The two systems, while generally similar, account for income in different ways that may allow a wounded company to hide its weakness by switching sides. Any change in accounting standards is a huge red flag that should prompt investors to go over the books with a fine-toothed comb. Damning statements are often casually mentioned in a company's financials. For example, a "going concern" note in the financials means that you should get out your magnifying glass and pay close attention to the following lines.
With the practice of overstating the positive and understating the negative, a company admitting to a "going concern" may actually be confiding that they are two steps from bankruptcy. Unexpectedly switching auditors or issuing a notice that the CEO is resigning to pursue "other interests" most likely in the Cayman Islands are also causes for concern.
Although there are many interesting numbers in a company's financials that allow you to make a quick decision about a company's health, you can't get the full story that way. Due diligence means rolling up your sleeves and scouring the sheets until you are sure that those main figures are real.
The best place to start looking for bloody fingerprints is in the footnotes. Reading the footnotes will provide you with the clues you'll need to track down the truth. Securities and Exchange Commission. Andrew S. Company Profiles. Financial Statements. Tools for Fundamental Analysis. Career Advice. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes.
Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Exaggerating the Facts. Smoke and Mirrors. Finding the Accomplice. Raiding the Pension. Getting Rid of the Body. Fleeing Town. Guilty Tongues Slip. The Bottom Line. Key Takeaways Companies are required to produce financial statements and disclosures to inform the public of their profitability and growth potential.
How will this work? Current GAAP rules would have the business recognize no revenue for the upgrades until the end of year five, when full cost information is available.
But under the new rules and under current IFRS rules , the company may estimate the cost of delivering those upgrades to allow it to recognize revenue. But the change will not completely eliminate problems. After all, estimating costs requires managers to exercise judgment, introducing yet another opportunity to make good-faith errors or to deliberately tilt estimates in such a way that the resulting revenues are closer to meeting financial targets.
Therefore, as these new revenue-recognition standards are adopted and implemented under GAAP and IFRS, investors will need to examine closely the assumptions and methods used to estimate costs and report revenues. Although unofficial measures of revenue are relatively new for many companies, all types of businesses have been employing non-GAAP and non-IFRS measures of earnings for a long time.
Today, Sarbanes-Oxley requires companies on U. In addition, the SEC requires that management be able to support the reasoning behind including an alternative measure in its financial disclosures. For example, a company might justify the use of a non-GAAP measure by noting that it is required by one of its bond covenants.
The alternative measure yielded a relatively modest price-to-earnings ratio of , rather than the mind-boggling 1, This suggests that unofficial measures may be a better representation of earnings. The danger, however, is that alternative measures are usually idiosyncratic. Investors and analysts should continue to exercise great caution in interpreting unofficial earnings measures and should look closely at corporate explanations that might depend on the use or abuse of managerial judgment. Some 25 years ago, before the rise of the internet, corporate financial statements relied on the former, which has the important virtue of being easily verifiable.
Today, however, companies use fair value for a growing number of asset classes in the hope that an examination of balance sheets will yield a truer picture of current economic reality. As the financial crisis took hold in , a myriad of adjustments to the methods of applying fair value were adopted by the U. The goal was to guide auditors on how to verify fair value, but the result has been more confusion, not less. The measurement process has proved difficult, often highly subjective, and controversial.
Consider the accounting treatment of Greek bonds by European banks in , during one of a seemingly endless stream of crises involving government debt in Greece. On that basis, RBS noted that market prices had dipped by just over half the price paid for those bonds when they were issued. If such difficulties arise with tradable securities, imagine how difficult it is to apply fair value principles consistently to intangibles such as goodwill, patents, earn-out agreements, and research and development projects.
Making matters worse, disclosures about how intangible assets are valued must offer only basic information about the assumptions that generated the estimates. If these reports included full disclosure of the assumptions behind fair value estimates—were such a thing even possible—the length of reports would be overwhelming.
Managers may, for instance, choose to overprovision—that is, deliberately overstate expenses or losses, such as bad debts or restructuring costs—to create a hidden cookie-jar reserve that can be released in future periods to artificially inflate profits. Or a company might underprovision, deliberately delaying the recognition of an expense or a loss in the current year. In that case, profit is borrowed from future periods to boost profit in the present. Recent changes in GAAP and IFRS rules have made such activities less egregious than they once were, although overprovisioning will most likely always be with us.
Managers want the accounting flexibility that comes from having hidden reserves, and external auditors will let them get away with it within limits because companies are unlikely to be sued for understating profits. A study published in the Journal of Accounting and Economics surveyed more than senior executives on how their companies managed reported earnings.
The researchers asked the executives to imagine a scenario in which their company was on track to miss its earnings target for the quarter. Within the constraints of GAAP, what choices might they make to reach the target?
The study revealed that managers tend to manipulate results not by how they report performance but by how they time their operating decisions.
Managers also goose the numbers by manipulating production. If a company has substantial excess capacity, for instance, mangers can choose to ramp up output, allowing fixed manufacturing costs to be spread over more units of output. The result is a reduction in unit cost and, therefore, lower costs of sales and higher profits.
But this practice also leads to high finished-goods inventories, imposing a heavy burden on a company in return for that short-term improvement in margins, as one study of the automobile industry shows.
When huge numbers of unsold cars sit on lots for extended periods, bad and costly things can happen to them: Windshields and tires may crack, wipers break, batteries wear down, and so on. Use depreciation methods to show lowered depreciation and therefore boost earnings.
Show inventory as being higher than it is or reduce the obsolete inventory amount. Manipulate figures for earnings from operations outside home base.
Some cases of manipulation of financial reports are so brazen, they can only be called fiction. Enron was one such instance. Skilling, Enron Corp. It also charged Richard A. Causey, Enron's former Chief Accounting Officer and others with charges of manipulating accounts.
0コメント