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Business analytics and FSA

Business analysis is useful for handling issues as --Whether to build capacities or acquire?- the classical

make/ Buy decision The issue is whether U would

primarily rely upon and use your internal resources or

U would look for external replacement to strengthenyour leadership asset

-- Whether upon acquisition, to Amalgamate or run it

as a stand alone? the hassles of absence of

Synergies, issues of Integration, tax issues,Regulatory compliance issues issues of monopoly etc

MOST OF ALL RELEASING CASH TRAPPED IN THE

ACQUIRED UNITAditya Birla groups acquisition of

Novell

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continued

Whether to Sell orHold? Shut down point(protracted Negative contribution, Revenues

being lower than Long run average costs for

a period)

--The Best Fund mix-in Cost and risk

parameters, tenure parameter, domestic and

International parameters( IPO/Follow on/Public

issue/ADR GDR/IDR) --Inputs for such Strategic Issues as

Outsourcing, Changing fund mix etc

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continued

The BACKGROUND-Industry and Strategy Analysis involving

the business Environ-B/A

The SpecificsFSA reflected by

1)Accounting analysis

2)Financial Analysis comprising of--

a)Analysis ofOperating activities

b)Analysis ofFinancing activities

c)Analysis ofInvesting Activities

3)Profitability analysis 4)Prospective analysis

5) Liquidity and Working Capital Analysis

6)Capital Structure analysis

7)Valuation of Business

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The steps in FSA Steps in Accounting Analysis

1)Identifying KEY accounting policies

Ex. For a bank it is Provision for bad and doubtful debts For

an insurance company it is accounting for warranties and

contingencies

2)assess Accounting flexibility

Firms have little flexibility in accounting forIn-House R&D

costs; they have to be expensed. Software firms have the

flexibility to decide the point at which the expenses can start

getting CAPITALIZED Rigid policies give little information though the scope for

earnings management is less

3)Evaluate Accntng. Strategy

How do the firms Accntng. Policies compare with those

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Steps--

For ex. A Bank could be providing less towards Bad and

Doubtful debts. This could be because of Good loan

Disbursement/ collection policies; or, is that a dressing?

Do these firms have reasons to adopt the policies they have

done?

Enron created Special purpose Vehicles to take certaintransactions off the B/srest is History

4)Evaluate the Quality ofDisclosures

Letters to shareholders is a good disclosure tool that GA

Cements has adopted. Dr. Reddy Labs. Did the same in theinitial years

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Steps--

How forth coming is the Management on Bad news?

Do the foot notes / notes to a/cs display policies expected?

How good is the SEGMENTWISEDISCLOSURE? Can one

see the different colors OR is it GREY?

Step 5)Identify the REDALERTS

--unexplained changes in Accounting WHEN THE

PERFORMANCEWASPOOR

--Disparity between GROWTH IN SALES and GROWTH IN

A/cs Receivables IIIly disparities between Sales AND

INVENTORY HOLDING

--Huge disparities between a firms CASH FLOWS

FROMOPERATIONS and Comprehensive income

---Huge Tax Deferrals arising out of Differences Between

Book and Tax Profits

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steps

Step 6) Undo Accounting Distortions Imprudent capitalization should be

reversed, for example.

The Analyst will have to make severaladjustments to arrive a properPicture

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1

Need forFSA -- In an ideal world FSA should be concentrating

ONLY on the bottom lines ofFinancial reportingNetincomes and Shareholders equity. Different methods

of accounting adopted, differing estimates and nonconformity in application ofAccounting principlesmake the course complicated.

Financial reports often contain supplementary data

that help the user of the statements to derive meaningand make relevant interpretations of numbersratios,cash flows etc. the effort here is to strike at thefundamentals that help differentiate the grain from the---

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1a

Economic events and accounting entries do notcorrespond by TIME in most cases and by Quantum in

some Accounting does not take cognizance of capital

appreciation in assets till they are sold. Similarly losses on

assets get accounted only on their sale though that loss of

value could be very visible much before. Contracts by and large are not accounted at the time they

are entered into but are accounted when Legal rights of

Ownership change! Some contracts like hedging are NOT

accounted but DISCLOSED as FOOT NOTES or as Notesto accounts, though they could later have significant

implications on the financial health of the Enterprise

Finally information from outside financial reports could help

drive meaningful conclusions that might not be otherwise

possible

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2

External users ofFinancial statements The common characteristic ofExternal users is their general

lack of authority to PRESCRIBE the info they want from the

company

External users are a diverse type but generally can beclassified in to 3 groups

1) Credit and Equity investors

2) Government , regulatory bodies and tax authorities

3) The general public and special interest groups, laborunions and Consumer groups

These groups have different objectives in FSA BUT THE

EQUITY INVESTORS and CREDITORS are the PRIMARY

USERS

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3

The info supplied to Equity investors and creditors is useful to

others as well; hence Accounting Standards are EQUITY

investors and Creditors Oriented

The UNDERLYING OBJECTIVE ofFSA is the COMPARATIVE

measurement ofRISKANDRETURNS so as to make

Investment and orCredit decisions. Predictions of the futureresults is by Historical extrapolations generally through special

models are covered here-Prospective analysis

Equity investors look at Profitability and Growth whereas

Creditors especially the short term ones look at LIQUIDITYLong term investors like insurance cos are interested in

long term asset growth and profitability

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4-The Financial Reporting System

The accounting process that generates accounting information

forExternal users are 5 principally

1) Balance sheet

2)Income statement

3)Statement ofComprehensive income

4)Statement ofCash Flows

5)Statement ofStock Holders equity

These 5 statements along with Notes to Accounts are

interpreted to provide relevant, timely and reliable information to

make investment, credit and similar decisions. Many

transactions are reflected in more than one Statement so that it

requires a foray in to all statements before comprehensive

conclusions can be drawn

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5

The Financial reporting System is based on data generated

from ACCOUNTING and Economic events. Financial

Statements recognize events and transactions meeting

certain criteria---Primarily Exchange transactions, passage

of time(accrual of interest), the use of services,

(insurance), use of assets ( depreciation), use of estimates( Bad debts) and impact of some contracts ( Financial

leases)

Accrual accounting rests on matching principle which says

Revenues are to be matched by corresponding costs and as

such have to be accounted even though cash did not change

hands.

Transactions are measured on HISTORICAL BASIS, with

events resulting in a hike in value generally ignored

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6

Financial statements are prepared measuring transactions at

theirHistorical Costs. These costs are OBJECTIVEand VERIFIABLE. Its UTILITY however DECLINES as 1) The

Specific prices 2) General Prices, changes Hence

additional disclosures are made mandatory by Regulating

authorities all over the world

Financial Reporting also relies on GOING CONCERN

CONCEPT; that the firm in question would continue its

operations indefinitely. This concept brings as to the difference

between Capital and Revenue all costs and Incomes wouldhave to be Revenue if this concept were not in place

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6a Reporting Environ

I) the Reporting environment A)The statutory reports Income statements

and B/S

B)Other reports 1)Financial statements-Quarterly

2)Earnings announcement

3)Other statutory reports

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6b

Financial statements-these are statutory reports acompany must file with the SEC; are not publicityoriented (unlike some annual reports) and containinfo. beyond what annual reports reflect---Form10-

k Form-10qare quarterly statements filed

with the SEC. these provide LATEST info.

While analyzing these data we need to take

cognizance ofa) seasonality factors b) Year endadjustments-which do not appear quarterly

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6c

Year end adjustments are done in the followingareas generally

1)inventory-difference between actual stockand book stocks

2) tax provision 3)Outstanding expensessalaries etc

4) provision for depreciation

5)Provisions forwork remaining to beexecuted on capital a/cs not providedfor basically contingent liability turning intoprovision

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6e

2)Earnings announcements Key announcements about cos. performance quarterly

and yearly

Cos. PROFORMAEarnings statement give a clear a/cof the Operational profits i.e profits from continuingoperations divested from non operational earningsand extraordinary income/ expenses

Pro forma earnings while reflecting operational profitsmight exclude from Profits certain non operating

incomes/expenses which could provide value to ananalyst

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6f

3)Other statutory reports Form10k- filed with annual report

Form 10 Q filed with Quarterly report

Form 20 fFiled by Foreign Issuers

Form 8k current report to be filed

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7

Financial reporting Systems

The SEBI

Has come out with disclosure norms for acquisitions, norms for

publishing information etc. The Annual report has the following

disclosure requirements---

Contents

--Business of the company

The properties and Assets it owns

--Management discussions and analysis-Directors report

--Auditors report including Qualifications if any

--Financial statements and Notes to Accounts

--Investee Financial statements ( Where applicable)

--Parent company statements and results to the extent required

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8

Schedules

--condensed Financial information including details ofAssets

Liabilities, Income and Expenses that are major

-- major expansion/ diversification plans including on going

acquisition talksbroad details

--Auditors statements including expression ofOpinion on

Accounts

--segment reporting

--Corporate governance standards adopted and Issues if any

------

Quarterly report

A birds eye view ofWorking results for the Quarter

The perception of the Management for the Quarters ensuing

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10

Relevance the capacity of information to make a difference to

a decision To a Technical analyst all financial data are

irrelevant To a Fundamental analyst, the RELEVANCE of

Information VARIESWITH the method ofAnalysis OfCash

flow/ Balance sheet/ orIncome statement

Timeliness is an important aspect of relevance. InformationLOSESVALUE RAPIDLY . As time passes FUTURE becomes

the PRESENT with the PAST becoming increasingly

IRRELEVANTHowever past data helps Projections

Reliability encompasses verifiability, representationalfaithfulness, and neutrality

Unfortunately Relevance and Reliability are OPPOSING

ATTRIBUTES. Auditing improves RELIABILITY but the

TIMELINESS which is a RELEVANCE attribute gets hit;

thus Quarterly results are NOT audited!!

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11

Relevance and Reliability also CLASHELSEWHERE. Marketprices may be very relevant but less reliable. Historical costs

though HIGHLYRELIABLE become LESSRELEVANT!!IT is

the OLDARGUMENT as to whether to be PRECISELY

WRONG or be APPROXIMATELYRIGHT ANALYSTS have

opted forESTIMATES in SEGMENTREPORTING, off balancesheet financing etc. whereas AUDITORS harp on RELIABILITY

and have opposed estimates in Financial Statements

Consistency and Comparability are again equally strong

attributes of Financial Statements . CONSISTENCY inadopting and continuing to use them is an ATTRIBUTE of good

Financial statements

Comparability becomes an Issue when accounting policies are

changed just as much as when NEW transactions like

SECURITIZATIONcome in to the picture between 2 firms

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12

Comparability becomes a PERVASIVEISSUE as choice ofcertain policies as also estimates in certain parameters make

comparability a flouted attribute. REAL DIFFERENCES let

alone Accounting policiesmake comparability a tricky issue

Ex Some Firms have INTERNATIONAL OPERATIONS while

others are Domestic MATERIALITY is arguably a CRUCIAL ASPECT An

INFORMATION is MATERIAL when it makes a DIFFERENCE

to the VALUATION of the firm. Sometimes even SMALL

CHANGES can have a MATERIAL EFFECT on VALUATIONEx Sales FORCED upon Customers to achieve the

PROJECTEDTARGET . Realizing Capital Gains to achieve

Profit targets

The SEC has announced that Auditors should recognize

QUALITATIVECHANGESASWELL. Examples

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13

1. Obscuring changes in EARNINGSTRENDS 2 HIDING the FAILURE to achieve PROJECTEDANALYST

FORECASTS

3Converting a LOSS to INCOME and Vice versa

4Obscuring CHANGES in SIGNIFICANT BUSINESSSEGMENTS

5Increasing Managerial Remuneration

6Things AFFECTING COMPLIANCE with REGULATORY

REQUIREMENTS, LOAN COVENANTS or other contracts 8Concealing UNLAWFUL A/CS

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14- PRINCIPAL FIN STATMENTS

BALANCESHEETS

The B/s Statement ofFinancial positionreports majorclasses ofASSETS( Resources OWNEDANDCONTROLLEDby the FIRM) LIABILITIES ( EXTERNAL CLAIMS on theseAssets) and Stock holders Equity ( Owners Capital

contributions and otherINTERNALLY GENERATEDFUNDS)and theirINTERRELATIONSHIPS at specific points in time

Capital= A L

Assets are defined as probable future economic benefitsobtained or controlled by a particular entity as a result of

past transactions or events. The weakness in the definition is the lack of reference to RISK

There are transactions where Assets are transferred but therisks of ownership still lie to some extent with the Seller--Financial lease

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15

Liabilities are defined as probable FUTURESACRIFICES of

Economic benefits arising from PRESENTOBLIGATIONS of a

particular entity to transfer assets or provide services to other

entities in the future as a result ofPASTTRANSACTIONS or

events

EQUITY is the residual interest in the net assets of anentity that remains AFTER DEDUCTING its LIABILITIES

In reality some Instruments have characteristics of BOTH

equity and debt making Categorization a difficult job

Convertible Debentures and Preferred Stock THE INCOME STATEMENT

Reports on the results of OPERATIONS and non operating

activities. It explains SOME IF NOT ALL of the changes in

Assets , Liabilities and Equities between two consecutive

Balance sheet dates

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16

The use ofACCRUAL CONCEPT brings about an interrelationship betweenIncome Statement and balance sheet

The preparation of the INCOMESTATEMENT is governed by the

MATCHING PRINCIPLE , which states that performance can be measured

ONLY IF revenues and related costs are accounted forduring the same

time period

Elements of the Income statements

Revenues are defined as

Inflowsof an entityfrom delivering or producing goods, rendering

services or carrying out other activities that constitute the entitys

ongoing major or central operations Expenses are defined as

Outflows from delivering or producing goods, rendering services, or

carrying out other activities that constitute the entitys major or central

operations

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17

The definitions ofRevenues and Expenses SPECIFICALLYEXCLUDE increases( decreases) in EQUITY from peripheral

or incidental transactions Thus GAINS( and LOSSES) are

NON OPERATING EVENTS. Examples would include GAINS

AND LOSSES from Sales ofAssets, Law suits and changes in

Values ( including Currency values)

While stating so may be easy, the problem centrally would

focus on GREYISSUES likeRecurring vs Non recurring,

Operational and Non Operational costs/ revenues, and

extraordinary items From the Analysts point of view DISCLOSURE rather than

classification is important while from the Data base USERs

end, the classification is EQUALLYIMPORTANT

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18

STATEMENTOFCOMPREHENSIVEINCOME

COMPREHENSIVEINCOME is defined as

The CHANGE in EQUITY of a Business enterprise during a

period from transactions and other events and

circumstances from non owner sources It includes all

changes to EQUITY during a period EXCEPT those

resulting from INVESTMENTS by OWNERS and

DISTRIBUTION to OWNERS

Comprehensive income INCLUDES BOTH NETINCOME and

DIRECTEQUITYADJUSTMENTS such as--- --Cumulative TRANSLATION ADJUSTMENTS

---Minimum Pension Liabilities

--Unrealized gains and losses on available for sale securities

--Deferred gains and losses on cash flow hedges

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19

These adjustments are COLLECTIVELY called OTHER

COMPREHENSIVEINCOME. SFAS130 requires that firms with

items of other comprehensive income report---;

--The CLOSING BALANCES ofEACHITEM. The total is

reported as a SEPARATECOMPONENT ofEQUITY called

accumulated OTHER COMPREHENSIVE INCOME

-- the CHANGE ( eitherPretax or post tax) in EACH item; the

change can be reported GROSSOr NET

---Reclassification adjustments to avoid DOUBLECOUNTING;

for example realized investment gains that include un-realized gains of EARLIER YEARS must be knocked off

from COMPREHENSIVE INCOME to avoid double counting

--Total Comprehensive in condensed financial statements

to be provided for interim periods

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20 Equity means property rights and refers to stockholders or owners equity.This owners equity

represents the claims of owners to the assets of the business, as shown in the accountingequation:

Assets = Liabilities + Equity

When the company reports net income on its incomestatement, that income amount is added to the stockholdersequity or property rights. Therefore, the components of net

income affect equity. Those components of net income arelimited to revenues, expenses, gains, and losses. All of thosecomponents of net income are included in comprehensiveincome. But there are changes in stockholders equity that arecomprehensive income but not net income. Some changes inassets and liabilities go right to the stockholders equity section

of the balance sheet without first affecting net income and beingincluded in the income statement. Unrealized gains and lossesthat are included in comprehensive income but are notrecognized or reported on the income statement are related toforeign currency translation adjustments, available-for-saleinvestments, and derivative financial instruments.

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21

Requirement---- The FASB requires companies to report

comprehensive income, either in a separate financial statement(as Dow Chemical Company does, shown in Exhibit 2.3) or aspart of the stockholders equity statement.

The definition of comprehensive income given earlier relates itto the change in equity during a period, but it is also described

as the change in wealth during a period. Wealth can increasenot only from business operations but also from changesin market values that are not related to operations. Thegoal of the requirement to report comprehensive income isto have a net income with results of business operationsand a separate comprehensive income with results of the

markets impact on the values of assets and liabilities.Three examples of items affecting comprehensive income are(1) foreign currency translation adjustments, (2) unrealized

gains and losses on available-for-sale securities, and (3)deferred gains and losses on derivative financial instruments.

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22

Foreign Currency Translation Adjustments When changes in the value of foreign currency

cause the assets of a company to increase invalue, the result will be an increase in the

stockholders equity (picture the accountingequation increasing on the left side as well ason the right side). Because the change in valueof the foreign currency is not related to the

companys operations, the increase instockholders equity cannot be reported as netincome. However, the increase in stockholdersequity is reported as comprehensive income.

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23

Unrealized Gains and Losses on Available-for- Sale Securities

Companies that own investments in marketable securities(bonds and stocks) will see the market values of theirinvestments increase and/or decrease over time. If thatinvestment is classified as available for sale (meaning that thecompany does not intend to sell but could if necessary, ascontrasted with trading investments not intended to be held along time), then the investment must be included in the balancesheet at its market value. If that market value is greater than thecost of the investment, there is an unrealized holding gain. Butthe gain in value is not related to the companys operations andthe company is in the same situation as for the foreign currencychange discussed above: an increase in asset value that mustbe balanced with an increase in stockholders equity thatcannot be reported as net income. Therefore, it iscomprehensive income.

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24

Deferred Gains and Losses on DerivativeFinancial Instruments

Companies may invest in derivative financial

instruments to hedge their exposure to the risk of

changing prices or rates. Such changes will

cause the value of the derivative to change, and

again, lead to unrealized gains or losses. If the

derivative instrument meets certain criteria, theunrealized gain or loss will be reported in

comprehensive income rather than in net income.

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25

Continued next slide

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26continued-Comprehensive Income

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27

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28

Statement of cash Flows

This Statement reports cash receipts and payments in the

period of their occurrence classified as Operating, Investing and

Financing Activities. It provides supplementary disclosures

about non cash Investing and Financing activities. Cash flow

data helps explain changes in consecutive balance sheets andsupplement information provided by Income statement

SAFS95 defines INVESTING ACTIVITIESCASHFLOWS as

those resulting from---

Acquisition orSale of property, plant and Equipment Acquisition orSale of a Subsidiary or segment

Purchase or sale ofInvestments in other firms

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25

Similarly FINANCING CASHFLOWS are those resulting from

Issuance or retirement ofDebt orEquity securities

Dividends paid to Stock holders

The Standard requires GROSS rather than NET reporting ofSIGNIFICANT investing and Financing activities, thereby

providing improved disclosures. Enterprises with Foreign Currency transactions on Foreign

operations must report the effect of exchange rates on

cash and cash equivalents as a separatecomponent of reconciliation of cash and cash equivalentsfor the period

Cash from OPERATIONS may be reported DIRECTLY usingMAJORCATEGORIES of GROSSCASHRECEIPTS andPAYMENTS; orINDIRECTLY by providing a reconciliation of

NETINCOME with Net Cash Flow from Operating activities

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26

Both the direct and Indirect methods require a separate

disclosure of cash outflows forINCOMETAXES and

INTERESTwithin the Statements or Elsewhere in the

financial Statements

STATEMENT OF STOCK HOLDERS EQUITY

the statement reports the amounts and Sources of changes inEquity from Capital transactions with Owners and may include

the following components

Preferred stock

Common stock Additional paid up capital

Retained earnings

Treasury shares ( Repurchased equity)

ESOPs

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27

And as components ofOTHERCOMPREHENSIVEINCOME,the following---

Minimum pension liability

Unrealized gains and losses on AVAILABLE forSale securities

Cumulative Translation Adjustment ( Foreign operations)

Unrealized gains and losses on Cash flow hedges

Shares issued are recorded at par in Equity and the ExcessoverPar value as, Share Premium a/c Additional capitalissued REPURCHASES or Buy backs are treated as TreasuryStocka Contra entry in the B/S. Retained earnings andESOPS are also reported

FOOT NOTES/ Notes to accounts

Are an integral part of the financial statements and provide dataon such subjects as Business segments, the financial position

ofRetirement plans and Off- balance sheet obligations

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28

These data are required by GAAP ( FASB) or regulatory

authorities The Notes to accounts and 10K filings to the SEC

are audited. Supplementary Schedules are however un audited

Notes provide info about Accounting methods, assumptions,

and estimates used by Management to develop the data

reported in Financial statements. They are designed to allowusers to improve assessments of the amounts, timings,

and uncertainty of the estimates reported in the Financial

statements. They provide additional disclosures related to

such areas as

Fixed assets Debts- interest rates etc

Inventories Law suits and contingencies

Taxes Marketable securities and Investments

Pensions and post employment benefit plans

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29

Marketable Securities

Hedging and other risk management activities

Business Segments

Significant customers, Sales to related parties and Exports

CONTINGENCIES

Notes to accounts often contain disclosures relating tocontingent losses These losses get classified either asprovisions or as contingent liabilities depending uponwhether the loss is fairly certain or not. This part isSUBJECTIVE and involves judgment.

Where losses are fairly certain a Provision is created bydebiting the Profit and loss account. Where losses are ONLYDEPENDENT on the happening of a certain event, aContingent liability by way of just a note in the accounts comesin to picture

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30

In India contingent liabilities are basically things like ---

--Claims against the company not acknowledged as debts

---Arrears of cumulative Preference dividends

--- Bills discounted and III party Gaurantees

--- Amounts yet to be called up on partly paid shares

-other matters for which the company is contingently liable

MANAGEMENTDISCUSSIONS and ANALYSIS ( MDA)

These are discussions on earnings that have been a part of theAnnual reports for Listed companies. In India they are called

Directors Report. The MDA is supposed to discuss Results ofOperations, including discussion of trends in Sales

and categories of expenses

Capital resources and liquidity including discussions of cashflow trends

Outlook based on known trends

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31

The discussions could involve the following---

1)prospective information and required discussion ofSignificant effects of

currently known trends, events and uncertainties ex decline in Market

share, inventory obsolescence etc. Firms may voluntarily disclose Forward

looking data that anticipates trends or events

2) Liquidity and Capital resources: Firms are expected to use cash flows

statements to analyze liquidity ; provide a balanced discussion ofOperating,Investing and Financing activities and events AFTERTHEDATEOF

BALANCESHEET

3)Discussions on Discontinued operations, Extraordinary items and

other unusual or infrequent events known as Non recurring and

Extraordinary gains/ losses 4)Extensive disclosures in interim financial statements in keeping with

the obligation to periodically up date MD&A-Directors report-- discussions

5)Disclosure of Segments disproportionate need for cash flowsor

Segments contribution to revenues orProfits

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32

The SEC in 2002 issued a statement reinforcing its views on

the importance of MDA disclosures the release remindsregistrants that disclosure must be both useful andunderstandable

Topics addressed include

1) Liquidity and capital resources, including the impact ofOffBalance sheet arrangements on Liquidity and Capital resources

2)Disclosures about contractual obligations and commercialcommitments ( that is Off balance sheet obligations)

3)Disclosures about Trading Activities, including non

Exchange traded contracts 4)The effects of transactions on related parties, including

persons ( like employees) who could fall outside the definitionofRelated parties

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33

Role of the Auditor

the auditor must ensure that the financial statements conform

to GAAP/IAS. Accounting policies must be appropriate and

estimates reasonable. The Auditor would also look into the true

and fair view that the statements must reflect and into the

correct position ofAssets and Liabilities. The Report the auditorsends out is a must read for any analyst though the auditor

does not certify that there are no errors in the statements

SAS sometimes requires the addition of an Explanatory para if

needed, that describes material uncertainties affecting Financialstatements such as Doubts regarding going concern

assumption that underlies the preparation ofFinancial

statements- Uncertainty regarding the Valuation and realization

ofAssets or Liabilities Uncertainty regarding Litigation

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34 THEACCRUAL CONCEPT-M2 Income cash Flows and AssetsDefinition and Relationships

In a world ofcertainty, the interrelationship amongIncome, cash flows and Assets is captured by theconcept of ECONOMIC EARNINGS , defined as net cash flows PLUS change in market values ofthe firms net assets. The market value of thefirms assets is the PRESENT VALUE of theirFUTURE Cash flows DISCOUNTED at the Risk freerate r

HoweverFuture Cash flows and Interest rates are

UNCERTAIN in the Real world!The market prices arealso uncertain and available prices may be difficultto relate to the Present value of generallyuncertain and estimated cash flows beingdiscounted at estimated discount rates!!

Moreover the market value of an Asset may end up being

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35

Moreover the market value of an Asset may end up being

measured with DIVERSE METHODs some at replacementcosts, some at capitalized value of earnings etc Thus in a realworld, income ( however measured) is at BEST a PROXYfor ECONOMIC INCOME. Economists analysts havedeveloped a number of analytic and practical definitions ofearnings to serve as PROXY forEconomic earnings

Distributable earnings are defined as the amount of earningsthat can be paid out as DIVIDENDS without changing theValue of the firm

A related measure, SUSTAINABLE INCOME refers to thelevel of income that can be MAINTAINED IN THE FUTUREgiven the firms assets

Another measure PERMANENTEARNINGS used by analystsfor valuation purposes is the amount that can be normallyearned given the firms assets and EQUALS the MARKETVALUEOFTHEASSETS TIMES the firms REQUIRED

RATEOFRETURN

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In Financial Reporting, the determination of---

Which cash flows are included in INCOME and When

Which changes in assets and Liabilities are included in Income

How and when the selected changes in asset and Liabilities are measured

Are BASSEDON ACCOUNTING RULES and PRINCIPLES that make up

the generally accepted accounting principles ( GAAP). With a few

exceptions the Accounting process ONLYRECOGNIZESVALUE

CHANGES arising from ACTUAL TRANSACTIONS

Reported income under the accrual concept provides a measure of current

Operating Performance that is NOT exactly based on ACTUAL CURRENT

Period Cash flows. Cash inflows and outflows ( past present and Future) are

recognized as income in the appropriate ACCOUNTING PERIODS. Theselected periods best indicates the firms present and continuing ability to

generate future cash flows Information about enterprise earnings based

on accrual accounting generally provides a better indication of an

enterprises ability to generate cash flows THAN in formation limited to

the FINANCIAL EFFECTS of cash receipts and Payments

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37 The accrual basis of accounting thus allocates ( recognizes as

Revenue and expense) many transactions and events toTIME PERIODS OTHER THANthose in which the Cashflows occur. Accrual accounting Principles are,fundamentally, the decision rules that tell preparers ofFinancial Statements WHEN to recognize the revenue and

Expense consequences of Cash flows and other events The recognition of Revenues and expenses in periods

other than when cash is actually received or spent has acorollary effect on the balance sheet. Both the recognitionand measurement of certain assets and liabilities are the

results of the application of the accrual concept of income.The differences between the income recognized and actualcash flows are accounted for as Assets or Liabilities TheMATCHING PRINCIPLE added on to the accrual conceptprovides a better info.than does cash flows perse

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38 The accrual process enhances the predictive ability of cash flows However

as evidence also indicates it does not mean that cash flows are not relevantthey provide information about the Quality of earnings and in the

process mitigate the weakness of the Accrual system

The determination of Accounting earnings is also governed by

General principles and measurement rules underlying all accounting

transactions and events Specific rules to determine Revenue, Expense gains and loss recognition

For ex. The HISTORICAL COST BASEDAPPROACH underlying GAAP

results in Rules that exclude unrealized holding gains and losses on

assets ( M2M gains/ losses). Recognition of gains/ losses in these

assets/ liabilities MUST AWAIT their DISPOSAL/ Settlement( for

liabilities)

However some NON TRANSACTIONAL related changes in asset values

can affect REPORTED INCOMES. For example,

CURRENT ASSETS must be EVALUATED at EACH FINANCIAL

STATEMENT DATE and any ESTIMATED DECLINES in ASSET VALUES

recognized as LOSSESno gains as it is conservatism u c!

SFAS 121 extended the above requirement to Fixed assets also except that

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39

SFAS121 extended the above requirement to Fixed assets also except that

certain IMPAIRMENTCONDITIONS will have to met before a WRITE

DOWN is possible!

Certain assets financial assets are Marked to the market and such gains

taken in as INCOME The Hassel here is that CURRENTINCOME is laden with these anomalies

and cant be taken at FACEVALUE!!

INCOME STATEMENTS

Suggested format

----- Revenues from sales of goods and services

------Operating expenses

= operating Income from continuing operations

+ Other incomes and expenses

= Recurring incomes before interest and taxes from continuing operations

-- Financing costs

= Recurring pretax incomes from continuing operations

+/- Unusual / infrequent items

= pretax earnings from continuing operations

---Income tax expense

+/ Income from discontinued operations( net of tax)

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40

+/_ Income from discontinued operations( net of tax)

+/_ Extra ordinary items ( net of tax)

+/- Cumulative effect of accounting changes

= net income

The OPERATING INCOMEFROM CONTINUING OPERATIONS is

independent of the Capital structure!

Recurring vs non recurring items Companies often change the Income

statement format to obscure areas of less than appreciable

performance Generally Income FROM A FIRMS RECURRING

OPERATIONS is considered to be the BEST INDICATOR of FUTUREINCOME. The PREDICTIVE ABILITY INCREASES upon EXCLUSION of

a firms NON RECURRING SPORADIC and RANDOM INCOME

Transitory gains and losses are NOT to be considered as a part of

SUSTAINABLEPERMANENTINCOME!!On the other hand the concept of

RECURRING INCOME portrays a predictable level of performance wheregrowth rates can be forecast and long term earnings fairly put in Black and

White. Recurring income portrays income from continuing operations

It is important to realize that non recurring incomes are NOT a TYPE

OF EVENT; in fact the same income depending on the NATURE OF

THE EVENT and to some extent MANAGEMENT DISCRETION may get

classified above/ below the line!!

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41

For example for some firms the gain/ loss on sale ofFIXED

ASSETS will be rare with LITTLEPREDICTIVEVALUE; Othersmay retire F/A regularly and report gains/ losses a Car Rental

company retiring a part of its fleet regularly

The Nonrecurring part may be segregated in to

A)Extra ordinary items not useful in predicting ROE B)Income from discontinued Operations not useful in

predicting ROE

C) Unusual and infrequent items are useful in predicting ROE

This IMPLIES item c) contains a RECURRING ELEMENT!! The predictive ability ofFinancial statements is LIMITEDWe

need to extrapolate going by available cues. For example a

huge sales in cars implies a corresponding sales in Tyres!

Accounting Income Revenue and Expense recognition

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42

Accounting Income Revenue and Expense recognition

There are 2 aspects to revenue recognition

1) the TIMING when do we recognize revenues

2) measurement how much of it do we recognize? For revenue to be recognized 2 conditions must be met

1)Completion of earnings process

2)Assurance ofPayments

Condition 1 has 2 parts

1a)The Firm MUSTHAVEPROVIDEDTHE BUYERWITH

virtually all the goods and services he was obliged to provide

the SELLER must have NO SIGNIFICANT CONTINGENT

OBLIGATION LEFT 1b)The second condition is a RELIABLE MEASUREMENT

of the REALIZABILITY of the claim for goods and services

rendered

Goods provided to date x Total Revenue expected

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43

The formula in the previous slide reflects recognition of

Revenue on a continuing basis

In cases where payment is received PRIOR to the DELIVERY

of goods/ services appropriate revenue recognition implies---

A)Revenue on LEASEDASSETS to be recognized by the

lessor on some reasonable basis.Ex No. of photo copies perperiod for recognizing rentals of a photo copier

B)Credit card fees are recognized as the right to use the card

keeps depleting time wise

C) Magazine subscriptions are recognized in PROPORTIONTOTHEDELIVERIES MADE

Departures from the recognition basis stated above is also

possible under extraordinary circumstances. For ex. Revenue is

NOT recognized even when Sales are completed if a huge

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44

Revenues for contracts are recognized on the basis of either

a)Percentage ofCompletion method or on b)Completedcontracts method

The Percentage of completion measures progress towards

completion using either

Engineering estimates( Physical progress) or Ratio of costs incurred TO expected total costs

This method may OVERSTATEREVENUES and Gross

PROFITS if expenditures incurred DO NOT CONTRIBUTE

TO PHYSICAL PROGRESS. IF A LOSS IS ANTICIPATED ITMUST BE INCLUDED IN THE PERIOD WHERE THE LOSS IS

VISIBLE OR CALCULABLE