Accounting: The Language of Business - Vol 2 [Intermediate (Part 2)]

Over the years, Charlie [Munger, Berkshire Hathaway Vice Chairman] and I have observed many accounting-based frauds of staggering size. Few of the perpetrators have been punished; many have not even been censured. It has been far safer to steal large sums with pen than small sums with a gun.

Warren Buffett

The Financial Reporting Environment

(Part B)

by

Charles Lamson

Sources of Financial Information. The financial reporting process generates a significant amount of finance information that uses the four basic financial statements, as well as the footnote disclosures. In the posts that follow, we continue the theory, rational, and principles underlying the four basic financial statements: 

• The balance sheet (also referred to as the statement of financial position)

• The statement of comprehensive income 

• The statement of cash flows

• The statement of shareholders' equity

Published financial statements are called general-purpose financial statements because they provide information to a wide spectrum of user groups: investors, creditors, financial analysts, customers, employees, competitors, suppliers, unions, and government agencies. Although considered general purpose, most financial information is provided to satisfy users with limited ability or authority to obtain additional information, which includes investors and creditors. The Financial Accounting Standard Board (FASB), which is the body responsible for promulgating U.S. GAAP, identifies investors, lenders, and other creditors as the primary users of the financial statements.

Financial statements are the culmination of the financial reporting process. These financial statements, along with the accompanying footnote disclosures are the primary source of publicly available financial information for investors and creditors. None of the other sources of financial information---such as management, forecasts, press releases, and regulatory reports provide as much information as the financial statements.

The term financial information includes more information than the financial statements. The financial statements include the four basic financial statements and the related footnotes. However, financial information also includes items such as: 

• A letter to the shareholders

• A formal discussion and analysis of the firm by the management of the firm

• Management report

• Auditor's report

• Financial summary

Therefore, the general-purpose financial statements and the related footnotes are subsets of financial information. The financial statements and the footnotes are governed by U.S.

GAAP, which may not always be the case for all components of financial information.

Economic Entity

The second element in the definition of financial accounting involves the economic entity for which the financial statements and other financial information are presented. An economic entity is an organization or unit with activities that are separate from those of its owners and other entities. Financial information always relates to a particular economic entity. Economic entities can be corporations, partnerships, sole proprietorships, or governmental organizations. Also, economic entities may be privately held or publicly held. If the entity is publicly held, then its equity can be bought and sold by external parties on stock exchanges. 

Financial Statement User Groups

The third element in the financial accounting definition involves identifying the primary user groups that demand financial information. Some assets employ accounting information to make economic decisions for their own benefit while other users employ accounting information to make economic decisions for the benefit of others, or to assist others in making investment or credit decisions. Exhibit 1.2 lists the user groups. 

EXHIBIT 1.2 User Groups

Equity Investors. Equity investors are the shareholders of the company. That is, an equity investor purchases a percentage ownership of the company. Equity investors include individuals, other corporations, partnerships, mutual funds, pension plans, and other financial institutions that expect to receive a return on their investment either through dividends (i.e., distributions of cash or other assets to owners) or in the form of an increase in the price of their equity shares.

Equity investors use financial information to determine a company's ability to generate earnings and cash flow, as well as to make an assessment of the potential risks and returns of their investments. Equity investors also use financial information to assess the ability of the entity to pay dividends and to grow over time. Firm growth in earnings and cash flow are important for the investor to sell his or her investment at a gain. 

*GORDON, RAELY, & SOMNELLA, 2019, INTERMEDIATE ALGEBRA, 2ND ED., PP. 3-4*

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Accounting: The Language of Business - Vol. 2 [(Intermediate) Part 1]

I don't mean to sugarcoat the figure on restatements, but I think it is positive - it shows a healthy system. The general impression of the public is that accounting rules are black and white. They are often anything but that, and in many instances the changes in earnings came after new interpretations by the chief accountant of the SEC.

Steve Odland

The Financial Reporting Environment

(Part A)

by

Charles Lamson

Introduction

Well developed accounting standards enable worldwide capital markets to function effectively by providing credibility to published financial information used by investors, creditors, and others. Transparent financial information included in the financial statements allows these parties to make rational investment and credit decisions that direct capital to corporations that develop new products and technology, create employment, and encourage growth and development.

Consider Twitter, Inc., the social networking company, which raised capital of over $2.09 billion by issuing 80.5 million shares of stock in its initial public offering. Investors subsequently traded over 194 million shares of Twitter stock valued at $8.2 billion during

the first month after the initial public offering (Twitter, Inc. Is traded on the New York Stock Exchange. It made its initial public offering on November 7th, 2013.) These investors based their decisions on the financial information provided by Twitter. The capital provided by such investment fuels the overall economy and directs capital to its most productive uses.

Multiple factors in the overall accounting environment influence economic decisions at the firm level. For example, user groups such as investors and creditors impact the demand for accounting information and influence the standard-setting bodies. Financial reporting encompasses much more than the financial statements: Other key elements include the footnote to the financial statements, the letter to the owners, management's discussion and analysis, the auditor's report, the management report, and press releases. Financial statement users rely on all categories of financial information to make rational economic decisions.

In the next several posts, we first define financial accounting and discuss the demand and supply of financial information. We identify the economic entities that prepare financial information as well as the users of financial information. We then explore factors that shape accounting information. We also overview the historical development of the U.S. and international standard-setting bodies and discuss the standard-setting processes. We conclude the next several posts with a review of recent trends in standard-setting.

Overview of Financial Reporting

Financial accounting is the process of identifying, measuring, and communicating financial information about an economic entity in various user groups within the legal, economic, political, and social environment. This definition contains four major elements:

1. Financial information

2. Economic entity

3. User groups

4. Legal, economic, political, and social environment

We will examine these elements in the following sections.

Financial Information

Financial information falls into two categories: information that is or that is not governed by rules set forth by the accounting standard-setting bodies. Firms prepare the financial statements and the footnotes to the financial statements (also referred to as footnote disclosures) based on accounting standard-setters rules. In contrast, the letter to the owners, management's discussion and analysis, the auditor's report, the management report, and press releases are not governed by the accounting standard-setting bodies, although they are regulated to some degree by other authoritative bodies.

Demand for financial information. The form, content, and extent that firms provide financial information is based on market participant demand. Financial accounting provides information that enables users to evaluate economic entities and make efficient resource allocation decisions based on the risks and returns of a particular investment. This process directs capital flows to their most productive uses. In this way, the demand for financial information is linked to the allocation of scarce resources, as Illustrated in Exhibit 1.1.

EXHIBIT 1.1 Demand for Financial Information

Capital is a scarce resource. How do investors and creditors make decisions regarding the amount of capital to invest in a given entity? Accountants report the economic performance and financial position of the firm so that potential debt and equity investors can adequately assess the risks and returns of investing in the entity. Similarly, lenders can use the financial statements to assess the potential for payment. For example, a bank limited in the number of loans that it can make would clearly prefer to lend to a business that has been profitable over the last five years rather than one that has not.

Transparent and complete financial statements aid investors in assessing the amount and timing of future cash flows, as well as the uncertainty of cash flow realization. However, financial statement users should be aware that performance-based compensation can create an incentive for managers to strategically manage or to misreport financial statements. Compensating managers based upon reported net income provides a financial incentive to inflate net income. For example, when the Securities and Exchange Commission found that the Computer Sciences Corporation (CSC) committed accounting fraud that increased net earnings in 2010 and 2011, CSC's CEO agreed to pay back 3.7 million dollars of compensation he received based on the fraudulent earnings. Financial accounting standards seek to limit this type of management behavior. Most managers faithfully report their financial statements, but it is important for standard-setters and auditors to be aware of incentives to alter net income. 

*GORDON, RAEDY, & SAMNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 1-3*

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Accounting: The Language of Business - Vol. 1 (Part 158 - Conclusion)

Go is to Western chess what philosophy is to double-entry accounting.

Trevanian

Capital Investment Analysis (Part D)

by

Charles Lamson

Factors that Complicate Capital Investment Analysis

In parts 156 and 157, we described four widely used methods of evaluating capital investment proposals. In practice, additional factors may have an impact on the outcome of a capital investment decision. In the following paragraphs, we discuss some of the most important of these factors: the federal income tax, unequal lives of alternative proposals, leasing, uncertainty, changes in price levels, and qualitative factors.

Income Tax

In many cases, the impact of the federal income tax on capital investment decisions can be material. For example, in determining depreciation for federal income tax purposes, useful lives that are much shorter than the actual useful lives are often used. Also, depreciation can be calculated by methods that approximate the 200-percent declining-balance method. Thus, depreciation for tax purposes often exceeds the depreciation for financial statement purposes in the early years of an asset's use. The tax reduction in these early years is offset by higher taxes in the later years, so that accelerated depreciation does not result in a long-run saving in taxes. However, the timing of the cash outflows for income taxes can have a significant impact on capital investment analysis.

Unequal Proposal Lives

In the preceding discussion, the illustrations of the methods of analyzing capital investment proposals were based on the assumption that alternative proposals had the same useful lives. In practice, however, alternative proposals may have unequal lives. To illustrate, assume that alternative investments, a truck and computers, are being compared. The truck has a useful life of 8 years, and the computer network has a useful life of 5 years. Each proposal requires an initial investment of $100,000, and the company desires a rate of return of 10%. The expected cash flows and net present value of each alternative are shown in Exhibit 4. Because of the unequal useful lives of the two proposals, however, the net present values in Exhibit 4 are not comparable.

EXHIBIT 4 Net Present Value Analysis---Unequal Lives of Proposals

To make the proposals comparable for the analysis, they can be adjusted to end at the same time. This can be done by assuming that the truck is to be sold at the end of 5 years. The residual value (the estimated value of a fixed asset at the end of its lease term or useful life) of the truck must be estimated at the end of 5 years, and this value must then be included as a cash flow at that date. Both proposals will then cover 5 years, and net present value analysis can be used to compare the two proposals over the same five-year period. If the truck's estimated residual value is $40,000 at the end of year five years, the net present value for the truck exceeds the net present value for the computers by $1,835 ($18,640 - $16,805), as shown in Exhibit 5. Therefore, the truck may be viewed as the more attractive of the two proposals.

Lease vs Capital Investment

Leasing fixed assets has become common in many Industries. For example, hospitals often lease diagnostic and other medical equipment. Leasing allows a business to use fixed assets without spending large amounts of cash to purchase them. In addition, management may believe that a fixed asset has a high risk of becoming obsolete. This risk may be reduced by leasing rather than purchasing the asset. Also, the Internal Revenue Code allows the lessor (the owner of the asset) to pass tax deductions on to the lessee (the party leasing the asset). These provisions of the tax law have made leasing assets more attractive. For example, a company that pays $50,000 per year for leasing a $200,000 fixed asset with a life of eight years is permitted to deduct from taxable income the annual lease payments.

In many cases, before a final decision is made, management should consider leasing assets instead of purchasing them. Normally, leasing assets is more costly than purchasing because the lessor must include in the rental price not only the costs associated with owning the assets but also a profit. Nevertheless, using the methods of evaluating capital investment proposals, management should consider whether it is more profitable to lease rather than purchase an asset.

Uncertainty

All capital investment analyses rely on factors that are uncertain. For example, the estimates related to revenues expenses, and cash flows are uncertain. The long-term nature of capital investments suggests that some estimates are likely to involve uncertainty. Errors in one or more of the estimates could lead to incorrect decisions.

Changes in Price Levels

In performing investment analysis, management must be concerned about changes in price levels. Price levels may change due to inflation, which occurs when the general price levels are rising. Thus, while general prices are rising, the returns on an investment must exceed the rising price level, or else the cash returned on the investment becomes less valuable over time.

Price levels may also change for foreign investments as the result of currency exchange rates. Currency exchange rates are the rates at which currency in another country can be exchanged for U.S. dollars. If the amount of local dollars that can be exchanged for one U.S. dollar increases, then the local currency is said to be weakening to the dollar. Thus, if a company made an investment in another country where the local currency was weakening, it would adversely impact the return on that investment as expressed in U.S. dollars. This is because the expected amount of local currency returned on the investment would purchase fewer U.S. dollars.

Management should attempt to anticipate future price levels and consider their effects on the estimates used in capital investment analyses. Changes in anticipated price levels could significantly affect the analyses.

Qualitative Considerations

Some benefits of capital investments are qualitative in nature and cannot be easily estimated in dollar terms. If management does not consider these qualitative considerations, the quantitative analyses may suggest rejecting a worthy investment.

Qualitative considerations in capital investment analysis are most appropriate for strategic investments. Strategic investments are those that are designed to affect the company's long-term ability to generate profits. Strategic investments often have many uncertainties and intangible benefits. Unlike capital investments that are designed to cut costs, strategic investments have very few "hard" savings. Instead, they may affect future revenues, which are difficult to estimate. An example of a strategic investment is Nucor's decision to be the first to invest in a new continuous casting technology that had the potential to make thin gauge sheet steel and thus open new product markets (2005). Nucor's new investment was justified more on the strategic importance of the investment than on the end economic analysis. As it turned out, that investment was very successful.

Quantitative considerations that may influence capital investment analysis include product quality, manufacturing flexibility, employee morale, manufacturing productivity, and market opportunity. Many of these qualitative factors may be as important, if not more important, than the results of quantitative analysis. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1045-1048*

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Accounting: The Language of Business - Vol. 1 (Part 157)

Anyone with an engineering frame of mind will look at [accounting standards] and want to throw up.

Charlie Munger

 Capital Investment Analysis (Part C)

by

Charles Lamson 

Net Present Value Method

The net present value method analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows. It is sometimes called the discounted cash flow method. The interest rate (return) used in net present value analysis is set by management. This rate, sometimes termed the hurdle rate, is often based upon such factors as the nature of the business, the purpose of the investment, the cost of securing funds for the investment, and the minimum desired rate of return. If the net present value of the cash flows expected from all proposed investment equals or exceeds the amount of the initial investment, the proposal is desirable.

To illustrate, assume a proposal to acquire $200,000 of equipment with an expected useful life of five years [no residual value ( the estimated value of a fixed asset at the end of its lease term or useful life)] and a minimum desired rate of return of 10%. The present value of the net cash flow for each year is computed by multiplying the net cash flow for the year by the present value factor of $1 for that year. For example, the $70,000 net cash flow to be received on December 31, 2023, is multiplied by the present value of $1 for one year at 10% (0.826) to yield $48,560, and so on. The amount to be invested, $200,000, is then subtracted from the total percent value, $2,900, as shown below. The net present value indicates that the proposal is expected to recover the investment and provide more than the minimum rate of return of 10%.

When capital investment funds are limited and the alternative proposals involve different amounts of investment, it is useful to prepare ranking of the proposals by using a present value index. The present value index is calculated by dividing the total present value of the net cash flow by the amount to be invested. The present value index for the investment in the previous illustration is calculated as follows:

If a business is considering three alternative proposals and has determined their net present values, the present value index for each proposal is as follows:

Although Proposal A has the largest net present value, the present value indices indicate that it is not as desirable as Proposal B. That is, Proposal B returns $1.08 present value per dollar invested, whereas Proposal A returns only $1.07. Proposal B requires an investment of $80,000, compared to an investment of $100,000 for Proposal A. Management should consider the possible use of the $20,000 difference between Proposal A and Proposal B investments before making a final decision.

An advantage of the net present value method is that it considers the time value of money. A disadvantage is that the computations are more complex than those for the methods that ignore present value. In addition, The net present value method assumes that the cash received from the proposal during its useful life can be reinvested at the rate of return used in computing the present value of the proposal. Because of changing economic conditions, this assumption may not always be reasonable.

Internal Rate of Return Method

The internal rate of return method uses present value concepts to compute the rate of return from the net cash flows expected from capital investment proposals. This method is sometimes called the time adjusted rate of return method. It is similar to the net present value method, in that it focuses on the present value of the net cash flows. However, the internal rate of return method starts with the net cash flows and, in a sense, works backwards to determine the rate of return expected from the proposal.

EXHIBIT 2 Partial Present Value of an Annuity Table

To illustrate, assume that management is evaluating a proposal to acquire equipment costing $35,530. The equipment is expected to provide annual net cash flows of $10,000 per year for five years. If we assume a rate of return of 12%, we can calculate the present value of the net cash flows, using the present value of an annuity table in Exhibit 2, from part 156 and reintroduced above. These calculations are shown in Exhibit 3.

EXHIBIT 3  Net Present Value Analysis at 12%

In Exhibit 3, the $36,050 present value of the cash inflows, based on a 12% rate of return, is greater than the $33,530 to be invested. Therefore, the internal rate of return must be greater than 12%. Through trial and error procedures, the rate of return that equates the $33,530 cost of the investment with the present value of the net cash flows is determined to be 15%, as shown below.

Such trial and error procedures are time consuming. However, when equal annual net cash flows are expected from a proposal, as in the illustration, the calculations are simplified by using the following procedures (Equal annual net cash flows are assumed in order to simplify the illustration. If the annual net cash flows are not equal, the calculations are more complex, but the basic concepts are the same.)

1. Determine a present value factor for an annuity of $1 by dividing the amount to be invested by the equal annual net cash flows, as follows: Present value factor for an annuity of $1 = Amount to be invested / Equal annual net cash flows.

2. In the present value of an annuity of $1 table, locate the present value factor determined in (1). First locate the number of years of expected useful life of the investment in the Year column, and then proceed horizontally across the table until you find the present value factor computed in (1).

3. Identify the internal rate of return by the heading of the column in which the present value factor in (2) is located.

To illustrate, assume that management is considering a proposal to acquire equipment costing $97,360. The equipment is expected to provide equal annual net cash flows of $20,000 for seven years. The present value factor for an annuity of $1 is 4.868, calculated as follows:

For a period of seven years, the partial present value of an annuity of $1 table indicates that the factor 4.868 is related to a percentage of 10%, as shown below. Thus, 10% is the internal rate of return for the proposal. 

If the minimum acceptable rate of return for similar proposals is 10% or less, then the proposed investment should be considered acceptable. When several proposals are considered, management often ranks the proposals by their internal rates of return. The proposal with the highest rate is considered the most desirable.

The primary advantage of the internal rate of return method is that the present values of the net cash flows over the entire useful life of the proposal are considered. In addition, by determining a rate of return for each proposal, all proposals are compared on a common basis. The primary disadvantage of the internal rate of return method is that the computations are more complex than for some of the other methods. However, spreadsheet software programs have internal rate of return functions that simplify the calculation. Also, like the net present value method, this method assumes that the cash received from a proposal during its useful life will be reinvested at the internal rate of return. Because of changing economic conditions, the assumption may not always be reasonable. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1040-1044*

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