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Don’t Trust Financial Statements

The most basic skill in picking stocks is the ability to read financial statements. From an income statement, balance sheet, and cash flow statement, a skilled reader can supposedly glean all sorts of valuable/actionable information.

As someone whose career and educational background is in accounting, I’ve spent my share of time creating and reading financial statements. What many non-accountants seem to miss is that most of the information included in them is extremely imprecise.

The reason behind this lack of precision is that, as I once heard the Controller of a Fortune 500 company say, “accounting figures are estimates, based upon estimates, based upon questionable assumptions.” (Depreciation and amortization expense are two prime examples.)

To give you an idea of where financial statements stand, I prepared this handy Guide to Accuracy & Precision:

DataAccuracySpectrumThe general rule of thumb is that line items on financial statements cannot be trusted beyond their first significant digit. (And I’ve seen more cases than I care to count in which I’d argue that even that was a stretch.)

Now, does all this mean that financial statements are completely worthless? No, not completely. But before you go betting your life savings on a stock, at least be aware of the quality of information you’re dealing with.

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Comments

  1. Hrm… didn’t nasa mess up units a few times =)?

  2. SJ: That’s why it isn’t all the way at the right. 🙂

  3. I certainly agree that there is much more to picking stocks effectively than reading financial statements.

    People often point to Buffett as the world’s greatest stock picker. Buffett certainly reads financial statements. But he also certainly does not stop there. Reading financial statements is perhaps one-third of what is involved in picking stocks effectively, in my assessment.

    Rob

  4. Hmmmmmmm, I would think an accountant like yourself might want to discuss “materiality” before discounting financial statements so heavily (I’m a CPA and have been enjoying your blog for a few months now).

    I think the general public needs to understand that financial statements are not 100% accurate, but they also do not propose to be.

    I know your post makes for interesting reading, but I wouldn’t sensationalize G.A.A.P. just for the sake of a good post . . .

  5. Hi Alex.

    Honestly, I don’t believe I’m sensationalizing GAAP. (Though clearly the diagram was intended to be tongue-in-cheek.) To me, the issues that arise as a result of differences in accounting methods cannot always be discounted as immaterial.

    In my opinion (which you’re welcome to disagree with) the flexibility within GAAP makes the comparative value of financial statements between two companies to be practically nil. Even if we consider two companies within the same industry, it’s almost certain that there will be significant differences in accounting methods. I’ve heard some people make the case that the differences are likely to cancel out in the aggregate. But isn’t it just as possible that, when aggregated, the differences become even larger?

    I think your statement that “The general public needs to understand that financial statements are not 100% accurate, but they also do not propose to be.” is really the heart of the matter. While people involved in the creation of financial statements understand that they’re not 100% precise, I suspect many would-be investors aren’t aware of that fact.

  6. Regarding NASA, their calculations might have been precise, but they still included something like eight independent computer systems in some of their spacecraft, which as I understand it ‘vote’ to decide when to do.

    Be interesting if companies had to include two independently produced profit and loss statements! 😉

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