Evaluating Balance Sheet Quality

High quality financial balance sheet reporting is evidenced by completeness, unbiased measurement, and clarity of presentation.

Completeness

Completeness of a balance sheet is compromised by the existence of off balance sheet liabilities such as purchase agreements structured as take or pay contracts. Analysts should restate the reported balance sheet by recording purchase contract obligations, if significant.

In the case of intercorporate investments, the equity method of accounting allows one line consolidation for investments in associates. The equity method of accounting would result in certain profitability ratios (e.g., net profit margin, return on assets) being higher than under the acquisition method. Firms consolidating several subsidiaries with close to a 50% ownership stake by using the equity method would be a cause for concern.

Unbiased Measurement

The balance sheet reflects subjectivity in the measurement of several assets and liabilities:

Value of the pension liability (based on several actuarial assumptions). Value of investment in debt or equity of other companies for which a market value is not readily available. Goodwill value (subjectivity in impairment testing).

Inventory valuation (subjectivity in testing for impairment). Impairment of PP&E and other assets.

Overstatement of asset values (i.e., not recognizing adequate impairment losses) overstates profitability and equity.

Clear Presentation

While accounting standards specify which items should be included in the balance sheet, they do not typically specify how such items must be presented. Companies have discretion regarding which items they present as a single line item versus those that are grouped together. Clarity of presentation allows an analyst to gather relevant information as well as to make comparisons across companies.

Clarity should be evaluated in conjunction with information found in the notes to financial statements and supplementary disclosures.

Evaluating the financial, operating, and other risks that a business is exposed to is an important part of analyst’s job. There are several sources of information about such risks:

Financial statements. Financial statements contain information regarding the leverage used by the company and the variability of cash flows and earnings over time. Quantitative models (e.g., Altman’s Z score) often rely on this accounting information. Auditor’s report. Because an audit report provides only historical information, such a report’s usefulness as an information source is limited.

However, involuntary changes in auditors, a small sized audit firm relative to the size of the company being audited, and a lack of auditor independence are red flags that an analyst should pay special attention to. Notes to financial statements. Companies are required to make certain risk related disclosures in the notes to financial statements. Both GAAP and IFRS require companies to disclose risks related to pension benefits, contingent obligations, and financial instruments.

Disclosures about contingent liabilities include a description of the liability, as well as estimated amounts and timing of the payments. Disclosures about pension benefits include information about actuarial assumptions. Disclosures about financial instruments include information about credit risk, liquidity risk and market risk.

Management Discussion and Analysis (MD&A). Ideally, companies should include principal risks that are unique to the business (as opposed to risks faced by most businesses) in their MD&A. However, discussion of generic risks and “boiler plate” language often makes this information of low utility.

SEC Form ‘NT’. In the United States, SEC form ‘NT’ is filed when a firm is unable to file required reports in a timely manner. Because such an occurrence is usually due to a breakdown in accounting systems or internal controls, or the discovery of misrepresentation that needs to be investigated, such filings typically signal problems in reporting quality.

Financial press. Often the initial information about accounting irregularities at a company is obtained from the financial press. Analysts should do their own due diligence to ensure that the information revealed has merit and to ascertain the magnitude of the irregularity and its impact on valuation.

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