I really like the Christmas season. It's a break from normal life and an opportunity to reflect on what's gone on over the past year and make plans for the next. It's a time to enjoy relaxing moments with friends and family. There are usually gorgeous displays in the windows at Macy's in New York City and Harrods in London; beautiful vignettes that remind us of the fantasies of Christmas.
I especially enjoy getting Christmas cards from family and friends all over the world. It's nice to get family updates and reconnect with friends from my past whom I don’t hear from during the year, but nonetheless still share a connection.
When personal computers and fancy printers appeared on the scene 30 years ago, it changed the Currier & Ives pastiche of Christmas cards. Instead of handwritten notes on the pre-printed cards we purchase in boxes from a Hallmark store, many of us have taken to creating personalized family letters that provide painfully detailed greetings for the holiday season. I refer to these as “Christmas Letters.” They are easy to spot, arriving in brightly colored envelopes and addressed with perfect calligraphy. They’re festooned with little stickers and adorned with seasonal postage up in the right-hand corner. They look beautiful when they arrive — something straight from a top-notch mass mailing.
And what's the first thing you see when you open one of these letters? The family photo. Don't they all look so happy? Do you think they’re all this happy all year long? Do you think the children wear those cute little dresses and those handsome little suits with bow ties every day? Are they always color-coordinated? Does the dog always stand still when you want him to?
In addition to this beautiful picture, there's the letter.
It starts something like:
Dear beloved friends:
Things are going smashingly well on all fronts for our family. The children, of course, continue to be the highlights of our story. (This would be a book if I listed all their accomplishments, so I'll just give you the highlights.)
Little Harold is now 17. He has finished all of his college applications for early decision and he's fretting over how to choose between MIT and Princeton. What a dilemma! Laila (15) is turning into quite the beauty, ready to compete in the Miss America contest. Stay tuned; you may see her there next year (even though she's a little underage…but don’t tell anyone).
Then the parental units go on about themselves:
We’ve had many outstanding years of work, but we never knew bonuses could be so big! In addition to Jane’s charity work in Sierra Leone, fundraising, organic gardening, yoga classes and beekeeping, she still finds time to be president of the PTA and secretary for various community committees. Bob continues to be the best father and breadwinner ever. Sadly, we had to say goodbye to Bob's mother this year, but we rejoice in the long life that she enjoyed.
So, from our home to yours, have a blessed holiday season; we'll be praying for you.
To be honest, when I see these letters, I don't always believe everything I read. Did Harold really apply for early decision at all those colleges? Does he really have a shot at both Princeton and MIT? Is Laila really that good-looking? What is Jane really doing in Sierra Leone? (I hear there are nice resorts there!)
I read the letters and try to figure out what is real and what isn’t. Then I just store the information in the back of my head.
Eventually the Christmas season winds down, the festive atmosphere fades, and I put away all the decorations. The collection of letters gets put where it belongs (recycling), I keep the pictures for some unknown reason and the New Year comes upon us. With that, almost everything starts anew. But one thing lingers on — the Christmas letter phenomenon. That seems to reboot. But how?
Around the end of January, I start getting annual reports from some of the companies in which I own stock. Being an accountant, I happen to enjoy reading annual reports. I especially enjoy the financial statements. I'm very happy to peruse a balance sheet, an income statement, a statement of cash flows, and a statement of stockholders’ equity. And because I'm an accountant and know the language of business that is GAAP, I'm very happy to read something in my native tongue.
But how do financial reports from companies relate to the Christmas letters?
Let's start with the balance sheet. A balance sheet is a financial snapshot of the company at a particular point in time. It provides a portrait of a company’s resources and obligations as well as a profile of its capitalization. Comparative balance sheets allow you to compare the company at two distinct points in time — the end of last year and the end of this year.
Well, guess what? That's kind of like the family photo from last year’s Christmas letter and the family photo this year! Put them side by side and you’ll notice some things are different. Who gained weight? Who lost weight? Who’s looking older? Awww, look at the new baby. What happened to Grandma?
The same observations apply to balance sheets. Some accounts are bigger, some are smaller, some are new, and some aren’t there anymore.
To help explain what's happened between two balance sheets, the income statement is useful. It is a depiction of what has come and gone during the year. An income statement summarizes revenues and expenses and then reports profits. Isn’t that just like the Christmas letter that summarized all the year’s activities?
But wait, there’s more!
The statement of cash flows zeroes in on one of the most important assets of the company — its cash. It provides us with information about how cash comes in and goes out of the company. Isn’t that just what that Christmas letter told us — that the children were the stars of the show and how they had grown and progressed?
Finally, there’s the statement of stockholders’ equity. This reports transactions between the owners of a company and the company itself. So, if a company issues new stock, the proceeds flowing into the company would explain why contributed capital is bigger. If the company pays a dividend, that capital outflow out would reduce retained earnings. It’s kind of like the family tree. The capital flowing into the company is like the new babies and boyfriends. The capital flowing out is...well...Grandma.
I couldn’t help but notice that those Christmas letters I read just a few weeks ago were a bit polished, a tad euphemistic, a smidgen hyperbolic and, in some cases, just not true. I have to wonder if my annual reports — being all glossy and well written — are doing the same thing. I wonder if they are perhaps overstating accomplishments and Photoshopping the blemishes, perhaps offering a picture that's just a little too rosy.
Here's an example. See if you can guess what company this is. These are statements that came from an actual annual report:
“The company's net income reached a record $1.3 billion.”
“We continued our record of strong returns.”
“Recurring earnings per share have increased steadily.”
Sounds good so far! Further, a comparison of the company's returns versus the S&P 500 suggested it was doing really well. On April 2, 2001, it released its annual report for the year 2000, everything looked good — the glossy pictures, the positive financial highlights. The report was beautiful.
Six months later it said it had to restate everything because it was all a lie.
If you guessed the company was Enron, you were correct.
So what kinds of tricks do companies have to optimize their own Christmas letters? They fall into two broad categories. The first is what are called real decisions. That's where the company alters the physical nature of a transaction so when it is reported, it makes something look different from what it would have without intervention.
For example, a company facing rising costs of inventory and using LIFO for inventory accounting might make more purchases than necessary at year-end to cause Cost of Goods Sold to increase. Conversely, the company might force a LIFO liquidation to boost reported profits.
The second category is accounting decisions. This is when the company plays fast and loose with accounting rules and chooses certain accounting methods over others (like Completed Contract instead of Percentage of Completion) in order to alter reported profits.
Some companies may interpret things in a way that suits their needs and report non-GAAP numbers. Tesla, for example, complies with GAAP and reports earnings per share. However, it has regularly computed an alternative measure of income that removes stock-based compensation expense, claiming it provides a better-than-GAAP measure of income. Without stock-based compensation expense, earnings are higher.
Just as it’s OK to be a bit doubtful that Harold really has an impossible college choice to make, it’s OK to look at annual reports with a touch of educated skepticism. The hyperbole of Laila’s beauty may be a bit like the hyperbole of overstated earnings. They’re both worthy of some scrutiny. Just as you are open to the notion that Sierra Leone was mostly good intentions on Jane’s part, keep your mind open to the different ways that companies can present their results.
So how can you find the truth? You have to look at a part of the financial statements that most people ignore — those boring notes in the back of a set of financial statements. That's where the dirt is; that's where you find the stuff you can tie back to the financial statements and ferret out the real story. (Don’t you wish your Christmas letters had those?)
So when you start to get your annual glut of Christmas cards this year, remember that annual reports will soon follow. And when those annual reports do show up, I hope you'll remember fondly all your pretty Christmas cards and apply the same skepticism.
The author gratefully acknowledges the outstanding editorial contributions made by Cameron F. Hutt, MBA.
