Imagine your company wants to make a substantial new investment and wants you to investigate three companies to determine which will offer the best return with the least risk. A colleague reminds you that earnings are the most popular metric for evaluating performance—and the most important to many chief financial officers—but an organization’s management can manipulate earnings statements to appear more profitable.
Your colleague’s caution is valid: managers in most companies have the opportunity to inflate earnings and smooth volatility in growth. Management often has incentive to manage earnings, too, because earnings affect the stock options and compensation managers receive. While investors eventually become aware of inflated earnings and the deceiving company’s stock will begin trade at a lower value, your business wants to avoid that scenario.
Therefore, as you begin your research, you look beyond the earnings metric to other, more revealing performance measurements, including:
- Operating cash flow.
- Free cash flow.
- Return on invested capital.
- Economic value added.
For each company, you perform an analysis using these alternative metrics to help you determine a more accurate financial picture than you might discover if you only used earnings statements. During your analysis, you also look for areas of concern—red flags—in the opportunities’ reported statements, such as big bath charges, other income, extraordinary items, discontinued items, and changes in estimates.
In addition, you determine what type of accounting methods each opportunity employs by asking:
- Does the company use conservative or aggressive revenue accounting?
- Does it employ percentage of completion or completed contracts when reporting sales?
- Does it use share count, depreciation, or inventory accounting?
- In its inventory accounting, does it employ average cost, FIFO, or LIFO?
- Does the company capitalize its interest?
Operating on the theory that the ratio will be higher with higher growth, lower risk, and higher payout, the last item you analyze is the company’s price-to-earnings ratio in conjunction with the complexity of its accounting methods and its level of transparency. Finally, you make your recommendation to pursue a company with transparent accounting methods whose mix of metrics reveals a solid, traceable accounting strategy.
Are you ready to assess the financial statements of firms with such rigorous analysis? The Accenture Academy course Applying Forensic Accounting can assist you with recognizing the various accounting techniques used to manipulate financial items to help you and your company avoid financial statement gimmickry and make stronger accounting decisions.