Lecture 3 - Outline 1. Accounting Analysis - Overview...

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Unformatted text preview: Outline 1. Accounting Analysis - Overview Earnings Management Conducting Accounting Analysis Step 1. Identify Key Accounting Policies Step 2. Identify Managers’ Reporting Incentives Accounting Analysis 2. 3. Lecture 3 Step 3: Assess Accounting Flexibility Step 4: Assess the Likelihood of Earnings Assess the Likelihood of Earnings Management Step 5. Adjust Financial Statements 4. Capitalizing operating leases 2 Accounting Analysis Overview Earnings Management What is accounting analysis? is accounting analysis? Accounting analysis is the analysis that the analyst performs to determine whether the financial statements reflect fi economic reality. A key objective is to determine the firm’s “financial reporting personality.” Why is this topic important? Accounting analysis is an important step in assessing a firm’s true economic condition and performance Understanding a firm’s true economic condition and performance is important for predicting its future performance What is earnings management? Reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results. Should be distinguished form financial fraud (earnings manipulation): The intentional, deliberate misstatement or omission of material facts, or accounting data, which is misleading and, when considered with all the information made available, would cause the reader to change available, would cause the reader to change or alter his or her judgment or decision. Earnings management is at the legal end of a continuum. Financial fraud is at the illegal end. Fraud clearly violates GAAP. 3 4 Strategy and Accounting Interaction Business Environment Labor markets Capital markets Product markets Suppliers Customers Competitors Business regulations Business Strategy Scope of business: Degree of diversification Type of diversification Competitive positioning: Cost leadership Differentiation Key success factors & risks Step 1. Identify Key Accounting Policies This step involves evaluating how well the financial statements reflect the effects of key business activities. ** Revenue recognition is always important. Beyond these, use what you learned about key business activities and business risks facing the company from your industry and strategy company from your industry and strategy analysis to identify key accounting policies. If all else fails, go down the income statement and balance sheet line and balance sheet, line-by-line, and make sure and make sure you understand the economic activities that affect those accounts. Business Activities Operating Activities Investing Activities Financing Activities Accounting Environment Capital market structure Contracting and governance and governance Accounting regulations Tax and financial accounting linkages Third-party auditing Legal system for accounting disputes Accounting System Measure and report economic consequences of business activities Accounting Strategy Choice of accounting policies Choice of accounting estimates Choice of reporting format Choice of supplementary disclosures Financial Statements Managers’ superior information on business activities Estimation errors Distortions from managers’ accounting choices 5 6 Key Accounting Policies for SBUX Key Activity Activity Accounting Policy Policy Adequate? Step 2. Identify Managers’ Reporting Incentives Earnings management requires opportunity and motive. We will analyze situations that create motives for earnings management. By understanding when companies have incentives to manage earnings, readers of financial statements can assess when a company is likely to engage in such behavior. Note that the earnings management decision represents a trade-off between costs and benefits. This discussion focuses on the benefits of earnings management. 7 8 Main Incentives Debt covenants Regulatory considerations Capital market considerations Stakeholder considerations Competitive considerations Outcome - Report truthfully - Overstate performance - Build hidden reserves - Take a bath - Off B/S financing, etc. Managing Earnings to Forecasts and Other Targets Managing Earnings to Forecasts and Other Targets: To avoid losses To meet/beat analyst forecast meet/beat analyst forecast Management compensation Tax considerations Managers’ accounting choices Corporate control control contests The strongest and most pervasive incentives arise from strongest and most pervasive incentives arise from capital markets and management compensation. 9 10 Managing Earnings to Avoid Losses Managing Earnings to Meet/Beat Analysts Forecasts The frequency with which companies report earnings that are barely less than zero is lower than the frequency with are barely less than zero is lower than the frequency with which companies report earnings just greater than zero. Forecast errors represent the difference between the actual earnings realization and the consensus forecast, for annual forecasts. A positive forecast error indicates that the actual earnings beat the forecast. The plot reveals an obvious pattern: A larger-than-expected number of companies meet or barely beat analysts' forecasts. There are more small positive forecast errors than small negative forecast errors. This pattern would not be expected if analysts were equally likely to overestimate or underestimate earnings and if companies did not engage in earnings manipulation to exceed a target. 12 11 Managing Earnings to Meet/Beat Analysts Forecasts Yahoo Gets Pinched After Profits Miss by a Penny By Will Swarts Will April 18, 2007 The Company Yahoo (YHOO1) Share price as of Tuesday's close: $32.09 Share price now: $28.31 Percent change: -11.8% Volume: 127.1 million shares, daily average 19.3 million The News News A penny saved is a penny earned, but a penny short was bad news for Yahoo (YHOO2). Shares of the Internet behemoth plunged 12% after quarterly per-share earnings fell one cent short of Wall Street's expectations. Yahoo, a portal and search engine that has in effect become one of the largest online advertising players on the planet, reported first-quarter earnings of 10 cents a share, down from 11 cents a share in the year-ago period, and a penny shy of analysts' consensus estimate of 11 cents, according to Thomson Financial. Revenue came in at $1.18 billion, up 9% from a year earlier but short of the $1.21 billion expected by analysts. The company warned late Tuesday that second-quarter revenue would be just $1.2 billion to $1.3 billion, potentially a bit out of sync with the average Street estimate of $1.28 billion. The company reiterated its full-year revenue and earnings guidance, saying it expects revenues of $4.95 billion to $5.45 billion and earnings before interest, taxes, depreciation and amortization or Ebitda of depreciation and amortization, or Ebitda, of $1.95 billion to $2.2 billion. That prompted billion to billion That prompted Deutsche Bank analyst Jeetil Patel to note Wednesday that management "only" reiterated earlier projections, making its performance in the second half of the year particularly important. 13 14 Meeting Earnings Benchmarks: What Managers Have to Say Yahoo completed its conversion to its Panama advertising platform during the first quarter, a much anticipated move that's designed to boost its search-based ad revenue. Despite the profit shortfall senior management said the strategic shift was moving according to plan. "Our first-quarter financial results reflect solid execution against our plan," Chief Financial Officer Susan Decker said on a conference call. "We maintained strong profitability and cash flow, while remaining focused on building innovative products and services for our large and growing base of users, advertisers and publishers." Needham & Co. analyst Mark May downgraded the stock to Hold from Buy, saying it was fully valued and that core display ad growth was slowing. "Our estimates are in-line with guidance, but we increasingly believe the [second half of 2007] acceleration implied in consensus revenue forecasts could be difficult to exceed given the recent slowdown in display ad growth," May wrote Wednesday. (from Graham, Harvey, and Rajgopal, Journal of Accounting and Economics 2005) Benefits of meeting earnings benchmarks Consequences of missing earnings benchmarks 15 16 Checklist At a minimum, check whether: Earnings are barely positive Earnings are barely better than prior year earnings earnings Earnings are equal to or barely better than analysts’ forecasts (quarterly and annually) over the past year (two years if available) over the past year (two years, if available) Top management had large option exercises during the year Top management has significant performancerelated compensation (options, restricted stock, stock appreciation rights, bonuses) What is the quality of earnings in this case? 17 18 Step 3: Assess Accounting Flexibility Delta and Pan-Am Property, Plant and Equipment Plant, and Equipment Delta Airline June 30, 1990 Depreciation and Amortization – Substantially all the Company’s flight equipment is being depreciated on a straight-line basis to residual values (10% of cost) over a 15-year period from dates placed in service. Ground property and equipment are depreciated on straight and equipment are depreciated on a straight-line basis over their estimated basis over their estimated service lives, which range from three to thirty years. Pan Am Corp. Dec 31, 1989 31 1989 G. Property and Depreciation Operating property and equipment is depreciated to estimated residual value on a straight-line basis over the estimated useful lives of the equipment, as follows: follows: Aircraft Type Useful Life Residual Value B747-100 21-25 years 15% B747-200 22-25 years 15% B727-200 22-25 years 15% A310 A310-200 18 years 18 years 15% 15% Other property and equipment, primarily of Pan Am, is depreciated over a period of 4 to 20 years without residual value. During 1987, the lives of B727200 aircraft were extended by an average of five years, decreasing 1987 depreciation expense by depreciation expense by $12,914,000. Is Pan Am too aggressive, Delta too conservative, or could both be correct? 19 20 Accounting flexibility results from the choices firms can make with respect to accounting policies. In the second step the analyst assesses how the firm uses its flexibility. Flexibility varies across accounts R&D must be expensed must be expensed software development can be capitalized banks can estimate bad loans Most firms have some level of flexibility firms have some level of flexibility depreciation & amortization Inventory pension estimates estimates The analyst should identify two types of flexibility: flexibility related to key success factors flexibility related to other factors that might materially misstate underlying business reality Firms can use flexibility to inform or distort Summary of Areas of Managerial Flexibility Managerial Flexibility Accounting Flexibility for SBUX Accounting Estimate or Method Effect on Earnings Summary of GAAP (or nearly GAAP) Earnings-Management through various accounts: Accounting Methods Revenue Recogni tion M anagerial Choice Over Accounting Estimates Structuring & Timing of Events W hen is revenue earned? ‘Substantial performance’ and ‘reasonably collectible’ criteria Amount of direct-response advertising to capitalize to capitalize Sales discounts Favorable credit terms Timing of write-offs & amort izat ion if cap italized cap ‘Real’ earnings management A llowance for Doubtful Accounts S pecial expense items: R&D A dvertising Expense Explorati on Costs Recei vables Software develop ment costs Oil and Gas exploration costs Inventory LIFO vs FIFO Cost allocation between COGS and Inventory for manufacturers. Timing of LIFO purchases Overproduction in current period W rite-offs Timing of write-offs Restructuring charges Property, Plant, & Equi pment and Intangi bles Straight line vs. accelerated Est. useful life Est. salvage value Impairment test Residual value of asset (90% test) Rate assumptions Expected rate of return on assets W arranty expense Insurance company liability reserves Environmental Liab ilit ies In-process R&D write-offs. Allocating purchase price Impairment amount Leases Capital vs Operating Pensions & OPEBs Commi tments and conti ngencies Restructuring charges Business Combinati ons Pooling vs. Purchase (Poo ling h as b een abolished under SFAS 141) Goodwill impairment test 21 22 Step 4. Assess the Likelihood of Earnings Management Earnings Management Step 5: Adjust Financial Statements This is usually impossible to know with certainty. The point is to critically evaluate the company’s exercise of discretion in light of the company’s incentives to achieve a particular reporting outcome. Does the company have an incentive to achieve a particular reporting objective, and did the company make accounting choices consistent with achieving that objective? When should you adjust financial statements? To promote comparability across companies Differences in income statement/balance sheet classification Differences in accounting methods Differences in fiscal periods To promote comparability over time Non-recurring gains/losses Changes in accounting methods Changes in accounting estimates To evaluate effects of off-balance sheet assets/liabilities evaluate effects of off sheet assets/liabilities Operating versus capital leases Capitalizing investment in R&D or advertising Joint ventures/equity method investments ventures/equity method investments 23 24 General Issues in Computing Net Income Net Income How should you adjust financial statements? Goal is to eliminate as many accounting distortions that cause differences in ratios over time/across firms as possible. In this way, your comparisons are more meaningful Unfortunately some distortions are meaningful. Unfortunately, some distortions are unavoidable. In this case, keep those distortions in mind when you interpret the ratios as possible explanations for differences you observe. One of the primary objectives of analyzing the income statement is to get a sense of the relative permanence of a firm’s earnings. th fi Items Affecting Earnings Permanence and The Prediction Of Future Earnings Income from continuing operations: Should include only the normal, recurring, more sustainable, ongoing economic activities of the organization. The one exception is often termed ‘Special Items’. There are two main groups of irregular items – ones that are determined by GAAP and one that are subject to the firm discretion. To differentiate between the two, GAAP's ones are reported below the net income number, net of tax. Firms are not allowed to report the second group net of tax. ll Special items or unusual items include any relatively infrequent or non-recurring items that nevertheless tend to arise from a firm’s on-going, continuing operations. Some frequent special items to account for: Restructuring charges Gain or loss on sale of PPE Gains and losses on sale of securities (reported as part of comprehensive income) 26 25 General Issues in Computing Net Income (cont Net Income (cont’d.) General Issues in Computing Net Income (cont’d.) Items excluded from income from continuing operations (all are reported net of tax): Pro-forma earnings or Pro-forma net income One tactic that firms have adopted to affect investors’ perception is to use the term ‘pro-forma’ to reflect financial statements that have removed the supposed transitory or non-operating items. (see Amazon example next page). Pro-forma earnings are not-GAAP, and any pro-forma earnings announcement must also include GAAP net income You should probably make the assessment for income. You should probably make the assessment for yourself about whether an item is part of operations. As you will see, we use the term pro-forma to describe financial statements that are prepared in advance and, hence, are estimates of future financial statements. When fi Wh companies report ‘pro-forma’ financial statements, however, they are referring to current financial statements with items selectively omitted. Discontinued Operations includes the income as well as the gain/loss from a discontinued business segment. Extraordinary Items include items that meet both the ‘unusual nature’ and ‘infrequent occurrence’ criteria. Changes in Accounting Principle typically involves an adjustment for the cumulative effect on all prior an adjustment for the cumulative effect on all prior periods. To provide comparable numbers, income from continuing operations are usually recomputed 27 28 Example Amazon.com released their annual results for fiscal 2001, reporting a net loss of $567,277,000. One number they often report is ‘pro-forma’ earnings, which is supposed to represent the sustainable and recurring earnings of the firm. Given the Income statement below, estimate pro-forma net earnings (or net loss) for Amazon net loss) for Amazon. AMAZON.COM, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) Years Ended December 31, 2001 2000 2000 1999 1999 To be continued… We will get back to this topic after will get back to this topic after completing the cash flow analysis. Net sales Cost of sales Gross profit Operating expenses: Fulfillment Marketing Technology and content General and administrative Stock-based compensation Amortization of goodwill and other intangibles Restructuring-related and other Total expenses Loss from operations Interest income Interest expense Other income (expense), net Other gains (losses), net Net interest and other Loss before equity in losses of equity-method investees Equity in losses of equity-method investees, net Loss before change in accounting principle Cumulative effect of change in accounting principle Net loss $ 3,122,433 2,323,875 798,558 374,250 138,283 241,165 89 89,862 4,637 181,033 181,585 1,210,815 (412,257) 29,103 (139,232) (1,900) (2,141) (114,170) (526,427) (30,327) $ 2,761,983 2,106,206 655,777 414,509 179,980 269,326 108 108,962 24,797 321,772 200,311 1,519,657 (863,880) 40,821 (130,921) (10,058) (142,639) (242,797) (1,106,677) (304,596) $ 1,639,839 1,349,194 290,645 237,312 175,838 159,722 70 70,144 30,618 214,694 8,072 896,400 (605,755) 45,451 (84,566) 1,671 — (37,444) (643,199) (76,769) $ $ (556,754) (10,523) (567,277) $ $ (1,411,273) — (1,411,273) $ $ (719,968) — (719,968) 29 30 A Note on Operating versus Capital Leases Capital Leases A Note on Operating versus Capital Leases Capital Leases Operating Leases: Capital Leases: Accounting treatment: Recognize rental (or lease) expense on an annual basis. Include financial statement disclosure in notes for future li liability. No asset or liability recognized. li Provide a source of off-balance sheet financing. Lower leverage and increase ROA. The primary criteria for classification as an operating lease is that minimum lease payments do not exceed 90% of the fair value of the leased asset. Accounting treatment: Capitalize and expense both the interest payments and depreciation expense. Lower the current ratio. Lower ROA and increase the leverage of the firm firm. 31 32 A Simplified Approach to Making Financial Statements Comparable Financial Statements Comparable A Simplified Approach to Making Financial Statements Comparable (cont’d.) (1) Ignore Income statement effects. For mature firms there often isn’t a material difference as both methods tend to have equal expense amounts at the mid-point of the lease period. (2) For the balance sheet, the most straightforward approach is to capitalize the leases of all companies. The liability that appears on the balance sheet is the discounted present on the balance sheet is the discounted present value of the minimum lease payments. To compute this you need (1) a discount rate, and (2) annual payments in the later years. A typical lease footnote disclosure taken from the SBUX 2007 annual report looks as follows: M inimum O perating Lease Payments (in thousands) 691,011 671,080 629,696 582,509 526,684 526,684 1,915,603 5,016,583 33 To obtain a discount rate, use the following if available: (1) The discount rate actually used might be disclosed in the lease footnote; (2) If there is no discount rate in the lease footnote, use the discount rate disclosed in the long-term debt footnote; (3) If the firm carries no debt, use the discount rate for debt on a comparable company. For the company above, we will use a discount rate of discount rate of 6.25% (taken from their debt footnote). (taken from their debt footnote) Estimating annual payments: For the ‘Later Years’ payments that are aggregated, simply use straight-line depreciation if the time horizon is given. If not, estimate the time horizon using the last available annual lease payment last available annual lease payment (2012 in the above example). in the above example) The time horizon is determined as: Minimum Op. Lease Payments after 2012 1,915,603 3.63 years 2012 annual payment 526,684 Fiscal Year 2008 2009 2010 2011 2012 2012 Later Years Net Minimum Lease Payments We’ll round this up to 4 years (always round up), for annual payments of $1,915,603 / 4= $478,901 per year. Now that we have the payment schedule, simply discount the stream of payments at a rate of 6.25% annually to get the present value of the lease obligation: PV of Lease = (691,001*0.9412) + (671,080*0.8858) + (629,696*0.8337) + (582,509*0.7847) + (526,684*0.7385) + (487,901*3.6607*0.6951) = $ 3,834,359 34 A Simplified Approach to Making Financial Statements Comparable (cont’d.) To adjust the balance sheet: Simplest approach – increase lease obligation (liability) and long-term leases (asset) each by $3,834,359. Use the adjusted numbers for ratio calculations. Assume interest expense at the discount rate multiplied by the computed value of the asset – this is required for EBI when computing ROA. Treat the capitalized lease as long term debt for solvency ratio calculations, etc. If you want more accurate guidance, see any intermediate accounting textbook such as Revsine, Collins, and Johnson, Financial Reporting and Analysis, Prentice-Hall Fi l (2008). 35 ...
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This note was uploaded on 04/09/2010 for the course NBA 5090 taught by Professor Yehuda,nir during the Fall '10 term at Cornell University (Engineering School).

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