Chapter 3

Overview of Accounting Analysis

Discussion Questions 1 & 6
1.A finance student states, I dont understand why anyone pays any
attention to accounting earnings numbers, given that a clean number
like cash from operations is readily available. Do you agree? Why or
why not?
There are several reasons why we should pay attention to accounting
earnings numbers. First, net income predicts a companys future cash flow
better than current cash flow does. Net income aids in predicting future cash
flows by reporting transactions with cash consequences at the time when the
transactions occur, rather than when the cash is received or paid. Net income
is computed on the basis of expected, not necessarily actual, cash receipts
and payments.
Second, net income is potentially informative when there is information
asymmetry between corporate managers and outside investors. Note that
corporate managers with superior information choose accounting methods
and accrual estimates which determine the net income number. Because
accrual accounting requires managers to record past events and to make
forecasts of future effects of these events, net income can be used to convey
managers superior information. For example, a companys decision to
capitalize some portion of current expenditure, which increases todays net
income, conveys potentially informative signals to outside investors about
the companys ability to generate future cash flows to cover the capitalized
costs.

6.The conservatism principle arises because of concerns about

managements incentives to overstate the firms performance. Joe
Banks argues, We could get rid of conservatism and make accounting
numbers more useful if we delegated financial reporting to independent
auditors rather than to corporate managers. Do you agree? Why or
why not?
We dont agree with Joe Banks because the delegation of accounting
decisions to auditors may reduce the quality of financial reporting. Auditors
possess less information and firm-specific business knowledge than
corporate managers when portraying the economic reality of a firm.
The divergence between managers and auditors business assessments is
likely to be most severe for firms with distinctive business strategies or ones
which operate in emerging industries. With such an information
disadvantage, even if auditors report truthfully without having any incentive
problem, they cannot necessarily choose better accounting methods and
accruals than corporate managers do.
Auditors also have their own incentive to record business transactions in a
mechanical way, rather than using their professional judgment, which leads
to poor quality of financing reporting. For example, auditors are likely to
choose accounting standards that require them to exercise minimum
business judgment in assessing a transactions economic consequences,
especially given their legal liability risk. The current debate on market value
accounting for financial institutions illustrates this point. While there is
considerable agreement that market value accounting produces relevant
information, auditors typically oppose it, citing concerns over audit liability.