Com 4FK3
Financial Statement Analysis
Week 8, 2012
Accounting Quality
Accounting Quality
• High quality accounting conveys economic
information about the firm
 earnings
quality
 balance sheet quality
 notes to the financial statements
 management’s discussion and analysis
• Should be fair and complete
• Provide relevant information for valuation
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Estimates
• GAAP, tries to set standards to enhance the
quality of accounting
• Certain transactions contain a high degree
of uncertainty, so there is some flexibility
 bad
debt expense, depreciation schedule, etc.
• Bias can be intentional or unintentional
• Analyst can restate the financial statements
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Persistence Over Time
• Earnings can be;
 informative
about both current and future
performance
 tell current performance but are unsustainable
 good for current performance, but not a good
predictor of future performance
 not informative about current performance, but
a good indicator of future performance
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Signals
• Results are high quality and as expected
• Earnings are different from expectations
and are likely to recur
• Earnings are unexpected, but not likely to
be seen again
• Current earnings are as expected, but the
disclosure changes expectations of future
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Types of Issues
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Discontinued operations
Extraordinary gains or losses
Well defined
Changes in accounting principles under GAAP
Other comprehensive income
Asset impairment
Restructuring charges
Changes in estimates
Gains and losses from peripheral activities
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Discontinued Operations
• Not relevant to ongoing value of the firm in
most cases
• Degree of integration may affect the
treatment of the decision
• Can adjust all financial statements for
analysis if enough information is given
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Extraordinary Items
• Classified as extraordinary if
 Unusual
in nature
 Infrequent in occurrence
 Material in amount
• Example: settlement of lawsuit
• Analysis should exclude income effect
• May want to modify cash flow from
operations before calculating ratios
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Changes in Accounting Principles
• Disclosed in financial statements
• Often imposed by outside agencies
• May be voluntary, analyst should consider
the possibility of earnings manipulation
 Cumulative
effect may result from several
periods and is not indicative of current activity,
so is not relevant to current year
 e.g. Ford: $7.5 b for post-retirement benefits
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Other Comprehensive Income
• Includes unrealized holding period gains
• For the analysis, arguments include:
 Consider 1) Relates to operations
2) Likely to recur
3) Objective if actively traded
 Ignore
1) Gains may reverse before sale
2) No effect on current cash flow
3) Subjective if not actively traded
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Impairment Losses
• Reported on an infrequent basis
• Usually reported on a pre-tax basis
 Deductible
now; shows in income tax note
 Deductible later; shows in deferred tax
 Not deductible; shows in tax reconcilliation
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Restructuring Charges
• Firms can decide not to leave an industry,
but to substantially change operations
• Gives rise to restructuring charges
• Can be difficult to asses due to spread out
or big bath approaches
• If judged to be unlikely to recur, exclude
from income (net of tax) for analysis
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Changes in Estimates
• New information can change estimates
• GAAP does not allow that to change prior
year statements, so results of past
misstatements will appear in current income
• Many issues to consider
• Current Enron testimony
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Gains and Losses
• Gains and losses from peripheral activities
• May occur on a regular basis and be related
to the operations of the firm
 e.g.
in 3 consecutive years Delta reported a gain
on the sale of flight equipment
• If excluded from income, the analyst must
also consider the income tax effect
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Restated Financial Statements
• Some changes require the company to issue
restated statements for previous years
 significant
discontinued operations
 some changes in accounting principles
• Often difficult for the analyst since they
only restate 2 or 3 years of statements and
that may not allow for useful analysis
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Earnings Management
• Reasons for
 Optimize
management compensation
 Improve managerial job security
 Avoid violation of debt covenants and
otherwise improve borrowing capacity
 Influence short term price performance
 Avoid anti-trust or similar attention
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Earnings Management
• Disincentives
 Earnings
and cash flows can not diverge
forever, aggressive earning today mean lower
earnings in the future
 Capital markets and regulators penalize firms
thought to manage earnings
 Possible legal actions (Enron)
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