ACCT30001 Financial Accounting Theory Weekly Summary - Week 4 Lecture Page 1 of 7 Week 4 Lecture Framework - Business Analysis

Valuation objective: Need to know the intrinsic/fundamental value of the firm From investors’ point of view, maximize investors return. Strategy is to buy the shares when intrinsic value > market value (under-priced) and sell when intrinsic value < market value (overpriced). When Intrinsic value=Market value, hold the shares Financial Analysis Purpose: to evaluate current and past performance and assess its sustainability (using ratios and CF analysis) Ratio analysis: to evaluate a firm’s product market performance and financial policies in the past and project into the future Cash flow analysis: to evaluate a firm’s liquidity and financial flexibility. Prospective Analysis (ultimate goal of business analysis framework) Purpose: to estimate fundamental (intrinsic) value of a company (or share). Basis: Firm's value is a function of its future CF performance, present value theory (use discounted CF to reflect time value of money). Alternative valuation model can be abnormal earnings model or residual earning model (assessed based on current book value of equity, the future return on equity (ROE) and growth) Accounting Analysis (Earning quality Analysis) Purpose: to evaluate the degree to which a firm’s accounting captures its underlying business reality through identifying areas of accounting flexibility, evaluating appropriateness of accounting policies and estimates and ‘undo’ any apparent distortions. Financial Reporting in Capital Markets (Assumptions) In a capitalist economy, the purpose is to allocate resources from savers/investors to entrepreneurs to gain returns on investment. Effectively functioning market will effectively allocate resources. Matching savings to business investment opportunities is complicated. 1. Entrepreneurs typically have better information than savers on the value of business investment opportunities. 2. Entrepreneurs’ communication to investors is not fully credible due to incentive to misreport (use accounting discretion to give

you distorted accounting number to inflate value of the firm) 3. Savers lack the financial sophistication to differentiate among various business investment opportunities. Accounting System Features Accrual accounting is used for corporate financial reports (rather than cash accounting). It deals with expectations of the future cash consequences of current activities, not necessarily coincide with actual, cash receipt and payments. Thus, it is subjective and based on various assumptions. Ø Manager’s insider knowledge is a source of both value (good managers promotes shareholders’ interest:efficiency hypothesis

on managers’ discretion) and distortion (managers acts in self interest, even at the expense of shareholders, oppoutunistic hypothesis on managers’ discretion) in accounting data

Ø Business analysis attempts to reveal manager’s insider information from public financial statement data Evaluating accounting quality Ø Analysts use financial statement information to get behind the numbers, however, financial statement do not always provide a

complete and faithful picture of a company. During accounting analysis, it’s analyst’s task to see behind the numbers to uncover distortions and make appropriate adjustments

ACCT30001 Financial Accounting Theory Weekly Summary - Week 4 Lecture Page 2 of 7

Financial reporting filters: Two sources that distort financial data/accounting information are 1. Accounting regulations (e.g. Internally generated good will is not recognized by AASB due to conservatism, however, they have a value, the customer base, trade mark will generate economic benefit in the future, underestimate asset value, introduce noise to the true value of the firm) and 2. Management discretion (accounting choice, e.g. Depreciation method and useful life can be play around to manipulate expense and profit). Accounting analysis overview Ø Financial reporting information is noisy and biased, even in presence of accounting regulation and external auditing If potential distortions are large, accounting analysis can add considerable value by correcting distortions (value added accounting analysis is an important precondition for effective financial analysis), and the quality of financial analysis and inferences drawn depend on the quality of the underlying accounting information, the raw materials for analysis. Example of value added accounting analysis: ‘The Briloff effect’, deconstruction of financials, interpretation and understanding of alternatives companies could have taken to portrays their results and how that refected the outcome. Accounting professor Abraham Briloff, review financials and criticized misuse of accounting policies by major companies in Barron’s magazine. Once published, market get the news and abnormal return is -ve after publication. What is accounting Misconception is accounting are process of work of keeping financial accountants, book keeping, black and white. In reality, Accounting is the language of business based on economic activities, choose the values, accounting judgments/strategies/flexibility are made from shades of gray. Useful information is generated for good decision-making. Accounting is an Information business that reflect business reality. Efficient Market Hypothesis The presumption that stock prices will at all times fully reflect relevant information including past prices (weak form), publicly available information (semi-strong form) and all information (strong form). To evaluate efficiency: to see if abnormal (risk adjusted) returns can be made from exploiting the ‘inefficiency’. Technical Analysis (Chartism): the assessment of a firm’s prospects using recent/past share price movements to predict subsequent changes, use historical share price to form a pattern to predict future price movements. Fundamental Analysis: the assessment of a firm’s performance and prospects using published financial statements and possible other forms of publicly available information. Earnings management Earnings management is the process of manipulating financial statement numbers through 1. accounting adjustments(accrual based accounting), 2. real activities (real earnings management) or both. Good(accounting discretion may be good, efficient contracting to avoid costly violation of contract etc.) or bad (misreporting)

ACCT30001 Financial Accounting Theory Weekly Summary - Week 4 Lecture Page 3 of 7 Method to manipulate earnings (note that fraudulent accounting, aka fraud is not part of earnings management, earnings management are legal!!!)

Research shows firms more likely to engage in real activities earnings management (postponing R&D or advertising expenditures, accelerating sales etc) rather than accrual accounting earnings management/accounting adjustments (e.g. Changing depreciation method, extend estimated useful life), because it is easier for them to justify that, e.g. New business strategy & plan. While it’s harder to justify for change in accrual accounting, because it’ll be easily detected. Also, it’s difficult to change accounting policy period to period (need to justify the change, otherwise outsider will be suspicious for earnings manipulation) and it requires extensive disclosure in financial statement

Manipulate accruals through incorrect classification, companies try to increase income to make it look good by having wrong classification, e.g. Shift normal operating costs below the line, hide operating expense under other headings such as restructuring charges (persistent operating expense into one off cost, less implication for the future), and shift non-operating income to operating income (make one time business earnings appear to be persistent core business earnings).

Real earnings management

Operating : cutting R&D and maintenance cost to reduce expense (boost earnings in short term, however, may be expense at long term performance by forgoing opportunity to growth), boosting sales through excessive sales discounts

Financing: pre-paying debt (save interest expense and maintain good D/E ratio, make the company look good and liquid, managers gets bonus. Downside is you forgo opportunity for business growth, you can use the loan to grow your business)

Investing: boosting income through selling of assets and securities

*It’s very hard to detect real earnings management and it can be easily justified (can relate the change to new business plan/strategy. Hence, more common than accrual accounting management. However, real earnings management are more detrimental to firm value relative to accrual base management since it have CF effect [accrual accounting management has no impact on future performance of the firm, hence no impact upon the firm’s valuation]

Patterns of earnings management

Big bath (usually happen when there’s a change in CEO): take more write off, more maintenance and restructuring charge, take more provision and allowances, deteriorate the firm’s performance and blame everything to old CEO, next year accruals will reverse, better chance to have good performance, ‘earnings turnaround’. Manipulating Income statement to make poor results look even worse. Often implemented in a bad year to enhance artificially next year’s earnings.

Income minimization: less extreme than earnings bath. Various reasons to have understate earnings.

Income maximization: accounting choices to maximize current earnings to make financial statement looks good (if bonus tie to performance)

Income soothing (Cookie jar accounting): the use of accounting techniques to level out net income fluctuations from one period to the next (in years you have good performance, put something in reserves, allowance or provision, for bad years in the future (to use this reserves to reduce expense in future period), shift earnings from current period to future period to sooth out earnings, earnings is less volatile. Good thing is earnings increase steadily, reduce volatility of earnings to avoid negative consequences of violating debt contract, and reduce risk of the business to maintain a low discount factors and maintain firm’s valuation)

Motives for Earnings Management

Contractual: 1.compensation (Bonus plan hypothesis, managers are incentivised by the way they’re paid to maximize cash bonus. Evidence: Healey (1985) which concludes allocation of funds to bonus pool is based on accounting profit, bonus scheme with bogey and cap. When performance is under bogey, managers have incentive to do big bath accounting, hit the target, gets nothing, between bogey and cap, managers have incentive to boost earnings to gets maximum bonus by earnings management. When performance is above cap, no effect on bonus, only achieve the cap bonus, will spend no efforts on EM) and 2.debt covenants (to avoid debt

ACCT30001 Financial Accounting Theory Weekly Summary - Week 4 Lecture Page 4 of 7 covenant violation (efficient contract purpose), evidence: Dichev & Skinner 2002 covenant slack=actual current ratio-required current ratio in lending agreement, negative covenant slack indicate covenant violation, positive means you still have some cushion for violation, abnormally high proportion of firms with zero or slightly positive covenant slack, the reason why the distribution of covenant slack is not bell shape, but discontinued is because many firms have earnings management to keep them not violating contract)

Regulatory/political incentives: avoid regulation, reduce political exposure (manipulates earnings downwards to avoid report high profitability. E.g.microsoft do cookie jar accounting since they’re under scrutiny. If company is so profitable, first attract higher tax, and even introduce new tax, also may increase spotlight for suspecting monopoly, and subject to antitrust law) and take advantage of government benefits/grants

Capital market: 1.Surrounding capital market transactions, use EM to manipulate higher earnings to boost share price (SEOs, IPOs), manipulate earnings downwards to buy the shares at lower price (management buyouts/repurchases to take ownership of the firm) insider tradings to manipulate earnings downward before they purchase shares or promote share value and manipulate earnings upward before sale of shares by managers. Evidence: in the year of IPO, earnings are higher then subsequent years, accruals are more positive then subsequent years, in subsequent years are reversed. E.g. Reserves and allowances are less in IPO year and reversed in later years(take more in the future. Overvalue the firm, share price are overpriced at IPO. 2. surrounding earnings announcements (meet or exceed analysts’ forecasts: benchmark beating, abnormally higher frequency simply meet the analysts’ forecast rather than missing it, discontinuity on distribution graph ) due to strong negative share price reaction if expectations are not met, may smooth earnings (good EM to signal true prospects of the firm), or to smooth growing earnings across time to reduce earnings volatility

Iron Law of earnings management

Net income = Cash flow (relevance, and more persistent earnings) +/- accruals (not persistent, if you have positive accruals in year 1, likely to have reverse accruals (-ve accruals) in the subsequent years)． ［ＮＩ－ａｃｃｒｕａｌｓ＝ｏｐｅｒａｔｉｎｇ ＣＦ）

Typical accruals: depreciation & amortisation, increase/decrease in receivables/payables, inventories, prepayments/ unearned revenue, provisions and write-offs.

Iron law of earnings management: accruals reverse. Hence, In long run, net income = cash flow, ∑accruals =0

Discretionary(due to manipulation of accounting policies) vs. Non-discretionary (due to growth in sales/earnings)

Can we say Higher accruals = higher earnings management? No, accrual accounting, accruals largely decides by size of the business［non-discretionary accruals] (e.g. More sales, more likely to do recognition in revenue and expenses in accruals basis which boost accruals), also decides by amount of PPE, higher size of fixed assets, more to think about depreciation & impairment which impacts accruals.

Other motivations for Earnings management

² Influence shareholder perceptions of management performance in board control contests (proxy fight or takeover, management try to prove their performance to stay in control, incentive to manipulates earnings upwards)

² Union contract negotiations (high profitability, employee demanding better pay, firm will have incentive to manipulate earnings downwards, to reduce earnings, to even make it appears as a loss)

² Implicit contracts (customers, suppliers, employees): Customer buy products for a company that is going concern (for warranty, after sales service etc, hence they usually buy from firm with high profitability, firm manipulates earnings to get their implicit contract). Supplier offer credit facilities, firm need to show liquidity, may have incentive to engage in EM to show liquidity and profitability. Employees want to work for firm that stay flow and have stable employment prospective, firm engage in EM.

Difficult to detect earnings management

² Difficult to know the ‘normal level of accruals’

² Can’t conclude definitively that the ‘abnormal’ accruals reflect earnings management [e.g.non-discretionary accruals as result of higher sales, not EM]

² Difficult to separately identify ‘real activities manipulation’ from real strategic decisions

ACCT30001 Financial Accounting Theory Weekly Summary - Week 4 Lecture Page 5 of 7 Models to estimate accruals to detect earnings management

Jones model measures discretionary accruals by identifying abonormal accruals based on expected normal levels of accruals in comparable firms ，use total accruals to run regression, focus on two variables, 1. Sales revenue and 2.PPE, give estimation of normal accruals. Error term=total accruals that’s not explained by the change in revenue and PPE (unexpected accruals). Step 1: regress model for group of comparable firms, step 2: apply estimated coefficient to firm under analysis

Beneish M-Score: 6 financial ratios to gather a score to give estimation of EM (Best option when comes to measuring a specific firm’s EM)

Burgastahler and Dichev: distribution of covenant slack and distribution of meeting analyst forecast (analyze distribution of earnings change and look for unusual pattern). Large sample, empirical evidence, but it’s only for collective level, can’t tell whether manager of a specific firm is engaging in EM

Two sides of Earnings Management

Good side (efficiency)

² Firm value maximization (cookie jar, sooth earnings, reduce volatile earnings for firm, lower discount rate, higher firm value)

² Contract based argument: Reduce contracting costs by giving some flexibility (efficient contracting, avoid costly debt covenants violation)

² Investor based argument: Signaling : conveying inside information to investors (e.g. Applying for a patent, if disclose, competitors may keep up with the opportunity to release products first and you lose market shares. Can’t disclose this, but then market won’t react to this positive information and shares will be undervalued. Use EM to correct this by manipulating accruals and real EM.) Blocked communication may inhibit direct disclosure of earnings expectations, discretionary accrual management as a way to credibly reveal management’s inside information about earnings expectations

Bad side (opportunistic argument)

² Contracting perspective: EM to maximize manager’s bonus (Healy 1985) or EM to avoid debt covenant violation which violates GAAP (Dechow, Sloan, and Sweeny 1996). Maximize manager’s payoff at the cost of shareholders or creditors (e.g. Carve R&D expense to get short term gain while forgoing long term profitability and growth).

² Financial reporting perspective(mis-classification of persistence vs non-persistence items, sometimes firms shift non persistent earnings to persistence in reporting) : Hanna (1999) Investors and analysts look to core earnings, ignoring extraordinary and non-recurring items, implies manager not penalized for non-core charges, such as write-downs, provisions for restructuring. But current non-core charges increase core earnings in future years, through lower amortization and absorption of future costs. As a result, managers tempted to overdose on non-core charges, and use EM to put earnings ‘in the bank’ reserve for bad time in the future to increase income (cookie jar soothing accounting)

Constraints on EM

² High quality audit: but note auditors allow EM (especially if choices are made within GAAP)

² Restrictions on choices by contracts in place (e.g. Can’t make choice on depreciation method, can’t change between methods)

² Increased regulations/reduced flexibility in accounting reporting requirements e.g. Changes to accounting for identifiable intangible assets

ACCT30001 Financial Accounting Theory Weekly Summary - Week 4 Lecture Page 6 of 7 ² Strong effective corporate governance arrangements through ethics, oversight and disclosure

² Duration and magnitude of effect (e.g. Short term gain vs. Long term reputation for credible reporting, reversing effect of accruals: income=cash over the life of the firm, accruals reverse, self-correcting mechanism, EM cannot be sustained, doesn’t make sense to continually engage in EM)

² Regulatory scrutiny and interventions

Flash points: Accounting area where manipulation is more likely

Banking Credit losses: quality of loan loss provisions (to reflect risk of default)

Computer hardware Technological change: quality of receivables and inventory

Computer software Marketability of products: quality of capitalised R&D

Retailing Credit losses: quality of net accounts receivable Inventory obsolescence: quality of carrying values of inventory Rebate programs: quantity of sales, rebate from sales (may report rebate as income rather than discount to artificially inflate revenue), and estimated liabilities

Manufacturing Warranties: quality of warranty liabilities, warranty provision

Automobile Overcapacity: quality of depreciation allowances

Telecommunication Technological change: quality of depreciation allowances

Drugs R&D: quality of R&D expenditures Product liability: quality of estimated liabilities

Note: last sem’s question ‘which of the following accounting policies most likely to be key accounting policy of wool worth’? Answer is rebate programs and credit losses.