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Understanding Financial Statements

Lyn M Fraser and Aileen Ormiston, 2001 updated to 2010

A beginner book taking again the field of financial statements from scratch.

Quality of Earnings

  1. Sales and Revenue
    • premature revenue recognition
    • gross vs net basis: gross revenue needs to be accounted if company assumes risk (thus more revenue and less margin for same earnings)
    • allowance for doubtful accounts
    • is sales growth is due to price or volume ?
  2. Cost of Goods Sold
    • cost flow assumption for inventory: Lifo generally leads to higher quality of earnings compared to FIFO or average cost.
    • base layer LIFO liquidation (Lifo inventories always keep a low cost bottom of the barrel, if company uses that inventory, it will raise earnings)
    • Loss recognition on inventory write-down
  3. Operating Expenses
    • Discretionary expense: watch out for deferred capex, lowering advertising cost that are not explained by management
    • Depreciation method: comparison between companies is difficult when they follow different depreciation speeds
    • Asset Impairment: companies used to be able to review down and up asset impairment. Now it is only down.
    • Reserves are sometimes used as a tool for "cookie-jar accounting" reserves are adjusted up and down to reduce the volatility of earnings.
    • In-process R&D: R&D that has not yet been put to use can be written-off during acquisition. It is sometimes used to manipulate earnings down for big bath accounting.
    • Pension accounting: Interest rate assumptions. SFAS 158 was issued in 2006 to require the employers to recognize the over or underfunded status of a defined benefit plan.
  4. Nonoperating Revenue and Expenses
    • Gains (Losses) from Sales of Assets: this item may improve earnings but needs to be excluded from forecast if not recurring
    • Interest Income: this may rely on imbalance in rates between different currencies or funding mismatch
    • Equity income: a company may elect to recognize dividends or consolidate all the earnings of companies it owns, irrespective of whether cash was distributed. This is a very optimistic stance on earnings.
    • Income tax: income tax rate may vary substantially from one year to another, for instance, and audit resolution can temporarily increase or decrease tax rate.
    • unusual items: items that the company wants to flag as exceptional. Investor to read the notes and make up his mind.
    • Discontinued operations: management should provide previous contribution of discontinued operations to past earnings to assess forward earnings
    • Extraordinary items: few items meet this definition and therefore they are rare.
  5. Other issues
    • Material changes in shares outstanding: determine whether stock repurchases they offset employee stock options, and whether they are financed by debt
    • Operating Earnings, Core Earnings, Pro-Forma Earnings, EBITDA: while management dazzlers want to emphasize on some non GAAP numbers, long term investment need to be taken into account.

Quality of Balance Sheet

The QoE items above impact balance sheet.

  • debt maturity should be matching assets
  • Parmalat at the moment of Fraud was issuing a lot debt despite claimning to have a lot of cash
  • commitment and contingencies disclosures need careful evaluation, they led to Enron downfall, litigation are described there too
  • capital leases are consildated on BS whereas operating leases are described in the commitment or note on lease should impact leverage ratio.

Quality of Cashflow Statement

This statement is mandatory in the US since the 80s.

  • CFO (casfhlow from operation) can be manipiulated.
  • Worldcom recorded opex as capex, which allow slow multi-year depreciation instead of expensing.
  • Accounts Receivable can be accelerated, or Account Payable slowed down, resulting in higher CFO.
  • SEC cracked down on large equipment companies putting vendor financing in CFINV to increase CFO.