A former chief accountant of the Securities and
Exchange Commission I think summarized it pretty eloquently.
Robert Herdman says, as the complexity and the subjectivity of judgments increase,
the inherent precision in the financial statements decreases,
which is a fact that investors should be told.
And I would hope that that's a fact that investors generally know,
certainly reasonably sophisticated investors.
So this comes down to a realization on your part,
that when you see different line items being added up in a balance sheet or
added and subtracted in an income statement,
that you're really not, even though everything is denominated in dollars, or
in pounds, or in euros.
And they look the same on the surface, you understand that there is
a different measurement basis being applied to many of this line items and
you're not adding really apples to apples.
It just looks like that and in
some sense these financial statements create the false sense of precision.
So what I want to hammer on right now, is characteristics
affecting users perceptions of the quality of earnings.
In that user definition I'm including auditors.
So take a look at this table. You have at the top row,
you have continua. So you have cash to non-cash, based on a fixed amount or
based on an estimate and recurring or nonrecurring.
And what I have here for you in these next series of slides is
some characteristics and some examples that would be relatively
higher quality and relatively lower quality when it comes to and,
I should say, perceived quality by users.
So, if you're looking at cash earnings, you're on the very cash end of that
continuum, and if it's a recurring sale, for which cash has been received,
this is a high quality...perceived high quality kind of earnings.
If it's something that rather is based on fixed and certain amounts from completed
transactions, like occurring sales of tangible delivered products,
you're again, in the space of relatively high perceived earnings quality.
But as you move to non-cash earnings,
like in the case of goods sold in exchange for stock of another company.
Well now you're in a little bit more complex area.
And you may remember from your intermediate accounting, that when you
have these types of non-cash exchanges, you usually look for the fair market value
of the consideration given or received, whichever is more readily determinable.
Another example here is if you have a transaction based on
an amount subject to change due to changes in estimates or market conditions.
And this is where you're really looking at some ambiguity with mark to market types
of derivative contracts.
I want to give you a couple more examples here to help drive home
these 3 continua, cash, non-cash,
based on fixed amount measurable or based on an estimate.
And, of course, estimates vary in terms of the inherent uncertainty of
the assumptions that drive those estimates, and also recurring and nonrecurring.
So let's look at another one.
What about a transaction that results from an arm's length, commonly
executed event, with independent parties? Well, a sale to independent customers.
That's going to be pretty easy to get high perceived earnings quality.
If you, on the other hand, moving over now to the...instead of going
down all the columns this time, I'll move from my left to the right.
What about a return or result from a sales to a related party or
something that is uniquely structured transaction, like you are selling
an off balance sheet, sales to an off balance sheet special purpose entity.
That would be something that
is going to have low perceived earnings quality, excuse me.
A couple more, if you have a transaction that's the result from assets or
liabilities recorded at cost, like interest on investments,
that's going to be pretty high quality in terms of perceived earnings.
If you have a transaction that results from assets or
liabilities recorded at some other value, like replacement value or fair value.
Fair value would mark to market held for sale securities,
if you're getting into a relatively low quality earnings.
And then there's one more row there that you can look at yourself and contemplate.
But what I'm really setting up here is two continua.
I think that is worthwhile in thinking about.
So on an x-axis you could think of cash and non cash transactions,
or y-axis I should say, and your x-axis is recurring and
fixed amounts are nonrecurring or estimates subject to change.
And really what I've got here obviously is those three continua and I've put cash,
non-cash on the y-axis.
And the x-axis, I've had two of those things, recurring, non-recurring, and
fixed amounts versus estimates.
And when you lay it out that way what you can see is you go to
that northeast quadrant, you're getting more and more subjective.
And that greater area of subjectivity is
where there is a perception of lower earnings quality.
And in some sense, those are the areas where bringing in a third party
independent verifier, like a financial statement auditor,
can be most helpful in reducing investors concerns about
the overall quality of the financial statements.
Mark E. Peecher, PhD, CPAAssociate Dean of Faculty and Deloitte Professor of Accountancy
