Intro-Accounting Analysis

1. Intro-Accounting Analysis

2. Intro- Accounting Analysis

3. Accounting Quality • Narrow definition: To what extent does the accounting represent underlying business reality? • Trying to understand accounting distortions • When distortions are large, accounting analysis is very beneficial • Broader Definition: Narrow definition + Sustainability- To what extent do earnings map to future profitability”? • Trying to separate core operating (non-operating) earnings from “unusual” earnings

4. Accounting #s and Economic RealitySources of noise and bias • Accounting rules -- rules can prevent management from telling the story they want to tell because of their restrictive nature • Forecast errors arise because of • complexity of business • predictability of firm’s environment • unforeseen economy wide events • Accounting choices

5. Doing Accounting Analysis • Identify key accounting policies • Assess Accounting Flexiblity • Evaluate Accounting Strategy • Evaluate the quality of disclosures • Identify Red Flags • Undo Accounting Distortions

6. Identifying Key Accounting Policies (Step 1) • Analysis requires the identification of key value-drivers i.e. important in explaining the success of the firm • Volatile and can change quickly • A change is unpredictable • Is significant enough that prompt action is required • Can be measured either directly or by surrogate

7. Possible Key Variables • Bookings • Back orders • Market share • Key account orders • The analyst has to identify the accounting measures that capture these constructs

8. Examples of Industry Key Variables • Airline Paid seats/capacity Fuel • Electrical utility KWH sold • Hospital Beds occupied/available beds • Hotel Beds occupied/available beds • Magazine Renewals/subscriptions expired • Railroad Carloadings • Restaurant Labor cost/revenue • Raw food cost/revenue • Retail Store Gross margin by department

9. Assess Accounting Flexiblity (Step 2) • Some firms have little flexibility e.g. utilities • All can make some choices

10. Evaluate Accounting Strategies (Step 3) • Compare to the industry • Incentives for reporting in one direction or the other • Have policies changed? • Have the firms policies been realistic in the past? • Does the firm appear willing to expend resources to achieve an accounting objective that is not economic based?

11. Evaluate Quality of Disclosures (Step 4) • Can you identify business strategy from disclosures (Pres Letter) • Do footnotes explain key accounting policies -- deviations from industry, accounting changes • Is current performance adequately explained • Does the firm provide you with a means of identifying performance with respect to key indicators • Bad news • Segment disclosures?

12. Identify Potential Red Flags (Step 5) -1 • Unexplained accounting changes • Switch from accelerated to st. line dep (Kaplan) • Switch to LIFO (Brown) • Unexpected transactions which boost profit (Debt swaps investigated by Hand, for example)

13. Identify Potential Red Flags (Step 5) -2 Unusual increases in accounts receivable • Firms having trouble selling products often ease credit terms • Could also suggest earnings manipulation

14. Identify Potential Red Flags (Step 5) -3 Unusual increases in inventories • Suggest difficulties in generating sales • May suggest slow or obselete items that are to be written off later • Increase current earnings at the expense of future earnings (Overhead spread)

15. Identify Potential Red Flags (Step 5) -4 • Increasing gap between earnings and cash flow from operations • A companies operating cycle is pretty much from cash to cash bulges may suggest some form of management • Increasing gap between reported inome and tax income • An increase may suggests that a firm has become agressive with its accounting

16. Identify Potential Red Flags (Step 5) -5 • A tendency to use financing mechanisms like R&D partnerships, sale of receivables with recourse • Gives management chance to play with the accounting • Unexpected large asset write-offs • Large Fourth-quarter write-offs • Qualified audit opinions • Related party transactions

17. Undo Distortions (Step 6) • Cash flow as an alternative • Footnotes

18. Accounting Myths: • “Conservative” accounting is “good” accounting • Unusual Accounting is questionable • “Professional Judgement” is questionable.

19. Sustainability • Separating Core and Non-Core Earnings Components

20. Analyzing Change in ROCE: The Scheme

21. Analyze Changes in Profitability of Operations Analyze the Effects of Changes in Financing (1) (2) Analysis of Changes in ROCE

22. Explaining the Changes in Operational Profitability Explaining RNOA • Distinguish core and transitory components Core OI is persistent income from core business UI is unusual items that are non-recurring, sometimes called transitory items. All items are after tax

23. Explaining Changes in Operational Profitability (cont’d.) • Distinguish margin and turnover drivers of core profits where,

24. Explaining Changes in Operational Profitability (cont’d.) • Explain changes in profit margins and asset turnoversExplain (i) by looking at profit margin drivers • GM (by segment) • Selling Expenses / Sales • Administrative Expenses / Sales • R&D / Sales Pay particular attention to GM: per unit sales prices, production costs… Explain (ii) by looking at turnovers • Accounts receivables turnover • Inventory turnover • PPE turnover • Accounts payable turnover • Operating liability turnover Also • Look at operating asset composition ratios • Look at operating liabilities composition ratios • Look at OLLEV

25. Reformulating Income Statements to Identify Core and Unusual Items Reformulated Operating Income Statement: Core and Unusual Items

26. To Analyze Sustainable Earnings, Analyze R&D Analysis of R&D: Abbott Laboratories

27. To Analyze Sustainable Earnings, Analyze Marketing Expenditures The Analysis of Advertising Costs: Coca-Cola

28. To Analyze Sustainable Earnings, Analyze Pension Costs Components of Pension Expense: • Service Cost • Interest Cost • Expected Return on Plan Assets • Amortization of Prior Service Cost • Amortization of Transaction Asset or Liability (before 2000) • Changes in Actuarial Estimates (accrual gains and losses)

29. Watch for the Expected Rate of Return on Pension Plan Assets • In the 1980s, firms were using expected rates of return of about 7% • In the 1990s, firms were using expected rates of returns of 10-10½% • Applying a high rate of return to bubble asset prices produces bubble earnings • Pricing on the basis of bubble prices perpetuates the bubble The Pension Pyramid Scheme

30. Watch for Gains of Pension Fund Assets • General Electric’s expected return • General Electric’s expected return on plan assets was $3,024 million in 1998 (22.4% earnings before tax) against a service cost of $625 million. Its net pension expense was a gain of $1,016 million. • IBM reported an expected return on plan assets of $6,264 million in 2001 (56.0% of operating income before tax).

31. Watch Gains and Losses on Sales of Shares Intel In its report for its third quarter for 1999, Intel reported net income of $1,458 million, with no indication of unusual items. Its cash flow statement, however, reported $556 million in gains on sales of investments, along with a $161 million loss on retirements of plant, as add backs to net income to calculate cash from operations. Delta Air Lines Delta reported operating income (before tax) of $350 million for its September quarter in 1999. However, notes to the report indicated that these earnings included pre-tax gains of $252 million from selling its interest in Singapore Airlines and Priceline.com. IBM IBM reported before-tax operating income of $4,085 for its June, 1999 quarter. However, footnotes revealed that this income included a $3,430 million gain from the sale of IBM's Global Network to AT&T. This gain reduced selling, general and administrative expenses in the income statement!

32. Watch for Bleed Backs of Restructuring and Merger Changes IBM: Creating earnings with restructuring charges

33. Miscellaneous Check List • Changes in estimates • Bad debt allowances • Deferred revenue and cookie jar accounts • Warranty allowances • Residual values for leases • Income Taxes • One-time or expiring credits • Valuation allowances for deferred tax assets • Investigate “other income”

34. Analyzing Operating Leverage Operating Leverage is the proportion of total costs that are fixed versus variable The first component here is called the contribution margin ratio This ratio measures the change in income from a change in one dollar of sales

35. Operating Leverage Measures Operating Leverage is sometimes calculated as the ratio of fixed costs to variable costs Another measure is: Applying this measure to core operations:

36. (i) Effect of change in operating profitability (ii) Effect of change in spread (iii) Effect of change in leverage Effect of Financing Analysis of Effect of Changes in Financing Change in ROCE = Change in RNOA + Change due to change in spread at previous level of financial leverage + Change due to change in financial leverage

37. Explaining Changes in the SPREAD SPREAD = RNOA – NBC RNOA has been explained Explain Change in NBC: Distinguish core and unusual borrowing cost Core financing expenses • Change in interest rates (risk free and risk premium) • Change in tax rates (and shield) • Substitution of preferred for debt financing Unusual financing expenses • Tax effect from unusually high or low taxes (operating losses) • Interest income from tax refunds of prior years • Gains and losses on financial items

38. A Rough Approximation • Some observations • The change in leverage effect (iii) is generally minor • The change in borrowing costs is generally small (then, Spread is largely determined by RNOA) • The RNOA effect (i) is generally the largest • So, if FLEV and NBC are small, a useful approximation is