FSA- WHITE

Business analytics and FSA

• Business analysis is useful for handling issues as
• --Whether to build capacities or acquire?- the classical
make/ Buy decision The issue is whether U would
primarily rely upon and use your internal resources or U
would look for external replacement to strengthen your
leadership asset-Is a valuable brand available for a
small additional sum?
• -- Whether upon acquisition, to Amalgamate or run it as
a stand alone? –the hassles of absence of Synergies,
issues of Integration, tax issues, Regulatory compliance
issues issues of monopoly etc MOST OF ALL
RELEASING CASH TRAPPED IN THE ACQUIRED
UNIT—Aditya Birla groups acquisition of Novell
 continued
• Whether to Sell or Hold? Shut down
point( protracted Negative contribution,
Revenues being lower than Long run
average costs for a period)
• --The Best Fund mix-in Cost and risk
parameters, tenure parameter, domestic and
International parameters( IPO/Follow on/Public
issue/ADR GDR/IDR)
• --Inputs for such Strategic Issues as
Outsourcing, Changing fund mix etc
 continued
• The BACKGROUND-Industry and Strategy Analysis involving
the business Environ-B/A
• The Specifics—FSA reflected by—
• 1) Accounting analysis
• 2)Financial Analysis comprising of--
• a) Analysis of Operating activities
• b) Analysis of Financing activities
• c) analysis of Investing Activities
• 3)Profitability analysis
• 4) Prospective analysis
• 5) Liquidity and Working Capital Analysis
• 6)Capital Structure analysis
• 7)Valuation of Business
 The steps in FSA
• Steps in Accounting Analysis
• 1) Identifying KEY accounting policies
• Ex. For a bank it is Provision for bad and doubtful debts– For an
insurance company it is accounting for warranties and
contingencies
• 2)assess Accounting flexibility
• Firms have little flexibility in accounting for In-House R&D costs;
they have to be expensed. Software firms have the flexibility to
decide the point at which the expenses can start getting
CAPITALIZED
• Rigid policies give little information though the scope for earnings
management is less
• 3) Evaluate Accntng. Strategy
• How do the firms Accntng. Policies compare with those followed
in the INDUSTRY?
 Steps--
• For ex. A Bank could be providing less towards Bad and
Doubtful debts. This could be because of Good loan
Disbursement/ collection policies; or, is that a ‘dressing’?
• Do these firms have reasons to adopt the policies they have
done?
• Enron created Special purpose Vehicles to take certain
transactions ‘off the B/s”—rest is History
• 4) Evaluate the Quality of Disclosures
• Letters to shareholders is a good disclosure tool that GA
Cements has adopted. Dr. Reddy Labs. Did the same in the
initial years
 Steps--
• How forth coming is the Management on Bad news?
• Do the foot notes / notes to a/cs display policies expected?
• How good is the SEGMENT WISE DISCLOSURE? Can one
see the different colors OR is it GREY?
• Step 5) Identify the RED ALERTS
• --unexplained changes in Accounting WHEN THE
PERFORMANCE WAS POOR
• --Disparity between GROWTH IN SALES and GROWTH IN
A/cs Receivables IIIly disparities between Sales AND
INVENTORY HOLDING
• --Huge disparities between a firm’s CASH FLOWS
FROMOPERATIONS and Comprehensive income
• ---Huge Tax Deferrals arising out of Differences Between
Book and Tax Profits
 steps
• Step 6) Undo Accounting Distortions
• Imprudent capitalization should be
reversed, for example.
• The Analyst will have to make several
adjustments to arrive a proper Picture
 1
• Need for FSA
• -- In an ideal world FSA should be concentrating
ONLY on the bottom lines of Financial reporting—Net
incomes and Shareholders equity. Different methods
of accounting adopted, differing estimates and non
conformity in application of Accounting principles
make the course complicated.
• Financial reports often contain supplementary data
that help the user of the statements to derive meaning
and make relevant interpretations of numbers—ratios,
cash flows etc. the effort here is to strike at the
fundamentals that help differentiate the grain from the
---
 1a
• Economic events and accounting entries do not correspond by
TIME in most cases and by Quantum in some Accounting does
not take cognizance of capital appreciation in assets till they are
sold. Similarly losses on assets get accounted only on their sale
though that loss of value could be very visible much before.
• Contracts by and large are not accounted at the time they
are entered into but are accounted when Legal rights of
Ownership change! Some contracts like hedging are NOT
accounted but DISCLOSED as FOOT NOTES or as Notes to
accounts, though they could later have significant implications
on the financial health of the Enterprise
• Finally information from outside financial reports could help
drive meaningful conclusions that might not be otherwise
possible
 2
• External users of Financial statements
• The common characteristic of External users is their general
lack of authority to PRESCRIBE the info they want from the
company
• External users are a diverse type but generally can be
classified in to 3 groups—
• 1) Credit and Equity investors
• 2) Government , regulatory bodies and tax authorities
• 3) The general public and special interest groups, labor
unions and Consumer groups
• These groups have different objectives in FSA BUT THE
EQUITY INVESTORS and CREDITORS are the PRIMARY
USERS
 3
• The info supplied to Equity investors and creditors is useful to
others as well; hence Accounting Standards are EQUITY
investors and Creditors Oriented
• The UNDERLYING OBJECTIVE of FSA is the COMPARATIVE
measurement of RISK AND RETURNS so as to make
Investment and or Credit decisions. Predictions of the future
results is by Historical extrapolations generally though special
models are covered here
• Equity investors look at Profitability and Growth whereas
Creditors especially the short term ones look at LIQUIDITY
Long term investors like insurance cos are interested in long
term asset growth and profitability
 4-The Financial Reporting System
• The accounting process that generates accounting information
for External users are 5 principally—
• 1) Balance sheet
• 2) Income statement
• 3) Statement of Comprehensive income
• 4) Statement of Cash Flows
• 5) Statement of Stock Holders equity
• These 5 statements along with Notes to Accounts are
interpreted to provide relevant, timely and reliable information to
make investment, credit and similar decisions. Many
transactions are reflected in more than one Statement so that it
requires a foray in to all statements before comprehensive
conclusions can be drawn
 5
• The Financial reporting System is based on data generated
from ACCOUNTING and Economic events. Financial
Statements recognize events and transactions meeting certain
criteria---Primarily Exchange transactions, passage of
time(accrual of interest), the use of services, (insurance), use
of assets ( depreciation), use of estimates ( Bad debts) and
impact of some contracts ( Financial leases)
• Accrual accounting rests on matching principle which says
Revenues are to be matched by corresponding costs and as
such have to be accounted even though cash did not change
hands.
• Transactions are measured on HISTORICAL BASIS, with
events resulting in a hike in value generally ignored
 6
• Financial statements are prepared measuring transactions at
their Historical Costs. These costs are OBJECTIVE and
VERIFIABLE. Its UTILITY however DECLINES as 1) The
Specific prices 2) General Prices, changes Hence additional
disclosures are made mandatory by Regulating authorities all
over the world
• Financial Reporting also relies on GOING CONCERN
CONCEPT; that the firm in question would continue its
operations indefinitely. This concept brings as to the difference
between Capital and Revenue– all costs and Incomes would
have to be Revenue if this concept were not in place
 6a Reporting Environ
• I) the Reporting environment
• A) The statutory reports– Income statements
and B/S
• B) Other reports
• 1) Financial statements-Quarterly
• 2) Earnings announcement
• 3) Other statutory reports
 6b
• Financial statements-these are statutory reports a
company must file with the SEC; are not publicity
oriented (unlike some annual reports) and contain
info. beyond what annual reports reflect---Form10-
k
• Form-10q—are quarterly statements filed with
the SEC. these provide LATEST info.
• While analyzing these data we need to take
cognizance of a) seasonality factors b) Year end
adjustments-which do not appear quarterly
 6c
• Year end adjustments are done in the following
areas generally
• 1) inventory-difference between actual stock
and book stocks
• 2) tax provision
• 3) Outstanding expenses—salaries etc
• 4) provision for depreciation
• 5) Provisions for work remaining to be executed on
capital a/cs not provided for– basically contingent
liability turning into provision
 6e
• 2) Earnings announcements
• Key announcements about cos. performance quarterly
and yearly
• Cos. PRO FORMA Earnings statement give a clear
a/c of the Operational profits i.e profits from
continuing operations divested from non operational
earnings and extraordinary income/ expenses
• Pro forma earnings while reflecting operational profits
might exclude from Profits certain non operating
incomes/expenses which could provide ‘value to an
analyst’
 6f
• 3) Other statutory reports
• Form10k- filed with annual report
• Form 10 Q filed with Quarterly report
• Form 20 f Filed by Foreign Issuers
• Form 8k current report to be filed <15 days of
1) Change in Management Control
• 2) acquisition/ disposition of major assets
• 3)bankruptcy/receivership
• 4) change of auditors
• 5) Directors resignation
• Prospectus– filed along with a security issue
 7
• Financial reporting Systems
• The SEBI
• Has come out with disclosure norms for acquisitions, norms for
publishing information etc. The Annual report has the following
disclosure requirements---
• Contents
• --Business of the company
• The properties and Assets it owns
• --Management discussions and analysis
• --Auditors report including Qualifications if any
• --Financial statements and Notes to Accounts
• --Investee Financial statements ( Where applicable)
• --Parent company statements and results to the extent required
 8
• Schedules
• --condensed Financial information including details of Assets
Liabilities, Income and Expenses that are major
• -- major expansion/ diversification plans including on going
acquisition talks—broad details
• --Auditors statements including expression of Opinion on
Accounts
• --segment reporting
• --Corporate governance standards adopted and Issues if any
• ------
• Quarterly report
• A birds eye view of Working results for the Quarter
• The perception of the Management for the Quarters ensuing
• IAS– Indian Accounting Standards
• Fixes Standards for Accounting of Companies and other Public
9
bodies. Before issuing a new Statement of Accounting
Standards, the Body holds elaborate discussions with Industry
representatives, Academicians, legal luminaries and all
important stake holders including the government. The ICA is
the Principal decision maker so far as the contents are
concerned. Views of the Ministry of Company Affairs also are
taken in to account before issuing these standards
• Qualitative character of Accounting
Information
• Analysts concern with Qualitative accounting Standards arises
from the need for Information that facilitates comparison of
firms using ALTERNATIVE REPORTING METHODS and is
useful for decision making. The characters are – RELEVANCE
and RELIABILITY, Timeliness, Neutrality, Consistency,
Comparability and Materiality
 10
• Relevance ‘ the capacity of information to make a difference to
a decision’ To a Technical analyst all financial data are
‘irrelevant’ To a Fundamental analyst, the RELEVANCE of
Information VARIES WITH the method of Analysis– Of Cash
flow’/ Balance sheet/ or Income statement
• Timeliness is an important aspect of relevance. Information
LOSES VALUE RAPIDLY . As time passes FUTURE becomes
the PRESENT with the PAST becoming increasingly
IRRELEVANT However past data helps Projections
• Reliability encompasses verifiability, representational
faithfulness, and neutrality
• Unfortunately Relevance and Reliability are OPPOSING
ATTRIBUTES. Auditing improves RELIABILITY but the
TIMELINESS which is a RELEVANCE attribute gets hit;
thus Quarterly results are NOT audited!!
 11
• Relevance and Reliability also CLASH ELSEWHERE. Market
prices may be very relevant but less reliable. Historical costs
though HIGHLY RELIABLE become LESS RELEVANT!! IT is
the OLD ARGUMENT as to whether to be ‘PRECISELY
WRONG or be APPROXIMATELY RIGHT’ ANALYSTS have
opted for ESTIMATES in SEGMENT REPORTING, off balance
sheet financing etc. whereas AUDITORS harp on RELIABILITY
and have opposed estimates in Financial Statements
• Consistency and Comparability are again equally strong
attributes of Financial Statements . CONSISTENCY in
adopting and continuing to use them is an ATTRIBUTE of good
Financial statements
• Comparability becomes an Issue when accounting policies are
changed just as much as when NEW transactions– like
SECURITIZATION—come in to the picture between 2 firms
 12
• Comparability becomes a PERVASIVE ISSUE as choice of
certain policies as also estimates in certain parameters make
comparability a flouted attribute. REAL DIFFERENCES – let
alone Accounting policies—make comparability a ‘tricky issue’
Ex Some Firms have INTERNATIONAL OPERATIONS while
others are ‘ Domestic’
• MATERIALITY is arguably a CRUCIAL ASPECT’ An
INFORMATION is MATERIAL when it makes a DIFFERENCE
to the VALUATION of the firm. Sometimes even SMALL
CHANGES can have a MATERIAL EFFECT on VALUATION
Ex Sales FORCED upon Customers to achieve the
PROJECTED TARGET . Realizing Capital Gains to achieve
Profit targets
• The SEC has announced that Auditors should recognize
QUALITATIVE CHANGES AS WELL. Examples
 13
• 1. Obscuring changes in EARNINGS TRENDS
• 2 HIDING the FAILURE to achieve PROJECTED ANALYST
FORECASTS
• 3 Converting a LOSS to INCOME and Vice versa
• 4 Obscuring CHANGES in SIGNIFICANT BUSINESS
SEGMENTS
• 5 Increasing Managerial Remuneration
• 6 Things AFFECTING COMPLIANCE with REGULATORY
REQUIREMENTS, LOAN COVENANTS or other contracts
• 8 Concealing UNLAWFUL A/CS
 14- PRINCIPAL FIN STATMENTS
• BALANCE SHEETS
• The B/s – Statement of Financial position—reports major
classes of ASSETS( Resources OWNED AND CONTROLLED
by the FIRM) LIABILITIES ( EXTERNAL CLAIMS on these
Assets) and Stock holders Equity ( Owners Capital
contributions and other INTERNALLY GENERATED FUNDS)
and their INTERRELATIONSHIPS at specific points in time
• Capital= A– L
• Assets are defined as probable future economic benefits
obtained or controlled by a particular entity as a result of
past transactions or events.
• The weakness in the definition is the lack of reference to RISK
There are transactions where Assets are transferred but the
risks of ownership still lie to some extent with the Seller--
Financial lease
 15
• Liabilities are defined as ‘ probable FUTURE SACRIFICES of
Economic benefits arising from PRESENT OBLIGATIONS of a
particular entity to transfer assets or provide services to other
entities in the future as a result of PAST TRANSACTIONS or
events’
• EQUITY is ‘the residual interest in the net assets of an
entity that remains AFTER DEDUCTING its LIABILITIES
• In reality some Instruments have characteristics of BOTH
equity and debt making Categorization a ‘ difficult job’—
Convertible Debentures and Preferred Stock
• THE INCOME STATEMENT
• Reports on the results of OPERATIONS and non operating
activities. It explains SOME IF NOT ALL of the changes in
Assets , Liabilities and Equities between two consecutive
Balance sheet dates
 16
• The use of ACCRUAL CONCEPT brings about an
interrelationship between Income Statement and
balance sheet
• The preparation of the INCOME STATEMENT is governed by the MATCHING
PRINCIPLE , which states that performance can be measured ONLY IF
revenues and related costs are accounted for during the same time period
• Elements of the Income statements
• Revenues are defined as
• Inflows…of an entity…from delivering or producing goods, rendering
services or carrying out other activities that constitute the entity’s
ongoing major or central operations
• Expenses are defined as
• Outflows… from delivering or producing goods, rendering services, or
carrying out other activities that constitute the entity’s major or central
operations
 17
• The definitions of Revenues and Expenses SPECIFICALLY
EXCLUDE increases( decreases) in EQUITY from peripheral
or incidental transactions Thus GAINS( and LOSSES) are
NON OPERATING EVENTS. Examples would include GAINS
AND LOSSES from Sales of Assets, Law suits and changes in
Values ( including Currency values)
• While stating so may be easy, the problem centrally would
focus on GREY ISSUES like—Recurring vs Non recurring,
Operational and Non Operational costs/ revenues, and ‘
extraordinary items’
• From the Analyst’s point of view DISCLOSURE rather than
classification is important while from the Data base USER’s
end, the classification is EQUALLY IMPORTANT
 18
• STATEMENT OF COMPREHENSIVE INCOME
• COMPREHENSIVE INCOME is defined as
• The CHANGE in EQUITY of a Business enterprise during a
period from transactions and other events and
circumstances from non owner sources It includes all
changes to EQUITY during a period EXCEPT those resulting
from INVESTMENTS by OWNERS and DISTRIBUTION to
OWNERS
• Comprehensive income INCLUDES BOTH NET INCOME and
DIRECT EQUITY ADJUSTMENTS such as---
• --Cumulative TRANSLATION ADJUSTMENTS
• ---Minimum Pension Liabilities
• --Unrealized gains and losses on available for sale securities
• --Deferred gains and losses on cash flow hedges
 19
• These adjustments are COLLECTIVELY called OTHER
COMPREHENSIVE INCOME. SFAS130 requires that firms with
items of other comprehensive income report---;
• --The CLOSING BALANCES of EACH ITEM. The total is
reported as a SEPARATE COMPONENT of EQUITY called
accumulated OTHER COMPREHENSIVE INCOME
• -- the CHANGE ( either Pretax or post tax) in EACH item; the
change can be reported GROSS Or NET
• ---Reclassification adjustments to avoid DOUBLE COUNTING;
for example realized investment gains that include un-
realized gains of EARLIER YEARS must be knocked off
from COMPREHENSIVE INCOME to avoid double counting
• --Total Comprehensive in condensed financial statements
to be provided for interim periods
 20
• Equity means property rights and refers to stockholders’ or owners’ equity.This owners’ equity
represents the claims of owners to the assets of the business, as shown in the accounting
equation:
• Assets = Liabilities + Equity
• When the company reports net income on its income statement,
that income amount is added to the stockholders’ equity or
property rights. Therefore, the components of net income
affect equity. Those components of net income are limited
to revenues, expenses, gains, and losses. All of those
components of net income are included in comprehensive
income. But there are changes in stockholders’ equity that
are comprehensive income but not net income. Some
changes in assets and liabilities go right to the
stockholders’ equity section of the balance sheet without
first affecting net income and being included in the income
statement. Unrealized gains and losses that are included in
comprehensive income but are not recognized or reported
on the income statement are related to foreign currency
translation adjustments, available-for-sale investments, and
derivative financial instruments.
 21
• Requirement---- The FASB requires companies to report
comprehensive income, either in a separate financial statement
(as Dow Chemical Company does, shown in Exhibit 2.3) or as
part of the stockholders’ equity statement.
• The definition of comprehensive income given earlier relates it to
the change in equity during a period, but it is also described as
the change in wealth during a period. Wealth can increase not
only from business operations but also from changes in
market values that are not related to operations. The goal of
the requirement to report comprehensive income is to have
a net income with results of business operations
and a separate comprehensive income with
results of the market’s impact on the values
of assets and liabilities. Three examples of items
affecting comprehensive income are (1) foreign currency
translation adjustments, (2) unrealized
• gains and losses on available-for-sale securities, and (3)
deferred gains and losses on derivative financial instruments.
 22
• Foreign Currency Translation Adjustments
• When changes in the value of foreign currency
cause the assets of a company to increase in
value, the result will be an increase in the
stockholders’ equity (picture the accounting
equation increasing on the left side as well as
on the right side). Because the change in value
of the foreign currency is not related to the
company’s operations, the increase in
stockholders’ equity cannot be reported as net
income. However, the increase in stockholders’
equity is reported as comprehensive income.
 23
• Unrealized Gains and Losses on Available-for- Sale Securities
• Companies that own investments in marketable securities
(bonds and stocks) will see the market values of their
investments increase and/or decrease over time. If that
investment is classified as “available for sale” (meaning that the
company does not intend to sell but could if necessary, as
contrasted with “trading” investments not intended to be held a
long time), then the investment must be included in the balance
sheet at its market value. If that market value is greater than the
cost of the investment, there is an unrealized holding gain. But
the gain in value is not related to the company’s operations and
the company is in the same situation as for the foreign currency
change discussed above: an increase in asset value that must
be balanced with an increase in stockholders’ equity that
cannot be reported as net income. Therefore, it is
comprehensive income.
 24
Deferred Gains and Losses on Derivative
Financial Instruments
Companies may invest in derivative financial
instruments to hedge their exposure to the risk of
changing prices or rates. Such changes will
cause the value of the derivative to change, and
again, lead to unrealized gains or losses. If the
derivative instrument meets certain criteria, the
unrealized gain or loss will be reported in
comprehensive income rather than in net income.
 25
• Continued next slide
26—continued-Comprehensive Income
27
 28
• Statement of cash Flows
• This Statement reports cash receipts and payments in the
period of their occurrence classified as Operating, Investing and
Financing Activities. It provides supplementary disclosures
about non cash Investing and Financing activities. Cash flow
data helps explain changes in consecutive balance sheets and
supplement information provided by Income statement
• SAFS 95 defines INVESTING ACTIVITIES CASH FLOWS as
those resulting from---
• Acquisition or Sale of property, plant and Equipment
• Acquisition or Sale of a Subsidiary or segment
• Purchase or sale of Investments in other firms
 25
• Similarly FINANCING CASH FLOWS are those resulting from—
• Issuance or retirement of Debt or Equity securities
• Dividends paid to Stock holders
• The Standard requires GROSS rather than NET reporting of
SIGNIFICANT investing and Financing activities, thereby
providing improved disclosures.
• Enterprises with Foreign Currency transactions on Foreign
operations must report the effect of exchange rates on
cash and cash equivalents as a separate
component of reconciliation of cash and cash equivalents
for the period
• Cash from OPERATIONS may be reported DIRECTLY using
MAJOR CATEGORIES of GROSS CASH RECEIPTS and
PAYMENTS; or INDIRECTLY by providing a reconciliation of
NET INCOME with Net Cash Flow from Operating activities
 26
• Both the direct and Indirect methods require a separate
disclosure of cash outflows for INCOME TAXES and
INTEREST within the Statements or Elsewhere in the
financial Statements
• STATEMENT OF STOCK HOLDERS EQUITY-START
• the statement reports the amounts and Sources of changes in
Equity from Capital transactions with Owners and may include
the following components—
• Preferred stock
• Common stock
• Additional paid up capital
• Retained earnings
• Treasury shares ( Repurchased equity)
• ESOPs
 27
• And as components of OTHER COMPREHENSIVE INCOME,
the following---
• Minimum pension liability
• Unrealized gains and losses on AVAILABLE for Sale securities
• Cumulative Translation Adjustment ( Foreign operations)
• Unrealized gains and losses on Cash flow hedges
• Shares issued are recorded at par in Equity and the Excess
over Par value as, Share Premium a/c Additional capital
issued REPURCHASES or Buy backs are treated as Treasury
Stock—a Contra entry in the B/S. Retained earnings and
ESOPS are also reported
• FOOT NOTES / Notes to accounts
• Are an integral part of the financial statements and provide data
on such subjects as Business segments, the financial position
of Retirement plans and Off- balance sheet obligations
 28
• These data are required by GAAP ( FASB) or regulatory
authorities The Notes to accounts and 10K filings to the SEC
are audited. Supplementary Schedules are however un audited
Notes to Accounts provide info about Accounting methods,
assumptions, and estimates used by Management to develop
the data reported in Financial statements. They are designed
to allow users to improve assessments of the amounts,
timings, and uncertainty of the estimates reported in the
Financial statements. They provide additional disclosures
related to such areas as
Fixed assets Debts- interest rates etc
Inventories Law suits and contingencies
Taxes Marketable securities and Investments
Pensions and post employment benefit plans
 29
• Marketable Securities
• Hedging and other risk management activities
• Business Segments
• Significant customers, Sales to related parties and Exports
• CONTINGENCIES
• Notes to accounts often contain disclosures relating to
‘contingent losses’ These losses get classified either as
‘provisions’ or as ‘ contingent liabilities’ depending upon
whether the loss is fairly certain or not. This part is
SUBJECTIVE and involves judgment.
• Where losses are fairly certain a Provision is created by
debiting the Profit and loss account. Where losses are ONLY
DEPENDENT on the happening of a certain event, a
Contingent liability by way of just a note in the accounts comes
in to picture
 30
• In India contingent liabilities are basically things like ---
• --Claims against the company not acknowledged as debts
• ---Arrears of cumulative Preference dividends
• --- Bills discounted and III party Gaurantees
• --- Amounts yet to be called up on partly paid shares
• -other matters for which the company is contingently liable
• MANAGEMENT DISCUSSIONS and ANALYSIS ( MDA)
• These are discussions on earnings that have been a part of the
Annual reports for Listed companies. In India they are called
Directors Report. The MDA is supposed to discuss—
• Results of Operations, including discussion of trends in Sales
and categories of expenses
• Capital resources and liquidity including discussions of cash
flow trends
• Outlook based on known trends
 31
• The discussions could involve the following---
• 1) prospective information and required discussion of Significant effects of
currently known trends, events and uncertainties– ex decline in Market
share, inventory obsolescence etc. Firms may voluntarily disclose Forward
looking data that anticipates trends or events
• 2) Liquidity and Capital resources: Firms are expected to use cash flows
statements to analyze liquidity ; provide a balanced discussion of Operating,
Investing and Financing activities and events AFTER THE DATE OF
BALANCE SHEET
• 3) Discussions on Discontinued operations, Extraordinary items and
other ‘ unusual or infrequent events known as ‘ Non recurring and
Extraordinary gains/ losses
• 4) Extensive disclosures in interim financial statements in keeping with
the obligation to periodically up date MD&A-Directors report-- discussions
• 5) Disclosure of Segment’s disproportionate need for cash flows or
Segment’s contribution to revenues or Profits
 32
• The SEC in 2002 issued a statement reinforcing its views on
the importance of MDA disclosures the release reminds
registrants that disclosure ‘must be both useful and
understandable’
• Topics addressed include—
• 1) Liquidity and capital resources, including the impact of
Off Balance sheet arrangements on Liquidity and Capital
resources
• 2) Disclosures about contractual obligations and
commercial commitments ( that is Off balance sheet
obligations)
• 3) Disclosures about Trading Activities, including non—
Exchange traded contracts
• 4) The effects of transactions on related parties, including
persons ( like employees) who could fall outside the
definition of Related parties
 33
• Role of the Auditor
• the auditor must ensure that the financial statements
conform to GAAP/ IAS. Accounting policies must be
appropriate and estimates reasonable. The Auditor would also
look into the ‘true and fair view’ that the statements must
reflect and into the correct position of Assets and
Liabilities. The Report the auditor sends out is a must read for
any analyst though the auditor does not certify that there
are no errors in the statements
• SAS sometimes requires the addition of an Explanatory
para if needed, that describes material uncertainties
affecting Financial statements such as – Doubts regarding ‘
going concern’ assumption that underlies the preparation
of Financial statements- Uncertainty regarding the
Valuation and realization of Assets or Liabilities–
Uncertainty regarding Litigation
 34– THE ACCRUAL CONCEPT-M2
• Income cash Flows and Assets—Definition and Relationships
• In a world of certainty, the interrelationship among
Income, cash flows and Assets is captured by the
concept of ECONOMIC EARNINGS , defined as ‘
net cash flows PLUS change in market
values of the firm’s net assets. The
market value of the firm’s assets is the PRESENT
VALUE of their FUTURE Cash flows DISCOUNTED
at the Risk free rate r
• However Future Cash flows and Interest rates are
UNCERTAIN in the Real world! The market prices are
also uncertain and available prices may be difficult
to relate to the Present value of generally
uncertain and estimated cash flows being
discounted at estimated discount rates!!
• Moreover the market value of an Asset may end up being
measured with DIVERSE METHODs some at replacement
35 of earnings etc Thus in a real
costs, some at capitalized value
world, income ( however measured) is at BEST a PROXY
for ECONOMIC INCOME. Economists analysts have
developed a number of analytic and practical definitions of
earnings to serve as PROXY for Economic earnings
• Distributable earnings are defined as the amount of earnings
that can be paid out as DIVIDENDS without changing the
Value of the firm
• A related measure, SUSTAINABLE INCOME refers to the
level of income that can be MAINTAINED IN THE FUTURE
given the firms assets
• Another measure PERMANENT EARNINGS used by
analysts for valuation purposes is the amount that can be
normally earned given the firms assets and EQUALS the
MARKET VALUE OF THE ASSETS TIMES the firms
REQUIRED RATE OF RETURN
 36
• In Financial Reporting, the determination of---
• Which cash flows are included in INCOME and When
• Which changes in assets and Liabilities are included in Income
• How and when the selected changes in asset and Liabilities are measured
• Are all BASSED ON ACCOUNTING RULES and PRINCIPLES that make up
the generally accepted accounting principles ( GAAP). With a few
exceptions, the Accounting process ONLY RECOGNIZES VALUE
CHANGES arising from ACTUAL TRANSACTIONS
• Reported income under the accrual concept provides a measure of current
Operating Performance that is NOT exactly based on ACTUAL CURRENT
Period Cash flows. Cash inflows and outflows ( past present and Future) are
recognized as ‘income’ in the appropriate ACCOUNTING PERIODS. The
selected period ‘best’ indicates the firm’s present and continuing ability to
generate future cash flows Information about enterprise earnings based
on accrual accounting generally provides a better indication of an
enterprises ability to generate cash flows THAN in formation limited to the
FINANCIAL EFFECTS of cash receipts and Payments
• The accrual basis of accounting thus allocates ( recognizes as
Revenue and expense) many transactions and events to
TIME PERIODS OTHER THAN 37 those in which the Cash
flows occur. Accrual accounting Principles are,
fundamentally, the decision rules that tell preparers of
Financial Statements WHEN to recognize the ‘Revenue and
Expense consequences’ of Cash flows and other events
• The recognition of Revenues and expenses in periods
other than when cash is actually received or spent has a
corollary effect on the balance sheet. Both the recognition
and measurement of certain assets and liabilities are the
results of the application of the accrual concept of income.
The differences between the income
recognized and actual cash flows are
accounted for as Assets or Liabilities The
MATCHING PRINCIPLE added on to the Accrual Concept
provides a better info.than does cash flows perse
• The accrual process enhances the predictive ability of cash flows However as
evidence also indicates it does not mean that cash flows are not relevant they
provide information about the Quality38 of earnings and in the process
mitigate the weakness of the Accrual system
• The determination of Accounting earnings is also governed by
• General principles and measurement rules underlying all accounting
transactions and events
• Specific rules to determine Revenue, Expense gains and loss
recognition
• For ex. The HISTORICAL COST BASED APPROACH underlying GAAP
results in Rules that exclude unrealized holding gains and losses on assets
( M2M gains/ losses). Recognition of gains/ losses in these assets/
liabilities MUST AWAIT their DISPOSAL/ Settlement( for liabilities) and
can be reported in the Statement of changes in Equity
• However some NON TRANSACTIONAL related
changes in asset values can affect REPORTED
INCOMES. For example,
• CURRENT ASSETS must be EVALUATED at EACH FINANCIAL
STATEMENT DATE and any ESTIMATED DECLINES in ASSET VALUES
recognized as ‘ LOSSES’—no gains as it is conservatism u c!
• SFAS 121 extended the above requirement to Fixed assets also except that
certain IMPAIRMENT CONDITIONS will have to met before a WRITE DOWN is
possible! 39
• Certain assets –financial assets are Marked to the market and such gains taken
in as INCOME- at least in Statement of changes in Equity
• The Hassel here is that CURRENT INCOME is laden with these anomalies and
cant be taken at FACE VALUE!!
• INCOME STATEMENTS
• Suggested format
• ----- Revenues from sales of goods and services
• ------Operating expenses
• = operating Income from continuing operations
• + Other incomes and expenses
• = Recurring incomes before interest and taxes from continuing operations
• -- Financing costs
• = Recurring pretax incomes from continuing operations
• +/- Unusual / infrequent items
• = pretax earnings from continuing operations
• ---Income tax expense
• Net income from continuing operations
• +/_ Income from discontinued operations( net of tax)
• +/_ Extra ordinary items ( net of tax)
• +/- 40changes
Cumulative effect of accounting
• = net income
• The OPERATING INCOME FROM CONTINUING OPERATIONS is
independent of the Capital structure!
• Recurring vs non recurring items Companies often change the Income
statement format to obscure areas of less than appreciable performance
Generally Income FROM A FIRMS RECURRING OPERATIONS is
considered to be the BEST INDICATOR of FUTURE INCOME. The
PREDICTIVE ABILITY INCREASES upon EXCLUSION of a firm’s NON
RECURRING SPORADIC and RANDOM INCOME
• Transitory gains and losses are NOT to be considered as a part of
SUSTAINABLE PERMANENT INCOME!! On the other hand the concept of
RECURRING INCOME portrays a predictable level of performance where
growth rates can be forecast and long term earnings fairly put in Black and
White. Recurring income portrays income from continuing operations
• It is important to realize that non recurring incomes are NOT a TYPE OF
EVENT; in fact the same income depending on the NATURE OF THE
EVENT and to some extent MANAGEMENT DISCRETION may get
classified ‘above/ below the line’!!
 41
• For example for some firms the gain/ loss on sale of FIXED
ASSETS will be rare with LITTLE PREDICTIVE VALUE; Others
may retire F/A regularly and report gains/ losses– a Car Rental
company retiring a part of its fleet regularly
• The Nonrecurring part may be segregated in to—
• A) Extra ordinary items– not useful in predicting ROE
• B)Income from discontinued Operations– not useful in
predicting ROE
• C) infrequent items are useful in predicting ROE
• This IMPLIES item c) contains a RECURRING ELEMENT!!
• The predictive ability of Financial statements is LIMITED
We need to extrapolate going by available cues. For
example a huge sales in cars implies a corresponding
sales in Tyres!
• Accounting Income– Revenue and Expense recognition
• There are 2 aspects to revenue recognition—
42
• 1) the TIMING– when do we recognize revenues
• 2) measurement– how much of it do we recognize?
• For revenue to be recognized 2 conditions must be met—
• 1) Completion of earnings process
• 2) Assurance of Payments
• Condition 1 has 2 parts—
• 1a)The Firm MUST HAVE PROVIDED THE BUYER WITH virtually
all the goods and services he was obliged to provide– the SELLER
must have NO SIGNIFICANT CONTINGENT OBLIGATION LEFT
• 1b)The second condition is a RELIABLE MEASUREMENT of the
REALIZABILITY of the claim for goods and services rendered
• Goods provided to date x Total Revenue expected
• total goods provided
•
• The formula in the previous slide reflects recognition of
Revenue on a continuing basis
43
• In cases where payment is received PRIOR to the
DELIVERY of goods/ services appropriate revenue
recognition implies---
• A) Revenue on LEASED ASSETS– to be recognized by the
lessor on some reasonable basis.Ex No. of photo copies per
period for recognizing rentals of a photo copier
• B) Credit card fees are recognized as the right to use the
card keeps depleting time wise
• C) Magazine subscriptions are recognized in PROPORTION
TO THE DELIVERIES MADE
• Departures from the recognition basis stated above is also
possible under extraordinary circumstances. For ex. Revenue is
NOT recognized even when Sales are completed if a huge
uncertainty exists regarding its realizability!!
 44
• Revenues for contracts are recognized on the basis of either—
a) Percentage of Completion method or on b) Completed
contracts method
• The Percentage of completion measures progress towards
completion using either—
• Engineering estimates( Physical progress) or
• Ratio of costs incurred TO expected total costs
• This method may OVERSTATE REVENUES and Gross
PROFITS if expenditures incurred DO NOT CONTRIBUTE
TO PHYSICAL PROGRESS. IF A LOSS IS ANTICIPATED IT
MUST BE INCLUDED IN THE PERIOD WHERE THE LOSS IS
VISIBLE OR CALCULABLE
• Best--- > Link Physical progress with Financial progress!!