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Playing the Accounting Game

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1 Response

  1. Lawrence Cunningham says:

    Great post. Reasonable estimates given prevailing conditions should be respected afterwards, whatever actually happened. Second-guessing is only justified when estimates were unreasonable when made. Reasonableness can be inferred both from the original assumptions and by how they were adjusted over time as the company’s own performance and its market environment changed.

    Arthur Levitt famously referred to manipulations of reserves as “cookie jar reserves.” The phrase suggests the feature of gaming, when choices are designed to meet earnings targets instead of reflecting best judgments of probable losses. Notably, the conservatism principle doesn’t really help there. Conservatism might suggest over-reserving. But Levitt’s criticism was about how over-reserving in one period can justify and enable over-adjustments in the next.

    I think GAAP’s “spirit” is for judgments to enable financial statements that “fairly present” financial condition and operating results from period to period. Notably, proponents of the current movement to replace GAAP with IFRS laud it, in part, because it increases discretion and judgment compared to US GAAP. If so, the problem of cookie jar reserves may be more difficult under IFRS than under US GAAP.