Watching for Misconceptions and Misleading Reports in Accounting

By John A. Tracy

One broad misconception about profit when it comes to accounting is that the numbers reported in the income statement are precise and accurate and can be relied on down to the last dollar. Call this the exactitude misconception. Virtually every dollar amount you see in an income statement probably would have been different if a different accountant had been in charge.

This doesn’t mean that some accountants are dishonest and deceitful. It’s just that business transactions can get very complex and require forecasts and estimates. Different accountants would arrive at different interpretations of the “facts” and therefore record different amounts of revenue and expenses. Hopefully, the accountant is consistent over time so that year-to-year comparisons are valid.

Another serious misconception is that if profit is good, the financial condition of the business is good. Currently, the profit of Apple is very good. But you shouldn’t automatically assume that its financial condition is equally good. If you look in Apple’s balance sheet and you will find that its financial condition is very good indeed. (It has more cash and marketable investments on hand than the economy of many countries.) The point is that its bottom line doesn’t tell you anything about the financial condition of the business. You find this in the balance sheet.

The income statement occupies center stage; the bright spotlight is on this financial statement because it reports profit or loss for the period. But remember that a business reports three primary financial statements — the other two being the balance sheet and the statement of cash flows. The three statements are like a three-ring circus. The income statement may draw the most attention, but you have to watch what’s going on in all three places. As important as profit is to the financial success of a business, the income statement is not an island unto itself.

Keep in mind that financial statements are supplemented with footnotes and contain other commentary from the business’s executives. If the financial statements have been audited, the CPA firm includes a short report stating whether the financial statements have been prepared in conformity with the appropriate accounting standards.

Not to end on a sour note, but it must be pointed out that an income statement you read and rely on — as a business manager, an investor, or a lender — may not be true and accurate. In most cases (even the large majority of cases), businesses prepare their financial statements in good faith, and their profit accounting is honest. They may bend the rules a little, but basically their accounting methods are within the boundaries of GAAP even though the business puts a favorable spin on its profit number.

But some businesses resort to accounting fraud and deliberately distort their profit numbers. In this case, an income statement reports false and misleading sales revenue and/or expenses in order to make the bottom-line profit appear to be better than the facts would support. If the fraud is discovered at a later time, the business puts out revised financial statements. Basically, the business in this situation rewrites its profit history.

It would be comforting to think that financial reporting fraud doesn’t happen very often, but the number of high-profile accounting fraud cases over the recent two decades (and longer in fact) has been truly alarming. The CPA auditors of these companies didn’t catch the accounting fraud, even though this is one purpose of an audit. Investors who relied on the fraudulent income statements ended up suffering large losses.

Anytime you read a financial report, keep in mind the risk that the financial statements may be “stage managed” to some extent — to make year-to-year reported profit look a little smoother and less erratic and to make the financial condition of the business appear a little better. Regrettably, financial statements don’t always tell it as it is. Rather, the chief executive and chief accountant of the business fiddle with the financial statements to some extent.