Financial statements are important documents upon which all the stakeholders such as investors, employees, bankers have full confidence. They can use the figures to make rational estimates of the company’s future financial position and determine whether the resulting value estimate was adequately represented in the stock’s current price. However, at times discrepancies arise that investors should be aware of in order to have a safe portfolio basket.
Why discrepancies arise?
Corporate financial statements are based on assumptions and judgments that may be widely off, even when well-intentioned. Furthermore, standard financial metrics that facilitate comparisons between companies may not be the most accurate method of judging the value of a company. This is especially true for startups leading to the development of unofficial measures which have their own limitations.
How discrepancies are imbibed?
Determining when a sale is complete 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 performed. Nevertheless, determining exactly when income has been earned can be difficult for some businesses. Moreover, it is necessary to exercise judgment in determining what constitutes revenue. Now the managers exercise their judgements to either postpone or prepone the revenue recorded depending on their needs. By doing so, the company’s earnings can be inflated or deflated.
For costs, losses from inventories, receivables, etc., must be taken into account, even if the amount can’t be determined with certainty. The manager’s discretion plays a significant role in reporting the costs, thereby creating a case for earnings manipulation practices. Thus, earnings estimates can be inflated to create deferred revenue to boost profits for some future period, or they can be diminished to enhance reported earnings for the current period.
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Managers have the discretion to deal with depreciation and amortisation components to manipulate the earnings and mislead the stakeholders. In addition, companies now are using unofficial measures of performance outside the ambit of the accounting principles. One of the widely used measures is EBITDA. Given the tighter accounting standards, another form adopted by the managers to manipulate the numbers is by manipulating operations rather than reports.
They do so by deliberately cutting down/inflating their discretionary expenditures such as marketing, advertising, selling, general and administrative costs. Sometimes the managers would also manipulate the production by increasing/ decreasing output so as to manipulate the cost of goods sold and ultimately the cash flow and profits recorded.
What should investors do?
Investors should equip themselves to detect any abnormalities so that their investments are safe. Managers orchestrate operations in order to register higher earnings in the short term, but this action runs the genuine risk of compromising the competitiveness of a company in the long term. As accounting regulations continue to improve to prevent accounting fraud, it’s likely that companies will manipulate decisions rather than accounting books as executives are motivated to meet short-term targets, given the strong incentives.
To determine whether operating decisions are optimal and for good business reasons, investors should demand greater disclosure of those decisions that are more susceptible to manipulation. In interpreting unofficial earnings measures such as EBITDA, investors and analysts should exercise great prudence and pay attention to corporate explanations which involve managerial judgments. The stakeholders should use other conventional metrics in addition to the unconventional earnings measures to arrive at a decision.
The writer is a professor of finance & accounting at IIM Tiruchirappalli. With inputs from A Paul Williams, research staff at IIM Tiruchirappalli