The Importance of Accounting Analysis

Understanding accounting allows the business analyst to effectively use the financial information disclosed by companies.

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Key Concepts in Chapter 3

Various factors influence the quality of accounting-based financial reports. Managers have some discretion in accounting choices used in financial reporting. Incentives for the management of financial reporting items must be considered by the analyst.
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Factors Influencing Accounting Quality

High quality accounting data are free of bias and noise. Three potential sources of noise and bias in accounting data:
1. Noise/bias from accounting rules One-size-fits-all problem 2. Forecast errors 3. Managers accounting choices

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Factors Influencing Accounting Quality

Three potential sources of noise and bias in accounting data:
1. Noise from accounting rules One-size-fits-all problem 2. Forecast errors 3. Managers accounting choices

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Noise/bias in Accounting Numbers

Reported accounting number = True number + noise/bias from accounting rules + noise/bias from forecast error + noise/bias from managers accounting choice True number is what would be reported if accounting rules were tailored to conform to the unique circumstances of the firm AND management had perfect foresight of the future AND management reported in an unbiased manner without consideration of the resulting economic consequences.
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Noise From Accounting Rules One-Size-Fits-All Problem

Accounting standards often specify uniform accounting for all firms (one size fits all). The fit between accounting standards and the nature of the firms transactions may introduce some distortion in the reported financial statements. Example: required expensing of R&D expenditures.

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Factors Influencing Accounting Quality

Three potential sources of noise and bias in accounting data:
1. Noise from accounting rules One-size-fits-all problem 2. Forecast errors 3. Managers accounting choices

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Forecast Errors
Accrual accounting requires that management make a host of forward-looking estimates. These estimates are inevitably inaccurate because management doesnt have perfect foresight of the future. Example: estimate of future bad-debts

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Factors Influencing Accounting Quality

Three potential sources of noise and bias in accounting data:
1. Noise from accounting rules One-size-fits-all problem 2. Forecast errors 3. Managers accounting choices

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Managers Accounting Choices

Managers have a number of incentives to choose accounting disclosures that are biased:
Debt covenants Compensation contracts Contests for corporate control Tax considerations Regulatory considerations Capital market and stakeholder considerations Competitive considerations
Chapter 3: Overview of Accounting Analysis Palepu & Healy

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Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies Step 2: Assess Accounting Flexibility Step 3: Evaluate Accounting Strategy Step 4: Evaluate the Quality of Disclosure Step 5: Identify Potential Red Flags Step 6: Undo Accounting Distortions

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies Step 2: Assess Accounting Flexibility Step 3: Evaluate Accounting Strategy Step 4: Evaluate the Quality of Disclosure Step 5: Identify Potential Red Flags Step 6: Undo Accounting Distortions

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Performing Accounting Analysis

Step 1: Identify Principal Accounting Policies
What are the key business success factors? What accounting policies are used to measure the effect of these success factors? Example 1: credit risk is a big success factor in banking, and the loan loss reserve (a/k/a allowance for doubtful accounts) is the account that reports on this success factor. Example 2: warranty claims is a big success factor in manufacturing and the warranty reserve is the account that reports on this success factor.
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Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies Step 2: Assess Accounting Flexibility Step 3: Evaluate Accounting Strategy Step 4: Evaluate the Quality of Disclosure Step 5: Identify Potential Red Flags Step 6: Undo Accounting Distortions

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Performing Accounting Analysis

Step 2: Assess Accounting Flexibility
Accounting flexibility can be a strength or a weakness, depending upon how management uses that flexibility. Example 1: R&D is a big success factor in biotechnology industry, but GAAP imposes one-size-fits-all accounting on this factor (all non-software R&D is expensed). No flexibility. Example 2: Similar activity in software development industry (software R&D), but GAAP allows firms latitude in deciding when to start capitalizing software development costs. Managers can use this flexibility in an unbiased manner or to opportunistically achieve some desired financial reporting objective (e.g., make the numbers).

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies Step 2: Assess Accounting Flexibility Step 3: Evaluate Accounting Strategy Step 4: Evaluate the Quality of Disclosure Step 5: Identify Potential Red Flags Step 6: Undo Accounting Distortions

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Performing Accounting Analysis

Step 3: Evaluate Accounting Strategy - Flexibility in accounting choices allows managers to strategically communicate economic information or hide true performance. -Issues to consider include:
Norms for accounting policies with industry peers Incentives for managers to manage earnings Changes in policies and estimates and the rationale for doing so Whether transactions are structured to achieve certain accounting objectives
Copyright (c) 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies Step 2: Assess Accounting Flexibility Step 3: Evaluate Accounting Strategy Step 4: Evaluate the Quality of Disclosure Step 5: Identify Potential Red Flags Step 6: Undo Accounting Distortions

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Performing Accounting Analysis

Step 4: Evaluate the Quality of Disclosure - Managers have considerable discretion in disclosing certain accounting information - Issues to consider include:
Whether disclosures seem adequate Adequacy of footnotes to the financial statements Whether MD&A sufficiently explains and is consistent with current performance Whether GAAP restricts the appropriate measurement of key measures of success Adequacy of segment disclosure
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Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies Step 2: Assess Accounting Flexibility Step 3: Evaluate Accounting Strategy Step 4: Evaluate the Quality of Disclosure Step 5: Identify Potential Red Flags Step 6: Undo Accounting Distortions

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Performing Accounting Analysis

Step 5: Identify Potential Red Flags -Some issues that warrant gathering more information include:
Unexplained transactions that boost profits Unusual increases in inventory or A/R in relation to sales Increases in the gap between net income and cash flows or taxable income

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Performing Accounting Analysis

Step 5: Identify Potential Red Flags, continued -More issues that warrant gathering more information:
Unexpected large asset write-offs Large fourth-quarter adjustments Qualified audit opinions or auditor changes Related-party transactions

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Accounting Analysis

Step 1: Identify Principal Accounting Policies Step 2: Assess Accounting Flexibility Step 3: Evaluate Accounting Strategy Step 4: Evaluate the Quality of Disclosure Step 5: Identify Potential Red Flags Step 6: Undo Accounting Distortions

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Steps in Performing Accounting Analysis

Step 6: Undo Accounting Distortions
If numbers appear distorted, recast the numbers to eliminate the distortion. This is discussed in the next chapter.

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Chapter 3: Overview of Accounting Analysis Palepu & Healy

Accounting Analysis Pitfalls

Avoid assuming that conservative accounting = good accounting.
Conservative accounting may also be misleading.
For example, accounting for intangible assets

Avoid assuming that unusual accounting practices = earnings management.

Not all unusual accounting practices are questionable. Earnings management does not necessarily motivate some accounting phenomena that seem unusual
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Concluding Comments
Accounting analysis is an essential step in analyzing corporate financial reports. A methodology consisting of six steps in analyzing accounting data is presented in this chapter.

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Chapter 3: Overview of Accounting Analysis Palepu & Healy