Tuesday, November 24, 2009

Adjusting Financial Statements

Investors should be aware that certain stakeholders of financial statements can exert pressure or political influence that results in accounting rules that distort the true economic picture of a business. Investors need to be aware that such situations exist so that they ensure they have made adjustments that reverse these distortions.

For example, it took many years before officials finally caved and made stock option expensing mandatory. Managements, fearing that they would have to lower the number of options they receive or face huge drops in their reported profits, lobbied hard against the move. This quote is attributed to Harvey Golub, former Chairman and CEO of American Express:

"…while stock options have value to the executives, …, they cost the corporation nothing. They are never a cost to the company and, therefore, should never be recorded as a cost on the income statement."

If they are not a cost to the company, then a company that pays out no cash but instead pays suppliers, bills, and employees in options has operating profit margins of 100%! Obviously, this is a distortion of the company's true economic picture.

Though option expensing is now mandatory, I would argue that option accounting requirements have not gone far enough. Currently, balance sheets omit any indication of the value of outstanding options, but the outstanding options are very real obligations that should be subtracted from the shareholder's equity. Fortunately, within the notes to the financial statements, investors have what they need to make the adjustments themselves.

This was but one example of adjustments that need to be made to accounting statements in order for investors to make a more accurate determination of a company's intrinsic value. Many other examples exist, some of which are discussed on this page.

1 comment:

Jason said...

Great! Yes, I think investors would benefit from paying closer attention to revenue per share rather than EPS which is often a manipulative tool.