"Financial Analysis and the Predictability of Important Economic Events"
Business strategy using financial statements Chapter 2 Overview of Accounting Analysis Financial Accounting Objectives Stewardship Information Perspective • Safeguard assets • Amount …of • Increase equity value • Timing prospective • Protect creditors • Uncertainty net cash Accountability & inflows Performance Predictability & Decision Measurement Usefulness Historical Emphasis Modern Emphasis (but still important) Financial Accounting Hierarchy of Accounting Qualities Users of accounting Decision makers and their characteristics information Benefits > Costs Materiality Constraints Understandability User-specific Decision usefulness qualities Primary qualities Relevance Reliability Ingredients of Predictive Feedback Neutrality Verifiability primary qualities value value Representational Timeliness faithfulness Secondary qualities Comparability and consistency Financial Accounting Important Accounting Principles • Double Entry - duality from accounting equation, A=L+E • Historical Cost - fair & objective values from arm’s-length transactions • Accrual Accounting - recognize revenues when earned, expenses when incurred • Full Disclosure - measure and/or disclose material events and transactions • Materiality - threshold when information impacts decision making • Conservatism - reporting or disclosing the least optimistic information about uncertain events and transactions FASB Financial Accounting Relevance of Accounting Numbers Relation between Accounting Numbers and Stock Prices Percent of Stock Price 100% 80% Explained Book Value 60% Earnings 40% Combined 20% 0% 65 70 75 80 85 90 95 Year Accruals--The Cornerstone Relevance and Reliability Trade off Relevance Analyst Forecasts Accrual Accounting Cash Flows Reliability Accruals--The Cornerstone Relation between Stock Returns and both Income and Operating Cash Flows for Different Horizons of a Large Sample of Companies . 45.00 40.26 40.00 35.00 Percent of Stock Returns Explained 30.00 25.00 OCF 20.00 NI 16.20 15.00 10.88 10.00 5.00 3.24 3.18 0.10 0.00 Quarter Annual Four-Year Time Horizon Source: Dechow, P Introduction to Accounting Analysis Process to evaluate and adjust financial statements to better reflect economic reality Involves different tasks: Evaluate accounting risk and earning quality Estimate earning power Make necessary adjustment An important precondition for effective financial analysis Accounting Analysis Demand for Accounting Analysis Adjust for accounting distortions so financial reports better reflect economic reality Adjust general-purpose financial statements to meet specific analysis objectives of a particular user Accounting Analysis Sources of Accounting Distortions Accounting Standards – attributed to (1) political process of standard-setting, (2) accounting principles and assumptions, and (3) conservatism Estimation Errors – attributed to estimation errors inherent in accrual accounting Reliability vs Relevance – attributed to over- emphasis on reliability at the loss of relevance Earnings Management – attributed to window- dressing of financial statements by managers to achieve personal benefits Accounting Analysis Earnings Management – Frequent Source of Distortion Three common strategies: Increasing Income – managers adjust accruals to increase reported income Big Bath – managers record huge write-offs in one period to relieve other periods of expenses Income Smoothing– managers decrease or increase reported income to reduce its volatility Accounting Analysis Earnings Management – Motivations Contracting Incentives -- managers adjust numbers used in contracts that affect their wealth (e.g., compensation contracts) Stock Prices – managers adjust numbers to influence stock prices for personal benefits (e.g., mergers, option or stock offering) Government Favors – managers adjust numbers to affect political actions (e.g., antitrust actions, IRS pressures, government subsidies) Other Reasons -- managers adjust numbers to impact (1) labor demands, (2) management changes, and (3) societal views Financial Accounting Limitations of Accounting Numbers • Timeliness - periodic disclosure, not • real-time basis • Frequency - quarterly and annually • Forward Looking - limited prospective information Accounting Analysis Earnings Management – Mechanics Incoming Shifting – Accelerate or delay recognition of revenues or expenses to shift income from one period to another Classificatory – Selectively classify revenues and expenses in certain parts of the income statement to affect analysis inferences regarding the recurring nature of these items Accounting Analysis Process of Accounting Analysis Accounting analysis involves several inter-related processes and tasks that can be grouped into two broad areas: Evaluating Earning Quality – Identify and assess key accounting policies Evaluate extent of accounting flexibility Determine the reporting strategy Assess the quality of disclosure Identify and assess red flags Adjusting Financial Statements -- Identify, measure, and make necessary adjustments to financial statements to better serve one’s analysis objectives. Study questions and problems The following items will be discussed with examples from the 2002 ABC Corp. Annual Report: The base LIFO layer reduction Cost of sales has been reduced and operating income increased by $143 million in 2002, $180 million in 2001, and $402 million in 2000 as a result of liquidations of LIFO inventories. Study questions and problems 2. Gains(losses) from sales of assets (in millions) 2002 2001 Other income includes Gains on disposal of assets $55 $265 The total income before taxes, extraordinary gains, and accounting changes for ABC was $797 million in 2002 and $980 million in 2001. The nonoperating gains from sales of assets accounted for 7% and 27% of pretax ordinary income Study questions and problems 3. Equity income (In millions) 2002 2001 Net income from ABC’s share in equity method entities $63 $35 Dividends received from equity method entities $31 $30 4. Loss recognition on write-down of assets (In millions) 2002 2001 Provisions for estimated shutdown costs $15 $0 Adjustment to provision for occupational disease claims $24 $0 Revaluation of assets $0 ($47) $39 ($47) Study questions and problems 5. Allowance for doubtful accounts (In millions) 2002 2001 change(%) Sales $19,283 $19,104 0.9 Receivables 1,570 1,650 (4.8) Less allowance for Doubtful accounts (12) (39) (62.2) Receivables(net) 1,558 1,611 Study questions and problems 6. Discretionary expenses (In millions) 2002 2001 2001 Repairs & maintenance $1,158 $1,176 $1,281 Research & development 54 61 84 Sales $19,283 $19,104 $17,539 Property, plant, equipment 23,735 23,670 21,807 Study questions and problems What are the real earnings? 1.start with total income before taxes, extraordinary gain, and effect of the change in accounting principle $797 2.Deduct Base LIFO layer reductions (143) Gain on disposal of assets (55) Amount by which equity income exceeds cash received (32) Unusual items (39) Adjust income $528 In addition, consider the following other items: • $27 in the allowance for doubtful accounts • $7 in research and development expenditures • $18 in maintenance and repair of plant and equipment