The Top Five Accounting

Mistakes Analysts Make

By Jason Voss, CFA
Posted In: Financial Statement Analysis

Prior to entering graduate school almost 20 years ago, I had a very

important phone conversation with an analyst at the Dreyfus Founders
Funds, Chuck Reed. That brief phone conversation changed my focus
in graduate school — and hence my life. One of the questions I asked
Chuck was, “What skills should I acquire that most analysts overlook?”
He answered unequivocally, saying, “Most analysts do not understand
accounting.”

Shocking as it may seem, I still believe Reed’s two-decade old

admonishment to me remains true, even despite the emphasis made by
CFA Institute in its CFA charter program. Here are what I believe are
the top five accounting mistakes analysts make:

1. Using Generalized Financial Statements

If analysts take the time to actually read financial statements — and I

think that few of them actually do — it is likely that they digest them
through a third-party provider, such as Bloomberg, FactSet, S&P
Capital IQ, Reuters, Yahoo! Finance, etc. The problem with this
approach is that each of these services modifies each company’s unique
financial statements to fit into a pre-created template. These services
do this to ensure comparability across companies, industries, and
nations.

However, I would argue that the generalization of these financial

statements obscures as much as it reveals. An example is the
compressing of one-time items into a single line item which hides the
fact that some companies have many more one-time items each year
than do other companies. If a company has five “one-time” items each
year, as compared with others in its industry that may have infrequent
“one-time” items, this is a sign of poor accounting standards or abuses
of management accounting discretion and is valuable information
about company character.

Additionally, the smearing of categories also hides the unique voice of

the CFO, the auditor, and others within the organization who prepare
financial statements. Knowing that some companies report a bland
“net revenues” while others report “customer sales” tells you something
about the culture of the organization. Taken individually, these
differences seem inconsequential, but taken as a whole, the financial
statements tell you a lot about the culture of a company you may invest
in.

Ideally, the unmodified financial statements are examined, and the

amounts reported in these statements are matched to the specific
narrative of the business as revealed in the management’s discussion
and analysis section. Are the two stories — the quantitative and the
qualitative — consistent? They better be!
I once caught an arithmetic error in the calculation of gross profit of a
huge multi-billion dollar company. I caught this because I was
following the numerical narrative of the statements. That I could not
get the third number down in the income statement, and the first
actual real calculation, to match what they reported was telling.
According to their investor relations pro, I was the only analyst to catch
this multi-million dollar reporting error on their part; and in fact, the
statistical agencies simply had entered the numbers from the
statements directly!

2. Not Understanding the Reflexivity/Interactivity of the

Three Major Financial Statements

In my experience, few analysts take the time to trace a dollar of capital

raised within a company (as shown on the balance sheet) through the
income statement, to the bottom line, and then back to the balance
sheet again. Nor do they relate changes in the balance sheet accounts to
the cash-flow statement to identify huge inconsistencies in either
amounts or categorizations. Instead, most analysts analyze the
statements in isolation from one another.

A brief example is that few analysts understand in what way a change

in accrued liabilities affects operating expenses on the income
statement, and, in turn, how this affects cash flows from operations.
Ditto for income taxes payable, short-term notes payable, long-term
notes payable, and so forth.

Yet, when you trace a unit of capital (rupees, yuan, yen, dollars, euros)
through the financial statements, you once more get a sense of how
straightforward and how consistent the financial reporting is at a
business. This, in turn, is indicative of the character of the people that
run the organization.

I once caught a company whose operating cash flows dramatically did

not match the number that could be gleaned by doing a comparable
calculation using balance sheet numbers to calculate the same! Only by
understanding the interactivity of the statements did I catch this
error/possible fraud.

3. Not Creating Apples-to-Apples Comparisons in Time

This particular accounting secret is one that I have never discussed

publicly. However, understanding this was one of the secrets to my
success as a portfolio manager. Specifically, have you ever noticed that
the temporal dimension for the income statement, balance sheet, and
cash-flow statement are all different?

The income statement is reported quarterly for the first three quarters
of the year and then annually, whereas the balance sheet is always
reported as a quarterly snapshot — even when it is the fourth quarter.
Last, the cash-flow statement is always shown as an amassing of
cumulative cash for the year. Each of these is very different from one
another, and they only align in the first quarter for any company.

In my experience, companies play games with these time dimension

mismatches. Consequently, analysts must put all of the financial
statements on the same temporal dimension. I put each of the financial
statements of the companies I examine on both a quarterly and annual
basis. This means that you must create a fourth quarter income
statement by subtracting the first three quarters of the year from the
annual income statement. This also means that you must subtract the
first quarter cash-flow statement from the second quarter’s, the first
two quarters’ from the third quarter’s, and the first three quarters’ from
the annual number. When you do this, you can see some of the games
companies play.

I once caught a company delaying a payment on a massive capital lease

so that the company could report positive operating cash flow in its
first quarter. In the second quarter, the operating cash flow barely
changed even though it was a steady cash-flow-generating business.
The reason was that the second quarter cash-flow statement included
the massive lease payment. Only by creating quarterly cash-flow
statements could I readily see that they did not match my narrative
understanding of how the business should work.

4. Not Adjusting Statements for Distortions

This is a classic problem in financial statement analysis. Despite this
fact, most analysts do not modify financial statements to adjust for
one-time items, including write-offs, sales of divisions, accounting
revisions, and so forth. Exactly what to look for is outside the scope of
this post, but most analysts simply do not take the time to do this.

As a brief tip, if you ever see a write-off number that is a bit too round,
such as ¥500 million or €75 million, you can bet that the amount is
management’s estimate of a loss and not the actual loss. Therefore, you
can expect future corrections to this initial write-off estimate.

5. Not Reading the Footnotes

Last, despite all of the warnings to pay attention to the information

contained in footnotes, most analysts do not read them. Nor do most
analysts take the numbers from the footnotes and put them into the
main three financial statements.

An example of this would be to take the detailed property, plant, and

equipment figures reported in the footnotes and incorporate these into
the analysis of the entire balance sheet. I once caught a company that
clearly was playing games with its useful expected lives figure because
when I looked at the common-size over assets financial ratios, I could
see that one of their property, plant, and equipment numbers had gone
down massively on a relative basis. This distortion, in turn, had big
ramifications for the reported depreciation and hence net income,
operating cash flow, and free cash flow.

While there are many other accounting mistakes analysts make, if you
correct those I have highlighted above, I believe you will successfully
separate yourself from your analyst peers and improve your returns.

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