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FINANCIAL ACCOUNTING THEORY
GRACE BARTZ, DANIELLE COOK, MARTINE DENHERTOG, DAVID DIMATTEO, MARK HALEY, FARIS ISMAILOVSKI , JULIE PHILLIPS, & DORIAN TEMLIN
Future-Oriented Financial Information
Agenda
IntroductionDetermining information about the futureAssumptionsForecastingTime-periodPresentationDisclosures
Introduction to Section 4250
Addresses Measurement Presentation and disclosure Formats:
General purpose Special purpose
Objective is to provide external users with information that assists them in evaluating an entity’s financial prospects
Introduction to Section 4250
Who might want to know future information about a company?
Lenders Owners Investors Management Auditors Analysts Employees and Suppliers
Introduction to Section 4250
Users of future information Lenders
See if borrowers will be generating sufficient cash flow to repay loans
Test borrowers knowledge of business Owners and Security Markets
See if capital is generating sufficient rate of return Determine the course of investing action
Management Benchmarks
Introduction to Section 4250
What could future financial prospect information be used for?
Evaluate company’s ability to pay back loans To determine if meeting investors’ expectations Benchmark for management
Introduction to Section 4250
What type of information about the future of a company would a user want to know?
Sales Net Income Cash Flow Debt to Equity
Determining Information About the Future
Based on assumptionsForecasts
Uses assumptions which reflect planned courses of action
Projections Same assumptions as a forecast with one or more
hypotheses consistent with the purpose of the information
Not necessarily the most probable in managements judgment
Importance of Future Information
Company can communicate its expectations to the market
Management knows its business better than anyone else Management can use the information to sway
investors
Assumptions
Complete Affects reliability
Reasonable Achievable
Provide relevant information Adds value
ConsistentInterdependence
Consistent Assumptions
The assumptions need to be consistent with…?
Plans and strategies of the company Past performance Industry performance
Assumptions
Complete Affects reliability
Reasonable Achievable
Provide relevant information Adds value
ConsistentInterdependence
Assumptions
Who should make the assumptions?
Management
Forecasts
Generated from reasonable and supportable assumptions by management
Reflect most probable economic conditions and planned courses of actions for the entity
Supportable vs. reasonable
Supportable
How can assumptions made by management be supportable?
Past performance of entity itself Performance of other entities with similar activities Feasibility studies Marketing studies Economic data Government and industry publications Other sources with objective corroboration of the
assumptions used
Supportable
Extent of detailed information to support assumptions
Influenced by factors such as the significance of the assumption, and availability and quality of information
Forecast Methods
Managements way of preparing financial information from the reasonable and supportable assumptions
May use statistical, mathematical, or specialized forecasting techniques
Forecast Methods
Once assumptions are determined, how do managers come up with the forecasted
numbers?
Forecast Methods
Quantitative Percentage of sales Ratios Regression Trend line, time series, moving average, naïve method
Qualitative/Subjective Management and executive opinions Delphi technique Consumer surveys
Forecast Methods
Forecasts can be prepared with extreme precision – to the nearest cent – why is this
accuracy misleading to analysts?
If limited to only one forecast number, which would you choose to see and why?
What if limited to only one financial statement?
Reasonability of Assumptions
To be reasonable, must be consistent with the plans of the entity.
How are assumptions considered consistent with the plans of the entity?
Reflect expected effects of anticipated strategy Include effects of likely economic conditions
Reasonability of Assumptions
Each assumption needs to be assessed as to its reasonableness Influenced by the significance of the assumption and
the quality of supporting information As availability of information decreases, it becomes
much more difficult for management to make reasonable attempts
Reasonability of Assumptions
A projection must also be based on reasonable assumptions including one or more hypotheses
What would the criteria be for a hypothesis to be considered reasonable?
Consistent with the purpose of the projection Plausible
Examination of Future Oriented Financial Statements (AuG-6)
An accountant’s objective is to form an opinion on the underlying assumptions used but not to the achievability of the forecast
Crucial that the PA get a well-developed understanding of the organization and its industry
Compilation of a Financial Forecast/Projection (AuG-16)
This pertains to subsequent earnings forecasts from the prospectus
The objective is to provide a service to those who require assistance
PA should question management’s approaches but not form an opinion
Shortfalls of Forecasts
Shortfalls of Forecasts
How could actions and abuses of pro-formas be prevented and stopped going forward?
Require more timely GAAP numbers Audit opinion on subsequent forecasts
Shortfalls of Forecasts
CEO’s who are “overconfident” are more likely to issues forecasts that are overly optimistic
Companies are protected by the Safe Harbour Rule, which ultimately allows for optimistic outlooks.
What is your opinion on the Safe Harbour Rule?
Time Period in Earnings Forecasts
Time period covered by future financial statements shouldn’t go beyond the period where information can be reasonably estimated It may not be shorter than ‘the period of long-term
undertakings for which an entity has set expenditure limits’
Time Period in Earnings Forecasts
Factors influencing reasonableness: Need of users Ability to make appropriate assumptions Nature of industry Operating cycle of entity
What are some reasons management would not be able to reasonably estimate information?
Economic volatility Uncertain future of the organization
Time Period in Earnings Forecasts
Future financial statements should be prepared in accordance with accounting policies and presentation format used in presenting historical financial statements ie. If preparing statements on a quarterly basis, pro
forma statements should be estimated on a quarterly basis
Time Period in Earnings Forecasts
Forecasts are not normally prepared for periods beyond the following fiscal year To be practical should be updated and revised for new
information as it becomes known Comparison to actual should be evaluated
Time Period in Earnings Forecasts
Projections may be prepared for periods beyond the following fiscal year if there is a reasonable base for making estimates Many entities use 3, 5, or 10 year projections in order
to make longer-term decisions
The degree of uncertainty normally increases with the length of the future period covered
Presentation
General purpose statements presented in the format of historical financial statements
Must use historical policies except… In the case of special purpose financial statements
Use whatever framework the two parties agree on
Special Purpose Financial Statements
Special purpose financial statements are a set of financial statements that are prepared using a special purpose framework to cater to the special needs of specific users of financial statements
Not prepared in accordance with the general reporting framework
Not made for public – limited use Internal users Those charged with governance Limited external users
Special Purpose Financial Statements
Can you give examples of industries or
companies that would use special purpose financial statements?
Banks Governments Financials for tax authorities (statements completed in
accordance with tax regulatory framework)
Presentation
If presentation using historical statements is not possible -> note and accounting policy disclosure… To the extent of adding understanding
Presentation
Exact dollar valuePresented as a range
Takes into account inherent imprecision with forecasting
Care to ensure that range is not too broad that the values are no longer meaningful
Presentation
When would a range be more useful?
Farming operations – weather unpredictable Bidding in an acquisition (min and max willing to pay) New market/market does not exist when a new product is
introduced into the market
When would an exact dollar value be useful?
Analyst Investors who use mathematical models
Presentation in an IPO Setting
As part of the prospectus Five periods of audited income statements Two most recent balance sheets
Is an earnings forecast required in an IPO prospectus? No: standard says that its optional but not required If included must be audited and include audit statement
Why might a company want to include an earnings forecast? Higher earnings = positive reaction from public Assurance – not hiding information from public Providing more information to investors
Why would a company decline to include an earnings forecast? Cant complete one with accuracy (volatile industries) Forecasted earnings may deter users information sharing -> competitors
Disclosure
Effective date of assumptions Date that information was approved: subsequent
events may impact usefulness of this informationExtent of inclusion of actual financial results
and its period Varying nature of actual results
Entities are faced with limitations and uncertainties in regards to future conditions and actions
Disclosure
Once a company discloses that actual results may vary significantly (or materially) from the
forecast, is the forecast still useful ?
Disclosure
Plans to update future-oriented financial information subsequent to issue Must disclose if the entity accepts no responsibility to
update the information
Disclosure of Assumptions
Use assumptions based on planned course of action Will this planned course of action likely occur?
Significant assumptions underlying future-oriented financial information should be disclosed What is significant?
Incorporate a sensitivity analysis
Other Disclosures
If future-oriented statements include a change in account policy must disclose Describe change Nature of effect
Special purpose financial information Disclose purpose & who it is meant for
Purpose/Limitation of usefulness of projection
Delta Air Lines/ComAir
ComAir is a wholly owned subsidiary of D.A.L.09/14/2005 – D.A.L. files for cpt. 11 bankruptcy
Forces ComAir into bankruptcyChapter 11 Bankruptcy
Allows for reorganization of company with a judges approval Value of business is greater if a going concern
Business “engine” can be restarted to generate cash to repay creditors
More economically efficient to: Cancel some debts Give ownership of reorganized company to creditors whose debts
cancelled
How do you prove this will work?
General Disclosure:
Passenger Revenue Projections:
Aircraft Fuel Cost Projections:
Other Disclosures
SportsGoodStop - Case
KPMG Study
1% of the firms reviewed hit their forecast exactly
22% came within five percent either wayOn average forecasts were out by 13%
Thank you
Questions?