When Financial Statements Stopped Telling the Whole Story

We are living in a rapidly changing financial environment. New business practices bring new concerns and challenges for people who rely on financial statements to understand how a company is performing.

One important change took place during the late 1990s and early 2000s. Companies began changing the way they designed executive compensation. Instead of focusing mainly on reported earnings, compensation plans increasingly focused on increasing shareholder value—in other words, making the company's share price rise. As a result, stock options became a major part of executive compensation.

The basic idea behind stock options was reasonable. If executives owned, or could benefit from, an increase in the company's share price, their interests would be aligned with those of shareholders. If the shareholders did well, the executives would do well too.

But this approach also had a darker side - Executives came under increasing pressure to make their companies appear successful and to keep their share prices rising. In some cases, they became much more aggressive in presenting their company's performance. At first, this might have involved exaggerating the company's performance. But eventually, in some companies, it went much further. There were cases where earnings were fabricated or manipulated using complicated financial arrangements.

Companies began making use of instruments such as derivatives and special-purpose vehicles (SPVs). Some of these arrangements were so complicated that they did not appear clearly in the company's financial statements. They could also have very little to do with the company's actual business of producing or selling goods and services. The pressure on CEOs was increasing.

Earlier, executives could sometimes increase their bonuses by manipulating the earnings reported in the financial statements. But as accounting rules, scrutiny, and corporate governance became stricter, simply manipulating reported earnings became more difficult and more dangerous.

Executives who wanted to keep pushing their company's share price higher therefore had to find less obvious and more complicated ways of presenting the company's financial position. This contributed to some of the major accounting and corporate scandals that came to light around this period.

The United States government responded by introducing the Sarbanes-Oxley Act of 2002, commonly known as SOX. One of the important features of the Act was that the CEO and CFO of a company were required to personally certify the integrity of the company's financial statements. This changed the level of responsibility faced by senior management.

CEOs and CFOs could no longer treat financial reporting as something that was entirely the responsibility of the accounting or finance department. They had to take personal responsibility for the accuracy and integrity of the company's financial reporting. This also exposed senior executives to a much greater risk of prosecution and conviction if they knowingly misrepresented the company's financial position. The message was clear: senior management could not simply distance itself from problems in the company's financial statements.

India did not introduce a law by itself, that was identical to the U.S. Sarbanes-Oxley Act. Instead, India developed a framework of corporate governance, financial accountability, and internal controls through a combination of laws and regulations. The most important among these are the Companies Act, 2013 and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, commonly known as the SEBI LODR Regulations. These provisions built on earlier corporate governance and financial reporting frameworks and addressed many of the areas covered by Sarbanes-Oxley in the United States.

Section 134(5)(e) and Section 143(3)(i) of the Companies Act, 2013 deal with management's responsibility for internal financial controls and their effectiveness. These provisions serve a role broadly comparable to Section 404 of SOX, which deals with internal controls over financial reporting.

CEO and CFO financial certification requirements place responsibility on senior management for the accuracy and integrity of financial information. This is broadly comparable to the management certification requirements under Section 302 of SOX.

Audit committees and corporate governance requirements provide additional oversight of financial reporting and management. These serve functions broadly comparable to Section 301 of SOX.

Penalties relating to fraud and alteration or destruction of company records provide another layer of protection and accountability. These address areas broadly covered by Sections 802 and 1106 of SOX. So, although India does not have a law called "Sarbanes-Oxley," many of the same objectives are addressed through different provisions of Indian corporate and securities law.

All these regulations introduced greater responsibility at every level, these requirements created a kind of sub-certification process within companies. Senior management could not simply sign off on the financial statements without relying on the people below them. Finance teams, business heads, internal auditors, and other employees had to become more careful about the information they were providing. This forced companies to become more vigilant about financial reporting at all levels of the organization.

There was also a change in the way companies viewed stock options. The enthusiasm for granting large amounts of stock options to executives cooled somewhat. The growing scrutiny around executive compensation, financial reporting, and corporate governance made companies more cautious.

This may have contributed to the relative paucity of major accounting scandals after 2002, at least compared with the period around the turn of the century. But stronger rules did not eliminate the problem. The game continued - Companies and their executives continued to look for ways to evade, escape, or conceal problems. The methods changed. Some became more complicated. Others simply took different forms. As a result, investors and creditors continued to face highly unpleasant surprises when the true financial position of a company eventually became clear.

This brings us to an important point - We often look at financial statements as if they are an objective and unbiased picture of a company's financial performance. They are not necessarily that.

Financial statements are prepared using accounting rules, estimates, assumptions, judgments, classifications, and management decisions. There can be legitimate differences in judgment, but there can also be incentives for management to present the company's performance in the most favorable way possible.

Therefore, investors need to be careful. A financial statement may tell us a great deal about a company, but we should not automatically assume that it is a perfect or unbiased portrait of the company's economic reality.

Financial markets continue to evolve. The techniques used by companies to present their performance also evolve. When regulators close one loophole, companies may look for another. When one method of manipulating perception becomes too obvious, a different method may emerge. The names and techniques may change, but the underlying incentives often remain the same. That is why many of the same phenomena keep appearing in new forms.

In this series of articles, I will try to examine some of the methods companies have used to influence how investors perceive their financial performance. The objective is not simply to identify individual accounting tricks. It is to understand the patterns behind them. If we can recognize the old themes, we may be better prepared to identify their new versions. And perhaps, by understanding how companies have found ways to skew the perception of their performance in the past, we can learn to spot similar strategies when they appear again in a different form.