Overview of Accounting Analysis Accounting Analysis The purpose

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