Measurement Error caused by GAAP Accounting Rules
The major sources of measurement error introduced by GAAP accounting rules relate to the recognition and valuation of non-financial assets. The problem arises because investments made in non-financial assets are typically expected to generate benefits over multiple accounting periods. Accounting rules often use simple procedures for setting asset values to increase reliability in computation and verifiability. Examples include the immediate expensing of certain investment expenditures and the use of mechanical depreciation and amortization techniques to assign periodic asset values to investment expenditures. As a result of these simple procedures given below, bias creeps in.
Immediate Expensing of Internally Generated Intangibles
Under GAAP, expenditures made on internally developed intangible assets are required to be expensed immediately. Immediate expensing of internally developed intangibles means that no asset is recognized on the balance sheet, causing the value of equity to understate the actual investment. This results in systematically negative measurement error in equity (because assets are understated) in all periods during which the expenditures
Depreciation and Amortization of Capitalized Non-financial Assets
Unlike internally developed intangible assets, GAAP generally recognizes expenditures on tangible assets and purchased intangibles. The accounting for such expenditures at their inception involves capitalizing the full value of the expenditure and is disclosed on the assets side. The paradox is in deciding how to subsequently reduce the value of the asset over the future periods in which it generates benefits. This process is known as depreciation for tangible assets and amortization for purchased intangible assets. The determination of quantum of depreciation entails subjective forecasts of the future benefits. So, once again the accountants sacrifice relevance for reliability as they make it necessary that the firm follows a predetermined depreciation schedule, with the most common method being straight line whereby the initial value of the asset is reduced in equal installments over the expected life of the asset. The general effect of these measurement errors is to understate assets' values by depreciating them too quickly.
Omission of Contingent Liabilities
Similar to accounting for intangibles, in case of contingent liabilities also they are not regarded as liabilities as the amount of loss is not sufficiently probable or not reasonably estimatable. Since contingent liabilities are not recorded in the financial statements to that extent, net assets and equity are overstated. In the periods that a contingent liability arises, measurement error increases so net income is overstated and the impact on ROE is ambiguous. In subsequent periods, as long as the contingent liability remains contingent, equity will be overstated and there is no effect on net income, and therefore, ROE will be understated.
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