ACCOUNTING ANALYSIS

▪ Explain the importance of accrual

accounting and its strengths and
limitations
▪ Describe the need for and techniques
of accounting analysis
 Accrual Accounting
▪ Illustration
▪ Definition of accrual accounting
▪ Describe accrual process
▪ Relation between accruals and cash
flows
▪ Relevance and limitations of accrual
accounting
 Accruals - Illustration
The company is established with the total capital
of $700. The company’s capital is financed
totally by equity. The company decide to sell
printed T-shirts for $10 each. The costs of this
business include purchasing 100 plain T-shirts for
$5 each, fixed screen cost of $100 and variable
print cost of $0.75 per T-shirt. By the end of the
company first week in business, all T-shirts are
ready for sale. Customers with orders totalling 50
T-shirts pick up their T-shirts in that first week.
But, of the 50 T-shirts picked up, only 25 are paid
for in cash. For the other 25, the company accept
customer’s late payment till next week.
 Case Illustration – Cash Accounting
Income Statement Balance Sheet (Cash basis)

Revenues Assets
T-Shirt sales 10x25 (paid in cash)Cash 275

The amount of T-shirt sales are not fitted with the amount of T-shirt costs

Costs
T-Shirt purchases 5x100

Screen purchase 100 Equity

Printing charges 0.75x100 Beginning Equity 700

Total payments 675 Retained earnings (425)

Net Income (425) Total equity 275

 Case Illustration – Accrual Accounting

Income Statement Balance Sheet (Accrual basis)

Revenues Assets
T-Shirt sales 500 Cash 275

T-Shirt inventory 337.5

Expenses 50 T-shirts Receivables 250

T-Shirts costs 250 Total assets 862.5

Screen depreciation $50 ($1/unit)

Printing charges 37.5 Equity

Total expenses (337.5) Beginning equity 700

Add net income 162.5

Net income 162.5 Total equity 862.5

 Accrual Accounting
An accounting method measures the
performance and position of a company by
recognizing economic events regardless of when
cash transactions occur.
 Accrual Process
Revenue Recognition – revenues are recognized when
(1) Earned – deliver products and services
(2) Realized (cash acquired) or Realizable (asset received)
Expense Matching – match with corresponding revenue
- Product costs – arise in the production
- Period costs – marketing, administrative expenses
 Cash Flows vs Accruals
- Operating cash flow (OCF)
refers to cash from a company’s on-going operating activities
CFO = NI + NCC (non-cash charges) - WCInv (tái đầu tư vào nguyên vật liệu,...)

- Free cash flow (FCF) FCF = CFO - FCInv (đầu tư vào tài sản cố định )
FCFF = FCF + (Int x (1-tax rate)) phải trả tiền trước khi trả lãi

reflects the added effects of investments and divestments in

operating assets. It represents cash available for both debt and
equity holders.

- Free cash flow to equity (FCFE) = FCF + Net borrowing

reflects the added effects of changes in the firm’s debt levels to free
cash flow to the firm. It represents cash available for equity holders.

- Net cash flow (NCF)

is the change in the cash account balance that is reported on the
statement of cash flows.
 Cash Flows vs Accruals

Net Operating
= + Accruals
Income Cash Flow

= +
 Relevance of accrual accounting
- Financial performance: Revenue recognition
and expense matching yield an income number
superior to cash flows for evaluating financial
performance.
- Financial condition: Accrual accounting
produces a balance sheet that more accurately
reflects the level of resources availability to the
company to generate future cash flows.
- Predicting future cash flows: accrual income is
a superior predictor of future cash flows than are
Why don't use NI to predict FCF ? Why accrual accounting more revelant
current cash flows than cash basis? why don't use current CF to predict future CF?
Limitations of accrual accounting
- Arbitrary rules
- Estimation errors
- Earnings management
 Accounting Analysis
o Accounting analysis is the process of evaluating the
extent to which a company’s accounting numbers
reflect economic reality - evaluating accounting’s
risk and earning quality, estimating earning power,
and making necessary adjustments to financial
statements to both reflect economic reality and assist
in financial analysis.
o Accounting analysis is the process an analyst uses to
identify and assess accounting distortions in a
company’s financial statements. It also includes the
necessary adjustments to financial statements that
reduce the distortions and make the statements
amenable to financial analysis.
 Demand for Accounting Analysis

o Accounting distortions are identified

and adjusted so that accounting
information better reflects economic
reality
o Accounting information usually
requires adjustments to meet the
analysis objectives of a particular user.
 Sources of Accounting Distortions
o Accounting Standards
o Estimation Errors

o Reliability vs Relevance

o Earnings Management
 Sources of Accounting Distortions
o Accounting Standards – attributed to
1) Accounting principles: the historical cost principle,
inventory rules
2) Conservatism – write down impaired assets

o Estimation Errors – attributed to estimation errors

inherent in accrual accounting (sold on credit)
o Reliability vs Relevance – attributed to over-emphasis
on reliability at the loss of relevance, trade-off bw
reliability and relevance
o Earnings Management – attributed to window-
dressing of financial statements by managers to achieve
personal benefits
 Earnings Management
Earning Management strategies:
o Increasing Income – managers adjust
accruals to increase
reported income
o Big Bath – managers record huge write-
offs in one period to relieve other periods
of expenses
o Income Smoothing – managers decrease
or increase reported income to reduce its
volatility
Process of Accounting Analysis
1) Evaluating earnings quality
2) Adjusting financial statements
 Process of Accounting Analysis
Evaluating Earning Quality: Steps
1) Identify and assess key accounting
policies
2) Evaluate extent of accounting
flexibility
3) Determine the reporting strategy
4) Identify and assess red flags
 Process of Accounting Analysis
Evaluating Earning Quality: Steps
1) Identify and assess key accounting
policies:
• Are the policies reasonable?
• Is the set of policies adopted consistent
with industry norms?
• What impact will the accounting
policies have on reported numbers in
financial statements?
 Process of Accounting Analysis
Evaluating Earning Quality: Steps
2) Evaluate extent of accounting
flexibility
The accounting for industries that have more
intangible assets, greater volatility in business
operations, a larger portion of its production
costs incurred prior to production, and unusual
revenue recognition methods requires more
judgments and estimates
 Process of Accounting Analysis
Evaluating Earning Quality: Steps
3) Determine the reporting strategy
▪ Is the company adopting aggressive reporting
practices?
▪ Does the company have a clean audit report?
▪ Has there been a history of accounting problems?
▪ Has the management of the company have a
reputation for integrity, or are they known to cut
corners?
▪ Examine incentives for earnings management and
evaluate the quality of a company’s disclosures
 4) Red Flags
▪ Poor financial performance,
▪ Reported earnings consistently higher
than operating cash flows,
▪ Qualified audit report, auditor resignation
or a unusual auditor change,
▪ Unexplained or frequent changes in
accounting policies,
▪ Sudden increase in inventories in
comparison to sales.
▪ Frequent one-time charges and big baths.
 Process of Accounting Analysis
Evaluating Earning Quality: Steps
1) Identify and assess key accounting policies
2) Evaluate extent of accounting flexibility
3) Determine the reporting strategy
4) Identify and assess red flags
Adjusting Financial Statements:
Identify, measure, and make necessary
adjustments to financial statements to better
serve one’s analysis objectives;