Financial Statement Analysis

Lecturer: Msc. Mai Thi Phuong Thao

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 CHAPTER 3

ACCOUNTING ANALYSIS

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What is the purpose of accounting
analysis?
For your note

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Does accounting affect business
strategy?

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Must follow the Generally Accepted Accounting
Principles (GAAP) or International Financial Reporting
Standard (IFRS)
Desirable quality
3. Accounting - Review
Annual Reports
◼ Management Discussion and Analysis (MD&A)

◼ Financial Statements

 Balance sheet (2 years)

 Income Statement (3 years)
 Statement of Stockholders’ Equity (3 years)
 Statement of Cash Flows (3 years)
◼ FS Notes

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3.1 MD&A

Results of operations, including discussion of trends

in sales and expenses
Capital resources and liquidity, including discussion of
cash flows trend
Outlook based on known trends

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3.2 Financial Statements
Accountants are confronted with the potential
dangers of bias, misinterpretation, inaccuracy, and
ambiguity

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List down 3 Importance of FS Notes

.
.
.

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Some formulas in FS reports

Balance Sheet
◼ Assets = 1_________ + 2 __________
◼ Ending balance =

3 ______________ carried from previous B/S

+/- 4__________ / 5__________
Stock Equity = 6__________ + 7__________
Capital stock = Opening balance + 8__________ –
9__________
Retained earning = Opening balance + 10__________
-Dividends
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When we record:
a. Revenue

b. Expense

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4. What Affect the Quality of Accounting
Data? – Not Reflect the Economic Reality
Reports are prepared by management
◼ Involves with management’s incentives
Accrual basis versus cash basis → forecast errors
◼ Involves estimations, not totally actual cash transactions
Noise of Accounting rules (GAAP)
◼ Standardization versus flexibility
Auditing
◼ Auditable?
Legal Liability
◼ Threat of lawsuits improves credibility, but limits disclosures

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5. How to Do Accounting Analysis

6 steps?
.

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5.1 Identify Key Accounting Policies

Ultimate goal
◼ How well are the key success factors and risks
identified by the Business Strategy analysis
managed by the firm?
Task
◼ Identify and evaluate the policies and estimates
the firm uses to measure its critical factors and
risks

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5.2 Assess Accounting Flexibility

All firms can choose:

◼ depreciation & amortization methods and

estimates
◼ inventory methods

◼ estimates of bad debts

Some items do not allow flexibility:

◼ R&D and marketing expenditures must be

expensed
◼ software development can be capitalized

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5.3 Flexibility, Informative, and Distortion

Low High

Flexibility

More Informative
Less Distortion Less Informative

More Distortion

Let’s arrange it to make sense!!!

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5.3 Evaluate Accounting Strategy
How do the firm’s policies compare to the industry
norm?
Does management face strong incentives to manage
earnings?
◼ covenants, bonuses, political pressures
Has the firm changed policies or estimates?
Were policies and estimates realistic in the past?
◼ write-off
◼ discontinued operation
Does the firm structure transactions to achieve
certain accounting objectives?
◼ capital lease versus operating lease
◼ pooling-of-interest versus purchase accounting
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5.4 Evaluate Quality of Disclosure
Do the firm’s disclosures make it easy to assess the
economic reality?
◼ Provide adequate disclosure of business strategies?
◼ Explain in footnotes accounting policies, assumptions, and
their logic?
◼ Explain current performance?
◼ Provide additional disclosures to assess business reality?
◼ Provide informative segment disclosure?
◼ Reveal forthcoming bad news?
◼ Provide detailed news to investors?

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5.5 Identify Potential Red Flags
Each group answers 2 cases

1. Unexplained changes in accounting especially when

performance is poor
2. Unexplained transactions that boost profits
3. Unusual increases in A/R in relation to sales increases
4. Unusual increases in inventories in relation to sales increases
5. Increasing gap between earnings and cash flow from
operations
6. Increasing gap between financial income and taxable income
7. Off-F/S transactions
8. Large asset write-offs
9. Large 4th-quarter adjustments
10. Qualified audit opinion or change in auditors
11. Related party transactions

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5.5 Identify Potential Red Flags
What are Fraud Red Flags?

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5.5 Identify Potential Red Flags

Inventory shrinkage

An auditor can detect inventory shrinkage by looking at

the balance sheet, the number of products in stock, and
those sold – and then comparing them with previous
records and projections. In certain circumstances, the
auditor may do unplanned stock-taking on random days
to detect any unusual inventory characteristics.

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5.5 Identify Potential Red Flags

Missing documents

An organization may experience frequent cases of

reported missing documents that relate to critical
departments. When the frequency of occurrence
becomes too often, it may be a sign of ongoing fraud
within the organization. Missing documents that are
fraud red flags include registration of motor vehicles,
lists of sales and purchases, checkbooks, and inventory
reports. When such records disappear, it may point to
an undesirable situation that may lead to loss of certain
assets or money.

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5.5 Identify Potential Red Flags

Multiple payments

• There are cases when a company’s accounting

department may erroneously process duplicate
payments to a vendor or service provider.

• Some employees may even process payments to

non-existent companies with the intention of
defrauding their employer. To prevent such errors, all
payments should be monitored and verified that they
are going to the intended parties.

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Understanding about Fraud Triangle
The concept of the Fraud Triangle is generally
credited to American sociologist Donald R.
Cressey who worked in the fields of criminology
and white-collar crime.
- Presenting when an individual commits
occupational fraud
- “Pressure” refers to the motivation of the
employee – that is, what is driving him or her
to commit fraud.
- “Opportunity” to commit fraud is a risk factor
that is heightened where internal controls
are weak or non-existent.

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Understanding about Fraud Triangle
The concept of the Fraud Triangle is generally
credited to American sociologist Donald R.
Cressey who worked in the fields of criminology
and white-collar crime.
- Presenting when an individual commits
occupational fraud
- “Pressure” refers to the motivation of the
employee – that is, what is driving him or her
to commit fraud.
- “Opportunity” to commit fraud is a risk factor
that is heightened where internal controls
are weak or non-existent.
- “Opportunity” to commit fraud is a risk factor
that is heightened where internal controls
are weak or non-existent.

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5.5 Identify Potential Red Flags

Employee Fraud Red Flags

A large proportion of fraud affecting organizations
comes from within the organization itself, mainly from
employees. Some of the behavioral signs of employee
fraud include:

◼ Lifestyle changes
◼ History of debts
◼ Excessive gambling

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5.6 Undo Accounting Distortions

Try to make adjustments

◼ use data in the notes
◼ use cash flow data
◼ use non-accounting sources:
 Newspapers
 Call investor relations
Example: Off-B/S financing

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6. PITFALLS

Conservative accounting is not “good” accounting,

because:
▪ Can be as misleading as aggressive accounting

(make payments as conservative and set aside as

much as possible for contingencies).
▪ Provide managers with opportunities for “income
smoothing” → prevent analyst

Not all unusual accounting is questionable:

▪ Should consider all possible explanations for
accounting changes and investigate them in term
of qualitative information 34
7. Implementing Accounting Analysis:
Assets Distortions
Firm owns/controls the economic resources?

The economic resources are likely to provide future economic

benefit that can be measured with reasonable certainty

The assets’ fair value lower/higher than book values?

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7.1 Implementing Accounting Analysis:
Overstated Assets

Delayed write-downs of current assets

Delayed write-downs of long-term assets

Underestimate reserves/provision

Understated depreciation/amortisation on long-term assets

Accelerated recognised revenue (increase of receivables)

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7.2 Implementing Accounting Analysis:
Understated Assets

Overstated write-downs of current assets

Overstated write-downs of long-term assets

Overestimated reserves/provision

Overstated depreciation/amortisation on long-term assets

Lease assets off balance sheet

Discounted receivables off balance sheet even though the firm

still retains considerable collection risk

Key intangible assets (R&D, trademarked brands) are not

reported on the balance sheet
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8. Implementing Accounting Analysis:
Liability Distortions

Has an obligation been incurred?

Can the obligation be measured?

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8.1 Implementing Accounting Analysis:
Understated Liabilities

Unearned revenues are understated through aggressive revenue

recognitition

Loans from discounted receivables are off balance sheet

Long-term liabilities for lease are off balance sheet

Pension and post-retirement obligation are not fully recorded

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9. Implementing Accounting Analysis:
Equity Distortions

Result from distortions of assets and liabilities

Hybrid securities (combined debt and equity). Eg. Convertible

debt and debt with warrants.

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Accounting Analysis for Dell

Main concern: higher return on equity

What are the major areas we need to look into at
Dell if we want to understand how well they are
doing?
◼ Based on the industry and competitive strategy

analyses
 growth, profitability

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Think About Dell
◼ Accounting Rules—biased?
◼ Accounting Estimation—biased?
◼ Factors that Affect Managers’ Accounting Choices
 debt covenants—does Dell have any?
 management compensation—does Dell have earnings-
based bonuses?
 corporate control contest—is Dell concerned about a
takeover?
 tax considerations—LIFO versus FIFO
 regulatory considerations—consider Microsoft
 capital market considerations
 stakeholder considerations —consider auto industry
 competitive considerations—how detailed should the
reporting be
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 Flexibility Analysis
Fiscal year-end: Friday nearest 1/31
Consolidate all wholly owned subsidiaries
Short-term investments: available-for-sale
Inventory: first-in, first-out
Depreciation: 2 to 5 years for non-buildings
Amortization of intangibles: 3 to 8 years
R&D and advertising: expensed
Warranty and post-sale support: estimated and
expensed
Software development costs: capitalized
Segment information

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THE END

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