Week 2 0 Reporting Performance — Transcript

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1. 0:02as we start to consider the regulation
2. 0:04which dictates the way in which
3. 0:06information is presented in general
4. 0:08purpose financial reports
5. 0:09it's probably appropriate that we start
6. 0:11off by focusing on how performance is
7. 0:13reported
8. 0:15we focus on performance because that
9. 0:17tends to be what most people focus on in
10. 0:19the first
11. 0:19instance it might be investors who are
12. 0:22concerned with firm performance and that
13. 0:24might dictate their decisions to buy or
14. 0:25sell shares
15. 0:27it might be competitors who are
16. 0:29interested in the
17. 0:30strategies which being employed by firms
18. 0:33they compete against
19. 0:35and trying to evaluate whether they are
20. 0:37successful or not
21. 0:39it might also be suppliers who are
22. 0:41concerned with our
23. 0:43firms across the supply chain are
24. 0:46generating profits and with
25. 0:47their profits in commercial their
26. 0:49contribution
27. 0:51it's fair to say that irrespective of
28. 0:54the
29. 0:54use that you have of financial reports
30. 0:57it's probably fair to say
31. 0:58that most people focus on performance
32. 1:00first
33. 1:01and that's equally applicable to the
34. 1:02different functions of accounting
35. 1:04whether it be stewardship
36. 1:06when resources are delegated to managers
37. 1:09then there is the assumption that
38. 1:10they're going to generate returns for
39. 1:12shareholders and demonstrate their
40. 1:13stewardship
41. 1:14and one way of focusing demonstrating
42. 1:16this is through the performance that the
43. 1:18firm achieves
44. 1:19maybe it's in financial contracting such
45. 1:22as the use of performance measures
46. 1:24in measuring compensation contracts
47. 1:27likewise decision making by investors
48. 1:30may focus on performance as
49. 1:32a starting point or a basis for
50. 1:34commencing valuation
51. 1:36and this will dictate decisions to buy
52. 1:37or sell shares
53. 1:39so it's fair to say that
54. 1:42performance is something that most users
55. 1:44of financial statements are
56. 1:46concerned with in terms of what
57. 1:49performance measure we use we need to
58. 1:51understand through a range of
59. 1:53performance metrics that are presented
60. 1:55the one that we tend to give most
61. 1:57emphasis to is the earnings number or
62. 1:59the profit or loss
63. 2:00the number that appears in the statement
64. 2:02of profit or loss
65. 2:03and other comprehensive income which is
66. 2:06dictated by is one
67. 2:08and we've talked about that previously a
68. 2:10challenge with earnings numbers though
69. 2:12is that this is presented on the basis
70. 2:13of the whole firm and investors often
71. 2:16just buy
72. 2:17parts of firms or shares and so we also
73. 2:20have the earnings number being restated
74. 2:22on a per share basis because that
75. 2:24reflects how investors buy the shares
76. 2:26their interests and the presentation or
77. 2:29the calculation of earnings per share
78. 2:30numbers is
79. 2:31dictated in is 33.
80. 2:35we also need to acknowledge that cash
81. 2:37flow is also a measure of performance
82. 2:39and this is dictated by ias 7 and
83. 2:42we can't overlook cash flow at this
84. 2:44point in time because at the end of the
85. 2:46day we need to appreciate that
86. 2:48profit equals cash flow plus accruals
87. 2:51and accruals represent the sum
88. 2:54or the consequences of all accounting
89. 2:56practices of all accounting standards
90. 2:59so when we look at the cash flow and we
91. 3:01compare it to profit
92. 3:02it gives us an appreciation of what
93. 3:04impact the accounting transfer
94. 3:06accounting processes have had in terms
95. 3:08of transforming
96. 3:09transforming cash flow into profit
97. 3:15in terms of whether these numbers are
98. 3:16useful or not there's quite a
99. 3:18significant empirical literature
100. 3:20focusing on income first we can look at
101. 3:22paul and brown
102. 3:23and what paul and brandt did was they
103. 3:25were concerned with demonstrating
104. 3:27whether
105. 3:28accounting and earnings were useful for
106. 3:31users of financial statements
107. 3:32shareholders so what they looked at was
108. 3:35an association between
109. 3:36changes in earnings and changes in share
110. 3:39price
111. 3:40and their study was published in the
112. 3:42journal of academic research in 1968
113. 3:46and what is reassuring for us is that
114. 3:48they found a positive association
115. 3:50between
116. 3:50changes in earnings and changes in share
117. 3:53price
118. 3:55the research has become a lot more
119. 3:57refined in the more recent years
120. 3:59in subsequent years and it was a paper
121. 4:02was
122. 4:03written by eastern harris which appeared
123. 4:05in the general account research in 1991
124. 4:08and this demonstrated that it wasn't
125. 4:09just the change in earnings
126. 4:11but the level of earnings which was
127. 4:13relevant to stock prices
128. 4:15i suppose the point to make here is that
129. 4:19in terms of the relevance of earnings
130. 4:21you want to have
131. 4:22lots of earnings and you want them to be
132. 4:24getting bigger
133. 4:26there's also a really interesting paper
134. 4:27by easton harrison olsen which was
135. 4:30published in the journal of an account
136. 4:31accounting and economics a year later in
137. 4:331992
138. 4:34and what this looked at was the
139. 4:36association between
140. 4:38earnings and stock prices over one years
141. 4:41two years five years and 10 years
142. 4:43and when this was really interesting is
143. 4:45that plus the association between
144. 4:46earnings and stock prices might be
145. 4:49minimal over short periods
146. 4:52eight percent over one year over a ten
147. 4:54year period
148. 4:55was 60 and i suppose the takeaway from
149. 4:59that is that
150. 5:01whilst we do try and manipulate cash
151. 5:02flows through accruals to get a profit
152. 5:04number which is more relevant
153. 5:06we still have significant issues with
154. 5:08timing
155. 5:10it also suggests that the end of the day
156. 5:12firms have to make a profit
157. 5:15now one of the arguments that we always
158. 5:16have is should we focus on earnings
159. 5:20or cash flow cash flows is real earnings
160. 5:23is subject to manipulation
161. 5:26i suppose probably the one reassurance
162. 5:28we can take from
163. 5:30from this uh paper here by the by the
164. 5:32child
165. 5:33that she demonstrates is that accounting
166. 5:36and the accounting processes
167. 5:37are a value adding process what she did
168. 5:40in her paper was she looked at the
169. 5:42association between stock prices
170. 5:45and alternative measures of firm
171. 5:48performance
172. 5:49earnings cash flow from operations
173. 5:52and net cash flow from operation so
174. 5:54let's focus on the first two columns
175. 5:56earnings and cash flow from operations
176. 6:00what did chow found was that
177. 6:02irrespective of whether you had
178. 6:04very short periods quarterly or longer
179. 6:06periods
180. 6:07annual there was a much stronger
181. 6:10association between
182. 6:11earnings and stock prices than cash flow
183. 6:14and stock prices
184. 6:16so it sort of suggests that the
185. 6:18accounting process is value-adding
186. 6:21what she also found was that the
187. 6:23association increases as you have a
188. 6:25longer observation window
189. 6:27so whilst it's telling us that earnings
190. 6:32earnings do represent a value-adding
191. 6:34process we probably haven't got things
192. 6:36as right as we could it could do
193. 6:39and that there are still issues with the
194. 6:41timing in terms of when we recognize
195. 6:43earnings
196. 6:44and this is probably something you can
197. 6:46see that we're working on with our
198. 6:47accounting standards
199. 6:48but here's something that we can
200. 6:50probably do better on at the end of the
201. 6:51day
202. 6:54in terms of what earnings or profit
203. 6:56represents we can look at the conceptual
204. 6:58framework
205. 7:00and in the conceptual framework we can
206. 7:01see that income
207. 7:05is an either an increase in assets or a
208. 7:07decrease in liabilities
209. 7:09expenses are a decrease in assets or an
210. 7:12increase in liabilities
211. 7:14and the profit or loss is income minus
212. 7:16expenses
213. 7:19no revelation there when we look at the
214. 7:22presentation of financial statements in
215. 7:23is 1
216. 7:24we can see that income has two
217. 7:26components to it it has revenues and
218. 7:28gains and expenses comprise expenses and
219. 7:32losses so it's
220. 7:33broadly consistent and at the end of the
221. 7:36day
222. 7:37earnings is the product of revenue gains
223. 7:40minus expenses and
224. 7:42losses
225. 7:44in terms of how performance is reported
226. 7:47or the accounting standards which guide
227. 7:48that performance
228. 7:50obviously we need to focus on standards
229. 7:52which are concerned with revenue
230. 7:53the most obvious standard here is
231. 7:55efforts 15 which is concerned with
232. 7:57revenue recognition when it comes to
233. 8:00expenses well we're actually not going
234. 8:01to see any specific standards today
235. 8:03and the reason for this is that most of
236. 8:05the expenses
237. 8:07the standards that are concerned with
238. 8:09expenses
239. 8:10are actually addressed also in standards
240. 8:13which address
241. 8:13assets and liabilities and so we're
242. 8:16going to defer consideration of
243. 8:17those standards until we talk about
244. 8:19those asset and liability standards
245. 8:22we'll talk about earnings per share
246. 8:24calculations is 33
247. 8:26and we're going to talk about the parts
248. 8:28of the standard cash flows io7
249. 8:31which are relevant to help us better
250. 8:33understand further performance