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3 Chapter 3: Data Analysis Applications in Accounting

Learning Objectives

  • List and describe important accounting issues and decisions
  • Indentify how data analysis tools and tasks relate to accounting issues and decisions

Chapter content

Accounting practitioners and academics have developed mental models to help analysts and decision makers understand and interpret accounting information. These models explain the relationships between accounting information and economic events. The models also identify the limitations of accounting information and the potential for accounting information to be manipulated. This chapter provides a brief overview of some of the most common accounting mental models. While these models are not exhaustive, they can provide a useful foundation for accounting thought.

Profitability analysis

Accountants measure and evaluate financial health and profitability. Most company decisions and activities are viewed through a lens of what effect they have on company revenues, expenses, assets, or liabilities. Profitability analysis as a mental model focuses on measuring profitability and understanding the factors that drive profitability.

Profitability analysis begins with comparing income earned to the investment made to generate that income. Profitability ratios vary depending on who the analysis is for. For a company that has shareholders that contribute equity to the company and expect a return on their investment, profitability analysis is often focused on the return to shareholders.

Shareholders get a return on their investment through dividends that are paid or are expected to be paid in future periods. The ability to pay dividends and the amount and timing of those dividends depends on the operations that generate profitable cash flows for the company. Profitability for shareholders therefore starts with the accounting return-on-equity (ROE) that compares the accounting income from operations to the equity invested. ROE is typically measured as the earnings available to common equity investors divided by the average or lagged (accounting) value of common equity.

ROE = \frac{\text{Net income} - \text{Preferred Dividends}}{\text{Average Common Equity}}

When viewed with a focus on ROE, higher ROE is preferred to lower ROE and actions a company takes to increase expected ROE are good. Profitability analysis further explores the drivers of ROE.

Various decompositions of this ratio are used to identify the sources of profitability. A common decomposition, the Dupont ROE decomposition, is shown below.

= \text{Profit margin}\times \text{Asset Turnover} \times \text{Leverage}

= \frac{\text{Net Income} - \text{preferred dividends}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Average Total Assets}} \times \frac{\text{Average Total Assets}}{\text{Average Common Equity}}

This decomposition shows that companies can increase ROE by increasing profit margins and asset turnover (efficiency) or by leveraging shareholder investments with borrowing.

Related ratios might also be used to study profitability. For example, ROA, or return on assets, compares the return on assets that are financed by debt and equity.

ROA = \frac{\text{Net income}}{\text{Average Total Assets}}

The related decomposition focuses on the first two parts of the ROE decomposition:

= \text{Profit margin}\times \text{Asset Turnover}

One benefit of using profitability ratios to measure and understand company performance is that these measures are comparable across companies and over time whereas dollar values of net income or other income statement measures are not. For example, comparing net income of $100M to net income of $10M does not compare the relative performance of the two companies. However, a 5% ROE versus a 10% ROE makes the performance comparable.

Decisions and data analysis

Managers, investors, and other stakeholders make decisions based on the profitablity of a company. Click on the following stakeholders to learn about how profitability and data analysis inform their decisions.

Earnings management and earnings quality

A concern from investors, regulators, and other stakeholders is that managers manipulate accounting information for their own benefit. Concerns about earnings management have led to various measures used to detect earnings management. Related to earnings management is the broader concern that accounting information may not accurately reflect company performance or financial health.

Earnings management

Earnings management refers to managers manipulating reported performance to achieve personal or company performance related objectives. As a consquence of earnings management, reported performance may be different from a company’s actual performance. When reported performance differs from actual performance, accounting income as a measure of performance may be low quality.

Managers might manipulate accounting income in various ways. A mental model of earnings management is that managers manipulate accounting income using components of income over which the manager has the most discretion. This mental model of earnings management has led to a focus on an accountants’ estimates and judgements that affect income. These estimates and judgments might be generically referred to as accruals.

Accruals according to this usage of the term, can be defined as the adjustments to cash flow accounting that accountants make to arrive at accounting net income. Accruals are used to match revenues and expenses in the period in which they are earned or incurred via a matching principle. Accruals also may recognize revenues or primarily expenses (i.e. depreciation) that are not recognized in cash flow accounting. Because accruals involve estimates and judgments, they are subject to managers’ choices and therefore may be subject to either errors or manipulation. This concept of accruals has led to a measure that tries to capture the component of income that is subject to the most managerial discretion.

Consider the following representation for income:

\text{Net Income} = \text{Operating Cash Flows} + \text{Accruals}

Accruals can increase or decrease net income relative to cash flows reported via cash flow accounting. Separating net income into operating cash flows and accruals adjustments has a close parallel to the indirect method for the statement of cash flows. This indirect method for the statement of cash flows reconciles the difference between operating cash flows and net income.

Managers that opportunistically increase income using their available discretion might have accruals that are too high relative to what they would otherwise be. One challenge with this representation is that non-opportunistic reasons also influence accruals.

Combining this focus on accruals with profitability leads to a potential measure of the component of ROE subject to managers’ discretion and the component perhaps less subject to managers’ discretion.

\text{ROE} = \frac{\text{Operating Cash Flows}}{\text{Average Common Equity}} + \frac{\text{Accruals}}{\text{Average Common Equity}}

Earnings quality

The extent to which accounting income reflects actual performance is referred to as earnings quality. Earnings quality is a useful concept; however, even more than earnings management, it is not observable.

As a concept, stakeholders prefer higher quality income because it better reflects performance. Because of the unobservable nature, various stakeholders have used observable indicators that might be associated with earnings quality. For instance, accruals that make large adjustments to cash flows, either positive or negative might reflect low earnings quality. Other possibilities include the extent to which accruals map into future income, whether companies issue restatements or are subject to SEC enforcement actions, whether the company has a high quality audtior,  or whether the company has had an unfavorable audit opinion.

Decisions and data analysis

Regulators, auditors, and other stakeholders make decisions based on earnings quality and earnings management. Click on the following stakeholders to learn about how concerns about earnings management and earnings quality and data analysis inform their decisions.

Valuation

 

 

 

 

Accounting is a primary source of information for equity valuation (https://mybusinesscourse.com/book/vfs2e). Closely related is using accounting for evaluating liability claims and enterprise value. Valuing claims on a company primarily rely on accounting derived information whether the information is about cash flows, dividends, earnings, or other related items. The two most common approaches linking accounting to valuation are algebraically equivalent to the dividend discount model and closely associated with the discounted free cash flow model and are referred to the residual income valuation model and the abnormal earnings growth model (see Penman textbook) or a simplified book version). Below is a short and simplified version of these valuation models. In each case, the intrinsic/true/economic value of equity for a company, $V_e$, is given for these models as follows.

  • Residual income valuation

V_e = BVE_0 + additional\ value

Here BVE_0 is the initial accounting value of common equity found in the financial statements. This value is given as an anchor to which additional value is added. The additional value is innovation of the residual income valuation model and is the present value of future residual income. The key aspect for our interests is that the additional value is determined by future expected earnings. Companies that have higher expected future earnings are worth more because they are expected to generate higher future earnings. Here we will avoid further complications and only present the basic idea rather than complications with its implementation.

V_e = BVE_0 + \sum_1^\infty \frac{Net\ Income_t - r BVE_{t-1}}{(1+r)^t}

In this formula, Net\ Income_t is the expected net income for period t, which is in a future period, like 1 year in the future, r is the required rate of return – the cost of equity. The additional value is the present value of residual income, economic value added, or the earnings beyond what is required for all future periods. Often when using this valuation, the value of equity is compared with the observed market value of equity to determine if the company is overvalued or undervalued. For example, the comparison below might be made to determine if the equity is a good buy.

Buy if:

V_e > Market\ Value\ of\ Equity

  • Abnormal earnings growth

The same reasoning and approach applies to a related, similar model, the abnormal earnings growth model.

V_e = \frac{Net\ Income_1}{r} + Additional\ Value

Here the anchor is a perpetuity of expected one year ahead net income. The additional value is growth in earnings that is beyond the required growth given by the required rate of return.

V_e = \frac{Net\ Income_1}{r} + \sum_2^\infty \frac{Net\ Income_t - r Net\ Income_{t-1}}{(1+r)^t}

A large focus when thinking about value derived from accounting is the forecasting of future earnings and earning growth. Other aspects discussed here are then relied on such as profitability decomposition and earnings quality.

Decisions and data analysis

 

 

Risk based auditing

The prototypical role of the auditor is to provide assurance that financial statements are free from material misstatement. One framework for thinking of the auditor’s view about the risk they face from the the financial statements being material misstated is the audit risk model. The audit risk model provides a framework for thinking about auditor’s willingness to accept risk and the risk they face in auditing. A simple equation outlines key features of audit risk.

Audit\ Risk = Inherent\ Risk \times Control\ Risk \times Detection\ Risk

With this framework, audit risk, i.e. the risk that the auditor will fail to detect a material misstatement, is a function of inherent risk, control risk, and detection risk. Inherent risk is the risk that the financial statements are materially misstated before considering the effectiveness of internal controls and is the risk that exists, for example, from auditing a company that has strong incentives or opportunities for misstatements or a company that has highly complex financial statements. Control risk is the risk that the internal controls will fail to prevent or detect a material misstatement. Detection risk is the risk that the auditor will fail to detect a material misstatement. The risk that is most under the control of the auditors. With unlimited time and effort, the auditor would be able to set detection risk to zero or near zero. Because clients and auditors have limited time and resources, the auditor’s goal is to reduce detection risk to an acceptably low level.

Decisions and data analysis

 

Accounting principles

Academics and standard setters have developed guiding principles for accounting that either summarize pre-existing principles and practices or set guidelines for developing future practices.

An ongoing project by the Financial Accounting Standards Board (FASB) is the conceptual framework. Included in the conceptual framework are descriptions about the purposes of financial statements, characteristics that make financial statements useful, and principles that guide the development of accounting standards.

For example, characteristics of useful financial information include: relevance, faithful representation, comparability, verifiability, timeliness, and understandability. Standard setters consider other choices when making standards that include measurement, recognition, presentation, and disclosure.

Accounting principles and practices help make financial reporting the most reliable and used resource for understanding a company’s operations, financial health, and performance.

Decisions and data analysis

 

 

What does accounting miss?

Despite the standards, auditing, and other efforts to make accounting information reliable, accounting information is has limitations beyond the concerns about the quality of the information. For example, summary accounting reports are less timely than other sources of information. For external users, the summary information may also not be as detailed as needed or useful for some decision making. Additionally, because accounting focuses on transactions that have occurred and reasonable and verifiable limited information about future events. These limits may mean that accounting information may fail to capture information or may only capture with substantial delay information about future events, value and performance that is not fully captured by historical transactions, or less tangible information such as customer satisfaction, innovation, or shocks to supply or demand.

Understanding what accounting does and does not capture can often be important for understanding uses and limitations for accounting data and accounting analytics.

 

 

Mini-case video

Note: include practice and knowledge checks

Review

 

References

 

Christensen, B. E., Glover, S. M., Omer, T. C., & Shelley, M. K. (2016). Understanding audit quality: Insights from audit professionals and investors. Contemporary Accounting Research, 33(4), 1648-1684.

Dechow, P., Ge, W., & Schrand, C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50(2-3), 344-401.

Dichev, I. D., Graham, J. R., Harvey, C. R., & Rajgopal, S. (2013). Earnings quality: Evidence from the field. Journal of Accounting and Economics, 56(2-3), 1-33.

Healy, P. M., & Wahlen, J. M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, 13(4), 365-383.

Nissim, D., & Penman, S. H. (2001). Ratio analysis and equity valuation: From research to practice. Review of Accounting Studies, 6, 109-154.

Penman, S., & Pope, P. F. (2025). Financial Statement Analysis for Value Investing. Columbia University Press.

 

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Data Analytics with Accounting Data and R Copyright © by Jeremiah Green. All Rights Reserved.

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