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Financial statements remain the primary source of information for most investors and analystsDifferences in accounting standards and practices Differences in accounting standards across countries affect the measurement of earnings. These differences, however, are not so great as they are made out to be and they cannot explain away radical departures from fundamental principles of valuation12. Choi and Levich, in a survey of accounting standards across developed markets, note that most countries subscribe to basic accounting notions of consistency, realization and historical cost principles in preparing accounting statements. Table 3.9 summarizes accounting standards in eight major financial markets and reveals that the common elements vastly outnumber those areas where there are differences. 12 At the peak of the Japanese market, there were many investors who explained away the price-earnings multiples of 60 and greater in the market, by noting that Japanese firms were conservative in measuring earnings. Even after taking into account the general provisions and excess depreciation used by many of these firms to depress current earnings, the price-earnings multiples were greater than 50 for many firms, suggesting either extraordinary expected growth in the future or overvaluation. The two countries that offer the strongest contrast to the United States are Germany and Japan. The key differences and their implications are as follows. First, companies in the United States generally maintain separate tax and financial reporting books, which in turn generates items like deferred taxes to cover differences between the two books. Companies in Germany and Japan do not maintain separate books. Consequently, depreciation methods in financial reports are much more likely to be accelerated and hence to reduce stated income. Second, the requirement that leases be capitalized and shown as a liability is much more tightly enforced in the United States. In Japan, leases are generally treated as operating leases and do not show up as liabilities in the balance sheet. In Germany, firms can capitalize leases, but they have more leeway in classifying leases as operating and capital leases than U.S. companies. Third, goodwill, once created, can be amortized over 40 years in the United States and over much shorter time periods in Germany and Japan, again depressing stated income. Fourth, reserves in the United States can be created only for specific purposes, whereas German and Japanese companies can use general reserves to equalize earnings across periods, leading earnings to be understated during the good years, and overstated during bad years. Most of these differences can be accounted and adjusted for when comparisons are made between companies in the U.S. and companies in other financial markets. Ratios such as price earnings, which use stated and unadjusted earnings, can be misleading when accounting standards vary widely across the companies being compared. Summary Financial statements remain the primary source of information for most investors and analysts. There are differences, however, in how accounting and financial analysis approach answering a number of key questions about the firm. We examine these differences in this chapter. The first question that we examined related to the nature and the value of the assets owned by a firm. Categorizing assets into investments already made (assets in place) and investments yet to be made (growth assets), we argued that accounting statements provide a substantial amount of historical information about the former and very little about the latter. The focus on the original price of assets in place (book value) in accounting statements can lead to significant differences between the stated value of these assets and their market value. With growth assets, accounting rules result in low or no values for assets generated by internal research. The second issue that we examined was the measurement of profitability. The two principles that seem to govern how profits are measured are accrual accounting - revenues and expenses are shown in the period where transactions occur rather than when the cash is received or paid - and the categorization of expenses into operating, financing and capital expenses. Operating and financing expenses are shown in income statements. Capital expenditures take the form of depreciation and amortization and are spread over several time periods. Accounting standards miscategorize operating leases and research and development expenses as operating expenses (when the former should be categorized as financing expenses and the latter as capital expenses). In the last part of the chapter, we examine how financial statements deal with shortterm liquidity risk and long-term default risk. While the emphasis in accounting statements is on examining the risk that firms may be unable to make payments that they have committed to make, there is very little focus on risk to equity investors. Problems Coca Colas balance sheet for December 1998 is summarized below (in millions of dollars) for problems 1 through 9: Cash & Near Cash1648Accounts Payable3141Marketable Securities159Short term Borrowings4462Accounts Receivable1666Other Short term liabilities1037Other Current Assets2017Current Liabilities8640Current Assets6380Long term Borrowings687Long term investments1863Other long term Liabilities1415Depreciable Fixed Assets5486Non-current liabilities2102Non-depreciable Fixed Assets199Accumulated Depreciation2016Share Capital (Paid-in)3060Net Fixed Assets3669Retained Earnings5343Other Assets7233Shareholder Equity8403Total Assets19145Total Liabilities & Equity19145 1. Consider the assets on Coca Colas balance sheet and answer the following questions: a. Looking at the assets that Coca Cola has on its balance sheet, which assets are likely to be assessed closest to market value? Explain. b. Coca Cola has net fixed assets of $3,669 million. Can you estimate how much Coca Cola paid for these assets? Is there any way to know the age of these assets? c. Coca Cola seems to have far more invested in current assets, rather than fixed assets. Is this significant? Explain. d. In the early 1980s, Coca Cola sold off its bottling operations, with the bottlers becoming independent companies. How would this action have impacted the assets on Coca Colas balance sheet? (The manufacturing plants are most likely to be part of the bottling operations) 2. Examine the liabilities on Coca Colas balance sheet. a. Based upon the balance sheet, how much interest-bearing debt does Coca Cola have outstanding. (You can assume that other short term liabilities represent sundry payables, and other long term liabilities represent health care and pension obligations.) b. Based upon the balance sheet, how much did Coca Cola obtain in equity capital when it issued stock originally to the financial markets? c. Is there any significance to the fact that retained earnings is much larger than the original paid-in capital? d. The market value of Coca Colas equity is $140 billion. What is the book value of equity in Coca Cola? Why is there such a large difference between the market value of equity and the book value of equity? 3. Coca Colas most valuable asset is its brand name. Where in the balance sheet do you see its value? Is there any way to adjust the balance sheet to reflect the value of this asset? 4. Assume that you have been asked to analyze Coca Colas working capital management. a. Estimate the net working capital and non-cash working capital for Coca Cola. b. Estimate the firms current ratio. c. Estimate the firms quick ratio. d. Would you draw any conclusions about the riskiness of Coca Cola as a firm by looking at these numbers? Why or why not? Coca Colas income statements for 1997 and 1998 are summarized below (in millions of dollars): 19971998Net Revenues$18,868$18,813Cost of Goods Sold6,1055,562Selling, G & A Expenses7,8528,284Earnings before interest and taxes5,0014,967Interest Expenses258277Non-operating Gains1,312508Income Tax Expenses1,9261,665Net Income4,1293,533Dividends1,3871,480 The following questions relate to Coca Colas income statement. 5. How much operating income did Coca Cola earn, before taxes, in 1998? How does this compare to how much Coca Cola earned in 1997? What are the reasons for the differences? 6. The biggest expense for Coca Cola is advertising, which is part of the selling, general and administrative expenses. A large portion of these expenses are designed to build up Coca Colas brand name. Should advertising expenses be treated as operating expenses or are they really capital expenses? If they are to be treated as capital expenses, how would you capitalize them? (Use the capitalization of R&D as a guide.) 7. What effective tax rate did Coca Cola have in 1998? How does it compare with what they paid in 1997 as an effective tax rate? What might account for the difference? 8. You have been asked to assess the profitability of Coca Cola, as a firm. To that end, estimate the pre-tax operating and net margins in 1997 and 1998 for the firm. Are there any conclusions you would draw from the comparisons across the two years. 9. The book value of equity at Coca Cola in 1997 was $7,274 million. The book value of interest-bearing debt was $3,875 million. Estimate: a. the return on equity (beginning of the year) in 1998 b. the pre-tax return on capital (beginning of the year) in 1998 c. the after-tax return on capital (beginning of the year) in 1998, using the effective tax rate in 1998. 10. SeeSaw Toys reported that it had a book value of equity of $1.5 billion at the end of 1998 and 100 million shares outstanding. During 1999, it bought back 10 million shares at a market price of $40 per share. The firm also reported a net income of $150 million for 1999, and paid dividends of $50 million. a. Estimate the book value of equity at the end of 1999 b. Estimate the return on equity, using beginning book value of equity. c. Estimate the return on equity, using the average book value of equity. |
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