Equity Valuation and Analysis with eVal

1. Equity Valuation and Analysis with eVal Chapter 4: Accounting Analysis

2. Framework for Business Analysis and Valuation

3. Purpose of Accounting Analysis • Evaluate how well the accounting reflects the underlying economics of the business • Adjust financial statements to mitigate accounting distortions -or- recognize that distortions must ultimately be reversed

4. Basic GAAP Assets = Liabilities + Shareholders’ Equity • Assets are probable future economic benefits under the control of the firm arising from prior transactions • Liabilities are probable future economic sacrifices that are obligations of the firm arising from past events • Revenues are increases in assets or reductions of liabilities arising from providing goods or services • Expenses are reductions in assets or increases in liabilities resulting from providing goods or services • Income is the increase in net assets arising from providing goods and services

6. Revenue Recognition Criteria • Definition • Net assets generated by an enterprise's operations. • Revenue cannot be recognized until: • An exchange transaction has taken place • Earnings process is complete (delivery has occurred or services have been rendered) • The selling price is determinable • Collectability is reasonably predictable

7. Revenue Recognition Examples • An appliance manufacturer convinces a major dealer to order $1 million more appliances than the dealer wants and books these sales as revenue. The manufacturer assures the dealer that the dealer will not have to pay until they are sold, and that the manufacturer will pay for their storage. • A waste-disposal company signs a contract with a municipality that provides the municipality with the right to use a landfill site owned by the company for each of the next five years in return for $12 million/year, payable at the beginning of each year. The company books revenue of $60 million on signing the contract. • An airline company offers ‘frequent flier miles’ as an inducement for customers to purchase tickets. The company then books the full ticket price as revenue when the customer takes the initial trip.

8. Expenses Recognition Criteria • Definition • Net assets consumed by an enterprise's operations. • Recognition • If the consumed net asset can be directly tied to the generation of some revenue, it is recognized in the same period the revenue is recognized (product cost) • or • If the consumed asset cannot be directly related to any revenues and it does not create another asset, then it is recognized in the period it is consumed (period expense).

9. Expense Recognition Examples • A bank incurs $24 million of costs marketing credit cards to new customers. The bank capitalizes the costs as an asset and expenses them over the next five years. • A computer software company incurs $2 million of costs developing a sequel to a popular computer game. It will be six months before the software is ready for release. The company capitalizes the costs and expenses them over the three years following the software release date. • An underwriter and marketer of legal insurance contacts pays $100 million of advance commissions to its sales associates. Contracts are renewable and premiums are payable on a monthly basis. The advance commissions represent commissions on three years worth of contract premiums. The company capitalizes the commissions as an asset and recognizes no expense.

10. Limitations of Accounting Information • Measurement Error Caused by GAAP • can’t recognize future sales • can’t capitalize R&D costs • Measurement Error Caused by Imperfect Foresight • loan loss provisions, employee benefit obligations • Measurement Error Caused by Managerial Manipulation • Enron, WorldCom etc.

11. Doing Accounting Analysis • Identify key accounting policies • Assess accounting flexibility • Evaluate the accounting quality • Consistency with GAAP • Consistency with underlying economics • Evaluate the overall quality of the firm’s disclosures

12. Some Red Flags • Use of different accounting methods/estimates from other firms in the industry • Unexplained changes in accounting methods/estimates • Large gap between earnings and cash flows • Unusual transactions that boost earnings • Qualified audit opinion (or change in auditor) • Significant related party transactions or contingent liabilities • Large gap between ‘GAAP’ earnings and ‘Street’ earnings

13. Why Do We Care About Cash Flows? Average Earnings and Cash Flow Performance of Firms Caught by the SEC for Manipulating Earnings (Manipulation Occurs in Year 0)

14. Why Do We Care About Cash Flows? Average Earnings and Cash Flow Performance of Firms Caught by the SEC for Manipulating Earnings (Manipulation Occurs in Year 0)

15. Converting Revenues and Expenses to a Cash Basis • Take the as-reported amount from the income statement • Identify all accrual adjustments relating to that amount from the operating section of the statement of cash flows (indirect method) • Net the adjustments against the as-reported amounts to get the cash basis amount • We will see an example of this procedure in the Bally Total Fitness Case

16. Overview of Subsequent Sessions on Accounting Analysis • Session 3: Overstock.com: Accounting Analysis • Case involves identifying and quantifying accounting distortions to sales and margins • Session 4: EnCom Corporation • Case involves a hypothetical company and illustrates the impact of accounting distortions on the financial statements • Session 5: Apple and the iFad • Case involves assessing the quality of earnings through the analysis of business strategy and accounting policies • Session 6: Boston Chicken: • Case involves assessing the quality of earnings through the analysis of business strategy and accounting policies • Session 7: Bally Total Fitness • Case involves assessing the quality of earnings through the analysis of business strategy and accounting policies