The importance of accounting analysis was emphasized in the Chapter 3. The authors stated that disclosures of the financial statements are made on the basement of accounting analysis. Also, they noted that understanding of accounting information collected helps use the financial information more effectively.
Chapter 3 of the book highlights three important concepts namely: factors influencing the quality of financial reports based on accounting analysis, the drivers of accounting choices, and incentives of the managers that should be considered when making the financial reports. According to Sarbanes-Oxley Act, CEO, CFO, Board of Directors and Controller can be responsible for accounting choices.
The concept of accrual accounting was explained in details. Accrual accounting is used more often than cash accounting. With regard to accrual accounting, the following elements of financial statements were outlined by GAAP: revenues, expenses, assets, liabilities, and equity.
Managers are responsible for financial reporting and applying the principles of accounting analysis in practice. Incentives distort accounting information. Violations in accounting information presented by unethical accountants leads to contract violation and damaged reputation of an accountant. Sarbanes-Oxley Act (SOX) helps mitigate the effects of distorted accounting information.
The following principles of GAAP help deliver relevant, reliable, and up-to-date accounting information: reliance on the FASB, consistency in reporting, uniform accounting standards, and harmonization of accounting standards internationally. The Securities and Exchange Commission relied on the Financial Accounting Standards Board when it was setting GAAP accounting standards. Accounting standards are set by SEC, FASB, and IASB. SEC is a legal authority, FASB is a delegated authority in US, and IASB enacts accounting law in several countries. Consistency of accounting information with the GAAP standards is becoming more popular. Unification of accounting standards minimizes the probability of manipulation by the information disclosed in the financial statements.
The majority of manipulations of the financial statements are connected with core expense and sales manipulation. The manipulations can be revealed by computing diagnostic ratios. Sales manipulations can be revealed by the differences in net sales and cash generated from sales, net accounts receivable, unearned revenues, warranty liabilities, or inventory. Expense manipulations can be diagnosed by computing asset turnover ratio, CFFO/OI, CFFO/NOA, total accruals to change in sales, pension expense to SG&A, other employment expenses to SG&A. Diagnostic ratios are computed either in raw form or in change form (usually, for 5 years). Raw form of diagnostic ratios measures trends and levels. Change ratios measure percentage of change in comparison to a similar company.
Revenue diagnostics are red flags for increases in items that cannot be explained. Unexplained increses may be a signal of overstatements. Unexplained decreases may signal so-called big bath. The diagnostic ratios must evaluate the sign of the ratio, but not its magnitude. Increased sales generate increased cash. Sales cannot increase if cash collection decrease.
External auditing of financial statements is required is a company is publicly traded. External auditing is conducted according to GAAS standards. According to SOX requirements, external auditors must report to the audit committee or to be overseen by this committee. The purpose and limitations of audit were explained. The main purposes of audit are ensure compliance with GAAP, assessment of internal control system, improvement of quality and credibility of data from finacial statements. However, audit does not serve to detect fraud and is not protected against unintentional negligence. Besides, audit is subject to conflict of interest between audit client and management services.
Accounting quality can be measured by qualitative and quantitative measures. Qualitative issues relate the assessment of business strategy and economic factors; sufficient disclosure in footnotes of the financial statements including accounting policies, deviations from accounting norms, relevant assumptions, and voluntary disclosure; disclosure of accounting restrictions; segment reporting quality; combination and timeliness of news.
There are three factors influencing accounting quality outlined: the necessity of discretion in application of accounting standards, accounting rules used for collecting and analysis of accounting information, forecast errors, and the accounting choices of the accounting managers. Incompliance of accounting standards and the transactions typical for the firms may cause distortion in the financial statements. The managerial estimation can be subjective thus leading to the errors in the forecasts reflected in the financial reports. Managers can use a number of incentives to choose the type of biased disclosure. Quality accounting allows users of financial information to assess the performance of the company without bias and forecast the performance in future with maximum accuracy possible. Quality accounting reduces the probability of the standard deviation of assessments. This deviation is also called noise. The quality of disclosure can be evaluated using quantitative and qualitative measures. Quantitative measures include the analysis of the ratios related revenue and expenses. Qualitative measures depend on the level of disclosure related the items relevant for valuation such as information breakdown, segment analysis, and assumptions about discount and growth rates. These incentives may include tax considerations, compensation contracts, competitive and regulatory considerations, contests for corporate control, debt covenants, considerations related capital markets and stakeholders.
Also, there are other quality indicators, such as GAAP quality standards, audit quality standards that include conflict of interests and audit failure, the choice of GAAP standards (conservative or aggressive), timing of transactions related revenue and expenses, massive shipments, and discretionary expenditures. Disaggregation quality depends on possibility of distinguishing between financial and operating items. It also depends on distinguishing between the items of operating profitability and unusual items.
Possible discretion in disclosing can be provided based on estimation of adequacy of disclosures and footnotes in the financial statements. Other issues to consider include estimation of consistency between MD&A and the current performance of the company analyzed, GAAP restrictions of key measures, and adequacy of the parts of disclosure. The potential red flags can be identified by tracking the transactions boosting profits that are difficult to explain, disproportional increase in inventory and sales, the gap between taxable or net income and cash flow or using SPE, selling receivables, transactions between special purpose entities, and R&D partnerships to finance operations. In case if the following issues were identified, gathering more information is needed: large write-offs of assets, large adjustments in the last quarter of the financial year, changes in auditor's reports or qualified audit options, and related-party transactions. Red flags can be identified with the help of qualitative and quantitative analyses. Also, an accounting manager should identify whether distortive items relate to other measures of financial statements. Besides, certain percentage of items should be established. Red flags are identified if accounts exceed this measure.
The potential accounting analysis pitfalls include changes in accounting practices and unusual accounting practices that are not misleading. For example, conservative accounting can be misleading (accounting related intangible assets and historical cost method). Also, accounting practices are not questionable even if they are unusual. Thus, earnings management may seem unusual. Inadequate accounting rules as well as inaccurate estimates may cause the problem of noise or accounting bias.
In conclusion, accounting analysis plays an important role in analysis of financial reports. Analysis of accounting data consists of six steps. Earnings management does not influence the reliability of accounting data.
Palepu, K. G. and Healy, P.M. (2013). Business analysis and valuation: using financial statements,
text and cases.5th ed. Boston: Cengage Learning.