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Financial Analysis > Week 3 > Flashcards

Week 3 Flashcards

1
Q

What does accounting analysis involve

A
  • Assess the reliability of the financial statements for the prediction of future performance

– Recast and adjust final statements to enhance comparability across firms / time

– Adjust firm’s reported profit to arrive at a measure that is more useful for valuing the company

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2
Q

Steps in performing accounting analysis

Step 1

A

Identify Key Accounting Policies

– Key policies and estimates used to measure risks and critical factors for success must be identified.

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3
Q

Steps in performing accounting analysis

Step 2

A

assess Accounting Flexibility

– Accounting information is more open to distortion if managers have a high degree of flexibility in choosing policies and estimates.

– Largely a function of industry membership

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4
Q

Steps in performing accounting analysis

Step 3

A

Evaluate Accounting Strategy

• Flexibility in accounting choices allows managers to strategically communicate economic information or distort performance

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5
Q

Steps in performing accounting analysis

Step 3

Issues to consider

A

Issues to consider include:

  • Typical accounting policies of industry peers
  • Incentives for managers to manage earnings
  • Changes in policies and estimates and the rationale for doing so
  • Whether transactions are structured to achieve financial reporting objectives
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6
Q

Steps in performing accounting analysis

Step 4

A

– Whether there is sufficient disclosure to identify the nature of key transactions

– Whether management discussion and analysis (MD&A) sufficiently explains and is consistent with current performance

– Whether GAAP reflects or restricts the appropriate measurement of key measures of success

– Adequacy of segment disclosures

• Segments may be defined geographically or by the nature of the different business areas in which a firm operates.

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7
Q

Steps in performing accounting analysis

Step 5: Identify Potential Red Flags

A

-Issues that warrant gathering more information include:

– Unexplained transactions that boost profits

– Unusual increases in inventory or receivables in relation to sales revenue

– Increases in the gap between net income and cash flows or taxable income

– Use of R&D partnerships, Special Purpose Entities or the sale of receivables to finance operations.

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8
Q

Steps in performing accounting analysis

Step 5: Identify Potential Red Flags

-Issues that warrant gathering more information continued

A

– Unexpected large asset write-offs

– Large fourth-quarter adjustments (US firms)

– Qualified or modified audit opinions or auditor changes

– Large related-party transactions.

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9
Q

Steps in performing accounting analysis

Step 6: Undo Accounting Distortions

A

-Financial statement footnotes often provide information from which the analyst can undo accounting distortions or make the financial statements more comparable.

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10
Q

Steps in performing accounting analysis

Step 6: Undo Accounting Distortions

A

-Financial statement footnotes often provide information from which the analyst can undo accounting distortions or make the financial statements more comparable.

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11
Q

Potential Sources of Noise and Bias in Published Financial Statements

A

Rigidity in accounting rules

Bias in Accounting Rules

Random managerial forecast errors

Abuse of manager’s accounting discretion, or discretion relating to the timing and structuring of transactions

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12
Q

Potential Sources of Noise and Bias in Published Financial Statements

Rigidity of Accounting Rules

What do many accounting decisions allow

A

Many accounting decisions allow or require a degree of discretion in the recognition and measurement of items

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13
Q

Potential Sources of Noise and Bias in Published Financial Statements

Rigidity of Accounting Rules

Many accounting decisions allow or require a degree of discretion in the recognition and measurement of items

Why?

A

allow management to signal their private information regarding the future profitability of the firm to outsiders

• However, because managers may have incentives to abuse this discretion, many accounting rules limit the manager’s reporting choices

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14
Q

Potential sources of noise and bias

Rigidity of accounting rules

Impact of accounting rules which limit the manager’s reporting choices

A

Limiting the range of accounting choices may impair a manager’s ability to reflect the economics of a firm’s transactions in the financial statements, for e.g.

– Cannot use LIFO inventory method, even if it is the method that best reflects the order in which inventories are sold

– Mandatory revaluations of financial assets not intended to be sold

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15
Q

Bias in accounting standards

describe conservative bias

A

bad news is typically reflected in the accounts more swiftly than good news.

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16
Q

Random (Honest) Managerial Forecast Errors

A

Estimating the ‘correct’ accounting value for most assets (except cash) requires the manager/accountant to predict the future

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17
Q

Random (Honest) Managerial Forecast Errors

What assets require prediction of the future

A

– Net receivables requires prediction of future collections of amounts owed to firm

– Inventories require prediction of whether goods are likely to be sold, and if so at what price (must record at lower of historic cost or market value of inventories)

– Machinery requires prediction as to the remaining service potential associated with the asse

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18
Q

Random (Honest) Managerial Forecast Errors

‘errors’ in predicting the future will affect the

A

errors’ in predicting the future will affect the usefulness of current earnings for predicting future earnings, and thus future cash flows, and thus the ‘true’ fair value of the firm

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19
Q

What can we do about random (Honest) Managerial Forecast Errors

A

We can observe the quality of a firm’s prior accounting estimates

– Large write-offs of receivables

– Large write-downs of inventory

– Large asset impairments

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20
Q

Many Accounting Estimation Errors Reflect

A

Inherent Uncertainty

• Firms differ in terms of the risks they face:

– Operating risk (what transactions do you engage in?)

– Financial risk (how much debt have you got?)

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21
Q

Many Accounting Estimation Errors Reflect Inherent Uncertainty

Operating risk in particular will

A

Operating risk in particular will naturally affect the reliability of accruals such as inventory and receivables

– Where cash flows from customers / to suppliers are very volatile….it’s harder to make judgements re receivables / inventories

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22
Q

Manager’s Accounting Discretion

Companies reporting practices are

A

Companies reporting practices are determined most directly by senior management (e.g. CEO / CFO)

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23
Q

Manager’s accounting discretion

Agency Theory

A

managers act in pursuit of their own interest, and not necessarily in the interest of shareholders (owners)

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24
Q

incentives for managers to deliberately abuse the discretion afforded in measuring profit, relate to either:

A

1) Purely self-interested reporting decisions
2) Decisions which may increase the value of the firm

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25
Q

incentives for managers to deliberately abuse the discretion afforded in measuring profit, relate to either:

Purely self-interested reporting decisions

A

maximising management compensation or the probability of keeping job, with no apparent benefit to shareholders

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26
Q

incentives for managers to deliberately abuse the discretion afforded in measuring profit, relate to either:

Decisions which may increase the value of the firm

A

increase management wealth (because mgmt. compensation may be linked to firm value)

– Increase in firm value may only be temporary, AND/OR

– Increase in firm value may result from transferring wealth from creditors (i.e. making shareholders better off / creditors worse-off)

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27
Q

Managers’ Accounting Discretion and Reporting Quality

A

Managers have a number of incentives to make accounting choices that bias measured profit and financial position

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28
Q

Managers have a number of incentives to make accounting choices that bias measured profit and financial position including, but not limited to

A

– Capital Market Incentives

– Contracting Incentives
– Political Incentives

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29
Q

Managers’ Accounting Discretion and Reporting Quality

Capital Market Incentives

A

Incentives to manipulate earnings to influence capital market perception of firms’ profitability and/or risk

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30
Q

Managers’ Accounting Discretion and Reporting Quality

Capital Market Incentives

including:

A

– Incentives meet / beat market earnings expectations

– Incentives to inflate earnings prior to issuing equity / debt

– Broad incentives to appear more profitable in the long-run, maintaining a higher stock price for several months or years (maybe)

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31
Q

Managers’ Accounting Discretion and Reporting Quality

Capital Market Incentives – Meet/Beat Earnings Expectations

what evidence is there

A

a stock market penalty (i.e. stock price fall) for firms whose reported earnings fall short of analyst consensus earning forecasts

managers of firms who fail to meet or beat consensus forecasts are more likely to be fired in the short- medium term

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32
Q

Managers’ Accounting Discretion and Reporting Quality

Capital Market Incentives – Meet/Beat Earnings Expectations

A

Creates incentive for managers to manipulate either reported earnings, or of the analyst forecasts (‘talking analysts down’) to avoid reporting earnings below the consensus forecast

i.e. manipulate reported earnings to meet or just beat consensus

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33
Q

Managers’ Accounting Discretion and Reporting Quality

Capital Market Incentives – Meet/Beat Earnings Expectations

limitation to manipulating earnings to meet or just beat consensus

A

they may not want to manipulate earnings to beat consensus by a long distance, as this may make it harder to beat next year’s consensus

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34
Q

Incentives to Meet/Beat Consensus Forecasts

Forecast Error

A

= Actual EPS –Forecast EPS (expressed as %ge of stock price).

– Small positive error = reported earnings just beat consensus

35
Q

Capital Market Incentives – Meet/Beat Earnings Expectations

which firms are more likely to engage in this behaviour

A

Not easy to predict

managers who are under pressure to retain their job

36
Q

Other Capital Market Incentives

Smoothing and Perceived Risk

A

the market may view a firm that has a relatively steady time-series of earnings as being of lower risk than a firm with volatile earnings

Lower perceived risk may reduce the firm’s ‘cost of capital’

37
Q

Other Capital Market Incentives

Smoothing and Perceived Risk

Manipulating earnings to smooth the time-series behaviour of earnings involves:

A

– Reducing profit in excessively good year

– Increasing profit in bad years

38
Q

Manager’s accounting discretion and reporting quality

Contracting Incentives

A

– Management Compensation Contracts

– Avoiding Debt Covenant Violation

39
Q

Manager’s accounting discretion and reporting quality

Contracting Incentives

Management Compensation Contracts

A

Compensation contracts frequently involve terms that limit the payment of bonuses according to the published profit of the firm

– Eg. No bonus unless earnings are > $X

– If Earnings > $X and <$Y, bonus is increases linearly

– If earnings > $Y bonus is the same as if Earnings =$Y

• Manager’s may try to manipulate earnings to maximise compensation under such a plan

40
Q

Manager’s accounting discretion and reporting quality

Contracting Incentives

Avoiding Debt Covenant Violation

Debt Contracts typically include

A

terms designed to protect lender, which restrict the risk-taking behaviour of the borrower

– E.g. Maximum Debt / Assets Ratio Allowed during life of loan

41
Q

Manager’s accounting discretion and reporting quality

Contracting Incentives

Avoiding Debt Covenant Violation

If a firm is close to breaching such a covenant,

A

manipulating earnings upwards also increases the amount of assets relative to liabilities, and may help avoid a breach of covenant

42
Q

Manager’s accounting discretion and reporting quality

Political Costs motivations

A

all incentives for a firm to portray itself as being LESS profitable than it actually is:

– Avoid regulation (or increased regulation)

– Increase the chance of govt. subsidy

– Limit the amount of wage increases demanded by employees

43
Q

Managers may manipulate reported earnings by

manipulating accruals via accruals based earnings management

A

– Abusing the discretion allowed / required in many accounting judgements

  • E.g. Deliberately under/over-estimate allowance for doubtful debts
  • Depreciating assets too slowly / quickly
  • Recognising revenue before earning process is substantively complete
44
Q

Managers may manipulate reported earnings by manipulating accruals / accounting policy choices / other judgement when applying accounting policies

Manipulating accruals has the effect of

A

Has the effect of shifting earnings between periods

45
Q

Managers may manipulate reported earnings by manipulating accounting policy choices

A

Managers also have discretion regarding long- term accounting policy choices, which may affect the pattern in which income is recognised:

– Depreciation method

– Historic Cost v Fair Value for physical assets

– Inventory Flow assumptions

46
Q

Managers may manipulate reported earnings by manipulating accounting policy choices

Changing policy is not really an effective way of fooling the market

A

any changes in accounting policy must be accompanied by a note explaining the impact on profit

47
Q

managers may also try to influence the market’s perception of firms’ underlying profitability by:

Classification Shifting

A

Accounting standards allow firms to separately identify items of expense whose nature is ‘unusual’ or ‘abnormal’ and to report sub-totals of profit on the income statement, e.g. Net Profit Before Abnormal Items

• Managers may opportunistically attempt to report ‘normal’ expenses as ‘abnormal’ in an attempt to influence Net Profit B4 Abnormal Items

48
Q

Other forms of manipulation

Reporting Non-GAAP Earnings

A

announcing their GAAP earnings to the public, many firms also publish alternative measures of earnings (non-GAAP earnings) which are argued to better reflect underlying economic profit

Non-GAAP earnings are typically higher than GAAP earnings, because a number of allegedly ‘one-off’ expenses are excluded from calculation

49
Q

•

Why Produce non-GAAP Earnings?

A

Can provide a better measure of firm’s ongoing earning power

– analysts also develop their own measure a firm’s ongoing earnings power

– The non-GAAP earnings reported by the firm can influence the items that analysts choose to include / exclude in their own measure of earnings>>>>>influences analysts’ valuation of firm

50
Q

•

Why Produce non-GAAP Earnings?

limitation

A

But….managers may opportunistically determine the items excluded from non-GAAP earnings

51
Q

Accounting for Investments in Other Companies

What 3 methods are there

A
  1. Consolidated accounting
  2. Equity accounting
  3. cost method
52
Q

Accounting for Investments in Other Companies

consolidated accounting

A

aggregates the accounts of the parent and subsidiary companies after eliminating internal balances and transactions

53
Q

Accounting for Investments in Other Companies

equity accounting

A

the acquiring company records the investment as an asset whose value increases when the investee makes a profit and decreases when dividends are remitted

54
Q

Accounting for Investments in Other Companies

Cost method

A

investment is recorded at cost and not adjusted until sold

55
Q

Accounting for Investments in Other Companies

Consolidation of Subsidiaries

basic rules

A

– If the investee is controlled, their accounts must be consolidated into the group accounts

– If the investee is only subject to significant influence by the parent company equity accounting is used

– If neither control nor significant influence are present the investment is recorded at cost (dividends received will be revenues)

56
Q

Difference between consolidated accounting and equity accounting

A

Consolidated and Equity Accounting should yield the same group profit, but:

– Consolidated Balance Sheet will include all of the subsidiaries’ assets and liabilities (less inter-company balances)

– Equity Balance Sheet include only the parent’s proportionate interest in the net assets of the investee (cost adjusted by subsequent profit and dividends)

– Affects almost all ratios of performance and position

57
Q

implications of accounting method

If cost method is able to be used,

A

subsequent debt raised by the investee will not be recorded in any way in the books of the investor

58
Q

Discretion and the Consolidation v Equity Accounting Decision

What decision needs to be made

A

whether control or significant influence is present, this allows considerable discretion

59
Q

Discretion and the Consolidation v Equity Accounting Decision

When is control present

A

Control is present where the investor company is able to dictate the operating and financing decisions of the investee (AASB 127)

but this is subjective

60
Q

Discretion and the Consolidation v Equity Accounting Decision

Where control is not present,

A

Where control is not present, but the investor is able to significantly influence the decisions of the investee the equity method must be used (normally 20% equity in the investee suggests ‘significant influence’ – AASB 128)

61
Q

Minority Interests Under Consolidated Accounting

how will the assets and liabilities appear?

A

100% of the assets and liabilities of the subsidiary will appear on Parent’s balance sheet. If Parent only owns 60% of Subsidiary, there will be an adjustment to Equity to account for the fact that someone else owns 40% of the net assets of Subsidiary

62
Q

Minority Interests in the Financial Statements

In current year’s profit?

A

Minority Interest’ in current year’s profit = proportion of group profits which the shareholders of the parent corporation have no claim upon

– Typically reported after the calculation of Net Profit

63
Q

Minority Interests in the Financial Statements

‘Minority Interest’ in shareholder’s equity section of balance sheet

A

the book value of the net assets of the subsidiary x proportion of shares in subsidiary NOT owned by the parent

64
Q

Minority Interests in the Financial Statements

what is a requirement

A

MUST be consistent when constructing ratios for financial analysis: if Minority Interest are excluded from profits, we must exclude Minority interests from equity invested to earn profits

65
Q

Goodwill in the Accounts

Goodwill on the balance sheet arises from

A

Goodwill on the balance sheet arises from acquisition of groups of assets (e.g. another firm) for a price greater than the estimated fair value of the individual assets acquired

66
Q

Goodwill in the accounts

the amount recognised may reflect at least three components:

A

– Difference in the book value and market value of each individual asset acquired (to the extent that the individual assets are not revalued fully on acquisition)

– Potential for growth in profitability (overlaps with first component somewhat), may include expected synergies

– Overpayment for the acquisition: the acquiring company simply pays too much for the target

67
Q

Goodwill on the Income Statement

Goodwill can only be carried on the balance sheet if

A

there is evidence of expected future profitability at a rate exceeding the normal return on tangible assets.

• If projected future excess profitability falls, must recognise impairment:

– Reduce Goodwill, Reduce Profit (Impairment Expense)

68
Q

If analysts believe that goodwill largely arises as a consequence of differences between market and book values of assets acquired, they may:

A

– Exclude goodwill from balance sheet (at least for the purpose of some ratio calculations)

– Exclude reductions in goodwill from adjusted income statement

69
Q

If analyst is confident that overpayment has occurred, they may

A

recognise this overpayment in their adjusted NPAT

70
Q

Intangibles are only recognised in the accounts if

A

if the cost of generating/acquiring that asset can be identified and reliably measured, e.g.:

– Acquisition of rights to brand name from other firm

– Cost of developing and obtaining approval for patent

71
Q

Intangibles are carried in the balance sheet as an asset because

A

they reflect an expectation of future benefit controlled by entity, where benefits arise from:

– Expected higher sales at constant margin – Expected abnormal profit margin
– Both of the above

72
Q

Intangibles are regularly tested for

A

‘impairment’ – seeking evidence that the expected future benefits equal or exceed book value of asset

73
Q
A
74
Q

Impariment of intangibles

Impairment charges (expenses) are recognised when

A

the firm believes that the future economic benefits associated with the asset are less than the asset’s book value.

– Signal of a fall in future expected profitability

75
Q

Impairment charges on intangibles are excluded from

A

Like goodwill, this impairment charge is typically excluded from analyst-defined Adjusted Net Profit, but affects analyst forecasts of future profits.

76
Q

Finance lease

A

a non-cancellable lease which transfers substantially all the risks and rewards of ownership to the lessee

77
Q
A
78
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79
Q
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80
Q
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81
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82
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83
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A

Financial Analysis (10 decks)

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