Valuation Issues Related to Derivative Financial Instruments and FAS 133, FAS
138, and IAS 39
Bob Jensen's documents, cases, and
glossaries on FAS 133, FAS 138, and IAS 39 are linked at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
One of the most popular downloads at my Website compares several types of
returns is the wtdcase2a.xls at the bottom of the list of files at
http://www.cs.trinity.edu/~rjensen/Excel/
Note the tab to the Answers spreadsheet.
Students can put in their own input numbers and then observe the sensitivity of
the outcomes to things like inflation rates.
Why Is the FASB Issuing This Statement?
This Statement permits entities to choose to measure many
financial instruments and certain other items at fair value. The objective
is to improve financial reporting by providing entities with the opportunity
to mitigate volatility in reported earnings caused by measuring related
assets and liabilities differently without having to apply complex hedge
accounting provisions. This Statement is expected to expand the use of fair
value measurement, which is consistent with the Board’s long-term
measurement objectives for accounting for financial instruments.
What Is the Scope of This Statement—Which Entities Does
It Apply to and What Does It Affect?
This Statement applies to all entities, including
not-for-profit organizations. Most of the provisions of this Statement apply
only to entities that elect the fair value option. However, the amendment to
FASB Statement No. 115, Accounting for Certain Investments in Debt and
Equity Securities, applies to all entities with available-for-sale and
trading securities. Some requirements apply differently to entities that do
not report net income.
The following are eligible items for the measurement
option established by this Statement:
Recognized financial assets and financial liabilities
except:
An investment in a subsidiary that the entity is required
to consolidate
An interest in a variable interest entity that the entity
is required to consolidate
Employers’ and plans’ obligations (or assets representing
net overfunded positions) for pension benefits, other postretirement
benefits (including health care and life insurance benefits), postemployment
benefits, employee stock option and stock purchase plans, and other forms of
deferred compensation arrangements, as defined in FASB Statements No. 35,
Accounting and Reporting by Defined Benefit Pension Plans, No. 87,
Employers’ Accounting for Pensions, No. 106, Employers’ Accounting for
Postretirement Benefits Other Than Pensions, No. 112, Employers’ Accounting
for Postemployment Benefits, No. 123 (revised December 2004), Share-Based
Payment, No. 43, Accounting for Compensated Absences, No. 146, Accounting
for Costs Associated with Exit or Disposal Activities, and No. 158,
Employers’ Accounting for Defined Benefit Pension and Other Postretirement
Plans, and APB Opinion No. 12, Omnibus Opinion—1967
Financial assets and financial liabilities recognized
under leases as defined in FASB Statement No. 13, Accounting for Leases
(This exception does not apply to a guarantee of a third-party lease
obligation or a contingent obligation arising from a cancelled lease.)
Deposit liabilities, withdrawable on demand, of banks,
savings and loan associations, credit unions, and other similar depository
institutions
Financial instruments that are, in whole or in part,
classified by the issuer as a component of shareholder’s equity (including
“temporary equity”). An example is a convertible debt security with a
noncontingent beneficial conversion feature.
Firm commitments that would otherwise not be recognized at
inception and that involve only financial instruments
Nonfinancial insurance contracts and warranties that the
insurer can settle by paying a third party to provide those goods or
services
Host financial instruments resulting from separation of an
embedded nonfinancial derivative instrument from a nonfinancial hybrid
instrument.
How Will This Statement Change Current Accounting
Practices?
The fair value option established by this Statement
permits all entities to choose to measure eligible items at fair value at
specified election dates. A business entity shall report unrealized gains
and losses on items for which the fair value option has been elected in
earnings (or another performance indicator if the business entity does not
report earnings) at each subsequent reporting date. A not-for-profit
organization shall report unrealized gains and losses in its statement of
activities or similar statement.
The fair value option:
May be applied instrument by instrument, with a few
exceptions, such as investments otherwise accounted for by the equity method
Is irrevocable (unless a new election date occurs)
Is applied only to entire instruments and not to portions
of instruments.
How Does This Statement Contribute to International
Convergence?
The fair value option in this Statement is similar, but
not identical, to the fair value option in IAS 39, Financial Instruments:
Recognition and Measurement. The international fair value option is subject
to certain qualifying criteria not included in this standard, and it applies
to a slightly different set of instruments.
What Is the Effective Date of This Statement?
This Statement is effective as of the beginning of an
entity’s first fiscal year that begins after November 15, 2007. Early
adoption is permitted as of the beginning of a fiscal year that begins on or
before November 15, 2007, provided the entity also elects to apply the
provisions of FASB Statement No. 157, Fair Value Measurements.
No entity is permitted to apply this Statement
retrospectively to fiscal years preceding the effective date unless the
entity chooses early adoption. The choice to adopt early should be made
after issuance of this Statement but within 120 days of the beginning of the
fiscal year of adoption, provided the entity has not yet issued financial
statements, including required notes to those financial statements, for any
interim period of the fiscal year of adoption.
This Statement permits application to eligible items
existing at the effective date (or early adoption date).
Foreign Currency Complications in Valuation Analysis
Big Mac Index of Purchasing Power Parity ---
http://en.wikipedia.org/wiki/Big_Mac_Index
"CHART OF THE DAY: The iPod And Big Mac Indexes Just Don't Work," by John
Carney and Kamelia Angelova, Business Insider, October 20, 2009 ---
http://www.businessinsider.com/chart-of-the-day-ipod-vs-big-mac-2009-10
The Economist's Big Mac Index and the
new
iPod Nano Index from CommSec are
both cute ways of getting attention for the organizations that produce them.
But do they really measure anything economically significant?
The idea is that the indexes are supposed to expose the relative under- or
over-valuation of various currencies. In theory, the same good should trade
at broadly the same price across the globe if
exchange
rates are adjusting properly. When
goods wind up priced very differently in different locations, it suggests
something is out of whack.
But a side-by-side comparison of the Big Mac Index and the iPod Nano Index
suggests that these might not really be good metrics for measuring
currency valuations. As you can see,
the two indexes result in wildly uncorrelated results. If it were really a
matter of currency valuation, you’d expect both to show similar valuation
problems. Instead, the pattern just seems random.
Many other U.S. and International Standards directly or indirectly impact on
fair value accounting!
Introduction to Valuation
Bob Jensen's site on The Controversy Over Fair Value
(Mark-to-Market) Financial Reporting ---
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Damodaran Online: A Great Sharing Site from a Finance Professor at New
York University and Textbook Writer ---
http://pages.stern.nyu.edu/%7Eadamodar/
This site has great sections on corporate finance, investments,
valuation, spreadsheets, research, etc. For example, take a look at the
helpers on valuation ---
http://pages.stern.nyu.edu/%7Eadamodar/
You can pick the valuation approach that you would like to go to, to
see illustrations, solutions and other supporting material.
|
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Discounted Cash flow Valuation |
| |
Relative
Valuation |
| |
Option
Pricing Approaches to Valuation |
| |
Acquisition Valuation |
| |
EVA,
CFROI and other Value Enhancement Strategies |
Or you can pick the material that you are interested in.
|
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| Spreadsheets |
Overheads |
Datasets |
References |
| Problems & Solutions
|
Derivations and Discussion
|
Valuation Examples |
PowerPoint presentations |
Jim Mahar's finance sharing site (especially note his great blog link)
---
http://financeprofessor.com/
Financial Rounds from an anonymous finance professor ---
http://financialrounds.blogspot.com/
Bob Jensen's threads on fair value controversies in accounting are at
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Bob Jensen's finance and investment helpers are at
http://faculty.trinity.edu/rjensen/Bookbob1.htm
From The Wall Street Journal Accounting Weekly Review on September
22, 2006
TITLE: FASB to Issue Retooled Rule for Valuing Corporate Assets
REPORTER: David Reilly
DATE: Sep 15, 2006
PAGE: C3
LINK:
http://online.wsj.com/article/SB115828639109763950.html?mod=djem_jiewr_ac
TOPICS: Accounting, Advanced Financial Accounting, Fair Value Accounting
SUMMARY: On 9/15/2006, the FASB issued Statement of Financial Accounting
Standards No. 157, Fair Value Measurements. The standard "...provides
enhanced guidance for using fair value to measure assets and liabilities.
The standard also responds to investors' requests for expanded information
about the extent to which companies measure assets and liabilities at fair
value, the information used to measure fair value, and the effect of fair
value measurements on earnings." (Source: FASB News Release available on
their web site at http://www.fasb.org/news/nr091506.shtml) This new standard
must be used as guidance whenever reporting entities use fair value to
measure value assets and liabilities as a required or acceptable method of
applying GAAP.
QUESTIONS:
1.) What is the purpose of issuing Statement of Financial Accounting
Standards No. 157? In your answer, describe how this standard should help to
alleviate discrepancies in practice. To help answer this question, you may
access the FASB's own news release about the standard, available at
http://www.fasb.org/news/nr091506.shtml or the new standard itself,
available on the FASB's web site.
2.) From your own knowledge, cite an example in which fair value is used
to measure an asset or liability in corporate balance sheets. Why is fair
value an appropriate measure for including these assets and liabilities in
corporate balance sheets?
3.) What is the major difficulty with using fair values for financial
reporting that is cited in the article?
4.) Define the term "historical cost." Name two flaws with the use of
historical costs, one cited in the article and one based on your own
knowledge. Be sure to explain the flaw clearly.
5.) How does this standard help to alleviate the issue described in
answer to question 3? Again, you may access the FASB's web site, and the
news release in particle, to answer this question.
6.) The article closes with a statement that "The FASB hopes to counter
some of [the issues cited in the article] by expanding disclosures required
for all balance sheet items measure at fair value..." What could be the
possible problem with that requirement?
Reviewed By: Judy Beckman, University of Rhode Island
"FASB to Issue Retooled Rule For Valuing Corporate Assets New Method
Repeals Limits Spurred by Enron Scandal; Critics Worry About Abuses," by
David Reilly, The Wall Street Journal, September 15, 2006; Page C3
---
http://online.wsj.com/article/SB115828639109763950.html?mod=djem_jiewr_ac
Accounting rule makers have wrapped up an
overhaul of a tricky but important method of valuing corporate assets,
despite some critics' warning that the change could reopen the door to
abuses like those seen at Enron Corp.
The overhaul, contained in an accounting
standard that could be issued as early as today, will repeal a ban put
in place after Enron collapsed into bankruptcy court in late 2001 amid
an array of accounting irregularities. The ban prohibited companies
immediately booking gains or losses from complex financial instruments
whose real value may not be known for years.
The Financial Accounting Standards Board's new
rule will require companies to base "fair" values for certain items on
what they would fetch from a sale in an open market to a third party. In
the past, firms often would use internal models to determine the value
of instruments that didn't have a readily available price.
FASB prohibited that practice after Enron used
overly optimistic models to value multiyear power contracts in a bid to
pad earnings. The ban was meant to give the board time to come up with a
new approach to determining fair values.
The accounting rule makers say the new standard
will give companies, auditors and investors much needed, and more
nuanced, guidance on how to measure market values. Companies will have
to think, "it's not my own estimate of what something is worth to me,
but what the market would demand for this," said Leslie Seidman, an FASB
member. While clarifying how to come up with appropriate values for some
instruments, the new standard doesn't expand the use of what is known as
fair-value accounting.
Critics say the new rule reopens the door to
manipulation and possibly fraud by unscrupulous managers. Requiring
market values for instruments where there isn't a ready price in a
market can be "a license for management to invent the financial
statements to be whatever they want them to be," Damon Silvers,
associate general counsel for the AFL-CIO, said at a meeting of an FASB
advisory group this spring.
Jousting over the standard reflects a deep rift
within accounting circles. For decades, accounting values were mostly
based on historical cost, or what a company paid for a particular asset.
In recent years, accounting rules have moved toward the use of market
values, known as fair-value accounting. In some ways this reflects the
shift in the U.S. from a manufacturing to a service economy, where
intangible assets are more important than the plant and equipment that
previously defined a company's financial strength.
Starting in the mid-1980s, companies also began
using ever-more-complicated financial instruments such as futures,
options and swaps to manage interest-rate, currency and other risks.
Such contracts often can't be measured based on their cost. This spurred
the use of market values, thought to be more realistic. But these values
can be tough to determine because many complex financial instruments are
tailor-made and don't trade on open markets in the same way as stocks.
Of course, valuations based on historical cost
also have flaws. The savings-and-loan crisis of the late 1980s, for
example, was prompted in part by thrifts carrying loans on their balance
sheets at historical cost, even though the loans had plummeted in value.
Robert Herz, the FASB's chairman, acknowledges
the difficulty in coming up with a market, or fair, value for many
instruments. In discussions, he often asks how a company could
reasonably be expected to come up with a fair value for a 30-year swap
agreement on the Thai currency, the baht, which is a bet on the future
value of that currency against another.
The answer, according to Mr. Herz and the FASB,
is to base the value on what a willing third-party would pay in the
market and possibly include a discount to reflect the uncertainty
inherent in the approach.
In an interview earlier this year, Mr. Herz
said this valuation approach would reduce the likelihood of a recurrence
of problems such as those seen at Enron. "The problem wasn't that Enron
was using fair values, it was that they were using 'unfair' values," he
said.
Still, "the bottom line is that fair-value
accounting is a great thing so long as you have market values," said J.
Edward Ketz, an associate accounting professor at Pennsylvania State
University, who is working on a book about the FASB's new standard. "If
you don't, you get into some messy areas."
The FASB hopes to counter some of these issues
by expanding disclosures required for all balance-sheet items measured
at fair value, the board's Ms. Seidman said.
October 15, 2006 reply from Bob Jensen
The original 157 Exposure Draft proposed a Fair Value Option (FVO)
that would have allowed carrying of virtually any financial asset or
liability at fair value rather than just limiting fair value accounting
to selected items that are now required to be carried at fair value
rather than historical cost. Business firms, and especially banks,
generally are against fair value accounting (due to reporting
instabilities that arise from fair value adjustments prior to contract
settlements). The FASB backed off of the FVO when it issued FAS 157,
thereby relegating FAS 157 to a standard that clarifies definitions of
fair value in various circumstances. Hence FAS 157 is largely semantic
and does not change the present fair value accounting rules.
I asked Paul Pacter (at Deloitte in Hong Kong where he's still very
active in helping to set IFRS and FASB standards) for an update on the
FVO Project (commenced in 2004) that failed to impact the new FAS 157
standard. His reply is below.
October 31 reply from Paul Pacter (CN - Hong Kong)
[paupacter@deloitte.com.hk]
Hi Bob,
Yes, FASB's FV Option (FVO) t is very much
active -- an ED on phase 1 was issued in January, and a final FAS is
expected before year end.
- Phase 1 addresses creating an FVO for
financial assets and financial liabilities.
- Phase 2 addresses creating an FVO for
selected nonfinancial items.
Thus phase 2 would go beyond IFRSs, though
several IFRSs have FV options for individual types of assets. IAS 16 and
IAS 38 allow it for PP&E and intangibles -- though the credit is to
surplus, not P&L, no recycling, subsequent depreciation of revalued
amounts. IAS 40 gives a FV option for investment property -- FV through
P&L. IAS 41 isn't an option, it's a requirement for FV through P&L for
agricultural assets.
Phase 2 would commence in 2007.
Re possible amendment to FAS 157, I don't think
FASB plans to do that, though I suppose there might be some
consequential amendment. But I don't think the FVO will change the
definition of fair value that's in FAS 157.
Here's FASB's web page:
http://www.fasb.org/project/fv_option.shtml
Warm regards,
Paul
Bob Jensen's threads on fair value accounting are at various other links:
I recently completed the first draft of a paper on fair value at
http://faculty.trinity.edu/rjensen/FairValueDraft.htm
Comments would be helpful.
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
http://faculty.trinity.edu/rjensen/roi.htm
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms
Interest Rate Swap Valuation, Forward Rate Derivation, and Yield
Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial
Instruments ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Robert Walker's First Blog Entry is About Fair Value
Accounting, October 27, 2006 ---
http://www.robertbwalkerca.blogspot.com/
Introduction
I have decided to begin a commentary which expresses my views on
accounting. As I begin to do this I envisage the source of my commentary
to comprise three different sorts of writing in which I may engage:
§ Simple notes directly to the ‘blog’ such as this.
§ Formal submissions I may make to various bodies including the IASB.
§ Letters or reports I may write for one reason or another that I think
might have some general readership.
The expression of my views will stray from the subject matter of
accounting per se to deal with matters of enormous significance to me
such as corporate or public administration. Such expressions will not be
too substantial a digression from the core subject matter because I
believe that the foundation of good ‘corporate governance’, to use a
vogue term, is accounting.
Source of my ideas on accounting
I would have to confess that the foundation upon which I base my
philosophy of accounting is derivative, as much of human knowledge is of
course. It is not for nothing that Newtown said that if he can see so
far it is because he stands on the shoulders of giants. In my case, that
‘giant’ is Yuiji Ijiri. As I begin a detailed exposition of my views I
shall return to the lessons I learned many years ago from Theory of
Accounting Measurement, a neglected work that will still be read in
1,000 years or so long as humankind survives whichever is the shorter.
As the depredations of the standard setting craze are visited upon us
with ever increasing complexity, the message delivered by Ijiri will be
heeded more an more.
The basic structure of accounting
Without wishing to be too philosophical about it, I need to begin by
outlining what I mean by accounting. Accounting, in my mind, comprises
three inter-related parts. These are:
§ Book-keeping.
§ Accounting.
§ Financial reporting.
Book-keeping is the process of recording financial data elements in the
underlying books of account. These financial data elements represent, or
purport to represent, real world events. The heart of book-keeping is
the double entry process. For instance at the most basic level a
movement in cash will result in the surrender or receipt of an asset,
the incurring or settlement of a liability and so on.
I have no complete and coherent theory of the limits of book-keeping.
Clearly cash movement (change of ownership) or the movement of commodity
is the proper subject matter of book-keeping. Whether all forms of
contract should be similarly treated is not clear to me. I am inclined
to say yes. That is to adopt Ijiri’s theory of commitment accounting,
but I can foresee that this leads me to conclusions that I may find
unpalatable later on. Incidentally I say this because an epiphany I had,
based on the notion of commitment accounting, some years ago is
beginning to unravel.
Book-keeping goes beyond recording to encompass control. That is the
process by which the integrity of the centre piece of book-keeping – the
general ledger expressing double entry – is ensured. I will not concern
myself with such processes though this is not to say that they are
unimportant.
Accounting is the process by which sense is made of what is a raw record
expressed in the general ledger. It is the process of distillation and
summation that enables the accountant to gain on overview of what has
happened to the entity the subject of the accounting. Accounting
fundamentally assumes that the accountant is periodically capable of
saying something useful about the real world using his or her special
form of notation.
Financial reporting is the process by which data is assembled into a
comprehensive view of the world in accordance with a body of rules. It
differs, in the ideal, from accounting in a number of ways. Most
benignly it differs, for instance, by including ancillary information
for the benefit of a reader beyond the mere abstraction from the general
ledger. Again in the ideal there is an inter-relationship between the
three levels in the accounting hierarchy. That is, the rules of
financial reporting will, to some degree shape the order and format of
the basic, book-keeping level so that the process of distillation and
summation follows naturally to the final level of reporting without
dramatic alteration.
Perhaps what concerns me is that the sentiment expressed above can be
seen, without much effort, to be only ideal and that in reality it does
not arise. In short the golden strand that links the detailed recording
of real world phenonmena to its final summation is broken.
An example
I was asked recently by a student of accounting to explain IAS 41, the
IASB standard on agriculture. As I don’t deal in primary production at
all, I had not thought about this subject for years.
IAS 41 admonishes the accountant to apply ‘fair value’ accounting. Fair
value accounting is the process by which current sale prices, or their
proxies, are substituted for the past cost of any given item.
For instance, you may have a mature vineyard. The vineyard comprises
land, the vine and its fruit, the plant necessary to sustain the vine
(support structures, irrigation channels etc.). Subsumed within the vine
are the materials necessary for it to grow and start producing fruit.
This will include the immature plant, the chemical supplements necessary
to nurture and protect it, and the labour necessary to apply it.
The book-keeping process will faithfully record all of these components.
Suppose for example the plant, fertliser and labour cost $1000. In the
books will be recorded:
Dr Vineyard $1000
Cr Cash $1000
At the end of the accounting period, the accountant will summarise this
is a balance statement. He or she will then obtain, in some way, the
current selling price of the vine. Presumably this will be the future
cash stream of selling the fruit, suitably discounted. Assume that this
is $1200.
The accountant will then make the following incremental adjustment:
Dr Vineyard $200
Cr Equity $200
Looked like this there is a connection between the original book-keeping
and the periodic adjustment at the end of the accounting period. This is
an illusion. The incremental entry disguises what is really happening.
It is as follows:
Dr Equity $1000
Cr Vineyard $1000
And
Dr Vineyard $1200
Cr Equity $1200
Considered from the long perspective, the original book-keeping has been
discarded and a substitute value put in its place. This is the truth of
the matter. The subject matter of the first phase of accounting was a
set of events arising in a bank and in the entity undertaking
accounting. The subject matter of the second phase is a set of future
sales to a party who does not yet exist.
From a perspective of solvency determination, a vital element of
corporate governance, the view produced by the first phase is next to
useless. However, the disquiet I had in my mind which I had suppressed
until recently, relates to the shattering of the linkages between the
three levels of accounting in the final reporting process. This disquiet
has returned as I contemplate the apparently unstoppable momentum of the
standard setting process.
October 28, 2006 reply from Bob Jensen
Hi Robert,
I hope you add many more entries to your blog.
The problem with "original book-keeping" is that it
provides no answer how to account for risk of many modern day contracts
that were not imagined when "original book-keeping" evolved in a simple
world of transactions. For example, historical costs of forward
contracts and swaps are zero and yet these contracts may have risks that
may outweigh all the recorded debt under "original book-keeping." Once
we opened the door to fair value accounting to better account for risk,
however, we opened the door to misleading the public that booked fair
value adjustments can be aggregated much like we sum the current
balances of assets and liabilities on the balance sheet. Such
aggregations are generally nonsense.
I don't know if you saw my recent hockey analogy or not.
It goes as follows:
Goal Tenders versus Movers and Shakers
Skate to where the puck is going, not to where it is.
Wayne Gretsky (as quoted for many years by Jerry Trites
at
http://www.zorba.ca/ )
Jensen Comment
This may be true for most hockey players and other movers and shakers,
but for goal tenders the eyes should be focused on where the puck is at
every moment --- not where it's going. The question is whether an
accountant is a goal tender (stewardship responsibilities) or a mover
and shaker (part of the managerial decision making team). This is also
the essence of the debate of historical accounting versus pro forma
accounting.
Graduate student Derek Panchuk and professor
Joan Vickers, who discovered the Quiet Eye phenomenon, have just
completed the most comprehensive, on-ice hockey study to determine where
elite goalies focus their eyes in order to make a save. Simply put, they
found that goalies should keep their eyes on the puck. In an article to
be published in the journal Human Movement Science, Panchuk and Vickers
discovered that the best goaltenders rest their gaze directly on the
puck and shooter's stick almost a full second before the shot is
released. When they do that they make the save over 75 per cent of the
time.
"Keep your eyes on the puck," PhysOrg, October 26, 2006 ---
http://physorg.com/news81068530.html
I have written a more serious piece about both
theoretical and practical problems of fair value accounting. I should
emphasize that this was written after the FASB Exposure Draft proposing
fair value accounting as an option for all financial instruments and the
culminating FAS 157 that is mainly definitional and removed the option
to apply fair value accounting to all financial instruments even though
it is still required in many instances by earlier FASB standards.
My thoughts on this are at the following two links:
http://faculty.trinity.edu/rjensen/FairValueDraft.htm
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Bob Jensen
October 30, 2006 reply from Robert B Walker
[walkerrb@ACTRIX.CO.NZ]
Bob
Thanks for the support. I have answered you in
my second installment (
www.robertbwalkerca.blogspot.com ).
I shall continue to write if for no other
reason than for myself. I have had it in mind to write a book. I shall
begin doing so this way.
Robert
October 30, 2006 reply from Bob Jensen
I have difficulty envisioning forward contracts as “executory
contracts.” These appear to be to be executed contracts that are
terminated when the cash finally flows.
Fair value appears to be the only way to book forward contracts if
they are to be booked at all, although fair value on the date they are
signed is usually zero.
Once you are in the fair value realm, you have all the aggregation
problems, blockage problems, etc. that are mentioned at
http://faculty.trinity.edu/rjensen/FairValueDraft.htm
I guess what I’d especially like you to address is the problem of
aggregation in a balance sheet or income statement based upon
heterogeneous measurements.
Bob Jensen
Bob Jensen's threads on fair value accounting are at various other links:
I recently completed the first draft of a paper on fair value at
http://faculty.trinity.edu/rjensen/FairValueDraft.htm
Comments would be helpful.
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
http://faculty.trinity.edu/rjensen/roi.htm
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms
Interest Rate Swap Valuation, Forward Rate Derivation, and Yield
Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial
Instruments ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Fair value is the
estimated best disposal (exit, liquidation) value in any sale other than a
forced sale. It is defined as follows in Paragraph 540 on Page 243 of FAS
133:
The amount at which an
asset (liability) could be bought (incurred) or sold (settled) in a
current transaction between willing parties, that is, other than in a
forced or liquidation sale. Quoted market prices in active markets are
the best evidence of fair value and should be used as the basis for the
measurement, if available. If a quoted market price is available, the
fair value is the product of the number of trading units times that
market price. If a quoted market price is not available, the estimate of
fair value should be based on the best information available in the
circumstances. The estimate of fair value should consider prices for
similar assets or similar liabilities and the results of valuation
techniques to the extent available in the circumstances. Examples of
valuation techniques include the present value of estimated expected
future cash flows using discount rates commensurate with the risks
involved, option- pricing models, matrix pricing, option-adjusted spread
models, and fundamental analysis. Valuation techniques for measuring
assets and liabilities should be consistent with the objective of
measuring fair value. Those techniques should incorporate assumptions
that market participants would use in their estimates of values, future
revenues, and future expenses, including assumptions about interest
rates, default, prepayment, and volatility. In measuring forward
contracts, such as foreign currency forward contracts, at fair value by
discounting estimated future cash flows, an entity should base the
estimate of future cash flows on the changes in the forward rate (rather
than the spot rate). In measuring financial liabilities and nonfinancial
derivatives that are liabilities at fair value by discounting estimated
future cash flows (or equivalent outflows of other assets), an objective
is to use discount rates at which those liabilities could be settled in
an arm's-length transaction.
This
is old news, but it does provide some questions for students to ponder. The
main problem of fair value adjustment is that many ((most?) of the
adjustments cause enormous fluctuations in earnings, assets, and liabilities
that are washed out over time and never realized. The main advantage is
that interim impacts that “might be” realized are booked. It’s a war
between “might be” versus “might never.” The war has been waging for over a
century with respect to booked assets and two decades with respect to
unbooked derivative instruments, contingencies, and intangibles.
CFA analysts' group favors full fair value reporting
The CFA Centre for Financial Market Integrity – a
part of the CFA Institute – has published a new financial reporting model
that, they believe, would greatly enhance the ability of financial analysts
and investors to evaluate companies in making investment decisions. The
Comprehensive Business Reporting Model proposes 12 principles to ensure that
financial statements are relevant, clear, accurate, understandable, and
comprehensive (See below).
"Analysts' group favours full fair value reporting," IAS Plus,
October 31, 2005 ---
http://www.iasplus.com/index.htm
CFA Institute Centre for Financial Market
Integrity
Comprehensive Business Reporting Model –
Principles
|
-
1. The company must be viewed from the
perspective of a current investor in the
company's common equity.
-
2. Fair value information is the only
information relevant for financial decision
making.
-
3. Recognition and disclosure must be
determined by the relevance of the
information to investment decision making
and not based upon measurement reliability
alone.
-
4. All economic transactions and events
should be completely and accurately
recognized as they occur in the financial
statements.
-
5. Investors' wealth assessments must
determine the materiality threshold.
-
6. Financial reporting must be neutral.
-
7. All changes in net assets must be
recorded in a single financial statement,
the Statement of Changes in Net Assets
Available to Common Shareowners.
-
8. The Statement of Changes in Net Assets
Available to Common Shareowners should
include timely recognition of all changes in
fair values of assets and liabilities.
-
9. The Cash Flow Statement provides
information essential to the analysis of a
company and should be prepared using the
direct method only.
-
10. Changes affecting each of the financial
statements must be reported and explained on
a disaggregated basis.
-
11. Individual line items should be reported
based upon the nature of the items rather
than the function for which they are used.
-
12. Disclosures must provide all the
additional information investors require to
understand the items recognized in the
financial statements, their measurement
properties, and risk exposures.
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|
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Standards of Value: Theory and Applications
Standards of Value covers the
underlying assumption in many of the prominent standards of value, including
Fair Market Value, investment value, and fair value. It discusses the
specific purposes of the valuation, including divorce, shareholders'
oppression, financial reporting, and how these standards are applied.
Standards of Value: Theory and Applications, by Jay E. Fishman,
Shannon P. Pratt, William J. Morrison Wiley: ISBN: 0-471-69483-5 Hardcover
368 pages November 2006 US $95.00) ---
http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471694835.html
"Will Fair Value Fly? Fair-value accounting could change the very basis
of corporate finance," by Ronald Fink, CFO Magazine September 01,
2006 ---
http://www.cfo.com/article.cfm/7851757/c_7873404?f=magazine_featured
Much has changed in financial reporting since
Andrew Fastow and Scott Sullivan, the finance chiefs of Enron and
WorldCom, respectively, brought disgrace upon themselves, their
employers, and, to a degree, their profession. Regulators and investors
have pressed companies to be more open and forthcoming about their
results — and companies have responded. According to a new CFO magazine
survey, 82 percent of public-company finance executives disclose more
information in their financial statements today then they did three
years ago. But that positive finding won't quell calls for further
accounting reform.
The U.S. reporting system "faces a number of
important and difficult challenges," Robert Herz, chairman of the
Financial Accounting Standards Board, told the annual conference of the
American Institute of Certified Public Accountants in Washington, D.C.,
last December. Chief among those, said Herz, is "the need to reduce
complexity and improve the transparency and overall usefulness" of
information reported to investors. ad
Critics contend that generally accepted
accounting principles (GAAP) remain seriously flawed, even as companies
have beefed up internal controls to comply with the Sarbanes-Oxley Act.
"We've done very little but play defense for the last five to six
years," charges J. Michael Cook, chairman and CEO emeritus of Deloitte &
Touche LLP. "It's time to play offense."
Cook, a respected elder statesman in the
accounting community, goes so far as to pronounce financial statements
almost completely irrelevant to financial analysis as currently
conducted. "The analyst community does workarounds based on numbers that
have very little to do with the financial statements," says Cook. "Net
income is a virtually useless number."
How can financial statements become more
relevant and useful? Many reformers, including Herz, believe that
fair-value accounting must be part of the answer. In this approach,
which FASB increasingly favors, assets and liabilities are marked to
market rather than recorded on balance sheets at historical cost.
Fair-value accounting, say its advocates, would give users of financial
statements a far clearer picture of the economic state of a company.
"I know what an asset is. I can see one, I can
touch one, or I can see representations of one. I also know what
liabilities are," says Thomas Linsmeier, a Michigan State University
accounting professor who joined FASB in June. On the other hand, "I
believe that revenues, expenses, gains, and losses are accounting
constructs," he adds. "I can't say that I see a revenue going down the
street. And so for me to have an accounting model that captures economic
reality, I think the starting point has to be assets and liabilities."
More than any other regulatory change, fair
value promises to end the practice of earnings management. That's
because a company's earnings would depend more on what happens on its
balance sheet than on its income statement (see "The End of Earnings
Management?" at the end of this article).
But switching from historical cost would
require enormous effort from overworked finance departments. Valuing
assets in the absence of active markets could be overly subjective,
making financial statements less reliable. Linsmeier's confidence
notwithstanding, disputes could arise over the very definition of
certain assets and liabilities. And using fair value could even distort
a company's approach to deal-making and capital structure.
A Familiar Concept Fair value is by no means
unfamiliar to corporate-finance executives, as current accounting rules
for such items as derivatives (FAS 133 and 155), securitizations (FAS
156), and employee stock option grants (FAS 123R) use it to varying
degrees when recording assets and liabilities. So does a proposal issued
last January for another rule, this one for accounting for all financial
instruments. FASB's more recent proposals to include pensions and leases
on balance sheets also embrace fair-value measurement (see "Be Careful
What You Wish For" at the end of this article).
While both Herz and Linsmeier are careful to
note that they don't necessarily favor the application of fair value to
assets and liabilities that lack a ready market, they clearly advocate
its application where there's sufficient reason to believe the
valuations are reliable. Corporate accounting, Herz says, is the only
major reporting system that doesn't use fair value as its basis, and he
points to the Federal Reserve's use of it in tracking the U.S. economy
as sufficient reason for companies to adopt it.
The corporate world, however, must grapple with
its own complexities. For one, fair value could make it even more
difficult to realize value from acquisitions. Take the question of
contingent considerations, wherein the amount that acquirers pay for
assets ultimately depends on their return. Under current GAAP, the
balance-sheet value of assets that are transferred through such earnouts
may reflect only the amount exchanged at the time the deal is completed,
because the acquirer has considerable leeway in treating subsequent
payments as expenses.
Under fair value, the acquirer would also
include on its balance sheet the present value of those contingent
payments based on their likelihood of materializing. Since the money may
never materialize, some finance executives contend those estimates could
be unreliable and misleading. "I disagree with [this application of fair
value] on principle," James Barge, senior vice president and controller
for Time Warner, said during a conference on financial reporting last
May. ad
Barge cites the acquisition of intangible
assets that a company does not intend to use as a further example of
fair value's potentially worrisome effects. Under current GAAP, their
value is included in goodwill and subject to annual impairment testing
for possible write-off. But if, as FASB is contemplating, the value of
those assets would be recorded on the balance sheet along with that of
the associated tangible assets that were acquired, Barge worries that an
immediate write-off would then be required — even though it would not
reflect the acquiring company's economics.
Fair value's defenders say such concerns are
misplaced. The possibility that a contingent consideration won't
materialize, for starters, is already reflected in an acquirer's bid,
says Patricia McConnell, a Bear Stearns senior managing director who
chairs the corporate-disclosure policy council of the CFA Institute, a
group for financial analysts. "It's in the price," she says.
As for intangibles that are acquired and then
extinguished, the analyst says a write-off would not in fact be required
under fair value if the transaction strengthens the acquirer's market
position. That position would presumably be reflected in the value of
the assets associated with those intangibles as recorded on the balance
sheet under fair-value treatment.
"It may be in buying a brand to gain
monopolistic position that you don't have an expense," McConnell
explains, "but rather you have the extinguishment of one asset and the
creation of another." Yet McConnell, among others, admits that
accounting for intangibles is an area that would need improvement even
if FASB adopted fair value.
Deceptive Debt? Another area of concern
involves capital structure, with Barge suggesting that fair value may
make it more difficult to finance growth with debt. He contends that
marking a company's debt to market could make a company look more highly
exposed to interest-rate risk than it really is, noting during the May
conference that Time Warner's debt was totally hedged.
Barge also cited as problematic the
hypothetical case of a company whose creditworthiness is downgraded by
the rating agencies. By marking down the debt's value on its balance
sheet, the company would realize more income, a scenario Barge called
"nonsensical." He warned of a host of such effects arising under fair
value when a company changes its capital structure.
Proponents find at least some of the complaints
about fair value and corporate debt to be misplaced. Herz notes fair
value would require the company to mark the hedge as well as the debt to
market, so that if a company is hedging interest-rate risk effectively,
its balance sheet should accurately reflect its lack of any exposure.
What's more, fair value could also improve
balance sheets in some cases. When, for instance, a company owns an
interest in another whose results it need not consolidate, the equity
holder's proportion of the other company's assets and liabilities is
currently carried at historical cost. If, however, the other company's
assets have gained value and were marked to market, the equity holder's
own leverage might decrease.
A real-life case in point: If the chemical
company Valhi marked to market its 39 percent stake in Titanium Metals,
Valhi's own ratio of long-term debt to equity would fall from 90 percent
(at the end of 2005) to 56 percent, according to Jack T. Ciesielski,
publisher of The Analyst's Accounting Observer newsletter. ad
Still, even some fair-value proponents share
Barge's concern about credit downgrades. As Ciesielski, a member of
FASB's Emerging Issues Task Force, wrote last April in a report on the
board's proposal for the use of fair value for financial instruments, it
is "awfully counterintuitive" for a company to show rising earnings when
its debt-repayment capacity is declining.
Herz and other fair-value proponents disagree,
noting that the income accrues to the benefit of the shareholders, not
to bondholders. "It's not at all counterintuitive," asserts Rebecca
McEnally, director for capital-markets policy of the CFA Institute
Centre for Financial Market Integrity, citing the fact that the item is
classified under GAAP as "income from forgiveness of indebtedness." But
Ciesielski says investors are unlikely to understand that, and that fair
value, in this case at least, may not produce useful results.
Resolving the Issues Even some of FASB's
critics agree, however, that the current system needs improvement, and
that fair value can help provide it. "Fair value in general is more
relevant than historical cost and can lead to reduced complexity and
greater transparency," Barge admits, though he has noted that the use of
fair value may also lead to "soft" results that "you can't audit."
For much the same reason, Colleen Cunningham,
president and CEO of Financial Executives International (FEI), expressed
concern in testimony before Congress last March that "overly theoretical
and complex standards can result in financial reporting of questionable
accuracy and can create a significant cost burden, with little benefit
to investors." In an interview, she explains that her biggest concern is
that FASB is pushing ahead with fair-value-based rules without
sufficient input from preparers. "Let's resolve the issues" before
proceeding, she insists.
Herz concedes that numerous issues surrounding
fair value need to be addressed. But important users of financial
statements are pressing him to move forward on fair value without delay.
As a comment letter that the CFA Institute sent to FASB put it: "All
financial decision-making should be based on fair value, the only
relevant measurement for assets, liabilities, revenues, and expenses."
Meanwhile, Herz isn't waiting for the
conceptual framework to be completed before enacting new rules that
embrace fair value. "In the end, we're not going to get everybody
agreeing," Herz says. "So we have to make decisions" despite lingering
disagreement.
Ironically, one fair-value-based proposal that
FASB issued recently may have created an artful means of defusing
opposition. The Board's proposal for financial instruments gives
preparers of financial reports the choice of using historical cost or
fair value in recording the instruments on their balance sheets. That
worries some people, who say giving companies a choice of methods will
make it harder to compare their results, even when they're in the same
industry.
Continued in article
"Guidance on fair value measurements under FAS 123(R)," IAS Plus, May 8,
2006 ---
http://www.iasplus.com/index.htm
Deloitte & Touche (USA) has updated its book of
guidance on FASB Statement No. 123(R) Share-Based Payment:
A Roadmap to Applying the Fair Value Guidance to Share-Based Payment
Awards (PDF 2220k). This second edition
reflects all authoritative guidance on FAS 123(R) issued as of 28 April
2006. It includes over 60 new questions and answers, particularly in the
areas of earnings per share, income tax accounting, and liability
classification. Our interpretations incorporate the views in SEC Staff
Accounting Bulletin Topic 14 "Share-Based Payment" (SAB 107), as well as
subsequent clarifications of EITF Topic No. D-98 "Classification and
Measurement of Redeemable Securities" (dealing with mezzanine equity
treatment). The publication contains other resource materials, including
a GAAP accounting and disclosure checklist. Note that while FAS 123 is
similar to
IFRS 2 Share-based Payment, there are some
measurement differences that are
Described Here.
Bob Jensen's threads on employee stock options are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Fair Value Accounting Book Review (Meeting the New FASB Requirements)
From SmartPros on May 1, 2006
Fair Value for Financial Reporting by Alfred King
highlights the accounting and auditing requirements for fair value
information and offers a detailed explanation of how the FASB is going
to change "fair value," from determining the fair value of intangible
assets to
selecting and working with an appraiser ---
http://accounting.smartpros.com/x35458.xml
Fair Value for Financial Reporting: Meeting the New FASB Requirements
by Alfred M. King
ISBN: 0-471-77184-8
Hardcover 352 pages April 2006
Click to
Download the Comprehensive Business Reporting Model from the CFA
Institute website.
Click here for
Press Release (PDF 26k).
As
you can see below, the war is not over yet. In fact it has intensified
between corporations (especially banks) versus standard setters versus
members of the academy.
From The
Wall Street Journal Accounting Educators' Review on April 2, 2004
TITLE: As IASB
Unveils New Rules, Dispute With EU Continues
REPORTER: David Reilly
DATE: Mar 31, 2004
PAGE: A2 LINK:
http://online.wsj.com/article/0,,SB108067939682469331,00.html
TOPICS: Generally accepted accounting principles, Fair Value Accounting,
Insider trading, International Accounting, International Accounting
Standards Board
SUMMARY:
Despite controversy with the European Union (EU), the International
Accounting Standards Board (IASB) is expected to release a final set of
international accounting standards. Questions focus on the role of the
IASB, controversy with the EU, and harmonization of the accounting
standards.
QUESTIONS:
1.) What is the role of the IASB? What authority does the IASB have to
enforce standards?
2.) List three
reasons that a country would choose to follow IASB accounting standards.
Why has the U.S. not adopted IASB accounting standards?
3.) Discuss the
advantages and disadvantages of harmonization of accounting standards
throughout the world. Why is it important the IASB reach a resolution
with the EU over the disputed accounting standards?
4.) What is
fair value accounting? Why would fair value accounting make financial
statements more volatile? Is increased volatility a valid argument for
not adopting fair value accounting? Does GAAP in the United States
require fair value accounting? Support your answers.
There are a number of software vendors of FAS 133 valuation
software.
One of the major companies is Financial CAD ---
http://www.financialcad.com/
FinancialCAD provides software and services
that support the valuation and risk management of financial securities
and derivatives that is essential for banks, corporate treasuries and
asset management firms. FinancialCAD’s industry standard financial
analytics are a key component in FinancialCAD solutions that are used by
over 25,000 professionals in 60 countries.
See
software.
Fair value accounting politics in the revised
IAS 39
From Paul Pacter's IAS Plus on July 13, 2005
---
http://www.iasplus.com/index.htm
Also see
http://faculty.trinity.edu/rjensen//theory/00overview/IASBFairValueFAQ.pdf
-
Why did the Commission
carve out the full fair
value option in the
original IAS 39
standard?
-
Do
prudential supervisors
support IAS 39 FVO as
published by the IASB?
-
When will the Commission
to adopt the amended
standard for the IAS 39
FVO?
-
Will companies be able
to apply the amended
standard for their 2005
financial statements?
-
Does the amended
standard for IAS 39 FVO
meet the EU endorsement
criteria?
-
What about the
relationship between the
fair valuation of own
liabilities under the
amended IAS 39 FVO
standard and under
Article 42(a) of the
Fourth Company Law
Directive?
-
Will the Commission now
propose amending Article
42(a) of the Fourth
Company Directive?
-
What about the remaining
IAS 39 carve-out
relating to certain
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On June 23, 2005, the Financial Accounting Standards Board
issued an Exposure Draft (ED) entitled "Fair Value Measurements." The original
ED can be downloaded free at
http://www.fasb.org/draft/ed_fair_value_measurements.pdf
"Response to the FASB's Exposure Draft on Fair Value Measurements," AAA
Financial Standards Committee, Accounting Horizons, September 2005, pp.
187-195 ---
http://aaahq.org/pubs/electpubs.htm
RESPONSES TO SPECIFIC ISSUES
The FASB invited comment on all matters related to
the ED, but specifically requested comments on 14 listed issues. The
Committee's comments are limited to those issues for which empirical
research provides some insights, or those sections of the ED that are
conceptually inconsistent or unclear. The Committee has previously
commented on other fair-value-related documents issued by the FASB and other
standard-setting bodies. This letter reiterates comments expressed in those
letters to the extent they are germane to the measurement issues contained
in the ED. However, to better understand our perspective on reporting fair
value information in the financial statements and related notes, we refer
readers to those comment letters (i.e., AAA FASC 1998, 2000).
Issue 1: Definition of Fair Value
The Committee believes that the ED contains some
conceptual inconsistencies between the definition and application of the
fair value measurement attribute. The ED proposes a definition of fair
value that is relatively independent of the entity-specific use of the
assets held or settlement of the liabilities owed. In contrast, the
proposed standard and related implementation guidance includes measurement
that is, at times, directly determined by the entity-specific use of the
asset or settlement of the liability in question.
Some of the inconsistencies with respect to fair
value measurement might be attributable to the attempt to apply general,
high-level fair value guidance to the idiosyncratic attributes of specific
accounts and transactions. In some cases, application to specific accounts
and transactions requires deviation from an entity-independent notion of
fair value to one that includes consideration of the specific types and uses
of assets held or liabilities owed by companies. For example, as we note in
our discussion of Issue 6 (below), one of the examples in the ED suggests
that the fair value of a machine should include an adjustment of quoted
market prices (based on comparable machines) for installation costs.
However, such an adjustment is dependent on the individual circumstances of
the company that purchases the equipment. That is, installation costs are
included in the fair value of an asset only when the firm intends to use
that asset for income producing activities. Alternatively, if the firm
intends to sell the asset, then installation costs are ignored.
Some members of the Committee, however, do not
perceive an inconsistency between the definition and application of the fair
value measurement attribute. These members view the definition of fair
value and the context within which it is applied (i.e., the valuation
premise) to be distinct, albeit related, attributes. Although the
definition of fair value can be entity-independent, the valuation premise
(e.g., value-in-use or value-in-exchange) cannot. Further, these members
argue that ignoring the valuation premise in determining fair value could
lead to unsatisfactory outcomes. For example, if installation costs are
ignored regardless of the valuation premise, then immediately after
purchasing an asset for use in income-producing activities, firms would
suffer impairment losses equal to the installation costs incurred to prepare
the assets for use.
The Committee raises the example of machinery
installation costs to illustrate the confusion we experienced trying to
reconcile the high-level (seemingly entity-independent) definition of fair
value with the contextually determined application standards. We note that
the Introduction of the Ed suggests that the intent of the proposed guidance
in the ED is to establish fair value measures that would be referenced in
other authoritative accounting to establish fair value measures that would
be referenced in other authoritative accounting pronouncements. Presumably,
these other pronouncements would also establish reasonable deviations from
the entity-independent notion of fair value. The Committee believes the
most effective general purpose fair value measurement standard would adopt a
general notion of fair value that is consistent across the definition of
fair value, the accounting standard, and the implementation guidance. To
the extent the Board generally believes that fair value is an
entity-specific concept, the high-level definition should reflect this as
well.
Issues 4 and 5: Valuation Premise and Fair Value
Hierarchy
Related to our previous comments, some members of
the Committee perceive a contradiction between the definition of fair value
in paragraphs 4 and 5 of the ED and the valuation premise described in
paragraph 13. The definition of fair value provided in paragraph 5 suggests
a pure value-in-exchange perspective where fair value is determined by the
market price that would occur between willing parties. In contrast, the
valuation premise described in paragraph 13 suggests that the fair value
estimate can follow either a value-in-use perspective or a value-in-exchange
perspective.
Moreover, the fair value hierarchy described in the
ED gives the highest priority to fair value measurements based on market
inputs regardless of the valuation premise. Some members of the Committee
believe that quoted market prices are not necessarily an appropriate measure
of fair value when a value-in-use premise is being considered. This is
especially true when a quoted price for an identical asset in an active
reference market (i.e., a Level 1 estimate) exists, but is significantly
different from a value-in-use estimate computed by taking the present value
of the firm-specific future cash flows expected to be generated by the asset
(i.e., a Level 3 estimate). In such instances, following the fair value
hierarchy might lead to a fair value estimate more in character with a
value-in-exchange premise than a value-in-use premise.
In summary, the Committee believes that: (1)
integrating the two valuation premises (i.e., value-in-use and
value-in-exchange) into the definition of fair value itself and (2)
elaborating on the differences between the two premises would help ensure
more consistent application of the standard.
Issue 6: Reference Market
Some members of the Committee are confused by the
guidance related to determining the appropriate reference market. With
respect to the Level 1 reference market, the ED states that when multiple
active markets exist, the most advantageous market should be used. The most
advantageous market is determined by comparing prices across multiple
markets net of transactions costs. However, the ED requires that
transactions costs be ignored subsequently in determining the fair value
measurement. In our view, ignoring transactions costs is problematic
because we believe such costs are an ordinary and predictable part of
executing a transaction.
In Example 5 (paragraph B9 (b) of the ED) where two
markets, A and B, are considered, the price in Market B ($35) is more
advantageous than the price in Market A ($25), ignoring transaction costs.
However, the fair value estimate is determined using the price in Market A
because the transactions cost in Market B ($20) is much higher than in
Market A ($5). The guidance is less clear if we modify the example by
reducing the transaction costs for Market B to $15. In this instance,
neither market is advantageous in a "net" sense, but Market B would yield
the highest fair value estimate (ignoring transactions costs), which
provides managers an opportunity to pick the most desirable figure based on
their reporting objectives.
Omitting transactions costs from the fair value
estimate in Example 5 contrasts sharply with Example 3 (Appendix B,
paragraph B7 (a)) where the value-in-use fair value estimate of a machine is
determined by adjusting the quoted market price of a comparable machine by
installation costs. Installation costs are ignored only if the firm intends
to dispose of the asset (Appendix B, paragraph B7 (b)). Thus, managerial
intent plays an integral role in determining whether fair value is computed
with or without installation costs, but the same does not hold for
transaction costs. Since transaction costs are not relevant unless
management intends to dispose of the asset, the Committee agrees that
ignoring transaction costs is justified when a value-in-use premise is
appropriate, but the Committee questions the appropriateness of ignoring
transaction costs when a value-in-exchange premise is adopted.
Issue 7: Pricing in Active Dealer Markets
The ED requires that the fair value of financial
instruments traded in active dealer markets where bid and asked prices are
readily available be estimated using bid prices for assets and asked prices
for liabilities. Some Committee members believe that this requirement is
inconsistent with the general concept of fair value and seems to be biased
toward valuing assets and liabilities at value-in-exchange instead of
value-in-use. Limiting our discussion to the asset case, if a buyer
establishes a long position through a dealer, the buyer must pay the asked
price. By purchasing the asset at the asked price, the buyer clearly
expects to earn an acceptable rate of return on the investment in the asset
(at the higher price). Moreover, if after purchasing the asset, the buyer
immediately applies the ED's proposed fair value measurement guidance (i.e.,
bid price valuation), the buyer would incur a loss on the asset equal to the
bid-ask spread.
In general, the bid price seems relevant only if
the holder wishes to liquidate his/her position. Although the Committee is
not largely in favor of managerial intent-based fair value measures, we are
uncomfortable with a bias toward a value-in-exchange premise for assets
in-use. If the Board decides to retain bid-based (ask-based) accounting for
dealer traded assets (liabilities) in the final standard, then we propose
that the final standard more clearly describe the conceptual basis for
liquidation basis asset and liability valuation.
Issue 9: Level 3 Estimates
Level 3 estimates require considerable judgment in
terms of both the selection and application of valuation techniques. As a
result, estimates using different valuation techniques with different
assumptions will likely yield widely varying fair value estimates. Examples
7 and 8 in Appendix B of the ED illustrate the wide variance in fair value
estimates obtained with different valuation techniques. The ED allows
considerable latitude in both the valuation technique and inputs used. Due
to their incentives, managers might use the flexibility afforded by the
proposed standard to produce biased and unreliable estimates. The
measurement guidance proposed in the ED is similar to the unstructured and
imprecise category of standards analyzed by Nelson et al. (2002). They
find that managers are more likely to attempt (and auditors are less likely
to question) earnings management under such standards compared to more
precise standards.
The income approach to determining a Level 3 fair
value estimate encompasses a basket of valuation techniques including two
different present value techniques--the discount rate adjustment technique
and the expected present value technique.4 The ED conjectures
that these two techniques should produce the same fair values (see
paragraphs A12, A13 and FN 17). But, from an application perspective, this
conjecture is not consistent with empirical results from studies of human
judgment and decision making.5 In particular, psychology
research repeatedly shows that people are very poor intuitive statisticians
(e.g., people consistently make axiomatic violations when estimating
probabilistic outcomes). In light of these findings, statements such as
"the estimated fair values should be the same" provide preparers, auditors,
and users with an unfounded (and descriptively false) belief that the
techniques suggested in the ED will produce the same fair value estimates.
Some members of the Committee believe that the ED
should explicitly caution preparers, auditors, and users by stating that
individuals consistently make these judgment errors. Further, these
Committee members recommend that the ED require companies (when practicable)
to (1) independently use the discount rate adjustment and expected
present value techniques if they decide to use a present value approach to
determine fair value and (2) reconcile the results of the two techniques in
a meaningful fashion and document the reconciliation so it can be audited
for reasonableness. Moreover, the application of the present value
techniques should be independent of suggested or existing fair value figures
when practicable (e.g., the fair value amount recorded in the previous
year's financial statements), because psychology research finds that
preconceived targets and legacy amounts unduly influence current judgments
and decisions (e.g., through "anchoring" and insufficient adjustment).
Although the disclosures required under paragraph
25 of the ED provide some information regarding the potential reliability of
a Level 3 estimate, they do not provide alternative benchmark models that
the firm may have considered in determining those fair value estimates.
Hence, the Committee also recommends that the FASB consider requiring firms
to disclose (1) fair value estimates under alternative valuation techniques,
and (2) sensitivity of fair value estimates to the specific assumptions and
inputs used.
Issue 11: Fair Value Disclosures
As mentioned previously, the Committee believes
that the proposed fair value measurement disclosures are not complete. The
Committee believes that when a firm uses alternative valuation methods to
determine fair value, information regarding the alternative techniques and
inputs employed should be provided. Furthermore, users of financial
statements would get a better understanding of the reliability of fair value
estimates if the financial statements provide detailed disclosures related
to (1) fair value estimates produced by alternative valuation techniques and
reasons for selecting a preferred estimate, and (2) information about the
sensitivity of fair value estimates to changes in assumptions and inputs.
The Committee also notes that the ED requires the
expanded set of reliability related disclosures only for fair value
estimates reported in the balance sheet (paragraph 25). A complete set of
financial statements also includes many fair value estimates reported in the
notes to the financial statements. Some members of the Committee believe
that financial statement users would also benefit from receiving the
reliability related disclosures for fair values disclosed in the footnotes.
Moreover, application of the fair value hierarchy has implications for the
reliability of the unrealized gains and losses reported in net (or
comprehensive) income. Accordingly, some members recommend that firms be
required to disclose a breakdown of unrealized gains or losses based on how
the related fair value amounts were determined (i.e., quoted prices of
identical items, quoted prices of similar items, valuation models with
significant market inputs, or valuation models with significant entity
inputs.)
CONCLUSION
The Committee supports the formulation of a single
standard that provides guidance on fair value measurement. We believe that
such a standard would improve the consistency of fair value measurement
across the many standards that require fair value reporting and disclosure.
In this comment letter, we identify some potential inconsistencies between
fair value definitions and fair value determination, and suggest ways to
improve disclosures so that users of financial statements can better
appreciate the reliability (or lack thereof) of fair value estimates.
Although the Committee recognizes that the ED is
intended to provide fair value measurement guidance, we wish to caution
against promulgating pronouncements that completely eliminate historical
cost information from the financial statements. Evidence reported in
Dietrich et al. (2000) suggests that historical cost information is
incrementally informative even after fair value information is included in
regression analyses.
4
FASB Concept Statement No. 7, Using Cash Flow Information and Present
Value in Accounting Measurements, describes these techniques, albeit
using different terminology. In that Concepts Statement, traditional
present value refers to the discount rate adjustment technique, while
expected cash flow approach refers to the expected present value technique.
5
Probability-related judgments and decisions are among the oldest branches of
psychology and decision-science research. Two excellent resources that
catalogue the problems that individuals have with probability judgments and
statistical reasoning are Baron (2000) and Goldstein and Hogarth (1997).
What are the advantages and disadvantages of requiring
fair value accounting for all financial instruments as well as derivative
financial instruments?
Advantages:
- Eliminate
arbitrary FAS 115 classifications that can be used by management to
manipulate earnings (which is what Freddie Mac did in 2001 and 1002.
- Reduce
problems of applying FAS 133 in hedge accounting where hedge accounting
is now allowed only when the hedged item is maintained at historical
cost.
- Provide a
better snap shot of values and risks at each point in time. For
example, banks now resist fair value accounting because they do not want
to show how investment securities have dropped in value.
Disdvantages:
- Combines
fact and fiction in the sense that unrealized gains and losses due to
fair value adjustments are combined with “real” gains and losses from
cash transactions. Many, if not most, of the unrealized gains and
losses will never be realized in cash. These are transitory
fluctuations that move up and down with transitory markets. For
example, the value of a $1,000 fixed-rate bond moves up and down with
interest rates when at expiration it will return the $1,000 no matter
how interest rates fluctuated over the life of the bond.
- Sometimes
difficult to value, especially OTC securities.
- Creates
enormous swings in reported earnings and balance sheet values.
- Generally
fair value is the estimated exit (liquidation) value of an asset or
liability. For assets, this is often much less than the entry
(acquisition) value for a variety of reasons such as higher transactions
costs of entry value, installation costs (e.g., for machines), and
different markets (e.g., paying dealer prices for acquisition and blue
book for disposal). For example, suppose Company A purchases a computer
for $2 million that it can only dispose of for $1 million a week after
the purchase and installation. Fair value accounting requires expensing
half of the computer in the first week even though the computer itself
may be utilized for years to come. This violates the matching principle
of matching expenses with revenues, which is one of the reasons why fair
value proponents generally do not recommend fair value accounting for
operating assets.
"Derivatives and
hedging: An Analyst's Response to US FAS 133," by Frank Will, Corporate
Finance Magazine, June 2002,
http://www.corporatefinancemag.com/pdf/122341.pdf
However, FAS 133 still needs further
clarification and improvement as the example of Fannie Mae
shows. Analysts focus more on the economic value of a company and less
on unrealised gains and losses. Much of the FAS 133 volatility in
earnings and in equity does not consistently reflect the economic
situation. This makes it difficult to interpret the figures.
Therefore, analysts welcome the decision of some companies voluntarily
to disclose a separate set of figures excluding the effect of FAS 133.
For more on Frank Will's analysis of FAS 133, Fair Value
Accounting, and Fannie Mae, go to
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's threads on accounting theory are
at
http://faculty.trinity.edu/rjensen/theory.htm
You can read more about fair value at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms
Forwarded on May 11, 2003 by Patrick E
Charles
[charlesp@CWDOM.DM]
Mark-to-market rule
should be written off
Richard A. Werner
Special to The Daily Yomiuri
Yomiuri
Since 1996,
comprehensive accounting reforms have been gradually introduced in Japan.
Since fiscal 2000, the valuation of investment securities owned by firms has
been based on their market value at book-closing. Since fiscal 2001,
securities held on a long-term basis also have been subjected to the
mark-to-market rule. Now, the Liberal Democratic Party is calling for the
suspension of the newly introduced rule to mark investments to market, as
well as for a delay in the introduction of a new rule that requires fixed
assets to be valued at their market value.
The proponents of
so-called global standards are up in arms at this latest intervention by the
LDP. If marking assets to market is delayed, they argue, the nation will lag
behind in the globalization of accounting standards. Moreover, they argue
that corporate accounts must be as transparent as possible, and therefore
should be marked to market as often and as radically as possible. On the
other hand, opponents of the mark-to-market rule argue that the recent slump
in the stock market, which has reached a 21-year low, can at least partly be
blamed on the new accounting rules.
What are we to make
of this debate? Let us consider the facts. Most leading industrialized
countries, such as Britain, France and Germany, so far have not introduced
mark-to-market rules. Indeed, the vast majority of countries currently do
not use them.
Nevertheless, there
is enormous political pressure to utilize mark-to-market accounting, and
many countries plan to introduce the standard in 2005 or thereafter.
Japan decided to
adopt the new standard ahead of everyone else, based on the advice given by
a few accountants--an industry that benefits from the revision of accounting
standards as any rule change guarantees years of demand for their consulting
services.
However, so far
there has not been a broad public debate about the overall benefits and
disadvantages of the new standard. The LDP has raised the important point
that such accounting changes might have unintended negative consequences for
the macroeconomy.
Let us first
reflect on the microeconomic rationale supporting mark-to-market rules. They
are said to render company accounts more transparent by calculating
corporate balance sheets using the values that markets happen to indicate on
the day of book- closing. Since book-closing occurs only once, twice or, at
best, four times a year, any sudden or temporary move of markets on these
days--easily possible in these times of extraordinary market
volatility--will distort accounts rather than rendering them more
transparent.
Second, it is not
clear that marking assets to market reflects the way companies look at their
assets. While they know that market values are highly volatile, there is one
piece of information about corporate assets that have an undisputed meaning
for
firms: the price at
which they were actually bought.
The purchase price
matters as it reflects actual transactions and economic activity. Marking to
market, on the other hand, means valuing assets at values at which they were
never transacted. The company has neither paid nor received this theoretical
money in exchange for the assets. This market value is hence a purely
fictitious value. Instead of increasing transparency, we end up increasing
the part of the accounts that is fiction.
While the history
of marking to market is brief, we do have some track record from the United
States, which introduced mark-to-market accounting in the 1990s.
Did the
introduction increase accounting transparency? The U.S. Financial Accounting
Standards Board last November concluded that the new rule of marking to
market allowed Enron Energy Services Inc. to book profits from long-term
energy contracts immediately rather than when the money was actually
received.
This enabled Enron
executives to create the illusion of a profitable business unit despite the
fact that the truth was far from it. Thanks to mark-to-market accounting,
Enron's retail division managed to hide significant losses and book billions
of dollars in profits based on inflated predictions of future energy prices.
Enron's executives received millions of dollars in bonuses when the energy
contracts were signed.
The U.S. Financial
Accounting Standards Board task force recognized the problems and has hence
recommended the mark-to-market accounting rule be scrapped. Since this year,
U.S. energy companies will only be able to report profits as income actually
is received.
Marking to market
thus creates the illusion that theoretical market values can actually be
realized. We must not forget that market values are merely the values
derived on the basis of a certain number of transactions during the day in
case.
Strictly speaking,
it is a false assumption to extend the same values to any number of assets
that were not actually transacted at that value on that day.
When a certain
number of the 225 stocks constituting the Nikkei Stock Average are traded at
a certain price, this does not say anything about the price that all stocks
that have been issued by these 225 companies would have traded on that day.
As market
participants know well, the volume of transactions is an important indicator
of how representative stock prices can be considered during any given day.
If the index falls 1 percent on little volume, this is quickly discounted by
many observers as it means that only a tiny fraction of shares were actually
traded. If the market falls 1 percent on record volume, then this may be a
better proxy of the majority of stock prices on that day.
The values at which
U.S. corporations were marked to market at the end of December 1999, at the
peak of a speculative bubble, did little to increase transparency. If all
companies had indeed sold their assets on that day, surely this would have
severely depressed asset prices.
Consider this: If
your neighbor decides to sell his house for half price, how would you feel
if the bank that gave you a mortgage argued that, according to the mark-to-
market rule, it now also must halve the value of your house--and, as a
result, they regret to inform you that you are bankrupt.
We discussed the
case of traded securities. But in many cases a market for the assets on a
company's books does not actually exist. In this case, accountants use
so-called net present value calculations to estimate a theoretical value.
This means even greater fiction because the theoretical value depends
crucially on assumptions made about interest rates, economic growth, asset
markets and so on.
Given the dismal
track record of forecasters in this area, it is astonishing to find that
serious accountants wish corporate accounts to be based on them.
There are
significant macroeconomic costs involved with mark-to-market accounting. As
all companies will soon be forced to recalculate their balance sheets more
frequently, the state of financial markets on the calculation day will
determine whether they are still "sound," or in accounting terms,
"bankrupt." While book value accounting tends to reduce volatility in
markets to some extent, the new rule can only increase it. The implications
are especially far-reaching in the banking sector since banks are not
ordinary businesses, but fulfill the public function of creating and
providing the money supply on which economic growth depends.
U.S. experts warned
years ago that the introduction of marking to market could create a credit
crunch. As banks will be forced to set aside larger loan-loss reserves to
cover loans that may have declined in value on the day of marking, bank
earnings could be reduced. Banks might thus shy away from making loans to
small or midsize firms under the new rules, where a risk premium exists and
hence the likelihood of marking losses is larger. As a result, banks would
have a disincentive to lend to small firms. Yet, for all we know, the small
firm loans may yet be repaid in full.
If banks buy a
10-year Japanese government bond with the intention to hold it until
maturity, and the economy recovers, thus pushing down bond prices
significantly, the market value of the government bonds will decline. Banks
would thus be forced to book substantial losses on their bond holdings
despite the fact that, by holding until maturity, they would never actually
have suffered any losses. Japanese banks currently have vast holdings of
government bonds. The change in accounting rules likely will increase
problems in the banking sector. As banks reduce lending, economic growth
will fall, thereby depressing asset prices, after which accountants will
quickly try to mark down everyone's books.
Of course, in good
times, the opposite may occur, as we saw in the case of Enron. During
upturns, marking to market may boost accounting figures beyond the actual
state of reality. This also will boost banks' accounts (similar to the Bank
for International Settlements rules announced in 1988), thus encouraging
excessive lending. This in turn will fuel an economic boom, which will
further raise the accounting values of assets.
Thus does it make
sense to mark everything to fictitious market values? We can conclude that
marking to market has enough problems on the micro level to negate any
potential benefits. On the macro level, the disadvantages will be far larger
as asset price volatility will rise, business cycles will be exacerbated and
economic activity will be destabilized.
The world economy
has done well for several centuries without this new rule. There is no
evidence that it will improve anything. To the contrary, it is likely to
prove harmful. The LDP must be lauded for its attempt to stop the
introduction of these new accounting rules.
Werner is an
assistant professor of economics at Sophia University and chief economist at
Tokyo-based investment adviser Profit Research Center Ltd.
Measuring the Business Value of
Stakeholder Relationships – all about social capital and how high-trust
relationships affect the bottom line. Plus a new measurement tool for
benchmarking the quality of stakeholder relationships ---
www.cim.sfu.ca/newsletter
Trust, shared
values and strong relationships aren't typical financial indicators but
perhaps they should be. A joint study by CIM and the Schulich School of
Business is examining the link between high trust stakeholder relationships
and business value creation. The study is sponsored by the Canadian
Institute of Chartered Accountants (CICA).
The research team
is looking at how social capital can be applied to business. The aim of this
project is to better understand corporate social capital, measure the
quality of relationships, and provide the business community with ways to
improve those relationships and in turn improve their bottom line.
Because stakeholder
relationships all have common features, direct comparisons of the quality of
relationships can be made across diverse stakeholder groups, companies and
industries.
Social capital is
“the stock of active connections among people; the trust, mutual
understanding, and shared values and behaviors that bind the members of
human networks and communities and make cooperative action possible” (Cohen
and Prusak, 2000).
So far the research
suggests that trust, a cooperative spirit and shared understanding between a
company and its stakeholders creates greater coherence of action, better
knowledge sharing, lower transaction costs, lower turnover rates and
organizational stability. In the bigger picture, social capital appears to
minimize shareholder risk, promote innovation, enhance reputation and deepen
brand loyalty.
Preliminary results
show that high levels of social capital in a relationship can build upon
themselves. For example, as a company builds reputation among its peers for
fair dealing and reliability in keeping promises, that reputation itself
becomes a prized asset useful for sustaining its current alliances and
forming future ones.
The first
phase of the research is now complete and the study moves into its second
phase involving detailed case studies with six companies that have earned a
competitive business advantage through their stakeholder relationships.
Click here for a full report
Bob Jensen's discussion of valuation
and aggregation issues can be found at
http://faculty.trinity.edu/rjensen/FraudConclusion.htm
That scenario isn't as farfetched as you might
think. It's called a prediction market, based on the notion that a marketplace
is a better organizer of insight and predictor of the future than individuals
are. Once confined to research universities, the idea of markets working within
companies has started to seep out into some of the nation's largest
corporations. Companies from Microsoft to Eli Lilly and Hewlett-Packard are
bringing the market inside, with workers trading futures contracts on such
"commodities" as sales, product success and supplier behavior. The concept: a
work force contains vast amounts of untapped, useful information that a market
can unlock. "Markets are likely to revolutionize corporate forecasting and
decision making," says Robin Hanson, an economist at George Mason University, in
Virginia, who has researched and developed markets. "Strategic decisions, such
as mergers, product introductions, regional expansions and changing CEOs, could
be effectively delegated to people far down the corporate hierarchy, people not
selected by or even known to top management."
Barbara Kiviat (See below)
"The End Of Management? by Barbara Kiviat, Time Magazine, July 12,
2004, pp. 88-92 ---
http://www.time.com/time/insidebiz/printout/0,8816,1101040712-660965,00.html
The end of management just might look something
like this. You show up for work, boot up your computer and log onto your
company's Intranet to make a few trades before getting down to work. You see
how your stocks did the day before and then execute a few new orders. You
think your company should step up production next month, and you trade on
that thought. You sell stock for the production of 20,000 units and buy
stock that represents an order for 30,000 instead. All around you, as
co-workers arrive at their cubicles, they too flick on their computers and
trade.
Together, you are buyers and sellers of your
company's future. Through your trades, you determine what is going to happen
and then decide how your company should respond. With employees in the
trading pits betting on the future, who needs the manager in the corner
office?
That scenario isn't as farfetched as you might
think. It's called a prediction market, based on the notion that a
marketplace is a better organizer of insight and predictor of the future
than individuals are. Once confined to research universities, the idea of
markets working within companies has started to seep out into some of the
nation's largest corporations. Companies from Microsoft to Eli Lilly and
Hewlett-Packard are bringing the market inside, with workers trading futures
contracts on such "commodities" as sales, product success and supplier
behavior. The concept: a work force contains vast amounts of untapped,
useful information that a market can unlock. "Markets are likely to
revolutionize corporate forecasting and decision making," says Robin Hanson,
an economist at George Mason University, in Virginia, who has researched and
developed markets. "Strategic decisions, such as mergers, product
introductions, regional expansions and changing CEOs, could be effectively
delegated to people far down the corporate hierarchy, people not selected by
or even known to top management."
To understand the hype, take a look at
Hewlett-Packard's experience with forecasting monthly sales. A few years
back, HP commissioned Charles Plott, an economist from the California
Institute of Technology, to set up a software trading platform. A few dozen
employees, mostly product and finance managers, were each given about $50 in
a trading account to bet on what they thought computer sales would be at the
end of the month. If a salesman thought the company would sell between, say,
$201 million and $210 million worth, he could buy a security — like a
futures contract — for that prediction, signaling to the rest of the market
that someone thought that was a probable scenario. If his opinion changed,
he could buy again or sell.
When trading stopped, the scenario behind the
highest-priced stock was the one the market deemed most likely. The traders
got to keep their profits and won an additional dollar for every share of
"stock" they owned that turned out to be the right sales range. Result:
while HP's official forecast, which was generated by a marketing manager,
was off 13%, the stock market was off only 6%. In further trials, the market
beat official forecasts 75% of the time.
Intrigued by that success, HP's business-services
division ran a pilot last year with 14 managers worldwide, trying to
determine the group's monthly sales and profit. The market was so successful
(in one case, improving the prediction 50%) that it has since been
integrated into the division's regular forecasts. Another division is
running a pilot to see if a market would be better at predicting the costs
of certain components with volatile prices. And two other HP divisions hope
to be using markets to answer similar questions by the end of the year. "You
could do zillions of things with this," says Bernardo Huberman, director of
the HP group that designs and coordinates the markets. "The idea of being
able to forecast something allows you to prepare, plan and make decisions.
It's potentially huge savings."
Eli Lilly, one of the largest pharmaceutical
companies in the world, which routinely places multimillion-dollar bets on
drug candidates that face overwhelming odds of failure, wanted to see if it
could get a better idea of which compounds would succeed. So last year Lilly
ran an experiment in which about 50 employees involved in drug development —
chemists, biologists, project managers — traded six mock drug candidates
through an internal market. "We wanted to look at the way scattered bits of
information are processed in the course of drug development," says Alpheus
Bingham, vice president for Lilly Research Laboratories strategy. The market
brought together all the information, from toxicology reports to clinical
results, and correctly predicted the three most successful drugs.
What's more, the market data revealed shades of
opinion that never would have shown up if the traders were, say, responding
to a poll. A willingness to pay $70 for a particular drug showed greater
confidence than a bid at $60, a spread that wouldn't show if you simply
asked, Will this drug succeed? "When we start trading stock, and I try
buying your stock cheaper and cheaper, it forces us to a way of agreeing
that never really occurs in any other kind of conversation," says Bingham.
"That is the power of the market."
The current enthusiasm can be traced in part, oddly
enough, to last summer's high-profile flop of a market that was supposed to
help predict future terrorist attacks. A public backlash killed that
Pentagon project a few months before its debut, but not before the media
broadcast the notion that useful information embedded within a group of
people could be drawn out and organized via a marketplace. Says George
Mason's Hanson, who helped design the market: "People noticed." Another
predictive market, the Iowa Electronic Markets at the University of Iowa,
has been around since 1988. That bourse has accepted up to $500 from anyone
wanting to wager on election results. Players buy and sell outcomes: Is
Kerry a win or Bush a shoo-in? This is the same information that news
organizations and pollsters chase in the run-up to election night. Yet Iowa
outperforms them 75% of the time.
Inspired by such results, researchers at Microsoft
started running trials of predictive markets in February, finding the system
inexpensive to set up. Now they're shopping around for the market's first
real use. An early candidate: predicting how long it will take software
testers to adopt a new piece of technology. Todd Proebsting, who is
spearheading the initiative, explains, "If the market says they're going to
be behind schedule, executives can ask, What does the market know that we
don't know?" Another option: predicting how many patches, or corrections,
will be issued in the first six months of using a new piece of software.
"The pilots worked great, but we had little to compare it to," he says. "You
can reason that this would do a good job. But what you really want to show
is that this works better than the alternative."
Ultimately, "you may someday see someone in a desk
job or a manufacturing job doing day trading, knowing that's part of the
job," says Thomas Malone, a management professor at M.I.T. who has written
about markets. "I'm very optimistic about the long-term prospects."
But no market is perfect. Economists are still
unsure of the human factor: how to get people to play and do their best. In
the stock market or even the Iowa prediction market, people put up their own
money and trade to make more. That incentive ensures that people trade on
their best information. But a company that asks employees to risk their own
money raises ethical questions, so most corporate markets use play money to
trade and small bonuses or prizes for good traders. "Though this may look
like God's gift to business, there are problems with it," says Plott, who
ran the first HP experiments. Tokyo-based Dentsu, one of the world's largest
advertising firms, is still grappling with incentives for an ad forecasting
market it will launch later this year with the help of News Futures, a U.S.
consultancy.
And even if companies can figure out how to make
their internal markets totally efficient, there are plenty of reasons that
corporate America isn't about to jump wholesale onto the markets bandwagon.
For one thing, markets, based on individuals and individual interests, could
threaten the kind of team spirit that many corporations have struggled to
cultivate. Established hierarchies could be threatened too. After all, a
market implies that the current data crunching and decision-making process
may not be as good as a gamelike system that often includes lower-level
employees. In a sense, an internal market's success suggests that if upper
managers would just give up control, things would run better. Lilly, which
is considering using a market to forecast actual drug success, is still
grappling with the potential ramifications. "We already have a rigorous
process," says Lilly's Bingham. "So what do you do if you use a market and
get different data?" Throw it out? Or say that the market was smarter,
impugning the tried-and-true system?
There could be risks to individual workers in an
internal trading system as well. If you lose money in the market, does that
mean you're not knowledgeable about something you should be? "You have to
get people used to the idea of being accountable in a very different way,"
says Mary Murphy-Hoye, senior principal engineer at Intel, which has been
experimenting with internal markets. "I can now tell if planners are any
good, because they're making money or they're not making money."
Continued in article
Robert Walker's First Blog Entry is About Fair Value Accounting,
October 27, 2006 ---
http://www.robertbwalkerca.blogspot.com/
Introduction
I have decided to begin a commentary which expresses my views on
accounting. As I begin to do this I envisage the source of my
commentary to comprise three different sorts of writing in which I
may engage:
§ Simple notes directly to the ‘blog’ such as this.
§ Formal submissions I may make to various bodies including the IASB.
§ Letters or reports I may write for one reason or another that I
think might have some general readership.
The expression of my views will stray from the subject matter of
accounting per se to deal with matters of enormous significance to
me such as corporate or public administration. Such expressions will
not be too substantial a digression from the core subject matter
because I believe that the foundation of good ‘corporate
governance’, to use a vogue term, is accounting.
Source of my ideas on accounting
I would have to confess that the foundation upon which I base my
philosophy of accounting is derivative, as much of human knowledge
is of course. It is not for nothing that Newtown said that if he can
see so far it is because he stands on the shoulders of giants. In my
case, that ‘giant’ is Yuiji Ijiri. As I begin a detailed exposition
of my views I shall return to the lessons I learned many years ago
from Theory of Accounting Measurement, a neglected work that will
still be read in 1,000 years or so long as humankind survives
whichever is the shorter. As the depredations of the standard
setting craze are visited upon us with ever increasing complexity,
the message delivered by Ijiri will be heeded more an more.
The basic structure of accounting
Without wishing to be too philosophical about it, I need to begin by
outlining what I mean by accounting. Accounting, in my mind,
comprises three inter-related parts. These are:
§ Book-keeping.
§ Accounting.
§ Financial reporting.
Book-keeping is the process of recording financial data elements in
the underlying books of account. These financial data elements
represent, or purport to represent, real world events. The heart of
book-keeping is the double entry process. For instance at the most
basic level a movement in cash will result in the surrender or
receipt of an asset, the incurring or settlement of a liability and
so on.
I have no complete and coherent theory of the limits of
book-keeping. Clearly cash movement (change of ownership) or the
movement of commodity is the proper subject matter of book-keeping.
Whether all forms of contract should be similarly treated is not
clear to me. I am inclined to say yes. That is to adopt Ijiri’s
theory of commitment accounting, but I can foresee that this leads
me to conclusions that I may find unpalatable later on. Incidentally
I say this because an epiphany I had, based on the notion of
commitment accounting, some years ago is beginning to unravel.
Book-keeping goes beyond recording to encompass control. That is the
process by which the integrity of the centre piece of book-keeping –
the general ledger expressing double entry – is ensured. I will not
concern myself with such processes though this is not to say that
they are unimportant.
Accounting is the process by which sense is made of what is a raw
record expressed in the general ledger. It is the process of
distillation and summation that enables the accountant to gain on
overview of what has happened to the entity the subject of the
accounting. Accounting fundamentally assumes that the accountant is
periodically capable of saying something useful about the real world
using his or her special form of notation.
Financial reporting is the process by which data is assembled into a
comprehensive view of the world in accordance with a body of rules.
It differs, in the ideal, from accounting in a number of ways. Most
benignly it differs, for instance, by including ancillary
information for the benefit of a reader beyond the mere abstraction
from the general ledger. Again in the ideal there is an
inter-relationship between the three levels in the accounting
hierarchy. That is, the rules of financial reporting will, to some
degree shape the order and format of the basic, book-keeping level
so that the process of distillation and summation follows naturally
to the final level of reporting without dramatic alteration.
Perhaps what concerns me is that the sentiment expressed above can
be seen, without much effort, to be only ideal and that in reality
it does not arise. In short the golden strand that links the
detailed recording of real world phenonmena to its final summation
is broken.
An example
I was asked recently by a student of accounting to explain IAS 41,
the IASB standard on agriculture. As I don’t deal in primary
production at all, I had not thought about this subject for years.
IAS 41 admonishes the accountant to apply ‘fair value’ accounting.
Fair value accounting is the process by which current sale prices,
or their proxies, are substituted for the past cost of any given
item.
For instance, you may have a mature vineyard. The vineyard comprises
land, the vine and its fruit, the plant necessary to sustain the
vine (support structures, irrigation channels etc.). Subsumed within
the vine are the materials necessary for it to grow and start
producing fruit. This will include the immature plant, the chemical
supplements necessary to nurture and protect it, and the labour
necessary to apply it.
The book-keeping process will faithfully record all of these
components. Suppose for example the plant, fertliser and labour cost
$1000. In the books will be recorded:
Dr Vineyard $1000
Cr Cash $1000
At the end of the accounting period, the accountant will summarise
this is a balance statement. He or she will then obtain, in some
way, the current selling price of the vine. Presumably this will be
the future cash stream of selling the fruit, suitably discounted.
Assume that this is $1200.
The accountant will then make the following incremental adjustment:
Dr Vineyard $200
Cr Equity $200
Looked like this there is a connection between the original
book-keeping and the periodic adjustment at the end of the
accounting period. This is an illusion. The incremental entry
disguises what is really happening. It is as follows:
Dr Equity $1000
Cr Vineyard $1000
And
Dr Vineyard $1200
Cr Equity $1200
Considered from the long perspective, the original book-keeping has
been discarded and a substitute value put in its place. This is the
truth of the matter. The subject matter of the first phase of
accounting was a set of events arising in a bank and in the entity
undertaking accounting. The subject matter of the second phase is a
set of future sales to a party who does not yet exist.
From a perspective of solvency determination, a vital element of
corporate governance, the view produced by the first phase is next
to useless. However, the disquiet I had in my mind which I had
suppressed until recently, relates to the shattering of the linkages
between the three levels of accounting in the final reporting
process. This disquiet has returned as I contemplate the apparently
unstoppable momentum of the standard setting process.
October 28, 2006 reply from Bob Jensen
Hi Robert,
I hope you add many more entries to your blog.
The problem with "original book-keeping" is that it provides
no answers about how to account for risk of many modern day contracts that
were not imagined when "original book-keeping" evolved in a simple world of
transactions. For example, historical costs of forward contracts and swaps
are zero and yet these contracts may have risks that may outweigh all the
recorded debt under "original book-keeping." Once we opened the door to fair
value accounting to better account for risk, however, we opened the door to
misleading the public that booked fair value adjustments can be aggregated
much like we sum the current balances of assets and liabilities on the
balance sheet. Such aggregations are generally nonsense.
I don't know if you saw my recent hockey analogy or not. It
goes as follows:
Goal Tenders versus Movers and Shakers
Skate to where the puck is going, not to where it is.
Wayne Gretsky (as quoted for many years by Jerry Trites at
http://www.zorba.ca/ )
Jensen Comment
This may be true for most hockey players and other movers and shakers, but
for goal tenders the eyes should be focused on where the puck is at every
moment --- not where it's going. The question is whether an accountant is a
goal tender (stewardship responsibilities) or a mover and shaker (part of
the managerial decision making team). This is also the essence of the debate
of historical accounting versus pro forma accounting.
Graduate student Derek Panchuk and professor
Joan Vickers, who discovered the Quiet Eye phenomenon, have just completed
the most comprehensive, on-ice hockey study to determine where elite goalies
focus their eyes in order to make a save. Simply put, they found that
goalies should keep their eyes on the puck. In an article to be published in
the journal Human Movement Science, Panchuk and Vickers discovered that the
best goaltenders rest their gaze directly on the puck and shooter's stick
almost a full second before the shot is released. When they do that they
make the save over 75 per cent of the time.
"Keep your eyes on the puck," PhysOrg, October 26,
2006 ---
http://physorg.com/news81068530.html
I have written a more serious piece about both theoretical
and practical problems of fair value accounting. I should emphasize that
this was written after the FASB Exposure Draft proposing fair value
accounting as an option for all financial instruments and the culminating
FAS 157 that is mainly definitional and removed the option to apply fair
value accounting to all financial instruments even though it is still
required in many instances by earlier FASB standards.
My thoughts on this are at the following link:
http://faculty.trinity.edu/rjensen/FairValueDraft.htm
Bob Jensen
E-COMMERCE AND AUDITING FAIR VALUES SUBJECTS OF NEW INTERNATIONAL GUIDANCE
The International Federation of Accountants (IFAC) invites comments on two new
exposure drafts (EDs): Auditing Fair Value Measurements and Disclosures and
Electronic Commerce: Using the Internet or Other Public Networks - Effect on the
Audit of Financial Statements. Comments on both EDs, developed by IFAC's
International Auditing Practices Committee (IAPC), are due by January 15, 2002.
See
http://accountingeducation.com/news/news2213.html
The IFAC link is at
http://www.ifac.org/Guidance/EXD-Download.tmpl?PubID=1003772692151
The purpose of this International Standard on Auditing (ISA) is to
establish standards and provide guidance on auditing fair value measurements
and disclosures contained in financial statements. In particular, this ISA
addresses audit considerations relating to the valuation, measurement,
presentation and disclosure for material assets, liabilities and specific
components of equity presented or disclosed at fair value in financial
statements. Fair value measurements of assets, liabilities and components of
equity may arise from both the initial recording of transactions and later
changes in value.
The Expectations Gap Between Professional Valuation Versus
What Students Learn in College
If you teach about valuation, you might want to add this to your teaching
notes.
"The Chart That Shows WhatsApp Was A Bargain At $19 Billion"
Read more:
http://www.businessinsider.com/price-per-user-for-whatsapp-2014-2#ixzz2ttINByKq
Recall that Bill Sharpe of CAPM fame and controversy is a Nobel Laureate ---
http://en.wikipedia.org/wiki/William_Forsyth_Sharpe
"Don’t Over-Rely on Historical Data to Forecast Future Returns," by
Charles Rotblut and William Sharpe, AAII Journal, October 2014 ---
http://www.aaii.com/journal/article/dont-over-rely-on-historical-data-to-forecast-future-returns?adv=yes
Jensen Comment
The same applies to not over-relying on historical data in valuation. My
favorite case study that I used for this in teaching is the following:
Questrom vs. Federated Department Stores,
Inc.: A Question of Equity Value," by University of Alabama faculty members
by Gary Taylor, William Sampson, and Benton Gup, May 2001 edition of
Issues in Accounting Education ---
http://faculty.trinity.edu/rjensen/roi.htm
Jensen Comment
I want to especially thank
David Stout, Editor of the May 2001
edition of Issues in Accounting Education. There has been something
special in all the editions edited by David, but the May edition is very
special to me. All the articles in that edition are helpful, but I want to
call attention to three articles that I will use intently in my graduate
Accounting Theory course.
- "Questrom vs. Federated
Department Stores, Inc.: A Question of Equity Value," by University of
Alabama faculty members Gary Taylor, William Sampson, and Benton Gup,
pp. 223-256.
This is perhaps the best short case that I've ever read. It will
undoubtedly help my students better understand weighted average cost of
capital, free cash flow valuation, and the residual income model. The
three student handouts are outstanding. Bravo to Taylor, Sampson, and
Gup.
- "Using the Residual-Income
Stock Price Valuation Model to Teach and Learn Ratio Analysis," by
Robert Halsey, pp. 257-276.
What a follow-up case to the Questrom case mentioned above! I have long
used the DuPont Formula in courses and nearly always use the excellent
paper entitled "Disaggregating the ROE: A
New Approach," by T.I. Selling and C.P. Stickney,
Accounting Horizons, December 1990, pp. 9-17. Halsey's paper guides
students through the swamp of stock price valuation using the residual
income model (which by the way is one of the few academic accounting
models that has had a major impact on accounting practice, especially
consulting practice in equity valuation by CPA firms).
- "Developing Risk Skills: An
Investigation of Business Risks and Controls at Prudential Insurance
Company of America," by Paul Walker, Bill Shenkir, and Stephen Hunn,
pp. 291
I will use this case to vividly illustrate the "tone-at-the-top"
importance of business ethics and risk analysis. This is case is easy
to read and highly informative.
Bob Jensen's threads on accounting theory ---
http://faculty.trinity.edu/rjensen/Theory01.htm
Teaching Case on Analysis of
Financial Statements
From The Wall Street Journal Accounting Weekly Review on September 12, 2014
Investing Tips from Warren Buffett? Try Writing Tips Instead
by: Michael Rapoport
Sep 08, 2014
Click here to view the full article on WSJ.com
TOPICS: Annual Report, Disclosures, Financial Accounting
SUMMARY: Regulators have been concerned that the volume of
disclosures required of public companies has made their financial reports so
lengthy it's become harder for investors to find the most relevant
information. To address that problem, a committee of the Association of the
Bar of the City of New York is proposing yet another required disclosure for
companies: A short, plain-English overview, at the start of a company's
annual report, that would describe what happened at the company over the
past year and management's expectations and concerns for the year to come.
CLASSROOM APPLICATION: This is a good article to share with
students as we discuss annual reports and required disclosures.
QUESTIONS:
1. (Introductory) What is an annual report? What are its
components? What is the purpose of an annual report?
2. (Advanced) Who are the users of the annual report? How is this
information used? Why is accurate information and full disclosure important?
3. (Advanced) What has a group of lawyers proposed regarding the
requirements for annual reports? What is the reasoning behind this proposal?
What are the benefits of this proposal? Are there any drawbacks?
4. (Advanced) Should this proposal be implemented? Why or why not?
SMALL GROUP ASSIGNMENT:
Find the annual report for a large public company (either a physical copy or
online). Do you find that the critiques detailed in the article apply to the
financial information you are reviewing? Is information organized well? Are
the disclosures easy to find, read, and understand? Would the proposal
presented in the article be an improvement for the annual report you are
reviewing? Do you have other ideas for improvements to presentation?
Reviewed By: Linda Christiansen, Indiana University Southeast
"Investing Tips from Warren
Buffett? Try Writing Tips Instead," by Michael Rapoport, The Wall Street
Journal, September 8, 2014 ---
http://blogs.wsj.com/moneybeat/2014/09/08/investing-tips-from-warren-buffett-try-writing-tips-instead/?mod=djem_jiewr_AC_domainid
A prominent lawyers’ group has an idea for how companies can improve
annual reports: write a letter explaining the results in plain English, as
Warren Buffett
often does it.
Regulators have been concerned that the volume of
disclosures required of public companies has made their financial reports so
lengthy it’s become harder for investors to find the most relevant
information.
To address that problem, a committee of the
Association of the Bar of
the City of New York is proposing yet another
required disclosure for companies: A short, plain-English overview, at the
start of a company’s annual report, that would describe what happened at the
company over the past year and management’s expectations and concerns for
the year to come.
“Business disclosure should not be akin to a game
of ‘Where’s Waldo’ in which a reader is left suspecting that critical
information is buried somewhere in the document but good luck finding it,”
Michael R. Young, who chairs the bar association’s financial-reporting
committee, wrote in a letter last week to Keith Higgins, the Securities and
Exchange Commission’s director of corporation finance. “Rather, the most
important information is best volunteered, up front, by management in a way
that is both understandable and provides context.”
The committee plans to announce its proposal
Monday. In an interview, Mr. Young called the proposal “a rule to cut
through the rules” and said it wouldn’t replace any of the existing,
more-detailed disclosures that the SEC requires of public companies. “The
goal is to encourage companies and executives to report on what’s going on
[to investors] much as they would to the board of directors,” he said.
The model, Mr. Young said, is the widely read,
plain-spoken
Berkshire Hathaway Inc.
shareholder letter that Mr. Buffett writes each
year. That “was sort of looked to as the platonic ideal” in developing the
new proposal, he said.
The SEC would be the agency to ultimately decide
whether to propose and implement such a move. The SEC’s Mr. Higgins said he
didn’t have any reaction to the committee’s proposal itself, but he likes
the idea in principle. “We encourage companies to make it easier to
understand what management thought for the prior year and what’s up for the
future,” he said.
According to 2012 research from accounting firm
Ernst & Young LLP, the average number of pages in annual reports devoted to
footnotes and management’s discussion and analysis has quadrupled over the
last two decades. In recent months, SEC officials have said they will look
at possible steps to make disclosure more effective, such as weeding out
outdated and redundant disclosure requirements.
“As the number of pages in annual reports has
steadily increased, it may become more difficult for investors to find the
most salient information,” Mr. Higgins said in an April speech to business
lawyers, in which he invited their suggestions.
Mr. Young says he “appreciates the irony” of
fighting disclosure overload by proposing another disclosure requirement.
But enacting such requirements is “the main tool regulators have to work
with” in solving the problem, he said.
Hi Dennis,
I do not have direct answers to your specific questions. However, I did combine
two tidbits that may be of interest to you and to other subscribers to the AECM.
These specialty certifications are commonly held by persons seeking to be paid
for expert witnessing. In my opinion, there's a lack of accountability of most
of these so-called "certificates" and the organizations that grant such
certificates.
On the other hand, there's also merit in some of the complaints by these
associations directed at our most respected colleges and universities. For
example, most college accounting programs teach about valuation accountics
science models (such as residual income and free cash flow models) that are
typically more misleading than helpful when it comes to real world valuation of
business firms. It's not common to find college professors who have a history of
outstanding professional experience in valuation or forensics.
College curricula in accounting and finance are terribly lacking in courses and
research professors knowledgeable about the professions of valuation or
forensics. For example, most of our auditing courses spend more time stressing
how financial audits are not designed to detect fraud rather than becoming
professionally focused on ways to detect fraud. We do have course modules on
internal controls, but these typically are very superficial relative to what
graduates will encounter in the real world of fraud and systems weaknesses.
The bottom line is that both valuation and forensics are topics that are poorly
covered at the university level. And coverage by mysterious associations
offering certificates do not always pass the smell tests of credibility.
The National Association of Certified Valuators and Analysts (NACVA)
---
http://www.nacva.com/
Business Valuation Standard ---
http://en.wikipedia.org/wiki/Business_valuation_standard
Business Valuation Standards (BVS) are codes of practice that
are used in
business valuation. Each of the three major United States valuation
societies — the
American Society of Appraisers (ASA),
American Institute of Certified Public Accountants (CPA/ABV), and the
National Association of Certified Valuation Analysts (NACVA) — has its own
set of Business Valuation Standards, which it requires all of its accredited
members to adhere to.[1]
The AICPA's standards are published as
Statement on Standards for Valuation Services No.1 and the ASA's standards
are published as the ASA Business Valuation Standards. All AICPA members
are required to follow SSVS1. Additionally, the majority of the State
Accountancy Boards have adopted SSVS1 for CPAs licensed in their state.
Criticism of the abovementioned organizations are
as follows:
1) These are neither the major
valuation societies, nor are they the only valuation societies. They are
however, organizations which engage in considerable self-promotion among
their members to foster the delusion among their members, that by the mere
fact of membership, their members are more qualified to perform business
appraisal than non-members.
2) These are all privately held organizations, in which membership is
voluntary.
3) There are no regulations mandating that one must belong to any of these
organizations in order to practice as a business appraiser.
4) In that these are voluntary membership organizations, their standards
have little or no weight with either the business valuation community at
large or with the legal and judicial community who appraisers often serve.
5) The standards and ethics of these organizations are constructed to be
vague and self-serving, with numerous exceptions, designed more to excuse
conflicts of interest, membership poor performance and unsupported opinion,
than to encourage, independence, scientific analysis and high quality work.
Conflicts of interest are a problem, particularly among CPA/Appraisers, who
regularly join these organizations so that they can offer valuation services
to their existing accounting clients, in violation of independence rules and
ethics.
6) The education which these organizations offer is unaccredited and of low
quality, in that it does not reach the threshold level of education in
finance of an accredited university.
7) Educational standards have to be kept low to attract new members and
membership dues.
8) The credentials which these organizations issue are often issued for
reasons of favoritism and cronyism over merit.
9) The purpose of these organizations is often tarnished by the politics of
a few active, insider members who consider themselves more entitled then
other members, and consequently use the organization resources to further
their own self-interests over the interests of the membership at large.
10) There is no accounting of the membership dues paid into these membership
organizations. Consequently, members do not know where, to whom, or on what
their dues money is spent.
Forensic Accounting ---
http://en.wikipedia.org/wiki/Forensic_accounting
American College of Forensic Examiners International (ACFEI) ---
http://www.acfei.com/
The ACFEI is mulit-disciplinary, only one discipline of which is accounting
Association of Certified Fraud Examiners (ACFE) ---
http://www.acfe.com/
The ACFE is more focused in on accounting and business fraud than the ACFEI
Other Forensic Associations ---
http://www.hgexperts.com/forensic-science.asp
To my knowledge, the only AACSB-accredited university to offer a forensic
accounting certificate is the University of West Virginia ---
http://www.be.wvu.edu/fafi/index.htm
There are also tracks for forensic accounting in the Masters of Public
Accounting Degree curriculum.
"Forensic Accounting And Auditing: Compared And Contrasted To Traditional
Accounting And Auditing," by Dahli Gray, American Journal of Business Education,
Volume 1, Number 2, 2008 ---
http://scholar.googleusercontent.com/scholar?q=cache:lnY92RzjASgJ:scholar.google.com/+ACFE+ACFEI+"lawsuit"&hl=en&as_sdt=0,20
Forensic versus traditional accounting and
auditing are compared and contrasted. Evidence gathering is detailed.
Forensic science and fraud symptoms are explained. Criminalists, expert
testimony and corporate governance are presented.
Teaching Case
From The Wall Street Journal Accounting Weekly Review on October 25,
2013
Funds Guess Twitter's Worth
by:
Joe Light
Oct 19, 2013
Click here to view the full article on WSJ.com
TOPICS: Disclosure, Fair Value Accounting, Fair-Value Accounting
Rules
SUMMARY: The author uses disclosures required under FAS 157
(Accounting Standards Codification (ASC) section 820) to examine investors'
estimates of Twitter's value with specific examples from three mutual funds.
CLASSROOM APPLICATION: The article is excellent for introducing
fair value requirements and disclosures with specific application to an
equity security.
QUESTIONS:
1. (Introductory) What is Twitter Inc.? When is its initial public
offering (IPO) expected?
2. (Introductory) In what price range are Twitter's shares valued?
How has the WSJ obtained these values?
3. (Advanced) How is it possible that "at least 11 mutual funds and
closed-end funds own shares" of the company when Twitter hasn't yet held its
IPO? Include in your answer definitions of the two fund entities.
4. (Advanced) Why must mutual funds estimate the fair value of
Twitter shares for financial statement disclosures? In your answer, state
what other measurement basis could be considered for financial statement
reporting and identify all authoritative accounting guidance requiring the
disclosures discussed in the article.
5. (Advanced) "In footnotes, many fund firms will say that a
stock's value is...a 'Level 3' asset...." What is a Level 3 asset? Identify
your source for this definition from authoritative accounting literature.
Reviewed By: Judy Beckman, University of Rhode Island
"Funds Guess Twitter's Worth," Joe Light, The
Wall Street Journal, October 19*, 2013 ---
http://online.wsj.com/news/articles/SB10001424052702304384104579139671400590510?mod=djem_jiewr_AC_domainid
Want to buy a piece of Twitter right now?
Its highly anticipated initial public offering
probably won't happen until November at the earliest, but at least 11 mutual
funds and closed-end funds own shares of the San Francisco-based social
network. For example, Twitter shares make up more than 2% of the holdings of
the Morgan Stanley Institutional Small Company Growth mutual fund.
Fund companies—including Morgan Stanley Investment
Management, T. Rowe Price Group TROW -3.06% and Fidelity Investments—have
invested lately in pre-IPO companies, either by participating in
venture-capital financing rounds or by buying shares from insiders on the
private market. Before Facebook's FB +1.05% May 2012 IPO, for example, more
than 50 mutual funds already owned shares.
On Twitter, some funds already have made a
killing—at least on paper.
For example, according to its holdings disclosures,
at the end of September, the Morgan Stanley fund valued its Twitter shares
at about $22.31, up a whopping 36% from $16.42 in June.
Because of the fund's hefty Twitter stake, about
0.78 percentage point of the fund's 16% return in the third quarter was due
to Twitter's rise alone.
But there is a big catch: Because Twitter isn't
publicly traded yet, mutual-fund firms must estimate the company's price,
and those estimates can vary significantly.
In contrast to Morgan Stanley, funds run by T. Rowe
Price said that Twitter shares were worth about $24.35 each on Sept. 30, up
34% from $18.18 at the end of June.
In an email, a T. Rowe Price spokeswoman said that
the company uses a variety of sources, such as significant transactions, new
rounds of financing and relative valuations of other companies to value
private assets.
Since investors can buy and redeem shares of the
funds based on those estimates, the discrepancies mean that some fund
investors can effectively buy shares of Twitter at a lower price than others
or, conversely, sell them for more.
On Twitter's price, "we're all wrong. It's just a
matter of degree," says Kevin Landis, portfolio manager of Firsthand
Technology Value. SVVC -0.35% Because the Firsthand fund is a closed-end
fund, unlike a traditional mutual fund, its trading price can deviate from
the estimated value of its holdings. The firm it hires to value its private
holdings estimates that Twitter was worth about $24.37 a share on Sept. 30.
To be sure, Twitter—and any other stock, for that
matter—makes up just a small portion of most funds. But how the fund firms
value the stock can cause the funds to behave unexpectedly.
For example, the rapid increase of the Morgan
Stanley estimate in the third quarter was a sharp break from how the fund
previously treated shares.
On Sept. 30, 2011, Morgan Stanley said its shares
of Twitter were worth $16.09. It didn't change that estimate until March
2013, when it raised the price to $16.60.
New York University professor and valuation expert
Aswath Damodaran says that it doesn't make sense that a fund firm would keep
Twitter's price constant throughout 2012, even as prices of other
social-media companies changed sharply.
"What it effectively means is that the old
investors of the fund are going to lose money to the people who are able to
buy the fund now at a depressed price," Mr. Damodaran says. "It's not fair
to existing shareholders if others can exploit dated pricing."
In an email, a Morgan Stanley Investment Management
spokesman said, "We have a robust process for valuing investments in private
companies that considers a variety of factors including the company's
performance, financing activity and operating environment."
Unfortunately, as one of thousands of small
investors, there probably isn't a lot an individual can do to change how the
fund prices its shares. But to see how much dated, or potentially incorrect,
pricing affects a fund, take a look at its latest holdings report filed with
the Securities and Exchange Commission.
Continued in article
Video
"How Managers Should Read Financial Statements," Harvard Business
Review Blog, February 19, 2013 ---
Click Here
http://blogs.hbr.org/video/2013/02/how-managers-should-read-finan.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date
CNBC Explains Accounting ---
http://www.cnbc.com/id/100000341
Bob Jensen's threads on accounting theory
New Performance Metrics
"New Performance Metrics or Something Else? The Deloitte - ModCloth
Relationship," by Anthony H. Catanach, Jr., Grumpy Old Accountants Blog,
December 28, 2013 ---
http://grumpyoldaccountants.com/blog/2013/12/28/new-performance-metrics-or-something-else-the-deloitte-modcloth-relationship
It’s the last
week of the calendar year, and much of the accounting world is abuzz.
Corporate accountants are putting the final touches on the those revenue
accrual entries that will ensure that their company’s earnings will meet
analyst expectations. Global accounting firm auditors are completing audit
“hand waving” exercises to justify their client’s optimistic balance sheet
valuations and earnings increases. And accounting standard-setters continue
to avoid meaningful solutions to significant reporting problems including
revenue recognition, lease accounting, and goodwill valuation, just to name
a few. What do grumpy old accountants do you ask? This
one tilts at windmills…
It’s only been three months since I expressed displeasure with recent hype
about what characterizes great CFOs today (see
“Ten
Commandments” for Today’s CFO),
and nine months since I ranted about innovative performance metrics that
were anything but (see
“Innovative
Performance Metric or Marketing Spin?”
Well, the business press is at it again with an article in the Wall Street
Journal (WSJ)
CFO
Journal titled
“ModCloth
CFO: Four Metrics That Mean More Than Money,”
penned by Jeff Shotts, ModCloth’s CFO. The “innovative” measures this time
are
engagement, relevant user generated content (UCG), underserved market
signals, and the
ratio of rules broken to rules followed. These four
non-financial measures purportedly “power a high return on investment,” but
instead are quite superficial, ill-defined, and clearly qualify as
MBA speak.
What’s my beef this time? ModCloth’s CFO fails my transparency
standard (Commandment No. 6) , and is close to violating my “real”
performance measurement criteria (Commandment No. 7). Also, as someone who
has clearly crossed the threshold of geezerdom, I have no patience for those
selling something as “new and innovative,” when it is not. Not
a good start at all at being a great CFO! So, let’s dig in…
My biggest disappointment in this article is the CFOs suggestion that some
performance metrics “can be” more important than others. This completely
ignores the basic principles outlined in the widely-used, and time tested
Balanced Scorecard planning and
management system. Performance metrics are supposed to provide evaluation
data on different aspects of an organization’s operations (financial,
customer, process, and learning and growth). So, if you decide to measure
something, presumably this dimension is important in its own right.
It also is interesting that the four key metrics touted are all
non-financial in nature. I am not surprised at all that financial measures
are ignored by the ModCloth CFO. Since ModCloth is still a young, private
company, presumably focused on growth, the financial metrics are likely not
very flattering (i.e., operating losses, negative cash flows, etc.). In
fact, I bet the Company’s senior leaders and investors regularly shrug off
the financial metrics as not being representative of the great things
happening in the organization. Could
“adjusted
EBITDA”
be far
behind?
But what about measures that provide insight into how ModCloth’s business
model is performing ? Only one of the four non-financial metrics (i.e., UGC)
appears to directly relate to even one of the Company’s five value chain
activities. And then there’s learning and growth? How are ModCloth’s
investments in its people and technology performing? How are these being
evaluated? But enough on what was NOT discussed in this article. Let’s take
a closer look at the customer-based measures about which ModCloth’s CFO is
so passionate.
Engagement
ModCloth’s
CFO defines engagement as user actions that have been proven to increase the
average lifetime value of a customer and drive powerful solutions to
otherwise intractable business problems. He concludes that:
Continued in article
Bob Jensen's threads on performance medtrics ---
http://faculty.trinity.edu/rjensen/roi.htm
Jensen Comment
I can only wish more quant papers were written in this style of blending the
English language with mathematics to make sense of investment risk for those who
cannot follow one equation after the other.
Bayesian Probability ---
http://en.wikipedia.org/wiki/Bayesian_probability
Financial Risk ---
http://en.wikipedia.org/wiki/Financial_Risk
Beta Risk ---
http://en.wikipedia.org/wiki/Beta_%28finance%29
Alpha Risk ---
http://en.wikipedia.org/wiki/Alpha_%28finance%29
"The forever elusive α (alpha)," by Salil Mehta, Statistical Ideas
Blog, February 2014 ---
http://statisticalideas.blogspot.com/2014/02/forever-elusive-alpha.html
Humans have been repeating this inefficient ritual
for over 700 years, with the first known origins then in Europe. There
sprung lenders and insurers who assessed the relative merits of
individual commercial risk. The methods were somewhat more crude versus
the resources available to people today, but none-the-less this is the
humble birthplace from where modern investment speculation gets its
origin. What should be the effective interest rate to lend an emerging
company wanting to complete a construction project? What should an
insurer charge to protect a ship voyaging across a stormy sea, so that
the premium pricing is both attractively profitable yet competitive?
Over time, more information was rapidly made
available concerning those who needed capital market resources. And
more ordinary people were able to invest in companies and products.
Through the distribution of personal wealth and technological progress,
society experienced episodic bouts of speculations and manias. The
conversion of defined benefit plans in the U.S. to one where American
workers invest their own contributions, combined with draining real
median wage growth, created a force for even greater heterogeneity of
outcomes in the desperate and greedy individual pursuit of α
(alpha). And then the digital age took these advances to another
level, now allowing virtually everyone to more quickly and easily trade
however they want. But how can these seeming innovations be good for
society, if there is a slimmer portion of risk-adjusted beneficiaries?
Let’s explore the outcomes and difficulties in the great, inefficient
search for exceptional alpha.
The true statistical test for outperformance
relative to a highly liquid, and investable benchmark takes into account
how likely such performance could have been attained by luck alone.
Afterall over any period of time, there will be separation in the market
fates of individual stocks within a basket. Concurrently, some purely
lucky stock holders will own specific stocks that just uniformly
outperforms the underlying index over this same period of time.
Nonetheless it is worth noting that the difficult
statistical standard necessary to warrant the concept of skill over a
long career, or life, has a smaller side effect. And that is that only
minorities of those who speculate will actually have, through skill,
statistically outperformed the broader stock index.
Let’s show how this works, using the time since
the recent financial crisis as a baseline frame for this analysis. From
there we’ll expand to a broader set of applications and timeframes. The
market has gone through a large hockey-stick pattern since the height of
the financial crisis, 5.5 years ago. Equity markets initially plummeted
through early 2009, but have since smoothly rallied to new highs.
If you and your friends had all tried your hand at
stock selection and market-timing along the way, then there is a good
chance that you are feeling pretty good right now. Making money is
always a welcome relief, but emotional ego perilously inflates
disproportionately with the rise of one’s portfolio. Even more, in the
case of the vast majority of people (those who basically doubled their
investments alongside the market index, instead of outright quadrupled
it), feeling too good is simply unwarranted. Humility must substitute
for hubris, since luck accounts for a great deal of post-crisis
performance.
How likely is it that an investor (or speculator)
in U.S. equities over the past 5.5 years has demonstrated significant
investment skills in this asset class? For our test we reduce the
investable universe to a mapping of the current 30 Dow Jones Industrial
Average (DJIA) stocks. We start with a performance threshold of
selecting a basket of any of the top quarter of these 30 stocks for each
of the past 5.5 years. And these top 8 stocks had a minimal monthly
outperformance of 1.2% (15% annualized), with a 0.5% standard
deviation. This implies a significantly low, 1% chance of straying that
far from the rest of the DJIA by chance alone.
Then being satisfied with our critical threshold,
we next solve the probability of continuously selecting a basket of the
annual top quarter of DJIA stocks by chance alone. This is an
elementary, compounded Bernoulli problem, and it comes to 0.1%.
We then use
Bayesian probability (see equality below)
to determine the portion of the population that
has skill near the required 1.2% monthly outperformance, in order to
compensate for the low 0.1% probability of attaining these results by
luck alone. And this portion of the population comes to 21%.
p(outperform) = p(outperform|luck)*p(luck) +
p(outperform|skill)*p(skill)
Which rearranges to the following.
p(skill) = [p(outperform) - p(outperform|luck)*p(luck)] /
p(outperform|skill)
While there are empirical differences that would
ensue from, not the β (beta) of the 30 DJIA stocks,
but rather from the component of the typical correlation and dispersion
components of beta. For example, when the correlation is high
and the dispersion is low, then more than typical portion of the
investing population at that time would be able to outperform based on
skill. And when the opposite parameters define the investment regime,
then less than the typical portion of the investment population would be
able to outperform based on skill.
Theoretically expanding this example to different
time frames, we get the following results. Note that these examples
work for the most common approach to equities speculation: market-timing
with a discretionary allocation towards individual stocks. For 2 years,
instead of 5.5 years, the portion of the population with skill increased
to 36%. This is because it is significantly less difficult to
outperform monthly at the stated 1.2%, for less years. And hence we
don't need as many lucky investors in order to get the same overall
portion of outperforms.
On the other end of the time spectrum, for 25 years and 50 years of
speculation, the portion of speculators who can maintain the same level
of statistical evidence of investment skills rapidly decreases to 0.76%
and 0.02%, respectively. This is shown in
blue, on
the left axis of the chart below.
We can also skills-adjust these data, so that we
can solve for the level of outperformance that a 2, 25, and 50 years
investment career would need to equate to the same level of investment
difficulty, as the 1.2% monthly outperformance that is now associated
with 5.5 years. This comes to 2.0%, 0.58%, and 0.4%, respectively.
See the red data below.
Incidentally these monthly outperformances equate
to an annual outperformance of about 27%, 7%, and 5%.
. . .
Now on the other end of the age spectrum, nearly a
few thousand people with 20-30 years of investing experience have
outperformed will skill. And finally of those in Warren’s age group
(45-55 years of investing experience), just less than a hundred have
also outperformed with skill.
Does this seem like a lot? Well to put this into
some perspective, 99% of the top managing directors on Wall Street would
have not outperformed with skill over this period.
With such daunting odds, what advice is there for
people who dimly choose to speculate anyway, tying up large amounts of
their human capital? There are five specific advice here to impart.
- The first advice is that this age-old
ritual is extraordinarily more transparent and fair then ever
before. This makes things brutally more difficult, and the fact
that more people attempt to acquire alpha doesn’t advance the
ease for you in actually achieving it. Just as additional people
playing the lottery can never increase your personal odds of holding
the winning ticket.
- The second advice is that simply learning
the rules of finance or working in the industry hardly increases
your chance of outperforming the market (see quote at bottom). This
chance we showed in the note is fairly established in probability
theory, and it's super low. The advice here is akin to knowing how
to throw a javelin or play chess doesn’t imply we should think we
can then compete in the Olympics nor play chess against a computer,
respectively.
- The third advice is that much more often
it is better to simply buy an index fund (and thereby be
guaranteed to outperform most of the people who are generally
unsuccessful in their attempt to outperform the market), and know
that investment capacity is often dear and that human capital are
often better spent only entertaining some other pursuits.
- The fourth advice is that the very small
number of people are skilled investors share some rare talents.
They are gifted with an unusual ability to seamlessly connect
specific dots within an investment problem, well beyond the
abilities of normal smart people. The skills could be in a subset
of understanding behavioral finance, consumer sentiment, technical
analysis, international public policy, global macro economics, risk,
statistics, derivatives, valuation accounting, etc. Of
greater importance, they know the many areas of investment knowledge
where they do not personally excel at a global level, and nimbly
have the sense then to avoid those investment areas that trap
others.
- And the fifth advice is that selecting
world-class stocks or a world-class investment manager are both
generally difficult, and anyway inefficient. If one can’t
successfully select the former, then one can’t usually successfully
select the latter. Simply selecting an investment manager for
example, such as BRK (which at least can proudly prove their
long-term record), can often provide a false reading for the
subsequent five years or so. Just see how the past 5.5 years of BRK
were, as they were the most disastrous for the company, since 1965!
Another example could be one of my college professor's (Merton) who
won a Nobel prize in economics, yet then went on to co-lead the
destruction of a master hedge fund.
We close with a 1998 quote from Warren Buffett. May the wisdom prove
promising to those who still want to toil away, in pursuit of that
magically elusive thing.
Success in
investing doesn't correlate with I.Q. once you're above the level of 25.
Once you have ordinary intelligence, what you need is the temperament to
control the urges that get other people into trouble in investing.
Bob Jensen's threads on financial performance and risk ---
http://faculty.trinity.edu/rjensen/roi.htm
"A Scrapbook on What's Wrong with the Past, Present and Future of Accountics
Science"
Bob Jensen
February 19, 2014
SSRN Download:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2398296
Introduction
to Valuation
Bob Jensen's site on The Controversy Over Fair Value
(Mark-to-Market) Financial Reporting ---
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Damodaran Online: A Great Sharing Site from a Finance Professor at New
York University and Textbook Writer ---
http://pages.stern.nyu.edu/%7Eadamodar/
This site has great sections on corporate finance, investments, valuation,
spreadsheets, research, etc. For example, take a look at the helpers on
valuation ---
http://pages.stern.nyu.edu/%7Eadamodar/
You can pick the valuation approach that you would like to go to, to see
illustrations, solutions and other supporting material.
| |
|
| |
Discounted Cashflow Valuation |
| |
Relative Valuation |
| |
Option Pricing Approaches to Valuation |
| |
Acquisition Valuation |
| |
EVA, CFROI and other Value Enhancement Strategies |
Or you can pick the material that you are interested in.
| |
|
|
|
| Spreadsheets |
Overheads |
Datasets |
References |
| Problems & Solutions |
Derivations and Discussion |
Valuation Examples |
PowerPoint presentations |
Jim Mahar's finance sharing site (especially note his great blog link)
---
http://financeprofessor.com/
Financial Rounds from an anonymous finance professor ---
http://financialrounds.blogspot.com/
Bob Jensen's finance and investment helpers are at
http://faculty.trinity.edu/rjensen/Bookbob1.htm
GAAP = Generally Accepted Accounting
Principles (including rules, laws, and conventional practices)
This definition is needed for the quote below, which is in the context of
U.S. GAAP rather than international GAAP.
The other
lesson, perhaps even more tallied, GAAP should be on everyone's Top 10 list.
The idea of GAAP -- so simple yet so radical -- is that tore important, is
contained in the embrace of GAAP. When the intellectual achievements of the
20th century here should be a standard way of accounting for profit and loss
in public businesses, allowing investors to see how a public company manages
its money. This transparency is what allows investors to compare businesses as
different as McDonald's, IBM and Tupperware, and it makes U.S. markets the
envy of the world.
Clay Shirky in "How Priceline Became A Real Business," The Wall
Street Journal, August 13, 2001
http://interactive.wsj.com/archive/retrieve.cgi?id=SB99765488066568057.djm&template=pasted-2001-08-13.tmpl
"The future of the accounting and finance profession is
changing daily. Tomorrow's accounting and finance professionals will shatter
longstanding stereotypes as they shift from being backroom statisticians to
boardroom strategists." http://www.accountingweb.com/item/50518
(See below)
If one were writing a history of the American capital market, it is a
fair bet that the single most important innovation shaping that market was the
idea of generally accepted accounting principles.
Lawrence Summers, President of Harvard University
and former Secretary of Treasury
AICPA’s Business Valuation and Forensic & Litigation Services Community ---
http://bvfls.aicpa.org/
Inside Footnotes (advice from and for security analysts) ---
http://www.footnoted.com/inside-footnotes/
Bob Jensen's investment helpers ---
http://faculty.trinity.edu/rjensen/Bookbob1.htm#InvestmentHelpers
Teaching Case from The Wall Street Journal Accounting Weekly Review on
February 8, 2013
Price/Earnings Ratio
by:
Simon Constable
Feb 04, 2013
Click here to view the full article on WSJ.com
TOPICS: Earnings Per Share, Financial Statement Analysis
SUMMARY: This article gives an excellent description of alternative
measures for the P/E ratio: the simple ratio, "forward" P/E, and "trailing"
P/E based on the last four quarters of results. The discussion also mentions
adjusting the historical quarterly results used in the trailing P/E
measurement to remove unusual gains and losses.
CLASSROOM APPLICATION: The article may be used in a financial
accounting or financial statement analysis class when covering the P/E ratio
and/or earnings per share calculations. Also, because of the reference to
adjustments for unusual items, it may be used when covering treatment of
unusual and extraordinary items. NOTE: INSTRUCTORS SHOULD REMOVE THE
FOLLOWING STATEMENT BEFORE DISTRIBUTING TO STUDENTS. Question two asks
students to obtain information from their class textbooks so answers will
vary; however, students should identify the simple P/E ratio as the measure
described in their textbooks.
QUESTIONS:
1. (Introductory) What three alternative measures of the
price-earnings ratio (P/E ratio) are described in this article?
2. (Advanced) Which of the three measures matches the definition of
the P/E ratio given in your textbook? Explain your answer.
3. (Introductory) What weakness in the simple P/E ratio is overcome
by using the "forward" P/E ratio? What problems arise with the forward
measurement?
4. (Advanced) What weakness in the simple P/E ratio is overcome by
using the trailing four quarters in the measurement? Specifically identify
how this measure differs from the simple P/E ratio first described in the
article.
5. (Advanced) The author states that users should make adjustments
for unusual items in the "trailing" P/E measure. Why do you think that is
his recommendation?
6. (Advanced) "'Low P/E stocks outperform high P/E stocks,' says
Jeff Mortimer...." Explain the argument for this assertion by the investment
strategy director at BNY Mellon Wealth Management.
Reviewed By: Judy Beckman, University of Rhode Island
"Price/Earnings Ratio," by Simon Constable, The Wall Street Journal, February
4, 2013 ---
http://professional.wsj.com/article/SB10001424127887323277504578189803847508428.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj
The price of a stock doesn't tell you anything
about whether it's a good deal, but the so-called price/earnings ratio can
help. The trick is figuring out which P/E ratio to use.
Obviously, just because one stock is $200 a share
and another $12 doesn't mean the latter is cheaper in terms of what you're
getting. For a better gauge, you need to calculate what you are paying for
each dollar of company earnings. Hence, the P/E ratio, derived by dividing
the price of the stock by one year of per-share earnings. So if one stock
has a P/E of 12 and the other of 10, the latter is cheaper.
"Low P/E stocks outperform high P/E stocks," says
Jeff Mortimer, director of investment strategy at BNY Mellon Wealth
Management, a unit of Bank of New York Mellon Corp. "It does work over time
with a broad basket of names."
But the simple P/E ratio is just a starting point.
You also can calculate a "forward" P/E, using average analyst estimates for
future earnings. That provides an indication of what the average investor is
prepared to pay for future earnings. A high forward P/E, though, can mean a
couple of things. It could be that investors are willing to pay up for a
stock because they expect earnings to grow at a rapid clip. Or it could be
they've simply gotten carried away in a frothy market.
Another wrinkle: Estimated earnings may be
unrealistic. "You can make the forward P/E anything you want [by boosting
the forecast]," says Mr. Mortimer.
He prefers to calculate a "trailing" P/E based on
the last four quarters of results, adjusted for unusual gains and charges.
Deciding what to exclude can get tricky, but generally items that aren't
likely to be repeated are left out.
That way, investors can get an idea of what the
business earned from operations before relatively unusual events like plant
closings.
Of course, historical earnings may not tell you
much about where a company is headed. Think about the hit the uranium
industry took following the 2011 Fukushima nuclear disaster in Japan. The
prior 12 months of earnings and the resulting P/E would have given you
little clue about how to invest.
Continued in article
Bob Jensen's threads on P/E and other financial ratios are at
http://faculty.trinity.edu/rjensen/roi.htm
One problem with any ratios containing earnings is that the FASB and the IASB
destroyed the concept of earnings to such a degree that they themselves can no
longer define earnings. One problem is the mixing of realized earnings contracts
with unrealized value changes that in many instances are never realized.
Hence, comparing earnings ratios of one company over time or multiple companies
at one point in time becomes like mixing apples with skate boards.
From The Wall Street Journal Accounting Weekly Review on September 3,
2010
The Decline of the P/E Ratio
by: Ben
Levisohn
Aug 30, 2010
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com 
TOPICS: Analysts'
Forecasts, Financial Statement Analysis, Forecasting
SUMMARY: "While
U.S. companies announced record profits during the second quarter, and beat
forecasts by a comfortable 10% margin, on average, the stock market has
dropped 5%. Based on trailing 12-month earnings, the average price earnings
(P/E) ratio in the overall market is about 14.9 compared to 23.1 in
September 2009; "based on profit expectations over the next 12 months, the
P/E ratio has fallen to 12.2 from about 14.5 in May, 2010." The reason for
this divergence is, of course, economic uncertainty that is not evident in
the (average) point estimates of earnings nor in the relatively good
earnings numbers of both the first and second calendar quarters of 2010. The
related article is a WSJ graphic of earnings per share actual compared to
average analyst estimates, by industry and by week.
CLASSROOM APPLICATION: The
article is useful to show the need for understanding context of ratios in
undertaking financial statement analysis. It also demonstrates that ratios
can be measured in more than one way, such as the use of past earnings or
analysts' average forecasts. The related article can be used to introduce
students to analysts' earnings forecasts.
QUESTIONS:
1. (Introductory)
Define the price earnings ratio (P/E) and explain its meaning.
2. (Introductory)
What two methods of measuring P/E are described in the article? Why do you
think both are used?
3. (Introductory)
Refer to the related article. How are analysts' estimates used in this WSJ
graphic analysis? In your answer, also describe who are the analysts
producing these estimates.
4. (Advanced)
How did companies perform relative to analysts' estimates in the second
calendar quarter of 2010?
5. (Advanced)
What has happened to the P/E ratio? Why does the author say the P/E has
fallen in relevance? Do you agree with that assessment?
6. (Introductory)
What other evidence in the article corroborates the issues in the recent
fall in the average P/E ratio?
Reviewed By: Judy Beckman, University of Rhode Island
RELATED ARTICLES:
Now Reporting: Earnings
by
Aug 01, 2010
Online Exclusive
"The Decline of the P/E Ratio," by: Ben Levisohn, The Wall Street Journal,
August 30, 2010 ---
http://online.wsj.com/article/SB10001424052748703618504575459583913373278.html?mod=djem_jiewr_AC_domainid
As investors fixate on the global forces whipsawing
the markets, one fundamental measure of stock-market value, the
price/earnings ratio, is shrinking in size and importance.
And the diminution might not stop for a while.
The P/E ratio, thrust into prominence during the
1930s by value investors Benjamin Graham and David Dodd, measures the amount
of money investors are paying for a company's earnings. Typically, companies
that post strong earnings growth enjoy richer stock prices and fatter P/E
ratios than those that don't.
But while U.S. companies announced record profits
during the second quarter, and beat forecasts by a comfortable 10% margin,
on average, the stock market has dropped 5% this month.
The stock market's average price/earnings ratio,
meanwhile, is in free fall, having plunged about 36% during the past year,
the largest 12-month decline since 2003. It now stands at about 14.9,
compared with 23.1 last September, based on trailing 12-month earnings
results. Based on profit expectations over the next 12 months, the P/E ratio
has fallen to 12.2 from about 14.5 in May.
So what explains the contraction? In short,
economic uncertainty. A steady procession of bad news, from the European
financial crisis to fears of deflation in the U.S., has prompted analysts to
cut profit forecasts for 2011.
"The market is worrying not just about a slowdown,
but worse," said Tobias Levkovich, chief U.S. equity strategist at Citigroup
Global Markets in New York. "People want clarity before they make a decision
with their money."
Three months ago, analysts expected the companies
in the Standard & Poor's 500-stock index to boost profits 18% in 2011. Now,
they predict 15%. Mutual-fund, hedge-fund and other money managers put the
increase at closer to 9%, according to a recent Citigroup survey, while Mr.
Levkovich's estimate is for 7% growth.
"The sustainability of earnings is in doubt," said
Howard Silverblatt, an index analyst at S&P in New York. "Estimates are
still optimistic."
Equally troublesome, analysts' forecasts are
becoming scattered. In May, the range between the highest and lowest analyst
forecasts of S&P 500 earnings per share in 2011 was $12. Morgan Stanley
predicted $85 per share, while UBS predicted $97 per share. Now, the spread
is $15. Barclays said $80 per share; Deutsche Bank predicts $95.
When profit forecasts are tightly clustered, it
signals to investors that there is consensus among prognosticators; when
they diverge wildly, it shows a lack of clarity. The P/E ratio tends to fall
as uncertainty rises, and vice versa.
"A stock is worth its future earnings, but that
involves uncertainty," said Jeremy Siegel, professor of finance at the
University of Pennsylvania's Wharton School. "The more uncertainty there is,
the lower the P/E will be."
Not only is the P/E ratio dropping, it also is in
danger of losing some of its prominence as a market gauge.
That is because, with profit and economic forecasts
becoming less reliable, investors are focusing more on global economic
events as they make trading decisions, parsing everything from Japanese
government-debt statistics to shipping patterns in the Baltic region.
To some extent this is in keeping with historical
patterns. P/E ratios often shrink in size and significance during periods of
uncertainty as investors focus on broader economic themes.
P/E ratios fell sharply during the Depression of
the 1930s and again after World War II, bottoming at 5.90 in 1949. They
plunged again during the 1970s, touching 6.97 in 1974 and 6.68 in 1980.
During those periods, global events sometimes took precedence over
company-specific valuation considerations in the minds of investors.
There have been periods when the P/E ratio was much
more in vogue. A century ago, the buying and selling of stocks was widely
considered to be a form of gambling. P/E ratios came about as a way to
quantify the true value of a company's shares. The creation of the
Securities and Exchange Commission during the 1930s made financial
information more available to investors, and P/E ratios gained widespread
acceptance in the decades that followed.
But thanks to the recent shift toward rapid-fire
stock trading, the P/E ratio may be losing its relevance. The emergence of
exchange-traded funds in the past 10 years has allowed investors to make
broad bets on entire baskets of stocks. And the ascendance of
computer-driven trading is making macroeconomic data and trading patterns
more important drivers of market action than fundamental analysis of
individual companies, even during periods of relative calm.
So where is the P/E ratio headed in the short term?
A few optimists think it could rise from here. If corporate borrowing costs
remain at record lows and stock prices remain depressed, companies will
start issuing debt to buy back shares, said David Bianco, chief U.S. equity
strategist for Bank of America Merrill Lynch. As a result, earnings per
share would increase, he said, even if profit growth remains sluggish, and
P/E ratios could jump with them.
But today's economic uncertainty argues against
that scenario. Consider that while P/E ratios dropped during the
inflationary 1970s, they also fell during the deflationary 1930s. The one
common thread tying those two eras of falling P/E ratios: unpredictable
economic performance.
"We're looking at a more volatile U.S. economy than
we experienced in the last 30 years," said Doug Cliggott, U.S. equity
strategist at Credit Suisse in Boston. "The pressure on multiples may be
with us for quite some time."
September 8, 2010 reply from John Briggs, John
[briggsjw@JMU.EDU]
I saw this
article and didn't quite "get" it...the title at least.
Of course the P/E
ratio is still relevant.
My favorite site for this is
www.multpl.com,
where a guy provides a daily look
at the Shiller ("Irrational Exuberance") 10-year P/E...10 years of data
instead of 1. It's currently 20. It used to be 45. Indeed, 45 was a
bubble.
Right now, you
would think 16 would be appropriate, but extremely low interest rates argue
for higher (in comparison to investing in bonds), but economic uncertainly
argues for lower.
So I'd make the
case that this metric should be around 16 right now...20 indicates to me
that stocks are slightly overvalued.
The only time the
P/E ratio really was ignored was in 2000, it seems to me. I'm glad I had no
money then.
Teaching Case on Financial Statement Analysis and P/E Ratios
From The Wall Street Journal Accounting Weekly Review on November 4, 2011
Earnings and Stocks: Is It Trick or Treat?
by:
Kelly Evans
Oct 31, 2011
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com ![WSJ Video]()
TOPICS: Earning Announcements, Earnings Forecasts, Financial
Analysis, Financial Statement Analysis, Stock Price Effects
SUMMARY: This and the related article highlight the relation
between stocks and earnings but also the influence of typical seasonal
patterns in stock market returns.
CLASSROOM APPLICATION: The article is useful to discuss financial
statement ratios, particularly the price-earnings ratio, and the
relationship between reported earnings, earnings expectations, and stock
prices.
QUESTIONS:
1. (Introductory) To what does author Kelly Evans attribute the
good stock market performance of October 2011? In your answer, describe the
quarterly earnings reporting process and analysts' estimates for earnings.
2. (Advanced) "The sticking point in all of this that estimates for
the fourth quarter have dropped by 3% in October." Describe how you think
this 3% drop is measured. (Hint: the video provides a helpful discussion of
this topic.)
3. (Advanced) Refer to the related article. How does the author use
the price-earnings ratio to answer questions raised in the article? In your
answer, define the price-earnings ratio and describe how it is measured for
purposes of these two articles.
4. (Introductory) Refer again to the related article. What other
factors influence overall stock market performance?
Reviewed By: Judy Beckman, University of Rhode Island
RELATED ARTICLES:
Stocks Going by the Book
by Jonathan Cheng
Oct 31, 2011
Page: C1
"Earnings and Stocks: Is It Trick or Treat?" by: Kelly Evans, The Wall
Street Journal, October 31, 2011 ---
http://online.wsj.com/article/SB10001424052970203707504577007754040669274.html?mod=djem_jiewr_AC_domainid
The strange dynamics of this earnings season are
reminiscent of two prior, but diametrically opposed, inflection points:
those of mid-2008 and mid-2009. That is, the stock market has surged even as
forward earnings estimates fall.
Typically, such declines would trigger a selloff as
investors reassess the value of shares. Right now, though, the opposite is
happening.
The Standard & Poor's 500-stock index as of Friday
was up 13.6% for the month—its best monthly performance since January 1987.
Certainly, seeming progress toward resolving Europe's sovereign-debt crisis
has played a big role in stocks' newfound favor. But on a more fundamental
basis, it helps that the third-quarter earnings season is going well,
despite some high-profile misses.
More than 70% of companies have beaten earnings
estimates, compared with 62% on average since the early 1990s. Prospects,
however, have been dimming. Earnings estimates for the S&P 500 in the
current fourthquarter have already fallen 3%—the biggest monthly decline
since April 2009, according to FactSet analyst John Butters.
The stock market has surged even as forward
earnings estimates fall, and typicall such declines would trigger a selloff
as investors reassess the value of shares. Right now, though, the opposite
is happening, Kelly Evans reports on Markets Hub. Photo: AP.
That doesn't have to mean disaster. In April 2009,
the stock market was also rallying sharply despite lowered earnings
expectations. Then, of course, stocks were building off the historic March
lows, which already had exceptionally weak forward earnings priced in. The
rally continued as investors grew more confident the U.S. was on the cusp of
recovery, and analysts eventually had to start raising their earnings
estimates to keep up.
That rally, however, started out of a deep
recession and came after a huge market selloff. This time, the S&P 500
started from a low point of about 1100—some 65% higher than in March 2009.
More to the point, the economy today isn't coming out of recession, but
trying to avoid falling back into one.
Continued in article
Bob
Jensen's bookmarks for financial ratios ---
http://faculty.trinity.edu/rjensen/Bookbob1.htm#010303FinancialRatios
Also see
http://en.wikipedia.org/wiki/Financial_ratios
The Full List of NFL Team Valuations ---
http://www.forbes.com/nfl-valuations/
"Dallas Cowboys Lead NFL With $2.1 Billion Valuation," by Mike Ozanian,
Forbes. September 5, 2012 ---
http://www.forbes.com/sites/mikeozanian/2012/09/05/dallas-cowboys-lead-nfl-with-2-1-billion-valuation/
The most famous quote attributed to legendary Green
Bay Packers coach Vince Lombardi is “winning isn’t everything, it’s the only
thing.” But if Lombardi had coached in this era instead of the 1960s he may
have substituted the word “marketing” for “winning.”
The Dallas Cowboys have not been to the Super Bowl
in 16 years. But the lack of a title game appearance has done nothing to
slow down the money that flows into the arms of Jerry Jones, the oilman who
bought the National Football League team and lease to its stadium in 1989
for $150 million. The Cowboys are now worth $2.1 billion, more than any
sports team on the planet, save Manchester United. And if the English soccer
club, which recently sold shares to the public, stumbles, the Cowboys will
run right past them because nobody in football can match Jones when it comes
to marketing and squeezing cash from a stadium.
Last season the Cowboys generated $500 million in
total revenue, a record for an American sports team, and posted operating
income (earnings before interest, taxes, depreciation and amortization) of
$227 million, $108 million more than any other football team and more than
either the entire National Basketball Association or National Hockey League.
A prime example of what separates Dallas from the league’s other 31 teams is
the more than $80 million in sponsorship revenue Cowboys Stadium rakes in
from companies such as Ford Motor, Bank of America, PepsiCo, Dr. Pepper and
Miller Brewing, almost $20 million more than any other football team.
Sponsorship revenue, unlike the NFL’s national television fees with NBC,
Fox, ESPN and CBS, are not shared equally with the other teams.
Continued in article
Jensen Comment
I think it's more than just marketing. Another factor is location, Texas is a
state where high schools will spend upwards of $60 million for a high school
stadium and books and television shows like Friday Night Lights are
written ---
http://www.nbc.com/friday-night-lights/
It also helps to be in a location where fans do not have to sit outdoors in
below-zero weather and raging blizzards.
Bob Jensen's threads on valuation ---
http://faculty.trinity.edu/rjensen/roi.htm
Question
At this juncture why would IBM spend almost $10 billion for its own shares?
Hint
The wildly-popular eps ratio has a denomator.
"IBM to spend $5 billion more on stock buyback," MIT's Technology Review,
October 27, 2009 ---
http://www.technologyreview.com/wire/23815/?nlid=2465
IBM Corp. has boosted its stock buyback program by
$5 billion, a sign of the company's ability to spit out cash despite the
fact the recession has choked off revenue growth.
The announcement Tuesday brings IBM's pot for stock
repurchases to $9.2 billion, and the company, based in Armonk, N.Y., plans
to ask for more at a board meeting in April 2010. IBM said it has spent $73
billion on dividends and buybacks since 2003.
Buybacks are one lever companies pull to meet
earnings targets, since they increase earnings per share by reducing the
number of shares outstanding. IBM has set aggressive earnings targets, and
twice this year raised its profit forecast for 2009, surprising investors
since revenue has fallen since last year. IBM has said it sees corporate
spending on technology "stabilizing." One way IBM wrings more profit despite
lower sales is by using software to automate certain tasks done by humans
and focusing on projects like the "smart" power grid that can carry higher
profit margins than other services work.
IBM's current forecasts call for earnings per share
of at least $9.85 this year, and the company has maintained that it is "well
ahead" of its pace for 2010 earnings of $10 to $11 per share.
IBM ended the third quarter with $11.5 billion in
cash. Free cash flow, a sign of a company's ability to generate more cash,
was $3.4 billion, up $1.3 billion from a year ago. Revenue in the past nine
months is down nearly 11 percent from a year ago.
Quality of Earnings Disputes ---
http://faculty.trinity.edu/rjensen/theory01.htm#CoreEarnings
Bob Jensen's threads on accounting theory ---
http://faculty.trinity.edu/rjensen/theory01.htm
"Among Different Classes of Equity: Valuation models can be tailored
to unique financing structures." by Andrew C. Smith and Jason C. Laurent,
Journal of Accouintancy, March 2008 ---
http://www.aicpa.org/pubs/jofa/mar2008/allocating_value.htm
EXECUTIVE SUMMARY
It is essential for board members, executive officers, CFOs, auditors and
private equity investors to comprehend option-pricing models used to
determine the per-share values of common and preferred shares.
The AICPA Practice Aid, Valuation of
Privately-Held-Company Equity Securities Issued as Compensation, describes
three methods of allocating value between preferred and common equity, which
include:
Current Value Method (“CVM”) Probability Weighted
Expected Return Method (“PWERM”) Option-Pricing Method (“OPM”)
OPM, which is based on the Black-Scholes model, is
a common method for allocating equity value between common and preferred
shares.
Valuation models must be tailored to the specific
facts and circumstances of the equity in the company being valued.
Bob Jensen's threads on fair value accounting are at
http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue
They
Do It With Mirrors --- GAAP Does Not "Cover" the entire
GAP
An Analogy Between GAAP and the GAP in a Woman's Dress or Skirt
So what is wrong with GAAP in recent years? GAAP's problems are somewhat
like a "GAP" incident that took place in a Target Store (the story
would have been better had it been inside a GAP Store) in San Antonio on August
21 (as reported on a local television
station). A man with a mirror was detained for peeking up the "GAP"
beneath women's dresses. Although he was tossed out of the store, this
pervert was
not arrested. The police claimed they had nothing to charge him with,
because there was no U.S. or Texas law against peeking beneath a woman's dress with a
mirror. Laws are enforced better in the U.S. than in many other nations, but the laws are
incomplete for many types of egregious behavior. In an analogous manner, GAAP
is enforced better in the U.S. than in most other nations, but U.S. GAAP is incomplete and does not control certain types of egregious
financial reporting
behavior that is becoming increasingly common in the "New Economy" ---
where intangible assets that are not measured well under GAAP comprise an
increasing proportion of the value and earnings of business firms. In some
ways, business firms are trying to "Do It With Mirrors," thereby,
causing a widening "GAP" in "GAAP." I will now give you
the WSJ quotation:
But there's a catch. In recent years, P/E ratios have
become increasingly polluted. The "E" in P/E used to refer simply to
earnings as reported under generally accepted accounting principles, or GAAP.
That's what it means when the historical average is cited. But in First Call's
figure, the "E" relates to something fuzzier, called "operating
earnings." And that can mean just about whatever a company wants it to
mean.
Based on earnings as reported under GAAP, the S&P
500 actually finished last week with a P/E ratio of 36.7, according to a Wall
Street Journal analysis. That is higher than any other P/E previously recorded
for the index. (Click
here to see
details of the calculation.)
This suggests the overall stock market could be
further from recovery than many suppose. "I don't think most people
realize that the market is as overvalued as it is," says David Blitzer,
chief investment strategist at S&P, a unit of McGraw-Hill Cos. "There
probably are a lot of people who would sell some stock if they realized how
overvalued the numbers are saying the market is."
Jonathan Weil, "Companies Pollute Earnings Reports, Leaving P/E Ratios
Hard to Calculate," The Wall Street Journal, August 21, 2001, Page
A1. For details and related articles, see http://faculty.trinity.edu/rjensen/roi.htm
What we teach just won't float?
Quite a few of you out there, like me, are trying to teach analysis of
financial statements and business analysis and valuation from books like Penman
or Palepu,
Healy, and Bernard. The current task of valuing MCI illustrates
how frustrating this can be in the real world and how financial statement
analysis that we teach, along with the revered Residual Income and Free Cash
Flow Models, are often Titanic tasks in rearranging the deck chairs on sinking
models. If you've not attempted valuations with these models I suggest
that you begin with my favorite case study:
"Questrom vs. Federated Department
Stores, Inc.: A Question of Equity Value," May 2001 edition of
Issues in Accounting Education, by University of Alabama faculty members Gary
Taylor, William Sampson, and Benton Gup, pp. 223-256.
In spite of all the sophistication in
models, it is ever so common for intangibles and forecasting problems to sink
the valuation models we teach. I have more to say about intangibles at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
A question I always ask my students
is: What is the major thing that has to be factored in when valuing
Microsoft Corporation?
The answer I'm looking for is certainly
not product innovation or something similar to that. The answer is also
not customer loyalty, although that probably is a huge factor. The big
factor is the massive cost of retraining the entire working world in something
that replaces MS Office products (Excel, Word, PowerPoint, Outlook, etc.).
It simply costs too much to retrain workers in MS Office substitues even if we
are so sick of security problems in Micosoft's systems. How do you
factor this "customer lock-in" into a Residual Income or FCF
Model? Our models are torpedoed by intangibles in the real world.
MCI's customer base is another torpedo
for valuation models. Here the value seems to lie in a "web of
corporate customers." And nobody seems to be able to value that.
"Valuing MCI in an Industry Awash in Questions," by Matt Richtel, The
New York Times, February 9, 2005 --- http://www.nytimes.com/2005/02/09/business/09phone.html
Industry bankers and accountants are trying to answer
just that: What is the value of MCI, a company for which Qwest Communications
has already made a tentative offer of about $6.3 billion, and on which Verizon
Communications has been running the numbers. Conversations between MCI and
Qwest have been suspended since late last week, and Verizon has yet to make a
formal offer, people close to the negotiations say.
Most analysts say MCI's extensive network assets in
this country and Europe may have diminishing value because of the industry's
continued capacity glut. Instead, they say, MCI's
worth lies more in its web of corporate customers.
But as MCI's revenue continues to tumble, the real
trick for the accountants is trying to forecast the future. Can the company meet
its stated goal of achieving profitable growth as a telecommunications company
emphasizing Internet technology before the bottom falls out of its traditional
voice and data business?
Continued in article
Bob Jensen's threads on intangibles are at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
What we teach just won't float?
Quite a few of you out there, like me, are trying to teach analysis of
financial statements and business analysis and valuation from books like Penman
or Palepu,
Healy, and Bernard. The current task of valuing Amazon illustrates
how frustrating this can be in the real world and how financial statement
analysis that we teach, along with the revered Residual Income and Free Cash
Flow Models, are often Titanic tasks in rearranging the deck chairs on sinking
models.
From The Wall Street Journal Accounting Weekly Review on
February 11, 2005
TITLE: Amazon's Net Is Curtailed by Costs
REPORTER: Mylene Mangalindan
DATE: Feb 03, 2005
PAGE: A3
LINK: http://online.wsj.com/article/0,,SB110735918865643669,00.html
TOPICS: Financial Accounting, Financial Statement Analysis, Income Taxes,
Managerial Accounting, Net Operating Losses
SUMMARY: Amazon "...had forecast that profit margins would rise in the
fourth quarter, while Wall Street analysts had expected margins to remain about
the same." The company's operating profits fell in the fourth quarter from
7.9% of revenue to 7%. The company's stock price plunged "14% in
after-hours trading."
QUESTIONS:
1.) "Amazon said net income rose nearly fivefold, to $346.7 million, or 82
cents a share, from $73.2 million, or 17 cents a share a year earlier." Why
then did their stock price drop 14% after this announcement?
2.) Refer to the related article. How were some analysts' projections borne
out by the earnings Amazon announced?
3.) One analyst discussed in the related article, Ken Smith, disagrees with
the majority of analysts' views as discussed under #2 above. Do you think that
his viewpoint is supported by these results? Explain.
4.) Summarize the assessments made in answers to questions 2 and 3 with the
way in which Amazon's operating profits as a percentage of sales turned out this
quarter.
5.) Amazon's results "included a $244 million gain from tax benefits,
stemming from Amazon's heavy losses earlier in the decade." What does that
statement say about the accounting treatment of the deferred tax benefit for
operating loss carryforwards when those losses were experienced? Be specific in
describing exactly how these tax benefits were accounted for.
6.) Why does Amazon adjust out certain items, including the tax gain
described above, in assessing their earnings? In your answer, specifically state
which items are adjusted out of earnings and why that adjustment might be made.
What is a general term for announcing earnings in this fashion?
Reviewed By: Judy Beckman, University of Rhode Island
--- RELATED ARTICLES ---
TITLE: Web Sales' Boom Could Leave Amazon Behind
REPORTER: Mylene Mangalindan
ISSUE: Jan 21, 2005
LINK: http://online.wsj.com/article/0,,SB110627113243532202,00.html
Bob Jensen's threads on intangibles are at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
An Exercise in Valuation
"Putting a Value on Google,"
by Scott Kessler, Business Week, June 11, 2004 --- http://www.businessweek.com/investor/content/jun2004/pi20040611_9275_pi076.htm
S&P
takes a hard look at the search giant's fundamentals -- and at the valuations of
its peers -- to find an answer
Amid an enormous level of interest in the Google IPO -- from investors, the
media, and seemingly every other person you talk to at cocktail parties -- we at
Standard & Poor's Equity Research Services decided to take an unbiased look
at the company and its competitive position (see BW Online, 6/11/04, "Google:
What Lies Beyond Search?"), including commissioning a proprietary
survey of Internet users (see BW Online, 6/14/04, "Search
Users Weigh In on Google").
Continued in the article
There is a link to Banister
Financial where you can find some tips of valuation and valuation
frauds.
"Independent" Auditors: Are They Becoming Dependents?
In recent years, a
dramatic increase in the revenues big accounting firms derive from management
consulting services has raised a red flag about auditor independence. The Wall
Street Journal reported in April, for example, that just last year Sprint paid
Ernst & Young $2.5 million for auditing but $63.8 million for other work,
including $12 million for the deployment of a financial-information system.
General Electric paid KPMG $24 million for auditing but more than three times
that for other services.
Study Finds Consulting Contracts Impair Auditor Objectivity --- http://www.smartpros.com/x30693.xml
From The Wall Street Journal Weekly Accounting Review on October 17,
2014
The Big Mystery: What's Big Data Really Worth?
by:
Vipal Monga
Oct 13, 2014
Click here to view the full article on WSJ.com
TOPICS: Asset Valuation, Data, Intangible
Assets, Valuation
SUMMARY: As more companies traffic in
information and use big-data analytic tools to find ways to generate
revenue, the lack of standards for valuing data leaves a widening gap in our
understanding of the modern business world. Corporate holdings of data and
other "intangible assets," such as patents, trademarks and copyrights, could
be worth more than $8 trillion, roughly equivalent to the gross domestic
product of Germany, France and Italy combined. The issue isn't confined to
the tech industry. Supermarket operator Kroger Co., for example, records
what customers buy at its more than 2,600 stores and also tracks the
purchasing history of its roughly 55 million loyalty-card members. It sifts
this data for trends and then, through a joint venture, sells the
information to the vendors who stock its shelves with goods ranging from
cereals to sodas.
CLASSROOM APPLICATION: This is an excellent
financial accounting article regarding the accounting for the value of data
collection and information.
QUESTIONS:
1. (Introductory) What "big data" is discussed in the article? Why
is this type of data so valuable? Who is interested in that information? How
could the information be used in businesses?
2. (Advanced) In general, what are the rules for accounting for
intangible assets? Is that the same treatment used to account for this type
of collected data? How is the value presented in annual reports? How are the
various costs booked? What accounts are affected?
3. (Advanced) What is FASB? Why would FASB be involved with big
data? How has FASB been dealing with this issue?
4. (Advanced) What companies and industries are more likely to be
affected by this accounting issue? Why are they affected? What industries or
types of business are not as likely to be affected by this issue?
5. (Advanced) Should the users of the financial statements be
interested in the value of a company's data? Why or why not? How does the
value (or lack of value) affect the business and, as a result, affect the
users of the financial statements?
6. (Advanced) What are the issues involved with valuing data that
makes it more challenging to value that other assets? How should this issue
be resolved?
Reviewed By: Linda Christiansen, Indiana University Southeast
RELATED ARTICLES:
Trouble with Big Data: If You Can't Value it, You Can't Insure it.
by Vipal Monga
Oct 13, 2014
Online Exclusive
"The Big Mystery: What's Big Data Really Worth?" by Vipal Monga, The Wall
Street Journal, October 13, 2014 ---
http://online.wsj.com/articles/whats-all-that-data-worth-1413157156?mod=djem_jiewr_AC_domainid
What groceries you buy, what Facebook FB +2.23%
posts you “like” and how you use GPS in your car: Companies are building
their entire businesses around the collection and sale of such data.
The problem is that no one really knows what all
that information is worth. Data isn’t a physical asset like a factory or
cash, and there aren’t any official guidelines for assessing its value.
“It’s flummoxing that companies have better
accounting for their office furniture than their information assets,” said
Douglas Laney, an analyst at technology research and consulting firm Gartner
Inc. IT +2.06% “You can’t manage what you don’t measure.”
As more companies traffic in information and use
big-data analytic tools to find ways to generate revenue, the lack of
standards for valuing data leaves a widening gap in our understanding of the
modern business world.
Corporate holdings of data and other “intangible
assets,” such as patents, trademarks and copyrights, could be worth more
than $8 trillion, according to Leonard Nakamura, an economist at the Federal
Reserve Bank of Philadelphia. That’s roughly equivalent to the gross
domestic product of Germany, France and Italy combined.
These intangibles are becoming an evermore
important part of the global economy. The value of patents, for example, has
become a major driver of both mergers and lawsuits for technology giants
like Google Inc., GOOGL +2.36% Apple Inc. AAPL +1.87% and Samsung
Electronics Co. 005930.SE -0.91% But those assets don’t appear on company
financial statements.
“We want some kind of accounting information about
it, so you have a better idea of how companies are investing for growth,”
said Mr. Nakamura.
The issue isn’t confined to the tech industry.
Supermarket operator Kroger Co. KR +0.68% records what customers buy at its
more than 2,600 stores and also tracks the purchasing history of its roughly
55 million loyalty-card members. It sifts this data for trends and then,
through a joint venture, sells the information to the vendors who stock its
shelves with goods ranging from cereals to sodas.
Consumer-products makers like Procter & Gamble Co.
PG -1.32% and Nestlé SA are willing to pay for those insights because it
allows them to tailor their products and marketing to consumer preferences.
Mr. Laney and others estimate that Kroger rakes in
$100 million a year from data sales. But Kroger executives are mum on the
subject.
Kroger does say that it follows generally accepted
accounting principles, which prohibit companies from treating data as an
asset or counting money spent collecting and analyzing the data as
investments instead of costs.
The Financial Accounting Standards Board, the
nation’s accounting authority, has struggled to update its rules for an
economy increasingly driven by information and intellectual property. FASB
has debated the question of intangible assets twice between 2002 and 2007.
Both times, complications convinced the agency to drop it from the agenda.
Last month, however, members of the advisory council again advised the board
to research intangibles, said agency spokeswoman Christine Klimek.
Among the issues: how to account for time employees
spent gathering data—as an expense or a capital investment?
Companies also would have to estimate the
shelf-life of their data, figure out its future worth and track and report
any changes in its value. Crunching those numbers would be relatively easy
for a physical asset like a factory. But in the squishy world of
intangibles, there’s little precedent for such calculations.
“When those kinds of questions arise, they
overwhelm the matter,” said Dennis Beresford, who was FASB’s chairman from
1987 to 1997.
The lack of consensus on how to measure data’s
value creates an especially big blind spot for investors in tech giants like
Facebook Inc., eBay Inc. EBAY +1.30% and Google, which rely on the data they
collect for the bulk of their revenue.
“A lot of what is going on at the companies is not
being reflected in public disclosures or the accounting,” said Glen Kernick,
a managing director at investment-banking and valuation advisory firm Duff &
Phelps Corp.
Facebook, eBay and Google have combined assets
minus combined debt of $125 billion. But the combined value of shares is
$660 billion. The difference reflects the stock market’s understanding that
the companies’ prize assets, such as search algorithms, patents and enormous
troves of information on their users and customers, don’t show up on their
balance sheets. That leads many investors to value them by other, more
volatile benchmarks, such as cash flow or the economic outlook.
Many experts argue that investors don’t need to
know the specific value of intangible assets like data. They say a company’s
stock price reflects the market’s appraisal of those assets.
“Data is worthless if you don’t know how to use it
to make money,” said Laura Martin, an analyst with Needham & Co. Information
on individual users loses value over time as they move or their tastes
change, she added. That makes data a perishable commodity and more difficult
to value at any given moment.
But relying on the collective wisdom of the market
can be dangerous. Many investors lost their shirts in the dot-com bust of
2000, which followed a buying frenzy fueled by the widespread belief that
traditional metrics for value and risk didn’t matter in the “new economy.”
One of the rare times that companies put a price
tag on data is during corporate takeovers. In fact, the value of the data to
be acquired in a deal is becoming an important consideration in mergers,
said Bruce Den Uyl, managing director at consulting firm AlixPartners LLP.
Nielsen NLSN -1.66% Holdings NV, which tracks what
people watch on television and buy in stores, acquired radio-audience
tracker Arbitron Inc. for $1.3 billion in September 2013. As part of that
deal, Nielsen broke out the intangible assets it acquired on its balance
sheet, including “customer-related intangibles” worth $271 million.
That item included the value of long-term customer
relationships as well as customer lists, but Nielsen didn’t specify how much
it paid for either.
Nielsen doesn’t give a value for the data it has
created on its own. But it assigned a value of $1.98 billion of
customer-related intangibles and $4.82 billion of other intangibles it had
acquired as of the end of the first quarter.
Nielsen declined to comment.
Mr. Den Uyl said that he values data based on how
companies will use it to make money, and its expected life. He likened the
process to solving a puzzle, in which he first values all the other acquired
assets and then assigns some of what’s left to data and goodwill.
A spate of hot patent auctions shows there is an
active market for some intangibles, said Alex Poltorak, chairman and chief
executive officer of General Patent Corp., which helps companies license and
protect their patents.
Nortel Networks Corp. NRTLQ -2.44% sold its
technology patents for $4.5 billion in 2011. That is more than the $3.2
billion it got from the sale of its operating businesses after filing for
bankruptcy protection in 2009.
That disconnect, Mr. Poltorak said, highlights how
“the accounting profession has completely failed modern business in not
being able to catch up to new forms of property.”
"What's the Investment Really Worth?" by Ann Grimes, The Wall
Street Journal, December 3, 2003 --- http://online.wsj.com/article/0,,SB107041216487726000,00.html?mod=mkts%5Fmain%5Fnews%5Fhs%5Fh
In Venture-Capital World, 'Standard Valuation' Rules
Could Clear Up Questions
In a sign that the private-equity world may be
starting to feel the impact of corporate reorganization, an industry group
Tuesday unveiled a set of guidelines aimed at standardizing the way private
companies are valued.
The move by a self-appointed but influential
coalition, the Private Equity Industry Guidelines Group, comes in response to
pressure for more transparency and consistency in valuing private-equity
investments -- the business of corporate buyouts and venture capital.
Historically, private-equity-investment valuations have been as much art as
science, sometimes creating a scattering of valuations among firms holding the
same investments.
It is far from clear what impact the proposals will
have on venture-capital and buyout funds, which hold billions of dollars in
investments in closely held companies. The proposals are voluntary, and some
top-tier investors said the recommendations, while welcome, wouldn't affect
their funding choices. And the industry's National Venture Capital Association
has yet to endorse the proposals.
Still, the collapse of the technology sector has
prompted investors in venture-capital funds -- which include wealthy
individuals, college endowments and pension funds -- to express concerns that
those funds failed to reflect potentially big losses in their investment
portfolios.
The guidelines, hammered out after a year of debate,
were endorsed by 15 of the 18 firms represented on the PEIGG board, including
HarborVest Partners LLC, Bank of America Corp. and the University of
California Regents. The three other firms are expected to offer their
endorsement shortly, the group said.
"A common valuation system agreed on by both
limited and general partners is an important step in the growth and maturation
of the private-equity industry," said PEIGG Chairman William Franklin,
managing director, Bank of America Capital Corp.
Under the standards, venture-capital, leverage-buyout
and other private-equity firms will be encouraged to adhere to a
"fair-market value" approach consistent with generally accepted
accounting principles when determining the value of private companies.
The drive for standardization stems in part from the
sometimes wildly different values recorded for similar investments. A case in
point: Santera Systems, Inc. Last year, The Wall Street Journal reported that
the same series of preferred stock in the Texas-based telecommunications firm
was being valued at $4.42 a share by Austin Ventures at the same time that
Sequoia Capital held it at 46 cents a share.
Fair value is defined by the U.S. accounting industry
as "the amount at which an investment could be exchanged in a current
transaction between unrelated willing parties, other than in a forced
liquidation sale," the group said.
Currently, many private-equity industry-fund managers
rely on historic cost as an approximation of fair-market value. While that may
be a reliable estimate in the short run, at some point, "cost or the
latest round of financing becomes less reliable as an approximation of fair
value," the PEIGG guidelines say.
The PEIGG guidelines recommend fund managers update
the value of their portfolios on a quarterly basis, and review them rigorously
at least once a year. They also recommend the establishment of valuation
committees composed of investors to calculate valuations using a common
methodology, an effort to minimize fund-manager bias.
"If you don't have standards, it's difficult to
compare apples to apples," says Rick Hayes, senior investment officer at
the California Employees' Retirement System, the nation's largest public
pension fund, which is in more than 360 limited partnerships. Mr. Hayes, who
is involved with another industry group, the Institutional Limited Partners
Association, has reviewed the guidelines and says he is supportive of the
effort.
Another source of pressure: fear of government
regulation. "When I reflect back on when the group was formed in the
fourth quarter of 2001, back then we were being bombarded with news of one
corporate scandal after another in the public sector," Mr. Franklin said
in an interview. "We felt at the time the government or regulators were
going to potentially step in once they got done with our public brethren. That
clearly was one of the motivating factors in developing guidelines."
The recommendations will allow private-equity firms
to periodically "write up" investments carried on their books at
lower-than-market costs. While general partners were slow to write down
losses, they are hesitant to mark them up. "That gives a very slanted
view of the portfolio," Mr. Franklin says.
At Calpers, Mr. Hayes, referring to a quickly
appreciating investment, says: "The accuracy of that number is very
important." That is because the way private equity works it can affect
how much of the profit distribution goes to a general partner versus a limited
partner. It can affect the LP's assessment of its own portfolio status. And it
can affect the price that an LP may able to get if they wanted to sell its
interest in the fund.
Jim Breyer, managing partner at Accel Partners in
Palo Alto, Calif., says the guidelines are "a move in the right
direction," though he is doubtful about adopting them in full. He says he
supports more consistency because "there still are a number of firms who
don't write down aggressively enough."
The next step for PEIGG is to send out their proposal
for more feedback from, and it is hoped endorsements by, other industry
groups, some of whom -- including ILPA and the Association for Investment
Management and Research -- are considering guidelines of their own.
How P/E Ratios Are Figured --- http://interactive.wsj.com/archive/retrieve.cgi?id=SB998339424717089333.djm&template=pasted-2001-08-21.tmpl#DETAILS
How the P/E Ratios Are Figured
|
To calculate the price-to-earnings ratio for the Standard &
Poor's 500-stock index, The Wall Street Journal divided the combined
market capitalization of the 500 companies currently in the index by
their most recently reported four quarters of earnings. These earnings
exclude only items classified under generally accepted accounting
principles as extraordinary items, discontinued operations or cumulative
effects of changes in accounting principles.
This methodology differs slightly from the one used by S&P, which
updates earnings statistics for the index just once a quarter. S&P
doesn't revise earnings from previously reported quarters to account for
additions or deletions to the index. And it historically hasn't revised
previously reported earnings to account for companies' financial
restatements. The Journal's calculations show a trailing P/E of 36.7 as
of Friday. S&P may report a somewhat lower P/E ratio when it
releases its second-quarter earnings tally, depending on how it handles
JDS Uniphase. JDS has announced a $50.6 billion loss for its fiscal year
ended June 30. But JDS said it would restate results for the March 31
quarter so that most of the loss appears in that quarter, not in the
June quarter. S&P has been considering revising its first-quarter
earnings figures to reflect JDS's restated losses, but hasn't announced
a decision.
The Journal used data from Multex.com Inc. as well as companies' news
releases and filings with the Securities and Exchange Commission. The
P/E ratios in the Journal's daily stock-price tables are calculated
using trailing earnings, excluding extraordinary items, accounting
changes and discontinued operations. |
Operating Earnings vs. Reality
Companies increasingly announce earnings on a 'pro forma' or 'operating'
basis, excluding various charges that are ordinary expenses under
generally accepted accounting principles (GAAP). The top chart shows how
10 companies reported their most recent quarterly earnings, compared
with their net income.
Sources: company news releases; Thomson Financial/First Call |
Fundamentals Analysis
and Value Investing
A Fundamentals Approach to Valuing a Business
In the great book Dear Mr. Buffett, Janet Tavakoli shows how Warren
Buffet learned value (fundamentals) investing while taking Benjamin Graham's
value investing course while earning a masters degree in economics from Columbia
University. Buffet also worked for Professor Graham.
The following book supposedly takes the Graham approach to a new level
(although I've not yet read the book). Certainly the book will be controversial
among the efficient markets proponents like Professors Fama and French.
Purportedly a Great, Great Book on Value Investing
From Simoleon Sense, November 16, 2009 ---
http://www.simoleonsense.com/
OMG Did I Die & Go To heaven?
Just Read, Applied Value Investing, My Favorite Book of the Past 5
Years!!
Listen To This Interview!
I have a confession, I might have read the best
value investing book published in the past 5 years!
The book is called
Applied Value Investing By Joseph Calandro Jr. In
the book Mr. Calandro applies the tenets of value investing via (real) case
studies. Buffett, was once asked how he would teach a class on security
analysis, he replied, “case studies”. Unlike other books which are
theoretical this book provides you with the actual steps for valuing
businesses.
Without a doubt, this book ranks amongst the best
value investing books (with SA, Margin of Safety, Buffett’s letters to
corporate America, and Greenwald’s book) & you dont have to take my word for
it. Seth Klarman, Mario Gabelli and many top investors have given the book a
plug!
Here is an interview with the author of the book, Applied Value Investing
( I recommend listening to this). Who knows perhaps
yours truly will interview him soon.
Miguel
P.S.
A fellow blogger and friend will soon post a review
of this book (hint: Street Capitalist!).
Bob Jensen's threads on the Efficient Market Hypothesis are at ---
http://faculty.trinity.edu/rjensen/theory01.htm#EMH
Warren
Buffett did a lot of almost fatal damage to the EMH
If you really want to understand the problem you’re apparently wanting to study,
read about how Warren Buffett changed the whole outlook of a great
econometrics/mathematics researcher (Janet Tavkoli). I’ve mentioned this
fantastic book before --- Dear Mr.
Buffett. What opened her eyes is how Warren Buffet built his vast, vast
fortune exploiting the errors of the sophisticated mathematical model builders
when valuing derivatives (especially options) where he became the writer of
enormous option contracts (hundreds of millions of dollars per contract). Warren
Buffet dared to go where mathematical models could not or would not venture when
the real world became too complicated to model. Warren reads financial
statements better than most anybody else in the world and has a fantastic
ability to retain and process what he’s studied. It’s impossible to model his
mind.
I finally grasped what Warren was saying. Warren has such a wide body of
knowledge that he does not need to rely on “systems.” . . . Warren’s vast
knowledge of corporations and their finances helps him identify derivatives
opportunities, too. He only participates in derivatives markets when Wall
Street gets it wrong and prices derivatives (with mathematical models)
incorrectly. Warren tells everyone that he only does certain derivatives
transactions when they are mispriced.
Wall Street derivatives traders construct trading models with no clear idea
of what they are doing. I know investment bank modelers with advanced math
and science degrees who have never read the financial statements of the
corporate credits they model. This is true of some credit derivatives
traders, too.
Janet Tavakoli, Dear Mr. Buffett, Page 19
October 28, 2009 reply from Paul Williams
[Paul_Williams@NCSU.EDU]
Bob, et al,
I never cease to marvel at the powers of rationalization defenders of sacred
institutions can muster. The above characterization of EMH was certainly not
the version pedaled by its accounting disciples (notably Bill Beaver) back
in the late 60s and early 70s. An accounting research industry was created
based on a version of EMH that was decidedly more certain that securities
were "properly priced." [Why else do studies to debunk the Briloff effect?].
Given the interpretation offered above,
"Information Content Studies" make no sense. The whole idea of this
methodology was that accounting data that correlated with prices implied
market participants found it useful for setting prices based on publicly
available data, which implied such prices were the ones that would exist in
an idealized world of perfectly informed investors. Thus, this data met the
test of being information and was to be preferred to other "non-information"
to which the market did not react.
But now we are told that this latest version of EMH
does not justify such sanguinity because "...the prices in the market are
mostly wrong...", thus prices are not an indicator of the value of data,
i.e., just because there is a price effect we still don't know if that data
is truly "information." Think of the millions and millions of taxpayer
dollars that have been wasted over the last forty years subsidizing people
to search for something that is indeterminate given the methodology they are
employing.
And for this the AAA awarded Seminal Contributions.
Jim Boatsman had an ingenious little paper in Abacus eons ago titled, "Why
Are There Tigers and Things," that cast serious doubts on the whole
enterprise of "testing" market efficiency. It addressed the issue Carl
Devine harped on about needing an independent definition of "information."
And this is related to the logical slight of hand EMH required of surmising
there is a way to know what the "true" price is since we glibly talk about
over and under and mis-priced securities.
But there is no way to know this, since security
prices are CREATED by the institution of the securities market. There does
not exist a natural process against which market performance can be
compared. "Market value," which is what a price is, is a value established
by the market. The market is all there is. To paraphrase NC's current
governor's favorite expression, "The price is what it is."
It isn't over or under or mis or proper or anything
else, other than what a particular institution created by us at one moment
in time determines it is. If we lived in a society in which mob rule settled
issues of justice, it would make little sense to argue that someone the mob
hung was "not guilty." Of course he was guilty, because the mob hung him!!
Paul Williams
paul_williams@ncsu.edu
(919)515-4436
Bob Jensen's threads on the economic crisis are at
http://faculty.trinity.edu/rjensen/2008Bailout.htm
Question
How do you compute the cost of capital when lenders pay you interest to
borrow their money?
Alan Blinder recommends that the Fed commence to pay FDIC banks to borrow money
from the Federal Reserve. This in turn means that banks my profit from paying
AAA creditors to borrow money from the bank.
"Cost of Capital Measure Sees Distortions," by Emily Chason, CFO
Report via The Wall Street Journal, July 25, 2012 ---
http://blogs.wsj.com/cfo/2012/07/25/cost-of-capital-measure-sees-distortions/?mod=wsjpro_hps_cforeport
The standard weighted average cost of capital
calculation, long-used by finance departments for budgeting analysis, has
been a bit distorted lately as low interest rates, record-low corporate
borrowing costs and a volatile stock market have changed many of the basic
inputs companies put into the measure.
WACC, which is based on a company’s cost of equity
and debt, corporate tax rate and market value of equity and debt, is used as
a hurdle rate to value corporate investments. The consequence of using a
distorted measure can be expensive, and some analysts say companies may want
to start thinking more broadly about revising their expected return
assumptions in the WACC number.
Continued in article
Bob Jensen's threads on ROI and Cost of Capital ---
http://faculty.trinity.edu/rjensen/roi.htm
Equity Valuation for the Real World Versus the Fantasyland of Accountics
Researchers and Teachers in Academe
Equity Valuation
TAR book reviews are free online. I found the September 2010 reviews quite
interesting, especially Professor Zhang's review of
PETER O. CHRISTENSEN and GERALD A. FELTHAM,
Equity Valuation, Hanover,
MA:Foundations and Trends® in Accounting, 2009,
ISBN 978-1-60198-272-8 ---
Click Here
This book is an advanced accountics research book
and the reviewer leaves many doubts about the theory and practicality of
adjusting for risk by adjusting the discount rate in equity valuation. The
models are analytical mathematical models subject to the usual limitations of
assumed equilibrium conditions that are often not applicable to the changing
dynamics of the real world.
The authors develop an equilibrium asset-pricing
model with risk adjustments depending on the time-series properties of cash
flows and the accounting policy. They show that operating characters such as
the growth and persistence of earnings can affect the risk adjustment.
What are the highlights of this book? The book
contains five chapters and three appendices. Chapters 2 to 5 each contain
separate yet closely related topics. Chapter 2 reviews and identifies
problems with the implementation of the classical model. In Chapters 3 to 5,
the authors develop an accounting-based, multi-period asset-pricing model
with HARA utility. My preferences are Chapters 2 and 5. Chapter 2 contains a
critical review of the classical valuation approach with a constant
risk-adjusted discount rate. As noted above, the authors highlight several
problems in estimating these models. Many of these issues are not properly
acknowledged and/or dealt with in many of the textbooks. The authors provide
a nice step-by-step analysis of the problems and possible solutions.
Chapter 5 contains the punch line. The authors push
ahead with the idea of adjusting risk in the numerator, and deal with the
thorny issue of identifying and simplifying the so-called “pricing kernel.”
Although the final model involves a rather simplifying assumption of a
simple VAR model of the stochastic processes of residual income and for the
consumption index, it provides striking and promising ideas of how to
estimate and adjust for risk based on fundamentals, as opposed to stock
return. It provides a nice illustration of how to incorporate time-change
risk characteristics of firms with the change in firms’ operations captured
by the change in residual income. This is very encouraging.
There are some unsettling issues in this book. Not
surprisingly, I find the authors’ review of the classical valuation approach
to be somewhat tilted toward the negative side. For instance, many of the
problems cited arise from the practice of estimating a single, constant
risk-adjusted discount rate for all future periods. This seems to be based
on the assumption that firms’ risk characteristics do not change materially
over future periods. Of course, this is a grossly simplified approach in
dealing with the issues of time-changing interest rates and inflation. To
me, errors introduced by such an approach reflect more the shortcomings in
the empirical or practical implementation, rather than the shortcomings in
the valuation approach per se. As noted by the authors, using date-specific
discount rates can avoid many of the problems. After all, under most
circumstances in a neo-classical framework, putting the risk adjustment in
the numerator or in the denominator may simply be an easy mathematical
transformation. In some cases, of course, adjusting risk in the denominator
does not lead to any solution to the problem. In that sense, adjusting in
the numerator is more flexible.
After finishing the book, I asked myself the
following question: Am I convinced that the practice of adjusting risk in
the discount rate should be abolished? The answer seems unclear, for a
couple of reasons. First, despite the authors’ admirable effort in bringing
context to it, the concept of “consumption index” still seems rather
elusive. As a result, it lacks the appeal of the traditional CAPM, namely, a
clear and intuitive idea of risk adjustment.
Professor Zhang seems to favor CAPM risk adjustment without delving
into the many controversies of using CAPM for risk adjustment in the real world
---
http://faculty.trinity.edu/rjensen/theory01.htm#AccentuateTheObvious
It would be interesting to see how these sophisticated analytical models are
really used by real-world equity valuation analysts.
Update on April 12, 2012
Leading Accountics researchers like Bill Beaver and Steve Penman have a hard
time owning up to CAPM's discovered limitations that trace back to their own
research built on CAPM. Steve Penman owns up to this somewhat in his own latest
book Accounting for Value that seems to run counter to his earlier
book Financial Statement Analysis and Security Valuation.
Bill Beaver's review of Accounting for Value makes an
interesting proposition:
Since Accounting for Value admits to limitations of CAPM and lack of
capital market efficiency it should be of interest to investors, security
analysts, and practicing accountants consulting on valuation. However, Penman's
Accounting for Value is not of much interest to accounting professors and
students who, at least according to Bill, should continue to dance in the
fantasyland of assumed efficient markets and relevance of CAPM in accountics
research.
Accounting for Value
by Stephan Penman
(New York, NY: Columbia Business School Publishing, 2011, ISBN
978-0-231-15118-4, pp. xviii, 244).
Reviewed by William H. Beaver
The Accounting Review, March 2012, pp. 706-709
http://aaajournals.org/doi/full/10.2308/accr-10208
Jensen Note: Since TAR book reviews are free to the public, I quoted
Bill's entire review
When I was asked by Steve Zeff to review Accounting
for Value, my initial reaction was that I was not sure I was the
appropriate reviewer, given my priors on market efficiency. As I shall
discuss below, a central premise of the book is that there are substantial
inefficiencies in the pricing of common stock securities with respect to
published financial statement information. At one point, the book suggests
that most, if not all, of the motivation for reading the book disappears if
one believes that markets are efficient with respect to financial statement
information (page 3). I disagree with this statement and found the book
to be of value even if one assumes market efficiency is a reasonable
approximation of the behavior of security prices.
It is unclear who is the intended audience—academic
or nonacademic. This is an important issue, because it determines the basis
against which the book should be judged. For an academic audience, the book
would be good as a supplemental text for an investments or financial
statement analysis course. However, for an academic audience, it is
not a replacement for his previous, impressive text, Financial
Statement Analysis and Security Valuation (2009). The earlier text goes into
much more detail, both in terms of how to proceed and what the evidence or
research basis is for the security valuation proposed. The previous book is
excellent as the prime source for a course, and the current effort is not a
substitute for the earlier text.
However, as clearly stated, the primary audience is
not academic and is certainly not the passive investor. The book was written
for investors, and for those to whom they trust their savings (page 1).
Moreover, as stated on pages 3–4, the intended audience is the investor who
is skeptical of the efficient market, who is one of Graham's “defensive
investors,” who thinks they can beat the market, and who perceives they can
gain by trading at “irrational” prices.1 For this reason, the book can be
compared with the plethora of “how to beat the market” books that fill the
“Investments” section of most popular bookstores. By this standard,
Accounting for Value is well above the competition. It is much more
conceptually based and includes references to the research that underlies
the basic philosophy. By this standard, the book is a clear winner.
Another standard is to judge the effort, not by the
average quality of the competition, but by one of the best, Benjamin
Graham's The Intelligent Investor (1949). This, indeed, is a high standard.
The Intelligent Investor is the text I was assigned in my first investments
course. My son is currently in an M.B.A. program, taking an investments
course, so for his birthday I gave him a copy of Graham's book. However,
markets and our knowledge of how markets work have changed enormously since
Graham's book was written.
The comparison with The Intelligent Investor is
natural in part because the text itself explicitly invites such comparisons
with the many references to Graham and by suggesting that it follows the
heritage of Graham's book. It also invites comparisons because, like
Graham's book, it is essentially about investing based on fundamentals and
tackles the subject at a conceptual level with simple examples, without
getting bogged down in extreme details of a “how to” book. I conclude that
Accounting for Value measures up very well against this high standard and is
one of the best efforts written on fundamental investing that incorporates
what we have learned in the intervening years since the first publication of
The Intelligent Investor in 1949. I have reached this conclusion for several
reasons.
One of the major points eloquently made is that
modern finance theory (e.g., CAPM and option pricing models) consists of
models of the relationship among endogenous variables (prices or returns).
These models derive certain relative relationships among securities traded
in a market that must be preserved in order to avoid arbitrage
opportunities. However, as the text points out, these models are devoid of
what exogenous informational variables (i.e., fundamentals) cause the model
parameters to be what they are. For example, in the context of the CAPM,
beta is a driving force that produces differential expected returns among
securities. However, the CAPM is silent on what fundamental variables would
cause one company's beta to be different from another's. One of major themes
developed in the text is that accounting data can be viewed as a primary set
of variables through which one can gain an understanding of the underlying
fundamentals of the value of a firm and its securities.2 This is extremely
important to understand, regardless of one's priors about market efficiency.
A central issue is the identification of informational variables that aid in
our understanding of security prices and returns. As accounting scholars, we
have an interest in the “macro” (or equilibrium) role of accounting data
beyond or independent of the “micro” role of determining whether it is
helpful to an individual in identifying “mispriced” securities.
Another major contribution is the development of a
valuation model of fundamentals through the lens of accounting data based on
accrual accounting. In doing so, the text makes another important
point—namely the role of accrual accounting in bringing the future forward
into the present (e.g., revenue recognition).3 In other words, accrual
accounting contains implicit (or explicit) predictions of the future. It is
argued that, since the future is difficult to predict, accrual accounting
permits the investor to make judgments over a shorter time horizon and to
base those judgments on “what we know.” The text develops the position that,
in general, forecasts and hence valuation analysis based on accrual
accounting numbers will be “better” than cash flow-based valuations. It is
important to understand that the predictive role is a basic feature of
accrual accounting, even if one disagrees about how well accrual accounting
performs that role. Penman believes it performs that function very well and
dominates explicit future cash flow prediction, based on the intuitive
assumption that the investor does not have to forecast accrual accounting
numbers as far into the future as would be required by cash flow
forecasting. The implicit assumption is that the prediction embedded in
accrual numbers is at least as good, if not better, than attempts to
forecast future cash flows explicitly.
A third major point is that book-value-only or
earnings-only models are inherently underspecified and fundamentally
incomplete, except in special cases. Instead, a more complete valuation
approach contains both a book value and a (residual) earnings term. A point
effectively made is that measurement of one term can be compensated for by
the inclusion of the other variable by virtue of the over-time compensating
mechanism of accrual accounting.
A major implication of the model is the myopic
nature of two of the most popular methods for selecting securities:
market-to-book ratios and price-to-earnings ratios. Stocks may appear to be
over- or underpriced when partitioning on only one these two variables.
Using a double partitioning can help alleviate this myopia.
The book is positioned almost exclusively from the
perspective of the purchaser of securities. For example, one of the ten
principles of fundamental analysis (page 6) is “Beware of paying too much
for growth.” Presumably, a fundamental investor of an existing portfolio is
a potential seller as well as a buyer. As a potential seller, the investor
has an analogous interest in selling overpriced securities, but this is not
the perspective explicitly taken. In spite of the apparent asymmetry of
perspective, the concepts of the valuation model would appear to have
important implications for the evaluation of existing securities held.
In the basic valuation model, value is equal to
current book value, residual earnings for the next two years, and a terminal
value term based on the present value of residual earnings stream beyond two
years.4 The model bears some resemblance to the modeling of Feltham and
Ohlson (1995) but adds context of its own. A central feature of the approach
is to understand what you know and separate it from speculation.5 In this
context, book value is “what you know,” and everything else involves some
degree of speculation. The degree of speculation increases as the time
horizon increases (e.g., long-term growth estimates).
A key feature is that it is residual earnings
growth, not simply earnings growth, that is the driver in valuation.
Price-earnings-only models are incomplete because of a failure to make this
distinction. The nature of the long-term residual earnings growth is highly
speculative, which leads to one of the investment principles—beware of
paying too much for growth. The text provides some benchmarks in terms of
the empirical behavior of long-term residual growth rates and reasons why
abnormal earnings might be expected to decay rapidly. A higher expected
residual growth is also likely to be associated with higher risk and hence a
higher discount rate. All of these factors mitigate against long-term growth
playing a large role in the fundamental value (i.e., do not pay too much for
growth). A similar point is made with respect to the effect of leverage upon
growth rates (Chapter 4).
A remarkable feature of the book is how far it is
able to develop its basic perspective without specifying the nature of the
accounting system upon which it is anchoring valuation other than to say
that it is based on accrual accounting. Chapter 5 begins to address the
nature of the accrual accounting system. A central point is that accounting
treatments that lower current book value (e.g., write-offs and the expensing
of intangible assets) will increase future residual earnings (Accounting
Principle 4). In particular, conservative accounting with investment growth
induces growth in residual income (Accounting Principle 5). However,
conservatism does not increase value. Hence, valuations that focus only on
earnings to the exclusion of book value can lead to erroneous valuation
conclusions. An investor must consider both (Valuation Principle 6).
Chapter 6 addresses the estimation of the discount
rate. A central theme is how little we know about estimating the discount
rate (cost of capital), and we can provide, at best, very imprecise
estimates. The proposed solution is to “reverse engineer” the discount rate
implied by the current market price and ask yourself if you consider this to
be a rate of return at which you are willing to invest, which is viewed as a
personal attribute. Several examples and sensitivity analyses are provided.
Chapter 7 synthesizes points made in earlier
chapters about how the investor can gain insights into distinguishing growth
that does not add to value from growth that does, through a joint analysis
of market-to-book and price-to-earnings partitions. The joint analysis is
clever and is likely to be informative to an investor familiar with these
popular partitioning variables, but is perhaps not yet ready to use the
explicit accounting-based valuation models recommended.
Chapter 8 addresses the attributes of fair value
and historical cost accounting and is the chapter that is the most
surprising. The chapter is essentially an attack on fair value accounting.
Up until this point, the text has been free of policy recommendations. The
strength lies in taking the accounting rules as you find them, which is a
very practical suggestion and has great potential readership appeal. The
flexibility of the framework to accommodate a variety of accounting systems
is one of its strengths. As a result, the conceptual framework is relatively
simple. It does not attempt to tediously examine accounting standards in
detail, nor does it attempt to adjust accounting earnings or assets to
conform to a concept of “better” earnings or assets, in contrast to other
valuation approaches. I found the one-sided treatment of fair value
accounting to be disruptive of the overall theme of taking accounting rules
as you find them.
The text provides an important caveat. The
framework is a starting point rather than the final answer. A number of
issues are not explicitly addressed. It can also be important to understand
the specific effects of complex accounting standards on the numbers they
produce. Further, there is ample evidence that the market does price
disclosures supplemental to the accounting numbers. Discretionary use of
accounting numbers also can raise a number of important issues.
In sum, the text provides an excellent framework
for investors to think about the role that accounting numbers can play in
valuation. In doing so, it provides a number of important insights that make
it worthwhile for a wide readership, including those who may have stronger
priors in favor of market efficiency.
"AOL and the Case Against Efficient Market Theory," by Roben Farzad,
Business Week, April 11, 2012 ---
http://www.businessweek.com/articles/2012-04-11/aol-and-the-case-against-efficient-market-theory
This time last week, I, like nine out of
every 10 investors, believed
AOL (AOL)
was a dead-end investment. How could it not be? This is no longer a
56k,
dial-up world, when those ubiquitous AOL disks
inundated mailboxes. AOL botched the chance to morph into a broadband player
with its
spectacularly bad marriage to
Time Warner (TWX).
AOL is behind on social media, and is struggling to
compete for ad dollars with
Google (GOOG)
and Facebook. Its sales declined in each quarter last year.
How many chances does a legacy company get?
(Remember
this reinvention?)
Then, on April 9, as if out of nowhere,
Microsoft (MSFT)dropped
in to buy $1 billion of AOL’s patents, sending the
latter’s shares up 43 percent in a single day. In the two years leading up
to the deal, the stock was down 37 percent.
How could a supposedly omniscient market get this
story so wrong? One explanation was offered by MDB, an intellectual
property-focused investment bank. MDB says the AOL patents had more
relevance to Microsoft and that company was uniquely well-studied on them,
especially in light of AOL’s ancient acquisition of Netscape, that Microsoft
nemesis in the age of Windows 95. MDB
found that Microsoft cited AOL patents as related
intellectual property 1,331 times in its own patent filings, vs. AOL citing
its own patents 1,267 times.
Even so, it’s surprising that this play remained
largely the province of tech-geek attorneys. After all, about 15 Wall Street
analysts cover AOL—nine of them rating it either a hold or sell. Hedge funds
and bloggers are constantly on it. The Microsoft deal shot AOL shares up two
and a half times where they traded in August, when the company owned the
same patents.
I was similarly puzzled last summer when Google
paid big (63 percent-premium-to-close big) for
remnants of Motorola—placing major emphasis on the legacy tech company’s
patents. Motorola
Mobility (MMI)
shares popped 57 percent in a matter of hours. I also
scratched my head in September 2010, when
Hewlett-Packard (HPQ)emerged
victorious from a bidding war for a tiny data
storage company called 3Par—by paying $33 a share for a stock that traded
below $10 just three weeks earlier. How did everyone completely whiff on
3Par’s desirability and valuation?
These disconnects have me thinking back to the
words of my friend, Justin Fox of the Harvard Business Review Group, whose
book
The Myth of the Rational Market excoriated
the idea that “the decisions of millions of investors, all digging for
information and striving for an edge, inevitably add up to rational, perfect
markets.”
Continued in article
Bob Jensen's threads on valuation are at
http://faculty.trinity.edu/rjensen/roi.htm
Bob Jensen's critical threads on the Efficient Market Hypothesis (EMH) are
at
http://faculty.trinity.edu/rjensen/theory01.htm#EMH
Innovative Corporate Performance Management: Five Key Principles to
Accelerate Results
by Bob Paladino
ISBN: 978-0-470-62773-0 Hardcover 415 pages November 2010|
Amazon has it priced for under $37 new and $23 used
http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470627735.html
Jensen Comment
This is a bit too much Harvard Business School-like for me, but it does cover
much of what we teach in managerial accounting.
There seem to be a dearth of reviews of this book. I don't know why?
April 19, 2011 reply from Jim Martin
Performance management seems to be a relatively new catch-all term like
cost management, activity-based management etc. I have been following this
concept, or catch-all term for a while. I suspect most of the book can be
found in Paladino's earlier and most recent works mainly in Strategic
Finance.
Paladino, B. 2007. Five Key Principles of Corporate Performance
Management. John Wiley and Sons.
Paladino, B. 2007. Five key principles of corporate performance
management. Strategic Finance (June): 39-45.
Paladino, B. 2007. Five key principles of corporate performance
management. Strategic Finance (July): 33-41.
Paladino, B. 2007. Five key principles of corporate performance
management. Strategic Finance (August): 39-45.
Paladino, B. 2008. Strategically managing risk in today's perilous
markets. Strategic Finance (November): 26-33.
Paladino, B. 2010. Innovative Corporate Performance Management: Five Key
Principles to Accelerate Results. John Wiley and Sons.
Paladino, B. 2011. Achieving innovative corporate performance management.
Strategic Finance (March): 43-51.
Paladino, B. 2011. Achieving innovative corporate performance management.
Strategic Finance (April): 43-53.
Google App Enhances Museum Visits; Launched at the Getty ---
Click Here
http://www.openculture.com/2011/06/google_app_getty.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+OpenCulture+%28Open+Culture%29
Earlier this year, Google rolled out “Art
Project,” a tool that lets you access 1,000 works of art appearing in 17
great museums across the world, from the Met
in New York City to the Uffizi
Gallery in Florence. (More
on that here.) Now, as part of a broader effort to put art in your
hands, the company has produced a new smartphone
app (available in Android and iPhone) that enriches the museum-going
experience, and it’s being demoed at the
Getty Museum in Los Angeles.
The concept is pretty simple. You’re wandering through the Getty. You
spot a painting that deeply touches you. To find out more about it, you open
the
Google Goggles app on your phone, snap a photo, and instantly download
commentary from artists, curators, and conservators, or even a small image
of the work itself.
Sample this, and you’ll see what we mean. And, for more on the story,
turn to Jori Finkel, the ace arts reporter for the LA Times.
Related Content:
Art in “Augmented Reality” at The Getty Museum
A Virtual Tour of the Sistine Chapel
MoMA Puts Pollock, Rothko & de Kooning on Your iPad
Jensen Comment
The concept is pretty simple. You’re wandering through the annual report
of Bank of America. You spot a reference to hedging of interest rates with
swaps that confuses you. To find out more about it, you open
the
Google Goggles app on your phone, find a reference to interest rate
swaps, and instantly download commentary interest rate hedging strategies
and accounting with comparisons of accounting under IFRS versus FAS 133. The
link might elaborate in detail on the very portion of the Bank of America
annual report that you are examining.
Question
What do financial analysts do on the backs of envelopes and does it really
matter to them whether we have IFRS-FASB convergence or fair value accounting?
Hulu (streaming video) ---
http://en.wikipedia.org/wiki/Hulu
"Hulu Wants To IPO At A $2 Billion Valuation," by Jay Yarow, Business
Insider, August 16, 2010 ---
http://www.businessinsider.com/hulu-ipo-2010-8
http://www.businessinsider.com/hulu-ceo-talks-ipo--here-are-the-financials-2010-7
Read more:
http://www.nytimes.com/2010/08/16/technology/16hulu.html?_r=2&dbk
This illustrates how difficult it is to teach, let alone do accountics,
research given the unknowns about impacts of variations in methodology. How do
professors who teach from a few of their chosen studies prepare students about
the simplifications inherent in any one model?
It would seem that students have to be pretty sophisticated to understand the
limitations of the accountics harvests.
"The Cross-Section of Expected Stock Returns: What Have We Learnt from the
Past Twenty-Five Years of Research," by Avanidhar Subrahmanyam University of
California, Los Angeles - Finance Area, European Financial Management,
Forthcoming
Abstract:
I review the recent literature on cross-sectional predictors of stock
returns. Predictive variables used emanate from informal arguments,
alternative tests of risk-return models, behavioral biases, and frictions.
More than fifty variables have been used to predict returns. The overall
picture, however, remains murky, because more needs to be done to consider
the correlational structure amongst the variables, use a comprehensive set
of controls, and discern whether the results survive simple variations in
methodology.
From Jim Mahar's blog on November 13. 2009 ---
http://financeprofessorblog.blogspot.com/
VERY good review article on the ability of
financial models (CAPM, APT, Fama-French, etc) to predict and explain cross
sectional stock returns).
Super short version: While we have progressed, we
have done so down different paths and there needs to be some
standardization, testing for robustness, and checks for correlations across
the many variables that have been used in past models.
From Introduction:
"The predictive variables are motivated principally
in one of four ways. These are: • Informal Wall Street wisdom (such as
“value-investing”) • Theoretical motivation based on risk-return (RR) model
variants • Behavioral biases or misreaction by cognitively challenged
investors • Frictions such as illiquidity or arbitrage constraints"
AN ABSOLUTE MUST FOR CLASSES.
From the Wall Street Journal
Accounting Weekly Review on May 5, 2016
The
Hottest Metric in Finance: ROIC
by:
David Benoit
May 04, 2016
Click here to view the full article on WSJ.com
TOPICS: Financial
Accounting, Financial Statement Analysis, ROIC
SUMMARY: ROIC
is all the rage. The popularity of return on invested capital is evidence of
the influence activists have come to wield in boardrooms. For ROIC lovers,
which also include traditional stock pickers, the measure is the best way to
distill what activists view as the most critical skill of management: how
they allocate capital. The typical ROIC equation divides a company's
operating income, adjusted for its tax rate, by total debt plus shareholder
equity minus cash. It aims to show how much new cash is generated from
capital investments.
CLASSROOM
APPLICATION: This
is an excellent article to use when covering ROIC in financial accounting
and financial statement analysis classes.
QUESTIONS:
1. (Introductory) What is ROIC? What is its definition of this term?
2. (Advanced) How can ROIC be used by corporations? How can it be
used by investors and other outside parties?
3. (Advanced) What is an activist? The article reported that the use
of ROIC placated activists. What does that mean? How were they placated? Why
didn't other financial information placate them? What does ROIC show to
activists?
4. (Advanced) Why do some parties love ROIC? What are some of the
issues or potential problems associated with ROIC?
5. (Advanced) Should management of companies be focused on ROIC? What
are some problems that could result if management focuses on ROIC?
Reviewed By: Linda Christiansen, Indiana University Southeast
"The Hottest Metric
in Finance: ROIC," by David Beno, The Wall Street Journal, May 4, 2016 ---
http://www.wsj.com/articles/the-hottest-metric-in-finance-roic-1462267809?mod=djem_jiewr_AC_domainid
Last year, General Motors Co. fended off a group of
activist investors with the help of an esoteric financial metric to which it
had previously paid little heed.
The century-old auto maker began publicly touting
the statistic, known as return on invested capital, or ROIC. It tied
compensation to a 20% target and said that above a $20 billion cushion, cash
it couldn’t earn that return on would be handed back to shareholders.
The steps placated the activists.
GM’s move underscores that, as much as a financial
metric can be, ROIC is all the rage.
The popularity of the figure is also more evidence
of the influence activists have come to wield in boardrooms. For ROIC
lovers, which also include traditional stock pickers, the measure is the
best way to distill what activists view as the most critical skill of
management: how they allocate capital.
The typical ROIC equation divides a
company’s operating income, adjusted for its tax rate, by total debt plus
shareholder equity minus cash. It aims to show how much new cash is
generated from capital investments.
For example, at GM, over the four quarters ended in
March, adjusted operating earnings were $11.4 billion, up from $8.1 billion
a year earlier. The denominator shrank as GM reduced, partly via buybacks,
its equity, even though debt went up. ROIC rose to 28.5% from 19.5%, showing
it was earning more with less.
“ROIC provides the clearest picture of how we are
managing our capital and our business,” said GM Chief Financial Officer
Chuck Stevens. “It’s really starting to become part of the DNA of our
decisions.”
Continued in article
Jensen Comment
The EIBTDA is a misleading ratio with trumped by earnings ratios more popular
with investors such as P/E ratios and e.p.s. trends
"The Relative and Incremental Explanatory Power of Earnings and
Alternative (to Earnings) Performance Measures for Returns"
by Jennifer Francis, Katherine Schipper, and Linda Vincent
Contemporary Accounting Research
Volume 20, Issue 1, pages 121–164, Spring 2003
Abstract
We analyze the ability of earnings and non-earnings performance metrics to
explain the variability in annual stock returns for industries where we
identify, ex ante, an allegedly preferred (for valuation purposes) summary
performance metric. We identify three industries where earnings before
interest, taxes, depreciation, and amortization (EBITDA) and cash from
operations (CFO) are preferred, and three industries where specific non-GAAP
performance metrics are preferred. As a benchmark, we also examine the
ability of EBITDA and CFO to explain returns for seven industries for which
earnings is the preferred metric. Results for the
benchmark earnings industries show that earnings dominates EBITDA and CFO in
explaining returns. All other results are inconsistent with the
view that perceptions of preferred metrics are reflected in actual aggregate
investment behaviors.
WARNING USE OF EBITDA MAY BE DANGEROUS TO YOUR CAREER
by ALFRED M. KING
Strategic Finance
http://go.galegroup.com/ps/anonymous?id=GALE%7CA78355003&sid=googleScholar&v=2.1&it=r&linkaccess=fulltext&issn=1524833X&p=AONE&sw=w&authCount=1&isAnonymousEntry=true
Using EBITDA
(earnings before interest, taxes, depreciation, and amortization) in
financial analysis may be dangerous to your career prospects. It's one of
the most flawed concepts to be adopted by the financial community. Finance
professionals rightly focus on cash flows. Valuations are based on the
present value of future cash flows. Standard discounted cash flow valuation
techniques taught in all finance and MBA programs have stood the test of
time. They have served us well. Many investors and security analysts have
also focused on price/earnings (PIE) ratios. The assumption is that if
Company "A" is now earning $2.00 per share and the stock is $30.00, then the
15 PIE ratio can: 1) be compared to other stocks and 2) used to forecast
future stock prices. To use a P/E ratio for comparative purposes, assume
Company "A" is in the auto parts business. All its competitors are selling
at PIE ratios between 13 and 17. Thus you might reasonably conclude that the
stock is fairly priced on a current basis. Using a PIE ratio for forecasting
purposes is simple: If the stock is likely to earn $2.40 a share next year,
it would be expected to sell for about $36 a share (15 * 2.40 = 36),
assuming the PIE ratio holds constant. So, cash flow and price/earnings
analyses are two tools with which financial professionals are familiar. They
work. But now we have detected an intruder on our financial radar: The rapid
approach of EBITDA is closing fast on cash flow and price/earnings. It's
time to shoot the enemy out of the sky before we suffer another defeat. HOW
EBITDA IS BEING USED EBITDA is being used by security analysts because its
"answers" appear more attractive. For example, if a company has $4 million
of after-tax earnings and one million shares outstanding, the earnings per
share are $4. If the stock is in a popular field such as media, it might
sell today for a PIE of 35x earnings, or $140 per share. But substitute
EBITDA for earnings per share, and you could easily get $7 per share or $7
million overall. Then, using the same current price of the stock,...
Bob Jensen's Threads on Return on Business Valuation, Business
Combinations,
Investment (ROI), and Pro
Forma Financial Reporting ---
http://faculty.trinity.edu/rjensen/roi.htm
"The Relative and Incremental Explanatory Power of Earnings and
Alternative (to Earnings) Performance Measures for Returns"
by Jennifer Francis, Katherine Schipper, and Linda Vincent
Contemporary Accounting Research
Volume 20, Issue 1, pages 121–164, Spring 2003
Abstract
We analyze the ability of earnings and non-earnings performance metrics to
explain the variability in annual stock returns for industries where we
identify, ex ante, an allegedly preferred (for valuation purposes) summary
performance metric. We identify three industries where earnings before
interest, taxes, depreciation, and amortization (EBITDA) and cash from
operations (CFO) are preferred, and three industries where specific non-GAAP
performance metrics are preferred. As a benchmark, we also examine the
ability of EBITDA and CFO to explain returns for seven industries for which
earnings is the preferred metric. Results for the
benchmark earnings industries show that earnings dominates EBITDA and CFO in
explaining returns. All other results are inconsistent with the
view that perceptions of preferred metrics are reflected in actual aggregate
investment behaviors.
WARNING USE OF EBITDA MAY BE DANGEROUS TO YOUR CAREER
by ALFRED M. KING
Strategic Finance
http://go.galegroup.com/ps/anonymous?id=GALE%7CA78355003&sid=googleScholar&v=2.1&it=r&linkaccess=fulltext&issn=1524833X&p=AONE&sw=w&authCount=1&isAnonymousEntry=true
Using EBITDA
(earnings before interest, taxes, depreciation, and amortization) in
financial analysis may be dangerous to your career prospects. It's one of
the most flawed concepts to be adopted by the financial community. Finance
professionals rightly focus on cash flows. Valuations are based on the
present value of future cash flows. Standard discounted cash flow valuation
techniques taught in all finance and MBA programs have stood the test of
time. They have served us well. Many investors and security analysts have
also focused on price/earnings (PIE) ratios. The assumption is that if
Company "A" is now earning $2.00 per share and the stock is $30.00, then the
15 PIE ratio can: 1) be compared to other stocks and 2) used to forecast
future stock prices. To use a P/E ratio for comparative purposes, assume
Company "A" is in the auto parts business. All its competitors are selling
at PIE ratios between 13 and 17. Thus you might reasonably conclude that the
stock is fairly priced on a current basis. Using a PIE ratio for forecasting
purposes is simple: If the stock is likely to earn $2.40 a share next year,
it would be expected to sell for about $36 a share (15 * 2.40 = 36),
assuming the PIE ratio holds constant. So, cash flow and price/earnings
analyses are two tools with which financial professionals are familiar. They
work. But now we have detected an intruder on our financial radar: The rapid
approach of EBITDA is closing fast on cash flow and price/earnings. It's
time to shoot the enemy out of the sky before we suffer another defeat. HOW
EBITDA IS BEING USED EBITDA is being used by security analysts because its
"answers" appear more attractive. For example, if a company has $4 million
of after-tax earnings and one million shares outstanding, the earnings per
share are $4. If the stock is in a popular field such as media, it might
sell today for a PIE of 35x earnings, or $140 per share. But substitute
EBITDA for earnings per share, and you could easily get $7 per share or $7
million overall. Then, using the same current price of the stock,...
Teaching Case on Dividend Yield, Dividends, Financial Statement Analysis
From The Wall Street Journal Accounting Weekly Review on September 28,
2012
Payout Appreciation
by:
Matt Jarzemsky
Sep 18, 2012
Click here to view the full article on WSJ.com
TOPICS: Dividend Yield, Dividends, Financial Statement Analysis
SUMMARY: "Since 2006, Hasbro, maker of the Monopoly board game, has
tripled its dividend, increasing it annually except in 2009." Investors like
Mark Freeman, "chief investment officer of Westwood Holdings Group in
Dallas, are seeking companies that typically have rising earnings,
relatively low debt levels and large piles of cash. Mr. Freeman also looks
for companies whose dividends are low relative to their earnings, a sign
there is room for growth [at more than the rate of inflation]."
CLASSROOM APPLICATION: The article is useful to introduce the
financial ratios of dividend payout, dividend yield and free cash flow.
QUESTIONS:
1. (Introductory) Define dividend payout ratio and dividend yield.
2. (Advanced) Do these two ratios measure different things?
Explain.
3. (Advanced) According to Paul Stocking, co-manager of Columbia
Management's Dividend Opportunity fund, "we have seen the marketplace
chasing these high-dividend payers." What will that do to the dividend yield
and the dividend payout ratio? Explain your answer.
4. (Advanced) "Cisco Chief Financial Officer Frank Calderoni said
last month that the company will return more than half its annual free cash
flow to shareholders through dividends and share buybacks." Is the company's
dividend payout ratio therefore 50%? Explain your answer and include a
definition of free cash flow.
Reviewed By: Judy Beckman, University of Rhode Island
"Payout Appreciation," by Matt Jarzemsky, The Wall Street Journal, September
18, 2012 ---
http://professional.wsj.com/article/SB10000872396390443720204578002381992037280.html?mod=djem_jiewr_AC_domainid&mg=reno-wsj
Call them the new growth stocks.
After rushing into dividend stocks of all stripes
this year, some investors are homing in on a more select group: stocks of
companies that are likely to keep raising their dividends at a fast clip.
It is all part of the chase for better returns on
the heels of the Federal Reserve's announcement last week of another round
of bond buying aimed to keep interest rates at rock-bottom levels until the
economy improves. As yields on the 10-year Treasury wallow at near-record
lows and "junk"-bond yields also are sinking, investors are seeking anything
that offers some extra income. For months, that meant investors bought
shares of nearly any high-dividend-paying company, be it telecommunications
companies such as Verizon Communications Inc. VZ +0.37% and AT&T Inc., T
-0.24% energy producers such as Sempra Energy and tobacco company Altria
Group Inc. But now that has made many stocks too expensive, some
investors said.
Investors like Mark Freeman, chief investment
officer of Westwood Holdings Group in Dallas, are seeking companies that
typically have rising earnings, relatively low debt levels and large piles
of cash. Mr. Freeman also looks for companies whose dividends are low
relative to their earnings, a sign there is room for growth. Moreover, many
also said they target companies that appear to have a board that has shown a
willingness to keep increasing dividend payments.
"All I'm looking for is high-quality companies that
have some dividend yield and also the ability to grow that dividend at more
than the rate of inflation," said Mr. Freeman, who helps oversee $14 billion
across stocks and bonds. Mr. Freeman said he bought shares of PepsiCo Inc.,
which increased its payout 4.4% in May and 7.3% a year earlier, compared
with consumer-price inflation of about 1.7% annually.
A dividend yield measures how much cash an investor
gets for each dollar invested and is calculated by dividing the annual
dividend by the stock price. The higher the yield, the bigger the payout.
The lure of dividend-appreciation stocks is
reflected in indexes and exchange-traded funds. The Vanguard Dividend
Appreciation ETF is up 11% this year, compared with a gain of 8.5% for the
S&P High-Yield Dividend Aristocrats index.
"In the dividend-yield area, we're seeing
valuations that are looking pretty full to us," said Paul Stocking, who
co-manages Columbia Management's $4.5 billion Dividend Opportunity fund. "We
have been looking for more dividend growth, relative to stable,
high-dividend payouts, partly because of this move that we have seen in the
marketplace chasing these high-dividend payers."
To be sure, some strategists are cautioning clients
that focusing too much on dividends could mean missing out on larger
returns, said J.P. Morgan Funds global market strategist Joseph Tanious.
That is especially true if the Fed's bond-buying measures help drive up
prices of riskier assets such as growth stocks, some of which don't offer
dividends, he said.
Mr. Tanious is telling clients to balance their
portfolios with stocks tied to global growth.
Other investors keep piling into
dividend-appreciation stocks. Capital Advisors, a money-management firm in
Tulsa, Okla., with $1.1 billion under management, recently sold shares of
Verizon, which has a dividend yield of 4.6%. Instead, the firm bought shares
of Hasbro Inc. after the toy maker boosted its payout 20% this year. Hasbro,
which offers a 3.7% yield, has increased its dividend at a compound annual
rate of 15% for the past five years. Capital Advisors also added shares of
Gannett Co. in August after the newspaper publisher doubled its payout.
"It has become more of a stock picker's game, with
respect to finding good dividend plays," said Channing Smith, managing
director at Capital Advisors. He said opportunities to buy blue-chip stocks
with high dividends "have disappeared" over the past year as the valuation
of those shares has risen.
Through July, U.S. mutual funds focused on
dividend-paying stocks had drawn in $18.63 billion in net cash, while U.S.
stock funds have seen a net $29.42 billion in withdrawals, according to data
provider EPFR.
PNC Financial Services Group Inc.'s
asset-management group bought shares in Cisco Systems Inc. last year
partly because of the potential they saw for the company to raise its
dividend, said Bill Stone, chief investment strategist for the group, which
oversees $109 billion in assets.
The move paid off when the
telecommunications-equipment maker more than doubled the quarterly payout
last month, sparking a 9.6% jump in the company's stock price, the biggest
daily increase in a year.
Bob Jensen's threads on investment ratios ---
http://faculty.trinity.edu/rjensen/roi.htm
From The Wall Street Journal Accounting Weekly Review on October 26,
2012
Debt Fuels a Dividend Boom
by:
Tyan Dezember and Matt Wirz
Oct 19, 2012
Click here to view the full article on WSJ.com
TOPICS: Bonds, Debt, Dividends
SUMMARY: Leonard Green & Partners LP, Bain Capital LLC and Carlyle
Group LP are among the private-equity firms that are adding debt to the
companies they own in order to fund dividend payouts to themselves. This
controversial practice "rose to popularity before the financial crisis" and
this year has resurged to $65 billion. "Critics say the dividends, which are
disclosed in offering documents, saddle a company with debt, potentially
burdening its operations, while reducing owners' investment exposure." The
deals are known as "dividend recapitalizations" and are only possible
because some investors are looking for higher yields in this low interest
rate environment in the U.S.
CLASSROOM APPLICATION: The article may be used in covering
dividends or debt issuance in a financial accounting class.
QUESTIONS:
1. (Introductory) What types of companies are adding debt to their
balance sheets in order to fund dividend payments to shareholders? Who are
the shareholder recipients of these dividends?
2. (Advanced) What are the effects on a company's balance sheet
from undertaking such a transaction?
3. (Advanced) What financial statement ratio is used to support the
argument that "companies doing [these debt issuances to fund
dividends]...are in better financial shape than those that sold such deals
in the 2000s"? What comparison is made with this ratio in order to support
this argument?
4. (Introductory) As described in the article, what are the risks
of taking on such transactions?
5. (Advanced) One company's chief executive is quoted as saying
that he is "pleased to have generated this early return for shareholders."
Why do you think he feels this way?
Reviewed By: Judy Beckman, University of Rhode Island
"Debt Fuels a Dividend Boom," by: Tyan Dezember and Matt Wirz, The
Wall Street Journal, October 19, 2012 ---
http://professional.wsj.com/article/SB10000872396390444592704578064672995070116.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj
Private-equity firms are adding debt to the
companies they own in order to fund payouts to themselves, a controversial
practice now reaching a record pace.
Leonard Green & Partners LP, Bain Capital LLC and
Carlyle Group LP CG -0.39% are among the firms using the tactic, which rose
in popularity before the financial crisis.
In these deals, known as "dividend
recapitalizations," private-equity-owned companies raise cash by issuing
debt. The proceeds are distributed in the form of dividends to buyout
groups.
The resurgence has been helped by investors'
appetite for high-yielding debt at a time of historically low interest
rates.
Debt issued to fund private-equity dividends has
topped $54 billion this year, after a flurry of deals earlier this month,
according to Standard & Poor's Capital IQ LCD data service. That is already
higher than the record $40.5 billion reached in all of 2010, when credit
markets reopened after the crisis.
For private-equity investors, the deals produce
payouts amid a slow market for initial public offerings and acquisitions.
"It's hard to be anything but happy" about the dividend boom, said Erik
Hirsch, chief investment officer for Hamilton Lane, a Philadelphia firm that
manages more than $163 billion in private-equity investments.
Likewise, many debt investors are happy to collect
yields as high as 10%.
Critics say the dividends, which are disclosed in
offering documents, saddle a company with debt, potentially burdening its
operations, while reducing a private-equity firm's investment exposure.
Also some of these deals involve a risky type of
debt known as "payment in kind toggle"—or PIK-toggle—bonds that give
companies the choice to defer interest payments to investors. Instead, they
could opt to add more debt to the balance sheet. The default rate for
companies that sold PIK-toggle bonds was 13% from 2006 to 2010, twice the
default rate for comparably rated companies that didn't use the bonds,
according to a study by Moody's Investors Service.
Six companies have sold PIK-toggle bonds to pay
private-equity dividends in September and October, double the number sold in
the previous 14 months.
"The market is simply letting its guard down at the
expense of getting some incremental yield," said Sandy Rufenacht, chief
investment officer of $1.3 billion high-yield asset manager Three Peaks
Capital. He said he is selling bonds he owns in companies that issue new PIK-toggle
bonds.
Despite concerns, the PIK-toggle deals are
generally finding a welcome reception among investors, because the
securities can yield more than standard junk bonds, which traded at
record-low rates in September.
One attraction for dividend recapitalizations
broadly is that some companies doing them these days are in better financial
shape than those that sold such deals in the 2000s. Debt of companies that
sold bonds to pay dividends this year averaged 4.21 times earnings, compared
with 5.36 times at the height of the last credit bubble in 2007, according
to Standard & Poor's.
Another driver of the trend, some say, is
private-equity investors' desire to reap dividends before the potential
increase in taxes on the proceeds next year.
Last week, drug developer Pharmaceutical Product
Development LLC, which is owned by Carlyle and Hellman & Friedman, sold $525
million of PIK-toggle bonds, with the proceeds going toward a roughly
$600-million dividend for the private-equity firms. To pay the full
dividend, the company is also contributing about a third of the cash on its
balance sheet.
The private-equity firms bought the company in
December for $3.9 billion. Nearly half of the purchase was funded by cash
and the rest by debt on the company's balance sheet.
Within days of the dividend recapitalization,
Jessica Gladstone, a senior analyst with Moody's, lowered the company's
credit rating by one notch to single-B and graded the new bonds triple-C,
the lowest junk rating. Such deals are "very reminiscent of the bubble era,"
she said.
A Carlyle spokesman said the private-equity firms
put more cash into the buyout than they would have normally because credit
markets then were more stressed. With markets improved, he said, the firms
are adjusting the debt load to a level more typical in leveraged buyouts.
Also, he said, the company can handle the debt.
In response to demand for the bonds, priced at
9.875%, the company boosted the size of its offering by 5%.
Continued in article
Teaching Case from The Wall Street Journal Weekly Accounting Review on
February 15, 2013
Apple Cash Pile Sets Off a Battle
by:
Jessica Lessin, Telis Demos, and David Benoit
Feb 08, 2013
Click here to view the full article on WSJ.com
TOPICS: Accounting, Cash, Cash Management, Financial Accounting,
Financial Ratios, Financial Statement Analysis, Preferred Stock
SUMMARY: For nearly 18 months, Tim Cook, CEO of Apple, has kept a
stream of new products rolling, produced a string of robust quarterly
results and introduced a dividend and stock buyback expected to cost $45
billion over three years. But an attack from one of Apple's prominent
investors underscores how that approach may not be enough anymore,
especially amid intensifying industry competition and the company's slowing
growth.
CLASSROOM APPLICATION: The article should be a great one to catch
our students' attention because it involves Apple. Whether someone loves
Apple or hates it, one must admit that the company is interesting from a
financial standpoint. You can use this article in a discussion about cash
management, and it would be excellent for financial statement analysis.
QUESTIONS:
1. (Introductory) What are the facts of David Einhorn's lawsuit
against Apple? What are his demands? Is he in a position to make demands of
Apple?
2. (Advanced) How would each of Apple's financial statements appear
under Mr. Einhorn's plan versus Mr. Cook's plan? How do the financial
statements differ? Draft the journal entries (just the accounts, no dollar
amounts) for the various aspects of each of the plans.
3. (Advanced) What is the history of the price of Apple's shares?
What are the reasons for these stock price changes? How many of the reasons
are related directly to financial statement information rather than other
factors?
4. (Advanced) What is the purpose of preferred stock? How does it
differ from common stock? When is preferred stock an appropriate vehicle for
a company?
5. (Advanced) Why is it good for a company to have a large amount
of cash? What are the possible problems with having large amounts of cash?
Why has Apple accumulated so much cash? Is this common among businesses or
is it an unusual position?
SMALL GROUP ASSIGNMENT:
Research Apple's financial statements for the past five years. Prepare a
complete set of financial ratios and analyze. Compare over five years,
studying trends. What is interesting about the company's financial
situation? Is Mr. Einhorn justified in his position? Or is he misguided?
Please offer support for your answer.
Reviewed By: Linda Christiansen, Indiana University Southeast
RELATED ARTICLES:
Apple's Cash Conundrum: Pay Tax or Borrow?
by Steven Russolillo
Feb 11, 2013
Online Exclusive
Einhorn Squeezes Apple for Its Cash
by Telis Demos
Feb 12, 2013
Page: B1
Apple Defends Position on Cash
by Jessica Lessin and Thomas Gryta
Mar 13, 2013
Online Exclusive
"Apple Cash Pile Sets Off a Battle," by Jessica Lessin, Telis Demos, and
David Benoit, The Wall Street Journal, February 8, 2013 ---
http://professional.wsj.com/article/SB10001424127887324590904578290440984350234.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj
Apple Inc. AAPL -0.09% Chief Executive Tim Cook is
facing a new reality: delivering steady results from one of the world's most
valuable companies is no longer good enough.
For nearly 18 months, Mr. Cook has kept a stream of
new products rolling, produced a string of robust quarterly results and
introduced a dividend and stock buyback expected to cost $45 billion over
three years.
But an attack from one of Apple's prominent
investors underscores how that approach may not be enough anymore,
especially amid intensifying industry competition and the company's slowing
growth.
On Thursday, hedge fund manager David Einhorn sued
Apple in a New York federal court in an effort to block an Apple shareholder
proposal that he argues could limit how the company could return some of its
$137 billion cash pile to investors. Apple is proposing to require a
shareholder vote before it can issue preferred stock, a kind of security
that Mr. Einhorn is urging the company to adopt. Apple's board already has
the right to issue such shares, but said in a filing it doesn't intend to do
so.
The proposal comes to a vote at Apple's annual
shareholder meeting on Feb. 27.
Mr. Einhorn, whose firm Greenlight Capital Inc. and
its affiliates own about $610 million worth of Apple stock, argues that
Apple should distribute a "perpetual preferred" stock that could pay a
dividend yield of 4%. The shares would return cash to shareholders by paying
a bigger yield than Apple's regular shares, which currently carry a 2.3%
dividend yield, according to FactSet.
The preferred stock dividends would only require
Apple to pay out small amounts over time, rather than tapping its cash
reserves to spend a large sum at once in the form of a special dividend or
stock buyback.
"It's a unique solution to a problem that's been
intractable—how does Apple reward its shareholders?" Mr. Einhorn said in an
interview. "This idea allows them to keep their cash and yet enables
shareholders to recognize value."
Apple later fired back in a statement Thursday,
asserting that passage of the proposed shareholder measure wouldn't prevent
Apple from issuing preferred stock in the future. Apple said it would
evaluate Greenlight's proposal to issue the security and that its management
team and board have been in "active" discussions about returning more cash
to shareholders.
Apple's statement didn't address the merits of
Greenlight's lawsuit, which argues that Apple is violating a securities rule
by bundling three items—including the preferred stock matter—under one
proposal.
The fracas encapsulates the growing investor unease
about Apple as the company stands at a growth crossroads.
When Mr. Cook took over as CEO in 2011, investors
widely believed he would be more receptive to distributing some of its cash,
something that his predecessor, Steve Jobs, had fiercely resisted. In March
2012, Mr. Cook announced Apple's first dividend since 1995 and a stock
buyback, and made a dividend payout last August.
But that hasn't appeased many shareholders as
Apple's historical growth streak has tempered amid signs that the company is
losing its competitive edge in smartphones to Samsung Electronics Co.
005930.SE +0.54%
Concerns are also rising over an apparent lack of
new game-changing products—like the iPad and the iPhone when they first
debuted—which have previously driven Apple's growth. Mr. Cook has said the
company continues to innovate at a rapid pace.
Last month, Apple reported a flat profit for its
most recently ended quarter and executives predicted that revenue growth
would continue to slow.
All of that has boiled over into a stock decline
and increasing pleas by investors to put more cash to use.
Continued in article
Bob Jensen's threads and other teaching cases on dividends, payout ratios,
and dividends yield ---
http://faculty.trinity.edu/rjensen/roi.htm#Dividends
Bob Jensen's threads on return on investment, other ratios, and financial
statement analysis ---
http://faculty.trinity.edu/rjensen/roi.htm
EBBS Earnings Before BS
"Questions About Tesla (TSLA) Accounting," by Tony Owusu,
The Street, March 10, 2014 ---
http://www.thestreet.com/story/12523254/1/kass-questions-about-tesla-tsla-accounting.html
Tesla's share price has soared 616% since March
2013. Such a meteoric rise has caused some investors consternation and
encouraged a closer look at Tesla's SEC filings such as last month's 10-k.
Doug Kass of RealMoneyPro.com and Seabreeze
Partners was highly critical of Tesla's book keeping this weekend. "Tesla's
accounting has long been controversial. In a prior post, I characterized
Tesla's reported profits as EBBS (earnings before B.S.)."
Kass specifically called into question Tesla's
claim that it went from $8 million under accrual on 2012 warranties during
the first three fiscal quarters and then suddenly reported a $2 million over
accrual for the year in its fourth quarter filings.
"In essence the question comes down to whether
Tesla's warranty reserve release was used as a cookie jar to boost profits
in the latest quarter, or did the company simply miscalculate its warranty
calculations," said Kass.
Continued in article
Equity Valuation Models
Equity Valuation
TAR book reviews are free online. I found the September 2010 reviews quite
interesting, especially Professor Zhang's review of
PETER O. CHRISTENSEN and GERALD A. FELTHAM,
Equity Valuation Hanover,
MA:Foundations and Trends® in Accounting, 2009,
ISBN 978-1-60198-272-8 ---
Click Here
This book is an advanced accountics research book
and the reviewer leaves many doubts about the theory and practicality of
adjusting for risk by adjusting the discount rate in equity valuation. The
models are analytical mathematical models subject to the usual limitations of
assumed equilibrium conditions that are often not applicable to the changing
dynamics of the real world.
The authors develop an equilibrium asset-pricing
model with risk adjustments depending on the time-series properties of cash
flows and the accounting policy. They show that operating characters such as
the growth and persistence of earnings can affect the risk adjustment.
What are the highlights of this book? The book
contains five chapters and three appendices. Chapters 2 to 5 each contain
separate yet closely related topics. Chapter 2 reviews and identifies
problems with the implementation of the classical model. In Chapters 3 to 5,
the authors develop an accounting-based, multi-period asset-pricing model
with HARA utility. My preferences are Chapters 2 and 5. Chapter 2 contains a
critical review of the classical valuation approach with a constant
risk-adjusted discount rate. As noted above, the authors highlight several
problems in estimating these models. Many of these issues are not properly
acknowledged and/or dealt with in many of the textbooks. The authors provide
a nice step-by-step analysis of the problems and possible solutions.
Chapter 5 contains the punch line. The authors push
ahead with the idea of adjusting risk in the numerator, and deal with the
thorny issue of identifying and simplifying the so-called “pricing kernel.”
Although the final model involves a rather simplifying assumption of a
simple VAR model of the stochastic processes of residual income and for the
consumption index, it provides striking and promising ideas of how to
estimate and adjust for risk based on fundamentals, as opposed to stock
return. It provides a nice illustration of how to incorporate time-change
risk characteristics of firms with the change in firms’ operations captured
by the change in residual income. This is very encouraging.
There are some unsettling issues in this book. Not
surprisingly, I find the authors’ review of the classical valuation approach
to be somewhat tilted toward the negative side. For instance, many of the
problems cited arise from the practice of estimating a single, constant
risk-adjusted discount rate for all future periods. This seems to be based
on the assumption that firms’ risk characteristics do not change materially
over future periods. Of course, this is a grossly simplified approach in
dealing with the issues of time-changing interest rates and inflation. To
me, errors introduced by such an approach reflect more the shortcomings in
the empirical or practical implementation, rather than the shortcomings in
the valuation approach per se. As noted by the authors, using date-specific
discount rates can avoid many of the problems. After all, under most
circumstances in a neo-classical framework, putting the risk adjustment in
the numerator or in the denominator may simply be an easy mathematical
transformation. In some cases, of course, adjusting risk in the denominator
does not lead to any solution to the problem. In that sense, adjusting in
the numerator is more flexible.
After finishing the book, I asked myself the
following question: Am I convinced that the practice of adjusting risk in
the discount rate should be abolished? The answer seems unclear, for a
couple of reasons. First, despite the authors’ admirable effort in bringing
context to it, the concept of “consumption index” still seems rather
elusive. As a result, it lacks the appeal of the traditional CAPM, namely, a
clear and intuitive idea of risk adjustment.
Professor Zhang seems to favor CAPM risk adjustment without delving
into the many controversies of using CAPM for risk adjustment in the real world
---
http://faculty.trinity.edu/rjensen/theory01.htm#AccentuateTheObvious
It would be interesting to see how these sophisticated analytical models are
really used by real-world equity valuation analysts.
Bob Jensen's threads on valuation are at
http://faculty.trinity.edu/rjensen/roi.htm
Also see controversies over validation of accountics research
http://faculty.trinity.edu/rjensen/TheoryTAR.htm
Teaching Case on Valuation
From The Wall Street Journal Accounting Weekly Review on September 12, 2014
The Heated Litigation Over Arizona Iced Tea
by:
Mike Esterl
Sep 04, 2014
Click here to view the full article on WSJ.com
TOPICS: Business Valuation
SUMMARY: As a business partnership soured, hot heads got in the way
of a cold calculation: What is the value of Arizona Beverage Co., maker of
the popular Arizona iced tea? A New York State Supreme Court judge is set to
hear closing arguments in a four-year-old fight over the valuation, in which
Arizona's estranged co-founders have been as far apart as water in the
desert. One co-founder, who wants to be bought out, contends that Arizona is
worth between $3 billion and $4 billion. The other, who is willing to buy
out his former partner, argues Arizona's value is closer to $500 million.
Aside from wrapping up the messy business-divorce proceedings, a conclusion
in the case could pave the way for Coca-Cola Co. or another drinks company
to buy a stake.
CLASSROOM APPLICATION: This article is appropriate for a class that
covers the topic of business valuation.
QUESTIONS:
1. (Introductory) What are the facts of this case? Who is the
plaintiff and who is the defendant? What issue do the parties want the court
to decide?
2. (Advanced) What is a business valuation? Besides litigation,
what are other uses of business valuations? Why might a business want to
know its value?
3. (Advanced) What are some methods used to value a business? Which
of these might methods might be appropriate for use in this case?
4. (Advanced) Why are the parties so far apart with these valuation
amounts? Do each of the parties have a legitimate basis for the amount they
are proposing? Which is more likely to be correct?
5. (Advanced) What knowledge and skills are necessary to do
business valuations? What education and business experience would be
beneficial for someone interested in a career in business valuation? What
are the career opportunities?
Reviewed By: Linda Christiansen, Indiana University Southeast
"The Heated Litigation Over
Arizona Iced Tea," by Mike Esterl, The Wall Street Journal, September 4, 2014
---
http://online.wsj.com/articles/the-heated-litigation-over-arizona-iced-tea-1409787182?mod=djem_jiewr_AC_domainid
As a business partnership soured, hot heads got in
the way of a cold calculation: What is the value of Arizona Beverage Co.,
maker of the popular Arizona iced tea?
On Thursday, a New York State Supreme Court judge
is set to hear closing arguments in a four-year-old fight over the
valuation, in which Arizona's estranged co-founders have been as far apart
as water in the desert. One co-founder, who wants to be bought out, contends
that Arizona is worth between $3 billion and $4 billion. The other, who is
willing to buy out his former partner, argues Arizona's value is closer to
$500 million.
Aside from wrapping up the messy business-divorce
proceedings, a conclusion in the case could pave the way for Coca-Cola Co.
KO -0.19% or another drinks company to buy a stake.
Nassau County, N.Y., Supreme Court Judge Timothy
Driscoll will be the one to determine how much co-founder Domenick Vultaggio
must pay co-founder John Ferolito to take full control. Depending on how
much the court values Mr. Ferolito's stake, Mr. Vultaggio might have to seek
outside investors for help. That could finally reopen talks between Arizona
and several beverage companies like Coke that are eager to grab a huge part
of the growing U.S. market for ready-to-drink tea.
Judge Driscoll has told both parties he will try to
issue a ruling by Columbus Day.
As young men, Messrs. Ferolito and Vultaggio, two
friends from Brooklyn, teamed up in 1971 to deliver beer around New York
City from a Volkswagen VOW3.XE -0.66% bus. Decades later, after seeing
Snapple teas fill up store shelves, they launched Arizona and its
Southwestern-inspired label motif in 1992, eventually taking it national and
unseating Snapple and several other brands owned by deeper-pocketed
companies.
Arizona had a 40% share of U.S. ready-to-drink tea
in 2013 by volume, ahead of PepsiCo Inc., PEP +0.93% which sells Lipton
through its joint venture with Unilever ULVR.LN -0.30% and had a 34% share,
according to industry tracker Beverage Digest. Snapple, now owned by Dr
Pepper Snapple Group Inc., DPS +0.56% had a 10% share.
Beverage Digest estimates annual U.S.
ready-to-drink tea sales to be around $6 billion.
The two founders have been feuding for years and
Mr. Ferolito has long stopped being involved in day-to-day operations,
moving to Florida.
Mr. Ferolito began looking at selling his stake in
Arizona roughly a decade ago, but was blocked by Mr. Vultaggio. An agreement
prevented either side from selling its stake without the other's consent.
The legal battle has featured plenty of fireworks.
Mr. Vultaggio's lawyers have accused Mr. Ferolito of trying to intimidate
Mr. Vultaggio at one point in the yearslong dispute by appearing at the
company with an armed former New York City detective. Nicholas Gravante, an
attorney for Mr. Ferolito, called the allegation "a complete fabrication.''
"Both sides have thrown a lot of grenades back and
forth. The court has shown absolutely no interest in that nonsense. This is
a valuation case,'' added Mr. Gravante, an attorney at Boies, Schiller &
Flexner LLP.
The case, which went to trial earlier this summer,
has produced about 5,000 pages of transcripts and thousands of pages in
exhibits, according to Louis Solomon, an attorney for Mr. Vultaggio.
Mr. Solomon, an attorney at Cadwalader, Wickersham
& Taft LLP, said Mr. Vultaggio has no intention of selling the company.
"He's not a seller. He's never been a seller,'' Mr. Solomon said, adding
that Mr. Vultaggio's children also are involved in the business.
But attorneys for both men acknowledge that
companies including Coke, Nestlé SA NESN.VX +0.28% and Tata Global Beverages
500800.BY -4.67% have approached Mr. Ferolito and Arizona in the past about
acquiring part or all of the company. The valuation court case, which began
in 2010, effectively killed such talks.
Coke and Nestlé declined Wednesday to comment on
any previous talks, or any potential interest in acquiring part or all of
Arizona if it becomes available. Tata, which is based in India, didn't
immediately return calls on Wednesday. The Wall Street Journal reported in
2007 that Coke and Arizona executives had held talks.
"If it is for sale, it would be a terrific deal for
Coke because it needs a much bigger North American tea business,'' said John
Sicher, publisher of Beverage Digest, adding tea should continue to grow
thanks to its "health and wellness aura.''
Coke's Fuze, Gold Peak and Honest Tea brands had a
5.5% share of the U.S. ready-to-drink tea market by volume last year,
according to Beverage Digest. Coke ended its Nestea partnership in the U.S.
with Nestlé in 2012.
Coke already has made two moves into caffeinated
drinks this year, buying minority stakes in countertop coffee maker Keurig
Green Mountain Inc. GMCR +1.16% and energy drink maker Monster Beverage
Corp. MNST -0.51%
Questions
Why Ciscco is taking an enormous beating in the stock market?
Why is Ralph Nader so upset with Cisco?
What does Susan Pulliam mean when she describes the first purchase price for
Cisco shares paid by Mr. Nader in 1995 as "an adjusted $7 per share"?
What does Ralph Nader mean when he says "If they can't give shareholders value,
then they have to give cash"?
Would my old friend Professor
Al
Rappaport (now emeritus from Northwestern University) double up in laughter
over this statement?
http://www.amazon.com/Creating-Shareholder-Value-ebook/dp/B000FBJHHG
From The Wall Street Journal Accounting Weekly Review on July 8, 2011
---
Nader Kindles Fires of Revolt
by:
Susan Pulliam
Jun 24, 2011
Click here to view the full article on WSJ.com
TOPICS: Dividends, Foreign Subsidiaries, Taxation
SUMMARY: Activist Ralph Nader "isn't calling for a router recall or
claiming the company's networks are unsafe at any speed. Instead, he wants
the tech company to pay a bigger dividend to boost its shares."
CLASSROOM APPLICATION: The article is useful to introduce dividend
policy and corporate governance issues in any financial reporting class.
QUESTIONS:
1. (Introductory) What has happened to Cisco's share price in the
last year?
2. (Introductory) Who is Ralph Nader? What have been his most
prominent activities in the past? What is his current concern?
3. (Advanced) What does Mr. Nader mean when he says "If they can't
give shareholders value, then they have to give cash"? Why will instituting
a cash dividend improve the company's shareholders' value?
4. (Advanced) What does the author mean when he describes the first
purchase price for Cisco shares paid by Mr. Nader in 1995 as "an adjusted $7
per share"?
5. (Advanced) What do analysts say is the problem with Cisco that
leads to abysmal stock price performance? What actions could shareholders
take to resolve this issue?
6. (Advanced) Why would Cisco incur significant tax payments in
order to amass the cash to pay dividends when it has such significant cash
and cash equivalents on its balance sheet?
Reviewed By: Judy Beckman, University of Rhode Island
"Nader Kindles Fires of Revolt," by: Susan Pulliam, The Wall Street
Journal, June 24, 2011 ---
http://online.wsj.com/article/SB10001424052702304231204576404120214834528.html?mod=djem_jiewr_AC_domainid
Ralph Nader, the scourge of American business and
onetime presidential candidate, has found his next corporate demon: Cisco
Systems Inc.
Mr. Nader isn't calling for a router recall or
claiming the company's networks are unsafe at any speed. Instead, he wants
the tech company to pay a bigger dividend to boost its shares.
The consumer advocate's motives are far from
altruistic. He is a longtime disgruntled Cisco investor who called the
company's share performance "appalling." In a private letter to Cisco Chief
Executive
John Chambers sent June 13, Mr. Nader blasted the
CEO for not doing enough to lift shares of the technology company and said
"it is time for a long overdue Cisco shareholder revolt against a management
that is oblivious to building or even maintaining shareholder value,"
according to the letter.
In 4 p.m. Nasdaq Stock Market composite trading
Thursday, Cisco's shares rose 11 cents, or 0.7%, to $15.47. They are down
nearly a third in the past year and are off 75% from their all-time,
tech-bubble high. In comparison, the Nasdaq Composite index is down about
48% from its all-time high in March 2000.
Among the specific actions Mr. Nader suggested in
the letter are the distribution of a one-time dividend of $1 a share and an
increase in Cisco's annual dividend to 50 cents from 24 cents.
"If they can't give shareholders value, then they
have to give cash," Mr. Nader said in an interview this week, adding that
the company's stock has plummeted even though its profits generally were on
the rise until recently.
Cisco, like many big tech companies, has been
accumulating cash despite its weak growth. It holds $43 billion in cash,
nearly half of its market value.
A Cisco spokeswoman said the company welcomes input
from shareholders and added that the company is considering "capital
allocation and returns to our shareholders," but declined to discuss
specifically whether a dividend increase or one-time payout are on the
table. She added that all but about $5 billion of the company's cash
represents foreign earnings, which would be subject to taxes if the funds
were brought back to the U.S.
The 77-year-old Mr. Nader, who rose to fame in the
1960s on his claims that American automobiles were unsafe, admitted the
letter is a departure from his typical antibusiness stance. He said he has
been an "adversary of corporate capitalism," but he is a believer in
capitalism, so long as shareholders have a voice. He wrote the letter to Mr.
Chambers, he said, because he objects to the "powerlessness of owner
shareholders."
Continued in article
Can the 2008 investment banking failure be traced to a math error?
Recipe for Disaster: The Formula That Killed Wall Street ---
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
Link forwarded by Jim Mahar ---
http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html
Some highlights:
"For five years, Li's formula, known as a
Gaussian copula function, looked like an unambiguously positive
breakthrough, a piece of financial technology that allowed hugely
complex risks to be modeled with more ease and accuracy than ever
before. With his brilliant spark of mathematical legerdemain, Li made it
possible for traders to sell vast quantities of new securities,
expanding financial markets to unimaginable levels.
His method was adopted by everybody from bond
investors and Wall Street banks to ratings agencies and regulators. And
it became so deeply entrenched—and was making people so much money—that
warnings about its limitations were largely ignored.
Then the model fell apart." The article goes on to show that correlations
are at the heart of the problem.
"The reason that ratings agencies and investors
felt so safe with the triple-A tranches was that they believed there was
no way hundreds of homeowners would all default on their loans at the
same time. One person might lose his job, another might fall ill. But
those are individual calamities that don't affect the mortgage pool much
as a whole: Everybody else is still making their payments on time.
But not all calamities are individual, and
tranching still hadn't solved all the problems of mortgage-pool risk.
Some things, like falling house prices, affect a large number of people
at once. If home values in your neighborhood decline and you lose some
of your equity, there's a good chance your neighbors will lose theirs as
well. If, as a result, you default on your mortgage, there's a higher
probability they will default, too. That's called correlation—the degree
to which one variable moves in line with another—and measuring it is an
important part of determining how risky mortgage bonds are."
I would highly recommend reading the entire thing that gets much more
involved with the
actual formula etc.
The
“math error” might truly be have been an error or it might have simply been a
gamble with what was perceived as miniscule odds of total market failure.
Something similar happened in the case of the trillion-dollar disastrous 1993
collapse of Long Term Capital Management formed by Nobel Prize winning
economists and their doctoral students who took similar gambles that ignored the
“miniscule odds” of world market collapse -- -
http://faculty.trinity.edu/rjensen/FraudRotten.htm#LTCM
The rhetorical question is whether the failure is ignorance in model building or
risk taking using the model?
Also see
"In Plato's Cave: Mathematical models are a
powerful way of predicting financial markets. But they are fallible" The
Economist, January 24, 2009, pp. 10-14 ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Wall Street’s Math Wizards Forgot a Few Variables
What wasn’t recognized was the importance of a
different species of risk — liquidity risk,” Stephen Figlewski, a professor of
finance at the Leonard N. Stern School of Business at New York University, told
The Times. “When trust in counterparties is lost, and markets freeze up so there
are no prices,” he said, it “really showed how different the real world was from
our models.
DealBook, The New York Times, September 14, 2009 ---
http://dealbook.blogs.nytimes.com/2009/09/14/wall-streets-math-wizards-forgot-a-few-variables/
Bob Jensen's threads on Bob Jensen's Threads on Real Options, Option
Pricing Theory, and Arbitrage Pricing Theory ---
http://faculty.trinity.edu/rjensen/realopt.htm
Real Options Valuation ---
https://en.wikipedia.org/wiki/Real_options_valuation
Real Options
by Vladimir Antikarov and Thomas E. Copeland
ISBN: 1587991861 Hard Cover 9/1/2003
http://www.traderslibrary.com/s/Real-Options-Revised-Edition-A-Practitio-9781587991868/2097420.htm
Synopsis:
This revised edition of the highly successful book, Real Options, offers
corporate decision-makers the ability to assess the profitability of their
ventures and decide which avenue of expansion or investment to go down and,
crucially, when to take that leap. The reader goes on a journey through real
options, from the basics to more advanced topics such as options and game
theory. It provides expert guidance on how to implement the theory to
maximize investment opportunities by utilizing uncertainty as an asset and
reducing downside risk.
Jacket Description:
Determining the feasibility and the priority of potential investments is
critical in business decision making. A new method for estimating the value
of investments -- real options -- is gaining ground over the traditional
approach of calculating net present value (NPV). Tom Copeland and Vladimir
Antikarov argue that in ten years real options will replace NPV as the
central paradigm for investment decisions. This book offers the first
practitioner's guide for understanding and implementing real options in
everyday decision making. The authors bring years of experience with dozens
of corporations in implementing real options. Copeland and Antikarov show
how NPV is flawed and tends to undervalue investment opportunities. NPV is a
static calculation that fails to consider the many options that management
has over the lifetime of an investment project. Such options include
expanding or extending the project if results are better than expected or
scaling down or abandoning the project if it turns out to be worse than
expected. There are chapters that deal with valuing various types of simple
options, such as deferral, abandonment, expansion, and contraction of
projects, and more advanced options such as compound and switching options.
Chapter 2 shows how Airbus Industrie uses real options in its marketing
efforts and discusses the difficulties encountered in implementing real
options. Chapter 7 shows how to write an Excel spreadsheet to value simple
options, combinations of them, and compound options. Chapters 9 and 10
discuss ways of modeling uncertainties. The analysis is enriched with case
histories and case solutions. The end-of-chapter questions and problems
provide both experience and additional insights into the application of real
options. The authors also offer solutions to the questions posed in the
book, as well as real option models useful to the would-be practitioner on
their Web site,
www.corpfinontine.com .
"Real option analysis of aircraft acquisition: A case study," by Qiwei
Hu and Anming Zhang, Journal of Air Transport Management, Volume 46, July
2015, Pages 19–29 ---
http://www.sciencedirect.com/science/article/pii/S0969699715000381
This paper demonstrates that aircraft acquisition
by airlines may contain a portfolio of real options (flexible strategies)
embedded in the investment's life cycle, and that if airlines rely solely on
the static NPV method, they are likely to underestimate the true investment
value. Two real options are investigated: i) the “shutdown-restart” option
(a carrier may shutdown a plane if revenues are less than costs, but
restarts it if revenues are more than costs), and ii) the option to defer
aircraft delivery. We quantify the values of these options in a case study
of a major U.S. airline. The economic insight could help explain observed
capital expenditures of airlines, and serve as a rule of thumb in evaluating
capital budgeting decisions. A compound option (consisting of both the
shutdown-restart and defer options) is also analyzed.
Airbus and Boeing: Superjumbo Decisions
by Samuel E BodilyKenneth C. Lichtendahl
Harvard Case
https://hbr.org/product/airbus-and-boeing-superjumbo-decisions/UV1312-PDF-ENG
Real Options Valuation Limitations ---
https://en.wikipedia.org/wiki/Real_options_valuation#Limitations
Jensen Comment
Many moons ago, Stewart Myers and I were in a doctoral program together at
Stanford University. After graduation, Stewart became one of the most
outstanding economics and financial researchers of the world --- http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=95&co_list=F
The term "real options" can be attributed to the Stewart Myers ("Determinants
of Capital Borrowing", Journal of Financial Economics, Vol..5, 1977). The theory
of real options extends the concept of financial options (in particular call
options) into the realm of capital budgeting under uncertainty and valuation of
corporate assets or entire corporations.
The real options approach is dynamic in the sense that includes the effect of
uncertainty along the time, and what/how/when the relevant real options shall be
exercised. Some argue that real options do little more than can be done with
dynamic programming of investment states under uncertainty, real options add a
rich economic theory to capital investing under uncertainty.
The real options problem can be viewed as a problem of optimization under
uncertainty of a real asset (project, firm, land, etc.) given the available
options. Since I have been asked to teach a bit about real options theory while
I lectured years ago at Monterrey Tech in Mexico, I thought I might share a bit
of my source material that I discovered on the Web.
Real Options are mentioned in the FASB's "Special Report: Business and
Financial Reporting, Challenges from the New Economy," by Wayne Upton, Financial
Accounting Standards Board, Document 219-A, April 2000 ---
http://accounting.rutgers.edu/raw/fasb/new_economy.html (Like so many
older Rutgers FASB links the link is broken and lost forever)
Wayne Upton wrote as follows on pp. 91-93:
Measurement and Real Options
Perhaps the most promising area for valuation of
intangible assets is the developing literature in valuation techniques based
on the concept of real options. Techniques using real options analysis are
especially useful in estimating the value of intangible assets that are
under development and may not prove to be commercially viable.
A real option is easier to describe than to define.
A financial option is a contract that grants to the holder the right but not
the obligation to buy or sell an asset at a fixed price within a fixed
period (or on a fixed date). The word option in this context is consistent
with its ordinary definition as “the power, right or liberty of choosing.”
Real option approaches attempt to extend the intellectual rigor of
option-pricing models to valuation of nonfinancial assets and liabilities.
Instead of viewing an asset or project as a single set of expected cash
flows, the asset is viewed as a series of compound options that, if
exercised, generate another option and a cash flow. That’s a lot to pack
into one sentence. In the opening pages of their recent book, consultant
Martha Amram and Boston University professor Nalin Kulatilaka offer five
examples of business situations that can be modeled as real options: 56
• Waiting to invest options, as in the case of a
tradeoff between immediate plant expansion (and possible losses from
decreased demand) and delayed expansion (and possible lost revenues)
• Growth options, as in the decision to invest in
entry into a new market
• Flexibility options, as in the choice between
building a single centrally located facility or building two facilities in
different locations
• Exit options, as in the decision to develop a new
product in an uncertain market
• Learning options, as in a staged investment in
advertising.
Real-options approaches have captured the attention
of both managers and consultants, but they remain unfamiliar to many.
Proponents argue that the application of option
pricing to nonfinancial assets overcomes the shortfalls of traditional
present value analysis, especially the subjectivity in developing
risk-adjusted discount rates. They contend that a focus on the value of
flexibility provides a better measure of projects in process that would
otherwise appear uneconomical. A real-options approach is consistent with
either fair value (as described in Concepts Statement 7) or an
entity-specific value. The difference, as with more conventional present
value, rests with the selection of assumptions. If a real option is
available to any marketplace participant, then including it in the
computation is consistent with fair value. If a real option is
entity-specific, then a measurement that includes that option is not fair
value, but may be a good estimate of entity-specific value.
Bob Jensen's threads on Bob Jensen's Threads on Real Options, Option
Pricing Theory, and Arbitrage Pricing Theory ---
http://faculty.trinity.edu/rjensen/realopt.htm
Bob Jensen's threads on valuation ---
http://faculty.trinity.edu/rjensen/roi.htm
How to Value a Website
March 8, 2010 message from Roger Collins
[Rcollins@TRU.CA]
www.peekstats.com
I came across this site by
accident. Quite apart from the reservations/limitations concerning the
specific components of the valuation there are some interesting questions
about the relationship between the value of a Web site on a "stand alone"
basis and its contribution to the overall value of an organisation that I'm
planning to put to my Accounting Theory students.
Roger Collins
TRU School of Business & Economics
Jensen Comment
Thank you for this Roger.
I find it interesting that a featured Website valuation ($ 107,863.70) for
Cardiff University in England ---
http://www.peekstats.com/www.cardiff.ac.uk
I would've guessed Cardiff's Website to have a much higher value.
March 8, 2010 reply from James R. Martin/University of South Florida
[jmartin@MAAW.INFO]
The peekstats.com website
valuation tool is not even in the ball park on MAAW's web traffic and page
views. I think this is because it only picks up visits from those who have
the Alexa toobar installed. I noticed that several years ago. Those who want
accurate traffic statistics should look at Google Analytics. You have to add
some code to the bottom of your pages, but the information you get is really
detailed.
Long-Term Pricing and Valuation
Teaching Case on Long-Term Product Valuation
From The Wall Street Journal Accounting Weekly Review on August 9, 2013
Tesla Investors Look Far Into the Future to Price Its Shares
by:
Mike Ramsey
Aug 07, 2013
Click here to view the full article on WSJ.com
TOPICS: Analysts' Forecasts, Financial Ratios, Fixed Costs,
Managerial Accounting, Manufacturing, Valuations
SUMMARY: The author opens this article by stating that "Tesla
Motors Inc. Chief Executive Elon Musk doesn't run his Silicon Valley
electric-car maker by traditional auto industry rules, and investors are so
far rewarding him by putting a value on the company that defies easy
comparisons." The related article describes operating differences in sales
methods the company uses and was covered in another WSJ Accounting Weekly
Review. Tesla's sales are about 1% of Ford Motor Co's U.S. sales, yet the
company's share price implies a market value of about $17.15 billion, about
25% of Ford's market cap and 70% more than Fiat SpA.
CLASSROOM APPLICATION: The article may be used to cover financial
reporting or managerial accounting topics. For financial reporting, the
article covers company valuation, forward P/E ratio, and analysts' earnings
forecasts. For managerial accounting, the article discussed manufacturing
economies of scale and cost behaviors. The article covers these topics with
a product innovation focus.
QUESTIONS:
1. (Introductory) What is Tesla Motors? How is its business model
different from older companies with which it competes? (Hint: the related
articles are helpful for the latter question.)
2. (Advanced) What is unusual about Tesla Motors' market value? In
your answer, explain how a company's market value is determined.
3. (Introductory) What amount of earnings do analysts project Tesla
Motors will achieve for the year in 2013? In 2014?
4. (Advanced) Explain how to determine a price-earnings ratio based
on current earnings and then how to determine a forward P/E ratio. Why may
only one of these measures be used in considering Tesla Motors? How is this
measure used to make a comparison about the company?
5. (Introductory) Summarize how investment firms and banks, as
described in the article, determine expected future prices for each share of
Tesla Motors stock.
6. (Advanced) Refer specifically to the Deutsche Bank target price
for the firm's stock. How do economies of scale influence the bank's
forecasts? In your answer, define the terms economies of scale and fixed
costs, then explain the behavior of fixed costs considered in the forecast.
Reviewed By: Judy Beckman, University of Rhode Island
RELATED ARTICLES:
Tesla Clashes with Car Dealers
by Mike Ramsey and Valerie Bauerlein
Jun 18, 2013
Page: B1
"Tesla Investors Look Far Into the Future to Price Its Shares," by
Mike Ramsey, The Wall Street Journal, August 7, 2013 ---
http://online.wsj.com/article/SB10001424127887323420604578652180360274840.html?mod=djem_jiewr_AC_domainid
Tesla Motors Inc. TSLA +0.58% Chief Executive Elon
Musk doesn't run his Silicon Valley electric car maker by traditional auto
industry rules, and investors are so far rewarding him by putting a value on
the company that defies easy comparisons.
Tesla is scheduled to report second quarter results
on Wednesday, and most analysts are forecasting a 17-cent-a-share loss. In
an industry where strategy is driven by the quest for economies of scale,
Tesla is tiny. It delivered just 1,400 Model S electric sedans in July,
according to researcher Autodata Corp., or about 1% of Ford Motor Co.'s F
+0.19% U.S. sales for the month.
Yet Tesla's share price has more than quadrupled in
the past year, to $142.15 on Tuesday and giving it a market value of about
$17.15 billion, a quarter of Ford's, and about 70% more than Fiat SpA—majority
owner of Chrysler Group LLC.
Despite its small size, the Palo Alto, Calif.,
company has become among the auto industry's most closely followed. General
Motors Co. GM +0.07% CEO Dan Akerson recently ordered a team of GM employees
to study Tesla and the ways that it could challenge the established auto
industry business model.
Even Wall Street analysts who are enthusiastic
about Tesla's prospects have put target prices on the company's shares that
are much lower than their current market price.
A Tesla spokesman wouldn't comment on the stock
price on Tuesday ahead of disclosing June quarter results on Wednesday. But
Mr. Musk and other company officials have said in the past that they foresee
a Tesla that is building 400,000 or 500,000 cars a year, and can achieve a
market capitalization of as much as $43 billion by 2022. That is the level
at which Mr. Musk can collect a chunk of stock under a multi-step
compensation plan adopted by Tesla's board last year.
Most car companies are judged on the results they
can deliver in the near term. Tesla investors are buying on results that
probably won't exist until sometime in the next decade. And even that is
only if it can deliver flawless manufacturing execution, continued annual
growth and crack through the consumer concerns about driving range and
upfront costs that have restrained demand for all-electric vehicles so far.
Analysts are expecting the company to lose 68 cents
a share this year and earn 50 cents a share next year, according to Zacks
Investment Research. By that 2014 projection, its forward price/earnings
ratio is 289, compared with Ford's PE of just under 10 and Toyota Motor
Corp.'s 7203.TO +0.16% P/E of less than 1, both based on 2014 earnings
projections, according to Zacks.
Tesla's P/E ratio is more akin to Internet stocks
than car makers. Supporters say that is because the company's electric
vehicle sales strategy is disruptive and the auto maker possesses
groundbreaking technologies.
Deutsche Bank recently raised its target price for
the company's shares to $160. The bank estimates that Tesla will be able to
achieve operating profit margins of 20%—or about twice that of BMW AG BMW.XE
+1.33% in its most recent quarter—as it ramps up sales and spreads costs
over a larger number of vehicles.
"We expect [Tesla] to reach at least 200,000 units
by near the end of the decade, which implies about 5% of what we calculate
as the addressable market of comparable vehicles in terms of capability and
price," the bank said in a note to investors last month.
Tesla sold 8,931 vehicles this year through June,
according to Autodata. In contrast, Porsche delivered 81,565 of its big
ticket and high margin vehicles globally during the same period.
Mr. Musk has said he believes Tesla can achieve 25%
gross margins by the end of this year, meaning that Tesla's direct costs of
building cars will be just three-quarters of the revenue it collects from
sales. In the first quarter, Tesla's gross margin was 17% of sales.
Wall Street analysts assume that Tesla will sell
around 100,000 of the company's "Gen 3" models—electric sedans that are
expected to start at about $35,000 when available in late 2016. Investors
are counting on Tesla being able to deliver a car that competes against
luxury sports cars such as the BMW 3 Series and Audi A4—and not
similarly-priced electric cars.
The hurdles are many. Other manufacturers now
offering electric cars for under $40,000 have so far failed to generate much
volume. The Nissan Leaf, which starts at about $28,800, is on a pace to sell
fewer than 50,000 cars this year on a global basis.
Established luxury brands also are planning to
challenge Tesla with plug-in models of their own, such as the BMW i3 and a
Cadillac ELR plug-in hybrid coming from GM.
Many analysts say the shares currently are
overpriced based on their sales and profit projections. Adam Jonas, a Morgan
Stanley analyst, says Tesla's shares should be trading at about $109. His
estimate assumes Tesla continues to expand its business 15 years into the
future to get to his stock value—which is about 23% less than its current
price.
Mr. Jonas assumes Tesla eventually can sell more
than 200,000 vehicles a year at an average price of $50,000, with the
majority of the sales coming from the company's Gen 3 models. This year,
Tesla is expected to deliver about 20,000 Model S vehicles.
"We argue that Tesla cannot be valued on
traditional near-term multiple metrics like traditional auto companies," Mr.
Jonas said.
Goldman Sachs analyst Patrick Archambault has one
of the lower stock price estimates at $84 a share. He estimated Tesla will
be making about 150,000 vehicles a year and earning about $1.1 billion, or
$8.59 a share, in 2018.
Barclays senior analyst Brian Johnson is pegging
Tesla at $90 a share. He thinks that Tesla, at a minimum, can sell about
50,000 Model S and Model X vehicles a year around the globe, making it is
successful "niche luxury car maker." But that should only get Tesla to about
$60 a share in value.
To be worth $90 a share, Tesla has to make a
credible entry-level luxury car that he thinks will be priced at between
$42,000 and $45,000. "They are going to have to do in five years what it
took Audi decades to do—break into the volume entry-level luxury market."
Today's stock price, he said, reflects investors
who believe Mr. Musk "is the next Henry Ford."
Bob Jensen's threads on valuation and ROI ---
http://faculty.trinity.edu/rjensen/roi.htm
Tesla Motors ---
http://en.wikipedia.org/wiki/Tesla_Motors
"Tesla Versus the Luxury Automakers: Does the introduction of luxury EVs
from BMW, Cadillac, and Mercedes spell doom for Tesla?" by Kevin Bullis,
MIT's Technology Review, July 25, 2013 ---
Click Here
http://www.technologyreview.com/view/517531/tesla-versus-the-luxury-automakers/?utm_campaign=newsletters&utm_source=newsletter-daily-all&utm_medium=email&utm_content=20130726
Jensen Comment
There won't be much competition from Japan since Japanese manufacturers have
given up on battery-powered cars. The Japanese shifted their attention to the
future of fuel cells, probably hydrogen fuel cells.
But competition from luxury car manufacturers in Michigan and Germany will be
intense. Much depends upon the competitive advantage of Tesla's new patents.
What seems to me as a stupid business model is to not have Tesla
dealers (or at least repair shops) across the entire geographic market where you
sell vehicles. If I by a Tesla in the White Mountains of New Hampshire, where do
I take it in for repairs and warranty service? Forget Tesla.
What seems to me as a stupid business model is to manufacture automobiles for
a mass market in the Freemont, California where Toyota and General Moters fled.
Tesla built its California factory using $365 million in low-interest loans from
the federal government. Firstly, housing costs are higher that most
manufacturing workers can afford. Secondly, Californians of fleeing their state
in droves due to high taxes on virtually everything. It should be noted that
choosing the Freemont abandoned plants helped Tesla land the $365 million. But
that was before Tesla seriously was a contender for the mass automobile market
across North America, Europe, and Asia.
When Tesla was building experimental cars for a niche market, Freemont made
some sense because of talented tech workers in Silicon Valley. Tesla is now
aiming for a mass market. How about new manufacturing plants in downtown
Detroit and Beijing?
Tesla will probably have to partner with automobile companies having
dealerships across North America, Europe, and Asia. To date, Tesla has made a
big deal about selling cars with having dealerships. This policy is
unsustainable unless Tesla builds cars that never need service and repairs.
Business Valuation Blunders
by the Pros
| Dumb Deals 101 |
By
Allan Sloan
NEWSWEEK,
September 6, 2001 --- http://www.msnbc.com/news/621862.asp |
| Attention,
class. Smart people can make really stupid mistakes. Here’s a primer
on some of the biggest investment fiascoes of recent years |
TO WIT, when
investment madness grips the world, big, smart investors can succumb just like
us not-so-big, not-so-smart types. The difference is that the big guys have
lots more money to lose, and if they make big enough investments, they leave
paper trails for all to see. Average people who bought dogs like ICG, Webvan
and Teligent at their highs can weep in private. But big hitters like John
Malone, Goldman Sachs or leveraged-buyout heavies Ted Forstmann and Tom Hicks
operate on the public stage. And they can lose bets that are measured in the
billions. Unlike Internet companies, most of which never had a credible plan
to make money, the telecom start-ups generally had proven leaders, real assets
and business plans that made a lot of sense.
You might think the
biggest smart-money bets were lost from imploding stocks of well-known
Internet companies like Priceline, Yahoo and Amazon. Not so. Most of the money
was lost in telecommunications companies that were formed to provide spiffy
“broadband” Internet-video-voice-data stuff. Unlike Internet companies,
most of which never had a credible plan to make money, the telecom start-ups
generally had proven leaders, real assets and business plans that made a lot
of sense. But so many companies flooded in that they slaughtered each other.
How could so many smart investors have been so foolish? What were they
thinking? Martin Fridson, the chief junk-bond strategist for Merrill Lynch,
says that already-hot Internet and telecom markets turned incandescent when
money came flooding into the United States after the Asian financial meltdown
started in 1997. “Ideas that you would have called ridiculous at other times
got funded,” he says. Another major factor in “smart” money’s flooding
into telecom start-ups was that the nation’s biggest telecom, AT&T,
bought upstart Teleport, and No. 2 WorldCom bought MFS and Brooks Fiber, all
at fancy prices. This encouraged others to rush out and start up telecoms that
could then be sold quickly to hairy-chested, deep-pocketed phone companies
that, it turned out, weren’t buying. So, you see, it wasn’t just callow
twentysomething supposed geniuses who lost big time on the Internet-telecom
bubble, but seasoned smart people, too. There are enough examples here for a
whole M.B.A. course. Call it Dumb Deals 101. So we’ve composed a list based
on an unscientific combination of big names who made big investments that went
bad embarrassingly quickly—and unwittingly provided us all a broader
business lesson. We’re not counting people like Amazon’s Jeff Bezos or
Priceline’s Jay Walker, who lost paper fortunes, money they never really
had. As you can imagine, our dealmakers were less than eager to talk on the
record, so these case studies are based on public filings and background
interviews. The current value, if any, of their investments is our estimate
based on recent stock prices. And let’s be generous—some of these
companies are indeed going to survive. But make no mistake. It will take a
miracle for our investors to come out ahead. And now, for our list of lessons
that these investors learned the hard way. And, by the way, should have known
in the first place.
LESSON #1
Don’t buy into your own hype
Paul Allen invested $1.65 billion in RCN in February 2000. Current value: $100
million. . . . .
LESSON #2
Buying low and selling high really is a good idea after all
John Malone’s Liberty Media invested $1.5 billion in ICG and Teligent in
1999 and 2000. Current value: $40 million. . . .
LESSON #3 A
discounted price isn’t necessarily a bargain
Janus Funds bought $930 million of WebMD stock in January 2000. Current value:
$75 million-$140 million.. . .
LESSON #4
Going steady isn’t the same as marriage
Verizon invested $1.7 billion in Metromedia Fiber in March 2000. Current
value: $100 million. . . .
LESSON #5
Stick with what you know,
Part I Hicks Muse invested $1 billion in four telecom start-ups in 1999 and
2000. Current value: $0. . . .
LESSON #6
Stick with what you know,
Forstmann, Little invested $2 billion in XO and McLeodUSA in 1999, and an
additional $350 million in them this year. Current value: $400 million. . . .
LESSON #7
Don’t mistake reinventing the wheel for innovation
Goldman Sachs and others invested $850 million in Webvan between 1998 and
2000. Current value: $0. . . .
LESSON #8
Remember to include a worst-case scenario
AT&T invested $3.4 billion for operating control of At Home in 2000 and
2001. Current value: $0. . . .
LESSON #9
The private sector isn’t always smarter than bureaucrats
European phone companies spent $96 billion for wireless Internet licenses
starting in 2000. Current value: lots, lots less. . . .
FINAL EXAM
The overarching lesson here is an eternal one: markets can swing from being
irrationally exuberant to being totally depressed in an instant.
Heaven help you if you don’t see the switch coming. When even smart people
start acting as if there’s some truth to the four most dangerous words on
Wall Street—”this time it’s different”—you can be sure it’s time
to take the money off the table. And the one thing you can certainly bet on is
that when the next investment mania strikes, that broader lesson—and, for
that matter, all the dealmaking-for-dummies lessons we just discussed—will
have been completely forgotten.
The Winner's Curse: Business Firm Valuation Errors by the Pros
Large-scale mergers often plague the "winning"
bidder with what academics call the "Winner's Curse." The winner's curse takes
place when a bidder does indeed win the object for which he or she was bidding,
but the value of that object turns out to be less than what was bid for it.
What's a recipe for a winner's curse in an M&A situation? Take one part highly
visible transaction for a highly motivated, deep-pocketed acquirer.
"Kraft, Cadbury, and Hershey: A Not-So-Sweet Deal," by Rita McGrath, Harvard
Business Review, November 19, 2009 ---
Click Here
Large-scale mergers often
plague the "winning" bidder with what academics call the "Winner's
Curse." The winner's curse takes place when a
bidder does indeed win the object for which he or she was bidding, but the value
of that object turns out to be less than what was bid for it. What's a recipe
for a winner's curse in an M&A situation? Take one part highly visible
transaction for a highly motivated, deep-pocketed acquirer. Add a bit of
reluctant bride (or outright naysaying bride) on the part of the target firm.
Add a potential white knight, preferably one that is despised by the original
bidder. Throw in a couple (or more) hard-charging CEOs who view the deal as
crucial to their company's good fortunes (or to their own reputations — either
will do). Finally, entrust the whole mixture to a bunch of sophisticated deal
packagers on Wall Street. Then, make it front-page news on the publications that
"everybody" reads.
The announcement on
Tuesday morning that chocolate maker Hershey (with a possible assist from
Italy's Ferrero) might make a counter-offer to the deal broached by Kraft Foods
for the United Kingdom's beloved Cadbury has exactly this flavor to it.
According to the
Wall Street Journal, Kraft Foods of
Northfield, IL, formally offered to purchase Cadbury for about $16 billion on
November 9, after publicly making its intentions known in September. Cadbury
rejected the initial offer, reports the Journal, as "derisory." But with no
other bidders on the horizon at the time that Kraft was required by the UK to
make its proposal official or to abandon the deal, it didn't increase the bid,
commenting that the offer is "fair and attractive." If Hershey successfully
figures out how to get in the game with a superior offer (and its bankers seem
quite keen on enabling them to do that), a bidding war of attrition could well
break out, as both sides seek to gain the upper hand. In such situations,
emotions run high, spreadsheets are more often used to justify decisions than to
inform them, and the individuals involved tend to get personal.
Something similar (with 3
bidders and a fourth who was enabling it) took place with Boston Scientific's
recent acquisition of Guidant, a merger that was dubbed by Fortune magazine to
be the "second
worst deal ever" right behind the AOL-Time Warner
merger (which is being unwound even as I write this). The stage for that merger
was set when Guidant, a spinoff from Eli Lilly, was entering its tenth year of
major success. Without much of a succession plan and a failed attempt to lure a
new CEO from GE, the company was a perfect target, with a market cap of about
$20 billion. Johnson & Johnson, in 2004, offered to buy the company for
$68/share and, much as Kraft was snubbed by Cadbury, was turned down.
Eventually, J&J was persuaded to increase its offer to $76/share, or $25.4
billion. In March of 2005, a patient equipped with a Guidant pacemaker died and
a public furor broke out when it was revealed that the company had known about
the flaw in the pacemaker for three years, but had not informed doctors about
it.
What happens? First, the
stock tanks, dropping to the mid-$50 range by 2005, amid a recall of over
290,000 devices. J&J's CEO Bill Weldon drops his offer by $6 billion to
$58/share. Guidant rejects that offer. Weldon eventually goes a little higher,
to $63/share, an offer which Guidant, seeing no other bidder, grudgingly
accepts. In November of 2005, however, a new player emerges on the scene —
Boston Scientific. They leverage a deal with a third party (Abbott Labs) to make
a $72/share offer. Guidant, smelling opportunity, uses the presence of two eager
bidders to ignite a bidding war. On January 11, 2006, J&J goes to $68/share —
and even though it's $4 under Boston's bid, Guidant sticks with J&J. Provoked,
Boston bids $73 on January 12. J&J comes back with $71. On January 17, Boston
Scientific makes a "bid to end this" of $80/share, a total of $27 billion. To
his credit, J&J's Weldon says that they "won't chase this deal to a price that
doesn't make sense for the company" and J&J makes no further offer.
The acquisition of
Guidant is widely regarded as a winners' curse situation for Boston Scientific;
yes, they won the prize, but their stock has shown a steady downward trend since
the time of the
merger and they bought a host of quality and
other problems along with the high-flying group.
Smells a bit like the
Hershey-Cadbury-Ferrero-Kraft recipe, no? What do you think? Is this another war
of attrition in the making? It certainly has all the necessary ingredients.
Introductory Dilbert Cartoon ---
http://dilbert.com/strip/2015-09-11
"Peter Thiel Explains Biotech Investing
Rationale: Get Rid of Randomness," by Antonio Regalado, MIT's Technology
Review, September 12, 2015 ---
http://www.technologyreview.com/news/541226/peter-thiel-explains-biotech-investing-rationale-get-rid-of-randomness/?utm_campaign=newsletters&utm_source=newsletter-daily-all&utm_medium=email&utm_content=20150914
. . .
How do you know what an
early stage biotech company is actually worth?
There is disturbingly little
intuition into what biotech companies are worth. If you are able to produce
a drug that cures some sizeable disease for which there is no cure at all,
that is worth billions, or tens of billions of dollars. And if you don’t
succeed it’s worth nothing.
You have to get through
basic research, preclinical, Phase I, II, and III, and then marketing. So
approaching it analytically, the question is how do you discount [the risk
of failure at each step]. If you do half on each step, and there are six
steps, that’s 2 to the 6th, or 64. So something worth a billion at the end
means you start at [a value of] $16 million.
The thing I don’t
like about this as an investor is that the numbers are totally arbitrary.
They are just made-up numbers.
And our feeling with many biotechs is that people understate these
probabilities. They say it’s half, but maybe it’s just one in 10. And if
even if just one of these steps is one in 10, you are really screwed. I
would be very nervous to invest in a company where it gets pitched as a
series of contingencies that “this has to work, and this has to work, and
this has to work.”
So is Stemcentrx doing it
differently?
The question is, can you
change those probabilities into different numbers? The reason we invested in
Stemcentrx at a valuation that would have been higher than many other
biotechs we looked at is that we felt the whole company was designed to get
these probabilities as close to one as possible at every step, to get rid of
as much of this randomness or contingency as possible. That is something
that we found deeply reassuring.
. . .
Potentially a Great Case for Managerial Accounting CoursesL How can
Harry Potter movies be financial losers?
"'Hollywood Accounting' Losing In The Courts: From the math-is-hard
dept," TechDirt ---
http://www.techdirt.com/articles/20100708/02510310122.shtml
If you follow the entertainment business at all,
you're probably well aware of "Hollywood accounting," whereby very, very,
very few entertainment products are technically "profitable," even as they
earn studios millions of dollars. A couple months ago, the Planet Money
folks did a great episode explaining how this works in very simple terms.
The really, really, really simplified version is that Hollywood sets up a
separate corporation for each movie with the intent that this corporation
will take on losses. The studio then charges the "film corporation" a huge
fee (which creates a large part of the "expense" that leads to the loss).
The end result is that the studio still rakes in the cash, but for
accounting purposes the film is a money "loser" -- which matters quite a bit
for anyone who is supposed to get a cut of any profits.
For example, a bunch of you sent in the example of
how Harry Potter and the Order of the Phoenix, under "Hollywood accounting,"
ended up with a $167 million "loss," despite taking in $938 million in
revenue. This isn't new or surprising, but it's getting attention because
the income statement for the movie was leaked online, showing just how
Warner Bros. pulled off the accounting trick:
In that statement, you'll notice the "distribution
fee" of $212 million dollars. That's basically Warner Bros. paying itself to
make sure the movie "loses money." There are some other fun tidbits in there
as well. The $130 million in "advertising and publicity"? Again, much of
that is actually Warner Bros. paying itself (or paying its own
"properties"). $57 million in "interest"? Also to itself for "financing" the
film. Even if we assume that only half of the "advertising and publicity"
money is Warner Bros. paying itself, we're still talking about $350 million
that Warner Bros. shifts around, which get taken out of the "bottom line" in
the movie accounting.
Now, that's all fascinating from a general business
perspective, but now it appears that Hollywood Accounting is coming under
attack in the courtroom... and losing. Not surprisingly, your average juror
is having trouble coming to grips with the idea that a movie or television
show can bring in hundreds of millions and still "lose" money. This week,
the big case involved a TV show, rather than a movie, with the famed
gameshow Who Wants To Be A Millionaire suddenly becoming "Who Wants To Hide
Millions In Profits." A jury found the whole "Hollywood Accounting"
discussion preposterous and awarded Celador $270 million in damages from
Disney, after the jury believed that Disney used these kinds of tricks to
cook the books and avoid having to pay Celador over the gameshow, as per
their agreement.
On the same day, actor Don Johnson won a similar
lawsuit in a battle over profits from the TV show Nash Bridges, and a jury
awarded him $23 million from the show's producer. Once again, the jury was
not at all impressed by Hollywood Accounting.
With these lawsuits exposing Hollywood's sneakier
accounting tricks, and finding them not very convincing, a number of
Hollywood studios may face a glut of upcoming lawsuits over similar deals on
properties that "lost" money while making millions. It's why many of the
studios are pretty worried about the rulings. Of course, these recent
rulings will be appealed, and a jury ruling might not really mean much in
the long run. Still, for now, it's a fun glimpse into yet another way that
Hollywood lies with numbers to avoid paying people what they owe (while at
the same sanctimoniously insisting in the press and to politicians that
they're all about getting content creators paid what they're due).
Bob Jensen's threads on case learning are at
http://faculty.trinity.edu/rjensen/000aaa/thetools.htm#Cases
Bob Jensen's threads on return on investment
http://faculty.trinity.edu/rjensen/roi.htm
Bob Jensen's threads on management accounting
http://faculty.trinity.edu/rjensen/theory01.htm#ManagementAccounting
Bob Jensen's threads on accounting theory are at
http://faculty.trinity.edu/rjensen/theory01.htm
Questions
Why might you want to teach a modified IRR?
Is the reinvestment-at-the-same-rate assumption true?
It may not be, when interim cash inflows occur far in the future, or if
there is limited available capital to fund competing projects.
Is timing important?
Yes, it is vital. A change in the expected receipt of future cash inflows by
as little as 30 days has a significant impact on the computed IRR.
"Spreadsheets at Work: Rating Your Own IRR Some tips for doing these key
calculations; and introducing "modified" internal rate of return," by Richard
Block and Jan Bell, CFO.com, February 20, 2009 ---
http://www.cfo.com/article.cfm/13052407/c_2984312?f=FinanceProfessor/SBU
It is budgeting season again. Financial analysts
are completing their analyses of the R&D or capital spending projects being
proposed. And financial executives are either anxiously awaiting those
analyses, or already getting started on their reviews. No doubt the analyses
include investment costs, anticipated future savings, discounted cash flows,
computed internal rates of return, and a ranking of which projects make the
"cut," and which do not.
Almost certainly, a spreadsheet was used for each
project — to compute the discounted cash flows, the internal rates of
return, and the presentation of the overall rankings.
You will take comfort, of course, because these
analyses, and your decision on which projects to accept or fund, were based
on a sound financial principle: namely, the better the internal rate of
return, the better the project.
But is that comfort warranted? Or might you be
vulnerable to the weaknesses long pointed out — if too often ignored — by
researchers who have warned that IRR calculations often contain built-in
reinvestment assumptions that improperly improve the appearance of bad
projects, or make the good ones look too good .
IRR, of course, is the actual compounded annual
rate of return from an investment, often used as a key metric in evaluating
capital projects to determine whether an investment should be made. IRR also
is used in conjunction with the Net Present Value (NPV) function,
determining the current value of the sum of a future series of negative and
positive cash flows; namely investments and savings. The prescribed discount
factor to be used in computing NPV is the company's weighted average cost of
capital, or WACC. The internal rate of return is the annual rate of return,
also known as the discount factor, which makes the NPV zero.
The rub in justifying long-term project funding
decisions by using IRR is two-fold. First, IRR assumes that interim cash
inflows, or savings, will be "reinvested," and will produce a return — the
reinvestment rate — equal to the "finance rate" used to fund the cash
outflows (the investment.) Second, the anticipated investment cash outflows
required for the project, and for the anticipated cash inflows from savings
once the project is complete, are so far in the future that their timing is
difficult to determine with reasonable accuracy.
Is the reinvestment-at-the-same-rate assumption
true? It may not be, when interim cash inflows occur far in the future, or
if there is limited available capital to fund competing projects. Is timing
important? Yes, it is vital. A change in the expected receipt of future cash
inflows by as little as 30 days has a significant impact on the computed IRR.
But by knowing and using the subtleties of the
various IRR functions available in an electronic spreadsheet, we can
safeguard ourselves against miscalculations based on faulty assumptions, and
minimize the range of error by early detection of faulty assumptions.
In this article, part one of a two-part series, we
will study the reinvestment issue. The second article will address how to
reduce inaccuracies — minimizing the range of error — based on timing
concerns.
Continued in article
Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper."Make Markets Be Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy,
Roosevelt Institute, March 2010 ---
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!
Abusive off-balance sheet accounting was a major
cause of the financial crisis. These abuses triggered a daisy chain of
dysfunctional decision-making by removing transparency from investors,
markets, and regulators. Off-balance sheet accounting facilitating the
spread of the bad loans, securitizations, and derivative transactions that
brought the financial system to the brink of collapse.
As in the 1920s, the balance sheets of major
corporations recently failed to provide a clear picture of the financial
health of those entities. Banks in particular have become predisposed to
narrow the size of their balance sheets, because investors and regulators
use the balance sheet as an anchor in their assessment of risk. Banks use
financial engineering to make it appear that they are better capitalized and
less risky than they really are. Most people and businesses include all of
their assets and liabilities on their balance sheets. But large financial
institutions do not.
Click here to read the full chapter.---
http://www.rooseveltinstitute.org/sites/all/files/Off-Balance Sheet
Transactions.pdf
Frank Partnoy is the George E.
Barnett Professor of Law and Finance and is the director of the Center on
Coporate and Securities Law at the University of San Diego. He worked as a
derivatives structurer at Morgan Stanley and CS First Boston during the
mid-1990s and wrote F.I.A.S.C.O.:
Blook in the Water on Wall Street, a
best-selling book about his experiences there. His other books include
Infectious Greed: How Deceit and Risk Corrupted the Financial Markets
and
The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall
Street Scandals.
Lynn Turner has the unique
perspective of having been the Chief Accountant of the Securities and
Exchange Commission, a member of boards of public companies, a trustee of a
mutual fund and a public pension fund, a professor of accounting, a partner
in one of the major international auditing firms, the managing director of a
research firm and a chief financial officers and an executive in industry.
In 2007, Treasury Secretary Paulson appointed him to the Treasury Committee
on the Auditing Profession. He currently serves as a senior advisor to LECG,
an international forensics and economic consulting firm.
The views expressed in this paper are those of the authors and do not
necessarily reflect the positions of the Roosevelt Institute, its officers,
or its directors.
Bob Jensen's threads on OBSF are at
http://faculty.trinity.edu/rjensen/theory01.htm#OBSF2
For over 15 years Frank Partnoy has been appealing in vain for financial
reform. My timeline of history of the scandals, the new accounting standards,
and the new ploys at OBSF and earnings management is at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
My Hero Lawyer, Professor, and Wall Street Financial Expert Weighs In
Question
In the bankruptcy court examiner's report on Lehman's downfall, is Volume 3 more
or less important than Volume 2?
Answer
For Ernst & Young it is probably Volume 3, but my true hero exposing Wall Street
scandals opts for Volume 2.
My favorite Wall Street books exposing the inside greed and fraud on Wall
Street are those written by Frank Partnoy. My timeline of his exposes can be
found at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds .
Professor Partnoy's Senate Testimony was among the first solid explanations
of how derivative financial instruments frauds took place at Enron. His entire
testimony can be found at
http://faculty.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony
See his explanation of the infamous Footnote 16 of the Year 2000 Enron Annual
report ---
http://faculty.trinity.edu/rjensen/FraudEnron.htm#Senator
His books are among the funniest and best books I've ever read in my life,
even better than the books of Michael Lewis.
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
They are the most dog-eared and scruffed up books in my entire library.
"Lehman Examiner Punted on Valuation,"
by Frank Partnoy, Professor of Law and Finance University of San Diego School of
Law and author of Fiasco, Infectious Greed, and
The Match King
Naked Capitalism, March 14, 2010 ---
http://www.nakedcapitalism.com/2010/03/frank-partnoy-lehman-examiner-punted-on-valuation.html
The buzz on the Lehman bankruptcy examiner’s report
has focused on Repo 105, for good reason. That scheme is one powerful
example of how the balance sheets of major Wall Street banks are fiction. It
also shows why Congress must include real accounting reform in its financial
legislation, or risk another collapse. (If you have 8 minutes to kill, here
is my
recent talk on the off-balance sheet problem, from
the Roosevelt Institute financial conference.)
But an even more
troubling section of the Lehman report is not Volume 3 on Repo 105. It is
Volume 2, on Valuation. The Valuation
section is 500 pages of utterly terrifying reading. It shows that, even
eighteen months after Lehman’s collapse, no one – not the bankruptcy
examiner, not Lehman’s internal valuation experts, not Ernst and Young, and
certainly not the regulators – could figure out what many of Lehman’s assets
and liabilities were worth. It shows Lehman was too complex to
do anything but fail.
The report cites extensive evidence of valuation
problems. Check out page 577, where the report concludes that Lehman’s high
credit default swap valuations were reasonable because Citigroup’s marks
were ONLY 8% lower than Lehman’s. 8%? And since when are Citigroup’s
valuations the objective benchmark?
Or page 547, where the report describes how
Lehman’s so-called “Product Control Group” acted like Keystone Kops: the
group used third-party prices for only 10% of Lehman’s CDO positions, and
deferred to the traders’ models, saying “We’re not quants.” Here are two
money quotes:
While the function of the Product Control Group
was to serve as a check on the
desk marks set by Lehman’s traders, the CDO product controllers were
hampered in
two respects. First, the Product Control Group did not appear to have
sufficient
resources to price test Lehman’s CDO positions comprehensively. Second,
while the
CDO product controllers were able to effectively verify the prices of
many positions
using trade data and third‐party prices, they did not have the same
level of quantitative sophistication as many of the desk personnel who
developed models to price CDOs. (page 547)
Or this one:
However, approximately a quarter of Lehman’s
CDO positions were not affirmatively priced by the Product Control
Group, but simply noted as ‘OK’ because the desk had already written
down the position significantly. (page 548)
My favorite section describes the valuation of
Ceago, Lehman’s largest CDO position. My corporate finance students at the
University of San Diego School of Law understand that you should use higher
discount rates for riskier projects. But the Valuation section of the report
found that with respect to Ceago, Lehman used LOWER discount rates for the
riskier tranches than for the safer ones:
The discount rates used by Lehman’s Product
Controllers were significantly understated. As stated, swap rates were
used for the discount rate on the Ceago subordinate tranches. However,
the resulting rates (approximately 3% to 4%) were significantly lower
than the approximately 9% discount rate used to value the more senior S
tranche. It is inappropriate to use a discount rate on a subordinate
tranche that is lower than the rate used on a senior tranche. (page 556)
It’s one thing to have product controllers who
aren’t “quants”; it’s quite another to have people in crucial risk
management roles who don’t understand present value.
When the examiner compared Lehman’s marks on these
lower tranches to more reliable valuation estimates, it found that “the
prices estimated for the C and D tranches of Ceago securities are
approximately one‐thirtieth of the price reported by Lehman. (pages 560-61)
One thirtieth? These valuations weren’t even close.
Ultimately, the examiner concluded that these
problems related to only a small portion of Lehman’s overall portfolio. But
that conclusion was due in part to the fact that the examiner did not have
the time or resources to examine many of Lehman’s positions in detail
(Lehman had 900,000 derivative positions in 2008, and the examiner did not
even try to value Lehman’s numerous corporate debt and equity holdings).
The bankruptcy examiner didn’t see enough to bring
lawsuits. But the valuation section of the report raises some hot-button
issues for private parties and prosecutors. As the report put it, there are
issues that “may warrant further review by parties in interest.”
For example, parties in interest might want to look
at the report’s section on Archstone, a publicly traded REIT Lehman acquired
in October 2007. Much ink has been spilled criticizing the valuation of
Archstone. Here is the Report’s finding (at page 361):
… there is sufficient evidence to support a
finding that Lehman’s valuations for its Archstone equity positions were
unreasonable beginning as of the end of the first quarter of 2008, and
continuing through the end of the third quarter of 2008.
And Archstone is just one of many examples.
The Repo 105 section of the Lehman report shows
that Lehman’s balance sheet was fiction. That was bad. The Valuation section
shows that Lehman’s approach to valuing assets and liabilities was seriously
flawed. That is worse. For a levered trading firm, to not understand your
economic position is to sign your own death warrant.
|
|
|
Selected works of FRANK PARTNOY
Bob Jensen at Trinity University
1. Who is Frank
Partnoy?
Cheryl Dunn
requested that I do a review of my favorites among the
“books that have influenced [my] work.” Immediately
the succession of FIASCO books by Frank Partnoy
came to mind. These particular books are not the best
among related books by Wall Street whistle blowers such
as Liar's Poker: Playing the Money Markets by
Michael Lewis in 1999 and Monkey Business: Swinging
Through the Wall Street Jungle by John Rolfe and
Peter Troob in 2002. But in1997. Frank Partnoy was the
first writer to open my eyes to the enormous gap between
our assumed efficient and fair capital markets versus
the “infectious greed” (Alan Greenspan’s term) that had
overtaken these markets.
Partnoy’s succession
of FIASCO books, like those of Lewis and Rolfe/Troob
are reality books written from the perspective of inside
whistle blowers. They are somewhat repetitive and
anecdotal mainly from the perspective of what each
author saw and interpreted.
My favorite among
the capital market fraud books is Frank Partnoy’s latest
book Infectious Greed: How Deceit and Risk Corrupted
the Financial Markets (Henry Holt & Company,
Incorporated, 2003, ISBN: 080507510-0- 477 pages). This
is the most scholarly of the books available on business
and gatekeeper degeneracy. Rather than relying mostly
upon his own experiences, this book drawn from Partnoy’s
interviews of over 150 capital markets insiders of one
type or another. It is more scholarly because it
demonstrates Partnoy’s evolution of learning about
extremely complex structured financing packages that
were the instruments of crime by banks, investment
banks, brokers, and securities dealers in the most
venerable firms in the U.S. and other parts of the
world. The book is brilliant and has a detailed and
helpful index.
What did I learn
most from Partnoy?
I learned about the
failures and complicity of what he terms “gatekeepers”
whose fiduciary responsibility was to inoculate against
“infectious greed.” These gatekeepers instead
manipulated their professions and their governments to
aid and abet the criminals. On Page 173 of
Infectious Greed, he writes the following:
Page #173
When
Republicans captured the House of Representatives in
November 1994--for the first time since the Eisenhower
era--securities-litigation reform was assured. In a
January 1995 speech, Levitt outlined the limits on
securities regulation that Congress later would support:
limiting the statute-of-limitations period for filing
lawsuits, restricting legal fees paid to lead
plaintiffs, eliminating punitive-damages provisions from
securities lawsuits, requiring plaintiffs to allege more
clearly that a defendant acted with reckless intent, and
exempting "forward
looking
statements"--essentially, projections about a company's
future--from legal liability.
The Private
Securities Litigation Reform Act of 1995 passed easily,
and Congress even overrode the veto of President
Clinton, who either had a fleeting change of heart about
financial markets or decided that trial lawyers were an
even more
important
constituency than Wall Street. In any event, Clinton
and Levitt disagreed about the issue, although it wasn't
fatal to Levitt, who would remain SEC chair for another
five years.
He later introduces
Chapter 7 of Infectious Greed as follows:
Pages
187-188
The
regulatory changes of 1994-95 sent three messages to
corporate CEOs. First, you are not likely to be
punished for "massaging" your firm's accounting
numbers. Prosecutors rarely go after financial fraud
and, even when they do, the typical punishment is a
small fine; almost no one goes to prison. Moreover,
even a fraudulent scheme could be recast as mere
earnings management--the practice of smoothing a
company's earnings--which most executives did, and
regarded as perfectly legal.
Second,
you should use new financial instruments--including
options, swaps, and other derivatives--to increase your
own pay and to avoid costly regulation. If complex
derivatives are too much for you to handle--as they were
for many CEOs during the years immediately following the
1994 losses--you should at least pay yourself in stock
options, which don't need to be disclosed as an expense
and have a greater upside than cash bonuses or stock.
Third, you
don't need to worry about whether accountants or
securities analysts will tell investors about any hidden
losses or excessive options pay. Now that Congress and
the Supreme Court have insulated accounting firms and
investment banks from liability--with the Central Bank
decision and the Private Securities Litigation Reform
Act--they will be much more willing to look the other
way. If you pay them enough in fees, they might even be
willing to help.
Of course,
not every corporate executive heeded these messages.
For example, Warren Buffett argued that managers should
ensure that their companies' share prices were accurate,
not try to inflate prices artificially, and he
criticized the use of stock options as compensation.
Having been a major shareholder of Salomon Brothers,
Buffett also criticized accounting and securities firms
for conflicts of interest.
But for
every Warren Buffett, there were many less scrupulous
CEOs. This chapter considers four of them: Walter
Forbes of CUC International, Dean Buntrock of Waste
Management, Al Dunlap of Sunbeam, and Martin Grass of
Rite Aid. They are not all well-known among investors,
but their stories capture the changes in CEO behavior
during the mid-1990s. Unlike the "rocket scientists" at
Bankers Trust, First Boston, and Salomon Brothers, these
four had undistinguished backgrounds and little training
in mathematics or finance. Instead, they were
hardworking, hard-driving men who ran companies that met
basic consumer needs: they sold clothes, barbecue
grills, and prescription medicine, and cleaned up
garbage. They certainly didn't buy swaps linked to
LIBOR-squared.
The book
Infectious Greed has chapters on other capital
markets and corporate scandals. It is the best account
that I’ve ever read about Bankers Trust the Bankers
Trust scandals, including how one trader named Andy
Krieger almost destroyed the entire money supply of New
Zealand. Chapter 10 is devoted to Enron and follows up
on Frank Partnoy’s invited testimony before the United
States Senate Committee on Governmental Affairs, January
24, 2002 ---
http://www.senate.gov/~gov_affairs/012402partnoy.htm
The controversial
writings of Frank Partnoy have had an enormous impact on
my teaching and my research. Although subsequent
writers wrote somewhat more entertaining exposes, he was
the one who first opened my eyes to what goes on behind
the scenes in capital markets and investment banking.
Through his early writings, I discovered that there is
an enormous gap between the efficient financial world
that we assume in agency theory worshipped in academe
versus the dark side of modern reality where you find
the cleverest crooks out to steal money from widows and
orphans in sophisticated ways where it is virtually
impossible to get caught. Because I read his 1997 book
early on, the ensuing succession of enormous scandals in
finance, accounting, and corporate governance weren’t
really much of a surprise to me.
From his insider
perspective he reveals a world where our most respected
firms in banking, market exchanges, and related
financial institutions no longer care anything about
fiduciary responsibility and professionalism in
disgusting contrast to the honorable founders of those
same firms motivated to serve rather than steal.
Young men and women
from top universities of the world abandoned almost all
ethical principles while working in investment banks and
other financial institutions in order to become not only
rich but filthy rich at the expense of countless pension
holders and small investors. Partnoy opened my eyes to
how easy it is to get around auditors and corporate
boards by creating structured financial contracts that
are incomprehensible and serve virtually no purpose
other than to steal billions upon billions of dollars.
Most importantly,
Frank Partnoy opened my eyes to the psychology of
greed. Greed is rooted in opportunity and cultural
relativism. He graduated from college with a high sense
of right and wrong. But his standards and values sank
to the criminal level of those when he entered the
criminal world of investment banking. The only
difference between him and the crooks he worked with is
that he could not quell his conscience while stealing
from widows and orphans.
Frank Partnoy has a
rare combination of scholarship and experience in law,
investment banking, and accounting. He is sometimes
criticized for not really understanding the complexities
of some of the deals he described, but he rather freely
admits that he was new to the game of complex deceptions
in international structured financing crime.
2. What really
happened at Enron? ---
http://faculty.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony
3. What are some
of Frank Partnoy’s best-known works?
Frank Partnoy,
FIASCO: Blood in the Water on Wall Street (W. W.
Norton & Company, 1997, ISBN 0393046222, 252 pages).
This is the first of a somewhat
repetitive succession of Partnoy’s “FIASCO” books that
influenced my life. The most important revelation from
his insider’s perspective is that the most trusted firms
on Wall Street and financial centers in other major
cities in the U.S., that were once highly professional
and trustworthy, excoriated the guts of integrity
leaving a façade behind which crooks less violent than
the Mafia but far more greedy took control in the
roaring 1990s.
After selling a succession of phony
derivatives deals while at Morgan Stanley, Partnoy blew
the whistle in this book about a number of his
employer’s shady and outright fraudulent deals sold in
rigged markets using bait and switch tactics.
Customers, many of them pension fund investors for
schools and municipal employees, were duped into complex
and enormously risky deals that were billed as safe as
the U.S. Treasury.
His books have received mixed reviews,
but I question some of the integrity of the reviewers
from the investment banking industry who in some
instances tried to whitewash some of the deals described
by Partnoy. His books have received a bit less praise
than the book Liars Poker by Michael Lewis, but
critics of Partnoy fail to give credit that Partnoy’s
exposes preceded those of Lewis.
Frank Partnoy,
FIASCO: Guns, Booze and Bloodlust: the Truth About High
Finance (Profile Books, 1998, 305 Pages)
Like his earlier books, some investment
bankers and literary dilettantes who reviewed this book
were critical of Partnoy and claimed that he
misrepresented some legitimate structured financings.
However, my reading of the reviewers is that they were
trying to lend credence to highly questionable offshore
deals documented by Partnoy. Be that as it may, it
would have helped if Partnoy had been a bit more
explicit in some of his illustrations.
Frank Partnoy,
FIASCO: The Inside Story of a Wall Street Trader
(Penguin, 1999, ISBN 0140278796, 283 pages).
This is a
blistering indictment of the unregulated OTC market
for derivative financial instruments and the million
and billion dollar deals conceived in investment
banking. Among other things, Partnoy describes
Morgan Stanley’s annual drunken skeet-shooting
competition organized by a “gun-toting strip-joint
connoisseur” former combat officer (fanatic) who
loved the motto: “When derivatives are outlawed
only outlaws will have derivatives.” At that event,
derivatives salesmen were forced to shoot entrapped
bunnies between the eyes on the pretense that the
bunnies were just like “defenseless animals” that
were Morgan Stanley’s customers to be shot down even
if they might eventually “lose a billion dollars on
derivatives.”
This book has one of the best accounts of the
“fiasco” caused almost entirely by the duping of
Orange
County ’s Treasurer (Robert Citron)
by the unscrupulous Merrill Lynch derivatives
salesman named Michael
Stamenson. Orange
County eventually lost over a billion
dollars and was forced into bankruptcy. Much of
this was later recovered in court from Merrill
Lynch. Partnoy calls
Citron and Stamenson
“The Odd Couple,” which is also the title of Chapter
8 in the book.Frank Partnoy, Infectious Greed:
How Deceit and Risk Corrupted the Financial Markets
(Henry Holt & Company, Incorporated, 2003, ISBN:
080507510-0, 477 pages)Frank Partnoy, Infectious
Greed: How Deceit and Risk Corrupted the Financial
Markets (Henry Holt & Company, Incorporated,
2003, ISBN: 080507510-0, 477 pages)
Partnoy shows how corporations gradually
increased financial risk and lost control over overly
complex structured financing deals that obscured the
losses and disguised frauds pushed corporate officers
and their boards into successive and ingenious
deceptions." Major corporations such as Enron, Global
Crossing, and WorldCom entered into enormous illegal
corporate finance and accounting. Partnoy documents the
spread of this epidemic stage and provides some
suggestions for restraining the disease.
"The Siskel and
Ebert of Financial Matters: Two Thumbs Down for the
Credit Reporting Agencies" by Frank Partnoy,
Washington University Law Quarterly, Volume 77, No. 3,
1999 ---
http://ls.wustl.edu/WULQ/
4. What are
examples of related books that are somewhat more
entertaining than Partnoy’s early books?
Michael Lewis,
Liar's Poker: Playing the Money Markets (Coronet,
1999, ISBN 0340767006)
Lewis writes in Partnoy’s earlier
whistleblower style with somewhat more intense and comic
portrayals of the major players in describing the double
dealing and break down of integrity on the trading floor
of Salomon Brothers.
John Rolfe and Peter
Troob, Monkey Business: Swinging Through the Wall
Street Jungle (Warner Books, Incorporated, 2002,
ISBN: 0446676950, 288 Pages)
This is
a hilarious tongue-in-cheek account by Wharton and
Harvard MBAs who thought they were starting out as
stock brokers for $200,000 a year until they
realized that they were on the phones in a bucket
shop selling sleazy IPOs to unsuspecting
institutional investors who in turn passed them
along to widows and orphans. They write. "It took
us another six months after that to realize
that we were, in fact, selling crappy public
offerings to investors."
There are other books along a similar
vein that may be more revealing and entertaining
than the early books of Frank Partnoy, but he was
one of the first, if not the first, in the roaring
1990s to reveal the high crime taking place behind
the concrete and glass of Wall Street. He was the
first to anticipate many of the scandals that soon
followed. And his testimony before the U.S. Senate
is the best concise account of the crime that
transpired at Enron. He lays the blame clearly at
the feet of government officials (read that Wendy
Gramm) who sold the farm when they deregulated the
energy markets and opened the doors to unregulated
OTC derivatives trading in energy. That is when
Enron really began bilking the public.
Some of the many, many
lawsuits settled by auditing firms can be found at
http://faculty.trinity.edu/rjensen/Fraud001.htm
|
|
The End of Wall Street?
Liars Poker II is called "The End"
The Not-Funny Punch Line is Not Until Page 9 of This Tongue in Cheek Explanation
of the Meltdown on Wall Street!
Now I asked
Gutfreund about his biggest decision. “Yes,” he said. “They—the heads of
the other Wall Street firms—all said what an awful thing it was to go public
(beg for a government bailout)
and how could you do such a thing. But when the
temptation arose, they all gave in to it.” He agreed that the main effect of
turning a partnership into a corporation was to transfer the financial risk
to the shareholders. “When things go wrong, it’s their problem,” he said—and
obviously not theirs alone. When a Wall Street investment bank screwed up
badly enough, its risks became the problem of the U.S. government. “It’s
laissez-faire until you get in deep shit,” he said, with a half chuckle. He
was out of the game.
This is a must read to understand what went wrong on Wall Street ---
especially the punch line!
"The End," by Michael Lewis December 2008 Issue The era that defined Wall Street
is finally, officially over. Michael Lewis, who chronicled its excess in Liar’s
Poker, returns to his old haunt to figure out what went wrong.
http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom?tid=true
To this day, the willingness of a Wall Street
investment bank to pay me hundreds of thousands of dollars to dispense
investment advice to grownups remains a mystery to me. I was 24 years old,
with no experience of, or particular interest in, guessing which stocks and
bonds would rise and which would fall. The essential function of Wall Street
is to allocate capital—to decide who should get it and who should not.
Believe me when I tell you that I hadn’t the first clue.
I’d never taken an accounting course, never run a
business, never even had savings of my own to manage. I stumbled into a job
at Salomon Brothers in 1985 and stumbled out much richer three years later,
and even though I wrote a book about the experience, the whole thing still
strikes me as preposterous—which is one of the reasons the money was so easy
to walk away from. I figured the situation was unsustainable. Sooner rather
than later, someone was going to identify me, along with a lot of people
more or less like me, as a fraud. Sooner rather than later, there would come
a Great Reckoning when Wall Street would wake up and hundreds if not
thousands of young people like me, who had no business making huge bets with
other people’s money, would be expelled from finance.
When I sat down to write my account of the
experience in 1989—Liar’s Poker, it was called—it was in the spirit of a
young man who thought he was getting out while the getting was good. I was
merely scribbling down a message on my way out and stuffing it into a bottle
for those who would pass through these parts in the far distant future.
Unless some insider got all of this down on paper,
I figured, no future human would believe that it happened.
I thought I was writing a period piece about the
1980s in America. Not for a moment did I suspect that the financial 1980s
would last two full decades longer or that the difference in degree between
Wall Street and ordinary life would swell into a difference in kind. I
expected readers of the future to be outraged that back in 1986, the C.E.O.
of Salomon Brothers, John Gutfreund, was paid $3.1 million; I expected them
to gape in horror when I reported that one of our traders, Howie Rubin, had
moved to Merrill Lynch, where he lost $250 million; I assumed they’d be
shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the
risks his traders were running. What I didn’t expect was that any future
reader would look on my experience and say, “How quaint.”
I had no great agenda, apart from telling what I
took to be a remarkable tale, but if you got a few drinks in me and then
asked what effect I thought my book would have on the world, I might have
said something like, “I hope that college students trying to figure out what
to do with their lives will read it and decide that it’s silly to phony it
up and abandon their passions to become financiers.” I hoped that some
bright kid at, say, Ohio State University who really wanted to be an
oceanographer would read my book, spurn the offer from Morgan Stanley, and
set out to sea.
Somehow that message failed to come across. Six
months after Liar’s Poker was published, I was knee-deep in letters from
students at Ohio State who wanted to know if I had any other secrets to
share about Wall Street. They’d read my book as a how-to manual.
In the two decades since then, I had been waiting
for the end of Wall Street. The outrageous bonuses, the slender returns to
shareholders, the never-ending scandals, the bursting of the internet
bubble, the crisis following the collapse of Long-Term Capital Management:
Over and over again, the big Wall Street investment banks would be, in some
narrow way, discredited. Yet they just kept on growing, along with the sums
of money that they doled out to 26-year-olds to perform tasks of no obvious
social utility. The rebellion by American youth against the money culture
never happened. Why bother to overturn your parents’ world when you can buy
it, slice it up into tranches, and sell off the pieces?
At some point, I gave up waiting for the end. There
was no scandal or reversal, I assumed, that could sink the system.
The New Order The crash did more than wipe out
money. It also reordered the power on Wall Street. What a Swell Party A
pictorial timeline of some Wall Street highs and lows from 1985 to 2007.
Worst of Times Most economists predict a recovery late next year. Don’t bet
on it. Then came Meredith Whitney with news. Whitney was an obscure analyst
of financial firms for Oppenheimer Securities who, on October 31, 2007,
ceased to be obscure. On that day, she predicted that Citigroup had so
mismanaged its affairs that it would need to slash its dividend or go bust.
It’s never entirely clear on any given day what causes what in the stock
market, but it was pretty obvious that on October 31, Meredith Whitney
caused the market in financial stocks to crash. By the end of the trading
day, a woman whom basically no one had ever heard of had shaved $369 billion
off the value of financial firms in the market. Four days later, Citigroup’s
C.E.O., Chuck Prince, resigned. In January, Citigroup slashed its dividend.
From that moment, Whitney became E.F. Hutton: When
she spoke, people listened. Her message was clear. If you want to know what
these Wall Street firms are really worth, take a hard look at the crappy
assets they bought with huge sums of borrowed money, and imagine what
they’d fetch in a fire sale. The vast assemblages of highly paid people
inside the firms were essentially worth nothing. For better than a year now,
Whitney has responded to the claims by bankers and brokers that they had put
their problems behind them with this write-down or that capital raise with a
claim of her own: You’re wrong. You’re still not facing up to how badly you
have mismanaged your business.
Rivals accused Whitney of being overrated; bloggers
accused her of being lucky. What she was, mainly, was right. But it’s true
that she was, in part, guessing. There was no way she could have known what
was going to happen to these Wall Street firms. The C.E.O.’s themselves
didn’t know.
Now, obviously, Meredith Whitney didn’t sink Wall
Street. She just expressed most clearly and loudly a view that was, in
retrospect, far more seditious to the financial order than, say, Eliot
Spitzer’s campaign against Wall Street corruption. If mere scandal could
have destroyed the big Wall Street investment banks, they’d have vanished
long ago. This woman wasn’t saying that Wall Street bankers were corrupt.
She was saying they were stupid. These people whose job it was to allocate
capital apparently didn’t even know how to manage their own.
At some point, I could no longer contain myself: I
called Whitney. This was back in March, when Wall Street’s fate still hung
in the balance. I thought, If she’s right, then this really could be the end
of Wall Street as we’ve known it. I was curious to see if she made sense but
also to know where this young woman who was crashing the stock market with
her every utterance had come from.
It turned out that she made a great deal of sense
and that she’d arrived on Wall Street in 1993, from the Brown University
history department. “I got to New York, and I didn’t even know research
existed,” she says. She’d wound up at Oppenheimer and had the most
incredible piece of luck: to be trained by a man who helped her establish
not merely a career but a worldview. His name, she says, was Steve Eisman.
Eisman had moved on, but they kept in touch. “After
I made the Citi call,” she says, “one of the best things that happened was
when Steve called and told me how proud he was of me.”
Having never heard of Eisman, I didn’t think
anything of this. But a few months later, I called Whitney again and asked
her, as I was asking others, whom she knew who had anticipated the cataclysm
and set themselves up to make a fortune from it. There’s a long list of
people who now say they saw it coming all along but a far shorter one of
people who actually did. Of those, even fewer had the nerve to bet on their
vision. It’s not easy to stand apart from mass hysteria—to believe that most
of what’s in the financial news is wrong or distorted, to believe that most
important financial people are either lying or deluded—without actually
being insane. A handful of people had been inside the black box, understood
how it worked, and bet on it blowing up. Whitney rattled off a list with a
half-dozen names on it. At the top was Steve Eisman.
Steve Eisman entered finance about the time I
exited it. He’d grown up in New York City and gone to a Jewish day school,
the University of Pennsylvania, and Harvard Law School. In 1991, he was a
30-year-old corporate lawyer. “I hated it,” he says. “I hated being a
lawyer. My parents worked as brokers at Oppenheimer. They managed to finagle
me a job. It’s not pretty, but that’s what happened.”
He was hired as a junior equity analyst, a helpmate
who didn’t actually offer his opinions. That changed in December 1991, less
than a year into his new job, when a subprime mortgage lender called Ames
Financial went public and no one at Oppenheimer particularly cared to
express an opinion about it. One of Oppenheimer’s investment bankers stomped
around the research department looking for anyone who knew anything about
the mortgage business. Recalls Eisman: “I’m a junior analyst and just trying
to figure out which end is up, but I told him that as a lawyer I’d worked on
a deal for the Money Store.” He was promptly appointed the lead analyst for
Ames Financial. “What I didn’t tell him was that my job had been to
proofread the documents and that I hadn’t understood a word of the fucking
things.”
Ames Financial belonged to a category of firms
known as nonbank financial institutions. The category didn’t include J.P.
Morgan, but it did encompass many little-known companies that one way or
another were involved in the early-1990s boom in subprime mortgage
lending—the lower class of American finance.
The second company for which Eisman was given sole
responsibility was Lomas Financial, which had just emerged from bankruptcy.
“I put a sell rating on the thing because it was a piece of shit,” Eisman
says. “I didn’t know that you weren’t supposed to put a sell rating on
companies. I thought there were three boxes—buy, hold, sell—and you could
pick the one you thought you should.” He was pressured generally to be a bit
more upbeat, but upbeat wasn’t Steve Eisman’s style. Upbeat and Eisman
didn’t occupy the same planet. A hedge fund manager who counts Eisman as a
friend set out to explain him to me but quit a minute into it. After
describing how Eisman exposed various important people as either liars or
idiots, the hedge fund manager started to laugh. “He’s sort of a prick in a
way, but he’s smart and honest and fearless.”
“A lot of people don’t get Steve,” Whitney says.
“But the people who get him love him.” Eisman stuck to his sell rating on
Lomas Financial, even after the company announced that investors needn’t
worry about its financial condition, as it had hedged its market risk. “The
single greatest line I ever wrote as an analyst,” says Eisman, “was after
Lomas said they were hedged.” He recited the line from memory: “ ‘The Lomas
Financial Corp. is a perfectly hedged financial institution: It loses money
in every conceivable interest-rate environment.’ I enjoyed writing that
sentence more than any sentence I ever wrote.” A few months after he’d
delivered that line in his report, Lomas Financial returned to bankruptcy.
Continued in article
Michael Lewis, Liar's Poker: Playing the Money Markets (Coronet, 1999, ISBN
0340767006)
Lewis writes in Partnoy’s earlier whistleblower
style with somewhat more intense and comic portrayals of the major players
in describing the double dealing and break down of integrity on the trading
floor of Salomon Brothers.
Continued at
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Bob Jensen's threads on the Lehman Examiner's Report ---
http://faculty.trinity.edu/rjensen/fraud001.htm#Ernst
Do Investors Overvalue Firms With Bloated Balance Sheets?
David A. Hirshleifer University of California, Irvine - Paul Merage School of
Business
Kewei Hou Ohio State University - Department of Finance
Siew Hong Teoh University of California - Paul Merage School of Business
Yinglei Zhang Chinese University of Hong Kong (CUHK) - School of Accountancy
SSRN, February 2004
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=404120
Abstract:
If investors have limited attention, then accounting outcomes that saliently
highlight positive aspects of a firm's performance will promote high market
valuations. When cumulative accounting value added (net operating income)
over time outstrips cumulative cash value added (free cash flow), it becomes
hard for the firm to sustain further earnings growth. When the balance sheet
is 'bloated' in this fashion, we argue that investors with limited attention
will overvalue the firm, because naďve earnings-based valuation disregards
the firm's relative lack of success in generating cash flows in excess of
investment needs. The level of net operating assets, the difference between
cumulative earnings and cumulative free cash flow over time, is therefore a
measure of the extent to which operating/reporting outcomes provoke
excessive investor optimism. Therefore, if investor attention is limited,
net operating assets will negatively predict subsequent stock returns. In
our 1964-2002 sample, net operating assets scaled by beginning total assets
is a strong negative predictor of long-run stock returns. Predictability is
robust with respect to an extensive set of controls and testing methods.
Bob Jensen's threads on valuation are at
http://faculty.trinity.edu/rjensen/roi.htm
The Berkeley Electronic Press publishes the Journal of
Business Valuation and Economic Loss Analysis ---
http://www.bepress.com/jbvela/
Why does the title of this journal strike me as funny?
Is there a hidden
message here?
From The
Wall Street Journal Accounting Review on October 8, 2009
Borrowing for Dividends Raises Worries
by Liz Rappaport
Oct 05, 2009
Click here to view the full article on WSJ.com
TOPICS: Bonds,
Debt, Dividends, Financial Accounting, Financial Analysis, Financial Statement
Analysis, Mergers and Acquisitions
SUMMARY: "Rock-bottom
interest rates and thawed credit markets are emboldening some companies to use
bond-sale proceeds...to pay out special dividends, buy back stock, or finance
acquisitions.... [In contrast,] most corporate-bond offerings during the
recession have been used to reduce debt or stockpile cash."
CLASSROOM
APPLICATION: The
article can be used in covering bond issuances, ratio analysis particularly of
debt-to-equity and interest versus earnings, dividend payments, and corporate
acquisitions.
QUESTIONS:
1. (Introductory) What was the effective interest rate for corporations
with high credit ratings who issued bonds in September 2009? How does that rate
compare to one year ago?
2. (Introductory) What reasons for that change are given in the article?
Do they have anything to do with changing creditworthiness of the borrowers?
3. (Introductory) Compare the actions of Intel Corporation and TransDigm
Group, Inc., with their debt issuance. How are they similar? How are they
different?
4. (Advanced) What is the impact on a corporate balance sheet of issuing
debt? Describe the impact ignoring use of the proceeds, in essence assuming the
company will "stockpile" the cash.
5. (Introductory) Define the financial statement ratios of debt-to-equity
and times interest earned.
6. (Advanced) Describe the change in impact of debt issuance on a balance
sheet equation and the two financial ratios if the proceeds are used to pay
dividends to shareholders.
7. (Advanced) Can a company issue bonds in order to "reduce debt" as the
author says was done in during the recession and credit crisis? Explain,
proposing a better term for such a transaction.
8. (Introductory) The author uses two benchmarks to make clear the impact
of TransDigm Group's debt issuance and dividend payment. What are these
benchmarks? How does using them increase clarity about the size of the $425
million bond offering and the $7.50 to $7.70 per share special dividend?
9. (Advanced) The author also includes use of bond proceed to finance
acquisitions as a risky action. How have debt analysts reacted to Kraft's offer
to buy Cadbury?
10. (Advanced) Describe the impact of a business combination financed by
debt on the total combined balance sheets of the firms entering into the
business combination. How does this impact compare to using bond proceeds to pay
dividends to shareholders? How does it differ?
Reviewed By: Judy Beckman, University of Rhode Island
"Borrowing
for Dividends Raises Worries," by Liz Rappaport, October 5, 2009 ---
http://online.wsj.com/article/SB125470107157763085.html?mod=djem_jiewr_AC
Rock-bottom interest rates and thawed credit markets are emboldening some
companies to use bond-sale proceeds to go on the offensive, even if that means
rewarding shareholders at the expense of bondholders.
The nascent trend is controversial because corporate borrowers are sinking
themselves deeper into debt to pay out special dividends, buy back stock or
finance acquisitions. While such moves were all the rage during the credit boom,
most corporate-bond offerings during the recession have been used to reduce debt
or stockpile cash.
Eric Felder, global head of credit trading at Barclays Capital, says the lure of
low rates and companies' stables of cash increases "the risk of non-bondholder
friendly events."
Last week's sale of $425 million of bonds by aircraft-parts manufacturer
TransDigm Group Inc. is one of the back-to-the-past corporate-bond deals causing
concern among some analysts. More than $360 million of the proceeds will be used
to pay a special cash dividend to shareholders and management of the Cleveland
company.
The added debt increased TransDigm's borrowings to 4.3 times its earnings before
interest and taxes, compared with 3.1 times before last week's deal. The
expected dividend of $7.50 to $7.70 a share is equal to nearly all of the net
income that TransDigm reported since the end of fiscal 2003, according to
Moody's Investors Service.
Moody's said the dividend "illustrates the company's aggressive financial
policy." Moody's gave the new debt a junk rating of B3, even though the ratings
firm said TransDigm's "strong operating performance will enable the company to
service the increased debt level."
Sean Maroney, director of investor relations at TransDigm, says the "stability
of our business, high profit margins and consistent cash flow" give the company
"the ability to support this level of leverage."
Borrowing from bondholders to pay shareholder dividends is "a hallmark of an
earlier credit era," Jeffrey Rosenberg, head of credit strategy at Bank of
America Merrill Lynch, wrote in a report Friday. Such deals were popular in 2003
and 2004, the last time the Federal Reserve lowered its benchmark interest rate
to historically low levels, keeping it at 1% for more than a year.
Companies like Dex Media Inc. took on debt to pay dividends to its
private-equity owners, including Carlyle Group and Welsh, Carson, Anderson &
Stowe, before taking the companies public. Dex Media filed for bankruptcy
earlier this year under a mountain of debt.
With the federal-funds rate at 0% for nine months now and confidence returning
to the stock and debt markets, investors have been driven to take on more risk.
That is flooding the corporate-bond market with cash. Investors poured $43
billion into investment-grade corporate-bond funds in the second quarter and
nearly $40 billion in the third quarter -- almost double previous peak quarters,
according to Lipper AMG Data Services.
The wave of buying drove down borrowing costs for the average highly rated
corporation to about 5%, according to Merrill, a level not seen since 2005. In
the heat of the crisis last October, such rates averaged 9%. Through the end of
September, more than 1,000 high-rated companies borrowed a record $860 billion,
according to Dealogic.
In July, Intel Corp. sold $1.75 billion of convertible bonds, planning to use
$1.5 billion of the proceeds to buy back shares. A spokesman for Intel declined
to comment.
The computer-chip giant has a strong credit rating of single-A, so it doesn't
carry a burdensome debt load. Still, the deal raised eyebrows among some
analysts and investors, who say floating debt to buy back stock could become
more common as companies regain confidence.
And as merger-and-acquisition activity revs up, the cheaper cost of debt
compared with equity is tempting companies to use bond sales as a deal-making
war chest.
Analysts are watching Kraft Foods Inc. in anticipation that the company would
finance its proposed purchase of U.K. chocolate, candy and chewing gum maker
Cadbury PLC by raising tons of debt. Last month's unsolicited bid by Kraft was
then valued at about $16.7 billion, but it could be weeks before Kraft submits a
formal offer.
Three major credit-ratings agencies have warned Kraft that they could slash the
company's debt ratings if the company reaches a deal agreement with Cadbury. At
the current offering price, Kraft would need to shell out at least $6 billion in
cash, much of it likely from the debt markets, according to corporate-bond
research firm Gimme Credit.
"Kraft is committed to maintaining an investment-grade rating," a Kraft
spokesman said, declining to comment further.
So far in 2009, returns to high-grade bond investors are 19%, according to
Merrill. "We've seen a feeding frenzy" because of low interest rates, says
Kathleen Gaffney, portfolio manager at Loomis, Sayles & Co. She sold some bonds
recently to take profits from the rally. Loomis Sayles wants to have cash on the
sidelines in case the Fed raises rates soon or Treasury bonds sell off.
Jensen
Comment
If you buy into the Modigliani and Miller Theorem of capital structure, how the
corporation is financed, including dividend payouts,
The Modigliani-Miller theorem
(of
Franco Modigliani,
Merton Miller)
forms the basis for modern thinking on
capital structure. The basic theorem
states that, under a certain market price process (the classical
random walk),
in the absence of
taxes,
bankruptcy
costs, and
asymmetric information,
and in an
efficient market,
the value of a firm is unaffected by how that firm is financed. It does not
matter if the firm's capital is raised by issuing
stock or selling debt.
It does not matter what the firm's
dividend
policy is.
Therefore, the Modigliani-Miller theorem is also often called the capital
structure irrelevance principle.
Modigliani was awarded the
1985 Nobel Prize in Economics for this and
other contributions.
Miller was awarded the 1990 Nobel Prize in Economics, along with
Harry Markowitz and
William Sharpe, for their "work in the
theory of financial economics," with Miller specifically cited for "fundamental
contributions to the theory of corporate finance."
Of course
these days, the assumption of market efficiency is a big stretch ---
http://faculty.trinity.edu/rjensen/theory01.htm#EMH
Bob
Jensen's threads on debt versus equity and capital structure (including investor
earn out contracts) are at
http://faculty.trinity.edu/rjensen/theory01.htm#FAS150
Bob
Jensen's bookmarks for financial ratios ---
http://faculty.trinity.edu/rjensen/Bookbob1.htm#010303FinancialRatios
Also see
http://en.wikipedia.org/wiki/Financial_ratios
Bob
Jensen's threads on valuation of the firm are at
http://faculty.trinity.edu/rjensen/roi.htm
Bob
Jensen's threads on accounting theory are at
http://faculty.trinity.edu/rjensen/theory01.htm
Alpha Return on Investment ---
http://en.wikipedia.org/wiki/Alpha_(investment)
What the professional investors don't tell you ---
I downloaded this video ---
http://www.cs.trinity.edu/~rjensen/temp/FinancialRounds.flv
From the Financial Rounds Blog on September 4, 2009 ---
http://financialrounds.blogspot.com/
When I teach investments, there's always a section
on market efficiency. A key point I try to make is that any test of market
efficiency suffers from the "joint hypothesis" problem - that the test is
not tests market efficiency, but also assumes that you have the correct
model for measuring the benchmark risk-adjusted return.
In other words, you can't say that you have "alpha" (an abnormal return)
without correcting for risk.
Falkenblog makes exactly this point:
In my book
Finding Alpha I describe these strategies, as
they are built on the fact that alpha is a residual return, a
risk-adjusted return, and as 'risk' is not definable, this gives people
a lot of degrees of freedom. Further, it has long been the case that
successful people are good at doing one thing while saying they are
doing another.
Even better, he's got a pretty good video on the topic
(it also touches on other topics). Enjoy.
You can watch the video under September 4, 2009 at
http://financialrounds.blogspot.com/
I downloaded this video ---
http://www.cs.trinity.edu/~rjensen/temp/FinancialRounds.flv
Bob Jensen's threads on market efficiency (EMH) are at
http://faculty.trinity.edu/rjensen/theory01.htm#EMH
Bob Jensen's threads on market efficiency (EMH) are at
http://faculty.trinity.edu/rjensen/theory01.htm#EMH
There's a shelf of financial bestsellers whose
titles now sound absurd: Ravi Batra's The Great Depression of 1990; James
Glassman's Dow 36,000; Harry Figgie's Bankruptcy 1995: The Coming Collapse of
America and How to Stop It. There’s BusinessWeek’s 1979 description of "the
death of equities as a near permanent condition,
Michael Lewis, "The Evolution of an
Investor," Blaine-Lourd Profile, December 2007 ---
http://www.portfolio.com/executives/features/2007/11/19/Blaine-Lourd-Profile#page3
As quoted by Jim Mahar in his Finance Professor Blog at
http://financeprofessorblog.blogspot.com/
As a group, professional money managers control more
than 90 percent of the U.S. stock market. By definition, the money they invest
yields returns equal to those of the market as a whole, minus whatever fees
investors pay them for their services. This simple math, you might think, would
lead investors to pay professional money managers less and less. Instead, they
pay them more and more...Nobody knows which stock is going to go up. Nobody
knows what the market as a whole is going to do, not even Warren Buffett. A
handful of people with amazing track records isn’t evidence that people can game
the market. Nobody knows which company will prove a good long-term investment.
Even Buffett’s genius lies more in running businesses than in picking stocks.
But in the investing world, that is ignored. Wall Street, with its army of
brokers, analysts, and advisers funneling trillions of dollars into mutual
funds, hedge funds, and private equity funds, is an elaborate fraud.
Michael Lewis, "The Evolution of an
Investor," Blaine-Lourd Profile, December 2007 ---
http://www.portfolio.com/executives/features/2007/11/19/Blaine-Lourd-Profile#page3
As quoted by Jim Mahar in his Finance Professor Blog at
http://financeprofessorblog.blogspot.com/
From Jim Mahar's blog on September 19, 2006 ---
http://financeprofessorblog.blogspot.com/
SSRN-102 Errors in
Company Valuations (102 Errores en Valoraciones de Empresas) by Pablo
Fernández
Want to practice your
Spanish while studying Finance as well? This paper provides you the
opportunity! It examines common mistakes that we tend to make in
valuation.
I won't try to translate it for you (I actually surprised myself as I
could read most of it!) but fortunately the abstract is in English.
SSRN-102 Errors in Company Valuations (102 Errores en Valoraciones de
Empresas) by Pablo Fernández:
"This paper contains a collection and
classification of 96 errors seen in company valuations performed by
financial analysts, investment banks and financial consultants. The
author had access to most of the valuations referred to in this
paper in his capacity as a consultant in company acquisitions,
sales, mergers, and arbitrage processes.
We classify the errors in six main categories: 1) Errors in the
discount rate calculation and concerning the riskiness of the
company; 2) Errors when calculating or forecasting the expected cash
flows; 3) Errors in the calculation of the residual value; 4)
Inconsistencies and conceptual errors; 5) Errors when interpreting
the valuation; and 6) Organizational errors"
September 19, 2006 message from Bob Deily,
MBAWare [bdeily@mbaware.com]
Dear Dr. Jensen,
First off, let me compliment you on an absolutely
exhaustively researched web site. There is an incredible amount of
information contained on the various pages, and I can’t imagine how long it
has taken to compile and separate the “wheat from the chaff.”
I am writing to request a review of my company's
offering of software for Finance/Accounting (
http://www.mbaware.com/finandacsof.html ) and for business
valuations (
http://www.mbaware.com/busvalsof.html ) for
possible inclusion on various web pages on your site. We are a retailer of a
variety of specialized, high-quality, off-the-shelf financial software
including software for amortization, accounting, business plans, business
strategy, business valuations, financial statement analysis, forecasting,
payroll, Sarbanes-Oxley compliance, treasury management and much more. Our
specialties are financial and business valuation software.
From my review of the site, it looks like the best
fit might be our valuation software and data page (
http://www.mbaware.com/busvalsof.html )
which would be a good fit on your “Threads on Return on Business Valuation,
Business Combinations, Investment (ROI), and Pro Forma Financial Reporting”
page (
http://faculty.trinity.edu/rjensen/roi.htm )
under the “BUSINESS VALUATION SITES” section.
Thanks very much for your consideration, and please let me know if you
have any questions.
Best regards,
Bob Deily, President
MBAWare - The Business Software Source
(703) 875-0660
E-mail: bdeily@mbaware.com
www.MBAWare.com
There is a link to Banister
Financial where you can find some tips of valuation and valuation
frauds.
Controversial Issues in Pro
Forma (non-GAAP) Financial Reporting
Updates for this topic are at
http://faculty.trinity.edu/rjensen/Theory02.htm#ProForma
A Forecast for the Future
www.financialwonder.com
CPAs will want to check out this Web site to find free tools for
corporate budgeting and forecasting. Users can build forecasts using the
formulas found here for free. They then can use the results on their individual
balance sheets or income statements and copy the results directly to their
spreadsheets or word processors.
Francine: Remarks at New York University
Forum on Non-GAAP Metrics ---
http://retheauditors.com/2016/11/09/remarks-at-new-york-university-forum-on-non-gaap-metrics/
Teaching Case from The Wall Street Journal Accounting Weekly Review on
October 21, 2016 ---
Buyout-Loan Strategy Questioned
by: Liz
Hoffman and Matt Wirz
Oct 17, 2016
Click here to view the full article on WSJ.com
TOPICS: Non-GAAP
Reporting
SUMMARY: Bank
regulatory requirements "discourage banks from lending more than six times a
company's earning before interest, taxes, depreciation and amortization, or
EBITDA." However, companies looking for financing adjust the amounts used to
determine that ratio in "potentially aggressive or unsupported" ways similar
to concerns about non-GAAP reporting of earnings in earnings releases by
publicly-traded firms. "The warnings come amid annual reviews in which
regulators expressed concerns that banks and their clients are being liberal
with adjustments to earnings to justify more borrowing...."
CLASSROOM
APPLICATION: The
article may be used in a class on financial reporting to cover non-GAAP
reporting or debt issuance.
QUESTIONS:
1. (Introductory) What are "leveraged loans"? Why are they of
particular interest now?
2. (Introductory) Why do federal banking regulators examine buyout
transactions such as the purchase of Ultimate Fighting Championship (UFC) by
William Morris Endeavor? Include in your answer a description of bank loan
portion of the transaction.
3. (Advanced) What benefit is obtained by limiting loan amounts to 6
times EBITDA?
4. (Advanced) What are the reporting requirements when publicly
traded companies disclose non-GAAP information in earnings releases? How are
regulators requiring similar information for mergers and acquisitions that
are financed with bank lending?
Reviewed By: Judy Beckman, University of Rhode Island
"Buyout-Loan Strategy Questioned," by Liz Hoffman and Matt Wirz, The Wall Street Journal, October
17, 2016 ---
http://www.wsj.com/articles/the-ultimate-earnings-fighting-championship-1476615601?tesla=y?mod=djem_jiewr_AC_domainid
Sale of UFC and other buyout deals are raising
concerns among regulators that banks and clients are being too liberal with
adjustments to earnings to justify more borrowing for transactions
When the
Ultimate Fighting Championship put itself up for sale this year, the
mixed-martial-arts organization showed one measure of earnings of about $170
million, according to people familiar with the deal.
But with a
few tweaks, the figure presented to debt investors helping finance the sale
climbed to $300 million, the people said.
The higher
number allowed the buyer, talent agency William Morris Endeavor, to borrow
$1.8 billion for the deal without exceeding a regulatory “leverage”
guideline. That discourages banks from lending more than six times a
company’s earnings before interest, taxes, depreciation and amortization, or
Ebitda.
Banking
regulators have shown increasing concern about such moves in the $900
billion-a-year leveraged-loan market, in which banks lend to risky
companies, often during a takeover, and then sell the debt in pieces to
investors. In 2013, the Federal Reserve and Office of the Comptroller of the
Currency started guiding banks to stay away from heavily leveraged deals.
In
recent weeks, Fed examiners have notified William Morris Endeavor’s lenders,
Goldman Sachs Group Inc. and
AG, that the way the UFC loans
stayed under the Ebitda guideline could be problematic, according to people
familiar with the matter.
Regulators in
recent months have also flagged at least two other buyouts—those of software
companies Cventand SolarWinds Inc.—for potentially aggressive or unsupported
adjustments to Ebitda, some of the people said.
The warnings
come amid annual reviews in which regulators expressed concerns that banks
and their clients are being liberal with adjustments to earnings to justify
more borrowing, the people said.
Goldman Sachs
and Deutsche Bank declined to comment.
Concerns
about companies massaging their financial figures in the debt markets echo
worries in stock markets. The Securities and Exchange Commission has
criticized companies’ increasing use of measures that don’t comply with
standard accounting rules.
The
adjustments often exclude charges for things like stock-based compensation
or restructuring expenses. In and of themselves, the adjustments aren’t
improper. Companies have said that the tweaks provide a truer picture of
their business. The fear is that they also provide an overly rosy view of
profits.
Continued in article
Bob Jensen's threads on non-GAAP and Pro Forma Reporting ---
Preliminary statistical data show the
difference between operating (pro forma) earnings and net income under generally
accepted accounting principles reached an all-time high in 2001. These
statistics cover the largest U.S. public companies, collectively known as the
Standard & Poor's 500. A timely analysis by TheStreet.Com shows why
investors should be concerned. http://www.accountingweb.com/item/70533
Sharpe Point: Risk Gauge Is Misused
Past average experience may be a terrible predictor
of future performance
The so-called Sharpe Ratio has become a cornerstone of
modern finance, as investors have used it to help select money managers and
mutual funds. Now, many academics -- including Sharpe himself -- say the gauge
is being misused . . . The ratio is commonly
used -- "misused," Dr. Sharpe says -- for promotional purposes by hedge funds.
Bayou Management LLC, the Connecticut hedge-fund firm under investigation for
what authorities suspect may have been a massive fraud, touted its Sharpe Ratio
in marketing material. Investment consultants and companies that compile
hedge-fund data also use it, as does a new annual contest for the best hedge
funds in Asia, by a newsletter called AsiaHedge. "That is very disturbing," says
the 71-year-old Dr. Sharpe. Hedge funds, loosely regulated private investment
pools, often use complex strategies that are vulnerable to surprise events and
elude any simple formula for measuring risk. "Past
average experience may be a terrible predictor of future performance,"
Dr. Sharpe says.
Ianthe Jeanne Dugan, "Sharpe Point: Risk Gauge Is Misused,"
The Wall Street Journal, August 31, 2005; Page
C1---
http://online.wsj.com/article/0,,SB112545496905527510,00.html?mod=todays_us_money_and_investing
Message from Ron Huefner [rhuefner@ACSU.BUFFALO.EDU]
For those needing a
break from Enron, the SEC today issued its first enforcement action in the
area of pro-forma earnings. AAER 1499, regarding Trump Hotels and Casino
Resorts, Inc., may be found at
http://www.sec.gov/news/headlines/trumphotels.htm
Ron Huefner
"SEC Brings First Pro Forma
Financial Reporting Case Trump Hotels Charged With Issuing Misleading Earnings
Release," FOR IMMEDIATE RELEASE 2002-6 --- http://www.sec.gov/news/headlines/trumphotels.htm
Washington, D.C.,
January 16, 2002
— In its first pro forma financial reporting case, the Securities and
Exchange Commission instituted cease-and-desist proceedings against Trump
Hotels & Casino Resorts Inc. for making misleading statements in the
company's third-quarter 1999 earnings release. The Commission found that the
release cited pro forma figures to tout the Company's purportedly positive
results of operations but failed to disclose that those results were primarily
attributable to an unusual one-time gain rather than to operations.
"This is the
first Commission enforcement action addressing the abuse of pro forma earnings
figures," said Stephen M. Cutler, Director of the Commission's Division
of Enforcement. "In this case, the method of presenting the pro forma
numbers and the positive spin the Company put on them were materially
misleading. The case starkly illustrates how pro forma numbers can be used
deceptively and the mischief that they can cause."
Trump Hotels
consented to the issuance of the Commission's order without admitting or
denying the Commission's findings. The Commission also found that Trump
Hotels, through the conduct of its chief executive officer, its chief
financial officer and its treasurer, violated the antifraud provisions of the
Securities Exchange Act by knowingly or recklessly issuing a materially
misleading press release.
"This case
demonstrates the risks involved in mishandling pro forma reporting," said
Wayne M. Carlin, Regional Director of the Commission's Northeast Regional
Office. "Enforcement action can result if a company fails to disclose
information necessary to assure that investors will not be misled by the pro
forma numbers."
Specifically, as
set forth in the Order, which is available on
the Commission's website, the Commission found that:
- On Oct. 25, 1999,
Trump Hotels issued a press release announcing its quarterly results. The
release used net income and earnings-per-share (EPS) figures that differed
from net income and EPS calculated in conformity with generally accepted
accounting principles (GAAP), in that the figures expressly excluded a
one-time charge. The earnings release was fraudulent because it created
the false and misleading impression that the Company had exceeded earnings
expectations primarily through operational improvements, when in fact it
had not.
- The release
expressly stated that net income and EPS figures excluded a $81.4 million
one-time charge. Although neither the earnings release nor the
accompanying financial data used the term pro forma, the net income and
EPS figures used in the release were pro forma numbers because they
differed from such figures calculated in conformity with GAAP by excluding
the one-time charge. By stating that this one-time charge was excluded
from its stated net income, the Company implied that no other significant
one-time items were included in that figure.
- Contrary to the
implication in the release, however, the stated net income included an
undisclosed one-time gain of $17.2 million. The gain was the result of the
termination, in September 1999, of the All Star Café's lease of
restaurant space at the Trump Taj Mahal Casino Resort in Atlantic City.
Trump Hotels, through various subsidiaries, owns and operates the Taj
Mahal and other casino resorts. The Company's executive offices are in New
York City, and its business and financial operations are centered in
Atlantic City.
- Not only was
there no mention of the one-time gain in the text of the release, but
the financial data included in the release gave no indication of it,
because all revenue items were reflected in a single line item.
- The misleading
impression created by the reference to the exclusion of the one-time
charge and the undisclosed inclusion of the one-time gain was reinforced
by the comparison in the earnings release of the stated earnings-per-share
figure with analysts' earnings estimates and by statements in the release
that the Company been successful in improving its operating performance.
Using the non-GAAP, pro forma figures, the release announced that the
Company's quarterly earnings exceeded analysts' expectations, stating:
Net income
increased to $ 14.0 million, or $ 0.63 per share, before a one-time
Trump World's Fair charge, compared to $ 5.3 million or $ 0.24 per share
in 1998. [Trump Hotels'] earnings per share of $ 0.63 exceeded First
Call estimates of $ 0.54.
In addition, the
release quoted Trump Hotels' chief executive officer as attributing the
stated positive results and improvement from third-quarter 1998 to
improvements in the Company's operations.
- In fact, had the
one-time gain been excluded from the quarterly pro forma results as well
as the one-time charge, those results would have reflected a decline in
revenues and net income and would have failed to meet analysts'
expectations. The undisclosed one-time gain was thus material, because it
represented the difference between positive trends in revenues and
earnings and negative trends in revenues and earnings, and the difference
between exceeding analysts' expectations and falling short of them.
- On Oct. 25, the
day the earnings release was issued, the price of the Company's stock rose
7.8 percent; subsequently, analysts learned of the one-time gain. On Oct.
28, the day on which an analysts' report and a news article revealing the
impact of the one-time gain were published, the stock price fell
approximately 6 percent.
The Commission found
that Trump Hotels violated Section 10(b) of the Exchange Act and Rule 10b-5
thereunder. The Company was ordered to cease and desist from violating those
provisions.
For information about
the use and interpretation of pro forma financial information, see the
cautionary advice for companies and their advisors at http://www.sec.gov/news/headlines/proforma-fin.htm
and the investor alert recently issued by the Commission at http://www.sec.gov/investor/pubs/proforma12-4.htm.
Contact:
Wayne M. Carlin tel.: (646) 428-1510
Additional Materials
Define each of the items and be sure to explain when
they use performance measures that are not in accordance with U.S. GAAP.
From The Wall Street Journal Accounting Weekly Review on October 14,
2010
Alcoa Profit Drops on Expenses as Sales Rise
by: Robert Guy Matthews
Oct 08, 2010
Click here to view the full article on WSJ.com
TOPICS: Earning Announcements, Earnings Forecasts, Interim Financial
Statements, Segment Analysis, Segment Margin
SUMMARY: Alcoa "...kicked off the quarterly earnings parade with mixed news,
saying high expenses, lower realized prices and a weak dollar resulted in a
21% drop in third-quarter profit but that volumes rose and global markets
continued to strengthen." The company's stock price rose 6.2%.
CLASSROOM APPLICATION: Questions ask the students to access the transcript
of and slides for the conference call with analysts. The related article is
a blog on comments by analysts from major investment houses.
QUESTIONS:
1. (Introductory) Summarize the results Alcoa reported for the 3rd quarter
of 2010. How did the company's stock price react to the earnings release?
Why did it react this way?
2. (Introductory) Access the transcript of Alcoa's conference call regarding
its quarterly earnings report, available on the SEC web site at
http://www.sec.gov/Archives/edgar/data/4281/000119312510228177/dex991.htm
Who participated in the conference call?
3. (Advanced) Review the presentation slides for the conference call also on
the SEC web site at
http://www.sec.gov/Archives/edgar/data/4281/000119312510228177/dex992.htm
What financial measures do they highlight first? Define each of the items
and be sure to explain when they use performance measures that are not in
accordance with U.S. GAAP.
4. (Advanced) Scroll through the slides to "Reconciliation of Adjusted
Income." What types of items do they exclude from their discussion of
Alcoa's operating results? Why do they do so?
5. (Advanced) What accounting codification section requires presentation of
segment information? What information must be provided? Where in the
financial statements can this information also be found?
6. (Advanced) Access the third quarter financial report available through
the link to the 8-K filing made on October 8, 2010, on the SEC web site at
http://www.sec.gov/Archives/edgar/data/4281/000119312510226872/0001193125-10-226872-index.htm
This filing is also available by clicking on the live link to Alcoa from the
online version of the WSJ article, then clicking on SEC Filings in the left
hand column, then clicking on the live link to the 8-K filing.. Confirm the
answer you gave to question 5 above. What information is included in the
financial statements that was excluded from the slides for the conference
call?
7. (Introductory) Refer to the related article, a blog of analysts'
comments. Alcoa beat the Goldman Sachs estimate for revenue increase, but
nonetheless that firm's analyst was concerned. Explain those concerns.
Reviewed By: Judy Beckman, University of Rhode Island
RELATED ARTICLES:
Alcoa up on Earnings: Analyst Takeaways
by MarketBeat
Oct 08, 2010
Online Exclusive
"Alcoa Profit Drops on Expenses as Sales Rise," by Robert Guy Matthews,
The Wall Street Journal, October 8, 2010 ---
http://online.wsj.com/article/SB10001424052748704696304575538402637158136.html?mod=djem_jiewr_AC_domainid
Aluminum giant Alcoa Inc. kicked off the quarterly
earnings parade with mixed news, saying high expenses, lower realized prices
and a weak dollar resulted in a 21% drop in third-quarter profit but that
volumes rose and global markets continued to strengthen.
Alcoa said prices for aluminum are rising and
inventories for the metal are starting to fall as Russia, India, Brazil and
other developing countries increase their usage. The Pittsburgh company
boosted its forecast of global aluminum usage to a rise of 13% for this
year, up one percentage point from a July forecast.
Chairman and Chief Executive Klaus Kleinfeld said
the company is seeing significant improvements in most markets. "In
countries such as China, Brazil, India, and Russia, more and more people are
moving into the middle class, driving demand in building and construction,
transportation, and packaging," said Mr. Kleinfeld.
But usage is still sluggish in Alcoa's main
markets, the U.S. and Europe. Analysts aren't expecting aluminum usage in
North America and Western Europe to strengthen significantly before the
third quarter of 2011.
Net income fell to $61 million, or six cents a
share, compared with $77 million, or eight cents a share, in the same
quarter last year. Results included a three-cents-a-share charge, while the
year-earlier period included a three-cent-a-share acquisition- related gain.
Revenue rose 15% to $5.3 billion, mainly due to
higher volumes in the aerospace market and increased market share in
construction.
However, Alcoa said that its selling prices for
aluminum fell 2% in the quarter compared to the prior quarter.
Alcoa also said it is trying to reshape how it
sells alumina to its customers for better profitability. The company wants
to sell its product based on a market-price index that sets prices according
to supply and demand, instead of an agreed-upon contract price. The more
contracts that are priced by the index, the more money Alcoa can get for
each batch of alumina it sells. And if the price rises, as Alcoa expects,
its products are more valuable.
Alcoa is also expected to benefit from the rise in
alumina, a key raw material that is used to make aluminum. Prices for
alumina, in high demand by China, are expected to rise faster that for
aluminum itself. That is good news for Alcoa, the largest supplier of
alumina in the world.
Though Alcoa reported a 5% drop in its alumina
price in the third quarter compared to the second quarter, stockpiles of
alumina are dropping worldwide as aluminum smelters ramp up their
production.
The improved outlook helped boost Alcoa shares in
after hour trading by 3%. Alcoa's shares were up 35 cents in after-hours
trading after finishing off 17 cents at $12.20 in 4 p.m. New York Stock
Exchange composite trading. The stock is down 24% this year after rising
nearly 50% in 2009.
Note that the quote below is not talking about GAAP profitability.
Instead it is that vapor concept of pro forma profitability --- whatever that is
as inconsistently defined by many firms trying to boost their image with
investors.
From Information Week Daily on October 24, 2001
Amazon Inching Toward Profitability
Amazon.com Inc. CEO Jeff Bezos, addressing the
company's third-quarter loss of $170 million, insisted Tuesday that the online
superstore was ready to meet its pledge for profitability in the final three
months of the year.
Of course, he's talking pro forma operating
profitability. Measured in that sense, Amazon's results look almost rosy: The
pro forma loss from operations for the quarter ended Sept. 30 shrunk 60% to
$27 million, compared with $68 million a year earlier. The U.S. retail and
services segments combined were profitable on a pro forma basis for the second
straight quarter--to the tune of $1 million, compared with a loss of $29
million last year.
But back to the non-pro forma loss of $170 million,
as computed according to generally accepted accounting principles: It was a
29% improvement from the $241 million loss a year ago, but $2 million worse
than the $168 million it lost during the previous quarter. Net sales were
basically flat--$639 million, compared with $638 million a year ago. One
bright spot for the quarter: Sales of used merchandise, launched just 11
months ago, totaled 17% of all U.S. orders.
"To reach pro forma profitability requires not
heroics, just execution," CFO Warren Jenson said during a conference
call. Jensen said net sales for the fourth quarter are expected to be between
$970 million and $1.07 billion, compared with $972 million for fourth quarter
of 2000. He expects revenue from services--fueled by partnerships with Target,
Circuit City, and Expedia formed in the past three months--to exceed $200
million this year. - Christopher T. Heun
Bob Jensen's threads on eCommerce are at http://faculty.trinity.edu/rjensen/ecommerce.htm
From The Wall Street Journal's Accounting Educator Reviews on January
24, 2002
TITLE: Amazon Had First-Ever Profit In 4th Quarter
REPORTER: Nick Wingfield
DATE: Jan 23, 2002
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011391206164562000.djm
TOPICS: Earning Announcements, Managerial Accounting
SUMMARY: The Wingfield article relates the surprise felt on Wall Street by
the first-ever reported profit for the last quarter for Amazon.com. Factors that
led to these results are discussed as well as the long-term outlook for the
e-commerce retailer's future.
QUESTIONS:
1.) Is the "new-economy" dead? Can you argue that there is no
fundamental difference between the new- and old-economy? What was the
universally recognized measure of performance in the old economy?
2.) What is a lag indicator of performance? Differentiate it from a lead
indicator of performance. How many lead indicators can you list? Can a lag
indicator of performance be a lead indicator at the same time?
3.) How long has Amazon.com Inc. been in business? Does it surprise you that
this is the first quarter that it has ever posted a profit? What factors are
cited explaining the profits for last year's 4th quarter? Is there anything
"new" about those factors?
4.) What has happened to Amazon's strategy since its inception? How do they
measure success against that strategic vision today and does it differ from its
view of their early success?
5.) What outside factor contributed to its reported profit? What does this
bode for Amazon's future? What enticements are they offering in the hopes of
spurring sales growth?
6.) What are "fulfillment" costs? What are "nonstandard"
accounting measures? Why does the article maintain that Amazon's future is
murky?
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
The Future of
Amazon.com: Unlike Enron, Amazon.com seems to thrive without
profits. How long can it last?
"Economy, the Web and E-Commerce:
Amazon.com." An Interview With Jeff Bezos CEO, Amazon.com, The
Washington Post, December 6, 2001 --- http://discuss.washingtonpost.com/zforum/01/washtech_bezos120601.htm
Amazon.com is pinning its hopes on pro
forma reporting to report the company's first profit in history. But wait!
Plans by U.S. regulators to crack down on "pro forma" abuses in
accounting may take a toll on Internet firms, which like the financial reporting
technique because it can make losses seem smaller than they really
are.
"When Pro Forma Is Bad Form,"
by Joanna Glasner, Wired News, December 6, 2001 --- http://www.wired.com/news/business/0,1367,48877,00.html
As part of efforts to
improve the clarity of information given to investors, the Securities and
Exchange Commission warned this week that it will crack down on companies that
use creative accounting methods to pump up poor earnings results.
In particular, the
commission said it will focus on abuse of a popular form of financial
reporting known as "pro forma" accounting, which allows companies to
exclude certain expenses and gains from their earnings results. The SEC said
the method "may not convey a true and accurate picture of a company's
financial well-being."
Experts say the
practice is especially common among Internet firms, which began issuing
earnings press releases with pro forma numbers en masse during the stock
market boom of the late 1990s. The list of new-economy companies using pro
forma figures includes such prominent firms as Yahoo (YHOO), AOL Time Warner
(AOL), CNET (CNET) and JDS Uniphase (JDSU).
Unprofitable firms
are particularly avid users of pro forma numbers, said Brett Trueman,
professor of accounting at the University of California at Berkeley's Haas
School of Business.
"I can't say for
sure why, but I can take a guess: They're losing big time, and they want to
give investors the impression that the losses are not as great as they
appear," he said.
Trueman said savvy
investors tend to know that companies may have self-serving interests in mind
when they release pro forma numbers. Experienced traders often put greater
credence in numbers compiled according to generally accepted accounting
principles (GAAP), which firms are required to release alongside any pro forma
numbers.
A mounting concern,
however, is the fact that many companies rely almost solely on pro forma
numbers in projections for future performance.
Perhaps the
best-known proponent of pro forma is the perennially unprofitable Amazon.com,
which has a history of guiding investor expectations using an accounting
system that excludes charges for stock compensation, restructuring or the
declining value of past acquisitions.
Invariably, the pro
forma numbers are better than the GAAP ones. In its most recent quarter, for
example, Amazon (AMZN) reported a pro forma loss of $58 million. When measured
according to GAAP, Amazon's net loss nearly tripled to $170 million.
Things are apt to get
even stranger in the last quarter of the year, when Amazon said it plans to
deliver its first-ever pro forma operating profit. By regular accounting
standards, the company will still be losing money.
Those results might
not sit too well with the folks at the SEC, however.
In its statements
this week, the SEC noted that although there's nothing inherently illegal
about providing pro forma numbers, figures should not be presented in a
deliberately misleading manner. Regulators may have been talking directly to
Amazon in one paragraph of their warning, which said:
"Investors are
likely to be deceived if a company uses a pro forma presentation to recast a
loss as if it were a profit."
Neither Amazon nor
AOL Time Warner returned phone calls inquiring if they planned to make changes
to their pro forma accounting methods in light of the SEC's recent statements.
According to Trueman,
few members of the financial community would advocate getting rid of pro forma
numbers altogether.
Even the SEC said
that pro forma numbers, when used appropriately, can provide investors with a
great deal of useful information that might not be included with GAAP results.
When presented correctly, pro forma numbers can offer insights into the
performance of the core business, by excluding one-time events that can skew
quarterly results.
Rather than ditching
pro forma, industry groups like Financial Executives International and the
National Investor Relations Institute say a better plan is to set uniform
guidelines for how to present the numbers. They have issued a set of
recommendations, such as making sure companies don't arbitrarily change what's
included in pro forma results from quarter to quarter.
Certainly some
consistency would make it easier for folks who try to track this stuff, said
Joe Cooper, research analyst at First Call, which compiles analyst projections
of earnings.
The boom in pro forma
reporting has created quite a bit of extra work for First Call, Cooper said,
because it has to figure out which companies and analysts are using pro forma
numbers and how they're using them.
But the extra work of
compiling pro forma numbers doesn't necessarily result in greater financial
transparency for investors, Cooper said.
"In days past,
before it was abused, it was a way to give an honest apples-to-apples
comparison," he said. "Now, it is being used as a way to continually
put their company in a good light."
See also:
SEC
Fires Warning Shot Over Tech Statements
Earnings Downplay Stock Losses
Change
at the Top for AOL
Where's the Money?,
Huh?
There's no biz like E-Biz
I added the following to my December 4, 2001
message from Phil Livinston to my threads on pro forma accounting statements
at http://faculty.trinity.edu/rjensen/roi.htm
Also see http://faculty.trinity.edu/rjensen/acct5341/theory/00overview/beresford01.htm
To: FEI Members and
Prospective Members From: Phil Livingston
Special FEI Express -
SEC Cautions Companies to Potential Dangers of "Pro Forma"
Financials
Today, the U.S.
Securities and Exchange Commission (SEC) issued a cautionary advisory on the
use of pro forma earnings per share measures used in earnings press releases.
The SEC warned that companies issuing earnings press releases should always
include net earnings per share determined according to U.S. Generally Accepted
Accounting Principles (GAAP), and recommended that any use of pro forma
measures should be accompanied by a plain English reconciliation back to the
GAAP results. The SEC stated that companies not following these practices
could be subject to the anti-fraud provisions of laws governing corporate
financial reporting. The SEC advisory went on to recommend the guidance
provided by the "FEI/NIRI Earnings Press Release Guidelines."
FEI strongly
encourages companies to follow the "best practice" standard created
by our Committee on Corporate Reporting and the National Institute of Investor
Relations. These guidelines can be found on the FEI website at http://www.fei.org/news/FEI-NIRI-EPRGuidelines-4-26-2001.cfm
. SEC officials have broadly endorsed these guidelines and repeatedly
encouraged their use in public speeches. Current market and economic
conditions make it important for all of us involved in financial reporting to
take extra steps to make sure we are fully and fairly presenting our
companies' financial results to investors. As financial officers, we have that
extra duty to our shareholders, employees and creditors to provide highly
transparent and meaningful information.
The use of pro forma
earnings has become increasingly widespread and is drawing more attention.
Some say the increased use of pro forma measures results from the inadequacies
and limitations of measures currently defined by GAAP. Meanwhile, critics cite
cases of abuse where pro forma earnings have been used to distort reality and
provide an opaque view of a company's results. Be in the camp that uses pro
forma earnings in a constructive way to provide meaningful supplemental data
to the GAAP results. Please share this SEC release and the FEI guidelines with
the rest of your management team. Be a best practices company in financial
reporting.
Read the official
release from the SEC here: http://www.sec.gov/news/headlines/proforma-fin.htm
That's all for now,
Phil
Bob Jensen's threads on accounting theory can be found at
http://faculty.trinity.edu/rjensen/acct5341/theory/00overview/theory01.htm
In spite of my highly negative views on pro forma statements, I will share a
more positive case fro pro forma forwarded by Janet Flatley.
"Money Managers Say Pro Forma Results Are
Useful," by Stephen Taub
Most money managers claim corporate financial
reporting needs to be improved. But when it comes to the controversial issue
of pro forma earnings, most professional investors say those figures are
useful or extremely useful.
Specifically, 9 out of 10 portfolio managers believe
that corporate financial reporting needs to be upgraded, according to a survey
of 223 fund managers taken in October by New York-based capital markets firm
Broadgate Consultants Inc. The survey of portfolio managers was intended to
gauge the reaction to recent proposals by the Financial Accounting Standards
Board (FASB). Officials at FASB are contemplating drawing up new standards for
financial reporting, and possibly requiring more information about intangible
assets to be carried on balance sheets.
Despite recent criticism of pro forma financial
reporting, nearly 76 percent of portfolio managers in the survey said they
found pro forma accounting at least somewhat useful, and many of these said
that it is extremely useful.
In fact, 67 percent of respondents opposed banning
pro forma reporting from press releases. However, 91 percent of that
two-thirds majority felt that corporations should provide more detail in their
pro forma statements.
The Financial Accounting Standards Board last week
added a project on financial performance reporting to its agenda. See recent
story.
Portfolio managers are somewhat divided about whether
FASB should broaden the scope of its project to require companies to include
financial metrics such as ratios in their statements. 47 percent said yes to
that, while 44 percent voted no.
Even so, 95 percent of the money managers said they
would like more consistency in how a common financial metric - earnings before
interest, taxes, depreciation and amortization (EBITDA) - is calculated. Sixty
percent of managers want more information about intangible assets, and 60
percent want more detailed disclosures about internally generated intangibles,
such as the value of brand names or customer lists, to name two.
So, what are the most relevant measures of financial
performance? In a tight financial market, cash flow after capital expenditures
and interest expense received the highest marks from the portfolio managers.
Balance sheet strength came in second. EBITDA and earnings tied for third.
Interestingly, book value ranked last.
As for FASB's decision not to categorize the effects
of the World Trade Center attacks as an extraordinary item, nearly 55 percent
of the managers agreed.
"The results of the survey clearly reveal that
professional investors want more detail, precision and clarity in financial
statements," said Thomas C. Franco, chairman and chief executive officer
of Broadgate, in a press release accompanying the survey's results.
"However, it is noteworthy that investors also appear to recognize the
obvious limitations with pro forma results, but consider such reporting
valuable in assessing the ongoing performance factors driving the businesses
they follow."
Read On! For More of Today in Finance http://m.s.maildart.net/link_30322_6594702_1_120093342_73938558_0_7e
I added the following December 4, 2001 message from Phil Livinston to my
threads on pro forma accounting statements at http://faculty.trinity.edu/rjensen/roi.htm
Also see http://faculty.trinity.edu/rjensen/acct5341/theory/00overview/beresford01.htm
To: FEI Members and Prospective Members From: Phil
Livingston
Special FEI Express - SEC Cautions Companies to
Potential Dangers of "Pro Forma" Financials
Today, the U.S. Securities and Exchange Commission
(SEC) issued a cautionary advisory on the use of pro forma earnings per share
measures used in earnings press releases. The SEC warned that companies
issuing earnings press releases should always include net earnings per share
determined according to U.S. Generally Accepted Accounting Principles (GAAP),
and recommended that any use of pro forma measures should be accompanied by a
plain English reconciliation back to the GAAP results. The SEC stated that
companies not following these practices could be subject to the anti-fraud
provisions of laws governing corporate financial reporting. The SEC advisory
went on to recommend the guidance provided by the "FEI/NIRI Earnings
Press Release Guidelines."
FEI strongly encourages companies to follow the
"best practice" standard created by our Committee on Corporate
Reporting and the National Institute of Investor Relations. These guidelines
can be found on the FEI website at http://www.fei.org/news/FEI-NIRI-EPRGuidelines-4-26-2001.cfm
. SEC officials have broadly endorsed these guidelines and repeatedly
encouraged their use in public speeches. Current market and economic
conditions make it important for all of us involved in financial reporting to
take extra steps to make sure we are fully and fairly presenting our
companies' financial results to investors. As financial officers, we have that
extra duty to our shareholders, employees and creditors to provide highly
transparent and meaningful information.
The use of pro forma earnings has become increasingly
widespread and is drawing more attention. Some say the increased use of pro
forma measures results from the inadequacies and limitations of measures
currently defined by GAAP. Meanwhile, critics cite cases of abuse where pro
forma earnings have been used to distort reality and provide an opaque view of
a company's results. Be in the camp that uses pro forma earnings in a
constructive way to provide meaningful supplemental data to the GAAP results.
Please share this SEC release and the FEI guidelines with the rest of your
management team. Be a best practices company in financial reporting.
Read the official release from the SEC here: http://www.sec.gov/news/headlines/proforma-fin.htm
That's all for now,
Phil
E-Business and E-Commerce
ROI Complications
Putting ROI Through The Wringer
Great Investment Return Calculators
Forwarded from Jim Mahar's Blog on July 23, 2009 ---
http://politicalcalculations.blogspot.com/2009/06/investing-through-time.html
1. Historic Rates of return from any two points of
time:
From
PoliticalCalculations:
" Now however, everything has changed because we
here at Political Calculations are putting the entire encapsulated
history of the S&P 500 at your fingertips!
We've taken the raw data from the sources
linked above, and made it easily accessible by selecting a month and
year in our tool below. The tool will provide the average index value of
the S&P 500 for the given month and year, the associated
dividends and
earnings for that month and year, not to
mention the
dividend yield and the
price to earnings ratio. For good measure, we threw in the value of
the Consumer Price
Index as
well!"
2. How much an investment would have grown from and to
any point in time from 1871 (yeah, so the data may not be perfectly clean,
still a good look!)
Political Calculations: Investing Through Time:
"All you need to do is to select the dates you
want to run your hypothetical investment between and to enter the amount
of money to invest either from the very beginning or to add each month
(beginning with that first month you select) for the duration that your
investment runs.
We'll determine how much your investment would be worth assuming the
amounts invested are adjusted for inflation for each month the
investment is active and accounting for the effects of either not
reinvesting dividends along the way or fully reinvesting dividends"
What is
PoliticalCalcuations?
From the site: "Welcome to the blogosphere's
toolchest! Here, unlike other blogs dedicated to analyzing current
events, we create easy-to-use, simple tools to do the math
Bob Jensen's threads about free online calculators of various types ---
http://faculty.trinity.edu/rjensen/Bookbob3.htm#080512Calculators
Question
What is wrong with the long colorful tail of the peacock?
An attack of ROE (and in effect the University of Chicago)
Video: Capitalism Gone Wild
Harvard Business Review Blog trying to appease the other side of the
Charles River
December 21, 2011 ---
Click Here
http://blogs.hbr.org/video/2011/12/capitalism-gone-wild.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date
Video on the opposing side (that the only responsibilities of business firms
are to earn a profit and obey the law)
http://www.youtube.com/watch?v=D3N2sNnGwa4
Case Illustration of ROI Issues
Teaching Case from The Wall Street Journal Accounting Weekly Review on
April 27, 2012
Unilever Takes Palm Oil in Hand
by:
Paul Sonne
Apr 24, 2012
Click here to view the full article on WSJ.com
TOPICS: Assurance Services, Financial Accounting, Managerial
Accounting, Nonfinancial performance measures, Supply Chains
SUMMARY: "Unilever PLC is negotiating to build a $100 million
palm-oil processing plant in Indonesia....which would make sustainable
palm-kernel oil in Sumatra and turn out about 10% of Unilever's annual
consumption....The company's new goal...is that within eight years all of
the palm oil it buys will come from traceable sources that are certified as
sustainable." The company currently supports its assessment that "about
two-thirds of the palm oil it used last year" was sustainably produced by
buying "803,000 GreenPalm certificates" in addition to sourcing 2% of its
palm oil from traceable plantations. GreenPalm certificates are issued by
the Roundtable on Sustainable Palm Oil, or RSPO, an organization comprising
producers, buyers and environmental groups.
CLASSROOM APPLICATION: Questions begin by addressing return on
investment and whether all benefits that Unilever perceives from its
investment in the Indonesian plant can be quantified. The article also is
useful to discuss the development of private sector demand for auditing
sustainability in business processes, just as private sector demand led to
the auditing of financial statements.
QUESTIONS:
1. (Introductory) Why is Unilever constructing a processing plant
in Indonesia?
2. (Advanced) What is return on investment? In general, what
factors are considered in undertaking an ROI calculation?
3. (Advanced) Consider Unilever's decision to invest in a new
plant. Indicate the specific factors listed in the article that you think
Unilever would include in an ROI analysis for this plant construction
project. Can you quantify all of the factors? Explain.
4. (Introductory) Consider the company's goal, within 8 years, to
source all of its palm oil from "traceable sources that are certified as
sustainable." How does Unilever currently identify the proportion of palm
oil it obtains in this way?
5. (Advanced) What audit functions are needed to satisfy demand by
companies such as Unilever for sustainable sources of their products?
Reviewed By: Judy Beckman, University of Rhode Island
"Unilever Takes Palm Oil in Hand," by: Paul Sonne, The Wall Street
Journal, April 25, 2012 ---
http://online.wsj.com/article/SB10001424052702303978104577362160223536388.html?mod=djem_jiewr_AC_domainid
LONDON—Unilever UN -1.29% PLC is negotiating to
build a $100 million palm-oil processing plant in Indonesia, an attempt to
accelerate its commitment to sourcing the oil in ways that don't destroy the
environment.
Unilever is trying to more closely trace the source
of the palm oil it uses at a time when the industry is falling short of
goals to make extraction of the key ingredient less insidious. The
harvesting of palm oil has become a hot-button environmental issue for the
role it plays in deforestation in countries such as Indonesia and Malaysia,
where rain forests have been cleared to make way for palm-oil plantations.
In the process, orangutan, tiger and rhino habitats have been destroyed.
Unilever is in advanced discussions with the
Indonesian government to build the plant, which would make sustainable
palm-kernel oil in Sumatra and turn out about 10% of Unilever's annual
consumption. The company hopes to break ground on the plant later this year.
The Anglo-Dutch company is the world's biggest
consumer of palm oil, using 1.36 million tons of the ingredient a year to
make products such as Dove soap, Magnum ice cream and Vaseline lotion.
The company's new goal, which will be formally
announced on Tuesday, is that within eight years all of the palm oil it buys
will come from traceable sources that are certified as sustainable. Last
year, only 27,000 tons, or about 2%, of the palm oil Unilever bought came
from such sources.
"I am not aware of anyone else who has made that
commitment, particularly on our scale," says Marc Engel, Unilever's chief
procurement officer.
The thirst for palm oil is rapidly expanding,
thanks to the widespread application of it and its derivatives in products
ranging from cakes to lipsticks. Last year, the world consumed about 50
million tons of the oil, according to the World Wildlife Foundation. About
five million to six million tons came from plantations certified as
sustainable by the Roundtable on Sustainable Palm Oil, or RSPO, an
organization comprising producers, buyers and environmental groups.
It isn't easy for consumer-goods companies to
figure out whether palm oil comes from an audited sustainable plantation.
Processing plants often combine oil from sustainable plantations with
nonsustainable oil in a vat, making the source of a final ingredient
difficult to pinpoint. Unilever also employs palm oil in lots of different
ways—often using derivatives of the oil rather than oil itself—making the
supply chain even more complex.
Mr. Engel compared it to crude oil. "When you
actually want to know where the petrol in your car is coming from—from which
oil well—it's very hard to see," he said.
For that reason, the RSPO developed a system of
GreenPalm certificates that companies such as Unilever can buy. The RSPO
certifies plantations as sustainable and awards them one certificate per ton
of palm oil they produce.
Unilever considered about two-thirds of the palm
oil it used last year sustainable, not because it actually came from
traceable sources, but because it bought 803,000 GreenPalm certificates,
plus the 27,000 tons of oil it bought from traceable plantations.
This year, the company says it will match all the
palm oil it doesn't buy from traceable plantations with certificates so it
reaches a target of 100% certified sustainable palm oil, three years ahead
of the 2015 deadline the company set in 2010.
That, however, doesn't mean the palm-oil derivative
in a bar of Dove soap or Magnum ice cream actually came from a sustainable
palm-oil plantation.
"In theory, all of the palm oil could be
sustainable, or none of it could be," Mr. Engel says.
He says that although the sustainable oil attached
to the certificates may not have ended up in Unilever products, the company
bought a certificate for a ton of palm oil "out there" that came from a
sustainable plantation, helping shift the balance toward sustainable
production.
The certificate system has its critics, who say it
allows companies to claim they are buying sustainable palm oil when they
aren't.
"A lot of people are hiding behind green
certificates as if that's going to change the industry," says Alan Chaytor,
executive director of New Britain Palm Oil Ltd., a Papua New Guinea-based
producer that makes about 600,000 tons of sustainable palm oil a year.
Continued in article
Bob Jensen's threads on ROI and other ratios ---
http://faculty.trinity.edu/rjensen/roi.htm
"End the Religion of ROE," by Chris Meyer & Julia Kirby, Harvard
Business Review Blog, October 20, 2011 ---
http://paper.li/businessschools?utm_source=subscription&utm_medium=email&utm_campaign=paper_sub
There is no more powerful question in a U.S.
corporation than "what's the ROE on that?" Social media spending? Wellness
checkups? Better working conditions? Return-on-equity hurdles threaten them
all. Conversely, why market cigarettes? ROE justifies the means.
We think there's more to business success — and
that something as straightforward as a simple equation could put capitalism
on a better path.
To an extent not widely recognized, it was an
equation in the first place that gave ROE the power to dominate not just
investment decisions, but an entire business culture. A hundred years ago,
the focus on squeezing every drop of return out of equity capital made great
sense. As the industrial revolution progressed, society was enjoying
enormous benefits from mass production, which brought former luxuries within
middle class reach. Just as electronic commerce would later sweep business,
mass production came to one industry after another. But unlike websites,
factories were capital intensive. The revolution ran on equity capital,
which was in short supply. Anyone would have concluded that allocating
capital according to expected return on equity would be optimal for growth.
The ability to do that rose to a new level in 1917,
when General Motors was in financial difficulty and DuPont took a major
position in the company. (GM represented an important channel for DuPont's
lacquer, artificial leather, and other products, and Pierre du Pont was on
GM's Board.) DuPont sent Donaldson Brown, a promising
engineer-turned-finance staffer, to Detroit to sort things out, and sort
them out he did.
Brown noted a simple fact: Return on equity can be
broken down into a three-part equation. It is logically the product of
return on sales times the ratio of sales to assets times the ratio of assets
to equity. By parsing ROE into the DuPont Equation (very rapidly to become a
business school mainstay), he provided the basis for organizations divided
into functions with their own objectives. He reasoned that if marketers
worked on maximizing return on sales, production managers were rewarded for
the sales they squeezed out of their physical plant, and finance managers
focused on minimizing the amount of equity capital they needed, ROE would
take care of itself.
Thus Brown not only sowed the seeds of the today's
hated silos, he also set three "runaways" in motion. That is to say, he
created objectives with such strong feedback loops that they were pursued
single-mindedly, even to unhealthy excess.
Biologists use the term "runaway" to describe what
happens when a single criterion dominates the mating choices of a species to
the exclusion of other valuable traits. Among peacocks, large tails so charm
the peahens that the male tail has grown to the point where the males are
stressed by the nutritional burdens of growing and carrying the stupendous
appendage, and are more subject to predation because of its weight. Even as
the population of peacocks declines, peahens persist in their preferences.
Runaway feedback reduces the fitness of the species. (And here's a simpler
version, courtesy of lab experiments in the 1950s: given a lever to
stimulate the pleasure centers in their brains, rats will allow themselves
to die of starvation and exhaustion. The feedback from pressing the lever
overwhelms the positive sensation they would experience from eat or sleep.)
In the case of ROE, spurred on by the DuPont
equation, society came to suffer from similarly entrenched corporate
runaways. In their pursuit of margin, marketers sought market power even to
the point of monopoly, requiring antitrust laws to cry stop at the last
moment of the end game. Similarly, production engineers treated their
factories royally and their labor as expendable, until unions and labor laws
intervened. Financial managers, supported by their bankers, increased their
debt-to-equity ratios until capital requirements were imposed—oops, we mean
until there was a catastrophic financial crash and a depression. Then
banking regulations were imposed. (Apparently unconvinced of the causal
link, in the 1980s we re-ran the experiment. Once again, stimulating the
financial pleasure center proved irresistible and near-fatal.)
The lesson: Return on Equity, like peacock tail
splendor, is a very poor guide for allocating resources. It fails for two
reasons. First, fixating on ROE fails to maximize the benefit of business to
society because it measures value in terms of returns to only one
stakeholder; second, it allocates human resources as if maximizing the
efficiency of financial capital were critical to growth of social welfare.
So it's time to address our measurement system
seriously at the firm level. It would help to have a new equivalent of the
DuPont Equation that propels individuals and organizations forward just as
powerfully but does not send capitalism off the rails. What might that look
like? Most fundamentally, the objective of business must be broadened beyond
ROE. Structurally, too narrow an objective function leads to runaways, in
particular the fetishizing of financial return and measurements. And
functionally, there is no longer a need to ration financial resources;
there's more money available than can be productively invested—which is why
the financial industry is only minimally about investing, and all about
flipping, swapping, hedging, engineering, and other forms of lever-pressing.
Instead, the measure of value creation should take
into account the benefits perceived by all stakeholders, not just equity
holders. (Note that this means accounting for negative externalities like
health effects on neighboring populations, as well as positive ones like
contributions to education.)
In addition, the measures should be broad enough to
take into account variations in valuation around the world. As Richard
Dickinson and Kate Pickett show in Spirit Level, a value like equality, for
example, is prized more highly in Norway than in the U.S.
And in terms of its effects on managerial
decision-making, the new system should create feedback and incentives that
nudge managers toward innovating for tomorrow's world, not optimizing for
today's. When ROE holds sway, a more or less certain return on a
cost-reduction investment nearly always trumps a speculative bet on a new
business model. That only makes sense if you are operating in a state of
equilibrium—which might have been close enough to the truth in some
sepia-toned time. Now we need managers to shift from a mindset of optimizing
an equilibrium to adapting to and capitalizing on a dynamic business
ecology. New measures can help reverse that priority, creating incentive
systems that encourage enterprises to invest in the growth of their
ecologies.
So here's our candidate: we believe that
corporations would do better for all their stakeholders and avoid the risks
of runaways by focusing on Return on Innovation. An innovation-based measure
would lead to an acceleration in investment with positive benefits for
growth.
Continued in article
Jensen Comment
Actually this paper is a recommendation to derive Return on Innovation which we
might call ROX since ROI is ready taken for Return on Investment. Use of X to
stand for the denominator "Innovation" since that term is ambiguous and not well
understood in the markets relative to ROE and ROI.
Also ROX has many of the same limitations of ROE and ROI apart from the
problem of defining "Innovation."
Bob Jensen's threads on the controversies surrounding ROI and ROE are at
http://faculty.trinity.edu/rjensen/roi.htm
Teaching Case About Return on Investment (ROI)
From The Wall Street Journal Accounting Weekly Review on October 8,
2010
CEO Redux Not Always
a Hit
by: Joe Light
Oct 04, 2010
Click here to view
the full article on
WSJ.com
TOPICS: Corporate
Governance,
Executive
Compensation
SUMMARY: This
short article
focuses on work by
researchers from the
IE Business School
in Madrid, Spain,
and Rouen Business
School, France.
These management
professors compared
rates of return on
assets for the three
years following
initial appointment
of the company's CEO
who was at the helm
in 2005. They
examined differences
in this performance
metric according to
whether the CEO had
prior experience as
CEO versus those who
had not; they found
consistently poorer
results for those
CEOs who had prior
experience. However,
one aspect of the
research that is
more fully discussed
in the online
version of the
article indicates
that the findings
may simply serve as
a marker of another
result: the negative
effect of being an
ex-CEO disappeared
if the CEO spent at
least two years with
the new firm before
being promoted.
Ex-CEOs also
performed better if
they had a long
break between CEO
positions or
repeated as CEO more
than twice.
CLASSROOM
APPLICATION: The
article may be used
to identify an
unusual use for ROA,
a financial
statement ratio
typically studied in
financial accounting
and MBA classes. The
article also is
useful to help
students understand
the nature of
academic research.
QUESTIONS:
1. (Introductory)
What were the
overall findings in
the study that is
being reported in
this article?
2. (Advanced)
How is return on
assets calculated?
How do you think
these researchers
could control for
industry performance
so that "CEOs
wouldn't get an
unfair advantage
from a soaring
sector"?
3. (Introductory)
How do the
researchers explain
their results?
4. (Advanced)
Are you surprised by
these research
results? Explain
your response,
considering the
expertise that
should be used in
searching for and
hiring a CEO
Reviewed By: Judy
Beckman, University
of Rhode Island
|
|
|
|
|
"CEO Redux Not Always a Hit," by: Joe Light. The Wall Street
Journal, October 4, 2010 ---
http://online.wsj.com/article/SB10001424052748703431604575522362723091490.html?mod=djem_jiewr_AC_domainid
For chief executives, past experience doesn't
necessarily lead to future success.
A new study found that CEOs who have previously
held other CEO posts actually perform worse than people who have never
been CEO, judging by a key metric.
The study looked at chief executives who led
S&P 500 companies in 2005 and analyzed their companies' returns on
assets in the first three years after their appointments. It was
conducted by Professors Monika Hamori of IE Business School in Madrid
and Burak Koyuncu of Rouen Business School in Rouen, France.
To measure CEO performance, Mr. Koyuncu and Ms.
Hamori focused on companies' returns on assets—the ratio of net income
divided by total assets, which is commonly used to compare company
performance in academia. In theS&P 500 sample, 98 CEOs had prior CEO
experience. Those repeat CEOs earned a median annual average return on
assets of 3.92% in the first three years of the CEO's tenure.
Companies with a CEO who hadn't been a chief
executive before saw a 5.4% return. The negative effect gets even worse
if the CEO transitioned from a similar-sized company or one in the same
industry. Same-industry repeat CEOs saw a median return on assets of
3.1%, and CEOs from similar-sized companies had a median return of
2.94%.
Ms. Hamori and Mr. Koyuncu factored in how well
their industries as a whole performed so CEOs wouldn't get an unfair
advantage from a soaring sector.
The findings don't necessarily mean that prior
CEO experience hurts performance. A second-time CEO is generally someone
who is coming from outside the company, while first-time CEOs are a mix
of both insiders and outsiders. Other research has shown that internally
promoted CEOs tend to outperform outsiders. So the problem may be that
the person is an outsider, not that he or she has been CEO previously.
"When you bring in CEOs from the outside, they
think outside the box but are less familiar with what works and what
doesn't work within the firm," says Nandini Rajagopalan, a business
management professor at the University of Southern California, who has
researched the insider-outsider phenomenon.
Mr. Koyuncu found that the negative effect of
being an ex-CEO disappeared if the CEO spent at least two years with the
new firm before being promoted. Ex-CEOs also performed better if they
had a long break between CEO positions or repeated as CEO more than
twice.
Still, Mr. Koyuncu thinks repeat CEOs might
underperform because they mistakenly think they can apply many of the
methods they used in their former job to their new one.
"Every CEO job and company is different from
the previous one," he said. "You can't just transfer learning between
the two."
"Decoding Business Profitability," by Lyn Denend
quoting Mark Soliman, Stefan Reichelstein, and Madhav Rajan, Stanford
Business Magazine, November 2007 ---
http://www.gsb.stanford.edu/news/bmag/sbsm0711/kn-decoding.html
For years, return on
investment (ROI) and related financial accounting ratios have been widely
used as key measures of business profitability. Now three Business School
accounting professors have written an award-winning paper that shows the
economic interpretation of the ROI metric requires more careful analysis.
For more than 40
years, business professionals and academics have relied on ROI
to infer a company’s economic rate of return, which is usually
conceptualized as the internal rate of return of a
firm’s investment projects. Many recognized that financial
accounting is subject to biases that could skew the magnitude of
the ROI ratio, but they tended to believe these effects would
average out over time, thereby enabling parity between ROI and
real economic return. On the other hand, when companies such as
those in the oil industry have been accused of abusing their
market power, as evidenced by excessive accounting
profitability, they tried to explain away high accounting
returns by claiming that standard metrics do not adequately
measure real economic returns.
“There wasn’t a
precise mathematical understanding of the issue,” said
Madhav Rajan, a professor of managerial accounting who
collaborated on the study with Stefan Reichelstein,
who also specializes in managerial accounting, and Mark
Soliman, a financial accountant.
The threesome
developed a model that enabled them to examine analytically and
empirically how a firm’s ROI was affected by two central
variables: accounting conservatism and growth in new
investments. They considered accounting to be conservative if it
resulted in book values that were understated because
investments were written off faster than they should be, given
the under-lying pattern of project cash flows. Direct expensing
of intangible investments is a prime example of such
conservatism.
The researchers
found that accounting conservatism and past growth in
investments jointly determined how ROI compared to the
underlying economic profitability of a business. Given
conservative accounting, higher growth tended to depress ROI, a
decline that was accentuated by more conservative accounting
rules. On the other hand, more conservative accounting increased
ROI only if the rate of past growth in new investments was below
some critical value, with the opposite effect emerging for
growth rates above that critical value. To test the theoretical
predictions of the model, the researchers used a data sample of
43,680 firm-year observations from 1982 to 2002.
The result is a
tool for “decoding the economic profitability of a firm given
the accounting profitability reported in the ROI number,”
Reichelstein said. Contrary to earlier examples and numerical
illustrations in textbooks and the relevant literature, “we now
have a much more systematic grasp of the linkage between
accounting and economic return.”
Both investors
and managers can use the tool, “From a management perspective,
it’s perfectly possible that one of your divisions has an ROI of
15 percent while another one has an ROI of 10 percent,”
Reichelstein said. “You shouldn’t jump to the conclusion that
the one giving you 15 percent is the one that’s adding more
value to the business.” By applying the model, taking into
account how rapidly both divisions have been growing and which
has assets that may be more subject to a conservatism,
management can more accurately determine the real economic
profitability of both business groups.
The research,
which earned best paper awards when presented at two
international accounting conferences, is published as
“Conser-vatism, Growth, and Return on Investment,” in the
September 2006 issue of the Journal of Accounting, Auditing,
and Finance.
Teaching Case on Managerial Accounting: Accounting Assessments of
New Strategy Performance
From The Wall Street Journal Accounting Review on August 13, 2010
Macy's Tailored Merchandise Pays Off
by:
Veronica Dagher
Aug 12, 2010
Click here to view the full article on WSJ.com
TOPICS: Earnings
Per Share, Financial Accounting, Financial Analysis, Financial Reporting,
Interim Financial Statements, Management Controls, Managerial Accounting,
Product strategy, Revenue Forecast
SUMMARY: Macy's
Inc. is benefiting from a plan to tailor merchandise to local markets, an
effort that helped push its fiscal second-quarter earnings higher. But the
retailer Wednesday reiterated uncertainty about the economy even as it
raised its yearly earnings forecast. The department-store operator is
entering the fall-shopping season "with tremendous momentum," but the
economy remains uncertain, Chairman and Chief Executive Terry Lundgren said
in a statement.
CLASSROOM APPLICATION: This
article can be used in both managerial and financial reporting classes. The
managerial topic of planning and control is addressed through the Macy's
tailoring process for regional U.S. tastes. Resultant quarterly reporting of
earnings, gross margin, and comparison to analysts' estimates is then
discussed.
QUESTIONS:
1. (Introductory)
Macy's is tailoring its offerings across the U.S. Summarize how this
retailer is taking this approach.
2. (Introductory)
How has the company assessed whether its strategy is working?
3. (Advanced)
What accounting information do you think is necessary to do the planning and
assessment that you described in answer to the first two questions above? In
your answer, describe how you would code accounting data to provide the
needed information.
4. (Introductory)
What was Macy's most recent quarter end? How did the company perform during
that quarter? In your answer, include definitions of revenue, gross margin,
and profit.
5. (Introductory)
How did Macy's results compare to forecasted earnings? In your answer, state
who forecasts these earnings and define the earnings per share metric they
use.
6. (Advanced)
What fiscal year end date corresponds to the quarter end reported in this
article? Why do you think retailers typically have this fiscal year end
date?
Reviewed By: Judy Beckman, University of Rhode Island
"Macy's Tailored Merchandise Pays Off," by Veronica Dagher, The Wall
Street Journal, August 12, 2010 ---
http://online.wsj.com/article/SB10001424052748704901104575423072657062954.html?mod=djem_jiewr_AC_domainid
Macy's Inc. is benefiting from a plan to tailor
merchandise to local markets, an effort that helped push its fiscal
second-quarter earnings higher. But the retailer Wednesday reiterated
uncertainty about the economy even as it raised its yearly earnings
forecast.
The department-store operator is entering the
fall-shopping season "with tremendous momentum," but the economy remains
uncertain, Chairman and Chief Executive Terry Lundgren said in a statement.
Macy's typically kicks off the earnings season for
major retailers and is seen by many analysts as a barometer of consumer
spending.
The Cincinnati-based company raised its earnings
forecast for the year by 10 cents to between $1.85 and $1.90 a share. The
company also increased its estimate for same-store-sales growth to 4% to
4.2%, from 3% to 3.5%.
The retailer's shares jumped after its earnings
report, rising 4.5% to $20.25 in afternoon trading Wednesday on the New York
Stock Exchange. Its shares were a bright spot as global economic worries
weighed on the broader market and concerns about consumer spending helped
pressure competing retailers such as J.C. Penney Co.
The stock through Tuesday was up 25% in the past
year.
Macy's, along with its peers, continues to face
challenges due, in part, to low levels of consumer confidence and anemic job
growth. Some analysts worry retailers face rougher going during the second
half as results are compared with the prior year when the economy seemed to
be improving.
The company on Wednesday reiterated that the effort
to tailor merchandise to local tastes, dubbed My Macy's, is paying off, with
major changes behind it and the opportunity ahead to push hard at driving
sales. The company stocks items based on individual market needs as part of
the initiative, pilot-tested in 20 markets in 2008 and rolled out nationally
in mid-2009.
During the company's earnings call, Chief Financial
Officer Karen Hoguet said private-brand and exclusive products also are
helping drive growth. She added that all regions of the country did
"relatively well" in the quarter, with the only cluster of weakness
occurring in some parts of California.
Ms. Hoguet said that on a two-year basis, the
strongest regions for the department store giant were the North and the
Midwest, both of which were original My Macy's pilot regions.
Macy's has also increased its efforts in targeting
teens and their mothers. With teen unemployment at record levels, teens have
less money for new back-to-school clothes, which may put purchasing
decisions back in the hands of their parents.
Some analysts say moms may have more confidence
shopping at department stores compared with teen retailers, which may give
names like Macy's a boost.
To that end, Macy's recently rolled out the
Material Girl line inspired by singer Madonna and her daughter to lure in
teens, an effort Ms. Hoguet said is performing well.
The Material Girl line adds to other private
labels—now more than 40% of Macy's stock—that also include the American Rag
brand for juniors and young men and the Martha Stewart home-furnishings
line.
For the period ended July 31, the company reported
a profit of $147 million, or 35 cents a share, up from $7 million, or two
cents a share, a year earlier, which included 18 cents a share in
restructuring-related charges.
Analysts polled by Thomson Reuters forecast
earnings of 29 cents a share for the second quarter.
Gross margin edged up to 41.9% from 41.5%.
Macy's last week reported total sales rose 7.3% to
$5.54 billion and same-store-sales growth of 4.9%, compared with prior-year
declines of 9.7% and 9.5%, respectively.
Ms. Hoguet said sales were strong in most
categories, with the only notable weaknesses in women's traditional career
apparel and young men's. The best sales results in the quarter included
men's, fashion watches, updated women's apparel and seasonal categories like
swimwear, luggage, furniture and mattresses, she said.
Combined online sales for macys.com and
bloomingdales.com were another highlight in the quarter, rising 28.1%.
Macy's has been making strides in the digital area and has boosted its
spending on various types of online media this year.
Macy's operates about 850 department stores in the
U.S. and its territories. The company is opening three department stores in
the second half, including its Bloomingdale's in Santa Monica, which opened
last week, and is also planning to open its first four Bloomingdale's
Outlets.
Alpha Return on Investment ---
http://en.wikipedia.org/wiki/Alpha_(investment)
What the professional investors don't tell you ---
I downloaded this video ---
http://www.cs.trinity.edu/~rjensen/temp/FinancialRounds.flv
From the Financial Rounds Blog on September 4, 2009 ---
http://financialrounds.blogspot.com/
When I teach investments, there's always a section
on market efficiency. A key point I try to make is that any test of market
efficiency suffers from the "joint hypothesis" problem - that the test is
not tests market efficiency, but also assumes that you have the correct
model for measuring the benchmark risk-adjusted return.
In other words, you can't say that you have "alpha" (an abnormal return)
without correcting for risk.
Falkenblog makes exactly this point:
In my book
Finding Alpha I describe these strategies, as
they are built on the fact that alpha is a residual return, a
risk-adjusted return, and as 'risk' is not definable, this gives people
a lot of degrees of freedom. Further, it has long been the case that
successful people are good at doing one thing while saying they are
doing another.
Even better, he's got a pretty good video on the topic
(it also touches on other topics). Enjoy.
You can watch the video under September 4, 2009 at
http://financialrounds.blogspot.com/
I downloaded this video ---
http://www.cs.trinity.edu/~rjensen/temp/FinancialRounds.flv
Bob Jensen's threads on market efficiency (EMH) are at
http://faculty.trinity.edu/rjensen/theory01.htm#EMH
Bob Jensen's threads on market efficiency (EMH) are at
http://faculty.trinity.edu/rjensen/theory01.htm#EMH
Today's smartest companies are
measuring a complex mix of business objectives, costs, and risks--and holding
managers accountable for results that maximize returns. http://www.informationweek.com/story/IWK20021017S0013
Companies are taking
a hard look at returns on IT investments, using complex valuation models
linked to business goals. by Eileen Colkin, October 21, 2002
Tough competition and
even tighter budgets mean that IT projects must go through a rigorous ROI
wringer. And that wringer is getting tougher all the time. Forget on time and
on budget, and don't even think about using a vendor's ROI tool. The smartest
companies are measuring a complex mix of business objectives, costs, and
risks, and holding managers accountable for results that maximize returns.
"It used to be the 'ta-da' strategy," says John Howell, VP and
program director of Internet solutions for Citibank Global Securities
Services. "We'd put the project together and throw it out there and say,
'Ta-da! It must be successful.' We didn't look to maximize ROI, we looked to
measure it."
Citibank Global
Securities Services has moved beyond the easy approach to ROI with a
methodology that looks to maximize returns, Howell says.
The new frontier is
"more acuity in computing ROI," says Howard Rubin, a principal at
Meta Group. Companies categorize IT initiatives by specific goals, such as
raising the stock price, increasing market share, or lowering operating costs,
then use historical and other data to quantify what returns can be expected.
"IT departments need to look at the big picture," says Calvin
Braunstein, president and executive research director at advisory firm Robert
Frances Group. They're also tightening the links between IT investment and its
impact on a company's sales and profit. Spending should go up only when
revenue is headed in the same direction or costs are going down. "It has
to impact either the top or bottom line," Braunstein says.
Still, only a few
companies are using broader definitions of ROI. About 8% of all businesses
examine IT investments through these more complex valuation filters, Rubin
says. And those that are doing so use a variety of methodologies.
Chris Lofgren,
president and CEO of Schneider National Inc., a $2.4 billion-a-year trucking
and logistics company, has embraced the move to a more complex approach to ROI.
"The emergence of the ROI metrics came from a realization in the tech
community that sometimes they built things that were neat and cool because
they could, even though there wasn't much value," Lofgren says. "Now
there's an evolution to the extent that if companies want to push capital into
a technology, IT has got to compete for that capital with proven
valuation."
Project valuation has
become more of an art than a science at Schneider National, president and CEO
Lofgren says.
Lofgren puts IT
investments into strategic buckets. Those that will lower costs go in one
bucket, revenue creators in another, and those expected to simplify business
processes in a third. He then considers different factors for each category,
consulting the executives and business units relevant to each set of projects.
But these sorts of valuations are still more of an art than a science.
"You can't take away judgment, business strategy, and insight,"
Lofgren says.
Citibank Global
Securities has made the transition away from the "ta-da" strategy to
a more comprehensive approach to assessing the potential returns on IT
projects. The company, which sells stocks and bonds to institutional
investors, is building an executive portal that will let it act as a central
information source and value-added service provider for C-level executives at
the 350 largest financial institutions in the world. Having such a small
target market leaves little room for error. One lost customer for the division
is equivalent to a global retailer losing a million consumers. But the
potential for gains is also huge: If the portal wins favor, Citibank's market
share should increase, and it will be positioned to sell other products to
this elite group, Howell says.
Continued at http://www.informationweek.com/story/IWK20021017S0013
EIR Method
Controversies
This is a rather
strong position taken by Deloitte (and Webmaster Paul Pacter) on IASPlus on June
17, 2008 ---
http://www.iasplus.com/index.htm
June 17, 2008: We disagree with IFRIC's draft
decision on effective interest rate
| |
In a
letter to IFRIC, Deloitte Touche Tohmatsu disagree with the IFRIC's
tentative decision not to take onto the IFRIC's agenda a request for
an interpretation on the application of the effective interest rate
(EIR) method. Click for our
Letter to IFRIC
(PDF 136k). Here is an excerpt: |
In summary, we
believe the tentative agenda decision wording does not provide
sufficient clarity and that additional interpretive guidance is
needed. We believe there are three important interpretative issues
that need to be addressed:
- (i)
how to apply the effective interest rate to debt instruments
with a market-based reset;
- (ii)
when should an entity apply AG7 compared to AG8; and
- (iii)
for inflation linked debt, is it possible to analogise with IAS
29 in the case when an entity is not applying that standard.
The
application of the EIR is critical in determining the balance sheet
carrying amount and the impact on profit or loss for debt
instruments held at amortised cost, as well as the income
recognition for those debt instruments classified as
available-for-sale. The EIR has widespread application for both
vanilla and complex debt instruments, yet the standard is not clear
as to how the EIR method applies for instruments with variable cash
flows. |
Our past comment letters
to IASB, IFRIC, IASC, and SIC are
Here.
From The Wall Street Journal Accounting Weekly Review on
October 27, 2006
TITLE: Xerox Net Jumps on a Tax Refund, Color-Page Output
REPORTER: William Bulkeley
DATE: Oct 24, 2006
PAGE: B3 LINK:
http://online.wsj.com/article/SB116160233330000697.html?mod=djem_jiewr_ac
TOPICS: Accounting, Income Taxes, Taxation
SUMMARY: Xerox's results are impacted both by factors affecting operating
earnings and by one-time items, including a tax refund following completion of
an audit of 1999 to 2003.
QUESTIONS:
1.) What factors disclosed in this article will affect operating earnings? Which
ones will impact net income but not operating income?
2.) Why do companies separate items in earnings releases that arise in only
one time period? Are these one time items the same as the items that are
excluded from operating income? Support your answer.
3.) Why does Xerox's tax refund have such a significant impact on this year's
third-quarter net income if the refund relates to a tax audit for the years 1999
to 2003? Specifically cite accounting support for including the effect of the
refund in the current period. How does this support differ from the reasoning
you offer in answer to question 2?
Reviewed By: Judy Beckman, University of Rhode Island
From The Wall Street Journal Accounting Weekly Review on
October 27, 2006
TITLE: Embattled Airbus Lifts Sales Target for A380 to Profit
REPORTER: Daniel Michaels
DATE: Oct 20, 2006
PAGE: A4
LINK:
http://online.wsj.com/article/SB116129654805798256.html?mod=djem_jiewr_ac
TOPICS: Accounting, Cost-Volume-Profit Analysis, Earning Announcements, Earnings
Forecasts, Managerial Accounting
SUMMARY: "European plane maker Airbus said it needs to sell significantly
more A380 superjumbos than originally planned to make a profit on the roughly 12
billion euro ($15 billion) project..." Questions relate to the use of
Cost-Volume-Profit analysis to make this announcement. The article follows on
one previously covered in a Weekly Review.
QUESTIONS:
1.) Describe the formula used to determine the number of units of a product that
must be sold in order to break-even or to generate a profit.
2.) What is the break-even point in units for sales of the Airbus A380? How
is that break-even point translated into sales dollars? What questions do you
think must be considered in forecasting sales of the A380 given its production
delays?
3.) Why is this break-even information of interest to financial analysts who
follow Airbus? That is, how does the break even information add on to
information previously announced regarding cost overruns and shipping delays for
the A380?
4.) How did Airbus calculate the 13% projected internal rate of return on the
A380 project? Specifically describe steps needed to make that calculation.
5.) In the article, the author states that the internal rate of return is
"essentially the project's payback rate." Do you agree? Support your answer and
include definitions of internal rate of return and payback period.
Reviewed By: Judy Beckman, University of Rhode Island
--- RELATED ARTICLE ---
TITLE: EADS Expects Further Delays in Airbus A380 Jetliner Program
REPORTER: Daniel Michaels
PAGE: B2 ISSUE: Sep 22, 2006
LINK:
http://online.wsj.com/article/SB115882214969669858.html?mod=djem_jiewr_ac
"Embattled Airbus Lifts Sales Target For A380 to Profit," by Daniel Michaels,
The Wall Street Journal, October 20, 2006; Page A6 ---
http://online.wsj.com/article/SB116129654805798256.html?mod=djem_jiewr_ac
European plane maker Airbus said it needs to sell
significantly more A380 superjumbos than planned to make a profit on the
roughly €12 billion ($15 billion) project, highlighting its uphill struggle
in making the giant plane a commercial success.
During a presentation to investors and equity
analysts in Hamburg, Germany, that was posted on the company's Web site,
Airbus Chief Financial Officer Andreas Sperl said Airbus would break even on
the project to build the world's largest passenger jet when it delivers some
420 of the two-deck aircraft.
The original target, set in 2000 when Airbus
launched the A380, was 250 deliveries. That was raised to around 270
deliveries last year. Since it started marketing the plane in 2000, Airbus
has garnered 159 firm orders for A380s from 16 customers and commitments to
buy nine additional 555-seat jetliners -- though some may cancel orders
because of the mounting delays.
Airbus has previously said the delays would result
in a financial hit, but Thursday's disclosure quantifies that impact in
terms of orders -- underscoring its increased need to make the plane
appealing to customers. Manufacturing problems, in particular with the
wiring of the A380, have forced Airbus to delay deliveries by two years and
have also pushed the project at least 30% over its original budget of €9
billion at current exchange rates. The A380 woes, which have angered many of
Airbus's best customers, have prompted Airbus and parent company European
Aeronautic Defence & Space Co. into drawing up a major restructuring plan to
tackle problems.
Mr. Sperl's presentation also said Airbus had cut
the internal rate of return on the A380 project -- essentially, the
project's payback rate -- to 13% from a previous prediction of 19%. The
lower return rate also is because of the delays and cost overruns. Airbus in
2000 predicted a rate of return above 20%.
Still, Airbus left unchanged its forecast of total
A380 sales, which it maintains at 751 planes over the next 20 years. Airbus
has said it expects orders to pick up once the plane enters service, now
late 2007 for its first delivery. Airbus rival Boeing Co. is far less
optimistic about sales prospects for very large jetliners. Boeing predicts a
total market for both itself and Airbus of 990 jetliners with more than 400
seats. That includes aircraft smaller than the A380, such as the Airbus A340
and the Boeing 777, and a large number of big cargo jets.
"Business: Strategic Investment: For many companies, launching
Internet initiatives that advance strategic goals is more important than getting
a hard-dollar return," by Clinton Wilder, Information Week Online,
May 24, 1999 --- http://faculty.trinity.edu/rjensen/acct1302/wilder01.htm
The Internet has changed the way companies
communicate, how they share information with business partners, and how they
buy and sell. It's also changing the way they view their IT investments.
As companies launch electronic-business projects,
many are tossing out conventional thinking about the need for a return on
investment and focusing on how the initiatives advance their overall business
strategy--whether it's to improve customer satisfaction, increase brand
awareness, or open new sales channels. A small but growing number of companies
have recently begun searching for new ways to measure the ROI of their
E-business projects. For less strategic projects, such as those that increase
the efficiency of the supply chain, traditional ROI evaluations are still
being used. But the bottom line is that E-business is seen increasingly as
something that must be pursued at all costs.
The Bank of Montreal, Canada's third-largest bank,
didn't even consider ROI when it committed between $55 million and $69 million
to online banking initiatives, much of it for the development of custom-built
middleware linking the Web to its mainframe applications and databases.
"We weren't sure if it would make money or not, but we didn't see how we
could continue to be a leading-edge, full-service bank if we didn't do
it," says Ron McKerlie, the Toronto bank's VP of smart cards and emerging
businesses.
The Bank of Montreal is hardly alone in pushing ahead
with E-business projects without formally evaluating their potential ROI. In a
recent survey of 375 IT and business executives conducted by InformationWeek
Research in conjunction with Business Week, only 17% of IT managers and 12% of
business executives said their companies formally required them to demonstrate
the potential payback of their E-business applications. And 28% of IT managers
and 39% of business executives said their companies required no ROI evaluation
whatsoever (see chart, below).
Consultants say many businesses are playing catch-up
with E-business, and as a result, they're often jumping into it without
carefully considering either the ROI or strategic implications of the move.
"Of the E-business projects we're familiar with, I'd say two-thirds are
done simply out of a sense of business urgency," says Bob Parker, an
analyst at AMR Research. "CEOs are walking in and saying, `I don't know
exactly what this is, but I know we have to do it.' There's an element of
fear--the fear of getting left behind."
That's the wrong approach, says Parker. Even if a
company doesn't do a formal ROI evaluation, there needs to be coordination
between the CEO, the CIO, employees, and business partners that will be
affected. A business case needs to be made. "The probability of failure
increases when you do a project just because the CEO read somewhere that he
needs to be on the Net," says Parker.
Critical Decisions Ironically, companies that weigh
those factors carefully often come to the same conclusion: They must
proceed--regardless of ROI. That's because the Internet has increased the
speed of business, changed the nature of customer service, and given companies
the ability to enter new markets, says Diana Brown, VP and general manager of
financial services for Web integrator Scient Corp. Companies must respond.
"You have to keep E-business out of the normal budgeting process,"
she says. "If these investments are held up to the same magnifying glass
as other line items--to make money this year--it's very hard to make anything
happen."
More companies are justifying their E-business
ventures not in terms of ROI but in terms of strategic goals. In the
InformationWeek Research survey, creating or maintaining a competitive edge
was cited most often as the reason for deploying an E-business application.
That was followed closely by improving customer satisfaction, keeping pace
with competitors, and establishing or expanding brand awareness (see chart,
below).
The business and IT executives surveyed largely
agreed on the top three goals. Where they differed was on the issue of cost
reduction: 78% of IT executives cited reducing operational costs as a motive
for deploying E-businesses applications, compared--perhaps surprisingly--with
just 66% of business executives. (Full results of the survey will be released
June 8 at InformationWeek's E-Business Conference & Expo in San Jose,
Calif. For information, see http://www.ebusinessexpo.com/.)
Customer satisfaction was a key reason the Bank of
Montreal launched Mbanx, an online banking service, and it has paid off. More
than 150,000 customers use the bank's service, and their customer-satisfaction
level is around 95%, compared with 60% to 70% for conventional customers, says
McKerlie.
The bank has other E-business initiatives under way,
including a joint venture with Canada Post for electronic billing and
mailings; an online stock brokerage; online loan, mortgage, and credit-card
applications; online billing for company credit cards; an automated E-mail
response system; and an expansion of the bank's U.S. business (through Harris
Bank in Chicago) that doesn't require opening new branches.
In assessing its investments in some of these
projects, the bank was able to use conventional ROI metrics. For example, it
could compare the estimated cost of sending an electronic bill vs. mailing a
paper bill and calculate how long it will take to recoup the IT investment.
But for other projects, the bank began using a new set of metrics for
E-business developed by Scient. These ask: Does the initiative target a
valuable customer segment?
Does it improve the quality of customer service?
Does it reuse existing IT infrastructure?
Does it give the bank a commanding market-share lead
from being first to market?
Does it help the bank learn more about its customers?
Is it a strategic fit with other existing ventures?
"We mainly use the new metrics to compare each
of these initiatives with each other," says McKerlie. If the company has
only $100 million to spend but wants to go ahead with projects that would cost
$200 million, it uses both traditional and new metrics to identify the most
important projects to pursue, he says
Related links: What's The Investment Worth?
And from our sister publications: InternetWeek
Measuring ROI For The Top Line Of The Business
Why Bother? Some companies don't even look at their
strategic E-business applications as IT projects, so there's little reason to
evaluate ROI. In January, Milacron Inc., a $1.7 billion machine-tool
manufacturer in Cincinnati, launched Milpro.com, an E-commerce site that uses
Open Market's Transact commerce server and LiveCommerce catalog software. Alan
Shaffer, Milacron's group VP of industrial products, jokes that he approved
the seven-figure budget request of the company's director of E-commerce
"in less than 10 seconds." He then doubled the budget in midproject
last year. "Return on investment? We never even discussed it,"
Shaffer says. "This isn't an IT project, it's just another market
channel. Very few people do ROI on expanding their market channels."
Shaffer gave his IT people one non-negotiable
imperative: Be the first to market in the industry. "I told them we could
change what we did or what it cost, but not when it would launch," he
says. He also accepted that Milacron wouldn't see significant online sales
until 2001. In fact, the company projects that Milpro.com will achieve only
$600,000 in online sales for the first six months ending June 30.
Milacron's analysis of the Web initiative is about as
far from traditional ROI calculations on IT spending as you can get. But like
the Bank of Montreal, it sees its E-business efforts as a way to boost
customer service. Milpro.com, which is upgraded every 90 to 120 days, is not
only a vehicle for sell-ing more cutting tools and fluids to small machine
shops, it also provides customers with technical advice about using the
company's products.
"A paper catalog gives you no clue about that
kind of information," says Shaffer. "To deliver that knowledge to
the point of sale around the clock--there's no other way besides the Web that
could do that as cost-effectively."
Milacron has included free services to encourage
customers and potential customers to use the site. The Milpro Wizard offers
advice on machine-tool and fluid problems, products, and other issues. The Job
Shop Mall lets customers post a classified ad or search ads posted by other
users, and users can list or search for new and used machinery and equipment
at the site's Machinery Flea Market. In Milpro.com's first three months, 400
machine shops registered to market their services on the Job Shop Mall, and
customers listed 200 pieces of equipment for sale in the Machinery Flea
Market. Shaffer says the number of customers using the Wizard on Sundays and
at midnight drops by only half from peak periods.
Milacron's tracking of site usage relates directly to
three of the top five ROI criteria for E-business cited by respondents to the
InformationWeek Research survey: improving customer or client satisfaction
(cited by 87% of IT and business executives), lowering the cost of promoting
products and services (70%), and increasing direct access to customers (68%).
(The other two measures were lowering operational costs and adding new
customers, cited by 85% and 72%, respectively.) Milacron's Web site may not
achieve a quantifiable ROI, but by doing well in these areas, it's advancing
the company's strategic goals. "If you treat your E-commerce site like an
IT project," says Shaffer, "it's the kiss of death."
Selling and providing services for customers over the
Internet are just two aspects of E-business. Many companies use the Web to
make their supply chains more efficient, cut back-office processing costs, and
achieve other efficiencies. IT executives and consultants say it's often
easier to show a quantifiable return on investment in these areas than more
strategic, customer-oriented projects.
"Clearly, a big part of ROI is shortening cycle
times with supply-chain partners, and that has a lot more to do with extranets
than with your Web site," says J.G. Sandom, senior partner and director
of interactive at marketing firm Ogilvy Interactive Worldwide, whose
E-business clients include Ford Motor Co. and GTE's wireless division.
"The less you have to deliver by print, phone, and fax, the more money
you'll save. It's a great way to show ROI quickly."
Cutting Calls That's why Philips Lighting Co., the $5
billion lighting products unit of Royal Philips Electronics, expects to see a
quick return on its investment in TradeLink, an ordering system that works on
the Web for smaller distributors that don't use electronic data interchange.
Call-center inquiries regarding inventory or order status account for about
half the expense of processing an order. In a pilot test of TradeLink, Philips
Lighting found the system reduced customer-service phone calls by 80%. Philips
expects big savings as it rolls out TradeLink to 400 distributors by year's
end.
Jim Worth, director of E-commerce at Philips
Lighting, in Somerset, N.J., says the best way to guarantee ROI is to start
small. "Metrics from small-scale pilots are the best way to go," he
says. "Until you have it running right, don't tell anyone about it,
because there will always be a lot of people who don't like what you're
doing."
Like Philips Lighting, McKessonHBOC Inc., a $24
billion pharmaceuticals wholesaler in San Francisco, took a traditional
approach to ROI when it began developing an E-business system to reduce
back-office processing costs in late 1997. The company expects to recoup its
$1 million investment in AR Link, a Web bill presentment and payment system,
nine to 12 months after rolling it out to most of its large customers later
this year, says John Amos, director of financial systems at McKesson. The
company expects AR Link to help increase operating margins over the following
two years.
How? In this case, the ROI calculation is
straightforward. McKesson handles 4.5 million customer-service calls per year,
at an estimated average cost of $2 per call, for a total of $9 million. And
25% of those calls are customers requesting a printed copy of a statement or
invoice via mail or fax. McKesson spends $3 each to produce and distribute
such documents. By contrast, McKesson's cost for customers to access its
accounts-receivable database over the Web via AR Link and print their own
statements is about 8 cents. As customer usage of AR Link increases, the
system should pay for itself quickly.
"It's easier to measure ROI from E-business,
because the ability to get information is greater," says Amos. "When
we measure customer-service calls, we can lose track of the call as it's
transferred around. But online, we can track what customers are looking
at--invoices, credit memos, billing status." AR Link went live in April
and about 60 McKesson customers use it now, including Wal-Mart, which came
online last week. Amos expects 9,000 customers to be on the system by year's
end.
McKesson expects to realize an even greater return
down the road from the development infrastructure it put in place for AR Link.
The company built the Windows NT system with just six people, including
developers from Web integrator Proxicom Inc., using JavaScript on the client,
Visual Basic Objects and Microsoft Transaction Server for the server, and
proprietary security technology. McKesson will use those same tools to build
at least two more planned Web systems: Contract/Pricing Link and an ordering
system called E Link. That will help cut development time, which McKesson
figures costs the company about $170 per hour.
Like the Bank of Montreal, McKesson leveraged its
existing IT infrastructure in developing AR Link by integrating it with the
company's existing Oracle8 accounts-receivable database, which it says is the
largest in the wholesale business with $2.5 billion in receivables at any
given time. The company is also integrating AR Link with its SAP Business
Information Warehouse. "We're learning that we can get a better return on
our technology if we Web-ify it," says Amos.
While McKesson's use of ROI metrics are conventional,
it illustrates how E-business is becoming more ingrained in the business
mainstream. Companies are less likely to jump into an E-business project
without doing an ROI study than they were a few years ago, according to Mike
Beck, VP at Proxicom, the Web integrator that worked with McKesson. "In
the last 12 months, there has been a re-emergence of ROI estimates for these
projects, even though the expectations are very low," he says. "But
they're often blown away by the actual results."
What's driving that change in some companies is the
realization that customer interaction on the Web produces more hard data about
the customer than any other "touch point". "Now that you can
measure things so accurately because it's all trackable," says Amos,
"you can put savings in terms that the CFO can really understand."
Cross-Functionality Of course, it's easier to measure
the ROI of an E-business application that cuts back-office processing costs
than one that improves customer satisfaction. As companies struggle to come up
with new metrics that measure the ROI of E-business projects, they must also
take into account another key aspect of nearly all E-business initiatives:
they're cross-functional. "The investments you need to make all come from
different buckets--IT, marketing, customer service, and others," says
Scient's Brown. "For each E-business project, it's not just a technology
risk. But in many organizations, it's very hard to look at projects--and
budgets--holistically."
United Parcel Service of America Inc. is trying to do
just that. It's developing new metrics for its customers to help measure the
payoff from E-commerce initiatives that UPS is helping with. "E-commerce
cuts across the entire organization, and if we just continue to focus on the
person who runs the shipping dock, that's not going to cut it," says Alan
Amling, director of E-commerce at UPS, in Atlanta. "We have to look at
accounts receivable, order entry, customer service--the whole value
proposition. We need new metrics because no company makes a huge investment
without monitoring the return at some point."
In the emerging era of E-business, ROI metrics must
be flexible enough to adapt as a company's E-business strategy evolves. And
even though the Internet has accelerated the pace of business like never
before, E-business metrics need to reflect a long-term view of ROI. "The
payoff of E-business could be a long time out," says Brown. "But if
you don't do it, you'll never get the payoff at all."
New Yahoo Service Looks To Improve ROI Of Online Ads
Yahoo Inc. and Marketing Management Analytics Inc. on
Friday launched a service that helps advertisers determine the effectiveness of
online ads on sales. The move comes as marketers are under increasing pressure
by companies to justify the high cost of advertising, both on and offline. The
new service delivers returns on investment by assessing ads on Yahoo and
measuring their effectiveness against ads on other media, whether it's on
another web site or on television or print. Besides the comparison of marketing
campaigns, the service provides recommendations to marketers on how to maximize
the effectiveness of their overall spending on advertising. The service would be
available at an additional cost. Greg Stuart, president and chief executive of
the Interactive Advertising Bureau, said marketers are increasingly under
pressure to show chief executives and financial officers that advertising
dollars are having a positive affect on sales.
Antone Gonsalves, "New Yahoo Service Looks To Improve ROI Of Online Ads,"
InformationWeek, December 16, 2005 ---
http://www.internetweek.cmp.com/showArticle.jhtml?sssdmh=dm4.161133&articleId=175004707
Implementing a framework for value assessment is the first step in
guaranteeing ROI from B2B e-commerce projects. Without one, you risk losing time
as well as money. http://www.iemagazine.com/010810/412feat1_1.shtml
"Warehouse ROI: Data warehouses are getting the same scrutiny as
other projects, by Rick Whiting, Information Week Online, May 24, 1999
--- http://www.informationweek.com/735/dw.htm
"What We Sell Is Between Our Ears," by Michael Hayes, Journal of
Accountancy, June 2001, 57-63 --- http://www.aicpa.org/pubs/jofa/jun2001/hayes.htm
TOOLS THAT
MAKE IT WORK
Because the firm’s staff is
not housed in the same building, it doesn’t have to worry about networks,
but both staff and clients must have high-speed access. “That’s one of the
things we’ve had to tell everybody to use. In some cases, we went to cable
modem about four years ago,” says Sechler. “Its speed and access were
unsurpassed at that time.” In areas where cable is not available, the firm
now uses DSL as an alternative.
Of the accounting
packages available as ASPs, Sechler prefers NetLedger (www.netledger.com).
Funded by Oracle, it’s “basically a QuickBooks living on the Web,”
Sechler says. “My clients and I can look at the accounting at the same time
anytime—in some cases while one of our firm’s bookkeepers with access at a
different level prepares the monthly activity.”
A user can set an astonishing
number of levels of access. “I can have the treasurer look at everything, or
everything except payroll, or write a check but not make deposits. There are
many areas where we can make the rules,” Sechler says. “It costs just $10
per user per month to use NetLedger, and there is no charge for the
subscribing CPA. I explain to my clients, ‘You can go out and buy a $5,000
software package—or pay $10 a month for this.’ For clients relying on
grantor or contribution money, it’s a great opportunity.” An expensive
package may have a few more bells and whistles to produce reports
automatically, but by exporting data from NetLedger to Excel Sechler can
customize reports so clients get what they want.
“I’ve got clients with
board members in many countries. NetLedger’s been a great solution for our
clients in Belgium, Budapest, Dublin, Melbourne and London because they
don’t have to wait for anything. I can have this moment’s activity sitting
in NetLedger when they decide they want to take a look at what’s going
on.”
Sechler also uses Office
2000, SuperForms, QuickBooks and Intuit’s tax package called ProSeries,
which QuickBooks talks to (see “Tools
You Can Use”). “I can upload and download
updates smoothly from the Web with it. The support’s very good, and I like
using it. It’s been good to me. It’s one of the few that were really doing
a good job in the 990 area, which is for the nonprofits’ tax return—a
nonstandard area. Not a lot of packages really support that area well,” she
says.
Tools You Can Use
NetMeeting
www.microsoft.com/windows/netmeeting/download/
Online conferences and collaboration. ASP. Free. |
PlaceWare
www.placeware.com
Excellent tool for larger groups, online seminars and
conferences. Pricing varies based on size of audience and frequency
of use. |
CoWorking
www.coworking.com
Updates on telework techniques and collaborative online
tools. |
Gil
Gordon
www.gilgordon.com
The guru of telework has tons of tips and techniques. |
NetLedger
www.netledger.com
Accounting ASP. $9.95 per user per month. |
QuickBooks
Pro
www.quickbooks.com
Accounting software. $90 to $500, depending on user needs. |
Quicken
Deluxe
www.quicken.com
Personal accounting software. $50. |
ICQ
www.icq.com
Instant messaging software for collaboration, communication
and file transfer. Free. |
Yahoo
groups
www.yahoo.com
Discussion groups, list servers, custom-moderated
communities. Free. |
uReach
www.ureach.com
Unified messaging software, virtual fax and voice mail, file
storage. ASP. $4 per month. |
Adobe
Acrobat reader
www.adobe.com
Reads messages sent in PDF format. Free. |
KMPG's eValuation
"Services Calculate Net ROI Consulting firms update traditional business
metrics for Internet" By Chuck Moozakis ---
http://www.internetwk.com/lead/lead082400.htm
Calculating Net ROI
The fledgling oil and
gas exchange PetroCosm knew it needed more than the backing of giants Chevron
and Texaco to win over customers and suppliers. Even more important was the
ability to demonstrate clear financial benefits for participants.
In the months leading
up to its July launch, PetroCosm worked with consulting firm KPMG to develop a
return-on-investment (ROI) model that would help potential customers make the
case for participating in the exchange.
PetroCosm used a new
KPMG service dubbed eValuation--announced last week--that takes into account
traditional ROI variables, such as up-front development costs, as well as more
Internet-centric variables, such as the additional sales that can be derived
by participating in a wide range of online marketplaces. It also factors in
the cross-company ramifications of Internet supply chains and how customers
and suppliers can also benefit.
"We were able to
come up with a business case that said this is a profitable business" for
both suppliers and PetroCosm's founding members, said PetroCosm controller Rod
Starr. "It sounds straightforward enough, but one of the great challenges
is that there are no existing models to gauge ROI."
Armed with results
from the ROI study that indicated the type of cost savings prospective members
could realize by participating in a B2B exchange, PetroCosm has been able to
sell prospective participants on the possibility of trimming anywhere from 5
percent to 20 percent of their procurement costs by joining the marketplace,
Starr said. --Chuck Moozakis
Read the rest: http://www.internetwk.com/lead/lead082400.htm
KPMG's Business
Measurement Process (BMP)
Auditing Organizations Through a Strategic-Systems Lens by Timothy
Bell et al.,-- http://www.cba.uiuc.edu/kpmg-uiuc/monograph.html
The Adobe Acrobat version can be downloaded from http://www.cba.uiuc.edu/kpmg-uiuc/monograph.PDF
|
The KPMG Business Measurement
Process
Timothy B. Bell
Frank O. Marrs
KPMG LLP
Ira Solomon
Howard Thomas
University of Illinois at Urbana-Champaign
Foreword by William R. Kinney, Jr.
Copyright 1997
by KPMG LLP, the U.S. member firm of
KPMG International, a Swiss association |
Chapter 7 is entitled the Business Measurement Process ---
The eight components comprising the client business model are:
• External Forces — political, economic,
social, and technological factors, pressures, and forces from outside the
entity that threaten the attainment of the entity’s business objectives;
• Markets/Formats — the domains in which
the entity may choose to operate, and the design and location of the
facilities;
• Strategic Management Process — the
process by which the:
– entity’s mission is developed
– entity’s business objectives are defined
– business risks that threaten attainment of the business objecttives
are identified
– business risk management processes are established
– progress toward meeting business objectives is monitored;
• Core Business Processes — the
processes that develop, produce, market, and distribute an entity’s
products and services. These processes do not necessarily follow traditional
organizational or functional lines, but reflect the interlinkage of related
business activities;
• Resource Management Processes — the
processes by which resources are acquired, developed, and allocated to the
core business activities;
• Alliances — the relationships
established by an entity to:
– attain business objectives
– expand business opportunities
– reduce or transfer business risk;
• Core Products and Services — the
commodities that the entity brings to the market;
• Customers — the individuals and
organizations that purchase the entity’s output.
Book Review from The CPA Journal, July 1999
BOOK REVIEW:
AUDITING ORGANIZATIONS THROUGH A STRATEGIC-SYSTEMS LENS: THE KPMG
BUSINESS MEASUREMENT PROCESS
By Timothy B. Bell, Frank O. Marrs, Ira Solomon, and Howard Thomas
Reviewed by Hema Rao, DBA, CPA, assistant professor, SUNY
Utica/Rome
This research monograph focuses on KPMG's new risk-based
strategic-systems audit approach. The firm believes that its new
holistic approach to evaluating client business risk is needed in
today's more complex business environment. The new business measurement
process (BMP) shifts the auditor's focus from an "accounting
lens," or transaction-based approach, to a "strategic-systems
lens" approach.
The Lincoln Savings and Loan (LSL) audit is cited in the monograph as
an example of the failure of a transaction-based approach to an audit.
In contrast, a BMP audit would consider macro information relevant to
the savings and loan industry in assessing audit risk. This would
include the weak economic environment, regulatory changes, disputes with
a regulator, changes in strategic business practices that allowed the
bank to invest in high risk securities, auditor changes, and business
risks peculiar to LSL. If she had used this new approach, the LSL
auditor might have been more skeptical about the 400500% overvalued
reported land sales.
The stated purposes of the monograph are to present--
* "an overview of the theories and trends that create a need for
a risk-based strategic-systems audit;
* a discussion of the systems theory and strategy concepts that
underlie the risk-based strategic-systems audit;
* an overview of some of the business measurement principles,
analytical procedures, and tools comprising KPMG's risk-based
strategic-systems audit--BMP; and
* examples that illustrate how BMP might be applied to a retail
client."
The Strategic-Systems Lens. KPMG applies concepts from systems theory
and views the client's accounting transactions as an outcome of a
complex web of economic and business interrelationships. The auditor's
"lens" (mental orientation) to assess audit risk is influenced
by the nature of these complex relationships. A broader and more
comprehensive focus heightens skepticism in evaluating the economic
reasonableness of reported management assertions.
Knowledge Acquisition Framework
To gain a comprehensive understanding of the client's business and
industry, the auditor should understand the client's systems dynamics.
Such a process includes the following:
* Gaining an understanding of the client's strategic advantage. How
does the client create value?
* Assessing the threats that put the client's attainment of its
business objectives at risk.
* Developing a client business model that will serve as a lens to
perceive and judge client assertions. This model is called the
"comprehensive decision frame guide."
* Developing expectations about key assertions embodied in the
overall financial statements
* Comparing reported financial results to expectations and designing
additional audit work to address gaps between the two.
The comprehensive decision frame guides the auditor to apply
professional judgment to evaluate the appropriateness of--
* recorded transactions and
* assumptions made about the underlying accounting principles in
executing nonroutine transactions, making accounting estimates, and
valuing recorded assets.
In the absence of this framework, the professional judgment developed
by the auditor to predict the client's ability to continue as a going
concern and detect management fraud may be misguided. The differences in
the new BMP audit and the traditional audit are explained in the Exhibit.
The KPMG Business Measurement Process (BMP)
The audit risk model components--inherent, control, and detection
risk--continue to be relevant to the BMP audit process. Under this
approach, audit risk assessment is made from the broader perspective of
the client rather than from the transaction level alone. The BMP
framework analysis is done at five different levels.
Strategic Analysis. This is intended to provide the auditor with a
deep understanding of the industry and global environment in which the
client organization operates. The analysis includes assessing business
risks that affect financial statement assertions due to threats to the
client from competition within its industry and the adequacy of the
client's response to these risks.
Business Process Analysis. At the second level, the auditor uses a
"value chain" approach to study the client's core business
processes and total quality management used for creating value in the
eyes of customers and resulting in profitable sales. The auditor
evaluates methods and systems used by the organization in conducting its
business using eight dimensions: process objectives, inputs, activities,
outputs, systems, classes of transactions, risks that threaten
objectives, and other symptoms of poor performance. The auditor develops
an understanding of the client's financial and nonfinancial performance
measures and determines the gaps that exist between the client's
processes and those of its direct competitors. Such measures may be used
as corroborative evidence in assisting the auditor support expectations
about financial statement assertions.
Risk Assessment. At the third level, the auditor gains an
understanding of the client's risk monitoring and management processes,
both internal and external. With this understanding, the auditor can
decide if the client has identified all aspects of business risk,
prioritized them appropriately, established controls to reduce the risk
to acceptable levels, and made accounting choices and disclosures in the
financial statements that address any uncontrolled risks.
Business Measurement. At the fourth level, the auditor measures
business processes and variables that have the greatest impact on the
client's business. The auditor analyzes the client's financial and
nonfinancial performance and measures both over time and against the
competition. Additional audit work is done on financial statement
assertions inconsistent with the auditor's understanding of the client's
strategic systems analysis.
Continuous Improvement. The final phase allows the auditor to provide
the client with valuable feedback for continuous improvement. The
auditor reports on client gaps in process and financial performance
measures based on standardized targets and competitor measures. Client
reaction to these types of diagnostic business assurance is valuable
information in assessing audit risk.
Improved Analytical Procedures
In external auditing, any significant deviations found in comparisons
of auditor expectations of client business performance and financial
position with financial statement assertions are evaluated in assessing
audit risk. In traditional audits, these expectations are tested based
on details of client accounting transaction samples. This reductionist
process may lead to a potential bias in auditor judgment in favor of
judging management assertions as being appropriate.
KPMG's complex business processoriented analytical procedures
(which develop financial and nonfinancial expectations regarding every
business activity of the audit client) may explain any uncontrolled
business risks that resulted in these deviations by looking beyond the
client's accounting system. This new comprehensive approach also allows
the BMP auditor to comply more effectively with the requirements of SAS
No. 82, Consideration of Fraud in a Financial Statement Audit, since
diagnosing the problem improves under this holistic approach to the
audit.
Conventional Auditing Still in Use
The BMP audit model retains much of existing conventional auditing.
The strategic systems auditor will continue to use the audit risk model,
allocate audit work on the basis of risk assessment, and for the most
part use conventional audit procedures. However, the BMP auditor will
use a higher level of knowledge base that combines traditional auditing
with systems theory and business strategy to come up with audit
expectations. The auditor understands the unexpected deviations from
expectations from a more comprehensive analysis of the client's external
and internal business environments and views the client's business and
other processes as part of a larger system. Audit risk evaluation
becomes more appropriate from this judgment plane.
In the opinion of this reviewer, current and future audit
practitioners will benefit from the BMP enhancements explained in this
monograph. Classroom use of this technical, yet easy to understand and
well illustrated, audit approach will provide good training for future
generations of auditors. *
http://www.kpmg.ie/audit/bmp.htm
|
e-Business and e-Commerce Managerial Accounting, Revenue Forecast
Every now and then I call your attention to the wonderful (almost free)
service called The Wall Street Journal Accounting Educator's Review.
I say "almost free" because users do have to subscribe to the
electronic version of the WSJ, but any accounting, finance, or business educator
who does not subscribe will miss boatloads of helpers for their students.
There are similar reviews for other business disciplines other than
accounting. Educators interested in subscribing should contact wsjeducatorsreviews@dowjones.com
The item that I am going to quote here appears in the Fall 2001 edition.
TITLE: Heard on the Street:
ComScore Aims For Better Data On Net Retailers
REPORTER: Nick Wingfield DATE: Aug 31, 2001 PAGE: C1, 2 LINK:
http://interactive.wsj.com/archive/retrieve.cgi?id=SB999219884208643973.djm
TOPICS:
Managerial Accounting, Revenue Forecast
SUMMARY:
Wingfield relates the art of sales forecasting for e-commerce firms. In
particular, the story tells of the efforts of ComScore Networks to
provide early indications of sales trends for online retailers with
greater detail than was previously available. ComScore, like other
prognostication firms, monitors the habits of Internet users, in their
case, 1.5 million of them. ComScore surveys a sample of the Internet
users to divine a percentage of sales estimate. Other firms use similar
technology to that used by ComScore, but ComScore follows many more
users than does its competitors and its competitors merely estimate Web
traffic rather than provide revenue forecasts.
QUESTIONS:
1.) The article mentions "metrics that require multiple leaps of
faith" in describing predicting revenues for Web-based firms. What
are some of these metrics? Why do these measures seem to be such poor
indicators of performance?
2.) Re-read the Weber article about
"stickiness" and relate it to the "tabulation of Web-page
hits" mentioned in the Wingfield article. How good is the
"correlation between increases in traffic and increases in
sales?"
3.) Why might some of the metrics previously
used by these forecasting firms be more useful for advertising-supported
sites compared to Web-based retailers?
Reviewed By:
Judy Beckman, University of Rhode Island
Benson Wier, Virginia Commonwealth University
Kimberly Dunn, Florida Atlantic University
This is just one of several "cases" in the Fall 2001
edition of The Wall Street Journal Accounting Educator's Review. |
Pro-Forma Earnings (Electronic Commerce, e-Commerce,
eCommerce)
From the Wall Street Journal's Accounting Educators' Reviews, October
4, 2001
Educators interested in receiving these excellent reviews (on a variety of
topics in addition to accounting) must firs subscribe to the electronic version
of the WSJ and then go to http://209.25.240.94/educators_reviews/index.cfm
Sample from the October 4 Edition:
TITLE: Sales Slump Could Derail Amazon's Profit Pledge
REPORTER: Nick Wingfield
DATE: Oct 01, 2001
PAGE: B1
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1001881764244171560.djm
TOPICS: Accounting, Creative Accounting, Earnings Management, Financial
Analysis, Net Income, Net Profit
SUMMARY: Earlier this year Amazon promised analysts that it will report
first-ever operating pro forma operating profit. However, Amazon is not
commenting on whether it still expects to report a fourth-quarter profit this
year. Questions focus on profit measures and accounting decisions that may
enable Amazon to show a profit.
QUESTIONS:
1.) What expenses are excluded from pro forma operating profits? Why are
these expenses excluded? Are these expenses excluded from financial statements
prepared in accordance with Generally Accepted Accounting Principles?
2.) List three likely consequences of Amazon not reporting a pro forma
operating profit in the fourth quarter. Do you think that Amazon feels pressure
to report a pro forma operating profit? Why do analysts believe that reporting a
fourth quarter profit is important for Amazon?
3.) List three accounting choices that Amazon could make to increase the
likelihood of reporting a pro forma operating profit. Discuss the advantages and
disadvantages of making accounting choices that will allow Amazon to report a
pro forma operating profit.
SMALL GROUP ASSIGNMENT: Assume that you are the accounting department for
Amazon and preliminary analysis suggest that Amazon will not report a pro forma
operating profit for the fourth quarter. The CEO has asked you to make sure that
the company meets its financial reporting objectives. Discuss the advantages and
disadvantages of making adjustments to the financial statements. What
adjustments, if any, would you make? Why?
Reviewed
By: Judy Beckman, University of Rhode Island Reviewed
By: Benson Wier, Virginia Commonwealth University Reviewed
By: Kimberly Dunn, Florida Atlantic University
Bob
Jensen's threads on electronic commerce are at http://faculty.trinity.edu/rjensen/ecommerce.htm
"Enterprises Tailor ROI To E-Business: Strategies for
tracking success of e-biz investment vary by company, industry," By
Chuck Moozakis and David Lewis, InformationWeek Online, December 18, 2000
---
http://www.internetweek.com/lead/lead121800.htm
For many companies, return on investment is a clear
way to determine whether they're earning a profit on their technology
investment. But when it comes to calculating online ROI, there are almost as
many paths to take as there are companies doing business on the Internet. And
in the coming year, the picture may get cloudier as more companies than ever
struggle to get their arms around this critical business measurement.
E-businesses that use ROI can be divided into three
main categories: those that develop their own measurement practices; those
that use off-the-shelf ROI products; and those that hire consultants to
develop a custom ROI measurement. Several companies, ranging from Big Five
consulting firms to Gartner Group and Hurwitz Group, as well as vendors,
including Comdisco and Nortel Networks, offer ROI measurement products or
services.
Early adopters of ROI--regardless of their
approach--are getting measurable results from their ROI initiatives today and
charting a path that others can follow.
Ryder System Inc., a trucking and transportation
company, is actually using Web-oriented ROI to help establish business
priorities. The company last month rolled out a product developed with
consulting help from IBM E-Business Services. The tool, dubbed Return on Web
Investment (ROWI), was fashioned "to quickly assess and prioritize
e-business initiatives that may come up," explains John Wormwood, group
director of e-commerce.
"We knew that traditional cycles for
planning--where a request for funding might take several months to get into
place--wouldn't work, so we put together ROWI. This is a framework that lets
us evaluate Web opportunities," Wormwood says.
Some Retailers De-Emphasize Web Payback By David Lewis, InternetWeek, October
19, 2000 --- http://www.internetweek.com/lead/lead101900.htm
Although most e-retailers are tracking their return
on online investment, a large minority of these e-businesses are taking a
contrarian approach. They've rejected ROI, at least temporarily, in favor of a
"path-to-profitability" approach that emphasizes planning and
patience.
About one-third of 50 e-retailers responding to a
recent survey said they are pursuing online strategies that give them as long
as two years before they'll shift focus to profit-oriented metrics such as ROI.
The survey was conducted by Hackett Benchmarking & Research and IBM Global
Services. Respondents included pure dotcoms as well as
"bricks-and-clicks" companies with online retail operations;
participants' total annual sales ranged from about $100 million to $8 billion.
Return on investment, usually defined as the ratio of
net income to invested capital, is a widely used operating efficiency measure.
But will "planning and patience" pay the bills?
"Rethinking ROI," InformationWeek Online, May 24, 1999 --- http://www.informationweek.com/735/roi.htm
Evaluating the potential return on an IT investment
can be fairly straightforward--at least in theory. If a CIO shows that a new
system will cut costs and pay for itself after a couple of years, or that it
will significantly improve efficiency at a reasonable price, business
executives usually give the green light. This is especially true of tactical
projects, such as applications that cut order-processing costs. But in other
cases, IT initiatives have become so important that companies are either not
evaluating ROI or they're looking to develop new ways to measure ROI to take
into account a project's strategic value. In this issue, InformationWeek
examines how companies are addressing ROI in four areas:
Electronic business: A sense of urgency is forcing
many companies to push ahead with projects without considering ROI. CEOs are
less concerned about a dollar return than with enhancing the company's
competitive edge, creating a marketing channel, or improving customer
satisfaction. Less-strategic initiatives are still subject to stringent ROI
calculations, and some companies are beginning to develop new metrics to help
them assess the value of all of their E-business projects (see
"E-Business: Strategic Investment").
Enterprise resource planning: Many high-priced
implementations have escaped the harsh scrutiny of company accountants because
the software was needed to replace legacy systems that weren't year 2000
compliant. With Y2K issues nearly resolved, companies are looking at the ROI
of their ERP projects and finding that the complexity of the systems and the
need for employee training often leads to a negative return over the first
five years (see "Making ERP Add Up").
Intranets: Many applications are so inexpensive to
develop and deploy that companies often assume they'll get a return on their
investments--or they justify these relatively small investments by pointing to
intangibles, such as improved employee morale from having easy access to their
human resources and 401(k) records, better workforce collaboration, and
quicker time to market (see "Intranet ROI: Leap Of Faith").
Data warehouses: While they can provide information
that leads to reduced costs and higher sales, it's hard to attach a dollar
value to the gains data warehouses offer because other processes must be
improved to get the benefits. Companies continue to introduce strategic data
warehouses--such as those that can identify their most profitable
customers--without calculating their potential ROI, but many are looking for a
hard-dollar return on data warehouses that help improve operational efficiency
(see "Warehouse ROI").
Regardless of the type of IT project, it's clear that
as technology becomes more central to a company's ability to compete, IT and
business executives are being forced to rethink their traditional approach to
ROI.
Investing in E-Commerce
and other technologies poses huge problems for business decision makers, because
the popular investment criteria such as Return on Investment (ROI) are so
difficult to compute and there are so many uncertainties about both investments
and returns. These topics make interesting case studies in both managerial
accounting and accounting information systems courses. Two articles of
interest are as follows:
"E-Commerce: New Sense of Urgency Companies
Rush For Online Market Share Flurry of multimillion-dollar deals signals new
effort to be competitive in E-commerce," by Clinton Wilder in Information
Week, May 24, 1999, 48-56.
"Rethinking ROI Some projects have become
so important that companies are looking for new ways to measure their return on
investment--or are dispensing wtih ROI studies completely," by Tom Stein in
Information Week, May 24, 1999, 59-68.
Both articles deal with problems of ROI as a
criterion for investment decisions and performance evaluation. The online
versions of these articles can be found at http://www.informationweek.com/maindocs/index_735.htm
One of our accounting educator experts on such
matters is Amy Ray (formerly with the University of Tennessee). Since
joining UT, she has received a grant to participate as part of an external
review team for Allen Bradley (1992) and is currently a member of a UT team
awarded an NSF grant to conduct a joint study with Eastman Chemical. See http://funnelweb.utcc.utk.edu/~scrusenb/ut_acct/faculty/gatian.html
Companies under fire to get e-commerce
systems up and running are finding it takes more than ROI to measure success ---
http://www.pcweek.com/a/pcwt0001131/2416552
For a sample, you may want to look at e-Business Basics at http://www.darwinmagazine.com/learn/ebusiness/basics.html
Have all companies jumped on the e-business
bandwagon? Not yet. PricewaterhouseCoopers and The Conference Board found that
70 percent of the global companies they surveyed derive less than 5 percent of
their revenues from e-business. Several factors have kept some companies
surveyed from rolling out e-business initiatives, including the following:
potentially high and uncertain implementation costs; lack of demonstrated ROI
within their industry; concern about tax, legal, and privacy issues related to
e-business; and scant use of the internet among their customers.
Managing in economic hard times
requires good communications, refocusing on short-term ROI and the ability to
change direction quickly. http://cgi.zdnet.com/slink?141834:2700840
Enterprise information portals from
Epicentric, iPlanet, Plumtree and Viador deliver more than just data--they also
provide a good ROI for companies that can afford them. http://cgi.zdnet.com/slink?141406:2700840
Bob Jensen's threads on ROI are at http://faculty.trinity.edu/rjensen/roi.htm
InternetWeek is running a poll on how to measure electronic business success.
Reader Poll What is the main way you currently measure
the success of your e-business initiatives?
- Return on investment of individual e-business
projects
- Separate profit/loss of combined e-business
initiatives
- Contribution of e-business initiatives to company
as a whole, both revenues and soft benefits (ie, multi-channel
reach)
- Against specific operational goals, such as
cutting inventory turns or improving call/Internet center response
times
- Other ways
To participate in the poll, go to http://www.internetweek.com/question01/quest091401.htm
From
Internet Week news on October 1, 2001
ROI: Little More Than Lip Service
Ever since the dotcom bust and economic slowdown, IT
organizations have latched on to all manner of "ROI" metrics to
justify their technology investments.
But whether they're really calculating return on
investment is suspect. New research and anecdotal evidence suggest that
managers may be fudging the numbers--or at least evaluating their projects
less than rigorously.
A new InternetWeek survey indicates a striking
disconnect between what businesses say about their ROI studies and their
actual e-business results. Some 82 percent of 1,000 managers surveyed by
InternetWeek said they expect their company's overall "e-business
operations" to be profitable in 2001. Yet only 34 percent said their
company had developed an ROI model to measure the success of those operations.
--David Lewis and Mike Koller
Read on: http://update.internetweek.com/cgi-bin4/flo?y=eEbG0Bdl6n0V30SpZ0Aj
E-COMMERCE AND AUDITING FAIR VALUES SUBJECTS OF NEW INTERNATIONAL GUIDANCE
The International Federation of Accountants (IFAC) invites comments on two new
exposure drafts (EDs): Auditing Fair Value Measurements and Disclosures and
Electronic Commerce: Using the Internet or Other Public Networks - Effect on the
Audit of Financial Statements. Comments on both EDs, developed by IFAC's
International Auditing Practices Committee (IAPC), are due by January 15, 2002.
See http://accountingeducation.com/news/news2213.html
The IFAC link is at http://www.ifac.org/Guidance/EXD-Download.tmpl?PubID=1003772692151
The purpose of this International Standard on Auditing (ISA) is to establish
standards and provide guidance on auditing fair value measurements and
disclosures contained in financial statements. In particular, this ISA addresses
audit considerations relating to the valuation, measurement, presentation and
disclosure for material assets, liabilities and specific components of equity
presented or disclosed at fair value in financial statements. Fair value
measurements of assets, liabilities and components of equity may arise from both
the initial recording of transactions and later changes in value.
From Information Week Between the LInes on February 5, 2002
Business Technology: ROI Mania Is Upon Us
Business as usual? What does that mean anymore? In
this rigid, scrutinize-every-expense-till-it-screams climate, it would hardly
be surprising to hear that a software entrepreneur is beta testing an
application that measures the ROI of ROI analyses while playing Elvis
Costello's "Watching The Detectives" in the background.
Companies must need such a tool, because ROI mania
has seized the business world in a headlock, and a smackdown and quick pin
are, by all accounts, imminent.
"This ROI analysis for the proposed CRM project
should be interesting--I'm really excited about heading up the project."
"Wait a minute--did you get it approved?"
"No, the CRM project hasn't been approved.
That's the point--our ROI analysis is going to help us make the decision on
whether it should be."
"You're not listening: Forget about the CRM
project; have you gotten approval for starting your ROI analysis?"
"You're scaring me. What the hell are you
talking about?"
"OK, lemme slow down a little. You're on the
company E-mail system, right?"
"Very funny."
"Then you must have received the memo late last
week from the CFO about ROI projects, right?"
"It's in my in-box, but it's pretty massive, so
I didn't read it. So what?"
"Well, Einstein, her royal CFOness says that in
the interest of increasing shareholder equity and focusing our resources on
only those projects that improve our bottom line, no new ROI analyses can be
started without first getting her approval on whether the time and resources
spent on doing that analysis will provide an appropriate return."
[Blank stare.]
"I'm not kidding. See, what she said was, ever
since the cafeteria found as a result of its mandatory ROI analysis of how it
prepares food that boiled all-goat hot dogs are more profitable to the company
than grilled all-beef hot dogs, and as a further result switched to the
all-goat boiled variety, our emergency-room medical claims have skyrocketed
and sick leave has doubled."
"And I'm not so happy about the 'special
composite protein deli sandwich' five days a week, either, even if it's only
$4.95."
"Yeah, whatever. The point, pinhead, is
unintended consequences."
[Silence.]
"Un-in-tend-ed con-se-quen-ces."
"You mean like when that NFL kicker made a field
goal and jumped up and down to celebrate but tore a ligament in his knee while
he was doing it?"
"Yeah, well, something like that. See, let me
speak your language: It's like that arcade game, Whack A Mole: When you hammer
one problem down, it triggers another one to pop up, and by solving one you
might really not have made any progress because you've just unleashed
another."
"So we're not allowed to play Whack A Mole at
lunchtime anymore?"
[Sigh.] "Earth to knucklehead: This is why the
CFO says we can't do any ROI analyses unless we've completed and received her
sign- off on the ROI of that ROI analysis."
"But what about the CRM project?"
"Listen, you gotta stop thinking small or you're
not going to get anywhere around here. Focus, my dippy friend, focus: The CRM
project is the tail, and the ROI analysis of the CRM project is the dog, but
the ROI measure of the ROI analysis of the CRM project is the owner of the
dog, and she holds the leash."
"Well, why didn't you say so in the first place?
So instead of just doing the approved $7 million, 12-month ROI analysis of the
$5 million, eight-month CRM project, I should first get approval for, say,
just a cool $1 million to do an eight-week ROI justification of the CRM-ROI
analysis? Now, that makes sense--it only pushes the CRM project out 14 months,
which the vendor says is average for our industry."
"Rockefeller, I do believe you've got
it."
Bob Evans is editor- in-chief of InformationWeek. E-mail him at mailto:bevans@cmp.com
Join in on the discussion at: http://update.informationweek.com/cgi-bin4/flo?y=eFuZ0BcUEY0V10NvU0Am
Fair Value and Fair
Value Hedges
Fair
Value =
the estimated best
disposal (exit, liquidation) value in any sale other than a forced sale.
It is defined as follows in Paragraph 540 on Page 243 of FAS 133:
The
amount at which an asset (liability) could be bought (incurred) or sold
(settled) in a current transaction between willing parties, that is, other
than in a forced or liquidation sale. Quoted market prices in active markets
are the best evidence of fair value and should be used as the basis for the
measurement, if available. If a quoted market price is available, the fair
value is the product of the number of trading units times that market price.
If a quoted market price is not available, the estimate of fair value should
be based on the best information available in the circumstances. The
estimate of fair value should consider prices for similar assets or similar
liabilities and the results of valuation techniques to the extent available
in the circumstances. Examples of valuation techniques include the present
value of estimated expected future cash flows using discount rates
commensurate with the risks involved, option- pricing models, matrix
pricing, option-adjusted spread models, and fundamental analysis.
Valuation techniques for measuring assets and liabilities should be
consistent with the objective of measuring fair value. Those techniques
should incorporate assumptions that market participants would use in their
estimates of values, future revenues, and future expenses, including
assumptions about interest rates, default, prepayment, and volatility. In
measuring forward contracts, such as foreign currency forward contracts, at
fair value by discounting estimated future cash flows, an entity should base
the estimate of future cash flows on the changes in the forward rate (rather
than the spot rate). In measuring financial liabilities and nonfinancial
derivatives that are liabilities at fair value by discounting estimated
future cash flows (or equivalent outflows of other assets), an objective is
to use discount rates at which those liabilities could be settled in an
arm's-length transaction.
The Financial Accounting
Standards Board (FASB)
requires estimation of fair value for many types of financial instruments,
including derivative financial instruments. The main guidelines are spelled
out in SFAS 107 and FAS 133 Appendix F Paragraph 540. If a range
is estimated for either the amount or the timing of possible cash flows, the
likelihood of possible outcomes shall be considered in determining the best
estimate of future cash flows according to FAS 133 Paragraph 17.
For related
matters under international standards, see IAS 39 Paragraphs 1,5,6, 95-100,
and 165. According to the FASB, fair value is the amount at which
an asset (liability) could be bought (incurred) or sold (settled) in a current
transaction between willing parties, that is, other than in a forced or
liquidation sale. Quoted market prices in active markets are the best evidence
of fair value and should be used as the basis for the measurement, if
available. If a quoted market price is available, the fair value is the
product of the number of trading units times that market price.
One of the best
documents the FASB generated for FAS 133 implementation is called
"summary of Derivative Types." This document also explains how
to value certain types. It can be downloaded free from at http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe
April 5, 2005 message from Dennis Beresford
[dberesfo@TERRY.UGA.EDU]
The SEC recently released an interesting memo
from its Office of Economic Analysis to the Chief Accountant on economic
valuation of stock options. It is available at:
http://www.sec.gov/interps/account/secoeamemo032905.pdf
The memo concludes that valuing employee stock
options under new FASB Statement 123R is "not unusual" and is quite
similar to valuations done in other areas of accounting and finance.
This seems to deflate the arguments of some within the business
community who continue to assert that employee stock options are too
hard to value. The memo footnotes several academic studies from both
accounting and finance scholars in supporting its findings.
Denny Beresford
Bob Jensen's threads on employee stock options are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob Jensen's threads on valuation are at
http://faculty.trinity.edu/rjensen/roi.htm
Damodaran Online: A Great Sharing Site from a Finance Professor at New
York University and Textbook Writer ---
http://pages.stern.nyu.edu/%7Eadamodar/
This site has great sections on corporate finance, investments,
valuation, spreadsheets, research, etc. For example, take a look at the
helpers on valuation ---
http://pages.stern.nyu.edu/%7Eadamodar/
You can pick the valuation approach that you would like to go to, to
see illustrations, solutions and other supporting material.
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|
| |
Discounted Cashflow Valuation |
| |
Relative Valuation |
| |
Option Pricing Approaches to Valuation |
| |
Acquisition Valuation |
| |
EVA, CFROI and other Value Enhancement Strategies |
Or you can pick the material that you are interested in.
| |
|
|
|
| Spreadsheets |
Overheads |
Datasets |
References |
| Problems & Solutions |
Derivations and Discussion |
Valuation Examples |
PowerPoint presentations |
Jim Mahar's finance sharing site (especially note his great blog
link) ---
http://financeprofessor.com/
Financial Rounds from an anonymous finance professor ---
http://financialrounds.blogspot.com/
Bob Jensen's finance and investment helpers are at
http://faculty.trinity.edu/rjensen/Bookbob1.htm
There
are some exceptions for hybrid instruments as discussed in
IAS 39 Paragraph 23c and FAS 133
Paragraph 12b. There are also exceptions
where value estimates are unreliable such as in the case of unlisted equity
securities (see IAS 39 Paragraphs 69, 93, and 95).
|
If an item is
viewed as a financial instrument rather than inventory, the
accounting becomes more complicated under SFAS 115. Traders in
financial instruments adjust such instruments to fair value with all
changes in value passing through current earnings. Business
firms who are not deemed to be traders must designate the instrument
as either available-for-sale (AFS) or hold-to-maturity (HTM).
A HTM instrument is maintained at original cost. An AFS
financial instrument must be marked-to-market, but the changes in
value pass through OCI rather than current earnings until the
instrument is actually sold or otherwise expires.
Under international
standards, the IASC requires fair value adjustments for most
financial instruments. This has led to strong reaction from
businesses around the world, especially banks. There are now two
major working group documents taking sides for and against fair
value accounting for all financial instruments.
Go to http://www.iasc.org.uk/frame/cen3_112.htm
|
Paul
Pacter states the following at http://www.iasc.org.uk/cmt/0001.asp?s=100107225&sc={D41D74AC-7D6C-11D5-BE63-003048110251}&n=3288
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IAS
39
All debt securities, equity securities, and other financial assets
that are not held for trading but nonetheless are available for sale
– except those unquoted equity securities whose fair value cannot
be measured reliably by another means are measured at cost subject
to an impairment test.
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SFAF 133
All debt securities, equity securities, and other financial assets
that are not held for trading but nonetheless are available for sale
– except all unquoted equity securities are measured at cost
subject to an impairment test.
FASB requires
fair value measurement for all derivatives, including those linked
to unquoted equity instruments if they are to be settled in cash but
not those to be settled by delivery, which are outside the scope of
133
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Paragraph 28
beginning on Page 18 of FAS 133 requires that the hedge be
formally documented from the start such that prior contracts such
as options or futures contracts cannot later be declared hedges. Under
international accounting rules, a hedged item can be a recognized
asset or liability, an unrecognized firm commitment, or a
forecasted transaction (IAS 39 Paragraph 127).
If quoted
market prices are not available, the estimate of fair value should
be based on the best information available in the circumstances.
The estimate of fair value should consider prices for similar
assets and liabilities and the results of valuation techniques to
the extent available in the circumstances. Examples of valuation
techniques include the present value of estimated expected future
cash flows using a discount rate commensurate with the risks
involved, option-pricing models, matrix pricing, option-adjusted
spread models, and fundamental analysis. Valuation techniques for
measuring assets and liabilities should be consistent with the
objective of measuring fair value. Those techniques should
incorporate assumptions that market participants would use in
their estimates of values, future revenues, and future expenses,
including assumptions about interest rates, default, prepayment,
and volatility.
Under
IAS 39 Paragraph 100, under circumstances when a quoted market
price is not available, estimation techniques may be used ---
which include reference to the current market value of another
instrument that is substantially the same, discounted cash flow
analysis, and option pricing models. When an enterprise has
matching asset and liability positions, it may use mid-market
prices according to IAS 39 Paragraph 99.
In reality,
the FASB in FAS 133 and the IASC in IAS 39 require
continual adjustments of financial instruments derivatives to fair
value without giving much guidance about such matters when the
instruments are not traded on exchange markets or are traded in
markets that are too thin to rely upon for value estimation.
Unfortunately, over half of the financial instruments derivative
contracts around the world are customized contracts for which
there are no markets for valuation estimation purposes. The
most difficult instruments to value are forward contracts and
interest rate and foreign currency swaps. In my Working
Paper 231 I discuss various approaches for valuation of interest
rate swaps.
The fair
value of foreign currency forward contracts should be based on the
change in the forward rate and should consider the time value of
money. In measuring liabilities at fair value by discounting
estimated future cash flows, an objective is to use discount rates
at which those liabilities could be settled in an arm's-length
transaction. Although the FASB does not give very explicit
guidance on estimation of a derivative’s fair market value, this
topic appears at many points in FAS 133. See Paragraphs 312-319
and 432-457.See blockage
factor and yield curve.
Paragraphs
216 on Page 122 and 220-231 beginning on Page 123 of FAS 133 leave
little doubt that the FASB feels "fair value is the most
relevant measure for financial instrument and the only relevant
measure for derivative instruments." This can be
disputed, especially when unrealized gains and value hide
operating losses. The December 1998 issue of the Journal of
Accountancy provides an interesting contrast on fair value
accounting. On Pages 12-13 you will find a speech by SEC
Chairman Arthur Levitt bemoaning the increasingly common practice
of auditors to allow earnings management. On Page 20 you
will find a review of an Eighth Circuit Court of Appeals case in
which a firm prevented the reporting of net losses for 1988 and
1989 by persuading its auditor to allow reclassification of a
large a large hotel as being "for sale" so that it could
revalue historical cost book value to current exit value and
record the gain as current income. Back issues of the
Journal of Accountancy are now online at http://www.aicpa.org/pubs/jofa/joaiss.htm
.
The FASB intends
eventually to book all financial instruments at fair value. Jim
Leisingring comments about " first shot in a religious
war" in my tape31.htm.
The IASC also is moving closer and
closer to fair value accounting for all financial instruments for
virtually all nations, although it too is taking that big step in
stages. Click
here to view Paul Pacter's commentary on this matter.
See DIG
Issue B6 under embedded
derivatives.
At the
moment, accounting standards dictate fair value accounting for
derivative financial instruments but not all financial
instruments. However, the entire state of fair value
accounting is in a state of change at the moment with respect to
both U.S. and international accounting standards.
If a
purchased item is viewed as an inventory holding, the basis of
accounting is the lower of cost or market for most firms unless
they are classified as securities dealers. In other words,
the inventory balance on the balance sheet does not rise if
expected net realization rises above cost, but this balance is
written down if the expected net realization falls below cost.
The one exception, where inventory balances are marked-to-market
for upside and well as downside price movements, arises when the
item in inventory qualifies as a "precious" commodity
(such as gold or platinum) having a readily-determinable market
value. Such commodities as pork bellies, corn,
copper, and crude oil, are not "precious" commodities
and must be maintained in inventory at lower-of-cost-or market.
If an item is viewed as a
financial instrument rather than inventory, the accounting becomes
more complicated under SFAS 115. Traders in financial instruments
adjust such instruments to fair value with all changes in value
passing through current earnings. Business firms who are not
deemed to be traders must designate the instrument as either
available-for-sale (AFS) or hold-to-maturity (HTM). A HTM
instrument is maintained at original cost. An AFS financial
instrument must be marked-to-market, but the changes in value pass
through OCI rather than current earnings until the instrument is
actually sold or otherwise expires. Under international standards,
the IASC requires fair value adjustments for most financial
instruments. This has led to strong reaction from businesses
around the world, especially banks. There are now two major
working group documents taking sides for and against fair value
accounting for all financial instruments.
Go to http://www.iasc.org.uk/frame/cen3_112.htm
- Financial Instruments:
Issues Relating to Banks
(strongly
argues for fair value adjustments of financial instruments). The
issue date is August 31, 1999.
Trinity University students may view this paper at J:\courses\acct5341\iasc\jwgbaaug.pdf.
Accounting for
financial Instruments for Banks (concludes
that a modified form of historical cost is optimal for bank
accounting). The issue date is October 4, 1999.
Trinity University students may view this paper at J:\courses\acct5341\iasc\jwgfinal.pdf
|
On December 14, 1999 the
FASB issued Exposure Draft 204-B entitled Reporting
Financial Instruments and Certain Related Assets and Liabilities at Fair Value.
See http://accounting.rutgers.edu//raw/fasb/project/fairvalue.html
(Trinity University students can find the document at J:\courses\acct5341\fasb\pvfvalu1.doc
).
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Dear Jamshed
XXXXX
First, it would seem that
KPMG is correct pursuant to Paragraph 74 of IAS 39.
FAS 133 is silent on this
matter, although the IAS 39 Paragraph 74 rules are, in my viewpoint,
consistent with US GAAP in general. My former student, Paul Pacter,
authored IAS 39 and helped author FAS 133. He does not mention that
Paragraph 74 of IAS 39 as a point where FAS 133 differs. You can
read his summary of where there are differences between Ias 39
versus FAS 133 at http://www.iasc.org.uk/cmt/0001.asp?s=100107225&sc={D41D74AC-7D6C-11D5-BE63-003048110251}&n=3288
An implicit rate of
interest is commonly used as a surrogate adjustment for fair value
since face value of a non-interest bearing receivable includes
implicit interest. See http://lcb1.uoregon.edu/sneed/Ch7.pdf
In practice, US GAAP allows firms to ignore implicit interest
adjustments to receivables due within one year unless such
adjustments are deemed material in amount. Your past-due
receivables probably extend beyond one year and implicit interest is
probably material in amount.
One of my favorite
documents showing implicit interest calculations in receivables is http://focusedmanagement.com/focus_magazine/back_issues/issue_02/pages/qhg.htm
Hope this helps.
Bob Jensen
-----Original
Message-----
From: XXXXX
Sent: Friday, July 20, 2001 11:59 PM
To: rjensen@trinity.edu
Subject: IAS 39 vs. FAS 133
Dear Bob
I've been surfing your website and find it most useful and
helpful.
I wonder
if you can help me with a relatively simple issue with these
standards.
I work
for a public quoted company in YYYYY, Oman (Persian Gulf) and are
required to follow IAS39 for local statutory reporting. Our parent
company is American and naturally requires us to follow FAS 133,
not IAS39. We do not have any hedges or derivatives and to that
extent the above standards do not apply.
However,
we do have accounts receivable (A/R) which are significant,
approx. 65% of the total capital employed. About 40% of these A/R
are overdue. KPMG our auditors insist that these A/R must be shown
at "fair value " on the balance sheet date as per IAS39.
They require that... on the overdue debt we must calculate
"imputed interest" and reduce the carrying value of the
A/R by that extent by charging the difference to the income
statement. This is done by estimating the date on which the debt
is expected to be recovered and the taking the simple interest on
the period from the BS date to the expected repayment date.
Example: Overdue debt on Dec 31, 2000 is USD 1,000. Expected date
of repayment : June 30, 2001 Overdue period : 180 days Simple
interest rate : 10 pct
Therefore
imputed interest: USD 1000 x 180/360 x 10 % = $ 50.
Question
for you Bob : Is imputed interest allowed under FAS 133? I shall
be most grateful if you would share with me your views
If you
have any queries please contact me
Best
regards
Jamshed XXXXX
|
Fair
Value Hedge =
a hedge that bases its
periodic settlements on changes in value of an asset or liability. This type
of hedge is most often used for forecasted purchases or sales. See FAS 133
Paragraphs 20-27,104-110, 111-120, 186, 191-193, 199, 362-370, 422-425,
431-457, and 489-491. The FASB intends to incrementally move towards fair
value accounting for all financial instruments, but the FASB feels that it is
too much of a shock for constituents to abruptly shift to fair value
accounting for all such instruments. See Paragraph 247 on Page 132,
Paragraph 331 on Page 159, Paragraph 335 on Page 160, and Paragraph 321 on
Page 156. The IASC adopted the same definition of
a fair value hedge except that the hedge
has also to affect reported net income (See IAS 39 Paragraph 137a)
Held-to-maturity
securities may not be hedged for fair value risk according to Paragraphs
426-431 beginning on Page 190 of FAS 133. See held-to-maturity.
In FAS 133, derivative
financial instruments come in three basic types that are listed in Paragraph 4
on Page 2 of FAS 133. One of these types is described in Section a and
Footnote 2 below:
Paragraph
4 on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, by
requiring that an entity recognize those items as assets or liabilities in
the statement of financial position and measure them at fair value. If
certain conditions are met, an entity may elect to designate a derivative
instrument as follows:
a.
A hedge of the exposure to changes in the fair value of a recognized asset
or liability, or of an unrecognized firm commitment, \2/
that are attributable to a particular risk (referred to as a fair value
hedge)
==========================================================================
Footnote 2
\2/ An unrecognized firm commitment can be viewed as an executory contract
that represents both a right and an obligation. When a previously
unrecognized firm commitment that is designated as a hedged item is
accounted for in accordance with this Statement, an asset or a liability
is recognized and reported in the statement of financial position related
to the recognition of the gain or loss on the firm commitment.
Consequently, subsequent references to an asset or a liability in this
Statement include a firm commitment.
==========================================================================
With respect to Section
a above, a firm commitment cannot have a cash flow risk exposure because the
gain or loss is already booked. For example, a contract of 10,000 units
per month at $200 per unit is unrecognized and has a cash flow risk exposure if
the payments have not been made. If the payments have been prepaid,
that prepayment is "recognized" and has no further cash flow risk
exposure. The booked firm commitment, however, can have a fair value risk
exposure.
Generally assets
and liabilities must be carried on the books at cost (or not be carried at all
as unrecognized firm commitments) in order to host fair value hedges.
The hedged item may not be revalued according to Paragraph 21c on Page 14 of
SFAS 113. However, since GAAP
prescribes lower-of-cost-or market write downs (LCM) for certain types of
assets such as inventories and receivables, it makes little sense if LCM
assets cannot also host fair value hedges. Paragraph
336 on Page 160 does not discuss LCM. It is worth noting, however, that
Paragraph 336 on Page 160 does not support fair value adjustments of hedged
items at the inception of a hedge.
The hedging instrument
(e.g., a forecasted transaction or firm commitment) must meet the stringent
criteria for being defined as a derivative
financial instrument under FAS 133. This includes the tests
for being clearly-and-closely
related. It also includes strict tests of Paragraphs 21 beginning on
Page 13 , 29 beginning on Page 20, and Paragraph 56 on Page 33 of FAS 133 with
respect to the host contracts that are being hedged. Those tests state
that if the forecasted "transaction" is in reality a group or
portfolio of individual transactions, all transactions in the group must bear
the same risk exposure within a 10% range discussed in Paragraph 21.
Also see Footnote 9 on Page 13 of FAS 133. The grouping tests are
elaborated upon in the following Paragraphs:
-
Paragraph 21 on Page
13,
-
Paragraph 29
beginning on Page 20,
-
Paragraph 241 on
Page 130,
-
Paragraph317 on Page
155,
-
Paragraphs 333-334
beginning on Page 159,
-
Paragraph 432 on
Page 192,
-
Paragraph 435 on
Page 193,
-
Paragraph 443-450
beginning on Page 196
-
Paragraph 462 on
Page 202,
-
Paragraph 477 on
Page 208.
For example, a group of
variable rate notes indexed in the same way upon LIBOR might qualify, whereas
having different indices such as LIBOR and U.S. Prime rate
underlyings will not qualify. Also, anticipated
purchases cannot be combined with anticipated sales in the same grouping
designated as a forecasted transaction even if they have the same underlying.
Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of
differing risk exposures for financial instruments designated in foreign
currencies so not to conflict with Paragraph 20 of SFAS 52. For
more detail see cash
flow hedge and foreign
currency hedge.
Those tests also state
that a compound
grouping of multiple derivatives (e.g., a portfolio of options or futures
or forward contracts or any combination thereof) is prohibited from
"separating a derivative into either separate proportions or
separate portions and designating any component as a hedging instrument
or designating different components as hedges of different exposures."
See Paragraphs 360-362 beginning on Page 167 of FAS 133. Paragraphs
dealing with compound derivative issues include the following:
-
Paragraph 18
beginning on Page 9,
-
Footnote 13 on Page
29,
-
Paragraphs 360-362
beginning on Page 167,
-
Paragraph 413 on
Page 186,
-
Paragraphs 523-524
beginning on Page 225.
Paragraph 18 on Page 10
does allow a single derivative to be divided into components provided but
never with partitioning of "different risks and designating
each component as a hedging instrument." An example using
Dutch guilders versus French francs is given under cash
flow hedge.
One question that arises
is whether a hedged item and its hedge may have different maturity dates.
Paragraph 18 beginning on Page 9 of FAS 133 rules out hedges such as interest
rate swaps from having a longer maturity than the hedged item such as a
variable rate loan or receivable. On the other hand, having a shorter
maturity is feasible according to KPMG's Example 13 beginning on Page 225 of
the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998)
states the following. A portion of that example reads as follows:
Although
the criteria specified in paragraph 28(a) of the Standard do not address
whether a portion of a single transaction may be identified as a hedged
item, we believer that the proportion principles discussed in fair value
hedging model also apply to forecasted transactions.
The
difference between a forward
exchange rate and a spot
rate is not excluded from a fair value hedging
relationship for
firm commitments measured in forward rates. However Footnote 22 on
Page 68 of FAS 133 reads as follows:
If the
hedged item were a foreign-currency-denominated available-for-sale security
instead of a firm commitment, Statement 52 would have required its carrying
value to be measured using the spot exchange rate. Therefore, the
spot-forward difference would have been recognized immediately in earnings
either because it represented ineffectiveness or because it was excluded
from the assessment of effectiveness.
Paragraph 399 on Page
180 of FAS 133 does not allow covered
call strategies that permit an entity to write an option on an asset that
it owns. See written
option.
Fair
value hedges are accounted for in a similar manner in both FAS 133 and
IAS 39. Paul Pacter states the following at http://www.iasc.org.uk/cmt/0001.asp?s=100107225&sc={D41D74AC-7D6C-11D5-BE63-003048110251}&n=3288
|
IAS
39 Fair Value Hedge Definition:
a hedge of the exposure to changes in the fair value of a recognised
asset or liability (such as a hedge of exposure to changes in the
fair value of fixed rate debt as a result of changes in interest
rates).
However,
a hedge of an unrecognised firm commitment to buy or sell an asset
at a fixed price in the enterprise’s reporting currency is
accounted for as a cash flow hedge
IAS
39 Fair Value Hedge Accounting:
To the extent that the hedge is effective, the gain or loss from
remeasuring the hedging instrument at fair value is recognised
immediately in net profit or loss. At the same time, the
corresponding gain or loss on the hedged item adjusts the carrying
amount of the hedged item and is recognised immediately in net
profit or loss.
|
FAS 133
Fair Value Hedge Definition:
Same as IAS 39
...except that
a hedge of an unrecognised firm commitment to buy or sell an asset
at a fixed price in the enterprise’s reporting currency is
accounted for as a fair value hedge or a cash flow hedge.
SFAS Fair Value Hedge Accounting:
Same as IAS 39
|
a. The
gain or loss from remeasuring the hedging instrument at fair value should be
recognized immediately in earnings; and
b. The
gain or loss on the hedged item attributable to the hedged risk should
adjust the carrying amount of the hedged item and be recognized immediately
in earnings.
c.
This applies even if a hedged item is otherwise measured at fair value with
changes in fair value recognized directly in equity under paragraph
103b. It also applies if the hedged item is otherwise measured at
cost.
(IAS 39 Paragraph 153)
See IAS 39 Paragraph 154 for example.
Also see
hedge and hedge
accounting.
Yield
Curve =
the graphical
relationship between yield and time of maturity of debt or investments in
financial instruments. In the case of interest
rate swaps, yield curves are also called swaps curves. Forward
yield (or swaps) curves are used to value many types of derivative financial
instruments. If time is plotted on the abscissa, the yield is
usually upward sloping due to term structure of interest rates.
Term structure is an empirically observed phenomenon that yields vary
with dates to maturity.
FAS 133 refers to
yield curves at various points such as in Paragraphs 112 and 319.
The Board also referred to by analogy at various points such as in
Paragraphs 162 and 428. Financial service firms obtain yield curves by
plotting the yields of default-free coupon bonds in a given currency against
maturity or duration. Yields on debt instruments of lower quality are
expressed in terms of a spread relative to the default-free yield curve.
Paragraph 112 of SFAS 113 refers to the "zero-coupon method."
This method is based upon the term structure of spot default-free zero
coupon rates. The interest rate for a specific forward period
calculated from the incremental period return in adjacent instruments. A
very interesting web site on swaps curves is at http://www.clev.frb.org/research/JAN96ET/yiecur.htm#1b
In the introductory Paragraph 111
of FAS 133, the Example 2 begins with the assumption of a flat yield curve.
A yield curve is the graphic or numeric presentation of bond equivalent
yields to maturity on debt that is identical in every aspect except time to
maturity. In developing a yield curve, default risk and liquidity, for
example, are the same for every security whose yield is included in the
yield curve. Thus yields on U. S. Treasury issues are normally used to plot
yield curves. The relationship between yields and time to maturity is often
referred to as the term structure of interest rates.
As explained by the expectations
hypothesis of the term structure of interest rates, the typical yield curve
increases at a decreasing rate relative to maturity. That is, in normal
economic conditions short-term rates are somewhat lower than longer-term
rates. In a recession with deflation or disinflation, the entire yield curve
shifts downward as interest rates generally fall and rotates indicating that
short-term rates have fallen to much lower levels than long-term rates. In
an economic expansion accompanied by inflation, interest rates tend to rise
and yield curves shift upward and rotate indicating that short-term rates
have increased more than long-term rates.
The different shapes of the yield
curve described above complicate the calculation of the present value of an
interest rate swap and require the calculation and application of implied
forward rates to discount future fixed rate obligations and principal to the
present value. Fortunately Example 2 assumes that a flat yield curve
prevails at all levels of interest rates. A flat yield curve means that as
interest rates rise and fall, short-term and long-term rates move together
in lock step, and future cash flows are all discounted at the same current
discount rate.
A yield curve is the graphic or
numeric presentation of bond equivalent yields to maturity on debt that is
identical in every aspect except time to maturity. In developing a yield
curve, default risk and liquidity, for example, are the same for every
security whose yield is included in the yield curve. Thus yields on U. S.
Treasury issues are normally used to plot Treasury yield curves. The
relationship between yields and time to maturity is often referred to as the
term structure of interest rates. Similarly, an unknown set of estimated
LIBOR yield curves underlie the FASB swap valuations calculated in all FAS
133/138 illustrations. The FASB has never really explained how swaps
are to be valued even though they must be adjusted to fair value at least
every three months. Other than providing the assumption that the yields in
the yield curves are zero-coupon rates, the FASB offers no information that
would allow us to derive the yield curves or calculate the swap values in
Examples 2 and 5 in Appendix B of FAS 133 and in other examples using FAS
138 rules.
The typical yield curve gradually
increases relative to years to maturity. That is, historically, short-term
rates are somewhat lower than longer-term rates. In a recession with
deflation or disinflation the entire yield curve shifts downward as interest
rates generally fall and rotates counter-clockwise indicating that
short-term rates have fallen to much lower levels than long-term rates. In
rapid economic expansion accompanied by inflation, interest rates tend to
rise and yield curves shift upward and rotate clockwise indicating that
short-term rates have increased more than long-term rates.
The different shapes of the yield
curve described above complicate the calculation of the present value of an
interest rate swap and require the calculation and application of implied
forward rates to calculate future expected swap cash flows. Example 2 in
Appendix B of FAS 133 assumed that a flat yield curve prevails at all levels
of interest rates. A flat yield curve means that as interest rates rise and
fall, short-term and long-term rates move together in lock step, and future
cash flows are all discounted at the same current discount rate. The cash
flows and values in the Appendix B Example 5, however, are developed from
the prevailing upward sloping yield curve at each reset date.
The accompanying Excel workbook
used the tool Goal Seek in Excel to derive upward sloping yield curves and
swap values at the reset dates that generated the $4,016,000 swap value used
in the FASB's Example 1 of Section 1 of the FAS 138 examples at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html.
Yield curves are typically computed
on the basis of a forward calculated in the following manner using the y(t)
yield curve values:
ForwardRate(t) = [1
+ y(t)]t/[1 + y(t-1)]t-1 – 1
The ForwardRate(t) is the forward
rate for time period t, y(t) is the multi-period yield that spans t periods,
and y(t-1) is the yield for an investment of t-1 periods --- for example, if
6.5% is y(t) and 6.0% is y(t-1). Thus, ForwardRate(2), the forward LIBOR for
year 2, is calculated as follows
ForwardRate(2) =
(1.065)2/1.06 – 1 = 0.07 or 7.0%
In practice, investors
and auditors often rely upon the Bloomberg swaps curve estimations.
The contact information for Bloomberg Financial Services is as follows:
Bloomberg Financial Markets, 499 Park Avenue, New York, NY 10022; Telephone:
212-318-2000; Fax: 212-980-4585; E-Mail: feedback@bloomberg.com; WWW Link:
<http://www.bloomberg.com/>
and <http://www.wsdinc.com/pgs_www/w5594.shtml>.
Various pricing services are available such as Anderson Investors Software
at http://www.wsdinc.com/products/p3430.shtml
Cutter & Co. provides some illustrations yield curves at http://www.stocktrader.com/summary.html
Discussion group messages about yield curves are archived at http://csf.colorado.edu/mail/longwaves/current-discussion/0086.html
Links to various sites
can be found at http://www.eight.com/websites.htm
You may also want to view my helpers at http://faculty.trinity.edu/rjensen/acct5341/index.htm
Also see my interest
rate accrual comments my "Missing
Parts of FAS 133" document.
Bob Jensen provides free
online tutorials (in Excel workbooks) on derivation of yield curves, swap
curves, single-period forward rates, and multi-period forward rates.
These derivations are done in the context of FAS 133, including the
derivations of the missing parts of the infamous Examples 2 and 5 of FAS
133. Since these tutorials contain answers that instructors may want
to keep out of the hands of students in advance of assignments, educators
and practitioners must contact Jensen for instructions on how to find the
secret URL. The key files on yield curve
derivations are yield.xls, 133ex02a.xls, and 133ex05a.xls. Bob
Jensen's email address is rjensen@trinity.edu
Measuring Value of Products and Services
Flip Video is No More ---
http://en.wikipedia.org/wiki/Flip_Video
"Cisco's Flip Flop and (Mis)Managing the Obvious," by Michael Schrage,
Harvard Business Review Blog, April 18, 2011 ---
Click Here
http://blogs.hbr.org/schrage/2011/04/ciscos-flip-flop-and-mismanagi.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date
"Did Cisco Slip on Flip or Was Flip a Flop?" by Rita McGrath, Harvard
Business Review Blog, April 18, 2011 ---
Click Here
http://blogs.hbr.org/hbr/mcgrath/2011/04/did-cisco-slip-on-flip-or-was-flip-a-flop.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date
So riddle me this: A business that generates an
estimated $400 million in revenue, with 550 employees, and which sells an
iconic product that was regularly praised as a model of innovation, is going
to be shut down. In an analysis of Cisco's decision to shut down its Flip
video recorder division, the
New York Times reported April 12, 2011,
that the networking giant had finally given up on a business that, at one
point, was destined to bring it to relevance in consumer markets (along with
networking gear company Linksys). The company was purchased just two years
ago for $590 million.
The story is a familiar one. Large organization
swallows up innovative smaller one, resulting eventually in the departure of
the acquired company's leadership, complaints that the large organization
doesn't understand what the small one is all about, lack of attention and
commitment to developing the small company's future technology, and eventual
disappearance of the small firm. It happens in technology all the time.
Theories on why Flip ...uh... flopped, abound. Did
smartphones with easy Internet access make its functionality obsolete? Is
running a consumer business simply not in the DNA of a company whose heart
and soul revolve around networking gear for corporate customers? That might
be an argument that Geoff Moore would make, in his well known distinction
between complex operations and high volume businesses (he's long said it's
extremely difficult to house both under a single corporate umbrella). Or
maybe analysts just hated Cisco's consumer strategy, and the company
struggled for too long to justify the acquisition. Or maybe they concluded
that the product had no future and just decided to bail, without even
attempting to find a buyer for the business.
One other theory is that, under the parental
umbrella, Flip was not really able to continue to develop the string of
innovations that would allow it to go beyond being just a small video camera
that would make it more relevant to people's lives. People that loved Flip
really loved it. And sales were up 15% over the prior year. Flip was also
the best-selling camcorder on Amazon. Despite these signs of relevance, the
good news was insufficient to keep it from the corporate chopping block.
Whatever the reason, the prognosis for using
small-company acquisitions to change the DNA of large, established ones
hasn't historically been very good. I guess we'll add the story of Flip to
that history.
Question
How do you compute the cost of capital when lenders pay you interest to
borrow their money?
Alan Blinder recommends that the Fed commence to pay FDIC banks to borrow money
from the Federal Reserve. This in turn means that banks my profit from paying
AAA creditors to borrow money from the bank.
"Cost of Capital Measure Sees Distortions," by Emily Chason, CFO
Report via The Wall Street Journal, July 25, 2012 ---
http://blogs.wsj.com/cfo/2012/07/25/cost-of-capital-measure-sees-distortions/?mod=wsjpro_hps_cforeport
The standard weighted average cost of capital
calculation, long-used by finance departments for budgeting analysis, has
been a bit distorted lately as low interest rates, record-low corporate
borrowing costs and a volatile stock market have changed many of the basic
inputs companies put into the measure.
WACC, which is based on a company’s cost of equity
and debt, corporate tax rate and market value of equity and debt, is used as
a hurdle rate to value corporate investments. The consequence of using a
distorted measure can be expensive, and some analysts say companies may want
to start thinking more broadly about revising their expected return
assumptions in the WACC number.
Continued in article
Bob Jensen's threads on ROI and Cost of Capital ---
http://faculty.trinity.edu/rjensen/roi.htm
Innovative Corporate Performance Management: Five Key Principles to
Accelerate Results
by Bob Paladino
ISBN: 978-0-470-62773-0 Hardcover 415 pages November 2010|
Amazon has it priced for under $37 new and $23 used
http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470627735.html
Jensen Comment
This is a bit too much Harvard Business School-like for me, but it does cover
much of what we teach in managerial accounting.
There seem to be a dearth of reviews of this book. I don't know why?
April 19, 2011 reply from Jim Martin
Performance management seems to be a relatively new catch-all term like
cost management, activity-based management etc. I have been following this
concept, or catch-all term for a while. I suspect most of the book can be
found in Paladino's earlier and most recent works mainly in Strategic
Finance.
Paladino, B. 2007. Five Key Principles of Corporate Performance
Management. John Wiley and Sons.
Paladino, B. 2007. Five key principles of corporate performance
management. Strategic Finance (June): 39-45.
Paladino, B. 2007. Five key principles of corporate performance
management. Strategic Finance (July): 33-41.
Paladino, B. 2007. Five key principles of corporate performance
management. Strategic Finance (August): 39-45.
Paladino, B. 2008. Strategically managing risk in today's perilous
markets. Strategic Finance (November): 26-33.
Paladino, B. 2010. Innovative Corporate Performance Management: Five Key
Principles to Accelerate Results. John Wiley and Sons.
Paladino, B. 2011. Achieving innovative corporate performance management.
Strategic Finance (March): 43-51.
Paladino, B. 2011. Achieving innovative corporate performance management.
Strategic Finance (April): 43-53.
May 7, 2007 message from Joe C Razum
[jcrazum@baldor.com]
Bob,
Hello. I came across your extensive "knowledge
garden" on the web. Very impressive and it looks like a lot of work...and a
labor of passion for what you do.
I am equally passionate about helping companies
measure the business value of their offerings, whether its a product system
or service.
In many industries, I sincerely believe that the
only way we can beat the "China Factor" is through better knowledge of value
delivered and better resultant pricing.
We've been building our own knowledge garden on
value, TCO and value pricing, via the TCO Toolbox software. With over a
thousand B2B case studies in our database, using a vendor neutral tool and
approach to measuring Total Cost of Ownership (TCO) and now Value, we are
attracting some good press:
Plant Engineering Magazine Gold Product of the Year
for Software. Harvard Business Review - Rockwell Automation TCO analysis
mentioned in Anderson & Narus' March 2006 article on Value Propositions. HBS
Press book ; Rare Commodity: Moving Business Markets Beyond Price to Value
(Fall 2007, Anderson, Narus et al) - details 2-4 pages on TCO Toolbox etc.
This program was born while our company was with
Rockwell Automation.
Since February our parent division is now part of
Baldor. I've been the program manager throughout.
We have a free 90 day demo (full enabled) of the
TCO Toolbox software available for download at
www.tcotoolbox.com .
I hope the site makes it on one of your lists....
value measurement, value pricing, etc. is a growing topic based on the
conferences I've been to recently.
All the Best, Joe
Joe Razum Baldor
Dodge Reliance mobile 864.363.2781
Please note my new email address:
jcrazum@baldor.com
Measure Value... TCO Toolbox
www.tcotoolbox.com
Potentially a Great Case for Managerial Accounting CoursesL How can
Harry Potter movies be financial losers?
"'Hollywood Accounting' Losing In The Courts: From the math-is-hard
dept," TechDirt ---
http://www.techdirt.com/articles/20100708/02510310122.shtml
If you follow the entertainment business at all,
you're probably well aware of "Hollywood accounting," whereby very, very,
very few entertainment products are technically "profitable," even as they
earn studios millions of dollars. A couple months ago, the Planet Money
folks did a great episode explaining how this works in very simple terms.
The really, really, really simplified version is that Hollywood sets up a
separate corporation for each movie with the intent that this corporation
will take on losses. The studio then charges the "film corporation" a huge
fee (which creates a large part of the "expense" that leads to the loss).
The end result is that the studio still rakes in the cash, but for
accounting purposes the film is a money "loser" -- which matters quite a bit
for anyone who is supposed to get a cut of any profits.
For example, a bunch of you sent in the example of
how Harry Potter and the Order of the Phoenix, under "Hollywood accounting,"
ended up with a $167 million "loss," despite taking in $938 million in
revenue. This isn't new or surprising, but it's getting attention because
the income statement for the movie was leaked online, showing just how
Warner Bros. pulled off the accounting trick:
In that statement, you'll notice the "distribution
fee" of $212 million dollars. That's basically Warner Bros. paying itself to
make sure the movie "loses money." There are some other fun tidbits in there
as well. The $130 million in "advertising and publicity"? Again, much of
that is actually Warner Bros. paying itself (or paying its own
"properties"). $57 million in "interest"? Also to itself for "financing" the
film. Even if we assume that only half of the "advertising and publicity"
money is Warner Bros. paying itself, we're still talking about $350 million
that Warner Bros. shifts around, which get taken out of the "bottom line" in
the movie accounting.
Now, that's all fascinating from a general business
perspective, but now it appears that Hollywood Accounting is coming under
attack in the courtroom... and losing. Not surprisingly, your average juror
is having trouble coming to grips with the idea that a movie or television
show can bring in hundreds of millions and still "lose" money. This week,
the big case involved a TV show, rather than a movie, with the famed
gameshow Who Wants To Be A Millionaire suddenly becoming "Who Wants To Hide
Millions In Profits." A jury found the whole "Hollywood Accounting"
discussion preposterous and awarded Celador $270 million in damages from
Disney, after the jury believed that Disney used these kinds of tricks to
cook the books and avoid having to pay Celador over the gameshow, as per
their agreement.
On the same day, actor Don Johnson won a similar
lawsuit in a battle over profits from the TV show Nash Bridges, and a jury
awarded him $23 million from the show's producer. Once again, the jury was
not at all impressed by Hollywood Accounting.
With these lawsuits exposing Hollywood's sneakier
accounting tricks, and finding them not very convincing, a number of
Hollywood studios may face a glut of upcoming lawsuits over similar deals on
properties that "lost" money while making millions. It's why many of the
studios are pretty worried about the rulings. Of course, these recent
rulings will be appealed, and a jury ruling might not really mean much in
the long run. Still, for now, it's a fun glimpse into yet another way that
Hollywood lies with numbers to avoid paying people what they owe (while at
the same sanctimoniously insisting in the press and to politicians that
they're all about getting content creators paid what they're due).
Bob Jensen's threads on case learning are at
http://faculty.trinity.edu/rjensen/000aaa/thetools.htm#Cases
Bob Jensen's threads on return on investment
http://faculty.trinity.edu/rjensen/roi.htm
Bob Jensen's threads on management accounting
http://faculty.trinity.edu/rjensen/theory01.htm#ManagementAccounting
Bob Jensen's threads on accounting theory are at
http://faculty.trinity.edu/rjensen/theory01.htm
Free Online Real Estate
Valuations
Question
How can you find, in less than a minute, the purported value of a home in the
United States?
Answer
None of the free major online appraisal sites (
Eppraisal.com,
Realestateabc.com ,
Homegain.com
and
Zillow ) can find my current boondocks cottage in the White
Mountains of New Hampshire. But these sites all tell me that I sold my home in
San Antonio too cheap. What can I say? It was my only offer after having my San
Antonio home on the market for nearly a year.
After testing these free online appraisal sites out today, I'm impressed by
the convenience of the online appraisal services. However, I think those
appraisals run a bit too high, but that's only my opinion. I'm absolutely
certain that the Bexar County Tax Appraisal District in San Antonio overvalues
homes for tax purposes, but this may be the reason the online free appraisal
services also provide, in my opinion, high appraisals. They probably get a lot
of their inputs from public taxation appraisal databases.
Several accounting professors have written to me that their home appraisals
at the online sites are way too low. They suspect that the appraisals are based
upon old transactions in nearby neighborhoods that are not comparable to their
neighborhoods.
In any case, these services are very fast and convenient if you are mildly
considering moving to another community and want to compare home values. They're
also convenient if you want to gossip, with wide margins of error, about what
your friends' and relatives' homes are worth. That way you can prioritize your
efforts to get cut into the better wills when they kick the bucket.
Warning
These online free services are no substitutes for more localized appraisals by
supposed experts in the community in question. But these experts are sometimes
dubious characters. When I purchased my current home my offering price was
heavily influenced by the appraisal of John Doe, the local expert appraiser in
the Sugar Hill area. The bank where I got my mortgage arranged for John Doe to
conduct the appraisal, because I was living in Texas and had no idea who to hire
for making an appraisal. The appraisal was $180 per square foot on the value of
the house apart from the land value (which in New Hampshire is appraised
separately for tax purposes). Keep in mind that high mortgage appraisals please
both buyers and sellers of homes. Buyers feel like they got a great deal when
they paid less than the appraised value. Sellers are relieved that the buyers
could get enough financing to close the deal.
Two years later, my property tax appraisal shot up to $164 per square foot on
my 140-year old cottage apart from the land value. In New Hampshire, the
appraisals of surrounding houses and land are mailed by the towns to all home
owners. Hence your neighbor's property tax appraisals are not secret. My
immediate neighbors' houses were being assessed for less than $100 per square
foot apart from land value. So I had John Doe do a second appraisal of my house.
Keep in mind that John Doe is the same John Doe who two years earlier appraised
my house for $180 per square foot. Since I was having the second appraisal done
for purposes of lowering my taxes, John Doe nicely appraised my house now for
$115 per square foot apart from the land value. There have been very few home
sales in Sugar Hill over the past two years, but realtors tell me that house
values have not declined. Certainly construction costs have greatly increased.
My point here is that you can get burned by both the online appraisal services
and the local John Doe expert appraisers. Sadly, the Town of Sugar Hill did not
agree with John Doe's lowered appraisal.
"What’s My House Worth? And Now?" by Michelle Slatalla, The New
York Times, August 2, 2007 ---
Click Here
THE
value of my house fluctuates more often — and for
even more mysterious reasons — than my weight these
days.
But is it going up? Or down?
Either my house lost $94,248
in value over the last two
months, or else it gained
$32,799 in the last 30 days.
I can’t tell, because I get
conflicting information from
online sites — like Eppraisal.com,
Realestateabc.com and
Homegain.com
—
where I find myself
obsessively comparing
numbers every day or so.
O.K., every hour or so (or
about as often as I used to
get on the scale when I was
in high school).
But if
I didn’t keep up with the
real estate sites, then I
wouldn’t know that earlier
this summer a center-hall
colonial a block away from
me sold for $2,439,500
despite its outdated kitchen
(thank you,
Cyberhomes.com).
Or
that most of my neighbors
are juggling payments on big
adjustable-rate mortgages
just like mine (thank you
Propertyshark.com).
Or
that the bathroom I recently
remodeled may have increased
my property value by $33,490
(thank you,
Zillow.com).
With a growing number of
Internet sites trolling
public databases for
financial facts, it has
become increasingly easy in
the last two years for
information addicts like me
to perform party tricks by
announcing to our friends
all kinds of delicious
snippets that once were
considered intimate, known
mainly to brokers or people
with enough time to drive to
the courthouse to flip
through musty files.
But it’s no longer just
cocktail chatter. With a
nationwide real estate
crisis in full bloom thanks
to subprime mortgage woes,
falling prices and rising
loan rates, homeowners are
increasingly turning to
Internet sites to try to
glean bits of information
that may shed light on when
to refinance, or whether to
sell.
And why not? I really,
really need every tiny bit
of information I can get
about managing my biggest
investment.
Don’t I?
“Oh,
no! Oh, my goodness, I have
to tell you to stop right
now,” said Baba Shiv, an
associate professor of
marketing at
Stanford University.
“You
are being completely
irrational. This information
can end up having a negative
effect on your life.”
This was not the response I
had hoped to hear from
someone who specializes in
studying how everyday
investors make decisions
about how to manage their
money.
“But everybody is doing it,”
I whined.
And in my defense, I would
like to point out that’s
true. In June, for instance,
more than 39 million people
visited the 20 most popular
real estate Web sites, a
22.4 percent increase in
visitors over the same
period in the previous year,
according to Nielsen/NetRatings
Inc. Not only that, but a
lot of those people are
becoming addicted. At
Zillow.com, for instance, 44
percent of the site’s users
visited five or more times
in June, and 25 percent of
them 10 or more times,
according to a spokeswoman
for the site.
Beyond catering to the
voyeuristic appeal of
knowing what your neighbor
paid per square foot, the
sites say they offer a
valuable service by making
information more accessible
to average folks.
Continued in article
Conclusion
As the Financial Accounting Standards Board in the United States and the
International Accounting Standards Board in London move closer and closer to
fair value accounting for non-financial and well as financial assets and
liabilities, the real estate appraisal industry does not give me much faith in
"fair value" estimates. Also fair value accounting mixes the hypothetical with
transpired transactions into an accounting stew that does mean much to anybody.
Bob Jensen's threads on the science and art of valuation can be found in the
following links:
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
http://faculty.trinity.edu/rjensen/roi.htm
One of my
PowerPoint slides (Slide 4) deals with real estate appraisals of all Days Inn
assets in that company's controversial 1987 annual report. That annual report
has traditional historical cost financial statements audited by Price
Waterhouse, forecasted financial statements reviewed by Price Waterhouse, and
exit (liquidation) value financial statements prepared by an appraisal firm
called Landhauer Associates. The PowerPoint show is the 10FairValue.ppt file at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/
Business Valuation References
and Resources
Whenever I get news about
increased interest in business (especially economics and
finance) professors on Wall Street, I think back to "The
Trillion Dollar Bet" (Nova
on PBS Video) a bond trader, two Nobel Laureates, and their
doctoral students who very nearly brought down all of Wall
Street and the U.S. banking system in the crash of a hedge fund
known as
Long
Term Capital Management where the biggest and most
prestigious firms lost an unimaginable amount of money ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#LTCM
Valuation for Financial Reporting : Fair
Value Measurements and Reporting, Intangible Assets, Goodwill and Impairment
, 2nd Edition, by Michael J. Mard, James R. Hitchner, Steven D. Hyden, Wiley,
ISBN: 978-0-471-68041-3 Hardcover 240 pages September 2007. The last time I
checked Amazon had eight used copies available ---
Click Here
From Jim Mahar's blog on April 26, 2008---
http://financialrounds.blogspot.com/
Is Valuation Driven More By Cash Flows or
Discount Rates?
Here's one for my next semester's Security Analysis
class: In "What Drives Stock Price Movement?" Long Chen and Xinlei Zhao use
analyst forecast and stock market data to examine whether stock price
changes are associated more with changes in cash flows or discount rates.
Here's the abstract (note: the emphasis is mine): A central issue in asset
pricing is whether stock prices move due to the revisions of expected future
cash flows or/and of expected discount rates, and by how much of each. Using
consensus cash flow forecasts, we show that there is a significant component
of cash flow news in stock returns, whose importance increases with
investment horizons. For horizons over three years, the importance of cash
flow news far exceeds that of discount rate news. These conclusions hold at
both firm and aggregate levels, and diversification only plays a secondary
role in affecting the relative importance of cash flow/discount rate news.
The conventional wisdom that cash flow news dominates at the firm level but
discount rate news dominates at the aggregate level is largely a myth driven
by the estimation methods. Finally, stock returns and cash flow news are
positively correlated at both firm and aggregate levels.
Link to the SSRN working paper ---
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1121893
"Hedge funds lure business school profs," CNN
Money,"September 10, 2007 ---
http://money.cnn.com/news/newsfeeds/articles/newstex/AFX-0013-19470175.htm
The growing and lightly
regulated hedge fund industry is attracting new players -- business school
professors eager to test their theories in a field known for big risks and
occasionally bigger rewards.
Hedge funds are becoming a
tempting tool for faculty members looking to sharpen research and giving a
Wall Street perspective to their students, all while making some extra
money.
'MBAs and, to a less extent,
Ph.D.'s have taken over the financial world,' said Roger Ibbotson, a
professor at the Yale University School of Management and co-founder of a
hedge fund. 'What we study is what people in finance know and use.' Hedge
funds are a $1.1 trillion industry, largely unregulated and traditionally
used by institutions and wealthy investors. Hedge funds profit by using
unconventional techniques, such as short-selling, or betting on falling
markets to make a profit during market downturns. They typically are active
traders and can use techniques off limits to mutual funds.
While hedge funds frequently
outperform more traditional investments, some have failed spectacularly.
Last year, Connecticut-based Amaranth Advisors wrongly guessed that tropical
storms in the Gulf of Mexico would cause natural gas prices to spike. The
storms didn't develop and Amarath lost billions within a week, prompting
lawsuits and congressional hearings.
Economic consultant Peter
Bernstein said the link between academic theory and Wall Street is not new,
but the interest among professors to run a hedge fund is.
'Wall Street does not know
very much about theory,' Bernstein said. 'The whole notion of risk is
something people didn't think about in a systematic sense. Academics come
with a structure about how to compose a portfolio.' Ibbotson and Yale
finance professor Zhiwu Chen founded Zebra Capital Management in 2001.
Housed in an out-of-the-way office park in nearby Milford and staffed by
analysts and computer technicians, Zebra has grown into a $265 million fund
by using mathematical and economic models to develop investment strategy.
Its 18.2 percent return for
the year through July outpaced the Standard & Poor's (NYSE:MHP) 500 Index,
which gained about 3.5 percent in the same period.
Links between university
research and hedge funds are good for both, said William Goetzmann, a Yale
business professor who is Ibbotson's research partner.
Hedge funds are part of a
'new frontier of finance,' boosting universities that draw students who are
interested in the industry, he said.
'It helps a school attract
the best and the brightest of students,' Goetzmann said.
Bernstein said many
professors are drawn to hedge funds by the lure of money and little
regulation.
'A lot more in fees, and a
lot less constrained,' he said.
Continued in article
Jensen Comment
I'm also reminded of two instructors in a valuation workshop I attended
(courtesy of Virginia Tech). These instructors were in the business of valuing
firms. What they stressed is that the best advice they could give is to stay
away from valuation researchers in academe. One problem in academe is that
researchers generally limit themselves to the information content contained in
databases that lack the subjective insights on the experts in the trenches.
Academic models are limited to the generally insufficient relevant data in their
databases. As Yogi Berra stated: "It is difficult to make predictions,
especially about the future"
True valuation experts would rather study the
Bill Belichick School for forecasting --- cheat if you can get away with it:
A former assistant under
Bill Belichick, Mangini arrived in New York last year with an insider's
knowledge of the Patriots' sign-stealing surveillance tactics and he shared
the dirty little secret with members of the Jets' organization, a person
with knowledge of the matter informed the Daily News yesterday.
It wasn't until the fifth
Mangini-Belichick showdown - last Sunday - that the Jets were able to catch
the Patriots. Tipped off by Jets security, an NFL security official
confiscated a video camera and tape from a Patriots employee at the
Meadowlands, and the evidence is believed to be damning
Rich Cimini, "Eric Mangini exposes
Bill Belichick's spy games," NY Daily News, September 12, 2007 ---
Click Here
You can read a more about valuation in the
following links:
From the Journal of Accountancy Smart
Stops on the Web, September 2007 ---
|
BUSINESS VALUATION |
|
BURNING BV
QUESTIONS
www.go-iba.org/blog
This site from the Institute of Business
Appraisers hosts a discussion group between its members and Rand M.
Curtiss, FIBA, MCBA, ASA, chairman of the American Business
Appraisers National Network. Its question-and-answer format covers a
range of topics relating to the appraisal of closely held
businesses, which, according to the IBA, make up 90% of U.S.
businesses and employ two out of every three taxpayers. Posts
include “Investment Profiles and Valuation Discounts,” “Financial
Forecasts and Willing Buyers and Sellers,” and “Investigating
Investment Value,” as well as quizzes to test your valuation
knowledge.
FOR WHAT IT’S WORTH
www.appraisalfoundation.org
This e-stop is the source for standards and
appraiser qualifications established by the Appraisal Standards
Board (ASB) and the Uniform Standards of Professional Appraisal
Practice (USPAP). Have record-keeping or ethics questions regarding
appraisals? Click on the “USPAP/Standards” tab for access to their
extensive archive of monthly Q&A documents or to read and submit
comments about ASB exposure drafts. Also, keep an eye out for
updates and news about the organization’s ongoing study of valuation
fraud and the relationship between appraisals and mortgage fraud.
|
"Guidance on fair value measurements under FAS 123(R)," IAS Plus, May
8, 2006 ---
http://www.iasplus.com/index.htm
Deloitte & Touche (USA) has updated its book of
guidance on FASB Statement No. 123(R) Share-Based Payment:
A Roadmap to Applying the Fair Value Guidance to Share-Based Payment Awards
(PDF 2220k). This second edition reflects all
authoritative guidance on FAS 123(R) issued as of 28 April 2006. It includes
over 60 new questions and answers, particularly in the areas of earnings per
share, income tax accounting, and liability classification. Our
interpretations incorporate the views in SEC Staff Accounting Bulletin Topic
14 "Share-Based Payment" (SAB 107), as well as subsequent clarifications of
EITF Topic No. D-98 "Classification and Measurement of Redeemable
Securities" (dealing with mezzanine equity treatment). The publication
contains other resource materials, including a GAAP accounting and
disclosure checklist. Note that while FAS 123 is similar to
IFRS 2
Share-based Payment, there are some measurement
differences that are
Described Here.
Bob Jensen's threads on employee stock options are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob Jensen's threads on fair value accounting are at
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Risk Glossary ---
http://www.riskglossary.com/
Although many of the links are to commercial (fee) sites, many
StumbleUpon hits under accounting were quite good, especially in financial
statement analysis and valuation.
- Five
Capital Budgeting Analysis (xls) - Basic program for doing
capital budgeting analysis with inclusion of opportunity costs,
working capital requirements, etc. -
Adamodar
Damodaran
-
Rating
Calculation (xls) - Estimates a rating and cost of debt
based on the coverage of debt by an organization -
Adamodar
Damodaran
-
LBO
Valuation (xls) - Analyzes the value of equity in a leverage
buyout (LBO) -
Adamodar Damodaran
-
Synergy (xls) - Estimates the value of synergy in a merger
and acquisition -
Adamodar Damodaran
-
Valuation Models (xls) - Rough calculation for choosing the
correct valuation model -
Adamodar
Damodaran
-
Risk
Premium (xls) - Calculates the implied risk premium in a
market. (uses macro's) -
Adamodar
Damodaran
-
FCFE
Valuation 1 (xls) - Free Cash Flow to Equity (FCFE)
Valuation Model for organizations with stable growth rates -
Adamodar
Damodaran
-
FCFE
Valuation 2 (xls) - Free Cash Flow to Equity (FCFE)
Valuation Model for organizations with two periods of growth,
high growth initially and then stable growth -
Adamodar
Damodaran
-
FCFE
Valuation 3 (xls) - Free Cash Flow to Equity (FCFE)
Valuation Model for organizations with three stages of growth,
high growth initially, decline in growth, and then stable growth
- Adamodar
Damodaran
-
FCFF
Valuation 1 (xls) - Free Cash Flow to Firm (FCFF) Valuation
Model for organizations with stable growth rates -
Adamodar
Damodaran
-
FCFF
Valuation 2 (xls) - Free Cash Flow to Firm (FCFF) Valuation
Model for organizations with two periods of growth, high growth
initially and then stable growth -
Adamodar
Damodaran
-
Time
Value (xls) - Introduction to time value concepts, such as
present value, internal rate of return, etc.
-
Lease
or Buy a Car (xls) - Basic spreadsheet for deciding to buy
or lease a car.
- Top Five
NPV &
IRR (xls) - Explains Internal Rate of Return, compares
projects, etc.
-
Real
Rates (xls) - Demonstrates inflation and real rates of
return.
-
Template (xls) - Template spreadsheet for project evaluation
& capital budgeting.
- Top Five
Free
Cash Flow (xls) - Cash flow worksheets - subsidized and
unsubsidized.
-
Capital Structure (xls) - Spreadsheet for calculating
optimal capital structures using different percents of debt.
-
WACC
(xls) - Calculation of Weighted Average Cost of Capital
using beta's for equity.
-
Statements (xls) - Generate a set of financial statements
using two input sheets - operational data and financial data.
-
Bond
Valuation (zip) - Calculates the value or price of a 25 year
bond with semi-annual interest payments.
-
Buyout
(zip) - Analyzes the effects of combining two companies.
-
Cash
Flow Valuation (zip) - Walks through a valuation of cash
flows under three models- capital cash flows, equity cash flows,
and free cash flows.
-
Financial Projections (zip) - Spreadsheet model for
generating projected financials along with valuation based on
WACC.
-
Leverage (zip) - Shows the effects on Net Income from using
debt (leverage).
-
Ratio
Calculator (zip) - Calculates a standard set of ratios based
on input of financial data.
-
Stock
Value (zip) - Calculates expected return on stock and value
based on no growth, growth, and variable growth.
-
CFROI (xls) - Simplified Cash Flow Return on Investment
Model.
-
Financial Charting (zip) - Add on tool for Excel 97,
consists of 6 files.
-
Risk
Analysis (exe) - Analysis and simulation add on for excel,
self extracting exe file.
-
Black
Scholes Option Pricing (zip) - Excel add on for the pricing
of options.
-
Cash Flow Matrix - Basic cash flow model.
-
Business Financial Analysis Template for start-up businesses
from Small Business Technology
Center
-
Forex (zip) - Foreign market exchange simulation for Excel
-
Hamlin
(zip) - Financial function add-on's for Excel
-
Tanly
(zip) - Suite of technical analysis models for Excel
-
Financial History Pivot Table - Microsoft Financials
-
Income Statement What If Analysis
-
Breakeven Analysis (zip) - Pricing and breakeven analysis
for optimal pricing - Biz
Pep.
-
SLG
Ratio Master (exe) - Excel workbook for creating 25 key
performance ratios.
-
DCF
- Menu driven Excel program (must enable macros) for Discounted
Cash Flow Analysis from the book Analysis for Financial
Management by
Robert C. Higgins
-
History - Menu driven Excel program (must enable macros) for
Historical Financial Statements from the book Analysis for
Financial Management by
Robert C.
Higgins
-
Proforma - Menu driven Excel program (must enable macros)
for Pro-forma Financial Statements from the book Analysis for
Financial Management by
Robert C.
Higgins
-
Business Valuation Model (zip) - Set of tabbed worksheets
for generating forecast / valuation outputs. Includes
instruction sheet. Bizpep
-
LBO Model - Excel model for leveraged buy-outs
-
Comparable Companies - Excel valuation model comparing
companies
-
Combination Model - Excel valuation model for combining
companies
- Top Five
Balanced Scorecard - Set of templates for building a
balanced scorecard.
-
Cash Model - Template for calculating projected financials
from CFO Connection
-
Techniques of Financial Analysis - Workbook of 11 templates
(breakeven, valuation, forecasting, etc.) from
ModernSoft
-
Ratio Reminder (zip) - Simple worksheet of comparative
financials and corresponding ratios from
Agilicor
-
Risk Analysis IT - Template for assessing risk of
Information Technology - Audit
Net
-
Risk Analysis DW - Template for assessing risk of Data
Warehousing - Audit Net
- Top Five
Excel Workbook 1-2 - Set of worksheets for evaluating
financial performance and forecasting - Supplemental Material
for Short Course 1 and 2 on this website.
-
Rule Maker Essentials - Excel Template for scoring a company
by entering financial data - The
Motley Fool
-
Rule
Maker Ranker - Excel Template for scoring a company by
entering comparable data - The
Motley Fool
-
IPO
Timeline - Excel program for Initial Public Offerings (must
enable macros)
-
Assessment Templates - Set of templates for assessing an
organization based on the Malcolm Baldrige Quality Model.
-
Cash
Gap in Days - Spreadsheet for calculating number of days
required for short-term financing.
-
Cash Flow Template - Simple spreadsheet for calculating Free
Cash Flow.
-
Six Solver Workbook (zip) - Set of various spreadsheets for
solving different business problems (inventory ordering, labor
scheduling, working capital, etc.).
-
Free Cash Flow Valuation - Basic Spreadsheet Valuation Model
-
Finance Examples - Seven examples in Business Finance -
Solver
-
Capital Budgeting Workbook - Several examples of capital
budgeting analysis, including the use of Solver to select
optimal projects.
-
Present
Value Tables (rtf) - Set of present value tables written in
rich text format, compatible with most word processors. Includes
examples of how to use present value tables.
-
Investment Valuation Model (zip) - Valuation model of
companies (must enable macros) -
Excel Business Tools
-
Cash
Flow Sensitivity (xlt) - Sensitivity analysis spreadsheet -
Small Business
Store
-
What If Analysis - Set of templates for sensitivity analysis
using financial inputs.
-
Risk Return Optimization - Optimal project selection (must
enable macro's) -
Metin Kilic
-
CI
- Basics #1 - Basic spreadsheet illustrating competitive
analysis -
Business Tools Templates.
-
CI
- Basics #2 - Basic spreadsheet illustrating competitive
analysis.
-
External Assessment - Assessment questions for
organizational assessment (must enable macros).
-
Internal Assessment - Assessment questions for
organizational assessment (must enable macros).
-
Formal Scorecard - Formal Balanced Scorecard Spreadsheet
Model (3.65 MB / must enable macros) -
Madison Area Quality Improvement
Network.
|
Questions
Why might you want to teach a modified IRR?
Is the reinvestment-at-the-same-rate assumption true?
It may not be, when interim cash inflows occur far in the future, or if
there is limited available capital to fund competing projects.
Is timing important?
Yes, it is vital. A change in the expected receipt of future cash inflows by
as little as 30 days has a significant impact on the computed IRR.
"Spreadsheets at Work: Rating Your Own IRR Some tips for doing these key
calculations; and introducing "modified" internal rate of return," by Richard
Block and Jan Bell, CFO.com, February 20, 2009 ---
http://www.cfo.com/article.cfm/13052407/c_2984312?f=FinanceProfessor/SBU
It is budgeting season again. Financial analysts
are completing their analyses of the R&D or capital spending projects being
proposed. And financial executives are either anxiously awaiting those
analyses, or already getting started on their reviews. No doubt the analyses
include investment costs, anticipated future savings, discounted cash flows,
computed internal rates of return, and a ranking of which projects make the
"cut," and which do not.
Almost certainly, a spreadsheet was used for each
project — to compute the discounted cash flows, the internal rates of
return, and the presentation of the overall rankings.
You will take comfort, of course, because these
analyses, and your decision on which projects to accept or fund, were based
on a sound financial principle: namely, the better the internal rate of
return, the better the project.
But is that comfort warranted? Or might you be
vulnerable to the weaknesses long pointed out — if too often ignored — by
researchers who have warned that IRR calculations often contain built-in
reinvestment assumptions that improperly improve the appearance of bad
projects, or make the good ones look too good .
IRR, of course, is the actual compounded annual
rate of return from an investment, often used as a key metric in evaluating
capital projects to determine whether an investment should be made. IRR also
is used in conjunction with the Net Present Value (NPV) function,
determining the current value of the sum of a future series of negative and
positive cash flows; namely investments and savings. The prescribed discount
factor to be used in computing NPV is the company's weighted average cost of
capital, or WACC. The internal rate of return is the annual rate of return,
also known as the discount factor, which makes the NPV zero.
The rub in justifying long-term project funding
decisions by using IRR is two-fold. First, IRR assumes that interim cash
inflows, or savings, will be "reinvested," and will produce a return — the
reinvestment rate — equal to the "finance rate" used to fund the cash
outflows (the investment.) Second, the anticipated investment cash outflows
required for the project, and for the anticipated cash inflows from savings
once the project is complete, are so far in the future that their timing is
difficult to determine with reasonable accuracy.
Is the reinvestment-at-the-same-rate assumption
true? It may not be, when interim cash inflows occur far in the future, or
if there is limited available capital to fund competing projects. Is timing
important? Yes, it is vital. A change in the expected receipt of future cash
inflows by as little as 30 days has a significant impact on the computed IRR.
But by knowing and using the subtleties of the
various IRR functions available in an electronic spreadsheet, we can
safeguard ourselves against miscalculations based on faulty assumptions, and
minimize the range of error by early detection of faulty assumptions.
In this article, part one of a two-part series, we
will study the reinvestment issue. The second article will address how to
reduce inaccuracies — minimizing the range of error — based on timing
concerns.
Continued in article
Looking for information on valuing your business? Look no further. Or look way further,
depending on your point of view. Here is a Web site, produced by Professor William C.
Weaver, that provides numerous links to online business valuation resources all assembled
in one easy-to-use location. http://www.accountingweb.com/item/56244
Business Valuation References --- http://www.bus.ucf.edu/weaver/
"Is risk increasing or decreasing? IPO Vintage and the Rise of Idiosyncratic
Risk by Jason Fink, Kristin Fink, Gustavo Grullon, James Weston," Jim Mahar's
Blog, April 18, 2005 ---
http://financeprofessorblog.blogspot.com/
While well documented, increased risk (and in
particular increased firm specific risk) has been a puzzle for researchers
for quite some time. With improve transparency and deeper markets, one could
speculate that risk should be decreasing, but researchers have not been
finding this. For instance:
"recent studies by Campbell, Lettau, Malkiel,
and Xu (2001) (henceforth CLMX), Malkiel and Xu (2003), Fama and French
(2004), Wei and Zhang (2004), and Jin and Myers (2004) document that,
over the past 30 years, U.S. public firms exhibit higher firm specific
return volatility, more volatile income and earnings, lower returns on
equity, and lower survival rates. The recurring theme in all these
studies is that firm risk, however defined, has increased." But now
Fink, Fink, Grullon, and Weston may provide the explanation: firms are
going public sooner. When the age of firms is controlled for, there does
not appear to be an increase in systematic risk and in fact there may be
a decrease!
"We argue that the rise in firm specific risk can
be explained by the interaction of two reinforcing factors: a dramatic
increase in the number of new listings and a simultaneous decline in the age
of the firm at IPO."
"we find that after controlling for age and
other measures of firm maturity (e.g., book-to-market, size,
profitability, etc.), there is a negative trend in idiosyncratic risk."
"Business
Valuation: 20 Steps For Pricing a Patent," by Timothy Cromley, Journal
of Accountancy, November 2004, pp. 31-34 --- http://www.aicpa.org/pubs/jofa/nov2004/cromley.htm
Some
patents are very valuable, while many are not. Because patents often are quite
complex, appraising one usually is a highly detailed and expensive process
that requires the input of lawyers and advisers with specific technical
knowledge and experience. The makeup of valuation teams will vary by
engagement, but it is axiomatic that before an appraiser can value something,
he or she has to understand what it is. Here are 20 steps to help valuators
such as CPA/ABVs do that:
From Smart Stops on
the Web, Journal of Accountancy, November 2004, Page 23 --- http://www.aicpa.org/pubs/jofa/nov2004/news_web.htm
Add a New Credential
bvfls.aicpa.org
Institute members looking for a new challenge can register at
this section of the AICPA Web site to take the November 15 or 30 Accredited in
Business Valuation (ABV) exam. Other resources include the BV Competence
Assessment Tool, Exam Candidate’s Reference Guide and Content Specification
Outline, a BV glossary and explanations of exam terminology.
What’s It Worth?
www.bvresources.com
CPAs can help clients value their businesses by taking
advantage of the free valuation court case downloads at this Web stop. Other
offerings include an international dictionary of business valuation terms, IRS
guidelines and links to the AICPA, Appraisal Foundation and Institute of
Business Appraisers. Users also can join the discussion forum and read more
definitions of BV terms and tips of the week.
Valuable Valuation Data
www.valuationresources.com
Does your client have an industry-specific valuation question?
Find the answer at this e-stop for information on a variety of topics such as
divorce, estate and gift taxes, limited partnerships and technology
valuations. The Industry Resources section has reports on compensation and
salary surveys, financial and operating ratios and sector outlooks covering
more than 250 industries. The legal and tax resource sections have links to
the federal tax code and regulations, state and federal case law and tax court
decisions.
Valuation Resources
August 22, 2007 message from Jerry Peters
[jerry.peters@yahoo.com]
Dr.
Jensen
Thank you for your assistance in this
matter. We appreciate your link to our site.
Jerry Peters, CPA, ASA, ABV
Valuation Resources, LLC
P.O. Box 5325
Evansville, Indiana 47716
Ph. 812-459-7742
jerry.peters@yahoo.com
Two valuation links of possible interest"
Bob Jensen's site mentioned above ---
http://faculty.trinity.edu/rjensen/roi.htm
Bob Jensen's PowerPoint file on Fair
Value Accounting --- see the 10FairValue.ppt file at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/
| SUCCESSION
PLANNING SITES |
Plan a Successful Exit
www.strategyletter.com/cp_0100/cp_fa.asp
Visitors can enter the Center for Simplified Strategic
Planning Web site through this backdoor to go directly to the article, “The
Strategy of Succession Planning,” which teaches retiring executives about
some advantages and possible pitfalls of succession planning. There’s also a
detailed outline of the article’s main points if readers want to cut right
to the chase. CPA/ABVs can click on the link at the end of the story for a
free subscription to the site’s e-zine Course and Direction.
Get the Buzz on the Family
Biz
www.familybizz.net
CPA/ABVs can go to the Business Issues section of this site
and click on succession planning for information on topics such as bringing in
the next generation or developing a written succession plan. Visitors also can
read up on the seven development stages of succession and find answers to the
questions “What are the options?” and “Can there be more than one
successor?”
There is a link to Banister
Financial where you can find some tips of valuation and valuation
frauds.
From The Wall Street Journal Accounting Educators'
Review on May 27, 2004
TITLE: Google Search: How Does It Value Its Shares?
REPORTER: Scott Thurm
DATE: May 13, 2004
PAGE: C1
LINK: http://online.wsj.com/article/0,,SB108439355400909719,00.html
TOPICS: Financial Accounting, Financial Analysis, Financial Statement Analysis,
Stock Options
SUMMARY: Jack Ciesielski, publisher of Analysts' Accounting Observer, used
Google's disclosures of compensation expense and deferred compensation from its
employee stock option plans to estimate the value corporate officers place on
their soon-to-be-issued stock.
QUESTIONS:
1.) In general, summarize the two ways in which Mr. Ciesielski estimated the
value placed on Google shares by corporate officers.
2.) What disclosures did Mr. Ciesielski use to estimate the value placed on
Google shares by corporate executives? In general, what standards and laws
require these disclosures? What specific SEC requirement provided useful
information in the disclosures for the first quarter of this year?
3.) Focus on the method of estimation using the deferred compensation account
and the SEC requirement reflected in the accounting during the first quarter of
this year. Where is "deferred compensation" under stock option plans
included in the financial statements? What amount is included in that account?
How could Mr. Ciesielski determine that Google added $75.4 million to that
account?
4.) Focus on the estimation using the Black-Scholes formula. What is that
formula designed to estimate? What inputs must be used to make this estimate?
How could Mr. Ciesielski, and Professor Larcker, run this model
"backwards"?
5.) What advantage in the marketplace can an analyst obtain by being able to
use accounting information in such a clever way as Mr. Ciesielski has done?
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
See how a professor from NYU valued Google in 2005 and 2006
(downloadable spreadsheets)
Damodaran Online ---
http://pages.stern.nyu.edu/~adamodar/
"Street Sleuth: Google
Search: How Does It Value Its Shares?" by Scott Thurm, The Wall
Street Journal, May 13, 2005, Page C1 --- http://online.wsj.com/article/0,,SB108439355400909719,00.html
Investors are puzzling over how to
value Internet-search innovator Google Inc. for its planned stock offering.
Some clues, from Google itself: Think
either $80 or $91 a share, which would value the company at $20 billion to $22
billion, before the initial public offering of stock.
Those numbers don't appear in Google's
IPO securities-registration statement. But accounting sleuths say other
disclosures in that document allow them to estimate how Google values its own
shares.
Those disclosures relate to the stock
options that Google granted to employees. Many of those options were granted
at share prices that now seem ridiculously low -- an average of $2.65 a share
for last year, for example. So, applying a common practice for companies going
public, Google has reassessed the value of those options and recorded the
difference as a compensation expense.
By digging into those numbers, Jack
Ciesielski, publisher of Analyst's Accounting Observer, says he can estimate
how Google itself valued its shares as recently as the first quarter of this
year.
One way to unravel the numbers, Mr.
Ciesielski says, is to track how much deferred compensation Google records for
the "excess" value of the options -- that is, the value above the
exercise price.
Bob Jensen's threads on employee stock options are at http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
A Forecast for the Future
www.financialwonder.com
CPAs will want to check out this Web site to find free tools for
corporate budgeting and forecasting. Users can build forecasts using the
formulas found here for free. They then can use the results on their individual
balance sheets or income statements and copy the results directly to their
spreadsheets or word processors.
How can petroleum industry accounting be improved? Some ideas from PwC
--- http://www.pwc.com/images/gx/eng/about/ind/petro/drilling_deeper.pdf
William C. Weaver from Central
Florida College of Business Administration
Online Resources, Links, and Literature for Business Valuation ---
http://www.bus.ucf.edu/weaver/
Business Valuation References --- http://www.bus.ucf.edu/weaver/
Valuation Resources For Business Appraisers --- http://www.valuationresources.com/
What's
New highlights recent additions to this site. For a complete list,
please select the "More new products and services . . ." link
below.
 |
| Small
Business Valuation Formula Multiples, 2002 Edition |
| Cost
of Capital: Estimation and Applications, 2nd Ed., Shannon Pratt |
| Valuation
for Financial Reporting: SFAS 141 & 142 |
| Industry
Resources Reports Expanded To Cover More Than 200 Industries |
| More
new products and services . . . |
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heading from the list below.
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