Overview of Accounting Analysis

1. Overview of Accounting Analysis

2. 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

3. 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

4. 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

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

6. 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

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