Accounting Analysis:

Accounting Adjustments

Chapter 4

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KEY CONCEPTS IN CHAPTER 4

• Analyzing elements of the balance sheet for possible

distortions allow the analyst to better understand the
economic substance of a firm’s transactions and financial
position.

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ASSET DISTORTIONS

• Assets are defined as resources with probable future

benefits. Distortions may generally arise from ambiguities
about whether:

– The firm owns/controls the economic resource

– Future economic benefits can be measured with
reasonable certainty
– Fair values of assets fall below their book values
– Fair value estimates are accurate

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ASSET DISTORTIONS: OWNERSHIP / CONTROL

• Some types of transactions make it difficult to assess the

ownership of an asset.

– Mechanical rules help to establish economic ownership

with noise or induce managers to structure transactions
– Principles-based rules increase managers’ reporting
discretion
• IAS 27: for preparing consolidated financial
statements
• IAS 17: on lease accounting
– Consequently, IFRS may not capture subtleties
associated with ownership or control over certain assets

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ASSET DISTORTIONS: ECONOMIC BENEFITS AND FAIR VALUES

• IFRS requires the immediate expensing of some resource

outflows that may have future economic benefits, such as
research expenditures.
– Example: IAS 38 R&D expenditures.

• Because considerable judgment is involved in determining

whether the value of an asset is impaired, and the amount
of the impairment, assets may be misstated.
– IAS 36: an impairment loss be recognized on a non-
current asset when its book value exceeds the greater
of its net selling price and the discounted cash flows
expected to be generated from future use.

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ASSET DISTORTIONS: ECONOMIC BENEFITS AND FAIR VALUES

• IAS 39: require a firm to recognize financial assets other than loans
and receivables, such as investments in asset-backed securities, at
their fair values if the firm does not intend to hold these assets to their
maturities.

• Fair value of financial assets must be derived from

– Quoted market prices if an active market for the assets exists
(referred to as marking to market).
– Firms’ own valuation technique if quoted market prices are not
available (referred to as marking to model).
– Exception: the credit market crisis of 2008.

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OVERSTATED ASSETS

• Incentives to inflate reported earnings can result in

overstated assets. Some of the most common forms
include:

– Understated depreciation/amortization of non-current

assets
– Delayed write-downs of current or non-current assets
• Accounting rules generally require that current
assets should be written down to their fair values if
their book values fall below their realizable values.
• Write-offs are charged directly to earnings, current
asset impairments affect earnings.
• Deferring current asset write-downs leads to
increased reported profits.
– Understatement of allowances
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UNDERSTATED ASSETS

• There may be incentives for earnings to be under-reported,

resulting in understated assets:
– Leased assets or key intangible assets off balance
sheet
– Overstated allowances
– Discounted receivables off balance sheet

• Conservatism in IFRS may also result in understated

assets.

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CASE: FOR OVERSTATED DEPRECIATION FOR NON-CURRENT

 Lufthansa v.s. British Airways (P123-125)

– In 2012 Lufthansa: straight-line method, useful life of 12 years,
residual value of 15% of initial cost of aircrafts, tax rate of 25%.
Thus, depreciation percentage is 7.1%, which is computed by
[(1-15%)/12].
– British Airways: straight-line method, depreciation percentage of
4.5% of initial cost of aircrafts, tax rate of 30%.
– Why different depreciation rate?
– Adjustment: decreasing Lufthansa’ s depreciation rates to match
those of BA’s.

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 Adjustment (millions unless otherwise noted):
– Using 4.5% as Lufthansa’ s depreciation rates
• The average age of Lufthansa’s fleet:
Accumulated depreciation/depreciable cost
=(€12,238/ €19113.1)*12 yrs =7.684 yrs
• Adjusted accumulated depreciation:
7.684 yrs*4.5%* €22,486 = €7,775
• The difference between the original accumulated depreciation
and the adjusted one:
€12,238- €7,775= €4,463 (Assets increase.)
• Offsetting increases of €1,116 (€4,463 *25%) to the Deferred
Tax Liability (Liab. Increase) and €3,347 (€4,463 *75%) to
Shareholders’ Equity (Equity increases).

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 Assuming that €1,902 million net new aircraft purchased in 2012 were
acquired throughout the year, and therefore require only half a year of
depreciation.
– The depreciation expense for 2012 would have been
• €1,055 [(€22,486+ €1,902*0.5)*4.5%] for the adjustment
• €1,660 [(€22,486+ €1,902*0.5)*85%/12] for the original
reporting
• The difference between the original accumulated depreciation
and the adjusted one
=>B/S: PPE increases €605 (€1,660- €1,055).
DTL increases €151 (€605 *25%).
Shareholders’ equity increases €454 (€605 *75%).
=>I/S: Cost of sales decreases €605.
Tax expense increases €151 (€605 *25%).
Net profit increases €454 (€605 - €151).
 In fiscal year 2013 Lufthansa decided to change its assumption of the
useful life and lowered its depreciation rate to slightly less than 5%.
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• In fiscal year 2013 Lufthansa decided to change its assumption of the
useful life and lowered its depreciation rate to slightly less than 5%.

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LIABILITY DISTORTIONS

• Liabilities are economic obligations requiring future

outflows of resources.

• Distortions may generally arise from ambiguities about

whether:
– An obligation has been incurred
• E.g., ongoing commitment to the customer for
servicing and supporting the license agreement.

– The proper measurement of an obligation

• Environmental clean-up; post-employment benefits.

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UNDERSTATED LIABILITIES

• Understated liabilities may arise from:

– Incentives to overstate earnings or the strength of

financial position

– Difficulties in estimating the amount of future financial

commitments

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UNDERSTATED LIABILITIES: LIKELY CONDITIONS

• Liabilities may be understated under some of the following

conditions:

– Aggressive revenue recognition

– Off-balance-sheet loans related to receivables
• Loans from discounted receivables are off-balance
sheet
– Off-balance-sheet non-current liabilities
• Non-current liabilities for leases are off-balance
sheet
– Pension and post-retirement obligation understatements
• E.g., pension obligations are not fully recorded

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CASE: FOR UNEARNED REVENUE UNDERSTATED

• MicroStrategy
– In March 2000 MicroStrategy conceded that it had incorrectly
overstated revenues on contracts that involved significant future
customization and consulting by $54.5 million. Adjustment:
• Sales would decline and unearned revenue would increase by
$54.5 m.
• Cost of Sales would decline and prepaid expenses would
increase by $1.6 m [$54.5*3%]. (Cost of license revenue was
3%.)
• Tax Expense and DTL would decline by $18.5 [$54.5*(1-
3%)*35%]
• Stock price plummeted 94% compared to the 37% drop by
NASDAQ.

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EQUITY DISTORTIONS

• Equity is the residual claim on a firm’s assets held by

stockholders.
• Since Assets = Liabilities + Equity, distortions in assets
and/or liabilities lead to distortions in equity.
• The nature of contingent claims needs to be considered to
reduce any possible bias in the financial statements.
– Stock options (IFRS2, fair value method).
– Contingent claim is by no means costless to the firm’s
shareholders.
– To improve current profit or loss as a measure of the
firm’s current economic performance, the economic cost
of contingent claims should be included in the income
statement.

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CONCLUDING COMMENTS

• Recasting financial statements is an important step to

facilitate comparability among financial statements
analyzed.
• Analysts should focus on evaluating and adjusting
accounting measures that describe the firms’ key strategic
value drivers.
• It is important to keep in mind that many accounting
adjustments will be estimates.

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