In the background of what is stated in section 5, lies the fact that P&L statements are not more than the mathematical interpretation of policies, experience, knowledge, foresight, and aggressiveness of the management of an enterprise.
They are also influenced by qualitative factors concerning issues which, super- ficially, look as if they are purely quantitative. Examples are:
● Income
● Expenses
● Gross margin
● Operating profit, and
● Net profit or loss.
Provided that it has been computed in a reliable and ethical way, the final net profit or loss is the ultimate measure of the skill of management. The time lways comes when an entity that is taking losses must lock its doors and disappear.
For all practical purposes, the income statement is of special importance not only to the firm’s own management and (for quoted companies) to the authori- ties, but also to investors and financial analysts who are interested in obtaining a longer-range view of an enterprise. The reader should appreciate, however, that for investors and analysts, the P&L is really an interimreport.
● Profits or losses are not necessarily the result of operations during any short period of time.
● They are a longer-term aftermath of a progress of decline, with part of the pattern based on assumptions as to future events.
This is one of the reasons why creative accounting intended to beef up the bal- ance sheet and impact P&L, like deferred tax allowances (DTAs), is an aberration (see Chapter 2). One quarter’s or one year’s massaged assets and income figures is a scalar point in a financial situation made out of wishful thinking – and being totally undocumented.
Even a true P&L statement means nothing when examined on the basis of just one or two years. Only 10, even better 20, P&L years can give a pattern in which some degree of confidence could be placed. It is also important to notice that P&L and balance sheet should be examined in unison in order to discover what is the entity’s financial staying power.
● Investors in the firm’s debt instruments and preferred stock, as well as stockholders (common stock), are inclined to pay more attention to the income statement.
● By contrast, short-term creditors, such as suppliers of raw materials and merchandise, and credit institutions that extend 3–6 months’ unsecured loans, generally pay more attention to the condition of the balance sheet.
The reader should moreover appreciate that the B/S and P&L don’t necessarily move the same way. As the overview in the 75th Annual Report 2004/2005 of the Bank for International Settlements (BIS) stated, in the course of the two half- years:
● Its balance sheet grew significantly to stand at special drawing rights (SDR) of 180.5 billion, representing an increase of 7.5%.
● But the result of lower average interest rates depressed income from secu- rities financed by the Bank’s equity, and net profits declined by 25% com- pared with the previous financial year.
On the other hand, both balance sheets and P&L statements can be manipulated.
In their excellent book Security Analysis, Graham and Dodd devote eight chapters to ‘Analysis of the Income Account’. Their analysisis only nominally concerned with variations in the expense items and their relations to net sales. Basically, it is aimed at acquainting the reader with artifactsand window dressingdesigned to:
● Misrepresent earnings, and
● Conceal losses from the public eye.
As we have seen in a certain length in Chapter 11, creative accounting is the practice of mishandling the intricate problems involved in corporate accounting.
‘There are unbounded opportunities for shrewd detective work, for critical com- parisons, for discovering and pointing out a state of affairs quite different from that indicated’, Graham and Dodd suggest.6
Because creative accounting is pervasive, every bondholder, stockholder, creditor, speculator, and analyst should realize that net profits have been and still are sub- ject ‘in extraordinary degree to arbitrary determination and manipulation’, accord- ing to Graham and Dodd. The three devices most commonly used for reaching this unethical goal are:
● Making charges to the surplus (retained earnings) account, instead of to the income statement, or vice versa.
● Overstating or understating depreciation, depletion, amortization, and other reserve charges, and
● Different proforma pronouncements, including EBITDA, manipulated to suit the CEO’s and directors purpose(s).7
Ethically managed companies appreciate that income should not be distorted, or artificially stabilized, by creating arbitrary reserves either by appropriating income or surplus or by overstating expenses in certain periods. Moreover, expenses or losses arising from contingencies thus anticipated should be reflected not as reduc- tions of the reserve, but in the income statement of the period in which they are recognized.
Also, as we saw in Part 1, new accounting rules promoted by IFRS bring forward specific regulations on how to handle recognized but not realized P&L associated to derivatives. Growth statistics of on-balance sheet and off-balance sheet items document that this requirement by IFRS, as well as by US GAAP, not only makes sense but has also become a ‘must’.
The rush towards ‘more assets’ and ‘more liabilities’ through derivatives started in the early 1990s. This rush has gained a great deal of momentum over the years, with many of the characteristics of a bubble. In research I carried out in the late 1990s, German commercial banks have given the following statistics on their business growth:
● On-balance sheet business increased by 1.7% per year.
● The now traditional currency and securities futures progressed by 4.9%
per year.
● But the growth rate of other derivatives, essentially the more risky, stood at 12.5% per year.
What has happened thereafter in credit institutions’ balance sheets? The answer is that they continued their leveraging in derivative financial instruments, widening the gap between the real and virtual economy. Their off-balance sheet growth at the time was 700% greater than the on-balance sheet. Today, it is a high multiple of that. When derivatives become the tool of mega-speculation, accounting standards setters and regulators are right to insist that fair value should gain the upper ground.