Accounting Analysis Pitfalls

0

There are several potential pitfalls in accounting analysis that an analyst should avoid. First, it is important to remember that from an analyst’s perspective, conservative accounting is not the same as “good” accounting. Financial analysts are interested in evaluating how well a firm’s accounting captures business reality in an unbiased manner, and conservative accounting can be as misleading as aggressive accounting in this respect.

Further, conservative accounting often provides managers with opportunities for “income smoothing.” Income smoothing may prevent analysts from recognizing poor performance in a timely fashion. A second potential mistake is to confuse unusual accounting with questionable accounting. While unusual accounting choices might make a firm’s performance difficult to compare with other firms’ performance, such an accounting choice might be justified if the company’s business is unusual. For example, firms that follow differentiated strategies or firms that structure their business in an innovative manner to take advantage of particular market situations may make unusual accounting choices to properly reflect their business. Therefore, it is important to evaluate a company’s accounting choices in the context of its business strategy. Another potential pitfall in accounting analysis arises when an analyst attributes all changes in a firm’s accounting policies and accruals to earnings management motives.

Accounting changes might be merely reflecting changed business circumstances. For example, as already discussed, a firm that shows unusual increases in its inventory might be preparing for a new product introduction. Similarly, unusual increases in receivables might merely be due to changes in a firm’s sales strategy. Unusual decreases in the allowance for uncollectible receivables might be reflecting a firm’s changed customer focus. It is therefore important for an analyst to consider all possible explanations for accounting changes and investigate them using the qualitative information available in a firm’s financial statements.

Step 6: Undo Accounting Distortions

0

If the accounting analysis suggests that the firm’s reported numbers are misleading, analysts should attempt to restate the reported numbers to reduce the distortion to the extent possible. It is, of course, virtually impossible to undo all the distortion using out-side information alone. However, some progress can be made in this direction by using the cash flow statement and the financial statement footnotes.

A firm’s cash flow statement provides a reconciliation of its performance based on accrual accounting and cash accounting. If the analyst is unsure of the quality of the firm’s accrual accounting, the cash flow statement provides an alternative benchmark of its performance. The cash flow statement also provides information on how individual line items in the income statement diverge from the underlying cash flows.

For example, if an analyst is concerned that the firm is aggressively capitalizing certain costs that should be expensed, the information in the cash flow statement provides a basis to make the necessary adjustment. Financial statement footnotes also provide a lot of information that is potentially useful in restating reported accounting numbers.

For example, when a firm changes its ac-counting policies, it provides a footnote indicating the effect of that change if it is material. Similarly, some firms provide information on the details of accrual estimates such as the allowance for bad debts. The tax footnote usually provides information on the differences between a firm’s accounting policies for shareholder reporting and tax reporting. Since tax reporting is often more conservative than shareholder reporting, the information in the tax footnote can be used to estimate what the earnings reported to shareholders would be under more conservative policies.

Step 5: Identify Potential Red Flags

0

In addition to the above analysis, a common approach to accounting quality analysis is to look for “red flags” pointing to questionable accounting quality. These indicators suggest that the analyst should examine certain items more closely or gather more information on them. Some common red flags are:

  • Unexplained changes in accounting, especially when performance is poor.

This may suggest that managers are using their accounting discretion to “dress up” their financial statements.

  • Unexplained transactions that boost profits.

For example, firms might undertake balance sheet transactions, such as asset sales or debt for equity swaps, to realize gains in periods when operating performance is poor.

  • Unusual increases in accounts receivable in relation to sales increases.

This may suggest that the company might be relaxing its credit policies or artificially loading up its distribution channels to record revenues during the current period. If credit policies are relaxed unduly, the firm may face receivable write-offs in the subsequent periods as a result of customer defaults. If the firm accelerates shipments to the distribution channels, it may either face product returns or reduced shipments in the subsequent periods.

  • Unusual increases in inventories in relation to sales increases.

If the inventory build-up is due to an increase in finished goods inventory, it could be a sign that the demand for the firm’s products is slowing down, suggesting that the firm may be forced to cut prices (and hence earn lower margins) or write down its inventory. A build-up in work-in-progress inventory tends to be good news on average, probably signaling that managers expect an increase in sales. If the build-up is in raw materials, it could suggest manufacturing or procurement inefficiencies, leading to an increase in cost of goods sold (and hence lower margins).

  • An increasing gap between a firm’s reported income and its cash flow from operating activities.

While it is legitimate for accrual accounting numbers to differ from cash flows, there is usually a steady relationship between the two if the company’s accounting policies remain the same. Therefore, any change in the relationship between reported profits and operating cash flows might indicate subtle changes in the firm’s accrual estimates. For example, a firm undertaking large construction contracts might use the percentage-of-completion method to record revenues. While earnings and operating cash flows are likely to differ for such a firm, they should bear a steady relationship to each other. Now suppose the firm increases revenues in a period through an aggressive application of the percentage-of-completion method. Then its earnings will go up, but its cash flow remains unaffected. This change in the firm’s accounting quality will be manifested by a change in the relationship between the firm’s earnings and cash flows.

  • An increasing gap between a firm’s reported income and its tax income. Once again, it is quite legitimate for a firm to follow different accounting policies for financial reporting and tax accounting, as long as the tax law allows it.

How ever, the relationship between a firm’s book and tax accounting is likely to remain constant over time, unless there are significant changes in tax rules or accounting standards. Thus, an increasing gap between a firm’s reported income and its tax income may indicate that the firm’s financial reporting to shareholders has become more aggressive. As an example, consider that warranty expenses are estimated on an accrual basis for financial reporting, but are recorded on a cash basis for tax reporting. Unless there is a big change in the firm’s product quality, these two numbers beara consistent relationship to each other. Therefore, a change in this relationship can be an indication either that the product quality is changing significantly or that financial reporting estimates are changing.

  • A tendency to use financing mechanisms like research and development partner-ships and the sale of receivables with recourse.

While these arrangements may have a sound business logic, they can also provide management with an opportunity to understate the firm’s liabilities and/or overstate its assets.

  • Unexpected large asset write-offs.

This may suggest that management is slow to incorporate changing business circumstances into its accounting estimates. Asset write-offs may also be a result of unexpected changes in business circumstances.

  • Large fourth-quarter adjustments.

A firm’s annual reports are audited by the external auditors, but its interim financial statements are usually only reviewed. If a firm’s management is reluctant to make appropriate accounting estimates (such as provisions for uncollectible receivables) in its interim statements, it could be forced to make adjustments at the end of the year as a result of pressure from its external auditors. A consistent pattern of fourth quarter adjustments, therefore, may indicate an aggressive management orientation towards interim reporting.

  • Qualified audit opinions or changes in independent auditors that are not well justified.

These may indicate a firm’s aggressive attitude or a tendency to “opinion shop.”

  • Related-party transactions or transactions between related entities.

These transactions may lack the objectivity of the marketplace, and managers’ accounting estimates related to these transactions are likely to be more subjective and potentially self-serving. While the preceding list provides a number of red flags for potentially poor accounting quality, it is important to do further analysis before reaching final conclusions. Each of the red flags has multiple interpretations; some interpretations are based on sound business reasons, and others indicate questionable accounting. It is, therefore, best to use the red flag analysis as a starting point for further probing, not as an end point in itself.

Step 4: Evaluate the Quality of Disclosure

0

Managers can make it more or less easy for an analyst to assess the firm’s accounting quality and to use its financial statements to understand business reality. While accounting rules require a certain amount of minimum disclosure, managers have considerable choice in the matter. Disclosure quality, therefore, is an important dimension of a firm’s accounting quality. In assessing a firm’s disclosure quality, an analyst could ask the following questions:

  • Does the company provide adequate disclosures to assess the firm’s business strategy and its economic consequences? For example, some firms use the Letter to the Shareholders in their annual report to clearly lay out the firm’s industry conditions, its competitive position, and management’s plans for the future. Others use the Letter to puff up the firm’s financial performance and gloss over any competitive difficulties the firm might be facing.
  • Do the footnotes adequately explain the key accounting policies and assumptions and their logic? For example, if a firm’s revenue and expense recognition policies differ from industry norms, the firm can explain its choices in a footnote. Similarly, when there are significant changes in a firm’s policies, footnotes can be used to disclose the reasons.
  • Does the firm adequately explain its current performance? The Management Discussion and Analysis section of the firm’s annual report provides an opportunity to help analysts understand the reasons behind the firm’s performance changes. Some firms use this section to link financial performance to business conditions. For example, if profit margins went down in a period, was it because of price competition or because of increases in manufacturing costs? If the selling and general administrative expenses went up, was it because the firm is investing in a differentiation strategy, or because unproductive overhead expenses were creeping up?
  • If accounting rules and conventions restrict the firm from measuring its key success factors appropriately, does the firm provide adequate additional disclosure to help outsiders understand how these factors are being managed? For example, if a firm invests in product quality and customer service, accounting rules do not allow the management to capitalize these outlays, even when the future benefits are certain. The firm’s Management Discussion and Analysis can be used to highlight how these outlays are being managed and their performance consequences. For example, the firm can disclose physical indexes of defect rates and customer satisfaction so that outsiders can assess the progress being made in these areas and the future cash flow consequences of these actions.
  • If a firm is in multiple business segments, what is the quality of segment disclosure? Some firms provide excellent discussion of their performance by product segments and geographic segments. Others lump many different businesses into one broad segment. The level of competition in an industry and management’s willingness to share desegregated performance data influence a firm’s quality of segment disclosure.
  • How forthcoming is the management with respect to bad news? A firm’s disclosure quality is most clearly revealed by the way management deals with bad news. Does it adequately explain the reasons for poor performance? Does the company clearly articulate its strategy, if any, to address the company’s performance problems?
  • How good is the firm’s investor relations program? Does the firm provide fact books with detailed data on the firm’s business and performance? Is the management accessible to analysts?

Step 3: Evaluate Accounting Strategy

0

When managers have accounting flexibility, they can use it either to communicate their firm’s economic situation or to hide true performance. Some of the strategy questions one could ask in examining how managers exercise their accounting flexibility include the following:

  • How do the firm’s accounting policies compare to the norms in the industry? If they are dissimilar, is it because the firm’s competitive strategy is unique? For example, consider a firm that reports a lower warranty allowance than the industry average. One explanation is that the firm competes on the basis of high quality and has in-vested considerable resources to reduce the rate of product failure. An alternative explanation is that the firm is merely understating its warranty liabilities.
  • Does management face strong incentives to use accounting discretion for earnings management? For example, is the firm close to violating bond covenants? Or, are the managers having difficulty meeting accounting-based bonus targets? Does management own significant stock? Is the firm in the middle of a proxy fight or union negotiations? Managers may also make accounting decisions to reduce tax payments, or to influence the perceptions of the firm’s competitors.
  • Has the firm changed any of its policies or estimates? What is the justification? What is the impact of these changes? For example, if warranty expenses decreased, is it because the firm made significant investments to improve quality?
  • Have the company’s policies and estimates been realistic in the past? For example, firms may overstate their revenues and understate their expenses during the year by manipulating quarterly reports, which are not subject to a full-blown external audit. However, the auditing process at the end of the fiscal year forces such companies to make large fourth-quarter adjustments, providing an opportunity for the analyst to assess the quality of the firm’s interim reporting. Similarly, firms that expense acquisition goodwill too slowly will be forced to take a large write-off later. A history of write-offs may be, therefore, a sign of prior earnings management.
  • Does the firm structure any significant business transactions so that it can achieve certain accounting objectives? For example, leasing firms can alter lease terms (the length of the lease or the bargain purchase option at the end of the lease term) so that the transactions qualify as sales-type leases for the lessors. Firms may structure a takeover transaction (equity financing rather than debt financing) so that they can use the pooling of interests method rather than the purchase method of accounting. Finally, a firm can alter the way it finances (coupon rate and the terms of conversion for a convertible bond issue) so that its reported earnings per share is not diluted. Such behavior may suggest that the firm’s managers are willing to expend economic resources merely to achieve an accounting objective.

Step 2: Assess Accounting Flexibility

0

Not all firms have equal flexibility in choosing their key accounting policies and estimates. Some firms’ accounting choice is severely constrained by accounting standards and conventions. For example, even though research and development is a key success factor for biotechnology companies, managers have no accounting discretion in reporting on this activity. Similarly, even though marketing and brand building are key to the success of consumer goods firms, they are required to expense all their marketing out-lays. In contrast, managing credit risk is one of the critical success factors for banks, and bank managers have the freedom to estimate expected defaults on their loans. Similarly, software developers have the flexibility to decide at what points in their development cycles the outlays can be capitalized.

If managers have little flexibility in choosing accounting policies and estimates related to their key success factors (as in the case of biotechnology firms), accounting data are likely to be less informative for understanding the firm’s economics. In contrast, if managers have considerable flexibility in choosing the policies and estimates (as in the case of software developers), accounting numbers have the potential to be informative, depending upon how managers exercise this flexibility. Regardless of the degree of accounting flexibility a firm’s managers have in measuring their key success factors and risks, they will have some flexibility with respect to several other accounting policies.

For example, all firms have to make choices with respect to depreciation policy (straight-line or accelerated methods), inventory accounting policy (LIFO,FIFO, or Average Cost), policy for amortizing goodwill (write-off over forty years or less), and policies regarding the estimation of pension and other post employment benefits (expected return on plan assets, discount rate for liabilities, and rate of increase in wages and health care costs). Since all these policy choices can have a significant impact on the reported performance of a firm, they offer an opportunity for the firm to manage its reported numbers.

Step 1: Identify Key Accounting Policies

0

A firm’s industry characteristics and its own competitive strategy determine its key success factors and risks. One of the goals of financial statement analysis is to evaluate how well these success factors and risks are being managed by the firm. In accounting analysis, therefore, the analyst should identify and evaluate the policies and the estimates the firm uses to measure its critical factors and risks. For example, one of the key success factors in the leasing business is to make accurate forecasts of residual values of the leased equipment at the end of the lease terms. For a firm in the equipment leasing industry, therefore, one of the most important accounting policies is the way residual values are recorded. Residual values influence the company’s reported profits and its asset base. If residual values are overestimated, the firm runs the risk of having to take large write-offs in the future.

Key success factors in the banking industry include interest and credit risk management; in the retail industry, inventory management is a key success factor; and for a manufacturer competing on product quality and innovation, research and development and product defects after the sale are key areas of concern. In each of these cases, the analyst has to identify the accounting measures the firm uses to capture these business constructs, the policies that determine how the measures are implemented, and the key estimates embedded in these policies. For example, the accounting measure a bank uses to capture credit risk is its loan loss reserves, and the accounting measure that captures product quality for a manufacturer is its warranty expenses and reserves.

Steps for Doing Accounting Analysis

0

Now we will discuss one by one a series of steps that an analyst can follow to evaluate a firm’s accounting quality.

Step 1: Identify Key Accounting Policies

Step 2: Assess Accounting Flexibility

Step 3: Evaluate Accounting Strategy

Step 4: Evaluate the Quality of Disclosure

Step 5: Identify Potential Red Flags

Step 6: Undo Accounting Distortions

Legal Liability

0

The legal environment in which accounting disputes between managers, auditors, and investors are adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and resulting penalties have the beneficial effect of improving the accuracy of disclosure.

However, the potential for a significant legal liability might also discourage managers and auditors from supporting accounting proposals requiring risky forecasts, such as forward looking disclosures. This type of concern is of-ten expressed by the auditing community in the U.S.

Factors Influencing Accounting Quality

0

There are three potential sources of noise and bias in accounting data:

  1. the noise and bias introduced by rigidity in accounting rules
  2. random forecast errors
  3. systematic reporting choices made by corporate managers to achieve specific objectives

Each of these factors is discussed below.

ACCOUNTING RULES: Accounting rules introduce noise and bias because it is often difficult to restrict management discretion without reducing the information content of accounting data. For example, the Statement of Financial Accounting Standards No. 2 issued by the FASB  requires firms to expense research outlays when they are incurred. Clearly, some research expenditures have future value while others do not. However, because SFAS  No. 2 does not allow firms to distinguish between the two types of expenditures, it leads to a systematic distortion of reported accounting numbers. Broadly speaking, the degree of distortion introduced by accounting standards depends on howwell uniform accounting standards capture the nature of a firm’s transactions.

FORECAST ERRORS: Another source of noise in accounting data arises from pure forecast error, because managers cannot predict future consequences of current transactions perfectly. For example, when a firm sells products on credit, accrual accounting requires managers to make a judgment on the probability of collecting payments from customers. If payments are deemed “reasonably certain,” the firm treats the transactions as sales, creating accounts receivable on its balance sheet. Managers then make an estimate of the proportion of receivables that will not be collected. Because managers do not have perfect foresight, actual defaults are likely to be different from estimated customer defaults, leading to a forecast error. The extent of errors in managers’ accounting forecasts depends on a variety of factors, including the complexity of the business transactions, the predictability of the firm’s environment, and unforeseen economy-wide changes.

MANAGERS’ ACCOUNTING CHOICES: Corporate managers also introduce noise and bias into accounting data through their own accounting decisions. Managers have a variety of incentives to exercise their accounting discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting:

Accounting-based debt covenants: Managers may make accounting decisions to meet certain contractual obligations in their debt covenants. For example, firms lending agreements with banks and other debt holders require them to meet covenants related to interest coverage, working capital ratios, and net worth, all defined in terms of accounting numbers. Violation of these constraints may be costly be-cause it allows lenders to demand immediate payment of their loans. Managers of firms close to violating debt covenants have an incentive to select accounting policies and estimates to reduce the probability of covenant violation. The debt covenant motivation for managers’ accounting decisions has been analyzed by a number of accounting researchers.

Management compensation: Another motivation for managers’ accounting choice comes from the fact that their compensation and job security are often tied to re-ported profits. For example, many top managers receive bonus compensation if they exceed certain pre specified profit targets. This provides motivation for managers to choose accounting policies and estimates to maximize their expected compensation.

Corporate control contests:  In corporate control contests, including hostile takeovers and proxy fights, competing management groups attempt to win over the firm’s shareholders. Accounting numbers are used extensively in debating managers’ performance in these contests. Therefore, managers may make accounting decisions to influence investor perceptions in corporate control contests.

Tax considerations: Managers may also make reporting choices to trade off between financial reporting and tax considerations. For example, U.S. firms are required to use LIFO  inventory accounting for shareholder reporting in order to use it for tax reporting. Under LIFO, when prices are rising, firms report lower profits, thereby reducing tax payments. Some firms may forgo the tax reduction in order to report higher profits in their financial statements.

Regulatory considerations:  Since accounting numbers are used by regulators in a variety of contexts, managers of some firms may make accounting decisions to influence regulatory outcomes. Examples of regulatory situations where accounting numbers are used include antitrust actions, import tariffs to protect domestic industries, and tax policies.

• Capital market considerations:  Managers may make accounting decisions to influence the perceptions of capital markets. When there are information asymmetries between managers and outsiders, this strategy may succeed in influencing investor perceptions, at least temporarily.

• Stakeholder considerations: Managers may also make accounting decisions to influence the perception of important stakeholders in the firm. For example, since labor unions can use healthy profits as a basis for demanding wage increases, managers may make accounting decisions to decrease income when they are facing union contract negotiations. In countries like Germany, where labor unions are strong, these considerations appear to play an important role in firms’ accounting policy. Other important stakeholders that firms may wish to influence through their financial reports include suppliers and customers.

• Competitive considerations: The dynamics of competition in an industry might also influence a firm’s reporting choices. For example, a firm’s segment disclosure decisions may be influenced by its concern that disaggregated disclosure may help competitors in their business decisions. Similarly, firms may not disclose data on their margins by product line for fear of giving away proprietary information. Finally, firms may discourage new entrants by making income-decreasing accounting choices.

Log in