Web3ch16 - CHAPTER SIXTEEN Creating Accounting Value and...

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CHAPTER SIXTEEN Creating Accounting Value and Economic Value Stephen H. Penman The web page for this chapter runs under the following headings: What this Chapter is Doing Metrics that Indicate the Hidden Reserves Created by Conservative Accounting and the Release of Hidden Reserves A Spreadsheet Program for Analyzing the Effects of Accounting Methods Accounting Issues in Forecasting: Starbucks Corporation Equivalences: Residual earnings and Discounted Cash Flow Approaches to Valuation Readers’ Corner What this Chapter is Doing Conservative accounting that features so much in this chapter is an accounting policy that keeps the balance sheet low, such that we always expect book value to be below market value. If LIFO inventory methods are consistently applied, then the balance sheet number for inventory will always be low (provided inventory costs are rising). Expensing R&D permanently results in (R&D) assets being omitted from the balance sheet, permanently. Conservative accounting is a feature of GAAP. Chapter 16 shows how conservative accounting affects numbers like ROCE, earnings, earnings growth, residual earnings growth. But most importantly, it shows how conservative accounting is handled in valuation, for conservative accounting affects accounting value added but not economic value added. It also deals with liberal accounting, the opposite of conservative accounting, although this is not common, except in the relative sense of a particular accounting being less conservative than otherwise. Boxes 16.2 and 16.3 provide good summaries. Focus on the valuations under conservative accounting. The chapter shows how the accounting does not affect the valuation, provided that steady state is forecasted. But conservative accounting does affect P/B ratios and P/E ratios, as the chapter demonstrates. Table 16.6 provides a summary.
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Metrics that Indicate the Hidden Reserves Created by Conservative Accounting and the Release of Hidden Reserves Table 16.7 shows how conservative accounting creates hidden reserves and how these hidden reserves can be liquidated, inflating earnings, if investment slows. This is not a concern for valuation if slowing of investment is forecasted within the forecast horizon (as the example there demonstrates). But one must be aware of earnings that are temporarily inflated by a liquidation of hidden reserves. A paper by Penman and Zhang, “ Accounting Conservatism, the Quality of Earnings, and Stock Returns,” published in The Accounting Review in April, 2002 develops metrics – C scores -- that estimate the amount of hidden reserves developed by the accounting for inventories, advertising and promotion, and R&D. It also develops diagnostics to estimate the amount of hidden reserves released into earnings in any period by the slowing of investment. The paper can be downloaded at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=201048 A Spreadsheet Program for Analyzing the Effects of Accounting Methods The following programs show how changes in accounting methods for book values change profitability, growth, residual earnings, and P/B and P/E ratios. Make sure you understand Tables
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Web3ch16 - CHAPTER SIXTEEN Creating Accounting Value and...

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