Accounting Principles Underlying Risk Measurement

To the extent that accounting statements and ratios do attempt to measure risk, there seem to be two common themes.

a. The first is that the risk being measured is the risk of default, i.e. the risk that a fixed obligation, such as interest or principal due on outstanding debt, will not be met. The broader equity notion of risk, which measures the variance of actual returns around expected returns, does not seem to receive much attention. Thus, an all-equity-financed firm with positive earnings and few or no fixed obligations will generally emerge as a low-risk firm from an accounting standpoint, in spite of the fact that its earnings are unpredictable.

b. Accounting risk measures generally take a static view of risk, by looking at the capacity of a firm at a point in time to meet its obligations. For instance, when ratios are used to assess a firm's risk, the ratios are almost always based upon one period's income statement and balance sheet.

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