Step 6: Undo Accounting Distortions

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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.

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