value on the balance sheet because only older costs are reflected in the inventory valuation. Other methods, such as FIFO or average cost, yield balance sheet inventory valuations that are closer to fair value obtained from selling the inventory (i.e., future cash inflow), and thus enable a better assessment of liquidity. The second inventory measurement issue that affects accounting quality arises from the financial reporting requirement that companies annually assess whether inventory costs reflected as assets exceed their market value due to obsolescence, unfavorable supply and demand conditions, or some other economic phenomenon that causes the inventory to decline in value. If so, then the inventory must be written down to market value under the lower-of-cost-or-market rule, triggering an associated loss on the income statement. Management judgments play a large role in the amount and timing of these write-downs and thus, accounting quality can be impaired
Ratios that measure short-term liquidity risk depend on the proper measurement and reporting of cash, short-term investments, accounts receivable, and inventories
Cash
Cash usually does not have significant measurement problems. Even cash amounts in foreign currencies can be readily estimated and measured in their U.S. dollar (or corporate home country currency) amounts. However, inclusion of cash as a current asset requires that it be available to satisfy current obligations, and you should carefully read the notes to the financial statements to ascertain whether there are any restrictions on the company’s use of cash for that purpose. Cash restricted for longer-term disbursements (e.g., bond sinking funds, plant expansions, etc.) should be reported as noncurrent
Short-Term Investments
Short-term investments are usually measured with readily available market values and thus are of less concern relative to measurement issues in accounting for accounts receivable and inventories.
Accounts Receivable
Accounts receivable are initially measured at the fair value of the exchange in a credit sale or service arrangement. At the balance sheet date, accounts receivable are adjusted downward by management’s estimate of the amount of uncollectible accounts arising from customer defaults or customer returns. Accounting quality for receivables is thus determined by the company’s revenue recognition policy and the quality of management’s uncollectible account estimation. If revenue is recognized too early or if it is recognized fraudulently, then accounts receivable will be overstated on the balance sheet. If the revenue comes from a product sale, then inventory is understated as well. Thus, the numerator of the current ratio (a key liquidity ratio) is overstated by the amount of the profit margin on the sale. Further, accounts receivable are overstated if management underestimates uncollectible accounts
Because balance sheets and income statements articulate, low-quality accounts receivable measurement also affects earnings quality. Aggressive recognition of receivables from sales and services will lead to overstated revenues and likely overstated net income. Underestimating uncollectible accounts receivable will give rise to understated bad debt expense and likely overstated income.
Inventory
Inventory is initially recorded at the original cost incurred to obtain the inventory. There are two primary asset measurement issues for inventory that affect accounting quality. The first is the choice of inventory method. LIFO is a popular method for inventory valuation under U.S. GAAP (but not allowed under IFRS).28 LIFO assumes that goods purchased more recently (generally at a higher cost) are sold first. LIFO generally yields higher earnings quality because most recent costs are matched with most recent revenues, earnings better capture the economist’s definition of income (based on replacement costs of goods sold), and earnings tend to be more persistent. However, LIFO results in far more conservative estimates of inventory value on the balance sheet because only older costs are reflected in the inventory valuation. Other methods, such as FIFO or average cost, yield balance sheet inventory valuations that are closer to fair value obtained from selling the inventory (i.e., future cash inflow), and thus enable a better assessment of liquidity. The second inventory measurement issue that affects accounting quality arises from the financial reporting requirement that companies annually assess whether inventory costs reflected as assets exceed their market value due to obsolescence, unfavorable supply and demand conditions, or some other economic phenomenon that causes the inventory to decline in value. If so, then the inventory must be written down to market value under the lower-of-cost-or-market rule, triggering an associated loss on the income statement. Management judgments play a large role in the amount and timing of these write-downs and thus, accounting quality can be impaired
No comments:
Post a Comment