Chapter 3
Overview of Accounting Analysis
1
Preliminary Topics
• Institutional Framework of Financial Reporting includes:
(1) Income Statement, (2) Balance Sheet and (3) Cash
Flow Statement. Balance Sheet analysis: Building
Blocks of assets, liability, debt & equity. Equity=Assetsliability. Book value vs. market value of share.
• Corporate financial report is prepared on accrual basis
rather than cash basis. Accrual implies economic
activities rather than true payment and receipts.
• A Responsibility Delegated to the Management.
Management holds the advantage of making the
assumption and financial report depends on that
assumption. This some times makes the reporting less
practical. Accounting analysis is then more valuable.
2
Accounting views
• Assets: Resources owned by the firm that are :
– likely to produce future economic benefits
– Measurable with a reasonable degree of certainty
• Liabilities are economic obligations of a firm arising from
benefits received in the past that are:
– Required to be met with reasonable degree of
certainty
– At reasonably well-defined time in the future
• Equity is the difference between a firm’s net assets and
its liabilities.
3
Accounting views (Contd..)
• Revenues are economic resources earned during a time period. It
would be recognized when:
– The firm has provided all, or substantially all, the goods and
services to be delivered to the customer
– The customer has paid cash or is expected to pay cash with
reasonable degree of certainty
• Expenses are economic resources used up in a time period. It is
governed by matching and conservative principles. These are:
– Costs directly associated with revenues recognized above
– Costs associated with benefits consumed
– Resources whose future benefits are uncertain
• Profit is the difference between revenue and costs
4
Factors Influencing Accounting Quality
•
1.
2.
3.
There are 3 sources of accounting noise:
Accounting Rules – Management discretion of accounting rule
introduces noise. The more accounting restricts management
discretion, the more accounting data loses information content.
Accounting standards may not match nature of the firm’s transactions.
(example: R&D expenses are recorded when incurred, the outcome or
future value of research is ignored.)
Forecast Errors – the dilemma of “reasonable certainty” in forecasting
future consequences of current transactions. (Example: credit sales
create accounts receivables and management makes an estimate of
the proportion of receivables that will not be collected. This is
extremely subjective)
Managers’ Accounting Choices – incentives to exercise discretion
for influencing behaviors of various stakeholders. Motivations are debt
covenant (TIE, liquidity ratio), management compensation (bonus
compensation & job security for excess profit), corporate control (like
hostile takeover), tax consideration (hidden profit), regulatory
consideration (SEC), capital market consideration (stockholders’
perception), trade union consideration, competitive considerations
(hiding a segmented disclosure), etc.
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Window Dressing
Last
year
Current assets
Current
Window dressing
year
Before Payoff After Payoff
$300
$600
$200
$150
Current liabilities
100
400
100
50
Working Capital
$200
$200
$100
$100
3:1
1.5:1
2:1
3:1
Current Ratio
Toward the close of a period, management will occasionally
press collection of receivables, reduce inventory levels, sell out
marketable securities, and delay normal purchases. Proceeds
from these activities are then used to pay off current liabilities.
The effects shows a better liquidity, called window dressing.
6
Steps in Accounting Analysis
1.
2.
Identify Key Accounting Policies: Identify the key success and
risk factors and see what accounting policies are used to reflect
that. (Example: valuation of residuals in case of leasing firms,
interest rate and credit risk management of banks, inventory
management for retail industry, R&D for manufacturing firms, etc.)
Assess Accounting Flexibility: Identify the management
flexibility to report its key success and risk factors. Example of
less flexibility: Marketing and brand building is key to success of
consumer goods but the strength can not be reported. Similarly,
R&D activity is important for a biotechnology firm but accounting
does not give them the discretion to report to the nature of activity.
Example of high flexibility: In most cases firms hold the freedom
regarding choice of depreciation method (straight-line or
accelerated), inventory accounting (FIFO or weighted average),
credit risk management for banks. Similarly, software developers
have the flexibility to decide at what points in their development
cycle the outlays can be capitalized.
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Steps in Accounting Analysis (Contd.)
3.
Evaluate Accounting Strategy:
i. Compare the accounting policies of the firm to the norms in the
industry.
ii. Evaluate the incentive of violation like bond covenants,
accounting-based bonus target, the share of management in
stock, role and state of trade union bargaining.
iii. Evaluate and rationalize recent change in accounting policies.
iv. Use the past as the guide to assess the dependability of
reporting.
8
Steps in Accounting Analysis (Contd.)
4. Evaluate Quality of Disclosure
i.
Reflection of the firm’s strategy and its economic consequences
in accounting disclosures. Some firms use annual report to
clearly layout the firm’s industry conditions, its competitive
position, and management's plan in future.
ii.
Footnotes for changes from industry or from past (particularly
regarding revenue and expense recognition)
iii.
Disclosures of current performances like changes in sales price,
quantity, cost of production etc.
iv.
Disclosure of key success factors like firm investing in product
quality or customer services may report change in defect rates or
customer satisfaction.
v.
For multiple business, disclosure of each segments on a
consistent basis
vi.
Disclosure of reasons of poor performances. Relating that with
the strategy of the firm
vii. Firm’s investor relation program (publication of fact books etc.)
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Steps in Accounting Analysis (Contd.)
5.
i.
ii.
Identify the points of questionable accounting quality
Unexplained changes when performances are poor
Unexplained transaction that boost profit like sale of assets or debt
for equity swap
iii.
Unusual increase in accounts receivable relative to sales
iv.
Unusual increase in inventories relative to sales
v.
An increasing gap between a firm’s reported income and its cash
flow from operations
vi.
An increasing gap between a firm’s reported income and its tax
income. Example, warranty expenses are recorded on accrual basis
for financial reporting and cash basis for tax reporting.
vii. Unexpected assets write-offs
6. Undo Accounting Distortions. Key areas are:
i.
Accrual accounting
ii.
Cash flow analysis (like capitalization of certain costs that should
have been revenue)
iii.
Evaluation of footnotes in case of changes
iv.
Evaluation of bad debts
v.
Difference between tax reporting and accounting reporting of profit
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Accounting Analysis Pitfalls
• 1. Conservative accounting may not be always
good as it may fail to capture the unique nature
of the business.
• 2. Unusual accounting is not always
questionable, it may be necessary with regard to
the nature of the business.
• 3. Changes in accounting policies and accruals
may be necessary as well.
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Effects of different depreciation methods
Assuming an investment Tk.500,000 and life of 10 years
Year
Annual depreciation
Book Value (end of period)
Accumulated depreciation
Straight line
Straight line
Straight line
Reducing
balance
method (20%)
Reducing
balance
method
Reducing balance
method
½
25,000
50,000
475,000
450,000
25,000
50,000
1
50,000
90,000
425,000
360,000
75,000
140,000
2
50,000
72,000
375,000
288,000
125,000
212,000
3
50,000
57,600
325,000
230,400
175,000
269,600
4
50,000
46,080
275,000
184,300
225,000
315,680
5
50,000
36,865
225,000
147,455
275,000
352,545
6
50,000
29,490
175,000
117,965
325,000
382,035
7
50,000
23,595
125,000
94,370
375,000
405,630
8
50,000
18,875
75,000
74,495
425,000
424,505
9
50,000
15,100
25,000
60,395
475,000
439,605
10
25,000
12,080
0
48,315
500,000
451,645
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Effects of inventory valuation choice
•
•
•
•
•
•
•
•
•
•
Determine net income under LIFO, FIFO, and average cost, and
calculate the current ratio, debt-to-equity ratio, inventory
turnover, gross margin ratio, and net margin ratio under each of
these inventory costing methods.
Assumptions:
Sales price per unit $25
1,000 units sold
Beginning inventory=100 units @$10 each=$1,000
Ending inventory=800 units
Operating expenses=$5,000
Tax Rate=0%
Assets excluding inventories=$75,000
Current assets excluding inventories=$50,000
Current liabilities=$25,000
Long term liabilities=$10,000
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Procurement of inventory
Purchases
March
Cost per unit
(Note: Increasing prices)
300
$11
$3,300
June
600
$12
$7,200
October
300
$14
$4,200
December
500
$15
$7,500
Total
Units
1,700
Value
$22,200
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Solution
FIFO
LIFO
Average Cost
$25,000
$25,000
$25,000
1,000
1,000
1,000
Add purchases
22,200
22,200
22,200
Less ending inventory*
11,700
9,100
10,312
COGS
11,500
14,100
12,888
Gross Profit
13,500
10,900
12,112
Operating expenses
5,000
5,000
5,000
Taxable/Net income
$8,500
$5,900
$7,112
Sales 1,000 @ $25
COGS
Beginning inventory
(800 units ending inventory=100 beginning+1,700 purchased-1,000 closing)
FIFO Inventory = (500 @ $15) + (300 @ $14)=$11,700
LIFO Inventory = (100 @ $10) + (300 @ $11) + (400 @ $ 12)=$9,100
Average cost inventory =
 $1,000  $22,200 

 * 800  $10,312
1700  100
Value of goods available for sale

(Units in ending inventory
15 )
Numberof units available for sale
Solution (Continued)
FIFO
LIFO
Average
Cost
(Current Assets excluding inventories + Ending
inventories) /Current liabilities=
($50,000+$11,700)/$25,000=2.47
2.36
2.41
Debt-to-equity ratio
Long term Debt/(Total assets excluding
inventory +ending inventory -current liabilities long term liabilities) =$10,000/($40,000 +ending
inventory)=$10,00/$51,700=
19.3%
20.4%
19.9%
Inventory turnover
COGS/((Beginning inventory+ Ending inventory)/2)
2.79
2.28
Current Ratio
=$11,500/(($1,000+$11,700)/2)=1.81
Gross margin as
percentage of sales
Gross profit/sales=$13,500/$25,000= 54% 43.6%
48.5%
Net profit as a
percentage of sales
Net Income/sales=$8,500/$25,000=34% 23.6%
28.5%
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Lessons from the problem
In the problem, prices are rising and inventory levels have not decreased.
Therefore, under these conditions following are true:
1.
2.
3.
4.
5.
6.
7.
8.
9.
LIFO results in the highest cost of goods sold, FIFO the lowest cost of
good sold.
FIFO results in the highest inventory values and working capital, LIFO
results in the lowest inventory values and working capital.
LIFO results in highest inventory turnover, FIFO the lowest.
Both gross and net profit margin is higher under FIFO.
Retained earnings will be higher for FIFO then LIFO, keeping dividend
payment constant (net income effect).
LIFO, if used for tax purposes, would results in the lowest tax paid.
Current ratio is higher under FIFO.
Debt to equity ratio is higher under LIFO (retained earning effect)
Average cost values always lie between FIFO and LIFO values.
Note: If prices are declining, then all the above will be opposite.
17
Final Note: Inventory valued at lower of cost
or market
• Regardless of the inventory method used, any significant
decrease in inventory value below cost should be
recorded immediately. Therefore, inventory would be
valued at market. Market is defined as the current
replacement cost through production or purchase. When
LIFO accounting is used, the LIFO reserve is reported.
This is the difference between LIFO inventory value and
FIFO inventory value.
• Also Note BAS allows FIFO and weighted average
method only for inventory valuation.
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