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    Capitulos 1 A 5 Palepu PDF

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    nardo

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    © All Rights Reserved
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    of 127
    ‘A Framework for Business Analysis and Valuation Using Financial Statements Thischapter outlines a comprehensive framework for financial statement analysis. Because financial statements provide the most widely available data on public corporations” eco- nomic activities, investors and other stakeholders rely on financial reports fo assess the Plans and performance of fms and corporate managers A variety of questions can be addressed by business analysis using {8 shown in the following examples: nancial statements, + A security analyst may be interested in asking: “How wel isthe fra Lam following performing? Did the firm met my performance expectations? I a, why ot? What isthe valve ofthe fms stock given my assessment of the firm's cuenta future performance” + A loan officer may need o ask: “What is the credit isk involved in lending acetain mount of money to this frm? How wel i the fim managing is liquidity and so ‘vency? What isthe firn’s busines isk What i the additional risk created by the Finn's financing ad dividend policies” +A mumagement consultant might ask: “What i the structure ofthe industry in which te frm is operating? Wha are he strategies pursued by various players inthe indus ‘ey? What is the relative performance of tferent fis in the ndusty + Acorporate manager ma’ ask“Ismy Firm properly valid by investors? I ur ‘or communication program adequate to facilitate this process + A corporate manager could ask: “I this frm a potential takeover target? How much ‘value canbe added if we aequite this firm? How can we finance the sequisition” + An independent auditor would wan to ask: “Are the accountng policies and accrual «sates inthis company’s financial statements consistent with my understanding of ‘his business and its ecent performance? Do these Financial reports communicate the current status and significant rss ofthe business” In the ewenteth century, we have seen two distinct models for channeling savings into business investments. Communist and socialist market economies have used central plan ning and government agencies to poo! auional savings and to dine investments in bus ness enterprises, The failre of this model is evident from the fat that most of these economies have abandoned it in favor ofthe second model—the market mre. In almost, ll eounties in the werld today, capital markets pay an important eo in channeling nan ‘lal resources fom svers to business enterprises that ned capital Financial statement analysis isa valuable activity when managers have compete infor- ‘ation ona firm's strategies ana varely of institutional factors make i unlikely that they fully disclose this information, n this sting ouside analysts attempt to create “inside information” from analyzing financial statement data, thereby gaining valuable insights about the firm's cutent performance and future prospects. To understand the contrition that financial statement analysis can make, itis Jmporant to understand the role of financial reporting in the Functioning of capital markets and the institutional Forces that shape financial statements. Therefore we present fist brief description ofthese fores; then we discuss the steps that an analyst mst perform 0 ‘extract information from financial statement and provide valuable forecasts THE ROLE OF FINANCIAL REPORTING IN CAPITAL MARKETS A citical challenge for any economy i the allocation of savings to ivestment opportni- tes. Economics that da this wel can exploit aew business ideas to spur imovation and re tte jobs and wealth ta rapid pace. In contrast, economies that manage this process poorly isipte their wealth and fall o support business opportunites, Figure [-1 provides a schematic representation of how capital markets rpieally work, Savings in any economy are widely distributed among households, There are usually many new entrepreneurs and existing companies that would keto aac these savings (0 fund thee busines ideas. While both sivers and entrepreneurs would lik to do business with each oer, matching savings to bsiness investment opportunites is complicated for least two reasons. First, entrepreneurs typically have beter inrmaton than savers on the vale of business investment opportunities. Second, communication by entrepreneurs to investors is not completely eredible hecause investors know enepreneurs have an incentive to inflate the vaive oftheir ideas. "These information and incentive problems lad to what economists cll the “lemons” problem, which can potentially break down te functioning ofthe pital market! Tk works like this. Consiersstuation where af the busines ideas are “004 athe ote half are ya” If iavestors cannot distinguish between the two types of busines ideas, ntreprenets witha eas il yt claim that their ides are Valuable asthe “goo” ideas, Reali ing tis possibility, investors value both god and bad ideas at an average level. Unfortu rately his penalizes good ideas, nd entrepreneur with good ideas find the terms on which they can get financing to be unattractive. As these enteprenewrs leave the capital marke, the proportion of bad ideas in the market increases. Overtime, bad ideas “crowd out” good ideas and investors lose confidence in his market. Information Financial Intermediaries “The emergence of intermediaries ean proven such a market breakdown. Intermediaries alike «car mechanic who provides an independent cerifieation of x used cat's quality © help buyer and seller agree on a price, There are 660 types of intermediaries in the A Frame for Bac rt and Van Ur nn Serene capital markets, Financial intermediaries, such as venture capital firms, banks, mutual, nds, ad insurance companies, focus on aggregating fonds fom individual investors and analyzing diffrent investment altematives to make investment decisions. Information imtermediares, such s auditors, financial analysts, bond-rating agencies, andthe financial ress, focus on providing information to investors (and to financial intermediaries Who represent them) on the quality of various business investment opportunities. Both these types of intermediaries add value by helping investors distinguish “good” investment ‘opportunites from the "bad ones. Financial reporting pays critical ole inthe functioning of ba the information inter mediaries and financial intermediaries, Information intermediaries add value by either ‘enhancing the credibility of financial report (as auditors do), or by analyzing the informa tion in the nancial statements (as analysts and the rating agencies do). Financia interme avis rely on the information in the financial statements to analyze investment ‘oppertunies, end supplement this information with other sources of information, In the following section, we discuss key aspects ofthe financial reporting system design that enable ito play effectively this vital ole nthe fontioning ofthe capital markets FROM BUSINESS ACTIVITIES TO FINANCIAL STATEMENTS, ‘Corporate manager ate responsible for acquiring physical and rancil resources fom the firms environment and using them to create value forthe firm's investors. Value is created when the firm earns a return on its investment i exces ofthe cost of capital. Managers for- rmolate busines strategies to achieve this goal, and they implement them through business activities. A firm's business activities are influenced by its economic environment and its ‘wn basiness strategy. The economic environment inclidesthefrm’s indi ts mp and ‘output markets andthe regulations under which the firm operates, The firm's business strat- egy determines how the firm positions ite in its environment to achieve a competitive ‘vantage. [As shown in Figure 1-2 fim's financial statements summarize the economic conse ‘quences ofits busines activites, The firm's business activites in any time period are too ‘humerous to he reported individually to outsiders, Further, some ofthe activites under taken bythe firm are proprietary in nature, and disclosing these activities in detail could be detriment tothe firm's competitive position. The fmn's sceounting system provides a mechanism though which busines activites ae selected, measured, and aggrepated into financial statement data Tnermediris using financial statement dat to do business analysis have to be aware ‘hat financial reports are inuenced both by the finm's business activities and by its accountng system. A key aspect of financial statement analysis, therefore, involves under- standing the influence of the accounting system on the quality of the financial statement ata being used inthe analysis. The institutional features of accounting systems discussed below determine the extent ofthat infloence Accounting System Feature 1: Accrual Accounting, (One ofthe fundamental features of corporat financial reports is that they are prepared us- Jing acral rather than cash accounting. Unlike cash accounting, acrual accountng distin _uishes between the recording of cst an heneis associated with economic activites and ‘he actual payment and receip of cash Net income isthe primary pericdic performance apc ara ava freee” | racer . iota cua sonawaaiwies || “Ceectatae oe. Cpe ee Sa | EE Ee 4 | —— ance i aaa Goel aieraee eae Gas decagey een feet moe og comers oe er: | eteene rere | coors rot | renames | peees ieee Seni | Mgr iperor ‘ximan eee index under accrual accountng. To compute net income, the effects of economic transac tions are recorded on the bass of expected, pot necessarily actu, cash receipts and pay ments. Expected cash receipts from the delivery of products or services are recognized as revenues, and expected cash outflows associated with these revenues are recognized a ex penses “The need for accrual accountng arises from investors’ demand for nancial eports on a period basis. Because firms undertake economic transactions ona continual basi the txbitrary closing of accounting books atthe end ofa reporting pried leads to a fundamen tal measurement problem. Since cash sccounting does nt report te fall economic conse ‘quence ofthe transactions undertaken in a given period, acrual accountng is designed (0 Provide more complete information on a fis pecodie performance. Accounting System Feature 2: Accounting Standards and Auditing ‘These of acraal accountng les atthe center of many important complexes in corporate financial reporting. Because acral accounting deals with expectations of future cash com A Frenork frBunas Arr and Van Using Fel Stamens Sequences of cutent evens, it is subjective and relies ona variety of assumptions. Who shouldbe charged withthe primary responsibilty of making these assumptions? A firm's managers are ented withthe task of making the appropriate estimates and assumptions to prepare the inncial statements because they have intimate knowledge oftheir fr's business, The accounting discretion granted to managers is potentially valuable because it allows ‘em to reflect inside information in reported financial statemenis. However, since ives- ‘ors view profits as a measure of manages’ performance, managers have incentives to use their accountng discretion to distort reported profits by making biased assumptions. Fur- ther, the use of accounting numbers in contacts between the fim and ontsiders provides another motivation for management manipulation of accounting numbers. Income man ‘agement distorts financial accountng data, making them lest valuable to extemal users of ‘financial statements. Therefore the delegation of nancial reporting decisions to corporate ‘manages has both costs and benefits ‘A numberof secounting conventions have evolved to ensure thet managers use their secounting Hlenblity to summarize thei knowledge ofthe firm's business activites, and not to disguise realty for selfserving purposes. Fr example, the measurably and con servatism conventions are accounting responses to concerns about distortions from mat ages" potentially optimise bias. Both these conventions attempt to limit managers ‘optimistic bias by imposing their own pessimistic bis ‘Accounting tandards, called Generally Accepted Accounting Principles (GAAP), pro ‘mulgated by the Financial Accounting Standards Board (FASB) and similar standan-se ting bodies in ther counties, also imit potential distortions that managers can introduce into reported numbers. Uniform accounting standards attempt to reduce managess ability to record similar economic tranietons in dissimilar ways, ether over time oF across firms, Increased uniformity from accounting standards, however, comes at the expense of, reduced flexibility for managers to reflect gemuine business differences in their firm's financial statements. Rigid accounting standards work est for economic transactions ‘whose accounting teatment i noe predicated on managers” proprietary information, How ver, when there is significant business gent involved in assessing a transaction’ co nomic consequences, righ standards which prevent managers from using their superior business knowledge would be dysfunctional. Further, if accounting standans ae 100 id, they may induce managers to expend economic esoures to restructure business trast ‘ions to achieve a desired secounting result ‘Auditing, broadly defined as a verification of the interty of the reported financial statements hy someone oter than the reparer, ensures that manages use accounting rules and conventions consistently over ime, and that their accountng estimates ar rea- sonable, Therefore auiting improves the quality of accounting daa ‘Thid-party auditing may also reduce the quality of financial reporting because it ‘constrain the kind of accounting rules and conventions that evolve ove ie, Forex ple, the FASH considers the views of auditors inthe standard-sting process, Auditors ae Tikely to argue agains accounting standards preideing numbers tha are cific to aud even f the proposed rules produce relevant information fr invesors ‘The legal environment in which accounting disputes between manages, auditors, and Jiestos are adjudicated can also have a significant effect onthe quality of reported num bors The teat of lawsuits and resulting penalties have the beneficial feet of improving the accuracy of disclosure. However, the potential fora significant legal Habity might also discourage managers and auitrs from supporting accounting propo Fishy forecasts, such a forward-looking disclosures, Accounting System Feature 3: Managers’ Reporting Strategy ecause the mechanisms that limit manager” ability to distort accountng data ad noise, itis nt optimal to use accounting regulation eliminate managerial Sesbility completely. “Therefore real-world accounting systems eave considerable room for managers to influ- cence financial statement data. A firm's poring strategy, that the tanner in which mat ‘agers use their accounting discretion, his an important influence onthe firs financial (Corporate managers can choose accounting an disclosure policies that make more oF less dificult for external user of financial repets to understand the rue economic pictre oftheir busineses. Accounting rules often provide abroad se of lernatives frm which manages an choose, Further, managers ar entrusted with making a range of estimates in implementing these accounting policies. Accounting regulations usually prescribe mini- ‘muon diselosure requirements, but they donot restrict managers rom voluntary providing ‘ditional disclosures, ‘A superior disclosure strategy will enable managers to communicate the underlying busines reality to outside investors. One important constant on firm's disclosure strat cay isthe competitive dynamics in pact markets Disclosure of proprietary information bout business strategies and their expected economic consequences may burt te tras ‘competitive poston. Subject ta this constraint, managers can use financial statements provide information wsefl to investors in asessing thei ims true economic performance “Managers can also use financial reporting strategies to manipulate investors’ percep- tions, Using the discretion granted ta them, manages ean make i fic or investors f entity pooe performance on a timely bass, For example, managers can choose account ing polices and estimates to prove an optimistic assessment of the firm's trve perfor ‘mance, They can also make it costly for investors to understand the true performance by ‘controlling the extent of information tht i isloned voluntarily. "The extent to which financial statements ae informative about the underying business realty varies aeross firms and scr0s ime fora given firm. This variation in accounting ‘quality provides both an impomtant opportunity and a challenge in doing business analyst ‘The process through which analysts can separate noise from information in financial state rents, and gain valuable business insights from financial statement analysis, is discussed FROM FINANCIAL STATEMENTS TO BUSINESS ANALYSIS, Because managers insider knowledge isa source both of value and distortion in counting ata, is difficult fr outside users of financial statement to separate woe information from ‘istonon and noise. Not being able to undo accounting distortions complete investors “is ‘count fim’s epented aounting performance. In doing s, they make a probabilistic as- sessment ofthe extent to which firm's reported numbers reflect economic elt. AS res investors can have nly an imprecise assessment ofan individual firm's performance. Finan ial and information intermediaries ea a value by improving investors’ understanding of firm's curent performance and its future prospects fective financial statement analysis is valuable because i tempts fo get st managers” inside information from public financial statement data, Because itemedates do not have root or complete access to this information, they rely on tier knowlege of the fim’ industry ad its competitive sategis to interpret financial statements. Soccessfl intermedi fates have at lett as good an understanding of the industry ezonomics as do the fim’ | Framework for ures Ansa nd Vaan Ung incl Stamnes managers as well as ¢reasonsly good understanding of the firm's competitive strategy. Although outside analyss have an information dsadvamage relative to the firm's managers, they are more objective in evaluating the economic consequences ofthe firm's investment and operating decisions, Figure I-3 provides schematic overview of how business interme dares use financial statements to accomplish four key steps: I busines sttegy analysis, (2) accounting analysis (3) financial analysis, and (6) prospective analysis Analysis Stop 1: Business Strategy Analysis ‘The purpose of business strategy analysis to identify ey profit divers and busines sk, and to sssess the company’s profit pent ata qualitative level. Business trategy analysis, involves analyzing a firm's industry ais strategy to create a sustainable competitive ae ‘vantage. This qualitative analysis is an esential fist step because it enables the analy © fame the subsequent accounting and financial analysis het For example, identifying the ‘Key sucess factor and key busines sks allows the identification of key accountng poli- cies. Assessment ofa fire's competitive strategy’ facilitates evaluating whether current profitability is sustainable. Finally business analysis enables the analyst to make sound a sumptions in forecasting a firm's future performance ‘Financial Seatements ‘Bunines Appleton Context | Menger ape norman Crete sa co baa actin Secure ays Nowe om ett errs Mergers an agin anys ern tem mage DebuDvierd aa senna cle Corrie communion ther Pc Dats ‘ey aah ener boat eas Instead frm te ~~ NALS Toots | | | [enna Serceny | ‘Analysis coments aN T \ | | Prospective Analysis | see | (Bee | R=" || Accum |_| Fania Cem conte | | Emiuapetrmee | | Hae reams sces.,| [foe | [oe \ Analysis Step 2: Accounting Analysis ‘The purpose of accounting analysis i to evaluate the depree to which a fim's accounting apres the underlying business reality. By ideniying plces where there is accounting fen, and by evaluating the appropriateness of he hs accounting policies and eti- rates analyst can ases the degre of distortion ina finm’s accounting numbers. Another important step in accounting analysis ito “undo any accounting distortions by recasting afi’ accounting numbers create unbiased accounting ata. Sound accounting analysis itprowes the clay of conslsions from foancal analysis, the next step in Hance statement analysis Analysis Step 3: Financial Analysis “The goal of financial analysis isto use financial data to evaluate the current and past per formance of fm and to asess its sustainability. Ther are two important kills related to finanial analysis. Fis, the analysis shouldbe systematic and efficient Second, the analy- sis should allow the analyst to use financial data to explore business issues. Ratio analysis and cath flow analysis are the 1wo most commonly used financial tools, Ratio analysis fo ‘uses on evaluating firm's product market performance and financial policies; cash low analysis focuses ona firm's liquidity and financial xiii Analysis Step 4: Prospective Analysis, Prospective analysis, which focuses on forecasting firm's future isthe final step in bus ness analysis, Two commonly used techniques in prospective analysis are financial state ‘ment forecasting and valuation, Both these tons allow the synthesis ofthe insights from business analysis, accounting analysis, and financial analysis in order to make predictions outa fim’ fare ‘While the value of a frm sa function ofits future cash low performance its aso po sible o asses afr’s valve based on the fr’scurent book vale of equity, and is future fetum on equity (ROE) and growth, Strategy analysis, accounting analysis, and financial analysis, the fist thee steps inthe framework discussed here, provide an excellent fun ation for estimating a fim’ intrinsic value, Strategy analy, in addition to enabling Sound accounting and financial analysis, also helps in assessing potential changes in a firm's competitive advantage and their implications fr the firm's fture ROE and growth ‘Accounting analysis provides an unbiased estimate ofa firm's current book value and ROE, Financial analysis allows you to gun an in-depth understanding of what drives the firm's eurtent ROE. “The predictions from a sound business analysis are useful toa variety of partes and can be applied in serious contexts. The exact nature ofthe analysis wll depend on the context ‘The context that we will examine include secures analysis, eredit evaluation, mergers and acquisitions, evaluation of debt and dividend policies, and assessing corprate com ‘munication strategies, The four analytical steps described above are useful in each of hese contexts. Appropriate use ofthese tools, however, requires familiarity with the economic theories and institatonal factors evant to the context. “Thete are several ways in which financial statement analysis can add value, even when capital markets are reasonably efficient. Fist, thee are many applications of financial Statement analysis whose focus is ouside the capital market context—credit analysis, ‘competitive benchmarking, analysis of mergers and aequistions, to name a few. Second, markets become efficent precisely because some market participants rely on analytes! Framework fr Sues ras nd Vaan Ui nel Sates tools suc asthe nes we discus in tis book to analyz information and make investment decisions, SUMMARY Financial statements prove the most widely availble data on public corporations’ eco- nomic activities; imvestors and other stakeholders ely on them to assess the plans and per ormance of fies and corporate manages. Acerual accounting daa in financial statements are noisy, and unsophisticated investors can assess firms’ performance only imprecise, Financial analysts who understand manager’ disclosure strategies have an opportunity f0 «eat inside information from public data, and they play a valuable ole in enabling ouside Parties to evaluste a fir's current and prospective performance "Tis chapter has outlined the framework for business analysis with financial state rents, using the four key steps: business strategy analysis, accounting analysis, financial analysis, and prospective analysis. The remaining chapters in this book describe these steps in greater detail an discuss how they ean be used ina variety of business contexts, DISCUSSION QUESTIONS 1. Join, who has just completed his fist finance cours, i unsure whether he should take ‘acourse in business analysis and valuation using financial statements since he believes ‘that financial analysis adds ite vale, given the efficiency of eapital markets. Explain to John when financial analysis can add value, even if capital markets are efficient. 2. Accounting statements rarely repo fnencal performance without enor, List three {ypes of errors tat can aise in financial reporting 3. Joe Smith argues that “learning how to do business analysis and valuation using fina al sutements isnot very useful, unless you ae interested in becoming a inancial an Iyst" Comment 4, Four stops for business analysis are discussed in the chapter (strategy analysis, sccounting analysis, financial analysis, and prospective analysis). As a financial analyst, explain why each ofthese steps ertcl part of your job and how they relate to one another. NOTE |. G. Aerio, “The Market for ‘Lemont: Qualty Unceraingy and de Market Mechanism, Quo Jounal of Eze (August 1970 48-500, Chapter 2 Strategy Analysis Chapter 3 Overview of Accounting Analysis Chapter 4 Implementing Accounting Analysis Chapter 5 Financial Analysis Chapter 6 Prospective Analysis: Forecasting Chapter 7 Prospective Analysis: Valuation Theory and Concepts Chapter 8 Prospective Analysis: Valuation Implementation Strategy Analysis Swategy analysis is an important starting pont forthe analysis of financial statement, Sategy analysis allows the analyst to probe the economics ofa firm at a qualitative level so tha the subsequent accounting and financial analysis is grounded in business realty ‘Strategy analysis als allows the identification ofthe fem’ profit divers and key sks, This ‘nturn enables the analyst to asess the sustainability ofthe frm’scurent performance and ‘make realise Torecats of future performance. ‘A film's value is determined by its bility to ean a retun on its capital in excess ofthe cost of capital. What determines whether or nota firm is able w accomplish this goa!” While a firm's cost of eaptl is deteemined by the capital markets, its profit potential is determined by its on strategic choices (1) the choice ofan industry ora set of industries, in which the frm operates (industry choice), 2) the manner in which the firm intends compete with other fms in its chosen industry or industries (competitive positioning), and (3) the way in which the firm expects to create and exploit synergies across the range of businesses in which it operates (corporate sategy). Strategy analysis, therefore, involves industry analysis, competitive stategy analysis, nd corporate steatepy analysis. In this chapter, we will briefly discuss these thee steps and use the personal computer industry and Amazon.com, respectively 1 illutae the application ofthe steps. In analyzing afm’ profit potential, an analyst has to fist sess the profit potential ofeach ‘ofthe industries in which he fim is competing because the profitability of various industries Aitfers systematically and predicably over ine. Fr example, te rato of earings before in terest and taxes tothe book value of assets oral U.S. companies between 198] and 1997 was 88 percent. Homever the average eturs varied widely across specific inte fr the bak ¢y products industry: the probity ratio was 43 percentage point greater han the popula tion average, and for the sver ore mining industry it was 23 percentage points less than he population average What causes these profitability diferences? ‘There isa vast ody of research in industrial organization on the influence of industry structure on profitably.’ Relying on tis research, strategy literature suggest tht the sverage profitability of an industry i infuenced by the “Bve forces” shown in Figure 2-14 Agconding to this framework, the intensity of competition determines the potential for creating abnormal rots by the ims in industry. Whether oF no the potential pro its are kept by the industry is determined bythe relative bargining power ofthe fms in the industry and their customers and suppliers. We will discuss each ofthese industry profi drivers in more detail below Degree of Actual and Potential Competition [Ac the most basic level, the profits in an industry area function ofthe maximum price that tomers are wllng to pay fo he industry's product or service, One ofthe key determi nants of the price isthe degree to which there is competition among suppliers ofthe same corsimilar products. Atoneexreme, if there is state of perfect competition inthe indus, iero-economie theory predicts that prices will be egal to marginal cost and here wil Pic 2 + Bins Amar Valaon Too [7 woryamane eat Tat ot | Indy owes Saleen | maaan Connon franc ae pemece Sondre fangs Tk | Deon Dusrbuton seco ers wigs | Saleterig Ueber | omarion aos ‘arganng Power ‘arziing Power a | ‘Bayer ‘tsumtes—| Diernttn iteration Inporaree of protuctor | Iparance af roduc or os gy ost wl ely ibe ete | Naber fers | few opportunites to eam supernormal profits. At the other extreme, if the industry is dominated by a single frm, there wil be potential to earn monopoly profits. In reality, the degree of competition in mos industries is somewhere in between perfect competition and monopoly “There are thee potemil sources of competition in an industry: (1) rivalry between exiting firms, (2 dret of entry of new firms, and (3) threat of substitute products or ser ‘ices. We wil discuss each ofthese competitive forces in the following paragraphs. Competitive Force 1: Rivalry Among Existing Firms In most industries the average level of profitability is primarily influenced by the nature of rivalry among existing irs i the industry. In some industries firms compete aggressively, pushing prices close fo (and sometimes below) the marginal cost. In other industries firms {donot compete aggressively on price. Instead, they find ways to coordinate their pricing, forcompeteon nonpice dimensions sich as innovation or brand image. Several factors de ‘ermine the intensity of competion between existing players in an industry: Seren ra Industry Growth Rate If an industy is growing very rapidly, incumbent firms need not ‘rab marketshare from each ote to grow: In contas, in stagnant industries the only way existing firms can grow is by taking share away from the other plays. In this situation one «am expect price wars among firms inthe nds. Concentration and Balance of Competitors ‘The aamber of firms in an industry and theirelatve sizes determine the degree of concentration in an industry.” The deeree of con ‘centration influences the extent to which Fins in an industry can coordinate ther pricing and other competitive moves, For example, if share is one dominant frm in an indastry (uch as TBM inthe mainframe computer industry inthe 19705, it ean Stand enforce the Iles of competion. Similarly, if there ae only two or three equal-sized players (such ‘Coke and Pepsi inthe US, soft-drink indus, they’ ean implicitly cooperate with each ‘other to avoid destructive price competition. Ian industry is fragmented, pice competion islikely to he severe Degree of Differentiation and Switching Costs The extent co which femsin an nds tty can avoid head-on competition depends onthe extent to which they can differentiate their products and services, Ifthe products in an industry are very similar, customers are ready to stl rom one competitor to anther purely on the basis of price, Switching costs, also determine customers propensity to move from one product to another. When switeh- ing cost are low, there isa greater incentive for fms in an industry to engage in price competition Scale/Learning Economies and the Ratio of Fixed to Variable Costs If there is a steep larg curve or there are other types of scale economies inan inst, size becomes an important factor for firms in the indus: In such situations, there are incentives to en- _nge in aggressive competition for marketshare. Similry, if the ratio of fixed to variable ‘oss high irs have an incentive to reduce prices to tilze installed capacity. The line industry, where price wars are quite contmn, i an example of his typeof situation, Excess Capacity and Exit Barriers If capacity in an industry is larger than customer ‘demand, there i a strong incentive for rms wo cu prices to fil capacity. The problem of excess capacity i key to be exacerbated if there ae significant hariers fr firms 0 exit ‘he industry. Ext barter are high when the assets ae specialized orf there are regulations ‘which make ext costly Competitive Force 2: Threat of New Entrants ‘The potential for earning abnormal profits wil stract new entrants ton industy. The very treat of new fms entering an industry potently constrains the pricing of existing firms within it. Therefore the ease with which new firms can enter an industy is key deere ‘inant of ts profitability, Several factors determine the height of barriers to eniy in an indus Economies of Scale When there ae large economies of scale, new entrants face the choice of having ether to invest in large capacity which might no be uilized ih away ‘orto enter with ess than the optimum capacity. Either way, new eatants wil a least ini- ‘ally sutfer from a cos disadvantage in competing with existing firms. Economies of scale ‘might arise from large investments in research and development (the pharmaceutical eet engine industries), in rand advertising (soft-drink industry), ori physical plant and equip- ‘ment (telecommunicatons industry). First Mover Advantage arly entrants in an industyy may deter future entrants if there fare fist mover advantages. For example, fist movers might be able to set industry 23 Fred + Bes Ans nd Vat Tost standards renter nto exclusive arrangements with suppliers of cheap raw materials. They may also acquire scarce government licenses to operate in regulated industries. Fialy if there ate leering economies, ey firms will have an absolute cost advantage over new ea trans, Fit mover advantages are also likely tobe larg when thee are signiicant switl- ing costs for customers once they start using existing products. For example, switching ‘oss faced by the users of Microsoft's DOS operating system make i dificult for software ‘companies to mirket anew operating system. Access to Channels of Distribution and Relationships Limited capacity in the exis ing dstibtion channels and high costs of developing new channels can act as povertul barriers to etry For example, a new entrant int the domestic auto industry in the US. is likely to face formidable barriers because of the difficulty of developing a desler network ‘Similarly, new consumer goods manufacturers find it difficult to obtain supermarket shelf space for ther products, Existing relationships betven fms and cusomers in a industry also make it dificult for new firms to ener an industry. Industry examples ofthis include fading investment banking, and advertising Legal Barriers There are many industries in which legal bariers such as patents and copyrights in researh-intensive industries lit etry, Similan licensing regulations limit entry int tai services, medial services, broadcasting, and telecommunications industries Competitive Force 3: Threat of Substitute Products “The third dimension of competition in an industry is the treat of substitute products o er- vices. Relevant subsiutes are not necessarily those that have the sume form as the existing products but those that perform te same function. For example airtnes an car rental er ‘ices might be substitutes foreach other when it comes to travel over short distances, Sim itary, plastic hotles and metal can subsite foreach other s packaging in the beverage indastry, In some cases, threat of substitution comes not fom customers’ switching to a ‘other product bu from uring technologies that allow them to do without, oF use less of, the existing products, For example, energy-conserving technologies allow customers tre ‘duce their consumption of electricity and fossil fel "The threat of substitutes depends onthe relative price and perfomance ofthe compet- ing produets or services and on customers willingness to substitute, Customers’ perce tion of whether two products are substitutes depends to some extent on whether they perform the same function for &siiar price, I two products perform an identical func tion, then it would be dificult for them to differ fom each other in price, However, cus tomers’ willingness (© switch is often the cftcal factor in making this competitive users these dizoron are age enough corer ith Fowt may nature a fins perio pe formance better than accouing profs. The rive ureters of ch flow ad aeceunting prot ss in measuring prforance, serefore, ars trom fem to frm For empl evidence ants Issue se P. Decion,"Aecouning Exige ad Cath Flows s Mesures of Firm Performance, The Role of Accounting crs Joural of counting and Ero 18 (ly 1984) 3-42. 5. For example, Abraham Bro wrote series of accountng arses of public compari laren’ over several yes. On average, te stock pies ofthe aaized compares changed by about 8 percent on te cy chee ares were publaha,ndeatng th poten vale of perform ing sue ani Fors more complete dscisiton ofthis evden, te G Foster, "Broan the (Capital Markee” Jura of caning Reo 17 (Spring 1909) 262-74, 16, Fora complet dicsion of these modvaton, ee "Posie Acting Tea" by R Wass 1nd} Zmmervan, (lewood Cis Nf: Pranie Hall 1966. A summary of is research pro ‘ied by T. Fils, T. Ls. and L. Vincent “Epral Research on Acounting Chole ura ef Accounting & Ecos 31 (September 201) 285-307 7. The most conicing evidence supporting the covenant hypothe raprtad in study of the acounng dciions by fers nfrancal dite: A. Swesney, “Debt-Coverat Velcon ed Manager” Accoureng Response, Jura of econting and Exons I? May 1994). 281-308 8 Studies that examine the bonus hypothesis general report evidence supporting the view ‘hat managers’ accounting decisions are iluenced by campenstion conieraons, Se, forex: ample P. Hel, "Th Efex of Bonus Schemes on Accounting Decora of ecating aed Ezapomes 7 (Apri 19855 85-107 R, Hoxhausen,D. Larcker, an. Soar “Anus! Boru Scheme andthe Manipulation of Easing aut of Pecurting ad Ezanrs 19 (February 1995). 29-78, land F Guidry. A. Leone, and 5: Rock “Earn Sed Gonut Plan and Earnings Managemen by Business Unt Managers Joura of Acoonng and Ecenames. 2 Yanry 1999) 113-42 ‘5. L_DoAngl, "Managerial Cmpaison, Information Cott, and Carprate Governance: The Use of Accounting Performance Measures in Pony Comat” of Becurng and Ecos 10 (anuary 1986 3-36 10. The wado-of Between taxes and Fanci poring he content of managers’ accountng lecions i dscusedin deta n Toes and Busnes Stegy by MScoles and M. Won Engle: ‘wood Cis, Nj Prenice-Hal, 1992), Many empirical studies have examined fms) LFOMFO oes 1. Several researchers have documented tat rs fected by sch stustlon have a mot tion to inuence regulators perceptions trough accountng decane For example, j Jones doc uments that fis selong mporeprotcuone make Inome-decreaing accouring econ ih Earngs Management Daring impor Rel lesions Juma of Ace Rserch 2, ho (Aura 1991; 198-228. A numberof ur fd ta bank that are cere to minum capil fe ‘ulremens oversate lean los prowsions understate loan write and vecape normale Bled fans on Secusear poroor (eee S Moyer, “Capital Adequacy Raco Regulions sd ‘Accounting Cocs in Commercal Bank” oul of Accuming ad cen 1 (1990) 123-54 Scholes, GP. Wilton and Mt Wlion, "Tax Panning, Regltory Capital Pansing nd Franca Reporang Satay for Carer Banks” Rene of Franc Stades 3 (1990) 625-30. Baty, S. Chambers ad J. Magi, "Managing ranch Repote of Commercial Banks; The uence ‘of Taxes, Regulatory Capal and Eating," Jumal of Acauning Research 33, 2 (1995) 231-61 and J Colin, D. Shakar andj Wahen "Bank Diferenca inthe Coor raion of Regltory Capital, Exings and Taxes” Jul of Accuning Reeearch 3, no. 2 (Aut 1995} 262-91), Fal, Petron’ fds ta ancl weak property cain insurers hats regulatory atencon Undersate cam loss reser: K, Petron, “Opts Repo inthe Property Caley su ance Industry." oural of Acouning and Ezooric15 (December 1992} 485-508, 12, F Hel nd KPleu "The Elect of Fem’ Fane Disclose Statepie an Stock Prices Accounting Horzons 7 March 1993): I= Fora sunonary ofthe empincal evidence. see P Healy and} Wahlen, "A Review of the Earring Management Literature an ls inpaton for Sanda Seung” counting Horzone 13 (December 1999) 265-84 13. Franca! aayss py lose atevon to managers’ dactonure trates the Assocation for Invesment Management and Reseach plstes sn annal report erlang them for U.S. frm. Fora discussion ofthese ating, se M, Lng and R, Lundholn,"Crosesaedons Determinants of ‘Anlst Ratings of Corporate Dieu,” Joma of ccurng Resear 31 (Autre 19995246 7 14 See P, Healy and K; Pap “The Fal of Enron” Juma of Econemie Pept (Spring 2003): 3-26, TS. Fora deal analyse of company tha made such changes see “Anatomy of Accouting ‘change by K. Flop in Aecsrang& Manopemer Fl Sway Perspectives, eed by Wi, Bruns, snd R Ksplan (Boston Harvard Busbss School Pres, 1987), 6. An exangle ofthe eye of behavior dacumente by Joba Hand in is ty. "Did Fens Undertake Dat-Equty Swap or an Aecourting Paper Profit oF True Financ Gain? Te Aco Ing Review 6 (Octber 1969} §87-823, 17, Foran engines! arly of aveniory bul-ups, see V. Berard and . Nal, “Do ventory Disclosures Pred Slr and Earings” oul of ecurar, Aang, and France (Fl 1991), TB Ths i tre by and large the Ute Sater ard in reverlotber counties. However. some countries as Germany and Jan tax aecouning and fae por are closely ed {ogether and thi parla red fag noe very mean TS. For research on accountng and econonnc center the formation of RAD partnerships, see A Beaty, P. Borger, andj, Maple, “Matier for Forming Research and Deelopent Franc ing Organations” Jura of ecouing& Ezonancs 19 (Ap 1995 4-42. An overview of Er- ‘on’ use of speci purpose ence to range earings and window.dress is bun is provided GP. Healy and K Plo, The Fal of Evan Jura of EzaamicPepece 17, no. 2 (Spring 200: 2-26, 20. Foran empirical examinton of ase wrote). oe and W. Sha "We 25 Ae counting Procedures ta Manage Perepions Jul of Acai Research 26, 1988: 91-9. 2, R Mendenhall and W. Nichols repors evidence consstene wth managers king advantage of ‘ei discretion so posfpone reporting bd news ol the fourth quer See R. Mendenhall and W. Nicbls,"Gad News and Diferenthl Markt Reaction to Announcenents of Err-Quarter ‘eres Fourth QuacerEnvings Jura of ecuning Reser Suppaman (1968) 63-86 "EL The role of isder transactions in the colapee of Enron are cussed by P, Healy an K aepu, "The Fl of Enron” Joma of anomie Pespecves 17, 0.2 (ping 2008 3-26. 2. This ype of ani i prevented ine context of provsons for bad debs by M.MeNichols and P. Wison in thet sca. "Evidence of Exings Management fem the Provisions for Bad Debs," ovnl of Accunirg Reseach, Suplement (198): 131 “A Tis pin as ben made by several accourting researchers. Fora summary of research on camings management soe K. Schipper, "Earnings Management.” Acuntng Hotons(Docerber 1989) 91-102. 35. S00]. Chan, “The Decline in Value Releance of nrings and Book Vales,” wpulshed ds sertaton Harvard Univers, 1998, Erdence eo reported by | Francis and K, Shipper, “Have ancl Satements Lore Tel Relevance!” Joral ef conto Reseech 37, 9.2 (Avtar 199) 319-52: and WE Cals, E Mayda, and. Wak, “Change inte Value Relevance of Earnings {nd Book Value over tha Past Forty Years Jura of Acaunting en Ecaraies 24 (197) 39-67 126. See G, Foster, "Belo andthe Capital Market, femal of Acorn Rerearch 17,90. | Spring 1919) 26-74, 2, See SH. Teoh. Weleh and TJ. Wong, “arings Management andthe Long-Run Maree Performance of intl Pble Oferings” oul of Franc 53 (December 1998): 135-74, §H, Teoh, 1 Welch, and T. Wong “Evrings Management andthe Post issue Underperformance of Seasoned Exuty Orferng” Jounal of Frc Eanomies 50 (October 1998) 63-99 and S Tec, T. Wong, and G. Ra, "Are Accrane During lial Puble Oferings Opportistc” Rsew of Accounting Stes 3, no. 1-2 (998) 175-208 8 See P. Dechow, Sloan, and A, Sweeney, “Castes and Consequences of Eangs Manipo= lation: An Anal of Fre Subject Enforcement Acton by the SEG" Cater Acountng Rereoch 13, no. | (1996; I-36, and M.D. Berash, ‘Detecting GAAP Viton: impleatons for ‘Acsesing Erings Management anon Firms with Exreme Fnac Performance” oul of e- ourting nd ube Poly 16 (1997) 271-308. 0.2, Implementing Accounting Analysis We lead in Chapter 3 that accounting analysis requies the analyst to adjust a ir’ ac ‘counting numbers using cash low and fotnote information to “undo” any accountng dis coaions. This entails recasting @ fms tnancial statements using standard reporting ‘nomenclature and formats. Firms frequently use somewhat ilferent formats ad terminal ‘ogy for presenting their iancial results. Recasting the fnancal statements using stan dard template, therefore helps ensure that performance metrics used for financial analysis are calculated using comparable definitions across companies and overtime. Once the financial statements have been standardized, the analyst is ready to identify ‘any distortions in financial statements. The analyst's primary’ focus should be on those secountng estimates and methods thatthe im uses to measure is key sucess factors and risks. If thee ae differences in these estes andor methods between fms or forthe same frm overtime, the analyst's jb is to assess whether they reflect lepkimte business sitferences and therefore require no adjustment, or whather they rele dtferences in ‘managerial judgment o bas and require adjustment. In ation, even if accountng rules sre adhered 10 consistently, accountng distortions can arse because accounting rules themselves do poor job of capturing firm economics, eeating opportanities Tor the analyst to adjust firm's financials in & way that presents a mone reste pictre of is performance This chapter shows how to recast he fim’s financial statements into tempat that uses stndand terminology and classifications, discusses the most common types of ‘sccountng distortions tht can arise, and shows how to make adjustments to the standart ized financial statements to und these distortions, Able shect approach i sed to dently whether there have been any distortions to assets, ables, or owners’ equity. Once any asset and lability misstatements have been identified, the analyst ean make adjustments othe balance sect atthe beginning andor end of the current year, 35 well as any needed adjustments to revenues and expenses in the Jatest income statement. This approach ensres tht the most ecen nancial ratios sed 0 alate a fm’s performance ad forecast is Tare results are based on financial data that, appropriately reflec is busines economics, In some instances, information taken from a firm's foosnotes a cashflow statement enables the analyst to make a precise adjustment for an accounting distortion, However for many types of accounting adjustments the company doesnot disclose al ofthe infor ‘mation needed to perfectly undo the distortion, requiring the analyst make an approx imate adjustment 0 the financial statement, Firms sometimes use diferent nomenclature and format to present their financial rests For example, the asset goodwill canbe reported separacly using Such tes as Goodwil Excess of cost over net asses of acquired companies,” and "Cast in excess of fir value ov itcan be included inthe ne tem Other touagible Asses, Interest Income ca be repor ‘ed asa subcatepory of Revenues, shown laver din the income statement as part of Other Income and Expenses, or itis Sometimes reported as Interest Expense, Net of Interest, Income. 2 Pred Busnes Ai and alton Tee ‘These diferenes in financial statement tenminology, classification, and formats can make it difcut to compare performance across fins, and sometimes to compare perfor- ‘mance forthe same frm overtime, The fist task forthe analyst in secounting analysis is, therefore, to recast the financial statements nto acomon format. This involves designing 1 template forthe balance sheet, income statement, and cashflow statement that can be ‘sed to standardize financial statements for any company. Tables 4-1, 4-2, and 4-3 present the format used throughout the book to standardize the income statement, balance sheet, nd cash low statement, espectivel ‘Table 4-1. Standardized Income Statement Format Standard Income Statement Accounts Sample Line lems Chssified in Account Sale Revesee ember oes Commasone a Con of marcha sit st fps sae (Cot of revenane Cenof sever Depeechtion on mantcuring ces ax eran siete race & ie Snes ad bene Servicing and marteance epee on sling ad admiiraiveaes ‘Gane Opertng Sparse ‘inorsaion annals Proce development Revere donlopent Proviion for onses on rec le Preopenng coms Spec care Taiyo om aoe rindincome “ais on ale cTrvarnTeng arn ori exe ne Pre gator ecu changes Tose onl of restmeriong era aie Fercgn exchange ses Fron ones Fem acouning hargst Aeseuctrng caress ergs exposes Aasetinparens NNonrecuring rg er of recone charges ImplaningAcounng Aras ‘Sosa anos po ADI ‘oss, Sunn sn ae ont sane wu spars pumas se sou soxge suse sou 120 ‘auumeg ras ‘eras (oust) pauspp nsiNo-UN wu) OM aL Bae om forge wun 310) se p99) de wi ta ‘angen a: — se PLA sy oyu ay 0) ney oping wu. 00) sey Wang 80, [aay wanna ~ soe paused s2ange7 91 980, bos eg no eepony soa wea wevuns | san2s ge. PoE ED ‘nba paw sonar poy uno PONS ‘munooay unes5y THN su un ofan sougeg prepuns ugeg prepares wunoy 1eayS SOUR pazipsEpUS Z-p aq, Pie2 + Busnes Ars nl Yaton Tels ‘Table 4-3 Standardized Cash Flow Statement Format Seandard Cash Flow Statement Accounts Sample Lin ems Csi in Account Novopentha Ga (asey—~—~SCSC*CSn os enn ‘Gin oa] en ne ol vesmenttran caren es Comat fc of aecoureng cares Gann ost onforenechnge Errors gre ost Ign Opogona Deters come ee ‘Other ners carer to operons Eel corns of aac unconeolisted sabe nt of Prnorey meres Stone bona ads ‘Nec meron Luion ‘Operuing okra Cnt ‘Nex ivsinene or Ugncon oF ‘Opera Lang Term Aves Nai Daic Raper a Beer ‘Braden yen] aoc Raprenor ance ‘hang "Tous acoun recehable ier recahabler Trade acco ate Acard expenses abs) ae ten fila Decoinsabi and ered expenses Reman rane te Prov for doubt acoues ier crrene abies (oer eurrene eet [Acq of rettrh and dovlopent ‘cgi of buns ip expenarer Eat semen ‘ueton of sbeisary stock Ctatston of compu saware developmen cots Cone exces of rte of et set eq Inarenenein sale ype ae dct arches, Prac payers on debe Borowigsreareny)ander ere fey levnce (ropaymer) longer abe Nerinerese (reese shorter borrowings ets pole Gath diene ad on coon Rak aah dives pl on peered stock Datroeson Proceed rom aaneealzanmon Naak leu region of preferred sears feo of tesa uy Parchase fnue) of eetry soc To crete standardized financial fora particular companyof interest, the analyst elas fies each line item in that firm's financial statements using the appropiate account name from the above templates. This may requce using information from the footnotes to laren Aecouning Ass ensure tat accounts are classified appropriately. An example, applying the above template to standardize the 2002 financial statements for fasion retailer Nowdsttom In. i shown inthe appendix atthe end ofthis chapter. ‘Once the financias have been standardized, the analyst can evaluate whether account ing adjustments are needed to correct for any distortions in assets, lilies, or equi ASSET DISTORTIONS. Accountants define asses as resources that a finn owns or contol as a est of past bus ess trstctions, and which are expected 0 produce future economic benefits that ean be measured with a reasonable degree of cent. Assets can take a variety of forms, inclu ing cash, marketable securities receivables from customer, inventor. ied ase, lon term investments in ther companies, and intangibles. Distortions in asset values generally arise because thee is ambiguity about whether + The frm owns or controls the economic resources in question, or + The economic resources are likely 1 prove future economic benefits that can be ‘measured with reasonable certainty, oF + The fair va of assets fall below ther book values, Who owns or controls resources? For most resources used by a fim, ownership or conte is relatively straightforward: the firm using the resource owns the asset. However, some types of transactions make i ie cult to assess who owns a resource, Fr example, who owas or controls a resource that has ‘een leased? Is it the Tess o he lessee? Or considera frm that discounts a customer te czivable witha bank. Hehe bank ha recourse agains the fim should the customer deal, isthe real owner ofthe ecevable the bank or the company’? Accountants frequetly use mechanical rules to determine whether company owns oF ‘controls an asset. While these rules make it eay for accountant to implement accounting standards, they also permit managers to “groom” wansactons to sats their own financial ‘reporting objectives, Fr example, U.S. rules on lease aecountng permit two lease tansae= ‘ons with essentially the same terms tobe tuctred 0 that ane i eported a an asset by the lessee, andthe other is shown as an asset by the lesor, Accounting analysis, therefore, involves assessing whether a firm's reported assets adequately reflect the key resoures. that are under its contol, and whether adjustments are required 9 compare its perfor ‘mance with that of competitors, ‘Asset ownership issues aso arise indirectly from the application of rales for revenue fecoprition. Finns are permited to reengnze revenves only when ther product as bee shipped or their sevice fas been provided t the customer. Revenues are then considered “cared,” and te custome has & legal commitment to pay’ Tor the praduct o service. As a resul, for the seller, recognition of revene frequently coincides with “ownership” of « teceivable tat is shown as an asset on its alance set. Accounting analysis that rises ‘questions about whether or not revenues have heen earned therfore often affect the vale ation of eset, Ambiguity over whether a company owns am aset crates a number of opportunities {or accounting analysis * Despite managements best intention, Financial statements sometimes do a poor job of reflecting the firm's economic assets since itis dificult fr accounting rules 10 capture al ofthe subtleties associated with ownership and conto 45 46 + Because accounting rules on ownership and contol permit managers to groom trans ‘actions so that essentaly sila transactins canbe reported in very different ways, important assets may be omitted from the Balance shet even though the firm bears many ofthe economic risks of ownership. ‘Thete may be legitimate differences in opinion between managers and analysts over residual ownership risks bare bythe company, leading to differences in opinion over reposting for these assets [Aggressive revenue recogition, which boosts reported earings sls likely 0 af Feet ase values Can economic benefits be measured with reasonable certainty? eis almost always ficult to accurately forecast the fature benefits associated with capital tutlays because the word is uncertain. A company doesnot know whether a competitor trill offer a new proctor service tht makes its own obsolete. It doesnot know whether the prodets manfactored at «new plant wil be the type that customers want to buy. A ‘ompany doesnot know whether changes in i prices will make the ol drilling equipment that it manufactures less valuable Accounting rules deal with these challenges by stipulating which types of resources ean be recorded as assets and which cannot, Far example, the economic benefits from research and development are generally considered highly uncertain: research projects may never deliver promised new product, the products they generate may not be economically ia be, or products may be made obsolete by competitors’ research, Accounting rules in most countries, therefore, require that R&D outlays be expensed In contrast, the economic tenefits from plant acquisitions are considered less uncertain and are required to be coptalized. ales that rquire dhe immediate expensing of outlays for some key resources may be ood accountng, but they erate a challenge for the analyt—namely, they lead to less timely financial statements, For example, if all firms expense RAD, Hancial statements willreflectdiferences in R&D success only when new product re commercialized rather than during the development process. The analyst may attempt ro coret fr this stortion by capitalizing key RAD outlays and adjusting the value of the intangible asset based on R&D updates? Have fair values of assets declined below book value? An asset is impaired when its fair value falls below its book value. In most counties a counting rules requite that a Toss he record for permanent asset impairments. U.S. rules (SPAS 144) specify that un impairment loss be recognized on a long-term aset when its book value exoseds the undiscounted cashflows expected to be generated from future use snd sale. If tis condition is satisied, the frm s required to report alos forthe diflerence between the asses air value and its book value (Of course markets for many long-term operating asses ae quid and incomplete, snaking it highly subjective to infer ther far values, Consequently considerable manage~ neat judgement is ivolved in deciding whether an asset is impaired and determining the ‘ale of any impairment loss. For the analyst this rates the possiblity that asset valves are misstated. U.S. decount= ing rles themselves permit a certain amount of aset overstatement since the est fo asset ‘impairment compares the asset's Book vale tothe expected value of wndiscounted (ater ImplmningAcouing Aris than discounted) future cash ows associated with the asset. This ean create situations ‘where no financial statement los is reported for an asset tht is economically impaired, a addition, the task of determining wheter there has been an asset impairment and ‘valuing the impairment is detested ro management, with oversight by the firm's auditors, potentially leaving opportunities for management basin valuing assets and for legtimate ferences in opinion between managers and analysts over asset valatons, In nos cases, ‘management bias wil ead to overstated assets since managers will prefer not to recognize an impairment. However, managers can also bias asset values downward by “taking a bay” reducing future expenses ad ineweasingGutre caring In summary, disortions in assets ae likely to arse when there is ambiguity about Whether the fim owns or catols a resource, when there is high degree of uncertainty bout the value of the economic benefit a be derived from the resoure, and wien there ae dferenes in opinion about the valu of asset impairments. Opportunities for count ing adjustments can arise in these stutions if + Accounting ues donot doa good jo ofcapeuring the ims economies, or + Managers use their disretion to distort the firm's performance, or + There are leytimate differences in opinion between managers and analsts about eeo- ‘nomic uncertainties facing the frm that are reflected in art values OVERSTATED ASSETS ‘Asset overstatements are likely to arse when managers have incentives to increase reported carings, Thus, ajustments to asets also typically require adjustments to the income sae ‘ment in the form of either increased expenses or reduced revenues, The most common forms of asset (and earnings) overstatement ae the flloming 1, Delays in writing down current axes. U current assets become impaired, tha is, ‘heir book values fall below their realizable values, accounting rules genetllyre- ‘quire that they be wrien down other fir values. Corent asset impaments aso fect earings since write-off ae charged directly to earnings. Deferrng current a Set writedowns is therefore, one way for managers o boost reported profits Ane Iysts that cover firms where management of inventories and receivables is a key succes ftor (ether and manufacturing industries) need tobe particularly ‘cognizant ofthis form of earnings management. If managers over-buy or ver-pro- ‘ce inthe current prio they ae likely to have to offer customers discounts to pet Fd of surplus inventories. In ation, providing customers with ered cami risks of default. Warning signs for delays in curent asset write-downs inlade growing ays" inventory and days’ receivable, wete-downs by competitors, and business

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