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://www.trinity.edu/rjensen/caseans/000index.htm
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://www.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 |
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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
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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://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Bob Jensen's finance and investment helpers are at
http://www.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://www.trinity.edu/rjensen/FairValueDraft.htm
Comments would be helpful.
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
http://www.trinity.edu/rjensen/roi.htm
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
http://www.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://www.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://www.trinity.edu/rjensen/FairValueDraft.htm
http://www.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://www.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://www.trinity.edu/rjensen/FairValueDraft.htm
Comments would be helpful.
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
http://www.trinity.edu/rjensen/roi.htm
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
http://www.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://www.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
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-
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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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://www.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://www.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://www.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's threads on accounting theory are
at
http://www.trinity.edu/rjensen/theory.htm
You can read more about fair value at
http://www.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://www.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://www.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.
Introduction
to Valuation
Bob Jensen's site on The Controversy Over Fair Value
(Mark-to-Market) Financial Reporting ---
http://www.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://www.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/
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://www.trinity.edu/rjensen/theory01.htm#CoreEarnings
Bob Jensen's threads on accounting theory ---
http://www.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://www.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://www.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://www.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://www.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://www.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
"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 |
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.
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
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://www.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://www.trinity.edu/rjensen/theory01.htm#FAS150
Bob
Jensen's bookmarks for financial ratios ---
http://www.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://www.trinity.edu/rjensen/roi.htm
Bob
Jensen's threads on accounting theory are at
http://www.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://www.trinity.edu/rjensen/theory01.htm#EMH
Bob Jensen's threads on market efficiency (EMH) are at
http://www.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://www.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 Financial Reporting
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.
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
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://www.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://www.trinity.edu/rjensen/roi.htm
Also see http://www.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://www.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://www.trinity.edu/rjensen/roi.htm
Also see http://www.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://www.trinity.edu/rjensen/Bookbob3.htm#080512Calculators
"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.
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://www.trinity.edu/rjensen/theory01.htm#EMH
Bob Jensen's threads on market efficiency (EMH) are at
http://www.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://www.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://www.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://www.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://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob Jensen's threads on valuation are at
http://www.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 |
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Relative Valuation |
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Option Pricing Approaches to Valuation |
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Acquisition Valuation |
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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 finance and investment helpers are at
http://www.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).
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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.
|
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
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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
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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.
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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
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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://WWW.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
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
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://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
http://www.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://www.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 ---
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