Accounting Interpretation – Painting a Financial Picture
Critics assumed the soft watches in Dali’s painting “Persistence of Memory” (above) were his interpretation of Einstein’s recently published theory of relativity. The bending of space and time. Dali responded that the soft watches were his interpretation of a Camembert melting in the sun!
Transactions in accounting can similarly be interpreted in different ways. Numbers can be recorded and recognised in ways that paint a quite different financial picture of a business. This article explores ways that accounting requires interpretation and judgement.
Accounting isn’t black and white. It isn’t black and white because it requires judgement on how to recognise items in the financial statements.
Take two businesses. They are the same, identical, but they have quite different sets of financial records. One company is very optimistic and aggressive in its accounting treatment and paints a very healthy and strong financial picture. The other company is pessimistic and reserved in its accounting treatment and paints a more conservative financial picture.
Key areas in accounting that require judgement include timing, recognition and value:
- Timing. Judgement as to when a transaction take place and what date, what period, the transaction is recognised in the accounting records. Should a transaction be recognised in this financial year or the next financial year?
- Recognition. Interpretations of transactions and judgement on how those transactions are recognised in the accounting records. Should an item be interpreted and recognised as an expense in the profit and loss or should it be recognised as an asset of the business, it will generate future economic benefit?
- Value. Judgement is required as to what value to ascribe to a transaction. That’s because the only value we can be sure of is cash. Cash is cash. Everything else is a judgment of value.
Fortunately for accountants, in preparing financial statements there are accounting rules. International Financial Reporting Standards. These rules guide and instruct us on when and how to recognise items in the financial statements. But these rules are themselves subject to interpretation.
In 2000 Enron was one of the world’s largest energy companies; it was one of the world’s largest companies. It was a habitual abuser of accounting rules. It aggressively interpreted the accounting rules.
This is how a former employee describes the process:
“Say you have a dog, but you need to create a duck on the financial statements. Fortunately, there are specific accounting rules
for what constitutes a duck: yellow feet, white covering, orange beak. So, you take the dog and paint its feet yellow and its fur white and you paste an orange plastic beak on its nose. The you say to your accountant, “This is a duck! Don’t you agree that it’s a duck?” And the accountants say, “yes, according to the rules, this is a duck”. Everyone knows that it’s a dog, not a duck, but that doesn’t matter, because you’ve met the rules for calling it a duck.”
Quite simply, Enron had lots of dogs pretending to be ducks. Eventually the duck imposters were discovered which ultimately led to the demise of Enron. At that time, Enron became the largest bankruptcy in US history.
Assets & liabilities
Assets. Assets are resources the business owns. Assets can also be resources that the business controls. Control is a matter of judgement.
Assets are resources that will be an economic benefit to the business. The Assets are either expected to generate future income or support the operations of the business. Whether an asset is going to generate future income or support the business is a matter of judgement.
Liabilities. Liabilities are defined as present obligations the settlement of which is expected to lead to an outflow of future economic benefit. This requires judgement.
Accruals. One of the most fundamental concept in accounting is the Accrual Concept. The Accrual Concept says that revenue and expenses are recognised in the financials in the period they occur. Which is not necessarily when the cash is received or paid. The Accrual Concept is about timing, which requires judgement.
Matching. An extension of the Accrual Concept is the Matching concept. The Matching concept states that a company needs to recognise the associated costs in generating revenue in the same period the revenue is generated. Expenses need to be matched against revenue. This requires judgement.
Accounting requires judgement. How have the financials been painted? Take a closer look. Make sure there are no dogs pretending to be ducks.
- Dick Smith shenanigans – overstated stock
- WorldCom shenanigans – overstated prepayments
- MCI shenanigans – understated bad debtor provisions
About the author
Simon is a CA Accredited Business Valuer, Chartered Accountant, and a Certified Fraud Examiner. Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the massive Bernie Madoff Ponzi scheme.
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