This week’s reading covers how different audiences interpret the income statement and balance sheet, how Goodwill was used to bolster expanding companies’ net worth, and how mark-to-market accounting contributed to the Financial Crisis of 2008.
Managers focus on the company’s income statement because for managers to budget effectively, they need to be aware of the revenue and expenses of the company. In addition, balance sheet data rarely considers an operating manager’s budgeting process. On the other hand, investors and analysts prefer looking at a company’s balance sheet, as it displays the assets, liabilities, and shareholders’ equity at a specific point in time. This snapshot allows investors and analysts to assess how liquid and solvent a company is, which helps them determine whether or not to invest in it.
Goodwill is an intangible asset on a company’s balance sheet when it acquires another business for a price greater than its net asset value. When Goodwill could be amortized, companies were incentivized to acquire companies to undervalue the physical assets that came with the company. However, since Goodwill can no longer be amortized, companies want to purchase companies with little to no inventory. Tyco was a prime example of doing this, as they bought more than six hundred companies in two years. As a result, investors and analysts started looking at tangible net worth, which is total assets minus intangible assets minus liabilities.
Congress commissioned Fannie Mae and Freddie Mac. These two enterprises were designed to buy mortgages from the banks, package them into securities, and sell the securities to investors. These are also called mortgage-backed securities. Many banks, including Lehman Brothers and Bear Stearns, suffered the consequences of buying these securities mixed with prime and subprime loans due to mark-to-market accounting. This accounting method means banks must mark these mortgages down to their current value. So if a bank held $10 billion worth of mortgages and the market dropped 10%, it would have to record a loss of $1 billion. Although these banks profited handsomely from the interest and principal payments from these securities, they were careless in determining who was worthy of paying their mortgages. As a result, too many people defaulted on their mortgages, which resulted in crashing home values and ultimately forced many creditors and lenders into bankruptcy.
Works Cited
Berman, Karen. “Financial Intelligence, Revised Edition: A Manager’s Guide to Knowing What the Numbers Really Mean.” Google Play, Google, Jan. 2013, play.google.com/store/books/details/Karen_Berman_Financial_Intelligence_Revised_Editio?id=7TfCiz1LkMMC
Written by Mikael La Ferla
Mikael La Ferla 