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Jack Rivers is an investment analyst for the equity fund of a family office. The head of the family, Charlotte Blackmon, is concerned that management may be manipulating the earnings of some of the companies that the fund invests in. Rivers explains to Blackmon, “Even though we don’t have access to the detailed transactions that underlie the financial statements, we can be sure that management is not manipulating earnings because I read the footnotes to the financial statements of every company we invest in. The footnotes would disclose any deviation from appropriate accounting parameters.” Rivers is:

correct.

B)	incorrect because deviation from appropriate accounting parameters is addressed in the auditor’s report, so a qualified opinion in the auditor’s report ensures that management is not manipulating earnings.

C)	incorrect because even within appropriate accounting parameters, management can manipulate earnings through the assumptions that rely on their discretion.

Because adjustments and assumptions within the financial statements are to some extent at the discretion of management, the possibility exists that management can try to manipulate or misrepresent the company’s financial performance. A clean auditor’s report does not ensure that management is unable to manipulate earnings, and a qualified opinion expresses reservations about the appropriateness of accounting policies. An analyst doesn’t have access to the detailed information that flows through a company’s accounting system, but only sees its end product, the financial statements.

Sergey Martinenko is an investment analyst with Profis, Martinenko and Verona. He is explaining to his new assistant, John Stevenson, why it is crucial for an investment analyst to read the footnotes to a firm’s financial statement and the Management Discussion and Analysis (MD&A) before making an investment decision. Which rationale is Martinenko least likely to provide to Stevenson regarding the importance of analyzing the footnotes and MD&A?

A)	Accruals, adjustments and assumptions are often explained in the footnotes and MD&A.

B)	The footnotes disclose whether or not the company is adhering to GAAP.

C)	Evaluating the footnotes helps the analyst assess whether management is manipulating earnings.

Various accruals, adjustments, and management assumptions that went into the financial statements are often explained in the footnotes to the statements and in Management’s Discussion and Analysis. Because adjustments and assumptions within the financial statements are to some extent at the discretion of management, the possibility exists that management can try to manipulate or misrepresent the company’s financial performance. With this information, the analyst can better judge how well the financial statements reflect the company’s true performance, and in what ways he needs to adjust the data for his own analysis. Whether or not the company is adhering to GAAP is addressed in the auditor’s opinion, not the footnotes.

Reading the footnotes to a company’s financial statements and the Management Discussion & Analysis is least likely to help an analyst determine:

A)	the various accruals, adjustments and assumptions that went into the financial statements.

B)	how well the financial statements reflect the company’s true performance.

C)	the detailed information that underlies the company’s accounting system.

An analyst doesn’t have access to the detailed information that flows through a company’s accounting system, but only sees its end product, the financial statements. The analyst needs to understand the various accruals, adjustments, and management assumptions that went into the financial statements. Much of this is often explained in the footnotes to the statements and in Management’s Discussion and Analysis, which is why it is crucial for an analyst to review these parts of the presentation. With this information, the analyst can better judge how well the financial statements reflect the company’s true performance, and in what ways he needs to adjust the data for his own analysis.

Regarding the use of financial statements in security analysis and selection, it would be most accurate to say that:

A)	analysts can verify the accuracy of financial statements by using a firm’s detailed accounting system information.

B)	analysts can use footnotes and Management’s Discussion and Analysis to better understand assumptions used in the financial statements.

C)	further analysis of a firm’s financial statements is typically not necessary if the firm has conformed to applicable accounting principles.

Analysts must have a good understanding of a firm’s accounting process and must read the footnotes to the financial statement as well as Management’s Discussion and Analysis to better understand assumptions used in the financial statements. Even if the firm conforms to appropriate accounting principles, there is still room for management discretion. Because analysts do not have access to a firm’s detailed accounting information, they must rely on what they can glean from the footnotes and Management’s Discussion and Analysis.