Imprecise Rule Book Better Than None

After reading “What Drives Earning Management?”( JofA, Oct.00, page 106) and “A Historical Look at Standards” ( JofA, Oct.00, page 16) , I offer the following comments:

There are several methodologies available to accountancy for reporting financial performance and financial status. At the extremes are

The simple and objective cash-basis model in which the only transactions reported are those that involve the receipt or disbursement of cash. The balance sheet is extremely simple—cash equals equity. Judgments and predictions are not allowed.

The complex and subjective market-basis scheme where every asset and liability on the balance sheet is appraised, reappraised and evaluated: What is the probability of bank failure devaluing cash balances? What is the present value of every liability? What are the future cash flows to be earned by each and every asset?

Most people can understand cash-basis accounting. Years in which significant productive assets are purchased might show a decrease in cash, but readers would understand something happened that might benefit the future. Disclose the facts; let the user of the information make the judgments.

Market-basis accounting would rarely measure the results of the operations of an entity. Most significant changes in equity would arise from changes in the estimated value of assets and liabilities. Profit or loss would arise depending on management’s ability to meet or better their previous predictions.

Our current accrual-basis system is designed around a set of assumptions and rules that issuers and users of financial statements, for the most part, understand. If some are so complex as to be misunderstood, then perhaps they are not useful.

A statement of cash flows is an essential part of financial reporting (cash basis isn’t dead). Simple accrual adjustments, such as “estimates” of accounts payable, accrued expenses, trade receivables and prepaid expenses, are commonly understood in the financial community. Such “predictions” and “interperiod allocations” help to display the economic decisions made by an enterprise during a specific period by more closely “matching” costs and revenues.

Accountants and the financial community should be happy that a rule book exists—that a referee can call “foul” if an infraction is observed.

I believe that blame for attempts to “smooth” earnings arises as much from the expectations of a formula-driven investment community as from industry’s desire to meet or beat those expectations. Knowledgeable investors should understand all the disclosures in financial statements, not just earnings per share. They should realize that fluctuations in financial performance are normal and that a consistent increase in earnings should be suspect, not normal. Maybe the “rule book” used for making investment decisions based on financial statements should relate to the rules used to compile them.

Today’s GAAP, while imprecise and subject to abuse by those who hope the next period will “cover” this period’s reporting “judgments,” is far better than no rule book at all. A thoughtful blending of cash-basis and market-basis theories will lead to a consistent (managed) growth in the usefulness of financial statements.

Charles S. Jennings, CPA, CFO
Kiddie Academy International, Inc.
Bel Air, Maryland