Building Blocks of Accrual Accounting

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One of the fundamental features of corporate financial reports is that they are prepared using accrual rather than cash accounting. Unlike cash accounting, accrual accounting distinguishes between the recording of costs and benefits associated with economic activities and the actual payment and receipt of cash. Net income is the primary periodic performance index under accrual accounting. To compute net income, the effects of economic transactions are recorded on the basis of expected, not necessarily actual, cash receipts and payments. Expected cash receipts from the delivery of products or services are recognized as revenues, and expected cash outflows associated with these revenues are recognized as expenses.

While there are many rules and conventions that govern a firm’s preparation of financial statements, there are only a few conceptual building blocks that form the foundation of accrual accounting. The principles that define a firm’s assets, liabilities, equities, revenues, and expenses are as follows:

  • Assets are economic resources owned by a firm that (a) are likely to produce future economic benefits and (b) are measurable with a reasonable degree of certainty.
  • Liabilities are economic obligations of a firm arising from benefits received in the past that are (a) required to be met with a reasonable degree of certainty and (b) at a reasonably well-defined time in the future.
  • Equity is the difference between a firm’s net assets and its liabilities. The definitions of assets, liabilities, and equity lead to the fundamental relationship that governs a firm’s balance sheet:

Assets = Liabilities + Equity

While the balance sheet is a summary at one point in time, the income statement summarizes a firm’s revenues and expenses and its gains and losses arising from changes in assets and liabilities in accord with the following definitions:

  • Revenues are economic resources earned during a time period. Revenue recognition is governed by the realization principle, which proposes that revenues should be recognized when (a) the firm has provided all, or substantially all, the goods or services to be delivered to the customer and (b) the customer has paid cash or is expected to pay cash with a reasonable degree of certainty.
  • Expenses are economic resources used up in a time period. Expense recognition is governed by the matching and the conservatism principles. Under these principles, expenses are (a) costs directly associated with revenues recognized in the same period, or (b) costs associated with benefits that are consumed in this time period, or(c) resources whose future benefits are not reasonably certain.
  • Profit is the difference between a firm’s revenues and expenses in a time period.

The Institutional Framework for Financial Reporting

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There is typically a separation between ownership and management in public corporations. Financial statements serve as the vehicle through which owners keep track of their firms financial situation. On a periodic basis, firms typically produce three financial reports:

  1. an income statement that describes the operating performance during a time period
  2. a balance sheet that states the firms assets and how they are financed
  3. a cash flow statement (or in some countries, a funds flow statement) that summarizes the cash flows of the firm.

These statements are accompanied by several footnotes and a message and narrative discussion written by the management. To evaluate effectively the quality of a firm’s financial statement data, the analyst needs to first understand the basic features of financial reporting and the institutional framework that governs them.

Applying Corporate Strategy Analysis

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Let us apply the concepts of corporate strategy analysis to Amazon.com, a pioneer in electronic commerce. Amazon started operations as an online bookseller in 1995 and went public in 1997 with a market capitalization of $561 million dollars. The company grew rapidly and began to pose a serious threat to the dominance of leading traditional booksellers like Barnes & Noble. Investors rewarded Amazon by increasing its market capitalization to a remarkable $36 billion dollars by April 1999.

Flush with his success in online book-selling, Jeff Bezos, the founder and chief executive officer of Amazon, moved the company into many other areas of electronic commerce. Amazon claimed that its brand, its loyal customer base, and its ability to execute electronic commerce were valuable assets that can be exploited in a number of other on-line business areas. Beginning in 1998, through a series of acquisitions, Amazon expanded into online selling of CDs, videos, gifts, pharmaceutical drugs, pet supplies, and groceries. In April 1999, Amazon announced plans to diversify into the online auction business by acquiring LiveBid.com. Bezos explained, “We are not a book company. We’re not a music company. We’re not a video company. We’re not an auctions company. We’re a customer company.”

Amazon’s rapid expansion attracted controversy among the investment community. Some analysts argued that Amazon could create value through its broad corporate focus because of the following reasons:

  • Amazon has established a valuable brand name on the Internet. Given that electronic commerce is a relatively new phenomenon, customers are likely to rely on well known brands to reduce the risk of a bad shopping experience. Amazon’s expansion strategy is sensible because it exploits this valuable resource.
  • Amazon has been able to acquire critical expertise in flawless execution of electronic retailing. This is a general competency that can be exploited in many are as of electronic retailing.
  • Amazon has been able to create a tremendous amount of loyalty among its customers through superior marketing and execution. As a result, a very high proportion of Amazon’s sales comes from repeat purchases by its customers. Amazon’s strategy exploits this valuable customer base.

There were also some skeptics who believed that Amazon was expanding too rapidly, and that its divers ification beyond book retailing was likely to fail. These skeptics questioned the value of Amazon’s brand name. They argued that traditional retailers, such as Barnes & Noble, Wal-Mart, and CVS, who are boosting their online efforts, also have valuable brand names, execution capabilities, and customer loyalty. Therefore, these companies are likely to offer formidable competition to Amazon’s individual business lines. Amazon’s critics also pointed out that expanding rapidly into so many different areas is likely to confuse customers, dilute Amazon’s brand value, and increase the chance of poor execution. Commenting on the fact that Amazon is losing money in all of its businesses while it is expanding rapidly, Barron’s business weekly stated, “Increasingly, Amazon’s strategy is looking like the dim-bulb businessman who loses money on every sale but tries to make it up by making more sales.”

Investor concerns about Amazon’s corporate strategy began to affect its share price, which dropped from a high of $221 dollars in April 1999 to $118 dollars by the end of May 1999. Still, at a total market capitalization of about $19 billion dollars, many investors are betting that Amazon’s corporate strategy is likely to yield rich dividends in the future.

Sources of Value Creation at the Corporate Level

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Economists and strategy researchers have identified several factors that influence an organization’s ability to create value through a broad corporate scope. Economic theory

suggests that the optimal activity scope of a firm depends on the relative transaction cost of performing a set of activities inside the firm versus using the market mechanism.

Transaction cost economics implies that the multi product firm is an efficient choice of organizational form when coordination among independent, focused firms is costly due to market transaction costs.

Transaction costs can arise out of several sources. They may arise if the production process involves specialized assets, such as human capital skills, proprietary technology, or other organizational know-how that is not easily available in the marketplace. Trans-action costs also may arise from market imperfections such as information and incentive problems. If buyers and sellers cannot solve these problems through standard mechanisms such as enforceable contracts, it will be costly to conduct transactions through market mechanisms.

For example, public capital markets may not work well when there are significant information and incentive problems, making it difficult for entrepreneurs to raise capital from investors. Similarly, if buyers cannot ascertain the quality of products being sold because of lack of information, or cannot enforce warranties because of poor legal infrastructure, entrepreneurs will find it difficult to break into new markets. Finally, if employers cannot assess the quality of applicants for new positions, they will have to rely more on internal promotions, rather than external recruiting, to fill higher positions in an organization. Emerging economies often suffer from these types of transaction costs because of poorly developed intermediation infrastructure.

Even in many advanced economies, examples of high transaction costs can be found. For example, in many countries other than the U.S., the venture capital industry is not highly developed, making it costly for new businesses in high technology industries to attract financing. Even in the U.S., transaction costs may vary across economic sectors. For example, until recently electronic commerce was hampered by consumer concerns regarding the security of credit card information sent over the Internet.

Transactions inside an organization may be less costly than market-based transactions for several reasons. First, communication costs inside an organization are reduced because confidentiality can be protected and credibility can be assured through internal mechanisms. Second, the headquarters office can play a critical role in reducing costs of enforcing agreements between organizational subunits. Third, organizational subunits can share valuable non tradable assets (such as organizational skills, systems, and processes) or non divisible assets (such as brand names, distribution channels, and reputation).

There are also forces that increase transaction costs inside organizations. Top management of an organization may lack the specialized information and skills necessary to manage businesses across several different industries. This lack of expertise reduces the possibility of realizing economies of scope in reality, even when there is potential for such economies. This problem can be remedied by creating a decentralized organization, hiring specialist managers to run each business unit, and providing them with proper incentives. However, decentralization will also potentially decrease goal congruence among subunit managers, making it difficult to realize economies of scope.

Analysts should ask the following questions to assess whether or not an organization’s corporate strategy has the potential to create value:

  • Are there significant imperfections in the product, labor, or financial markets in the industries (or countries) in which a company is operating? Is it likely that transaction costs in these markets are higher than the costs of similar activities inside a well managed organization?
  • Does the organization have special resources such as brand names, proprietary know-how, access to scarce distribution channels, and special organizational processes that have the potential to create economies of scope?
  • Is there a good fit between the company’s specialized resources and the portfolio of businesses in which the company is operating?
  • Does the company allocate decision rights between the headquarters office and the business units optimally to realize all the potential economies of scope?
  • Does the company have internal measurement, information, and incentive systems to reduce agency costs and increase coordination across business units?

Achieving And Sustaining Competitive Advantage

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The choice of competitive strategy does not automatically lead to the achievement of competitive advantage. To achieve competitive advantage, the firm has to have the capabilities needed to implement and sustain the chosen strategy. Both cost leadership and differentiation strategy require that the firm make the necessary commitments to acquire the core competencies needed, and structure its value chain in an appropriate way. Core competencies are the economic assets that the firm possesses, whereas the value chain is the set of activities that the firm performs to convert inputs into outputs. The uniqueness of a firm’s core competencies and its value chain and the extent to which it is difficult for competitors to imitate them determines the sustainability of a firm’s competitive advantage.

To evaluate whether or not a firm is likely to achieve its intended competitive advantage, the analyst should ask the following questions:

  • What are the key success factors and risks associated with the firm’s chosen competitive strategy?
  • Does the firm currently have the resources and capabilities to deal with the key success factors and risks?
  • Has the firm made irreversible commitments to bridge the gap between its current capabilities and the requirements to achieve its competitive advantage?
  • Has the firm structured its activities (such as research and development, design, manufacturing, marketing and distribution, and support activities) in a way that is consistent with its competitive strategy?
  • Is the company’s competitive advantage sustainable? Are there any barriers that make imitation of the firm’s strategy difficult?
  • Are there any potential changes in the firm’s industry structure (such as new technologies, foreign competition, changes in regulation, changes in customer requirements) that might dissipate the firm’s competitive advantage? Is the company flexible enough to address these changes?

Sources Of Competitive Advantage

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Cost leadership enables a firm to supply the same product or service offered by its competitors at a lower cost. Differentiation strategy involves providing a product or service that is distinct in some important respect valued by the customer. For example, in retailing, Nordstrom has succeeded on the basis of differentiation by emphasizing exception-ally high customer service. In contrast, Filene’s Basement Stores is a discount retailer competing purely on a low-cost basis.

Competitive Strategy 1: Cost Leadership 

Cost leadership is often the clearest way to achieve competitive advantage. In industries where the basic product or service is a commodity, cost leadership might be the only way to achieve superior performance. There are many ways to achieve cost leadership, including economies of scale and scope, economies of learning, efficient production, simpler product design, lower input costs, and efficient organizational processes. If a firm can achieve cost leadership, then it will be able to earn above-average profitability by merely charging the same price as its rivals. Conversely, a cost leader can force its competitors to cut prices and accept lower returns, or to exit the industry.

Firms that achieve cost leadership focus on tight cost controls. They make investments in efficient scale plants, focus on product designs that reduce manufacturing costs, minimize overhead costs, make little investment in risky research and development, and avoid serving marginal customers. They have organizational structures and control systems that focus on cost control.

Competitive Strategy 2: Differentiation

A firm following the differentiation strategy seeks to be unique in its industry along some dimension that is highly valued by customers. For differentiation to be successful, the firm has to accomplish three things. First, it needs to identify one or more attributes of a product or service that customers value. Second, it has to position itself to meet the chosen customer need in a unique manner. Finally, the firm has to achieve differentiation at a cost that is lower than the price the customer is willing to pay for the differentiated product or service.

Drivers of differentiation include providing superior intrinsic value via product quality, product variety, bundled services, or delivery timing. Differentiation can also be achieved by investing in signals of value, such as brand image, product appearance, or reputation. Differentiated strategies require investments in research and development, engineering skills, and marketing capabilities. The organizational structures and control systems in firms with differentiation strategies need to foster creativity and innovation.

While successful firms choose between cost leadership and differentiation, they can-not completely ignore the dimension on which they are not primarily competing. Firms that target differentiation still need to focus on costs, so that the differentiation can be achieved at an acceptable cost. Similarly, cost leaders cannot compete unless they achieve at least a minimum level on key dimensions on which competitors might differentiate, such as quality and service.

Competitive Strategy Analysis

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The profitability of a firm is influenced not only by its industry structure but also by the strategic choices it makes in positioning itself in the industry. While there are many ways to characterize a firm’s business strategy, there are two generic competitive strategies:

1- Cost Leadership
2- Differentiation

Both these strategies can potentially allow a firm to build a sustainable competitive advantage.

1- Cost Leadership

Supply same product or service at a lower cost.

  • Economies of scale and scope
  • Efficient production
  • Simpler product designs
  • Lower input costs
  • Low-cost distribution
  • Little research and development or brand advertising
  • Tight cost control system

2- Differentiation

Supply a unique product or ser-vice at a cost lower than the price premium customers will pay.

  • Superior product quality
  • Superior product variety
  • Superior customer service
  • More flexible delivery
  • Investment in brand image
  • Investment in research and development
  • Control system focus on creativity and innovation

Strategy researchers have traditionally viewed cost leadership and differentiation as mutually exclusive strategies. Firms that straddle the two strategies are considered to be “stuck in the middle” and are expected to earn low profitability. These firms run the risk of not being able to attract price conscious customers because their costs are too high; they are also unable to provide adequate differentiation to attract premium price customers.

Industry Analysis

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In analyzing a firm’s profit potential, an analyst has to first assess the profit potential of each of the industries in which the firm is competing, because the profitability of various industries differs systematically and predictably over time. For example, the ratio of earnings before interest and taxes to the book value of assets for all U.S. companies between1981 and 1997 was 8.8 percent. However, the average returns varied widely across specific industries: for the bakery products industry, the profitability ratio was 43 percentage points greater than the population average, and 23 percentage points less than the population average for the silver ore mining industry.

What causes these profitability differences? There is a vast body of research in industrial organization on the influence of industry structure on profitability.

Relying on this research, strategy literature suggests that the average profitability of an industry is influenced by the “five forces” are as follows:

Degree Of Actual And Potential Competition

1- Rivalry AmongExisting Firms
2- Threat of New Entrants
3- Threat of Substitute Products

Bargaining Power In Input And Output Markets

4- Bargaining Power of Buyers
5- Bargaining Power of Suppliers

According to this framework, the intensity of competition determines the potential for creating abnormal profits by the firms in an industry. Whether or not the potential profits are kept by the industry is determined by the relative bargaining power of the firms in the industry and their customers and suppliers.

Strategy Analysis

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Strategy analysis is an important starting point for the analysis of financial statements. Strategy analysis allows the analyst to probe the economics of the firm at a qualitative level so that the subsequent accounting and financial analysis is grounded in business reality. Strategy analysis also allows the identification of the firm’s profit drivers and key risks. This, in turn, enables the analyst to assess the sustainability of the firm’s current performance and make realistic forecasts of future performance.

A firm’s value is determined by its ability to earn a return on its capital in excess of the cost of capital. What determines whether or not a firm is able to accomplish this goal? While a firm’s cost of capital is determined by the capital markets, its profit potential is determined by its own strategic choices:

1- The choice of an industry or a set of industries in which the firm operates (industry choice).

2- The manner in which the firm intends to compete with other firms in its chosen industry or industries (competitive positioning).

3- The way in which the firm expects to create and exploit synergies across the range of businesses in which it operates (corporate strategy).

Strategy analysis, therefore, involves industry analysis, competitive strategy analysis, and corporate strategy analysis.

From Financial Statements To Business Analysis

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Because managers’ insider knowledge is a source both of value and distortion in accounting data, it is difficult for outside users of financial statements to separate true information from distortion and noise. Not being able to undo accounting distortions completely, investors “discount” a firm’s reported accounting performance. In doing so, they make a probabilistic assessment of the extent to which a firm’s reported numbers reflect economic reality. As a result, investors can have only an imprecise assessment of an individual firm’s performance. Financial and information intermediaries can add value by improving investors’ understanding of a firm’s current performance and its future prospects.

Effective financial statement analysis is valuable because it attempts to get at managers inside information from public financial statement data. Because intermediaries do not have direct or complete access to this information, they rely on their knowledge of the firm’s industry and its competitive strategies to interpret financial statements. Successful intermediaries have at least as good an understanding of the industry economics as do the firm’s managers, and a reasonably good understanding of the firm’s competitive strategy. Although outside analysts have an information disadvantage relative to the firm’s managers, they are more objective in evaluating the economic consequences of the firm’s investment and operating decisions.

Business intermediaries use financial statements to accomplish four key steps: (1) business strategy analysis, (2) accounting analysis, (3) financial analysis, and (4) prospective analysis.

1: Business Strategy Analysis

The purpose of business strategy analysis is to identify key profit drivers and business risks, and to assess the company’s profit potential at a qualitative level. Business strategy analysis involves analyzing a firm’s industry and its strategy to create a sustainable competitive advantage. This qualitative analysis is an essential first step because it enables the analyst to frame the subsequent accounting and financial analysis better. For example, identifying the key success factors and key business risks allows the identification of key accounting policies. Assessment of a firm’s competitive strategy facilitates evaluating whether current profitability is sustainable. Finally, business analysis enables the analyst to make sound assumptions in forecasting a firm’s future performance.

2: Accounting Analysis

The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures the underlying business reality. By identifying places where there is accounting flexibility, and by evaluating the appropriateness of the firm’s accounting policies and estimates, analysts can assess the degree of distortion in a firm’s accounting numbers. Another important step in accounting analysis is to “undo” any accounting distortions by recasting a firm’s accounting numbers to create unbiased accounting data. Sound accounting analysis improves the reliability of conclusions from financial analysis, the next step in financial statement analysis.

3: Financial Analysis

The goal of financial analysis is to use financial data to evaluate the current and past performance of a firm and to assess its sustainability. There are two important skills related to financial analysis. First, the analysis should be systematic and efficient. Second, the analysis should allow the analyst to use financial data to explore business issues. Ratio analysis and cash flow analysis are the two most commonly used financial tools. Ratio analysis focuses on evaluating a firm’s product market performance and financial policies; cash flow analysis focuses on a firm’s liquidity and financial flexibility.

4: Prospective Analysis

Prospective analysis, which focuses on forecasting a firm’s future, is the final step in business analysis. Two commonly used techniques in prospective analysis are financial statement forecasting and valuation. Both these tools allow the synthesis of the insights from business analysis, accounting analysis, and financial analysis in order to make predictions about a firm’s future.

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