Preface to third edition
This third edition of Financial Statement Analysis, like its predecessors, seeks to equip its readers for practical challenges of contemporary business.
Once again, the intention is to acquaint readers who have already acquired basic accounting skills with the complications that arise in applying textbook-derived knowledge to the real world of extending credit and investing in securities. Just as a swiftly changing environment necessitated extensive revisions and additions in the second edition, new concerns and challenges for users of financial statements have accompanied the dawn of the twenty-first century.For one thing, corporations have shifted their executive compensation plans increasingly toward rewarding senior managers for “enhancing shareholder value.” This lofty-sounding concept has a dark side. Chief executive officers who are under growing pressure to boost their corporations’ share prices can no longer increase their bonuses by goosing reported earnings through financial reporting tricks that are transparent to the stock market. They must instead devise more insidious methods that gull investors into believing that the reported earnings gains are real. In response to this trend, we have expanded our survey of revenue recognition gimmicks designed to deceive the unwary.
Another innovation that demands increased vigilance by financial analysts is the conversion of stock market proceeds into revenues. In terms of accounting theory, this kind of transformation is the equivalent of alchemy. Companies generate revenue by selling goods or services, not by selling their own shares to the public.
During the Internet stock boom of the late 1990s, however, clever operators found a way around that constraint.
Companies took the money they raised in initial public offerings, bought advertising on one another’s websites, and recorded the shuttling of dollars as sales. Customers were superfluous to the revenue recognition process. In another variation on the theme, franchisers sold stock, lent the proceeds to franchisees, then immediately had the cash returned under the rubric of fees. By going out for a short stroll and coming back, the proceeds of a financing mutated into revenues.The artificial nature of these revenues becomes apparent when readers combine an understanding of accounting principles with a corporate finance perspective. We facilitate such integration of disciplines throughout Financial Statement Analysis, making excursions into economics and business management as well. In addition, we encourage analysts to consider the institutional context in which financial reporting occurs. Organizational pressures result in divergences from elegant theories, both in the conduct of financial statement analysis and in auditors’ interpretations of accounting principles. The issuers of financial statements also exert a strong influence over the creation of the financial principles, with powerful politicians sometimes carrying their water.
A final area in which the new edition offers a sharpened focus involves success stories in the critical examination of financial statements. Wherever we can find the necessary documentation, we show not only how a corporate debacle could have been foreseen through application of basis analytical techniques, but how practicing analysts actually did detect the problem before it became widely recognized. Readers will be encouraged by these examples, we hope, to undertake genuine, goal-oriented analysis, instead of simply going through the motions of calculating standard financial ratios. Moreover, the case studies should persuade them to stick to their guns when they spot trouble, despite management’s predictable litany.
(“Our financial statements are consistent with Generally Accepted Accounting Principles. They have been certified by one of the world’s premier auditing firms. We will not allow a band of greedy short-sellers to destroy the value created by our outstanding employees.”) Typically, as the vehemence of management’s protests increases, conditions deteriorate and accusations of aggressive accounting give way to revelations of fraudulent financial reporting.As for the plan of Financial Statement Analysis, readers should not feel compelled to tackle its chapters in the order we have assigned to them. To aid those who want to jump in somewhere in the middle of the book, the third edition provides increased cross-referencing and an expanded Glossary. Words that are defined in the Glossary are shown in bold faced type in the text. Although skipping around will be the most efficient approach for many analysts, a logical flow does underlie the sequencing of the material.
In Part I (“Reading between the Lines”), we show that financial statements do not simply represent unbiased portraits or corporations’ financial performance and explain why. The section explores the complex motivations of issuing firms and their managers. We also study the distortions produced by the organizational context in which the analyst operates.
Part II (“The Basic Financial Statements”) takes a hard look at the information disclosed in the balance sheet, income statement, and statement of cash flows. Under close scrutiny, terms such as value and income begin to look muddier than they appear when considered in the abstract. Even cash flow, a concept commonly thought to convey redemptive clarification, is vulnerable to stratagems designed to manipulate the perceptions of investors and creditors.
In Part III (“A Closer Look at Profits”), we zero in on the lifeblood of the capitalist system.
Our scrutiny of profits highlights the manifold ways in which earnings are exaggerated or even fabricated. By this point in the book, the reader should be amply imbued with the healthy skepticism necessary for a sound, structured approach to financial statement analysis.Application is the theme of Part IV (“Forecasts and Security Analysis”). For both credit and equity evaluation, forward-looking analysis is emphasized over seductive but ultimately unsatisfying retrospection. Tips for maximizing the accuracy of forecasts are included and real-life projections by professional securities analysts are dissected. We cast a critical eye on standard financial ratios and valuation models, however widely accepted they may be.
Financial markets continue to evolve, but certain phenomena appear again and again in new guises. In this vein, companies never lose their resourcefulness in finding new ways to skew perceptions of their performance. By studying their methods closely, analysts can potentially anticipate the variations on old themes that will materialize in years to come.
Martin Fridson Fernando Alvarez