ACCOUNTING ANALYSIS

Accounting
Accrual Accounting distinguishes between

the recording of costs and benefits

associated with economic activities and the
actual payment and receipt of cash.
Expected, not necessarily actual cash
receipts and payments.

Accounting
While basic definitions of the elements of a firms

financial statements are simple, their application in

practice often involves complex judgements
Because corporate managers have intimate
knowledge of firms businesses they make
appropriate judgements in portraying myriad
business transactions using basic accrual
accounting framework

Accounting
Accounting discretion

Potentially valuable as it allows managers to reflect

inside information in reported financial statements
But managers have an incentive to use this discretion to
distort reported profits by making biased assumptions.
Use of accounting numbers in contracts between firm and
outsiders provides motivation for manipulation of
accounting numbers.
Distortion makes financial statements less valuable to
external users. Difficult for outsiders to determine whether
managers have misused flexibility.
Delegation of financial reporting decisions to managers has
both costs and benefits.
Accounting rules and auditing reduce cost and preserve
benefits

Accounting
Conventions
Historical cost
Accounting Standards
Lease
Uniformity in accounting standards
Reduce ability to record similar economic transactions in
dissimilar ways either over time or across firms
Increase credibility of financial statements
Comes at the expense of reduced flexibility for managers to reflect
genuine business differences in a firms accounting decisions
Rigid Standards
Good Economic transactions whose accounting treatment is not
predicated on managers proprietary information
Dysfunctional Significant business judgement involved in
assessing a transactions economic consequences
Induce managers to expend economic resources to restructure
business transactions to achieve desired accounting result

Factors Influencing Accounting Quality

Noise from Accounting Rules
Forecast Errors
Managers accounting choices

Noise from Accounting Rules

Difficult to restrict management discretion

without reducing information content of

accounting data
Research outlay expense as incurred
Some research expenditures have future value while
others do not

Forecast Errors
Management cannot predict future

consequences of current transactions

perfectly.
Estimates
Useful life of assets depreciation
Probability of collecting payments accounts
receivable

Managers accounting choices

Accounting based debt covenants
Management compensation
Corporate control contests
Tax considerations
Regulatory considerations
Capital Market considerations
Stakeholder considerations
Competitive considerations

Steps in Accounting Analysis

Identify Key Accounting Policies
Assess Accounting Flexibility
Evaluate Accounting Strategy
Evaluate the Quality of Disclosure
Identify Potential Red Flags
Undo Accounting Distortions

Identify Key Accounting Policies

Evaluate how KSF and risks are being managed by the

firm
In accounting analysis, identify and evaluate the policies
and the estimates the firm uses to measure its critical
factors and risks
Accounting measures to capture these business constructs
Banking interest and credit risk mgt (loan loss reserves)
Retail Inventory mgt
Leasing accurate forecast of residual value at the end of lease
term (residual values influence reported profits and asset base)
Manufacturer R&D and product defects after sale (warranty
expenses)

Evaluate Accounting Strategy

How do firms accounting policies compare

to the norms in the industry?

Does the management face strong incentive
to use accounting discretion for earnings
management?
Has the firm changed its accounting
policies? What is the justification?

Evaluate Accounting Strategy

Have companys policies and estimates

been realistic in the past?

Does the firm structure any significant
business transactions so that it can achieve
certain accounting objectives?

Evaluate the Quality of

Disclosure
Does the firm provide adequate disclosures to assess the

firms business strategy and economic consequences?

Letter to shareholders
Do the the footnotes adequately explain the key accounting
policies and assumptions and their logic?
Changes
Does the firm adequately explain current performance?
Management Discussion and Analysis Section
Link performance to business conditions
SG&A differentiation or increase in unproductive
overheads
Profits Margins competition or manufacturing
costs

Evaluate the Quality of

Disclosure
If the accounting rules and regulations

restrict the firm from measuring its key

success factors appropriately, does the firm
provide additional disclosures to help
outsiders understand how these factors are
being managed?
If the firm is in multiple businesses, what is
the quality of segment disclosure?

Evaluate the Quality of

Disclosure
How forthcoming is the management with

respect to bad news?

How good is the firms investor relations
programme?

Identify Potential Red Flags

Unexplained changes in Accounting, policies,

estimates especially when the performance is poor.

Unexplained transactions to boost profits
Unusual increase in AR in relation to sales
Unusual increase in inventories in relation to sales
increases
Unusual increase in intangible assets
Reduction in managed costs like advt to boost
profits

Identify Potential Red Flags

Onetime source of income like sale of

non-productive assets
Reliance on income sources other than companys
core business
Business combination accounting is being used to
give illusion of growth
An increasing gap between a firms reported
income and its tax income
An increasing gap between the reported income
and the reported cash flows

Identify Potential Red Flags

Unexplained large asset write-off
Tendency to use financial mechanisms like R&D

partnerships, sale of receivables with recourse,

special purpose entities
Large fourth quarter adjustments
Qualified audit report or changes in auditors
Unusually long audit report with unusual wording
Related party transactions

BUT..
Conservative Accounting is not good

accounting
Not all unusual accounting is questionable

Accounting Minefields
Revenue Measurement and Recognition
Determining when a sale is complete or service fully
rendered
Revenue recognition when delivery is taken but
payments are over several years. Customer may not
survive
What constitutes revenue auctions, Dell
MicroStrategy, a data-mining software producer
restated revenues $12.6 mn profit to $34 mn loss

Accounting Minefields
Revenue Measurement and Recognition
How is revenue defined? And what event triggers its
recognition
Does this present a reasonable measure of revenue
earned by business during reporting period? Is it
consistent with revenue measures of competitors?
If revenue is measured in an unusual or new way, is that
disclosed? Is the approach justified in terms of risks and
advantages?

Accounting Minefields
Provision for Uncertain Future Costs

Estimates inflated to create hidden reserves or diminished to enhance

reported profits
Xerox slow payments but no allowance for bad debts
Overstated Restructuring Costs
Segregated from other expenses Non recurring
Digital Early 1990s
Heinz overestimated costs by $ 25 mn in 1997. Subsequent reversal
not disclosed in income statement enhancing income. SEC sued WR
Grace in 1999.
Comprehensive Income
Shareholders equity section of B/S. Covers variety of gains or losses
not reported in I/S as true impact not certain or irreversible
Translating financial statements of subsidiary from local currency
to parent company currency
Unrealized gains or losses on investments in financial securities
Coca Cola added $ 965 mn of translation losses in 2000 bringing
total to $ 2.5 bn

Accounting Minefields
Provision for Uncertain Future Costs

Are estimates for uncertain events included in

financial statements?
Do the financial statements present a reasonable
measure of current period operating expenses and
revenues, with sufficient disclosure in footnotes
of these estimates and accounting treatment?
Should gains or losses included in
comprehensive income (foreign currency,
investment gains and losses) and in the footnotes
instead be included in the current periods net
income?

Accounting Minefields
Asset Valuation

Delta Airlines revised useful life of its aircraft

fleet twice in 10 years
Adjustment motivated by real change in
airplanes life spans, by desire to match
competitors accounting method or by some
other reason?
Accelerated write off R&D in process of
acquired company
Conduct R&D through investments in partners to
avoid treating costs as current expenses

Accounting Minefields
Asset Valuation

Do tangible and intangible asset values and write

downs of assets reflect real values and changes in
value during current period?
Are these value adjustments fully disclosed?
Is the accounting treatment consistent with
industry and global competitors? If not, are the
differences justifiable and adequately discussed
in the financial statements?

Accounting Minefields
Derivatives

What hedging programs are in place?

To what extent are derivatives used?
What are the worst case scenarios of companys
use of derivatives?
Is the accounting treatment complete and in the
spirit of GAAP? Is GAAP treatment sufficient to
describe the business value and risks of the
derivative program?

Accounting Minefields
Related-Party Transactions

Made with entities that are controlled by the company or have

control over the company
Belgian company Learnout & Hauspie Speech Products
Share price dropped from $65 to $9 in 2000.
30 customers all start-ups based in Singapore were
responsible for major revenues
L&H had helped create those companies many had
received seed money from venture capital firm linked to
L&H founders
Korean companies purchase of assets unrelated to business
future sale at discount to related companies
Heavily mined for companies that operate in countries where
practices and disclosures less regulated compared to U.S or
Western Europe

Accounting Minefields
Related-Party Transactions

Are all significant related party transactions and commitments

disclosed?
What policy determines which transaction will be disclosed
and what level of detail will be included in financial
statements?

Information Used for Benchmarking Performance

Accounting Rules of different countries
Deutsche Telecom in Germany
Wal-Mart and Carrefour

Companies Manipulating Accounts

High growth companies entering low growth phase
Companies that receive extensive coverage in

business or popular press

New businesses where there are ambiguities about
how key transactions should be measured
Weak control environments in which managers can
manipulate reported financial results with impunity
Companies that are followed by small number of
analysts
Companies with complex ownership and financial
structures

Companies Manipulating Accounts

Companies with significant market share with faster

growth than industry

Companies doing too well to believe
History of using accounting decisions to achieve
earning expectations
Firing of auditors