Role of Accounting Methodologies

Financial reporting is a critical aspect of the finance function as it is the way in which the company is communicated to stakeholders, whether internal (management and owners) or external (creditors, governmental agencies, and absentee shareholders). Ultimately it is the owner of the business who is responsible for the accuracy of data disseminated in financial statements, a point worth noting especially when external data customers are significant. How the finance function deals with the challenge of data issues and financial statement preparation, particularly misinterpretations, bias, and ambiguities related to data, is ultimately the owner’s responsibility. Avoiding these potential shortfalls in the reporting process will depend, to a large extent, on the implementation of uniform, relevant, and practical accounting methodologies that fit the business.

The common set of standards and procedures set forth by the accounting profession are embodied in GAAP. These principles and practices represent, in some cases, very specific rules on accounting for specific transactions in particular industries or general guidance on how to approach circumstances and events. Because the goal of GAAP is not to prescribe the correct treatment for every possible transaction that could be encountered in every business circumstance, a certain level of judgment must be exercised when applying GAAP. A transaction may fit more than one GAAP treatment, depending on the business circumstance. This level of subjectivity makes applying GAAP more of an art than a science. Nevertheless, establishing the accounting standards that fit the business and applying them consistently will underscore the financial reporting effort. Finance strategists must discern such matters as what accounting treatments to use and when. They also will have to identify the manner in which certain rules will be applied. Is it appropriate to be aggressive or conservative with revenue recognition? Should expenses be capitalized or charged to the P&L? Although one would think taking a conservative stance on applying accounting principles would be the rule, executives and managers have an obligation to act in the best interest of owners (shareholders). If the company is publicly traded and market capitalization (shares outstanding share price) is the chief metric, management may have an obliga
tion to be aggressive with certain accounting rules to fulfill their duty as data stewards for the owners. This is a very subjective and controversial area. It is enough, though, to understand that many gray areas exist in applying GAAP to the company and that financial reporting will be heavily dependent on how it is interpreted by the organization and applied to the company’s circumstances.

Role of Policies and Procedures

Establishing clear, consistent accounting methodologies is the first step to ensuring that financial reporting is adequate. The finance strategist will be charged with creating a mechanism that employs all accounting and reporting methodologies consistently over time and across the organization. Publishing a set of companywide finance policies and procedures will lend uniformity to the entire finance function and ensure that all members of the organization have a uniform resource for processes, accounting treatments, systems maintenance, and the like. Creating a policies and procedures manual may be as simple as accumulating certain documentation related to the finance function or as complex as codifying best practices developed from careful studies and research.

Not having key finance policies and procedures documented and available in one location could be expensive to the organization. The lack of uniformity may result in costly learning curves, inefficiencies, turnover, and high training costs. A more subtle cost of not having clearly communicated policies and procedures will be incorrect or inadequate financial reports produced by the finance function.
Policies and procedures can apply to any aspect of the organization; however, in the context of the finance function, they define what accounting methodologies are to be used and how they will be applied. They also outline how processes are to be followed, particularly who does what and when. This area is particularly critical as it relates to time-sensitive closing processes. They should clearly communicate management’s expectations for specific job tasks and include a clear definition of the policy, its purpose, scope, and the steps (if necessary) that accompany it. The policy and procedures manual must be easily accessible to all relevant members of the finance team. It may reside on an intranet website or common network directories or be stored in a shared area of the office. Finance strategists must go beyond creating policies and procedures and challenge the organization to ensure that they are being used properly. To do so they must rely on the culture of the enterprise and strength of management.

Benchmarking and Seeking Consensus

The business owner/manager will have two perspectives in approaching the application of GAAP to the organization: external and internal reporting. The objective in applying GAAP to the business for external reporting purposes is to find the most defensible position (whether it is aggressive or otherwise) for the company’s reporting objectives. For internal reporting purposes, needs will center on translating the business accurately to financial statements to facilitate analysis and decision making. In most cases the level of sophistication of data customers (both internal and external) will dictate the quality level of accounting and disclosures. Where does the finance strategist go to seek guidance on applying GAAP to the business?

The most reliable methodology for applying GAAP “correctly” to the company’s circumstances is to see what the business’s peer group in the industry is doing. Crucial areas of reporting are revenue recognition and the treatment of expenditures. The best place to go for guidance is to seek out public disclosures of companies in similar industries. The SEC’s Form 10K provides the most comprehensive disclosure of accounting results and policies. This is an annual filing of results and policies required by public companies as dictated by the SEC. A key area of Form 10K as it relates to accounting policy is Footnote 1 to the financials, “Summary of Significant Accounting Policies.” This footnote allows the company to explain the way it employs certain accounting methodologies peculiar to its circumstances. For example, seeking guidance on how to book research and development and software costs may be as easy as going to Footnote 1 of the financial statements in Form 10K for Microsoft and IBM. The biggest challenge for the finance strategist is identifying public companies in the business’s industry. The Internet is a good resource, particularly the SEC website (www.sec.gov). Bloomberg Professional™ service is also a useful tool for this purpose, although it is a subscription service.

Form 10Ks issued by companies in similar industries. Other resources for benchmarking may be a local CPA or industry gathering. Oddly enough, one of the most effective ways to benchmark may be a simple phone call to a controller or CFO of a company in a similar industry. Professionals often welcome the opportunity to network and share thoughts on these matters.

Why is it important to seek a consensus on accounting methods? As indicated earlier, GAAP are far from detailed rules set in stone. They are as their name implies—a widely held consensus of acceptable methodologies. Data customers will, however, seek consistency and consensus with the rest of the reporting world. If the company is private and/or closely held, applying GAAP may not be an urgent matter. However, doing so becomes an issue when and if the business seeks financing, pursues public funds, or wishes to be acquired. Employing GAAP inappropriately in financial statements may result in adjustments to them during the due diligence process. Examiners (auditors) who are well versed in industry accounting will use this consensus approach to evaluate the fairness with which the company’s financial statements conform to GAAP. Almost overnight company results can be significantly diluted if they are not prepared initially in accordance with GAAP. Waiting for an important event in the company life cycle to find out that GAAP has been employed inappropriately may be expensive and lead to a besmirched management reputation and/or the expense related to a due diligence process that does not yield financing. If the purpose for being examined is stymied because of financial statement adjustments, the whole company suffers and the business life cycle could be drastically altered.

Developing Accounting Methodologies

Translating the business to financials will require management/owners to determine the level of aggressiveness of certain accounting positions. Purists in the accounting world maintain that the company’s performance is what it is and there is no room for editorializing results. Practically speaking, the objective of external reporting is to make the company look good on paper without materially misrepresenting results. The objective for internal reporting purposes is to translate the company’s performance and financial state accurately. There are two potential pitfalls to avoid:

1. Making the company look good in the near term at the expense of the future

2. Sacrificing presentation on one financial statement to enhance that of another

To navigate these issues properly, the finance strategist must employ a companywide approach to preparing financial statements and setting accounting policy.
To avoid making the company look good in the near term at the expense of the future, the finance strategist must understand revenue streams and disbursements. If accelerating revenue from a certain transaction serves a reporting purpose now, what are the effects on reporting in the future? An example of this dilemma is recognizing the steady revenue from operating leases over an extended period versus accelerating the lease payments and employing sales-type lease accounting. Although many other factors affect the use of sales-type lease accounting, in this circumstance the steady revenue stream would be eliminated in return for a lump-sum revenue number today. This may be good if the company is positioning itself for an acquisition, but it may backfire if the company is public and feeling pressure to make periodic earnings estimates indefinitely. Essentially the company would be mortgaging future revenue for a quick hit now.

Avoiding a sacrifice on the presentation of one financial statement to enhance that of another also requires an understanding of revenue streams and disbursements. A good example involves the deferral of expenses. If the company is trying to maximize earnings, it is tempting to capitalize expenses (i.e., put them on the balance sheet rather than on the P&L). Doing so also may distort the long-term view of financial statements. This approach will have an impact on other financial statements, unlike employing sales-type lease accounting, however. Inconsistencies may result when analyzing the P&L in relation to the statement of cash flows. Atelling statistic is comparing cash flow from operations to earnings over time. A rate of growth in cash flow over time that lags behind the rate of earnings growth is a red flag to financial data customers. Although certain company initiatives are expected to have this effect (a planned investment in infrastructure over time, for example), systematically window-dressing earnings by moving P&L items to the balance sheet eventually will create a situation that is difficult to explain to stakeholders. Companies that overcapitalize expenses fall into this analytical quagmire, as do companies that take advantage of nonrecurring write-offs. Companies that regularly announce restructuring or special below-the-line charges are a prime example of offenders in this area.

Both cases illustrate that financial statements as a whole must be taken into account when considering accounting policy. The finance strategist will be compelled to maximize company results on paper and position the company for the future or at the least avoid putting the company in a disadvantaged situation. Regardless of reporting needs, the finance strategist must ensure that the finance function translates the company accurately to financials to give data customers the opportunity to make well-informed decisions.

Aunique circumstance that is worth discussing as it relates to applying proper accounting methodologies to the business is the issue of addressing foreign GAAP. Multinational companies face a unique challenge in dealing with both statutory reporting requirements of a particular country in which they do business and U.S. GAAP requirements. Public or private, if the company is doing business in other countries, it will have to submit to local reporting rules. Local GAAP in a particular country may be made up of International Accounting Standards (IAS), its own particular accounting rules, or a combination of the two. These rules vary from country to country, and ignorance of the rules is no excuse for not complying. How well has the finance function mastered the foreign rules that govern operations? How well is the company converting foreign GAAP financials to U.S. GAAP?
How will the different levels of the organization address the knowledge level of local and U.S. GAAP? It is not uncommon for a multinational company to hire local professionals to manage a local subsidiary. When cultural and language considerations are factored in, this is often the best way to position the local subsidiary for success. Although local professionals may be familiar with local GAAP, how familiar are they with U.S. GAAP? This becomes an issue only when the world headquarters consolidates the worldwide data. U.S. personnel more often than not assume that the data they receive is in U.S. GAAP form, while local professionals submitting the data assume the U.S. team will convert it where necessary. Unless told otherwise, the headquarters team has no reason to believe any differences exist in the first place. This creates concern when management is looking at data submissions from many different countries. Two issues must be addressed here:

1. What, if any, differences between U.S. GAAP and foreign GAAP exist on the financials?

2. How challenging is the process of converting foreign GAAP to U.S. GAAP?

The finance strategist must understand where the differences in accounting methodologies lie. Are there differences in revenue recognition, expense accruals, or the recording of intangibles? Whether the GAAP conversions are done manually or automatically, the time and effort put into making conversions every period can create slowdowns in the data flow process and leave it prone to error.
This issue has become a hot topic with the SEC of late as more and more bigmarket players are competing globally. The SEC’s goal is to arrive at a consensus on global GAAP. The chances of this happening within a reasonable amount of time are slim due to the myriad of cultural and governmental barriers. However, it is worth noting that the SEC and external data customers are aware of the impact of foreign GAAP on the financial statements, which behooves all multinational organizations to address the issue in some way. If the business is currently or intends to be multinational, the finance strategist must:

- Understand the differences in revenue recognition methodologies

- Know when hyperinflationary accounting must be addressed

- Know when thin capitalization rules must be addressed

- Understand the treatment of intangibles for both local and foreign GAAP purposes