CONCLUSION
A primary objective of this chapter has been to supply an essential ingredient that is missing from many discussions of financial statement analysis.
Aside from accounting rules, cash flows, and definitions of standard ratios, analysts must consider the motivations of corporate managers, as well as the dynamics of the organizations in which they work. Neglecting these factors will lead to false assumptions about the underlying intent of issuers’ communications with users of financial statements.Moreover, analysts may make incorrect inferences about the quality of their own work if they fail to understand the workings of their own organizations. If a conclusion derived from thorough financial analysis is deemed “wrong,” it is important to know whether that judgment reflects a flawed analysis or a higher-level decision to override analysts’ recommendations. Senior managers sometimes subordinate financial statement analysis to a determination that idle funds must be put to work or that loan volume must be increased. At such times, organizations rationalize their behavior by persuading themselves that the principles of interpreting financial statements have fundamentally changed. Analysts need not go to the extreme of resigning in protest, but they will benefit if they can avoid getting caught up in the prevailing delusion.
To be sure, organizational behavior has not been entirely overlooked up until now in the literature of financial statement analysis. Typically, academic studies depict issuers as profit-maximizing firms, inclined to overstate their earnings if they can do so legally and if they believe it will boost their equity market valuation. This model lags behind the portrait of the firm now prevalent in other branches of finance.19 Instead of a monolithic organization that consistently pursues the clear-cut objective of share price maximization, the corporation is now viewed more realistically as an aggregation of individuals with diverse motivations.
Using this more sophisticated model, an analyst can unravel an otherwise vexing riddle concerning corporate reporting.
Overstating earnings would appear to be a self-defeating strategy in the long term, since it has a tendency to catch up with the perpetrator. Suppose, for example, a corporation depreciates assets over a longer period than can be justified by physical wear-and-tear and the rate of technological change in manufacturing methods. When the time comes to replace the existing equipment, the corporation will face two unattractive options. The first is to penalize reported earnings by writing off the remaining undepreciated balance on equipment that is obsolete and hence of little value in the resale market. Alternatively, the company can delay the necessary purchase of more up-to-date equipment, thereby losing ground competitively and reducing future earnings. Would the corporation not have been better off if it had refrained from overstating its earnings in the first place, an act that probably cost it some measure of credibility among investors?If the analyst considers the matter from the standpoint of management, a possible solution to the riddle emerges. The day of reckoning, when the firm must “pay back” the reported earnings “borrowed” via underdepreciation, may be beyond the planning horizon of senior management. A chief executive officer who intends to retire in five years, and who will be compensated in the interim according to a formula based on reported earnings growth, may have no qualms about exaggerating current results at the expense of future years’ operations. The long-term interests of the firm’s owners, in other words, may not be consistent with the short-term interests of their agents, the salaried managers.
Plainly, analysts cannot be expected to read minds or to divine the true motives of management in every case. There is a benefit, however, in simply being cognizant of objectives other than the ones presupposed by introductory accounting texts.
If nothing else, the awareness that management may have something up its sleeve will encourage readers to trust their instincts when some aspect of a company’s disclosure simply does not ring true. In a given instance, management may judge that its best chance of minimizing analysts’ criticism of an obviously disastrous corporate decision lies in stubbornly defending the decision and refusing to change course. Even though the chief executive officer may be able to pull it off with a straight face, however, the blunder remains a blunder. Analysts who remember that managers may be pursuing their own agendas will be ahead of the game. They will be properly skeptical that management is genuinely making tough choices designed to yield long-run benefits to shareholders, but which individuals outside the corporation cannot envision.Armed with the attitude that the burden of proof lies with those making the disclosures, the analyst is now prepared to tackle the basic financial statements. Methods for uncovering the information they conceal, as well as that which they reveal, constitute the heart of the next three chapters. From that elementary level right on up to making investment decisions with the techniques presented in the final two chapters, it will pay to maintain an adversarial stance at all times.
More on the topic CONCLUSION:
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- Conclusion and Recommendations
- Hare C., Neo D. (eds.). Trade Finance: Technology, Innovation and Documentary Credit. Oxford University Press,2021. — 417 p., 2021
- SOURCES FOR SLAVIC RELIGION
- Fligstein Neil. The Banks Did It: An Anatomy of the Financial Crisis. Harvard University Press,2021. — 334 p., 2021