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Chapter 4: Implementing Accounting Analysis

Chapter 4: Implementing Accounting Analysis. Key Concepts in Chapter 4. Recasting financial statements into a template that uses standard terminology makes analysis more meaningful.

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Chapter 4: Implementing Accounting Analysis

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  1. Chapter 4: Implementing Accounting Analysis Chapter 4: Implementing Accounting Analysis Palepu & Healy

  2. Key Concepts in Chapter 4 • Recasting financial statements into a template that uses standard terminology makes analysis more meaningful. • Analyzing elements of the balance sheet for possible distortions allow the analyst to better understand the economic substance of a firm’s transactions and financial position. Chapter 4: Implementing Accounting Analysis Palepu & Healy

  3. Recasting Financial Statements • Balance sheets, income statements, and statements of cash flows may be recast with standardized line-item descriptions to increase their usefulness. • Firms can vary in the nomenclature and formats used to report financial results • Templates have been designed for each of the three major financial statements to standardize the format and nomenclature • Refer to Tables 4-1, 4-2, and 4-3 in the text. Chapter 4: Implementing Accounting Analysis Palepu & Healy

  4. Asset Distortions • Assets are defined as resources with probable future benefits. Distortions may generally arise from ambiguities about whether: • The firm owns/controls the economic resource • Future economic benefits can be measured with reasonable certainty • Fair values are higher or lower than book values Chapter 4: Implementing Accounting Analysis Palepu & Healy

  5. Asset Distortions: Ownership / Control • Some types of transactions make it difficult to assess the ownership of an asset. For example: • Aggressive revenue recognition is likely to affect related asset values • Management may differ in opinion with auditors or analysts over the valuation of assets • GAAP may not capture subtleties associated with ownership or control over certain assets Chapter 4: Implementing Accounting Analysis Palepu & Healy

  6. Asset Distortions: Economic Benefits and Fair Values • GAAP requires the immediate expensing of some resource outflows that may have future economic benefits. • Because considerable judgment is involved in determining whether the value of an asset is impaired, and the amount of the impairment, assets may be misstated. Chapter 4: Implementing Accounting Analysis Palepu & Healy

  7. Overstated Assets • Incentives to inflate reported earnings can result in overstated assets. Some of the most common forms include: • Delayed write-downs of current or long-term assets • Understatement of reserves • Accelerated recognition of revenues • Understated depreciation/amortization of long-term assets Chapter 4: Implementing Accounting Analysis Palepu & Healy

  8. Understated Assets • There may be incentives for earnings to be under-reported, resulting in understated assets. • Conservatism in GAAP may also result in understated assets. Chapter 4: Implementing Accounting Analysis Palepu & Healy

  9. Understated Assets: The Most Common Causes • Overstated write-downs of current or long-term assets • Overestimated reserves • Overstated depreciation / amortization • Leased assets off balance sheet • Discounted receivables off balance sheet • Key intangible assets not capitalized Chapter 4: Implementing Accounting Analysis Palepu & Healy

  10. Liability Distortions • Liabilities are economic obligations requiring future outflows of resources. • Distortions may generally arise from ambiguities about whether: • An obligation has been incurred • The proper measurement of an obligation Chapter 4: Implementing Accounting Analysis Palepu & Healy

  11. Understated Liabilities • Understated liabilities may arise from: • Incentives to overstate earnings or the strength of financial position • Difficulties in estimating the amount of future financial commitments Chapter 4: Implementing Accounting Analysis Palepu & Healy

  12. Understated Liabilities:Likely Conditions • Liabilities may be understated under some of the following conditions: • Aggressive revenue recognition • Off-balance-sheet loans related to receivables • Off-balance-sheet long-term liabilities • Pension and post-retirement obligation understatements Chapter 4: Implementing Accounting Analysis Palepu & Healy

  13. Equity Distortions • Equity is the residual claim on a firm’s assets held by stockholders. • Since Assets = Liabilities + Equity, distortions in assets and/or liabilities lead to distortions in equity. • The nature of hybrid securities needs to be considered to reduce any possible bias in the financial statements. Chapter 4: Implementing Accounting Analysis Palepu & Healy

  14. Concluding Comments • Recasting financial statements is an important step to facilitate comparability among financial statements analyzed. • Analysts should focus on evaluating and adjusting accounting measures that describe the firms’ key strategic value drivers. • It is important to keep in mind that many accounting adjustments will be estimates. Chapter 4: Implementing Accounting Analysis Palepu & Healy

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