© 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)
© 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
© 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?)
© 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
© 2005 by Robert F. Halsey
Accrual Exercise
Accrual Cash
Sales Revenue
COGS
Payment on Mdse
Salaries Expense
Utilities Exp
Interest exp
Net income
© 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
© 2005 by Robert F. Halsey
International Paper mini-case – Q1
© 2005 by Robert F. Halsey
International Paper mini-case – Q2
Components of $969 million charge
© 2005 by Robert F. Halsey
International Paper mini-case – Q3
Components of $824 million charge
© 2005 by Robert F. Halsey
International Paper mini-case – Q4
Components of $125 million charge
© 2005 by Robert F. Halsey
International Paper mini-case – Q5
Components of $541 million charge
© 2005 by Robert F. Halsey
International Paper mini-case – Q6
Components of $34 million reversal
© 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?
© 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
© 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?
© 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)
© 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)
© 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
© 2005 by Robert F. Halsey
Accruals and Reversion of ROA
Source: Richard G. Sloan, The Accounting Review, July 1996
© 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.
© 2005 by Robert F. Halsey
Source: CFRA 2004
CFRA Comments on Accruals
© 2005 by Robert F. Halsey
Coca-Cola mini-case
(projections)