March 2011Finance

Finance Fundamentals: What You Don't Know Could Hurt You

finance fundamentals

As the dire consequences of financial reporting scandals continue to make headlines, many executives have difficulty reading and understanding the financial statements at the center of those scandals. "You don't have the luxury of passing off the numbers as someone else's problem," notes Wharton accounting associate professor Brian Bushee. “Numbers are subjective, they're easily manipulated, and they can create the perception of wrongdoing even when that's not the case. It's important for everyone in the management function to have some knowledge of how financial statements are put together and where there are areas for discretion.

"Nothing can bring down a company faster than a financial reporting scandal," says Bushee, who teaches in Wharton's executive program Finance and Accounting for the Non-Financial Manager. "You can recover from product liability problems or CEO misdeeds, but when you're accused of manipulating earnings numbers or putting out misleading disclosures, things quickly unravel. Many large-scale financial scandals started with moves that were a little aggressive but within the rules. But managers quickly found themselves on a slippery slope, getting more aggressive incrementally until it reached the level of fraud.

"We tend to think of reporting problems originating with one or two people, often the CEO or CFO, in a dark room. But in fact numbers can be manipulated by anybody throughout the organization. And that's just one of the misconceptions executives bring to the program. The common belief is that there are clear rules about how to put together a financial statement, and that it's all done by an auditor. The reality is that there is a lot of discretion in what things get recorded and how they get recorded; and management, not the auditor, is in charge of preparing the financial statement.

"We are essentially letting companies grade their own performance through the reporting process. In one way that makes sense because they can provide better information, but it also creates an opportunity to manipulate. We give managers a lot of discretion so that they can match the accounting and the financial statements to the specifics of their business. A one-size-fits-all financial reporting system wouldn't help companies report their strategy effectively in terms of their financial results. But the problem in giving managers discretion in reporting what's going on is that you also give them discretion to mislead."

Managing Perceptions

Bushee notes that even when you're confident that you're reporting ethically, you need to pay attention to how your numbers will be perceived. “Let's say you have some cost in developing software. Your division where that software was created can take the cost and spread it out over time by creating an asset, as opposed to recognizing those costs immediately. But if outside investors or analysts see that you are doing this and think it's aggressive, especially compared to what other companies in your industry are doing, you could be criticized for manipulating the results when in fact you thought you were doing it correctly. You have to be aware how others might perceive your actions even when you believe you're in the right, so it's important to understand what your competitors and other firms in the industry are doing."

Asking the Right Questions

Understanding where the potential for manipulation lies can also help you head off a potential problem. “Discretion in accounting,” says Bushee, “is sometimes used to make division results look better. It then trickles down to a manipulation for the corporation.” What should you look for? “Some transactions are tricky to account for in financial statements. Look at investments in intangible activities like research and development, advertising, or human capital and be prepared to ask questions if you have any concerns.”

Bushee recommends questioning assumptions to determine the thinking behind the reporting. "Ask, 'What's the business reason for doing it this way?' Most often, people are not intentionally saying to themselves, 'I'm going to be dishonest.' But if the reporting seems more aggressive than the situation warrants, it could be a warning sign.

"Many times there is a legitimate business reason to account for something in a certain way. But you need to understand that reason and be able to communicate it clearly. Having the knowledge to be able to read your statements and speak in the language of accounting allows you to explain that you're not trying to manipulate your financial statements; they're an accurate reflection of what your organization is doing."