ACC 327

1995

disclose actual value of stock in footnotes

FIFO

higher net income, lower cost

The value of business analysis in FSA:

how competition and strategy shape profitability and its sustainability

Where crucial

Any business where credit to customers is crucial

Tax expense vs. Tax payment

Tax expense: the expense you recognize in your income statement Tax payment: tax you pay to the tax authority

Really? No economic impact?

- Market reactions? - Earnings management? - The role of SFAS 145 (moving gains/losses from extraordinary items to operating income) - The role of SFAS 159 (allowing firms to report liabilities at fair value)

Main goal: distinguish between "good" vs. "bad" accruals

- Good accruals represent accurate estimates of expected future benefits and obligations - Bad accruals do not represent future benefits and obligations and thus accounting distortions

Cash flows from financing activities

Arise from increases and decreases in debt and equity capital, including cash received from loans, repayment of loans, issuance and repurchase of stock, payment of dividends, etc...

Earnings Management

"...a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process)...." "Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers"

Cash flows from investing activities

Arise from the purchase and sale of assets, including land, PP&E, equity investments, etc...

GAAP requires companies to report sales revenue at the net amount expected to be received in cash. This means companies must deduct from gross sales the expected sales returns, discounts, promotions, etc.

"Additions charged to net sales" as compared with gross sales for both sales returns and sales discounts and incentives. - This ratio reveals any effects of the pricing pressure on net sales and we would expect the percentage of sales allowances to gross sales to increase (thus reducing net sales) as pricing pressure increases. Adequacy of the allowance account. - This analysis compares the dollar amount of the estimates for future sales returns with the amount actually realized during the year.

Operating flexibility

- May be easier to transfer a leased 737 back to the lessor than to sell it if a new route doesn't work out.

Deferred revenue/Sales

(Def Revt+ Def Revt+1)/2) / Sales

Taxes?

(Profitable) lessor firm may be better able to take advantage of depreciation deduction than (loss-making) lessee.

AMZN's focus on free cash flow

- Low DSO - High DPO Amazon DSO = consumers are using your cash (they have not paid you) DPO = you are using supplier's cash (you have not paid them) Negative CCC firms to focus on Free Cash Flows CCC = DSO + DIO - DPO

The first step is to assess qualitative factors to determine "whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount".

- "More likely than not" means >50% - Factors include macroeconomic conditions, operating environment, costs, cash flows, changes in management, change in share price...

Infer discount rate and capitalize operating leases

- About 20 billion assets off balance sheet... - Do you care?

Why are intangible assets largely off balance sheet?

- Accounting conservatism -firms are usually not allowed to capitalize R&D, advertising etc-even if they create assets - Firms can capitalize these assets in some circumstances (software) and when assets are purchased

The Accrual Anomaly

- Accruals = Earnings -CFO - Timing and matching difference - Firms have high (low) earnings because of accruals tend to haver lower (higher) earnings in the future. - Sloan (1996) shows that high accruals predict low future return because investors don't understand that accruals are less persistent than cash flows (i.e., tend to reverse).

Two simple red flags

- Accruals unusually large - Large accruals relate to balance sheet accounts that typically consist of less reliable accrual estimates

Pooling: - what you pay is irrelevant for financial statements (not taken into account)

- Acquiring firm added book value of acquired assets and liabilities to its balance sheet. - Acquired firm's income recognized for entire year - No goodwill recognized

Purchase

- Acquiring firm added fair value of acquired assets (including identifiable assets not previously recognized by the acquired firm) and liabilities to its balance sheet. - Acquired firm's income recognized from acquisition date - Excess of purchase price over revalued net assets = goodwill - Goodwill amortized over maximum of 40 years

Tax is extremely important for FSA

- All profitable firms need to pay tax. - It eats a big chunk of profit. - $-to-$ impact on net income.

Why distorted

- Amortization period not appropriate (for finite lived intangibles) - Impairment not taken (indefinite life intangibles)

2. Accruals for contingent liabilities. Contingent liabilities depend on the occurrence of a future uncertain event in order to determine whether a liability exists and, if so, in what amount.

- An example is litigation that has been brought against the company whose outcome and amount depends upon adjudication. - Another is warranty liabilities for products sold which depend upon the occurrence of product defects to require the company to repair or replace the product purchased.

Where crucial

- Any business where inventory levels are high, and obsolescence/style is crucial (manufacturing, retail, electronics)

AMZN's management incentives

- Any evidence to influence stock price? - Yes - Any evidence to influence executive compensation? - Yes

When/Why do they get distorted

- At origination (too high or too low) - When expense is incurred (diversion of legitimate expenses)

Deferred Tax Liabilities

- At the end of Year 1, the company knows that this additional tax must be paid in Year 2 because the financial reporting and tax reporting depreciation schedules are set when the asset is placed in service. - Since tax depreciation will be less in Year 2, taxable income will be higher and additional tax will be owed. - We are accruing this known additional tax in year 1 since the liability is probable and can be estimated.

Lower of Cost or Market (LCM)

- At the end of each accounting period, AMZN compares the ending FIFO inventory balance with the market value of the inventory (its replacement cost). - If the market value is less than the FIFO amount, AMZN "writes down" the inventory to its market value. - The result is that the inventory is carried on the balance sheet at whichever amount is lower: the cost of the inventory or its market value.

Why do firms generally favor operating leases over capital leases?

- Avoid recording an asset and liability related to leases - Avoid reporting higher expenses in early years of lease (Depreciation + Interest) > Rent Expense in early years - in the beginning you will see higher net income in the very beginning - less liabilities: your liabilities look better (lower leverage ratio) - asset turnover will be higher

Telltale signs

- Balance sheet has "missing" assets and corresponding equity - Impact on income statement depends on life cycle. Income is lower initially, but in steady state makes little difference - Profitability ratios like ROE and ROA will invariably be higher!

Financial resources

- Can't borrow or raise funds required to purchase asset outright. - Avoid initial cash outflow required to purchase asset outright. - Need cash, so sell and lease back a currently owned asset. - Some managers have fixed budgets and cannot buy in current period

Estimate the approximate income statement effect of the goodwill Cisco would recognize in acquiring ArrowPoint, assuming:

- Cisco uses the purchase method to account for the transaction - Transaction date of 30 April 2000 - Transaction price of $5.7 billion - Fair value of ArrowPoint's net assets is $700 million - Goodwill is amortized over 20 years

Stock-based compensation expense is included on the income statement but rarely reported as a separate line item.

- Cost of goods sold (for employees in R&D and manufacturing) or - Selling general and administrative expense (for employees in selling and administration and executive roles).

AMZN Accounts Receivables

- Customer accounts receivable = AWS (customers are businesses) - Sellers accounts receivable - Vendors accounts receivable

Examples:

- Diageo accused of channel stuffing. 500 mill. Revenues, 200 COGS - Lucent under-reserved by 200 mill. around the internet bust period (2001)

Diluted EPS

- Diluted EPS reflects the impact of additional shares that would be issued if all stock options and convertible securities are converted into common shares at the beginning of the year. - Diluted EPS never exceeds basic EPS.

Before Grant date?

- Disclose more bad news, hold good news - Manage earnings downward - Missing earnings targets - Etc.

Why Segregate Discontinued Operations?

- Discontinued operations are segregated in the income statement because they represent a transitory item. - Transitory are largely irrelevant to predicting future performance. - Investors tend to focus on income from continuing operations because that is the level of profitability that is likely to persist (continue) into the future. - In order to be classified as a discontinued operation, the disposal of the business unit must represent a strategic shift for the company that has or will have a major effect on a company's financial results.

Different accounts have some general relations due to:

- Economic forces (e.g., competition) - Accounting properties (e.g., accruals reverse)

The competitive landscape

- Existing rivals - New entrants - Suppliers - Customers - Substitutes

So, why change the standard at all?

- Fewer estimation errors Management has the best information - Protect less sophisticated investors, who may use recognized information mechanically - Recognize lease obligations for what they really are...debt - Convergence between US and international standards

Measuring reliability

- Financial B/S items: high - Operational B/S items: low/median - Operating assets reliability < operating liabilities - Noncurrent items reliability < current items

Pooling method could only be used if:

- Firms independent of one another - Purchase consideration entirely in acquirer's common stock

Accounting standards require a company to:

- First compute the taxes it owes (per its tax return), then - Compute any changes in deferred tax liabilities and assets, and finally - Compute tax expense reported in the income statement (as a residual amount).

Foreign currency translation adjustments

- Foreign subsidiaries often maintain their financial statements in foreign currencies and these statements are translated into $US before the subsidiaries' financial statements are included in the company's 10-K. - The strengthening and weakening of the $US vis-à-vis foreign currencies results in decreases and increases in the $US-value of subsidiaries' assets and liabilities. - These unrealized gains or losses in the $US value of foreign subsidiaries' assets and liabilities are included in AOCI.

Financial Information Sources

- Form 10-K and Form 10-Q - Form 20-F and Form 40-F - Yahoo!/Google finance - Many other websites

Sum of operating and investing cash flows

- Free cash flow - If negative: check if the operations warrant financing (is this company's operations good enough to support and secure further financing?)

Example -HP purchase of Autonomy

- HP purchased Autonomy for $11 Billion. Transaction resulted in $6.9 Billion of goodwill and $4.3 Billion of other intangible assets - Within a year or so, HP wrote off $5.7 Billion of goodwill and $3.1 Billion of other intangibles

Are Reported Gains (Losses) Economic Gains (Losses)?

- How should we treat these gains and losses for analysis purposes? - That is, do they carry economic effects? - The [Textbook's] answer is no—the gain or loss on repurchase is exactly offset by the present value of the future cash flow implications of the repurchase.

Steps to recognizing revenue:

- Identify the contract with a customer - Identify the performance obligations (promises) in the contract (performance obligations to satisfy) - Determine the transaction price - Allocate the transaction price to the performance obligations in the contract - Recognize revenue when (or as) the reporting organization satisfies a performance obligations

2. Asset utilization.Companies strive to optimize their inventory investment. Carrying too much inventory is expensive, and too little inventory risks stock-outs and lost sales. Companies can make the following operational changes to optimize inventory.

- Improved manufacturing processes can eliminate bottlenecks and the consequent buildup of work-in-process inventories. - Just-in-time (JIT) deliveries from suppliers, which provide raw materials to the production line when needed, can reduce the level of raw materials and associated holding costs. - Demand-pull production, in which raw materials are released into the production process when final goods are demanded by customers instead of producing for estimated demand.

Telltale signs

- Improvement in cost ratios with reduction in reserves (when you see improvement in cost, but no breakthroughs in science. You are probably using lower quality materials, so you should expect customers will come back to you more often, so you should actually increase reserves) - Unexpectedly large reserves (restructuring)

Cash basis - less difficult to commit fraud

- Income statement: Record revenue when we receive cash, and record expense when we pay cash. - Balance sheet: Cash is the only asset.

How would capitalizing R&D affect financial statements?

- Increase Assets - Decrease Expenses by spreading costs over time (via amortization) - Increase Equity SCF - higher cash flow from operations - lower cash flow from investing BS - higher assets - Is it enough to swing a loss to a profit? - Are there differences for firms in different stages?

Impairment recognizes the reduction in value when it happens.

- Increases volatility, but may better reflect actual change in economic value. - But if that's what we want, should we also allow upward revaluations?

Gains and losses on marketable securities

- Investments in certain types of marketable securities are reported at fair value on the asset side of a company's balance sheet. - If the fair value differs from the securities' cost, there are unrealized gains and losses on these securities included in AOCI.

The line item for discontinued operations has two distinct components.

- Net income (or loss) from the segment's business activities prior to the divestiture or sale. - Any gain (or loss) on the sale of the business.

Cisco acquired 76 companies between 1993 and 2000.

- Nineteen acquisitions, or 25%, were accounted for using pooling... - But these deals accounted for 64% of deals by value.

1. Plan Activity

- Number of shares granted to employees during the year. - Number of shares issued during the year to satisfy awards that vested. - Any shares forfeited—when employees leave the company or fail to exercise options within the specified time period.

CSFs related to innovation

- One of the most common/important CSFs - But how to measure it? - R&D intensity such as R&D/Sales? - But it only measures the INPUTs. - Inputs vs. outputs (efficiency)

Fixed assets can get distorted for two reasons

- Ongoing (differences in depreciation) - Episodic (impairment charge delayed/not taken)

Cash flow categories

- Operating activities - Investing activities - Financing activities Disclose: Significant non-cash transactions

Why distorted

- Overstated because of fraudulent sales from "channel stuffing" - asking customers to do you a favor - Overstated because of inadequate reserving for bad debts•Conversely - understated because of cookie jar reserves (new CEO effect)

Why distorted

- Overstated because of impairment charges not taken - Conversely: understated because of excessive impairment - Overstated because of deliberate overproduction (absorption costing = Cost of Goods will be lower)

1. Inventory quality. Fewer days implies that products are salable, preferably without undue discounting. Our conclusions about higher or lower days inventory outstanding must consider alternative explanations including the following.

- Product mix can include more (or less) higher margin inventories that sell more slowly. - A company can change its promotion policies. - A company can realize improvements in manufacturing efficiency and lower investments in direct materials and work-in-process inventories.

When is this crucial

- Products/services with lengthy warranty - M&A or New CEO

Amortization spreads reduction in value over multiple periods.

- Reduces volatility and increases predictability, but does it also overstate performance in a period when value of the business unit declines?

Amazon PPE turnover is decreasing

- Related to AMZN's strategy of "leveraging fixed assets"? - Product part is stable; service part is declining.

Discontinued Operations - not sustainable

- Separate out "Net Assets" and Net Income impact - Important to remove for forecasting

Why does it matter?

- Shift in accounting treatment could cause apparent increase in performance - EBITDA or CFO is sometimes used in debt covenants, compensation contracts, and valuation multiples.

AOCI -Accumulated Other Comprehensive Income

- Some items recorded on the B/S at fair value. - But unrealized gains or losses are not reported in net income or retained earnings -the balance sheet does not balance - Solution: AOCI as a stockholders' equity account

For financial accounting, accounting standards (usually GAAP or IFRS) prescribe:

- Standardized format - Standardized measurement (comparability) - easier for people to understand the info

Basic EPS

- Subtracting preferred stock dividends, in the numerator, yields the income available for dividend payments to common shareholders. - The denominator is the average number of common shares outstanding during the year.

There is usually no adjustment for taxes

- Such impairments are not generally tax deductible - Tax code does not recognize the "write-up" of these assets and correspondingly does not allow a write-off Why should the taxman subsidize HP's bad deals?

The adjustment is very simple

- Take an impairment expense on the income statement - Reduce the value of the asset on the balance sheet

Create incentives for employees to think and act like shareholders.

- The amount of the stock award is often tied to corporate performance targets including sales, income, and stock price. - Stock-based compensation plans motivate employees to work hard and make decisions that improve company performance.

The company writes off an uncertain deferred tax asset.

- The asset is reduced to zero. - The amount written off is subtracted from the valuation allowance. - There is no effect on income from this write off. - reduce DTA and reduce VA

The company determines that the deferred tax assets will be realized. It can reverse the deferred tax asset valuation allowance.

- The deferred tax asset valuation allowance is reduced. - The tax expense is reduced by the same amount. - The net income is increased by the same amount. - increase DTA and reduce VA

Revenue is typically:

- The largest single line item in financial statements (Biggest number in 10-K) - Made up of numerous smaller transactions - Manipulable by managers? (room for managers to manipulate)

After Vesting date?

- The opposite

2. Management is underestimating the allowance account. - management can use this to inflate net income

- This is the more troubling of the two possibilities. - The management might be attempting to increase its profitability by not adding to the allowance account, and, thus, avoiding more bad debt expense.

Consequences of Depreciation

- This speaks to the incentives of management on deprecation. - Companies typically use the SL method for financial reporting purposes and an accelerated depreciation method for tax returns.

If the obligation is probable and the amount estimable with reasonable certainty, GAAP requires manufacturers

- To record the expected cost of warranties as a liability and - To record the related expected warranty expense in the income statement in the same period that the sales revenue is reported.

Extra-ordinary items - categorization of items

- Unusual and Infrequent - Firms attempt to manipulate classification - Not allowed in IFRS but allowed in US GAAP

Changes in accounting

- Usually cumulative effect presented - Past years accounting is rarely restated (too cumbersome)

Do you think preparers of financial statements welcomed this change? Why or why not?

- Very likely yes... - Increases discretion and reduces cost/complexity. - But what about credibility? Is a qualitative assessment likely to satisfy concerned investors and analysts?

1. Accruals for routine contractual liabilities. These accruals include items such as:

- Wages that the company is contractually obligated to pay to employees for work performed, but not yet paid for in the current period. - Interest due in the current period on borrowed money, but has not yet been paid. - Income taxes owed, but not yet paid, as a result of profit earned during the period. - Other operating liabilities that have been incurred but not yet paid for in the current period (like rent, utilities, etc.).

The overestimation would shift income from the current period to one or more future periods. - how many customers that make claims in the current year is irrelevant to the current year's income statement

- Warranty liabilities must, therefore, be examined closely and compared with sales levels. - Any deviations from the historical relation of the warranty liability to sales, or from levels reported by competitors, should be scrutinized.

AMZN's stock-based compensation: Anything missing?

- What is Amazon just made up the cost? - Volatility of stock not mentioned - any good reason? - stock options for Amazon are insignificant & immaterial (not big part)

Capitalization and Depreciation of PPE Assets

- When PPE is acquired, it is recorded at cost on the balance sheet. This is called capitalization, which explains why expenditures for PPE are called CAPEX. - Once capitalized, the cost of plant and equipment is recognized as expense over the period of time that the assets produce revenues (directly or indirectly) in a process called depreciation.

Regardless of the type of stock-based compensation plan, there are common accounting steps.

- When the award is granted to employees, the company estimates the fair value of the award. - The fair value of the award is recorded as an expense in the income statement, ratably over the vesting period. - When the shares are issued,common stock and additional paid-in capital increase in the same manner as for cash-based stock issuances.

Both the indirect and direct methods are allowed under US GAAP and IFRS

- When the direct method is used, a reconciliation of net income to the net change in cash must be presented in the footnotes. - Both boards prefer use of the direct method, but allow indirect.

Encourage employee retention and longevity.

- With most plans, employees earn the right to own or purchase shares over time. The period of time over which ownership rights are earned is called the vesting period. - During this vesting period, employees have greater incentive to stay with the company.

Telltale signs

- Worsening fixed asset turnover - Others taking asset write-downs - ROA consistently lower than cost of capital

Telltale signs

- Worsening inventory turnover - Others taking impairments (competitors are taking big impairment but this company isn't) - Slowdown in demand

Telltale signs

- Worsening receivables turnover (AR/sales) - ratio gets bigger and bigger - Others increasing reserves (competitors increase reserves for bad debt) - Customers doing badly

Two transactions

- borrow money from the bank - use the borrowed money to buy an asset

How to interpret a decreasing allowance/A/R?

- expect more and more customers will pay you back

When would DTL never settle?

- if a company never stops growing - Rapid growth= the tax expense is always higher than the tax payment

IFRS lease "Guidance"

- principle based - burden on auditors and managers - generally leads to higher quality accounting reporting

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease include the following:

- the lease transfers ownership of the asset to the lessee by the end of the lease term - the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised - the lease term is for the major part of the economic life of the asset, even if title is not transferred - at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset - the lease assets are of a specialised nature such that only the lessee can use them without major modifications being made

We will consider two examples of liability distortions

1. Deferred revenue 2. Reserves

Companies must record an accrual (a contingent liability) on the balance sheet, when two conditions are met.

1. It is probable that one or more future events will confirm that a liability existed at the financial statement date. 2. The amount required to settle the liability in the future can be reasonably determined at the financial statement date.

Why do these occur

Uncertainty about whether a liability has been incurred - Environmental liabilities, Litigation Uncertainty about the value of the liability - Warranty reserves, restructuring costs

GAAP criteria for capital lease recognition (by lessee) - more clear and clean cut - uses numbers - might lead to lower quality accounting reporting

1. The lease transfers ownership to the lessee by the end of the lease term; 2. The lease contains a bargain purchase option; 3. The lease term is > = 75% of the estimated economic life of the leased property; 4.The PV of the minimum lease payments is > = 90% of the fair value of the leased property. - Lease is a capital lease if any oneof the four criteria is met. - IFRS applies similar criteria for finance leases, although bright line rules are not specified.

Two possibilities for how we, as analysts, can view goodwill...

1.A real asset...that is, a future economic benefit arising from other assets acquired in a business combination that are not separately identifiable and measurable (but which nevertheless have value). 2.An overpayment by the acquirer for the target, which does not indicate the presence of resources beyond those that are separately identifiable.

To determine depreciation expense, a company makes three estimates.

1.Useful life: period of time over which the asset is expected to generate measurable benefits. 2.Salvage value: amount expected for the asset when disposed of at the end of its useful life. 3.Depreciation method: estimate of how the asset is used up over its useful life.

days payable outstanding (DPO) ratio

365 x Average Accounts Payable / COGS

Days Sales Outstanding (DSO)

365 x Average Accounts Receivable / Sales

Average days inventory outstanding (DIO), also called days inventory outstanding

365 x Average Inventory / COGS

PPE Turnover Rate

A crucial issue in analyzing PPE is determining their productivity(utilization). - What level of plant assets is necessary to generate a dollar of revenues? - How capital intensive are the company and its competitors?

Interpretation of A/R Statistics

A lower accounts receivable turnover ratio, a higher percentage of accounts receivable to sales, and a lengthening of the DSO all provide a signal that accounts receivable have grown more quickly than sales.

Examples

AMZN and BBBY use different useful life for their fixed assets

What does GAAP say?

Accounting for R&D depends whether it was internally generated or externally purchased.

Capital leases

Accounting is very similar to a purchase financed by a note - Recognize lease asset and lease liability at present value of future lease payments - Use amortization tables to allocate payments between interest expense (I/S) and reduction of lease liability (B/S) - Lease asset is depreciated over lease term

Remember the goal of financial reporting... - "Help investors, lenders and other creditors to assess the amount, timing and uncertainty of future cash flows" (FASB/IASB).

Accrual accounting exists because it usually does a better job of helping us to predict future cash flows.

Percent used up

Accumulated depreciation / Depreciable asset cost

Allowances are a balance sheet account

Additions = expected amount Deductions = what actually happened

Which method of accounting for goodwill (amortization or impairment) includes more subjectivity in financial reporting?

Amortization is based on historical cost, and involves more certainty, but estimates still play a role... - In initial recognition and in estimating useful life. Impairment is based on fair value, and involves more discretion, but irreversibility puts some limits on discretion.

How are the income statement and the balance sheet linked?

Another way of thinking about the income statement is that it provides a breakdown of the change in equity during the period.

Accounts Receivable as a Percentage of Sales

Average Accounts Receivable / Sales

Dark side

numbers can be manipulated by managers to benefit themselves

Example

BBRY took 1.6 Billion charge for poor sales of Z series handsets

2nd transcation

Balance Sheet: increase PPE assets and decrease cash Income: Depreciation expense

1st transaction

Balance Sheet: increase liabilities and increase cash Income Statement: Interest expense

New Leasing Standard: Key changes:

Balance sheet treatment for leases of longer than 12 months will be similar to current capital lease treatment. - Change Income statement treatment retains distinction between operating and capital leases (now called "finance leases") - same - Finance leases: Depreciation + interest - Operating leases: Single lease expense Criteria for identifying finance leases no longer includes bright line rules (similar to IFRS guidance). - change

GAAP and IFRS impairment tests are similar, but some differences exist.

Both GAAP and IFRS require that impairment test is conducted at the level of the business unit (i.e., where assets are combined to produce cash flows). - GAAP defines a reporting unit as a business with separate financial information that management reviews regularly. - IFRS defines a cash generating unit as "the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets."

How is EBITDA or CFO affected when moving from operating to capital leases?

Both go up... - For EBITDA: Rent expense is not in ITDA - For CFO: Rent expense > interest expense [note: the principal payment is in financing activities]

When preparing financial statements for stockholders and other external constituents, companies use GAAP.

But when companies prepare their income tax returns, they prepare financial statements using the Internal Revenue Code (IRC).

What is your thoughts?

Credit risk increases -> fair value of the financial liabilities decreases -> record gains and net income increases. Counterintuitive?

AMZN - Goodwill Comparison

COSTCO's acquisitions don't have a lot of intangible assets compared to Amazon, which is more internet and technology based.

One concept:

CSFs (Critical Success Factors) - How these factors shape the competition - Identify them in Business Analysis - Find measurements in financial statements

Capitalization of Inventory Cost

Capitalization means that a cost is recorded on the balance sheet and is not immediately expensed in the income statement. For purchased inventories, the amount capitalized is the purchase price. For manufacturers, manufacturing costs consist of three components: 1.Cost of direct (raw) materials used in the product 2.Cost of direct labor to manufacture the product 3.Manufacturing overhead.

Direct Method

Cash received from operating sources -> Cash paid for operating resources -> Cash provided by operations -> Reconciliation

Discontinued Operations

Companies may divest a segment of their business. When this occurs, the company reports the event at the bottom of the income statement by segregating income from continuing versus discontinued operations.

Valuation Allowance for Deferred Tax Assets - uncertainty of deferred tax assets

Companies must establish a valuation allowance for deferred tax assets if the future realization of the tax benefits is uncertain.

What do the CoCreports' authors get wrong?

Confusing reported numbers with real numbers. - These are real obligations, whether they are on the balance sheet or not. Try missing a payment and see what happens! Assuming that analysts and others use reported numbers mechanically and uncritically. - As we will see, most of the information required to produce "as if" balance sheets is disclosed in notes under current standards. - Analysts, credit rating agencies and lenders use this information to capitalize operating leases. this only affects the book, to the business reality

Flow of Costs

Costs -> Costs capitalized -> Assets (expensed over a certain period of time) -> Expenses Costs -> Costs not capitalized -> Expenses

Pricing of bonds:

Coupon rate determines cash flows Market rate determines price Initial book value = price at the time of issuance (which may or may not equal par value) When bonds are retired prior to maturity the gain or loss depends on how the bond repurchase price compares to the book value of the bonds - Gain or Loss on Bond Repurchase = Net Bonds Payable -Repurchase payment

cash conversion cycle

DSO + DIO - DPO = CCC - Each time a company completes one cash conversion cycle, it has purchased and sold inventory (realizing sales and gross profit), and paid accounts payable and collected accounts receivable. - The cycle increases cash flow. - The aim is to minimize the time to complete a cycle.

Compared to pooling, the purchase method would: Pooling: nothing going on on the balance sheet Purchase: bigger balance sheet at the beginning, but will go down through amortization over time

Decrease net income via annual amortization of goodwill Increase Cisco's asset base, further reducing ROA Possibly reduce Cisco's market value if... - Price was based on mechanical application of P/E - Market could not fully undo differences between purchase and pooling methods

Cash flows from operating activities

Defined by FASB as all transactions and events other than those specifically defined as investing or financing activities Generally cash flows from operating activities are those associated with the production and delivery of goods and services. - Collecting cash from customers - Paying suppliers, employees, tax authorities, etc...

Example

Dell overstated reserves by 50 million in 2007 (cookie jar) -restatement increased income

Two-step process

Determine the fair value of the business unit and compare to carrying (book) value. If fair value of entire business unit is less than its carrying value, compare fair value of the unit to fair value of all identifiable assets to determine implied amount of goodwill. - If other assets (tangible or intangible) are determined to be impaired, they are written down prior to determining goodwill impairment. - Finally, goodwill is written down to its current value. - Impairment amount is charged against operating income for the period.

2. Potential Dilution

Dilution relates to the number of common shares outstanding that have a claim against the company's earnings or net assets.

What is "EBITDA" and do you think it is a good performance measure for top executives?

EBITDA - no because interest, taxes, depreciation, and amortization are NOT out of executives' control so they should be held responsible for it.

Deduct sale of store from net income and add $1 million gained in sale to cash flows from investing activity

EX: Potbelly selling there store on guadalupe

Restricted stock units (RSUs)

Employee is awarded the right to receive a specified number of shares (or cash equivalent) after a vesting period. - Unlike restricted stock, shares are not issued to the employee until after the restriction period, at which time the employee has all of the rights of a shareholder (but not during the vesting period).

Stock option plans

Employees are given the right to purchase shares at a fixed (strike) price for a specified period of time. - can have higher leverage than restricted stock

Stock appreciation rights (SARs)

Employees are paid in cash or stock for the increase in share price, but do not purchase shares of stock.

Employee share purchase plans

Employees are permitted to purchase shares directly from the company at a discounted price, typically a set percentage (such as 85%) of the prevailing market price.

Expenses vs. Deductions

Expenses: financial reporting technology Deductions: tax reporting terminology

If market values of PPE assets decrease

and the asset value is deemed to be permanently impaired—then, companies must write off the impaired cost and recognize losses on those assets.

2. Fair Value and Expense

Fair value of the stock-based compensation awards. How fair value is determined. - Restricted stock awards are valued using the share price on the date of the award. - Stock option plans are valued using option pricing models (Black-Scholes model and the bilateral model). - The expense on the income statement. - Value of the shares issued to employees over and above the price the employee paid for shares (this difference is called the intrinsic value).

Higher PPE turnover rate: favorable or unfavorable?

Favorable

Under the new lease standard, will companies prefer operating or finance lease classification?

Finance lease, because all leases will be on balance sheet.

Articulation of financial statements

Financial statements are linked together in a particular way.

Where crucial

Fixed asset intensive businesses (manufacturing, mining, fast food, airlines)

Managers want: high earnings, but low tax payments.

For financial reports: depreciate long-term assets using a straight-line method For tax returns: depreciate long-term assets using an accelerated method - depreciation is higher in the beginning As a result: the depreciation deduction for tax purposes is higher and taxable income (and tax payment) is lower in the early years of the assets' lives.

Violates GAAP

Fraudulent Accounting

Evaluating cash from financing

Free cash flow - Positive: distributing to debt/equity holders - Negative: issuing new debt/equity If primarily equity: uncertainty in its near future - Firm constantly issuing equity = bad sign/company is very risky (if you think your company is doing well, you wouldn't want to share)

Economics of leasing: What do GAAP and IFRS say?

GAAP: Rules distinguish "Capital leases" and "Operating leases" IFRS: Principles distinguish "Finance leases" and "Operating leases"

Gains & Losses

Gains and losses arise from the sale of assets when the amount of cash received differs from the carrying value of the asset. The cash received on the sale of an asset is classified as an inflow from investing activities. Because gains and losses affect net income on the Income Statement, we need to reverse their effect when calculating CFO using the indirect method: - Deduct the amount of any gains from net income - Add the amount of any losses to net income

From an accounting perspective...

Goodwill is a residual value. Goodwill is not recognized except in the case of an acquisition. At acquisition date, acquirer recognizes, at fair value, the identifiable assets acquired and liabilities assumed. - Including assets that the acquiree (target) had not previously recognized (e.g., patents, trademarks, customer lists, R&D projects). Goodwill is equal to: - The sum of the fair value of consideration transferred (i.e., the purchase price) in excess of the net fair value of identifiable assets acquired (i.e., FV of total assets minus FV of liabilities.)

Strong relation between earnings and future stock performance

High AR -> Sell Stock Low AR -> Buy Stock

DTAs and DTLs are because of "temporary" difference

How about "permanent" difference between book and tax? - Interest of municipal bond - Write-off of goodwill - Etc.

How DTAs affect strategy

How does this make sense? DTAs allow you to pay lower tax, so you can AFFORD to have lower margin!

Delaying payment to suppliers allows the purchasing company to increase its available cash.

However, excessive delays (called "leaning on the trade") can damage supplier relationships.

FASB definition of revenue:

Inflows or other enhancements of assets an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.

R&D: Expense or Asset?

If an asset, what criteria would you use to determine how much of the R&D expense to capitalize as an asset? For a Pharmaceutical company: - Where is the drug in the FDA approval process - Results of clinical trials - Potential market for drug - Some combination of these? (Evidence the product will be successful)

If higher cost units are transferred from the balance sheet, then cost of goods sold is higher and gross profit (sales less cost of goods sold) is lower.

If lower cost units are transferred to cost of goods sold, gross profit is higher.

1. Credit quality has improved.

If management feels that the collectability of its remaining receivables has improved, it can feel confident in allowing the allowance for uncollectible accounts to decline.

Indirect method more popular because you have to do the indirect method when you do the direct method anyway

Indirect method is simpler and easier

Where crucial

In addition to I.P. intensive industries, also M&A intensive firms/industries

How did GAAP accounting for goodwill change in 2012?

In essence, the update introduces a third step to the two-step process.

These two different sets of accounting rules can yield markedly different levels of income.

In general, companies desire to report lower income to taxing authorities than they do to their stockholders so that they can reduce their tax liability and increase after-tax cash flow.

Where crucial

Industries with high levels of R&D and advertising - capitalize R&D, increase assets on balance sheet

CFO

Operating lease = decrease (outflows treated as operating activities) Capital lease = increase (only 1 outflow treated as operating activities)

GAAP vs. Non-GAAP: Financial Statement Impact

Income statement: - Revenue, COGS, Net income Balance sheet: - Deferred costs ("other current assets" and "other assets") - Deferred revenues ("accrued expenses" and "non-current liabilities") Statement of Cash Flows: - No change to actual cash flows - Reconciliation between net income and cash flow from operations (changes in deferred costs and revenues)

Why a statement of cash flows?

Investors need information about: - The sources of cash -firms cannot survive without cash - Cash flows to meet operating needs and debt obligations when due. - Ability to generate cash in its business and pay cash dividends. - Also, quality of earnings as trouble is sometimes suggested on the Statement of Cash Flows before trouble appears on the Income Statement.

Do you think the change will lead to higher quality financial reporting?

Is there any way this could lead to more impairment of goodwill? - Hard to see how... We increase the probability of "Type 2" errors (not recording an impairment when one exists) without decreasing the probability of "Type 1" errors (recording an impairment when there isn't one). So the change is probably only justifiable on cost/complexity grounds. The latest change (2017) is also to simplify the standards.

Unearned (Deferred) Revenue

It evidences the company's obligation to deliver a good or perform a service at a future date. When the good is provided or the service rendered, the unearned revenue liability is reduced and earned revenue is recognized in the income statement. - Generally speaking, should deferred revenue liabilities decrease, we infer the company's current reported revenue was collected from customers in a prior accounting period and there have been fewer new prepayments for which revenue will be recognized in future periods.

Cash flows and life cycle

It is sometimes useful to categorize companies by life cycle stage: - Introduction / Startup - Growth - Maturity - Decline

How to interpret PPE% used up?

Keep updating equipment, etc.

Elements of the balance sheet:

LEFT: Assets are resources held by the firm that will provide future benefits to the firm RIGHT: Liabilities are obligations to pay cash or other resources Equity is equal to a firm's assets minus its liabilities. - Also called "net assets" Ranked and ordered based on liquidity

Operating leases - don't recognize on balance sheet

Lease (or "rent") expense recognized in each period as payments are received - Rent-free periods & other incentives amortized over lease term Interest is not recorded under an operating lease Balance Sheet: no change Income Statement: lease expense

AMZN deferred revenue

Long Term Deferred Revenue -> "Other long-term liabilities" AWS long term contracts with businesses - started in 2014

Financial Leverage

Long-Term Debt / Total Assets

Accruals: difference between earnings and cash flows

Manifest themselves as changes in assets and liabilities on the balance sheet

What would you expect operating, investing and financing cash flows to look like as the firm moves through these cycles?

Mature Firm = CFO = + CFI = can be negative or positive, but close to zero) CFF = -

Look stronger

May lower cost of capital if analysts, lenders, etc, don't consider off-balance sheet lease obligations in calculating level of debt.

What inferences would you make when you see a high percent used up?

More purchases of assets should occur soon.

Profit Margin

Net Income (NOPAT) / Revenue

- AOCI are based on fair value -market value - They inevitably change; but the changes in unrealized gains and losses do not flow to the income statement

Net Income + OCI = CI

Basic EPS is computed as:

Net Income - Dividends on preferred stock / Weighted average number of common shares outstanding during the year

The role of cash reserves

Positive(negative) free cash flow -> add(subtract) cash reserves - How long the reserves can support negative free cash flow (i.e., burn rate) - Management incentive to hoard positive free cash flow The last few lines of the CFS

Under what circumstances should leased assets be accounted for as if they were purchased assets (with associated financing liability)?

Substance over Form - this is a lease, you pay rent to the company who provided the asset - A lease: the lessee pays rent to the lessor periodically

Indirect Method

Net income (loss) -> Adjust effects of non-cash items that affect net income -> Cash provided by operations

- Amount of goodwill recognized? $5 billion - Annual amortization? $250m per year over 20 years - Is this a lot?

Net income for most recent quarter was $662m - On annual basis, $250m might reduce net income by 10% - hit income statement as an expense But remember... - This is only one transaction...Cisco acquires lots of companies Why Cisco wanted to keep pooling method

Stock option less attractive after 2005 because they were costless and didn't have to be recognized as an expense before 2005

Now, RSU are being more attractive compared to stock options

Research and development -IFRS

Once criteria for development phase have been met, development costs are capitalized. US GAAP has similar rules for software to be marketed, but not for other industries.

EBITDA

Operating lease = decrease Capital lease = increase Interest and Depreciation not included in not included in EBITDA

Telltale signs

Others taking impairments (competitors) , especially for goodwill

Big Bath Charges

Overstating restructuring charges on the balance sheet. People overlook a one-time loss and, if charges are overstated, the overstated charges turn into future income. - include other normal losses into the one-time big restructuring cost that the market will overlook

Positive or negative?

Positive: see how it goes - how is this cash going out? - being reinvested? - going out in dividends? - accumulation on balance sheet? Negative: mixed signal - Pool performance: evaluate whether it has future (is this firm growing or dying?) - Investing in working capital: grow business vs. no growth (see what exactly the firm is doing) - inventories, accounts receivable, etc - Are these good investments? (grant credit to customers to gain market share & later see an increase in accounts receivable) - A good sign! Big gap between net income and CFO? - not good/red flag! (EX: all sales are accounts receivable) CFO is distorted by unusual one-time items? - not a concurrent/reoccurinsg event (not sustainable)

Pre-tax income vs. Taxable income

Pre-tax income: income before taxes (financial reporting terminology) Taxable income: tax reporting terminology

Gain or Loss on Asset Sale

Proceeds from Sale - Net Book Value of Asset Sold

The pro and cons of pro forma metrics

Pros: - Eliminate one-time items to enhance year-to-year comparability - allows a company to provide a better picture of the company's financial situation Cons: - Loss of between firm comparability - One-time items also have information - Gives management too much discretion

Intangibles:

Purchased are mostly goodwill from acquisitions - Make sure acquisitions make sense and prices are reasonable

Externally purchased:

R&D purchased in the form of a patent or license is capitalized. When R&D is included in a business acquisition: - Completed R&D projects (along with all identifiable assets --tangible, intangible & financial) are recorded as assets at fair value, then amortized over useful lives. - In-process R&Dis capitalized as an asset with an indefinite life and subjected to impairment testing (not amortization).

What are reserves?

Recognition of expenditures before they are actually incurred -e.g. warranty expenses, restructuring

Internally generated:

Research and development (R&D) expenditures are generally expensed in the period incurred. - Exception: legal fees related to obtaining and defending a patent for a proven technology may be capitalized. - Exception: development stage costs for certain software developed for sale.

What would performance have looked like during the 1990s if Cisco had used purchase method for all acquisitions?

Retained earnings 4/29/2000? $7.6 billion Assume 80%, or $19bn, of deal value would have been attributed to goodwill - This is a big assumption, but reasonable given... - ArrowPointdeal ($5.7 billion versus $162 million book value of net assets) - "Of the combined purchase price of Cisco's acquisitions through February 2000, Powell attributed 95% to goodwill and other intangibles." Assume amortization over 20 years

Accounts Receivable Turnover Ratio

Sales / Average Accounts Receivable

PPE Turnover

Sales / Average PPE, net

Restricted stock.

Shares are issued to the employee but the employee is not free to sell the shares during a restriction period.

From an economic perspective, why does goodwill arise?In other words, why would an acquirer pay more for a target than the fair value of its assets?

Strategic reasons? Target is worth more to the acquirer than as a standalone business. - non-recognizable value: brand name, synergy, brand recognition Represents assets that are not separately identifiable and measurable? - E.g., Human capital Other reasons? - Management overconfidence? - Empire building? - Market mispricing of acquirer's shares? - multiple companies are biding?

Tax Expense

Taxes Paid - Increase (or + Decrease) in Deferred Tax Assets + Increase (or - Decrease) in Deferred Tax Liabilities

Fraud vs. earnings management

The Distinction between Fraud and Earnings Management

Days Payable Outstanding

The average length of time that payables are deferred

Generally, such a trend is not favorable for two possible reasons.

The company is becoming more lenient in granting credit to its customers. - Perhaps in response to greater competition, or perhaps the company is finding it difficult to maintain sales volume and is reaching for additional volume by selling to new customers with weaker credit scores. Credit quality is deteriorating. - If existing customers are not paying on time, the level of accounts receivable relative to the level of sales will increase. This will be highlighted in the DSO statistic, which will increase as the percentage of receivables to sales grows. (A third explanation is that the mix of products sold has changed toward markets with longer payment terms.)

Asset Sales and Impairments

The gain or loss on the sale (disposition) of a tangible asset is computed as follows.

Why is maintaining a high market cap important to Cisco?

The higher the share price, the fewer shares Cisco had to issue to acquired firms' shareholders. - So a high price effectively reduced the cost of acquisitions for Cisco. - make acquisitions cheaper - they do a lot of acquisitions in order to grow

What should we look at as analysts?

The persistence of diff between STR and ETR? The un/certainty of DTAs Valuation Allowance Information content in tax - Tax loss carryforwards - Value allowance if this DTA is risky -it might be loss-making for many years - No/low valuation allowance may signal positive information from the managers

GAAP requires that the warranty liability should reflect the estimated cost that the company expects to incur as a result of warranty claims.

There is the possibility that a company might intentionally underestimate its warranty liability to report higher current income, or overestimate it so as to depress current income and create an additional liability on the balance sheet (cookie jar reserve) that can be used to absorb future warranty costs and, thus, to reduce future expenses.

This creates a benefit (an "asset") for tax reporting for which there is no corresponding financial reporting asset. - future benefit to the company

Thus, the company records a deferred tax asset but only if the company is "more likely than not" to be able to use the loss to reduce future taxes.

Gains and losses on derivatives and hedges.

Unrealized gains and losses on certain financial securities (derivatives) that companies purchase to hedge exposures to interest rate, foreign exchange rate, and commodity price risks are included in AOCI.

Employee benefit plans

Unrealized gains and losses on some pension investments and pension liabilities are reported in AOCI.

How could/should we account for goodwill after recognition?

Until 2001, goodwill was amortized over its estimated life, not to exceed 40 years. - Similar to treatment of other intangible assets with determinable useful lives. Eliminate goodwill at time of acquisition - Charge against retained earnings in period of acquisition - This was the old UK GAAP rule Goodwill as a permanent asset (considered but never allowed) - No subsequent amortization or impairment

Evaluate cash from investing

Usually negative: invest to maintain operations - (unless the firms are declining) Capex: Increasing investment base? - Does this make sense?: is there an improvement in profit margin? - do they talk about it in the MDA discussion. - Capex vs. depreciation add-back - Grow business vs. no growth (inefficient use of capital or accounting distortion) Cash expenditure - What are the investments: risky or not? - how easily can they be turned into cash?

Under the previous tax law:

When a company reports a loss for tax purposes, it can carry back that loss for up to two years to recoup previous taxes paid. Any unused losses can be carried forward for up to twenty years to reduce future taxes.

Deferred revenue

When firms get paid, before they provide a good/service, they should not treat it as revenue. - Instead they should treat it as deferred revenue - In the future year, they recognize revenue and remove the deferred revenue Often firms are aggressive and prematurely recognize revenue. Adjustments are similar to channel stuffing with an increase in a liability (deferred revenue) instead of decrease in an asset (accounts receivable) - both increase revenue Microstrategy example -prematurely recognized 50 million of revenue (and 2 million of associated cost)

Gross Profit

When inventories are sold, their costs are transferred from the balance sheet to the income statement as cost of goods sold (COGS). COGS is then deducted from sales to yield gross profit.

Flow of Inventory Costs

When inventory is purchased or produced, it is capitalized. When the inventory is sold, its cost is transferred from the balance sheet to the income statement as an expense (cost of goods sold).

1. Expense Recognition

When shares or options are awarded to employees, companies estimate the fair value of the award and recognize the fair value as compensation expense in the income statement over the period in which the employee provides service.

Is Stock-Based Compensation an Expense?

Yes, its like paying employees - when the option is exercised there will be real costs

The cost of inventory available at the beginning of a period

a carryover from the ending inventory balance of the prior period.

The statement of cash flows

a financial statement that summarizes information about the flow of cash into and out of a company.

Current period inventory purchases or costs

added to the beginning inventory balance, yielding the total cost of goods (inventory) available for sale.

the goods available

are either sold, and end up in cost of goods sold for the period (reported on the income statement), or the goods available remain unsold and are still in inventory at the end of the period (reported on the balance sheet).

Deferred tax assets

arise when the tax payment is greater than the tax expense for financial reporting purposes. - They represent future tax deductions that reduce taxes payable (cash outflow) and, therefore, provide a future benefit; hence the designation as an asset.

Amortization

based on useful life that managers estimate

Warranty liabilities

commitments that manufacturers make to their customers to repair or replace defective products within a specified period of time.

Impairment

companies don't have to disclose how they are coming to the value of the goodwill each year

Under the new tax law:

company cannot carry back loss but can carry forward indefinitely (up to 80% of the taxable income each year).

The average cost method

computes the cost of goods sold as an average of the cost to purchase or manufacture all of the inventories that were available for sale during the period.

straight-line (SL) method

depreciation expense is recognized evenly over the estimated useful life of the asset as follows.

Using Amortization

don't know whether good will is still valuable in X years - useful life is just a measurement and could easily change

Contingent liabilities

firms engage in tax-planning activities and unsure if they will be "caught" by IRS.

AMZN's sales allowance

good? - less returns & quality is high bad? - managers inflating sales numbers

Statutory tax rate =

government-set rate

2004

have to recognize value of stock as an expense

Retained earnings

increase by the net income reported in the income statement and decrease by the dividends to shareholders.

The income statement

informs us about the degree to which consumers value the products and/or services offered by the company.

The balance sheet

informs us about the resources available to the company and the claims against those resources by creditors and owners.

The relative magnitude of accounts receivable

is usually measured with respect to sales volume using any or all of the following ratios:

Intangible Assets

measurable, identifiable, and recognizable intangible assets

Pro forma income statements

non-GAAP numbers that company management believes provide a better measure of their financial performance. The Securities and Exchange Commission (SEC), requires that companies reconcile such non-GAAP information to GAAP numbers (Regulation G). It is important to remember that a company's purpose for making a non-GAAP disclosure is to portray its financial performance the way that management would like us to analyze it. Unscrupulous companies can attempt to lower the bar for analysis by presenting financial results in the best possible light.

1972

recognize intrinsic value

Depreciation

recognizes using up of the asset over its useful life.

Accounts receivable

reported on the balance sheet net of the allowance for doubtful (uncollectable) accounts:

Deferred (or unearned) revenue

represents deposits or other prepayments from customers that the company has not yet earned. - Deferred revenue is an accrued liability until the company provides the purchased goods or performs the related services, - At which time the liability is reduced and (earned) revenue is recognized.

DTL

tax expense is higher than tax payment "i owe the tax authority"

Effective tax rate =

tax expense/pre-tax income

double-declining-balance (DDB) method

the depreciation base is net book value, which declines over the life of the asset. The depreciation rate is twice the straight-line (SL) rate. - Income Statement: Income lower (larger depreciation expense) - Balance Sheet: less assets and equity (more accumulated depreciation) - Cash Flow Statement: No Change

Percent used up

the proportion of a company's depreciable assets that have already been transferred to the income statement. This ratio reflects the percent of depreciable assets that are no longer productive and is computed as follows.

DTA

the tax payment is higher then the tax expense - expect to pay less in future - "we payed more money than we needed to"

The FIFO inventory costing method

transfers costs from inventory in the order that they were initially recorded.

The LIFO inventory costing method

transfers the most recent inventory costs from the balance sheet to COGS.

Goodwill

unrecognizable, unidentifiable, unclassifiable intangible assets

Capital and Finance Leases

you have the assets for so long as if you are the owner of the asset. You treat the asset like you are the owner

The five accounting gimmicks in Levitt's speech

- Big bath charges - Merger magic - Cookie jar reserves - Materiality - Revenue recognition

Will the difference between GAAP and non-GAAP be this dramatic in future quarters?

probably not -future recognition of revenue from past sales will offset deferral of current sales. - the difference will even out if sales are stable - there will still be a difference if sales continue to increase

The statement of stockholders' equity

reconciles the beginning and ending balances of stockholders' equity accounts.

How big a difference does it make?

Q4 (2008) - GAAP Revenue: $7.9 billion - GAAP Earnings: $1.1 billion - Non-GAAP Revenue: $11.7 billion - Non-GAAP Earnings: $2.4 billion

Return on Assets

ROA (Operating Performance)

Why are ratios important in FSA?

Recall the One Concept of CSFsand Two Questions of Is it Real/Sustainable.

Revenue Recognition

Recognizing revenue before the sale is complete, before the product is delivered to the customer, or at a time when the customer still has options to terminate, void, or delay the sale. - Recognizing Revenues too early or too late

Flexibility in AMZN's 10-K

Revenue - return allowances - $100 million dollar less in Return allowance in 2017 compared to 2015 & 2016. Why?

Asset Turnover

Revenue / Assets

Could Apple have structured iPhone sales to avoid subscription accounting?

Very likely... - By charging a nominal amount for upgrades as they did for new wireless standard on MacBooks. - By arguing that fair value of upgrades was estimable. - By not offering upgrades?

Is this an improvement?

Yes

In favor of up-front recognition:

- Apple has no obligation to provide software upgrades (although it is reasonable to expect them to do so). - The value of the iPhone (with current) software does not depend on future software upgrades. - Minimizes the role of discretion in determining results.

In favor of subscription accounting:

- Apple's obligation extends beyond the initial purchase. - Customer is buying a set of bundled products (hardware + software, including future upgrades). - Technology is new and Apple may incur future costs as a result (i.e., they may not have "earned" all the revenue yet).

Gatekeepers

- Auditors - Analysts - Rating agencies - Media - (maybe) Short-sellers

Assuming it was possible to avoid the subscription model for recognizing iPhone revenue, why did Apple choose it anyway? - decrease volatility of sales and revenue - they didn't know how successful the iPhone would be: want to be conservative

- Avoid upsetting customers by charging for upgrades - Preference for conservatism - Desire to smooth revenue and earnings - Downplay importance of iPhone to growth - Avoid possible restatement - Already meeting/beating estimates, so no downside to conservatism (and good for future quarters)

Four statements

- Balance sheet - Income statement - Cash flow statement - Statement of stockholders' equity

Can you guess which comes first for most firms?

- Cash Flow Statement comes first for Amazon because Amazon because Amazon really values their cashflows (want to highlight to investors) - Balance Sheet comes first for most companies - New companies put Income Statements first -> income sheet is more relevant

Two main ways of reporting transactions and events:

- Cash basis - Accrual basis

Critical Success Factors (CSFs)

- From economic forces to accounting measurements One example: how do we measure product quality (or the consequence of gaining/losing it)? - number of returns - return statistic

Differences between GAAP and non-GAAP approaches to revenue recognition for the iPhone?

- GAAP uses subscription accounting, which spreads iPhone revenue and COGS over two years (eight quarters). - Non-GAAP approach recognizes all revenue and COGS "up-front" (i.e., at time of sale)

Accrual Basis

- Income statement: Record revenue when it is earned, and record expense when we receive the good or service (usually at the same time as associated revenue; matching of revenue and expense). - Balance sheet: Record assets and liabilities to account for the timing differences between the payment of cash and the use or provision of goods and services.

The role of management incentives

- Managers have much more information regarding the business - Is the number real? - Is there information related to sustainability?

Popular tools for business analysis

- Value chain - SWOT - Five-forces

Visualizing earnings management

- alot of managers report small positive changes in earnings and not many report small negative changes - managers bump up their small negative earnings to small positive earnings so they have positive earnings

Why is revenue recognition important?

- can help us understand the business - can help us understand how sustainable the business is

Drawbacks of standardization?

- competition is lessened by standardization

Why Financial Statements?

- easy to compare between companies - set a benchmark - to level the playing field

Why we need business analysis in FSA?

- in order to know the business and the industry - see the competitive landscape and be able to see and forecast trends

Standardization generally makes accounting information more useful

- increases competition between standards for public companies - having two different choices for companies to choose encourages both standards to keep improving

Given flexibility in the accounting system, why management incentive is important?

- management incentives encourage managers to manipulate numbers - in a principle-agent framework, managers have much more information regarding the business - is the number real?

Relative benefits and drawbacks of cash versus accrual accounting?

- probably easier to commit fraud with cash accounting - accrual earnings are very good at predicting future earnings

Reasons not to be misguided by the accounting system

- the system by design is to be balanced because of double entry - you can make adjustments to numbers

Top 5 motivations for mangers to misrepresent accounting numbers based on the CFOs' survey.

1. To influence stock price 2. To influence executive compensation 3. Because there is outside pressure to hit earnings benchmarks 4. Because there is inside pressure to hit earnings benchmarks 5. Because senior managers fear adverse career consequences if they report poor performance

Merger Magic

Classifying a good amount of the acquisition price as a one-time "in-process" Research and Development charge, so the acquisition charge won't affect future earnings. - Write off a great deal of acquisition costs to R&D in process so the acquisition doesn't affect future earning numbers

Within GAAP

Conservative Accounting - lead to lower earnings Neutral Earnings Aggressive Accounting - lead to higher earnings

Revenue Recognition Criteria

FASB SFAC 5: Revenue is recognized when it is... - Earned - Realized or realizable (cash is collected or highly likely to be collected) SEC Staff Accounting Bulletin (SAB 104): - Persuasive evidence of an arrangement exists - Delivery has occurred or services has been rendered - The seller's price to the buyer is fixed or determinable - Collectability is reasonably assured Multiple statements of position, EITF pronouncements, etc, for specific revenue recognition scenarios...

How would Apple's accounting for the iPhone have differed under IFRS?

IFRS would allow Apple to defer only the portion of the revenue associated with the future software upgrades (probably very small as % of total). In fact, GAAP allowed this too, but only if standalone fair value of upgrades could be determined (IFRS allowed management more flexibility in determining value of future deliverables).

Business information beyond 10K

Industry reports, comments, etc. Ability to foresee critical trends - Self-driving car - The rise (and possible fall) of globalization - AI - Etc. Ability to uncover hidden facts - Managerial background - Tunneling through related parties - Fake deals - So, Trust, but verify

Corporate transparency - increase confidence in company

Interpreting accounting numbers in a world of earnings management - Corporate disclosure - Management credibility The two questions: real & sustainable? The power of "Adverse selection" - take concern into pricing (buying a used car or smoker getting insurance)

Two questions:

Is it real? - Can managers manipulate this number? - Our focus in Accounting Analysis - Flexibility & incentives -> accounting quality issues Is it sustainable? - Consistent - Our focus in Financial/Prospective Analysis - Transient $ <<< Permanent $ (way smaller than permanent stream of money)

What determines whether GAAP or non-GAAP numbers are bigger?

Mainly sales growth (as long as prices don't change too much). If sales start to decline, GAAP revenue will be increased by past sales more than it is decreased by deferring current sales. - sales growth

Sales Allowances

Many companies offer customers a variety of sales allowances, including - Rights of return - Sales discounts for volume purchases, and - Retailer promotions (point-of-sale price markdowns, and other promotions). All of these costs have the effect of reducing the amount of cash companies receive from sales.

Materiality

Misusing the concept of materiality to intentionally make errors in order to meet the consensus estimate. - Recognizing material numbers as immaterial and treat it as if its not a big deal

New Standard (Joint FASB/IASB Project)

Objectives: - Remove inconsistencies and weaknesses in existing revenue requirements - Provide a more robust framework for addressing revenue issues (i.e., what is the underlying principle?) - Improve comparability - Improve disclosure requirements - Simplify financial statement preparation by reducing the number of requirements

Porter's Value-Chain Model

Primary activities - Inbound logistics - Operations - Outbound logistics - Marketing and sales - Servicing Support activities - Firm infrastructure - Human resource management - Technology/product development - Procurement

Achieving Competitive Advantage

Product differentiation - Technological innovation - Product design - Marketing, distribution, and after-sale customer support Cost leader - Access to low-cost raw materials or labor - Manufacturing or service efficiency - Manufacturing scale efficiencies, greater bargaining power with suppliers, sophisticated IT systems, etc.

Elements of the income statement

Revenue is the inflow of cash or other resources to the firm (from the firm's primary business activity) - Other inflows are called "other income" or "gains" Expense is the outflow of cash or other resources from the firm (in pursuit of revenue) - Other outflows are called losses Net income (or profit, earnings, etc...) is equal to inflows minus outflows during the period

SWOT Analysis of the Business Environment

SWOT - strengths - weaknesses - opportunities - threats - Internal—strengths and weaknesses - External—opportunities and threats

Cookie Jar Reserves

Using unrealistic assumptions to over-estimate liabilities during the good times, so the accruals can be used during the bad times. - During good times, over estimate liability accounts so they can use this money during bad times to increase earning numbers

Accounting standard setting

Why did standards change? - because Apple lobbied for the change Standard setters believe new rules better reflect economics of smartphones? - Yes, but... Apple and other smartphone manufacturers lobbied the FASB for the rule change... - Standard setting is interactive. - Accounting standards are not (usually) "imposed" on firms.

The Statement of Cash Flows

breaks down the change in cash for a period into three categories: - Operating Cash Flows - Investing Cash Flows - Financing Cash Flows

Revenue recognition is among the most frequent reasons for public companies' financial restatements.

company forced to redo numbers because there was a mistake made

Common stock and additional paid-in capital

increase by the proceeds from the sale of stock.

Accumulated other comprehensive income

increases and decreases by changes in asset and liability fair values that are not reported in the income statement.

The balance sheet

measures financial position at the end of the period (i.e., a single point in time)

The income statement

measures performance over a period of time (e.g., quarter, year)

Bright side

there are so many different types of businesses also estimates are being made