Presentation Transcript

1. Creating Competitive Advantage

   Financial Reporting Strategies and Measurement
2. Outline of Our Prior Session Reviewed fundamentals of financial accounting adopted users’ perspective Measurement of profitability and risk understanding financial statement impact of key accounting choices inventory depreciation research and development consolidations In what industries will these choices be important?
3. Outline of This Session Adjusting financials for more informed analysis continue external user focus don’t overlook implications for internal analysis don’t believe and act on financial fiction e.g., smoothing
4. Quick Review The accounting system captures transactions and other events Provides information to users internal (Frank’s sessions) for planning and control external (financial reporting) for investment analysis balance sheet reports resources and outsiders’ claims against them income statement reports operating changes in resources and claims
5. External Users’ Perspective Historical performance measurement profitability (DuPont Model) ROA profit margin asset turnover ROE ROA financial leverage risk solvency risk operating leverage financial leverage
6. The Big Challenge of Analysis Predicting future performance (vs. measuring current performance) evaluate the components of GAAP income permanent earnings (recurring, persistent) transitory earnings
7. Finding the Nonrecurring (Transitory) Earnings Sales -Cost of goods sold Gross profit - Operating expenses Income from operations + Other revenues/gains - Other expenses/losses Income before taxes - Income tax expense Net Income
8. Finding the Nonrecurring (Transitory) Earnings Sales -Cost of goods sold Gross profit - Operating expenses Income from operations + Other revenues/gains - Other expenses/losses Income before taxes - Income tax expense Net Income
9. Nonrecurring Earnings Other Revenue/Gains gains from peripheral activities (e.g., the sale of PP&E, investments) Other Expenses/Losses losses from peripheral activities (e.g., the sale of PP&E, investments) restructuring charges impairment losses Q7-9
10. Other Sources of Nonrecurring Earnings Sales -Cost of goods sold Gross profit - Operating expenses Income from operations + Other revenues/gains - Other expenses/losses Income before taxes - Income tax expense Income before …
11. Special Income Statement Items Discontinued Operations Extraordinary Items Both are nonrecurring--by their very definition
12. Another Challenge of Analysis Financial Statements tell us… only part of the story accounting standards provide opportunities for managing income (smoothing, etc.) off-balance sheet financing (OBSF) do managers exploit this situation?
13. Psychology of Reporting Management’s natural desire to cast things in a favorable light management vs. manipulation why we have GAAP audits millennium scandals why we now have Sarbanes/Oxley Act 404 PCAOB
14. An Economic Explanation Why is it so? agency theory Q3.6 Q1.13
15. The Big Issue Why does GAAP permit managers to make self-serving choices? WYWAP PEAP POOP
16. Not GAAP but… Politically Expedient Accounting Principles Concessions, concessions, concessions! for preparers and auditors ‘to customize reporting to best reflect circumstances’ ‘to control reporting costs’ ‘mitigate audit risk’ Whatever You Want Accounting Principles GAAP has a long history of allowing choices FIFO/LIFO Accelerated/St. line supply-side thinking
17. Not GAAP but… Pitifully Old and Obsolete Principles Many old standards still around: Treasury stock (1934) – Stock splits (1941) Depreciation (1946) – Inventory (1947) – LT contracts (1955) – Quarterly reporting (1934)
18. A Case Study—Stock Options Could as easily be pensions cash flows investments business combinations foreign currency translation derivatives etc.
19. Brief History of Stock Options marketexerciseintrinsic $20 $25 1972 APB Opinion 25 issued stock options measured at intrinsic value 0 $40 $35 5 no effect on earnings in typical form option price = market price at grant date 1982 Stock options growing in popularity FASB asked by AICPA to reexamine accounting
20. Brief History of Stock Options 1984 FASB adds project to agenda releases Invitation to Comment discussing expensing generates more than 100 letters, all opposing 1985-88 FASB deliberates but is unable to resolve measurement issues added issues to broader conceptual project
21. Brief History of Stock Options 1992 Growing media interest in excessive executive compensation FASB adds options to agenda again urged to do so by Big 4 CPA firms and SEC 1993 FASB issued exposure draft requiring expensing substantial opposition in corporate sector 1786 comment letters received (1000+ form letters) six days of public hearings (73 presenters) two ‘Sense of the Senate’ resolutions
22. Sense of the Senate Resolution 1 “It is the sense of the Senate that the status of FASB as a private body of independent accounting experts should be respected and safeguarded; and Congress should not impair the objectivity or integrity of the FASB’s decisionmaking process by legislating accounting rules.” (94-2 vote)
23. Sense of the Senate Resolution 2 “The FASB proposal on stock options had generated opposition which is unprecedented in both its intensity and universality and it is the sense of the Senate that the proposal will have grave economic consequences particularly for businesses in new-growth sectors; the new accounting treatment will diminish rather than expand broad-based employee stock option plans; FASB should not at this time change the accounting treatment for stock options.” (88-9 vote)
24. Expensing Backlash “I fear that existing proposals for expensing options will result in very few options being issued, thereby limiting the kind of risk-taking and reward-sharing that has made companies like Schwab, Intel, Pepsi and Wells Fargo (to name a few) such great places to build careers.” David Pottruck CEO Charles Schwab Corp.
25. Brief History of Stock Options 1995 FASB issues SFAS 123 caved to pressure expensing preferred but not required APB 25 treatment allowed with disclosure of expense “the debate on accounting for stock-based compensation became so divisive that it threatened the Board’s future working relationship with some of its constituents. Eventually, the nature of the debate threatened the future of accounting standard setting in the private sector.” SFAS 123, para. 60
26. A Brief History of Stock Option Accounting 2002 a growing number of companies begin expensing options why?
27. A Brief History of Stock Option Accounting 2003 FASB adds options to agenda coordinates project with IASB 2004 FASB issues exposure draft including required expensing several limiting bills introduced in the House of Representatives no action in Senate
28. A Brief History of Stock Option Accounting 2005 FASB issues 123R requires expensing for beginning in FYE 2006 Many companies begin moving away from options to restricted stock awards why?
29. Another Perspective on Options David Pottruck is probably right options use will decline Evidence shows executives discount options value (30-50% of Black Scholes) explained by economics theory risk averse poorly diversified market value = $10 (Black and Scholes) stock option Q11.9 Is this a bad thing?
30. My Mantra What you measure, you manage What you don’t measure…
31. Overcoming GAAP Limitations Standard setting is slow and ineffective fixing up poor measurements falls on users major problem areas investments (smoothing) leases (OBSF) retirement benefits (smoothing)
32. Accounting for Corporate Investments in Stocks and Bonds Small* investments placed into one of three portfolios trading available-for-sale held-to-maturity B/S--marked-to-market with Δ to I/S B/S--marked-to-market with Δ to AOCI B/S--historical cost
33. E8.17 Q8.1
34. Fixing Up the Investments in Stocks and Bonds Trading portfolio is OK balance sheet reflects mark-to-market gains/losses flow directly to income
35. Fixing Up the Investments in Stocks and Bonds Adjust the other two portfolios for available for sale balance sheet ok—already marked to market income statement move gain/loss from AOCI to net income for held to maturity balance sheet mark investments to market (reported at cost) income statement report change in value on I/S as gain/loss In what industries will this be an important issue?
36. Leasing Fixed Assets Q9.7
37. Leasing as Off-Balance-Sheet Financing Financial Statement Variations capital lease lessee treats lease as an asset purchase (transfer of risks, rights, rewards) required treatment when lease covers most of asset’s life operating lease lessee treats lease as a simple rental agreement required treatment when lease term is short (in relation to asset’s life) In what industries will this be an important issue? THE KEY POINT: Even operating leases stipulate noncancellable future lease payments
38. Fixing the Operating Leases On the balance sheet adjust by adding the value of the future minimum lease payments to long-term assets and long-term liabilities income statement replace rent expense with depreciation expense interest expense Use the schedule of minimum lease payments from the footnotes
39. E9.24
40. Retirement Benefit Plans as Off-Balance-Sheet Financing Types of Plans pension benefits other (OPEB) health insurance benefits life insurance benefits tuition assistance dependent care
41. Pension Plans Defined contribution plans (most BSU faculty) company recognizes expense when contributions made no remaining obligation (risk) after contribution Defined benefit plans (PERSI) benefit formula benefit =.02 x years of service x salary (per mo)
42. Defined Benefit Pensions Terminology Projected Benefit Obligation (PBO) present value of expected future benefits already earned by employees (including salary progression) Plan Assets assets set aside in trust to pay future benefits
43. Defined Benefit Pensions Adjustments Full difference between PBO and plan assets should be reported as an asset--if plan assets > PBO (overfunded) a liability--if plan assets < PBO (underfunded) A tradition of poor reporting reported amounts ≠ real economic amounts SFAS 158 has fixed balance sheets… but not income statement expense still lots of smoothing In what industries will this be an important issue?
44. Q10.7 Q10.3
45. Defined Benefit Pensions Adjustments (continued) Balance sheet ok Income statement adjustments remove artifacts of smoothing expected vs. actual return on assets deferral of gains/losses on liabilities all amortization (prior service cost, initial obligation, actuarial gains/losses) put in full amounts of new actuarial gains and losses
46. HP’s Pensions Plan assets = 10.6% of total assets PBO = 13.1% of total assets
47. HP’s Pensions Expense 10/31/12 expense actual return -1,411 1,327 actuarial loss 1,4792,143 adj. expense 1,4791,803 expense difference +2,239 (18% of the net income of $12,650)
48. Other Post-Employment Benefits (OPEB) Accounting (in concept) similar to pensions Some practical differences unfunded plans (pay-as-you-go) step function benefit increases common 10 years of service 25% of premium cost 20 years of service 50% of premium cost 25 years of service 70% of premiums cost
49. OPEB Terminology Accumulated Postretirement Benefit Obligation (APBO) PV of future promised benefits like PBO for pensions Requires adjustment similar to that made for pensions balance sheet is ok income statement needs adjusting In what industries will this be an important issue?
50. HP’s OPEB Expense 10/31/12 expense actual return -36 actuarial loss 34 adj. OPEB expense 237 expense difference +118 (0.1% of the net income of $12,650)
51. Financial Reporting Model is Broken Need a systemic change will the current economic turmoil bring it about? What might it look like? a potential competitive advantage
52. The QFR Solution Demand driven reporting voluntarily giving users what they want motivation comes from existing economic incentives (not ethics) four axioms
53. The Four Axioms Incomplete information leads to uncertainty Uncertainty leads to risk Risk leads to demand for high rate of return A high rate of return leads to a high cost of capital and a low stock price So, what should you do if you want a higher stock price?
54. High Quality Reporting = Lower Cost of Capital Evidence Lots of supporting evidence Welker, Disclosure Policy, “Information Asymmetry and Liquidity in Equity Markets,” Contemporary Accounting Research, Spring 1995. Lang & Lundholm, “Corporate Disclosure Policy and Analyst Behavior,” The Accounting Review, Oct. 1996. Botosan, “Disclosure Level and the Cost of Equity Capital,” The Accounting Review, July 1997. Sengupta, “Corporate Disclosure Quality and the Cost of Debt.” The Accounting Review, Oct. 1998.
55. This is not rocket science!

56. The Four Markets

    QFR as comparable to HRM, TQM, and JIT
57. HRM thinking Labor Customers The Firm Capital Markets Supply Chain 59
58. QFR thinking Labor Customers The Firm Supply Chain Capital Markets 60
59. QFR as a Solution We think it is natural evolution in thinking we’re just ahead of the curve Treat the capital markets like you would your product market figure out what users want and supply it VOLUNTARILY

60. Demand Driven Reporting

61. Free your mind--innovate no formula or recipe for QFR what is it that users want to know? provide it Demand Driven Reporting
62. Our book identifies important information deficiencies for: investments inventory stock options pensions leases PP&E intangibles business combinations Supplemental Disclosures
63. The Point The whole point of QFR is to go overboard voluntarily to ensure that the capital markets are satisfied close relationship built on trust reduce uncertainty and risk reduce cost of capital increase security prices A way for the “good guys” to stand apart
64. Looking Ahead QFR presents a huge competitive advantage advantage to those managers and accountants who can see the economic payoff from TELLING THE TRUTH