esop and Schiller were correct: appearances are deceptive, and they rule the world. To appreciate the
complexities of the financial game in which all actuaries are players, it’s important to remember that
judgment in certain areas—including the selection and implementation of accounting methods—plays
an important role in how generally accepted accounting principles (GAAP) are applied.
Depending on the reporting basis and its application, the financial statements of two almost identical companies can convey
completely different messages. And there might be good, legal
reasons for this, such as dissimilar economic environments and
capabilities. Acquiring companies, for example, estimate the value
of goodwill at different levels because their projections of additional income depend on the specific circumstances of the firms
involved. But we also need to remember that this flexibility in financial accounting can be used aggressively—or even fraudulently.
The motivations for playing the financial game (which can result, and often has, in lost fortunes, jail time, truncated careers,
and other evils) include:
; Providing incentive compensation to executives, which depends on financial metrics such as earnings, profit margins,
loss ratios, and stock price;
; Meeting Wall Street earnings expectations to avoid drainage
of market capitalization;
; Increasing market valuation via high operating earnings;
; Sustaining a certain stock price for a successful initial
; Decreasing the cost of capital with a high debt rating, which
is mostly determined by financial performance;
; Remaining within the boundaries of financial covenants;
; Justifying certain strategic initiatives, such as mergers, acquisitions, and reorganizations;
; Projecting an image of stability or growth or profitability, etc.
There are many areas in which creative accounting may surface.
Measuring and Recognizing Revenue
The specifics of revenue measurement and recognition are important for two reasons:
; Wall Street places a premium on earnings growth;
; Some companies (e.g., startups) are valued at a multiple
It might be surprising to learn that revenue measurement and
recognition can be problematic. Revenue, in fact, can be booked
before the transaction that generates it takes place, or without any
such transaction occurring. An insurance company, for example,
could submit nonexistent claims to a reinsurer for reimbursement
and create ghost records in an attempt to cover the trail.
To appreciate the circumstances that make revenue
measurement and recognition difficult, consider the following
hypothetical situation. A software developer ships a software CD
to a retailer. Should the developer recognize the revenue when
the CD is shipped? Or when it is received by the retailer? Or
when a customer purchases it? Or would it be better to recognize
only part of the revenue immediately and the rest once the return
period expires? What about the costs incurred by the developer
with periodic online updates? Should those costs be spread over
that horizon and revenue recognized ratably? Several approaches are reasonable, each one painting a different financial picture.
It’s not surprising that the U.S. Securities and Exchange Commission (SEC) has had to issue guidance for the recognition of
revenue generated by the sale of software products.
To further illustrate the problem of revenue recognition,
consider related-party transactions. A related party is an entity whose managerial decisions are controlled or at least
influenced by another entity. Examples include an insurance
company and its captive reinsurer or firms in which the same
group of investors has a significant voting share. Since the
interests of the related-party entities are commingled, it cannot be assumed that each entity pursues its own interest. One
entity, for instance, may buy assets from another at an above-market price to allow the buying entity to record a gain on the
transaction. The complexities in the accounting treatment of
related-party transactions can explode when they involve international subsidiaries.
Acknowledging the inevitability of revenue recognition in
related-party transactions, authorities have focused their attention on full disclosure—that is, on the nature of the relationship