CHAPTER 2

FINANCIAL REPORTING &

ANALYSIS
INAM-UL-HAQUE
 ACCRUALS—CORNERSTONE
OF ACCOUNTING
• Financial statements are primarily prepared
on an accrual basis. Supporters strongly
believe that accrual accounting is superior to
cash accounting, both for measuring
performance and financial condition.
 ACCRUALS—CORNERSTONE
OF ACCOUNTING
• Statement of Financial Accounting Concepts
No. 1 states that “information about
enterprise earnings based on accrual
accounting generally provides a better
indication of enterprises’ present and
continuing ability to generate cash flows than
information limited to the financial aspects of
cash receipts and payments.”
 Accrual Accounting—An Illustration

• Assume you decide to sell printed T-shirts for

$10 each.
• you can buy plain T-shirts for $5 a piece.
• Printing , fixed fee of $100 for the screen and
another $0.75 per printed T-shirt.
• Your initial advertisement yields orders for 100
T-shirts.
• You then invest $700 in the venture,
 Accrual Accounting—An Illustration

• Customers with orders totaling 50 T-shirts pick

up their T-shirts in that first week. But, of the
50 T-shirts picked up, only 25 are paid for in
cash. For the other 25, you agree to accept
payment next week.
• To evaluate the financial performance of your
venture, you prepare cash accounting records
at the end of this first week.
CASH BASED ACCOUNTING
1. You have not recognized any revenues from the
25 shirts that have been sold on account (e.g.,
for which you have an account receivable).
2. You have treated all of the T-shirts purchased
as an expense.
3. Likewise, you have treated all of the screen
purchase and the T-shirt printing charges as an
expense.
Shouldn’t this cost be matched with the
revenues those T-shirts will produce when they
are sold?
Accrual Accounting
• Cash Flows are simple, easy to calculate
• when it comes to measuring cash-generating
capacity of a company, cash flows are of limited
use.
• Most business transactions are on credit. Further,
companies invest billions of dollars in inventories
and long-term assets, the benefits of which occur
over many future periods.
• In these scenarios, cash flow accounting (no
matter how reliable it is) fails to provide a relevant
picture of a company’s financial condition and
performance.
 Accruals and Cash Flows
• Operating cash flow refers to cash from a
company’s ongoing operating activities.
• Free cash flow to the firm represents cash that is
free to be paid to both debt and equity holders.
• Accruals are the sum of accounting adjustments
that make net income different from net cash
flow.
• Net income = Operating cash flow + Accruals.
 Accrual Accounting Reduces Timing and
Matching Problems
• Timing problems refer to cash flows that do not
occur contemporaneously with the business
activities yielding the cash flows.
• For example, a sale occurs in the first quarter, but
cash from the sale arrives in the second quarter.
• Matching problems refer to cash inflows and cash
outflows that occur from a business activity but
are not matched in time with each other.
 Accrual Process—Revenue Recognition and
Expense Matching.
• Revenue recognition:
• Revenues are recognized when both earned and either
realized or realizable.
• Revenues are earned when the company delivers its
products or services.
• Revenues are realized when cash is acquired for
products or services delivered.
• Revenues are realizable when the company receives an
asset for products or services delivered (often
receivables) that is convertible to cash
 Accrual Process—Revenue Recognition and
Expense Matching.
• Expense matching.
• Accrual accounting dictates that expenses are
matched with their corresponding revenues.
• This matching process is different for two
major types of expenses.
• Expenses that arise in production of a product
or service, called product costs, are recognized
when the product or service is delivered.
 Accrual Process—Revenue Recognition and
Expense Matching.
• All product costs remain on the balance sheet
as inventory until the products are sold, at
which time they are transferred into the
income statement as cost of goods sold
(COGS).
• Period costs: Some period costs relate to
marketing the product or service and are
matched with revenues when the revenues to
which they relate are recognized.
 Short- and Long-Term Accruals
• Short-term accruals refer to short-term timing
differences between income and cash flow.
• These accruals generate working capital items
in the balance sheet (current assets and
current liabilities) and are also called working
capital accruals.
• Payables, Receivables, Prepaid Expenses,
Advance Payments etc.
 Short- and Long-Term Accruals
• Long-term accruals arise from capitalization.
• Asset capitalization is the process of deferring
costs incurred in the current period whose
benefits are expected in future periods.
• This process generates long-term assets such as
plant, machinery, and goodwill.
• Costs of these assets are allocated over their
benefit periods and make up a large part of long-
term accruals.
 Relevance of Accrual Accounting
• Relevance of short-term accruals:
• Short-term accruals improve the relevance of
accounting by helping record revenues when
earned and expenses when incurred.
• These accruals yield an income number that
better reflects profitability and also creates
current assets and current liabilities that
provide useful information about financial
condition.
 Relevance of long-term accruals
• Free cash flow to the firm is computed by
subtracting investments in long-term
operating assets from operating cash flow.
 Superiority of accruals
• Financial performance:
• Revenue recognition and expense matching
yields an income number superior to cash flows
for evaluating financial performance.
• Revenue recognition ensures all revenues earned
in a period are accounted for.
• Matching ensures that only expenses
attributable to revenues earned in a period are
recorded.
 Superiority of accruals
• Financial condition:
• Accrual accounting produces a balance sheet
that more accurately reflects the level of
resources available to the company to
generate future cash flows.
• Predicting future cash flows:
• Accrual income is a superior predictor of
future cash flows than are current cash flows
for at least two reasons.
• First, through revenue recognition, it reflects
future cash flow consequences.
• For example, a credit sale today forecasts cash
to be received from the customer in the future
• Second, accrual accounting better aligns
inflows and outflows over time through the
matching process.
 Myths and Truths about Accruals and Cash
Flows
• Myths:
1. Because company value depends on future
cash flows, only current cash flows are
relevant for valuation.
• (current income is a better predictor of future
cash flows than is current cash flows)
2. All cash flows are value relevant.
 Myths
3. All accrual accounting adjustments are value
irrelevant.
4. Cash flows cannot be manipulated
5. All income is manipulated.
6. It is impossible to consistently manage
income upward in the long run
 Truths
1. Accrual accounting (income) is more relevant
than cash flow
2. Cash flows are more reliable than accruals
3. Accrual accounting numbers are subject to
accounting distortions
4. Company value can be determined by using
accrual accounting numbers
 INTRODUCTION TO
A C C O U N T I N G A N A LY S I S
• Accounting analysis is the process of evaluating
the extent to which a company’s accounting
numbers reflect economic reality.
• Accounting analysis involves a number of different
tasks, such as evaluating a company’s accounting
risk and earnings quality, estimating earning
power, and making necessary adjustments to
financial statements to both better reflect
economic reality and assist in financial analysis.
 Need for Accounting Analysis
• First, accrual accounting improves upon cash
accounting by reflecting business activities in a
more timely manner.
• accounting distortions need to be identified and
adjusted
• Second, financial statements are prepared for a
diverse set of users and information needs.
• Adjustments needed to meet analysis objectives
 Accounting Distortions
• Accounting distortions are deviations of
reported information in financial statements
from the underlying business reality.
• These distortions arise from the nature of
accrual accounting—this includes its
standards, errors in estimation, the trade-off
between relevance and reliability.
 1. Accounting Standards
• First, accounting standards are the output of a
political process. Different user groups lobby
to protect their interests.
• In this process, standards sometimes fail to
require the most relevant information.
 1. Accounting Standards
• A second source of distortion from accounting
standards arises from certain accounting
principles. For example, the historical cost
principle can reduce the relevance of the
balance sheet by not reflecting current market
values of assets and liabilities
 1. Accounting Standards
• A third source of distortion is conservatism.
For example, accountants often write down or
write off the value of impaired assets, but very
rarely will they write up asset values.
Conservatism leads to a pessimistic bias in
financial statements that is sometimes
desirable for credit analysis but problematic
for equity analysis.
 2. Estimation Errors.
• Accrual accounting requires forecasts and
other estimates about future cash flow
consequences.
• Use of these estimates improves the ability of
accounting numbers to reflect business
transactions in a timely manner.
• These estimates yield errors that can distort
the relevance of accrual accounting number
 3. Reliability versus Relevance
• Accounting standards trade off reliability and
relevance
• One example is loss contingencies
• Second Research & Development Cost
 4. Earnings Management
• Earnings management can be defined as the
“purposeful intervention by management in
the earnings determination process, usually to
satisfy selfish objectives” (Schipper, 1989)
• For example, managers sometimes use the
FIFO method of inventory valuation to report
higher income even when use of the LIFO
method could yield tax savings.
Earnings Management Strategies
• There are three typical strategies to earnings
management.
(1) Managers increase current period income.
(2) Managers take a big bath by reducing
current period income.
(3) Managers reduce earnings volatility by
income smoothing.
 1. Increasing Income.
• One earnings management strategy is to increase a
period’s reported income to portray a company more
favorably.
• It is possible to increase income in this manner over
several periods.
• In a growth scenario, the accrual reversals are smaller
than current accruals that increase income.
• This leads to a case where a company can report
higher income from aggressive earnings management
over long periods of time.
 2. Big Bath.
• A “big bath strategy” involves taking as many
write-offs as possible in one period.
• The period chosen is usually one marked with
poor performance (often in a recession when
most other companies also report poor
earnings)
• or one with unusual events such as a
management change, a merger, or a
restructuring.
 3. Income Smoothing
• Income smoothing is a common form of
earnings management.
• Under this strategy, managers decrease or
increase reported income so as to reduce its
volatility.
• Not reporting a portion of earnings in good
years through creating reserves or earnings
“banks,” and then reporting these earnings in
bad years.
Motivations for Earnings Management

• Contracting Incentives for Managers

• Stock Price Effects

• Other Incentives
 Process of Accounting Analysis
1. Evaluating Earnings Quality:
• Earnings quality as the extent of conservatism
adopted by the company—a company with
higher earnings quality is expected to have a
higher price-to-earnings ratio than one with
lower earnings quality
• A company has high earnings quality if its
financial statement information accurately
depicts its business activities (less Distortions)
 Steps in Evaluating Earnings Quality
• Identify and assess key accounting policies:
• An important step in evaluating earnings quality
is identifying key accounting policies adopted by
the company.
• Are the policies reasonable or aggressive?
• Is the set of policies adopted consistent with
industry norms?
• What impact will the accounting policies have on
reported numbers in financial statements?
• Evaluate extent of accounting flexibility:
• It is important to evaluate the extent of
flexibility available in preparing financial
statements. The extent of accounting
flexibility is greater in some industries than
others.
• Industries with more intangible assets, major
cost is production, more judgments are used,
resulting lower earning quality
• Determine the reporting strategy:
• Identify the accounting strategy adopted by
the company.
• Is the company adopting aggressive reporting
practices?
• Does the company have a clean audit report?
• Has there been a history of accounting
problems?
• Does management have a reputation for
integrity?
• Identify and assess red flags:
• Red flags are items that alert analysts to potentially more
serious problems. Some examples of red flags are:
• Poor financial performance—desperate companies are
prone to desperate means.
• Reported earnings consistently higher than operating cash
flows.
• Reported pretax earnings consistently higher than taxable
income.
• Qualified audit report.
• Auditor resignation or a nonroutine auditor change.
• Unexplained or frequent changes in accounting policies.
• Sudden increase in inventories in comparison to sales.
 2. Adjusting Financial Statements
• The final and most involved task in accounting
analysis is making appropriate adjustments to
financial statements, especially the income
statement and balance sheet.
• The need for these adjustments arises both
because of distortions in the reported
numbers and because of specific analysis
objectives.
• Capitalization of long-term operating leases, with
adjustments to both the balance sheet and income
statement.
• Recognition of ESO expense for income
determination.
• Adjustments for one-time charges such as asset
impairments and restructuring costs.
• Recognition of the economic (funded) status of
pension and other postretirement benefit plans on
the balance sheet.
• Removal of the effects of selected deferred income
tax liabilities and assets from the balance sheet.
 Assignment # 1
Pick an Organization from below list as per last digit of your student ID.
Student ID Company Student ID Company
0 Coca Cola Pakistan 5 Ghani Glass Pakistan
1 Unilever Pakistan 6 Atlas Honda
2 FFC 7 Lucky Cement
3 Pakistan Tobacco Co. 8 Toyota Indus
4 Pepsi 9 ICI Pakistan

1. Download Last Five Years' Annual Financial Reports from

Company Websites or Stock Exchange.
(2015,2016,2017,2018,2019)
2. Perform Horizontal & Vertical Analysis for last Five Years Data.
3. Last Date Tuesday 21-04-2020