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AF420 Session 3 - Accounting Analysis.2020pptx

1. Complete elimination of management discretion would not allow accounting standards to reflect firm-specific economic realities and transactions. 2. Some management discretion is necessary and inevitable given the need for estimates and judgments in accrual-based accounting. 3. While uniform standards can improve comparability, they may also introduce unnecessary rigidity and prevent the reflection of underlying economic conditions of individual firms. 4. Investors still need to evaluate management incentives and strategies to understand how accounting choices may distort reported financial information. Eliminating all discretion does not remove this need for critical analysis of reported accounting numbers.

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64 views

AF420 Session 3 - Accounting Analysis.2020pptx

1. Complete elimination of management discretion would not allow accounting standards to reflect firm-specific economic realities and transactions. 2. Some management discretion is necessary and inevitable given the need for estimates and judgments in accrual-based accounting. 3. While uniform standards can improve comparability, they may also introduce unnecessary rigidity and prevent the reflection of underlying economic conditions of individual firms. 4. Investors still need to evaluate management incentives and strategies to understand how accounting choices may distort reported financial information. Eliminating all discretion does not remove this need for critical analysis of reported accounting numbers.

Uploaded by

Rahul Narayan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Text Book Reference

Chapter 3 & 4

AF420
Financial Statement Analysis
Session 3
Accounting Analysis

Acknowledgement
This presentation uses some material from the slide pack accompanying
the text
Introduction
1. Use of IFRS
 Mandatory for large entities and those raising funds from
the public
2. Accrual Accounting
 Cash transactions, credit transactions & estimates
3. Financial Statements
 Financial Performance, Financial Position, Changes in
Equity, Cash Flows & Notes to F/Statements
4. External Auditing
Learning Outcomes
On successful completion of this session/topic, you
should be able to:

1. Discuss three factors that may affect accounting


quality.
2. Discuss and apply the 6 steps in accounting analysis.
3. Recast financial statements to reduce the effect of
accounting distortions
LO 1

Factors Influencing
Accounting Quality
Accrual Accounting
• Financial reports are prepared using accrual
accounting instead of cash accounting.
• The conceptual framework defines the following
financial statement elements and their relation:
Assets = Liabilities + Equity
Profit = Revenues – Expenses
• Another important relation:
Comprehensive income = profit for the period + items
recognised directly in equity.

5
Delegation of Reporting to Management
• Management is responsible for the application of accounting
methods (recognition, measurement and disclosure) in
financial statements.
• Management have some discretion in the choice of
accounting policies and the estimates made in financial
statements.
• Management can use this discretion in revealing their private
information about the firm or in distorting the accounting
numbers.
• Distortion of accounting may reflect incentives facing
managers.

6
Reporting Standards
• Accounting standards try to eliminate
unsatisfactory reporting practices, thereby
promoting consistency and comparability.
• Many countries in the world are now
reporting or converging to International
Financial Reporting Standards (IFRS).
• IFRS have been described as more principles-
based (rather than rules-based).

7
External Auditing of Financial Statements

• Audits provide an independent (third party)


opinion on the quality of the financial
statements.
• Audits are required for many companies, private
and public.
• There is a move towards international auditing
standards by many countries.
• Audit committees enhance the auditing process.

8
LO 1
Measuring Accounting Quality
1. Input approaches
 Higher audit fees (proxy) may reflect higher accounting
quality. Fees signal the expertise and rigour of the
audit.
2. Cash flow approaches
 Compare cash flows to past accruals. Higher (and
growing) divergence may reflect lower accounting
quality. Cash flows don’t involve professional judgement.
3. Industry approaches
 Compare discretionary accruals to the industry. Higher
divergence may reflect lower accounting quality. This
includes depreciation, credit sales etc.
LO 1
Nature of Underlying Transactions, Events &
Conditions
Consider whether the transactions, events and
conditions are:

1. Conducted on a cash or credit basis?


 Require estimates of doubtful debts
2. Settled in the short-term or long-term?
 May involve use of DCF and estimates
3. Common across industries or specialised/unique?
 e.g. PP&E, seasonality (tourism)
Factors Influencing
Accounting Quality
• It is necessary to allow managers some
discretion in applying accounting standards.
• As a result, three potential sources of noise
and bias in accounting data include:
1. Rigidity in accounting rules
2. Random forecast errors
3. Manager’s accounting choices.

11
Rigidity of Accounting Rules and
Random Forecast Errors
• Accounting standards may not reflect the
economics of the firm’s transactions.
• Management’s estimates may result in
accounting forecasting errors.

12
LO 1
Managers’ Discretion
Managers have intimate knowledge of their
organization’s business
 Choose accounting policies & estimates (within IFRS
framework)
1. Discretion allows managers to reflect firm-specific
information in reported financial statements
 e.g. allowance for d/debts, provision for warranty
2. However, self-interest provides an incentive for
managers to distort reported profits, reducing value
to users
 e.g. performance measurement, debt contracts etc.
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.

14
LO 1

Institutional Factors
IFRS Designed to improve comparability, reduce
(principles cost of analysis and reduce distortion in
based) reported statements
 May introduce unnecessary rigidity e.g.
intangibles
 May induce “transaction structuring” e.g.
leasing

Auditing Designed to improve quality & credibility of


accounting data
 internationally recognized & specialist
auditors

Legal Threat of lawsuit and penalties may


Environment improve accuracy of disclosures
LO 1
Summary
Accounting quality may be reduced by:
1. Random estimation errors
 Since the future can’t be known with certainty
2. Rigidity in accounting rules
 May prevent reflection of underlying economic
reality and/or reduce comparability e.g.
amortization of goodwill
3. Earnings management
 Systematic accounting choices made by managers
to achieve specific objectives
These factors distort accounting data
LO 2

Steps in Accounting Analysis


LO 2

Step 1: Identify Accounting Policies


Identify (using f/statements & industry knowledge)
1. accounting measures used to capture relevant
business constructs (success factors & risks)
 e.g. loan loss reserves measure credit risk in the
banking sector, warranties manage product
quality in manufacturing
2. policies that determine how measures are
implemented
3. key estimates embedded in those policies
LO 2
Step 2: Assess Accounting Flexibility
Identify (using IFRS) the level of flexibility relating to
1. Industry specific factors
 e.g. credit risk is a critical success factor for banks
 Managers are free to estimate expected defaults
 Accounting numbers are potentially informative
2. General accounting policies
 e.g. depreciation (straight-line, reducing balance,
units of use)
 May lead to differences in profitability
LO 2
Step 3: Evaluate Accounting Strategy
Consider/Compare
1. accounting policies with those of the industry
2. managers’ incentives for earnings management
3. structuring of significant business transactions to
achieve certain accounting objectives
4. Recent changes in policies or estimates
5. Quality (how realistic) of policies and estimates in
the past e.g. adjustments

How would you identify/assess 2, 3 and 4?


LO 2
Step 4: Evaluate Quality of Disclosure
Consider
1. Disclosure of business strategy and economic
consequences through chairman’s/directors’ report
2. Explanation of current performance through
management commentary
3. Disclosure (how forthcoming) of bad news
4. Investor relations programme
5. Use of footnotes to explain accounting policies and
assumptions
6. Use of non-financial information to supplement
accounting disclosures
LO 2

Step 5: Identify Potential Red Flags


1. Unexplained changes in accounting
 especially when performance is poor
2. Unexplained/unusual transactions that boost profits
3. Unusual increases in accounts receivable or
inventory, relative to sales (e.g. turnover ratios)
4. Increasing gap between reported income and cash
flow from operating activities
5. Qualified audit opinions
 or unjustified changes in independent auditors
6. Related party transactions
 not at arm’s length (lack market rigour)
LO 2
Step 6: Undo Accounting Distortions
If reported numbers are misleading
 restate reported numbers to reduce the distortion

Use
1. cash flow information
2. financial statement notes
LO 2
Accounting Analysis Pitfalls
1. Conservative accounting is not always good
 Financials statements should reflect economic
reality in an unbiased way
2. Unusual accounting is not always bad
 May reflect unusual circumstances
 Same applies to changes in policies
Discussion Question
Fred argues “The standards that I like most are the
ones that eliminate all management discretion in
reporting – that way I get uniform numbers across all
companies and don’t have to worry about doing
accounting analysis.”

1. Do you agree?
2. Why or why not?

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