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¬rm™s accrual accounting, the cash ¬‚ow statement provides an alternative benchmark of
its performance. The cash ¬‚ow statement also provides information on how individual
line items in the income statement diverge from the underlying cash ¬‚ows. For example,
if an analyst is concerned that the ¬rm is aggressively capitalizing certain costs that
should be expensed, the information in the cash ¬‚ow statement provides a basis to make
the necessary adjustment.
Financial statement footnotes also provide a lot of information that is potentially use-
ful in restating reported accounting numbers. For example, when a ¬rm changes its ac-
counting policies, it provides a footnote indicating the effect of that change if it is
material. Similarly, some ¬rms provide information on the details of accrual estimates
such as the allowance for bad debts. The tax footnote usually provides information on
the differences between a ¬rm™s accounting policies for shareholder reporting and tax
reporting. Since tax reporting is often more conservative than shareholder reporting, the
information in the tax footnote can be used to estimate what the earnings reported to
shareholders would be under more conservative policies.

There are several potential pitfalls in accounting analysis that an analyst should avoid.
First, it is important to remember that from an analyst™s perspective, conservative ac-
counting is not the same as “good” accounting. Financial analysts are interested in eval-
uating how well a ¬rm™s accounting captures business reality in an unbiased manner, and
conservative accounting can be as misleading as aggressive accounting in this respect.
Further, conservative accounting often provides managers with opportunities for “in-
come smoothing.” Income smoothing may prevent analysts from recognizing poor per-
formance in a timely fashion.
A second potential mistake is to confuse unusual accounting with questionable ac-
counting. While unusual accounting choices might make a ¬rm™s performance dif¬cult
to compare with other ¬rms™ performance, such an accounting choice might be justi¬ed
if the company™s business is unusual. For example, ¬rms that follow differentiated strat-
egies or ¬rms that structure their business in an innovative manner to take advantage of
particular market situations may make unusual accounting choices to properly re¬‚ect
their business. Therefore, it is important to evaluate a company™s accounting choices in
the context of its business strategy.
Another potential pitfall in accounting analysis arises when an analyst attributes all
changes in a ¬rm™s accounting policies and accruals to earnings management motives.22
Accounting changes might be merely re¬‚ecting changed business circumstances. For
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Overview of Accounting Analysis

example, as already discussed, a ¬rm that shows unusual increases in its inventory might
be preparing for a new product introduction. Similarly, unusual increases in receivables
might merely be due to changes in a ¬rm™s sales strategy. Unusual decreases in the al-
lowance for uncollectable receivables might be re¬‚ecting a ¬rm™s changed customer fo-
cus. It is therefore important for an analyst to consider all possible explanations for
accounting changes and investigate them using the qualitative information available in
a ¬rm™s ¬nancial statements.

What is the value of accounting information and accounting analysis? Given the incen-
tives and opportunities for managers to affect their ¬rms™ reported accounting numbers,
some have argued that accounting data and accounting analysis are not likely to be use-
ful for investors.
Researchers have examined the value of accounting by estimating the return that
could be earned by an investor with perfect earnings foresight one year prior to an earn-
ings announcement.23 The findings show that by buying stocks of firms with increased
earnings and selling stocks of firms with decreased earnings each year, a hypothetical
investor could earn an average portfolio return of 37.5 percent in the period 1954 to
1996. This is equivalent to 44 percent of the return that could have been earned if the
investor had perfect foresight of the stock price itself for one year, and bought stocks
with increased prices and sold stocks whose price decreased. Perfect foresight of ROE
permits the investor to earn an even higher rate of return, 43 percent, than perfect earn-
ings foresight. This is equivalent to 50 percent of the return that could be earned with
perfect stock price foresight.
In contrast, cash ¬‚ow data appear to be considerably less valuable than earnings or
ROE information. Perfect foresight of cash ¬‚ows from operations would permit the hy-
pothetical investor to earn an average annual return of only 9 percent, equivalent to
11 percent of the return that could be earned with perfect foresight of stock prices.
Overall, this research suggests that the institutional arrangements and conventions
created to mitigate potential misuse of accounting by managers are effective in provid-
ing assurance to investors. The research indicates that investors do not view earnings
management as so pervasive as to make earnings data unreliable.
A number of research studies have examined whether superior accounting analysis is
a valuable activity. By and large, this evidence indicates that there are opportunities for
superior analysts to earn positive stock returns. Research ¬ndings indicate that compa-
nies criticized in the ¬nancial press for misleading ¬nancial reporting subsequently
suffered an average stock price drop of 8 percent.24 Firms where managers appeared to
in¬‚ate reported earnings prior to an equity issue and subsequently reported poor earn-
ings performance had more negative stock performance after the offer than ¬rms with
no apparent earnings management.25 Finally, ¬rms subject to SEC investigation for earn-
ings management showed an average stock price decline of 9 percent when the earnings
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3-15 Part 2 Business Analysis and Valuation Tools

management was ¬rst announced and continued to have poor stock performance for up
to two years.26
These ¬ndings imply that analysts who are able to identify ¬rms with misleading ac-
counting are able to create value for investors. The ¬ndings also indicate that the stock
market ultimately sees through earnings management. For all of these cases, earnings
management is eventually uncovered and the stock price responds negatively to evi-
dence that ¬rms have in¬‚ated prior earnings through misleading accounting.

In summary, accounting analysis is an important step in the process of analyzing corpo-
rate ¬nancial reports. The purpose of accounting analysis is to evaluate the degree to
which a ¬rm™s accounting captures the underlying business reality. Sound accounting
analysis improves the reliability of conclusions from ¬nancial analysis, the next step in
¬nancial statement analysis.
There are six key steps in accounting analysis. The analyst begins by identifying the
key accounting policies and estimates, given the ¬rm™s industry and its business strategy.
The second step is to evaluate the degree of ¬‚exibility available to managers, given the
accounting rules and conventions. Next, the analyst has to evaluate how managers exer-
cise their accounting ¬‚exibility and the likely motivations behind managers™ accounting
strategy. The fourth step involves assessing the depth and quality of a ¬rm™s disclosures.
The analyst should next identify any red ¬‚ags needing further investigation. The ¬nal ac-
counting analysis step is to restate accounting numbers to remove any noise and bias in-
troduced by the accounting rules and management decisions.
The subsequent ¬ve chapters apply these concepts to the analysis of assets, liabilities
and equity, revenues, expenses, and business entity accounting.

1. A finance student states, “I don™t understand why anyone pays any attention to ac-
counting earnings numbers, given that a ˜clean™ number like cash from operations is
readily available.” Do you agree? Why or why not?
2. Fred argues, “The standards that I like most are the ones that eliminate all manage-
ment 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?
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?
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 com-
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Overview of Accounting Analysis

panies, one of which ships its product 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 thirty days after receiving shipment. How can you distinguish these
companies, using accounting ratios?
5. a. If management reports truthfully, what economic events are likely to prompt the
following accounting changes?
• Increase in the estimated life of depreciable assets
• Decrease in the uncollectibles allowance as a percentage of gross receivables
• Recognition of revenues at the point of delivery, rather than at the point cash is
• Capitalization of a higher proportion of software R&D costs
b. What features of accounting, if any, would make it costly for dishonest managers
to make the same changes without any corresponding economic changes?
6. The conservatism principle arises because of concerns about management™s incen-
tives to overstate the firm™s performance. Joe Banks argues, “We could get rid of con-
servatism 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?
7. A fund manager states, “I refuse to buy any company that makes a voluntary account-
ing change, since it™s certainly the case that its management is trying to hide bad
news.” Can you think of any alternative interpretation?

1. Accounting analysis is sometimes also called quality of earnings analysis. We prefer to use
the term accounting analysis, since we are discussing a broader concept than merely a firm™s earn-
ings quality.
2. These definitions paraphrase those of the Financial Accounting Standards Board, Statement
of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (1985). Our intent
is to present the definitions at a conceptual, not technical, level. For more complete discussion of
these and related concepts, see the FASB™s Statements of Financial Accounting Concepts.
3. Strictly speaking, the comprehensive net income of a firm also includes gains and losses
from increases and decreases in equity from nonoperating activities or extraordinary items.
4. Thus, although accrual accounting is theoretically superior to cash accounting in measuring
a firm™s periodic performance, the distortions it introduces can make accounting data less valuable
to users. If these distortions are large enough, current cash flows may measure a firm™s periodic
performance better than accounting profits. The relative usefulness of cash flows and accounting
profits in measuring performance, therefore, varies from firm to firm. For empirical evidence on
this issue, see “Accounting earnings and cash flows as measures of firm performance: The role of
accounting accruals” by Patricia M. Dechow, Journal of Accounting and Economics 18, 1994.
5. For example, Abraham Brilloff wrote a series of accounting analyses of public companies
in Barron™s over several years. On average, the stock prices of the analyzed companies changed
by about 8 percent on the day these articles were published, indicating the potential value of
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3-17 Part 2 Business Analysis and Valuation Tools

performing such analysis. For a more complete discussion of this evidence, see “Brilloff and the
Capital Market: Further Evidence” by George Foster, Stanford University, working paper, 1985.
6. For a complete discussion of these motivations, see Positive Accounting Theory by Ross L.
Watts and Jerold L. Zimmerman (Englewood Cliffs, NJ: Prentice-Hall, 1986).
7. The most convincing evidence supporting the covenant hypothesis is reported in a study of
the accounting decisions by firms in financial distress: “Debt-covenant violations and managers™
accounting responses,” Amy Patricia Sweeney, Journal of Accounting and Economics 17, 1994.
8. Studies that examine the bonus hypothesis report evidence supporting the view that manag-
ers™ accounting decisions are influenced by compensation considerations. See, for example, “The
effect of bonus schemes on accounting decisions,” Paul M. Healy, Journal of Accounting and
Economics 12, 1985; R. Holthausen, D. Larcker, and R. Sloan, 1995, “Annual Bonus Schemes
and the Manipulation of Earnings,” Journal of Accounting and Economics 19: 29“74; and Flora
Guidry, Andrew Leone, and Steve Rock, 1998, “Earnings-Based Bonus Plans and Earnings Man-
agement by Business Unit Managers,” Journal of Accounting and Economics, forthcoming.
9. “Managerial competition, information costs, and corporate governance: The use of account-
ing performance measures in proxy contests,” Linda DeAngelo, Journal of Accounting and Eco-
nomics 10, 1988.
10. The trade-off between taxes and financial reporting in the context of managers™ accounting
decisions is discussed in detail in Taxes and Business Strategy by Myron Scholes and Mark Wolf-
son (Englewood Cliffs, NJ: Prentice-Hall, 1992). Many empirical studies have examined firms™
LIFO/FIFO choices.
11. Several researchers have documented that firms affected by such situations have a motiva-
tion to influence regulators™ perceptions through accounting decisions. For example, J. Jones doc-
uments that firms seeking import protections make income-decreasing accounting decisions in
“Earnings management during import relief investigations,” Journal of Accounting Research 29,
1991. A number of studies find that banks that are close to minimum capital requirements overstate
loan loss provisions, understate loan write-offs, and recognize abnormal realized gains on securities
portfolios (see S. Moyer, 1990, “Capital Adequacy Ratio Regulations and Accounting Choices in
Commercial Banks,” Journal of Accounting and Economics 12: 123“154; M. Scholes, G. P. Wil-
son, and M. Wolfson, 1990, “Tax Planning, Regulatory Capital Planning, and Financial Reporting
Strategy for Commercial Banks,” Review of Financial Studies 3: 625“650; A. Beatty, S. Chamber-
lain, and J. Magliolo, 1995, “Managing Financial Reports of Commercial Banks: The Influence of
Taxes, Regulatory Capital and Earnings,” Journal of Accounting Research 33, No. 2: 231“261; and
J. Collins, D. Shackelford, and J. Wahlen, 1995, “Bank Differences in the Coordination of Regu-
latory Capital, Earnings and Taxes,” Journal of Accounting Research 33, No. 2: 263“291). Finally,
Petroni finds that financially weak property-casualty insurers that risk regulatory attention under-
state claim loss reserves: K. R. Petroni, 1992, “Optimistic Reporting in the Property Casualty In-
surance Industry,” Journal of Accounting and Economics 15: 485“508.
12. “The effect of firms™ financial disclosure strategies on stock prices,” Paul Healy and Krish-
na Palepu, Accounting Horizons 7, 1993. For a summary of the empirical evidence, see P. Healy
and J. Wahlen, “Earnings Management,” (Harvard Business School, working paper, 1999).
13. Financial analysts pay close attention to managers™ disclosure strategies; the Financial An-
alysts™ Federation publishes annually a report evaluating them in U.S. firms. For a discussion of
these ratings, see “Cross-sectional Determinants of Analysts™ Ratings of Corporate Disclosures”
by Mark Lang and Russ Lundholm, Journal of Accounting Research 31, Autumn 1993: 246“271.
14. For a detailed analysis of a company that made such changes, see “Anatomy of an Account-
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ing Change” by Krishna Palepu in Accounting & Management: Field Study Perspectives, edited
by William J. Bruns, Jr. and Robert S. Kaplan (Boston: Harvard Business School Press, 1987).
15. An example of this type of behavior is documented by John Hand in his study, “Did Firms
Undertake Debt-Equity Swaps for an Accounting Paper Profit or True Financial Gain?,” The Ac-
counting Review 64, October 1989.
16. For an empirical analysis of inventory build-ups, see “Do Inventory Disclosures Predict


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