TOPICS FOR THE SESSION

 Accounting analysis

 Discussion problem: Does it matter?

 Framework for accounting analysis

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 Accounting analysis

II. S4. Discussion problem. Does it really matter?

The accounts were randomly selected according to the following criteria:

pair of firms with very similar reported numbers

Which firm would you prefer: A or B? And why?

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 Accounting analysis

The importance of accounting analysis

 Accounting practices govern the reporting and disclosures of the financial statements.
Understanding accounting allows the business analyst to effectively use the financial
information disclosed by companies.

 Accounting analysis consists of:

o Accounting quality analysis
o Accounting adjustments

 Three potential factors affecting accounting quality:

1. Noise from rigidity of accounting rules
2. Random forecast errors
3. Systematic reporting choices made by manager to achieve specific objectives

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 Accounting analysis

1. Rigidity from accounting rules

Examples:
• Accounting for R&D
• Accounting for brand, marketing expenses
• Accounting for PPE – revaluation method
• Accounting for financial instruments

2. Noise from random forecast errors

• Impairments related to PPE, inventories,…
• Customer defaults
• Estimates of used warranties

3. Manager’s choices
Managers have various incentives to bias accounting disclosures:
• Debt covenants (based on eg., interest coverage, working capital ratios,…)
• Compensation contracts (based on pre-specified performance targets
• Tax and/or regulatory considerations (based on accounting numbers)

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 Performing accounting analysis

 1. Identify principal accounting policies and assess accounting flexibility

 2. Evaluate accounting strategy and quality of disclosure

 3. Identify potential red flags

 4. Undo accounting distortions and adjust financial statements

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 Steps in performing accounting analysis

Step 1: Identify principal accounting areas and estimates and assess flexibility

• Main accounting areas and estimates are disclosed in the annual reports and are
closely related to the main business activities and risks

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 Steps in performing accounting analysis

Applying to Carnival Corporation

Carnival Corporation is a British-American cruise company and the world's largest travel leisure company.
It operates a fleet of cruise ships under various brand names, including Carnival Cruise Line, Princess
Cruises, Holland America Line, and others. Carnival Corporation offers vacation experiences to millions of
passengers each year, with destinations all around the world.
Source: ChatGPT

Source: PHP, 5th ed. Page 81

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 Steps in performing accounting analysis

 Identify flexibility within accounting policies, i.e., identify the choices made by
management assess the impact of these choices on the financial statements

Source: PHP, 5th ed. Page 82

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 Steps in performing accounting analysis

Industry Examples of key accounting areas (and estimates)

- Revenue (% bundles of products and services, % of miles that will be
Air Transportation used,...)
- PPE (depreciation rates, % residual values)
- Revenue (accounting for discounts, returns estimates, warranty
Automobiles expenses)
- PPE (depreciation rates, % residual values)
- Inventory (impairments rates)
Retail
- PPE (depreciation rates, % residual values)
- R&D (% capitalized vs expensed)
Life Sciences & Pharma
- Intangible (GW impairments)
- Inventory (impairments rates)
Consumer Goods
- PPE (depreciation rates, % residual values)
- R&D (% capitalized vs expensed)
Telecoms&IT '- Revenue (% bundles of products and services, % of points that will be
used,...)
- Revenue (accounting for on-demand services /subscription based
Media&Entertainment revenue
- R&D versus intangibles (content developed versus content acquired)

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 Steps in performing accounting analysis

Step 2: Evaluate accounting strategy and quality of disclosure

 Flexibility in accounting choices allows managers to strategically communicate economic
information or hide true performance
 Issues to consider include:
• Comparison of accounting policies with industry peers
Eg: why does the firm have lower impairments rates than the industry average? Due to better
risk control procedures? Different markets – lower risk profile customers? Does the firm explain
why it is different from the industry?

• Incentives for managers to manage earnings

Is the firm close to debt covenant violation? Having difficulties in meeting analyst forecast or
accounting based bonus? Does management own significant amount of shares?

• Changes in policies and estimates and the rationale for doing so

Has the firm changed any of the policies or estimates? Does it provide a justification? Does it
provide the impact of such change?

• Do disclosures seem adequate

Is it possible to assess the firm’s business strategy and its economic consequences from the
disclosures? Are there notes explaining the key accounting policies and assumptions and their
logic? Does Management Report section sufficiently explain and is consistent with current
performance?

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 Steps in performing accounting analysis

Step 3: Identify potential red flags

Some issues that warrant gathering more information include:

• Unusual increases in inventory or A/R in relation to sales
• Increases in the gap between net profit and cash flows or tax profit
• Unexpected large asset write-offs
• Large year-end adjustments
• Qualified audit opinions or auditor changes.

Step 4: Synthesize risks and undo accounting distortions

• Synthesize all information, often in a subjective and qualitative manner, to assess
accounting quality.
• Use information from the financial statements statement and notes to the financial
statements to (possibly imperfectly) undo distortions.

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Steps in performing accounting analysis

Applying to Apple
• From MD&A of Form 10-K:
– Revenue Recognition
• Key area is the deferral of revenue on multi-element arrangements relating to “future
unspecified software upgrades”. Revenue is deferred and amortized on a straight-line basis.
– Valuation of Marketable Securities
• All carried at fair value and categorized as Level 1 and 2. No big concerns here.
– Inventory Valuation
• Inventory obsolescence is a concern. No indication of allowance on inventory. Note that
while inventory balance is relatively small at $4.9B, the ‘vendor non-trade receivables’
balance of $17.8B and off-balance sheet manufacturing ‘purchase obligations’ of 37.6B
expose the company to inventory risk.
– Warranty Costs
• Seem reasonable, given no evidence of recent reduction in quality/increase is failure rates.
– Income Taxes
• Key issue here is the lower tax rate applied to indefinitely reinvested earnings of foreign subs
and the deferred tax liability on unremitted earnings of foreign subs (see Note 5 on pp. 55-56)
– Legal Contingencies
• From Note 1
– ‘Research & Development Costs’ and ‘Advertising Costs’
• These are expensed as incurred, consistent with GAAP, but conservative from an economic
perspective.
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 Steps in performing accounting analysis

Applying to Apple

• Identify one example of an economic asset or liability of Apple’s that is missing from
Apple’s balance sheet or is carried on Apple’s balance at a value that differs significantly
from its true economic value.

• Do you think that Apple’s reported earnings are a good reflection of Apple’s underlying
economic performance? Briefly explain your answer.

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Steps in performing accounting analysis

Applying to Apple

• Identify one example of an economic asset or liability of Apple’s that is missing

from Apple’s balance sheet or is carried on Apple’s balance at a value that
differs significantly from its true economic value.
- Obvious examples here are the intangible assets created by past investments in R&D
and advertising. These amounts have been expensed as incurred by Apple and so
are missing from the balance sheet.

• Apple’s reported earnings are a reasonable reflection of underlying economic

performance. Potential distortions include:
– Excessive deferral of revenue for unspecified future software upgrades
– Immediate expensing of R&D and advertising costs that are investments and are
expected to yield future economic benefits
– Uncertainty concerning the taxes obligation on foreign earnings
– Lack of any reserve for obsolescence on inventory and purchase obligations

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 Accounting analysis

Extra materials

• Example of the accounting analysis’ framework used by Moody’s

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 Accounting analysis

Source: https://www.moodys.com

Adjustments :
• To make FS more comparable

• To include own assumptions

• Even when numbers are complying with

accounting rules

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Accounting analysis

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Accounting analysis

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Accounting analysis

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Accounting analysis

Accounting analysis
 Why? “To make things comparable”
• Assess appropriateness of firm’s accounting policies and estimates to capture its
underlying business reality;

• Identify accounting flexibility within the choosen accounting policies;

• Assess level of distortion of accounting numbers and undo accounting distortions;

 How? Based on the info collected in the strategy analysis:

• Read notes to understand what accounting standards (IFRS, US GAAP) have been
used, what accounting choices have been done (when is revenue recognized), what
operating decisions have been made that affect reported FS (leasing versus purchasing
equipment)?

• Assess whether the accounting choices and standards are the best to reflect the economics

• Prepare adjusted financial statements (after standardization), if needed, to be used for ratio
analysis purpose

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 Next class

Preparation, deliveries and deadlines:

 Prepare Exercise 2
This exercise corresponds to Step 4 – undoing of the accounting distortions.
Each of you should prepare the exercise and be ready to answer questions with the
rationale of the exercise during the next class.

Computations related to Exercise 2 available on Moodle.

Videos for each case (A – F) explaining the computations are available on

Moodle.

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes