“It Was a Dark and Stormy Fiscal Year…”: When Financial Reporting Is Financial Fiction

They say that numbers don’t lie, but that’s, well, a lie—especially in the world of corporate accounting. In fact, what’s seen and what’s real are often two very different things, making it almost impossible for investors, board members, and executives to have confidence in the numbers. Harvard Business Review does an excellent job analyzing why companies’ financial statements are often more fiction than fact:

 

Problem 1: Not-so-standard universal accounting standards

Earlier in this century, there was an initiative to create a single set of international accounting standards, ultimately uniting the U.S. Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS). Not too surprisingly, a complete unification has yet to take place—and seems unlikely to do so in the short-term. Analyzing investment targets, acquisitions, or competitors will often continue to require comparison of financial statements under these two standards. The resulting differences are quite startling—and can be large enough to change an acquisition decision.

 

Problem 2: Revenue recognition is a murky crystal ball

Revenue recognition has always been tricky, especially for those who do business in the virtual space, such as Software-as-a-Service (SaaS) companies. New accounting guidelines (ASC 606/IFRS 15) are meant to help. They allow companies that bundle future goods and services into contracts to recognize revenue in the year it is earned by using estimates of future costs and revenues. However, applying these criteria still requires businesses to exercise judgment—an additional opportunity to make good-faith errors or, worse, deliberate deceptions.

 

Problem 3: Unofficial earnings measures

The financial accounting world is rife with unofficial measures of revenue, such as EBITDA (or earnings before interest, taxes, depreciation, and amortization). Regulations—such as Sarbanes-Oxley, which requires companies on U.S. exchanges to reconcile GAAP measures of earnings to non-GAAP measures—are in place to bring some order out of the chaos. Yet significant reporting discrepancies remain, and some evidence suggests that unofficial measures may actually better represent earnings. These so-called alternative measures are unreliable and highly variable, however.

 

Problem 4: The unfairness of fair value accounting

There are two measures for calculating a company’s assets: the price originally paid (acquisition cost or historical cost) and the amount those assets would bring in if sold today (fair value). Since not everyone agrees on the definition of “fair value,” it’s made the financial reporting process extremely subjective. Even regulatory attempts to help auditors verify fair value have created greater confusion—not less.

 

Problem 5: Cooking the decisions, not the books

Regulations have made it difficult for companies to manipulate financial reports—a good thing, right? Not really. The so-called “gaming of results” has moved to a new place beyond the long arm of accounting rules: manipulating operations to generate better financial results.

 

A study published in the Journal of Accounting and Economics surveyed more than 400 senior executives on how their companies managed reported earnings. It “revealed that managers tend to manipulate results not by how they report performance but by how they time their operating decisions. For example, nearly 80% of the respondents said that if they were falling short of earnings targets, they would cut discretionary spending (such as R&D, advertising, maintenance, hiring, and employee training).”

 

Sadly, these tactics are not in violation of GAAP or IFRS, so executives can game the results knowing they are safe from auditors. Deep scrutiny of operating decisions is impractical because of the high volume of information being reported.

 

Living in an imperfect world

We don’t live in a utopia of perfectly factual financial reporting—and we never will. That doesn’t mean we don’t try, however. Indeed, as the Harvard Business Review points out, in this world of manipulation and deceit, “vigilance becomes vital.”

 

Today’s financial management/ERP systems can help put the facts back in financial reporting. These tools track both operational and financial performance at the most granular level and provide real-time, visual insights on how the business is doing. And a trusted implementation partner like the experts at Trustantial can ensure the job is done right, providing a trusted foundation on which to grow your business.

 

Call us today—we’re here to help.

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