Monday, November 10, 2008

Politics And Accounting

Investors should be aware that certain stakeholders of financial
statements can exert pressure or political influence that results in
accounting rules that distort the true economic picture of a business.
Investors need to be aware that such situations exist so that they
ensure they have made adjustments that reverse these distortions.

For
example, it took many years before officials finally caved and made
stock option expensing mandatory. Managements, fearing that they would
have to lower the number of options they receive or face huge drops in
their reported profits, lobbied hard against the move. This quote is
attributed to Harvey Golub, former Chairman and CEO of American Express:

"…while
stock options have value to the executives, …, they cost the
corporation nothing. They are never a cost to the company and,
therefore, should never be recorded as a cost on the income statement."

If
they are not a cost to the company, then a company that pays out no
cash but instead pays suppliers, bills, and employees in options has
operating profit margins of 100%! Obviously, this is a distortion of
the company's true economic picture.

Though option expensing is
now mandatory, I would argue that option accounting requirements have
not gone far enough. Currently, balance sheets omit any indication of
the value of outstanding options, but the outstanding options are very
real obligations that should be subtracted from the shareholder's
equity. Fortunately, within the notes to the financial statements,
investors have what they need to make the adjustments themselves.

This
was but one example of adjustments that need to be made to accounting
statements in order for investors to make a more accurate determination
of a company's intrinsic value. Many other examples exist, some of
which are discussed on this page.