Financial Reporting and Analysis

Types of Accounting rules and guidelines

• Statements of Financial Accounting Standards
• APB Opinions.
• Accounting Research Bulletins (ARB).
• AICPA pronouncements. The AICPA issues guidelines for certain topics yet to be addressed by the FASB in its Statements of Position (SOP) or for those involving industry-specific matters in its Industry Audit and Accounting Guidelines.
• EITF Bulletins. EITF Bulletins are issued by the FASB’s Emerging Issues Task Force.
• Industry practices.

Environmental Factors

Securities and Exchange Commission (SEC)

• Independent, quasi-judicial government agency
• Administer securities regulations & disclosures
• Can modify & set GAAP, if necessary 
• Rarely directly challenges FASB
• Major player in global accounting

Managers of Companies

• Primary responsibility for fair & accurate reports
• Applies accounting to reflect business activities
• Managerial discretion is necessary in accounting
• Major lobbyist on GAAP

Auditing

• SEC requires Audit Report
• Audit opinion can be:
• clean (fairly presented)
• qualified (except for)
• disclaimer (no opinion)
• Check Auditor quality & independence

Corporate Governance

• Board of directors oversight
• Audit committee of the board
• oversee accounting process
• oversee internal control
• oversee internal/external audit
• Internal Auditor

Internal and eksternal user

Alternative information sources

Economic, Industry & Company News

Impacts current & future financial condition and performance

Voluntary Disclosure

Motivation - Legal liability, Expectations Adjustment, Signaling, Managing expectations

Information Intermediaries

- Industry devoted to collecting, processing, interpreting & disseminating company information

- Includes analysts, advisers, debt raters, buy- and sell-side analysts, and forecasters

- Major determinant of GAAP

Desirable Qualities of Accounting Information

Relevance - the capacity of information to affect a decision

Reliability - For information to be reliable it must be verifiable, representationally faithful, and neutral. Verifiability means the information is confirmable. faithfulness means the information reflects reality, and neutrality means it is truthful and unbiased.

Important Accounting Principles

Historical Cost - fair & objective values from arm’s-length bargaining

Accrual Accounting - recognize revenues when earned, expenses when incurred

Materiality - threshold when information impacts decision making

Conservatism - reporting or disclosing the least optimistic information about uncertain events and transactions

Limitations of Accounting Information

Timeliness - periodic disclosure, not real-time basis

Frequency - quarterly and annually

Forward Looking - limited prospective information

Accruals-The Cornerstone

Illustration - Case Facts

• Establish company and invest $700 equity
• Purchase plain T-shirts for $5 each
• Fixed screen cost of $100
• Variable print cost of $0.75 per T-shirt
• Sold 25 T-shirts at $10 each for cash
• Sold 25 T-shirts at $10 each on credit

Foundations of Accrual Accounting

Revenue Recognition – recognize revenues when

(1)  Earned

(2)  Realized or Realizable

Expense Matching – match with corresponding revenues

     - Product costs

     - Period costs 

Accruals-The Cornerstone

Operating cash flow (OCF)

 -/+ Cash investment & divestment in operating assets

  = Free cash flow (FCF)

 +/- Financing cash flows (including investment &

      divestment in financing assets)

  = Net cash flow (NCF)

Short-Term and Long-Term Accruals

Short-Term Accruals: Yield current assets and current liabilities (also called working capital accruals)

Long-Term Accruals: Yield non-current assets and non-current liabilities (arise mainly from capitalization)

Note: Analysis research suggests short-term accruals are more useful in company valuation

Accruals and Cash Flows - Myths

Myth: Since company value depends on future cash flows, only current cash flows are relevant for valuation.

Myth: All cash flows are value relevant. 

Myth: All accrual accounting adjustments are value irrelevant.

Myth: Cash flows cannot be manipulated. 

Myth: All income is manipulated. 

Myth: It is impossible to consistently manage income upward in the long run. 

Accruals and Cash Flows - Truths

Truth: Accrual accounting (income) is more relevant than cash flow.

Truth: Cash flows are more reliable than accruals.

Truth: Accrual accounting numbers are subject to accounting distortions.

Truth: Company value can be determined by using accrual accounting numbers.