Chapter 3:  Overview of Accounting  Analysis
The Importance of Accounting Analysis <ul><li>Accounting practices govern the types of disclosures made in the financial s...
Key Concepts in Chapter 3 <ul><li>Various factors influence the quality of accounting-based financial reports. </li></ul><...
Accrual Accounting <ul><li>Financial reports are prepared using accrual accounting instead of cash accounting. </li></ul><...
Management’s Responsibility for Reporting Financial Information <ul><li>Applying accounting principles is the responsibili...
International Financial Reporting Standards (IFRS) <ul><li>The EU and other countries worldwide have relied on the IASB to...
External Auditing of Financial Statements <ul><li>Required for publicly traded companies; within the EU also required for ...
Public enforcement <ul><li>Most countries have public enforcement bodies to review compliance and take actions to correct ...
Factors Influencing Accounting Quality <ul><li>It is necessary to allow managers some discretion in applying accounting st...
Noise From Accounting Rules and Forecast Errors <ul><li>The fit between accounting standards and the nature of the firm’s ...
Manager’s Accounting Choices <ul><li>Managers have a number of incentives to choose accounting disclosures that are biased...
Steps in Performing Accounting Analysis <ul><li>Step 1: Identify Principal Accounting Policies </li></ul><ul><ul><li>Key p...
Steps in Performing Accounting Analysis <ul><li>Step 3: Evaluate Accounting Strategy </li></ul><ul><ul><li>Flexibility in ...
Steps in Performing Accounting Analysis <ul><li>Step 4: Evaluate the Quality of Disclosure </li></ul><ul><ul><li>Managers ...
Steps in Performing Accounting Analysis <ul><li>Step 5: Identify Potential Red Flags </li></ul><ul><ul><li>Some issues tha...
Steps in Performing Accounting Analysis <ul><li>Step 5: Identify Potential Red Flags , continued </li></ul><ul><ul><li>Mor...
Steps in Performing Accounting Analysis <ul><li>Step 6: Undo Accounting Distortions </li></ul><ul><ul><li>Use information ...
Accounting Analysis Pitfalls <ul><li>Conservative accounting may also be misleading. </li></ul><ul><ul><li>For example, hi...
Concluding Comments <ul><li>Accounting analysis is an essential step in analyzing corporate financial reports. </li></ul><...
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  1. 1. Chapter 3: Overview of Accounting Analysis
  2. 2. The Importance of Accounting Analysis <ul><li>Accounting practices govern the types of disclosures made in the financial statements. </li></ul><ul><li>Understanding accounting allows the business analyst to effectively use the financial information disclosed by companies. </li></ul>
  3. 3. Key Concepts in Chapter 3 <ul><li>Various factors influence the quality of accounting-based financial reports. </li></ul><ul><li>Managers have some discretion in accounting choices used in financial reporting. </li></ul><ul><li>Incentives for the management of financial reporting items must be considered by the analyst. </li></ul>
  4. 4. Accrual Accounting <ul><li>Financial reports are prepared using accrual accounting instead of cash accounting. </li></ul><ul><li>IFRS defines the following financial statement elements: </li></ul><ul><ul><li>Revenues </li></ul></ul><ul><ul><li>Expenses </li></ul></ul><ul><ul><li>Assets </li></ul></ul><ul><ul><li>Liabilities </li></ul></ul><ul><ul><li>Equity </li></ul></ul>
  5. 5. Management’s Responsibility for Reporting Financial Information <ul><li>Applying accounting principles is the responsibility of management, who has superior knowledge of a firm’s business. </li></ul><ul><li>Incentives exist for management to distort accounting numbers in their favor. </li></ul><ul><ul><li>Contracts </li></ul></ul><ul><ul><li>Reputation </li></ul></ul><ul><li>Mitigating effects of legal liability, auditing, public enforcement. </li></ul>
  6. 6. International Financial Reporting Standards (IFRS) <ul><li>The EU and other countries worldwide have relied on the IASB to set accounting standards (IFRS); many countries have endorsement procedures. </li></ul><ul><li>IFRS allows for consistency in reporting between firms and over different time periods of the same firm. </li></ul><ul><li>Uniform accounting standards minimize manager’s ability to manipulate financial statement information. </li></ul><ul><li>Rigid accounting rules may be disfunctional; calls for principles-based accounting standards. </li></ul>
  7. 7. External Auditing of Financial Statements <ul><li>Required for publicly traded companies; within the EU also required for some private firms. </li></ul><ul><li>Conducted according to standards: </li></ul><ul><ul><li>EU: minimum standards set by the 8 th Directive (US: Sarbanes-Oxley Act) </li></ul></ul><ul><ul><li>International Auditing Standards (US: GAAS) </li></ul></ul><ul><li>Auditing has its limitations; it is backed up by legal liability and public enforcement. </li></ul>
  8. 8. Public enforcement <ul><li>Most countries have public enforcement bodies to review compliance and take actions to correct noncompliance. </li></ul><ul><li>Public enforcement cannot ensure full compliance because enforcement bodies work: </li></ul><ul><ul><li>Proactively on a sampling basis or </li></ul></ul><ul><ul><li>On a complaint basis </li></ul></ul><ul><li>There is international diversity in enforcement quality; the CESR coordinates enforcement activities in the EU </li></ul>
  9. 9. Factors Influencing Accounting Quality <ul><li>It is necessary to allow managers some discretion in applying accounting standards. </li></ul><ul><li>As a result, three potential sources of noise and bias in accounting data include: </li></ul><ul><ul><ul><li>Noise from accounting rules </li></ul></ul></ul><ul><ul><ul><li>2. Forecast errors </li></ul></ul></ul><ul><ul><ul><li>3. Manager’s accounting choices </li></ul></ul></ul>
  10. 10. Noise From Accounting Rules and Forecast Errors <ul><li>The fit between accounting standards and the nature of the firm’s transactions may introduce some distortion in the reported financial statements. </li></ul><ul><li>Management’s estimates may result in accounting forecasting errors reflected in the financial statements. </li></ul>
  11. 11. Manager’s Accounting Choices <ul><li>Managers have a number of incentives to choose accounting disclosures that are biased: </li></ul><ul><ul><li>Debt covenants </li></ul></ul><ul><ul><li>Compensation contracts </li></ul></ul><ul><ul><li>Contests for corporate control </li></ul></ul><ul><ul><li>Tax considerations </li></ul></ul><ul><ul><li>Regulatory considerations </li></ul></ul><ul><ul><li>Capital market and stakeholder considerations </li></ul></ul><ul><ul><li>Competitive considerations </li></ul></ul>
  12. 12. Steps in Performing Accounting Analysis <ul><li>Step 1: Identify Principal Accounting Policies </li></ul><ul><ul><li>Key policies and estimates used to measure risks and critical factors for success must be identified. </li></ul></ul><ul><ul><li>IFRS require firms to identify critical accounting estimates </li></ul></ul><ul><li>Step 2: Assess Accounting Flexibility </li></ul><ul><ul><li>Accounting information is less likely to yield insights about a firm’s economics if managers have a high degree of flexibility in choosing policies and estimates. </li></ul></ul>
  13. 13. Steps in Performing Accounting Analysis <ul><li>Step 3: Evaluate Accounting Strategy </li></ul><ul><ul><li>Flexibility in accounting choices allows managers to strategically communicate economic information or hide true performance.. </li></ul></ul><ul><ul><li>Issues to consider include: </li></ul></ul><ul><ul><ul><li>Norms for accounting policies with industry peers </li></ul></ul></ul><ul><ul><ul><li>Incentives for managers to manage earnings </li></ul></ul></ul><ul><ul><ul><li>Changes in policies and estimates and the rationale for doing so </li></ul></ul></ul><ul><ul><ul><li>Whether transactions are structured to achieve certain accounting objectives </li></ul></ul></ul>
  14. 14. Steps in Performing Accounting Analysis <ul><li>Step 4: Evaluate the Quality of Disclosure </li></ul><ul><ul><li>Managers have considerable discretion in disclosing certain accounting information </li></ul></ul><ul><ul><li>Issues to consider include: </li></ul></ul><ul><ul><ul><li>Whether disclosures seem adequate </li></ul></ul></ul><ul><ul><ul><li>Adequacy of notes to the financial statements </li></ul></ul></ul><ul><ul><ul><li>Whether the Management Report section sufficiently explains and is consistent with current performance </li></ul></ul></ul><ul><ul><ul><li>Whether IFRS restricts the appropriate measurement of key measures of success </li></ul></ul></ul><ul><ul><ul><li>Adequacy of segment disclosure </li></ul></ul></ul>
  15. 15. Steps in Performing Accounting Analysis <ul><li>Step 5: Identify Potential Red Flags </li></ul><ul><ul><li>Some issues that warrant gathering more information include: </li></ul></ul><ul><ul><ul><li>Unexplained transactions that boost profits </li></ul></ul></ul><ul><ul><ul><li>Unusual increases in inventory or A/R in relation to sales </li></ul></ul></ul><ul><ul><ul><li>Increases in the gap between net profit and cash flows or tax profit </li></ul></ul></ul><ul><ul><ul><li>Use of R&D partnerships, SPEs or the sale of receivables to finance operations </li></ul></ul></ul>
  16. 16. Steps in Performing Accounting Analysis <ul><li>Step 5: Identify Potential Red Flags , continued </li></ul><ul><ul><li>More issues that warrant gathering more information: </li></ul></ul><ul><ul><ul><li>Unexpected large asset write-offs </li></ul></ul></ul><ul><ul><ul><li>Large year-end adjustments </li></ul></ul></ul><ul><ul><ul><li>Qualified audit opinions or auditor changes </li></ul></ul></ul><ul><ul><ul><li>Related-party transactions </li></ul></ul></ul>
  17. 17. Steps in Performing Accounting Analysis <ul><li>Step 6: Undo Accounting Distortions </li></ul><ul><ul><li>Use information from the cash flow statement and notes to the financial statements to (possibly imperfectly) undo distortions </li></ul></ul><ul><ul><li>Continued in chapter 4 </li></ul></ul>
  18. 18. Accounting Analysis Pitfalls <ul><li>Conservative accounting may also be misleading. </li></ul><ul><ul><li>For example, historical cost and accounting for intangible assets </li></ul></ul><ul><li>Not all unusual accounting practices are questionable. </li></ul><ul><ul><li>Earnings management does not necessarily motivate some accounting phenomena that seem unusual </li></ul></ul><ul><li>Common standards ≠ common practices </li></ul>
  19. 19. Concluding Comments <ul><li>Accounting analysis is an essential step in analyzing corporate financial reports. </li></ul><ul><li>A methodology consisting of six steps in analyzing accounting data was presented in this chapter. </li></ul><ul><li>Research suggests earnings management is not so pervasive as to make earnings data unreliable. </li></ul>

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