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Earnings Forecasts. Geoffrey Jones, Spencer Steckley , John MacFarlane, Joel Zhang, Ellen Truong, Lucy Zhang, Manjeet Warha. Agenda. Overview of Future-Oriented Financial Information SuperSportsGoodStop Analysis Users & Providers of Earnings Forecasts
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Earnings Forecasts Geoffrey Jones, Spencer Steckley, John MacFarlane, Joel Zhang, Ellen Truong, Lucy Zhang, ManjeetWarha
Agenda • Overview of Future-Oriented Financial Information • SuperSportsGoodStop Analysis • Users & Providers of Earnings Forecasts • Examining Hypotheses – Earnings Forecasting Errors • Earnings Forecasts – Initial Public Offerings
CICA Handbook 4250 – Future-Oriented Financial Information Objective: • Provide external users with information to assist evaluation entity’s financial projections Forward Looking Financial Information • Information about prospective results of: • Operations • Financial position • Cash Flows • Based on assumptions about future economic conditions & courses of action
Types of Future Financial Information Forecast • Assumptions to reflect entity’s planned course of action over period covered given management’s judgment as to most probable set of economic conditions • Sales forecasts provided by management to users Projections • Contain one or more hypotheses as assumptions consistent with purpose of information but not necessarily most probable in management’s judgment
Future Financial Information – Projections • Management’s expectations on future operations of coming year & certain planned events • Illustrative example on Olympus Pacific Minerals Ltd. March 31, 2012 MD&A • Response to question: “What would happen if…?” • Start-up phase entity when certain key assumptions can’t be supported such as Olympus
How a Forecast Becomes A Projection • Time Period • Time period encompassed by forward looking information is extended • Supportable Assumptions • Assumption reflecting management’s judgment as to most probable set of economic conditions and planned courses of action become no longer supportable • Hypotheses • Assumptions as a result become hypotheses
General & Special-Purpose Future-Oriented Financial Information General-Purpose Future-Oriented Financial Information • Financial information prepared for external users whom entity operating at arm’s length • MD&A forward-looking information available as published data Special-Purpose Future-Oriented Financial Information • Financial information for external users whom entity negotiating or dealing directly with • Internal budgets / forecasts not released for public but for management purposes
MEASUREMENT • Management responsible for process and ensuring assumptions developed are appropriate in circumstances • Quality of forward looking information is dependant on: • Completeness • Reasonableness • Assumptions must be consistent • I.e. Sales ↑ Wages & Raw Material Costs↑
Measurement – Assumptions • Consistent with plans of entity & reflect expected economic effects of: • Comparable entities • Past Data • Feasibility & Market Studies • Actions • Anticipated strategies • Programs Support Assumptions
TIME PERIOD • Should not extend beyond point in time for which such information can be reasonably estimated • Depends on factors: • Needs of users • Ability to make appropriate assumptions • Nature of industry • Operating cycle of industry
TIME PERIOD (continued) • Periods covered correspond with historical financial statements and information presented • Use consistent timing whether annually, semi-annually, quarterly, monthly… • Forecasts usually not prepared subsequent fiscal yearends unless reasonable assurance to operations of forecast period • Reasonable basis for making estimates • As Time Period covered ↑ then degree of uncertainty ↑
Accounting Policies • “Future-oriented financial information should be prepared in accordance with the accounting policies expected to be used in presenting historical financial statements for the future period, except when otherwise agreed to for special purpose future-oriented financial information” • Preparation on basis of accounting policies expected to be used in historical financial statements for future period facilitating comparison to actual results
Presentation • General Purpose Future-Oriented information includes income statement • Special Purpose level of detail & format agreed upon by both parties • Minimum requirement – future results of operations • Inclusion of other statements
Presentation (continued) • Presented in format of historical financial statements • Amounts are presented as single monetary unit, a range or a single amount supplemented by a range • When information not presented jointly with historical statements, require disclosures BUT only to extent they are necessary for understanding of information
General Disclosures • Cautionary Note • Actual V.S. Presented Results • Label as: • Forecast OR Projection • Include date of underlying assumptions • Extent to which actual results incorporated & whether information updated subsequent to issue
Disclosure of Assumptions • Assumptions vary in both nature and significance therefore significant assumptions should be disclosed along with significant hypotheses • Reflects an expectation of economic conditions significantly different from those currently prevailing • High probability of sizeable variation • Small change in the assumption would have a significant impact on the future-oriented financial information
Disclosure of Assumptions (continued) • When opting to select one assumption over another, need not quantify the effects of using different assumptions • However, a sensitivity analysis may enhance the usefulness of the information presented when selecting one equally appropriate assumption over the other
Disclosure of Assumptions (continued) • All future-oriented information based on certain common assumptions about future conditions such as: • These assumptions, while significant, are so general they pertain to the whole economy and need not be disclosed • a) • b) • c) • Government courses of action • Absence of natural disasters • Continuation of peace
Other Disclosures • Special purpose future-oriented information entity should disclose the identity of the intended users, purpose for which the information has been prepared and a caution regarding the information provided • Projections also need to outline purpose for which it has been prepared and a cautionary note on the appropriateness of the information.
SuperSportsGoodStop Case Overview - Client • Retailer of sports jerseys and other fan paraphernalia for 13 years (1988-2001) • 15 retail stores and 5+ upcoming franchise stores in Western Canada • Company has a debt to assets ratio of 80% Decide it is time to go public with an IPO • Goal: Expansion into Toronto by opening company owned outlet
SuperSportsGoodStop Case Overview – Your firm (S&T) • Derek and Steven are long time friends • SSGS needs audited earnings forecast by Wednesday –otherwise Derek is threatening to move to Big 5 firm • Steven has his promotion to Partner riding on keeping this client • Derek Jeffries – Owner of SuperSportsGoodStop • Steven Snipes – CA at Sloan & Travis (S&T)
Case discussion • Identify the problems • How will the audited Earnings Forecast help the IPO prospectus? • Are there any auditor’s independence issue in this case?
SuperSportsGoodStop Consider the reasonableness of assumptions:
SuperSportsGoodStop Consider assumptions made in Forecast: • Completeness • Did not factor in Management bonuses ($1MM in previous income statement) • Reasonableness • 8% increase in sales per outlet • Method of estimating cost of sales • Franchise fees • Royalties
SuperSportsGoodStop Gathering Evidence
Case discussion • Do you think this is a sustainable client relationship? • What would you do in Steven’s position? Do you think he is able to complete the quality audit in the short time span?
Users of Earnings Forecast • Investors • Shareholders • Management • Financial Institutions • Creditors
Main Users of Earnings Forecast: Investors • Investors rely heavily on earnings forecast for making their investment decisions • Earnings Forecast Provide Information On: • Whether to Buy, Sell, or Hold Certain Securities • Whether a Company’s Stock is Overvalued or Undervalued • Whether a Company is meeting its Financial Objectives • Current and Future Company Performance
Who Provides Earnings Forecast to Investors? • Industry Analysts (External) • Management (Internal) Which Forecast Should Investors Use in Regards to Their Investment Decisions?
Information Advantage: Management vs. Analyst • Management • Firm Specialists • Information Advantage Resides at the Firm Level • Analyst • Industry Specialists • Information Advantage Resides at the Macroeconomic Level
Managements Earnings Forecast Accuracy Managements Forecast is substantially more accurate than Analysts when: • Managements actions are hard to predict by outsiders (Analyst) • Examples of this would be the following: • What is management going to do with abnormal inventory buildup • When a firm has excess capacity • When a firm is experiencing a Loss Year • When a firms costs are largely fixed and they experience a decline in revenue
Analysts Earnings Forecast Accuracy • Analysts Forecast is substantially more accurate than Managements when: • Afirm’s revenue move in relation with broad macroeconomic factors and management has little or no control over these factors • Examples of these factors include the following • GDP • Interest rates • Energy costs
An Examination of Hypotheses concerning Earnings Forecast Errors • An examination of typical forecasting errors • Testing the relationship between the accuracy of earnings and basic characteristics of a company • Focus on investor forecasting rather than management forecasting
Five hypotheses Tested • The Financial Leverage of the firm • The previous variability of earnings • The size of the firm • How current the forecast is • Value Line’s timeliness index
Financial Leverage of the Firm • Greater financial leverage should cause greater variability in earnings • Greater variability in earnings should lead to larger prediction errors Financial Leverage = (Long Term Debt + Short Term Debt) / Total Assets • Assuming that past variability is an indicator of future variability • Firms with less variability in the past should exhibit smaller forecasting errors • Value Line’s Index of Predictability was used to measure previous variability in earnings Previous Variability of Earnings
The Size of the Firm • The forecasting error will be inversely related to the size of the firm. • With smaller firms there is less information available to make accurate forecasts • Total Assets of firms were used to determine size • The closer a forecast is made to an earnings announcement, the more up-to-date the information • Implies forecasting errors will be smaller for forecasts made at an earlier date • Measured by trading days between forecast date and the announcement date How Current the Forecast is
Value Line’s Timeliness Index • Examining the relationship (if any) between forecasting errors and the firms Value Line’s Timeliness ranking • Rank 1 (Highest):These stocks, as a group, are expected to be the best performers relative to the Value Line universe during the next six to 12 months (100 stocks). • Rank 2 (Above Average):These stocks, as a group, are expected to have better-than-average relative price performance (300 stocks). • Rank 3 (Average):These stocks, as a group, are expected to have relative price performance in line with the Value Line universe (approximately 900 stocks). • Rank 4 (Below Average):These stocks, as a group, are expected to have below-average relative price performance (approximately 300 stocks). • Rank 5 (Lowest): These stocks, as a group, are expected to have the poorest relative price performance (100 stocks).
Methodology • Forecasting errors generated by finding for most up-to-date forecast prior to a firms earning announcement. • A total sample of 6,729 earnings announcements representing 776 different firms were used. • Forecasting errors are calculated as follows:
Results and Conclusion • The first four hypothesis proved true, showing strong correlation using the Least of Squares analysis • The fifth hypothesis (comparison to Timeliness ranking) showed that forecasting errors were more predominant with lower ranked stocks • All variable were analyzed independently of each other rather than simultaneously. • Financial community heavily considers earnings estimates in security valuation, and accuracy is extremely important.
IPO Process • Planning for the IPO Process • Choosing Underwriters • Filing a Prospectus • IPO Promotion • Final Offering Price and Amount • Selling on the Stock Market
Prospectus • Prior sales • Directors and officers • Executive compensation • Plan of distribution • Risk factors • Pro forma financial statements • Future-oriented financial information
Earning forecast • Is earning forecast required in prospectus? • Should it be required?
Danier Case Background: • IPO in 1998 • Optimistic forecast • Could not achieve forecast • Share price dropped • Class action lawsuit
Danier Case What happened: • Initial trail found liable • Court of appeal • Reversed and dismissed the class action • Reasonable decision • “Business judgment rule” • “Range of reasonableness”
Disclosure requirement • Pros: • Reduce information asymmetry • More accurate IPO price • Investor confidence • Cons: • Lack of reliability • Counter-productive effect • Start-up disadvantage
Firm motivation Influencing factors: • Historical earnings variability • Market trend • Age of the firm • Risk of under-performance • Equity based compensation
Facebook IPO • Forecast revision • Selective disclosure • Unfair information disadvantage • Decrease in public confidence • Share price drops by 11%
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