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Financial statements: revealing profits GAAP may conceal.

Credit managers must make major decisions regarding the extension of credit based on very limited information. In the best of situations you might only have a prospective customer's audited financial statements--along with the sales representative's assurance that "this customer has great sales potential." The salesperson may describe how the prospect is currently making major investments in new equipment, gearing up for a substantial increase in production. In turn, as a supplier of raw material, your firm has an unbelievable opening "to get in on the ground floor, before your competitor seizes the opportunity."

The fact that the sales representative has a personal financial stake in the outcome of your decision as credit manager should not prejudice your evaluation of his or her claim. In this scenario there is only one problem. The prospect is barely breaking even on current business--at least according to the audit report. Furthermore, investing in new equipment, with the associated start-up costs, will clearly put the company in a loss position.

This is a typical "good news, bad news" story. The good news is the opportunity to profit from increasing your sales volume. The bad news is that the customer's financial picture does not look too promising. What should a conscientious credit manager do?

How Reliable Is The Audit Report?

What does an audited financial statement tell us? The standard auditor's certificate states:

These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on them based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.

In our opinion, such financial statements present fairly, in all material respects, the financial position of -- and the results of its operation and its cash flows, in conformity with generally accepted accounting principles.

Since the audit certificate is virtually identical in wording for every client, it is all too easy for a credit manager to overlook what is said, and even more important, what is not said. Working backwards, the key phrase is "the financial statements present the financial position and the results of operations in conformity with generally accepted accounting principles." Management prepared the statements. The auditor, with a small hedge about "reasonable assurance," asserts that there is no material misstatement. Let us not quibble about "reasonable assurance" or what is a "material" misstatement.

The key point to remember is that the statements were prepared and audited in accordance with generally accepted accounting principles (GAAP). GAAP is promulgated by the Financial Accounting Standards Board (FASB) under the authority of the Securities and Exchange Commission. While even the seven members of the FASB do not always agree on what GAAP is, or should be, there is one overriding concept governing accounting-conservatism.

In short, when you read a set of financial statements, prepared and audited in accordance with GAAP, you are looking at a biased picture. Now many, if not most, users of financial statements might well choose conservatively prepared financials--especially when considering the alternative. Would we really want optimistic financial statements? Before answering, let us look at the effect of this omnipresent bias towards conservatism.

Is Conservatism in Our Best Interest?

One of the little secrets in accounting is that much subjectivity goes into the preparation of any financial report. After all, we are trying to condense a full year's operations of a complex business into a single page P & L or a two-page balance sheet. Some of the questions which must be answered include:

* Should sales revenue include prepaid orders which

were shipped out on the first working day of the

next fiscal year?

* How much of a warranty allowance should we

provide on goods shipped this year, but which

customers won't report for months?

* How much are we going to recover from our major

customer who just declared bankruptcy?

* What is the cost of medical care going to be 10

years from now for current employees who will be

retired then?

The answers to these and many other questions like them must be made by management and attested to by auditors before comprehensive financials can be prepared and issued. If management has a bias and wants to put a positive slant on things, there is still plenty of flexibility in accounting principles. That is why independent auditors are required to express their professional opinion, to provide outsiders with some assurance. Of course, the number of audit failures and the resultant lawsuits against accounting firms suggest that even this procedure is not foolproof.

I am not arguing against the need for auditors or saying that conservatively prepared financial statements are wrong. What should be understood is that the focus on conservatism, instilled in accountants from day one, represents a choice. Being conservative, not recognizing income until a sale is consummated but recognizing even potential losses right away, minimizes reported income. If someone gains from minimizing reported income, who loses?

Consider the stock market. Blue sky promoters sell stock by puffing up the future potential of a company. Because unwary stock purchasers can lose, laws are written to protect investors.

But now take the situation of an existing company, one with relatively poor operating results to date, but with real breakthrough potential. A conservative approach to financial reporting will most likely depress the price of the stock, assuming it is publicly traded. Buyers of the stock will gain, since all the bad news is out but the good news potential has not appeared in the financials. This means that it is the stock sellers who will be hurt, receiving a lower price because of lower earnings.

There is one school of economic analysis that says in an "efficient market," users of financial statements "see through" reported income and know (and act on) what is really happening. This concept may be true, and there are numerous academic studies arguing both pro and con. But the bottom line on the efficient market hypothesis is that billions of dollars of resources, and hundreds of thousands of people, are involved in preparing, auditing, and using financial statements.

The auditors, many of the users, and some of the preparers are focusing on making the financial statements as conservative as possible. This emphasis on conservatism serves to not mislead investors, but to protect them from experiencing losses. However, the possible unintended consequence of this perspective is that investors who are willing to take a risk and are looking for investment opportunities may be poorly served.

There is one other force which may lead to the possibility of overly conservative financial reporting. As mentioned above, independent auditors, primarily the Big Six, are defendants in innumerable lawsuits. Plaintiff's attorneys, recognizing the "deep pockets" of the major public accounting firms, find them an attractive target.

Effect of Conservation on Credit Managers

Getting back to the scenario at the beginning of the article, what should be done about a prospective customer with marginal income, making current investments which will further depress reported income in the short term? The easiest answer would be to refuse to grant credit, to say "no." Not doing business with this new customer will never show up directly in financial statements.

If your company does sell to this customer, and the company goes into Chapter 11, the resulting loss will show up in the P & L. Even worse, as a credit manager, you will be held accountable for bad debts. In theory, credit managers are encouraged to "take a chance, now and then," to use initiative to help the business. But in practice, credit managers responsible for approving credit omits do not get much respect over what are considered "bad decisions."

Nonetheless, there is a solution to this problem. Traditional financial statements need not be taken at face value. We do not need to be held hostage to the overly conservative bias of GAAP. In part two of this series, I will show how credit managers can look beneath the surface of audited GAAP statements. I will show you what questions can be asked and give you some ideas for truly creative analysis. Creative analysis can separate credit managers from credit clerks.
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:generally accepted accounting principles
Author:King, Alfred M.
Publication:Business Credit
Article Type:Cover Story
Date:Oct 1, 1992
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