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Overview and Implementing of

Accounting Analysis
Group 1 :
Adyanto Budi Rachmansyah (041714153001)
Elliv Hidayatul Lailiyah (041714153006)
Ersandhi Primantara (041714153009)
Budi Yuda Prawira (041714153011)
OVERVIEW OF
ACCOUNTING
ANALYSIS

Purpose

Improve the reliability of conclusions from financial


analysis (GIGO)

Evaluate the degree to which a firms accounting


captures its underlying business reality.

Undo any accounting Distortions


INSTITUTIONAL
FRAMEWORK

Accrual Accounting

REVENUE EXPENSES PROFIT ASSETS LIABILITIES


The firm has Costs directly Likely to Required to be
provided all, or associated with
revenues recognized
produce future met with a
substantially all, economic
the goods or in the same period Profit = Revenues reasonable
services to be
(COGS) - Expenses benefits degree of EQUITY
Costs associated
delivered to the with benefits that are And, certainty.
customer consumed in this measurable with And, whose
The customer has time period (period a reasonable timing is Assets =
paid cash or is expenses) degree of reasonably Liabilities +
expected to pay Or, resources whose Equity
cash with a future benefits are certainty well defined
reasonable degree not reasonably
of certainty certain (R&D,
advertising)
Delegation of
Reporting to
Management

Involves Complex
Costs & Benefits
Judgments

Use their accounting discretion to reflect inside information in


Sales with customer financing
reported FSs

But have an incentive to distort reported profits by making


Potential defaults
biased assumptions

Manipulate accounting numbers in contracts between the firm and


R&D assets or contingent liabilities
outsiders
Factor Influencing
Accounting Quality

Noise from Managers


Accounting Forecast Errors Accounting
Rules Choices
Conservatism Timing of The extent of errors Accounting based debt covenants
recognition due to double- depend on a variety of Management compensation
entry accounting. factors : Corporate control contests: inTax
Managerial behavior considerations
may not necessarily be
Competitive considerations:
consistent with conservatism. The complex of the segment disclosure, new entrants.
business transactions
Dissimilar economic events with The predictability of the
similar accounting rules, e.g., firms environment
R&D
Unforeseen economic-wide
changes.
Steps In Perfoming Accounting
Analysis

Step 1
Identify Principal 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
PITFALLS

Conservatism is not good accounting


Evaluate how well accounting captures
business reality in an unbiased manner.
Mercks research ability and sales force.
Look to alternative sources of information.
Provide opportunities for income
smoothing.
Prevent analysts from recognizing poor
performance in a timely fashion.
Not all unusual accounting is questionable
Justified if the business is unusual.
Accounting changes might reflect changed
business circumstances.
Value of Accounting
Data and Anaysis
Accounting data
Perfect earnings foresight one year prior to
announcement

Accounting analysis
Opportunities for superior analysts to earn positive profit.
Implementing
Accounting Analysis

Recasting Financial Statement


Making Accounting Adjustments
Assets Distortion
Overstated Assets
Understated Assets
Liability Distortions
Understated Lialibility
Equity Distortions
Recasting
Financial Statements

How to recast financial statements into a


common format, involves designing a
template using standardized accounts

Standardized Income Statement Format

Standardized Balance Sheet Format

Standardized Cash Flow Statement


Format
Asset Distortions

Definition of assets

Resources that a firm owns or controls as a result of past


business transactions, and which are expected to produce
future economic benefits that can be measured with a
reasonable degree of certainty

Arise because there is ambiguity


The firm owns or controls the economic resources
in question
The economic resources are likely to provide future
economic benefits that can be measured with
reasonable certainty
The fair values of asset are lower or higher than
their book values
Asset
Distortions

1. The firm owns or controls the economic


resources in question
Difficult for accounting rules to capture all
of the subtleties associated with
ownership.
Example:
oLeases: lessor or lessee?
oDiscounting receivables with resource
(bank)
Asset
Distortions

2. The economic resources are likely to provide future


economic benefits that can be measured with
reasonable certainty
oDifficult to accurately forecast the future
benefits associated with capital outlays.
oWhether a competitor will offer a new product or
service.
oWhether the products manufactured at a new
plant will be the type that customers want to buy
3. The fair values of asset are lower or higher than their
book values
oThe possibility that asset values are misstated.
oThe task of impairment judgment is delegated to
management, with oversight by the auditor.
Overstated
Assets

Incentives to increase reported earnings


Delays in writing down current assets
Impaired if book values fall below realizable values.
Write-offs are charged directly to earnings.
Underestimated reserves
Allowances for bad debts or loan losses.
Warning signs: growing days receivable, business
downturns for major clients, and loan delinquencies.
Accelerated recognition of revenue
Increasing receivables (at the periods end while cash
collection may not be reasonably likely)
Understated depreciation/amortization on long-term
assets
Estimates of asset lives, salvage values, and
amortization schedules
Heavy asset businesses: airlines, utilities, and
semiconductor foundries.
Overstated
Assets

Incentives to deflate reported earnings

Conservative accounting rules


- Expense R&D and advertising outlays
- Pooling of interests
Income smoothing Common forms
- Performed exceptional well and decided to store away - Overstated write-downs of current assets
some of the current strong earnings for a rainy day. - Overestimated reserves
- Overstating period expenses - Overestimated depreciation/armortization on long-term
assets
Take a bath - Overstated depreciation/amortization: accelerated tax
- In a particular bad year to create the appearance of a depreciation
- Lease assets off balance sheet
- Key Intangible Assets
Liabilities

An economic obligation
arising from benefits
received in the past, and
the amount & timing is
known with reasonable
certainly
Liabilities

Obligations to customers that have been paid


in advance for product or services
including
Commitments to employees for unpaid wages
&pensions

Commitments to public and private providers


of debt financing

Obligations from court or government fines or


enviromental cleanup orders
Liabilities
Distortions

Distortion in liabilities generally arise


because an ambiguity of:

An obligation has really been incurred


The obligation can be measured
Cont(1)
1. Has an obligation been incurred?

For most liabilities there is a little ambiguity about


whether an obligation has been incured. For
some transactionit is more difficult to decide
wether there is any such obligation.
Example: if a software firm receives cash from
its customers for five-year software lisence,
should the firm report the full cash inflow as
revenues, or should some of it represent the
ongoing commitment to the customer for
servicing & supporting the license agreement?
Cont(2)
2. Can the obligation be measured?

For some liabilities it is difficult to estimate the


amount of the obligation.
Accounting rules cannot cover all contractual
posibilities and reflect all of the complexities of a
firms business relationships, they also require
managers to make subjective estimate of future events
to value the firms commitments.
Analysis of liabilities is usually with an eye to
assesing wheter the firms financial commitments and
risk are understated or its earnings overstated
Understated Liabilities

the most common forms of liabilities understatements


arise when the following conditions exist:

1.Unearned revenues are understated through aggressive


revenue cognition
2.Loans from discounted receivablesare off balance sheet
3.Long term liabilities for leases are off balance sheet
Equity distortion

1. Equity distortions arise because of distortions in assets and


liabilities
2. And also arise that are not captured in an asset and liability
analysis.
Two forms of equity distortion that do not arise due to asset distortion
and liability distortion:
a. Hybrid securities effect, partially pure debt & partially equity.
Current US accounting rules do not separate thes components,
and impliying that balance sheet overstates firm debt and
understates its equity.
b. New accounting rules, separate such as convertible debt into
two components on the balance sheet, a debt component and
equity compinent. Each would be valued at its dair value at the
date of issue.
Thank You