Financial Accounting

							                Top Ten Key points from Financial Accounting
                               Suneel Udpa

1) The basic accounting equation is the foundation of financial reporting:

           Assets                  =         Liabilities    +           Owner’s Equity
           Investing Activities    =           Financing Activities

   Revenue and expense accounts are really Owner’s Equity accounts. Revenues
   increase retained earnings and expenses decrease retained earnings.

   The symmetry of the Dr/Cr convention and the accounting equation implies that
   for each transaction the dollar total of the debits must equal the dollar total of the
   credits.

   Using T-accounts, one can reconstruct transactions that have occurred during the
   period and obtain/deduce unknown/unavailable numbers.


2) The Income Statement and the Balance Sheet are prepared using the accrual
   system of accounting – revenues are recorded in the period when they are
   “earned” and expenses are recorded to match revenues and when they are
   incurred. Although the accrual system of accounting provides a more accurate
   measure of economic value added and performance during the period, it provides
   significant opportunities for earnings management and manipulation. For this
   reason, analysts need to reconcile Net Income with Cash Flow from Operations. A
   significant difference between Net Income (based on accrual system) and Cash
   Flow from operations may be a “red flag” that signals distortions of reported
   profits or impending financial difficulties.

3) Effective financial analysis begins with analyzing the industries to which the firm
   belongs and the firm’s strategies to create a sustainable advantage. This enables
   the analyst to frame the subsequent accounting and financial analysis better. The
   next step is to conduct an accounting analysis to examine the degree to which the
   firm’s accounting captures the underlying business reality. If there are significant
   distortions, then an analyst needs to “undo” any accounting distortions by
   recasting a firm’s accounting numbers to create unbiased data. Sound accounting
   analysis improves the reliability of the conclusions drawn from financial
   statement analysis and can be a major competitive advantage for an analyst.

4) The starting point for ratio analysis is the company’s ROA. ROA measures the
   firm’s performance independent of the source of financing of the assets. ROA can
   be decomposed into its components: Profit Margin and Asset Turnover ratio.
   Differences in the business strategies companies adopt give rise to differences in
   profit margin and asset turnover ratios. Firms that adopt strategies of product and
   service differentiation have higher profit margins, whereas firms adopting low-
   cost leadership strategies to achieve high sales volume have high asset turnover
   ratios. Profit Margin can be further analyzed using common-size income
   statements and Asset Turnover ratios can be probed further by examining the
   turnover ratios for Accounts Receivable, Inventory and Fixed Assets separately.

   ROCE measures a company’s performance in using the capital provided by
   common equity shareholders to generate income. ROCE explicitly considers how
   the company’s assets are financed. ROCE can be decomposed into its three
   components: Profit Margin, Asset turnover ratio and Financial Leverage.
   Financial Leverage indicates the proportion of total assets provided by common
   shareholders. As the proportion of capital provided by common shareholders
   shrinks, larger is the proportion that creditors provide and larger is the financial
   leverage. A firm can increase ROCE beyond its ROA by increasing its financial
   leverage if its ROA exceed the after-tax cost of debt. The common shareholder
   earns a higher return, but they operate under more restrictive debt covenants and
   undertake more risk in their investment. The risk results from the firm incurring
   debt obligations with fixed payment amounts and dates.


5) GAAP rules for revenue and expense recognition leave room for considerable
   latitude and judgment and managers exploit this flexibility to manipulate reported
   earnings. There are several reasons as to why managers manipulate reported
   earnings: to meet analysts’ expectations, to avoid violations of debt covenants, to
   maximize compensation (in many instances, incentives are tied to accounting
   numbers), and for political and regulatory reasons.

6) Accounts Receivables (AR):

   Test for the adequacy of the Allowance for Doubtful Accounts by computing and
   analyzing appropriate ratios

   Examine whether existing receivables represent real sales by comparing growth in
   sales with growth in accounts receivables (or cash collections from customers).
   Large increases in AR relative to sales could be due to collection difficulties
   and/or fictitious sales.

   Be cautious of sale (or factoring) of receivables. When firms sell receivables, the
   receivable number reported in the balance sheet will understate the true growth in
   receivables over the period


7) Inventory:

   In periods of rising prices, LIFO gives the lowest income, lowest taxes, and
   highest cash flow.
   Use LIFO Reserve disclosures to transform LIFO financial statements to FIFO
   basis to make comparisons between firms more meaningful, when one firm is
   using LIFO and the other FIFO.

   LIFO liquidation can have large impacts on reported earnings and can be used to
   manage earnings. The earnings effect arises from a mismatching, since LIFO
   layers carried at “old” (and usually lower) costs are liquidated and “matched”
   against sales dollars at higher current prices. LIFO liquidations distort reported
   margins and the income growth trend. Many analysts eliminate the effects of
   LIFO liquidation to provide a clearer picture of the underlying real and
   sustainable gross margin each year. LIFO also makes it possible to manage
   earnings by making strategic purchases towards the year-end.


8) Long-term Assets:

   GAAP requires long-term fixed assets to be shown in the Balance Sheet at
   Original Historical Cost – Accumulated Depreciation = Book Value. You should
   not expect the balance sheet numbers for fixed assets to necessarily approximate
   their real economic worth. This is one of the limitations of fixed asset reporting
   under GAAP.

   Another issue that is problematic is determining the expenditures that get
   capitalized and the expenditures that get expensed. Ordinary Repairs &
   Maintenance expenses that simply maintain the asset should be expensed.
   Expenditures that extend the life/capacity/efficiency of the asset should be
   capitalized. Sometimes, however, for certain expenditures the distinction between
   the two are blurred and the firm’s management has the discretion to either
   capitalize or expense.

   Issue with depreciation: a) GAAP allows different depreciation methods, although
   most firms use straight line, b) Firms have discretion in their estimate of useful lie
   and salvage value, and c) Firms can change depreciation methods, useful life, and
   salvage value, although they have to have real economic reasons for doing so. As
   a result, valid comparisons are often hindered by different depreciation
   assumptions across firms.

   One way to address the problem of two (comparable) firms in the same industry
   having different estimated lives is to estimate Average Useful Life =
   Average Gross PP & E/ Depreciation Expense and use this estimate to undo
   differences in estimated lives. The process is crude and based on several
   assumptions, but it makes an attempt to address the problem.

   Intangible assets when developed internally are expensed to R & D. The one
   exception to this rule relates to Software Development Costs. Intangible assets
   purchased from another company is recorded at the purchase price and then
   amortized. This difference in GAAP treatment leads to an understatement of
   internally developed intangible assets and hinders useful comparisons across
   firms.


9) Liabilities

   Be aware of contingent liabilities (potential future obligations that arise from an
   event that has occurred in the past but whose outcome is not known) disclosed in
   the footnotes to the financial statements

   Price of the Bond = Present Value of cash flows discounted at the market discount
                         rate or effective yield

   The cash interest and principal payments on the bond are set before the bond is
   issued, but market forces determine the issue price and thus effective yield. Bonds
   can be issued at par, at discount, or at premium.

   When interest rates change after the bond has been issued, the bond’s reported
   book value and market value will no longer be the same. That is because GAAP
   requires firms to use the yield determined at the time of issue for the amortization
   schedule to determine book value. So, when market rates have increased and the
   bonds are retired before maturity, market value of the bond is below its book
   value and this generates a gain on retirement. When the opposite is true, a loss
   results. Retirement of bonds before maturity provides opportunities for managing
   reported earnings and balance sheets numbers.


10) When all else fails, call 1-800-ASK-UDPA ($3.50/hr – bulk discounts available)