FINANCIAL ACCOUNTING THEORY

GRACE BARTZ, DANIELLE COOK, MARTINE DENHERTOG, DAVID DIMATTEO, MARK HALEY, FARIS ISMAILOVSKI , JULIE PHILLIPS, & DORIAN TEMLIN

Future-Oriented Financial Information

Agenda

IntroductionDetermining information about the futureAssumptionsForecastingTime-periodPresentationDisclosures

Introduction to Section 4250

Addresses Measurement Presentation and disclosure Formats:

General purpose Special purpose

Objective is to provide external users with information that assists them in evaluating an entity’s financial prospects

Introduction to Section 4250

Who might want to know future information about a company?

Lenders Owners Investors Management Auditors Analysts Employees and Suppliers

Introduction to Section 4250

Users of future information Lenders

See if borrowers will be generating sufficient cash flow to repay loans

Test borrowers knowledge of business Owners and Security Markets

See if capital is generating sufficient rate of return Determine the course of investing action

Management Benchmarks

Introduction to Section 4250

What could future financial prospect information be used for?

Evaluate company’s ability to pay back loans To determine if meeting investors’ expectations Benchmark for management

Introduction to Section 4250

What type of information about the future of a company would a user want to know?

Sales Net Income Cash Flow Debt to Equity

Determining Information About the Future

Based on assumptionsForecasts

Uses assumptions which reflect planned courses of action

Projections Same assumptions as a forecast with one or more

hypotheses consistent with the purpose of the information

Not necessarily the most probable in managements judgment

Importance of Future Information

Company can communicate its expectations to the market

Management knows its business better than anyone else Management can use the information to sway

investors

Assumptions

Complete Affects reliability

Reasonable Achievable

Provide relevant information Adds value

ConsistentInterdependence

Consistent Assumptions

The assumptions need to be consistent with…?

Plans and strategies of the company Past performance Industry performance

Assumptions

Complete Affects reliability

Reasonable Achievable

Provide relevant information Adds value

ConsistentInterdependence

Assumptions

Who should make the assumptions?

Management

Forecasts

Generated from reasonable and supportable assumptions by management

Reflect most probable economic conditions and planned courses of actions for the entity

Supportable vs. reasonable

Supportable

How can assumptions made by management be supportable?

Past performance of entity itself Performance of other entities with similar activities Feasibility studies Marketing studies Economic data Government and industry publications Other sources with objective corroboration of the

assumptions used

Supportable

Extent of detailed information to support assumptions

Influenced by factors such as the significance of the assumption, and availability and quality of information

Forecast Methods

Managements way of preparing financial information from the reasonable and supportable assumptions

May use statistical, mathematical, or specialized forecasting techniques

Forecast Methods

Once assumptions are determined, how do managers come up with the forecasted

numbers?

Forecast Methods

Quantitative Percentage of sales Ratios Regression Trend line, time series, moving average, naïve method

Qualitative/Subjective Management and executive opinions Delphi technique Consumer surveys

Forecast Methods

Forecasts can be prepared with extreme precision – to the nearest cent – why is this

accuracy misleading to analysts?

If limited to only one forecast number, which would you choose to see and why?

What if limited to only one financial statement?

Reasonability of Assumptions

To be reasonable, must be consistent with the plans of the entity.

How are assumptions considered consistent with the plans of the entity?

Reflect expected effects of anticipated strategy Include effects of likely economic conditions

Reasonability of Assumptions

Each assumption needs to be assessed as to its reasonableness Influenced by the significance of the assumption and

the quality of supporting information As availability of information decreases, it becomes

much more difficult for management to make reasonable attempts

Reasonability of Assumptions

A projection must also be based on reasonable assumptions including one or more hypotheses

What would the criteria be for a hypothesis to be considered reasonable?

Consistent with the purpose of the projection Plausible

Examination of Future Oriented Financial Statements (AuG-6)

An accountant’s objective is to form an opinion on the underlying assumptions used but not to the achievability of the forecast

Crucial that the PA get a well-developed understanding of the organization and its industry

Compilation of a Financial Forecast/Projection (AuG-16)

This pertains to subsequent earnings forecasts from the prospectus

The objective is to provide a service to those who require assistance

PA should question management’s approaches but not form an opinion

Shortfalls of Forecasts

Shortfalls of Forecasts

How could actions and abuses of pro-formas be prevented and stopped going forward?

Require more timely GAAP numbers Audit opinion on subsequent forecasts

Shortfalls of Forecasts

CEO’s who are “overconfident” are more likely to issues forecasts that are overly optimistic

Companies are protected by the Safe Harbour Rule, which ultimately allows for optimistic outlooks.

What is your opinion on the Safe Harbour Rule?

Time Period in Earnings Forecasts

Time period covered by future financial statements shouldn’t go beyond the period where information can be reasonably estimated It may not be shorter than ‘the period of long-term

undertakings for which an entity has set expenditure limits’

Time Period in Earnings Forecasts

Factors influencing reasonableness: Need of users Ability to make appropriate assumptions Nature of industry Operating cycle of entity

What are some reasons management would not be able to reasonably estimate information?

Economic volatility Uncertain future of the organization

Time Period in Earnings Forecasts

Future financial statements should be prepared in accordance with accounting policies and presentation format used in presenting historical financial statements ie. If preparing statements on a quarterly basis, pro

forma statements should be estimated on a quarterly basis

Time Period in Earnings Forecasts

Forecasts are not normally prepared for periods beyond the following fiscal year To be practical should be updated and revised for new

information as it becomes known Comparison to actual should be evaluated

Time Period in Earnings Forecasts

Projections may be prepared for periods beyond the following fiscal year if there is a reasonable base for making estimates Many entities use 3, 5, or 10 year projections in order

to make longer-term decisions

The degree of uncertainty normally increases with the length of the future period covered

Presentation

General purpose statements presented in the format of historical financial statements

Must use historical policies except… In the case of special purpose financial statements

Use whatever framework the two parties agree on

Special Purpose Financial Statements

Special purpose financial statements are a set of financial statements that are prepared using a special purpose framework to cater to the special needs of specific users of financial statements

Not prepared in accordance with the general reporting framework

Not made for public – limited use Internal users Those charged with governance Limited external users

Special Purpose Financial Statements

Can you give examples of industries or

companies that would use special purpose financial statements?

Banks Governments Financials for tax authorities (statements completed in

accordance with tax regulatory framework)

Presentation

If presentation using historical statements is not possible -> note and accounting policy disclosure… To the extent of adding understanding

Presentation

Exact dollar valuePresented as a range

Takes into account inherent imprecision with forecasting

Care to ensure that range is not too broad that the values are no longer meaningful

Presentation

When would a range be more useful?

Farming operations – weather unpredictable Bidding in an acquisition (min and max willing to pay) New market/market does not exist when a new product is

introduced into the market

When would an exact dollar value be useful?

Analyst Investors who use mathematical models

Presentation in an IPO SettingAs part of the prospectus

Five periods of audited income statements Two most recent balance sheets

Is an earnings forecast required in an IPO prospectus? No: standard says that its optional but not required If included must be audited and include audit statement

Why might a company want to include an earnings forecast? Higher earnings = positive reaction from public Assurance – not hiding information from public Providing more information to investors

Why would a company decline to include an earnings forecast? Cant complete one with accuracy (volatile industries) Forecasted earnings may deter users information sharing -> competitors

Disclosure

Effective date of assumptions Date that information was approved: subsequent

events may impact usefulness of this informationExtent of inclusion of actual financial results

and its period Varying nature of actual results

Entities are faced with limitations and uncertainties in regards to future conditions and actions

Disclosure

Once a company discloses that actual results may vary significantly (or materially) from the

forecast, is the forecast still useful ?

Disclosure

Plans to update future-oriented financial information subsequent to issue Must disclose if the entity accepts no responsibility to

update the information

Disclosure of Assumptions

Use assumptions based on planned course of action Will this planned course of action likely occur?

Significant assumptions underlying future-oriented financial information should be disclosed What is significant?

Incorporate a sensitivity analysis

Other Disclosures

If future-oriented statements include a change in account policy must disclose Describe change Nature of effect

Special purpose financial information Disclose purpose & who it is meant for

Purpose/Limitation of usefulness of projection

Delta Air Lines/ComAir

ComAir is a wholly owned subsidiary of D.A.L.09/14/2005 – D.A.L. files for cpt. 11 bankruptcy

Forces ComAir into bankruptcyChapter 11 Bankruptcy

Allows for reorganization of company with a judges approval Value of business is greater if a going concern

Business “engine” can be restarted to generate cash to repay creditors

More economically efficient to: Cancel some debts Give ownership of reorganized company to creditors whose debts

cancelledHow do you prove this will work?

General Disclosure:

Passenger Revenue Projections:

Aircraft Fuel Cost Projections:

Other Disclosures

SportsGoodStop - Case

KPMG Study

1% of the firms reviewed hit their forecast exactly

22% came within five percent either wayOn average forecasts were out by 13%

Thank you

Questions?