Monte Carlo: it's not just gambling.

• Author: Barnett, Bruce H.

Increased Financial Statement Scrutiny

Recent events have increased interest in the accuracy, reliability, and honesty of financial statements. This attention already has led to new standards and procedures that generally will be helpful to financial statement users. There is no doubt that we have not seen the last of such changes. Unfortunately, but inevitably, the pendulum will likely swing too far thereby planting the seeds for further reform in the future. Nevertheless, the presentation of financial statements now is a central focus of senior management of publicly traded (and many private) companies.

Financial Accounting

At its most fundamental level, financial statements aim to represent the current state of the enterprise. They provide critical information to interested parties who rely upon them to make decisions such as buying or selling stocks and securities, and extending credit.

For many reasons, companies prefer strong financial statements depicting an enterprise with a solid balance sheet, steady earnings, and attractive cash flows. Among the advantages solid companies enjoy are access to capital, access to inexpensive capital, and strong stock prices. The preference for strong financial statements creates an incentive to include income and exclude expense in the income statement with a concomitantly similar balance sheet effect. Whether income or expense should be included in the income statement generally is clear-cut. In some cases, however, the answer is not obvious. To illustrate the difficulties, consider an enterprise facing a lawsuit that has some but not overwhelmingly clear merit. Since the outcome of the lawsuit is unknown, the enterprise faces a liability that may, but is not certain to arise. Should the company win the suit, it would have no payment obligation and therefore have no liability. On the other hand, the company may lose and be required to make a substantial payment. Of course, lawsuits often are settled, and in such case, the payment would fall in a range bounded by no payment and a large payment. What, then, should the company do with respect to including this contingent liability in its financial statements?

Fortunately, the accounting rules provide guidance for the appropriate treatment of contingencies. In general, those rules require a contingency to be expensed in the income statement if the amount can be reasonably estimated and it is "probable" that a liability has been incurred. For this purpose, a loss is probable if it is likely to occur. The accrual is measured by the amount of the loss to be incurred. If the amount of the loss is uncertain but will fall within a range, the most likely outcome in that range should be accrued. If...