accounting gambit

Investor requirements

An investor's job is to analyze whether a stock is worth buying at its current trading price; the investor is naturally an analyst first. The task on hand is estimating the intrinsic value of the business behind the stock and making informed decisions.  

The pursuit is estimating the earning power of the business on a sustainable basis. This requires at least some knowledge about the business, the industry where it operates, and of course the macro environment. In acquiring such knowledge, the analyst has to check whether the business enjoys any particular competitive advantages, and how sustainable these special advantages are. Tough entry barriers, favorable regulation, great brand name, superior technology, economies of scale make the businesses earn superior (excess) returns over a sustainable period. 

The analyst has to estimate the extent and timing of free cash flows a business can generate during the initial, high-growth and stable-growth periods. This leads to estimating revenues and operating margins, and reinvestment needs, i.e. capital spending and working capital requirements to generate those revenues. The book capital then should include both the existing capital and reinvestment to be made in future. This capital is usually funded by equity and debt in proportions envisaged by the managers. 

The analyst will also have to assess the risk associated with these cash flows before a valuation can be carried out. 

Suppliers of information

However, none of this is possible in the absence of the financial statements of the business, both historical and current. This brings us to discuss the role of accounting in business valuation. 

The fact that financial statements are more a product of accounting is not for debate. Financial statements are prepared using a framework which is the GAAP as directed by FASB for the companies incorporated in the US, or the IFRS as directed by IASB for most of the other companies. There are exceptions (as of now) such as India where financial statements are prepared using the GAAP as directed by the ICAI. 

In the past the accounting standards setting bodies such as FASB and IASB focused on the historical costs as the basis for preparation of the financial statements. This presented the financial statements as the cash was spent or received with adjustments made for the accruals accounting. 

Particularly the last decade has drastically changed the way financial statements are prepared. The basis for preparation has moved towards fair value accounting rather than the historical cost. The rationale primarily has been that historical costs told nothing much about the indicative value of the company, but fair value accounting makes an attempt to supply much useful information required by the investors in assessing the value of the company. 

The financial statements in their current form, however, still lag behind the information that is required by the investors. Check this out:

Acquired assets include property, plant and equipment, goodwill and other intangible assets. PPE are presented based on the historical costs usually, or based on revalued amounts when managers consider that book value appears too low, or based on fair values when these assets form part of a business acquisition. For an investor, each of these could pose challenges both when assessing the current book value of capital employed and when comparing with other firms. All PPE are presented net of depreciation, but the method adopted to calculate depreciation can be different. 

Goodwill is presented as a product of business acquisition which remains on the balance sheet until someone wakes up and says it is impaired when its value is brought down. Intangible assets such as brand names, customer relations and copyrights arising out of business acquisition accounting are more dicey. If these were not presented in the balance sheet the acquisition costs would be allocated to goodwill. We can see that these intangibles are presented as acquired assets to lower the goodwill value on the balance sheet. A firm on a stand-alone basis cannot bring its brands or customer relations on to its balance sheet, then why when it acquires a business that is allowed - is it purchase-price allocation, or window dressing?

Investments in associates are presented based on equity method of accounting; all other financial investments are usually carried at fair value. All derivative instruments are presented at fair value. Estimation of fair value, however, is left to the accountants. Quoted marked prices are considered as fair values; and when there are no quoted market prices the preference is to call the book value as fair value.

All these games make the job of calculating book value of capital difficult which otherwise is a very easy task.

Details of acquisitions are also not supplied keeping investors in mind. If acquisition is made in cash, there is a chance that it shows up in the statement of cash flows, and we can get some more information from the footnotes. If the acquisition is made in stock, the financial statements hardly supply more details regarding this. 

Debt is categorized in the balance sheet as short-term and long-term. However, further information on debt is presented as the managers feel about it; some present well, some don't. The cost, maturity profile and special covenants for each debt instrument is not presented in a way that is useful for an analyst. Operating lease commitments are considered as operating costs even when these are long-term and non-cancellable. 

Costs related to research, advertising and staff training are charged to the income statement in the year when incurred. For an analyst these could be in the nature of investment for future depending upon the nature of the business. 

Information related to stock options, and other derivative financial instruments is usually not presented in a manner an analyst would have liked. The same is true regarding pension and health care obligations. 

All these factors pose serious challenges to the analyst when making estimates for reinvestment, growth, and return on capital. 

The least the managers, accountants and auditors can do to help analysts is to present in a more transparent manner. Asking for too much?