Reading Between the Lines: What Financial Statements Really Mean
Tips on what financial statements do not tell you
Financial statements are like a selfie on Instagram. The financial statements can be carefully curated to show only the best parts of someone's life. Just as people are guilty of airbrushing their photos and leaving out the less desirable aspects, businesses can use accounting principles to make their financial statements look better than they are. So making pretty financial statements isn't necessarily nefarious- after all, no one wants to broadcast their flaws for the world to see. However, it's essential to be aware of the limitations of financial statements to get a more accurate picture of a company's health.
For example, financial statements don't always give us the whole story of a company's liabilities. Off-balance sheet liabilities, such as underfunded pension obligations and other post-retirement benefits, can significantly impact a company's bottom line. Similarly, the accounting method used can substantially impact earnings. The inventory method (LIFO vs. FIFO) is one example of how businesses can use creative accounting to improve their financial position.
Finally, financial statements also rely on estimates for specific values. This means that there is always some degree of uncertainty surrounding the numbers. While this isn't necessarily a bad thing, it's essential to keep in mind. But, also, what is important is that financial statements hold hidden assets and liabilities.
A little understanding of accounting analysis helps
A company’s strength cannot be measured by its financial statements alone. A little understanding by you of accounting and financial statement analysis helps to put the financial statements in perspective.
The bottom line is that you should rely on more than just financial statements when reviewing the numbers to determine the company's story. I'm trying to give you a starting point in this effort.
Did you know that financial statements must have predictive value?
Although financial statements report historical events, the financial reports, taken as a whole, are supposed to generate forward-looking attributes for the benefit of users. One of the quality characteristics of financial statements is that the report must contain predictive value to make the report relevant. The financials must have predictive value to make informed decisions. So, the user should the information and make necessary adjustments to get a clear picture of the business's story.
The Importance of the Financial Statements' Footnotes
In addition to the income statement, balance sheet, cash flow statement, and shareholders' equity statement, the footnotes to the financial statements are also critically important. Unfortunately, the financial footnotes are often overlooked and minimized as to their importance.
The notes to the financial statements give more in-depth information about items on the financial statements. The notes explain complex transactions, resources and liabilities, significant estimates used in preparing the financial statements, and other disclosures. And with the auditor's opinion, the financial footnotes include critical schedules and explanations of financial statement line items.
Specifically for public companies, the management's discussion and analysis (MD&A) is vital. The MD&A is a report by management that accompanies the company's financial statements. The MD&A should discuss the company's overall financial condition, results of operations, liquidity, and other matters. It is often called the "management commentary."
Making a "Pig Look Pretty"
I have mentioned to some of my past students, "As a CPA, I can make a pig look pretty!" Unfortunately, it is up to the users to ferret out the truth, the real story of the business. If you’re relying solely on financial statements to make decisions about a company, you could be missing out on important information. It’s always best to get a complete picture of a company before making any decisions.
When making decisions about a company, it’s critical to remember that financial statements don’t tell the whole story. Many factors can affect the numbers reported on the financial statements, and it’s essential to understand all of them before making any decisions. Know that financial shenanigans exist.
The following provides some vital areas that require your review:
The assets section
Understated and overstated assets
When reviewing financial statements, it’s essential to keep in mind that they don’t tell the whole story. Several items are not accounted for, which can impact your decision-making. It’s always best to get a complete picture of a company before making any decision. Understand that assets can be understated or overstated.
Understated assets happen because:
Conversely, overstated assets happen due to the:
The inventory method used impacts earnings
Let's start with short-term assets. Companies can choose from different accounting methods for inventory , with the two primary ways being last-in, first-out (LIFO), and first-in, first-out (FIFO). LIFO results in lower reported income in periods of inflation because the latest, most expensive items are expensed first. The flip side is that in periods of deflation, LIFO results in higher reported income because the earliest, least costly items are expensed first.
Obsolete inventory not written down or off
he second point is that companies often have obsolete inventory on their books that is not written down or off. This means that the company is continuing to carry the asset on its balance sheet at an inflated value, making the company look healthier than it really is.
Quality of accounts receivables
Accounts receivables are often overstated. Companies frequently grant credit to customers with higher credit risk to pump up sales. And with higher days receivables outstanding, the company does not aggressively attempt to collect the outstanding receivables. Additionally, the company may fail to write off bad receivables as a loss. This can make the company look more efficient at collecting its receivables than it is.
领英推荐
Insufficient accounts receivable allowance for doubtful reserve
Companies often don't have a sufficient accounts receivable allowance for doubtful receivables. This means that the company is carrying an asset on its balance sheet at an inflated value, making the company look healthier than it is.
Underreported intangible assets
Another issue has to do with underreported intangible assets . These assets don’t have a physical presence, such as patents, copyrights, and goodwill. Understating intangible assets is a result of expensing rather than capitalizing the asset value. This results in a lower reported profit in the year the costs are incurred but a higher reported profit in future years as the benefits of the research and development are realized. Thus, the total cost of the asset is not reflected on the balance sheet.
Intermingling personal assets with business assets
Intermingling personal assets with the business is particularly relevant for small, entrepreneurial-owned businesses. The owners of these businesses often intermingle personal assets with business assets. This can make it difficult to picture the business’s actual financial condition accurately. For example, the owner may have purchased a vehicle for personal use but had the company pay for it or may have used company funds to pay personal expenses. This can create red flags that may cause potential investors to be wary of the business.
Lack of market value of long-term assets
Under the generally accepted accounting principles (GAAP) of the United States, the value reported for long-term assets does not provide a proper valuation. Fixed assets such as property, plant, and equipment do not carry the assets at market value on the balance sheet but rather at historical cost less accumulated depreciation. For example, a company would still maintain a building purchased for $1 million 20 years ago with no major renovations since on the balance sheet at $1 million. However, today's market value (mark-to-market) of that same building might be $2 million or more. Thus, long-term assets may hold hidden value for a prospective buyer.
Use of accounting estimates to determine assets' useful life.
The estimates used to determine an asset's useful life are essential. The assumptions made about an asset's expected lifetime can significantly impact the reported value of the assets and, as a result, a company's financial position and reported earnings. For example, if a company assumes that a piece of equipment will last for ten years, it will depreciate its cost. However, if the equipment lasts for 20 years, the company will be understating its profits in the early years and overstating profits in the later years.
These are just a few examples of what financial statements don’t tell you. As you can see, there is a lot of room for error and interpretation regarding financial statements.
Large customer concentrations
Large customer concentrations can also be a sign of financial trouble. The financial statement does not report large contract concentrations. If a company gets the majority of its revenue from just a few customers, it is at risk if those customers were to cancel their contracts or reduce their business with the company. This could have a devastating effect on the company’s bottom line.
The liabilities section
Overestimated liabilities
On the other side of the balance sheet, financial statements do not tell the true financial position and often underestimate their liabilities. For example, underfunded pension plans and other post-retirement benefits can create significant liability for a company that is not reflected on the balance sheet. In addition, Environmental Protection Agency (EPA) fines and other litigation costs can also create significant liabilities that may not be reflected on the balance sheet.
Underfunded Pension Plans
One example of an off-balance sheet liability is an underfunded pension plan . If a company has a defined benefit pension plan, it is required to report the funded status of the plan on its balance sheet. However, pension plan underfunding does not report as a shortfall on its balance sheet. This can create significant liability not reflected in its financial statements. We report underfunded pension liabilities as a footnote of the financial statements.
Post-retirement benefits
Another example of an off-balance sheet liability is post-retirement benefits (OPEBs) other than pensions. These can include health care, and life insurance benefits that the company does not fully fund. As with pension plans, underfunded benefits create an off-balance liability for the company.
Reported Performance Manipulation
Revenue recognition
Revenue recognition is where companies can manipulate their financial statements to show higher revenues and profits. For example, a company might recognize revenue upon the production of a produced but, not yet shipped. This can create the appearance of higher sales and profits than exist.
In addition, companies often use estimates that inflate or deflate reported performance.
Overhead Cost Allocation
Another area where companies can manipulate their financial statements is in the allocation of overhead costs . Overhead costs include rent, utilities, office supplies, and other indirect business costs. Many factors impact the overhead allocation. Individual departments or products allocate costs based on several factors, such as square footage, the number of employees, or activities. The allocation of overhead costs can significantly impact the profitability of a company’s products or departments.
To maintain a company's gross profit margin, some companies do not allocate sufficient costs to the cost of goods sold and as a result, overstate their gross profit. Without proper cost allocation, it is challenging to determine departmental inefficiencies.
For example, a company might allocate a higher percentage of its research and development costs than they exist. This can make it appear that the company is more efficient than it is.
In summary
It is essential to know what financial statements don't tell you. Financial statements do not tell the whole picture of a company’s financial health. Several things can be misleading or outright false. Companies can use accounting tricks to manipulate their reported performance. This can make it difficult. Investors and other stakeholders get an accurate picture of the company’s true financial condition. And both hidden assets and liabilities do not show on the financial statements. And it is almost impossible to assess. A company's risk profile without performing an accounting and financial analysis makes it difficult.