Steps in Accounting Analysis Module 3 (Class 4)

Module 3
Steps of Accounting Analysis

Steps in Performing Accounting Analysis
Step 1: Identify Principal Accounting Policies
• One of the major goal of financial statement analysis is to evaluate how well the key
success factors and risks such as firm's industry characteristics and its own competitive
strategy are being managed by the firm.
• Such as a significant success factor in the leasing business is to make accurate forecasts
of residual values of the leased equipment at the end of the lease terms.
• The analyst has to identify the

accounting measures the firm uses to capture these business constructs
the policies that determine how the measures are implemented
the important estimates embedded in these policies.
Step 2: Access Accounting Flexibility
• Firms do not have equal flexibility in choosing their accounting policies and estimates.
• Some firm’s accounting choice is severely constrained by accounting standards and

conventions. Such as R&D outlay for biotechnology firms, marketing and brand
building outlay of consumer goods firms, managing credit risk for banks etc.
• Regardless of the degree of accounting flexibility a firm’s managers have in measuring

their key success factors and risks, they have come flexibility with respect to other
accounting policies. Such as depreciation policies, inventory accounting policies etc.
• All these policy choices can have a significant impact on the reported performance of
a firm. Hence, analyst should focus on that how firms are managing its reported
numbers using these opportunities.
Step 3: Evaluate Accounting Strategy
Analyst has to evaluate that how managers are utilizing the accounting flexibility if they
have that facility. Following questions one should ask in examining how managers
exercise their accounting flexibility:
• How do the firm’s accounting policies compare to the norms in the industry?
• Do managers face strong incentives to use accounting discretion to manage earnings?
• Has the firm changed any of its policies or estimates?
• Have the company's policies and estimates been realistic in the past?
• Does the firm structure any significant business transactions so that it can achieve
certain accounting objectives?
Step 4: Evaluate the Quality of Disclosure
Disclosure quality is an important dimension of a firm’s accounting quality. Hence

accounting rules require a certain amount of minimum disclosure in which managers have
considerable choice. An analyst could ask the following questions, in assessing a firm’s
disclosure quality:
• Does the company provide adequate disclosures to assess the firm’s business strategy and
its economic consequences?
• Do the footnotes adequately explain the key accounting policies and assumptions and
their logic?
• Does the firm adequately explain its current performance? (Management Discussion and
Analysis (MD&A) section of the annual report helps the analyst to understand the reasons
behind a firm’s performance changes.)
• If accounting rules and conventions restrict the firm from measuring its key success
factors appropriately, does the firm provide adequate additional disclosure to help
outsiders understand how these factors are being managed?
• If a firm is in multiple business segments, what is the quality of segment disclosure?
• How forthcoming is the management with respect to bad news?
• How good is the firm’s investor relations program?
Step 5: Identify Potential Red Flags
A common approach to accounting quality analysis is to look for “red flags” pointing to
questionable accounting. Some of the red flags are as follows:
• Unexplained changes in accounting, especially when performance is poor
• Unexplained transactions that boost profits
• Unusual increase in accounts receivable in relation to sales increases
• Unusual increase in inventories in relation to sales increase.
• An increasing gap between a firm’s reported income and its cash flow from operating
activities.
• An increasing gap between a firm’s reported income and its tax income.
• A tendency to use financing mechanism such as research and development
partnerships, special-purpose entities and the sale of receivables with recourse.
• Unexpected large asset write-offs
• Large fourth-quarter adjustments
• Qualified audit opinions or changes in independent auditors that are not well justifies.
• Related party transactions or transactions between related entities.
• Unexplained increase in contingencies and off-balance sheet transactions.
Step 6: Undo Accounting Distortions
• If the accounting analysis suggests that the firm’s reported numbers are misleading,
analysts should attempt to restate the reported numbers to reduce the distortion to
the extent possible.
• A firm’s cash flow statement provides a reconciliation of its performance based on

accrual accounting and cash accounting.
• Financial statement footnotes also provide information that is potentially useful in

restating reported accounting numbers.
Accounting Analysis Pitfalls
There are several potential pitfalls and common misconceptions in accounting analysis
that an analyst should avoid. Such as
1. Conservative Accounting is not “Good” Accounting

Financial Statement users want to evaluate how well a firm’s accounting
captures business performance in an unbiased manner and conservative accounting can
be just as misleading as aggressive accounting in this respect.
2. Not all Unusual Accounting is Questionable
Unusual accounting choices might take a firm’s performance difficult to compare

with other firm’s performance, such an accounting choice might be justified if the
company’s business is unusual.
Value of Accounting Data and Accounting Analysis
• Analysts who are able to identify firms with misleading accounting are able to create
value for investors.
• The findings also indicate that the stock market ultimately sees through earnings
management.
• In most cases, earnings management is eventually uncovered and the stock price
responds negatively to evidence that firms have inflated price earnings through
misleading accounting.

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Module 3

Steps of Accounting Analysis

Step 1: Identify Principal Accounting Policies

• The analyst has to identify the

Step 2: Access Accounting Flexibility

• Some firm’s accounting choice is severely constrained by accounting standards and

• Regardless of the degree of accounting flexibility a firm’s managers have in measuring

Step 3: Evaluate Accounting Strategy

Disclosure quality is an important dimension of a firm’s accounting quality. Hence

Step 6: Undo Accounting Distortions

• A firm’s cash flow statement provides a reconciliation of its performance based on

• Financial statement footnotes also provide information that is potentially useful in

1. Conservative Accounting is not “Good” Accounting

2. Not all Unusual Accounting is Questionable

Unusual accounting choices might take a firm’s performance difficult to compare

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