Financial Reporting and Analysis FSs are the products of financial process governed by, Accounting rules and standards Managerial incentives Enforcement and monitoring mechanisms It is important to understand the financial reporting environment along with the objectives and concepts underling the accounting information presented in FS

Financial Reporting and Analysis Reporting Environment Introduction to Accounting Analysis Accrual Cornerstones of Accounting Nature & Purpose of Accounting Statutory FR Factors Affecting to SR Other Reporting Features Qualities of Accounting information Principles of Accounting Relevance of Accounting Accrual Accounting Illustration Accrual Accounting Framework Relevance of accruals Analysis implications of Accruals Need of Accounting Analysis Earnings Management Process of Accounting Analysis

Reporting Environment Statutory FRs are the most important product of financial reporting environment. Information in Fs is judged relative to i The information needs of FS users ii Alternative sources of information such as economic and industry data, analysts reports and voluntary disclosures by managers

Factors that affect the FR Factors that affect the nature and content of financial reports to appreciate the financial accounting information are, Accounting rules (GAAP) Manager motivation Monitoring and enforcement mechanism, regulations, industry practices and other information sources

Statutory financial reports There are three categories of SFR i Financial statements Ii Earning announcement iii Other statutory reports

Financial statements Statutory financial reports includes FR to be filed with company registrar FR to be published FR to be filed with SEc

Earning announcement Companies release key summary information to the public through an earning announcement. This is made available to traders on the stock exchange Earning announcement provids key summary information abut the company position and performance

Other Statutory reports Annual report to be filed with company registrar Prospectors Proxy statement

Factors Affecting SFR GAAP Managers Monitoring and enforcement Mechanism Alternative information sources

GAAP Rules and guidelines of financial accounting. These rules determine measurement and recognition policies such as how assets are measured when liabilities are incurred when revenues and gains are recognized when expenses and losses are incurred what information must be provided in the notes

GAAP Defined GAAP are collection of standards, pronouncements opinion, interpretations and practice guidelines various professional and quasistatutary bodies such as FASB, SEC, AICPA set GAAP. The most important types of accounting rules and guidelines are statement of financial accounting standard APB opinions Accounting research bulleting AICPA Pronouncements Industry practices

Setting Accounting Standards Accounting and Auditing Standard Act no Accounting Standard committee has statutory power to set standard The committee consist of, Members from SLICA CIMA SEC Central Bank Chambers of commerce

Role of the SEC By Laws of SEC Quarterly Report Recommendations and GL Circulars

International Financial Reporting Standards IFRS are formulated by the international accounting standard board

2. Managers Primary responsibility for fair financial reporting rest with managers. Managers have control over the integrity of Accounting system and the financial records Standards allow managers to choose among alternative accounting methods. Judgment in financial accounting involve managerial discretions. Earning management is made by the managers Managers can indirectly affect financial reports through collective influence on the standard setting process.

3. Monitoring and Enforcement Mechanisms It ensure the reliability and integrity of financial reports. 3.1 Auditors External auditing is an important mechanism to help ensure the quality and reliability of FS Auditor’s report is an integral part of financial statements. Audit opinion tells about quality and content of FS

3.2 Corporate governance FS need approval by the board of directors Audit committees Internal audit

3.3 SEC SEC plays an active role in monitoringand enforcing accounting standard. Companies must file audited FS with SEC SEC checks these reports to ensure compliance with statutory requirements. SEC has brought enforcement actions against for accounting violations. This leads to restatement of Fs

3.4 Litigation The threat of litigation influences managers to adopt more responsible reporting practices both for statutory and voluntary disclosures.

4. Alternative information sources Analysts’ forecasts and recommendations Economic, industry and company news Information available in the internet Voluntary disclosures

Nature and purpose of Financial Accounting Nature and purpose of financial accounting depends on desirable qualities, principles and conventions underlying financial accounting.

Qualities of Accounting Information Relevance and reliability are the most important qualities Relavance The capacity of information to affect a decision Forecast Feedback Timeliness

Reliability For information to be reliable it must be Verifiable: Information is confirmable Faithful: Information reflect reality Neutral: Truthful and unbiased Other important features Comparability: Information is measured in similar manner Consistency: Same method is applied for similar transaction

Principles of Accounting Historical cost Accrual Materiality Conservatism

Limitations of FS information Limitations of FS information Timeliness: FSs are prepared annually or quarterly. Other information sources are readily available Frequency: Less frequency Forward-looking: FS contain limited forecast. Alternative information sources provide much forward looking information

Accruals – Cornerstone of Accounting FS are primarily prepared on an accrual basis. Supporters believe that accrual accounting is superior to cash accounting for both measuring performance and financial conditions.

Accrual Concept An appealing feature about cash flows is simplicity. CF are easy to understand and straightforward to compute. There is something tangible and certain about CF. It is a real thing – not a creation of accounting method. But when it comes to measuring cash generating capacity CF’s are of limited use.

Accrual Concept Cont… Most business transactions are on credit Investments are made in inventories and long term asset, the benefit of which occur over many years. In these scenarios, CF accounting fails to provide a relevant picture of a company’s financial condition and performance.

Accrual Concept Cont… Accrual accounting aims to inform users, about the consequences of business activities for company’s future cash flows with a reasonable level of certainty. This is achieved by recognizing revenue earned and expenses incurred. This need accrual adjustments.

Accrual and cash Flows To explore the relationship between accrual and CF it is important to recognize alternative types of CF. 1.Operating CF – Cash from ongoing operating activities 2. Free CF – Cash that is free to be paid to both debt and equity holder. 3. Net CF – Net of inflow & outflow.

Accrual Accruals are sum of accounting adjustments that make net income different from net CF..

Accruals Accounting adjustments that convert operating cash flow to net income. Net income = operating cash flow + accruals Accruals are of two types. 1.Short term accruals : related to working capital items 2. Long term accruals : related to non current assets ex. Depreciation and amortization

Accrual Accounting reduces Timing & Matching concept Timing problem refer to CF that do not occur contemporaneously with business activities yielding the cash flows. Matching problems refer cash inflows and outflows that occur but are not matched in time with each other.

Timing and matching problems arise for two reasons. 1.Transactions do not involve immediate transfer of cash 2.Cost are incurred before their benefits are realized.

Accrual process – Revenue Recognitions and expense Matching Accrual Accounting comprised of two principles. 1. Revenue recognition. Revenue are recognized when earned and either realized or realizable. Revenue are earned when the company delivers its product. It means company has carried out its part of the deal.

Accrual process Cont …. Revenues are realized when cash is acquired for product or services delivered. Revenues are realizable when the company receives an asset for products or service delivered that is convertible to cash.

Expense matching Under the accrual accounting expenses are matched with their corresponding revenues. Matching process is different for two major types of expense. 1.Product cost 2. Period cost

Short term and long term accrual Short term accrual refer to short term timing differences between income and cash flow. These accruals generate working capital items in the balance sheet. They are called working capital accruals. 1. Inventories 2. Credit transactions

Relevance of Accrual Accounts 1.Conceptual relevance Accrual based income statement is more relevant for measuring a company’s cash generating capacity. Accrual account is superior in providing relevant information about. 1. Financial performance 2. Financial conditions 3. Predicting future cash flows.

Empirical Relevance Critics of accrual accounting decry its lower reliability and prefer reliable cash flows. Supporters assert the added relevance of accrual accounting compensates for lower reliability

Accrual and Cash Flow -Myths 1. Since company value depends on future cash flows only current cash flows are relevant for valuation 2. All cash flows are value relevant 3. All accrual accounting adjustments are value irrelevant 4. Cash flow cannot be manipulated. 5. All income is manipulated. 6. It is impossible to consistently manage income upward in the long run.

Accrual and Cash flow -truth 1.Accrual accounting is more relevant than cash flow. 2.Cash flows are more reliable than accruals. 3.Accrual accounting numbers are subject to accounting distorters. 4.Company value can be determined by using accrual accounting numbers.

Introduction to accounting analysis Accounting analysis is the process of evaluating the extent to which a company’s accounting numbers reflect economic reality. Accounting analysis involves. Evaluating a company’s accounting risk and earning quality Estimating earning power Making adjustments to financial statement to better reflect economic reality and assist in financial analysis.

Accounting analysis Accounting analysis is the process analyst uses to identify and asses accounting distortions in FS It also includes the necessary adjustments that reduce distortions and make the statement amenable to financial analysis.

Need for accounting analysis Two major reasons. 1.Accrual accounting yields some accounting distortions 2.FS are prepared for a divers set of users and information needs.