Column : Reliability questions

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A fairly common and enduring belief of modern commerce has been that the published financial statements of companies are manipulated. Entrepreneurs, with the help of managers and accountants, it is believed, manipulate financial statements to dodge taxes or to mislead minority shareholders.

According to a recent study, 340 chartered accountants responded to a survey which concluded that 1,200 companies misrepresented facts in their financial statements. The report has once again, fueled the perception that financial statements of companies are manipulated, and therefore are not a reliable source of information.

There are several reasons for the financial statements of companies to be manipulated. Yet, they are the most reliable source of information on the business sector and even on the economy. Inferences drawn from the financial statements of a randomly picked listed company are far more reliable than the inferences one can draw from surveys.

Manipulation usually means overstating or understating revenues or expenses, overvaluing or undervaluing assets or not recognising liabilities sufficiently. It involves shifting the period of recording of a transaction or changing the method of valuation of assets and liabilities with the objective of achieving a pre-determined outcome. Such manipulation cannot be condoned but, it does not undermine or significantly reduce the reliability of financial statements of companies.

Manipulation of financial statements is different from fraud. A fraud could take the form of a pilferage that may lead to systematically higher expenses (when, for example, personal expenses are charged to the company) or lower income (when goods are sold off the records). In such cases, the financial statements faithfully record this pilferage as well. This is fraud, not manipulation of financial statements. And the financial statements do appropriately reflect the effect of the fraud. It would however, be unfair to expect the financial statements to provide evidence of frauds. Arresting frauds is the task of supervisors and regulators.

It would be fair to assume that the distribution of reliability of financial statements represents the normal curve. There would be a few companies whose accounts could be highly fraudulent and manipulated and a correspondingly few companies whose statements could be highly accurate representation of the reality. In between these two extremes would be the large mass of companies with financial statements of varying degrees of reliability. It is thus unfair to make any sweeping generalisation about manipulation or fraud.