Bob Jensen's Threads on Return on Business Valuation, Business Combinations, 
Investment (ROI), and Pro Forma Financial Reporting

 

Bob Jensen at Trinity University

There are many different types of "returns"

The Dupont Formula and Its Extensions

Introduction to Fair Value Accounting

The Expectations Gap Between Professional Valuation Versus What Students Learn in College

New and Old Performance and Risk Metrics  (including Alpha and Beta)

Introduction to P/E Ratios and Business Valuation

Dividends and Dividend Yield

EBBS Eranings Before BS

Equity Valuation Models

How to Value a Website  

Fundamentals Analysis and Value Investing

Long-Term Pricing and Valuation of Products (Teaching Case on Tesla Electric Cars) 

Business Valuation Blunders by the Pros:  The Winner's Curse

Controversial Issues in Pro Forma Financial Reporting

E-Business and E-Commerce  ROI Complications

Putting ROI Through The Wringer 

Fair Value and Fair Value Hedges

Forecasting  

KPMG's Business Valuation and Risk Measurement

Measuring Value of Products and Services

Free Online Real Estate Valuations

Business Valuation References and Resources (Including Business Combinations) 

Video
"How Managers Should Read Financial Statements," Harvard Business Review Blog, February 19, 2013 --- Click Here
http://blogs.hbr.org/video/2013/02/how-managers-should-read-finan.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

CNBC Explains Accounting --- http://www.cnbc.com/id/100000341

Bob Jensen's threads on accounting theory

 

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 

Bob Jensen's theory document related to valuation of intangibles is at 
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm
 

Real Options, Option Pricing Theory, and Arbitrage Pricing Theory 
http://www.trinity.edu/rjensen/realopt.htm

Things to Consider When Valuing Options ---
http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

Bob Jensen's theory documents related to valuation are linked at 
http://www.trinity.edu/rjensen/theory

Bob Jensen's Documents on e-Commerce and e-Business 
http://www.trinity.edu/rjensen/ecommerce.htm
 

Bob Jensen's threads on fair value accounting are at various links:

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//theory/00overview/theory01.htm#FairValue

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 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

 

This is what Professor Jim Mahar says about ERisk in the March 24, 2003 edition of TheFinanceProfessor (an absolutely fabulous newsletter) --- www.FinanceProfessor.com 

Erisk.com. I simply love the site. I know it has been site of the week before, but it is so good, it earned it again. Try it, you’ll love the case studies and the newsletter! http://www.erisk.com

ERisk --- http://www.erisk.com/ 

ERisk is the leading provider of strategic solutions for risk and capital management. We deliver a unique combination of world-class analytics for risk-based capital, strategic risk management expertise, risk transfer advice and risk information.

You can find out more about our products and services in the Overview section. On this page, you can find out more about the people and ideas that power our company.

The ERisk Report --- http://www.erisk.com/about/about_company.asp?ct=n#report 

The ERisk Report is a concise monthly briefing for senior financial executives. Every month, contributors from ERisk's team of risk management experts address today's most pressing issues in strategic risk and capital management. Sign up today for your personal copy of this cutting-edge publication!

Vol 1.6: Measuring the return on risk management; leveraging the economic benefits of risk management

Vol 1.5: Putting the real value on customer relationships; rolling out risk management

Vol 1.4: Making risk more transparent; fed takes pulse of economic capital practices

Vol 1.3: Credit scoring: robots versus humans; James Lam's three lessons from Enron

Vol 1.2: Weathering credit losses; regulators line up behind economic capital

Vol 1.1: Revamping your credit ratings system; measuring bank profitability

The ERisk Portal --- http://www.erisk.com/portal/home.asp 
Resources for Enterprise Risk Management

ERisk today continues to successfully develop and install its analytics at client sites, conduct high-value consulting engagements, offer unbiased advice on risk transfer alternatives, and attract thousands of readers to the ERisk portal.

 

 

There Are Many Different Types of "Returns"

"Which Type of Returns Are You Referring To?" by Barry Ritholtz,, March 28, 2013 ---
http://www.ritholtz.com/blog/2013/03/real-nominal-total-aftertax/

Jensen Comment
Barry only a few of the many types of returns that should be understood by our students. For a more complete summary scroll down this document.

One of the most popular downloads at my Website compares several types of returns is the wtdcase2a.xls at the bottom of the list of files at
http://www.cs.trinity.edu/~rjensen/Excel/
Note the tab to the Answers spreadsheet.
Students can put in their own input numbers and then observe the sensitivity of the outcomes to things like inflation rates.

From the Harvard Business School:  Working Knowledge --- http://hbswk.hbs.edu/
Topics --- http://hbswk.hbs.edu/topics/
Accounting and Control is listed under Finance --- http://hbswk.hbs.edu/topics/accountingandcontrol.html

From the CPA Newsletter on May 22, 2014

CFOs ocus on misaligned marketing ROIs with eye on greater accuracy
CFOs are stepping up their attention on their companies' marketing spend with the goals of gaining a more accurate return-on-investment figure. One example is VF Corp., which is matching marketing spend in certain regions with revenue growth in those areas. CoreBrand estimates that about 10% of companies match their marketing spend to their return-on-investment targets. The Wall Street Journal (tiered subscription model)/CFO Journal blog (5/20)

Bob Jensen's threads on ROIs ---
http://www.trinity.edu/rjensen/roi.htm




 

 

The Dupont Formula and Its Extensions

Dupont Formula Partitioning of Return on Equity ---
http://en.wikipedia.org/wiki/DuPont_formula

I really liked the following "classic" article by Selling and Stickney:
A New Approach," by T.I. Selling and C.P.  Stickney, Accounting Horizons, December 1990, pp. 9-17. 

"Goldman Sachs Explains The 'Return On Equity' Formula That Every CFA Test Taker Needs To Know," by Sam Ro, Business Insider, May 26, 2014 ---
 http://www.businessinsider.com/cfa-dupont-roe-model-2014-5

For investors, one of the most important metrics of a company is return on equity (ROE), which can be calculated by taking net income and dividing it by equity.

"The decision to expand into the market of a competitor and seek additional return is not a decision driven by the expected profit margin, the expected return relative to the anticipated quantity of sales," said Jesse Livermore, the pseudonymous author of the Philosophical Economics blog. "Rather, it’s a decision driven instead by the expected ROE, the expected return relative to the amount of capital that will have to be invested, put at risk, in order to earn it."

Unfortunately, ROE alone doesn't tell you much about a company's operating or capital structure. That's why analysts decompose the ROE into multiple components, including a measure of profit margin (see article).

The Chartered Financial Analyst (CFA) exam, which will be administered on June 7, is among the advanced Wall Street exams that tests test-takers on at least two decompositions of ROE.  The more complicated one is the DuPont model. Goldman Sachs' Stuart Kaiser recently included the formula for reference in an April 2 note sent out to its clients.

[Exhibit not shown here]

Continued in article

Jensen Comment
I want to especially thank David Stout, Editor of the May 2001 edition of Issues in Accounting Education.  There has been something special in all the editions edited by David, but the May edition is very special to me.  All the articles in that edition are helpful, but I want to call attention to three articles that I will use intently in my graduate Accounting Theory course.

 

There is a flurry of literature flying by us daily, and it is rare to find three articles in one journal that will become central to my theory course.  Thank you David for giving me those three articles in this AAA journal that now rejects over 90% of the submissions.  I am grateful that you did not reject the three articles mentioned above.

 




 Introduction to Fair Value Accounting

  • Bob Jensen's threads on fair value accounting are at various other links:

    Bob Jensen's threads on fair value accounting --- http://www.trinity.edu/rjensen/Theory01.htm#FairValue

    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

    Video
    "How Managers Should Read Financial Statements," Harvard Business Review Blog, February 19, 2013 --- Click Here
    http://blogs.hbr.org/video/2013/02/how-managers-should-read-finan.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    CNBC Explains Accounting --- http://www.cnbc.com/id/100000341

    Bob Jensen's threads on accounting theory

     


    Teaching Case
    From The Wall Street Journal's Weekly Accounting Review on March 21, 2014

    Ahead of the Tape: Justifying Nike's Share Price Is No Layup
    by: Spencer Jakab
    Mar 20, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Financial Ratios, Financial Statement Analysis

    SUMMARY: The author looks at Nike's fiscal second quarter results and expects decent quarterly results for the third quarter period ended December 2013, but whether the stock merits its lofty valuation "is another matter."

    CLASSROOM APPLICATION: The article covers basic topics of gross profit, P/E ratio, sales mix, and foreign currency transactions.

    QUESTIONS: 
    1. (Advanced) What is gross profit?

    2. (Introductory) Given that Nike sales increased by only 8% in the quarter ended September 2013 (the fiscal second quarter) compared to the previous year, how did the company achieve a "big jump in gross profit"?

    3. (Advanced) Define the term price-earnings (P/E) ratio.

    4. (Introductory) How is the P/E ratio measured in assessing Nike's performance? How does this ratio compare to previous periods?

    5. (Advanced) "Nike outfits 43 out of the 68 teams in the NCAA Men's Basketball Tournament" and the World Cup host and favorite team, Brazil, will also wear Nike's logo. Then why does the author argue that "the smart money should shy away from Nike"?

    6. (Advanced) Review the graphic related to the article entitled "Air Europe." According to the author, the overall orders growth expected "would have been even stronger without currency weakness in Japan and emerging markets." Explain your understanding of this statement.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Ahead of the Tape: Justifying Nike's Share Price Is No Layup," Spencer Jakab, The Wall Street Journal, March 20, 2014 ---
    http://online.wsj.com/news/articles/SB10001424052702304026304579449620895705180?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    The sports world will be on tenterhooks Thursday afternoon, and so will the world of sporting goods.

    But at least investors who tear themselves away from the start of March Madness to review Nike Inc. NKE -0.25% 's fiscal third-quarter performance can rest easy about one thing: Their brackets may lie in tatters by the end of the day, but Nike should still look good.

    Nike outfits 43 out of the 68 teams in the NCAA Men's Basketball Tournament, according to AdWeek. The Super Bowl, which occurred during the quarter to be reported, was a lock with both teams sporting the swoosh symbol. This summer's FIFA World Cup, the globe's most watched sporting event, will be dicier with only 10 of 32 teams carrying Nike's logo—though Nike did snag host and favorite Brazil.

    As so many stars gracing the cover of Sports Illustrated have learned, though, high expectations are dangerous. Nike should hit the consensus earnings forecast of 72 cents a share, down from 73 cents a year earlier.

    Justifying the 48% gain in its share price over the past year is another matter. The stock now trades at nearly 24 times forward earnings, its highest multiple in 15 years.

    And that is despite the fact second-quarter results, released in December, didn't make investors want to party like it's 1999. Sales increased 8% year over year. Coupled with more premium products, that led to a big jump in gross profit. But "demand creation expense"—essentially marketing costs, such as sponsorships—jumped by 13%. Net income was only 3% higher than a year earlier.

    Investors tend to care more about what are called "futures orders," an indication of expected sales growth in coming months. For the period from December through April 2014, the scheduled pace of 12% would have been even stronger without currency weakness in emerging markets and Japan.

    Continued in article


    Marc Depree stated the following:

    Begin Quotation
    If we choose to take a political route, accountants/auditors might align themselves with and apply a principle of advancing big business managers/CEOs' interests. They/we could apply contradiction as a basis of reasoning to advance management/CEO interests. For example, accounting for a stock portfolio, recognize unrealized gains and ignore unrealized losses. We can easily specify reasons for our accounting. And advocating manager/CEO interests would have the support of wealth that would assure our success and the success of other stakeholders.
    End Quotation

    Jensen Comment
    Actually, before FAS 115 and operating under the Principle (Concept) of Conservatism combined with the Lower-of-Cost-or-Market Principle (LCM) we did just the opposite where we recognized marketable portfolio losses but not gains to the extent that those investments adjusted for gains exceeded original purchase costs. FAS 115 altered that for Trading and AFS securities by marking gains and losses to market (fair value), although in the case of AFS securities the gains were posted to OCI rather than current earnings. HTM securities only recognized losses and not gains making it crucial how auditors and their clients partitioned investments into AFS versus HTM versus Trading (were all gains and losses went to current earnings).

    Later on the IASB changed the rules to include recognizing fair-value gains and losses to consistently apply to all securities, thereby doing away with the HTM classifications. The Principle of Conservatism was abandoned in this instance --- but only for marketable securities. Later on, under heavy EU political pressure. the IASB rescinded the earlier ruling to the extent that the HTM classification of marketable securities was restored due to a rebellion of European Union banks.

    It would seem that the LCM Principle is now being inconsistently applied in some areas of marketable HTM versus AFS and Trading Securities. (Actually, I applaud this inconsistency, but I doubt that Pat Walters and Tom Selling are clapping their hands).

    LCM and Conservatism Principles (Concepts) are also not being inconsistently applied to product inventories. LCM does not apply to precious metal inventories, but it does apply under IFRS and US GAAP to most other metal inventories as well as most commodity inventories and other inventories like an inventory of unsold vehicles or speculation homes.

    Actually, big businesses would probably rather do away with LCM and Conservatism Principles (Concepts) entirely.
    They would like to recognize profits on vehicle inventories and speculation homes before they've found customers to purchase those inventories. For long-term construction contracts companies are allowed to realize profits at various stages of constructions but only when they have sales contracts in hand. Contractors would like to do so even if they don't have sales contracts in hand.

    My point is that it's very easy to finger-point all the inconsistencies in standards to the big bad corporations that allegedly control accounting standard setters like the IASB, FASB, and SEC. In reality, the big bad corporations would like to eliminate inconsistencies in such standards as the how the concepts of LCM and Conservatism Principles are applied in those standards. But the standard setters have not yet cave in to big business wishes in these areas.

    In truth, many of those accounting standards inconsistencies exist to avoid abuses by big bad businesses in reality.
    The reality is that house builders would probably over-estimate values of unsold speculation homes (where valuation is a very soft science) and mislead investors about unrealized profits.  Tradition, therefore, dictates that most inventories are still maintained under LCM and Conservatism Principles (Concepts).

    Tradition dictates reporting some operating fixed assets at depreciated or amortized costs even though exit values may be much lower. For example, a printing press costing $2 million dollars installed may only be worth half that after the first batch is printed. Accounting standards, however, still use the Matching Concept for depreciation even though standard setters hate to admit using the Matching Concept. I

    If the first batch printed bore a $1 million depreciation charge it would greatly defy the tradition of matching costs with revenues generated. Thereafter, the profits of all batches would be grossly overstated by not matching enough depreciation to those jobs. Standard setters generally avoid the big-bath theory of accounting that allows companies to take a big bath in earnings one period and then overstate profits every period thereafter.

    If exit value was fully adopted for a new manufacturing line, the marginal cost of that first unit produced might exceed revenues by a million percent. The big bath exit value theory consistently applied would require showing a monumental loss on that first product produced on the line and create an enormous distortion in the ROI of every produced thereafter. In instances where variable costs are negligible, the ROI of every product produced thereafter might be close to infinity. Big bad businesses would jump for joy.

    My point here, Marc, is that we can't assert big bad corporations are totally dictating our accounting standards.
    Standard setters really do try to make it harder for companies to mislead investors and my clinging to conservative accounting traditions that are still built into standards bear this out.

    The fundamental problem of deriving a set of standards that are consistent with a set of concepts, axioms, and postulates is that doing so sometimes results in standards that will be abused by business firms and mislead the investing public such as when recognizing inventories in advance of finding customers is likely to be abused even though maintaining inventories at LCM is inconsistent with the way firms carry Trading and AFS securities.

    Respectfully,
    Bob Jensen


    Estates Are Particularly Difficult to Value

    From the CPA Newsletter on July 30, 2013

    Minnesota Twins heirs fight IRS over team valuation ---
    http://www.accountingweb.com/article/minnesota-twins-heirs-go-bat-against-irs-tax-court/222153
    Minnesota Twins owner Carl Pohlad's heirs -- sons Robert, James and William -- are battling the Internal Revenue Service in U.S. Tax Court over estate taxes. The argument centers on the valuation of the major league baseball team. The IRS says the stake was grossly undervalued and is adding a $48 million penalty on the taxes it says the heirs still owe.

    Jensen Comment
    This is an example of where a balance sheet prepared in accordance with GAAP is useless for valuation. The bulk of the value resides in unbooked intangibles, especially human resources and reputation for future television deals.

    Some Thoughts on Fair Value Accounting

    Our recent AECM regarding why accounting standard setters require mark-to-market (fair value) adjustments of marketable securities (except for HTM securities) and do not generally allow mark-to-market adjustments to inventories (except for precious metals and LCM downward adjustments for permanent impairments).

    Fungible --- http://en.wikipedia.org/wiki/Fungible
    I think this "inconsistency" in the accounting standards hinges on the concept of fungible. Marketable securities are generally fungible. A General Motors share of stock NYC is identical to other GM shares in Bavaria versus Hong Kong versus Sugar Hill, New Hampshire. One advantage of fair value accounting for marketable securities is that these securities are fungible until they become unique such as when companies go bankrupt.

    The classic example for fungible inventories that I always used in class is the difference between new cars in a dealer's lot and used cars in that same lot is that new cars are fungible (there are thousands or tens of thousands in the world exactly like that new car) and used cars are not fungible. There is no other car in the world exactly like any of the used cars in a dealer's parking lot. We have Blue Book pricing of used cars of every make and model, but these are only suggested prices before serious negotiations between buyers and a seller of used models with varying mileage, accident histories, flooding histories such as being trapped while being parked in flood waters, new parts installed such as a new engine or new transmission, etc.

    My point here is that it's almost impossible to accurately value a used car until a buyer and seller have negotiated a purchase price. And the variation from Blue Book suggested prices can be quite material in amount. Thus we can value General Motors common shares before we have a buyer, but we can't value any used car before we have a buyer.

    I used to naively claim that this was not the case of new cars because they were fungible like General Motors common shares. But on second thought I was wrong. New cars are not fungible items. Consider the case of a particular BMW selling for $48,963 in Munich. The same car will sell for varying prices in NYC versus Hong Kong versus Sugar Hill, NH. This variation is due largely to delivery cost differentials.

    Now consider the Car A and Car B BMW models that are exactly alike (including color) in a Chicago dealership lot. After three months, a buyer and the dealer agree on a $67.585 price for Car A. Car B sits in the lot for over 11 months before a buyer and the dealer agree on a price of $58,276. This discount is prompted mostly by the fact that the new models are out making Car B seem like its a year old even though it odometer has less than two miles.

    My point here is that until a dealer finds a buyer for either a new car or a used car, we really don't know what the inventory fair value is for those non-fungible items. Similarly the same grade and quality of corn in Minneapolis has a different price than identical corn in Chicago. Corn and other commodities like oil are not really fungible for inventory valuation purposes.

    There are numerous examples of where inventory product values really can't be known until a sales transaction takes place. We can fairly accurately estimate the replacement costs of some of the new items for sale although FAS 33 found that the cost of generally doing so accurately for inventory valuation purposes probably exceeds the value of such replacement cost adjustments at each financial reporting date.

    There's great moral hazards in allowing owners of non-fungible inventories to estimate fair values before sales transactions actually take place. Creative accounting would be increasingly serious if accounting standards allowed fair value accounting for non-fungible items that vary in value depending upon the buyer and the time and place of sales negotiations.

    Thus we can explain to our students that the reason we report marketable securities at fair value and inventories at transaction or production historical costs is that marketable securities are fungibles and most inventories are not fungible. The main reason is that estimating the value of truly fungible marketable securities is feasible before we have a sales transaction whereas the value of so many non-fungible (unique) items is not known until we have a sales transaction at a unique time and place.

     

    Bob Jensen's valuation threads are at
    http://www.trinity.edu/rjensen/Theory02.htm#FairValue

    Bpb Jensen's threads on contingencies and intangibles ---
    http://www.trinity.edu/rjensen/theory01.htm#TheoryDisputes

     


    May 17, 2006 message from Peter Walton

    I would like to take this opportunity to let you know about a forthcoming book from Routledge:

    The Routledge Companion to Fair Value and Financial Reporting --- Click Here

    Edited by Peter Walton

    May 2007: 246x174: 406pp

    Hb: 978-0-415-42356-4: £95.00 $170.00

    Jensen Comment
    Even though I have a paper published in this book, I will receive no compensation from sales of the book. And since I'm retired, lines on a resume no longer matter.


    FASB Statement No. 107
    Disclosures about Fair Value of Financial Instruments
    (Issue Date 12/91)
    [Full Text] [Summary] [Status]

    This Statement extends existing fair value disclosure practices for some instruments by requiring all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the statement of financial position, for which it is practicable to estimate fair value. If estimating fair value is not practicable, this Statement requires disclosure of descriptive information pertinent to estimating the value of a financial instrument. Disclosures about fair value are not required for certain financial instruments listed in paragraph 8.

    This Statement is effective for financial statements issued for fiscal years ending after December 15, 1992, except for entities with less than $150 million in total assets in the current statement of financial position. For those entities, the effective date is for fiscal years ending after December 15, 1995.

    FASB Statement No. 115
    Accounting for Certain Investments in Debt and Equity Securities
    (Issue Date 5/93)
    [Full Text] [Summary] [Status]

    This Statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows:

    Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.

    Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.

    Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity.

    This Statement does not apply to unsecuritized loans. However, after mortgage loans are converted to mortgage-backed securities, they are subject to its provisions. This Statement supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities, and related Interpretations and amends FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities, to eliminate mortgage-backed securities from its scope.

    This Statement is effective for fiscal years beginning after December 15, 1993. It is to be initially applied as of the beginning of an enterprise's fiscal year and cannot be applied retroactively to prior years' financial statements. However, an enterprise may elect to initially apply this Statement as of the end of an earlier fiscal year for which annual financial statements have not previously been issued.

    FASB Statement No. 130
    Reporting Comprehensive Income
    (Issue Date 6/97)
    [Full Text] [Summary] [Status]

    This Statement establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of general-purpose financial statements. This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. This Statement does not require a specific format for that financial statement but requires that an enterprise display an amount representing total comprehensive income for the period in that financial statement.

    This Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.

    This Statement is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required.

     

    FASB Statement No. 133 and Amendments in FAS 137, 138, 149, and 155
    Accounting for Derivative Instruments and Hedging Activities
    (Issue Date 6/98)
    [Full Text] [Summary] [Status]

    This Statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation.

    For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value. For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately. For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction. For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. Under this Statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.

    This Statement applies to all entities. A not-for-profit organization should recognize the change in fair value of all derivatives as a change in net assets in the period of change. In a fair value hedge, the changes in the fair value of the hedged item attributable to the risk being hedged also are recognized. However, because of the format of their statement of financial performance, not-for-profit organizations are not permitted special hedge accounting for derivatives used to hedge forecasted transactions. This Statement does not address how a not-for-profit organization should determine the components of an operating measure if one is presented.

    This Statement precludes designating a nonderivative financial instrument as a hedge of an asset, liability, unrecognized firm commitment, or forecasted transaction except that a nonderivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation.

    This Statement amends FASB Statement No. 52, Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative. It supersedes FASB Statements No. 80, Accounting for Futures Contracts, No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. It amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to include in Statement 107 the disclosure provisions about concentrations of credit risk from Statement 105. This Statement also nullifies or modifies the consensuses reached in a number of issues addressed by the Emerging Issues Task Force.

    This Statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Initial application of this Statement should be as of the beginning of an entity's fiscal quarter; on that date, hedging relationships must be designated anew and documented pursuant to the provisions of this Statement. Earlier application of all of the provisions of this Statement is encouraged, but it is permitted only as of the beginning of any fiscal quarter that begins after issuance of this Statement. This Statement should not be applied retroactively to financial statements of prior periods.

    FASB Statement No. 142
    Goodwill and Other Intangible Assets
    (Issue Date 6/01)
    [Full Text] [Summary] [Status]

    This Statement changes the subsequent accounting for goodwill and other intangible assets in the following significant respects:
    • Acquiring entities usually integrate acquired entities into their operations, and thus the acquirers' expectations of benefits from the resulting synergies usually are reflected in the premium that they pay to acquire those entities. However, the transaction-based approach to accounting for goodwill under Opinion 17 treated the acquired entity as if it remained a stand-alone entity rather than being integrated with the acquiring entity; as a result, the portion of the premium related to expected synergies (goodwill) was not accounted for appropriately. This Statement adopts a more aggregate view of goodwill and bases the accounting for goodwill on the units of the combined entity into which an acquired entity is integrated (those units are referred to as reporting units).

       

    • Opinion 17 presumed that goodwill and all other intangible assets were wasting assets (that is, finite lived), and thus the amounts assigned to them should be amortized in determining net income; Opinion 17 also mandated an arbitrary ceiling of 40 years for that amortization. This Statement does not presume that those assets are wasting assets. Instead, goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives, but without the constraint of an arbitrary ceiling.

       

    • Previous standards provided little guidance about how to determine and measure goodwill impairment; as a result, the accounting for goodwill impairments was not consistent and not comparable and yielded information of questionable usefulness. This Statement provides specific guidance for testing goodwill for impairment. Goodwill will be tested for impairment at least annually using a two-step process that begins with an estimation of the fair value of a reporting unit. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. However, if certain criteria are met, the requirement to test goodwill for impairment annually can be satisfied without a remeasurement of the fair value of a reporting unit.

       

    • In addition, this Statement provides specific guidance on testing intangible assets that will not be amortized for impairment and thus removes those intangible assets from the scope of other impairment guidance. Intangible assets that are not amortized will be tested for impairment at least annually by comparing the fair values of those assets with their recorded amounts.

       

    • This Statement requires disclosure of information about goodwill and other intangible assets in the years subsequent to their acquisition that was not previously required. Required disclosures include information about the changes in the carrying amount of goodwill from period to period (in the aggregate and by reportable segment), the carrying amount of intangible assets by major intangible asset class for those assets subject to amortization and for those not subject to amortization, and the estimated intangible asset amortization expense for the next five years.

    From CFO.com Morning Ledger on April 11, 2013

    Why you should stop using ROI.
    Companies that aim to maximize their ROI tend to under-invest, under-innovate and leave value on the table,
    writes Bennett Stewart, CEO of EVA Dimensions, in this guest column. To maximize ROI, managers will size projects to just where the forecast return peaks when they should continue expanding the planned scale so long as the incremental return exceeds the cost of the incremental capital. Instead, CFOs should focus on their firms’ profit less a capital charge, or economic value added. ROI brings capital into the management equation by division, and EVA by subtraction – by turning the balance sheet into a charge to profit, just like any other operating cost. EVA is additive where ROI is not. Add a good enough investment to a great business and EVA is greater still. Add a low margin business to a strong one, and EVA increases so long as the cost of capital is covered.

    evaDimensions --- http://www.evadimensions.com/


    Updates on Venture Capital, Environmental Accounting, Green Accounitng: Two Teaching Cases

    Venture Capital --- http://en.wikipedia.org/wiki/Venture_capital

    From The Wall Street Journal Accounting Weekly Review on March 12, 2010

    Venture-Capital firms Caught in a Shakeout
    by: Pui-Wing Tam
    Mar 09, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Mergers and Acquisitions, Valuations

    SUMMARY: "Venture firms are struggling to raise new cash, hampered by poor investment returns and a difficult economy...There were 794 active venture-capital firms in the U.S. at the end of 2009, meaning they have raised money in the last eight years, down from a peak of 1,023 in 2005....Many venture-capital firms...profited handsomely in the boom years in the late 1990s and early 2000....[as well,] their funds typically are set up as long-term, 10-year investment vehicles that don't quickly close down. But in the past decade, many start-ups have flopped or have struggled to go public amid an unwelcoming market for initial public offerings. The tough environment has been exacerbated by the credit crunch...." The related article assesses top promising start up companies by assessing management teams and change in equity valuation over a recent 12-month period.

    CLASSROOM APPLICATION: The article may be used in entrepreneurship, financial accounting, MBA, or management accounting classes.

    QUESTIONS: 
    1. (Introductory) What is a venture capitalist? How does a venture capital firm make profits?

    2. (Advanced) How does the article identify the reduction in returns to venture capitalists in 2009 relative to 2008?

    3. (Introductory) In the related article ranking "the top 50 venture capital-backed firms," how does the WSJ assess these firms, implying likely success? Specifically identify the four criteria used in the analysis.

    4. (Advanced) Given that the firms are not yet publicly traded, does any of the information in the article help to assess profitability of these firms in the past year? Explain.

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    Sizing Up Promising Young Firms
    by Colleen DeBaise and Scott Austin
    Mar 09, 2010
    Page: B6


    Where the Smart Money Is
    by: Alan Murray
    Mar 08, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Accounting, Entrepreneurship, Environmental Cleanup Costs, Investments

    SUMMARY: The article is part of a special section on "Eco:nomics-Creating Environmental Capital and is based on interviews of venture capitalists John Doerr, a partner at Kleiner Perkins Caufield & Byers; Vinod Khosla, founder and managing partner of Khosla Ventures; and Paul Holland, general partner of Foundation Capital. They comment on their "bets" on clean technology and respond to a question on what has so far been "a dud" of their investments in this area.

    CLASSROOM APPLICATION: The article may be used in financial reporting, MBA, entrepreneurship, or management accounting classes.

    QUESTIONS: 
    1. (Introductory) What is a venture capitalist? How does a venture capital firm make profits?

    2. (Introductory) What do these three venture capitalists see as an area of opportunity for investment now in the environmental arena?

    3. (Advanced) What does the interviewer mean when he speaks about a "price on carbon"?

    4. (Advanced) Mr. Doerr says that none of their investments they expect to make an outstanding rate of return depend on putting a price on carbon. Define expected rate of return. How could a "price on carbon" make an investment economically viable which otherwise may not be viable without this "price"? What is the significance of Mr. Doerr's statement?

    5. (Advanced) What benefit does Mr. Doerr think will come from our government putting in place a system that will price carbon emissions?

    6. (Advanced) In the related article, start up firms in the solar energy area are assessed and ranked. What factors does The Journal use to rank these firms? In particular, given that they are not public and so financial statements are not available, does The Journal assess profitability over a recent year? Explain.

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    And the Top Clean-Tech Companies Are...
    by Colleen DeBaise
    Mar 08, 2010
    Page: R7

    Bob Jensen's threads on Return on Investment and Valuation ---
    http://www.trinity.edu/rjensen/roi.htm


    Accounting valuation models for securities do not, to my knowledge, allow for the "value added" by the middle men/women hawking/touting those securities. For example, it is common to value derivatives based upon yield curves generated in a Bloomberg or Reuters terminal or turn to Steve Penman's textbook recommendations for valuing a potential investment.

    It turns out that those middle men/women make a huge difference in sales volume and prices of securities. This is something that I certainly neglected to teach back when I was teaching valuation, and I suspect many other accounting and finance teachers and researchers have been just as negligent.

    The success of hawking/touting may have some really undesirable implications for fair value accounting.
    Has this ever been taken up in the literature of fair value accounting or in standard setting commentaries?

    I missed this one until Simoleon Sense and Jim Mahar picked up on this in recent blog postings.

    "Spam Works: Evidence from Stock Touts and Corresponding Market Activity," by Laura Frieder and Jonathan Zittrain, SSRN, March 14, 2007 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=920553

    Abstract:
    |We assess the impact of spam that touts stocks upon the trading activity of those stocks and sketch how profitable such spamming might be for spammers and how harmful it is to those who heed advice in stock-touting e-mails. We find convincing evidence that stock prices are being manipulated through spam. We suggest that the effectiveness of spammed stock touting calls into question prevailing models of securities regulation that rely principally on the proper labeling of information and disclosure of conflicts of interest as means of protecting consumers, and we propose several regulatory and industry interventions.

    Based on a large sample of touted stocks listed on the Pink Sheets quotation system and a large sample of spam emails touting stocks, we find that stocks experience a significantly positive return on days prior to heavy touting via spam. Volume of trading responds positively and significantly to heavy touting. For a stock that is touted at some point during our sample period, the probability of it being the most actively traded stock in our sample jumps from 4% on a day when there is no touting activity to 70% on a day when there is touting activity. Returns in the days following touting are significantly negative. The evidence accords with a hypothesis that spammers "buy low and spam high," purchasing penny stocks with comparatively low liquidity, then touting them - perhaps immediately after an independently occurring upward tick in price, or after having caused the uptick themselves by engaging in preparatory purchasing - in order to increase or maintain trading activity and price enough to unload their positions at a profit. We find that prolific spamming greatly affects the trading volume of a targeted stock, drumming up buyers to prevent the spammer's initial selling from depressing the stock's price. Subsequent selling by the spammer (or others) while this buying pressure subsides results in negative returns following touting. Before brokerage fees, the average investor who buys a stock on the day it is most heavily touted and sells it 2 days after the touting ends will lose close to 5.5%. For those touted stocks with above-average levels of touting, a spammer who buys on the day before unleashing touts and sells on the day his or her touting is the heaviest, on average, will earn 4.29% before transaction costs. The underlying data and interactive charts showing price and volume changes are also made available.

    Bob Jensen's threads on valuation are at
    http://www.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on fair value accounting are at
    http://www.trinity.edu/rjensen/theory01.htm#FairValue

     


    FASB Statement No. 155
    Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140
    (Issue Date 02/06)
    [Full Text] [Summary] [Status]
     

    This Statement amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.”

    This Statement:

    Permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation

    Clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133

    Establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation

    Clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives

    Amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.

    Reasons for Issuing This Statement

    In January 2004, the Board added this project to its agenda to address what had been characterized as a temporary exemption from the application of the bifurcation requirements of Statement 133 to beneficial interests in securitized financial assets.

    Prior to the effective date of Statement 133, the FASB received inquiries on the application of the exception in paragraph 14 of Statement 133 to beneficial interests in securitized financial assets. In response to the inquiries, Implementation Issue D1 indicated that, pending issuance of further guidance, entities may continue to apply the guidance related to accounting for beneficial interests in paragraphs 14 and 362 of Statement 140. Those paragraphs indicate that any security that can be contractually prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment should be subsequently measured like investments in debt securities classified as available-for-sale or trading under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and may not be classified as held-to-maturity. Further, Implementation Issue D1 indicated that holders of beneficial interests in securitized financial assets that are not subject to paragraphs 14 and 362 of Statement 140 are not required to apply Statement 133 to those beneficial interests until further guidance is issued.

    How the Changes in This Statement Improve Financial Reporting

    This Statement improves financial reporting by eliminating the exemption from applying Statement 133 to interests in securitized financial assets so that similar instruments are accounted for similarly regardless of the form of the instruments. This Statement also improves financial reporting by allowing a preparer to elect fair value measurement at acquisition, at issuance, or when a previously recognized financial instrument is subject to a remeasurement (new basis) event, on an instrument-by-instrument basis, in cases in which a derivative would otherwise have to be bifurcated. Providing a fair value measurement election also results in more financial instruments being measured at what the Board regards as the most relevant attribute for financial instruments, fair value.

    Effective Date and Transition

    This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The fair value election provided for in paragraph 4(c) of this Statement may also be applied upon adoption of this Statement for hybrid financial instruments that had been bifurcated under paragraph 12 of Statement 133 prior to the adoption of this Statement. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year. Provisions of this Statement may be applied to instruments that an entity holds at the date of adoption on an instrument-by-instrument basis.

    At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument should be recognized as a cumulative-effect adjustment to beginning retained earnings. The cumulative-effect adjustment should be disclosed gross (that is, aggregating gain positions separate from loss positions) determined on an instrument-by-instrument basis. Prior periods should not be restated.

     

    FASB Statement No. 157
    Fair Value Measurements
    (Issue Date 09/06)
    [Full Text] [Summary] [Status]
     

    This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.

    Reason for Issuing This Statement

    Prior to this Statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. Moreover, that guidance was dispersed among the many accounting pronouncements that require fair value measurements. Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.

    Differences between This Statement and Current Practice

    The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

    The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).

    This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, this Statement establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.

    This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. Therefore, a measurement (for example, a “mark-to-model” measurement) that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one in pricing the related asset or liability.

    This Statement clarifies that market participant assumptions also include assumptions about the effect of a restriction on the sale or use of an asset. A fair value measurement for a restricted asset should consider the effect of the restriction if market participants would consider the effect of the restriction in pricing the asset. That guidance applies for stock with restrictions on sale that terminate within one year that is measured at fair value under FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations.

    This Statement clarifies that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements, including FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.

    This Statement affirms the requirement of other FASB Statements that the fair value of a position in a financial instrument (including a block) that trades in an active market should be measured as the product of the quoted price for the individual instrument times the quantity held (within Level 1 of the fair value hierarchy). The quoted price should not be adjusted because of the size of the position relative to trading volume (blockage factor). This Statement extends that requirement to broker-dealers and investment companies within the scope of the AICPA Audit and Accounting Guides for those industries.

    This Statement expands disclosures about the use of fair value to measure assets and liabilities in interim and annual periods subsequent to initial recognition. The disclosures focus on the inputs used to measure fair value and for recurring fair value measurements using significant unobservable inputs (within Level 3 of the fair value hierarchy), the effect of the measurements on earnings (or changes in net assets) for the period. This Statement encourages entities to combine the fair value information disclosed under this Statement with the fair value information disclosed under other accounting pronouncements, including FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, where practicable.

    The guidance in this Statement applies for derivatives and other financial instruments measured at fair value under Statement 133 at initial recognition and in all subsequent periods. Therefore, this Statement nullifies the guidance in footnote 3 of EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” This Statement also amends Statement 133 to remove the similar guidance to that in Issue 02-3, which was added by FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments.

    How the Conclusions in This Statement Relate to the FASB’s Conceptual Framework

    The framework for measuring fair value considers the concepts in FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. Concepts Statement 2 emphasizes that providing comparable information enables users of financial statements to identify similarities in and differences between two sets of economic events.

    The definition of fair value considers the concepts relating to assets and liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements, in the context of market participants. A fair value measurement reflects current market participant assumptions about the future inflows associated with an asset (future economic benefits) and the future outflows associated with a liability (future sacrifices of economic benefits).

    This Statement incorporates aspects of the guidance in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, as clarified and/or reconsidered in this Statement. This Statement does not revise Concepts Statement 7. The Board will consider the need to revise Concepts Statement 7 in its conceptual framework project.

    The expanded disclosures about the use of fair value to measure assets and liabilities should provide users of financial statements (present and potential investors, creditors, and others) with information that is useful in making investment, credit, and similar decisions—the first objective of financial reporting in FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises.

     

    FASB Statement No. 159
    The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115

    (Issue Date 02/07)
    [Full Text] [Summary] [Status]
     
  • 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.

       
      Discounted Cash flow 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 threads on valuation are at http://www.trinity.edu/rjensen/roi.htm

    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.

    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

    • 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.

    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

     
    The European Commission has published Frequently Asked Questions – IAS 39 Fair Value Option (FVO) (PDF 94k), providing the Commission's views on the following questions:
    • 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

    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:

     

    1. Eliminate arbitrary FAS 115 classifications that can be used by management to manipulate earnings (which is what Freddie Mac did in 2001 and 1002.
    2. 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.
    3. 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:

     

    1. 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.
    2. Sometimes difficult to value, especially OTC securities.
    3. Creates enormous swings in reported earnings and balance sheet values.
    4. 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.

     

    Download
    "Auditing Fair Value Measurements And Disclosures"
    in MS Word format.

    File Size: 123 Kbytes
     
    Download
    "Auditing Fair Value Measurements And Disclosures"
    in Adobe Acrobat format.

    File Size: 209 Kbytes
     
     


    The Expectations Gap Between Professional Valuation Versus What Students Learn in College

    If you teach about valuation, you might want to add this to your teaching notes.
    "The Chart That Shows WhatsApp Was A Bargain At $19 Billion"

    Read more: http://www.businessinsider.com/price-per-user-for-whatsapp-2014-2#ixzz2ttINByKq


    Hi Dennis,

    I do not have direct answers to your specific questions. However, I did combine two tidbits that may be of interest to you and to other subscribers to the AECM. These specialty certifications are commonly held by persons seeking to be paid for expert witnessing. In my opinion, there's a lack of accountability of most of these so-called "certificates" and the organizations that grant such certificates.


    On the other hand, there's also merit in some of the complaints by these associations directed at our most respected colleges and universities. For example, most college accounting programs teach about valuation accountics science models (such as residual income and free cash flow models) that are typically more misleading than helpful when it comes to real world valuation of business firms. It's not common to find college professors who have a history of outstanding professional experience in valuation or forensics.


    College curricula in accounting and finance are terribly lacking in courses and research professors knowledgeable about the professions of valuation or forensics. For example, most of our auditing courses spend more time stressing how financial audits are not designed to detect fraud rather than becoming professionally focused on ways to detect fraud. We do have course modules on internal controls, but these typically are very superficial  relative to what graduates will encounter in the real world of fraud and systems weaknesses.


    The bottom line is that both valuation and forensics are topics that are poorly covered at the university level. And coverage by mysterious associations offering certificates do not always pass the smell tests of credibility.

     

    The National Association of Certified Valuators and Analysts (NACVA) ---
    http://www.nacva.com/

    Business Valuation Standard --- http://en.wikipedia.org/wiki/Business_valuation_standard

    Business Valuation Standards (BVS) are codes of practice that are used in business valuation. Each of the three major United States valuation societies — the American Society of Appraisers (ASA), American Institute of Certified Public Accountants (CPA/ABV), and the National Association of Certified Valuation Analysts (NACVA) — has its own set of Business Valuation Standards, which it requires all of its accredited members to adhere to.[1] The AICPA's standards are published as Statement on Standards for Valuation Services No.1 and the ASA's standards are published as the ASA Business Valuation Standards. All AICPA members are required to follow SSVS1. Additionally, the majority of the State Accountancy Boards have adopted SSVS1 for CPAs licensed in their state.

    Criticism of the abovementioned organizations are as follows:


    1) These are neither the major valuation societies, nor are they the only valuation societies. They are however, organizations which engage in considerable self-promotion among their members to foster the delusion among their members, that by the mere fact of membership, their members are more qualified to perform business appraisal than non-members.


    2) These are all privately held organizations, in which membership is voluntary.


    3) There are no regulations mandating that one must belong to any of these organizations in order to practice as a business appraiser.


    4) In that these are voluntary membership organizations, their standards have little or no weight with either the business valuation community at large or with the legal and judicial community who appraisers often serve.


    5) The standards and ethics of these organizations are constructed to be vague and self-serving, with numerous exceptions, designed more to excuse conflicts of interest, membership poor performance and unsupported opinion, than to encourage, independence, scientific analysis and high quality work. Conflicts of interest are a problem, particularly among CPA/Appraisers, who regularly join these organizations so that they can offer valuation services to their existing accounting clients, in violation of independence rules and ethics.


    6) The education which these organizations offer is unaccredited and of low quality, in that it does not reach the threshold level of education in finance of an accredited university.


    7) Educational standards have to be kept low to attract new members and membership dues.


    8) The credentials which these organizations issue are often issued for reasons of favoritism and cronyism over merit.


    9) The purpose of these organizations is often tarnished by the politics of a few active, insider members who consider themselves more entitled then other members, and consequently use the organization resources to further their own self-interests over the interests of the membership at large.


    10) There is no accounting of the membership dues paid into these membership organizations. Consequently, members do not know where, to whom, or on what their dues money is spent.

     

    Forensic Accounting --- http://en.wikipedia.org/wiki/Forensic_accounting

    American College of Forensic Examiners International (ACFEI) ---
    http://www.acfei.com/
    The ACFEI is mulit-disciplinary, only one discipline of which is accounting

    Association of Certified Fraud Examiners (ACFE) ---
    http://www.acfe.com/
    The ACFE is more focused in on accounting and business fraud than the ACFEI

    Other Forensic Associations ---
    http://www.hgexperts.com/forensic-science.asp

    To my knowledge, the only AACSB-accredited university to offer a forensic accounting certificate is the University of West Virginia ---
    http://www.be.wvu.edu/fafi/index.htm
    There are also tracks for forensic accounting in the Masters of Public Accounting Degree curriculum.

    "Forensic Accounting And Auditing: Compared And Contrasted To Traditional Accounting And Auditing," by Dahli Gray, American Journal of Business Education, Volume 1, Number 2, 2008 ---
    http://scholar.googleusercontent.com/scholar?q=cache:lnY92RzjASgJ:scholar.google.com/+ACFE+ACFEI+"lawsuit"&hl=en&as_sdt=0,20

    Forensic versus traditional accounting and auditing are compared and contrasted. Evidence gathering is detailed. Forensic science and fraud symptoms are explained. Criminalists, expert testimony and corporate governance are presented.


    Teaching Case
    From The Wall Street Journal Accounting Weekly Review on October 25, 2013

    Funds Guess Twitter's Worth
    by: Joe Light
    Oct 19, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Disclosure, Fair Value Accounting, Fair-Value Accounting Rules

    SUMMARY: The author uses disclosures required under FAS 157 (Accounting Standards Codification (ASC) section 820) to examine investors' estimates of Twitter's value with specific examples from three mutual funds.

    CLASSROOM APPLICATION: The article is excellent for introducing fair value requirements and disclosures with specific application to an equity security.

    QUESTIONS: 
    1. (Introductory) What is Twitter Inc.? When is its initial public offering (IPO) expected?

    2. (Introductory) In what price range are Twitter's shares valued? How has the WSJ obtained these values?

    3. (Advanced) How is it possible that "at least 11 mutual funds and closed-end funds own shares" of the company when Twitter hasn't yet held its IPO? Include in your answer definitions of the two fund entities.

    4. (Advanced) Why must mutual funds estimate the fair value of Twitter shares for financial statement disclosures? In your answer, state what other measurement basis could be considered for financial statement reporting and identify all authoritative accounting guidance requiring the disclosures discussed in the article.

    5. (Advanced) "In footnotes, many fund firms will say that a stock's value is...a 'Level 3' asset...." What is a Level 3 asset? Identify your source for this definition from authoritative accounting literature.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Funds Guess Twitter's Worth," Joe Light, The Wall Street Journal, October 19*, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702304384104579139671400590510?mod=djem_jiewr_AC_domainid

    Want to buy a piece of Twitter right now?

    Its highly anticipated initial public offering probably won't happen until November at the earliest, but at least 11 mutual funds and closed-end funds own shares of the San Francisco-based social network. For example, Twitter shares make up more than 2% of the holdings of the Morgan Stanley Institutional Small Company Growth mutual fund.

    Fund companies—including Morgan Stanley Investment Management, T. Rowe Price Group TROW -3.06% and Fidelity Investments—have invested lately in pre-IPO companies, either by participating in venture-capital financing rounds or by buying shares from insiders on the private market. Before Facebook's FB +1.05% May 2012 IPO, for example, more than 50 mutual funds already owned shares.

    On Twitter, some funds already have made a killing—at least on paper.

    For example, according to its holdings disclosures, at the end of September, the Morgan Stanley fund valued its Twitter shares at about $22.31, up a whopping 36% from $16.42 in June.

    Because of the fund's hefty Twitter stake, about 0.78 percentage point of the fund's 16% return in the third quarter was due to Twitter's rise alone.

    But there is a big catch: Because Twitter isn't publicly traded yet, mutual-fund firms must estimate the company's price, and those estimates can vary significantly.

    In contrast to Morgan Stanley, funds run by T. Rowe Price said that Twitter shares were worth about $24.35 each on Sept. 30, up 34% from $18.18 at the end of June.

    In an email, a T. Rowe Price spokeswoman said that the company uses a variety of sources, such as significant transactions, new rounds of financing and relative valuations of other companies to value private assets.

    Since investors can buy and redeem shares of the funds based on those estimates, the discrepancies mean that some fund investors can effectively buy shares of Twitter at a lower price than others or, conversely, sell them for more.

    On Twitter's price, "we're all wrong. It's just a matter of degree," says Kevin Landis, portfolio manager of Firsthand Technology Value. SVVC -0.35% Because the Firsthand fund is a closed-end fund, unlike a traditional mutual fund, its trading price can deviate from the estimated value of its holdings. The firm it hires to value its private holdings estimates that Twitter was worth about $24.37 a share on Sept. 30.

    To be sure, Twitter—and any other stock, for that matter—makes up just a small portion of most funds. But how the fund firms value the stock can cause the funds to behave unexpectedly.

    For example, the rapid increase of the Morgan Stanley estimate in the third quarter was a sharp break from how the fund previously treated shares.

    On Sept. 30, 2011, Morgan Stanley said its shares of Twitter were worth $16.09. It didn't change that estimate until March 2013, when it raised the price to $16.60.

    New York University professor and valuation expert Aswath Damodaran says that it doesn't make sense that a fund firm would keep Twitter's price constant throughout 2012, even as prices of other social-media companies changed sharply.

    "What it effectively means is that the old investors of the fund are going to lose money to the people who are able to buy the fund now at a depressed price," Mr. Damodaran says. "It's not fair to existing shareholders if others can exploit dated pricing."

    In an email, a Morgan Stanley Investment Management spokesman said, "We have a robust process for valuing investments in private companies that considers a variety of factors including the company's performance, financing activity and operating environment."

    Unfortunately, as one of thousands of small investors, there probably isn't a lot an individual can do to change how the fund prices its shares. But to see how much dated, or potentially incorrect, pricing affects a fund, take a look at its latest holdings report filed with the Securities and Exchange Commission.

    Continued in article

     


    Video
    "How Managers Should Read Financial Statements," Harvard Business Review Blog, February 19, 2013 --- Click Here
    http://blogs.hbr.org/video/2013/02/how-managers-should-read-finan.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    CNBC Explains Accounting --- http://www.cnbc.com/id/100000341

    Bob Jensen's threads on accounting theory

     


    New Performance Metrics

    "New Performance Metrics or Something Else? The Deloitte - ModCloth Relationship," by Anthony H. Catanach, Jr., Grumpy Old Accountants Blog, December 28, 2013 ---
    http://grumpyoldaccountants.com/blog/2013/12/28/new-performance-metrics-or-something-else-the-deloitte-modcloth-relationship

    It’s the last week of the calendar year, and much of the accounting world is abuzz. Corporate accountants are putting the final touches on the those revenue accrual entries that will ensure that their company’s earnings will meet analyst expectations.  Global accounting firm auditors are completing audit “hand waving” exercises to justify their client’s optimistic balance sheet valuations and earnings increases.  And accounting standard-setters continue to avoid meaningful solutions to significant reporting problems including revenue recognition, lease accounting, and goodwill valuation, just to name a few.  What do grumpy old accountants do you ask?  This one tilts at windmills… 

    It’s only been three months since I expressed displeasure with recent hype about what characterizes great CFOs today (see Ten Commandments” for Today’s CFO), and nine months since I ranted about innovative performance metrics that were anything but (see Innovative Performance Metric or Marketing Spin?  Well, the business press is at it again with an article in the Wall Street Journal (WSJ) CFO Journal titledModCloth CFO: Four Metrics That Mean More Than Money,” penned by Jeff Shotts, ModCloth’s CFO.  The “innovative” measures this time are engagement, relevant user generated content (UCG), underserved market signals, and the ratio of rules broken to rules followed.  These four non-financial measures purportedly “power a high return on investment,” but instead are quite superficial, ill-defined, and clearly qualify as MBA speak.  What’s my beef this time?  ModCloth’s CFO fails my transparency standard (Commandment No. 6) , and is close to violating my “real” performance measurement criteria (Commandment No. 7).  Also, as someone who has clearly crossed the threshold of geezerdom, I have no patience for those selling something as “new and innovative,” when it is not.  Not a good start at all at being a great CFO!  So, let’s dig in…

    My biggest disappointment in this article is the CFOs suggestion that some performance metrics “can be” more important than others.  This completely ignores the basic principles outlined in the widely-used, and time tested Balanced Scorecard planning and management system.  Performance metrics are supposed to provide evaluation data on different aspects of an organization’s operations (financial, customer, process, and learning and growth).  So, if you decide to measure something, presumably this dimension is important in its own right.  

    It also is interesting that the four key metrics touted are all non-financial in nature.  I am not surprised at all that financial measures are ignored by the ModCloth CFO. Since ModCloth is still a young, private company, presumably focused on growth, the financial metrics are likely not very flattering (i.e., operating losses, negative cash flows, etc.).  In fact, I bet the Company’s senior leaders and investors regularly shrug off the financial metrics as not being representative of the great things happening in the organization.  Could adjusted EBITDA be far behind?  

    But what about measures that provide insight into how ModCloth’s business model is performing ?  Only one of the four non-financial metrics (i.e., UGC) appears to directly relate to even one of the Company’s five value chain activities.  And then there’s learning and growth?  How are ModCloth’s investments in its people and technology performing?  How are these being evaluated?  But enough on what was NOT discussed in this article. Let’s take a closer look at the customer-based measures about which ModCloth’s CFO is so passionate.

    Engagement

    ModCloth’s CFO defines engagement as user actions that have been proven to increase the average lifetime value of a customer and drive powerful solutions to otherwise intractable business problems. He concludes that:

    Continued in article

    Bob Jensen's threads on performance medtrics ---
    http://www.trinity.edu/rjensen/roi.htm


    Jensen Comment
    I can only wish more quant papers were written in this style of blending the English language with mathematics to make sense of investment risk for those who cannot follow one equation after the other.

    Bayesian Probability --- http://en.wikipedia.org/wiki/Bayesian_probability

    Financial Risk --- http://en.wikipedia.org/wiki/Financial_Risk

    Beta Risk --- http://en.wikipedia.org/wiki/Beta_%28finance%29

    Alpha Risk --- http://en.wikipedia.org/wiki/Alpha_%28finance%29

    "The forever elusive α (alpha)," by Salil Mehta, Statistical Ideas Blog, February 2014 ---
    http://statisticalideas.blogspot.com/2014/02/forever-elusive-alpha.html

    Humans have been repeating this inefficient ritual for over 700 years, with the first known origins then in Europe.  There sprung lenders and insurers who assessed the relative merits of individual commercial risk.  The methods were somewhat more crude versus the resources available to people today, but none-the-less this is the humble birthplace from where modern investment speculation gets its origin.  What should be the effective interest rate to lend an emerging company wanting to complete a construction project?  What should an insurer charge to protect a ship voyaging across a stormy sea, so that the premium pricing is both attractively profitable yet competitive?

     
    Over time, more information was rapidly made available concerning those who needed capital market resources.  And more ordinary people were able to invest in companies and products.  Through the distribution of personal wealth and technological progress, society experienced episodic bouts of speculations and manias.  The conversion of defined benefit plans in the U.S. to one where American workers invest their own contributions, combined with draining real median wage growth, created a force for even greater heterogeneity of outcomes in the desperate and greedy individual pursuit of α (alpha).  And then the digital age took these advances to another level, now allowing virtually everyone to more quickly and easily trade however they want.  But how can these seeming innovations be good for society, if there is a slimmer portion of risk-adjusted beneficiaries?  Let’s explore the outcomes and difficulties in the great, inefficient search for exceptional alpha.

     
    The true statistical test for outperformance relative to a highly liquid, and investable benchmark takes into account how likely such performance could have been attained by luck alone.  Afterall over any period of time, there will be separation in the market fates of individual stocks within a basket.  Concurrently, some purely lucky stock holders will own specific stocks that just uniformly outperforms the underlying index over this same period of time.

     
    Nonetheless it is worth noting that the difficult statistical standard necessary to warrant the concept of skill over a long career, or life, has a smaller side effect.  And that is that only minorities of those who speculate will actually have, through skill, statistically outperformed the broader stock index.

     
    Let’s show how this works, using the time since the recent financial crisis as a baseline frame for this analysis.  From there we’ll expand to a broader set of applications and timeframes.  The market has gone through a large hockey-stick pattern since the height of the financial crisis, 5.5 years ago.  Equity markets initially plummeted through early 2009, but have since smoothly rallied to new highs. 

     
    If you and your friends had all tried your hand at stock selection and market-timing along the way, then there is a good chance that you are feeling pretty good right now.  Making money is always a welcome relief, but emotional ego perilously inflates disproportionately with the rise of one’s portfolio.  Even more, in the case of the vast majority of people (those who basically doubled their investments alongside the market index, instead of outright quadrupled it), feeling too good is simply unwarranted.  Humility must substitute for hubris, since luck accounts for a great deal of post-crisis performance.

     

    How likely is it that an investor (or speculator) in U.S. equities over the past 5.5 years has demonstrated significant investment skills in this asset class?  For our test we reduce the investable universe to a mapping of the current 30 Dow Jones Industrial Average (DJIA) stocks.  We start with a performance threshold of selecting a basket of any of the top quarter of these 30 stocks for each of the past 5.5 years.  And these top 8 stocks had a minimal monthly outperformance of 1.2% (15% annualized), with a 0.5% standard deviation.  This implies a significantly low, 1% chance of straying that far from the rest of the DJIA by chance alone.

     
    Then being satisfied with our critical threshold, we next solve the probability of continuously selecting a basket of the annual top quarter of DJIA stocks by chance alone.  This is an elementary, compounded Bernoulli problem, and it comes to 0.1%.

     
    We then use Bayesian probability (see equality below) to determine the portion of the population that has skill near the required 1.2% monthly outperformance, in order to compensate for the low 0.1% probability of attaining these results by luck alone.  And this portion of the population comes to 21%.

     
    p(outperform) = p(outperform|luck)*p(luck) + p(outperform|skill)*p(skill)

    Which rearranges to the following.

    p(skill) = [p(outperform) - p(outperform|luck)*p(luck)] / p(outperform|skill)

     
    While there are empirical differences that would ensue from, not the β (beta) of the 30 DJIA stocks, but rather from the component of the typical correlation and dispersion components of beta.  For example, when the correlation is high and the dispersion is low, then more than typical portion of the investing population at that time would be able to outperform based on skill.  And when the opposite parameters define the investment regime, then less than the typical portion of the investment population would be able to outperform based on skill.

     
    Theoretically expanding this example to different time frames, we get the following results.  Note that these examples work for the most common approach to equities speculation: market-timing with a discretionary allocation towards individual stocks.  For 2 years, instead of 5.5 years, the portion of the population with skill increased to 36%.  This is because it is significantly less difficult to outperform monthly at the stated 1.2%, for less years.  And hence we don't need as many lucky investors in order to get the same overall portion of outperforms.  

    On the other end of the time spectrum, for 25 years and 50 years of speculation, the portion of speculators who can maintain the same level of statistical evidence of investment skills rapidly decreases to 0.76% and 0.02%, respectively.  This is shown in
    blue, on the left axis of the chart below.

     
    We can also skills-adjust these data, so that we can solve for the level of outperformance that a 2, 25, and 50 years investment career would need to equate to the same level of investment difficulty, as the 1.2% monthly outperformance that is now associated with 5.5 years.  This comes to 2.0%, 0.58%, and 0.4%, respectively.  See the red data below.  Incidentally these monthly outperformances equate to an annual outperformance of about 27%, 7%, and 5%.

    . . .

    Now on the other end of the age spectrum, nearly a few thousand people with 20-30 years of investing experience have outperformed will skill.  And finally of those in Warren’s age group (45-55 years of investing experience), just less than a hundred have also outperformed with skill. 

     
    Does this seem like a lot?  Well to put this into some perspective, 99% of the top managing directors on Wall Street would have not outperformed with skill over this period.

     
    With such daunting odds, what advice is there for people who dimly choose to speculate anyway, tying up large amounts of their human capital?  There are five specific advice here to impart. 
    • The first advice is that this age-old ritual is extraordinarily more transparent and fair then ever before.  This makes things brutally more difficult, and the fact that more people attempt to acquire alpha doesn’t advance the ease for you in actually achieving it.  Just as additional people playing the lottery can never increase your personal odds of holding the winning ticket.  
    • The second advice is that simply learning the rules of finance or working in the industry hardly increases your chance of outperforming the market (see quote at bottom).  This chance we showed in the note is fairly established in probability theory, and it's super low.  The advice here is akin to knowing how to throw a javelin or play chess doesn’t imply we should think we can then compete in the Olympics nor play chess against a computer, respectively.  
    • The third advice is that much more often it is better to simply buy an index fund (and thereby be guaranteed to outperform most of the people who are generally unsuccessful in their attempt to outperform the market), and know that investment capacity is often dear and that human capital are often better spent only entertaining some other pursuits.  
    • The fourth advice is that the very small number of people are skilled investors share some rare talents.  They are gifted with an unusual ability to seamlessly connect specific dots within an investment problem, well beyond the abilities of normal smart people.  The skills could be in a subset of understanding behavioral finance, consumer sentiment, technical analysis, international public policy, global macro economics, risk, statistics, derivatives, valuation accounting, etc.  Of greater importance, they know the many areas of investment knowledge where they do not personally excel at a global level, and nimbly have the sense then to avoid those investment areas that trap others.  
    • And the fifth advice is that selecting world-class stocks or a world-class investment manager are both generally difficult, and anyway inefficient.  If one can’t successfully select the former, then one can’t usually successfully select the latter.  Simply selecting an investment manager for example, such as BRK (which at least can proudly prove their long-term record), can often provide a false reading for the subsequent five years or so.  Just see how the past 5.5 years of BRK were, as they were the most disastrous for the company, since 1965!  Another example could be one of my college professor's (Merton) who won a Nobel prize in economics, yet then went on to co-lead the destruction of a master hedge fund.

    We close with a 1998 quote from Warren Buffett.  May the wisdom prove promising to those who still want to toil away, in pursuit of that magically elusive thing.

     
    Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

    Bob Jensen's threads on financial performance and risk ---
    http://www.trinity.edu/rjensen/roi.htm

    "A Scrapbook on What's Wrong with the Past, Present and Future of Accountics Science"
    Bob Jensen
    February 19, 2014
    SSRN Download:  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2398296 

     

     


    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 threads on valuation are at http://www.trinity.edu/rjensen/roi.htm

    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/

    Inside Footnotes (advice from and for security analysts) ---
    http://www.footnoted.com/inside-footnotes/ 

    Bob Jensen's investment helpers ---
    http://www.trinity.edu/rjensen/Bookbob1.htm#InvestmentHelpers


    Teaching Case from The Wall Street Journal Accounting Weekly Review on February 8, 2013

    Price/Earnings Ratio
    by: Simon Constable
    Feb 04, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Earnings Per Share, Financial Statement Analysis

    SUMMARY: This article gives an excellent description of alternative measures for the P/E ratio: the simple ratio, "forward" P/E, and "trailing" P/E based on the last four quarters of results. The discussion also mentions adjusting the historical quarterly results used in the trailing P/E measurement to remove unusual gains and losses.

    CLASSROOM APPLICATION: The article may be used in a financial accounting or financial statement analysis class when covering the P/E ratio and/or earnings per share calculations. Also, because of the reference to adjustments for unusual items, it may be used when covering treatment of unusual and extraordinary items. NOTE: INSTRUCTORS SHOULD REMOVE THE FOLLOWING STATEMENT BEFORE DISTRIBUTING TO STUDENTS. Question two asks students to obtain information from their class textbooks so answers will vary; however, students should identify the simple P/E ratio as the measure described in their textbooks.

    QUESTIONS: 
    1. (Introductory) What three alternative measures of the price-earnings ratio (P/E ratio) are described in this article?

    2. (Advanced) Which of the three measures matches the definition of the P/E ratio given in your textbook? Explain your answer.

    3. (Introductory) What weakness in the simple P/E ratio is overcome by using the "forward" P/E ratio? What problems arise with the forward measurement?

    4. (Advanced) What weakness in the simple P/E ratio is overcome by using the trailing four quarters in the measurement? Specifically identify how this measure differs from the simple P/E ratio first described in the article.

    5. (Advanced) The author states that users should make adjustments for unusual items in the "trailing" P/E measure. Why do you think that is his recommendation?

    6. (Advanced) "'Low P/E stocks outperform high P/E stocks,' says Jeff Mortimer...." Explain the argument for this assertion by the investment strategy director at BNY Mellon Wealth Management.
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Price/Earnings Ratio," by Simon Constable, The Wall Street Journal, February 4, 2013 ---
    http://professional.wsj.com/article/SB10001424127887323277504578189803847508428.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    The price of a stock doesn't tell you anything about whether it's a good deal, but the so-called price/earnings ratio can help. The trick is figuring out which P/E ratio to use.

    Obviously, just because one stock is $200 a share and another $12 doesn't mean the latter is cheaper in terms of what you're getting. For a better gauge, you need to calculate what you are paying for each dollar of company earnings. Hence, the P/E ratio, derived by dividing the price of the stock by one year of per-share earnings. So if one stock has a P/E of 12 and the other of 10, the latter is cheaper.

    "Low P/E stocks outperform high P/E stocks," says Jeff Mortimer, director of investment strategy at BNY Mellon Wealth Management, a unit of Bank of New York Mellon Corp. "It does work over time with a broad basket of names."

    But the simple P/E ratio is just a starting point. You also can calculate a "forward" P/E, using average analyst estimates for future earnings. That provides an indication of what the average investor is prepared to pay for future earnings. A high forward P/E, though, can mean a couple of things. It could be that investors are willing to pay up for a stock because they expect earnings to grow at a rapid clip. Or it could be they've simply gotten carried away in a frothy market.

    Another wrinkle: Estimated earnings may be unrealistic. "You can make the forward P/E anything you want [by boosting the forecast]," says Mr. Mortimer.

    He prefers to calculate a "trailing" P/E based on the last four quarters of results, adjusted for unusual gains and charges. Deciding what to exclude can get tricky, but generally items that aren't likely to be repeated are left out.

    That way, investors can get an idea of what the business earned from operations before relatively unusual events like plant closings.

    Of course, historical earnings may not tell you much about where a company is headed. Think about the hit the uranium industry took following the 2011 Fukushima nuclear disaster in Japan. The prior 12 months of earnings and the resulting P/E would have given you little clue about how to invest.

    Continued in article

    Bob Jensen's threads on P/E and other financial ratios are at
    http://www.trinity.edu/rjensen/roi.htm
    One problem with any ratios containing earnings is that the FASB and the IASB destroyed the concept of earnings to such a degree that they themselves can no longer define earnings. One problem is the mixing of realized earnings contracts with unrealized value changes that in many instances are never realized.  Hence, comparing earnings ratios of one company over time or multiple companies at one point in time becomes like mixing apples with skate boards.

     


    From The Wall Street Journal Accounting Weekly Review on September 3, 2010

    The Decline of the P/E Ratio
    by: Ben Levisohn
    Aug 30, 2010
    Click here to view the full article on WSJ.com
    Click here to view the video on WSJ.com WSJ Video

    TOPICS: Analysts' Forecasts, Financial Statement Analysis, Forecasting

    SUMMARY: "While U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% margin, on average, the stock market has dropped 5%. Based on trailing 12-month earnings, the average price earnings (P/E) ratio in the overall market is about 14.9 compared to 23.1 in September 2009; "based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May, 2010." The reason for this divergence is, of course, economic uncertainty that is not evident in the (average) point estimates of earnings nor in the relatively good earnings numbers of both the first and second calendar quarters of 2010. The related article is a WSJ graphic of earnings per share actual compared to average analyst estimates, by industry and by week.

    CLASSROOM APPLICATION: The article is useful to show the need for understanding context of ratios in undertaking financial statement analysis. It also demonstrates that ratios can be measured in more than one way, such as the use of past earnings or analysts' average forecasts. The related article can be used to introduce students to analysts' earnings forecasts.

    QUESTIONS: 
    1. (Introductory) Define the price earnings ratio (P/E) and explain its meaning.

    2. (Introductory) What two methods of measuring P/E are described in the article? Why do you think both are used?

    3. (Introductory) Refer to the related article. How are analysts' estimates used in this WSJ graphic analysis? In your answer, also describe who are the analysts producing these estimates.

    4. (Advanced) How did companies perform relative to analysts' estimates in the second calendar quarter of 2010?

    5. (Advanced) What has happened to the P/E ratio? Why does the author say the P/E has fallen in relevance? Do you agree with that assessment?

    6. (Introductory) What other evidence in the article corroborates the issues in the recent fall in the average P/E ratio?

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    Now Reporting: Earnings
    by
    Aug 01, 2010
    Online Exclusive

    "The Decline of the P/E Ratio," by: Ben Levisohn, The Wall Street Journal, August 30, 2010 ---
    http://online.wsj.com/article/SB10001424052748703618504575459583913373278.html?mod=djem_jiewr_AC_domainid

    As investors fixate on the global forces whipsawing the markets, one fundamental measure of stock-market value, the price/earnings ratio, is shrinking in size and importance.

    And the diminution might not stop for a while.

    The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.

    But while U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% margin, on average, the stock market has dropped 5% this month.

    The stock market's average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.

    So what explains the contraction? In short, economic uncertainty. A steady procession of bad news, from the European financial crisis to fears of deflation in the U.S., has prompted analysts to cut profit forecasts for 2011.

    "The market is worrying not just about a slowdown, but worse," said Tobias Levkovich, chief U.S. equity strategist at Citigroup Global Markets in New York. "People want clarity before they make a decision with their money."

    Three months ago, analysts expected the companies in the Standard & Poor's 500-stock index to boost profits 18% in 2011. Now, they predict 15%. Mutual-fund, hedge-fund and other money managers put the increase at closer to 9%, according to a recent Citigroup survey, while Mr. Levkovich's estimate is for 7% growth.

    "The sustainability of earnings is in doubt," said Howard Silverblatt, an index analyst at S&P in New York. "Estimates are still optimistic."

    Equally troublesome, analysts' forecasts are becoming scattered. In May, the range between the highest and lowest analyst forecasts of S&P 500 earnings per share in 2011 was $12. Morgan Stanley predicted $85 per share, while UBS predicted $97 per share. Now, the spread is $15. Barclays said $80 per share; Deutsche Bank predicts $95.

    When profit forecasts are tightly clustered, it signals to investors that there is consensus among prognosticators; when they diverge wildly, it shows a lack of clarity. The P/E ratio tends to fall as uncertainty rises, and vice versa.

    "A stock is worth its future earnings, but that involves uncertainty," said Jeremy Siegel, professor of finance at the University of Pennsylvania's Wharton School. "The more uncertainty there is, the lower the P/E will be."

    Not only is the P/E ratio dropping, it also is in danger of losing some of its prominence as a market gauge.

    That is because, with profit and economic forecasts becoming less reliable, investors are focusing more on global economic events as they make trading decisions, parsing everything from Japanese government-debt statistics to shipping patterns in the Baltic region.

    To some extent this is in keeping with historical patterns. P/E ratios often shrink in size and significance during periods of uncertainty as investors focus on broader economic themes.

    P/E ratios fell sharply during the Depression of the 1930s and again after World War II, bottoming at 5.90 in 1949. They plunged again during the 1970s, touching 6.97 in 1974 and 6.68 in 1980. During those periods, global events sometimes took precedence over company-specific valuation considerations in the minds of investors.

    There have been periods when the P/E ratio was much more in vogue. A century ago, the buying and selling of stocks was widely considered to be a form of gambling. P/E ratios came about as a way to quantify the true value of a company's shares. The creation of the Securities and Exchange Commission during the 1930s made financial information more available to investors, and P/E ratios gained widespread acceptance in the decades that followed.

    But thanks to the recent shift toward rapid-fire stock trading, the P/E ratio may be losing its relevance. The emergence of exchange-traded funds in the past 10 years has allowed investors to make broad bets on entire baskets of stocks. And the ascendance of computer-driven trading is making macroeconomic data and trading patterns more important drivers of market action than fundamental analysis of individual companies, even during periods of relative calm.

    So where is the P/E ratio headed in the short term? A few optimists think it could rise from here. If corporate borrowing costs remain at record lows and stock prices remain depressed, companies will start issuing debt to buy back shares, said David Bianco, chief U.S. equity strategist for Bank of America Merrill Lynch. As a result, earnings per share would increase, he said, even if profit growth remains sluggish, and P/E ratios could jump with them.

    But today's economic uncertainty argues against that scenario. Consider that while P/E ratios dropped during the inflationary 1970s, they also fell during the deflationary 1930s. The one common thread tying those two eras of falling P/E ratios: unpredictable economic performance.

    "We're looking at a more volatile U.S. economy than we experienced in the last 30 years," said Doug Cliggott, U.S. equity strategist at Credit Suisse in Boston. "The pressure on multiples may be with us for quite some time."

    September 8, 2010 reply from John Briggs, John  [briggsjw@JMU.EDU]

    I saw this article and didn't quite "get" it...the title at least.

    Of course the P/E ratio is still relevant.

    My favorite site for this is www.multpl.com, where a guy provides a daily look at the Shiller ("Irrational Exuberance") 10-year P/E...10 years of data instead of 1.  It's currently 20.  It used to be 45.  Indeed, 45 was a bubble.

    Right now, you would think 16 would be appropriate, but extremely low interest rates argue for higher (in comparison to investing in bonds), but economic uncertainly argues for lower.

    So I'd make the case that this metric should be around 16 right now...20 indicates to me that stocks are slightly overvalued.

    The only time the P/E ratio really was ignored was in 2000, it seems to me.  I'm glad I had no money then.

    Teaching Case on Financial Statement Analysis and P/E Ratios


    From The Wall Street Journal Accounting Weekly Review on November 4, 2011

    Earnings and Stocks: Is It Trick or Treat?
    by: Kelly Evans
    Oct 31, 2011
    Click here to view the full article on WSJ.com
    Click here to view the video on WSJ.com WSJ Video
     

    TOPICS: Earning Announcements, Earnings Forecasts, Financial Analysis, Financial Statement Analysis, Stock Price Effects

    SUMMARY: This and the related article highlight the relation between stocks and earnings but also the influence of typical seasonal patterns in stock market returns.

    CLASSROOM APPLICATION: The article is useful to discuss financial statement ratios, particularly the price-earnings ratio, and the relationship between reported earnings, earnings expectations, and stock prices.

    QUESTIONS: 
    1. (Introductory) To what does author Kelly Evans attribute the good stock market performance of October 2011? In your answer, describe the quarterly earnings reporting process and analysts' estimates for earnings.

    2. (Advanced) "The sticking point in all of this that estimates for the fourth quarter have dropped by 3% in October." Describe how you think this 3% drop is measured. (Hint: the video provides a helpful discussion of this topic.)

    3. (Advanced) Refer to the related article. How does the author use the price-earnings ratio to answer questions raised in the article? In your answer, define the price-earnings ratio and describe how it is measured for purposes of these two articles.

    4. (Introductory) Refer again to the related article. What other factors influence overall stock market performance?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Stocks Going by the Book
    by Jonathan Cheng
    Oct 31, 2011
    Page: C1

     

    "Earnings and Stocks: Is It Trick or Treat?" by: Kelly Evans, The Wall Street Journal, October 31, 2011 ---
    http://online.wsj.com/article/SB10001424052970203707504577007754040669274.html?mod=djem_jiewr_AC_domainid

    The strange dynamics of this earnings season are reminiscent of two prior, but diametrically opposed, inflection points: those of mid-2008 and mid-2009. That is, the stock market has surged even as forward earnings estimates fall.

    Typically, such declines would trigger a selloff as investors reassess the value of shares. Right now, though, the opposite is happening.

    The Standard & Poor's 500-stock index as of Friday was up 13.6% for the month—its best monthly performance since January 1987. Certainly, seeming progress toward resolving Europe's sovereign-debt crisis has played a big role in stocks' newfound favor. But on a more fundamental basis, it helps that the third-quarter earnings season is going well, despite some high-profile misses.

    More than 70% of companies have beaten earnings estimates, compared with 62% on average since the early 1990s. Prospects, however, have been dimming. Earnings estimates for the S&P 500 in the current fourthquarter have already fallen 3%—the biggest monthly decline since April 2009, according to FactSet analyst John Butters.

    The stock market has surged even as forward earnings estimates fall, and typicall such declines would trigger a selloff as investors reassess the value of shares. Right now, though, the opposite is happening, Kelly Evans reports on Markets Hub. Photo: AP.

    That doesn't have to mean disaster. In April 2009, the stock market was also rallying sharply despite lowered earnings expectations. Then, of course, stocks were building off the historic March lows, which already had exceptionally weak forward earnings priced in. The rally continued as investors grew more confident the U.S. was on the cusp of recovery, and analysts eventually had to start raising their earnings estimates to keep up.

    That rally, however, started out of a deep recession and came after a huge market selloff. This time, the S&P 500 started from a low point of about 1100—some 65% higher than in March 2009. More to the point, the economy today isn't coming out of recession, but trying to avoid falling back into one.

    Continued in article

    Bob Jensen's bookmarks for financial ratios --- http://www.trinity.edu/rjensen/Bookbob1.htm#010303FinancialRatios
    Also see http://en.wikipedia.org/wiki/Financial_ratios

     


    The Full List of NFL Team Valuations --- http://www.forbes.com/nfl-valuations/

    "Dallas Cowboys Lead NFL With $2.1 Billion Valuation," by Mike Ozanian, Forbes. September 5, 2012 ---
    http://www.forbes.com/sites/mikeozanian/2012/09/05/dallas-cowboys-lead-nfl-with-2-1-billion-valuation/

    The most famous quote attributed to legendary Green Bay Packers coach Vince Lombardi is “winning isn’t everything, it’s the only thing.” But if Lombardi had coached in this era instead of the 1960s he may have substituted the word “marketing” for “winning.”

    The Dallas Cowboys have not been to the Super Bowl in 16 years. But the lack of a title game appearance has done nothing to slow down the money that flows into the arms of Jerry Jones, the oilman who bought the National Football League team and lease to its stadium in 1989 for $150 million. The Cowboys are now worth $2.1 billion, more than any sports team on the planet, save Manchester United. And if the English soccer club, which recently sold shares to the public, stumbles, the Cowboys will run right past them because nobody in football can match Jones when it comes to marketing and squeezing cash from a stadium.

    Last season the Cowboys generated $500 million in total revenue, a record for an American sports team, and posted operating income (earnings before interest, taxes, depreciation and amortization) of $227 million, $108 million more than any other football team and more than either the entire National Basketball Association or National Hockey League. A prime example of what separates Dallas from the league’s other 31 teams is the more than $80 million in sponsorship revenue Cowboys Stadium rakes in from companies such as Ford Motor, Bank of America, PepsiCo, Dr. Pepper and Miller Brewing, almost $20 million more than any other football team. Sponsorship revenue, unlike the NFL’s national television fees with NBC, Fox, ESPN and CBS, are not shared equally with the other teams.

    Continued in article

    Jensen Comment
    I think it's more than just marketing. Another factor is location, Texas is a state where high schools will spend upwards of $60 million for a high school stadium and books and television shows like Friday Night Lights are written ---
    http://www.nbc.com/friday-night-lights/

    It also helps to be in a location where fans do not have to sit outdoors in below-zero weather and raging blizzards.

    Bob Jensen's threads on valuation ---
    http://www.trinity.edu/rjensen/roi.htm


    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.
    Name
    Link to Earnings Report
    First Call
    Operating EPS
    Net Income
    Per-Share
    Per-Share
    Difference
    FMC
    earnings report
    $1.58 –$9.62 $11.20
    Applied Micro Circuits
    earnings report
    –0.05 –11.18 11.13
    Great Lakes Chemical
    earnings report
    +0.35 –3.06 3.41
    AMR
    earnings report
    –0.68 –3.29 2.61
    Conexant Systems
    earnings report
    –0.45 –3.02 2.57
    Eastman Chemical
    earnings report
    +0.55 –1.92 2.47
    Cummins
    earnings report
    +0.06 –2.14 2.20
    Qwest Communications
    earnings report
    +0.08 –1.99 2.07
    Broadcom
    earnings report
    –0.16 –1.73 1.57
    Sears Roebuck
    earnings report
    +0.96 –0.60 1.56

    Sources: company news releases; Thomson Financial/First Call


    Fundamentals Analysis and Value Investing

    A Fundamentals Approach to Valuing a Business

    In the great book Dear Mr. Buffett, Janet Tavakoli shows how Warren Buffet learned value (fundamentals) investing while taking Benjamin Graham's value investing course while earning a masters degree in economics from Columbia University. Buffet also worked for Professor Graham.

    The following book supposedly takes the Graham approach to a new level (although I've not yet read the book). Certainly the book will be controversial among the efficient markets proponents like Professors Fama and French.

    Purportedly a Great, Great Book on Value Investing
    From Simoleon Sense, November 16, 2009 --- http://www.simoleonsense.com/

    OMG Did I Die & Go To heaven?
    Just Read, Applied Value Investing, My Favorite Book of the Past 5 Years!!
    Listen To This Interview!

    I have a confession, I might have read the best value investing book published in the past 5 years!

    The book is called Applied Value Investing By Joseph Calandro Jr. In the book Mr. Calandro applies the tenets of value investing via (real) case studies. Buffett, was once asked how he would teach a class on security analysis, he replied, “case studies”.  Unlike other books which are theoretical this book provides you with the actual steps for valuing businesses.

    Without a doubt, this book ranks amongst the best value investing books (with SA, Margin of Safety, Buffett’s letters to corporate America, and Greenwald’s book) & you dont have to take my word for it. Seth Klarman, Mario Gabelli and many top investors have given the book a plug!

    Here is an interview with the author of the book, Applied Value Investing ( I recommend listening to this). Who knows perhaps yours truly will interview him soon.

    Miguel

    P.S.

    A fellow blogger and friend will soon post a review of this book (hint: Street Capitalist!).

    Bob Jensen's threads on the Efficient Market Hypothesis are at ---
    http://www.trinity.edu/rjensen/theory01.htm#EMH

    Warren Buffett did a lot of almost fatal damage to the EMH
    If you really want to understand the problem you’re apparently wanting to study, read about how Warren Buffett changed the whole outlook of a great econometrics/mathematics researcher (Janet Tavkoli). I’ve mentioned this fantastic book before --- Dear Mr. Buffett. What opened her eyes is how Warren Buffet built his vast, vast fortune exploiting the errors of the sophisticated mathematical model builders when valuing derivatives (especially options) where he became the writer of enormous option contracts (hundreds of millions of dollars per contract). Warren Buffet dared to go where mathematical models could not or would not venture when the real world became too complicated to model. Warren reads financial statements better than most anybody else in the world and has a fantastic ability to retain and process what he’s studied. It’s impossible to model his mind.

    I finally grasped what Warren was saying. Warren has such a wide body of knowledge that he does not need to rely on “systems.” . . . Warren’s vast knowledge of corporations and their finances helps him identify derivatives opportunities, too. He only participates in derivatives markets when Wall Street gets it wrong and prices derivatives (with mathematical models) incorrectly. Warren tells everyone that he only does certain derivatives transactions when they are mispriced.

    Wall Street derivatives traders construct trading models with no clear idea of what they are doing. I know investment bank modelers with advanced math and science degrees who have never read the financial statements of the corporate credits they model. This is true of some credit derivatives traders, too.
    Janet Tavakoli, Dear Mr. Buffett, Page 19

    October 28, 2009 reply from Paul Williams [Paul_Williams@NCSU.EDU]

    Bob, et al,
    I never cease to marvel at the powers of rationalization defenders of sacred institutions can muster. The above characterization of EMH was certainly not the version pedaled by its accounting disciples (notably Bill Beaver) back in the late 60s and early 70s. An accounting research industry was created based on a version of EMH that was decidedly more certain that securities were "properly priced." [Why else do studies to debunk the Briloff effect?].

    Given the interpretation offered above, "Information Content Studies" make no sense. The whole idea of this methodology was that accounting data that correlated with prices implied market participants found it useful for setting prices based on publicly available data, which implied such prices were the ones that would exist in an idealized world of perfectly informed investors. Thus, this data met the test of being information and was to be preferred to other "non-information" to which the market did not react.

    But now we are told that this latest version of EMH does not justify such sanguinity because "...the prices in the market are mostly wrong...", thus prices are not an indicator of the value of data, i.e., just because there is a price effect we still don't know if that data is truly "information." Think of the millions and millions of taxpayer dollars that have been wasted over the last forty years subsidizing people to search for something that is indeterminate given the methodology they are employing.

    And for this the AAA awarded Seminal Contributions. Jim Boatsman had an ingenious little paper in Abacus eons ago titled, "Why Are There Tigers and Things," that cast serious doubts on the whole enterprise of "testing" market efficiency. It addressed the issue Carl Devine harped on about needing an independent definition of "information." And this is related to the logical slight of hand EMH required of surmising there is a way to know what the "true" price is since we glibly talk about over and under and mis-priced securities.

    But there is no way to know this, since security prices are CREATED by the institution of the securities market. There does not exist a natural process against which market performance can be compared. "Market value," which is what a price is, is a value established by the market. The market is all there is. To paraphrase NC's current governor's favorite expression, "The price is what it is."

    It isn't over or under or mis or proper or anything else, other than what a particular institution created by us at one moment in time determines it is. If we lived in a society in which mob rule settled issues of justice, it would make little sense to argue that someone the mob hung was "not guilty." Of course he was guilty, because the mob hung him!!

    Paul Williams
    paul_williams@ncsu.edu 
    (919)515-4436

    Bob Jensen's threads on the economic crisis are at http://www.trinity.edu/rjensen/2008Bailout.htm


    Question
    How do you compute the cost of capital when lenders pay you interest to borrow their money?
    Alan Blinder recommends that the Fed commence to pay FDIC banks to borrow money from the Federal Reserve. This in turn means that banks my profit from paying AAA creditors to borrow money from the bank.

    "Cost of Capital Measure Sees Distortions," by Emily Chason, CFO Report via The Wall Street Journal, July 25, 2012 ---
    http://blogs.wsj.com/cfo/2012/07/25/cost-of-capital-measure-sees-distortions/?mod=wsjpro_hps_cforeport

    The standard weighted average cost of capital calculation, long-used by finance departments for budgeting analysis, has been a bit distorted lately as low interest rates, record-low corporate borrowing costs and a volatile stock market have changed many of the basic inputs companies put into the measure.

    WACC, which is based on a company’s cost of equity and debt, corporate tax rate and market value of equity and debt, is used as a hurdle rate to value corporate investments. The consequence of using a distorted measure can be expensive, and some analysts say companies may want to start thinking more broadly about revising their expected return assumptions in the WACC number.

    Continued in article

    Bob Jensen's threads on ROI and Cost of Capital ---
    http://www.trinity.edu/rjensen/roi.htm


    Equity Valuation for the Real World Versus the Fantasyland of Accountics Researchers and Teachers in Academe

    Equity Valuation
    TAR book reviews are free online. I found the September 2010 reviews quite interesting, especially Professor Zhang's review of
    PETER O. CHRISTENSEN and GERALD A. FELTHAM, Equity Valuation, Hanover, MA:Foundations and Trends® in Accounting, 2009,
    ISBN 978-1-60198-272-8 --- Click Here

    This book is an advanced accountics research book and the reviewer leaves many doubts about the theory and practicality of adjusting for risk by adjusting the discount rate in equity valuation. The models are analytical mathematical models subject to the usual limitations of assumed equilibrium conditions that are often not applicable to the changing dynamics of the real world.

    The authors develop an equilibrium asset-pricing model with risk adjustments depending on the time-series properties of cash flows and the accounting policy. They show that operating characters such as the growth and persistence of earnings can affect the risk adjustment.

    What are the highlights of this book? The book contains five chapters and three appendices. Chapters 2 to 5 each contain separate yet closely related topics. Chapter 2 reviews and identifies problems with the implementation of the classical model. In Chapters 3 to 5, the authors develop an accounting-based, multi-period asset-pricing model with HARA utility. My preferences are Chapters 2 and 5. Chapter 2 contains a critical review of the classical valuation approach with a constant risk-adjusted discount rate. As noted above, the authors highlight several problems in estimating these models. Many of these issues are not properly acknowledged and/or dealt with in many of the textbooks. The authors provide a nice step-by-step analysis of the problems and possible solutions.

    Chapter 5 contains the punch line. The authors push ahead with the idea of adjusting risk in the numerator, and deal with the thorny issue of identifying and simplifying the so-called “pricing kernel.” Although the final model involves a rather simplifying assumption of a simple VAR model of the stochastic processes of residual income and for the consumption index, it provides striking and promising ideas of how to estimate and adjust for risk based on fundamentals, as opposed to stock return. It provides a nice illustration of how to incorporate time-change risk characteristics of firms with the change in firms’ operations captured by the change in residual income. This is very encouraging.

    There are some unsettling issues in this book. Not surprisingly, I find the authors’ review of the classical valuation approach to be somewhat tilted toward the negative side. For instance, many of the problems cited arise from the practice of estimating a single, constant risk-adjusted discount rate for all future periods. This seems to be based on the assumption that firms’ risk characteristics do not change materially over future periods. Of course, this is a grossly simplified approach in dealing with the issues of time-changing interest rates and inflation. To me, errors introduced by such an approach reflect more the shortcomings in the empirical or practical implementation, rather than the shortcomings in the valuation approach per se. As noted by the authors, using date-specific discount rates can avoid many of the problems. After all, under most circumstances in a neo-classical framework, putting the risk adjustment in the numerator or in the denominator may simply be an easy mathematical transformation. In some cases, of course, adjusting risk in the denominator does not lead to any solution to the problem. In that sense, adjusting in the numerator is more flexible.

    After finishing the book, I asked myself the following question: Am I convinced that the practice of adjusting risk in the discount rate should be abolished? The answer seems unclear, for a couple of reasons. First, despite the authors’ admirable effort in bringing context to it, the concept of “consumption index” still seems rather elusive. As a result, it lacks the appeal of the traditional CAPM, namely, a clear and intuitive idea of risk adjustment.

     Professor Zhang seems to favor CAPM risk adjustment without delving into the many controversies of using CAPM for risk adjustment in the real world ---
    http://www.trinity.edu/rjensen/theory01.htm#AccentuateTheObvious
    It would be interesting to see how these sophisticated analytical models are really used by real-world equity valuation analysts.

    Update on April 12, 2012
    Leading Accountics researchers like Bill Beaver and Steve Penman have a hard time owning up to CAPM's discovered limitations that trace back to their own research built on CAPM. Steve Penman owns up to this somewhat in his own latest book Accounting for Value that seems to run counter to his earlier book Financial Statement Analysis and Security Valuation.

    Bill Beaver's review of Accounting for Value makes an interesting proposition:
     Since Accounting for Value admits to limitations of CAPM and lack of capital market efficiency it should be of interest to investors, security analysts, and practicing accountants consulting on valuation. However, Penman's Accounting for Value is not of much interest to accounting professors and students who, at least according to Bill, should continue to dance in the fantasyland of assumed efficient markets and relevance of CAPM in accountics research.

    Accounting for Value
    by Stephan Penman
    (New York, NY: Columbia Business School Publishing, 2011, ISBN 978-0-231-15118-4, pp. xviii, 244).
    Reviewed by William H. Beaver
    The Accounting Review, March 2012, pp. 706-709
    http://aaajournals.org/doi/full/10.2308/accr-10208
    Jensen Note:  Since TAR book reviews are free to the public, I quoted Bill's entire review

    When I was asked by Steve Zeff to review Accounting for Value, my initial reaction was that I was not sure I was the appropriate reviewer, given my priors on market efficiency. As I shall discuss below, a central premise of the book is that there are substantial inefficiencies in the pricing of common stock securities with respect to published financial statement information. At one point, the book suggests that most, if not all, of the motivation for reading the book disappears if one believes that markets are efficient with respect to financial statement information (page 3). I disagree with this statement and found the book to be of value even if one assumes market efficiency is a reasonable approximation of the behavior of security prices.

    It is unclear who is the intended audience—academic or nonacademic. This is an important issue, because it determines the basis against which the book should be judged. For an academic audience, the book would be good as a supplemental text for an investments or financial statement analysis course. However, for an academic audience, it is not a replacement for his previous, impressive text, Financial Statement Analysis and Security Valuation (2009). The earlier text goes into much more detail, both in terms of how to proceed and what the evidence or research basis is for the security valuation proposed. The previous book is excellent as the prime source for a course, and the current effort is not a substitute for the earlier text.

    However, as clearly stated, the primary audience is not academic and is certainly not the passive investor. The book was written for investors, and for those to whom they trust their savings (page 1). Moreover, as stated on pages 3–4, the intended audience is the investor who is skeptical of the efficient market, who is one of Graham's “defensive investors,” who thinks they can beat the market, and who perceives they can gain by trading at “irrational” prices.1 For this reason, the book can be compared with the plethora of “how to beat the market” books that fill the “Investments” section of most popular bookstores. By this standard, Accounting for Value is well above the competition. It is much more conceptually based and includes references to the research that underlies the basic philosophy. By this standard, the book is a clear winner.

    Another standard is to judge the effort, not by the average quality of the competition, but by one of the best, Benjamin Graham's The Intelligent Investor (1949). This, indeed, is a high standard. The Intelligent Investor is the text I was assigned in my first investments course. My son is currently in an M.B.A. program, taking an investments course, so for his birthday I gave him a copy of Graham's book. However, markets and our knowledge of how markets work have changed enormously since Graham's book was written.

    The comparison with The Intelligent Investor is natural in part because the text itself explicitly invites such comparisons with the many references to Graham and by suggesting that it follows the heritage of Graham's book. It also invites comparisons because, like Graham's book, it is essentially about investing based on fundamentals and tackles the subject at a conceptual level with simple examples, without getting bogged down in extreme details of a “how to” book. I conclude that Accounting for Value measures up very well against this high standard and is one of the best efforts written on fundamental investing that incorporates what we have learned in the intervening years since the first publication of The Intelligent Investor in 1949. I have reached this conclusion for several reasons.

    One of the major points eloquently made is that modern finance theory (e.g., CAPM and option pricing models) consists of models of the relationship among endogenous variables (prices or returns). These models derive certain relative relationships among securities traded in a market that must be preserved in order to avoid arbitrage opportunities. However, as the text points out, these models are devoid of what exogenous informational variables (i.e., fundamentals) cause the model parameters to be what they are. For example, in the context of the CAPM, beta is a driving force that produces differential expected returns among securities. However, the CAPM is silent on what fundamental variables would cause one company's beta to be different from another's. One of major themes developed in the text is that accounting data can be viewed as a primary set of variables through which one can gain an understanding of the underlying fundamentals of the value of a firm and its securities.2 This is extremely important to understand, regardless of one's priors about market efficiency. A central issue is the identification of informational variables that aid in our understanding of security prices and returns. As accounting scholars, we have an interest in the “macro” (or equilibrium) role of accounting data beyond or independent of the “micro” role of determining whether it is helpful to an individual in identifying “mispriced” securities.

    Another major contribution is the development of a valuation model of fundamentals through the lens of accounting data based on accrual accounting. In doing so, the text makes another important point—namely the role of accrual accounting in bringing the future forward into the present (e.g., revenue recognition).3 In other words, accrual accounting contains implicit (or explicit) predictions of the future. It is argued that, since the future is difficult to predict, accrual accounting permits the investor to make judgments over a shorter time horizon and to base those judgments on “what we know.” The text develops the position that, in general, forecasts and hence valuation analysis based on accrual accounting numbers will be “better” than cash flow-based valuations. It is important to understand that the predictive role is a basic feature of accrual accounting, even if one disagrees about how well accrual accounting performs that role. Penman believes it performs that function very well and dominates explicit future cash flow prediction, based on the intuitive assumption that the investor does not have to forecast accrual accounting numbers as far into the future as would be required by cash flow forecasting. The implicit assumption is that the prediction embedded in accrual numbers is at least as good, if not better, than attempts to forecast future cash flows explicitly.

    A third major point is that book-value-only or earnings-only models are inherently underspecified and fundamentally incomplete, except in special cases. Instead, a more complete valuation approach contains both a book value and a (residual) earnings term. A point effectively made is that measurement of one term can be compensated for by the inclusion of the other variable by virtue of the over-time compensating mechanism of accrual accounting.

    A major implication of the model is the myopic nature of two of the most popular methods for selecting securities: market-to-book ratios and price-to-earnings ratios. Stocks may appear to be over- or underpriced when partitioning on only one these two variables. Using a double partitioning can help alleviate this myopia.

    The book is positioned almost exclusively from the perspective of the purchaser of securities. For example, one of the ten principles of fundamental analysis (page 6) is “Beware of paying too much for growth.” Presumably, a fundamental investor of an existing portfolio is a potential seller as well as a buyer. As a potential seller, the investor has an analogous interest in selling overpriced securities, but this is not the perspective explicitly taken. In spite of the apparent asymmetry of perspective, the concepts of the valuation model would appear to have important implications for the evaluation of existing securities held.

    In the basic valuation model, value is equal to current book value, residual earnings for the next two years, and a terminal value term based on the present value of residual earnings stream beyond two years.4 The model bears some resemblance to the modeling of Feltham and Ohlson (1995) but adds context of its own. A central feature of the approach is to understand what you know and separate it from speculation.5 In this context, book value is “what you know,” and everything else involves some degree of speculation. The degree of speculation increases as the time horizon increases (e.g., long-term growth estimates).

    A key feature is that it is residual earnings growth, not simply earnings growth, that is the driver in valuation. Price-earnings-only models are incomplete because of a failure to make this distinction. The nature of the long-term residual earnings growth is highly speculative, which leads to one of the investment principles—beware of paying too much for growth. The text provides some benchmarks in terms of the empirical behavior of long-term residual growth rates and reasons why abnormal earnings might be expected to decay rapidly. A higher expected residual growth is also likely to be associated with higher risk and hence a higher discount rate. All of these factors mitigate against long-term growth playing a large role in the fundamental value (i.e., do not pay too much for growth). A similar point is made with respect to the effect of leverage upon growth rates (Chapter 4).

    A remarkable feature of the book is how far it is able to develop its basic perspective without specifying the nature of the accounting system upon which it is anchoring valuation other than to say that it is based on accrual accounting. Chapter 5 begins to address the nature of the accrual accounting system. A central point is that accounting treatments that lower current book value (e.g., write-offs and the expensing of intangible assets) will increase future residual earnings (Accounting Principle 4). In particular, conservative accounting with investment growth induces growth in residual income (Accounting Principle 5). However, conservatism does not increase value. Hence, valuations that focus only on earnings to the exclusion of book value can lead to erroneous valuation conclusions. An investor must consider both (Valuation Principle 6).

    Chapter 6 addresses the estimation of the discount rate. A central theme is how little we know about estimating the discount rate (cost of capital), and we can provide, at best, very imprecise estimates. The proposed solution is to “reverse engineer” the discount rate implied by the current market price and ask yourself if you consider this to be a rate of return at which you are willing to invest, which is viewed as a personal attribute. Several examples and sensitivity analyses are provided.

    Chapter 7 synthesizes points made in earlier chapters about how the investor can gain insights into distinguishing growth that does not add to value from growth that does, through a joint analysis of market-to-book and price-to-earnings partitions. The joint analysis is clever and is likely to be informative to an investor familiar with these popular partitioning variables, but is perhaps not yet ready to use the explicit accounting-based valuation models recommended.

    Chapter 8 addresses the attributes of fair value and historical cost accounting and is the chapter that is the most surprising. The chapter is essentially an attack on fair value accounting. Up until this point, the text has been free of policy recommendations. The strength lies in taking the accounting rules as you find them, which is a very practical suggestion and has great potential readership appeal. The flexibility of the framework to accommodate a variety of accounting systems is one of its strengths. As a result, the conceptual framework is relatively simple. It does not attempt to tediously examine accounting standards in detail, nor does it attempt to adjust accounting earnings or assets to conform to a concept of “better” earnings or assets, in contrast to other valuation approaches. I found the one-sided treatment of fair value accounting to be disruptive of the overall theme of taking accounting rules as you find them.

    The text provides an important caveat. The framework is a starting point rather than the final answer. A number of issues are not explicitly addressed. It can also be important to understand the specific effects of complex accounting standards on the numbers they produce. Further, there is ample evidence that the market does price disclosures supplemental to the accounting numbers. Discretionary use of accounting numbers also can raise a number of important issues.

    In sum, the text provides an excellent framework for investors to think about the role that accounting numbers can play in valuation. In doing so, it provides a number of important insights that make it worthwhile for a wide readership, including those who may have stronger priors in favor of market efficiency.

    "AOL and the Case Against Efficient Market Theory," by Roben Farzad, Business Week, April 11, 2012 ---
    http://www.businessweek.com/articles/2012-04-11/aol-and-the-case-against-efficient-market-theory 

    This time last week, I, like nine out of every 10 investors, believed AOL (AOL) was a dead-end investment. How could it not be? This is no longer a 56k, dial-up world, when those ubiquitous AOL disks inundated mailboxes. AOL botched the chance to morph into a broadband player with its spectacularly bad marriage to Time Warner (TWX). AOL is behind on social media, and is struggling to compete for ad dollars with Google (GOOG) and Facebook. Its sales declined in each quarter last year.

    How many chances does a legacy company get? (Remember this reinvention?)

    Then, on April 9, as if out of nowhere, Microsoft (MSFT)dropped in to buy $1 billion of AOL’s patents, sending the latter’s shares up 43 percent in a single day. In the two years leading up to the deal, the stock was down 37 percent.

    How could a supposedly omniscient market get this story so wrong? One explanation was offered by MDB, an intellectual property-focused investment bank. MDB says the AOL patents had more relevance to Microsoft and that company was uniquely well-studied on them, especially in light of AOL’s ancient acquisition of Netscape, that Microsoft nemesis in the age of Windows 95. MDB found that Microsoft cited AOL patents as related intellectual property 1,331 times in its own patent filings, vs. AOL citing its own patents 1,267 times.

    Even so, it’s surprising that this play remained largely the province of tech-geek attorneys. After all, about 15 Wall Street analysts cover AOL—nine of them rating it either a hold or sell. Hedge funds and bloggers are constantly on it. The Microsoft deal shot AOL shares up two and a half times where they traded in August, when the company owned the same patents.

    I was similarly puzzled last summer when Google paid big (63 percent-premium-to-close big) for remnants of Motorola—placing major emphasis on the legacy tech company’s patents. Motorola Mobility (MMI) shares popped 57 percent in a matter of hours. I also scratched my head in September 2010, when Hewlett-Packard (HPQ)emerged victorious from a bidding war for a tiny data storage company called 3Par—by paying $33 a share for a stock that traded below $10 just three weeks earlier. How did everyone completely whiff on 3Par’s desirability and valuation?

    These disconnects have me thinking back to the words of my friend, Justin Fox of the Harvard Business Review Group, whose book The Myth of the Rational Market excoriated the idea that “the decisions of millions of investors, all digging for information and striving for an edge, inevitably add up to rational, perfect markets.

    Continued in article

    Bob Jensen's threads on valuation are at
    http://www.trinity.edu/rjensen/roi.htm

    Bob Jensen's critical threads on the Efficient Market Hypothesis (EMH) are at
    http://www.trinity.edu/rjensen/theory01.htm#EMH

     


    Innovative Corporate Performance Management: Five Key Principles to Accelerate Results
    by Bob Paladino
    ISBN: 978-0-470-62773-0 Hardcover 415 pages November 2010|
    Amazon has it priced for under $37 new and $23 used
    http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470627735.html

    Jensen Comment
    This is a bit too much Harvard Business School-like for me, but it does cover much of what we teach in managerial accounting.

    There seem to be a dearth of reviews of this book. I don't know why?

    April 19, 2011 reply from Jim Martin

    Performance management seems to be a relatively new catch-all term like
    cost management, activity-based management etc. I have been following this
    concept, or catch-all term for a while. I suspect most of the book can be
    found in Paladino's earlier and most recent works mainly in Strategic
    Finance.

    Paladino, B. 2007. Five Key Principles of Corporate Performance
    Management. John Wiley and Sons.

    Paladino, B. 2007. Five key principles of corporate performance
    management. Strategic Finance (June): 39-45.

    Paladino, B. 2007. Five key principles of corporate performance
    management. Strategic Finance (July): 33-41.

    Paladino, B. 2007. Five key principles of corporate performance
    management. Strategic Finance (August): 39-45.

    Paladino, B. 2008. Strategically managing risk in today's perilous
    markets. Strategic Finance (November): 26-33.

    Paladino, B. 2010. Innovative Corporate Performance Management: Five Key
    Principles to Accelerate Results. John Wiley and Sons.

    Paladino, B. 2011. Achieving innovative corporate performance management.
    Strategic Finance (March): 43-51.

    Paladino, B. 2011. Achieving innovative corporate performance management.
    Strategic Finance (April): 43-53.


    Google App Enhances Museum Visits; Launched at the Getty --- Click Here
    http://www.openculture.com/2011/06/google_app_getty.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+OpenCulture+%28Open+Culture%29

    Earlier this year, Google rolled out “Art Project,” a tool that lets you access 1,000 works of art appearing in 17 great museums across the world, from the Met in New York City to the Uffizi Gallery in Florence. (More on that here.) Now, as part of a broader effort to put art in your hands, the company has produced a new smartphone app (available in Android and iPhone) that enriches the museum-going experience, and it’s being demoed at the Getty Museum in Los Angeles.

    The concept is pretty simple. You’re wandering through the Getty. You spot a painting that deeply touches you. To find out more about it, you open the Google Goggles app on your phone, snap a photo, and instantly download commentary from artists, curators, and conservators, or even a small image of the work itself. Sample this, and you’ll see what we mean. And, for more on the story, turn to Jori Finkel, the ace arts reporter for the LA Times.

    Related Content:

    Art in “Augmented Reality” at The Getty Museum

    A Virtual Tour of the Sistine Chapel

    MoMA Puts Pollock, Rothko & de Kooning on Your iPad

     

    Jensen Comment

    The concept is pretty simple. You’re wandering through the annual report of Bank of America. You spot a reference to hedging of interest rates with swaps that confuses you. To find out more about it, you open the Google Goggles app on your phone, find a reference to interest rate swaps, and instantly download commentary interest rate hedging strategies and accounting with comparisons of accounting under IFRS versus FAS 133. The link might elaborate in detail on the very portion of the Bank of America annual report that you are examining.

     


    Question
    What do financial analysts do on the backs of envelopes and does it really matter to them whether we have IFRS-FASB convergence or fair value accounting?

    Hulu (streaming video) --- http://en.wikipedia.org/wiki/Hulu

    "Hulu Wants To IPO At A $2 Billion Valuation," by Jay Yarow, Business Insider, August  16, 2010 ---
    http://www.businessinsider.com/hulu-ipo-2010-8

    http://www.businessinsider.com/hulu-ceo-talks-ipo--here-are-the-financials-2010-7
    Read more: http://www.nytimes.com/2010/08/16/technology/16hulu.html?_r=2&dbk


    This illustrates how difficult it is to teach, let alone do accountics, research given the unknowns about impacts of variations in methodology. How do professors who teach from a few of their chosen studies prepare students about the simplifications inherent in any one model?

    It would seem that students have to be pretty sophisticated to understand the limitations of the accountics harvests.

    "The Cross-Section of Expected Stock Returns: What Have We Learnt from the Past Twenty-Five Years of Research," by Avanidhar Subrahmanyam University of California, Los Angeles - Finance Area, European Financial Management, Forthcoming

    Abstract:
    I review the recent literature on cross-sectional predictors of stock returns. Predictive variables used emanate from informal arguments, alternative tests of risk-return models, behavioral biases, and frictions. More than fifty variables have been used to predict returns. The overall picture, however, remains murky, because more needs to be done to consider the correlational structure amongst the variables, use a comprehensive set of controls, and discern whether the results survive simple variations in methodology.

    From Jim Mahar's blog on November 13. 2009 --- http://financeprofessorblog.blogspot.com/

    VERY good review article on the ability of financial models (CAPM, APT, Fama-French, etc) to predict and explain cross sectional stock returns).

    Super short version: While we have progressed, we have done so down different paths and there needs to be some standardization, testing for robustness, and checks for correlations across the many variables that have been used in past models.

    From Introduction:

    "The predictive variables are motivated principally in one of four ways. These are: • Informal Wall Street wisdom (such as “value-investing”) • Theoretical motivation based on risk-return (RR) model variants • Behavioral biases or misreaction by cognitively challenged investors • Frictions such as illiquidity or arbitrage constraints"

    AN ABSOLUTE MUST FOR CLASSES.


  • Teaching Case on Dividend Yield, Dividends, Financial Statement Analysis

    From The Wall Street Journal Accounting Weekly Review on September 28, 2012

    Payout Appreciation
    by: Matt Jarzemsky
    Sep 18, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Dividend Yield, Dividends, Financial Statement Analysis

    SUMMARY: "Since 2006, Hasbro, maker of the Monopoly board game, has tripled its dividend, increasing it annually except in 2009." Investors like Mark Freeman, "chief investment officer of Westwood Holdings Group in Dallas, are seeking companies that typically have rising earnings, relatively low debt levels and large piles of cash. Mr. Freeman also looks for companies whose dividends are low relative to their earnings, a sign there is room for growth [at more than the rate of inflation]."

    CLASSROOM APPLICATION: The article is useful to introduce the financial ratios of dividend payout, dividend yield and free cash flow.

    QUESTIONS: 
    1. (Introductory) Define dividend payout ratio and dividend yield.

    2. (Advanced) Do these two ratios measure different things? Explain.

    3. (Advanced) According to Paul Stocking, co-manager of Columbia Management's Dividend Opportunity fund, "we have seen the marketplace chasing these high-dividend payers." What will that do to the dividend yield and the dividend payout ratio? Explain your answer.

    4. (Advanced) "Cisco Chief Financial Officer Frank Calderoni said last month that the company will return more than half its annual free cash flow to shareholders through dividends and share buybacks." Is the company's dividend payout ratio therefore 50%? Explain your answer and include a definition of free cash flow.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Payout Appreciation," by Matt Jarzemsky, The Wall Street Journal, September 18, 2012 ---
    http://professional.wsj.com/article/SB10000872396390443720204578002381992037280.html?mod=djem_jiewr_AC_domainid&mg=reno-wsj

    Call them the new growth stocks.

    After rushing into dividend stocks of all stripes this year, some investors are homing in on a more select group: stocks of companies that are likely to keep raising their dividends at a fast clip.

    It is all part of the chase for better returns on the heels of the Federal Reserve's announcement last week of another round of bond buying aimed to keep interest rates at rock-bottom levels until the economy improves. As yields on the 10-year Treasury wallow at near-record lows and "junk"-bond yields also are sinking, investors are seeking anything that offers some extra income. For months, that meant investors bought shares of nearly any high-dividend-paying company, be it telecommunications companies such as Verizon Communications Inc. VZ +0.37% and AT&T Inc., T -0.24% energy producers such as Sempra Energy and tobacco company Altria Group Inc.  But now that has made many stocks too expensive, some investors said.

    Investors like Mark Freeman, chief investment officer of Westwood Holdings Group in Dallas, are seeking companies that typically have rising earnings, relatively low debt levels and large piles of cash. Mr. Freeman also looks for companies whose dividends are low relative to their earnings, a sign there is room for growth. Moreover, many also said they target companies that appear to have a board that has shown a willingness to keep increasing dividend payments.

    "All I'm looking for is high-quality companies that have some dividend yield and also the ability to grow that dividend at more than the rate of inflation," said Mr. Freeman, who helps oversee $14 billion across stocks and bonds. Mr. Freeman said he bought shares of PepsiCo Inc., which increased its payout 4.4% in May and 7.3% a year earlier, compared with consumer-price inflation of about 1.7% annually.

    A dividend yield measures how much cash an investor gets for each dollar invested and is calculated by dividing the annual dividend by the stock price. The higher the yield, the bigger the payout.

    The lure of dividend-appreciation stocks is reflected in indexes and exchange-traded funds. The Vanguard Dividend Appreciation ETF is up 11% this year, compared with a gain of 8.5% for the S&P High-Yield Dividend Aristocrats index.

    "In the dividend-yield area, we're seeing valuations that are looking pretty full to us," said Paul Stocking, who co-manages Columbia Management's $4.5 billion Dividend Opportunity fund. "We have been looking for more dividend growth, relative to stable, high-dividend payouts, partly because of this move that we have seen in the marketplace chasing these high-dividend payers."

    To be sure, some strategists are cautioning clients that focusing too much on dividends could mean missing out on larger returns, said J.P. Morgan Funds global market strategist Joseph Tanious. That is especially true if the Fed's bond-buying measures help drive up prices of riskier assets such as growth stocks, some of which don't offer dividends, he said.

    Mr. Tanious is telling clients to balance their portfolios with stocks tied to global growth.

    Other investors keep piling into dividend-appreciation stocks. Capital Advisors, a money-management firm in Tulsa, Okla., with $1.1 billion under management, recently sold shares of Verizon, which has a dividend yield of 4.6%. Instead, the firm bought shares of Hasbro Inc. after the toy maker boosted its payout 20% this year. Hasbro, which offers a 3.7% yield, has increased its dividend at a compound annual rate of 15% for the past five years. Capital Advisors also added shares of Gannett Co. in August after the newspaper publisher doubled its payout.

    "It has become more of a stock picker's game, with respect to finding good dividend plays," said Channing Smith, managing director at Capital Advisors. He said opportunities to buy blue-chip stocks with high dividends "have disappeared" over the past year as the valuation of those shares has risen.

    Through July, U.S. mutual funds focused on dividend-paying stocks had drawn in $18.63 billion in net cash, while U.S. stock funds have seen a net $29.42 billion in withdrawals, according to data provider EPFR.

    PNC Financial Services Group Inc.'s asset-management group bought shares in Cisco Systems Inc.  last year partly because of the potential they saw for the company to raise its dividend, said Bill Stone, chief investment strategist for the group, which oversees $109 billion in assets.

    The move paid off when the telecommunications-equipment maker more than doubled the quarterly payout last month, sparking a 9.6% jump in the company's stock price, the biggest daily increase in a year.

    Bob Jensen's threads on investment ratios ---
    http://www.trinity.edu/rjensen/roi.htm


    From The Wall Street Journal Accounting Weekly Review on October 26, 2012

    Debt Fuels a Dividend Boom
    by: Tyan Dezember and Matt Wirz
    Oct 19, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Bonds, Debt, Dividends

    SUMMARY: Leonard Green & Partners LP, Bain Capital LLC and Carlyle Group LP are among the private-equity firms that are adding debt to the companies they own in order to fund dividend payouts to themselves. This controversial practice "rose to popularity before the financial crisis" and this year has resurged to $65 billion. "Critics say the dividends, which are disclosed in offering documents, saddle a company with debt, potentially burdening its operations, while reducing owners' investment exposure." The deals are known as "dividend recapitalizations" and are only possible because some investors are looking for higher yields in this low interest rate environment in the U.S.

    CLASSROOM APPLICATION: The article may be used in covering dividends or debt issuance in a financial accounting class.

    QUESTIONS: 
    1. (Introductory) What types of companies are adding debt to their balance sheets in order to fund dividend payments to shareholders? Who are the shareholder recipients of these dividends?

    2. (Advanced) What are the effects on a company's balance sheet from undertaking such a transaction?

    3. (Advanced) What financial statement ratio is used to support the argument that "companies doing [these debt issuances to fund dividends]...are in better financial shape than those that sold such deals in the 2000s"? What comparison is made with this ratio in order to support this argument?

    4. (Introductory) As described in the article, what are the risks of taking on such transactions?

    5. (Advanced) One company's chief executive is quoted as saying that he is "pleased to have generated this early return for shareholders." Why do you think he feels this way?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Debt Fuels a Dividend Boom," by: Tyan Dezember and Matt Wirz, The Wall Street Journal, October 19, 2012 ---
    http://professional.wsj.com/article/SB10000872396390444592704578064672995070116.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    Private-equity firms are adding debt to the companies they own in order to fund payouts to themselves, a controversial practice now reaching a record pace.

    Leonard Green & Partners LP, Bain Capital LLC and Carlyle Group LP CG -0.39% are among the firms using the tactic, which rose in popularity before the financial crisis.

    In these deals, known as "dividend recapitalizations," private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups.

    The resurgence has been helped by investors' appetite for high-yielding debt at a time of historically low interest rates.

    Debt issued to fund private-equity dividends has topped $54 billion this year, after a flurry of deals earlier this month, according to Standard & Poor's Capital IQ LCD data service. That is already higher than the record $40.5 billion reached in all of 2010, when credit markets reopened after the crisis.

    For private-equity investors, the deals produce payouts amid a slow market for initial public offerings and acquisitions. "It's hard to be anything but happy" about the dividend boom, said Erik Hirsch, chief investment officer for Hamilton Lane, a Philadelphia firm that manages more than $163 billion in private-equity investments.

    Likewise, many debt investors are happy to collect yields as high as 10%.

    Critics say the dividends, which are disclosed in offering documents, saddle a company with debt, potentially burdening its operations, while reducing a private-equity firm's investment exposure.

    Also some of these deals involve a risky type of debt known as "payment in kind toggle"—or PIK-toggle—bonds that give companies the choice to defer interest payments to investors. Instead, they could opt to add more debt to the balance sheet. The default rate for companies that sold PIK-toggle bonds was 13% from 2006 to 2010, twice the default rate for comparably rated companies that didn't use the bonds, according to a study by Moody's Investors Service.

    Six companies have sold PIK-toggle bonds to pay private-equity dividends in September and October, double the number sold in the previous 14 months.

    "The market is simply letting its guard down at the expense of getting some incremental yield," said Sandy Rufenacht, chief investment officer of $1.3 billion high-yield asset manager Three Peaks Capital. He said he is selling bonds he owns in companies that issue new PIK-toggle bonds.

    Despite concerns, the PIK-toggle deals are generally finding a welcome reception among investors, because the securities can yield more than standard junk bonds, which traded at record-low rates in September.

    One attraction for dividend recapitalizations broadly is that some companies doing them these days are in better financial shape than those that sold such deals in the 2000s. Debt of companies that sold bonds to pay dividends this year averaged 4.21 times earnings, compared with 5.36 times at the height of the last credit bubble in 2007, according to Standard & Poor's.

    Another driver of the trend, some say, is private-equity investors' desire to reap dividends before the potential increase in taxes on the proceeds next year.

    Last week, drug developer Pharmaceutical Product Development LLC, which is owned by Carlyle and Hellman & Friedman, sold $525 million of PIK-toggle bonds, with the proceeds going toward a roughly $600-million dividend for the private-equity firms. To pay the full dividend, the company is also contributing about a third of the cash on its balance sheet.

    The private-equity firms bought the company in December for $3.9 billion. Nearly half of the purchase was funded by cash and the rest by debt on the company's balance sheet.

    Within days of the dividend recapitalization, Jessica Gladstone, a senior analyst with Moody's, lowered the company's credit rating by one notch to single-B and graded the new bonds triple-C, the lowest junk rating. Such deals are "very reminiscent of the bubble era," she said.

    A Carlyle spokesman said the private-equity firms put more cash into the buyout than they would have normally because credit markets then were more stressed. With markets improved, he said, the firms are adjusting the debt load to a level more typical in leveraged buyouts. Also, he said, the company can handle the debt.

    In response to demand for the bonds, priced at 9.875%, the company boosted the size of its offering by 5%.

    Continued in article


    Teaching Case from The Wall Street Journal Weekly Accounting Review on February 15, 2013

    Apple Cash Pile Sets Off a Battle
    by: Jessica Lessin, Telis Demos, and David Benoit
    Feb 08, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting, Cash, Cash Management, Financial Accounting, Financial Ratios, Financial Statement Analysis, Preferred Stock

    SUMMARY: For nearly 18 months, Tim Cook, CEO of Apple, has kept a stream of new products rolling, produced a string of robust quarterly results and introduced a dividend and stock buyback expected to cost $45 billion over three years. But an attack from one of Apple's prominent investors underscores how that approach may not be enough anymore, especially amid intensifying industry competition and the company's slowing growth.

    CLASSROOM APPLICATION: The article should be a great one to catch our students' attention because it involves Apple. Whether someone loves Apple or hates it, one must admit that the company is interesting from a financial standpoint. You can use this article in a discussion about cash management, and it would be excellent for financial statement analysis.

    QUESTIONS: 
    1. (Introductory) What are the facts of David Einhorn's lawsuit against Apple? What are his demands? Is he in a position to make demands of Apple?

    2. (Advanced) How would each of Apple's financial statements appear under Mr. Einhorn's plan versus Mr. Cook's plan? How do the financial statements differ? Draft the journal entries (just the accounts, no dollar amounts) for the various aspects of each of the plans.

    3. (Advanced) What is the history of the price of Apple's shares? What are the reasons for these stock price changes? How many of the reasons are related directly to financial statement information rather than other factors?

    4. (Advanced) What is the purpose of preferred stock? How does it differ from common stock? When is preferred stock an appropriate vehicle for a company?

    5. (Advanced) Why is it good for a company to have a large amount of cash? What are the possible problems with having large amounts of cash? Why has Apple accumulated so much cash? Is this common among businesses or is it an unusual position?
     

    SMALL GROUP ASSIGNMENT: 
    Research Apple's financial statements for the past five years. Prepare a complete set of financial ratios and analyze. Compare over five years, studying trends. What is interesting about the company's financial situation? Is Mr. Einhorn justified in his position? Or is he misguided? Please offer support for your answer.

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    Apple's Cash Conundrum: Pay Tax or Borrow?
    by Steven Russolillo
    Feb 11, 2013
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    Einhorn Squeezes Apple for Its Cash
    by Telis Demos
    Feb 12, 2013
    Page: B1

    Apple Defends Position on Cash
    by Jessica Lessin and Thomas Gryta
    Mar 13, 2013
    Online Exclusive

     

    "Apple Cash Pile Sets Off a Battle," by Jessica Lessin, Telis Demos, and David Benoit, The Wall Street Journal, February 8, 2013 ---
    http://professional.wsj.com/article/SB10001424127887324590904578290440984350234.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    Apple Inc. AAPL -0.09% Chief Executive Tim Cook is facing a new reality: delivering steady results from one of the world's most valuable companies is no longer good enough.

    For nearly 18 months, Mr. Cook has kept a stream of new products rolling, produced a string of robust quarterly results and introduced a dividend and stock buyback expected to cost $45 billion over three years.

    But an attack from one of Apple's prominent investors underscores how that approach may not be enough anymore, especially amid intensifying industry competition and the company's slowing growth.

    On Thursday, hedge fund manager David Einhorn sued Apple in a New York federal court in an effort to block an Apple shareholder proposal that he argues could limit how the company could return some of its $137 billion cash pile to investors. Apple is proposing to require a shareholder vote before it can issue preferred stock, a kind of security that Mr. Einhorn is urging the company to adopt. Apple's board already has the right to issue such shares, but said in a filing it doesn't intend to do so.

    The proposal comes to a vote at Apple's annual shareholder meeting on Feb. 27.

    Mr. Einhorn, whose firm Greenlight Capital Inc. and its affiliates own about $610 million worth of Apple stock, argues that Apple should distribute a "perpetual preferred" stock that could pay a dividend yield of 4%. The shares would return cash to shareholders by paying a bigger yield than Apple's regular shares, which currently carry a 2.3% dividend yield, according to FactSet.

    The preferred stock dividends would only require Apple to pay out small amounts over time, rather than tapping its cash reserves to spend a large sum at once in the form of a special dividend or stock buyback.

    "It's a unique solution to a problem that's been intractable—how does Apple reward its shareholders?" Mr. Einhorn said in an interview. "This idea allows them to keep their cash and yet enables shareholders to recognize value."

    Apple later fired back in a statement Thursday, asserting that passage of the proposed shareholder measure wouldn't prevent Apple from issuing preferred stock in the future. Apple said it would evaluate Greenlight's proposal to issue the security and that its management team and board have been in "active" discussions about returning more cash to shareholders.

    Apple's statement didn't address the merits of Greenlight's lawsuit, which argues that Apple is violating a securities rule by bundling three items—including the preferred stock matter—under one proposal.

    The fracas encapsulates the growing investor unease about Apple as the company stands at a growth crossroads.

    When Mr. Cook took over as CEO in 2011, investors widely believed he would be more receptive to distributing some of its cash, something that his predecessor, Steve Jobs, had fiercely resisted. In March 2012, Mr. Cook announced Apple's first dividend since 1995 and a stock buyback, and made a dividend payout last August.

    But that hasn't appeased many shareholders as Apple's historical growth streak has tempered amid signs that the company is losing its competitive edge in smartphones to Samsung Electronics Co. 005930.SE +0.54%

    Concerns are also rising over an apparent lack of new game-changing products—like the iPad and the iPhone when they first debuted—which have previously driven Apple's growth. Mr. Cook has said the company continues to innovate at a rapid pace.

    Last month, Apple reported a flat profit for its most recently ended quarter and executives predicted that revenue growth would continue to slow.

    All of that has boiled over into a stock decline and increasing pleas by investors to put more cash to use.

    Continued in article

    Bob Jensen's threads and other teaching cases on dividends, payout ratios, and dividends yield ---
    http://www.trinity.edu/rjensen/roi.htm#Dividends

    Bob Jensen's threads on return on investment, other ratios, and financial statement analysis ---
    http://www.trinity.edu/rjensen/roi.htm

     


    EBBS Earnings Before BS

    "Questions About Tesla (TSLA) Accounting," by Tony Owusu, The Street, March 10, 2014 ---
    http://www.thestreet.com/story/12523254/1/kass-questions-about-tesla-tsla-accounting.html

    Tesla's share price has soared 616% since March 2013. Such a meteoric rise has caused some investors consternation and encouraged a closer look at Tesla's SEC filings such as last month's 10-k.

    Doug Kass of RealMoneyPro.com and Seabreeze Partners was highly critical of Tesla's book keeping this weekend. "Tesla's accounting has long been controversial. In a prior post, I characterized Tesla's reported profits as EBBS (earnings before B.S.)."

    Kass specifically called into question Tesla's claim that it went from $8 million under accrual on 2012 warranties during the first three fiscal quarters and then suddenly reported a $2 million over accrual for the year in its fourth quarter filings.

    "In essence the question comes down to whether Tesla's warranty reserve release was used as a cookie jar to boost profits in the latest quarter, or did the company simply miscalculate its warranty calculations," said Kass.

    Continued in article

     


    Equity Valuation Models

    Equity Valuation
    TAR book reviews are free online. I found the September 2010 reviews quite interesting, especially Professor Zhang's review of
    PETER O. CHRISTENSEN and GERALD A. FELTHAM, Equity Valuation Hanover, MA:Foundations and Trends® in Accounting, 2009,
    ISBN 978-1-60198-272-8 --- Click Here

    This book is an advanced accountics research book and the reviewer leaves many doubts about the theory and practicality of adjusting for risk by adjusting the discount rate in equity valuation. The models are analytical mathematical models subject to the usual limitations of assumed equilibrium conditions that are often not applicable to the changing dynamics of the real world.

    The authors develop an equilibrium asset-pricing model with risk adjustments depending on the time-series properties of cash flows and the accounting policy. They show that operating characters such as the growth and persistence of earnings can affect the risk adjustment.

    What are the highlights of this book? The book contains five chapters and three appendices. Chapters 2 to 5 each contain separate yet closely related topics. Chapter 2 reviews and identifies problems with the implementation of the classical model. In Chapters 3 to 5, the authors develop an accounting-based, multi-period asset-pricing model with HARA utility. My preferences are Chapters 2 and 5. Chapter 2 contains a critical review of the classical valuation approach with a constant risk-adjusted discount rate. As noted above, the authors highlight several problems in estimating these models. Many of these issues are not properly acknowledged and/or dealt with in many of the textbooks. The authors provide a nice step-by-step analysis of the problems and possible solutions.

    Chapter 5 contains the punch line. The authors push ahead with the idea of adjusting risk in the numerator, and deal with the thorny issue of identifying and simplifying the so-called “pricing kernel.” Although the final model involves a rather simplifying assumption of a simple VAR model of the stochastic processes of residual income and for the consumption index, it provides striking and promising ideas of how to estimate and adjust for risk based on fundamentals, as opposed to stock return. It provides a nice illustration of how to incorporate time-change risk characteristics of firms with the change in firms’ operations captured by the change in residual income. This is very encouraging.

    There are some unsettling issues in this book. Not surprisingly, I find the authors’ review of the classical valuation approach to be somewhat tilted toward the negative side. For instance, many of the problems cited arise from the practice of estimating a single, constant risk-adjusted discount rate for all future periods. This seems to be based on the assumption that firms’ risk characteristics do not change materially over future periods. Of course, this is a grossly simplified approach in dealing with the issues of time-changing interest rates and inflation. To me, errors introduced by such an approach reflect more the shortcomings in the empirical or practical implementation, rather than the shortcomings in the valuation approach per se. As noted by the authors, using date-specific discount rates can avoid many of the problems. After all, under most circumstances in a neo-classical framework, putting the risk adjustment in the numerator or in the denominator may simply be an easy mathematical transformation. In some cases, of course, adjusting risk in the denominator does not lead to any solution to the problem. In that sense, adjusting in the numerator is more flexible.

    After finishing the book, I asked myself the following question: Am I convinced that the practice of adjusting risk in the discount rate should be abolished? The answer seems unclear, for a couple of reasons. First, despite the authors’ admirable effort in bringing context to it, the concept of “consumption index” still seems rather elusive. As a result, it lacks the appeal of the traditional CAPM, namely, a clear and intuitive idea of risk adjustment.

     Professor Zhang seems to favor CAPM risk adjustment without delving into the many controversies of using CAPM for risk adjustment in the real world ---
    http://www.trinity.edu/rjensen/theory01.htm#AccentuateTheObvious
    It would be interesting to see how these sophisticated analytical models are really used by real-world equity valuation analysts.

    Bob Jensen's threads on valuation are at
    http://www.trinity.edu/rjensen/roi.htm

    Also see controversies over validation of accountics research
    http://www.trinity.edu/rjensen/TheoryTAR.htm


    Questions
    Why Ciscco is taking an enormous beating in the stock market?

    Why is Ralph Nader so upset with Cisco?

    What does Susan Pulliam mean when she describes the first purchase price for Cisco shares paid by Mr. Nader in 1995 as "an adjusted $7 per share"?

    What does Ralph Nader mean when he says "If they can't give shareholders value, then they have to give cash"?
    Would my old friend Professor Al Rappaport (now emeritus from Northwestern University) double up in laughter over this statement?
    http://www.amazon.com/Creating-Shareholder-Value-ebook/dp/B000FBJHHG

    From The Wall Street Journal Accounting Weekly Review on July 8, 2011 ---

    Nader Kindles Fires of Revolt
    by: Susan Pulliam
    Jun 24, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Dividends, Foreign Subsidiaries, Taxation

    SUMMARY: Activist Ralph Nader "isn't calling for a router recall or claiming the company's networks are unsafe at any speed. Instead, he wants the tech company to pay a bigger dividend to boost its shares."

    CLASSROOM APPLICATION: The article is useful to introduce dividend policy and corporate governance issues in any financial reporting class.

    QUESTIONS: 
    1. (Introductory) What has happened to Cisco's share price in the last year?

    2. (Introductory) Who is Ralph Nader? What have been his most prominent activities in the past? What is his current concern?

    3. (Advanced) What does Mr. Nader mean when he says "If they can't give shareholders value, then they have to give cash"? Why will instituting a cash dividend improve the company's shareholders' value?

    4. (Advanced) What does the author mean when he describes the first purchase price for Cisco shares paid by Mr. Nader in 1995 as "an adjusted $7 per share"?

    5. (Advanced) What do analysts say is the problem with Cisco that leads to abysmal stock price performance? What actions could shareholders take to resolve this issue?

    6. (Advanced) Why would Cisco incur significant tax payments in order to amass the cash to pay dividends when it has such significant cash and cash equivalents on its balance sheet?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Nader Kindles Fires of Revolt," by: Susan Pulliam, The Wall Street Journal, June 24, 2011 ---
    http://online.wsj.com/article/SB10001424052702304231204576404120214834528.html?mod=djem_jiewr_AC_domainid

    Ralph Nader, the scourge of American business and onetime presidential candidate, has found his next corporate demon: Cisco Systems Inc.

    Mr. Nader isn't calling for a router recall or claiming the company's networks are unsafe at any speed. Instead, he wants the tech company to pay a bigger dividend to boost its shares.

    The consumer advocate's motives are far from altruistic. He is a longtime disgruntled Cisco investor who called the company's share performance "appalling." In a private letter to Cisco Chief Executive John Chambers sent June 13, Mr. Nader blasted the CEO for not doing enough to lift shares of the technology company and said "it is time for a long overdue Cisco shareholder revolt against a management that is oblivious to building or even maintaining shareholder value," according to the letter.

    In 4 p.m. Nasdaq Stock Market composite trading Thursday, Cisco's shares rose 11 cents, or 0.7%, to $15.47. They are down nearly a third in the past year and are off 75% from their all-time, tech-bubble high. In comparison, the Nasdaq Composite index is down about 48% from its all-time high in March 2000.

    Among the specific actions Mr. Nader suggested in the letter are the distribution of a one-time dividend of $1 a share and an increase in Cisco's annual dividend to 50 cents from 24 cents.

    "If they can't give shareholders value, then they have to give cash," Mr. Nader said in an interview this week, adding that the company's stock has plummeted even though its profits generally were on the rise until recently.

    Cisco, like many big tech companies, has been accumulating cash despite its weak growth. It holds $43 billion in cash, nearly half of its market value.

    A Cisco spokeswoman said the company welcomes input from shareholders and added that the company is considering "capital allocation and returns to our shareholders," but declined to discuss specifically whether a dividend increase or one-time payout are on the table. She added that all but about $5 billion of the company's cash represents foreign earnings, which would be subject to taxes if the funds were brought back to the U.S.

    The 77-year-old Mr. Nader, who rose to fame in the 1960s on his claims that American automobiles were unsafe, admitted the letter is a departure from his typical antibusiness stance. He said he has been an "adversary of corporate capitalism," but he is a believer in capitalism, so long as shareholders have a voice. He wrote the letter to Mr. Chambers, he said, because he objects to the "powerlessness of owner shareholders."

    Continued in article


    Can the 2008 investment banking failure be traced to a math error?
    Recipe for Disaster:  The Formula That Killed Wall Street --- http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
    Link forwarded by Jim Mahar ---
    http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html 

    Some highlights:

    "For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

    His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

    Then the model fell apart." The article goes on to show that correlations are at the heart of the problem.

    "The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time. One person might lose his job, another might fall ill. But those are individual calamities that don't affect the mortgage pool much as a whole: Everybody else is still making their payments on time.

    But not all calamities are individual, and tranching still hadn't solved all the problems of mortgage-pool risk. Some things, like falling house prices, affect a large number of people at once. If home values in your neighborhood decline and you lose some of your equity, there's a good chance your neighbors will lose theirs as well. If, as a result, you default on your mortgage, there's a higher probability they will default, too. That's called correlation—the degree to which one variable moves in line with another—and measuring it is an important part of determining how risky mortgage bonds are."

    I would highly recommend reading the entire thing that gets much more involved with the actual formula etc.

    The “math error” might truly be have been an error or it might have simply been a gamble with what was perceived as miniscule odds of total market failure. Something similar happened in the case of the trillion-dollar disastrous 1993 collapse of Long Term Capital Management formed by Nobel Prize winning economists and their doctoral students who took similar gambles that ignored the “miniscule odds” of world market collapse -- -
    http://www.trinity.edu/rjensen/FraudRotten.htm#LTCM  

    The rhetorical question is whether the failure is ignorance in model building or risk taking using the model?

    Also see
    "In Plato's Cave:  Mathematical models are a powerful way of predicting financial markets. But they are fallible" The Economist, January 24, 2009, pp. 10-14 --- http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout

    Wall Street’s Math Wizards Forgot a Few Variables
    What wasn’t recognized was the importance of a different species of risk — liquidity risk,” Stephen Figlewski, a professor of finance at the Leonard N. Stern School of Business at New York University, told The Times. “When trust in counterparties is lost, and markets freeze up so there are no prices,” he said, it “really showed how different the real world was from our models.
    DealBook, The New York Times, September 14, 2009 ---
    http://dealbook.blogs.nytimes.com/2009/09/14/wall-streets-math-wizards-forgot-a-few-variables/

     

     


    How to Value a Website

    March 8, 2010 message from Roger Collins [Rcollins@TRU.CA]

    www.peekstats.com

    I came across this site by accident. Quite apart from the reservations/limitations concerning the specific components of the valuation there  are some interesting questions about the relationship between the value of a Web site on a "stand alone" basis and its contribution to the overall value of an organisation that I'm planning to put to my Accounting Theory students.

    Roger Collins
    TRU School of Business & Economics

    Jensen Comment
    Thank you for this Roger.
    I find it interesting that a featured Website valuation ($ 107,863.70) for Cardiff University in England ---
    http://www.peekstats.com/www.cardiff.ac.uk
    I would've guessed Cardiff's Website to have a much higher value.

    March 8, 2010 reply from James R. Martin/University of South Florida [jmartin@MAAW.INFO]

    The peekstats.com website valuation tool is not even in the ball park on MAAW's web traffic and page views. I think this is because it only picks up visits from those who have the Alexa toobar installed. I noticed that several years ago. Those who want accurate traffic statistics should look at Google Analytics. You have to add some code to the bottom of your pages, but the information you get is really detailed.

     

     


    Long-Term Pricing and Valuation

    Teaching Case on Long-Term Product Valuation
    From The Wall Street Journal Accounting Weekly Review
    on August 9, 2013

    Tesla Investors Look Far Into the Future to Price Its Shares
    by: Mike Ramsey
    Aug 07, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Analysts' Forecasts, Financial Ratios, Fixed Costs, Managerial Accounting, Manufacturing, Valuations

    SUMMARY: The author opens this article by stating that "Tesla Motors Inc. Chief Executive Elon Musk doesn't run his Silicon Valley electric-car maker by traditional auto industry rules, and investors are so far rewarding him by putting a value on the company that defies easy comparisons." The related article describes operating differences in sales methods the company uses and was covered in another WSJ Accounting Weekly Review. Tesla's sales are about 1% of Ford Motor Co's U.S. sales, yet the company's share price implies a market value of about $17.15 billion, about 25% of Ford's market cap and 70% more than Fiat SpA.

    CLASSROOM APPLICATION: The article may be used to cover financial reporting or managerial accounting topics. For financial reporting, the article covers company valuation, forward P/E ratio, and analysts' earnings forecasts. For managerial accounting, the article discussed manufacturing economies of scale and cost behaviors. The article covers these topics with a product innovation focus.

    QUESTIONS: 
    1. (Introductory) What is Tesla Motors? How is its business model different from older companies with which it competes? (Hint: the related articles are helpful for the latter question.)

    2. (Advanced) What is unusual about Tesla Motors' market value? In your answer, explain how a company's market value is determined.

    3. (Introductory) What amount of earnings do analysts project Tesla Motors will achieve for the year in 2013? In 2014?

    4. (Advanced) Explain how to determine a price-earnings ratio based on current earnings and then how to determine a forward P/E ratio. Why may only one of these measures be used in considering Tesla Motors? How is this measure used to make a comparison about the company?

    5. (Introductory) Summarize how investment firms and banks, as described in the article, determine expected future prices for each share of Tesla Motors stock.

    6. (Advanced) Refer specifically to the Deutsche Bank target price for the firm's stock. How do economies of scale influence the bank's forecasts? In your answer, define the terms economies of scale and fixed costs, then explain the behavior of fixed costs considered in the forecast.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Tesla Clashes with Car Dealers
    by Mike Ramsey and Valerie Bauerlein
    Jun 18, 2013
    Page: B1

    "Tesla Investors Look Far Into the Future to Price Its Shares," by Mike Ramsey, The Wall Street Journal, August 7, 2013 ---
    http://online.wsj.com/article/SB10001424127887323420604578652180360274840.html?mod=djem_jiewr_AC_domainid

    Tesla Motors Inc. TSLA +0.58% Chief Executive Elon Musk doesn't run his Silicon Valley electric car maker by traditional auto industry rules, and investors are so far rewarding him by putting a value on the company that defies easy comparisons.

    Tesla is scheduled to report second quarter results on Wednesday, and most analysts are forecasting a 17-cent-a-share loss. In an industry where strategy is driven by the quest for economies of scale, Tesla is tiny. It delivered just 1,400 Model S electric sedans in July, according to researcher Autodata Corp., or about 1% of Ford Motor Co.'s F +0.19% U.S. sales for the month.

    Yet Tesla's share price has more than quadrupled in the past year, to $142.15 on Tuesday and giving it a market value of about $17.15 billion, a quarter of Ford's, and about 70% more than Fiat SpA—majority owner of Chrysler Group LLC.

    Despite its small size, the Palo Alto, Calif., company has become among the auto industry's most closely followed. General Motors Co. GM +0.07% CEO Dan Akerson recently ordered a team of GM employees to study Tesla and the ways that it could challenge the established auto industry business model.

    Even Wall Street analysts who are enthusiastic about Tesla's prospects have put target prices on the company's shares that are much lower than their current market price.

    A Tesla spokesman wouldn't comment on the stock price on Tuesday ahead of disclosing June quarter results on Wednesday. But Mr. Musk and other company officials have said in the past that they foresee a Tesla that is building 400,000 or 500,000 cars a year, and can achieve a market capitalization of as much as $43 billion by 2022. That is the level at which Mr. Musk can collect a chunk of stock under a multi-step compensation plan adopted by Tesla's board last year.

    Most car companies are judged on the results they can deliver in the near term. Tesla investors are buying on results that probably won't exist until sometime in the next decade. And even that is only if it can deliver flawless manufacturing execution, continued annual growth and crack through the consumer concerns about driving range and upfront costs that have restrained demand for all-electric vehicles so far.

    Analysts are expecting the company to lose 68 cents a share this year and earn 50 cents a share next year, according to Zacks Investment Research. By that 2014 projection, its forward price/earnings ratio is 289, compared with Ford's PE of just under 10 and Toyota Motor Corp.'s 7203.TO +0.16% P/E of less than 1, both based on 2014 earnings projections, according to Zacks.

    Tesla's P/E ratio is more akin to Internet stocks than car makers. Supporters say that is because the company's electric vehicle sales strategy is disruptive and the auto maker possesses groundbreaking technologies.

    Deutsche Bank recently raised its target price for the company's shares to $160. The bank estimates that Tesla will be able to achieve operating profit margins of 20%—or about twice that of BMW AG BMW.XE +1.33% in its most recent quarter—as it ramps up sales and spreads costs over a larger number of vehicles.

    "We expect [Tesla] to reach at least 200,000 units by near the end of the decade, which implies about 5% of what we calculate as the addressable market of comparable vehicles in terms of capability and price," the bank said in a note to investors last month.

    Tesla sold 8,931 vehicles this year through June, according to Autodata. In contrast, Porsche delivered 81,565 of its big ticket and high margin vehicles globally during the same period.

    Mr. Musk has said he believes Tesla can achieve 25% gross margins by the end of this year, meaning that Tesla's direct costs of building cars will be just three-quarters of the revenue it collects from sales. In the first quarter, Tesla's gross margin was 17% of sales.

    Wall Street analysts assume that Tesla will sell around 100,000 of the company's "Gen 3" models—electric sedans that are expected to start at about $35,000 when available in late 2016. Investors are counting on Tesla being able to deliver a car that competes against luxury sports cars such as the BMW 3 Series and Audi A4—and not similarly-priced electric cars.

    The hurdles are many. Other manufacturers now offering electric cars for under $40,000 have so far failed to generate much volume. The Nissan Leaf, which starts at about $28,800, is on a pace to sell fewer than 50,000 cars this year on a global basis.

    Established luxury brands also are planning to challenge Tesla with plug-in models of their own, such as the BMW i3 and a Cadillac ELR plug-in hybrid coming from GM.

    Many analysts say the shares currently are overpriced based on their sales and profit projections. Adam Jonas, a Morgan Stanley analyst, says Tesla's shares should be trading at about $109. His estimate assumes Tesla continues to expand its business 15 years into the future to get to his stock value—which is about 23% less than its current price.

    Mr. Jonas assumes Tesla eventually can sell more than 200,000 vehicles a year at an average price of $50,000, with the majority of the sales coming from the company's Gen 3 models. This year, Tesla is expected to deliver about 20,000 Model S vehicles.

    "We argue that Tesla cannot be valued on traditional near-term multiple metrics like traditional auto companies," Mr. Jonas said.

    Goldman Sachs analyst Patrick Archambault has one of the lower stock price estimates at $84 a share. He estimated Tesla will be making about 150,000 vehicles a year and earning about $1.1 billion, or $8.59 a share, in 2018.

    Barclays senior analyst Brian Johnson is pegging Tesla at $90 a share. He thinks that Tesla, at a minimum, can sell about 50,000 Model S and Model X vehicles a year around the globe, making it is successful "niche luxury car maker." But that should only get Tesla to about $60 a share in value.

    To be worth $90 a share, Tesla has to make a credible entry-level luxury car that he thinks will be priced at between $42,000 and $45,000. "They are going to have to do in five years what it took Audi decades to do—break into the volume entry-level luxury market."

    Today's stock price, he said, reflects investors who believe Mr. Musk "is the next Henry Ford."

    Bob Jensen's threads on valuation and ROI ---
    http://www.trinity.edu/rjensen/roi.htm


    Tesla Motors --- http://en.wikipedia.org/wiki/Tesla_Motors

    "Tesla Versus the Luxury Automakers: Does the introduction of luxury EVs from BMW, Cadillac, and Mercedes spell doom for Tesla?" by Kevin Bullis, MIT's Technology Review, July 25, 2013 --- Click Here
    http://www.technologyreview.com/view/517531/tesla-versus-the-luxury-automakers/?utm_campaign=newsletters&utm_source=newsletter-daily-all&utm_medium=email&utm_content=20130726 

    Jensen Comment
    There won't be much competition from Japan since Japanese manufacturers have given up on battery-powered cars. The Japanese shifted their attention to the future of fuel cells, probably hydrogen fuel cells.

    But competition from luxury car manufacturers in Michigan and Germany will be intense. Much depends upon the competitive advantage of Tesla's new patents.

    What seems to me as a stupid business model is to not have Tesla dealers (or at least repair shops) across the entire geographic market where you sell vehicles. If I by a Tesla in the White Mountains of New Hampshire, where do I take it in for repairs and warranty service? Forget Tesla.

    What seems to me as a stupid business model is to manufacture automobiles for a mass market in the Freemont, California where Toyota and General Moters fled. Tesla built its California factory using $365 million in low-interest loans from the federal government. Firstly, housing costs are higher that most manufacturing workers can afford. Secondly, Californians of fleeing their state in droves due to high taxes on virtually everything. It should be noted that choosing the Freemont abandoned plants helped Tesla land the $365 million. But that was before Tesla seriously was a contender for the mass automobile market across North America, Europe, and Asia.

    When Tesla was building experimental cars for a niche market, Freemont made some sense because of talented tech workers in Silicon Valley. Tesla is now aiming for a mass market. How about new manufacturing plants in downtown Detroit and Beijing?

    Tesla will probably have to partner with automobile companies having dealerships across North America, Europe, and Asia. To date, Tesla has made a big deal about selling cars with having dealerships. This policy is unsustainable unless Tesla builds cars that never need service and repairs.

     

     


    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.


    The Winner's Curse:  Business Firm Valuation Errors by the Pros
    Large-scale mergers often plague the "winning" bidder with what academics call the "Winner's Curse." The winner's curse takes place when a bidder does indeed win the object for which he or she was bidding, but the value of that object turns out to be less than what was bid for it. What's a recipe for a winner's curse in an M&A situation? Take one part highly visible transaction for a highly motivated, deep-pocketed acquirer.
    "Kraft, Cadbury, and Hershey: A Not-So-Sweet Deal," by Rita McGrath, Harvard Business Review, November 19, 2009 ---
    Click Here

    Large-scale mergers often plague the "winning" bidder with what academics call the "Winner's Curse." The winner's curse takes place when a bidder does indeed win the object for which he or she was bidding, but the value of that object turns out to be less than what was bid for it. What's a recipe for a winner's curse in an M&A situation? Take one part highly visible transaction for a highly motivated, deep-pocketed acquirer. Add a bit of reluctant bride (or outright naysaying bride) on the part of the target firm. Add a potential white knight, preferably one that is despised by the original bidder. Throw in a couple (or more) hard-charging CEOs who view the deal as crucial to their company's good fortunes (or to their own reputations — either will do). Finally, entrust the whole mixture to a bunch of sophisticated deal packagers on Wall Street. Then, make it front-page news on the publications that "everybody" reads.

    The announcement on Tuesday morning that chocolate maker Hershey (with a possible assist from Italy's Ferrero) might make a counter-offer to the deal broached by Kraft Foods for the United Kingdom's beloved Cadbury has exactly this flavor to it. According to the Wall Street Journal, Kraft Foods of Northfield, IL, formally offered to purchase Cadbury for about $16 billion on November 9, after publicly making its intentions known in September. Cadbury rejected the initial offer, reports the Journal, as "derisory." But with no other bidders on the horizon at the time that Kraft was required by the UK to make its proposal official or to abandon the deal, it didn't increase the bid, commenting that the offer is "fair and attractive." If Hershey successfully figures out how to get in the game with a superior offer (and its bankers seem quite keen on enabling them to do that), a bidding war of attrition could well break out, as both sides seek to gain the upper hand. In such situations, emotions run high, spreadsheets are more often used to justify decisions than to inform them, and the individuals involved tend to get personal.

    Something similar (with 3 bidders and a fourth who was enabling it) took place with Boston Scientific's recent acquisition of Guidant, a merger that was dubbed by Fortune magazine to be the "second worst deal ever" right behind the AOL-Time Warner merger (which is being unwound even as I write this). The stage for that merger was set when Guidant, a spinoff from Eli Lilly, was entering its tenth year of major success. Without much of a succession plan and a failed attempt to lure a new CEO from GE, the company was a perfect target, with a market cap of about $20 billion. Johnson & Johnson, in 2004, offered to buy the company for $68/share and, much as Kraft was snubbed by Cadbury, was turned down. Eventually, J&J was persuaded to increase its offer to $76/share, or $25.4 billion. In March of 2005, a patient equipped with a Guidant pacemaker died and a public furor broke out when it was revealed that the company had known about the flaw in the pacemaker for three years, but had not informed doctors about it.

    What happens? First, the stock tanks, dropping to the mid-$50 range by 2005, amid a recall of over 290,000 devices. J&J's CEO Bill Weldon drops his offer by $6 billion to $58/share. Guidant rejects that offer. Weldon eventually goes a little higher, to $63/share, an offer which Guidant, seeing no other bidder, grudgingly accepts. In November of 2005, however, a new player emerges on the scene — Boston Scientific. They leverage a deal with a third party (Abbott Labs) to make a $72/share offer. Guidant, smelling opportunity, uses the presence of two eager bidders to ignite a bidding war. On January 11, 2006, J&J goes to $68/share — and even though it's $4 under Boston's bid, Guidant sticks with J&J. Provoked, Boston bids $73 on January 12. J&J comes back with $71. On January 17, Boston Scientific makes a "bid to end this" of $80/share, a total of $27 billion. To his credit, J&J's Weldon says that they "won't chase this deal to a price that doesn't make sense for the company" and J&J makes no further offer.

    The acquisition of Guidant is widely regarded as a winners' curse situation for Boston Scientific; yes, they won the prize, but their stock has shown a steady downward trend since the time of the merger and they bought a host of quality and other problems along with the high-flying group.

    Smells a bit like the Hershey-Cadbury-Ferrero-Kraft recipe, no? What do you think? Is this another war of attrition in the making? It certainly has all the necessary ingredients.


    Potentially a Great Case for Managerial Accounting CoursesL  How can Harry Potter movies be financial losers?
    "'Hollywood Accounting' Losing In The Courts:  From the math-is-hard dept," TechDirt ---
    http://www.techdirt.com/articles/20100708/02510310122.shtml

    If you follow the entertainment business at all, you're probably well aware of "Hollywood accounting," whereby very, very, very few entertainment products are technically "profitable," even as they earn studios millions of dollars. A couple months ago, the Planet Money folks did a great episode explaining how this works in very simple terms. The really, really, really simplified version is that Hollywood sets up a separate corporation for each movie with the intent that this corporation will take on losses. The studio then charges the "film corporation" a huge fee (which creates a large part of the "expense" that leads to the loss). The end result is that the studio still rakes in the cash, but for accounting purposes the film is a money "loser" -- which matters quite a bit for anyone who is supposed to get a cut of any profits.

    For example, a bunch of you sent in the example of how Harry Potter and the Order of the Phoenix, under "Hollywood accounting," ended up with a $167 million "loss," despite taking in $938 million in revenue. This isn't new or surprising, but it's getting attention because the income statement for the movie was leaked online, showing just how Warner Bros. pulled off the accounting trick:

    In that statement, you'll notice the "distribution fee" of $212 million dollars. That's basically Warner Bros. paying itself to make sure the movie "loses money." There are some other fun tidbits in there as well. The $130 million in "advertising and publicity"? Again, much of that is actually Warner Bros. paying itself (or paying its own "properties"). $57 million in "interest"? Also to itself for "financing" the film. Even if we assume that only half of the "advertising and publicity" money is Warner Bros. paying itself, we're still talking about $350 million that Warner Bros. shifts around, which get taken out of the "bottom line" in the movie accounting.

    Now, that's all fascinating from a general business perspective, but now it appears that Hollywood Accounting is coming under attack in the courtroom... and losing. Not surprisingly, your average juror is having trouble coming to grips with the idea that a movie or television show can bring in hundreds of millions and still "lose" money. This week, the big case involved a TV show, rather than a movie, with the famed gameshow Who Wants To Be A Millionaire suddenly becoming "Who Wants To Hide Millions In Profits." A jury found the whole "Hollywood Accounting" discussion preposterous and awarded Celador $270 million in damages from Disney, after the jury believed that Disney used these kinds of tricks to cook the books and avoid having to pay Celador over the gameshow, as per their agreement.

    On the same day, actor Don Johnson won a similar lawsuit in a battle over profits from the TV show Nash Bridges, and a jury awarded him $23 million from the show's producer. Once again, the jury was not at all impressed by Hollywood Accounting.

    With these lawsuits exposing Hollywood's sneakier accounting tricks, and finding them not very convincing, a number of Hollywood studios may face a glut of upcoming lawsuits over similar deals on properties that "lost" money while making millions. It's why many of the studios are pretty worried about the rulings. Of course, these recent rulings will be appealed, and a jury ruling might not really mean much in the long run. Still, for now, it's a fun glimpse into yet another way that Hollywood lies with numbers to avoid paying people what they owe (while at the same sanctimoniously insisting in the press and to politicians that they're all about getting content creators paid what they're due).

    Bob Jensen's threads on case learning are at
    http://www.trinity.edu/rjensen/000aaa/thetools.htm#Cases

    Bob Jensen's threads on return on investment
    http://www.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on management accounting
    http://www.trinity.edu/rjensen/theory01.htm#ManagementAccounting

    Bob Jensen's threads on accounting theory are at
    http://www.trinity.edu/rjensen/theory01.htm

     


    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


    Watch the video! (a bit slow loading)
    Lynn Turner is Partnoy's co-author of the white paper."Make Markets Be Markets"
    "Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt Institute, March 2010 ---
    http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
    Watch the video!

    Abusive off-balance sheet accounting was a major cause of the financial crisis.  These abuses triggered a daisy chain of dysfunctional decision-making by removing transparency from investors, markets, and regulators.  Off-balance sheet accounting facilitating the spread of the bad loans, securitizations, and derivative transactions that brought the financial system to the brink of collapse.

    As in the 1920s, the balance sheets of major corporations recently failed to provide a clear picture of the financial health of those entities.  Banks in particular have become predisposed to narrow the size of their balance sheets, because investors and regulators use the balance sheet as an anchor in their assessment of risk.  Banks use financial engineering to make it appear that they are better capitalized and less risky than they really are.  Most people and businesses include all of their assets and liabilities on their balance sheets.  But large financial institutions do not.

    Click here to read the full chapter.---
    http://www.rooseveltinstitute.org/sites/all/files/Off-Balance Sheet Transactions.pdf

    Frank Partnoy is the George E. Barnett Professor of Law and Finance and is the director of the Center on Coporate and Securities Law at the University of San Diego.  He worked as a derivatives structurer at Morgan Stanley and CS First Boston during the mid-1990s and wrote F.I.A.S.C.O.: Blook in the Water on Wall Street, a best-selling book about his experiences there.  His other books include Infectious Greed: How Deceit and Risk Corrupted the Financial Markets and The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals.

    Lynn Turner has the unique perspective of having been the Chief Accountant of the Securities and Exchange Commission, a member of boards of public companies, a trustee of a mutual fund and a public pension fund, a professor of accounting, a partner in one of the major international auditing firms, the managing director of a research firm and a chief financial officers and an executive in industry.  In 2007, Treasury Secretary Paulson appointed him to the Treasury Committee on the Auditing Profession.  He currently serves as a senior advisor to LECG, an international forensics and economic consulting firm.

    The views expressed in this paper are those of the authors and do not necessarily reflect the positions of the Roosevelt Institute, its officers, or its directors. 

    Bob Jensen's threads on OBSF are at
    http://www.trinity.edu/rjensen/theory01.htm#OBSF2

    For over 15 years Frank Partnoy has been appealing in vain for financial reform. My timeline of history of the scandals, the new accounting standards, and the new ploys at OBSF and earnings management is at
    http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

     


    My Hero Lawyer, Professor, and Wall Street Financial Expert Weighs In

    Question
    In the bankruptcy court examiner's report on Lehman's downfall, is Volume 3 more or less important than Volume 2?

    Answer
    For Ernst & Young it is probably Volume 3, but my true hero exposing Wall Street scandals opts for Volume 2.

    My favorite Wall Street books exposing the inside greed and fraud on Wall Street are those written by Frank Partnoy. My timeline of his exposes can be found at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds .

    Professor Partnoy's Senate Testimony was among the first solid explanations of how derivative financial instruments frauds took place at Enron. His entire testimony can be found at http://www.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony
    See his explanation of the infamous Footnote 16 of the Year 2000 Enron Annual report ---
    http://www.trinity.edu/rjensen/FraudEnron.htm#Senator

    His books are among the funniest and best books I've ever read in my life, even better than the books of Michael Lewis.
    http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
    They are the most dog-eared and scruffed up books in my entire library.

    "Lehman Examiner Punted on Valuation,"
    by Frank Partnoy, Professor of Law and Finance University of San Diego School of Law and author of Fiasco, Infectious Greed, and The Match King
    Naked Capitalism, March 14, 2010 --- http://www.nakedcapitalism.com/2010/03/frank-partnoy-lehman-examiner-punted-on-valuation.html

    The buzz on the Lehman bankruptcy examiner’s report has focused on Repo 105, for good reason. That scheme is one powerful example of how the balance sheets of major Wall Street banks are fiction. It also shows why Congress must include real accounting reform in its financial legislation, or risk another collapse. (If you have 8 minutes to kill, here is my recent talk on the off-balance sheet problem, from the Roosevelt Institute financial conference.)

    But an even more troubling section of the Lehman report is not Volume 3 on Repo 105. It is Volume 2, on Valuation. The Valuation section is 500 pages of utterly terrifying reading. It shows that, even eighteen months after Lehman’s collapse, no one – not the bankruptcy examiner, not Lehman’s internal valuation experts, not Ernst and Young, and certainly not the regulators – could figure out what many of Lehman’s assets and liabilities were worth. It shows Lehman was too complex to do anything but fail.

    The report cites extensive evidence of valuation problems. Check out page 577, where the report concludes that Lehman’s high credit default swap valuations were reasonable because Citigroup’s marks were ONLY 8% lower than Lehman’s. 8%? And since when are Citigroup’s valuations the objective benchmark?

    Or page 547, where the report describes how Lehman’s so-called “Product Control Group” acted like Keystone Kops: the group used third-party prices for only 10% of Lehman’s CDO positions, and deferred to the traders’ models, saying “We’re not quants.” Here are two money quotes:

    While the function of the Product Control Group was to serve as a check on the
    desk marks set by Lehman’s traders, the CDO product controllers were hampered in
    two respects. First, the Product Control Group did not appear to have sufficient
    resources to price test Lehman’s CDO positions comprehensively. Second, while the
    CDO product controllers were able to effectively verify the prices of many positions
    using trade data and third‐party prices, they did not have the same level of quantitative sophistication as many of the desk personnel who developed models to price CDOs. (page 547)

    Or this one:

    However, approximately a quarter of Lehman’s CDO positions were not affirmatively priced by the Product Control Group, but simply noted as ‘OK’ because the desk had already written down the position significantly. (page 548)

    My favorite section describes the valuation of Ceago, Lehman’s largest CDO position. My corporate finance students at the University of San Diego School of Law understand that you should use higher discount rates for riskier projects. But the Valuation section of the report found that with respect to Ceago, Lehman used LOWER discount rates for the riskier tranches than for the safer ones:

    The discount rates used by Lehman’s Product Controllers were significantly understated. As stated, swap rates were used for the discount rate on the Ceago subordinate tranches. However, the resulting rates (approximately 3% to 4%) were significantly lower than the approximately 9% discount rate used to value the more senior S tranche. It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche. (page 556)

    It’s one thing to have product controllers who aren’t “quants”; it’s quite another to have people in crucial risk management roles who don’t understand present value.

    When the examiner compared Lehman’s marks on these lower tranches to more reliable valuation estimates, it found that “the prices estimated for the C and D tranches of Ceago securities are approximately one‐thirtieth of the price reported by Lehman. (pages 560-61) One thirtieth? These valuations weren’t even close.

    Ultimately, the examiner concluded that these problems related to only a small portion of Lehman’s overall portfolio. But that conclusion was due in part to the fact that the examiner did not have the time or resources to examine many of Lehman’s positions in detail (Lehman had 900,000 derivative positions in 2008, and the examiner did not even try to value Lehman’s numerous corporate debt and equity holdings).

    The bankruptcy examiner didn’t see enough to bring lawsuits. But the valuation section of the report raises some hot-button issues for private parties and prosecutors. As the report put it, there are issues that “may warrant further review by parties in interest.”

    For example, parties in interest might want to look at the report’s section on Archstone, a publicly traded REIT Lehman acquired in October 2007. Much ink has been spilled criticizing the valuation of Archstone. Here is the Report’s finding (at page 361):

    … there is sufficient evidence to support a finding that Lehman’s valuations for its Archstone equity positions were unreasonable beginning as of the end of the first quarter of 2008, and continuing through the end of the third quarter of 2008.

    And Archstone is just one of many examples.

    The Repo 105 section of the Lehman report shows that Lehman’s balance sheet was fiction. That was bad. The Valuation section shows that Lehman’s approach to valuing assets and liabilities was seriously flawed. That is worse. For a levered trading firm, to not understand your economic position is to sign your own death warrant.

     


  •  

  • Selected works of FRANK PARTNOY
    Bob Jensen at Trinity University

    1.  Who is Frank Partnoy?

    Cheryl Dunn requested that I do a review of my favorites among the “books that have influenced [my] work.”   Immediately the succession of FIASCO books by Frank Partnoy came to mind.  These particular books are not the best among related books by Wall Street whistle blowers such as Liar's Poker: Playing the Money Markets by Michael Lewis in 1999 and Monkey Business: Swinging Through the Wall Street Jungle by John Rolfe and Peter Troob in 2002.  But in1997.  Frank Partnoy was the first writer to open my eyes to the enormous gap between our assumed efficient and fair capital markets versus the “infectious greed” (Alan Greenspan’s term) that had overtaken these markets.

    Partnoy’s succession of FIASCO books, like those of Lewis and Rolfe/Troob are reality books written from the perspective of inside whistle blowers.  They are somewhat repetitive and anecdotal mainly from the perspective of what each author saw and interpreted. 

    My favorite among the capital market fraud books is Frank Partnoy’s latest book Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0- 477 pages).  This is the most scholarly of the books available on business and gatekeeper degeneracy.  Rather than relying mostly upon his own experiences, this book drawn from Partnoy’s interviews of over 150 capital markets insiders of one type or another.  It is more scholarly because it demonstrates Partnoy’s evolution of learning about extremely complex structured financing packages that were the instruments of crime by banks, investment banks, brokers, and securities dealers in the most venerable firms in the U.S. and other parts of the world.  The book is brilliant and has a detailed and helpful index.

     

    What did I learn most from Partnoy?

    I learned about the failures and complicity of what he terms “gatekeepers” whose fiduciary responsibility was to inoculate against “infectious greed.”  These gatekeepers instead manipulated their professions and their governments to aid and abet the criminals.  On Page 173 of Infectious Greed, he writes the following: 

    Page #173

    When Republicans captured the House of Representatives in November 1994--for the first time since the Eisenhower era--securities-litigation reform was assured.  In a January 1995 speech, Levitt outlined the limits on securities regulation that Congress later would support: limiting the statute-of-limitations period for filing lawsuits, restricting legal fees paid to lead plaintiffs, eliminating punitive-damages provisions from securities lawsuits, requiring plaintiffs to allege more clearly that a defendant acted with reckless intent, and exempting "forward looking statements"--essentially, projections about a company's future--from legal liability.

    The Private Securities Litigation Reform Act of 1995 passed easily, and Congress even overrode the veto of President Clinton, who either had a fleeting change of heart about financial markets or decided that trial lawyers were an even more important constituency than Wall Street.  In any event, Clinton and Levitt disagreed about the issue, although it wasn't fatal to Levitt, who would remain SEC chair for another five years.

     

    He later introduces Chapter 7 of Infectious Greed as follows:

    Pages 187-188

    The regulatory changes of 1994-95 sent three messages to corporate CEOs.  First, you are not likely to be punished for "massaging" your firm's accounting numbers.  Prosecutors rarely go after financial fraud and, even when they do, the typical punishment is a small fine; almost no one goes to prison.  Moreover, even a fraudulent scheme could be recast as mere earnings management--the practice of smoothing a company's earnings--which most executives did, and regarded as perfectly legal.

    Second, you should use new financial instruments--including options, swaps, and other derivatives--to increase your own pay and to avoid costly regulation.  If complex derivatives are too much for you to handle--as they were for many CEOs during the years immediately following the 1994 losses--you should at least pay yourself in stock options, which don't need to be disclosed as an expense and have a greater upside than cash bonuses or stock.

    Third, you don't need to worry about whether accountants or securities analysts will tell investors about any hidden losses or excessive options pay.  Now that Congress and the Supreme Court have insulated accounting firms and investment banks from liability--with the Central Bank decision and the Private Securities Litigation Reform Act--they will be much more willing to look the other way.  If you pay them enough in fees, they might even be willing to help.

    Of course, not every corporate executive heeded these messages.  For example, Warren Buffett argued that managers should ensure that their companies' share prices were accurate, not try to inflate prices artificially, and he criticized the use of stock options as compensation.  Having been a major shareholder of Salomon Brothers, Buffett also criticized accounting and securities firms for conflicts of interest.

    But for every Warren Buffett, there were many less scrupulous CEOs.  This chapter considers four of them: Walter Forbes of CUC International, Dean Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass of Rite Aid.  They are not all well-known among investors, but their stories capture the changes in CEO behavior during the mid-1990s.  Unlike the "rocket scientists" at Bankers Trust, First Boston, and Salomon Brothers, these four had undistinguished backgrounds and little training in mathematics or finance.  Instead, they were hardworking, hard-driving men who ran companies that met basic consumer needs: they sold clothes, barbecue grills, and prescription medicine, and cleaned up garbage.  They certainly didn't buy swaps linked to LIBOR-squared.

     

    The book Infectious Greed has chapters on other capital markets and corporate scandals.  It is the best account that I’ve ever read about Bankers Trust the Bankers Trust scandals, including how one trader named Andy Krieger almost destroyed the entire money supply of New Zealand.  Chapter 10 is devoted to Enron and follows up on Frank Partnoy’s invited testimony before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm

    The controversial writings of Frank Partnoy have had an enormous impact on my teaching and my research.  Although subsequent writers wrote somewhat more entertaining exposes, he was the one who first opened my eyes to what goes on behind the scenes in capital markets and investment banking.  Through his early writings, I discovered that there is an enormous gap between the efficient financial world that we assume in agency theory worshipped in academe versus the dark side of modern reality where you find the cleverest crooks out to steal money from widows and orphans in sophisticated ways where it is virtually impossible to get caught.  Because I read his 1997  book early on, the ensuing succession of enormous scandals in finance, accounting, and corporate governance weren’t really much of a surprise to me.

    From his insider perspective he reveals a world where our most respected firms in banking, market exchanges, and related financial institutions no longer care anything about fiduciary responsibility and professionalism in disgusting contrast to the honorable founders of those same firms motivated to serve rather than steal.

    Young men and women from top universities of the world abandoned almost all ethical principles while working in investment banks and other financial institutions in order to become not only rich but filthy rich at the expense of countless pension holders and small investors.  Partnoy opened my eyes to how easy it is to get around auditors and corporate boards by creating structured financial contracts that are incomprehensible and serve virtually no purpose other than to steal billions upon billions of dollars.

     

    Most importantly, Frank Partnoy opened my eyes to the psychology of greed.  Greed is rooted in opportunity and cultural relativism.  He graduated from college with a high sense of right and wrong.  But his standards and values sank to the criminal level of those when he entered the criminal world of investment banking.  The only difference between him and the crooks he worked with is that he could not quell his conscience while stealing from widows and orphans.

     

    Frank Partnoy has a rare combination of scholarship and experience in law, investment banking, and accounting.  He is sometimes criticized for not really understanding the complexities of some of the deals he described, but he rather freely admits that he was new to the game of complex deceptions in international structured financing crime.

    2.  What really happened at Enron? --- http://www.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony 

     

    3.  What are some of Frank Partnoy’s best-known works?

    Frank Partnoy, FIASCO: Blood in the Water on Wall Street (W. W. Norton & Company, 1997, ISBN 0393046222, 252 pages). 

    This is the first of a somewhat repetitive succession of Partnoy’s “FIASCO” books that influenced my life.  The most important revelation from his insider’s perspective is that the most trusted firms on Wall Street and financial centers in other major cities in the U.S., that were once highly professional and trustworthy, excoriated the guts of integrity leaving a façade behind which crooks less violent than the Mafia but far more greedy took control in the roaring 1990s. 

    After selling a succession of phony derivatives deals while at Morgan Stanley, Partnoy blew the whistle in this book about a number of his employer’s shady and outright fraudulent deals sold in rigged markets using bait and switch tactics.  Customers, many of them pension fund investors for schools and municipal employees, were duped into complex and enormously risky deals that were billed as safe as the U.S. Treasury.

    His books have received mixed reviews, but I question some of the integrity of the reviewers from the investment banking industry who in some instances tried to whitewash some of the deals described by Partnoy.  His books have received a bit less praise than the book Liars Poker by Michael Lewis, but critics of Partnoy fail to give credit that Partnoy’s exposes preceded those of Lewis. 

    Frank Partnoy, FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance (Profile Books, 1998, 305 Pages)

    Like his earlier books, some investment bankers and literary dilettantes who reviewed this book were critical of Partnoy and claimed that he misrepresented some legitimate structured financings.  However, my reading of the reviewers is that they were trying to lend credence to highly questionable offshore deals documented by Partnoy.  Be that as it may, it would have helped if Partnoy had been a bit more explicit in some of his illustrations.

    Frank Partnoy, FIASCO: The Inside Story of a Wall Street Trader (Penguin, 1999, ISBN 0140278796, 283 pages). 

    This is a blistering indictment of the unregulated OTC market for derivative financial instruments and the million and billion dollar deals conceived in investment banking.  Among other things, Partnoy describes Morgan Stanley’s annual drunken skeet-shooting competition organized by a “gun-toting strip-joint connoisseur” former combat officer (fanatic) who loved the motto:  “When derivatives are outlawed only outlaws will have derivatives.”  At that event, derivatives salesmen were forced to shoot entrapped bunnies between the eyes on the pretense that the bunnies were just like “defenseless animals” that were Morgan Stanley’s customers to be shot down even if they might eventually “lose a billion dollars on derivatives.”
     
    This book has one of the best accounts of the “fiasco” caused almost entirely by the duping of Orange County ’s Treasurer (Robert Citron) by the unscrupulous Merrill Lynch derivatives salesman named Michael Stamenson. Orange County eventually lost over a billion dollars and was forced into bankruptcy.  Much of this was later recovered in court from Merrill Lynch.  Partnoy calls Citron and Stamenson “The Odd Couple,” which is also the title of Chapter 8 in the book.Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages)Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages)

    Partnoy shows how corporations gradually increased financial risk and lost control over overly complex structured financing deals that obscured the losses and disguised frauds  pushed corporate officers and their boards into successive and ingenious deceptions." Major corporations such as Enron, Global Crossing, and WorldCom entered into enormous illegal corporate finance and accounting.  Partnoy documents the spread of this epidemic stage and provides some suggestions for restraining the disease.

    "The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" by Frank Partnoy, Washington University Law Quarterly, Volume 77, No. 3, 1999 --- http://ls.wustl.edu/WULQ/ 
     

    4.  What are examples of related books that are somewhat more entertaining than Partnoy’s early books?

    Michael Lewis, Liar's Poker: Playing the Money Markets (Coronet, 1999, ISBN 0340767006)

    Lewis writes in Partnoy’s earlier whistleblower style with somewhat more intense and comic portrayals of the major players in describing the double dealing and break down of integrity on the trading floor of Salomon Brothers.

    John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle (Warner Books, Incorporated, 2002, ISBN: 0446676950, 288 Pages)

    This is a hilarious tongue-in-cheek account by Wharton and Harvard MBAs who thought they were starting out as stock brokers for $200,000 a year until they realized that they were on the phones in a bucket shop selling sleazy IPOs to unsuspecting institutional investors who in turn passed them along to widows and orphans.  They write. "It took us another six months after that to realize that we were, in fact, selling crappy public offerings to investors."

    There are other books along a similar vein that may be more revealing and entertaining than the early books of Frank Partnoy, but he was one of the first, if not the first, in the roaring 1990s to reveal the high crime taking place behind the concrete and glass of Wall Street.  He was the first to anticipate many of the scandals that soon followed.  And his testimony before the U.S. Senate is the best concise account of the crime that transpired at Enron.  He lays the blame clearly at the feet of government officials (read that Wendy Gramm) who sold the farm when they deregulated the energy markets and opened the doors to unregulated OTC derivatives trading in energy.  That is when Enron really began bilking the public.

    Some of the many, many lawsuits settled by auditing firms can be found at http://www.trinity.edu/rjensen/Fraud001.htm
     

     

     

     

    The End of Wall Street?

    Liars Poker II is called "The End"
    The Not-Funny Punch Line is Not Until Page 9 of This Tongue in Cheek Explanation of the Meltdown on Wall Street!

    Now I asked Gutfreund about his biggest decision. “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public (beg for a government bailout) and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game.

    This is a must read to understand what went wrong on Wall Street --- especially the punch line!
    "The End," by Michael Lewis December 2008 Issue The era that defined Wall Street is finally, officially over. Michael Lewis, who chronicled its excess in Liar’s Poker, returns to his old haunt to figure out what went wrong.
    http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom?tid=true

    To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

    I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous—which is one of the reasons the money was so easy to walk away from. I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.

    When I sat down to write my account of the experience in 1989—Liar’s Poker, it was called—it was in the spirit of a young man who thought he was getting out while the getting was good. I was merely scribbling down a message on my way out and stuffing it into a bottle for those who would pass through these parts in the far distant future.

    Unless some insider got all of this down on paper, I figured, no future human would believe that it happened.

    I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind. I expected readers of the future to be outraged that back in 1986, the C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I expected them to gape in horror when I reported that one of our traders, Howie Rubin, had moved to Merrill Lynch, where he lost $250 million; I assumed they’d be shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the risks his traders were running. What I didn’t expect was that any future reader would look on my experience and say, “How quaint.”

    I had no great agenda, apart from telling what I took to be a remarkable tale, but if you got a few drinks in me and then asked what effect I thought my book would have on the world, I might have said something like, “I hope that college students trying to figure out what to do with their lives will read it and decide that it’s silly to phony it up and abandon their passions to become financiers.” I hoped that some bright kid at, say, Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Morgan Stanley, and set out to sea.

    Somehow that message failed to come across. Six months after Liar’s Poker was published, I was knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share about Wall Street. They’d read my book as a how-to manual.

    In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?

    At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.

    The New Order The crash did more than wipe out money. It also reordered the power on Wall Street. What a Swell Party A pictorial timeline of some Wall Street highs and lows from 1985 to 2007. Worst of Times Most economists predict a recovery late next year. Don’t bet on it. Then came Meredith Whitney with news. Whitney was an obscure analyst of financial firms for Oppenheimer Securities who, on October 31, 2007, ceased to be obscure. On that day, she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. It’s never entirely clear on any given day what causes what in the stock market, but it was pretty obvious that on October 31, Meredith Whitney caused the market in financial stocks to crash. By the end of the trading day, a woman whom basically no one had ever heard of had shaved $369 billion off the value of financial firms in the market. Four days later, Citigroup’s C.E.O., Chuck Prince, resigned. In January, Citigroup slashed its dividend.

    From that moment, Whitney became E.F. Hutton: When she spoke, people listened. Her message was clear. If you want to know what these Wall Street firms are really worth, take a hard look at the crappy assets they bought with huge sums of ­borrowed money, and imagine what they’d fetch in a fire sale. The vast assemblages of highly paid people inside the firms were essentially worth nothing. For better than a year now, Whitney has responded to the claims by bankers and brokers that they had put their problems behind them with this write-down or that capital raise with a claim of her own: You’re wrong. You’re still not facing up to how badly you have mismanaged your business.

    Rivals accused Whitney of being overrated; bloggers accused her of being lucky. What she was, mainly, was right. But it’s true that she was, in part, guessing. There was no way she could have known what was going to happen to these Wall Street firms. The C.E.O.’s themselves didn’t know.

    Now, obviously, Meredith Whitney didn’t sink Wall Street. She just expressed most clearly and loudly a view that was, in retrospect, far more seditious to the financial order than, say, Eliot Spitzer’s campaign against Wall Street corruption. If mere scandal could have destroyed the big Wall Street investment banks, they’d have vanished long ago. This woman wasn’t saying that Wall Street bankers were corrupt. She was saying they were stupid. These people whose job it was to allocate capital apparently didn’t even know how to manage their own.

    At some point, I could no longer contain myself: I called Whitney. This was back in March, when Wall Street’s fate still hung in the balance. I thought, If she’s right, then this really could be the end of Wall Street as we’ve known it. I was curious to see if she made sense but also to know where this young woman who was crashing the stock market with her every utterance had come from.

    It turned out that she made a great deal of sense and that she’d arrived on Wall Street in 1993, from the Brown University history department. “I got to New York, and I didn’t even know research existed,” she says. She’d wound up at Oppenheimer and had the most incredible piece of luck: to be trained by a man who helped her establish not merely a career but a worldview. His name, she says, was Steve Eisman.

    Eisman had moved on, but they kept in touch. “After I made the Citi call,” she says, “one of the best things that happened was when Steve called and told me how proud he was of me.”

    Having never heard of Eisman, I didn’t think anything of this. But a few months later, I called Whitney again and asked her, as I was asking others, whom she knew who had anticipated the cataclysm and set themselves up to make a fortune from it. There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria—to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded—without actually being insane. A handful of people had been inside the black box, understood how it worked, and bet on it blowing up. Whitney rattled off a list with a half-dozen names on it. At the top was Steve Eisman.

    Steve Eisman entered finance about the time I exited it. He’d grown up in New York City and gone to a Jewish day school, the University of Pennsylvania, and Harvard Law School. In 1991, he was a 30-year-old corporate lawyer. “I hated it,” he says. “I hated being a lawyer. My parents worked as brokers at Oppenheimer. They managed to finagle me a job. It’s not pretty, but that’s what happened.”

    He was hired as a junior equity analyst, a helpmate who didn’t actually offer his opinions. That changed in December 1991, less than a year into his new job, when a subprime mortgage lender called Ames Financial went public and no one at Oppenheimer particularly cared to express an opinion about it. One of Oppenheimer’s investment bankers stomped around the research department looking for anyone who knew anything about the mortgage business. Recalls Eisman: “I’m a junior analyst and just trying to figure out which end is up, but I told him that as a lawyer I’d worked on a deal for the Money Store.” He was promptly appointed the lead analyst for Ames Financial. “What I didn’t tell him was that my job had been to proofread the ­documents and that I hadn’t understood a word of the fucking things.”

    Ames Financial belonged to a category of firms known as nonbank financial institutions. The category didn’t include J.P. Morgan, but it did encompass many little-known companies that one way or another were involved in the early-1990s boom in subprime mortgage lending—the lower class of American finance.

    The second company for which Eisman was given sole responsibility was Lomas Financial, which had just emerged from bankruptcy. “I put a sell rating on the thing because it was a piece of shit,” Eisman says. “I didn’t know that you weren’t supposed to put a sell rating on companies. I thought there were three boxes—buy, hold, sell—and you could pick the one you thought you should.” He was pressured generally to be a bit more upbeat, but upbeat wasn’t Steve Eisman’s style. Upbeat and Eisman didn’t occupy the same planet. A hedge fund manager who counts Eisman as a friend set out to explain him to me but quit a minute into it. After describing how Eisman exposed various important people as either liars or idiots, the hedge fund manager started to laugh. “He’s sort of a prick in a way, but he’s smart and honest and fearless.”

    “A lot of people don’t get Steve,” Whitney says. “But the people who get him love him.” Eisman stuck to his sell rating on Lomas Financial, even after the company announced that investors needn’t worry about its financial condition, as it had hedged its market risk. “The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “ ‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.

    Continued in article

    Michael Lewis, Liar's Poker: Playing the Money Markets (Coronet, 1999, ISBN 0340767006)

    Lewis writes in Partnoy’s earlier whistleblower style with somewhat more intense and comic portrayals of the major players in describing the double dealing and break down of integrity on the trading floor of Salomon Brothers.

    Continued at http://www.trinity.edu/rjensen/FraudRotten.htm

    Bob Jensen's threads on the Lehman Examiner's Report ---
    http://www.trinity.edu/rjensen/fraud001.htm#Ernst


    Do Investors Overvalue Firms With Bloated Balance Sheets?
    David A. Hirshleifer University of California, Irvine - Paul Merage School of Business
    Kewei Hou Ohio State University - Department of Finance
    Siew Hong Teoh University of California - Paul Merage School of Business
    Yinglei Zhang Chinese University of Hong Kong (CUHK) - School of Accountancy
    SSRN, February 2004
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=404120

    Abstract:
    If investors have limited attention, then accounting outcomes that saliently highlight positive aspects of a firm's performance will promote high market valuations. When cumulative accounting value added (net operating income) over time outstrips cumulative cash value added (free cash flow), it becomes hard for the firm to sustain further earnings growth. When the balance sheet is 'bloated' in this fashion, we argue that investors with limited attention will overvalue the firm, because naïve earnings-based valuation disregards the firm's relative lack of success in generating cash flows in excess of investment needs. The level of net operating assets, the difference between cumulative earnings and cumulative free cash flow over time, is therefore a measure of the extent to which operating/reporting outcomes provoke excessive investor optimism. Therefore, if investor attention is limited, net operating assets will negatively predict subsequent stock returns. In our 1964-2002 sample, net operating assets scaled by beginning total assets is a strong negative predictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods.

    Bob Jensen's threads on valuation are at
    http://www.trinity.edu/rjensen/roi.htm

     


    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:

    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

       * Order re: Trump Hotels & Casino Resorts, Inc.
       * SEC Caution Regarding "Pro Forma" Financials
       * Investor Alert Regarding "Pro Forma" Financials

    Define each of the items and be sure to explain when they use performance measures that are not in accordance with U.S. GAAP.

    From The Wall Street Journal Accounting Weekly Review on October 14, 2010

    Alcoa Profit Drops on Expenses as Sales Rise
    by: Robert Guy Matthews
    Oct 08, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Earning Announcements, Earnings Forecasts, Interim Financial Statements, Segment Analysis, Segment Margin
    SUMMARY: Alcoa "...kicked off the quarterly earnings parade with mixed news, saying high expenses, lower realized prices and a weak dollar resulted in a 21% drop in third-quarter profit but that volumes rose and global markets continued to strengthen." The company's stock price rose 6.2%.


    CLASSROOM APPLICATION: Questions ask the students to access the transcript of and slides for the conference call with analysts. The related article is a blog on comments by analysts from major investment houses.


    QUESTIONS:
    1. (Introductory) Summarize the results Alcoa reported for the 3rd quarter of 2010. How did the company's stock price react to the earnings release? Why did it react this way?

    2. (Introductory) Access the transcript of Alcoa's conference call regarding its quarterly earnings report, available on the SEC web site at http://www.sec.gov/Archives/edgar/data/4281/000119312510228177/dex991.htm  Who participated in the conference call?

    3. (Advanced) Review the presentation slides for the conference call also on the SEC web site at http://www.sec.gov/Archives/edgar/data/4281/000119312510228177/dex992.htm  What financial measures do they highlight first? Define each of the items and be sure to explain when they use performance measures that are not in accordance with U.S. GAAP.

    4. (Advanced) Scroll through the slides to "Reconciliation of Adjusted Income." What types of items do they exclude from their discussion of Alcoa's operating results? Why do they do so?

    5. (Advanced) What accounting codification section requires presentation of segment information? What information must be provided? Where in the financial statements can this information also be found?

    6. (Advanced) Access the third quarter financial report available through the link to the 8-K filing made on October 8, 2010, on the SEC web site at http://www.sec.gov/Archives/edgar/data/4281/000119312510226872/0001193125-10-226872-index.htm  This filing is also available by clicking on the live link to Alcoa from the online version of the WSJ article, then clicking on SEC Filings in the left hand column, then clicking on the live link to the 8-K filing.. Confirm the answer you gave to question 5 above. What information is included in the financial statements that was excluded from the slides for the conference call?

    7. (Introductory) Refer to the related article, a blog of analysts' comments. Alcoa beat the Goldman Sachs estimate for revenue increase, but nonetheless that firm's analyst was concerned. Explain those concerns.

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES:
    Alcoa up on Earnings: Analyst Takeaways
    by MarketBeat
    Oct 08, 2010
    Online Exclusive

    "Alcoa Profit Drops on Expenses as Sales Rise," by Robert Guy Matthews, The Wall Street Journal, October 8, 2010 ---
    http://online.wsj.com/article/SB10001424052748704696304575538402637158136.html?mod=djem_jiewr_AC_domainid

    Aluminum giant Alcoa Inc. kicked off the quarterly earnings parade with mixed news, saying high expenses, lower realized prices and a weak dollar resulted in a 21% drop in third-quarter profit but that volumes rose and global markets continued to strengthen.

    Alcoa said prices for aluminum are rising and inventories for the metal are starting to fall as Russia, India, Brazil and other developing countries increase their usage. The Pittsburgh company boosted its forecast of global aluminum usage to a rise of 13% for this year, up one percentage point from a July forecast.

    Chairman and Chief Executive Klaus Kleinfeld said the company is seeing significant improvements in most markets. "In countries such as China, Brazil, India, and Russia, more and more people are moving into the middle class, driving demand in building and construction, transportation, and packaging," said Mr. Kleinfeld.

    But usage is still sluggish in Alcoa's main markets, the U.S. and Europe. Analysts aren't expecting aluminum usage in North America and Western Europe to strengthen significantly before the third quarter of 2011.

    Net income fell to $61 million, or six cents a share, compared with $77 million, or eight cents a share, in the same quarter last year. Results included a three-cents-a-share charge, while the year-earlier period included a three-cent-a-share acquisition- related gain.

    Revenue rose 15% to $5.3 billion, mainly due to higher volumes in the aerospace market and increased market share in construction.

    However, Alcoa said that its selling prices for aluminum fell 2% in the quarter compared to the prior quarter.

    Alcoa also said it is trying to reshape how it sells alumina to its customers for better profitability. The company wants to sell its product based on a market-price index that sets prices according to supply and demand, instead of an agreed-upon contract price. The more contracts that are priced by the index, the more money Alcoa can get for each batch of alumina it sells. And if the price rises, as Alcoa expects, its products are more valuable.

    Alcoa is also expected to benefit from the rise in alumina, a key raw material that is used to make aluminum. Prices for alumina, in high demand by China, are expected to rise faster that for aluminum itself. That is good news for Alcoa, the largest supplier of alumina in the world.

    Though Alcoa reported a 5% drop in its alumina price in the third quarter compared to the second quarter, stockpiles of alumina are dropping worldwide as aluminum smelters ramp up their production.

    The improved outlook helped boost Alcoa shares in after hour trading by 3%. Alcoa's shares were up 35 cents in after-hours trading after finishing off 17 cents at $12.20 in 4 p.m. New York Stock Exchange composite trading. The stock is down 24% this year after rising nearly 50% in 2009.


    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


    Question
    What is wrong with the long colorful tail of the peacock?
    An attack of ROE (and in effect the University of Chicago)

    Video:  Capitalism Gone Wild
    Harvard Business Review Blog trying to appease the other side of the Charles River
    December 21, 2011 --- Click Here
    http://blogs.hbr.org/video/2011/12/capitalism-gone-wild.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Video on the opposing side (that the only responsibilities of business firms are to earn a profit and obey the law)
    http://www.youtube.com/watch?v=D3N2sNnGwa4


    Case Illustration of ROI Issues
    Teaching Case from The Wall Street Journal Accounting Weekly Review on April 27, 2012

    Unilever Takes Palm Oil in Hand
    by: Paul Sonne
    Apr 24, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Assurance Services, Financial Accounting, Managerial Accounting, Nonfinancial performance measures, Supply Chains

    SUMMARY: "Unilever PLC is negotiating to build a $100 million palm-oil processing plant in Indonesia....which would make sustainable palm-kernel oil in Sumatra and turn out about 10% of Unilever's annual consumption....The company's new goal...is that within eight years all of the palm oil it buys will come from traceable sources that are certified as sustainable." The company currently supports its assessment that "about two-thirds of the palm oil it used last year" was sustainably produced by buying "803,000 GreenPalm certificates" in addition to sourcing 2% of its palm oil from traceable plantations. GreenPalm certificates are issued by the Roundtable on Sustainable Palm Oil, or RSPO, an organization comprising producers, buyers and environmental groups.

    CLASSROOM APPLICATION: Questions begin by addressing return on investment and whether all benefits that Unilever perceives from its investment in the Indonesian plant can be quantified. The article also is useful to discuss the development of private sector demand for auditing sustainability in business processes, just as private sector demand led to the auditing of financial statements.

    QUESTIONS: 
    1. (Introductory) Why is Unilever constructing a processing plant in Indonesia?

    2. (Advanced) What is return on investment? In general, what factors are considered in undertaking an ROI calculation?

    3. (Advanced) Consider Unilever's decision to invest in a new plant. Indicate the specific factors listed in the article that you think Unilever would include in an ROI analysis for this plant construction project. Can you quantify all of the factors? Explain.

    4. (Introductory) Consider the company's goal, within 8 years, to source all of its palm oil from "traceable sources that are certified as sustainable." How does Unilever currently identify the proportion of palm oil it obtains in this way?

    5. (Advanced) What audit functions are needed to satisfy demand by companies such as Unilever for sustainable sources of their products?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Unilever Takes Palm Oil in Hand," by: Paul Sonne, The Wall Street Journal, April 25, 2012 ---
    http://online.wsj.com/article/SB10001424052702303978104577362160223536388.html?mod=djem_jiewr_AC_domainid

    LONDON—Unilever UN -1.29% PLC is negotiating to build a $100 million palm-oil processing plant in Indonesia, an attempt to accelerate its commitment to sourcing the oil in ways that don't destroy the environment.

    Unilever is trying to more closely trace the source of the palm oil it uses at a time when the industry is falling short of goals to make extraction of the key ingredient less insidious. The harvesting of palm oil has become a hot-button environmental issue for the role it plays in deforestation in countries such as Indonesia and Malaysia, where rain forests have been cleared to make way for palm-oil plantations. In the process, orangutan, tiger and rhino habitats have been destroyed.

    Unilever is in advanced discussions with the Indonesian government to build the plant, which would make sustainable palm-kernel oil in Sumatra and turn out about 10% of Unilever's annual consumption. The company hopes to break ground on the plant later this year.

    The Anglo-Dutch company is the world's biggest consumer of palm oil, using 1.36 million tons of the ingredient a year to make products such as Dove soap, Magnum ice cream and Vaseline lotion.

    The company's new goal, which will be formally announced on Tuesday, is that within eight years all of the palm oil it buys will come from traceable sources that are certified as sustainable. Last year, only 27,000 tons, or about 2%, of the palm oil Unilever bought came from such sources.

    "I am not aware of anyone else who has made that commitment, particularly on our scale," says Marc Engel, Unilever's chief procurement officer.

    The thirst for palm oil is rapidly expanding, thanks to the widespread application of it and its derivatives in products ranging from cakes to lipsticks. Last year, the world consumed about 50 million tons of the oil, according to the World Wildlife Foundation. About five million to six million tons came from plantations certified as sustainable by the Roundtable on Sustainable Palm Oil, or RSPO, an organization comprising producers, buyers and environmental groups.

    It isn't easy for consumer-goods companies to figure out whether palm oil comes from an audited sustainable plantation. Processing plants often combine oil from sustainable plantations with nonsustainable oil in a vat, making the source of a final ingredient difficult to pinpoint. Unilever also employs palm oil in lots of different ways—often using derivatives of the oil rather than oil itself—making the supply chain even more complex.

    Mr. Engel compared it to crude oil. "When you actually want to know where the petrol in your car is coming from—from which oil well—it's very hard to see," he said.

    For that reason, the RSPO developed a system of GreenPalm certificates that companies such as Unilever can buy. The RSPO certifies plantations as sustainable and awards them one certificate per ton of palm oil they produce.

    Unilever considered about two-thirds of the palm oil it used last year sustainable, not because it actually came from traceable sources, but because it bought 803,000 GreenPalm certificates, plus the 27,000 tons of oil it bought from traceable plantations.

    This year, the company says it will match all the palm oil it doesn't buy from traceable plantations with certificates so it reaches a target of 100% certified sustainable palm oil, three years ahead of the 2015 deadline the company set in 2010.

    That, however, doesn't mean the palm-oil derivative in a bar of Dove soap or Magnum ice cream actually came from a sustainable palm-oil plantation.

    "In theory, all of the palm oil could be sustainable, or none of it could be," Mr. Engel says.

    He says that although the sustainable oil attached to the certificates may not have ended up in Unilever products, the company bought a certificate for a ton of palm oil "out there" that came from a sustainable plantation, helping shift the balance toward sustainable production.

    The certificate system has its critics, who say it allows companies to claim they are buying sustainable palm oil when they aren't.

    "A lot of people are hiding behind green certificates as if that's going to change the industry," says Alan Chaytor, executive director of New Britain Palm Oil Ltd., a Papua New Guinea-based producer that makes about 600,000 tons of sustainable palm oil a year.

    Continued in article

    Bob Jensen's threads on ROI and other ratios ---
    http://www.trinity.edu/rjensen/roi.htm


    "End the Religion of ROE," by Chris Meyer & Julia Kirby, Harvard Business Review Blog, October 20, 2011 ---
    http://paper.li/businessschools?utm_source=subscription&utm_medium=email&utm_campaign=paper_sub

    There is no more powerful question in a U.S. corporation than "what's the ROE on that?" Social media spending? Wellness checkups? Better working conditions? Return-on-equity hurdles threaten them all. Conversely, why market cigarettes? ROE justifies the means.

    We think there's more to business success — and that something as straightforward as a simple equation could put capitalism on a better path.

    To an extent not widely recognized, it was an equation in the first place that gave ROE the power to dominate not just investment decisions, but an entire business culture. A hundred years ago, the focus on squeezing every drop of return out of equity capital made great sense. As the industrial revolution progressed, society was enjoying enormous benefits from mass production, which brought former luxuries within middle class reach. Just as electronic commerce would later sweep business, mass production came to one industry after another. But unlike websites, factories were capital intensive. The revolution ran on equity capital, which was in short supply. Anyone would have concluded that allocating capital according to expected return on equity would be optimal for growth.

    The ability to do that rose to a new level in 1917, when General Motors was in financial difficulty and DuPont took a major position in the company. (GM represented an important channel for Dupont's lacquer, artificial leather, and other products, and Pierre du Pont was on GM's Board.) DuPont sent Donaldson Brown, a promising engineer-turned-finance staffer, to Detroit to sort things out, and sort them out he did.

    Brown noted a simple fact: Return on equity can be broken down into a three-part equation. It is logically the product of return on sales times the ratio of sales to assets times the ratio of assets to equity. By parsing ROE into the DuPont Equation (very rapidly to become a business school mainstay), he provided the basis for organizations divided into functions with their own objectives. He reasoned that if marketers worked on maximizing return on sales, production managers were rewarded for the sales they squeezed out of their physical plant, and finance managers focused on minimizing the amount of equity capital they needed, ROE would take care of itself.

    Thus Brown not only sowed the seeds of the today's hated silos, he also set three "runaways" in motion. That is to say, he created objectives with such strong feedback loops that they were pursued single-mindedly, even to unhealthy excess.

    Biologists use the term "runaway" to describe what happens when a single criterion dominates the mating choices of a species to the exclusion of other valuable traits. Among peacocks, large tails so charm the peahens that the male tail has grown to the point where the males are stressed by the nutritional burdens of growing and carrying the stupendous appendage, and are more subject to predation because of its weight. Even as the population of peacocks declines, peahens persist in their preferences. Runaway feedback reduces the fitness of the species. (And here's a simpler version, courtesy of lab experiments in the 1950s: given a lever to stimulate the pleasure centers in their brains, rats will allow themselves to die of starvation and exhaustion. The feedback from pressing the lever overwhelms the positive sensation they would experience from eat or sleep.)

    In the case of ROE, spurred on by the DuPont equation, society came to suffer from similarly entrenched corporate runaways. In their pursuit of margin, marketers sought market power even to the point of monopoly, requiring antitrust laws to cry stop at the last moment of the end game. Similarly, production engineers treated their factories royally and their labor as expendable, until unions and labor laws intervened. Financial managers, supported by their bankers, increased their debt-to-equity ratios until capital requirements were imposed—oops, we mean until there was a catastrophic financial crash and a depression. Then banking regulations were imposed. (Apparently unconvinced of the causal link, in the 1980s we re-ran the experiment. Once again, stimulating the financial pleasure center proved irresistible and near-fatal.)

    The lesson: Return on Equity, like peacock tail splendor, is a very poor guide for allocating resources. It fails for two reasons. First, fixating on ROE fails to maximize the benefit of business to society because it measures value in terms of returns to only one stakeholder; second, it allocates human resources as if maximizing the efficiency of financial capital were critical to growth of social welfare.

    So it's time to address our measurement system seriously at the firm level. It would help to have a new equivalent of the DuPont Equation that propels individuals and organizations forward just as powerfully but does not send capitalism off the rails. What might that look like? Most fundamentally, the objective of business must be broadened beyond ROE. Structurally, too narrow an objective function leads to runaways, in particular the fetishizing of financial return and measurements. And functionally, there is no longer a need to ration financial resources; there's more money available than can be productively invested—which is why the financial industry is only minimally about investing, and all about flipping, swapping, hedging, engineering, and other forms of lever-pressing.

    Instead, the measure of value creation should take into account the benefits perceived by all stakeholders, not just equity holders. (Note that this means accounting for negative externalities like health effects on neighboring populations, as well as positive ones like contributions to education.)

    In addition, the measures should be broad enough to take into account variations in valuation around the world. As Richard Dickinson and Kate Pickett show in Spirit Level, a value like equality, for example, is prized more highly in Norway than in the U.S.

    And in terms of its effects on managerial decision-making, the new system should create feedback and incentives that nudge managers toward innovating for tomorrow's world, not optimizing for today's. When ROE holds sway, a more or less certain return on a cost-reduction investment nearly always trumps a speculative bet on a new business model. That only makes sense if you are operating in a state of equilibrium—which might have been close enough to the truth in some sepia-toned time. Now we need managers to shift from a mindset of optimizing an equilibrium to adapting to and capitalizing on a dynamic business ecology. New measures can help reverse that priority, creating incentive systems that encourage enterprises to invest in the growth of their ecologies.

    So here's our candidate: we believe that corporations would do better for all their stakeholders and avoid the risks of runaways by focusing on Return on Innovation. An innovation-based measure would lead to an acceleration in investment with positive benefits for growth.

    Continued in article

    Jensen Comment
    Actually this paper is a recommendation to derive Return on Innovation which we might call ROX since ROI is ready taken for Return on Investment. Use of X to stand for the denominator "Innovation" since that term is ambiguous and not well understood in the markets relative to ROE and ROI.

    Also ROX has many of the same limitations of ROE and ROI apart from the problem of defining "Innovation."

    Bob Jensen's threads on the controversies surrounding ROI and ROE are at
    http://www.trinity.edu/rjensen/roi.htm

     


    Teaching Case About Return on Investment (ROI)

    From The Wall Street Journal Accounting Weekly Review on October 8, 2010

    CEO Redux Not Always a Hit
    by: Joe Light
    Oct 04, 2010
    Click here to view the full article on WSJ.com
     

    TOPICS: Corporate Governance, Executive Compensation

    SUMMARY: This short article focuses on work by researchers from the IE Business School in Madrid, Spain, and Rouen Business School, France. These management professors compared rates of return on assets for the three years following initial appointment of the company's CEO who was at the helm in 2005. They examined differences in this performance metric according to whether the CEO had prior experience as CEO versus those who had not; they found consistently poorer results for those CEOs who had prior experience. However, one aspect of the research that is more fully discussed in the online version of the article indicates that the findings may simply serve as a marker of another result: the negative effect of being an ex-CEO disappeared if the CEO spent at least two years with the new firm before being promoted. Ex-CEOs also performed better if they had a long break between CEO positions or repeated as CEO more than twice.

    CLASSROOM APPLICATION: The article may be used to identify an unusual use for ROA, a financial statement ratio typically studied in financial accounting and MBA classes. The article also is useful to help students understand the nature of academic research.

    QUESTIONS: 
    1. (Introductory) What were the overall findings in the study that is being reported in this article?

    2. (Advanced) How is return on assets calculated? How do you think these researchers could control for industry performance so that "CEOs wouldn't get an unfair advantage from a soaring sector"?

    3. (Introductory) How do the researchers explain their results?

    4. (Advanced) Are you surprised by these research results? Explain your response, considering the expertise that should be used in searching for and hiring a CEO
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

     

    "CEO Redux Not Always a Hit,"  by: Joe Light. The Wall Street Journal, October 4, 2010 ---
    http://online.wsj.com/article/SB10001424052748703431604575522362723091490.html?mod=djem_jiewr_AC_domainid

    For chief executives, past experience doesn't necessarily lead to future success.

    A new study found that CEOs who have previously held other CEO posts actually perform worse than people who have never been CEO, judging by a key metric.

    The study looked at chief executives who led S&P 500 companies in 2005 and analyzed their companies' returns on assets in the first three years after their appointments. It was conducted by Professors Monika Hamori of IE Business School in Madrid and Burak Koyuncu of Rouen Business School in Rouen, France.

    To measure CEO performance, Mr. Koyuncu and Ms. Hamori focused on companies' returns on assets—the ratio of net income divided by total assets, which is commonly used to compare company performance in academia. In theS&P 500 sample, 98 CEOs had prior CEO experience. Those repeat CEOs earned a median annual average return on assets of 3.92% in the first three years of the CEO's tenure.

    Companies with a CEO who hadn't been a chief executive before saw a 5.4% return. The negative effect gets even worse if the CEO transitioned from a similar-sized company or one in the same industry. Same-industry repeat CEOs saw a median return on assets of 3.1%, and CEOs from similar-sized companies had a median return of 2.94%.

    Ms. Hamori and Mr. Koyuncu factored in how well their industries as a whole performed so CEOs wouldn't get an unfair advantage from a soaring sector.

    The findings don't necessarily mean that prior CEO experience hurts performance. A second-time CEO is generally someone who is coming from outside the company, while first-time CEOs are a mix of both insiders and outsiders. Other research has shown that internally promoted CEOs tend to outperform outsiders. So the problem may be that the person is an outsider, not that he or she has been CEO previously.

    "When you bring in CEOs from the outside, they think outside the box but are less familiar with what works and what doesn't work within the firm," says Nandini Rajagopalan, a business management professor at the University of Southern California, who has researched the insider-outsider phenomenon.

    Mr. Koyuncu found that the negative effect of being an ex-CEO disappeared if the CEO spent at least two years with the new firm before being promoted. Ex-CEOs also performed better if they had a long break between CEO positions or repeated as CEO more than twice.

    Still, Mr. Koyuncu thinks repeat CEOs might underperform because they mistakenly think they can apply many of the methods they used in their former job to their new one.

    "Every CEO job and company is different from the previous one," he said. "You can't just transfer learning between the two."


    "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.


    Teaching Case on Managerial Accounting:  Accounting Assessments of New Strategy Performance

    From The Wall Street Journal Accounting Review on August 13, 2010

    Macy's Tailored Merchandise Pays Off
    by: Veronica Dagher
    Aug 12, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Earnings Per Share, Financial Accounting, Financial Analysis, Financial Reporting, Interim Financial Statements, Management Controls, Managerial Accounting, Product strategy, Revenue Forecast

    SUMMARY: Macy's Inc. is benefiting from a plan to tailor merchandise to local markets, an effort that helped push its fiscal second-quarter earnings higher. But the retailer Wednesday reiterated uncertainty about the economy even as it raised its yearly earnings forecast. The department-store operator is entering the fall-shopping season "with tremendous momentum," but the economy remains uncertain, Chairman and Chief Executive Terry Lundgren said in a statement.

    CLASSROOM APPLICATION: This article can be used in both managerial and financial reporting classes. The managerial topic of planning and control is addressed through the Macy's tailoring process for regional U.S. tastes. Resultant quarterly reporting of earnings, gross margin, and comparison to analysts' estimates is then discussed.

    QUESTIONS: 
    1. (Introductory) Macy's is tailoring its offerings across the U.S. Summarize how this retailer is taking this approach.

    2. (Introductory) How has the company assessed whether its strategy is working?

    3. (Advanced) What accounting information do you think is necessary to do the planning and assessment that you described in answer to the first two questions above? In your answer, describe how you would code accounting data to provide the needed information.

    4. (Introductory) What was Macy's most recent quarter end? How did the company perform during that quarter? In your answer, include definitions of revenue, gross margin, and profit.

    5. (Introductory) How did Macy's results compare to forecasted earnings? In your answer, state who forecasts these earnings and define the earnings per share metric they use.

    6. (Advanced) What fiscal year end date corresponds to the quarter end reported in this article? Why do you think retailers typically have this fiscal year end date?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Macy's Tailored Merchandise Pays Off," by Veronica Dagher, The Wall Street Journal, August 12, 2010 ---
    http://online.wsj.com/article/SB10001424052748704901104575423072657062954.html?mod=djem_jiewr_AC_domainid

    Macy's Inc. is benefiting from a plan to tailor merchandise to local markets, an effort that helped push its fiscal second-quarter earnings higher. But the retailer Wednesday reiterated uncertainty about the economy even as it raised its yearly earnings forecast.

    The department-store operator is entering the fall-shopping season "with tremendous momentum," but the economy remains uncertain, Chairman and Chief Executive Terry Lundgren said in a statement.

    Macy's typically kicks off the earnings season for major retailers and is seen by many analysts as a barometer of consumer spending.

    The Cincinnati-based company raised its earnings forecast for the year by 10 cents to between $1.85 and $1.90 a share. The company also increased its estimate for same-store-sales growth to 4% to 4.2%, from 3% to 3.5%.

    The retailer's shares jumped after its earnings report, rising 4.5% to $20.25 in afternoon trading Wednesday on the New York Stock Exchange. Its shares were a bright spot as global economic worries weighed on the broader market and concerns about consumer spending helped pressure competing retailers such as J.C. Penney Co.

    The stock through Tuesday was up 25% in the past year.

    Macy's, along with its peers, continues to face challenges due, in part, to low levels of consumer confidence and anemic job growth. Some analysts worry retailers face rougher going during the second half as results are compared with the prior year when the economy seemed to be improving.

    The company on Wednesday reiterated that the effort to tailor merchandise to local tastes, dubbed My Macy's, is paying off, with major changes behind it and the opportunity ahead to push hard at driving sales. The company stocks items based on individual market needs as part of the initiative, pilot-tested in 20 markets in 2008 and rolled out nationally in mid-2009.

    During the company's earnings call, Chief Financial Officer Karen Hoguet said private-brand and exclusive products also are helping drive growth. She added that all regions of the country did "relatively well" in the quarter, with the only cluster of weakness occurring in some parts of California.

    Ms. Hoguet said that on a two-year basis, the strongest regions for the department store giant were the North and the Midwest, both of which were original My Macy's pilot regions.

    Macy's has also increased its efforts in targeting teens and their mothers. With teen unemployment at record levels, teens have less money for new back-to-school clothes, which may put purchasing decisions back in the hands of their parents.

    Some analysts say moms may have more confidence shopping at department stores compared with teen retailers, which may give names like Macy's a boost.

    To that end, Macy's recently rolled out the Material Girl line inspired by singer Madonna and her daughter to lure in teens, an effort Ms. Hoguet said is performing well.

    The Material Girl line adds to other private labels—now more than 40% of Macy's stock—that also include the American Rag brand for juniors and young men and the Martha Stewart home-furnishings line.

    For the period ended July 31, the company reported a profit of $147 million, or 35 cents a share, up from $7 million, or two cents a share, a year earlier, which included 18 cents a share in restructuring-related charges.

    Analysts polled by Thomson Reuters forecast earnings of 29 cents a share for the second quarter.

    Gross margin edged up to 41.9% from 41.5%.

    Macy's last week reported total sales rose 7.3% to $5.54 billion and same-store-sales growth of 4.9%, compared with prior-year declines of 9.7% and 9.5%, respectively.

    Ms. Hoguet said sales were strong in most categories, with the only notable weaknesses in women's traditional career apparel and young men's. The best sales results in the quarter included men's, fashion watches, updated women's apparel and seasonal categories like swimwear, luggage, furniture and mattresses, she said.

    Combined online sales for macys.com and bloomingdales.com were another highlight in the quarter, rising 28.1%. Macy's has been making strides in the digital area and has boosted its spending on various types of online media this year.

    Macy's operates about 850 department stores in the U.S. and its territories. The company is opening three department stores in the second half, including its Bloomingdale's in Santa Monica, which opened last week, and is also planning to open its first four Bloomingdale's Outlets.


    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? 

    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.

     
    Download
    "Auditing Fair Value Measurements And Disclosures"
    in MS Word format.

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    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.

       
      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 threads on valuation are at http://www.trinity.edu/rjensen/roi.htm

    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).   

    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 

    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

     

    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 

     

    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 ).

     

    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:

    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 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 

    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.

     

    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

     

    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.

     

    DIG issues on fair value at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html 
    Section F: Fair Value Hedges

    *Issue F1—Stratification of Servicing Assets (Cleared 02/17/99)

    *Issue F2—Partial-Term Hedging (Cleared 07/28/99)
    See Partial-Term Hedgingn

    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

    Flip Video is No More --- http://en.wikipedia.org/wiki/Flip_Video

    "Cisco's Flip Flop and (Mis)Managing the Obvious," by Michael Schrage, Harvard Business Review Blog, April 18, 2011 --- Click Here
    http://blogs.hbr.org/schrage/2011/04/ciscos-flip-flop-and-mismanagi.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    "Did Cisco Slip on Flip or Was Flip a Flop?" by Rita McGrath, Harvard Business Review Blog, April 18, 2011 --- Click Here
    http://blogs.hbr.org/hbr/mcgrath/2011/04/did-cisco-slip-on-flip-or-was-flip-a-flop.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    So riddle me this: A business that generates an estimated $400 million in revenue, with 550 employees, and which sells an iconic product that was regularly praised as a model of innovation, is going to be shut down. In an analysis of Cisco's decision to shut down its Flip video recorder division, the New York Times reported April 12, 2011, that the networking giant had finally given up on a business that, at one point, was destined to bring it to relevance in consumer markets (along with networking gear company Linksys). The company was purchased just two years ago for $590 million.

    The story is a familiar one. Large organization swallows up innovative smaller one, resulting eventually in the departure of the acquired company's leadership, complaints that the large organization doesn't understand what the small one is all about, lack of attention and commitment to developing the small company's future technology, and eventual disappearance of the small firm. It happens in technology all the time.

    Theories on why Flip ...uh... flopped, abound. Did smartphones with easy Internet access make its functionality obsolete? Is running a consumer business simply not in the DNA of a company whose heart and soul revolve around networking gear for corporate customers? That might be an argument that Geoff Moore would make, in his well known distinction between complex operations and high volume businesses (he's long said it's extremely difficult to house both under a single corporate umbrella). Or maybe analysts just hated Cisco's consumer strategy, and the company struggled for too long to justify the acquisition. Or maybe they concluded that the product had no future and just decided to bail, without even attempting to find a buyer for the business.

    One other theory is that, under the parental umbrella, Flip was not really able to continue to develop the string of innovations that would allow it to go beyond being just a small video camera that would make it more relevant to people's lives. People that loved Flip really loved it. And sales were up 15% over the prior year. Flip was also the best-selling camcorder on Amazon. Despite these signs of relevance, the good news was insufficient to keep it from the corporate chopping block.

    Whatever the reason, the prognosis for using small-company acquisitions to change the DNA of large, established ones hasn't historically been very good. I guess we'll add the story of Flip to that history.

     


    Question
    How do you compute the cost of capital when lenders pay you interest to borrow their money?
    Alan Blinder recommends that the Fed commence to pay FDIC banks to borrow money from the Federal Reserve. This in turn means that banks my profit from paying AAA creditors to borrow money from the bank.

    "Cost of Capital Measure Sees Distortions," by Emily Chason, CFO Report via The Wall Street Journal, July 25, 2012 ---
    http://blogs.wsj.com/cfo/2012/07/25/cost-of-capital-measure-sees-distortions/?mod=wsjpro_hps_cforeport

    The standard weighted average cost of capital calculation, long-used by finance departments for budgeting analysis, has been a bit distorted lately as low interest rates, record-low corporate borrowing costs and a volatile stock market have changed many of the basic inputs companies put into the measure.

    WACC, which is based on a company’s cost of equity and debt, corporate tax rate and market value of equity and debt, is used as a hurdle rate to value corporate investments. The consequence of using a distorted measure can be expensive, and some analysts say companies may want to start thinking more broadly about revising their expected return assumptions in the WACC number.

    Continued in article

    Bob Jensen's threads on ROI and Cost of Capital ---
    http://www.trinity.edu/rjensen/roi.htm

     


    Innovative Corporate Performance Management: Five Key Principles to Accelerate Results
    by Bob Paladino
    ISBN: 978-0-470-62773-0 Hardcover 415 pages November 2010|
    Amazon has it priced for under $37 new and $23 used
    http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470627735.html

    Jensen Comment
    This is a bit too much Harvard Business School-like for me, but it does cover much of what we teach in managerial accounting.

    There seem to be a dearth of reviews of this book. I don't know why?

    April 19, 2011 reply from Jim Martin

    Performance management seems to be a relatively new catch-all term like
    cost management, activity-based management etc. I have been following this
    concept, or catch-all term for a while. I suspect most of the book can be
    found in Paladino's earlier and most recent works mainly in Strategic
    Finance.

    Paladino, B. 2007. Five Key Principles of Corporate Performance
    Management. John Wiley and Sons.

    Paladino, B. 2007. Five key principles of corporate performance
    management. Strategic Finance (June): 39-45.

    Paladino, B. 2007. Five key principles of corporate performance
    management. Strategic Finance (July): 33-41.

    Paladino, B. 2007. Five key principles of corporate performance
    management. Strategic Finance (August): 39-45.

    Paladino, B. 2008. Strategically managing risk in today's perilous
    markets. Strategic Finance (November): 26-33.

    Paladino, B. 2010. Innovative Corporate Performance Management: Five Key
    Principles to Accelerate Results. John Wiley and Sons.

    Paladino, B. 2011. Achieving innovative corporate performance management.
    Strategic Finance (March): 43-51.

    Paladino, B. 2011. Achieving innovative corporate performance management.
    Strategic Finance (April): 43-53.

     


    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


    Potentially a Great Case for Managerial Accounting CoursesL  How can Harry Potter movies be financial losers?
    "'Hollywood Accounting' Losing In The Courts:  From the math-is-hard dept," TechDirt ---
    http://www.techdirt.com/articles/20100708/02510310122.shtml

    If you follow the entertainment business at all, you're probably well aware of "Hollywood accounting," whereby very, very, very few entertainment products are technically "profitable," even as they earn studios millions of dollars. A couple months ago, the Planet Money folks did a great episode explaining how this works in very simple terms. The really, really, really simplified version is that Hollywood sets up a separate corporation for each movie with the intent that this corporation will take on losses. The studio then charges the "film corporation" a huge fee (which creates a large part of the "expense" that leads to the loss). The end result is that the studio still rakes in the cash, but for accounting purposes the film is a money "loser" -- which matters quite a bit for anyone who is supposed to get a cut of any profits.

    For example, a bunch of you sent in the example of how Harry Potter and the Order of the Phoenix, under "Hollywood accounting," ended up with a $167 million "loss," despite taking in $938 million in revenue. This isn't new or surprising, but it's getting attention because the income statement for the movie was leaked online, showing just how Warner Bros. pulled off the accounting trick:

    In that statement, you'll notice the "distribution fee" of $212 million dollars. That's basically Warner Bros. paying itself to make sure the movie "loses money." There are some other fun tidbits in there as well. The $130 million in "advertising and publicity"? Again, much of that is actually Warner Bros. paying itself (or paying its own "properties"). $57 million in "interest"? Also to itself for "financing" the film. Even if we assume that only half of the "advertising and publicity" money is Warner Bros. paying itself, we're still talking about $350 million that Warner Bros. shifts around, which get taken out of the "bottom line" in the movie accounting.

    Now, that's all fascinating from a general business perspective, but now it appears that Hollywood Accounting is coming under attack in the courtroom... and losing. Not surprisingly, your average juror is having trouble coming to grips with the idea that a movie or television show can bring in hundreds of millions and still "lose" money. This week, the big case involved a TV show, rather than a movie, with the famed gameshow Who Wants To Be A Millionaire suddenly becoming "Who Wants To Hide Millions In Profits." A jury found the whole "Hollywood Accounting" discussion preposterous and awarded Celador $270 million in damages from Disney, after the jury believed that Disney used these kinds of tricks to cook the books and avoid having to pay Celador over the gameshow, as per their agreement.

    On the same day, actor Don Johnson won a similar lawsuit in a battle over profits from the TV show Nash Bridges, and a jury awarded him $23 million from the show's producer. Once again, the jury was not at all impressed by Hollywood Accounting.

    With these lawsuits exposing Hollywood's sneakier accounting tricks, and finding them not very convincing, a number of Hollywood studios may face a glut of upcoming lawsuits over similar deals on properties that "lost" money while making millions. It's why many of the studios are pretty worried about the rulings. Of course, these recent rulings will be appealed, and a jury ruling might not really mean much in the long run. Still, for now, it's a fun glimpse into yet another way that Hollywood lies with numbers to avoid paying people what they owe (while at the same sanctimoniously insisting in the press and to politicians that they're all about getting content creators paid what they're due).

    Bob Jensen's threads on case learning are at
    http://www.trinity.edu/rjensen/000aaa/thetools.htm#Cases

    Bob Jensen's threads on return on investment
    http://www.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on management accounting
    http://www.trinity.edu/rjensen/theory01.htm#ManagementAccounting

    Bob Jensen's threads on accounting theory are at
    http://www.trinity.edu/rjensen/theory01.htm

     


    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 ---

    BUSINESS VALUATION

    BURNING BV QUESTIONS
    www.go-iba.org/blog

    This site from the Institute of Business Appraisers hosts a discussion group between its members and Rand M. Curtiss, FIBA, MCBA, ASA, chairman of the American Business Appraisers National Network. Its question-and-answer format covers a range of topics relating to the appraisal of closely held businesses, which, according to the IBA, make up 90% of U.S. businesses and employ two out of every three taxpayers. Posts include “Investment Profiles and Valuation Discounts,” “Financial Forecasts and Willing Buyers and Sellers,” and “Investigating Investment Value,” as well as quizzes to test your valuation knowledge.

    FOR WHAT IT’S WORTH
    www.appraisalfoundation.org

    This e-stop is the source for standards and appraiser qualifications established by the Appraisal Standards Board (ASB) and the Uniform Standards of Professional Appraisal Practice (USPAP). Have record-keeping or ethics questions regarding appraisals? Click on the “USPAP/Standards” tab for access to their extensive archive of monthly Q&A documents or to read and submit comments about ASB exposure drafts. Also, keep an eye out for updates and news about the organization’s ongoing study of valuation fraud and the relationship between appraisals and mortgage fraud.
     


     


    "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

    Bob Jensen's threads on fair value accounting are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue


    Risk Glossary --- http://www.riskglossary.com/


    Although many of the links are to commercial (fee) sites, many StumbleUpon hits under accounting were quite good, especially in financial statement analysis and valuation.

    1. Five Capital Budgeting Analysis (xls) - Basic program for doing capital budgeting analysis with inclusion of opportunity costs, working capital requirements, etc. - Adamodar Damodaran
    2. Rating Calculation (xls) - Estimates a rating and cost of debt based on the coverage of debt by an organization - Adamodar Damodaran
    3. LBO Valuation (xls) - Analyzes the value of equity in a leverage buyout (LBO) - Adamodar Damodaran
    4. Synergy (xls) - Estimates the value of synergy in a merger and acquisition - Adamodar Damodaran
    5. Valuation Models (xls) - Rough calculation for choosing the correct valuation model - Adamodar Damodaran
    6. Risk Premium (xls) - Calculates the implied risk premium in a market. (uses macro's) - Adamodar Damodaran
    7. FCFE Valuation 1 (xls) - Free Cash Flow to Equity (FCFE) Valuation Model for organizations with stable growth rates - Adamodar Damodaran
    8. FCFE Valuation 2 (xls) - Free Cash Flow to Equity (FCFE) Valuation Model for organizations with two periods of growth, high growth initially and then stable growth - Adamodar Damodaran
    9. FCFE Valuation 3 (xls) - Free Cash Flow to Equity (FCFE) Valuation Model for organizations with three stages of growth, high growth initially, decline in growth, and then stable growth - Adamodar Damodaran
    10. FCFF Valuation 1 (xls) - Free Cash Flow to Firm (FCFF) Valuation Model for organizations with stable growth rates - Adamodar Damodaran
    11. FCFF Valuation 2 (xls) - Free Cash Flow to Firm (FCFF) Valuation Model for organizations with two periods of growth, high growth initially and then stable growth - Adamodar Damodaran
    12. Time Value (xls) - Introduction to time value concepts, such as present value, internal rate of return, etc.
    13. Lease or Buy a Car (xls) - Basic spreadsheet for deciding to buy or lease a car.
    14. Top Five NPV & IRR (xls) - Explains Internal Rate of Return, compares projects, etc.
    15. Real Rates (xls) - Demonstrates inflation and real rates of return.
    16. Template (xls) - Template spreadsheet for project evaluation & capital budgeting.
    17. Top Five Free Cash Flow (xls) - Cash flow worksheets - subsidized and unsubsidized.
    18. Capital Structure (xls) - Spreadsheet for calculating optimal capital structures using different percents of debt.
    19. WACC (xls) - Calculation of Weighted Average Cost of Capital using beta's for equity.
    20. Statements (xls) - Generate a set of financial statements using two input sheets - operational data and financial data.
    21. Bond Valuation (zip) - Calculates the value or price of a 25 year bond with semi-annual interest payments.
    22. Buyout (zip) - Analyzes the effects of combining two companies.
    23. Cash Flow Valuation (zip) - Walks through a valuation of cash flows under three models- capital cash flows, equity cash flows, and free cash flows.
    24. Financial Projections (zip) - Spreadsheet model for generating projected financials along with valuation based on WACC.
    25. Leverage (zip) - Shows the effects on Net Income from using debt (leverage).
    26. Ratio Calculator (zip) - Calculates a standard set of ratios based on input of financial data.
    27. Stock Value (zip) - Calculates expected return on stock and value based on no growth, growth, and variable growth.
    28. CFROI (xls) - Simplified Cash Flow Return on Investment Model.
    29. Financial Charting (zip) - Add on tool for Excel 97, consists of 6 files.
    30. Risk Analysis (exe) - Analysis and simulation add on for excel, self extracting exe file.
    31. Black Scholes Option Pricing (zip) - Excel add on for the pricing of options.
    32. Cash Flow Matrix - Basic cash flow model.
    33. Business Financial Analysis Template for start-up businesses from Small Business Technology Center
    34. Forex (zip) - Foreign market exchange simulation for Excel
    35. Hamlin (zip) - Financial function add-on's for Excel
    36. Tanly (zip) - Suite of technical analysis models for Excel
    37. Financial History Pivot Table - Microsoft Financials
    38. Income Statement What If Analysis
    39. Breakeven Analysis (zip) - Pricing and breakeven analysis for optimal pricing - Biz Pep.
    40. SLG Ratio Master (exe) - Excel workbook for creating 25 key performance ratios.
    41. DCF - Menu driven Excel program (must enable macros) for Discounted Cash Flow Analysis from the book Analysis for Financial Management by Robert C. Higgins
    42. History - Menu driven Excel program (must enable macros) for Historical Financial Statements from the book Analysis for Financial Management by Robert C. Higgins
    43. Proforma - Menu driven Excel program (must enable macros) for Pro-forma Financial Statements from the book Analysis for Financial Management by Robert C. Higgins
    44. Business Valuation Model (zip) - Set of tabbed worksheets for generating forecast / valuation outputs. Includes instruction sheet. Bizpep
    45. LBO Model - Excel model for leveraged buy-outs
    46. Comparable Companies - Excel valuation model comparing companies
    47. Combination Model - Excel valuation model for combining companies
    48. Top Five Balanced Scorecard - Set of templates for building a balanced scorecard.
    49. Cash Model - Template for calculating projected financials from CFO Connection
    50. Techniques of Financial Analysis - Workbook of 11 templates (breakeven, valuation, forecasting, etc.) from ModernSoft
    51. Ratio Reminder (zip) - Simple worksheet of comparative financials and corresponding ratios from Agilicor
    52. Risk Analysis IT - Template for assessing risk of Information Technology - Audit Net
    53. Risk Analysis DW - Template for assessing risk of Data Warehousing - Audit Net
    54. Top Five Excel Workbook 1-2 - Set of worksheets for evaluating financial performance and forecasting - Supplemental Material for Short Course 1 and 2 on this website.
    55. Rule Maker Essentials - Excel Template for scoring a company by entering financial data - The Motley Fool
    56. Rule Maker Ranker - Excel Template for scoring a company by entering comparable data - The Motley Fool
    57. IPO Timeline - Excel program for Initial Public Offerings (must enable macros)
    58. Assessment Templates - Set of templates for assessing an organization based on the Malcolm Baldrige Quality Model.
    59. Cash Gap in Days - Spreadsheet for calculating number of days required for short-term financing.
    60. Cash Flow Template - Simple spreadsheet for calculating Free Cash Flow.
    61. Six Solver Workbook (zip) - Set of various spreadsheets for solving different business problems (inventory ordering, labor scheduling, working capital, etc.).
    62. Free Cash Flow Valuation - Basic Spreadsheet Valuation Model
    63. Finance Examples - Seven examples in Business Finance - Solver
    64. Capital Budgeting Workbook - Several examples of capital budgeting analysis, including the use of Solver to select optimal projects.
    65. Present Value Tables (rtf) - Set of present value tables written in rich text format, compatible with most word processors. Includes examples of how to use present value tables.
    66. Investment Valuation Model (zip) - Valuation model of companies (must enable macros) - Excel Business Tools
    67. Cash Flow Sensitivity (xlt) - Sensitivity analysis spreadsheet - Small Business Store
    68. What If Analysis - Set of templates for sensitivity analysis using financial inputs.
    69. Risk Return Optimization - Optimal project selection (must enable macro's) - Metin Kilic
    70. CI - Basics #1 - Basic spreadsheet illustrating competitive analysis - Business Tools Templates.
    71. CI - Basics #2 - Basic spreadsheet illustrating competitive analysis.
    72. External Assessment - Assessment questions for organizational assessment (must enable macros).
    73. Internal Assessment - Assessment questions for organizational assessment (must enable macros).
    74. Formal Scorecard - Formal Balanced Scorecard Spreadsheet Model (3.65 MB / must enable macros) - Madison Area Quality Improvement Network.

    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

     


    Looking for information on valuing your business? Look no further. Or look way further, depending on your point of view. Here is a Web site, produced by Professor William C. Weaver, that provides numerous links to online business valuation resources all assembled in one easy-to-use location. http://www.accountingweb.com/item/56244 

    Business Valuation References --- http://www.bus.ucf.edu/weaver/ 


    "Is risk increasing or decreasing? IPO Vintage and the Rise of Idiosyncratic Risk by Jason Fink, Kristin Fink, Gustavo Grullon, James Weston," Jim Mahar's Blog, April 18, 2005 --- http://financeprofessorblog.blogspot.com/

    While well documented, increased risk (and in particular increased firm specific risk) has been a puzzle for researchers for quite some time. With improve transparency and deeper markets, one could speculate that risk should be decreasing, but researchers have not been finding this. For instance:

    "recent studies by Campbell, Lettau, Malkiel, and Xu (2001) (henceforth CLMX), Malkiel and Xu (2003), Fama and French (2004), Wei and Zhang (2004), and Jin and Myers (2004) document that, over the past 30 years, U.S. public firms exhibit higher firm specific return volatility, more volatile income and earnings, lower returns on equity, and lower survival rates. The recurring theme in all these studies is that firm risk, however defined, has increased." But now Fink, Fink, Grullon, and Weston may provide the explanation: firms are going public sooner. When the age of firms is controlled for, there does not appear to be an increase in systematic risk and in fact there may be a decrease!

    "We argue that the rise in firm specific risk can be explained by the interaction of two reinforcing factors: a dramatic increase in the number of new listings and a simultaneous decline in the age of the firm at IPO."

    "we find that after controlling for age and other measures of firm maturity (e.g., book-to-market, size, profitability, etc.), there is a negative trend in idiosyncratic risk."

    "Business Valuation: 20 Steps For Pricing a Patent," by Timothy Cromley, Journal of Accountancy, November 2004, pp. 31-34 --- http://www.aicpa.org/pubs/jofa/nov2004/cromley.htm 

    Some patents are very valuable, while many are not. Because patents often are quite complex, appraising one usually is a highly detailed and expensive process that requires the input of lawyers and advisers with specific technical knowledge and experience. The makeup of valuation teams will vary by engagement, but it is axiomatic that before an appraiser can value something, he or she has to understand what it is. Here are 20 steps to help valuators such as CPA/ABVs do that:

    From Smart Stops on the Web, Journal of Accountancy, November 2004, Page 23 --- http://www.aicpa.org/pubs/jofa/nov2004/news_web.htm 

    BUSINESS VALUATION SITES

    Add a New Credential
    bvfls.aicpa.org
    Institute members looking for a new challenge can register at this section of the AICPA Web site to take the November 15 or 30 Accredited in Business Valuation (ABV) exam. Other resources include the BV Competence Assessment Tool, Exam Candidate’s Reference Guide and Content Specification Outline, a BV glossary and explanations of exam terminology.

    What’s It Worth?
    www.bvresources.com
    CPAs can help clients value their businesses by taking advantage of the free valuation court case downloads at this Web stop. Other offerings include an international dictionary of business valuation terms, IRS guidelines and links to the AICPA, Appraisal Foundation and Institute of Business Appraisers. Users also can join the discussion forum and read more definitions of BV terms and tips of the week.

    Valuable Valuation Data
    www.valuationresources.com
    Does your client have an industry-specific valuation question? Find the answer at this e-stop for information on a variety of topics such as divorce, estate and gift taxes, limited partnerships and technology valuations. The Industry Resources section has reports on compensation and salary surveys, financial and operating ratios and sector outlooks covering more than 250 industries. The legal and tax resource sections have links to the federal tax code and regulations, state and federal case law and tax court decisions.


    Valuation Resources

    August 22, 2007 message from Jerry Peters [jerry.peters@yahoo.com]

    Dr. Jensen

    Your webpage
    http://www.trinity.edu/rjensen/roi.htm includes an index of resources available at ValuationResources.Com under the heading  "Valuation Resources For Business Appraisers --- http://www.valuationresources.com/ This index has been signficantly updated since you listed it on your site--for example, the number of specific industries covered has expanded from over 200 then to almost 400 now--and we encourage you to include the latest index on your webpage. You will find the latest index at http://www.valuationresources.com/

    Thank you for your assistance in this matter. We appreciate your link to our site.

    Jerry Peters, CPA, ASA, ABV
    Valuation Resources, LLC
    P.O. Box 5325
    Evansville, Indiana 47716
    Ph. 812-459-7742

    jerry.peters@yahoo.com

    Two valuation links of possible interest"

    Bob Jensen's site mentioned above --- http://www.trinity.edu/rjensen/roi.htm

    Bob Jensen's PowerPoint file on Fair Value Accounting --- see the 10FairValue.ppt file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/

     


     

    SUCCESSION PLANNING SITES

    Plan a Successful Exit
    www.strategyletter.com/cp_0100/cp_fa.asp
    Visitors can enter the Center for Simplified Strategic Planning Web site through this backdoor to go directly to the article, “The Strategy of Succession Planning,” which teaches retiring executives about some advantages and possible pitfalls of succession planning. There’s also a detailed outline of the article’s main points if readers want to cut right to the chase. CPA/ABVs can click on the link at the end of the story for a free subscription to the site’s e-zine Course and Direction.

    Get the Buzz on the Family Biz
    www.familybizz.net
    CPA/ABVs can go to the Business Issues section of this site and click on succession planning for information on topics such as bringing in the next generation or developing a written succession plan. Visitors also can read up on the seven development stages of succession and find answers to the questions “What are the options?” and “Can there be more than one successor?”


    There is a link to Banister Financial where you can find some tips of valuation and valuation frauds.


    From The Wall Street Journal Accounting Educators' Review on May 27, 2004 

    TITLE: Google Search: How Does It Value Its Shares? 
    REPORTER: Scott Thurm 
    DATE: May 13, 2004 
    PAGE: C1 
    LINK: http://online.wsj.com/article/0,,SB108439355400909719,00.html  
    TOPICS: Financial Accounting, Financial Analysis, Financial Statement Analysis, Stock Options

    SUMMARY: Jack Ciesielski, publisher of Analysts' Accounting Observer, used Google's disclosures of compensation expense and deferred compensation from its employee stock option plans to estimate the value corporate officers place on their soon-to-be-issued stock.

    QUESTIONS: 

    1.) In general, summarize the two ways in which Mr. Ciesielski estimated the value placed on Google shares by corporate officers.

    2.) What disclosures did Mr. Ciesielski use to estimate the value placed on Google shares by corporate executives? In general, what standards and laws require these disclosures? What specific SEC requirement provided useful information in the disclosures for the first quarter of this year?

    3.) Focus on the method of estimation using the deferred compensation account and the SEC requirement reflected in the accounting during the first quarter of this year. Where is "deferred compensation" under stock option plans included in the financial statements? What amount is included in that account? How could Mr. Ciesielski determine that Google added $75.4 million to that account?

    4.) Focus on the estimation using the Black-Scholes formula. What is that formula designed to estimate? What inputs must be used to make this estimate? How could Mr. Ciesielski, and Professor Larcker, run this model "backwards"?

    5.) What advantage in the marketplace can an analyst obtain by being able to use accounting information in such a clever way as Mr. Ciesielski has done?

    Reviewed By: Judy Beckman, University of Rhode Island 
    Reviewed By: Benson Wier, Virginia Commonwealth University 
    Reviewed By: Kimberly Dunn, Florida Atlantic University

    See how a professor from NYU valued Google in 2005  and 2006 (downloadable spreadsheets)
    Damodaran Online --- http://pages.stern.nyu.edu/~adamodar/

    "Street Sleuth: Google Search:  How Does It Value Its Shares?" by Scott Thurm, The Wall Street Journal, May 13, 2005, Page C1 --- http://online.wsj.com/article/0,,SB108439355400909719,00.html 

    Investors are puzzling over how to value Internet-search innovator Google Inc. for its planned stock offering.

    Some clues, from Google itself: Think either $80 or $91 a share, which would value the company at $20 billion to $22 billion, before the initial public offering of stock.

    Those numbers don't appear in Google's IPO securities-registration statement. But accounting sleuths say other disclosures in that document allow them to estimate how Google values its own shares.

    Those disclosures relate to the stock options that Google granted to employees. Many of those options were granted at share prices that now seem ridiculously low -- an average of $2.65 a share for last year, for example. So, applying a common practice for companies going public, Google has reassessed the value of those options and recorded the difference as a compensation expense.

    By digging into those numbers, Jack Ciesielski, publisher of Analyst's Accounting Observer, says he can estimate how Google itself valued its shares as recently as the first quarter of this year.

    One way to unravel the numbers, Mr. Ciesielski says, is to track how much deferred compensation Google records for the "excess" value of the options -- that is, the value above the exercise price.

    Bob Jensen's threads on employee stock options are at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm 


    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.

    How can petroleum industry accounting be improved?  Some ideas from PwC --- http://www.pwc.com/images/gx/eng/about/ind/petro/drilling_deeper.pdf 

    William C. Weaver from Central Florida College of Business Administration
    Online Resources, Links, and Literature for Business Valuation --- http://www.bus.ucf.edu/weaver/ 

    Business Valuation References --- http://www.bus.ucf.edu/weaver/ 


    Valuation Resources For Business Appraisers --- http://www.valuationresources.com/ 

    What's New highlights recent additions to this site. For a complete list, please select the "More new products and services . . ." link below.
    Small Business Valuation Formula Multiples, 2002 Edition
    Cost of Capital: Estimation and Applications, 2nd Ed., Shannon Pratt
    Valuation for Financial Reporting: SFAS 141 & 142
    Industry Resources Reports Expanded To Cover More Than 200 Industries
    More new products and services . . .  
     
    Publications 
    Publications provides a comprehensive listing of publications covering valuation and valuation-related topics. Please select the appropriate subject heading from the list below.
    General Valuation Economic Data
    Industry-Specific Valuation Transaction Data
    Professional Practice Valuation Valuation Discounts and Premiums
    Estate & Gift Tax Valuation Economic Value Added (EVA)
    Limited Partnership Valuation Real Options
    Divorce Valuation Litigation Support
    ESOP Valuation Lost Profits and Damages
    Mergers & Acquisitions Appraisal Standards & Definitions
    Intangible Assets Valuation Sample Valuation Reports
    SFAS 141 & 142 Valuation Valuation Software
    Technology Valuation Practice Management
    Real Property Valuation Valuation Newsletters
     
    Industry Resources
    Industry Resources provide links to industry overview and outlook, financial benchmarking, and compensation resources for a wide variety of industries. For resources specific to a particular industry, see Industry Resources Reports which cover over 200 individual industries.
    Industry Resources Reports Financial Ratios
    Industry Overview and Outlook Salary Surveys
     
    Economic Data
    Economic Data provides links to cost of capital, risk premiums, royalty rates, interest rates, inflation, and economic forecast resources.
    Cost of Capital Inflation / CPI Index 
    Risk Premiums Economic Forecasts
    Bond Yields and Interest Rates Royalty Rates
     
    Public Company Data
    Public Company Data provides resources for identifying public guideline companies by industry, shows where to find business and financial information on these companies, lists sources for current and historical price quotes, and how to obtain research reports for public companies and their industries.
    Identifying Guideline Companies  Finding Company Information
    Current & Historical Price Quotes Investment Research Reports
    Closed-End Funds REITs
     
    Transaction Data
    Transaction Data provides links to various sources of merger and acquisition transaction data for public and private companies and secondary market data for limited partnerships.
    Merger & Acquisition Data    Limited Partnership Interests
    Valuation Formula Multiples
     
    Legal and Tax Resources
    Legal and Tax Resources provides links to legal resources directories, federal tax code and regulations, state and federal case law, and Tax Court decisions.
    Legal Resources Directories Federal Tax Code and Regulations
    State and Federal Case Law Tax Court Decisions
     
    More Resources
    More Resources provides links to business publications libraries, market research reports, company profiles and credit reports, trade association directories, appraisal associations, appraiser directories, valuation newsletters, and valuation forums.
    Business Publications Libraries Appraisal Associations
    Market Research Reports Appraiser Directories
    Company Profiles Valuation Newsletters
    D&B Business / Credit Reports Valuation Forums
    Trade Association Directories  

     


    Selected Web Resources on Business Valuation --- http://www.demaio.com/vcbv/#sources 


    Smart Stops on the Web, Journal of Accountancy, November 2002 --- http://www.aicpa.org/pubs/jofa/nov2002/news_web.htm 

    SMART STOPS ON THE WEB
     
    BUSINESS VALUATION SITES

    Definitions, Discussions and Downloads
    www.bvresources.com
    CPAs involved in business valuation (BV) can obtain free information and purchase books and software here. The forums online section features various discussion topics such as what happened at recent BV-related conferences and court case decisions. The definition of the week clarifies valuation terms, and the free downloads section offers archived issues of BV newsletters and an international glossary.

    “Credibility Is Everything”
    www.nacva.com
    Business valuation professionals looking to recertify or professionals interested in adding a business valuation designation to their credentials can find information at the National Association of Certified Valuation Analysts (NACVA) site. It houses resources for members, such as information on training programs, and provides enough free information to warrant a visit from curious Web surfers—including certification requirements for a new designation: certified forensic financial analyst, or CFFA.

    Lengthy List of Links
    http://condor.depaul.edu/~dshannon/BVsites.htm
    (Note: This URL is case-sensitive.)
    For CPAs in business valuation, this section of DePaul University’s Web site is worth a stop, if not a bookmark. The College of Commerce’s Professor Donald Shannon lists links to other relevant sites such as Valuation Strategies and to company information—specifically, analyst reports, financial statements and historical information. Users also can find links to economic and industry information such as the article, “14 Steps for Researching an Industry.”

    Virtual Becomes Reality
    www.demaio.com/vcbv
    In its continuing efforts to encourage professionals to “use Internet resources effectively,” the New Jersey-based law firm DeMaio & DeMaio has created the Virtual Committee on Business Valuation. Interested professionals can network electronically with their peers and research summaries on new developments in business valuation and planning. No site registration is required.

    Comment on Exposure Drafts
    www.appraisalfoundation.org
    Appraisers have their own home on the Web—the Appraisal Foundation, with news about the goings-on at the Appraisal Standards Board, as well as a call for public comments on the board’s latest exposure drafts. Consumers and finance professionals can find local appraisers in the site’s database, get information on how to become an appraiser, and link to related Web sites such as www.appraiseremail.com, which offers real estate appraisers e-mail services that can accommodate large appraisal files.


    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 


    Important Journal Note --- A special thanks to David 
    (I realize editing a major journal is almost as thankless as editing a minor journal.)

    I want to especially thank David Stout, Editor of the May 2001 edition of Issues in Accounting Education.  There has been something special in all the editions edited by David, but the May edition is very special to me.  All the articles in that edition are helpful, but I want to call attention to three articles that I will use intently in my graduate Accounting Theory course.

    There is a flurry of literature flying by us daily, and it is rare to find three articles in one journal that will become central to my theory course.  Thank you David for giving me those three articles in this AAA journal that now rejects over 90% of the submissions.  I am grateful that you did not reject the three articles mentioned above.


    Hi Leo,
     
    First, I might note that the FASB originally did not think that the valuation problems should prevent expensing of stock options.  The original June 1993 Exposure Draft on "Accounting for Stock-based Compensation" took a strong position that the options have (time) value when they are issued and can be valued at something other than intrinsic value (which is usually zero) at the time the options are issued.  It was political pressure (even from the U.S. Senate) that prevented the booking of such options when issued.
     
    Option valuation is a complex issue and I don't think your proposed solution, albeit a clever solution, based upon the current tax returns properly accounts for time value (as opposed to the intrinsic value) of the stock options.  It seems to me that it would be better to value such options at what the company calculates as the value at the time these are issued.  Most companies have stock compensation valuation software or hire consultants who specialize in compensation valuation.  Several links to such specialists are shown below:
     
    http://www.myoptionvalue.com/relatedlinks/vt/software.html
     
    http://www.fintools.com/frame_fasvalue.html
     
    Auditors can run their own valuation software to verify that the estimates used were reasonable.  The point is that there may be differences of opinion with respect to stock option valuation, but there are also differences of opinion of valuation of options in general.  This did not prevent the FASB from requiring fair value booking adjustments (at least every 90 days) to options and other derivative financial instruments in FAS 133/138.  Similarly the IASB requires fair value booking in IAS 39. 
     
    However, the intrinsic value method you propose would not be accepted for option valuation under FAS 133.  Time value must be estimated and accounted for differently than intrinsic value under FAS 133.  See Example 9 of Appendix B of FAS 133.  When a deep market does not exist for purposes of valuing investment and financing options, FAS 133 does let firms off the hook in applying FAS 133 fair value adjustments.
     
    My point is simply that derivative financial instrument options must be valued, booked, and revalued at least every 90 days under FAS 133.  The FASB excluded FAS 123 employee stock options from FAS 133 fair value bookings, but this was mainly due to intense political pressure rather than an admission that such options cannot be valued.  Obviously they can be valued and are valued when firms and employees include such options in compensation packages.

    Bob (Robert E.) Jensen
    Jesse H. Jones Distinguished Professor of Business
    Trinity University, San Antonio, TX 78212
    Voice: (210) 999-7347  Fax:  (210) 999-8134 
    Email:  rjensen@trinity.edu 
    http://www.trinity.edu/rjensen

    -----Original Message-----
    From: Leo.McMenimen [mailto:mcmenimenl@MAIL.MONTCLAIR.EDU
    Sent: Monday, July 23, 2001 8:04 PM
    To: AECM@LISTSERV.LOYOLA.EDU
    Subject: Stock Options

    Dear Friends,
        I am hoping that you might accept my imposing on this group.  I received the following e-mail from a former student.  I have some responses that I intend to provide to the student, but I was hoping that further, more knowledgeable information might be provided by the members of this group.  Thank you very much for your help.

    Leo McMenimen
    Montclair State University
    Upper Montclair, NJ

    My current accounting difficulties center mostly around finding a reliable way of evaluating the impact of options on a company's "real" earnings. By that I mean, the amount of excess cash a company generates from its operations, as opposed to what the income statement says. It did not take me too long in the business for me to realize those two figures are not necessarily closely related.

    By not going through the income statement, options compensation, to me, is much like the large unfunded pension and medical care liabilities of the 80s. It is eventually going to come back and bite a lot of shareholders on the butt.
    FASB has weakly required only that companies report the effect of options compensation in a footnote in the 10K. Each company is required to state what earnings would have been if potential options liabilities (calculated by the Black-Scholes model) were recognized as current compensation expense. Of course, the big problem with valuing the affect of options issued in any given year is that they generally don't have any value immediately, and are based on estimates of future variables such as growth rates, interest rates, etc. This difficulty in valuing them is also the excuse the companies (and FASB) give for not putting them in the income statement.

    From what I hear from the few analysts talking about this issue, Black-Scholes significantly understates the effect on income because some of the rates used are usually underestimated.  But I have another way of viewing the whole problem.  In my view, this problem -- while not being solved for future affect -- is well appraised in the present by the impact of past option grants on current earnings. In other words, my stance is: "okay, you can't say for sure how current options will affect future earnings, but you can see how past options affect today's earnings."

    I theorize that one "quick and dirty" way to calculate that affect is to look at the line in the cash flow (from operations section) statement that says: "Tax benefits of employee stock options plans"

    For example, on page 26 of Applied Materials' (NASDAQ:AMAT) 10K for 1998, 1999, and 2000, it lists amounts in this row of approx. 28 mil, 161 mil, and 387 mil.  If I understand this correctly, these are tax credits the company gets when an employee exercises a "non-qualified" stock option.  Upon a  grantee's exercise  of a  non-qualified stock  option, 

    (i) the grantee will recognize ordinary income in an amount equal to the difference between the  fair market value of  the shares on the  exercise date and the exercise price of the shares; and 

    (ii) the Company will be entitled to  a tax deduction in an amount equal  to the income recognized by the grantee.

    So, it looks to me like what is happening is that the IRS is, in effect, saying that they recognize that this "in the money" exercise of stock options costs the company in a form of veiled compensation expense. It is therefore giving the company a tax-deduction (in the amount equal to the difference in the exercise price and the market price) that it would have gotten if this expense had been run through the income statement. In other words, for tax purposes, this is recognized as real compensation expense. Since the IRS is seldom in the charity business, that seems good enough evidence to me that there is a real cost to the company.

    I conclude from this that this veiled compensation reduces after tax income by the "benefit" amount times (1minus the tax rate), or net income affect = benefit x (1-tax rate)


    As I mentioned earlier, this isn't the effect of options issued this year (that's Black-Scholes' job), but the effect of options issued in prior years, hitting home now.  I would like your opinion on a few matters, but primarily on two things:

    One, do you think my "quick and dirty" calculations portray a valid approximation of the real economic effect on the company?

    And, two, do you see any other way to make a better judgment in this regard?

    It seems to me there should be some way to trace this affect through the financial statements more precisely, but I can't get my mind around it.

    There's another related matter I'd like you to comment on if you care to. Up until recently, I felt comfortable that I was finding the "truth" by looking at the cash flow statement. That is, I thought that when I waded through the non-cash charges in the operating cash flow section and decided which ones were real expenses, and when I looked with a gimlet eye at the build-up in accounts receivable, etc. I would have a reliable idea of what a company was taking in. Now, having looked into this options mess, I'm no longer confident that any of the inputs into the cash flow statement can be trusted. Do you have an opinion on my concern?

    And lastly -- on an unrelated matter -- while many 10Ks break out depreciation expense from amortization of intangibles somewhere, either in the income statement or in the footnotes, many do not. When trying to figure real, usable excess cash flow, it is important to know which is which, since depreciating assets have to be replaced, whereas "goodwill" doesn't. Do you know of someway to deduce this that I don't?

    Student XXXXX


    GE Capital Credit Line Calculator for Business Firms (Finance) --- https://www.mygedeal.com/cfcalculator/abcalc.jsp 


    Although the following article is not online, it is an interesting hardcopy article entitled "Quantitative Measures of the QUALITY of Financial Reporting," by George B. Moriarty and Philip B. Livingston, Financial Executive, July/August 2001, 53-56.  Both authors are officers of the Financial Executives International (FEI).  The FEI homepage is at http://www.fei.org/ 

    One informative table in the article is the following table accompanied by a chart showing the trend stock market value losses of companies due to restatement of reported earnings after the audited financial reports were originally published showing (usually) higher levels of earnings:

    Percentage of Total Restatement Stock Value Losses to Total Value of Public Companies
    1990   0.021%     1996   0.032%
    1991   0.009        1997   0.011
    1992   0.032        1998   0.129   
    1993   0.004        1999   0.137
    1994   0.022        2000   0.194
    1995   0.015

    Although, most of the restatements are among smaller companies, the 10 largest annual market value losses comprise most of the reinstatement dollar value losses shown above.  Of course the denominators in the above calculations are enormous values in trillions of dollars.  In the last five years shown above, the value of U.S. equity markets increased by $7.14 trillion.

    Why Are Companies Restating?

    The underlying reason for each restatement was organized into one of 10 groups: revenue, cost, revenue and cost, loan loss, acquisition, in-process research and development (IPR&D), reclassification, bookkeeping errors, others and unknown.  Revenue recognition issues caused 33 percent of restatements.  Cost problems, with inventory valuation as the leading source, caused 28 percent.

    Restatements due to revenue recognition issues make up the largest portion of the database, providing 360 cases.  The following were common themes for revenue restatements:

    Cost and expense-based restatements ran a close second, with 305 cases.  Surprisingly, the common errors in these cases stem primarily from the fundamental aspects of inventory valuation, including improper overhead absorption, obsolescence and valuation.

    In-process research and development emerged as an issue in 1998, when the SEC addressed how firms accounted for in-process R&D in mergers and acquisitions.  Based on what the SEC perceived to be overly aggressive IPR&D write-offs, the commission pursued and evaluated cases very aggressively in late 1998 and throughout 1999.

    This resulted in 57 restatements in 1999 and 67 in total since 1998.  By and large, these restatements had minimal effect on the companies' market value.  By 2000, this issue seemed to have been absorbed into business practices, as there was just one IPR&D restatement for the year.  Indeed, because the effects of IPR&D were so localized in 1999 and the market value effect so minimal, the bulk of the FEI Research Foundation analysis excluded those cases.

    The number of cases enforced by the SEC for any reason averaged eight per year from 1990 to 1997.  However, that number rose to 17 in 1998 and 21 in 2000.  There were fully 75 SEC enforced restatements in 1999, but 48 were IPR&D cases.  Identifying cases of SEC enforcement is an inexact science, because companies are not required to disclose this information.

     . . .

    What Happened in 1998?

    Despite the low overall rate of restatements and the minimal losses associated with them, the number of restatements increased noticeably in the last three years of this study, which raises the obvious question, Why?  Although certain constituencies might answer differently, metrics developed by the research produce two broad reasons:

    The clearest start date for the more aggressive stance on earnings management at the SEC was the September 1998 speech by then-Chairman Arthur Levitt.  Its impact was considerable: 397 restatements, or 36 percent of all restatements between 1977 and 2000, occurred after that speech.

    Today's corporate environment is driven by increasing shareholder activism, particularly regarding stock price performance on behalf of the shareholders.  Large public pension funds such as CalPERS and TIAA-CREFF have become closely organized in pressuring management teams and boards to deliver returns or get out.  Furthermore, boards of directors, increasingly made up of independent outsiders, have become much more aggressive in removing senior officers when performance measures aren't met.

    Overall, corporations have responded favorably to these heightened expectations and pressures.  The result has often been spectacular results for shareholders, but some have clearly come at a cost.  Pressure to deliver the numbers rose during the period leading up to the increase in restatements.  While the gains are high, and total market value has increased more than $4.7 trillion since 1997, the cost to shareholders from restatements has been $74.3 billion, or 1.6 percent of the growth.  On balance, companies and shareholders have plainly benefited from successfully managed businesses.

    Conclusions

    The study indicates that the overall quality of financial reporting is high.


    The latest FEI Research publication studies four institutions - Mayo Clinic Rochester, Nortel Networks, Pitney Bowes and Southwest Airlines - and how they implemented, or are implementing, the balanced scorecard. Results from a survey of more than 170 companies are also included: http://www.fei.org/rf/PubDetail.cfm?Pub=70 


    Hi Pat,

    I am now digging into over 1,500 backed up email messages, so if I duplicate replies from others, the reason is that I have not yet seen those replies.

    You may want to have the student look into the following sources:

    John's Finance Page --- http://members.attcanada.ca/~johnjaz/equity.htm 

    "The role of book value in equity valuation: Does the stock variable merely proxy for relevant past flows?," by Mohan Venkatachalam and K.R. Subramanyam, Stanford University GSB Research Paper 1491 R --- http://gobi.stanford.edu/researchpapers/detail1.asp?Paper_No=1491 

    "Conservative Accounting and Equity Valuation," by Xiao-Jun Zhang Columbia University --- http://accounting.rutgers.edu/raw/aaa/98annual/abstracts/cs1/cs1-52.htm 

    Business Analysis and Valuation, Using Financial Statements by Palepu et al --- http://www.swcollege.com/acct/palepu/palepu_main.html 

    FASB REPORT - BUSINESS AND FINANCIAL REPORTING, CHALLENGES FROM THE NEW ECONOMY NO. 219-A April 2001 Author: Wayne S. Upton, Jr. Source: Financial Accounting Standards Board --- http://accounting.rutgers.edu/raw/fasb/new_economy.html 

    The Garten SEC Report: A press release and an executive summary are available at http://www.mba.yale.edu  
    (You can request a copy of the full report using an email address at the above URL)

    This is only a sampling of hundreds of references on equity valuation.

    Bob Jensen

    -----Original Message----- 
    From: Patricia Doherty [mailto:pdoherty@BU.EDU]  
    Sent: Monday, July 09, 2001 11:03 AM 
    To: AECM@LISTSERV.LOYOLA.EDU Subject: research sources

    Hi, Everyone, A student sent me the following request. Equity prices are not my area, so I thought I would ask my favorite pool of information people. Anyone have any favorite books in this area? He is a pretty sophisticated student, reads a lot and catches on very quickly, so the level is not a problem. What he doesn't understand, he will find out.

    I need help with something and I thought you might know about it, I need some books that discuss methods and models to evaluate equity prices. I might write a small research about this subject. So, please if you recommend any books I would really appreciate it.

    Thanks for your help! pd

    -- Patricia A. Doherty Department of Accounting Boston University School of Management 595 Commonwealth Avenue Boston, MA 02215 1-617-353-4415 FAX 1-617-353-6667

    Instructor in Accounting Coordinator, Managerial Accounting

    You will only be remembered for two things: the problems you solve or the ones you create. Mike Murdock

     


    Business Combinations

    The FASB has finalized Statements No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets which change the rules for how companies must account for business combinations, goodwill and other intangible assets.

    Andersen developed a four-page Executive Summary (PDF 26k, 4 pages) on these new standards. With this summary, Andersen will help you understand the key rule changes, the issues raised by the new rules and a timeline for transitioning to them. Also included is a primer on fair value and a one page supplement (PDF 14k, 1 page) that describes the transition rules for companies with a noncalendar year end.

    Coming Soon!
    Andersen's Controller's Supplement on the new rules. The Controller's Supplement identifies the action steps needed to implement the new rules, and contains a topic-by-topic comparison of the new rules to the old. Visit this site to download this update when it is available.

    Accounting for Business Combinations Publication
    The provisions of Statements No. 141 and No. 142 as well as Andersen's interpretations of them will be included in Andersen's loose-leaf publication in the near future.

    Accounting Research ManagerTM
    As with most accounting literature, the accounting for business combinations, goodwill and intangible assets will continue to evolve. To ensure that you have the most relevant, up-to-date and comprehensive accounting and SEC guidance on all topics, Andersen provides its internet-based research database, Accounting Research Manager.

    Get more information about Accounting Research Manager and our 30-day free trial offer.


    Pricewaterhouse Coopers also has a helper site called "FASB STATEMENTS NO. 141, BUSINESS COMBINATIONS, AND NO. 142, GOODWILL AND OTHER INTANGIBLE ASSETS" --- http://www.cfodirect.com/cfopublic.nsf/?opendatabase&id=MSRA-4ZUUH4&doc=public 

    PwC Observation: We expect that the staff of the U.S. Securities and Exchange Commission (SEC) will have a heightened interest in the initial application of FAS 141 and FAS 142, given their (1) public comments expressing concern over the identification and valuation of intangible assets and (2) continued focus on impairment issues. Therefore, SEC registrants should ensure that their conclusions are well supported and documented. They should also be prepared to address questions relative to identification of reporting units; identification and valuation of intangible assets; selection of useful lives; determination of whether an intangible asset has an indefinite life; and recognition of transitional impairment losses.


    Forwarded by Storhaug [storhaug@BTIGATE.COM

    To follow up on this list's earlier brief discussion on FASB 141 & 142, below is a bookmark to a site "CFO.COM" which has an excellent compendium of articles and links, all of which help you evaluate these new FASB's.

    http://www.cfo.com/fasbguide 

    "The Goodwill Games How to Tackle FASB's New Merger Rules," by Craig Schneider, CFO.com --- http://www.cfo.com/fasbguide 

    The thrill of victory and the agony of defeat. Chances are senior financial executives will experience a similar range of emotions while wrestling with the Financial Accounting Standards Board's new rules for business combinations, goodwill, and intangibles. Use CFO.com's special report for tips on tackling the impairment test, avoiding Securities & Exchange Commission inquiries, finding valuation experts, and much more. While accounting is not yet an Olympic sport, with the right training, you'll take home the gold. We welcome your questions and comments. E-mail craigschneider@cfo.com.
    Take Your First Steps

    How to Survive the SEC's Second Guessing
    New rules for recording goodwill and intangibles may inadvertently produce more restatements.

    Cramming for the Final
    Get up to speed on the latest accounting rule changes for treating goodwill and intangibles.

    Pool's Closed
    FASB's new merger-accounting rules have already won some fans among deal makers.
    (CFO Magazine)

    Intangibles Revealed
    Once you identify them, how much will the fair value assessments cost?

    Four Ways to Say Goodbye to Goodwill Amortization
    Expert tips for tackling the impairment test.

     


    The FASB Goodwill Games --- http://accountingeducation.com/news/news1941.html 

    Those interested in how to handle the new FASB rules on business combinations and goodwill can now go to www.cfo.com and view their special report "The Goodwill Games: How to Tackle FASB's New Merger Rules."

    Senior financial executives will likely experience a similar range of emotions while wrestling with the Financial Accounting Standards Board's new rules for business combinations, goodwill, and intangibles.

    Use CFO.com's special report for tips on tackling the impairment test,
    avoiding Securities & Exchange Commission inquiries, finding valuation
    experts, and more.

    To read the Goodwill Games Special Report, click here:
    http://www.cfo.com/FASBguide

     

     


    Update on the International Accounting Standards Board (IASB that was formerly the IASC)
    by Phil Livingston (President of the FEI) --- http://www.fei.org/newsletters/express/feiexpress69.cfm 

    I just got back from an interesting meeting of the Advisory Council to the new International Accounting Standards Board. I was impressed by the Board members' breadth of experience. They appeared open and willing to listen. Time will tell… Here's a recap of some of the discussions.

    One of the most interesting parts of the meeting came the first day, when the council members were asked to give their thoughts on why they were participating in the process, the projects that were important to them, and any special expertise they brought to the group.

    As we went around the table, it was clear that there was a strong faction from developing countries, that was expressing a need for stronger accounting standards. One representative from Nigeria commented that he appreciated sitting at the table of a "rich man's club," but that his countrymen were not members yet. He also said he looked forward to the day when developing countries truly benefited from as result of implementing better financial reporting. They appreciated that the "rich man's club" could afford to build these accounting standards, as they cannot afford the effort themselves. Additionally, speakers from Russia, China, Malaysia and Estonia all commented on the need for small country accounting standards. This has been a long-running debate, and many in the room felt that the true strategic and near-term agenda should be focused on establishing one set of global standards for cross-border companies interested in accessing the large capital markets. However, the concern that the needs of developing countries may be overlooked was reinforced many times.

    IASB Chairman David Tweedie summarized the advisory council's overall discussion of the objectives and issues with this list:

    1. the IASB should strive for principle-based standards, not detailed rulemaking;
    2. the issue of small companies/countries vs. large company/countries is a concern;
    3. getting to convergence with US GAAP is critical for many companies and a premium should be placed on projects in which IAS can move toward US GAAP, or US GAAP can be brought toward IAS;
    4. there needs to be a strong conceptual basis upon which all their standards are built.

    . . . 

    Fair Value Accounting of All Financial Instruments Rather Than Only FAS 133/IAS 39 Derivatuves
    International accounting standards have their own version of the US's FAS 133/138. IAS 39 is also complex and controversial, and we just implemented it this past January 1. Some of the differences in the two standards include IAS #39's requirement for the company to assess the effectiveness or ineffectiveness of hedge transactions. Further, IAS 39 allows the company to choose between charging the changes in the value of derivatives to either net income or other comprehensive income.

    Related to this project is a recently issued joint working group statement on fair value accounting, which suggests that all financial instruments be marked to market and NO hedge accounting be allowed. This is obviously a controversial proposal, and is opposed by our Committee on Corporate Reporting (CCR). The majority of the group seemed to encourage the IASB to make certain clean-up amendments to IAS 39. Board member Jim Leisenring was quick to point out that most comments on 39 were largely administrative in nature. There was little support for the fair value accounting study by the joint working group. There was also extensive discussion about the desirability of converging IAS 39 and FAS 133. While the two are very similar, there are substantial differences. More time and experience with both would be good before trying to select the better standard or the best of each.

    . . . 

    Employee Stock Option Accounting (as related to FAS 123 of the FASB in the U.S.)
    This was obviously a tense discussion. There were mixed views in the room. I gave a strong statement that we had been through 10 years of debate on this subject in the U.S., and were not interested in reopening the huge wounds that resulted from the battle with the FASB. I said that the issues here had been debated over and over again, and it was not possible to state a new argument for either side. Neither side has changed its view of this issue, and neither will. I suggested that they recognize the reality that stock option accounting is not going to change in the U.S. Therefore, they should get the issue off their plate and adopt a disclosure-based standard using whatever valuation method they deem theoretically correct. Other abuse areas, like repricing and cheap stock, could also be addressed.

    Interestingly enough, each of the CFOs of European companies agreed that it would be unacceptable for the IASB to adopt a standard that requires expense recognition for stock options, if U.S. standards did not also change. The possible competitive disadvantage for European companies, which will be required to use IAS by 2005, was a very large concern.

    I hope the IASB will not jeopardize the historical opportunity in its grasp. Many participants will watch to see the outcome on this issue. Some want to know the answer quickly to avoid wasting time. An adverse decision could secure the future of US GAAP as the only acceptable methodology for the public capital markets

     

    The IASB homepage is at http://www.iasc.org.uk/ 


     

    Also see Bob Jensen's documents on accounting theory at http://www.trinity.edu/rjensen/theory.htm 

    Bob Jensen's Threads are at http://www.trinity.edu/rjensen/threads.htm 

    Bob Jensen's Homepage is at http://www.trinity.edu/rjensen/