AccountingFinanceSeminar.February.2011.XLRI.Kemsley.StudentFile

Copyright © 2010 Deen Kemsley

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XLRI ACCOUNTING SEMINAR 2011

http://tulane.edu/


Course TitleCourse Title

Financial Accounting Seminar:

Practical Equity andCredit Analysis


Syllabus: Page 1Syllabus: Page 1

Accounting SeminarFebruary, 2011

Course Description and SyllabusProfessor: Deen Kemsley E-mail: [email protected]

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mailto:[email protected]


Syllabus: Page 2Syllabus: Page 2Seminar Description This seminar covers the role of accounting in the context of capital markets and

the value of the firm. Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) pronouncements are applied to analyze firms, and current issues in the accounting and financial analyst profession are evaluated. This is a practical, hands-on course for future accountants and financial analysts.

Seminar Approach and GoalsThis is a hands-on seminar taught as if you were a working analyst on Wall Street.

We will conduct several cases in class, so class participation is central to the course. See the course schedule for specific topics we will cover. After taking this course, students will have the tools to analyze firms in depth, leading to better global management and investment decisions.

Student Learning ObjectivesKey objectives are (1) to learn how to more thoroughly read and understand

financial statements, (2) to identify potential manipulation of the financial statements through the five accounting ploys, (3) to understand the capital structure decisions of firms, (4) to practice valuing firms using the financial statements and other available information, and (5) to create accounting models that you can use throughout your career to analyze firms.

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Course OutlineCourse Outline

Lecture 1 (2/25): New Wave Ice Tea: AccountingLecture 2 (2/25): Primary Financial RatiosLecture 3 (2/25): New Wave Ice Tea Case: RatiosLecture 4 (2/26): Valuation Methods and AnalysisLecture 5 (2/26): New Wave Ice Tea Case: ValuationLecture 6 (2/26): Credit AnalysisLecture 7 (2/27): Earnings QualityLecture 8 (2/27): U.S. Budget AccountingLecture 9 (2/27): Group Project

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Lecture 1Lecture 1

New Wave Ice Tea:Accounting

The Accounting EquationThe Accounting Equation

A = L + OE


Sample Accounting BoxSample Accounting Box

Cash A/R A/P LTDCapital Stock

RetainedEarnings

A = L + OE


Accounting Box: Accounting Box: RequirementsRequirements

To record transactions, note:

• Each row represents one transaction• Positive numbers represent additions• Negative numbers represent subtractions• Each row must balance out


Accounting Box: FeaturesAccounting Box: Features

Key features of the accounting box include:

• The top row represents the beginning balance sheet

• The bottom row represents the ending balance sheet

• The left-hand column provides all input for the cash flow statement

• The right-hand column provides all input for the income statement

Cash A/R A/P LTD CS RE


Accounting Box: TipsAccounting Box: Tips

When using the accounting box note:

• Each and every entry in the cash column must enter the cash flow statement. No other information should enter the statement.

• Each and every entry in the retained earnings column must enter the income statement. No other information should enter the statement.– Exception: Dividends affect retained earnings but not

earnings

• Apply the tax rate to pretax earnings (not to total revenue)


CaseCase

New Wave Ice Tea


Case Purpose and Case Purpose and OverviewOverviewThe purpose of this case is to refresh you

regarding the fundamental principles of accounting. The case describes the first three years of a start-up company. Using the templates I provide, you get hands-on practice of accounting principles as follows:

• In Class: Record transactions for the years 2011 -

2013 (include all necessary year-end adjusting entries and the year-end closing entry). Prepare the Income Statement, Balance Sheet, and direct Cash Flow Statement.


Case SettingCase Setting

After your first day of training, you and four of your colleagues go out for cold refreshments at a cafe. A friend at the table describes this great ice-tea, Napa, which is produced in her hometown. You and your friends believe there is a bright future in selling this excellent ice-tea in area. Napa is not distributed here presently.

To take advantage of this business opportunity, you start a company named New Wave Ice-Tea that will distribute Napa’s ice-tea. Napa agrees to produce ice-tea for your company and sell it to you for $0.75 per can. Napa signs an agreement giving New Wave Ice-Tea the exclusive right to sell their ice-tea in this area. You are first going to sell the cans to colleagues with the hope of later selling it to a broader market. You and your partners get the firm to agree to let you have an ice-tea stand in front of the building. You have been appointed the CFO and therefore are responsible to keep the books of this new enterprise.


Income TaxesIncome Taxes

The appropriate tax rate for New Wave Ice Tea is 40%.

New Wave Ice-Tea must accrue taxes for any profits earned each year. Assume the taxes are paid in the following year.


Initial Start-up: 2011Initial Start-up: 2011

• Dec 31, 2011: Issued 25,000 shares for $25,000 ($5,000 from each of you).

• Dec 31, 2011: Leased the space in front of business school for $3000 per year. Paid three years of rent in advance ($9,000).

• Dec 31, 2011: Purchased a juice stand for $10,000 in cash. The stand

has a 10-year life with $0 salvage value. Depreciation will be $1,000 each year.

• Dec 31, 2011: The 5 owners of New Wave Ice-Tea agree to earn a small salary of $1000 each for the entire year. You do not need other employees at this point in time.

• Dec 31, 2011: Purchased 6,000 ice-tea cans from Napa at a price of $0.75 each, for a total amount of $4,500 that was paid for in cash. Napa was able to deliver them the same day.


2012 Events2012 Events

• Jan 1, 2012: Spent $1,000 cash for advertising.• Mar 15, 2012: Purchased 14,000 more ice-tea cans for $10,500

on account. The cans were received on this date, but have not yet been paid for.

• April 30, 2012: Paid $8,000 to Napa for the purchase. You still owe them $2,500.

• Summary Sales revenue for the year was $36,000. Most of it was received as cash, but for some of your best customers you have set up accounts receivable. During the year, $7,000 of the $36,000 was accounts receivable.

• Summary: During the year, customers paid $5,000 of the accounts receivable, so they still owed $2,000 at the end of the year.

• Summary: Total salaries earned during the year were $5,000. Cash expended on salaries was $4,000.

• Dec 31, 2012: Count of ice-tea cans inventory at the end of the year showed that 2000 cans remained that were valued at $0.75 each for a total ending inventory value of $1,500.

• Dec 31, 2012: Ordered 60,000 more cans from Napa to be delivered next year. New Wave Ice-Tea does not advance any money to Napa for this order at this time.


2012 Adjusting Entries2012 Adjusting Entries

Be sure to record year-end adjusting entries for the following items:

• Inventory used • Depreciation expense on the stand ($10,000 / 10

year = $1,000) • Rental expense for leasing the space in front of

school• Taxes accrued for pretax income earned this year

(at 40%). These taxes will not be paid until next year.



2013 2013

Sales have dramatically increased. You and your partners have decided to expand and sell the ice-tea on the Internet. The cans will be delivered to your client’s home or office in less than five minutes from they time they place the order.


2013 Events: Page 12013 Events: Page 1

• Jan 1, 2013: Paid tax liability for the prior year.• Jan 1, 2013: Paid $5,000 cash to have a web site developed.

Assume this cost is expensed immediately.• Jan 1, 2013: Purchased a computer for $1,800 that will be used

as the server for the web site. The computer has a 3-year useful life. Depreciation will be $600 each year.

• Jan 1, 2013: Hired a high-school student to deliver the ice-tea cans on his bicycle and agreed to pay him $15,000 for the year. You will pay him at the end of the year along with the other employees.

• Jan 1, 2013: Issued $50,000 of 8% 10-year bonds. The bonds pay 8% interest annually on January 1st of the following year.

• Jan 15, 2013: Received the 60,000 cans (cost =$0.75 per bottle). New Wave Ice-Tea does not make a payment at this time.

• Jan 30, 2013: Paid Napa $40,000 as a partial payment for the 60,000 cans ordered at the end of 2009.


2013 Events: Page 22013 Events: Page 2

• Sales revenue was $112,000, $78,000 of which was in cash and the remainder was on account.

• Summary: Total accounts receivable collected during the year amounted to $18,000.

• Summary : Salaries earned for the year were $20,000 (includes high-school student’s salary of $15,000 and the owner’s salary of $5,000). By the end of the year, all salaries earned during this year, as well as salaries owed at the end of the last year, had all been paid (e.g., salaries payable at the end of the year is zero).

• Dec 31, 2013: Inventory count at the end of the year indicated there was 6000 cans on hand valued at $0.75 each for a total ending inventory value of $4,500.

• Dec 31, 2013: Paid interest on the $50,000 loan.


2013 Adjusting Entries2013 Adjusting Entries

Be sure to record year-end adjusting entries for the following items:

• Inventory used • Depreciation expense for the stand• Depreciation expense for the computer• Rental expense for leasing the space in front of

the firm • Taxes accrued for income earned this year (at

40%). These taxes will not be paid until next year


2014 (Bonus Year)2014 (Bonus Year)

Work backwards to solve the 2014 box.

• Use your 2013 ending balances to complete the top row of the 2014 box.

• Use the 2014 ending balance sheet from the spreadsheet to complete the bottom row of the 2014 box.

• Use the 2014 income statement and cash flow statement from the spreadsheet to complete the box.

Enjoy the Challenge

New Wave Ice TeaNew Wave Ice Tea2011 Template: Box2011 Template: Box

Date Description Cash A/RInven-tory

PrepaidExpens

ePPE A/P

TaxesPayabl

e

SalaryPayabl

eLTD

CapitalStock RE

BegBal

EndBal


New Wave Ice TeaNew Wave Ice Tea2011 Template: Balance 2011 Template: Balance SheetSheet

AssetsCurrent Assets:

CashReceivablesInventoriesPrepaid Expenses

Total Current AssetsLong-Term Assets

Land, Building and EquipmentLess: Accumulated DepreciationOther Assets

Total LT Assets

Total Assets

Liabilities and EquityCurrent Liabilities:

Accounts PayableAccrued Taxes

Total Current Liabilities

Long-term DebtTotal Liabilities

Stockholders' Equity:Capital StockRetained Earnings

Total Stockholders' Equity

Total Liabilities and Equity


New Wave Ice TeaNew Wave Ice Tea2011 Template: Cash Flow2011 Template: Cash Flow

Cash Flow from Operating Activities

Cash Payments to SuppliersLeased Space

Cash Flow from Investing Activities

Purchased Stand

Cash Flow from Financing Activities

Issue Stock

Total Cash Flow

Cash at the beginning of the yearCash at the end of the year Increase/ (Decrease) in cash




PrepaidExpens

ePPE A/P

TaxesPayabl

e

SalaryPayabl

eLTD

CapitalStock RE

BegBal

EndBal





Total Current Assets

Land, Building and Equipment (PPE)Less: Accumulated Depreciation

Total Assets


Accounts PayableAccrued TaxesSalaries Payable

Total Current LiabilitiesLong-term Debt

Total LiabilitiesStockholders' Equity:

Capital StockRetained Earnings

Total Stockholders' EquityTotal Liabilities and Equity


New Wave Ice TeaNew Wave Ice Tea2012 Template: Income Stmt2012 Template: Income Stmt

SalesCosts and Expenses:

Cost of SalesSelling, general and administrativeDepreciationInterest

Total Costs and ExpensesEarnings before TaxesIncome TaxesNet Earnings




Payments received from customersCash Payments to SuppliersCash Payments of Salaries



Total Cash Flow






PrepaidExpens

ePPE A/P

TaxesPayabl

e

SalaryPayabl

eLTD

CapitalStock RE

BegBal

EndBal





Total Current AssetsLand, Building and EquipmentLess Accumulated Depreciation

Total Assets


Accounts PayableAccrued TaxesInterest Payable

Total Current LiabilitiesLong-term Debt

Total LiabilitiesStockholders' Equity:

Capital StockRetained Earnings

Total Stockholders' EquityTotal Liabilities and Equity


New Wave Ice TeaNew Wave Ice Tea2013 Template: Income Stmt2013 Template: Income Stmt

SalesCosts and Expenses:

Cost of SalesSelling, general and administrativeDepreciationInterest

Total Costs and ExpensesEarnings before TaxesIncome Taxes (@40%)Net Earnings




Payments received from customersCash Payments to SuppliersCash Payments of SalariesPayment of Taxes


Purchased Computer


Issue Bonds

Total Cash Flow



Case Wrap UpCase Wrap Up

What are your key takeaways from this case?


Lecture 2Lecture 2

Primary Financial Ratios


Lecture OutlineLecture Outline

• Primary Financial Ratios• Exercises


ROE: Primary Performance ROE: Primary Performance MetricMetric

Net IncomeShareholder’s Equity

The Return on Equity represents the return the company earns on the shareholders’ investment in the firm. This metric accounts for both operating and financing performance.


Operating vs. Financing Operating vs. Financing ActivitiesActivities

One of the first steps in sound equity or credit research analysis is to separate a company’s activities into two separate categories: Operating and Financing.

Why Separate the Two Sets of Activities?– The projected growth for operating activities is

different from the projected growth for financing activities.

– Hence, the valuation multiples for operating activities are different from the multiples for financing activities.


Primary ROE ComponentsPrimary ROE Components

ROEROE

RNOARNOA Return onDebt

Return onDebt

• Focuses on operating aspects of the company – measures performance regardless of financing method

• Viewpoint of the business management

• Focuses on the financing aspects of the company

= Operating Profit after Tax

Net Operating Assets

= Debt/Equity Ratio x Financing Spread

+


Primary RNOA Primary RNOA ComponentsComponents

RNOARNOA

OperatingProfit MarginOperating

Profit MarginOperating Asset

TurnoverOperating Asset

Turnover

• Focuses on the profit the company generates per dollar of sales.

• Focuses on the efficiency with which the company generates revenue from its operating assets

= Operating Profit after Tax

Operating Revenue

= Operating RevenueNet Operating Assets

X

“DuPont Analysis”


Operating Profit after TaxOperating Profit after Tax

+ Operating Revenue- Operating Expenses

• COGS• Selling, General, and Administrative• Depreciation• Etc.

- Taxes• Taxes as Reported• Tax Benefit from Debt*

Tax Rate x Interest Expense

*Note: Required adjustment because in the absence of debt, tax expense would be greater than reported.

Note: If you know the tax rate (t), it’s sometimes simpler to account for taxes using: Operating Profit After Tax = Operating Income x (1 – t).


NOANOA

+ Operating Assets• All assets except financial assets.

– Financial assets include short-term investments, long-term investments in debt, etc. Excess cash (i.e., cash not required to run operations) also represents a financial asset. Note: For the sake of simplicity, we will begin by assuming that all cash is operating capital – we will change that assumption later.

- Operating Liabilities (Don’t forget to subtract these!)

• Accounts Payable• Salaries Payable• Taxes Payable• All other liabilities except financial liabilities (such as long-

term debt, etc.).


Cool Ice TeaCool Ice TeaBalance Sheet

Current Assets:Cash 245,000*

Receivables 150,000Inventories 22,000

Total 417,000PPE

353,600Other Oper. Assets 47,000Total Assets 817,600Current Liabilities:

Accounts Payable 23,900Accrued Taxes 60,000

Total 83,900Long-Term Debt 337,100Total Liabilities 421,000Stockholder’s Equity:

Capital Stock 198,600Retained Earnings 198,000

Total Stockholder’s Equity 396,600Total Liabilities and SE 817,600

Income StatementSales 523,000Costs and Expenses:

Cost of Goods Sold (201,000)SG&A (198,000)Depreciation (18,000)Interest (21,000)

Total Expenses (438,000)Earnings Before Taxes 85,000Income Taxes (34,000)Net Income 51,000

*For this part of the course, assume all cash is operating in nature


Exercise 1Exercise 1

(1) Calculate the following for Cool Ice Tea:

• RNOA• Operating Profit Margin• Operating Asset Turnover

(2) Express RNOA in terms of Operating Profit Margin and Operating Asset Turnover.


Expense RatiosExpense Ratios

OperatingProfit Margin

OperatingProfit Margin

Gross ProfitMargin

Gross ProfitMargin

Operating Expense Margin

Operating Expense Margin

-

+ + +

Gross Profit Margin = (Operating Revenue – COGS)/Operating Revenue

Operating Expense Margin = (Operating Expenses* + Taxes**)/Operating Revenue

* Excluding COGS ** Taxes as reported plus the tax benefit from debt

SG&A Exp. Margin

SG&A Exp. Margin

Taxes Exp. Margin

Taxes Exp. Margin

Other Exp. Margin

Other Exp. Margin

Depreciation Exp. Margin

Depreciation Exp. Margin



(1)Decompose Cool Ice Tea’s Operating Profit Margin into its subcomponents of Gross Profit Margin and Operating Expense Margin.

(2)Decompose Cool Ice Tea’s Operating Expense Margin into it various subcomponents.


TurnoverTurnover

OperatingAsset Turnover

OperatingAsset Turnover

OperatingRevenue

OperatingRevenue NOA NOA ÷

+ + - +/-InventoryInventory FixedAssetsFixedAssets

AccountsPayable

AccountsPayable

AccountsReceivableAccounts

Receivable OtherOther


Inventory TurnoverInventory Turnover

Inventory Turnover = COGS/Inventory

Days of Inventory on Hand = Inventory/(COGS/365)

Inventory Turnover ↑

Operating Asset Turnover ↑RNOA ↑ROE ↑


Accounts Receivable Accounts Receivable TurnoverTurnover

Accounts Receivable Turnover = Operating Revenue / Accounts Receivable

Days of Accounts Receivable = Accounts Receivable/(Sales/365)

Accounts Receivable Turnover ↑



Fixed Asset TurnoverFixed Asset Turnover

Fixed Asset Turnover = Operating Revenue / Fixed Assets

Fixed Asset Turnover ↑



Days of Accounts PayableDays of Accounts Payable

Days of Accounts Payable = Accounts Payable / (COGS/365)

Days of Accounts Payable ↑




(1)Calculate the following metrics for Cool Ice Tea:• Inventory Turnover• Days of Inventory• Accounts Receivable Turnover• Days of Accounts Receivable• Fixed Asset Turnover• Days of Accounts Payable(2) Holding all else constant, calculate the Accounts

Receivable Turnover if Cool Ice Tea reduced its receivables from 150,000 to 75,000.

(3) Given the new Accounts Receivable Turnover you calculated, what is the new RNOA?


Primary ROE ComponentsPrimary ROE Components

ROEROE

RNOARNOA Return onDebt

Return onDebt

• Focuses on operating aspects of the company – measures performance regardless of financing method

• Viewpoint of the business management

• Focuses on the financing aspects of the company

= Operating Profit after Tax Net Operating Assets

= Debt/Equity Ratio x Financing Spread

+


Return on DebtReturn on Debt

Return on Debt

Return on Debt

DebtRatioDebtRatio

FinancingSpread

FinancingSpread

X

÷ -

÷

EquityEquityDebtDebt

DebtDebtInterestExpense

(1-t)

InterestExpense

(1-t)

RNOARNOA Cost ofDebt

Cost ofDebt

Debt/EquityRatio

Debt/EquityRatio



(1) Calculate the following metrics for Cool Ice Tea:• Debt/Equity Ratio• Cost of Debt• Financing Spread• Return on Debt• ROE (Net Income/Shareholders’ Equity)

Note: Recall that RNOA = 8.7%

(2) Express Cool Ice Tea’s ROE in terms of RNOA and the Return on Debt


Lecture 3Lecture 3

New Wave Ice Tea Case:Ratios


New Wave Ice Tea Case New Wave Ice Tea Case RequirementsRequirementsTo conduct this case:• Open the New Wave Ice Tea ROE Template in Excel• Using what you have learned in the course, create

appropriate formulas for each box. Note that you may reference the cells to New Wave’s 2013 income statement and balance sheet, which are on the spreadsheet

• Calculate ROE directly (net income/shareholders’ equity) and compare it to the value you obtain from the ROE template. If there are any discrepancies, correct the template

• On the Excel sheet, write a short summary interpreting your findings using concise bullet points


HintsHints

• Start on the RNOA (left-hand) side of the matrix because you will need the RNOA calculation to complete the right side of the matrix

• Start toward the bottom• Note that you will have to carefully determine

which lines on the income statement and balance sheet represent operating items

• As you interpret your calculations, consider what the matrix teaches you that is not as apparent on the financials themselves

• Check your ultimate answer for ROE to make sure it equals Net Income/Stockholders’ Equity


New Wave ROE TemplateNew Wave ROE Template

New Wave Ice Tea Template2010

ROE

RNOA Ret Debt

OPM OpAT D/E F Spread

GPM OpExp% OpRev NOA Tot. Debt Equity RNOA Cst Debt

SG&A % Depr% Tax% Cash A/R Inventory Accr. Tax Prepaids PPE A/PInt Exp LT Debt

(1-t)


Lecture 4Lecture 4

Valuation MethodsAnd Analysis


Fundamental AnalysisFundamental Analysis

Investors employ a wide variety of strategies:• Short-term intraday trading on reactions to news,

etc.• Programmed trading• Momentum trading• Long-term investment

Fundamental research analysis primarily relates to long-term investment


Fundamental ValueFundamental Value

The fundamental value of the firm is its true “intrinsic” value to investors.

If Fundamental Value > Current Price → Buy

If Fundamental Value < Current Price → Sell


Intrinsic Value at its Intrinsic Value at its RootsRootsAt its roots, intrinsic value must represent the value

of all future distributions to shareholders.

• Dividends• Share repurchases• Liquidating distributions


Valuation ModelsValuation Models

There are three primary valuation models:

• Dividend Discount Model (DDM)• Discounted Cash Flow Model (DCF)• Residual Income Model (RIM)


Relations among ModelsRelations among Models

DDMDDM

DCFDCF RIMRIM

All three models are simply different mathematical representations of the same model!


Implementation of Implementation of ModelsModelsEach model focuses on a unique metric, so

implementation of the models varies:

Earnings → Cash Flows → Dividends (RIM) (DCF) (DDM)

Nevertheless, if we could implement all three models perfectly, they would all lead to the same intrinsic value!


Dividend Discount ModelDividend Discount Model

Value = DIV1/(1+r) + DIV2 /(1+r)2 + … + DIVn/(1+r)n

• Fundamental Value equals the present value of all future dividends

• Dividends include liquidating distributions, share repurchases, etc.

Pro: The DDM focuses on cash that reaches investors’ pockets

Con: It is difficult to project future dividends because current dividends often have little to do with future dividends.


Discounted Cash Flow Discounted Cash Flow ModelModel

Value = FCF1/(1+r) + FCF2 /(1+r)2 + … + FCFn/(1+r)n

• Fundamental Value equals the present value of all future free cash flows

• Often, analysts measure FCFs for operations as a whole, although it is easy to adjust this value to focus on equity investors alone. When focusing on operations, r equals the weighted-average cost of capital (WACC)

Pro: The DCF Model focuses on the source of dividends → cash generated by the firm

Cons: In many cases, current cash flow is not highly correlated with future cash flow, and the correct use of WACC is tricky


DCF Equity – Method OneDCF Equity – Method One

There are two related ways to adjust DCF Operations to DCF Equity. The first way is simply to subtract the value of debt from the value of operations:

DCF Operations Value - Value of Debt

DCF Equity Value Note: Treat financial cash as negative debt.


DCF Equity – Method TwoDCF Equity – Method Two

The second way to convert a DCF Operations value into a DCF Equity value is to discount free cash flows for equity instead of discounting free cash flows for operations:

FCF Operations + Net Financial Income - Net Debt Reductions

FCF Equity

Note: Treat financial cash as negative debt. Therefore, increases in cash balances reduce net debt and must be subtracted from FCF Operations to obtain FCF Equity. Making this adjustment ensures the result represents FCF for equity investors only.


Residual Income (Economic Residual Income (Economic Profit) ModelProfit) Model

Value = BV + Premium

Value = BV0 + RI1/(1+r) + RI2/(1+r)2 + … + RIn /(1+r)n

RI1 = NI1 – rBV0

Pros: Focuses on earnings, which are generally correlated with long-run future cash flows. Focuses on the residual income a firm generates, which is fundamental to valuation (using any model). Clarifies market-to-book ratios. Earnings are the ultimate source of cash flows.

Cons: Earnings can be manipulated, so use of the model requires thorough understanding of accounting. Error in r reduces the benefits of the RIM.


Forecast and Terminal Forecast and Terminal PeriodsPeriods

Forecast Period: The years for which an analyst specifically forecasts dividends, free cash flow, or residual income.

Terminal Period: The period beyond the forecast period.

Estimated Value = Forecast Period Value + Terminal Value


Terminal Value Terminal Value EstimationEstimationEstimate terminal value by:

• Assuming a final liquidating distribution, or• Assuming the cash flow in the final forecast period

remains constant in perpetuity, or• Assuming the cash flow in the final forecast period

grows at a constant rate in perpetuity, or• Assuming residual income grows (unlikely), remains

constant, or fades to zero (standard assumption) over time.


DDM with Terminal ValueDDM with Terminal Value

Forecast Period: 2 Years

Constant Terminal Dividend:

Value = DIV1/(1+r) + DIV2 /(1+r)2 + [DIV3/r](1+r)-2

Growing Terminal Dividend:

Value = DIV1/(1+r) + DIV2 /(1+r)2 + [DIV3/(r-g)] (1+r)-2


DCF with Terminal ValueDCF with Terminal Value


Constant Terminal Cash Flow:

Value = FCF1/(1+r) + FCF2 /(1+r)2 + [FCF3/r](1+r)-2

Growing Terminal Cash Flow:

Value = FCF1/(1+r) + FCF2 /(1+r)2 + [FCF3/(r-g)] (1+r)-

2


Residual Income with Residual Income with Terminal ValueTerminal Value


Constant Terminal Residual Income:

Value = BV0 + RI1/(1+r) + RI2 /(1+r)2 + [RI3/r](1+r)-2

Fading Terminal Residual Income over 5 Years:

Value = BV0+ RI1/(1+r) + RI2 /(1+r)2 + RI2(4/5)/(1+r)3 +RI2(3/5)/(1+r)4 +RI2(2/5)/(1+r)5 +RI2(1/5)/(1+r)6


Cool Ice TeaCool Ice Tea

Exercises


Cool Ice TeaCool Ice TeaBalance Sheet

Current Assets:Cash 245,000*

Receivables 150,000Inventories 22,000

Total 417,000PPE

353,600Other Oper. Assets 47,000Total Assets 817,600Current Liabilities:

Accounts Payable 23,900Accrued Taxes 60,000





Cost of Goods Sold (201,000)SG&A (198,000)Depreciation (18,000)Interest (21,000)

Total Expenses (438,000)Earnings Before Taxes 85,000Income Taxes (34,000)Net Income 51,000

*For this part of the course, assume all cash is financial in nature.


Exercise 1: DDMExercise 1: DDM

Use the DDM to estimate the fundamental value of equity for Cool Ice Tea assuming:

• The company pays out 80 percent of net income as dividends each year.

• For the first two periods, you forecast that earnings will grow by 5 percent per year.

• Beginning in the third period, you forecast earnings will grow by 3 percent per year in perpetuity.

• The first dividend will be paid one year from now (out of next year’s earnings)

• The discount rate is 9 percent

Hint: Calculate the forecasted Period 1, Period 2, and Period 3 dividends and then implement the relevant formula precisely. Note that Period 3 earnings are only 3 percent higher than Period 2 earnings.


Exercise 2: DCFExercise 2: DCF

Use the DCF to estimate the fundamental value of equity for Cool Ice Tea assuming:

• For the first two periods, you forecast free cash flows for total operations of 60,000 and 65,000 respectively.

• Beyond the first two periods, you forecast free cash flows will grow by 5 percent per year in perpetuity. Hence, free cash flow for Period 3 is 68,250 (1.05 x 65,000).

• You forecast that debt will remain unchanged and that the market value of debt equals the book value reported on the balance sheets.

• The discount rate is 12 percent.


Exercise 3: RIMExercise 3: RIM

Use the RIM to estimate the fundamental value of equity for Cool Ice Tea assuming:

• For the first two periods, you forecast that earnings will grow by 5 percent per year

• You forecast that the shareholders’ equity will grow by 5 percent for the first year

• Beyond the first two periods, you forecast that residual income will fade to zero (linearly) over 3 years

• The discount rate is 10 percent


Lecture 5Lecture 5

New Wave Ice Tea Case:Valuation


Case OverviewCase Overview

In this case, you are to do the following:

• Open the New Wave Ice Tea Valuation Template and complete the income statement, balance sheet, and cash flow forecasts.

• Complete the RIM, DDM, and FCF Equity Valuations for New Wave Ice Tea as of the end of 2013.

• Address the case questions.

Note: The company will wrap up operations at the end of 2018 and liquidate all net assets to shareholders in a final dividend.


New Wave Ice Tea 2013New Wave Ice Tea 2013Balance Sheet

Current Assets:Cash 95,700Receivables 18,000Inventories 4,500Prepaid Expenses 3,000

Total Current Assets 121,200PPE 9,200Total Assets 130,400Current Liabilities:Accounts Payable 7,500Accrued Taxes 14,560Interest Payable 4,000





Cost of Goods Sold ( 42,000)SG&A ( 28,000)Depreciation ( 1,600)Interest ( 4,000)

Total Expenses ( 75,600)Earnings Before Taxes 36,400Income Taxes (14,560)Net Income 21,840


Case: Phase 1Case: Phase 1

Using the financial statements provided, enter 2013 income statement and balance sheet information. Doing so will begin to populate some of the other cells on the spreadsheet.

How does the format of the income statement on the spreadsheet vary from the format of the reported income statement? Comment on the rationale for the difference.


Phase 1 Solution: Income Phase 1 Solution: Income StatementsStatements

New Wave Ice Tea

Income Statement 2013A 2014E 2015E 2016E 2017E 2018E

Revenue 112000 112000 112000 112000 112000 112000

Growth Rate % 0% 0% 0% 0% 0%

Cost of Sales -42000 -42000 -42000 -42000 -42000 -42000

Gross Profit 70000 70000 70000 70000 70000 70000

SG&A -28000 -28000 -28000 -28000 -28000 -28000

Depreciation -1600 -1380 -1173 -997 -847 -720

------- ------- ------- ------- ------- -------

Operating Income Before Tax 40400 40620 40827 41003 41153 41280

Tax on Operations at 40% -16160 -16248 -16331 -16401 -16461 -16512

------- ------- ------- ------- ------- -------

Operating Income After Tax 24240 24372 24496 24602 24692 24768

Interest Income on Cash 0 0 0 0 0 0

Interest Expense -4000 -4000 -4000 -4000 -4000 -4000

------- ------- ------- ------- ------- -------

Financial Income Before Tax -4000 -4000 -4000 -4000 -4000 -4000

Tax on Financial Income at 40% 1600 1600 1600 1600 1600 1600

------- ------- ------- ------- ------- -------

Net Financial Income -2400 -2400 -2400 -2400 -2400 -2400

------- ------- ------- ------- ------- -------

Net Income 21840 21972 22096 22202 22292 22368

Interest Rate 0%


Phase 1 Solution: Balance Phase 1 Solution: Balance SheetsSheets

Balance Sheet 2013A 2014E 2015E 2016E 2017E 2018E

Cash 95700 137,140 160,492 183,761 206,960 -

Receivables 18000 - - - - -

Days of Receivables 59 0 0 0 0 0

Inventories 4500 - - - - -

Days of Inventory 39 0 0 0 0 0

Prepaid Expenses 3000 - - - - -

Depreciable Assets 9200 7820 6647 5650 4802 0

Total Assets 130400 144960 167139 189411 211762 0

Accounts Payable 7500 0 0 0 0 0

Days of Accounts Payable 65 0 0 0 0 0

Accrued Taxes 14560 14648 14731 14801 14861 0

Interest Payable 4000 4000 4000 4000 4000 0

Long-term Debt 50000 50000 50000 50000 50000 0

Shareholders' Equity 54340 76312 98408 120610 142901 0

Total Liabilities and Equity 130400 144960 167139 189411 211762 0


Phase 1 Solution: SE and Phase 1 Solution: SE and Depreciable AssetsDepreciable Assets

Shareholders' Equity Detail 2013 2014 2015 2016 2017 2018

Beginning Balance 32500 54340 76312 98408 120610 142901

Contributions 0 0 0 0 0 0

Net Income 21840 21972 22096 22202 22292 22368

Dividends 0 0 0 0 0 0

Final Dividend 165269

Ending Balance 54340 76312 98408 120610 142901 0

Dividend Payout Ratio 0%

Depreciable Assets Detail

Beginning Balance 0 9,200 7,820 6,647 5,650 4,802

CAPEX 0 - - - - (4,082)

Depreciation 0 (1,380) (1,173) (997) (847) (720)

Ending Balance 9200 7820 6647 5650 4802 0



Choose your interest rate for cash balances and enter it into the appropriate cell (one cell only). In addition, choose your dividend payout ratio and enter it into the appropriate cell (one cell only). You can try a few values just to see how different values affect the forecast.

How does a positive (or higher) interest rate affect projected future net income?



Choose values for Days of Receivables, Days of Inventories, and Days of Accounts Payable (do not change the value for the first year, because that value is based on actual data). If desired, you may choose different values for each year. For 2018, set all three values to zero.

When you increase the values for each of these parameters, how does it affect the forecasted balance sheets (such as cash and other balances)? Intuitively, why does the balance sheet change the way it does?



In the Depreciable Assets Schedule, choose values for CAPEX each year. For 2018, let the model calculate the value.

How do positive values for CAPEX affect forecasted cash balances? Why?



Choose a revenue growth rate for each year. As you do, recognize that, theoretically, the revenue growth rate should be related to the dividend payout ratio and CAPEX. All else equal, the more earnings a company retains and invests in CAPEX, the higher the forecasted revenue growth rate. So don’t a high revenue growth rate unless you also choose a lot of CAPEX. Feel free to try a variety of growth rates before settling on your final choice.

How sensitive is forecasted net income to your choice of revenue growth rates?



Compare your forecasted values for FCF Operations versus FCF Equity. What are the primary reconciling items between these two numbers? NOTE: There are rows in the model that specify the reconciling items line by line. Intuitively, why do these reconciling items make sense?

Compare your forecasted values for FCF Equity versus forecasted dividends? What does this comparison teach us about the relation between the DDM and DCF methods?



Complete the Residual Income valuation schedule. To do so:

• Link the net income line in the schedule to your forecasted income statement

• Recall that residual income = net income – required return

• To estimate the required return, use the 2013 Book Value of equity for your beginning book value

How does changing the cost of equity affect your estimate value?



Complete the Dividend and DCF valuation schedules.

Now compare the estimates you obtain for all three methods. What is the key point? What are your most important takeaways from this case?



Now that your model is up and running, go back and change all of your assumptions, one at a time. As you do, determine how sensitive your estimated intrinsic value depends on each assumption. Summarize your conclusions from this sensitivity analysis.

97


Lecture 6Lecture 6

Credit Analysis


Role for Rating AgenciesRole for Rating Agencies

Moody’sMoody’s

CreditRatingsCredit

Ratings

PerceivedRisk and

Interest Rates

PerceivedRisk and

Interest Rates

CreditAnalysisCredit

Analysis

Standard& Poor’s

Standard& Poor’s

Note: Other U.S. rating agencies include Fitch, AM Best, CreditPointe, & Egan-Jones


The RatingsThe Ratings

Moody’s S&PInvestment Grade

Aaa AAA Aa AA A A Baa BBB

Speculative (Junk) Grade Ba BB B B Caa CCC

MaximumSafety

Risky


Rating ObjectivesRating Objectives

Moody’sMoody’s Standard& Poor’s

Standard& Poor’s

EstimatedRecovery

EstimatedRecovery

DefaultRisk

DefaultRisk


S&P Ratings S&P Ratings Performance:Performance:1981 - 20011981 - 2001Listed below are the average 1-year default rates for

selected industries for the period from 1981-2001:

S&P Rating Utilities High TechChemicalAAA 0.00 0.00 0.00AA 0.00 0.00 0.00A 0.11 0.00 0.00BBB 0.14 0.73 0.19BB 0.25 0.75 1.12B 6.31 4.35 5.29CCC 71.4 9.52 21.6


Moody’s Ratings Moody’s Ratings Performance: 1982 - 2006Performance: 1982 - 2006


Moody’s Recent Rating Moody’s Recent Rating PerformancePerformance

Note: Per S&P, there were 124 total defaultsIn 2008, with credit losses of $429.4 billion


Rating ProcessRating Process

Overall CreditAnalysis

Financial RiskAnalysis

Business RiskAnalysis


Business Risk AnalysisBusiness Risk Analysis

OperationalDiversity

OperationalDiversity

CompetitivePosition

CompetitivePosition

BusinessStability

BusinessStability

CollateralCollateral

IndustryRisks

IndustryRisks

CountryRisks

CountryRisks

ManagementCharacter

ManagementCharacter

BusinessRisk


Management CharacterManagement Character

Evaluate management’s track record by asking:

• What level of risk does management pursue?• What return on investment (ROA and ROE) has

management obtained?• Is the return commensurate with the risk?• How effective are corporate governance controls?• What is management’s history of integrity?


Country RisksCountry Risks

Evaluate Country Risks by asking:

• How effective is the regulatory and legal environment?

• How good is the labor force?• How strong is the infrastructure?• How favorable is monetary policy?• What are the political risks?• What is the foreign exchange risk?• What is expected GDP growth?• Etc.


Industry RisksIndustry Risks

Evaluate Industry Risks by asking:

• What are future prospects for the size of the industry’s overall market?

• Will product obsolescence threaten the industry?• Will changing consumer preferences threaten the

industry?• Will changes in technology enhance or threaten the

industry?• Will the industry be able to maintain barriers to entry? • How might business cycles affect the industry?


Competitive PositionCompetitive Position

Evaluate the company’s competitive position by asking:

• How unique is the company’s main product?• How innovative is the company?• How much threat is posed by existing competitors?• What is the threat of new entrants in the firm’s

market?• What is the threat of substitute products?• How much bargaining power do the firm’s suppliers

have?


Operational DiversityOperational Diversity

Evaluate the company’s operational diversity by asking:

• How many businesses does the company conduct?• How many types of products does it provide?• How many plants does it use?• How many distribution outlets does the company

use?• How many types of customers does the company

serve?


Business StabilityBusiness Stability

Evaluate the company’s business stability by asking:

• How sensitive is the firm to economic downturns?• How stable are historical sales?• How has the company weathered prior disruptions?


CollateralCollateral

Evaluate a company’s collateral by asking:

• Does the company own valuable tangible assets?• What is the estimated life of the assets?• Do the assets already have other claims on them?• How easily could the assets be converted to cash?• Does the company own valuable financial assets

to act as collateral, such as marketable securities or receivables?

• Does the company own any intangible assets for collateral, such as rights, patents, contracts, etc.?


Business Risk ExerciseBusiness Risk Exercise

For each of the seven business risk factors, work with your partner to identify a sub-factor that you believe is especially important and explain why you believe it is important.


Financial Risk AnalysisFinancial Risk Analysis

CapitalStructureCapital

Structure

ProfitabilityProfitability

LiquidityLiquidity

CashFlowCashFlow

FinancialRisk


Profitability MetricsProfitability Metrics

Future profitability is central to a firm’s ability to pay its debt obligations, therefore all measures of profitability are important, including the following:

EBIT/Total AssetsOperating Income/SalesEBIT/Interest Expense

EBITDA/Interest ExpenseROE: Net Income/Equity

ROA: Net Income/Total AssetsEarnings Growth %


Profitability Metrics: Profitability Metrics: DetailsDetailsEBIT = Net Income + Net Interest Expense + Income

Taxes• Net Interest Expense = Interest Expense – Interest

Income (Note: Capitalized interest should be included in this calculation).

EBITDA = EBIT + Depreciation and Amortization Expense• For Jet Blue use the depreciation and amortization

numbers from the cash flow statement

Equity = Total Stockholders’ Equity

Sales = Total Operating Revenue


Cash Flow MetricsCash Flow Metrics

Relevant Cash Flow Metrics include:

FFO/Total LiabilitiesOperating Cash Flow/Total Liabilities

(Free Operating Cash Flow + Interest Expense)/Interest Expense

FFO/CAPEXOperating Cash Flow/CAPEX


Cash Flow Metrics: Cash Flow Metrics: DetailsDetailsFFO = Operating Cash Flow after backing out the

effects of changes in working capital assets and liabilities, such as changes in receivables, payables, and inventories.

Total Liabilities = Total Assets – Shareholders’ Equity = All Current and Long-Term Liabilities

CAPEX = Capital Expenditures from the Cash Flow Statement

Free Operating Cash Flow = Operating Cash Flow + Net Interest Expense - CAPEX


Liquidity MetricsLiquidity Metrics

Liquidity ratios include:

Current Assets/Current Liabilities

(Cash + Short-term Investments)/Current Liabilities


Capital Structure MetricsCapital Structure Metrics

Capital structure metrics help creditors assess a firm’s ability to take on new debt. Key metrics include:

Debt Ratio: Total Liab/Total Assets

Market Debt Ratio: Total Liab/Total AssetsLT Debt Ratio: Long-Term Debt/(Long-Term Debt + Equity)

Note: The rating agencies often treat cash as negative debt. This is called the “net debt” approach.

Note: There are several common variations of these ratios.


Primary Financial Ratios per Primary Financial Ratios per Rating: 1998-2000Rating: 1998-2000

AAA AA A BBB BB B CCC

EBIT/Interest Expense* 21.4 10.1 6.1 3.7 2.1 0.8 0.1EBITDA/Interest Expense* 26.5 12.9 9.1 5.3 3.4 1.8 1.3Free Op CF/Total Liab(%) 84.2 25.2 15.0 8.5 2.6 (3.2)

(12.9)FFO/Total Liab (%) 128.8 55.4 43.2 30.8 18.8 7.8 1.6ROA (%) 34.9 21.7 19.4 13.6 11.6 6.6 1.0Oper. Income/Sales (%) 27.0 22.1 18.6 15.4 15.9 11.9 11.9Long-term Debt Ratio (%) 13.3 28.2 33.9 42.5 57.2 69.7 68.8Total Liab/Assets (%) 22.9 37.7 42.5 48.2 62.6 74.8 87.7

*This is gross interest expense. Do not adjust for interest income or capitalized interest.

Note: These are overall averages. Companies in capital-intensive industries generally can get away with poorer ratios than other companies.


CaseCase

Jet Blue Airways


Case AssignmentCase Assignment

Using the information that follows, as well as information from the web, to address the following points:

(1)Conduct a simple business risk analysis in which you identify at least one point for each of the seven business risk factors.

(2)In terms of bond ratings, assess overall business risk.(3)For 2008 and 2009, calculate the eight primary

financial ratios for Jet Blue.(4)In terms of bond ratings, assess overall financial risk.(5)Guess S&P’s overall issuer (organization) bond rating

for Jet Blue.


Jet Blue Worksheet:Jet Blue Worksheet:Business Risk AnalysisBusiness Risk Analysis

Management Character:

Country Risks:

Industry Risks:

Competitive Position:

Operational Diversity:

Business Stability:

Collateral:


Jet Blue Worksheet:Jet Blue Worksheet:Primary Financial RatiosPrimary Financial Ratios

Financial Ratio 2009 2008


Jet Blue Check FiguresJet Blue Check Figures

EBIT 2008= 109Interest Expense 2008 = 242 EBITDA 2008 = 319Free Op CF 2008 = (472)Total Liab 2008 = 4754FFO 2008 = (26)Long-Term Debt 2008 = 2872Equity 2008 = 1266


Jet Blue AssetsJet Blue Assets

December 31,

2009 2008

CURRENT ASSETS

Cash and cash equivalents $ 896 $ 561

Investment securities 240 —

Receivables, less allowance (2009-$6; 2008-$5) 81 86

Inventories, less allowance (2009-$3; 2008-$4) 40 30

Restricted cash 13 78

Prepaid expenses 147 91

Other 43 10

Deferred income taxes 78 106

Total current assets 1,538 962

PROPERTY AND EQUIPMENT

Flight equipment 4,170 3,832

Predelivery deposits for flight equipment 139 163

4,309 3,995

Less accumulated depreciation 540 406

3,769 3,589

Other property and equipment 515 487


346 353

Assets constructed for others 549 533


523 528

Total property and equipment 4,638 4,470

OTHER ASSETS

Investment securities 6 244

Restricted cash 64 69

Other 308 275

Total other assets 378 588

TOTAL ASSETS $ 6,554 $ 6,020


Jet Blue Liabilities and Jet Blue Liabilities and EquityEquity

December 31,

2009 2008 LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES

Accounts payable $ 93 $ 144 Air traffic liability 455 445 Accrued salaries, wages and benefits 121 107 Other accrued liabilities 116 113 Short-term borrowings — 120 Current maturities of long-term debt and capital leases 384 152

Total current liabilities 1,169 1,081

LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS 2,920 2,872 CONSTRUCTION OBLIGATION 529 512 DEFERRED TAXES AND OTHER LIABILITIES

Deferred income taxes 259 197 Other 138 92

397 289 STOCKHOLDERS’ EQUITY

Common Stock 3 3 Treasury stock, at cost; 27,102,136 and 16,878,876 shares in 2009 and

2008, respectively (2) — Additional paid-in capital 1,419 1,287 Retained earnings 118 60 Accumulated other comprehensive income (loss), net of taxes 1 (84)

Total stockholders’ equity 1,539 1,266

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $ 6,554 $ 6,020


Jet Blue Income Jet Blue Income StatementsStatements

Year Ended December 31, 2009 2008 2007

OPERATING REVENUES Passenger $ 2,928 $ 3,056 $ 2,636

Other 358 332 206 Total operating revenues 3,286 3,388 2,842

OPERATING EXPENSES

Aircraft fuel and related taxes 945 1,397 968 Salaries, wages and benefits 776 694 648

Landing fees and other rents 213 199 180 Depreciation and amortization 228 205 176

Aircraft rent 126 129 124 Sales and marketing 151 151 121 Maintenance materials and repairs 149 127 106

Other operating expenses 419 377 350 Total operating expenses 3,007 3,279 2,673

OPERATING INCOME 279 109 169 OTHER INCOME (EXPENSE)

Interest expense (197) (242) (235)Capitalized interest 7 48 43

Interest income and other 10 (5) 54 Total other income (expense) (180) (199) (138)

INCOME (LOSS) BEFORE INCOME TAXES 99 (90) 31

Income tax expense (benefit) 41 (5) 19 NET INCOME (LOSS) $ 58 $ (85) $ 12


Jet Blue Cash Flow Page 1Jet Blue Cash Flow Page 1


CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) $ 58 $ (85) $ 12

Deferred income taxes 40 (6) 19 Depreciation 190 189 161 Amortization 44 21 19 Stock-based compensation 16 16 15 Gains on sale of flight equipment (3) (45) (9)Collateral returned (deposits) for derivative

instruments 132 (149) — Restricted cash returned by (paid for) business

partners 65 (70) — Decrease (Increase) in receivables 3 4 (14)Decrease (Increase) in inventories, prepaid and

other (43) (10) 3 Increase (Decrease) in accounts payable (66) 15 36

Other, net 50 103 116 Net cash provided by (used in) operating

activities 486 (17) 358


Jet Blue Cash Flow Page 2Jet Blue Cash Flow Page 2


CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures (434) (654) (617)Predelivery deposits for flight equipment (32) (49) (128)Assets constructed for others (47) (142) (242)Proceeds from sale of flight equipment 58 299 100 Refund of predelivery deposits for flight equipment 5 — 12 Purchase of held-to-maturity investments (22) — (11)Proceeds from maturities of held-to-maturity investments — — 24 Purchase of available-for-sale securities (636) (69) (654)Sale of available-for-sale securities 486 — 719 Sale of auction rate securities 175 397 — Return of (deposits for) security deposits (10) 1 72 Other — (30) (9)

Net cash used in investing activities (457) (247) (734)CASH FLOWS FROM FINANCING ACTIVITIES

Proceeds from: Issuance of common stock 120 320 26 Issuance of long-term debt 446 716 376 Aircraft sale and leaseback transactions — 26 183 Short-term borrowings 10 17 48 Borrowings collateralized by ARS 3 163 — Construction obligation 49 138 242

Repayment of: Long-term debt and capital lease obligations (180) (673) (265)Short-term borrowings (20) (52) (44)Borrowings collateralized by ARS (110) — —

Other, net (12) (20) (10)Net cash provided by financing activities 306 635 556

INCREASE IN CASH AND CASH EQUIVALENTS 335 371 180 Cash and cash equivalents at beginning of period 561 190 10 Cash and cash equivalents at end of period $ 896 $ 561 $ 190


Wrap UpWrap Up

What are you primary takeaways from this case?


Lecture 7Lecture 7

Earnings Quality


Lecture OutlineLecture Outline

• Part 1: The Five Ploys• Part 2: Detecting the Ploys• Part 3: Earnings Quality Cases


Part 1Part 1

The Five Ploys


Earnings QualityEarnings Quality

Companies sometimes manage their financial results to meet earnings expectations or to otherwise reflect strength. As they do, their actions reduce the “quality” of reported earnings.

QualityEarningsQuality

Earnings

ReliableReliable RelevantRelevant ConservativeConservative SustainableSustainable


Why Earnings Management Why Earnings Management is Possibleis Possible

Possibility forEarnings

Management

Possibility forEarnings

Management

Audits are notPerfect

Detectorsof Fraud

Audits are notPerfect

Detectorsof Fraud

Flexibility inGAAP

RequiresJudgment

Flexibility inGAAP

RequiresJudgment


Degree of Earnings Degree of Earnings ManagementManagement

Continuum of earnings management

Employmentof

conventionalGAAP

flexibility

Employmentof flexibilitythat strains

GAAP

Behavior beyond theboundaries

of GAAP

Fraudulentfinancial reporting


The Five PloysThe Five Ploys

(1)Recognizing revenue early

(2)Recording fictitious revenue

(3)Overstating assets to defer expenses

(4)Understating liabilities

(5)Taking big baths


Ploy 1: Recognize Revenue Ploy 1: Recognize Revenue EarlyEarly

RevenueRecognition

Criteria

RevenueRecognition

Criteria

SubstantialPerformanceSubstantial

PerformanceGood Handle

OnCosts

Good HandleOn

Costs

ConfidenceIn

Collections

ConfidenceIn

Collections

Firms often recognize revenue before they qualify to do so


Ploy 1: DiscussionPloy 1: Discussion

Bristol-Myers Squibb• Put pressure on distributors to purchase

extraordinary amounts of Bristol-Myers goods at year end.

• SEC stepped in to require the company to restate earnings.

FASB Discussion Memorandum emphasizes substantial performance, as defined by the contract between buyers and sellers.


Ploy 2: Record Fictitious Ploy 2: Record Fictitious RevenueRevenue

Firms record fictitious revenue by employing aggressive accounting procedures or by conducting outright fraud. Examples include:

• Recording revenue when the firm ships goods to its own off-site warehouse even though the goods have not yet been purchased by customers.– MiniScribe

• Grossing up revenue, e.g., recording large amounts of revenue along with offsetting cost of sales for swap transactions, etc.– Qwest and Enron

• Selling goods to affiliated parties, which may technically qualify as sales under GAAP (if the affiliates are not consolidated) but which are primarily conducted to increase reported revenue.

• Recording investment income as operating revenue.• Otherwise recording revenue that lacks economic substance.

– Thousand Trails


Ploy 3: Overstating Ploy 3: Overstating Assets to Understate Assets to Understate ExpensesExpensesExamples:• Capitalizing expenditures as assets rather than

recording them as an expense.– WorldCom

• Failing to write down assets which have permanently declined in value (i.e., the PV of expected cash flows is less than book value).

• Failing to properly amortize intangible assets when impairment occurs.

• Otherwise overstating assets, e.g., ending inventory.– Crazy Eddie

• Understate reserves for bad debts, inventory, etc.– SunTrust Reserve/Non-Performing Loans has declined from

130% (9/2007) to 62% (9/2008) and then to 60% (12/2008)


Ploy 4: Understate Ploy 4: Understate Liabilities to Understate Liabilities to Understate Expenses Expenses Examples:

• Simply ignoring invoices when received. – Crazy Eddie: In 1987, hid $3 million of A/P from auditors

• Recording revenue when cash is received even though services have not yet been performed (this cash should be recorded as an unearned revenue liability).

• Ignoring lawsuits and other contingent liabilities that are likely to be realized.


Ploy 5: Take Big BathsPloy 5: Take Big Baths

Firms sometimes record large special charges in the current period. These charges set up reserve accounts that reduce recorded expenses in later periods.

• Theory: Investors will largely ignore the one-time charge, and by taking the charge today the income statement will look stronger in the future.

Special Charges: Primarily asset write-offs of goodwill, inventory, or PP&E (asset impairments).

Restructuring Charges: Restructuring charges are associated with major changes in an entity’s business and/or strategy, such as divestment of business units, termination of employees with severance packages, etc.


Trend in Special Items: Trend in Special Items: SalesSales

Special Items as a Percent of Sales

0

0.5

1

1.5

2

2.5

3

3.5

4

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Per

cen

tag

e


Trend in Special Items: Trend in Special Items: FirmsFirms

Percentage of Firms Recognizing Special Items

0

10

20

30

40

50

60

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Per

cen

tag

e


Mini CasesMini Cases

Duane Read Pharmacies in New York (October, 2008)

• Asked suppliers to give DR a credit for purchases• Promised to pay back the credit after year end• Asked suppliers to send a “construction project”

invoice for the credit.• Total Ploy = $17.5 millionQ:What ploy(s) was Duane Read using?

Xerox (1998)• Treated equipment rentals to customers as capital

leases so they could record “sales” ($592 million). Q: What ploy(s) was Xerox using?


Part 2Part 2

Detecting the

Ploys


Audit ReportAudit Report

Look For:

• A qualified opinion• Any reservations the auditors may express

regarding the financials • Any changes in accounting methods the auditors

highlight


Proxy StatementsProxy Statements

Look for:

• Executive stock options, which often provide the incentive for earnings management

• Related-party transactions, which can be used to inflate reported revenue or hide liabilities (e.g., Enron)

• Litigation that is not accrued on the financials• Changes in auditors which may relate to disputes.

– OCA switched auditors right before it got caught cheating on its financials


Financial Statement Financial Statement InvestigationInvestigationAnalyze financial statement metrics:

• Across firms in the same industry (e.g., cross-sectional analysis), and

• Over time for the same firm (e.g. cross-time analysis).

Key Point: Note that the indicators listed in this table often can be interpreted two ways. On the one hand, they could reflect earnings management. On the other hand, they could reflect actual strength or improvement for the firm. Therefore, when an indicator is detected, it simply means that further analysis must be conducted to distinguish between actual strength and feigned strength.


Detection RatiosDetection Ratios

Metric Indicator Ploy Possibly Suggested

1 Accounts Receivable/Sales High or increasing

2 CFFO/Operating Income Low (below one) or decreasing

3 Accounts Receivable Cash Flow Effect Material and Negative

4 Ending Inventory/Sales High or increasing

5 Prepaid Expense/Sales High or increasing

6 Other Assets/Sales High or increasing

7 PPE/Sales High or increasing

8 Operating Expense/Sales Low or decreasing

9 Allowance for Doubtful Accounts/AR Low or decreasing

10 Inventory Reserve/Inventory Low or decreasing

11 Valuation Reserve/Deferred Tax Assets Low or decreasing

12 Deferred Revenue/Sales Low or decreasing

13 Accounts Payable/Sales Low or decreasing

14 Other Liabilities/Sales Low or decreasing

15 Special Charges High


Part 3Part 3

Earnings QualityCases

155


Earnings Quality Cases IEarnings Quality Cases I

CompanyWhen Scandal Went Public

Allegations Ploy Involved

Adelphia Communications April 2002Overstated results by inflating capital assets and underreporting expenses.

Bristol-Myers Squibb July 2002

Inflated its 2001 revenue by $1.5 billion by "channel stuffing," or forcing wholesalers to accept more inventory than they can sell now to get it off the manufacturer's books, thus accelerating sales

Duke Energy July 2002Engaged in 23 "round-trip" trades to boost trading volumes and revenue.

Enron October 2001

Boosted profits and hid debts totaling over $1 billion by improperly using off-the-books partnerships.

Halliburton May 2002Improperly booked $100 million of revenue for annual construction cost overruns even though customers had not agreed to pay for them.

Peregrine Systems May 2002Overstated $100 million in sales by improperly recognizing revenue from third-party resellers

WorldCom March 2002Overstated income by booking $3.8 billion in operating expenses as capital expenditures.

Xerox June 2000Falsifying financial results for five years, boosting income by $1.5 billion by treating term rentals of equipment as current sales of capital assets.

Satyam Computer ServicesJanuary 2009

Inflated figures for cash and related sales156


Earnings Quality Cases IIEarnings Quality Cases II

Company Allegations Ploy

AOL Time WarnerAOL booked ads it sold on behalf of others as revenue instead of just booking the commission AOL earned.

McAfee Anti-VirusUsing steep discounts, McAfee sold millions of dollars of product to its distributors that the distributors did not yet need, and then secretly paid the distributors to keep the extra product rather than return it to McAfee.

Nicor EnergyUnderstated the legal settlement owed to ComEd

GE Recorded $370 million for the sale of trains that hadn’t yet occurred

Cisco Wrote off $2 billion of inventory even though much of this inventory retained a great deal of value

Microstrategy Backdated sales contracts

Phar-MorReported greater ending inventory than really existed

Stayam Computer Services

Did not report a $250 million debt owed to others.

ParmalatReported non-existent sales of milk to Cuban residents and reported corresponding non-existent cash on its balance sheet

Anglo Irish Bank Hid loans (87 million Euros) the bank owed to shareholders

Mirant Overstated gas inventory by $85 million, increasing gross profits

MerckAccounted for customers copayments for the purchase of Merck drugs even though Merck never collected the copayments

Computer AssociatesPrematurely recognized $3.3 billion of revenue from at least 363 software contracts that the company had not yet executed.

Waste Management Understated depreciation by $1.7 billion by using long useful lives 157


Satyam Computer Satyam Computer ServicesServicesCase FormatCase Format• Read the statement by Satyam’s former CEO• Identify the relevant items on Satyam’s quarterly

balance sheet and income statement.• Address the following questions:

– What ploys did Satyam use?– Overall, how much were net assets (i.e., assets – liabilities)

overstated?• In crores rupees (which is the denomination used; one crore

rupees equals 10 million rupees). Note: Round each item to the nearest crore.

• As a percentage of total reported net assets (i.e., shareholder’s equity)

– What stands out to you in this case?

Satyam Computer ServicesJanuary, 2009 Page 1


Satyam Computer ServicesJanuary, 2009 Page 2



Satyam Computer Satyam Computer ServicesServicesStandalone Balance Standalone Balance SheetSheet


Lecture 8Lecture 8

U.S. Budget Accounting

162


The View from the Year The View from the Year 20002000• U.S. Budget Surpluses for three years straight

• Budget Surplus for the year 2000 sets a new record: $236 billion (2.4% of GDP)

• The CBO projects large, rising surpluses for the next ten years

163


CBO Budget Projections CBO Budget Projections (2001) vs. Actual (Billions)(2001) vs. Actual (Billions)

2001 2002 2003 2004 2005 2006 2007 2008 2009

ProjectedSurplus (Deficit)

281 313 359 397 433 505 573 635 710

Percent of GDP

2.8 3.0 3.3 3.5 3.5 3.9 4.1 4.5 5.0

ActualSurplus (Deficit) 128 (158) (378) (413) (318) (248) (162) (455

)(1413

)Percent of GDP

1.3 (1.5) (3.5) (3.6) (2.6) (1.9) (1.2) (3.2) (10)

164


Budget Deficit for 2010Budget Deficit for 2010

Revenue $2.162 trillionExpenditures 3.456 trillionDeficit $1.294 trillion

October 2010 Deficit $140 billionNovember 2010 Deficit $150 billion

165


Discussion QuestionDiscussion Question

What factors do you think contributed to the budget deficits after 2001?

166


Projected Budget Deficits Projected Budget Deficits (Billions) (Billions)

2010 2011 2012 2013 2014 2015 2016 2017

2018 2019 2020

CBO Proj. : -

1349-980 -650 -539 -475 -480 -521 -525 -542 -649 -687

Percent of GDP

-9.2 -6.5 -4.1 -3.2 -2.7 -2.6 -2.7 -2.6 -2.6 -3.0 -3.0

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

WH Proj.7/2010

-1471

-1416

-911 -736 -698 -762 -758 -721 -749 -822 -900

Percent of GDP

-10.0 -9.2 -5.6 -4.3 -3.8 -4.0 -3.8 -3.4 -3.4 -3.6 -3.8167


White House Projection: White House Projection: Selected AssumptionsSelected Assumptions

• A strong, sustained economic recovery will occur, with GDP growth of 3.9% in 2010, 4.7% in 2011, 5.8% in 2012, 5.9% in 2013, etc.

• Projections for 2016-2020 all assume full employment (5.2%)• These projections do not include the December, 2010 extension

of unemployment benefits and Bush tax cuts.• Any new health care plan will reduce the sum of deficits by $122B

(Gross cost of $590B offset by $712B of new taxes and savings)• Total disaster costs over the 10-year period will be $44B• As a percentage of GDP, defense and security spending will fall

dramatically (from 5.8% in 2010 to 4.1% in 2020)• As a percentage of GDP, discretionary spending will drop to lower

levels than it has been for 50 years (from 3.8% in 2010 to 2.2% in 2019)

• State budget deficits are excluded.Discussion: What are your views on these assumptions?168


Paying for the DeficitsPaying for the Deficits

There are three fundamental ways to pay for the deficits. All three ways represent tough choices.

• Reduce spending

• Raise tax revenue

• Monetize the debt

169


Reduce SpendingReduce Spending

Obstacles• The bulk of spending occurs in programs that are

hard to cut, including social security, Medicare, Medicaid, defense, interest, etc.

• Cutting spending requires conscious political decisions to induce pain now– Lower GDP– More Unemployment– Lower Growth

170


Reduce Spending: The SettingReduce Spending: The Setting

171


Raise Tax RevenueRaise Tax Revenue

Obstacles:

• Both political parties have announced opposition to broad-based tax increases

• Large state and local government deficits are leading to an increase in local tax rates

• Raising taxes depresses economic growth• Raising tax rates reduces economic activity, thus

reducing taxable income• Raising corporate tax rates does not increase

overall tax revenue very much; individuals would have to be taxed more

172


Raise Tax Revenue: The Raise Tax Revenue: The SettingSetting

173


Monetize the Debt Monetize the Debt (Quantitative Easing)(Quantitative Easing)

One way to pay off debt is simply to print enough money to pay it off (such as to continue buying mortgage backed securities). This naturally leads to inflation and higher interest rates. Inflation increases nominal GDP, so inflation itself decreases the ratio of Public Debt/GDP.

The most common way the Fed monetizes the debt is to print more money and use that money to buy treasuries (i.e., print money to pay off its debt).

174


Part 2Part 2

The National Debt

175


U.S. Debt Totals (Billions): U.S. Debt Totals (Billions): White House Projections White House Projections

2009

2010

2011

2012

2013

2014

2015

2016 2017

2018 2019 2020

Public Debt 7545 9298 1049

81147

21232

61313

91398

81483

31568

61653

517502 18573

% of GDP 53.0 63.6 68.6 70.8 71.7 72.2 72.9 73.6 74.2 74.9 75.9 77.2

2009 2010 2011

2012

2013

2014

2015

2016 2017

2018 2019 2020

Gross with intra-govt

11876

13787

15144

16336

17453

18532

19683

20837

22011

23197

24450 25777

% of GDP 83.4 94.3 99.0 100.8 101.5 101.8 102.6 103.4 104.

1105.1 106.0 107.1176


Federal Public Debt:Federal Public Debt:CBO’s 10-Year Projection CBO’s 10-Year Projection

177


Total Federal Debt: Total Federal Debt: CBO’s Long-Term ProjectionCBO’s Long-Term Projection

The source is the spreadsheet for CBO's alternative fiscal

scenario in its June Long-Term Budget Outlook.178


CBO Long-Term Spending and CBO Long-Term Spending and Revenue ProjectionRevenue Projection

179


CBO: Long-Term Interest CBO: Long-Term Interest Expense ProjectionExpense Projection

180


Part 3Part 3

Potential Outcomes

181


Some PossibilitiesSome Possibilities

• Grow our way out of the woods through innovation

• Consciously Reset the Economy to a Sustainable Level through Austerity

• Argentine Disease (Hyperinflation)

• Japanese Disease (Long-term Economic Malaise Followed by ?)

182


Reset the Economy through Reset the Economy through AusterityAusterity

Strategy:• Cut Spending Dramatically• Raise Taxes SubstantiallyConsequences:• Lower spending reduces GDP• Higher taxes reduce GDP• Unemployment swells• Prices of goods and services (including homes)

reset to fundamental values (no bubbles) • Permanently lower government benefits• From this foundation, slowly rebuild the economy

183


Deficit Reduction PanelDeficit Reduction Panel

Objective: To reduce deficit to sustainable level• Reduce defense spending by $100 billion• Reduce discretionary non-defense spending by $100 billion• Cut federal workforce by 10%• Eliminate mortgage interest deduction and earned income

credit• Raise gas tax by 15%• Reduce tax rates to 23%• Cap medical lawsuit damages• Reduce Medicaid and Medicare payments to doctors• Increase copayments for Medicaid and Medicare patients• Reduce social security inflation adjustments• Increase social security retirement age from 67 to 69• Increase payroll taxes

184


Argentine DiseaseArgentine Disease

Strategy:• Monetize the debt by printing money

Consequences:• The dollar crashes• The price of imported goods skyrockets• Interest rates skyrocket• Investment plummets• Wealth is destroyed

What are the odds? 185


Japanese DiseaseJapanese Disease

Strategy:• Keep spending• Raise taxes• Borrow to finance remaining deficits• Intervene to maintain low interest ratesConsequences:• National debt continues to rise• Taxes drag on the economy• Government spending crowds out private investment• Asset prices do not fully reset to fundamental values• Through government intervention, inflation and interest rates

remain under control for a season• Eventually, the bond market reacts to enormous debt. When?

And then what?What are the odds? 186


Discussion Wrap UpDiscussion Wrap Up

What can we do as individuals to address these issues on a

personal and family basis?

187


Lecture 9Lecture 9Final Project:

Groups: Maximum of 3 individualsSubmission Guidelines: Email electronic copy to meMaximum Length: 8 pages plus tables

The Project:• Choose a (possibly U.S.-based) company to analyze (in some cases, you also may

choose a competitor)• Use any combination of the techniques from the course to analyze the primary

company. Only use relevant techniques from the course. Ignore techniques that do not relate well to your company.

• Write a report on the relevant aspect(s) of the company you have chosen to emphasize. The report is not intended to be a comprehensive investment report. Instead, you should report on a key item for investors to consider.

• Example Topics (this list is far from complete): Indicators of potential earnings management; unique capital structure decisions; insights obtained from a DuPont analysis; the impact of fair value accounting; a specific bond rating upgrade or downgrade, or the potential for a change in rating; a critical analysis of analysts’ buy/hold/sell recommendations; a residual-income-based valuation; the viability of a particular bank, etc.

188

AccountingFinanceSeminar.February.2011.XLRI.Kemsley.StudentFile

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