Sources of Complexity
The financial statements of firms are made complex by a number of factors, some of which are external to the firms, like accounting standards (often designed to force more information disclosure) and some of which are the consequence of operating and financial decisions made by the firm. In this section, we will consider these factors.
Accounting standards and practices clearly bear some of the responsibility for the increasing complexity of financial statements. Some of the problems with accounting statements arise from the way in which accounting standards are written and the leeway that they provide to firms in their interpretation, and some of the problems arise from the changes that have been made to these standards, often with the best of intentions.
Inconsistency in applying accounting principles
The accounting standards that are on the books today were originally written for manufacturing firms that dominated business forty years ago, and have been amended and modified to fit the very different firms that exist in the market today. The accounting rules developed for the industrial age have not traveled well into the information age. The way in which the intangible assets of technology firms are valued in balance sheets offers some of the most visible example of the shortcomings and contradictions that bedevil current day accounting.
To illustrate, a firm that buys a patent from another firm will show the patent as an asset, whereas another firm that develops a similar patent based upon internal research will not show the patent as an asset at all. But there are other examples. A retail firm that borrows money and buys its store sites will show the sites as assets and the borrowing as debt, but a competing retail firm that leases these store sites will often show not show any of the leases as debt and no assets. The ways in which accounting statements deal with employee options and acquisitions have also created problems for investors over the last few decades.
Firms that use options to reward managers and employees clearly use them as management compensation. It stands to reason, therefore, that these options should be valued and treated as operating expenses in the period in which they are granted. Under current accounting standards, we ignore these options when they are granted and consider them only when they are exercised. The use of pooling and purchase accounting in acquisitions has allowed firms that qualify for pooling to essentially hide the cost of acquisitions from most investors.
Why might this add to the complexity of financial statements? Depending upon what assets they invest in, and how they structure these investments, firms can hide assets and debt from investors. To be fair to accountants, there is usually enough information provided in the footnotes to financial statements to correct for many of the inconsistencies in the United States.
Fuzzy Accounting Standards
In the last few years, we have acquired a sense of how much discretionary power firms have in how the measurement of income and capital. During the 1990s, for instance, more aggressive firms used the leeway that was available to them in the accounting standards to report higher earnings, lower capital invested and much higher returns on capital. Consider three examples:
• One Time Charges: Firms have been increasingly inventive in their use of one-time and non-operating charges to move normal operating expenses below the operating income line. In fact, the appearance of these charges year after year essentially overstates operating income and can simultaneously reduce the book value of capital invested.
• Hidden Assets: Firms have also used the wiggle room in accounting standards to move assets and debt off their books, using special purpose entities and partnerships. While some of these firms use these entities as legitimate devices to reduce their cost of debt and then provide information about their existence in their financial statements, others use them to hide their indebtedness from the public.
• Earnings Smoothing: Firms have used a variety of techniques to smooth earnings out over periods. In the 1990s, Microsoft routinely underestimated its earnings from upgrades to both operating and applications software, building up a reserve it could draw on in those quarters where its true earnings threatened to fall short of earnings expectations. Intel reported the price appreciation on the equity investments it had in other companies as profit and used these additional earnings to meet market expectations. During the stock market boom of the 1990s, some firms reported some of their excess pension fund assets as profits. What harm is done by these practices? For better or worse, investors who look at earnings stability as a measure of equity risk are misled into believing that these firms (and others like them) are less risky than they truly are. Does this mean that we should eliminate all discretionary power granted to firms?
We do not believe so, since there are clearly one-time expenses and income that should be separated from operating expenses and income. Can more effective policing by auditors prevent this type of abuse? Perhaps, but we seriously doubt it. In other words, no matter how strictly an accounting rule is written, there will be some firms that are more aggressive than others in their interpretation of the rule.
2 This is a direct consequence of the fact that money spent on research and development is expensed in the year of the expenditure, even though it is really investment for the future, i.e. capital expenditure (which should be spread out over time).
3 Most retail store leases are operating leases and are treated as operating expenses in the United States. Outside the United States, almost all leases are treated as operating expenses.
4 Even at exercise, firms use different practices to reflect the exercise of options. Some show the exercise value as expenses, while others make the adjustments to book equity in the balance sheet.
5 With pooling, firms can add up the book values of the acquiring and acquired firm and report it as book value for the combined firm. The premium paid over book value is ignored. In purchase accounting, the premium over book value show sup as goodwill on the combined firm’s balance sheet and is amortized over time.
6 See my working papers on converting operating leases into debt and research and development into assets on my web site.
7 In fact, analysts coined the term EBBS (Earnings before bad stuff) to represent the reported operating earnings of some of the more aggressive firms.
8 Using quirks in accounting rules, a firm can carve out some of its assets into a special purpose entity and have the entity issue debt. If the assets carved out are low risk (say receivables), the debt that is issued will often have a lower interest rate.
9 With a defined benefit pension plan, an increase in the value of the pension assets (invested in stocks) can cause over funding. Note though that the reverse will happen if stock prices drop.
Prof. Aswath Damodaran
Information Transparency and Valuation: Can you value what you cannot see?
It is clear that some firms are more forthcoming about their financial affairs than other firms, and that the financial statements of a few firms are designed to obscure rather than reveal information.
By Prof. Aswath Damodaran