Chapter 5 - Chapter 5: Essentials of Financial Statement...

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Unformatted text preview: Chapter 5: Essentials of Financial Statement Analysis Learning objectives 1. Essentials of financial statement analysis, financial statement analysis tools and approaches. 2. How ROA is used to analyze profitability and the insight to separate ROA to profit margin and asset turnover rate. 3. How ROA and financial leverage combine to determine a firms return on equity (ROCE). 5-1 Learning objectives (contd.) 3. Capital structure and credit risk: How short-term liquidity risk and long-term solvency risk are assessed and how to use the statement of cash flows to assess credit risk. 4. Why do companies issue pro forma earnings? 5-2 Qualitative Characteristics of Accounting Information: How do we define financial reporting quality? Qualitative characteristics of accounting Information: Understandability Decision usefulness Reliability Relevance Consistency Comparability 3 Attributes of High Quality Financial Reporting Financial reporting (earnings) quality has been considered positively associated with the following: High persistence of earnings and cash flows High predictive ability of earnings and cash flows High earnings response coefficient Low level of earnings management More voluntarily disclosure Strong corporate governance 4 Manipulating Income and Earnings Management Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1 Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the companys underlying performance . Most managers prefer to report earnings that follow a smooth, regular, upward path. 2 1. Arthur Levitt, former SEC chairman. 2. Bethany McLean, Hocus-Pocus: How IBM Grew 27% a Year, Fortune , June 26, 2000, p. 168. 5 What should the users be aware of ? Statement users must: Understand current financial reporting settings and standards. Recognize that management may manipulate the financial information. Distinguish between reliable financial statement information and poor quality information. 6 Financial statement analysis and accounting quality The accounting distortions need to be watched when analyzing statements. Examples include: 1. Nonrecurring gains and losses 2. Differences in accounting methods. 3. Differences in accounting estimates. 4. GAAP implementation differences. 5. Historical cost convention. 7 Learning Objective: Essentials of Financial Statement Analysis 8 Analysis, Forecast and Vulation Procedure s Reviewing the Financial Statements: Review comparative financial statements and audit opinion....
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Chapter 5 - Chapter 5: Essentials of Financial Statement...

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