Monday, March 16, 2009

Why Financial Accounting is Neither Simple Nor Precise

Financial accounting strives to answer two basic questions: how did the business do last year, and what did the business own and owe at the end of the year? The answers to these questions are summarized in two basic statements, the income statement and the balance sheet. Unfortunately, financial statements rarely are able to give completely definitive and precise answers to what seem to be simple economic questions.

Accounting's measurement problems derive primarily from three factors. First, it is difficult to pin down exact criteria for measuring economic performance and economic condition. Second, accounting uses money as its fundamental measurement unit, and money's unit value is not stable over time. Third, accounting rule makers have to allow for the fact that business managers often are motivated to distort economic reality rather than reflect it accurately.

What is Economic Performance and Economic Condition?

A business does well if it brings in more cash than it spends and vice versa. Negative cash flow is not necessarily equivalent to poor economic performance and vice versa.

Accounting encounters even more difficulty in trying to pin down a firm's economic condition. To determine economic condition we want to find out about a firm's assets and their values. But there is more than one standard of value. Should accountants use current market values for assets owned or the original cost incurred to acquire them? For example, should the value of personnel or intangible assets, such as patents, trademarks and goodwill, be measured and included? Money: Accounting's Unstable Measurement Unit

In accounting the unit of measurement is money. Money is a medium of exchange that has value only to the extent that it can be traded for goods and services.

The practical ramifications of this instability of money as a measuring unit are pervasive. If a company had net income last year of $100,000, was its economic performance the same as it was five years ago when its income statement also showed a $100,000 net income? Decidedly not, if the purchasing power of the dollar changed significantly in the intervening five years.

Questions about economic condition are also affected by the instability of money as a measurement unit. Are the economic conditions of the companies the same?

Accounting rule makers have struggled greatly with the questions of how and when these changes in the value of money should be reflected.

Measurement Error: Management's Motivation for Mendacity

Measurement error is unavoidable. Sadly, this is not the case, because business managers often wish to avoid accurate measurements if such accuracy would lead to significant damage to their career and finances. Facing such ruin, managers will be strongly tempted to avoid fair and accurate measurements. Managers will seek to "cook the books". Second, in formulating accounting rules, the rule makers have to carefully consider how any proposed measurement procedures might be subverted by managers intent on providing a skewed view of economic performance or condition.

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