Understanding Financial Statements and Measuring Wealth Conservatively

by March 7, 2016

This article is the second of a series focused on financial accounting disclosures and how journalists can interpret and report on them. Post me blog ideas in the comments or email me at steven.orpurt@asu.edu.

How do accountants measure wealth created?

In our first article, we learned that financial accounting measures wealth and wealth created. The next question is: how? The answer: conservatively, as defined in accounting.

Conservatism in accounting

Conservatism in accounting means that wealth outflows, termed expenses and losses, are recorded sooner, with more estimates, and often less precisely than wealth inflows, which are termed revenues and gains. Measuring wealth inflows and outflows this way means that financial statements are biased towards a conservative measure of net wealth created (net income or net loss) by a firm during an accounting period of time.

Why produce conservative measures for financial statements?

Why measure wealth inflows and outflows conservatively? The answer is intuitive. Humans, by nature, embellish reality. Firm managers are (highly) likely to bias their descriptions, presentations and if allowed, their rendition of net wealth created (net income) toward an optimistic view of their firm’s financial performance. In other words, left to their own devices, managers’ optimism would translate into a natural tendency to delay reporting and minimize wealth outflows (expenses and losses) while accelerating (and perhaps embellishing) wealth inflows (revenues and gains). Financial accounting adds social value to the capital markets by combating these natural human tendencies via its conservative bias. Accounting acts as a reality check on managers’ behaviors.

Conservatism is a feature or characteristic of generally accepted accounting principles (GAAP). GAAP is the set of principles and rules that firms use to produce their financial statements. GAAP is enforced through various corporate governance mechanisms including audits of the financial statements by audit firms; regulations and laws enforced by the U.S. Securities and Exchange Commission and similar governmental bodies in other countries; ethics requirements for CPA’s; whistleblowers; etc. In the U.S., public companies must disclose their financial statements four times per year (quarterly) which helps discipline managers to disclose both good (and bad) financial news promptly.

Examples of conservatism in financial statements

Examples of conservatism are plentiful. A graphic, albeit older, example is the Exxon Valdez oil spill. When the Exxon Valdez tanker spilled oil into an Alaskan bay, a wealth outflow occurred. Exxon immediately recorded a loss in its next quarterly report, caveating the expense/loss as an early estimate using best available information. Exxon acknowledged that the actual wealth outflow could be substantially different from what it initially recorded. But consider when the company would have recorded a wealth inflow if the oil spill had not occurred. The record would have appeared much later, after Exxon delivered the oil to a customer who had agreed and was able to pay for it. Note the conservative, biased treatment of wealth inflows and outflows.

As other examples of conservatism, suppose a firm spends wealth on research. Even if it is likely or highly likely that the research will lead to new products that are salable, the wealth spent on research is an expense (wealth outflow). Any wealth inflows are only recorded at a later date when the research does generate new products and customers do purchase them. Wealth outflows are recorded sooner in this series of economic events than wealth inflows because of the conservative nature of accounting. This same idea applies to marketing and advertising expenditures as well as many others.

As a journalist, understanding that financial accounting measures wealth and wealth created and does so conservatively will help you assess and interpret many managers’ assertions that financial statements do not “correctly” or “accurately” reflect their wealth-creating activities. These managers believe that wealth inflows have occurred but the financial accountants won’t record them (yet). Or, they believe that wealth outflows have not occurred (yet) but the financial accountants want to record them. Either way, financial accounting restricts managers’ behaviors and helps you assess managers’ comments about their firms’ financial performances.

Because of conservatism, numerous firms offer “pro-forma” earnings, sometimes called “non-GAAP” earnings, in addition to their regular financial statement disclosures including net earnings. Academic research documents strong evidence that when managers present and discuss non-GAAP, pro-forma earnings, they tend to exclude wealth outflows. Many management teams try avoiding the conservative nature of financial accounting. Savvy investors (and journalists) always compare and contrast managers’ financial announcements and presentations to conservative GAAP financial statements to form their own opinion about firms’ financial performances.

In his 2015 annual letter to shareholders released just a few days ago, iconic investor Warren Buffett stated, “it has become common for managers to tell their owners to ignore certain expense items that are all too real. ‘Stock-based compensation’ is the most egregious example. The very name says it all: ‘compensation.’ If compensation isn’t an expense, what is it?” Technology firms often exclude employee compensation expenses from their non-GAAP pro-forma earnings disclosures, claiming these expenses are not a wealth outflow. Obviously, Buffett thinks poorly of this practice and his thinking is aligned with GAAP which requires including these expenses in GAAP net earnings.

Generally then, you can compare and assess a firm’s GAAP financial statements (presented conservatively) with any pro-forma, non-GAAP figures presented by managers, analysts or others to form your own opinion of a firm’s financial performance. Investors have been doing that with Boeing, and not coincidentally, Boeing recently announced it is under investigation by the U.S. SEC. The heart of this investigation will center on whether Boeing has been appropriately conservative in its financial statements as required by GAAP.

Next week we’ll describe the link between the balance sheet and income statement and start describing various accounts often encountered on balance sheets and income statements.

Numbers and Finance Photo via Ken Teegardin, CC BY-SA 2.0