LECTURE 2: ACCOUNTING ANALYSIS 1

Quality of accounting
Introduction to accounting analysis
Earnings sustainability
Earnings management
Steps in accounting analysis
Income tax

Accounting information should be a fair and

complete representation of the firms
economic performance, financial position
and risk
Accounting informaton should provide
relevant information to forecast the firms
expected future earnings and cash flows

Consider
Economic faithfulness of accounting measurement
and classifications
Reliability of the measurements
Fit of GAAP
Reasonableness of the estimates
Adequacy of disclosures

Adjust for accounting distortions so financial

reports better reflect economic reality
Adjust general-purpose financial statements
to meet specific analysis objectives of a
particular user

What do the reported or restated amounts

for current period suggest about the long
run persentance of income, and therefore
the economic value of a firm?
Economic value implications of the current
periods earnings
Long run sustainability of earnings

Whether reported earnings is a good

predictor of future sustainable earnings?
Judging the sustainability of current
earnings: Concern of analysts is the recurring or

permanent nature

Discontinued operations: when a firm decides

to divest a particular segment of business.
In most cases, income from discontinued operations
represents a nonrecurring source of earnings.

Extraordinary items:
Unusual in nature
Infrequent in occurrence
Material in amount

Changes in accounting principles:

voluntary

changes should be carefully examined.

Other comprehensive income items

Impairment losses on long lived assets:

Restructuring charges:

when
the carrying value of long lived assets are not recoverable,
assets need to be written down to market values and an
impairment loss is recognised.
Costs relating to the major
changes in the strategic direction or level of operations of
business

Gains and losses from peripheral activities:

Changes in estimates

Retroactively restate prior years revenues and expenses to

reflect the new estimates
Include the effect as an adjustment to beginning retained
earnings
Spread the effect of new estimate over current & future years

Choice made by management within the

bounds of GAAP to manage earnings to its
advantage.
Earnings management can occur via

Choice of accounting method (i.e. switching)

Accounting judgment (i.e. discretionary
accruals)
Cash flow timing
Asset sales
Financial policy

Contracting Incentives: managers adjust

numbers used in contracts that affect their
wealth (e.g.compensation contracts)
Stock Prices: managers adjust numbers to
influence stock prices for personal benefits
(e.g., mergers, option or stock offering)
Other Reasons: managers adjust numbers
to impact (1) labor demands, (2)
management changes, and (3) societal
views

Earnings can not be managed forever

Earnings management will be penalised by
the market
Likelihood of losing reputation and
trustworthiness because of earnings
management
Legal consequences

Three typical strategies

Increasing Income: managers adjust accruals
to increase reported income
Big Bath: managers record huge write-offs in
one period to relieve other periods of expenses
Income Smoothing: managers decrease or
increase reported income to reduce its volatility

Identify key accounting policies

Assess accounting flexibility
Evaluate accounting strategy
Evaluate the quality of disclosure
Identify potential red flags
Undo accounting distortions

Are the policies reasonable or aggressive

Is the set of policies adopted consistent
with industry norms?
What impact will the accounting policies
have on financial statements?

If managers have less flexibility in

choosing accounting policies and
estimates, accounting data are likely to be
less informative and vice versa.

Is the company adopting aggressive

reporting practices?
Does the company have a clean audit
report?
Has there been a history of accounting
problems?
Does management have strong
incentives for earnings management?

Forthcoming and detailed disclosures can

mitigate weaknesses in financial
statements
Disclosure to assess the firms business strategy, to
explain current performance
Disclosure of key accounting policies and assumptions
Segment disclosure

Poor financial performance

Reported earnings consistently higher than
operating cash flows
Reported earnings consistently higher than
taxable income
Qualified audit opinions or changes in
independent auditors that are not well justified
Unexplained or frequent changes in accounting
policies
Sudden increase in inventories in comparison to
sales
Frequent one-time charges or large asset writeoffs

If the accounting analysis suggests that

the reported numbers are misleading,
analysts should attempt to restate the
reported numbers.

Problem 9.6
Problem 9.9
Problem 9.10