We already know that the value of our firm is determined by its underlying projects. We already know that these projects have cash flows that we use in our NPV analyses. So, why should you bother with learning about what companies say in their financials? A rose is a rose is a rose, isn’t it? The projects and thus the firm have the same value no matter what we report.
Yes and no. There are many good reasons why you should understand financial statements:
1. If you want to have an intelligent conversation with someone else about corporations, you must understand the language of accounting. In particular, you must understand what earnings are—and what they are not.
2. Subsidiaries and corporations report financial statements, designed by accountants for accountants. They rarely report the exact cash flows and cash flow projections that you need for PV discounting. How can you make good decisions which projects to take if you cannot understand most of the information that you will ever have at your disposal?
3. It may be all the information you will ever get. If you want to get a glimpse of the operation of a publicly traded corporation, or understand its economics better, then you must be able to read what the company is willing to tell you. If you want to acquire it, the corporate financials may be your primary source of information.
4. The IRS levies corporate income tax. This tax is computed from a tax-specific variant of the corporate income statement, which relies on the same accounting logic as the published financials. (The reported and tax statements are not the same!) Because income taxes are definite costs, you must be able to understand and construct financial statements that properly subtract taxes from the cash flows projected from projects when you want to compute NPV. And, if you do become a tax guru, you may even learn how to structure projects to minimize the tax obligations.
5. Many contracts are written on the basis of financials. For example, a bond covenant may require the company to maintain a price-earnings ratio above 10. So, even if a change in accounting rules should not matter theoretically, such contracts can create an influence of the reported financials on your projects’ cash flows.
6. There is no doubt that managers care about their financial statements. Managerial compensation is often linked to the numbers reported in the financial statements. Moreover, managers can also engage in many maneuvers to legally manipulate their earnings. For example, firms can often increase their reported earnings by changing their depreciation policies (explained below). Companies are also known to actively and expensively lobby the accounting standards boards. For example, in December 2004, the accounting standards board finally adopted a mandatory rule that companies will have to value employee stock options when they grant them. Until 2004, firms’ financial statements could treat these option grants as if they were free. This rule was adopted despite extremely vigorous opposition by corporate lobbies, which was aimed at the accounting standards board and
Congress. The reason is that although this new rule does not ask firms to change projects, it will drastically reduce the reported net income (earnings) especially of technology firms. But why would companies care about this? After all, investors can already determine that many high-tech firms (including the likes of Microsoft a few years ago) may have never had positive earnings if they had had to properly account for the value of all the stock options that they have given. This is a big question. Some behavioral finance researchers believe that the financial markets value companies as if they do not fully understand corporate financials. That is, not only do they share the common belief that firms manage their earnings, but they also believe that the market fails to see through even mechanical accounting computations. Naturally, the presumption that the financial markets cannot understand accounting is a very controversial hypothesis—and, if true, this can lead to all sorts of troublesome consequences.
For example, if the market cannot understand financials, then managers can legally manipulate their share prices. A firm would especially benefit from a higher share price when it wants to sell more of its shares to the public. In this case, managers could and should maneuver their financials to increase their earnings just before the equity issue. There is good evidence that firms do this—and also that the financial markets are regularly disappointed by these firms’ performances years after their equity issues.
Even more troublesome, there is also evidence that managers do not take some positive NPV projects, if these projects harm their earnings. Does this sound far-fetched? In fact, in a survey of 401 senior financial executives Graham, Harvey, and Rajgopal found that 55% would delay starting a project and 80% would defer maintenance and research spending in order to meet earnings targets. Starting projects and doing maintenance and R&D are presumably the right kind of (positive NPV) projects, so not taking them decreases the underlying real value of the firm—even though it may increase the financial image the firm projects.