Topic 2 - Accounting Analysis

Topic 2 - Accounting Analysis

1. Accounting Analysis

   • Purpose
     • Evaluate the degree to which a firm's accounting captures its underlying business reality and to undo any accounting distortions.
   • Why
     • Financial Reporting information is noisy and biased (even in the presence of accounting regulation and external auditing
     • It s an important precondition for effective financial analysis, as the quality of the inferences drawn depend on the quality of underlying accounting information
   • The Briloff Effect
   • Prelude to analysis
     • Understand the business
     • Understand the accounting policies
     • Understand the business areas where accounting quality is most doubtful
     • Understand the situations in which management are particularly tempted to 'manager earnings' (manipulation)
   • Process
     • Evaluating Earnings Quality
       • Identify and Assess Key Accounting Policies
       • Assess Accounting Flexibility
       • Evaluate Accounting/Reporting Strategy
       • Evaluate the Quality of Disclosure
       • Identify and Assess Potential Red flags
     • Adjusting Financial Statements
       • Undo Accounting Distortions to better serve your analysis

2. Income Statement Analysis

   • The income statement provides information about the profitability of a firm for a period of time 
   • Earnings Management
     • The choice of discretionary accruals and accounting policies within GAAP so as to achieve specified objectives
     • as opposed to Earnings Manipulation
     • Types
       • Discretionary accruals
       • Discretionary Accounting Policies
     • Motives
       • Capital Market (Shar prices, IPOs, takeovers)
       • Debt covenants
       • Political motives
       • Executive compensation
       • Capital Market: Share prices, IPOs, Takeovers
       • Debt covenants
       • Political Motives
       • Executive compensation
     • Empirical Evidence
       • The Kay Review 2012
       • Graham et al. (2005)
   • Revenue Recognition
     • Defined
     • Key Issue - Timing of revenue recognition
     • Adjusting Journal Entries
       • Dr decreases, CR increases
         • Dr Revenues     Cr Unearned revenues (Take out of recorded revenues and 'reclassify' as unearned, when they have been recorded too early, more conservative accounting)
       • Revenue with deferred payment
         • Recognition at time of job: Dr: A/R     Cr: Revenue Dr: Expense (e.g. Line costs)    Cr:Liability when receive payment: Dr: Liability     Cr: Expense Results in lower expenses and higher earnings. Ensure that this hasn't been prematurely done as opportunism.
         • Dr: A/R     Cr: Rev Dr: Bad debt expense    Cr: Allowance for bad debts
       • Capitalisation
         • Dr: Asset to be capitalised    Cr: Operating Costs Dr: Depr'n     Cr: Asset to be capitalised
       • Reversing premature realisation
         • Dr: Rev     Cr: A/R Dr: Inventory     Cr: COGS Dr: Deffered Tax Liability     Cr: Tax expense
       • Unearned Revenue
         • Dr: Revenue     Cr: Unearned Revenue (Reduce sales, and increase amount of unearned revenue)

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