3.4 Financial Statements: Interpretation
Financial Statements are fraught with interpretive problems, due to accrual accounting methods, emanating from historical bias, arbitrary choice of one or another cost method, and the use of estimates and reserves, all of which are legitimate applications of “generally accepted accounting principles.” The larger the corporation, the more susceptible its financial statements are to misleading data for the financial analyst to decipher and comprehend.
Accounting presentations complicate analysis, and in particular make difficult the use of analytic financial ratios, which are compiled from the accounting data. Hence, financial analysis is not straightforward, as it would otherwise be if the numerical bases of the accounting data were themselves not subject to variation over time and from firm to firm, and thus to – interpretation!
Historical bias – In most, but not all cases, asset cost is recorded by the accountant based on invoiced, historical values.Such costs are determined at a point in time and are not adjusted upward later for changing, and possibly increasing, market values. (These assets may then be depreciated, adding still further to the difficulty in interpretation.)
For example, in the case of long-term assets, a building may be built (or purchased) at a (historical) cost of $1 million dollars. Another, virtually identical building, which may be built (or purchased) by the same company some years later could have a cost of $2 million; the newer building costs more due to inflation and/or market conditions. The accountant will not necessarily show the details of the original costs of each property and the respective depreciation schedules for each property separately. The accountant will carry the building’s value at its original cost, and at a combined sum, in this case of $3 million, leaving the reader of the data with a kind of mixed bag of information. Secondly, the depreciation expense will be based on this original value.
Market values of buildings often, in fact, exceed the recorded, “book” carrying values, i.e., historical cost minus accumulated depreciation. The accountant will not adjust the carrying value of such an asset upward, thereby making it difficult to know the asset’s, and therefore the company’s, true worth.
This is not an issue where current assets are concerned. It certainly does not apply to cash or accounts receivable; these values do not change. (Under certain narrowly defined circumstances, cash equivalents, a.k.a., “marketable securities” values may be adjusted.) Inventory is generally not marked down in value and never marked up, under accounting rules.
Estimates – This too will be illustrated (below) with the use of the (same) example of long-term asset accounting. We will examine both the asset’s “salvage value” and the asset’s estimated “life,” both of which are estimated. This leaves ample room for “judgment” and, hence, earnings manipulation. Other examples may also pertain.
Reserves – For example, management has some leeway in setting up loss accounts or “reserves,” e.g., for “uncollectible accounts receivable,” better known as “allowance for doubtful accounts.” We will not demonstrate this phenomenon; suffice it to say that this is a notable problem where accounting “manipulation” is concerned. While reserves have been listed here as a category by itself, the reader may also think of it as an example of an estimate.
Arbitrary use of cost or other methods – The accountant (together with company management) has alternatives regarding the manner in which s/he may choose to “cost” certain items. This will be illustrated (below) with respect to inventory (a “current asset”) and long-term asset accounting, including plant and equipment. You must recall that “property,” i.e., land cannot be depreciated.
An external financial analyst must dig below the surface in order to understand the accountant’s summary of the corporation’s ledgers. He must also have a deep understanding of the nature of the industry in which the corporation operates. A good place to start is by reading the accountant’s footnotes and thoroughly understanding the firm’s GAAP reporting policies. “GAAP” refers to “generally accepted accounting principles,” which are the rules to which accountants must adhere.