UNSW Business School/ Accounting
ACCT3610 Business Analysis and Valuation
Seminar 3: Accounting analysis
and earnings quality
Today’s plan
1. What is accounting analysis?
2. Assessing accounting quality
a) Why would managers manipulate earnings?
b) How could managers manipulate earnings?
3. Defining and measuring earnings quality
4. Non-GAAP earnings
5. Preparing financial statements for further analysis
6. Adjusting financial statements
Course structure – a recap
Business
analysis
 How does your business make money?
 Industry conditions + firm-specific strategy
Accounting
analysis
 How is business strategy reflected in the financial statements?
 Opportunities and incentives for manipulation
Financial
analysis
 Analyse recent performance
 Identify key ratios, within a structure (e.g., Alternative DuPont)
Prospective
analysis
 Forecasting – how will future performance differ from current/recent
 Structure – sales, then how items vary with respect to sales
 Focus on key items
Valuation
 Using forecasts in a systematic way
 Dividends / Cash flows / Earnings
 Assess growth / profitability implications of current price
1. What is accounting analysis?
 To evaluate the degree to which a firm’s accounting
captures its underlying business reality
 Accounting analysis assesses the “integrity of
accounting”
 Why is accounting analysis important?
2. What explains variation in accounting quality?
Managerial discretion in accounting rules Incentives for managers to manipulate
Advantages Disadvantages Capital Market Contractual
• Managers have
intimate knowledge of
their firm’s business
environment
• Managers can use
discretion to report
distorted accounting
information
 Avoid stock price
declines / maintain
share price
 Bonus plans that
include financial
statement-based
‘hurdles’
• Discretion allows
managers to reflect
inside information
 Avoid volatility in
earnings
 Loan agreements
with covenants
based on financial
statement numbers
 Meet analyst &
investor
expectations
What explains variation in accounting quality?
Managerial discretion in accounting rules
Advantages Disadvantages
• Managers have
intimate knowledge
of their firm’s
business
environment
• Managers can use
discretion to report
distorted accounting
information
• Discretion allows
managers to reflect
inside information
Accounting rules & discretion – some examples
Rules that allow discretion Rules with no discretion
Depreciation Accounts receivable Expense R&D Fair value gains or
losses to income
• Managers select
depreciation
method, useful life,
expected salvage
value
• Managers need to
estimate likelihood of
customers not paying
(ie bad debts)
 Managers have no
choice whether to
capitalise or expense
 FV movements on
financial
instruments go
through income
• This allows
managers to reflect
expected usage of
the asset, but…
• Could be used to
manage earnings
 This allows
managers to reflect
credit policies, but..
 Could be used to
manage earnings
 Avoids overstating
assets, but…
 Firms with different
quality R&D can’t
differentiate
 Shows how the
value of assets has
changed, but..
 May not reflect
actual use of the
assets
How well do accounting rules reflect the underlying business?
 What creates value for ‘digital’ companies?
 To what extent is that reflected in the financial statements?
What explains variation in accounting quality?
Incentives for managers to manipulate
Capital Market Contractual
• •  Avoid stock price
declines / maintain
share price
 Bonus plans that
include financial
statement-based
‘hurdles’
•  Avoid volatility in
earnings
 Loan agreements
with covenants
based on financial
statement numbers
 Meet analyst &
investor expectations
Incentives – what do CFOs say?
 You can access this article,
and a summary ‘teaching
guide’ on Moodle
Incentives – “market expectations”
 Usually when the media say ‘market expectations’ they mean security analysts earnings forecasts
 Note that Dick Smith also ‘took advantage of’ accounting flexibility
Identify key accounting policies What are the main transactions that the business undertakes? What are the key assets that business develops?
Assess accounting flexibility How much flexibility exists in the accounting rules that relate to the key accounting policies? [Know your accounting!]
Evaluate accounting strategy How does the firm appear to be using any flexibility? Are the accounting decisions consistent with industry norms?
Evaluate quality of disclosure How well does the firm explain its strategy and associated accounting issues?
Identify potential ‘red flags’ Check the indicators pointing to questionable accounting quality
2. Assessing accounting quality
Accounting rules change!
The better you understand the rules and changes, the better your analysis
“Red flags”
3. What is earnings quality ?
What do CFOs say?

4. What to do if the accounting rules don’t ‘work’ for your firm?
We’ve observed the increasing use of non-GAAP, or pro-forma financial reporting
Non-GAAP
GAAP
Non-GAAP earnings
Two competing arguments:
1. Managers use non-GAAP numbers to mislead investors about performance (especially
by excluding expenses)
2. Managers use non-GAAP numbers to provide more informative numbers than those
required by the accounting rules
Australian evidence on non-GAAP earnings
 Non-GAAP earnings are
more persistent and more
predictable than GAAP
earnings
 Persistence test:
 Predictability test:
Almost half of the ASX 500
provide non-GAAP earnings
The non-GAAP number exceeds
the GAAP number about 60% of
the time
The non-GAAP number is
more informative than the
GAAP number
Here’s a recent example (article on Moodle)
Methods of managing earnings
Recall that Income = Cash Flows + Accruals
Think about how the
Balance Sheet and the
Income Statements
articulate (i.e., how they
work together).
Methods of managing earnings
Income = Cash Flows + Accruals
To manage cash flows To manage accruals
 Manage sales  Estimates on accounts receivables
 Manage expenses  PPE / depreciation
 Offer discounts for early payment  Provisions
 Delay capital expenditure  Impairments (eg, inventory,
intangibles)
Note: the majority of companies that get ‘caught’ with bad accounting have overstated
revenues
Methods of detecting earning management (on large samples)
Most of the existing techniques are ‘blunt’
Detecting cash flow
management
Detecting accruals
management
Other techniques
 Model expected level of
sales/Cash Flows
 Model expected level of
accruals, based on size,
PPE and sales growth
 Ratio-based techniques; eg
F-score
 Model expected levels of
production costs
(inventory/COGS)
 Compare difference
between actual and
expected accruals
 Model expected cash flows
for discretionary expenses
 Compare difference
between actual and
expected cash flows
5. Preparing financial statement for further analysis
Recast financial
statements
Identify significant changes
and suspicious items
Adjust for distortion
 Use a standardised
format – to group ‘like
with like’
 Keep in mind the link
between Balance Sheet
and Income Statement
 Involves subjective
estimates
 Re-classify (Bal Sheet
and P&L) accounts;
often into operating &
financing activities
 Look at Assets, Liabilities,
as well as Income
Statement items
 May require more
information than on the
face of the financial
statements
 This may require
information from
footnotes
 Reverse journal entries
and consider tax effect
Preparing financial statement for further analysis
Recast financial
statements
 Use a standardised
format – to group ‘like
with like’
 
 Re-classify (Bal Sheet
and P&L) accounts;
often into operating &
financing activities
 
 This may require
information from
footnotes

Recasting financial statements
Recast Income Statement Recast Balance Sheet
Net Operating Profit After Tax
+ Net Interest Expense After Tax
= Net Income
Net Operating Assets
= Net Operating Working Capital
+ Net Operating Long-Term Assets
=
 Net Interest Expense After Tax
= (Interest Expense – Interest Income) * (1-t)
Net Interest Bearing Debt
Interest bearing debt (short + long-term)
- Excess Cash
Plus
Shareholders’ Equity
6. Adjusting financial statements
Assets
Overstated
 Delayed write-down of current assets
 Delayed write-down of non-current
assets
 Accelerated revenue recognition
 Understated depreciation
 Correct by decreasing assets,
decreasing Net Income
 Consider tax effect
Understated
 Overestimated allowance for bad debts
 Overstated depreciation
 Off-balance sheet leases
 Correct by increasing assets,
increasing Net Income
 Consider tax effect
Liabilities
Overstated
 Long-term employee benefits
 Long-term super/pension obligations
 Correct by decreasing
liabilities, increasing Net
Income
 Consider tax effect
Understated
 Understated unearned revenue
 Off-balance sheet financing
 Correct by increasing liabilities,
deceasing Net Income
 Consider tax effect
An analyst may need to ‘correct’ the financial statements if they believe that the accounting does
not reflect the underlying economics. There are a number of possible adjustments.
Example adjustments – Microsoft’s (off-balance sheet) intangible assets
From https://www.microsoft.com/investor/reports/ar22/index.html
7. Summary
 Accounting analysis tries to inform us about the extent to which the financial statements
reflect the underlying economics of the business
 Our analytical tools allow us to recast the financial statements – to allow more effective
and structured performance analysis (see next class)
 We should also be able to adjust a company’s accounts to reflect the impact of a
‘preferred’ accounting treatment
 The incentives and opportunities for earnings manipulation will impact on the extent to
which we observe earnings quality