Accounting Research Notes Chapters 1 & 2

Chapter 1 How to Analyze a Company:? Identify economic characteristics of industry Identify firm’s strategies (10-k, MD&A) Assess quality of financial statements -Free of error/misstatements Analyze profitability and risk Projected financial statements Valuation Porters 5 forces Existing competitive rivalry look at number of competitors- monopoly, oligopoly, etc size of competitors- any vulnerabilities quality of differences among competitors customer loyalty Threat of new entry is it expensive to compete? Need a lot of expertise? (ex: pharmaceutical) Time to develop? Less competition if need more time Buyer Power Number of buyers Price sensitivity Price takers/ price setters Cost of switching suppliers Supplier Power Cost of changing suppliers Different levels of quality Threat of forward integration Threat of substitutes Could another company substitute use for your product? Ease of switching to substitute? Cost of changing? Step 1: Identify the industry economic characteristics Grocery store - low entry barriers because commodities - lots of competition low profit margins - low exit barriers Pharmaceutical - high barriers - high litigation-product liability risks - finance with stock Utility Co’s - high barriers - high profit margins Banking (Investments/loans) - low fixed asset - financial services – high margins - loans – low Economic Attributes Framework Demand highly price sensitive? Demand growing rapidly? Does demand move with the economic cycle? Is demand seasonal? Supply Are many suppliers offering similar products? Are there high barriers to entry? Are there high barriers to exit? Manufacturing Is the manufacturing process capital- intensive? Labor intensive? Or both? Manufacturing process complex with low tolerance for error? (heart pacemakers) Marketing Promoted to other businesses with a sales staff? Or marketed to consumers through advertising? Investing and Financing Are assets short term or long term? Relatively little risk? Is industry relatively profitable and mature? Step 2: Identify the Company Strategies Nature of Product or Service Attempting to create unique products or services for particular market niches, achieving relatively high profit margins? (product differentiation strategy) Offering non differentiated products at low prices accepting a lower profit margin in return for a higher sales volume and market share? (low-cost leadership strategy) Degree of Integration in Value Chain pursuing vertical integration? Or selecting just certain phases in the chain? for manufacturing is the firm conducting all manufacturing operations itself, outsourcing all, outsourcing the manufacturing of components but conducting assembly in house? for distribution is the firm maintaining control over the distribution function or outsourcing it? (franchises) Degree of geographical diversification domestic market or across many countries? Degree of industry diversification operating in a single industry or diversifying across multiple industries? Step 3: Assess the Quality of Financial Statements 4 principal financial statements balance sheet- statement of financial position income statement statement of comprehensive income statement of cash flows statement of shareholder’s equity Accounting Principles SEC delegates responsibility of setting US GAAP to FASB FASB- independent board with 7 members and a full time professional staff IASB- 16 members and a full time staff, set IFRS FASB and IASB are working together to harmonize accounting standards and principles worldwide SEC accepts financial statement filings prepared under IFRS from non US registrants, but not IFRS based financial statement filings from US firms Balance Sheet- measuring financial position Assets Probable future economic benefits, probable that will generate revenue Reports the effects of a firms operating activities and investing activities A firm can recognize as assets only those resources for which it: - controls the rights to future economic benefits as a result of a past transaction or event - can predict and measure or quantify, the future benefits with a reasonable degree of precision and reliability if cannot meet above criteria it cannot be capitalized as an asset and must be expensed monetary assets- claims to specific amounts of cash cash and cash equivalents A/R- reported at NRV Notes receivable (if LT- PV calculation) Non monetary assets- tangible such as inventories, buildings, and equipment and intangible such as brand names, patents, trademarks, licenses, and goodwill do not represent claims to future cash flows represent benefits from future service potential reported at amounts initially paid to acquire them (Acquisition/historical cost) adjusted for the use of the asset over time (accumulated depreciation or amortization) or the amounts currently required to replace them (Replacement cost) or the amounts for which firms could currently sell them (NRV) Current Assets expects to collect, sell or consume during normal operating cycle usually 1 year Investments short term and long term investments in debt and equity securities of other entities short term investments go under current assets PP&E tangible long lived assets that a firm uses over a period of years Intangibles Include legal or contractual rights to the future use of property Valuation Purchase- purchase price +associated costs Internally created –expensed (cap. Legal fees) Amortize Limited life- amortize cost less residual value Indefinite life- impairment test- goodwill Liabilities Reports obligations that arise from a firms operating decisions involving obligations to suppliers, employees, and customers which are reported as accounts payable, accrued liabilities and deferred revenues Also reports obligations from raising long term debt capital from banks and other lenders Probable future sacrifices of economic benefits arising from present obligations of an entity to transfer assets to another entity as a result of a past transaction - executory contracts - contingent liabilities (contingent on other event (lawsuit) - unearned revenues Stockholders Equity Separated into: - Amounts invested by common shareholders for an ownership interest in a firm (common stock and APIC) - Cumulative net income in excess of dividends declared (Retained Earnings) - accumulated other comprehensive loss- effects the recognition or valuation of certain assets or liabilities - treasury stock- amounts a firm uses for repurchases of its own shares (deducts from common stock, APIC and RE - non controlling interests- which reflects the amounts of equity capital invested by non controlling investors in subsidiaries the firm controls and consolidates Assessing quality of balance sheet as a complete representation of financial position Valuation of intangibles - PP&E likely undervalued, depreciation- using up investment (historical costs- reliable vs market values-relevant) - does not record only discloses: - rights to use resources or commitments to make future payments LT liabilities appear at discount rates Income statement- measuring performance Accrual basis Shows performance of company A firm recognizes revenue when it meets the following 2 criteria: it has completed all or substantially all of the revenue-generating process by delivering products or services to customers it is reasonably certain it has satisfied a liability or generated an asset that it can measure reliably Comprehensive income is measured as net income plus or minus the other comprehensive income items which are: (PUFIE) foreign currency translation adjustments cash flow hedges, net of tax certain changes in pension and retiree medical plan obligations, net of taxz unrealized gains/losses on AFS securities Assessing the quality of earnings - accelerate recognition of revenue, underestimate bad debt expense, warranty expense as a means of increasing earnings in a particular period - reduce discretionary spending Advertising R&D Delay maintenance Channel stuffing Statement of Cash Flows Operating Activities Investing Activities - acquisition of long-lived productive assets (PP&E) Financing Activities - short and long term borrowing - issuance of preferred and common stock -pay dividends - reacquire shares of outstanding preferred and common stock Notes to Financial statements - accounting methods used (inventory methods) - provide important details about key financial statement estimates, such as fair values of investment securities, pension and post employment benefit liabilities, income taxes and intangible assets MD&A - Management required to write a section describing risks and how to mitigate - Insights on strategies and expectations about the future of the company - evaluate company pro forma financial statement- not GAAP but income statement on companies accounting methods Auditor opinion letter Unqualified opinion- best to get - unqualified with explanatory paragraph Qualified opinion - major deviation from GAAP Limited scope - were not able/ allowed to see certain things Adverse opinion - significant material misstatement Step 4: Analyze Profitability and Risk Financial statement ratios - Profitability ratios: most common EPS (net income minus dividends on preferred stock divided by weighted average of common shares outstanding) Return on common equity (ROCE) = net income available to the common shareholder divided by average common shareholders’ equity for the year -Risk ratios: simple method to assess the volatility of a firms earnings over time and gauge uncertainty inherent in future earnings is to simply calculate the standard deviation in ROCE Liquidity ratios- to assess the ability of firms to repay short term obligations analysts frequently calculate various short term liquidity ratios such as current ratio (= current assets/ current liabilities) Solvency ratios- to assess the ability of firms to continue operating for a longer term (to avoid bankruptcy) Such as the ratio of long term debt to common shareholders equity Step 5: Prepare Forecasted Financial Statements and Step 6: Value the Firm The primary reason we analyze a firms industry, strategy, accounting quality, and financial statement ratios is to gather information and insights for our forecasts of future performance Forecasted financial statements rely on assumptions we make about the future such as will the firms strategy remain the same or change? Capital market participants most commonly use financial statement analysis to value firms Role of financial statement Analysis in an efficient capital market Market efficiency describes the degree to which the capital market impounds information into security prices Sources of financial statement information annual report to shareholders 10-K 10-Q Prospectus or Registration Statement- firms intending to issue new bonds or equity shares Chapter 2- up to page 94 Balance sheet- not to look at for market value Relevance- capable of making a difference in the decisions made by users VS Representational Faithfulness Complete Neutral Free from error Accounting Quality- function of economics, measurement error, bias Both measurement error and bias decrease the representational faithfulness of reported financial information Historical cost: Historical value- (acquisition) Cost – amount initially paid Ex: Land At point of purchase it is both relevant and reliable Not adjusted Historical Value- Adjusted Historical Cost Buildings, Machinery Trade off between relevance and representational faithfulness Historical Value- Initial Present Value Long term receivables and payables Fair Value: Current Value- Market Value Putting mkt value on balance sheet- how much value they have on the market, see more of the flexibilities management has FASB definition- fair value would be the price that would be received when selling an asset or price paid to transfer a liability in an orderly transaction between market participants on the measurement date Therefore, this is an exit price GAAP guidance on estimating FV: (SFAS 157; IFRS 7) -Level 1- look at readily available active market prices -Level 2- Quoted prices for similar assets (or liabilities) in active or inactive markets or other observable information and data inactive- not many sales or trades observable- still finding it somewhere -Level 3- Firm’s assumptions as goes down the levels, more and more subjective, less and less faithful representation/less useful Investments in marketable equity securities Current Value- Replacement Cost (FV based on replacement cost)”entry price” Current replacement cost LCM More relevant than representationally faithful Hybrid of Historical and Fair values: Current Value- FV based on NRV NRV Hybrid approach Adjusted Historical Cost Current Replacement Cost Lower of cost or fair value for inventory, net realizable value of inventory, accounts receivable net of an allowance for uncollectible accounts Page 88 Income Measurement Rules: (impact on balance sheet and income statement) 3 approaches Value changes are recognized on balance sheet and income statement when realized Realization for revenues occurs either when the firms receive cash, a receivable, or some other asset subject to representationally faithful measurement from a customer for goods sold or services performed or when the firm satisfies a liability to a customer by delivering goods or services owed For expenses, depends on the consumption of assets or incurrence of liabilities which often is not a directly observable as an event like a sale to a customer. Commonly, expenses are recognized in the particular period in which they’re realized by the consumption of resources Economic value changes are recognized on balance sheet and income statement when they occur (trading securities) Value changes are recognized on balance sheet when they occur but on income statement when realized (OCI- available for sale securities, pension obligations) Unrealized gains and losses that receive this treatment: - foreign currency translation gains and losses - fair value gains and losses on revaluations of investments in available for sale securities - fair value gains and losses on derivatives designated as hedges of future cash flows - certain adjustments to pension and post retirement benefit obligations