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
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