Welcome back to The Language and Tools of Financial Analysis. This third module will discuss accounting principles and how they fit with financial decision making. Just to recap how this module fits within the course. We've discussed financial statements we've discussed how accountants, how financial analysts, interpret those financial statements. Now it's time to take a closer look at the possible limitations of that information. Or how we could feasibly use that information in financial decision making. So lets start with a buyer beware. Financial analysts rely crucially on the accuracy of the information they work with. Internal and external auditors of the firm's accounts aim to establish that trust. But make no mistake, that trust is constantly challenged. First, there's the possibility of a conflict of interest. Internal auditors tend to speak the language of their employer. External auditors could they possibly be conflicted? Well it depends on the services that their firm already provides to the corporation. Then the information is getting ever more complicated and accountants will have to deal with it to make that information sensible to a lay person, to the investor, to the owner of the cooperation and finally sometimes it is just simply ambiguous. It is not clear what a particular line item on a financial statement is actually telling us. So aren't there any rules that provide us with the necessary guidance surely there are global accounting standards. Nowadays, corporations operate globally. And they have global ownership as well. So all the more reason, therefore, that accountants speak a single, global accounting language. Generally accepted accounting principals adopted widely differ, in fact, across countries, but there is a glimmer of hope on the horizon. Ever more countries are adopting international financial reporting standards, so there is some hope that there is convergence of the accounting principles, but there's still some divergence. Then, the ambiguity. How can it be that the line items on the financial statements are not telling us exactly what we want to know? Well, first, there's this interpretation of value. Value, in the balance sheet, in the profit and loss statement, is book value. We've already seen that there is another notion of value called market value, what the market is prepared to pay for the assets. Which one is right, and what is the gap between market value and book value actually telling us? Then there is the possibility that corporations use cash based accounting rather than accrual accounting. We'll take a closer look at what that distinction actually means. And lastly, the accounting profession has been accused of focusing too much on profit maximization, rather than wealth creation for the owners in the corporation. Which one is right? And then there are other items. We've discussed goodwill, for example what goes in goodwill? What kind of items can we record as goodwill for the corporation? They’re substantial, very important for evaluation exercises of our financial analysts. The accounting profession has not always been in the limelight, but it has been in that limelight for the last ten years or so. And not for the right reasons. A series of accounting scandals hit the profession. And further undermined the trust that is so necessary for financial analysts to rely on the accuracy of their information. ENRON is a key example and we'll take a closer look at what happened. But it's not restricted to these large global corporations where the accounting standards, the accounting practices have been questioned. It is also in public institutions. Another example here is Jefferson County's collapse, where accounting practices were seriously questioned. Those experiences have had some bearing on the public's perception of honesty and integrity in the accounting profession. In the graph that you see here, I've depicted the public's trust So what you can see in this graph on the blue line is the percentage of the surveyed population rating the accounting profession either as high or very high for their honesty and integrity. And you can see that compared to the other two professions I put in this graph, stockbrokers and bankers. The accountants do reasonably well, much better for sure than stockbrokers. But you can also see something rather important, you can see if you look in the graph you can see a sudden dip in the rating by the surveyed population in the honesty and integrity of the accounting profession. And that happened to coincide with a whole series of accounting scandals, some of which we will discuss in this module. You can also see that, from that dip, it almost took ten years before the accounting profession was back to its levels that it was before the Enron Scandal. So let's take a closer look.
