Competitive forces (Industry Analysis)

 Rivalry among existing firms

o Industry growth rate
o Concentration and balance of Competitors (number and size)
o Law Degree of differentiation (and hence switching costs)
o High Scale/ ratio of fixed to variable costs
o Excess capacity
o High exit barriers
 Threat of new entrants
o Economies of scale
o First mover advantage (higher switching costs from customer – DOS?)
o Access to Channels of distribution and relationships
o Legal/ licensing barriers
 Treat of substitute products
 Bargaining power of Buyers
 Bargaining power of Suppliers

Competitive Strategy

 Cost Leadership
 Differentiation
o Analysis of differentiation
o Success factors and risks
o Resources and capabilities
o Irreversible commitments
o Structuring of activities
o Sustainable competitive advantage
o Potential changes to firms’ industry structures

Company Analysis

 Corporate Profile
 Industry characteristics
 Analysis of demand and products/ services
 Financial Ratios
o Activity Ratios
o Liquidity ratios
o Solvency Ratios
o Profitability Ratios
o Financial Statistics and Related considerations (EPS etc)
ROE (Net profit margin: Net earnings/ Net sales) ×

(Asset turnover: Net sales / Average total assets) ×

(Financial leverage: Average total assets/ Average common equity)

Blind spots

 Misjudging industry boundaries;

 Poor identification of the competition;
 Over emphasis on competitors‘ visible competence;
 Over emphasis on where, not how, rivals will compete;
 Faulty assumptions about the competition
 Paralysis by analysis.

Why do we need accounting rules and auditing

Rules

 Delegation of reporting to management - Benefits

o Cost of delegation to management
 Historical cost concepts – Benefits
o Limits misuse of accounting judgement
o Create uniform accounting language
 Historical cost concepts – Limitations
o Create uniform accounting language
 Intellectual capital
 Proprietary information (Brand Value, Innovation etc)

External Auditing = Benefits

 Accounting Rules/ policies usage consistently over time

 Accounting estimate is reasonable
 Quality and credibility of accounting data (limit firm’s ability to distort financial statements)

Limitations

 Ability to see all transactions

 Fear of losing future business
 Reduces quality of financial reporting (limit to time evolved accounting principles)

Noise and Bias

 Rigidity in accounting rules (e.g. R&D)

 Forecast errors (e.g. Receivable)
 Accounting choices (Debt covenants -- present it good to lenders to avoid immediate payment
obligations
  Management compensation linked to reported Profits
 Corporate control contests (Influence Investor perception, win over stake holders to avoid
takeover threats)
 Tradeoff between financial reporting / tax considerations
 Regulatory Considerations (anti-trust actions, import tariffs etc)
 Capital market considerations
 Other stake holder considerations (e,g, labor Unions)
 Competitive Considerations (Segment disclosure may be influenced, margins on product line)

Analysis

 Identify key accounting policies to measure critical factors and risks

 Assess accounting flexibility
 Evaluate accounting strategy
o Hos is the firms accounting policies compared to industry? Is not same, is it because
firm’s strategy is different? (reduced Warranty liability is due to better product
investment or merely to increase PAT)
o Does Managers face incentives to use accounting discretion to manage earning?
o Dos management own significant stake (higher or lower dividend?)? is any union
negotiation planned?
o Has the firm changed its policies? (Warranty liability)
o Has firm’s policies consistent / realistic ? (higher profit in quarter results and adjustment
in last quarter?)
o Any significant business transactions to achieve certain accounting objectives (lease
shown as sale type lease?)
 Evaluate quality of disclosure?
o Does the company provide adequate disclosure to asses business strategy ?
o Does the foot notes explain key accounting policies / assumptions and their logic?
o Does the firm explain its current performance?
o Quality of segment disclosure?
o How forthcoming is the management with respect to bad news?
o How good is the firm’s investor relation program?
 Identify potential red flags
o Unexplained changes in accounting (especially when performance is poor)
o Unexplained transactions that boost profits
o Unusual increase in accounts receivable in relation to sales increase
o Unusual increase in inventory in relation to increased sales
o Increasing gap between reported income and its cash flow from operating activities
o Increasing gap between reported income and tax income
o Large asset write off
o Large forth quarter adjustments
o Opinion shopping from auditors / independent directors (may be change in independent
directors to suit this)
o Related party transactions
 Undo accounting distortions