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 Second Edition

B U S I N E S S A N A LY S I S &
VA L U AT I O N
viii CONTENTS

7 Prospective analysis: valuation theory and concepts 235

The discounted dividends valuation method 236
The discounted abnormal earnings valuation method 237
Valuation using price multiples 240
Shortcut forms of earnings-based valuation 246
The discounted cash flow model 248
Comparing valuation methods 249
Summary 252
Discussion questions 252
Case link 253
Endnotes 253
Appendix: Reconciling the discounted dividends and discounted abnormal
earnings models 255
CASE: Valuation ratios in the retail industry 2010 to 2013 256

8 Prospective analysis: valuation implementation 261

Detailed forecasts of performance 261
Terminal values 265
Computing a discount rate 269
Summary 277
Discussion questions 277
Case link 278
Endnotes 278
Appendix: estimating Bega Cheese’s overall asset value 278
CASE: Qantas 282

Part 3 Business analysis and VALUATION applications 285

9 Equit y securit y analysis 287

Investor objectives and investment vehicles 288
Equity security analysis and market efficiency 289
Approaches to fund management and securities analysis 292
The process of a comprehensive security analysis 293
Performance of security analysts and fund managers 298
Summary 300
Discussion questions 301
Case link 302
Endnotes 302
CASE: David Jones 304

10 Credit analysis and distress prediction 309

The market for credit 310
The credit analysis process 312
Financial statement analysis and listed debt 320
Prediction of distress and turnaround 323
Summary 325
 CONTENTS ix

Discussion questions 326

Case link 327
Endnotes 327
CASE: Evans and Tate Limited 329

11 Mergers and acquisitions 341

Motivation for merger or acquisition 341
Acquisition pricing 345
Acquisition financing and form of payment 351
Acquisition outcome 354
Summary 357
Discussion questions 358
Case link 359
Endnotes 359
CASE: Billabong International Ltd 360

12 Communication and governance 369

Governance overview 370
Management communication with investors 372
Communication through financial reporting 374
Other forms of communicating with investors 377
Corporate board 380
Auditor analysis 381
Audit committee reviews 385
Summary 387
Discussion questions 387
Case link 388
Endnotes 389
CASE: Diligent: governance issues 391

Part 4 Additional cases 399

America Online, Inc. 400
Comdisco, Inc.: Financial Statement Analysis (A) 422
Comdisco, Inc.: Financial Statement Analysis (B) 446
Hewlett-Packard–Compaq: The Merger Decision 475
Manufactured Homes, Inc. 503
Oracle Systems Corporation 530
Sensormatic Electronics Corporation – 1995 540
Harnischfeger Corporation 566
Schneider and Square D 588
The Risk-Reward Framework at Morgan Stanley Research 613
The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000 639
New Century Financial Corporation 660
VIZIO, Inc. 683
Amazon.com in the Year 2000 706

Index 729
x

Preface

Financial statements are the basis for a wide range of business analysis. Managers use them to
monitor and judge their firms’ performance relative to competitors, to communicate with external
investors, to help judge what financial policies they should pursue and to evaluate potential
new businesses to acquire as part of their investment strategy. Securities analysts use financial
statements to rate and value companies they recommend to clients. Bankers use them in deciding
whether to extend a loan to a client and to determine the loan’s terms. Investment bankers use them
as a basis for valuing and analysing prospective buyouts, mergers and acquisitions. Consultants
use them as a basis for competitive analysis for their clients. Not surprisingly, therefore, we find
that there is a strong demand among business students for a course that provides a framework
for using financial statement data in a variety of business analysis and valuation contexts. The
purpose of this book is to provide such a framework for business students and practitioners.

An Asia–Pacific Edition
Many of us as teachers or students of financial statement analysis have sought a quality textbook
in this area that is contextualised for our region. Starting with the strong foundations provided
by the highly successful US edition, the first Asia–Pacific edition addressed regional issues of
terminology, institutional setting and accounting standards with a number of improvements
including the following:
v Chapters 3 and 4 were rewritten to streamline and better explain the process of accounting
analysis, particularly in the context of International Financial Reporting Standards (IFRS).
v Chapter 5 used a DuPont-style ratio analysis to supplement operating vs. financial spread
methodology. This provided a better method for diagnosing performance measurement. More focus
was also placed on the elements of financial leverage and their impact on the firm’s performance,
and ratio formulas were more precisely specified to answer relevant business questions.
In this second Asia–Pacific edition, we have built on these changes, revising all the material to
ensure the relevance of each chapter for our audience. It now includes a full set of regionally
recognised examples and case studies in each chapter, a new worked example throughout the
book, and several new discussion questions and exercises at the end of each chapter.
v A new Asia–Pacific integrated example runs through chapters 2 to 8. Bega Cheese is the main
illustration, with a peer analysis to the Warrnambool Cheese and Butter Factory. The dairy
food industry was chosen because it is well known to students and teachers, and the companies
chosen are of a medium size and consistent profitability. The industry is undergoing structural
changes at the time of writing, making our analysis even more pertinent as we consider the
drivers of valuations!
v Additional references to recent research from Australasia as well as other regions have been
included in this edition, ensuring that the content is informed by and consistent with the latest
academic ideas and knowledge. From this, the interested reader may themselves discover ideas
for future research.
 PREFACE xi

v All new Australasian firms and analyses have been included as end of chapter case studies
in this edition. Link boxes to the Harvard end of chapter cases from the previous edition
have been included because those cases have proved to be very effective for many instructors
and their students, illustrating important teaching points and providing examples of different
business structures/models.

Key Features
This book differs from other texts in business and financial analysis in a number of important
ways. We introduce and develop a framework for business analysis and valuation using financial
statement data. We then show how this framework can be applied to a variety of decision contexts.

Framework for Analysis

We begin the book with a discussion of the role of accounting information and intermediaries
in the economy, and how financial analysis can create value in well-functioning markets. We
identify four key components of effective financial statement analysis:
v business strategy analysis
v accounting analysis
v financial analysis
v prospective analysis.
The first of the components, business strategy analysis, involves developing an understanding of
the business and competitive strategy of the firm being analysed. Incorporating business strategy
into financial statement analysis is one of the distinctive features of this book. Traditionally, this
step has been ignored by other financial statement analysis books. However, we believe that it
is critical to begin financial statement analysis with a company’s strategy because it provides
an important foundation for the subsequent analysis. The strategy analysis section discusses
contemporary tools for analysing a company’s industry, its competitive position and sustainability
within an industry and the company’s corporate strategy.
Accounting analysis involves examining how accounting rules and conventions represent a
firm’s business economics and strategy in its financial statements and, if necessary, developing
adjusted accounting measures of performance. In the accounting analysis section, we do not
emphasise accounting rules. Instead we develop general approaches to analysing assets, liabilities,
entities, revenues and expenses. We believe that such an approach enables students to effectively
evaluate a company’s accounting choices and accrual estimates, even if students have only a basic
knowledge of accounting rules and standards. The material is also designed to allow students to
make accounting adjustments rather than merely identify questionable accounting practices.
Financial analysis involves analysing financial ratio and cash flow measures of the operating,
financing and investing performance of a company relative to either key competitors or historical
performance. Our distinctive approach focuses on using financial analysis to evaluate the
effectiveness of a company’s strategy and to make sound financial forecasts.
Finally, under prospective analysis, we show how to develop forecasted financial statements
and how to use these to make estimates of a firm’s value. Our discussion of valuation includes
traditional discounted cash flow models as well as techniques that link value directly to accounting
xii PREFACE

numbers. In discussing accounting-based valuation models, we integrate the latest academic

research with traditional approaches, such as earnings and book value multiples that are widely
used in practice.
While we cover all four components of business analysis and valuation in the book, we
recognise that the extent of their use depends on the user’s decision context. For example,
bankers are likely to use business strategy analysis, accounting analysis, financial analysis and the
forecasting portion of prospective analysis. They are less likely to be interested in formally valuing
a prospective client.

Application of the Framework to Decision Contexts

The next section of the book shows how our business analysis and valuation framework can be
applied to a variety of decision contexts:
v securities analysis
v credit analysis
v merger and acquisition analysis
v governance and communication analysis.
For each of these topics we present an overview to provide a foundation for the class discussions.
Where possible we discuss relevant institutional details and the results of academic research
that are useful in applying the analysis concepts developed earlier in the book. For example, the
chapter on credit analysis shows how banks and rating agencies use financial statement data to
develop analysis for lending decisions and to rate public debt issues. This chapter also presents
academic research on how to determine whether a company is financially distressed.

Case Approach
We have found that teaching a course in business analysis and valuation is significantly enhanced,
both for teachers and students, by using cases as a pedagogical tool. Students want to develop
‘hands-on’ experience in business analysis and valuation so that they can apply the concepts in
decision contexts similar to those they will encounter in the business world. Cases are a natural
way to achieve this objective by presenting practical issues that might otherwise be ignored in a
traditional classroom exercise.
Our end-of-chapter cases all present Australasian-focused business analysis and valuation issues in
a specific decision context relevant to the particular chapter, and we find that this makes the material
more interesting and exciting for students. The multi-purpose cases at the end of the book can be used
with more than one chapter. As noted earlier, access to the Harvard end of chapter cases from the
previous edition have been retained in this edition via link boxes. Together these various cases provide
a rich set of resources that can be used by instructors in a number of ways to provide their students
with an appreciation of the complexities of business analysis and valuation in the real world.

Using the Book

We designed the book so that it is flexible for courses in financial statement analysis for a variety of
student audiences, from undergraduate students with Accounting or Finance majors through to
 PREFACE xiii

post-graduate students in Masters programs in business, and even Executive Education Program
participants. Depending upon the audience, the instructor can vary the manner in which the
conceptual materials in the chapters, end-of-chapter questions and case examples are used.

Prerequisites
To get the most out of the book, students should have completed basic courses in financial
accounting, finance and either business strategy or business economics. The text provides a
concise overview of some of these topics, primarily as background for preparing the cases. But it
would probably be difficult for students with no prior knowledge in these fields to use the chapters
as stand-alone coverage of them. We have integrated only a small amount of business strategy
into each case and do not include any cases that focus exclusively on business strategy analysis.
The extent of accounting knowledge required for the cases varies considerably. Some
require only a basic understanding of accounting issues, whereas others require a more detailed
knowledge at the level of a typical intermediate financial accounting course. However, we have
found it possible to teach even these more complex cases to students without a strong accounting
background by providing additional reading on the topic.

How to Use the Text and Case Materials

The materials can be used in a variety of ways. If the book is used for students with prior working
experience or for executives, the instructor can use almost a pure case approach, adding relevant
lecture sections as needed. When teaching students with little work experience, a lecture class can
be presented first, followed by an appropriate case. It is also possible to use the book primarily for
a lecture course and include some of the cases as in-class illustrations of the concepts discussed
in the book.
Alternatively, lectures can be used as a follow-up to cases to more clearly lay out the
conceptual issues raised in the case discussions. This may be appropriate when the book is used
in undergraduate capstone subjects. In such a context, cases can be used in course projects that
can be assigned to student teams.
xiv

Resources guide
As you read this text you will find a number of features in every chapter to enhance
your study of Business Analysis and Valuation and help you understand how the
theory is applied in the real world.

Key analysis boxes provide extra research

information and some questions to encourage
you to critically analyse the concepts
introduced in the chapter.

An introduction at the start of each chapter

provides a clear overview of each chapter’s
key concepts.

A continuous case related to Bega Cheese,

Warrnambool Cheese and Fonterra is
outlines in Case Example boxes found
throughout the book. These boxes help
tie the theory in the chapter to real world
examples. A Cheese Icon can also be found
next to Figures and Tables that relate to the
continuous case.
Supporting Case boxes provide relevant
real world examples, supporting the
theory outlined in the chapter and the
continuous cases.
 RESOURCES GUIDE xv

At the end of each chapter you’ll find several tools to help you to review the chapter
and key learning concepts, and to help extend your learning.

The Summary enables you to consolidate The Case Link box provides you with links
your understanding of the concepts being to extra relevant case studies, published and
learnt as you work through each chapter. sold by Harvard, which you might use for
further research.

Discussion Questions enable you to test

your comprehension of key concepts in
each chapter.

Relevant Australian and New Zealand

cases are provided at the end of each chapter,
including a comprehensive continuous case
on Qantas provided in Chapters 2, 4, 5, 6
and 8.
xvi RESOURCES GUIDE

Part 4 contains further extended international cases to help you develop strong skills in
applying the financial analysis framework to real-world situations.

For the Instructor

Cengage Learning is pleased to provide you with a selection of resources that will help you
prepare for your lectures. These teaching tools are available on the Instructors companion
website accessible via http://login.cengage.com.

Instructor Solutions Manual PowerPointTM presentations

This includes complete solutions to all the
end-of-chapter questions and cases.
Chapter-by-chapter PowerPoint presentations
cover the main concepts addressed within
the text and can be edited to suit your own
requirements. Use these slides to enhance
your lecture presentations and to reinforce
the key principles of your subject, or for
student handouts.
 xvii

About the authors

Krishna G. Palepu is the Ross Graham Walker Professor of Business Administration and
Senior Associate Dean for International Development at the Harvard Business School, Harvard
University. His current research and teaching activities focus on strategy and governance.
Professor Palepu serves on a number of public company and non-profit Boards. He has been
on the Editorial Boards of leading academic journals, and has served as a consultant to a wide
variety of businesses. Professor Palepu is also a frequent commentator in the news media on
issues related to emerging markets and corporate governance.

Paul M. Healy is James R. Williston Professor of Business Administration, and Chair of the
Accounting and Management Unit at Harvard Business School, Harvard University. Professor
Healy joined Harvard Business School as a Professor of Business Administration in 1997. His
primary teaching and research interests include corporate financial reporting, financial analysis,
corporate governance and corporate finance. Professor Healy’s research includes studies of the
role and performance of financial analysts, how firms’ disclosure strategies affect their costs
of capital, the performance of merging firms after mergers and managers’ financial reporting
decisions. His work has been published in leading journals in accounting and finance. In 1990, his
article ‘The Effect of Bonus Schemes on Accounting Decisions’, published in Journal of Accounting
and Economics, was awarded the AICPA/AAA Notable Contribution Award. His text Business
Analysis & Valuation was awarded the AICPA/AAA’s Wildman Medal for contributions to the
practice in 1997 and the AICPA/AAA Notable Contribution Award in 1998.

Victor L. Bernard, who passed away 14 November 1995, was the Price Waterhouse Professor of
Accounting and Director of the Paton Accounting Center at the University of Michigan. He was
also the Director of Research for the American Accounting Association.

Sue Wright is an Associate Professor in the Department of Applied Finance and Actuarial Studies
at Macquarie University. Her research interests include corporate governance, financial reporting
and valuation, and business education. Sue has taught Financial Statement Analysis for over 15
years, and supervises many PhD and masters students. She was awarded Fellow membership of
the Accounting and Finance Association of Australia and New Zealand in 2014.

Michael Bradbury is Professor of Accounting at Massey University, Albany, and FCA of the
New Zealand Institute of Chartered Accountants. His research has examined issues in financial
reporting and financial analysis. Michael became a Life member of the Accounting and Finance
Association of Australia and New Zealand in 2002 and received the Outstanding Contribution
to Practice Award in 2001.

Philip Lee is a consultant and financial controller currently working with businesses and in the
financial services industry. Philip holds memberships in various professional organisations such
as CPA Australia, Governance Institute of Australia and Australian Institute of Management.
His research interests include financial reporting, earnings management, corporate finance and
valuation. Previously, Philip taught both postgraduate and undergraduate students in Financial
Statement Analysis at Sydney University.
xviii

Acknowledgements

Like the first Asia–Pacific edition of Business Analysis and Valuation, this second edition is
the result of the combined efforts, energies and encouragement of each of the Australasian co-
authors, as well as our colleagues, students, friends and family.
Our colleagues in our various universities have provided much encouragement and support,
and have materially contributed to the improvements evident in this second edition. We thank
them for so willingly sharing their skill and experience, and for providing feedback and advice
along the way. In particular, we thank those who have shared case material and examples, and
other tips acquired from teaching business analysis and valuation in the Australasian context.
We have consulted various practitioner and academic colleagues, whose practical experience
and research papers have made important contributions to our text. Our sincere thanks go to these
colleagues for their contributions. We also acknowledge all the students we have had the privilege
of meeting in the courses we teach, and for their enthusiastic questions and astute observations as
we have introduced them to various topics using the content and methods of this book.
We are grateful to the many people at Cengage who have been involved in the preparation of
this book, for their vision, patience, support and encouragement.
Finally, we thank our many friends and family members for their genuine interest in the
progress of the manuscript, and their understanding of our passion for this subject matter.

The authors and Cengage Learning would like to thank the following reviewers for their incisive
and helpful feedback:

Warwick Anderson - University of Canterbury

Shyam Bhati - University of Wollongong
Dane Etheridge - Curtin University
Mukesh Garg - Monash University
Paskalis Glabadanidis - University of Adelaide Business School
Meiting Lu - Macquarie University
Maria Prokofieva - Victoria University
Ian Sims - Southern Cross University
Connie Spasich - University of Wollongong
Judy Taylor - La Trobe University
Anna Wright - UTS
Pa r t 1

Fr a m e wo r k

C h a p t e r 1 A framework for business analysis and valuation

using financial statements

C h a p t er 1
A framework for business
analysis and valuation using
financial statements
This chapter outlines a comprehensive framework for
financial statement analysis. Because financial statements
provide the most widely available data on any organisation’s
economic activities, investors and other stakeholders rely
on financial reports to assess the plans and performance of
organisations and corporate managers.
A variety of questions can be addressed by business
analysis using financial statements, as shown in the
following examples:
v A security analyst may be interested in asking: ‘How
well is the firm I am following performing? Did the
firm meet my performance expectations? If not, why
not? What is the value of the firm’s shares given my
assessment of its current and future performance?’
v A loan officer may need to ask: ‘What is the credit risk
involved in lending a certain amount of money to this
organisation? How well is the organisation managing
its liquidity and solvency? What is the organisation’s
business risk? What is the additional risk created by
the organisation’s financing and dividend policies?’
v A management consultant might ask: ‘What is the
structure of the industry in which the organisation
is operating? What are the strategies pursued by
various players in the industry? How have these
factors affected the relative performance of different
organisations in the industry?’
v A corporate manager may ask: ‘Is my firm properly
valued by investors? Is our investor communication
program adequate to facilitate this process?’ or ‘Is this
firm a potential takeover target? How much value can
be added if we acquire this firm? How can we finance
the acquisition?’
v An independent auditor would want to ask: ‘Are
the accounting policies and accrual estimates in
this organisation’s financial statements consistent
with my understanding of this business and its
recent performance? Do these financial reports
communicate the current status and significant risks
of the business?’
Different models for channelling savings into business
investments have prevailed in different countries through
history. The prevailing model in almost all countries in the
world today is the market model, in which capital markets
play an important role in channelling financial resources
from savers to business enterprises that need capital.
Financial statement analysis is a valuable activity when
managers have in-depth information on an organisation’s
strategies and performance, and a variety of institutional
4 PART 1 Fra mework

factors make it unlikely that they will fully disclose this
information. In this setting, outside analysts attempt
to uncover ‘inside information’ from analysing financial
statement data, thereby gaining valuable insights about the
organisation’s current performance and future prospects.
To understand the contribution that financial
statement analysis can make, it is important to
understand the role of financial reporting in the
functioning of capital markets and the institutional
forces that shape financial statements. Therefore we first
present a brief description of these forces, followed by
a discussion of the steps that an analyst must perform
to extract information from financial statements and
provide meaningful forecasts.

The Role of Financial Reporting in Capital Markets

A critical challenge for any economy is the allocation of savings to investment opportunities.
Economies that do this well can exploit new business ideas to spur innovation and create jobs and
wealth at a rapid pace. In contrast, economies that manage this process poorly do not maximise
their wealth and fail to support business opportunities.
Figure 1.1 provides a schematic representation of how capital markets typically work in a
broad sense. Savings in any economy are widely distributed among households. There are usually
many new entrepreneurs and existing companies that would like to attract these savings to
fund their business ideas. While both savers and entrepreneurs would like to do business with
each other, matching savings to business investment opportunities is complicated for at least
two reasons. First, entrepreneurs typically have better information than savers on the value of
business investment opportunities. Second, communication by entrepreneurs to investors is
not completely credible because investors know entrepreneurs have an incentive to inflate the
value of their ideas. Third, savers generally lack the financial sophistication needed to analyse and
differentiate among the various business opportunities.
These information and incentive problems lead to what economists call the ‘lemons’ problem,
which can potentially break down the functioning of the capital market.1 It works like this. Consider
a situation where half the business ideas are ‘good’ and the other half are ‘bad’. If investors cannot
distinguish between the two types of business ideas, entrepreneurs with bad ideas will try to claim

Savings

Financial Information
intermediaries intermediaries

Business
ideas

Figure 1.1 Capital markets

 CHAPTER 1 A fra mework for business analysis and valuation 5

that their ideas are as valuable as the good ideas. Recognising this possibility, investors value both
good and bad ideas at an average level. Unfortunately, this penalises good ideas, and entrepreneurs
with good ideas find the terms on which they can get financing to be unattractive. As these
entrepreneurs leave the capital market, the proportion of bad ideas in the market increases. Over
time, bad ideas ‘crowd out’ good ideas and investors lose confidence in this market.
The emergence of intermediaries can prevent such a market breakdown. There are several
types of intermediaries in a fully-informed capital market system. Financial intermediaries, such as
venture capital and private equity firms, banks, superannuation funds, managed funds and insurance
companies, focus on aggregating funds from individual investors and distributing those funds to
businesses seeking sources of capital. Information intermediaries, such as auditors and company audit
committees, serve as credibility enhancers to provide an independent assessment of business claims.
Information analysers and advisers such as financial analysts, credit rating agencies and the financial
press are another type of information intermediary that collect and analyse business information
used to make business decisions. Transaction facilitators such as stock exchanges and brokerage
houses play a crucial role in capital markets by providing a platform to facilitate buying and selling
in markets. Finally, regulatory intermediaries such as the Australian Securities Exchange (ASX)
and the Australian Securities and Investments Commission (ASIC) create appropriate regulatory
policy that establishes the legal framework of the capital market system, while adjudicators such
as the court system resolve disputes that arise between participants. In a well-functioning capital
market, the market institutions described above add value by both helping investors distinguish
good investment opportunities from bad ones and by directing funding to those business ideas
deemed most promising.
Financial reporting plays a critical role in the effective functioning of the capital markets.
Information intermediaries add value either by enhancing the credibility of financial reports
(as auditors do) or by analysing the information in the financial statements (as analysts and the
rating agencies do). Financial intermediaries rely on information in the financial statements to
analyse investment opportunities, and supplement this information from other sources.
Ideally, the different intermediaries serve as a system of checks and balances to ensure
the efficient functioning of the capital markets system. However, this is not always the case,
as on occasion they mutually reinforce rather than counterbalance each other. This can arise
from imperfections in financial and information intermediaries’ incentives, governance issues
within the intermediary organisations themselves, and conflicts of interest, as evidenced by the
spectacular failures of large international companies and markets in the early part of the 21st
century, and again during the global financial crisis.
The examples above demonstrate that while this market mechanism over time has been seen
to function efficiently with prices reflecting all available information on a particular investment,
individual securities may still be mispriced, thereby justifying the need for financial statement analysis.
In the following section, we discuss key aspects of the financial reporting system design that
enable it to effectively play this vital role in the functioning of the capital markets.

From Business Activities to Financial Statements

Corporate managers are responsible for acquiring physical and financial resources from the firm’s
environment and using them to create value for the firm’s investors. Value is created when the
6 PART 1 Fra mework

firm earns a return on its investment in excess of the cost of capital. Managers formulate business
strategies to achieve this goal, and they implement them through business activities. A firm’s
business activities are influenced by its economic environment and its own business strategy.
The economic environment includes the firm’s industry, its input and output markets, and the
regulations under which it operates. The firm’s business strategy determines how it positions itself
in its environment to achieve a competitive advantage.
As shown in Figure 1.2, a firm’s financial statements summarise the economic consequences
of its business activities. The firm’s business activities in any time period are too numerous to
be reported individually to outsiders. Further, some of the activities undertaken by the firm are
proprietary in nature, and disclosing these activities in detail could be detrimental to the firm’s
competitive position. The accounting system provides a mechanism through which business
activities are selected, measured and aggregated into financial statement data.
Intermediaries using financial statement data to do business analysis have to be aware that
financial reports are influenced both by the firm’s business activities and by its accounting system.
A key aspect of financial statement analysis, therefore, involves understanding the influence of

Business environment Business strategy

Labour markets Scope of business:
Capital markets Degree of diversification
Product markets: Type of diversification
Suppliers Competitive positioning:
Customers Business activities Cost leadership
Competitors Operating activities Differentiation
Business regulations Investment activities Key success factors and risks
Financing activities

Accounting environment Accounting strategy

Capital market structure
Contracting and governance
Accounting conventions and
regulations
Tax and financial
accounting linkages
Third-party auditing
Legal system for
accounting disputes
Accounting system Choice of accounting policies
Measure and report Choice of accounting
economic estimates
consequences of Choice of reporting format
business activities Choice of supplementary
disclosures

Financial statements
Managers’ superior
information on business
activities
Estimation errors
Distortions from
managers’ accounting
choices

Figure 1.2 From business activities to financial statements

 CHAPTER 1 A fra mework for business analysis and valuation 7

the accounting system on the quality of the financial statement data being used in the analysis.
Some important features of the accounting systems are discussed in the following section.

Accounting System Feature 1: Accrual Accounting

One of the fundamental features of corporate financial reports is that they are prepared using
accrual rather than cash accounting. Unlike cash accounting, accrual accounting distinguishes
between the recording of costs and benefits associated with economic activities and the actual
payment and receipt of cash. Profit is the primary periodic performance index under accrual
accounting. To compute profit, the effects of economic transactions are recorded on the basis of
expected, not necessarily actual, cash receipts and payments. Expected cash receipts from the
delivery of products or services are recognised as revenues, and expected cash outflows associated
with these revenues are recognised as expenses.
The need for accrual accounting arises from investors’ demand for financial reports on a
periodic basis. Because firms undertake economic transactions continually, the arbitrary closing
of accounting books at the end of a reporting period leads to a fundamental measurement
problem. Since cash accounting does not report the full economic consequence of the transactions
undertaken in a given period, accrual accounting is designed to provide more complete information
about a firm’s periodic performance.

Accounting System Feature 2: Accounting

Standards and Auditing
The use of accrual accounting lies at the centre of many important complexities in corporate
financial reporting. Because accrual accounting deals with expectations of future cash
consequences of current events, it is subjective and relies on a variety of assumptions. Who
should be charged with the primary responsibility of making these assumptions? In the current
system, a firm’s managers are entrusted with the task of making the appropriate estimates and
assumptions to prepare the financial statements because they have intimate knowledge of their
firm’s business.
The accounting discretion granted to managers is potentially valuable because it allows
them to reflect inside information in reported financial statements. However, managers also
have incentives to use accounting discretion to distort reported profits. One obvious incentive is
where the manager is rewarded on the basis of accounting profits. The use of accounting numbers
in contracts between the firm and outsiders provides another motivation for management
manipulation of accounting numbers. Income management distorts financial accounting data,
making them less valuable to external users of financial statements. Therefore, the delegation of
financial reporting decisions to corporate managers has both costs and benefits.
A number of accounting practices (such as accounting standards and independent audits) have
evolved to ensure that managers use their accounting flexibility to summarise their knowledge of
the firm’s business activities, and not to disguise reality for self-serving purposes.
Accounting standards are developed to improve the quality of financial reporting. They often
improve the comparability of accounting by recording similar economic transactions in a like
manner. This increases comparability both over time and across organisations. The demand for
international comparability of financial reports has led to over 100 countries worldwide, including
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