Reporting on the Past: A New Approach to Improving Accounting Today
by
Russell J. Lundholm
Arthur Andersen Professor of Accounting
University of Michigan Business School
forthcoming in
Accounting Horizons
June 4, 1999
I would like to thank Dave Wright for numerous discussions on this topic, and Joe Piotroski and Doug Skinner for helpful comments on an earlier draft. Please address all correspondence to University of Michigan Business School, 701 Tappan, Ann Arbor, MI 48109-1234, or email to lundholm@umich.edu.
SYNOPSIS
In the last few years the financial accounting model has been attacked on a number of fronts. Some argue that the model reports irrelevant information in today's knowledge-based economy, while others argue that the model's reporting discretion makes the results unreliable. Accruals allow the model to report wealth creation or depletion in a more timely manner, yet they also allow abuse when the underlying estimates are intentionally distorted. But surprisingly, the accuracy of the estimates underlying the accruals is never examined; rather current accruals are mixed together with the reversals of prior accruals. I propose that the financial reporting model be amended to report on the ex post accuracy of a firm's prior estimates. Doing so will identify firms who have abused their reporting discretion in the past and provide valuable information about the expected credibility of the firm's disclosures in the present. Firms will also have a greater incentive to make accurate estimates and accruals if they know that opportunistic estimates will be explicitly revealed in the future. Finally, accounting regulators might be more inclined to recognize non-traditional assets in the financial statements if a system is in place that gives firms an incentive to accurately estimate the value of these assets. In the paper I give an example of the type of disclosure I am proposing, discuss the benefits it offers to investors, and address some practical implementation issues.
INTRODUCTION
SEC chairman Arthur Levitt recently spoke out against abuses of the flexibility in the accounting system, claiming that earnings management is eroding the quality of the financial reporting process (Levitt 1998). After citing examples of abuse based on restructuring charges, acquisition accounting and miscellaneous reserves, he outlined an action plan that called for the elimination of much accounting discretion by making guidelines on these issues clearer. To the extent that the eliminated discretion will only eliminate abuse, this will surely improve financial reporting. However, to the extent that the tighter guidelines cause different transactions and circumstances to be accounted for in the same way, the change will reduce the informativeness of financial statements.
Chairman Levitt's proposal is also troubling because it comes at a time when the traditional financial reporting system is already under fire for a lack of relevance. Detractors claim that the historical reporting model may have worked well in an industrial economy, but that it fails to capture the creation of value in a timely fashion in the present, information-based economy (Elliott and Jacobson 1991, Rimerman 1990 and Jenkins 1994). Many of the proposed remedies to the financial reporting system's lack of relevance would require a large increase in accounting discretion, such as estimating the useful life of an R&D expenditure (Lev 1997). So, while chairman Levitt's concern with accounting abuse may be well founded, his proposed remedy may further erode the information content of financial reports. In this paper I argue for a different approach to improving financial reporting. Rather than attempt the nearly impossible task of mandating new accounting measurements that will be both free of manipulation and value-relevant, I argue that accounting regulation can be used to encourage firms to choose the best measure themselves.
The accrual accounting process necessarily requires firms to estimate many different things - the net realizable value of receivables, the expected warranty liability, the projected benefit obligation of pensions. Yet, surprisingly, the current system never reports on the accuracy of these estimates after the fact. The reversal of an accrual from one period is mixed together with reversals and originations from other periods, making it generally impossible to tell even ex post how accurate the firm's estimates were.1The solution I propose would be to give firms great latitude in financial reporting decisions, but augment the existing system to report on the ex post accuracy of their estimates. Thus, if a firm systematically overstates the value of its assets or the amount of its income, the augmented disclosures will reveal this ex post. By giving investors the necessary data to assess the credibility of a firm's prior accounting reports, these new accounting disclosures will allow them to reward firms who report without bias and punish those who report opportunistically.
Accounting theory has long recognized a trade-off between the relevance and the reliability of information (Ijiri and Jaedicke 1966, Imhoff 1981, FASB 1980). Generally, the longer the lag between the economic event and when it is reported, the more reliably its effect can be estimated, but the less relevant the information is for current decision-making. Viewed this way, attesting to the accuracy of a firm's past estimates would appear to be reporting completely reliable but completely irrelevant information. However, this view misses the fact that a reliable report on the firm's past accuracy creates an incentive for firms to report accurate information today. If the accounting system causes firms to internalize the cost of opportunistic reporting then it is possible that relevant current information can be reported without a corresponding loss in reliability. And, by augmenting the existing reporting system in this way, it may be possible to recognize "softer" assets, such as the value of an R&D expenditure, without suffering a significant loss in the reliability of resulting financial statements.
Before I argue further why this change in the mandatory reporting system can improve the information that flows from firms to investors, consider a simple example of the type of disclosure I have in mind.
AN EXAMPLE
The augmented disclosure I have in mind could apply to any part of the accounting system that requires estimates but, as a simple example, consider the allowance for doubtful accounts. Suppose that each year a firm makes a credit sale at the beginning of the year and a credit sale at the end of the year. The accounts are either collected or written off after six months, and the firm's overly optimistic estimate is that 10 percent of the ending gross receivable balance will be uncollectible. In the example, the firm becomes increasingly aggressive in recognizing revenues, but the underlying collections remain constant (hence the 10 percent estimate is overly optimistic). Figure 1 gives the T-accounts for gross receivables and the allowance for three years of increasing revenues and a fourth year which winds up the accounts. The chronology of events progresses down the page. Figure 2 gives financial statements for each year, along with my proposed supplemental financial statements reporting the actual outcomes.
In this example the allowance estimate is purposely understated in each of the first three years. For example, in year 1 the allowance is 12 -- 10 percent of the 120 credit sale made at the end of the year. But, as is seen in year 2, 30 of this sale turns out to be uncollectible. Therefore, with hindsight, the actual bad debt expense in year 1 is 50, rather than the reported amount of 32. It is not until year 4, when no sales are recorded, that the accrual accounting system corrects the errors of the overly optimistic estimates in the prior periods. But armed with the reported financial statements only (shown at the top of figure 2), and even given a supplemental disclosure of the aggregate debit and credit each year (as given in the 10K filing), it is impossible to recover the actual write-off of the accounts outstanding at year end and compare it to the estimated allowance. This is because the write-offs from the prior year and the current year are aggregated together. For example, in year 1 the write-off of 30 of receivables from year 1 sales is aggregated with the write-off of 40 from year 2 sales. In general, the only time the write-off associated with the prior period's estimated allowance is recoverable from the accounting disclosures is when there are no write-offs of the current period credit sales and no write-offs from two periods prior -- a very rare occurrence indeed.
In my proposed accounting system the firm would be free to report based on its estimate of 10 percent uncollectible accounts, resulting in the reported financial statements shown at the top of figure 2. But in addition, the firm would also have to disclose the previous year's actual balance sheet and income statement, as shown at the bottom of figure 2. With the disclosure of actual amounts from the previous year, in year 2 an investor could see that, while the firm reported net receivables of 108 and net income of 198 in year 1, the actual receivables were only worth 90 and the actual net income was only 180. And in year 3 the investor could see that the firm overstated assets and income in both of the previous years. These would be very useful facts when an investor is deciding how much faith to place in the firm's future disclosures.
THE APPLICABILITY OF THIS NEW DISCLOSURE
The basic idea I am proposing goes far beyond the accounting for bad debts. The accrual accounting system is full of estimates, and many of the new proposals for improvements in the financial reporting system will require even more estimation. In general, whenever the accounting system requires an estimate of something to be realized in the future, it also determines what an ex post report could evaluate.
To illustrate how an ex post report might also support wider recognition of intangible assets than GAAP currently allows, consider the case of R&D expenditures. Lev (1997) argues that once an intangible investment can be associated with an identifiable and measurable future economic benefit it should warrant asset recognition. Suppose, for example, that R&D at a drug company has progressed to the point that the economic benefit from the sale of a new drug is identifiable and measurable, and that a revised version of GAAP therefore requires the recognition of an R&D asset. If the recognized R&D asset value is estimated as the future cash flows from new drug sales, then the actual sales of the new drugs can be compared to the prior estimate. The key point is that, whatever the method of estimation, the basis for the asset recognition determines the basis for the ex post report. By linking the asset measurement of expected future benefits with an ex post report on realized economic benefits, firms will have an incentive to be precise in their original estimate, and investors will have the information to assess the firm's past accuracy.
This proposal will work best if the asset recognition is based on some estimate of identifiable future economic benefits, not simply on the amount of the expenditure. If the asset is measured simply as the amount expended then there is no clear statement of what is being estimated and hence no clear ex post report. But even under the most radical proposals for revision to the financial accounting system, certain expenditures will never rise to the level of recognizable assets. While Lev argues that many R&D projects meet the criteria of creating identifiable and measurable future economic benefits, he also points out that other expenditures, such as employee development costs, do not. And, even in the case where the asset value is based only on the expenditure, the accounting system still requires an estimate of the asset's useful life and an ex post report could attest to this estimate's accuracy.
Finally, the idea of an ex post report applies equally well to voluntary disclosures made completely outside the mandatory reporting system - disclosures about customer retention rates, expected growth in market share, or the prospects of a new product. Firms frequently make estimates of these and other important value-drivers in press releases and conference calls, yet the ex post accuracy of these statements is rarely verified after the fact. 2
THE BENEFIT OF SUCH A DISCLOSURE
An ex post report on the accuracy of prior discretionary estimates by itself does not assure that the estimates will be truthful and unbiased ex ante. Such a disclosure will have the greatest impact on firms who need investor confidence in the future. If this new accounting disclosure reveals that a firm behaved opportunistically in the past, rational investors should be wary of the firm's future disclosures. And because the equity market is characterized by many close substitutes, investors can simply re-allocate their capital to firms with better records of credible disclosure. Thus, firms that are particularly sensitive to their future stock market valuation, possibly because they need to raise capital in the future or because they rely heavily on stock compensation, will be the most reluctant to mislead investors in the present. By establishing a clear measure of a firm's disclosure credibility, my proposed ex post report will give these firms an incentive to report accurately ex ante. Further, with a well-defined system in place to identify firms who are accurate and unbiased versus inaccurate and biased, it is likely that competition will arise between firms for high-quality, credible disclosures.3
The ex post report will have the smallest impact on firms that are only concerned with their present stock valuation. These firms may see the loss of future credibility as a small price to pay in order to mislead investors today. So other remedies such as private litigation and SEC enforcement activities still have an important role to play. But the primary emphasis of regulation in the U.S. securities markets has always been on disclosure. An investor might be wise to distinguish between a firm who reports a small warranty liability, for example, but has no past history of accurate estimates and a firm who reports the same estimated liability but can back it up with a history of realized warranty claims close to its prior estimates. While the mere disclosure of a firm's prior estimating accuracy cannot prevent investors from investing in the first firm, such a disclosure would certainly cause investors to think more carefully about the believability of the company's reports. But ultimately it is up to the investor to assess a firm's long-term versus short-term incentives to be misleading. A cautious investor might want to avoid firms without a proven track record of accurate reporting, or firms with an obvious short horizon, such as those near bankruptcy, while a risk-taker might choose to invest in these firms.4
The ex post report I am proposing will also have less impact if there is a large amount of residual uncertainty (i.e. the error in a good-faith estimate). It may not be that management is attempting to mislead investors; they may simply not have very good information themselves about the uncertain variable being estimated. But this too is useful information to an investor. And repeated outcomes with the same signed forecast error can still reveal bias. Similarly, if there is a long lag between when the estimate is made and when the uncertainty is resolved, then the ex post report might reveal opportunistic estimates too late to be of much use. This raises a number of new measurement issues. For instance, if it becomes clear that the estimated warranty liability in a past year was way too optimistic, but the exact ex post amount of liability has not yet been determined because of a small amount of outstanding exposure, the ex post reporting system will have to trade off the timeliness of reporting the error in the prior estimate with some noise against waiting for a perfect measure of the error.
My proposal has many similarities to disclosures that are found on a newly created online market, eBay. Sellers auction items to buyers using eBay as the electronic auction-house. The only information the buyer has about the item being purchased is that provided by the seller. Once an auction is complete the buyer typically sends a money order directly to the seller. But what assurance does the buyer have that the seller will actually deliver an item that fits the description? Why doesn't adverse selection cause this market to completely unravel? To combat these effects eBay supports the market by soliciting buyer feedback about the seller after the transaction is complete. Thus, before a buyer purchases an item she can access the seller's profile, which contains a list of prior buyers' testimonies (often comparing the quality of the goods promised to the quality delivered) and an overall seller rating.5 Buyers can avoid sellers with bad reputations or short histories. A seller with a very short horizon can clearly mislead buyers with false disclosures and reap the benefits, but a seller intending to transact in the future risks losing all future business. This simple ex post disclosure system has allowed eBay to thrive; they have more than 3.8 million registered users and enabled $1.2 billion in transactions in 1998.
CONCLUSION
As the accounting profession struggles to provide a relevant product in the face of a rapidly-changing economy, my proposal offers many advantages. First, it is aimed at getting firms to internalize the benefits of accurate reporting, rather than compelling them based on some one-size-fits-all accounting standard. As such it will lead to reporting that is more flexible and adaptive than could ever be achieved through a purely mandatory, standards-based approach. Second, with a system in place to report on the ex post accuracy of a firm's estimates, regulators might be more willing to allow the booking of more difficult-to-measure assets, such as the value of R&D expenditures. Assets that are difficult to measure in the current period become easier to measure with hindsight. In my proposed system, by booking the asset today, a firm is committing to report on how valuable the asset turned out to be ex post. By giving firms incentives to report accurately, regulators might be more willing to allow greater latitude in what is reported. If accounting is going to adapt to a rapidly changing economy and report on whole new classes of assets and liabilities, then along with attempting to get accurate ex ante measures of these items, the system would benefit from an ex post check on the accuracy of such measurements. Finally, many of the other proposed improvements to the financial reporting system will require accountants and auditors to become experts in measuring new types of assets and liabilities, such as the value of employee talent or the level of customer satisfaction. In contrast, my proposal draws on the traditional strength of the accounting system and the audit profession - the ability to assess the past.
FIGURE 1
T-accounts for Example
(events proceed chronologically down the page)
Gross Accounts Receivable Allowance for Doubtful Accounts
0 0
credit sale 110
90 collect
year 1 20 write off write off 20
credit sale 120
32 expense
__________________________ ______________________________
balance 120 12 allowance
90 collect
30 write off write off 30
year 2 credit sale 130
90 collect
40 write off write off 40
credit sale 140
72 expense
___________________________ _______________________________
balance 140 14 allowance
90 collect
50 write off write off 50
year 3 credit sale 150
90 collect
60 write off write off 60
credit sale 160
112 expense
_________________________ ________________________________
balance 160 16 allowance
90 collect
year 4 70 write off 70 write off
54 expense
__________________________ ________________________________
balance 0 0 allowance
Each year $90 of each credit sale is collected, with the remainder written off. The collection and write-off of the first sale of the year is completed during the year; the collection and write-off of the second sale of the year is completed in the following year. Despite the rising percentage of write-offs to collections, the firm estimates that 10% of the ending gross receivables will be uncollectible each year. The example unwinds in the fourth and final year.
FIGURE 2
Reported and Actual Financial Statements for Example
for the period ending in year |
1 |
2 |
3 |
4 |
Balance Sheet Reported |
||||
Gross Accounts Receivable |
120 |
140 |
160 |
0 |
Allow. for Doubtful Accounts |
12 |
14 |
16 |
0 |
Net Accounts Receivable |
108 |
126 |
144 |
0 |
Income Statement Reported |
||||
Sales |
230 |
270 |
310 |
0 |
Bad Debt Expense |
32 |
72 |
112 |
54 |
Net Income |
198 |
198 |
198 |
-54 |
Balance Sheet Actual |
||||
Gross Accounts Receivable |
120 |
140 |
160 |
0 |
Allow. for Doubtful Accounts |
30 |
50 |
70 |
0 |
Net Accounts Receivable |
90 |
90 |
90 |
0 |
Income Statement Actual |
||||
Sales |
230 |
270 |
310 |
0 |
Bad Debt Expense |
50 |
90 |
130 |
0 |
Net Income |
180 |
180 |
180 |
0 |
The Reported financial statements are prepared following standard GAAP. The Actual financial statements are restatements of the reported financial statements after the actual collections are realized. The Actual financial statements would be disclosed with a one year lag to the Reported financial statements.
REFERENCES
Elliot, R. and P. Jacobson. 1991. "U.S. accounting: a national emergency." Journal of Accountancy (November): 54-8.
Financial Accounting Standards Board. 1980. "Qualitative characteristics of accounting information." Statement of financial accounting concepts No. 2.
Ijiri, Y. and R. Jaedicke. 1966. "Reliability and objectivity of accounting measurements." The Accounting Review 41 (July): 474-83.
Imhoff, G. 1981. "Evaluating accounting alternatives." Management Accounting (October): 54-72.
Jenkins, E. 1994. "An information highway in need of capital improvements," Journal of Accountancy (May): 77-80, 82.
Lev, B. 1997. "The old rules no longer apply," Forbes (April 7): 34-6.
Levitt, A. 1998. "The numbers game," Speech delivered at the NYU Center for Law and Business, New York, NY, September 28.
Lundholm, R. 1999. "Historical accounting and the endogenous credibility of current disclosures," University of Michigan working paper.
Petroni, K. 1992. "Optimistic reporting in the property-casualty insurance industry," Journal of Accounting and Economics 15: 485-508.
Rimerman, T. 1990. "The changing significance of financial statements," Journal of Accountancy 79 (April): 82-3.
ENDNOTES
1 An interesting exception to this is in regulatory reporting for property-casualty insurers. In these filings a firm must report the difference between the originally reported claim loss reserve and the actual losses that materialized after five years (i.e. the five-year developed reserve). See Petroni (1992) for details.
2 Lundholm (1999) presents a game-theoretic repeated-play model illustrating an equilibrium where rational investors generally believe a firm's voluntary disclosures and the firm's disclosures are generally truthful. The key to the result is the existence of a lagged ex post report on the veracity of the firm's prior voluntary disclosures.
3 Such competition already exists in voluntary disclosures. For example, when some firms voluntarily reported the size of their anticipated Other Post Employment Benefit liability, other firms were compelled to make a similar disclosure; otherwise the capital market would have assumed their liability was so large that they wished to hide it.
4 An alternative remedy to the one proposed here is to require management to reveal all the information upon which their estimates are based in the current period. While such a change would certainly improve the information investors receive, it has many operational difficulties. Rather than attempt to compel the ideal disclosure ex ante, my proposal aims to change the information environment so that management will see it in their own best interest to report accurate and unbiased information.
5 A difference between eBay and my proposed disclosure is that on eBay the ex post report is provided by the buyer, so it is quite credible, whereas the ex post report in my proposal is provided by the seller (i.e. the firm). For the firm's ex post report to be credible, then, it will have to be audited.