Financial Reporting and AnalysisFinancial Reporting and Analysis

FSs are the products of financial process governed by,

• Accounting rules and standards• Managerial incentives• Enforcement and monitoring mechanisms

It is important to understand the financial reporting environment along with the objectives and concepts underling the accounting information presented in FS

Financial Reporting and Analysis

Reporting Environment

Introduction to Accounting Analysis

Accrual Cornerstones of

Accounting

Nature & Purpose of Accounting

Statutory FR

Factors Affectingto SR

Other Reporting Features

Qualities of Accounting information

Principles of Accounting

Relevance of Accounting

Accrual Accounting Illustration

Accrual Accounting

Framework

Relevance of accruals

Analysis implications ofAccruals

Need of Accounting Analysis

Earnings Management

Process of Accounting Analysis

Reporting EnvironmentReporting Environment

Statutory FRs are the most important product of financial reporting environment.

Information in Fs is judged relative to i The information needs of FS users ii Alternative sources of information

such as economic and industry data, analysts reports and voluntary disclosures by managers

Factors that affect theFactors that affect the FRFR

Factors that affect the nature and content of financial reports to appreciate the financial accounting information are ,

• Accounting rules (GAAP)

• Manager motivation

• Monitoring and enforcement mechanism, regulations, industry practices and other information sources

Statutory financial reportsStatutory financial reports

There are three categories of SFR

i Financial statements

Ii Earning announcement

iii Other statutory reports

Financial statementsFinancial statements

Statutory financial reports includes

• FR to be filed with company registrar

• FR to be published

• FR to be filed with SEc

Earning announcementEarning announcement• Companies release key summary

information to the public through an earning announcement. This is made available to traders on the stock exchange

• Earning announcement provids key summary information abut the company position and performance

Other StatutoryOther Statutory reportsreports

• Annual report to be filed with company registrar

• Prospectors

• Proxy statement

Factors Affecting SFRFactors Affecting SFR

• GAAP

• Managers

• Monitoring and enforcement Mechanism

• Alternative information sources

GAAPGAAPRules and guidelines of financial accounting. These rules determine measurement and recognition policies such as• how assets are measured • when liabilities are incurred• when revenues and gains are recognized • when expenses and losses are incurred• what information must be provided in the notes

GAAP DefinedGAAP DefinedGAAP are collection of standards, pronouncements opinion, interpretations and practice guidelines various professional and quasistatutary bodies such as FASB, SEC, AICPA set GAAP. The most important types of accounting rules and guidelines are

• statement of financial accounting standard •APB opinions• Accounting research bulleting• AICPA Pronouncements• Industry practices

Setting Accounting StandardsSetting Accounting Standards

Accounting and Auditing Standard Act no. 15-1995 Accounting Standard committee has statutory power to

set standard The committee consist of ,

Members from SLICA

CIMASECCentral BankChambers of commerce

Role of the SECRole of the SEC

By Laws of SEC

Quarterly Report

Recommendations and GL

Circulars

International Financial Reporting Standards

IFRS are formulated by the international accounting standard board

2. Managers2. Managers• Primary responsibility for fair financial reporting

rest with managers.• Managers have control over the integrity of

Accounting system and the financial records• Standards allow managers to choose among

alternative accounting methods.• Judgment in financial accounting involve

managerial discretions.• Earning management is made by the managers• Managers can indirectly affect financial reports

through collective influence on the standard setting process.

3. Monitoring and Enforcement 3. Monitoring and Enforcement MechanismsMechanisms It ensure the reliability and integrity of financial

reports.

3.1 Auditors

External auditing is an important mechanism to help ensure the quality and reliability of FS

Auditor’s report is an integral part of financial statements.

Audit opinion tells about quality and content of FS

3.2 Corporate governance3.2 Corporate governance

• FS need approval by the board of directors

Audit committees

Internal audit

3.3 SEC3.3 SEC

• SEC plays an active role in monitoringand enforcing accounting standard.

• Companies must file audited FS with SEC

• SEC checks these reports to ensure compliance with statutory requirements.

SEC has brought enforcement actions against for accounting violations.

• This leads to restatement of Fs

3.4 Litigation3.4 Litigation

The threat of litigation influences managers to adopt more responsible reporting practices both for statutory and voluntary disclosures.

4. Alternative information sources4. Alternative information sources

• Analysts’ forecasts and recommendations

• Economic, industry and company news

• Information available in the internet

• Voluntary disclosures

Nature and purpose of Financial Nature and purpose of Financial AccountingAccounting

Nature and purpose of financial accounting depends on desirable qualities, principles and conventions underlying financial accounting.

Qualities of Accounting InformationQualities of Accounting Information

Relevance and reliability are the most important qualities

Relavance

The capacity of information to affect a decision

Forecast

Feedback

Timeliness

ReliabilityReliabilityFor information to be reliable it must be

Verifiable: Information is confirmable

Faithful: Information reflect reality

Neutral: Truthful and unbiased

Other important features

Comparability: Information is measured in similar manner

Consistency: Same method is applied for similar transaction

Principles of AccountingPrinciples of Accounting

• Historical cost

• Accrual

• Materiality

• Conservatism

Limitations of FS informationLimitations of FS information

• Timeliness: FSs are prepared annually or quarterly. Other information

sources are readily available• Frequency: Less frequency• Forward-looking: FS contain limited

forecast. Alternative information sources provide much forward looking information

Accruals – Cornerstone of AccountingAccruals – Cornerstone of Accounting

FS are primarily prepared on an accrual basis. Supporters believe that accrual accounting is superior to cash accounting for both measuring performance and financial conditions.

Accrual ConceptAccrual Concept

An appealing feature about cash flows is simplicity. CF are easy to understand and straightforward to compute. There is something tangible and certain about CF. It is a real thing – not a creation of accounting method. But when it comes to measuring cash generating capacity CF’s are of limited use.

Accrual Concept Cont…• Most business transactions are on credit

• Investments are made in inventories and long term asset, the benefit of which occur over many years.

• In these scenarios, CF accounting fails to provide a relevant picture of a company’s financial condition and performance.

Accrual Concept Cont…Accrual accounting aims to inform users, about the consequences of business activities for company’s future cash flows with a reasonable level of certainty.

This is achieved by recognizing revenue earned and expenses incurred. This need accrual adjustments.

Accrual and cash FlowsAccrual and cash Flows

To explore the relationship between accrual and CF it is important to recognize alternative types of CF.

1.Operating CF – Cash from ongoing operating activities

2. Free CF – Cash that is free to be paid to both debt and equity holder.

3. Net CF – Net of inflow & outflow.

AccrualAccrual

Accruals are sum of accounting adjustments that make net income different from net CF.

.

AccrualsAccruals

Accounting adjustments that convert operating cash flow to net income.

Net income = operating cash flow + accruals

Accruals are of two types.

1.Short term accruals : related to working

capital items

2. Long term accruals : related to non current assets

ex. Depreciation and amortization

Accrual Accounting reduces Timing Accrual Accounting reduces Timing & Matching concept& Matching concept

Timing problem refer to CF that do not occur contemporaneously with business activities yielding the cash flows.

Matching problems refer cash inflows and outflows that occur but are not matched in time with each other.

Timing and matching problems Timing and matching problems arise for two reasonsarise for two reasons..

1. Transactions do not involve immediate transfer of cash

2. Cost are incurred before their benefits are realized.

Accrual process – Revenue Accrual process – Revenue Recognitions and expense MatchingRecognitions and expense Matching

Accrual Accounting comprised of two principles.

1. Revenue recognition.

Revenue are recognized when earned and either realized or realizable.

Revenue are earned when the company delivers its product. It means company has carried out its part of the deal.

Accrual process Cont….

Revenues are realized when cash is acquired for product or services delivered.

Revenues are realizable when the company receives an asset for products or service delivered that is convertible to cash.

Expense matchingExpense matching

Under the accrual accounting expenses are matched with their corresponding revenues.

Matching process is different for two major types of expense.

1. Product cost

2. Period cost

Short term and long term accrualShort term and long term accrual

Short term accrual refer to short term timing differences between income and cash flow.

These accruals generate working capital items in the balance sheet. They are called working capital accruals.

1. Inventories

2. Credit transactions

Relevance of Accrual AccountsRelevance of Accrual Accounts

1.Conceptual relevance

Accrual based income statement is more relevant for measuring a company’s cash generating capacity.

Accrual account is superior in providing relevant information about.

1. Financial performance

2. Financial conditions

3. Predicting future cash flows.

Empirical RelevanceEmpirical Relevance

Critics of accrual accounting decry its lower reliability and prefer reliable cash flows.

Supporters assert the added relevance of accrual accounting compensates for lower reliability

Accrual and Cash Flow -MythsAccrual and Cash Flow -Myths

1. Since company value depends on future cash flows only current cash flows are relevant for valuation

2. All cash flows are value relevant3. All accrual accounting adjustments are value

irrelevant4. Cash flow cannot be manipulated.5. All income is manipulated.6. It is impossible to consistently manage income

upward in the long run.

Accrual and Cash flow -truthAccrual and Cash flow -truth

1. Accrual accounting is more relevant than cash flow.

2. Cash flows are more reliable than accruals.

3. Accrual accounting numbers are subject to accounting distorters.

4. Company value can be determined by using accrual accounting numbers.

Introduction to accounting analysisIntroduction to accounting analysis

Accounting analysis is the process of evaluating the extent to which a company’s accounting numbers reflect economic reality. Accounting analysis involves.• Evaluating a company’s accounting risk and earning quality• Estimating earning power• Making adjustments to financial statement to better reflect economic reality and assist in financial analysis.

Accounting analysisAccounting analysis

Accounting analysis is the process analyst uses to identify and asses accounting distortions in FS

It also includes the necessary adjustments that reduce distortions and make the statement amenable to financial analysis.

Need for accounting analysisNeed for accounting analysis

Two major reasons.

1. Accrual accounting yields some accounting distortions

2. FS are prepared for a divers set of users and information needs.