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3.2 Reported Profitability and the Impact of Conservatism
At the end of this section, students should be able to meet the following objectives:
- Describe the method used to differentiate assets from expenses.
- Discuss the rationale for the practice of conservatism and its effect on financial reporting.
- Explain the reason dividend distributions are not reported as expenses within net income.
- Discuss the need for decision makers to study an entire set of financial statements rather than focus exclusively on one or two numbers such as net income or gross profit.
Differentiating between an Asset and an Expense
Question: Previously, the term “asset” was defined as a probable future economic benefit owned or controlled by a reporting entity. On an income statement, items such as rent and advertising are listed as expenses. Why are such costs not grouped with the assets on the balance sheet? For example, rent paid for a building could provide a probable future economic benefit but it is included in Figure 3.1 "Income Statement" as an expense. The same is true for advertising. How does an organization determine whether a cost represents an asset or an expense?
Answer: Deciding whether a particular cost should be classified as an asset or an expense is not always easy for an accountant. If a business makes a $10,000 rent payment, an expense might have been incurred because an outflow of an asset (cash) has taken place. However, the cost of this rent could also be reported as an asset if it provides probable future economic benefit.
A cost is identified as an asset if the benefit clearly has value in generating future revenues whereas an expense is a cost that has already helped earn revenues in the past. With an asset, the utility associated with a cost is yet to be consumed completely. With an expense, the utility has already been consumed. To illustrate, assume that on December 31, Year One, a business pays $10,000 for rent on a building that was used during the previous month as a retail outlet. The benefit gained from occupying that space has already occurred. Use of the building helped the business make sales during December. The reduction in net assets to pay for the rent is reflected on the income statement as a rent expense. The benefit is in the past.
If on that same day, another $10,000 is paid to rent this building again during the upcoming month of January Year Two, the acquired benefit relates directly to the future. The building will be occupied in January in hopes of creating additional revenue. Until consumed, this second cost is shown as a $10,000 asset (referred to as “prepaid rent”).
- Expense. A cost that helped a business generate revenue in the past.
- Asset. A cost expected to help generate additional revenue in the future.
When a cost is incurred, the accountant must investigate its purpose to determine when the related benefit is expected. This timing—as guided by U.S. GAAP or IFRS—indicates whether an asset should be recognized or an expense.
In a set of financial statements, a company reports an account balance of $19,000 labeled as “prepaid insurance.” Which of the following is not true in connection with this account?
- The account appears on the company’s income statement.
- The money was paid in the past but will provide benefit in the future.
- The account is an asset.
- The cost is expected to help generate future revenue.
The correct answer is choice a: The account appears on the company’s income statement.
The account title implies a benefit to the company in the future. A payment has been made for insurance coverage on assets such as buildings and equipment over the next few months or years. Because the benefits are yet to be derived, this cost cannot be reported on the income statement; rather, it must be reported as an asset on the balance sheet.
Conservatism in Financial Accounting
Question: A business or other organization can face many complicated situations. Determining fair presentation is often not easy. For example, at times, the decision whether a cost will generate revenue in the future (and be reported as an asset) or has already helped create revenue in the past (and is, thus, an expense) is difficult. When an accountant encounters a case that is “too close to call,” what reporting is appropriate? To illustrate, assume that a business agrees to pay $24,000 but corporate officials cannot ascertain the amount of the related benefit that has already occurred versus the amount that will take place in the future. When clear delineation of a cost between asset and expense appears to be impossible, what reporting is made?
Answer: Working as an accountant is a relatively easy job when financial events are distinct and easily understood. Unfortunately, in real life, situations often arise where two or more outcomes seem equally likely. The distinction raised in this question between an asset and an expense is simply one of numerous possibilities where multiple portraits could be envisioned. At such times, financial accounting has a long history of following the practice of conservatismPreference of accountants to avoid making an organization look overly good; when faced with multiple reporting options that are equally likely, the worse possible outcome is reported to help protect the decision maker from information that is too optimistic..
The conservative nature of accounting influences many elements of U.S. GAAP and must be understood in order to appreciate the meaning of financial information conveyed about an organization. Simply put, conservatism holds that whenever an accountant faces two or more equally likely possibilities, the one that makes the reporting company look worse should be selected. In other words, financial accounting attempts to ensure that an organization never looks significantly better than it actually is.
Differentiating between an asset and an expense provides a perfect illustration of conservatism. If a cost is incurred that might have either a future value (an asset) or a past value (an expense), the accountant always reports the most likely possibility. That is the only appropriate way to paint a portrait of an organization that is the fairest representation. However, if neither scenario appears more likely to occur, the cost is classified as an expense rather than an asset because of conservatism. Reporting a past benefit rather than a future benefit has a detrimental impact on the company’s appearance to a decision maker. This handling reduces reported income as well as the amount shown as the total of the assets.
Conservatism can be seen throughout financial accounting. When the chance of two possibilities is the same, accounting prefers that the more optimistic approach be avoided.
The Reason for Conservatism
Question: Why does conservatism exist in financial accounting? Every organization must want to look as successful as possible. Why does a bias exist for reporting outcomes in a negative way?
Answer: Accountants are well aware that the financial statements they produce are relied on by decision makers around the world to determine future actions that will place significant amounts of money at risk. For example, if a company appears to be prosperous, an investor might decide to allocate scarce cash resources to obtain shares of its capital stock. Similarly, a creditor is more willing to make a loan to a business that seems to be doing well economically.
Such decision makers face potential losses that can be substantial. Accountants take their role in this process quite seriously. As a result, financial accounting has traditionally held that the users of financial statements are best protected if the reporting process is never overly optimistic in picturing an organization’s financial health and future prospects. Money is less likely to be lost if the accountant paints a portrait that is no more rosy than necessary. The practice of conservatism is simply an attempt by financial accounting to help safeguard the public.
The problem that can occur when a business appears excessively profitable can be seen in the downfall of WorldCom where investors and creditors lost billions of dollars. A major cause of this accounting scandal, one of the biggest in history, was the fraudulent decision by members of the company’s management to record a cost of nearly $4 billion as an asset rather than as an expense. Although any future benefit resulting from those expenditures was highly doubtful, the cost was reported to outsiders as an asset. Conservatism was clearly not followed.
Consequently, in its financial statements, WorldCom appeared to have $4 billion more in assets and be that much more profitable than was actually true. At the same time that its two chief rivals were reporting declines, WorldCom seemed to be prospering. Investors and creditors risked incredible amounts of their money based on the incorrect information they had received. Later, in 2002, when the misstatement was uncovered, the stock price plummeted, and WorldCom went bankrupt. Conservatism is designed to help prevent such unnecessary losses. If no outcome is viewed as most likely, the accountant should always work to prevent an overly optimistic picture of the reporting entity and its financial health.
Which of the following is not an example of the effect of the practice of conservatism?
- A company has revenue, but the revenue is not reported because of some uncertainty.
- A company has a liability, but the liability is not reported because of some uncertainty.
- A company has an asset, but the asset is not reported because of some uncertainty.
- A company has a cost that is reported as expense because of an uncertainty about the future benefit.
The correct answer is choice b: A company has a liability, but the liability is not reported because of some uncertainty.
The practice of conservatism holds that when outcomes are equally likely, the option that makes the reporting entity look worse should be reported. Delaying the revenue in A and the asset in C are both examples of conservative reporting. Recognizing an expense in D rather than an asset also reduces reported income and total assets. However, delaying the reporting of the liability in B improves the way the company’s financial position appears. Reporting fewer debts makes the company look better.
Reporting Dividend Distributions
Question: Previously, the term “dividends” was introduced and discussed. Dividend distributions made to owners reduce the net assets held by an organization. In Figure 3.1 "Income Statement", a number of expenses are listed, but no dividends are mentioned. Why are dividend payments not included as expenses of a corporation on its income statement?
Answer: Dividends are not expenses and, therefore, are omitted in preparing an income statement. Such distributions obviously reduce the amount of net assets owned or controlled by a company. However, they are not related in any way to generating revenues. A dividend is a reward paid by a corporation (through the decision of its board of directors) to the owners of its capital stock. A dividend is a sharing of profits and not a cost incurred to create revenue.
In Figure 3.1 "Income Statement", Davidson Groceries reports net income for the year of $230,000. The board of directors might look at that figure and opt to make a cash dividend distribution to company owners. That is one of the most important decisions for any board. Such payments usually please the owners but reduce the size of the company and—possibly—its future profitability.
An income statement reports revenues, expenses, gains, and losses. Dividend distributions do not qualify and must be reported elsewhere in the company’s financial statements.
A company has the following reported balances at the end of the current year: revenues—$100,000, rent expense—$40,000, dividends paid—$12,000, loss on sale of truck—$2,000, salary expense—$19,000, gain on sale of land—$9,000, and prepaid insurance—$8,000. What should be reported by this company as its net income for the year?
The correct answer is choice d: $48,000.
Net income is made up of revenues ($100,000) less expenses ($40,000 plus $19,000, or $59,000) plus gains ($9,000) less losses ($2,000), or $48,000. Dividends paid is not an expense, and prepaid insurance is an asset.
The Significance of Reported Net Income
Question: The final figure presented on the income statement is net income. This balance reflects the growth in an organization’s net assets during the period resulting from all revenues, expenses, gains, and losses. More specifically, it is the revenues and gains less the expenses and losses. For example, in 2010, the income statement reported by the Kellogg Company indicated that the size of that company’s net assets grew in that one year by $1.24 billion as a result of net income (revenues and gains less expenses and losses). In evaluating the operations of any business, this figure seems to be incredibly significant. It reflects the profitability for the period. Is net income the most important number to be found in a set of financial statements?
Answer: The net income figure reported for any business is an eagerly anticipated and carefully analyzed piece of financial information. It is the most discussed number disclosed by virtually any company. It is reported in newspapers and television, on the Internet and the radio.
However, financial statements present a vast array of data and the importance of any one balance should never be overemphasized. A portrait painted by an artist is not judged solely by the small section displaying the model’s ear or mouth but rather by the representation made of the entire person. Likewise, only the analysis of all information conveyed by a set of financial statements enables an interested party to arrive at the most appropriate decisions about an organization.
Some creditors and investors seek shortcuts when making business decisions rather than doing the detailed analysis that is appropriate. Those individuals often spend an exorbitant amount of time focusing on reported net income. Such a narrow view shows a fundamental misunderstanding of financial reporting and the depth and breadth of the information being conveyed. In judging a company’s financial health and future prospects, an evaluation should be carried out on the entity as a whole. Predicting stock prices, dividends, and cash flows requires a complete investigation. That is only possible by developing the capacity to work with all the data presented in a set of financial statements. If a single figure such as net income could be used reliably to evaluate a business organization, creditors and investors would never incur losses.
Conservatism is an often misunderstood term in financial reporting. Despite a reputation to the contrary, financial accounting is not radically conservative. However, when two reporting options are equally likely, the one that makes the company look best is avoided. The portrait that results is less likely to be overly optimistic. In this way, decision makers are protected. Their chance of incurring losses is reduced. For example, expenses refer to costs that helped generate revenue in the past while assets reflect costs that provide future economic benefits. If the timing of these benefits cannot be ascertained, the cost should be recognized as an expense. This assignment reduces both reported income and total assets. The resulting net income figure (revenues and gains less expenses and losses) is useful in evaluating the financial health and prospects of a company but no single figure should be the sole source of information for a decision maker. Dividend distributions are not included in this computation of net income because they reflect a sharing of profits with owners and not a cost incurred to generate revenue.