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I don't know what extent many of you use financial results and financial statements in making decisions to buy or sell shares, but here are some of my thoughts on company financials that you may find interesting or you may think are rubbish...
When a company is conducting a business where is can capitalise assets using the basis of MANAGEMENTS BEST ESTIMATES to value that asset, be very careful (you will find this information in Note 1 of every annual report). Management will always try to value up the asset, and as an auditor, it is very hard to disprove managements estimates unless they are fundamentally flawed.
To try to understand the concept further, lets use some real life examples. Coles Myer has stock in its Myer stores. It has plenty of imported plasma TVs in their stores. These are valued on Coles Myers balance sheet at cost. Simple. Can't go wrong. The asset is very easily valued and identifiable.
Now, lets say Coles Myer has a long-term contract to supply these TVs to a customer...at a profit margin of 50%, locked in. This contract is also an asset, because it has value. The problem is that there are literally millions of ways to value this asset. The higher the value, the more that Coles Myer will be stealing profits from tomorrow and booking them today. At Enron, they were using this principal to steal profits from 20 years down the track, tweaking models that created fictional profits 20 years down the track and stealing them for today too, which is how Enron kept reporting massive profits despite bleeding cash.
Accounting standards allow for something called percentage of completion accounting...this is where you can book the profits of a long term contract that you have achieved to date - even though the cash register hasn't gone off, even though the customer is nowhere near paying. So if you are 10% into a contract that is 'expected' to deliver a 50% profit margin, you can recognise 10% of that profit margin now. Forget about the fact that the project may turn ugly and end up making a loss.
From next year, Australian companies be changing accounting standards to IFRS. These standards promote something called 'fair value accounting'. Principles of historical cost and conservatism will be officially out the window. This will make it even harder to use financial statements and profit figures to value a company...and I think will potentially increase the volitility of earnings for many companies.
Hope you found this interesting and would love to hear any other opinions on this matter.
When a company is conducting a business where is can capitalise assets using the basis of MANAGEMENTS BEST ESTIMATES to value that asset, be very careful (you will find this information in Note 1 of every annual report). Management will always try to value up the asset, and as an auditor, it is very hard to disprove managements estimates unless they are fundamentally flawed.
To try to understand the concept further, lets use some real life examples. Coles Myer has stock in its Myer stores. It has plenty of imported plasma TVs in their stores. These are valued on Coles Myers balance sheet at cost. Simple. Can't go wrong. The asset is very easily valued and identifiable.
Now, lets say Coles Myer has a long-term contract to supply these TVs to a customer...at a profit margin of 50%, locked in. This contract is also an asset, because it has value. The problem is that there are literally millions of ways to value this asset. The higher the value, the more that Coles Myer will be stealing profits from tomorrow and booking them today. At Enron, they were using this principal to steal profits from 20 years down the track, tweaking models that created fictional profits 20 years down the track and stealing them for today too, which is how Enron kept reporting massive profits despite bleeding cash.
Accounting standards allow for something called percentage of completion accounting...this is where you can book the profits of a long term contract that you have achieved to date - even though the cash register hasn't gone off, even though the customer is nowhere near paying. So if you are 10% into a contract that is 'expected' to deliver a 50% profit margin, you can recognise 10% of that profit margin now. Forget about the fact that the project may turn ugly and end up making a loss.
From next year, Australian companies be changing accounting standards to IFRS. These standards promote something called 'fair value accounting'. Principles of historical cost and conservatism will be officially out the window. This will make it even harder to use financial statements and profit figures to value a company...and I think will potentially increase the volitility of earnings for many companies.
Hope you found this interesting and would love to hear any other opinions on this matter.
