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Samenvatting - Business Analysis and Valuation: Using Financial Statements
2 Tekst 4.1 Overview of accounting analyses blz. 10-24
What are the three potential sources of noise and bias in accounting data?
- that introduced by rigidity in accounting rules
- random forecast errors
- systematic reporting choices made by corporate managers to achieve specific objectives
Noise from accounting rules - the degree of distortion introduced by accounting standards depends on how well uniform accounting standards capture the nature of a firm's transactions.
Forecast errors - managers cannot predict future consequences of current transactions perfectly.
Which incentives do managers have to exercise their accounting discretion to achieve certain objectives?
- Accounting-based debt covenants. Managers may make accounting decisions to meet certain contractual obligations in their debt covenants.
- Management compensation. Compensation and job security are often tied to reported profits.
- Corporate control contests. In corporate control contests, such as hostile takeovers, competing management groups attempt to win over the firm's shareholders. Managers may make accounting decisions to influence investor perceptions in corporate control contests. The acquiring firm may overstate its performance to boost its share price and by this reduce the share exchange ratio.
- Tax considerations.
- Regulatory considerations. Since accounting numbers are used by regulators in a variety of contexts, managers of some firms may make accounting decisions to influence regulatory outcomes.
- Capital market considerations. Managers may make accounting decisions to influence the perceptions of capital markets. When there are information asymmetries between managers and outsiders, this strategy may succeed in influencing investor perceptions, at least temporarily.
- Stakeholder considerations. Managers ma also make accounting decisions to influence the perception of important stakeholders in the firm.
- Competitive considerations. The dynamics of competition in an industry might also influence a firm's reporting choice. Firms may discourage new entrants by making profit-decreasing accounting choices.
Which steps can an analyst follow to evaluate a firm's accounting quality?
- Identify key accounting policies.
- Assess accounting flexibility.
- Evaluate accounting strategy.
- Evaluate the quality of disclosure.
- Identify potential red flags.
- Undo accounting distortions.
What are some of the questions to ask in examining how managers exercise their accounting flexibility?
- How do the firm's accounting policies compare to the norms in the industry? if they are dissimilar, is it because the firm's competitive strategy is unique?
- Do managers face strong incentives to use accounting discretion to manage earnings? Managers may also make accounting decisions to reduce tax payments or to influence the perceptions of the firm's competitors.
- Has the firm changed any of its policies or estimates? What is the justification? What is the impact of these changes?
- Have the company's policies and estimates been realistic in the past?
- Does the firm structure any significant business transactions so that it can achieve certain accounting objectives?
What questions can an analyst ask to assess a firm's disclosure quality?
- Does the company provide adequate disclosures to assess the firm's business strategy and its economic consequences?
- Do the notes to the financial statements adequately explain the key accounting policies and assumptions and their logic?
- Does the firm adequately explain its current performance? The Management Report section of the annual report provides an opportunity to help analysts understand the reasons behind a firm's performance changes.
- If accounting rules and conventions restrict the firm from measuring its key success factors appropriately, does the firm provide adequate additional disclosure to help outsiders understand how these factors are being managed?
- If a firm is in multiple business segments, what is the quality of segment disclosure?
- How forthcoming is the management with respect to bad news? Does it adequately explain the reasons for poor performance? Does the company clearly articulate its strategy, if any, to address the companies performance problems?
- How good is the firm's investor relations program? Does the firm provide fact books with detailed data on the firm's business and performance? Is the management accessible to analysts?
Name some common red flags.
- Unexplained changes in accounting, especially when performance is poor.
- Unexplained transactions that boost profits.
- Unusual increases in trade receivables in relation to sales increases.
- Unusual increases in inventories in relation to sales increases.
- An increasing gap between a firm's reported profit and its cash flow from operating activities.
- An increasing gap between a firm's reported profit and its tax profit.
- A tendency to use financing mechanisms like research and development partnerships, special purpose entities, and the sale of receivables with recourse (toevlucht).
- Unexpected large asset write-offs.
- Large year-end adjustments. A consistent pattern of year-end adjustments, therefore, may indicate aggressive management of interim reporting.
- Poor internal governance mechanisms. When a firm's supervising directors or audit committee lack independence from management or its internal control system has deficiencies, accounting may be of questionable quality.
- Related-party transactions or transactions between related entities.These transactions may lack objectivity and are likely to be more subjective and potentially self-serving.
If the accounting analysis suggests that the firm's reported numbers are misleading, analysts should attempt to restate the reported numbers to reduce the distortion to the extent possible.
A firm's cash flow statement provides a reconciliation of its performance based on accrual accounting and cash accounting.
The notes to the financial statements also provide a lot of information that is potentially useful in restating reported accounting numbers.
Conservative accounting often provides managers with opportunities for reducing the volatility of reported earnings, typically referred to as "earnings smoothing", which may prevent analysts from recognising poor performance in a timely fashion.
It is easy to confuse unusual accounting with questionable accounting. Therefore it is important to evaluate a company's accounting choices in the context of its business strategy. Accounting changes might be merely reflecting changed business circumstances.
The adoption of IFRS makes financial statements more comparable across countries and lowers the barriers to cross-border investment analyses. IFRS may not be similarly enforced throughout Europe because all European countries have their own public enforcement bodies. Finally, the role of financial reports in communication between managers and investors differs across firms and countries.
What helps to ensure that performance metrics are calculated using comparable definitions?Recasting the financial statements using a standard template, helps ensure that performance metrics used for financial analysis are calculated using comparable definitions across companies and over time.
What is used to identify whether there have been any distortions to assets, liabilities, or shareholders' equity?A balance sheet approach. Once any assets and liability misstatements have been identified, the analyst can make adjustments to the balance sheet at the beginning and/or end of the current year, as well as any needed adjustments to revenues and expenses in the latest income statement.
The first task for the analyst in accounting analysis is to recast the financial statements into a common format. This involves designing a template for the balance sheet, income statement, cash flow statement and statement of changes in equity that can be used to standardise financial statements for a company.
Describe the classification by nature.The classification by nature defines categories with reference to the cause of operating expenses. Firms using this classification typically distinguish between the cost of materials, the cost of personnel and the cost of non-current assets (vaste activa) such as depreciation and amortisation.
Describe the classification by function.The classification by function defines categories with reference to the purpose of operating expenses. Costs that are incurred for the purpose of production the products or services sold (cost of sales) and costs for overhead activities such as administrative work and marketing (Selling, General and Administrative Expenses (SG&A)).
The IFRS require that when firms classify their expenses by function, they should also report a classification of expenses by nature in the notes to the financial statement.
Income statement - classification by function page 27.
Income statement - classification by nature page 28.
Standardized balance sheet - page 29-30
Standardized cash flow statement - page 31-32
Standardized statement of changes in equity format - page 32
What do firms have to disclose in their first IFRS based financial statements?To illustrate the effects of IFRS adoption on their financial figures firms have to disclose in their first IFRS based financial statements:
- A description of the sources of differences between equity reported under previous accounting standards and under IFRS as well as the effects of these differences in quantitative terms.The firm must provide such reconciliations for equity in both its opening and its closing comparative balance sheets.
- A reconciliation of net profit reported under previous accounting standards and under IFRS for the prior year.
What distortions in asset values can arise?Distortions in asset values generally arise because there is ambiguity about whether:
- The firm owns or controls the economic resources in question.
- The economic resources are likely to provide future economic benefits that can be measured with reasonable certainty.
- The fair value of assets fall below their book values.
- Fair value estimates are accurate.
What is the basic principle on lease accounting?When a lessee (huurder) carries substantially all the risks of a leased asset, the asset is essentially owned by the lessee and must be reported on its balance sheet.
Although firms are generally inclined to understate the assets that they control, thereby inflating the return on capital invested, they may sometimes pretend to control subsidiaries for the sake of inflating (opblazen) asset and revenue growth. Analyzing the accounting of a firm that follows a strategy of growing through acquisitions thus would include identifying subsidiaries that are fully consolidated but not fully owned and assessing their impact on the firm's net assets, revenues, and growth figures.
When is a firm permitted (toegestaan) to recognise revenues?Firms are permitted to recognise revenues only when the product has been shipped or their service has been provided to the customer. Revenues are then considered earned, and the customer has a legal commitment to pay for the product or service.
Ambiguity over whether a company owns an asset creates a number of opportunities for accounting analyses, which are they?
- Financial statements sometimes do a poor job of reflecting the firm's economic assets because it is difficult for accounting rules to capture all of the subtleties associated with ownership and control.
- Accounting rules cannot always prevent important assets being omitted from the balance sheet even though the firm bears many of the economic risks of ownership.
- There may be legitimate differences in opinion between managers and analysts over residual ownership risks borne by the company, leading to differences in opinion over reporting for these assets.
- Aggressive revenue recognition, which boosts reported earnings, is also likely to affect asset values.
When is an asset impaired?An asset is impaired when its fair value falls below its book value.
Managers make estimates of asset lives, salvage values, and amortisation schedules for depreciable non-current assets. if these estimates are optimistic, non-current assets and earnings will be overstated. this issue is likely to be most pertinent for firms in heavy asset businesses (airlines, utilities), whose earnings contain large depreciation components. Firms that use tax depreciation estimates of asset lives, salvage values, or amortisation rates are likely to amortise assets more rapidly than justifiable given the assets' economic usefulness, leading to non-current asset understatements. if there do not appear to be operating differences that explain the differences in the two firms' depreciation rates, the analyst may well decide that it is necessary to adjust the deprecation rates for one or both firms to ensure that their performance is comparable.
Mention the common items that can lead to overstatement or understatement of assets (and earnings).
- depreciation and amortisation on non-current assets
- impairment of non-current assets
- leased assets
- intangible assets
- the timing of revenue (and receivables) recognition
- write-downs of current assets
- discounted receivables
What are the two ways in which a firm can record its leased assets?
- Operating method (rental contract). The firm recognises the lease payment as an expense in the period in which it occurs, keeping the leased asset off its balance sheet.
- Finance method (equivalent to a purchase). The firm records the asset and an offsetting lease liability on its balance sheet. During the lease period, the firm then recognises depreciation on the asset as well as interest on the lease liability.
IAS 17 explains that a firm would normally consider a lease transaction equivalent to an asset purchase if any of the following conditions hold, which are these conditions?
- Ownership of the asset is transferred to the lessee at the end of the lease term.
- The lessee has the option to purchase the asset for a bargain price at the end of the lease term.
- The lease term is for the major part of the asset's expected useful life.
- The present value of the lease payments is equal to substantially all of the fair value of the asset.
- The asset cannot be used by other than the lessee without major modifications.
Wat zijn ImmateriÃ«le activa (intangible assets)?
ImmateriÃ«le activa zijn vaste activa die niet tastbaar zijn. Het betreft bezittingen die wel een rol spelen in het financiÃ«le proces, maar nooit in het fysieke bedrijfproces. ImmateriÃ«le activa kunnen alleen dan op de balans opgevoerd worden, wanneer zij een objectief bepaalbare waarde hebben. Over de waardering van immateriÃ«le activa zijn per soort verschillende afspraken vastgelegd. Uitgangspunt van de waardering is dat er een inschatting moet zijn van de nuttige gebruiksduur, de afschrijving per jaar is dan het waardeverlies over de totale tijd gedeeld door het aantal jaren nuttig gebruik. Voorbeelden van immateriÃ«le activa zijn:
- Goodwill. Het bedrag dat betaald moet worden voor de overname van klanten. Klanten vertegenwoordigen een potentiÃ«le omzet, en in die zin een waarde voor een bedrijf.
- Octrooien en patenten. Dit zijn de rechten om een product in monopolie te maken.
- Research / Ontwikkelingskosten. Kosten die gemaakt worden om een product te ontwikkelen kunnen gespreid worden over de levenscyclus van het product.
Accounting rules in most countries specifically prohibit the capitalisation of research outlays (expenses), primarily because it is believed that the benefits associated with such outlays are too uncertain.
Expensing the cost of intangibles has two implications for analysts, which are they?
- Omission of intangible assets from the balance sheet inflates measured rates of return on capital (return on assets or return on equity).
- It makes it more difficult for the analyst to assess whether the firm's business model works.
Recent changes in international rules for merger accounting require that firms report mergers using the purchase method. Under this method the cost of the merger for the acquirer is the actual value of the consideration (vergoeding) paid for the target firm's shares. The identifiable assets and liabilities of the target are then recorded on the acquirer's (overnemende partij) books at their fair values. If the value of the consideration paid for the target exceeds the fair value of its identifiable assets and liabilities, the excess is reported as goodwill on the acquirer's balance sheet. The new rules require goodwill assets to be written off only if they become impaired in the future.
What are the warning signs of inadequate allowances?Growing days receivable, business downturns for a firm's major clients, and growing loan delinquencies (betalings achterstanden).
How can a tax loss carry forward influence earnings?Understated allowances are a point of attention when analysing the financial statements of loss-making firms. When a firm reports a loss in its tax statement, it does not receive an immediate tax refund but becomes the holder of a claim against the tax authorities, a tax loss carry forward, which can be offset against future taxable profits. The period over which the firm can exercise this claim differs across tax jurisdictions. The international accounting standard for income taxes requires that firms record a deferred tax asset for a tax loss carry forward that is probable of being realised. Because changes in this deferred tax asset affect earnings through the tax expense, managers can manage earnings upwards by overstating the probability of realisation.
What are receivables that are discounted with a financial institution?They are considered sold if the seller cedes (afstaan) control over the receivables to the financier. Control is surrendered if the receivables are beyond the reach of the seller's creditors should the seller file for bankruptcy, if the financier has the right to pledge or sell its interest in the receivables, and if the seller has no legal right or commitment to repurchase the receivables. The seller can then record the discount transaction as an asset sale.
With discount receivables is their any risk for the seller?Financial institutions that discount receivables often have recourse (terughalen, beroep) against the seller, requiring the seller to continue to estimate bad debt losses and record recourse liability (aansprakelijkheid) for the amount of losses that it guarantees.
When do distortions arise with liabilities?When there is ambiguity about whether an obligation has really been incurred and/or the obligation can be measured.
How should liabilities be assessed?Analysis of liabilities is usually with an eye to assessing whether the firm's financial commitments and risks are understated and/or its earnings overstated.
When are liabilities likely to be understated?Liabilities are likely to be understated when the firm has key commitments that are difficult to value and therefore not considered liabilities for financial reporting purposes.
The most common forms of liability understatement arise when the following conditions exist:
- unearned revenues are understated through aggressive revenue recognition
- provisions are understated
- loans from discounted receivables are off-balance sheet
- non-current liabilities for leases are off-balance sheet
- post-employment obligations, such as pension obligations, are not fully recorded
Explain unearned revenues understated.If cash has already been received but the product or service has yet to be provided, a liability (unearned or deferred revenues) is created. Firms that recognise revenues prematurely, after the receipt of cash but prior to fulfilling their product or service commitments to customers, understate deferred revenue liabilities and overstate earnings. Firms that bundle service contracts with the sale of a product are particularly prone to deferred revenue liability understatement since separating the price of the product from price of the service is subjective.
What is a provision?Obligations that are likely to result in a future outflow of cash or other resources but for which the exact amount is hard to establish.
When can a firm recognise a provision on its balance sheet according to international accounting rules?
- When it is probable that the obligation will lead to a future outflow of cash
- The firm has no or little discretion to avoid the obligation
- The firm can make a reliable estimate of amount of the obligation
Name two contingent claims.1. employee stock options2. conversion options on convertible debentures (obligaties)
What is a stock option?A stock option gives the holder the right to purchase a certain number of shares at a predetermined price, called the exercise or strike price, for a specified period of time, termed the exercise period.
What do proponents (voorstanders) of options argue?They argue that they provide managers with incentives to maximise shareholder value and make it easier to attract talented managers.
What are convertible debentures?They contain a stock option component. Holders of these debentures (obligaties) have the right to purchase a certain number of shares in exchange for their fixed claim.
Name two important factors to consider on how to account for contingent claims in a firm's financial statement.
- The potential exercise of the option dilutes current shareholder's equity and as such imposes an economic cost on the firm's shareholders. To improve current net profit as a measure of the firm's current economic performance the economic cost of contingent claims should therefore be included in the income statement in the same period in which the firm receives the benefits from these claims.
- The contingent claims are valuable to those who receive them. Employees are willing to provide services to the firm in exchange for employee stock options. Convertible debenture holders are willing to charge a lower interest rate to the firm in exchange for the conversion option. To improve current net profit as a predictor of the firm's future net profit the income statement should therefore include an expense that reflects the value of the contingent claims to the recipients.