Accounting: The Language of Business - Vol. 2 (Intermediate: Part 16)

There are two kinds of discontented in this world, the discontented that works and the discontented that wrings its hands. The first gets what it wants and the second loses what it has. There is no cure for the first but success and there is no cure at all for the second. The very worst of my vices and bad habits will abate of themselves if they are brought to an accounting every day.

Og Mandino

Judgment and Applied Financial Accounting Research (Part A)

by

Charles Lamson

Introduction

Accountants use judgment almost every day in their work when they evaluate facts to make a decision. For example, analyzing a business event and determining whether to record it or deciding whether to record a liability for pending litigation involves a great deal of judgment. Selecting and applying accounting methods such as the choice of a cost flow assumption (e.g., LIFO versus FIFO, see part 52 of Vol. 1) in inventory valuation---and using assumptions and estimates in financial reporting also require judgment. Determining the provision for bad debts relies on the use of estimates. Financial statement preparers use the best information available to make these judgments, knowing business activities could change and there could be new information in the future.

Managers use judgement in preparing financial statements, making the best estimates at that time. Consider Activision Blizzard, a leading provider of interactive game services. Activision Blizzard users play games for free yet, within these games, they can purchase virtual currency to obtain virtual goods to enhance their game playing experience. For example a Candy Crush player may purchase "gold bars." How does Activision Blizzard determine when the virtual goods are used and when to record revenues? Initially, Activision Blizzard records on earned revenue when players buy the virtual currency and virtual goods. Activision Blizzard recognizes revenue as the players use their virtual goods. Some virtual goods are consumable and used within days whereas others are durable and used over long periods of time. Activision Blizzard relies on historical data and making judgments about when the virtual goods are used and when to record revenues. However, assumptions based on historical data can change rapidly in young, growing, and dynamic markets such as social game services. If Activision Blizzard revises assumptions based on new data, changes its product mix due to new game introductions, or modifies estimates used such as average playing periods, the amount of revenue recognized may differ significantly from one period to the next.

In the next several posts, we identify areas in financial reporting that require judgment. We explore the assumptions and estimates disclosed in financial reports and highlight key judgement areas found in practice. We then discuss some obstacles to the use of good judgment and ways to overcome them. Because accountants are required to make judgments based on accounting standards and other authoritative literature, the authoritative literature in use for both U.S. GAAP and IFRS will be explained. We then outline the six steps used in the applied financial accounting research process. While the accounting standards differ, the use of judgment in the applied financial accounting research process are similar under U.S. GAAP and IFRS.

The Importance and Prevalence of Judgement in Financial Reporting 

When first studying accounting, most people expect to encounter clear cut methods and rules. In practice, accountants frequently use judgment to prepare and audit financial statements. Judgment is the process by which an accountant or manager reaches a decision in situations in which there are multiple alternatives.

Judgment and the Accountant

Accountants use judgment in several aspects of accounting and financial reporting, including researching and interpreting standards. Here, accountants seek answers to questions such as:

1. Should the company report a business event and, if so, when? For example, at times there are complexities involved in deciding when to recognize revenue. Specifically, should the company recognize revenue this year or deferred until future periods?

2.  If the company decides to report a business event in the current period, then what is the appropriate financial reporting treatment? For example, there are multiple methods for reporting an investment in the equity of another company. Thus, when a company acquires that investment, accountants must decide which accounting method is most appropriate.

3.  What amount(s) should the company report in the financial statements related to this business event? For example, when a company purchases inventory, there may be costs (such as freight costs) associated with that purchase other than the cost of the inventory itself. Accountants must determine what costs to include in the amount recorded as inventory.

Activision Blizzard, the social game service company, faced these types of questions when it started its business. In the new social media field, Activation Blizzard, needed to grapple with how to apply revenue recognition rules developed years earlier to the way it delivers its virtual products.

Judgment: Use and Abuse

Accounting standards allow financial statement preparers to use judgment to report the substance of a transaction in the financial statements, within certain boundaries, in the manner that best reflects economic reality. The ability to apply judgement enhances the usefulness of the financial statements. Of course, management might also use this latitude to engage in earnings management behavior. Earnings management occurs when managers manipulate financial information and misrepresent the firm's financial position and performance. We will discuss earnings management in more depth in a later post.

Judgment and Financial Statement Comparisons

Accounting standards afford management discretion in selecting accounting methods, applying these methods, and changing methods or estimates. This latitude can be problematic for users comparing the financial information reported by two firms in the same industry when each firm uses a different set of accounting methods or estimation techniques. In addition, the same firm may change its methods or estimation techniques over time. However, the flexibility afforded in the selection and application of accounting standards permits managers to choose those methods and assumptions that best reflect the economic reality of their transactions. Therefore, the financial information provided and user decisions based on that information may be enhanced by not requiring all companies to use the same accounting methods.

For example, consider two firms in the same industry: one uses the average-cost inventory method and the other uses the first-in, first-out (FIFO) inventory costing method (for a brief review of these methods, see part 52 of Vol. 1). The different inventory costing methods mean that the firm's financial statements will reflect different measurement bases for inventory. To compare the inventory balances as well as the cost of goods sold of these two firms, the investor will need to "undo" the effects of the inventory costing method choice. That is, a reasonably informed financial statement user would understand that ending inventory would be higher under FIFO than under average cost in a period of rising prices. Knowledge of the direction of the bias in the reported inventory valuation enables the financial statement user to interpret the results with ratio analysis and other financial statistics.

Accountants use their judgment to estimate and record economic events as accurately as possible.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 55-56*

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