Management Accounting

Financial Reporting & Analysis

Dr. Prakash Singh

Finance & Accounting Area
IIM Lucknow
 The Classical Firm Structure
STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting
Lend Money No Social Costs
BONDHOLDERS Managers SOCIETY
Protect Costs can be
bondholder traced to firm
Interests

Reveal Markets are

information efficient and
honestly and assess effect on
on time value
FINANCIAL MARKETS
 General Introduction

Principal Agent Theory : Owners and Managers

Conflict of Interest: Agency Cost

Shareholders: Residual Claim to Profit: Providing Risk Capital

Shareholders to Managers: Fiduciary / Trust relationship

Managers to Shareholders: Communicate performance
 The Basics of Corporate Finance
• Firm structure dominates corporate landscape
• Various Stakeholders; lens are different for everyone -
Triple Bottom line
• Shareholder wealth maximization is the prime driver
• The Principal Agent Conflict: Agency Costs
• To reduce agency costs: both external and internal
mechanisms are needed.
• Corporate governance: Board and Independent directors
• Auditors to the firm have to ensure full, proper and timely
disclosure
• Communication is the key to build that trust
Accounting: Language of Business
 Why Accounting
• In any markets, the participants need to value the assets to facilitate
buy and sell
• All tradable assets need a price discovery mechanism
• Price discovery is possible only if we have information about the asset
(full, reliable and consistent)
• Organizations report their performance four times in a year to the
markets
• The information therefore should be structured, standard, easy
to understand and timely
• And they should be driven by the same philosophy (accounting
standards)
• Markets are smart enough to understand this information and
incorporate this into the price.
• Markets analyze the information and “discover” the fair value
 Accounting has 3 main activities
1. Identifying
 select events that are evidence of economic activity
2. Recording
 provide a chronological diary of measured events in an orderly &
systematic manner
3. Communicating
 preparation & distribution of accounting reports and financial statements;
as well as analyzing and interpreting data
 The Basic Accounting Elements
Asset
– Has future benefit to the entity
Liability
– Obligation to transfer assets in the future
Owners’ Equity
– Owners’ interest in the company
Revenue
– Increase in economic resources resulting from
normal operations of the company
Expense
– Decrease in economic resources resulting from
normal operations of the company
 The Basic Accounting Equation

Assets = Liabilities + Equity

Revenues - Expenses = Profit/ Loss
Assets = Liabilities + Equity + Revenue - Expense
 The Annual Report: Conveyance Vehicle
• Accounting Statements: Construction and Analysis:
how to read them ?
– The Balance Sheet
– The Profit & Loss Account
– The Cash Flow Statement

• Accounting Policies: Standards, practices and the

impact on the statements (Indian GAAP, US GAAP, IFRS…what
next ? Convergence)
 Balance Sheet Format:

 Sources of Funds
 Shareholders Funds
 Loan Funds
 Application of Funds
 Net Block (Gross Block – Accumulated Depn.)

 Investments

 Net Current Assets (Current Assets, Loans and Advances – Current

Liabilities & Provisions)
 Misc. Expenditure (to the extent not yet written off)
 The Balance Sheet

Presents the financial position of a company at a particular

point in time.
The Quick Corporation
Balance Sheet
December 31, 2004
• Three
categories:
Assets Liabilities
Cash $40,000 Accounts Payable $80,000
Account Receivable 5,000 Notes Payable 20,000
– Assets Inventories 90,000 Total Liabilities $100,000
Land 10,000 Stockholders' Equity
– Liabilities Plant and equip. 125,000 Capital Stock $145,000
Retained Earnings 25,000
– Owners’ Total Stockholders'
Equity 170,000
Equity Total Liabilites and
$270,000 Stockholders' Equity $270,000

29
Income Statement

Revenue

- Expenses

Net Income
Profit & Loss Account: No specific
format
 Sample format:
 INCOME
 Operating income

 Non-operating income

 EXPENDITURE
 Manufacturing expenses

 Administration expenses

 Selling & distribution expenses

 Depreciation

 Interest expenses

 Profit before tax (INCOME- EXPENDITURE)

 Provision for tax

 Profit after tax (Profit before tax – Provision for tax)

 Statement of Cash Flows

• Cash from operating activities

• Cash from investing activities
• Cash from financing activities
 The Statement of Cash Flows

The Quick Corporation

• Classifies individual Statement of Cash Flows
For the Year Ended December 31, 2004
cash flows according to
three main activities: Cash flows from Operations
Cash revenues $535,000
– Operating activities Less cash expenses
Net cash provided by operating activities
(485,000)
$50,000
– Investing activities
Cash flows from Investing Activities
– Financing activities Purchase of land (30,000)
Sale of equipment 10,000
Net cash used by investing activities (20,000)

Cash flows from Financing Activities

Issuance of capital stock 10,000
Issuance of dividends (15,000)
Net cash used by financing activities (5,000)

Net increase in cash 25,000

Cash Balance January 1, 2004 15,000
Cash Balance December 31, 2004 $40,000

Diamond Chapter 2 33
 The Flipkart story…treatment of Discount

• Tempted to report higher revenues

• Cost of Discount: how it is to be treated
• Discount is being capitalized as marketing
expense; perceived to bring long term benefit
• Resulting in higher reported revenues and
profits
• Good way to attract PE funds
• Business has clocked turnover of $1 billion,
still to make $1 profit
 Defining Earnings Management
• Healy (1999), “earnings management occurs when managers use
judgment in financial reporting and in structuring transactions to
alter financial reports to either mislead some stakeholders about
the underlying economic performance of the company or to
influence contractual outcomes that depend on reported
outcomes.”
• Levitt (1998) defines “earnings management as a grey area
where the accounting is being perverted, where managers are
cutting corners; and, where earnings reports reflect the desires
of management rather than the underlying financial
performance of the company.”
• Schiper (1989) defines earnings management as a purposeful
intervention in the external financial reporting process, with the
intent of obtaining some private gain.
 Why Earnings Management
• Ahead of a major Corporate Event: The period
prior to going public, mergers, divestures or
demergers
• Managers compensation/ Incentives are aligned
in such a manner that he/ she tries to dress up
the numbers
• To avoid failing to meet bank covenants
 Major Corporate Event
• IPO (public listing); premium, post issue performance
(Uber, Lyft etc)
• While Uber's IPO Slumped, Big Banks Took Home
$106 Million in Fees (Fortune, May 14, 2019)
• Lyft's Fast-Slumping Stock Quickly Leads to Investor
Lawsuits (Bloomberg, 20 April, 2019)
• Mergers/ Demergers: Fraudulent Conveyance
 Manager’s Incentives

• CEO compensation
• Board Seat
• Role of Independent Directors
 Meeting the Bank Covenants
• The Requirement to maintain some ratios
below or above a benchmark
• Change in DE Ratio sends messages to
markets
• Credit Ratings downgrades
• Cost of Borrowings
 Few Other Reasons

• Meeting targets/ expectations of Financial

Markets
• Reduce Regulatory Costs
 Elements Responsible for Greyness
• Recognition Issue
– Accrual versus Actual
• Classification Issue
– Managerial Discretion on treatment of some
items
• Valuation Issue
– Book value versus Market Value
• Going Complexity of nature of business
• Subjective language of the accounting standards
• Role of the Auditors
– Conflict of interest
 What does the rule Book say ?
Duckworth Lewis of Accounting

• Persuasive Evidence that an agreement exists

• Significant part of the risk has been transferred
• Legal transfer of ownership must happen
• The amount to be realized can be measured
reliably
• Payment is reasonably assured
• no significant uncertainty exists regarding the
amount of consideration that will be realized
from the sale
 Some other recent news item …
• Deloitte was aware of loan evergreening in IL&FS Financial
Services: SFIO
• IL&FS probe: Not just connivance, auditors also pitched
products to top-brass
• SFIO and IL&FS board probing why rating co ignored analyst’s
concerns
• Probe reveals how IL&FS bosses showed fictitious profits for
salary hikes
• What ex-IL&FS top brass got for loans? Foreign trips, private
jets and chopper rides
 Some more……
• Jet Airways' lenders asked to submit forensic audit
findings to government
• I-T dept to conduct a special audit of grounded Jet
Airways books
• YES Bank hits near 4-year low, may fall further
• DHFL shares nosedive 18% as company stops
accepting fresh deposits, halts renewals
• Most IPOs fail to ride the bull run in last 10
years
Lyft and Uber IPOs make us wonder: when will Indian
unicorns go public?
International scenarios is no better…

• While Uber's IPO Slumped, ($45, $36) Big

Banks Took Home $106 Million in Fees
• IPO debacle: Uber blame game focuses on
Morgan Stanley
• Uber Has Poisoned an IPO Market That Was
Sick Anyway
• Lyft's (72, 47)Fast-Slumping Stock Quickly
Leads to Investor Lawsuits
 Lehman Brothers
• America’s fourth largest investment bank; providing financial
services to the world
• Post the sub prime crisis, files for bankruptcy and closure
• Major assets included Mortgage based securities under the
head of Investments
• Share prices crash to less than $1; no buyers available
• Most of the assets reported on the Balance Sheet were soon
junk
• Company goes down in six straight months
• Volcker Rule
 Enron Corporation
• Multi billion dollar energy utility company files for bankruptcy
• Just before declaration of bankruptcy, one of the top Fortune
500 companies
• CEO and CFO in jail, one of them commits suicide soon
• Misrepresentation of earnings, particularly derivatives
exposure leading to hugely inflated profits.
• Auditors: Arthur Anderson; one of the big four auditors in the
world close their shops soon.
• Sarbanes Oxley Act
 Indian Railways
• LPY: Indian Railways; surplus of 80,000 Crores
• MB: Indian Railways; surplus of 8,000 Crores
• Major Expenses not expensed but capitalized leading
to huge under reporting of expense; resulting in huge
surpluses
• What decides whether a cost incurred is expense or
an asset
• There is an element of subjectivity involved; role of
the auditor is very critical; agency costs involved
 Satyam Technologies
• Among top 5 players in the Indian IT space.
• Winner of Golden Globe awards for corporate excellence
• Board members included who’s who of the corporate and
academic world
• Inflated revenues to match market expectations; in line with
the other big 3 players
• Created fictitious clients across the globe
• Fictitious employees, fictitious addresses, fictitious bank
accounts
• Lots of artificial cash on the Balance Sheet
• Started printing FDR of HDFC Bank
• Satyam sold to Mahindra; Raju out on bail; case on..
 Contemporary Issues
• IFRS/Accounting Standards (GAAP) / Companies Act e.g. AS 28
• Interpretation of Accounting Policies: Fair Value / Income
Recognition
• Contingent Liabilities: The Bottom line in the Sub prime
Mortgage Crisis (report and relax)
• Recapitalization/ Write offs/ Selective Bailouts: Why Lehman
was not saved ?
• Role of the Auditors: The Satyam fiasco
• Role of Independent Directors
• Corporate Governance: Disclosure is the buzz word
• Compensation to the Directors and other top management
professionals: Obscene bonuses
Q&A