Accounting Concepts in Finance
By Carlos Fuentes
Innovators & Entrepreneurs, March 2021
Note: This article is an adaptation of “The Financial Game.” Copyright ©2021 American Academy of Actuaries. Published in Contingencies, Mar/Apr 2011, by the American Academy of Actuaries. All rights reserved. Reproduced with permission of the American Academy of Actuaries.
Most people agree that although accounting principles are relatively simple, the non-specialist can feel overwhelmed by the amount of detail they involve. The fact is that financial accounting is so conspicuous and important that most professionals ignore it at their own peril. This article gives an overview of fundamental concepts which can help the entrepreneur and manager to understand the underpinnings of financial reports.
The Sometimes Unfathomable Accounting Rules
Measuring and Recognizing Revenue
It might be surprising to realize that revenue measurement and recognition is sometimes problematic; in fact, revenue can be booked before the transaction that generates it takes place, or without any such transaction existing at all. For example, an insurance company could submit non-existing claims to a reinsurer for reimbursement and create ghost records to cover the trail. To appreciate the circumstances that make revenue measurement and recognition difficult, consider the following: a manufacturer ships a computer to a retailer; should the manufacturer recognize the revenue when the computer is shipped? When received by the retailer? When purchased? Or would it be better to recognize only part of the revenue immediately and the rest once the returning period expires? Maybe the retailer should recognize the full amount after the warranty period expires? Several approaches are reasonable, each of them paints a different financial picture.
Provision for uncertain future costs is an area with which actuaries are familiar. For example, given the fact that the estimation of health claims reserves requires a fair amount of professional judgment, it is possible to justify development factors within a range to manage earnings. Furthermore, "trades" between business segments (defined by product, geography, or otherwise) can be employed to manage the earnings of individual business segments even if aggregate reserves are estimated fairly.
The treatment of policy acquisition costs and commissions differs between GAAP and SAP. Whereas GAAP aims at matching revenues and expenses, SAP mandates that policy acquisition costs and commissions, once incurred, should be expensed. The effect of SAP accounting is to depress earnings in the current period and roll them over into the future because expenses are recognized immediately but premia are earned over an extended period. This is why insurers that write substantial amounts of new business can strain their surplus and, consequently, may consider reinsurance as a mechanism to reduce the amounts of acquisition costs and commissions that must be written off as expenses.
Next, consider the king of the financial game: Cash. Cash and cash equivalents rule because many people believe that a stock’s price is determined by economic value, that is, by the discounted stream of earnings that the firm will distribute in the future in the form of dividends, which are paid in cash, not in earnings. Estimating future dividends is not only a complex task but one where judgment, personal interests, and chance play a major role. Recall also that the basis for reporting earnings is matching the expenses that correspond to recognized revenue, that is, looking at assets consumed, or liabilities incurred in the generation of revenue, whereas cash flow is a change in cash. This implies that the reason for the difference between earnings and cash is only timing, but timing can be everything in one’s career.
To understand how even the king can be lured to play the financial game, remember that cash is classified as operating, investing, or financing. Operating activities involve using current assets and current liabilities in the ongoing operation of the firm. Cash flows from operating activities are related mostly to current assets, current liabilities, retained earnings (all balance sheet accounts), and revenue (income statement), but there are exceptions such as gains and losses from the operating income of discontinued operations prior to disposition, and income taxes paid. Typical examples of operating activities include selling an insurance policy or consulting services.
Investing activities involve using cash to acquire or dispose of long-term assets that will generate operating income over a long period of time. Cash flows from investing activities are related mostly to non-current assets (balance sheet accounts) but there are exceptions such as extraordinary gains or losses related to the disposal of assets, and gains and losses that result from the disposal of discontinued operations. Typical examples include the acquisition and disposal of investments (except for trading securities), and the acquisition of another firm.
Financing activities involve the acquisition and disposition of funds by issuing and retiring long-term debt and equities. These activities help raise the cash required for investing. Cash flow from financing activities is related to non-current liabilities and equity (balance sheet accounts) but there are exceptions such as early debt repayment. Typical examples include repaying or incurring long-term debt and issuing common equity.
The fact that income, i.e., earning power, results from operating activities, not from investing or financing activities, cautions about the tendency to classify items creatively in the Statement of Cash Flow to boost cash from operations:
- An investing or financing inflow of cash might be classified as an operating item, and
- an operating expenditure might be classified as an investing or financing item.
For instance, if the collected premium is higher than expected due to low lapse rates and the insurer desires to store the surplus in operating cash flow for a future date, it can do so by purchasing trading securities, thus reducing operating cash, and selling them in a subsequent period to then increase operating cash.
Another relevant observation about cash flow, one that follows from the definition of operating activities, is that operating cash includes the operating component of discontinued operations; without this understanding, one might erroneously believe that operating cash is generated exclusively by ongoing activities.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
There are other measures of performance related to cash flow that, although not part of GAAP, are calculated with elements of the income statement. The reason for the use of such metrics is the belief by many that they better explain operating results and provide a good baseline for forecasting earnings.
Perhaps the most prominent of these so-called pro-forma measures is Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and its variations. The basic problem with the use of EBITDA is that the adjustments to earnings tend to go beyond interest, taxes, depreciation, and amortization, hence the need for a new term: adjusted EBITDA. It is the process of selecting the non-recurring and non-operating elements from the income statement (e.g., revenue, expenses, gains, losses) that makes the calculation of adjusted EBITDA subjective, open to manipulation, and renders performance comparisons among companies meaningless. The latter point should be kept in mind when assessing the performance of different companies that in all likelihood use dissimilar adjusted EBITDAs, thus adding to the lack of comparability already present due to the firm-specific selection of accounting policies and estimates.
Asset valuation can also be part of the financial game. To begin with, the valuation of intangible assets (e.g., goodwill) is, by its own nature, subjective. But even when there is a robust market for a given asset, the depreciating horizon is subjective and open to restatements to account for the circumstances that surround the company that owns them. This is an important consideration for assets that are carried in the books at cost less estimated amortization (for intangible assets) such as copyrighted material, or at cost less depreciation (for tangible assets) such as machinery. The complexities of asset valuation go deeper and can start with the decision whether to recognize an expense or capitalize it. Recall that capitalization entails the creation of an asset to be amortized or depreciated over time; accordingly, expensing an item depresses revenues in the current period, whereas capitalizing it spreads the costs over a long horizon.
Long-lived assets can be tangible such as land and equipment, or intangible such as copyrights and patents. They generate benefits for the firm over long periods of time; their economic value is determined by future expected cash flows, which typically are difficult to quantify. To match revenues with expenses, GAAP require that depreciation or amortization be recorded over the useful life of the asset.
Consider the following situation: At the beginning of its fiscal year, Insurer A spends $100,000 on its direct marketing campaign to promote one of its products. Insurer A estimates that the benefits of such investment will produce additional earnings for a period not to exceed one year.
Insurer B sells the same product and makes the same investment at the beginning of its fiscal year, but management believes that the economic value of the investment will produce additional earnings for two years. Insurer B spreads the cost of the marketing campaign over two years, boosting revenues in the first period and depressing them in the second.
The contrast in asset valuation between GAAP and SAP is striking. SAP treats illiquid assets and assets that are unavailable due to encumbrances or other third-party interests as valueless, and classifies them as non-admitted because they are not readily available to meet policyholder obligations. According to SAP, the cost of these assets when acquired, or of existing assets whose availability becomes questionable, should be charged against surplus. Examples of non-admitted assets are agents’ balances and premium balances that are more than 90 days past due, unsecured reinsurance from a non-admitted reinsurer, tangible property, and prepaid expenses.
Furthermore, under SAP, the values of securities owned by insurers are established by the National Association of Insurance Commissioners’ (NAIC) Securities Valuation Office (SVO). This requirement ensures consistency in the valuation of illiquid assets in contrast with GAAP, where firms have leeway in the determination of economic value (see next section).
The differences in asset valuation between GAAP and SAP highlight their respective purpose:
- GAAP focuses on measuring earnings, and
- SAP focuses on measuring liquidation values.
Derivatives and Marketable Securities
Derivatives are valued at fair market value according to SFAS 133 (Accounting for Derivative Instruments and Hedging Activities) with gains or losses recognized in income unless the entity qualifies for hedge accounting.
How is economic value determined in practice? That depends on asset liquidity. According to the FASB, financial assets follow into one of three categories: (i) Level I, the most liquid; (ii) Level II, moderately liquid; or (iii) Level III, the least liquid. Valuation of Level I assets, for which there exists a robust trading market and prices are readily available (mark-to-market), is straightforward. Valuation of Levels II and III assets is more difficult. When the market is moderately liquid, entities are allowed to value assets using observable market inputs such as trading prices of similar securities. When the market is illiquid as in the case of private equity funds and certain types of derivatives, entities are allowed to value assets by marking-to-model, that is, by using their own assumptions to estimate fair market value.
On the one hand entities must attempt to determine the elusive economic value of derivatives by marking-to-model; on the other, accounting rules dictate that gains (losses) must flow to earnings. Whereas it is difficult to argue against the need for marking-to-model in illiquid markets, it is equally difficult to ignore the human tendency of selecting assumptions that will paint a favorable picture when incentives are on the line.
Since, in theory, the purpose of using derivatives is risk reduction, one must ask the following questions when reading financial statements: What risks are being hedged? To what extent are derivatives used? Do they reduce or increase risk? How much loss can the derivatives produce under the most adverse financial conditions (worst case scenario)?
Although the details of financial accounting can be convoluted, the basic rules are relatively straightforward but open to manipulation. An understanding of the big picture should equip senior managers to ask probing questions. This understanding enhances the appreciation of reporting decisions and their implications, such as whether to carry distressed assets at book or market value, a controversial topic heightened by the introduction of Fair Value Accounting.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers.
Carlos Fuentes, FSA, FCA, MAAA, MBA, MS is president of Axiom Actuarial Consulting LLC. He can be reached at firstname.lastname@example.org.