Last week, I shared a link to Jake Taylor’s interview of me with regard to “Choose Stocks Wisely.” During that interview, Jake asked me about my view as to “why” the balance sheet is so disregarded in the market relative to the attention given to earnings. I’m going to address this question again today in a bit more detail.

During my doctoral education, I learned much about “positive accounting theory.” Two men, Ross Watts and Jerold Zimmerman, researched and wrote about why managers choose the accounting methods they choose in preparation of financial statements. There are many other researchers who followed in this field of research and related fields. And, yes, generally accepted accounting principles (GAAP) include multiple methods of accounting for events. For example, there are multiple ways to depreciate assets (straight line, sum of the years digits, double declining balance, etc.), multiple ways to cost inventory units sold (first-in, first-out, or FIFO; last-in, first-out, or LIFO, etc.), and on and on.

Out of all this research spilled evidence that managers select accounting methods to increase earnings per share in the near term and also seek to smooth the earnings out over time. This, of course, creates investor perception of lower risk and higher reward.

And why would managers manage accounting for earnings in this manner? The conclusions drawn include that management’s incentive rewards like bonuses, for example, are tied to the bottom line earnings number. That is, they are incentivized toward ever-increasing earnings.

Also, university programs tend to teach that the stock market is all about earnings. Graduate training in both accounting and finance programs leave a student believing that earnings is the central basis for most stock valuation.

It seems that education begets practice and practice begets education and all of it leads to a stock market that is focused on earnings like a laser beam.

These are my personal notions for why earnings are held in such high esteem relative to the balance sheet.  But if the balance sheet is nothing more than a potted plant, why does it even exist?

The balance sheet is no potted plant but rather the company, financially speaking, on paper at any point in time. The balance sheet position enables future earnings to occur. Earnings, in turn, build the balance sheet equity. But if earnings become the whole ball game, in the background, the balance sheet will eventually become sorely compromised, revealing too little liquidity and too much debt, thereby jeopardizing the company’s ability to continue.

I could go on, but I’ll tidy it up by saying that I believe from the university which trains that it’s all about earnings to the world of practice where management incentive structures are completely tied to the bottom line, it all filters down to an earnings emphasis taken on by the stock market itself. Yet, to succeed with investing, risk has to be managed when buying common stocks and disregarding the balance sheet upon investing can prove devastating in the long run since only the balance sheet provides information regarding the amount and quality of equity; and a share of common stock is a share of company equity! In fact, earnings have no context without the balance sheet.