Sausages are like financial statements… If you saw how they are made, you’d have a growing distaste for them both!
While often attributed to Otto Von Bismarck, the famous quote is more likely stated first by John Godfrey Saxe, when he said in the 1860’s “Laws, like sausages, cease to inspire respect in proportion as we know how they are made.”
Regardless of who said it, the concept remains as relevant to the laws of accounting and financial reporting — as it ever was to laws made by any government.
Over the years, the governing organizations of financial statement reporting have changed, overlapped, and even collided. Simply, the various organizations that have created and influenced GAAP accounting rules have simply been different people during changing economic periods with differing goals.
That has created a hodge-podge of financial reporting that bears no representation to economic reality.
That means the as-reported numbers that you use — that we are all bombarded with in the press — create a foundation for bad investment decisions.
The CFO and auditing firms are not to blame. By simply following the GAAP rules as they are made, we end up with as-reported numbers as different from economic reality as these:
Archer-Daniels-Midland (NYSE:ADM) More “expensive…”
Forward P/E is in reality closer to 25x, not 16x in as-reported databases.
Abbott Laboratories (NYSE:ABT) Higher profitability in actuality…
Return on Assets is 15%, not the low 5% as-reported.
Brunswick Corporation (NYSE:BC) Higher profitability in actuality…
Return on Assets is 15%, not 9% as-reported.
Return on Assets is 22%, not 4% as-reported.
If the database you’re using yields numbers far from these, there’s a good reason. The financial statements are just too complex to easily discern the economic reality of the firm.
The differences between as-reported metrics and economic reality are significant and direction-changing. It’s not just valuation. The above are current examples of major differences in corporate profitability, directly from the Valens Research database of 3,000+ companies:
A working paper on the subject is available here. It discusses the adjustments required to be implemented to come up with reliable financial statement analysis. Please download your complimentary copy here.
The goal of all of this is a better understanding of true corporate performance and valuation. In other words, better investing by avoiding portfolio torpedoes and identifying unique investment opportunities earlier.
Also, please save the date for a special seminar and workshop called “The Dark Side of Financial Statements” in Chicago on September 9. Event details and registration can be found HERE.