Financial statements are heavily relied upon to make estimates of the magnitude, timing, and uncertainty of future cash flows and to judge whether the resulting estimate of value was fairly represented in the stock price. “In order for financial statements to fulfill their important social and economic function, they must reveal the underlying economic truth of a business.” (David Sherman, David Young, 2016). Here are three challenges in the financial accounting world:
Fair Value Accounting
Two key measures for determining the value of a firm’s assets are the acquisition cost and the fair value amount.
Historically, corporate financial statements relied on the acquisition cost, which has the important virtue of being easily verifiable. Today, we use fair value for a growing number of asset classes in the hope that an examination of balance sheets will yield a more accurate picture of the current economic reality. David Sherman and David Young of HBR had the opinion that “The nightmare of risky accounting is on the increase. In the current economic climate, there is tremendous pressure—and personal financial incentive for managers—to report sales growth and meet investors’ revenue expectations.”. This results in a heavily contested definition of ‘fair value’, and a measure that has injected enormous subjectivity into the financial reporting process, creating significant challenges for both preparers and users of the reporting.
Lack of a single universal standard.
In 2002, an initiative was underway to create a single set of international accounting standards, with the ultimate aim of uniting the U.S. Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) that European countries were in the process of adopting. Today, over 110 countries around the world use the IFRS or GAAP systems.
However, the fact that there is no single system results in several implications, and review sites are needed. Consider the implications of failing to reconcile GAAP and IFRS. Analysis of investment targets, acquisitions, or competitors will in many cases continue to require comparison of financial statements under two distinct accounting standards where in each case, one company uses GAAP and the other uses IFRS. To further complicate matters, the way that IFRS regulations are applied varies widely in various countries. Each has its own system of regulation and compliance, and compliance and enforcement are weak in many countries – especially the quickly developing ones. As a result, results under GAAP versus IFRS can be different enough to change an acquisition decision.
Recognition of revenue.
Revenue recognition is a complexity of the regulatory environment. For example, the contract for a SaaS often includes future upgrades whose costs cannot be predicted at the time of the sale. With this complexity in mind, it is therefore not possible to accurately forecast the revenue it will generate.
Companies are increasingly using unofficial measures to report financial performance, especially for businesses operating in the virtual space, where recognition of revenue is a complex task. The colossal success of social networks such as Facebook, Twitter, and online marketplaces such as Amazon, eBay, and Alibaba have quickly demonstrated that traditional guidelines for the recognition and measurement of revenue and expenses were preventing them from truly reflecting their businesses’ value in reported accounts.