Page 137 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT
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Security Analysis and Portfolio Management
Notes Fundamental analysts find it necessary to significantly alter the income statements, to obtain
estimates for two reasons.
1. The accountant has used an accounting procedure, which is inappropriate for the relevant
economic transaction and/or
2. The accountant, perhaps under the pressure of top management, has adopted a procedure
to minimise the firm’s income taxes or window dress the firm’s financial statements.
We will now discuss the differences in accounting procedures. These are only illustrative of the
controversy in reporting incomes.
1. Sales – Revenue Recognition Principle: Sales can be either cash sales or credit sales. Sales
can be recognized as early as the date the sale order is signed. However, in the case of
long-term construction contracts the sale may not be recognized until as late as the day the
cash is fully paid. Between these two extremes, the accountant may choose a suitable time
point to recognize the sales revenue in the financial statements. He may do it either in an
attempt to improve current income or because he has grown confident about its
collectability. In the case of credit sales, companies may factor their accounts receivable
and realize cash proceeds. One firm may recognize this immediately, whereas another
firm may wait until the customer’s final cash payment is actually received.
2. Inventory:
Inventory valuation is done based on two methods
FIFO – First in, first out method
LIFO – Last in, first our method
3. Depreciation: Several depreciation methods may be used in financial statements that a
firm to the public.
(a) Straight line method
(b) Sum-of-digit method
(c) Double declining balance method
(d) Units of production method
The second and third methods are accelerated methods of deprecation. The second method
may be used to accelerate depreciation during a period of rapid production.
Accounting Income Effect on Balance Sheet
A balance sheet is a summary of account balance carried after the appropriate closing of the
books. Income statements deal with flows, whereas balance sheet deals with stocks. Since stocks
are accumulations of flows, vagaries that undermine the estimates of accounting income are
cumulated in certain sheet items.
Example: The impact of inflation should be considered to make the balance sheet items
realistic. Measures suggested are.
1. Assets Side:
(a) Report marketable securities at current value.
(b) Inventory should be valued at replacement cost.
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