Financial Statement Analysis Acct 592 July 10, 2003

Chapter 4 Relevant Financial Statement Data for Analysis

Why Data May be Incomparable Sustainability, measurement, or manageability of reported earnings may be at issue* Previous years are restated in the current year Items are classified in different ways across firms Statements are prepared for different time periods across firms Accounting principles differ across countries* * Indicates most problematic issues

Earnings Management and Earnings Sustainability

Earnings Quality Underlying reported earnings is the assumption that it represents a reasonably accurate measure of the economic value-added by the firm during the reporting period and the economic value likely to be added in future periods. The correlation between earnings and EVA may be compromised by these factors: –Inclusion in reported earnings of nonrecurring items –Inadequacy of accounting systems to measure EVA from operations accurately and reliably –The opportunity to manage or manipulate the level or trend of reported earnings

Earnings Sustainability – 8 categories of financial disclosures used to judge 1.Discontinued Operations 2.Extraordinary Gains and Losses 3.Changes in Accounting Principles 4.Impairment on Long-Lived Assets –question: where shown?

Earnings Sustainability Factors (con’t) 5.Restructuring Charges 6.Changes in Estimates 7.Gains and Losses from Peripheral Operations 8.Management Discussion and Analysis

Earnings Sustainability Comprehensive Income “Income” shown in Stockholders’ Equity As compared with “Income” shown on the Income Statement How do Intangible Assets impact Earnings?

Earnings Management Choices, judgments, and estimates Distinction between management within bounds of GAAP and fraud is often thin Why manage? –Earnings smoothing –Compensation incentives –Job security incentives Can’t “manage” forever Capital markets penalize “extreme” managers

3 Basic Ways to Manage 1.Selection of accounting principles 2.Application of accounting principles 3.Timing of asset acquisitions and dispositions Violations observed often involve revenue recognition and shifting of expenditures.