PHASE I -- QUESTION 1
For accounting information to be useful, it must possess certain qualitative characteristics. Read Statement of Financial Concepts Number 2 (SFAC No. 2) and The Numbers Game speech by former SEC Chairman, Arthur Levitt (1998). Discover what they are. Choose a single qualitative characteristic and tell us about it. How does it relate to the corporate scandals? How does it relate to the other qualitative characteristics? Is it more or less important than the other qualitative characteristics? How? Why? To you other bloggers, do you agree? Disagree? Is there something else to add or point out? Do not forget to refer us to your links/references.
posted by Dr. Scott @ 9/06/2005 11:00:00 AM
25 comments
25 Comments:
According to the Statement of Financial Concepts Number 2, there are two primary qualitative characteristics for accounting information to be considered useful. These two primary characteristics are relevance and reliability. In addition, information must also be consistent and comparable. Our textbook, Financial Accounting: Tools for Business Decision Making, defines reliability as the quality of accounting information that gives assurance that the insurance provided is free of error and bias. A lack of reliability is center in most corporate scandals. For example, Enron’s financial documents were unreliable because they did not properly record or disclose all of their debts. As a result, many investors felt misled by Enron’s financial documents, and Enron investors lost a good deal of money when Enron filled bankruptcy. I feel that reliability is a more important qualitative characteristic than the others because it is the one characteristic that can completely mislead a potential investor. If financial documents are not reliable a company can say it sold $20 billon when it actually only sold $10 billion, or vice versa, it can only report $5 billion of debt when it really experienced $15 billion of debt. A company’s information can be irrelevant, inconsistent, or incomparable and investors could still get a clear picture of the company. But, when a company’s accounting information is unreliable their information is not useful and there is no possible way an investor could make an informed decision.
In addition to what Andrew Harp said, "I feel that reliability is a more important qualitative characteristic than the others because it is the one characteristic that can completely mislead a potential investor." I feel that consistency is of equal importance as reliability because you need be reliable on a consistent basis. Consistency relates to corporate scandals in that, a company may not report a change in their method of accounting if it helps them in any way, they may disclose that information until another point n time when it could further them more in their business. Consistency and comparability are alike in that should consistently use the same accounting principles and, "comparability results when different companies use the same accounting principles." (Kimmel, Weygandt, Kieso. 57).
In addition to the opinion of Andrew Harp and Ashley Smith, I also agree that reliability is a very important qualitative characteristic, as a company must be reliable to succeed and be a reputable business. A company will in no way prosper by being unreliable and erratic. Reliability is a characteristic that provides an incentive to other companies and partners to the company, as you can depend on the decisions and the financial documents the company endorses. In addition to reliability, the characteristic of relevance is an important quality a company must exude. It is absolutely important and necessary that a company provides financial statements and documents that show relevance, that which predict and demonstrate a realistic statement. For future statements for example, the data under a firm who shows the quality of relevance, they would not show an unrealistic statement of the company for the future and its financial position in the future. A company without relevance would mislead employees, customers and partners, ect. with unrealistic data, that although is appeasing to the eyes and ears, the statement shows no relevancy to the financial position the company will be in, in the future.
To elaborate on the previous responses, Arthur Levitt stresses the need for integrity, reliability, and transparency of financial statements in his speech, “The Numbers Game” given on Sept. 28 1998. In his speech, he discusses 5 different ways to manipulate financial statements that lower a company’s integrity. To mention one, Levitt explains how companies sometimes misuse materiality, and intentionally make minor errors in their financial reports. In addition, they argue that the errors are so minor, they are insignificant. However, Levitt disagrees, that it is clearly not insignificant if it is in violation with GAAP and that even being a penny off in the earnings estimation can throw off the company’s market capitalization by millions.
I agree with what everyone else had posted, however at the same time I do not feel that there is one qualitative characteristic that is more important than any other one. Both reliability and relevance comes hand in hand. I agree with Rickwood who said reliability is crucial because investors will not work with companies which are erratic and undependable. However, I feel that no matter how reliable the company is the information that the company provides must be relevant and accurate, otherwise to the investor, the information is useless. To prosper, companies must provide reliable, relevant information.
one such qualitative characteristic that accounting must use is the accurate and truthful representation of equipment depreciation. In "Bigger Than Enron", the company Waste Management extended the lifespan of some of their equipment on paper, which decreased the rate of depreciation and made earnings appear greater than they were, though the equipment was not truly useful or valuable with this extension of depreciation.
I agree with what Rickwood said that a company can mislead the general public with unrealistic data, that although is appeasing to the eyes and ears, shows no relevancy to the financial position the company will experience in the future. Arthur Levitt in his speech had this to say, "When a company decides to restructure, management and employees, investors and creditors, customers and suppliers all want to understand the expected effects. We need, of course, to ensure that financial reporting provides this information. But this should not lead to flushing all the associated costs -- and maybe a little extra -- through the financial statements." The general belief on Wall Street then is that the company will take a one-time loss, and they focus only on future earnings, which misleads the general public because the company has overstated its charges to restructure. The information is there unrelevant and unreliable.
I agree with anna who said that reliability and relevance come hand in hand. Also, after these characteristics are determined, I would like to point out that comparability is an important characteristic that makes accounting information even more useful. When an investor is trying to choose which company he would like to invest in, comparability is essential. If company A and company B have the same accounting methods and company B's outcome is better, then obviously an investor will put his money into company B.
After looking extensively at Arthur Levitt's Numbers Game speech, I think that one of the most important qualitative characteristics of accounting information is objectivity. Accountants, auditors, CEO's, board of directors, and investors alike need to keep in mind the importance of the value of objectivity. In order for the accounting world to be more honest and ethical in their practices, all actors in this arena must work together with one goal in mind. As quoted by Levitt, "It is essential that we work together to ensure credibility and transparency".
I concur with Anna in saying that each qualitative characteristic is of equal importance. Although, I feel many bloggers are underestimating the importance of relevance in reporting financial information. Relevance, as defined in an accounting contexts is information’s capacity to make a difference in decision-making. Relevance provides predictability to future events by providing feedback about prior events in a timely manner. As just stated, relevance has three parts: predictability, feedback, and punctuality. Each one of these pieces is crucial to relevance. Financial statements would be worthless without every element.
Though I feel relevance isn’t getting enough credit I still believe overall each element is as important as any other in financial statements. To those of you who believe reliability is a superior characteristic, my argument is this: Imagine a financial statement without each of the following: relevance, reliability, comparability, consistency or any other qualitative characteristic. Each statement would be equally worthless. Just like reliability, without relevance, a financial statement is a waste of paper. Equal importance should be put on every qualitative characteristic. The absence of one characteristic is equally detrimental to a financial statement as any other characteristic would be. Does anyone still believe that one is more important than the other?
When I did The Numbers Game reading, I was shocked to see how influential the reliability factor is upon a corperation's revenues. As Emily already mentioned, Author Levit mentions a certain company that miscalculated by a single cent, they lost around 6% of their stock. Depending on some of the larger Fortune 500 corperations, that can mean billions of investment dollars lost. Google alone is priced anywhere between 200-300 dollars a share ( http://money.cnn.com/quote/quote.html?shownav=true&symb=GOOG ) with a market cap of 87 billion dollars any given day! If their balence sheet is askew at all, that will show a major shift of power in the internet market. This to me by far is the most important characteristic.
In agreement with Anna, I believe that there are many important qualitive characteristics in financial reporting and it is hard to focus on just one. Although, relevance definetely has a huge impact on a financial decision. According to our textbook "Fiancial Accounting: Tools for Business Decision Making", "Accounting information is relevant if it would make a difference in a business decision(55)." Before you can even decide if information is reliable, it must first be relevant. Without relevance, you are unable to predict future events and the financial position of the company. In contrast to Ashley Smith, I believe that relevance affects a potential investor more so than reliability. Partially due to the FASB webpage, one individual Todd Johnson states, "Similarly, auditors are likely to place greater importance on the reliability of measures in the financial statements that they audit because of their legal exposure. In contrast, investors might place greater emphasis on the relevance of those measures in forecasting the entity's future earnings or financial positions" (Article from The FASB Report, February 28,2005; http://www.fasb.org/articles&reports/relevance_and_reliability_tfr_feb_2005.pdf) Here Johnson explains why an investor would place greater importance on relevance than an auditor. In my opinion, one of the most prominent ways for a company to guarentee a sucessful future they must present relevant information.
I belive an important element that was somewhat overlooked by the previous post was transparency. Arthur Levitt mentioned transparency during his Numbers game speech but I belive that transparency's role should not be overlooked. Transparency having acountabiltiy for every meaningful action taken by a company. Transparency also refers to making all financial information availble to the public. Transparency protects the public and investor's by making people with power accountable for their actions. If there were more transparency in the auditing firm Arthur Anderson, then there would have been someone to take responsablity for the destrution of ENORN related files and for the re-assigning of chief auditor for ENRON. Currently I belive that lack of transparency not only hurts investors but it also prohits potential investors because they are less sure of the financial information of a company.
In response to my previous comment about the importance of objectivity, we have to keep in mind that the SEC's job is to protect investors. All of the other organizations working with the SEC must base their rulings and practices on this same objective. The investors need to be educated and correctly informed by company's financial statements. The main problems the SEC ran into, like Enron and Worldcom, resulted in a huge loss to investors. In keeping this common objective in mind, all organizations can work to protect investors from future complications.
In the "Bigger Than Enron" video, Sunbeam Corporation was involved in a corporate scandal that included accounting fraud. As mentioned in "The Numbers Game", corporations that try to cut corners can use a method called "cookie-jars reserves", which is one of the ways that Sunbeam committed fraud. In addition, something that was not mentioned in Arthur Levitt's speech is a practice that Sunbeam used known as "channel stuffing". This is "a deceptive business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell to the public"(http://www.investopedia.com/terms/c/channelstuffing.asp). This is something that is done to boost up the value of a stock. Clearly, Sunbeam violated the rule of reliability of its accounting information. Their information was not neutral, not verifiable and definitely not a faithful representation of the company's earnings.
Another qualitative characteristic that I believe is being overlooked is materiality. According to our textbook, materiality seeks to find if an item is substantial enough for investors or other users to be influenced by it. Arthur Levitt put it best in his speech, “The Numbers Game” when he explained how we work in a market where millions of dollars could be lost by missing an earnings projection by a single penny. I, like Levitt, also have a hard time accepting the fact that these minute items be called immaterial and fail to matter. Levitt also explains how materiality is sometimes used as one of the tools to make a business’s numbers look better to its investors. Being that this is an unethical practice it must be stopped. How could we stop this, you ask? In the Statement of Financial Concepts Number 2 there is a brief suggestion of having a written set of guidelines to define materiality. Immediately after this suggestion being made, it was put down by the reasoning that there are too many different considerations to have a set of guidelines to specify materiality. In my opinion, a solution lies within a single person, independent of the company, whose job it is to become familiar with the situation and assess materiality. One can begin to assess materiality by following these general steps respectively: Identification of the level of service, Identification of the financial statements and periods presented, Identification of the basis of accounting, Description of the scope of the service, Identification of significant departures from accounting basis, Statement of assurance, Judgment. Though this is not a definitive answer to what is material, it is one way of beginning to assess the situation. I believe materiality is a qualitative characteristic that should not be under estimated in our economy and is important enough to hire a “materiality analyst” to determine materiality and prevent scandals.
General Steps for Assessing Materiality taken from: http://www.reyhl.com/peer_review/materiality
.html#report
Conservatism is another qualitative characteristic that seems to be overlooked. Our textbook defines conservatism as a company choosing an accounting method that will be least likely to overstate assets and income. There have been several instances where corporations have overstated their assets and income by reporting business deals as future revenue, but these deals never take place. One such corporation was Sunbeam as already discussed by Caroline Perdreaux. Sunbeam reported sales that it knew it would never make just so the company's stock would rise and the executives stock options would increase as well. This intentional fraud made Sunbeam's financial doucments useless and caused many investors to lose a great deal.
In agreement with comments from anna, Caroline Perdreaux, Steve Schirripa, and Ashley Temple, there is no one qualitative characteristic for accounting information to be considered useful. Many of these characteristics must be used in order for financial statements to be used correctly and efficiently. One aspect that I am suprised no one has mentioned yet is the quality of timeliness. Even though timeliness is a component of relevancy, keeping on a timely basis with accounting information is critical. According to the Statement of Financial Concepts Number 2, timeliness means having information available to decision makers before it loses its capacity to influence decisions. Also there is said to be certain degrees of timeliness. Some information is needed days or hours and other financial information is not needed more than every month of even year. Certain situations such as take over bids or strikes fluctuates the necessity in terms of time for the information.
While Emily Shapiro touched on it, I believe that integrity is one of the most important factors in deciding the usefulness of data. Reliability, consistency, and relevance all play their own role in determining a business' integrity. If a company is morally sound, then it is only fitting that the data that they put out is considered useful. If a company has a less than acceptable level of integrity (usually in those 3 areas), it is probably true that the data output is not worthy of use. By re-examining Enron again for the 50th time, it is easy to see what can happen to companies that lack integrity in the accounting department.
To support my previous argument, the following website contains the views regarding integrity of a company called Longview Solutions. This company creates Corporate Performance Management software and they sum up the importance of integrity very convincingly. Read this short page, if you don't happen to agree with my previous comment.
http://www.longview.com/
In relation to my last post about the timeliness factor, it is not only related to the relevance characteristic as mentioned before, if the information is presented in a timely fashion then it can also be qualified as reliable. Even though it is not stated in our textbook, I feel that timeliness can be labeled under both relevance and reliability. Timeliness may have played a major factor in the surfacing of the corporate scandals. If the financial statements are not presented on time then some suspicion may arise because of the lack of promptness.
In response to Steve Schirripa's comment, I agree that there should be some sort of materiality analying procedure. I disagree, however, in his idea that there should be one single person in charge of this. From past scandels, it is evident that one single person can be so corrupt and driven by greed that they practice dishonest accounting, obviously creating huge problems. A committee of people would most likely be a safer bet. I do, however, agree that materiality is an essential qualitative characteristic in accounting.
I think that it is almost impossible to say that one qualitative characteristic is more important than the rest because without every single aspect of quality. Without reliability, a corporation can't be trusted, and without consistency and comparability, the information is also useless. No accurate decisions can be made without reliability, relevance, comparability, and consistency.
In response to my last comment, I meant to say that there would be a major shift in the internet advertising market. Anyhow, reading down the thread, I noticed Andrew Harp mentioning conservatism. I find this to personally be the worst qualitative characteristics. In all agreement with Andrew, conservatism is a very shakey tool that can easily distort numbers, more specifically, future earnings. As it says in this article (www.kenan-flagler.unc.edu/Faculty/academicarea/ accounting/Events/conservatism-duke-winedt.pdf), conservatism is an influance that can use the slightest bit of good news in a firm to greatly overstate the future income. For example, I could say that I set up a lemonade stand on the beach and the President of the United States comes by and buys a lemonade. Using a radical form of conservatism, I could justify that since he came by today, he can come back tomorrow and leave a big tip. What it comes down to is whether or not the information influencing the balence sheet is ambiguous or not. Conservatism is a dangerous tool and should be taken out of the equation all together.
i agree with kristen mcnamee, there should certainly not be one person in charge of a large corporation, the movie "Bigger than Enron", showed how the new CEO of Sunbeam inflated earnings of the company for his own personal interest, and in the end even though he was fired for his actions, his selfishness proved to still be very profitable for him.
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