Realization Principle p' 31

1
Realization Principle (p. 3-1)

• Revenue is recognized when
• 1. The firm has provided all, or substantially
  all, the goods or services to be delivered
• AND
• 2. The customer has paid cash or is expected to
  pay cash with a reasonable degree of certainty.

2
Matching and Conservatism

• Expenses are
• 1. Costs directly associated with revenues
  recognized in the same period, or
• 2. Costs associated with benefits consumed in
  this time period, or
• 3. Resources whose future benefits are not
  reasonably certain (i.e. expense rather than
  depreciate).

3
Assets

• Def Resources that a firm owns or controls which
  are expected to produce future economic benefits
  that can be measured with a reasonable degree of
  certainty.

4
Liabilities

• Def Economic obligations of a firm arising from
  benefits received in the past that
• 1. Are required to be met with a reasonable
  degree of certainty and
• 2. Whose timing is reasonably well-defined.

5
Purpose of GAAP

• Attempt to reduce managers ability to record
  similar economic transactions in dissimilar ways
  either over time or across firms.
• Advantage Increased credibility of F/S
• Disadvantage Reduced flexibility for managers to
  reflect legitimate business differences.

6
Threat of Legal Action

• Advantage provides incentive for accurate
  accounting disclosures.
• Disadvantage may result in overly conservative
  or overly qualified financial statements.

7
Steps in Accounting Analysis

• Step 1 ID Key Accounting Policies (consistent
  with results of business strategy analysis)
• Examples
• Manufacturing firms Inventory method and
  management of receivables
• Mutual funds Investment risk management.
• Restaurants Inventory control and internal
  controls (cash).

8
Steps in Accounting Analysis

• Step 2 Assess Accounting Flexibility
• Rigid accounting rules vs. manager discretion in
  reporting.

9
Steps in Accounting Analysis

• Step 3 Evaluate Accounting Strategy
• If managers have flexibility, they can either
  communicate or hide true economic condition.
• Assessment
• How do their strategies compare to the industry
  (cross-sectional analysis)?
• Have their strategies changed from the past (time
  series analysis)?
• Where does managements incentive lie?

10
Steps in Accounting Analysis

• Step 4 Evaluate the Quality of Disclosures.
• Examples from book
• Do the footnotes adequately explain the
  accounting policies and underlying logic?
• Does the firm adequately explain its current
  performance in the Management Discussion and
  Analysis section of the annual report?
• How forthcoming is management with respect to bad
  news?

11
Steps in Accounting Analysis

• Step 5 Identify Potential Red Flags
• Unexplained changes in accounting.
• Unusual increases in A/R w/ respect to sales.
• Unusual increases in inventories with respect to
  sales.
• Large fourth-quarter adjustments.

12
Steps in Accounting Analysis

• Step 6 Undo Accounting Distortions
• Recasting the financial statements.

13
Value of Accounting Data

• During the period 1954 1996
• Cash flow appears to be considerably less
  valuable than earnings or ROE information.
• Overall, research suggests that the rules
  designed to mitigate accounting misuse is
  effective.