Do Financial Statements Tell the Truth?
Do financial statements tell the truth?
Financial statements are often referred to as “reports”. As you scan the pages, you will find neat columns of precise numbers. Financial statements look objective. Looks can be deceiving. The questions that financial statements are intended to address do not have objectively true answers. Suppose a firm builds a factory, with custom-built machinery designed to specifically to produce the firm’s product. That factory would become an asset on the left-hand side of the balance sheet. How much is that asset worth?
Often in this course we will emphasize “market value”. But our specialized equipment may not be usable by other firms, so if we tried to sell it in the market, it’d be valued as scrap, and would be worth a fraction of what we paid for it. (The salvage value of firm assets is referred to as liquidation value, and is usually far less than what appears on a balance sheet.) Alternatively, we could estimate the value we believe the equipment will ultimately provide to our business, which will be substantially higher than the price we paid for it. After all, we designed and built our machinery because we anticipate we can put it to profitable use.
If we value the machinery at liquidation prices, we will take an immediate loss on our books when we buy the equipment, as cash on the books is exchanged for fancy high-tech robots that we treat as though it were scrap. The more we work to expand the capacity of our business, the less valuable our firm will appear to be. That doesn’t seem right.
Conversely, if we use our best estimate of the revenues our purchase of the equipment will eventually enable, we will show an immediate gain on our books. (We would not have bought the stuff if we didn’t think it was going to generate more cash than it cost us.) However, even if our firm’s managers are honest and competent, allowing them to conjure instant profits with optimistic estimates of asset values might tempt corruption.
Financial statements are often referred to as “reports”. As you scan the pages, you will find neat columns of precise numbers. Financial statements look objective. Looks can be deceiving. The questions that financial statements are intended to address do not have objectively true answers. Suppose a firm builds a factory, with custom-built machinery designed to specifically to produce the firm’s product. That factory would become an asset on the left-hand side of the balance sheet. How much is that asset worth?
Often in this course we will emphasize “market value”. But our specialized equipment may not be usable by other firms, so if we tried to sell it in the market, it’d be valued as scrap, and would be worth a fraction of what we paid for it. (The salvage value of firm assets is referred to as liquidation value, and is usually far less than what appears on a balance sheet.) Alternatively, we could estimate the value we believe the equipment will ultimately provide to our business, which will be substantially higher than the price we paid for it. After all, we designed and built our machinery because we anticipate we can put it to profitable use.
If we value the machinery at liquidation prices, we will take an immediate loss on our books when we buy the equipment, as cash on the books is exchanged for fancy high-tech robots that we treat as though it were scrap. The more we work to expand the capacity of our business, the less valuable our firm will appear to be. That doesn’t seem right.
Conversely, if we use our best estimate of the revenues our purchase of the equipment will eventually enable, we will show an immediate gain on our books. (We would not have bought the stuff if we didn’t think it was going to generate more cash than it cost us.) However, even if our firm’s managers are honest and competent, allowing them to conjure instant profits with optimistic estimates of asset values might tempt corruption.