Accounting Rules Enable Exaggeration of Profits

Wall Street analyst Merrill Lynch & Co. has released a report demonstrating how the top 36 technology companies have used accounting rules to their advantage to exaggerate profits on financial statements.

Because tech companies have a high level of stock options, investments, mergers, and tax benefits, the report explains, the accounting rules work to their benefit and disguise the real bottom line for these companies.

The Merrill Lynch report recommends that investors should look at a company's cash flow when making investment decisions instead of relying solely on profits and earnings per share.

According to Merrill Lynch, investors would have been able to foresee the recent market downturn in tech stocks had they concentrated on cash flow reports. Tech stocks are still overpriced, according to Merrill Lynch.

In particular, the accounting rules most likely to play into the hand of inflated financial statements include rules for these items:

  • Investments. The top tech companies received nearly a quarter of their pretax income from investments during last year's boom market.
  • Stock options. Companies take a tax deduction when employees exercise options.
  • More stock options. Stock options are treated as compensation to employees but aren’t reportable as a cost on company income statements.

The report cites the example of Yahoo explaining that had Yahoo reported stock options as compensation, the company's $71 million profit last year would have been a $1.2 billion loss.

The report goes on to state that the companies are following accounting rules correctly, but the rules don't do an adequate job of providing information to investors.

The Financial Accounting Standards Board has tried to enlist Congress to require a stricter method of accounting, but so far lobbyists representing the tech companies have prevailed in influencing Congress to take no action on the matter.

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