CH 3 Palepu 1 Accounting Analysis

The Importance of Accounting Analysis
Understanding accounting allows the business analyst to effectively use the fina
ncial information disclosed by companies.
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Tho
mson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 3: Overview of Accounting Analysis Palepu & Healy
Key Concepts in Chapter 3

Various factors influence the quality of accounting-based financial reports. Man
agers have some discretion in accounting choices used in financial reporting. In
centives for the management of financial reporting items must be considered by t
he analyst.
Factors Influencing Accounting Quality

High quality accounting data are free of bias and noise. Three potential sources
of noise and bias in accounting data:
1. Noise/bias from accounting rules One-size-fits-all problem 2. Forecast errors
3. Managers accounting choices

Three potential sources of noise and bias in accounting data:
1. Noise from accounting rules One-size-fits-all problem 2. Forecast errors 3. M
anagers accounting choices
Noise/bias in Accounting Numbers

Reported accounting number = True number + noise/bias from accounting rules + nois
e/bias from forecast error + noise/bias from managers accounting choice True numbe
r is what would be reported if accounting rules were tailored to conform to the uni
que circumstances of the firm AND management had perfect foresight of the future
AND management reported in an unbiased manner without consideration of the resu
lting economic consequences.
Noise From Accounting Rules One-Size-Fits-All Problem

Accounting standards often specify uniform accounting for all firms (one size fi
ts all). The fit between accounting standards and the nature of the firms transac
tions may introduce some distortion in the reported financial statements. Exampl
e: required expensing of R&D expenditures.

Forecast Errors
Accrual accounting requires that management make a host of forward-looking estim
ates. These estimates are inevitably inaccurate because management doesnt have pe
rfect foresight of the future. Example: estimate of future bad-debts

Managers Accounting Choices

Managers have a number of incentives to choose accounting disclosures that are b
iased:
Debt covenants Compensation contracts Contests for corporate control Tax consid
rations Regulatory considerations Capital market and stakeholder considerations
Competitive considerations
Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies Step 2: Assess Accounting Flexibi
lity Step 3: Evaluate Accounting Strategy Step 4: Evaluate the Quality of Disclo
sure Step 5: Identify Potential Red Flags Step 6: Undo Accounting Distortions

Steps in Performing Accounting Analysis

Step 1: Identify Principal Accounting Policies
What are the key business success factors? What accounting policies are used to
measure the effect of these success factors? Example 1: credit risk is a big suc
cess factor in banking, and the loan loss reserve (a/k/a allowance for doubtful
accounts) is the account that reports on this success factor. Example 2: warrant
y claims is a big success factor in manufacturing and the warranty reserve is th
e account that reports on this success factor.


Step 2: Assess Accounting Flexibility
Accounting flexibility can be a strength or a weakness, depending upon how manag
ement uses that flexibility. Example 1: R&D is a big success factor in biotechno
logy industry, but GAAP imposes one-size-fits-all accounting on this factor (all
non-software R&D is expensed). No flexibility. Example 2: Similar activity in s
oftware development industry (software R&D), but GAAP allows firms latitude in d
eciding when to start capitalizing software development costs. Managers can use
this flexibility in an unbiased manner or to opportunistically achieve some desi
red financial reporting objective (e.g., make the numbers).


Step 3: Evaluate Accounting Strategy - Flexibility in accounting choices allows
managers to strategically communicate economic information or hide true performa
nce. -Issues to consider include:
Norms for accounting policies with industry peers Incentives for managers to man
age earnings Changes in policies and estimates and the rationale for doing so Wh
ether transactions are structured to achieve certain accounting objectives


Step 4: Evaluate the Quality of Disclosure - Managers have considerable discreti
on in disclosing certain accounting information - Issues to consider include:
Whether disclosures seem adequate Adequacy of footnotes to the financial stateme
nts Whether MD&A sufficiently explains and is consistent with current performanc
e Whether GAAP restricts the appropriate measurement of key measures of success
Adequacy of segment disclosure


Step 5: Identify Potential Red Flags -Some issues that warrant gathering more in
formation include:
Unexplained transactions that boost profits Unusual increases in inventory or A/
R in relation to sales Increases in the gap between net income and cash flows or
taxable income

Step 5: Identify Potential Red Flags, continued -More issues that warrant gather
ing more information:
Unexpected large asset write-offs Large fourth-quarter adjustments Qualified aud
it opinions or auditor changes Related-party transactions


Step 6: Undo Accounting Distortions
If numbers appear distorted, recast the numbers to eliminate the distortion. Thi
s is discussed in the next chapter.
Accounting Analysis Pitfalls

Avoid assuming that conservative accounting = good accounting.
Conservative accounting may also be misleading.
For example, accounting for intangible assets
Avoid assuming that unusual accounting practices = earnings management.
Not all unusual accounting practices are questionable. Earnings management does
not necessarily motivate some accounting phenomena that seem unusual
Concluding Comments
Accounting analysis is an essential step in analyzing corporate financial report
s. A methodology consisting of six steps in analyzing accounting data is present
ed in this chapter.

CH 3 Palepu 1 Accounting Analysis

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The Importance of Accounting Analysis

Key Concepts in Chapter 3

Factors Influencing Accounting Quality

Factors Influencing Accounting Quality

Noise/bias in Accounting Numbers

Noise From Accounting Rules One-Size-Fits-All Problem

Factors Influencing Accounting Quality

Factors Influencing Accounting Quality

Managers Accounting Choices

Steps in Accounting Analysis

Steps in Accounting Analysis

Steps in Performing Accounting Analysis

Steps in Accounting Analysis

Steps in Performing Accounting Analysis

Steps in Accounting Analysis

Steps in Performing Accounting Analysis

Steps in Accounting Analysis

Steps in Performing Accounting Analysis

Steps in Accounting Analysis

Steps in Performing Accounting Analysis

Steps in Performing Accounting Analysis

Steps in Accounting Analysis

Steps in Performing Accounting Analysis

Accounting Analysis Pitfalls

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