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Advanced Financial Accounting, Week 7 Notes

by: Kwan

Advanced Financial Accounting, Week 7 Notes BU.201.650.53.SP16

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Advanced Financial Accounting
David He
Class Notes
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This 10 page Class Notes was uploaded by Kwan on Tuesday March 1, 2016. The Class Notes belongs to BU.201.650.53.SP16 at Johns Hopkins University taught by David He in Spring 2016. Since its upload, it has received 72 views. For similar materials see Advanced Financial Accounting in Finance at Johns Hopkins University.


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Date Created: 03/01/16
Advanced Financial Reviews Chapter 1: Know the six steps in Financial Statement Analysis (especially steps 1 and 2) I. *Identify economic characteristic and competitive dynamics in the industry A. Value chain analysis 1. Research 2. Approval by regulations 3. Manufacture 4. Create demand 5. Distribution to customer B. Porter’s five forces 1. Rivalry: concentrated or diffuse a. Greater concentration, lower the competition and more profitable the firms will be 2. New entrants: entry barriers? a. Do existing rivals have distinct competitive advantage to create entry barriers? 3. Substitutes a. Close substitutes will increase competition and decrease profitability 4. Buyer power a. Relative number of buyers and sellers in the industry b. Leverage buyers have with respect to price (elasticity) c. Are buyers price takers or price setters? 5. Supplier power a. Leverage in negotiating input prices from suppliers b. Few suppliers will have greater power in setting prices C. Economic attributes framework 1. Demand 2. Supply 3. Manufacturing 4. Marketing 5. Investing & Financing II. *Identify company strategies A. Framework for strategy analysis 1. Nature of product/service a. Product differentiation b. Low-cost leadership strategy 2. Integration within value chain: controlling or outsourcing? a. Manufacturing b. Distribution 3. Geographical diversification: domestic or global? 4. Industry diversification: operating in single industry or diversified? III. Assess the quality of the Financial Statements A. Income statement B. Balance sheet: A=L+SE C. Statement of cash flows D. Statement of stockholder’s equity are required E. Statement of comprehensive income IV. Analyze profitability and risk (lecture 3,4) A. Common-sized financial statement B. Percentage change financial statement 1 C. Ratios 1. Profitability: EPS, ROCE 2. Risk: current ratio, debt-to-equity 3. Project future financial statements D. Rely on assumptions E. quality of decisions rest on the reliability of the forecasts F. basis for valuation model V. Value the firm (Ch12-14, Lecture 7) A. Dividend B. Earnings cash flows C. Market Chapter 2: I. Asset and Liability Valuation - Primary Valuation Alternatives: Historical Cost versus Fair Value A. Historical cost 1. Acquisition cost: include all costs required to prepare the asset to use (i.e. shipping) 2. Adjusted acquisition cost: PPE and other depreciable assets 3. Initial present value: bonds, long-term receivables and payables B. Fair value 1. Exit price (FASB requirement) or entry price 2. Based on current replacement cost or net realizable value (current probable sale price) a. Current replacement cost example: long lived assets 1) Generally applies to nonmonetary assets b. Net realizable value example: inventory (lower cost or market) 1) Shares features of adjusted historical cost II. Income Recognition A. Approach 1: Historical Value (usually applies to HTM investment) 1. Maximum reliability 2. Recognition in B/S: when realized in market transaction (no adjustment) 3. Recognition in I/S: when realized in market transaction (no adjustment until sale) 4. Nature: traditional B. Approach 2: in between (usually applies to AFS investment) 1. An attempt to incorporate the benefits of relevant and timely fair values on the balance sheet while minimizing net income volatility 2. Recognition in B/S: when changes over time (adjustment) 3. Recognition in I/S: when realized in market transaction (record in OCI) 4. Nature: hybrid C. Approach 3: Current Value (usually applies to trading investment) 1. Maximum relevance and timeliness 2. Recognition in B/S: when changes over time (adjustment) 3. Recognition in I/S: when changes over time (adjustment) 4. Nature: conservative 2 Chapter 3: I. Purpose of the Statement of Cash Flows A. Provide key insights into 1. Three sections logically corresponding to generate profits 2. Cash flows to and from the entities 3. Can be combine with other statements to assess overall quality of F/S II. Cash Flow Activities and a Firm’s Life Cycle (pg. 151-154) A. Cash flow activities −∆????????????ℎ = ∆???????????????????????????????????????? + ∆????????????????????ℎ???????????????????? ???????????????????????????? − ∆???????????? − ????????????ℎ ???????????????????????? 1. OCF 2. ICF 3. FCF B. Life cycle 1. Introduction a. Revenue low, negative net income b. Positive CF from financing 2. Growth a. Increasing revenue, positive net income b. Increasing OCF and decreasing positive CF from financing 3. Maturity a. Peak revenue and net income b. CF from investing increases, FCF negative 4. Decline a. Revenue and net income decreases b. OCF decreases, FCF negative, ICF positive III. Understanding the Relations Among Net Income, Balance Sheets, and Cash Flows A. OCF methods 1. Direct method 2. Indirect method a. Type1: Non-working capital accounts adjustment (depreciation, amortization, differed tax, G/L from disposition of assets, impairment) b. Type 2: Adjustment for changes in WC accounts (CA and CL) B. Net income relative to OCF 1. Type 1 adjustment increase CF over net income (OCF>NI) 2. Type 2 adjustments’ effect depend on a. Firm stage in life cycle b. Length of firm’s operating cycle Chapter 4 (Very Important): I. Overview of Profitability Analysis Based on Various Measures of Income A. Profitability analysis Helps to develop an understanding of a firm’s performance to enable forecasts of future performance 1. Measure net income Approaches: a. EPS analysis – only ratio that GAAP requires to disclose ???????????? ????????????????????????−???????????????????????????????????? ???????????????????? ???????????????????????????????????? 1) ???????????????????? ???????????? = ????????????????ℎ???????????? ???????????????????????????? ???????????????????????? ???????? ???????? ???????????????????????????????????????????? 2) Diluted EPS ▯ reflects the dilution potential of convertible securities, options, and warrants 3) shortcomings: ▯ EPS does not consider the amount of assets or capital required to generate a particular level of earnings 3 ▯ Two firms with the same earnings and EPS are not necessarily equally profitable b. Common-size analysis – enable comparison across firms and time c. Percentage change analysis – focus on changes in individual line items d. Alternative definitions of profits 2. Rate of return metrics a. Return on total assets b. Return on common equity II. Return of Assets – measure operating performance independent of financing A. General ???????????? ???????????????????????? + 1 − ???? ∗ ???????????????????????????????? ???????????????????????????? ???????????????????????????? ???????????????????? ???????????????????????? 1. Measures ongoing profitability 2. Unusual items may be removed, net of tax 3. Does not consider financing decisions B. Disaggregating ROA ???????????????????????????????? ???????????? ???????????????????????? ???????????????????? ???????????? = ???????????????????????? ???????????????????????? ∗ ???????????????????? ???????????????????????????????? = ∗ ???????????????????? ???????????????????????????? ???????????????????? ???????????????????????? 1. ROA is an incomplete measure of economic rates of return 2. Operating leverage (FC vs. VC), cyclicality of sales, product life cycle are elements of risk that changes ROA over time. 3. Relative mix of profit margin and assets turnover in ROA a. Due to microeconomic theory (different nature of product/industry) b. Company strategy III. Return of Common Shareholders’ Equity (ROCE) Consider cost of debt and preferred stock financing A. General ???????????? ???????????????????????? − ???????????????????????????????????? ???????????????????? ???????????????????????????????????? ???????????????????????????? ???????????????????????? ???????? B. Disaggregating ROCE ???????????? ???????????????????????? ???????????????????? ???????????????????????????? ???????????????????? ???????????????????????? ∗ ∗ ???????????????????? ???????????????????????????? ???????????????????? ???????????????????????? ???????????????????????????? ???????????????????????? ???????? IV. Economic and Strategic Factors in the Interpretation of ROA and ROCE A. Microeconomic theory 1. Capacity constraint (heavy fixed capacity cost) a. Upper limit on size of assets turnover achievable b. Only way is to increase profit margin 2. Competitive constraint (commodity-like) a. Upper limit on achievable profit margin b. Only way is to achieve high asset turnover 1) Control costs with aggressively low prices to gain market share B. Business strategy 1. Product differentiation: obtain market power over revenue 2. Low-cost leadership: achieve higher sales volumes V. Analyzing Total Assets Turnover Captures how efficiently assets are being utilized to generate revenues A. Turnover ratios provides insight into changes in total assets turnover 1. Account receivables turnover (convert into cash 2. Inventory turnover (length of time needed to produce, hold and sell) 3. Fixed assets turnover (Sales vs. PPE) 4 Chapter 5 (Very Important): I. Analyzing Financial Flexibility by Disaggregating ROCE A. Disaggregation of ROCE 1. When’s good to have debt: If ROA > Cost of capital, then ROCE > ROA 2. Provides insight about degree of benefit derived from using leverage 3. Financial leverage/ Financial flexibility can enhance return to shareholders but suggests greater financial risk (default risk and sales fluctuation) 4. Only need to know terms and their impact on ROCE and risk a. ROCE = operating ROA + (leverage ∗ spread) b. ???????????????????????????????? = ???????????????????? ???????????????????????????????????? ???????????????????????? ???????????????????????? ???????????????????????????????????? ????????????−???????????????????????????????????? ???????????????? c. ???????????????????????? = ???????????????????? ???????????????????????????????????? II. Short-Term Liquidity Risk A. Based on operating section of financial statement B. Measure a firm’s ability to generate sufficient cash to supply operating working capital needs (operating cash outflow) and to service debts (current liability) C. ST liquidity risk arise from 1. untimed cash inflows and outflows (time lag between income received and cash received) 2. high degree of long-term leverage 3. financial statement ratios CA a. current ratio = CL b. quick ratio = cash+MS+receivables CL c. operating cash flow to current liabilities ratio 4. working capital activity ratios a. A/R turnover b. Inventory turnover 1) Accounts payable turnover III. Long-TermSolvency Risk A. Examines a firm’s ability to make interest and principal payments on long-term debts and other obligations B. Three measures 1. Debt ratios: higher the greater risk a. Debt-to-asset b. Debt-to-equity 2. Interest coverage ratios a. Times interested earned 3. Operating cash flow to total liabilities ratio IV. Bankruptcy Risk A. Bankruptcy prediction models using multiple discrimination analysis (MDA) 1. Altman’s Z-score a. High probability of bankruptcy: Z < 1.81 b. Gray area: 1.81-3.0 c. Low probability: Z > 3.0 B. Factors for bankruptcy 1. Investment a. Asset turnover rate 5 b. Liquidity of assets (current asset %) 2. Financing a. Proportion of debt b. Proportion of short-term debt 3. Operating a. Level of profitability b. Variability of operations 4. Others a. Size b. Growth/stage/trend 5. Qualified audit opinion Chapter 6 I. Accounting Quality A. “What to include and what not to include?” B. Fair complete representation of firm’s performance, position, and risk C. Provide relevant information for forecasting future earnings and cash flow D. High accounting quality 1. Reflect economic information content a. Involve subjective estimates – must be reasonable (ex: useful life) b. Informative disclosures are important 2. Leads to earnings persistence over time II. Earnings Management A. Incentives to practice earnings management (always unethical, but not necessary illegal) 1. Earning-based bonuses 2. Job security (smooth earning) 3. Debt financing B. Deterrents – rising issues 1. Ethics (trust with investors) 2. Regulation III. Specific Events and Conditions That Affect Earnings Persistence A. Infrequent items 1. Discontinued operations a. Separable business with distinguished operations and cash flows b. Measurement date vs. disposal date 2. Extraordinary items a. Unusual in nature b. Infrequent c. Reported net of tax d. Included on OCF 3. Impairment losses a. No cash flow effect b. Firms do not require to test every asset except goodwill and intangibles 4. Restructuring charges a. One-time, strategic decision b. Some firms take all at once, some spread it across years 6 5. Change in accounting principles a. Adjust current and prior years records in order to compare on a same standard b. Consistency is important 6. Change in estimate a. May raise earning manipulations- subjective Chapter 7 I. Equity Financing A. Investment by shareholders 1. Common equity a. Measurement: Fair value into Common Stock (par) and APIC b. Character: Residual upside and downside risk 2. Preferred stock a. Measurement: Fair value into Preferred Stock (par) and APIC b. Character: May be converted into CS or callable at schedule date B. Distribution to shareholders 1. Dividends a. Dates 1) Declaration (dr. R/E cr. Dividend payable) 2) Record (n/a) 3) Payment (dr. Dividend Payable cr. Cash) b. Forms 1) Cash, scrip, and property dividends: reduce R/E and asset 2) Stock dividends: no change to R/E ▯ Small stock dividend (<20-25%) ▯ Stock split: affect only # of shares, not total Equity 2. Share repurchases a. Purpose: Company buys back shares to distribute to service options, to decrease debt- financing weight, to signal undervalued stock, or to have higher voting powers over investors b. Treasury stock: stock repurchased for reissue at a later date Cost method: 1) At repurchase, cash disbursement and increase in treasury stock account 2) At subsequent issue, increase/decrease APIC when reissue price not equal treasury cost C. Equity issued as compensation 1. Stock options a. Benefit for employer: : No use of cash, use as part of sign-on or retention package for employees b. Benefit for employee: Exercise at a later time if stock price increases above exercise price II. Exhibits 7.2 and 7.3. 7 Chapter 8 I. Investment in Long-Lived Operating Assets A. Long-lived tangible fixed assets 1. Asset recorded at fair value= cash paid + fair value of debt + fair value of lease payment 2. Capitalize expenditures that increase service life beyond original life 3. Expense repairs & maintenances- subjective B. Amortizable intangible assets 1. Internally incurred R&D costs are expensed (reduce NI, record in OCF) a. EX: software research cost- expensed until feasible- subjective; self-construction cost- up until fair value in the market 2. Externally acquired R&D are capitalized (b/c it has a price) C. Non-amortizable intangible assets II. Choices making to allocate acquisition costs to periods benefited A. Steps to allocate M&A purchase price 1. Fair value of identifiable tangible assets & liabilities 2. Identifiable intangible assets 3. Remainder allocated to good will B. Managers make three primary choices 1. Choose an allocation method a. Depreciation: tangible assets b. Amortization: intangible assets c. Depletion: natural resources 2. Estimated useful life 3. Estimated salvage value Only relevant calculation from this Chapter: “Average Total Estimated Useful Life of Depreciable Assets” Chapter 9 I. Revenue Recognition A. Criteria 1. Firm has provided all or substantial portion of product or service 2. Firm has received an asset or satisfied a liability with a value measurable with reasonable precision II. Expense Recognition A. Product cost: matching principle with revenue (ex: COGS) B. Period cost: not directly associated with revenue (ex: SG&A) C. Cost-flow assumption 1. LIFO: provide low, out-of-date inventory values, therefore results a poor indication of actual inventory turnover rate-> analyst concerned and make adjustments 2. FIFO: not very accurate reflection of COGS based on market value; results in highest NI and highest inventory value 3. Weighted average: most recent, higher price receives greater weightage in cost 8 Chapter 10 (Very Important) I. General principles – produce reliable and realistic expectations 1. Assumptions must be internally consistent 2. Forecasts must rely on externally valid assumptions II. Seven-step forecasting game plan A. Steps are integrated and interdependent, but not necessarily sequential or linear 1. Project revenues from sales and other revenue a. Determined by price and sales volume 2. Project operating expenses a. Fixed vs. variable components 3. Project operating assets and liabilities a. Forecast based on operating activities projected (step 1- turnover based) 4. Project the financial leverage and capital structure a. Project effects of financing on net income b. Consider leverage strategy and maintain a particular capital structure 5. Project non-recurring items, provisions for income tax, and changes in R/E 6. Check whether the projected balance sheet is in balance a. Projected assets less projected liabilities and SE=amount of adjustments 7. Derive the projected statement of cash flows B. Quality will depend on assumptions 1. Analyst should perform sensitivity analysis on forecasts III. Shortcut approach to forecast (only if firm is stable and mature) A. Projected sales and income approach a. Use recent sales growth b. Use recent profit margin B. Projected total assets approach a. Use historical asset growth rate or total assets turnover ratio IV. Sensitivity analysis A. Can be used to assess sensitivity of firm’s liquidity and leverage to key assumptions B. Can be used to assess the impact of new announcements Chapters 12 (not so important) I. Cash-flow based approach A. Value of an investment is present value of projected future payoffs 1. Dividends-based valuation a. Periodic dividend payments b. Stock buybacks 2. Cash-flows-based valuation a. Focus on cash that flows into the firm b. Measures the cash flows that are “free” to be distributed to investors 3. Free-cash-flows-valuation a. Advantages: 1) free cash flows are believed to have more economic meaning than earnings 2) focuses directly on net cash inflows available to be distributed to capital providers b. disadvantage: 1) time-consuming and costly 2) sensitive to assumptions growth (subjective) 3) must be internally consistent with long-run assumptions regarding growth and payout 9 Chapter 13 (not so important) I. Earnings-based approach A. Earnings: 1. primary measure of firm performance under accrual accounting system 2. direct impact on capital markets and pricing of shares B. Value relevance of earnings (normal earnings) C. Residual income valuation 1. in theory: excess earnings over required earnings ???????????????????????? ???????????????????????????????? − ???????????????????????????????? ???????????????????????????????? = ???????????????????????? ???????????????????????????????? − (???? ∗ ???????? ???? ????−1) ???? = ???????????????????????????????? ???????????????? ???????? ???????????????????????? = ???????????????? ???? ???????? ????−1= ???????????????? ???????????????????? ???????? ????ℎ???? ???????????????????????????????? ???????? ????ℎ???? ???????????????? II. Sensitivity analysis 1. Estimates inversely related to discount rate 2. Estimate positively related to growth rate III. Potential causes of valuation errors A. “Dirty surplus” accounting (OCI) B. Advantages and concerns 1. Earnings align closely to capital markets and management’s focus 2. Residual income valuation is easy computation 3. Earnings are not as reliable or as meaningful as cash or dividends 4. Accrual accounting does not reflect underlying economic value Chapter 14 (not so important) I. Market-based approach A. Market multiplies: shortcut valuation tools 1. MB does not imply value of firm, need to compare with ratios of other companies B. PE ratio ???????????????????????????? ????ℎ???????????? ???????????????????? ???????? = ???????????? ???????????? ???????????????? ???????????????????????? ???????????????????? ???????????????????????? ???????????????? 1. Advantage: quick and efficient way to value of a firm 2. Disadvantage: compare data from two different periods (current share price vs. historic EPS) 3. Solution: forward PE ratio is more logical as it sues a forecast of future EPS 4. Factors causing PE to differ across firms a. Risk, cost of capital b. Growth and profitability c. Accounting measures 10


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