Common mistakes in reading financial statements – revealed!

I came across an interesting blog post by Jason Voss, CFA : The Top Five Accounting Mistakes Analysts Make

It’s actually several years old, and presumably written in the context of US GAAP rather than IFRS. Even so, I thought it was a very stimulating reference point, so here are the five mistakes, along with some brief commentary on each.

  1. Using Generalized Financial Statements

“If analysts take the time to actually read financial statements — and I think that few of them actually do — it is likely that they digest them through a third-party provider, such as Bloomberg, FactSet, S&P Capital IQ, Reuters, Yahoo! Finance, etc. The problem with this approach is that each of these services modifies each company’s unique financial statements to fit into a pre-created template. These services do this to ensure comparability across companies, industries, and nations.

However, I would argue that the generalization of these financial statements obscures as much as it reveals. An example is the compressing of one-time items into a single line item which hides the fact that some companies have many more one-time items each year than do other companies…

Additionally, the smearing of categories also hides the unique voice of the CFO, the auditor, and others within the organization who prepare financial statements. Knowing that some companies report a bland “net revenues” while others report “customer sales” tells you something about the culture of the organization. Taken individually, these differences seem inconsequential, but taken as a whole, the financial statements tell you a lot about the culture of a company you may invest in.

Ideally, the unmodified financial statements are examined, and the amounts reported in these statements are matched to the specific narrative of the business as revealed in the management’s discussion and analysis section. Are the two stories — the quantitative and the qualitative — consistent? They better be!”

  • (I think we’d all endorse the general point, that the financial statements (especially in conjunction with the MD&A) help convey a “feel” for the organization they depict, beyond just providing cold financial data. It’s rather unusual, and yet meaningful, to have this expressed on the level of such detail as the difference between “net revenues” and “customer sales.” In a way, it might be an analyst’s equivalent of how the eyes are said to be the window to the soul (except, of course, as in George W. Bush’s infamous early assessment of Putin, when they’re not).

2. Not Understanding the Reflexivity/Interactivity of the Three Major Financial Statements

“In my experience, few analysts take the time to trace a dollar of capital raised within a company (as shown on the balance sheet) through the income statement, to the bottom line, and then back to the balance sheet again. Nor do they relate changes in the balance sheet accounts to the cash-flow statement to identify huge inconsistencies in either amounts or categorizations. Instead, most analysts analyze the statements in isolation from one another.”

“…Yet, when you trace a unit of capital (rupees, yuan, yen, dollars, euros) through the financial statements, you once more get a sense of how straightforward and how consistent the financial reporting is at a business. This, in turn, is indicative of the character of the people that run the organization.”

  • (Another aspect of that would perhaps be the excessive focus on a few key performance measures. Of course it’s much harder to engage with financial statements as an integrated portrayal of a complex entity, rather than as (say) a collection of somewhat disconnected indicators, but the challenge is surely a necessary one to fully understand the entity’s capabilities. Most interesting again is how Voss presents this as a window on character.)
  1. Not Creating Apples-to-Apples Comparisons in Time

“This particular accounting secret is one that I have never discussed publicly. However, understanding this was one of the secrets to my success as a portfolio manager. Specifically, have you ever noticed that the temporal dimension for the income statement, balance sheet, and cash-flow statement are all different?

The income statement is reported quarterly for the first three quarters of the year and then annually, whereas the balance sheet is always reported as a quarterly snapshot — even when it is the fourth quarter. Last, the cash-flow statement is always shown as an amassing of cumulative cash for the year. Each of these is very different from one another, and they only align in the first quarter for any company.

In my experience, companies play games with these time dimension mismatches. Consequently, analysts must put all of the financial statements on the same temporal dimension… “

  • (To make just a single comment, companies can help at least a little with this by electively providing a statement of cash flows for the current interim period as well as cumulatively for the year to date, even though IAS 34 doesn’t require it.)
  1. Not Adjusting Statements for Distortions

“This is a classic problem in financial statement analysis. Despite this fact, most analysts do not modify financial statements to adjust for one-time items, including write-offs, sales of divisions, accounting revisions, and so forth. Exactly what to look for is outside the scope of this post, but most analysts simply do not take the time to do this…”

  • (I admit to being a bit puzzled by this item as it seems companies are all too happy to provide adjusted earnings measures that encourage readers to look away from such one-time items. But anyway…)
  1. Not Reading the Footnotes

“Last, despite all of the warnings to pay attention to the information contained in footnotes, most analysts do not read them…”

  • (Although he explains further, I doubt any reader of this blog will need any more convincing.)

There’s much more detail and colour in Voss’ full article than I’ve conveyed here, so it’s well worth going to the original. Just as with financial statements!

The opinions expressed are solely those of the author

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