ACCT7106 Financial Statement Analysis

Class 4 Accounting Analysis 2

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Overview

Six steps in accounting analysis

Undo earnings management
Identify red flags
Estimate distorted numbers
Make accounting adjustments
Readings:
Business Analysis and Valuation: Chapter 3 and 4
International Financial Statement Analysis: Section 2 and
4 in Chapter 16, and Section 6 in Chapter 8
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A. Earnings Management

Earnings Management occurs “when managers use judgment in

financial reporting and in structuring transactions to alter
financial reports to either mislead some stakeholders about the
underlying economic performance of the company or to
influence contractual outcomes that depend on reported
accounting numbers.”

Schipper (1998)

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A. Detecting Accounting Manipulations

Cash flow management

Accruals management
But managers can use reporting discretions to signal private
information
Increase in inventory
Manipulation to decrease COGS and increase earnings
Signal of expected high sales in the future
Decrease in allowance
Manipulation to increase earnings
Signal of improved economic prospects or quality of receivables
A. Detecting Accounting Manipulations

It is important to
Analyze managers’ incentives
What if earnings is lower/higher?
Earnings targets
Contractual obligations
Understand the firm’s business and industry practice
Do other firms report similar changes?
Does the firm change its corporate strategy?
B. Steps in Accounting Quality Analysis

1. Identify key accounting policies

Example: depreciation policies for airlines
Example: revenue recognition

2. Assess accounting flexibility

Example: expected default on bank loans

3. Evaluate accounting strategy

Compare with industry practise
Analyse managers’ incentives
Examine changes in accounting policies
Assess accounting policies and estimates
Investigate unusual transactions
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B. Steps in Accounting Quality Analysis

4. Evaluate disclosure quality

Sufficient and clear information

5. Identify potential red flags

Accruals and cash flows
Financing activities
Financial market pressure
A list of red flags in Section 4 of Chapter 16

6. Undo accounting distortions

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B. Red Flags
C. Analysts’ Adjustments

Adjustment to ensure consistency

Example: FIFO and LIFO inventory
Example: Depreciation policies
Adjustment for distortion
Involve subjective estimates
use peer firms or historical performance as a benchmark
Require more information
Reverse journal entries
Consider tax effect
C1. Adjustment for Consistency

Example: Adjustment for depreciation expenses

Assume: straight line method, PPE cost = $100, useful life = 10
years, residual value = 0. then annual depreciation expense = $10
3 years later, accumulated depreciation = 30, net PPE = 70
Accumulated depreciation divided by annual depreciation
expense indicates the average age of the asset.
Net PPE divided by annual depreciation cost indicates how many
more years’ useful life is left.
C1. Adjustment for Consistency

Estimate the average remaining useful life of PPE

If an analyst believe both companies’ PPE should have 10
years’ remaining useful life, what adjustments does the
analyst need to make?
C1. Adjustment for Consistency

Assuming 0% tax rate

Depreciation expense + 25 (IS)
Accumulative Depreciation + 25
• Net PPE - 25 (BS)
Net Income - 25 (IS)
Retained earnings - 25 (BS)
C2. Adjustments for Assets Distortion

Overstated assets
Delayed write-down of current assets
Delayed write-down of long-term assets
Underestimated provisions
Accelerated recognition of revenues
Understated depreciation/amortization
C2. Adjustments for Assets Distortion

Understated Assets
To deflate reported earnings
Save for the future
Take a “big bath”
Overstated write-down of assets
Overestimated provisions
Overstated depreciation
Off-balance sheet lease
C2. Adjustments for Assets Distortion

Correction for assets overstatement

Decrease assets
Decrease net income
Consider tax effect
C2. Adjustments for Assets Distortion

To write down $1.4 billion goodwill (assuming 50% tax rate)

Decrease Goodwill 1.4 billion (BS)

Increase write-down expenses 1.4 billion (I)
Decrease tax expense 0.7 billion (I)
Decrease deferred tax liabilities 0.7 billion (BS)
Decrease net income 0.7 billion (I)
Decrease retained earnings 0.7 billion (BS)
C2. Adjustments for Assets Distortion

To capitalize research expenses of $6 billion

Assume: 3-year straight-line depreciation, 0.5 year for current

year, zero tax rate
Decrease research expenses 6 billion (I)
Increase intangible assets 6 billion (BS)
Increase amortization expenses 1 billion (I)
Increase accumulated amort. 1 billion (BS)
Increase net income 5 billion (I)
Increase retained earnings 5 billion (BS)
C3. Adjustments for Liabilities Distortion

Understated liabilities
To increase earnings
To reduce liabilities in the book
Understated unearned revenue
Off-balance sheet discounted receivables
Off-balance sheet lease
Operating lease
Capital lease
C3. Adjustments for Liabilities Distortion

Operating leases
Decrease assets and liabilities
Decrease depreciation and interest expenses
Increase operating expense
Firms may choose to use operating lease to under-report liabilities.
Lease payments are real cash outflow, just like interest payments.
Converting operating lease into capital lease helps correctly assess
financial risk.
C2. Adjustments for Liabilities Distortion

Step 1: Estimate the fair value of leased assets

Step 2: Increase assets and liabilities
Step 3: Estimate depreciation and interest expenses
Step 4: Adjust income statements and balance sheet
C3. Adjustments for Liabilities Distortion
C3. Adjustments for Liabilities Distortion

Assume equal payment after 2013 for next three years

Use cost of debt as the discount rate to find present value of lease
payments
C3. Adjustments for Liabilities Distortion
C3. Adjustments for Liabilities Distortion

Decrease operating/rent expense by removing lease payments

Increase interest expense
Present value of lease payment x cost of debt
Increase depreciation expense
Choose a depreciation method
If using straight-line method, make assumptions on useful life and
residual value
C3. Adjustments for Liabilities Distortion
Summary

Understand managers’ incentives to manage earnings

Understand possible methods of earnings management
Analyze accounting quality in six steps
Adjust for accounting distortions