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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Introduction to Fundamental Analysis Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions

Introduction to Fundamental Analysis

 - The Accounting Process
 - Postulates and Principles
    of Accounting
    * Postulates of Accounting
     * Principles of Accounting

The Financial Statements
   * The Balance Sheet
* The Income Statement
    * The Cash Flow Statement
    *  Shareholders' Equity


Principles of Accounting

5. Historical Cost

Rule: Transactions should be initially valued at historical costs, rather than at market or appraised values.

Issue:  Assets are usually recorded at their purchase prices, and are subsequently written down (expensed) when utilized. Assets are almost never written up in value. Companies, however, may have assets that have appreciated in value over time, but are still recorded at their lower accounting values. While land is the classic example, buildings, brand names, trademarks, and in some cases, equipment, may also appreciate.  

Accounting authorities have been gradually moving away from historical costs and towards fair market values, where realistically obtainable, in areas like marketable securities and derivative instruments. Generally, however, the use of historical costs to value transactions remains the bedrock of accounting theory and practice. 

Land Example: St. Joe Company (Joe) is often mentioned as an aberration. They own approximately 750,000 acres of land in Northwest Florida, purchased decades ago, but valued on their balance sheets at a fraction of fair market value. The historical cost principle distorts their financial position.

One can see from the above example that the historical cost concept has inherent flaws. Nonetheless, even with its drawbacks, the historical cost concept is still, by far, the best available method. Investors need to appreciate the conservative nature of historical cost accounting. Fair market accounting is too risky; it is very subjective, costly, and can lead to valuation manipulation.

6. Revenue Realization

Rule: Revenues are recorded in the period that they are realized (earned).

The broader recognition issues center on when should business transactions be recorded?  Normally, a transaction is recorded when the critical event has occurred and there is evidence that a transaction has taken place. Capital invested, inventory purchased, products sold and shipped, invoices paid, cash collected, etc.  

Issue: The big problem area, however, revolves around revenue. The SEC’s Bulletin # 101 has specific critical events and transaction guidelines that need to be followed, in order to accrue revenue.

Companies, therefore, to accrue revenue, must meet all of the following conditions:

1.       Persuasive evidence of an arrangement exists.

2.       Delivery has occurred or services have been rendered.

3.       The seller’s price to the buyer is fixed or determinable.

4.       Collectability is reasonably assured.

This is an excellent ruling, but it’s rigid and sometimes not practical.

For example:  Standard Automotive Corporation, produced trailer chassis from a customer’s sales order. The customer inspected, accepted, insured, and paid for the units; the units, however, were stored at the company’s facilities, until the customer needed them.

The storing of the units created a “bill and hold” inventory transaction, and was not considered a sale until the customer moved the units from the lot. This example of a bill and hold sale demonstrates that even the receipt of cash, after essentially all the work was performed, does not necessarily equate to revenues being realized. 

Investors should understand that revenue realization concepts are not simple and that the cookbook approach to accounting procedures can produce atypical results.   

7. Matching

Rule: Revenues and associated costs should be recognized in the same periods.

Issue: Accrual accounting is used to match revenues with expenses. Revenues are recognized in the period when earned, and expenses are recognized when incurred, rather than when paid. Evolving from the matching principle is the differential treatment between product and period costs. This is the overriding principle as to why inventory costs are capitalized on the balance sheet until a sale takes place. Product revenues should match product costs on the income statement. Some of the high profile cases in the news, like WorldCom, centered on period costs that were improperly capitalized on the balance sheet (like product cost), but should have been expensed when incurred. Period costs are current operating costs that are usually expensed when incurred.

A more poignant example of the difficulties involved in the matching principle is how banks match loan income (interest) against loan expenses. The capitalization and amortization of loan origination costs is tricky. Loan interest income is collected over time; therefore loan costs must also be expensed over time. Take a loan officer who specializes in 5 year loans: his commission would be solely based on successful deals, so they would all be capitalized and amortized over a five-year loan period.  His expenses; salary, telephone, office rent, support services, etc. would be allocated between his successful and unsuccessful deals.  The successful portion would be capitalized and amortized over the life of the loan, while the unsuccessful portion would be expensed as incurred.

If that loan officer only worked on two loans, a judgmental decision would be made on how to allocate origination expenses between successful and unsuccessful loans. Many methods could be used, such as the number of loans, the size of the loans, the time spent on the loans, etc.  

Additionally, a loan generates more interest income in the early years, when the payoff amount is the highest and less income towards the end of the loan. Loan costs, therefore, are allocated to the P&L consistent with how income is recognized.

One can see that many matching issues are not clear-cut; nevertheless, expenses should follow revenues. 

8. Objectivity

Rule: Financial information must be relevant (useful), reliable and measurable.

Issue: The merchant energy industry (Dynegy, El Paso, Enron, Williams, etc.) underscores the significance of the objectivity principle. The lack of objectivity, in financial reporting, is one of the reasons why the merchant energy companies ran into financial difficulties, in the late 1990’s.  On average, the financial statements of the industry overstated revenues, earnings, cash flows and equity, and understated assets and liabilities. The specific GAAP rules may have been met, but the objectivity principle somehow got lost, which ultimately resulted in the downfall of some of these companies.

The generally accepted accounting principles (GAAP) used in the industry were neither transparent nor objective, and failed to report the true financial status of the companies, resulting in massive losses for investors. As the restatements came in, it was disheartening to see certified figures changing daily by tens of billions of dollars, causing loss of life and money. The “bottom line” was that the industry produced financial statements that were not useful to anyone.     

Companies presenting information that is not useful, or that is constantly being restated, should raise red flags for investors.

9. Consistency

Rule: Similar transactions should be reported in a consistent manner from period to period. A company, moreover, should use the same accounting principles from year to year.

Transactions recorded in financial statements must be applied consistently, for the information to be useful to a company’s stakeholders. Once a methodology is adopted and accepted, it should be continued. Consistency, however, is not an excuse for bad or unethical decisions.   

Issue: One often sees the switching of accounting methods when it is beneficial to the owners of a company. For example, private aerospace and construction type companies that work on long-term projects regularly use the easier completed contract accounting method when privately held. However, when these companies need to raise capital, they often switch to the more complicated percentage-of-completion accounting. The inconsistent accounting treatment for similar transactions, from period-to-period, makes it very challenging, if not impossible, for investors to evaluate a company.

10. Conservatism

Rule: When choosing two acceptable accounting methods, pick the one that has the lowest impact on owners’ equity.

Issue: Conservatism can have a negative side; it can be used as an excuse for not reporting a transaction in the fairest manner. Taken to an extreme, it can mislead investors and cause losses where none should have occurred. It’s a fine line and a company should never intentionally understate equity.

11. Materiality

Rule: Insignificant transactions and events need not be disclosed.

Issue: Materiality refers to the relative importance of a business transaction to the users of the financial statement. The current view towards materiality is that if an item is immaterial, there should be no reason not to “book it,” because it has no effect on the financial statements. So every adjustment should be recorded.  Public companies, however, compete and operate within the realities of the business community. Companies need a certain amount of “wiggle room” to function under the constraints of running a business.

Stock market reactions have placed management in a peculiar situation.  Companies have seen substantial drops in their stock prices by being short on earnings estimates by even a penny. Many stocks are priced-to-perfection, causing immaterial P&L items to have serious stock market consequences. Investors need to be responsible for their irrational exuberance, in over paying for stocks.   

12. Full Disclosure

Rule: All substantive and relevant information required by the users of the financial statements needs to be disclosed.

Issue: The argument against transparency has always been that full disclosure can put a public company and its management at a serious competitive disadvantage.  For example, Halliburton, the oil service company and KBR the construction company, must report complete and full disclosures with the SEC, while their major competitor, Bechtel, is a private company not subject to the same disclosure rules.  This puts Halliburton and KBR at a significant disadvantage when negotiating contracts.   

Transparency, however, is essential. Investors and management need to accept that the price of being a public company is full-disclosure. 

13. Comparability

Rule: Financial statements should be reported in a uniform manner and on a comparative basis. When different accounting methods exist, companies should disclose which method is being used.

Issue: Investors need to compare “apples with apples” when evaluating a business; anything less is deceiving. Information must be presented in such a fashion that similar transactions can be compared from period to period. The one glaring issue undermining the comparability concept is the accounting for restructuring charges.

The auditors and the SEC have been really scrutinizing the authorization, notification, timing and amounts of restructuring accruals. Companies are prohibited from overestimating restructuring charges for the benefit of future periods.  In general, restructuring charges tend to distort the comparability between accounting periods and can mislead investors.

Unusual and nonrecurring transactions can distort comparability analysis, and should not be downplayed or ignored. These transactions represent past decisions on how a company managed its money, and are good indicators of the future.

Next review the financial statements




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