accounting memo

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EARNINGS VOLATILITY

Key components

Stability of earnings

Less Volatility → More Confident

Earnings in 10-K or 10-Q

High fluctuation → Risky Investment

Management uses to plan ahead

Seasonality, politics effect earnings

Normalized Earnings

What makes GOOD volatility?

Prinicples

Matching- match expenses with related revenues

Accounting Period- 12 month period

Conservatism- if you have two acceptable alternatives… choose the more conservative alternative (lesser profit between the two)

Consistency → Comparability

Materiality

All above are necessary for appropriate analysis of earnings and their volatility

Earnings Volatility vs. Market Volatility

Market Volatility

stocks are priced and traded daily

More data and information

Analysts do not have to wait to calculate volatility

Earnings Volatility

stability or instability of a company's earnings

big volatility makes it difficult for management to plan

managers try to maximize earnings and normalize them

So what’s the relationship between them?

In general, stable earnings lead to a more stable market

Investors?

Stability minimizes the potential of a total loss

Not all volatility is bad: 4.5% daily average

The relationship can be disastrous

Before Scandal: $90.75 After Scandal: $0.67

They hid debts and losses through accounting loopholes

Made their earnings look stronger, in return it kept investors interested

Low Volatility

Greed: Showing Good Volatility

CEO wanted to show rapid increase in value

9B false accounting entries

Earnings Management

Show a firm’s financial position

Judgment calls

Management Pressure

and Manipulation

Financial Expectations

Stock Price → Bonuses

Examples

LIFO → FIFO

Capitalized costs

FASB in Action

What has FASB done to stabilize Earnings Volatility?

Updates on Comprehensive Income

Updates on Credit Losses

Updates on Available for Sale Debt Securities

FASB and Earnings Volatility

In 1997, FASB created “comprehensive income” so that investors could have a better idea of the companies’ true financials.

For much of the 1990’s, companies like Coca-Cola were engaged in earnings management. They wanted their earnings to appear smooth, when in reality they were very volatile. From 1994-1997, Coca-Cola reported 17% annual profit year over year. However, the true figures were 36% for 1994, 4% for 1995, and 16% in 1996.

FASB and Credit Losses

Another problem FASB faced was Credit Losses. According to GAAP, you can only recognize a loss once it is “probable” that it has been incurred.

Is it possible that GAAP could restrict the ability to record credit losses that are expected, but do not meet the “probable” threshold?

FASB and Credit Losses (cont.)

During the financial crisis, analysts used forward-looking information to assess an entity’s allowance for credit losses on the basis of their own expectations.

The problem arose when they made estimates of expected credit losses and devalued financial institutions before accounting losses were recognized.

This created a huge problem and showed that there was valuable information not disclosed via GAAP.

FASB and Credit Losses (cont.)

The Financial institutions were also upset because they could not record credit losses that they were expecting because they were not probable.

FASB corrected this, in an update, by allowing consideration of a broader range of reasonable and supportable information to inform credit loss estimates.

FASB and Available for Sale Debt Securities

Under GAAP, credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses.

FASB decided that there should be a limit on the amount of the allowance for credit losses compared to the amount by which fair value is below amortized cost.

They do this because available for sale debt securities are premised on an investment strategy that recognizes that the investment could be sold at fair value.