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Advanced Concepts in Accounting. Dr Ashish Varma. Corporate Reporting Framework. Contents Introduction CRF Model Evaluation Summary. Corporate Reporting Framework. Introduction: Need for CRF Mandatory disclosure of financial and non financial information. - PowerPoint PPT Presentation
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Advanced Concepts in Accounting
Dr Ashish Varma
Corporate Reporting Framework
Contents• Introduction• CRF Model• Evaluation• Summary
Corporate Reporting Framework
Introduction:• Need for CRF• Mandatory disclosure of financial
and non financial information
Enhanced Corporate Transparency
Major Drivers:
– Building trust management and other stakeholders.
– Need for information. – Better and transparent
communication.
REPORTING FRAMEWORKS
1. UNCTAD (United Nations Conference on Trade and Development)
2. HKSAs (Hongkong Society of Accountants)
3. PwC (PricewaterhouseCoopers)
FEATURES OF FRAMEWORKS
• Financial• Non financial• General meetings• Timing and means of disclosure• Good practices for compliance
1. UNCTADs
FEATURES OF FRAMEWORKS
• Capital structure.• Board structure and functioning.• Managements discussion and
analysis.• Remuneration.
2. HKSAs
FEATURES OF FRAMEWORKS
• Audit committee.• Related party transactions.• Other mandatory disclosure.• Other voluntary disclosure.
2. …HKSAs continued
FEATURES OF FRAMEWORKS
• Market overview.• Strategy and structure.• Managing for value.• Performance.
3. PwCs: PowerWaterhouse Cooper
STRENGTHS WEAKNESSES
Objectives adequately mentioned. May have put more stress on technology or process innovation.
Transparent communication. Framework should be crisp.
Evaluation mechanism. Management of customers and employees can be included.
Good practices for compliance. Does not mandate disclosure of environment in which company operates.
Corporate communication.
STRENGTHS & WEAKNESSES OF UNCTADs
STRENGTHS WEAKNESSES
Detailed mention about CGR practices.
Company objectives may be shared with stakeholders.
Mandatory disclosures mentioned in detail.
Risk and their mitigation strategies did not find the importance they deserve.
CSR Remuneration is too detailed to capture readers interest.
Qualitative reporting. Does not mandate disclosure of environment in which company operates.
Strength and clarity to satisfy the shareholders.
Framework should be compact and crisp.
STRENGTHS & WEAKNESSES OF HKSAs
STRENGTHS WEAKNESSES
Compact framework for revealing non-financial information.
The factors ‘Regulatory environment’ and ‘Macro environment’ may be superfluous.
Market overview.
Strategy and structure.
Managing for value.
Performance.
STRENGTHS & WEAKNESSES OF PwCs
Proposed CRF
Defining Corporate Reporting • Qualitative or Quantitative
• Financial or Non Financial
• Forward Going or Historical
Reporting Framework
1. CGR Practices
CGR directly impacts EVA (Economic Value CGR directly impacts EVA (Economic Value Added)Added)
the Sincerity, Honesty, Truthfulness & the Sincerity, Honesty, Truthfulness & Exhaustiveness of Info Exhaustiveness of Info
Ensures optimum use of human, physical & Ensures optimum use of human, physical & financial resourcesfinancial resources
CGR Models can involve the Stakeholders for CGR Models can involve the Stakeholders for gaining confidencegaining confidence.
…CGR Practices continued
• Formation of Board of DirectorsFormation of Board of Directors
• Freedom given to the BoardFreedom given to the Board
• Audit Committee – Internal & External Audit Committee – Internal & External namely namely First LineFirst Line & & Second lineSecond line: to keep : to keep an eye on the working of the Board.an eye on the working of the Board.
Various CGR Models
Anglo-American Model: Empowering the Investors
German Model: • More emphasis on the Employees.• Information Supply Chain starts at
Employee Level.• So, it is more transparent than other CRF
models.Japanese Model: is more regulator-driven
2. Company Objectives
• Disclosure of objectives of the enterprise
Objectives
Business/Economical: stating operational &business targets.Social & Ethical……….: Relationship withcommunity & ethical practices (moral values).Environmental………..: Outlook towardsPollution Control
3. Value Management
… refers to Brand Value, Knowledge Base, Networked Relationships – the intangible assets which help the firm stand out from the billions of other firms.
Parameters of Value Management
• Employees
• Customers
• Innovation
• Brands & Intellectual Assets
• Supply Chain
• Awards & Achievements
• Competitors
4. Technology Driven Initiatives
Improving Information Technologythrough:1.Communication & Network2.Knowledge Management3.Integration with Stake Holders4.Core Areas
5. Risk Management
How does a Firm tackle risk owing to:
Operational: Supply Chain/Distribution Channels risks
Market-related: New Competition/Varying Economic Scenarios/Government Regulations
…tackling Risks
Technological: Transaction Processing faults/Telecommunication Security/Data Privacy/Hardware or Software malfunctioning/Network Malfunctioning
Financial: Extent of Liquidity/Interest Rate/Foreign Exchange/Different Financial Instruments/Derivatives Usage
6. Non GAAP Financial disclosure
• Other than GAAP info • pro-forma reporting• helps excluding special or one time
expenses/incomes• Cash Flows
Few Non GAAP Financial Info
EBITDA – Earnings before interest, tax, depreciation & amortization – Highlights the Performance of Assets
Improved pro-forma by detailed level description like disclosure of Interest & Dividend, Taxation breakup, Reporting of Unrealized Gains/Losses from foreign currency Translation.
…..Few Non GAAP Financial Info
Margin (Total Revenue generated – Cost of Purchases without inter-subsidiary businesses ) measurement for Upstream Segment performance.
Operating profit (minus the effect of acquisitions)
XBRL- Extensive Business Reporting Language
• XML based language• Enables electronic publication, exchange &
analysis of info• Common Reporting Framework• Eliminates rumors, duplications, guesswork.• Basic requirement for XBRL – Internet• An integrator – because of platform neutrality.
Evaluation
• Ford Motor Company• Maruti Suzuki India Limited
• Comparison
Summary
Finally on comparing the annual reports of the two companies we conclude that the Ford annual report is more presentable and more readable. The quality of analysis in Ford is also better with respect to Maruti.
Conclusion• Potential advantage of CRF
• Stakeholders Interests– Investors : Lower cost of equity and debt.– Employees :Recruitment and retention– Customers :Reputation and advocacy– Press and NGO:Reputation– Government :Enhanced license to operate– Competitor : Striving for excellence, motivation for
innovation.
SUSTAINABILITY REPORTING
Overview
Presented By
o Corporate Sustainibility Developmento Example from Indian Scenario : TATA POWERo Sustainibility : DJSI & SAMo Aim of the Papero Methodology : Determinants of CSPo Hypothesiso Conclusion
Sustainable Development
Development which meets the needs of the present world without compromising the ability of future generations to meet their own needs
Environmentally conscious business practice. Socially conscious business practice. Triple bottom line
Social and Environmental Corporate Impact Financial Reports
Corporate Social Responsibility Corporate Citizenship
Sustainability Considerations
Example from Indian Scenario : TATA POWER
Sustainibility : DJSI & SAM
Dow Jones Sustainability Indexes are the first global indexes tracking the financial performance of the leading sustainability-driven companies worldwide
Sustainable Asset Management (SAM) Group, involved in sustainability research the opportunities and risks associated with each firm’s economic, environmental and social development.
Sustainibility Assessment Criteria
Examples : DJSI Firms
The extent of the oil-spill catastrophe in the Gulf of Mexico and its foreseeable long-term effectson the environment and the local population – in addition to the economic effects and the longtermdamage to the reputation of the companyThe oil company BP plc. was removed from the Dow Jones Sustainability Indexes (DJSI) w.e.f May 31st 2010
Aim of the Paper
• To investigate the factors that drive high levels of corporate sustainability performance
• To examine the incentives of US firms to invest in sustainability principles and develop a number of hypothesis that relate CSP to firm specific characteristics
Methods & Materials
• Stakeholder theory
• Hypothesis testing _t-test & Wilcoxon-signed ranks
• Dependent Variable – CSP
• Sample taken from DJSI & S&P listed firms
Methodology : Determinants of CSP
• Usage of Stakeholder Framework• Comparison between
Group of High Ranking CSP DJSI
Firms
Non DJSI Firms
•Hypothesis testing _t-test & Wilcoxon-signed ranks•Dependent Variable – CSP•Sample taken from DJSI & S&P listed firms
Sustainability : Stakeholder Theory
Any group or individual who can affect or is affected by the achievement of the firm’s objectives- (Freeman, 1984, on defining Stakeholder)
Firms must manage their relationship with key stakeholders to ensure that such access to resources is maintained(Stakeholder theory, Roberts, 1992)
Hypothesis 1
SIZE Firm size and corporate sustainability performance
are positively related.o Pollution ≈ f (Size of Operations)o High Political Visibilityo Size ≈ f (Larger Social Problem)o Faster realization of Economics of Scale
Hypothesis 2
LEVERAGE Leverage and corporate sustainability
performance are negatively related.
o Level of debt in the firm’s capital structureo Power is more with Debtholders etc
Stakeholderso Power is less with communities etc Stakeholders
Hypothesis 3
FREE CASH FLOW & PROFITABILITY Free Cash Flow along with Profitability and
corporate sustainability performance are positively related.
o Low profitability, Focus -> Economic Demandso High profitability , Invest -> Sustainibility
programmes without affecting economic demands
Hypothesis 4
GROWTH OPTIONS Growth Options and corporate sustainability
performance are positively related.
o Higher Level Product Mix -> Better integration Sustainibility priciples into Corporate Strategy
o Investment in R & D -> Innovation & product differentiation
Conclusion
• Hypothesis 1 :Firm size and corporate sustainability performance are positively related _ found to be consistently & strongly related
• Hypothesis 2 :Leverage and corporate sustainability performance are negatively related _ not found related
• Hypothesis 3: Free Cash Flow along with Profitability and corporate sustainability performance are positively related_ Cash Flow is not related; However CSP firms are more related though ROE was the only indicator used in this case
• Growth Options and corporate sustainability performance are positively related _ weak & less direct influence on CSP
The implementation of IFRS in Europe:
• Since 2005 all listed companies in the E.U. must comply with IFRS
• In Continental Europe, IFRS adoption represents a major change: replacement of stakeholder-oriented accounting regulations by market-oriented standards heavily influenced by the Anglo-Saxon accounting model
• Aim of this presentation: Review the empirical evidence on the economic consequences of IFRS adoption
The expected consequences of IFRS adoption
• Information asymmetry should decrease:– IFRS are more market-oriented– IFRS disclosure requirements are larger
• Earnings management should decrease:– IFRS are more precise– They admit a limited number of options– Hidden reserves are prohibited
• Accounting data should be more value relevant– Value relevance: Ability of accounting data to
reflect contemporaneous market prices or returns– IFRS-based earnings should be more value
relevant:• IFRS are more market-oriented• Earnings management is more difficult under IFRS• IFRS make a larger use of fair value
• The cost of capital should decrease
Effect on information asymmetry
• Has the bid-ask spread declined?– YES:
• Germany: Leuz & Verrecchia (JAR 2000), Gossen & Sellhorn (WP 2006): Companies using IFRS exhibit smaller bid-ask spreads than those using German GAAP
• Europe: Platikanova & Nobes (WP 2006): On average, the bid-ask spread declines after IFRS adoption
– BUT:• Switzerland: The effect is limited to small companies: Dumontier &
Maghraoui (CCA 2006)
• Are analysts' forecasts more accurate?• YES:
– Ashbaugh & Pincus (JAR 2001): Analyst forecast accuracy improves after IFRS adoption
– Hodgdon et al. (JIAAT 2008): Compliance with IFRS reduces analyst forecast errors
– Germany: Ernstberger et al. (WP 2008): Forecast accuracy is higher for estimates based on IFRS or US GAAP data than for those based on German GAAP figures
• NO:– Germany: Maghraoui (PhD 2008): Compliance with IFRS does not
reduce the dispersion of analyst forecasts or forecast errors– Europe: Cuijpers & Buijink (EAR 2005): Dispersion of analyst forecasts
is higher for firms using IFRS or US GAAP than for those using local GAAPs
Effect on earnings management
• Does IFRS compliance restrict earnings management?– NO:
• Germany: Van Tendeloo & Vanstraelen (EAR 2005): IFRS adopters do not present different earnings management behavior compared to companies reporting under German GAAP
• Sweden: Paananen (WP 2007): IFRS adoption does not reduce income smoothing.
• Germany: Lin & Paananen (WP 2008): Earnings management is higher in the post IFRS-adoption period
– YES:• Barth et al. (JAR 2008): In the post-adoption period, firms applying
IFRS evidence less earnings management
Effect on the value relevance of accounting data• Has value relevance of earnings increased following
IFRS adoption?– YES:
• Barth et al. (JAR 2008): Firms applying IFRS exhibit more value relevant accounting figures than other companies
• Germany: Bartov et al. (JAAF 2005): The value relevance of IFRS-based earnings is higher than that of German GAAP-based earnings
• Germany: Jermakowicz et al. (JIFMA 2007): The value relevance of earnings is higher for DAX-30 companies using IFRS or US GAAP
– NO:• Germany: Hung & Subramanyam (RAS 2007): IFRS adoption has no
effect on the value relevance of book value and net income• Sweden: Paananen (WP 2008): The value relevance of accounting
figures is not affected by IFRS adoption• Germany: Lin & Paananen (WP 2008): The value relevance of
equity and earnings decreases after IFRS adoption
Effect on the cost of capital• Has the cost of equity capital declined after IFRS adoption?
– YES:• Germany: Ernstberger & Vogler (WP 2008): The cost of equity
capital is lower for companies that adopted IFRS or US GAAP• Kim & Shi (WP 2007): The cost of equity capital is significantly
lower for IFRS adopters– NO:
• Europe: Cuijpers & Buijink (EAR 2005): No evidence of a lower cost of equity capital for IFRS adopters
• Germany: Daske (JBFA 2006): Voluntary IFRS adopters do not exhibit lower cost of equity capital
• Has the cost of debt declined after IFRS adoption?– YES:
• Kim et al. (WP 2007): IFRS adopters have lower interest rates, larger amount of loan facility, less restrictive loan covenants, and they attract more foreign lenders
Summary of the empirical evidence
• No clear conclusion can be drawn from these studies because:– The evidence is mixed– Many studies were conducted in a single country
(Germany in particular)– Most studies deal with voluntary adoption
Explaining the conflicting evidence
• The impact of IFRS adoption is a function of the degree of compliance with IFRS– Vogel et al. (WP 2008): There is considerable variation in
the level of IFRS compliance among European companies (compliance index ranging from 13% to 100%)
– Daske et al. (WP 2007): "Serious" IFRS adopters experience stronger effects on the cost of capital and market liquidity than "label" adopters
– Hodgdon et al. (JIAAT 2008): Compliance with the disclosure requirements of IFRS enhances the ability of financial analysts to provide more accurate forecasts
• The impact of IFRS adoption is a function of the firm's incentives to comply with IFRS
– Germany: Christensen et al. (WP 2008): Improvements in accounting quality are confined to firms with incentives to adopt IFRS
– Daske et al. (JAR 2008): The capital-market benefits of IFRS adoption occur only in countries where firms have incentives to be transparent and where legal enforcement is strong
– Wang & Yu (WP 2008): Better accounting standards are helpful only in countries with proper reporting incentives i.e. in common-law countries, in countries with better shareholder protection and effective legal enforcement
– Kim & Shi (WP 2007): The cost of capital-reducing effect of IFRS adoption is greater when the IFRS adopters are from countries with weak institutional infrastructures
Thus is can be said that:
• The adoption of IFRS will probably not be sufficient to standardize the quality of earnings throughout Europe
• Strong enforcement mechanisms (laws and corporate governance systems) also are necessary
• Adopting high quality standards might be a necessary condition for high quality information, but not a sufficient one (Ball et al., JAE 2003)
PRESENTATION ON Impact of IFRS Adoption on key financial ratios
ABSTRACT :1.This study is based in a continental European
Country (Finland).2.Examination of how IFRS changes the
magnitude of the key accounting ratios.3.How adoption of fair value accounting rules
and stricter requirements on certain accounting issues are impacting changes in accounting figures and key ratios.
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INTRODUCTION
• Earlier literatures shows that the level of capital market orientation of a financial environment explains the differences in accounting system internationally
• UK and US had different accounting systems.• North American accounting (IASC / IASB)
systems have been more capital market orientated than European cluster.
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What did Europe do ?• Financial environments of the continental Europe
developed recently from the so-called bank-based system towards a market oriented one.
• The biggest step in development was taken in 2005, when all listed firms in member states of the European Union started to shift to IFRS.
Has IFRS lead to improved accounting quality in continental Europe ?
• Earlier studies report that adoption of IFRS has improved the quality of financial reporting.
• But earlier studies do not tell about the impact on the impact of IFRS on key financial ratios. (used by analysts and investors to study performance of the firm)
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3 step process used in the paper1. Collection of database financial statements prepared by listed
companies in DAS (Domestic accouning System) and IFRS2. Investigation of changes in key rations due to IFRS.3. Investigation of the main reasons for the differences by analyzing DAS
and IFRS
Why Finland ?1. FAS (Finnish Accounting standards) are similar to European DAS.2. Finnish’s finance reporting are generally more extensive in nature, as
compared to rest of Europe.3. Finland has a strong system of legal enforcement and high quality DAS. 4. Hence it is assumed that Finnesh authorities provide high-quality data
and are generally more reliable.
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Advantages of IFRS
• Implementation of IFRS is costly and more than 7000 firms needed to do this (Jermakowicz and Gornik-Tomaszewski, 2006)
But why IFRS ?• IFRS improves transperancy.• IFRS improves comparability .• IFRS improves comprehensiveness of Fin Info.• IFRS improves investor protection.• IFRS improves accessibility to foreign investors (Daske
and Gebjardt, 2006; Barth et al 2008)
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Methodology used
RIFRS/IAS =NumeratorFAS + StandardIFRS/IAS
DenominatorFAS + StandardIFRS/IAS
Δ = RIFRS/IAS - RFAS
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A comprehensive database of financial statement information prepared under DAS adnd IFRS from the published transition reports.
Measure the impact of IFRS adoption on key financial rations in Finland. (Analysed on Profitability, Leverage and Liquidity).
Analysis done through statistical massage, through median, standard deviation, skewness, kurtosis, minima and maxima.
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Results Also Shows :The results of the study indicate that the adoption of IFRS changes the magnitudes of the key accounting ratios of Finnish companies by considerably increasing the profitability rations and gearing ratio moderately, and considerably decreasing the PE ration and equity and quick ratios slightly.
Key Factors of IFRS influencing change of key ratiosIncreases in debt items, Removal of amortization of purchased goodwill Fair value accountingLease AccountingIncome tax accountingRules concerning the accounting of financial instruments
Results Show :1.Increase in Profitability ratio2.Decrease in price to earnings ratio3.Decrease in Liquidity ratio4.Increase in Gearing ratio5.Decrease in Equity ratio
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Ratio mathematical expression of the relationship between two
accounting figures.
Calculated by dividing one number by the other.
Ratio
Pure Ratio or ‘Rate’ or ‘Times’ Percentage
Simple Ratio Ratio Ratio
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Advantages
Helpful in analysis of Financial Statements
Simplifies accounting data
Helps in comparative study
Helps in forecasting
Helps in the estimation of trends of the business
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Contd……
Fixation of ideal standards
Facilitates effective control
Helps in locating the weak points of the business
Helps in studying the financial soundness of the company.
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Limitations
False accounting data gives false ratios
Comparison is not possible if different firms adopt different accounting policies.
Ratio Analysis becomes less effective due to price level changes
Ratios may be misleading in the absence of absolute data.
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Contd……
A single ratio has limited use.
Problem due to window dressing by the company
Lack of proper standards
Ratios alone are not adequate for proper conclusions
Effect of personal ability and bias of the analyst.
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Classification of Ratios
1) Liquidity Ratios
2) Solvency Ratios
3) Activity or Turnover Ratios
4) Profitability Ratios
Infosys Comparison of Key Ratios
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Liquidity ratiosMeasure the concern’s ability to meet short-term obligations as and when they become due.
Show the short term financial solvency of the concern.
Liquidity ratiosLiquidity ratios
Current / Working Capital Ratio
Quick / Acid Test / Liquid Ratio
Liquidity Ratio
Liquidity RatioIFRS 2008
IFRS 2009
GAAP 2008
GAAP 2009
Current Assests 31270 31200 13018 16646
Current Liabilities 5490 5370 1722 2004
Current ratio 5.7 5.8 7.6 8.3
Current Ratio =Current Assets
Current Liability
Quick Ratio =Current Assets – Inventory – Prepaid Expenses
Current Liability
Liquidity Ratio IFRS 2008 IFRS 2009 GAAP 2008GAAP 2009
Quick Assests 30020 30390 12740 16414
Current Liabilities 5490 5370 1722 2004
Quick ratio 5.5 5.7 7.4 8.280
Decrease in Liquidity Ratio
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Profitability Ratio
In relation to sales
In relation to investments
In relation to equity shareholder’s funds
1)G.P.Ratio
2)N.P.Ratio
3) Operating Profit Ratio
1) Return on Capital Employed
2) Return on total Assets
1) Return on equity
2) EPS
Profitability Ratio
Operating Profit Ratio =Operating Profit
Net Sales
Profitability RatioIFRS 2008
IFRS 2009
GAAP 2008
GAAP 2009
Operating Profit 11590 13740 5238 7195Net Sales 41760 46630 16692 21693Operating Profit Ratio 27.8% 29.5% 31.4% 33.2%
Profitability RatioIFRS 2008
IFRS 2009
GAAP 2008
GAAP 2009
Net profit after interest and tax 11630 12810 4659 5988Shareholders' Equity 640 640 286 286Return on Equity 1817% 2002% 1629% 2094%
Return on Equity =
Net Profit After Int & Tax
Share Holder Equity
Infy has other and interest income and this is more than tax
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Profitability Ratio IFRS 2008 IFRS 2009GAAP 2008
GAAP 2009
Net Income-Dividend 11496 12620 3314 4086Capital invested 39160 37840 13795 18254Return on invested capital 29% 33% 24% 22%
Profitability Ratio IFRS 2008 IFRS 2009GAAP 2008
GAAP 2009
Market value per share 1753 1381 1753 1381
EPS(Earning per share=Net profit after int., tax & pref. Div./No. of Equity share) 102 112.5 81.53 104.6Price to Earning ratio 1719% 1227% 2150% 1320%
Operating Profit Ratio =Net Income - Divident
Capital Invested
Price to Earning Ratio =Mkt Value per Share
Earning per Share
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Gearing Ratios
The higher a company's degree of leverage, the more the company is considered risky.
A greater proportion of equity provides a cushion and is seen as a
measure of financial strength.
Gearing RatioIFRS 2008
IFRS 2009
GAAP 2008
GAAP 2009
Total shareholder equity 640 640 286 286
Total Assets 45070 43760 18128 13604
Equity ratio 1.4% 1.5% 1.6% 2.1%
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Gearing Ratio
Operating Profit Ratio =Operating Profit
Net Sales
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Differences between IFRS and GAAP
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Summarized Significant Differences between
US GAAP, Indian GAAP and IFRS
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Indian GAAP US GAAP IFRS1. Revenue Recognition
Revenues are recognized when all significant risks and rewards of ownership are transferred or on apercentage of completion basis. No detailed industry specific guidelines.
Industry specific revenue recognition guidelines. Could be different from what I-GAAP has recognized.
Revenues are recognized when all significant risks and rewards of ownership are transferred.
2. Balance sheet Conforms to statute and Captions are in the following order :--Equity and reserves--Debt--Fixed assets--Investments--Net current assets--Deferred expenditure and--Accumulated lossesRequired only for the current year with the prior year comparatives.
Balance sheet captions are presented in order of liquidity starting with the most liquid assets, cash. Also requires disclosure of movements in stockholder’ equity, including the number of shares outstanding for all years presented.
Balance sheet captions are presented in the inverse order of liquidity i.e. illiquid items appear earlier. Requires disclosure of either changes in equity or changes in equity other than those arising from capital transactions with owners and distribution of owners.
3. Correction of fundamental errors
Include effect in current yearincome Statement
Restate comparatives. Adjustments required to be made to previously issued financial statements.
Include cumulative effect in current year income statement.For material items, restate comparatives.
4.Derivative and other financial instrument- Measurement of hedges of foreign entity investments.
No definitive standard yet. Newstandard on financial instruments:Recognition and Measurement ispresently under formulation.
Gains/losses on hedges of foreignentity investments recognized inequity. All hedge ineffectiveness recognize in the income statement.Gains/losses held in equity must be transferred to the incomestatement on disposal of investment.
Similar to US GAAP. Except, ineffectiveness of non-derivativesrecognized in equity.
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Indian GAAP US GAAP IFRS5. Comprehensive income No standards, not required. Unrealized gains/losses on
investment and Foreign currency translation disclosed as a separate component of equity.
Option to present a statement that shows all changes or only Those changes in equity that did not arise from capital transactions with owners or distributions to owners.
6. Derivatives and other financial instruments – measurement of derivative instruments and hedging activities.
No definitive standard yet. New Standard on financial instruments: Recognition and Measurement is presently under formulation.
Measure derivatives and hedge instrument at fair value: recognize changes in fair value in income statement except for effective cash flow hedges, defer in equityuntil effect of the underlying transaction is recognized in the income statement.Gains/losses on hedge instrument used to hedge forecast transaction, included in cost of asset/liability.
Similar to US GAAP. Gains/losses on hedge instrument used to hedge forecast transaction, included in the cost of asset/liability ( basis adjustment ).
7. Business Combinations Restricts the use of pooling of interest method to circumstances which meet the criteria listed for an amalgamation in the nature of a merger. In all other cases, thepurchase method is used.
Only accounted for by the purchasemethod. Several differences can arise in terms of date of combination, calculation Of share value to use for purchase price, especially if the I-GAAP method is ‘amalgamation’.
Business combinations under IFRS should be accounted for as an acquisition (purchase method). Where an acquirer cannot be identified then the pooling of
interests method should be adopted.
8. Cash Flow Statement Mandatory only for listed companies and companies meeting certain turnover conditions.
Mandatory for all entities. Mandatory for all entities.
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Indian GAAP US GAAP IFRS9. Property, Plant and Equipment
Use historical costs or revalued amounts. On revaluation, an entire class of assets is revalued, or selection of assets for revaluation is made on a systematic basis. No current restriction on frequency of valuation.
Revaluations not permitted. Tested for impairment whenever events or changes in circumstances Indicate that its carrying amount may not be recoverable.
Use historical cost or revalued amounts. On revaluation, an entire class of assets is revalued.
10. Share Issue Expenses May be accounted for as deferred expenses and amortized.
Expenses are written off when Incurred against proceeds of capital.
There is no specific requirement under IFRS.
11. Dividends Dividends are reflected in the financial statements of the year to which they relate even if proposed or approved after the year end.
Dividends are accounted for when approved by the Board/shareholders. If the approval is after the year end, the dividend is not considered as a subsequent event to adjust the financials.
Dividends are classified as a financial liability and are reported in the income statement as an expense. If dividends are declared subsequent to the balance sheet date, it is not recognized as a liability.
12. Leases Similar to US GAAP but, no quantitative thresholds defined.
Leases are classified as capital and operating leases as per certain criteria. Capital leases are included under property, plant and equipment of the lessor. Lease rentals on operating leases are expensed as incurred. Quantitative thresholds have been defined.
Similar to US except that the criteria for distinguishing between capital and revenue leases is different.
13. Prior period adjustments Prior period items are separately disclosed in the current statement of Profit and Loss together with their nature and amount in a manner that their impact on current profit and loss can be perceived.
Correction of an error in previously issued financial statement is recognized by restating previously issued financial statements.
Prior period errors are generally corrected in the current financial statements. However, where the error is of such significance that the prior period financial statements cannot be considered to have been reliable at the date of their issue, the error should be corrected by adjusting the opening retained earnings.
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Indian GAAP US GAAP IFRS14. Accounting for Foreign Currency Transactions
Exchange differences on foreign currency transactions arerecognized in the profit and loss account with the exception that exchange differences related to the acquisition of fixed assets adjusted to the carrying cost of the relevant fixed asset.
All exchange differences are included in determining net income for the period in which differences arise.
All exchange differences are included in determining net income for the period in which differences arise.
15. Goodwill Goodwill is capitalized and tested for impairment annually. Except for goodwill from amalgamation, which is amortized over 3-5 years.
Goodwill is not amortized but goodwill is to be tested for impairment annually.
Goodwill is amortized to expense on a systematic basis over its useful life with a maximum of twenty years. The straight line method should be adopted unless the use of any other method can be justified.
16. Negative Goodwill (i.e. the excess of the fair value of net assets acquired over the aggregate purchase consideration)
Negative goodwill is credited to the capital reserve account, which is a component of stockholders’ equity.
Negative goodwill is allocated to reduce proportionately the value assigned to non-current assets. Any remaining excess is considered to be extraordinary gain.
Negative goodwill that relates to expectations of future losses and expenses should be recognized as income when the future losses and expenses are recognized. Where it does not relate to identifiable future losses and expenses, an amount not exceeding the fair values of the acquired identifiable non-monetary Assets should be recognized as income on a systematic basis over the remaining weighted average useful life of such assets and the balance, if any immediately charged to income.
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Indian GAAP US GAAP IFRS17. Related parties Determined by ability to control or
to exercise significant influence over the other party. Detailed disclosure required of all material related party transactions. Mandatory for listed companies and companies meeting certain turnover threshold.
Related parties are determined based on common ownership and control. Disclosure required of all material related party transactions, in particular, the nature of relationship involved, a description of the transactions, the amounts of the transactions, the amounts of the transactions for the financial year and the amount due from or to related parties at the end of the financial year.
Similar to US GAAP except that the existence of related parties are to be disclosed even if there are no transactions during the period.
18.Pension / Gratuity / Post Retirement Benefits
Required to be mandatorily provided Based on either actuarial valuation or Contribution to a defined plan. Follows AS-15, Acturial gain/losses are recognized immediately.
To be provided for and funded based on acturial valuation. Significant disclosurerequirements exist. Acturial gains/losses are amortized.
To be provided for and funded based on acturial valuation. Significant disclosurerequirements exist. Acturial gains/losses are amortized.
19. Stock Options to Non- Employees
No specific guidance Complex guidance with respect to measurement date and timing of recognition of expense.
Disclosures required but, no guidance on recognition and measurement.
20. Balance sheet Does not need segregation of current and non-current portions of assets and liabilities.
Segregation necessary. Disclosed only as part of the footnotes.
21. Stock based Compensation
SEBI requires compensation cost to be recognized based on intrinsic value or fair value. Not mandatory for un-listed companies.
US GAAP had similar rules as what SEBI later required. However, there is new standard effective 2005, which requires fair value to be expensed for all options.
Compensation costs to be disclosed. Recognition of compensation costs is not mandatory.
104
Indian GAAP US GAAP IFRS22. Investment and Marketable Securities.
Only unrealized depreciation on AFS ( Available-For-Sale ) securities is recognized in the income statement.
Both appreciation and depreciation ( if unrealized ) is recognized as Other Comprehensive Income. Separate standard for treatment of cost of development of computer software.
Similar to US GAAP. Except option to recognize gains/losses in AFS eeither income statement or equity. However, the selection is a one-time option. No guideline under IFRS.
23. Segment Information Specific requirements govern the format and content of a reportable segment and the basis of identification of a reportable segment. The information for disclosure is to be prepared in conformity with the accounting standards used for the company as a whole.
Disclose revenues, profits and assets identified by product and geographically of each reportable segment. Segments based on information reviewed by CODM (Chief Operating Decision Maker)
Largely similar to US GAAP requirements however, mandatory only for listed companies. Segment liabilities are also to be shown.
24. JV ( Jointly controlled assets or corporation )
Allows proportionate consolidation Generally only uses Equity method of accounting except certain specified industries such as Oil and Gas.
Allows either Equity method or proportionate consolidation.
25. Research and development costs
Deferred where technical or commercial feasibility is established and the enterprise has adequate resources to enable the product or process to be marketed.
Research costs can be capitalized and amortized as intangible assets in the following cases: Research costs related to activities conducted for others, costs unique to extractive industries and cost of intangibles which have alternative future uses. All other costs are Charged to expense as and when incurred.
Deferred where technical or commercial feasibility is established and the enterprise has adequate resources to enable the product or process to be marketed.
Operating Profit Margin
105
106
107
108
109
110
111
112
EARNINGS QUALITY
114
Objective of the Study
• This paper assesses the effectiveness of the audit committee in discharging these responsibilities by
• comparing the quality,• or informativeness of earnings reports before and after audit
committee formation.
• The informativeness is measured by the extent to which the market reacts to the release of earnings reports.
• Economic theory predicts that the magnitude of the market's reaction to earnings is a non- decreasing function of earnings quality.
What is earnings Quality
• Earnings quality, in accounting, refers to the overall reasonableness of reported earnings
• It is an assessment criterion for how "repeatable, controllable and bankable” a firm's earnings are,
• A degree to which earnings reflect underlying economic effects, are better estimates of cash flows, are conservative, or are predictable.
Source: Knechel, W Robert, Salterio, Steven E, Ballou, Brian (2007), Auditing: Assurance & Risk, 3e. Canada,
116
High Earnings Quality
Companies whose earnings are largely the result of their operations are said to have high quality earnings.
High Quality Earnings:– Earnings that reflect underlying economic Activity.– Earnings reported in an established reporting standard– Earnings that are better estimates of cash flows.– Earnings that are more conservative (lower).– Earnings that are predictable.
117
Low Earnings Quality
The earnings which is manipulated by – Murky financial accounting– Artificial profits – Inflation or other short term profit such as tax
relaxation.– by changing their accounting measures.
This might work in the short-term but it'll eventually come back to hurt the company.
118
Ways to manipulate earnings
• Recording revenue too soon or of questionable quality,
• Recording fictitious revenue, • Boosting income with one-time gains, • Shifting current expense to a different period, • Failing to record or improperly reducing liabilities, • Shifting current revenue to a later period, and • Shifting future expenses to the current period as a
special charge
119
Assessing earnings Quality
• A correlation between reported earnings and underlying economic activity,
• The permanence and sustainability of reported earnings, • The relationship between reported earnings and market valuation, • The extent and impact of discretionary accruals, • The transparency and completeness of disclosures, • The impact of low reported earnings on corporate image, • The handling of “bad” news, and • The degree to which earnings are good estimates of cash flows.[
120
Audit committee?
• Body formed by a company's board of directors to oversee audit operations and circumstances. It selects and appraises the performance of the CPA firm. In accordance with Securities and Exchange Commission (SEC) regulation, the Committee must be composed of outside directors. Besides evaluating external audit reports, the Committee may evaluate internal audit reports as well. Management representations under the realm of the Foreign Corrupt Practices Act are also reviewed. The Committee may also get involved with public disclosure of corporate activities.
Source: Answer.com
121
I. Oversight responsibilities of Audit Committees
• Integrity of financial reporting• People and culture• Compliance and ethics• Risk management• Internal control and systems
122
Financial Reporting
• Committees need to– Understand financial statements through discussion
with management and external auditors – Understand accounting policies– Assess quality, not just reliability, of earnings – Apply appropriate level of skepticism and ask probing
questions– Be comfortable with treatment of unusual/complex
issues
123
Financial Reporting
• Other keys– Review significant period-to-period changes and
challenge sudden changes – Recognize financial reporting areas most susceptible to
fraud
– Maintain healthy skepticism when considering the risk of fraud―it is never zero
• Understand any concerns raised by auditors
Revenue recognition
Expense classification
Accounting for business combinations
Provisions
Areas of judgement
Suspense / Clearing accounts
124
Narrative Reporting
• Review disclosures and consider consistency with financial statements
• Many specific disclosures required by regulators
• Leading audit committees focus on transparency―whether all significant developments are fully disclosed
125
Risk Management
• Audit committees increasingly oversee risk management processes
• Committees can fully embrace this role by– Understanding how risk management processes are
tailored to company’s specific needs– Probing whether the processes are ongoing—not just
at a point in time– Ensuring responsible individual has appropriate
stature, expertise, and time– Meeting periodically with chief risk officer
126
Members’ Attributes
• Key is good understanding of the business — including company’s products, services, and industry
• Willingness to dedicate substantial time and energy • Other relevant attributes
– Extremely high level of integrity– Healthy skepticism and courage to challenge– Inquisitiveness and independent judgment
• Good financial knowledge• Regular training
127
Participants
• Both internal audit director and external auditors typically attend every meeting
• Management’s participation is important• Meet privately with internal audit director, external
auditors, finance management, and others, as warranted
• Guard against too many observers• Audit Committees should meet at least 4 times a year
128
Primary Hypothesis
This paper's primary hypothesis (in alternative form) is as follows:
• The variability of unexpected stock returns at earnings announcement dates is greater
• For earnings released after the formation of an audit committee than before.
129
Sample collection
it is necessary that the test sample of companies 1. Have information on the year and month of committee formation
(which eliminates 122 of the 475 companies)," 2. Have annual earnings announcement dates available in the Wall Street
Journal Index for one year both before and after the formation date (this eliminates 31 companies), and
3. Have returns data on the Center for Research in Security Prices (CRSP) data base (which eliminates 62 companies).
The final sample consists of 260 companies and spans 47 different two-digit SIC code industries.
Models Deployed
• Holthausen and Verrecchia(1988): Variables Used– Market consists of single risky Asset(Firm)– One Information Release(earnings)– Competitive Risk neutral market maker.
• Within Firms Temporal Analysis– Estimates of abnormal returns at earnings
announcement dates• Control Sample Temporal Analysis
– Sample of firms for same period that did not establish audit committee
130
Dependent Variables Derived
• Indicator which shows earning reports are released after audit committee formation
• Market Value of Common Equity at the beginning of period
• Risk Parameter based on returns of 200 days• Ratio of market-to-book value of equity ,
computed at the end of period• Ratio of noncurrent liabilities to market value
of equity
131
132
Investor reaction to Audit committee Contd…
• The results show a significant increase in the market's reaction to earnings reports subsequent to the formation of the audit committee.
• Specifically, the reaction to earnings reports is more than 20 percent greater after the formation of the committee than before.
• These findings are robust to alternative variations in the research design.
• Overall, the evidence is consistent with the audit committee providing meaningful oversight of the financial reporting and auditing process.
133
Annual reports and strategy disclosures…
SOURCE: Research Paper by R Srinivasan, IIMB
Key
cont
ents
of a
n an
nual
repo
rt ▪ A Letter from the Chairman of the Board to shareholders describing the results of the past year
▪ Brief information about the company
▪ The notice for Annual General Meeting (AGM) where the annual report is presented
▪ Detailed financial results
▪ Management Discussion Analysis (MD&A)
▪ Other specific corporate reports including corporate governance reports etc
▪ Auditors reports on financial statements and/or specific reports
▪ Details pertaining to investor service
2 narratives where the Firm can detail their
strategy
134
Discussion on strategy disclosures… ▪ Concern:
• Effective disclosure of strategy by the company to the stakeholders• Minimum necessary requirements for disclosure are covered
▪ Necessity: • Listed companies educating all the stakeholders about its past
performance, present state and future strategy
▪ Probable Solution: One of the governance mechanisms to overcome this agency problem is to regulate corporate disclosures
▪ Existing gaps: • Content of non financial disclosures • Quality of non-financial disclosures
▪ Probable pitfalls: Given the ever increasing competitive positions, the firms may shy away from providing details on their strategies
SOURCE: Research Paper by R Srinivasan, IIMB
135
Limited/ no regulations on disclosures…SEBI requires a company to include the following discussions within the limits set by the company’s competitive position
▪ Industry structure and developments
▪ Opportunities and threats
▪ Segment wise or product wise performance
▪ Outlook
▪ Risks and concerns
▪ Internal control systems and their adequacy
▪ Discussion on financial performance wrt operational performance
▪ Material developments in Human resources/ Industrial relations front, including number of people employed
SOURCE: Research Paper by R Srinivasan, IIMB
136
The payoffs and risks of communication of Firm’s strategy The annual report is viewed as an “Undisguised advertisement” or “platforms
forpreaching philosophies and touting themselves and their companies”
▪ Improved relations with shareholders▪ Increased share value▪ Increased customer recognition▪ Increased effectiveness in dealing with
suppliers ▪ Improved relations with regulators & govt
agencies
▪ Competitors could use this information to their advantage
▪ Lost credibility in situations where the changes in business environment requires shifts in strategy
SOURCE: Research Paper by R Srinivasan, IIMB
137
The research objectives▪ What is the content of the MD&A text published in the annual reports and
are they useful for understanding and interpreting firm strategy?
▪ Does the firm performance affect the language of the text?
▪ Are there incidents of self-serving attributions in communicating firm performance?
SOURCE: Research Paper by R Srinivasan, IIMB
138
Understanding the results
22
25
31
40
DCA B E
A - Description of performanceB – Actions & StrategiesC – External EnvironmentD – Total Resource MobilizationE – Prediction of Performance
▪ Major focus is describing and analyzing firm performance
▪ Firms justify their performance a discussion of business environment
▪ They justify their performance through their actions and strategies
▪ Little attention on what the firm is doing about facing future opportunities and threats in terms of mobilizing financial, technological ad human resources
▪ Least focus on their future business outlook and how the firm is expected to perform
Mean no. of texts in annual report
SOURCE: Research Paper by R Srinivasan, IIMB
139
Heading
Text
Ext Env
Text
Resources
0.070
Desc Perf
-0.728
Correlations
Ext Env Heading1.000
Act &Str
-0.220
Pred Perf
0.248
Text Text 1.000 -0.211Resources Heading 0.062 -0.137
Text Text -0.497Actions& Strategies Heading 1.000 0.040
Text Text 1.000Description Perf Heading -0.289
Text TextPrediction Perf Heading 1.000
▪ Desc of Ext env is significantly –vely correlated to Firm’s Desc. Of Performance
▪ Desc of Firm perf is significantly –vely correlated with desc of firm’s actions and strategies
▪ Firm’s actions and strategies is not correlated to prediction of future performance
▪ Negative correlation between description of past performance and prediction of future performance
Studying the Correlation of the major variables
SOURCE: Research Paper by R Srinivasan, IIMB
140
▪ Attribution of Good Performance: ▪ Good performance is more attributed to internal efficiencies and strategies than to
favorable external conditions. ▪ MD&A texts do not highlight how the external business environment or factors
outside the firm helps them achieve good performance
▪ Attribution of poor performance: ▪ Poor performance is attributed to unfavorable external conditions. ▪ MD&A texts focuses on external justifications of poor performance than internal
actions and strategies
▪ Performance and Positive language: Irrespective of the firm’s performance, positive language will be used in text.
Interpreting the results
▪ Firm might not want investors to be guided by their perceptions
▪ The Firm may not want to commit itself to one view of the future and wishes to be flexible.
▪ Afraid of shareholder’s reaction and its affect on the share prices
Probable causes of variation
SOURCE: Research Paper by R Srinivasan, IIMB
141
▪ Irrespective of the firm performance, the texts present rosy picture to the stakeholders. Further research on antecedents and consequences of the language used in text would be of great value. Firms need to be conscious of using positive language, as too much positive statements might lead to a situation where stakeholders do not pay heed to significance of the statements
▪ A further research on the determinants of self serving attributions would add significant value. Analysts and stakeholders might question the sustainability of firm performance in the wake of excessive external justifications of poor performance as well as purely internal justifications of good performance.
▪ This research provides insights to regulators in defining qualitative disclosure norms. If firms shy away from disclosing “forward looking information” small investors with no access to boardrooms would be kept in the dark about the firm’s perception of the future business environment, strategies, etc.
Unanswered questions and Implications for top management
What the paper is about .. • This paper studies how strategic changes effect
operating income.• Shows how much the impact of the market
factors is and how much the management strategies have on operating income / profits.
• It studies all these strategic factors and compares it with the benchmark company in the industry.
• All parameters of cost and revenues are restructured so that they are comparable and the variance w.r.t market factors and benchmark company.
Background .. • US airlines industry faced its most turbulent
period in the post 911 era. • Passenger demand decreased significantly .• Additional costs for high security , fuel costs ,
competitions from low cost carriers , the large network airlines taken strategic steps .
• Reduce the capacity of seats available , new sources of revue , restructuring operation and labor contracts to cut the cost was done .
contd.• SWA (South West Airlines) improved operating
income by $ 266 million by combining revenue growth and improvement in productivity
• UA (United Airlines) reduced its operating loss by $888 million from 2004 to 2005
• Other significant changes were made to control the cost and increase the profit .
Initiatives taken • Delta and United have launched low cost airlines • Delta has launched ‘Songs’ as low cost subsidiary • UA also improved their services as compared to some low
cost airlines • United initiated Economy plus services , On – Demand movies
etc .
Analysis • Strategic Variance Analysis (SVA)• Strategic benchmarking variance analysis (SBVA)• Components of SBVA
– Impact of managing firm size - Growth– Impact of managing product differentiation – Price Recovery– Impact of managing cost positions – Price Recovery– Impact of managing productivity - Productivity– Impact of managing capacity underutilization - Capacity
Underutilization • United Airline’s SVA of Income• SBVA: United Airlines vs. Southwest Airlines• Conclusions
Strategic Variance Analysis
• Used to explain how the strategic changes of companies effect the their operating income
• Focuses on difference in operating incomes between two time periods
• Components :– Growth– Price-recovery– Productivity &– Capacity underutilization
• Identifies performance variances for a focal competitor based on standard comparison
• Provides a basis for examining a focal company’s strategic position and its sources of advantages and disadvantages relative to industry competitors
• UA as the focal competitor and SWA as the benchmark
competitor
Strategic Benchmarking Variance Analysis
Comparison Between Two Competitors
• Two adjustments are required– Organize variance into five categories– Variances are normalized
• Comparison is done between to firms after normalization (to take into account the size difference).
SBVA components • Managing firm size • Managing product differentiation • Managing cost positions• Managing productivity • Managing capacity underutilization
SVA: GrowthSBVA: Managing Firm Size
• Measures change in operating income keeping sales price & input cost constant
• Driven by two issues– Change in size of general market– Change in firm’s market share
SVA: Price Recovery
SBVA: Managing Differentiation• Measures variance related to
– Increase in product prices– Increase in input costs
SBVA: Managing Cost PositionMeasures the variances associated with changes relative
to cost positionsReduction in product pricingReduction in Input Cost
SVA: ProductivitySBVA: Managing Productivity
• Measure the relative efficiency in converting inputs to outputs
SVA: Capacity UnderutilizationSBVA: Managing Capacity UnderutilizationMeasures the change in operating income caused by
variation in the cost of unused capacity
United Airline’s SVA of Income
• We will consider the case of UAL, which has managed to decrease its operating loss by $888 million & compare it with the benchmark firm Southwest, which has managed to make profits in the difficult times.
Quantitative analysis…
Selected Operational Data
2005 2004 Difference Amount Difference %
Domestic revenue passenger enplanements 5,65,28,048 6,14,63,010 -49,34,962 -8.03%
Domestic revenue passenger miles (RPMs) 68,30,47,12,078 72,60,38,49,616 -4,29,91,37,538 -5.92%
Domestic available seat miles (ASMs) 83,83,40,02,564 93,35,26,76,998 -9,51,86,74,434 -10.20%
Selected Financial Data
2005 2004 Difference Amount Difference %
Total Domestic operating revenue $ 11,36,50,22,000 $ 10,48,60,61,000 $ 87,89,61,000 8.38%
Total Domestic operating expenses
Domestic flying operations $ 3,24,34,73,000 $ 3,09,01,34,000 $ 15,33,39,000 4.96%
Domestic maintenance $ 1,21,12,55,000 $ 1,34,70,18,000 $ -13,57,63,000 -10.08%
Domestic passenger service $ 76,31,86,000 $ 91,46,38,000 $ -15,14,52,000 -16.56%
Domestic aircraft and traffic servicing $ 1,53,19,48,000 $ 1,75,64,80,000 $ -22,45,32,000 -12.78%
Domestic promotion and sales $ 88,98,53,000 $ 96,69,57,000 $ -7,71,04,000 -7.97%
Domestic general and administrative $ 42,07,84,000 $ 54,36,38,000 $ -12,28,54,000 -22.60%
Domestic depreciation and amortization $ 51,68,88,000 $ 55,14,53,000 $ -3,45,65,000 -6.27%
Domestic transport related expenses $ 3,11,32,87,000 $ 2,52,94,82,000 $ 58,38,05,000 23.08%
$ 11,69,06,74,000 $ 11,69,98,00,000 $ -91,26,000 -0.08%
Domestic operating profit $ -32,56,52,000 $ -1,21,37,39,000 $ 88,80,87,000 -73.17%
Selected Fuel Data
2005 2004 Difference Amount Difference %
Total scheduled domestic gallons used 1,22,58,44,554 1,40,16,84,774 $ -17,58,40,220 -12.54%
Total scheduled domestic fuel cost $ 2,14,41,92,231 $ 1,66,40,83,178 $ 48,01,09,053 28.85%
Average domestic fuel cost per gallon $ 1.75 $ 1.19 $ 0.56 47.33%
Reclassified Financial Data
2005 2004 Difference Amount Difference %
Total domestic operating revenues $ 11,36,50,22,000 $ 10,48,60,61,000 $ 87,89,61,000 8.38%
Less: Total domestic operating expanses
Domestic fuel costs $ 2,14,41,92,231 $ 1,66,40,83,178 $ -48,01,09,053 -28.85%
Domestic flight-related costs $ 7,12,46,80,769 $ 7,31,22,79,822 $ 18,75,99,053 2.57%
Domestic passenger-related costs $ 2,42,18,01,000 $ 2,72,34,37,000 $ 30,16,36,000 11.08%
$ 11,69,06,74,000 $ 11,69,98,00,000 $ 91,26,000 0.08%
Domestic operating income $ -32,56,52,000 $ -1,21,37,39,000 $ 88,80,87,000 -73.17%
Selected Industry Data
2005 2004 Difference Amount Difference %
Scheduled domestic traffic (RPMs) 5,72,88,57,32,000 5,47,95,85,02,000 24,92,72,30,000 4.55%
Explanations for $888 Million Decrease in United Airline's 2005 Operating LossImpact of growth during 2005 due to i. Decrease in operating revenue $ -62,09,17,743 ii. Decrease in expected fuel costs $ 9,85,36,407 iii. Decrease in expected flight-related costs $ 33,67,49,815 iv. Decrease in expected passenger-related costs $ 16,12,64,593 $ 59,65,50,815 Net decrease in the growth component during 2005 $ -2,43,66,928 Represented by Impact of market size increase (4.55%/-5.92%)($2,43,66,928) $ 1,87,19,984 Impact of loss of market share [(-5.92%-4.55%)/(-5.92%)]($2,43,66,928) $ -4,30,86,913 $ -2,43,66,928
Impact of price recoveries during 2005 due to v. Increase in air fares $ 1,49,98,78,743 vi. Increase in price per gallon $ -74,10,39,423 vii. Increase in average flight-related costs per ASM $ -45,46,32,895 Viii. Decrease in costs to service an average passenger $ 8,48,68,391 $ -1,11,08,03,927 $ 38,90,74,816 Impact of productivity during 2005 due to ix. Decrease in fuel usage per galllon $ 6,03,19,544 x. Decrease in fuel usage due to fewer ASMs $ 10,20,74,420 xi. Decrease in costs because fewer passengers served $ 5,55,03,016 $ 21,78,96,980 Change in the capacity underutilization during 2005 due to Flight-related capacity underutilization during 2005 $ 1,31,97,65,655 Flight-related capacity underutilization during 2004 $ 1,62,52,47,788 Net decrease in the capacity underutilization component during 2005 $ 30,54,82,133 Represented by: xii. Increase in cost of acquired but unused flight-related capacity $ -10,33,62,214
xiii. Decrease in the cost of additional flight-related capacity aquired $ 74,55,94,162 xiv. Decrease in the cost of flight-relatedcapacity used $ -33,67,49,815 $ 30,54,82,133 $ 88,80,87,001
Stratigic Benchmarking Variance Analysis with United Airlines and Southwest Airlines
United Airlines
(2005 bRPMs = 68.304 billion) Southwest Airlines
(2005 bRPMs = 60.223) SVA SVA/bRPM SVA SVA/bRPM SBVAImpact of growth during 2005 due to
Decrease in operating revenue $ -62,09,17,743 $ 83,23,33,246 Decrease in expected fuel costs $ 9,85,36,407 $ -12,71,37,885 Decrease in expected flight-related costs $ 33,67,49,815 $ -28,45,50,439
Decrease in expected passenger-related costs $ 16,12,64,593 $ 59,65,50,815 $ -22,51,62,687 $ -63,68,51,011
Net change Represented by $ -2,43,66,928 $ 19,54,82,235
Impact of market size change $ 1,87,19,984 $ 2,74,066 $ 6,97,62,866 $ 11,58,404 $ -8,84,338
Impact of market share change $ -4,30,86,913 $ -6,30,804 $ 12,57,19,369 $ 20,87,554 $ -27,18,358
$ -2,43,66,929 $ -3,56,739 $ 19,54,82,235 $ 32,45,958 $ -36,02,697 Impact of managing product differentiation
Increase in air fares $ 1,49,98,78,743 $ 2,19,58,642 $ 22,18,83,754 $ 36,84,352
Increase in average flight-related costs per ASM $ -45,46,32,895 $ -66,55,952
Increase in costs to service an average passenger _____________________ $ -1,85,83,235 $ -3,08,572
$ 1,04,52,45,848 $ 1,53,02,690 $ 20,33,00,519 $ 33,75,779 $ 1,19,26,911 Impact of managing cost positions
Descrease in average flight-related costs per ASM $ 5,17,68,215 $ 8,59,605
Decrease in cost to service an average passenger $ 8,48,68,391 $ 12,42,497
Changes in non-differentiating costs (fuel price per gallon) $ -74,10,39,423 $ -1,08,49,023 $ -27,71,14,281 $ 46,01,448
$ -65,61,71,032 $ -96,06,527 $ -22,53,46,066 $ -37,41,843 $ -58,64,684 Impact of managing productivity
Decrease in fuel usage per gallon due to longer flights $ 6,03,19,544 $ 8,83,095 $ 4,55,69,596 $ 7,56,677
decrease in fuel usage due to higher passenger load factor $ 10,20,74,420 $ 14,94,398 $ 2,30,30,181 $ 3,82,413
Increase in average miles per passenger $ 5,55,03,016 $ 8,12,580 $ 6,64,10,923 $ 11,02,745
$ 21,78,96,980 $ 31,90,072 $ 13,50,10,700 $ 22,41,835 $ 9,48,237 Impact of manging capacity underutilization
Flight-related capacity underutilization during 2005 $ 1,31,97,65,655 $ 1,93,21,737 $ 1,02,19,17,459 $ 1,69,68,810
Flight-related capacity underutilization during 2004 $ 1,62,52,47,788 $ 2,37,94,080 $ 97,99,69,072 $ 1,62,72,262
$ 30,54,82,133 $ 44,72,343 $ -4,19,48,387 $ -6,96,548 $ 51,68,891
Change in operating income ___________________
_____________________
_____________________
__________________
__________________
$ 88,80,87,000 $ 1,30,01,841 $ 26,64,99,001 $ 44,25,181 $ 85,76,660
Conclusion
• Strategic Variance Analysis (SVA):– A single competitors strategic actions affect its
accounting variance between 2 time periods
• Strategic Benchmarking Variance Analysis (SBVA):– Comparison across two different competitors.
Methodology for understanding whether the variances identified in SVA result in improvements in the focal firm’s competitive position. This methodology checks whether company has improved compared to their key rivals
Difference between SVA and SBVA…
• UAL improved its competitive position through managing differentiation, Managing productivity and Managing Capacity.
• The competitive position weakened in relation to Managing Firm Size and Cost position
Results – UA and SWA…
Focus firm - UA
• Managing Differentiation– Up by $11.9 Million per week
• Managing Productivity– Up by $0.95 Million per week
• Managing Capacity– Up by $5.2 Million per week
Improved Areas (UA Vs SWA)…
Focus firm - UA
• Firm Size– Down by $3.6 Million per week
• Cost Position– Down by $5.9 Million per week
Weak Area(UA Vs SWA)…
Focus firm - UA
• In all UAL improved its competitive position relative to SWA by approximately $8.6 million for each week of operation.
• Net Variance shown by SBVA is 66% of UALs strategic variance between 2004 and 2005
Total SBVA Results (UA Vs SWA)…
Focus firm - UA
DISCLOSURES
ANOTHER STUDY
The study show relationship between firm’s Investment opportunity set and the voluntary disclosure of it’s Operating Income for firms in New Zealand
Two hypothesis are tested in the research paper :
H1 : Assets-in-place are positively related to the voluntary disclosure of operating income/EBIT in the income statement.
H2 : Leverage is positively related to the voluntary disclosure of operating income/EBIT in the income statement.
Definitions of related terms
Investment Opportunity Set (IOS):
The universe of choices as to investments available to an individual or corporation.
Operating Income
Operating Income = Operating Revenue – Operating ExpensesAlso known as Earnings before Interest and tax (EBIT)
Assets-In-Place (AIP)Assets already owned, e.g. property, plant, equipment
Future AssetsAssets that will be owned with time, also called, Growth opportunities
NOPATNet Operating Profit After Tax
Definitions of related terms
Leverage (also known as gearing or levering)
Refers to the use of debt capital to supplement equity capital
Companies leverage to attempt to increase returns on equity capital
It can increase the scope for gains or losses
Deleveraging is the action of reducing borrowings
In macroeconomics, a key measure of leverage is the debt to GDP ratio
*The temporary increases in stock prices due to leverage at some banks in the United States have been blamed for the unusually high overall remuneration for top executives during the financial crisis of 2007–2010, since gains in stock prices were often rewarded regardless of how they were achieved.
Investment Opportunity Set
Equity financing
Debt financing
Venture capital
Personal savings
Key factors:
Debt holders are ready to finance assets-in-place
Apprehensive of growth opportunities i.e. future assets.
Creation of future assets may result in discretionary expenditures e.g. R&D.
So, these expenditures are financed by residual claimants i.e. equity holders.
Important Factors in Disclosure
Managers voluntarily make good news disclosures to differentiate themselves from firms that are not performing as well
Managers make pre-emptive bad news disclosures to prevent litigation that may arise from withholding or delaying bad news
Research design, data and results
Logit regression: Used for prediction of probability of occurrence of an event by fitting data to a logit (logistic) function logistic curve.
General:
Z = B0 + B1X1 + B2X2 + B3X3 + … + BkXk
Z: Measure of the total contribution of all independent variables used in the model and is known as the logitB0 : Intercept, value of z when all independent variables are zero B1, B2…: Regression coefficients of X1 , X2, X3 … respectively
Logit function for the study:
DISC = a + B1AIP + B2LEV + B3SIZE + B4ROA + B5ANCOV+ B6LOSS + e
DISC: 1 Operating income/EBIT is disclosed in income statement0 Otherwise
Research design, data and results
AIP (Assets-in-Place):Book value of property, plant and equipment / sum of market capitalization of equity, minority interest and liabilities.
LEV (Leverage): Total liabilities/ Total Assets
SIZE: Natural log of total assets
ANCOV: 1 Financial analysts provide earning forecast(Analysts coverage) 0 Otherwise
LOSS: 1 If firms make a loss0 Otherwise
a, B1, B2, B3, B4, B5, B6 Parameters of the modele Error term
Research design, data and results
Measures of IOS
Study tries to capture IOS variable using 3 measures
•AIP : Assets-in-place•MKTBVA : Market-to-book value of assets•NOPAT/MKTA : Net Operating Profit after Tax /
Market Value of Assets
*Study Assumes IOS is predetermined
Data for study
Companies Studied
Statistics
Descriptive statistics in logit regression analysis
Analysis
AIP:t-test : Difference is significant at the 5 per cent levelMann–Whitney U-test : Difference is significant at the 1 per cent level
MKTBVA :t-test : Difference is significant at the 5 per cent levelMann–Whitney U-test : Difference is insignificant at the 1 per cent level
NOPAT/MKTA : t-test : Difference is insignificantMann–Whitney U-test : Difference is insignificant
LEV:t-test : Difference is significant at the 1 per cent levelMann–Whitney U-test : Difference is significant at the 1 per cent level
SIZE:t-test : Difference is significant at the 1 per cent levelMann–Whitney U-test : Difference is significant at the 1 per cent level
ROA : t-test : Difference is significant at the 5 per cent levelMann–Whitney U-test : Difference is insignificant
Analysis
Statistics
Contingency table analysis to examine the relation between operating income/EBIT disclosureand analyst coverage (ANCOV)
Contingency table analysis to examine the relation between operating income/EBIT disclosureand LOSS
Analysis
ANCOV analysis:
Companies that disclose EBIT: Analysts provide earnings forecast for 70%Companies that don’t disclose EBIT: Analysts provide earnings forecast for 39%
LOSS:
Companies that disclose EBIT: 13 % are loss makingCompanies that don’t disclose EBIT: 27 % are loss making
Statistics
Analysis
Regression 1:
The sign of the coefficient on the ANCOV variable is positive, indicatingthat if financial analysts provide earnings forecasts for a firm, there is ahigher probability that the firm discloses operating income/EBIT in the incomeStatement
Regression 2:
LEV variable continues to be positive and significant at the 1 per cent level (using a one-tailed test). This finding is similar to the result in Regression 1 and again provides support for hypothesis 2. The only other variable that is significant in Regression 2is the ANCOV
Regression 3:
LEV variable continues to have the expected positive signand to be significant (again at the 1 per cent level using a one-tailed test). As inRegressions 1 and 2, Regression 3 also shows that ANCOV is significantly positive.
Proof of Hypothesis
Hypothesis 1:
Regression 1 shows that the coefficient of the AIP variable is positive, and it is significant at the 10 per cent level (one-tailed test). While this result isnot strong, it does provide some support for hypothesis 1 that assets-in-placeare positively related to the voluntary disclosure of operating income/EBIT in the income statement.
Hypothesis 2:
The coefficient of the LEV variable is also positive, and it is significant at the 1 per cent level using a one-tailed test. This finding provides support for hypothesis 2, which says that leverage is positively related to the voluntary disclosure of operating income/EBIT in the income statement.
Conclusion of the Study
1. The logit regression results provide: • Support for H1 when the AIP variable is used to measure the IOS• Support for H2 that LEV is associated with the voluntary disclosure of
operating income/EBIT. • Overall, this study provides some evidence for a phenomenon that has
not been documented previously in the accounting literature.
Overall prediction:• Managers are more likely to voluntarily disclose EBIT in the income statement
where operating income/EBIT presents an appropriate measure of performance to the firm’s capital providers, thereby facilitating efficient contracting between the parties to the firm.
• Firms with high assets-in-place and, hence, high leverage are more likely to voluntarily disclose operating income/EBIT, the pre-tax measure of NOPAT that is used by capital providers to assess manager’s performance
References
• Voluntary disclosure of operating Income by Jilnaught Wong, Norman Wong• Voluntary disclosure of Forward-Looking Earnings Information in Australia by Pamela
Kent and Karen Ung
Content Introduction – Objectives and definitions
Research Design
Results and conclusion
CG AND FIN STATEMENTS
• To establish relationship between corporate governance structures
on the quality of financial statement information – specifically
relation between governance and earnings management or
manipulation.
Studies indicate that the governance mechanisms is important to monitor the
earnings manipulation. However a little is known about the effect of governance
structures on the quality of reported earnings more generally.
This presentation summarizes the paper , which contributes to the existing literature by
providing analysis of how governance structures mitigate the effects of environmental
uncertainty and management discretion on the quality of reported earnings.
Accrual Accrual (accumulation) of something is, in finance, the adding together of interest or
different investments over a period of time.
It holds specific meanings in accounting, where it can refer to accounts on a balance
sheet that represent liabilities and non-cash-based assets used in accrual-based
accounting.
These types of accounts include, among others, accounts payable, accounts receivable,
goodwill, deferred tax liability and future interest expense.
Types:
Innate;
Discretionary
http://en.wikipedia.org/wiki/Accrual
Accrual Quality This approach to determining earnings quality is based on assessing how well
working capital accruals map into realised cash flows.
It directly measures the extent to which accruals reflect actual cash flows to
determine the quality of accrual earnings information.
In 2002, Dechow and Dichev empirically determined accrual quality as the standard
deviation of the residual of a regression of current period accruals (measured as the
change in working capital) on past, current and future operating cash flows.
This study recognizes Accrual Quality as “PROXY” for quality of earning management
and ultimately firm’s image among investors.
Corporate Governance Studies indicate that the investors all across face huge uncertainty due to quality
of firm’s accounting information and cost of capital.
Empirical analysis showed that the accrual quality measure was significant and
positively associated with a firm’s credit rating.
Accrual Quality is dependent on following factors:
Internal Controls and voluntary disclosures
Disclosures before Audit
Auditors Independence
Expanses on Audit practices; and
Corporate Governance Structure
Corporate Governance - Structure The research paper used as Hypothesis and tested it empirically;
H1: Companies with sound corporate governance structures have more
accurate accrual estimation than those without sound corporate governance
structures.
Conclusion: It is reasonable to conclude that governance characteristics and
associated internal controls that affect intentional earnings management are
also relevant to unintentional accrual estimation errors.
Key Structures:
board of directors,
audit committee, its size and measure of its independence
external audit function
Content Introduction – Objectives and definitions
Research Design
Results and conclusion
Sampling The sample was comprised of Australian public companies listed on the Australian
Stock Exchange in 2004.
Data was obtained for companies with a 30 June balance date in 2004 from the
Aspect Data Analysis database.
The preliminary sample of companies was then screened for data availability based
on criteria designed to ensure the measure of the dependent variable accrual
quality (AQ) was able to be calculated.
Companies in the sample were also required to have an audit committee in their
corporate governance structure.
The final sample was comprised of 381 companies.
Variables related to CG Board Independence : First, the proportion of non-executive directors to total directors; and, whether the roles of the chairperson and CEO are separate. Board diligence was measured by the number of board meetings per year.
Selected audit committee: Independence: measured as the proportion of committee members that are
described as non-executive; Expertise of committee members: Formal qualifications - B.Com., FCA, CPA. The
proportion of committee members with qualifications was included as a proxy for expertise.
Diligence was measured by the number of audit committee meetings held during the year.
Audit committee Size : Number of directors assigned to the audit committee.
Measuring Accrual Quality Approach to determining accrual quality is developed from the observation that accruals shift or adjust the recognition of cash flows over time representing the representing underlying economic achievements and sacrifices.
However, they require estimates to be made and are subject to the exercise of managerial discretion assigned to the audit committee. Hence the benefit of using accruals comes at the cost of including estimation errors in reported earnings’.
Estimation error for working capital accruals can be measured by the residuals from firm specific regressions of changes in working capital (ΔWC ) on prior year, present year, and one-year ahead operating cash flows (CFO). Dechow and Dichev (2002) focused on working capital accruals and operating cash flows because the cash flow realisation of these accruals generally occurs within a year.
ΔWC = β0 + β1*CFOt-1 + β2*CFOt + β3*CFOt+1 + εt (1)
Measuring Accrual Quality
.
iYiYieˆError
YY
X : Operating Cash Flow X : Operating Cash Flow Y : Change in Working CapitalY : Change in Working Capital (ΔWC )
Yi
Yi
XiXi
10ˆ XbbY
iXfor Y of valuepredicted theˆ
iY
point data Observed
Measuring Accrual Quality .. contd Minor adjustments to the DD model in an effort to refine the measure of accrual
quality.
It is established that the regression residual was strongly correlated with change in
sales. This indicated that cash from operations was a noisy proxy for the cash flows
that result from the reported accruals.
To overcome this model misspecification, our accrual quality regressions use
targeted components of operating cash flows; that is, we include only ‘cash receipts
from customers’ (CRC) and ‘cash payments to suppliers and employees’ (CPSE).
ΔWC = β0 + β1*[CRC + CPSE]t-1 + β2*[CRC + CPSE]t + β3*[CRC + CPSE]t+1 + εt (2)
Measuring Accrual Quality .. contd
0.40.20.0-0.2-0.4
4
3
2
1
0
Residual
Frequency
Histogram(response is NOISE)
Regression ResidualsHistogram
Residuals Rs. In M$
Mean = 2.05 M$Std. Dev = 0.5 M$
Innate and Discretionary componentsFrancis et al. (2005) explain approach to separate accruals quality innate and discretionary accruals
Innate : Characteristics like negative earnings, volatility in sales and operating cash flows, length of operating cycle, and company size affect accrual quality.
AQt = α + β1*SIZEt + β2*LOSS + β3*OPCYC + β4*SDOR + εt (3)
The predicted values from the regression provide an estimate of innate accrual
quality (IAQ), and
residual values provide an estimate of discretionary accrual quality (DAQ).
The estimates of the components of accrual quality derived from equation (3)
were subsequently regressed on selected corporate governance variables.
Regression – Governance Regression was used to test proposition regarding the relation between accrual quality and corporate governance structures. The dependent variables (Y) are innate accrual quality (IAQ) and discretionary accrual quality (DAQ) determined according to equation (3)
IAQ = α + β1*PROIND +β2*DUAL + β3*MEETBD + β4*AUDITOR + β5*NDIRAC + β6*PRONEDAC + β7*MEETAC + β8*PROEXP (4)DAQ = α + β1*PROIND +β2*DUAL + β3*MEETBD + β4*AUDITOR + β5*NDIRAC + β6*PRONEDAC + β7*MEETAC + β8*PROEXP (5)
PROIND: Proportion of independent directorsDUAL : Dual CEO and board chairMEETBD: Number of board meetings each yearAUDITOR : Existence of Big 4 + 2 auditor NDIRAC : Number of directors on the audit committeePRONEDAC: Proportion of non-executive directors on the audit committeeMEETAC: Number of audit committee meetings each yearPROEXP : Proportion of audit committee members that have accounting and finance qualifications
Content Introduction – Objectives and definitions
Research Design
Results and conclusion
Descriptive Results Mean Asset Size : 635 M$;
Average Operating Cycle: 62 Days;
Std. Dev – O/P Revenue : 0.23;
38% of firms reported loss in the FY;
Boards were structured to promote independence;
Board activities were conducted diligently;
Average proportion of independent directors was substantial at 52 percent;
12% percent of companies in the sample had a joint CEO and board chair;
Range in the number of board meetings per year was from a minimum of 1 to a
maximum of 34, with a median value of 11.
Descriptive Results……….. Contd. In relation to external audit, 75 percent of the sample companies utilised the
services of one of the ‘Big 4 +2’ audit firms;
Audit committee size ranged from 1 to 7 with a median of 3. On average, 51
percent of audit committee members had experience in accounting and finance
expertise. The frequency of audit committee meetings ranged from 0 to 16 per
year, with a median of 3 per year;
Audit committee independence was favourable, with 88 percent of members
being non-executive directors;
The highest correlation for the corporate governance variables is between the
proportion of independent board directors (PROIND) and the proportion of
nonexecutive directors on the audit committee (r = .301).
None of the correlations between variables were of sufficient magnitude to
raise concerns about multi-colinearity for the regression analyses
Governance Structure and AQLarger companies have higher AQ, and firms with more volatile operating revenues have lower AQ;
The regression of governance characteristics on innate accrual quality was significant at p <.01 (F=13.577). Characteristics of the board, the audit committee, and the external auditor significantly explain the level of innate accrual quality;
Companies with a dual CEO and board chair (DUAL), and the number of board meetings (MEETBD) were significant at p<.05.
When the dual CEO and chair role occurred, the predicted AQ measure was greater which indicates lower accrual quality;
Companies that used the services of the ‘Big 4 plus 2’ audit firms had higher accrual quality.
Larger audit committees, a greater proportion of non executive directors assigned to the committee, and more frequent committee meetings were associated with higher accrual quality.
Discretionary Accrual Quality Regressions of governance characteristics on DAQ showed that a small
proportion of the variance in DAQ is explained by the selected governance
characteristics (R2=0.055)
Results (p=0.007) show that the only significant variables were the size of the
audit committee (NDIRAC) and the number of audit committee meetings held
(NOMEETAC).
Larger audit committees and more frequent committee meetings were
associated with higher accrual quality.
Results also suggest that the audit committee serves to maintain reported
earnings quality by minimising discretionary accruals, we find different audit
committee characteristics to be important.
ConclusionsEmpirical analysis provides the useful insight into the importance of the issue
of how corporate governance structures affect the quality of reported
company earnings.
Study establishes and emphasizes on impact of well estimated accruals on
actual cash flows, and ultimately a direct measure of earnings quality.
The results of the analysis suggest that the relation between sound governance
structures and accrual quality is stronger for innate than discretionary accruals
and benefits extend beyond mitigating dysfunctional management reporting.
Sound governance and associated internal controls reduce environmental
uncertainty for managers and reduce the likelihood of unintentional accrual
estimation errors leading to a less noisy and more reliable earnings
information.
LimitationBoard and audit committee independence, larger audit committees, and diligence of the audit committee all related positively to accrual quality;
Firms with larger audit committees and frequent audit committee meetings were associated with higher accrual quality.
Measure of earnings quality is limited to considering how well current accruals estimate operating cash flows.
This approach has been shown to be a suitable proxy for accrual quality; however, it does not provide a complete analysis of earnings quality.
This necessarily excludes some components of reported earnings that are not associated with current accruals.
Second, the results of the analysis are subject to the effectiveness of the measures adopted to operationalise various characteristics of corporate governance structures.
STUDY 3
“Men are so consituted that every one undertakes what he sees another successful in, whether he has aptitute for it or not”-
Johann Wolfgang Von Goethe (1749-1831),
German Poet, Dramatist, Novelist
MERGERS
What is a Merger
• A merger is where two or more businesses join forces to become one organization.
• After the merger, each of the businesses and their shares will no longer exist. Instead a new legal entity has been formed.
What is an Acquisition
• An acquisition is the purchase or takeover ofanother business, so that the organizationbecomes the legal owner and controller ofthe business they have acquired.
• This can be expensive as the acquiring company will be paying for the net assets, goodwill and brandname of the company they are buying.
Types Of Merger & Acquisition
• Horizontal merger
• Vertical merger
• Conglomeration merger • Forward Merger • Reverse Merger
• Horizontal MergerThis occurs when two companies that are in direct competition with each other in the same product lines and markets decide to merge.
• Vertical MergerThis occurs when a supplier company,mergers with a company that they supply goods or services to i.e. supply and customer decide to merge. An example of this is a pizza restaurant chain merging with the company that supplies them with pizzabases.
• Conglomeration Merger If two companies that do not have a common business area merge together this is called a conglomeration.
Forward Merger
Mechanism • The target merges into the acquirer
Taxability • Forward merger would be taxable in the hands of the
target since the same would be considered as asset sale by the target to the acquirer
• Shareholders would be taxable on the amount distributed at the time of liquidation of the target
Reverse Merger
Mechanism • The acquirer merges into the target
Taxability • Reverse merger would be treated as stock
acquisition by the acquirer since the shareholders of the acquirer get stock in the target
Terms used in Mergers....
• In reality, there is always a bidder and a target. Almost all transactions could be classified as acquisitions.
• Divestiture: a transaction in which a firm sells one of its subsidiaries or divisions to another firm.
• Spin-off: a transaction in which a firm either sells or issues all or part of its subsidiaries to its existing public investors by issuing public equity.
Terms used in Mergers
• Target: the corporation being purchased, when there is a clear buyer and seller
• Bidder: The corporation that makes the purchase, when there is a clear buyer and seller. Also known as the acquiring firm.
• Friendly: The transaction takes place with the approval of each firm’s management
• Hostile: The transaction is not approved by the management
of the target firm.
Bull and Bear Market
• Bull Market A prolonged period in which investment prices rise faster than their historical average.
• Bear Market A prolonged period in which investment prices fall, accompanied by widespread pessimism.
Reasons for Mergers & Acquisitions
Reasons for mergers & acquisitions:• Strategic
The combined FCFs (Free Cash Flows) of the merged operation are greater than the sum of the individual cash flows
• Financial
The cash flows and also the market value of the target are below their true value due to perhaps inefficient management. Such firms are typically restructured after the acquisition
Diversification “Don’t put all your eggs in one basket.” Current finance literature seriously questions the merits of this reasoning: Why does the management know better than the shareholders how to achieve diversification?
• It is usually the case that shareholders can diversify much more easily than can a corporation.
• Individuals can easily diversify by buying shares in mutual
funds.
Reasons for divestitures and spin-offs
• To undo non-profitable mergers (originally motivated by pure diversification)
• To “break up” a inefficiently run conglomerate
• In the case of spin-offs, to improve managerial efficiency in the subsidiary, by offering a directly observable stock price as an (admittedly imperfect) measure of managerial performance.
• Also, in the case of spin-offs, to give equity investors more flexibility in diversifying their investment portfolios.
Are there any other reasons of Mergers?
May be!
CEOs envy towards each other based on their compensation
Purpose of this study
• A model is developed in which CEOs envy each other based on their compensation.
• When CEO compensation is increasing in the
firm’s market value and size, we show that envy can cause merger waves
Insights on Mergers
• Corporate mergers redefine firms boundaries • The merger wave improve operational
efficiency • Merger waves are procyclical • fundamental industry-specific economic
shocks cause merger waves
What still needs to be understood..
• Are merger waves in some industries motivated by scale economies?
• Why merger waves are more commonplace in bull markets than in bear markets?
• What might cause a merger wave in an industry in which the wave-precipitating shock is not motivated by market mispricing?
How Envy plays....
The literature on the biological, sociological and economic foundations for envy-based preferences display that If CEOs envy each other based on relative compensation and CEOs of bigger firms get paid more, then a merger in the industry that increases firm size for one CEO will cause other envious CEOs to be tempted to undertake value dissipating but size-enhancing acquisitions, thereby starting a merger wave. Envy explains the urge to merge despite poor bidder returns.
THE MODEL
Model
The model developed will predict:
• Envy-induced cross-sectional correlation in mergers is generated by the sequential decisions of firms, which then leads to results about how the gains from mergers vary depending on the timing of the merger within the wave
• Bidder gains for later acquisitions in a merger wave are smaller than those for earlier acquisitions in the wave
• More envious CEOs are more likely to engage in acquisitions and pay higher premia.
Components of Model
• Firms in the Economy• Mergers• Time Line• CEO Wages and Preferences
MODEL ANALYSIS MERGER WAVES
Merger Decisions Without Envy
• If the CEOs do not envy each other and the shocks to value gains from acquisitions are independent across firms, then the acquisition decisions for different firms are stochastically independent of each other and are uncorrelated
• Merger decisions are positively correlated across firms when the value gains from acquisitions are correlated in the cross-section
• Merger waves can arise even though there is no causal relationship between the mergers of different firms
• Nothing can be said about the timing of mergers by different firms within a wave.
Sequential Decision with Envy
• Proposition 1 The proposition asserts that it is a sequential equilibrium for a firm to acquire on a particular date only if the CEO’s post-acquisition wage exceeds a threshold wage
• When the CEO observes acquisitions by other firms, he observes the wage increases of the acquiring CEOs, which induces an envy-related reduction in his utility and an envy-related increase in the marginal utility of the wage increase associated with his own acquisition
• Consequently, the threshold wage for an acquisition declines as more firms acquire.
Envy and Merger Waves
• Proposition 2There is a positive correlation between merger events of different firms when CEOs envy each other
• Proposition 3 The merger-induced increase in the wage of an acquiring firm’s CEO is higher in an earlier merger than in a later merger. The value gain to an acquirer is higher in an earlier merger than in a later merger, controlling for target size.
The Triggering Effect of Bull Markets on Merger Waves
• The merger waves are more likely during periods of high market returns than during periods of low market returns, so envy offers a clear explanation for the puzzling stylized fact that merger waves are a bull-market phenomenon and not a bear-market phenomenon.
• Moreover, because this effect is due to envy, mergers that do occur in bear markets are predicted to have greater synergies than those that occur in bull markets
• The bear-market acquisitions exhibit significantly better long-term operating performance than bull-market acquisitions
Cross Sectional Variation in Target Size
• Proposition 5 The target size is smaller in an earlier acquisition than in a later acquisition, controlling for the value gain to an acquirer.
REAL-WORLD COMPENSATION PRACTICES, INDUSTRY EFFECTS
&COMPARISON WITH OTHER EXPLANATIONS
FOR MERGER WAVES
Real World Executive Compensation Practices
• Executive compensation in the real world is set on the basis of benchmarking
• The real-world executive compensation practices exacerbate the envy-based motivation to grow firm size through acquisitions by shining the spotlight on the compensation packages of CEOs at other firms and explicitly linking CEO compensation to firm size
• The likelihood of envy-induced merger waves is elevated by greater transparency in executive compensation
• The merger waves are less likely when the CEOs of initial acquirers have relatively low compensation.
Industry Effects
• The effect of envy on acquisition strategies is likely to differ across industries.
• It is particularly strong in high-growth, high-risk industries
• Industries where product market competition and scale economies trigger acquisitions of relatively large players by other firms are more likely to experience envy-induced merger waves
• By contrast, envy is likely to play a smaller role in industries with a small number of major players of comparable size who cannot acquire each other
Comparison with other Explanations of Merger Waves
• Industry-specific economic shocks cause correlation in mergers across firms in an industry
• Earlier acquisitions in a merger wave will be more valuable than later acquisitions
• The targets in earlier acquisitions will be smaller than those in later acquisition.
• The mergers are correlated because market misevaluation is correlated across firms
EMPIRICAL ANALYSIS
Merger Wave Classification
Merger Wave Classification
Prediction No. 1
Prediction No. 1
Prediction No. 2
Prediction No. 2
Prediction No. 3
Prediction No. 3
Robust Check: Mean Increase Compensation
Robust Check: Size of Deal
Robust Check: Method of Payment
Robust Check: IT
ConclusionsThe analysis produces numerous empirical predictions
which are summarised below
1. Merger waves are more likely in bull stock markets than in bear stock markets
2. Acquisitions undertaken during bull markets have lower bidder returns than those undertaken during bear markets.
3. If we control for the dispersion in firm values, then the difference in merger activity acrossbull and bear markets largely disappears.
Conclusions....
4. The later mergers in a wave will have lower bidder returns than earlier mergers.
5. Targets in earlier acquisitions in a merger wave will be smaller than those in later acquisitions in the wave.
6. Earlier acquisitions in a wave will result in larger increases in top management compensation than later acquisitions in the wave.
Conclusions....
7. Greater transparency in executive compensation will elevate the likelihood of an envy-induced merger wave.
8. More envious CEOs are more likely to engage in takeovers and pay higher acquisition premiums than less envious CEOs.
9. The proportion of acquisitions undertaken by non-envious CEOs will be lower during mergerbooms than during other periods.
References
• Anand M.Goel, “Do Envious CEOS Cause Merger Waves?,” Review of Financial Studies, Feb 2010
MICROSOFT
• Founded in 1975 by Bill Gates and Paul Allen• Went public in 1986 at $25.75 per share• Phenomenal financial success between 1986 -1996
– In 1986, Revenue and operating income grew an average of 43% and 49% per year
• Report higher than expected financial performance in June 1999– Asset totaling $37 billion– Book value of equity equal to $28 billion– Market value about $460 billion
Introduction
• Conservative accounting policies• GAAP allow managerial discretion in
accounting policies• In two key areas, Microsoft choose a rather
conservative method of reporting (1) Software development costs (2) Revenue recognition
Introduction
• FASB’s guideline (SFAS NO.86)– Require capitalization once technological feasibility has been
established.• Microsoft’s policy
– Expensed as incurred– FASB’s guideline does not materially affect the company• Note - From 1986 to 1999, annual outlays for R&D
ranged from 11% to 17% of revenue
Software Development Costs
• Guidance on the treatment – AICPA statement of position 97-2: require that a part of software
revenue be deferred when the software arrangement consist of upgrades, add-ons and other enhancements
• Microsoft’s policy—revenue deferred– Prior to 1996, recognition—straightforward– From 1996, recognition-- changed because the company
expected to integrate its internet technologies into both Window95 and Office97 at no additional costs
– For window95, recognized 20% of revenue at two years and unearned revenue was $425 million and $860 million in 1996 and 1997.
– For office97, recognized 20% of revenue at 18-month life and unearned revenue was $300 million in 1997
Software Revenue Recognition
• What factors can explain the different between market value of equity and book value of equity?– Inability to record certain intangible assets
such as brand value, customer loyalty and human capital—most obvious reason
– The choice of conservative accounting policies—not the biggest reason
Case Analysis
Speculate why Microsoft thought SEC guideline did not materially affect the company(expense or capitalize).
– Technological feasibility of product may be sufficiently late in the development process
– Useful life of the product may be so short-lived
Note: Microsoft likely has the least uncertainty regarding the technological feasibility and useful lives of product
Case Analysis
Why Microsoft chose to expense all software costs as incurred rather than capitalizing these costs ?
– A possibility for manipulating income– The company can control net income by
reducing actual cash spent on research and development
Case Analysis
What effect did Microsoft’s software capitalization policy have on its financial statement ?
– The company’s asset and stockholder’s equity would increase by the net capitalized software costs
– The company’s income would also increase by the deceasing amount of software costs expensed
Case Analysis
What effect did the recognition policy of not deferring revenue have on its financial statements?– The company’s revenue and income would
increase by effect of not deferring revenue– The company’s liabilities would decrease and
stockholder’s equity would increase by the same amount
Case Analysis
Speculate why Microsoft decided to defer a portion of its revenues in 1996 ?– Smooth revenue growth– The company’s decision to defer revenues
came at a time of significant growth in revenues—suggesting that the company’s decision to defer revenues was probably to smooth the company’s revenue growth
Case Analysis
Describe Microsoft’s overall financial reporting strategy.
• Software capitalization policy is more consistent with cash-basis accounting
• Revenue recognition policy is more consistent with accrual accounting
• The two policies are both conservative—reporting lower assets, higher liabilities and less income in the current period.
Case Analysis
Why Microsoft adopted this strategy ?– Hiding profits– Signaling– Competitive weapon– Avoiding complacency– Smooth reported earning
Case Analysis
What and Why was the SEC concerned about Microsoft’s report?
• The company smoothed earnings using “accounting slack”
• The company established hidden reserve• The company manipulated its reported earnings
in order to meet expectation.• Any company is required to properly reflect
economics in the financial statements of a company
Case Analysis
• Conservative accounting policies potentially misrepresent the economics of a company’s business.
• There are many reasons for companies to select conservative rather than aggressive accounting policies.
• Examining the portfolio of accounting choices that company’s make can often provide insight into the motivation/incentives behind these choices.
Summary
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