Chapter 3 Overview of Accounting Analysis

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Chapter 3 - Overview of Accounting Analysis

• September 12, 2007

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Course overview

• 4 steps of financial statement analysis
• Step 1 Understand the firms operations and
  strategies
• Step 2 Accounting Analysis
• Step 3 Evaluate current position of the firm
  (profitability, sustainability, risk, governance)
• Step 4 Predict future course of the firm

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Framework

• Accrual Accounting
• Delegation of Reporting to Management
• GAAP
• External Audits
• Legal Liability

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Factors Influencing Accounting Quality

• Accounting Rules
• How can accounting rules make information less
  useful?
• Forecast Errors
• What financial statement items are based on
  forecasts?
• Managements Accounting Choices
• Motivation

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Factors Influencing Management Choices

• Compensation
• Stock Price
• Debt Covenants or Credit Ratings
• Tax Considerations
• Regulatory Considerations
• MA, Competition, Stakeholders
• What are some restraining factors on managements
  choices?

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Accounting Analysis

• Identify Key Accounting Policies
• Assess Accounting Flexibility
• Evaluate Accounting Strategy
• Evaluate Quality of Disclosure
• Identify Potential Red Flags
• Undo distortions

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Accounting Analysis

• Identify Key Accounting Policies
• Industry
• What are the financial statement items that are
  most significant for that industry?
• Banking vs. Oil exploration and production
• Strategy
• How is the firms strategy reflected in F/S?
• Differentiation vs. Cost Leadership

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Accounting Analysis

• Assess Accounting Flexibility
• Flexibility in choosing accounting methods and
  estimates by industry
• Software Developer vs. Pharmaceutical
• Impact of degree of flexibility
• What choices are available in almost every
  industry?

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Evaluate Accounting Strategy

• Industry Comparisons
• Incentives to Manage Earnings
• Changes in Policies or Estimates
• Credibility
• Transaction Structures

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Evaluate Quality of Disclosure

• Business Strategy
• Key Accounting Policies
• Current Performance
• Critical Accounting Estimates and Judgments
• Key success factors non GAAP
• Segments
• Bad News
• Analysis

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Example

• Yahoo! Vs. Progress Energy
• How does each make money?
• What are most important accounts?
• What are most critical estimates?
• Whose financial statements better reflect the
  financial position of the company?

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Potential Red Flags

• Accounting Changes
• Unusual Transactions
• A/R or Inventory Changes vs. Sales
• Earnings vs. Cash Flow
• Earnings vs. Taxable Income
• Large Write-offs
• 4th Quarter Adjustments
• Qualified opinions or auditor changes
• Related Party or Related Entity Transactions

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Undo Distortions

• Look for additional information
• Statement of Cash Flows
• Footnotes
• Or make estimates
• Make adjustments

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Summary

• Limitation of Accounting Rules
• Value of Accounting Data
• Importance of Accounting Analysis