ACCT6101 – Session #1: Introduction to Valuation
PART 1 – Background
assumed objective of management = maximize shareholders’ wealth
maximize share price!
roles / functions management executes in generating value –
1. Controller function asset efficiency (efficient use of working capital)
2. Treasury function long-term funds acquisition (debt or equity?)
3. Capital budgeting real (productive) asset acquisition (fixed productive assets)
the fundamental decisions that ultimately determine the firm’s profitability and its operating risk
the ‘Value Drivers’
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ACCT7106 – Session #5: Understanding the Financial Statements
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Our objective – an understanding of how the firm (management) generates value
purpose – development of the pro-forma Financial Statements
projected over the forecast horizon
core inputs into the valuation model x g
Balance Sheet (B/S)
Income Statement (I/S)
Statement of Cash Flows (SCF)
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Stage 1 – Understanding the Business
‘Strategy Analysis’
product market
competition
regulatory constraints
business strategies
technology
Stage 2 – Analysing Information
Accounting Analysis & Financial Analysis
quality of accounting information
reformulating the F/S to uncover business activities
ratio and cash flow analysis
Stages of the Analysis
Stage 3 – Prospective Analysis: Forecasting
pro-forma – Income Statement
– Balance Sheet
– Statement of Cash Flows
Stage 4 – Prospective Analysis: Valuation
Abnormal Earnings Model
Alternative Valuation Models
Statement of Cash Flows
Stage 5 – Prospective Analysis: Application
investment decision
investor – decision to buy, hold, sell
manager – decision to adopt strategy or not
e.g., proforma Income Statement
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caution – for ‘clean surplus’ and consistent estimates, the accounting system must reconcile
must concurrently develop the proforma Balance Sheets and Statement of Cash Flows
2019 2020 2021E 2022E 2023E
Sales 38,176 37,408 ? % ? % ? %
Other operating revenue 288 376
Cost of sales (29,253) (28,043) ? % ? % ? %
Other income 428 108
Administrative expenses (8,031) (8,081) ? % ? % ? %
Other expenses (146) —
Share – equity investments 5 (6)
Financing costs (42) (443) ? % ? % ? %
Income tax expense (347) (341) ? % ? % ? %
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‘tool box’ i.e.,
external factors economic climate (cycle), macroeconomic factors, political/regulatory, socio-cultural
industry structure and dynamics suppliers, buyers, new entrants, substitutes, rivalry
competitive strategy cost leader, differentiation, first mover
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Now seek to add an understanding of the firm’s underlying ‘financial performance’ to the ‘tool box’ by analysing the Financial Statements
why? insights into (among other factors), operating policies, production technologies and techniques, inventory and credit systems
operating decisions financial performance
Step #1 – the Financial Statements as presented ̴ Session #5
Step #2 – reformulation of the Financial Statements
Step #3 – assessment of ‘accounting quality’ ̴ Sessions #6, 7, 8
Step #4 – analysis ratios
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Reporting Obligations of Australian Publicly Listed Companies
Legally, publicly-listed Australian companies are public and ‘disclosing entities’ under the Corporations Act (2001)
they must provide:
an annual financial report that includes financial statements, notes to the financial statements, and a directors’ report
the financial report must comply with Australian Accounting Standards (AASB standards) and must be audited
the directors’ report provides a summary across a broad range of aspects relating to the firm and its operations
a half-year report that has similar requirements, but usually does not provide as much detail, and might be reviewed rather than audited
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Listed companies must also comply with ‘continuous disclosure’ requirements
they must immediately disclose information that might materially affect their share price through the Australian Stock Exchange (ASX) website
(in the US, this is done through the Securities Exchange Commission (SEC) website instead)
Information disclosed on the ASX website are called company ‘announcements’
https://www.asx.com.au/asx/statistics/announcements.do
includes annual/half year reports
news released under continuous disclosure rules
insider trading reports
significant ownership reports
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Accounting Standards (AASB)
Australian companies must comply with Australian Accounting Standards Board pronouncements (AASB standards)
these are a local variant of International Financial Reporting Standards (IFRS)
IFRS standards are used in most countries, usually with minor local tweaks
the US uses its own standards called US GAAP, that is not based on IFRS. However, IFRS and US GAAP are very similar
the ‘tools’ developed in this course can be used broadly in any jurisdiction
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AASB 101 requires five things:
Balance Sheet (or Statement of Financial Position)
Income Statement (or Statement of Profit & Loss) and/or Statement of Comprehensive Income
Statement of Changes in Equity
Statement of Cash Flows
Notes to the financial statements
Comprehensive Income can be reported in two different ways:
prepare a Statement of Comprehensive Income separate from the Income Statement, but immediately following it (this is how Coles reports – pages 98/99)
combine the two as one Statement of Profit/Loss and Comprehensive Income
Financial Statements must show at least two-years of comparative numbers under AASB 101 (e.g. FY19 and FY20 in the 2020 Annual Report)
Financial Statements
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the financial statements we will be using are Consolidated, meaning they represent the combined financial statements of the parent company and all the subsidiaries it controls
Parent Co
Subsidiary Co 1
Subsidiary Co 1
Subsidiary Co 1
Sub Co 1A
Sub Co 1A
Sub Co 1A
the consolidated entity produces one set of Financial Statements
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Cautions –
the financial statements are general purpose; they are prepared for a variety of stakeholders (shareholders, creditors, suppliers, customers, etc.)
they are not set-out perfectly for shareholders and for doing valuation
need to ‘reformulate’ the financial statements in order to make them more useful for fundamental analysis and valuation
separation of ‘operating activities’ and ‘financing activities’
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Directors’ Report
Australian companies must provide a Directors’ Report in their Annual Report
usually placed towards the start of the Annual Report
similar the ‘Management Discussion & Analysis’ (MD&A) provided by US firms
the requirements for the Directors’ Report are contain in the Corporations Act (2001, sections 299-300A) and Regulatory Guidance notes issued by ASIC (especially RG 247)
the Directors’ Report provides information useful for understanding how the company has performed, and some clues about how it might perform in the future e.g.,
description of the company’s operations and strategy
explanation of the current year’s results
business strategies
risks
future outlook
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PART 2 – The Accounting Process:
(1) Balance Sheet (B/S): position at a specific point in time measured in accordance with GAAP
(2) Income Statement (I/S): summary of activities for period, part of bridge between two B/S
(3) Statement of Cash Flows (SCF): uses and sources of cash
(4) Notes to F/S: supplementary information for full disclosure
The “building blocks” of Financial Accounting (GAAP) are:
1) basic elements – definitions specific to accounting
2) qualitative characteristics – characteristics necessary for the F/S to meet users’ needs
3) environmental assumptions – structure of framework within which accounting must function
4) accounting principles – broad standards/guidelines (man-made based on “logic” not on natural law)
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Basic Elements definitions specific to accounting
e.g., asset – future benefit
– controlled by the firm
– result of a past transaction
liability – currently exists, from a past transaction
– determinable maturity value and date
– payee identifiable
– cannot avoid future sacrifice ( no offset)
‘assets’, ‘liabilities’, ‘owners’ equity’, ‘revenue’, ‘gain’, ‘expense’, ‘loss’, ‘earnings (net income)’
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Qualitative Characteristics characteristics necessary for the F/S to meet users’ needs
1. relevance – makes a difference in decisions i.e., improves predictive ability, confirms expectations
2. reliability – dependability
3. timeliness – information available before it loses capacity to influence decisions
4. verifiability
5. neutrality
6. comparability – improves both reliability and relevance
7. consistency – select the same method each year
8. uniformity – same method used by all firms
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Environmental Assumptions
provide structure of framework within which accounting functions
1. economic (separate) entity assumption – each enterprise is considered as an accounting unit separate and apart from the owners and other entities irrespective of legal status
e.g., proprietorship: unlimited liability BUT keep books of “store” separately!
2. periodicity assumption – recognizes the need for short-term, periodic F/S even though the results can not be know specifically until liquidation
3. continuity assumption – in absence of evidence to the contrary, the business entity is assumed to remain in operation long enough to carry out its contemplated operations, contracts, and commitments
4. monetary unit assumption – money is the best common denominator since it is “relevant, simple, available, understood, and useful” (also states that fluctuations in the value of the dollar can be ignored without impairing usefulness)
5. dual aspect – there are 2 sides to every transaction
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Accounting Principles
rules giving guidance to measurement, classification, and interpretation of economic information
broad standards or guidelines (are man-made based on “logic” not on natural law)
The next set of slides (#18 – #24) presents an illustration of the mechanics of accounting for a small retail organisation, and thereby the development of its Financial Statements *** this material is illustrative only; it is not eligible for examination ***
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Example #5-1
In late 20X0, CM and MC decided to open a sporting goods wholesale operation, CMMC Ltd. The firm’s balance sheet as at 31 December 31, 20X0 consisted of only two items, cash of $1,000,000 and contributed capital of $1,000,000. Information concerning the firm and its activities during 20X1 follows:
1. On January 1, 20X1, CMMC purchased land and a building for $500,000, paying $300,000 in cash and financing the remainder with a new $200,000 10-year 12% bond issue. The fair market value of the land at that date was $300,000. The building had an estimated life of 20 years and has no expected scrap value.
2. Because of its relative immaturity, CMMC decided to focus its attention on the distribution of only one item, sailboards. The following purchases were made on credit during 20X1:
2 January: 350 units @ $200 each 30 June: 400 units @ $300 each
CMMC still owed suppliers $55,000 at the end of the year.
3. Sales for the year were $350,000 (700 units). While all sales were on credit, only $85,000 remained uncollected at year-end. CMMC decided to use the FIFO method of inventory valuation. Based on the experiences of similar firms, CMMC believes that 1.5% of the outstanding receivables will ultimately be uncollectible.
4. CMMC paid $4,000 for a two-year insurance policy on July 1, 20X1.
5. Administrative, selling, and general expenses (other than interest, depreciation, and labour) were $31,000 for the year. All of these expenses had been paid by the end of the year.
6. Labour wages for 20X1 were to $45,000. Of this amount, only wages from the last half of December remain unpaid (assume wages are earned uniformly throughout the year).
7. CMMC declared a dividend of $30,000 on December 31, 20X1, to be paid on January 10, 20X2.
8. The firm’s tax rate is 43%
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‘Mechanics’ –
Step #1: Journal Entries
identifies each event and amount in the journals
Step #2: t-accounts
summarises each event and amount by account, and produces final balances
Step #3: Financial Statements
structured presentation of the final balances from the t-accounts
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Shareholders’ equity
Liabilities
Assets
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CMMC Ltd.
Income Statement for the year ended December 31, 20X1
Sales 350,000
COGS (175,000)
Gross Profit 175,000
Operating Expenses
depreciation 10,000
bad debt expense 1,275
insurance 1,000
administrative 31,000
labour expense 45,000 (88,275)
Operating Income 86,725
Financing costs (interest expense) (24,000)
NIBT 62,725
tax expense (43%) (26,972)
Net Income 35,753
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CMMC Ltd.
Balance Sheet, December 31, 20X1
cash 700,903
accounts receivable 85,000
allowance (1,275) 83,725
inventory 15,000
prepaid insurance 3,000
land 300,000
building 200,000
acc depn (10,000) 190,000
Total Assets 1,292,628
accounts payable 55,000
wages payable 1,875
dividends payable 30,000
bonds payable 200,000
capital stock 1,000,000
retained earnings 5,753
Total Liabilities and Shareholders’ Equity 1,292,628
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CMMC Ltd.
Statement of Cash Flows for the year ended December 31, 20X5
Operations:
Cash receipts 265,000
purchases (135,000)
insurance (4,000)
G,S & A expenses (31,000)
labour (43,125)
interest (24,000)
taxes (26,972) 903
Investing:
purchase of land (300,000)
purchase of building (200,000) (500,000)
Financing:
bonds payable 200,000
dividends (0) 200,000
Net Decrease in Cash (299,097)
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PART 3 – The Financial Statements
1. Balance Sheet (Statement of Financial Position:
presents the company’s financial position as at a particular point in time (end of the reporting period)
classifications: Assets, Liabilities and Equity
Assets and Liabilities further classified into:
current (realised within 12 months)
non-current (economic value to firm > 12 months)
Accounting relation: Total Assets = Total Liabilities + Common Shareholders’ Equity
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Companies must show at least the following items on the face of the Balance Sheet (assuming the item exists for the company) (AASB 101):
Assets:
Property, plant and equipment (PPE)
Investment property
Intangible assets
Financial assets
Investment accounted for using the equity method
Inventories
Trade and other receivables
Cash & cash equivalents
Assets held for sale as part of discontinued operations
Deferred tax assets
Liabilities:
Trades and other payables
Provisions
Financial liabilities
Income tax payable
Deferred tax liabilities
Liabilities associated with discontinued operations
Equity:
Non-controlling interests (NCI)
Issued capital
Reserves
Total Assets = Total Liabilities + Shareholders’ Equity
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2. Income Statement (‘Statement of Financial Performance’ or ‘Profit and Loss Statement’)
shows financial performance over a period of time (usually 12 months)
the core aspect of the I/S typically has the following basic structure:
Revenue
– Cost of goods sold (COGS)
= Gross margin (or gross profit)
– Operating expenses (SG&A, wages, advertising, R&D)
= Earnings before interest, tax, depreciation and amortisation (EBITDA)
– Depreciation and amortisation
= Earnings before interest and tax (EBIT)
– Net interest expense (or net of interest revenue)
= Profit before tax (PBT)
– Income tax expense
= Net profit after tax (NPAT) (but before extraordinary items)
extraordinary items
= Net Income
– Preferred dividends
= Net Income to Common Shareholders
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3. Statement of Changes in Shareholders’ Equity
provides a detailed break-down of changes in equity accounts over the period
Shareholders’ Equity typically consists of up to five accounts:
Contributed capital: how much shareholders have historically invested in the company
Treasury stock: cost of shares repurchased (but not retired)
Retained earnings: (basically) sum of past profits less past dividends
Non-controlling interest (minority interest): portion of controlled subsidiaries not owned by the parent company
Reserves: used for various items that affect equity, but do not pass into retained earnings (typically these items go through Other Comprehensive Income) e.g.,
if PPE is revalued upwards to fair value, the increment is placed in a Revaluation Reserve (AASB 116)
most companies place share-based payments in a reserve until the share-based payments (typically options) are exercised/expire (AASB 2)
translation of foreign operations into the company’s presentation currency (AASB 121)
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changes in equity accounts can be classified into two categories:
Comprehensive income (CI):
=NPAT
+OCI
Net transactions with shareholders:
= Cash dividends
+ Share repurchases (treasury share repurchased, etc.)
Shares issued (dividend reinvestment plans, issued to executives or NCI, treasury shares issued, etc.)
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4. Statement of Cash Flows
sources and uses of cash over a period of time (usually 12 months)
similar to the Income Statement, but based on cash accounting, rather than accrual accounting
structure:
cash flow from operations (CFO):
cash flow from investing (CFI):
cash flow from financing (CFF):
CFO can be presented in two different ways in Australia:
Direct method: itemised cash receipts less cash payments related to operations
Indirect method: profit +/- non-cash items and net changes in working capital
the direct method was historically required in Australia and is still the most common
the indirect method can be used in Australia and is very common in other countries
in Australia, if the direct method is used, the indirect method must be shown in the notes
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indirect method from Footnote 2.1
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5. Notes to the Financial Statements (pages 103 – 148 of Coles 2020 Annual Report)
usually appear at the end of the financial report after the financial statements
typically provide details of the following:
description of accounting policies
details of segments
finer detail on financial statement items
miscellaneous disclosures required under Australian law, such as list of subsidiaries, shareholder statistics, major shareholders
The details provided in the ‘Notes’ are an imperative for fully understanding the information conveyed by the Financial Statements (I/S, B/S, and SCF)
The Articulation of the Financial Statements (Figure 2.1, page 42)
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Investment and disinvestment by owners (including dividends)
+ Net income and other earnings (comprehensive)
Net change in owners’ equity
Statement of Shareholders’ Equity
Revenues
Net income
Income Statement
Cash from operations
Cash from investing
Cash from financing
Net change in cash
Cash Flow Statement
Cash
– Liabilities
Total Assets
Owners’ equity
Beginning Balance Sheet
+ Other Assets
– Liabilities
Cash
Total Assets
Owners’ equity
Ending Balance Sheet
Beginning stocks
Flows
Ending stocks
+ Other Assets
Expenses
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PART 4 – Comprehensive income (CI) (and ‘dirty’ versus ‘clean’ surplus)
The ‘clean surplus’ relation is the standard accounting identity
Ending book value (shareholders’ equity)
= beginning book value + income – dividends changes in contributed capital
BVt = BVt-1 + Et – Dt NCCt
The key within this equation is that income (E) is in fact ‘comprehensive income’ (CI) and not ‘net profit after tax’ (NPAT or OI)
consider Coles again
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Accounting adjustment
Comprehensive Income
Dividends
BVt-1
BVt
NCC
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Comprehensive Income (CI)
basically a more complete measure of performance than ‘net profit after tax’ (NPAT)
CI = NPAT + Other Comprehensive Income (OCI)
OCI is also called ‘dirty surplus’ – it is termed ‘dirty’ because it is not counted towards NPAT (note – surplus is an ‘old’ name for profit)
CI satisfies an important relation called the clean surplus relation (CSR):
(usually, net profit does not satisfy this relation)
a list of OCI items appears in AASB 101 (and is summarised following):
bottom line – basically a lot of messy, complicated things; the most common ones are FX translation gains/losses and cash flow hedging gains/losses
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(a) changes in revaluation surplus (AASB 116 Property, Plant and Equipment and AASB 138 Intangible Assets);
(b) re-measurements of defined benefit plans (AASB 119 Employee Benefits);
(c) gains and losses arising from translating the financial statements of a foreign operation (AASB 121 The Effects of Changes in Foreign Exchange Rates);
(d) gains and losses from investments in equity instruments designated at fair value through other comprehensive income in accordance with paragraph 5.7.5 of AASB 9 Financial Instruments;
(da) gains and losses on financial assets measured at fair value through other comprehensive income in accordance with paragraph 4.1.2A of AASB 9.
the effective portion of gains and losses on hedging instruments in a cash flow hedge and the gains and losses on hedging instruments that hedge investments in equity instruments measured at fair value through other comprehensive income in accordance with paragraph 5.7.5 of AASB 9 (Chapter 6 of AASB 9);
(f) for particular liabilities designated as at fair value through profit or loss, the amount of the change in fair value that is attributable to changes in the liability’s credit risk (paragraph 5.7.7 of AASB 9);
(g) changes in the value of the time value of options when separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the changes in the intrinsic value (Chapter 6 of AASB 9); and
(h) changes in the value of the forward elements of forward contracts when separating the forward element and spot element of a forward contract and designating as the hedging instrument only the changes in the spot element, and changes in the value of the foreign currency basis spread of a financial instrument when excluding it from the designation of that financial instrument as the hedging instrument (see Chapter 6 of AASB 9).
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PART 5 – Accounting Concepts: Recognition and Disclosure
Recognition formally including an item in the financial statements
Disclosure merely disclosing the existence of an item in the Notes, but not formally including it in the financial statements
Example: contingent liabilities
“A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity” (AASB 137)
e.g., a loan guarantee – will only become a liability only if the other company defaults (or becomes likely to default)
does NOT currently meet the definition of a liability and hence can not be formally recognised (included) in the Balance Sheet (see Slide #16 for definition of a liability)
disclosed in the notes (see Coles 2020 Annual Report Note 6.2 on page 143)
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Accounting Policies
Revenue Realization Principle:
revenue is the creation of wealth
any inflow other than from owners’ equity or creditors, measured as net cash equivalent price from an arm’s-length transaction
in general, revenue is recognized when there has been an exchange transaction and the earnings process is essentially complete
sales basis (employed when collection of price in full is reasonably certain and when related expenses are determinable)
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Matching Principle:
based on cause and effect i.e., all expenses incurred in generating revenue should be reported in the period when the revenue is recognized
definitions:
expenditure – decrease in asset or increase in liability associated with incurrence of a cost
expense – using up of resources by entity’s earnings activities during current period
an expenditure may benefit the period in which it occurs and/or future periods (e.g., acquisition of fixed assets) whereas an expense is of benefit only to the period in which it is consumed
an item of cost must either be defined as an asset or as an expense
e.g., purchase inventory for resale – becomes cost of goods sold (COGS) on I/S only in period when sold else held on the B/S as an asset (inventory)
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exceptions to the matching principle include
a) period expenses
– costs of doing business e.g., administrative costs, costs of accountant, etc.
– these costs are expensed in the period in which they are incurred
why? they don’t have an obvious link to revenue of some future period
question – what about advertising expenses? will impact on future revenue BUT causal link is difficult to establish
are typically expensed in period when incurred
b) dividends
– dividends are not expenses from the accounting perspective
recorded directly to Retained Earnings (as a reduction) when declared
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Accounting Concepts: Accruals
Why accrual accounting?
recognises revenues (expenses) when they are earned (incurred), rather than when the cash is received (paid)
resulting earnings generally provides a better measure of economic value added than cash flow
e.g., suppose a company made $10m in cash sales and $100m in credit sales for a year – looking only at cash sales would provide an incomplete picture of the company’s performance
accruals accounting is better for forecasting – it produces smoother and more predictable earning
accrual accounting simply changes the timing of when items are recognised in the F/S – over the life of the company, cash flows and revenues/expenses must be the same
accruals involve some estimation (e.g., provision for doubtful debts) – this introduces the possibility of estimation errors
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the main measure of performance under accrual accounting is NPAT (or CI)
the main measure under cash accounting is CFO
total accruals = NPAT – CFO
From the Coles’ presentation in Footnote 2.1 of its CFO using the indirect method
Profit = 978
Accruals = 1,574 (adding up all the adjustments and changes in assets and liabilities)
CFO = 2,552
caution – determination of ‘accruals’ involves managerial discretion (e.g., estimates) and thereby can impact the quality of the accounting figures
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PART 6 – Accounting Concepts: Measurement
having decided to recognise an item in the Financial Statements, its value (amount) must then be measured –
four main measurements methods used under AASB/IFRS (see Conceptual Framework):
Historical Cost: how much the item originally cost less (if applicable) accumulated depreciation/amortisation and less (if applicable) accumulated impairments
Fair Value (or current cost): basically current market value – what would it cost today to buy the asset or to repay the liability
Realisable Value: what could the asset be sold for today?
Present Value: present value of future cash flows related to the asset or liability
(note – typically, Realisable Value and Present Value are viewed as being the same as Fair value)
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Cash and Cash Equivalents Fair value (cash is cash)
Accounts Receivable, net of Provision for Doubtful Debts Expected amount to be collected from receivables. This should be close to Fair value
Inventories Lower of cost and net realisable value
Property, plant and equipment (PPE) Can be carried at Historical cost (most companies) or Fair value less depreciation and impairments
Intangibles Can be carried at Historical cost (most companies) or Fair value less amortisation and impairments
Goodwill Historical cost (with impairments, but no amortisation)
Investment property Fair value (typically) or Historical cost
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Accounts payable Historical cost, which is usually close to fair value
Borrowings Amortised cost (usually); fair value is permitted, but not used often by industrial companies
Deferred revenue Estimated revenue to be earned in the future. This should be close to fair value
Provisions, e.g., provision for warranty expenses Present value of estimated future expenses. This should be close to fair value
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Measurement – Equity Investments
For equity investments in another company, the accounting depends on whether the company has ‘control’, ‘significant influence’, or neither
Control (usually >50% ownership):
the investee company is known as a ‘subsidiary’ and the owner is called the ‘parent’
consolidation method: basically add the subsidiary and parent’s accounts together – no separate asset for the investment is recognised
Significant influence (usually 20-50% ownership):
the investee company is known as an ‘associate’
equity method of accounting: recognise an asset on balance sheet; recognise share of profits/losses of associate; recognise dividends received from associate
Joint control (usually 50% ownership):
the investee company is known as a ‘joint venture’
equity method of accounting is used
Neither (usually < 20% ownership):
recognise an asset
measurement depends on management’s intention
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For investments in debt securities (e.g. bonds) and minor investments in equity securities (<20% ownership), measurement depends on management’s intentions with respect to the investment
Held to maturity (debt only)
management intends to hold the debt until it matures
measurement is at amortised cost
Held for trading (debt/equity)
management intends profit from trading the debt/equity
measurement at fair value, with gains/losses recognised in the Income Statement
Available for sale (debt/equity)
management’s intention is not to hold to maturity or hold for trading
measurement at fair value, with gains/losses recognised in OCI
(note – see updated AASB 9 for specific details)
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Accounting Concepts: Classification
once an item is recognised and measured, the final decision is how to classify the item
typical issues:
is an item a liability or equity? (Balance Sheet)
is an item a recurring or non-recurring item (e.g. an extraordinary item)? (Income Statement)
is it an operating, investing or financing cash flow (e.g. interest paid)? (Cash Flow Statement)
our interest is also in re-classification
example: preference shares – financial instruments that have features of both equity and liabilities
equity: pay dividends; rank below debt in payment of dividends and repayment on liquidation
liability: typically dividends are fixed; rank above ordinary shares for dividends and repayments
difficult to classify in the Balance Sheet: are they liabilities or equity?
in practice, can be classified as liabilities, equity or split into both (depending on the exact terms of the preference share)
we will reclassify all preference shares as financial obligations
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Accounting Concepts: Going Concern Assumption
IFRS/AASB accounting is done on the basis that the company will continue to operate for the foreseeable future (it is a going concern) (continuity assumption, Slide #18)
the business/company/venture is an ongoing, continuing business
AASB 101:
management must assess whether the company is a going concern i.e., it is not likely to be liquidated or cease to trade – management must disclose if there is uncertainty
if a going concern, normal accounting is used; if not, the company should disclose the accounting method (could be anything)
auditors must check on management’s going concern assessment (see ASA 570)
for purposes of the valuation exercise, we typically assume the company is a going concern (there are special valuation techniques for companies that are not going concerns, for example asset-based valuation)
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PART 7 – Summary: Sessions #1 #5
overarching focus – fundamental value (‘intrinsic value’)
requires an understanding of the ‘value drivers’
need to accumulate a ‘tool kit’ as the basis for developing the
pro forma Financial Statements
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models – AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
Figure 1.1 Lundholm & Sloan, Framework for Equity Valuation
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Stage 1 – Understanding the Business
‘Strategy Analysis’
product market
competition
regulatory constraints
business strategies
technology
Stage 2 – Analysing Information
Accounting Analysis & Financial Analysis
quality of accounting information
reformulating the F/S to uncover business activities
ratio and cash flow analysis
Stages of the Analysis
Stage 3 – Prospective Analysis: Forecasting
pro-forma - Income Statement
- Balance Sheet
- Statement of Cash Flows
Stage 4 – Prospective Analysis: Valuation
Abnormal Earnings Model
Alternative Valuation Models
Statement of Cash Flows
Stage 5 – Prospective Analysis: Application
Investment decision
investor – decision to buy, hold, sell
manager – decision to adopt strategy or not
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external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory
Industry dynamics
Porter’s five forces
(suppliers, buyers, new entrants, substitutes, rivalry)
Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality
??
e.g., proforma Income Statement
64
caution – for ‘clean surplus’ and consistent estimates, the accounting system must reconcile
must concurrently develop the proforma Balance Sheets and Statement of Cash Flows
2019 2020 2021E 2022E 2023E
Sales 38,176 37,408 ? % ? % ? %
Other operating revenue 288 376
Cost of sales (29,253) (28,043) ? % ? % ? %
Other income 428 108
Administrative expenses (8,031) (8,081) ? % ? % ? %
Other expenses (146) ---
Share – equity investments 5 (6)
Financing costs (42) (443) ? % ? % ? %
Income tax expense (347) (341) ? % ? % ? %
64
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