Chapter 3
Overview of Accounting Analysis
Discussion Questions
1. A finance student states, “I don’t understand why anyone pays any attention to accounting earnings
numbers, given that a ‘clean’ number like cash from operations is readily available.” Do you agree? Why
or why not?
There are several reasons why we should pay attention to accounting earnings numbers. First, net
income predicts a company’s future cash flow better than current cash flow does. Net income aids
in predicting future cash flows by reporting transactions with cash consequences at the time when
2. Fred argues, “The standards that I like most are the ones that eliminate all management discretion in
reporting—that way I get uniform numbers across all companies and don’t have to worry about doing
accounting analysis.” Do you agree? Why or why not?
We don’t agree with Fred because the delegation of financial reporting decisions to corporate
managers may provide an opportunity for managers to convey their superior information to
investors. Corporate managers are typically better than outside investors at interpreting their firms’
managers may expend economic resources to restructure business transactions to achieve a desired
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3. Bill Simon says, “We should get rid of the FASB and SEC since free market forces will make sure that
companies report reliable information.” Do you agree? Why or why not?
We partly agree with Bill on the point that corporate managers will disclose only reliable
information when rational managers realize that disclosing unreliable information is costly in the
4. Many firms recognize revenues at the point of shipment. This provides an incentive to accelerate
revenues by shipping goods at the end of the quarter. Consider two companies, one of which ships its
product evenly throughout the quarter, and the second which ships all its products in the last two weeks of
the quarter. Each company’s customers pay thirty days after receiving shipment. Using accounting ratios,
how can you distinguish these companies?
There is no difference between the two companies in their income statements. Both companies have
the same amount of revenues and expenses. However, the two companies are different in their
Chapter 3 Overview of Accounting Analysis 3
The company with even sales will show lower days’ receivable.
5. a. If management reports truthfully, what economic events are likely to prompt the following
accounting changes?
• Increase in the estimated life of depreciable assets Managers may increase the estimated life of
depreciable assets when they realize that the assets are likely to last longer than was initially
• Decrease in the uncollectible allowance as a percentage of gross receivables The firm’s
• Recognition of revenues at the point of delivery, rather than at the point cash is received
Revenues can be recognized when the customer is expected to pay cash with a reasonable
• Capitalization of a higher proportion of software R&D costs According to SFAS No. 86, costs
5. b. What features of accounting, if any, would make it costly for dishonest managers to make the same
changes without any corresponding economic changes?
Third-Party Certification. Public companies are required to get third-party certification (auditor’s
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Reversal Effect. Aggressive accounting choices may inflate net income in the current period but
they hurt future net income due to the nature of accrual reversal. For example, aggressive
6. The conservatism principle arises because of concerns about management’s incentives to overstate the
firm’s performance. Joe Banks argues, “We could get rid of conservatism and make accounting numbers
more useful if we delegated financial reporting to independent auditors rather than to corporate
managers.” Do you agree? Why or why not?
We don’t agree with Joe Banks because the delegation of accounting decisions to auditors may
reduce the quality of financial reporting. Auditors possess less information and firm-specific
Auditors also have their own incentive to record business transactions in a mechanical way, rather
7. A fund manager states, “I refuse to buy any company that makes a voluntary accounting change, since
it’s certainly a case of management trying to hide bad news.” Can you think of any alternative
interpretation?
One of the pitfalls in accounting analysis arises when analysts attribute all changes in a firm’s
accounting policies and accruals to earnings management motives. Voluntary accounting change
Chapter 3 Overview of Accounting Analysis 5
Promises that require future expenditures are liabilities even if they cannot be measured precisely.
According to the definition, liabilities are economic obligations of a firm arising from benefits
received in the past that are (a) required to be met with a reasonable degree of certainly and (b) at a
However, it is not easy to measure the costs associated with frequent flyer program accurately. At
least the following three cost categories should be considered in the estimation:
1. The administrative costs, such as maintaining the accounting system for the program, mailings
to program members, and providing service to those who request free flights
8. Fair value accounting attempts to make financial information more relevant to financial statement
users, at the risk of greater subjectivity. What factors would you examine to evaluate the reliability of fair
valued assets?
There are several factors that one should consider when evaluating the reliability of a firm’s fair
valued assets:
• What assumptions is the firm making in valuing its assets? Are there details in the footnotes
of the financial statements that can be examined for reasonableness?
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Chapter 3