Module 3:

Accounting
Analysis
• Institutional framework for financial reporting

• Need for accounting rules and conventions

• Source of noise and bias in the accounting data

• Drivers of accounting quality

• Steps on doing accounting analysis

• Accounting analysis pitfalls

• Value of accounting analysis

 Accounting Analysis

• Process of examining financial statements, reports, and

other financial data
• It involves assessing the information presented in financial
Objectives of Accounting Analysis
statements
• Key aspects of accounting analysis include evaluating
profitability, liquidity, solvency, efficiency, and compliance
with accounting standards and regulations
Accounting Analysis - Goal

• Assessing Financial Performance

• Forecasting Future Performance
• Facilitating Decision-Making – exp. Scenarios
• Evaluating Financial Health
• Ensuring Compliance
• Finding Accounting Distortion
 Key Financial Reports

• Income Statement (Profit and Loss

Statement):
• Balance Sheet:
Objectives of Accounting Analysis
• Statement of Cash Flows:
 Institutional Framework

Accrual Accounting
• An accounting method that recognizes revenues and
expenses when they are incurred, regardless of when
Objectives of Accounting Analysis
cash transactions occur.
• It contrasts with cash accounting, which records
revenues and expenses only when cash is actually
received or paid out. Accrual accounting provides a
more accurate picture of a company's financial position
andIncome
performance
Statement over aBalance
specific
Sheet period.
Revenues Assets
Expenses Liabilities
Profit Equity
 Assigning Reporting to Management

• Complex Judgments in Financial Statements

• Revenue Recognition and Customer Financing
• Objectives ofResearch
Treatment of Accounting
andAnalysis
Development Costs
• Role of Corporate Managers in Accounting
• Delegation of Financial Reporting Decisions
• Role of Accounting Rules and Auditing

Generally Accepted Accounting Principles

• Mitigate potential distortions by managers in financial reporting.

• Standard-setting bodies like FASB in the U.S. and IASC globally
create uniform standards to enhance credibility.
• Uniform standards reduce flexibility but ensure consistency
across firms and over time.
 External Auditing

• Independent verification of financial statements to ensure

consistent application of accounting rules.
• U.S. listed companies must have financial statements audited by
Objectives of Accounting Analysis
independent accountants.
• Auditing enhances the credibility of financial data but can
constrain the evolution of accounting rules.

Legal Liability

• The legal environment influences the quality of financial

reporting.
• Threat of lawsuits improves disclosure accuracy but may
discourage risky forecasts and forward-looking disclosures.
 Drivers of Accounting Quality

• Noise and Bias from Accounting Rules:

• Rigidity in accounting rules can reduce the information content of
accounting data.
Objectives of Accounting
• Example: SFASAnalysis
requires expensing research outlays immediately, leading
to potential distortion.

• Random Forecast Errors:

Accounting
• Analysis - Goalcannot perfectly predict future outcomes of current
Managers
transactions.
• Regulatory Considerations
• Example: Estimating uncollectible accounts receivable, which can lead
• Capital Market Considerations
to forecast errors.
• Stakeholder Considerations – Labor
Union
• Systematic Reporting Choices by Managers:
• Competitive Considerations
• Accounting-based Debt Covenants • New entrants, profit margin on
• Management Compensation individual products, avoid
 Steps for Conducting Accounting
Analysis

Step 1: Identify Key Accounting Policies

• Understand the industry and competitive strategy.

• Objectives
Evaluateofhow the firm's
Accounting policies and estimates measure critical success factors
Analysis
and risks.
• banking, retailors, manufacturing ,
• Example: Leasing business's critical accounting policy is recording residual
values.
Step 2: Assess Accounting Flexibility

• Determine the flexibility a firm has in choosing accounting policies and

estimates.
• Consider the impact of limited flexibility (e.g., biotechnology firms) versus
high flexibility (e.g., software developers).
• All firms make choices regarding depreciation, inventory accounting,
 Step 3: Evaluate Accounting Strategy

• Compare the firm's accounting policies to industry norms.

• Assess if management has incentives to manage earnings.
• Examine changes in policies or estimates and their justifications.
• Objectives
Review theof Accounting Analysis
history of the firm's policies for realism and past
accuracy.
• Identify if transactions are structured to meet accounting
objectives. Brothers
Step 4: Evaluate the Quality of Disclosure

• Enough Disclosure about Business Strategy –e.g future plan disclosure

• Adequate Footnotes info- different policy than industry, like revenue
• Explaining Current Performance – why profit has decreased?
• Handling Important Factors – Investment in quality and customer service
• Segment Disclosure – like geography, products and so on e.g Amazon
• Transparency with Bad News
 Step 5: Identify Potential Red Flags

• Look for unexplained changes in accounting policies (like provisions for bad
debts), transactions that boost profits, or unusual increases in receivables or
inventories against the sales.
•Objectives
Monitorof the
Accounting Analysis between reported income and cash flow, and between
relationship
reported income and tax income.
• Be cautious of financing mechanisms that may understate liabilities or overstate
assets, using R&D, SPEs.
Step 6: Undo Accounting Distortions
• Note large asset write-offs, fourth-quarter adjustments, qualified audit opinions
or opinion
• Restate shopping,
reported and to
numbers related-party transactions,
reduce distortions Unexplained
using the cash flow contingency.
statement and financial statement footnotes.
• The cash flow statement helps reconcile accrual and cash accounting.
• Footnotes provide details on accounting policy changes and differences
between shareholder and tax reporting.
 Accounting Analysis Pitfalls

• Conservative Accounting Misconceptions

• Misleading Perception: Conservative
accounting does not necessarily equate to
Objectives
accurateofor
Accounting
unbiased Analysis
financial reporting. • Attributing All Accounting Changes to
Earnings Management
• Income Smoothing: Conservative practices
• Consideration of Business Context:
may obscure true performance by smoothing
Not all changes in accounting policies or
income fluctuations, delaying recognition of
accruals are driven by earnings
Accounting Analysis - Goal
poor performance.
management.
• Confusing Unusual Accounting with
• Changed Business Circumstances:
Questionable Practices
Accounting changes may reflect legitimate
• Contextual Evaluation: Unusual accounting
shifts in business strategy, such as
choices should be assessed in light of a firm's
inventory increases for new product
unique business strategy.
launches or adjustments in receivables
• Justification: Firms with differentiated
due to sales strategy changes.
 Accounting Analysis

· Value of Accounting Information: · Value of Superior Accounting Analysis:

o Research shows investors with perfect earnings o Evidence indicates opportunities for
foresight could earn an average 37.5% annual superior analysts to earn positive stock
return (1954-1996) returns
o Perfect
Objectives ROE foresight
of Accounting Analysis could yield even higher o Companies criticized for misleading
returns (43% annually, 50% of perfect price financial reporting suffered average
foresight) 8% stock price drop
· Comparison to Cash Flow Data: o Firms with apparent earnings inflation prior
o Cash flow information is less valuable than to equity issues showed poor subsequent
Accounting Analysis
earnings - Goal
or ROE stock performance
· Effectiveness of Accounting Conventions: · Market Reaction to Earnings
o Research suggests institutional Management:
arrangements and conventions mitigate o Analysts who can identify firms with
potential misuse of accounting by managers misleading accounting can create
o Investors do not view earnings management as value for investors
so pervasive as to make earnings data o When uncovered, stock prices respond
unreliable negatively to evidence of inflated prior
earnings