Financial Challenges

Chapter 3
Earnings Management and Financial Performance Measurement

One of Canada’s largest and most well-known firms, BCE, reported in its annual and quarterly reports to shareholders that its earnings during the period of 1999 to mid-2002 were $4.36 billion. Various media reports asserted, however, that the firm could have reported earnings as high as $10.77 billion if it took advantage of the alternatives offered by Canadian generally accepted accounting principles (GAAP) or that it could have reported a loss of $1.25 billion if it had used US GAAP during the same period.

As the BCE example demonstrates, generally accepted accounting principles provide companies with considerable latitude in the preparation of key financial statements used to measure performance. Some firms take advantage of this latitude and choose financial reporting methods that do not provide a fair reflection of ongoing performance. As a consequence, it is important for financial managers and analysts to have a solid understanding of financial statement analysis so that it is possible to make a balanced assessment of the true performance of a company.

The earnings management tricks that have been used by some companies include

1. Timing store openings or asset sales in a way that keeps earnings growing at a smooth rate
2. Accelerating (or delaying) shipments at the end of a quarterly reporting period to either increase sales in a weak quarter or defer sales into the next quarter when the current quarter’s numbers are especially strong
3. Capitalizing normal operating expenses. Without this accounting treatment, a firm may report losses instead of profits
4. Taking “big bath” write-offs and using “spin” control for bad earnings. Many companies have found that if they take large so-called one-time write-offs, it will be easier to meet earnings objectives in future years
5. Increasing reserves in good times and drawing down on them in bad times. Many firms create reserves for product returns, bad loans, retirement benefits, and insurance losses. In good years these reserve allocations can be overfunded so that, in bad years, they can be drawn against while protecting reported earnings. Banks, with their loan-loss reserves, are especially able to use these practices to manage earnings, but other types of firms are not supposed to do so

This chapter introduces financial statement analysis techniques that can be used in the evaluation of a company’s true performance and for forecasting its future performance. Good financial analysts need to have a strong understanding of the interpretation of financial statements—including their associated notes, which often provide excellent clues regarding potential problems and hidden sources of value. Conclusions about a company’s financial performance derived from its financial statements should be regarded with caution and considered only as a sign of the company’s strengths and weaknesses. Some of the shortcomings of financial statement analysis as a performance measure can be overcome by considering alternative measures of performance derived directly from the financial marketplace. These market measures of performance are also discussed in this chapter.

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