Where Financial Reporting Still Falls Short

Even after a raft of reforms, corporate accounting remains murky. Here’s what you need to know to evaluate a company accurately.

by

H. David Sherman

and

S. David Young

by

H. David Sherman

and

S. David Young

From the Magazine (July–August 2016) · Long read

Bruce Peterson

Summary.

For financial statements to be useful, they must be accurate. Unfortunately, these reports often depend on subjective judgement calls, offer misleading comparisons, and fall prey to manipulation due to misaligned incentives. The authors examine several examples of poor accounting from recent history and discuss what went wrong in each of these cases. They then go on to suggest several strategies to help leaders improve accuracy in financial reporting, including techniques to detect fraudulent numbers and recognize verbal cues that indicate unscrupulous behavior.

Idea in Brief

The Problem

Despite tightening financial regulations, such as Sarbanes-Oxley and Dodd-Frank, investors, board members, and executives are still unable to rely on financial statements in order to make wise decisions about whether to invest in or acquire a company, for several reasons.

Why It Happens

First, flawed estimates creep in to financial statements, even when made in good faith. Second, standard metrics often don’t capture the true value of companies, especially for innovative firms in new markets. And third, executives continue to face strong incentives to manipulate the numbers.

What to Do About It

In this article, the authors examine the impact of recent financial regulations and consider new techniques to combat the gaming of performance numbers.

In a perfect world, investors, board members, and executives would have full confidence in companies’ financial statements. They could rely on the numbers to make intelligent estimates of the magnitude, timing, and uncertainty of future cash flows and to judge whether the resulting estimate of value was fairly represented in the current stock price. And they could make wise decisions about whether to invest in or acquire a company, thus promoting the efficient allocation of capital.

A version of this article appeared in the July–August 2016 issue (pp.76–84) of Harvard Business Review.

H. David Sherman (h.sherman@neu.edu) is a professor of accounting at Northeastern University’s D’Amore-McKim School of Business and a former fellow at the SEC Division of Corporate Finance. He is a coauthor of “Tread Lightly Through These Accounting Minefields” (HBR July–August 2001).
S. David Young (david.young@insead.edu) is a professor of accounting and control at INSEAD. He is a coauthor of “Tread Lightly Through These Accounting Minefields” (HBR July–August 2001).

Where Financial Reporting Still Falls Short

Idea in Brief

The Problem

Why It Happens

What to Do About It

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