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 firm’s
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 firm’s 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 transaction’s 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

Manager’s 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
Manager’s 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 firm’s 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 company’s 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
firm’s 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 company’s
core business
 Business combination accounting is being used to
give illusion of growth
 An increasing gap between a firm’s 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 1990’s
 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
 Shareholder’s 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 period’s 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 company’s
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