Accounting Analysis

Overview of Accounting Analysis
Purpose of Accounting Analysis
to evaluate accounting quality -- the degree to

which a firms accounting captures its underlying
business reality.
By identifying places where there is accounting

flexibility, and by evaluating the appropriateness
of the firms accounting policies and estimates,
analysts can assess the degree of distortion in a
firms accounting numbers.
Dr. Mahmood Osman Imam
Professor & Chairman, Department of Finance, DU
Accounting Analysis
Purpose of Accounting Analysis
Another important step in accounting analysis is

to undo any accounting distortions by
recasting a firms accounting numbers using
cash flow and footnote information to create
unbiased accounting data.
Sound accounting analysis improves the

reliability of conclusions from financial analysis,
the next step in financial statement analysis.
Analysis Using Financial Statements

Financial Statement
Business Application Context
Managers superior
information on
business activities
Noise from estimation errors
Distortions from managers
accounting choices
Credit analysis
Securities analysis
Mergers and acquisitions
analysis
Debt/Dividend analysis
Corporate communication
strategy analysis
General business analysis
Other Public Data

Industry and firm data
Outside financial statements
Business Strategy Analysis
ANALYSIS TOOLS
Generate performance
expectations through
industry analysis and competitive
strategy analysis.
Accounting Analysis
Financial Analysis
Prospective Analysis
Evaluate accounting
quality by assessing
accounting policies
and estimates.
Evaluate performance
using ratios and cash
flow analysis.
Make forecasts and

value business.

Accounting Analysis--THE INSTITUTIONAL

FRAMEWORK FOR FINANCIAL REPORTING
Separation between ownership and

management in public corporations.
Financial statements serve as the vehicle
through which owners keep track of their firms
financial situation.
On a periodic basis, firms typically produce
three financial reports:
(1) an income statement that describes the operating performance
during a time period,
(2) a balance sheet that states the firms assets and how they are
financed, and
(3) a cash flow statement (or in some countries, a funds flow
statement) that summarizes the cash flows of the firm.

Accounting Analysis
Building Blocks of Accrual Accounting
To evaluate effectively the quality of a firms

financial statement data, the analyst
needs to first understand the basic features of financial
reporting and
the institutional framework that governs them.
One of the fundamental features of corporate financial
reports is that they are prepared using accrual rather than
cash accounting.
Net income is the primary periodic performance index
under accrual accounting.
To compute net income, the effects of economic
transactions are recorded on the basis of expected, not
necessarily actual, cash receipts and payments.

Accounting Analysis
The principles that define a firms assets, liabilities,

equities, revenues, and expenses are as follows:
Assets are economic resources owned by a firm that (a) are

likely to produce future economic benefits and (b) are
measurable with a reasonable degree of certainty.
Liabilities are economic obligations of a firm arising from
benefits received in the past that are (a) required to be met
with a reasonable degree of certainty and (b) at a
reasonably well-defined time in the future.
Equity is the difference between a firms net assets and its
liabilities.
the fundamental relationship that governs a firms balance

sheet:
Assets = Liabilities + Equity
Accounting Analysis
While the balance sheet is a summary at one point in time, the

income statement summarizes a firms revenues and expenses
and its gains and losses arising from changes in assets and
liabilities in accord with the following definitions:
Revenues: its recognition is governed by the realization principle,
which proposes 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: its recognition is governed by the matching and the
conservatism principles. Under these principles, expenses are (a) costs
directly associated with revenues recognized in the same period, or (b)
costs associated with benefits that are consumed in this time period, or
(c) resources whose future benefits are not reasonably certain.
Profit is the difference between a firms revenues and expenses in a
time period

Delegation of Reporting to Management
The accounting discretion granted to managers is potentially

valuable because it allows them
to reflect inside information in reported financial statements.

However, since investors view profits as a measure of managers
performance, managers have an incentive to use their accounting
discretion to distort reported profits by making biased assumptions.
Further, the use of accounting numbers in contracts between

the firm and outsiders provides a motivation for management
manipulation of accounting numbers.
Earnings management distorts financial accounting data, making them

less valuable to external users of financial statements.
The delegation of financial reporting decisions to managers has both
costs and benefits.
Accounting rules and auditing are mechanisms designed to reduce the
cost and preserve the benefit of delegating financial reporting to
corporate managers.

Accounting Analysis
Generally Accepted Accounting Principles
Given that it is difficult for outside investors to determine whether

managers have used their accounting flexibility to signal their
proprietary information or merely to disguise reality, a number of
accounting conventions have evolved to mitigate the problem.
Accounting conventions and standards promulgated by the
standard-setting bodies limit potential distortions that managers can
introduce into reported accounting numbers.
External Auditing
Broadly defined as a verification of the integrity of the reported
financial statements by someone other than the preparer, external
auditing ensures that managers use accounting rules and
conventions consistently over time, and that their accounting
estimates are reasonable.
Auditing improves the quality and credibility of accounting data by

limiting a firms ability to distort financial statements to suit its own
purposes.

Limitations of Accounting Analysis
Because the mechanisms that limit managers ability to distort

accounting data themselves add noise, it is not optimal to use
accounting regulation to eliminate managerial flexibility
completely.
real-world accounting systems leave considerable room for
managers to influence financial statement data.
The net result is that information in corporate financial reports is
noisy and biased, even in the presence of accounting regulation
and external auditing.
The objective of accounting analysis is to evaluate the degree to
which a firms accounting captures its underlying business
reality and to undo any accounting distortions.
When potential distortions are large, accounting analysis can
add considerable value.

10
Factors Influencing Accounting Quality and

Doing Accounting Analysis
There are three potential sources of noise and bias in accounting

data:
(1) the noise and bias introduced by rigidity in accounting rules,
(2) the noise and bias introduced by random forecast errors, and
(3) systematic reporting choices made by corporate managers to
achieve specific objectives.
Doing Accounting Analysis

A series of steps that an analyst can follow to evaluate a firms
accounting quality are:
Step 1: Identify Key Accounting Policies
Step 2: Assess Accounting Flexibility
Step 3: Evaluate Accounting Strategy
Step 4: Evaluate the Quality of Disclosure
Step 5: Identify Potential Red Flags
Step 6: Undo Accounting Distortions
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Identification of Potential Red Flags
A common approach to accounting quality analysis is to look for

red flags pointing to questionable accounting quality. These
indicators suggest that the analyst should examine certain items
more closely or gather more information on them.
Some common red flags are:.
Unexplained changes in accounting, especially when

performance is poor
Unexplained transactions that boost profits
Unusual increases in accounts receivable in relation to
sales increases
Unusual increases in inventories in relation to sales
increases.
An increasing gap between a firms reported income and
its cash flow from operating
activities.
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Identification of Potential Red Flags

Some common red flags are:.
An increasing gap between a firms reported income and

its tax income.
Unexpected large asset write-offs.
Large fourth-quarter adjustments
Related-party transactions or transactions between
related entities.
Qualified audit opinions or changes in independent
auditors that are not well justified.

13
Accounting Analysis Pitfalls
There are several potential pitfalls in accounting analysis that an

analyst should avoid:
(1) First, it is important to remember that from an analysts
perspective, conservative accounting is not the same as good
accounting. Further conservative accounting often provides
managers with opportunities for income smoothing.
(2) A second potential mistake is to confuse unusual accounting with
questionable accounting.
(3) Another potential pitfall in accounting analysis arises when an
analyst attributes all changes in a firms accounting policies and
accruals to earnings management motives.
VALUE OF ACCOUNTING DATA AND ACCOUNTING ANALYSIS

14
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Overview of Accounting Analysis

Purpose of Accounting Analysis

to evaluate accounting quality -- the degree to

By identifying places where there is accounting

Another important step in accounting analysis is

Sound accounting analysis improves the

Analysis Using Financial Statements

Business Application Context

Other Public Data

Business Strategy Analysis

Make forecasts and

Dr. Mahmood Osman Imam