(Moore)
Draft 2 Requirements – Valuation Project
Draft 2 Requirements
Formal Accounting Analysis
Structure of the Formal Accounting Analysis
1.
Identify Key Accounting Policies (KAP)
 Key accounting policies must be directly linked to the Key
Success Factors (KSF’s) identified and discussed in the first
draft.
 These are NOT the “boilerplate” significant accounting
policies listed in the supplementary disclosure of the 10-K.
 KAP’s regard disclosure related to those items you found to
be significant either in terms of activities that drive (create)
corporate value via the KSF’s identified in draft 1 or
significant asset or liability items that materially affect the
user’s view of the company.
o This means that depreciation methods and inventory
accounting methods are typically NOT considered
KAP’s for the purpose of this analysis.
o Significant asset and liability items can include (and
are not limited to) the extent, relative mix and use of
operating vs. capital leases; defined benefit plan
pension liabilities (and expenses) as they are based on
actuarial assumptions; commodity, interest-rate, and
currency derivative risk management exposure,
disclosure and assumptions; Off balance-sheet
collateralized debt obligations; etc.
o A very broad perspective is used when defining KAP’s
in that it looks at overall disclosure related to things
the valuation analyst finds important and not just the
underlying debits and credits.
o This section still involves and industry perspective, so
you must look at the 10-K’s of the company you are
valuing as well as the 10-K’s of the main competitors
in the industry
(Moore)
Draft 2 Requirements – Valuation Project
2.
Assess Degree of Potential Accounting Flexibility
3.
Evaluate Actual Accounting Strategy
4.
 Again, this relates to the flexibility related to those items you
identify as KAP’s.
 Be specific. Use institutional knowledge of GAAP and look at
relative disclosures among firms in the industry.
 Accounting strategy includes two basic dimensions:
o First, you need to assess whether your company is a
high disclosure company (levels of dis-aggregation,
segment reporting, extensive discussion and disclosure
within the financial report related to those items you
find important in assessing value) vs. low disclosure
(minimal reporting that satisfies GAAP).
o Second, you need to assess (within the confines of
accounting flexibility on the KAP’s whether the
company is conservative (leads to lower reported
earning) or aggressive (leads to higher reported
earnings) in its choice of accounting policies. Make
sure to do this on an absolute and relative basis.
Evaluate the Quality of Disclosure
 Qualitative Analysis
o This is essentially a matter of opinion (logical
argumentation) that is grounded in supportive facts
that lead to your conclusion. Main issue is overall
transparency and decision usefulness of the financial
reporting information. Ultimately, does the financial
information presented by the company provide
sufficient decision useful information that satisfies your
information needs (level of disclosure, discussion,
analysis,
dis-aggregation,
appropriate
segment
disclosure, etc. This analysis should be prepared on
both an absolute and relative basis.
5.
Identify Potential “Red Flags”
 Previous Qualitative and Quantitative Factors.
 Asset Write-offs. 4th quarter adjustments.
transactions; Special purpose entities
Related Party
Draft 2 Requirements – Valuation Project
(Moore)
6. Undo Accounting Distortions
 Should you determine that significant balance sheet and
income statement items are materially misstated (for the
purpose of your analysis), then restate the financial statements
based upon your analysis.
 Items that sometimes arise are overstated inventory (resulting
from understated obsolescence rates), capitalizing operating
leases (GAAP is not in violation, but off-balance sheet assets
and liabilities are present that materially affect your
assessments of resources and liabilities); capitalizing research
and development, restating collateralized debt obligations and
incorporating special purpose entities into the financials.
 You will only want to restate when the items materially
alter your perception of the underlying company.
i. Goodwill > 30% of Net Fixed Assets
ii. Goodwill Impairment eliminates > 30% Operating
Income
iii. R&D expense reduces operating income by more
than 20%
iv. Capitalized Operating Leases would increase noncurrent liabilities by more than 20%

If the boundaries above are exceeded, then you must prepare
restated financial statements in good form for the entire 5 or
6 previous years.