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.


Thought questions:

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?

 
 

21 Responses to “Do financial statements tell the truth?”

  1. JKH writes:

    “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?”

    This was a relatively small but horrific symptom of the underlying problem – which was the steady incursion of investment banking management and thinking into the commercial bank management mindset. This included the stock option phenomenon.

    The universal banks that most successfully weathered the storm (sorry – again in Canada) were the ones who demonstrated at least some innate strength of cultural character in resisting the siren call to at least some prudent degree.

    The gain on sale feature is a specific example of a more general marked to market accounting abuse that was fundamental to the financial crisis.

    Obviously, the problem wasn’t only on the way up.

    The universal accounting failure is this – for some reason, there doesn’t seem to be the capacity to recognize the distinction between transparency of asset values versus the numbskull reflexive action of ramming those values through the capital account to the exclusion of any other related considerations. This in short was why TARP was necessary. With a more reasonable attitude toward the information value of disclosure per se, quite separate from ongoing capital accounting, that program might have been avoided, or at least mitigated to a greater degree.

    The sensible corollary to the more reasonable separation of valuation disclosure and capital accounting is that the stock market is then in the unambiguously supreme position of factoring hypothetical (and hypothetically risky) asset values into the assessment of future cash flow and valuation – rather than this being done in some slip shod volatile manner through the capital account of the firm itself. This allows for greater clarity in who is attempting to do what in the process of hypothetical asset value disclosure and its effect on stock market values.

  2. [...] tweeted a great post from @interfluidity entitled Do Financial Statements Tell the Truth that takes us well beyond the basics to provide insights as to what is really happening when public [...]

  3. [...] Do financial statements tell the truth? – via Interfluidity – 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? Video Lecture: Evolutionary biology & Sexual Selection – via Video Lectures – Sexual selection is a component of natural selection in which mating success is traded for survival. Natural selection is not necessarily survival of the fittest, but reproduction of the fittest. Sexual dimorphism is a product of sexual selection. In intersexual selection, a sex chooses a mate. In intrasexual selection, individuals of one sex compete among themselves for access to mates. Often honest, costly signals are used to help the sex that chooses make decisions. [...]

  4. drfrank writes:

    Wouldn’t it be fun to talk about financial statements as if they were literary forms? Beginning with the question of the reliability of the narrator of those reports that purport to tell a story that covers a given period. Investors want the mother of all representations: things are as they appear to be. Plus, past performance is indeed a reliable guide to the unfolding future (what else do you have?). For an exercise, your students might also enjoy working out the correspondences between balance sheets and sonnets, taken as logical structures of fourteen lines in rhyming pattern with variations (plus, minus, conclusion or Assets: AABBCC; Liabilities: DDEEFF; New Equity GG).

    I want to encourage you to blog more often. More along the lines of the piece about sticky wage rate prices, as it pertains to the real politic we inhabit.

    Recently I stumbled upon a book published in 1932 containing a series of essays by a writer for the Saturday Evening Post. His theme is the way US allies in the First War managed to squiggle out of war debts to the US by linking their payments to German reparations. He claims that German reparations to the extent they were paid were paid by loans from the US. He claims that credits to Great Britain and France funded by US Liberty Bonds were used by the beneficiaries to raid US gold reserves. Interesting for the cross light on the difficulties of a creditor nation, say China.

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  6. Nick Rowe writes:

    This makes a lot of sense to me. It was really good to read it.

    A question: do accountants actually think about this stuff (the Philosophy of accounting)? Or do 99% of them simply remember “Number A goes into box B, it must it must!”?

    I think the “stickiest price” is not debt, but accounting conventions. Think of how inflation would play havoc with the meaning of historical cost.

  7. VJK writes:

    Nick,

    Historical cost is not affected by inflation. If you bought a building at $60K in 1960, it will remain at $60K on the books (minus accumulated depreciation) no matter what is the date today. In accounting it’s called “cost principle” ( http://www.businessdictionary.com/definition/cost-principle.html )

  8. Nick Rowe writes:

    VJK: but that’s exactly the problem. Suppose a business has one asset, some land they bought for $60k in 1960. And it rents that land out at (say) $6k per year. Suppose the market price of everything rises tenfold, land and rents. Which is to say the value of money falls 90%. So the rents rise to $60k per year. At a P/E ratio of (say) 10, that business is worth $600k, in inflated dollars. But the books say it is still only worth $60k, which is one tenth of its real value. At $60k, that business is a steal. The books give you a very misleading picture.

  9. VJK writes:

    The primary reason FA uses historical rather than, say, replacement cost is reliability. Price is an attribute of completed transaction for which some supporting documentation exists, such as a canceled check, an invoice, a contract, etc. Thus, historical cost is a generally accepted trade-off between reliability and relevancy. In order to recognize an economical value increase, accounting rules require that an actual transaction should occur showing the new price.

    If you want to know the so-called company market ‘price’ which is more or less a mere speculation possibly embellished by some irrelevant math, you can hire an appraiser/auditor who will be happy to cook that number for you.

  10. [...] Do financial statements tell the truth? Steve Waldman. Eeek, from a few days ago…… [...]

  11. Harald Korneliussen writes:

    Nick Rove: I’d also like to know whether they teach accountants about “the philosophy of accounting”, and if they do, whether they pay attention. Finance isn’t the only field where it’s important to figure out what to count, and how to count it once.

  12. Jim Haygood writes:

    Saw your essay linked at Naked Capitalism.

    Maybe you could write another one on government accounting standards. How does the federal government get away with cash-basis accounting, when it has long-lived obligations such as entitlements programs?

    The Treasury publishes an accrual-basis Financial Report of the United States. But it doesn’t seem to be used in budgeting by the president and Congress. And the financial press happily reports cash-basis deficits, which usually understate accrual-basis deficits.

    Why do government accountants allow this situation to continue? It strikes me as a violation of professional integrity, to materially misstate the financial position of the largest entity on the planet.

  13. [...] Do financial statements tell the truth? – I guess it’s mostly about the agreement between the company and the auditor. [...]

  14. beowulf writes:

    Randy, OT but I wanted to make a point about your “Monetary Policy in the 21st Century” piece (comments already closed). I agree with you that helicopter drop money should be the buffer, but for both practical and political reasons, the helicopter drop has to be done by Tsy. Congress will almost certainly oppose the Fed directly wiring their constituents’ money and will absolutely oppose the Fed directly taxing their constituents’ money. They will gut the Federal Reserve Act and give Tsy total authority over the FRS before that happens (which they should probably do anyway).

    Couldn’t you get to the same place by Congress using the FICA tax system by adjusting FICA collections based on that month’s unemployment rate? Easy enough to come up with different formulas, but, say, FICA collection reduced by (U3 x 10)%, so a 9.7% U3 rate means FICA collections reduced by 97%. As soon as the DOL updates its monthly U3 rate, Tsy could automatically update the FICA reduction percentage up or down. FICA collects almost $900 billion a year, if you wanted a bigger stick, you could add more taxes to the same regime– capital gains taxes, state sales taxes (with Tsy reimbursing the states), federal and state income taxes or even a future VAT regime– they could all have their weekly or quarterly tax payments adjusted based on unemployment (though FICA’s regressive nature make it the best single tax to cut).

    And how to fund the shortfalls? Tsy could simply use its open-ended coin seigniorage authority (31 US 5112(k)), and mint as much legal tender coinage as it needs, which the Fed buys at face value, to replace the tax holiday amount. Ronald Reagan on, say, the $100 billion platinum coin would be grand. Since seigniorage is booked as income and not debt, if nothing else, we could balance the budget every year. :o)

  15. Ted K writes:

    Mr. Waldman this is a terrific post. Some people are so good at writing about the dry topic of finance I wonder what would happen if that person tried their hand at a novel. You’re one of those guys. Very insightful, yet fun reading. Quality is always better than quantity, but I can’t wait for your next post. Awesome stuff.

    Also, I like reading when you give those guys in Treasury hell. Don’t forget to bark next time you go please.

  16. [...] the capital ratios mean nothing if the assets are overvalued. Waldman is always going on about this. It ends up as quite a radical critique: capital ratios without valuation reform = cart before [...]

  17. [...] the capital ratios mean nothing if the assets are overvalued. Waldman is always going on about this. It ends up as quite a radical critique: capital ratios without valuation reform = cart before [...]

  18. well I guess you learn something new everyday. Got something outta this that I realize before. Thanks…

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  21. Roland Crane writes:

    Don’t you think financial statements are just fluff for the rest of us. Until true audits are done, everything can be setup as smoke and mirrors. This is just the way it is I guess.