McGrau-Hl||/lruln

Corlght 2009 b The McGrau-Hl|| Comanles. lnc. A|| rlghts reserted.

FinanciaI
Statement
AnaIysis
K R Subramanyam
John J Wild
2-2

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FinanciaI Reporting
and AnaIysis
2-3
Statutory FinanciaI Reports
2-4
AAP
Types of Accounting ruIes and guideIines
4 Statements of Financial Accounting Standards
4 APB Opinions.
4 Accounting Research Bulletins (ARB).
4 ACPA pronouncements. The ACPA issues guidelines
for certain topics yet to be addressed by the FASB in its
Statements of Position (SOP) or for those involving
industry-specific matters in its ndustry Audit and
Accounting Guidelines.
4 ETF Bulletins. ETF Bulletins are issued by the FASB's
Emerging ssues Task Force.
4 ndustry practices.
2-5
nvironmentaI Factors
FinanciaI Accounting Standards Board FinanciaI Accounting Standards Board
eneraIIy Accepted Accounting PrincipIes eneraIIy Accepted Accounting PrincipIes
Provide input to Provide input to
HeIp set HeIp set
Securities and
change
Commission
Securities and
change
Commission
Unions Unions
Investors Investors
Accountants Accountants
PoIiticians PoIiticians
Lenders Lenders
Others Others
AICPA AICPA
FinanciaI Accounting Standards Board
eneraIIy Accepted Accounting PrincipIes
Provide input to
HeIp set
Securities and
change
Commission
Unions
Investors
Accountants
PoIiticians
Lenders
Others
AICPA
2-6
nvironmentaI Factors
Securities and change Commission (SC) Securities and change Commission (SC)
4 Independent, quasi-judiciaI government agency
4 Administer securities reguIations & discIosures
4 Can modify & set AAP, if necessary
4 RareIy directIy chaIIenges FASB
4 Major pIayer in gIobaI accounting
4 Independent, quasi-judiciaI government agency
4 Administer securities reguIations & discIosures
4 Can modify & set AAP, if necessary
4 RareIy directIy chaIIenges FASB
4 Major pIayer in gIobaI accounting
2-7
nvironmentaI Factors
InternationaI FinanciaI Reporting
Standards (IFRS)
Set by InternationaI
Accounting Standards Board
Not currentIy accepted in U.S.
SC under pressure to accept
IAS
2-8
nvironmentaI Factors
Managers of Companies
4 Primary responsibiIity for fair & accurate
reports
4 AppIies accounting to refIect business
activities
4 ManageriaI discretion is necessary in
accounting
4 Major Iobbyist on AAP
2-9
nvironmentaI Factors
Auditing
4 SEC requires Audit Report
4 Audit opinion can be:
4 clean (fairly presented)
4 qualified (except for)
4 disclaimer (no opinion)
4 Check Auditor quality & independence
Auditors
2-10
nvironmentaI Factors
Corporate overnance
4 Board of directors oversight
4 Audit committee of the board
4 oversee accounting process
4 oversee internal control
4 oversee internal/external audit
4 nternal Auditor
2-11
nvironmentaI Factors
InternaI Users InternaI Users ternaI Users ternaI Users
ControIIer
Budget Officers
SaIes Managers
InternaI Auditors
Officers
Managers
Customers
ternaI Auditors
Labor Unions
overnments
SharehoIders
Lenders
2-12
AIternative information sources
VoIuntary DiscIosure
conomic, Industry & Company News
4 mpacts current & future financial condition and performance
Information Intermediaries
4 ndustry devoted to collecting, processing, interpreting &
disseminating company information
4 ncludes analysts, advisers, debt raters, buy- and
sell-side analysts, and forecasters
4 Major determinant of GAAP
Motivation - Legal liability, Expectations Adjustment, Signaling,
Managing expectations
2-13
DesirabIe QuaIities of Accounting
Information
4 ReIevance - the capacity of information to affect a
decision
4 ReIiabiIity - For information to be reliable it must be
verifiable, representationally faithful, and neutral.
4 Verifiability means the information is confirmable.
4 faithfulness means the information reflects reality,
and
4 neutrality means it is truthful and unbiased.
2-14
FinanciaI Accounting
4 HistoricaI Cost - fair & objective values from arm's-length
bargaining
4 AccruaI Accounting - recognize revenues when earned,
expenses when incurred
4 MateriaIity - threshold when information impacts decision
making
4 Conservatism reporting or disclosing the least optimistic
information about uncertain events and transactions
Important Accounting PrincipIes
2-15
FinanciaI Accounting
ReIevance of Accounting Information
ReIation between Accounting Numbers and Stock Prices
2-16
FinanciaI Accounting
4 TimeIiness - periodic disclosure, not real-time
basis
4 Frequency - quarterly and annually
4 Forward Looking - limited prospective
information
Limitations of Accounting Information
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AccruaIs-The Cornerstone
4 Establish company and invest $700 equity
4 Purchase plain T-shirts for $5 each
4 Fixed screen cost of $100
4 Variable print cost of $0.75 per T-shirt
4 Sold 25 T-shirts at $10 each for cash
4 Sold 25 T-shirts at $10 each on credit
IIIustration - Case Facts
2-18
Receipts Assets
T-Shirt saIes $250 Cash $275
!ayments
T-Shirt purchases $500 Equity
Screen purchase 100 Beginning quity $700
Printing charges 75 Less net cash outfIow (425)
TotaI payments $(675) TotaI equity $275
Net cash outfIow $(425)
AccruaIs- The Cornerstone
Case IIIustration - Cash Accounting
Statement of Cash FIows BaIance Sheet (Cash basis)
2-19
Revenues Assets
T-Shirt saIes $500.00 Cash $275.00
T-Shirt inventory 337.50
Expenses ReceivabIes 250.00
T-Shirts costs $250.00 TotaI assets $862.50
Screen depreciation 50.00
Printing charges 37.50 Equity
TotaI epenses (337.50) Beginning equity $700.00
Add net income 162.50
Net income $162.50 TotaI equity $862.50
Accruals-The Cornerstone
Case IIIustration - AccruaI Accounting
BaIance Sheet (AccruaI basis) Income Statement
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AccruaIs-The Cornerstone
Net
ncome
=
Accruals
Operating
Cash Flow
+
=
+
2-21
Revenue Recognition recognize revenues when
(1) Earned
(2) Realized or Realizable
Expense Matching match with corresponding revenues
- Product costs
- Period costs
AccruaIs-The Cornerstone
Foundations of AccruaI Accounting
2-22
AccruaIs-The Cornerstone
ReIation between Cash FIows and AccruaIs
Operating cash flow (OCF)
-/+ Cash investment & divestment in operating assets
= Free cash flow (FCF)
+/- Financing cash flows (including investment &
divestment in financing assets)
= Net cash flow (NCF)
Operating cash flow (OCF)
-/+ Cash investment & divestment in operating assets
= Free cash flow (FCF)
+/- Financing cash flows (including investment &
divestment in financing assets)
= Net cash flow (NCF)
Operating cash flow (OCF)
-/+ Cash investment & divestment in operating assets
= Free cash flow (FCF)
+/- Financing cash flows (including investment &
divestment in financing assets)
= Net cash flow (NCF)
2-23
AccruaIs-The Cornerstone
Short-Term and Long-Term AccruaIs
Short-Term AccruaIs: Yield current assets and current liabilities (also called
4rking capital accruals)
Long-Term AccruaIs: Yield non-current assets and non-current liabilities (arise
mainly from capitalizati4n)
Note: Analysis research suggests short-term accruals
are more useful in company valuation
2-24
AccruaIs-The Cornerstone
AccruaIs and Cash FIows - Myths
4 Myth: Since company value depends on future cash
flows, only current cash flows are relevant for
valuation.
4 Myth: All cash flows are value relevant.
4 Myth: All accrual accounting adjustments are value
irrelevant.
4 Myth: Cash flows cannot be manipulated.
4 Myth: All income is manipulated.
4 Myth: t is impossible to consistently manage
income upward in the long run.
2-25
AccruaIs-The Cornerstone
AccruaIs and Cash FIows - Truths
4 Truth: Accrual accounting inc42e) is more
relevant than cash flow.
4 Truth: Cash flows are more reliable than
accruals.
4 Truth: Accrual accounting numbers are subject
to accounting distortions.
4 Truth: Company value can be determined by
using accrual accounting numbers.
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conomic concepts of income
Economic income Economic income
Permanent income Permanent income
Operating income Operating income
conomic income
4 Measures changes in Shareholders wealth.
4 Cash flows + Present value of expected future cash flows.
4 Useful when the objective of analysis is determining the exact
return to the shareholder for the period.
4 Less useful for forecasting future earnings potential.
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Accounting concept of income
4 Based on the concept of accrual accounting
4 Main purpose is income measurement
4 Two main processes
4 Revenue recognition
4 Expense matching
2-28
Accounting Vs conomic income
Reasons for difference
4 Alternative income concepts
4 Historical cost
4 Transaction basis
4 Conservatism
4 Earnings management
2-29
Fair vaIue accounting
Asset and liability values are determined on the
basis of their fair values (typically market prices)
on the measurement date (i.e., approximately
the date of the financial statements).
2-30
HistoricaI cost Vs Fair vaIue
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Advantages & Disadvantages
Advantages
4 Reflects current information.
4 Consistent measurement criteria.
4 Comparability
4 No conservative bias
4 More useful for equity analysis
Disadvantages
4 Lower objectivity
4 Susceptibility to manipulation. Use of Level 3 inputs.
4 Lack of conservatism.
4 Excessive income volatility.
2-32
ImpIications for AnaIysis
4 Focus on the balance sheet.
4 Restating income.
4 Analyzing use of inputs.
4 Analyzing financial liabilities.
2-33
Accounting AnaIysis
Demand for Accounting AnaIysis
4 Adjust for acc4unting dist4rti4ns so financial
reports better reflect economic reality
4 Adjust general-purpose financial statements to
meet specific analysis 4bjectives of a particular
user
2-34
Accounting AnaIysis
Sources of Accounting Distortions
4 Accounting Standards attributed to
1) political process of standard-setting,
2) accounting principles and assumptions, and
3) conservatism
4 stimation rrors attributed to estimation errors inherent in accrual
accounting
4 ReIiabiIity vs ReIevance attributed to over-emphasis on reliability at
the loss of relevance
4 arnings Management attributed to window-dressing of financial
statements by managers to achieve personal benefits
2-35
Accounting AnaIysis
AnaIysis Objectives
4 Comparatives AnaIysis demand for financial comparisons
across companies and/or across
time
4 Income Measurement - demand for (1) equity wealth
changes and (2) measure of
earning power. These correspond
to two alternative income
concepts
(1) Economic ncome (or
empirically, ec4n42ic pr4fit)
(2) Permanent ncome (or
empirically, sustainable pr4fit)
Chapter 6 discusses these measures in detaiI
2-36
Accounting AnaIysis
arnings Management - Frequent Source of Distortion
arning Management strategies:
4 Increasing Income managers adjust accruals to increase
reported income
4 Big Bath managers record huge write-offs in one period to
relieve other periods of expenses
4 Income Smoothing managers decrease or increase reported
income to reduce its volatility
2-37
Accounting AnaIysis
arnings Management - Motivations
4 Contracting Incentives - managers adjust numbers used in
contracts that affect their wealth (e.g., compensation contracts)
4 Stock Prices managers adjust numbers to influence stock
prices for personal benefits (e.g., mergers, option or stock
offering)
4 Other Reasons - managers adjust numbers to impact
1) labor demands,
2) management changes, and
3) societal views
2-38
Accounting AnaIysis
arnings Management - Mechanics
4 Incoming Shifting:
Accelerate or delay recognition of revenues or expenses to
shift income from one period to another
4 CIassificatory arnings Management:
Selectively classify revenues Earnings and expenses in
certain parts Management of the income statement to affect
analysis inferences regarding the recurring nature of these
items
2-39
Accounting AnaIysis
Process of Accounting AnaIysis
Accounting analysis involves several inter-related processes and
tasks that can be grouped into two broad areas:
4 vaIuating arning QuaIity: Steps
1) dentify and assess key accounting policies
2) Evaluate extent of accounting flexibility
3) Determine the reporting strategy
4) dentify and assess red flags
4 Adjusting FinanciaI Statements:
dentify, measure, and make necessary adjustments to financial
statements to better serve one's analysis objectives;
Chapters 3-6 focus on adjusting (recasting) the statements
2-40
Auditing And FinanciaI Statement AnaIysis