Financial Statemnt Analysis

Question 1

Explain why high book-to-market-ratios, loss-making start-ups have high market prices (accounting conventions)

Answer 1

conservatism in the face of uncertainty about the future

Question 2

The financial statements provide three great advantages

Answer 2

Book equity (profit) is a conservative lower bound on value (change in value)

Accounting depicts the firm’s business model and tracks its conversion of income/expense into cash flows

The financial statements provide a structure that disciplines our analysis and forecasting activities

Question 3

Financial statement analysis seeks to identify… (how?)

Answer 3

Understanding and adjusting for earnings management;

Identifying and adjusting for one-time effects, e.g., extraordinary shocks to certain expenses;

Undoing measurement error introduced by accounting standards, e.g., treating investments as expenses.

Question 4

How many general types of accounting measurement error?

Answer 4

2. Aggressive accounting & Conservative accounting

Question 5

Aggressive Accounting

Answer 5

• Boosting profit and equity
• Book value of equity (net assets) is overstated relative to its economic value because assets are overstated and/or liabilities are understated
• Consequences:
  Profit is overstated in the period in which the aggressive accounting distortion originates
  Profit is understated in the period in which the aggressive accounting distortion reverses
  Exception: Misstatement is reflected in OCI rather than P&L

Question 6

Conservative Accounting

Answer 6

• Better safe than sorry
• Book value of equity (net assets) is understated relative to its economic value because assets are understated and/or liabilities are overstated
• Managers often use conservative accounting to hide abnormally high profits or to create hidden reserves to boost future profitability
• Some systems, including the German HGB, encourage conservatism.