Practical analysis for investment professionals
28 January 2016

Is Accrual Accounting Actually Accurate?

Accrual accounting seeks to temporally match expenses to revenues. That is, it corrects for time differences between when the cash from revenues is actually received by a business and when expenses are paid out by that business.

For example, in selling a product, firms frequently pay out cash for the manufacture of a widget and then pay to house that widget in a warehouse or retail location that was built at some earlier time. Cash from the sale of the widget sometimes comes in well after its manufacture date. Accrual accounting attempts to calculate those future earnings relative to the cost to produce them. Additionally, accrual accounting tries to quantify the cost of the wear and tear on equipment (i.e., depreciation) so that the value lost through usage is matched to the revenues earned by the product manufactured. And so on for many other business activities.

Given its philosophical underpinnings, accrual accounting, not surprisingly, relies on abstraction and human judgment. As it relates to the latter, accrual accounting is complex because it asks for judgment from the business executives themselves as well as their auditors, and, of course, from the research analysts and portfolio managers who are trying to assess the accuracy of those judgments. Throw in the economic incentives handed out to business executives, and you have a built-in impetus to nudge and fudge financial numbers in a preferred direction.

All of this, of course, raises the question of our recent CFA Institute Financial NewsBrief poll: How accurate is accrual accounting in capturing actual business reality? Since many investing decisions depend on the accuracy of accrual accounting, this is a vital question.


How accurate is accrual accounting in capturing actual business reality?

How accurate is accrual accounting in capturing actual business reality?


Reassuringly, three quarters of the 568 respondents believe that accrual accounting captures at least half of the reality of a business, while the smallest category of poll participants (7%) believe that it is accurate a quarter of the time or less. Whew!

But many respondents recognize that the accrual accounting lens is a bit greasy, as the second smallest segment of respondents (8%) believe the image shining through the accrual accounting lens is at least 90% accurate. About two in three participants understand accrual accounting provides a less-than-perfect image of business reality (i.e., the combination of the groups ranging from 50–89%), but that, at the very least, half of what they are seeing is real. That is, they are at least 50% confident that accrual accounting represents real business activities. What was surprising to those of us inside of CFA Institute — who had placed our bets on the 76–89% category — is that the largest group of respondents picked the 50–75% range. So accounting standard setters, are you listening? Readers of CFA Institute Financial NewsBrief feel there is some work to do.

These results raise a natural question: What would help make accrual accounting more accurate? More thorough audits? Better internal accounting software and controls? Inclusion of economic, social, and governance (ESG) factors so the actual footprint of the business was better represented? Unified global accounting standards? Less complex businesses? And so on. We promise to revisit this question in a future poll.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

31 thoughts on “Is Accrual Accounting Actually Accurate?”

  1. I think what the issue might be is that people are confused with what GAAP is. While GAAP used to be primarily focused on accrual basis account – which requires that revenues be recognized in the period in which a sale is made and expenses in the period in which they are incurred, this is no longer the case. For at least the last 20 years, the Financial Accounting Standards Board has focused on fair value accounting, rather than pure accrual accounting. By its very nature, fair value accounting gives management significant leeway in the numbers that it reports. Thus, what is reported may not be a company’s actual financial position on the balance sheet date or its results of operations for the period covered by the profit and loss statement.

    For small businesses not required to produce GAAP financial statements, the AICPA has developed the Financial Reporting Framework for Small and Medium-sized Entities, which follows accrual principles much more closely than current GAAP.

    1. Hello Michael,

      Thank you for taking the time to comment. I consider the information you provided to be invaluable; thank you.

      Yours, in service,

      Jason

  2. Ahmed says:

    Hello Jason ,
    How about using accrual accounting in business valuations and preparing business plans ?

    I am Ahmed From Egypt and preparing for CFA level 2 and Appreciate if you give me your opinion in this regard.

    Thanks ,
    Ahmed

    1. Hello Ahmed in Misr,

      An excellent question! Thanks for taking the time to ask it of me. Here I am going to share my opinion – recognize it is my opinion and not necessarily the opinion of CFA Institute. Me personally? I think accrual accounting is at least 75% reflective of reality. I also think that in order to really make use of it, that you need to study accounting so that you can learn the tricks that executives might use in order to skew reality in their favor. I had a professor in graduate school that would begin a class like this:

      * It is 15 November, you are the controller at a publicly traded firm, your annual bonus is based on net income growing by 7% this year, currently it has only grown 6%, and your wife wants to go on an expensive vacation to Dubai. What do you do in order to make sure that you help your wife be happy?

      To me this is the correct approach for analysts to learning accounting. Debits and credits are interesting, but when you combine accounting with contexts, motivations, and frailties then you get true insight. If you know how to get information out of financial statements then they are extremely helpful raw material in accurate valuations of businesses, in my opinion.

      Yours, in service,

      Jason

      PS – My wife and I honeymooned in Misr, and it is our favorite country!

      1. Nathaniel says:

        I hope the holiday wasn’t around the 15th of December, around when target-affecting decisions had to be made :p.

  3. Chris says:

    IMO the population polled skews the results. The analyst community is only of value if their personal models of reality are different from accrual accounting. When you are trained to model cash flows, when you are paid to produce cash flows, you will believe that cash flows measure reality.

    But I have never heard a rational argument why some analyst’s (or mgmt) $$ for maintenance capX is a better measure of long-run requirements than the accountant’s depreciation. Certainly lumpy capX from one particular year is not valid for any valuation that is supposed to see into the future.

    I disagree completely with the author’s claim that it is accrual accounting that “relies on abstraction and human judgment”. Accrual accounting uses actual transaction prices and uses judgement only to allocate the transactions over time. But over the long run those reported rev/exp will always add up exactly to the sum of the actual transactions.

    Contrast that with cash models used by analysts where the $$ input are invented with no necessity that they get validated/corrected by actual transactions – ever. If the analysts’ estimates of maintenance capX were booked in the accounts instead of depreciation, the size of assets on the balance sheet would balloon into improbably high values, that would only correct when the asset was sold/chucked out.

    I agree with the first comment above about today’s prevalence of mark-to-market accounting (which I hate). It has been my impression that the movement toward this non-transaction accounting has been BECAUSE of lobbying by the financial analysts community. I believe they have done us a great dis-service.

    1. Hello Chris,

      Thanks for taking the time to share your thoughts with folks reading my post. Clearly you are a passionate advocate of your opinions of accrual accounting and other forms of accounting. Nice of you to share that with each of us. Also, in my 20+ years as an analyst I have never met anyone who is looking for her or his model to be different from reality. The pursuit of accountants and analysts is the same: bringing our minds, and the models created by them, into accord with reality. The respondents to this poll believed that accrual accounting was better than half a representation of reality. In most models of reality that would be considered high praise, especially ones where human judgment/free-will is involved.

      Yours, in service,

      Jason

    2. Rich Jones says:

      This is the “chicken-or-egg” problem. As I understand it, analysts rely on financial reporting information to develop their valuation models. But, financial accounting includes many very soft accruals, among those are: (1) estimates on revenue from long-term contracts and estimates of the related costs assocated with those revenues, (2) the allowance for losses on receivables and loans, (3) reserves for contingencies, (4) recorded amonunts for intangibles and goodwill acquired in a business combination and the related subsequent impairment losses, (5) valuations associated with financial hedges and hedged instruments, etc. etc. etc.

      As I say to my students, we don’t know the company’s actual “numbers”, we just know what they report. We’ll know the actual numbers when they are liquidated. That’s when cash accounting “catches-up” with accrual accounting.

      1. Hello Rich,

        Thank you for taking the time to weigh-in on the article : ) Regarding how the information provided in financial reporting is used…usually well before a valuation model is created comes financial statement analysis with its common-size work, ratio analysis, adjustments, and so forth. This is GAAP accounting, more than just pure accrual accounting. But as analysts we are certainly aware of the parts of accrual accoutning that are soft.

        Thank you for including your list of some of the soft assumptions. May I add one of those soft bits that is certainly open to squishy judgments is depreciation and its partner, useful lives? There are many such judgments undertaken by business people, their accountants, and auditors to try and best reflect the tenor and direction of the company.

        Last, thanks for tuning into The Enterprising Investor!

        Yours, in service,

        Jason

    3. Chris, I respectfully disagree with your assertion that ‘the movement toward this non-transaction accounting has been BECAUSE of lobbying by the financial analysts community.’ I have been involved on the ‘anti’ side of this movement since its inception. In 2008, ‘CFA Magazine’ published one of my broadsides against fair-value accounting [FVA]; the same year, ‘Strategic Finance’ (the flagship publication of the Institute of Management Accountants’ published a much longer, detailed piece that I wrote in strong opposition to FVA. I am happy to send PDFs of either or both of these to anyone who sends a note to me via wmiller@beckmill.com.

      In point of fact, we got FVA because the SEC said to FASB, in effect, ‘No more Enrons.’ Enron, you may recall, got into trouble for a number of reasons, not the least of which was that it valued the derivatives that Enron itself created. It inflated those values, which led to a dreadfully over-priced stock, when finally collapsed in 2002. Two of Enron’s senior executives–CEO Jeff Skilling and CFO Andy Fastow–went to prison as a direct result. A third, chairman Ken Lay, died before he could be tried; had he lived, doubtless he would have joined Skilling and Fastow in a much-deserved trip to the slammer.

      ‘No More Enrons’ gave us SFAS 157 (“Fair Value Measurements”), which later morphed into ASC 820. The implementation side of FVA for M&A plays out in ASC 805 (“Business Combinations”). In my view, ASC 820 and ASC 805 constitute prime examples of the bad that can happen when 65 really smart people–the headcount @ FASB–have far too much time on their hands.

      For those who might not aware, the definition of ‘Fair Value’ is not–repeat, NOT–the price that actually occurred in a transaction. It is defined thusly: “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” In other words, the price is not what was actually paid, but the price that could be obtained in some future–and almost always hypothetical–transaction. It’s an ‘exit price’.

      In typical bean-counter fashion–and I am a CPA so I take license to use that characterization–the FASB folks failed to consider the incentives that such a definition would create: a bazaar (bizarre?) where assets and liabilities are traded in a frenzy, but creating annuity streams of revenue from high-value products and services is a secondary consideration. In my view, it’s the greatest hoax since ‘One size fits all.’ I’ve done a slug of work under ASC 805 for clients and I can attest that if there’s a difference between FVA and astrology, I’ve never detected it.

      As to your reference to the analyst community, everything I’ve seen, and everything I’ve heard from others who are closer to the buy-side of that community, tells me that they ignore the ‘impairments’ in asset values, especially intangibles (usually Goodwill), as a result of annual impairment-testing. They just plain ignore it. That’s why this bad idea of FVA didn’t originate with them. It started @ the SEC.

      1. Hello Warren,

        Thank you for your extended and continued contributions to this post!

        Yours, in service,

        Jason

  4. Jake Chazan says:

    “The boards propose that the objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers.

    The objective of financial reporting is the foundation of the conceptual framework. Other aspects of the framework – qualitative characteristics, elements of financial statements, recognition and measurement – will build on that foundation with the aim of ensuring that financial reporting achieves its objective.”

    This is the stated purpose of financial reporting under IFRS. Presumably there is a similar statement of purpose under US GAAP. So in the absence of framing your comments against the purpose of financial reporting, might it be fair to say that more work needs to be done here? There is no stated purpose of accuracy. Accuracy is tempered by materiality. Those who expect accuracy do not have a clear understanding of the stated purpose of financial reporting under GAAP (US or IFRS).

    1. Hi Jake,

      Thank you for your comment. I think that you may have backed yourself into a corner here. If we take your premise as true, then those that make use of financial statements can only do so if their use is in accord with the intentions of those creating them. I gotta reject that notion. Just as it is legitimate for a lover of opera to reject Rihanna as being of a different substance than Maria Callas, it is also okay for research analysts (i.e. “Rihanna fans, in keeping with the analogy) to still use (listen to) financial statements (opera), even if the audience of the creators (i.e. “opera fans”) ends up being different, and having a different opinion. In other words, it is okay for research analysts to complain about accrual accounting as being slightly less than what they would want it to be. Just as it is fine for a CPA true believer to argue that accrual accounting is the only substantive form of financial reporting. Same material, different goals and contexts = now we know why setting accounting standards is difficult.

      I wonder if the CPAs commenting on this post have an explanation for the poll results, other than that investment professionals “just don’t understand?”

      Yours, in service,

      Jason

      1. Jake Chazan says:

        Investment professionals just don’t understand. I don’t believe that the debate should be about whether or not they are “accurate”. They were never intended to be accurate. So you have the wrong end of the hockey stick.

        The question in my opinion properly phrased is do we have the right objective/purpose for financial reporting? Once you decide what the purpose is then you can discuss whether or not they were accurate. Otherwise I think that you are just being critical without offering a solution.

        1. Hi Jake,

          This was exactly why the end of this poll’s write up asks and then states: “These results raise a natural question: What would help make accrual accounting more accurate? More thorough audits? Better internal accounting software and controls? Inclusion of economic, social, and governance (ESG) factors so the actual footprint of the business was better represented? Unified global accounting standards? Less complex businesses? And so on. We promise to revisit this question in a future poll.”

          Look for the follow up poll around the beginning of March, if memory serves.

          Also, regarding models that CFAs use…no doubt, was anyone offering up the models of a Chartered Financial Analyst as a scion of accuracy? If anything, the famous concept of a ‘Margin of Safety’ is explicit acknowledgment that the models are inherently imprecise. One growth manager’s DCF is a ‘sell’, while a value manager looking at the same numbers says it is a ‘buy.’ In fact, I think almost every research analyst and portfolio manager would tell you that they get paid for their opinions, fully recognizing the variability in their opinions relative to the competition. But they would also say, given all of that variability, that their accuracy in assessing the reality of a business, the economy, and of financial markets is what they hope will keep them employed.

          Yours, in service,

          Jason

        2. Hi Jake,

          I am not sure if you are an accountant, or not, but did you just state that accounting was never intended to be accurate? I think that is true in the modern era with the Corporationus Giganticus, but I certainly hope that my small business software can handle my eBay business with some accuracy. I think the creators of accounting absolutely wanted accurate insight into the activities of a business. I think that is probably what business people themselves want, too.

          Regarding your proposed question…different audiences are still going to want different things from them. That could be a bank considering lending to the firm to shore up the pension plan, or the regulator wanting to build a case that management has misrepresented certain aspects of the business, to the college professor wanting to compare and contrast Coke with Pepsi. I think it is a legitimate question to ask how accurate accrual accounting is in capturing business activity.

          Yours, in service,

          Jason

          1. Jake Chazan says:

            You continue to look at things from a non-accounting perspective. Let’s just agree to disagree. Accuracy is a subjective term not an objective term. You as a CFA should know that.

            Are your valuation models accurate? Perhaps you should have a poll on that. DCF and NPV and the like are mathematically accurate but in application not accurate at all.

            Your perception of accounting is bookkeeping, and not accounting. As long as you continue to take that view, I’m afraid that the discussion will go in circles.

            If you ask over simplistic questions you should not be surprised if you get overly simplistic answers.

          2. Hello Jake,

            Actually I was on record earlier in this thread as saying I was a believer in accrual accounting and that I thought it was about 75% accurate. I also said that was good enough for me. I think it is always appropriate to ask if our models are reflective of reality, don’t you?

            Regarding DCF and NPV, you asked me to take a position on an issue that you raised. I know that these things are inaccurate, and I do not hold them, or accrual accounting up to a standard of perfection. Show me where in this thread, or in anything that I have written where I held that accrual accounting would be 100% accurate, or even 90% accurate. At no point have I said that was the standard. However, when a group of people that subscribe to our Newsbrief poll find that the range is 50% to 75%, I think that means that there is room for improvement. Or do you find accrual accounting good enough, as is?

            It seems to me as if you are staking this out as a research analyst vs. accountant debate, and am not sure what set you off in this polarized position. Also, I don’t recall having agreed that this discussion was about DCF/NPV as perfect vs. accrual accounting. Those were the arms you took up. I am guessing that you expected that to be a valid point, but I don’t defend those models as perfectly accurate either. Where did I indicate that?

            The spirit of the question about accrual accounting is a valid one. And the results are what they are. There is no need to agree to disagree. What I agree with is that it is okay to ask about the accuracy of a model, any model, a DCF/NPV, a quant’s algorithm, and certainly an accountant’s accrual accounting, and any model. Are you saying that accounting is not big enough and safe enough in its quality to stand a little scrutiny? I am guessing that you feel that some scrutiny is warranted, as well as improvements along the way to reflect the ever-changing nature of business and business activity. It was in that spirit that the question was asked.

            Yours, in service,

            Jason

          3. Jake Chazan says:

            By the way, here is a definition of accurate. Do you honestly believe that accounting under any circumstances can meet every part of this definition?

            free from error or defect; consistent with a standard, rule, or model; precise; exact.

            Now Jason, we really do need to be more careful in defining the terms we use when we ask a question, don’t we? By definition accrual accounting is consistent with a standard, rule or model. You seem to be using the term as free from error or defect. Precise, exact. Because of the way the question was asked, the answer became a self-fulfilling prophecy.

            I modify my comments and argue then that accrual accounting is accurate as it meet the standard, rule or model as in GAAP.

      2. Jason, I’m both a CFA charterholder and a CPA. But I’m an extreme outlier in the distribution of the latter.

  5. Jerry McGuire says:

    Hum? A theoretical discussion? Perhaps that is all that it should be here, and an uneducated reader could walk away learning something valuable depending on what form of accounting is necessary for them and depending on their needs. But accrual accounting rocks! And it must be understood completely, to see if it’s the right art to practice and if there’s a worthwhile benefit. It’s been a while since I considered this question thoroughly, but it’s always out there in the subconscious, and a great question, and I wanna stir the pot of thought a little. Why not just accecpt the fact that there are various points of view with regard to “accounting” and the information collected and presented by many different professionals for many different purposes. Follow the money. Accounting is an art, not a science, although it could be an exact science, and may be in several yeas as Artificial Intelligence progresses. Be careful, the robots are coming. So why is the so much confusion? I’m not confused. Different people hope to use the numbers for different purposes, so imagine an eloquent system where one could flick a switch and have the acutal correct numbers change for different purposes. I remember the concept of objectivity (and other accounting principles/concepts), and believe in it theoretically, but it’s proven to only be a theoritical concept. In actual prictice, hum? People are motivated by different things and needs, as one previous writer here wrote – he’s got it right!!, and because they have to be. Materiality is also very important, in the right time and place. So you can see, there are conflicts built into the system. But GAAP must be followed in the right environment! No if’s and’s or butts.

    I leave with this. Don’t trust the analysts on Wall Street. I listen to what they say and do the opposite. Very profitable. Don’t get me started. And don’t solicit me, thats illegal as far as I’m concerned.

    🙂
    La Place got it write, but its impossible.
    “If you know the velocity and the position of every particle in the universe, you can predict every future event”. With that, think about the possible honesty of financial statements.

    1. For Jerry, above. Wow! In all the years that I have had my opinion in the public domain, that is the single greatest response to anything I have written. Well done! Drop the mic, Jerry!

    2. Jake Chazan says:

      Well put. There are conflicts built into every system. Those criticizing should in my opinion offer a solution. In the absence of that, well it’s just being critical. Many of the models that CFA’s use have embedded conflicts, limitations and bias (DCF, NPV, Payback). We need to educate ourselves as to what those are and then come to our own educated conclusions.

    3. As a CPA myself, I respectfully disagree with your assertion that “Accounting is an art, not a science.” In my view, accounting is neither.

      Accounting is a ‘craft’. The best accountants are neither artists, whose output is highly personal and generally unpredictable. Nor are they scientists, whose output follows known factual principles and is both rigorous and logical.

      The only way to get good at a craft is do it. Assuming that one is not just going through unthinking and automatic-pilot-type motions, the more one does a craft, the better one gets.

  6. Rusty Abernathy, CPA says:

    Jake you are so far off the mark as to be almost absurd. The ultimate goal of financial reporting is to “fairly” (read accurately) represent the results of the operations of a business, etc. I agree with some of the comments about the complexity of GAAP etc. which I too agree is the result of the influence (lobbying) of Wall Street and the largest accounting firms who are totally lacking independence.

    I do not understand the comment about materiality. Materiality and accuracy are related and the relationship is an important aspect of financial reporting today where we deal with such large numbers.

    I also disagree with Michael about the new AICPA framework more accurately reflecting accrual accounting. The new framework is a weak approach to the basic complexity of standards and the differences in financial reporting for large and small businesses today. I do want to say that at least the AICPA has tried to address the problem with large and small GAAP which the FASB has failed so miserably at.

    I believe that the poll is skewed due to confusion of accrual accounting and GAAP. GAAP, in my opinion, is too complex for most businesses today and there is such a large area now in GAAP where “judgements” about transactions and events are not consistent and are used to distort results for purposes seen or unforeseen as Jason so accurately related in his example.

    Everyday you read about the big accounting firms being fined and penalized due to accounting irregularities in financial reporting. We have made financial reporting inordinately complex under GAAP and provided opportunities for those who are lacking ethical and moral standards to take advantage of. …..but we all have to live with what we have until we have better solutions to this hubris of those at FASB and others in our profession.

    1. Hello Rusty,

      Your answer is thoughtful and well-considered, in my opinion. Thank you for sharing it with folks.

      Undoubtedly the financial profession has lobbied/does lobby for changes to accounting standards. I am a fan of mark-to-market, but only as a complement to earlier standards. Due to mark-to-market accounting there are anecdotal reports of financial institutions managing the end of the quarter balance sheet in conjunction with shadow banks and hedge funds inr oder to present the prettiest of pictures. Clearly, this has brought a level of absurdity to financial statements. However, I also know that the firm for whom I dedicated my portfolio management years, along with many others, felt that stock options were an expense and so should appear in the income statement. So the lobbying hasn’t entirely been misguided, in my opinion.

      Again, thank you for sharing your point of view,

      Jason

      1. Once one gets below current assets and current liabilities on the balance sheet, fair-value accounting (FVA) is the greatest hoax since one-size-fits-all. Start with the fact that FVA is highly judgmental because there are seldom active markets for long-lived assets. (Seldom, but not never.) So, invariably it’s a Level 3 measurement (something just this side of pure fiction, no matter how ‘precise’ it may appear). That goes in spades for intangible assets.

        Besides that, two other aspects of fair-value accounting trouble me. The first is that the people being asked to compute fair values on long-lived assets tend to be accountants. Value is prospective. Accounting looks backwards. And, frankly, other than an annual budget, ne’er the twain shall meet for accountants. If my CPA and non-CPA colleagues wanted to deal with the kind of ambiguity that we who do work under ASC 805 routinely embrace, they would have never become accountants. And, unfortunately, based on my anecdotal inquiries of professors around the country, accounting education on the college campus seriously lags what those of us reading this blog often have to confront.

        Exercising the kind of judgment that is required to make Level 3 calls in the fair-value hierarchy will give most accountants migraines. Embracing the lack of precision and the softness of ‘fair-value rules’ is not why most of my colleagues became bean-counters. (I’m an extreme outlier in the distribution, which, I trust, is obvious.)

        The second and arguably more troubling aspect of fair value is the incentives it creates: because fair value is an “exit price”–what it might be worth, rather than what was paid for a long-lived asset–the incentive is to trade assets (“The bazaar [bizarre?] is open!”), NOT to create unique capabilities that generate annuity streams of free cash flows that create real value for companies through returns that far exceed a company’s cost of equity capital. Except in an article I wrote for the August 2008 edition of the IMA’s “Strategic Finance” magazine (“The Fatal Flaw in SFAS 157”), I’ve not seen any substantive discussion of incentives in the context of FVA. I also argued strongly against FVA’s assumption of homogeneity among both long-lived assets and the values thereof.

        Along with that is the truly bizarre implementation of FVA: If a company gets a downgrade in the creditworthiness of long-term debt, well, that debit to funded debt has to have an offsetting credit somewhere–it really is helpful to understand the debits-and-credits side of accounting, folks. Under fair-value, that offsetting credit juices up the bottom line of the P&L. So, get a credit downgrade, and boost the bottom line. Terrific.

        Bear Stearns did that in Q2 of 2007. They even managed to keep from laughing hysterically about it when they discussed it during the earnings call. Of course, less than year later, they were out of business. But writing down debt and pumping up the P&L is stark-raving nuts.

        But then, so is fair-value, IMHO. Accrual accounting based on historical costs is far from perfect, but it has the rigor of real transactions, as one of our colleagues already observed, standing behind it. That alone makes it a helluva lot better than anything related to FVA applied to long-lived assets and liablities. As a former CFO, too, I cannot imagine having to sign off personally on Qs every quarter. I’d sooner take up cordless bungee-jumping.

        FWIW, I believe that, with ‘big GAAP’, the FASB is trying to move towards balance sheets that reflect the market value of invested capital. It’s not just a futile idea. It’s a horrific idea because value is subjective. It always has been, and it always will be.

        Fair-value accounting is a textbook case of the dreadful things that can happen when 65 really, really smart people–this particular group is in Norwalk, Conn., but they could be anywhere–have far too much time on their hands. They don’t understand the wisdom of the old adage, “Don’t just do something. STAND THERE!”

        Thanks, Jason.

        1. Hello Warren,

          What an extended and thoughtful reply, thank you. I learned something, too, about accounting for the first time in years and years. Namely, the bit about Bear Stearns. Thank you. I have a Masters in Accounting, though am not a CPA. So, the incremental knowledge bits are rare. Woohoo! You have made my night!

          Regarding “fair value” – I think the original intention was probably correct – to better reflect the actual value of the assets. In retrospect what is likely better is to simply provide transparency as to the nature of the assets (many of the assets are contractual in nature) so that the diligent and interested analyst can agree or disagree with the assumptions to calculate her own estimate of the fair value of the assets.

          Again, thank you!

          Jason

  7. Thank you for your kind words, Jason. Since obtaining my charter at the ripe old age of 62–I did it to escape the embarrassment of having to pay dues to the AICPA–I have strongly believed that Level I of the CFA regimen doesn’t put nearly enough emphasis on the nuts-and-bolts of accounting. I know that the mechanics of debits and credits don’t do much for one’s intellect, but they are a real godsend when it comes to understanding bad ideas such as FVA.

    In addition, accounting professors have done neither their students nor the potential employers of those young people any favors with how they now teach the basic “Accounting Principles” course. That is “course,” not “courseS,” the way it was decades ago when I was an undergraduate. That’s right, they devour a 1,200-page book in a single semester. Why? Well, as a recovering academic, I’d bet a bunch of money that it was because accounting professors hated teaching a “boring” subject such as the principles courses, so they compressed it into a single semester. That is why I advise some of the young people that I mentor to take that course at a community college, not at a four-year institution. At the junior college, it is still a two-semester course. The pace of doing it that way ensures that they will actually learn a lot, not to have to memorize-and-regurgitate on tests a mountain of information that they probably don’t understand.

    In addition, when the professors jammed the two-course regimen into one, they also–conveniently, I would argue–ditched the ‘Practice Set’ project that capped off the two-semester principles courses. This was a soup-to-nuts exercise near the end of the second semester that required students to create a chart of accounts, make the opening entries for a new company, and then record transactions for several months with a month-end “closings,” including accruals and reversing entries. Students also had to present a balance sheet and a P&L; back in those days, there was no Statement of Cash Flows, unfortunately. (If one holds a gun to my head and tells me I can have only one of the components in the financial-statement package, I’ll take the SoCF every time because that’s where the chickens from the accounting games played on the balance sheet and the P&L come home to roost.)

    Just 2-1/2 years out of my undergraduate degree, I landed a job as the first Controller in the then-59-year history of a retailer and wholesaler of engineering supplies and art supplies; it employed 93 full-timers. And it had, for all practical purposes, no accounting system. (It did have an outside CPA who did the tax returns and who had been slumbering for many years.) I saw before the end of my first day on the payroll that it had no system, so, on my second day, I brought my accounting textbooks and my old ‘Practice Set’ to the office and set out to design a soup-to-nuts accounting system.

    Wonder of wonders, the damned thing worked. . .on the first try. That was in 1978, a year of high inflation. I also published monthly “Expense Summaries” by department. The department managers screamed bloody murder. But a funny thing happened: SG&A went down that year. The cash-register system at the flagship retail store, which had been more than $5,000 “short” in 1977, was $7.18 long in 1978. . .on $1.5 million in sales. Of course, the guy that ran that store was also making cash advances to sales people. . .out of the cash drawer. I stopped that practice the second day I was on the payroll. But I couldn’t have changed a thing–because I wouldn’t have known how to change it–had I been forced to injest that gargantuan accounting principles textbook in a single semester–without the ‘Practice Set’.

    Luckily, various iterations of Practice Sets are available for purchase now on Amazon. I have recommended to several of my proteges that they buy one of those and work through it because it will be a learning experience that does more to prepare them for their later professional lives than any other. Several have let me know early in their careers that the Practice Set knowledge stayed with them in numerous fortunate ways.

    One last comment in this vein: I think it is borderline criminal for universities to allow young people majoring in finance to graduate with only two or three semesters of accounting courses. I think they need at least five (5), including the two intermediate courses. Substantive–serious–accounting knowledge is a key requirement of careers in corporate finance or securities analysis. It is also essential, I believe, to have a gut-level appreciation of what attracts certain people to accounting as a career. IMHO, the best way to do that is to require five or six accounting courses for finance majors. I took seven of them, including four (4) (Intermediate II, Corporate Income Tax, Advanced, and Auditing) in my last semester of undergraduate school. Looking back, I don’t know how I did it, but I also know that I didn’t give myself a choice.

    Segue: I agree with your idea about disclosure and descriptions, Jason. However, unless I am mistaken, that can be done only with intangible assets that are not already on the balance sheet. I infer that is what you meant by your reference to “contractual in nature,” but I thought I’d seek clarification just in case. I should also mention that “contract-based” is one of five broad classifications of intangible assets cited in ASC 805. The other four are marketing-related, customer-related, artistic-related, and technology-based.

    Hope these comments are helpful.

    1. Holy moley, Warren!

      Thank you for the extended discussion. Yes, nothing helps more than learning that approximates reality.

      In answer, to your questions, yes, you understood what I meant by ‘contractual’ in nature. An example is bond covenants lay out exactly what is exchanged for capital by a company. With the covenant in hand a smart investor can do prospective analyses given her assumptions about future economic states, business conditions, the shape of the yield curve, and so on. If there is something contracted, then let’s have some detail, and then let’s let the research analysts contribute their value add to the understanding of the company’s prospects.

      Yours, in service,

      Jason

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