- F. A. Harper, Introduction
- Gustavo R. Velasco, On the 90th Anniversary of Ludwig Von Mises
- F. A. Harper, Ludwig Von Mises
- Property and Freedom, Alberto Benegas Lynch
- Technological Progress and Social Resistance, Guillermo Walter Klein
- Principles Or Expediency? F. A. Von Hayek
- Protection For Farmers, Antony Fisher
- For a Philosophy of Choice, Lord Grantchester
- The Surest Protection, Ralph Harris
- Towards the Just Society, Ralph Horwitz
- Size and Well-being, J. Enoch Powell
- Pour Eviter “une Collectivisation Par Annuities”, René Berger-perrin
- En Défense De L'economie Libérale: Réponse à Quelques Objections, Gaston Leduc
- L'occident Pour Son Malheur a Choisi Keynes Contre Mises, Pierre Lhoste-lachaume
- Das Ordnungsdenken In Der Martwirtschaft, Ludwig Erhard
- Unsere Gesellschaftsordnung Und Die Radikale Linke, Edith Eucken-erdsiek
- Privateigentum— Die Für Mitmenschen Günstigste Lösung Bei Den Produktionsmitteln, Wolfgang Frickhöffer
- Macht Oder ökonomisches Gesetz, Ernst Heuss
- The Reliability of Financial Statements, Ulrich Leffson and Jörg Baetge
- Ist Die Inflation Unser Schicksal? Alfred Müller-armack
- Der Reiche Goethe Und Der Arme Schiller, Volkmar Muthesius
- Krise Der Politischen Formen In Europa, Otto Von Habsburg
- The Need to Make Cognizance Available, Ulysses R. Dent
- Ways to Communism, Giuseppe Ugo Papi
- Convergence Theories and Ownership of Property, Kenzo Kiga
- Soaring Urban Land Prices and Market Economy, Toshio Murata
- Jesus and the Question of Wealth, Alberto G. Salceda
- A Program For a Liberal Party, Gustavo R. Velasco
- On the Entrepreneur Andries De Graaff
- La Integracion Economica De America Latina, Romulo A. Ferrero
- Problems of Economic Responsibility and Initiative Re-emerging In Eastern Europe, Ljubo Sirc
- Rent Control In Sweden: Lessons From a Thirty Year Old Socio-economic Experiment, Sven Rydenfelt
The Reliability of Financial Statements
Ulrich Leffson and Jörg Baetge
1. Accounts give information about the economic facts, activities and transactions of a company, thus providing a basis for decisions by the owners and creditors. The accounts are closed at the end of every business year and the balances are indicated in the balance sheet (financial status) and the profit and loss account (results from operations).
Besides the task of documentation, i.e. the accurate description of the economic facts and events in the company during the past period the financial statements must indicate the success of the decisions taken by the management and the influence of environmental economic changes and provide information about the state of assets and liabilities at the balance sheet date.
The need to provide information to outsiders - investors, potential partners, creditors, and last but not least, the public - has arisen out of the so called splitting of the entrepreneur's functions. The entrepreneur of former times was a person who at one and the same time invested and disposed of capital. Nowadays the tendency is for these functions of the entrepreneurs to be split. In many cases a company is dependent on two different groups of people: one group provides the enterprise with capital, while the other group is responsible for the management.
Owing to this splitting of the owner's functions the management has to state the result of its dispositions in annual financial statements. The investors require information which will enable them to judge the manner in which the management has dealt with or is likely to deal with capital investment and to judge the soundness of planned or already executed outlays of the money the investors have invested in the company.
The annual report, including the financial statements, is the only instrument that gives the outsider an overall information about the financial success of an enterprise. But although the generally accepted accounting principle of fairness or of fair presentation has been acknowledged throughout the world, the financial statements do not reflect the financial success of an enterprise either with a satisfactory degree of probability or with the necessary accuracy. This is due to the fact that only a small part of the financial statement is based on fully reliable data; the greater part is the result of estimation.
Oskar Morgenstern states that the annual report has as a cell a hard core with absolutely safe and at the same time exact figures surrounded by heaps of figures which are less reliable and more inaccurate the farther they are away from the kernel. These figures are unreliable and inaccurate because they are based on estimates. For the most part quantities in the annual report can be stated exactly by counting, weighing, and measuring; there are only a few instances where the quantities have to be estimated. Valuation, however, is more frequently based on estimates. If we consider long-term assets, for example, both the quantity and the price (value) the firm paid for them are fixed; they can be counted and added up. The economic life of these assets, and consequently the annual depreciation, must, however, be estimated.
The nominal amount of accounts receivable and the cost of purchased assets are parts of the hard core of the annual report, in Morgenstern's view; many of the contingency provisions and reserves, and the depreciation of assets belong to the successive surrounding layers. Ex-ante these parts can never be calculated exactly. Thus the surrounding layers of the kernel reduce the accuracy and probability of the information given in the annual report and must necessarily contravene the principle of fairness in the presentation of the balance sheet.
Up to now it has been generally accepted, in theory and practice, that the principle of fairness must therefore be complemented by the principle of conservatism. The Accounting Research Study No. 7 prepared by Paul Grady states “conservatism is not a justification for deliberate understatement. It is rather a quality of judgement to be exercised in evaluating the uncertainties and risks present in a business entity to assure that reasonable provisions are made for potential losses in the realization of recorded assets and in the settlement of actual and contingent liabilities.”
We agree with the basic philosophy of this interpretation. But we have to ask who could and would guarantee a sufficiently high level of “quality of judgement”, when the principle of conservatism itself is so subjective that even highly qualified accountants may and do disagree on the amount of a “reasonable provision” for a particular expected loss in specific business enterprise even when they have exactly the same information available. These various possibilities of evaluation show that the traditional definition of the principle of conservatism is too imprecise and gives too much space for manipulation. The principle of conservatism has to pass through a process of objectivation, where independent accountants having the same information available agree on the evaluation of every section of the balance sheet and the profit and loss statement. This objectiveness is only possible if the generally accepted accounting principles are deduced from the main objectives of accounting. We believe that we can only obtain a set of consistent accounting principles by deductive logic.
2. The main objective of preparing financial statements throughout the world is to obtain a comparable profit or loss figure, which “…is to provide financial information that assists financial statement users in estimating the earning potential of an enterprise.”
On the basis of research work at the Institut für Revisionswesen of the University of Munster (Germany) we believe that we are able to present a form of annual report which is more informative than the usual reports and which is at the same time in accordance with the principle of conservatism.
The basis for our proposal is that the principle of fairness, (also termed the principle of “truth”) depends on two postulates:
1) the precision or accuracy of estimates,
2) the relative frequency of occurence of financial events (probability ).
Neither of these requirements can ever be fulfilled especially in the case of advance estimates. This dilemma has to be solved by the principle of conservatism.
When dealing with estimation there is either a high degree of probability as in interval estimation, or a high degree of accuracy as in point estimates. In the case of point estimation probability is frequently renounced, and in interval estimation accuracy is renounced. Therefore if data is to be estimated a compromise between the two postulates must be found. Thus the question arises how to define accuracy or probability so that annual report figures can be obtained in cases of uncertainty. It must be stipulated which factors and to what extent are to be considered, i.e. the nature of expectations, their timing and the degree of their probability and accuracy. In order to solve the problem we would like to propose the fixing of a certain degree of probability for all estimations. It follows from this proposal that we shall normally obtain interval estimates. Because the financial statements require point-figures, we need a rule which fixes the value within the range of the interval which is to be balanced.
In the case of valuations based on statistical data, it has hitherto been necessary to balance the statistical mean value as in the case of reserves for pensions. In these cases the accountants considered a conservative valuation unjustified since they knew the law of large numbers and its error compensation.
However, in other cases values were estimated which were low in the case of assets and high in the case of liabilities. This rule of conservatism justified almost every deliberate understatement in cases of uncertainty.
This interpretation of the principle of conservatism was founded on the idea of ensuring that dividends are not higher than the real profit of the year just ended. The principle of conservatism is therefore looked upon by some people as the principle of maintaining capital. But we believe that the principle of conservatism does not force anyone to include these unreliable and unverifiable values in the annual report, thus falsifying the year's results. If the annual report is to give due information about the results from operations of the past year, we agree with those who argue that fairness or fair presentation is the one and only basic concept of accounting . The objective of preserving the capital cannot be a basic concept of accounting. Maintaining the capital and calculating the results of operations are two completely different things.
The question of maintaining the capital, i.e. of the non-payment of profits is a typical investment decision which must be justified by means of an investment calculus. And the annual report is not an investment calculus. Thus it can at best give additional information for the decision on the retention of profits but cannot determine the amount of the dividends to be paid.
If one wishes to provide reliable information in the annual report, the report must actually show the “true” annual success and its components and therefore cannot be based on the principle of understatement.
The absolutely “true” annual income as already proved cannot be computed with the annual report because of the estimations of certain parts of the financial statements. Now the question arises whether it is not possible to introduce more objectivism into the financial statements by calculating a figure to indicate the “true” annual income. The “true” annual income is that figure which could be ascertained with the knowledge of all uncertainties and on the basis of a set of consistent and generally accepted accounting principles. This would only be possible if all “double standards” were eliminated from the set of the generally accepted accounting principles. “The…double standards…result in several methods of accounting for goodwill, and in the omission of certain liabilities from the balance sheet.”
A “true” income figure, adequate for these criteria, would result if after the liquidation of the business enterprise all annual reports were prepared again. All uncertainties would then be eliminated, for the economic life of the long-term assets would be known and the payments necessitating reserves would already be effected. We would obtain for each year an income figure about which no one could disagree. Such a “true” income figure is only an ex-post one. But annual reports have to be presented before the liquidation of the firm, i.e. at every balance sheet date. The accountant's task can only be to calculate financial data so that the profit or loss shown in the balance sheet comes as near as possible to the “true” annual income. Then the income figure would be an indicator for the ups and downs of the business enterprise. This indicator function can be further improved by publishing previous financial statements.
If the problems of estimation could be eliminated, accounting (balancing) would be a pure expost matter. The principle of conservatism would be redundant, for there would be no uncertainty about the financial data. But since in reality much financial data is uncertain the principle of conservatism must be taken into consideration. But the content of the principle has to be restricted so that deliberate understatements would be impossible. Our problem can be solved by the following two rules, if in cases where precise estimation is impossible the financial data are assessed by intervals:
1. The mean value of the confidence interval must be balanced.
2. The difference between the mean value and the most pessimistic value of the confidence interval is calculated and inserted in a special “interval-reserve”.
This suggestion is based on the following considerations:
Although the balance sheet is a calculus which only contains point estimates, information about the confidence intervals can be passed on without a direct accounting of the intervals. “Interval estimates indicate the precision or accuracy of an estimate and are therefore preferable to point estimates.”
The reader of the annual report gets less information than necessary if the accountant records pessimistic values and conceals the size of the intervals.
By recording mean values we are able to calculate a mean profit of the period. As shown later this figure gives a fair indication of the ups and downs of the firm .
Furthermore by balancing an interval reserve the mean profit is reduced to the same degree (or even more) as in the case of balancing the most pessimistic value according to the traditional principle of conservatism.
Thus this method combines the principle of fair presentation with the principle of conservatism.
To be sure, the calculated mean values are not the “true” values (ex-post values). But the central limit theorem allows the assumption that owing to the number of accounts and to the independence among these accounts the single deviations are in summa mostly compensated if mean values are balanced. Therefore an income figure calculated on the basis of mean values seems to be a fair indicator for the success of the enterprise. The computation of this indicator does not take the interval-reserve into consideration.
Since the effect of compensation is not guaranteed entirely, the reader of the statements should be also informed about the interval estimates.
3. This method of balancing, however, involves a number of difficulties.
Until now we assumed that the limits of intervals can be stipulated clearly and that the frequency distribution of the estimated figure within the interval is known. In the case of symmetrical distributions - which are the most frequent distributions in accounting - the mean value is always found exactly in the centre between the optimistic range and the corresponding pessimistic range of the interval. The mean values cannot be balanced unless the extreme values of the interval can be stated objectively. For this reason we need a significant and verifiable (objective) method to state the extreme values. This method can only be developed by a convention about the degree of probability for the estimation of intervals. A hundred percent probability is not available for any one figure of the annual report except the amount of cash. Besides, the estimated intervals would be so wide that no reader of the balance sheet could deal with such information. In the case of a Gaussian Normal Distribution, for example, the confidence interval would increase indefinitely if we tried to attain a hundred percent probability. But if we are satisfied with a cumulative probability of 95 percent we get intervals which are rather short: only 1.96 times the standard deviation over and under the mean value. In this way it is possible to reduce the size of intervals considerably without noticeably diminishing the probability of estimation.
The estimation of intervals in cases of subjective credibility is extremely difficult, for the frequency distributions within these intervals are unknown.
We must establish principles which prevent these estimations from being misused for manipulations in annual reports. Thus we propose replacing subjectivity by standardized intervals in cases of credibility.
For example, the difficult problem of depreciation could easily be solved with the aid of standardization. That this is practicable is shown by the fact that German tax authorities have published depreciation tables which have to be applied by the people doing the balancing . The proposal of standardization does not imply that in special cases it would not be permissible to use divergent depreciations. But the amount of divergence has to be reported and notated in footnotes of the balance sheet.
If standardization is impossible the accountant has to make a subjective estimate of the confidence interval and the mean value. In cases which are not solvable by statistical methods or by standardization the reader must be informed about the subjective expectations.
4. The modification of the interval-reserve ought to be shown period by period for each item of the annual report.
The profit and loss statement should have the following scheme in order to show the “profit or loss indicator” as well as the “conservatively computed profit or loss”:
All extraordinary items of revenues and expenses should be included in the non-operating revenues and expenses and shown clearly
Another method of fair presentation according to our proposals would be to show two columns in the balance-sheet as well as in the profit and loss statement. In one column mean values would be given, in the other one conservative values. Thus the reader would be able to calculate the interval-reserve.
Either of these proposals would present fair annual reports. The user of the financial statements would receive better information than hitherto (a) by the computation of the profit or loss indicator on the basis of mean values and (b) by the presentation of an “interval-reserve” on the basis of pessimistic expectations.