Financial statement analysis exam notes

Chapter 3:
The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business
reality.

 identifying places where there is accounting flexibility, and

 by evaluating the appropriateness of the firm’s accounting policies and estimates,
 analysts can assess the reliability of a firm’s accounting numbers
THE IMPORTANCE OF ACCOUNTING ANALYSIS

 Accounting practices govern the types of disclosures made in the financial statements.
 Understanding accounting allows the business analyst to effectively use the financial information disclosed by
companies.
KEY CONCEPTS IN CHAPTER 3

 Various factors influence the quality of accounting-based financial reports.

 Managers have some discretion in accounting choices used in financial reporting.
 Incentives for the management of financial reporting items must be considered by the analyst.
 Recasting of financial statements in a common format helps to improve financial statement comparability.

THE INSTITUTIONAL FRAMEWORK FOR FINANCIAL REPORTING

Financial statements serve as the vehicle through which owners keep track of their firms’ financial situation.
Three primary financial reports:
1. an income statement that describes the operating performance during a time period,
2. a balance sheet that states the firm’s assets and how they are financed, and
3. a cash flow statement (or in some countries, a funds flow statement) that summarizes the cash (or fund) flows of
the firm.
These statements are accompanied by footnotes that provide additional details on the financial statement line items,
ACCRUAL ACCOUNTING AND ACCOUNTING QUALITY

 Financial reports are prepared using accrual accounting instead of cash accounting.
 Applying accounting principles is the responsibility of management, who has superior knowledge of a firm’s
business. Incentives exist for management to distort accounting numbers in their favor.
 Mitigating effects of legal liability, auditing, public enforcement.
 Three potential sources of noise and bias in accounting data include:
1. Noise from accounting rules
2. Forecast errors
3. Manager’s accounting choices
INCOME STATEMENT
The following definitions are critical to the income statement, which summarizes a firm’s revenues and expenses: The
following fundamental relationship is therefore reflected in a firm’s income statement:
Profit = Revenues −Expenses
Revenues - are economic resources earned during a time period. Recognition is governed by the realization principle,
which establishes that revenues should be recognized when;
a) the firm has provided all, or substantially all, the goods or services to be delivered to the customer and
b) the customer has paid cash or is expected to pay cash with a reasonable degree of certainty
Expenses - are economic resources used up in a time period. Expense recognition is governed by the matching and the
conservatism principles. Under these principles, expenses are resource costs
a) directly associated with revenues recognized in the same period,
b) associated with benefits that are consumed in this time period, or
c) whose future benefits are not reasonably certain.
Profit - is the difference between a firm’s revenues and expenses in a time period
BALANCE SHEET
In contrast, the balance sheet is a summary at one point in time. The definitions of assets, liabilities, and equity lead to the
fundamental relationship that governs a firm’s balance sheet:
Assets = Liabilities + Equity
The principles that define a firm’s assets, liabilities, and equity are as follows:
Assets - are economic resources owned by a firm that are;
a) likely to produce future economic benefits and
b) measurable with a reasonable degree of certainty.
Liabilities - are economic obligations of a firm arising from benefits received in the past that;
a) are required to be met with a reasonable degree of certainty and
b) whose timing is reasonably well defined.
Equity - is the difference between a firm’s assets and its liabilities
Delegation of Reporting to Management
 Because corporate managers have intimate knowledge of their firms’ businesses,
 they are entrusted with the primary task of making the appropriate judgments in portraying myriad business
transactions using the basic accrual accounting framework.
 The accounting discretion granted to managers is potentially valuable
 because it allows them to reflect inside information in reported financial statements
Generally Accepted Accounting Principles
Given that it is difficult for outside investors to determine;
 whether managers have used accounting flexibility to signal their proprietary information or merely to disguise
reality,
 In recognition of this, the world’s major standard setters have increasingly required the use of fair value
accounting in their respective standards.
 Accounting standards and rules also limit management’s ability to misuse accounting judgment by regulating how
particular types of transactions are recorded.
  Uniform accounting standards attempt to reduce managers’ ability to record similar economic transactions in
dissimilar ways, either over time or across firms.
 Rigid accounting standards work best for economic transactions whose accounting treatment is not predicated on
managers’ proprietary information.
 rigid standards are likely to be dysfunctional for some companies because they prevent managers from using their
superior knowledge of the business to determine how best to report the economics of key business events.
External Auditing
Broadly defined as a verification of the integrity of the reported financial statements by someone other than the preparer,
ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are
reasonable.
Legal Liability
The legal environment in which accounting disputes among managers, auditors, and investors are adjudicated can also
have a significant effect on the quality of reported numbers.
 The threat of lawsuits and penalties has the beneficial effect of improving the accuracy of disclosure. However,
 the potential for significant legal liability might also discourage managers and auditors from supporting
accounting proposals where management and auditor judgment and increased complexity or nuance come into
play.
FACTORS INFLUENCING ACCOUNTING QUALITY
Because the mechanisms that limit managers’ ability to distort accounting data themselves add noise, it is not optimal to
use accounting regulation to completely eliminate managerial flexibility. Therefore, real-world accounting systems leave
considerable room for managers to influence financial statement data.
There are three potential sources of noise and bias in accounting data:
1. noise introduced by rigidity in accounting rules,
2. random forecast errors, and
3. systematic reporting choices made by corporate managers to achieve specific objectives.
Each of these factors is discussed below.
Noise from Accounting Rules
Accounting rules introduce noise and bias because it is often difficult to restrict management discretion without reducing
the information content of accounting data. The degree of distortion introduced by accounting standards depends on how
well uniform accounting standards capture the nature of a firm’s transactions.
Forecast Errors
Another source of noise in accounting data arises from pure forecast error, because managers cannot predict future
consequences of current transactions perfectly. The extent of errors in managers’ accounting forecasts depends on a
variety of factors including;
 the complexity of the business transactions,
 the predictability of the firm’s environment,
 and unforeseen economy-wide changes.
Managers’ Accounting Choices
Corporate managers also introduce noise and bias into accounting data through their own accounting decisions. Managers
have a variety of incentives to exercise their accounting discretion to achieve certain objectives:

 Accounting-based debt covenants.

Managers may make accounting decisions to meet certain contractual obligations in their debt covenants.
 Management compensation.
Another motivation for managers’ accounting choice comes from the fact that their compensation and job security
are often tied to reported profits.
 Corporate control contests.
In corporate control contests, including hostile takeovers and proxy fights, competing management groups attempt
to win over the firm’s shareholders
 Tax considerations.
Managers may also make reporting choices to tradeoff between financial reporting and tax considerations.
 Capital market considerations.
Managers may make accounting decisions to influence the perceptions of capital markets
 Stakeholder considerations.
Managers may also make accounting decisions to influence the perception of important stakeholders in the firm
 Competitive considerations.
The dynamics of competition in an industry might also influence a firm’s reporting choices
STEPS IN PERFORMING ACCOUNTING ANALYSIS
Step 1: Identify Principal Accounting Policies
 One of the goals of financial statement analysis is to evaluate how well these success factors and risks are being
managed by the firm.
 In accounting analysis, therefore, the analyst should identify and evaluate the policies and the estimates the firm
uses to measure its critical factors and risks.
 IFRS require firms to identify critical accounting estimates
Step 2: Assess Accounting Flexibility
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.
 Not all firms have equal flexibility in choosing their accounting policies and estimates. Some firms’ accounting
choice is severely constrained by accounting standards and conventions
 If managers have little flexibility in choosing accounting policies and estimates related to their key success
factors, accounting data are likely to be less informative for understanding the firm’s economics.
 Regardless of the degree of accounting flexibility a firm’s managers have in measuring their key success factors
and risks, they have some flexibility with respect to other accounting policies.
Step 3: Evaluate Accounting Strategy
When managers have accounting flexibility, they can use it either to communicate their firm’s economic situation or to
hide true performance.

 Issues to consider include:

 Norms for accounting policies with industry peers
 Incentives for managers to manage earnings
 Changes in policies and estimates and the rationale for doing so
 Whether transactions are structured to achieve certain accounting objectives
Step 4: Evaluate the Quality of Disclosure

 Managers can make it more or less easy for an analyst to assess the firm’s accounting quality and to use its
financial statements to understand business reality.
 Managers have considerable discretion in disclosing certain accounting information
 Issues to consider include:
 Whether disclosures seem adequate
 Adequacy of notes to the financial statements
 Whether the Management Report section sufficiently explains and is consistent with current performance
 Whether IFRS restricts the appropriate measurement of key measures of success
 Adequacy of segment disclosure
Step 5: Identify Potential Red Flags
In addition to the preceding steps, a common approach to accounting quality analysis is to look for “red flags” pointing to
questionable accounting. Some issues that warrant gathering more information include:

 Unexplained transactions that boost profits

 Unusual increases in inventory or A/R in relation to sales
 Increases in the gap between net profit and cash flows or tax profit
 Use of R&D partnerships, SPEs or the sale of receivables to finance operations
 Unexpected large asset write-offs
 Large year-end adjustments
 Qualified audit opinions or auditor changes
 Related-party transactions
Step 6: Undo Accounting Distortions
If the accounting analysis suggests that the firm’s reported numbers are misleading, analysts should attempt to restate the
reported numbers to reduce the distortion to the extent possible Use information from the cash flow statement and notes to
the financial statements to (possibly imperfectly) undo distortions.

RECASTING FINANCIAL STATEMENTS

 Balance sheets, (comprehensive) income statements, and statements of cash flows may be recast with
standardized line-item descriptions to increase their usefulness.
 Firms can vary in the nomenclature and formats used to report financial results
 Templates have been designed for each of the three major financial statements to standardize the format
and nomenclature
 One complication is that under IFRS firms may classify operating expenses by nature or by function.
 Standardization of financial statements builds on two principles:
1. Analysts typically analyze business (operating and investment) activities separately from financing
activities. Business activities primarily affect value creation; financing activities primarily affect the
allocation of value (among, for example, various equity and debt holders).
2. Financial statements must remain sufficiently disaggregated to understand items’ different future
performance consequences.
 Classification of financial statement items along the following dimensions:
 Business (operating and investment) versus financial assets or liabilities.
 Current versus non-current assets or liabilities.
 Assets or liabilities from continued versus discontinued operations.
 Templates: Refer to Tables 3.1, 3.2, 3.3, 3.4, and 3.5 in the text
ACCOUNTING ANALYSIS PITFALLS
There are several potential pitfalls and common misconceptions in accounting analysis that an analyst should avoid.
1. Conservative Accounting Is Not “Good” Accounting
Some firms take the approach that it pays to be conservative in financial reporting and to set aside as much as
possible for contingencies
 From the standpoint of a financial statement user conservative accounting is not the same as “good”
accounting can be just as misleading as aggressive accounting in this respect
 For example, historical cost and accounting for intangible assets
2. Not All Unusual Accounting Is Questionable
unusual accounting choices might make a firm’s performance difficult to compare with other firms’ performance,
such an accounting choice might be justified if the company’s business is unusual.
 Earnings management does not necessarily motivate some accounting phenomena that seem unusual
 Common standards ≠ common practices.

Conclusion
In summary, accounting analysis is an important step in the process of analyzing corporate financial reports.

 The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying
business reality.
 Sound accounting analysis improves the reliability of conclusions from financial analysis, the next step in
financial statement analysis.
 There are six principal steps in accounting analysis.

1. The analyst begins by identifying the key accounting policies and estimates given the firm’s industry and
its business strategy.
2. The second step is to evaluate the degree of flexibility available to managers given the accounting rules
and conventions.
3. Next, the analyst evaluates how managers exercise their accounting flexibility and the likely motivations
behind managers’ accounting strategy.
4. The fourth step involves assessing the depth and quality of a firm’s disclosures.
5. The analyst should next identify any red flags, indicating a need for further investigation.
6. The final step in accounting analysis is to restate accounting numbers to remove any noise and bias
introduced by the accounting rules and management decisions.
 Research suggests earnings management is not so pervasive as to make earnings data unreliable