Powerpoint slidessteps in performing accounting analysisstep 4 - 6 only
Financial analysis and valuation Topic presentation: Accounting Analysis: Implementation and Recasting of Financial Statements TELSTRA COMPANY 1. Step 4: Evaluate the Quality of Disclosure Although accounting rules require a certain amount of minimum disclosure, managers have considerable choice in the matter. What is the quality of disclosure? Can we quantitatively measure disclosure quality? · Earnings Persistence · Accrual Quality Why are these measures important? How about qualitatively? What questions should analysts ask when assessing quality of disclosure? · Enough disclosure to assess the organization’s business strategy and its economic consequence? · Do footnotes adequately explained key accounting policies and assumption? · Current performance explained? · Accounting rules and convention too restrictive to measure success factor? Any additional information provided? · Multiple segments? Quality of segment disclosures? · Hiding bad news? · Good investor relation program? 2. Step 5: Identify Potential Red Flags Indicators that suggest the analyst should gather additional information Further issues to consider include: · Unexplained changes in accounting policy · Unexplained transactions that boost profits · Increases in: · Inventory in relation to sales revenue · Accounts receivable in relation to sales revenue · Depreciation charge (Example: Arrium Ltd write-down of inventory by $21.2m) · Further issues to consider include: · Increases in the gap between profit and: · Operating cash flows · Taxable income · Unexpected large asset write-offs · Large year-end adjustments · Example: Arrium Ltd impairment of land, building and mine development expenditure (total $8m) · $961m write-downs announced on 19 August 2013. Share price went down 13.6% on the day 3. Step 6: Undo Accounting Distortions How can we get financial statements that truly represent performance and financial position of a company? Title slide with an image Lecture 4 Overview of Accounting Analysis (1) MONASH BUSINESS SCHOOL 1 Valuation flow chart MONASH BUSINESS SCHOOL Topic Objectives Theories Financial statements are prepared under accounting rules, but accounting rules give flexibility to the preparer. Are financial reports of high quality? Financial statements that are prepared under accounting rules sometimes combined operation and financial activities and we need to separate them. Applications First, we need to understand the basic features of financial reporting. Measure accounting quality. Identify the factors influencing financial reporting quality. Appreciate the incentives behind financial statement manipulation. Understand the steps in performing accounting analysis (how to undo manipulations). MONASH BUSINESS SCHOOL Financial Statements A statement of financial position as at the end of the period A statement of profit and loss and other comprehensive income for the period A statement of changes in equity for the period A statement of cash flows for the period Notes Definitions Assets =Liabilities + Equity (Book value and Market Value Balance Sheets) Comprehensive Income = Profit for the year + Other comprehensive Income Profit for the year = Revenue - Expenses MONASH BUSINESS SCHOOL Review of some basic GAAP concepts Assets = Liabilities + Shareholders’ Equity Assets are probable future economic benefits under the control of the firm arising from prior transactions Liabilities are probable future economic sacrifices that are obligations of the firm arising from past events MONASH BUSINESS SCHOOL 5 Financial Statements Revenues- Gross Inflow of economic benefits Expenses- Decreases in economic benefits (simultaneous recognition of decreases in assets and increases in liabilities) Profit- Difference between Revenue and Expenses Other Comprehensive Income – Income items that by-pass profit for the year and are directly recorded in equity. Changes in fair value of property, plant and equipment Changes in fair value of Investment property, available for sales securities Derivatives used in cash flow hedges and actuarial changes in defined benefit pension plans. MONASH BUSINESS SCHOOL The purpose of accounting analysis Accounting analysis evaluates the degree to which accounting captures the underlying reality of the business Understanding accounting allows the analyst to effectively use the accounting information disclosed by companies In particular, the analyst aims to assess the quality of the financial statements Adjust financial statements to mitigate accounting distortions, or recognize that distortions must ultimately be reversed To do so requires an understanding of the basic features of financial reporting To do so, an analysts should also have very good knowledge of the industry MONASH BUSINESS SCHOOL 7 The Importance of Accounting Analysis Accounting analysis evaluates the degree to which accounting captures the underlying reality of the business: In particular, the analyst is trying to assess the accounting quality of the financial statements. To do so requires an understanding of accounting and the basic features of financial reporting. Good Start: Do the financial statements reflect economic reality? when do managers have incentives to reveal truth? when do managers have incentive to obscure truth? MONASH BUSINESS SCHOOL Accrual accounting and limitations of accounting information: Accruals Financial reports are prepared using accrual accounting instead of cash accounting Indicating income statement is more important than cash flow statement Examples of accrual transactions include credit sales, credit purchases, estimates of assets useful lives, provisions, and allowance for doubtful debts and similar items. Thus, accrual accounting show the financial picture of a company more accurately than cash accounting which relies only on cash transactions. MONASH BUSINESS SCHOOL Theoretical Background: Accrual Accounting Under accrual accounting Net Profit After Tax (NPAT) has two components NPAT= cash (transactions-based) + accruals (adjustments-based) Little manipulation Can be manipulated: earnings management MONASH BUSINESS SCHOOL Average Earnings and Cash Flow Performance of Firms Caught by the SEC for Manipulating Earnings (Manipulation Occurs in Year 0) The importance of cash flow How do you interpret this graph? and how can you use such concept in identifying the red flags in the accounting analysis section of your group assignment. MONASH BUSINESS SCHOOL 11 What is Earnings Management? Arthur Levitt: “practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company.” Earnings management (or income smoothing) is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. Earnings management can also be used to decrease current earnings in order to increase income in the future. MONASH BUSINESS SCHOOL The Impact of Earnings Management The practice of earnings management damages the perceived quality of reported earnings over the entire market, resulting in the belief that reported earnings do not reflect economic reality. This will eventually lead to unnecessary stock price fluctuation. This uncertainty ultimately has the potential to undermine the efficient flow of capital thereby damaging the markets as a whole. MONASH BUSINESS SCHOOL Earnings Management: Incentives A.EXTERNAL FORCES Analyst Forecasts Debt markets and contractual obligations (Debt Covenants) Competition Capital Market Considerations B.INTERNAL FACTORS Potential mergers Management Compensation Planning and budgets Unlawful transactions C.PERSONAL FACTORS Personal bonuses Promotions and job retention MONASH BUSINESS SCHOOL 14 Two Directions for Manipulation Borrowing income from the future Increase in current revenue Decrease in current expenses Banking income for the future Decrease current revenue Increase current expenses Distinguish: Conservative Accounting vs. Liberal Accounting Aggressive Accounting vs. Big Bath Accounting Both increase current NOA Both reduce current NOA A matter of Accounting Policy A matter of short-term application of accounting that will reverse MONASH BUSINESS SCHOOL 15 How Specific Balance Sheet Items are Managed to Increase Income MONASH BUSINESS SCHOOL 16 How Specific Balance Sheet Items are Managed to Increase Income (cont) MONASH BUSINESS SCHOOL 17 Factors affecting Accounting Quality Nature of underlying transactions, events and conditions that impact entity’s financial position and performance Discretions that managers have on making reporting decisions Institutional factors that moderate these effects External Auditing IFRS Legal Environment MONASH BUSINESS SCHOOL Managers’ Accounting Discretion Why discretion? Preparation of financial statements involves complex judgments and estimates. Examples Revenue when an organization sells land to customers and also provide financing. Revenue cognition before collection of cash – how to estimate default rate? Research and development activities when payoff are uncertain Managers have intimate knowledge of the organization and they “should” use these knowledge to portray informative business transactions However, they may have alternative incentives Delegation of financial reporting decisions to managers have costs and benefits. MONASH BUSINESS SCHOOL Management Incentive (examples) 1. Debt Covenants Minimum Interest Coverage: “The company will not permit the ratio of EBIT to interest expense as at any fiscal quarter end for the four fiscal quarters then ending to be less than 2.25 to 1” 2. Compensation Contracts BlueScope 2012 CEO: Paul O’Malley current annual base pay ($1,750,000) financial performance eligible to participate in the Short Term Incentive (STI) Plan and Long Term Incentive (LTI) Plan awards. was provided with 50,000 BlueScope Steel Limited shares Other Key Management-Executives Annual base salary+ provision of performance-related STI+ LTI MONASH BUSINESS SCHOOL 20 Institutional Factors: External Auditing Audits provide an independent (third party) opinion on the quality and integrity of the financial statements Verification of the reported financial statements by an expert independent of the preparer – issue an opinion Audit committees can enhance the auditing process – Independence of audit committee reflects corporate governance strength However, still imperfect - Audited financial statements does not guarantee credible financial statement – Corporate collapses MONASH BUSINESS SCHOOL Institutional Factors: International Financial Reporting Standards (IFRS) Aim: increase comparability – over time and across firms However, managers may lack flexibility Legal Environment Difference between quality of accounting standards and enforcement of those standards Can also have significant impact on quality of accounting numbers. MONASH BUSINESS SCHOOL Flash Points: Institutional Situations where Manipulation is More Likely The firm is in the process of raising capital or renegotiating borrowing. Watch public offerings Debt covenants are likely to be violated A management change An auditor change Management rewards (like bonuses) are tied to earnings Management is repricing executive stock options A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all Regulatory ratio requirements (like capital ratios for banks and insurance companies) are likely to be violated Transactions are with related parties rather than at arm's length Special events such as union negotiations and proxy fights The firm is "in play" as a takeover target The firm engages in exotic arrangements (structured off-balance-sheet vehicles) MONASH BUSINESS SCHOOL 23 Flash Points: Financial Statement Indicators that Manipulation is More Likely A change in accounting principles or estimates An earnings surprise A drop in profitability after a period of good profitability Constant sales or falling sales Earnings growing faster than sales Very low earnings (that might be a loss without manipulation) Small or zero increases in profit margins (that might be a decrease without manipulation) A firm meets analysts’ earnings expectations, but just so. Differences in expenses for tax reporting and financial reporting Financial reports are used for other purposes, like tax reporting and union negotiations. Accounting adjustments in the last quarter of the year MONASH BUSINESS SCHOOL 24 Delegation of Reporting to Management Management is responsible for accounting policy choice: Measurement, recognition and disclosure in financial statements Some discretion exists, which management can use to: revealing their superior (private) information about the firm; or behave opportunistically to distort the accounting numbers Distortion of accounting may reflect incentives facing managers MONASH BUSINESS SCHOOL Distortion in Accounting Data There are three potential sources of accounting data distortions Random estimation errors Manager s cannot perfectly predict future consequences E.g. accrual accounting requires managers to estimate