Overcoming the Problem
The question of reliability has to be addressed by the fundamental analyst. At the very least, you have to expect accurate information. Because each financial statement tends to be outdated by the time it is issued, you depend on long-term information—trends established over time—to make informed decisions. If those trends are artificially created in an accounting department within the corporation, how can you make an informed decision?
It helps to remember the primary role of the SEC to oversee the securities industry and to ensure that the market operates in a fair and orderly manner. Its objective is to protect the investing public. That means you have a right to full disclosure of information. This concept is most often applied to new public offerings and to information provided in an offering prospectus; but the principle also has application to the methods used for reporting financial transactions in any publicly listed corporation.
The role of the regulatory system is to protect investors. It cannot provide an ironclad guarantee that financial statements are absolutely true and correct.
Depending on the extensive accounting regulatory system is one way to assure yourself that the markets are efficient, not only as a marketplace, but in terms of disclosure. A second method is to study financial information over a number of years. The two trends to look out for appear to contradict one another. You should be suspicious when a company's financial results swing wildly from excessive profits to deep losses. Such a company is not being well-managed and growth is occurring in an out-of-control environment. That should not be seen as a situation appropriate for long-term investing. Equally suspicious is the company whose earnings rise almost predictably on the same course each and every year; whose profit margins are generally within a narrow range every year; and whose other fundamentals follow a straight-line trend—to a fault. In reality, such dependability is rare or nonexistent. In such a case, there is a good chance that some accounting manipulation is taking place.
If you have invested in the stock of a company and its fundamentals are predictable, perhaps even boring, the question you need to ask is: If the company is manipulating the financial results, is that a bad thing? From the point of view of an investor, you might realize that to a degree, managing the timing of income may have a positive effect on the stock price without materially affecting the true results. Because the leeway is provided, management has considerable discretion in how and when it recognizes transactions, values inventories, and establishes its reserves. The truth is, as long as no one is defrauded or otherwise damaged, it is unlikely that the practice will be considered a violation of the rules and regulations.
Accounting is not precise. It is so highly regulated and requires such time and effort because of its complexity. The practice of banking earnings usually is motivated by the desire to bring order to a chaotic world, rather than being intended to defraud or deceive anyone.
KEY POINT
No one really knows where the line is between discretionary accounting decision making and misrepresentation. It appears that the line may be in one place or another, depending on whether or not anyone is damaged.
Trusting the Fundamentals
- With the observation that accounting has many variables, you might wonder whether financial statements can be trusted. People tend to believe that a published, audited statement is the last word and in many respects it is. Having gone through the internal systems, independent audits, and oversight by the SEC, a published financial statement probably is as accurate as it can be. Remember that the fundamental analyst is a long-term thinker. Thus, you should not be preoccupied with momentary changes: stock price changes, rumors or gossip, or exceptionally high reports of transactions, especially those involving onetime write-offs or other changes materially affecting results. Think long-term. This thinking makes sense in the supply and demand environment of the market, where technical indicators rale the thinking of most people (i.e., the Dow Jones Industrial Average).
Long-term thinking also applies to financial statements and the dependability of financial information. Let's assume that in its latest financial statement a company made certain accounting decisions that do not completely disclose matters. Chances are good that the changes will be absorbed in coming years, for better or worse, and that the tinkering will have a short-term effect. If you are able to overcome the tendency most investors have to think short term, and become a long-term thinker, then what does it matter? Most of the accrual adjustments made by companies to interpret the treatment of income, costs, and expenses, have consequences in only two years: the current year and the year following. Thus, interpretive decisions are short term in nature and, in truth, may do much to maintain your investment's value. It is important to keep in mind the way the market thinks. Short-term indicators rale. So if the analyst of a large brokerage house says your company will have a net margin of 11 percent, and it comes in at 10.25 percent, the stock price may tumble. It will probably recover the following quarter so it does not really matter in terms of long-term value.
