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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.

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

\text{ROE} = \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.

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

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

\text{ROA} = \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.

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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.

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Accounting standards and risk based auditing

Academics, regulators, and standard setters have developed guiding principles and standards that define what earnings quality means and the characteristics of high quality accounting. These principles and standards include the purposes of financial statements, characteristics that make financial statements useful, principles that guide the development of accounting standards, and rules and guidelines that determine how accounting is done. For example, useful financial information is relevant and verifiable and revenue is earned when goods and services are delivered.

Closely related to the concept of earnings quality is the assurance role of the auditor. The  auditor provides assurance that financial statements are free from material misstatement. To do so, the auditor works to assure financial statement users that the financial statements adhere to the standards and principles that make accounting useful and high quality. A mental model for how auditors do their work is risk based auditing. The audit risk model below represents the risk auditors have when performing an audit. It can also be used to consider the tradeoffs that auditors make when performing an audit.

\text{Audit Risk} = \text{Inherent Risk} \times \text{Control\Risk} \times \text{Detection Risk}

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 merely from the nature of the business. For example, a company that has physical equipment and inventory might be inherently less risky than a company whose assets are not physical, e.g. goodwill or intellectual property. This is a risk that an auditor can only alter by the clients it accepts. 

Control risk is the risk that internal controls will fail to prevent or detect a material misstatement. Control risk is lower for companies that have effective controls. For example, a company that has segregation of duties will have lower control risk than a company without the segregation of duties. 

Detection risk is the risk that the auditor will fail to detect a material misstatement. Detection risk is chosen by auditors in the extent of their audit procedures. 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

Various stakeholders make decisions that affect accounting standards or the the extent to which financial reports comform with accounting standards and principles. Click on the following stakeholders to learn about how stakeholders use accounting standard and data analysis to inform their decisions.

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Valuation

Accounting is a primary source of information for equity valuation. 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 are closely associated with the discounted free cash flow model. These are referred to as the residual income valuation and the abnormal earnings growth models. 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 = \text{BVE}_0 + \text{additional value}

Here \text{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 based on forecasts of future income that the company will generate. In the residual income valuation model, this is the present value of future residual income. Companies that have higher expected future residual earnings are worth more because they are expected to generate higher future earnings in excess of what is required. Here we will avoid further complications and only present the basic idea rather than complications with its implementation.

V_e = \text{BVE}_0 + \sum_1^\infty \frac{\text{Net Income}_t - r \text{BVE}_{t-1}}{(1+r)^t}

In this formula, \text{Net Income}_t is the expected net income for period t, which is in a future period, e.g. 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 or the present value of expected net income above the required return on equity. This may also be referred to as economic value added.

Abnormal Earnings Growth

The same reasoning and approach applies to an algebraically identical model, the abnormal earnings growth model. With this model, the anchor value is a perpetuity of the next period forecast for net income (or more precisely income available to common shareholders).

V_e = \frac{\text{Net Income}_1}{r} + \text{Additional Value}

The additional value is growth in earnings that is beyond the required growth given by the required rate of return.

V_e = \frac{\text{Net Income}_1}{r} + \sum_2^\infty \frac{\text{Net Income}_t - r \text{Net Income}_{t-1}}{(1+r)^t}

Also to be precise, Net Income here is forecasted cum-dividend income available to common shareholders. Note that in both of these models, the focus is on forecasting future earnings and future earnings growth. This means that data analysis informs valuation if it helps to forecast earnings or earnings growth. Related to the mental models described above, understanding the drivers of profitability and the quality of earnings becomes important for forming valuation estimates.

Decisions and data analysis

Many stakeholders may be interested in the fundamental value of a company. Click on the following stakeholders to learn about how valuation and data analysis inform their decisions.

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Accounting Usefulness

A final mental model relates to how accounting fits into the broader corporate information environment. This mental model views accounting as a source of information among a larger set of possible sources of information such as news articles, company advertising, analyst reports, CEO disclosures, etc.

Accounting information is useful to stakeholders if it provides new information that is different from information from other sources. Accounting information could provide new information if it is more timely than other sources, more reliable than other sources, or contains information that other sources do not.

There are reasons that accounting information might be useful and reasons that it might not be useful. For example, because of the standards, assurance from auditors, and the regulations requiring detailed reporting, accounting reports provide information that is largely reliable and not available via other sources. On the other hand, financial statements and the related disclosures are less timely than other sources of information. Accounting reports are also based on historical transactions rather than expectations about future periods and may be less relevant than information about future performance. Additionally, many important pieces of information are not captured by accounting such as customer satisfaction, competitor strategy, or brand recognition.

Decisions and data analysis

The information view of accounting informs decisions of investors, managers, and other stakeholders. Click on the following stakeholders to learn about how accounting (lack of) usefulness and data analysis inform their decisions.

Complete the knowledge check for this section.

Mini-case video

Beaver, W. H. (1968). The information content of annual earnings announcements. Journal of Accounting Research, 67-92.

Review

References

Beaver, W. (1997). Financial Reporting: An Accounting Revolution. Prentice Hall. ISBN: 9780137371495.

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.

Easton, P. D. (1985). Accounting earnings and security valuation: empirical evidence of the fundamental links. Journal of Accounting Research, 54-77.

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.

Sommers, Easton, and Drake (2025). Valuation Using Financial Statements. Cambridge Business Publishers. ISBN: 9781618535726.

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

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