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LEARNING OBJECTIVES
ACCOUNTING ANALYSIS Understand what is meant by “quality” of accounting
information. Identify factors that enhance and limit the
quality of financial reports.
Lecturer: Phan Ngoc Anh, MBA Develop qualitative and quantitative methods to measure
Resources:
and evaluate the quality of financial information
Chapter 3- Business Analysis and Valuation by Palepu, Healy, Bernard
Chapter 17 – Financial Statement Analysis and Security Valuation by Stephen Penman
Recommend signals of potential accounting problems
(things to “watch out” for..)
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PRELIMINARIES PRELIMINARIES
INCOME STATEMENT COMPONENTS CONVENTIONAL ACCOUNTING BALANCE SHEET
Sales
Assets Liabilities & Equity
- Cost of Goods Sold (COGS)
= Gross Profit
- SG & A (Selling, general & administrative expenses) Current liabilities: Notes Payable,
Current assets: Cash & Current portion of long-term Debt,
= EBITDA (Earnings before Interest, Taxes, Depreciation & Amortization)
marketable securities, Accounts Accounts Payable, other C/L
- Depreciation/Amortization
Receivables, Inventory, other C/A (Accrued Liabilities, Unearned
= Operating Income / EBIT (Earnings before Interest, Taxes)
(Prepaid expenses)… Revenue, Taxes/Dividends
+ Other Income
- Other Expenses Payables…)
- Interest Expenses
+/- Unusual or infrequent items (gross of tax) Fixed assets – tangible: Plant,
Property & Equipment (PPE), Long-term liabilities: Long-term
= EBT (Earnings before Taxes) from continuing operations
Land.. Debt, Notes…
- Taxes (%)
= Net Income from continuing operations
+/- Income from discontinued operations
Net of tax Fixed assets – Intangible: Equity: Preferred Stock, Common
+/- Extraordinary items
+/- Cumulative effect of accounting change Goodwill, trademarks, license stock, Retained Earnings, Treasury
Net Income rights… stock…
- Preferred Dividends
Income available for common stockholders 3 4
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PRELIMINARIES PRELIMINARIES
CASH VS. ACCRUAL ACCOUNTING ACCRUAL ACCOUNTING
Cash accounting: transactions are recorded in the book Revenue recognition: Revenue is recognized when both
when cash actually changes hands. of the following conditions are met:
- Does a good job of tracking cash flows, but it does a poor a. Revenue is earned (when products are delivered or
job of matching revenues earned with money laid out for services are provided.)
expenses. b. Revenue is realized or realizable (cash is received or
it is reasonable to expect that cash will be received in the
Accrual accounting: transactions are recorded in the
future)
books when they occur, even if no cash changes hands.
- implies economic activities rather than true payment
and receipts. Expense recognition: Expense is recognized in the
period in which related revenue is recognized (Matching
Principle).
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PRELIMINARIES
CASH ACCOUNTING
FACTORS AFFECTING ACCOUNTING QUALITY
Revenue recognition: Revenue is recognized when cash is received. There are three potential sources of noise and bias in
Expense recognition: Expense is recognized when cash is paid.
accounting data:
Potential timing differences in recognizing revenues and expenses
between accrual basis and cash basis accounting: Noise from accounting rules
Forecast errors
- Unearned Revenue: Revenue is recognized after cash is received (We
already received the $ but we haven’t delivered the goods/services yet) Manager’s accounting choices
- Prepaid Expense: Expense is recognized after it is paid for (we have
paid for the goods/services but we haven’t received them yet)
- Accrued Revenue: Revenue is recognized before cash is received (we
already provided goods/services but we haven’t got paid yet)
- Accrued Expense: Expense is recognized before it is paid for (we
already received the goods/services but we haven’t paid suppliers yet)
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NOISES FROM ACCOUNTING RULES FORECASTING ERRORS
Accounting standards create a uniform accounting Management holds the advantage of making the
language to increase the credibility of financial statements assumption and financial report depends on that
by limiting a firm’s ability to distort them assumption.
But, increased uniformity comes at the expense of - Ex: assumptions about certainties/uncertainties (%) of
Bad Debts, Warranty expenses…which are extremely
reduced flexibility for managers to reflect genuine business subjective
activities.
Pure forecast errors resulted from manager’s inability to
have a perfect foresight of events
The more accounting restricts management discretion, the
more accounting data loses information content Forecast errors also depend on:
Accounting standards may not match nature of the firm’s
- The complexity of business transactions
transactions.
- The industry
- The macro-economic changes
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MANAGER’S ACCOUNTING CHOICES
Managers have various incentives to misstate
Earnings/Balance Sheet items
• To meet contractual obligations of Debt covenants
STEPS FOR ACCOUNTING
• To have tax advantages
• To maximize bonuses/ ensure job security for
ANALYSIS
managers
• To avoid regulatory restrictions
• To influence the perception of important
stakeholders in the firm
• Stock market incentives: meet analyst’ targets
• Potential mergers/ additional stock issuance
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STEPS FOR ACCOUNTING ANALYSIS STEP 1 – IDENTIFY KEY ACCOUNTING POLICIES
The job of the analyst is to identify the accounting
• Identify key accounting policies measures the firm uses to capture these key success
Step 1
factors and risks (metrics)
For ex:
Step 2
• Assess accounting flexibility
- In Banking industry, the metrics for credit risk is Provision
for Bad Debts (%); for borrowing/lending policies is Net
Step 3
• Evaluate accounting strategy Interest Margin (spread)
- In Manufacturing industry, the metrics for Product quality
and product defects could be returned sales, warranty
Step 4
• Evaluate the quality of disclosure expenses, provisions for warranty...
- In Pharmaceutical industry, the metrics for R&D could be
Step 5
• Identify potential red flags R&D expenditures..
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STEP 1 – IDENTIFY KEY ACCOUNTING POLICIES STEP 2 – ASSESS ACCOUNTING FLEXIBILITY
Not all firms have equal accounting flexibility in measuring their
Firm’s industry characteristics and its own competitive strategy key success factors and risks
determine its key success factors and risks
An industry's key success factors (KSFs) are those things that - Ex: Biotechnology firms are required to expense all the R&D or
most affect industry members' ability to prosper in the consumer goods firms are required to expense all marketing
marketplace-the particular strategy elements, product attributes, outlays
resources, competencies, competitive capabilities…that spell the
difference between profit and loss - Vs. banks have freedom to estimate expected defaults (Bad
Debts) on their loans, or software developers have freedom to
decide at what points in their development cycle the outlays can
KSFs by their very nature are so important that all firms in the
industry must pay close attention to them be capitalized.
Ex: for retail industry inventory control But managers have flexibility regarding the following accounting
for banking credit management, borrowing/lending rates policies:
for manufacturing product quality & innovation, R&D, - Inventory accounting policy (LIFO vs. FIFO vs. Average cost)
product defects after sales - Depreciation policy (straight line vs. accelerated methods)
Note: The key success factors may change depending on the - Amortizing goodwill policy (write-off over 40 years or less)
competitive dynamics of the industry, which changes across time!!!
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STEP 3 – EVALUATE ACCOUNTING STRATEGY
STEP 3 – EVALUATE ACCOUNTING STRATEGY HOW MANAGERS “COOK THE BOOK”?
Managers can use accounting flexibility to strategically Revenue Recognition: Overstate Revenue
communicate the firm’s financial health or hide true
performance • Ex:
Check to see if accounting flexibility is closely linked to • Revenue acceleration: Record unearned revenue
the firm’s strategy: (“advances from customers”) as earned
- If the firm’s accounting policies is similar to the industry’s
norms? If not, is it because firm’s competitive strategy is • Unearned revenue: revenue collected but not yet
unique? earned should be recorded as Liability rather than
- Has the firm changed any of its policies or estimates? Earned Revenue
What is the implications of the changes? • Ex: computer software: revenue recorded when shipped, not
when done with installations, applications tailored..
In scrutinizing accounting choices, always check if • Problem: Overstate revenue inflated financial
managers have a strong incentives to “cook the book”!!! statements now at the expense of future earnings
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STEP 3 – EVALUATE ACCOUNTING STRATEGY STEP 3 – EVALUATE ACCOUNTING STRATEGY
HOW MANAGERS “COOK THE BOOK”? HOW MANAGERS “COOK THE BOOK”?
Expense Recognition : Understate expenses Depreciation/Amortization
• Ex:
• Ex:
• Under-accrue expenses (wages, interests, taxes…)
• Depreciation of long-lived assets over longer
period than they will be useful to the business
• Not writing off the cost of un-saleable inventory (un-
saleable inventory due to damage, obsolescence… no
longer generate value in the future and needs to be • Estimating salvage value: Estimate a high salvage
written off, which represents a cost to the firm) value (residual value) at the end of the asset’s
useful lives
• Failure to recognize the likelihood of return (warranty
expenses) or Bad debts • Problem: Understate Depreciation expenses to
boost Profit
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STEP 3 – EVALUATE ACCOUNTING STRATEGY
WHICH COMPANY DO YOU PREFER? HOW MANAGERS “COOK THE BOOK”?
“Cookie Jar Reserve” Technique
• If a company is having a particularly good year and next
year’s results are uncertain, they can over-accrue some
expenses in the current year and then have the ability to
under-accrue them in the next year if needed.
• Result: The following year’s income is inflated at the
expense of this year’s income income appears smoother
• Usually done for expenses that are based on estimates:
• Estimating sales returns and allowances
• Estimating bad debt write-offs
• Estimating inventory write-downs
Years • Estimating warranty costs
To make Earnings look like that of Company A is called “Income • Estimating % of completion for long-term projects
Smoothing”! 21 22
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STEP 3 – EVALUATE ACCOUNTING STRATEGY “BIG BATH” – ONE –TIME CHARGE TECHNIQUE
HOW MANAGERS “COOK THE BOOK”? ILLUSTRATION
“Big Bath” one-time charge Technique
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• Effectively accelerate expenses and losses into a single 15
year with already poor results so that future income looks 10
better and smoother. Employ an unusual or one-time 5
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charge and blame all the poor results on that event!
-5 1 2 3 4 5 6 7 8 9 10 Company C
-10 Company D
• Ex: Recognizing losses on assets that have a fair -15
market value below the current book value/ Doing a -20
restructuring (restructuring charge)/ an operations -25
disposal -30
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• Why? Analysts and investors can overlook non-
recurring charges since they are not part of the firm’s Years Company D recognized all of its
ongoing operations (core business)! stock price less bad news in one year—thus,
affected! took a “big bath” loss.
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STEP 4 – EVALUATE THE QUALITY OF DISCLOSURE STEP 5 – IDENTIFY POTENTIAL RED FLAGS
Check the following _______________ for: Increasing gap between Net Income and CFO: while NI
(accrual accounting) can differ from CFO (cash accounting), there
Letter to Shareholders: for the layout of the firm’s is usually a steady relationship between the two if company
industry conditions, competitive position, and doesn’t change accounting policies
management’s plan for future
- Reported Net Income grows faster than CFO could be sign of
earnings manipulation
Footnotes: for key accounting policies and assumptions
- Ex: If a firm’s revenue/expense recognition policies differ from Unusual increases in A/R in relation to sale increases
industry norm, the firm could explain its choices in footnotes. - A/R grows faster than Sales: Problems collecting? Tough econ?
Or maybe company relaxed its credit policies to boost revenue ?
Management Discussion and Analysis: for the reasons Unusual increases in Inventories in relation to sale increases
behind a firm’s performance changes
- Ex: If profit margins went down in a period, was it because of price - Sales slow while Inventory piles up: market demand decreases
competition or because of increase in manufacturing costs? while company stores too much goods ? may have to write off
Inventory (un-saleable) or reduce prices to sell quickly in the
Check for adequacy and quality (consistency)!!! future
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STEP 5 – IDENTIFY POTENTIAL RED FLAGS STEP 5 – IDENTIFY POTENTIAL RED FLAGS
Unexplained transactions that boost earnings: to realize gains
in periods when operating performance is poor Unexplained changes in accounting methods estimates,
- E.g. Sale of assets especially when performance is poor
- E.g. Debt for Equity swap: borrow $ to buy back shares to boost - E.g. switch from LIFO to FIFO, from Straight line to accelerated
EPS depreciation…
Unexpected large assets write-offs Change of auditors, key executives...that are not well
- May suggest that management is slow to incorporate changing justified
business circumstances into its accounting estimates…or - May indicate a firm’s aggressive attitude or a tendency to
- Come back to previous years to check if management inflated “opinion shop”
revenue/earnings in the past Large fourth-quarter adjustments
Significant related party transactions - A consistent pattern of fourth-quarter adjustments may indicate
aggressive management of interim reporting
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MINI-CASE 1 : GATEWAY (2000) MINI-CASE 2 : AMR (2000)
Financed its computer sales to high-risk customers Changed accounting estimate: Increase useful lives of
Accounts Receivables, net allowance for Bad Debts aircraft (from 20 years to 25 years) and extend salvage
increased from 3.3% of Sales to 7.3% of Sales value (from 10% to 15%)
In 2000, the company wrote off $100 million of A/R Depreciation thus reduced by $158m (after-tax effect of
$99m) – accounted for 44% increase income for the year
2000 ( Income increased from $1,156m to $1,381m)
What seemed to Was management correct
be the problem to claim that the change
“more accurately reflects
here? the expected life of its
aircrafts?”
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ACCOUNTING ANALYSIS PITFALLS
Avoid assuming that conservative accounting is
good accounting
- Investors want F/S that truly reflect business reality in an
unbiased manner, and conservative accounting can be as
misleading as aggressive accounting in this respect.
Not all unusual accounting is questionable
- Firm’s accounting choices can be justified if it just
implements a strategy change Check firm’s strategy
first!
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