Seminar 04 - 1 Accounting Analysis Seminar 4 2 Analysis of...

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Unformatted text preview: 1 Accounting Analysis Seminar 4 2 Analysis of Operating Activities (Income) Seminar 4 Seminar 4 1. Financial Statements Reflect Business Activities 2. Limitations of Financial Statements 3. Accrual Accounting 4. Overview and Implementation of Accounting Analysis 1. Undo Accounting Distortions Earnings Management and Red Flag Indicators 2. Earnings Persistence Recasting and Adjusting Financial Statements 1. Income measures Definitions of accounting income: Core income, Continuing income, Net income and Comprehensive income 3 1. UNDO ACCOUNTING DISTORTIONS: EARNINGS MANAGEMENT & RED FLAG INDICATORS 4 Earnings Management (EM) EM can be defined as purposeful intervention by management in the earnings determination process, usually to satisfy selfish objectives K. Schipper (1989) Strategies ( what do I want? ) Increase income , Big Bath relieve other period expenses , Income Smoothing reduce volatility Motivations ( why am I doing it? ) Contracting Incentives, Stock Price Effects, Political reasons 5 Earnings Management (EM) Mechanics ( how can I do it? ) Income Shifting accelerate or delay recognition of revenues or expenses to shift income from one period to another Classificatory EM selectively classify revenues and expenses to affect analysis inferences such as reclassify as many recurring expenses into non-recurring charge and report higher recurring or future pro forma earnings 6 Earnings Management & Red Flags Look for red flag indicators cash flow statement source of information on accruals footnotes contingent liabilities note, related-party note, and note relating to equity investments, unconsolidated investments and operational plans 7 The Cash Flow Statement is a Source of Information on Accruals Sales Quality diagnostics Compare changes in net accounts receivable with changes in sales Compare changes in unearned revenue and warranty liabilities with changes in sales Compare changes in prepaid expenses with changes in sales Compare changes in accrued expenses with changes in sales Restructuring charges Track restructuring charges and their reversals 8 9 Some Red Flags Using different accounting methods or estimates than the industry Unexplained changes in methods, estimates Big gap between Net Income (NI) and Cash Flow from Operation (CFO) Unusual income-boosting transactions Related-party transactions Change in auditor ( not earnings management) Paid attention to assets and liabilities that require the most estimation Poor overall disclosure 10 Institutional Situations where Manipulation is More Likely The firm is in the process of raising capital or renegotiating borrowing. Watch public offerings Debt covenants are likely to be violated Unexplained changes in accounting, especially when performance is poor (dress up financial statements) Poor performance & prove to turn around An increasing gap between a firms reported income...
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Seminar 04 - 1 Accounting Analysis Seminar 4 2 Analysis of...

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