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Differences in accounting standards across countries affect the measurement of earnings. These differences, however, are not as great as they are made out to be and they cannot explain away radical departures from fundamental principles of valuation.11 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.12 As countries increasingly move toward international financial reporting standards (IFRS), it is worth noting that IFRS and U.S. GAAP are more similar than dissimilar on many issues. It is true that there are areas of differences that still remain, and we note some of them in Table 3.1.

The accounting convergence notwithstanding, differences remain across accounting standards. Ratios such as price-earnings that use stated and unadjusted earnings can be misleading when accounting standards vary widely across the companies being compared. However, the information exists for us to make the adjustments needed to accounting numbers for comparisons to be valid.

C O N C L U S I O N

Financial statements remain the primary source of information for most investors and analysts. There are differences, however, between how accounting analysis and financial analysis approach answering a number of key questions about the firm. We examined 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

11At 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.

12F. D. S. Choi and R. M. Levich, The Capital Market Effects of International Accounting Diversity (New York: Dow Jones Irwin, 1990).

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T A B L E 3 . 1 (Continued)

information about the former and very little about the latter. The focus on the original price paid to acquire 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 govern how profits are measured are accrual accounting (in which revenues and expenses are shown in the period when 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 do not affect income in the year of the expenditure but affect income in subsequent time periods in the form of depreciation and amortization. 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 examined how financial statements deal with short-term liquidity risk and long-term default risk. 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 in accounting statements on risk to equity investors.

E X E R C I S E S

Pick a company that you are familiar with in terms of its business and history. Try the following:

1.Compute measures of profitability for your company relative to:

a.Revenues (net profit margin, operating margin).

b.Capital invested (return on invested capital, return on equity).

Compare the company’s measures to the averages on these measures for the sector in which it operates (from my website).

2.Compute measures of leverage for your company, by estimating the debt-to-equity and debt-to-capital ratios, on both a book value and a market value basis. Again, compare to the averages for the sector in which it operates.

3.Is the accrual income (reported in the income statement) consistent with the cash income (from the statement of cash flows)? If not, what accounts for the difference?

Lessons for Investors

The purpose of accounting statements is to give you a measure of how a company performed in the past. Your objective in investing is to consider how a firm will perform in the future.

Accounting rules provide significant discretion to firms in how they measure and report earnings. Firms that adopt aggressive accounting practices, even though the practices may be legal, will report higher earnings than firms that adopt more conservative practices.

As firms age, the book value of their assets will become less and less relevant as measures of what the assets are truly worth.

Firms with operating leases and off-balance-sheet financing owe much more than what they reveal as debt on their balance sheets.

The footnotes to the financial statements often carry more information than the financial statements themselves.

a function of the cash flows generated by that asset, the life of the asset, the expected growth in the cash flows, and the riskiness associated with the cash flows. We begin this section by looking at valuing assets that have finite lives (at the end of which they cease to generate cash flows) and conclude by looking at the more difficult case of assets with infinite lives. We will also start the process by looking at firms whose cash flows are known with certainty and conclude by looking at how we can incorporate the effect of uncertainty into value.

T h e M e c h a n i c s o f P r e s e n t V a l u e

Almost everything we do in intrinsic valuation rests on the concept of present value. The intuition of why a dollar today is worth more than a dollar a year from now is simple. Our preferences for current over future consumption, the effect of inflation on the buying power of a dollar, and uncertainty about whether we will receive the future dollar all play a role in determining how much of a discount we apply to the future dollar. In annualized terms, this discount is measured with a discount rate. However, it is worth reviewing the basic mechanics of present value before we consider more complicated valuation questions.

In general, there are five types of cash flows that you will encounter in valuing any asset. You can have a single cash flow in the future, a set of equal cash flows each period for a number of periods (annuity), a set of equal cash flows each period forever (perpetuity), a set of cash flows growing at a constant rate each period for a number of periods (growing annuity), and a cash flow that grows at a constant rate forever (growing perpetuity).

The present value (PV) of a single cash flow in the future can be obtained by discounting the cash flow back at the discount rate for the time period in question. Thus, the value of $10 million in five years with a discount rate of 15 percent can be written as:

$10

Present value of $10 million in five years = (1.15)5 = $4.97 million

You could read this present value to mean that you would be indifferent between receiving $4.97 million today or $10 million in five years.

What about the present value of an annuity? You have two choices. One is to discount each of the annual cash flows back to the present and add them all up. For instance, if you had an annuity of $5 million every year for the next five years and a discount rate of 10 percent, you could compute the present value of the annuity in Figure 4.1.