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Intro-Accounting Analysis. Intro- Accounting Analysis. Accounting Quality. Narrow definition: To what extent does the accounting represent underlying business reality? Trying to understand accounting distortions When distortions are large, accounting analysis is very beneficial

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accounting quality
Accounting Quality
  • Narrow definition: To what extent does the accounting represent underlying business reality?
    • Trying to understand accounting distortions
    • When distortions are large, accounting analysis is very beneficial
  • Broader Definition: Narrow definition + Sustainability- To what extent do earnings map to future profitability”?
    • Trying to separate core operating (non-operating) earnings from “unusual” earnings
accounting s and economic reality sources of noise and bias
Accounting #s and Economic RealitySources of noise and bias
  • Accounting rules -- rules can prevent management from telling the story they want to tell because of their restrictive nature
  • Forecast errors arise because of
    • complexity of business
    • predictability of firm’s environment
    • unforeseen economy wide events
  • Accounting choices
doing accounting analysis
Doing Accounting Analysis
  • Identify key accounting policies
  • Assess Accounting Flexiblity
  • Evaluate Accounting Strategy
  • Evaluate the quality of disclosures
  • Identify Red Flags
  • Undo Accounting Distortions
identifying key accounting policies step 1
Identifying Key Accounting Policies (Step 1)
  • Analysis requires the identification of key value-drivers i.e. important in explaining the success of the firm
  • Volatile and can change quickly
  • A change is unpredictable
  • Is significant enough that prompt action is required
  • Can be measured either directly or by surrogate
possible key variables
Possible Key Variables
  • Bookings
  • Back orders
  • Market share
  • Key account orders
  • The analyst has to identify the accounting measures that capture these constructs
examples of industry key variables
Examples of Industry Key Variables
  • Airline Paid seats/capacity Fuel
  • Electrical utility KWH sold
  • Hospital Beds occupied/available beds
  • Hotel Beds occupied/available beds
  • Magazine Renewals/subscriptions expired
  • Railroad Carloadings
  • Restaurant Labor cost/revenue
  • Raw food cost/revenue
  • Retail Store Gross margin by department
assess accounting flexiblity step 2
Assess Accounting Flexiblity (Step 2)
  • Some firms have little flexibility e.g. utilities
  • All can make some choices
evaluate accounting strategies step 3
Evaluate Accounting Strategies (Step 3)
  • Compare to the industry
  • Incentives for reporting in one direction or the other
  • Have policies changed?
  • Have the firms policies been realistic in the past?
  • Does the firm appear willing to expend resources to achieve an accounting objective that is not economic based?
evaluate quality of disclosures step 4
Evaluate Quality of Disclosures (Step 4)
  • Can you identify business strategy from disclosures (Pres Letter)
  • Do footnotes explain key accounting policies -- deviations from industry, accounting changes
  • Is current performance adequately explained
  • Does the firm provide you with a means of identifying performance with respect to key indicators
  • Bad news
  • Segment disclosures?
identify potential red flags step 5 1
Identify Potential Red Flags (Step 5) -1
  • Unexplained accounting changes
    • Switch from accelerated to st. line dep (Kaplan)
    • Switch to LIFO (Brown)
  • Unexpected transactions which boost profit (Debt swaps investigated by Hand, for example)
identify potential red flags step 5 2
Identify Potential Red Flags (Step 5) -2

Unusual increases in accounts receivable

  • Firms having trouble selling products often ease credit terms
  • Could also suggest earnings manipulation
identify potential red flags step 5 3
Identify Potential Red Flags (Step 5) -3

Unusual increases in inventories

  • Suggest difficulties in generating sales
  • May suggest slow or obselete items that are to be written off later
  • Increase current earnings at the expense of future earnings (Overhead spread)
identify potential red flags step 5 4
Identify Potential Red Flags (Step 5) -4
  • Increasing gap between earnings and cash flow from operations
    • A companies operating cycle is pretty much from cash to cash bulges may suggest some form of management
  • Increasing gap between reported inome and tax income
    • An increase may suggests that a firm has become agressive with its accounting
identify potential red flags step 5 5
Identify Potential Red Flags (Step 5) -5
  • A tendency to use financing mechanisms like R&D partnerships, sale of receivables with recourse
    • Gives management chance to play with the accounting
  • Unexpected large asset write-offs
  • Large Fourth-quarter write-offs
  • Qualified audit opinions
  • Related party transactions
undo distortions step 6
Undo Distortions (Step 6)
  • Cash flow as an alternative
  • Footnotes
accounting myths
Accounting Myths:
  • “Conservative” accounting is “good” accounting
  • Unusual Accounting is questionable
  • “Professional Judgement” is questionable.
sustainability
Sustainability
  • Separating Core and Non-Core Earnings Components
analysis of changes in roce
Analyze Changes in Profitability of Operations

Analyze the Effects of Changes in Financing

(1)

(2)

Analysis of Changes in ROCE
explaining the changes in operational profitability
Explaining the Changes in Operational Profitability

Explaining RNOA

  • Distinguish core and transitory components

Core OI is persistent income from core business

UI is unusual items that are non-recurring,

sometimes called transitory items.

All items are after tax

explaining changes in operational profitability cont d
Explaining Changes in Operational Profitability (cont’d.)
  • Distinguish margin and turnover drivers of core profits

where,

explaining changes in operational profitability cont d1
Explaining Changes in Operational Profitability (cont’d.)
  • Explain changes in profit margins and asset turnoversExplain (i) by looking at profit margin drivers
      • GM (by segment)
      • Selling Expenses / Sales
      • Administrative Expenses / Sales
      • R&D / Sales

Pay particular attention to GM: per unit sales prices, production costs…

Explain (ii) by looking at turnovers

      • Accounts receivables turnover
      • Inventory turnover
      • PPE turnover
      • Accounts payable turnover
      • Operating liability turnover

Also

      • Look at operating asset composition ratios
      • Look at operating liabilities composition ratios
      • Look at OLLEV
reformulating income statements to identify core and unusual items
Reformulating Income Statements to Identify Core and Unusual Items

Reformulated Operating Income Statement: Core and Unusual Items

to analyze sustainable earnings analyze r d
To Analyze Sustainable Earnings, Analyze R&D

Analysis of R&D: Abbott Laboratories

to analyze sustainable earnings analyze marketing expenditures
To Analyze Sustainable Earnings, Analyze Marketing Expenditures

The Analysis of Advertising Costs: Coca-Cola

to analyze sustainable earnings analyze pension costs
To Analyze Sustainable Earnings, Analyze Pension Costs

Components of Pension Expense:

  • Service Cost
  • Interest Cost
  • Expected Return on Plan Assets
  • Amortization of Prior Service Cost
  • Amortization of Transaction Asset or Liability (before 2000)
  • Changes in Actuarial Estimates (accrual gains and losses)
watch for the expected rate of return on pension plan assets
Watch for the Expected Rate of Return on Pension Plan Assets
  • In the 1980s, firms were using expected rates of return of about 7%
  • In the 1990s, firms were using expected rates of returns of 10-10½%
  • Applying a high rate of return to bubble asset prices produces bubble earnings
  • Pricing on the basis of bubble prices perpetuates the bubble

The Pension Pyramid Scheme

watch for gains of pension fund assets
Watch for Gains of Pension Fund Assets
  • General Electric’s expected return
  • General Electric’s expected return on plan assets was $3,024 million in 1998 (22.4% earnings before tax) against a service cost of $625 million. Its net pension expense was a gain of $1,016 million.
  • IBM reported an expected return on plan assets of $6,264 million in 2001 (56.0% of operating income before tax).
watch gains and losses on sales of shares
Watch Gains and Losses on Sales of Shares

Intel

In its report for its third quarter for 1999, Intel reported net income of $1,458 million, with no indication of unusual items. Its cash flow statement, however, reported $556 million in gains on sales of investments, along with a $161 million loss on retirements of plant, as add backs to net income to calculate cash from operations.

Delta Air Lines

Delta reported operating income (before tax) of $350 million for its September quarter in 1999. However, notes to the report indicated that these earnings included pre-tax gains of $252 million from selling its interest in Singapore Airlines and Priceline.com.

IBM

IBM reported before-tax operating income of $4,085 for its June, 1999 quarter. However, footnotes revealed that this income included a $3,430 million gain from the sale of IBM\'s Global Network to AT&T. This gain reduced selling, general and administrative expenses in the income statement!

watch for bleed backs of restructuring and merger changes
Watch for Bleed Backs of Restructuring and Merger Changes

IBM: Creating earnings with restructuring charges

miscellaneous check list
Miscellaneous Check List
  • Changes in estimates
    • Bad debt allowances
    • Deferred revenue and cookie jar accounts
    • Warranty allowances
    • Residual values for leases
  • Income Taxes
    • One-time or expiring credits
    • Valuation allowances for deferred tax assets
  • Investigate “other income”
analyzing operating leverage
Analyzing Operating Leverage

Operating Leverage is the proportion of total costs that are fixed versus variable

The first component here is called the contribution margin ratio

This ratio measures the change in income from a change in one dollar of sales

operating leverage measures
Operating Leverage Measures

Operating Leverage is sometimes calculated as the ratio of fixed costs to variable costs

Another measure is:

Applying this measure to core operations:

analysis of effect of changes in financing

(i)

Effect of change in operating profitability

(ii)

Effect of change in spread

(iii)

Effect of change in leverage

Effect of Financing

Analysis of Effect of Changes in Financing

Change in ROCE

=

Change in RNOA

+

Change due to change in spread at previous level of financial leverage

+

Change due to change in financial leverage

explaining changes in the spread
Explaining Changes in the SPREAD

SPREAD = RNOA – NBC

RNOA has been explained

Explain Change in NBC:

Distinguish core and unusual borrowing cost

Core financing expenses

  • Change in interest rates (risk free and risk premium)
  • Change in tax rates (and shield)
  • Substitution of preferred for debt financing

Unusual financing expenses

  • Tax effect from unusually high or low taxes (operating losses)
  • Interest income from tax refunds of prior years
  • Gains and losses on financial items
a rough approximation
A Rough Approximation
  • Some observations
    • The change in leverage effect (iii) is generally minor
    • The change in borrowing costs is generally small (then, Spread is largely determined by RNOA)
    • The RNOA effect (i) is generally the largest
  • So, if FLEV and NBC are small, a useful approximation is
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