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Creating Competitive Advantage Financial Reporting Strategies and Measurement.

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Presentation on theme: "Creating Competitive Advantage Financial Reporting Strategies and Measurement."— Presentation transcript:

1 Creating Competitive Advantage Financial Reporting Strategies and Measurement

2 Outline of Our Prior Session u Reviewed fundamentals of financial accounting –adopted users’ perspective u Measurement of profitability and risk –understanding financial statement impact of key accounting choices »inventory »depreciation »research and development »consolidations In what industries will these choices be important?

3 Outline of This Session u Adjusting financials for more informed analysis –continue external user focus »don’t overlook implications for internal analysis u don’t believe and act on financial fiction –e.g., smoothing

4 Quick Review u The accounting system captures transactions and other events u Provides information to users –internal (Frank’s sessions) »for planning and control –external (financial reporting) »for investment analysis u balance sheet –reports resources and outsiders’ claims against them u income statement –reports operating changes in resources and claims

5 External Users’ Perspective u Historical performance measurement –profitability (DuPont Model) »ROA u profit margin u asset turnover »ROE u ROA u financial leverage –risk »solvency risk »operating leverage »financial leverage

6 The Big Challenge of Analysis u Predicting future performance (vs. measuring current performance) –evaluate the components of GAAP income »permanent earnings (recurring, persistent) »transitory earnings

7 Finding the Nonrecurring (Transitory) Earnings Sales -Cost of goods sold Gross profit - Operating expenses Income from operations + Other revenues/gains - Other expenses/losses Income before taxes - Income tax expense Net Income

8 Finding the Nonrecurring (Transitory) Earnings Sales -Cost of goods sold Gross profit - Operating expenses Income from operations + Other revenues/gains - Other expenses/losses Income before taxes - Income tax expense Net Income

9 Nonrecurring Earnings u Other Revenue/Gains –gains from peripheral activities (e.g., the sale of PP&E, investments) u Other Expenses/Losses –losses from peripheral activities (e.g., the sale of PP&E, investments) –restructuring charges –impairment losses Q7-9

10 Other Sources of Nonrecurring Earnings Sales -Cost of goods sold Gross profit - Operating expenses Income from operations + Other revenues/gains - Other expenses/losses Income before taxes - Income tax expense Income before …

11 Special Income Statement Items u Discontinued Operations u Extraordinary Items u Both are nonrecurring--by their very definition

12 Another Challenge of Analysis u Financial Statements tell us… –only part of the story »accounting standards provide opportunities for u managing income (smoothing, etc.) u off-balance sheet financing (OBSF) »do managers exploit this situation?

13 Psychology of Reporting u Management’s natural desire to cast things in a favorable light –management vs. manipulation »why we have u GAAP u audits –millennium scandals »why we now have u Sarbanes/Oxley Act –404 u PCAOB

14 An Economic Explanation u Why is it so? –agency theory Q1.13 Q3.6

15 The Big Issue –WYWAP –PEAP –POOP u Why does GAAP permit managers to make self-serving choices?

16 Not GAAP but… u Politically Expedient Accounting Principles –Concessions, concessions, concessions! »for preparers and auditors u ‘to customize reporting to best reflect circumstances’ u ‘to control reporting costs’ u ‘mitigate audit risk’ u Whatever You Want Accounting Principles –GAAP has a long history of allowing choices »FIFO/LIFO »Accelerated/St. line –supply-side thinking

17 Not GAAP but… u Pitifully Old and Obsolete Principles –Many old standards still around: –Treasury stock (1934) – Stock splits (1941) –Depreciation (1946) – Inventory (1947) – LT contracts (1955) – Quarterly reporting (1934)

18 A Case Study—Stock Options u Could as easily be –pensions –cash flows –investments –business combinations –foreign currency translation –derivatives –etc.

19 19 Brief History of Stock Options u 1972 –APB Opinion 25 issued »stock options measured at intrinsic value u 1982 –Stock options growing in popularity –FASB asked by AICPA to reexamine accounting market exercise intrinsic $20 $25 $40 $ u no effect on earnings in typical form option price = market price at grant date

20 20 Brief History of Stock Options u 1984 –FASB adds project to agenda »releases Invitation to Comment discussing expensing u generates more than 100 letters, all opposing u –FASB deliberates but is unable to resolve measurement issues –added issues to broader conceptual project

21 21 Brief History of Stock Options u 1992 –Growing media interest in excessive executive compensation –FASB adds options to agenda again »urged to do so by Big 4 CPA firms and SEC u 1993 –FASB issued exposure draft requiring expensing »substantial opposition in corporate sector u 1786 comment letters received (1000+ form letters) u six days of public hearings (73 presenters) u two ‘Sense of the Senate’ resolutions

22 22 Sense of the Senate Resolution 1 “It is the sense of the Senate that the status of FASB as a private body of independent accounting experts should be respected and safeguarded; and Congress should not impair the objectivity or integrity of the FASB’s decisionmaking process by legislating accounting rules.” (94-2 vote)

23 23 Sense of the Senate Resolution 2 “The FASB proposal on stock options had generated opposition which is unprecedented in both its intensity and universality and it is the sense of the Senate that the proposal will have grave economic consequences particularly for businesses in new- growth sectors; the new accounting treatment will diminish rather than expand broad-based employee stock option plans; FASB should not at this time change the accounting treatment for stock options.” (88-9 vote)

24 Expensing Backlash “I fear that existing proposals for expensing options will result in very few options being issued, thereby limiting the kind of risk- taking and reward-sharing that has made companies like Schwab, Intel, Pepsi and Wells Fargo (to name a few) such great places to build careers.” David Pottruck CEO Charles Schwab Corp.

25 25 Brief History of Stock Options u 1995 –FASB issues SFAS 123 »caved to pressure u expensing preferred but not required u APB 25 treatment allowed with disclosure of expense “the debate on accounting for stock-based compensation became so divisive that it threatened the Board’s future working relationship with some of its constituents. Eventually, the nature of the debate threatened the future of accounting standard setting in the private sector.” SFAS 123, para. 60

26 26 A Brief History of Stock Option Accounting u 2002 – a growing number of companies begin expensing options »why?

27 27 A Brief History of Stock Option Accounting u 2003 – FASB adds options to agenda »coordinates project with IASB u 2004 –FASB issues exposure draft including required expensing –several limiting bills introduced in the House of Representatives »no action in Senate

28 28 A Brief History of Stock Option Accounting u 2005 –FASB issues 123R »requires expensing for beginning in FYE 2006 –Many companies begin moving away from options to restricted stock awards »why?

29 Another Perspective on Options u Evidence shows executives discount options value (30-50% of Black Scholes) Is this a bad thing? stock option u David Pottruck is probably right –options use will decline market value = $10 (Black and Scholes) Q11.9 –explained by economics theory »risk averse »poorly diversified

30 My Mantra What you measure, you manage What you don’t measure…

31 u Standard setting is slow and ineffective –fixing up poor measurements falls on users »major problem areas u investments (smoothing) u leases (OBSF) u retirement benefits (smoothing) Overcoming GAAP Limitations

32 Accounting for Corporate Investments in Stocks and Bonds u Small* investments placed into one of three portfolios –trading –available-for-sale –held-to-maturity B/S--marked-to-market with Δ to I/S B/S--marked-to-market with Δ to AOCI B/S--historical cost

33 E8.17 Q8.1

34 Fixing Up the Investments in Stocks and Bonds u Trading portfolio is OK –balance sheet reflects mark-to-market –gains/losses flow directly to income

35 Fixing Up the Investments in Stocks and Bonds u Adjust the other two portfolios –for available for sale »balance sheet u ok—already marked to market »income statement u move gain/loss from AOCI to net income –for held to maturity »balance sheet u mark investments to market (reported at cost) »income statement u report change in value on I/S as gain/loss In what industries will this be an important issue?

36 Leasing Fixed Assets Q9.7

37 Leasing as Off-Balance-Sheet Financing u Financial Statement Variations –capital lease »lessee treats lease as an asset purchase (transfer of risks, rights, rewards) u required treatment when lease covers most of asset’s life –operating lease »lessee treats lease as a simple rental agreement u required treatment when lease term is short (in relation to asset’s life) THE KEY POINT: Even operating leases stipulate noncancellable future lease payments In what industries will this be an important issue?

38 Fixing the Operating Leases –On the balance sheet »adjust by adding the value of the future minimum lease payments to u long-term assets and u long-term liabilities –income statement »replace rent expense with u depreciation expense u interest expense Use the schedule of minimum lease payments from the footnotes

39 E9.24

40 Retirement Benefit Plans as Off- Balance-Sheet Financing u Types of Plans –pension benefits –other (OPEB) »health insurance benefits »life insurance benefits »tuition assistance »dependent care

41 Pension Plans u Defined contribution plans (most BSU faculty) –company recognizes expense when contributions made »no remaining obligation (risk) after contribution u Defined benefit plans (PERSI) –benefit formula benefit =.02 x years of service x salary (per mo)

42 Defined Benefit Pensions Terminology u Projected Benefit Obligation (PBO) –present value of expected future benefits already earned by employees (including salary progression) u Plan Assets –assets set aside in trust to pay future benefits

43 Defined Benefit Pensions Adjustments u Full difference between PBO and plan assets should be reported as –an asset--if plan assets > PBO (overfunded) –a liability--if plan assets < PBO (underfunded) u A tradition of poor reporting –reported amounts ≠ real economic amounts u SFAS 158 has fixed balance sheets… –but not income statement expense »still lots of smoothing In what industries will this be an important issue?

44 Q10.3 Q10.7

45 Defined Benefit Pensions Adjustments (continued) u Balance sheet –ok u Income statement adjustments –remove artifacts of smoothing »expected vs. actual return on assets »deferral of gains/losses on liabilities »all amortization (prior service cost, initial obligation, actuarial gains/losses) –put in full amounts of new actuarial gains and losses

46

47 HP’s Pensions Plan assets = 10.6% of total assets PBO = 13.1% of total assets

48 HP’s Pensions Expense 10/31/12 actual return -1,411 1,327 actuarial loss 1,479 2,143 adj. expense 1,479 1,803 expense difference +2,239 (18% of the net income of $12,650) expense

49 Other Post-Employment Benefits (OPEB) u Accounting (in concept) similar to pensions u Some practical differences –unfunded plans (pay-as-you-go) –step function benefit increases common »10 years of service25% of premium cost »20 years of service50% of premium cost »25 years of service70% of premiums cost

50 OPEB Terminology u Accumulated Postretirement Benefit Obligation (APBO) –PV of future promised benefits »like PBO for pensions u Requires adjustment similar to that made for pensions –balance sheet is ok –income statement needs adjusting In what industries will this be an important issue?

51 HP’s OPEB Expense 10/31/12 actual return -36 actuarial loss 34 adj. OPEB expense 237 expense difference +118 (0.1% of the net income of $12,650) expense

52 Financial Reporting Model is Broken u Need a systemic change –will the current economic turmoil bring it about? u What might it look like? –a potential competitive advantage

53

54 The QFR Solution u Demand driven reporting –voluntarily giving users what they want –motivation comes from existing economic incentives (not ethics) »four axioms

55 The Four Axioms u Incomplete information leads to uncertainty u Uncertainty leads to risk u Risk leads to demand for high rate of return u A high rate of return leads to a high cost of capital and a low stock price So, what should you do if you want a higher stock price?

56 High Quality Reporting = Lower Cost of Capital Evidence u Lots of supporting evidence –Welker, Disclosure Policy, “Information Asymmetry and Liquidity in Equity Markets,” Contemporary Accounting Research, Spring –Lang & Lundholm, “Corporate Disclosure Policy and Analyst Behavior,” The Accounting Review, Oct –Botosan, “Disclosure Level and the Cost of Equity Capital,” The Accounting Review, July –Sengupta, “Corporate Disclosure Quality and the Cost of Debt.” The Accounting Review, Oct

57 This is not rocket science!

58 The Four Markets QFR as comparable to HRM, TQM, and JIT

59 The Firm LaborCustomers Supply Chain Capital Markets HRM thinking 59

60 The Firm Customers Supply Chain Capital Markets QFR thinking 60 Labor

61 QFR as a Solution u We think it is natural evolution in thinking –we’re just ahead of the curve u Treat the capital markets like you would your product market –figure out what users want and supply it –VOLUNTARILY

62 Demand Driven Reporting

63 u Free your mind--innovate –no formula or recipe for QFR –what is it that users want to know? »provide it

64 Supplemental Disclosures u Our book identifies important information deficiencies for: –investments –inventory –stock options –pensions –leases –PP&E –intangibles –business combinations

65 The Point u The whole point of QFR is to go overboard voluntarily to ensure that the capital markets are satisfied –close relationship built on trust »reduce uncertainty and risk »reduce cost of capital »increase security prices u A way for the “good guys” to stand apart

66 Looking Ahead u QFR presents a huge competitive advantage –advantage to those managers and accountants who can see the economic payoff from TELLING THE TRUTH


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