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Accounting Analysis

The steps involved in Business Analysis

Step 5 – Application Step 4 – Prospective
for example: analysis: Valuation
•Outside Investor •RIM
Compare Value with Price to BUY,
SELL, or HOLD •Alternatives
•Inside Investor •Sensitivity
Compare Value with Cost to ACCEPT
or REJECT Strategy
Step 3 – Prospective
analysis: Forecasting
•Profit and Loss
•Balance Sheet
•Cash Flow

Step 1 – Understanding the Step 2 - Analyzing Information

Business – Accounting Analysis and
e.g.: Financial Analysis
•The Product market Strategy •Quality of Accounting
•The Competition information?
•The Regulatory Constraints •Re-formatting to uncover
business activities
•Business strategies
•Ratio and cash flow analysis

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Learning Objectives
At the conclusion of this lecture you should

Chapter 3:
1. The institutional framework of
2. Factors that influence accounting quality
3. The steps in accounting analysis
4. Accounting analysis pitfalls
5. The value of accounting information

Chapter 4:
6. How to implement accounting analysis

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Accounting Analysis
 Assess the degree to which the firm’s accounting reflects the
underlying business reality. Identify any accounting distortions
and evaluate their impact on profits and the sustainability of

 The importance of accounting analysis:

 Understanding accounting allows the business analyst to
more effectively use the financial information disclosed by
 In particular, the analyst is trying to assess the accounting
quality of the financial statements.
 Sound accounting analysis improves the reliability of
conclusions from financial analysis.
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From Lecture 1

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From Lecture 1
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Prelude to An Accounting Quality Analysis

 Understand the business

 Understand the accounting policy
 Understand the business areas where accounting quality is most
 Understand situations in which management are particularly
tempted to manipulate

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Types of Financial Statements
 According to the International Accounting Standards Board
(IASB), a ‘complete set of financial statements’ comprises:
 Statement of financial position as at the end of the period

 Statement of profit or loss and other comprehensive income

for the period
 Statement of changes in equity for the period

 Statement of cash flows for the period

 Notes (comprising a summary of significant accounting

policies and other explanatory information).

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The Basic Features of Financial Reporting

 The basic features of financial reporting include:

 Accrual accounting

 Delegation of reporting to management

 Reporting standards

 External auditing.

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Accrual Accounting
 Financial reports are prepared using accrual accounting instead
of cash accounting.
 The conceptual framework defines the following financial
statement elements and their relation:
Assets = Liabilities + Equity
Profit = Revenues – Expenses
 Another important relation:
Comprehensive income = profit for the period + items
recognised directly in equity

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Delegation of Reporting to Management
 Management is responsible for the application of accounting
methods (recognition, measurement and disclosure) in financial
 Management have some discretion in the choice of accounting
policies and the estimates made in financial statements.
 Management can use this discretion in revealing their private
information about the firm or in distorting the accounting
 Distortion of accounting may reflect incentives facing managers.

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Reporting Standards

 Accounting standards try to eliminate unsatisfactory reporting

practices, thereby promoting consistency and comparability.
 Many countries in the world are now reporting or converging to
International Financial Reporting Standards (IFRS).
 IFRS have been described as more principles-based (rather than

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External Auditing of Financial Statements

 Audits provide an independent (third party) opinion on the

quality of the financial statements.
 Audits are required for many companies, private and public.
 There is a move towards international auditing standards by
many countries.
 Audit committees enhance the auditing process.

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Factors Influencing Accounting Quality

 It is necessary to allow managers some discretion in applying

accounting standards.
 As a result, three potential sources of noise and bias in
accounting data include:
1. Random estimation errors
2. Rigidity in accounting rules
3. Manager’s accounting choices.

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Rigidity of Accounting Rules and
Random Forecast Errors
 Accounting standards may not reflect the economics of the
firm’s transactions.
 Some flexibility in accounting required.
 Management’s estimates may result in accounting forecasting
 Accrual accounting requires forecast estimates that can be

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Managers’ Accounting Choices

 Managers have a number of incentives to choose accounting

disclosures that are biased:
 Accounting-based debt covenants
 Management compensation contracts
 Contests for corporate control
 Tax considerations
 Regulatory considerations
 Capital market and stakeholder considerations
 Competitive considerations.

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Industry Flash Point
Banking Credit losses: quality of loan loss provisions
Computer hardware Technological change: quality of receivables and inventory
Computer software Market ability of products: quality of capitalized r&d
Retailing Credit losses: quality of net accounts receivable
Inventory obsolescence: quality of carrying values of inventory
Rebate programs: quantity of sales and estimated liabilities

Manufacturing Warranties: quality of warranty liabilities

Flash Points:
Product liability: quality of estimated liabilities

Accounting Automobiles Overcapacity: quality of depreciation allowances

Areas where Telecommunications Technological change: quality of depreciation allowances

Error is More Equipment leasing Lease values: quality of carrying values for leases

Likely Tobacco Liabilities for health effects of smoking: quality of estimated


Drugs R&D: quality of R&D expenditures

Product liability: quality of estimated liabilities

Airlines Frequent flier programs: estimated liabilities for travel awards

Real estate Property values: quality of carrying values for real property

Aircraft and ship Revenue recognition: quality of estimates under percentage of

manufacturing completion method and “program accounting”

Subscriber services Development of customer base: quality of capitalized promotion

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Identify Earnings Management

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Steps in Accounting Analysis
 Step 1: Identify key accounting policies
 Key policies and estimates used to measure risks and critical
factors for success must be identified.

 Step 2: Assess Accounting Flexibility

 Accounting information is more open to distortion if
managers have a high degree of flexibility in choosing policies
and estimates.

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Steps in Accounting Analysis
 Step 3: Evaluate Accounting Strategy
 Flexibility in accounting choices allows managers to
strategically communicate economic information or distort
 Issues to consider include:
 Norms for accounting policies with industry peers

 Incentives for managers to manage earnings

 Changes in policies and estimates and the rationale for

doing so
 Whether transactions are structured to achieve certain
accounting objectives.

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Steps in Accounting Analysis
 Step 4: Evaluate the Quality of Disclosure
 Issues to consider include:
 Whether disclosures seem adequate
 Adequacy of footnotes to the financial statements
 Whether notes sufficiently explain and are consistent with
current performance
 Whether GAAP reflects or restricts the appropriate
measurement of key measures of success
 Adequacy of segment disclosure.

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Steps in Accounting Analysis
 Step 5: Identify Potential Red Flags
 Issues that warrant gathering more information include:
 Unexplained changes in accounting, especially when performance is
 Unexplained transactions that boost profits

 Unusual increases in inventory or receivables in relation to sales revenue

 Increases in the gap between net income and cash flows or taxable
 Use of R&D partnerships, SPEs or the sale of receivables to finance
 Unexpected large asset write-offs

 Large fourth-quarter adjustments

 Qualified audit opinions or auditor changes

 Related-party transactions.
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Flash Points: Institutional Situations Where
Manipulation is More Likely

 The firm is in the process of raising capital or renegotiating borrowing.

Watch public offerings
 Debt covenants are likely to be violated
 A management change
 An auditor change
 Management rewards (like bonuses) are tied to earnings
 A weak governance structure: inside management dominate the board;
there is a weak audit committee or none at all
 Transactions are with related parties rather than at arm's length
 Special events such as union negotiations
 The firm is "in play" as a takeover target
 Tax considerations
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Steps in Accounting Analysis
 Step 6: Undo Accounting Distortions
 Financial statement footnotes often provide information from
which the analyst can undo accounting distortions or make
the financial statements more comparable.

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IPOs and Manipulation

Year of Year after IPO
Diagnostic (%) IPO 1 2 3 4 5 6
Net income/sales 4.6 2.8 2.1 1.6 1.3 1.3 1.8
Abnormal accruals/book value 5.5 1.6 -0.4 -0.8 -2.0 -1.4 -2.7

Allowance for uncollectibles/gross

accounts receivable 2.91 3.32 3.46 3.62 3.81 3.77 3.85
Source: S. Teoh, T. Wong and G. Rao, "Are Accruals During An Initial Public Offering Opportunistic?" Review of
Accounting Studies, 1998.

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Abnormal Returns to Quality Analysis

Source: R. Sloan, "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?"
Accounting Review 71 (1996), p. 312.

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Accounting Analysis
 Conservative accounting is not
always ‘Good’ accounting.
 For example, historical cost
and accounting for intangible
 Not all unusual accounting
practices are questionable.
 Earnings management does
not necessarily motivate some
accounting phenomena that
seem unusual.

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Concluding Comments

 Accounting analysis is an essential step in analysing corporate

financial reports.
 A methodology consisting of six steps in analysing accounting
data was presented.
 Research suggests earnings management is not so pervasive as to
make earnings data unreliable.
 The value of accounting information vs cash flows

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This week Next week
 Accounting analysis as a  Reformatting accounting
quality control process information
 ‘Understand’ the business
model and how this is
captured in the financial

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