Accounting distortions

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Accounting distortions are deviations of reported information in financial statements from the underlying business reality. These distortions arise from the nature of accrual accounting this includes its standards, errors in estimation, the trade-off between relevance and reliability, and the latitude in application. We separately discuss each of these sources of distortion.

Accounting Standards

Accounting standards are sometimes responsible for distortions. At least three sources of this distortion are identifiable. First, accounting standards are the output of a political process. Different user groups lobby to protect their interests. In this process, standards sometimes fail to require the most relevant information. One example is accounting for employee stock options (ESOs).

A second source of distortion from accounting standards arises from certain accounting principles. For example, the historical cost principle can reduce the relevance of the balance sheet by not reflecting current market values of assets and liabilities. Also, the transaction basis of accounting results in inconsistent goodwill accounting wherein purchased goodwill is recorded as an asset but internally developed goodwill is not. Additionally, double entry implies that the balance sheet articulates with the income statementm meaning that many transactions affect both statements. However, an accounting rule that improves one statement often does so to the detriment of the other. For example, FIFO inventory rules ensure the inventory account in the balance sheet reflects current costs of unsold inventory. Yet LIFO inventory rules better reflect current costs of sales in the income statement.

A third source of distortion is conservatism. For example, accountants often write down or write off the value of impaired assets, but very rarely will they write up asset values. Conservatism leads to a pessimistic bias in financial statements that is sometimes desirable for credit analysis but problematic for equity analysis.

Estimation Errors

 Accrual accounting requires forecasts and other estimates about future cash flow consequences. Use of these estimates improves the ability of accounting numbers to reflect business transactions in a timely manner. Still, these estimates yield errors that can distort the relevance of accrual accounting numbers. To illustrate, consider credit sales. Whenever goods or services are sold on credit, there is a possibility the customer will default on payment. There are two approaches to confront this uncertainty. One approach is to adopt cash accounting that records revenue only when cash is eventually collected from the customer. The other approach, followed by accrual accounting, is to record credit sales as revenue when they are earned and then make an allowance for bad debts based on collection history, customers’ credit ratings, and other  facts. While accrual accounting is more relevant, it is subject to distortions from errors in estimation of bad debts.

Reliability versus Relevance

Accounting standards trade off reliability and relevance. An emphasis on reliability often precludes recognizing the effects of certain business events and transactions in financial statements until their cash flow consequences can be reasonably estimated. One example is loss contingencies. Before a loss contingency is recorded as a loss, it must be reasonably estimable. Because of this criterion, many loss contingencies are not reported in financial statements even several years after their existence is established beyond reasonable doubt. Another example of distortion due to the reliability emphasis is accounting for research and development costs. While R&D is an investment, current accounting standards require writing it off as an expense because payoffs from R&D are less certain than payoffs from investments in, say, plant and equipment.

Earnings Management

Earnings management is probably the most troubling outcome of accrual accounting. Use of judgment and estimation in accrual accounting allows managers to draw on their inside information and experience to enhance the usefulness of accounting numbers. However, some managers exercise this discretion to manage accounting numbers, particularly income, for personal gain, thereby reducing their quality. Earnings management occurs for several reasons, such as to increase compensation, avoid debt covenants, meet analyst forecasts, and impact stock prices. Earnings management can take two forms: (1) changing accounting methods, which is a visible form of earnings management, and (2) changing accounting estimates and policies that determine accounting numbers, which is a hidden form of earnings management. Earnings management is a reality that most users reluctantly accept as part of accrual accounting. While it is important we recognize that earnings management is not as  widespread as the financial press leads us to believe, there is no doubt it hurts the credibility of accounting information. The next section includes an in-depth discussion of earnings management.

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