Perfect foresight of the direction of earnings change one year prior to announcement (Ball & Brown)
Buy up sell down, 37.5% 1954-1996
Equivalent to 44% of the return given perfect foresight of the direction of stock price change (85.2%).
Perfect foresight of ROE, 43%
Perfect foresight of cash flow, 9%
Earnings management not so pervasive as to make earnings data unreliable.
Actual vs. expected performance
Analyst own & consensus forecasts
Valuation given assessment of current & future performance
Credit risk involved in lending (trades)
Management of liquidity & solvency
Business risk & financial risk
Loan & credit derivatives pricing
Accounting policies & accrual estimates consistent with the business & its recent performance.
Financial reports communicate current status & significant risks of the business.
Role of Financial Reporting
Channeling savings into business investments
Socialist (communist) model
Through central planning and government agencies to pool national savings and to direct investments in industries (GOEs).
Delegation of both the political power and economic power to the central planners.
Capital markets: shareholder vs. capitalist capitalism (McKinsey).
Current status: capitalism without competing alternatives.
The functioning of capital markets
Savings Business Ideas Information Intermediaries Financial Intermediaries
Recreate credible “inside information”
Information asymmetry & incentive compatibility problems
Cost and credibility of communication.
Lemon markets: unable to differentiate, bad proposals crowed out good proposals, and investors lose confidence in the market.
Financial & information intermediaries
FSs for laymen vs. for experts
The level of financial supervision.
Corporate governance & transparency (faithful & full disclosure).
Business Environment Business Strategy Business Activities Accounting Environment Accounting Strategy Accounting System Financial Statements Summarize the economic consequences of business activities Financial Accounting
From FSs to business analysis
Get at managers’ inside information from public FS data about
current performance and future prospects
Successful intermediaries have at least as good an understanding of the industry economies as well as a reasonable good understanding of the firm’s competitive strategy.
Although outside analysts have an information disadvantage, they are more objective.
Business strategy analysis
Identify key profit drivers and business risks
Assess the company’s profit potential at a qualitative level.
Frame the subsequent accounting and financial analysis, i.e., key accounting policies and sustainable profits.
Make sound assumptions in forecasting future performance.
Evaluate the degree to which a firm’s accounting captures the underlying business reality.
Undo any accounting distortions
Improve the reliability of conclusion from financial analysis (GIGO).
Evaluate the current and past performance and assess its sustainability.
Analysis should be systematic and efficient.
Explore business issues through ratio analysis and cash flow analysis.
Forecasting a firm’s future
FS forecasting and valuation
Synthesis of the above analyses
For decision contexts such as securities analysis, credit evaluation, M&As, debt and dividend policies, and corporate communication strategies.
Why FS analysis?
Application outside the capital market context.
Driving force of market efficiency (market efficiency paradox).
The average number of segments
For the top 500 U.S. companies is 11 in 1992.
An attempt to reduce the diversity and focus on core businesses
Diversified companies trade at a discount in the stock market relative to a comparable portfolio of focused companies,
M&A of two unrelated businesses often fail to create value, and value can be created through spin-offs and asset sales.
Managers’ decisions to diversify and expand are driven by a desire to maximize the size rather than shareholder value (incentive misalignment problems), and capital markets find it difficult to monitor and value multibusiness organizations .
The economic consequences of managing all the different businesses under one corporate umbrella.
Sources of value creation
Relative transaction costs of performing a set of activities inside the firm versus using the market mechanism, such as
production process involves specialized assets such as human capital skills, proprietary technology, other organizational know-how that is not easily available in the marketplace, and market imperfection such as information and incentive problem.
Conglomerates in 1980
M&As after oil crises
Evolution in management accounting (Kaplan)
Financial engineering in 1985
Off-balance-sheet and off-income-statement
Revolution in financial accounting
Committed to this area of research since 1983.
New economy in 1995
Advocating increasing returns (network effect)
No suitable data to analyze and no history to guide (P/Dream ratio).
Econometric analysis neglects regime shift.
Asia financial crisis in 1997
All three happened closely together.
Corporate scandals 2000
Fair value vs. historical cost
Off-balance-sheet assets and liabilities
Financial vs. non-financial firm commitments
If not measured at fair value through profit or loss (FVtPL).
Tangible vs. intangible assets
Purchased vs. self-developed
Groups vs. individual firms
Definition of control
Consolidation policies and segmental reporting
Compound instruments, equity-like debts
Board members and employees stock (options) and/or cash bonus
Unrealized gains or losses recognized as equity adjustments (FVtEA)