Financial statements serve as a foundation for credit and equity analysis, including security valuation. Analysts may need to make adjustments to reflect items not reported in the statements (certain assets/liabilities and future earnings). Analysts may also need to assess the reasonableness of management judgment (e.g., in accruals and valuations). Because analysts typically will not have access to the accounting system or individual entries, they will need to infer what transactions were recorded by examining the financial statements.
Quite apart from deliberate misrepresentations, even efforts to faithfully represent the economic performance and position of a company require judgments and estimates. Financial reporting systems need to accommodate complex business models by recording accruals and changes in valuations of balance sheet accounts. Accruals and valuation entries require considerable judgment and thus create many of the limitations of the accounting model. Judgments could prove wrong or, worse, be used for deliberate earnings manipulation. An important first step in analyzing financial statements is identifying the types of accruals and valuation entries in an entity’s financial statements. Most of these items will be noted in the critical accounting policies/estimates section of management’s discussion and analysis (MD&A) and in the significant accounting policies footnote, both found in the annual report. Analysts should use this disclosure to identify the key accruals and valuations for a company. The analyst needs to be aware, as Example 4 shows, that the manipulation of earnings and assets can take place within the context of satisfying the mechanical rules governing the recording of transactions.