Business Analysis

& Valuation
Using Financial Statements

Lecture Notes
Professor David M. Chen
Graduate Institute of Finance

Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard

3rd edn, South-Western, Thomson, 2004
 Content
I. Framework
II. Tools
2. Strategy Analysis
3 & 4. Overview of & Implementing Accounting Analysis
5. Financial Analysis
6. Prospective Analysis: Forecasting
7 & 8. Prospective Analysis: Valuation Theory &
Concepts / Implementation
III. Applications
9. Equity Security Analysis
10. Credit Analysis and Stress Prediction
11. Merger & Acquisitions
12. Corporate Financing Policies
13. Communication & Corporate Governance
 5 Minutes to Accounting
Balance Sheet
Storage of fund: Sources of fund:
Current Owed or borrowed
Cash & equivalents Trade credits
Marketable securities Short-term borrowing
Receivables Long-term borrowing
Inventory Invested
Prepaid items Common stock
Long-term investments Paid-in capital
Land, plant & equipments Preferred stock
Others Earned
Intangibles Retained earnings
Goodwill Adjustments
Income Statement Statement of Cash Flows

Revenue Net income

- Cost of good sold + Non-cash expenses
Gross profit - Non-cash revenue
- S&A expenses + Net interest expenses
Operating profit Operating cash flow
+- Non-operating G/L +- Working capital
EBT +-  Long-term assets
- Income taxes +-  Debt financing &
Net income interest expenses
+-  Equity financing &
dividend payouts
 Cash
 Major Accounting Issues
Off-balance-sheet liabilities
Off-balance-sheet financing
Derivatives (financial guarantees)
Financing vs. sales
Purchases vs. leases
Concealed liabilities
Contingent liabilities
Environmental
Employee relationships
Pending lawsuits
Distorted earnings
Timing of revenue recognition
Period-closing sales
Timing of expense recognition
Taking a big bath
Dirty surplus
Asset recognition and measurement
Methods of measurement
Fair value vs. historical cost (impairment)
Depreciation and amortization
Intangible assets
Phantom assets
Fraud
 II. Framework
Questions Addressed
Security analysis
Actual vs. expected performance?
• Analyst own & consensus forecasts?
• Why different?
Valuation given assessment of current &
future performance?
Credit analysis
Credit risk involved in lending (trades)?
• Management of liquidity & solvency?
• Business risk & financial risk?
• Loan pricing?
Management consulting
Industry structure?
Strategies pursued by various players?
• Relative performance of different firms?
Corporate management
Fair market valuation?
• Investor communication program adequate?
Search for a potential takeover target
• Value could be added by M&A?
• M&A financing?
Auditing
Accounting policies & accrual estimates
consistent with the business & its recent
performance?
• Financial reports communicate current status &
significant risks of the business*?
Role of Financial Reporting
Channeling savings into business
investments
Socialist (communist) model
• Through central planning and government
agencies to pool national savings and to direct
investments in business enterprises (GOEs).
• Delegation of both the political power and the
economic power to central planners.
Capitalist model
• The Future of Capitalism*
• Capital markets: shareholder vs. capitalist
capitalism (McKinsey).
Recreate credible “inside information”
The functioning of capital markets
 Savings
Financial Information
Intermediaries Intermediaries
Business
Ideas

Information asymmetry & incentive

compatibility problems
• Cost and credibility of communication.
• Lemon markets: unable to differentiate, bad
proposals crowed out good proposals, and
investors lose confidence in the market.
Financial & information intermediaries
• FSs for laymen vs. for experts?
• The level of financial supervision.*
Ascendancy of Shareholder Value
 Major influencing factors
1. Emergence of an active market for
corporate control (LBOs) in the 1980s
 Many mature, established industries that
have been subject to hostile takeovers
generate high levels of free cash flow.
 Money is invested in businesses that the
company knows, but are not attractive, or in
businesses that the company is unlikely to
succeed in (diversification).
LBOs substitute equity with debt, forcing
much of the free cash flow back into the
capital markets in the form of interest and
principle payments.
This can also be accomplished voluntarily
through a leveraged recapitalization, where
a company takes on debt and uses the
proceeds to repurchase a large proportion of
its own equity.
The basic premise of the market for
corporate control is that managers have the
right to manage the corporation as long as its
market value cannot be significantly
enhanced by an alternative group of
managers with an alternative strategy.
2. Growing importance of equity-based
features in the pay package of most
senior executives.
 Perceived divergence between managers’
and shareholders’ interest.
• Anxiousness over 10 years of falling corporate
profitability and stagnant share prices.
• The increasing attention paid to stakeholder
arguments, which, in the eyes of shareholder
value proponents, had become an excuse for
inadequate performance.
• Agency theory called for redesigning
management’s incentives to be more closely
aligned with the interests of the shareholders.
 • By 1998, the estimated PV of stock options
represented 45% of the median pay package of
CEOs.
• A movement developed to require that
nonexecutive board members have an equity
stack in the companies they represented so that
they would be more inclined to pay attention to
shareholder returns, if only for self-interest.
• By the late 1990s, 48% of medium and large
companies had a stock grant or option package
for board members, in contrast to virtually none
in 1983.
The widening use of stock options has
greatly increased the importance of
shareholder returns in the measurement of
managerial performance.*
3. Increased penetration of equity holdings
as a percentage of household assets.
 Growing segments of the population are
becoming shareholders through mutual
funds and retirement programs.
 Among the most vocal proponents of
shareholder value are the managers of
major retirement systems.
 Privatization of large government
monopolies where governments became
active marketers of the share of these
companies.
 The old notions of labor vs. capital are
losing currency.
4. Growing recognition that many social
systems are heading for insolvency.
 Most of the public pension plans are set up as
pay-as-you-go systems: contributions of
workers today are used to pay the retirement
of current retirees, however, the number of
workers to support one retiree is decreasing.*
 Have to move to some form of funded
pension system where at least a part of the
premiums that workers pay are actually set
aside for their retirement.
 The challenge is how to make it through the
transition: no solution unless the savings in
the funded part (raising retirement premiums)
of the system generate attractive returns.
Shareholder Capitalism
The U.S. corporate focus on shareholder value
tends to limit investment in outdated strategies,
even encourage divestment, well before any
competing governance model would.
It is hard to claim that the capital markets are
shortsighted compared with other corporate
governors—the high number and value of
technology and internet companies going
public in recent years attests to this.
McKinsey Global Institute attributed the U.S.
advantage in GDP per capita to much higher
factor productivity, especially capital
productivity (financial returns).*
Virtuous cycle: the most productive and
innovative companies would create the
highest returns to shareholders and attract
better workers, who would be more
productive and increase returns further
(Adam Smith).
An economy’s ability to create jobs, or its
lack thereof, is the better measure of fairness.
A company that focuses on building
shareholder value is served well by being a
good corporate citizen: does not come at the
expense of other stakeholders.
Market economy: market value added is
positively related to labor productivity as
well as employment growth.
 Financial Accounting

Business Environment Business Strategy

Business Activities

Accounting Environment Accounting Strategy

Accounting System

Financial Statements
Summarize the economic consequences of business activities
From Business Environment to
Financial Statements
Business environment
Acquire physical and financial resources.
Create value for investors.
• Labor markets, product markets (suppliers,
customers, competitors), capital markets
(shareholders, creditors), regulations.
Business strategy
Earns a ROI in excess of the cost of capital
• Scope of business (degree and type
diversification), competitive positioning (cost
leadership or differentiation), key success factors
and risks.
Business activities
Implementing business strategy
• Investment, operating and financing activities*
Accounting system
A mechanism through which business
activities are selected (recognized),
measured, and aggregated (presentation and
disclosure) into FSs.
• Business activities are too numerous to be
reported individually, some are proprietary.*
Accounting environment
Institutional features of accounting systems.
• Capital market structure, contracting and
governance, accounting convention and
regulation, tax and financial accounting linkage,
third party auditing, legal system for accounting
disputes.
 Accounting strategy
Management discretion
• Choices of accounting policies, estimates,
reporting format, supplementary disclosure.
FSs
The influence of the accounting system on
the quality of FSs.
Accounting system features
Accrual accounting
Periodic performance reports
• Costs and benefits associated with economic
activities vs. actual payment and receipt of cash
• The effects of economic transactions are
recorded on the basis of expected not necessarily
actual cash receipts and payments.
Accounting standards and auditing
The expectations of future cash flow
consequences are subjective and rely on a
variety of assumptions.
• The accounting discretion granted to managers is
potentially valuable because it allows them to
reflect inside information, however, they have
incentives to use accounting discretion to distort
reported profits by making biased assumptions
(management performance assessments,
accounting based contracts).
• Accounting conventions are responses to
concerns about distortion, yet they attempt to
limit managers’ optimistic bias by imposing their
own pessimistic bias (conservatism,
measurability).
• Uniform accounting standards GAAP attempt to
reduce managers’ ability to record similar
economic transactions in dissimilar ways: SFAS
(FASB), IFRS (IASB).
• Increased uniformity comes at the expense of
reduced flexibility for managers to reflect
genuine business differences in FSs.
• If accounting standards are too rigid, they may
induce managers to expend economic resources
to restructure business transactions to achieve a
desired accounting results.*
• Third party auditing provide a verification of the
integrity of the reported FSs, ensures that
managers use accounting rules and convention
consistently over time, and their accounting
estimates are reasonable.
• May also reduce the quality of financial
reporting because it constraints the kind of
accounting rules and conventions that evolve
over time. Auditors are likely to argue against
accounting standards producing numbers that are
difficult to audit.
• The threat of lawsuits and resulting penalties
have the benefits of improving the accuracy of
disclosure.
 • However, it might also discourage managers and
auditors from supporting accounting proposals
requiring risky forecasts, such as forward-
looking disclosures.
Managers’ reporting strategy
Some flexibility
• Accounting alternatives and estimates
• Voluntary disclosures
• Proprietary information
• Manipulate investors’ perceptions
Opportunity and challenge in doing business
analysis
• Separate distortion and noise from information
• Gain valuable business insights
From FSs to business analysis
Get at managers’ inside information from
public FS data.
About current performance and future
prospects
• Successful intermediaries have at least as good
an understanding of the industry economies as
well as a reasonable good understanding of the
firm’s competitive strategy.
• Although outside analysts have an information
disadvantage, they are more objective.*
Business strategy analysis
Identify key profit drivers and business risks
• Assess the company’s profit potential at a
qualitative level.
 • Frame the subsequent accounting and financial
analysis, i.e., key accounting policies and
sustainable profits.
• Make sound assumptions in forecasting future
performance.
Accounting analysis
Evaluate the degree to which a firm’s
accounting captures the underlying business
reality.
• Undo any accounting distortions
• Improve the reliability of conclusion from
financial analysis (GIGO)*
Financial analysis
Evaluate the current and past performance
and assess its sustainability.
 • Analysis should be systematic and efficient.
• Explore business issues through ratio analysis
and cash flow analysis.
Prospective analysis
Forecasting a firm’s future
• FS forecasting and valuation
• Synthesis of the above analyses
• For decision contexts such as securities analysis,
credit evaluation, M&As, debt and dividend
policies, and corporate communication strategies.
EMH
Why FS analysis?
• Application outside the capital market context.
• Driving force of market efficiency.*
 Ch. 2 Strategy Analysis
 Starting point
 Strategic decisions
1. The choice of an industry or a set of
industries in which the firm operates.
2. The manner in which the firm intends to
compete (competitive position).*
3. The way in which the firm expects to
create and exploit synergies across the
range of businesses (corporate or group
strategy)**
 Roles
Probe the economics of a firm at a
qualitative level
• Subsequent accounting and financial analysis is
grounded in business reality.
Identify profit drivers and key risks.
• Assess the sustainability of current performance
• Make realistic forecasts of future performance
Industry analysis
The profitability of various industries
differs systematically and predictably
over time.
Industrial organization: influence of industry
structure on profitability.
 Industry Structure and Profitability
Degree of Actual and Potential Competition
Rivalry among Threat of Threat of
existing firms new entrants substitute products

Industry Profitability

Bargaining Power in Input and Output Markets

Bargaining power Bargaining power
of buyers of suppliers

Firm Profitability
 EBIT/BV of assets was 8.8% (average of U.S.
companies between 1981-97).
• Bakery products was 43% higher, silver ore
mining was 23% lower.*
Degree of actual and potential competition
One of the key determinants of price
• Perfect competition: price = marginal cost, no
abnormal profits
• Monopoly profits
Rivalry among existing firms
• Industry growth rate: in stagnant industries, the
only way existing firms can grow is by taking
share away from the other firms.
• Concentration and balance of competitors: the
number of firms in an industry and their relative
sizes determine the degree of concentration, which
in turn influences the extent to which firms can
coordinate their pricing and other moves.*
 • Degree of differentiation and switching costs
• Scale/learning economics (learning curve) and
the ratio of fixed to variable costs (degree of
operating leverage = CM/F)
• Excess capacity and exit barriers*
Threat of new entrants
• Economies of scale: might arise from large
investment in R&D, brand advertising, or
physical plant & equipment
• First mover advantage: set industry standards,
enter into exclusive arrangements with suppliers
of cheap new materials, acquire scarce
government licenses, achieve learning
economies, or impose significant switching costs.
• Access to channels of distribution (dealer
network, supermarket shelf) and relationships
 • Legal barriers: patents and copyrights, licensing
regulations
Threat of substitute products
• Perform the same function, not necessary of the
same form (replacement not reproduction).
• Technologies enable efficiency in (reduced)
usage.*
• Image offered by designer labels.
Bargaining power of buyers and suppliers
Price sensitivity
• Product differentiation and switching costs.
• Importance to cost structure.
• Importance to product quality or composition.
Relative bargaining power
• The extent to which firms will succeed in
forcing price down: the cost of each party of not
doing business with the other party
 • Number of buyers relative to number of
suppliers, volume of purchase, number of
alternative products, switching costs, threat of
forward or backward integration.*
Limitations of industry analysis
The assumption that industries have clear
boundaries.
Competitive strategy analysis
Cost leadership
Tight cost control
• Economies of scale and scope, economies of
learning, efficient production, simpler product
design, lower input costs, low distribution costs,
little R&D or brand advertising, and efficient
organizational processes.
Differentiation
 Provide a product or service that is distinct
in some important respect valued by the
customer.
• Identify one or more attributes of a product that
customers value: quality, appearance, variety,
reputation or brand image, bundled services,
delivery time, or turnkey solutions.
• Position itself to meet the chosen customer need
in a unique manner.
• Achieve differentiation at a cost that is lower
than the price the customer is willing to pay.
• Investments in R&D, engineering skills, and
marketing capabilities.
• The organizational structures and control
systems need to foster creativity and innovation.
Mutually exclusive
Firms that straddle the two are considered to
be “stuck in the middle”
 • Not able to attract price conscious customers and
unable to provide adequate differentiation to
attract premium price customers.
• Firms cannot completely ignore the dimension
on which they are not primarily competing:
distinctive and high quality yet inexpensive.*
Achieving and sustaining competitive
advantage
The capabilities needed to implement and
sustain the chosen strategy
• Acquire the core competencies (economic assets)
needed and structure value chain (the set of
activities performed to convert inputs into
outputs) in an appropriate way.**
• Difficult for competitors to imitate.
Questions asked
• Key success factors and risks associated with
chosen competitive strategy?
 • Having resources and capabilities to deal with?
• Making irreversible commitments to bridge the
capabilities gap?
• Structuring activities consistently?
• Creating barriers to imitate?
• Having flexibility to address potential changes in
the industry structure that might dissipate
competitive advantage?
Corporate strategy analysis (scope)*
Multibusiness organization
• The average number of segments operated by
the top 500 U.S. companies is 11 in 1992.
• An attempt to reduce the diversity and focus on
a relatively few core businesses: diversified
companies trade at a discount in the stock
market relative to a comparable portfolio of
focused companies, M&A of two unrelated
businesses often fail to create value, and value
can be created through spin-offs and asset sales.
 • Managers’ decisions to diversify and expand are
driven by a desire to maximize the size rather
than shareholder value, incentive misalignment
problems, and capital markets find it difficult to
monitor and value multibusiness organizations.*
• Evaluate the economic consequences of
managing all the different businesses under one
corporate umbrella.
Sources of value creation
• Relative transaction cost of performing a set of
activities inside the firm versus using the market
mechanism, in particular, when coordination
among independent firms is costly due to market
transaction costs.
• Transaction costs: production process involves
specialized assets such as human capital skills,
proprietary technology, other organizational
know-how that is not easily available in the
marketplace, and market imperfection such as
information and incentive problem.
 • Emerging economies often suffer from market
imperfection because of poorly developed
intermediation infrastructure.
• Internal advantages: lower communication costs
because confidentiality can be protected and
credibility can be assured through internal
mechanism, headquarters office can play a
critical role in reducing costs of enforcing
agreements, organizational subunits can share
nontradable or nondivisible assets.
• Top management may lack the specialized
information and skills necessary to maintain
businesses across several different industries.
Can be remedied by creating a decentralized
organization, hiring specialist managers and
providing with proper incentives, but will
potentially decrease goal congruence.
Questions asked
• Significant imperfections in the product, labor,
or financial markets?
 • Special resources such as brand names,
proprietary know-how, access to scarce
distribution channels, and special organizational
processes?
• Good fit between specialized resources and the
portfolio of businesses?
• Allocation of decision rights between the
headquarters office and business units?
• Internal measurement, information, and
incentive system to reduce agency costs?
Cases
Personal computer industry
Intense competition and low profitability
• The industry was fragmented with many firms
producing virtually identical products, though
top five vendors controlling close to 60% of the
market.
• Component cost accounted for more than 60%
of total hardware costs and volume purchases
reduced these costs, hence intense competition
for market share.
• Brand name and service became less important
as buyers became more informed about the
technology.
• Switching costs were relatively low.
• Access to distribution was not a significant
barrier (direct mail & internet-based sales).
Computer superstores were willing to carry
several brands.
• Very few barriers to entering the industry
(assembled in a dormitory room).
• Apple’s and workstations offered competition as
substitutes.
• Key hardware and software components were
controlled by firms with virtual monopoly (Intel,
Microsoft).
 • Corporate buyers were highly price sensitive (a
significant IT cost).
• Tremendous pressure on firms to introduce new
products rapidly, maintain high quality and
provide excellent customer support.
Dell’s low-cost competitive strategy
• Direct selling: saving on retail markups
• Made-to-order manufacturing: a system of
flexible manufacturing (5 days), save inventory
working capital and write-off costs.
• Third-party service: telephoned-based and third-
party maintenance service (Xerox).*
• Low accounts receivable: pay by credit card or
electronic payment.
• Focused investment in R&D: primarily in
creating low-cost, high velocity organization that
can respond quickly to changes.
Electronic commerce
Amazon.com, an online bookseller in 1995
and went public in 1997 with a market cap of
$561m and increasing to $36b by April 1999.
• Jeff Bezos moved the company into many other
areas, claimed that its brand, loyal customer base,
and ability to execute electronic commerce were
valuable assets that can be exploited in a number
of other online business areas: CDs, videos, gifts,
prescription drugs, pet suppliers, and groceries
(a “customer” company).
• Traditional retailers such as Barnes & Noble,
Wal-Mart, and CVs who are boosting their
online efforts also have valuable brand names,
execution capabilities, and customer loyalty.
• Expanding rapidly into so many different areas
is likely to confuse customers, dilute brand name,
and increase the chance of poor execution.*
 Ch. 3 Accounting Analysis
Overview
Purpose
Improve the reliability of conclusions from
financial analysis (GIGO)
Evaluate the degree to which a firm’s
accounting captures its underlying business
reality.
• Identifying places where there is accounting
flexibility
• Evaluating the appropriateness of the firm’s
accounting policies and estimates
 • Consistent with stated strategy
Undo any accounting distortions
• Adjusting a firm’s accounting numbers using
cash flow and footnote information
Institutional Framework
Accrual accounting
Recording of costs and benefits associated
with economic activities.
• The effects of economic transactions are
recorded on the basis of expected, not
necessarily actual, cash receipts and payments.
Revenue
• Economic resources earned during a time period
• Governed by the realization principle
 • The firm has provided all, or substantially all,
the goods or services to be delivered to the
customer
• The customer has paid cash or is expected to pay
cash with a reasonable degree of certainty
Expenses
• Economic resources used up in a time period
• Governed by the matching and conservatism
principles*
• Costs directly associated with revenues
recognized in the same period (COGS)
• Costs associated with benefits that are consumed
in this time period (period expenses)
• Or, resources whose future benefits are not
reasonably certain (R&D, advertising)
• Expenses vs. losses
Assets
• Economic resources owned by a firm
• Likely to produce future economic benefits
• And, measurable with a reasonable degree of
certainty*
• Costs: sacrifice foregone to acquire goods or
services, initially as assets then as expenses.
Liabilities
• Economic obligation of a firm arising from
benefits received in the past
• Required to be met with a reasonable degree of
certainty.*
• And, whose timing is reasonably well defined
Equity: net worth (limited liability)
Delegate reporting to management
Involves complex judgments
• Sales with customer financing*
• Potential defaults
• R&D assets or contingent liabilities
• Contractual commitments such as lease
arrangements or post-retirement plans
Costs and benefits
• Use their accounting discretion to reflect inside
information in reported FSs
• But have an incentive to distort reported profits
by making biased assumptions
• Manipulate accounting numbers in contracts
between the firm and outsiders
• GAAPs, external auditing, and legal system to
reduce the cost and preserve the benefit (only
institutional investors’ supervision is effective).
GAAPs
Historical cost convention to reduce value
manipulation
• Limits the information that is available to
investors about the potential of the assets
• Fair value and impairment
Uniform accounting Standards
• Create a uniform accounting language and
increase the credibility of FSs
• Regulate how particular types of transactions are
recorded to limit management’s ability to misuse
accounting judgment
• Rigid standards work best for economic
transactions whose accounting judgment is not
predicated on managers’ proprietary information.
At the expense of reduced flexibility to
reflect genuine business differences
• Likely to be disfunctional because they prevent
managers from using their superior business
knowledge.
• May induce managers to expend economic
resources to structure business transactions to
achieve a desired accounting result.*
SEC has the legal authority to set accounting
standards
• Typically relies on private sector accounting
bodies to undertake this task
• FASB’s SFAS since 1973
IASB’s IFRS after reform since 1998
External auditing
All listed companies are required
• GAASs set by AICPA
• Issue an opinion on published FSs
• Primary responsibility still rests with corporate
managers
Imperfect
• Cannot review all of a firm’s transactions
• Failure because of lapses in quality or lapses in
judgment by auditors who fail to challenge
management for fear of losing future business.
• Outside supervision replaces peer reviews
• Also under international harmonization because
of capital markets integration.
• Constrain the type of accounting rules and
conventions that evolve over time
 • Auditors are likely to argue against accounting
standards that produce numbers which are
difficult to audit, even if the proposed rules
produce relevant information for investors.
Legal system
Adjudicate disputes between managers,
auditors, and investors
• The threat of lawsuits and resulting penalties
have the beneficial effect of improving FSs.
• The potential for significant legal liability might
also discourage managers and auditors from
supporting accounting proposals requiring risky
forecasts.
Quality Factors
Noise and bias from accounting rules
Conservatism: not possible
• Timing of recognition due to double-entry
accounting.
• Managerial behavior may not necessarily be
consistent with conservatism.
Dissimilar economic events with similar
accounting rules, e.g., R&D
Forecast errors
The extent of errors depends on a variety of
factors
• The complex of the business transactions
 • The predictability of the firm’s environment
• Unforeseen economic-wide changes.
Managers’ accounting choices
Incentives to exercise discretion to achieve
certain objectives
• Accounting based debt covenants
• Management compensation
• Corporate control contests: in hostile takeovers
and proxy fights, accounting numbers are used
extensively in debating managers’ performance.
• Tax considerations
• Regulatory considerations: to influence
regulatory outcomes such as antitrust actions,
import tariffs, and tax policies.
• Capital market considerations (IPOs, ECBs, may
simply due to market timing)
 • Stakeholder considerations: labor unions,
suppliers, and customers (stockholders,
community)
• Competitive considerations: segment disclosure,
new entrants.
Level of disclosures
• Managers can choose disclosure policies that
make it more or less costly for external users to
understand the true economic picture.
• Voluntary disclosures: Letter to the shareholders,
MD&A, footnotes (part of FSs)
 Steps in accounting analysis
1. Identify key accounting policies
 Industry characteristics and competitive
strategy
• Key success factors and risks
• Identify and evaluate the accounting policies
and estimates the firm uses to measure them
• Evaluate how well they are managed
 Examples
• Banking: interest and credit risk management
(loan loss reserves)
• Retail: inventory management
• Manufacturer: product quality and innovation,
R&D, product defects after the sale (warranty
expenses and reserves)
 • Leasing: accurate forecasts of residual values
2. Assess accounting flexibility
 Little flexibility
• Accounting data are likely to be less
informative
• R&D of biotechnology companies
• Marketing outlays of consumer goods firms
 Considerable flexibility
• Potential to be informative depending on how
managers exercise it
• Expected defaults of bank loans
• The point in the development cycles to
capitalize outlay by software developers
 Common flexibility
• Accounting alternatives allowed
3. Evaluate accounting strategy
 Strategy questions asked
• Compare to the norms of the industry
• Dissimilarity because of unique competitive
strategies? (e.g., high quality low warranty
allowance or understating)
 Strong incentives to use accounting
discretion to manage earnings?
 Policies and estimates changed
• Justification & impact
 Realistic in the past
• Seasonality in interim earnings or manipulation
• Large period-ending adjustments
• A history of write-offs
  Structure any significant business
transactions to achieve certain accounting
objectives?
• Hiding losses in SPEs or joint ventures
4. Evaluate the quality of disclosure
 Questions asked
• Adequate disclosures to assess the firm’s
business strategy and its economic
consequences (letter to the shareholders)?
• Footnotes adequately explain the key
accounting policies and assumptions and their
logic?
• Adequately explain current performance
(MD&A)?
 • If accounting rules and conventions restrict the
firm from measuring them appropriately?
Adequate additional disclosure to help
understand how key success factors are
managed, e.g., disclose physical indexes of
defect rates and consumer satisfaction. KPIs
• Quality of segment disclosure
• Forthcoming with respect to bad news: reasons
and coping strategy.
• Investor relations program
5. Identify potential red flags
 Examine more closely or gather more
information
• Unexplained changes in accounting, especially
when performance is poor.
• Unexplained transactions that boost profits.
• Unusual increases in accounts receivables in
relation to sales increases: relaxing credit policy
or artificially loading up distribution channels
• Unusual increases in inventory in relation to
sales increases (FG: demand slowing down, WIP:
expect an increase in sales, RM: manufacturing
or procurement inefficiencies).*
• Increasing gap between reported income and
cash flow from operating activities. If not a
steady relationship, might indicate subtle
changes in the firm’s accrual estimates.*
• Increasing gap between reported income and tax
income: might indicate subtle changes in
accounting standards or tax rules.
• Large fourth-quarter adjustments: may indicate
aggressive management of interim reporting.
 • Tendency to use financial mechanisms such as
R&D partnerships, SPEs, and the sale of
receivables with recourse: opportunity to
understate liabilities and/or overstate assets.
• Unexpected large write-offs: slow to
incorporate changing business circumstances
into accounting estimates.
• Qualified audit opinions or changes in
independent auditors not well-justified:
tendency to opinion shop.
• Related-party transactions: lack the objectivity
of the marketplace and likely to be more
subjective and self-serving.
6. Undo accounting distortion
 Some progress can be made by using the
cash flow statement and footnotes.
Pitfalls
Common misconceptions
Conservatism is not “good” accounting
• Evaluate how well accounting captures business
reality in an unbiased manner.
• Merck’s research ability and sales force.
• Look to alternative sources of information.
• Provide opportunities for income smoothing.
• Prevent analysts from recognizing poor
performance in a timely fashion.
Not all unusual accounting is questionable
• Justified if the business is unusual.
• Accounting changes might reflect changed
business circumstances.
Value of accounting data and analysis
Accounting data
Perfect earnings foresight one year prior to
announcement
• Buy up sell down, 37.5% 1954-1996
• Equivalent to 44% of the return given perfect
foresight of the stock price (85.2%)
• Perfect foresight of ROE, 43%
• Perfect foresight of cash flow, 9%
• Earnings management not so pervasive as to
make earnings data unreliable.
Accounting analysis
Opportunities for superior analysts to earn
positive profit.
• Companies criticized in the financial press for
misleading financial reporting suffered an
average stock price drop of 8%.
• Firms appeared to inflate reported earnings prior
to an equity issue and subsequently reported
poor performance had more negative stock
performance after the offer than firms with no
apparent inflating.
• Firms subject to SEC investigation for earnings
management showed an average stock price
decline of 9% when first announced and
continued to have poor stock price performance
for up to two years.
Ch. 4 Implementing Accounting
Analysis
Undo any accounting distortions
Recasting FSs using standard reporting
nomenclature and formats
Performance metrics based on comparable
definitions across companies and over time
• Focus on those accounting estimates and
methods used to measure key success factors
and risk.
• Assess whether variations reflect legitimate
business differences or differential managerial
judgment or bias.