Provide an example from the text or the Internet that demonstrates a situation in which a company’s net profits appeared good in the statements, but the gross or operating profits presented a different picture. Discuss how this might have occurred. Respond to the following question, addressed in Problem 3.6 on p. 109 (Ch. 3): “Why is the bottom-line figure, net income, not necessarily a good indicator of a firm’s financial success?” Look for indicators like liquidity or solvency to answer this discussion question.
One example that can be found on the Internet is the case of Enron Corporation. Enron was an energy company that achieved significant growth and appeared to have high net profits on its financial statements. However, upon closer inspection, it became clear that the company's gross or operating profits painted a different picture.
Enron employed complex accounting techniques and aggressive reporting methods to inflate its revenue and hide its mounting debt. This allowed the company to report impressive net profits, making it appear financially successful. However, the underlying operations and cash flow of the company were weak, which was not reflected in the net income figures.
The inflated net profits were mainly a result of overvalued assets, off-balance-sheet entities, and fictitious transactions. Enron engaged in mark-to-market accounting, recording anticipated future profits from energy contracts as present earnings. This inflated their reported revenue and net income.
So, in this case, the net income figure did not accurately reflect the actual financial success of Enron. The company's heavy reliance on debt, the lack of underlying cash flow, and poor liquidity were indicators that net income alone was not a reliable measure of financial success. It is crucial to consider other financial indicators like liquidity, solvency, and cash flow to evaluate the overall financial health of a company.