Most people find accounting very boring but as Warren Buffett said “it is the language of business”. To be a good investor, you need to understand the language. I would recommend three good sources to learn the basics of accounting:
- The interpretation of financial statements by Benjamin Graham
- Valuation: Measuring and managing the value of companies by Mckinsey & Company
- Reading a company’s financial statements – highlight anything you don’t understand and goggle it
The aim of this article is not to explain how to read financial statements but more as a guide of things to be wary of. During most earnings calls, quarterly and annual reports, what gets reported the most by the media is the net income or earnings per share (EPS) generated by the company. This figure can be been easily manipulated and new GAAP (generally accepted accounting principles) makes this number even more meaningless for some companies.
Any company that holds a significant amount of marketable securities (i.e. stocks, bonds for example) will need to report unrealized gains and losses in their income statement. In plain English, this means that a company’s earnings will be affected by the price of any marketable securities it holds. This rule will affect banks and insurance companies because they hold substantial amounts of marketable securities.
This new reported net income figure will be largely meaningless because a company can suddenly report a huge profit or loss based solely on the market value of securities it holds and not because actual operations were profitable or making a loss.
This problem will especially affect banks. When interest rates rise, banks make more money by paying lower interest on customers deposits and charging higher interest on loans. Banks typically do well as interest rates rise. The new accounting rules will mean that as interest rates rise, any bonds held by banks will fall in value and the unrealized loss will be reported in the income statement. For the first time in history, banks will not be as profitable (on paper at least) as usual in a rising rate environment.
If you follow the news headlines alone, the EPS figure reported by banks will swing wildly from quarter to quarter. This means stock prices are also likely to swing wildly. Assuming the bank is well capitalized and the paper loss is not material to the health of its balance sheet, any decline in net income caused by a decline in marketable security prices will provide opportunities for the intelligent investor.
Accounting may be boring but a basic understanding of it will help you spot value where no one else is looking.