Financial Statement Analysis

• Smoothing earnings growth gives the impression of stability, which lowers the cost of capital.

 How to smooth earnings-shortfalls

• It is late in the quarter and earnings appear to be falling short of last quarter’s.
• Borrow sales from next quarter

--contact customers and offer a substantial discount if they place orders this quarter

--acquire a small firm with good earnings that you can consolidate into yours

How to smooth earnings-downfalls

• Raise expenses

--Invoke non essential expenses like training programs, etc

--Begin required maintenance sooner than planned.

• Rainy Day Reserves

--When should revenue be recognized?

1. Relative easy for the firms to account for bad debts losses and returns of detective items

2.  More difficult to deal with contingent sales agreements

3.  There can be big problems with “new economy” firms like software sellers

Loading the Distribution Channel

--The firm persuades its customer to purchase more now than it needs by offering better credit terms.

--But more now means less later.

--With a more generous discount it may mean less now and less later.

--When should expenses be recognized?

 1.  The firms managers may decide that the stability of the earning is more valuable, so instead of reporting the additional earnings, they create a reserve (rainy day) fund.

2.  It is legitimate for a firm to set aside reserves from current earnings for expected future contingencies

3.  Not ok to set aside reserves for unspecified future contingencies.

--Hiding Risky ventures

--Making unreasonable assumptions

Evidence that earnings are managed

• Corporate books reflected an unbiased view of the firm’s condition; the laws of probability suggest that they should reflect small decreases about as often as small increases.
• A study by Harvard economist shows that small increases occur far more frequently. When firms see a small decline coming they pull out the discretionary items to push earnings to the positive side.

Taking a “Big Bath”

--Big Bath=Maximizing the reported loss

--Logic is to get all the bad news out at once and get it over with

--Future expenses are moved into current reporting period.

--Expenses that might be accelerated

• Write downs of assets that have permanently lost market value.
• Good will from prior unsuccessful acquisitions.

--Overestimating the amount of the write down can provide method for future “adjustments” by reversing the excess write offs.

Capitalizing Vs Expensing

--In 1994, AICPA created an exception to a long standing rule by allowing direct mail advertising costs to be capitalized rather than expensing

--To qualify the direct mailer had to demonstrate that it possessed historical evidence that could accurately predict response rates and, by extension, the revenue that the advertising would generate.

How do you decide if growth assumptions are reasonable?

--Life cycle of the firm

--Saturation

--Competition

Downplaying Contingencies (Future Liability)

-- Legal Actions

-- Changes in regulation

-- Pension Fund Liabilities

--Bankruptcy

Relying on information provided by Wall Street

--2 classes of investors

        - Institutional

        - Individual

-- Individual investors want a story

        - A new product with unlimited sales potential

        - A play on economic trends, e.g. interest rates

--Analysts seems happy to provide fuel for these stories

Wall Street Analyst conflict of Interest

--Recent history of analysts touting stocks that the IB is divesting

--Good reviews for good investment banking customers

The Financial Accounting Standards Board FASB

--Operates under authority granted SEC

--Composed of

        - Accounting professionals

        - Issuers of financial statements

        - Users of financial statements

        

Confrontations between FASB and Corporate America

--FASB seems slow to act

--Actions don’t go far enough

--Rule making by negotiation

--Better than congress doing it

Firm Analysis

--Compare firm to itself-trend over time

--Compare firm to other firms-industry, sector, market.

DuPont Analysis of ROE

ROE =(NPM)(TAT)(EM)

The equity multiplier is a function of the firm’s debt ratio; the higher the debt ratio, the higher the EM

This illustrates the fact that a good or bad ROE may result from problems or strengths in each of the three areas

--Profitability relative to sales

--efficient use of assets

--use of debt in capital structure

Debt usage is of most concern, since it can be used to mask problems in the other 2 areas

ROE of firm if higher than Industry ROE, decide to purchase the firm’s share.