Chapter 3

Overview of Accounting Analysis

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 Accounting views
• Assets: Resources owned by the firm that are :
– likely to produce future economic benefits
– Measurable with a reasonable degree of certainty
• Liabilities are economic obligations of a firm arising from
benefits received in the past that are:
– Required to be met with reasonable degree of
certainty
– At reasonably well-defined time in the future
• Equity is the difference between a firm’s net assets and
its liabilities.

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 Accounting views (Contd..)
• Revenues are economic resources earned during a time period. It
would be recognized when:
– The firm has provided all, or substantially all, the goods and
services to be delivered to the customer
– The customer has paid cash or is expected to pay cash with
reasonable degree of certainty
• Expenses are economic resources used up in a time period. It is
governed by matching and conservative principles. These are:
– Costs directly associated with revenues recognized above
– Costs associated with benefits consumed
– Resources whose future benefits are uncertain
• Profit is the difference between revenue and costs

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Factors Influencing Accounting Quality
Managers’ Accounting Choices – incentives to exercise
discretion for influencing behaviors of various stakeholders.
Motivations are debt covenant (TIE, liquidity ratio),
management compensation (bonus compensation & job
security for excess profit), corporate control (like hostile
takeover), tax consideration (hidden profit), regulatory
consideration (SEC), capital market consideration
(stockholders’ perception), trade union consideration,
competitive considerations (hiding a segmented
disclosure), etc.

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 Window Dressing
Last Current Window dressing
year year Before Payoff After Payoff
Current assets $300 $600 $200 $150
Current liabilities 100 400 100 50
Working Capital $200 $200 $100 $100
Current Ratio 3:1 1.5:1 2:1 3:1
Toward the close of a period, management will occasionally
press collection of receivables, reduce (sell a part of) inventory
levels, sell out marketable securities, and delay normal
purchases. Proceeds from these activities are then used to pay
off current liabilities. The effects shows a better liquidity, called
window dressing. What is the cost of window dressing? $100.
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 Effects of different depreciation methods
Assuming an investment Tk.500,000 and life of 10 years

Year Annual depreciation Book Value (end of period) Accumulated depreciation

Straight line Reducing Straight Reducing Straight line Reducing
balance method line balance method balance method
(20%)

½ 25,000 50,000 475,000 450,000 25,000 50,000

1 50,000 90,000 425,000 360,000 75,000 140,000
2 50,000 72,000 375,000 288,000 125,000 212,000
3 50,000 57,600 325,000 230,400 175,000 269,600
4 50,000 46,080 275,000 184,300 225,000 315,680
5 50,000 36,865 225,000 147,455 275,000 352,545
6 50,000 29,490 175,000 117,965 325,000 382,035
7 50,000 23,595 125,000 94,370 375,000 405,630
8 50,000 18,875 75,000 74,495 425,000 424,505
9 50,000 15,100 25,000 60,395 475,000 439,605
10 25,000 12,080 0 48,315 500,000 451,645
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 Effects of inventory valuation choice
Determine net income under LIFO, FIFO, and average cost, and
calculate the current ratio, debt-to-equity ratio, inventory
turnover, gross margin ratio, and net margin ratio under each of
these inventory costing methods.
Assumptions:
• Sales price per unit $25
• 1,000 units sold
• Beginning inventory=100 units @$10 each=$1,000
• Ending inventory=800 units
• Operating expenses=$5,000
• Tax Rate=0%
• Assets excluding inventories=$75,000
• Current assets excluding inventories=$50,000
• Current liabilities=$25,000
• Long term liabilities=$10,000

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 Procurement of inventory
Purchases Units Cost per unit Value
(Note: Increasing prices)
March 300 $11 $3,300

June 600 $12 $7,200

October 300 $14 $4,200

December 500 $15 $7,500

Total 1,700 $22,200

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 Solution
FIFO LIFO Average Cost
Sales 1,000 @ $25 $25,000 $25,000 $25,000
COGS
Beginning inventory 1,000 1,000 1,000
Add purchases 22,200 22,200 22,200
Less ending inventory* 11,700 9,100 10,312
COGS 11,500 14,100 12,888
Gross Profit 13,500 10,900 12,112
Operating expenses 5,000 5,000 5,000
Taxable/Net income $8,500 $5,900 $7,112
(800 units ending inventory=100 beginning+1,700 purchased-1,000 sales)
FIFO Inventory = (500 @ $15) + (300 @ $14)=$11,700
LIFO Inventory = (100 @ $10) + (300 @ $11) + (400 @ $ 12)=$9,100
 $1,000  $22,200 
Average cost inventory =  1700  100  * 800  $10,312
Value of goodsavailable for sale
 (Units in ending inventory
9 )
Number of units available for sale
 Solution (Continued)
FIFO LIFO Average
Cost
Current Ratio (Current Assets excluding inventories + Ending 2.36 2.41
inventories) /Current liabilities= ($50,000+
$11,700)/$25,000=2.47
Debt-to-equity ratio Long term Debt/(Total assets excluding 20.4% 19.9%
inventory +ending inventory -current liabilities -
long term liabilities) =$10,000/($40,000 +ending
inventory)=$10,00/$51,700= 19.3%
Inventory turnover COGS/((Beginning inventory+ Ending inventory)/2) 2.79 2.28
=$11,500/(($1,000+$11,700)/2)=1.81
Gross margin as Gross profit/sales=$13,500/$25,000= 54% 43.6% 48.5%
percentage of sales
Net profit as a Net Income/sales=$8,500/$25,000=34% 23.6% 28.5%
percentage of sales

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 Lessons from the problem
In the problem, prices are rising and inventory levels have not decreased.
Therefore, under these conditions following are true:

1. LIFO results in the highest cost of goods sold, FIFO the lowest cost of
good sold.
2. FIFO results in the highest inventory values and working capital, LIFO
results in the lowest inventory values and working capital.
3. LIFO results in highest inventory turnover, FIFO the lowest.
4. Both gross and net profit margin is higher under FIFO.
5. Retained earnings will be higher for FIFO then LIFO, keeping dividend
payment constant (net income effect).
6. LIFO, if used for tax purposes, would results in the lowest tax paid.
7. Current ratio is higher under FIFO.
8. Debt to equity ratio is higher under LIFO (retained earning effect)
9. Average cost values always lie between FIFO and LIFO values.

Note: If prices are declining, then all the above will be opposite.
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Final Note: Inventory valued at lower of cost
or market
• Regardless of the inventory method used, any significant
decrease in inventory value below cost should be
recorded immediately. Therefore, inventory would be
valued at market. Market is defined as the current
replacement cost through production or purchase. When
LIFO accounting is used, the LIFO reserve is reported.
This is the difference between LIFO inventory value and
FIFO inventory value.
• Also Note BAS allows FIFO and weighted average
method only for inventory valuation.

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 Steps in Accounting Analysis
1. Identify Key Accounting Policies: Identify the key success and
risk factors and see what accounting policies are used to reflect
that. (Example: valuation of residuals in case of leasing firms,
interest rate and credit risk management of banks, inventory
management for retail industry, R&D for manufacturing firms, etc.)
2. Assess Accounting Flexibility: Identify the management
flexibility to report its key success and risk factors. Example of
less flexibility: Marketing and brand building is key to success of
consumer goods but the strength can not be reported. Similarly,
R&D activity is important for a biotechnology firm but accounting
does not give them the discretion to report to the nature of
activity. Example of high flexibility: In most cases firms hold the
freedom regarding choice of depreciation method (straight-line or
accelerated), inventory accounting (FIFO or weighted average),
credit risk management for banks. Similarly, software developers
have the flexibility to decide at what points in their development
cycle the outlays can be capitalized.

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 Steps in Accounting Analysis (Contd.)
3. Evaluate Accounting Strategy:
i. Compare the accounting policies of the firm to the norms
in the industry.
ii. Evaluate the incentive of violation like bond covenants,
accounting-based bonus target, the share of management in
stock, role and state of trade union bargaining.
iii. Evaluate and rationalize recent change in accounting policies.
iv. Use the past as the guide to assess the dependability of
reporting.

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 Steps in Accounting Analysis (Contd.)
4. Evaluate Quality of Disclosure
i. Reflection of the firm’s strategy and its economic consequences
in accounting disclosures. Some firms use annual report to
clearly layout the firm’s industry conditions, its competitive
position, and management's plan in future.
ii. Footnotes for changes from industry or from past (particularly
regarding revenue and expense recognition)
iii. Disclosures of current performances like changes in sales price,
quantity, cost of production etc.
iv. Disclosure of key success factors like firm investing in product
quality or customer services may report change in defect rates or
customer satisfaction.
v. For multiple business, disclosure of each segments on a
consistent basis
vi. Disclosure of reasons of poor performances. Relating that with
the strategy of the firm
vii. Firm’s investor relation program (publication of fact books etc.)
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 Steps in Accounting Analysis (Contd.)
5. Identify the points of questionable accounting quality
i. Unexplained changes when performances are poor
ii. Unexplained transaction that boost profit like sale of assets or debt
for equity swap
iii. Unusual increase in accounts receivable relative to sales
iv. Unusual increase in inventories relative to sales
v. An increasing gap between a firm’s reported income and its cash
flow from operations
vi. An increasing gap between a firm’s reported income and its tax
income. Example, warranty expenses are recorded on accrual basis
for financial reporting and cash basis for tax reporting.
vii. Unexpected assets write-offs
6. Undo Accounting Distortions. Key areas are:
i. Accrual accounting
ii. Cash flow analysis (like capitalization of certain costs that should
have been revenue)
iii. Evaluation of footnotes in case of changes
iv. Evaluation of bad debts
v. Difference between tax reporting and accounting reporting of profit16