FINANCIAL STATEMENT ANALYSIS

Chapter 2: Financial Reporting and Analysis

EXAM-READY NOTES

Complete Concepts + Numericals with Step-by-Step Solutions

Based on K.R. Subramanyam (11th Edition)

# TOPIC Key Focus

1 Reporting Environment GAAP, SEC, FASB, Managers

2 Nature of Financial Accounting Qualities, Principles, Limitations

3 Accrual Accounting T-Shirt Numerical + Framework

4 Concept of Income Economic vs. Accounting vs. Permanent

5 Fair Value Accounting Historical Cost vs. Fair Value Numerical

6 Accounting Analysis Earnings Management + Red Flags

7 Earnings Quality (Appendix 2A) Determinants + Red Flags

8 Exam Practice Questions Q&A for Last-Minute Revision

1. THE REPORTING ENVIRONMENT

What is the Financial Reporting Environment?

Financial statements are the most important product of the reporting environment. They are judged based
on (1) information needs of users and (2) alternative information sources like analyst reports and economic
data.

Key Components:
Component What It Does Exam Tip

GAAP (US) Rules & guidelines for financial accounting FASB sets standards
(how to measure assets, recognize revenue, etc.) SEC enforces them

FASB Financial Accounting Standards Board 7 full-time members

Issues SFAS (Statements of Financial Accounting Standards)
Political process

SEC Securities and Exchange Commission Can override FASB

Final authority on financial reporting More aggressive lately

IFRS International Financial Reporting Standards More principles-based

Used outside the USA – set by IASB (London) Less detailed than US GAAP

Managers Primary responsibility for fair reporting Judgment leads to

CEO must certify accuracy (Sarbanes-Oxley Act 2002) earnings management

Auditors External CPAs verify financial statements Internal audit also exists
Issue clean, qualified, or disclaim opinion

Litigation Legal threat keeps managers honest Important monitor

Billions in damages paid for accounting violations

KEY SEC FILINGS (VERY IMPORTANT FOR EXAM)

Form What It Is Key Content

Form 10-K Annual Report Audited financials + MD&A

Form 10-Q Quarterly Report Quarterly financials + MD&A

Form 20-F Foreign Company Annual Report Reconciliation to US GAAP

Form 8-K Current Report (filed within 15 days) Auditor change, bankruptcy, acquisition

Regulation 14-A Proxy Statement Board, managerial compensation, stock options

Prospectus New Share Offering Audited financials for IPO

EXAM TIP: Two crucial factors when analyzing quarterly (10-Q) reports: (1) Seasonality — compare with
same quarter of prior year, not previous quarter. (2) Year-end adjustments — many adjustments (like
inventory write-offs) happen in Q4, making Q4 data less reliable.

Alternative Information Sources:

• Economic, Industry & Company News — macro news (GDP, employment), industry news,
company-specific news (acquisitions, auditor changes)
• Voluntary Disclosure — managers disclose good/bad news voluntarily (Safe Harbor Rules protect
genuine mistakes). Motivations: legal liability, expectations management, signaling, beating market
expectations.
• Information Intermediaries (Analysts) — buy-side analysts (in-house for investment firms) vs. sell-side
analysts (public recommendations). 4 functions: Information gathering, Interpretation, Prospective
analysis, Recommendations.
2. NATURE AND PURPOSE OF FINANCIAL ACCOUNTING

Desirable Qualities of Accounting Information

Quality Meaning Trade-off

Relevance (Primary) Info can affect a decision More relevant = less reliable
Timeliness is key feature (e.g., forecasts are relevant but uncertain)

Reliability (Primary) Verifiable + Representationally More reliable = less relevant

Faithful + Neutral (unbiased) (historical data is reliable but may be old)

Comparability (Secondary)
Same measurement across different companies
Requires uniform standards

Consistency (Secondary)Same method used by one company over time

Allows trend analysis

Important Accounting Principles

1. ACCRUAL ACCOUNTING
Revenue is recognized when EARNED. Expenses are recognized when INCURRED — regardless of
when cash is received or paid. This is the most important principle in modern accounting.

2. HISTORICAL COST vs. FAIR VALUE

Historical Cost: Assets recorded at original purchase price. Advantage: objective and verifiable
(arm's-length transaction). Disadvantage: values become outdated.

Fair Value: Assets recorded at current market value. Advantage: more relevant. Disadvantage: less
reliable, especially when market is illiquid.

3. MATERIALITY
An omission or misstatement is material if it would influence the judgment of a reasonable person using
the information. Problem: no set criteria to define 'material.'

4. CONSERVATISM
Report the LEAST OPTIMISTIC view under uncertainty. Gains are recognized only when realized. Losses
are recognized immediately.

Type Meaning Example

Unconditional Conservatism
Applied consistently regardless of circumstances.
R&D costs
Leads
aretoalways
permanent
expensed
understatement
immediatelyof(even
assets.
if econo

Conditional ConservatismRecognize all losses immediately, but gainsWrite

only down
when impaired
realized. PP&E immediately, but don't write UP

EXAM TIP: Unconditional conservatism is MORE USEFUL for a credit analyst because it provides timely
information about adverse changes in a company's financial position.

Limitations of Financial Statement Information

• Timeliness: Statements released 3-6 weeks after quarter-end; analysts update in real-time.
• Frequency: Only quarterly; alternative sources update continuously.
• Forward-looking: Financial statements use historical data; analysts use future-oriented forecasts.
• Accounting distortions: Estimation errors, conservatism, earnings management reduce accuracy.
KEY FINDING: Earnings (net income) + Book Value together explain 50-75% of stock price behavior.
This shows financial accounting information IS relevant for decision making.
3. ACCRUALS — CORNERSTONE OF ACCOUNTING

What is Accrual Accounting?

Under accrual accounting, revenues are recognized when earned and expenses when incurred —
regardless of cash flow timing. This is the most important but also most controversial feature of modern
accounting.

THE FAMOUS T-SHIRT NUMERICAL (MUST KNOW)

Scenario: You start a T-shirt business. You invest $700 in cash. You buy plain T-shirts for $5 each, pay
$100 for a printing screen, and $0.75 per shirt for printing. You get orders for 100 shirts and complete all of
them. In Week 1, you sell 50 shirts: 25 for cash at $10 each, and 25 on credit (payment next week).

STEP 1: Cash Basis Accounting (What you see first)

STATEMENT OF CASH FLOWS

Cash Receipts

T-shirt sales (only 25 paid in cash x $10) $250

Cash Payments

Plain T-shirts (100 x $5) ($500)

Screen purchase ($100)

Printing charges (100 x $0.75) ($75)

Total Payments ($675)

NET CASH OUTFLOW ($425)

Problem: Cash says you LOST $425! But that's wrong — cash accounting fails because: (1) Ignored the
25 shirts sold on credit (receivable) (2) Treated ALL shirts as expense, not just the 50 sold (3) Treated
ALL screen/printing as expense, not just 50% used

STEP 2: Accrual Basis Accounting (The Right Picture)

ACCRUAL INCOME STATEMENT

REVENUES

T-shirt sales (50 sold x $10) $500.00

EXPENSES

T-shirt costs (50 sold x $5) ($250.00)

Screen depreciation (50/100 x $100) ($50.00)

Printing charges (50 x $0.75) ($37.50)

NET INCOME $162.50 PROFIT!

ACCRUAL BALANCE SHEET

ASSETS EQUITY

Cash $275.00 Beginning equity $700.00

T-shirt inventory (50 remaining x $6.75) $337.50 Add: Net income $162.50
 Accounts Receivable (25 shirts x $10) $250.00

TOTAL ASSETS $862.50 TOTAL EQUITY $862.50

KEY INSIGHT from T-Shirt Example: Cash Basis said: LOSS of $425 Accrual Basis said: PROFIT of
$162.50 Accrual accounting gives the TRUE picture of business performance!

Accrual Accounting Framework

The key formula to remember:

Net Income = Operating Cash Flow + Accruals

Two Types of Accruals:

Type What Creates Them Examples

Short-term Accruals Short-term timing differences Accounts receivable, Accounts payable,

(Working Capital Accruals)
between income and cash flow Prepaid expenses, Inventory

Long-term Accruals Capitalization of costs — Depreciation on PP&E, Goodwill

deferring costs whose benefits amortization, Deferred charges
occur in future periods

Revenue Recognition Rules:

Revenue must be recognized when BOTH conditions are met:

✓ EARNED: Company has delivered its product or service (completed its obligations)
✓ REALIZED or REALIZABLE: Company has received cash OR has a receivable that is convertible to
cash

Expense Matching:
✓ Product Costs: Recognized when the product/service is DELIVERED (e.g., Cost of Goods Sold)
✓ Period Costs: Recognized in the period they OCCUR (e.g., admin expenses, selling expenses)

Accrual vs. Cash: Myths and Truths

MYTHS (Common misconceptions) TRUTHS (What's actually true)

Only current cash flows matter for valuation Current INCOME is a better predictor of future cash flows than current cas

All cash flows are value relevant Some cash flows don't affect value (e.g., collecting A/R). Some are negati

Cash flows cannot be manipulated Cash flows CAN be manipulated (delay capex, accelerate collections, dela

All accruals are value irrelevant Accruals for credit sales are value relevant — they reflect FUTURE cash in

Accrual income is always managed upward Earnings management is NOT as widespread as the press suggests. SEC

EMPIRICAL EVIDENCE: Research shows net income explains 48% of stock prices, while Free Cash
Flow explains only 24%, and Net Cash Flow only 7%. Income is SUPERIOR to cash flow in predicting
stock prices.
4. CONCEPT OF INCOME

Three Types of Income — Key Distinctions

Type Definition Formula/Key Feature Exam Tip

Economic Income Change in shareholder wealth during

= Cash
a period.
flowsIncludes
+ ChangeBOTH
in PVrealized
Less
of future
useful
(cash)
cash
forand
flows
forecasting
UNREALIZED
(change—inincludes
market
(holding
non-recu
value
gains
of n

Permanent Income Stable average income a businessCompany

is expected
Valueto earn
= Permanent
over its life.
MOST
Income
DoesIMPORTANT
/NOT
Costinclude
of Capital
for
transitory
equity
(r) valuation
items. and cre
(Sustainable/Recurring Income) Value = PI / r

Operating Income Income from operating activities ONLY.

NOPATExcludes
= Net Operating
financing Profit
income/expense
Used
After in
Tax
DuPont
(interest,
analysis
investment
and ROICincome).
calculations
(NOPAT) Excludes: Interest expense, investment income

Accounting Income Based on accrual accounting rulesRevenue

and GAAP.
Recognition
Has elements
+ Expense
of Subject
bothMatching
economic
to estimation
and permanent
errors, earnings
income,managem
but with
(Reported Income) Includes: historical cost, conservatism, GAAP rules

INCOME NUMERICAL EXAMPLE (Condominium)

A company raises $100,000 in cash and buys a condo. It rents the condo for $12,000/year. At year-end,
the condo is worth $125,000. Condo's useful life = 50 years, salvage value = $75,000.

Step-by-Step Calculations:
Measure Calculation Amount

Free Cash Flow $12,000 rental - $100,000 purchase = ($88,000)

Operating Cash Flow Only rental income received in cash $12,000

Economic Income Rental income: $12,000 $37,000

+ Condo appreciation: $125,000 - $100,000 = $25,000
= Total Economic Income

Accounting Income Rental income: $12,000 $11,500

- Depreciation: ($100,000 - $75,000) / 50 years = $500
= Accounting Income

CONCLUSION: • Economic income ($37,000) is COMPREHENSIVE but less useful for forecasting —
$25,000 appreciation may not repeat every year. • Accounting income ($11,500) is CLOSER to
permanent/sustainable income — more useful for predicting future earnings. • Both differ from cash flow
measures.

Components of Accounting Income:

Component Description Effect on Company Value

Permanent (Recurring) Expected to persist indefinitely (e.g., regular

Each
operating
$1 = $1/r
income)
of company value
(e.g., if r=10%, $1 permanent income = $10 of value)

Transitory (Nonrecurring)One-time events (e.g., gain on sale of building,

$1 forrestructuring
$1 effect oncharge)
value
(no multiplier)

Value Irrelevant Pure accounting distortions with no economic

ZEROreality
effect
(e.g.,
on cosmetic
companychanges
value in accounting methods)
5. FAIR VALUE ACCOUNTING

Historical Cost vs. Fair Value — Core Difference

Dimension Historical Cost Model Fair Value Model

Asset Valuation Original purchase price ± depreciation Current market value on balance sheet date

Income Determination Revenue recognition + Expense matchingNet change in fair values of all assets and liabilities
(cost allocation principle)

Reliability Higher — based on actual transactions Lower — especially for Level 3 inputs

Relevance Lower — values can be outdated Higher — reflects current conditions

Conservative bias Yes — conservatism embedded No — aims for neutrality

Income volatility Lower — depreciation smooths costs Higher — market values fluctuate

Income concept approximated

Permanent/Sustainable income Economic income (total change in wealth)

FAIR VALUE NUMERICAL (Condo + Bond Example)

Company starts Year 1 with: $50,000 equity + $50,000 in 6% bonds (par). Buys a condo for $100,000.
Rents it for $12,000/year. End of Year 1: condo = $125,000 market value; bonds = $48,000 market value
(fallen). Condo: 50-year life, $75,000 salvage. Rent and interest are received/paid in cash at year-end.

Year 1 — Income Statement Comparison:

Item Historical Cost Fair Value

Rental income $12,000 $12,000

Depreciation [($100k-$75k)/50] ($500) NIL

Interest expense (6% x $50k) ($3,000) ($3,000)

Unrealized gain on condo ($125k-$100k) NIL $25,000

Unrealized gain on bonds ($50k-$48k) NIL $2,000

NET INCOME / (LOSS) $8,500 $36,000

Year 2 — Condo value falls to $110,000; bond market value rises to $50,500; rental =
$12,500:
Item Historical Cost Fair Value

Rental income $12,500 $12,500

Depreciation ($500) NIL

Interest expense (6% x $50k) ($3,000) ($3,000)

Unrealized loss on condo ($110k-$125k) NIL ($15,000)

Unrealized loss on bonds ($50.5k-$48k) NIL ($2,500)

 NET INCOME / (LOSS) $9,000 ($8,000) LOSS!

KEY INSIGHT: Fair value causes EXTREME income volatility! Year 1 = $36,000 profit, Year 2 = $8,000
LOSS — even though the underlying business (rental income) is almost identical in both years. Historical
cost gives STABLE income ($8,500 and $9,000).

Hierarchy of Fair Value Inputs (VERY EXAM IMPORTANT)

Level Input Type Example Reliability

LEVEL 1 Quoted prices in ACTIVE markets for Stock

IDENTICAL
price of
assets
Apple on NYSE on balance
HIGHEST
sheet date
(Most Reliable) Use whenever available

LEVEL 2 Quoted prices for SIMILAR assets in active

Bond price
markets
from
ORanidentical
infrequently
assets
traded
in INACTIVE
MODERATE
market; markets
(Moderate) similar real estate prices in the area Less precise than Level 1

LEVEL 3 UNOBSERVABLE inputs — based onValuing

management's
a uniqueown
piece
assumptions
of equipment
because
with
LOWEST
nonomarket;
market exists
(Least Reliable) internal DCF model for private company
Highest manipulation risk

RULE: Level 1 inputs should be MOST commonly used. Level 3 inputs should be used SPARINGLY.
Wide use of Level 3 inputs is a RED FLAG for lower quality financial statements.

Advantages vs. Disadvantages of Fair Value Accounting:

ADVANTAGES DISADVANTAGES

Reflects CURRENT information — no hidden assets/liabilities

LOWER OBJECTIVITY — especially with Level 3 inputs

Conceptually CONSISTENT measurement across all SUSCEPTIBLE

assets/liabilities TO MANIPULATION — managers can game Level 3 assu

Better COMPARABILITY across firms EXCESSIVE INCOME VOLATILITY — market fluctuations affect income s

NO CONSERVATIVE BIAS — neutrality improves reliability

LACK OF CONSERVATISM — bad for credit analysis which prefers down

More useful for EQUITY ANALYSIS (shows upside potential)

Counterintuitive: declining creditworthiness = LOWER liability = GAIN on i
6. INTRODUCTION TO ACCOUNTING ANALYSIS

What is Accounting Analysis?

Accounting analysis is the process of evaluating the extent to which a company's accounting numbers
reflect economic reality. It involves identifying accounting distortions and making necessary adjustments to
financial statements.

Sources of Accounting Distortions:

Source Explanation Example

Accounting Standards Political process means standards may not give

FIFO
most
gives
relevant
betterinformation.
balance sheet;
Historical
LIFO gives
cost reduces
better income
balance
stateme
shee

Estimation Errors Accruals require forecasts of future cash flows.

BadThese
debt estimates
allowance:can
Could
be wrong
be too—
high
improving
or too low
timeliness
based onbutcollecti
introd

Reliability vs. Relevance

Emphasizing
Trade-off reliability means delaying recognition
R&D expensed
until cash immediately
flows can beeven
estimated.
if economically
This delays
valuable
relevant
because
inform

Earnings ManagementManagers use judgment and discretion to manage

Accelerating
reportedrevenue
numbers
recognition,
for personal
delaying
gain. expense recognition, ta

EARNINGS MANAGEMENT — Deep Dive

Definition: 'Purposeful intervention by management in the earnings determination process, usually to
satisfy selfish objectives.' (Schipper, 1989)

3 Key Strategies:
Strategy How It Works When Used Example

1. Income INCREASING
Report higher earnings than economic
Whenreality.
managerAggressive
wants bonus,
accruals
Recognizing
before
that IPO,
will
revenue
reverse
beforeearly
merger,
[Link] channel
to beat analyst
loading;forecasts
delaying

2. BIG BATH Take as many write-offs as possible

Management
in ONE badchange,
period. 'Clear
merger,
IBM's
the
recession,
Louis
deck' for
Gerstner
future
restructuring
wrote
incomeoff
—increases.
~$4
whenbillion
bad in
news
yearcan
he be
too

3. INCOME SMOOTHING
Reduce income volatility by creating
When
secret
company
'earnings
wants
banks'
to appear
in
Building
goodstable
years
up excessive
and
andlow-risk
releasing
loantoloss
them
investors
reserves
in bad
and
years.
increditors
good years,

Motivations for Earnings Management:

• CONTRACTING INCENTIVES: Bonus tied to earnings (earn more bonus by hitting earnings targets);
avoid violating debt covenants.
• STOCK PRICE EFFECTS: Boost stock price before share offering or merger; smooth income to
lower perceived risk (lower cost of capital); beat analyst forecasts.
• OTHER: Lower political costs (avoid antitrust scrutiny); fight labor union demands; management
change (new CEO takes big bath to blame predecessor).

Two Mechanics of Earnings Management:

Mechanic Definition Examples

1. Income SHIFTING Moving income from one period to another •by

Channel
accelerating/delaying
loading (persuade
revenue
dealers
or expense
to buy excess
recognition.
productsUsua
be
• Capitalizing expenses instead of expensing immediately
• Switching from LIFO to FIFO (delays COGS expense)
• Taking large one-time charges to accelerate expense recognit

2. CLASSIFICATORYMoving
Earnings
expenses
Management
to 'below the line' nonrecurring
• Loading
section
discontinued
so analysts
segment
ignorewith
[Link]
Earnings
costs
appear
(improves
better
• Calling recurring expenses 'special charges' or 'restructuring c
• Use of discontinued operations classification strategically
Effects of Transactions on Income, Cash Flow, and Company Value:
Transaction Income Effect Free Cash Flow Effect Company Value Effect

Sales on credit INCREASE NIL INCREASE

Cash collection on credit sales NIL INCREASE NIL

Inventory markdowns DECREASE NIL DECREASE

Change depreciation: straight-line to declining

DECREASE balance NIL NIL

Cash purchase of plant asset NIL DECREASE NIL (unless return > cost of capital)
7. EARNINGS QUALITY (APPENDIX 2A)

What is Earnings Quality?

Earnings quality refers to the RELEVANCE of earnings in measuring company performance. It reflects
how well accounting income represents the true economic reality of a business. Higher quality = less
distorted income.

3 Determinants of Earnings Quality:

Factor Description How to Assess

1. Accounting PRINCIPLES
Conservative
selected
principles = higher quality (less
Check
likelyif to
accounting
overstate).
policies
Aggressive
are industry-standard.
principles = lower quality.
Are they conservative or aggressive?

2. Accounting APPLICATION
Manager's discretion over timing of certain Look
expenses
at year-to-year
(advertising,
variation
R&D, maintenance)
in advertising,can
R&D.
manage earnin
(Discretionary Expenses) Inconsistent amounts suggest manipulation.

3. Business RISK Higher earnings variability = lower quality. Higher

Check risk
cyclicality,
industries
regulatory
have lower
environment,
earnings revenue
quality. stability, con

Balance Sheet Analysis of Earnings Quality:

Two critical rules every exam student must know:

RULE 1: When assets are OVERSTATED → Cumulative earnings are OVERSTATED (Because: If
you delay writing down an impaired asset, you avoid the expense. So earnings look better than
they should.) Example: Delay recognizing obsolete inventory write-down → Inventory overstated
→ Earnings overstated

RULE 2: When provisions/liabilities are UNDERSTATED → Cumulative earnings are OVERSTATED

(Because: If you under-provide for a liability, you avoid the expense. So earnings look better than
they should.) Example: Understate warranty provision → Liability understated → Earnings
overstated

RED FLAGS for Earnings Quality Problems:

Watch out for these warning signs in any company's financial statements:

■ Poor financial performance (desperate companies resort to desperate measures)

■ Reported earnings CONSISTENTLY HIGHER than operating cash flows
■ Reported PRE-TAX earnings consistently higher than TAXABLE income
■ QUALIFIED audit report or auditor RESIGNATION
■ Non-routine auditor CHANGE
■ Unexplained or FREQUENT changes in accounting policies
■ Sudden INCREASE in inventories compared to sales
■ Use of OFF-BALANCE-SHEET mechanisms (operating leases, receivables securitization)
■ Frequent ONE-TIME charges and big baths
■ Management compensation tied heavily to earnings targets

Process of Accounting Analysis (Steps):

Step Action What to Look For
1 Identify key accounting policies Are policies reasonable or aggressive? Consistent with industry norms?

2 Evaluate accounting flexibility How much judgment is required? More judgment = more opportunity for distortion

3 Determine reporting strategy Aggressive reporting? Clean audit? History of accounting problems? Management re

4 Identify red flags See red flags list above

5 Adjust financial statements Capitalize operating leases; recognize ESO expense; adjust for one-time charges; fix
8. EXAM PRACTICE — QUICK Q&A;
Quick-fire questions and answers for last-minute revision
Q1: What is the FASB and what does it do?
FASB = Financial Accounting Standards Board. It is the standard-setting body in the US. It issues SFAS
(Statements of Financial Accounting Standards). It has 7 full-time members and operates via a political
process. However, it has NO legal enforcement authority — that belongs to the SEC.

Q2: What is the difference between US GAAP and IFRS?

US GAAP is detailed and rule-based (many specific rules). IFRS is principle-based (more conceptual, less
detail). Both cover the same basic transactions but approach them differently. FASB and IASB are working on
convergence to eliminate differences.

Q3: What are two problems with analyzing quarterly (10-Q) reports?
(1) SEASONALITY: Must compare with same quarter last year, not prior quarter. (2) YEAR-END
ADJUSTMENTS: Many write-offs and adjustments happen in Q4, making quarterly data unreliable.

Q4: What is the difference between Relevance and Reliability?

Relevance = capacity to affect a decision (timeliness is key). Reliability = verifiable, representationally faithful,
and neutral. TRADE-OFF: More relevant = less reliable (e.g., forecasts are relevant but uncertain). More
reliable = less relevant (e.g., historical cost is reliable but outdated).

Q5: What is conservatism and what are its two types?

Conservatism = reporting the least optimistic view under uncertainty. Gains recognized only when realized;
losses recognized immediately. Type 1 — UNCONDITIONAL: Applied consistently (e.g., all R&D; expensed
immediately). Leads to permanent understatement of assets. MORE useful for credit analysis. Type 2 —
CONDITIONAL: 'Recognize losses now, gains when realized' (e.g., asset write-downs). Only triggered by
adverse events.

Q6: State the basic accrual identity.

Net Income = Operating Cash Flow + Accruals This means accruals are the adjustments that make net
income different from operating cash flow.

Q7: What are the two conditions for revenue recognition?

Revenue must be (1) EARNED — company has fulfilled its obligations, AND (2) REALIZED or REALIZABLE
— cash received OR a valid receivable exists.

Q8: What is Economic Income vs. Accounting Income? Give the condo example.
ECONOMIC INCOME = Cash flows + Unrealized gains/losses (change in market value) Condo example: Rent
$12,000 + Appreciation $25,000 = Economic Income $37,000 ACCOUNTING INCOME = Revenue - Matched
costs (using accrual accounting) Condo example: Rent $12,000 - Depreciation $500 = Accounting Income
$11,500

Q9: What is Permanent Income and why is it important?

Permanent Income = stable average income expected over the company's life. Formula: Company Value =
Permanent Income / Cost of Capital (r). Benjamin Graham called it 'sustainable earning power' — the single
most important indicator of company value. An analyst must EXCLUDE transitory items to estimate permanent
income (core earnings).

Q10: What is the difference between Level 1, 2, and 3 fair value inputs?
Level 1: Quoted prices in ACTIVE markets for IDENTICAL assets (most reliable — e.g., stock price) Level 2:
Quoted prices for SIMILAR assets, or identical assets in INACTIVE markets Level 3: UNOBSERVABLE inputs
— management's own assumptions (least reliable, most manipulation risk). Key rule: Level 1 must be used
most; Level 3 used sparingly.

Q11: What is the counterintuitive problem with fair value of liabilities?

When a company's creditworthiness DECREASES, its debt's fair value DECLINES (less likely to be repaid at
full value). This decrease in liability = GAIN on income statement. So a financially distressed company shows
a PROFIT due to declining credit quality! Analysts should use FACE VALUE of debt in debt-equity ratios, not
fair value.

Q12: Name the 3 strategies for earnings management and explain each.
1. INCOME INCREASING: Report higher earnings than reality (before bonus period, before IPO, to beat
analyst forecasts). 2. BIG BATH: Take all write-offs in one bad period to 'clear the deck' for future earnings
increases (common during management change, recession). 3. INCOME SMOOTHING: Create earnings
'banks' in good periods, draw down in bad periods — reduces income volatility to appear stable.

Q13: What is 'classificatory earnings management'?

Moving expenses to 'below the line' (nonrecurring) sections of the income statement so analysts ignore them.
Example: including normal operating expenses in 'restructuring charges' which analysts typically exclude from
analysis. About 40% of companies report at least one special charge annually.

Q14: What does research show about net income vs. free cash flow?
Net income explains 48% of stock prices while free cash flow explains only 24%. Net income is a SUPERIOR
predictor of stock prices than free cash flow. Wal-Mart example: While net income grew consistently and
matched stock price, free cash flow was NEGATIVE during growth phase — a misleading signal.

Q15: State the two balance sheet rules for earnings quality.
Rule 1: Overstated assets → Overstated cumulative earnings Rule 2: Understated liabilities/provisions →
Overstated cumulative earnings Conversely: Understated assets → Understated earnings; Overstated
liabilities → Understated earnings
MASTER CHEAT SHEET — Chapter 2 Key Formulas & Facts
CONCEPT KEY FORMULA / FACT TO REMEMBER

Accrual Identity Net Income = Operating Cash Flow + Accruals

Permanent Income & Value Company Value = Permanent Income / Cost of Capital (r)

Economic Income = Cash Flows + Change in Market Value of Net Assets (Unrealized gains/losses)

Accounting Income (Condo) = Rent $12,000 - Depreciation $500 = $11,500

Economic Income (Condo) = Rent $12,000 + Appreciation $25,000 = $37,000

T-Shirt Accrual Profit Revenue (50x$10=$500) - T-shirts (50x$5=$250) - Screen (50/100x$100=$50) - Print (50x$0

Stock Price Explanation Earnings + Book Value explain 50-75% of stock prices

NI vs. FCF vs. NCF NI=48%, FCF=24%, OCF=37%, NCF=7% of stock price explained

Fair Value Input Hierarchy Level 1 (Active market, identical) > Level 2 (Similar/inactive) > Level 3 (Unobservable)

Asset Quality Rule Overstated Assets → Overstated Earnings

Liability Quality Rule Understated Liabilities → Overstated Earnings

Key SEC Forms 10-K (Annual), 10-Q (Quarterly), 8-K (Current events), 14-A (Proxy), 20-F (Foreign)

Earnings Management Strategies 1. Income Increasing 2. Big Bath 3. Income Smoothing

Earnings Management Mechanics 1. Income Shifting (timing changes) 2. Classificatory (move expenses 'below the line')

Conservatism Types Unconditional (always conservative, e.g., R&D) vs. Conditional (loss-triggered, e.g., impairme

Better for Credit Analysis Unconditional Conservatism (provides timely info about downside risk)

Accruals vs Cash Flow Accruals are MORE RELEVANT; Cash flows are MORE RELIABLE. Both are complementary

GAAP = Political Process? YES — different user groups lobby FASB. Standards are compromise solutions.

CEO Certification Required by Sarbanes-Oxley Act of 2002

Core Earnings = ? Accounting income MINUS transitory items. Starting point for estimating permanent income.

GOOD LUCK ON YOUR EXAM! Remember: Chapter 2 tests your understanding of WHY accounting
works the way it does, not just memorizing terms. Always connect concepts to real-world impact on
financial statements.