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Occasional Paper Series
Accounting is often criticized for omitting intangible assets from the balance sheet. With value in firms of today flowing less from tangibles assets and more from so-called intangibles – brands, distribution systems, supply chains, “knowledge capital,” “organization capital” – accounting is seen as remiss, with high price-to-book ratios as evidence. The remedy often proposed involves booking these intangible assets to the balance sheet.
This paper makes the point that accounting is not necessarily deficient in omitting intangible assets from the balance sheet: there is also an income statement, and the value of intangible (and other) assets can be ascertained from the income statement. For example, although The Coca-Cola Company does not report its brand asset on its balance sheet (and trades about five time book value), earnings from the brand flows through its income statement. Thus the firm is readily valued from its earnings; the income statement remedies the deficiency in the balance sheet. Accordingly, accounting that calls for the recognition of “intangible assets” on the balance sheet may be misconceived.
The paper explores the case where the income statement perfectly corrects for a deficient balance sheet, and the case where it does not. It then explores whether, in the latter case, accounting in the balance sheet – by capitalization and amortization of intangible assets or carrying them at fair value – could remedy the deficiency in the income statement (or makes it worse). The investigation involves an analysis and valuation of Microsoft Corporation and Dell, Inc., two companies presumed to possess a good deal of “intangibles assets.”
The paper is instructive, not only to those concerned with accounting issues, but also to analysts attempting to value firms with assets missing from the balance sheet. It shows how to handle the accounting information in valuation and how to deal with the perceived deficiencies, real or imagined, with respect to intangible assets. In the case of Microsoft and Dell, the reader can observe at how close one comes to their market valuation by using valuation techniques that use accounting information currently provided by GAAP.
Columbia Business School Professor Stephen Penman is an author of this Occasional Paper.
The Subject Matter of Financial Reporting: The Conflict between Cash Conversion Cycles and Fair Value in the Measurement of Income
This paper challenges the view of primacy of a balance sheet-based financial reporting model and its extension into a full fair value accounting model. The paper considers that the business activity is the primary object of financial reporting, which is characterised as investing cash in non-cash resources to be combined according to a specific economic logic to generate future net cash flows. The production of net cash flows is the business activity in its entirety, not single non-cash resources or constructs like "net assets". The paper argues that different business activities have different business models based on a different economic logic and that the value of a non-cash resource to an activity depends on the way it contributes to the net cash inflows under the economic logic of the activity in progress, i.e. depending on its function and use. The paper claims that accounting concepts and measurement attributes have to be aligned with the inherent economic logic of an activity if faithful representation is to be achieved.
Andreas Bezold, a former chief risk officer and deputy CFO of a large German Bank, authored the paper.
Financial Reporting Model
The FASB adopted a balance sheet-based model of financial reporting about 30 years ago, and this model has been gradually expanded and solidified to become the required norm around the world today. Currently, the FASB and the IASB are re-considering their Conceptual Framework, and this is the right time to have a much-needed debate about the proper conceptual foundations of accounting.
Professor Ilia Dichev of the Ross School of Business at the University of Michigan has been commissioned to prepare this Occasional Paper.
Fair Value Policy: Impact on the Banking Industry
This paper studies the application of fair value accounting in bank holding companies in the United States with the purpose of evaluating the effects of expanding fair value accounting in the banking industry.
The paper documents the current application of fair value accounting in the industry, showing what proportions of recognized assets and liabilities of bank holding companies are at or close to fair value on the balance sheet, have related unrealized gains and losses in income, or have fair values disclosed in the footnotes. In each case, it evaluates the advantages and disadvantages of the current treatment and makes an assessment of the magnitudes of economic assets and liabilities that currently are omitted from the balance sheet. Turning to the issue of the likely impact of expanded application of fair values, the paper asks how large are the actual and potential differences between fair values and book values of various assets and liabilities and how credit, interest rate and prepayment risks are likely to determine those differences. It considers the availability of market-based information for measuring fair value and evaluates the correlations between fair values of economic assets and liabilities due to natural hedges, asset-liability management, and changes in asset values affecting the risk and value of liabilities. It also addresses the issue of how a switch to fair value accounting would mitigate or, alternatively, facilitate earnings management activities.
The primary conclusion of the analysis is that expanding fair value accounting is not likely to significantly improve the information in bank financial statements and, in some cases, may introduce distortions that reduce accounting quality. The analysis is pertinent to bank analysts and investors for it not only documents the impact of fair value accounting on banks but also informs about the drivers of value and risk on which accounting should report.
Cash Flow Statement Analysis: Part II
Cash Flow Statement Occasional Paper
Investors have increasingly turned to the analysis of cash flows as a complement to, or even substitute for, the income statement. This occasional paper deals with this issue by addressing two questions. First, under what circumstances does it make sense to evaluate a firm's performance by focusing on cash flows rather than income/expense flows? Second, given the answer to this question, how can one best conceptualize a schedule of cash flows? This paper argues that the analysis of cash flows works effectively if one focuses on what is often referred to as "modified cash accounting". This approach is not equivalent to the usual analysis based on the statement of cash flows. The paper then discusses how one applies and implements modified cash accounting, with particular emphasis on the measures that indicate the quality of a firm's reported earnings.
Professor James Ohlson of Arizona State University has been commissioned to prepare this Occasional Paper.
Cash Flow Statement Analysis: Part I
Topic: Cash Flow Statement Occasional Paper
The presentation and classification of cash flow statement items has been an issue since 1987, when the FASB required businesses to provide a cash flow statement to investors. Reconsideration of several components on the cash flow statement are addressed and considered in two parts in CEASA's occasional paper series: Part I, "Perspectives on the Cash Flow Statement under FASB Statement No. 95" and Part II, "On the Analysis of Firms' Cash Flows", are now available online.
Our first Occasional Paper, "Perspectives on the Cash Flow Statement under FASB Statement No. 95," by Hugo Nurnberg, is now available on our website. This paper demonstrates that the current FASB cash flow statement classification rules are simplistic and wrought with internal contradictions, in part because they do not distinguish between financial and non-financial enterprises. As a result, the operating cash flow subtotal is often contaminated by the effects of certain investing and financing transactions, including the income tax effects of those transactions. Among other recommendations, the paper favors changing the classification rules to (1) require income tax allocation in the cash flow statement; and (2) distinguish between financial and non-financial enterprises.
For non-financial companies, interest payments are financing outflows, because they arise from borrowing, a financing activity; purchases and sales of most short-term non-trading debt securities are also financing flows, together with interest collections thereon, because they arise from parking excess cash balances, another financing activity, just the opposite of borrowing. For financial companies, however, taking deposits and honoring withdrawals are the opposite of making and collecting loans; both involve investing flows, whereas interest payments on deposits and interest collections on loans are operating flows. The paper demonstrates that reporting gross operating inflows and outflows under the direct method with a supplemental reconciliation of net income and cash flow from operations is more informative than reporting cash flow from operations under the indirect method. It also discusses how to adjust the cash flow statement to a prospective basis for analytical purposes.
Hugo Nurnberg is Professor of Accountancy at the Zicklin School of Business, Baruch College, City University of New York.
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