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Topic 4 Impact of accounting methods on Forecasts.pptx

Topic 4 Impact of accounting methods on Forecasts.pptx -...

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Forecasting Earnings: Firm and Industry Analysis Topic 3 Buying a stock is buying a business … know the business ...?
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Impact of Accounting Methods and Earnings Management Topic 4 2+2=5??
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Lecture Outline Why allow flexibility in accrual accounting? Why not focus on cash flow? Which accounting methods matter? Accounting games companies play Analysing accruals Check list of adjustments Estimating earnings management/quality Implications for analysis & valuation
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CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.) FORECASTING Valuation Framework Based on Financial Statement Data RISK ASSESSMENT (and Book Values) FORECAST OF CASH FLOWS DISCOUNTED CASH FLOWS VALUE OF FIRM DISCOUNTED RESIDUAL EARNINGS FORECASTS OF EARNINGS (and Book Values) CAPITALIZED PERMANENT EARNINGS Each of these steps constitute one of your workshops Adjusting for Accounting Methods
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Objectives The objectives of this lecture are: To consider the accounting options available in preparing financial statements To assess the impact of the options, and To discuss the appropriateness of adjusting the financial data for appraisal purposes To examine models for estimating and ranking earnings quality
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Why Allow Accounting Flexibility ? Flexibility allows system to adapt with business innovations Abuses - earnings management - when people exploit this flexibility via accruals, method choices, judgement
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Accruals/Method Choice Evidence Poor performers (declining share price, & falling profits) change accounting methods more often (Ball 1972, Archibald, 1975) Distressed firms have significantly more material changes in accounting methods than non- distressed firms (Schwartz, 1986) Excess accruals indicate future earnings problems - Analysts & auditors not fully alert investors to implications of high accruals/earnings management (Bradshaw, Richardson & Sloan, Schwartz, 2001)
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Why Not Focus on Cash Flow? Ignores flows just because not cash yet Highly volatile Capital expenditure can swamp CFO Can be manipulated by timing transactions (see reading by Graham, Harvey & Rajgopal 2005) No integrated base to measure return Harder to forecast vs accrual earnings
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Why Do Analysts Adjust Accruals ? 2+2=5! Accrual A/c involves choice/judgement Can be biased/manipulated What examples can you think of? So adjust financials to arrive at: Normalised financials Consistent treatment Comparable data
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A good analyst adjusts financial numbers for arbitrary accounting choices, distortions and one off items Analysts “ normalise profit ” - the profit one could expect the company to make in the normal course of business. And “ normalise/pro forma balance sheet Normalised Financials
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Adjustment Options How deal with accounting method choice issue when analysing firms?
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