Net income—always the focus of investors and stakeholders, eagerly awaited. Of course, it's from there that equity growth and dividend distributions eventually arise.
But here's the real question: Should investors rely on net income, an accounting metric easily manipulated by creative techniques, for their investment decisions?
Table of Contents
Creative Accounting Impact on Net Income
Quoting Investopedia, creative accounting is the practice of following necessary laws and regulations but exploiting gaps in accounting standards to falsely portray a better financial image of a company. [1]
| Financial Concept | Description |
|---|---|
| Manipulability of Net Income | Can be easily manipulated using creative accounting techniques. |
| Definition of Creative Accounting | Exploiting gaps in accounting standards to portray a better financial image. |
| Techniques of Creative Accounting | Boosting revenue, capitalizing inappropriate expenses, deferring expenses, and more. |
| Accounting Flexibility | Allows manipulation due to recognition of revenue on an accrual basis. |
Some techniques include boosting revenue through flexible accrual accounting, capitalizing expenses that shouldn't be, deferring expenses to future periods, and several other methods.
So, what's the point here?
Well, the point is that net income can be manipulated to a significant extent without violating any laws, simply by exploiting accounting flexibility.
This manipulation is possible because accounting recognizes revenue on an accrual basis, allowing revenue to be recognized without receiving payment from customers. Remember, there's no need for cash to come in!
Financial Footnotes: Insights into Net Income
Now, revisiting the previous discussion, since net income can be manipulated using creative accounting techniques, it means we shouldn't fully trust a company's net income release.
Sure, net income is important, but don't swallow it whole as the ultimate indicator of a company's profitability. Just because it's called the bottom line doesn't mean it tells the whole story.
Other important factors to consider include reviewing the footnotes to the financial statements to assess whether the company has significant contingent liabilities and examining any capital expenditure plans that could enhance the company's future prospects.
| Finance Term | Description |
|---|---|
| Contingent Liabilities | Liabilities depending on future events, disclosed in footnotes to financial statements. |
| Footnotes to Financial Statements | Disclose accounting policies, asset depreciation, inventory valuation, and other essential information. |
According to IFRS, contingent liabilities are potential obligations dependent on uncertain future events beyond the entity's control. For instance, this could involve litigation against the entity where it's uncertain whether wrongdoing has occurred and settlement isn't probable. [2]
Contingent liabilities can be reported in financial statements if they're estimable. If they cannot be estimated but are deemed material, they must be disclosed. Where are they disclosed? In the footnotes to the financial statements. Therefore, it's crucial to frequently review these footnotes.
Footnotes to financial statements offer a wealth of information. As per the Corporate Finance Institute, they disclose accounting policies, asset depreciation, inventory valuation, intangible assets, and other vital information not presented in the financial statements. [3]
Analyzing Cash Flow Statements to Assess Net Income Quality
In addition to reviewing the footnotes of the financial statements, it's crucial to examine the cash flow statement, which is arguably the most pivotal statement. Unlike the income statement, the cash flow statement is less susceptible to manipulation. After all, how can cash flow be manipulated when you're dealing with actual cash transactions? Where's the money coming from?
| Financial Statement | Description |
|---|---|
| Cash Flow Statement | Depicts cash inflows and outflows, difficult to manipulate unlike the income statement. |
| Operating Cash Flow Section | Provides insights into cash inflows and outflows from company operations. |
The cash flow statement illustrates the cash inflows and outflows of a company, making it less prone to manipulation compared to the income statement.
Consider the case of Enron. Techniques such as "channel stuffing," which involve shipping excess goods to distributors to inflate revenue, may boost profit temporarily but won't affect cash flow.
Therefore, it's essential to scrutinize the cash flow statement, particularly the operating cash flow section. This statement comprises three sections: operating cash flow, investing cash flow, and financing cash flow.
The operating section details cash inflows and outflows from the company's operations, while the investing section pertains to cash flows from capital expenditure activities like purchasing or selling fixed assets. The financing section depicts cash inflows and outflows from fundraising activities such as issuing stocks and bonds or repaying bond principal.
Watch Non-Recurring Events, Understand Asset Impact on Net Income
Now, I just recalled something relevant to our discussion on investing cash flow. A company's net income may experience a notable increase in a given period, not due to boosted sales or improved cost management, but rather because it sold fixed assets.
Confusing, right?
Indeed, the sale of fixed assets can generate a substantial cash inflow, consequently elevating net income. However, this shouldn't serve as a reliable measure of company performance due to its non-recurring nature.
| Financial Transaction | Description |
|---|---|
| Sale of Fixed Assets | The sale of fixed assets can boost net income. |
| Non-Recurring Nature | Net income increase from asset sales is non-recurring. |
| Net Income Composition | Net income comprises factors beyond asset transactions. |
| Impact of Fixed Asset Purchases | Purchase of fixed assets affects financial statements gradually. |
Speaking of fixed assets, it's important to understand that net income isn't solely derived from all cash inflows and outflows, including those used to purchase fixed assets. When accounting for the acquisition of fixed assets, they aren't immediately expensed in the income statement alongside their full costs in one period.
Instead, the purchase of fixed assets is initially recorded on the balance sheet under fixed assets, and their depreciation is allocated over the asset's useful life.
Still not clear?
So, for example, if a company purchases a machine for $210,000 in cash in April 2024, it doesn't mean the company will deduct the full $210,000 from sales as a fixed asset expense in April 2024.
Instead, the company will spread out the expense gradually through depreciation. For instance, if the asset has a useful life of 5 years, using the straight-line method, the company will depreciate it by $3,500 per month.
In Net Income Evaluation: ROE Trumps EPS
Next, let's delve into the shortcomings of net income.
| Financial Metric | Description |
|---|---|
| ROE vs. EPS | EPS often correlates with stock price changes, but ROE should also be considered for stability. |
| EPS Calculation | EPS = (Net income - Preferred shares) / Common shares outstanding |
| ROE Calculation | ROE = Net income / Company's equity |
When it comes to metrics like return on equity (ROE) and earnings per share (EPS), EPS often garners significant attention. Numerous studies have shown a strong correlation between EPS and stock price movements.
While it's crucial for EPS to show consistent growth, this growth must be accompanied by stability or an increase in ROE.
EPS represents the net income of a company minus preferred shares, divided by the number of common shares outstanding, while ROE is calculated by dividing net income by the company's equity.
Therefore, if EPS continues to rise while ROE decreases or falls below the industry average, it's wise to exercise caution. ROE serves as a measure of return for investors.
Dividends vs. Retained Earnings: Net Income Priority?
In the current economic climate, investors heavily favor the mindset of pursuing expansion for larger growth prospects. Many prefer companies not to distribute dividends but to retain net income for investment purposes. The crucial aspect is that stock prices often rise due to expansion.
Capital gain is often perceived as more favorable than dividends, not only due to its potential for higher returns but also because of lower taxes. However, the most accurate way to calculate stock valuation is by discounting future dividends at the desired return rate.
The absence of dividends can create an illusion, shaping intersubjective reality and ultimately influencing stock prices. As someone who leans towards conservatism, I believe having money now is preferable to an uncertain future.
| Financial Consideration | Description |
|---|---|
| Importance of Dividends | Dividends provide a more reliable indicator of a company's financial health than retained earnings. |
| Impact of Economic Climate | Investors favor companies retaining net income for growth, leading to stock price appreciation. |
Therefore, the most convincing aspect of a company's net income is its dividends. Unlike retained earnings, dividends cannot be easily manipulated because they must be distributed at certain times. Take Enron, for example, with its creative accounting techniques that allowed it to book large retained earnings for expansion based on its inflated net income.
However, when it came to distributing dividends, the question arose: where's the money coming from?
Bottom Line
So, what's the point of my writing? Well, investor vigilance regarding net income can prevent many unwanted things in the future. Broadly speaking, this can also avoid potential bubbles. Good valuation is when the money is actually there, not just based on prospects. Everything related to net income could be illusory and lack real money behind it, unlike cash flow and dividends.
And, let's not worship EPS too much. When presenting to investors, fundraisers don't need to start by talking about profit or profit-related metrics like EPS, PER, or even EBITDA, except maybe ROE.
Oh yeah, specifically about EBITDA, don't equate it with operating cash flow; it's different! EBITDA doesn't include asset and interest expenses. It has been discussed before on Investopedia. [4] EBITDA is highly intriguing and widely utilized by startup companies to depict their performance. There's a humorous saying, 'Cash doesn't lie, EBITDA does.'
What should be discussed first are the prospects of operating cash flow or dividends. Well, it's a different story if investors only want to boost stock prices and look for an exit when the valuation is high.
Those caught up and unable to exit are confused because their stocks aren't selling when everything has been revealed, or if they do sell, they become penny stocks.
Be careful with net income. It's not as reliable as you might think! And ROE is much more significant than EPS. An increase in net income without a corresponding increase in cash flow from operations is also concerning. There might be something fishy, like companies loosening credit policies, selling assets, or even using creative accounting techniques like Enron.
Footnotes to the financial statements are underrated; they're very important!
Be cautious with net income!
ARTICLE SOURCES
- Daniel Liberto. (July 10, 2023). "Creative Accounting: Definition, Types, and Examples." Investopedia. [Online]. Available: https://www.investopedia.com/terms/c/creative-accounting.asp. [Accessed: April 2, 2024].
- International Accounting Standards Board (IASB). (2024). "IAS 37 Provisions, Contingent Liabilities and Contingent Assets." [Online]. Available: https://www.ifrs.org/issued-standards/list-of-standards/ias-37-provisions-contingent-liabilities-and-contingent-assets/. [Accessed: April 2, 2024].
- Jeff Schmidt. (n.d.). "Financial Statement Notes." Corporate Finance Institute (CFI). [Online]. Available: https://corporatefinanceinstitute.com/resources/accounting/financial-statement-notes/. [Accessed: April 2, 2024].
- Adam Hayes. (January 28, 2024). "EBITDA: Definition, Calculation Formulas, History, and Criticisms." Investopedia. [Online]. Available: https://www.investopedia.com/terms/e/ebitda.asp. [Accessed: April 2, 2024].
