Assessing Risk from Financial Statements: an Essay

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INDIAN INSTITUTE OF MANAGEMENT INDORE

Course Title: Emerging Issues in Accounting Research-2
Term Paper on “Assessing risk from financial statements: An Essay”

Submitted to: Prof. V.K Gupta

Submitted by: Pankaj Gupta (FPM 1109)

Abstract
This paper presents insights for assessment of accounting risk from financial statements. Financial statement is only a source of information for external users not the exact presentation of the activities of a firm. The main purpose of this paper is to highlight those accounting variables which are needed to estimate the risk profile of a firm and various accounting issues related.

1) Introduction
Since long we have been preparing, presenting and publishing financial statements but what is the purpose of external financial statements? The answer can be providing information to the stockholders. Instead of stock holders we may find it useful for stakeholders. Like, it can be useful for debt holders to estimate the probability of default or suppliers of goods and services, who may be interested in the return and risk of the dealing with the firm. So, why external statements is necessary only for stockholders? Financial statements help stock holders to decide the market price of the firm’s stock. Since the stock holders are the owners of the firm and by determining stock prices they can take the decision regarding the resource allocation for the firm. Other stake holders may access the information from other sources but these are the shareholders whose basic source of information is the annual reports including balance sheet and income statements (external accounting statements) Earlier, accounting statements designed to measure the level of earnings as a performance measure i.e. return measure. But after Markowitz (1952/March) Roy (1952), risk was introduced as second aspect of performance. So does the financial statements are properly designed to estimate the risk? Even if we accept that financial statements are properly designed than what about the accounting manipulations made by the accountants to reduce the risk. For example –

Let us suppose that financial statements are designed in such a way that time series data related to EPS can be helpful in measuring the variance of earnings which is nothing but is the indication of risk of investing in the stock. Now if accountants use matching conventions for revenue and expense and thereby smoothing earnings over a period of time then time series analysis to calculate variability in earnings is not much helpful. This might be a practical issue while using financial statements. In this way there is interplay between accounting statements and its reflection in stock prices. In this paper I have tried to find how the accounting information is reflecting in stock prices if the stock and what could be the issues in measuring risk and return from the accounting statements. Remaining of the paper is organized as follows. Section 2 is brief literature review of accounting measures of risk and return thereof. Section 3 describes the mechanism of accounting information and it reflection in stock prices. Section 4 explains type of risks and their accounting measures. Section 5 focuses upon some accounting issues that might play a role in manipulating these measures and thus affect the calculation of risk and return. Section 6 concludes.

2) Literature review on risk and return from accounting information

Alexander (1949) studied the effect of size of firm on the distribution of the rate of return. He concluded that conclude that small corporations have greater variability of profits than do large, in two different senses. For any given year the dispersion of profit rate is much greater among small corporations than among large. From bad times to good the profit rates of small and medium sized corporations fluctuate more than do those of large ones. Finally, the small corporations probably misclassify a greater part of their...
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