Future-Oriented Financial Information

1. Future-Oriented Financial Information Financial Accounting Theory Grace Bartz, Danielle Cook, Martine Denhertog, David DiMatteo, Mark Haley, FarisIsmailovski, Julie Phillips, & Dorian Temlin

2. Agenda Introduction Determining information about the future Assumptions Forecasting Time-period Presentation Disclosures

3. Introduction to Section 4250 • Addresses • Measurement • Presentation and disclosure • Formats: • General purpose • Special purpose • Objective is to provide external users with information that assists them in evaluating an entity’s financial prospects

4. Introduction to Section 4250 Who might want to know future information about a company? • Lenders • Owners • Investors • Management • Auditors • Analysts • Employees and Suppliers

5. Introduction to Section 4250 • Users of future information • Lenders • See if borrowers will be generating sufficient cash flow to repay loans • Test borrowers knowledge of business • Owners and Security Markets • See if capital is generating sufficient rate of return • Determine the course of investing action • Management • Benchmarks

6. Introduction to Section 4250 What could future financial prospect information be used for? • Evaluate company’s ability to pay back loans • To determine if meeting investors’ expectations • Benchmark for management

7. Introduction to Section 4250 What type of information about the future of a company would a user want to know? • Sales • Net Income • Cash Flow • Debt to Equity

8. Determining Information About the Future • Based on assumptions • Forecasts • Uses assumptions which reflect planned courses of action • Projections • Same assumptions as a forecast with one or more hypotheses consistent with the purpose of the information • Not necessarily the most probable in managements judgment

9. Importance of Future Information • Company can communicate its expectations to the market • Management knows its business better than anyone else • Management can use the information to sway investors

10. Assumptions • Complete • Affects reliability • Reasonable • Achievable • Provide relevant information • Adds value • Consistent • Interdependence

11. Consistent Assumptions The assumptions need to be consistent with…? • Plans and strategies of the company • Past performance • Industry performance

12. Assumptions • Complete • Affects reliability • Reasonable • Achievable • Provide relevant information • Adds value • Consistent • Interdependence

13. Assumptions Who should make the assumptions? • Management

14. Forecasts Generated from reasonable and supportable assumptions by management Reflect most probable economic conditions and planned courses of actions for the entity Supportable vs. reasonable

15. Supportable How can assumptions made by management be supportable? • Past performance of entity itself • Performance of other entities with similar activities • Feasibility studies • Marketing studies • Economic data • Government and industry publications • Other sources with objective corroboration of the assumptions used

16. Supportable Extent of detailed information to support assumptions Influenced by factors such as the significance of the assumption, and availability and quality of information

17. Forecast Methods Managements way of preparing financial information from the reasonable and supportable assumptions May use statistical, mathematical, or specialized forecasting techniques

18. Forecast Methods Once assumptions are determined, how do managers come up with the forecasted numbers?

19. Forecast Methods • Quantitative • Percentage of sales • Ratios • Regression • Trend line, time series, moving average, naïve method • Qualitative/Subjective • Management and executive opinions • Delphi technique • Consumer surveys

20. Forecast Methods Forecasts can be prepared with extreme precision – to the nearest cent – why is this accuracy misleading to analysts? If limited to only one forecast number, which would you choose to see and why? What if limited to only one financial statement?

21. Reasonability of Assumptions • To be reasonable, must be consistent with the plans of the entity. How are assumptions considered consistent with the plans of the entity? • Reflect expected effects of anticipated strategy • Include effects of likely economic conditions

22. Reasonability of Assumptions • Each assumption needs to be assessed as to its reasonableness • Influenced by the significance of the assumption and the quality of supporting information • As availability of information decreases, it becomes much more difficult for management to make reasonable attempts

23. Reasonability of Assumptions • A projection must also be based on reasonable assumptions including one or more hypotheses What would the criteria be for a hypothesis to be considered reasonable? • Consistent with the purpose of the projection • Plausible

24. Examination of Future Oriented Financial Statements (AuG-6) • An accountant’s objective is to form an opinion on the underlying assumptions used but not to the achievability of the forecast • Crucial that the PA get a well-developed understanding of the organization and its industry

25. Compilation of a Financial Forecast/Projection (AuG-16) • This pertains to subsequent earnings forecasts from the prospectus • The objective is to provide a service to those who require assistance • PA should question management’s approaches but not form an opinion

26. Shortfalls of Forecasts

27. Shortfalls of Forecasts How could actions and abuses of pro-formas be prevented and stopped going forward? • Require more timely GAAP numbers • Audit opinion on subsequent forecasts

28. Shortfalls of Forecasts • CEO’s who are “overconfident” are more likely to issues forecasts that are overly optimistic • Companies are protected by the Safe Harbour Rule, which ultimately allows for optimistic outlooks. What is your opinion on the Safe Harbour Rule?

29. Time Period in Earnings Forecasts • Time period covered by future financial statements shouldn’t go beyond the period where information can be reasonably estimated • It may not be shorter than ‘the period of long-term undertakings for which an entity has set expenditure limits’

30. Time Period in Earnings Forecasts • Factors influencing reasonableness: • Need of users • Ability to make appropriate assumptions • Nature of industry • Operating cycle of entity What are some reasons management would not be able to reasonably estimate information? • Economic volatility • Uncertain future of the organization

31. Time Period in Earnings Forecasts • Future financial statements should be prepared in accordance with accounting policies and presentation format used in presenting historical financial statements • ie. If preparing statements on a quarterly basis, pro forma statements should be estimated on a quarterly basis

32. Time Period in Earnings Forecasts • Forecasts are not normally prepared for periods beyond the following fiscal year • To be practical should be updated and revised for new information as it becomes known • Comparison to actual should be evaluated

33. Time Period in Earnings Forecasts • Projections may be prepared for periods beyond the following fiscal year if there is a reasonable base for making estimates • Many entities use 3, 5, or 10 year projections in order to make longer-term decisions • The degree of uncertainty normally increases with the length of the future period covered

34. Presentation • General purpose statements presented in the format of historical financial statements • Must use historical policies except… • In the case of special purpose financial statements • Use whatever framework the two parties agree on

35. Special Purpose Financial Statements • Special purpose financial statements are a set of financial statements that are prepared using a special purpose framework to cater to the special needs of specific users of financial statements • Not prepared in accordance with the general reporting framework • Not made for public – limited use • Internal users • Those charged with governance • Limited external users

36. Special Purpose Financial Statements Can you give examples of industries or companies that would use special purpose financial statements? • Banks • Governments • Financials for tax authorities (statements completed in accordance with tax regulatory framework)

37. Presentation • If presentation using historical statements is not possible -> note and accounting policy disclosure… • To the extent of adding understanding

38. Presentation • Exact dollar value • Presented as a range • Takes into account inherent imprecision with forecasting • Care to ensure that range is not too broad that the values are no longer meaningful

39. Presentation When would a range be more useful? • Farming operations – weather unpredictable • Bidding in an acquisition (min and max willing to pay) • New market/market does not exist when a new product is introduced into the market When would an exact dollar value be useful? • Analyst • Investors who use mathematical models

40. Presentation in an IPO Setting • As part of the prospectus • Five periods of audited income statements • Two most recent balance sheets • Is an earnings forecast required in an IPO prospectus? • No: standard says that its optional but not required • If included must be audited and include audit statement • Why might a company want to include an earnings forecast? • Higher earnings = positive reaction from public • Assurance – not hiding information from public • Providing more information to investors • Why would a company decline to include an earnings forecast? • Cant complete one with accuracy (volatile industries) • Forecasted earnings may deter users • information sharing -> competitors

41. Disclosure • Effective date of assumptions • Date that information was approved: subsequent events may impact usefulness of this information • Extent of inclusion of actual financial results and its period • Varying nature of actual results • Entities are faced with limitations and uncertainties in regards to future conditions and actions

42. Disclosure Once a company discloses that actual results may vary significantly (or materially) from the forecast, is the forecast still useful ?

43. Disclosure • Plans to update future-oriented financial information subsequent to issue • Must disclose if the entity accepts no responsibility to update the information

44. Disclosure of Assumptions • Use assumptions based on planned course of action • Will this planned course of action likely occur? • Significant assumptions underlying future-oriented financial information should be disclosed • What is significant? • Incorporate a sensitivity analysis

45. Other Disclosures • If future-oriented statements include a change in account policy must disclose • Describe change • Nature of effect • Special purpose financial information • Disclose purpose & who it is meant for • Purpose/Limitation of usefulness of projection

46. Delta Air Lines/ComAir • ComAir is a wholly owned subsidiary of D.A.L. • 09/14/2005 – D.A.L. files for cpt. 11 bankruptcy • Forces ComAir into bankruptcy • Chapter 11 Bankruptcy • Allows for reorganization of company with a judges approval • Value of business is greater if a going concern • Business “engine” can be restarted to generate cash to repay creditors • More economically efficient to: • Cancel some debts • Give ownership of reorganized company to creditors whose debts cancelled • How do you prove this will work?

47. Other Disclosures General Disclosure: Passenger Revenue Projections: Aircraft Fuel Cost Projections:

48. SportsGoodStop - Case

49. KPMG Study 1% of the firms reviewed hit their forecast exactly 22% came within five percent either way On average forecasts were out by 13%

50. Thank you Questions?