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Financial

Statement
Analysis
K R Subramanyam
John J Wild

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Reporting
and Analysis

CHAPTER

2-2

2-3

Statutory Financial Reports

2-4

GAAP
Types
Typesof
ofAccounting
Accountingrules
rulesand
andguidelines
guidelines
o Statements of Financial Accounting Standards
o Statements of Financial Accounting Standards
o APB Opinions.
o APB Opinions.
o Accounting Research Bulletins (ARB).
o Accounting Research Bulletins (ARB).
o AICPA pronouncements. The AICPA issues guidelines
o AICPA pronouncements. The AICPA issues guidelines

for
forcertain
certaintopics
topicsyet
yettotobe
beaddressed
addressedby
bythe
theFASB
FASBininits
its
Statements
StatementsofofPosition
Position(SOP)
(SOP)or
orfor
forthose
thoseinvolving
involving
industry-specific
industry-specificmatters
mattersininits
itsIndustry
IndustryAudit
Auditand
and
Accounting
AccountingGuidelines.
Guidelines.
o EITF Bulletins. EITF Bulletins are issued by the FASBs
o EITF Bulletins. EITF Bulletins are issued by the FASBs
Emerging
EmergingIssues
IssuesTask
TaskForce.
Force.
o Industry practices.
o Industry practices.

2-5

Environmental Factors

2-6

Environmental Factors

Securities and Exchange Commission (SEC)

o
o
o
o
o

Independent, quasi-judicial government agency


Administer securities regulations & disclosures
Can modify & set GAAP, if necessary
Rarely directly challenges FASB
Major player in global accounting

2-7

Environmental Factors
International
InternationalFinancial
FinancialReporting
Reporting
Standards
Standards(IFRS)
(IFRS)

2-8

Environmental Factors
Managers of Companies
oo Primary responsibility for fair & accurate
Primary responsibility for fair & accurate

reports
reports
oo Applies accounting to reflect business
Applies accounting to reflect business
activities
activities
oo Managerial discretion is necessary in
Managerial discretion is necessary in
accounting
accounting
oo Major lobbyist on GAAP
Major lobbyist on GAAP

2-9

Environmental Factors
Auditing
oo SEC requires Audit Report
SEC requires Audit Report
oo Audit opinion can be:
Audit opinion can be:
oo clean (fairly presented)
clean (fairly presented)
oo qualified (except for)
qualified (except for)
oo disclaimer (no opinion)
disclaimer (no opinion)

oo Check Auditor quality & independence


Check Auditor quality & independence

Auditors

2-10

Environmental Factors
Corporate Governance
oo Board of directors oversight
Board of directors oversight
oo Audit committee of the board
Audit committee of the board
oo oversee accounting process
oversee accounting process
oo oversee internal control
oversee internal control
oo oversee internal/external audit
oversee internal/external audit

oo Internal Auditor
Internal Auditor

2-11

Environmental Factors
Internal Users

External Users

2-12

Alternative information sources


Economic,
Economic,Industry
Industry&&Company
CompanyNews
News
o

Impacts current & future financial condition and performance

Voluntary
VoluntaryDisclosure
Disclosure
Motivation - Legal liability, Expectations Adjustment, Signaling,
Managing expectations

Information
InformationIntermediaries
Intermediaries

Industry devoted to collecting, processing, interpreting &


disseminating company information

Includes analysts, advisers, debt raters, buy- and


sell-side analysts, and forecasters

Major determinant of GAAP

2-13

Desirable Qualities of Accounting


Information

2-14

Financial Accounting
Important Accounting Principles
o Historical Cost - fair & objective values from arms-length
o Historical Cost - fair & objective values from arms-length

bargaining
bargaining
o Accrual Accounting - recognize revenues when earned,
o Accrual Accounting - recognize revenues when earned,
expenses
expenseswhen
whenincurred
incurred

o Materiality - threshold when information impacts decision


o Materiality - threshold when information impacts decision

making
making
o Conservatism - reporting or disclosing the least optimistic
o Conservatism - reporting or disclosing the least optimistic
information
informationabout
aboutuncertain
uncertainevents
eventsand
andtransactions
transactions

2-15

Financial Accounting
Relevance
Relevanceof
ofAccounting
AccountingInformation
Information
Relation
Relationbetween
betweenAccounting
AccountingNumbers
Numbersand
andStock
StockPrices
Prices

2-16

Financial Accounting
Limitations of Accounting Information
ooTimeliness - periodic disclosure, not real-time
Timeliness - periodic disclosure, not real-time

basis
basis

ooFrequency - quarterly and annually


Frequency - quarterly and annually
ooForward Looking - limited prospective
Forward Looking - limited prospective

information
information

2-17

Accruals-The Cornerstone
Illustration - Case Facts
ooEstablish company and invest $700 equity
Establish company and invest $700 equity
ooPurchase plain T-shirts for $5 each
Purchase plain T-shirts for $5 each
ooFixed screen cost of $100
Fixed screen cost of $100
ooVariable print cost of $0.75 per T-shirt
Variable print cost of $0.75 per T-shirt
ooSold 25 T-shirts at $10 each for cash
Sold 25 T-shirts at $10 each for cash
ooSold 25 T-shirts at $10 each on credit
Sold 25 T-shirts at $10 each on credit

2-18

Accruals- The Cornerstone


Case Illustration Cash Accounting
Statement of Cash Flows
Receipts
T-Shirt sales

Assets
$250

Payments
T-Shirt purchases $500
Screen purchase
100
Printing charges
75
Total payments
Net cash outflow

Cash

Balance Sheet (Cash basis)

$275

Equity
Beginning Equity
$700
Less net cash outflow (425)
$(675)
Total equity
$275
$(425)

2-19

Accruals-The Cornerstone
Case Illustration Accrual Accounting
Income Statement
Revenues
T-Shirt sales

Balance Sheet (Accrual basis)


$500.00

Expenses
T-Shirts costs
$250.00
Screen depreciation 50.00
Printing charges
37.50
Total expenses

(337.50)

Net income

$162.50

Assets
Cash
T-Shirt inventory
Receivables
Total assets

$275.00
337.50
250.00
$862.50

Equity
Beginning equity
Add net income
Total equity

$700.00
162.50
$862.50

2-20

Accruals-The Cornerstone

2-21

Accruals-The Cornerstone
Foundations of Accrual Accounting
Revenue
RevenueRecognition
Recognitionrecognize
recognizerevenues
revenueswhen
when
(1)
(1) Earned
Earned
(2)
(2) Realized
Realizedor
orRealizable
Realizable
Expense
ExpenseMatching
Matchingmatch
matchwith
withcorresponding
correspondingrevenues
revenues
- -Product
Productcosts
costs
- -Period
Periodcosts
costs

2-22

Accruals-The Cornerstone
Relation between Cash Flows and Accruals

2-23

Accruals-The Cornerstone
Short-Term and Long-Term Accruals

2-24

Accruals-The Cornerstone
Accruals and Cash Flows - Myths
ooMyth: Since company value depends on future cash
Myth: Since company value depends on future cash

flows,
flows,only
onlycurrent
currentcash
cashflows
flowsare
arerelevant
relevantfor
for
valuation.
valuation.
ooMyth: All cash flows are value relevant.
Myth: All cash flows are value relevant.
ooMyth: All accrual accounting adjustments are value
Myth: All accrual accounting adjustments are value
irrelevant.
irrelevant.
ooMyth: Cash flows cannot be manipulated.
Myth: Cash flows cannot be manipulated.
ooMyth: All income is manipulated.
Myth: All income is manipulated.
ooMyth: It is impossible to consistently manage
Myth: It is impossible to consistently manage
income
incomeupward
upwardininthe
thelong
longrun.
run.

2-25

Accruals-The Cornerstone
Accruals and Cash Flows - Truths
ooTruth: Accrual accounting (income) is more
Truth: Accrual accounting (income) is more

relevant
relevantthan
thancash
cashflow.
flow.
ooTruth: Cash flows are more reliable than
Truth: Cash flows are more reliable than
accruals.
accruals.
ooTruth: Accrual accounting numbers are subject
Truth: Accrual accounting numbers are subject
to
toaccounting
accountingdistortions.
distortions.
ooTruth: Company value can be determined by
Truth: Company value can be determined by
using
usingaccrual
accrualaccounting
accountingnumbers.
numbers.

2-26

Economic concepts of income

Economic
Economicincome
income
o
o
o
o
o
o
o
o

Measures
Measureschanges
changesininShareholders
Shareholderswealth.
wealth.
Cash
Cashflows
flows++Present
Presentvalue
valueofofexpected
expectedfuture
futurecash
cashflows.
flows.
Useful
Usefulwhen
whenthe
theobjective
objectiveofofanalysis
analysisisisdetermining
determiningthe
theexact
exact
return
returntotothe
theshareholder
shareholderfor
forthe
theperiod.
period.
Less
Lessuseful
usefulfor
forforecasting
forecastingfuture
futureearnings
earningspotential.
potential.

2-27

Accounting concept of income


Based
Basedon
onthe
theconcept
conceptof
ofaccrual
accrualaccounting
accounting
oo Main purpose is income measurement
Main purpose is income measurement
oo Two main processes
Two main processes
oo Revenue recognition
Revenue recognition
oo Expense matching
Expense matching
oo

2-28

Accounting Vs Economic income


Reasons
Reasonsfor
fordifference
difference
oo Alternative income concepts
Alternative income concepts
oo Historical cost
Historical cost
oo Transaction basis
Transaction basis
oo Conservatism
Conservatism
oo Earnings management
Earnings management

2-29

Fair value accounting


Asset
Assetand
andliability
liabilityvalues
valuesare
aredetermined
determinedon
onthe
the
basis
basisof
oftheir
theirfair
fairvalues
values(typically
(typicallymarket
marketprices)
prices)
on
onthe
themeasurement
measurementdate
date(i.e.,
(i.e.,approximately
approximately
the
thedate
dateof
ofthe
thefinancial
financialstatements).
statements).

2-30

Historical cost Vs Fair value

2-31

Advantages & Disadvantages


Advantages
Advantages
o
o
o
o
o
o
o
o
o
o

Reflects
Reflectscurrent
currentinformation.
information.
Consistent
Consistentmeasurement
measurementcriteria.
criteria.
Comparability
Comparability
No
Noconservative
conservativebias
bias
More
Moreuseful
usefulfor
forequity
equityanalysis
analysis

Disadvantages
Disadvantages
o
o
o
o
o
o
o
o

Lower
Lowerobjectivity
objectivity
Susceptibility
Susceptibilitytotomanipulation.
manipulation.Use
UseofofLevel
Level33inputs.
inputs.
Lack
Lackofofconservatism.
conservatism.
Excessive
Excessiveincome
incomevolatility.
volatility.

2-32

Implications for Analysis


oo Focus on the balance sheet.
Focus on the balance sheet.
oo Restating income.
Restating income.
oo Analyzing use of inputs.
Analyzing use of inputs.
oo Analyzing financial liabilities.
Analyzing financial liabilities.

2-33

Accounting Analysis
Demand for Accounting Analysis
oo Adjust for accounting distortions so financial
Adjust for accounting distortions so financial

reports
reportsbetter
betterreflect
reflecteconomic
economicreality
reality

oo Adjust general-purpose financial statements to


Adjust general-purpose financial statements to

meet
meetspecific
specificanalysis
analysisobjectives
objectivesof
ofaaparticular
particular
user
user

2-34

Accounting Analysis
Sources of Accounting Distortions
Accounting
AccountingStandards
Standardsattributed
attributedtoto
1)
political
1)
politicalprocess
processofofstandard-setting,
standard-setting,
2)
accounting
2)
accountingprinciples
principlesand
andassumptions,
assumptions,and
and
3)
conservatism
3)
conservatism
o Estimation Errors attributed to estimation errors inherent in accrual
o Estimation Errors attributed to estimation errors inherent in accrual
accounting
accounting
o Reliability vs Relevance attributed to over-emphasis on reliability at
o Reliability vs Relevance attributed to over-emphasis on reliability at
the
theloss
lossofofrelevance
relevance
o Earnings Management attributed to window-dressing of financial
o Earnings Management attributed to window-dressing of financial
statements
statementsby
bymanagers
managerstotoachieve
achievepersonal
personalbenefits
benefits
o

2-35

Accounting Analysis
Analysis Objectives
Comparatives
ComparativesAnalysis
Analysisdemand
demandfor
forfinancial
financialcomparisons
comparisons
across
time
acrosscompanies
companiesand/or
and/oracross
across
time
o Income Measurement - demand for (1) equity wealth
o Income Measurement - demand for (1) equity wealth
changes
changesand
and(2)
(2)measure
measureofof
earning
tototwo
earningpower.
power.These
Thesecorrespond
correspond
twoalternative
alternative
income
concepts
income
concepts
(1)
(1)Economic
EconomicIncome
Income(or
(or
empirically,
empirically,economic
economicprofit)
profit)
(2)
(2)Permanent
PermanentIncome
Income(or
(or
empirically,
empirically,sustainable
sustainableprofit)
profit)
o

2-36

Accounting Analysis
Earnings Management Frequent Source of Distortion
Earning
EarningManagement
Managementstrategies:
strategies:

Increasing
IncreasingIncome
Incomemanagers
managersadjust
adjustaccruals
accrualstotoincrease
increase
reported
reportedincome
income
o Big Bath managers record huge write-offs in one period to
o Big Bath managers record huge write-offs in one period to
relieve
relieveother
otherperiods
periodsofofexpenses
expenses
o Income Smoothing managers decrease or increase reported
o Income Smoothing managers decrease or increase reported
income
incometotoreduce
reduceits
itsvolatility
volatility
o
o

2-37

Accounting Analysis
Earnings Management Motivations
Contracting
ContractingIncentives
Incentives- - managers
managersadjust
adjustnumbers
numbersused
usedinin
contracts
contractsthat
thataffect
affecttheir
theirwealth
wealth(e.g.,
(e.g.,compensation
compensationcontracts)
contracts)
o Stock Prices managers adjust numbers to influence stock
o Stock Prices managers adjust numbers to influence stock
prices
pricesfor
forpersonal
personalbenefits
benefits(e.g.,
(e.g.,mergers,
mergers,option
optionororstock
stock
offering)
offering)
o Other Reasons - managers adjust numbers to impact
o Other Reasons - managers adjust numbers to impact
1) labor demands,
1) labor demands,
2) management changes, and
2) management changes, and
3) societal views
3) societal views
o
o

2-38

Accounting Analysis
Earnings Management Mechanics
o

Incoming Shifting:
Accelerate or delay recognition of revenues or expenses to
shift income from one period to another

Classificatory Earnings Management:


Selectively classify revenues Earnings and expenses in
certain parts Management of the income statement to affect
analysis inferences regarding the recurring nature of these
items

2-39

Accounting Analysis
Process of Accounting Analysis
Accounting
Accountinganalysis
analysisinvolves
involvesseveral
severalinter-related
inter-relatedprocesses
processesand
and
tasks
tasksthat
thatcan
canbe
begrouped
groupedinto
intotwo
twobroad
broadareas:
areas:
ooEvaluating Earning Quality: Steps
Evaluating Earning Quality: Steps
1)
1)
2)
2)
3)
3)
4)
4)

Identify
Identifyand
andassess
assesskey
keyaccounting
accountingpolicies
policies
Evaluate
Evaluateextent
extentofofaccounting
accountingflexibility
flexibility
Determine
Determinethe
thereporting
reportingstrategy
strategy
Identify
Identifyand
andassess
assessred
redflags
flags

oAdjusting
AdjustingFinancial
FinancialStatements:
Statements:

Identify,
Identify,measure,
measure,and
andmake
makenecessary
necessaryadjustments
adjustmentstotofinancial
financial
statements
to
better
serve
ones
analysis
objectives;
statements to better serve ones analysis objectives;

Chapters
Chapters3-6
3-6focus
focuson
onadjusting
adjusting(recasting)
(recasting)the
thestatements
statements

2-40

Auditing And Financial Statement Analysis