Financial Statement Analysis Acct 592 July 10, 2003
Chapter 4 Relevant Financial Statement Data for Analysis
Why Data May be Incomparable • Sustainability, measurement, or manageability of reported earnings may be at issue* • Previous years are restated in the current year • Items are classified in different ways across firms • Statements are prepared for different time periods across firms • Accounting principles differ across countries* * Indicates most problematic issues
Earnings Quality • Underlying reported earnings is the assumption that it represents a reasonably accurate measure of the economic value-added by the firm during the reporting period and the economic value likely to be added in future periods. • The correlation between earnings and EVA may be compromised by these factors: • Inclusion in reported earnings of nonrecurring items • Inadequacy of accounting systems to measure EVA from operations accurately and reliably • The opportunity to manage or manipulate the level or trend of reported earnings
Earnings Sustainability – 8 categories of financial disclosures used to judge • Discontinued Operations • Extraordinary Gains and Losses • Changes in Accounting Principles • Impairment on Long-Lived Assets • question: where shown?
Earnings Sustainability Factors (con’t) • Restructuring Charges • Changes in Estimates • Gains and Losses from Peripheral Operations • Management Discussion and Analysis
Earnings Sustainability • Comprehensive Income “Income” shown in Stockholders’ Equity • As compared with “Income” shown on the Income Statement • How do Intangible Assets impact Earnings?
Earnings Management • Choices, judgments, and estimates • Distinction between management within bounds of GAAP and fraud is often thin • Why manage? • Earnings smoothing • Compensation incentives • Job security incentives • Can’t “manage” forever • Capital markets penalize “extreme” managers
3 Basic Ways to Manage • Selection of accounting principles • Application of accounting principles • Timing of asset acquisitions and dispositions • Violations observed often involve revenue recognition and shifting of expenditures.