Where Financial Reporting Still Falls Short
HBR, July-August 2016, p77
By H. David Sherman and S. David Young
It is apparent from this examination of the perils of financial reporting that said reports are marvelous instruments for executives to use in deceiving the investors of this world, and this despite the advances made, with great effort by many, to reduce financial reporting’s value at deception and increase its value at helping investors fairly judge the worth of their investments. This article really is quite a remarkable look at what financial reports can and cannot do.
There are three primary ways in which financial statements can be inaccurate and thus less useful for investors. “First, corporate financial statements necessarily depend on estimates and judgement calls that can be wildly off the mark, even when made with good faith. . . . Second, standard financial metrics intended to enable comparisons between companies may not be the most accurate way to judge the value of any particular company. . . . Finally, managers and executives routinely encounter strong incentives to deliberately inject error into financial statements.” I love how the first two conditions enable the third. Are you taking notes here about what you will need to avoid doing on your next financial statement?
As the authors see it, there are five problems with the current status of financial statements. The first is that there are no universal reporting standards. There is GAAP and IFRS and they do not agree although they are slowly moving closer to each other. There are also a variety of spices added to the recipe depending on in which country the company is based. Second, is the revenue recognition timing issue in which there are different rules about when to recognize the money coming in the door, which is dependent on the first problem. Third, unofficial earnings measures are often used because the official measures (GAAP and IFRS) are simply not going to present a fair picture of what the company is earning and these are often impossible to compare with the results from other companies. Fourth is fair value accounting because in many instances who really knows what the fair value of an asset is if you didn’t buy it last year?
Finally, while cooking the books is universally frowned upon, cooking the decisions is fair game. The authors note that this is a pernicious problem. Did management cut discretionary spending to boost short term profit and bonuses? Did they offer incentives to customers at interesting times of the year? Did production in March fall, or increase, precipitously for reasons not fully enumerated? These are not violations of GAAP or IFRS. I do hope you have taken good notes as there is much here that can be quite useful information. As the article says, the timing of operating decisions is a practice that is hard to detect and regulate.