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FSA- WHITE
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Business analytics and FSA
Business analysis is useful for handling issues as --Whether to build capacities or acquire?- the classical
make/ Buy decision The issue is whether U would
primarily rely upon and use your internal resources or
U would look for external replacement to strengthenyour leadership asset-Is a valuable brand available for
a small additional sum?
-- Whether upon acquisition, to Amalgamate or run it
as a stand alone? the hassles of absence ofSynergies, issues of Integration, tax issues,
Regulatory compliance issues issues of monopoly etc
MOST OF ALL RELEASING CASH TRAPPED IN THE
ACQUIRED UNITAditya Birla groups acquisition of
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continued
Whether to Sell orHold? Shut down point(protracted Negative contribution, Revenues
being lower than Long run average costs for
a period)
--The Best Fund mix-in Cost and risk
parameters, tenure parameter, domestic and
International parameters( IPO/Follow on/Public
issue/ADR GDR/IDR) --Inputs for such Strategic Issues as
Outsourcing, Changing fund mix etc
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The steps in FSA Steps in Accounting Analysis
1)Identifying KEY accounting policies
Ex. For a bank it is Provision for bad and doubtful debts For
an insurance company it is accounting for warranties and
contingencies
2)assess Accounting flexibility
Firms have little flexibility in accounting forIn-House R&D
costs; they have to be expensed. Software firms have the
flexibility to decide the point at which the expenses can start
getting CAPITALIZED Rigid policies give little information though the scope for
earnings management is less
3)Evaluate Accntng. Strategy
How do the firms Accntng. Policies compare with those
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Steps--
For ex. A Bank could be providing less towards Bad and
Doubtful debts. This could be because of Good loan
Disbursement/ collection policies; or, is that a dressing?
Do these firms have reasons to adopt the policies they have
done?
Enron created Special purpose Vehicles to take certaintransactions off the B/srest is History
4)Evaluate the Quality ofDisclosures
Letters to shareholders is a good disclosure tool that GA
Cements has adopted. Dr. Reddy Labs. Did the same in theinitial years
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Steps--
How forth coming is the Management on Bad news?
Do the foot notes / notes to a/cs display policies expected?
How good is the SEGMENTWISEDISCLOSURE? Can one
see the different colors OR is it GREY?
Step 5)Identify the REDALERTS
--unexplained changes in Accounting WHEN THE
PERFORMANCEWASPOOR
--Disparity between GROWTH IN SALES and GROWTH IN
A/cs Receivables IIIly disparities between Sales AND
INVENTORY HOLDING
--Huge disparities between a firms CASH FLOWS
FROMOPERATIONS and Comprehensive income
---Huge Tax Deferrals arising out of Differences Between
Book and Tax Profits
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steps
Step 6) Undo Accounting Distortions Imprudent capitalization should be
reversed, for example.
The Analyst will have to make severaladjustments to arrive a properPicture
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1
Need forFSA -- In an ideal world FSA should be concentrating
ONLY on the bottom lines ofFinancial reportingNetincomes and Shareholders equity. Different methods
of accounting adopted, differing estimates and nonconformity in application ofAccounting principlesmake the course complicated.
Financial reports often contain supplementary data
that help the user of the statements to derive meaningand make relevant interpretations of numbersratios,cash flows etc. the effort here is to strike at thefundamentals that help differentiate the grain from the---
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1a
Economic events and accounting entries do not correspond byTIME in most cases and by Quantum in some Accounting does
not take cognizance of capital appreciation in assets till they are
sold. Similarly losses on assets get accounted only on their sale
though that loss of value could be very visible much before.
Contracts by and large are not accounted at the time theyare entered into but are accounted when Legal rights of
Ownership change! Some contracts like hedging are NOT
accounted but DISCLOSED as FOOT NOTES or as Notes to
accounts, though they could later have significant implicationson the financial health of the Enterprise
Finally information from outside financial reports could help
drive meaningful conclusions that might not be otherwise
possible
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2
External users ofFinancial statements The common characteristic ofExternal users is their general
lack of authority to PRESCRIBE the info they want from the
company
External users are a diverse type but generally can beclassified in to 3 groups
1) Credit and Equity investors
2) Government , regulatory bodies and tax authorities
3) The general public and special interest groups, laborunions and Consumer groups
These groups have different objectives in FSA BUT THE
EQUITY INVESTORS and CREDITORS are the PRIMARY
USERS
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3
The info supplied to Equity investors and creditors is useful to
others as well; hence Accounting Standards are EQUITY
investors and Creditors Oriented
The UNDERLYING OBJECTIVE ofFSA is the COMPARATIVE
measurement ofRISKANDRETURNS so as to make
Investment and orCredit decisions. Predictions of the futureresults is by Historical extrapolations generally though special
models are covered here
Equity investors look at Profitability and Growth whereas
Creditors especially the short term ones look at LIQUIDITYLong term investors like insurance cos are interested in long
term asset growth and profitability
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4-The Financial Reporting System
The accounting process that generates accounting information
forExternal users are 5 principally
1) Balance sheet
2)Income statement
3)Statement ofComprehensive income
4)Statement ofCash Flows
5)Statement ofStock Holders equity
These 5 statements along with Notes to Accounts are
interpreted to provide relevant, timely and reliable information to
make investment, credit and similar decisions. Many
transactions are reflected in more than one Statement so that it
requires a foray in to all statements before comprehensive
conclusions can be drawn
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5
The Financial reporting System is based on data generated
from ACCOUNTING and Economic events. Financial
Statements recognize events and transactions meeting certain
criteria---Primarily Exchange transactions, passage of
time(accrual of interest), the use of services, (insurance), use
of assets ( depreciation), use of estimates ( Bad debts) andimpact of some contracts ( Financial leases)
Accrual accounting rests on matching principle which says
Revenues are to be matched by corresponding costs and as
such have to be accounted even though cash did not change
hands.
Transactions are measured on HISTORICAL BASIS, with
events resulting in a hike in value generally ignored
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6
Financial statements are prepared measuring transactions at
theirHistorical Costs. These costs are OBJECTIVE andVERIFIABLE. Its UTILITY howeverDECLINES as 1)The
Specific prices 2) General Prices, changes Hence additional
disclosures are made mandatory by Regulating authorities all
over the world
Financial Reporting also relies on GOING CONCERN
CONCEPT; that the firm in question would continue its
operations indefinitely. This concept brings as to the difference
between Capital and Revenue all costs and Incomes wouldhave to be Revenue if this concept were not in place
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6a Reporting Environ
I) the Reporting environment A)The statutory reports Income statements
and B/S
B)Other reports 1)Financial statements-Quarterly
2)Earnings announcement
3)Other statutory reports
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6b
Financial statements-these are statutory reports acompany must file with the SEC; are not publicityoriented (unlike some annual reports) and containinfo. beyond what annual reports reflect---Form10-
k Form-10qare quarterly statements filed with
the SEC. these provide LATEST info.
While analyzing these data we need to take
cognizance of a) seasonality factors b)Year endadjustments-which do not appear quarterly
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6c
Year end adjustments are done in the followingareas generally
1)inventory-difference between actual stockand book stocks
2) tax provision 3)Outstanding expensessalaries etc
4) provision for depreciation
5)Provisions for work remaining to be executed oncapital a/cs not provided for basically contingentliability turning into provision
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6e
2)Earnings announcements Key announcements about cos. performance quarterly
and yearly
Cos. PRO FORMA Earnings statement give a cleara/c of the Operational profits i.e profits fromcontinuing operations divested from non operationalearnings and extraordinary income/ expenses
Pro forma earnings while reflecting operational profitsmight exclude from Profits certain non operating
incomes/expenses which could provide value to ananalyst
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6f
3)Other statutory reports Form10k- filed with annual report
Form 10 Q filed with Quarterly report
Form 20 fFiled by Foreign Issuers
Form 8k current report to be filed
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7
Financial reporting Systems
The SEBI
Has come out with disclosure norms for acquisitions, norms for
publishing information etc. The Annual report has the following
disclosure requirements---
Contents
--Business of the company
The properties and Assets it owns
--Management discussions and analysis
--Auditors report including Qualifications if any
--Financial statements and Notes to Accounts
--Investee Financial statements ( Where applicable)
--Parent company statements and results to the extent required
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8
Schedules
--condensed Financial information including details ofAssets
Liabilities, Income and Expenses that are major
-- major expansion/ diversification plans including on going
acquisition talksbroad details
--Auditors statements including expression ofOpinion on
Accounts
--segment reporting
--Corporate governance standards adopted and Issues if any
------
Quarterly report
A birds eye view ofWorking results for the Quarter
The perception of the Management for the Quarters ensuing
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9
IAS Indian Accounting Standards
Fixes Standards forAccounting ofCompanies and otherPublic
bodies. Before issuing a new Statement ofAccounting
Standards, the Body holds elaborate discussions with Industryrepresentatives, Academicians, legal luminaries and all
important stake holders including the government. The ICA is
the Principal decision maker so far as the contents are
concerned. Views of the Ministry ofCompany Affairs also are
taken in to account before issuing these standards
Qualitative character of Accounting
Information
Analysts concern with Qualitative accounting Standards arisesfrom the need forInformation that facilitates comparison of
firms using ALTERNATIVEREPORTING METHODS and is
useful for decision making. The characters are
RELEVANCE and RELIABILITY, Timeliness, Neutrality,
Consistency, Comparability and Materiality
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10
Relevance the capacity of information to make a difference to
a decision To a Technical analyst all financial data are
irrelevant To a Fundamental analyst, the RELEVANCE of
Information VARIESWITH the method ofAnalysis OfCash
flow/ Balance sheet/ orIncome statement
Timeliness is an important aspect of relevance. InformationLOSESVALUE RAPIDLY . As time passes FUTURE becomes
the PRESENT with the PAST becoming increasingly
IRRELEVANTHowever past data helps Projections
Reliability encompasses verifiability, representationalfaithfulness, and neutrality
Unfortunately Relevance and Reliability are OPPOSING
ATTRIBUTES. Auditing improves RELIABILITY but the
TIMELINESS which is a RELEVANCE attribute gets hit;
thus Quarterly results are NOT audited!!
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11
Relevance and Reliability also CLASHELSEWHERE. Marketprices may be very relevant but less reliable. Historical costs
though HIGHLYRELIABLE become LESSRELEVANT!! IT is
the OLDARGUMENT as to whether to be PRECISELY
WRONG or be APPROXIMATELYRIGHT ANALYSTS have
opted forESTIMATES in SEGMENTREPORTING, off balancesheet financing etc. whereas AUDITORS harp on RELIABILITY
and have opposed estimates in Financial Statements
Consistency and Comparability are again equally strong
attributes of Financial Statements . CONSISTENCY inadopting and continuing to use them is an ATTRIBUTE of good
Financial statements
Comparability becomes an Issue when accounting policies are
changed just as much as when NEW transactions like
SECURITIZATIONcome in to the picture between 2 firms
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12
Comparability becomes a PERVASIVEISSUE as choice ofcertain policies as also estimates in certain parameters make
comparability a flouted attribute. REAL DIFFERENCES let
alone Accounting policiesmake comparability a tricky issue
Ex Some Firms have INTERNATIONAL OPERATIONS while
others are Domestic MATERIALITY is arguably a CRUCIAL ASPECT An
INFORMATION is MATERIAL when it makes a DIFFERENCE
to the VALUATION of the firm. Sometimes even SMALL
CHANGES can have a MATERIAL EFFECT on VALUATIONEx Sales FORCED upon Customers to achieve the
PROJECTEDTARGET . Realizing Capital Gains to achieve
Profit targets
The SEC has announced that Auditors should recognize
QUALITATIVECHANGESASWELL. Examples
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13
1. Obscuring changes in EARNINGSTRENDS 2 HIDING the FAILURE to achieve PROJECTEDANALYST
FORECASTS
3Converting a LOSS to INCOME and Vice versa
4Obscuring CHANGES in SIGNIFICANT BUSINESSSEGMENTS
5Increasing Managerial Remuneration
6Things AFFECTING COMPLIANCE with REGULATORY
REQUIREMENTS, LOAN COVENANTS or other contracts 8Concealing UNLAWFUL A/CS
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14- PRINCIPAL FIN STATMENTS
BALANCESHEETS
The B/s Statement ofFinancial positionreports majorclasses ofASSETS( Resources OWNEDANDCONTROLLEDby the FIRM) LIABILITIES ( EXTERNAL CLAIMS on theseAssets) and Stock holders Equity ( Owners Capital
contributions and otherINTERNALLY GENERATEDFUNDS)and theirINTERRELATIONSHIPS at specific points in time
Capital= A L
Assets are defined as probable future economic benefitsobtained or controlled by a particular entity as a result of
past transactions or events. The weakness in the definition is the lack of reference to RISK
There are transactions where Assets are transferred but therisks of ownership still lie to some extent with the Seller--Financial lease
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15
Liabilities are defined as probable FUTURESACRIFICES of
Economic benefits arising from PRESENTOBLIGATIONS of a
particular entity to transfer assets or provide services to other
entities in the future as a result ofPASTTRANSACTIONS or
events
EQUITY is the residual interest in the net assets of anentity that remains AFTER DEDUCTING its LIABILITIES
In reality some Instruments have characteristics of BOTH
equity and debt making Categorization a difficult job
Convertible Debentures and Preferred Stock THE INCOME STATEMENT
Reports on the results of OPERATIONS and non operating
activities. It explains SOME IF NOT ALL of the changes in
Assets , Liabilities and Equities between two consecutive
Balance sheet dates
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16
The use of ACCRUAL CONCEPT brings about aninterrelationship between Income Statement and
balance sheet The preparation of the INCOMESTATEMENT is governed by the
MATCHING PRINCIPLE , which states that performance can be measured
ONLY IF revenues and related costs are accounted forduring the same
time period
Elements of the Income statements
Revenues are defined as
Inflowsof an entityfrom delivering or producing goods, renderingservices or carrying out other activities that constitute the entitys
ongoing major or central operations
Expenses are defined as
Outflows from delivering or producing goods, rendering services, or
carrying out other activities that constitute the entitys major or centralo erations
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17
The definitions ofRevenues and Expenses SPECIFICALLYEXCLUDE increases( decreases) in EQUITY from peripheral
or incidental transactions Thus GAINS( and LOSSES) are
NON OPERATING EVENTS. Examples would include GAINS
AND LOSSES from Sales ofAssets, Law suits and changes in
Values ( including Currency values)
While stating so may be easy, the problem centrally would
focus on GREYISSUES likeRecurring vs Non recurring,
Operational and Non Operational costs/ revenues, and
extraordinary items From the Analysts point of view DISCLOSURE rather than
classification is important while from the Data base USERs
end, the classification is EQUALLYIMPORTANT
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18
STATEMENTOFCOMPREHENSIVEINCOME
COMPREHENSIVEINCOME is defined as
The CHANGE in EQUITY of a Business enterprise during a
period from transactions and other events and
circumstances from non owner sources It includes allchanges to EQUITY during a period EXCEPT those
resulting from INVESTMENTS by OWNERS and
DISTRIBUTION to OWNERS
Comprehensive income INCLUDES BOTH NETINCOME and
DIRECTEQUITYADJUSTMENTS such as---
--Cumulative TRANSLATION ADJUSTMENTS
---Minimum Pension Liabilities
--Unrealized gains and losses on available for sale securities
--Deferred gains and losses on cash flow hedges
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19
These adjustments are COLLECTIVELY called OTHER
COMPREHENSIVEINCOME. SFAS130 requires that firms with
items of other comprehensive income report---;
--The CLOSING BALANCES ofEACHITEM. The total is
reported as a SEPARATECOMPONENT ofEQUITY called
accumulated OTHER COMPREHENSIVE INCOME
-- the CHANGE ( eitherPretax or post tax) in EACH item; the
change can be reported GROSSOr NET
---Reclassification adjustments to avoid DOUBLECOUNTING;
for example realized investment gains that include un-realized gains of EARLIER YEARS must be knocked off
from COMPREHENSIVE INCOME to avoid double counting
--Total Comprehensive in condensed financial statements
to be provided for interim periods
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20 Equity means property rights and refers to stockholders or owners equity.This owners equity
represents the claims of owners to the assets of the business, as shown in the accounting
equation: Assets = Liabilities + Equity
When the company reports net income on its incomestatement, that income amount is added to the stockholdersequity or property rights. Therefore, the components of netincome affect equity. Those components of net income arelimited to revenues, expenses, gains, and losses. All ofthose components of net income are included incomprehensive income. But there are changes instockholders equity that are comprehensive income butnot net income. Some changes in assets and liabilities go
right to the stockholders equity section of the balancesheet without first affecting net income and being includedin the income statement. Unrealized gains and losses thatare included in comprehensive income but are notrecognized or reported on the income statement arerelated to foreign currency translation adjustments,
available-for-sale investments, and derivative financialinstruments.
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21
Requirement---- The FASB requires companies to report
comprehensive income, either in a separate financial statement(as Dow Chemical Company does, shown in Exhibit 2.3) or aspart of the stockholders equity statement.
The definition of comprehensive income given earlier relates itto the change in equity during a period, but it is also described
as the change in wealth during a period. Wealth can increasenot only from business operations but also from changesin market values that are not related to operations. Thegoal of the requirement to report comprehensive income isto have a net income with results of businessoperations and a separate comprehensiveincome with results of the markets impacton the values ofassets and liabilities. Threeexamples of items affecting comprehensive income are (1)foreign currency translation adjustments, (2) unrealized
gains and losses on available-for-sale securities, and (3)deferred gains and losses on derivative financial instruments.
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22
Foreign Currency Translation Adjustments When changes in the value of foreign currency
cause the assets of a company to increase invalue, the result will be an increase in the
stockholders equity (picture the accountingequation increasing on the left side as well ason the right side). Because the change in valueof the foreign currency is not related to the
companys operations, the increase instockholders equity cannot be reported as netincome. However, the increase in stockholdersequity is reported as comprehensive income.
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23
Unrealized Gains and Losses on Available-for- Sale Securities
Companies that own investments in marketable securities(bonds and stocks) will see the market values of theirinvestments increase and/or decrease over time. If thatinvestment is classified as available for sale (meaning that thecompany does not intend to sell but could if necessary, ascontrasted with trading investments not intended to be held along time), then the investment must be included in the balancesheet at its market value. If that market value is greater than thecost of the investment, there is an unrealized holding gain. Butthe gain in value is not related to the companys operations andthe company is in the same situation as for the foreign currencychange discussed above: an increase in asset value that mustbe balanced with an increase in stockholders equity thatcannot be reported as net income. Therefore, it iscomprehensive income.
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24
Deferred Gains and Losses on DerivativeFinancial Instruments
Companies may invest in derivative financial
instruments to hedge their exposure to the risk of
changing prices or rates. Such changes will
cause the value of the derivative to change, and
again, lead to unrealized gains or losses. If the
derivative instrument meets certain criteria, theunrealized gain or loss will be reported in
comprehensive income rather than in net income.
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25
Continued next slide
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26continued-Comprehensive Income
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27
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28
Statement of cash Flows
This Statement reports cash receipts and payments in the
period of their occurrence classified as Operating, Investing and
Financing Activities. It provides supplementary disclosures
about non cash Investing and Financing activities. Cash flow
data helps explain changes in consecutive balance sheets andsupplement information provided by Income statement
SAFS95 defines INVESTING ACTIVITIESCASHFLOWS as
those resulting from---
Acquisition orSale of property, plant and Equipment Acquisition orSale of a Subsidiary or segment
Purchase or sale ofInvestments in other firms
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25
Similarly FINANCING CASHFLOWS are those resulting from
Issuance or retirement ofDebt orEquity securities
Dividends paid to Stock holders
The Standard requires GROSS rather than NET reporting ofSIGNIFICANT investing and Financing activities, thereby
providing improved disclosures. Enterprises with Foreign Currency transactions on Foreign
operations must report the effect of exchange rates on
cash and cash equivalents as a separatecomponent of reconciliation of cash and cash equivalentsfor the period
Cash from OPERATIONS may be reported DIRECTLY usingMAJORCATEGORIES of GROSSCASHRECEIPTS andPAYMENTS; orINDIRECTLY by providing a reconciliation of
NETINCOME with Net Cash Flow from Operating activities
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26
Both the direct and Indirect methods require a separatedisclosure of cash outflows forINCOMETAXES andINTERESTwithin the Statements or Elsewhere in thefinancial Statements
STATEMENT OF STOCK HOLDERS EQUITY-START
the statement reports the amounts and Sources of changes inEquity from Capital transactions with Owners and may includethe following components
Preferred stock
Common stock
Additional paid up capital
Retained earnings
Treasury shares ( Repurchased equity)
ESOPs
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27
And as components ofOTHERCOMPREHENSIVEINCOME,the following---
Minimum pension liability
Unrealized gains and losses on AVAILABLE forSale securities
Cumulative Translation Adjustment ( Foreign operations)
Unrealized gains and losses on Cash flow hedges
Shares issued are recorded at par in Equity and the ExcessoverPar value as, Share Premium a/c Additional capitalissued REPURCHASES or Buy backs are treated as TreasuryStocka Contra entry in the B/S. Retained earnings andESOPS are also reported
FOOT NOTES/ Notes to accounts
Are an integral part of the financial statements and provide dataon such subjects as Business segments, the financial position
ofRetirement plans and Off- balance sheet obligations
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28
These data are required by GAAP ( FASB) or regulatory
authorities The Notes to accounts and 10K filings to the SEC
are audited. Supplementary Schedules are however un audited
Notes to Accounts provide info about Accounting methods,
assumptions, and estimates used by Management to develop
the data reported in Financial statements. They are designedto allow users to improve assessments of the amounts,
timings, and uncertainty of the estimates reported in the
Financial statements. They provide additional disclosures
related to such areas as
Fixed assets Debts- interest rates etc
Inventories Law suits and contingencies
Taxes Marketable securities and Investments
Pensions and post employment benefit plans
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29
Marketable Securities
Hedging and other risk management activities
Business Segments
Significant customers, Sales to related parties and Exports
CONTINGENCIES
Notes to accounts often contain disclosures relating tocontingent losses These losses get classified either asprovisions or as contingent liabilities depending uponwhether the loss is fairly certain or not. This part isSUBJECTIVE and involves judgment.
Where losses are fairly certain a Provision is created bydebiting the Profit and loss account. Where losses are ONLYDEPENDENT on the happening of a certain event, aContingent liability by way of just a note in the accounts comesin to picture
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30
In India contingent liabilities are basically things like ---
--Claims against the company not acknowledged as debts
---Arrears of cumulative Preference dividends
--- Bills discounted and III party Gaurantees
--- Amounts yet to be called up on partly paid shares
-other matters for which the company is contingently liable
MANAGEMENTDISCUSSIONS and ANALYSIS ( MDA)
These are discussions on earnings that have been a part of theAnnual reports for Listed companies. In India they are called
Directors Report. The MDA is supposed to discuss Results ofOperations, including discussion of trends in Sales
and categories of expenses
Capital resources and liquidity including discussions of cashflow trends
Outlook based on known trends
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31
The discussions could involve the following---
1)prospective information and required discussion ofSignificant effects of
currently known trends, events and uncertainties ex decline in Market
share, inventory obsolescence etc. Firms may voluntarily disclose Forward
looking data that anticipates trends or events
2) Liquidity and Capital resources: Firms are expected to use cash flows
statements to analyze liquidity ; provide a balanced discussion ofOperating,Investing and Financing activities and events AFTERTHEDATEOF
BALANCESHEET
3)Discussions on Discontinued operations, Extraordinary items and
other unusual or infrequent events known as Non recurring and
Extraordinary gains/ losses 4)Extensive disclosures in interim financial statements in keeping with
the obligation to periodically up date MD&A-Directors report-- discussions
5)Disclosure of Segments disproportionate need for cash flowsor
Segments contribution to revenues orProfits
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32
The SEC in 2002 issued a statement reinforcing its views on
the importance of MDA disclosures the release remindsregistrants that disclosure must be both useful andunderstandable
Topics addressed include
1) Liquidity and capital resources, including the impact of
Off Balance sheet arrangements on Liquidity and Capitalresources
2) Disclosures about contractual obligations andcommercial commitments ( that is Off balance sheetobligations)
3) Disclosures about Trading Activities, including nonExchange traded contracts
4) The effects of transactions on related parties, includingpersons ( like employees) who could fall outside thedefinition of Related parties
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33
Role of the Auditor
the auditor must ensure that the financial statementsconform to GAAP/ IAS. Accounting policies must beappropriate and estimates reasonable. The Auditor would alsolook into the true and fair view that the statements mustreflect and into the correct position of Assets andLiabilities. The Report the auditor sends out is a must readfor any analyst though the auditor does not certify thatthere are no errors in the statements
SAS sometimes requires the addition of an Explanatorypara if needed, that describes material uncertaintiesaffecting Financial statements such as Doubts regarding going concern assumption that underlies the preparationof Financial statements- Uncertainty regarding theValuation and realization of Assets or LiabilitiesUncertainty regarding Litigation
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34 THEACCRUAL CONCEPT-M2 Income cash Flows and AssetsDefinition and Relationships
In a world ofcertainty, the interrelationship amongIncome, cash flows and Assets is captured by theconcept of ECONOMIC EARNINGS , defined as net cash flows PLUS change in market
values of the firms net assets. Themarket value of the firms assets is the PRESENTVALUE of their FUTURE Cash flows DISCOUNTEDat the Risk free rate r
HoweverFuture Cash flows and Interest rates are
UNCERTAIN in the Real world! The market prices arealso uncertain and available prices may be difficultto relate to the Present value of generallyuncertain and estimated cash flows beingdiscounted at estimated discount rates!!
Moreover the market value of an Asset may end up being
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35
Moreover the market value of an Asset may end up being
measured with DIVERSE METHODs some at replacementcosts, some at capitalized value of earnings etc Thus in a realworld, income ( however measured) is at BEST a PROXYfor ECONOMIC INCOME. Economists analysts havedeveloped a number of analytic and practical definitions ofearnings to serve as PROXY for Economic earnings
Distributable earnings are defined as the amount of earningsthat can be paid out as DIVIDENDS without changing theValue of the firm
A related measure, SUSTAINABLE INCOME refers to thelevel of income that can be MAINTAINED IN THE FUTUREgiven the firms assets
Anothermeasure PERMANENT EARNINGS used byanalysts for valuation purposes is the amount that can benormally earned given the firms assets and EQUALS theMARKET VALUE OF THE ASSETS TIMES the firms
REQUIRED RATE OF RETURN
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36
In Financial Reporting, the determination of---
Which cash flows are included in INCOME and When
Which changes in assets and Liabilities are included in Income
How and when the selected changes in asset and Liabilities are
measured
Are all BASSED ON ACCOUNTING RULES and PRINCIPLES that make
up the generally accepted accounting principles ( GAAP). With a few
exceptions, the Accounting process ONLY RECOGNIZES VALUE
CHANGES arising from ACTUAL TRANSACTIONS
Reported income under the accrual concept provides a measure of current
Operating Performance that is NOT exactly based on ACTUAL CURRENT
Period Cash flows. Cash inflows and outflows ( past present and Future)are recognized as income in the appropriate ACCOUNTING PERIODS.
The selected period best indicates the firms present and continuing
ability to generate future cash flows Information about enterprise
earnings based on accrual accounting generally provides a better
indication of an enterprises ability to generate cash flows THAN information limited to the FINANCIAL EFFECTS of cash recei ts and
The accrual basis of accounting thus allocates ( recognizes as
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The accrual basis of accounting thus allocates ( recognizes asRevenue and expense) many transactions and events to
TIME PERIODS OTHER THANthose in which the Cashflows occur. Accrual accounting Principles are,
fundamentally, the decision rules that tell preparers ofFinancial Statements WHEN to recognize the Revenue and
Expense consequences of Cash flows and other events
The recognition of Revenues and expenses in periodsother than when cash is actually received or spent has a
corollary effect on the balance sheet. Both the recognitionand measurement of certain assets and liabilities are theresults of the application of the accrual concept of income.
The differences between the income
recognized and actual cash flows areaccounted for as Assets or Liabilities TheMATCHING PRINCIPLE added on to the Accrual Conceptprovides a better info.than does cash flows perse
The accrual process enhances the predictive ability of cash flows However
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The accrual process enhances the predictive ability of cash flows However
as evidence also indicates it does not mean that cash flows are not relevant
they provide information about the Quality of earnings and in the
process mitigate the weakness of the Accrual system
The determination of Accounting earnings is also governed by General principles and measurement rules underlying all accounting
transactions and events
Specific rules to determine Revenue, Expense gains and loss
recognition
For ex. The HISTORICAL COST BASEDAPPROACH underlying GAAPresults in Rules that exclude unrealized holding gains and losses on
assets ( M2M gains/ losses). Recognition of gains/ losses in these
assets/ liabilities MUST AWAIT their DISPOSAL/ Settlement( for
liabilities) and can be reported in the Statement of changes in Equity
However some NON TRANSACTIONAL relatedchanges in asset values can affect REPORTED
INCOMES. For example, CURRENT ASSETS must be EVALUATED at EACH FINANCIAL
STATEMENT DATE and any ESTIMATED DECLINES in ASSET VALUESreco nized as LOSSESno ains as it is conservatism u c!
SFAS 121 extended the above requirement to Fixed assets also except that
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SFAS121 extended the above requirement to Fixed assets also except that
certain IMPAIRMENTCONDITIONS will have to met before a WRITE
DOWN is possible!
Certain assets financial assets are Marked to the market and such gains
taken in as INCOME- at least in Statement of changes in Equity The Hassel here is that CURRENTINCOME is laden with these anomalies
and cant be taken at FACEVALUE!!
INCOME STATEMENTS
Suggested format
----- Revenues from sales of goods and services
------Operating expenses
= operating Income from continuing operations
+ Other incomes and expenses
= Recurring incomes before interest and taxes from continuing operations
-- Financing costs
= Recurring pretax incomes from continuing operations
+/- Unusual / infrequent items
= pretax earnings from continuing operations
---Income tax expense
+/ Income from discontinued operations( net of tax)
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+/_ Income from discontinued operations( net of tax)
+/_ Extra ordinary items ( net of tax)
+/- Cumulative effect of accounting changes
= net income
The OPERATING INCOMEFROM CONTINUING OPERATIONS is
independent of the Capital structure!
Recurring vs non recurring items Companies often change the Income
statement format to obscure areas of less than appreciable
performance Generally Income FROM A FIRMS RECURRING
OPERATIONS is considered to be the BEST INDICATOR of FUTUREINCOME. The PREDICTIVE ABILITY INCREASES upon EXCLUSION of
a firms NON RECURRING SPORADIC and RANDOM INCOME
Transitory gains and losses are NOT to be considered as a part of
SUSTAINABLEPERMANENTINCOME!! On the other hand the concept of
RECURRING INCOME portrays a predictable level of performance wheregrowth rates can be forecast and long term earnings fairly put in Black and
White. Recurring income portrays income from continuing operations
It is important to realize that non recurring incomes are NOT a TYPE
OF EVENT; in fact the same income depending on the NATURE OF
THE EVENT and to some extent MANAGEMENT DISCRETION may get
classified above/ below the line!!
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For example for some firms the gain/ loss on sale ofFIXED
ASSETS will be rare with LITTLEPREDICTIVEVALUE; Othersmay retire F/A regularly and report gains/ losses a Car Rental
company retiring a part of its fleet regularly
The Nonrecurring part may be segregated in to
A)Extra ordinary items not useful in predicting ROE B)Income from discontinued Operations not useful in
predicting ROE
C) infrequent items are useful in predicting ROE
This IMPLIES item c) contains a RECURRING ELEMENT!! The predictive ability of Financial statements is LIMITED
We need to extrapolate going by available cues. For
example a huge sales in cars implies a corresponding
sales in Tyres!
Accounting Income Revenue and Expense recognition
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Accounting Income Revenue and Expense recognition
There are 2 aspects to revenue recognition
1) the TIMING when do we recognize revenues
2) measurement how much of it do we recognize? For revenue to be recognized 2 conditions must be met
1) Completion of earnings process
2) Assurance of Payments
Condition 1 has 2 parts
1a)The Firm MUSTHAVEPROVIDEDTHE BUYERWITH
virtually all the goods and services he was obliged to provide
the SELLER must have NO SIGNIFICANT CONTINGENT
OBLIGATION LEFT 1b)The second condition is a RELIABLE MEASUREMENT
of the REALIZABILITY of the claim for goods and services
rendered
Goods provided to date x Total Revenue expected
The formula in the previous slide reflects recognition of
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The formula in the previous slide reflects recognition of
Revenue on a continuing basis
In cases where payment is received PRIOR to the
DELIVERY of goods/ services appropriate revenuerecognition implies---
A)Revenue on LEASED ASSETS to be recognized by the
lessor on some reasonable basis.Ex No. of photo copies per
period for recognizing rentals of a photo copier
B)Credit card fees are recognized as the right to use the
card keeps depleting time wise
C)Magazine subscriptions are recognized in PROPORTION
TOTHEDELIVERIES MADE
Departures from the recognition basis stated above is alsopossible under extraordinary circumstances. For ex. Revenue is
NOT recognized even when Sales are completed if a huge
uncertainty exists regarding its realizability!!
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Revenues for contracts are recognized on the basis of either
a)Percentage ofCompletion method or on b)Completedcontracts method
The Percentage of completion measures progress towards
completion using either
Engineering estimates( Physical progress) or Ratio of costs incurred TO expected total costs
This method may OVERSTATEREVENUES and Gross
PROFITS if expenditures incurred DO NOT CONTRIBUTE
TO PHYSICAL PROGRESS. IF A LOSS IS ANTICIPATED ITMUST BE INCLUDED IN THE PERIOD WHERE THE LOSS IS
VISIBLE OR CALCULABLE
Best--- > Link Physical progress with Financial progress!!