The Need for Reading Between the Lines

There are two distinct approaches to Financial Statement analysis. The first is to follow a prescribed routine, filling in boxes with standard financial ratios (precise and inflexible definitions), a cookie-cutter approach.

The second and a more rewarding alternative is a relentless pursuit of accurate financial profiles. This tenacity is required because financial statements often conceal more than they reveal. This approach is looks at the first approach as a means rather than an end. So the real analysis begins after all the usual questions have been answered.

The financial statements are generally prepared following the traditional, rule-bound framework like US GAAP / Indian GAAP (IGAAP) / Ind AS, which are guided / modeled / mandated would likely produce fair and useful indications of relative value. It follows that the companies that issue the financial statements go all out and are very eager to make their financial results known to investors and can be expected to report their results in a transparent and straightforward fashion... or so it would seem.

This leads us to the next obvious question - what is the purpose of financial reporting?

We need to recall the sarcastic and cutting remark of Howard Schilit about the purpose of financial reporting - "The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company." Missing from this formulation is an indication of whose primary goal is accurate measurement. The issuers of financial statements are for-profit companies, and they exists for the benefit of its shareholders. And, a direct method of maximizing shareholders' wealth is to reduce the company's cost of capital. it can be either borrowing at a lower interest rate or sell stock to new investors at a higher price. The best kind of financial statement is not one that represents the company's condition most fully and fairly, but rather one that produces the highest possible credit rating and price-earning multiple. So, the purpose of financial reporting is to obtain cheap capital. And hence reporting is a means unto an end.

There are arguments that say that, misleading the users of financial statements is not a sustainable strategy over the long run. For example, if an overstated historical profits to project company's future earnings will find that results fail to meet their expectations. Thereafter, they will have to adjust for the upward bias in the financial statements by projecting lower earnings. The outcome will be a stock valuation no higher than accurate reporting would have produced. Based on this reasoning, can we take the numbers at face value because the company's that act in their self-interest will anyway report their results honestly. But the inconvenient truth is that financial statements do not invariably reflect their issuers' performance faithfully. Though the number conform to the accounting standards, yet convey a misleading impression of profits, worse yer, companies frequently bend and sometimes break the rules for financial reporting. Not even the second line of defense, an affirmation by independent auditors stating that the statements have been prepared in accordance with the standards assure that the numbers are reliable. Auditing firms, no less than companies, are for-profit businesses with incentives to sweep their failings under the rug.

There are other reasons that drive companies toward candid financial reporting. The managers have their own agenda - managers seek to maximize their wealth and if producing bonafide economic profits advances that objective, they will as well try to do so. A typical example would be if CEO's year-end bonus is based on growth in earnings per share. If anything, companies became more creative and more aggressive over time in their financial reporting.