Hey friends. When I did my doctoral work, reading accounting (and finance) research studies was a constant assignment. Numerous empirical studies found evidence that earnings management is commonplace. Managing earnings may seem reasonable since research also shows that earnings drive stock prices. But is it really wise?

No company starts with earnings. A business starts when it raises capital and acquires assets. To the degree that capital invested in assets exceeds the assets that are levered (financed), there is positive equity. The accounting reflection of this start-up is a “balance sheet.”

The company then “operates” in a quest to generate a return on that balance sheet equity. But does the company manage its financial situation to grow equity by managing the income it generates from its assets or by managing the assets intended to generate income? I posit that the company starts with a balance sheet and if it closes shop one day, it ends with a balance sheet. Earnings are what lie between. Therefore, it is the balance sheet assets that must be the focal point of financial management.

You may think this is just “semantics.” I wish it was only that. In a nutshell, good financial management involves managing assets so as to maintain and grow (based on taking reasonable and calculated risks) positive healthy equity. Negative equity is the textbook definition of insolvency.

Keeping the balance sheet healthy and moving forward is the key to longevity and the ability to produce future income. This is true for every institution and person. The failure of our society to have that balance sheet focus can readily be seen today from the massive levels of government deficits to massive levels of corporate negative tangible equity to massive levels of negative equity positions of many consumers. When income (short term — next month or next quarter, etc.) is the primary focus, the health of the balance sheet (long-term financial standing) can be allowed to slide. In my view, we’ve become a country that survives its insolvent balance sheet by making the necessary interest payments on time and lives as though its underlying debt can be forever “re-financed.”

Focusing on managing earnings has endangered us all in my view. There’s good reason for believing the Fed has to keep interest rates low. How else can we persist with our insolvent balance sheets if the interest charges exceed our ability to keep up with the required minimum payments?

This is clearly not a “feel good” post today. We aren’t going to get out of the hole by continuing to dig deeper. But refocusing attention back to the balance sheet and rewarding sound asset management (to maintain and grow healthy positive equity) rather than continuing to focus on next quarter’s EPS is a step in the right direction and one we must take sooner than later. The main point of my book, Choose Stocks Wisely, is its admonition to place primary emphasis on the balance sheet in making valuation judgment.