Transcript Accruals - Babson College

Accruals
Agenda:
 Review accrual accounting
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Discuss cases
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Statement preparation exercise
International Paper (accruals)
Sears (A/R reserves)
Projections (Coca-Cola mini-case)
© 2005 by Robert F. Halsey
Accrual Accounting
Revenue recognition principle: record revenues
when “realized or realizable” and “earned”
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“realized or realizable” means received in cash or
have another asset that will generate cash (e.g.,
A/R)
“Earned” means the transaction is complete
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No rights of return or other contingencies
No involvement in resale
© 2005 by Robert F. Halsey
Accrual Accounting
Matching principle: once the revenues have
been recognized, match against those
revenues the expenses incurred in order to
generate them.
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Record expenses when “incurred” (not
necessarily when cash is paid)
Expenses should not precede nor lag revenues
(why?)
© 2005 by Robert F. Halsey
Accrual Accounting
Examples:
 Capitalize and depreciate fixed assets
Record expenses in advance of payment (e.g., wages,
severance accruals, contingent liabilities)
 Defer revenues until earned even though cash paid in
advance (e.g., magazine subscriptions)
Accrual exercises (Hennessey F/S)
International Paper mini-case
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© 2005 by Robert F. Halsey
Accrual Exercise
Accrual
Sales Revenue
COGS
Payment on Mdse
Salaries Expense
Utilities Exp
Interest exp
Net income
© 2005 by Robert F. Halsey
Cash
Accrual Exercise
ASSETS
Amount
LIABILITIES
Cash
Accounts Receivable
Inventories
Accounts payable
Note payable
Interest payable
Salaries payable
Utilities payable
Total Liabilities
Furn, Fix & Equip
Accumulated Depreciation
Furn, Fix & Equip (net)
EQUITY
Total Assets
Total Liabilities and Equity
© 2005 by Robert F. Halsey
Contributed Capital
Earned Capital
amount
International Paper mini-case – Q1
© 2005 by Robert F. Halsey
International Paper mini-case – Q2
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Components of $969 million charge
© 2005 by Robert F. Halsey
International Paper mini-case – Q3
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Components of $824 million charge
© 2005 by Robert F. Halsey
International Paper mini-case – Q4
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Components of $125 million charge
© 2005 by Robert F. Halsey
International Paper mini-case – Q5
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Components of $541 million charge
© 2005 by Robert F. Halsey
International Paper mini-case – Q6
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Components of $34 million reversal
© 2005 by Robert F. Halsey
International Paper mini-case – Q7
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In sum, do you think these accruals provide
investors with relevant information? How
might a company use accruals to
misrepresent its financial condition? What
might you look as an analyst to analyze the
appropriateness of accruals?
© 2005 by Robert F. Halsey
A/R Allowance for Uncollectible Accounts
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A/Rs are reported net of uncollectible accounts (UA)
Estimate bad debts and make the following journal
entry:
Bad debt expense
Allowance for UA
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xxx
xxx
Expense is recorded when incurred (bad debts
estimated), no expense when A/R is written off
Sears mini-case
© 2005 by Robert F. Halsey
Sears Mini-Case
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Describe the actions Sears took with respect to its
allowance for uncollectible accounts in 1993? How did this
affect earnings? What other actions occurred in that year?
Why does the analyst think that Sears’ reported earnings
are overstating its “true” earnings”
What is the response of Sears’ CFO to these allegations?
Do you believe him?
How can a company use the allowance for uncollectible
accounts to shift earnings from one period into another?
As an outsider, what might you look at to give you a clue
that the company might be managing earnings via the
allowance account?
© 2005 by Robert F. Halsey
Accruals and Future Stock Performance
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“Most investors claim to pay attention to earnings
quality, but recent academic research suggests
otherwise. Investors often ignore valuable publicly
disclosed information regarding the reliability of
reported earnings and their potential improvement or
deterioration, creating an opportunity to exploit the
likely impact on stock performance.”
Our own research has confirmed the academic
findings and enhanced a stock-selection tool the
academics suggested, making it more timely and
broadly applicable. Just as important, our research
sheds insight on the fundamentals the tool captures,
making it a very useful addition to our researchreview process. The tool appears to be capturing
information that our existing tool set doesn’t, and
thus could be additive to the returns of our US value
portfolios. (US Value Equities)
© 2005 by Robert F. Halsey
While some of its underlying drivers seem to have a value flavor,
our research shows the tool to be style-agnostic. In a large-cap
universe sorted on the basis of price to book, it is effective for
both value and growth stocks (Display 2). In fact, it was
somewhat more effective for stock selection within growth.
(US Value Equities)
© 2005 by Robert F. Halsey
Essentially, we believe that balancesheet accruals speak to the persistency
of reported earnings. It implies that
investors take earnings reports literally
and treat all sources of reported
earnings as equal, although the accrual
component of reported earnings is less
reliable than the cash component.
US Value Equities
© 2005 by Robert F. Halsey
Accruals and Reversion of ROA
Source: Richard G. Sloan, The Accounting
Review, July 1996
© 2005 by Robert F. Halsey
Figure 2
Average Cumulative Excess Returns
Average Cumulative Excess Return
0.1
0.05
0
-0.05
-0.1
-0.15
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Months After Test Year
Cycle Peaks
Cycle Troughs
Halsey, R.F. 2001. "Stationary Components of Earnings and
Stock Prices," Advances in Quantitative Analysis of Finance
and Accounting, vol. 9, pp 81-110.
© 2005 by Robert F. Halsey
CFRA Comments on Accruals
Source: CFRA 2004
© 2005 by Robert F. Halsey
Coca-Cola mini-case
(projections)
© 2005 by Robert F. Halsey