1. 2-1 Environmental factors on Financial Reporting Presentation objectives Understand factors influencing financial reporting Discuss the primary qualities of (Accounting) financial statement information State Alternative information sources State Limitations of Accounting Information Discuss the concept of Fair Value Accounting State and discuss the steps of financial Analysis

2. 2-2 Environmental Factors influencing Financial Reporting

3. 2-3 Environmental Factors on financial reporting. Capital Markets Authority (CMA)  Independent, quasi-government agency  Administer securities regulations & disclosures  Can modify & set reporting requirements for listed companies, if necessary

4. 2-4 Environmental Factors cont International Accounting Standards Board (IASB)  The board is an independent, not-for-profit private sector organization working in the public interest.  Its principal objectives are:  to develop a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRSs)  to promote the use and rigorous application of those standards;  to take account of the financial reporting needs of emerging economies and small and medium-sized entities (SMEs); and  to bring about convergence of national accounting standards and IFRSs to high quality solutions.

5. 2-5 Environmental Factors International Financial Reporting Standards (IFRS) Set by International Accounting Standards Board Kenya Adopted the standards in 1999 IASB encouraging worldwide recognition

6. 2-6 Environmental Factors Managers of Companies o Primary responsibility for fair & accurate reports o Applies accounting to reflect business activities o Managerial discretion is necessary in accounting o Major lobbyist on IFRS

7. 2-7 Environmental Factors Auditing o CMA /Legislation requires Audit Report o Audit opinion can be: o clean (fairly presented) o qualified (except for) o disclaimer (no opinion) o Check Auditor quality & independence Auditors

8. 2-8 Environmental Factors Corporate Governance o Board of directors oversight o Audit committee of the board o oversee accounting process o oversee internal control o oversee internal/external audit o Internal Auditor

9. 2-9 Environmental Factors Internal Users External Users Controller Budget Officers Sales Managers Internal Auditors Officers Managers Customers External Auditors Labor Unions Governments Shareholders Lenders

10. 2-10 Alternative information sources Voluntary Disclosure Economic, Industry & Company News o Impacts current & future financial condition and performance Information Intermediaries o Industry devoted to collecting, processing, interpreting & disseminating company information o Includes analysts, advisers, debt raters, buy- and sell-side analysts, and forecasters o Major determinant of IFRS Motivation - Legal liability, Expectations Adjustment, Signaling, Managing expectations

11. 2-11 Desirable Qualities of Accounting Information o Relevance - the capacity of information to affect a decision o Information is relevant is it is capable of making a difference in a decision. o Relevant information has three ingredients o Has predictive value o Has a feedback value o Is timely

12. 2-12 Desirable Qualities of Accounting Information cont… o Reliability - For information to be reliable it must be verifiable, representationally faithful, neutral and reflect substance. o Verifiability means the information is confirmable. o faithfulness means the information reflects reality o neutrality means it is truthful and unbiased. o Substance over form- means information presented in accordance with its substance and economic reality and not merely its legal form

13. 2-13 Financial Accounting Important Accounting Concepts

14. 2-14 Financial Accounting Relevance of Accounting Information Relation between Accounting Numbers and Stock Prices

15. 2-15 Financial Accounting Limitations of Accounting Information

16. 2-16 Revenue Recognition – recognize revenues when (1) Earned (2) Realized or Realizable Expense Matching – match with corresponding revenues - Product costs - Period costs Accruals-The Cornerstone Foundations of Accrual Accounting

17. 2-17 Accounting concept of income o Based on the concept of accrual accounting o Main purpose is income measurement o Two main processes – o Revenue recognition o Expense matching

18. 2-18 Fair value accounting Asset and liability values are determined on the basis of their fair values (typically market prices) on the measurement date (i.e., approximately the date of the financial statements).

19. 2-19 Historical cost Vs Fair value

20. 2-20 Advantages & Disadvantages of Fair Value Accounting Advantages o Reflects current information. o Consistent measurement criteria. o Comparability o No conservative bias o More useful for equity analysis Disadvantages o Lower objectivity o Susceptibility to manipulation. o Lack of conservatism. o Excessive income volatility.

21. 2-21 Implications of Fair value Accounting for Analysis o Focus on the statement of financial position (balance sheet). o Restating income. o Analyzing financial liabilities.

22. 2-22 Financial Analysis Process Financial analysis is the process of evaluating financial and other information for decision-making. A six-step approach is suggested for systematic financial analysis.

23. 2-23 Financial Analysis Process –The Steps 1.Identify purpose of financial analysis 2.Corporate overview 3.Financial analysis techniques 4.Detailed accounting analysis 5.Comprehensive analysis 6.Decision or recommendation

24. 2-24 2. Corporate Overview Industry analysis— – key economic characteristics, – historical context, – profit drivers, – business risks Firm’s business strategy— – competitive strategy given the industry characteristics

25. 2-25 2.Industry Analysis Competition— Evaluate:  growth rates,  concentration ratios,  degree of product differentiation,  economies of scale  relative fixed & variable costs,  substitute products

26. 2-26 2. Industry Analysis cont… Legal barriers— – patent & copyrights, – licensing, – regulation bargaining power of – buyers – & suppliers Price sensitivity

27. 2-27 2.Industry Analysis Criteria What is the industry? Relative size & significance Largest companies Geographic presence Business cycle effects, current situation Future potential

28. 2-28 2.Business Strategy Cost leadership: Achieved through:  low cost producer,  economies of scale,  efficient production,  low input prices

29. 2-29 2.Business Strategy cont… Product differentiation:  specific attributes that customers value  e.g.,  quality,  variety,  service,  delivery time,  brand name Importance of core competencies

30. 2-30 2.Business Strategy Criteria Historical perspective Primary focus of operations Most important strategy Major operating segments Corporate outlook/ forecast

31. 2-31 Qualitative Analysis Practical Example-- Dell Computer Industry— – primarily PCs: high tech, competitive (e.g., Gateway, IBM, Apple, others), changing products, high growth rates, low barriers of entry

32. 2-32 Qualitative Analysis Practical Example-- Dell Computer cont… Business strategy— (1) cost leadership strategy: – direct selling, – made-to-order manufacturing, – early on the internet, – low receivables; (2) product differentiation?? – IBM clones, – Intel & Microsoft components

33. 2-33 Qualitative Analysis Practical Example--Dell Computer cont… Current situation— – market share; – what is the impact of the business cycle (e.g., PCs are durable goods)?

34. 2-34 3.Quantitative Financial Analysis Systematic analysis of key elements based on analysis context Ratios, cash flows, common-size, time series, comparative (e.g., specific firms, industry, all firms), models (e.g., DuPont, Altman’s) In-depth analysis for “red flag” items

35. 2-35 3.Quantitative Financial Analysis Financial Statements – Common-size Analysis – Financial Ratios – Growth/trend Analysis Quarterly analysis DuPont Model Market Analysis

36. 2-36 4.Detailed Accounting Analysis cont.. Does accounting information capture the underlying business reality? Identify areas of “accounting flexibility” & evaluate accounting policies (choices) & disclosures; especially notes & MD&A Evaluate earnings management potential Recast accounting numbers when necessary

37. 2-37 Detailed Accounting Analysis cont.. o Adjust for accounting distortions so financial reports better reflect economic reality o Adjust general-purpose financial statements to meet specific analysis objectives of a particular user

38. 2-38 Detailed Accounting Analysis cont.. Sources of Accounting Distortions o Accounting Standards – attributed to 1) political process of standard-setting, 2) accounting principles and assumptions, and 3) conservatism o Estimation Errors – attributed to estimation errors inherent in accrual accounting o Reliability vs Relevance – attributed to over-emphasis on reliability at the loss of relevance o Earnings Management – attributed to window-dressing of financial statements by managers to achieve personal benefits

39. 2-39 Detailed Accounting Analysis cont.. Analysis Objectives o Comparatives Analysis – demand for financial comparisons across companies and/or across time o Income Measurement - demand for (1) equity wealth changes and (2) measure of earning power.)

40. 2-40 Detailed Accounting Analysis cont.. Earnings Management – Frequent Source of Distortion Earning Management strategies: o Increasing Income – managers adjust accruals to increase reported income o Big Bath – managers record huge write-offs in one period to relieve other periods of expenses o Income Smoothing – managers decrease or increase reported income to reduce its volatility

41. 2-41 Detailed Accounting Analysis cont.. Earnings Management – Motivations o Contracting Incentives - managers adjust numbers used in contracts that affect their wealth (e.g., compensation contracts) o Stock Prices – managers adjust numbers to influence stock prices for personal benefits (e.g., mergers, option or stock offering) o Other Reasons - managers adjust numbers to impact 1) labor demands, 2) management changes, and 3) societal views

42. 2-42 5.Comprehensive Analysis Summarize key points: what is particularly important for decision making? “Red flags” are particularly important Consider a written executive summary Consider a rating scale, such as 1-10

43. 2-43 6.Decision What is the recommendation or decision? What is the key rationale for this decision? [This is based on the specific decision: for a credit decision the key factors relate to credit risk, with particular focus on leverage and liquidity.] Be prepared to defend this decision.

44. 2-44 END OF PRESENTATION THANK YOU