Chapter 3 liabilities + profit for the period + other
Overview of accounting analysis comprehensive income + other equity)
1. Financial statements - structured
representations, or models, of a firm’s financial
position and financial performance. Financial
statements are to reflect the firm’s underlying
business, they should reflect the transactions
the firm undertakes.
2. elements - They reflect the financial results of
transactions and other events by grouping them
into broad classes of economic characteristics
called this.
3. statement of financial position / balance sheet -
summary of the levels of resources and
obligations of the firm at a point in time.
4. Assets = liabilities + equity -> equation governs
the structure of the statement of financial
position:
5. assets, liabilities and equity - elements that
directly relate to the measurement of financial
position
6. income and expenses - elements that directly
relate to the measurement of performance
7. Comprehensive income = profit for the year +
other comprehensive income ; Profit for the
year = revenue – expenses (relations reflect the
measurement in the firm’s performance)
8. Clean surplus’ - is a concept where all gains and
losses go through income. In practice, this ideal
can never be reached.
9. dirty surplus - Traditionally, some items avoid
profit and are reported directly in equity
10. comprehensive income - However, more
recently standard setters have tried to limit the
number of items that bypass profit for the year
by developing this concept
11. statement of comprehensive income - is a
statement that links revenue and expenses with
the balance sheet elements. Because of this
link, we can combine the balance sheet and
income statement equations to form an
expanded bookkeeping equation (Assets =
12. accounting policies and segment information -
Accompanying the financial statements is an
extensive set of notes that provide further
details on the items reported in the primary
financial statements. These notes also include
these two important pieces of information for
the analyst
13. management commentary - Managers often
include a narrative discussion of performance
with the financial statements
14. extended external reports (EER) - sustainability
reports or social responsibility reports, or
reports that use the frameworks of the
International Integrated Reporting Council and
the Global Reporting Initiative. Such reports go
beyond the traditional financial statements and
report strategic risk information on how
environmental, social and governance matters
impact the firm. Such reports can be part of
management commentary, a separate section
in the annual report or a separately published
report.
15. consolidated financial statements - provide
aggregated information on the group’s
activities. This aggregation can cover multiple
industries and multiple jurisdictions. To enable
analysts to more fully understand the business,
segment reports can reveal which areas are
profitable.
16. operating segment - is a component of an entity
that engages in business activities which earns
revenue and incurs expenses and where the
chief decision maker reviews the operating
results on a regular basis and makes decisions
on resource allocation.
17. Operating profit - is segment revenue less
segment expense and excludes net finance
costs.
18. Transactions - refer to contracts made between
the firm and external third parties. Transactions
internal to the firm cannot change or create
wealth. There is a saying ‘transferring money
from one pocket to another does not create
wealth’. Thus, the financial statements ought to
 reflect transactions that are external to the
firm.
19. Events - An uninsured factory that has burnt to
the ground is not a transaction, but the write-
down in value is an event that needs to be
recorded. Another example is borrowings in
foreign currency, which are affected by changes
in exchange rates.
20. Conditions - A bottling plant working with
corrosive materials will wear out faster than a
similar plant bottling mineral water. Hence, the
financial statements will also need to reflect the
underlying conditions.
21. accrual accounting - Because managers have
inside knowledge of the firm’s business, they
are entrusted to make the appropriate
judgements in portraying the myriad of business
transactions using this.
22. accounting discretion – this is granted to
managers to allow them to enhance the
information reported in financial
statements. However, as profits are
regarded as a measure of managers’
performance, managers have an incentive
to use their accounting discretion to distort
reported profits.2 The use of accounting
numbers in contracts between the firm and
outsiders provides further incentives for
managers to manipulate accounting
numbers. Earnings management distorts
financial accounting data, making this data
less valuable to external users of financial
statements.
23. Institutional factors - management does not
have limitless discretion over accounting
matters. These affect financial statements
and restrict managers’ discretion. These
include accounting standards, audit, legal
enforcement and governance.
24. objective of the IASB - to develop, in the
public interest, a single set of high quality,
understandable, enforceable and globally
accepted financial reporting standards
based on clearly articulated principles.
These standards should require high quality,
transparent and comparable information in
financial statements and other financial
reporting to help investors, other
participants in the various capital markets
of the world and other users of financial
information make economic decisions.
25. accounting standards - create a common
accounting language. This ought to reduce
the cost of analysis and limit managers’
ability to distort financial statements.
26. Proponents of principles-based standards -
claim they reflect the economic substance
of a transaction instead of its legal form.
27. Proponents of the rules-based approach -
claim that their approach increases
verifiability and uniformity of financial
statement information.
28. Auditing - improves the credibility of
accounting data by limiting the firm’s ability
to manipulate financial statements and
ensures consistency of reporting over time.
To be effective, the audit must be
conducted by an expert who is independent
of the preparer.
29. quality of financial reporting - is a joint
product of the quality of accounting
standards and the quality of enforcement of
those standards.
30. objective of accounting analysis - is to
evaluate the degree to which a firm’s
accounting captures its underlying business
reality and to ‘undo’ any accounting
distortions. When potential distortions are
large, accounting analysis can add
considerable value.
31. corporate governance - framework of rules,
relationships, systems and processes within
and by which authority is exercised and
controlled within corporations. It
encompasses the mechanisms by which
companies, and those in control, are held to
 account. It is common for the annual report
to have a separate section on governance.
32. Good corporate governance - is designed to
promote investor confidence and is
therefore important in accounting analysis.
A disclosure is a requirement of the ASX. If
firms do not comply with governance
guidelines, they must explain why
STEPS IN ACCOUNTING ANALYSIS
- series of steps that the analyst
should follow to evaluate a firm’s
accounting quality.
- Steps 1–3 are preliminary parts of
the process.
- The subsequent steps follow the
managers’ ability to affect the
financial statements noted earlier in
the chapter: (4) the underlying
transactions, (5) choosing between
acceptable alternative accounting
policies and methods, (6) making
assumptions and estimates, and (7)
choosing the level of explanatory
disclosures.
Step 1: What is the objective?
- The first step in almost any process
is to identify the end goal.
Step 4: Look for unusual transactions and events
Step 2: What information is available?
- This is important because, to limit
liability, the consultant’s report will
state ‘... we have relied on the
following documents...’. Also
important is whether there are
limitations or any restrictions placed
on information that has been made
available.
Step 3: Examine the audit report
- A useful preliminary step in
assessing accounting quality is to
read an expert’s opinion on the
financial statements – the audit
report.
- The date between balance date and
when the audit report is signed is
called the audit lag. Abnormal audit
lags (either from prior years or from
industry norms) may indicate that
the firm has had audit problems that
have taken time to resolve.
- Auditor independence can be
compromised if the firm pays the
auditor large amounts of consulting
income relative to other fees. The
following footnote reports the fees
earned by the auditor.
- In most cases, the firm is a going
concern and the auditor issues a
‘clean’ audit report.
- While auditors issue an opinion on
published financial statements, it is
important to remember that the
primary responsibility for the
statements still rests with the firm’s
board of directors.
- In the Kathmandu case ‘Going
concern’, the audit report clearly
states the responsibility of the
directors.
- Sometimes unusual or non-recurring
transactions and events can
dominate the financial statements.
These might include acquisitions,
mergers, discontinued operations,
major changes in management,
potential lawsuits and major
refinancing arrangements.
- accounting bath - That is, they will
choose extremely conservative
accounting by writing down and
impairing assets. The bath (or lower
profit) created by this accounting
can be blamed on the old managers.
This also creates ‘cookie jar
 reserves’. As accruals reverse over
time, this accounting technique
effectively transfers profit to the
future.
- opinion shopping - client has chosen
a new auditor because they want a
certain accounting treatment not
approved of by the old auditor. Such
changes in auditor is termed
Step 5: Assess accounting policies
how does the analyst know if the accounting
policies are appropriate? Possible approaches are:
➢ Do the firm’s accounting policies compare
to industry norm
➢ Has the firm changed any of its policies?
➢ Are there any prior period adjustments?
Step 6: Assess accrual quality
- it is important to identify the basis on
which the financial statements are
prepared.
- One of the underlying features of
financial statements is that they are
prepared using the accrual basis of
accounting.
- Accountants use accrual accounting to
allocate current cash flow to past,
current and future periods. For
example, cash payments to purchase
goods can be carried forward to the
future (as inventory) until the goods are
sold. Accrual accounting can also
anticipate future cash flows. That is,
revenues are recoded when the sales
contract has been signed and not when
the cash is received. Hence, accrual
accounting requires accountants to
make estimates and judgements in
allocating cash flows to past, current
and future periods.
- The evidence shows that accruals
improve the ability of earnings to
measure performance, as reflected in
stock returns.
- However, in the short term, new
accruals can more than offset reversing
accruals.
- Accruals are the link between income
and cash flows
Income = operating cash flows + accruals
- impact of accruals on income; that is,
the potential impact of accounting
discretion. If the financial statements
are of IFRS quality, then they will show a
reconciliation of net profit after tax with
cash inflow from operations.
- Another way to assess accrual quality is
to assess if the policies and estimates
have been realistic in the past. For
example, firms that depreciate non-
current assets too slowly will be forced
to take a large write-off later. A history
of loss on sale may be, therefore, a sign
of under- depreciation in early years.
Similarly, if a firm makes substantial
provisions for losses it might be creating
‘cookie jar’ reserves that it can realise in
future years when profitability is not so
good.
Step 7: Assess disclosure quality
- While accounting rules require a certain
amount of minimum disclosure,
managers have considerable choice in
the matter. Disclosure quality, therefore,
is an important dimension of a firm’s
accounting quality.
In assessing disclosure quality, an analyst could ask the
following questions:
➢ Does the firm provide adequate disclosures to
assess business strategy and its economic
consequences?
➢ Does the firm adequately explain its current
performance?
➢ If accounting rules and conventions restrict the
firm from reporting its key success factors
appropriately, are additional disclosure
provided?
alternative performance measures (APM) - APM are
non-GAAP measures of firm performance and may
provide a view of ‘normalised earnings’ as seen through
the ‘eyes of management’. These measures may have
more predictive ability than comprehensive income, analysis is to evaluate the degree to which a firm’s
which includes gains and losses that may not recur. accounting captures the underlying business reality.
Thus, APM are useful when viewed alongside GAAP Sound accounting analysis improves the reliability of
income. APM are more reliable if they are reconciled to conclusions from financial analysis.
GAAP income and the method of calculation is
consistently applied. It is important to know that There are eight key steps in accounting analysis. The
comparability of APM across firms and even within an preliminary steps include considering the objective of
industry can be very low. the analysis and determining what information is
available. An important starting point is to examine the
➢ If a firm operates multiple business segments, audit report, which is the expert’s opinion of the
what is the quality of segment disclosure financial statements. The analyst will then look for
➢ Are there any related party disclosures? unusual transactions
➢ How forthcoming is the management with
respect to bad news? and events, assess whether the accounting policies
➢ How good is the firm’s investor relations
program? are appropriate, assess the accrual quality and assess
disclosure quality. Based on this analysis, the analyst
Step 8: Evaluate and conclude
will assess the quality of the financial statements. In this
- accounting analysis is a review of the final stage, the analyst will consider whether to recast
information available, keeping in mind the financial statements.
the objective of the analysis. We have
described this review as a series of
steps. In fact, steps 4–7 are more likely
to be an iterative process rather than a
strict sequential analysis. The analyst
will go back and forth between and
within financial statements, the annual
report and other pieces of information.
The process may indicate further
information is required. However,
collecting additional data is a cost-
benefit activity. The accounting analysis
should be a preliminary overview rather
than an extensive investigation
- This accounting analysis will give the
analyst an understanding of the
available data. However, the main
purpose is to come to a qualitative
assessment of the information. The
main features of this review will be
considered during the analysis phase.
- The accounting analysis might suggest
that the firm’s reported numbers need
to be restated. While it is virtually
impossible to undo the accounting
without the help of outside information,
often a reasonable attempt can be
made in this direction.

SUMMARY

Accounting analysis is an important step in analysing

corporate financial reports. The purpose of accounting