Question

A famous analyst once said it is not important what financial statement shows us- it’s what they hide that counts. What does the analyst mean by this statement? How would a company hide information inside financial statements? What is a pro forma financial statement and how is this used in the financial markets?

Answer 1

"It is not important what financial statement shows us - it's what they hide that counts" , means  

A company hide information in the financial statement by not showing all transactions of debit and credit in it. Every company manipulates its number to a certain extent to make sure budgets balances, executive scores bonuses and the investors continue to offer up funding. Such creative accounting is nothing new. However, facts such as greed, desperation, immorality, and bad judgement can cause some executives to cross the line into outright corporate fraud.

Investors should still know how to recognize the basic warning signs of falsified statements. While the details are typically hidden, even from accountants, there are red flags in financial statements that can point to use of manipulating methods. The 8 ways company cooks the books are;

1. Accelerating revenues : One way to accelerate revenue is to book lump-sum payments as current sales when services are actually provided over a number of years. another way of this is channel stuffing, here a manufacturer makes a large shipment to a distributor at the end of the quarter and records the shipments as sales.The goods can be guaranteed as a sales, the manufacturer should keep the products classified as a type of inventory until the distributor has sold the product.
2. Delaying expenses
3. Accelerating pre-merged expenses
4. Non-recurring expenses : By accounting extra ordinary events non-recurring expenses are one-time charges designed to help investors better analyze ongoing operating results. some companies take advantages of these each year.
5. Other income or expenses : It is a category that can hide a multitude of sins. Here companies book any excess reserves from prior charges. Other income or expenses is also the place where companies can hide other expenses by netting them against other new found income. Sources of other income include selling equipment or investments.
6. Pension plans : If a company has a defined benefit plan, it can cause the plan to its advantages. the company can improve earnings by reducing the plan's expenses. If the investments in the plan then grow faster than the company could record these gains as revenue.
7. Off-balance-sheet items : A company can create separate subsidiaries that can house liabilities or incur expenses that the parent company does not want to disclose. If these subsidiaries are set up as separate legal entities that are not wholly owned by the parents, they do not hae to be recorded on the parents financial statements and the company can hide them from investor
8. Synthetic leases : it can be used to keep the cost of new building. It allows a company to rent assets to itself. through this there can be created a way to hide some details.

PRO FORMA FINANCIAL STATEMENTS

These are financial reports issued by an entity , using assumptions about events that may have occurred in the past or which may occur in the future. These statements are are used to present a view of corporate results to outsiders, perhaps as a part of an investment or lending proposal. A budget may also be considered a variation on pro forma financial statements, since it represents the projected results of an organization during the future period. Pro forma financial statements are:

1. pro forma income statements
2. pro forma balance sheet
3. pro forma balance sheet statements

HOW IT IS USED IN THE FINANCIAL MARKET

A company uses pro forma statements in the process of business planning and control. It is useful in the financial market by :

1. Identify the assumption about the financial and operating characteristics that generate the scenario.
2. Develops the various sales and budgeted projections
3. Assemble the results in profit and loss projections
4. Translate these data into cash flow Projections
5. Compare the resulting balance sheets.
6. Perform ratio analysis to compare projections against each other and against those of similar companies.
7. Review proposed decisions on marketing , production , research and development , etc.. and assess their impact on profitability and liquidity.

Simulating competing plans csn be quite useful in evaluating the financial effects of the different alternatives under consideration.