Eeny, Meeny, Miny, Mo - What Accounting Rules Do You Want?
Throughout my career, I've been fortunate to work on multi-disciplinary projects, many of which combined accounting with finance. It is my personal view that the two areas are integral to good business decision-making. Whether I've taught eager MBAs or corporate executives or managed analysts, I've cautioned people to look beyond the numbers, try to ascertain what information is missing and identify whether there are gaps between the accounting representation and potential economic profitability. Citing Columbo and the need to "be a good financial detective," I've suggested that (dare we say it?) accounting numbers can be illusory and therefore require a proper vetting. (By the way, my mention of the venerable television sleuth drew blank stares from the students so I had to switch to CSI characters instead.)
What does this mean for institutional investors?
Anyone committing funds to fixed income, equity or hybrids must have a solid understanding of what financial statements convey, and by extension, what they do not reflect. Assessing the quality of earnings (balance sheet) is often difficult. Rules are complex. Companies can have tremendous latitude in their reporting choices. This puts the onus on the investor to do a good job of comparing reported numbers against industry/company factors as they relate to predicting future expected cash flow or some other measure of economic profitability.
Always challenging, it may become more so now that the SEC has opened the door to foreign companies (and perhaps U.S. firms by extension) being able to choose which standards make sense for them. In his April 25 article, ("SEC to Mull Letting U.S. Companies Use International Accounting Rules"), Wall Street Journal reporter David Reilly writes: "The commission said it will begin soliciting comments this summer on a possible change allowing foreign companies registered with it to file financial results using international financial reporting standards, or IFRS. Currently, foreign companies that file with the SEC must reconcile their results to U.S. GAAP, a costly and time-consuming process that many companies, especially in Europe, want to do away with."
Whatever the choice, financial statement users have a tough job. First of all, analyzing industry peers could require even more attention being paid to HOW numbers are put together. Company X uses U.S. GAAP (Generally Accepted Accounting Principles) and Company Y uses an altogether different approach. You have two sets of numbers. Which one is right in terms of assessing economic potential?
Still a classic (but pay attention to new rules) is Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 2nd edition by Dr. Howard Shilit. Also check out Michelle Leder's blog, Footnoted.org. Author of Financial Fine Print: Uncovering a Company's True Value," Leder drills down deep into the footnotes that many ignore.
On the pension accounting front, European firms are still reeling from rigorous rules. The adoption of new financial strategies and plan redesign (or perhaps termination) are not uncommon in some countries such as the UK. Stateside, FAS 158 is getting lots of attention with much more to come.
If people ignored accounting numbers and chose instead to focus on economic forecasts alone (i.e. take a fundamental approach to investing that emphasizes competitive structure, operating environment, etc), that would be one thing. However, there is extensive research that suggests that companies DO behave a certain way in response to accounting rules.
Therefore, as companies get to choose accounting rules by which they will abide, investors must:
1. Understand what the different standards mean in terms of an accounting - economics "gap"
2. Identify whether a reporting entity is perversely changing its behavior to game a particular rule and buoy its numbers
3. Roll up those shirt sleeves and sleuth away. What you see may not be what you get!
