Acctg 371 Notes

ACCTG 371 MODULE 1: FRAMEWORK FOR FINANCIAL STATEMENT ANALYSIS & VALUATION Valuing assets & equity securities (ordinary shares) LO: Users & suppliers of F/S info; 4 F/S & acctg equation; business analysis in context of competitive environment; profitability analysis; acctg principles & regulations framing F/S Berkshire Hathaway’s Acquisition Criteria (investment company) 1. large purchases (& pretax earnings) 2. consistent earning power (future projection irrelevant, neither are ‘turnarounds’); good cash flows (affects SPrice = net worth of firm for investors) 3. business earning good returns on equity while employing little/no debt 4. management in place (we cannot supply) 5. simple businesses (not many technologies) 6. an offering price Financial Statement Analysis & Valuation 1. F/S Analysis: process of extracting info from F/S to better understand company’s current & future performance & financial condition 2. Valuation: process of drawing on results of analysis to estimate company’s value/worth (of debt or equity securities = value of firm’s total assets)

Step 2: fin. performance & resultant financial position/condition. Step 3: future predicted performance Step 4: present value total assets (debt + equity securities) or net worth (value of equity securities/shares) = decision of investing

Step 1: Business Environment & Accounting Information Firm’s business activities: financing, investing, operating Business forces impact how well firm performs activities: market constraints & competitive pressures impacting firm. To reduce their adverse effects, firms prepare business plans to achieve goals & identify when corrective actions needed. Source of info for bus. plans arise from prior & current F/S. Understanding BP helps analyst focus F/S analysis by placing analysis in proper context: appropriately assess fin. perf. & position given env. firm operates in. In order to understand bus. env. & acctg info business operates in, demand for fin. acctg. info. is created,

Financial Accounting Information: Demand & Supply -

managers & employees investment analysts & info intermediaries shareholders, directors customers, strategic partners regulators, tax agencies voters & their representatives

Demand due to variety of reasons (amount of dividends firm pays, make policies/regulations, lending decisions). Firms present general purpose F/S to satisfy demand from users. Supply of Acctg Info (quantity & quality provided): -

determined by managers & regulators (setting minimum disclosures) primary SEC (security & exchange) annual report filing requirements (form 10-K annual, 10-Q quarterly). NZ: annual reports to companies office benefits of disclosure: lower costs of funds (good prospects reflected by acctg info; investors more willing to invest at decreased cost of capital; lower interest charged by creditors due to perceived lower risk) & labour,

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economic benefits form reliable disclosures (unqualified opinion from auditors; users place higher value on firm as info verified; reduces info uncertainty) costs of disclosure: preparation & dissemination (production costs), competitive disadvantages (due to disclosure, info is proprietary), litigation potential (info used against firm; financial expectations not upheld, potential civil lawsuits), adverse political costs (affects value)

International Acctg Standards & Convergence International Acctg Standards Board (IASB) oversees development of acctg standards for countries outside US & regulates supply fin. info. FASB (USA) & IASB: development high-quality, compatible acctg standards used for both domestic & cross-border financial reporting (GAAP to converge with IFRS) a) make existing financial reporting standards fully compatible b) coordinate future work programs to ensure compatibility maintained. GAAP vs IFRS Both accrual acctg & similar conceptual frameworks. Both same set F/S (SOFP, SOCI, SOCF, statement of stockholders’ equity & explanatory footnotes) Differences technical in nature, do not differ on broad principles.

Accounting Equation

Balance Sheet

Investing & Financing Activities Debt: implications on riskiness Balance Sheet -

Investment-type companies (Berkshire Hathaway) & high-tech (Cisco Systems) carry high levels cash (costs of holding cash) Relative proportion short & long-term assets dictated by business models (composition of assets on SOFP in same industry similar; can deviate from industry norm by small degree)

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Trade-offs in financing company by owner vs. non-owner financing (nonowner financing less costly) Shareholders & long-term creditors influence strategic direction of company A & L reported on SOFP at acquisition price (historical cost instead of fair value)

Income Statement Operating activities: lists amounts of sales (revenues) less expenses (costs) over period of time. Sales – expenses = net income

Trends; net income as percentage of sales; factors driving success (competitive threat) -

Sale recognised when made, not when cash collected.

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When company purchases long-term asset (buildings), cost reported on SOFP as asset (not expense on SOCI). Report cost of asset over course of useful life as depreciation. Manufacturers & merchandisers report cost of product as expense when sale recorded. Using cash as base of measurement problematic for financial reporting. If asset increase in value, increase not reported as income until building sold (if record increases in asset values as part of income when measurement based on appraised value, issues arise) employees earn wages yet to be paid at end of particular period (ie. wages are accrued). Recognised as expense in period work performed, not when paid companies are not allowed to report profit on transactions relating to own stock (don’t report income when stock sold, or expense when dividends paid to shareholders)

Statement of Equity Changes in accounts that make equity: contributed & earned capital (RE + accumulated OCI); other (accumulated OCI & minority/non-controlling interest) Owner may prefer money reinvested, not received as dividends: reinvestment can drive further profit & growth.

Statement of Cash Flows Operating, investing, financing activities over period of time.

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provides cash flow info not reflected in SOCI & SOFP report net cash inflows relating to operating activities over the longer term (implications if negative for extended period of time) composition of investment activities (positive may not be favourable) sources of financing composition operating, investing, financing CF changes over firm’s life cycle bottom line increase in CF may not be key number (composition changes)

Financial Statement Linkages -

SOCI & SOFP linked via RE Berkshire: 13213mil increase in RE (SOFP) = net income (SOCI) + 28mil adjustment relating to adoption new acctg standard. No dividends paid.

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RE, contributed capital & other equity balances appear on both statement of stockholders’ equity & SOFP SOCF linked to SOCI as net income is component of operating cash flow. SOCF also linked to SOFP as change in SOFP cash account reflects net cash inflows & outflows for period.

Information Beyond F/S -

management discussion & analysis independent auditor’s report F/S footnotes regulatory filings & proxy statements

Value Chain Model Primary Inbound logistics Operations Outbound logistics Servicing

Competitive Analysis -

industry competition bargaining power buyers bargaining power suppliers threat substitution threat entry

5 Forces of Competitive Intensity

Support Firm infrastructure HR management Technology/product development Procurement

Step 2: Adjusting & Assessing Financial Info GAAP allows acceptable alternatives in preparing F/S (inventories, property, equipment) F/S depend on estimates Acctg choices make info difficult to compare companies Sarbanes-Oxley Act SEC requires CEO & CFO of company to sign statement attesting to accuracy & completeness of company’s F/S Commitments: -

both CEO & CFO personally reviewed annual report

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no untrue statements of material fact that would made statements misleading F/S fairly present in all material respects the financial condition of company all material facts disclosed to auditors & board of directors no changes to its system of internal controls are made unless properly communicated

Profitability Analysis

Profit Margin, Asset Turnover & ROA High A turnover = high profit margin Step 3: Forecasting Financial Numbers Theoretical linkage between earnings & stock prices: -

current earnings predict future future earnings may determine expected future dividends future dividends, when discounted, determine current stock price

Future Earnings & Excess Returns -

excess annual returns 10-25% for earnings increases 10-25% negative returns for earnings decreases

Step 4: Company Valuation Worth of company = current value of expected payoffs (Modules 12-14: compute value using dividends, CF, earnings as payoffs) Module 15: market-based valuation Appendix 1A: Accessing SEC filings

Appendix 1B: Oversight of Financial Accounting SEC oversees all publicly-traded companies FASB (Finacnial acctg standards board) PCAOB (public company acctg oversight board)

Audit Report F/S = management’s responsibility. Auditor responsibility: express opinion on statements Involves sampling transactions, not investigating each trans. Audit opinion provides reasonable assurance statements free of material misstatements, NOT guarantee Auditors review acctg policies used by management & estimates used in preparing statements F/S present fairly, in all material respects, a company’s financial condition, in conformity w/GAAP (unqualified opinion)

MODULE 2: BUSINESS ACTIVITIES & FINANCIAL STATEMENTS 1. 2. 3. 4.

balance sheet income statement statement of SHolder’s equity statement of cash flows

BALANCE SHEET A=L+E Uses of funds = sources of funds -

assets listed in order liquidity liabilities listed in order maturity equity = contributed capital & retained earnings

Assets Converted into cash or used up to generate revenues To be reported on SOFP, asset: 1. owned (controlled) by company 2. possess expected future economic benefits Current assets: converted into cash within a year -

cash: currency, bank deposits, investments w/original maturity