Where Financial Reporting Still Falls Short

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. Unfortunately, that's not what happens in the real world, for several reasons. First, financial statements necessarily depend on estimates and judgment calls that can be widely off the mark, even when made in good faith. Second, standard financial metrics intended to enable comparisons from one company to another often fall short, giving rise to unofficial measures that have their own problems. Finally, executives routinely face strong incentives to manipulate financial statements. In recent years, we've seen the implosion of Enron, the passage of the Sarbanes-Oxley Act, the 2008 financial crisis, the adoption of the Dodd-Frank regulations, and the launch of a global initiative to reconcile U.S. and international accounting regimes. Meanwhile, the growing importance of online platforms has dramatically changed the competitive environment for all businesses. In this article, the authors examine the impact of those developments and consider new techniques to combat the gaming of performance numbers.

• Accrual accounting
• Government policy and regulation
• Accounting standards
• Finance and investing