I'll admit it. Keeping up with policy changes in the accounting world is not nearly as riveting as, say, following the gossip on Page Six of the New York Post.
But if you invest in publicly traded companies you have no choice. These changes in accounting policies affect a company's financial statement and that, in turn, affects its stock price.
In the midst of earnings season, understanding these changes is even more imperative. Your favorite company may have missed the Street's earnings estimates because of fundamental reasons, but the problem could've been that an accounting change forced it to restate its numbers.
Part of the reason companies get caught restating is because accounting standards generally are put in place once industry develops, says Allan Anderson, senior vice president of technical services at the
American Institute of Certified Public Accountants
. New businesses need to exist for some time and, yes, make mistakes before the
Securities and Exchange Commission
or the accounting boards react.
Until new standards are created, companies are stuck working with the one-size-fits-all financial statements that were created back in the 1930s when the steel industry was all the rage. But what works for a steel mill might not cut it for a business-to-business software provider, which is why many companies are required to restate once new policies are developed.
So let's walk through the some of the major developments that affected the accounting world -- and therefore financial statements -- last year.
Materiality has long been a pedestrian concept among auditors.
is accountant-speak for any information that would affect the stock price were the public to find out about it.
When an audit is performed on a company's financials, auditors used to be able to establish a floor on the numbers that they would audit. For instance, many used 2% of income as the standard threshold. So if net income is $50 million, then any amounts below $1 million would not be audited.
Staff Accounting Bulletin No. 99 on materiality basically did away with this concept. It is an attempt to prevent auditors from calling a number immaterial, and therefore ignoring it. Now, no matter how small the number, the auditors should look at it.
This is good news for investors. Anyone who has ever gone food shopping knows how quickly little items can add up. Not to mention, it is very easy to "play with" smaller numbers when you know your auditors are not going to look at them.
What's worse, especially with a big global company, lots of bad business decisions could be made that you'd never know about. For instance, the company could be investing in lots of smaller companies that tank but have losses below the materiality threshold. Then you'd have no idea that your company is making loads of mistakes. What makes it all the more important is that today's little niche or fringe business opportunity may be tomorrow's billion-dollar market.
The new requirements offer more disclosure to investors on the "small" numbers, so pay attention.
Arthur Levitt and the Auditors
Speaking of auditors, the long, drawn-out soap opera with the SEC's chairman on auditor independence was almost as bothersome as this year's presidential election.
The importance of high quality accounting and auditing was at the top of Levitt's to-do list last year. And while the idea was sound, I would argue that his
tactics were a bit over the top.
Nevertheless, we have
The new rules allow accounting firms to offer computer consulting to their audit clients, but require them to disclose the dollar value of the consulting and audit services each year. The rule also defines the pool of accounting firm employees whose personal investments might be deemed as potential conflicts with their firm's audit work.
story on the results of this saga.
Again, this is good for investors, who rely on auditors to give an unbiased opinion of the companies in which they are investing. These new guidelines take us a step closer to that utopia.
Recognizing revenue was not an easy task in 2000, especially with the introduction of so many new business models. For instance, selling products and services on the Internet became the norm, with dot-coms acting as the middleman between a business and its consumers. As a result, the existing revenue recognition rules did not apply. So the new economy companies were left to make judgment calls.
Unfortunately, many of them made the wrong call.
While there were many different revenue recognition issues that surfaced in 2000, one of the hot topics was the debate over reporting gross revenue or net revenue.
was a much talked-about practitioner of the gross revenue style back in April 2000. For example, the company buys an airline ticket from a carrier for $100 and sells it for $150. It makes $50 on the deal. But the company records $150 as revenue and the $100 as a cost. Granted, the net effect is still $50, but that's inflating revenue.
Fortunately, the SEC responded with some guidelines.
Staff Accounting Bulletin No. 101 was introduced and became the new bible. As a result, many companies have had to restate their numbers to comply with these new rules, so expect to see adjustments to the financial statements, says Norman Strauss, the national director of accounting standards for
Ernst & Young
in New York.
SAB 101 had to be implemented in the fourth quarter of 2000, so be on the lookout for these adjustments in the midst of earnings season. As a matter of fact, most recent earnings releases have some reference to SAB 101 and how it affected the company's bottom line.
The problem of revenue recognition will never go away, though. As long as new biz models keep popping up, new methods of making money and, therefore, of recognizing revenue will arise, says Robert Garland, national managing partner in the assurance and advisory practice of
Deloitte & Touche
Other Trends Started in 2000
One area that did not receive as much publicity in 2000 was the push to globalize accounting and auditing standards, says Garland. Currently, financial statements differ from country to country. This makes doing business across borders difficult. For example, if a U.S. company is trying to analyze a prospective acquisition target from, say, Brazil, the target's financials first must be translated into U.S. standards.
Much progress has been made to harmonize to the standards, says Garland. But look for this to continue during the next few years.
Performance measures or value drivers are making their way to the forefront. In many instances, the numbers on the financial statements do not tell the whole story, so investors need a broader set of information, says Anderson.
For instance, what's the company's capacity for new product innovation? How does management stack against its peers? What's the customer satisfaction level? All these intangibles can add (or subtract) merit to a company's position. The
Financial Accounting Standards Board
has started to issue literature on how to measure and report these value drivers, and while there are no standards at this time, expect to see these measures sprinkled in some analysts' reports and company financials.
Of course, I'd be remiss without mentioning the much publicized
Regulation FD, the other legacy of the SEC's Arthur Levitt, that is supposed to promote the fair disclosure of company information to all investors, from the pros to the do-it-yourselfers.
It's a bit early to tell what kind of impact this policy will have on investors, although we have already seen a ramp-up in earnings preannouncements, since most companies are being diligent about following the new rules. We'll know more as 2001 rolls on, though.
So don't give up the gossip rags. Just be sure you place as much emphasis on new accounting changes as you do on the
who-wore-what to the recent Golden Globe Awards.
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