Care required when analyzing financial statements

DO you have an eye and an attitude?

That's the critical question Gregory Harter posed to his audience in his presentation, “Popular Tools and Techniques for Analyzing Financial Statements of Your Company.”

“Financial statement analysis requires a state of mind where one lets the numbers do the talking while the reader does the interpretation,” said Harter, of RSM EquiCo. “Thus an eye to looking at the numbers, and an attitude to understanding what the numbers and associated trends mean.

“Financial analysis is often the ability to ask the right questions as the data and reports are reviewed, and then being able to answer those questions. That's the easy part. The tough part is looking at data and saying, ‘What does it mean?’ For my own company, does what this means represent what my company is actually doing? Do the reports I see accurately communicate to my board of directors the true performance of my company in the past and present, and provide a basis for the future?”

He said assets are recorded, or recognized, when they are owned (including real estate and training programs that create skilled people and) or when there is a reasonable expectation of providing future benefits in amounts that exceed costs.

“If you have an investment on the books of $1 million, I would hope there's a reasonable expectation that you will be able to sell that inventory and receive an amount equal to or greater than $1 million,” he said.

Assets recorded

He said assets also are recorded when these future events are measurable:

  • Bad debts in excess of that which is reasonable and customary. “Some of you don't record an accrual for a bad-debt experience. It's OK if you don't. But you need to look at your accounts receivable.”

  • Bankruptcy filings by major trading partners. “It's significant whether that's a supplier or customer. Maybe it's a critical supplier. Maybe it's someone from whom you single source.”

He posed these critical asset questions and issues:

  • For assets that are difficult to value, what are the underlying assumptions that form the basis for valuation? Have the above changed in the past five years?

  • Have operating policies changed that would affect asset valuations or expected lives?

  • When assets are sold, what does the gain or loss recorded tell about the value estimations?

  • Are there assets that are sufficiently vague as to not be recorded on the balance sheet? Why? “Some intangibles offer value only in certain situations. They can only be there if there is some expectation that it's an asset.”

  • What is the market value of all securities held versus the acquisition cost?

  • If assets are revalued, what is the basis for doing so?

  • Is there a good track record for asset valuations?

  • What assets are off-balance sheet because resultant benefits don't necessarily accrue to the firm?

  • Is the conservatism principle applied to assets?

He said liabilities are recorded when an obligation has been incurred by the firm and that obligation can be quantified as to the amount and specified as to the time period.

The critical questions and issues:

  • Are there obligations not on the balance sheet? Why? Are they significant?

  • Is owner financing extensive, and if so, are imputed interest costs reasonable?

  • Is there a defined benefit or defined contribution plan? Is it funded adequately? Is there a current estimate of liability?

  • Has the market value of debt increased or decreased?

  • Is the change due to changes in interest rates or business conditions?

  • Are taxes payable adjusted based on changes in laws and regulations?

Are long- and short-term definitions clear and documented?

Harter said equity is an output of the income statement, and should generally not include items that did not flow through that statement. Conversely, all items recorded on the income statement should flow through to equity.

Critical questions and issues:

  • Is there consistency regarding what is or is not included in earnings?

  • Are debt and equity definitions clear?

  • Does the equity position reflect what the shareholders can recover if the firm is sold or liquidated?

  • From an outsider's perspective, are all decisions made by the board of directors recorded appropriately, meaning dividends declared and payable, stock ownership/transfers, and executive compensation?

Revenues recorded

He said revenues are recorded when goods and/or services have been provided and when there is a reasonable expectation that cash will be timely collected.

He said that if customers pay in advance, there are risks: Costs incurred to provide goods or services will be higher than those used in establishing sales prices; booking revenue over multiple periods, such as maintenance agreements or warranty programs, offers challenges to match revenue and expense; and costs for each period should be quantified and documented.

Critical questions and issues:

  • Are sales/lease agreements accounted for correctly?

  • Have receivables been sold to a factor or a bank?

  • Are reasonable estimates of collection in place and are bad debt allowances correctly accrued?

  • Are credit policies adhered to in adding customers?

  • Are customer default risks being monitored? What is the track record of the firm in managing this risk?

  • How are sales returns and refunds handled, and are there significant trends over time?

Expenses recognized

He said expenses are recognized when there is a cause-and-effect relationship with corresponding revenues and they are consumed nonetheless.

Critical questions and issues:

  • With respect to amortization of goodwill, have the assets become impaired? How are they quantified?

  • How much asset depreciation is done by judgments and how much is done by tables of values and schedules? Is the former consistent?

  • How certain is the timing and amount of costs to be incurred in the future?

  • What costing methods are used when reducing inventory in a period? How are absorption and timing handled?

Harter said cash flow statements present a picture of the sources and uses of funds in a given period, usually in concert with an income statement for the same period.

“They provide a contrast to the accruals,” he said, “and can be a source of misunderstanding during periods when significant amounts of cash are being collected, such as: In a period of expansion, cash is absorbed by purchases of inventory, advertising, and marketing; in a period of expansion, steady state, cash is generated by receivables collection.”

Harter said no two firms are alike when using an eye and an attitude.

“Financial analysis first requires generating consistent accounting statements that form the basis for reliance,” he said. “Accountants can become analysts; analysts cannot become accountants. You can turn an accountant into an analyst, but companies have a difficult time turning an analyst into an accountant. The people providing the numbers upon which you rely have to understand accounting.”

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