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potential defaults be estimated? Are the outlays associated with research and develop-
ment activities, whose payoffs are uncertain, assets or expenses when incurred? Do fre-
quent ¬‚yer reward programs create accounting liabilities for airline companies? If so,
when and at what value?
Because corporate managers have intimate knowledge of their ¬rms™ businesses, they
are entrusted with the primary task of making the appropriate judgments in portraying
myriad business transactions using the basic accrual accounting framework. The ac-
counting discretion granted to managers is potentially valuable because it allows them
to re¬‚ect inside information in reported ¬nancial statements. However, since investors
view pro¬ts as a measure of managers™ performance, managers have an incentive to use
their accounting discretion to distort reported pro¬ts by making biased assumptions.
Further, the use of accounting numbers in contracts between the ¬rm and outsiders pro-
vides a motivation for management manipulation of accounting numbers.
Earnings management distorts ¬nancial accounting data, making them less valuable
to external users of ¬nancial statements. Therefore, the delegation of ¬nancial reporting
decisions to managers has both costs and bene¬ts. Accounting rules and auditing are
mechanisms designed to reduce the cost and preserve the bene¬t of delegating ¬nancial
reporting to corporate managers.

Generally Accepted Accounting Principles
Given that it is dif¬cult for outside investors to determine whether managers have used
their accounting ¬‚exibility to signal their proprietary information or merely to disguise
reality, a number of accounting conventions have evolved to mitigate the problem. Ac-
counting conventions and standards promulgated by the standard-setting bodies limit
potential distortions that managers can introduce into reported accounting numbers. In
the United States, the Securities and Exchange Commission (SEC) has the legal author-
ity to set accounting standards. The SEC typically relies on private sector accounting
bodies to undertake this task. Since 1973 accounting standards in the United States have
been set by the Financial Accounting Standards Board (FASB). There are similar private
sector or public sector accounting standard-setting bodies in many other countries. In
addition, the International Accounting Standards Committee (IASC) has been attempting
to set worldwide accounting standards, though IASC™s pronouncements are not legally
binding as of now.
Uniform accounting standards attempt to reduce managers™ ability to record similar
economic transactions in dissimilar ways either over time or across ¬rms. Thus they cre-
ate a uniform accounting language and increase the credibility of ¬nancial statements by
limiting a ¬rm™s ability to distort them. Increased uniformity from accounting standards,
however, comes at the expense of reduced ¬‚exibility for managers to re¬‚ect genuine
business differences in a ¬rm™s accounting decisions. Rigid accounting standards work
best for economic transactions whose accounting treatment is not predicated on manag-
ers™ proprietary information. However, when there is a signi¬cant business judgment
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involved in assessing a transaction™s economic consequences, rigid standards are likely
to be dysfunctional, because they prevent managers from using their superior business
knowledge. Further, if accounting standards are too rigid, they may induce managers to
expend economic resources to restructure business transactions to achieve a desired ac-
counting result.

External Auditing
Broadly de¬ned as a veri¬cation of the integrity of the reported ¬nancial statements by
someone other than the preparer, external auditing ensures that managers use accounting
rules and conventions consistently over time, and that their accounting estimates are rea-
sonable. In the U.S., all listed companies are required to have their ¬nancial statements
audited by an independent public accountant. The standards and procedures to be fol-
lowed by independent auditors are set by the American Institute of Certi¬ed Public Ac-
countants (AICPA). These standards are known as Generally Accepted Auditing
Standards (GAAS). While auditors issue an opinion on published ¬nancial statements, it
is important to remember that the primary responsibility for the statements still rests
with corporate managers.
Auditing improves the quality and credibility of accounting data by limiting a ¬rm™s
ability to distort ¬nancial statements to suit its own purposes. However, third-party au-
diting may also reduce the quality of ¬nancial reporting because it constrains the kind
of accounting rules and conventions that evolve over time. For example, the FASB con-
siders the views of auditors in the standard-setting process. Auditors are likely to argue
against accounting standards that produce numbers which are dif¬cult to audit, even if
the proposed rules produce relevant information for investors.

Legal Liability
The legal environment in which accounting disputes between managers, auditors, and
investors are adjudicated can also have a signi¬cant effect on the quality of reported
numbers. The threat of lawsuits and resulting penalties have the bene¬cial effect of im-
proving the accuracy of disclosure. However, the potential for a signi¬cant legal liability
might also discourage managers and auditors from supporting accounting proposals re-
quiring risky forecasts, such as forward looking disclosures. This type of concern is of-
ten expressed by the auditing community in the U.S.

Limitations of Accounting Analysis
Because the mechanisms that limit managers™ ability to distort accounting data them-
selves add noise, it is not optimal to use accounting regulation to eliminate managerial
¬‚exibility completely. Therefore, real-world accounting systems leave considerable
room for managers to in¬‚uence ¬nancial statement data. The net result is that informa-
tion in corporate ¬nancial reports is noisy and biased, even in the presence of accounting
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3-5 Part 2 Business Analysis and Valuation Tools

regulation and external auditing.4 The objective of accounting analysis is to evaluate the
degree to which a ¬rm™s accounting captures its underlying business reality and to “un-
do” any accounting distortions. When potential distortions are large, accounting analysis
can add considerable value.5

Factors Influencing Accounting Quality
There are three potential sources of noise and bias in accounting data: (1) the noise and
bias introduced by rigidity in accounting rules, (2) random forecast errors, and (3) sys-
tematic reporting choices made by corporate managers to achieve speci¬c objectives.
Each of these factors is discussed below.

ACCOUNTING RULES. Accounting rules introduce noise and bias because it is often
dif¬cult to restrict management discretion without reducing the information content of
accounting data. For example, the Statement of Financial Accounting Standards No. 2
issued by the FASB requires ¬rms to expense research outlays when they are incurred.
Clearly, some research expenditures have future value while others do not. However, be-
cause SFAS No. 2 does not allow ¬rms to distinguish between the two types of expendi-
tures, it leads to a systematic distortion of reported accounting numbers. Broadly
speaking, the degree of distortion introduced by accounting standards depends on how
well uniform accounting standards capture the nature of a ¬rm™s transactions.

FORECAST ERRORS. Another source of noise in accounting data arises from pure
forecast error, because managers cannot predict future consequences of current transac-
tions perfectly. For example, when a ¬rm sells products on credit, accrual accounting re-
quires managers to make a judgment on the probability of collecting payments from
customers. If payments are deemed “reasonably certain,” the ¬rm treats the transactions
as sales, creating accounts receivable on its balance sheet. Managers then make an esti-
mate of the proportion of receivables that will not be collected. Because managers do
not have perfect foresight, actual defaults are likely to be different from estimated cus-
tomer defaults, leading to a forecast error. The extent of errors in managers™ accounting
forecasts depends on a variety of factors, including the complexity of the business trans-
actions, the predictability of the ¬rm™s environment, and unforeseen economy-wide

MANAGERS™ ACCOUNTING CHOICES. Corporate managers also introduce noise
and bias into accounting data through their own accounting decisions. Managers have a
variety of incentives to exercise their accounting discretion to achieve certain objectives,
leading to systematic in¬‚uences on their ¬rms™ reporting6:
• Accounting-based debt covenants. Managers may make accounting decisions to
meet certain contractual obligations in their debt covenants. For example, firms™
lending agreements with banks and other debt holders require them to meet cove-
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Overview of Accounting Analysis

nants related to interest coverage, working capital ratios, and net worth, all defined
in terms of accounting numbers. Violation of these constraints may be costly be-
cause it allows lenders to demand immediate payment of their loans. Managers of
firms close to violating debt covenants have an incentive to select accounting pol-
icies and estimates to reduce the probability of covenant violation. The debt cove-
nant motivation for managers™ accounting decisions has been analyzed by a number
of accounting researchers.7
• Management compensation. Another motivation for managers™ accounting choice
comes from the fact that their compensation and job security are often tied to re-
ported profits. For example, many top managers receive bonus compensation if
they exceed certain prespecified profit targets. This provides motivation for man-
agers to choose accounting policies and estimates to maximize their expected com-
• Corporate control contests. In corporate control contests, including hostile take-
overs and proxy fights, competing management groups attempt to win over the
firm™s shareholders. Accounting numbers are used extensively in debating manag-
ers™ performance in these contests. Therefore, managers may make accounting de-
cisions to influence investor perceptions in corporate control contests.9
• Tax considerations. Managers may also make reporting choices to trade off be-
tween financial reporting and tax considerations. For example, U.S. firms are re-
quired to use LIFO inventory accounting for shareholder reporting in order to use it
for tax reporting. Under LIFO, when prices are rising, firms report lower profits,
thereby reducing tax payments. Some firms may forgo the tax reduction in order to
report higher profits in their financial statements.10
• Regulatory considerations. Since accounting numbers are used by regulators in a
variety of contexts, managers of some firms may make accounting decisions to in-
fluence regulatory outcomes. Examples of regulatory situations where accounting
numbers are used include antitrust actions, import tariffs to protect domestic indus-
tries, and tax policies.11
• Capital market considerations. Managers may make accounting decisions to influ-
ence the perceptions of capital markets. When there are information asymmetries
between managers and outsiders, this strategy may succeed in influencing investor
perceptions, at least temporarily.12
• Stakeholder considerations. Managers may also make accounting decisions to in-
fluence the perception of important stakeholders in the firm. For example, since
labor unions can use healthy profits as a basis for demanding wage increases, man-
agers may make accounting decisions to decrease income when they are facing
union contract negotiations. In countries like Germany, where labor unions are
strong, these considerations appear to play an important role in firms™ accounting
policy. Other important stakeholders that firms may wish to influence through their
financial reports include suppliers and customers.
• Competitive considerations. The dynamics of competition in an industry might also
influence a firm™s reporting choices. For example, a firm™s segment disclosure
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3-7 Part 2 Business Analysis and Valuation Tools

decisions may be influenced by its concern that disaggregated disclosure may help
competitors in their business decisions. Similarly, firms may not disclose data on
their margins by product line for fear of giving away proprietary information.
Finally, firms may discourage new entrants by making income-decreasing account-
ing choices.
In addition to accounting policy choices and estimates, the level of disclosure is also
an important determinant of a ¬rm™s accounting quality. Corporate managers can choose
disclosure policies that make it more or less costly for external users of ¬nancial reports
to understand the true economic picture of their businesses. Accounting regulations usu-
ally prescribe minimum disclosure requirements, but they do not restrict managers from
voluntarily providing additional disclosures. Managers can use various parts of the ¬-
nancial reports, including the Letter to the Shareholders, Management Discussion and
Analysis, and footnotes, to describe the company™s strategy, its accounting policies, and
its current performance. There is wide variation across ¬rms in how managers use their
disclosure ¬‚exibility.13

In this section we will discuss a series of steps that an analyst can follow to evaluate a
¬rm™s accounting quality. In the subsequent ¬ve chapters, these concepts are illustrated
for the analysis of assets, liabilities and equity, revenues, expenses, and business entity

Step 1: Identify Key Accounting Policies
As discussed in the chapter on business strategy analysis, a ¬rm™s industry characteris-
tics and its own competitive strategy determine its key success factors and risks. One of
the goals of ¬nancial statement analysis is to evaluate how well these success factors and
risks are being managed by the ¬rm. In accounting analysis, therefore, the analyst should
identify and evaluate the policies and the estimates the ¬rm uses to measure its critical
factors and risks.
For example, one of the key success factors in the leasing business is to make accu-
rate forecasts of residual values of the leased equipment at the end of the lease terms.
For a ¬rm in the equipment leasing industry, therefore, one of the most important ac-
counting policies is the way residual values are recorded. Residual values in¬‚uence the
company™s reported pro¬ts and its asset base. If residual values are overestimated, the
¬rm runs the risk of having to take large write-offs in the future.
Key success factors in the banking industry include interest and credit risk manage-
ment; in the retail industry, inventory management is a key success factor; and for a man-
ufacturer competing on product quality and innovation, research and development and
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