© 2005 by robert f. halsey accruals agenda: review accrual accounting statement preparation...

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2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears (A/R reserves) Projections (Coca-Cola mini-case)

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Page 1: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Accruals

Agenda: Review accrual accounting

Statement preparation exercise Discuss cases

International Paper (accruals) Sears (A/R reserves)

Projections (Coca-Cola mini-case)

Page 2: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Accrual Accounting

Revenue recognition principle: record revenues when “realized or realizable” and “earned” “realized or realizable” means received in cash or

have another asset that will generate cash (e.g., A/R)

“Earned” means the transaction is completeNo rights of return or other contingenciesNo involvement in resale

Page 3: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Accrual Accounting

Matching principle: once the revenues have been recognized, match against those revenues the expenses incurred in order to generate them.

Record expenses when “incurred” (not necessarily when cash is paid)

Expenses should not precede nor lag revenues (why?)

Page 4: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Accrual Accounting

Examples: Capitalize and depreciate fixed assets Record expenses in advance of payment (e.g., wages,

severance accruals, contingent liabilities) Defer revenues until earned even though cash paid in

advance (e.g., magazine subscriptions) Accrual exercises (Hennessey F/S) International Paper mini-case

Page 5: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Accrual Exercise

Accrual Cash

Sales Revenue

COGS

Payment on Mdse

Salaries Expense

Utilities Exp

Interest exp

Net income

Page 6: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Accrual Exercise

ASSETS Amount LIABILITIES amount Cash Accounts payable Accounts Receivable Note payable Inventories Interest payable Salaries payable Utilities payable Total Liabilities Furn, Fix & Equip EQUITY Accumulated Depreciation Contributed Capital Furn, Fix & Equip (net) Earned Capital Total Assets Total Liabilities and Equity

Page 7: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

International Paper mini-case – Q1

Page 8: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

International Paper mini-case – Q2

Components of $969 million charge

Page 9: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

International Paper mini-case – Q3

Components of $824 million charge

Page 10: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

International Paper mini-case – Q4

Components of $125 million charge

Page 11: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

International Paper mini-case – Q5

Components of $541 million charge

Page 12: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

International Paper mini-case – Q6

Components of $34 million reversal

Page 13: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

International Paper mini-case – Q7

In sum, do you think these accruals provide investors with relevant information? How might a company use accruals to misrepresent its financial condition? What might you look as an analyst to analyze the appropriateness of accruals?

Page 14: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

A/R Allowance for Uncollectible Accounts

A/Rs are reported net of uncollectible accounts (UA) Estimate bad debts and make the following journal

entry:Bad debt expense xxx

Allowance for UA xxx Expense is recorded when incurred (bad debts

estimated), no expense when A/R is written off Sears mini-case

Page 15: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Sears Mini-Case Describe the actions Sears took with respect to its

allowance for uncollectible accounts in 1993? How did this affect earnings? What other actions occurred in that year?

Why does the analyst think that Sears’ reported earnings are overstating its “true” earnings”

What is the response of Sears’ CFO to these allegations? Do you believe him?

How can a company use the allowance for uncollectible accounts to shift earnings from one period into another?

As an outsider, what might you look at to give you a clue that the company might be managing earnings via the allowance account?

Page 16: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Accruals and Future Stock Performance “Most investors claim to pay attention to earnings quality,

but recent academic research suggests otherwise. Investors often ignore valuable publicly disclosed information regarding the reliability of reported earnings and their potential improvement or deterioration, creating an opportunity to exploit the likely impact on stock performance.”

Our own research has confirmed the academic findings and enhanced a stock-selection tool the academics suggested, making it more timely and broadly applicable. Just as important, our research sheds insight on the fundamentals the tool captures, making it a very useful addition to our research-review process. The tool appears to be capturing information that our existing tool set doesn’t, and thus could be additive to the returns of our US value portfolios. (US Value Equities)

Page 17: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

While some of its underlying drivers seem to have a value flavor, our research shows the tool to be style-agnostic. In a large-cap universe sorted on the basis of price to book, it is effective for both value and growth stocks (Display 2). In fact, it was somewhat more effective for stock selection within growth.

(US Value Equities)

Page 18: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Essentially, we believe that balance-sheet accruals speak to the persistency of reported earnings. It implies that investors take earnings reports literally and treat all sources of reported earnings as equal, although the accrual component of reported earnings is less reliable than the cash component.

US Value Equities

Page 19: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Accruals and Reversion of ROA

Source: Richard G. Sloan, The Accounting Review, July 1996

Page 20: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Figure 2Average Cumulative Excess Returns

-0.15

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36

Months After Test Year

Ave

rage

Cum

ulat

ive

Exc

ess

Ret

urn

Cycle Peaks Cycle Troughs

Halsey, R.F. 2001. "Stationary Components of Earnings and Stock Prices," Advances in Quantitative Analysis of Finance and Accounting, vol. 9, pp 81-110.

Page 21: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Source: CFRA 2004

CFRA Comments on Accruals

Page 22: © 2005 by Robert F. Halsey Accruals Agenda: Review accrual accounting Statement preparation exercise Discuss cases International Paper (accruals) Sears

© 2005 by Robert F. Halsey

Coca-Cola mini-case

(projections)