Question

5 steps in accounting analysis and why we do it

Answer 1

Step 1: Identify Principal Accounting Policies
Key accounting policies used to estimate revenues, expenses, profit , tax, etc.,as well as those used to measure risks and identify critical factors for success must be identified.
IFRS (i.e. International Financial Reporting Standards) require firms to identify critical accounting estimates (e.g., loan loss provisions for banks, depreciation expenses for airlines, inventory valuation for retail business).

Step 2: Assess Accounting Flexibility
Accounting information is less likely to yield insights about a firm’s dynamics if managers have a high degree of flexibility in choosing policies and estimates. For instance, for R&D expenses in the there is concept of expending it in the year of occurance, But in IFRS we capitalise it but for loan loss provisions according to Expected Loss Model the level of flexibility is higher in US GAAP

Step 3: Evaluate Accounting Strategy
Flexibility in accounting choices allows managers to strategically communicate economic information or hide true performance.
Issues to consider include:
a)Norms for accounting policies with industry peers (does the firm applies any different procedure than mentioned in accounting standards it can do so to present better presentation)
• Incentives for managers to manage earnings (Manipulation of accounts needs to be checked)
• Changes in policies and estimates and the rationales for making them
• Whether transactions are structured to achieve certain accounting objectives

Step 4: Evaluate the Quality of Disclosure
Managers have considerable discretion in disclosing certain accounting information
– Issues to consider include:
a)Whether disclosures seem adequate (clear business strategy, industry competitive position, etc.)
b)Proper notes to accounts in the financial statements
c)Whether the Management Report section sufficiently explains and is consistent with current performance
d)prdence and conservatism followed bu GAAP
e)Adequacy of segment disclosure

Step 5: Identify Potential Red Flags
Some issues that warrant gathering more information include:
a)Unexplained transactions that boost profits (asset sales)
b)Unusual increases in inventory or trade receivables in relation to sales
c)Increases in the gap between net profit and cash flows (changes in accrual estimates , using LIFO or FIFO ) or tax profit
d)Unexpected large asset write-offs
e)Large year-end adjustments (earnings management for ad-interim reports)
f)Qualified audit opinions or auditor changes

You can expand on any points you feel like