Valuation Issues Related to Derivative Financial Instruments and FAS 133, FAS
138, and IAS 39
Bob Jensen's documents, cases, and
glossaries on FAS 133, FAS 138, and IAS 39 are linked at
http://www.trinity.edu/rjensen/caseans/000index.htm
Why Is the FASB Issuing This Statement?
This Statement permits entities to choose to measure many
financial instruments and certain other items at fair value. The objective
is to improve financial reporting by providing entities with the opportunity
to mitigate volatility in reported earnings caused by measuring related
assets and liabilities differently without having to apply complex hedge
accounting provisions. This Statement is expected to expand the use of fair
value measurement, which is consistent with the Board’s long-term
measurement objectives for accounting for financial instruments.
What Is the Scope of This Statement—Which Entities Does
It Apply to and What Does It Affect?
This Statement applies to all entities, including
not-for-profit organizations. Most of the provisions of this Statement apply
only to entities that elect the fair value option. However, the amendment to
FASB Statement No. 115, Accounting for Certain Investments in Debt and
Equity Securities, applies to all entities with available-for-sale and
trading securities. Some requirements apply differently to entities that do
not report net income.
The following are eligible items for the measurement
option established by this Statement:
Recognized financial assets and financial liabilities
except:
An investment in a subsidiary that the entity is required
to consolidate
An interest in a variable interest entity that the entity
is required to consolidate
Employers’ and plans’ obligations (or assets representing
net overfunded positions) for pension benefits, other postretirement
benefits (including health care and life insurance benefits), postemployment
benefits, employee stock option and stock purchase plans, and other forms of
deferred compensation arrangements, as defined in FASB Statements No. 35,
Accounting and Reporting by Defined Benefit Pension Plans, No. 87,
Employers’ Accounting for Pensions, No. 106, Employers’ Accounting for
Postretirement Benefits Other Than Pensions, No. 112, Employers’ Accounting
for Postemployment Benefits, No. 123 (revised December 2004), Share-Based
Payment, No. 43, Accounting for Compensated Absences, No. 146, Accounting
for Costs Associated with Exit or Disposal Activities, and No. 158,
Employers’ Accounting for Defined Benefit Pension and Other Postretirement
Plans, and APB Opinion No. 12, Omnibus Opinion—1967
Financial assets and financial liabilities recognized
under leases as defined in FASB Statement No. 13, Accounting for Leases
(This exception does not apply to a guarantee of a third-party lease
obligation or a contingent obligation arising from a cancelled lease.)
Deposit liabilities, withdrawable on demand, of banks,
savings and loan associations, credit unions, and other similar depository
institutions
Financial instruments that are, in whole or in part,
classified by the issuer as a component of shareholder’s equity (including
“temporary equity”). An example is a convertible debt security with a
noncontingent beneficial conversion feature.
Firm commitments that would otherwise not be recognized at
inception and that involve only financial instruments
Nonfinancial insurance contracts and warranties that the
insurer can settle by paying a third party to provide those goods or
services
Host financial instruments resulting from separation of an
embedded nonfinancial derivative instrument from a nonfinancial hybrid
instrument.
How Will This Statement Change Current Accounting
Practices?
The fair value option established by this Statement
permits all entities to choose to measure eligible items at fair value at
specified election dates. A business entity shall report unrealized gains
and losses on items for which the fair value option has been elected in
earnings (or another performance indicator if the business entity does not
report earnings) at each subsequent reporting date. A not-for-profit
organization shall report unrealized gains and losses in its statement of
activities or similar statement.
The fair value option:
May be applied instrument by instrument, with a few
exceptions, such as investments otherwise accounted for by the equity method
Is irrevocable (unless a new election date occurs)
Is applied only to entire instruments and not to portions
of instruments.
How Does This Statement Contribute to International
Convergence?
The fair value option in this Statement is similar, but
not identical, to the fair value option in IAS 39, Financial Instruments:
Recognition and Measurement. The international fair value option is subject
to certain qualifying criteria not included in this standard, and it applies
to a slightly different set of instruments.
What Is the Effective Date of This Statement?
This Statement is effective as of the beginning of an
entity’s first fiscal year that begins after November 15, 2007. Early
adoption is permitted as of the beginning of a fiscal year that begins on or
before November 15, 2007, provided the entity also elects to apply the
provisions of FASB Statement No. 157, Fair Value Measurements.
No entity is permitted to apply this Statement
retrospectively to fiscal years preceding the effective date unless the
entity chooses early adoption. The choice to adopt early should be made
after issuance of this Statement but within 120 days of the beginning of the
fiscal year of adoption, provided the entity has not yet issued financial
statements, including required notes to those financial statements, for any
interim period of the fiscal year of adoption.
This Statement permits application to eligible items
existing at the effective date (or early adoption date).
Foreign Currency Complications in Valuation Analysis
Big Mac Index of Purchasing Power Parity ---
http://en.wikipedia.org/wiki/Big_Mac_Index
"CHART OF THE DAY: The iPod And Big Mac Indexes Just Don't Work," by John
Carney and Kamelia Angelova, Business Insider, October 20, 2009 ---
http://www.businessinsider.com/chart-of-the-day-ipod-vs-big-mac-2009-10
The Economist's Big Mac Index and the
new
iPod Nano Index from CommSec are
both cute ways of getting attention for the organizations that produce them.
But do they really measure anything economically significant?
The idea is that the indexes are supposed to expose the relative under- or
over-valuation of various currencies. In theory, the same good should trade
at broadly the same price across the globe if
exchange
rates are adjusting properly. When
goods wind up priced very differently in different locations, it suggests
something is out of whack.
But a side-by-side comparison of the Big Mac Index and the iPod Nano Index
suggests that these might not really be good metrics for measuring
currency valuations. As you can see,
the two indexes result in wildly uncorrelated results. If it were really a
matter of currency valuation, you’d expect both to show similar valuation
problems. Instead, the pattern just seems random.
Many other U.S. and International Standards directly or indirectly impact on
fair value accounting!
Introduction to Valuation
Bob Jensen's site on The Controversy Over Fair Value
(Mark-to-Market) Financial Reporting ---
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Damodaran Online: A Great Sharing Site from a Finance Professor at New
York University and Textbook Writer ---
http://pages.stern.nyu.edu/%7Eadamodar/
This site has great sections on corporate finance, investments,
valuation, spreadsheets, research, etc. For example, take a look at the
helpers on valuation ---
http://pages.stern.nyu.edu/%7Eadamodar/
You can pick the valuation approach that you would like to go to, to
see illustrations, solutions and other supporting material.
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Discounted Cash flow Valuation |
| |
Relative
Valuation |
| |
Option
Pricing Approaches to Valuation |
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Acquisition Valuation |
| |
EVA,
CFROI and other Value Enhancement Strategies |
Or you can pick the material that you are interested in.
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| Spreadsheets |
Overheads |
Datasets |
References |
| Problems & Solutions
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Derivations and Discussion
|
Valuation Examples |
PowerPoint presentations |
Jim Mahar's finance sharing site (especially note his great blog link)
---
http://financeprofessor.com/
Financial Rounds from an anonymous finance professor ---
http://financialrounds.blogspot.com/
Bob Jensen's threads on fair value controversies in accounting are at
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Bob Jensen's finance and investment helpers are at
http://www.trinity.edu/rjensen/Bookbob1.htm
From The Wall Street Journal Accounting Weekly Review on September
22, 2006
TITLE: FASB to Issue Retooled Rule for Valuing Corporate Assets
REPORTER: David Reilly
DATE: Sep 15, 2006
PAGE: C3
LINK:
http://online.wsj.com/article/SB115828639109763950.html?mod=djem_jiewr_ac
TOPICS: Accounting, Advanced Financial Accounting, Fair Value Accounting
SUMMARY: On 9/15/2006, the FASB issued Statement of Financial Accounting
Standards No. 157, Fair Value Measurements. The standard "...provides
enhanced guidance for using fair value to measure assets and liabilities.
The standard also responds to investors' requests for expanded information
about the extent to which companies measure assets and liabilities at fair
value, the information used to measure fair value, and the effect of fair
value measurements on earnings." (Source: FASB News Release available on
their web site at http://www.fasb.org/news/nr091506.shtml) This new standard
must be used as guidance whenever reporting entities use fair value to
measure value assets and liabilities as a required or acceptable method of
applying GAAP.
QUESTIONS:
1.) What is the purpose of issuing Statement of Financial Accounting
Standards No. 157? In your answer, describe how this standard should help to
alleviate discrepancies in practice. To help answer this question, you may
access the FASB's own news release about the standard, available at
http://www.fasb.org/news/nr091506.shtml or the new standard itself,
available on the FASB's web site.
2.) From your own knowledge, cite an example in which fair value is used
to measure an asset or liability in corporate balance sheets. Why is fair
value an appropriate measure for including these assets and liabilities in
corporate balance sheets?
3.) What is the major difficulty with using fair values for financial
reporting that is cited in the article?
4.) Define the term "historical cost." Name two flaws with the use of
historical costs, one cited in the article and one based on your own
knowledge. Be sure to explain the flaw clearly.
5.) How does this standard help to alleviate the issue described in
answer to question 3? Again, you may access the FASB's web site, and the
news release in particle, to answer this question.
6.) The article closes with a statement that "The FASB hopes to counter
some of [the issues cited in the article] by expanding disclosures required
for all balance sheet items measure at fair value..." What could be the
possible problem with that requirement?
Reviewed By: Judy Beckman, University of Rhode Island
"FASB to Issue Retooled Rule For Valuing Corporate Assets New Method
Repeals Limits Spurred by Enron Scandal; Critics Worry About Abuses," by
David Reilly, The Wall Street Journal, September 15, 2006; Page C3
---
http://online.wsj.com/article/SB115828639109763950.html?mod=djem_jiewr_ac
Accounting rule makers have wrapped up an
overhaul of a tricky but important method of valuing corporate assets,
despite some critics' warning that the change could reopen the door to
abuses like those seen at Enron Corp.
The overhaul, contained in an accounting
standard that could be issued as early as today, will repeal a ban put
in place after Enron collapsed into bankruptcy court in late 2001 amid
an array of accounting irregularities. The ban prohibited companies
immediately booking gains or losses from complex financial instruments
whose real value may not be known for years.
The Financial Accounting Standards Board's new
rule will require companies to base "fair" values for certain items on
what they would fetch from a sale in an open market to a third party. In
the past, firms often would use internal models to determine the value
of instruments that didn't have a readily available price.
FASB prohibited that practice after Enron used
overly optimistic models to value multiyear power contracts in a bid to
pad earnings. The ban was meant to give the board time to come up with a
new approach to determining fair values.
The accounting rule makers say the new standard
will give companies, auditors and investors much needed, and more
nuanced, guidance on how to measure market values. Companies will have
to think, "it's not my own estimate of what something is worth to me,
but what the market would demand for this," said Leslie Seidman, an FASB
member. While clarifying how to come up with appropriate values for some
instruments, the new standard doesn't expand the use of what is known as
fair-value accounting.
Critics say the new rule reopens the door to
manipulation and possibly fraud by unscrupulous managers. Requiring
market values for instruments where there isn't a ready price in a
market can be "a license for management to invent the financial
statements to be whatever they want them to be," Damon Silvers,
associate general counsel for the AFL-CIO, said at a meeting of an FASB
advisory group this spring.
Jousting over the standard reflects a deep rift
within accounting circles. For decades, accounting values were mostly
based on historical cost, or what a company paid for a particular asset.
In recent years, accounting rules have moved toward the use of market
values, known as fair-value accounting. In some ways this reflects the
shift in the U.S. from a manufacturing to a service economy, where
intangible assets are more important than the plant and equipment that
previously defined a company's financial strength.
Starting in the mid-1980s, companies also began
using ever-more-complicated financial instruments such as futures,
options and swaps to manage interest-rate, currency and other risks.
Such contracts often can't be measured based on their cost. This spurred
the use of market values, thought to be more realistic. But these values
can be tough to determine because many complex financial instruments are
tailor-made and don't trade on open markets in the same way as stocks.
Of course, valuations based on historical cost
also have flaws. The savings-and-loan crisis of the late 1980s, for
example, was prompted in part by thrifts carrying loans on their balance
sheets at historical cost, even though the loans had plummeted in value.
Robert Herz, the FASB's chairman, acknowledges
the difficulty in coming up with a market, or fair, value for many
instruments. In discussions, he often asks how a company could
reasonably be expected to come up with a fair value for a 30-year swap
agreement on the Thai currency, the baht, which is a bet on the future
value of that currency against another.
The answer, according to Mr. Herz and the FASB,
is to base the value on what a willing third-party would pay in the
market and possibly include a discount to reflect the uncertainty
inherent in the approach.
In an interview earlier this year, Mr. Herz
said this valuation approach would reduce the likelihood of a recurrence
of problems such as those seen at Enron. "The problem wasn't that Enron
was using fair values, it was that they were using 'unfair' values," he
said.
Still, "the bottom line is that fair-value
accounting is a great thing so long as you have market values," said J.
Edward Ketz, an associate accounting professor at Pennsylvania State
University, who is working on a book about the FASB's new standard. "If
you don't, you get into some messy areas."
The FASB hopes to counter some of these issues
by expanding disclosures required for all balance-sheet items measured
at fair value, the board's Ms. Seidman said.
October 15, 2006 reply from Bob Jensen
The original 157 Exposure Draft proposed a Fair Value Option (FVO)
that would have allowed carrying of virtually any financial asset or
liability at fair value rather than just limiting fair value accounting
to selected items that are now required to be carried at fair value
rather than historical cost. Business firms, and especially banks,
generally are against fair value accounting (due to reporting
instabilities that arise from fair value adjustments prior to contract
settlements). The FASB backed off of the FVO when it issued FAS 157,
thereby relegating FAS 157 to a standard that clarifies definitions of
fair value in various circumstances. Hence FAS 157 is largely semantic
and does not change the present fair value accounting rules.
I asked Paul Pacter (at Deloitte in Hong Kong where he's still very
active in helping to set IFRS and FASB standards) for an update on the
FVO Project (commenced in 2004) that failed to impact the new FAS 157
standard. His reply is below.
October 31 reply from Paul Pacter (CN - Hong Kong)
[paupacter@deloitte.com.hk]
Hi Bob,
Yes, FASB's FV Option (FVO) t is very much
active -- an ED on phase 1 was issued in January, and a final FAS is
expected before year end.
- Phase 1 addresses creating an FVO for
financial assets and financial liabilities.
- Phase 2 addresses creating an FVO for
selected nonfinancial items.
Thus phase 2 would go beyond IFRSs, though
several IFRSs have FV options for individual types of assets. IAS 16 and
IAS 38 allow it for PP&E and intangibles -- though the credit is to
surplus, not P&L, no recycling, subsequent depreciation of revalued
amounts. IAS 40 gives a FV option for investment property -- FV through
P&L. IAS 41 isn't an option, it's a requirement for FV through P&L for
agricultural assets.
Phase 2 would commence in 2007.
Re possible amendment to FAS 157, I don't think
FASB plans to do that, though I suppose there might be some
consequential amendment. But I don't think the FVO will change the
definition of fair value that's in FAS 157.
Here's FASB's web page:
http://www.fasb.org/project/fv_option.shtml
Warm regards,
Paul
Bob Jensen's threads on fair value accounting are at various other links:
I recently completed the first draft of a paper on fair value at
http://www.trinity.edu/rjensen/FairValueDraft.htm
Comments would be helpful.
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
http://www.trinity.edu/rjensen/roi.htm
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms
Interest Rate Swap Valuation, Forward Rate Derivation, and Yield
Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial
Instruments ---
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Robert Walker's First Blog Entry is About Fair Value
Accounting, October 27, 2006 ---
http://www.robertbwalkerca.blogspot.com/
Introduction
I have decided to begin a commentary which expresses my views on
accounting. As I begin to do this I envisage the source of my commentary
to comprise three different sorts of writing in which I may engage:
§ Simple notes directly to the ‘blog’ such as this.
§ Formal submissions I may make to various bodies including the IASB.
§ Letters or reports I may write for one reason or another that I think
might have some general readership.
The expression of my views will stray from the subject matter of
accounting per se to deal with matters of enormous significance to me
such as corporate or public administration. Such expressions will not be
too substantial a digression from the core subject matter because I
believe that the foundation of good ‘corporate governance’, to use a
vogue term, is accounting.
Source of my ideas on accounting
I would have to confess that the foundation upon which I base my
philosophy of accounting is derivative, as much of human knowledge is of
course. It is not for nothing that Newtown said that if he can see so
far it is because he stands on the shoulders of giants. In my case, that
‘giant’ is Yuiji Ijiri. As I begin a detailed exposition of my views I
shall return to the lessons I learned many years ago from Theory of
Accounting Measurement, a neglected work that will still be read in
1,000 years or so long as humankind survives whichever is the shorter.
As the depredations of the standard setting craze are visited upon us
with ever increasing complexity, the message delivered by Ijiri will be
heeded more an more.
The basic structure of accounting
Without wishing to be too philosophical about it, I need to begin by
outlining what I mean by accounting. Accounting, in my mind, comprises
three inter-related parts. These are:
§ Book-keeping.
§ Accounting.
§ Financial reporting.
Book-keeping is the process of recording financial data elements in the
underlying books of account. These financial data elements represent, or
purport to represent, real world events. The heart of book-keeping is
the double entry process. For instance at the most basic level a
movement in cash will result in the surrender or receipt of an asset,
the incurring or settlement of a liability and so on.
I have no complete and coherent theory of the limits of book-keeping.
Clearly cash movement (change of ownership) or the movement of commodity
is the proper subject matter of book-keeping. Whether all forms of
contract should be similarly treated is not clear to me. I am inclined
to say yes. That is to adopt Ijiri’s theory of commitment accounting,
but I can foresee that this leads me to conclusions that I may find
unpalatable later on. Incidentally I say this because an epiphany I had,
based on the notion of commitment accounting, some years ago is
beginning to unravel.
Book-keeping goes beyond recording to encompass control. That is the
process by which the integrity of the centre piece of book-keeping – the
general ledger expressing double entry – is ensured. I will not concern
myself with such processes though this is not to say that they are
unimportant.
Accounting is the process by which sense is made of what is a raw record
expressed in the general ledger. It is the process of distillation and
summation that enables the accountant to gain on overview of what has
happened to the entity the subject of the accounting. Accounting
fundamentally assumes that the accountant is periodically capable of
saying something useful about the real world using his or her special
form of notation.
Financial reporting is the process by which data is assembled into a
comprehensive view of the world in accordance with a body of rules. It
differs, in the ideal, from accounting in a number of ways. Most
benignly it differs, for instance, by including ancillary information
for the benefit of a reader beyond the mere abstraction from the general
ledger. Again in the ideal there is an inter-relationship between the
three levels in the accounting hierarchy. That is, the rules of
financial reporting will, to some degree shape the order and format of
the basic, book-keeping level so that the process of distillation and
summation follows naturally to the final level of reporting without
dramatic alteration.
Perhaps what concerns me is that the sentiment expressed above can be
seen, without much effort, to be only ideal and that in reality it does
not arise. In short the golden strand that links the detailed recording
of real world phenonmena to its final summation is broken.
An example
I was asked recently by a student of accounting to explain IAS 41, the
IASB standard on agriculture. As I don’t deal in primary production at
all, I had not thought about this subject for years.
IAS 41 admonishes the accountant to apply ‘fair value’ accounting. Fair
value accounting is the process by which current sale prices, or their
proxies, are substituted for the past cost of any given item.
For instance, you may have a mature vineyard. The vineyard comprises
land, the vine and its fruit, the plant necessary to sustain the vine
(support structures, irrigation channels etc.). Subsumed within the vine
are the materials necessary for it to grow and start producing fruit.
This will include the immature plant, the chemical supplements necessary
to nurture and protect it, and the labour necessary to apply it.
The book-keeping process will faithfully record all of these components.
Suppose for example the plant, fertliser and labour cost $1000. In the
books will be recorded:
Dr Vineyard $1000
Cr Cash $1000
At the end of the accounting period, the accountant will summarise this
is a balance statement. He or she will then obtain, in some way, the
current selling price of the vine. Presumably this will be the future
cash stream of selling the fruit, suitably discounted. Assume that this
is $1200.
The accountant will then make the following incremental adjustment:
Dr Vineyard $200
Cr Equity $200
Looked like this there is a connection between the original book-keeping
and the periodic adjustment at the end of the accounting period. This is
an illusion. The incremental entry disguises what is really happening.
It is as follows:
Dr Equity $1000
Cr Vineyard $1000
And
Dr Vineyard $1200
Cr Equity $1200
Considered from the long perspective, the original book-keeping has been
discarded and a substitute value put in its place. This is the truth of
the matter. The subject matter of the first phase of accounting was a
set of events arising in a bank and in the entity undertaking
accounting. The subject matter of the second phase is a set of future
sales to a party who does not yet exist.
From a perspective of solvency determination, a vital element of
corporate governance, the view produced by the first phase is next to
useless. However, the disquiet I had in my mind which I had suppressed
until recently, relates to the shattering of the linkages between the
three levels of accounting in the final reporting process. This disquiet
has returned as I contemplate the apparently unstoppable momentum of the
standard setting process.
October 28, 2006 reply from Bob Jensen
Hi Robert,
I hope you add many more entries to your blog.
The problem with "original book-keeping" is that it
provides no answer how to account for risk of many modern day contracts
that were not imagined when "original book-keeping" evolved in a simple
world of transactions. For example, historical costs of forward
contracts and swaps are zero and yet these contracts may have risks that
may outweigh all the recorded debt under "original book-keeping." Once
we opened the door to fair value accounting to better account for risk,
however, we opened the door to misleading the public that booked fair
value adjustments can be aggregated much like we sum the current
balances of assets and liabilities on the balance sheet. Such
aggregations are generally nonsense.
I don't know if you saw my recent hockey analogy or not.
It goes as follows:
Goal Tenders versus Movers and Shakers
Skate to where the puck is going, not to where it is.
Wayne Gretsky (as quoted for many years by Jerry Trites
at
http://www.zorba.ca/ )
Jensen Comment
This may be true for most hockey players and other movers and shakers,
but for goal tenders the eyes should be focused on where the puck is at
every moment --- not where it's going. The question is whether an
accountant is a goal tender (stewardship responsibilities) or a mover
and shaker (part of the managerial decision making team). This is also
the essence of the debate of historical accounting versus pro forma
accounting.
Graduate student Derek Panchuk and professor
Joan Vickers, who discovered the Quiet Eye phenomenon, have just
completed the most comprehensive, on-ice hockey study to determine where
elite goalies focus their eyes in order to make a save. Simply put, they
found that goalies should keep their eyes on the puck. In an article to
be published in the journal Human Movement Science, Panchuk and Vickers
discovered that the best goaltenders rest their gaze directly on the
puck and shooter's stick almost a full second before the shot is
released. When they do that they make the save over 75 per cent of the
time.
"Keep your eyes on the puck," PhysOrg, October 26, 2006 ---
http://physorg.com/news81068530.html
I have written a more serious piece about both
theoretical and practical problems of fair value accounting. I should
emphasize that this was written after the FASB Exposure Draft proposing
fair value accounting as an option for all financial instruments and the
culminating FAS 157 that is mainly definitional and removed the option
to apply fair value accounting to all financial instruments even though
it is still required in many instances by earlier FASB standards.
My thoughts on this are at the following two links:
http://www.trinity.edu/rjensen/FairValueDraft.htm
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Bob Jensen
October 30, 2006 reply from Robert B Walker
[walkerrb@ACTRIX.CO.NZ]
Bob
Thanks for the support. I have answered you in
my second installment (
www.robertbwalkerca.blogspot.com ).
I shall continue to write if for no other
reason than for myself. I have had it in mind to write a book. I shall
begin doing so this way.
Robert
October 30, 2006 reply from Bob Jensen
I have difficulty envisioning forward contracts as “executory
contracts.” These appear to be to be executed contracts that are
terminated when the cash finally flows.
Fair value appears to be the only way to book forward contracts if
they are to be booked at all, although fair value on the date they are
signed is usually zero.
Once you are in the fair value realm, you have all the aggregation
problems, blockage problems, etc. that are mentioned at
http://www.trinity.edu/rjensen/FairValueDraft.htm
I guess what I’d especially like you to address is the problem of
aggregation in a balance sheet or income statement based upon
heterogeneous measurements.
Bob Jensen
Bob Jensen's threads on fair value accounting are at various other links:
I recently completed the first draft of a paper on fair value at
http://www.trinity.edu/rjensen/FairValueDraft.htm
Comments would be helpful.
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
http://www.trinity.edu/rjensen/roi.htm
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms
Interest Rate Swap Valuation, Forward Rate Derivation, and Yield
Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial
Instruments ---
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Fair value is the
estimated best disposal (exit, liquidation) value in any sale other than a
forced sale. It is defined as follows in Paragraph 540 on Page 243 of FAS
133:
The amount at which an
asset (liability) could be bought (incurred) or sold (settled) in a
current transaction between willing parties, that is, other than in a
forced or liquidation sale. Quoted market prices in active markets are
the best evidence of fair value and should be used as the basis for the
measurement, if available. If a quoted market price is available, the
fair value is the product of the number of trading units times that
market price. If a quoted market price is not available, the estimate of
fair value should be based on the best information available in the
circumstances. The estimate of fair value should consider prices for
similar assets or similar liabilities and the results of valuation
techniques to the extent available in the circumstances. Examples of
valuation techniques include the present value of estimated expected
future cash flows using discount rates commensurate with the risks
involved, option- pricing models, matrix pricing, option-adjusted spread
models, and fundamental analysis. Valuation techniques for measuring
assets and liabilities should be consistent with the objective of
measuring fair value. Those techniques should incorporate assumptions
that market participants would use in their estimates of values, future
revenues, and future expenses, including assumptions about interest
rates, default, prepayment, and volatility. In measuring forward
contracts, such as foreign currency forward contracts, at fair value by
discounting estimated future cash flows, an entity should base the
estimate of future cash flows on the changes in the forward rate (rather
than the spot rate). In measuring financial liabilities and nonfinancial
derivatives that are liabilities at fair value by discounting estimated
future cash flows (or equivalent outflows of other assets), an objective
is to use discount rates at which those liabilities could be settled in
an arm's-length transaction.
This
is old news, but it does provide some questions for students to ponder. The
main problem of fair value adjustment is that many ((most?) of the
adjustments cause enormous fluctuations in earnings, assets, and liabilities
that are washed out over time and never realized. The main advantage is
that interim impacts that “might be” realized are booked. It’s a war
between “might be” versus “might never.” The war has been waging for over a
century with respect to booked assets and two decades with respect to
unbooked derivative instruments, contingencies, and intangibles.
CFA analysts' group favors full fair value reporting
The CFA Centre for Financial Market Integrity – a
part of the CFA Institute – has published a new financial reporting model
that, they believe, would greatly enhance the ability of financial analysts
and investors to evaluate companies in making investment decisions. The
Comprehensive Business Reporting Model proposes 12 principles to ensure that
financial statements are relevant, clear, accurate, understandable, and
comprehensive (See below).
"Analysts' group favours full fair value reporting," IAS Plus,
October 31, 2005 ---
http://www.iasplus.com/index.htm
CFA Institute Centre for Financial Market
Integrity
Comprehensive Business Reporting Model –
Principles
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-
1. The company must be viewed from the
perspective of a current investor in the
company's common equity.
-
2. Fair value information is the only
information relevant for financial decision
making.
-
3. Recognition and disclosure must be
determined by the relevance of the
information to investment decision making
and not based upon measurement reliability
alone.
-
4. All economic transactions and events
should be completely and accurately
recognized as they occur in the financial
statements.
-
5. Investors' wealth assessments must
determine the materiality threshold.
-
6. Financial reporting must be neutral.
-
7. All changes in net assets must be
recorded in a single financial statement,
the Statement of Changes in Net Assets
Available to Common Shareowners.
-
8. The Statement of Changes in Net Assets
Available to Common Shareowners should
include timely recognition of all changes in
fair values of assets and liabilities.
-
9. The Cash Flow Statement provides
information essential to the analysis of a
company and should be prepared using the
direct method only.
-
10. Changes affecting each of the financial
statements must be reported and explained on
a disaggregated basis.
-
11. Individual line items should be reported
based upon the nature of the items rather
than the function for which they are used.
-
12. Disclosures must provide all the
additional information investors require to
understand the items recognized in the
financial statements, their measurement
properties, and risk exposures.
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Standards of Value: Theory and Applications
Standards of Value covers the
underlying assumption in many of the prominent standards of value, including
Fair Market Value, investment value, and fair value. It discusses the
specific purposes of the valuation, including divorce, shareholders'
oppression, financial reporting, and how these standards are applied.
Standards of Value: Theory and Applications, by Jay E. Fishman,
Shannon P. Pratt, William J. Morrison Wiley: ISBN: 0-471-69483-5 Hardcover
368 pages November 2006 US $95.00) ---
http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471694835.html
"Will Fair Value Fly? Fair-value accounting could change the very basis
of corporate finance," by Ronald Fink, CFO Magazine September 01,
2006 ---
http://www.cfo.com/article.cfm/7851757/c_7873404?f=magazine_featured
Much has changed in financial reporting since
Andrew Fastow and Scott Sullivan, the finance chiefs of Enron and
WorldCom, respectively, brought disgrace upon themselves, their
employers, and, to a degree, their profession. Regulators and investors
have pressed companies to be more open and forthcoming about their
results — and companies have responded. According to a new CFO magazine
survey, 82 percent of public-company finance executives disclose more
information in their financial statements today then they did three
years ago. But that positive finding won't quell calls for further
accounting reform.
The U.S. reporting system "faces a number of
important and difficult challenges," Robert Herz, chairman of the
Financial Accounting Standards Board, told the annual conference of the
American Institute of Certified Public Accountants in Washington, D.C.,
last December. Chief among those, said Herz, is "the need to reduce
complexity and improve the transparency and overall usefulness" of
information reported to investors. ad
Critics contend that generally accepted
accounting principles (GAAP) remain seriously flawed, even as companies
have beefed up internal controls to comply with the Sarbanes-Oxley Act.
"We've done very little but play defense for the last five to six
years," charges J. Michael Cook, chairman and CEO emeritus of Deloitte &
Touche LLP. "It's time to play offense."
Cook, a respected elder statesman in the
accounting community, goes so far as to pronounce financial statements
almost completely irrelevant to financial analysis as currently
conducted. "The analyst community does workarounds based on numbers that
have very little to do with the financial statements," says Cook. "Net
income is a virtually useless number."
How can financial statements become more
relevant and useful? Many reformers, including Herz, believe that
fair-value accounting must be part of the answer. In this approach,
which FASB increasingly favors, assets and liabilities are marked to
market rather than recorded on balance sheets at historical cost.
Fair-value accounting, say its advocates, would give users of financial
statements a far clearer picture of the economic state of a company.
"I know what an asset is. I can see one, I can
touch one, or I can see representations of one. I also know what
liabilities are," says Thomas Linsmeier, a Michigan State University
accounting professor who joined FASB in June. On the other hand, "I
believe that revenues, expenses, gains, and losses are accounting
constructs," he adds. "I can't say that I see a revenue going down the
street. And so for me to have an accounting model that captures economic
reality, I think the starting point has to be assets and liabilities."
More than any other regulatory change, fair
value promises to end the practice of earnings management. That's
because a company's earnings would depend more on what happens on its
balance sheet than on its income statement (see "The End of Earnings
Management?" at the end of this article).
But switching from historical cost would
require enormous effort from overworked finance departments. Valuing
assets in the absence of active markets could be overly subjective,
making financial statements less reliable. Linsmeier's confidence
notwithstanding, disputes could arise over the very definition of
certain assets and liabilities. And using fair value could even distort
a company's approach to deal-making and capital structure.
A Familiar Concept Fair value is by no means
unfamiliar to corporate-finance executives, as current accounting rules
for such items as derivatives (FAS 133 and 155), securitizations (FAS
156), and employee stock option grants (FAS 123R) use it to varying
degrees when recording assets and liabilities. So does a proposal issued
last January for another rule, this one for accounting for all financial
instruments. FASB's more recent proposals to include pensions and leases
on balance sheets also embrace fair-value measurement (see "Be Careful
What You Wish For" at the end of this article).
While both Herz and Linsmeier are careful to
note that they don't necessarily favor the application of fair value to
assets and liabilities that lack a ready market, they clearly advocate
its application where there's sufficient reason to believe the
valuations are reliable. Corporate accounting, Herz says, is the only
major reporting system that doesn't use fair value as its basis, and he
points to the Federal Reserve's use of it in tracking the U.S. economy
as sufficient reason for companies to adopt it.
The corporate world, however, must grapple with
its own complexities. For one, fair value could make it even more
difficult to realize value from acquisitions. Take the question of
contingent considerations, wherein the amount that acquirers pay for
assets ultimately depends on their return. Under current GAAP, the
balance-sheet value of assets that are transferred through such earnouts
may reflect only the amount exchanged at the time the deal is completed,
because the acquirer has considerable leeway in treating subsequent
payments as expenses.
Under fair value, the acquirer would also
include on its balance sheet the present value of those contingent
payments based on their likelihood of materializing. Since the money may
never materialize, some finance executives contend those estimates could
be unreliable and misleading. "I disagree with [this application of fair
value] on principle," James Barge, senior vice president and controller
for Time Warner, said during a conference on financial reporting last
May. ad
Barge cites the acquisition of intangible
assets that a company does not intend to use as a further example of
fair value's potentially worrisome effects. Under current GAAP, their
value is included in goodwill and subject to annual impairment testing
for possible write-off. But if, as FASB is contemplating, the value of
those assets would be recorded on the balance sheet along with that of
the associated tangible assets that were acquired, Barge worries that an
immediate write-off would then be required — even though it would not
reflect the acquiring company's economics.
Fair value's defenders say such concerns are
misplaced. The possibility that a contingent consideration won't
materialize, for starters, is already reflected in an acquirer's bid,
says Patricia McConnell, a Bear Stearns senior managing director who
chairs the corporate-disclosure policy council of the CFA Institute, a
group for financial analysts. "It's in the price," she says.
As for intangibles that are acquired and then
extinguished, the analyst says a write-off would not in fact be required
under fair value if the transaction strengthens the acquirer's market
position. That position would presumably be reflected in the value of
the assets associated with those intangibles as recorded on the balance
sheet under fair-value treatment.
"It may be in buying a brand to gain
monopolistic position that you don't have an expense," McConnell
explains, "but rather you have the extinguishment of one asset and the
creation of another." Yet McConnell, among others, admits that
accounting for intangibles is an area that would need improvement even
if FASB adopted fair value.
Deceptive Debt? Another area of concern
involves capital structure, with Barge suggesting that fair value may
make it more difficult to finance growth with debt. He contends that
marking a company's debt to market could make a company look more highly
exposed to interest-rate risk than it really is, noting during the May
conference that Time Warner's debt was totally hedged.
Barge also cited as problematic the
hypothetical case of a company whose creditworthiness is downgraded by
the rating agencies. By marking down the debt's value on its balance
sheet, the company would realize more income, a scenario Barge called
"nonsensical." He warned of a host of such effects arising under fair
value when a company changes its capital structure.
Proponents find at least some of the complaints
about fair value and corporate debt to be misplaced. Herz notes fair
value would require the company to mark the hedge as well as the debt to
market, so that if a company is hedging interest-rate risk effectively,
its balance sheet should accurately reflect its lack of any exposure.
What's more, fair value could also improve
balance sheets in some cases. When, for instance, a company owns an
interest in another whose results it need not consolidate, the equity
holder's proportion of the other company's assets and liabilities is
currently carried at historical cost. If, however, the other company's
assets have gained value and were marked to market, the equity holder's
own leverage might decrease.
A real-life case in point: If the chemical
company Valhi marked to market its 39 percent stake in Titanium Metals,
Valhi's own ratio of long-term debt to equity would fall from 90 percent
(at the end of 2005) to 56 percent, according to Jack T. Ciesielski,
publisher of The Analyst's Accounting Observer newsletter. ad
Still, even some fair-value proponents share
Barge's concern about credit downgrades. As Ciesielski, a member of
FASB's Emerging Issues Task Force, wrote last April in a report on the
board's proposal for the use of fair value for financial instruments, it
is "awfully counterintuitive" for a company to show rising earnings when
its debt-repayment capacity is declining.
Herz and other fair-value proponents disagree,
noting that the income accrues to the benefit of the shareholders, not
to bondholders. "It's not at all counterintuitive," asserts Rebecca
McEnally, director for capital-markets policy of the CFA Institute
Centre for Financial Market Integrity, citing the fact that the item is
classified under GAAP as "income from forgiveness of indebtedness." But
Ciesielski says investors are unlikely to understand that, and that fair
value, in this case at least, may not produce useful results.
Resolving the Issues Even some of FASB's
critics agree, however, that the current system needs improvement, and
that fair value can help provide it. "Fair value in general is more
relevant than historical cost and can lead to reduced complexity and
greater transparency," Barge admits, though he has noted that the use of
fair value may also lead to "soft" results that "you can't audit."
For much the same reason, Colleen Cunningham,
president and CEO of Financial Executives International (FEI), expressed
concern in testimony before Congress last March that "overly theoretical
and complex standards can result in financial reporting of questionable
accuracy and can create a significant cost burden, with little benefit
to investors." In an interview, she explains that her biggest concern is
that FASB is pushing ahead with fair-value-based rules without
sufficient input from preparers. "Let's resolve the issues" before
proceeding, she insists.
Herz concedes that numerous issues surrounding
fair value need to be addressed. But important users of financial
statements are pressing him to move forward on fair value without delay.
As a comment letter that the CFA Institute sent to FASB put it: "All
financial decision-making should be based on fair value, the only
relevant measurement for assets, liabilities, revenues, and expenses."
Meanwhile, Herz isn't waiting for the
conceptual framework to be completed before enacting new rules that
embrace fair value. "In the end, we're not going to get everybody
agreeing," Herz says. "So we have to make decisions" despite lingering
disagreement.
Ironically, one fair-value-based proposal that
FASB issued recently may have created an artful means of defusing
opposition. The Board's proposal for financial instruments gives
preparers of financial reports the choice of using historical cost or
fair value in recording the instruments on their balance sheets. That
worries some people, who say giving companies a choice of methods will
make it harder to compare their results, even when they're in the same
industry.
Continued in article
"Guidance on fair value measurements under FAS 123(R)," IAS Plus, May 8,
2006 ---
http://www.iasplus.com/index.htm
Deloitte & Touche (USA) has updated its book of
guidance on FASB Statement No. 123(R) Share-Based Payment:
A Roadmap to Applying the Fair Value Guidance to Share-Based Payment
Awards (PDF 2220k). This second edition
reflects all authoritative guidance on FAS 123(R) issued as of 28 April
2006. It includes over 60 new questions and answers, particularly in the
areas of earnings per share, income tax accounting, and liability
classification. Our interpretations incorporate the views in SEC Staff
Accounting Bulletin Topic 14 "Share-Based Payment" (SAB 107), as well as
subsequent clarifications of EITF Topic No. D-98 "Classification and
Measurement of Redeemable Securities" (dealing with mezzanine equity
treatment). The publication contains other resource materials, including
a GAAP accounting and disclosure checklist. Note that while FAS 123 is
similar to
IFRS 2 Share-based Payment, there are some
measurement differences that are
Described Here.
Bob Jensen's threads on employee stock options are at
http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Fair Value Accounting Book Review (Meeting the New FASB Requirements)
From SmartPros on May 1, 2006
Fair Value for Financial Reporting by Alfred King
highlights the accounting and auditing requirements for fair value
information and offers a detailed explanation of how the FASB is going
to change "fair value," from determining the fair value of intangible
assets to
selecting and working with an appraiser ---
http://accounting.smartpros.com/x35458.xml
Fair Value for Financial Reporting: Meeting the New FASB Requirements
by Alfred M. King
ISBN: 0-471-77184-8
Hardcover 352 pages April 2006
Click to
Download the Comprehensive Business Reporting Model from the CFA
Institute website.
Click here for
Press Release (PDF 26k).
As
you can see below, the war is not over yet. In fact it has intensified
between corporations (especially banks) versus standard setters versus
members of the academy.
From The
Wall Street Journal Accounting Educators' Review on April 2, 2004
TITLE: As IASB
Unveils New Rules, Dispute With EU Continues
REPORTER: David Reilly
DATE: Mar 31, 2004
PAGE: A2 LINK:
http://online.wsj.com/article/0,,SB108067939682469331,00.html
TOPICS: Generally accepted accounting principles, Fair Value Accounting,
Insider trading, International Accounting, International Accounting
Standards Board
SUMMARY:
Despite controversy with the European Union (EU), the International
Accounting Standards Board (IASB) is expected to release a final set of
international accounting standards. Questions focus on the role of the
IASB, controversy with the EU, and harmonization of the accounting
standards.
QUESTIONS:
1.) What is the role of the IASB? What authority does the IASB have to
enforce standards?
2.) List three
reasons that a country would choose to follow IASB accounting standards.
Why has the U.S. not adopted IASB accounting standards?
3.) Discuss the
advantages and disadvantages of harmonization of accounting standards
throughout the world. Why is it important the IASB reach a resolution
with the EU over the disputed accounting standards?
4.) What is
fair value accounting? Why would fair value accounting make financial
statements more volatile? Is increased volatility a valid argument for
not adopting fair value accounting? Does GAAP in the United States
require fair value accounting? Support your answers.
There are a number of software vendors of FAS 133 valuation
software.
One of the major companies is Financial CAD ---
http://www.financialcad.com/
FinancialCAD provides software and services
that support the valuation and risk management of financial securities
and derivatives that is essential for banks, corporate treasuries and
asset management firms. FinancialCAD’s industry standard financial
analytics are a key component in FinancialCAD solutions that are used by
over 25,000 professionals in 60 countries.
See
software.
Fair value accounting politics in the revised
IAS 39
From Paul Pacter's IAS Plus on July 13, 2005
---
http://www.iasplus.com/index.htm
Also see
http://www.trinity.edu/rjensen//theory/00overview/IASBFairValueFAQ.pdf
-
Why did the Commission
carve out the full fair
value option in the
original IAS 39
standard?
-
Do
prudential supervisors
support IAS 39 FVO as
published by the IASB?
-
When will the Commission
to adopt the amended
standard for the IAS 39
FVO?
-
Will companies be able
to apply the amended
standard for their 2005
financial statements?
-
Does the amended
standard for IAS 39 FVO
meet the EU endorsement
criteria?
-
What about the
relationship between the
fair valuation of own
liabilities under the
amended IAS 39 FVO
standard and under
Article 42(a) of the
Fourth Company Law
Directive?
-
Will the Commission now
propose amending Article
42(a) of the Fourth
Company Directive?
-
What about the remaining
IAS 39 carve-out
relating to certain
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On June 23, 2005, the Financial Accounting Standards Board
issued an Exposure Draft (ED) entitled "Fair Value Measurements." The original
ED can be downloaded free at
http://www.fasb.org/draft/ed_fair_value_measurements.pdf
"Response to the FASB's Exposure Draft on Fair Value Measurements," AAA
Financial Standards Committee, Accounting Horizons, September 2005, pp.
187-195 ---
http://aaahq.org/pubs/electpubs.htm
RESPONSES TO SPECIFIC ISSUES
The FASB invited comment on all matters related to
the ED, but specifically requested comments on 14 listed issues. The
Committee's comments are limited to those issues for which empirical
research provides some insights, or those sections of the ED that are
conceptually inconsistent or unclear. The Committee has previously
commented on other fair-value-related documents issued by the FASB and other
standard-setting bodies. This letter reiterates comments expressed in those
letters to the extent they are germane to the measurement issues contained
in the ED. However, to better understand our perspective on reporting fair
value information in the financial statements and related notes, we refer
readers to those comment letters (i.e., AAA FASC 1998, 2000).
Issue 1: Definition of Fair Value
The Committee believes that the ED contains some
conceptual inconsistencies between the definition and application of the
fair value measurement attribute. The ED proposes a definition of fair
value that is relatively independent of the entity-specific use of the
assets held or settlement of the liabilities owed. In contrast, the
proposed standard and related implementation guidance includes measurement
that is, at times, directly determined by the entity-specific use of the
asset or settlement of the liability in question.
Some of the inconsistencies with respect to fair
value measurement might be attributable to the attempt to apply general,
high-level fair value guidance to the idiosyncratic attributes of specific
accounts and transactions. In some cases, application to specific accounts
and transactions requires deviation from an entity-independent notion of
fair value to one that includes consideration of the specific types and uses
of assets held or liabilities owed by companies. For example, as we note in
our discussion of Issue 6 (below), one of the examples in the ED suggests
that the fair value of a machine should include an adjustment of quoted
market prices (based on comparable machines) for installation costs.
However, such an adjustment is dependent on the individual circumstances of
the company that purchases the equipment. That is, installation costs are
included in the fair value of an asset only when the firm intends to use
that asset for income producing activities. Alternatively, if the firm
intends to sell the asset, then installation costs are ignored.
Some members of the Committee, however, do not
perceive an inconsistency between the definition and application of the fair
value measurement attribute. These members view the definition of fair
value and the context within which it is applied (i.e., the valuation
premise) to be distinct, albeit related, attributes. Although the
definition of fair value can be entity-independent, the valuation premise
(e.g., value-in-use or value-in-exchange) cannot. Further, these members
argue that ignoring the valuation premise in determining fair value could
lead to unsatisfactory outcomes. For example, if installation costs are
ignored regardless of the valuation premise, then immediately after
purchasing an asset for use in income-producing activities, firms would
suffer impairment losses equal to the installation costs incurred to prepare
the assets for use.
The Committee raises the example of machinery
installation costs to illustrate the confusion we experienced trying to
reconcile the high-level (seemingly entity-independent) definition of fair
value with the contextually determined application standards. We note that
the Introduction of the Ed suggests that the intent of the proposed guidance
in the ED is to establish fair value measures that would be referenced in
other authoritative accounting to establish fair value measures that would
be referenced in other authoritative accounting pronouncements. Presumably,
these other pronouncements would also establish reasonable deviations from
the entity-independent notion of fair value. The Committee believes the
most effective general purpose fair value measurement standard would adopt a
general notion of fair value that is consistent across the definition of
fair value, the accounting standard, and the implementation guidance. To
the extent the Board generally believes that fair value is an
entity-specific concept, the high-level definition should reflect this as
well.
Issues 4 and 5: Valuation Premise and Fair Value
Hierarchy
Related to our previous comments, some members of
the Committee perceive a contradiction between the definition of fair value
in paragraphs 4 and 5 of the ED and the valuation premise described in
paragraph 13. The definition of fair value provided in paragraph 5 suggests
a pure value-in-exchange perspective where fair value is determined by the
market price that would occur between willing parties. In contrast, the
valuation premise described in paragraph 13 suggests that the fair value
estimate can follow either a value-in-use perspective or a value-in-exchange
perspective.
Moreover, the fair value hierarchy described in the
ED gives the highest priority to fair value measurements based on market
inputs regardless of the valuation premise. Some members of the Committee
believe that quoted market prices are not necessarily an appropriate measure
of fair value when a value-in-use premise is being considered. This is
especially true when a quoted price for an identical asset in an active
reference market (i.e., a Level 1 estimate) exists, but is significantly
different from a value-in-use estimate computed by taking the present value
of the firm-specific future cash flows expected to be generated by the asset
(i.e., a Level 3 estimate). In such instances, following the fair value
hierarchy might lead to a fair value estimate more in character with a
value-in-exchange premise than a value-in-use premise.
In summary, the Committee believes that: (1)
integrating the two valuation premises (i.e., value-in-use and
value-in-exchange) into the definition of fair value itself and (2)
elaborating on the differences between the two premises would help ensure
more consistent application of the standard.
Issue 6: Reference Market
Some members of the Committee are confused by the
guidance related to determining the appropriate reference market. With
respect to the Level 1 reference market, the ED states that when multiple
active markets exist, the most advantageous market should be used. The most
advantageous market is determined by comparing prices across multiple
markets net of transactions costs. However, the ED requires that
transactions costs be ignored subsequently in determining the fair value
measurement. In our view, ignoring transactions costs is problematic
because we believe such costs are an ordinary and predictable part of
executing a transaction.
In Example 5 (paragraph B9 (b) of the ED) where two
markets, A and B, are considered, the price in Market B ($35) is more
advantageous than the price in Market A ($25), ignoring transaction costs.
However, the fair value estimate is determined using the price in Market A
because the transactions cost in Market B ($20) is much higher than in
Market A ($5). The guidance is less clear if we modify the example by
reducing the transaction costs for Market B to $15. In this instance,
neither market is advantageous in a "net" sense, but Market B would yield
the highest fair value estimate (ignoring transactions costs), which
provides managers an opportunity to pick the most desirable figure based on
their reporting objectives.
Omitting transactions costs from the fair value
estimate in Example 5 contrasts sharply with Example 3 (Appendix B,
paragraph B7 (a)) where the value-in-use fair value estimate of a machine is
determined by adjusting the quoted market price of a comparable machine by
installation costs. Installation costs are ignored only if the firm intends
to dispose of the asset (Appendix B, paragraph B7 (b)). Thus, managerial
intent plays an integral role in determining whether fair value is computed
with or without installation costs, but the same does not hold for
transaction costs. Since transaction costs are not relevant unless
management intends to dispose of the asset, the Committee agrees that
ignoring transaction costs is justified when a value-in-use premise is
appropriate, but the Committee questions the appropriateness of ignoring
transaction costs when a value-in-exchange premise is adopted.
Issue 7: Pricing in Active Dealer Markets
The ED requires that the fair value of financial
instruments traded in active dealer markets where bid and asked prices are
readily available be estimated using bid prices for assets and asked prices
for liabilities. Some Committee members believe that this requirement is
inconsistent with the general concept of fair value and seems to be biased
toward valuing assets and liabilities at value-in-exchange instead of
value-in-use. Limiting our discussion to the asset case, if a buyer
establishes a long position through a dealer, the buyer must pay the asked
price. By purchasing the asset at the asked price, the buyer clearly
expects to earn an acceptable rate of return on the investment in the asset
(at the higher price). Moreover, if after purchasing the asset, the buyer
immediately applies the ED's proposed fair value measurement guidance (i.e.,
bid price valuation), the buyer would incur a loss on the asset equal to the
bid-ask spread.
In general, the bid price seems relevant only if
the holder wishes to liquidate his/her position. Although the Committee is
not largely in favor of managerial intent-based fair value measures, we are
uncomfortable with a bias toward a value-in-exchange premise for assets
in-use. If the Board decides to retain bid-based (ask-based) accounting for
dealer traded assets (liabilities) in the final standard, then we propose
that the final standard more clearly describe the conceptual basis for
liquidation basis asset and liability valuation.
Issue 9: Level 3 Estimates
Level 3 estimates require considerable judgment in
terms of both the selection and application of valuation techniques. As a
result, estimates using different valuation techniques with different
assumptions will likely yield widely varying fair value estimates. Examples
7 and 8 in Appendix B of the ED illustrate the wide variance in fair value
estimates obtained with different valuation techniques. The ED allows
considerable latitude in both the valuation technique and inputs used. Due
to their incentives, managers might use the flexibility afforded by the
proposed standard to produce biased and unreliable estimates. The
measurement guidance proposed in the ED is similar to the unstructured and
imprecise category of standards analyzed by Nelson et al. (2002). They
find that managers are more likely to attempt (and auditors are less likely
to question) earnings management under such standards compared to more
precise standards.
The income approach to determining a Level 3 fair
value estimate encompasses a basket of valuation techniques including two
different present value techniques--the discount rate adjustment technique
and the expected present value technique.4 The ED conjectures
that these two techniques should produce the same fair values (see
paragraphs A12, A13 and FN 17). But, from an application perspective, this
conjecture is not consistent with empirical results from studies of human
judgment and decision making.5 In particular, psychology
research repeatedly shows that people are very poor intuitive statisticians
(e.g., people consistently make axiomatic violations when estimating
probabilistic outcomes). In light of these findings, statements such as
"the estimated fair values should be the same" provide preparers, auditors,
and users with an unfounded (and descriptively false) belief that the
techniques suggested in the ED will produce the same fair value estimates.
Some members of the Committee believe that the ED
should explicitly caution preparers, auditors, and users by stating that
individuals consistently make these judgment errors. Further, these
Committee members recommend that the ED require companies (when practicable)
to (1) independently use the discount rate adjustment and expected
present value techniques if they decide to use a present value approach to
determine fair value and (2) reconcile the results of the two techniques in
a meaningful fashion and document the reconciliation so it can be audited
for reasonableness. Moreover, the application of the present value
techniques should be independent of suggested or existing fair value figures
when practicable (e.g., the fair value amount recorded in the previous
year's financial statements), because psychology research finds that
preconceived targets and legacy amounts unduly influence current judgments
and decisions (e.g., through "anchoring" and insufficient adjustment).
Although the disclosures required under paragraph
25 of the ED provide some information regarding the potential reliability of
a Level 3 estimate, they do not provide alternative benchmark models that
the firm may have considered in determining those fair value estimates.
Hence, the Committee also recommends that the FASB consider requiring firms
to disclose (1) fair value estimates under alternative valuation techniques,
and (2) sensitivity of fair value estimates to the specific assumptions and
inputs used.
Issue 11: Fair Value Disclosures
As mentioned previously, the Committee believes
that the proposed fair value measurement disclosures are not complete. The
Committee believes that when a firm uses alternative valuation methods to
determine fair value, information regarding the alternative techniques and
inputs employed should be provided. Furthermore, users of financial
statements would get a better understanding of the reliability of fair value
estimates if the financial statements provide detailed disclosures related
to (1) fair value estimates produced by alternative valuation techniques and
reasons for selecting a preferred estimate, and (2) information about the
sensitivity of fair value estimates to changes in assumptions and inputs.
The Committee also notes that the ED requires the
expanded set of reliability related disclosures only for fair value
estimates reported in the balance sheet (paragraph 25). A complete set of
financial statements also includes many fair value estimates reported in the
notes to the financial statements. Some members of the Committee believe
that financial statement users would also benefit from receiving the
reliability related disclosures for fair values disclosed in the footnotes.
Moreover, application of the fair value hierarchy has implications for the
reliability of the unrealized gains and losses reported in net (or
comprehensive) income. Accordingly, some members recommend that firms be
required to disclose a breakdown of unrealized gains or losses based on how
the related fair value amounts were determined (i.e., quoted prices of
identical items, quoted prices of similar items, valuation models with
significant market inputs, or valuation models with significant entity
inputs.)
CONCLUSION
The Committee supports the formulation of a single
standard that provides guidance on fair value measurement. We believe that
such a standard would improve the consistency of fair value measurement
across the many standards that require fair value reporting and disclosure.
In this comment letter, we identify some potential inconsistencies between
fair value definitions and fair value determination, and suggest ways to
improve disclosures so that users of financial statements can better
appreciate the reliability (or lack thereof) of fair value estimates.
Although the Committee recognizes that the ED is
intended to provide fair value measurement guidance, we wish to caution
against promulgating pronouncements that completely eliminate historical
cost information from the financial statements. Evidence reported in
Dietrich et al. (2000) suggests that historical cost information is
incrementally informative even after fair value information is included in
regression analyses.
4
FASB Concept Statement No. 7, Using Cash Flow Information and Present
Value in Accounting Measurements, describes these techniques, albeit
using different terminology. In that Concepts Statement, traditional
present value refers to the discount rate adjustment technique, while
expected cash flow approach refers to the expected present value technique.
5
Probability-related judgments and decisions are among the oldest branches of
psychology and decision-science research. Two excellent resources that
catalogue the problems that individuals have with probability judgments and
statistical reasoning are Baron (2000) and Goldstein and Hogarth (1997).
What are the advantages and disadvantages of requiring
fair value accounting for all financial instruments as well as derivative
financial instruments?
Advantages:
- Eliminate
arbitrary FAS 115 classifications that can be used by management to
manipulate earnings (which is what Freddie Mac did in 2001 and 1002.
- Reduce
problems of applying FAS 133 in hedge accounting where hedge accounting
is now allowed only when the hedged item is maintained at historical
cost.
- Provide a
better snap shot of values and risks at each point in time. For
example, banks now resist fair value accounting because they do not want
to show how investment securities have dropped in value.
Disdvantages:
- Combines
fact and fiction in the sense that unrealized gains and losses due to
fair value adjustments are combined with “real” gains and losses from
cash transactions. Many, if not most, of the unrealized gains and
losses will never be realized in cash. These are transitory
fluctuations that move up and down with transitory markets. For
example, the value of a $1,000 fixed-rate bond moves up and down with
interest rates when at expiration it will return the $1,000 no matter
how interest rates fluctuated over the life of the bond.
- Sometimes
difficult to value, especially OTC securities.
- Creates
enormous swings in reported earnings and balance sheet values.
- Generally
fair value is the estimated exit (liquidation) value of an asset or
liability. For assets, this is often much less than the entry
(acquisition) value for a variety of reasons such as higher transactions
costs of entry value, installation costs (e.g., for machines), and
different markets (e.g., paying dealer prices for acquisition and blue
book for disposal). For example, suppose Company A purchases a computer
for $2 million that it can only dispose of for $1 million a week after
the purchase and installation. Fair value accounting requires expensing
half of the computer in the first week even though the computer itself
may be utilized for years to come. This violates the matching principle
of matching expenses with revenues, which is one of the reasons why fair
value proponents generally do not recommend fair value accounting for
operating assets.
"Derivatives and
hedging: An Analyst's Response to US FAS 133," by Frank Will, Corporate
Finance Magazine, June 2002,
http://www.corporatefinancemag.com/pdf/122341.pdf
However, FAS 133 still needs further
clarification and improvement as the example of Fannie Mae
shows. Analysts focus more on the economic value of a company and less
on unrealised gains and losses. Much of the FAS 133 volatility in
earnings and in equity does not consistently reflect the economic
situation. This makes it difficult to interpret the figures.
Therefore, analysts welcome the decision of some companies voluntarily
to disclose a separate set of figures excluding the effect of FAS 133.
For more on Frank Will's analysis of FAS 133, Fair Value
Accounting, and Fannie Mae, go to
http://www.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's threads on accounting theory are
at
http://www.trinity.edu/rjensen/theory.htm
You can read more about fair value at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms
Forwarded on May 11, 2003 by Patrick E
Charles
[charlesp@CWDOM.DM]
Mark-to-market rule
should be written off
Richard A. Werner
Special to The Daily Yomiuri
Yomiuri
Since 1996,
comprehensive accounting reforms have been gradually introduced in Japan.
Since fiscal 2000, the valuation of investment securities owned by firms has
been based on their market value at book-closing. Since fiscal 2001,
securities held on a long-term basis also have been subjected to the
mark-to-market rule. Now, the Liberal Democratic Party is calling for the
suspension of the newly introduced rule to mark investments to market, as
well as for a delay in the introduction of a new rule that requires fixed
assets to be valued at their market value.
The proponents of
so-called global standards are up in arms at this latest intervention by the
LDP. If marking assets to market is delayed, they argue, the nation will lag
behind in the globalization of accounting standards. Moreover, they argue
that corporate accounts must be as transparent as possible, and therefore
should be marked to market as often and as radically as possible. On the
other hand, opponents of the mark-to-market rule argue that the recent slump
in the stock market, which has reached a 21-year low, can at least partly be
blamed on the new accounting rules.
What are we to make
of this debate? Let us consider the facts. Most leading industrialized
countries, such as Britain, France and Germany, so far have not introduced
mark-to-market rules. Indeed, the vast majority of countries currently do
not use them.
Nevertheless, there
is enormous political pressure to utilize mark-to-market accounting, and
many countries plan to introduce the standard in 2005 or thereafter.
Japan decided to
adopt the new standard ahead of everyone else, based on the advice given by
a few accountants--an industry that benefits from the revision of accounting
standards as any rule change guarantees years of demand for their consulting
services.
However, so far
there has not been a broad public debate about the overall benefits and
disadvantages of the new standard. The LDP has raised the important point
that such accounting changes might have unintended negative consequences for
the macroeconomy.
Let us first
reflect on the microeconomic rationale supporting mark-to-market rules. They
are said to render company accounts more transparent by calculating
corporate balance sheets using the values that markets happen to indicate on
the day of book- closing. Since book-closing occurs only once, twice or, at
best, four times a year, any sudden or temporary move of markets on these
days--easily possible in these times of extraordinary market
volatility--will distort accounts rather than rendering them more
transparent.
Second, it is not
clear that marking assets to market reflects the way companies look at their
assets. While they know that market values are highly volatile, there is one
piece of information about corporate assets that have an undisputed meaning
for
firms: the price at
which they were actually bought.
The purchase price
matters as it reflects actual transactions and economic activity. Marking to
market, on the other hand, means valuing assets at values at which they were
never transacted. The company has neither paid nor received this theoretical
money in exchange for the assets. This market value is hence a purely
fictitious value. Instead of increasing transparency, we end up increasing
the part of the accounts that is fiction.
While the history
of marking to market is brief, we do have some track record from the United
States, which introduced mark-to-market accounting in the 1990s.
Did the
introduction increase accounting transparency? The U.S. Financial Accounting
Standards Board last November concluded that the new rule of marking to
market allowed Enron Energy Services Inc. to book profits from long-term
energy contracts immediately rather than when the money was actually
received.
This enabled Enron
executives to create the illusion of a profitable business unit despite the
fact that the truth was far from it. Thanks to mark-to-market accounting,
Enron's retail division managed to hide significant losses and book billions
of dollars in profits based on inflated predictions of future energy prices.
Enron's executives received millions of dollars in bonuses when the energy
contracts were signed.
The U.S. Financial
Accounting Standards Board task force recognized the problems and has hence
recommended the mark-to-market accounting rule be scrapped. Since this year,
U.S. energy companies will only be able to report profits as income actually
is received.
Marking to market
thus creates the illusion that theoretical market values can actually be
realized. We must not forget that market values are merely the values
derived on the basis of a certain number of transactions during the day in
case.
Strictly speaking,
it is a false assumption to extend the same values to any number of assets
that were not actually transacted at that value on that day.
When a certain
number of the 225 stocks constituting the Nikkei Stock Average are traded at
a certain price, this does not say anything about the price that all stocks
that have been issued by these 225 companies would have traded on that day.
As market
participants know well, the volume of transactions is an important indicator
of how representative stock prices can be considered during any given day.
If the index falls 1 percent on little volume, this is quickly discounted by
many observers as it means that only a tiny fraction of shares were actually
traded. If the market falls 1 percent on record volume, then this may be a
better proxy of the majority of stock prices on that day.
The values at which
U.S. corporations were marked to market at the end of December 1999, at the
peak of a speculative bubble, did little to increase transparency. If all
companies had indeed sold their assets on that day, surely this would have
severely depressed asset prices.
Consider this: If
your neighbor decides to sell his house for half price, how would you feel
if the bank that gave you a mortgage argued that, according to the mark-to-
market rule, it now also must halve the value of your house--and, as a
result, they regret to inform you that you are bankrupt.
We discussed the
case of traded securities. But in many cases a market for the assets on a
company's books does not actually exist. In this case, accountants use
so-called net present value calculations to estimate a theoretical value.
This means even greater fiction because the theoretical value depends
crucially on assumptions made about interest rates, economic growth, asset
markets and so on.
Given the dismal
track record of forecasters in this area, it is astonishing to find that
serious accountants wish corporate accounts to be based on them.
There are
significant macroeconomic costs involved with mark-to-market accounting. As
all companies will soon be forced to recalculate their balance sheets more
frequently, the state of financial markets on the calculation day will
determine whether they are still "sound," or in accounting terms,
"bankrupt." While book value accounting tends to reduce volatility in
markets to some extent, the new rule can only increase it. The implications
are especially far-reaching in the banking sector since banks are not
ordinary businesses, but fulfill the public function of creating and
providing the money supply on which economic growth depends.
U.S. experts warned
years ago that the introduction of marking to market could create a credit
crunch. As banks will be forced to set aside larger loan-loss reserves to
cover loans that may have declined in value on the day of marking, bank
earnings could be reduced. Banks might thus shy away from making loans to
small or midsize firms under the new rules, where a risk premium exists and
hence the likelihood of marking losses is larger. As a result, banks would
have a disincentive to lend to small firms. Yet, for all we know, the small
firm loans may yet be repaid in full.
If banks buy a
10-year Japanese government bond with the intention to hold it until
maturity, and the economy recovers, thus pushing down bond prices
significantly, the market value of the government bonds will decline. Banks
would thus be forced to book substantial losses on their bond holdings
despite the fact that, by holding until maturity, they would never actually
have suffered any losses. Japanese banks currently have vast holdings of
government bonds. The change in accounting rules likely will increase
problems in the banking sector. As banks reduce lending, economic growth
will fall, thereby depressing asset prices, after which accountants will
quickly try to mark down everyone's books.
Of course, in good
times, the opposite may occur, as we saw in the case of Enron. During
upturns, marking to market may boost accounting figures beyond the actual
state of reality. This also will boost banks' accounts (similar to the Bank
for International Settlements rules announced in 1988), thus encouraging
excessive lending. This in turn will fuel an economic boom, which will
further raise the accounting values of assets.
Thus does it make
sense to mark everything to fictitious market values? We can conclude that
marking to market has enough problems on the micro level to negate any
potential benefits. On the macro level, the disadvantages will be far larger
as asset price volatility will rise, business cycles will be exacerbated and
economic activity will be destabilized.
The world economy
has done well for several centuries without this new rule. There is no
evidence that it will improve anything. To the contrary, it is likely to
prove harmful. The LDP must be lauded for its attempt to stop the
introduction of these new accounting rules.
Werner is an
assistant professor of economics at Sophia University and chief economist at
Tokyo-based investment adviser Profit Research Center Ltd.
Measuring the Business Value of
Stakeholder Relationships – all about social capital and how high-trust
relationships affect the bottom line. Plus a new measurement tool for
benchmarking the quality of stakeholder relationships ---
www.cim.sfu.ca/newsletter
Trust, shared
values and strong relationships aren't typical financial indicators but
perhaps they should be. A joint study by CIM and the Schulich School of
Business is examining the link between high trust stakeholder relationships
and business value creation. The study is sponsored by the Canadian
Institute of Chartered Accountants (CICA).
The research team
is looking at how social capital can be applied to business. The aim of this
project is to better understand corporate social capital, measure the
quality of relationships, and provide the business community with ways to
improve those relationships and in turn improve their bottom line.
Because stakeholder
relationships all have common features, direct comparisons of the quality of
relationships can be made across diverse stakeholder groups, companies and
industries.
Social capital is
“the stock of active connections among people; the trust, mutual
understanding, and shared values and behaviors that bind the members of
human networks and communities and make cooperative action possible” (Cohen
and Prusak, 2000).
So far the research
suggests that trust, a cooperative spirit and shared understanding between a
company and its stakeholders creates greater coherence of action, better
knowledge sharing, lower transaction costs, lower turnover rates and
organizational stability. In the bigger picture, social capital appears to
minimize shareholder risk, promote innovation, enhance reputation and deepen
brand loyalty.
Preliminary results
show that high levels of social capital in a relationship can build upon
themselves. For example, as a company builds reputation among its peers for
fair dealing and reliability in keeping promises, that reputation itself
becomes a prized asset useful for sustaining its current alliances and
forming future ones.
The first
phase of the research is now complete and the study moves into its second
phase involving detailed case studies with six companies that have earned a
competitive business advantage through their stakeholder relationships.
Click here for a full report
Bob Jensen's discussion of valuation
and aggregation issues can be found at
http://www.trinity.edu/rjensen/FraudConclusion.htm
That scenario isn't as farfetched as you might
think. It's called a prediction market, based on the notion that a marketplace
is a better organizer of insight and predictor of the future than individuals
are. Once confined to research universities, the idea of markets working within
companies has started to seep out into some of the nation's largest
corporations. Companies from Microsoft to Eli Lilly and Hewlett-Packard are
bringing the market inside, with workers trading futures contracts on such
"commodities" as sales, product success and supplier behavior. The concept: a
work force contains vast amounts of untapped, useful information that a market
can unlock. "Markets are likely to revolutionize corporate forecasting and
decision making," says Robin Hanson, an economist at George Mason University, in
Virginia, who has researched and developed markets. "Strategic decisions, such
as mergers, product introductions, regional expansions and changing CEOs, could
be effectively delegated to people far down the corporate hierarchy, people not
selected by or even known to top management."
Barbara Kiviat (See below)
"The End Of Management? by Barbara Kiviat, Time Magazine, July 12,
2004, pp. 88-92 ---
http://www.time.com/time/insidebiz/printout/0,8816,1101040712-660965,00.html
The end of management just might look something
like this. You show up for work, boot up your computer and log onto your
company's Intranet to make a few trades before getting down to work. You see
how your stocks did the day before and then execute a few new orders. You
think your company should step up production next month, and you trade on
that thought. You sell stock for the production of 20,000 units and buy
stock that represents an order for 30,000 instead. All around you, as
co-workers arrive at their cubicles, they too flick on their computers and
trade.
Together, you are buyers and sellers of your
company's future. Through your trades, you determine what is going to happen
and then decide how your company should respond. With employees in the
trading pits betting on the future, who needs the manager in the corner
office?
That scenario isn't as farfetched as you might
think. It's called a prediction market, based on the notion that a
marketplace is a better organizer of insight and predictor of the future
than individuals are. Once confined to research universities, the idea of
markets working within companies has started to seep out into some of the
nation's largest corporations. Companies from Microsoft to Eli Lilly and
Hewlett-Packard are bringing the market inside, with workers trading futures
contracts on such "commodities" as sales, product success and supplier
behavior. The concept: a work force contains vast amounts of untapped,
useful information that a market can unlock. "Markets are likely to
revolutionize corporate forecasting and decision making," says Robin Hanson,
an economist at George Mason University, in Virginia, who has researched and
developed markets. "Strategic decisions, such as mergers, product
introductions, regional expansions and changing CEOs, could be effectively
delegated to people far down the corporate hierarchy, people not selected by
or even known to top management."
To understand the hype, take a look at
Hewlett-Packard's experience with forecasting monthly sales. A few years
back, HP commissioned Charles Plott, an economist from the California
Institute of Technology, to set up a software trading platform. A few dozen
employees, mostly product and finance managers, were each given about $50 in
a trading account to bet on what they thought computer sales would be at the
end of the month. If a salesman thought the company would sell between, say,
$201 million and $210 million worth, he could buy a security — like a
futures contract — for that prediction, signaling to the rest of the market
that someone thought that was a probable scenario. If his opinion changed,
he could buy again or sell.
When trading stopped, the scenario behind the
highest-priced stock was the one the market deemed most likely. The traders
got to keep their profits and won an additional dollar for every share of
"stock" they owned that turned out to be the right sales range. Result:
while HP's official forecast, which was generated by a marketing manager,
was off 13%, the stock market was off only 6%. In further trials, the market
beat official forecasts 75% of the time.
Intrigued by that success, HP's business-services
division ran a pilot last year with 14 managers worldwide, trying to
determine the group's monthly sales and profit. The market was so successful
(in one case, improving the prediction 50%) that it has since been
integrated into the division's regular forecasts. Another division is
running a pilot to see if a market would be better at predicting the costs
of certain components with volatile prices. And two other HP divisions hope
to be using markets to answer similar questions by the end of the year. "You
could do zillions of things with this," says Bernardo Huberman, director of
the HP group that designs and coordinates the markets. "The idea of being
able to forecast something allows you to prepare, plan and make decisions.
It's potentially huge savings."
Eli Lilly, one of the largest pharmaceutical
companies in the world, which routinely places multimillion-dollar bets on
drug candidates that face overwhelming odds of failure, wanted to see if it
could get a better idea of which compounds would succeed. So last year Lilly
ran an experiment in which about 50 employees involved in drug development —
chemists, biologists, project managers — traded six mock drug candidates
through an internal market. "We wanted to look at the way scattered bits of
information are processed in the course of drug development," says Alpheus
Bingham, vice president for Lilly Research Laboratories strategy. The market
brought together all the information, from toxicology reports to clinical
results, and correctly predicted the three most successful drugs.
What's more, the market data revealed shades of
opinion that never would have shown up if the traders were, say, responding
to a poll. A willingness to pay $70 for a particular drug showed greater
confidence than a bid at $60, a spread that wouldn't show if you simply
asked, Will this drug succeed? "When we start trading stock, and I try
buying your stock cheaper and cheaper, it forces us to a way of agreeing
that never really occurs in any other kind of conversation," says Bingham.
"That is the power of the market."
The current enthusiasm can be traced in part, oddly
enough, to last summer's high-profile flop of a market that was supposed to
help predict future terrorist attacks. A public backlash killed that
Pentagon project a few months before its debut, but not before the media
broadcast the notion that useful information embedded within a group of
people could be drawn out and organized via a marketplace. Says George
Mason's Hanson, who helped design the market: "People noticed." Another
predictive market, the Iowa Electronic Markets at the University of Iowa,
has been around since 1988. That bourse has accepted up to $500 from anyone
wanting to wager on election results. Players buy and sell outcomes: Is
Kerry a win or Bush a shoo-in? This is the same information that news
organizations and pollsters chase in the run-up to election night. Yet Iowa
outperforms them 75% of the time.
Inspired by such results, researchers at Microsoft
started running trials of predictive markets in February, finding the system
inexpensive to set up. Now they're shopping around for the market's first
real use. An early candidate: predicting how long it will take software
testers to adopt a new piece of technology. Todd Proebsting, who is
spearheading the initiative, explains, "If the market says they're going to
be behind schedule, executives can ask, What does the market know that we
don't know?" Another option: predicting how many patches, or corrections,
will be issued in the first six months of using a new piece of software.
"The pilots worked great, but we had little to compare it to," he says. "You
can reason that this would do a good job. But what you really want to show
is that this works better than the alternative."
Ultimately, "you may someday see someone in a desk
job or a manufacturing job doing day trading, knowing that's part of the
job," says Thomas Malone, a management professor at M.I.T. who has written
about markets. "I'm very optimistic about the long-term prospects."
But no market is perfect. Economists are still
unsure of the human factor: how to get people to play and do their best. In
the stock market or even the Iowa prediction market, people put up their own
money and trade to make more. That incentive ensures that people trade on
their best information. But a company that asks employees to risk their own
money raises ethical questions, so most corporate markets use play money to
trade and small bonuses or prizes for good traders. "Though this may look
like God's gift to business, there are problems with it," says Plott, who
ran the first HP experiments. Tokyo-based Dentsu, one of the world's largest
advertising firms, is still grappling with incentives for an ad forecasting
market it will launch later this year with the help of News Futures, a U.S.
consultancy.
And even if companies can figure out how to make
their internal markets totally efficient, there are plenty of reasons that
corporate America isn't about to jump wholesale onto the markets bandwagon.
For one thing, markets, based on individuals and individual interests, could
threaten the kind of team spirit that many corporations have struggled to
cultivate. Established hierarchies could be threatened too. After all, a
market implies that the current data crunching and decision-making process
may not be as good as a gamelike system that often includes lower-level
employees. In a sense, an internal market's success suggests that if upper
managers would just give up control, things would run better. Lilly, which
is considering using a market to forecast actual drug success, is still
grappling with the potential ramifications. "We already have a rigorous
process," says Lilly's Bingham. "So what do you do if you use a market and
get different data?" Throw it out? Or say that the market was smarter,
impugning the tried-and-true system?
There could be risks to individual workers in an
internal trading system as well. If you lose money in the market, does that
mean you're not knowledgeable about something you should be? "You have to
get people used to the idea of being accountable in a very different way,"
says Mary Murphy-Hoye, senior principal engineer at Intel, which has been
experimenting with internal markets. "I can now tell if planners are any
good, because they're making money or they're not making money."
Continued in article
Robert Walker's First Blog Entry is About Fair Value Accounting,
October 27, 2006 ---
http://www.robertbwalkerca.blogspot.com/
Introduction
I have decided to begin a commentary which expresses my views on
accounting. As I begin to do this I envisage the source of my
commentary to comprise three different sorts of writing in which I
may engage:
§ Simple notes directly to the ‘blog’ such as this.
§ Formal submissions I may make to various bodies including the IASB.
§ Letters or reports I may write for one reason or another that I
think might have some general readership.
The expression of my views will stray from the subject matter of
accounting per se to deal with matters of enormous significance to
me such as corporate or public administration. Such expressions will
not be too substantial a digression from the core subject matter
because I believe that the foundation of good ‘corporate
governance’, to use a vogue term, is accounting.
Source of my ideas on accounting
I would have to confess that the foundation upon which I base my
philosophy of accounting is derivative, as much of human knowledge
is of course. It is not for nothing that Newtown said that if he can
see so far it is because he stands on the shoulders of giants. In my
case, that ‘giant’ is Yuiji Ijiri. As I begin a detailed exposition
of my views I shall return to the lessons I learned many years ago
from Theory of Accounting Measurement, a neglected work that will
still be read in 1,000 years or so long as humankind survives
whichever is the shorter. As the depredations of the standard
setting craze are visited upon us with ever increasing complexity,
the message delivered by Ijiri will be heeded more an more.
The basic structure of accounting
Without wishing to be too philosophical about it, I need to begin by
outlining what I mean by accounting. Accounting, in my mind,
comprises three inter-related parts. These are:
§ Book-keeping.
§ Accounting.
§ Financial reporting.
Book-keeping is the process of recording financial data elements in
the underlying books of account. These financial data elements
represent, or purport to represent, real world events. The heart of
book-keeping is the double entry process. For instance at the most
basic level a movement in cash will result in the surrender or
receipt of an asset, the incurring or settlement of a liability and
so on.
I have no complete and coherent theory of the limits of
book-keeping. Clearly cash movement (change of ownership) or the
movement of commodity is the proper subject matter of book-keeping.
Whether all forms of contract should be similarly treated is not
clear to me. I am inclined to say yes. That is to adopt Ijiri’s
theory of commitment accounting, but I can foresee that this leads
me to conclusions that I may find unpalatable later on. Incidentally
I say this because an epiphany I had, based on the notion of
commitment accounting, some years ago is beginning to unravel.
Book-keeping goes beyond recording to encompass control. That is the
process by which the integrity of the centre piece of book-keeping –
the general ledger expressing double entry – is ensured. I will not
concern myself with such processes though this is not to say that
they are unimportant.
Accounting is the process by which sense is made of what is a raw
record expressed in the general ledger. It is the process of
distillation and summation that enables the accountant to gain on
overview of what has happened to the entity the subject of the
accounting. Accounting fundamentally assumes that the accountant is
periodically capable of saying something useful about the real world
using his or her special form of notation.
Financial reporting is the process by which data is assembled into a
comprehensive view of the world in accordance with a body of rules.
It differs, in the ideal, from accounting in a number of ways. Most
benignly it differs, for instance, by including ancillary
information for the benefit of a reader beyond the mere abstraction
from the general ledger. Again in the ideal there is an
inter-relationship between the three levels in the accounting
hierarchy. That is, the rules of financial reporting will, to some
degree shape the order and format of the basic, book-keeping level
so that the process of distillation and summation follows naturally
to the final level of reporting without dramatic alteration.
Perhaps what concerns me is that the sentiment expressed above can
be seen, without much effort, to be only ideal and that in reality
it does not arise. In short the golden strand that links the
detailed recording of real world phenonmena to its final summation
is broken.
An example
I was asked recently by a student of accounting to explain IAS 41,
the IASB standard on agriculture. As I don’t deal in primary
production at all, I had not thought about this subject for years.
IAS 41 admonishes the accountant to apply ‘fair value’ accounting.
Fair value accounting is the process by which current sale prices,
or their proxies, are substituted for the past cost of any given
item.
For instance, you may have a mature vineyard. The vineyard comprises
land, the vine and its fruit, the plant necessary to sustain the
vine (support structures, irrigation channels etc.). Subsumed within
the vine are the materials necessary for it to grow and start
producing fruit. This will include the immature plant, the chemical
supplements necessary to nurture and protect it, and the labour
necessary to apply it.
The book-keeping process will faithfully record all of these
components. Suppose for example the plant, fertliser and labour cost
$1000. In the books will be recorded:
Dr Vineyard $1000
Cr Cash $1000
At the end of the accounting period, the accountant will summarise
this is a balance statement. He or she will then obtain, in some
way, the current selling price of the vine. Presumably this will be
the future cash stream of selling the fruit, suitably discounted.
Assume that this is $1200.
The accountant will then make the following incremental adjustment:
Dr Vineyard $200
Cr Equity $200
Looked like this there is a connection between the original
book-keeping and the periodic adjustment at the end of the
accounting period. This is an illusion. The incremental entry
disguises what is really happening. It is as follows:
Dr Equity $1000
Cr Vineyard $1000
And
Dr Vineyard $1200
Cr Equity $1200
Considered from the long perspective, the original book-keeping has
been discarded and a substitute value put in its place. This is the
truth of the matter. The subject matter of the first phase of
accounting was a set of events arising in a bank and in the entity
undertaking accounting. The subject matter of the second phase is a
set of future sales to a party who does not yet exist.
From a perspective of solvency determination, a vital element of
corporate governance, the view produced by the first phase is next
to useless. However, the disquiet I had in my mind which I had
suppressed until recently, relates to the shattering of the linkages
between the three levels of accounting in the final reporting
process. This disquiet has returned as I contemplate the apparently
unstoppable momentum of the standard setting process.
October 28, 2006 reply from Bob Jensen
Hi Robert,
I hope you add many more entries to your blog.
The problem with "original book-keeping" is that it provides
no answers about how to account for risk of many modern day contracts that
were not imagined when "original book-keeping" evolved in a simple world of
transactions. For example, historical costs of forward contracts and swaps
are zero and yet these contracts may have risks that may outweigh all the
recorded debt under "original book-keeping." Once we opened the door to fair
value accounting to better account for risk, however, we opened the door to
misleading the public that booked fair value adjustments can be aggregated
much like we sum the current balances of assets and liabilities on the
balance sheet. Such aggregations are generally nonsense.
I don't know if you saw my recent hockey analogy or not. It
goes as follows:
Goal Tenders versus Movers and Shakers
Skate to where the puck is going, not to where it is.
Wayne Gretsky (as quoted for many years by Jerry Trites at
http://www.zorba.ca/ )
Jensen Comment
This may be true for most hockey players and other movers and shakers, but
for goal tenders the eyes should be focused on where the puck is at every
moment --- not where it's going. The question is whether an accountant is a
goal tender (stewardship responsibilities) or a mover and shaker (part of
the managerial decision making team). This is also the essence of the debate
of historical accounting versus pro forma accounting.
Graduate student Derek Panchuk and professor
Joan Vickers, who discovered the Quiet Eye phenomenon, have just completed
the most comprehensive, on-ice hockey study to determine where elite goalies
focus their eyes in order to make a save. Simply put, they found that
goalies should keep their eyes on the puck. In an article to be published in
the journal Human Movement Science, Panchuk and Vickers discovered that the
best goaltenders rest their gaze directly on the puck and shooter's stick
almost a full second before the shot is released. When they do that they
make the save over 75 per cent of the time.
"Keep your eyes on the puck," PhysOrg, October 26,
2006 ---
http://physorg.com/news81068530.html
I have written a more serious piece about both theoretical
and practical problems of fair value accounting. I should emphasize that
this was written after the FASB Exposure Draft proposing fair value
accounting as an option for all financial instruments and the culminating
FAS 157 that is mainly definitional and removed the option to apply fair
value accounting to all financial instruments even though it is still
required in many instances by earlier FASB standards.
My thoughts on this are at the following link:
http://www.trinity.edu/rjensen/FairValueDraft.htm
Bob Jensen
E-COMMERCE AND AUDITING FAIR VALUES SUBJECTS OF NEW INTERNATIONAL GUIDANCE
The International Federation of Accountants (IFAC) invites comments on two new
exposure drafts (EDs): Auditing Fair Value Measurements and Disclosures and
Electronic Commerce: Using the Internet or Other Public Networks - Effect on the
Audit of Financial Statements. Comments on both EDs, developed by IFAC's
International Auditing Practices Committee (IAPC), are due by January 15, 2002.
See
http://accountingeducation.com/news/news2213.html
The IFAC link is at
http://www.ifac.org/Guidance/EXD-Download.tmpl?PubID=1003772692151
The purpose of this International Standard on Auditing (ISA) is to
establish standards and provide guidance on auditing fair value measurements
and disclosures contained in financial statements. In particular, this ISA
addresses audit considerations relating to the valuation, measurement,
presentation and disclosure for material assets, liabilities and specific
components of equity presented or disclosed at fair value in financial
statements. Fair value measurements of assets, liabilities and components of
equity may arise from both the initial recording of transactions and later
changes in value.
The Expectations Gap Between Professional Valuation Versus
What Students Learn in College
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.
Introduction
to Valuation
Bob Jensen's site on The Controversy Over Fair Value
(Mark-to-Market) Financial Reporting ---
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Damodaran Online: A Great Sharing Site from a Finance Professor at New
York University and Textbook Writer ---
http://pages.stern.nyu.edu/%7Eadamodar/
This site has great sections on corporate finance, investments, valuation,
spreadsheets, research, etc. For example, take a look at the helpers on
valuation ---
http://pages.stern.nyu.edu/%7Eadamodar/
You can pick the valuation approach that you would like to go to, to see
illustrations, solutions and other supporting material.
| |
|
| |
Discounted Cashflow Valuation |
| |
Relative Valuation |
| |
Option Pricing Approaches to Valuation |
| |
Acquisition Valuation |
| |
EVA, CFROI and other Value Enhancement Strategies |
Or you can pick the material that you are interested in.
| |
|
|
|
| Spreadsheets |
Overheads |
Datasets |
References |
| Problems & Solutions |
Derivations and Discussion |
Valuation Examples |
PowerPoint presentations |
Jim Mahar's finance sharing site (especially note his great blog link)
---
http://financeprofessor.com/
Financial Rounds from an anonymous finance professor ---
http://financialrounds.blogspot.com/
Bob Jensen's finance and investment helpers are at
http://www.trinity.edu/rjensen/Bookbob1.htm
GAAP = Generally Accepted Accounting
Principles (including rules, laws, and conventional practices)
This definition is needed for the quote below, which is in the context of
U.S. GAAP rather than international GAAP.
The other
lesson, perhaps even more tallied, GAAP should be on everyone's Top 10 list.
The idea of GAAP -- so simple yet so radical -- is that tore important, is
contained in the embrace of GAAP. When the intellectual achievements of the
20th century here should be a standard way of accounting for profit and loss
in public businesses, allowing investors to see how a public company manages
its money. This transparency is what allows investors to compare businesses as
different as McDonald's, IBM and Tupperware, and it makes U.S. markets the
envy of the world.
Clay Shirky in "How Priceline Became A Real Business," The Wall
Street Journal, August 13, 2001
http://interactive.wsj.com/archive/retrieve.cgi?id=SB99765488066568057.djm&template=pasted-2001-08-13.tmpl
"The future of the accounting and finance profession is
changing daily. Tomorrow's accounting and finance professionals will shatter
longstanding stereotypes as they shift from being backroom statisticians to
boardroom strategists." http://www.accountingweb.com/item/50518
(See below)
If one were writing a history of the American capital market, it is a
fair bet that the single most important innovation shaping that market was the
idea of generally accepted accounting principles.
Lawrence Summers, President of Harvard University
and former Secretary of Treasury
AICPA’s Business Valuation and Forensic & Litigation Services Community ---
http://bvfls.aicpa.org/
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
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 
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
Question
At this juncture why would IBM spend almost $10 billion for its own shares?
Hint
The wildly-popular eps ratio has a denomator.
"IBM to spend $5 billion more on stock buyback," MIT's Technology Review,
October 27, 2009 ---
http://www.technologyreview.com/wire/23815/?nlid=2465
IBM Corp. has boosted its stock buyback program by
$5 billion, a sign of the company's ability to spit out cash despite the
fact the recession has choked off revenue growth.
The announcement Tuesday brings IBM's pot for stock
repurchases to $9.2 billion, and the company, based in Armonk, N.Y., plans
to ask for more at a board meeting in April 2010. IBM said it has spent $73
billion on dividends and buybacks since 2003.
Buybacks are one lever companies pull to meet
earnings targets, since they increase earnings per share by reducing the
number of shares outstanding. IBM has set aggressive earnings targets, and
twice this year raised its profit forecast for 2009, surprising investors
since revenue has fallen since last year. IBM has said it sees corporate
spending on technology "stabilizing." One way IBM wrings more profit despite
lower sales is by using software to automate certain tasks done by humans
and focusing on projects like the "smart" power grid that can carry higher
profit margins than other services work.
IBM's current forecasts call for earnings per share
of at least $9.85 this year, and the company has maintained that it is "well
ahead" of its pace for 2010 earnings of $10 to $11 per share.
IBM ended the third quarter with $11.5 billion in
cash. Free cash flow, a sign of a company's ability to generate more cash,
was $3.4 billion, up $1.3 billion from a year ago. Revenue in the past nine
months is down nearly 11 percent from a year ago.
Quality of Earnings Disputes ---
http://www.trinity.edu/rjensen/theory01.htm#CoreEarnings
Bob Jensen's threads on accounting theory ---
http://www.trinity.edu/rjensen/theory01.htm
"Among Different Classes of Equity: Valuation models can be tailored
to unique financing structures." by Andrew C. Smith and Jason C. Laurent,
Journal of Accouintancy, March 2008 ---
http://www.aicpa.org/pubs/jofa/mar2008/allocating_value.htm
EXECUTIVE SUMMARY
It is essential for board members, executive officers, CFOs, auditors and
private equity investors to comprehend option-pricing models used to
determine the per-share values of common and preferred shares.
The AICPA Practice Aid, Valuation of
Privately-Held-Company Equity Securities Issued as Compensation, describes
three methods of allocating value between preferred and common equity, which
include:
Current Value Method (“CVM”) Probability Weighted
Expected Return Method (“PWERM”) Option-Pricing Method (“OPM”)
OPM, which is based on the Black-Scholes model, is
a common method for allocating equity value between common and preferred
shares.
Valuation models must be tailored to the specific
facts and circumstances of the equity in the company being valued.
Bob Jensen's threads on fair value accounting are at
http://www.trinity.edu/rjensen/Theory01.htm#FairValue
They
Do It With Mirrors --- GAAP Does Not "Cover" the entire
GAP
An Analogy Between GAAP and the GAP in a Woman's Dress or Skirt
So what is wrong with GAAP in recent years? GAAP's problems are somewhat
like a "GAP" incident that took place in a Target Store (the story
would have been better had it been inside a GAP Store) in San Antonio on August
21 (as reported on a local television
station). A man with a mirror was detained for peeking up the "GAP"
beneath women's dresses. Although he was tossed out of the store, this
pervert was
not arrested. The police claimed they had nothing to charge him with,
because there was no U.S. or Texas law against peeking beneath a woman's dress with a
mirror. Laws are enforced better in the U.S. than in many other nations, but the laws are
incomplete for many types of egregious behavior. In an analogous manner, GAAP
is enforced better in the U.S. than in most other nations, but U.S. GAAP is incomplete and does not control certain types of egregious
financial reporting
behavior that is becoming increasingly common in the "New Economy" ---
where intangible assets that are not measured well under GAAP comprise an
increasing proportion of the value and earnings of business firms. In some
ways, business firms are trying to "Do It With Mirrors," thereby,
causing a widening "GAP" in "GAAP." I will now give you
the WSJ quotation:
But there's a catch. In recent years, P/E ratios have
become increasingly polluted. The "E" in P/E used to refer simply to
earnings as reported under generally accepted accounting principles, or GAAP.
That's what it means when the historical average is cited. But in First Call's
figure, the "E" relates to something fuzzier, called "operating
earnings." And that can mean just about whatever a company wants it to
mean.
Based on earnings as reported under GAAP, the S&P
500 actually finished last week with a P/E ratio of 36.7, according to a Wall
Street Journal analysis. That is higher than any other P/E previously recorded
for the index. (Click
here to see
details of the calculation.)
This suggests the overall stock market could be
further from recovery than many suppose. "I don't think most people
realize that the market is as overvalued as it is," says David Blitzer,
chief investment strategist at S&P, a unit of McGraw-Hill Cos. "There
probably are a lot of people who would sell some stock if they realized how
overvalued the numbers are saying the market is."
Jonathan Weil, "Companies Pollute Earnings Reports, Leaving P/E Ratios
Hard to Calculate," The Wall Street Journal, August 21, 2001, Page
A1. For details and related articles, see http://www.trinity.edu/rjensen/roi.htm
What we teach just won't float?
Quite a few of you out there, like me, are trying to teach analysis of
financial statements and business analysis and valuation from books like Penman
or Palepu,
Healy, and Bernard. The current task of valuing MCI illustrates
how frustrating this can be in the real world and how financial statement
analysis that we teach, along with the revered Residual Income and Free Cash
Flow Models, are often Titanic tasks in rearranging the deck chairs on sinking
models. If you've not attempted valuations with these models I suggest
that you begin with my favorite case study:
"Questrom vs. Federated Department
Stores, Inc.: A Question of Equity Value," May 2001 edition of
Issues in Accounting Education, by University of Alabama faculty members Gary
Taylor, William Sampson, and Benton Gup, pp. 223-256.
In spite of all the sophistication in
models, it is ever so common for intangibles and forecasting problems to sink
the valuation models we teach. I have more to say about intangibles at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
A question I always ask my students
is: What is the major thing that has to be factored in when valuing
Microsoft Corporation?
The answer I'm looking for is certainly
not product innovation or something similar to that. The answer is also
not customer loyalty, although that probably is a huge factor. The big
factor is the massive cost of retraining the entire working world in something
that replaces MS Office products (Excel, Word, PowerPoint, Outlook, etc.).
It simply costs too much to retrain workers in MS Office substitues even if we
are so sick of security problems in Micosoft's systems. How do you
factor this "customer lock-in" into a Residual Income or FCF
Model? Our models are torpedoed by intangibles in the real world.
MCI's customer base is another torpedo
for valuation models. Here the value seems to lie in a "web of
corporate customers." And nobody seems to be able to value that.
"Valuing MCI in an Industry Awash in Questions," by Matt Richtel, The
New York Times, February 9, 2005 --- http://www.nytimes.com/2005/02/09/business/09phone.html
Industry bankers and accountants are trying to answer
just that: What is the value of MCI, a company for which Qwest Communications
has already made a tentative offer of about $6.3 billion, and on which Verizon
Communications has been running the numbers. Conversations between MCI and
Qwest have been suspended since late last week, and Verizon has yet to make a
formal offer, people close to the negotiations say.
Most analysts say MCI's extensive network assets in
this country and Europe may have diminishing value because of the industry's
continued capacity glut. Instead, they say, MCI's
worth lies more in its web of corporate customers.
But as MCI's revenue continues to tumble, the real
trick for the accountants is trying to forecast the future. Can the company meet
its stated goal of achieving profitable growth as a telecommunications company
emphasizing Internet technology before the bottom falls out of its traditional
voice and data business?
Continued in article
Bob Jensen's threads on intangibles are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
What we teach just won't float?
Quite a few of you out there, like me, are trying to teach analysis of
financial statements and business analysis and valuation from books like Penman
or Palepu,
Healy, and Bernard. The current task of valuing Amazon illustrates
how frustrating this can be in the real world and how financial statement
analysis that we teach, along with the revered Residual Income and Free Cash
Flow Models, are often Titanic tasks in rearranging the deck chairs on sinking
models.
From The Wall Street Journal Accounting Weekly Review on
February 11, 2005
TITLE: Amazon's Net Is Curtailed by Costs
REPORTER: Mylene Mangalindan
DATE: Feb 03, 2005
PAGE: A3
LINK: http://online.wsj.com/article/0,,SB110735918865643669,00.html
TOPICS: Financial Accounting, Financial Statement Analysis, Income Taxes,
Managerial Accounting, Net Operating Losses
SUMMARY: Amazon "...had forecast that profit margins would rise in the
fourth quarter, while Wall Street analysts had expected margins to remain about
the same." The company's operating profits fell in the fourth quarter from
7.9% of revenue to 7%. The company's stock price plunged "14% in
after-hours trading."
QUESTIONS:
1.) "Amazon said net income rose nearly fivefold, to $346.7 million, or 82
cents a share, from $73.2 million, or 17 cents a share a year earlier." Why
then did their stock price drop 14% after this announcement?
2.) Refer to the related article. How were some analysts' projections borne
out by the earnings Amazon announced?
3.) One analyst discussed in the related article, Ken Smith, disagrees with
the majority of analysts' views as discussed under #2 above. Do you think that
his viewpoint is supported by these results? Explain.
4.) Summarize the assessments made in answers to questions 2 and 3 with the
way in which Amazon's operating profits as a percentage of sales turned out this
quarter.
5.) Amazon's results "included a $244 million gain from tax benefits,
stemming from Amazon's heavy losses earlier in the decade." What does that
statement say about the accounting treatment of the deferred tax benefit for
operating loss carryforwards when those losses were experienced? Be specific in
describing exactly how these tax benefits were accounted for.
6.) Why does Amazon adjust out certain items, including the tax gain
described above, in assessing their earnings? In your answer, specifically state
which items are adjusted out of earnings and why that adjustment might be made.
What is a general term for announcing earnings in this fashion?
Reviewed By: Judy Beckman, University of Rhode Island
--- RELATED ARTICLES ---
TITLE: Web Sales' Boom Could Leave Amazon Behind
REPORTER: Mylene Mangalindan
ISSUE: Jan 21, 2005
LINK: http://online.wsj.com/article/0,,SB110627113243532202,00.html
Bob Jensen's threads on intangibles are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes
An Exercise in Valuation
"Putting a Value on Google,"
by Scott Kessler, Business Week, June 11, 2004 --- http://www.businessweek.com/investor/content/jun2004/pi20040611_9275_pi076.htm
S&P
takes a hard look at the search giant's fundamentals -- and at the valuations of
its peers -- to find an answer
Amid an enormous level of interest in the Google IPO -- from investors, the
media, and seemingly every other person you talk to at cocktail parties -- we at
Standard & Poor's Equity Research Services decided to take an unbiased look
at the company and its competitive position (see BW Online, 6/11/04, "Google:
What Lies Beyond Search?"), including commissioning a proprietary
survey of Internet users (see BW Online, 6/14/04, "Search
Users Weigh In on Google").
Continued in the article
There is a link to Banister
Financial where you can find some tips of valuation and valuation
frauds.
"Independent" Auditors: Are They Becoming Dependents?
In recent years, a
dramatic increase in the revenues big accounting firms derive from management
consulting services has raised a red flag about auditor independence. The Wall
Street Journal reported in April, for example, that just last year Sprint paid
Ernst & Young $2.5 million for auditing but $63.8 million for other work,
including $12 million for the deployment of a financial-information system.
General Electric paid KPMG $24 million for auditing but more than three times
that for other services.
Study Finds Consulting Contracts Impair Auditor Objectivity --- http://www.smartpros.com/x30693.xml
"What's the Investment Really Worth?" by Ann Grimes, The Wall
Street Journal, December 3, 2003 --- http://online.wsj.com/article/0,,SB107041216487726000,00.html?mod=mkts%5Fmain%5Fnews%5Fhs%5Fh
In Venture-Capital World, 'Standard Valuation' Rules
Could Clear Up Questions
In a sign that the private-equity world may be
starting to feel the impact of corporate reorganization, an industry group
Tuesday unveiled a set of guidelines aimed at standardizing the way private
companies are valued.
The move by a self-appointed but influential
coalition, the Private Equity Industry Guidelines Group, comes in response to
pressure for more transparency and consistency in valuing private-equity
investments -- the business of corporate buyouts and venture capital.
Historically, private-equity-investment valuations have been as much art as
science, sometimes creating a scattering of valuations among firms holding the
same investments.
It is far from clear what impact the proposals will
have on venture-capital and buyout funds, which hold billions of dollars in
investments in closely held companies. The proposals are voluntary, and some
top-tier investors said the recommendations, while welcome, wouldn't affect
their funding choices. And the industry's National Venture Capital Association
has yet to endorse the proposals.
Still, the collapse of the technology sector has
prompted investors in venture-capital funds -- which include wealthy
individuals, college endowments and pension funds -- to express concerns that
those funds failed to reflect potentially big losses in their investment
portfolios.
The guidelines, hammered out after a year of debate,
were endorsed by 15 of the 18 firms represented on the PEIGG board, including
HarborVest Partners LLC, Bank of America Corp. and the University of
California Regents. The three other firms are expected to offer their
endorsement shortly, the group said.
"A common valuation system agreed on by both
limited and general partners is an important step in the growth and maturation
of the private-equity industry," said PEIGG Chairman William Franklin,
managing director, Bank of America Capital Corp.
Under the standards, venture-capital, leverage-buyout
and other private-equity firms will be encouraged to adhere to a
"fair-market value" approach consistent with generally accepted
accounting principles when determining the value of private companies.
The drive for standardization stems in part from the
sometimes wildly different values recorded for similar investments. A case in
point: Santera Systems, Inc. Last year, The Wall Street Journal reported that
the same series of preferred stock in the Texas-based telecommunications firm
was being valued at $4.42 a share by Austin Ventures at the same time that
Sequoia Capital held it at 46 cents a share.
Fair value is defined by the U.S. accounting industry
as "the amount at which an investment could be exchanged in a current
transaction between unrelated willing parties, other than in a forced
liquidation sale," the group said.
Currently, many private-equity industry-fund managers
rely on historic cost as an approximation of fair-market value. While that may
be a reliable estimate in the short run, at some point, "cost or the
latest round of financing becomes less reliable as an approximation of fair
value," the PEIGG guidelines say.
The PEIGG guidelines recommend fund managers update
the value of their portfolios on a quarterly basis, and review them rigorously
at least once a year. They also recommend the establishment of valuation
committees composed of investors to calculate valuations using a common
methodology, an effort to minimize fund-manager bias.
"If you don't have standards, it's difficult to
compare apples to apples," says Rick Hayes, senior investment officer at
the California Employees' Retirement System, the nation's largest public
pension fund, which is in more than 360 limited partnerships. Mr. Hayes, who
is involved with another industry group, the Institutional Limited Partners
Association, has reviewed the guidelines and says he is supportive of the
effort.
Another source of pressure: fear of government
regulation. "When I reflect back on when the group was formed in the
fourth quarter of 2001, back then we were being bombarded with news of one
corporate scandal after another in the public sector," Mr. Franklin said
in an interview. "We felt at the time the government or regulators were
going to potentially step in once they got done with our public brethren. That
clearly was one of the motivating factors in developing guidelines."
The recommendations will allow private-equity firms
to periodically "write up" investments carried on their books at
lower-than-market costs. While general partners were slow to write down
losses, they are hesitant to mark them up. "That gives a very slanted
view of the portfolio," Mr. Franklin says.
At Calpers, Mr. Hayes, referring to a quickly
appreciating investment, says: "The accuracy of that number is very
important." That is because the way private equity works it can affect
how much of the profit distribution goes to a general partner versus a limited
partner. It can affect the LP's assessment of its own portfolio status. And it
can affect the price that an LP may able to get if they wanted to sell its
interest in the fund.
Jim Breyer, managing partner at Accel Partners in
Palo Alto, Calif., says the guidelines are "a move in the right
direction," though he is doubtful about adopting them in full. He says he
supports more consistency because "there still are a number of firms who
don't write down aggressively enough."
The next step for PEIGG is to send out their proposal
for more feedback from, and it is hoped endorsements by, other industry
groups, some of whom -- including ILPA and the Association for Investment
Management and Research -- are considering guidelines of their own.
How P/E Ratios Are Figured --- http://interactive.wsj.com/archive/retrieve.cgi?id=SB998339424717089333.djm&template=pasted-2001-08-21.tmpl#DETAILS
How the P/E Ratios Are Figured
|
To calculate the price-to-earnings ratio for the Standard &
Poor's 500-stock index, The Wall Street Journal divided the combined
market capitalization of the 500 companies currently in the index by
their most recently reported four quarters of earnings. These earnings
exclude only items classified under generally accepted accounting
principles as extraordinary items, discontinued operations or cumulative
effects of changes in accounting principles.
This methodology differs slightly from the one used by S&P, which
updates earnings statistics for the index just once a quarter. S&P
doesn't revise earnings from previously reported quarters to account for
additions or deletions to the index. And it historically hasn't revised
previously reported earnings to account for companies' financial
restatements. The Journal's calculations show a trailing P/E of 36.7 as
of Friday. S&P may report a somewhat lower P/E ratio when it
releases its second-quarter earnings tally, depending on how it handles
JDS Uniphase. JDS has announced a $50.6 billion loss for its fiscal year
ended June 30. But JDS said it would restate results for the March 31
quarter so that most of the loss appears in that quarter, not in the
June quarter. S&P has been considering revising its first-quarter
earnings figures to reflect JDS's restated losses, but hasn't announced
a decision.
The Journal used data from Multex.com Inc. as well as companies' news
releases and filings with the Securities and Exchange Commission. The
P/E ratios in the Journal's daily stock-price tables are calculated
using trailing earnings, excluding extraordinary items, accounting
changes and discontinued operations. |
Operating Earnings vs. Reality
Companies increasingly announce earnings on a 'pro forma' or 'operating'
basis, excluding various charges that are ordinary expenses under
generally accepted accounting principles (GAAP). The top chart shows how
10 companies reported their most recent quarterly earnings, compared
with their net income.
Sources: company news releases; Thomson Financial/First Call |
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
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.
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.
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.
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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
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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:
- On Oct. 25, 1999,
Trump Hotels issued a press release announcing its quarterly results. The
release used net income and earnings-per-share (EPS) figures that differed
from net income and EPS calculated in conformity with generally accepted
accounting principles (GAAP), in that the figures expressly excluded a
one-time charge. The earnings release was fraudulent because it created
the false and misleading impression that the Company had exceeded earnings
expectations primarily through operational improvements, when in fact it
had not.
- The release
expressly stated that net income and EPS figures excluded a $81.4 million
one-time charge. Although neither the earnings release nor the
accompanying financial data used the term pro forma, the net income and
EPS figures used in the release were pro forma numbers because they
differed from such figures calculated in conformity with GAAP by excluding
the one-time charge. By stating that this one-time charge was excluded
from its stated net income, the Company implied that no other significant
one-time items were included in that figure.
- Contrary to the
implication in the release, however, the stated net income included an
undisclosed one-time gain of $17.2 million. The gain was the result of the
termination, in September 1999, of the All Star Café's lease of
restaurant space at the Trump Taj Mahal Casino Resort in Atlantic City.
Trump Hotels, through various subsidiaries, owns and operates the Taj
Mahal and other casino resorts. The Company's executive offices are in New
York City, and its business and financial operations are centered in
Atlantic City.
- Not only was
there no mention of the one-time gain in the text of the release, but
the financial data included in the release gave no indication of it,
because all revenue items were reflected in a single line item.
- The misleading
impression created by the reference to the exclusion of the one-time
charge and the undisclosed inclusion of the one-time gain was reinforced
by the comparison in the earnings release of the stated earnings-per-share
figure with analysts' earnings estimates and by statements in the release
that the Company been successful in improving its operating performance.
Using the non-GAAP, pro forma figures, the release announced that the
Company's quarterly earnings exceeded analysts' expectations, stating:
Net income
increased to $ 14.0 million, or $ 0.63 per share, before a one-time
Trump World's Fair charge, compared to $ 5.3 million or $ 0.24 per share
in 1998. [Trump Hotels'] earnings per share of $ 0.63 exceeded First
Call estimates of $ 0.54.
In addition, the
release quoted Trump Hotels' chief executive officer as attributing the
stated positive results and improvement from third-quarter 1998 to
improvements in the Company's operations.
- In fact, had the
one-time gain been excluded from the quarterly pro forma results as well
as the one-time charge, those results would have reflected a decline in
revenues and net income and would have failed to meet analysts'
expectations. The undisclosed one-time gain was thus material, because it
represented the difference between positive trends in revenues and
earnings and negative trends in revenues and earnings, and the difference
between exceeding analysts' expectations and falling short of them.
- On Oct. 25, the
day the earnings release was issued, the price of the Company's stock rose
7.8 percent; subsequently, analysts learned of the one-time gain. On Oct.
28, the day on which an analysts' report and a news article revealing the
impact of the one-time gain were published, the stock price fell
approximately 6 percent.
The Commission found
that Trump Hotels violated Section 10(b) of the Exchange Act and Rule 10b-5
thereunder. The Company was ordered to cease and desist from violating those
provisions.
For information about
the use and interpretation of pro forma financial information, see the
cautionary advice for companies and their advisors at http://www.sec.gov/news/headlines/proforma-fin.htm
and the investor alert recently issued by the Commission at http://www.sec.gov/investor/pubs/proforma12-4.htm.
Contact:
Wayne M. Carlin tel.: (646) 428-1510
Additional Materials
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
"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
|
|
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"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 ta
