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reports include:
Quarterly data*
Accruals for
deferred taxes
Consolidation of
parent and majority
owned subsidiaries**
Discretionary or
hidden reserves
Immediate deduction
of research and
development costs†
* In Austria companies issue only annual data. Other countries besides the U.S. and Canada issue semiannual data. In the Netherlands,
companies issue quarterly or semiannual data.
** In Austria, Japan, Hong Kong, and West Germany, the minority of companies fully consolidate.
† In Austria, Hong Kong, Singapore, and Spain, the accounting treatment for R&D costs”whether they are immediately deducted or capitalized
and deducted over later years”isn't disclosed in financial reports.

F I G U R E 13.2
Comparative accounting rules
Source: Center for International Financial Analysis and Research, Princeton, NJ; and Frederick D. S. Choi and Gerhard G. Mueller, International Accounting,
2d. ed. (Englewood Cliffs, NJ: Prentice Hall, 1992).

F I G U R E 13.3
Adjusted versus Australia
reported price“
earnings ratios 12.6 Reported P/E
Source: Lawrence S. Adjusted P/E
Speidell and Vinod
Bavishi, “GAAP Arbitrage: Germany
Valuation Opportunities in
International Accounting
Standards,” Financial Japan
Analysts Journal,
1992, pp. 58“66. Switzerland
Copyright 1992.
Association for Investment
Management and Research. United Kingdom
Reproduced and
republished from Financial
Analysts Journal with 0 10 20 30 40 50 60 70 80
permission from the
Association for Investment
Management and Research.
All Rights Reserved.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

13 Financial Statement Analysis

Such differences in international accounting standards have become more of a problem as
the drive to globally integrate capital markets progresses. For example, many foreign firms
would like to list their shares on the New York Stock Exchange in order to more easily tap the
U.S. equity markets, and the NYSE would like to have those firms listed. But the Securities
and Exchange Commission (SEC) will not allow such shares to be listed unless the firms pre-
pare their financial statements in accordance with U.S. GAAP standards. This has limited the
listing of non-U.S. companies dramatically.
In contrast to the U.S., most large non-U.S. national stock exchanges allow foreign firms
to be listed if their financial statements conform to International Accounting Standards (IAS)
rules. IAS disclosure requirements tend to be far more rigorous than those of most countries,
and they impose greater uniformity in accounting practices. Its advocates argue that IAS rules
are already fairly similar to GAAP rules and provide nearly the same quality financial infor-
mation about the firm. While the SEC does not yet deem IAS standards acceptable for listing
in U.S. markets, negotiations are currently underway to change that situation.
The Enron and other accounting debacles have given U.S. regulators a dose of humility
concerning GAAP standards. While European IAS regulation tends to be principle-based,
GAAP regulation tends to be rules-based. GAAP mandates lengthy, detailed, and specific
rules about the widest range of allowed accounting practices. Critics argue that by doing so, it
gives legal protection to firms that use clever accounting practice to misportray their true
status while still satisfying a legalistic checklist approach to their financial statements. In the
aftermath of Enron, Harvey Pitt, chairman of the SEC, stated his intention to move the U.S.
more in the direction of principle-based standards and to require firms to explain both why
they have chosen their accounting conventions and how their results would be affected by
changes in those accounting assumptions.

No presentation of fundamental security analysis would be complete without a discussion
of the ideas of Benjamin Graham, the greatest of the investment “gurus.” Until the evolution
of modern portfolio theory in the latter half of this century, Graham was the single most

Accounting in Crisis
The headlines in the last quarter of 2001 and the first half of 2002 were dominated by
stories related to the meltdown and bankruptcy of the energy giant Enron. As the story
unfolded, issues related to the accounting industry made the front pages of the financial
press and stories related to Enron were featured on the evening news. The January issue
of BusinessWeek contained a special report entitled “Accounting in Crisis,” which can be
found at http://www.businessweek.com/magazine/content/02_04/b3767712.htm.
After reading the article, identify and briefly describe the seven steps that the article
discussed for reform of the accounting industry.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

478 Part FOUR Security Analysis

important thinker, writer, and teacher in the field of investment analysis. His influence on
investment professionals remains very strong.
Graham™s magnum opus is Security Analysis, written with Columbia Professor David Dodd
in 1934. Its message is similar to the ideas presented in this chapter. Graham believed careful
analysis of a firm™s financial statements could turn up bargain stocks. Over the years, he de-
veloped many different rules for determining the most important financial ratios and the crit-
ical values for judging a stock to be undervalued. Through many editions, his book has had a
profound influence on investment professionals. It has been so influential and successful, in
fact, that widespread adoption of Graham™s techniques has led to elimination of the very bar-
gains they are designed to identify.
In a 1976 seminar Graham said4
I am no longer an advocate of elaborate techniques of security analysis in order to find superior
value opportunities. This was a rewarding activity, say, forty years ago, when our textbook
“Graham and Dodd” was first published; but the situation has changed a good deal since then. In
the old days any well-trained security analyst could do a good professional job of selecting under-
valued issues through detailed studies; but in the light of the enormous amount of research now
being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently
superior selections to justify their cost. To that very limited extent I™m on the side of the “efficient
market” school of thought now generally accepted by the professors.

Nonetheless, in that same seminar, Graham suggested a simplified approach to identify
bargain stocks:
My first, more limited, technique confines itself to the purchase of common stocks at less than
their working-capital value, or net current-asset value, giving no weight to the plant and other
fixed assets, and deducting all liabilities in full from the current assets. We used this approach ex-
tensively in managing investment funds, and over a thirty-odd-year period we must have earned
an average of some 20% per year from this source. For awhile, however, after the mid-1950s, this
brand of buying opportunity became very scarce because of the pervasive bull market. But it has
returned in quantity since the 1973“1974 decline. In January 1976 we counted over 100 such is-
sues in the Standard & Poor™s Stock Guide”about 10% of the total. I consider it a foolproof
method of systematic investment”once again, not on the basis of individual results but in terms
of the expectable group outcome.

There are two convenient sources of information for those interested in trying out the
Graham technique. Both Standard & Poor™s Outlook and The Value Line Investment Survey
carry lists of stocks selling below net working capital value.


• The primary focus of the security analyst should be the firm™s real economic earnings
rather than its reported earnings. Accounting earnings as reported in financial statements
can be a biased estimate of real economic earnings, although empirical studies reveal that
reported earnings convey considerable information concerning a firm™s prospects.
• A firm™s ROE is a key determinant of the growth rate of its earnings. ROE is affected
profoundly by the firm™s degree of financial leverage. An increase in a firm™s debt/equity
ratio will raise its ROE and hence its growth rate only if the interest rate on the debt is less
than the firm™s return on assets.

As cited by John Train in Money Masters (New York: Harper & Row, Publishers, Inc., 1987).
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition


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