© 2000 John Petroff
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© 2000 John Petroff |
D- Limitations of accounting numbers
In spite of accountants' stated aspiration to provided future oriented numbers, the major shortcoming of all accounting data from the point of view of an outside analyst is that what is relevant for financial decisions is what pertains to future (i.e. forecasted) cash flows, and is precisely what the accounting profession is reluctant to deal with under any circumstance. It is understandable that accountants do not want to create potentially false expectations from any data present in projected income statements, for which they may be held liable. Indeed, when projected income statements do appear in annual reports, they are always accompanied by disclaimers, and are never audited or otherwise approved by external auditors. To stand behind projections of financial results is obviously more than accountants can do since the actual performance is the responsibility of a company's management and not that of any outside accountant. Management of some companies (e.g. Fuqua) does publish projections, but they are very few, and again, their pro forma statements are not audited.
The Securities and Exchange Commission has been encouraging American corporations to make forward looking statements by providing a "safe-harbor" from prosecution if adequate disclosure is present. Annual reports of American companies make reference to the Private Securities Litigation Reform Act of 1995, and list factors that may cause results to differ form those projected. Moreover, in SEC 10-K filing, it is common to find lengthy descriptions of all the major sources of company risk. Because accountants do not want to be involved in these projections, no standards have been formulated for their preparation. As a result, it is difficult to compare projections made by firms. Still, it is unfortunate that forecasted results can't be made more uniform and acceptable.
It is also understandable that accountants do not want to be involved in forecasts because that could taint their credibility with regard to those accounting results they present as reliable. Although accounting numbers are as reliable as they can be, in the sense that this is the best the profession can offer, there are many instances where adjustments are warranted. For, even if the numbers are arithmetically correct and are verifiable (by tracing them to some document), they may not reflect reality. Or at least not the reality as it is useful to make predictions about future performance. Throughout the following chapters, each accounting number will be scrutinized for possible modifications, additions or deductions that would make it more meaningful.
See research assignments R-6.9 and R-6.10.
Problems with accounting numbers
can come from four distinct sources:
- known limitations due to accounting conventions and standards;
- departures from generally accepted principles because of circumstances
specific to the industry or the firm;
- legitimate management strategies that cannot be adequately handled
by accounting without departure from the method used in prior
years;
- deliberate attempts to manipulate results by management.
There is also a range of corporate strategies for tax avoidance
(i.e. legal steps to pay as little tax as possible), and/or tax
evasion (i.e. illegal steps to achieve the same), which are entirely
beyond the purpose of this manual.
Although cases of outright fraud in financial reporting are rare nowadays, they do occur from time to time. In some cases, even major auditing firms have been dragged into law suits and became liable for damages. For most part, financial analysts are unlikely to be involved in such cases. In a less harmful context, management of any firm is always seeking to show the best appearance possible. That means reporting the highest profit and lowest risk. One very common example of such strategy is that of income smoothing (as for instance, discussed in Chapter 13 Section A-4). If perceived risk stems from stock price instability, and that, in turn, is caused by profit instability, it goes without saying that avoiding large profit one year and small the next is desirable. How much of income smoothing is legitimate, and how much is not, is very difficult to tell, even for the external auditor, let alone an outside analyst. Many ways of switching revenues and expenses from one year to the next will be presented in Chapter 13 Section A-4. An analyst must be on a constant alert of such tactics, and should try to make corrections when it is feasible and justifiable, notwithstanding the fact that presumably the external auditor has not found it necessary to do so. Obviously, a correction would be justifiable if it removes an event or an entry that is unlikely to repeat itself in the future. But realistically, as explained in Chapter 13 Section A-5, corrections are beyond what an outside analyst should do (except in the case of acquisition or merger).
Let us spend a little time on a few limitations stemming from the previously described accounting goals and conventions themselves.
a)- Clarity dictates aggregation and requires that both income statement and balance sheet have only a few significant lines shown. This causes many items to be merged in one single line removing useful information that individual items may have had. This is the case of overhead expense in which depreciation can be dumped. In 2000, many income statements of non-manufacturing firms show just one line of operating expenses. This is certainly a self defeating emphasis on clarity which accounting principles writers have neglected to denounce. Some industries, such as airlines, have inherited financial reporting requirements that break down operating expenses into its constituent parts, and that list certain performance statistics (such as number of employees and output per employee): such industries should be an inspiration for accounting principles writers.
See research assignment R-6.12.
b)- Unit of operations for which the financial reporting is prepared may need disaggregation. This is true of practically all consolidated reports. Even if annual reports of conglomerates give sale and profit results by product line, this is just not enough. There is too much information about performance that is not available.
For a company with many departments, plants or regions, understanding
what takes place in each can be important. A major difficulty
of ratio analysis for companies with multiple product lines is
to choose the correct industry, because comparative ratios are
different for each product line industry. That is true not just
for conglomerates but the majority of companies. If financial
statements were prepared by product line, this difficulty would
disappear. Some relief of this problem has emerged since SFAS
131 that requires "disclosures about segments of an enterprise
and related information". The choice of what is reported
for each sector, while useful, is somewhat strange. For instance,
depreciation appears by segment, but does not for the consolidated
income statement; whereas, research and development may appear
for the consolidated data but not for each segment. We return
to this issue in Chapter 9 Section
B-4.
In some cases, the problem may be a lack of consolidation rather than consolidation. This is especially true of situation where a company splits off portion of its assets into independent companies or partnerships in order to hide liabilities or to boost revenues with sales to the "independent" entity. The most infamous example of such tactics is that of Enron, but many unreported cases successfully deceive investors. So much so that the FASB is working on proposed rules that will require consolidation of certain unconsolidated businesses even if less than 50% owned.
| Coca-Cola Co. is reported (by Betsy McKay in WSJ of 1/23/02 page C16) to have spinned off bottling operations for two reasons. First, the bottling operation (e.g. Coca-Cola Entreprises Inc) takes the large debt needed to finance the capital-intensive bottling operations off the books of Coca-Cola Co. because the bottling company is just less than 50% owned. And second, Coca-Cola Co. can charge for the concentrate it sells to the bottling operation higher prices whenever it needs to boost its own profits. Not surprisingly, Coca-Cola chief financial officer, Gary Fayard, is an outspoken opponent to the proposed FASB consolidation rule. |
See research assignment R-6.13.
c)- Timing of revenues and expenses may not synchronize with accounting periods. Economic activity does not stop on December 31 or any other end of fiscal year. Naturally, the end of a fiscal year is normally chosen to correspond to the lowest level of activity of the firm; for instance that of department stores is end of January, and that of ski stations end of May. But many projects straddle the year end. Accruals and deferrals offer some means of assigning revenues and expenses to the proper time period. But not always. For instance, if sales orders are received in the first month of the year, as a result of a promotion campaign at the end of the previous year, to an analyst these revenues will appear to have taken place throughout the year, and there would be no basis to assume that these revenues will not repeat themselves in the following year. The issue will come up in many ratio calculations.
See research assignment R-6.14.
d)- Seasonal patterns are rarely reported for either costs or income, other than a few management excuses for poor results. Yet, for instance, knowing whether political or economic events take place during the peak season of a firm or the low season, would be useful in studying the impact of such events.
See research assignment R-6.15.
e)- Allowing different accounting methods for depreciation, inventory, pension expense, and the like, may be useful for different management strategies, but that does not really reflect what physically takes place with assets, inventory or pension funds. Such strategies may precisely be the ones for the previously observed inclination of management to manipulate income. For an outside analyst, it makes it impossible to compare firms.
f)- The estimations are necessary for some items (e.g. life of asset, price change temporary of not, proportion of anticipated bad debt) offer additional income manipulation opportunities, prevent comparison with other companies and frustrate claims of objectivity.
| Companies that have long term contracts must include in earnings unrealized gains or losses by using the mark-to-market accounting method in which the contract value is estimated on the basis of current market prices. In the case of Williams, a pipeline company also engaged in trading electricity contracts, over one billion dollars of 2001 profits from trading make financial analysts such as Jeff A. Dietert very uncomfortable because FASB does not have rules for the wide variety of energy contracts. In fact, there is no real market for electricity to be delivered in 15 years, and Williams does not disclose its method of valuing the contracts (as reported by William M. Bulkeley in WSJ 1/23/02 page C16). |
g)- Justification of objectivity for the use of historical costs for fixed assets (and also for some other balance sheet and expense items), causes after a few years of even mild inflation such a major distortion that the balance sheet becomes a poor analytical tool. The American approach to report the effect of inflation in the two statements used in the 1980's and discussed above, has proven to be useless, if not actually misleading. In countries of Latin America, Europe and former Soviet Union, where high inflation was experienced for several years, a reevaluation of assets with official indexes is a necessary process to give back some meaning to the balance sheet, but has also opened the door to manipulation.
See research assignment R-6.16.
h)- Some of the most valuable assets and most damaging liabilities are not accounted for at all in many cases. Goodwill and intangible property rights are not shown as assets for American firms that have not acquired them. But clearly, clients and inventions are the sources of prosperity of any company. This is one of the differences between International accounting and GAAP accounting. In most countries except the United States, the costs of inventions, patents, copyrights, and the like, are allowed to be capitalized. But even with this method, the amounts recorded can be trivial compared to the potential revenues. On the liability side, guarantees offered and insufficient insurance may result in life threatening obligations for the firm.
See research assignment R-6.17.
i)- Quality is not measurable with accounting numbers.
For instance, salary expense does not reflect employee motivation. Yet, quality is obviously often far more important than quantity.
See research assignment R-6.18.
Naturally, presenting all these limitations and problems of accounting numbers is not intended to suggest that accounting numbers should not be used. Proper recognition should also be given to past and continuing effort of the accounting profession to overcome some of these limitations and problems. Accounting data as it is prepared is the best one can hope for, specially when compared to other accounting data, such as the one presented in next chapter. However, analysts should be aware of the shortcomings underlying the numbers they are using, and when possible make correction for them.
See review questions Q-6D.1 through Q-6D.15.
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