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Summary Recap Lectures FSAV Master Accountancy & Control
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Summary FSAVWeek 1
Financial statements provide a lens on a companies business. They are a reflection of the
performance of a company over a certain period and the financial position at the end of the year.
Stakeholders that make use of financial statements: managers, bankers and analysts.
In this course we take the perspective of an outside equity analyst who evaluates the company on
performance, quality of the financial statements and the value of the company as a whole.
Fundamentals of valuation
Determine the value of a company > receiving a return on their investment
Dividend Discount Model (DDM) say that the value of the investment in equity of a company is
determined by the present value of all future expected dividends. For this model we have to guess
what the dividend in the future will be. This is not practical for al companies. So often in practice
analysts use Discounted cashflow models (DCF). These models focus on the present value of future
expected free cashflows. What is important here: to determine the value of a companies equity we
need to form expectations of what will happen in the future.
This valuation task is different from observing the stock price of a company. We are going to use the
fundamental valuation and try to compare this to the stock market price, to see if we can make any
recommendations based on the differences.
So to do valuations we need expectations and forecasts. To create proper forecasts we need to
understand the current performance based on the financial statements. Financial statement analysis
consist of 4 key steps:
1. Business and strategy analysis: what is the companies primary business, key profit drivers and risk
areas?
2. Accounting analysis: do the financial statements accurately reflect the underlying business?
3. Financial (ratio) analysis: what factors drive current performance and how sustainable is this
performance?
4. Prospective analysis: how will the company perform in the next years and how does this map into
its valuation?
Three important features we need to take in consideration in analyzing the financial statements.
1. Accrual accounting: which distinguishes between the recording of the costs and benefits that are
associated with the economic activities of a company and the actual payments and receipts of cash.
2. Managers are responsible for financial reporting and entrusted with making key assumptions and
estimates. Such discretion given to managers can be valuable, but could also lead to distortions in
case of incentives for example.
3. All accounting standards reflect specific trade offs between the relevance and reliability of
information. Sometimes information about some benefits or costs can be highly relevant, but might
not reflected in the financial statements because these benefits or costs are too difficult to measure
reliably. An example can be R&D or advertising costs.
To summarize from these three features, an important financial statement analysis task is to
understand:
- The consequences and accuracy of accruals and deferrals of benefits and costs;
- The consequences and accuracy of managers estimates and assumptions;
- The consequences and accuracy of the reporting required by accounting standards.
,Business and strategy analysis
We spend not too much time on this step, but still this step is important, because we need to
understand the company we are dealing with. So before we extract information from a company’s
financial statements we need to understand the business: like what industry do they operate, what is
their profit driver etc.
Answer to these questions are essential, because they determine where we have to look in the
financial statements to identify the most important line items.
Accounting analysis
Getting an understanding of whether the financial statements accurately reflect the underlying
business reality. So after getting an idea about the business and strategy of a company, in this step
we try to find out if there is any distortion in the numbers. And if there is distortion we need to make
adjustments to make the financial statements better reflect the reality. This is important, because for
the next step, ratio analysis, we need to make sure the numbers are accurate and informative to us.
Also in our forecasting exercise we need to get an understanding about how sustainable the numbers
are that we are relying on.
Where does distortion in financial statements come from?
1. The imperfection of accounting rules: this reflects the trade-off between relevance and reliability
for example that R&D activities are not reflected in the balance sheet;
2. Forecast errors: managers cannot predict the future in a perfect way;
3. Earnings management: managers might use their flexibility in making estimates and assumptions
to produce earnings numbers that meet internal (bonus) or external (stock market) targets.
When financial statements are distorted due to earnings management, for the majority of cases this
is related to the overly aggressive recognition of revenues. For example recognition of revenues on
fake sales or understatements of product return allowances.
A key task for us as analysist is to adjust any distortions in the financial statements. We will do this by
an balance sheet approach: to identify distortions in assets, liabilities and equity. We choose for the
balance sheet, because of double entry bookkeeping distortion in the income statement will also
have an effect on the balance sheet.
When we correct for an distortion in assets or liabilities in the balance sheet, we should think about
all the financial statement items what are affected. One important item is the income tax. What is
important to keep in mind, is that the income tax that we see in the financial statements is different
from the income tax that the company pays over the period.
Income tax expense = tax rate x pre-tax book profits
Income tax payable = tax rate x pre-tax taxable profit
The distinction comes from the fact that companies have financial reporting purposes and different
tax purposes. This means if we adjust the financial reporting for external purposes the gap in the
balance sheet and asset and liability values between the financial reporting and tax reporting will
also change. So we are going to adjust the external financial reporting, but not the tax reporting and
therefore we get differences. This applies that we should account for any changes in deferred taxes.
See the following example:
,The financial reporting book value overstates the future amount of tax-deductible depreciation by
250 This should be disclosed in the financial reporting. We assume that the tax rate is 20%
In this case do we have to recognize a deferred tax liability of 250 x 20% = 50
The deferred tax liability basically reflects the additional amount of tax the firm is expected to pay in
the future, in addition to the tax expense that will be reported in future financial statements based
on pre-tax book income.
Any recognition of deferred tax liability is associated with the recognition of a deferred tax expense
(income).
For the opposite when tax basis of assets are higher than the book value of assets > we have to
create deferred tax assets.
Example of adjusting the financial statement for revenue overstatement:
What do we need to do:
1. Balance sheet: reflects the correction of the cumulative effect of revenue overstatement in all
years.
2. Income statement: reflects the correction of the revenue overstatement in the current year.
What financial statements will be affected by our adjustments:
- Sales revenue (IS)
- Account receivables (BS)
- Cost of sales (IS)
- Prepaid expenses and other current assets (BS)
- Income tax expense (IS)
- Deferred tax liability (BS)
Step 1: we start with the balance sheet: under the revised recognition, how much would not yet have
been recognized by 2008?
If 6,8 in invoices would not have been sent out, the total receivables asset would decrease by 6,8.
Step 2: we need to adjust the cost of sales. The costs are recognized in the period in which the
associated revenue is recognized. So under our adjusted recognition of revenue the cost would be:
, We need to adjust the cost of sales downwards by 0,9. What is important here is that these are
unrecognized costs that have been incurred, but are not yet recognized in profit/loss. They are
parked on the balance sheet as other assets similar to the capitalization of inventory assets.
Step 3: we look at the net effect of the asset side of the balance sheet which is -6,8 + 0,9 = -5,9
negative adjustment to the assets on the balance sheet.
Step 4: it is important to allocate this change in assets to equity and liabilities using the marginal tax
rate (for this case 28,5%):
So with the aggressive revenue recognition the company had basically overstated its pre-tax profit
over the four years in total by 5,9 million. This means, because the pre-tax profit was overstated, the
income tax expense was also overstated. The total accumulate overstatement of the tax expense is
1,7 million. So we need to adjust the tax liability downwards by 1,7 million. Finally the change in
equity can be seen as the sum of the overstatement in net income.
This was everything for the balance sheet, and now we will focus on the income statement. For the
income statement we just have to make adjustment for the year 2018.
All these calculations are for 2018, so for example the revenue of 2018 should be 3,4 instead of 5,3.
All these calculations bring us to the following outcome:
Companies can also understate their profitability. Conservative accounting practices are often viewed
as desirable: from a governance perspective, it is often less of a problem when companies understate
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