Financial Statement Analysis

A Practitioner's Guide

Martin S. Fridson, Fernando Alvarez

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118064207
• Edition: 4
• Topic: Business
• Subtopic: Finanza
• Index: Business

The updated, real-world guide to interpreting and unpacking GAAP and non-GAAP financial statements

In Financial Statement Analysis, 5th Edition, leading investment authority Martin Fridson returns with Fernando Alvarez to provide the analytical framework you need to scrutinize financial statements, whether you're evaluating a company's stock price or determining valuations for a merger or acquisition.Rather than taking financial statements at face value, you'lllearn practical and straightforwardanalyticaltechniquesfor uncovering the reality behind the numbers.This fully revised and up-to-date 5th Edition offers fresh information that will help you to evaluate financial statements in today's volatile markets and uncertain economy. The declining connection between GAAP earnings and stock priceshasintroduced a needto discriminate between instructive and misleading non-GAAP alternatives.This book integrates the alternatives and provides guidance on understanding the extent to which non-GAAP reports, particularly from US companies, may be biased.

Understanding financial statements is an essential skill for businessprofessionalsand investors. Most books on the subject proceed from the questionable premise that companies' objective is to present a true picture of their financial condition. A safer assumption is that they seek to minimize the cost of raising capital by portraying themselves in the most favorable light possible.Financial Statement Analysisteachesreaders the tricks that companies use to mislead, so readers can more clearly interpret statements.

• Learn how to read and understand financial statements prepared according to GAAP and non-GAAP standards
• Compare CFROI, EVA, Valens, and other non-GAAP methodologies to determine how accurate companies' reports are
• Improve your business decision making, stock valuations, or merger and acquisition strategy
• Develop the essential skill of quickly and accurately gathering and assessing information from financial statements of all types

Professional analysts, investors, and students willgain valuable knowledge from this updated edition of the popular guide.Filled with real-life examples and expert advice, Financial Statement Analysis, 5th Edition, will help you interpret and unpack financial statements.

Part One

Reading between the Lines

Chapter 1

The Adversarial Nature of Financial Reporting

Financial statement analysis is an essential skill in a variety of occupations, including investment management, corporate finance, commercial lending, and the extension of credit. For individuals engaged in such activities, or who analyze financial data in connection with their personal investment decisions, there are two distinct approaches to the task.

The first is to follow a prescribed routine, filling in boxes with standard financial ratios, calculated according to precise and inflexible definitions. It may take little more effort or mental exertion than this to satisfy the formal requirements of many positions in the field of financial analysis. Operating in a purely mechanical manner, though, will not provide much of a professional challenge. Neither will a rote completion of all of the proper standard analytical steps ensure a useful, or even a nonharmful, result. Some individuals, however, will view such problems as only minor drawbacks.

This book is aimed at the analyst who will adopt the second and more rewarding alternative, the relentless pursuit of accurate financial profiles of the entities being analyzed. Tenacity is essential because financial statements often conceal more than they reveal. To the analyst who embraces this proactive approach, producing a standard spreadsheet on a company is a means rather than an end. Investors derive but little satisfaction from the knowledge that an untimely stock purchase recommendation was supported by the longest row of figures available in the software package. Genuinely valuable analysis begins after all the usual questions have been answered. Indeed, a superior analyst adds value by raising questions that are not even on the checklist.

Some readers may not immediately concede the necessity of going beyond an analytical structure that puts all companies on a uniform, objective scale. They may recoil at the notion of discarding the structure altogether when a sound assessment depends on factors other than comparisons of standard financial ratios. Comparability, after all, is a cornerstone of generally accepted accounting principles (GAAP). It might therefore seem to follow that financial statements prepared in accordance with GAAP necessarily produce fair and useful indications of relative value.

The corporations that issue financial statements, moreover, would appear to have a natural interest in facilitating convenient, cookie-cutter analysis. These companies spend heavily to disseminate information about their financial performance. They employ investor-relations managers, they communicate with existing and potential shareholders via interim financial reports and press releases, and they dispatch senior management to periodic meetings with securities analysts. Given that companies are so eager to make their financial results known to investors, they should also want it to be easy for analysts to monitor their progress. It follows that they can be expected to report their results in a transparent and straightforward fashion … or so it would seem.

THE PURPOSE OF FINANCIAL REPORTING

Analysts who believe in the inherent reliability of GAAP numbers and the good faith of corporate managers misunderstand the essential nature of financial reporting. Their conceptual error connotes no lack of intelligence, however. Rather, it mirrors the standard accounting textbook's idealistic but irrelevant notion of the purpose of financial reporting. Even Howard Schilit (see the MicroStrategy discussion, later in this chapter), an acerbic critic of financial reporting as it is actually practiced, presents a high-minded view of the matter:

The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company.1

Missing from this formulation is an indication of whose primary goal is accurate measurement. Schilit's words are music to the ears of the financial statements users listed in this chapter's first paragraph, but they are not the ones doing the financial reporting. Rather, the issuers are for-profit companies, generally organized as corporations.2

A corporation exists for the benefit of its shareholders. Its objective is not to educate the public about its financial condition, but to maximize its shareholders’ wealth. If it so happens that management can advance that objective through “dissemination of financial statements that accurately measure the profitability and financial condition of the company,” then in principle, management should do so. At most, however, reporting financial results in a transparent and straightforward fashion is a means unto an end.

Management may determine that a more direct method of maximizing shareholder wealth is to reduce the corporation's cost of capital. Simply stated, the lower the interest rate at which a corporation can borrow or the higher the price at which it can sell stock to new investors, the greater the wealth of its shareholders. From this standpoint, the best kind of financial statement is not one that represents the corporation's condition most fully and most fairly, but rather one that produces the highest possible credit rating (see Chapter 13) and price-earnings multiple (see Chapter 14). If the highest ratings and multiples result from statements that measure profitability and financial condition inaccurately, the logic of fiduciary duty to shareholders obliges management to publish that sort, rather than the type held up as a model in accounting textbooks. The best possible outcome is a cost of capital lower than the corporation deserves on its merits. This admittedly perverse argument can be summarized in the following maxim, presented from the perspective of issuers of financial statements:

The purpose of financial reporting is to obtain cheap capital.

Attentive readers will raise two immediate objections. First, they will say, it is fraudulent to obtain capital at less than a fair rate by presenting an unrealistically bright financial picture. Second, some readers will argue that misleading the users of financial statements is not a sustainable strategy over the long run. Stock market investors who rely on overstated historical profits to project a corporation's future earnings will find that results fail to meet their expectations. Thereafter, they will adjust for the upward bias in the financial statements by projecting lower earnings than the historical results would otherwise justify. The outcome will be a stock valuation no higher than accurate reporting would have produced. Recognizing that the practice would be self-defeating, corporations will logically refrain from overstating their financial performance. By this reasoning, the users of financial statements can take the numbers at face value, because corporations that act in their self-interest will report their results honestly.

The inconvenient fact that confounds these arguments is that financial statements do not invariably reflect their issuers’ performance faithfully. In lieu of easily understandable and accurate data, users of financial statements often find numbers that conform to GAAP yet convey a misleading impression of profits. Worse yet, outright violations of the accounting rules come to light with distressing frequency. Not even the analyst's second line of defense, an affirmation by independent auditors that the statements have been prepared in accordance with GAAP, assures that the numbers are reliable. A few examples from recent years indicate how severely an overly trusting user of financial statements can be misled.

Interpublic Tries Again… and Again

Interpublic Group of Companies announced on August 13, 2002, that it had improperly accounted for $68.5 million of expenses and would restate its financial results all the way back to 1997. The operator of advertising agencies said the restatement was related to transactions between European offices of the McCann-Erickson Worldwide Advertising unit. Sources indicated that when different offices collaborated on international projects, they effectively booked the same revenue more than once. In the week before the restatement announcement, when the company delayed the filing of its quarterly results to give its audit committee time to review the accounting, its stock sank by nearly 25 percent.

Perhaps not coincidentally, Interpublic's massive revision coincided with the effective date of new Securities and Exchange Commission (SEC) certification requirements. Under the new rules, a company's chief executive officer and chief financial officer could be subject to fines or prison sentences if they certified false financial statements. It was an opportune time for any company that had been playing games with its financial reporting to get straight.

The August 2002 restatement did not clear things up once and for all at Interpublic. In October, the company nearly doubled the amount of the planned restatement to $120 million, and in November, it emerged that the number might go even higher. By that time, Interpublic's stock was down 55 percent from the start of the year, Standard & Poor's had downgraded its credit rating from BBB+ to BBB, and several top executives had been dismissed.

Like many other companies that have issued financial statements that subsequently needed revision, Interpublic was under earnings pressure. Advertising spending had fallen drastically, producing the worst industry results in decades. Additionally, the company was having difficulty assimilating a huge number of acquisitions. Chairman John J. Dooner was understandably eager to shift the focus from all that. “The finger-pointing is about the past,” he said. “I'm focusing on the present and future.”3

Unfortunately, the future brought more accounting problems. A few days after Dooner's statement, the company upped its estimated restatement to $181.3 million, nearly triple the original figure. Another blow arrived a week later as the SEC requested information related to the errors that gave rise to the restatement. It also turned out that the misreporting was not limited to double-counting of revenue by McCann-Erickson's European offices. Other items included an estimate of not-yet-realized insurance proceeds, write-offs of accounts receivable and work in progress, and understated liabilities at other Interpublic subsidiaries dating back as far as 1996. Dooner commented, “The restatement that we have been living through is finally filed.”4 He also stated that he was resolved that the turmoil created by the accounting problems would never happen again.

Fast-forward to September 2005. Dooner's successor and the third CEO since the accounting problems first surfaced, Michael I. Roth, declared that his top priority was to put Interpublic's financial reporting problems behind it. For the first time, the company acknowledged that honest mistakes might not have accounted for all of the erroneous accounting. Furthermore, said Interpublic, investors should not rely on previous estimates of the restatements, which also involved procedures for tracking the company's hundreds of agency acquisitions. That proved to be something of an understatement. Interpublic ultimately announced a restatement of $550 million, three times the previous estimate, for the period 2000 through September 30, 2004. In May 2008, the company paid $12 million to settle the SEC's accusation that it fraudulently misstated its results by booking intercompany charges as receivables instead of expenses.

MicroStrategy Changes Its Mind

On March 20, 2000, MicroStrategy announced that it would restate its 1999 revenue, originally reported as $205.3 million, to around $150 million. The company's shares promptly plummeted by $140 to $86.75 a share, slashing Chief Executive Officer Michael Saylor's paper wealth by over $6 billion. The company explained that the revision had to do with recognizing revenue on the software company's large, complex projects.5 MicroStrategy and its auditors initially suggested that the company had been obliged to restate its results in response to a recent (December 1999) SEC advisory on rules for booking software revenues. After the SEC objected to that explanation, the company conceded that its original accounting was inconsistent with accounting principles published way back in 1997 by the American Institute of Certified Public Accountants.

Until MicroStrategy dropped its bombshell, the company's auditors had put their seal of approval on the company's revenue recognition policies. That was despite questions raised about MicroStrategy's financials by accounting expert Howard Schilit six months earlier and by reporter David Raymond in an issue of Forbes ASAP distributed on February 21.6 It was reportedly only after reading Raymond's article that an accountant in the auditor's national office contacted the local office that had handled the audit, ultimately causing the firm to retract its previous certification of the 1998 and 1999 financials.7

No Straight Talk from Lernout & Hauspie

On November 16, 2000, the auditor for Lernout & Hauspie Speech Products (L&H) withdrew its clean opinion of the company's 1998 and 1999 financials. The action followed a November 9 announcement by the Belgian producer of speech-recognition and translation software that an internal investigation had uncovered accounting errors and irregularities that would require restatement of results for those two years and the first half of 2000. Two weeks later, the company filed for bankruptcy.

Prior to November 16, 2000, while investors were relying on the auditor's opinion that Lernout & Hauspie's financial statements were consistent with generally accepted accounting principles, several events cast doubt on that opinion. In July 1999, short seller David Rocker criticized transactions such as L&H's arrangement with Brussels Translation Group (BTG). Over a two-year period, BTG paid L&H $35 million to develop translation software. Then L&H bought BTG and the translation product along with it. The net effect was that instead of booking a $35 million research and development expense, L&H recognized $35 million of revenue.8 In August 2000, certain Korean companies that L&H claimed as customers said that they in fact did no business with the corporation. In September, the Securities and Exchange Commission and Europe's EASDAQ stock market began to investigate L&H's accounting practices.9 Along the way, Lernout & Hauspie's stock fell from a high of $72.50 in March 2000 to $7 before being suspended from trading in November. In retrospect, uncritical reliance on the company's financials, based on the auditor's opinion and a presumption that management wanted to help analysts get the true picture, was a bad policy.

THE FLAWS IN THE REASONING

As the preceding deviations from GAAP demonstrate, neither fear of antifraud statutes nor enlightened self-interest invariably deters corporations from cooking the books. The reasoning by which these two forces ensure honest accounting rests on hidden assumptions. None of the assumptions can stand up to an examination of the organizational context in which financial reporting occurs.

To begin with, corporations can push the numbers fairly far out of joint before they run afoul of GAAP, much less open themselves to prosecution for fraud. When major financial reporting violations come to light, as in most other kinds of white-collar crime, the real scandal involves what is not forbidden. In practice, generally accepted accounting principles countenance a lot of measurement that is decidedly inaccurate, at least over the short run.

For example, corporations routinely and unabashedly smooth their earnings. That is, they create the illusion that their profits rise at a consistent rate from year to year. Corporations engage in this behavior, with the blessing of their auditors, because the appearance of smooth growth receives a higher price-earnings multiple from stock market investors than the jagged reality underlying the numbers.

Suppose that, in the last few weeks of a quarter, earnings threaten to fall short of the programmed year-over-year increase. The corporation simply borrows sales (and associated profits) from the next quarter by offering customers special discounts to place orders earlier than they had planned. Higher-than-trendline growth, too, is a problem for the earnings-smoother. A sudden jump in profits, followed by a return to a more ordinary ra...