The Intersection of Accounting, Reporting, and Capital Markets: A Q&A with Marc Siegel

An accounting and investing expert discusses the potential effects of accounting judgments on investor decisions.

Marc Siegel: Founder and Executive Advisor, Metrix Advisory

Many investment professionals who toil over whether to buy, sell, or hold equity and debt investments may have limited experience with technical accounting issues and the rules and regulations that underpin the corporate reporting landscape. They are not experts in the Financial Accounting Standards Board (FASB) Codification or the Securities and Exchange Commission (SEC) rules that govern the content and format of regulatory filings.

On the other hand, many accounting technicians with deep expertise in those standards and regulations may lack professional experience in analyzing corporate reporting for the purpose of making portfolio decisions. Understanding the complexities of accounting rules is not, in and of itself, sufficient to understand how reported values affect stock prices.

To explore the complex topic of accounting judgments – that is, estimates and appraisals based on available objective information – and their ripple effects on financial statements, disclosures, and investor decisions, Analysis Group Managing Principal Mark Howrey and Vice President John Drum spoke with affiliate Marc Siegel, an expert fluent in the dialects of both accounting and investing. Throughout a career that sits at the intersection of accounting, reporting, and capital markets, he has gained deep experience in auditing, investing, standard setting, and consulting. Mr. Siegel served a 10-year term as a member of the FASB, where he focused on the perspective of the investor community. Prior to his time at the FASB, he was a director of research at a forensic accounting–focused equity research firm. Mr. Siegel was also a member of the Sustainability Accounting Standards Board (SASB) and served on the FASB Investors Technical Advisory Committee. He started his career as an auditor with Arthur Andersen.

A common view of accounting is that it provides objective, precise, and absolute figures. Can you describe how accounting judgments affect the reported financial results of a company?

First, it might be surprising to point out that accounting judgments pervade nearly every line item on a financial statement. They often reflect predictions about the future. For example, in the accounts receivable line item on a balance sheet, there’s an implicit judgment about which portion of accounts receivable will not be collectible. Other examples include: How many customers will return their purchases? What is the expected default rate on residential mortgages for a financial institution? Will I be able to recover the investment in inventory at a retailer? How likely is it that I lose a litigation? To varying degrees, these predictions will be informed by historical experience.

These judgments affect the value of assets and liabilities, every quarter and year end. Changes in those judgments from one period to the next can affect an entity’s reported income. When circumstances in the organization’s environment change, many accounting rules require that its management team take those changes into account when revising its judgments. The resulting impacts can meaningfully affect the entity’s financial position and results of operations.

Mark Howrey: Managing Principal, Analysis Group

You’ve made a career out of evaluating accounting judgments. Can you comment on how one can evaluate whether an accounting judgment made at a certain point in time was reasonable or not?

Suffice it to say, it is complicated. Actual realized results will almost always differ from expectations. As a result, evaluating judgments in hindsight can be difficult and requires careful analysis.

For example, one could consider whether a change in an accounting judgment reflects the application of a longstanding accounting policy. To illustrate: Companies often analyze substantial amounts of data to estimate an allowance for doubtful accounts. They might review the “aging” of accounts receivable to see if fewer (or more) customers are paying their amounts due within the first 30, 60, or 90 days in order to estimate how many receivables will go unpaid. One could evaluate whether a change in the allowance for doubtful accounts reflects a change in the data or a change in the process used to evaluate that data.

Furthermore, if it’s a change in process, does the new method produce an improved measure? And does the new method more appropriately reflect changing circumstances?

When judgments do change, is the shift likely to be uniform?

Generally, when analyzing changes to a company’s judgments from public filings, one might reasonably expect some judgments to go up and some to go down. One’s concern level might become more elevated when many or most changes in judgments go in one direction – for example, if those changes in judgments favor earnings.

In a litigation context, we are always evaluating accounting judgments after the fact. A holistic evaluation of accounting judgments requires careful consideration of both the judgment itself and the context in which it was made.

John Drum: Vice President, Analysis Group

Ultimately, financial statements have an audience: investors. But not every accounting judgment will influence a stock price. How do you assess whether or not an accounting judgment is impactful?

This really comes down to understanding the market for a company’s securities. In other words, how do market participants value the company? The ways in which market participants value securities is influenced by the industry, growth stage, profitability, use of tangible or intangible assets, and many other factors.

This is very important to keep in mind because even judgments that have a significant impact on the reported numbers may not be meaningful to market participants, and vice versa. For example, early in my career I included the impacts on earnings from changes to a company’s estimated depreciation schedule in a research report, only to be summarily informed by a hedge fund client that this particular stock traded based on EBITDA – that is, earnings before interest, taxes, depreciation, and amortization – and, therefore, most market participants would not revise their price target due to a change in management’s judgment about estimated depreciation lives.

To put these various puzzle pieces together: A full analysis of the impact of an accounting judgment on investors requires the careful consideration of a number of complicated questions. Among other things, one must consider the technical accounting standards, the company’s historical application of those standards, the context in which an accounting judgment was made, and the impact that the resulting accounting value could have on market participants’ view of a company. While this may seem like a tall order, it’s also important to remember that accounting judgments are not to be feared but to be understood. ■