Week 1 Lecture. Framework - Business Analysis

Transcription

1 ACCT30001 Financial Accounting Theory Weekly Summary - Week 1 Lecture Page 1 of 4 Week 1 Lecture What Is Accounting? Based upon economic activity, accounting judgements are made from shades of grey not black and white. Then, useful information is generated for good decision-making which consequently influences economic activity and accounting judgements. We are in an information business. Framework - Business Analysis Business Strategy Analysis (see self-study) Assumed firm s objective is to earn a return on capital in excess of its cost of capital which is determined by its own strategy choices: industry choice, competitive positioning and corporate strategy. Thus, business strategy analysis involves: the importance of industry-level analysis, competitive strategy analysis of the firm and corporate strategy analysis for multi-business organisations. Accounting Analysis (Quality of Earning Analysis) Purpose: to evaluate the degree to which a firm s accounting captures its underlying business reality through identifying areas of accounting flexibility, evaluating appropriateness of accounting policies and estimates and undo any apparent distortions. Financial Analysis Purpose: to evaluate current and past performance and assess its sustainability. Ratio analysis: to evaluate a firm s product market performance and financial policies. Cash flow analysis: to evaluate a firm s liquidity and financial flexibility. Prospective Analysis The process to forecast future payoffs: business strategy analysis, accounting analysis, financial analysis and fundamental (intrinsic) value.

2 ACCT30001 Financial Accounting Theory Weekly Summary - Week 1 Lecture Page 2 of 4 Purpose: to estimate fundamental (intrinsic) value of a company (or share). Basis: present value theory (time value of money). Firm's value can be assessed based on the current book value of equity, the future return on equity (ROE) and growth. Financial Statements Analysis Financial statements provide investors and other stakeholders with data on listed companies economic activities, in order to assess the firm and managers plans and performance. Financial statement analysis is used when mangers have complete information on firm s strategy but is unlikely to fully disclose the information due to variety of institutional factors. Managers inside information is a source of both value and distortion in accounting data. FSA attempts to get managers inside information. Key Aspects of FSA: Understanding the influence of accounting system on the quality of the financial statement data being used in the analyses. Financial Reporting in Capital Markets In a capitalist economy, matching savings to business investment opportunities is complicated. 1. Entrepreneurs typically have better information than savers on the value of business investment opportunities. 2. Entrepreneurs communication to investors is not fully credible due to incentive of value inflation. 3. Savers lack the financial sophistication to differentiate among various business investment opportunities. Intermediaries can help to resolve these problems. 1. Financial intermediaries: venture capitalist, bank, collective investment fund, pension fund, insurance company, etc. 2. Information intermediaries: auditors, financial analysts, credit-rating agencies, the financial press, etc. 3. Regulatory intermediaries: ASX, ASIC, taxation, government, etc. Accounting System Features Accrual accounting is used for corporate financial reports which deals with expectations of the future cash consequences of current activities. Thus, it is subjective and based on various assumptions. - Accounting conventions aimed at limiting bias: measurability and conservatism. - Uniform accounting standards - Auditing which verifies the integrity of reported financial statements - Legal environment which affects the accuracy of disclosures Efficient Market Hypothesis The presumption that stock prices will at all times fully reflect relevant information including past prices (weak form), publicly available information (semi-strong form) and all information (strong form). To evaluate efficiency: to see if abnormal (risk adjusted) returns can be made from exploiting the inefficiency. Technical Analysis (Chartism): the assessment of a firm s prospects using recent/past share price movements to predict subsequent changes Fundamental Analysis: the assessment of a firm s performance and prospects using published financial statements and possible other forms of publicly available information. Important Concepts and Definitions Insider trading: the use of privileged (non-public) relevant information for share trading. i.e. Airbus Group Agency theory: the analysis of the relationship between agents (e.g., management) and principals (e.g., shareholders) which acknowledges that the two parties may have divergent objectives and that the principal may incur monitoring or contracting costs to control the agent. i.e. Enron, Worldcom Information asymmetry: acknowledgement that one party (e.g.,a firm s management) will have access to privileged information not available to others (e.g., shareholders, fund managers and financial analysts). Signalling: the method by which informed individuals pass information to others by their actions. For the signal to have credibility it must be costly to the signaller if untrue. Management: may be concerned to stabilise share prices, and manage information flows. Investment analysts: seek to stimulate trading and attract corporate finance business through building reputation. Fund managers: want to beat the market and to minimise costs. Investors: looking to maximise return and minimise risk.

3 ACCT30001 Financial Accounting Theory Weekly Summary - Week 1 Lecture Page 3 of 4 Self-Study (Business Strategy Analysis) From Business Activities to Financial Statements the Importance of Industry-Level Analysis A firm s strategy is heavily influenced by the industry it belongs to. Understand the environment and competitive forces within the industry helps evaluate the quality of the particular firm s strategy. Porter s Competitive Five Forces Three forces from horizontal competition 3 forces from vertical competition

4 ACCT30001 Financial Accounting Theory Weekly Summary - Week 1 Lecture Page 4 of 4 Competitive Strategy Analysis of the Firm Two basic competitive strategies: Cost Leadership and Differentiation Choice of Strategy is an important first step for a firm. The likelihood of achieving and sustaining competitive advantage must be evaluated. Factors to evaluate include: Resources and capabilities to implement strategies. Whether the firm s activities, infrastructure, and other operating elements are consistent with its competitive strategy Corporate Strategy Analysis for Multi-Business Organisations Companies with multiple business segments require an analysis of how the separate segments are managed within the corporate governance structure. Factors to analyse include: transaction costs, specific benefits to operate under corporate group. Accounting misrepresentations often come in the wake of strategic mishaps and are aimed at portraying business as usual

5 ACCT30001 Financial Accounting Theory Weekly Summary - Week 2 Lecture Page 1 of 5 Week 2 Lecture Accounting Analysis Purpose To evaluate the degree to which a firm s accounting captures its underlying business reality and to undo any accounting distortions. To evaluate accounting quality by assessing accounting policies and estimates. To decompose financial statements and try to get behind the numbers. Evaluate Accounting Quality Financial statement is not always a complete and faithful representation of a firm s financial activities and conditions due to accounting rules and management discretion. - GAAP puts capital leases on the balance sheet, but operating leases are off-balance-sheet now changing - GAAP fully expenses R&D and advertising/marketing outlay, but some of them have future value GAAP accounting rules - Managers can choose any of several different inventory accounting methods Accounting methods - Managers have some discretion over estimates such as bad debt expense Accounting estimates - Managers have some discretion over the timing of business transactions such as when to buy advertising Transaction structure and timing Accounting Analysis Overview Financial reporting information can be noisy and biased even with accounting regulation and external auditing (maybe soft due to intimate relationship between auditors and the company s owner; or incentive to do business/get good payment from the firm). Accounting analysis can add value if potential distortions are large. Also, it is an important precondition for effective financial analysis. The quality of financial analysis and inferences drawn depend on the quality of the underlying accounting information and raw material inputs for analysis. 4 Points to Understand Before Analysis - Understand the business - Understand the accounting policies - Understand the business areas where accounting quality is most doubtful - Understand situations in which management are particularly tempted to manage earnings i.e. incentives to report higher/lower profits against union negotiation Flash points: Accounting area where manipulation is more likely Banking Credit losses: quality of loan loss provisions Computer hardware Computer software Technological change: quality of receivables and inventory Marketability of products: quality of capitalised R&D