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 firm’s economic
performance, financial position and risk
 Accounting informaton should provide relevant
information to forecast the firm’s 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
persistence of income, and therefore the economic
value of a firm?
◦ Economic value implications of the current period’s
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: 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.
 Restructuring charges: 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 firm’s 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 write-offs
 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