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ACCT30001 FINANCIAL ACCOUNTING THEORY
SUBJECT NOTES TOPIC LIST
- Topic 1: Objective of Financial Accounting - Topic 2: Recognition
- Topic 3: Measurement - Topic 4: Income - Topic 5: Ratio Analysis - Topic 6: Valuation Part 1 - Topic 7: Valuation Part 2 - Topic 8: Earnings Management - Topic 9: Efficient Markets - Topic 10: Contracting
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Topic 11: Voluntary Disclosure
1 Week 1: Objective of Financial Accounting
1. What is the objective of financial reports?
i. Valuation objective: to produce financial report that help to assist the valuation of the company ii. Stewardship/ Contracting objective: to measure the performance of the company by holding
economic agents into account 2. INFORMATION ASYMMETRY
(a) What is information asymmetry in accounting?
Information asymmetry exists when one party to a transaction is at an informational disadvantage to the other.
(b) What are the two types of information asymmetry?
(c) What are the consequences of adverse selection to the firm? How do we mitigate this problem?
The consequences of adverse selection to the firm are:
• Increased information risk, thus higher cost of capital (ke) because lower cost cost of capital (the offered share price) means the lower the funds raised by the firm.
• Lower liquidity
• Decreased informativeness of prices to guide resource allocation Managers can mitigate the adverse selection problem by:
• Mandatory reporting
• Voluntary reporting
• Information intermediaries: financial analysts and the media
(d) What are the consequences of moral hazard problem to the shareholders and the debtholders?
There are potential moral hazard costs to the shareholders as they can’t observe managers’ effort:
• Managers may be tempted to shirk (neglect their responsibility) i. Adverse Selection
When a party to a stransaction has an informational advantage over other parties
and exploit this advantage E.g. insider trading
Capital Market Perspective Role of accounting reports to improve decision making (before entering into a transaction) aka. decision usefulness view
Valuation Role
ii. Moral Hazard
Whereby a party to a transaction/ contract can observe their actions in fulfillment of the transaction but the other party cannot
E.g. shirking
Contracting Perspective Role of accounting reports to reduce
agency costs (after entering into a transaction) aka. efficient contracting view
Stewardship Role
Information users: Capital providers (shareholders + debtholders)
8 Week 3: Measurement
1. What is measurement?
Measurement is the process of quantifying (in monetary terms) information about an entity’s assets, liabilities, equity, income and expenses. It allows us to attribute numbers to the items that appear in the financial reports.
2. What are the methods available for measurement?
There are three choices of measurement methods:
i. Historic costs (past price) ii. Current value:
a. Fair-value (exit price) b. Value-in-use
The choice should depend on the objective of the financial reports (valuation or stewardship?), and relevance vs. reliability trade-off of the measurement information required.
3. HISTORICAL COST MODEL
(a) Explain the historical cost model.
• Historical cost model may be relevant to measure operating performance of a business and if margins are stable, then HC may be suitable for predicting future operating returns. This is because past transactions (or performance) is an important input into the analysis and prediction of future cash flows, which are also important for stewardship objective to make management accountable.
• Historical numbers provide integrity to the forecast by providing a means to confirm (verify)their accuracy after the fact → Confirmatory Value
• Hence, HC model is reliable and verifiable.
(b) What are the advantages and disadvantages of the historical cost model?
Advantages:
• HC is the predominant method used for many years;
• Various assets are still measured on a HC model basis. For example: inventory, PPE and intangible assets.
Disadvantages:
• Profit & Loss:
o There’s a mismatch between current revenue with current operating costs as HC matches current revenue against historic operating cost
o Revenue recognition lag: no recognition in P&L of losses or gains from simply holding assets due to their changing value. For example, there’s no gains of a building’s value until it’s sold.
o Problem in times of rising prices: companies can turn their operating performance by selling some assets
• Balance Sheet:
o No recognition in BS of the current value of assets and liabilities as BS reflects only the costs
o Different measurement units can reduce the comparability both within and between reporting entities
17 4. RETURN ON COMMON EQUITY (ROCE)
*NOPAT = NPAT + NFE AT NOTE:
• ROCE is the return demanded by firm’s shareholders for use of their capital or the rate of return demanded by shareholders for time and bearing risks.
• RNOA (Return on Net Operating Assets) measures the firm’s performance in using assets to generate earnings independent of the financing costs of those assets.
• NPM is how much the company is able to keep as profits for each dollar sales it makes.
• ATO is how many dollars of sales the firm is able to generate for each dollar of assets.
• When the Spread is positive (negative), a higher Financial Leverage (FLEV) increases (decreases) ROCE.
ROCE
Return from Operating Activities RNOA
= NPAT+ 1−tax rate × Financing Expense
Average NOA = NOPATNOA
NPM= NOPAT
Sales
ATO= SalesNOA
Return from Financing Activities Financial Leverage ✖Spread
Financial Leverage = NFO
Equity
NFO = Financial Liabilities -
Financial Assets
Spread = RNOA - NBC
NBC = NFEAT Average NFO
✖ +
✖
22 5. FUNDAMENTAL VALUATION: FREE CASH FLOW MODEL
(a) Discounted Free Cash Flow (DCF) Model
Free CF to Firm (Unlevered) = Operating CF – Capital Outlay (Investment)
• Free cash flow: cash flow from operations that results from investments minus cash used to make investments in operating assets
(b) Unlevered versus Levered FCF
• Levered FCF: FCF to equity-holders, and thus after net payments to debtholders (i.e. taking into account financing activities)
o Determined Levered FCF
o Discount to determine value of equity
o Cost of equity capital (CAPM) → 𝐫𝐞= 𝐫𝐟+ 𝛃[𝐄(𝐫𝐌) − 𝐫𝐟]
• Unlevered FCF: FCF to the firm, and thus to both equity and debtholders o Determine value of the firm using Unlevered FCF
o Then, deduct net debt (the market value) to determine the value of equity
o Weighted average cost of capital (WACC): weight based on market value of debt and equity 𝐖𝐀𝐂𝐂 = 𝐕𝐝
𝐕𝐝+ 𝐕𝐞𝐫𝐝(𝟏 − 𝐓) + 𝐕𝐞 𝐕𝐝+ 𝐕𝐞𝐫𝐞
▪ Vd : net debt
▪ Ve : equity
▪ rd : before tax cost of debt after tax cost of debt: 𝐫𝐝(𝟏 − 𝐓)
▪ re : cost of equity capital 𝐫𝐞= 𝐫𝐟+ 𝛃[𝐄(𝐫𝐌) − 𝐫𝐟]
▪ T : tax rate
(c) Steps for a Discounted Free Cash Flow (DCF) Valuation 𝐕𝟎𝐄= 𝐕𝟎𝐅− 𝐕𝟎𝐃 𝐕𝟎𝐄 =𝐂̿𝟏− 𝐈̅𝟏
𝛒𝐅 +𝐂̿𝟐− 𝐈̅𝟐
𝛒𝐅𝟐 + ⋯ +𝐂̿𝐓− 𝐈̅𝐓 𝛒𝐅𝐓 +𝐂̅𝐕̅𝐓
𝛒𝐅𝐓 − 𝐕𝟎𝐃 1. Forecast free cash flow to a horizon
a. Remove Financing from Reported Operating Cash Flow:
𝐂𝐓= 𝐑𝐞𝐩𝐨𝐫𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧𝐬 + 𝐀𝐟𝐭𝐞𝐫 𝐭𝐚𝐱 𝐧𝐞𝐭 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐩𝐚𝐲𝐦𝐞𝐧𝐭𝐬
where 𝐍𝐞𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 = 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐏𝐚𝐲𝐦𝐞𝐧𝐭𝐬 − 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐞𝐜𝐞𝐢𝐩𝐭𝐬
and 𝐀𝐟𝐭𝐞𝐫 𝐭𝐚𝐱 𝐧𝐞𝐭 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐩𝐚𝐲𝐦𝐞𝐧𝐭𝐬 = 𝐍𝐞𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 × (𝟏 − 𝐭𝐚𝐱 𝐫𝐚𝐭𝐞)
b. Remove Financing from Reported Investment Cash Flow:
𝐈𝐓= 𝐑𝐞𝐩𝐨𝐫𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐟𝐫𝐨𝐦 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐚𝐜𝐭𝐢𝐯𝐢𝐭𝐢𝐞𝐬 + 𝐀𝐟𝐭𝐞𝐫 𝐭𝐚𝐱 𝐧𝐞𝐭 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐩𝐚𝐲𝐦𝐞𝐧𝐭𝐬 2. Discount the free cash flow to present value
3. Calculate a continuing value at the horizon with an estimated growth rate 4. Discount the continuing value (VCT) to the present
5. Add step #2 and #4
6. Subtract net debt: (the BV of debt liability – debt asset)
35 Week 11: Voluntary Disclosure
1. Why do managers disclose information?
Information is a commodity, and managers have private incentives. There are four incentives to disclose information:
1. The Disclosure Principle 2. Contractual Incentives 3. Market-Based Incentives 4. Signalling
2. THE DISCLOSURE PRINCIPLE (a) What is the Disclosure Principle?
• Market know that the manager has the information (e.g. forecast)
• BUT, manager does not release the information to the public
• THEN, the market fears the worse because manager always disclose good news and hide bad news, and the share price might crashes.
• THUS, to avoid it, manager releases the information (if the news is not that bad) (b) What are the examples of the Disclosure Principle?
• Management forecasts → firm voluntarily disclose information about their future performance
• Conference calls → organised by firms to disclose information and answer questions from analysts (c) Why the Disclosure Principle may not work?
Because…
• There is a cost of disclosure, such as proprietary cost, and company will only disclose information if the benefits > the costs;
• Investors might also think that there’s something wrong with the company, if a company stop disclosing information when they used to;
• Investors can’t also immediately verify whether the disclosure is truthful or not, as it can only be verified at earnings announcement in the next year;
• Investors don’t know if managers have private information or not.
3. CONTRACTUAL INCENTIVES
(a) What are the two Contractual Incentives?
i. Compensation contracts → performance measures need information production
ii. Debt contracts → debt covenants need information production (e.g. Debt-to-Equity ratio) 4. MARKET-BASED INCENTIVES
(a) What are the three market-based incentives?
i. Securities market → poor disclosure creates adverse selection, thus increases the cost of capital ii. Managerial labour market → poor disclosure lowers manager’s reputation, such as promotion and
future job
iii. Takeover market → poor disclosure increases estimation risk, which leads to managers being fired or replaced
