Resulting from the accounting process is the preparation of financial statements which provide useful and meaningful information on the financial performance of a company. This information is particularly useful to managers, investors, creditors, and analysts who need the information to make business decisions.
Analysts are able to conclude what business transactions were recorded by examining these financial statements. A company’s management can, however, manipulate its financial statements to produce the desired result. An analyst has to be therefore 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 identifying the types of accruals and valuation entries which are included. These are typically noted in the critical accounting policies/estimates section of the management’s discussion and analysis (MD&A) and 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 prove wrong or even be used for deliberate earnings manipulation.
Management can improperly record 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 choose to 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, which 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 and as a result should skeptically look at financial statements and take special note of any large increases in existing assets, new unusual 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 is likely to 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.
If a company spends cash on something but does not want its financial records to reflect an 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
C. Increasing revenue
The correct answer is B.
In order for the accounting equation to remain in balance, 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 in balance.
Reading 22 LOS 22h:
Describe the use of the results of the accounting process in security analysis