According to Lee (1999), accounting analysis is done to make sure that every financial transaction is well accounted for in the right general ledger. It makes the process important to the management as well as accounting personnel. When transactions are recorded incorrectly, the financial statement totals would be incorrect too. As a result, preparing budget for the following year might be hard. Accounting analysis also helps tell how deep a company’s financial statement has captured the latent economic conditions. It is also through this process that an analyst is able to assess if there is any distortion in the financial statements. If this person finds any misleading reporting, they can alter the accounting numbers to improve the results as well as undo the misleading reporting. It is completed through the footnotes found in the financial statements and cash flow statements.
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To perform the accounting analysis, there are steps that need to be followed; first is to identify the key accounting policies that the company uses to measure the risks and other critical factors. It is followed by assessing the accounting flexibility (Lee, 1999). The process varies from company to company, as they have different ways of choosing their accounting policies. Some are constrained by accounting standard and selecting policies that are related to their key factors of success.
After assessing the accounting flexibility, the next step would be to evaluate accounting strategy followed by evaluating the quality of disclosures that managers used in the company’s financial statements. The other important step in the account analysis is to identify red flags. Such are the issues that analysts need to look in depth. The final step is to undo accounting distortions that would suggest a company’s data was misleading.
Identify Principal Accounting Policies
Big Lot’s financial statements are prepared according to the U.S. GAAP, and as required, the management bases their estimates upon historical experience and other reasonable circumstantial assumptions (Big Lot, Inc. Form 10-K, 2018). Real results are expected to be different from the estimated owing to the deep-rooted risk factors. Some of the key accounting policies include merchandise inventories, long lived asset, share-based compensation, income taxes, insurance and insurance-related reserves, and lease accounting.
Big Lot’s merchandise inventories are valued using the market or lower of cost. The net realizable values are used to determine the market demand, including the price to be implemented for the products (Big Lot, Inc. Form 10-K, 2018). The management ought to use judgements and assumptions to determine the retail procedures, such as the slow-moving products for inventory efficiency and improvement of productivity through the anticipation of a positive gross margin in the future. The assumptions and judgments used for management decisions are based on the historical purchases made, movement of inventory, as well as the current market research results showing the needs of customers to determine the possible procedures that would grow the productivity and efficiency of the company (Big Lot, Inc. Form 10-K, 2018).
From the Big Lot, Inc. Form 10-K (2018), the long-lived assets include property and equipment. Management is responsible for ensuring that the store level is efficient through the process of analyzing the long-lived assets impairment. It is mostly done annually or when there are signs of impairments (Big Lot, Inc. Form 10-K, 2018). Accounting policies identified as “non-vested restricted stock units” and “PSUs” are seen to influence the company’s financial performance through the profits achieved, including the shareholders returns. The policies are provided to the company’s staff, which improves their well-being. For example, they stand at a chance of attaining common shares based on the awards they have cumulated (Big Lot, Inc. Form 10-K, 2018).
The other critical accounting policy for Big Lot is an income tax, which is highly affected by the income/loss before tax. Due to the uncertainty, the management uses significant judgement and estimates to state deferred tax asset and liability, refundable tax, and income tax expenses among others. Insurance and insurance-related services are the other factor that the company considers crucial to their performance. The accumulated insurance liabilities plus the associated expenses are accounted for from the both claims that have been reported and estimation of claims that have already been brought on but are yet to be reported. On the lease accounting, the initial term that has the least value is what is used to do the calculations of the future lease (Big Lot, Inc. Form 10-K, 2018).
Assessing Accounting Flexibility
The management uses estimation and assumptions to find accounting numbers, and it leads to unreliability of the figures that have been stated in the consolidated financial statements. Big Lot has accounting flexibility that they can manipulate to make the accounting numbers more close to the actual. From the Costco Wholesale Form 10-K (2018), Big Lot can account for merchandise inventories using the LIFO last-in, first-in method like the close competitor Costco. The organization uses the market or lower of cost technique for the calculations. LIFO technique depicts operations in a way that is more fairly by tightly harmonizing the current cost and current revenues. The approximated numbers are changed to the actual numbers at the end of the year. It is always after actual rates of inflation or deflation and inventory levels for the specific year are outlined.
Lease accounting for Big Lot makes use of the original lease term provided, which is the minimum period. For the organization to get a figure that is more close to the actual, they can use the first minimum term and depreciate over the remaining useful life of the property.
Evaluating Accounting Strategy
Looking across the industry, there is no consistent method of accounting for merchandise. Big Lot has a goal of increasing their net sales. The company puts more focus on the major influences of net sales, which are marketing, merchandising, and clients ‘experience during shopping. In the merchandising, they would be narrowing their definition of merchandise to “ownable’ or “winnable”. The organization should put more effort on offering product selections that are highly rated in terms of fashion, brand, quality, and affordable price or the customers. Customer expectations should be implemented as the guiding principles through quality services and meeting their needs, hence leading to the increased flexible purchases (Big Lot, Inc. Form 10-K, 2018).
By doing so, the company would meet their goal of increasing the net sales. It would be achievable by simply redefining the merchandise since there is no consistent way to define it in the market. The company can attain its objectives that are focused on ensuring that the shareholders have a high return. In return, the company would achieve the goal of driving shareholders return.
Evaluating Disclosure Quality
Companies do not usually disclose much information on their financial statements and reports. However, without some information, an analyst cannot carry out their accounting analysis effectively. Managers have the right to choose the amount of information to disclose to the public, but there is the required data that they must make available to the public.
The management of Big Lot has disclosed the necessary information. The authorities have listed the risk factors that their business anticipates and explained well why each factor is of much concern to them. Moreover, they have outlined clearly the critical accounting policies (Big Lot, Inc. Form 10-K, 2018). The managers have explained in great depth the assumptions used and why they believe the policies affect their business. Moreover, they provided their financial situation using the financial statements. Thus, they have made everything clear by explaining further what everything listed on the statements entails.
Identify Potential Red Flags
In the process of accounting analysis, there is a need to outline the factors that the analysts ought to look in more depth. The team noted that the company had unsteady cashflow for the last few years. The cashflow is back and forth. It shows that accounts are been settled, and there is a lot of new work coming for the company.
Undo Accounting Distortions
Unlike what may people think about accounting rules, they are not straightforward. Nowadays, there are many instances that the management is given choices when it comes to accounting for some transactions. Such choices are disclosed on the finical statement, but this alone does not remove the distortions (Lee, 1999).
From the Big Lot’s financial statement, the subject of distortion is the depreciation. Each product produced contributes to wear and tear of the machine used for manufacturing. Therefore, the depreciation expenses should be spread evenly through all the products. When depreciation expenses are reduced, the profits of the company increase. Big Lot Company reports for the depreciation expenses to proportions of net sales.
In order to fairly represent the financial position of Big Lot to provide clear information to the potential and existing investors, the accounting distortions on the matter of depreciation expenses were reversed. Big Lot, currently, uses the depreciation rate from the sales. The company does not put into consideration whether the products that have been sold were manufactured in the previous financial year or not. The depreciation of the machine used to manufacture the product depends on the number of products manufactured that particular year. In this way, using the percentage of sales leads to distortion of the accounting. To undo the distortion, the percentage of inventory instead to account for depreciation expenses should be used.
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