Learning to Use Financial Accounting Numbers Strategically

Catherine Schrand, a professor of accounting at the Wharton School of the University of Pennsylvania, gets what you really think of her. “I know the reputation of accounting,” she told a group of high school students visiting Wharton’s campus during our summer Cross-program lecture series. “I know that we are seen as a boring group of people.”

Dr. Schrand fights that stereotype. Accounting is her life’s work and her research interest. Accounting, she said, is like financial forensics; it requires deep investigation into how companies operate and is about uncovering the hidden stories behind the numbers.  “Accounting is the preparation and generation of information and the aggregation of that information in a way that’s useful in decision-making,” noted Schrand. “People think accountants are all about preparing accounting information, but I focus on actually using that accounting information to make decisions.”

Here are 4 ways Professor Schrand talks about using financial accounting information (see sidebar below) as a strategic tool for understanding a company’s true financial health and potential:

💰 Equity valuation. What is the fair value of a public company’s stock? Investors are hungry for this information as they figure out where to put their money. Investors use accounting data, particularly earnings, to forecast future cash flows and use discounted cash flow valuation models. Small changes in earnings persistence (the continuity of earnings from one period to the next) can dramatically impact a company’s valuation. “It is true based on research, that earnings, current period earnings, are a better predictor of future period cash flows than current period cash flows,” noted Schrand.

💰 Disaggregation techniques. An income statement aggregates accounting information, meaning it combines financial data from different sources into a consolidated view. It’s important to analyze disaggregated components like Research and Development (R&D) expenses, income taxes, and interest expenses to understand a business and to get at why, for example, certain earnings are likely to persist. “Financial statements are highly aggregated,” said Schrand. “But the standard setters do require certain items to be disaggregated, and they’re meant to be helpful to people who are trying to forecast future cash flows.”

💰 Analyzing managers’ decisions. Company managers can influence reported earnings in different ways, in particular structuring transactions for accounting benefits. What are the numbers telling you that might obscure or distort the true economic position of a firm? One example is reporting of research and development, an important innovation arm of a company. “There’s a lot of evidence out there that managers, if they want to show higher earnings, reduce their R&D,” observed Schrand. “Every dollar of R&D that you save increases your earnings by $1. Is that a good business decision to reduce R&D? How are you going to grow in the future if you’re not developing new things? But it makes your earnings that year look better.”

💰 Knowing the risks. Accurate risk assessment for analysts and investors depends a lot on understanding how accounting works – not just reading the surface numbers, but also interpreting what they represent. For example, Dr. Schrand, whose research focuses on earnings quality, said that not all earnings are equal in terms of persistence.  Earnings that come from unusual or non-recurring events (like a legal settlement) are less reliable predictors of future performance. Higher-quality earnings translate to lower risk.

Concluded professor Schrand: “You need to understand the business model of a firm in order to be able to interpret its income statement. But on top of that, you need to understand how the accounting represents their business activities.”