Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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Financial Reporting
and Analysis

2
CHAPTER
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Statutory Financial Reports

Form 10-K (Annual Report)

10-Q (Quarterly Report)

20-F (Registration Statement/ Annual Report

[Foreign])

8-K (Current Report)

14-A (Proxy Statement/Prospectus)

Other SEC Filings

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GAAP
Types of Accounting rules and guidelines

o Statements of Financial Accounting Standards

o APB Opinions.
o Accounting Research Bulletins (ARB).
o AICPA pronouncements. The AICPA issues guidelines
for certain topics yet to be addressed by the FASB in its
Statements of Position (SOP) or for those involving
industry-specific matters in its Industry Audit and
Accounting Guidelines.
o EITF Bulletins. EITF Bulletins are issued by the FASBs
Emerging Issues Task Force.
o Industry practices.
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Environmental Factors
Unions AICPA Lenders
Securities and
Exchange Investors Politicians
Commission
Accountants Others

Provide input to

Financial Accounting Standards Board

Help set
Generally Accepted Accounting Principles
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Environmental Factors

Securities and Exchange Commission (SEC)

o Independent, quasi-judicial government agency

o Administer securities regulations & disclosures
o Can modify & set GAAP, if necessary
o Rarely directly challenges FASB
o Major player in global accounting
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Environmental Factors
International Financial Reporting
Standards (IFRS)
Set by International
Accounting Standards Board

Not currently accepted in U.S.

SEC under pressure to accept

IAS
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Environmental Factors
Managers of Companies
o Primary responsibility for fair & accurate
reports
o Applies accounting to reflect business
activities
o Managerial discretion is necessary in
accounting
o Major lobbyist on GAAP
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Environmental Factors
Auditing
o SEC requires Audit Report
o Audit opinion can be:
o clean (fairly presented)
o qualified (except for)
o disclaimer (no opinion) Auditors
o Check Auditor quality & independence
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Environmental Factors
Corporate Governance

o Board of directors oversight

o Audit committee of the board
o oversee accounting process
o oversee internal control
o oversee internal/external audit
o Internal Auditor
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Environmental Factors
Internal Users External Users

Managers Lenders

Officers Shareholders

Internal Auditors Governments

Sales Managers Labor Unions

Budget Officers External Auditors

Controller Customers
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Alternative information sources

Economic, Industry & Company News
o Impacts current & future financial condition and performance

Voluntary Disclosure
Motivation - Legal liability, Expectations Adjustment, Signaling,
Managing expectations

Information Intermediaries
o Industry devoted to collecting, processing, interpreting &
disseminating company information
o Includes analysts, advisers, debt raters, buy- and
sell-side analysts, and forecasters
o Major determinant of GAAP
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Desirable Qualities of Accounting

Information
o Relevance - the capacity of information to affect a
decision

o Reliability - For information to be reliable it must be

verifiable, representationally faithful, and neutral.
o Verifiability means the information is confirmable.
o faithfulness means the information reflects reality,
and
o neutrality means it is truthful and unbiased.
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Financial Accounting
Important Accounting Principles
o Historical Cost - fair & objective values from arms-length
bargaining
o Accrual Accounting - recognize revenues when earned,
expenses when incurred
o Materiality - threshold when information impacts decision
making
o Conservatism - reporting or disclosing the least optimistic
information about uncertain events and transactions
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Financial Accounting
Relevance of Accounting Information

Relation between Accounting Numbers and Stock Prices

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Financial Accounting
Limitations of Accounting Information

o Timeliness - periodic disclosure, not real-time

basis

o Frequency - quarterly and annually

o Forward Looking - limited prospective

information
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Accruals-The Cornerstone
Illustration - Case Facts

o Establish company and invest $700 equity

o Purchase plain T-shirts for $5 each

o Fixed screen cost of $100

o Variable print cost of $0.75 per T-shirt

o Sold 25 T-shirts at $10 each for cash

o Sold 25 T-shirts at $10 each on credit

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Accruals- The Cornerstone

Case Illustration Cash Accounting

Statement of Cash Flows Balance Sheet (Cash basis)

Receipts Assets
T-Shirt sales $250 Cash $275

Payments
T-Shirt purchases $500 Equity
Screen purchase 100 Beginning Equity $700
Printing charges 75 Less net cash outflow (425)
Total payments $(675) Total equity $275
Net cash outflow $(425)
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Accruals-The Cornerstone
Case Illustration Accrual Accounting
Income Statement Balance Sheet (Accrual basis)
Revenues Assets
T-Shirt sales $500.00 Cash $275.00
T-Shirt inventory 337.50
Expenses Receivables 250.00
T-Shirts costs $250.00 Total assets $862.50
Screen depreciation 50.00
Printing charges 37.50 Equity
Total expenses (337.50) Beginning equity $700.00
Add net income 162.50
Net income $162.50 Total equity $862.50
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Accruals-The Cornerstone

Net Operating
= + Accruals
Income Cash Flow

= +
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Accruals-The Cornerstone

Foundations of Accrual Accounting

Revenue Recognition recognize revenues when
(1) Earned
(2) Realized or Realizable
Expense Matching match with corresponding revenues
- Product costs
- Period costs
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Accruals-The Cornerstone
Relation between Cash Flows and Accruals
Operating cash flow (OCF)
-/+ Cash investment & divestment in operating assets
= Free cash flow (FCF)
+/- Financing cash flows (including investment &
divestment in financing assets)
= Net cash flow (NCF)
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Accruals-The Cornerstone
Short-Term and Long-Term Accruals
Short-Term Accruals: Yield current assets and current liabilities (also called
working capital accruals)

Long-Term Accruals: Yield non-current assets and non-current liabilities (arise

mainly from capitalization)

Note: Analysis research suggests short-term accruals

are more useful in company valuation
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Accruals-The Cornerstone
Accruals and Cash Flows - Myths
o Myth: Since company value depends on future cash
flows, only current cash flows are relevant for
valuation.
o Myth: All cash flows are value relevant.
o Myth: All accrual accounting adjustments are value
irrelevant.
o Myth: Cash flows cannot be manipulated.
o Myth: All income is manipulated.
o Myth: It is impossible to consistently manage
income upward in the long run.
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Accruals-The Cornerstone
Accruals and Cash Flows - Truths

o Truth: Accrual accounting (income) is more

relevant than cash flow.
o Truth: Cash flows are more reliable than
accruals.
o Truth: Accrual accounting numbers are subject
to accounting distortions.
o Truth: Company value can be determined by
using accrual accounting numbers.
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Economic concepts of income

Economic income
Permanent income
Operating income

Economic income
o Measures changes in Shareholders wealth.
o Cash flows + Present value of expected future cash flows.
o Useful when the objective of analysis is determining the exact
return to the shareholder for the period.
o Less useful for forecasting future earnings potential.
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Accounting concept of income

o Based on the concept of accrual accounting

o Main purpose is income measurement
o Two main processes
o Revenue recognition

o Expense matching
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Accounting Vs Economic income

Reasons for difference

o Alternative income concepts
o Historical cost
o Transaction basis
o Conservatism
o Earnings management
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Fair value accounting

Asset and liability values are determined on the

basis of their fair values (typically market prices)
on the measurement date (i.e., approximately
the date of the financial statements).
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Historical cost Vs Fair value

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Advantages & Disadvantages

Advantages
o Reflects current information.
o Consistent measurement criteria.
o Comparability
o No conservative bias
o More useful for equity analysis
Disadvantages
o Lower objectivity
o Susceptibility to manipulation. Use of Level 3 inputs.
o Lack of conservatism.
o Excessive income volatility.
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Implications for Analysis

o Focus on the balance sheet.

o Restating income.
o Analyzing use of inputs.
o Analyzing financial liabilities.
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Accounting Analysis
Demand for Accounting Analysis
o Adjust for accounting distortions so financial
reports better reflect economic reality

o Adjust general-purpose financial statements to

meet specific analysis objectives of a particular
user
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Accounting Analysis
Sources of Accounting Distortions
o Accounting Standards attributed to
1) political process of standard-setting,
2) accounting principles and assumptions, and
3) conservatism
o Estimation Errors attributed to estimation errors inherent in accrual
accounting
o Reliability vs Relevance attributed to over-emphasis on reliability at
the loss of relevance
o Earnings Management attributed to window-dressing of financial
statements by managers to achieve personal benefits
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Accounting Analysis
Analysis Objectives
o Comparatives Analysis demand for financial comparisons
across companies and/or across
time
o Income Measurement - demand for (1) equity wealth
changes and (2) measure of
earning power. These correspond
to two alternative income
concepts
(1) Economic Income (or
empirically, economic profit)
(2) Permanent Income (or
empirically, sustainable profit)
Chapter 6 discusses these measures in detail
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Accounting Analysis
Earnings Management Frequent Source of Distortion

Earning Management strategies:

o Increasing Income managers adjust accruals to increase
reported income
o Big Bath managers record huge write-offs in one period to
relieve other periods of expenses
o Income Smoothing managers decrease or increase reported
income to reduce its volatility
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Accounting Analysis
Earnings Management Motivations

o Contracting Incentives - managers adjust numbers used in

contracts that affect their wealth (e.g., compensation contracts)
o Stock Prices managers adjust numbers to influence stock
prices for personal benefits (e.g., mergers, option or stock
offering)
o Other Reasons - managers adjust numbers to impact
1) labor demands,

2) management changes, and

3) societal views
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Accounting Analysis
Earnings Management Mechanics
o Incoming Shifting:
Accelerate or delay recognition of revenues or expenses to
shift income from one period to another

o Classificatory Earnings Management:

Selectively classify revenues Earnings and expenses in
certain parts Management of the income statement to affect
analysis inferences regarding the recurring nature of these
items
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Accounting Analysis
Process of Accounting Analysis
Accounting analysis involves several inter-related processes and
tasks that can be grouped into two broad areas:
o Evaluating Earning Quality: Steps
1) Identify and assess key accounting policies
2) Evaluate extent of accounting flexibility
3) Determine the reporting strategy
4) Identify and assess red flags
o Adjusting Financial Statements:
Identify, measure, and make necessary adjustments to financial
statements to better serve ones analysis objectives;
Chapters 3-6 focus on adjusting (recasting) the statements
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Auditing And Financial Statement Analysis