Financial statements are important documents on which all stakeholders such as investors, employees, bankers have full confidence. They can use the numbers to make rational estimates of the company’s future financial condition and determine whether the resulting estimate of value has been adequately represented in the current stock price. However, deviations sometimes occur which investors should be aware of in order to have a safe portfolio basket.
Why do deviations occur?
Corporate financial statements are based on assumptions and judgments that can be grossly wrong, even when well intentioned. Additionally, standard financial measures that facilitate comparisons between companies may not be the most accurate method of judging a company’s value. This is especially true for startups leading to the development of unofficial metrics which have their own limitations.
How are the gaps imbibed?
Determining when a sale is made or a service has been rendered is straightforward: Revenue is recorded when the product has been shipped or received, or when the service has been rendered. However, determining exactly when income was earned can be difficult for some businesses. In addition, judgment is required in determining what constitutes income. From now on, managers exercise their judgment to defer or anticipate recorded income according to their needs. By doing so, the company’s profits can be inflated or deflated.
For costs, losses on inventories, receivables, etc., must be taken into account, even if the amount cannot be determined with certainty. Manager discretion plays an important role in reporting costs, thus creating a case for profit manipulation practices. Thus, earnings estimates may be inflated to create deferred revenue to increase earnings for a future period, or they may be decreased to improve reported earnings for the current period.
Managers have discretion to manage depreciation and amortization components to manipulate earnings and mislead stakeholders. Additionally, companies are now using unofficial measures of performance outside the scope of accounting principles. EBITDA is one of the most widely used metrics. Given the stricter accounting standards, another form taken by managers to manipulate numbers is to manipulate transactions rather than reports.
They do this by deliberately reducing/inflating their discretionary expenses such as marketing, advertising, sales, general and administrative expenses. Sometimes managers would also manipulate production by increasing/decreasing output in order to manipulate the cost of goods sold and ultimately the cash flow and profits recorded.
What should investors do?
Investors must equip themselves to detect any anomalies so that their investments are safe. Managers orchestrate operations to record higher gains in the short term, but this action actually risks undermining a company’s long-term competitiveness. As accounting regulations continue to improve to prevent accounting fraud, it is likely that companies will manipulate decisions rather than accounting books, as leaders are motivated to achieve short-term goals given strong incentives.
To determine whether operating decisions are optimal and for good business reasons, investors should demand greater disclosure of those decisions most susceptible to manipulation. When interpreting unofficial earnings measures such as EBITDA, investors and analysts should exercise great caution and pay attention to corporate explanations that involve managerial judgments. Stakeholders must use other conventional measures in addition to unconventional revenue measures to arrive at a decision.
The author is a professor of finance and accounting at IIM Tiruchirappalli. With contributions from A Paul Williams, IIM Tiruchirappalli research staff member