Overview of Accounting Analysis

1
Overview of Accounting Analysis

• Evaluate the degree to which a companys
  accounting captures its underlying business
  reality
• Evaluate the appropriateness of accounting
  policies and estimates
• Assess the distortion, if any, in the numbers
• see where distortions are and whether they can
  undone
• Goal To improve the reliability of conclusions
  from financial analyses

Does accounting affect business strategy?
(positive accounting)
2
Analysis of the Income Statement (Chapters 6 7)

• Goal
• Assess earnings quality and persistence
• Exclude components of reported income (regardless
  their accounting labels) that reduce predictive
  ability
• Predict future income and cash flows
• Remember
• The income statement is just one part of an
  information set that should be examined to
  estimate future earnings

3
Income Statement Items and Format

• Continuing or recurring
• Revenues
• Expenses
• Operating income
• / Other income and loss
• Pretax earnings from continuing operations
• Income tax expense
• After-tax income from continuing operations

• Non-Recurring (net of tax)
• Discontinued operations
• Extraordinary items
• Cumulative effect of accounting changes
  (mandatory, voluntary)

4
Income Statement Items and Format (continued)

• Net income
• /-Other foreign currency translation
  gains/losses, unrealized changes in market value
  of AFS securities, etc.
• Comprehensive income
• Earnings per share (basic and diluted)

5
Earnings Management the Revenue Side

• Revenue Recognition
• Rule (1) earnings process is complete or
  virtually complete (2) recognized or recognizable
• Accrual basis is better than cash basis
• Tendency to overstate revenue
• Challenges
• Customers pay in advance
• Products or services provided over multiple
  periods
• Products or services sold, but seller retains the
  residual rights
• Credit-worthiness of customers
• Sales returns

6
Possible Time Points For Revenue Recognition

• At time of sale (normal)
• When goods are delivered or services are rendered
• Before time of sale
• Long-term construction percentage of completion,
  completed-contract
• More liberal
• After time of sale
• Installment sales, cost recovery, cash basis
• More conservative

7
How About Sports Clubs?

• Sell memberships for cash or in installment
  contracts
• One-time membership fee
• When should revenue from memberships recorded?
  When the membership agreements are signed?
• Are memberships refundable?
• How about the associated costs?
• marketing
• potential collection losses from installment
  collection of memberships
• facility improvements?

8
More About Sports Clubs

• The Operating Cash Flow amount and trend in
  Statement of Cash Flow becomes very important for
  the analysis
• Check the discrepancy between income and OCF
• If the discrepancy becomes larger and larger,
  there are definitely problems!

9
Earnings Management The Expense Side

• Matching principle and conservatism
• Tendency to understate expense or classify into
  non-returning category
• Challenges
• COGS use specific identification method
• RD capitalized rather than expensed
• Repairs and maintenance capitalized, deferred,
  accelerated
• Investments classify as available-for-sale
• Operating expense classify as other or special
  items
• Depreciation and amortization change useful
  lives
• Pension change assumptions
• Ignore cost items e.g. contingencies, impairments

10
Recurring Operating Income

• Needs to be subjectively determined
• Not always disclosed neatly
• Think about the types of revenue earned by
  Boston Chicken(4-20) and other franchise
  business
• One-time initial franchise fees when the store
  opens
• Royalties on gross revenues when the stores
  generate sales
• Service fees for advertising campaigns
• Interest income from franchise developers
• Are all revenue equally persistent?

11
Unusual or Infrequent Items

• What are they?
• special charge
• non-recurring items
• merger expenses
• restructuring costs
• and a whole lot more!
• How are they disclosed?
• usually a separate line item
• Tendency to selectively highlight items

• How are they described?
• read MDA, press releases
• Tendency to report favorable items lumped in
  operations and unfavorable items listed
  separately?
• I/S classification and quality of disclosure

12
Does Non-Recurring Mean To Ignore?

• Maybe. Maybe not. Probably not!
• What does the non-recurring item say about
• prior accounting estimates
• quality of prior management decisions
• the economic environment
• the quality of prior disclosures
• impacts on cash flows

13
Discontinued Operations

• Operating income and gains/losses from
  discontinued segments is shown separately, net of
  tax
• Discontinue of a segment whose activities
  represent a separate major line of business or
  class of customer
• Subjective
• Determine gains/losses
• Actual and expected
• Impacts on future I/S

14
Extraordinary Items

• Unusual AND Infrequent
• Subjective
• Gains and losses on early retirement of debt
• Discretionary in timing
• Varies by locations
• Litigation settlements are sometimes
  includeddepends on reason for lawsuit

15
Accounting Changes

• Analyst should distinguish between mandatory and
  voluntary changes
• Most mandated changes require
• footnote disclosures
• sometimes restatements are made in the F/S
• A lot have no cash flow implications

16
Prior Period Adjustments

• Usually relate to correction of accounting errors
• Disclosed in Statement of Changes in Retained
  Earnings
• Prior F/S resented together need to be
  retroactively adjusted

17
Other Issues

• Big Bath Theory
• Make it worse when it is bad already
• Income Smoothing
• Reduce earnings volatility

18
Analysis of Balance Sheet(Chapters 4 and 5)

• Asset Analysis
• Liability and Equity Analysis
• Impacts on I/S

19
Analysis of Assets

• What are assets?
• (1) Future economic benefits (2) Owned (3) Past
  transactions
• Challenges
• Ownership is uncertain
• Future economic benefits are difficult to measure
• Human capital
• Goodwill, brand names
• Changes in economic value
• Criticism Historical and conservative

20
Investment

• Equity securities and debt securities
• Classification
• Equity securities with controlling interest less
  than 20 to 25 and debt securities
• Trading securities
• Held-to-maturity
• Available-for-sale
• TS are short-term HTM and AFS depend
• Affect I/S due to
• sale
• changes in market value
• TS ? I/S
• HTM ? R/E

21
Disclosure of Unrealized Holding Gains/Losses

• Statement of SE
• Comprehensive Income
• E.g. Dell, page 32
• For 1999, Income would be 559 million higher if
  the unrealized holding gains were included

22
Accounts Receivable

• Amount expected to be collected from customers
• Affected by when revenue is recognized
• Quality of receivable check whether they are
  genuine, due, and enforceable
• Allowance for uncollectible accounts
• Estimate cash collected from customers
• Perfect information
• Net A/R OB Allowance OB sales Net A/R EB
  Allowance EB Write off
• Imperfect information
• Net A/R OB Sales Net A/R EB

23
Estimate Cash Collections from Customers

• 1999 Sales 221,932
• Bad debt expense 1,403
• Write off of A/R 1,459
• Estimated cash collection
• Most accurate 25,282 221,932 1,459
  28,074
• 217,681
• Approximation 24,049 221,932 26,897
  219,084
• Difference 1,403, the amount of bad debt
  expense

24
Inventory

• Inventory accounting choices first-in, first-out
  (FIFO), last-in, first-out (LIFO), average cost,
  specific identification
• LIFO versus FIFO
• When inventory prices are increasing and no
  severe inventory liquidation
• Which assumption result in
• higher inventory amount on B/S?
• higher net income on I/S?
• LIFO conformity rule in the U.S.

25
Accounting Reporting for Inventory

• Balance Sheet
• Inventory as a current asset
• Income Statement
• Cost of goods sold
• Loss due to decrease in inventory value
• Notes
• Inventory method
• Inventory composition finished goods,
  work-in-process, raw materials

26
More Inventory Disclosure by LIFO Firms

• Philip Morris
• Inventories Inventories are stated at the lower
  of cost or market.The last-in,first-out (LIFO )
  method is used to cost substantially all domestic
  inventories.The cost of other inventories is
  determined by the average cost or
  first-in,first-out methods.
• Note 4. Inventories
• The cost of approximately 47and 50of
  inventories in 1999 and 1998,respectively,was
  determined using the LIFO method. The stated
  LIFO values of inventories were approximately
  0.8 billion and 1.1 billion lower than the
  current cost of inventories at December 31,1999
  and 1998,respectively.

27
As-If FIFO Adjustment

• Additional information for 1999
• Ending inventory 9,028 million
• Cost of sales 29,561 million
• Net income 7,675 million
• Effective tax rate 40
• Adjustment
• As-If FIFO inventory LIFO inventory LIFO
  reserve 9,028 800 9,828 an 8.9 increase
• As-if FIFO COGS LIFO COGS Opening LIFO
  reserve Ending LIFO reserve 29,561 1,100
  800 29,861 300 more
• As-IF FIFO income LIFO income - (1-tax
  rate)x(Opening LIFO reserve Ending LIFO reserve
  ) 7,675 60 x 300 7,495 180 LESS (?)

28
Property, Plant and Equipment (PPE)

• Composition of PPE
• E.g. Dell, page 47
• Depreciation method and depreciable years
• Mostly straight-line for financial reporting
  purpose
• E.g.
• Buildings Cost is 1,000 Accumulated
  depreciation is 700 depreciated over 10 years
• Depreciated years Accumulated depreciation ?
  Cost x Depreciable years 700 ? 1,000 x 10 7
  years
• Implication Need to replace buildings in 3 years
• Impairment

29
Analysis of Liability

• What is a liability?
• (1) Future economic sacrifice (2) Owed (3) Past
  transactions
• Challenge
• Not sure about the obligation
• Amount and timing difficult to measure
• Changes in economic value
• Criticism Off-Balance Sheet financing

30
Analysis of LiabilityOff-Balance Sheet
Obligations

• What is Off-Balance Sheet financing?
• Why do companies engage in it?
• How can analysts recognize it?
• What should analysts do about it?

31
What is Off-B/S Financing?

• An arrangement whereby a company is able to avoid
  reporting obligations on its balance sheet
• The company may also avoid the recognition of
• related assets
• related expenses

32
Why Do Companies Engage in Off-B/S Financing?

• To make their B/S look better
• less liability, less expense, higher income
• Because everybody else is doing it
• Because it adds financial flexibility
• Avoid debt covenant violations
• Enhance ability to obtain new capital

33
Examples of Off-B/S Financing

• Unrecognized Pension Obligations
• Operating leases
• Sale of receivables with recourse

34
Why Should An Analyst Care?

• The more debt a company has, the riskier it is
• more fixed charges, lower income
• Affect cost of capital computation
• Affect the valuation analysis

35
Example Leases

• Why do companies lease? Why Lease Assets? Why
  not just Buy them?
• Avoid risks of ownership and obsolesce
• Lower down payment
• Tax reasons
• Lessor can use depreciation write off, but lessee
  cant
• Lessor is in a higher tax bracket than lessee
• Dont want to report assets on the books
• Higher return on assets
• Dont want liabilities on the books
• Bond covenants

36
Capital Lease versus Operating Lease

• Statement of FASB No. 13
• Basic rationale risks and benefits of ownership
  have been transferred from lessor to lessee
• Transfer of title at end of lease term
• Bargain purchase option at end of lease term
• Lease Term is 75 or more of estimated useful
  life of the leased asset
• Present value of lease payments is 90 or more of
  the fair market value of the leased asset

37
Comparison of Operating Lease and Capital Lease

• Operating Lease
• B/S No asset, no liability
• I/S Rent expense

• Capital Lease
• B/S Leased asset and Lease obligation
• I/S
• Depreciation expense
• Interest expense

Capital lease Higher liability Lower income in
earlier years of lease term
38
Restatement of Operating Leases to Capital Leases

• Why capitalize operating leases?
• To show true risks faced by the company
• To make different companies comparable
• To assess risk and fixed charges on a more
  consistent basis
• Procedure
• Determine the amount and timing of future lease
  payments
• Determine discount rate
• Calculate present value of future payments as
  estimate of off-B/S lease liability
• similar amount should be capitalized as an asset

39
ExampleDell

• B/S (p.29) no leased assets, no lease liability
• Note 10 (p. 43)Lease Commitments
• master lease facilities?
• Other noncancellable lease

• Minimum Lease Payments
• 2000 46
• 2001 34
• 2002 29
• 2003 183
• 2004 405
• Thereafter 26
• Total 723

40
Lease Adjustment Dell 1999

• Present Value
• 46?1.07 34?1.072 29?1.073 183?1.074 405
  ?1.075 524.7
• Adjustment
• Dr. PPE 524.7
• Cr. L-T debt 524.7
• future periods should depreciate assets and
  record interest

• When do lease payments end?
• compare average payment and thereafter figure
• Average 139.4
• Thereafter 26 can be ignored
• About 5 years
• payment stream 46. 34, 29, 183, 405
• Discount rate
• Note 3 (p.37)
• About 7

41
Lease AdjustmentDell 1999

• Effect on 1999 earnings
• Additional interest _at_7 36.73
• Additional depreciation, assume straight line
  over lease term 524.7 ? 5 104.9
• Take off rental 81
• Capitalizing lease decreases 2000 NIBT by 23.9
• Effect on 2000 debt
• original 507
• adjusted 1,031.7 a 103.5 increase

42
Example Pension Liability

• Pension plan
• Defined Contribution versus Defined Benefit
• Actual pension liability
• Projected Benefit Obligation (PBO) Plan
  Assets
• Reported pension liability
• Accrued Pension Cost
• Adjustments
• Actual - Reported

43
Off-B/S FinancingSummary

• Firms have incentives to keep obligations off
  their balance sheets
• A variety of ways exist to do so
• The FASB has plugged holes, but still possible
• Be prepared to restate the F/S to get the debt
  back on the books

44
Framework Four Steps of Analysis
Business Strategy Analysis
Accounting Analysis
Financial Analysis
Prospective Analysis
Business Analysis and Valuation Applications
45
Next Step Financial Analysis
Taxes Profitability
Leverage Interest
Efficiency