Chapter 3 Overview of Accounting Analysis 1 Preliminary Topics • Institutional Framework of Financial Reporting includes: (1) Income Statement, (2) Balance Sheet and (3) Cash Flow Statement. Balance Sheet analysis: Building Blocks of assets, liability, debt & equity. Equity=Assetsliability. Book value vs. market value of share. • Corporate financial report is prepared on accrual basis rather than cash basis. Accrual implies economic activities rather than true payment and receipts. • A Responsibility Delegated to the Management. Management holds the advantage of making the assumption and financial report depends on that assumption. This some times makes the reporting less practical. Accounting analysis is then more valuable. 2 Accounting views • Assets: Resources owned by the firm that are : – likely to produce future economic benefits – Measurable with a reasonable degree of certainty • Liabilities are economic obligations of a firm arising from benefits received in the past that are: – Required to be met with reasonable degree of certainty – At reasonably well-defined time in the future • Equity is the difference between a firm’s net assets and its liabilities. 3 Accounting views (Contd..) • Revenues are economic resources earned during a time period. It would be recognized when: – The firm has provided all, or substantially all, the goods and services to be delivered to the customer – The customer has paid cash or is expected to pay cash with reasonable degree of certainty • Expenses are economic resources used up in a time period. It is governed by matching and conservative principles. These are: – Costs directly associated with revenues recognized above – Costs associated with benefits consumed – Resources whose future benefits are uncertain • Profit is the difference between revenue and costs 4 Factors Influencing Accounting Quality • 1. 2. 3. There are 3 sources of accounting noise: Accounting Rules – Management discretion of accounting rule introduces noise. The more accounting restricts management discretion, the more accounting data loses information content. Accounting standards may not match nature of the firm’s transactions. (example: R&D expenses are recorded when incurred, the outcome or future value of research is ignored.) Forecast Errors – the dilemma of “reasonable certainty” in forecasting future consequences of current transactions. (Example: credit sales create accounts receivables and management makes an estimate of the proportion of receivables that will not be collected. This is extremely subjective) Managers’ Accounting Choices – incentives to exercise discretion for influencing behaviors of various stakeholders. Motivations are debt covenant (TIE, liquidity ratio), management compensation (bonus compensation & job security for excess profit), corporate control (like hostile takeover), tax consideration (hidden profit), regulatory consideration (SEC), capital market consideration (stockholders’ perception), trade union consideration, competitive considerations (hiding a segmented disclosure), etc. 5 Window Dressing Last year Current assets Current Window dressing year Before Payoff After Payoff $300 $600 $200 $150 Current liabilities 100 400 100 50 Working Capital $200 $200 $100 $100 3:1 1.5:1 2:1 3:1 Current Ratio Toward the close of a period, management will occasionally press collection of receivables, reduce inventory levels, sell out marketable securities, and delay normal purchases. Proceeds from these activities are then used to pay off current liabilities. The effects shows a better liquidity, called window dressing. 6 Steps in Accounting Analysis 1. 2. Identify Key Accounting Policies: Identify the key success and risk factors and see what accounting policies are used to reflect that. (Example: valuation of residuals in case of leasing firms, interest rate and credit risk management of banks, inventory management for retail industry, R&D for manufacturing firms, etc.) Assess Accounting Flexibility: Identify the management flexibility to report its key success and risk factors. Example of less flexibility: Marketing and brand building is key to success of consumer goods but the strength can not be reported. Similarly, R&D activity is important for a biotechnology firm but accounting does not give them the discretion to report to the nature of activity. Example of high flexibility: In most cases firms hold the freedom regarding choice of depreciation method (straight-line or accelerated), inventory accounting (FIFO or weighted average), credit risk management for banks. Similarly, software developers have the flexibility to decide at what points in their development cycle the outlays can be capitalized. 7 Steps in Accounting Analysis (Contd.) 3. Evaluate Accounting Strategy: i. Compare the accounting policies of the firm to the norms in the industry. ii. Evaluate the incentive of violation like bond covenants, accounting-based bonus target, the share of management in stock, role and state of trade union bargaining. iii. Evaluate and rationalize recent change in accounting policies. iv. Use the past as the guide to assess the dependability of reporting. 8 Steps in Accounting Analysis (Contd.) 4. Evaluate Quality of Disclosure i. Reflection of the firm’s strategy and its economic consequences in accounting disclosures. Some firms use annual report to clearly layout the firm’s industry conditions, its competitive position, and management's plan in future. ii. Footnotes for changes from industry or from past (particularly regarding revenue and expense recognition) iii. Disclosures of current performances like changes in sales price, quantity, cost of production etc. iv. Disclosure of key success factors like firm investing in product quality or customer services may report change in defect rates or customer satisfaction. v. For multiple business, disclosure of each segments on a consistent basis vi. Disclosure of reasons of poor performances. Relating that with the strategy of the firm vii. Firm’s investor relation program (publication of fact books etc.) 9 Steps in Accounting Analysis (Contd.) 5. i. ii. Identify the points of questionable accounting quality Unexplained changes when performances are poor Unexplained transaction that boost profit like sale of assets or debt for equity swap iii. Unusual increase in accounts receivable relative to sales iv. Unusual increase in inventories relative to sales v. An increasing gap between a firm’s reported income and its cash flow from operations vi. An increasing gap between a firm’s reported income and its tax income. Example, warranty expenses are recorded on accrual basis for financial reporting and cash basis for tax reporting. vii. Unexpected assets write-offs 6. Undo Accounting Distortions. Key areas are: i. Accrual accounting ii. Cash flow analysis (like capitalization of certain costs that should have been revenue) iii. Evaluation of footnotes in case of changes iv. Evaluation of bad debts v. Difference between tax reporting and accounting reporting of profit 10 Accounting Analysis Pitfalls • 1. Conservative accounting may not be always good as it may fail to capture the unique nature of the business. • 2. Unusual accounting is not always questionable, it may be necessary with regard to the nature of the business. • 3. Changes in accounting policies and accruals may be necessary as well. 11 Effects of different depreciation methods Assuming an investment Tk.500,000 and life of 10 years Year Annual depreciation Book Value (end of period) Accumulated depreciation Straight line Straight line Straight line Reducing balance method (20%) Reducing balance method Reducing balance method ½ 25,000 50,000 475,000 450,000 25,000 50,000 1 50,000 90,000 425,000 360,000 75,000 140,000 2 50,000 72,000 375,000 288,000 125,000 212,000 3 50,000 57,600 325,000 230,400 175,000 269,600 4 50,000 46,080 275,000 184,300 225,000 315,680 5 50,000 36,865 225,000 147,455 275,000 352,545 6 50,000 29,490 175,000 117,965 325,000 382,035 7 50,000 23,595 125,000 94,370 375,000 405,630 8 50,000 18,875 75,000 74,495 425,000 424,505 9 50,000 15,100 25,000 60,395 475,000 439,605 10 25,000 12,080 0 48,315 500,000 451,645 12 Effects of inventory valuation choice • • • • • • • • • • Determine net income under LIFO, FIFO, and average cost, and calculate the current ratio, debt-to-equity ratio, inventory turnover, gross margin ratio, and net margin ratio under each of these inventory costing methods. Assumptions: Sales price per unit $25 1,000 units sold Beginning inventory=100 units @$10 each=$1,000 Ending inventory=800 units Operating expenses=$5,000 Tax Rate=0% Assets excluding inventories=$75,000 Current assets excluding inventories=$50,000 Current liabilities=$25,000 Long term liabilities=$10,000 13 Procurement of inventory Purchases March Cost per unit (Note: Increasing prices) 300 $11 $3,300 June 600 $12 $7,200 October 300 $14 $4,200 December 500 $15 $7,500 Total Units 1,700 Value $22,200 14 Solution FIFO LIFO Average Cost $25,000 $25,000 $25,000 1,000 1,000 1,000 Add purchases 22,200 22,200 22,200 Less ending inventory* 11,700 9,100 10,312 COGS 11,500 14,100 12,888 Gross Profit 13,500 10,900 12,112 Operating expenses 5,000 5,000 5,000 Taxable/Net income $8,500 $5,900 $7,112 Sales 1,000 @ $25 COGS Beginning inventory (800 units ending inventory=100 beginning+1,700 purchased-1,000 closing) FIFO Inventory = (500 @ $15) + (300 @ $14)=$11,700 LIFO Inventory = (100 @ $10) + (300 @ $11) + (400 @ $ 12)=$9,100 Average cost inventory = $1,000 $22,200 * 800 $10,312 1700 100 Valueof goodsavailablefor sale (Unitsinendinginventory 15 ) Num berof unitsavailablefor sale Solution (Continued) FIFO LIFO Average Cost (Current Assets excluding inventories + Ending inventories) /Current liabilities= ($50,000+$11,700)/$25,000=2.47 2.36 2.41 Debt-to-equity ratio Long term Debt/(Total assets excluding inventory +ending inventory -current liabilities long term liabilities) =$10,000/($40,000 +ending inventory)=$10,00/$51,700= 19.3% 20.4% 19.9% Inventory turnover COGS/((Beginning inventory+ Ending inventory)/2) 2.79 2.28 Current Ratio =$11,500/(($1,000+$11,700)/2)=1.81 Gross margin as percentage of sales Gross profit/sales=$13,500/$25,000= 54% 43.6% 48.5% Net profit as a percentage of sales Net Income/sales=$8,500/$25,000=34% 23.6% 28.5% 16 Lessons from the problem In the problem, prices are rising and inventory levels have not decreased. Therefore, under these conditions following are true: 1. 2. 3. 4. 5. 6. 7. 8. 9. LIFO results in the highest cost of goods sold, FIFO the lowest cost of good sold. FIFO results in the highest inventory values and working capital, LIFO results in the lowest inventory values and working capital. LIFO results in highest inventory turnover, FIFO the lowest. Both gross and net profit margin is higher under FIFO. Retained earnings will be higher for FIFO then LIFO, keeping dividend payment constant (net income effect). LIFO, if used for tax purposes, would results in the lowest tax paid. Current ratio is higher under FIFO. Debt to equity ratio is higher under LIFO (retained earning effect) Average cost values always lie between FIFO and LIFO values. Note: If prices are declining, then all the above will be opposite. 17 Final Note: Inventory valued at lower of cost or market • Regardless of the inventory method used, any significant decrease in inventory value below cost should be recorded immediately. Therefore, inventory would be valued at market. Market is defined as the current replacement cost through production or purchase. When LIFO accounting is used, the LIFO reserve is reported. This is the difference between LIFO inventory value and FIFO inventory value. • Also Note BAS allows FIFO and weighted average method only for inventory valuation. 18