© 2000 John Petroff
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© 2000 John Petroff |
A- Distortions in income statements
The magnitude of actual distortions in the income statement is almost trivial when compared to distortions that can be found in fixed assets, inventory and equity on the balance sheet. This is because, with the exception of depreciation, depletion and amortization expenses, almost all items of revenue or expense represent real sums of money in the current year, and therefore, would not be distorted by inflation as items of balance sheet are. Yet, the overall consequence of distortions in the income statement is much more important because it affects directly earnings, and therefore, owner's wealth. Indeed, if the replacement value of inventory is much higher than what the balance sheet shows, it simply means that the balance sheet does not correspond to reality, but dividends and stock price are not affected. In fact, the inventory on the balance sheet may be understated by using LIFO with the very purpose of avoiding understatement of cost of goods sold and inflation of profits. If an item of revenue or expense is misstated, that affects not only dividends, but also taxes paid and accumulation of retained earnings. The latter will have an impact on the market price of the common stock.
There are three types of possible distortions: 1) those caused by accounting, 2) those caused by strategies and events that overlap several accounting periods but are recorded only in one period, and 3) those resulting from voluntary or involuntary income smoothing. None of these are illegal or fraudulent, and usually they are not intended to mislead.
It is explicitly assumed here that the accounting data is correct, and that a clean auditor's opinion is entirely reliable. After going through the listing of all the different possible distortions below, it should become apparent that avoiding everyone of these is practically impossible for any company. The problem takes on its full dimension when an analysis is conducted - as it should be - comparing one company with other companies. Then, it is certain that income statements are not prepared on identical basis. Even more serious problems can be suspected if the financial statements are not audited, or a qualified opinion has been issued by the auditors.
See review questions Q-13A.1 through Q-13A.5.
See research assignment R-13A.1.
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