Accounting For Dummies, 4th edition
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340 Part V: The Part of Tens
Look for Signs of Financial Distress
A business can build up a good sales volume and have very good profit margins, but if the company can’t pay its bills on time, its profit opportunities could go down the drain. Solvency refers to the prospects of a business being able to meet its debt and other liability payment obligations on time. Solvency analysis asks whether a business will be able to pay its liabilities, looking for signs of financial distress that could cause serious disruptions in the business’s profit-making operations. Even if a business has a couple billion bucks in the bank, you should ask: How does its solvency look?
Frankly, detailed solvency analysis of a business is best left to the pros. The credit industry has become very sophisticated in analyzing solvency. For example, bankruptcy prediction models have been developed that have proven useful. I don’t think the average financial report reader should spend the time to calculate solvency ratios. For one thing, many businesses massage their accounting numbers to make their liquidity and solvency appear to be better than they are at the balance sheet date.
Although many accountants and investment analysts would view my advice here as heresy, I suggest that you just take a quick glance at the company’s balance sheet. How do its total liabilities stack up against its cash, current assets, and total assets? Obviously, total liabilities should not be more than total assets. Duh! And obviously, if a company’s cash balance is close to zero, things are bad. Beyond these basic rules, things are a lot more complex. Many businesses carry a debt load you wouldn’t believe, and some get into trouble even though they have hefty cash balances.
The continued solvency of a business depends mainly on the ability of its managers to convince creditors to continue extending credit to the business and renewing its loans. The credibility of management is the main factor, not ratios. Creditors understand that a business can get into a temporary bind and fall behind on paying its liabilities. As a general rule, creditors are slow to pull the plug on a business. Shutting off new credit may be the worst thing lenders and other creditors could do. Doing so may put the business in a tailspin, and its creditors may end up collecting very little. Usually, it’s not in their interest to force a business into bankruptcy — doing so is a last resort.
Recognize the Risks of Restatement
and Fraud
In 2007, the CEO of one of the Big Four global CPA firms testified before a blue-ribbon federal government panel on the state of auditing and financial reporting. He said that one out of every ten financial reports issued by public
Chapter 17: Ten Tips for Reading a Financial Report 341
companies is revised and restated at a later time. If that’s true, there’s a 10 percent chance that the financial statements you’re reading are not entirely correct and could be seriously misleading. An earlier study of financial restatements arrived at a much lower estimate. You’d think that the incidence of companies having to redo their financial reports would be extremely rare, but you see financial restatements with alarming regularity.
When a business restates its original financial report and issues a new version, it does not make restitution for any losses that investors suffered by relying on the originally reported financial statements. In fact, few companies even say they’re sorry when they put out revised financial statements. Generally, the language explaining financial restatements is legalistic and exculpatory. “We didn’t do anything wrong” seems to be the underlying theme. This attitude is hard to swallow.
All too often the reason for the restatement is that someone later discovered that the original financial statements were based on fraudulent accounting. As I explain in Chapter 15, CPAs don’t have a very good track record for discovering financial reporting fraud. What it comes down to is this: Investors take the risk that the information in financial statements they use in making decisions is subject to revision at a later time. I suppose you could go to the trouble of searching for a business that has never had to restate its financial statements, but there’s always a first time, of course.
Remember the Limits
of Financial Reports
There’s a lot more to investing than reading financial reports. Financial reports are an important source of information, but investors also should stay informed about general economic trends and developments, political events, business takeovers, executive changes, technological changes, and much more. Undoubtedly, the information demands required for investing have helped fuel the enormous popularity of mutual funds; investors offload the need to keep informed to the investment managers of the mutual fund. Many advertisements of financial institutions stress this point — that you have better things to do with your time.
When you read financial statements, keep in mind that these accounting reports are somewhat tentative and conditional. Accountants make many estimates and predictions in recording sales revenue and income, and expenses and losses. Some soft numbers are mixed in with hard numbers in financial statements. In short, financial statements are iffy to some extent. There’s no getting around this limitation of accounting.
342 Part V: The Part of Tens
Having said that, let me emphasize that financial reports serve an indispensable function in any developed economy. We really couldn’t get along without financial reports, despite their limits and problems. People wouldn’t know which way to turn in a financial information vacuum. Even though the financial air is polluted, we need the oxygen of financial reports to breathe.
Appendix
Glossary: Slashing Through the
Accounting Jargon Jungle
ABC: The acronym for activity-based costing, which is a cost allocation scheme that allocates the cost of support functions in an organization
(such as maintenance) based on the units of activity of the support function that are used by other departments and processes in the business.
accounting: The methods and procedures for identifying, analyzing, recording, accumulating, and storing information and data about the activities of an entity that have financial results, and preparing summary reports of these activities internally for managers and externally for those entitled to receive financial reports about the entity. A business’s managers, investors, and lenders depend on accounting reports called financial statements to make informed decisions. Accounting also encompasses preparing tax returns that must be filed with government tax authorities by the entity, and facilitating day-to-day operating functions.
accounting equation: Assets = Liabilities + Owners’ Equity. This equation expresses the fundamental duality, or two-sided nature, of accounting and is useful for explaining double-entry accounting, which uses debits and credits for recording transactions. It summarizes the balance or equality of an entity’s assets and the sources of its assets, which fall into two categories: liabilities and owners’ equity.
accounting fraud (also called cooking the books): The deliberate falsification or manipulation of accounting numbers to make the profit performance and/or the financial condition of a business appear better than reality. Accounting fraud is sophisticated and even fools the CPA auditors of a business. Recent years have seen an embarrassing number of high-profile accounting fraud cases, which resulted in the establishment of a new federal regulatory agency with broad powers over public companies and the CPA auditors of public businesses: the Public Company Accounting Oversight Board (PCAOB).
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accounts payable: One main type of the short-term operating liabilities of a business, in which are recorded the amounts owed to vendors or suppliers for the purchase of products, supplies, parts, and services that are bought on credit. Generally these liabilities are non-interest bearing (although an interest charge may be added as a penalty for late payment).
accounts receivable: The short-term asset in which are recorded the amounts owed to the business from sales of products and services on credit to its customers. Customers are not normally charged interest, unless they do not pay their bills when due. The balance of this asset in a balance sheet is net of write-offs for uncollectible amounts (bad debts).
accrual-basis accounting: Recording the financial effects of economic events when they happen, as opposed to simple cash accounting. Using accrualbasis accounting, revenue is recorded when sales are made (rather than when cash is received from customers), and expenses are recorded to match with sales revenue or in the period benefited (rather than when expenses are paid). The accrual basis of accounting is seen in the recording of assets such as receivables from customers, inventory (cost of products not yet sold), and cost of long-term assets (fixed assets) — and in the recording of liabilities such as accounts payable to vendors and payables for unpaid expenses.
accrued expenses payable: The generic term for liability accounts used to record the gradual accumulation of unpaid expenses, such as vacation pay earned by employees and profit-based bonus plans that aren’t paid until the following period. Note: The specific title of this liability varies from business to business; you may see accrued liabilities, accrued expenses, or some other similar account title.
accumulated depreciation: The total cumulative amount of depreciation expense that has been recorded since the fixed assets being depreciated were acquired. In the balance sheet, the amount in this account is deducted from the original cost of fixed assets. The balance of cost less accumulated depreciation is included in the book value of the fixed assets.
acid-test ratio: An alternative name for the quick ratio.
adjusting entries: At the end of the period, these important entries are recorded to complete the bookkeeping cycle. These end-of-period entries record certain expenses to the period (such as depreciation) and update revenue, income, expenses, and losses for the period. Note: This term also refers to making correcting entries when accounting errors are discovered.
amortization: The allocation of the cost of an intangible asset over its expected useful life to the business. Amortization expense is recorded on the straight-line basis (equal amounts each period).
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asset turnover ratio: Annual sales revenue divided by total assets (at yearend, or the average total assets during the year).
audit report: The opinion on the financial report of a business issued by a CPA firm upon its completion of auditing the company’s financial statements and footnotes. The audit report states whether the financial statements are in conformity with applicable U.S. or international financial reporting standards. A “clean opinion” means the CPA auditor has no serious disagreements with the financial report of the business.
bad debt: The expense that arises from a customer’s failure to pay the amount owed to the business from a credit sale. When the credit sale was recorded, the accounts receivable asset account was increased. When it becomes clear that this debt owed to the business will not be collected, the asset is written down and the amount is charged to bad debts expense.
balance sheet: This financial statement summarizes the assets, liabilities, and owners’ equity of a business at a moment in time. It’s prepared at the end of every profit period and whenever else it is needed. The main elements of a balance sheet are called accounts — such as cash, inventory, notes payable, and capital stock. Each account has a dollar amount, which is called its balance. But be careful: The fact that the accounts have balances is not the reason this financial statement is called a balance sheet. Rather, the equality (or balance) of assets with the total of liabilities and owners’ equity is the reason for the name. This financial statement is also called the statement of financial condition and the statement of financial position.
book value (of assets and owners’ equity): Refers to the recorded amounts on the books (accounting records) of a business, which are reported in its balance sheet. Often this term is used to emphasize that the amounts recorded in the accounts of the business are less than the current replacement costs of certain assets, or less than the market value of owners’ equity.
break-even: The annual sales volume or sales revenue at which total margin equals total annual fixed expenses — that is, the exact sales amount at which the business covers its fixed expenses and makes a zero profit and avoids a loss. Break-even is a useful point of reference in analyzing profit performance and the effects of making sales in excess of break-even.
capital expenditures: Outlays for fixed (long-term) assets in order to overhaul or replace old fixed assets or to expand and modernize the long-lived operating resources of a business. Fixed assets is a broad category that includes buildings, machinery, equipment, vehicles, furniture, fixtures, and computers. These operating assets have useful lives from 3 to 39 (or more) years. The term “capital” implies that substantial amounts are invested for many years.
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capital stock: The ownership shares issued by a corporation for capital invested in the business by owners. Total capital is divided into units of ownership called capital stock shares. In the old days, you actually got engraved certificates as legal evidence of your ownership of a certain number of shares. Today, book entry is the norm: Your ownership is recorded in the books, or records, of the registrar for the stock shares. A business corporation must issue at least one class of capital stock, called common stock. It may also issue other classes of stock, such as preferred stock.
cash flow: An ambiguous term that can refer to several different sources of or uses of cash. Some friendly advice: Always use this term with which source or use of cash you have in mind!
cash flow from operating activities: Equals the total cash inflow from sales and other income during the period minus the total cash outflow for expenses and losses during the period. This important number is reported in the first section of the statement of cash flows; it is not found in the income statement.
certified public accountant (CPA): The CPA designation is a widely recognized and respected badge of a professional accountant. A person must meet educational and experience requirements and pass a national uniform exam to qualify for a state license to practice as a CPA. Many CPAs are not in public practice; they work for business organizations, government agencies, and nonprofit organizations, or they teach accounting (a plug for educators here if you don’t mind). CPAs in public practice do audits of financial statements, and they also provide tax, management, and financial consulting services.
common stock: The one class of capital stock that must be issued by a business corporation. It has the most junior, or “last in line,” claim on the business’s assets in the event of liquidation, after all liabilities and any senior capital stock (such as preferred stock) are paid. Owners of common stock receive dividends from profit only after preferred stockholders (if any) are paid. Owners of common stock generally have voting rights in the election of the board of directors, although a business may issue both voting and nonvoting classes of common stock.
comprehensive income: Includes net income reported in the income statement plus certain rather technical gains and losses that are recorded but don’t necessarily have to be included in the income statement. In other words, the effects of these developments can bypass the income statement. Most companies report these special types of gains and losses (if they have any) in their statement of changes in owners’ (stockholders’) equity.
controller: The chief accounting officer of an organization. The controller may also serve as the chief financial officer (CFO) in a business or other organization, although in large organizations the two jobs are usually split.
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cooking the books: See accounting fraud. Should not be confused with the lesser offenses of massaging the numbers and income smoothing.
current assets: Includes cash plus accounts receivable, inventory, and prepaid expenses (and short-term marketable securities if the business owns any). These assets will be converted into cash during one operating cycle or sooner, which determines the liquidity of a business.
current liabilities: Short-term liabilities, principally accounts payable, accrued expenses payable, income tax payable, short-term notes payable, and the portion of long-term debt that falls due within the coming year. This group includes both non-interest-bearing and interest-bearing liabilities that must be paid in the short term, usually defined to be one year or less.
current ratio: One test of a business’s short-term solvency (debt-paying capability). Find the current ratio by dividing a business’s total current assets by its total current liabilities.
debits and credits: Accounting jargon for decreases and increases recorded in accounts for assets, liabilities, owners’ equity, revenue, and expenses according to the centuries’ old method that is based on the accounting equation. In recording a transaction, the total of debits must equal the total of credits. “The books are in balance” means that the sum of debit balance accounts equals the sum of credit balance accounts. Even though the accounts are in balance, there may be errors due to other reasons.
depreciation: Allocating a fixed asset’s cost over three or more years, based on its estimated useful life to the business. Each year of the asset’s life is charged with part of its total cost as the asset gradually wears out and loses its economic value to the business. Either an accelerated depreciation
method or straight-line depreciation is used. An accelerated method allocates more of the cost to the early years than the later years. The straight-line method allocates an equal amount to every year.
dividend yield: Measures the cash income component of return on investment in stock shares of a corporation. The dividend yield equals the most recent 12 months of cash dividends paid on a stock divided by the stock’s current market price. If a stock is selling for $100 and over the last 12 months paid $3 cash dividends, its dividend yield equals 3 percent.
double-entry accounting: Simply put, this term means that both sides of an economic event or business transaction are recorded. For every action recorded there is a reaction that is also recorded. The debits and credits method is the means used to implement double-entry accounting.
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earnings before interest and income tax (EBIT): Sales revenue less cost of goods sold and all operating expenses — but before deducting interest
expense and income tax expense (and usually, but not always, before extraordinary gains and losses). This intermediate measure of profit also is called operating earnings, operating profit, or something similar.
earnings per share (EPS): Equals net income for the most recent 12 months reported, called the trailing 12 months, divided by the number of capital stock shares. Dividing net income by the actual number of shares in the hands of stockholders, called outstanding shares, gives basic EPS. Diluted EPS equals the same net income figure divided by the sum of the actual number of shares outstanding plus additional shares that will be issued under terms of stock options awarded to managers and for the conversion of senior securities into common stock (if the company has issued convertible debt or preferred stock securities).
EDGAR: The first name of my father-in-law. Seriously, this is the acronym for the database of financial reports and other required filings under federal securities laws with the Securities and Exchange Commission (SEC). Go to www.sec.gov and navigate to Filings & Forms (EDGAR).
extraordinary gains and losses: Unusual, nonrecurring gains and losses that happen infrequently and that are aside from the normal, ordinary sales and expenses of a business. These gains and losses, in theory, are one-time events that come out of the blue. But in actual practice many businesses record these gains and losses too frequently to be called nonrecurring. These gains and losses (net of income tax effects) are reported separately in the income statement. In this way, attention is directed to net income from the normal continuing operations of the business — as if the special gains and losses should be put out of mind.
Financial Accounting Standards Board (FASB): The highest authoritative, private sector, standard-setting body of the accounting profession in the United States. The FASB issues pronouncements that establish generally accepted accounting principles (GAAP).
financial leverage: Generally refers to using debt capital on top of equity capital. The strategy is to earn a rate of return on assets (ROA) higher than the interest rate on borrowed money. A favorable spread between the two rates generates financial leverage gain to the benefit of net income and owners’ equity.
financial reports: The periodic financially oriented communications from a business (and other types of organizations) to those entitled to know about the financial performance and position of the entity. Financial reports of businesses include three primary financial statements (balance sheet, income
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statement, and statement of cash flows), as well as footnotes and other information relevant to the owners of the business. Public companies must file several types of financial reports and forms with the Securities and Exchange Commission (SEC), which are open to the public. The financial reports of private businesses are sent only to its owners and lenders.
financial statement: Generally refers to one of the three primary accounting reports of a business: the balance sheet, statement of cash flows, or income statement. Sometimes financial statements are called simply financials. Internal financial statements and other accounting reports to managers contain considerably more detail, which is needed for decision making and control.
financing activities: One of three basic types of cash flows reported in the statement of cash flows. These are the dealings between a business and its sources of debt and equity capital — such as borrowing and repaying debt, issuing new stock shares, buying some of its own stock shares, and paying dividends to shareowners.
first-in, first-out (FIFO): A widely used accounting method by which costs of products when they are sold are charged to cost of goods sold expense in chronological order. One result is that the most recent acquisition costs remain in the inventory asset account at the end of the period. The reverse order also is acceptable, which is called the last-in, first-out (LIFO) method.
fixed assets: The shorthand term for the long-life physical resources used by a business in conducting its operations, which include land, buildings, machinery, equipment, furnishings, tools, and vehicles. Please note that fixed assets is an informal term; the more formal term used in a balance sheet is property, plant, and equipment.
fixed costs: Those expenses or costs that remain unchanged over the short run and do not vary with changes in sales volume or sales revenue. Common examples are building rent under lease contracts, salaries of many employees, property taxes, and monthly utility bills. Fixed expenses provide the capacity for carrying out operations and for making sales.
footnotes: Think of footnotes in a book. Footnotes are attached to the three primary financial statements included in an external financial report, and they present detailed information that cannot be put directly in the body of one of the financial statements. Footnotes have the reputation of being difficult to read, poorly written, overly detailed, and too technical. Unfortunately, these criticisms have a lot of truth behind them.
free cash flow: Be very cautious about this term because it has no uniform meaning; different people use it to mean different things. Some people use it to mean cash flow from operating activities — to emphasize that this source of cash is free from the need to borrow money, issue capital stock shares, or sell assets. But this is not the only meaning you see in practice.