Overview of Accounting Analysis

Accounting Analysis The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business reality –Analyst can assess the degree of distortion in a firm’s accounting numbers –Adjusting a firm’s accounting numbers using cash flows and footnote information to “undo” any accounting distortions –Sound accounting analysis improves the reliability of conclusions from financial analysis

The Institutional Framework for Financial Reporting (Cont’d) Accrual accounting Delegation of reporting to management –Managers are entrusted with the primary task of making the appropriate judgments in portraying myriad business transactions using the basic accrual accounting framework –Managers have incentive to use their accounting discretion to distort reported profits

The Institutional Framework for Financial Reporting Generally accepted accounting principles –It is difficult for outside investors to determine whether managers have used accounting flexibility to signal their proprietary information or merely to disguise reality –A number of accounting conventions have evolved to mitigate External auditing –Ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable Legal liability

Factors Influencing Accounting Quality Noise from accounting rules Forecast errors Manager’s accounting choice

Steps in Doing Accounting Analysis Identify key accounting policies Assess accounting flexibility Evaluate accounting strategy Evaluate the quality of disclosure Identify potential red flags Undo accounting distortions

Accounting Analysis Pitfalls Conservative accounting is not “good” accounting Not all unusual accounting is questionable