Shareholder Scoreboard (A Special Report): The Best & Worst Performers of the WSJ 1000 --Beyond Quarterly Earnings: How to Improve Financial Reporting
By Alfred Rappaport
2,174 words
8 March 2004
The Wall Street Journal
R2
English
(Copyright (c) 2004, Dow Jones & Company, Inc.)
RECENT CORPORATE-governance reforms, including the Sarbanes-Oxley Act, fail to address the root
cause of accounting scandals: a widespread obsession with earnings that drives companies to push
accounting standards to the limit and, in extreme cases, to engage in outright fraud.
Analysts fixate on quarterly earnings at the expense of fundamental research. Corporate executives point
to the investment community's behavior to rationalize their own preoccupation with earnings. To meet
Wall Street expectations, managers make decisions to increase short-term earnings -- even at the
expense of long-term shareholder value -- and may employ accounting gimmicks. The resulting
misallocation of resources shortchanges everyone -- investors, employees, and consumers alike.
There is another way to track a company's progress that offers advantages to investors, company
management, board members, auditors and accounting standard-setters: a Corporate Performance
Statement, which would present a more straightforward picture of a company's results -- and would deal
directly with uncertainty about the future.
Unless a company can generate cash to fund growth and pay dividends, its shares are essentially
worthless. Neither last year's earnings nor next year's estimated earnings provide much help in gauging
the magnitude, timing and uncertainty of future cash flows. To anticipate shifts in a company's
prospects, no single-period performance measure, including cash flow, can substitute for a detailed
analysis of the industry's attractiveness and the company's chosen strategies. Earnings are an amalgam
of facts (realized cash flows) and subjective assumptions about the future (accruals). By combining
yesterday's accomplishments and tomorrow's uncertainties, accountants produce a bottom line that
doesn't tell investors what they need to know.
Two basic accounting principles govern the calculation of earnings -- revenue recognition and expense
matching. Companies recognize revenue when they deliver products or services, can establish the
amount due from customers and are reasonably assured that they will collect. But estimating the
contribution of this period's costs to future revenue can be capricious speculation. How much revenue,
for example, will a company generate (and when will it materialize?) from current-period expenditures
for research and development, employee training, brand building, or additions to production capacity?
Accountants typically cope with this uncertainty by arbitrarily expensing the entire cost of intangible
investments such as research and development. Just as arbitrarily, they allocate the cost of tangible
investments such as plant and equipment over their estimated useful life using straight-line depreciation
or one of a variety of accelerated depreciation methods.
Matching costs with revenue is a subjective exercise that invites companies to push the limits of
accounting. Nonetheless, companies report earnings per share with to-the-penny precision. In the name
of better corporate governance, the Sarbanes-Oxley Act requires that chief executives and chief
financial officers certify the "accuracy" of their financial statements.
In the present unforgiving climate for accounting shenanigans, companies have an unprecedented
opportunity to meaningfully improve their financial statements.
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