A Shadow of Doubt
In today’s and next week’s edition of The Board Room, I want you the readers to be judges. I want you to assess the credibility of the financial statements of local en- terprises that are periodically splashed on local newspapers. Let me first of all give you a background on financial statements and how they can be manipulated.
Financial statements present a report on the financial performance and financial position of an enterprise. These accounts are the principal way in which the directors make themselves accountable to the shareholders. Shareholders and other investors use the information to assess the stewardship of directors and the financial health of the enterprise. The accounts allow the shareholders to assess how well the enterprise has been governed and managed. The accounts should therefore be clear and understandable to a reader with reasonable financial awareness; and should be reliable and believable.
However, there are several ways in which published financial statements could be misleading. There could be a fraudulent misrepresentation of the affairs of the company, where the company’s management presents a false picture of the financial position and performance; the company might use accounting policies whereby it presents its reported position and profit more favourably than would be the case if more conservative accounting policies were used. Again the financial statements could be complex and difficult for investors to understand. It is a relatively easy matter for accountants particularly in enterprises whose business is itself quite complex to present financial statements in a way that readers will find difficult to comprehend properly.
The following are some known ways in which companies sometimes employ to window dress their accounts; a company may claim to earn revenue and profits earlier than it probably should. For example a company that enters into a three-year contract that will earn P20 million in total might try to claim all the revenue of P20 million in the first year instead of spreading the revenue over the three year life of the contract; a company may try to take debts off its balance sheet. This is usually done by setting up separate companies known as ‘special purpose vehicles’; a company may disguise money from loans as operating income, to increase its reported cash flow from operating activities; and lastly a company may over value assets that it owns, either to increase its reported balance sheet reserves or avoid writing off a fall in value as a loss in its income statement.
Occasionally some companies may want to report strong growth in revenue and profits or even to improve the look of the balance sheet by hiding debts or other liabilities. A company could probably succeed in presenting an excessively favourable picture of its performance for a number of years, particularly when the economy is growing. Eventually however, it becomes impossible to ‘massage’ the figures any further.
In June 2002 US telecommunications group, Qwest Communications ousted it’s CEO, partly over concerns about the reliability of the company’s financial statements. In July the company disclosed that it had incorrectly accounted for large amounts of revenue over the past three years. Apparently the company had recorded millions of dollars of income at the end of each quarter that should properly have been attributed to the next quarter. In this way the company reported revenue and profits before they properly occurred.
That is the picture ladies and gentlemen and I hope it is clear enough to enable you to make fair assessment of the credibility of the financial statements published in our lo- cal newspapers next week when we look at them.