Professional Documents
Culture Documents
Non-GAAP items
Firms can and do report non-GAAP items
Tradeoff:
(+) More relevant numbers for the business community
EBITDA, revenue per subscriber, # of Amazon Prime customers,
etc.
Auditing
Verified by auditors
Independent third party (e.g. Big four)
30% of all leading 1000 US firms have used same
auditors for at least a quarter of a century!
Conflicts of interests?
Potential solution?
Current investors:
Monitor their
investment
BONDHOLDERS
BANKERS
Board of Directors
Bankers:
Monitor for
solvency risk
MANAGEMENT
(running the firm)
Regulators
(SEC, FDIC)
Tax (IRS)
Evaluate
managers
performance
SOCIETY
FINANCIAL MARKETS
1. Balance sheet
Liabilities
Assets
List of everything the
company owns (snapshot)
Stockholders Equity
1. Current Assets
Assets
I.
II.
III.
Cash
Accounts receivable (what customers owe you)
Inventory
2. Long-Term Assets
I.
Liabilities
1. Current Liabilities
2. Long-term Liabilities
I.
II.
Long-term debt
Capital lease obligations
Stockholders equity
Difference between what you own and what you owe:
Measure of net worth
B. Market value
Value of house asset = How much you can sell it for today
Two-Finger approach
I.
Rules
1.
2.
II.
1.
2.
2. Income statement
Accountants attempt to measure profitability:
Accrual accounting
Decomposition of expenses
1.
Operating expenses
2.
Capitalized expenses
3.
Accrual accounting: Costs need to be reflected (capitalized) over those multiple periods
Dollar outflows incurred at time of purchase but written off over time
Depreciation: Expense that corresponds to the use of a long-term assets
during the quarter/year under review
Example: Cost of buying buildings and machinery
Financing expenses
Operating income
Bottom line
EPS
Very useful: Gives the sources and uses of cash through the
following 3 activities:
1.
Operating Activity
2.
Investment Activity
A.
B.
I.
II.
3.
Capital expenditures
Acquisitions
CRUCIAL ITEMS: They correspond to necessary investments to generate
future cash flows
Financing Activity
Increase in borrowing
Stock issuances
Sources:
INDIRECT METHOD:
Adjustments to
eliminate effects of
accrual accounting
4.
5.
Reasoning: Non-cash operating expense, hence it lowered income but had no corresponding outflows
Add back
Reasoning: All sales were recognized in net income yet no cash was received for the portion
corresponding to the increase in accounts receivable
Deduct
Reasoning: Purchases from suppliers were recognized in net income as a cost, yet increases in accounts
payable correspond to increases in borrowings from suppliers hence correspond to purchases with no
corresponding cash outflows
Add back
Increase in inventory
Reasoning: Net income includes the cost of goods sold (COGS). Inventories are associated with goods
not sold hence are not reflected in net income computations. However, given that inventory is recorded
at cost, increases in inventory corresponds to a cash expense
Deduct
2. Retained earnings
Book equity:
Historical by nature: Equity investment in the firm
plus accumulated earnings/losses over time
Not useful for assessment of firm value!
Incentives to manipulate
Incentives are strong
Combination of two effects:
1.
2.
Large stock/options
compensation for management
Market rewarding firms that
meets or beats EPS forecast
Other manipulations:
Cash flows
Non-GAAP metrics
E.g. Revenue per user
Check the case of Groupon!
Profit-before-bad-stuff!
Earnings manipulations
A. EPS increasing manipulations:
Examples
b)
2.
a)
Extended depreciable life for some of its fixed assets (fiber) from 15 to
20 years
It inflated profits by about $4.9M in that quarter, relative to an
operating income of $5.4M
Public outcry
New regulation for publicly traded companies
Section 302:
CEO and CFO now required to unequivocally take ownership for their
financial statements
Less incentives to manipulate earnings going forward
FORWARD LOOKING
ACCOUNTANTS
BACKWARD LOOKING
2. Accountants:
Conservatism principle: