Basic Accounting Concepts for Corporate Valuation

Transcription

1 APPENDIX B Corporate Valuation for Portfolio Investment: Analyzing Assets, Earnings, Cash Flow, Stock Price, Governance, and Special Situations by Robert A. G. Monks, Alexandra Reed Lajoux Copyright 2011 by Robert A. G. Monks and Alexandra Reed Lajoux. Basic Accounting Concepts for Corporate Valuation Valuation-minded investors can benefit from knowing current accounting principles and standards. These two terms are used interchangeably, but they are different. A principle is a general concept that can be applied in all situations. A standard is a rule that fits a particular situation. One of the hottest topics in accounting today is principles versus rules. Non - U.S. accounting tends to emphasize principles, whereas U.S. accounting tends to emphasize rules. Although the effort to develop a global standard seems to be headed toward principles, U.S. accounting is still focused on rules. The following materials should make this clear. Summary of Tentative Global Accounting Decisions on Objectives and Qualitative Characteristics of Accounting As of mid , the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) were well underway in their plans, launched October 2004, to develop a common conceptual framework, based on and built on both the existing IASB framework ( ) and the FASB Conceptual Framework ( -a.shtml ). Here is the report they issued at their foundational meeting, followed by a current epilogue: 1 411

2 412 appendix b Summary of Tentative Decisions on Objectives Financial reports should be prepared from the entity s perspective and should aim to provide information to a wide range of users, rather than focus on the information needs of existing common shareholders only. The framework should identify the primary users as present and potential investors and creditors (and their advisors). Later in the project, the boards will consider whether financial reporting also should provide information to meet the information needs of particular types of users, such as different kinds of equity participants. The objective is to provide information about the entity to the external users who lack the power to prescribe the information they require and therefore must rely on the information provided by an entity s management. The entity s management also will be interested in that information. However, because management has the power to obtain the information it requires, any additional information needs of management are beyond the scope of the framework. Similarly, certain external users (for example, a credit rating agency or a bank lender) generally have the power to prescribe the information they require. Additional information needs, therefore, may be beyond the scope of the framework. As discussed in the two boards existing frameworks, the financial statements should provide information to help users assess an entity s liquidity and solvency. However, that objective should be consistent with the overall objective of providing information to a wide range of users. Therefore, the information provided in the financial statements should not be focused on meeting the information needs of particular types of users that primarily use the financial statements to help them assess an entity s liquidity and solvency. As with the existing frameworks, the boards converged framework should be concerned with general -purpose financial reports that focus on the common information needs of users. That does not preclude the Boards from concluding, in a standards -level project, that additional information should be provided to meet the information needs of particular types of users.

3 BASIC ACCOUNTING CONCEPTS FOR CORPORATE VALUATION 413 Summary of Tentative Decisions on Qualitative Characteristics Relevance is an essential qualitative characteristic. To be relevant, information must be capable of making a difference in the economic decisions of users by helping them evaluate the effect of past and present events on future net cash inflows (predictive value) or confirm or correct previous evaluations (confirmatory value), even if it is not now being used. Being capable of making a difference, rather than now being used, is a change from the present IASB framework; confirmatory rather than feedback value is a change from the present FASB framework. Also, the information must be available when the users need it (timeliness). Accounting information has predictive value if users use it, or could use it, to make predictions. Accounting information is not intended, in itself, as a prediction or as synonymous with statistical predictability or persistence. Faithful representation of real -world economic phenomena is an essential qualitative characteristic, which includes capturing the substance of those economic phenomena. Faithful representation also includes the quality of completeness. The common conceptual framework will need to discuss thoroughly what faithful representation means and what it does not mean. Financial information needs to be neutral free from bias intended to influence a decision or outcome. To that end, the common conceptual framework should not include conservatism or prudence among the desirable qualitative characteristics of accounting information. However, the framework should note the continuing need to be careful in the face of uncertainty. Financial information needs to be verifiable to provide assurance to users that the information faithfully represents what it purports to represent and that the information is free from material error, complete, and neutral. Descriptions and measures that can be directly verified through consensus among observers are preferable to descriptions or measures that can only be indirectly verified. Representations are faithful there is correspondence or agreement between the accounting measures or descriptions in financial reports and the economic phenomena they purport to

4 414 appendix b represent when the measures and descriptions are verifiable, and the measuring or describing is done in a neutral manner. Therefore, faithful representation requires completeness, not subordinating substance to form, verifiability, and neutrality. Consequently, the common framework should drop the widely misinterpreted term reliability from the qualitative characteristics, replacing it with faithful representation. That replacement is a change from the current IASB and FASB frameworks. Although empirical research may provide evidence useful in standard - setting decisions, for example, in assessing trade - offs between desirable qualities, the conceptual framework project should not seek to develop empirical measures of faithful representation or its component qualities. Comparability is an important characteristic of decision - useful financial information and should be included in the converged conceptual framework. Comparability, which enables users to identify similarities in and differences between economic phenomena, should be distinguished from consistency (the consistent use of accounting methods). Concerns about comparability or consistency should not preclude reporting information that is of greater relevance, or that more faithfully represents the economic phenomena it purports to represent. If such concerns arise, disclosures can help to compensate for lessened comparability or consistency. Understandability also is an essential characteristic of decision - useful financial information and should be included in the converged conceptual framework. Information is made more understandable by aggregating, classifying, characterizing, and presenting it clearly and concisely. Whether reported information is sufficiently understandable depends on who is using it. The information in general -purpose external financial reports should be understandable to financial statement users who have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence. Relevant information should not be excluded because it is too complex or difficult for some users to understand. Materiality relates not only to relevance, but also to faithful representation. Materiality should be included in the converged

5 BASIC ACCOUNTING CONCEPTS FOR CORPORATE VALUATION 415 framework as a screen or filter to determine whether information is sufficiently significant to influence the decisions of users in the context of the entity, rather than as a qualitative characteristic of decision-useful financial information. Transparency, often cited recently as a desirable characteristic of financial information, seems to be difficult to define. In current usage, it appears to encompass some of the qualitative characteristics already included in the framework. Because it would be redundant, transparency should not be added to the converged framework as a separate, qualitative characteristic of decision - useful financial information. Other possible characteristics considered, including credibility, high quality and internal consistency, do not describe attributes of decision-useful financial information that are distinct from other qualitative characteristics. Thus, they should not be added as separate qualitative characteristics in the converged framework. The converged framework should include information about the types of costs that should be considered in deciding what financial information to provide, as well as criteria to help standard setters decide how to take particular types of costs into account. The converged framework should include presumptions not only about the capabilities of financial statement users but also about the capabilities of financial statement preparers and auditors. The relevant standard here is FRS It says that an entity should judge the appropriateness of accounting policies to its particular circumstances against the objectives of Relevance Reliability Comparability Understandability FRS Standard 18 also says that an entity should balance its different objectives, as well as balancing the cost of providing information with the likely benefit of such information to users of the entity s financial statements.

6 416 appendix b The standard notes that an entity s accounting policies should be reviewed regularly to ensure that they remain the most appropriate to its particular circumstances. An entity should implement a new accounting policy if it is judged more appropriate to the entity s particular circumstances than the present accounting policy. It also requires specific disclosures about the accounting policies followed and changes to those policies, including, in some circumstances, disclosures about the estimation techniques used in applying those policies. Accounting Principles: U.S. GAAP U.S. GAAP issued a similar concept a quarter century ago: FASB Statement of Financial Accounting Concept No. 5 (SFAC 5). An item and information about it must meet four fundamental recognition criteria to be recognized (and must be recognized when the criteria are met), subject to a cost -benefit constraint and a materiality threshold. Those criteria are: Definitions. The item meets the definition of an element of financial statements. Measurability. It has a relevant attribute measurable with sufficient reliability. Relevance. The information about it is capable of making a difference in user decisions. Reliability. The information is representationally faithful, verifiable, and neutral. 3 Ironically, despite all the discussion surrounding principles - based accounting rather than rules - based accounting, concept statements like this are considered to be less authoritative than narrow standards. In June 2009, the FASB issued Statement of FAS No. 168, Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, 4 effective September 15, The Codification project organized all the FASB standards into one hierarchical system, refreshed through Accounting Standards Updates (ASUs). The Codification and ASUs do not change GAAP, but they supercede everything else, unless they are grandfathered or issued by the Securities

7 BASIC ACCOUNTING CONCEPTS FOR CORPORATE VALUATION 417 and Exchange Commission. Companies accounting for a transaction must first look to authoritative (codified) standards and only secondly to nonauthoritative standards. Sources of nonauthoritative accounting guidance and literature include, for example, practices that are widely recognized and prevalent either generally or in the industry, FASB concept statements, American Institute of Certified Public Accountants (AICPA) issues papers, International Financial Reporting Standards of the IASB, pronouncements of professional associations or regulatory agencies, Technical Information Service inquiries and replies included in AICPA Technical Practice Aids, and accounting textbooks, handbooks, and articles. The appropriateness of other sources of accounting guidance depends on their relevance to particular circumstances, the specificity of the guidance, the general recognition of the issuer or author as an authority, and the extent of their use in practice, says Statement 168. Despite this development, companies and their investors can still rely generally on the fundamental concepts of accounting, even if they are not explicitly spelled out in any FASB - codified standard. Such concepts, which underlie the Uniform CPA Examination, 5 are as follows: Accounting period. The income statement should be prepared at periodic intervals for purposes such as performance evaluation and determination of taxes. Conventionally, the time span covered is one year. Accrual concept. Expenses incurred for a particular accounting period should be reckoned in the same period, regardless of whether these expenses have been paid in cash or not in that year. The same holds true for revenues; that is, revenues earned in a specific accounting period are construed as incomes of the same period, irrespective of their receipts. Conservativism concept. This concept, associated with the reliability factor, says that the accountant should adopt a worst-case scenario for reporting. The accountant should anticipate no profits unless they are realized, but at the same time, provide for all probable future losses. Inventory is generally valued at cost or market price, whichever is lower. 6 Consistency principle. This principle requires accountants to apply the same methods and procedures from period to period. When

8 418 appendix b they change a method from one period to another, they must explain the change clearly on the financial statements. Cost concept. The assets of the firm are shown at their acquisition cost, not at current market value or current worth. (The only exception is for intangibles, per the going concern concept, and for securities, per the fair market value concept. 7 ) The rationale for the cost concept is that it provides objective and verifiable basis for accounting records. Market valuation of assets in use, although it is being used increasingly, is difficult to accomplish and is prone to subjectivity and continual change. Going concern concept. This c oncept implies that the firm will continue to operate in the foreseeable future. That is the reason accountants give for recording the value of intangible assets based on the value of goods and services they are likely to produce in future years. 8 Matching principle. This principle requires matching of expenses or costs incurred to revenues realized in an accounting period. A related concept is the double entry concept. Double entry accounting, the foundation for the balance sheet, was first described in Fr. Luca Pacioli s Summa de arithmetica, geometria, proportioni et proportionalita (Venice, 1494). It says that for every change in value of one account in a balance sheet item, there must be an equivalent change in the balancing account. So, for example, if a transaction diminishes an asset, it must increase either a liability or equity (Assets Liabilities Equity). This concept is also known as the principle of balance. Money measurement concept. Financial reports prepared under GAAP must be expressed in terms of money. Any business events and facts that cannot be expressed in cash are excluded, even if they are important. This makes it clear that financial statements do not and cannot provide all the necessary information about a business.9 These principles, even if not specifically articulated in any document that has been codified as authoritative, will still hold for accounting. Corporate investors can benefit from understanding them.

9 BASIC ACCOUNTING CONCEPTS FOR CORPORATE VALUATION 419 Notes 1. Deloitte, IASB Agenda Project, IAS Plus, agenda/framework-a.htm. 2. Accounting Standards Board (ASB), Accounting Policies: FRS 18, December 2000, Pronouncement_C &pagename FASB%2FPronouncement_C%2FSummaryPage &cid Individuals must pass this exam to be licensed as certified public accountants in any of the 55 U.S. jurisdictions. 6. See FAS No. 157, Fair Value Measurements. 7. Ibid. 8. Meanwhile, physical assets are carried at their historic value, with adjustments for deterioration and depreciation. The advent of fair value accounting (see Chapter 2), has begun to erode this physical approach. 9. For an excellent discussion of these fundamental concepts from an online learning course based in India and branded by Macmillan, see ch1_accountingp.html.