The Accounting Process in Security Analysis

Financial statements  are products of the accounting process. They provide useful and meaningful information on the financial performance of a company. These pieces of information are particularly useful to managers, investors, creditors, and analysts who rely on them to make business-related decisions.

Analysts are able to tell the business transactions that were recorded by examining these financial statements. A company’s management can, however, manipulate its financial statements to produce the desired outcome. An analyst, therefore, has to be perceptive enough to detect these manipulations and misrepresentations.

Using Financial Statements in Security Analysis

An integral initial step in analyzing a company’s financial statements involves the identification of the types of accruals and valuation entries which are included in them. These are typically noted in the critical accounting policies or estimates section of the management’s discussion and analysis (MD&A). Besides, accruals and valuation entries can be found in the significant accounting policies footnote, both of which are found in the annual report.

Accruals and valuation entries rely on significant judgment and estimation which could be wrong or even be used for deliberate earnings manipulation.

A company’s management can deliberately doctor the recording of a transaction to produce the desired result. For example, instead of appropriately recording an expense when cash is used to purchase an asset, a company may increase the amount reported as another type of asset. Both options result in a balancing of the accounting equation, but the latter option allows the company to report less expenses,. It is noteworthy, however, that this results in higher net income and owners’ equity and a healthier looking company.

An analyst should, therefore, be cognizant of the fact that a company may have manipulated its earnings. They should, therefore, skeptically look at financial statements and pay attention to any large increments in existing assets, unusual new assets, and unexplained changes in financial ratios.

Appreciating the fact that every accounting entry must have another side is key in identifying misrepresentations or inappropriate accounting. Typically, when “cooking” the books or “fixing” one account, a person leaves another account with a balance which does not appear to make any sense. For example, when recording fictitious revenue, there will likely be a growing receivable amount which is unlikely to be collected.

Financial ratio analysis may assist an analyst in detecting suspicious amounts that have been reported in accounts. The accounting equation can also be used to detect accounts which are likely to have been subject to fraudulent accounting.

Question

If a company spends cash on something but does not want its financial records to reflect the expense, the company would most likely manipulate its books by reducing the cash account balance and which of the following:

A. decreasing another asset;

B. increasing another asset; or

C. increasing revenue.

Solution

The correct answer is B.

In order for the accounting equation to remain balanced, if cash (an asset) is decreased, then, of the three options presented, the value of another asset would have to be increased. Decreasing another asset or increasing revenue will not let the accounting equation remain balanced.

Reading 22 LOS 22h:

Describe the use of the results of the accounting process in security analysis