ACCT6101 Session #1: Introduction to Valuation
PART 1 Background
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ACCT7106 Session #8: Accounting / Earnings Quality
overarching objective:
to conduct the fundamental valuation exercise for the purpose of estimating the intrinsic value of a firms common shares
requires an understanding of the firms value drivers
need to accumulate a tool kit as the basis for developing the pro forma Financial Statements
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projected over the forecast horizon
core inputs into the valuation modelxg
Balance Sheet (B/S)
Income Statement (I/S)
Statement of Cash Flows (SCF)
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STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
Figure 1.1Lundholm & Sloan, Framework for Equity Valuation
Sessions #3 #10
Sessions #10 #12
Sessions #1 #3; #12 #13
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external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory
Industry dynamics
Porters five forces
(suppliers, buyers, new entrants, substitutes, rivalry)
Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality ** Session #8
ratio analysisSessions #9 & #10
analysts reports
management forecasts
financial press
???
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Financial Statements AASB 101:
Balance Sheet
Income Statement and/or Statement of Comprehensive Income
Statement of Changes in Equity
Statement of Cash Flows
Notes to the financial statements
building blocks definitions specific to accounting
accounting principles AASB / IFRS rules to guide accounting decisions/choices
recognition (item to F/S) versus disclosure (notes)
accountability & stewardship
accountabilitypreservation by management of the resources entrusted to them
stewardship efficient use by management of resources entrusted to them (earning a return)
articulationFinancial Statements constitute an integrated system
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beginning stock
Beginning Balance Sheet
Cash
+ Other assets
= Total Assets
Liabilities
= Shareholders Equity (BVt-1)
Statement of Changes in S/E
Cash from operations
+ Net Income & OCI
= Net Change in S/E
Cash Flow Statement
Cash from operations
+ Cash from investing
+ Cash from financing
= Net change in cash
Income Statement
Revenue
Expenses
= Net Income (NPAT)
Ending Balance Sheet
Cash
+ Other assets
= Total Assets
Liabilities
= Shareholders Equity (BVt)
flows
ending stock
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Objectives:
separate operating activities from financing activities
Operations: buying and selling goods and services
Financing: the companys use of debt and equity to finance its operations, as well as the companys investment in financial assets
Why? industrial companies generate value from their operations, not from their financial activities
alter several accounting classifications
for the Income Statement, separate revenues and expenses based on their driver (sales volume or other), and whether they are recurring or non-recurring
for Statement of Cash Flows, separate operating from financing activities; determine free cash flows operations-related cash flows split by operating versus investing; and separate equity and debt financing cash flows
Reformulation
PART 2 Accounting Quality & Earnings Management
Definition:earnings management
choices by management to influence earnings in a systematic direction
strategic (intentional) choice
Conceptual foundation commonly argued that reported earnings serve as:
a measure of the past and current operating profitability of a firm
a principal variable in valuing a firms common stock
Definition:earnings quality
a firms reported earnings number is said to be of high quality if it accurately and reliably measures current economic value-added and is a good predictor of economic value likely to be added in the future
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reasons why the link between reported earnings and economic value-added may not be clean:
1. the sustainability issue
inclusion of non-recurring items in reported income
2. the earnings measurement issue
inadequacy of accounting systems to accurately and reliably measure economic value-add
3. the earnings management issue
the opportunity (and incentive) for management to manage the level or trend of reported earnings to its advantage
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Mechanisms available to manage earnings:
accounting-based: selection and/or application of accounting principles within GAAP
e.g., choice of depreciation method (straight-line versus accelerated)
estimating the useful life & salvage value for non-current assets
real activities managementbusiness strategy / operations
e.g.,timing of discretionary expenditures (R&D, advertising, maintenance)
timing of acquisitions & disposals (gain/loss)
The decision to manage earnings:
reasons cited as to why management might wish to manage earnings include:
share price; compensation; job security; reduce perceived risk by smoothing
reasons cited as to why management may decide not to manage earnings include:
earnings and cash flow ultimately coincide; capital markets penalise firms
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Constraints on management behaviour (relating to accounting-based EM):
securities regulators and stock exchange requirements and monitoring
independent audit of the financial statements
financial analysts typically have a sense of the reporting personalities of various firms
the frequency, timeliness, and quality of managements communications serve as signals of the forthrightness of management and the likelihood of earnings being managed
since earnings and cash flows must ultimately coincide, earnings can not be managed forever
analysts (and investors) must understand the GAAP that adapt to earnings management so that they can separate economic value-added from cosmetic (i.e., earnings managed) value-added
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Healy and Wahlen
a central question for standard setters and regulators is to decide how much judgment to allow management to exercise in financial reporting
ideally, financial reporting helps the best-performing firms to distinguish themselves from poor performers, and facilitates efficient resource allocation and stewardship
accounting standards add value if they enable financial statements to effectively portray differences in firms economic positions and performance in a timely and credible manner
if accounting policy choice and implementation can be employed to signal firm quality
i.e., managers can then use their knowledge about the business and its opportunities to select reporting methods, estimates, and disclosures that match the firms business economics, potentially increasing the value of accounting as a form of communication
however, because auditing is imperfect, managements use of judgment also creates the opportunities for earnings management
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Healy and Wahlen, 1999. A review of the earnings management literature and its implications for standard setting, Accounting Horizons, 13(4), 365-383
excerpt from Notes to Financial Statements
DeltaAll of the companys flight equipment is being depreciated on a straight-line basis to residual value (10% of cost) over a 15-year period from dates placed in service.
Pan AmOperating property and equipment is depreciated to estimated residual value (15% of cost) on a straight-line basis over the estimated useful lives of the equipment, typically 25 years.
Are these policy choices:defensible (e.g., auditor)?
rational / reasonable?
informative?
** Depn Policy for Delta and Pan Am (1988) **
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hypothetical illustration
1 January, 2010, each firm purchases a new Boeing 777 aircraft at a cost of $100 million
each company sells the aircraft for $35 million on December 31, 2019
Based on this assumed information and each companys stated depreciation policy:
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Calculations: DeltaPan Am
Original cost100,000,000100,000,000
Residual value (10% / 15%)(10,000,000)(15,000,000)
Amount to depreciate 90,000,000 85,000,000
Estimated life15 years25 years
Depreciation (2010 2019) 6,000,000 3,400,000
Net Book Value (31/12/19)40,000,000 66,000,000
Sales proceeds (31/12/19)35,000,000 35,000,000
Loss (to 2019 I/S) (5,000,000)(31,000,000)
Are these policy choices:
defensible (e.g., auditor)?rational?informative?
operating statisticsDeltaPan Am
Operating inc (loss)497,054(84,183)
Net income (loss)306,826(118,254)
Accounting choiceshorter life (15 years)
lower residual (10%)longer life (25 years)
higher residual (15%)
currently affordable?
signal of future profitability?higher depn chargelower depn charge
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ongoing debate rules-based versus principles-based
rules-based
accounting standards prescribe in detail exactly how to account for various items and situations without providing discretion
more limited scope for earnings management type behaviour BUT also limited opportunity for management to use accounting policy choice as a means of communication
principles-based
accounting standards provide guidance on how various items and situations should be accounted for, but also provide flexibility for management to exercise judgement within the spirit of the guidance
more opportunity for management to use accounting policy choice as a means of communication BUT also increased scope for earnings management type behaviour
debate about trade-offs between costs and benefits of allowing discretion
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Graham, Harvey, Rajgopal
survey CFOs of both public and private companies
focus on the factors that drive choices related to reporting accounting numbers
basic questions:
do managers care about earnings benchmarks or earnings trends?
if so, which benchmarks are perceived to be important?
what factors motivate firms to exercise discretion, and even sacrifice economic value, to manage reported earnings?
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Graham, J., C. Harvey, and S. Rajgopal, 2005. The economic implications of corporate financial reporting, Journal of Accounting and Economics, 40, 3-73
PART 3 Academic Evidence
1. earnings vs. cash flow CFOs believe that earnings and not cash flows, are the key metric
2. earnings benchmarks CFOs treat same quarter last year EPS and consensus analyst forecast as the most important benchmarks hitting benchmarks builds credibility and enhances share price
3. why focus on benchmarks benefits and consequences
benefits credibility with capital markets, reputation of management, portrays stability
consequences uncertainty, possibility of unknown problems, time required to explain
4. actions taken to meet benchmarks CFOs express a strong preference towards real activities manipulation over GAAP management while auditors can second-guess accounting policies, they cannot readily challenge real economic actions to meet earnings targets; important to assure stakeholders that there is no accounting-based earnings management in their books
5. voluntary disclosure:benefits reputation for transparent & accurate reporting; reduce information risk
constraints setting a precedent; revealing proprietary information
willing to sacrifice economic value to meet earnings targets; also a clear tension between short-term and long-term objectives of the firm
sacrifice of value perceived to be the lesser of two evils (relative to short-term turmoil in debt and equity markets)
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why voluntarily disclose?
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constraints on voluntary disclosure?
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bad news vs good news? no real evidence of an asymmetry in terms of the timing of the disclosure of good and bad news argued that both need to be disclosed to build credibility with the market; better that news come from the firm rather than from outside sources
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Burgstahler and Dichev
do managers manage earnings to avoid reporting earnings decreases and losses?
conclusions:
approximately 8% 12% of firms with small pre-managed earnings decreases exercise discretion to report increases
approximately 30% 44% of firms with slightly negative pre-managed earnings exercise discretion to report positive earnings
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Burgstahler, D. and I. Dichev, 1997. Earnings management to avoid earnings decreases and losses, Journal of Accounting and Economics, 24, 99-126
figure 1: histogram of scaled earnings changes with an irregularity near zero
consistent with earnings management to avoid decreases
figure 3: histogram of scaled earnings with an irregularity near zero
consistent with earnings management to avoid losses
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Roychowdhury
the management of operational activities to avoid losses
real activities manipulation management actions that deviate from normal business practices, undertaken with the primary objective of meeting certain earnings thresholds
focus on three specific manipulation methods:
sales manipulation (increased price discounts, more lenient credit terms)
reduction of discretionary expenditures (R&D, advertising, maintenance)
overproduction (to report lower COGS)
focus on suspect firm-yearsnet income just right of zero
findings:abnormal CFO unusually low for suspect firm-years
abnormal discretionary expenditures unusually low for suspect firm-years
abnormal production costs (% of sales) unusually high for suspect firm-years
documents evidence consistent with real activities manipulation around earnings thresholds commonly discussed in the literature, in particular, the zero threshold
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Roychowdhury, S., 2006. Earnings management through real activities manipulation, Journal of Accounting and Economics, 42(3), 335-370
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Dichev, I.. J. Graham, C. Harvey & S. Rajgopal, 2013. Earnings quality: Evidence from the field. Journal of Accounting and Economics, 56(2-3), 1-33
Dichev, Graham, Harvey, Rajgopal
survey of 169 CFOs of public companies and in-depth interviews of 12 CFOs and two standard setter
believe earnings management is quite common (T10 18.3% of earnings are managed)
believe that when EM occurs, it is a big problem (T11 almost 10% of earnings figure)
greatest incentives to influence stock price; pressure to hit earnings benchmarks; to influence compensation
common red flags disconnect between earnings and cash flow; deviations from industry norms; consistently meet or beat earnings targets; large/frequent one-time items; significant accruals and changes in accruals
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Table 13
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Table 14
PART 4 Methodological Issue Detection / Measurement of EM
there are a number of methodological challenges or issues associated with the detection of earnings management (irrespective of whether undertaken cosmetically through the financial statements or alternatively through real operating decisions)
Why?management has a strong incentive to hide the earnings management
Approaches to detection
Academic studieslarge samplestatistical power
Regulatory (enforcement)/ Investingcase study red flag required
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The 3 basic questions that frame the notion of power to detect are the following:
Where is it most profitable to look?
under what set of circumstances is earnings management activity most likely to occur?
which firms are the most suspicious (in the most suspicious circumstances)?
what are managements incentives? (earnings targets? contractual obligations? compensation?)
i.e., small positive earnings; small earnings increases; earnings volatility (smooth earnings)
2. What should be examined?
what should the search focus on? what lever is management most likely to utilize to accomplish the earnings management?
i.e., accounting (accruals); real activities
3. How should the investigation be conducted? technique(s)?
**** our focus accounting statements (especially Income Statement) accruals ****
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Basic Steps in the Analysis of Accounting Quality
1. Identify key accounting policiese.g., revenue recognition; depreciation policies for airlines
2. Assess accounting flexibilitye.g., expected default on bank loans
3. Evaluate accounting strategy
compare with industry practise
analyse managers incentives
examine changes in accounting policies
assess accounting policies and estimates
investigate unusual transactions
4. Evaluate disclosure qualityi.e., sufficient and clear information
5. Identify potential red flagssee Penman Table 18.1, Figure 18.2 (reproduced below)
accruals and cash flows
financing activities
financial market pressure
6. Undo accounting distortions
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Why accruals as the lever?
recall from the reformulation process (Session #6, slide 53)
OI (after tax) = NOA FCF
FCF is difficult to manipulate it involves relatively few assumptions/estimates; cash flow is generally easier to audit/verify
NOA involves accruals and hence judgement & estimates
usually where earnings management (EM) takes place
if accrual-based earnings management is taking place, it should be reflected in abnormal changes in NOA (i.e., beyond normal growth)
diagnostics to discriminate between growth-related changes and EM
notes:accruals affect both earnings and NOA
accruals reverse over time a company cannot inflate its earnings forever using accruals (accrual-based earnings management is like borrowing earnings from the future)
To illustrate return to the data underlying the Delta / Pan Am example
residual value estimate 10% versus 15%
useful life estimate 15 years versus 25 years
assume
XYZ Airlines Ltd purchased a new Boeing 787 for $200 million on 31/12/20; XYZs tax rate is 30%; accounting requires an impairment charge at the end of 2025
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YearDepreciation
(10%, 15 years)Depreciation
(15%, 25 years)Difference in Operating Income (after tax) Difference in NOADifference in S/E
202112,000,0006,800,0003,640,0005,200,0003,640,000
202212,000,0006,800,0003,640,00010,400,0007,280,000
202312,000,0006,800,0003,640,00015,600,00010,920,000
202412,000,0006,800,0003,640,00020,800,00014,560,000
202512,000,0006,800,0003,640,00026,000,00018,200,000
Impairment charge to return to appropriate balance (based on 10% & 15 years)
2025Impairment charge = 26,000,00018,200,00000
Further illustration provision for doubtful debts
$100,000 in credit sales in Year 1; collected in Year 2; no sales in Year 2
true expected bad debt = 10%company understates the amount as 5% (i.e., EM)
true bad debt realised in second year when customers do not pay
OI overstated in Year 1 (due to EM); understated in Year 2 (due to reversal of EM)
NOA overstated in Year 1 (due to EM)
OI over the 2-year period is the same ($90,000)
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YearCorrect AccountingWith Earnings Management
NOA
(A/R provision)OI (component)
(sales bad debt exp)NOA
(A/R provision)OI (component)
(sales bad debt exp)
190,000 (= 100 10)90,000 (= 100 10)95,000 (= 100 5)95,000 (= 100 5)
2000-5,000
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Returning to the relation
OI (after tax) = NOA FCF
recall NOA = OA OL
earnings can be inflated by increasing OA and/or by decreasing OL
Overview Penman: Table 18.1, Figure 18.2(pages 599 602)
focus management (manipulation) of accounting reports for the purposes of increasing income
summary of how specific Balance Sheet items can be managed to increase income
accounts most likely manipulated across different industry sectors
summary of situations when manipulation is more likely
diagnostic template to facilitate detection of operating income manipulation
PART 5 Diagnostic Approach to Detecting Earnings Management
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Sensitive areas prone to manipulation
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Situations where manipulation is more likely
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Penman Figure 18.2 Diagnostics to Detect Manipulation of Operating Income
Step #1 investigate the quality of sales revenue
Step #2 investigate the quality of core expenses
Step #3 investigate unusual items
Step #1
note much of the investigation will involve ratios (value of one account(s) relative to value of another account(s))
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Step #2
Step #3
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PART 6 Worked Example
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Reformulated Balance Sheet (assuming operating cash = $28 million each year)
19841985198619871988
OA
Operatingcash2828282828
Acc receivable8,55111,71914,40227,80151,076
Inventory11,1096,3259,76219,57739,135
Other1,1242,2502,5922,5615,496
PPE (net)17,21917,18216,38314,78821,548
Total38,03137,50443,16764,755117,283
OL
Acc payable3,0824,7247,34415,07213,288
Accrued liab3,8003,0913,1275,4684,710
Taxes payable2,3491,1451,5542,6193,782
Deferred tax liability01186851,2541,881
Total9,2319,07812,71024,41323,661
NOA28,80028,42630,45740,34293,622
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Diagnostics
19841985198619871988
NOA28,80028,42630,45740,34293,622
NOA -3742,0319,88553,280
% NOA -1.30%7.14%32.46%132.07%
Sales67,65476,144128,234181,123
Sales 8,49052,09052,889
% Sales 12.55%68.41%41.24%
Asset turnover (ATO)
= Sales / NOA2.3802.5003.1791.935
normal ATO = ave 1985 1987 = 2.6862
normal NOA = Sales / normal ATO19,391.4019,668.84
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Diagnostics
19841985198619871988
NOA28,80028,42630,45740,34293,622
NOA -3742,0319,88553,280
% NOA -1.30%7.14%32.46%132.07%
Sales67,65476,144128,234181,123
Sales 8,49052,09052,889
% Sales 12.55%68.41%41.24%
Asset turnover (ATO)
= Sales / NOA2.3802.5003.1791.935
normal ATO = ave 1985 1987 = 2.6862
normal NOA = Sales / normal ATO19,391.4019,668.84
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In sum:
while sales growth is similar in 1987 and 1988, NOA increased dramatically in 1988, but not in 1987
actual change in NOA is much larger than normal change in NOA in 1988
suggests that accrual-based earnings management might be a problem
Next step:are there patterns withinany of the OA and OL accounts that suggestive of earnings management (EM) behaviour?
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Diagnostics (cont)
1985198619871988
A/R Turnover = Sales / A/R5.7735.2874.6133.546
Inventory Turnover = Sales / Inventory10.6967.8006.5504.628
pp&e Turnover = Sales / pp&e3.9374.6488.6718.406
A/P Turnover = Sales/Accounts receivable14.32110.3688.50813.631
Accrued Liab Turnover =Accrued Liab21.88724.35023.45238.455
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The increase in NOA in 1988 is mainly due to:
large increase in Accounts Receivable (decrease in receivables turnover)
Is provision for doubtful debts understated?
Have adequate provisions been made for sales returns?
large increase in Inventory (decrease in inventories turnover)
Is the company struggling to sell its inventory?
Is inventory overvalued? Should it be written down?
sudden build-up in Other assets
decrease in Accounts Payable: why would it decrease, despite increasing sales?
decrease in Accrued Liabilities: why would it decrease, despite increasing sales?
These appear to be suspicious changes that are consistent with earnings management (EM)
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any change in NOA that is different than what you might expect should be investigated
it could be okay (defensible / normal)
extra investment in long-term OAs, such as pp&e or intangibles
normal growth in short-term OAs, such as A/R and Inventory because of sales growth
normal decline in OLs due to changes in operating model or better efficiency
acquisition of another business
it could be a problem (the result of earnings management activity)
aggressive accrual estimates, resulting in overstated/understated NOA
look for unusual build-up in accrual accounts, such as A/R, inventory, etc.
***the identification of statements materially affected by earnings management activity is critical when deciding whether to rely on the reported financial statements as a basis for developing forecasts of the firms future financial performance (i.e., its pro forma financial statements)
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To re-iterate,
Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers. (Healy & Wahlen, 1999)
most earnings management is initiated by the senior management (e.g., CEO, CFO)
why do managers (e.g. CEO, CFO) engage in earnings management? two basic drivers (Healy and Wahlen):
Valuation: an attempt to mislead investors (shareholders) into believing that the company is performing better, or is less risky, than it would appear without the earnings management in hopes of achieving a higher share price
Contracting: an attempt to manipulate a contractual outcome that depends on accounting numbers, most typically compensation contracting (incentive bonuses based on accounting figures) and debt contracting (covenants based on accounting numbers)
PART 7 Fair Value
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Major types of earnings management:
Manipulation of accrual estimates, e.g., underestimate Provision for Doubtful Debts; underestimate Provision for Warranty Expenses
Manipulation of accounting policies, e.g., changing depreciation method to one that involves a lower expense; changing from cost to fair value method for an asset that has increased in value
Manipulation of fair value estimates, e.g., overestimating fair value of an investment
Changing the timing of transactions, e.g., delaying spending on R&D or advertising until the next year
Transaction structuring: complex forms of earnings management that usually exploit loopholes in accounting rules by entering specially designed transactions
Earnings management activity is restricted by:
external auditor (note only provide reasonable assurance)
internal auditor ( but can be pressured)
regulation and regulators (including fines, shareholder lawsuits, and imprisonment)
board of directors oversight (governance)
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Finally, the possibility of manipulating fair value (FV) estimates:
under AASB / IFRS, there are two measurement methods historical cost & fair value
historical cost is typically viewed as more reliable but less relevant
with historical cost, the two accounting quality concerns are depreciation and impairment
fair value defined under AASB 13 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
the reliability of a fair value measure depends primarily on how it is determined
the estimate (and thereby its integrity) will also affect NPAT or CI (depending on whether the change in FV is recorded in the I/S or in OCI)
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AASB 13 (IFRS 13) defines three levels of fair value from most to least reliable:
Level1inputsarequotedprices(unadjusted)inactivemarketsforidenticalassetsorliabilitiesthatthe entity can access at the measurement date.
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. (i.e., quoted prices for similar assets or liabilities in active markets)
Level 3 inputs are unobservable inputs for the asset or liability (i.e., internal estimates)
**clearly, Level 3 fair values are to ones that should be viewed with the greatest scepticism
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Illustration Harvey Normans financial assets and liabilities (Levels 1 and 2 )
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Illustration (cont) Harvey Normans property holdings
Harvey Normans property holdings are measured at fair value and recognised through profit and loss under AASB 140 Investment Property
key concern what is the quality of these fair value estimates? As revealed through Note 15, the revaluations are Level 3 internal estimates
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Ernst & Youngs audit report included the following Key Audit Matter:
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key concern what is the quality of these fair value estimates?
they are all Level 3 fair values fair values are based on internal estimates, rather than observable market prices
Harvey Norman does use an independent valuation expert (unnamed?) to check the valuations.
the independent valuer checks the valuation of each property at least once every three years.
the auditor (EY) has also randomly checks valuations and discusses the issue as a key audit matter
Interpretation of the reliability of these estimates is ultimately a matter of judgement !!
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overarching objective:
to conduct fundamental value for the purpose of estimating the intrinsic value of a firms common shares
requires an understanding of the firms value drivers
need to accumulate a tool kit as the basis for developing the pro forma Financial Statements
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
PART 8 Summary: Sessions #1 #6
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external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory
Industry dynamics
Porters five forces
(suppliers, buyers, new entrants, substitutes, rivalry)
Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality
ratio analysis ** Sessions #9 & #10
analysts reports
management forecasts
financial press
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