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Accruals. Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears (A/R reserves) Projections (Coca-Cola mini-case). Accrual Accounting. Revenue recognition principle: record revenues when “realized or realizable” and “earned”

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Accruals
Accruals

Agenda:

  • Review accrual accounting

    • Statement preparation exercise

  • Discuss cases

    • International Paper (accruals)

    • Sears (A/R reserves)

  • Projections (Coca-Cola mini-case)


Accrual accounting
Accrual Accounting

Revenue recognition principle: record revenues when “realized or realizable” and “earned”

  • “realized or realizable” means received in cash or have another asset that will generate cash (e.g., A/R)

  • “Earned” means the transaction is complete

    • No rights of return or other contingencies

    • No involvement in resale


Accrual accounting1
Accrual Accounting

Matching principle: once the revenues have been recognized, match against those revenues the expenses incurred in order to generate them.

  • Record expenses when “incurred” (not necessarily when cash is paid)

  • Expenses should not precede nor lag revenues (why?)


Accrual accounting2
Accrual Accounting

Examples:

  • Capitalize and depreciate fixed assets

  • Record expenses in advance of payment (e.g., wages, severance accruals, contingent liabilities)

  • Defer revenues until earned even though cash paid in advance (e.g., magazine subscriptions)

  • Accrual exercises (Hennessey F/S)

  • International Paper mini-case





  • International paper mini case q2
    International Paper mini-case – Q2

    • Components of $969 million charge


    International paper mini case q3
    International Paper mini-case – Q3

    • Components of $824 million charge


    International paper mini case q4
    International Paper mini-case – Q4

    • Components of $125 million charge


    International paper mini case q5
    International Paper mini-case – Q5

    • Components of $541 million charge


    International paper mini case q6
    International Paper mini-case – Q6

    • Components of $34 million reversal


    International paper mini case q7
    International Paper mini-case – Q7

    • In sum, do you think these accruals provide investors with relevant information? How might a company use accruals to misrepresent its financial condition? What might you look as an analyst to analyze the appropriateness of accruals?


    A r allowance for uncollectible accounts
    A/R Allowance for Uncollectible Accounts

    • A/Rs are reported net of uncollectible accounts (UA)

    • Estimate bad debts and make the following journal entry:

      Bad debt expense xxx

      Allowance for UA xxx

    • Expense is recorded when incurred (bad debts estimated), no expense when A/R is written off

    • Sears mini-case


    Sears mini case
    Sears Mini-Case

    • Describe the actions Sears took with respect to its allowance for uncollectible accounts in 1993? How did this affect earnings? What other actions occurred in that year?

    • Why does the analyst think that Sears’ reported earnings are overstating its “true” earnings”

    • What is the response of Sears’ CFO to these allegations? Do you believe him?

    • How can a company use the allowance for uncollectible accounts to shift earnings from one period into another?

    • As an outsider, what might you look at to give you a clue that the company might be managing earnings via the allowance account?


    Accruals and future stock performance
    Accruals and Future Stock Performance

    • “Most investors claim to pay attention to earnings quality, but recent academic research suggests otherwise. Investors often ignore valuable publicly disclosed information regarding the reliability of reported earnings and their potential improvement or deterioration, creating an opportunity to exploit the likely impact on stock performance.”

    • Our own research has confirmed the academic findings and enhanced a stock-selection tool the academics suggested, making it more timely and broadly applicable. Just as important, our research sheds insight on the fundamentals the tool captures, making it a very useful addition to our research-review process. The tool appears to be capturing information that our existing tool set doesn’t, and thus could be additive to the returns of our US value portfolios. (US Value Equities)


    While some of its underlying drivers seem to have a value flavor, our research shows the tool to be style-agnostic. In a large-cap universe sorted on the basis of price to book, it is effective for both value and growth stocks (Display 2). In fact, it was somewhat more effective for stock selection within growth.

    (US Value Equities)


    Essentially, we believe that balance-sheet accruals speak to the persistency of reported earnings. It implies that investors take earnings reports literally and treat all sources of reported earnings as equal, although the accrual component of reported earnings is less reliable than the cash component.

    US Value Equities


    Accruals and reversion of roa
    Accruals and Reversion of ROA to the persistency of reported earnings. It implies that investors take earnings reports literally and treat all sources of reported earnings as equal, although the accrual component of reported earnings is less reliable than the cash component.

    Source: Richard G. Sloan, The Accounting Review, July 1996


    Halsey, R.F. 2001. "Stationary Components of Earnings and Stock Prices," Advances inQuantitative Analysis of Finance and Accounting, vol. 9, pp 81-110.


    CFRA Comments on Accruals Stock Prices,"

    Source: CFRA 2004


    Coca-Cola mini-case Stock Prices,"

    (projections)