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 persentance 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