Chapter 4 Understanding Financial Statements

Financial statements will be studied in great detail in accounting courses. Here we simply go over them briefly from finance perspective. First we will discuss views about accounting from Jack Treynor and Fischer Black, two of the foremost thinkers in finance.

In 1972, jack Treynor sounded another alarm in an article titled “The Trouble with Earnings.” This time his target was the accountant, “the oldest of the professionals in the investment industry,” and therefore the one most resistant to replacing craft with science, and the one most insistent on holding fast to “accounting ritual” in the face of rational judgment. The problem was that the most important output of the accounting ritual, namely a measure of “accounting earnings,” bears no very close relationship to the “economic earnings” that the security analyst wants for his caslculation of the value of the firm.

In Treynor’s view, the security analyst poses a deadly threat to the accountant, since the security analyst’s modern and scientific method of judging the worth of a company is demonstrably superior. What the world wants to know is the value of the firm, not the change in value with which the accountant is obsessed. There is no room for both analyst and the accountant, because one is rational and the other is ritual. The best thing would be for the accountant to disclose as much information as he (or she ) knows about the firm, with as little ritualistic processing as possible, and leave the rest up to the analyst.

Fischer’s lifelong engagement with the problem of accounting starts here but characteristically he finds a more positive approach. Although there could be no question that the theories of modern finance require far-reaching changes in accounting practice, there could also be no question that at the end of the day the role of the accountant would remain important and distinct from that of the security analyst. Simple disclosure could not be the answer, because anything disclosed to the analyst is also disclosed to competitors. In this respect, “an accountant’s job is to conceal, not to reveal.” Even more, because the accountant is privy to a great deal of proprietary information inside the firm, he should in principle be able to produce a better estimate of the firm’s value than the analyst. The goal should therefore not to replace the accountant but to redirect his attention toward the task of estimating value. (p. 224, Mehrling, 2005)

We will read this chapter from Fischer Black’s perspective. Although we can criticize a lot of methodologies in accounting practice, the alternatives often have more serious consequences.

The Basic Accounting Statements

Balance sheet

Income statement

Statement of cash flows

Informational Needs

Assets-in-place

Growth assets: The value of growth assets represents market power of a firm.

In Figure 4.4, A Financial Balance Sheet, Debt is of fixed maturity and Equity is described as of perpetual life. In real life, firms, just like humans, will die. Instead of describing firm life to be perpetual, it is more precise to give it a finite life. This precision will help improve the quality of valuation of a firm.

Asset Measurement and Valuation

Accounting Principles Underlying Asset Measurement

An asset is any resource that has the potential to either generate future cash inflows or reduce future cash outflows. Although this general definition is broad enough to cover almost any kinds of asset, accountants add a caveat that for a resource to be an asset, a firm has to have acquired it in a prior transaction and be able to quantify future benefit with reasonable precision.

Historical cost

Book value: Historical cost adjusted for depreciation, or market value if lower than the historical cost.

Three principles underlie the way assets are valued:

An abiding belief in book value as the bet estimate of value

A distrust of market or estimate value

A preference for underestimating value rather than overestimation

Measuring Asset Value

Fixed assets: long term assets of the firm, such as plant, equipment, land, and buildings. Fixed assets can be depreciated in straight line or accelerated.

Current assets: short term assets, including inventory of both raw material and finishing goods, receivable.

Valuing inventory

First in, first out: (FIFO)

Last-in, first-out: (LIFO)

Weighted Average

Financial assets: investments in the assets and securities of other firms.

Marking-to-Market: Investment banking vs. commercial banking, equity swap, why investment banks will do it, commercial banks won’t? trade on low margin, why futures market allows trade on margin?

Majority active investment, represents more than 50% of the overall ownership. It leads to a consolidation of the balance sheets of the two firms. Example, AOL sold 1% of its ownership of AOL-Europe to Goldman Sachs before its merger with Time Warner.

Intangible assets: patents, trademarks, goodwill.

Goodwill: purchase price minus tangible asset.

How Well Do Accountants Categorize Assets and Measure Value?

Value of Assets-in-Place

Book value vs. market value: Book value, with all kinds of shortcomings, limits the scope of scandals.

Value of Growth Assets

Accounting measures of growth assets are at best shoddy and at worst nonexistent. Growth value is best left to financial analyst than accountants to minimize abuse.

Valuing the Research Asset

Under the rational that the products of research are too uncertain and difficult to quantify, accounting standards have evolved requiring all R&D expenses to be expensed in the period in which they occur. This requirement has several consequences, but one of the most profound is that the value of the assets created by research does not show up on the balance sheets as part of the total assets of the firm. This, in turn, creates ripple effects for the measurement of capital and profitability ratios for the firm.

Comments: It is often for good reason for a standard to form. While expensing R&D has significant shortcomings, capitalizing R&D will have much more serious consequences. For one thing, R&D is by nature much less transparent than fixed assets. R&D is always very secretive. The high level of information asymmetry will determine that capitalizing R&D will create a mountain of accounting scandals.

Fischer Black pointed out: Simple disclosure could not be the answer, because anything disclosed to the analyst is also disclosed to competitors. In this respect, “an accountant’s job is to conceal, not to reveal.” Since accountants are paid by firms, it is unlikely that they will reveal sensitive information to others. It is the job of financial analysts to uncover relevant information for investors.

Warren Buffet once stated that if a firm always need high capital expense, it doesn’t really have much competitive advantage. In other words, continuous R&D expenses are really expenses, not much capitalization.

Measuring Financing Mix

Accounting Principles Underlying Liability and Equity measurement

Liability:

1. It must be expected to lead to a future cash outflow or the loss of a future cash inflow at some specified or determinable date.
2. The firm cannot avoid the obligation
3. The transaction giving rise to the obligation has to have happened.

Measuring the Value of Liabilities and Equities

Current liabilities: All obligations that the firm has coming due in the next year.

Long-term debt

Other long-term liabilities: such as long term pension funds.

Writing in 1972, Jack Treynor sounded an alarm. Corporations were promising pension benefits to their employees, but taking no very substantial steps to ensure their ability to fulfill on their promises. “Ultimately many pension beneficiaries are going to wake to find that their investment losses have deprived them of their main source of support in retirement.” Treynor urged that promised pension benefits be recognized as proper liabilities of the firm, and hence as claims not just to specifically designated pension fund assets but also to the general assets of the firm itself. In his mind, the ambiguous status of pension benefits served to disguise a fundamental conflict of interest. If the firm did well, shareholders enjoy the upside, while if the firm did poorly, pension beneficiaries absorbed the downside. The ambiguity served to increase current stock value to the benefit of shareholders, but only to the extent that pension promises were a fraud. ( p, 220, Mehrling, 2005)

It is marvelous that Jack Treynor pointed out in 1972, long before pension problems surface seriously. It is also marvelous that even today, after Jack Treynor pointed the problem more than 30 years ago, many established firms, such as auto manufacturers and airliners, are still struggle with the problem of pension under funding. What has been the main solution? How it affects the financial obligations of employers and pension benefits to employees?

How Well Do Accountants measure the Financing Mix of the Firm

Classification into Debt and Equity

In the categorization of financing into debt and equity, the treatment of hybrid securities is the most troublesome component. Consider, for instance, the example of convertible bonds, which are part debt and part equity (i.e., the conversion option). The accounting convention is to treat these securities as debt until they get converted and then to treat them as equity. A far more rational approach is to try to break convertible bonds into their conversion option and straight bond components, and to treat the first as equity and the second as debt.

Comments: This could cause a lot of technical difficulties. First, one has to evaluate the bond part and equity part. One needs to find the proper discounting rates for the convertible bonds, which are not easy for firms issuing CB are generally not rated. Second, as long as CB is not converted, firm has to pay dividend and CB owners don’t have voting rights. So CB functions as bonds and not equities. But mainly CB valuation is highly technical, which will add much cost to accounting.

Measuring Earning and Profitability

Accounting Principles underlying Measurement of Earnings and Profitability

Accrual accounting: the revenue from selling a good or service is recognized in the period in which the good is sold or the service is performed (in whole or substantially). A corresponding effort is made on the expense side to match expenses to revenues. Cash-based system of accounting: Revenues are recognized when payment is received, while expenses are recorded when paid.

The difference between Accrual accounting and Cash-based system of accounting is another demonstration about the nature of time flow in business practices. Whether one adopt one or another approach depends on the relative difficulty of each task. If the business side is more difficult and more crucial, it will be natural to adopt accrual accounting. If the collecting of money is difficult, the accounting system may tilt toward cash based system.

Measuring Accounting Earning and Profitability

Revenue recognition and the matching principle

Operating expenses

Adjusting income to reflect research expenses and operational leases

Nonrecuring items in earning reports

How Well Do Accountants Measure Profitability?

Not only is accounting depreciation almost never equal to economic depreciation, but there is almost no attempt to estimate economic depreciation.

Comments: What about the alternative? Estimating economic depreciation will need great amount of expertise and high cost. It will also open doors to manipulation.

The other problem with the cost categorization is the inconsistency in its applications, as evidenced in the treatment of operational leases and research expense as operating expenses.

Comments: High R&D firms generally require continuous high R&D expenditures, which suggested that R&D in these companies are real expenses.

Measuring Risk

Accounting principles Underlying Risk Measurement

1. The risk being measured is the risk of default. The broader equity notion of risk does not seem to receive much attention. Comments: Accounting measure the probability of survival, which is of utmost important to a business. Financial analyst measure the risk of equity returns, which, frankly, is of much lower level of importance to society.
2. Accounting measures of risk generally take a static view of risk by looking at the firm’s capacity at a point in time to meet its obligation. For instance, when ratios are used to assess a firm’s risk, the ratios are almost always based on one period’s income statement and balance sheet. Comments: a long term measure will inevitably increase measurement errors, which make results less useful. Anyway, a long term measure is of not much help because business environment and strategy changes very much over the long term. It is the management’s job to understand long term perspective. An accounting measure is to provide short term indicator of a business’ health.

Accounting Measures of Risk

Disclosures in financial statements

Contingent liabilities: In recent years, FASB requires that derivatives be disclosed as a part of a financial statement. For example, a forward contract has zero value and zero liability when it was first established. It used to be off balance sheet. Now it is on balance sheet.

Financial ratios

Current ratios = Current Assets/ Current liabilities

Quick ratio = (Cash + Marketable Securities)/ Current Liabilities

Summary

For a system of accounting to be viable, indeed for other social system to be viable, it has to satisfy the following requirements

1. The system should be of relatively low cost: The accounting standard that marks value to book value is of low cost. A system that requires marking to market is much more expensive. Values of different items have to be frequently checked and updated. Very often, there are no easily available data from the market. For a small company, (most companies are small) there is no easy way to get good measure of its own discount rate. Land value cannot be easily assessed in an area where real estate transactions are not active. In general, measurement of higher quality is more expensive.
2. The system has to be simple enough so many people can work competently on it. For example, many sophisticated risk management techniques are employed successfully in investment banks. But they require very expensive technology and highly trained and expensive people, who need both good business sense and high level of mathematical sophistication. While deep pocket investment banks can hire small amount of highly skilled people at high price tags to handle the intricacies of those sophisticated risk management tools, it is impossible for the accounting profession, which has millions of practitioners, to adopt the same risk management systems from investment banks, although they measure risks more accurately.
3. The system should not be prone to manipulation: Expense R&D often under state earnings at a period with heavy R&D expenditure. But capitalizing R&D will create a mountain of accounting scandal. How much to capitalize? What is the amortization rate? Which par of R&D expense to capitalize? Like other parts of businesses, R&D involves a lot of administration. Does the administration part of R&D be capitalized? If so, why not other administration expenditures? The most expensive part of R&D is salary. Why should only salaries of R&D people be capitalized? Should CEOs salaries be capitalized? Capitalize R&D expense, while solving one problem, will generate a lot other problems.
4. Any measurement will disturb the object that is being measured. This is a fundamental insight gained from quantum mechanics. From uncertainty principle, any measurement will cause the system to deviate from its original state. If the measurement and disclosure is very detailed, it will discourage companies from innovative activities because any new ideas will be quickly disclosed to the public and competitors.

References

Mehrling, Perry, (2005) Fischer Black and the Revolutionary Idea of Finance, John Wiley and Sons.

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