Overview of accounting analysis Essay
1. A finance student states, “I don’t understand why anyone pays any attention to accounting earnings numbers, given that a ‘clean’ number like cash from operations is readily available.” Do you agree? Why or why not?
I disagree with the finance student, because net income forecasts future cash flow and is informative.
a. Net income forecasts future cash flow better than current cash flow, and does so by recording transactions associated with cash consequences when the transactions occur, rather than when the cash is received or paid. To compute net income, the effects of economic transactions are recorded on the basis of expected, not necessarily actual, cash receipts and payments.
b. Net income is informative when corporate managers have better information than outside investors. Corporate managers use accrual rather than cash accounting to prepare financial reporting and determine net income. Since accrual accounting helps managers to record past events and forecast future events, net income gives superior information.
2. Fred argues: “The standards that I like most are the ones that eliminate all management discretion in reporting – that way I get uniform numbers across all companies and don’t have to worry about doing accounting analysis”. Do you agree? Why or why not?
I disagree with Fred, because the elimination of delegation of reporting to management will create chaos and misinterpretation of financial statements. Corporate managers know how to apply and judge business transactions using the accrual accounting framework. They have inside information and make appropriate judgments to convey that information to investors and forecast future performance. If this discretion is eliminated, managers will be unable to make use of inside information in reported financial statements.
However, since investors view profits as a measure of a manager’s performance, some managers have an incentive to use their accounting discretion to distort reported profits by making biased assumptions. Also, the use of accounting numbers in contracts between the firm and outsiders provides a motivation for management manipulation of accounting numbers. Therefore, the delegation of financial reporting decisions to managers has both costs and benefits. Accounting rules and auditing are mechanisms deigned to reduce the cost and preserve the benefit of delegating financial reporting to corporate managers.
3. Bill Simon says, “We should get rid of the FASB and SEC, since free market forces will make sure that companies report reliable information.” Do you agree? Why or why not?
Free market forces do not make sure that all companies report reliable information. Bill assumes that corporate managers do not disclose unreliable information and that they share inside information with outside investors. In real life, managers disclose false information and investors don’t detect inside information right away. Therefore, FASB and SEC force managers to disclose reliable information and comply reasonably with U.S. GAAP standards.
4. Many firms recognize revenues at the point of shipment. This provides an incentive to accelerate revenues by shipping goods at the end of the quarter. Consider two companies, one of which ships its products evenly throughout the quarter, and the second of which ships all its products in the last two weeks of the quarter. Each company’s customers pay 30 days after receiving shipment. Using accounting ratios, how can you distinguish these companies?
Both companies will have the same amount of revenues and expenses in their income statements. However, their balance sheets will show different amounts. At the end of each quarter, the company that ships its products evenly throughout the quarter should have higher cash and a lower accounts receivable balance than the company that ships all its products in the last two weeks of the quarter.
We can distinguish between these companies using the following accounting ratios:
a. Accounts Receivable Turnover Ratio = Sales
The company that ships its products evenly throughout the quarter and has steady sales will have a higher accounts receivable turnover ratio.
b. Accounts Receivable Days Ratio = Accounts Receivable
Average Sales per Day
The company that ships its products evenly throughout the quarter and has steady sales will have a lower accounts receivable days ratio.
c. Cash Ratio = Cash + Short-Term Investments
The company that ships its products evenly throughout the quarter and has steady sales will have a higher cash ratio.
5. A. If management reports truthfully, what economic events are likely to prompt the following accounting changes?
a. Increase in the estimated life of depreciable assets.
If managers find out that the actual life of the depreciable assets lasted longer than was expected, managers will increase the estimated life of depreciable assets.
b. Decrease in the uncollectible allowance as a percentage of gross receivables. The firm will decrease the percentage of uncollectable allowance when it receives orders from reliable customers. In contrast, the firm will increase the percentage of uncollectable allowance when it receives orders from unreliable customers.
c. Recognition of revenues at the point of delivery, rather than at the point cash is received. A firm could recognize revenues at the point of delivery rather than at the point of cash receipt when its customer’s credit improves or its customer’s cash payment is not a risk.
d. Capitalization of a higher proportion of software R&D costs. A firm will capitalize a higher proportion of software R&D costs when the firm has established the technical and commercial feasibility of the asset for sale or use. For example, technical and commercial feasibility may be established when the firm completes the software and either uses it or sells it and is able to demonstrate how the intangible asset will generate future economic benefits.
5.B. What features of accounting, if any, would make it costly for dishonest managers to make the same changes without any corresponding economic changes?
Opinion of third parties. Auditors provide a clean opinion of a firm’s financial statements. If the changes in the accounting policy are reasonably consistent with economic changes, auditors will not provide a clean opinion of the financial statements.
Accrual reversal effect. Aggressive capitalization of software R&D expenditures will increase net income in the current period, but the later writing-off of capitalized R&D costs will decrease net income in the following period.
Lawsuit. If a firm discloses false financial information and its investor loses because of that information, the firm will pay legal penalties.
Labor Market Discipline. The labor market for managers will discipline those who are perceived as unreliable managers in dealing with external parties.
6. The conservatism principle arises because of concerns about management’s incentives to overstate the firm’s performance. Joe Banks argues: “We could get rid of conservatism and make accounting numbers more useful if we delegated financial reporting to independent auditors, rather than to corporate managers.” Do you agree? Why or why not?
I don’t agree with Joe Banks, because if we delegate financial reporting to independent auditors rather than to corporate managers, we will decrease the quality of financial reporting. Auditors don’t have all the inside information that corporate managers have when the economic reality of the firm is displayed. Furthermore, the way managers and auditors assess a firm is different. Auditors could apply accounting standards to assess business transactions in a mechanical way rather than using their professional judgment, leading to poor quality financial reporting. For example, everybody agrees that market-value accounting provides relevant information; however, auditors are concerned more about the audit liability.
7. A fund manager states: “I refuse to buy any company that makes a voluntary accounting change, since it’s certainly a case of management trying to hide bad news.” Can you think of any alternative interpretation?
Voluntary accounting change could happen because business circumstances have changed in the firm. For example, unusual increases in receivables might be due to changes in a firm’s sales strategy, or unusual decreases in the allowance for uncollectible receivables might be reflecting a change in a firm’s customer focus. Therefore, an analyst should use qualitative information such as the evaluation of the context of the business strategy and economic circumstances, and not deliberately interpret the firm’s accounting change as earnings manipulation.
8. Fair value accounting attempts to make financial information more relevant to financial statement users, at the risk of greater subjectivity. What factors would you examine to evaluate the reliability of fair value assets?
We should examine the fair value hierarchy to evaluate the reliability of fair value assets. Level 1 is the most reliable in terms of valuating fair value assets because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets
Level 3 is the least reliable level because it requires a good deal of judgment and is based on the best information available (such as a company’s own data or assumptions) to arrive at a relevant and reliable fair value measurement. Financial statement users can trust prices in liquid markets as long as observable inputs such as level 1 and 2 reflect quoted prices for identical assets or liabilities. In level 3, we encounter unobservable inputs.
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