Do financial statements tell the truth?
I produced this as a handout for an introductory course in corporate finance. Maybe it is interesting, or maybe I just feel bad about how infrequently I am blogging.
Financial statements are often referred to as “reports”. As you scan the pages, you will find neat columns of precise numbers. Financial statements look objective. Looks can be deceiving. The questions that financial statements are intended to address do not have objectively true answers. Suppose a firm builds a factory, with custom-built machinery designed to specifically to produce the firm’s product. That factory would become an asset on the left-hand side of the balance sheet. How much is that asset worth?
Often in this course we will emphasize “market value”. But our specialized equipment may not be usable by other firms, so if we tried to sell it in the market, it’d be valued as scrap, and would be worth a fraction of what we paid for it. (The salvage value of firm assets is referred to as liquidation value, and is usually far less than what appears on a balance sheet.) Alternatively, we could estimate the value we believe the equipment will ultimately provide to our business, which will be substantially higher than the price we paid for it. After all, we designed and built our machinery because we anticipate we can put it to profitable use.
If we value the machinery at liquidation prices, we will take an immediate loss on our books when we buy the equipment, as cash on the books is exchanged for fancy high-tech robots that we treat as though it were scrap. The more we work to expand the capacity of our business, the less valuable our firm will appear to be. That doesn’t seem right.
Conversely, if we use our best estimate of the revenues our purchase of the equipment will eventually enable, we will show an immediate gain on our books. (We would not have bought the stuff if we didn’t think it was going to generate more cash than it cost us.) However, even if our firm’s managers are honest and competent, allowing them to conjure instant profits with optimistic estimates of asset values might tempt corruption. Potential investors might be reluctant to rely on statements compiled this way.
In the United States, firm assets are initially valued at “cost”. Very simply, we say an asset is worth whatever a firm paid for it. For our machinery, that value is almost certainly “wrong”: If our expansion works out as planned, the equipment will have been much more valuable than its cost, and if our expansion turns out poorly cost will have been an overoptimistic estimate. The great virtue of “historical cost” is not that it is a good estimate, but that it is objectively measurable. Accounting conventions seem to prefer objective, verifiable lies to subjective truths! Is that dumb?
No, it’s not.
Uncertainty and bias are unavoidable in financial statements. Fortunately, the purpose of financial statements is not to whisper truth in God’s ear, but to inform human action. Since “truth” is not on the menu, long-term investors prefer that estimates be conservative. When you are going to put money on the line based on a bunch of numbers, you prefer any surprises to be to the upside. Plus, managers have incentives to overstate firm performance, because their compensation is performance-linked or because they wish to attract cheap financing. Historical cost accounting helps prevent self-serving optimism. On average, businesses do recoup more than the cost of the assets they purchase, so on average historical cost is conservative.
US accounting conventions skew even further towards conservatism: Older assets are valued at the lower of depreciated historical cost or “market value”. But market value often can’t be known without a sale. So managers are allowed to use subjective estimates to “write down” assets, but they are generally forbidden from estimating values higher than cost. Again, this asymmetrical policy is not designed to render accounting statements accurate, but to render their distortions less harmful. The deeper we examine them, we find that accounting statements look less like “snapshots” of a corporation and more like impressionistic portraits. Some aspects of a firm’s situation are emphasized or skewed, while other aspects may be hidden. If accounting rules can’t render statements 100% accurate, they can at least go for “usefulness”.
What characteristics render financial statements useful? We’ve already talked about conservatism. Another important characteristic is consistency. Investors often need to make comparisions between firms, in order to decide where to invest money, or to evaluate firms they already own against industry peers. Accounting standards boards try to define consistent standards, but there are trade-offs between consistency and accuracy. For example, an accounting rule that computer equipment should be depreciated over 5 years may be appropriate for an ordinary firm, but not for a cutting-edge software company whose workstations must be replaced every 2 years. Enforcing that rule uniformly might lead to the software developer’s profits being overstated in some years and understated in others, rendering bottom-line profitability less comparable between firms!
If financial statements are designed to be “useful”, it’s worth asking the question, “useful to whom”? So far, we’ve mostly considered the interests of the long-term investor, who usually desires that statements be as accurate as possible, but conservative where estimation is required. There are other constituencies interested in financial statements, including creditors, analysts, regulators, tax authorities, and firm managers. There may even be conflicts of interest between these groups. Accounting choices affect reported profitability, and therefore taxable earnings. Managers and current investors may prefer accounting choices that defer recognition of profit, while tax authorities want profits to be recognized as quickly as possible. On the other hand, managers and shareholders of firms that borrow much of their capital — leveraged firms — may prefer optimistic choices that enhance apparent profitability, because lenders demand lower interest payments from firms that are “financially strong”. (Note that shareholders of leveraged firms have a kind of conflict of interest with themselves! On the one hand, they prefer conservative accounts in order to safely evaluate their own positions. On the other hand, they prefer “aggressive” accounts that paint a picture of financial strength, in order to help the firm get cheaper loans. Interest payments are a direct hit to shareholder profits, so shareholders of very leveraged firms may be willing to forego conservatism and accuracy of statements in favor of profitability.) Managers and short-term investors may wish to “smooth earnings”, because the stock market rewards reliable earnings, while long-term investors prefer clear information about the timing of firm performance. Analysts often desire consistency and comparability between firms above all, while investors and managers may wish to tailor accounting choices to the unique circumstances of their business.
How can all of these interests be accommodated by a single set of financial statements? They can’t be. The financial statements that are actually published are hard-fought compromises that try to square an impossible circle. Both at the accounting standards level (e.g. the Financial Accounting Standards Board in the United States) and within individual firms, different groups struggle to have their interests and preferences reflected in the disarmingly precise columns of numbers that will become the centerfold of annual reports.
This struggle takes place in boardrooms and public policy debates. But it leaves footprints, or more literally footnotes. Accounting statements are generally accompanied with a set of notes that is much longer than the statements themselves. These “drill down” into the summary values presented in consolidated statements, and explain the accounting choices beneath the published numbers. Usefully, the notes include quantitative information with which a dedicated analyst can compute alternative statements based on different accounting choices. Even a casual reader may learn more from a careful read of the footnotes than from the headline statements. When financial analysts wish to compare a group of firms, they need “apples-to-apples” financial statements. One of the first thingsthey do is adopt a uniform set of accounting choices and recompute the various firms’ financial statements, using information from the notes.
Financial statements are like fictional works “based on a true story”. They bear some relationship to actual events, but they are interpretations with their own biases and agendas. Successful investors and analysts will read them critically, piecing together clues, sometimes learning as much from the paths not taken as from the numbers actually published.
1) Your textbook is very cognizant of the ambiguities surrounding accounting values. Rather than get all hermeneutical with financial statements, your book encourages you to circumvent them and rely on data that seems objective, especially market values and cash flows. What are some benefits and drawbacks of this strategy?
2) Prior to the 2008 financial crisis, financial firms found ways of circumventing the accounting conventions that generally render financial statements conservative. In particular, “gain on sale” accounting allowed banks to effectively write-up the value of recently purchased assets above historic cost (via the trick of “selling” the assets to a special purpose entity that the bank itself organized, as part of the process of securitization). Why would bank managers and employees want to do this? Don’t long-term shareholders generally prefer conservative accounts? Why might shareholders tolerate this practice at banks?