T h e “ Qu a l i t y ” o f F i n a n c i a l S t a t e me n t s

Financial Statements,

Cash Flow, and Taxes

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CHAPTER

54

The financial statements presented in a typical

company’s annual report look quite official. They

are signed by the firm’s top executives and are

certified by a Big Four accounting firm, so one

would think that they must be accurate. That

may not be true, though, for three reasons: legiti-

mate misjudgments in valuing assets and mea-

suring costs, “flexible” accounting rules that

result in differently reported results for similar

companies, and outright cheating.

One blatant example of cheating involved

WorldCom, which reported asset values that

exceeded their true value by about $11 billion.

This led to an understatement of costs and a cor-

responding overstatement of profits. Enron is

another example. That company overstated the

value of certain assets, reported those artificial

value increases as profits, and transferred the

assets to subsidiary companies to hide the true

facts. Enron’s and WorldCom’s investors eventu-

ally learned what was happening, the companies

were forced into bankruptcy, their top execu-

tives went to jail, the accounting firm that audited

their books was forced out of business, and mil-

lions of investors lost billions of dollars.

After the Enron and WorldCom blowups,

Congress passed the Sarbanes-Oxley Act (SOX),

which required companies to improve their

internal auditing standards and required the CEO

and CFO to certify that the financial statements

were properly prepared. The SOX bill also cre-

ated a new watchdog organization to help make

sure that the outside accounting firms were

doing their job. From all indications, financial

statements are generally more accurate and

clearer than they were in the past.

But the world is dynamic, and a new account-

ing problem surfaced in 2007. Big banks, most

notably Citigroup, owned many risky but high-

yielding subprime mortgages. The banks

invented a complex legal procedure that they

called a structured investment vehicle (SIV) to

conceal the fact that they held all of these risky

mortgages. They correctly feared that people

wouldn’t want to do business with a risky bank.

But when the subprime market fell apart in 2007,