Financial Reporting and Analysis

Statutory Financial Reports

Financial Statements

  1. Seasonality
  2. Year-end adjustments

Earnings Announcements

  1. Time lag
  2. Pro forma earnings

Nature and Purpose of Financial Accounting

Desirable Qualities of Accounting Information

  1. Relevance – Timeliness
  2. Reliability – Reality & neutrality
  3. Comparability – information measured in the same manner
  4. Consistency – same method used for similar transactions

Principles of Accounting

  1. Accrual accounting
  2. Historical cost and fair value
  3. Materiality
  4. Conservatism

Limitations of Financial Statement Information

  1. Timeliness, time lag
  2. Frequency, not on demand
  3. Forward-looking, not forecasts

Accruals – Cornerstone of Accounting

Cash flow accounting

  1. Simple
  2. Tangible

Accrual accounting

  1. Revenue recognition, reduce timing problem
  2. Expense matching, reduce matching problem

Accrual accounting is better in measuring:

  1. Financial performance
  2. Financial condition
  3. Predicting future cash flows

Concept of Income

  • Income – net effect if a business’s operations
  • Change in shareholder’s wealth
  • Extent to which costs of operations is covered
  • Indicator of profitability

Types of Income

  1. Economic Income, present value of expected cash flows
  2. Permanent Income, sustainable earning power, company’s value
  3. Operating Income, income excluding nonrecurring components
  4. Accounting income, reduced ability to reflect economic reality

Income Distortions

  1. Alternative income concepts
  2. Historical cost
  3. Transaction basis
  4. Conservatism
  5. Earnings management

Earnings Management

Strategies

  1. Increasing income
  2. Big bath
  3. Income smoothing

Evaluating Earnings Quality

  1. Identify and acess key accounting policies
  2. Evaluate extent of accounting flexibility
  3. Determine reporting strategy
  4. Identify and assess red flags

Determinants of Earnings Quality

  1. Accounting principles
  2. Accounting application
  3. Business risk

External factors affecting Earnings Quality

  1. Foreign earnings
  2. Regulation
  3. Earnings sources
  4. Changing price levels
  5. Complexities of operations

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