Summary lectures Financial Statement Analysis
Week 1 – Introduction to FSA and accounting analysis (Book CH1-2-3-4)
Why financial statement analysis?
Adverse selection: before engaging in a transaction, corporate managers (insiders) know
more about the quality of their company and its future prospects than do outside
shareholders and expertise asymmetry: savers/investors lack financial skills
Moral hazard: after engaging in a transaction, corporate managers have incentives to use
invested resources for their own benefit instead of for the benefit of shareholders
‘Lemons’ problem: because of these information and incentive problems, investors are not
able to distinguish between good and bad investments
Financial intermediaries: venture capital firms, banks, collective investment funds, pension
funds, and insurance companies that focus on aggregating funds from individual investors
and analysing different investment alternatives to make investment decisions
Information intermediaries: auditors, financial analysts, credit rating agencies, and the
financial press focus on providing information to investors on the quality of investment
opportunities
The accounting system
Feature 1: accrual accounting
Feature 2: accounting conventions and standards
Feature 3: managers’ reporting strategy
Feature 4: auditing, legal liability, and enforcement
Four steps of Financial Statement Analysis
- Business strategy analysis
- Accounting analysis
- Financial analysis
- Prospective analysis
Strategy analysis
● Accounting analysis: an analyst can examine whether a company’s accounting
policies and estimates are consistent with its stated strategy
● Financial analysis: an analyst can expect companies with a cost leadership strategy
to have relatively high margins and low asset turnover; or expect profitable R&D
companies to have high ROE due to the accounting treatment of R&D
● Prospective analysis: an analyst can assess the extent to which abnormal rates of
return are likely to persist
Why accounting analysis?
The purpose of accounting analysis is to evaluate the degree to which a firm’s financial
statements capture the underlying business reality.
- Ratio analysis: base our analyses on the most informative numbers
- Forecasting: how sustainable current revenues and earnings are
- Valuing: forecasts used in the valuation model to be sound and to capture business
reality
1
, Distortion can arise from:
1. Noise in accounting rules
2. Forecast errors
3. Managers’ accounting choices
Steps in accounting analysis
1. Identify key accounting policies
2. Assess accounting flexibility
3. Evaluate accounting strategy
4. Evaluate quality of disclosure
5. Identify potential ‘red flags’
6. Recast financial statements and undo accounting distortions
Asset are resources a company owns or controls as a result of past business transactions,
and which are expected to produce future economic benefits that can be measured with
reasonable degree of certainty.
Liabilities are economic obligations arising from benefits received in the past, and for which
the amount and timing is known with reasonable certainty.
The deferred tax liability represents the additional amount of tax the firm is expected to pay in
the future, in addition to the tax expense that will be reported in future financial statements
based on pretax book income.
Subscription accounting was more ‘conservative’ and led to much ‘smoother’ earnings
patterns.
Week 2 – Accounting and cash flow analysis (Book CH3-4-5)
1. Earnings management: managers’ choice of accounting policies or estimates in order
to achieve a specific reporting objective.
2. Conservative accounting: practice of understating net assets in situations of
uncertainty, e.g.:
- Inventory valuation; lower of cost or market value
- Treatment of R&D outlays as expense
The allowance for doubtful accounts and its income-statement counterpart bad debts
expense.
Conclusions and implications
- Consistent with concerns expressed by regulators, some firms use conservative
accounting to overstate current expenses and to understate earnings, in order to be
able to use income-increasing adjustments in the future
- On average, the allowance for doubtful accounts is overstated and, therefore, net
receivables are understated
- Overstated allowance gives managers more flexibility to increase reported earnings
when necessary by reducing bad debts expense
- Conservative accounting is not good accounting per se: stricter limits on the amount
by which firms are allowed to understate net assets may reduce the ability of firms to
manage earnings.
- Another account that firms may use to understate current period earnings and
overstate future period earnings: deferred revenue.
2
Week 1 – Introduction to FSA and accounting analysis (Book CH1-2-3-4)
Why financial statement analysis?
Adverse selection: before engaging in a transaction, corporate managers (insiders) know
more about the quality of their company and its future prospects than do outside
shareholders and expertise asymmetry: savers/investors lack financial skills
Moral hazard: after engaging in a transaction, corporate managers have incentives to use
invested resources for their own benefit instead of for the benefit of shareholders
‘Lemons’ problem: because of these information and incentive problems, investors are not
able to distinguish between good and bad investments
Financial intermediaries: venture capital firms, banks, collective investment funds, pension
funds, and insurance companies that focus on aggregating funds from individual investors
and analysing different investment alternatives to make investment decisions
Information intermediaries: auditors, financial analysts, credit rating agencies, and the
financial press focus on providing information to investors on the quality of investment
opportunities
The accounting system
Feature 1: accrual accounting
Feature 2: accounting conventions and standards
Feature 3: managers’ reporting strategy
Feature 4: auditing, legal liability, and enforcement
Four steps of Financial Statement Analysis
- Business strategy analysis
- Accounting analysis
- Financial analysis
- Prospective analysis
Strategy analysis
● Accounting analysis: an analyst can examine whether a company’s accounting
policies and estimates are consistent with its stated strategy
● Financial analysis: an analyst can expect companies with a cost leadership strategy
to have relatively high margins and low asset turnover; or expect profitable R&D
companies to have high ROE due to the accounting treatment of R&D
● Prospective analysis: an analyst can assess the extent to which abnormal rates of
return are likely to persist
Why accounting analysis?
The purpose of accounting analysis is to evaluate the degree to which a firm’s financial
statements capture the underlying business reality.
- Ratio analysis: base our analyses on the most informative numbers
- Forecasting: how sustainable current revenues and earnings are
- Valuing: forecasts used in the valuation model to be sound and to capture business
reality
1
, Distortion can arise from:
1. Noise in accounting rules
2. Forecast errors
3. Managers’ accounting choices
Steps in accounting analysis
1. Identify key accounting policies
2. Assess accounting flexibility
3. Evaluate accounting strategy
4. Evaluate quality of disclosure
5. Identify potential ‘red flags’
6. Recast financial statements and undo accounting distortions
Asset are resources a company owns or controls as a result of past business transactions,
and which are expected to produce future economic benefits that can be measured with
reasonable degree of certainty.
Liabilities are economic obligations arising from benefits received in the past, and for which
the amount and timing is known with reasonable certainty.
The deferred tax liability represents the additional amount of tax the firm is expected to pay in
the future, in addition to the tax expense that will be reported in future financial statements
based on pretax book income.
Subscription accounting was more ‘conservative’ and led to much ‘smoother’ earnings
patterns.
Week 2 – Accounting and cash flow analysis (Book CH3-4-5)
1. Earnings management: managers’ choice of accounting policies or estimates in order
to achieve a specific reporting objective.
2. Conservative accounting: practice of understating net assets in situations of
uncertainty, e.g.:
- Inventory valuation; lower of cost or market value
- Treatment of R&D outlays as expense
The allowance for doubtful accounts and its income-statement counterpart bad debts
expense.
Conclusions and implications
- Consistent with concerns expressed by regulators, some firms use conservative
accounting to overstate current expenses and to understate earnings, in order to be
able to use income-increasing adjustments in the future
- On average, the allowance for doubtful accounts is overstated and, therefore, net
receivables are understated
- Overstated allowance gives managers more flexibility to increase reported earnings
when necessary by reducing bad debts expense
- Conservative accounting is not good accounting per se: stricter limits on the amount
by which firms are allowed to understate net assets may reduce the ability of firms to
manage earnings.
- Another account that firms may use to understate current period earnings and
overstate future period earnings: deferred revenue.
2
