Investors Urged to Examine Complete Financial Picture
When Reading Financial Statements, Look for Footnotes
BY PHILLIP L. JELSMA
Special to the Business Journal
The recent, very public and contentious death of Enron and Global Crossing focused media attention on audited financial statements and the role of independent certified public accountancy firms.
Many people believe that the problems and irregularities revealed with the “autopsy” of Enron ultimately were inevitable, given the increased emphasis by the Big Five accounting firms on profitability via the sale of products and non-accountancy services. Regardless, the Enron and Global Crossing debacles are good reminders that financial statements are limited tools; they provide some information, but not a complete picture of the financial health of an enterprise.
It is vital for the well-informed investor to recognize what financial statements show , and do not show , about a business enterprise.
Financial statements are prepared on a historical cost basis and thus do not reflect the fair market value or marketability of any asset of a corporation. As an example, an accounting professor once commented that the land owned by the Irvine Co. in south Orange County was shown at 14 cents an acre, which was the original purchase price paid by James Irvine and his partners in 1864 for the original 122,000 acres of the Irvine Ranch. Today we know the 93,000-acre Irvine Ranch, which is nearly 25 percent of the land in Orange County, is worth billions of dollars , but not on the historical cost basis!
Certified financial statements are prepared using generally accepted accounting principles or “GAAP.” Because the GAAP method does not deal clearly with some difficult issues such as off-balance sheet financing, ambiguities and subjective interpretations are bound to arise at some point in time.
– Footnotes Reveal Hidden Information
Another professor cautioned that if you read nothing else in a financial statement, be sure to read the footnotes since “that’s where all the action is.” Certain items are required to be disclosed in footnotes, including contingencies and possible future events that may impact the company.
You should find in the footnotes to financial statements insight into management’s approach to issues and problems that may not be reflected in the financial statements themselves. As some commentators have observed, if financial analysts had understood the disclosures with respect to liabilities of Enron’s off-balance sheet partnerships, Enron’s problems could have been detected much sooner.
Reviews of financial statements for privately held companies require emphasis on different issues. Generally, independent CPA firms audit the most extensive and complete financial statements.
The first important consideration is the level of review. Have the financial statements been audited, reviewed, compiled or, perhaps, has the auditor used some agreed-upon procedure?
Also, there are standards for different audit opinions within certified financial statements. An unqualified or “clear” opinion generally provides that the financial statements present fairly the financial condition of the company in accordance with GAAP. The qualified opinion is normally given if there is a scope limitation or departure from GAAP.
Adverse opinions reflect the auditor’s opinion that the financial statements do not present fairly the financial position of the company.
– Make Inquiries
Finally, don’t expect to find disclosed in a financial statement everything you need to make an informed investment decision. Among the information you may not necessarily find disclosed is that on business prospects, future and strategic plans of the company.
Thus, readers of financial statements should feel free to make inquiries to both the company and its outside auditors with respect to documents and as a means of determining whether the company and/or its auditors are strictly adhering to GAAP or rely on some reasonable interpretation of the accounting literature where opinions may vary.
In fact, you should not only feel free to make such inquiries, if you are considering an investment you might feel duty-bound to make them. Success or failure is driven in large part by management and the people working for a particular business , and financial statements neither determine nor analyze this most crucial component of an enterprise.
In the aftermath of Enron and Global Crossing, we all are well advised to think of audited financial statements as merely a snapshot: It is a diagnostic tool which tells you about the historic performance of a business, but should not be used as a substitute for due diligence and an independent evaluation of a company and its business prospects.
Jelsma is a partner in the business, public finance and taxation practice groups of Luce, Forward, Hamilton & Scripps LLP in the Carmel Valley/Del Mar office.
