Topic 16: Accounting analysis Flashcards
Purpose of accounting analysis
Evaluate the degree to which a firm’ accounting captures the underlying business reality by:
- identifying places where there is accounting flexibility
- identifying the appropriateness of the firm’s accounting policies and estimates
- estimating the degree of accounting quality
Importance of accounting analysis?
Evaluate effectiveley the quality of a firm’s financial statement data, the analyst needs to first understand:
- The institutional framework that governs financial reporting
- ther firm-specific factors influencing accounting quality
Institutional Framework of accounting quality
- GAAP
- External Auditing
- Legal Liability
- Public enforcement
Characteristics Auditing (External Auditing)
- Improves the quality and credibility of accounting data
- Limits a firm’s ability to distort financial statements to suit its own purposes
- Might sometimes fail (Enron and Parmalat)
- Might sometimes constrains the evolution of accounting rules and conventions
Characteristics of GAAP
- Allows for consistency in reporting between firms and over different time period of the same firm
- Uniform accounting standard minimize manager’s ability to manipulate financial statement information
- Reduce processing costs for financial statement users by providing a commonly accepted language that managers can use to communicate with investors
Characteristics of the legal environment
The legal environment have a significant effect on the quality of reported numbers
- Threat of lawsuits and resulting penalties improve the accuracy of disclosure.
- Every EU Member state has a statutory civil liability regime for misstatements that managers make in their periodic disclosures to investors.
- The strictness of legal liability regimes vary in accross countries (within and outside Europe)
Characteristics of Public enforcement
Final guarantee on reporting quality
-Strong accounting enforcement bodies either proactively or on a complaint basis initiate reviews of companies’ compliance with accounting standards and take actions to correct noncompliance
Factors influencing accounting quality
- Information asymmetries
- Accounting discretion
3 Potential sources of noise data and bias in accounting data
① Noise from the rigidity of accounting rules
② Random Forecast Errors => Managers cannot predict future consequences of current transactions perfectly
③ Manager’s accounting choices => Applying accounting principles is the responsability of management, who has superior knowledge of a firm’s business.
Incentives to distort accounting numbers
- Debts covenants
- Compensation contracts
- Contests for corporate control
- Tax considerations
- Regulatory considerations
- Capital market and stakeholder considerations
- Competitive considerations
Characteristics of the Income statement approach
- Focus on the discretion embedded in the recording of various revenues and expenses, then net income
- Simple measures capture the aggregate discretion reflected in reported net income
- Effective way to measure financial reporting quality
Characteristics of balance sheet approach
-Focus on the discretion embedded in the recording of various assets and liabilities
-Qualitative approach:
Identify where distorsions arise
Recongnize practices designed to understate/overstate asset and understate liabilities
Where asset distorsions generally comes from?
Distorsions may generally arise from ambiguities about wheter:
- Owneship/control of economic resource
- Forecast of future economic benefits
- Impairment test: fair values are higher or lowe than book values
- Fair values estimates (accuracy)
Where liabilities distorsions generally comes from?
Distorsions may generally arise from ambiguities about wheter:
- An obligation has been incurred
- The proper measurement of an obligation
What measures the income statement approach?
It measures the earnings quality. Accounting quality signals earnings persistence (sustainability): The extent to which current change in earnings persist into the future; Current earnings are a good indicator for future earnings
