Financial analysis and valuation Topic presentation: Accounting Analysis: Implementation and Recasting of Financial Statements TELSTRA COMPANY 1. Step 4: Evaluate the Quality of Disclosure Although...

Financial analysis and valuation
Topic presentation:
Accounting Analysis: Implementation and Recasting of Financial Statements
TELSTRA COMPANY
1. Step 4: Evaluate the Quality of Disclosure
Although accounting rules require a certain amount of minimum disclosure, managers have considerable choice in the matter.
What is the quality of disclosure?
Can we quantitatively measure disclosure quality?
· Earnings Persistence
· Accrual Quality
Why are these measures important?
How about qualitatively?
What questions should analysts ask when assessing quality of disclosure?
· Enough disclosure to assess the organization’s business strategy and its economic consequence?
· Do footnotes adequately explained key accounting policies and assumption?
· Cu
ent performance explained?
· Accounting rules and convention too restrictive to measure success factor? Any additional information provided?
· Multiple segments? Quality of segment disclosures?
· Hiding bad news?
· Good investor relation program?
2. Step 5: Identify Potential Red Flags
Indicators that suggest the analyst should gather additional information
Further issues to consider include:
· Unexplained changes in accounting policy
· Unexplained transactions that boost profits
· Increases in:
· Inventory in relation to sales revenue
· Accounts receivable in relation to sales revenue
· Depreciation charge (Example: A
ium Ltd write-down of inventory by $21.2m)
· Further issues to consider include:
· Increases in the gap between profit and:
· Operating cash flows
· Taxable income
· Unexpected large asset write-offs
· Large year-end adjustments
· Example: A
ium Ltd impairment of land, building and mine development expenditure (total $8m)
· $961m write-downs announced on 19 August 2013. Share price went down 13.6% on the day
3. Step 6: Undo Accounting Distortions
How can we get financial statements that truly represent performance and financial position of a company?

Title slide with an image
Lecture 4
Overview of Accounting Analysis (1)
MONASH
BUSINESS
SCHOOL
1
Valuation flow chart
MONASH
BUSINESS
SCHOOL
Topic Objectives
Theories
Financial statements are prepared under accounting rules, but accounting rules give flexibility to the preparer. Are financial reports of high quality?
Financial statements that are prepared under accounting rules sometimes combined operation and financial activities and we need to separate them.
Applications
First, we need to understand the basic features of financial reporting.
Measure accounting quality.
Identify the factors influencing financial reporting quality.
Appreciate the incentives behind financial statement manipulation.
Understand the steps in performing accounting analysis (how to undo manipulations).
MONASH
BUSINESS
SCHOOL
Financial Statements
A statement of financial position as at the end of the period
A statement of profit and loss and other comprehensive income for the period
A statement of changes in equity for the period
A statement of cash flows for the period
Notes
Definitions
        Assets =Liabilities + Equity (Book value and Market Value Balance Sheets)
        Comprehensive Income = Profit for the year + Other comprehensive Income
         Profit for the year = Revenue - Expenses
MONASH
BUSINESS
SCHOOL
Review of some basic GAAP concepts
Assets = Liabilities + Shareholders’ Equity
Assets are probable future economic benefits under the control of the firm arising from prior transactions
Liabilities are probable future economic sacrifices that are obligations of the firm arising from past events
MONASH
BUSINESS
SCHOOL
5
Financial Statements
Revenues    - Gross Inflow of economic benefits
Expenses    - Decreases in economic benefits (simultaneous recognition of decreases in assets and increases in liabilities)
Profit        - Difference between Revenue and Expenses
Other Comprehensive Income – Income items that by-pass profit for the year and are directly recorded in equity.
Changes in fair value of property, plant and equipment
Changes in fair value of Investment property, available for sales securities
Derivatives used in cash flow hedges and actuarial changes in defined benefit pension plans.
MONASH
BUSINESS
SCHOOL
The purpose of accounting analysis
Accounting analysis evaluates the degree to which accounting captures the underlying reality of the business
Understanding accounting allows the analyst to effectively use the accounting information disclosed by companies
In particular, the analyst aims to assess the quality of the financial statements
Adjust financial statements to mitigate accounting distortions, or recognize that distortions must ultimately be reversed
To do so requires an understanding of the basic features of financial reporting
To do so, an analysts should also have very good knowledge of the industry
MONASH
BUSINESS
SCHOOL
7
The Importance of Accounting Analysis
Accounting analysis evaluates the degree to which accounting captures the underlying reality of the business:
In particular, the analyst is trying to assess the accounting quality of the financial statements.
To do so requires an understanding of accounting and the basic features of financial reporting.
Good Start: Do the financial statements reflect economic reality?
when do managers have incentives to reveal truth?
when do managers have incentive to obscure truth?
MONASH
BUSINESS
SCHOOL
Accrual accounting and limitations of accounting information: Accruals
Financial reports are prepared using accrual accounting instead of cash accounting
Indicating income statement is more important than cash flow statement
Examples of accrual transactions include credit sales, credit purchases, estimates of assets useful lives, provisions, and allowance for doubtful debts and similar items.
Thus, accrual accounting show the financial picture of a company more accurately than cash accounting which relies only on cash transactions.
MONASH
BUSINESS
SCHOOL
Theoretical Background: Accrual Accounting
Under accrual accounting
Net Profit After Tax (NPAT) has two components
NPAT= cash (transactions-based) + accruals (adjustments-based)
                                                                                        
Little manipulation
Can be manipulated: earnings management
MONASH
BUSINESS
SCHOOL
Average Earnings and Cash Flow Performance of Firms Caught by the SEC for Manipulating Earnings (Manipulation Occurs in Year 0)
The importance of cash flow
How do you interpret this graph? and how can you use such concept in identifying the red flags in the accounting analysis section of your group assignment.
MONASH
BUSINESS
SCHOOL
11
What is Earnings Management?
Arthur Levitt: “practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company.” 
Earnings management (or income smoothing) is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings.
In most cases, earnings management is used to increase income in the cu
ent year at the expense of income in future years.
Earnings management can also be used to decrease cu
ent earnings in order to increase income in the future.
MONASH
BUSINESS
SCHOOL
The Impact of Earnings Management
The practice of earnings management damages the perceived quality of reported earnings over the entire market, resulting in the belief that reported earnings do not reflect economic reality.
This will eventually lead to unnecessary stock price fluctuation. 
This uncertainty ultimately has the potential to undermine the efficient flow of capital thereby damaging the markets as a whole.
MONASH
BUSINESS
SCHOOL
Earnings Management: Incentives
A.    EXTERNAL FORCES
Analyst Forecasts
Debt markets and contractual obligations (Debt Covenants)
Competition
Capital Market Considerations
B.    INTERNAL FACTORS
Potential mergers
Management Compensation
Planning and budgets
Unlawful transactions
C.    PERSONAL FACTORS
Personal bonuses
Promotions and job retention
MONASH
BUSINESS
SCHOOL
14
Two Directions for Manipulation
Bo
owing income from the future
Increase in cu
ent revenue
Decrease in cu
ent expenses
Banking income for the future
Decrease cu
ent revenue
Increase cu
ent expenses
Distinguish:
Conservative Accounting
                                vs.
Liberal Accounting
Aggressive Accounting
                                vs.
Big Bath Accounting
Both increase cu
ent NOA
Both reduce cu
ent NOA
A matter of Accounting Policy
A matter of short-term application of accounting that will reverse
MONASH
BUSINESS
SCHOOL
15
How Specific Balance Sheet Items are Managed to Increase Income
MONASH
BUSINESS
SCHOOL
16
How Specific Balance Sheet Items are Managed to Increase Income (cont)
MONASH
BUSINESS
SCHOOL
17
Factors affecting Accounting Quality
Nature of underlying transactions, events and conditions that impact entity’s financial position and performance
Discretions that managers have on making reporting decisions
Institutional factors that moderate these effects
External Auditing
IFRS
Legal Environment
MONASH
BUSINESS
SCHOOL
Managers’ Accounting Discretion
Why discretion?
Preparation of financial statements involves complex judgments and estimates.
Examples
Revenue when an organization sells land to customers and also provide financing.
Revenue cognition before collection of cash – how to estimate default rate?
Research and development activities when payoff are uncertain
Managers have intimate knowledge of the organization and they “should” use these knowledge to portray informative business transactions
However, they may have alternative incentives
Delegation of financial reporting decisions to managers have costs and benefits.
MONASH
BUSINESS
SCHOOL
Management Incentive (examples)
1. Debt Covenants
Minimum Interest Coverage:
    “The company will not permit the ratio of EBIT to interest expense as at any fiscal quarter end for the four fiscal quarters then ending to be less than 2.25 to 1”
2. Compensation Contracts
BlueScope 2012
CEO: Paul O’Malley
cu
ent annual base pay ($1,750,000) financial performance
eligible to participate in the Short Term Incentive (STI) Plan and Long Term Incentive (LTI) Plan awards.
was provided with 50,000 BlueScope Steel Limited shares
Other Key Management-Executives
Annual base salary+ provision of performance-related STI+ LTI
MONASH
BUSINESS
SCHOOL
20
Institutional Factors:
External Auditing
Audits provide an independent (third party) opinion on the quality and integrity of the financial statements
Verification of the reported financial statements by an expert independent of the preparer – issue an opinion
Audit committees can enhance the auditing process – Independence of audit committee reflects corporate governance strength
However, still imperfect - Audited financial statements does not guarantee credible financial statement – Corporate collapses
MONASH
BUSINESS
SCHOOL
Institutional Factors:
International Financial Reporting Standards (IFRS)
Aim: increase comparability – over time and across firms
However, managers may lack flexibility
Legal Environment
Difference between quality of accounting standards and enforcement of those standards
Can also have significant impact on quality of accounting numbers.
MONASH
BUSINESS
SCHOOL
Flash Points: Institutional Situations where Manipulation is More Likely
The firm is in the process of raising capital or renegotiating bo
owing. Watch public offerings
Debt covenants are likely to be violated
A management change
An auditor change
Management rewards (like bonuses) are tied to earnings
Management is repricing executive stock options
A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all
Regulatory ratio requirements (like capital ratios for banks and insurance companies) are likely to be violated
Transactions are with related parties rather than at arm's length
Special events such as union negotiations and proxy fights
The firm is "in play" as a takeover target
The firm engages in exotic a
angements (structured off-balance-sheet vehicles)
MONASH
BUSINESS
SCHOOL
23
Flash Points: Financial Statement Indicators that Manipulation is More Likely
A change in accounting principles or estimates
An earnings surprise
A drop in profitability after a period of good profitability
Constant sales or falling sales
Earnings growing faster than sales
Very low earnings (that might be a loss without manipulation)
Small or zero increases in profit margins (that might be a decrease without manipulation)
A firm meets analysts’ earnings expectations, but just so.
Differences in expenses for tax reporting and financial reporting
Financial reports are used for other purposes, like tax reporting and union negotiations.
Accounting adjustments in the last quarter of the yea
MONASH
BUSINESS
SCHOOL
24
Delegation of Reporting to Management
Management is responsible for accounting policy choice:
Measurement, recognition and disclosure in financial statements
Some discretion exists, which management can use to:
evealing their superior (private) information about the firm; o
ehave opportunistically to distort the accounting numbers
Distortion of accounting may reflect incentives facing managers
MONASH
BUSINESS
SCHOOL
Distortion in Accounting Data
There are three potential sources of accounting data distortions
Random estimation e
ors
Manager s cannot perfectly predict future consequences
E.g. accrual accounting requires managers to estimate