Stream II - Lecture 2 Flashcards
What is the purpose of accounting analysis?
To understand the extent to which a business’ accounting information captures the underlying business reality
What are some solutions to limit management discretion?
- The concept of prudence (assets and liabilities should be recorded at their fair value)
- Accounting standards
- External auditing
- Legal liability (threat of litigation)
- Public enforcement (enforcement agencies)
Why can mechanisms that limit discretion add noise and bias?
- Rigidity in accounting bias
- Random forecast errors
- Systematic reporting choices made by managers
What is a barter transaction?
The exchange of goods or services for other goods or services
What is a bill and hold transaction?
This is where a seller bills a buyer for goods or services but has not shipped/provided them yet. Certain conditions must be met for this type of transaction to be allowed e.g. the buyer must explicitly say in writing that they are going to buy the goods.
What is ‘big bath’ in accounting?
This is where a company may take a large write-off today to set the books up for the future. The main aim is to take a reduction in profits today to make future profits look better.
How can you detect earnings management?
1) Compare the volatility of income with the volatility of cash flow and benchmark with competitors
2) Compare the volatility of income with the volatility of sales and benchmark with competitors
What are the 6 steps to accounting analysis?
1) Identify key accounting policies
2) Assess degree of accounting flexibility
3) Evaluate accounting strategy
4) Evaluate quality of disclosure
5) Identify potential ‘red flags’
6) Undo accounting distortion
What equation do we use in profitability analysis?
Net Financial Assets + Net Financial Obligations = Common Stockholders’ Equity
When we standardise an income statement what are the 2 ways in which we can classify operating expenses?
- By “nature”: Reference to the CAUSE of the expense
- By “function”: Reference to the PURPOSE of the expense
What are some expenses that can be classified by “nature”?
- Cost of materials
- Personnel expense
- Depreciation and amortisation
That are some expenses that can be classified by “function”?
- Cost of goods sold
- Depreciation and amortisation
What are operating activities?
The earnings-related activities of a company
What are investing activities?
The means of acquiring and disposing of non-cash assets
What are financing activities?
The means of contributing, withdrawing and servicing funds to support business activities.
