ACCG350 Financial Statement Analysis

Week 3

Accounting Analysis
(Chapter 3)
 - Four key components of financial statement
analysis

Process of
- Investment recommendation
Financial
Statement
Analysis

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Importance of Accounting Analysis

• Understanding accounting allows analysts to more

effectively use the financial information disclosed by
companies.

• Accounting analysis helps to understand which factors

drove past performance (and how).

• Analysts need assess the reliability of a company’s

accounting numbers.

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Types of Financial Statements

• According to the International Accounting Standards

Board (IASB), a ‘complete set of financial statements’
comprises:
o Statement of financial position as at the end of the period
o Statement of profit or loss and other comprehensive income
for the period
o Statement of changes in equity for the period
o Statement of cash flows for the period
o Notes (comprising a summary of significant accounting
policies and other explanatory information).

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The Basic Features of
Financial Reporting

• The basic features of financial reporting include:

o Accrual accounting
o Delegation of reporting to management
o Reporting standards
o External auditing.

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Accrual Accounting

• Financial reports are prepared using accrual accounting

instead of cash accounting.
• Applying accounting principles is the responsibility of
management who has superior knowledge of a firm’s
business.
• The potential to choose appropriate accounting methods and
accruals which portray business transactions more accurately.
• Incentives exist for management to distort accounting
numbers in their favour.

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Delegation of Reporting to
Management
• Management is responsible for the application of
accounting methods (recognition, measurement and
disclosure) in financial statements.
• Management have some discretion in the choice of
accounting policies and the estimates made in financial
statements.
• Management can use this discretion in revealing their
private information about the firm or in distorting the
accounting numbers.
• Distortion of accounting may reflect incentives facing
managers.

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Earnings management
• Earnings management may be defined as “reasonable and legal
management decision making and reporting intended to achieve
stable and predictable financial results.”
• The popular earnings management techniques: (1) Cookie jar
reserve, (2) Big bath, (3) Big bet on future, (4) Flushing the
investment portfolio
• Famous example
of earnings
management:
GE under Jack
Welch.

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Reporting Standards
• Accounting standards try to eliminate unsatisfactory reporting
practices, thereby promoting consistency and comparability.
• Many countries in the world are now reporting or converging to
International Financial Reporting Standards (IFRS).
• IFRS have been described as more principles-based (rather than
rules-based).

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External Auditing of Financial
Statements

• Audits provide an independent (third party) opinion on

the quality of the financial statements.
• Audits are required for many companies, private and
public.
• There is a move towards international auditing standards
by many countries.
• Audit committees enhance the auditing process.

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Factors Influencing Accounting
Quality

• It is necessary to allow managers some discretion in

applying accounting standards.
• As a result, three potential sources of noise and bias in
accounting data include:
o Random estimation errors
o Rigidity in accounting rules
o Manager’s accounting choices.

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Rigidity of Accounting Rules
and Random Forecast Errors

• Accounting standards may not reflect the economics of

the firm’s transactions.
• Some flexibility in accounting required.

• Management’s estimates may result in accounting

forecasting errors.
• Accrual accounting requires forecast estimates that can be
incorrect.

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Managers’ Accounting Choices

• Managers have a number of incentives to choose accounting

disclosures that are biased:
o Accounting-based debt covenants
o Management compensation contracts
o Contests for corporate control
o Tax considerations
o Regulatory considerations
o Capital market and stakeholder considerations
o Competitive considerations.

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Steps in Performing Accounting
Analysis

• Step 1: Identify Key Accounting Policies

• Key policies and estimates used to measure risks and

critical factors for success must be identified
• Have a material effect, relating to the company’ strategic or
operational factors
• Require significant judgment

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Steps in Performing Accounting
Analysis
• For example, one key accounting policy is the depreciation
expense estimate.
• Depreciation is an application of accrual accounting for using up a
fixed asset (property, plant and equipment) over its useful life.
• Essentially depreciation is the process of calculating an expense by
allocating the cost of fixed assets over their useful lives.

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Steps in Performing Accounting
Analysis

• Step 2: Assess Accounting Flexibility

• Accounting information is more open to distortion if managers
have a high degree of flexibility in choosing policies and estimates
• Identify areas of judgement
• Conclude the level of accounting flexibility
• Limited
• Moderate
• Substantial

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Steps in Performing Accounting
Analysis

• Step 3: Evaluate Accounting Strategy

o Flexibility in accounting choices allows managers to strategically
communicate economic information or distort performance.
• Issues to consider include:
o Norms for accounting policies with industry peers
o Incentives for managers to manage earnings
o Changes in policies and estimates and the rationale for doing so
o Whether transactions are structured to achieve certain accounting
objectives.
o Continues next slide
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Steps in Performing Accounting
Analysis

• Step 4: Evaluate the Quality of Disclosure

• Issues to consider include:
o Whether disclosures seem adequate
o Adequacy of footnotes to the financial statements
o Whether notes sufficiently explain and are consistent with current
performance
o Whether accounting rule reflects or restricts the appropriate measurement of
key measures of success
o Adequacy of segment disclosure.
o How forthcoming is the managers w.r.t. bad news
o How good is the company’s investor relation

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Steps in Performing Accounting
Analysis
• Step 5: Identify Potential Red Flags
• Issues that warrant gathering more information include:
o Unexplained changes in accounting, especially when performance is poor
o Unexplained transactions that boost profits
o Unusual increases in inventory or receivables in relation to sales revenue
o Increases in the gap between net income and cash flows or taxable
income
o Use of R&D partnerships, SPEs or the sale of receivables to finance
operations
o Unexpected large asset write-offs
o Large fourth-quarter adjustments
o Qualified audit opinions or auditor changes
o Related-party transactions.
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Steps in Performing Accounting
Analysis

o Step 6: Undo Accounting Distortions

o Financial statement footnotes often provide information from
which the analyst can undo accounting distortions or make
the financial statements more comparable.

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End of chapter case (p.87)

• Airlines: Depreciation Differences

• Analysis suggests variation in presentation, classification
and accounting policies.
• Issue of underlying reasons why depreciation rates and
residual values differ between airlines
• Comparison of accounting policies on aircraft, engine
and spares

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