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Transcript of Accounting Analysis
Step 1: Identify Key Accounting Policies
For example, key success factors in banking industry are interest and credit risk management, for the manufacturing industry are R&D and product innovation.
Step 2: Assess Accounting Flexibility
Different firms operate on different degrees of accounting flexibility.
Firms’ accounting freedom may be constrained by accounting conventions.
For example, R&D although is a success factor for biotech firms, it is not permitted to be shown on the accounting statements, similarly marketing expenditure for retail firms.
Step 3: Evaluate Accounting Strategy
The accounting strategies of a firm can be evaluated by answering the following questions:
How do the firm’s accounting policies compare to the norms in the industry? If they are dissimilar, is it because the firm’s competitive strategy is unique?
Has the firm changed any of its policies or estimates? What is the justification? What is the impact of these changes?
Step 5: Analysis of Red Flags
Red Flags point to questionable accounting quality. These indicators suggest that the analyst should examine certain items more closely or gather more information on them. Some common red flags are:
Unexplained changes in accounting, especially when performance is poor.
Unexplained transactions that boost profits.
Unusual increases in accounts receivable in relation to sales increases.
Unusual increases in inventories in relation to sales increases.
An increasing gap between a firm’s reported income and its cash flow from operating activities.
An increasing gap between a firm’s reported income and its tax income.
Unexpected large asset write-offs.
Large fourth-quarter adjustments.
Step 6: Undo Accounting Distortions
A firm’s cash flow statement provides a reconciliation of its performance based on accrual accounting and cash accounting.
Financial statement footnotes also provide a lot of information that is potentially useful in restating reported accounting numbers.
The tax footnote usually provides information on the differences between a firm’s accounting policies for shareholder reporting and tax reporting.
It enables an analyst to assess the degree of distortion in a firm's financial statements and possibly undo any accounting distortions by recasting the firm's accounting numbers.
Accounting analysis is done to evaluate the degree to which a firm's accounting captures the underlying economic reality.
The goal of accounting analysis is to identify key accounting policies that show and measure the success and risk factors that affect a firm with maximum accuracy.
Step 4: Evaluate the Quality of Disclosure
Analysts can evaluate this by answering the following questions :
Does the company provide adequate disclosures to assess the firm’s business strategy and its economic consequences?
Do the footnotes adequately explain the key accounting policies and assumptions and their logic?
If accounting rules and conventions restrict the firm from measuring its key success factors appropriately, does the firm provide adequate additional disclosure to help outsiders understand how these factors are being managed?