Financial Statements

admin — Mon, 08 Jun 2009 18:55:52 +0000

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.

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Financial Statements