Why Financial Statements Are So Darn Complicated
If only measuring businesses’ profits and values is as simple as looking at their dividends or share prices, investors’ lives would be much easier. But financial statements’ structures are the result of decades of negotiations between stakeholders with vastly different needs.
Readers evaluate companies from many different perspectives. Investors are concerned with the takeover value or future value of a firm. The government is concerned with how much tax a company should pay and the risk to the economy if the firm fails. A bank wants to know whether a loan can be paid back and the interest rate it should charge. Reporting companies want to minimize reporting costs.
In the interest of full disclosure, statements come with enormous amounts of detail. Making them even more challenging is the need for estimates. Some essential components of a company’s worth or income can’t be directly measured. That can allow executives to tilt some numbers in their favor.
Luckily, there are accounting standards that CEOs and CFOs must follow and an audience that’s highly motivated can catch anyone bending the rules too far. In the United States, they’re known as generally accepted accounting principles or GAAP. Accounting standards evolve to adjust to new industries, new laws and different needs.
There are also other standards across countries, such as the International Financial Reporting Standards. Underlying all accounting standards is a set of bedrock principles that will help us understand where the rules come from and how to better interpret companies’ financial statements.
Here are seven principles that investors should always keep in mind.
1. The Monetary Unit Assumption
A firm’s activity is measured in dollars and all dollars are equivalent. We all appreciate a good corporate citizen, but this will not appear on the statements unless an activity can be measured in dollars.
Great ideas alone will not influence reports until they lead to economic activity. A dollar earned in 1999 is assumed to be worth the same as one made in 2019. Inflation is not accounted for in statements, except in rare instances.
2. The Cost Principle
Purchases and assets are included in financial statements at their historical costs, not their current market values. This principle is most relevant to asset-rich firms. A company’s real estate could easily be worth more than the amount listed on a balance statement. Some rare exceptions to this, such as a broker-dealer’s inventory of stock and bonds, can be marked at market value. But a General Motors factory would be listed at the cost to build it or its acquisition cost.
3. The Matching Principle
Costs are associated with revenues when the revenue is earned. This means that every cost that can be matched with a sale is expensed when the revenue is recognized. This leads to what’s known as accrual accounting. The firm might estimate future taxes to offset sales income. Likewise, an estimate of future warranty repairs will also be expensed, whether or not the estimate is accurate.
4. The Revenue Recognition Principle
Revenues are recognized when they are earned, not when payment is received. As soon as a sale takes place, costs are matched with the sale and that revenue is booked. If the company is reasonably confident how much in sales it will fail to collect, it will deduct an estimate of bad debt from the sales number. But the timing of the cash receipt might be very different from the actual sale. That is why analysts watch the changes in short-term assets.
5. The Principle of Conservatism
When there is an accounting choice to be made, conservatism directs the accountant to choose the value that leads to either lower profit or lower assets. That does not mean accountants must understate numbers. But when an estimate must be made, it should err on the conservative side.
6. The Principle of Full Disclosure
Accountants should provide the contextual information that would help statement users understand the company’s current situation. That’s why the footnotes of financial statements are so relevant. They supplement the numbers and often lead to investors making significant adjustments to the statements.
7. The Going Concern Principle
Numbers are reported under the assumption the company will continue to operate indefinitely. That permits companies to defer some expenses and income in the interest of matching costs with income. If an auditor has reasonable doubt that the company may not be able to fulfill its obligations or continue its operations, it must be disclosed. A going concern disclosure is a big deal when the market hasn’t anticipated it.
Why Accounting Standards Matter
As dry as accounting jargon might be, understanding where accounting standards come from will make reviewing financial statements easier. Further, widespread adherence to these standards and enforcement by regulators maintains trust in our economic system.
This article was originally published in the January / February 2021 issue of BetterInvesting Magazine.
Sam Levine is the investment strategist for Antonelli Financial Advisors in Grosse Pointe, Michigan. He holds the Chartered Financial Analyst and Chartered Market Technician designations and taught stock portfolio management at Wayne State University.