Red Flags to Look for in the Financial Statement

Financial Statements

There are two primary financial statements:

The balance sheet summarizes the value of all assets, liabilities and net worth as of the end of the current quarter or fiscal year.

The income statement lists all revenues, costs, expenses and profit or loss for the past quarter or year.

The balance sheetThe balance sheet reports balances of assets as of a fixed date, usually the

end of the current quarter or fiscal year:- current assets- long-term assets- other assets

It also lists all liabilities as of the same date:- current liabilitieslong-term liabilities

The balance sheet concludes with reporting the value of shareholders’ equity:- capital stock-retained earnings

The balance sheet

This financial statement is also “balanced” because a formula is applied to it:

Assets = Liabilities + Net Worth

This financial report is a summary of what the company is worth net of its liabilities. However, it also may contain inaccuracies.

The balance sheet

Some liabilities are not listed on the balance sheet, but are shown only in footnotes:

- lease obligations- contingent liabilities

Some assets may also be valued incorrectly:

- capital assets that have appreciated in value

The income statement

The second financial statement summarizes transactions occurring during a specific period of time (the past quarter or fiscal year).

The income statement concludes on the same date that the balance sheet reports.

The income statementThe formula for the income statement is:

Revenues - direct costs = gross profit - expenses = net operating profit +(-) non-operational income or expenses = net pre-tax profit - liability for federal taxes = net after-tax profit

Footnotes to financial statements

The primary financial statements are accompanied by a series of explanations, found in the footnotes.

This is where disclosures are made about accounting methods, valuation, excluded liabilities, and dozens of other important explanations.

Footnotes to financial statements

Footnotes often tell the real story. The financial statements are only summaries of what the company is required to report.

Beyond these requirements, many additional and material points might be found.

The audited financial statement

Investors may believe that because a company’s records and statements have been audited, the financial statements are reliable.

This is not always so. The accounting rules give companies considerable latitude in how to report transactions, set up reserves, and set the value of what gets reported.

Problems to look for

In evaluating financial statements and published reports by companies, look for:

- volatility in year-to-year trends- complex explanations of unusual items- repetitive extraordinary items- excessive restatements of previous years- frequent changes in accounting methods

Volatility in year-to-year trends

Anyone thinking about in vesting in a company wants to see consistent and logical trends:

- growing revenues- steady earnings- controlled cash flow trends

Volatility in year-to-year trends

For example, Wal-Mart reports revenue and earnings in a very consistent manner:

(in $ millions) . Year Revenue Earnings Net Return2012 $446,950 $15,766 3.5%2011 421,849 15,355 3.62010 408,214 14,414 3.5 2009 405,607 13,254 3.3 2008 378,799 12,884 3.4

Volatility in year-to-year trends

In comparison, J.C. Penney has reported declining revenue and earnings over the same five years:

(in $ millions) . Year Revenue Earnings Net Return2012 $17,260 $- 152 -0.9%2011 17,759 378 2.12010 17,556 249 1.4 2009 18,486 567 3.1 2008 19,860 1,105 5.6

Complex explanations of unusual items

Footnotes should be fairly easy to understand. Even if complex financial concepts are involved, the footnotes should explain clearly.

Some footnotes are not well explained. This could be a danger signal.

Repetitive extraordinary items

An “extraordinary item” is a one-time, non-recurring adjustment to reported profits.

By definition, these should not be repeated.

Another danger signal is the frequent occurrence of extraordinary items. It could be a sign of accounting manipulation.

Excessive restatements of previous years

Corporations occasionally have t restate a previously published financial statement. This may be due to discovered errors or audit decisions; mergers; or changes in accounting rules.

These restatements should not occur often. When they do, it could be a signal that the reported revenues, costs and expenses are being manipulated.

Frequent changes in accounting methods

The “accounting method” refers to how companies set up reserves, value inventory, and make other decisions about reporting revenue, costs and expenses.

Once set, accounting decisions like this should be applied consistently.

If the company makes frequent accounting method adjustments, it could signal manipulation.

ConclusionCompanies may interpret annual results with latitude under

the accounting rules.

Not all manipulation is illegal. The rules can be used to report under different standards.

The goal of tracking annual trends is to determine whether the company is reporting consistently and whether its results are reliable.

This is the basis for choosing a company based on its fundamentals – the balance sheet and income statement.