Numbers Talk

Yesterday, I argued that raw cash flow numbers alone are not enough information for an investor to understand a company. The accounting industry always understood this. In fact, cash flow statements were not required until 1987!

What about giving an investor complete access to all (non-confidential) financial information, which the investor then can massage as she sees fit? While this would have seemed impossible in 1933, presumably it could be done today. The SEC is trying to get companies to do financial filings in a format called XBRL, which permits the reader to analyze underlying data. More sub fold.

Of course, the average investor would not be able to deal with all of this information. But software would become available. And the brokerages and other investment advisors would provide their analyses to customers. But that is not enough.

Investors need management’s analysis of the numbers. Today, the principle expression of that analysis is the financial state usually called the “income statement,” also called the “profit and loss statement” and, most precisely the “statement of operations.” This statement shows management’s analysis of how the business did over the year (or quarter). Lots of judgments are reflected in the numbers. Revenues are shown as earned, not when paid for. Expenses are booked when incurred. Borrowings are not reflected, as they make a business no better or worse off. Buying assets per se is not reflected, since the cash spent bought the company an asset and the business is no better or worse off. And so on.

Which gets us back to 1933. How is the key information on how the business is doing going to be assembled, analyzed, and presented to the markets? A government agency could work with management to provide the best possible analysis. This is what happens with the taxation of most large corporations. The company prepares its tax returns; but the largest corporations are continually under audit, frequently by IRS personnel who are permanently assigned to the company’s audit, so that the final taxes really are a negotiated deal.

Congress decided to keep government out of the financial information process as much as possible. Under current law, a company’s management prepares its financial statements. Private outside auditing firms hired by management then opines on the statements. The auditors do not opine as to whether a company’s statements are the best analysis, merely as to whether they are “generally acceptable.” In a Supreme Court opinion, the late Justice Blackmun, a former tax law professor, cited authority for the proposition that, to an accountant, “generally acceptable” can mean “somebody tried it.” Most big public companies today use one of the Big 4 audit firms: Deloitt & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers.

Tomorrow: what the process means about the result.

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