Bennet Tchaikovsky, CPA, Esq. is of our guest authors who shares his instruction successes with our professors and CPA community. In this article series, “Making Accounting Connect with Students: Part 2-Making Financial Statement Analysis Personal to the Student”, Tchaikovsky talks about different classroom teaching methods he uses to help students understand financial analysis more concretely.
Too tough to test
I have found financial statement analysis is difficult to teach from a textbook. Students generally are not interested in hypothetical companies that textbooks often provide. Also, effectively testing on financial statement analysis is extremely challenging. As an example on how I tested this on a written exam, I gave a balance sheet with a very small amount of accounts receivable and a high amount of inventory (as a percentages of total assets). Students were given ratios including accounts receivable turnover and inventory turnover. The question required students to first analyze the balance sheet to determine what asset account was most significant, select the most meaningful ratio, and justify why they chose the ratio. The test did not go very well for most students as the time to take the exam and complete this type of problem was simply not long enough. But financial statement analysis is a very important skill to nail down for first through third year auditor positions: testing on balance sheet accounts and the time spent on each area often directly correlates to the balance sheet account significance. So how do we make this more relatable to students?
Qualitative analysis- just as important as quantitative
If you refer to my previous blog post on “Getting to Know Your Client,” this can give you some thoughts on qualitative analysis. Students must look beyond the financial statements in order to properly analyze a company. However, if you include this part in the project, you may open up a Pandora’s Box (wishing you had stuck with IHeartRadio). So here’s what I’d recommend starting off with.
Step 1- Before you start the project….
Create your own example and share with the class. By doing the project in its entirety on your own, you are setting very clear expectations as to what you are expecting from students. Decide whether you want to have the project done in groups or individually. Personally, I like the individual projects as the students then really have to do the work. Assume that your students have never looked up a company’s financial statement via www.sec.gov. Therefore, spend time teaching the students how to look up a company’s ticker symbol. Once the symbol is obtained, this can be entered using the fast search here. You may also need to educate students on the difference of the SEC filings: 10-K, 10-Q, and other filings. To make financial statement look-up easier on annual reports (the 10-Q’s have them at the front), all 10-K and 10-Q’s should have an “interactive data” button. This will allow the student immediate access to the related financial statements from the filings. An example from Microsoft (NASDAQ: MSFT) can be found here. In this first step alone, you have just introduced your students to an extremely valuable skill and resource: looking up financial statements on the SEC’s website.
Step 2: Students select two United States based publicly traded comparable companies using www.sec.gov.
The student should select the companies; not the instructor. Giving the student the power of what to select will make the project easier for them. Some sample pairings: Wal-Mart /Target 21st Century Fox/Disney GM/FordHome Depot/Lowe’sApple/MicrosoftConstellation Brands/Brown-Forman Students will also learn about what companies are and are not publicly traded in the U.S. and comparability limitations. I’ve had students want to select Samsung and In-N-Out and then learn that Samsung is a Korean company while In-n-Out is family owned. A student may want to choose Tesla or Netflix. The challenge with these types of companies is that Netflix and Tesla do not have competition that is close to what each of these companies does. Tesla does sell cars, however, after their recent acquisition of SolarCity, but their financials are not necessarily comparable to a traditional company such as Ford or GM. Netflix and Amazon both stream films and create original content; however, streaming is only a small fraction of Amazon’s overall business structure. Students should also be careful of not selecting too large of organizations. I had a student choose Wells Fargo and Chase in the Spring 2017 semester and she may be still working on the project. I require my students to let me know the companies they are choosing as I do not want too many students comparing the same companies and choosing companies that are not directly comparable.
Step 3: Students create common sized balance sheets and income statements for the selected companies and align them for comparability.
Creation of a common sized financial statement is critical for financial statement analysis: by showing all balance sheet accounts as a percentage of total assets and income statement accounts as a percentage of revenue, students are immediately able to determine what balances are meaningful to a particular entity. After the common sized financial statements are created, have the students consolidate the financials so that the numbers are comparable. I’ve created an example using Lowe’s and Home Depot here. This is a great time to ask your students to show you their work to date and to make sure that they are on the right track.
Step 4: Students select the three best ratios to best evaluate the companies
At this point during class, I review the various ratios and their categories (liquidity, solvency, profitability, and market prospects). I will show the students how to calculate all the ratios for my sample companies.
After all ratios that I am covering have been computed, I ask the class to determine which ratios are most meaningful and which requires critical thinking. Anyone can calculate a ratio; however, can the student decide which ratios are most relevant to a company?
For Home Depot and Lowe’s (the Step 3 company examples), the inventory turnover ratio is more important than the accounts receivable turnover. Why? Receivables are insignificant as an overall percentage to either company while inventory (beyond fixed assets) are the most significant balance sheet items for both Home Depot and Lowe’s.
If you are having the students craft a paper for the project, you can have them identify the three ratios (or however many you choose to evaluate) and then give details as to why the student chose each ratio (e.g. % of assets, revenue, etc.). While I am pretty flexible on grading, I do reduce the points given if the student did not put some thought into the ratios they selected.
You will be surprised as to what else will potentially come out of the discussion. While reviewing the acid-test ratio of a publicly traded company (which was less than .1), a student shared that her husband had done business with that company and had not been paid in over 150 days. The class quickly realized that just because a company is publicly traded does not mean that they will pay their obligations timely. Before doing business with anyone, a company needs to perform its due diligence prior to extending credit even to a publicly traded company.
Step 5: Students must compute the price to earnings ratio
I always have my students compute the Price to Earnings (“P/E”) ratio so that they gain perspective as to how companies are currently valued by investors. For instance, as of October 20, 2017, Amazon had a P/E ratio of 248.01…Amazon will need approximately 248 years to earn back its share price (at current earnings / price levels). This is longer than the United States has been independent. Also, some companies such as Tesla have no P/E ratio as these companies continue to operate at a loss.
Step 6: Students draft a paper and comment on their findings
I require my students to submit a paper that details, in their own words, why they selected the two companies. I’ve had some great responses from “I like to drink beer” to “I worked at that company and I hated it.” The students then craft a corporate summary (this can be pulled from the 10-K as long as they acknowledge the source) and include the ratio analysis from Steps 4 and 5. Lastly, the student makes a recommendation to buy or sell the stocks they have chosen based on their financial statement analysis.
One of my most awesome Irvine Valley College students, Edmond King, gave the prototype for a lifetime. This paper compares Under Armour to Nike.
Step 7: Extra credit opportunities
If a student does not complete the assignment or creates work that is not up to your standard, you may consider giving the student an opportunity to obtain additional points. I make it very clear to the student that if they ask me to make a custom assignment for them, they need to do the work. This generally stops the point fishing expedition.
At this point, you can make the project a true research vehicle. Goodwill, intangibles, stock compensation expense, fair value vs. historical cost of assets are all fertile ground for further investigation by the student. Here you will find a sample e-mail that I initially send to my student as well as a follow up e-mail if a student failed to complete the additional work.
Final thoughts – teaching financial statement analysis:
Some of my most gratifying moments as an accounting instructor have come as a result of assigning the paper. A parent was shocked to learn that his daughter (my student) knew what a 10-K was in a lower division managerial accounting course. Another student was able to have a conversation with a prospective employer about the real-life project that she had done while in class. While grading and creating these assignments will take a considerable amount of time, the practical education you are giving will give them an advantage as your students start their professional careers.
Thank you for reading this article. Stay tuned, because our next post will be the Part 3 of this series, which is accounting ethics. Please feel free to leave your comments below!
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