Chapter 1
Introduction
By means of this he can at any time survey the general whole, without needing to perplex himself in the details. What advantages does he derive from the system of book-keeping by double entry! It is among the finest inventions of the human mind.
Johann Wolfgang von Goethe
Accounting is the language of businesses. Those who wish to value companies and invest successfully in the long term have to be able to understand and interpret financial statements. The primary purpose of accounting is to quantify operational processes and to present them to stakeholders including shareholders and creditors but also suppliers, employees and the financial community. The financial statement forms a condensed representation of these processes. It delineates the assets and liabilities as well as performance indicators such as turnover, profit and cash flow. Evaluating and interpreting this data against the background of business activity is an important component of the valuation process. Developing an understanding of this âlanguage of businessesâ and, at the same time, including qualitative factors in the analysis provides a solid foundation for anyone interested in valuing enterprises. Accountancy illustrates, in one snapshot, the corporate world in the past and the present. Company valuation joins in at this point and attempts to predict the future development and the risks of an enterprise with the help of data obtained from the financial statement. This chapter addresses the weaknesses and limits of modern accounting. A particular disadvantage of accountancy is that it is by nature a purely quantitative model. A sound financial statement analysis, meanwhile, while being quantitative by design, requires the combination of both quantitative facts and qualitative characteristics in order to be a reliable forecast of the future.
This chapter deals primarily with different types of accounting systems, the components of financial statements and the calculation of a first set of key financial ratios. Chapter 2 lays the foundation for further ratio-based analysis, and also for the following qualitative analyses, which are at least oriented towards the financial statement.
1.1 IMPORTANCE AND DEVELOPMENT OF BUSINESS ACCOUNTANCY
The precursors of todayâs accounting rules came into being after the stock market crash of 1929, when the American Institute of Accountantsâ special committee first proposed a list of generally applicable accounting principles. By 1939, the first Committee on Accounting Procedure was created in the US in order to establish a coherent and reliable system of accounting standards. This set of rules was meant to tackle the rather dubious and unreliable accounting procedures and helped to restore the trust in financial statements published by listed companies. Now the Financial Accounting Standards Board (FASB) prescribes the main accounting standards in the United States. This set of rules, the US Generally Accepted Accounting Principles, or US GAAP for short, governs the accounting principles for all companies subject to Securities and Exchange Commission (SEC) regulation.
On the other side of the Atlantic, beginning in 1973, the European Union began harmonizing the diverse accounting rules of its member countries. This process eventually culminated in the creation of the International Financial Reporting Standards. The IFRS have so far been adopted by more than 100 countries, including all the members of the European Union, Hong Kong, Australia, Russia, Brazil and Canada. Whilst there are several differences between the US GAAP and IFRS, both accounting systems are based on a similar set of principles and are, by and large, comparable. Following the previously mentioned international harmonization of accounting standards around the globe, a key future milestone is the planned full adoption of the International Financial Reporting Standards by the SEC. This adoption, when it occurs, will also require US companies to employ the IFRS, which will effectively unify the accounting standards in most developed countries. This process, which was initially aimed to be completed by 2014 but might require more time, will allow investors to directly compare financial figures and ratios between European and American companies without having to adjust them for diverging accounting treatments.
Given the fact that large-scale regulatory projects such as the US GAAP/IFRS convergence are rarely implemented on schedule, this book covers both accounting standards, presenting case studies of companies using the US GAAP as well as IFRS. The book focuses primarily on US-based and British corporations but also considers emerging market companies. This approach is simply a recognition that the vast majority of investors will have access to equity markets around the world.
Whilst the accounting systems in the US and Europe are by and large comparable, the outward appearance of the annual reports is not. Whereas there are virtually no restrictions as to the presentation and quantity of information contained in European annual reports and financial statements, US companies have to complete a predefined form (commonly called form 10-K) which must be fled with the SEC. The latter leaves little room for supplementary charts and data, which may often provide further information about the market and business model of the company. The standardized presentation and submission requirements can be mainly attributed to the US accounting scandals and frauds in the late 1990s which resulted in the passage of the Sarbanes-Oxley Act. As a result of this legislation, financial statements of listed corporations are more or less standardized, and have to be signed by management and fled with the SEC. From an investorâs point of view, this offers both benefits and drawbacks. On the one hand, US-style annual reports (10-K) are well structured and clearly laid out once the reader gets used to the numerous legal phrases peppering the reports. Information about the market or additional industry data, however, is only rarely contained within these reports. In contrast, European annual reports not only supply their recipients with the essential annual accounts, but also include additional data intended to deepen an understanding of the company. It can, however, be argued that forming a true opinion of a companyâs performance and prospects is more likely in the case of a US-style annual report, as the additional information and graphs that can be included in European-style reports have at least the potential of being suggestive. Given the laxer rules, European annual reports also exhibit a considerably lower degree of comparability than their US counterparts. US annual (10-K) and quarterly reports (10-Q) can also be easily accessed via the SEC web page, whereas the reports of European companies can only be obtained directly from their respective investor relations websites. Having said this, it must be mentioned that the SECâs EDGAR system to access 10-K and 10-Q fling isnât the most user-friendly. Retrieving company reports may sometimes be faster by simply searching for the term âcompany name + Investor Relationsâ in a search engine.
Listed companies usually publish interim reports on a quarterly basis as well as a more detailed and extensive annual report at the end of each fiscal year. Smaller companies, whose stock is traded in less regulated markets, often face less rigorous reporting obligations. In this case issuers are commonly able to r...