Balance sheet and income statement

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Introduction:

In recent years, there are many cases which have been involved in fraudulent accounting practice, such as the Enron and the WorldCom had tried to exaggerate their earnings for the purpose of maintaining high share prices. Those problems lead to a lack of confidence in information in financial reporting. The answer to the question whether a firm's balance sheet and income statement prepared under Generally Accepted Accounting Principles (GAAP) inform investor of company's performance within next few years has been controversial for long time. In our research we focus on profitability as an important factor of future performance. Efficient securities markets theories state that financial reporting play a very important role in improving useful information in stock market. The facts are that the role is not large and it seems to be declining. On the contrary, behavioral theories say that investors do not use any information in financial statements in inefficient securities market. Clearly, this issue is very important because a large number of users rely upon financial statement namely balance sheet and income statement to make decisions in choosing among alternative investments in order to maximize their wealth. To deal with this issue, first we will discuss about issues in GAAP, and then we will show how the balance sheet and the income statement under GAAP provide the information to investors in predicting future performance.

"Information provided in financial statements, specifically, balance sheet and income statement is very complex and challenging. Due to this complexity, investors interpret and react differently to information provided in the financial statement proper. This challenge is result of the existence of different groups with conflicting demands and interests in financial reporting" (Scott,2006: pg9). Thus, in order to survive in such a complex environment, accountants must work vigorously and continuously to come up with standards such as GAAP to serve these different constituencies of accounting. In order to serve its purpose, this information must be free from bias for the different users who rely on it.

GAAP's principals play a role in reducing the risks of material misrepresentation or misstatement in a company's accounting figures but it is not a perfect standard for reflecting the company's economic performance. In this context, GAAP will be a better standard if the historical approach was changed toward the fair value approach. Because in GAAP , historical cost accounting used requires assets and liabilities to be recorded at their values when first acquired and do not reflect the fair market values. Although those amounts are objective and less subject to errors of estimation and bias because those numbers are based on events that have already taken place and thus are verifiable, its reliability is not absolute because the managers still have some room to manage their reported profitability such as the choice of amortization method (Scott, 2006:pg38). Furthermore, regardless of the market conditions and the market price changes, historical cost will be similar as at the date of acquisition (Scott, 2006:pg37). In other words, historical cost measurement does not likely reflect the current economic benefit represented by the asset, which has a indirect impact on profit creation. So, the historical cost loses its relevance when time passes because the actual value of assets including gains or losses in value would be unrealized until disposal transactions. Therefore, current economic benefit represented by assets and net income lag behind its real economic performance. As a result, investors need to make many adjustments by themselves to accounting figures to know the real picture about the company in order to inform them of company's continuing earning power in the next few years. In addition, the same kind of assets acquire from different companies may have different amounts because of negotiation of prices at the time of acquisition. Therefore, it does not provide a good comparative base[1]. On the contrary, the investor in our interview thought that GAAP has enhanced his confidence using the accounting information in their investment decision, because the guidelines in GAAP has reduced error or fraud in financial reporting.

Companies are required to follow the reporting standards when GAAP is in place. "GAAP plays an important role in the reporting of financial because it provides a consistent basis for companies to report their financial statements. This consistency allows investors to easily interpret and process a firm's financial information and compare them to the financial data of the firms' prior periods as well as of other companies. This therefore, helps to reduce the risk of material misrepresentation or misstatements inherent in a company's accounting figures"[2]. However, the guidelines provided by GAAP have inherent problems in the information presented on the balance sheet and income statement, when investors are seeking to predict the company's future profitability.

Discussion 1: The Balance Sheet Approach

When investors are interested in investing their capital to companies, it is assumable that, they would like to put their money to firms that they believe will bring them the largest return. In order to do so, they often evaluate candidate companies in means of one way or the other. Regardless of the methods they used, it is common to conduct their analytical evaluation in relation to available information given. Within the various types of information, a balance sheet is a source of information that is readily available to investors in the open market, although their informativeness is arguable. In this section, we will examine whether the balance sheet plays a role in informing investors in regard to persistent firm profit as a performance measure in the short term. In this context, we will define persistent income as reoccurring income in different periods resulting from the company's normal business operation, in which there is a high likelihood of continuance for its existence in the present and future.

The method of asset measurement on the balance sheet hinders investors from evaluating the productivity of various companies' assets, which hampers its overall comparability in firm profitability. Assets are presumed to be productive in nature which means they are expected to bring in future benefits or profit to the firm. However, because most assets are measured under GAAP based on the historical cost approach, assets measured on different companies' balance sheet of the same nature, detail and productivity can be shown at various amounts due to the difference in cost of payment or consideration rendered for these assets. This nature of the balance sheet induces any excessive payment made for assets to be capitalized, which will hamper the comparability of assets among companies. As discussed earlier, because assets are productive tools of the firm to bring in profits, this would affect investor's knowledge about the firm's profit creation ability. For example, the finance manager might decide to acquire new software to manage the accounts receivables from a company that his relative owns and the asset was purchased for $20,000 higher than the fair market value. In this case, the firm has paid $20,000 in excess of the fair market value because the manager wants to give the non-arm's length seller excessive revenues that he/she otherwise would not get. With the historical approach, this asset will be recorded on the balance sheet at an overstated amount in relation to its fair market value. Hence, investors would be unaware that this asset has the same profit creation power or productivity as other assets that worth only $20,000 less in the market.

Consequently, balance sheet prepared under GAAP might report distorted values for assets of the same characteristic, which along with the assumed productive nature of assets, mislead investors to perceive higher profit creating ability of the firms with a larger asset base. Hence, the historical approach of asset measurement will sometimes misinform investors about the company's future profitability.

In addition, investor could hardly predict the firm's future profitability by observing what assets the firm holds from the balance sheet. In order to make profit, it first entails the firms to have a strong business strategy that is suitable to its environment, and then the firm needs to incorporate the use of its assets to implement the business strategy. However, the balance sheet has no reference about the firm's business strategy and how individual assets are contributive to the business's profitability, therefore investors can not make any sound profit prediction based on the balance sheet. As Dichev and Penman argue, "the main problem with the balance sheet approach is that it is largely silent about the notions of business model and business performance, which are central to a firm's success and value-creation. The balance sheet model takes asset values as given, as stores of value, which are divorced from what the firm is doing, and diverts attention from operations, which are the key to firm success and value. (Dichev & Penman, 2007). In their view, the balance sheet is problematic because it fails to provide a link between the company's asset and the role these assets play in the firm's business model, which is developed to make profit. Because a firm's profitability lies in the success of its operation, this missing information indeed is the most crucial and informative to investors about the firm's profitability. In addition, they argue that the presence of assets on the balance sheet merely capture the company's value of holdings rather than indicate success factors, which has little relevance to investors in predicting profitability. In relation to our topic question, because the balance sheet neither provide information to predict how the firm can use particular assets in creating profit nor how these assets are beneficial to the company's business strategy, it fails to inform investors of connection between these assets and profit creation. Also, according to the interviewee when posed with the topic question, what he had to say was valid. The net income is not provided in the balance sheet and a potential investor will not know of how the retained earnings figure is determined. Which in turn results in the investor being unable to predict future profits. The balance sheet approach does not outline how a business is run, and what particular assets, generate what proportion of profits. Where the retained earnings figure was generated from is an important question. Was it from operating activities or from sale of assets? The truth is, when using the balance sheet approach, according to the interviewee, this information is not provided.

Moreover, the acquisition of additional assets is not always intended to bring in additional profits for the firm. In their article, Chan, Karceski, Lakonishok, Sougiannis (2008) quoted what Wei and Xie (2004) argued in their article "...excessive accumulation of assets is a consequence of the agency cost of delegated management, as firm executives engage in wasteful spending that serves their own interests."(Chan, Karceski, Lakonishok & Sougiannis, 2008). When shareholders (investors) delegate authority to management, they are expecting management to serve for the firm's best interest which is to generate profit, but often management deviate from this goal if by pursuing their self interest is more beneficial. The above phenomenon occurs when there is a lack of goal congruence between management and shareholders, namely the investors. Although the balance sheet can reflect on how many assets are purchased by management as operating assets, it would not provide any qualitative detail to investors to assess whether management has acquire those assets for the purpose of deriving profits or benefiting themselves somehow. To exemplify this case, let us use the same example as above, the finance manager might had already acquired a similar software two months ago, by acquiring this new software, it is clear to benefit his relative by purchase a wasteful piece of assets. This could cause the cost of the firm's asset base to increase, while no obvious benefit to profitability can be observed. In my view, although GAAP has encouraged disclosure on significant issues of balance sheet accounts in the notes, there is no GAAP that entails management to disclose their intention of acquiring assets. Even if there are disclosures, there will be hardly any justification because intention is a psychological matter that lies in their mental thoughts, in which its evidence could not be observed or assessed by outsiders.

This intention plays a role in determining whether an asset will add additional or zero productivity for the firm and because it is not observable from the balance sheet, investors are not informed about whether the balance sheet assets are existed to serve their best interest in generating profits.

Lastly, if the company owns any marketable securities, any gain resulted from periodic adjustments are not persistent, in which investors are not particularly concerned with. When conducting the interview, it was evident that the balance sheet provides a list of Assets and Liabilities and the amount in these accounts, however it does not provide what these assets generate and lead to. When using the balance sheet approach, there are many uncertainties pertaining how the business is being run, how the assets generate income, Is profitability temporary or on-going and consistent. For firms that hold held-for-trading and available for sale investments as non-operating assets, there is periodic adjustment of their book value to fair market value with any change in value booked to the balance sheet and income or the other comprehensive income. The increase in the fair market value might seem favorable in the current period since the total assets of the firm would increase accordingly. However, such increases in assets and income are not persistent because they lack future continuity. First of all, this income does not result from the firm's normal operation; Second, security prices are volatile and there is low probability for permanent continuing appreciation; Third, these profit will be reversed if their value decreases when they are sold, therefore investors do not expect positive FMV adjustments to be persistent income. As Dichev and Penman argue, "...the balance sheet approach creates earnings, which are at odds with what investors consider "good earnings" (Dichev & Penman, 2007). In their view, earnings which result from market price adjustment are meaningless in a sense that this earning is highly dynamic and unpredictable, which is not the type of persistent income that investors perceive as the most important to their investment value. For this reason, any growth or earning resulted from non-operating assets on the balance sheet would not be informative to investors about the firm's performance in the short term.

In conclusion, the balance sheet fails to inform investors of future company performance.

Discussion 2: The Income Statement Approach

Income statement can be used to measure a company's financial performance over a specific accounting period. Even though financial statements provide other financial performance indicators, earnings measurements are the easiest to interpret and the most applicable to many investors. Income statement summarizes the company's incurred revenues and expensesthrough different activities, and generates the outcomes (gain or loss) which can indicate the company's periodic performance. The nature of its feature indicated that it is likely a valuable indicator of current performance for the users to realize a company's financial situation. How is the profitability the company can get return after paying all the expenses? How efficient of the company operates during the current period? All the answers can be extracted from the income statement.

Recently, we have two interviews regarding our topic question of income statement. One is with the manager in Risk Management Department of Scotia bank. He mentioned that Income Statement could roughly reflect the current situation of the company, but it's not reliable. The reason is that sometimes the managers intend to present an excellent condition of a company's financial situation to attract the investors, they may manipulate the statements such as the higher profit and returns; Moreover, under GAAP Income Statement is not useful for all the users. For example, for the manager, it is meaningless as it cannot reflect the accurate performance of the company. Items with an estimated basis, such as amortizations and write off are too noisy to the users. For the managers the pro forma statement is more valuable to overview the company's performance over a time period.

The second interview was with a controller of Non-profit agency, CGA, who has more than 15 years of accounting experience. She is the committee of company RRSP fund and company investment group. This interviewee's answer is positive. Her opinion is that Income Statements prepared under GAAP are the useful tools to help her with her investment decisions. She emphasized about the tools. The numbers of expenses and earnings from income statements are not everything she saw from income statement. Investors with strong accounting background like her will analyze income statements and calculate different financial ratio ( capital structure , operating leverage , after tax profit margin , etc) by the number she can get from income statements. Analyze the position of a company's position. Then she will know how well she is investing the money under her control.

From the second interview with the controller, we found out that for investors, income statement analysis reveals much more than the earning of a company. Investors can use income statement analysis to calculate financial ratios that will reveal the rate of return the business is earning on the shareholders' retained earnings and assets. Investors also have to use other accounting knowledge. It is really important to read into those numbers of companies of income statements and perform analysis. For example, how the after tax profit ratio change? Is the change under reasonable range? What causes the change? By comparing historical financial ratios based on income statements, investors will know the companies better and will more likely to manage their investment well (i.e better predict the profitability of their investment). Also, our interviewee mentioned that it is necessary to read the disclosures of financial statements and auditor's report. These two sections disclose the underlying assumptions and provide additional details to investors for their analysis of the company's future performance.

However, this interviewee also addressed that it is always hard for a regular investor without sufficient accounting background to use income statements. Income statements contain estimated numbers under the accrual basis. For these investors, they might ponder the following questions. How is the accrued revenue or expenses calculated at the end of the period?

Did managers manipulate income statement numbers for their own benefit? For example, how hydro cost will be accrued at the end of period? Did the accountant use previous month's expense or last year's expense to estimate the number? The regular way is to use the same month of last year's expense to estimate this year 's expense as same as revenue accrual entries. This interviewee does not think regular investors without sufficient accounting background will even realize questions like these.

In the following, I would like to further explore the relationship between income statement and the future earnings through the following two aspects: the quality of earning and earning per share. Earning is a broad concept in accounting area, for instance, the income from operation or income from investment activities or income from abnormal transactions. The net income and income from operation are two main categories appeared on the statement, and they play important roles in evaluating and forecasting the company's future performance. There has been an argument on earnings since long time ago; however, like the interviewee from Scotia Bank mentioned that for most inside users such as the managers, the earnings from operation are more meaningful. The reason is that it provides a direct view on the company's daily performance, as it merely involves the sale and expenses related to operation. Bradford and Wayne where is the reference to them stated that " The common rational given by analysts and firms that compile forecasting data is that GAAP measures of earnings, which include temporary and nonrecurring items, provide a nosier signal of future earning power of a company than do pro forma measures that focus on the permanent components of earnings." (Cornell and Landsman, 2003, P20) Although all the Canadian companies have to following the GAAP to prepare their Income statement, it does not contribute the great effort on evaluating the company's future performance.

Moreover, we have to explore the usefulness of the Income Statement for the external users such as the investors, creditors and the shareholders. First of all, we have to introduce the concept of earning quality. It is the ability of current earnings to enable investors to infer future performance. It is a material tool to measure the company's earning ability and to predict the future performance. However, does quality earning can accurately forecast the company's future earning without bias? We can apply the predictive ability method as an example to discuss on our doubt. Predictive ability method is used to measure how well the future performance would be according to the current existing information from the current income statement. For example, we can use this year's net income to predict next year's net income if all the conditions won't change. The smallest mean absolute and mean square can best predict the future figures. However, this method is against the standard of GAAP which means we can not apply it as the predictor. (Cornell & Landsman, 2003, p20) Consequently, under predictive ability method, we could not use quality earning to accurately predict the future earnings because of violation of GAAP.

Earning per share is another important term to measure a company's earnings during specific period. "The portion of a company's profit allocated to each outstanding share of common stock.Earning per shareserves as an indicator ofa company's profitability."[3] For the most investors especially the shareholders, EPS is one of the most important terms for them. From their point of view, they can get the significant feedback about the company's current profitability from this number. More important, the shareholders (common share) can realize their earnings through EPS as well. However, EPS is calculated based on the net income which we discussed above, we could not get different conclusion rather than poor indicator of future earning. We can not deny that most investors pay attention on the stock price and EPS of the past and current periods to make their investment decisions, but this information is not the reliable and dose not make great effort on predicting future earnings indeed. "Unreliability of EPS as measure of stock performance: Despite being an important ratio, EPS can be quite an unreliable indicator of stock performance. It does not take into account the opportunity cost of capital and is influenced by short-term activities." [4] Consequently, Earning per Share can not be taken into account for the company to predict its future performance.

We will introduce Investment Decision Theory, behavioral finance and prospect theory to understand better why it is always hard for a regular investor without sufficient accounting background to use income statements. According to the "Investment Decision Theory", investors want to maximize their wealth by having smallest risk and highest return. Income statement will indicate clear and direct data for investors to observe company's current status and future state of nature. The income statement itself does not necessarily contain a direct prediction of the future, but investors can use these relevant, reliable and timely information for their own predictions of the company's future performance. But under behavioral finance, investor behavior my not correspond with the rational decision theory and invest models which lead a behavior based market inefficiencies. For example, non-professional investors do not have the time and ability to process all the information they can get from income statements. These investors will focus on main and neglect notes. Investors are based in their reaction to information relative to how they should react. Theses mean instead of using relevant information and fact to make buy-sell decision. Investors often use emotion to make the important decision by overlooking the relevant fact. This type of behavior can also explain for market overacts to changes in earning expectations. According to prospect theory, an investor considering risky investment will separately evaluate prospective gains and losses. This means instead of looking at the big picture and react the same way for both gain and losses investor treats both scenarios as separate incident. Given that investor's action is determined and measure by its utility, this assumes loss aversion. This means an non-professional investor dislike very small losses. Beginning at the point where the investment starts to lose in value the investor's rate of utility loss is greater than the rate of utility increase for the same amount.

From above interviews and analysis, we will say an income statement complies with standards and rules of GAAP are reasonable indicator for investment. The income statement under GAAP could provide valuable information for both internal and external users to have an overview of the company's past performance. But investors can not 100% rely on the income statements for their investment decision .There are chances that income statements can be manipulated by managers and the numbers on income statements will be interpreted wrongly by investors.

Both the balance sheet and the income statement prepared under GAAP could provide some valuable information for investor to analyze the company's past and current performance but they fail to fails to inform investors of the company's future performance. This failure is caused by the following underlying issues in the two statements. For the balance sheet approach, there is a lack of comparability and informativeness of historical cost t used for asset measurement; the lack of connection between assets reported on the balance and the firm's profit creation ability, the lack of management's intend in purchasing the assets and lastly, the lack of income persistence for unrealized income resulted from fair market value of investment assets. These missing but significant information obstructs investors to predict the company's future profitability using the balance sheet. On the other hand, for the income statement approach, there are a lot of opportunities and power in hands of managers to manipulate income statements figures discretionally which induces to misinterpret these numbers and make the wrong projection about future company performance. As a result, investors cannot rely on either the balance sheet or the income statement to inform themselves of the company's performance in the next few years.

References:

  • Bradford Cornell & Wayne R Landsman, Accounting Valuation: Is Earnings Quality an Issue Financial Analysts Journal; Nov/Dec 2003; 59, 6; ABI/INFORM Global, p20
  • Dichev, l. D., Penman, S. (2007). ON THE BALANCE SHEET-BASED MODEL OF FINANCIAL REPORTING. Centre for Excellence in Accounting and Security Analysis. Retrieved Nov 28, 2009 from http://proquest.umi.com.ezproxy.library.yorku.ca/pqdweb?index=1&did=1632118821&SrchMode=1&sid=1&Fmt=4&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1260654125&clientId=5220
  • Louis K. C. Chan, Jason Karceski, Josef Lakonishok, and Theodore Sougiannis. (2008). Balance sheet growth and the predictability of stock returns. Retrieved Nov 28, 2009 from http://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=3151
  • Scott, William R. Financial Accounting Theory. 2006 and 2009; Pearson Prentice Hall; Toronto, ON.
  • Teets, Quality of Earnings: An Introduction to the Issues in Accounting Education," Issues in Accounting Education, 17 (4), 2002
  • http://www.stanford.edu/~mikefan/metrics/gaap.html
  • www.theibfr.com/INTERNET/CR03130901-Holban-Presentation.pdf
  • Earnings Per Share - EPS. Investopedia ULC, retrieved November 28, 2009 from http://www.investopedia.com/terms/i/incomestatement.asp
  • Should you rely on EPS for stock performance?.BankBazaar.com. retrieved From http://in.finance.yahoo.com/personal-finance/mutualfunds_basics/27 /should-you-rely-on-eps-for-stock-performance/
  1. www.theibfr.com/INTERNET/CR03130901-Holban-Presentation.pdf
  2. http://www.stanford.edu/~mikefan/metrics/gaap.html
  3. http://www.investopedia.com/terms/e/eps.asp
  4. http://in.finance.yahoo.com/personal-finance/mutualfunds_basics/27/should-you-rely-on-eps-for-stock-performance/

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