The Reliability Problem— Accuracy of the Numbers
financial reports, while generally reliable and accurate, do not always reflect what is really happening in a company. If fundamental analysts make decisions based on a financial statement that is not entirely true and correct, then the fundamental analysis will be misleading.
The procedural rules imposed on the accounting and auditing professions by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, and the Securities and Exchange Commission (SEC) (as well as state agencies) are intended to set down specific reporting rules. However, in the complexity of the rules themselves, it is possible to find more than one interpretation of how data should be presented. In the financial world, it is possible to substantially affect financial statements and annual reports by tinkering with the numbers. This is disturbing for several reasons. First, if it is possible for a statement to be misrepresented, we next have to wonder if the practice is widespread. Second, if results are commonly misrepresented, then how reliable are the fundamentals?
KEY POINT
Outright fraud is rare, but the rales allow management broad discretion for interpretation of their own financial results.
Fortunately, significant tinkering—to the point of fraud—is a rare event. Yet, you should be aware that such abuses can and do occur.
The accounting rules are broad enough that companies have considerable latitude, and much of the accounting process involves estimates. What you hope the reporting reflects is a best efforts attempt at reporting the quality of earnings for operations, rather than an artificial reflection of positive results. Some interpretations are conservative, while others are aggressive. As a shareholder or potential shareholder, you are interested in seeing reliable results.
The real value of the auditing process is to ensure shareholders that they can rely on the financial statements issued by management. There is no promise that the statements represent the one absolute correct answer—because there is no such thing.
The Question of Reliability
Every investor who follows the fundamentals wants to believe that financial statements are completely reliable. The truth, in some cases, is more simple. The chief executive officer's (CEO) job might be more easily described as maintaining or improving the price of the company's common stock. If the CEO is given incentives in the form of stock options—rewards for reporting ever-growing profits and profit margins, for example—then the incentives certainly could provide motivation for manipulating what is reported on financial statements. This practice is not necessarily widespread, but it does occur.
KEY POINT
The chief executive officer's job might be to lead operations to ever-increasing profits, or it might be to improve the market value of the stock.
The vast majority of publicly traded companies report with integrity and can be depended on for reliable financial information. The danger arises when investors themselves rely on the wrong information, or invest without thoroughly understanding the nature of information they receive. Some recommendations follow.
• Never make decisions when you are approached by telephone. Period. No one is going to solicit your business with a truly good deal. You have to find those on your own.
• Recognize the narrative sections of annual reports for what they are. One annual report included current-year losses exceeding previous years'. Even so, the letter from the CEO expressed great optimism: "The reduction in the rate of increases in net losses underscores our move toward the direction of profitability."
• Watch a company's performance over the long term. The annual report includes financial statements for the latest year and for the two years preceding (for the balance sheet) and three years preceding (for the statement of income).
• Identify the causes of wide swings in any accounts on the financial statements. It should trouble you if a company's operating results swing widely from one year to the next. If you see a history of inconsistent results, you may wonder why. It happens in every company that one-time extraordinary items have to be included.
• Read the auditor's report. Finally, read the auditor's report accompanying the financial statement. The auditor's report contains three sections. First is the introductory paragraph, which states that an audit has occurred and identifies responsibilities of management and of the auditor. Second is the scope paragraph, stating that the audit was performed in accordance with generally accepted auditing standards, and that the audit provides a reasonable basis for the opinion. Third is the opinion paragraph, reporting the auditor's professional judgment about the accuracy and fairness of the financial statements. If a fourth paragraph is included, there is a problem. Only when qualifying remarks are required is there a fourth paragraph.
KEY POINT
The auditor's report should always be read carefully. Any qualifying remarks might be red flags and should not be ignored.
Remember, the statements are management's reports; the auditor only examines them for accuracy and compliance. So when qualifying remarks are found, that provides you with valuable insight and information.
