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FSA-2

Financial reporting and analysis

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recollects

_Asset securitization- what way does it help a Banker?

_Bonus issue- can Capital reserves realized in cash be Capitalized?

_Difference between Contingent liabilities- provisions and Charges

--Buy backThe only route is u/s 77a other routes lead to Reduction

of Capital u/s 100 of the Cos. Act --All assets in the Balance sheet are really not assetsDeferred

revenue expenditure and Fictitious assetsset off against net worth

--Conservatism-not really appreciated; Prudence is

--Difference between Economic income and accounting income

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M2-1 I) the Reporting environment

A) The statutory reports Income statements

and B/S

B) Other reports 1) Financial statements-Quarterly

2) Earnings announcement

3) Other statutory reports

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M2-2

Financial statements-these are statutory reports acompany must file with the SEC; are not publicityoriented (unlike some annual reports) and

contain info. beyond what annual reports reflect---Form10-k

Form-10qare quarterly statements filed withthe SEC. these provide LATEST info.

While analyzing these data we need to takecognizance of a) seasonality factors b) Year endadjustments-which do not appear quarterly

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M2-3 Year end adjustments are done in the following

areas generally

1) inventory-difference between actual stockand book stocks

2) tax provision

3) Outstanding expensessalaries etc

4) provision for depreciation

5) Provisions for work remaining to be executedon capital a/cs not provided for basicallycontingent liability turning into provision

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M2-4

2) Earnings announcements Key announcements about cos. performance quarterly

and yearly

Cos. PRO FORMA Earnings statement give a clear a/c

of the Operational profits i.e profits from continuingoperations divested from non operational earnings andextraordinary income/ expenses

Pro forma earnings while reflecting operational profitsmight exclude from Profits certain non operatingincomes/expenses which could provide value to ananalyst

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M2-5

3) Other statutory reports Form10k- filed with annual report

Form 10 Q filed with Quarterly report

Form 20 f Filed by Foreign Issuers

Form 8k current report to be filed

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M2-6 Factors affecting Statutory financial reports The main factor- GAAP

Others-the reporting authorities & the Regulators

GAAP is a collection of standards,pronouncements, Opinions and interpretationsalong with practice guidelines. Professionalaccounting bodies along with the Regulators

have formed GAAP The Standards setting body in the US is FASB

which consists of 7 members-Accountant,investor, managers, analysts etc

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M2-7

Setting standardsExposure draft, debate and

implementation

SEC

Final authority on financial reporting International financial reporting standards-

IFRS. Us cos. go by GAAP. IFRS are standards

set by interested parties in different countries

India and US should accept IFRS by 2011

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M2-8- hurdles created for Analyst

Managers-interest in Accounts

Brazen Accounting gimmicksdeferred

interest capitalization and capital standby Window dressing- - making lower provisions,

avoiding inventory write offs

Oppose standards that could impact theprofits

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M2-9-contd. M

onitoring and regulatory organizations 1) the auditors internal auditors not exposing a

possible adverse event in time. External auditorgiving a clean opinion when not deserving orrefraining from giving an opinion when it is

actually called for! 2) Corporate governance

The audit committee of the board of directors-right to oversee accounting principles,

disclosures, internal audit remarks etc. SEC initiatives for wrong doings and the

damages bill in litigation paid by cos. powerfuldisincentives!

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M2-10 Other sources of information- for a S/H 1) The Economy, the Industry and Company

sourcesannouncements made in the Stock

exchanges, analyst inferences on certain

economic events changing a companys

performance etc.

2) SelfdisclosureSafe Harbor Rules provide

legal protection to managers against genuinemistakes

Managers to avoid signaling- a process that lets

out only good info. to push up stock prices

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M2-11Information intermediaries

Analysts

Experts on channels

FundManagers Technical analysts etc

They do the job of

1) information gathering 2) Information interpretation

3) Prospective analysis

4) Recommendations

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M2-12 Qualities of accounting information 1) Relevance- timeliness

2) Reliability-reality and unbiased

Accounting information is a trade off betweenrelevance and reliability;forecasts increase

Relevance but reduce Reliability

3) Comparability and consistency

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M2-13 Important principles of Accounting 1) Recording at Historical costs-objectivity takes the place

of relevance!

2) Accrual basis- Cash and Accruals together make

Accounts. In accrual Revenues are recognized when earned

and expenses when incurred regardless of cash movements

3) Materiality- the magnitude of an omission or mis-

statement of information that, in the light of surroundingcircumstances, makes it possible that the judgment of a

reasonable person relying ---

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M2-14 -- would be changed or influenced by the

omission or misstatement

Conservatism and prudence

Reporting the lowest estimate or a fairly lowestimate as compared to Optimistic ones while

reporting estimates

Recognize losses but not unrealized gains; delaythe good news while accepting the bad ones

immediately-wrong part of Conservatism!!

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M2-15 Limitations of financial statements 1) Timeliness

2) frequency

3) Not Forward looking

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

Accrual system of accounting

Are the sum of all accounting adjustments thatmake net income different from net cash flow

Net income=Operating cash flows+ Accruals

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M2-16 Accrual process involves 1) Revenue recognitionwhen earned and

realized or realizable. The goods need to be

delivered and the company should run intoan asset ( Cash/receivables) very likely to be

converted into cash

2) Expense matching-expenses should as far

as possible be matched with their Revenues.

This applies to both product and period cost

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M2-16A-Revenue recognition Recognition of revenue from five types of transactions:

1)Revenues from selling inventory are recognized at thedate of sale often interpreted as the date of delivery.

2)Revenues from rendering services are recognized whenservices are completed and billed.

3)Revenue from permission to use companys assets (e.g.interests for using money, rent for using fixed assets, androyalties for using intangible assets is recognized as timepasses or as assets are used.

4)Revenue from selling an asset other than inventory isrecognized at the point of sale when it takes place

5)Revenue from LONG TERM contracts--% of CompletionMethod.

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Percentage-of-completion method says that if (1) the contract

clearly specifies the price and payment options with transfer ofownership, (2) the buyer is expected to pay the whole amount and(3) the seller is expected to complete the project, then revenues,costs, and gross profit can be recognized each period based upon theprogress of construction (that is, percentage of completion). Forexample, if during the year, 25% of the building was completed, thebuilder can recognize 25% of the expected total profit on thecontract. This method is preferred. However, expected loss shouldbe recognized fully and immediately due to conservatism

Completed contract method should be used only if percentage-of-completion is not applicable or the contract involves extremely high

risks. Under this method, revenues, costs, and gross profit arerecognized only after the project is fully completed. Thus, if acompany is working only on one project, its income statement will

show $0 revenues and $0 construction-related costs until thefinal year. However, expected loss should be recognized fully and

immediately due to Prudence constraint.

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M2-17

Relevance of accrual accounting 1) Short term accruals-create some Current assets(

receivables, prepaid expenses etc) and Current liabilities(

Creditors, advances received etc). This presents the

Accounts more coherent 2) Long term accruals Freecash flows calculated by subtracting investments in

long term Capital assets from Operating cash

flows. This induces Volatility in free cash flows. Accrual byCAPITALIZING these expenses reduces this volatility andby way of amortizations brings a match between

Revenue& Costs

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M2-18

The relationship among Operating Cash flows, Investingcash flows and free cash flows

Investing cash flows- in Fixed Assets say-- are usually

Negative until Maturity stage, -- because of cash outflows

on Investment--especially for growth cos. The Operatingcash flows during this period are Positive and usually high

for growth cos. Passing maturity stage, the Operating

cash flows decline-- while because of asset

divestment-- the Investing cash flows increase

The Free cash flows till maturity stage are NEGATIVE

possibly and turn positive beyond it as less or no

capital expenses are deducted from Operating Cash Flows

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M2-19 The market could treat free cash flow the same way it treats the

operating cash flows; it could be different also. However Accrual

accounting is given predominance over cash accounting as it

recognizes the financial effects of business activities in a more

relevant manner

All cash flows are NOT treated on the same footing in themarkets. A reduction in free cash flows arising out of growth

could push up stock prices other factors not being adverse!

Cosmeticwindowdressing exercises in accrual changing the

method of stock valuation- will be ill received alright

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M2-20 It is easier to manipulate cash flows than income Accrual accounting is more relevantthan cash

flow accounting

Cash flows are more reliable than accrualaccounting figures though they are more

volatile.

Though the cash flow picture can bemanipulated ( C/A valuation) they are less

susceptible to it than Income figures

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M2-23

EarningsManagement Purposeful intervention byManagement in the earnings determination process,usually to serve their own objectives

Happens by 1) changing accounting methods-sufficient

disclosure requirement not adhered to 2) Changing accounting estimates

Earnings Management Strategies

1)Increase Current earnings 2) BIG BATH 3)

income smoothing-creating hidden reservesin good year if the next year looks tough 4)Taking asset impairments in a good year

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M2-24 Reasons for EarningsManagement- 1)Incentive based remuneration

2)Stock price angle To reduce it for

consolidating holdings Or to increase it forholding gains/ realising Capital gains

3) Other reasons

Tax management

Avoiding monopoly tags

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M2-25Mechanics

1) Channel loading coaxing dealers to buy stocks at

year end in a BIGWAY

2)Capitalizing what really are revenue expenses

3) Changing methods of valuation/ depreciation

4) taking one time charges-impairments and

restructuringBig bath

5) classificatory management shifting certainabove the line costs/ revenues to below the line to

avoid glare

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M2-26 Classificatory Loading a larger proportion of

expenses to discontinued operations; reflectingSales of Previous Year as that of current year

Analysts generally take cognizance of costs and

revenues of continuing businesses only; a goodreason for Classificatory Management

An analyst should look at the reputation of themanagement/ past records, the Industry practice etc

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M2-28

Auditing and FSA Auditors go by GAAP

Auditors express an opinion on the Accounts

submitted to them for audit Apply procedures like test check and detailed

check to verify the veracity of the numbers

Assess accounting policies and whether theylie in line with GAAP

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M2-29

Types of Qualification 1)Primary objective- to express an opinion as

to whether the financial statements present a

true and fair view of the Financial position(Balance sheet) and the financial performance

(P&L a/c) during the period under review

2) secondary Objective-detection of errors and

fraud and their effect on the financial

statements

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M2-32

2) Adverse opinion The Financial statements under purview do

not present a true and fair view regardingthe state of affairs of the company

Happens when the accounts are not drawn upin conformity with GAAP

3) Disclaimer of opinion absence of sufficient

evidence to form an opinion, truncated termsof reference, incomplete set of accounts etc

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M2-33

Auditing generally involves test checks. Audit risksare heavy

1) Auditors professional integrity and competence

2) Overall audit quality

3) Tie up with theM

anagement 4) the nature of auditsulphur closing stock

verification; verification of fuel oil at zero hours in acontinuous process industry-parallax error inphysical stock verification

5) higher error tolerance by the auditor 6) Specialization being subjectivediamond

valuation

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M2-34

Determinants of earnings quality

1) The willingness to apply GAAP

aggressive/mild 2)The management mind not incurring

discretionary expenses like advertisement etc

during a/cs closing

3) Treatment of cyclical expenses

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