Lecture 2 Flashcards
Why care about strategy, if we are interested in accounting?
Strategy analysis allows us to exploit the connection between business activities and financial statements
What enables the analyst caring about strategy?
- Assess economic and financial outlook from a qualitative perspective
- Place the firm within its industry, assess its relative power and industry outlook
- Identify firm’s profit drivers, risks and the sustainability of its performance
- Evaluate management’s forecasts and make own assessments
Why care about strategy, if we are interested in accounting? (Tesla example)
Because the market value can be different from the book value depending on the strategy and there for future cashflows
Explain the model five forces of porter (pest model)
A model with five forces that affects the profitability of an industry. The five forces can be applied on firms. The model exists of two components:
1. DEGREE OF ACTUAL AND POTENTIAL COMPETITION
2. BARGAINING POWER IN INPUT AND OUTPUT MARKETS
The three forces of the first component are:
1. Rivalry among existing firms
2. Threat of new entrants
3. Threat of substitute products
The two forces of the second component are:
4. Bargaining power of buyers
5. Bargaining power of suppliers
What are two basic competitive strategies? (and if not any of them?)
Cost leadership
Product / service differentiation
Stuck in the middel
Cost leaders and differentiators differ in terms of their:
- Cost control
- Investments in brand image, reputation, R&D, overhead, etc
Where is the link between competitive strategy and financial statements particularly evident? (2 examples)
The income statement:
- Gross profit margin
- Inventory turnover, etc.
Accounting policies
the specific principles, rules and practices applied by an entity in their financial statements
Why should we understand accounting?
Because it allows an analyst to effectively use the financial information disclosed by companies.
Why is it ‘difficult’ to understand accounting?
Theme 1: Managers have discretion when making accounting choices.
Theme 2: Analysts need to consider managers’ incentives in their choices
Three potential sources and examples of noise and bias in accounting data:
- Noise from accounting rules
For example: Accounting for intangible assets
- Internally generated intangible assets are typically not capitalized on the balance sheet
- Separately acquired intangible assets are capitalized on the balance sheet - Forecast errors
For example: The estimation of future cash flows.
A provision is a liability of uncertain timing or amount, to be measured at management’s best estimate of the cash outflow required - Managers’ accounting choices
Managers have incentives to choose biased accounting policies: - Compensation contracts
- Debt covenants
- Capital market considerations
- Mergers and acquisitions
- Tax and regulatory considerations
Why care about Accounting analysis?
Accounting analysis helps analysts:
- to identify areas of noise and bias in a firm’s financial statements
- to make adjustments so as to estimate a firm’s ‘true’ performance (i.e., the analyst’s view thereof).
What are the 6 steps in accounting?
Step 1: Identify Principal Accounting Policies
Rather than doing an item-by-item analysis, analysts focus on key policies and estimates.
Step 2: Assess Accounting Flexibility
Do accounting standards constrain management in making these choices and estimates?
Step 3: Evaluate Accounting Strategy
Are policies and estimates in line with industry peers? Are there important incentives for management? Were there any changes in policies or estimates?
Step 4: Evaluate the Quality of Disclosure
Are disclosures consistent with the information presented?
Step 5: Identify Potential Red Flags
Are there any:
1. Unexplained transactions that boost profits?
2. Unusual increases in inventory or trade receivables in relation to sales?
3. Increases in the gap between net profit and cash flows (i.e., accruals)?
4. Large year-end adjustments (e.g., asset write-offs)?
Step 6: Undo Accounting Distortions
Make adjustments to financial statements to assess what performance would look like under revised estimates / different accounting.
Explain the golden rule of accounting
Accruals reverse! That means that Initial positive (negative) accruals reverse into negative (positive) ones.
Yet there are three accounting analysis pitfalls:
- Not all unusual accounting practices are dubious.
Accounting flexibility and management incentives do NOT mean that all unusual accounting practices are questionable.
- Some unusual accounting phenomena can be explained by economic developments. - Less flexibility does not mean more informative accounting.
For example: Accounting for intangible assets - Common standards are not the same as common practices
