FIN 4461 Final Exam Comprehensive Study Guide

Enron

¤ 2001 • October: Reduced after-tax income by $500 million and shareholders' equity by $1.2 billion • November: Restated 1997-2000 net income • December: Filed for bankruptcy ¤ Techniques • Investment in special-purpose entities • Fair value of investments Complex and opaque financial statements

WorldCom

¤ 2002 • June: $3.8 billion of overstated profits over previous 5 quarters • Declared bankruptcy • November: Special bankruptcy court examiner reported that the improper accounting would exceed $7.2 billion ¤ When business declined in 2000, the company used following techniques • Moved funds from reserve accounts to bolster profits • Capitalized operating costs

Valuation

¤ A process of estimating the value of a firm or some component of a firm ¤ Approaches to valuation • Fundamental analysis • Discounted valuation

Multivariate Model: Z score

¤ Altman's multiple regression model with five ratios produces an overall discriminant score called Altman's Z score • The Altman Z score model has less significance if there is no listed market value of a firm's stock (non-public company) ¤ Z > 3.00 is considered the "Safe Zone" ¤ The lower the "Z" score, the more likely is failure ¤ Between 1.81 to 2.99 is considered the "Gray Zone" ¤ Z < 1.81 is considered the "Distress Zone" ¤ The Z score calculation includes Retained Earnings but not Accumulated Other Comprehensive Income (AOCI) which is a relatively new reported equity account. • To be more conservative, AOCI could be added to RE and included especially if it is a negative number.

Stock Options

¤ An employer is contingently obligated on the grant date to issue shares to the employee who renders the requisite service based on the conditions of the award ¤ Recognize an expense for all employee services received in share-based payment transactions, using a fair-value-based method based on the grant date fair value ¤ Allocate the fair value of the option as compensation expense over the service period: • The date of grant through the vesting date when the option is no longer contingent on future service ¤ Non-compensatory plans like stock options • Encourage widespread ownership by employees • Slight discount from fair value • No compensation expense is recognized ¤ Impact of options can be substantial • It may result in lower net income and earnings per share

Dot.com Companies

¤ Apply classic discounted cash flow approach to pricing of dot.coms ¤ Have investments in customer acquisitions ¤ Factors that drive customer-value analysis • Average revenue per customer per year • Total number of customers • Contribution margin per customer • Average per-customer acquisition cost • Customer churn rate

Regulated Utilities: Financial Statements

¤ Balance Sheet • Plant and equipment is listed first, followed by investments and other assets, current assets, and deferred charges • Under liability and equity section, the first section is capitalization and includes all sources of long-term capital • Followed by current liabilities and deferred credits ¤ Income Statement • Net operating income • Income before interest charges • Income before income taxes ¤ Construction work in progress (balance sheet asset) • Substantial construction work in progress in utilities should be viewed as more risky • Most utility commissions allow no construction work in progress or only a small amount in the rate base • Disallowed costs provide no return • For the costs allowed, the risk exists • Allowance for funds used during construction (income statement accounts) • Allowance for equity funds (other income) has an assumed rate of return on equity funds • Allowance for borrowed funds (interest charges) concerns the cost of borrowed funds and Interest is added to cost base

Transportation: Financial Statements

¤ Balance Sheet • Similar to manufacturing and retailing reporting • Property and equipment makes up large portion of assets • Supplies and parts comprise basic inventory part ¤ Income Statement • Similar to utility reporting • Revenues and expenses grouped by natural objectives and functional activities • Reports operating income • Presented in single-step fashion

Insurance: Balance Sheet

¤ Balance Sheet for Insurance is Under GAAP ¤ Investments (Assets) • High degree of liquidity, typically bonds • Review spread between cost or amortized cost and fair value • Review stockholders' equity for unrealized gains and losses on investments ¤ Assets Other than Investments • Real estate used in operations • Deferred policy acquisition costs are deferred and matched over premium-paying period for GAAP and expensed under SAP • Goodwill and other intangibles which are not recognized under SAP ¤ Liabilities • Loss reserves are reported at present value of commitments • Policy and contract claims are claims accrued as of the balance sheet date and reported net of recoverable portion ¤ Shareholders' Equity • Resembles other industry's shareholders' equity • Review for unrealized gains and losses on investments [Accumulated Other Comprehensive Income (loss)]

What Analysts Use

¤ Barker study • Price-earnings ratio: the preferred method • Valuation models are important in the context of one another rather than in isolation ¤ Demirakos et al. • Price-earnings ratio is predominant • Analysts tailor valuation methodologies to the industry ¤ Asquith, et al. • Analyst use market-to-book value as the asset multiple

Insurance: Sources of comparative data

¤ Best's Insurance Reports separate ratings for life-health and property-casualty companies ¤ Ratings range from A+ (Superior) to C− (Fair) ¤ The other companies are classified as "Not Assigned"

Management of Earnings

¤ Cash basis of accounting • Recognize revenue when cash is received • Recognize expenses when cash is paid • Does not usually provide reasonable determination of income in the short run ¤ Because of the shortcomings of the cash basis, the accrual basis has been adopted for income reporting for most firms ¤ Accrual basis of accounting • Usually provides reasonable determination of income in the short run • Revenue is recognized when realized (realization concept) • Expenses are recognized when incurred (matching concept) • Requires use of estimates, assumptions, and judgment ¤ Manipulate earnings through • Improper use of estimates • Improper judgment • Intentional errors ¤ Revenue recognition is often the focus of financial manipulation • Premature recognition of revenue • Inventory cutoff • Receivable timing and valuation

Bank's Balance Sheet ("Report of condition") Assets

¤ Checking accounts or demand deposits are liabilities ¤ Loans to customers are assets, they are the receivables of banks ¤ Assets are not subdivided into current and noncurrent ¤ Typical assets • Cash on hand or due from other banks • Investment securities • Loans • Bank premises • Equipment ¤ Fixed-rate assets expose bank to risk if interest rates rise because the receivable decreases in value ¤ LDC (less-developed countries) loans more risky than domestic loans ¤ Important things regarding Assets • Review the disclosure that describes related-party loans • Review the disclosure of allowance for loan losses • Review the disclosure of nonperforming assets and restricted assets Review subprime residential real estate loans risks

Transportation: Regulation and oversight

¤ Civil Aeronautics Board • Regulates interstate commercial aviation • Uniform system of accounts and reporting ¤ Interstate Commerce Commission • Regulates interstate railroads • Regulates interstate motor carriers • Uniform system of accounts and reporting

Conservatism and Quality of Earnings

¤ Conservatism • Achieved through the slowest reporting of net income • Yields higher quality of earnings ¤ Inventory (in periods of inflation) • Matching of current cost against the current revenue results in the lowest income for a period of time • LIFO inventory method follows this procedure ¤ Fixed Assets • The conservative method of depreciation are the sum-of-the-years'-digits and the declining balance method • The period of time selected to depreciate an asset, shorter period of time results in lower income ¤ Intangible Assets • Shorter life estimates • Expensing of R&D as incurred ¤ Pensions • Defined benefit plan, must determine the assumed interest rate and rate of compensation increase

Real Estate Companies

¤ Construct and operate income-producing real properties ¤ Contend that conventional accounting misleads investors ¤ Some real estate companies supplement historical cost information with current value • Current value is based on future income potential

Multiperiod Discounted Earnings Models

¤ Discounted abnormal earnings (DAE) • The value of the firm's equity is the sum of its book value and discounted forecasts of abnormal earnings ¤ Residual income (RI) • Discounted future expected earnings • Focus is on earnings as a periodic measure of shareholder wealth creation ¤ Free cash flow (FCF) • The discounted free cash flow equals the sum of the stream of expected free cash flows discounted to the present ¤ Dividend discount model (DDM) • Discounts the projected dividend stream to present value ¤ Discounted cash flow (DCF) • Involves a multiple-year forecast of cash flows • Forecasts are discounted at the firm's estimated cost of capital to arrive at an estimated present value

Valuation as Seen by Management Consultants

¤ Discounted cash flows • Provide a more reliable picture of a company's value than an earnings-multiple approach • Drive the value of a company and focus on long-term cash flows ¤ Mergers and acquisitions • Shareholders of the acquired company experience greater returns • Acquiring companies may pay too much for the acquired company

Graphing Financial Information

¤ Easier to grasp key financial information in annual reports ¤ Better communication device than written report or tabular presentation ¤ Different types • Line graph: A set of points connected by a line and shows change over time • Column graph: Most appropriate for presenting accounting data • Bar graph: Similar to column graph, except that the bars are horizontal • Pie graph: Divided into segments and segments aggregate to 100%

The Housing Bust

¤ Fannie Mae and Freddie Mac control a substantial portion of the mortgage market • Because of implied protection of the federal government received AAA rating from Standard & Poor's • Controlled trillions of dollars of mortgages • Government auditors in 2003 and 2004 found company's manipulated accounting rules • During 2007 and 2008 when the market blew up, the world was polluted with high-risk mortgages

Regulated Utilities: Ratios

¤ Few of the traditional ratios are appropriate ¤ Operating Ratio • Measures efficiency • Operating expenses ÷ Operating revenue • Low ratio indicates high profitability ¤ Funded Debt to Operating Property • Operating (net) property is plant and equipment less accumulated depreciation and also include construction in progress • Measures debt coverage and indicates how funds are supplied

Bank's Ratios

¤ Few of the traditional ratios are appropriate for banks ¤ Exceptions • Return on assets • Return on equity • Most of the investment-related ratios ¤ Earning Assets to Total Assets • Earnings assets are loans, leases, investments securities, and money market assets -Exclude cash and nonearning deposits plus fixed assets • High result reflects how well the bank puts bank assets to work ¤ Interest Margin to Average Earning Assets • A key measure of bank profitability • Indicates management's ability to control the spread between interest income and interest expense ¤ Loan Loss Coverage Ratio • (Pretax income + Provision for loan losses) ÷ Net charge-offs • Measures asset quality and the level of protection of loans ¤ Equity Capital to Total Assets • Also called funds to total assets • Measures the extent of equity ownership in the bank ¤ Deposits Times Capital • Concerns both depositors and stockholders • A type of debt-to-equity ratio • Indicators such as more capital implies greater margin of safety and more deposits indicate investment potential • Average deposits ÷ Average stockholders' equity ¤ Loans to Deposits • Average total loans to average deposits • A type of asset to liability or debt coverage ratio • Measures the bank's position with regard to taking risks

Management's Use of Analysis

¤ Financial ratios and common-size analysis • Indicates relative liquidity, debt, and profitability • Indicates how investors perceive a firm • Detect emerging problems and strengths in a firm • As part of corporation planning in general and specific objectives and budgeting

Special Areas of Usefulness of Ratios and Financial Analyses

¤ Financial ratios as perceived by • Commercial loan departments • Corporate controller • Certified public accountants • Chartered financial analysts ¤ Financial ratios used in annual reports ¤ Degree of conservatism ¤ Forecasting financial failure ¤ Analytical review procedures ¤ Management's use of analysis ¤ Use of LIFO reserves ¤ Graphing financial information ¤ Management of earnings ¤ The housing bust ¤ Valuation

Use of LIFO Reserves

¤ Firms that use LIFO for financial reporting discloses a LIFO reserve account in a note on the face of the balance sheet • The excess of FIFO over LIFO is termed LIFO reserve ¤ Determine adjusted financial statement information based on LIFO reserve • Inventory • Deferred income tax • Cost of goods sold • Net income • Liquidity, debt, and profitability ratios

Stock Appreciation Rights (SARs)

¤ Gives the employee right to receive compensation in cash or stock or in a combination of both • Based on the difference between established option price and market price at the exercise date ¤ Expense is a function of market price • Year-end spread is measured • Compensation expense is spread minus prior recognition, multiplied by number of shares of stock appreciation rights outstanding

Dividend Yield

¤ Indicates the relationship between the dividends per common share and the market price per common share ¤ The yield depends on a firm's dividend policy and market price

Insurance: Ratios

¤ Industry-specific based on SAP reporting to states ¤ Ratios based on GAAP data concerning profitability and Investor-related ¤ Confusion surrounding the insurance industry reporting • Insurance stock typically have a stock market price at discount to the average market price • Two accounting standards are SAP and GAAP

Bank's Income Statement

¤ Interest • Principal revenue is interest earned from loans and investment securities • Principal expense is interest on deposits and other debt • Excess of interest revenue over interest expense is net interest income (margin) • Interest rates that are of concern is falling rates that reduces expense (interest paid on deposits) and increasing rates increases expense ¤ Other income (noninterest income) •Fees, service charges, trading account profits (losses), and securities transactions • It is of increasing importance to banks

Transportation: Ratios

¤ Long-Term Debt to Operating Property • Operating property is defined as long-term property and equipment • Measures the sources of funds with which property has been obtained and borrowing capacity ¤ Operating Revenue to Operating Property • Measures turnover of operating assets • Operating objective is to generate as many dollars in revenue per dollar of property ¤ Per-Mile, Per-Person, and Per-Ton Passenger Load Factors • Additional insight can be gained by looking at revenues and expenses on a per unit of usage basis • Often presented in the financial statement notes or highlights

Oil and Gas

¤ Major impact on financial statements from the method of accounting for exploration and production ¤ Specific required supplemental disclosures for oil and gas exploration, development, and production activities ¤ Traditional ratios are applied

Can Financial Failure of a Firm be Forecasted?

¤ Many academic studies exist to forecast financial failure. ¤ The studies try to isolate specific ratios that may forecast failure & are used as follows: • by management in order to take preventative measures to prevent failure • by investors in selecting & disposing stocks in portfolio management • by creditors in lending decisions • by the auditor to assess 'going concern' status ¤ Financial failure defined in many ways, such as: • Liquidation • Deferment of debt payments (interest &/or principle) • Omission of preferred dividend ¤ Two Recognized models to predict failure • Univariate model by William Beaver 1968 • Multivariate model by Edward Altman & Thomas McGough (used for financial data from 1946-1965)

Dividend Payout

¤ Measures the portion of current earnings per common share being paid out in dividends ¤ A stable dividend policy is developed by consideration of recurring earnings ¤ Lower payout typically found in growth firms

Price/Earnings Ratio

¤ Measures the relationship between the market price of a share of common stock and that stock's current earnings per share ¤ Use of diluted earnings per share gives a more conservative price/earnings ratio (since diluted EPS < basic EPS) • Otherwise it is normally: P/E = Market price per share/EPS ¤ Investors view P/E ratio as a gauge of the future earnings power of a firm • High-growth-potential firms have higher P/E ratios • P/E ratio is a function of the market • Performance is compared with competitors, industry average, and exchange averages ¤ Calculation factors: • Use last annual EPS (fully diluted) and current price • Trailing P/E: uses earnings for the most recent 4 quarters • Forward P/E: uses estimates of earnings for the next 4 quarters

Analytical Review Procedures

¤ Objective is to isolate • Significant fluctuations • Unusual items in operating statistics ¤ Performed in various stages of the audit • Planning stage • During the audit • Near the completion of the audit

Book Value per Share

¤ Preferred equity should be measured at liquidation value, if available & is excluded from total equity ¤ Book value reflects past unrecovered asset costs ¤ Market value reflects the potential of the firm

Insurance: Regulation and Accounting

¤ Primary regulation of Insurance is at the state level ¤ Accounting is done under Uniform statutory accounting practices (SAP) ¤ Reporting of insurance is under auspices of the National Association of Insurance Commissioners • The Balance sheet is emphasized and the focus is on financial solvency • Ratio analysis conducted by the NAIC ¤ The annual reports are based on GAAP ¤ SEC has jurisdiction only over publicly-traded companies

Oil and Gas: Required supplementary disclosure

¤ Proved oil and gas reserve quantities ¤ Capitalized costs relating to oil- and gas-producing activities ¤ Costs incurred in oil and gas property acquisition, exploration, and development activities ¤ Results of operations for oil- and gas-producing activities ¤ A standardized measure of discounted future net cash flows relating to provided oil and gas reserve quantities

Financial Ratios in Annual Reports

¤ Ratios related to profitability and investing most frequently included ¤ The method of computing ratios is inconsistent ¤ No regulatory agency currently accepts responsibility for determining content or format of presentation of ratios for annual reports

Percentage of Earnings Retained

¤ Reflects the proportion of current earnings retained for internal growth ¤ Trend analysis is improved by exclusion of nonrecurring items ¤ Higher percentage typically found in growth firms

Banks

¤ Regulation and structure • Federal charter submit reports to Comptroller of the Currency • State charter is controlled by state banking departments and sphere of operations are controlled by state • Members of federal reserve system submit reports to Federal Deposit Insurance Corporation and Federal Reserve System. Member banks maintain reserves at their district Federal Reserve Bank ¤ Banking systems involve two types of structures 1. Individual banks 2. Bank holding companies which consists of a parent that owns one or many banks and may own bank-related financial services and nonfinancial subsidiaries

Restatement of Prior Financial Statements

¤ Restatements have become a substantial problem when analyzing financial statements ¤ Review companies that are being analyzed for restatement during period of time that is being analyzed • Make similar review for companies with which the company is being compared • Impossible to guard against some unreliable industry data

Bank's Balance Sheet ("Report of condition") Liabilities

¤ Review liabilities for favorable and unfavorable trends ¤ Deposits are the dominant liability ¤ Significant commitments and contingent liability are revealed in note to the balance sheet

Restricted Stock

¤ Sometimes offered to employees in lieu of stock option plans • An expense is recorded similarly to compensation expense for stock options • Shares are received & dividends but restricted. ¤ Restrictions: • Employee cannot sell stock for a specified period of time • Employees may forfeit their shares if they leave employer before vesting • Awards may be linked to financial goals

Regulated Utilities: Regulation and structure

¤ Subject to government regulation and rate regulation ¤ Uniformity of accounting is prescribed by: ¤ Federal Energy Regulatory Commission • Interstate electric and gas companies ¤ Federal Communications Commission • Telephone and telegraph companies ¤ State regulatory agencies ¤ Regulated utilities have added nonregulated businesses

Oil and Gas: Successful-Efforts versus Full-Costing Methods

¤ Successful-efforts • Capitalize costs of successful efforts • Immediately expense costs of unsuccessful efforts • Direct relationship exists between costs incurred and specific reserves discovered • More conservative approach yielding lower net income due to immediate expensing of unsuccessful efforts ¤ Full-costing • All costs are a part of eventually finding successful wells • Capitalize all costs of exploration • Items capitalized are subject to depletion ¤ In total, the same amount is expensed under either method, but the timing of expense recognition varies dramatically ¤ Smaller companies choose full-costing method • Larger balance sheet due to full capitalization • Short-run higher profit • Presents more favorable picture to creditors and investors ¤ Larger companies use variation of successful-efforts method • Smaller balance sheet with only successful efforts capitalized • Lower reported net income in the short run

Univariate [Beaver] Model

¤ The Beaver study indicated the following ratios as best to forecast financial failure in order of their predictive power: • Cash flow/total debt • Net income/total assets (Return On Assets) • Total debt/total assets (Debt Ratio) ¤ Beaver observed these relationships: • Failed firms have less cash and more receivables • When cash and receivables are added, difference between failed and successful firms are less visible • Failed firms tend to have less inventory

Insurance: Income Statement

¤ The Income Statement of Insurance is Under GAAP ¤ Duration of contract governs revenue recognition • For short-duration revenue is recognized over the period of the contract in proportion to protection provided • For long-duration revenue is recognized when premium is due • Low-risk contracts are "investment contracts" and accounted for as liabilities ¤ Realized gains/losses from investments are reported in the period incurred

Earnings per Common Share

¤ The amount of income earned on a share of common stock during an accounting period • Earnings pertain to an entire fiscal period ¤ Required disclosure for corporate income statements ¤ Pertains only to common stock • Average common shares outstanding is used for parity of information ¤ Per share amounts for discontinued operations and extraordinary items must be presented in the income statement and the notes to the financial statements ¤ Earnings per share for recurring items are significant for primary analysis ¤ Retroactive recognition must be given to events such as stock dividend and stock split ¤ Diluted earnings per share is calculated the same as basic plus the dilutive effect of potentially dilutive securities • Convertible securities, options, warrants, or other rights that upon conversion or exercise could in the aggregate dilute earnings per common share are potential dilutive securities

Degree of Financial Leverage

¤ The degree of financial leverage is the multiplication factor by which the net income changes in respect to changes in EBIT (Earnings before interest and taxes) ¤ Degree of financial leverage calculations should exclude • Non-controlling interest • Equity income • Nonrecurring items such as income/loss from discontinued operations & extraordinary items

Oil and Gas: Cash Flow

¤ The potential for a significant difference exists between the reported income and cash flow from operations ¤ Large sums can be spent for exploration and development ¤ Significant differences between when expenses are deducted on the financial statements and when they are deducted on the tax return

Financial Leverage

¤ The use of financing with a fixed charge (interest) is termed financial leverage ¤ Interest as related to debt financing is a contractual obligation • Must be paid regardless of entity's current profits in contrast with dividends that are discretionary • Interest is tax deductible which reduces taxable income and income tax expense ¤ Financing with debt is successful if the firm earns more on the borrowed funds than it pays to use them.

Insurance

¤ Types of service • Identified contract service such as mortality protection and loss protection • Investment management service ¤ Types of insurance organizations • Stock companies: Organized to return a profit for its stockholders • Mutual companies: Incorporated entity, without private ownership interest • Fraternal benefit societies which is similar to a mutual insurance company and does not have capital stock, and operates for the benefit of its members and beneficiaries • Assessment companies: Organized group with a similar interest

Bank's Balance Sheet ("Report of condition") Shareholders' equity

¤ Typically low in relation to total assets (averages 6-7%) • Low shareholders' equity indicates greater risk of failure • High shareholders' equity is less risky but less profitable because of additional capital requirements ¤ Review for accumulated other comprehensive income/loss ¤ Regulators view capital in relation to risk-adjusted assets

Financial Ratios as Perceived by Commercial Loan Departments

¤ Used to aid the loan officers • Deciding whether to grant a commercial loan • Maintaining control of a loan once it is granted ¤ It can be assumed that these ratios would have the greatest influence on a loan decision

Fundamental Valuation Analysis

¤ Utilize basic accounting measures • Reported earnings • Cash flow • Book value ¤ Use one or more multiples • Price-to-earnings, price-to-book • Price-to-operating cash flow • Price-to-sales ¤ Acceptance • Not well accepted by traditional financial literature • Preferred by security analysts and fund managers

Forecasting Financial Failure

¤ Weaker ratios indicate higher risk of failure ¤ No conclusive model has been identified • Use an integrated approach