4.3. Implications for Financial Analysis

#cfa-level-1 #expense-recognition #reading-25-understanding-income-statement

A company’s estimates for doubtful accounts and/or for warranty expenses can affect its reported net income. Similarly, a company’s choice of depreciation or amortisation method, estimates of assets’ useful lives, and estimates of assets’ residual values can affect reported net income. These are only a few of the choices and estimates that affect a company’s reported net income.

As with revenue recognition policies, a company’s choice of expense recognition can be characterized by its relative conservatism. A policy that results in recognition of expenses later rather than sooner is considered less conservative. In addition, many items of expense require the company to make estimates that can significantly affect net income. Analysis of a company’s financial statements, and particularly comparison of one company’s financial statements with those of another, requires an understanding of differences in these estimates and their potential impact.

If, for example, a company shows a significant year-to-year change in its estimates of uncollectible accounts as a percentage of sales, warranty expenses as a percentage of sales, or estimated useful lives of assets, the analyst should seek to understand the underlying reasons. Do the changes reflect a change in business operations (e.g., lower estimated warranty expenses reflecting recent experience of fewer warranty claims because of improved product quality)? Or are the changes seemingly unrelated to changes in business operations and thus possibly a signal that a company is manipulating estimates in order to achieve a particular effect on its reported net income?

As another example, if two companies in the same industry have dramatically different estimates for uncollectible accounts as a percentage of their sales, warranty expenses as a percentage of sales, or estimated useful lives as a percentage of assets, it is important to understand the underlying reasons. Are the differences consistent with differences in the two companies’ business operations (e.g., lower uncollectible accounts for one company reflecting a different, more creditworthy customer base or possibly stricter credit policies)? Another difference consistent with differences in business operations would be a difference in estimated useful lives of assets if one of the companies employs newer equipment. Or, alternatively, are the differences seemingly inconsistent with differences in the two companies’ business operations, possibly signaling that a company is manipulating estimates?

Information about a company’s accounting policies and significant estimates are described in the notes to the financial statements and in the management discussion and analysis section of a company’s annual report.

When possible, the monetary effect of differences in expense recognition policies and estimates can facilitate more meaningful comparisons with a single company’s historical performance or across a number of companies. An analyst can use the monetary effect to adjust the reported expenses so that they are on a comparable basis.

Even when the monetary effects of differences in policies and estimates cannot be calculated, it is generally possible to characterize the relative conservatism of the policies and estimates and, therefore, to qualitatively assess how such differences might affect reported expenses and thus financial ratios.


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