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Principles of Accounting
5. Historical Cost
Rule: Transactions should be initially valued
at historical costs, rather than at market or appraised values.
Issue: Assets are usually recorded at their
purchase prices, and are subsequently written down (expensed) when utilized.
Assets are almost never written up in value. Companies, however, may have
assets that have appreciated in value over time, but are still recorded at
their lower accounting values. While land is the classic example, buildings,
brand names, trademarks, and in some cases, equipment, may also appreciate.
Accounting authorities have been gradually moving
away from historical costs and towards fair market values, where
realistically obtainable, in areas like marketable securities and derivative
instruments. Generally, however, the use of historical costs to value
transactions remains the bedrock of accounting theory and practice.
Land Example: St. Joe Company (Joe) is often
mentioned as an aberration. They own approximately 750,000 acres of land in
Northwest Florida, purchased decades ago, but valued on their balance sheets
at a fraction of fair market value. The historical cost principle distorts
their financial position.
One can see from the above example that the
historical cost concept has inherent flaws. Nonetheless, even with its
drawbacks, the historical cost concept is still, by far, the best available
method. Investors need to appreciate the conservative nature of historical
cost accounting. Fair market accounting is too risky; it is very subjective,
costly, and can lead to valuation manipulation.
6. Revenue Realization
Rule: Revenues are recorded in the period that
they are realized (earned).
The broader recognition issues center on when should
business transactions be recorded? Normally, a transaction is recorded when
the critical event has occurred and there is evidence that a transaction has
taken place. Capital invested, inventory purchased, products sold and
shipped, invoices paid, cash collected, etc.
Issue: The big problem area, however, revolves
around revenue. The SEC’s Bulletin # 101 has specific critical events and
transaction guidelines that need to be followed, in order to accrue revenue.
Companies, therefore, to accrue revenue, must meet
all of the following conditions:
1.
Persuasive evidence of an arrangement
exists.
2.
Delivery has occurred or services
have been rendered.
3.
The seller’s price to the buyer is
fixed or determinable.
4.
Collectability is reasonably assured.
This is an excellent ruling,
but it’s rigid and sometimes not practical.
For example: Standard Automotive Corporation,
produced trailer chassis from a customer’s sales order. The customer
inspected, accepted, insured, and paid for the units; the units, however,
were stored at the company’s facilities, until the customer needed them.
The storing of the units created a “bill and hold”
inventory transaction, and was not considered a sale until the customer
moved the units from the lot. This example of a bill and hold sale
demonstrates that even the receipt of cash, after essentially all the work
was performed, does not necessarily equate to revenues being realized.
Investors should understand that revenue realization
concepts are not simple and that the cookbook approach to accounting
procedures can produce atypical results.
7. Matching
Rule: Revenues and associated costs should be
recognized in the same periods.
Issue: Accrual accounting is used to match
revenues with expenses. Revenues are recognized in the period when earned,
and expenses are recognized when incurred, rather than when paid. Evolving
from the matching principle is the differential treatment between product
and period costs. This is the overriding principle as to why inventory costs
are capitalized on the balance sheet until a sale takes place. Product
revenues should match product costs on the income statement. Some of the
high profile cases in the news, like WorldCom, centered on period costs that
were improperly capitalized on the balance sheet (like product cost), but
should have been expensed when incurred. Period costs are current operating
costs that are usually expensed when incurred.
A more poignant example of the difficulties involved
in the matching principle is how banks match loan income (interest) against
loan expenses. The capitalization and amortization of loan origination costs
is tricky. Loan interest income is collected over time; therefore loan costs
must also be expensed over time. Take a loan officer who specializes in 5
year loans: his commission would be solely based on successful deals, so
they would all be capitalized and amortized over a five-year loan period.
His expenses; salary, telephone, office rent, support services, etc. would
be allocated between his successful and unsuccessful deals. The successful
portion would be capitalized and amortized over the life of the loan, while
the unsuccessful portion would be expensed as incurred.
If that loan officer only worked on two loans, a
judgmental decision would be made on how to allocate origination expenses
between successful and unsuccessful loans. Many methods could be used, such
as the number of loans, the size of the loans, the time spent on the loans,
etc.
Additionally, a loan generates more interest income
in the early years, when the payoff amount is the highest and less income
towards the end of the loan. Loan costs, therefore, are allocated to the P&L
consistent with how income is recognized.
One can see that many matching issues are not
clear-cut; nevertheless, expenses should follow revenues.
8. Objectivity
Rule: Financial information must be relevant
(useful), reliable and measurable.
Issue: The merchant energy industry (Dynegy,
El Paso, Enron, Williams, etc.) underscores the significance of the
objectivity principle. The lack of objectivity, in financial reporting, is
one of the reasons why the merchant energy companies ran into financial
difficulties, in the late 1990’s. On average, the financial statements of
the industry overstated revenues, earnings, cash flows and equity, and
understated assets and liabilities. The specific GAAP rules may have been
met, but the objectivity principle somehow got lost, which ultimately
resulted in the downfall of some of these companies.
The generally accepted accounting principles (GAAP)
used in the industry were neither transparent nor objective, and failed to
report the true financial status of the companies, resulting in massive
losses for investors. As the restatements came in, it was disheartening to
see certified figures changing daily by tens of billions of dollars, causing
loss of life and money. The “bottom line” was that the industry produced
financial statements that were not useful to anyone.
Companies presenting information that is not useful,
or that is constantly being restated, should raise red flags for investors.
9. Consistency
Rule: Similar transactions should be reported
in a consistent manner from period to period. A company, moreover, should
use the same accounting principles from year to year.
Transactions recorded in financial statements must be
applied consistently, for the information to be useful to a company’s
stakeholders. Once a methodology is adopted and accepted, it should be
continued. Consistency, however, is not an excuse for bad or unethical
decisions.
Issue: One often sees the switching of
accounting methods when it is beneficial to the owners of a company. For
example, private aerospace and construction type companies that work on
long-term projects regularly use the easier completed contract accounting
method when privately held. However, when these companies need to raise
capital, they often switch to the more complicated percentage-of-completion
accounting. The inconsistent accounting treatment for similar transactions,
from period-to-period, makes it very challenging, if not impossible, for
investors to evaluate a company.
10. Conservatism
Rule: When choosing two acceptable accounting
methods, pick the one that has the lowest impact on owners’ equity.
Issue: Conservatism can have a negative side;
it can be used as an excuse for not reporting a transaction in the fairest
manner. Taken to an extreme, it can mislead investors and cause losses where
none should have occurred. It’s a fine line and a company should never
intentionally understate equity.
11. Materiality
Rule: Insignificant transactions and events
need not be disclosed.
Issue:
Materiality refers to the relative importance of a business transaction to
the users of the financial statement. The current view towards
materiality is that if an item is immaterial, there should be no reason not
to “book it,” because it has no effect on the financial statements. So every
adjustment should be recorded. Public companies, however, compete and
operate within the realities of the business community. Companies need a
certain amount of “wiggle room” to function under the constraints of running
a business.
Stock market
reactions have placed management in a peculiar situation. Companies have
seen substantial drops in their stock prices by being short on earnings
estimates by even a penny. Many stocks are priced-to-perfection, causing
immaterial P&L items to have serious stock market consequences.
Investors need to be responsible for their
irrational exuberance, in over paying for stocks.
12. Full Disclosure
Rule:
All substantive and relevant information required by the users of the
financial statements needs to be disclosed.
Issue:
The argument against transparency has always been that full disclosure can
put a public company and its management at a serious competitive
disadvantage. For example, Halliburton, the oil service company and KBR the
construction company, must report complete and full disclosures with the
SEC, while their major competitor, Bechtel, is a private company not subject
to the same disclosure rules. This puts Halliburton and KBR at a
significant disadvantage when negotiating contracts.
Transparency,
however, is essential. Investors and management need to accept that the
price of being a public company is full-disclosure.
13. Comparability
Rule:
Financial statements should be reported in a uniform manner and on a
comparative basis. When different accounting methods exist, companies should
disclose which method is being used.
Issue:
Investors need to compare “apples with apples” when evaluating a business;
anything less is deceiving. Information must be presented in such a fashion
that similar transactions can be compared from period to period. The one
glaring issue undermining the comparability concept is the accounting for
restructuring charges.
The auditors and the SEC have been really
scrutinizing the authorization, notification, timing and amounts of
restructuring accruals. Companies are prohibited from overestimating
restructuring charges for the benefit of future periods. In general,
restructuring charges tend to distort the comparability between accounting
periods and can mislead investors.
Unusual and
nonrecurring transactions can distort comparability analysis, and should not
be downplayed or ignored. These transactions represent past decisions on how
a company managed its money, and are good indicators of the future.
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