The fundamental elements of financial statements are assets and liabilities because all other elements depend on them. As expected, this drastic standard-setting shift didn't sit well with accounting constituents. After all, how many investment models and valuation methodologies are centred on assets? Very few, I venture. Indeed, as late as , Storey and Storey p. Misunderstanding isn't the real problem of the balance sheet model.
The problem is a misguided focus on asset valuation while neglecting the revenue—cost matching which articulates the universal business model: expending resources in the process of generating revenues. Unhindered by the widespread preference of preparers and users for the income statement approach, the two Boards pursued vigorously the balance sheet model in accounting and reporting standard-setting.
The ideological homogenization of the FASB. PhD Dissertation, Emory University. View all notes Most of the consequential standards enacted in the past quarter century — adjusting assets and liabilities to fair values, recognising impairments of assets and goodwill, etc. These adverse income statement effects of the balance sheet approach could not, of course, be ignored by managers and investors. Since, by definition, earnings income equal the periodic change in net assets adjusted for capital flows , it shouldn't make any difference whether earnings are measured as the difference in the values of net assets at two points in time the balance sheet approach , or directly by matching revenues to costs.
So, what's all this agonising about the choice between the balance sheet and income statement approaches? Who cares? Well, investors definitely care, because the choice between the income statement and balance sheet models is also a choice between the following two very different views of the purpose of reported earnings: The balance sheet model : earnings reflect the change in net assets equity between two points in time adjusted for capital changes. The income statement model : earnings is an indicator of the periodic performance of the enterprise and the quality of its management, as measured by revenues matched to expenses.
Thus, for example, goodwill write-off or restructuring costs recognised in a given period are often the consequences of past managerial blunders and have little to do with current or future enterprise performance. Painful as it was for HP shareholders and CEO, who was fired, the goodwill write-off had nothing to do with HP's performance during fourth quarter View all notes In contrast with the balance sheet approach to earnings measurement, the income statement-based earnings, derived by a process of carefully matching revenues recognised over the period with all the costs incurred in their generation, follow closely the business model of the enterprise.
Such earnings faithfully reflect enterprise performance, and provide a solid basis for predicting future performance.
As Dichev Dichev, I. On the conceptual foundations of financial reporting. Accounting and Business Research , 47, — Obviously, without such a detailed guidance, investors would have been unaware of these one-time items in the income statement. Qualifying special items: an identification and examination of lower-quality vs. Working Paper, University of Washington. Abandoning the matching principle and dumping on the income statement a host of valuation-adjustment items, whether related to current performance or not, was bad enough.
But this dwarfs compared with the damage to financial information from a major misapplication of the balance sheet asset valuation model: ignoring the most important value-creating resources of modern enterprises: intangible assets.
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Figure 2 , based on Corrado et al. Intangible capital and growth in advanced economics: measurement methods and comparative results. Discussion Paper No. Intangible capital and U. Review of Income and Wealth , 55, — View all notes Figure 2 clearly reflects a fundamentally transformed economy, dominated by intangibles which are currently the prime value-creators of business enterprises.
I raise the intangibles issue here not because it's novel or particularly original, rather because it is still a major cause of the deteriorating usefulness of financial information to investors. In the process, I will address several widely-held misconceptions regarding the accounting for intangibles. It is important to note that intangibles are the major resources of all competitive firms, not just high tech and science-based enterprises. Brands and trademarks are the major assets of durable and nondurable e. Intangibles are literally everywhere in the business world.
The intangibles revolution. US private sector investment in tangible and intangible capital relative to gross value added , — Source: Courtesy of Corrado and Hulten. Figure 2. The well-known deficient accounting treatment of intangibles — expensing internally generated intangible investments, while capitalising the functionally identical acquired intangibles — decreases substantially the usefulness of reported earnings as a measure of performance and value creation, as the following evidence shows. However, few major software developers follow this rule. View all notes And all this occurred while standard-setters took their eyes off the income statement focusing on the fair values of assets.
Ironically, the wrong assets.
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Dichev and Tang Dichev, I. Earnings quality: evidence from the field. Journal of Accounting and Economics , 56, 1 — Adequate matching, crucial to the quality of earnings, manifests itself in a high contemporaneous correlation between revenues and expenses, whereas poor matching income statement expenses unrelated to revenues, and vice versa detracts from the revenue—cost correlation. The adverse impact of this decline on the quality of earnings was, according to Dichev and Tang, serious: Earnings volatility has nearly doubled while the underlying volatilities of revenues and expenses have remained roughly the same [meaning that it's not macro or industry revenue or expense volatility increases that raised earnings volatility; rather it's the self-inflicted deteriorating matching that did the damage].
Earnings persistence [a necessary condition for the ability of earnings to predict firm performance] has substantially declined from [an intertemporal earnings association of] 0. In addition, the prevailing philosophy and the specific current agenda of both the FASB and IASB suggest that this trend is going to continue, and thus a future in which reported earnings have evolved into something which is divorced from their classic role as a gauge of long-term value looks highly probable in the next 30 to 50 years.
I concur, as my research indicates that reported earnings are already largely divorced from long-term value changes Lev and Gu Lev, B. What caused the deterioration in the revenue—cost matching and the quality of earnings: the proliferation of one-time items in the income statement, resulting from the fair value and impairment standards, or the failure of standard-setters to adjust accounting to the fundamental economic changes portrayed by Figure 2?
A similar view of the impact of one-time items on earnings usefulness is obtained from the R 2 of annual regressions of market values on earnings, which is reported in Figure 3. So, while a nuisance, one-time items are not the major cause of the revenue—cost matching deterioration, and the consequent earnings relevance lost. One-time items are not the cause of the deteriorating relation between earnings and market values.
Figure 3. As made clear by Figure 4 , the intensity of intangible investments, expensed in the income statement, is the major reason for the deteriorating revenue—cost matching and the consequent quality of earnings decline. It therefore shows the regression coefficient on current expenses. View all notes It is evident from Figure 4 that while the revenue—cost correlations matching of both groups were fast deteriorating over the past five decades, the correlations of intangibles-intensive firms are consistently and substantially lower than those of less intangible-intensive firms.
It is thus the indiscriminate expensing of intangibles in the income statement that adversely affects earnings message and quality. Declining matching between revenue and expenses over time: Low-intangibles vs.
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Figure 4. Finally, a different perspective of the impact of intangibles on financial information relevance is portrayed in Figure 5 from The End of Accounting , The upward-sloping curve in Figure 5 portrays the increasing intangibles-intensity of successive vintages of new firms entering the market, while the fast-decreasing bars indicate the consequent decline in the relation between market values and the two key financial report variables: earnings and book values.
Corrado et al. Re-computing segments of the national accounts with intangibles as capital led Corrado et al. What is surprising is that intangibles have been ignored for so long, and that they continue to be ignored in financial accounting practice [GAAP] at the firm level.
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Measurement challenges remain, like the proper amortisation rate of the capitalised intangibles, but these challenges didn't deter the Bureau of Labor Statistics from recognising reality — that intangibles are the major value drivers at both the business enterprise and economy levels. Keep reading please. R 2 s of regressions of market values on earnings and book values of companies entering the public market in successive decades, — Figure 5.
Recall A. Value and price in accounting. The Accounting Review , 4, — Has goodwill accounting gone bad? Review of Accounting Studies , 22 2 , — Figure 6 , from Lev and Gu Lev, B. Researchers, therefore, use a proxy of the number of mentions of estimates-related terms in financial reports for the actual number of estimates. See, for example, Chen and Li Chen, J.
Estimating the amount of estimation in accruals.
Working Paper, University of Illinois. View all notes The five-fold increase in the frequency of estimates mentioning in the reports, from 30 per firm in to in , is the obvious outcome of pursuing the balance sheet model of fair valuation. Increasing frequency of estimates-related terms in financial reports. Figure 6. They require that estimates be described as such in the reports, that the nature and limitation of the estimation process be explained, and that no errors are made in selecting an appropriate process for developing the estimates.
But these requirements primarily deal with representation issues, and don't mitigate the adverse consequences of accounting estimates on the quality of financial information.