Accounting Concepts and Financial Analysis BUS512Mbus.emory.edu/scrosso/BUS512M/2015-2016/Session 3.11.21.15.inked… · Accounting Concepts, Time Value of Money, and Financial Analysis

Accounting Concepts,

Time Value of Money,

and

Financial Analysis &

Reporting

BUS512M

November 21, 2015

Session 3

7:00-10:30

Susan Crosson

Homework

See Handout

Today’s Learning Outcomes

• Time Value of Money

• Professional Judgment

• Accounting Concepts and Principles

• Accrual Accounting

• Earning Management and Detecting

Accounting Abuse

• Valuation Methods on the Financial

Statements

Key Questions:

Future Value v. Present Value?

n= number of periods?

r=effective or market interest rate?

Single payment or Ordinary annuity

(multiple payments)?

Interest bearing or Noninterest bearing?

Draw a Timeline:

Future Value of a Single Sum EA-1

If $150 were invested today, how large a sum could be withdrawn at the end of the following time periods?

Compound Interest Rates 5 years 10 years 15 years

5%

10%

15%

Future Value of an Ordinary Annuity EA-3

If $150 were invested at the end of each year over the following time periods, how large a sum could be withdrawn at the end of the final time period?


5%

10%

15%

Future and Present Values EA-9

Ben found $25,000 and decided to invest it. He believes he can earn 10% (compounded annually) on his investment for the first 4 years, 12% for the following 3 years, and 15% for the following 5 years.

a. How much money will Ben have at the end of 4 years, 7 years, and 12 years?

Future and Present Values EA-9 Ben found $25,000 and decided to invest it. He believes he can earn 10% (compounded annually) on his investment for the first 4 years, 12% for the following 3 years, and 15% for the following 5 years.

b. If someone offered to pay him $36,000 at the end of 4 years for the $25,000, should he accept? Why or why not?

Present Value of a Single Sum EA-2

Compute the present value of $10,000 received at the end of the following time periods at the following discount rates.


5%

10%

15%

Present Value of an Ordinary Annuity EA-5

Compute the present value of $10,000 received at the end of each year over the following time periods at the following discount rates.


5%

10%

15%

Present Value of different payment patterns EA-7

Compute the present value of the payment patterns provided below, given an 8% discount rate.

a. $50 at the end of year 2, $100 at the end of year 5, and $80 at the end of year 8.



b.$100 at the end of years 1,2,3,4; and $100 at the end of year 8.



c. $60 at the end of years 5,6,7,8; and $100 at the end of year 10.



d. $90 at the end of years 7,8,9.

Highest Present Value EA-11 Congrats! You have just won the lottery. The lottery board offers you 3 different options for collecting your winnings:

1. Payments of $500,000 at the end of each year for 20 years.

Assume that all earnings can be invested at 10% annual rate. Which option should you consider and why?

Highest Present Value EA-11

Congrats! You have just won the lottery. The lottery board offers you 3 different options for collecting your winnings:

2. Lump-sum payment of $4,500,000 today.


Highest Present Value EA-11

Congrats! You have just won the lottery. The lottery board offers you 3 different options for collecting your winnings:

3. Lump-sum of a $1,000,000 today and payments of $2,100,000 at the end of Years 5, 6, and 7.


Valuation

Input Market (purchase)-original, replacement

Output Market (sell)-present, fair market

Financial Statements:

• Original (Historic) Cost: Land, LT Invt – Lower of Cost or Market: Inventory

– Net Realizable Value: net AR

– Net Book Value: PP&E, Intang.

• Face: Cash, Current liabilities

• Fair Market Value (sales price): ST Invt

• Present Value: LT NR & LTL

IFRS v. US GAAP

Principles based

Rules based

Financial Accounting Fundamentals

Financial Accounting Fundamentals

Assumptions

• Economic Entity (identified and measured)

• Fiscal Period (periodicity)

• Going Concern (life indefinite)

• Stable Dollar (across time)

Measurement Principles

• Objectivity (Verifiable and documented)

• Revenue Recognition

• Expense Recognition

• Matching No More (costs & benefits)

• Consistency (methods same across time)

• Two Exceptions – Materiality –little to no effect on user decisions

– Conservatism -understate assets, overstate liabilities, accelerate losses, and delay gains (due to legal liability)

First Level = Basic Objectives

Second Level = Qualitative

Characteristics and Elements

Third Level = Recognition,

Measurement, and Disclosure

Concepts.

Overview of the Conceptual Framework

Conceptual Framework

LO 4

Conceptual Framework for

Financial Reporting

Investment by owners

Distribution to owners

Comprehensive income

Revenue

Expenses

Gains

Losses

Concepts Statement No. 6 defines ten interrelated elements

that relate to measuring the performance and financial status of

a business enterprise.

Assets

Liabilities

Equity

“Moment in Time” “Period of Time”

Second Level: Basic Elements

Economic Entity – company keeps its activity separate from

its owners and other businesses.

Going Concern - company to last long enough to fulfill

objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity - company can divide its economic activities into

time periods.

Third Level: Basic Assumptions

Measurement Principle – The most commonly used

measurements are based on historical cost and fair value.

Issues:

Historical cost provides a reliable benchmark for measuring

historical trends.

Fair value information may be more useful.

Recently the FASB has taken the step of giving companies

the option to use fair value as the basis for measurement of

financial assets and financial liabilities.

Reporting of fair value information is increasing.

Third Level: Basic Principles

Revenue Recognition - requires that companies recognize

revenue in the accounting period in which the performance

obligation is satisfied.


Expense Recognition - “Let the expense follow the

revenues.” Illustration 2-6

Expense Recognition

Full Disclosure – providing information that is of sufficient

importance to influence the judgment and decisions of an

informed user.

Provided through:

Financial Statements

Notes to the Financial Statements

Supplementary information


Cost Constraint – cost of providing information must be

weighed against the benefits that can be derived from using it.

Third Level: Constraints

Illustration: The following two situations represent applications

of the cost constraint.

(a) Rafael Corporation discloses fair value information on its

loans because it already gathers this information internally.

(b) Willis Company does not disclose any information in the notes

to the financial statements unless the value of the information

to users exceeds the expense of gathering it.

Conceptual Framework for

Financial Reporting

Summary

of the

Structure

Cash Basis Accounting

• Primarily used by individuals and small businesses.

• Not permitted for revenue and expenses measurement and reporting under GAAP.

• Under cash basis accounting, revenues are recognized only in the period when cash is received.

• Under cash basis accounting, expenses are recognized only in the period when cash is disbursed.

• Cash basis accounting Income Statement reports the cash received as revenue and the cash expenses incurred.

Accrual Accounting

• Basic to financial reporting of corporations. • Concerned with the timing of revenue and expense

recognition. • Purpose is to accurately measure revenues and

expenses (and profits) for each accounting period. • Accrual accounting’s Income Statement attempts

to match revenues earned and the expenses incurred, NOT cash flows.

• Accrual accounting’s Statement of Cash Flows reports the cash inflows and outflows for the period.

E4-16 The difference between cash and accrual accounting

Washington Forest Products began operations on January 1, 2014. On December 31, 2014, the company accountant ascertains that the following amounts should be reported as expenses on the income statement: Insurance Expense $20,000; Supplies Expense $11,000; Rent Expense $14,000. A Review of the company’s cash disbursements indicates the company made related cash payments during 2014 as follows: Insurance $29,000; Supplies $27,000; Rent $8,000 Explain why the amounts shown as expenses do not equal the cash paid. For each expense account, compute the amount that should be shown in the related balance sheet account as of December 31, 2014 (remember the company begin operations this year).





Accrual Accounting Revenues

• Revenues are recognized and recorded when they are (1) earned and are (2) realized or realizable. – Revenues are earned when the primary revenue generating activities

are substantially completed (usually the point of delivery of goods or completion of services, i.e., title passes).

– Revenues are realized when cash is collected. Revenues are realizable when a viable and measurable claim to cash is acquired. A viable claim is one that is expected to be collected under normal terms of collection.

• The actual receipt of cash is not required for revenue to be recognized, and in many cases the receipt of cash does not trigger an immediate recognition of revenue. Hence, under accrual accounting, depending on when both conditions (earned & realized) have been met, it may be necessary to recognize revenues either before, at the time, or after cash is collected, i.e. accruals, unearned.

Revenue Recognition: Text 4 Steps v. Just Released 5 Steps

1. The company has completed a significant portion of the production and sales efforts.

2. The amount of revenue can be objectively measured.

3. The company has incurred the majority of costs, and remaining costs can be reasonably estimated, and

4. Cash collection is reasonably assured.

When is revenue recognized?

Accrual Accounting Expenses

• Accrual accounting recognizes expenses when the cost of goods and services consumed expires. An expense is and expired cost; one that has no future benefit. – A cost that is associated with a future benefit is an unexpired

cost, an asset, not an expense.

• The actual payment of cash is not required before an expense can be recognized, and in some cases the payment of cash to employees/vendors/suppliers does not trigger an immediate recognition of expense. Hence, under accrual accounting, depending on when a cost expires, it may be necessary to recognize expenses either before, at the time, or after cash is disbursed, i.e. accrual, prepaid.

Accruals and Deferrals

• An accrual asset or liability is created on the balance sheet any time revenue or expense is recognized (accrued) BEFORE the associated cash flow is received or paid. Examples: Accounts Receivable, Interest Receivable, Accounts Payable, Taxes Payable.[Expense now, Pay later. OR Receive later, Revenue now.]

• A deferral asset or liability is created on the balance sheet anytime cash is collected or paid BEFORE the associated expense or revenue is recognized (deferred). Examples: Inventories, Prepaid expenses, Equipment, Unearned revenues.

Accrual Income Statement

Reported revenues include:

• Revenues collected in a prior period deferred to the current period (reported previously on the balance sheet as a liability, Unearned Revenues)

• Revenues collected in the current period that were also earned currently.

• Revenues earned (and accrued) currently that will be collected in future periods (reported currently on the balance sheet as an asset, Accounts Receivable.

Accrual Income Statement

Reported expenses include: • The cost of goods or services consumed in the current

period that were paid for in a prior period, but deferred to the current period (reported previously on the balance sheet as an asset; i.e., Inventories, Prepaid Expenses).

• The cost of goods or services consumed in the current period that were also paid for in the current period.

• The cost of goods or services consumed in the current period that will be paid for in future periods (reported on the current balance sheet as a liability; i.e., Accounts Payable).

Accrual Balance Sheet

Assets on the Balance Sheet include: • Something that has future or potential value.

• Future expenses for which cash has already been paid. (Prepaid—i.e., deferred—Expenses)

• Past revenues for which cash has not been collected. (Accounts Receivable –i.e., accrued revenues)

Liabilities on the Balance Sheet include: • Responsibilities or promises to others • Past expenses for which cash has not been paid. (Accrued

Expenses Payable) • Future revenues for which cash has already been

collected. (Deferred or Unearned Revenues)

The numbers are the numbers….but

Schlit’s Seven Accounting Shenanigans 1. Recording revenue too soon or of questionable

quality. 2. Recording bogus revenue. 3. Boosting income with one-time gains. 4. Shifting current period expenses into a later period or

earlier period. 5. Failing to record (or improperly decreasing) liabilities. 6. Shifting current revenue to a later period. 7. Shifting future expenses to the current period

through improper accruals or one-time charges.

From the Center for Financial Research & Analysis, Inc.

Bottom Line….. Accrual accounting fails to serve its intended purpose of matching revenues and expenses on the income statement and reporting appropriate amounts for accruals and deferrals on the balance sheet unless those responsible (Managers, Accountants, & Auditors) are people of integrity.

IoT: Sensor driven revenues and expenses

Issue:

Estimates from various sources indicate that from 20-50 billion sensor-

enabled devices (i.e., the Internet of Things) will exist within five years. These

sensors will provide detailed information re: equipment condition, quantity

levels, temperature readings and location data just to name a scant few of the

uses. Already devices exist to measure physical characteristics of machine

operators (e.g., heart rate, eye movement, etc.).

7 Resources: http://www.chicagotribune.com/business/breaking/ct-allstate-patent-data-0618-biz-20150618-

story.html#page=1

http://www.msn.com/en-us/adexperience/nativo?prx_t=K8MBAdR0DAYbILA

“No Thawing Allowed”, CIO, Tom Kaneshige, pg. 16-17, July/August 2015

“Big Data and Big Oil: GE’s Systems and Sensors Drive Efficiencies for BP”, Harvard Business

Review, GE, https://hbr.org/sponsored/2015/06/big-data-and-big-oil-ges-systems-a

“IoT and the Growing Use of Location Features in Business Intelligence Software”, SandHill.com,

Howard Dresner, May 25, 2015

http://www.tcs.com/SiteCollectionDocuments/White%20Papers/Internet-of-Things-The-Complete-

Reimaginative-Force.pdf

http://www.chicagotribune.com/business/breaking/ct-allstate-patent-data-0618-biz-20150618-story.html#page=1


















https://hbr.org/sponsored/2015/06/big-data-and-big-oil-ges-systems-a















http://www.tcs.com/SiteCollectionDocuments/White Papers/Internet-of-Things-The-Complete-Reimaginative-Force.pdf













Accounting IS Big Data Case

What surprised you?

• Give examples of where big data is creeping into financial statements. Which line is influenced? How big of an impact is big data having?

• Identify the unique issues of the case that came up in your discussions. What are the risks, impediments, challenges, arguments for/against IoT big data?

ID3-7 Matching and mismatching

Much has been written about accounting fraud and subsequent bankruptcy of WorldCom. The Baltimore Sun reported that the “Fraud was brazen (and) easy to spot…The scheme was not complicated: the company’s financial officers recorded routine maintenance expenses totaling $3.9 billion as capital expenditures, which can be written off over decades rather than booked as immediate expenses.” a. Explain how capitalizing an item, instead of

expensing it, affects the financial statements. b. Which principle of accounting is being violated?

Are other principles involved? Discuss.

P3-12 Revenue recognition and net income a. Assuming that Hydra recognizes revenue when the toasters are produced, how much revenue should be recognized in each of the 3 years? b. Assuming Hydra recognizes revenue at delivery, how much revenue should be recognized in each of the 3 years? c. Calculate net income for the 3 periods under each of the two assumptions above. d. If Hydra’s management is paid an income-based bonus, which of the two assumptions would be preferred? Hydra sells appliances to Seasons Department Store. A recent order requires Hydra to manufacture and deliver 500 toasters at a price of $100 per unit. Hydra’s manufacturing costs are approximately $40 per unit. The following schedule summarizes the production and delivery record of Hydra: Year 1 2 3 Total

Toasters produced 200 200 100 500

Costs incurred $8,000 $8,000 $4,000 $20,000

Toasters delivered 150 200 150 500

Cash received $10,000 $15,000 $20,000 $45,000

P3-12

E3-5 Matching and Revenue recognition

Cascade Enterprises ordered 4,000 brackets from McKay and Company on 12.1.2014, for a contract price of $40,000. McKay completed manufacturing the brackets on 1.17.15 and delivered them to Cascade on 2.9.15. McKay received a check for $40,000 from Cascade on 3.14.15.

a. Assume that McKay and Company prepare monthly income statements. In which month should McKay recognize the $40,000 revenue from the sale?

a. Justify your answer in (a.) in terms of the criteria of revenue recognition.

E3-5 Matching and Revenue recognition

Cascade Enterprises ordered 4,000 brackets from McKay and Company on 12.1.2014, for a contract price of $40,000. McKay completed manufacturing the brackets on 1.17.15 and delivered them to Cascade on 2.9.15. McKay received a check for $40,000 from Cascade on 3.14.15.

c. Are their conditions under which the revenue could be recognized in a different month than the month you chose?

d. Provide several reasons McKay’s management might be interested in the timing of the recognition of revenue.

Materiality Q: Have you ever wondered why companies… • Sometimes do not restate for the prior period when a major event occurs,

such as an acquisition, that makes current and prior years non-comparable? • Can avoid recording losses on the income statement • Can capitalize (record as an asset) normal operating expenses • Fail to disclose one-time gains or losses as separate line items on the income

statement • In short—ignore the normal accounting conventions. Q: How can you convince your independent auditor to allow your company to circumvent normal accounting conventions? • Materiality exception—the impact of recording a transaction in a more

expedient (although technically improper) way has no significant impact on the investor, normal accounting conventions could be ignored.

• Thus, prior-period financial statements need not be restated if the change is deemed immaterial; and normal operating expenses could be capitalized if the amount is insignificant.

Adapted from: Center for Research and Financial Analysis, Inc.

Interpreting Materiality Rather than relying on a numerical threshold, materiality judgments should be based on all the facts, qualitative and quantitative. The SEC’s SAB No. 99 provides certain valuable insights to help investors make material judgments. Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are whether the misstatement: • Arises from an item capable of precise measurement or whether it arises

from an estimate and, if so, the degree of imprecision inherent in the estimate

• Masks a change in earnings or other trends • Hides a failure to meet analysts’ consensus expectations for the enterprise • Changes a loss into income or visa versa • Concerns a segment or other portion of the registrant’s business that has

been identified as playing a significant role in the registrant’s operations or profitability

• Affects the registrant’s compliance with regulatory requirements • Affects the registrant’s compliance with loan covenants or other contractual

requirements • Has the effect of increasing management’s compensation—for example, by

satisfying requirements for the award of a bonus or other forms of incentive compensation whether the misstatement involves concealment of an unlawful transaction.

E3-8 The concept of materiality

All large U.S. companies have policies in which all expenditures under a certain dollar amount are expensed. Many of these expenditures are for assets, items that are useful to a company beyond the period in which they were purchased.

a. Explain the proper accounting treatment for expenditures for items that are expected to generate benefits in the future.

b. Explain why it might make economic sense to expense some of these items. Upon what exception to the principles of financial accounting would such a decision be based?

Conservatism

Conservatism in measurement and reporting –

–understate assets,

–overstate liabilities,

–accelerate losses, and

–delay gains (due to legal liability)

ID3-10 Income management and conservatism

Whitney Tilson, a noted analyst, warns investors in an article in The Motley Fool that more than any other type of company, financial companies have immense discretion regarding what earnings to report. The key is the rate of loan losses that they expect to experience, which must be estimated at the end of every period. By changing the estimate, which in turn changes one of the largest expenses on their income statement, financial companies can manage net income. Tilson specifically cites Farmer Mac, the agency created by the federal government to provide funds in the agricultural lending market, which many analysts believe smooths it earnings across time by simply changing its estimate of loss rates.

a. What does it mean to “smooth earnings across time”? How might a financial company practice this strategy, and why might it engage in this activity?

b. Earnings smoothing has also been associated with conservatism. Why?

Red Flags for Detecting Earnings Management Gamesmanship

1. Profits grow faster than cash flow 2. Sales slow while inventories pile up faster 3. Reserves (allowance) for bad debts are cut sharply 4. Ways of calculating revenue and expenses change 5. Unpaid customer bills outpace sales 6. Sales are booked before payments are received 7. Gross margins (Sales-COGS) increase or decrease

dramatically 8. Auditors, lawyers, or key executives change

From Business Week, “The Numbers Game” 5/14/01

Techniques for Detecting Accounting Abuses

Quantitative Red Flags:

• Decline in cash flows relative to net income

• Large sales growth spurts followed by declines

• Growth in receivables relative to sales

• Growth in inventories relative to sales and cost of goods sold

• Sudden changes in gross margin percentages

• Large increase in “soft’ assets such as prepaid expenses, other current assets, etc.

• Big decline in deferred revenue


Qualitative Red Flags: • Change in accounting estimates, principles, or

policies • Extension of credit terms to major customers • Changes in account classification • Change in auditors • Bill and hold arrangements • Insider stock sales • Decline in backlog • Non-monetary transactions • Related-party transactions


Monitor Change in Net Accruals on the Balance Sheet:

• Accrual assets (accounts receivable)

• Deferral assets (inventories, prepaid expenses)

• Accrual liabilities (accounts payable, accrued expenses payable)

• Deferral liabilities (unearned or deferred revenue)

Exam Instructions

Exams are designed for you to test your understanding of the BUS 512M material. Exam format is generally multiple choice questions. Once you have downloaded the exam, there can be no further discussion of the topics covered on the exam with anyone. So if you are planning on seeking assistance in preparing for the exam or if your study group is planning to discuss any of the topics, you should not download the exam until those discussions are completed. After downloading the exam, read the instructions on the cover page before answering the questions. You will also be signing an the Goizueta Honor Code Pledge.