General Accounting Information and Recreational Site: Accounting Evaluation

The purpose of accounting evaluation is usually to assess the extent to which a firm’s reported outcomes reflect economic reality. The analyst desires to evaluate the firm’s accounting policies and estimates, and assess the nature and extent of a firm’s accounting flexibility.

The latter refers to management’s discretion in picking out which accounting policies and estimates to apply to a specific accounting event. To reach reliable conclusions, the analyst have to adjust reported accounting amounts to get rid of distortions caused by the use of accounting procedures the analyst deems inappropriate. Examples may include things like marking trading assets to market place and not recording the gains or losses in income but in an allowance account, prematurely recognizing revenues, or reversing estimated liability accruals to smooth earnings.

Corporate managers are allowed to create a lot of accounting-related judgments for the reason that they know essentially the most about their firm’s operations and economic condition. Flexibility in monetary reporting is crucial because it makes it possible for managers to use accounting measurements that most effective reflect the company’s particular operating circumstances. Even so, managers have incentives to distort operating reality by utilizing their accounting discretion to distort reported earnings. One particular cause is the fact that reported earnings are often used to evaluate their managerial performance.

Healy and colleagues suggest the following process for evaluating a firm’s accounting good quality:

Identify important accounting policies
Assess accounting flexibility
Evaluate accounting technique
Evaluate the superior of disclosure
Determine possible red flags (e.g., unusually large asset write-offs, unexplainedtransactions that boost profits, or an growing gap among a company’s reported income and its cash flow from operations)
Adjust for accounting distortions

To illustrate this approach, take into consideration the accounting superior of WorldCom, a sizable U.S. provider whose accounting policies resulted in a key Wall Street scandal. In formally indicting the provider on its faulty accounting practices, the following concerns may well be asked: (1) How did WorldCom account for its important operating expenditures? (two) What solutions does U.S. GAAP enable for such expenditures? (3) Did WorldCom adopt an overly aggressive or conservative approach to accounting for these expenditures? (4) Did WorldCom capitalize an expenditure that should have been expensed to manage its earnings? (5) Did WorldCom disclose sufficient information and facts for investors to undo the company’s aggressive accounting therapy? (6) Would reversal of WorldCom’s selected accounting posture have a substantial depressing impact on reported earnings? In this case, WorldCom chose to capitalize what were in effect operating costs. Although this practice is in clear violation of U.S. GAAP, management chose to conceal this information from investors by disguising operating costs as capital expenditures. The economic statement effects of capitalizing versus expensing its key expenditures had a considerable effect on reported earnings as the amounts involved approached $2 billion! Two significant problems confront those carrying out accounting evaluation in an international setting. The first is cross-country variation in accounting measurement excellent, disclosure superior, and audit quality; the second issues the difficulty in acquiring facts essential to conduct accounting analysis.

Cross-country variation in good quality of accounting measurement, disclosure, and auditing is dramatic. National characteristics that trigger this variation consist of required and generally accepted practices, monitoring and enforcement, and extent of managerial discretion in economic reporting.