Analyzing Financial Statements

1. Analyzing Financial Statements • Financial Information • Balance Sheet • Income Statement • Cash Flow Statement • Financial Ratios • Trends • Industry Norms • Industry/Competitive Analysis

2. Cooking the Books • Aggressive application of accounting rules • Estimates • Fraud

3. Overstating Revenues • Selling to Related Entities • The party must be an “arms length” • Stuffing the Channels • Excessive quantities to distributors/retailers • Extended credit terms • Installment sales at Low Interest Rates • Artificially low interest rate to calculated time-adjusted cash flows = higher recognized Revenues

4. Overstating Revenues • Using funds from Over-funded Reserves • Reserves obligation will fluctuate • Using over-funded Reserves can result in under-funding at later accounting periods. • Treat Nonrecurring Dispositions as Ordinary Income • “Below-the-line” gains are nonrecurring • Can over-state Income from normal business operations

5. Overstating Revenues • Record Income for Future Services • “Bundled price” includes deferred expenses • May underestimate value of future services to over-state current Revenues

6. Understating Expenses • Unrealistic Depreciation/Amortization • Allowable to use a different method for public financial reports from Tax (IRS) reporting • Capitalize Questionable Expenses • Capitalization or Expense? • Capitalization = deferred expenses • Match Expenses to Revenues

7. Understating Expenses • Ignore the cost of Stock Options • When exercised • Increases outstanding shares and affects EPS • Loss of value to company if strike price below market price • How to value? • Must have some value to have meaning to recipient • Valuation methods require making assumptions

8. Overstate Assets or Understate Liabilities • Delay Recognizing Declining Asset Value • Dressing up the Balance Sheet • Accounts Receivable and Allowance for Doubtful Accounts • Loans Receivable and Allowance for Bad Debt • Inventory and Allowance for Obsolete Inventory • Fixed Assets and writing off obsolete assets • Investments and unrealistic market valuation • Conservatism requires the Accountant to understate assets

9. Failure to Disclose Liabilities • Must disclose all liabilities • Pending lawsuits • Pension costs • Toxic cleanup • Deferred Executive compensation • Use Unconsolidated Debt • Offload debt from one affiliated to another • Dresses up Balance Sheet • Relationships must be reported in footnotes