Red Flags to Look for
in the Financial Statement
Financial Statements
There are two primary financial statements:
The balance sheet summarizes the value of all
assets, liabilities and net worth as of the end
of the current quarter or fiscal year.
The income statement lists all revenues, costs,
expenses and profit or loss for the past
quarter or year.
The balance sheet
The balance sheet reports balances of assets as of a fixed date, usually the
end of the current quarter or fiscal year:
- current assets
- long-term assets
- other assets
It also lists all liabilities as of the same date:
- current liabilities
long-term liabilities
The balance sheet concludes with reporting the value of shareholders’ equity:
- capital stock
-retained earnings
The balance sheet
This financial statement is also “balanced” because a
formula is applied to it:
Assets = Liabilities + Net Worth
This financial report is a summary of what the company
is worth net of its liabilities. However, it also may
contain inaccuracies.
The balance sheet
Some liabilities are not listed on the balance sheet, but
are shown only in footnotes:
- lease obligations
- contingent liabilities
Some assets may also be valued incorrectly:
- capital assets that have appreciated in value
The income statement
The second financial statement summarizes
transactions occurring during a specific period
of time (the past quarter or fiscal year).
The income statement concludes on the same
date that the balance sheet reports.
The income statement
The formula for the income statement is:
Revenues
- direct costs
= gross profit
- expenses
= net operating profit
+(-) non-operational income or expenses
= net pre-tax profit
- liability for federal taxes
= net after-tax profit
Footnotes to financial statements
The primary financial statements are
accompanied by a series of explanations,
found in the footnotes.
This is where disclosures are made about
accounting methods, valuation, excluded
liabilities, and dozens of other important
explanations.
Footnotes to financial statements
Footnotes often tell the real story. The financial
statements are only summaries of what the
company is required to report.
Beyond these requirements, many additional
and material points might be found.
The audited financial statement
Investors may believe that because a company’s
records and statements have been audited,
the financial statements are reliable.
This is not always so. The accounting rules give
companies considerable latitude in how to
report transactions, set up reserves, and set
the value of what gets reported.
Problems to look for
In evaluating financial statements and published
reports by companies, look for:
- volatility in year-to-year trends
- complex explanations of unusual items
- repetitive extraordinary items
- excessive restatements of previous years
- frequent changes in accounting methods
Volatility in year-to-year trends
Anyone thinking about in vesting in a company
wants to see consistent and logical trends:
- growing revenues
- steady earnings
- controlled cash flow trends
Volatility in year-to-year trends
For example, Wal-Mart reports revenue and
earnings in a very consistent manner:
Year
2012
2011
2010
2009
2008
(in $ millions) .
Revenue Earnings
$446,950 $15,766
421,849
15,355
408,214
14,414
405,607
13,254
378,799
12,884
Net Return
3.5%
3.6
3.5
3.3
3.4
Volatility in year-to-year trends
In comparison, J.C. Penney has reported declining
revenue and earnings over the same five years:
Year
2012
2011
2010
2009
2008
(in $ millions) .
Revenue Earnings
$17,260
$- 152
17,759
378
17,556
249
18,486
567
19,860
1,105
Net Return
-0.9%
2.1
1.4
3.1
5.6
Complex explanations of unusual items
Footnotes should be fairly easy to understand.
Even if complex financial concepts are
involved, the footnotes should explain clearly.
Some footnotes are not well explained. This
could be a danger signal.
Repetitive extraordinary items
An “extraordinary item” is a one-time, nonrecurring adjustment to reported profits.
By definition, these should not be repeated.
Another danger signal is the frequent
occurrence of extraordinary items. It could be
a sign of accounting manipulation.
Excessive restatements of previous years
Corporations occasionally have t restate a
previously published financial statement. This
may be due to discovered errors or audit
decisions; mergers; or changes in accounting
rules.
These restatements should not occur often. When
they do, it could be a signal that the reported
revenues, costs and expenses are being
manipulated.
Frequent changes in accounting methods
The “accounting method” refers to how companies
set up reserves, value inventory, and make other
decisions about reporting revenue, costs and
expenses.
Once set, accounting decisions like this should be
applied consistently.
If the company makes frequent accounting method
adjustments, it could signal manipulation.
Conclusion
Companies may interpret annual results with latitude under
the accounting rules.
Not all manipulation is illegal. The rules can be used to report
under different standards.
The goal of tracking annual trends is to determine whether
the company is reporting consistently and whether its
results are reliable.
This is the basis for choosing a company based on its
fundamentals – the balance sheet and income statement.