Accounting systems take the cash and accruals from various transactions and generate financial reports and statements. Information flows through an accounting system in four steps:
1. The first step is to create journal entries and adjusting entries. The general journal is list of each transaction, the amount, and the accounts affected in chronological order. At the end of accounting periods adjustments are made to record accruals not yet made.
2. The general ledger show the journal entries sorted by the accounts affected rather than in chronological order. This can be useful for reviewing the activity in a specific account.
3. At the end of the accounting period an initial trial balance is prepared lists the ending balance of each account on a given date. If needed, adjusting entries are recorded in an adjusted trial balance.
4. The financial statements are prepared as a final product of the system, based on the totals from an adjusted trial balance.
In conducting security analysis, an analyst cannot solely rely on the financial statements. Financial reporting is affected by the choice of accounting methods, and the estimates that management uses to determine the value of assets. In order to get a good understanding of the earnings potential of a business, an analyst must understand the accounting process used to produce the financial statements to better understand the business and the results for the period.
Since much of the detail information on management's accruals, adjustments and estimates is contained in the footnotes to the statements and Management's Discussion and Analysis, it is imperative that the analyst review these sections of the financial statements. Using this information an analyst should determine:
- The various accruals, adjustments and assumptions that went into the financial statements.
- The detailed information that underlies the company's accounting system.
- How well the financial statements reflect the company's true performance.
- How the data needs to be adjusted for the analyst's own analysis
Because adjustments and assumptions are at the discretion of management, analysts should always be on the lookout for possible financial statement manipulation and any situation that might incent management to falsify or misrepresent the actual operations of the firm
Income Statement Basics
InvestingAn accounting cycle consists of the traditional procedures performed to record business events and transactions in a company’s accounting records.
InvestingDiscover how to keep score of companies to increase your chances of choosing a winner.
InvestingFinancial statements are a picture of a company’s financial health for a given period of time at a given point in time. The statements provide a collection of data about a company’s financial ...
InvestingFinancial statement analysis is the process of reviewing a company’s statements to gain an understanding of its financial health.
InvestingCash flow from operating activities is a section of the Statement of Cash Flows that is included in a company’s financial statements after the balance sheet and income statements.
InvestingIn accrual-based accounting, transactions are recorded on the books as they occur, even if payment has not yet been received or made. Accruals represent liabilities and non-cash-based assets. ...
Financial AdvisorFinancial accounting is the process of gathering, recording, summarizing and reporting financial data relating to a business. The ultimate goal is to accurately report the financial picture and ...
MarketsAccounting is the recording of financial transactions of a business or organization. It also includes the process of summarizing, analyzing and reporting these transactions in financial statements.
Managing WealthDiscover what the job description of an accountant entails, along with education and training, salary and skills necessary for success.
RetirementLearn how to trace where your tax dollars and charitable donations are going.