Overview of Accounting Analysis

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Chapter 3
Overview of Accounting Analysis

1

Preliminary Topics
• Institutional Framework of Financial Reporting includes: (1) Income Statement, (2) Balance Sheet and (3) Cash Flow Statement. Balance Sheet analysis: Building Blocks of assets, liability, debt & equity. Equity=Assetsliability. Book value vs. market value of share. • Corporate financial report is prepared on accrual basis rather than cash basis. Accrual implies economic activities rather than true payment and receipts. • A Responsibility Delegated to the Management. Management holds the advantage of making the assumption and financial report depends on that assumption. This some times makes the reporting less practical. Accounting analysis is then more valuable. 2

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. 3

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 4

Factors Influencing Accounting Quality
• 1. There are 3 sources of accounting noise: Accounting Rules – Management discretion of accounting rule introduces noise. The more accounting restricts management discretion, the more accounting data loses information content. Accounting standards may not match nature of the firm’s transactions. (example: R&D expenses are recorded when incurred, the outcome or future value of research is ignored.) Forecast Errors – the dilemma of “reasonable certainty” in forecasting future consequences of current transactions. (Example: credit sales create accounts receivables and management makes an estimate of the proportion of receivables that will not be collected. This is extremely subjective) 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. 5

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Window Dressing
Last year Current assets Current liabilities Working Capital Current Ratio $300 100 $200 3:1 Current Window dressing year Before Payoff After Payoff $600 400 $200 1.5:1 $200 100 $100 2:1 $150 50 $100 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. 6

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...
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