The desirable qualities of accounting information serve as conceptual criteria for accounting principles. Skillful use of accounting numbers for financial analysis requires an understanding of the accounting framework underlying their computation. This includes the principles governing measurement of assets, liabilities, equity, revenues, expenses, gains, and losses.
Accrual Accounting
Modern accounting adopts the accrual basis over the more primitive cash flow basis. Under accrual accounting, revenues are recognized when earned and expenses when incurred, regardless of the receipt or payment of cash. The accrual basis is arguably the most important, but also controversial, feature of modern accounting. We focus on accrual accounting later in this chapter.
Historical Cost and Fair Value
Traditionally, accounting has used the historical cost concept for measuring and recording the value of assets and liabilities. Historical costs are values from actual transactions that have occurred in the past, so historical cost accounting is also referred to astransactions-based accounting. The advantage of historical cost accounting is that the value of an asset determined through arm’s-length bargaining is usually fair and objective. However, when asset (or liability) values subsequently change, continuing to record value at the historical cost that is, at the value at which the asset was originally purchased impairs the usefulness of the financial statements, in particular the balance sheet.
Recognizing the limitations of historical cost accounting, standard setters are increasingly moving to an alternative form of recording asset (or liability) values based on the concept of fair value. Broadly, fair values are estimates of the current economic value of an asset or liability. If a market exists for the asset, it is the current market value of the asset. Fair value accounting is currently being used to record the value of many financial assets, such as marketable securities. However, the FASB has recognized the conceptual superiority of the fair value concept and has, in principle, decided to eventually move to a model where all asset and liability values are recorded at fair value. For the purposes of analysis, it is crucially important to understand the exact nature of fair value accounting, its current status and where it is heading, and also its advantages and limitations both for credit and equity analysis.
Materiality
Materiality, according to the FASB, is “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it possible that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.” One problem with materiality is a concern that some preparers of financial statements and their auditors use it to avoid unwanted disclosures. This is compounded by the fact there is no set criteria guiding either the preparer or user of information in distinguishing between material and nonmaterial items.
Conservatism
Conservatism involves reporting the least optimistic view when faced with uncertainty in measurement. The most common occurrence of this concept is that gains are not recognized until they are realized (for example, appreciation in the value of land) whereas losses are recognized immediately. Conservatism reduces both the reliability and relevance of accounting information in at least two ways. First, conservatism understates both net assets and net income. A second point is that conservatism results in selectively delayed recognition of good news in financial statements, while immediately recognizing bad news. Conservatism has important implications for analysis. If the purpose of analysis is equity valuation, it is important to estimate the conservative bias in financial reports and make suitable adjustments so that net assets and net income are better measured. In the case of credit analysis, conservatism provides an additional margin of safety. Conservatism also is a determinant of earnings quality. While conservative financial statements reduce earnings quality, many users (such as Warren Buffett) viewconservative accounting as a sign of superior earnings quality. This apparent contradiction is explained by conservative accounting reflecting on the responsibility, dependability, and credibility of management.
Academic research distinguishes between two types of conservatism. Unconditional conservatism is a form of conservative accounting that is applied across the board in a consistent manner. It leads to a perpetual understatement of asset values. An example of unconditional conservatism is the accounting for R&D: R&D expenditures are written off when incurred, regardless of their economic potential. Because of this, the net assets of R&D-intensive companies are always understated.
Accrual Accounting
Modern accounting adopts the accrual basis over the more primitive cash flow basis. Under accrual accounting, revenues are recognized when earned and expenses when incurred, regardless of the receipt or payment of cash. The accrual basis is arguably the most important, but also controversial, feature of modern accounting. We focus on accrual accounting later in this chapter.
Historical Cost and Fair Value
Traditionally, accounting has used the historical cost concept for measuring and recording the value of assets and liabilities. Historical costs are values from actual transactions that have occurred in the past, so historical cost accounting is also referred to astransactions-based accounting. The advantage of historical cost accounting is that the value of an asset determined through arm’s-length bargaining is usually fair and objective. However, when asset (or liability) values subsequently change, continuing to record value at the historical cost that is, at the value at which the asset was originally purchased impairs the usefulness of the financial statements, in particular the balance sheet.
Recognizing the limitations of historical cost accounting, standard setters are increasingly moving to an alternative form of recording asset (or liability) values based on the concept of fair value. Broadly, fair values are estimates of the current economic value of an asset or liability. If a market exists for the asset, it is the current market value of the asset. Fair value accounting is currently being used to record the value of many financial assets, such as marketable securities. However, the FASB has recognized the conceptual superiority of the fair value concept and has, in principle, decided to eventually move to a model where all asset and liability values are recorded at fair value. For the purposes of analysis, it is crucially important to understand the exact nature of fair value accounting, its current status and where it is heading, and also its advantages and limitations both for credit and equity analysis.
Materiality
Materiality, according to the FASB, is “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it possible that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.” One problem with materiality is a concern that some preparers of financial statements and their auditors use it to avoid unwanted disclosures. This is compounded by the fact there is no set criteria guiding either the preparer or user of information in distinguishing between material and nonmaterial items.
Conservatism
Conservatism involves reporting the least optimistic view when faced with uncertainty in measurement. The most common occurrence of this concept is that gains are not recognized until they are realized (for example, appreciation in the value of land) whereas losses are recognized immediately. Conservatism reduces both the reliability and relevance of accounting information in at least two ways. First, conservatism understates both net assets and net income. A second point is that conservatism results in selectively delayed recognition of good news in financial statements, while immediately recognizing bad news. Conservatism has important implications for analysis. If the purpose of analysis is equity valuation, it is important to estimate the conservative bias in financial reports and make suitable adjustments so that net assets and net income are better measured. In the case of credit analysis, conservatism provides an additional margin of safety. Conservatism also is a determinant of earnings quality. While conservative financial statements reduce earnings quality, many users (such as Warren Buffett) viewconservative accounting as a sign of superior earnings quality. This apparent contradiction is explained by conservative accounting reflecting on the responsibility, dependability, and credibility of management.
Academic research distinguishes between two types of conservatism. Unconditional conservatism is a form of conservative accounting that is applied across the board in a consistent manner. It leads to a perpetual understatement of asset values. An example of unconditional conservatism is the accounting for R&D: R&D expenditures are written off when incurred, regardless of their economic potential. Because of this, the net assets of R&D-intensive companies are always understated.
Conditional conservatism refers to the adage of “recognize all losses immediately but recognize gains only after they are realized.” Examples of conditional conservatism are writing down assets such as PP&E or goodwill when there has been an economic impairment in their value, that is, reduction in their future cash-flow potential. In contrast, if the future cash flow potential of these assets increases, accountants do not immediately write up their values the financial statements only gradually reflect the increased cash flow potential over time as and when the cash flows are realized. Of the two forms of conservative accounting, unconditional conservatism is clearly more valuable to an analyst especially a credit analyst because it conveys timely information about adverse changes in the company’s underlying economic situation.
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