Apr 03

Introduction to Financial Statement Analysis. Part 1a: Who’s in Charge

by David Harper, CFA, FRM, CIPM

FinStatements |

Note: this a blog highlight of our 19-minute movie: An Introduction to Financial Statement Analysis. Chapter 1: Who's in Charge.

Accounting is a social science...

Accounting is a social not a natural science. In physics, there is an underlying truth about gravity revealed in an elegant equation. Financial statements don't convey an underlying truth about business performance because there isn't one. Statements are social documents informed by rules and accounting standards. If a rule changes, a company's bottom line changes without any an underlying economic change.

This can be forgotten by investors who expect "more accurate" financial statements. We don't mean fraud (of course fraud is bad). But management (and their auditors) apply discretion to the representation of economic transactions within the accounting framework. It cannot be otherwise. Efforts to produce a single, universally calibrated metric like diluted earning per share (EPS) or economic value-added (EVA) measure are doomed not because there aren't better metrics, there probably are. They are doomed for the same reason we can't agree on the point of, say, Milton's Paradise Lost: the reader brings a point of view that informs a non-scientific document. With financial statements, different consumers of financial statements project different concerns onto a business and its future prospects.

...but the financial analyst is a reverse engineer

It is not the job of a financial statement to produce an accurate bottom line. It is the job of an analyst to carefully deconstruct the financial statement depending on analytical goals. To those of us who make a craft of financial analysis, WorldCom and Enron were failures of Wall Street: the clues were hiding in plain site. In a practical sense, net income and reported EPS are meaningless. The analyst is supposed to deconstruct, or reverse-engineer, the statement in order to make deeper sense of business performance. Our advice to the aspiring analyst is: before you tackle the P/E multiple, understand how 'E' is generated. It's almost infinitely flexible. You will soon see why statements such as "P/Es are above their long-term average of 15x or 16x" and "the stock is trading above its industry average P/E" are hopelessly imprecise. Because the rules change, even comparing a company to its own (historical) P/E can be misleading.

Consumers of financial statements

Under the traditional Conceptual Framework (which FASB is now revisiting with the goal of a unified international standard), there are three key users of financial statements: the government (including regulatory bodies), capital markets (creditors and investors), and the public. Traditionally, creditors (e.g., banks that hold debt obligations) and investors (equity holders) are considered the primary users of financial statements:

 

The SEC is in charge but delegates to FASB

The Financial Accounting Foundation (FAF) is a private-sector organization that oversees both the Financial Accounting Standards Board (FASB) and its counterpart, the Governmental Accounting Standards Board.

Legally, the Securities and Exchange Commission (SEC) has final authority over financial accounting and reporting standards.  The SEC, however, delegates rule-making to FASB (although recently, the FAF said it wants to give the SEC more input on appointments to the FASB). As a practical matter, at the end of the day, FASB develops financial reporting standards.

This includes rules that govern the corporating filings that contain financial statements. Public companies must file, among other documents, an Annual Report (10K) within three months of the end of its fiscal year, a Quarterly Report (10Q) within 45 days of the end of its fiscal quarter, and a material events report (an 8K) when certain material events occur (e.g., change in control, resignation of a Board member). The 8K in recent years has become very important; it is often the first document that reports bad news (e.g., a bad restatement).

Further, the SEC mandates the disclosure of certain elements within each of these documents. The 10K and the 10Q must include the five financial statements. The 10K must also, for example, contain a text-based management discussion & analysis (MD&A). The 10K must be audited, but 10Q reports technically can be reviewed but not audited.

As we said above, the SEC delegates day-to-day work to Financial Accounting Standards Board (FASB), which has seven full-time members. (The Accounting Principles Board, the APB, predates FASB. Some standards issued by APB continue to apply today. APB standards will apply until they are superceded by more recent FASB statements.) Both the SEC (which issues Staff Accounting Bulletins, SABs) and FASB (which issues FASB Statements) contribute to the massive, living document known as Generally Accepted Accounting Principles (GAAP).

 

That's how we get to GAAP 

That's roughly how we get to GAAP. We mention all of this to be mindful: accounting principles are set, changed, and updated by social organizations (i.e., a foundation, a public SEC led by presidential appointees and the private-sector FASB) which, while professional and well-intentioned, are neither perfect nor totally immune to political pressure.

Comments

  1. Be the first to leave a comment!

Leave a Comment