L5,6 and 7 –FAT ( do not forget to read ) PDF

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What ever the Lecturer BOO Qin has said in the recording is on the paper with Explanations. ...

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LECTUR 5 – FAT

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Slide 2 Some stocks are not reflecting the true value, they are mispriced so we have to find them and make full use. So the financial analyst do. Accounting information will be used to understand the numbers and motive ,

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Slide 5 Those values that are not picked by the price of the stock. Short sell overpriced stock

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Slide6 What incentives Managers might have regarding the earnings quality and what does it tell? By manipulating the numbers in a way increase or decrease number which creates noise, financial analysit will undo those noise. The basic purpose is to depict the true underlying or fundamental value of the firm through accountng numbers. Therefore we have to identify areas where accounting flexibility which allows managers discretion and the policies they use to estimate to make their numbers look better.

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Slide after removing the distortions from the accounting numbers, more cxssleaner financiAl statemnets, which will be more close to the true value of the firm performance in the past and will be able to more accurately estimate the future forecast. Ration analysis: combination of numbers for better understanding. Ratio allows to forecast> for valuatioin analysis> based on future cash flows> we use forecasting > so ratio allows to build the connection between the past and future performance. Slide 12 Accounting analysis is the analysis of the earnings quality. The distorion created by the managers and the accounting standards does not allow to capture the true fundamental value of the firm. The more deviation of accounting distortions the more distorted the true value is. slide 14 Capital markets work through entrepreneur and investors. Capital market provide the channels to connect the entrepreneur and investors There is information gap between the insiders ( entrepreunuer) and the outsiders. SO they have to disclose some information , that is what the accouters job to breach this information. * Advese selection problem: one party has potential adv over the other. Insiders have more information than outrsiders, they will have adverse selection problem. If there is no accounting disclosure what would happen? Uncertainity, they will discount the busiess ideas. The investors would discount the offerto 75%. The

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entreprenuers wll walk away.The bad ideas will remain. The capital market will collapse because all bad ideas would be there . Will distroy all the confidnece. So this is the imp of the accoutning disclosure by the managers to picture their idea

slide 15: Acc inf is not oerfect, it is fraud info. Because it is based on accrued accounting When we book our revenue and expenses, they do not co insides with receipts( casH) You estimate the acc recievable and so you make the provisions( made by managers), its their discretipn on the estiamtion. The mangers might use the discretuion in bad or good way. slide 16: Managers might serve the shareholders interest or might have their own interest . By doing that they will distort the financial info slide 17: accounting numbers can be fraud by management manipulation , can be deviating fro mthe true value. Financial analyst will use the fiannial reports as analytical tool to find the fundamental value of the firm

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slide 18: How accounting standards make noise? Internally generated goodwill is not recognized as assets, but they are value relevant , speak to the future cash flow. Other eg firms investment in maintenance , Rnd and marketing . Speak to future cash flow. Infact they are expensed. ( deflate the profit) so that’s the noise creasted by accounting rules/ Managers have incentive to serve their interest or shareholdeers interest for eg the depreciation methods. That will lead to different income Managers can also change by estimating the accruals such as provision for Doubtful debts. gIve rise to distortion Transactions timings : purchase the advertisment next year or this year will have the dif on the earnings > numbers not reflecting the fundamental vlaue

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slide 20 : How usefeull is the informatuon that is not available to the public. They are vlaue relevant if the the market reaction is huge. Market may not be that efficient. If they were efficient the market should be already reacted upon the information . So the new information created value. Decompose the financial informations and have a look at the implications of those earnings. * We use the fraud info to clean them up, where managers have incentive or standards created the distortions. This is the whole framework’

Slide 24:  Earnings management have nothing to do with the cash flow and reported earnings  It is the accruals that have the effect on the cash flows  Choice of managers is earnings management  For eg the investing activity to invest now or later will have an affect on the current performance that is earniungs and also will affect the future as the advestiment will today will allow more cash to be flown in future  Accounting choices are less imp because they ahave nothing to do on the future cash flow.

Slide 25 :  Accounting standards give managers within the range : which are set by standards> they can push it . if they push very forward and violate rules is called FRADULENT Accounting. SLIDE 26  by increase the useful life, the expense is decreased and the earnings increased.  Doesn’t mean every firm are doing it  When you change the policy you have to disclose everything , and how would you justify the choice  Its hard to justify the choice.  That why firms do not change and hence theyt have the sticky pruposes. Slide 27 :  Before providing the service the computer associates recorded the revenues.  Therefore they received the over estimation of accounts rec .  Whereas on the expense side the del under booked the warranty Slide 28 : Why do firms do this? ACCRUAL ACCOUNTING:  Accruals does not have persistence than cash flows  There is no effect on the firm share price because it doesn’t affect the cash flow. They are not value relevant Why do managers still do it?  Investors do not understand the components of reported earnings > decomposed into accruals and cash. ACCRUAL ANOMALY  If company Reporting too much positive accruals the investors fixate on those accruals and believe that those accurAls will persist inot the future cash flow, and reach more positively. Likewise if reporting too much negative accruals.  Later investors find that they over reacted to the accruals and hence the price will be reacted. What is Earnings management? why managers do it? how bad is it for the firm. 

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If the managers estimate the ACC REC higher than what they truly know, wil result in reporting less exp for higher Earnings. The managers then have to write off next year, THAT Is that accruals have to be reversed. That’s why you look the earnings for the firm for more periods and not just one period and study the accruals

Slide 30  How managers classify those income’s and expenses:  How to make the operating income look good  By shifting the operating cost ( one off) under restructuring chargers you expect that market can distinguish between non persistent and persistent costs and hence market would underreact and shareprice will not be dropped. Managers have the tendency to do it. Slide 31:  Real earnings management:  OPERATING :  Manipulate their earnings by giving discount to customer to boost your sales > but you hurt your profit margin. Its hard to reverse it. Real effect on the future cash flow.  Or you provide enough credit > will increase the accruals > beacsue of the high risk of not receiving cash .  Overproduction will allow managers to reduce the cost by spreading it out the number of units.  FINANCING  Debt early repayment > in order to reduce the interest expense you repay the debt> but you limit the growth  INVESTING  Timings of the sale of capital assets : when you want to boost your earnings you sell which might not be in the best interest of the shareholder

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GENERAL discussion Managers find it easy to manipulate their earnings than the accounting policies> because of more disclosure to public of the change. Real earnings management is much easier

Slide 32  Big bath :  The managers take a big bath in the bad year to make the future years look more better > making more write offs, provisions. They make the bad year look more worse  “ Income smoothing : purpose is to shift the earnings to make the volatility lower “ – lecturer  managers move the future earnings into this year , the purpose is to make the earnings to look better year by year because it will be appreciated by the market that earnings per year is gradually increasing .

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MOTIVES FOR Earning Management: THE PURPOSE OF THIS LECTURE CONTRACTUAL: REGULATORY: to avoid regulators, such as taxation regulation, managers have the incentive to report lower earnings. When companies are growing the politics will exploit in one way or the other. CAPITAL MARKET : The local firms in the country which are faced competition from the foreign companies use earnings management to report lower earnings to gain govt sympathy and take advantage of govt benefits and grants

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CONTRACTUAL INCENTIVES BONUS PLAN HYPOTHESIS Look at the slide diagram> the 1m has a bonus of 30k, then linearly related to the firms earnings to the cap of 2.5m firm earnings The starting point is the bogey point Managers is very rational to miximise the cash bonuses. If the earnings are below bogey point, managers will take a bath because they understand that they will have REVERSAL of accruals so this is the time to write off all the negative accurals while will also enable the mangers to max bonus next year.

Slide 35: DEBT COVENANT HYPOTHESIS LISTEN IT FORM 40:00 lecture 29 march Slide 36: Slide 42 :  Prospect theory: decision making of prospect theory. Investors utility will drop marginally if they see moral loss. 43 : Other incentives of EM :  To impress the investors or attract investors to select the management on the board.  Union Contract negotiations : to make a point at union contracts(employees), Em can be used to deflate the Earnings to show that we cannot our employees our wage because we have a loss. 44 :  How Can we detect Earnings management  Analyse Financial Statements LOOK at normal levels of accruals , then we can subtract the total from the normal levels then we can use it (discretionary or abnormal ) accruals to identify the Earnings management  The second approach is to use some financial ratio:

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Error term in the slide 45 is the discretionary accruals.

46 : it is difficult to understand the normal level of accruals. Also it is difficult to identify and differentiate between real activity earnings management from real strategic decisions. It is easier to justify the real activities so managers often use more for Earnings management . 47: two sides of Earnings management: Bright side : efficiency argument  Firm value maximization  Reduces contracting costs  Signaling the inside information The dark Side :  Managers can use to it maximize their payoff 48 : VALAUTION PERSPECTIVE :  If managers are using EM to facilitate the valuation perspective  It’s difficult to convey the inside info to outside info especially for large firms due to complexity.  However management has the responsibility to convey the inside info  Its hard to convey the good news, they going to introduce the competition  It will be costly for management  So They use Earnings management.  As a result they report higher Earnings to predict higher future cash flow. So they signal that there is good news coming up.  Market should also know, if Managers use EM without any reason, mangers will be foolih because it accruals cannot be used consecutively. They will report the earnings that can be sustained Contracting perspective : To give managers some flexibility in the face of rigid and incomeplete contracts Firms have Their contracts signed between Debt covenant > because the violation is costly aswell. So it makes sense to inference the reported earnings. Same applies to bonus contract > managers are compensated for bearing some risk > shareholders can diversify by diversified portfolio. But mangers have undiversified portfolio. They Are very much tight. If accounting numbers are volatile through economic conditions or regulatory. Then by giving the discretion’s , then EM will allow company to save cost for not compensating for the risk . Slide 50BAD EARNINGS MANAGEMENT: Good slides itself

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High quality audit Regulation and contracting terms Strong corporate governance: strong board

Consequences of Earnings management : 1) smooth earnings >convey inside info and minimizing adverse selection problem (one party has advantage of info than other) 2) Also can allow to reduce Costs such as debt covenant contract violation costs .

Lecture 6 Slide 3  Managers have incentive to manipulate earnings  Reversal ( week 5 off recording)

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How its relates to other steps? How its related to accounting analysis : the input of financial anlaysis is the output frm accounting analysis ( week 5) We will asses the firm performance in the past : if the managers have reported distorted info so we have the wrong input for financial analysis . In cash flow we will look at the operating, financial activities where we will study how managers can manipulate for earnings management. The value of the firm is the NPV; discounted future cash flows. Risk factors are relativey simple, for future cash flow? Need connection between previous and future cash flows, so we will use condensed balance sheet for forecasting purpose

Slide 4  Ratio analysis  Ratios are not absolutes values of accounting numbers  To assess the firm performance

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To project into the future By using absolute values : the big firm have big sales number so they have huge COST of sales, high profit in absolute firm when we have to compare with the small firm , for comparision of apples to apples we need ratios Cashflow anlayisis To understand what cash flow is ? ifa 1 Operating activities, investing and financing activites: how firm is doing day to day basis Also can understand the liquidy, how much cash flow is available to invest? Any left over cash ? to pay debt for eg, or does the firm still requires equity To understand better firm performance and value of the firm ‘

Slide 5 :  For valuation purpose we need ratio analysis  Firm value is dertemined by growth rate and profitability  To get this future cash flow we need to read the statement  The we need growth rate between todays earnings and future earnings  Financial analysist have to know how to read the rates  Profitability : we nee to know how to generate more earnings  Slide 6 and 7 :  How do we know is the best ratio to anlayse? Attributes? To connect the underlying activities> then we can get way to improve them  Slide 7  Return on equity:  Why is imp? Which item you specifically look into ? we look at PNL . why ? firms profitability summaries the activities in the past . This tell you a lot about the firm . where does the Investors get return? You get stock return … the rise in the price pf share (capital gain) .. dividend is the gain as well …  Why would you be interested in earnings?  Share price have reaction in earnings because it affects share price and market response to earnings  Transfer of wealth from firm to shareholder is known as dividend, it is only given when the firm has profits. The higher the profit the higher the dividend.  Why do we divide net income by shareholder equity ? in accounting term it is the investment of the shareholder.  If you divide net income by shareholder equity you get the return on equity  That’s your return on investment in the firm  Ratios can be used time series (same firm but across years) and cross sectional (same time but similar different firms.    

Slide 9 What is the benchmark for ROE? We have to think about the return and cost .. Earnings is the return.. What is the cost of equity ? next week lecture

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Decompose ROE : The firm component is the net profit over assets and the second is the assest over equity ROA * financial leverage we will have ROE Return on assets : tells you about how much profit for each dollar of assets.. the higher ratio the higher efficiency of the use of the asset Doesn’t make much sense without decomposing because the denominator has equity. why would you want to reduce shareholder equity .. no you don’t You need financial leverage to improve your return on equity .. the m0re debt you can use the higher return you can get from the assest . That how you improve the ROE Operations are alos important .. Furture decompose ROE..

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Return on assets is decomposed by using the sales figure The net profit margin : efficiency measurement for your operations The slaes over assest is asset turnover: how many dollars of sales you can deploy into profit. The dollar figure Total decomposition is the net profit margin( effeicency of operations) * asset turn( efficiency of asset measurement into sales) over * financial leverage ( to what extent you use debt financing to get your return) This is also known as DUpont analysis. Libility over equity : to what extent the debt financing relative to equity ANSWER questions on how to improve ROE of profit

Slide 12:  The ultimate goal is to value of the firm .. understand the currenct and future cash flows .. the growth basically .. profitability  Two strategies :  Product market strategy : Operating management( operating effecienceis) and investment management (managing working capital and FA)  Financial market policies ; financing and dividend policy  This slide is explained ( broken up)  Mangement of dividend policy 

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Higher ROE of loere is because of the better financial leverage because of better capital structure and the better effeceincy in the assets

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Drawbacks with the Dupont analysis Come up with new equation to solve the drawbacks

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Who have the right to claim of the asset (debt and shareholders) when in time of liquidation (denominator) 1) Whereas the numenator the net profit (earnings) the claimant is ONLY the equity holders (so debt holders are left ) mismatch problem .. denominator include both while the numenator only include claim for equity holders. if you ROE is a flawed component In order to improve ROE you have to improve financial leverage and return on assets Net profit margin measures the efficiency with operations Sales/ asset > how efficient in translating ( each dollar assest) in dollors ^^ yellow part repeated 2) Different returns for operating and investment assests but in the formula we cannot differentiate , and hence we cannot determine the driver of our earnings or returns 2 ) Which assest will generate a higaher return ? operating assest( inventory, working capital or ) (Financial assest > govt bond) .. generally operating assets generate higher return .. if your business is not recieveing more return than financial investment (shares), u would rather sell your capital assest and invest in other firms.. 3) part of income related to cost of financing also...