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Critical accounting involves the application of financial analysis in contexts that are especially vulnerable to the selective reporting of favorable information. To use critical accounting, an organization must have a critical accounting policy (CAP), which dictates how subjective information will be interpreted. The goal is for the CAP to define a method that is consistent, is accurate, and gives the most useful “big picture” view of the place in the market the business occupies, rather than present information in a way that pleases the intended audience but that may not give them a realistic idea of the organization’s future prospects.
Critical accounting has the goal of avoiding the dangers that accompany what is variously referred to as smoothing or slush fund accounting. Both terms refer to a practice that some companies employ to deal with variations in financial performance from year to year. There is a widely held perception that a stable, well-managed company will show consistent and predictable growth in its earnings over time, increasing its profits each year. This kind of performance tends to attract investors because it seems to suggest a secure investment and, more important, one that is relatively predictable compared with more volatile financial instruments.
The problem is that this type of performance is not typical or even possible for all types of businesses, yet all types of businesses want to appear to be stable and well managed. To accomplish this, many businesses seek to set aside assets earned in years that are unusually profitable and then use these assets to supplement the bottom line in the years when the company does not perform as well as expected. Some refer to this as “cookie jar” accounting because it is similar to a family saving extra money informally by keeping it in a cookie jar until it is needed for an emergency.
Cookie jar accounting may make investors happy in the short term, but it tends to cause major concerns further down the line. This is because it misrepresents the financial position of the company, meaning that any decisions made based on the company’s financial statements are suspect. For example, if a company made $100 in profits during the first year of its operations, but set aside $50 in its cookie jar, then that year’s profits would appear to be $50. If the company earned only $40 in the second year, but wished to appear continuously profitable, it could take $15 from the cookie jar (leaving $35 in the jar) and add this to its bottom line, so that the second year’s earnings would appear to be $55—a 10-percent increase over the previous year’s profits. This would attract new investors and encourage existing investors to keep their money with the company, even though the company’s performance during the second year was poorer than in the previous year. For a time, this trend could continue, so that in the third year, even if the company’s profits were only $30, it could draw from the cookie jar yet again, adding an extra $30 (leaving only $5 in the jar) to the annual profits, so that they would appear to be $60—another substantial increase over the previous year’s $55 profit. Accountants’ concern with this slush fund strategy is clear—it misleads the public about a company’s performance, with potentially disastrous results.
Critical Accounting Policies
Critical accounting is frequently implemented through the establishment of a CAP. A CAP has been defined as having two distinct characteristics. First, it concerns accounting estimates that had a significant degree of uncertainty at the time they were made. This uncertainty may have been due to rapid changes occurring in the segments of the market in which the company is active, difficulties internal to the company (e.g., the departure of individuals with a large amount of institutional knowledge or the arrival of new staff with their own agendas), or noneconomic factors like political transitions, natural disasters, and so forth. Whatever the source of the uncertainty, the important point is that it had the potential to affect the accuracy of the financial estimates that were made and that the parties making the estimates were aware of the potential effects of the uncertainty.
The second component of a CAP is that the estimates that the accountants had to choose between because of the uncertainty are important enough so that depending on which estimates were used, there could be a major difference in the picture of the organization’s finances that emerges from the accounting reports. In other words, CAPs are not concerned with trivial uncertainties that could only have minor effects on the overall financial analysis. For example, an international shipping company with a fleet of delivery vehicles naturally will have some uncertainty about its performance because on any given day some of its vehicles will undoubtedly experience mechanical problems. However, the likely impact on a large company of a handful of delivery vehicles being delayed for a day or even 2 days would be minute and would not change the company’s financial outlook in a way that would be perceptible on a macrolevel. On the other hand, if the shipping company was preparing its financial statements during a period when it was also negotiating its way through a contentious labor dispute with the union representing its delivery drivers, the case would be different; if the dispute were to drag on, it could have a major effect on the company’s profitability. Conversely, if the dispute were settled quickly on terms favorable to the drivers, this would mean greater expense for the company and changes to its financial status.
Because critical accounting estimates can have such a large impact on how investors evaluate the financial health of a company, there is a danger that companies may choose the estimates (and their underlying assumptions) that are most favorable to themselves, to encourage investors to maintain or increase their commitment to the firm. To counteract such incentives, the Securities and Exchange Commission, the federal agency tasked with regulating the stock market, requires companies to disclose their CAPs in the “management discussion and analysis” section of the company’s financial statement. The goal of this rule is to give the public access to a clear description of how the company approached the areas of uncertainty that had to be addressed during the completion of its financial reports, so that if the public image of the company seems overly optimistic, investors can check to see whether the corporate expectations are realistic or unduly speculative.
The need for CAPs tends to arise for many different companies around the same small number of issues. The most common issue requiring a CAP tends to be income tax. This is because a company’s tax burden depends on many different factors— sales, expenses, benefit payouts—and when making predictions about the future, the more factors subject to change, the greater is the uncertainty of the overall prediction. Pensions in particular are difficult to predict and often require their own CAPs.
Another frequent requirement for CAPs arises because of impairments. Impairments are long-term assets that are tied to markets that experience sharp declines. An example of an impairment would be a company that spends several million dollars expanding its asbestos insulation plant, just 6 months before the discovery of asbestos’s carcinogenic properties.
Some industries have CAP issues that are particular to their market segments. The insurance industry is one of these, as many of the CAPs for insurance companies pertain to the number and size of claims liabilities. While companies keep statistics about the frequency of different types of claims, and these are helpful in producing estimates for the future, some types of insurance are occasionally triggered by large-scale disasters that are less predictable. An example of this occurred in 2005 when Hurricane Katrina struck the Gulf Coast of the United States, killing hundreds and causing nearly $150 billion in damage. Because the insurance companies holding the policies that covered the affected properties could not have predicted Katrina, a “400-year storm” with a 0.25 chance of occurring during any 1-year period, when such a storm struck, it had a huge impact on the insurance companies’ balance sheets.
There is a difference of opinion about the effectiveness and appropriateness of critical accounting, both within the financial sector and across society. Some business leaders view it, and particularly its disclosure requirements, as an unnecessary infringement on their rights to conduct business as they see fit, and to pay the market consequences in the event that they miscalculate. Others in the business world (usually those on the investment side of the equation) support critical accounting and rely on its requirements as part of their overall investment and risk management strategy.
Looking across society, recent years have seen a rise in favorable perceptions of the goals of critical accounting. In the wake of the 2008 market disturbance and the subsequent slow recovery, groups such as the Occupy Wall Street movement have begun to make quite vocal demands for greater transparency in regulation of the finance sector and more objective and accessible reporting of financial transactions and methods of calculation. There have been numerous reports in the media about the “shrinking middle class,” and one implication of such stories is that wealth and power are being concentrated among a smaller and smaller group of elites, who maintain their positions through, among other strategies, questionable accounting practices. Critical accounting, inasmuch as it advocates an open sharing of accounting methods and assumptions, addresses these concerns and thus is frequently advocated by proponents of financial regulation and reform.
Critical accounting is not an approach that has been embraced by all. In addition to those who resist it because of the personal inconvenience it causes them, there are some who oppose it on more philosophical grounds. One such group objects to the political agenda they attribute to critical accounting. They view critical accounting not as a valid and objective method of accounting but as a social and political movement seeking to redistribute wealth by imposing reporting requirements that interfere with businesses’ attempts to operate in their investors’ best interests. Those who hold such views argue that critical accounting is unnecessary because the issues that it seeks to shed light on would eventually be corrected by the natural operation of the market—unsustainable businesses would close or be acquired by other entities. This view generally does not take into account the negative consequences that investors in such a business would experience, loss of their investment being first and foremost, because the information that would have helped them avoid such a disaster was not available to them.
Another criticism of critical accounting is based on the perceived connection between critical accounting and postmodernism. Postmodernism is a philosophical perspective that rejects the idea that the world contains objective truths that are discoverable and comprehensible; instead, postmodernism suggests that the world we know is a social construct built up out of our individual and shared perceptions of reality. Many people reject this view of the world because it provides very little in the way of security or stability: Nothing can be depended on; nothing can be trusted; all is merely subjective perception and appearance. This is sometimes called relativism, since truths are believed to only exist relative to the observer rather than objectively: An apple is red because that is how we perceive it, not because its essential nature includes an abstract trait of “redness.” Many object to relativism because they feel that it permits people to do anything they want; if there are no rules, then the only limitation is on what one can get away with under the circumstances. In the context of accounting, this type of objection to a critical accounting approach generally takes the form of opposition to the proposition that a business entity is not either a good investment or a bad investment but that its value depends on the observer and the value judgments she or he makes about the accounting methods being used. This view of the world has too much ambiguity for those who would prefer to have clear-cut answers about whether or not an investment strategy is sound.
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