Financial Statement Analysis: A Practitioner’s Guide is a well-organized, thorough exploration of the challenges facing practitioners who rely on financial statements to make investment and lending decisions. In the preface, Martin Fridson and Fernando Alvarez state that their “intention is to acquaint readers who have already acquired basic accounting skills with the complications that arise in applying textbook-derived knowledge to the real world.”
Throughout the book, Fridson and Alvarez make a persuasive case that in the “real world,” accepting financial reporting at face value is both naive and dangerous and that the best analysis requires “the relentless pursuit of accurate financial profiles of the entities being analyzed.”
The book is divided into four parts: (1) “Reading between the Lines,” (2) “The Basic Financial Statements,” (3) “A Closer Look at Profits,” and (4) “Forecasts and Security Analysis.” The first three parts focus on the limitations of financial statements, and the fourth is a survey of techniques for use in forecasting and analyzing.
The authors establish the focus of the book in Chapter 1, appropriately titled “The Adversarial Nature of Financial Reporting,” wherein they challenge the classic textbook view that the goal of financial reporting is to measure accurately the profitability and financial condition of a company. On the contrary, they argue,
the purpose of financial reporting is to obtain cheap capital…Simply stated, the lower the interest rate at which a corporation can borrow or the higher the price at which it can sell stock to new investors, the greater the wealth of its shareholders. From this standpoint, the best kind of financial statement is not one that represents the corporation’s condition most fully and most fairly, but rather one that produces the highest possible credit rating and price–earnings multiple. If the highest ratings and multiples result from statements that measure profitability and financial condition inaccurately, the logic of fiduciary duty to shareholders obliges management to publish that sort, rather than the type held up as a model in accounting textbooks.
It is a sober assessment of the profession; throughout the remainder of the book, Fridson and Alvarez repeatedly demonstrate that financial statements often conceal as much information as they reveal. And to complicate matters, the authors show that much of what transpires in the industry is perfectly legal, even when it seems that it should not be.
In Chapter 8, “The Income Statement” (in Part 2), the authors provide additional evidence that financial reporting cannot be taken at face value and that manipulation of the income statement is a routine practice. Companies regularly designate expenses as “extraordinary, nonrecurring, or unusual” to give the impression that they are one-time events that should not be part of future net income projections:
A search of the Capital IQ database revealed that 487 of the companies represented in the Standard & Poor’s 500 Index reported unusual items in at least half of the years from 2002 to 2009. Nearly half (230) recorded unusual items in all eight years of that span.
Obviously, items that recur annually, or even biannually, are not extraordinary, nonrecurring, or unusual. Analysts need to be aware of these situations and be prepared to distinguish between truly one-time events and those that are merely designated as such by the statement issuer.
In Chapter 9, “The Reliability of Disclosure and Audits” (in Part 3), the authors explain the challenges inherent in our current auditing system. In theory, publicly traded companies are required to hire highly trained auditors to validate their financial statements annually. This requirement is supposed to assure investors that the statements have been prepared in compliance with generally accepted accounting principles.
In practice, however, “a tension necessarily exists between standards of professional excellence (which, it must be acknowledged, matter a great deal to most accountants) and fear of the consequences of losing a client.” Auditors, after all, are paid by the company issuing the statements, and they can push only so far without losing business.
Taking a harder line may not produce fuller disclosure for investors but merely mean sacrificing the auditing contract to another firm with a more accommodating policy. Given the observed gap between theory and practice in financial reporting, users of financial statements must provide themselves with an additional layer of protection through tough scrutiny of the numbers.
Part 4, “Forecasts and Security Analysis,” is a little different from the first three. It provides a broad survey of techniques for use in forecasting and analyzing, as well as a discussion of the limitations of each. Fridson and Alvarez recognize that these are the most important functions of an analyst’s job, but they also acknowledge that predicting the future is irreducibly challenging. For example, in the conclusion of Chapter 13, “Credit Analysis,” they write, “In the end, credit analysts must equip themselves with all the tools described in this chapter yet not be made complacent by them.”
One final point to make about Financial Statement Analysis is that it is surprisingly entertaining, particularly considering the genre. Reference books about accounting, while valuable for their insights, are seldom this enjoyable to read. This book is different because the authors seamlessly integrate fascinating real-life examples and instructive fictional scenarios into each chapter to illustrate their points. Although mostly unrelated, the series of stories draws the reader in, creating a unique literary experience that is part detective novel, part finance textbook.
My only reservation about recommending this book is that sophisticated security analysts may find it too elementary. Although I am a CFA charterholder, my background is not in accounting or financial statement analysis, and so I found the book to be a veritable treasure trove of interesting insights. A seasoned analyst, however, will undoubtedly be more familiar with the issues the authors discuss and thus may not find the book quite as valuable. But for anyone with a passing interest in the subject, or for new analysts still learning the trade, Financial Statement Analysis is an amazing resource.