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Assessing the quality of the financial statements

Assessing the quality of the financial statements

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Published by ClassOf1.com
Our experience, and that of our students, is that careful and thorough reading of the financial statements yields a great deal of information about the firm. The financial statements, the notes, and management’s discussion and analysis provide valuable insights into the business strategies, profitability, and risk of the firm.
Our experience, and that of our students, is that careful and thorough reading of the financial statements yields a great deal of information about the firm. The financial statements, the notes, and management’s discussion and analysis provide valuable insights into the business strategies, profitability, and risk of the firm.

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Published by: ClassOf1.com on Jul 10, 2013
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Financial Accounting
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Sub: Financial Accounting Topic:
 
Financial Statement Analysis
*
Assessing the Quality of the Financial Statements
To assess the quality of the financial statements the following steps are necessary:
Reading the Financial Statements and Creating a Data File
Our experience, and that of our students, is that careful and thorough reading of the financialstatements yields a great deal of information about the firm. The financial statements, the
notes, and management’s discussion and analysis pro
vide valuable insights into the businessstrategies, profitability, and risk of the firm. Many firms explicitly disclose elements of thebusiness that are performing well or poorly, also providing explanations about theperformance. Many firms explicitly disclose projections of future business activities, such asexpected future sales growth rates or capital expenditures, which are helpful information forprojecting future financial statements. Analysts who do not carefully read the financialstatements stand to miss this valuable information. After careful reading, the analyst shouldenter the financial statement data into a data file. One initial choice in creating a data file iswhether to use the accounts and amounts that the firm provides in its
Form 10-K or annualreport
to shareholders or to download and use amounts from various online sources ordatabases that format the amounts into a standardized template. One advantage of followingthe first approach is that you rely on the primary source of the financial statements, not on asecondary source about which you may not know all of the reclassifications and adjustmentsmade to confirm the reported amounts to the standardized template. Another advantage of following the first approach is that the financial statement data will be classified into accountsconsistent with the notes to the financial statements, the main source of information forassessing the quality of the reported amounts. The principal advantages of using amounts in astandardized template are that use of the template can save time and the financial statementamounts are reasonably comparable across firms. The next decision to be made is whether to
 
 
Sub: Financial Accounting Topic:
 
Financial Statement Analysis
*
input the financial statement data into FSAP, a
financial statement analysis package
thataccompanies this text, or to create a new spreadsheet file. The principal advantages of FSAPare that it provides spreadsheets that have embedded formulas for the various profitabilityand risk ratios, it provides a template for preparing forecasted financial statements using thepreviously reported actual amounts as a base, and it inputs the forecasted amounts intoseveral valuation models to arrive at equity values.
Assessing the Quality of the Reported Amounts
One of the most important steps in financial statement analysis is to assess the quality of thereported amounts and make appropriate adjustments before proceeding to the analysis of 
profitability and risk. The saying “garbage in, garbage out” app
lies with particular importanceto financial statements. To assess quality, you must read the financial statements and notes.Material nonrecurring or unusual income items are candidates for adjustment. Significant off-balance-sheet assets or liabilities also are candidates. Some adjustments may be needed toincrease the comparability of the financial statement amounts for each of the firms analyzedin the term project.

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