The usefulness of accounting data to investors and creditors for predictive purp
ID: 2479734 • Letter: T
Question
The usefulness of accounting data to investors and creditors for predictive purposes is necessarily forward looking. However, under generally accepted accounting principles, financial statements are constructed primarily as an historical record.
a. What limitation does this impose on the usefulness of financial statements for predictive purposes, and how is this limitation evident from the research reviewed in the chapter?
b. Provide examples of important forward-looking events that either are not reported in financial statements or are not reported in a timely manner.
c. Why may the feedback value of audited financial statements make them very important to investors and creditors even though predictive value is not necessarily high?
Explanation / Answer
Solution:
a) The FASB conceives of accounting as an information system with the emphasis mainly on prospective cash flows. Since accounting systems are, by construction, historical records, they are necessarily backward- looking. So feedback value is going to be better achieved than predictive value. Consistent with this is the very low explanatory power of capital market research. Unexpected earnings "explain" only about 5 percent or less of a firm's abnormal stock return around the time of earnings announcements. The capital market literature presumes that accounting functions as an information system, but it is more likely that its main role is for contracting and hence feedback purposes.
b) The best example is the mutually unperformed (executory) contract in which the firm and an outside party have an unperformed contract. By convention, such contracts do not meet the criteria for recognition.
c) If accounting is primarily a feedback system, it is nevertheless useful precisely for this reason. From a contracting perspective, accounting is important in bringing about control and accountability to investors and creditors, and it is for this reason that accounting numbers are used in writing contracts. e.g., debt contracts with restrictive covenants, and employment contracts with managers, especially incentive compensation agreements, also feedback and accountability do have significance for helping users to predict cash flows.
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