Financial Statements and Corporate Managers

Table of contents

A Framework for Business Analysis Using Financial Statements

Question 1

Matti, who has just completed his first finance course, is unsure whether he should take a course in business analysis and valuation using financial statements since he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to Matti when financial analysis can add value, even if capital markets are efficient. The efficient market hypothesis states that security prices reflect all available information, as if such information could be costlessly digested and translated immediately into demands for buys or sells.

The efficient market hypothesis implies that there is no further need for analysis involving a search for mispriced securities. However, if all investors adopted this attitude, no equity analysis would be conducted, mispricing would go uncorrected, and markets would no longer be efficient. This is why there must be just enough mispricing to provide incentives for the investment of resources in security analysis. Even in an extremely efficient market, where information is fully impounded in prices within minutes of its revelation (i. e. where mispricing exists only for minutes), Matti can get rewards with strong financial analysis skills:

  1. Matti can interpret the newly-announced financial data faster than others and trade on it within minutes;
  2. financial analysis helps Matti to understand the firm better, placing him in a better position to interpret other news more accurately as it arrives.

Markets may be not efficient under certain circumstances. Mispricing of securities may exist even days or months after the public revelation of a financial statement when the following three conditions are satisfied:

  1. elative to investors, managers have superior information on their firms’ business strategies and operation;
  2. managers’ incentives are not perfectly aligned with all shareholders’ interests;
  3. accounting rules and auditing are imperfect.

When these conditions are met in reality, Matti could get profit by using trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process. Capital in market efficiency is not relevant in some areas. Matti can get benefits by using financial analysis skills in those areas.

For example, he can assess how much value can be created through acquisition of target company, estimate the stock price of a company considering initial public offering, and predict the likelihood of a firm’s future financial distress.

Question 2

Accounting statements rarely report financial performance without error. List three types of errors that can arise in financial reporting. Three types of potential errors in financial reporting include:

  • error introduced by rigidity in accounting rules;
  • random forecast errors;

systematic reporting choices made by corporate managers to achieve specific objectives.

Accounting Rules

Uniform accounting standards may introduce errors because they restrict management discretion of accounting choice, limiting the opportunity for managers’ superior knowledge to be represented through accounting choice. For example, SFAS No. 2 requires firms to expense all research and development expenditures when they are occurred. Note that some research expenditures have future economic value (thus, to be capitalized) while others do not (thus, to be expensed). SFAS No. does not allow managers, who know the firm better than outsiders, to distinguish between the two types of expenditures. Uniform accounting rules may restrict managers’ discretion, forgo the opportunity to portray the economic reality of firm better and, thus, result in errors.

Forecast Errors

Random forecast errors may arise because managers cannot predict future consequences of current transactions perfectly. For example, when a firm sells products on credit, managers make an estimate of the proportion of receivables that will not be collected (allowance for doubtful accounts).

Because managers do not have perfect foresight, actual defaults are likely to be different from estimated customer defaults, leading to a forecast error. Managers’ Accounting Choices. Managers may introduce errors into financial reporting through their own accounting decisions. Managers have many incentives to exercise their accounting discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting. For example, many top managers receive bonus compensation if they exceed certain prespecified profit targets.

This provides motivation for managers to choose accounting policies and estimates to maximize their expected compensation.

Question 3

Juan Perez argues that “learning how to do business analysis and valuation using financial statements is not very useful, unless you are interested in becoming a financial analyst. ” Comment. Business analysis and valuation skills are useful not only for financial analysts but also for corporate managers and loan officers. Business analysis and valuation skills help corporate managers in several ways.

First, by using business analysis for equity security valuation, corporate managers can assess whether the firm is properly valued by investors. With superior information on a firm’s strategies, corporate managers can perform their own equity security analysis and compare their estimated “fundamental value” of the firm with the current market price of share. If the firm is not properly valued by outside investors, corporate managers can help investors to understand the firm’s business strategy, accounting policies, and expected future performance, thereby ensuring that the stock price is not seriously undervalued.

Second, using business analysis for mergers and acquisitions, corporate managers (acquiring management) can identify a potential takeover target and assess how much value can be created through acquisition. Using business analysis, target management can also examine whether the acquirer’s offer is a reasonable one.

Loan officers can also benefit from business analysis, using it to assess the borrowing firm’s liquidity, solvency, and business risks. Business analysis techniques help loan officers to predict the likelihood of a borrowing firm’s financial distress.

Commercial bankers with business analysis skills can examine whether or not to extend a loan to the borrowing firm, how the loan should be structured, and how it should be priced.

Question 4

Four steps for business analysis are discussed in the chapter (strategy analysis, accounting analysis, financial analysis, and prospective analysis). As a financial analyst, explain why each of these steps is a critical part of your job and how they relate to one another. Managers have better information on a firm’s strategies relative to the information that outside financial analysts have.

Superior financial analysts attempt to discover “inside information” from analyzing financial statements. The four steps for business analysis help outside analysts to gain valuable insights about the firm’s current performance and future prospects.

Business strategy analysis is an essential first step because it enables the analysts to frame the subsequent accounting, financial, and prospective analysis better. For example, identifying the key success factors and key business risks allows the identification of key accounting policies.

Assessment of a firm’s competitive strategy facilitates evaluating whether current profitability is sustainable. Finally, business strategy analysis enables the analysts to make sound assumptions in forecasting a firm’s future performance. Accounting analysis enables the analysts to “undo” any accounting distortion by recasting a firm’s accounting numbers. Sound accounting analysis improves the reliability of conclusions from financial analysis. The goal of financial analysis is to use financial data to evaluate the performance of a firm.

The outcome from financial analysis is incorporated into prospective analysis, the next step in financial statement analysis. Prospective analysis synthesizes the insights from business strategy analysis, accounting analysis, and financial analysis in order to make predictions about a firm’s future.

Strategy Analysis

Question 1

Judith, an accounting major, states: “Strategy analysis seems to be an unnecessary detour in doing financial statement analysis. Why can’t we just get straight to the accounting issues? ” Explain to Judith why she might be wrong.

  1. Strategy analysis enables the analyst to understand the underlying economics of the firm and the industry in which the firm competes. There are a number of benefits to developing this knowledge before performing any financial statement analysis.
  2. Strategy understanding provides a context for evaluating a firm’s choice of accounting policies and hence the information reflected in its financial statements. For example, accounting policies (such as revenue recognition and cost capitalization) can differ across firms either because of differences in business economics or because of differences in management’s financial reporting incentives. Only by understanding differences in firms’ business strategies is it possible to assess how much to rely on a firm’s accounting information.
  3. Strategy analysis highlights the firm’s profit drivers and major areas of risk. An analyst can then use this information to evaluate current firm performance and to assess the firm’s likelihood of maintaining or changing this performance based on its business strategy.
  4. Strategy analysis also makes it possible to understand a firm’s financial policies and whether they make sense.

As discussed later in the book, the firm’s business economics is an important driver of its capital structure and dividend policy decisions. In summary, understanding a firm’s business, the factors that are critical to the success of that business, and its key risks is critical to effective financial statement analysis.

Question 2

What are the critical drivers of industry profitability?

Rivalry Among Existing Firms

The greater the degree of competition among firms in an industry, the lower average profitability is likely to be.

The factors that influence existing firm rivalry are industry growth rate, concentration and balance of competitors, degree of differentiation and switching costs, scale/learning economies and the ratio of fixed to variable costs, and excess capacity and exit barriers.

Threat of New Entrants

The threat of new entry can force firms to set prices to keep industry profits low. The threat of new entry can be mitigated by economies of scale, first mover advantages to incumbents, greater access to channels of distribution and existing customer relationships, and legal barriers to entry.

Threat of Substitute Products

The threat of substitute products can force firms to set lower prices, reducing industry profitability. The importance of substitutes will depend on the price sensitivity of buyers and the degree of substitutability among the products.

Bargaining Power of Buyers

The greater the bargaining power of buyers, the lower the industry’s profitability. Bargaining power of buyers will be determined by the buyers’ price sensitivity and their importance to the individual firm.

As the volume of purchases of a single buyer increases, its bargaining power with the supplier increases.

Bargaining Power of Suppliers

The greater the bargaining power of suppliers, the lower the industry’s profitability. Suppliers’ bargaining ability increases as the number of suppliers declines when there are few substitutes available.

Question 3

One of the fastest growing industries in the last twenty years is the memory chip industry, which supplies memory chips for personal computers and other electronic devices. Yet the average profitability has been very low.

Using the industry analysis framework, list all the potential factors that might explain this apparent contradiction.

Concentration and Balance of Competitors

The concentration of the memory chip market is relatively low. There are many players that compete on a global basis, none of which has a dominant share of the market. Due to this high degree of fragmentation, price wars are frequent as individual firms lower prices to gain market share. Degree of Differentiation and Switching Costs. In general, memory chips are a commodity product characterized by little product differentiation.

While some product differentiation occurs as chip makers squeeze more memory on a single chip or design specific memory chips to meet manufacturers’ specific power and/or size requirements, these differences are typically short-lived and have not significantly reduced the level of competition within the industry. Furthermore, because memory chips are typically interchangeable, switching costs for users of memory chips (computer assemblers and computer owners) encouraging buyers to look for the lowest price for memory chips.

Scale/Learning Economies and the Ratio of Fixed to Variable Costs

Scale and learning economies are both important to the memory chip market. Memory chip production requires significant investment in “clean” production environments. Consequently, it is less expensive to build larger manufacturing facilities than to build additional ones to satisfy additional demand. Moreover, the yield of acceptable chips goes up as employees learn the intricacies of the extremely complicated and sensitive manufacturing process.

Finally, while investments in memory chip manufacturing plants are typically very high, the variable costs of materials and labor are relatively low, providing an incentive for manufacturers to reduce prices to fully utilize their plant’s capacity.

Excess Capacity

Historically, memory chip plants tend to be built in waves, so that several plants will open at about the same time. Consequently, the industry is characterized by periods of significant excess capacity where manufacturers will cut prices to use their productive capacity (see above).

Threat of Substitute Products. There are several alternatives to memory chips including other information storage media (e. g. , hard drives and disk drives) and memory management software that “creates” additional memory through more efficient use of computer system resources. 8 Price Sensitivity. There are two main groups of buyers: computer manufacturers and computer owners. Faced with an undifferentiated product and low switching costs, buyers are very price sensitive. All the above factors cause returns for memory chip manufacturers to be relatively low.

Question 4

Examples of European firms that operate in the pharmaceutical industry are GlaxoSmithKline and Bayer. Examples of European firms that operate in the tour-operating industry are Thomas Cook and TUI. Rate the pharmaceutical and tour operating industries as high, medium, or low on the following dimensions of industry structure:

  1. Rivalry;
  2. Threat of new entrants;
  3. Threat of substitute products;
  4. Bargaining power of suppliers,
  5. Bargaining power of buyers.

Given your ratings, which industry would you expect to earn the highest returns?

Pharmaceutical firms historically have had some of the highest rates of return in the economy, whereas tour operators have had moderate returns. The following analysis reveals why. Pharmaceutical Industry Medium Firms compete fiercely to develop and patent drugs. However, once a drug is patented, a firm has a monopoly for that drug, dramatically reducing competition. Competitors can only enter the same market by developing a drug that does not infringe on the patent. Low Economies of scale and first mover advantages are very high for the industry. Patents deter new entrants.

In addition, drug firms’ sales forces have established relationships with doctors which act as a further deterrent for a new entrant. This distribution advantage is changing as managed-care firms have begun negotiating directly with drug companies on behalf of the doctors in their network. Low New drugs are protected by patents giving manufacturers a monopoly position.

In the 1990s the European tourism industry exhibited strong growth. After a slowdown in growth due to the 2001 terrorism attacks, growth has been steady in the 2000s.

However, the trend towards short-term bookings and web-based bookings (in combination with high price transparency) has structurally changed the industry and increased competition. Medium to high “Tourism e-mediaries” such as expedia. com can relatively easily enter the market. In addition, suppliers of accommodation and travel services (such as Ryanair) start bypassing tour operators by offering their products online.

Once the patent expires, a company will reduce prices as other manufacturers enter the market. The threat of substitute products, however, is likely to increase as biotech products enter the market. Low Historically, doctors have had little buying power. However, in some countries managed-care providers have become more powerful recently, and have begun negotiating substantial discounts for drug purchases. Low The chemical ingredients for drugs can be obtained from a variety of chemical suppliers.

High The online offering of accommodation, flight services, car rentals etc. has increased price transparency and, consequently, increased buyers’ bargaining power. Medium Tour operators are large and concentrated relative to the suppliers of accommodation and other services. However, suppliers have the ability to “bypass” tour operators by selling their accommodation directly through the internet. Tour operators respond to this threat by means of vertically integrating their activities (e. g. , owning their own hotels and airlines).

Question 5

Joe argues: “Your analysis of the five forces that affect industry rofitability is incomplete. For example, in the banking industry, I can think of at least three other factors that are also important; namely, government regulation, demographic trends, and cultural factors. ” His classmate Jane disagrees and says, “These three factors are important only to the extent that they influence one of the five forces. ” Explain how, if at all, the three factors discussed by Joe affect the five forces for the banking industry. Government regulation, demographic trends, and cultural factors will each impact the analysis of the banking industry.

While these may be important, they can each be recast using the five forces framework to provide a deeper understanding of the industry. The power of the five forces framework is its ability to incorporate industry-specific characteristics into analysis for any industry. To see how government regulation, demographic trends, and cultural factors are important in the banking industry, we can apply the five forces framework as follows: Rivalry Among Existing Firms. Government regulation has played a central role in promoting, maintaining, and limiting competition among banks.

Banks are regulated at the national and European levels. In the past, national regulations restricted banks from 10 operating across (some European) borders. The government also regulates the riskiness of a bank’s portfolio in an effort to prevent banks from competing for new customers by taking on too many high-risk investments, loans, or other financial instruments. These regulations have limited the degree of competition among banks. However, European deregulation of the industry has made it easier for banks to expand into new geographic areas, increasing the level of competition.

  • Threat of New Entrants. Government regulations have limited the entry of new players into the banking industry. New banks must meet the requirements set by regulators before they can begin operation. However, as noted above, deregulation of some aspects of banking has made it easier for out-of-country banks to enter new markets. Further, it appears to be relatively easy for non-banking companies to successfully set up financial services units (e. g. , car manufacturers). Finally, as consumers have become more comfortable with technology, “Internet banks” have formed.

These “banks” provide the same services as traditional banks, but with a very different cost structure. Threat of Substitute Products. The primary functions of banks are lending money and providing a place to invest money. Potential substitutes for these functions are provided by thrifts, credit unions, brokerage houses, mortgage companies, and the financing arms of companies such as car manufacturers. Government regulation of these entities varies dramatically, affecting how similar their products are to those of banks.

In addition, consumers have been become increasingly familiar with non-bank options for investing money. As another example, some brokerage houses provide money market accounts that function as checking accounts. As a result, the threat of substitutes for bank services has grown over time. Bargaining Power of Buyers. Business and consumer buyers of credit have little direct bargaining power over banks and financial institutions. The buying power of customers is probably also stronger in relationship banking than under a transactions approach, where consumers seek the lowest-cost lender for each new loan.

Because the use of these approaches varies across countries (due to legal differences; see chapter 10), the bargaining power of buyers may also vary. Bargaining Power of Suppliers. Depositors have historically had little bargaining power. In summary, bank regulations have historically had a very important role in determining bank profitability by restricting competition. However, deregulation in the industry as well as the emergence of non-bank substitutes has increased competition in the industry.

Question 6

In 2005, Puma was a very profitable sportswear company. Puma did not produce most of the shoes, apparel and accessories that it sold. Instead, the company entered into contracts with independent manufacturers, primarily in Asia. Puma also licensed independent companies throughout the world to design, develop, produce and distribute a selected range of products under its brand name. Use the five forces framework and your knowledge of the sportswear industry to explain Puma’s high profitability in 2005. While consumers perceive an intensely competitive relationship between companies such as Puma, Nike and Adidas, these major players in the portswear industry have structured their 11 businesses to retain most of the profits in the industry by concentrating operations in its least competitive segments. Puma competes primarily on brand image rather than on price. The company sources the manufacturing of its sports products to smaller independent manufacturers, located in Asia and Eastern Europe, over which the company has significant bargaining power. The threat of new entrants is restricted by limited access to adequate distribution channels, (even more) by the valuable brand name that has been created by Puma, and Puma’s expertise in development and design.

While sportswear is relatively inexpensive and easy to make (also given the large number of independent manufacturers), a sportswear manufacturer would have difficulty finding a distributor that could get its products to retail stores and placed in desirable shelf space. The high levels of advertising by Puma (including sponsoring contracts with celebrity athletes) have created a highly valued, universally recognized brand, which would be difficult for a potential competitor to replicate. Puma’s valuable brand name and the great demand for the company’s products improve the company’s bargaining power over its distributors (retail stores).

To reduce the power of distributors/retail stores even more, the company has started to open own stores in an increasingly number of large cities around the world (such as in Amsterdam, Stockholm, Frankfurt, London, Rome, Milan, Melbourne, Tokyo, Boston, Seattle, Sydney, Osaka, Philadelphia, and Las Vegas). Puma also makes money by licensing other companies to produce and distributes products under the Puma brand name. The sports licensing business tends to be highly competitive, which makes that Puma has substantial bargaining power over licensees.

Potential threats to Puma’s competitive position are the following: – Puma needs to continue investing substantial amounts in advertising, sponsoring, design and innovation in order to sustain its brand image. – Some of the companies to which Puma sources its production are by no means small, powerless production companies. For example, in 2005, one of Puma’s suppliers was Hong-Kong-based Yue Yuen. This supplier employed 252,000 people, had production plants in China, Vietnam and Indonesia with in total 3. 4 million square meters of floor space, and produced 167. million pairs of shoes per year for most of the larger athletic shoe sellers.

Question 7

In response to the deregulation of the European airline industry during the 1980s and 1990s, European airlines followed their U. S. peers in starting frequent flier programs as a way to differentiate themselves from others. Industry analysts, however, believe that frequent flyer programs had only mixed success. Use the competitive advantage concepts to explain why. Initially, frequent flier programs had only limited success in creating differentiation among airlines.

Airlines tried to bundle frequent flier mileage programs with regular airline transportation to increase customer loyalty and to create a differentiated product. Furthermore, the airlines anticipated that the programs would fill seats that would otherwise have been empty and would, so they believed, have had a low marginal cost. However, because the costs of implementing a program were low, there were very few barriers to other airlines starting their own frequent flier programs. Before long, every airline had a frequent 12 flier program with roughly the same requirements for earning free air travel.

Simply having a frequent flier program no longer differentiated airlines. Airlines have had some success in differentiating frequent flier programs by creating additional ways to earn frequent flier mileage and increasing the number of destinations covered. Airlines have developed “tie-ins” with credit card companies, car rental companies, hotels, etc. to allow members of a particular frequent flier program more ways to earn frequent flier mileage. They have also reached agreements with foreign airlines (within alliances) so that frequent flier mileage can be redeemed for travel to locations not served by the carrier.

Finally, the programs have provided additional services for their best customers, including special lines for check-in and better flight upgrade opportunities. As a result of these efforts, airline programs have been somewhat successful in increasing customer loyalty. Question 8. What are the ways that a firm can create barriers to entry to deter competition in its business? What factors determine whether these barriers are likely to be enduring? Barriers to entry allow a firm to earn profits while at the same time preventing other firms from entering the market.

The primary sources of barriers to entry include economies of scale, absolute costs advantages, product differentiation advantages, and government restrictions on entry of competitors. Firms can create these barriers through a variety of means.

  1. A firm can engineer and design its products, processes, and services to create economies of scale. Because of economies of scale, larger plants can produce goods at a lower cost that smaller plants. Hence, a firm considering entering the existing firm’s market must be able to take advantage of the same scale economies or be forced to charge a higher price for its products and services.
  2. Cost leaders have absolute cost advantages over rivals. Through the development of superior production techniques, investment in research and development, accumulation of greater operating experience or special access to raw materials, or exclusive contracts with distributors or suppliers, cost leaders operate at a lower cost than any potential new entrants to the market.
  3. Differentiation of the firm’s products and services may also help create barriers to entry for other firms. Firms often spend considerable resources to differentiate their products or services. Soft drink makers, for example, invest in advertising designed to differentiate their products from other products in the market. Other competitors that would like to enter the market will be forced to make similar investments in any new products.
  4. Firms often try to persuade governments to impose entry restrictions through patents, regulations, and licenses. In the U. S. , AT fought with the government for many years to prevent other providers of long distance telephone service from entering the market. Similarly, the local Bell operating companies have lobbied the ederal government to write laws to make it difficult for other firms to provide local phone service. Several factors influence how long specific barriers to entry are effective at preventing the entry of competitors into an industry.

Economies of scale depend on the size and growth of the market. If a market is growing quickly, a competitor could build a larger plant capable of producing at a cost lower than the incumbent. If a market is flat, there may not be enough demand to support additional production at the efficient scale, which forces new entrants to have higher costs. Absolute cost advantages depend on competitors’ difficulty in designing better processes. Some processes receive legal protection from patents. Entrants must either wait for the patent to expire or bear the expense of trying to invest around the patent. Similarly, differentiation advantages last only so long as a firm continues to invest in differentiation and it is difficult for other firms to replicate the same differentiated product or service.  Incumbent firms and potential entrants can both lobby the government.

If potential entrants launch intensive lobbying and public interest campaigns, laws, regulations, and rules can change to ease entry into a once-protected industry. Several recent examples in Europe are deregulation of the airline and banking industries.

Question 9

Explain why you agree or disagree with each of the following statements.

It’s better to be a differentiator than a cost leader, since you can then charge premium prices. Disagree. While it is true that differentiators can charge higher prices compared to cost leaders, both strategies can be equally profitable.

  • Differentiation is expensive to develop and maintain. It often requires significant company investment in research and development, engineering, training, and marketing. Consequently, it is more expensive for companies to provide goods and services under a differentiated strategy. Thus, profitability of a firm using the differentiated strategy depends on being able to produce differentiated products or services at a cost lower than the premium price. On the other hand, the cost leadership strategy can be very profitable for companies.

A cost leader will often be able to maintain larger margins and higher turnover than its nearest competitors. If a company’s competitors have higher costs but match the cost leader’s prices, the competitors will be forced to have lower margins. Competitors that choose to keep prices higher and maintain margins will lose market share. Hence, being a cost leader can be just as profitable as being a differentiator.

  • It’s more profitable to be in a high-technology than a low-technology industry. Disagree. There are highly profitable firms in both high technology and low technology industries.

The argument presumes that high technology always creates barriers to entry. However, high technology is not always an effective entry barrier and can be associated with high levels of competition among existing firms, high threat of new entrants, substitute products, and high bargaining power of buyers and/or sellers. For example, the personal computer industry is a high-technology business, yet is highly competitive. There are very low costs of entering the industry, little product differentiation in terms of quality, and two very powerful suppliers (Microsoft and Intel).

Consequently, firms in the PC business typically struggle to earn a normal return on their capital. In contrast, Aldi is a cost leader in a very low-tech industry, and is one of the most profitable retailers in Europe.

  • The reason why industries with large investments have high barriers to entry is because it is costly to raise capital. Disagree. The cost of raising capital is generally related to risk of the project rather than the size of the project. As long as the risks of the project are understood, the costs of raising the necessary capital will be fairly priced.

However, large investments can act as high entry barriers in several other ways. First, where large investments are necessary to achieve scale economies, if additional capacity will not be fully used, it may make it unprofitable for entrants to invest in new plant. Second, a new firm may be at an initial cost disadvantage as it begins to learn how to use the new assets in the most efficient manner. Third, existing firms may have excess capacity in reserve that they could use to flood the market if potential competitors attempt to enter the market.

Question 10. There are very few companies that are able to be both cost leaders and differentiators. Why? Can you think of a company that has been successful at both? Cost leadership and differentiation strategies typically require a different set of core competencies and a different value chain structure. Cost leadership depends on the firm’s ability to capture economies of scale, scope, and learning in its operations. These economies are complemented by efficient production, simpler design, lower input costs, and more efficient organizational structures.

Together, these core competencies allow the firm to be the low cost producer in the market. On the other hand, differentiation tends to be expensive. Firms differentiate their products and services through superior quality, variety, service, delivery, timing, image, appearance, or reputation. Firms achieve this differentiation through investment in research and development, engineering, training, or marketing. Thus, it is the rare firm that can provide differentiated products at the lowest cost.

Companies that attempt to implement both strategies often do neither well and as a result suffer in the marketplace. Differentiation exerts upward pressure on firm costs while one of the easiest sources of cost reduction is reducing product or service complexity which leads to less differentiation. Question 11. Many consultants are advising diversified companies in emerging markets, such as India, Korea, Mexico, and Turkey, to adopt corporate strategies proven to be of value in advanced economies, like the U. S. and the U. K. What are the pros and cons of this advice?

Economic theory suggests that the optimal level of diversification depends on the relative transaction costs of performing activities inside or outside the firm. A focus on core businesses, as is popular in advanced economies, is economically efficient if markets, such as capital, product, and labor markets, work well. However, market failures in emerging economies are a good reason to choose for diversification. For example, in some emerging economies, information problems prevent companies from raising capital at economically efficient rates in public capital markets.

Instead, these companies rely strongly on internal sources of financing. Because subsidiaries of diversified companies can cross-subsidize each other, diversification is necessary in emerging markets to create and benefit from internal capital markets. Similarly, large diversified companies in emerging economies can benefit from having internal labor markets.

Overview of Accounting Analysis

Question 1

A finance student states: “I don’t understand why anyone pays any attention to accounting earnings numbers, given that a ‘clean’ number like cash from operations is readily available. ” Do you agree?

Why or why not? There are several reasons for why we should pay attention to accounting earnings numbers. First, net profit predicts a company’s future cash flow better than current cash flow does. Net profit aids in predicting future cash flows by reporting transactions with cash consequences at the time when the transactions occur, rather than when the cash is received or paid. Net profit is computed on the basis of expected, not necessarily actual, cash receipts and payments. Second, net profit is potentially informative when there is information asymmetry between corporate managers and outside investors.

Note that corporate managers with superior information choose accounting methods and accrual estimates which determine the net profit number. Because accrual accounting requires managers to record past events and to make forecasts of future effects of theses events, net profit can be used to convey managers’ superior information. For example, a company’s decision to capitalize some portion of current expenditure, which increases today’s net profit, conveys potentially informative signals to outside investors about the company’s ability to generate future cash flows to cover the capitalized costs.

Question 2

Fred argues: “The standards that I like most are the ones that eliminate all management discretion in reporting—that way I get uniform numbers across all companies and don’t have to worry about doing accounting analysis. ” Do you agree? Why or why not? We don’t agree with Fred because the delegation of financial reporting decisions to corporate managers may provide an opportunity for managers to convey their superior information to investors. Corporate managers are typically better than outside investors at interpreting their firms’ current condition and forecasting future performance.

Since managers have better knowledge of the company, they have the potential to choose appropriate accounting methods and accruals which portray business transactions more accurately. Note that accrual accounting not only requires managers to record past events, but also to make forecasts of future effects of these events. If all discretion in accounting is eliminated, managers will be unable to reflect their superior information in their accounting choices.

When managers’ incentives and investors’ incentives are different and contracting mechanisms are incomplete, giving no accounting flexibility to managers may result in a costlier solution to investors. Further, if uniform accounting standards are required across all companies, corporate managers may expend economic resources to restructure business transactions to achieve a desired accounting result. Manipulation of real economic transactions is potentially more costly than manipulation of earnings.

Question 3

Bill Simon says, “We should get rid of the IASB, IFRS, and E. U. Company Law Directives, since free market forces will make sure that companies report reliable information. ” Do you agree? Why or why not? We partly agree with Bill on the point that corporate managers will disclose only reliable information when rational managers realize that disclosing unreliable information is costly in the long run. The long-term costs associated with losing reputation, such as incurring a higher capital cost when visiting a capital market to raise capital over time, can be greater than the short-term benefits from disclosing false information.

However, free market forces may work for some companies but not all companies to disclose reliable information. Note that Bill’s argument is based on the assumption that there is no information asymmetry between corporate managers and outside investors. In reality, the outside investors’ limitation in accessing the private information of the company makes it possible for corporate managers to report unreliable information without being detected immediately. The E. U. and IASB standards attempt to reduce managers’ ability to record similar economic transactions in dissimilar ways either over time or across firms.

Compliance with these standards is enforced by external auditors, who attempt to ensure that managers’ estimates are reasonable. Without the E. U., IASB standards, and auditors, the likelihood of disclosing unreliable information would be high.

Question 4

Many firms recognize revenues at the point of shipment. This provides an incentive to accelerate revenues by shipping goods at the end of the quarter. Consider two companies, one of which ships its product evenly throughout the quarter, and the second of which ships all its products in the last two weeks of the quarter.

Each company’s customers pay thirty days after receiving shipment. How can you distinguish these companies, using accounting ratios? There is no difference between the two companies in their income statements. Both companies have the same amount of revenues and expenses. However, the two companies are different in their balance sheets. Assuming that all other things are equal, the company that sells product evenly has a higher cash and a lower trade receivables balance at the quarter-end than the company which ships all products in the last two weeks.

The following accounting ratios can be used to differentiate the two companies: Trade Receivables Turnover = Sales Trade Receivables The company with even sales will have a higher receivable turnover ratio. Trade Receivables Days’ Receivables = Average Sales per Day The company with even sales will show lower days’ receivable. Cash Ratio = Cash + Marketable Securities Current Liabilities. The company with even sales will have a higher cash ratio.

Question 5

If management reports truthfully, what economic events are likely to prompt the following accounting changes?

Increase in the estimated life of depreciable assets. Managers may increase the estimated life of depreciable assets when they realize that the assets are likely to last longer than was initially expected. For example, Delta Airlines extended the estimated life of the Boeing 747, a relatively new product, by 5 years when Delta found out that some of the first Boeing 747s manufactured were still flying in commercial service. Excellent maintenance and less usage than initially expected may also prompt corporate managers to extend the estimated life of depreciable assets.

Decrease in the allowance for doubtful accounts as a percentage of gross trade receivables. The firm’s change of customer focus may prompt managers to decrease the allowance for uncollectible receivables. For example, when a firm gets large sales orders from reliable customers such as Tesco and Volvo, it does not have to reserve the same percentage of allowance used for small (or high default risk) customers. Recognition of revenues at the point of delivery, rather than at the point cash is received. Revenues can be recognized when the customer is expected to pay cash with a reasonable degree of certainty.

Suppose that a company re-evaluated its customer’s credit and found out that its customer’s financials improved significantly. In dealing with that customer, the company can recognize revenues at the point of delivery rather than at the point when cash is received, because the risk of cash collection is no longer significant. Capitalization of a higher proportion of development expenditures. According to IAS No. 38, costs incurred on product development (after the establishment of technical feasibility and commercial feasibility) are to be capitalized.

Technical feasibility is considered to be established when the firm has completed a product design. Commercial feasibility is established when the uncertainty surrounding the development of new products or processes is sufficiently reduced. If the company completes the product design earlier than it initially expected, it can capitalize a higher proportion of development costs during that period.

  • What features of accounting, if any, would make it costly for dishonest managers to make the same changes without any corresponding economic changes?

Third-Party Certification

Public companies are required to get third-party certification (auditor’s opinion) on their financial statements. Unless the accounting policy changes are reasonably consistent with underlying economic changes, auditors would not provide clean auditor’s opinion. A qualified auditors’ opinion will penalize the company by increasing its cost of capital. Reversal Effect. Aggressive accounting choices may inflate net profit in the current period but they hurt future net profit due to the nature of accrual reversal.

For example, aggressive capitalization of software R expenditures may boost current period earnings but it will 18 lower future periods’ net profit when the capitalized costs have to be subsequently writtenoff. Investors’ Lawsuit. If a company disclosed false or misleading financial information and investors incurred a loss by relying on that information, the company may have to pay legal penalties. Labor Market Discipline. The labor market for managers is likely to penalize individuals who are perceived to be unreliable in their dealings with external parties.

Question 6

The conservatism (or prudence) principle arises because of concerns about management’s incentives to overstate the firm’s performance. Joe Banks argues, “We could get rid of conservatism and make accounting numbers more useful if we delegated financial reporting to independent auditors rather than to corporate managers. ” Do you agree? Why or why not? We don’t agree with Joe Banks because the delegation of accounting decisions to auditors may reduce the quality of financial reporting.

Auditors possess less information and firmspecific business knowledge than corporate managers when portraying the economic reality of a firm. The divergence between managers’ and auditors’ business assessments is likely to be most severe for firms with distinctive business strategies or ones which operate in emerging industries. With such an information disadvantage, even if auditors report truthfully without having any incentive problem, they cannot necessarily choose “better” accounting methods and accruals than corporate managers do.

Auditors also have their own incentive to record business transactions in a mechanical way, rather than using their professional judgment, which leads to poor quality of financing reporting. For example, auditors are likely to choose accounting standards that require them to exercise minimum business judgment in assessing a transaction’s economic consequences, especially given their legal liability risk. The current debate on market value accounting for financial institutions illustrates this point.

While there is considerable agreement that market value accounting produces relevant information, auditors typically oppose it, citing concerns over audit liability.

Question 7

A fund manager states: “I refuse to buy any company that makes a voluntary accounting change, since it’s certainly the case that its management is trying to hide bad news. ” Can you think of any alternative interpretation? One of the pitfalls in accounting analysis arises when analysts attribute all changes in a firm’s accounting policies and accruals to earnings management motives.

Voluntary accounting change may be due merely to a change in the firm’s real economic situations. For example, unusual increases in receivables might be due to changes in a firm’s sales strategy. Unusual decreases in the allowance for uncollectable receivables might be reflecting a firm’s changed customer focus. A company’s accounting change should be evaluated in the context of its business strategy and economic circumstances and not mechanically interpreted as earnings manipulation. 19 Promises that require future expenditures are liabilities even if they cannot be measured precisely.

According to the definition, liabilities are economic obligations of a firm arising from benefits received in the past that are (a) required to be met with a reasonable degree of certainly and (b) at a reasonably well-defined time in the future. Airline companies have economic obligations to serve frequent flyer program passengers due to ticket sales (benefits) in the past to the frequent flyer program passengers. These obligations are (a) likely to be met (for example, United Airline frequent flyer program totaled 1. million free trips in 1990) and (b) fulfilled within a well-defined time in the future (for example, within 3 to 5 years after the revenue ticket sales are made). A frequent flyer program has an impact not only on the balance sheet but also on the income statement. In principle, the costs associated with benefits that are consumed in this time period are estimated and recognized as expenses (matching concept). Note that airline companies increased revenue ticket sales (i. e. , benefits) in this period by promising free-trip tickets (i. e. , costs) in the future.

However, it is not easy to measure the costs associated with frequent flyer program accurately. At least the following three cost categories should be considered in the estimation:

  1. The administrative costs, such as maintaining the accounting system for the program, mailings to program members, and providing service to those who request free flights
  2. The costs related to the flight itself, including meal expenses, luggage handling costs, addition fuel expenditure, etc.
  3. The opportunity costs that airline companies may incur because the seats used by flight award passengers could have been sold to revenue paying passengers

Implementing Accounting Analysis

Question 1

On the companion website to this book you can find a spreadsheet containing the financial statements of the Unilever Group. Use the templates shown in Tables 4-1, 4-2, 4-3, and 4-4 to recast Unilever’s financial statements. [See spreadsheet CH4Q1Unilever_solution.

Question 2

On March 31, 2006, Germany’s largest retailer Metro AG reported in its quarterly financial statements that it held inventories for 54 days sales. The inventories had a book value of €6,345 million.

How much excess inventory do you estimate Metro is holding in March 2006 if the firm’s optimal Days’ Inventories is 45 days? Calculate the inventory impairment charge for Metro if 50 percent of this excess inventory is deemed worthless? Record the changes to Metro’s financial statements from adjusting for this impairment. Metro’s inventories on March 31, 2006 were €6. 345 billion, equivalent to 54 days. If the optimal days’ inventories was 45 days, the value of the optimal inventories would be 45/54*€6. 345 billion, or $5. 88 billion. If 50% of the gap (50%*(6. 345-5. 288)=$0. 529 billion was impaired, the changes to Metro’s financial statements would be as follows: Adjustment Liabilities Assets & Equity -529 -185 -344 +529 -185 -344 (€millions) Balance Sheet Inventories Deferred Tax Liability Ordinary Shareholders’ Equity Income Statement Cost of Sales Tax Expense Net Profit

Question 3

Dutch Food retailer Royal Ahold provides the following information on its finance leases: Finance lease liabilities are principally for buildings.

Terms range from 10 to 25 years and include renewal options if it is reasonably certain, at the inception of the lease, that they will be exercised. At the time of entering into finance lease agreements, the commitments are recorded at their present value using the interest rate implicit in the lease, if this is practicable to determine; if not the interest rate applicable for long-term borrowings is used.

Question 4

What approaches would you use to estimate the value of brands? What assumptions underlie these approaches?

As a financial analyst, what would you use to assess whether the brand value of 3. 2 billion reported by Cadbury Schweppes in 2005 was a reasonable reflection of the future benefits from these brands? What questions would you raise with the firm’s CFO about the firm’s brand assets? In the United Kingdom firms like Cadbury Schweppes have been allowed to report brand value on their balance sheets. Generally, these firms must hire independent valuation experts to value the brand assets. The valuation experts may use any of the following approaches to estimate brand value. First, the experts might estimate brand value based on the premium price hat branded products command over their non-branded counterparts. Given the firm’s sales volume of branded products, the expected life of the brand, and a discount rate, it is possible to estimate the present value of any price premium over the foreseeable future. Second, a brand could be valued based on the present value of advertising costs required to convert a non-branded product into a branded product. Third, brand valuation experts could estimate value based on industry practice, amounts that were paid for similar branded products in recent mergers and acquisition transactions.

Several assumptions underlie the above brand valuation approaches. First, under the price premium approach, brands will only have value if:

  • the consumers will continue to value branded products more highly than non-branded in the foreseeable future,
  • companies continue to maintain the value of their brands, despite potential competition,
  • premium prices are accompanied by higher advertising outlays, so that brands create economic value for shareholders.

The second and third valuation approaches requires that the valuer assume that the product being valued requires the same level of advertising or has the same relative value as comparable brands used to benchmark the valuation. A financial analyst should question the 3. 2 billion pounds reported on Cadbury Schweppes’ financials. Is this outlay reasonable or excessive compared to similar companies that report brands on their balance sheet? How was the figure calculated? Was an independent valuation expert hired? Did the independent auditors question the amount?

Has the amount grown or declined in the past couple years? Why? What activities and expenditures did Cadbury incur to maintain the brand name?

Question 5

As the CFO of a company, what indicators would you look at to assess whether your firm’s non-current assets were impaired? What approaches could be used, either by management or an independent valuation firm, to assess the value of any asset impairment? As a financial analyst, what indicators would you look at to assess whether a firm’s non-current assets were impaired? What questions would you raise with the firm’s CFO about any charges taken for asset impairment?

Impairment is the loss of a significant portion of the utility of an asset through casualty, obsolescence, or lack of demand for the asset’s service. A loss should be recognized when an asset suffers permanent impairment. A CFO should look for evidence of such potential impairment of the firm’s assets. Assessing the monetary value of an asset impairment: If the current book value exceeds the sum of the expected undiscounted future cash flows, an asset impairment has occurred. The conservatism principle requires that a firm write down 24 its asset to its then current fair value, which is the market value of the asset.

The accounting transaction would show the asset and any contra-asset being written off, the new market value of the asset being recorded, and the residual amount recorded as a loss due to impairment of the asset. Hence, the loss amount that appears in the income statement is the difference between the old net book value and the current market value. On the other hand, if the firm cannot assess the current market value of the asset, the impairment loss amount is calculated as the difference between the old net book value and the expected net present value of the future cash flows.

Example: Darden Restaurants Inc. Darden recorded asset impairment charges of $158,987 in 1997, representing the difference between fair value and carrying value of impaired assets. The asset impairment charges relate to low-performing restaurant properties and other long-lived assets. Fair value is generally determined based on appraisals or sales prices of comparable properties. ” A financial analyst should look for the same types of indicators that the CFO looks for, of course understanding that the CFO, as an insider of the company, has a great deal more information about such issues as casualty, obsolescence, or lack of demand of certain assets.

Indicators of impairment include sustained declines in a firm’s and/or industry’s return on assets relative to its cost of capital, recognition of asset impairments by competitors, and the introduction of new technologies that make existing assets obsolete. The financial analyst should question the CFO concerning the cause of the asset impairment. Was the loss due to casualty, obsolescence, or lack of demand? If not, what did cause the loss? The analyst should inquire about the method the impairment of asset loss was calculated? If it was calculated using a fair market value, how was the fair value determined?

Question 6

Refer to the British American Tobacco example on provisions in this chapter. The cigarette industry is subject to litigation for health hazards posed by its products. In the U. S. , the industry has been negotiating a settlement of these claims with state and federal governments. As the CFO for U. K.-based British American Tobacco (BAT), which is affected through its U. S. subsidiaries, what information would you report to investors in the annual report on the firm’s litigation risks?

How would you assess whether the firm should record a provision for this risk, and if so, how would you assess the value of this provision? As a financial analyst following BAT, what questions would you raise with the CFO over the firm’s litigation provision? The litigation risks that BAT faces are reported as contingent liabilities defined in IAS 37. Contingent liabilities arise from events or circumstances occurring before the balance sheet date, here the filling of lawsuits against BAT, the resolution of which is contingent upon a future event, the court ruling or a potential settlement.

The accounting treatment for BAT’s pending litigation depends on the likelihood that it will lose or settle the lawsuit and whether the amount of damages the firm will be liable for is reasonably estimable. Accounting rules on required disclosure for these types of liabilities depend on whether the loss is probable, possible, or remote. Probable – If it is probable that BAT will lose the lawsuit and the loss can be reasonably estimated, the estimated loss should be reported as a charge to profit and as a liability. If the 25 loss is probable but no specific reasonable estimate can be agreed upon, rather only a range of possible losses can be estimated without any amount being more reasonable than the other, the amount that should be

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