Analyzing Your Financial Accounting System

Financial accounting (FA) caters to the needs of business owners (shareholders). The fundamental objective of FA is to supply the latter with structured financial knowledge about the company in question so that can make informed investment decisions. This knowledge is structured in standard financial reports (financial statements) that I will cover in more detail a little bit later.

For prospective investors evaluating a potential investment opportunity (‘investment target’) this decision is (a) whether to invest or not and (2) how much to invest. In case of private equity investment where price of company shares is negotiable, analysis of corporate financial statements (which is the subject of the whole chapter on Financial KPI) helps to determine the optimal acquisition price.   

For corporate shareholders who already own shares in the company in question, these decisions depend on whether the investor is of passive or active variety. For a passive investor it is the proverbial buy/sell/hold choice while an active investor – if not satisfied with financial performance of his holding – might want to take action. For example, replace the management team. It happens.

Also, in corporate governance system (discussed above), decisions on certain strategic issues must be approved (or even made) by its shareholders (or their representatives on the Board of Directors). And financial statements come very handy in helping to evaluate alternative and to make the best decision. In terms of financial value, of course.

Your financial accounting system (FAS) captures financial data from financial transactions in your company and places is into accounts of your general ledger – the core of your financial accounting database. And of your whole financial knowledge management system – the most important component of your corporate KMS. After all, your financial value is ‘the first among the equals’.

From these accounts FAS then generates (on a periodic basis – annual, semiannual, quarterly or even monthly) four key financial statements – balance sheet, income statement (or profit-and-loss statement – P&L), statement of retained earnings (usually combined with income statement) and statement of cash flows in direct or indirect form. Financial valuation models typically use the latter as the more convenient for this purpose.

Investors (both prospective and actual shareholders) then analyze these statements and – based on conclusions they draw from this analysis – make their investment decisions. I will cover in more detail the process of analyzing financial statements in Financial KPI section of this guide.  

In reality, investors need (and use) a whole lot more information than is contained in these four statements. For starters, they study and analyze footnotes to your financial statements (often called ‘the fifth financial statement’). Footnotes contain ‘unstructured’ (textual) information that can not be captured by your FAS but is still considered by company management and investors to have a substantial (‘material’) effect on corporate financial performance. And, therefore, needs to be considered and analyzed by shareholders and potential investors.

Footnotes typically cover the following important areas:

·         Financial accounting policies that are most important to the portrayal of the company’s financial condition and results (more on that later);

·         Current and deferred corporate income taxes, broken down by level – federal, state, local and (if applicable) foreign, plus the main items that affect the company’s effective tax rate are.

·         Pension plans and other retirement programs (e.g. post-employment benefit programs). The notes contain specific information about the assets, costs and liabilities associated with these programs.

·         Corporate stock options granted to managers and employees, including the method of accounting for stock-based compensation and its effect corporate financial performance

If investors are dealing with the public company, they carefully study corporate annual report, especially its MD&A section. MD&A stands for Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Essentially, MD&A reflects company management’s view of the financial performance and condition of the company. It is used by management to tell current and prospective investors what the financial statements show and do not show, as well as to identify important trends and risks that have shaped the company past or are reasonably likely to shape its future.

The SEC’s rules governing MD&A require disclosure about trends, events or uncertainties known to management that would have a material impact on reported financial information. The purpose of MD&A is to provide investors with information that the company’s management believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations.

It is intended to help investors to see the company through the eyes of its management. It is also intended to provide context for the financial statements and information about the company’s earnings and cash flows.

Prospective investors in public companies carefully study and analyze information (or investment) memorandum usually developed by an investment bank – a financial advisor of the company seeking private equity investment.

True, financial statements form the core of this memorandum (which contains essentially well-structured and detailed comments and explanations for various items on these statements), but these typically run for dozens (sometimes even hundreds) of pages.

Even in its financial section, memorandum contains additional statements (tables) that transform corporate financial statements into a comprehensive financial valuation model. These include tables for computing important financial KPI (covered in the appropriate section of this guide) – NOPLAT, ROIC, WACC, economic profit and financial value proper.

Even that usually is not enough, because prospective investors – after analyzing information memorandum - almost always perform so-called due diligence of a potential investment target. Which is essentially the same comprehensive business analysis as covered in this guide, but with a more limited depth and scope.

There are two primary reasons why your (or any other company, for that matter), needs financial accounting standards. First, all information systems work according to GIGO principle. Garbage in, garbage out. Including your financial information and knowledge management system.

Hence, this system is only as good as the raw data that gets into this system. Data supplied by your corporate financial accounting system. Therefore, you need some reasonable assurances that this data is, indeed, reliable and relevant. These assurances are provided by detailed accounting standards.

Second, your investors always have a choice where to invest. Which corporate shares to purchase. Therefore, investors need means to compare financial statements of different companies. And to make such comparison meaningful, financial statements of all companies must be prepared according to the same accounting standards.

These standards cover methods, rules and procedures for (a) identifying and recording financial transactions thus entering raw financial data into your financial knowledge base; (2) structuring this data into the system of accounts in your general ledger and (3) developing financial statements based on information in general ledger accounts. Obviously, the number and general structure of corporate financial statements are also covered by financial accounting standards.

There are two systems of accounting standards used in the business world today. The first are Generally Accepted Accounted Principles (GAAP) developed by Federal Accounting Standards Board (FASB) and used in the USA and Canada. The second are called International Financial Reporting Standards (IFRS) developed by IFRS Foundation and used pretty much everywhere else (in over 110 countries, in fact).

What’s the difference? Well, their fundamental as their accounting frameworks are similar in many respects. Which can be expected, of course. However, there is a substantial conceptual difference. IFRS is considered more of a "principles based" accounting standard in contrast to U.S. GAAP which is considered more "rules based". By being more "principles based", IFRS, is believed to represent and capture the economics of a transaction better than U.S. GAAP.

However, there is no indication that the USA will convert to IFRS any time soon as GAAP perfectly satisfies its key stakeholder – the U.S. investment community. And it is all that matters. Therefore, which one you will use is determined primarily by your country of residence.

Analysis or your accounting system is typically outsourced to professionals – companies that specialize in financial audit – which become your partners in conducting a CBA. However, it is still important to get an overview of what must be analyzed (including the appropriate questions to be asked).

Why? Because purely financial audit (or, more precisely financial statements audit) has a very limited scope compared to the financial – and even accounting – component of CBA – a comprehensive business (or corporate) audit.

Professional auditors (Certified Public Accountants and the like) perform an unbiased examination and evaluation of the financial statements of a business entity. Specifically, the auditor expresses an opinion on the fairness with which the corporate financial statements presents the financial position, results of operations, and cash flows of a business entity; in accordance with GAAP/IFRS and "in all material respects". An auditor is also required to identify circumstances in which GAAP/IFRS has not been consistently observed.

Unfortunately, this is not enough to complete the accounting section of a comprehensive business analysis.

To make sure that your company maximizes its performance in this functional area, you must make sure not only that its accounting system conforms to GAAP/IFRS (which is not even required of private companies) but supplies your investors with the most accurate financial information.

Unfortunately – even after decades of FASB efforts - this is not always so under GAAP. In some cases the situation is so bad that some investors and corporate managers have metamorphosed GAAP into BAAP – Barely Acceptable Accounting Principles. In these cases, in order to satisfy informational needs of your investors, you must intentionally deviate from GAAP (or IFRS, for that matter).

Therefore, you must make sure that your financial accounting methodology and the business process (which obviously must be highly efficient) do supply your corporate knowledge base with the ‘good’ financial data.

Which also requires highly competent corporate accountants and auditors (even private companies must be audited on at least an annual basis to make sure that their FAS, indeed, to their jobs). Who use highly efficient accounting tools and have access to comprehensive, well-structured, accurate and up-to-date description of your FAS. Which must be tightly integrated into your corporate and financial KMS and your overall corporate management system.