The Sparhawk Effect in Financial Statement Analysis

Stephen V. Senge
Professor of Accounting
Simmons College
409 Commonwealth Avenue
Boston, MA 02215-2380
Voice: 617-521-3867
Fax: 617-521-3880
stephen.senge@simmons.edu



The Sparhawk Effect in Financial Statement Analysis

Stephen V. Senge

Both undergraduate and graduate students often approach a course in financial statement analysis anticipating an extremely technical discussion. They expect the course to focus on the numerous ratios a manager or analyst might use to better understand the relationships among a firm’s assets, liabilities, equities, revenues, and expenses. These calculations provide insights for the current or potential investor, creditor, employee, or business partner. Although these technical relationships form an integral part of the typical financial statement analysis curriculum, the humanities – specifically, art history – provide an alternative starting point. From a brief analysis of the portrait of Mr. Nathaniel Sparhawk, students see first hand the importance of background knowledge and informed, professional judgment as bases for a technical analysis of financial reports.

Nathaniel Sparhawk and the Sparhawk Effect

Nathaniel Sparhawk lived in Kittery, Maine in the years just prior to the American Revolution.¹ He gained some wealth as a merchant trading wood and molasses and married the daughter of the wealthy Sir William Pepperill. In 1764, the noted American painter, John Singleton Copley, produced a life-size portrait of Sparhawk that depicts an 18th century gentleman.² The red silk and satin of his breeches, waistcoat, and topcoat, his ample girth, and the aristocratic surroundings all suggest prosperity. Examining this portrait in isolation leaves the viewer with the impression that Sparhawk was a man of social standing and economic prominence.

A vastly different picture unfolds, however, when an observer asks critical questions about Sparhawk, the portrait itself, and the genre of the painting. Further investigation of Nathaniel Sparhawk reveals that although he achieved some success as a merchant, he was bankrupt by 1758.³ In that year, his property was auctioned to pay his debts. When Sir William Pepperill died in 1759, he left his estate to his daughter and grandson rather than his son-in-law, Nathaniel. In an effort to outdo his father-in-law, Sir William, Sparhawk commissioned a portrait that was self-congratulatory. A detailed examination of the painting even reveals that the artist moved the waistcoat’s buttons to increase Sparhawk’s apparent girth and thus make him appear even more prosperous.⁴

The Sparhawk portrait is an example of a swagger portrait – paintings known for their “inflated if not actually imaginary settings.”⁵ Prominent citizens of the colonial era favored these portraits, but Nathaniel Sparhawk had only the pretense of prominence and prosperity. The Sparhawk Effect, then, refers to a circumstance where the impression created by a portrait or picture does not reflect the underlying reality.

Linking Sparhawk and Financial Statement Analysis

Art historians provide some significant lessons from Nathaniel Sparhawk’s portrait that apply to aspects of financial statement analysis. Specifically, the discussion of the Sparhawk Effect reminds beginning students about the significance of image, the impact of genre, and the importance of information not found in the primary financial statements.

The Significance of Image. In a picture – either a portrait or photograph – people generally want to look their best. Nathaniel Sparhawk thought the image of a wealthy, prominent citizen was appropriate even though this perspective considerably stretched reality. For a firm and its senior managers, the financial statements represent a type of portrait. For a firm to look its best, that portrait should project strong asset, revenue, and income positions. To enhance this perspective, managers might rely on accounting policies as well as effective competitive strategy and efficient operations. Managerial choices of accrual policies provide effective examples. Accounting policy decisions about allowances and reserves, depreciation and amortization methods, and the timing of impairment recognition all exemplify managerial choices that impact the image displayed in the financial portrait of a firm.

The Impact of Genre. An observer gains additional insight about the Nathaniel Sparhawk portrait through an understanding of the artistic genre known as the swagger painting. An examination of several of these paintings reveals similar poses and surroundings designed to impress the viewer. Features such as a setting that emphasized the girth or dress of the subject played an important role. The parallel concept in financial statement analysis involves a viewer’s understanding of what a firm may try to emphasize given certain expectations of a given era. For example, in the late 1990s, many new technology firms struggled to generate income. With little income, however, investors became interested in the revenues reported by these firms. Their logic suggested that if revenue kept on growing, income would surely follow. This focus on revenue growth – to the detriment of other income statement measures – influenced firms’ decisions about revenue recognition policies. In other firms, the rush to report income caused managers to treat certain costs as assets rather than expenses even though these items contained few if any future economic benefits.

The Importance of Background Information. Without the historical narrative to accompany the portrait, the Sparhawk Effect is invisible to the novice viewer of 18th century American art. The painting tells the world that Sparhawk was a wealthy colonial gentleman. Additional narrative information about both the man and his era provide the valuable context. In financial statement analysis, the Management Discussion and Analysis (MD&A;) and Notes to the Financial Statements along with independent, qualitative information can provide a reader with this greater context. Just as the interested viewer could investigate background information on Nathaniel Sparhawk, the financial statement analyst can discover valuable information in various narrative disclosures. These lessons of the Sparhawk Effect – the significance of image, the impact of genre, and the importance of background information – provide a useful framework from which to begin the study of financial statement analysis.

Teaching Strategy

The use of a portrait such as that of Nathaniel Sparhawk represents an interesting way to start a course in financial statement analysis. Regardless of the level of the discussion, the lasting image created by the painting and subsequent comments carries throughout the course. An instructor can substitute many different portraits that would have the same effect. The key, of course, is to select artwork that portrays one view of reality and also has accompanying information that reveals a different view.

An instructor can develop this introductory lesson by first showing a good quality picture of Sparhawk or other suitable portrait and asking for general observations. Discussion often follows on attributes of the painting such as the use of light and darkness, the subject’s pose, and the portrait’s setting. As conversation continues, students often highlight more minute aspects of the painting itself such as the brush technique or the color highlights. At this point, the instructor might mention that the detailed analysis of these attributes of the portrait is comparable to the ratio analysis based on a review of a firm’s income statement, balance sheet, and statement of cash flows.

Students should then review the narrative facts that lie behind the Sparhawk portrait. An instructor can either provide a short lecture or written summary. Subsequent discussion then emphasizes the significance of image, the impact of genre, and the importance of background information linking the Sparhawk circumstances to various elements of financial reporting and financial statement analysis. Summary comments often focus on the need for an awareness of the managerial incentives and rewards inherent in the financial reporting system. In case discussion or problem review in subsequent class sessions, an instructor might provide a helpful reminder by asking, “If the Sparhawk Effect were present in this circumstance, where would it likely be?”

A Timely Postscript

Toward the end of this initial discussion, students might point out what they see as a key difference in the circumstances of the Sparhawk portrait and modern financial statements – the role of the auditor in providing assurance that the financial portrait reflects underlying economic reality. Given the recent questions about audit reliability amidst well-publicized corporate accounting scandals, could students discover a more timely issue at the outset of a contemporary financial statement analysis course?

Notes:
1. Carrie Rebora, Paul Staiti, Erica Hirshler, Theodore E. Stebbins, Jr., and Carol Troyan, John Singleton Copley in America, The Metropolitan Museum of Art, New York, 1995, p. 65.
2. Rebora and Staiti, et al, p. 204.
3. Rebora and Staiti, et al, p. 65.
4. Rebora and Staiti, et al, p. 66.
5. Rebora and Staiti, et al, p. 203.