Preface to Fifth Edition

This fifth edition of Financial Statement Analysis, like its predecessors, seeks to equip its readers for the practical challenges of contemporary business. Once again, the 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 of extending credit and investing in securities. Just as a swiftly changing environment necessitated extensive revisions and additions in the second through fourth editions, new concerns and challenges for users of financial statements have emerged as the third decade of the twenty-first century unfolds.

A fundamental change reflected in the third edition was the shift of corporations' executive compensation plans from a focus on reported earnings toward enhancing shareholder value. Stock options became a major component of corporate leaders' pay. In theory, this new approach aligned the interests of management and shareholders, but the concept had a dark side. Chief executive officers who were under growing pressure to boost their corporations' share prices could no longer increase their bonuses by goosing reported earnings through financial reporting tricks that were transparent to the stock market. Instead, they had to devise more opaque methods that gulled investors into believing that the reported earnings gains were real.

To adapt to the new environment, corporate managers became far more aggressive in misrepresenting their performance. They moved beyond exaggeration to outright fabrication of earnings through the use of derivatives and special purpose vehicles that never showed up in financial statements and had little to do with the production and sale of goods and services. This insidious trend culminated in colossal accounting scandals involving companies such as Enron and WorldCom, which shook confidence not only in financial reporting but also in the securities markets.

Government responded to the outrage over financial frauds by enacting the Sarbanes-Oxley Act of 2002. Under its provisions, a company's chief executive officer and chief financial officer were required to attest to the integrity of the financial statements. They were thereby exposed to greater risk than formerly of prosecution and conviction for misrepresentation. Prior to enactment of this legislation, it was not unheard of for a CEO who stood to profit massively from share price appreciation to escape prosecution by implausibly disavowing knowledge of the fraud and shifting the consequences to an underling whose compensation was not tied in any way to the company's stock price.

Sarbanes-Oxley has had a profound effect. True, the fourth edition of Financial Statement Analysis examined several major financial reporting frauds that came to light later than 2002. Upon close examination, however, those scams turned out to have originated prior to Sarbanes-Oxley's passage, but exposed sometime later. By the 2010s, outright, large-scale financial reporting fraud was rare in the U.S. Compiling this new edition was not hampered, however, by any shortage of case studies involving accounting that deceived investors without breaking the law. In addition, flat-out financial reporting fraud continued to flourish outside the U.S.

Curiously, there have been cases since the enactment of Sarbanes-Oxley in which corporate executives have gone to prison for faking the financials, yet the CEO managed to escape prosecution. This is an outcome that Congress clearly sought to prevent. Financial writer Alison Frankel explained the snag in a July 27, 2012, Reuters article entitled, "Sarbanes-Oxley's Lost Promise: Why CEOs Haven't Been Prosecuted."

According to the legislation, a top corporate executive who knowingly signs off on a false financial report is subject to a 10-year prison term and a fine of up to $1 million. The penalties rise to 20 years and $5 million if the misconduct is willful. In practice, few executives were convicted or even charged with false certification in the first decade after passage of Sarbanes-Oxley.

Federal prosecutors attributed this to the fact that most major corporations responded to the new law by instituting multiple layers of subcertification. They required lower-level officials to affirm the financial statements' accuracy. The subcertifications insulated CEOs and CFOs from charges of false certification, making it difficult to impossible for prosecutors to prove that they signed financial reports they knew to be false.

Frankel noted that the subcertification process has forced corporations to be more vigilant at all levels about financial reporting. That likely accounted for the paucity of major accounting scandals subsequent to 2002. In short, Sarbanes-Oxley has succeeded in deterring untruthful reporting that rises to the level of a felony. As case studies presented in this fifth edition of Financial Statement Analysis demonstrate, however, legal subterfuges continue to expose investors and creditors to highly unpleasant surprises. Sometimes, too, corporate executives still cross the line into criminality. Therefore, users of financial statements still cannot breathe easy.

In a somewhat more favorable development, corporations' passion for granting stock options to senior managers cooled somewhat after the Financial Accounting Standards Board instituted FAS 123R, a 2006 financial accounting standard introduced by the Financial Accounting Standards Board (FASB) requiring annual expensing of equity-based employee compensation amounts. The result was some shift from stock option to restricted stock units (RSUs). Unlike options, which can lose all their value if the company's stock price falls, RSUs retain part of their value if that happens. Emphasizing RSUs rather than options somewhat reduces management's incentive to raise the share price by artificial means.

To help readers avoid being misled by deceptive financial statements, we continue to prescribe a combination of solid understanding of accounting principles with a corporate finance perspective. We facilitate such integration of disciplines throughout the book, making excursions into economics and business management as well. In addition, we encourage analysts to consider the institutional context in which financial reporting occurs. Organizational pressures result in divergences from elegant theories, both in the conduct of financial statement analysis and in auditors' interpretations of accounting principles. The issuers of financial statements also exert a strong influence over the creation of the accounting principles, with powerful politicians sometimes carrying their water.

As in previous editions, we highlight success stories in the critical examination of financial statements. Wherever we can find the necessary documentation, we show not only how a corporate debacle could have been foreseen through application of basis analytical techniques but also how practicing analysts actually did detect the problem before it became widely recognized. Readers will be encouraged by these examples, we hope, to undertake genuine, goal-oriented analysis, instead of simply going through the motions of calculating standard financial ratios. Moreover, the case studies should persuade them to stick to their guns when they spot trouble, despite management's predictable litany. ("Our financial statements are consistent with generally accepted accounting principles. They have been certified by one of the world's premier auditing firms. We will not allow a band of greedy short sellers to destroy the value created by our outstanding employees.") Typically, as the vehemence of management's protests increases, conditions deteriorate further, culminating in revelations that suddenly wipe out substantial shareholder value.

As for the plan of Financial Statement Analysis, readers should not feel compelled to tackle its chapters in the order we have assigned to them. To aid those who want to jump in somewhere in the middle of the book, we provide cross-referencing and a glossary. Words that are defined in the glossary are shown in bold-faced type in the text. Although skipping around will be the most efficient approach for many readers, a logical flow does underlie the sequencing of the material.

In Part One, "Reading Between the Lines," we show that financial statements do not simply represent unbiased portraits of corporations' financial performance and explain why. The section explores the complex motivations of issuing firms and their managers. We also study the distortions produced by the organizational context in which the analyst operates.

Part Two, "The Basic Financial Statements," takes a hard look at the information disclosed in the balance sheet, income statement, and statement of cash flows. Under close scrutiny, terms such as value and income begin to look muddier than they appear when considered in the abstract. Even cash flow, a concept commonly thought to convey redemptive clarification, is vulnerable to stratagems designed to manipulate the perceptions of investors and creditors.

In Part Three, "A Closer Look at Profits," we zero in on the lifeblood of the capitalist system. Our scrutiny of profits highlights the manifold ways in which earnings are exaggerated or even fabricated. By this point in the book, the reader should be amply imbued with the healthy skepticism necessary for a sound, structured...