Invest Skeptically

One of my CFA textbooks contains a chapter called “Searching for Shenanigans”. It emphasizes that a significant portion of what gets reported in financial statements is subject to management’s judgment and estimates.

This is nothing new to accounting experts. Al Rosen often writes and speaks about accounting trickery as he does in his piece, Cash flow myths (Canadian Business Online), which talks about how “most textbooks are wrong in praising the cash flow statement as the answer to investors’ needs”. This is a good example of accounting versus the real world: as important as cashflows are from a valuation standpoint, companies may not even have a process to report them. Rosen reminds us that, “actual cash flows into a company are first recorded using an accrual (non-cash) income basis, and then translated back into a quasi-cash basis on the cash flow statement”.

At the heart of the matter is that translating the real world operations of a company into an accounting basis requires decisions about timing (e.g. time horizon for depreciation/amortization), substance (e.g. will amount X show up on the balance sheet under assets or on the income statement as an expense?), and standards (e.g. LIFO or FIFO inventory accounting).

Rosen cautions that, “company management might not even be trying to mislead investors, and you could still end up making a serious investment mistake,” and, “just think what’s possible when unscrupulous executives try to actively manipulate their financial statements.”

The conclusion: accounting numbers are not as easy to interpret as they seem and any “DIY” investor needs — at least — a meaningful understanding what they mean.