Basic in Accounting

From Financial Statement
to Business Analysis
Step 1: Business strategy analysis
Step 2: Accounting analysis
Step 3: Financial analysis
Step 4: Prospective analysis
1
Financial & Accounting Analysis
Accounting Analysis Financial Analysis
Financial
Statement
Unbiased Accounting
Recasting Financial Statement:

firms could adopt different classifications
2
Accrual Accounting
Fundamental features of corporate financial reports
Recording of economic transactions
On the basis of expected cash receipt and payments
Not necessarily actual
3
Income statement
Revenues Expenses
economic resources economic resources
earned during used up in

a time period
realization matching and conservatism

principle principle
Profit = revenues - expenses

4
Balance sheet
Assets Liabilities
economic resources owned by a firm economic obbligations arising from

past benefit
future economic benefit met with reasonable certainty
measurable with reasonable certainty time reasonably well defined
Equity = assets - liabilities

5
Delegation of reporting to management
Corporate managers
accounting discretion
intimate knowledge of management manipulation
firm’s businesses of accounting numbers
Benefits Costs
preserved reduced
Accounting rules and auditing

6
Accounting analysis
Identify key accounting Assess Evaluate

policies accounting flexibility accounting strategy
(1) (2) (3)
Six steps to evaluate

a firm’s accounting
quality
Evaluate the quality Identify potential red Undo accounting

of disclosure flags distortions
(4) (5) (6)
7
Accounting analysis
Identify key accounting Business

policies strategy analysis
(1)
How well the success factors and risks are being managed by the firm
•Bank: interest and credit risk management

•Retail: inventory management
•Pharmaceuticals: research and development
•…
Accounting Business
measures events
8
Accounting analysis
Assess
accounting flexibility
(2)
•Expense or capitalize costs

•Estimate expected defaults on loans
•Estimate long-terms projects
•Depreciation policy (straight.line or accelerated methods)
•Inventory accounting policy (LIFO, FIFO, or average cost)
•…
More flexibility
Trade Off
Less flexibility
9
Accounting analysis
Evaluate
accounting strategy
(3)
•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? (tax policy)
•What is the impact of the changes in policies? (warranty expenses)
•Does the firm structure any significant business transactions so that it can
achieve certain accounting objectives? (leasing firms)
•…
10
Accounting analysis
•Does the company provide adequate disclosure to assess the firm’s business strategy
and its economic consequences? (industry condition, competitive position, plans for
the future)
•Does the firm adequately explain its current performance? (financial notes)
•Does the firm provide adequate additional disclosure to help outsiders understand
how key success factors are being managed? (decrasing in profit)
•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 program?
•…
Evaluate the quality

of disclosure
(4)
11
Accounting analysis
Certain items must be examined more closely

•Unexplained changes in accounting, especially when performance is poor
•Unexplained transaction that boost profits
•Unusual increases in trade receivables in relation to sales increases
•Unusual increases in inventories in relation to sales increases
•An increasing gap between a firm’s reported profit and its cash flow from operations
•An increasing gap between a firm’s reported profit anche its tax profit
•Unexpected large asset write-offs
•Large year-end adjustments
•Qualified audit opinions or changes in independent auditors that are not well justified
•Poor internal governance mechanisms
•…
Identify potential red

flags
(5)
12
Accounting analysis
•Restate numbers to reduce the distortion to the extent possible

•Impossibility to perfectly undo the distortion using outside information alone
•Use the cash flow statement and the notes to the financial statements
•Use the tax notes
•…
Undo accounting
distortions
(6)
13
Accounting analysis pitfalls
Potential pitfalls and common misconceptions
Conservative accounting Not all unusual

is not the same as accounting
“good” accounting is questionable
14
Accounting analysis
The Airline Industry

Most airlines have frequent flyer programs that promise customers free flights
once they have accumulated 25,000 miles of travel with the same airline.
How should these programs be reflected in the airlines’financial statements?
15
Accounting analysis
Promises that require future expenditure Liabilities
ticket sales in the past economic obbligation arising from

past benefit
for example: 1.2 milion free trips met with reasonable certainty
within 3 to 5 years after the revenue

time reasonably well defined
ticket sales are made
Balance sheet
16
Accounting analysis
Expenses
Free-trip tickets in the future cost associated
with benefit that are comsumed in

increase in revenue ticket sales
this time period
 Administrative cost matching concept

 Costs related to the flight
 Opportunity cost
Income statement
17
Implement accounting analysis
Process
Analyst
Accounting
Undo distortions
Analysis
Balance Sheet
Adjustments to the
financial statement
Income Statement
(revenue/expenses)
18
RECASTING FINANCIAL
STATEMENT
DIFFERENCES
Nomenclature Classifications Formats
New Template Time-series & cross

sectional comparison
19
Different format
IFRS: format for operating

expenses
By nature By function
Cause Purpose
- Cost of materials
- Cost of sold
- Cost of personnel
Recast using -SG&A (selling,
Financial Notes General &
- Cost of non current
Administrative)
assets
20

Basic in Accounting

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Basic in Accounting

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From Financial Statement

Step 1: Business strategy analysis

Step 2: Accounting analysis

Step 3: Financial analysis

Step 4: Prospective analysis

Accounting Analysis Financial Analysis

Recasting Financial Statement:

Fundamental features of corporate financial reports

Recording of economic transactions

On the basis of expected cash receipt and payments

Not necessarily actual

economic resources economic resources

earned during used up in

realization matching and conservatism

Profit = revenues - expenses

economic resources owned by a firm economic obbligations arising from

future economic benefit met with reasonable certainty

measurable with reasonable certainty time reasonably well defined

Equity = assets - liabilities

Accounting rules and auditing

Identify key accounting Assess Evaluate

Six steps to evaluate

Evaluate the quality Identify potential red Undo accounting

Identify key accounting Business

•Bank: interest and credit risk management

•Expense or capitalize costs

Evaluate the quality

Certain items must be examined more closely

Identify potential red

•Restate numbers to reduce the distortion to the extent possible

Potential pitfalls and common misconceptions

Conservative accounting Not all unusual

The Airline Industry

Promises that require future expenditure Liabilities

ticket sales in the past economic obbligation arising from

within 3 to 5 years after the revenue

Free-trip tickets in the future cost associated

with benefit that are comsumed in

 Administrative cost matching concept

Nomenclature Classifications Formats

New Template Time-series & cross

IFRS: format for operating

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