Overview of

Accounting Analysis

July 5, 2016
Course overview

4 steps of financial statement analysis

 Step 1: Understand the firm’s 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
Framework

 Accrual Accounting
 Delegation of Reporting to Management
 GAAP
 External Audits
 Legal Liability
Accounting Quality
 Extent to which balance sheet is an accurate
reflection of economic assets and liabilities

 Extent to which income is an accurate

measure of current economic performance
and accurate signal of future earnings (likely
to recur in future)
Factors Influencing
Accounting Quality
 Accounting Rules
 How can accounting rules make information less
useful?
 Forecast Errors
 What financial statement items are based on
forecasts (estimates)?
 Management’s Accounting Choices
 Motivation
Factors Influencing
Management Choices
 Compensation
 Stock Price
 Debt Covenants or Credit Ratings
 Tax Considerations
 Regulatory Considerations
 M&A, Competition, Stakeholders

What are some restraining factors on management’s

choices?
Earnings Management

 Use of judgment (choices)

 in financial reporting or
 in structuring transactions
 to alter financial reports to either
 mislead some stakeholders about the
underlying economic performance of the
company, or
 to influence contractual outcomes.
 Earnings Management
Question
Controller A and Controller B work for


similar companies and have both

historically used very conservative average
useful lives for their properties.
 Controller A’s company has been very

successful while Controller B’s company

has been struggling.
 Controller B hired a consultant last fiscal

year to study the useful lives of its

properties and, as a result of the
Whoconclusions
is managingof its study, decided toWhy?
earnings?
lengthen its estimates of useful lives on its
  properties beginning this year.
Steps in Accounting Analysis
 Identify Key Accounts and Policies
 Assess Accounting Flexibility
 Evaluate Accounting Strategy
 Evaluate Quality of Disclosure
 Identify Any Potential Red Flags
 Identify and potentially “Undo” material
distortions, for example non-recurring items
Example
 First Citizens Vs. Bristol Myers Squibb
 How does each make money? What is critical to
their success?
 What are the company’s most significant assets?
Are there significant assets that are omitted from
their books due to the operation of GAAP?
 What are most critical estimates?
 Whose financial statements better reflect the
economic performance and position of the
company?
Potential Earnings
Distortions:
Non-recurring
 Non-recurring items initems most
the Income statement
common
Examples?


 Impact of income taxes?

 Objective: Improve quality of earnings

 Remove non-recurring items
 Remaining income is likely to recur in the future
Non-Recurring Items
 Management’s Motivations
 Reg. G –Non-GAAP financial measures
 Key Elements:
 Prohibits potentially misleading disclosures of non-GAAP
measures – considered in context of entire disclosure
 Mandates the following disclosures:
 Presentation gives equal or greater prominence to
comparable GAAP measures (said another way, non-GAAP
should not be more prominent than GAAP)
 Reconciliation of non-GAAP measures to GAAP
 Statement disclosing why management believes the non-
GAAP measures are useful to investors, and
 To extent material, statement disclosing additional purposes
for which management uses the non-GAAP measures.
Non-GAAP Financial Measures

 Examples
Summary

 Limitation of Accounting Rules

 Value of Accounting Data
 Importance of Accounting Analysis