From the Sigma Investment Counselors blog
Early in my career, a very successful investor shared this bit of advice with me. His logic follows: Companies do not like to report poor results or results that fall short of Wall Street estimates.
Financial statements, both income and balance sheets, include a significant number of estimates. For example, balance sheets show accounts receivable as a specific number, but no one can be completely certain as to how many customers will actually pay their bills. Hence, the company’s financial statement’s listing of accounts receivable is an estimate, after an allowance for expected bad debts. Estimates of inventory values face similar issues.
More complicated is estimating future liabilities for pension payments and retiree health care.
Investors should remember that business activity is a movie, while financial statements are a snapshot.
In the end, the final financial statements represent an accumulation of estimates that have been negotiated between the auditors and management, typically through audit committees.
Accepting the concept that managements are reluctant to report disappointing quarterly operating results could lead to the conclusion that, in order to avoid reporting a bad quarter, management will push the auditors to be as optimistic as possible in the area of estimates. In this scenario, it is theoretically possible to disguise one quarter’s disappointing results.
The logic behind the contention that there is no such thing as one bad quarter is based on the assumption that if things are so bad that the company can’t avoid reporting disappointing short-term results, even with optimistic estimates, business is actually quite disappointing and future reported results are likely to fall short of expectations.