When pundits offer statistics in support of their opinions, it is hard to know whether to trust the numbers; economics and finance are difficult enough to navigate without suspecting that someone with an agenda is deliberately misleading you. Even the numbers on your own financial statements are not a true reflection of your business operations. This column begins a series that explores how financial information can be distorted. Let’s begin with your own financial statements.
Raw data and cooking the books
Financial statements are not just summaries of raw data; they market your business to stakeholders, such as stockholders, lenders, sureties and customers. Although you would not deliberately “cook the books” or falsify data, some line items do not reflect a true picture of your business.
Accounting practices and tax regulations allow for adjustments that alter actual values, and statistics can be finessed or massaged to create the most positive picture for your annual report, often by choosing a percentage instead of a dollar amount or selectively omitting certain details. Also, changing conditions often necessitate revisions and readjustments after the fact. Through no fault of your own, the original information has become a lie because no forecast is ever perfect.
There are ways in which financial statements alter real values. The balance sheet, for example, is supposed to show the values of your assets (what you own), your liabilities (what you owe) and your equity (what you actually own). Since it is a snapshot of a moment, it cannot provide a picture of operations or cash flow, unless you graph the data over time, using several consecutive balance sheets.
Since you are allowed to depreciate your assets by deducting a portion of their value each year, many of your assets still have value that is not reflected on the statement. The allowances for depreciating assets over their “useful lives” accelerate their drop in value to zero well before most of them are actually worthless.
For example, you own a building that is fully depreciated but is still useful and can usually be sold for much more than its original purchase price. Many of your vehicles are still operating and have trade-in value, but this is not reflected on the balance sheet. Your employees, often considered your “most valuable asset,” are not even listed on the statement, obviously because you cannot “own” people.
Even your equity value is questionable, since most electrical contracting businesses are privately held, and there is little agreement about the value of stock in such companies. Only the very largest companies can be matched with comparable publicly traded firms to determine stock value or price-earnings ratios.
Finally, there are the construction-specific issues that affect your numbers. Retainage generally is listed as part of your accounts receivable, but it often remains uncollected for more than a year. In that case, it is not technically a current asset, since that category is designated for cash and assets that are expected to convert to cash within a year. However, it is not really a part of fixed assets, either.
Cost in excess of billings and billings in excess of cost are peculiar line items that often seem to be reversed. Billings in excess account for the receipt of money before you have incurred any costs of doing the work. Billing in excess seems to grant you an advantage, but your obligation to perform means you owe the work. Therefore, it is a liability, not an asset. Cost in excess means you have not coordinated payments received with the cost of doing the work. A client owes you money, so it is an asset. If the numbers are too large, the statement reflects mismanagement of your operations, since the timing of your cash flow does not coordinate with performance of your work.
Sales and profit
The revenue line on your income statement can be distorted because it is not always clear when you may book a sale. Is it when you have received a letter of intent, signed the contract or received your first payment? Also, the regulations affecting cost accounting for multiyear projects can be convoluted. If you begin a large project this year and book half of it, but the contract total substantially increases or decreases next year, have you misstated your sales or profit? Often, you must revise your tax forms when such conditions change.
Profit totals can be affected by strategies that minimize taxes. Do you want to show the highest profit possible, even if you pay more taxes? Or will you expedite larger purchases earlier to reduce your tax burden, even though your profit for that year will be artificially reduced as well?
As you can see, your strategic decisions, as well as accepted accounting practices and regulatory structures, all affect the final picture generated by your financial statements. There is no universal financial truth, and the resulting lies are not necessarily evil or unethical. In the next two columns, you will see examples of deliberate distortions and manipulated statistics that will ratify your belief in your own honesty.
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at email@example.com.