F AT N OTES
TABLE OF CONTENTS
WEEK 1:OBJECTIVES OF FINANCIAL STATEMENTS 2
WEEK 2:RECOGNITION 4
WEEK 3:MEASUREMENT 10
WEEK 4:INCOME REPORTING AND CLASSIFICATION 15
WEEK 5:RATIO ANALYSIS 20
WEEK 6:VALUATION 25
WEEK 7:VALUATION 2 29
WEEK 8:EARNINGS MANAGEMENT 32
WEEK 9:EFFICIENT MARKETS 37
WEEK 10:EXECUTIVE COMPENSATION 41
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EEK1: O
BJECTIVES OFF
INANCIALS
TATEMENTSObjective of Financial Accounting
• Reduce information asymmetry in the forms of adverse selection and moral hazard to reduce adverse selection/improve resource allocation and ensure effective stewardship
o Different objectives require different sets of information
• Accounting numbers are used to assess performance and whether management compensation and debt contracts have been fulfilled
Financial Reports
• Properties of financial reports are determined by demand and supply (economic good)
• Demand for information is from stakeholders to reduce adverse selection and moral hazard
• Supply by firms but is costly in terms of audit and verification Information Asymmetry
• One party to a transaction has an informational advantage compared to the other
• Unifying theme that formally recognises that some parties to business transactions may have an information advantage over others
Types of Information Asymmetry
Adverse Selection (Valuation) Moral Hazard (Stewardship) Objective Impacted Valuation: ability to estimate future cashflows,
discount rates and have efficient capital markets (selection problem)
Stewardship: assess past performance of managers and ensure that managers are maximising wealth (incentive problem) as well as efficient contracting where contracts with lenders etc are accurate Definition Management knows more about firm value than
shareholders and shareholders may know more than other shareholders (hidden information, pre- transaction)
Management may act in their own interests due to separation of ownership and control and as shareholders and debtholders can’t observe their actions (hidden action, post-transaction) Entities Affected Shareholders – Managers
Shareholders – Other Shareholders Shareholders – Managers
Debtholders (principal) – Shareholders/Managers (agent)
Potential Problems • Managers may behave opportunistically, delaying or selectively releasing
information which reduces ability for investors to make good decisions
• Managers have an incentive to issue overvalued shares, increasing existing shareholder wealth
Shareholders
• Managers may shirk
• Remuneration may be unrelated to firm performance
• Dividend retention and empire building (excess cash should be paid out)
• Risk aversion (might ignore positive NPV projects)
Debtholders
• Excessive dividend payments (wealth transfer)
• Asset dilution/substitution (riskier projects)
• Claim dilution (more debt)
• Under-investment (if likely to go bankrupt) Real Consequences • Information risk at IPO leads to lower
prices and higher cost of capital
• Greater bid-ask spreads reduce liquidity and increase cost of capital
• Inability to value assets properly leads to inefficient allocation of resources (should be allocated towards high performing
resources)
• Higher cost of capital
• Higher interest rates
Mitigating Info
Asymmetry Information to predict future cash flows and discount rate that is relevant
• Mandatory financial reporting
• Voluntary information reporting such as forecasts
• Other financial information intermediaries such as financial analysts and the media
Information on past performance of managers that is reliable and conservative
• Adopt remuneration packages that align shareholder and management interests such as by using net income as a performance measure
• Covenants to prevent wealth transfer
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EEK2: R
ECOGNITIONTrade-Off Between Relevance and Reliability
• Relevance
o Everything that concerns the firm’s ability to generate value for stakeholders
• Reliability
o Degree to which an asset and related cash flows can be measured and presented in an unbiased manner Recognition Criteria in Accounting Standards
• Probable that future economic benefit will flow to or from the entity (more likely than not >50%)
• Reliable measurement (free from bias) Recognition Criteria Bias in Financial Reports
• Probability and reliability criteria create a downwards bias for both assets and liabilities Downwards Bias and Skewness of Asset Payoffs
• Downwards bias could be made more severe due to the nature of asset payoff distributions
• Share/asset returns have systematic skewness implying a small number of extreme low probability events have very high payoffs
o This is consistent with corporate managers having an investment strategy with high positive skewness o Implies that high expected value projects (low probability x high payoff) may not be recognised and thus
value isn’t recorded under accounting standards Revenue Recognition
• Recognition criteria that must be met for revenue to be recognised on the income statement o Earned (delivered a good or service)
o Realised or realisable (probable the entity will collect) Revenue from Contracts with Customers
• An entity shall account for a contract with a customer only when all the following criteria are met:
o It is probable that the entity will collect consideration to which it will be entitled in exchange for goods or services that will be transferred to the customer
o Entity shall recognise revenue when the entity satisfies a performance obligation by transferring a promised good or service to a customer. An asset is transferred when the customer obtains control over that asset
Performance Obligations
• Performance obligation is satisfied when the entity transfers a promised good to the customer o Good is transferred when the customer obtains control over that asset
o Recognise revenue at point in time when control passes
o If control passes over a period of time, then recognise revenue according to progress of completion
§ % of completion if construction
§ % of time elapsed if a service contract
§ % of items delivered if nominated quantity of goods Expense Recognition
• Expenses are recognised under the accrual basis of accounting
o Costs directly associated with revenues must be recognised as expenses in the period in which a firm recognises revenue (product costs)
o Costs not directly associated with revenues must be recognised as expenses in the period in which a firm consumes the benefits (period costs)
Asset Criteria
• Future economic benefit
• Control
• Past event Liability Criteria
• Future economic outflow
• Obligation
• Past event
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EEK3: M
EASUREMENTMeasurement
• Process of quantifying in monetary terms, information about an entity’s assets, liabilities, equity, income and expenses
Choice of Measurement Methods
• Should depend on objective of financial reports and the relevance/faithful representation trade-off o Historical cost (less accumulated depreciation)
§ Cost most relevant for items that will be used in combination with other assets to produce goods
• Assuming stable margins, HC may be a suitable basis for predicting future returns o Current value (FV or ViU)
§ FV most relevant to valuation of assets held from trading and sale i.e. financial instruments
§ ViU most relevant for assets used to generate revenues for firm i.e. non-current assets and impairments
Measurement in Current Accounting Standard
• No conceptual framework for measurement so there is a lot of measurement choice
• Firms usually use different methods for different classes of assets, creating additivity issues when aggregating assets.
Time value of money and inflation means that historical cost and fair value aren’t comparable
• Different measurement methods may be warranted in different situations to reflect economic substance
• For comparability, need to ensure that similar items are measured in a similar manner
• Can choose a different measurement method if it will provide more relevant information Benefits of Historical Cost
• Past transactions are an important input into the prediction of future cash flows
o Profit provides a measure of past economic value added, measured as the excess of selling price over historical cost
o Past nominal financial capital measures wealth
o HC may be relevant to measuring operating performance of a business and if margins are stable where it can also be used to predict future operating return
• Past transactions and events are important for stewardship and keeping management accountable, acting as an incentive
• Reliable and verifiable
o Confirmatory role where historical numbers provide integrity to the forecasts by providing a means to confirm their accuracy in the future. Forecasts are more credible if they can be checked
Criticisms of Historical Cost: P&L Statement
• HC doesn’t match current revenue with current operating costs
o HC matches current revenue against historical operating costs and if current operating costs differ from historical operating costs (such as depreciation), reported profit may be uninformative of future profits o Can overstate profits in times of rising asset prices with distribution of profits unknowingly leading to an
erosion of operating capacity
• Revenue recognition lag (revenue not recognised until receipt of cash is probable and can be reliably measured) o No recognition in P&L of losses or gains from holding assets or liabilities due to their changing value
• Problem with P&L in times of rising prices
o Including gains from selling an asset which accrued in previous periods in current year’s incomes distorts the current year’s operating results
Criticisms of Historical Cost: Balance Sheet
• No recognition in balance sheet of the current value of assets and liabilities as it only reflects unallocated value
• Aggregation of mixed measurement and different measurement units
o Problem of additivity (adding together assets bought at different times) – also a problem if mixed measurement is used
o HC will report similar assets/liabilities acquired at different points in time at very different amounts (inflation etc)
o Reduces comparability both within and between reporting entities
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EEK4: I
NCOMER
EPORTING ANDC
LASSIFICATION Purpose of Statement of Profit or Loss• Depict the return that an entity has made on its economic resources during the period
o Should be comparing profits to assets to make returns comparable over time and between firms
• Provide information that is helpful in assessing prospects for future cash flows (valuation) and in assessing management’s stewardship of the entity’s resources (by looking at past manager decisions – moral hazard) True Net Income
• No accounting definition for income
• True net income = Change in the value of a firm between two periods or the change in the present value of future receipts during the period
o Similar to a return on a security which includes both dividends and capital gains
• Don’t know the true net income of a firm as we don’t know the value at time t and t-1 as PV estimates are subject to substantial error and as markets are incomplete
Approaches to Measuring Income
• Balance sheet (asset/liability) view
o Income is the increase in the net assets of the firm during a period
§ Balance sheet doesn’t include all assets such as internally generated intangibles o Balance sheet has conceptual primacy
• Income statement (revenue/expense matching) view
o Income is the excess of revenues earned over expenses incurred during a period
§ Income statement only records revenues earned from exchanges with external parties so economic value added through discoveries etc are not considered
o Income statement has conceptual primacy and the balance sheet is a store of unallocated costs Types of Income
• Recurring/nonrecurring income
o Recurring is stable average income a business expects to earn over its life given the current state of business conditions (likely to persist into the future)
• Operating (NOPAT)/non-operating income
o Income that arises from a company’s operating activities (economic value added before financing) o Excludes all income and expenses arising from a firm’s financing activities such as interest and investment
income Reporting of Income
• Requirements by Accounting Standards (GAAP) such as profit, other comprehensive income, total comprehensive income and EPS
• Non-GAAP measures such as underlying earnings, EBIT and EBITDA are not governed by accounting standards and are up to manager discretion
AASB 101 Presentation of Financial Statements
• Statement of profit or loss and other comprehensive income shall present o Profit or loss
§ Income less expenses during the period excluding other comprehensive income o Other comprehensive income
§ Includes items required by Accounting Standards to be included in OCI and not recognised in profit or loss such as:
• Revaluation gains relating to PPE or intangible assets
o Revaluation losses go through P/L rather than OCI due to conservatism
• Remeasurements of defined benefit obligations
• Gains and losses arising from translating the financial statements of a foreign operation
• Gains and losses on remeasuring financial assets for sale
• Effective portion of unrealised gains and losses on hedging instruments in a cash flow hedge
o Total comprehensive income (total of profit or loss and other comprehensive income)
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EEK5: R
ATIOA
NALYSISRatio Analysis
• Firm value is determined by growth and profitability of that growth
• Four levels to achieve profit and growth o Operating management o Investing management o Financing management o Dividend policies
• Objective of ratio analysis is to evaluate the effectiveness of firm policies in each of these areas (insight into performance of firm)
Ratio Analysis Features
• Effective ratio analysis involves relating financial numbers to the underlying business factors in as much detail as possible
o There are a number of possible benchmarks
§ Compare ratios for a firm over several years (time series)
§ Compare ratios of different firms (cross sectional)
§ Compares ratios to some absolute benchmark
o Investigate abnormal performance to identify if it will persist into the future or revert to normal Return on Common Equity/Investment
• Return to ordinary shareholders on capital invested
• 122 4ℎ6'7ℎ8297' !"# = !"# <&'()"
9A: *+,-"+(./"-0 123%#4
• Accountant’s estimate on how well managers are using the funds invested by firm’s shareholders to generate returns
• Not true rate of return as it is distorted by GAAP recognition and measurement error and distortions from large changes in equity from beginning and end. Starting point to systematically analysing firm performance
• Average long run ROE is 10–12%. Supernormal profitability, in the absence of significant barriers to entry will attract competition and lower ROE
Benchmarks on Return on Common Equity
• Average ROE for competitors
• Return demanded by firm’s shareholders for use of their capital (rate of return demanded by shareholders for time value of money and bearing risk)
ROE for Common Shareholders vs Parent Company Shareholders
• A firm may have both parent company shareholders as well as non-controlling interests
• For understanding the drivers of ROE, we use ROE for all shareholders as company controls all assets and makes decisions
o -8::8; &ℎ6'7ℎ8297' !"# = !"# <&'()">6-"?"--"/ @%A%/"&/0 9A"-,:"(*+,-"+(./"-0 "23%#4>6-"?"-"&'" 0+,-"0)
§ Preferred dividends are often fixed obligations and behave like interest
• For valuation of equity, we use ROE for parent company shareholders
o %6'7;< -8:=6;> &ℎ6'7ℎ8297' !"# = !"# <&'()" 9##-%=3#,=." #( 6,-"&#>6-"?"--"/ @%A%/"&/0 9A"-,:"(123%#4 9##-%=3#,=." #( 6,-"&#>6-"?"-"&'" 0+,-"0)
Return on Equity Adjusted for Non-Recurring Items
• !"# =!"# <&'()">6-"?"--"/ @%A%/"&/0>9?#"- #,K !(&-"'3--%&: <#")0 9A"-,:"(*+,-"+(./"-0 "23%#4>6-"?"-"&'" 0+,-"0)
o 1?<7' <6@ A8;'7BC''D;E D<7:4 = A8;'7BC''D;E D<7:4 ∗ (1 − <) o < = 7??7B<DH7 <6@ '6<7 = <&'()" L,K"0
1,-&%&:0 ="?(-" #,K"0 8' 30% D; 1C4<'62D6
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EEK6: V
ALUATIONCorporate Valuation
• Estimating the intrinsic value of a company, one of its operating units or ownership shares
• Required in many occupations
o Auditing and accounting firms for fair values and impairment testing o Sell-side equity research
o Active fund management o M&A and IPOs
o Private equity
• Fundamental to the efficient operation of a market economy
• Accountants and auditors play a crucial role by providing/verifying the main input to valuation, earnings o Important to understand uncertainties and areas at risk
Fundamental Principle of Valuation
• /62C7 =1K8"'#"/ M3#3-" 6,4(??0 #( V(./"-
@%0'(3&# Q,#" = ∑X#YW(WP-)7M!!=(WP-)7M""+(WP-)7M##+ ⋯ +(WP-)7M!$
o Expected payoffs are cashflows that will eventually accrue to owners of assets (through dividends and capital appreciation)
o Different valuation models are alternative approaches to estimating future payoffs (e.g. using earnings, free cash flows or dividends)
Approaches to Valuation
• Fundamental valuation
o Forecast future payoffs and discount to present value
• Relative valuation (multiples)
o Value the company on how the market values similar companies Levered vs Unlevered Approaches
• Levered
o Directly estimate the future payoffs after debt expense to equity holders (direct) o Uses NPAT, Cost of Equity and CAPM
• Unlevered
o Value the firm as a whole (NOA) then deduct value of debt (NFO) to determine equity value (indirect) o Uses NOPAT, WACC and BV of NOA
Basic Steps of Fundamental Valuation
• Forecast future cash flows (both timing and amounts) of some financial attributes that attempt to measure future cash payoffs to owners
o Main variables are dividends, free cash flows or accounting earnings (same outcome over life of firm)
• Determine the risk associated with the attribute’s forecasted future value o Discount rate reflects the risk inherent to the value attribute
• Determine the present value of the expected future values of the value-relevant attribute Valuation Models
• Discounted dividends o /62C7 = ∑X#YW(WP-)@%A!!
• Discounted free cash flow o /62C7 = ∑X#YW(WP-)M7M!!
• Discounted abnormal earnings (residual income)
o /62C7 = #SCD<> T88U H62C7 + ∑ Q"0%/3,. <&'()"! (WP-)! X#YW
• Dividends = FCF = Earnings in the long term so should pick model which is the best estimate of the final payoff using short term numbers
Valuation Method Choices
• Levered or unlevered
• Approach to forecasting future payoffs
• Estimation of terminal value
• Estimation of cost of equity capital (for levered) and WACC (for unlevered)
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EEK7: V
ALUATION2
Approaches to Valuation
• Fundamental valuation
o Forecast future payoffs and discount to present value
• Relative valuation (multiples)
o Value the company on how the market values similar companies Levered vs Unlevered Approaches
• Levered
o Directly estimate the future payoffs after interest expense to equity holders and then discount by cost of equity (direct)
o Uses NPAT, Cost of Equity and CAPM
• Unlevered
o Value the firm’s assets (and thus the value of both equity and debt holders together) o 1447<4 = MD6TD2D<D74 + #SCD<> or A"1 = AL" (T88U H62C7) + #SCD<>
o Estimate cash flows earned by assets before debt expense and then discount at WACC to find NOA o After you calculate (NOA), you then deduct value of net debt (NFO after removing excess cash) to
determine equity value (indirect) o Uses NOPAT, WACC and BV of NOA Free Cash Flow Model (Unlevered)
• Derived from the dividend discount model
• Free cash flow to firm is cash flow from operations less cash used to make investments
• L-L = "=7'6<D;E -64ℎ L28] − V;H74<:7;< #@=7;9D<C'74 (assumption that more outflows than inflows)
• Forecast future FCF then discount at WACC Steps for a Discounted Cash Flow Valuation
• Forecast FCF to a horizon
o Remove financing from reported operating cash flow o Remove financing from reported investment cash flow
o Find UFCF by deducting investments from operating cash flow
• Discount FCF to present value
• Calculate a terminal value at the horizon with an estimated growth rate (such as GDP growth rate)
• Discount the terminal value to present
• Add the discounted FCF and discounted terminal value and subtract NFO (FL – FA) o Net debt subject to judgement as you need to decide what is considered debt Cash Flows from Operations for FCF
• Reported operating and investing cash flows includes interest (a financing component)
• Cash flows from operations for FCF = Reported cashflow from operations + After-tax net interest payments
• Cash flows from investment for FCF = Reported cashflow from investment activities + After-tax net interest payments
o Sometimes investment section has interest payments (sometimes a firm may have assets that are part of the financing/borrowing portfolio and pay interest)
o Net interest – interest payments – interest receipts o After-tax net interest = net interest*0.7
WACC
• ^1-- =HH)
*'/(1 − O) +HH+
*'"
• '"= '?+ )[#(')) − '?]
• '/=<&#"-"0# 1K8"&0"
9A"-,:" @"=# ∗ (1 − <) Advantages of FCF
• Cashflows are less subject to estimates (accounting biases) and thus the potential for opportunistic manipulation.
Investors can make their own judgements as to what numbers should go into their valuations
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EEK8: E
ARNINGSM
ANAGEMENTEarnings Management
• No generally agreed definition
• Schipper: Purposeful intervention in the external financial reporting process, with the intent of obtaining some gain (as opposed to merely facilitating the neutral operation of the process)
o Intentional biased application of the financial reporting process
• Healey: Use of judgement in financial reporting and in structuring transactions to alter financial reports o Either to mislead some stakeholders about the underlying economic performance of the company or o To influence contractual outcomes that depend on reported accounting numbers
• Deliberate manipulation of accounting information within GAAP rules Methods of Earnings Management
• Choices within GAAP legally available to managers (not fraudulent) and earnings over its life will generally be the same
o Accounting decisions (paper effects)
§ Accounting policy choices, discretionary accruals, recognition vs disclosure and classification
§ Advantage is that accounting adjustments do not sacrifice real value. Not ignoring positive NPV projects.
§ No first order cash flow impact but there are second order
cash flow impacts such as through managerial bonuses and covenants o Real cash flow choices
§ Advantage is that it is difficult to observe and difficult to attribute to earnings management
§ First order cash flow impact
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EEK9: E
FFICIENTM
ARKETSImportance of Market Efficiency
• Leads to the efficient allocation of resources to enterprises providing the goods and services that we require
• Allows the appropriate pricing of capital costs (less risk leads to lower costs)
• Has implications for how we should prepare and regulate the production of information such as financial reports Levels of Efficiency in Markets
• Weak
o Only past price data is incorporated into current stock prices (technical analysis)
• Semi-strong
o All publicly available information is incorporated into current stock prices
o Most reflective of markets since investors trade on public information and don’t have access to private information
• Strong
o All publicly and privately available information incorporated into current stock prices Efficient Securities Market: Public Information
• An efficient securities market is where the prices of securities traded on that market always fully reflects all publicly known information about those securities (rational decision makers)
o Instantaneous with no time lag (trade on new information immediately)
o Incorporated into prices in an unbiased manner (rational investors)
o All publicly available information (investors are aware and use it to inform their beliefs)
• Relative to public information
o Relative to public information as prices don’t necessarily reflect true value, especially if information is private
o New information will influence beliefs about future performance Conditions for Efficient Market (Market Prices Reflecting all Public Information)
• Competition for information
• Aggregation and randomisation away from random errors
o Investors’ estimates of security values must be on average unbiased and rational o On average, the market uses all the available information
o Individual’s act independently (overall no correlation) Consequences of Efficient Market Hypothesis
• Investing is a fair game and can’t earn abnormal returns (can’t pick winners as all information is incorporated)
• Market prices follow a random walk (up and down as you can’t predict future)
• Naïve investors are price protected by an efficient market Implications of Efficiency for Financial Reporting
• Full disclosure enhances efficiency
o All information will be used and managers should disclose as much as is cost-effective o More disclosure leads to less concern about inside information
• Accounting policies adopted by the firms don’t affect security prices
o Recognition vs disclosure and choice such as depreciation method do not matter
o Investors are only interested in future cash flows and dividends (compared to technical analysis)
• Naive investors are price protected
o Can prepare complex reporting where institutional investors would incorporate all the information, protecting those who don’t understand it
• Accountants in competition
o Must provide relevant, reliable, timely and cost-effective information (relative to other sources) o Responsibility to public
• If investors are fully efficient, then the market reaction is a good way to measure the usefulness of financial information
• Increases argument for fair value measurement which is based on market prices (assuming they are more efficient)
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EEK10: E
XECUTIVEC
OMPENSATION Incentive Contracts• Remuneration is linked to performance rather than being fixed regardless of performance
• Purpose is to mitigate the moral hazard problem between shareholders (principal) and the managers (agents)
• Moral hazard problem occurs because principal-agent interest is not aligned and because of information asymmetry where the agent has an informational advantage compared to the principal (shareholder)
o Manager may be effort averse and shirk, want to invest in pet projects that have a negative NPV, risk averse where they don’t want to accept high risk positive NPV projects or have a short horizon compared to shareholders who have a long horizon
o Shareholders can’t fully observe actions of managers as they don’t run the operations (hidden action) Necessity of Incentive Contracts
• Fama (1980)
o Not necessary as the forces of reputation on managerial labour market is enough to motivate managers.
Working not only for today’s pay, but also for their future pay
o Assumes that the managerial labour market works well where managerial opportunism will be detected and punished
• In reality, the labour market is not fully efficient (perfect) and thus incentive contracts are required in addition to base contracts
Efficient Contracts with Executives
• We want to reduce agency costs and align incentives of managers and shareholders. Can do this by:
o Giving/increasing management ownership interest in firm o Pay based on performance
• Reason to create well designed compensation contracts is to provide incentives for managers to maximise value of the firm
• Summary measure of performance is required since ultimate payoffs are not yet known, and managers need to be paid on a periodic basis
o Includes metrics such as net income (accounting measure) and share price (share market measure)
• Reporting on manager performance is thus a second major role for financial reporting Managerial Effort
• Number of performance metrics such as net income, share price and underlying earnings
• Should use performance metrics that can motivate manager effort Desirable Properties of Managerial Performance Measures
• Highly informative about manager effort
• How informative a measure is depends on:
o Precision of the performance measure
§ Degree of noise or volatility in a measure unrelated to managers effort (amount of random error and the measure’s ability to be controlled)
o Sensitivity of the performance measure
§ Rate at which the expected value of performance measure increases as manager works harder (correlation between measure and effort)
• Should be a correlation between effort and performance metric but there is a trade-off between precision and sensitivity. Full disclosure also improves the informativeness of performance measures
Levels of Precision and Sensitivity
• Performance measurement = 6(;8D47) + )Effort
• Perfect performance measure (perfectly precise and sensitive) o ) will equal 1 in every period and α=0
• Precise but not sensitive
o ) will be low (not capturing all effort) but not subject to any variance (small α)
§ Such as R&D performance
• Sensitive but not precise
o ) will be high but is subject to large variance (large α)
§ Other factors could influence performance metrics
