CHAPTER 1

AN INTRODUCTION TO SECURITY ANALYSIS

LEARNING OBJECTIVES
1. The many kinds of financial professionals who use security analysis in their jobs and the types of analyses
they do.
2. The sources of information security analysts use to prepare their analyses.
3. How the financial reporting environment affects security analysis and how regulators, management, and
auditors influence financial reporting.
4. Why analysts consider accounting method choices, accounting estimates, and disclosures when using
financial reporting to prepare a valuation.
5. What are the limitations of generally accepted accounting principles in presenting information for valuation
purposes.
6. How analysts assess the quality of financial information.
7. How equity security analysis consists of four phases: business analysis, financial statement analysis,
forecasting, and valuation.

TRUE/FALSE QUESTIONS
1. Buy-side analysts advise clients on financial matters such as corporate restructurings, acquisitions, and
divestitures.
(easy, L.O. 1, Section 1, false)

2. One condition for the acquisition of a private company would be an audit of the financial statements
prepared under GAAP.
(moderate, L.O. 2, Section 2, true)

3. Due to breakthroughs in technology over the last decade, sell-side analysts may have to find new ways to
add value to their services.
(moderate, L.O. 2, Section 2, true)

4. SEC Regulation FD prohibits firms from providing information to securities analysts and other market
professional unless that information is already in the public domain.
(moderate, L.O. 2, Section 2, true)

5. The problem of asymmetric information occurs when investors know more about the firm than the
managers do.
(moderate, L.O. 3, Section 3, false)

6. The investors and managers of publicly held companies each have a role in setting accounting standards
in the United States.
(easy, L.O. 3, Section 3, false)

7. The primary stated objective of GAAP is to ensure that the information in financial statements is useful
to investors.
(easy, L.O. 3, Section 3, true)

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8. The Securities and Exchange Commission consists of seven commissioners who are appointed by the
president (subject to Senate consent) for staggered five-year terms.
(easy, L.O. 3, Section 3, false)

9. Before issuing an accounting standard, the SEC goes through a due process procedure, gathering public
comment on the issues and a draft of the standard.
(easy, L.O. 3, Section 3, false)

10. Management has significant influence over financial statements; that can create situations in which
management’s personal goals conflict with the goal of financial reporting to provide useful information
to investors.
(moderate, L.O. 4, Section 3, true)

11. There would be no limitations to GAAP if management was free of biases in preparing financial
statements and audits were completely accurate and free of error.
(moderate, L.O. 5, Section 4, false)

12. Historical cost helps ensure consistency and conservatism in reporting, and it always provides
information the analyst would like.
(moderate, L.O. 5, Section 4, false)

13. GAAP financial statements may not always provide the financial analyst with financial measures other
than earnings.
(moderate, L.O. 6, Section 5, true)

14. The second phase of security analysis is forecasting.

(easy, L.O. 7, Section 5, false)

15. In a free cash flow model, the analyst uses ratios such as the sales growth rate, operating margins, and
investment to sales to construct a forecast.
(moderate, L.O. 7, Section 5, true)

MULTIPLE CHOICE QUESTIONS

16. A person who works for a large pension fund that invests in equities is known as a(an):
a. buy-side analyst
b. sell-side analyst
c. investment banker
d. corporate financial specialist
(easy, L.O. 1, Section 1, a)

17. An individual who prepares significant amounts of analysis to help market an initial public offering of
stock is known as:
a. an individual investor
b. a buy-side analyst
c. a sell-side analyst
d. an investment banker
(easy, L.O. 1, Section 1, d)

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18. The primary source(s) of information for security analysis is(are):
a. live conference calls provided by the firm that are accessible through the Internet
b. various stock analyst reports and magazine articles
c. the financial statements and disclosures of the firm under analysis
d. industry experts, the firm’s competitors, and customers
(moderate, L.O. 2, Section 2, c)

19. Technology is changing the traditional role of the sell-side analyst. As their traditional role is becoming
less important, such analysts should:
a. emphasize their role as a wholesale distributor of information, linking firms with investors
b. provide insightful analyses of information to continue to add value
c. provide the simple dissemination of information to continue to add value
d. strengthen their position as “information intermediary” by developing relationships with the
companies they follow
(difficult, L.O. 2, Section 2, b)

20. A private equity investor uses three quantitatively based stages to identify buyout candidates among
publicly traded companies. The third quantitative stage in such an assessment involves:
a. the development of a buyout model
b. a review to identify the suitability of a company for buyout purposes
c. an examination to determine if the buyout candidate’s financial statements have been audited
d. a detailed analysis of the candidate, including modeling and valuation
(difficult, L.O. 2, Section 2, a)

21. The SEC adopted regulation FD in 2000. This regulation was endorsed by the SEC due to concern that:
a. investors would be enabled to access information directly from companies on a more timely basis
b. unfiltered information was not useful to investors
c. analysts were using their superior access to company-provided information to act as “information
gatekeepers”
d. companies would refuse to provide any information at all to analysts, causing a “chilling effect”
(moderate, L.O. 2, Section 2, c)

22. Managers face the problem of asymmetric information when presenting financial information about their
publicly held firms to investors. Managers can convince investors of the fairness of their financial reports
by:
a. issuing press releases to investors and the general public
b. relying on established financial statement reporting rules and mandated audits
c. disclosing unfiltered information to key capital market analysts
d. analyzing the financial reporting environment in which their firm operates
(easy, L.O. 3, Section 3, b)

23. The Securities and Exchange Commission (SEC) has statutory authority to prescribe the accounting
methods used in financial reports and specify disclosure requirements for publicly held companies. The
SEC has delegated such responsibilities to:
a. public accounting firms who audit publicly held companies
b. the management of publicly held firms who are responsible for financial statements and reports
c. the Financial Accounting Standards Board
d. the General Accounting Office
(moderate, L.O. 3, Section 3, c)

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24. The SEC has been organized into several divisions that deal with financial reporting matters. The
division that functions as the principal adviser to the commission on accounting and auditing issues is
the:
a. Office of Chief Accountant
b. Division of Corporate Finance
c. Financial Accounting Standards Board
d. Division of Enforcement
(easy, L.O. 3, Section 3, a)

25. Management is responsible for the way in which it uses the assets of the business, and financial reports
are designed to inform shareholders of how managers are satisfying their fiduciary responsibilities.
Managers have significant influence over and may affect financial statements by their:
a. choices of the accounting methods used to prepare the financial statements
b. decisions about the levels of disclosure
c. estimates used to prepare the financial statements
d. All the above answers are correct.
(easy, L.O. 4, Section 3, d)

26. One way in which management can exert influence over financial statements is in choosing a particular
way to value its inventory. This is an example of management’s choice of an accounting:
a. estimate
b. method
c. disclosure
d. principle
(easy, L.O. 4, Section 3, b)

27. There are several constraints that dictate how much information is disclosed by management. One
constraint is the minimum disclosure prescribed by GAAP. Another constraint placed on management
disclosure is:
a. the use of certain accounting estimates
b. the global impact of press releases from the business
c. the competitive environment in which the business operates
d. the use of certain accounting methods
(moderate, L.O. 4, Section 3, c)

28. There are two basic ways to value a company. It is suggested that one method may be better to use than
the other to minimize accounting distortions. Which of the following choices below is correct regarding
this statement?
a. The equivalent method is never affected by accounting distortions and it should be used in
valuations.
b. The discounted cash flow analysis is never affected by accounting distortions and should be used in
valuations.
c. Multiples analysis is never affected by accounting distortions and it should be used in valuations.
d. Both of the basic methods to value a company can be impacted by accounting distortions.
(difficult, L.O. 4, Section 3, d)

29. The auditor must deal with the problem of asymmetrical information in financial reporting. By
performing an audit, the independent auditor provides a measure of reliability about the reports made by
management. Auditors perform certain tests of the firm’s internal control system to establish that:
a. the general public can trust the specifications found in the firm’s catalogue of new and existing
products
b. the likelihood of material errors is small
c. external communications made by management to the media about the company are truthful
d. disclosures made by the marketing department about a new product are reliable
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 (moderate, L.O. 4, Section 3, b)

30. It is acknowledged that there are limitations to GAAP. One practical limitation is that financial
statements are not created exclusively for valuation purposes. A poor example of this limitation is:
a. GAAP financial statements tell us about the past while valuations often deal with the future
b. GAAP relies on a historical cost basis for financial statements
c. financial statement book values are often not good estimates of fair market or current values
d. GAAP prescribes minimum disclosure requirements
(moderate, L.O. 5, Section 4, d)

31. Certain valuation measures are different than those used for financial statement items under GAAP. For
an analyst to take GAAP information and transform it for valuation purposes, the analyst must:
a. use the recommendations made by sell-side analysts about a firm’s financial position and future value
b. thoroughly understand how GAAP statements are constructed so they can be adjusted as necessary
c. consult with investment bankers to obtain analysis about a firm’s future growth potential
d. realize that the free cash flow model is the equivalent of the GAAP statement of cash flows
(moderate, L.O. 5, Section 4, b)

32. Which of the following would not be considered a limitation of GAAP for security analysis?
a. the information necessary for security analysis is not available under GAAP
b. the information necessary for security analysis is not in an appropriate format
c. governmental regulation in well-developed capital markets require accounting standards and
mandated audits
d. a final decision from FASB regarding some aspect of financial statements may be a compromise that
addresses the needs of many constituent groups with diverse perspectives
(moderate, L.O. 5, Section 4, c)

33. Successful business analysis relies on the analyst’s ability to understand all aspects of the internal and
external environment of the business. There are many external factors to consider in such an analysis.
Which factor listed below is not considered an external factor?
a. the firm’s marketing and selling strategies
b. the firm’s key customers
c. the prospects for growth for the industry in which the firm operates
d. the barriers to entry into the industry in which the firm operates
(moderate, L.O. 6, Section 5, a)

34. Accounting analysis is part of the second phase of security analysis known as financial statement
analysis. In this phase of security analysis, an accounting analysis of the firm’s financial statements is
important because the analyst:
a. tries to understand the key business drivers affecting the firm
b. attempts to predict the future financial results of the firm
c. attempts to strip away any management distortions about the firm’s financial statements
d. will determine a value for the firm’s equity
(moderate, L.O. 7, Section 5, c)

35. The phase in which the analyst must possess both a thorough understanding of the business environment
and the entity is known as:
a. financial statement analysis
b. forecasting
c. valuation
d. business analysis
(moderate, L.O. 7, Section 5, b)

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36. The phase in which the analyst brings together all of the information and analysis to form findings and
conclusions about the firm is known as:
a. financial statement analysis
b. forecasting
c. valuation
d. business analysis
(moderate, L.O. 7, Section 5, c)

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ESSAYS
37. Discuss the three major factors that influence GAAP and financial reporting under GAAP.

Suggested solution:

The three major factors that influence GAAP and financial reporting are:
 Management
 Auditors
 Regulators

Management has influence over GAAP and public financial reporting because they can choose which
accounting methods and estimates to use and make judgments about the level of disclosure. Management
is allowed such discretion in the preparation of financial statements under current GAAP guidelines.

In some cases the desires and wishes of management may conflict with the goals of responsible financial
reporting. Management may consciously choose to portray the firm as financially healthy, when the
reality may be otherwise. In response to such possible tendencies of management, GAAP requires that
the principle of conservatism be followed in applying accounting rules to financial statements.
Conservatism, which states that accountants should be biased toward delaying the recognition of income
and accelerate the recognition of losses, places limits on the natural tendency of management to be
optimistic regarding financial reporting.

Auditors provide some assurance that limits the results of management’s influence on the financial
statements. Through the use of structured tests and analytical tools, auditors attest to the reasonableness
of the financial statements and attempt to limit material errors and the misstatement of certain items on
the financial statements. Auditors follow the rules established by GAAP and make efforts to uniformly
apply them to the financial statements of the firms they audit. Even though auditors cannot provide total
assurance regarding a firm’s financial statements, the fact that auditors examine the firm’s statements
tends to make managers more careful in preparing them.

Regulators such as the Securities and Exchange Commission (SEC) and the Financial Accounting
Standards Board (FASB) are major influences in the evolution of GAAP since these agencies are
primarily responsible for public financial reporting standards in the United States. The SEC has been
granted authority to impose financial reporting rules. It has, however, maintained a stance of voluntary
regulation by delegating this responsibility to the FASB; hence this agency bears primary responsibility
for setting accounting standards. The FASB goes through numerous steps before it issues an accounting
standard. The FASB asks for public comment about proposed regulations. Businesses, security analysts,
regulators, practicing accountants, credit analysts, bankers, academicians, and employees may participate
in the process. Noting that these various groups may have their own concerns and agendas, the final
decisions rendered by the FASB (and embodied in GAAP) may involve compromises based on the input
and concerns of such diverse groups.
(moderate, L.O. 3, Section 3)

38. Discuss the beginning and ending points in the securities analysis process.

Suggested solution:

The securities analysis process consists of four phases, two of which overlap to some degree. The starting
point in the process is to apply business analysis (phase one) to the GAAP financial statements of the
firm undergoing the analysis. The analyst must begin with what has been audited and is available to the
public, which are the GAAP financial statements. The business analysis process is one in which the
analyst, armed with the firm’s financials, attempts to understand the key business drivers that affect the

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 firm. This includes both internal and external factors. To build such an understanding, the analyst must
collect a considerable amount of information about the firm.

The ending point in the process culminates with phase four—valuation. The key goal of valuation is to
use the analysis and forecasts generated in the prior phases to determine a value for the firm’s equity.
This is the end result of the process, and the information that securities analysts require to base informed
decision upon about a given publicly held firm.
(moderate, L.O. 7, Section 5)

39. Explain why accounting analysis “strips” away any management distortions in the financial statements.

Suggested solution:

Accounting analysis (sometimes referred to as quality of earnings analysis) is an element of financial

statement analysis. As part of the second phase of security analysis, the analyst looks carefully at the
historical financial statements and any factors that may distort the underlying economics of the firm
being examined. Accounting analysis is designed to examine all of the financial statements and
disclosures. Accounting analysis looks at the firm’s accounting policies and how management has used
estimates, accounting choices, and judgments to affect the numbers found on the financial statements.
Accounting analysis looks beyond the numbers and, like peeling an onion, uncovers “layers” underneath
the reported financial statements. It is assumed that immediately underneath the observed financial
statements is a layer known as “accounting distortions.” The depth of this layer depends on how much
management has exercised its accounting choices in preparing the firm’s financials. As part of this phase
of work, the analyst may recreate the financial statements in a format different than GAAP. Certain items
that are unlikely to recur may be excluded from the recast financials, while other items that GAAP
ignores may be included. The goal is to obtain financial statements that can be used to assess the firm’s
true economic picture.

(moderate, L.O. 7, Section 5)