Financial accounting 10th pratt peters chapter 05

Chapter 5: Using Financial Statement Information Learning Objective Describe the two basic uses of financial statements Control and Prediction  Financial accounting numbers are useful in two fundamental ways:  They help investors and creditors influence and monitor the business decisions of a company’s managers  They help to predict a company’s future earnings and cash flows Financial Accounting Numbers as Prediction Aids  Financial statements not reflect the company’s prospects within its business environment  Statements are backward looking, not focusing on the future prospects  Financial statements are inherently limited  Statements leave out some current and historical information such as human resources and the effects of inflation  Management prepares the financial statements in a biased manner  Managers often choose accounting methods and estimates that make them look good Concept Practice Learning Objective Describe the four elements of successful companies and how they link to the company’s overall financial performance Overall Financial Performance  Leverage  Looks at capital structure  Using borrowed funds (debt) to produce revenues for the shareholders Solvency  The ability to meet payments as they come due Asset Quality  The extent to which assets generate revenues Expense Control  Expenses must be managed and minimized where possible Figure 5-3 Capital Flows Using borrowed funds to generate returns for shareholders is called a leverage b profitability c taking a bath d solvency Assessing Earnings Quality Earnings quality may be affected by a number of strategies managers use to influence accounting numbers Four major strategies: • Overstating operating performance • Taking a bath • Creating hidden reserves • Employing off-balance-sheet financing Assessing Earnings Quality Overstating operating performance through the acceleration of recognition of revenue or the deferring of the recognition of expenses Assessing Earnings Quality Taking a bath - large losses and expenses this year may increase income in future years Rationale: if the current year is going to be disappointing to investors anyway, increase the loss to make next year look better For example: • Excessive write-downs of equipment will lead to lower depreciation expense in future years • Excessive write-downs of inventory will lead to lower cost of goods sold next year Assessing Earnings Quality • Creating hidden reserves - expenses may be shifted from one year to another year by overestimating expense accrual • Excessive bad debt expense or warranty expense in the current year will lead to reduced estimates in future years, as the “reserve” is used up • Note that these “reserves” have nothing to with cash reserves; they simply reserve some of the “income” to future periods Assessing Earnings Quality • Employing off-balance-sheet financing - this relates to certain economic transactions that are not reflected in the balance sheet • Managers prefer to keep certain liabilities off the balance sheet when GAAP permits it, primarily because of potential debt covenant violations, and because of the effect on certain ratios Examples include: • Enron’s financial fraud did not report billions of dollars of liabilities on its balance sheet Concept Practice Concept Practice (cont) Learning Objective Explain the role of financial statement analysis when valuing a company’s equity securities Annual Report Information, Company Value, and Projected Financial Statements Book value does not reflect market value because market value includes future prospects Projecting future financial statements is complex but has some basic concepts: Predict future sales Predict future profit margin Based on the sales prediction, estimate the level of assets necessary to support that level of sales Choose a target financing mix (liabilities vs equity) Comparisons Across Different Countries Investors interested in comparing the financial performance and condition of companies from different countries often must contend with two difficult issues: • If the companies use different accounting standards (e.g., U.S GAAP vs IFRS), the reported values must be adjusted to a common basis so that reasonable comparisons can be made • Adjusting financial statements to a common basis by itself may not be sufficient to achieve meaningful comparisons In other words, not only must the financial statements of a foreignbased company be adjusted, but the resulting numbers can only be interpreted through an understanding of the foreign environment Learning Objective (Appendix 5A) Identify and analyze the factors (or drivers) causing changes in a company’s return on equity Shareholder Value, ROE, and Cash Flow Analyses *Appendix 5A To create shareholder value, ROE must exceed cost of equity Analyzing return on equity: DuPont (ROE) Model: Return On Equity = Return on Assets X Capital Structure Leverage X Common Equity Leverage Return on Assets = Profit Margin (Return on Sales) X Asset Turnover Cash Flow Analysis – *Appendix 5A • Analyzing a company’s cash flow tells us a great deal about company performance and financial position • Operating performance • Financial flexibility • Liquidity • The statement of cash flows can be used to develop a cash flow profile Solvency Assessment – *Appendix 5A Figure 5A-6 – Important factors in solvency assessment Wiley © 2017 .. .Chapter 5: Using Financial Statement Information Learning Objective Describe the two basic uses of financial statements Control and Prediction  Financial accounting numbers... Comparisons Within the Industry  Financial accounting numbers can also be made more meaningful if they are compared to those of similar companies  Comparison of financial accounting numbers with industry... Time  Financial accounting numbers can be made more meaningful if they are compared across time  GAAP require side-by-side comparison of the current and the preceding years in published financial