1、Some notes on reports1.Good reports have the following attributes:StructuredLogicalClearly worded2.Most groups may draw different conclusions from income statement and balance sheet.This report highlights the difficulty of analyzing financial statements and a business,you need more information,backg
2、round knowledge,current events,etc.to stay informed.Event studies and Market anomalies1.Realized rate of return(or return)（实现回报）Firm A stocks close price on 12/31/00 was$1,and on 12/31/01 is$1.15,then Realized rate of return for 2001 is 15%2.Required rate of return(normal rate of return)（正常回报，预期回报）I
3、f firm As CAPM beta is 1.1,risk-free rate is 5%,and market risk premium is 6%,then firm As required rate of return according to CAPM0.05+1.1*0.06=11.6%3.Abnormal rate of return(or abnormal return)（超常回报）15%-11.6%=3.4%for 2001Portfolio returns and Portfolio abnormal returns in 2001-Compared to CAPM de
4、mandsRealized rate of returnRequired rate of return(CAPM)Abnormal returnStock A15%11.6%3.4%Stock B20%15%5.0%Stock C-5%10%-15%(Equally-weighted)beta-adjusted abnormal return to the portfolio:(3.4+5.0-15)/3=-2.2%Portfolio returns and Portfolio abnormal returns in 2001 Compared to the general marketRea
5、lized rate of returnRealized return on DJ 30 IndexAbnormal returnStock D15%5%10%Stock E20%5%15%Stock F-5%5%-10%(Equally-weighted)market-adjusted abnormal return to the portfolio:(10+15-10)/3=5%Portfolio returns and Portfolio abnormal returns in 2001 Compared to the general market Another caseRealize
6、d rate of returnRealized return on DJ 30 IndexAbnormal returnStock G10%5%5%Stock H9%5%4%Stock I-15%5%-20%(Equally-weighted)market-adjusted abnormal return to the portfolio:(5+4-20)/3=-3.67%Hedging strategy and hedge returnSuppose that,God forbid,on Jan.1,2001,you know the end results in the two prev
7、ious slides,then you buy stocks D,E,F(using$1M)and sell short（空卖）stocks G,H,I(for$1M).Now you have a hedge portfolio with six stocks.Your investment in this hedge portfolio is zero dollar.On Dec.31,2001,your realized return is(5-(-3.67)=8.67%.This is your hedge return.Event studies and Market anomal
8、iesWe know:Net Income=Cash flow from operation(cash earnings)+accrued earningsOn April 1 of every year,we rank all stocks on the ratio of accrual earnings/total assets,then we buy stocks whose ratios are in the lowest 10%of all stocks(low accrual stock),and sell short stocks whose ratios are in the
9、highest 10%of all stocks(high accrual stocks).Other analogical(类似）anomalies1.P/B anomaly2.P/E anomalyFinancial statement analysis is about 1)identifying mis-valued individual stocks,and 2)identifying accounting-based systematic market anomaliesOutline for the rest of this course1.Analyze accounts in
10、 financial statements:The measurement of each accountEarnings management through specific accountsValuation implications of specific accounts2.Ratio analysis:Profitability analysis Growth analysis Liquidity analysis and solvency analysisEarnings management common techniques1.Selecting accounting pri
11、nciples or standards when GAAP allows a choice,e.g.（例如的简写）,LIFO/FIFO for inventory costing(先进先出/后进先出）2.Making estimates in the application of accounting principles,e.g.,bad debts ratio（坏帐准备率）3.Timing transactions or constructing transactions to allow recognizing a)revenues or expense in regular oper
12、ation,e.g.,early delivery of products（提前送货）b)non-recurring or one-time items,e.g.,take asset impairment charge（资产减值）Chapter 6:Revenue recognition and Account receivable1.Revenue recognition principles2.Recognize revenues at the time of sale 3.Account receivable and bad debts4.Manage earnings through
13、 account receivables5.Recognize revenues at a time other than the time of sale6.Manage earnings through revenue recognition Chapter 6:Revenue recognition and Account receivableSales are the core activity of a companyCredit sales are used to promote salesOnce a company has credit sales,it runs the ri
14、sk of some customers not payingSome customers not paying generates bad debtsBut no credit sales is even worse,because the company loses businessRevenue recognition:Realization principle1.A firm has performed all,or a substantial portion of the services it expects to provide or,in the case of product
15、 warranties,can forecast with reasonable precision the cost of providing future services-obligations2.The firm has received cash,a receivable,or some other asset capable of reasonably precise measurement or,if the firm has offered to let the customer return the product for refund,the firm can estima
16、te the returns with reasonably precision-benefitsRecognize revenues at the time of saleAssume the following are the balances of I-sell company on Jan.1,2001.Account ReceivableAllowance(reserves)for bad debts（坏帐准备）Customer group A:$1M(3 months old)Customer group B:$3M(6 months old)$4M$70,000$70,000In
17、 2001,I-Sell company sold$2M goods to customer group C on account（赊帐）on July 1,2001,so the company:Dr.Account Receivable 2M Cr.Sales Revenue 2M The company expects to collect cash from this customer group in June 2002.Assume the only cost/expense item in 2001 is COGS of$1.5M,then the income statemen
18、t for 2001:Revenue 2M-COGS 1.5M Net Income 0.5MIn Match 2002,customer I-bankrupt from customer group C defaults（拒付）on the money he owes the company,$15,000.What shall the company do?Dr.bad debt expense 15,000（坏帐费用）Cr.Account Receivable 15,000What is wrong with this treatment?Which accounting princip
19、le does this treatment violate?So the direct write-off method（直接注销法）of bad debts violates the matching principle of accounting.The manager in 2001 could sell products like crazy by making unsafe credit sales,which results in high revenues and high earnings.The Manager then collects huge-amount of ea
20、rnings-based bonus and leaves the company.If the company changes its manager on Jan.1,2002,then the new manager takes the blame for bad judgment made by or bad behavior of the old manager.Therefore,we should recognize the bad debt expense in the year the credit sale is made,i.e.,in 2001,not in 2002
21、when the default actually occurs.But in 2001,we do not know whether any customer,let alone（更别提）a particular customer,will default.So we have to estimate bad debt expense according to our experience.Allowance method（预提法）Let us estimate bad debt expense at the time of sales in 2001.According to I-Sell
22、 companys past experience,1%of total new account receivables from current year credit sales will ultimately become uncollectible.In 2001,$2M credit sales*1%=20,000This amount should go into 2001 income statement since it matches the revenues recognized in 2001.Revenue 2M-COGS 1.5M -Bad debt expense:
23、0.02M Net Income 0.48MAllowance method-Journal entriesWhen the credit sale was made in 2001,Dr.Account Receivable 2MCr.Revenue 2MDr.Bad debt expense 20,000 Cr.Allowance for bad debts 20,000Understand allowance:Since the birth of a child,each year the parents put$3,000 into a bank account earmarked f
24、or the childs college education.We may call the money in the bank account allowance.Basically,allowance method puts something aside to prepare for an event to occur in the future.Allowance method-T-accountsOn Dec.31,2001,the T-accounts look like this:Account ReceivableAllowance for bad debtsCustomer
25、 group A:$1M(15 months old)Customer group B:$3M(21 months old)$4MCustomer group C:$2M(6 months old)$6M$70,000$70,000$20,000$90,000Allowance method-balance sheetCurrent assetsCash#Account receivable 6MLess:allowance for bad debts 0.09MNet account receivable 5.91MInventory#Estimating bad debt expense-
26、two method1.The method we used to estimate bad debt expense is called percentage-of-sales method.That is,based on our historical experience,we know NEW credit sales made in the current year will has 1%uncollectible.2.Another method is called aging method.Estimate bad debt expense-aging methodOn 12/3
27、1/01We look at the account receivable T-account on Dec.31,2001,and say to ourselves,“Gee,the longer a customer owes us money,the more likely he will in the end defaults”.Then we should estimate the possibility of defaults for the three customer groups separately.GroupAcct ReceivableDefault rateBad d
28、ebts expenses B3M(21 months old)3%90,000A1M(15 months old)2%20,000C2M(6 months old)1%20,000Total6M130,000Remember,$130,000 is all bad debt expenses we should recognize on our outstanding account receivables.But up to Jan.1,2001,we already recognized$70,000.Allowance for bad debts$70,000$130,000$?So
29、the bad debt expense for 2001 is NOT$130,000,it is$60,000=$130,000-$70,000Dr.Bad debt expense 60,000Cr.Allowance for bad debts 60,000Then 2001 I/S and B/S areRevenue 2M-COGS 1.5M -Bad debt expense:0.06M Net Income 0.44MCurrent assetsCash#Account receivable 6MLess:allowance for bad debts 0.13MNet acc
30、ount receivable 5.87MInventory#In Match 2002,customer I-bankrupt from customer group C defaults on the money he owes the company,$15,000.What shall the company do?Under direct write-off method,they do:Dr.bad debt expense 15,000Cr.Account Receivable 15,000This recognizes expense of 2001 in 2002.Under
31、 allowance method,they do:Dr.Allowance for bad debts 15,000 Cr.Account receivable 15,000This recognizes expense of 2001 in 2001.Because this journal entry has not impact on 2002 income statement,and no net impact on 2002 balance sheet.(why?)Perfect!Optimal credit sales policy1.Most companies have to
32、 use credit sales to survive2.Once you have credit sales,there will be uncollectibles3.Although it sounds odd（奇怪）,the optimal amount of uncollectible is NOT zero4.Because if you want to make sure every customer pays,1)you need to spend costly resources to screen（识别）customers;2)you reject customers w
33、ho do not pass the screening but would ultimately pay;3)customers do not do business with you to begin withOptimal credit sales policyYou benefit from selling to a group of customers if the uncollectible from this group is less than your gross profit from selling the goods to this group.Assume this
34、group buys from you on account 100%Additional Revenues-Additional COGSAdditional Gross Profit-Additional Expense(other than bad-debt expense related to this new group)$0*-Bad debt expense related to this new groupAdditional Net Income*Assume this category of expenses is constant with or without sell
35、ing to this new group,so the additional portion is zero)Earnings management using bad-debt allowanceGroupAcct ReceivableDefault rate Bad debts expenses B3M(21 months old)3%90,000A1M(15 months old)2%20,000C2M(6 months old)1%20,000Total6M130,000Earnings management using bad-debt allowanceGAAP requires
36、 companies to estimate default rates basing on 1)historical experience,2)industry norm（规范）,3)other considerations.But the discretion（选择余地）left to management is still big.In the previous example,suppose managers decreases default rates by 0.5%,bad debt expense will decrease by$30,000,then net income
37、will be$0.47M instead of$0.44M.This act may increase managers bonus and company stock prices.Note that in this example,we have assumed that the true default rates are the original ones.Sears RoebuckDo companies always underestimate bad debt ratios to increase earnings?NO!Suppose you are Arthur Marti
38、nez in 1993.You just became CEO of Sears Roebuck.You want to show that you are THE man!So you want to have increases in earnings over the next few years.What can you do from account receivables perspective?Sears RoebuckSears Roebuck has a large credit card division(in the U.S.,many large retailers h
39、ave credit card divisions).For Sears Roebuck,credit cardholders unpaid account balances are account receivables.So Sears has to estimate bad debt expenses.Shortly after Mr.Martinez took the helm,Sears increased its allowance for bad debts to$2 billion,a far bigger amount that other retailers.Sears R
40、oebuckOf course,when Sears increased allowance,it had to debit bad debt expense,which in turn vastly decreased 1993 net income.But it was ok for Mr.Martinez because he just took over the job.No one would blame him for a bad fiscal year 1993.In 1994,1995,and 1996,actual customer default was much smal
41、ler than(falsely)anticipated in 1993.So the allowance was too large.Remember,every time a customer defaults,company Dr.Allowance for bad debts#Cr.Account receivable#Sears RoebuckNow because in 1994-1996,there was always enough balance in the allowance account,Sears did not need to estimate new bad d
42、ebt expenses.So in these three years,SearsDr.Bad debt expenses$0(#for simplified illustration only)Cr.Allowance for bad debts$0What was the effects?In these three years,Sears earnings were higher than if it had not take the big allowance in 1993.Mr.Martinez achieved his goal!Revenue recognition at a
43、 time other than the time of sale1.Long-term contractors:Percentage-of-completion methodCompleted contract method2.Insurance companies3.Franchisors:Installment methodCost Recovery methodLong-term contract-percentage-of-completion methodA construction company is building a bridge for a city governmen
44、t;1)The total cost of the bridge can be reasonably estimated,and 2)The total price charged to the city government is set,and 3)It takes three years to finish the bridge.Note:in this case,the time of sale is at the end of the third year,when the bridge is completed and passed to the city government f
45、or use.Under percentage-of-completion method,if the bridge is 30%done in year 1,the company can recognize revenues and costs 30%of their respective totals.Long-term contract-Completed contract methodIn the bridge example,under completed contract method,in the first two years,the company does not rec
46、ognize any revenues or costs.In the third year when the bridge is finished,the company recognizes total revenues and total costs in third-year income statement all at once.Note:under both methods,the company may still receive cash from the government in the first two years as partial payments.The ca
47、sh payments just do not show up in first two-years income statementsInsurance companiesCompany Receive premium Payment of$100,Invest in stock marketCompany Receive premium Payment of$100,Invest in stock market;Receive dividend From year 1Stock investment of$10Invest the$10 onStock market againSimila
48、r transactionIf policy holders run Into accident,pay Coverage of$1,000;If policy holders Stop insurance,then Nothing occurs;The company keeps All the money.Year 1When does the insurance company recognize revenues?Insurance companies1.When the policy holders terminate their coverage because the claim
49、 of coverage is very uncertain.For example,a car accident may result in minor injury only,or may cause death.2.Or each period the insurance coverage is provided.Despite the uncertainty about one particular policy holders,as a pool,the probability of accidents and the amount of damage can be reasonab
50、ly estimated.FranchisorsMcDonalds(franchisor)in many places sells franchise rights to individuals(franchisees).Franchisees can then use McDonalds name,advertising and other services.In return,Franchisee pays McDonalds a franchise fee of$50,000.Since small business can not afford to pay at once,the f
