SEM 3A & 4A - Accounting Analysis

SIT Internal
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek 1
(ISBN 9781473779075) © 2022 Cengage EMEA
SIT Internal
CHAPTER 3
Accounting analysis:
The basics
2 (ISBN 9781473779075) © 2022 Cengage

For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
For use with Business
EMEA Analysis and Valuation 6e by Palepu, Healy and Peek 2
SIT Internal
The importance of accounting analysis

• Accounting practices govern the types of disclosures made in the
financial statements. Understanding accounting allows the business
analyst to effectively use the financial information disclosed by
companies.
• Accounting analysis consists of:

• Accounting quality analysis
• Accounting adjustments
• Financial statement standardization.
SIT Internal
Key concepts
• Various factors influence the quality of accounting-based financial reports.
• Managers have some discretion in accounting choices used in financial

reporting.
• Incentives for the management of financial reporting items must be

considered by the analyst.
• Recasting of financial statements in a common format helps to improve

financial statement comparability.
SIT Internal
Recap: Accrual accounting and accounting

quality
• Financial reports are prepared using accrual accounting instead of cash
accounting.
• Applying accounting principles is the responsibility of management, who

has superior knowledge but incentives to distort accounting numbers.
There are the mitigating effects of legal liability, auditing, and public
enforcement.
• Three potential sources of noise and bias in accounting data are:

1. Noise from accounting rules
2. Forecast errors
3. Managers’ accounting choices.
SIT Internal
Managers’ accounting choices

• Managers have various incentives to bias accounting disclosures:
• Debt covenants
• Compensation contracts
• Contests for corporate control
• Tax considerations
• Regulatory considerations
• Capital market and stakeholder considerations
• Competitive considerations.
SIT Internal
Steps in performing accounting analysis

• Step 1: Identify principal accounting policies
• Key policies and estimates used to measure risks and critical factors for
success must be identified.
• IFRS Standards require firms to identify critical accounting estimates.
• International Standards on Auditing (ISA) require auditors to describe
“Key
Audit Matters”.
• Step 2: Assess accounting flexibility

• Accounting information is less likely to yield insights about a firm’s economics
if managers have a high degree of flexibility in choosing policies and
estimates.
SIT Internal

• Step 3: Evaluate accounting strategy
• Flexibility in accounting choices allows managers to strategically communicate
economic information or hide true performance.
• Issues to consider include:

• Norms for accounting policies with industry peers
• Incentives for managers to manage earnings
• Changes in policies and estimates and the rationale for doing so
• Whether transactions are structured to achieve certain accounting objectives.
SIT Internal

• Step 4: Evaluate the quality of disclosure
• Managers have considerable discretion in disclosing certain accounting
information.
• Issues to consider include:

• Whether disclosures seem adequate
• Adequacy of notes to the financial statements
• Whether the Management Report section sufficiently explains and is consistent
with
current performance
• Whether IFRS Standards restrict the appropriate measurement of key measures of
success
• Adequacy of segment disclosure.
SIT Internal
• Step 5: Identify potential red flags

• Some issues that warrant gathering more information include:
• Unexplained transactions that boost profits
• Unusual increases in inventory or A/R in relation to sales
• Increases in the gap between net profit and cash flows or tax profit
• Use of R&D partnerships, SPEs or the sale of receivables to finance operations.
• Unexpected large asset write-offs
• Large year-end adjustments
• Qualified audit opinions or auditor changes
• Related-party transactions.
SIT Internal

• Step 6: Synthesize risks and undo accounting distortions
• Synthesize all information, often in a subjective and qualitative manner, to
assess accounting quality.
• Use information from the cash flow statement and notes to the financial
statements to (possibly imperfectly) undo distortions.
• Continued in Chapter 4.
SIT Internal
Recasting financial statements

• Balance sheets, (comprehensive) income statements, and statements
of cash flows may be recast with standardized line-item descriptions
to increase their usefulness.
• Firms can vary in the nomenclature and formats used to report financial
results.
• Templates have been designed for each of the three major financial
statements to standardize the format and nomenclature.
• One complication is that under IFRS Standards firms may classify

operating expenses by nature or by function.
SIT Internal
Recasting financial statements (continued)

• Standardization of financial statements builds on two principles:
1. Analysts typically analyze business (operating and investment) activities
separately from financing activities.
• Business activities primarily affect value creation.
• Financing activities primarily affect the allocation of value.
1. Financial statements must remain sufficiently disaggregated to

understand
items’ different future performance consequences.
SIT Internal
Recasting financial statements (continued)

• Classification of financial statement items along the following
dimensions:
• Business (operating and investment) versus financial assets or
liabilities.
• Current versus non-current assets or liabilities.
• Assets or liabilities from continued versus discontinued operations.
• Templates: Refer to Tables 3.1, 3.2, 3.3, 3.4, and 3.5 in the
text.
SIT Internal
Accounting analysis pitfalls

• Conservative accounting may also be misleading.
• For example, historical cost and accounting for intangible assets.
• Not all unusual accounting practices are questionable.

• Earnings management does not necessarily motivate some accounting
phenomena that seem unusual.
• Common standards ≠ common practices.
SIT Internal
Concluding comments
• Accounting analysis is an essential step in analyzing corporate
financial reports.
• A methodology consisting of six steps in analyzing accounting data

was presented in this chapter.
• Research suggests earnings management is not so pervasive as to

make earnings data unreliable.
SIT Internal
CHAPTER 4
Accounting analysis:
Accounting adjustments
17 (ISBN 9781473779075) © 2022 Cengage

For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
For use with Business
EMEA Analysis and Valuation 6e by Palepu, Healy and Peek 17
SIT Internal
Key concepts
• Analyzing elements of the balance sheet for possible distortions
allows the analyst to better understand the economic substance of a
firm’s transactions and financial position.
• Key distortions include:

• Depreciation, amortization, and impairment
• Off-balance sheet assets
• Revenue recognition, contract assets, and contract liabilities
• Allowances and provisions.
SIT Internal
Asset distortions
• Assets are defined as resources with probable future benefits.
Distortions may generally arise from ambiguities about whether:
• The firm owns/controls the economic resource.
• Future economic benefits can be measured with reasonable certainty.
• Fair values of assets fall below their book values.
• Fair value estimates are accurate.
SIT Internal
Asset distortions: Ownership/control
• Some types of transactions make it difficult to assess the ownership

of an asset.
• Mechanical rules help to establish economic ownership with noise or induce
managers to structure transactions.
• Principles-based rules increase managers’ reporting discretion.
• Consequently, IFRS Standards may not capture subtleties associated with
ownership or control over certain assets.
SIT Internal
Asset Distortions: Economic benefits and

fair values
• IFRS Standards require the immediate expensing of some resource
outflows that may have future economic benefits, such as research
expenditures.
• Because considerable judgment is involved in determining whether

the value of an asset is impaired, and the amount of the impairment,
assets may be misstated.
• Similarly, management can bias fair value estimates used in, for
example, accounting for goodwill or financial instruments.
SIT Internal
Overstated assets
• Incentives to inflate reported earnings can result in overstated assets.
Some of the most common forms include:
• Understated depreciation/amortization of non-current assets
• Delayed write-downs of current or non-current assets
• Understatement of allowances
• Accelerated recognition of revenues.
SIT Internal
Understated assets
• There may be incentives for earnings to be under-reported, resulting
in understated assets:
• Key intangible assets off balance sheet
• Overstated allowances
• Discounted receivables off balance sheet.
• Conservatism in IFRS Standards may also result in understated

assets.
SIT Internal
Example 1: Depreciation
• Key steps in adjusting depreciation are:
1. Determine the average asset age: Accumulated depreciation × Depreciable life

Depreciable cost
2. Calculate the asset adjustment: −∆Depreciation rate × Average age × Initial cost
3. Calculate the depreciation adjustment: ∆Depreciation rate × Initial cost
• Depreciation adjustments should take purchases or disposals of new

assets into account.
SIT Internal
• Step 1: The average age of Lufthansa’s aircraft
(€ millions unless otherwise noted)
Aircraft cost, 1/1/2020 €32,945 Reported
Depreciable cost €31,298 Cost × (1 – 0.05)
Accumulated depreciation, 1/1/2020 €16,698 Reported
Accumulated depreciation/Depreciable cost 53.4%
Depreciable life 20 years Reported
Average age of aircraft 10.7 years 20 × 0.534 years
SIT Internal
• Step 2: Asset adjustment
Depreciation rates
[1 – old residual value (%)]/old asset life (years) 3.80 percent [100% – 5%]/20y
[1 – new residual value (%)]/new asset life (years) 4.75 percent [100% – 5%]/25y
Asset adjustment = −∆Depreciation rate × Average age × Initial cost

= −(−0.95%) × 10.7 years × 32,945
= 3,303m euro
SIT Internal
• Step 3: Depreciation adjustment
Depreciation rates
[1 – old residual value (%)]/old asset life (years) 3.80 percent [100% – 5%]/20y
[1 – new residual value (%)]/new asset life (years) 4.75 percent [100% – 5%]/25y
Depreciation adjustment = ∆Depreciation rate × Initial cost of average assets

= −0.95% × [32,945 + (1,004/2)]
= −318m euro
SIT Internal
Example 2: Intangible assets

• Key steps in capitalizing off-balance intangible assets are:
1. Determine the economic useful life: L
2. Calculate the capitalized proportion of year i expenditure: i +1

1− L 2 × Expenditurei
3. Calculate the asset capitalization adjustment: σ 0−(L−1) Expenditurei
SIT Internal

• Sanofi’s R&D asset, assuming an expected life of 5 years:
Proportion capitalized Asset Proportion capitalized Asset
Year R&D outlay 31/12/19 31/12/19 31/12/20 31/12/20
2020 €5,529m (1 – [1/5 × 0.5]) €4,976m

2019 6,018 (1 – [1/5 × 0.5]) €5,416m (1 – [1/5 × 1.5]) 4,213
2018 5,894 (1 – [1/5 × 1.5]) 4,126 (1 – [1/5 × 2.5]) 2,947
2017 5,472 (1 – [1/5 × 2.5]) 2,736 (1 – [1/5 × 3.5]) 1,642
2016 5,172 (1 – [1/5 × 3.5]) 1,552 (1 – [1/5 × 4.5]) 517
2015 5,082 (1 – [1/5 × 4.5]) 508
Total €14,338m €14,295m
SIT Internal

• Key steps in calculating amortization of capitalized intangible assets
are:
1. Determine the economic useful life: L
2. Calculate the currently amortized proportion of year i expenditure:

• For i ≠ 0 and i ≠ -L: 1
L × Expenditurei
• For i = 0 and i = -L: 2 1L 1

× ×
Expenditurei
3. Calculate the amortization adjustment: σ 0−L Amortization of expenditurei
SIT Internal

• Sanofi’s R&D amortization, assuming an expected life of 5 years:
Proportion Proportion
Year R&D outlay amortized in 2019 Expense in 2019 amortized in 2020 Expense in 2020
2020 €5,529m 1/5 × 0.5 €553m
2019 6,018 1/5 × 0.5 €602m 1/5 1,204
2018 5,894 1/5 1,179 1/5 1,179
2017 5,472 1/5 1,094 1/5 1,094
2016 5,172 1/5 1,034 1/5 1,034
2015 5,082 1/5 1,016 1/5 × 0.5 508
2014 4,667 1/5 × 0.5 467
Total €5,392m €5,572m
SIT Internal
Liability distortions
• Liabilities are economic obligations requiring future outflows of
resources.
• Distortions may generally arise from ambiguities about

whether:
• An obligation has been incurred.
• The proper measurement of an obligation.
SIT Internal
Understated liabilities
• Understated liabilities may arise from:

• Incentives to overstate earnings or the strength of financial position.
• Difficulties in estimating the amount of future financial commitments.
SIT Internal
Understated liabilities: Likely conditions

• Liabilities may be understated under some of the following
conditions:
• Aggressive revenue recognition
• Off-balance sheet loans related to receivables
• Off-balance sheet non-current liabilities
• Pension and post-retirement obligation understatements.
SIT Internal
Equity distortions
• Equity is the residual claim on a firm’s assets held by stockholders.
• Since Assets = Liabilities + Equity, distortions in assets and/or

liabilities lead to distortions in equity.
• The nature of contingent claims needs to be considered to reduce any

possible bias in the financial statements.
SIT Internal
Concluding comments
• Recasting financial statements is an important step to facilitate
comparability among analyzed financial statements.
• Analysts should focus on evaluating and adjusting accounting

measures that describe the firms’ key strategic value drivers.
• It is important to keep in mind that many accounting adjustments will

be estimates.

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SIT Internal

2 (ISBN 9781473779075) © 2022 Cengage

The importance of accounting analysis

• Accounting analysis consists of:

• Managers have some discretion in accounting choices used in financial

• Incentives for the management of financial reporting items must be

• Recasting of financial statements in a common format helps to improve

Recap: Accrual accounting and accounting

• Applying accounting principles is the responsibility of management, who

• Three potential sources of noise and bias in accounting data are:

Managers’ accounting choices

Steps in performing accounting analysis

• Step 2: Assess accounting flexibility

Steps in performing accounting analysis

• Issues to consider include:

Steps in performing accounting analysis

• Issues to consider include:

Steps in performing accounting analysis

• Step 5: Identify potential red flags

Steps in performing accounting analysis

Recasting financial statements

• One complication is that under IFRS Standards firms may classify

Recasting financial statements (continued)

1. Financial statements must remain sufficiently disaggregated to

Recasting financial statements (continued)

Accounting analysis pitfalls

• Not all unusual accounting practices are questionable.

• Common standards ≠ common practices.

• A methodology consisting of six steps in analyzing accounting data

• Research suggests earnings management is not so pervasive as to

17 (ISBN 9781473779075) © 2022 Cengage

• Key distortions include:

Asset distortions: Ownership/control

• Some types of transactions make it difficult to assess the ownership

Asset Distortions: Economic benefits and

• Because considerable judgment is involved in determining whether

• Conservatism in IFRS Standards may also result in understated

1. Determine the average asset age: Accumulated depreciation × Depreciable life

3. Calculate the depreciation adjustment: ∆Depreciation rate × Initial cost

• Depreciation adjustments should take purchases or disposals of new

Aircraft cost, 1/1/2020 €32,945 Reported

Depreciable cost €31,298 Cost × (1 – 0.05)

Accumulated depreciation, 1/1/2020 €16,698 Reported

Accumulated depreciation/Depreciable cost 53.4%

Depreciable life 20 years Reported

Average age of aircraft 10.7 years 20 × 0.534 years

Asset adjustment = −∆Depreciation rate × Average age × Initial cost

Depreciation adjustment = ∆Depreciation rate × Initial cost of average assets

Example 2: Intangible assets

1. Determine the economic useful life: L

2. Calculate the capitalized proportion of year i expenditure: i +1

3. Calculate the asset capitalization adjustment: σ 0−(L−1) Expenditurei

Example 2: Intangible assets

2020 €5,529m (1 – [1/5 × 0.5]) €4,976m

Example 2: Intangible assets

1. Determine the economic useful life: L

2. Calculate the currently amortized proportion of year i expenditure:

• For i = 0 and i = -L: 2 1L 1

Example 2: Intangible assets