 Hello and welcome to this session in which we would look at limitations of financial statement analysis. Simply put after we run the financial statements we look at the numbers we are pretty happy with the numbers. Now we need to understand certain shortcomings from those financial statement analysis. So this way if we understand the shortcoming we might be able to understand a little bit more and make certain adjustments for those financial statement analysis. In this session we're going to be looking at some aspect that distort the financial statement analysis such as inventory valuation, depreciation, inflation, and interest expense, fair value accounting, and quality of earnings, and accounting practices. As always when I have a list I'm going to go through each component of this list separately. But before I start I would like to remind you to check out my website farhatlectures.com if you are taking this course, accounting courses, or CPA exam. I don't replace your CPA prep course such as Wiley Gleim, Roger and Becker. I supplement. I'll give you additional material to help you pass the exam. Just visit my website if not for anything is to know how well your university does on the CPA exam. I do have those results. I have many accounting, audit, finance, and tax courses. Please connect with me on LinkedIn. Like my YouTube so you would receive notification about my new videos. Follow me on Instagram and Facebook. So starting with inventory valuation, we have two common used methods to value inventory. We have more than these two but those are common method. We have LIFO which stands for lost and first out and FIFO first and first out. In this session you really have to go back to your basic accounting knowledge but without even remembering that basic accounting knowledge I will try to explain the aspect of this. So bear in mind those are not the only two accounting method. We have the specific identification. We have the weighted average. Although I'm not discussing every single inventory valuation, before I start I would like to let you know that each one of them has a pros and cons. So although I'm only covering FIFO and LIFO bear in mind that the other methods, they also have shortcomings when it comes to financial statement analysis. Okay, so let's simply put if the price of generic goods has been constant say $1, the book value of inventory will be the same whether you're using FIFO, LIFO or any other method. But you know that's not true in the real world. You know in the real world that prices go up and the prices go down. We're going to be illustrating the concept where prices go up because prices usually go up their upward bias but also prices could go down. Whatever I say about prices go up, if prices go down the opposite is 100% true when it comes to inventory valuation. So suppose that the price of generic goods rises by 10 cent per unit during the year as a result of inflation. So you are dealing with units that cost us a dollar and we're dealing with 101 million unit and let's suppose the cost of each of these unit rises by 10 pennies or 10 percent. That's fine. If we are using LIFO, what does LIFO stand for? LIFO stand for last and first out. So let me show you how LIFO work. Let's assume you have, you are buying inventory and your cost is going from two to three to four to five dollars. So your cost is rising two dollars, three dollars, four dollars, five dollars. Now when you make a sale most likely you're going to sell something for seven dollars because if the last time you bought it for five you want to make a profit. If you are using LIFO last and first out what's going to happen is last in was the five dollars. So you're going to match this sale with five dollars. So what's going to happen? Your profit is two dollars. So this is under LIFO. If you are using FIFO you're going to sell the item, you're going to sell the item for seven but if you're using FIFO first and first out what's going to happen is you are going to match the sale with two dollars therefore your profit is five dollars. So notice how your profit is different whether you used FIFO or LIFO, whether you used the last unit you purchased or whether we used the oldest unit which is FIFO first in, first out. The two dollars were first in, they leave the company first, the five dollars are the last items to come in, therefore the first item to leave. So this is the basic idea of FIFO and LIFO. So here what happened is if inflation kicks in and the cost of your inventory went up by 10% the goods remaining are the previously produced at the cost of a dollar. So your old inventory here what happened is because you're using LIFO, what LIFO is going to do when you make a sale, so here's how LIFO works for our specific, for our specific example, when you make a sale you are going to deduct $1.10 as cost, cost of goods sold. What happened is on the balance sheet you are going to have the inventory because you're going to have the old inventory at a dollar because you are selling the new cost, you are getting rid of the new cost. Therefore LIFO accounting would result in cost of goods sold 1.1 million which is higher while the ending inventory will be 1 million. So what happened is your cost is higher, if your cost is higher remember your profit is lower. But your inventory is lower too. So you have old inventory at a dollar which is a million, your cost of goods sold is 1.1 million because you are costing your inventory at the most recent cost. You can see that LIFO accounting accurately measure the cost of goods sold so that's good. The pros of LIFO is your cost of goods sold is a recent figure. However your inventory is old so this is the problem with LIFO. You have a good recent cost of goods sold that's reflecting today's economic conditions. However your inventory is old. Now in contrast if you are using FIFO for this example, if you are using FIFO the opposite will happen. Under FIFO what's going to happen is this, FIFO is first and first out. So if you're using FIFO when you make a sale you are going to deduct the 1 million and your inventory will be 1.1 million. The inventory will be the most recent because you're selling the old and keeping the recent. The recent inventory should be valued at 1.1 million. So your inventory is new or recent but your cost of goods sold is old. What happened here you have more profit you're going to show more profit because you are using old cost. Your inventory will be more accurate reflecting the recent inventory. So notice you can't win. You'll either have good cost or bad inventory number or good inventory number and good inventory number and bad cost. The result is that LIFO firm has both a lower reported profit of course because it has a higher cost and a lower balance sheet value. So you have lower profit and lower balance sheet. LIFO result in a more realistic estimate of economics earnings. So your earnings are accurate. Why? Because you are matching your recent sales with your recent cost because you use up prices to evaluate cost of goods sold. However your balance sheet account which is your inventory is distorted because your inventory is lower. So when you compute return on asset your return on asset will be inflated because you are dividing your earnings by a lower inventory figure. So this is the problem with inventory valuation. The second problem we can face but by the way I mean financial analysts are aware of all of this. Therefore what you have to do when you are making financial statement analysis you have to make adjustments. You have for example if you want to use LIFO you have to convert all the numbers for both companies to LIFO or if you're using LIFO you will convert to LIFO. Depreciation is another computation that could distort your financial statement analysis. Let's first start by looking at the economic definition of depreciation. It's the depreciation is the amount of operating cash flow. What cash flow you will need to have that the firm must reinvest. You need to take this cash flow and buy a new asset to sustain your real cash flow at the current level. So basically depreciation from an economic perspective is the use of the cash flow to replace your old asset. This is when they kind of count depreciation. Now accounting depreciation which is totally different. And accounting depreciation we look at the original cost how much we paid for the asset then we allocate this cost over an arbitrary specified life of the asset. So basically if we paid $10,000 for a truck we say we're going this truck is going to last us five years and every year we're going to take $2,000 of depreciation. It's basically the five years and it's arbitrary. I would say well it's going to last us 10 years for that matter. Then my depreciation expense is $1,000. So notice depreciation expense is the actual number that goes on the financial statements. And through the financial statements through net income we compute return on asset return on equity price earnings earnings per share in all these figures. But all these figures are based on numbers that I created in a sense based on the accounting method that I'm using. Assume for example that a firm buys a machine with a useful life of 20 years at a cost of 100,000. Well in its financial statement assuming we're going to be using the straight line method because also we have many methods we can use therefore we'll take 100,000 divided by 20 years and every year we'll take 10,000 of depreciation. Now after 10 years the machine will be fully depreciated and going forward year 11, 12, 13 you are no more you are no more deducting that expense that depreciation expense. Although the machine is still productive because this machine would last you 20 years but you depreciated the machine over 10. I sorry I apologize I made a mistake. What I was saying earlier the useful life or the economic life is 20 years 20 years but you decided to depreciate it over 10. So you could depreciate it over 20, 10, 15. It's an arbitrary number that you make up when you compute your depreciation. So in computing accounting earnings this firm will overstate depreciation in the first 10 years. So in the first 10 years you are taken 10,000 of expenses. If you want to depreciate it over 20 years you would be taken 5,000 of depreciation then the remaining 10 years you are under reporting your depreciation. Why? Because your depreciation is zero and now your financial statements would look good because you eliminated that depreciation expense. So this will cause reported earnings to be understated compared with economic earnings in the first 10 years and overstated in the last 10 years. Why? Because there's a difference between the way you do depreciation for from an economic perspective compute depreciation versus accounting. Also the way you do depreciation for GAP which is accounting it's different than the IFRS which is for tax purposes that also disturbed the numbers. Also the estimated life of the asset we said here it's 20 years. Why not 25 years? Why not 15? So that number is arbitrary. Arbitrary in a sense that we decide how many years we need to compute. Also we also estimate something called residual value when we compute depreciation. Residual value is how much we're going to be able to sell this asset after we use it. That's also an estimate that could distort depreciation computation. Also we have many depreciation methods. For example here we said this company is using the straight line method. Well there's the straight line method. There is the double declining method. There is the sums of the year's digit. There's 150 double declining balance. Practically for depreciation you could use any method as long as it's reasonable and logical and systematic. GAP doesn't care which method you use. You could make up your own method if you would like to. Straight line is the most common method because it's the most simple method. So another complication arise from depreciation when we introduce inflation. Now remember when we depreciate an asset conventional depreciation is based on historical cost. So we're saying we said we paid 100,000 for this asset. But the current replacement cost of the asset is different. The current replacement cost five years later could be 125,000. What you do is you keep depreciating the asset using the 100,000. And the reason why depreciation is higher because of inflation supposed to be higher because the cost of this asset went up because of depreciation. So here what's happening because of depreciation because of inflation. So inflation is distorting the depreciation figure. So that's a problem that could distort the financial statements. Now from a firm's perspective that's good. Why? Because you don't want to book more depreciation expense. More expense means less earnings because if you want to do that. Inflation and interest expense play a role also in distorting figures. While inflation can distort, can cause distortion in inventory and depreciation cost which we just saw this, it perhaps can even have a greater effect on the interest expense. So you have to compute your interest expense. Remember the nominal interest expense. Remember the nominal is composed of the inflation plus the real. So the nominal equal to the inflation that compensate the lender for inflation induced erosion in real value. So what we have to know is how much is inflationary that we're paying and how much is real. So from the perspective of both lender and borrower, part of what's conventionally measured as interest expense should be treated more properly as repayment of principle. Because the interest expense should only be the real interest expense. Inflation is not an expense. You are paying extra as interest is because you have to compensate for inflation. But that's not really an expense. That's not really an expense. So simply put, let's work an example to see how it works. It is an expense but it should not be an expense. That's the point that they're trying to make. Suppose generic product has outstanding debt with a face value of 10 million and interest rate of 10%. What does that mean? It means every year they pay an interest. Interest expense is 1 million. 10 million times 10%. Let's assume inflation during the year is 6%. If inflation, if the nominal rate is 6, 6 of it is inflation. 6% is inflation and 4% only real. So your real interest rate is only approximately 4%. What does that mean? It means the 600,000 of what appears as interest expense on the income statement, which you do, is really an inflation premium or compensation for the anticipated reduction in the real value of 10 million principle. So the reason they want you to pay extra, it's not because it's an actual expense. It's because they want to protect, the lender want to protect themselves from the erosion of inflation. So only the true expense, the true economic, in quote, expense is only 400,000. Now the good thing in the US, we practically have no inflation, so we don't have to worry about this. So the 600,000 reduction in the purchasing power of the outstanding principle may be thought of as repayment of the principle rather than an interest expense. So really that 600,000 should be a reduction in the principle. That's not really true. You know, companies would love to do this, but that's not how it works. So the real income of the firm, what's happening to the real income of the firm is being understated because of inflation by 600,000 and extra inflation money you are paying to your lender. Otherwise you should be only paying them 400,000. Let's take a look at this example to see kind of make this, make sure we understand all of this. In a period of rapid inflation, it means prices are going up. Companies ABC and XYZ have the same reported earnings. They both have the same reported earnings. That's fine. ABC uses LIFO inventory accounting and XYZ uses FIFO. ABC has relatively fewer depreciable asset and has more debt than XYZ. Okay, so what happened to ABC? So ABC, let's see, ABC, XYZ. Let's start with inventory. From an inventory perspective, ABC uses LIFO. Just give me one second. Let me write inventory here. Inventory. So what happened to the earnings of ABC? If they're using LIFO last and first out and prices are going up, their profit will go down. Their profit will go down. Why? Because they are matching the most recent sale with the most recent cost and the most recent cost is higher than the old cost. Now for XYZ, the profit will be higher. The profit will be higher. Why? Because they're using FIFO. They are matching recent sales with old cost. Okay, now from a depreciation perspective, ABC have LIFO has fewer depreciation. Well, if they have fewer depreciation, they're not really taking advantage of the inflation because if you have more assets, that's really good. So they take less advantage from the depreciation. Why? Because they don't have a lot of assets. If they have a lot of assets, their depreciation expense will be lower relative to the inflationary environment. Here, if they have more, then they will take more advantage of depreciation. And the third aspect is that the ABC has, I believe ABC have more that, ABC have uses LIFO, has a relative fewer depreciation, and it has more that. If they have more that, they have to pay higher interest because with inflation comes higher nominal rate. Here, they pay lower because they have less that. Overall, they have lower interest expense. So what's happening here, this environment is hurting ABC. Okay, ABC, so relatively speaking, ABC is better than XYZ because they're taking hits on their profit from their accounting method. They're taking hit on the depreciation because XYZ is taking more advantage of the depreciation, but also here because they have more expenses, they have lower profit. Okay, because at least they have more assets, more, we're assuming they have more, more physical assets to be depreciated, but definitely from the debt, they have more expenses than XYZ. So ABC is being, from a profit perspective, they're more profitable, in my opinion, than XYZ, in real profit than XYZ because if they have both the same reported earnings, in reality, if ABC switches their accounting method to LIFO and they have less interest, then they will be more profitable. Fair value accounting, what's fair value accounting? Fair value means report, things at fair value, report things on the balance sheet, how much they are today. So the many major assets and liabilities are not traded in financial market and they don't have easily observable, observable value. When we talk about fair value accounting, simply put, GAP allows you to report things at fair value, things specifically financial assets and financial liabilities. Why? Because those assets and liabilities like stocks and bonds, they have an active market. Okay, but many assets and liabilities that you have, they don't have an active market. For example, we can simply look up the value of the employee stock options, healthcare benefit for our retired employee or building another real state. So those are not reported at fair value. Okay, while the true financial status of the firm may depend critically on these values, which can swing widely over time, common practice has been to simply report them at cost. So this is another problem with financial statement analysis. When we are looking at the balance sheet, most of the balance sheet figures are not fair value. Those figures, they could be old, two years, three, five, or for example, if you purchased a building 10 years ago, the building will have a different fair value today. But when you are running those ROEs and ROAs and ROI, they're all based on old figures. So proponent of fair value accounting, also known as mark to market, argued that financial statements would give a truer picture of the firm if they have, if they have better reflected the current market value of all assets and liabilities. Those are the proponent. Now, what would the opposite party said? The opposite party would said, look, if you're going to report things at fair value, you're going to have to do a lot of estimates. And once you make estimates, you are subject to bias, then you can actually manipulate the numbers figures and trying to, you're trying to kind of make the picture better. You'll even make it worse than it should be. So let's take a look at fair value accounting, FASB statement 157 discusses fair value and places assets in three different buckets. So when you are determining the fair value of an asset, we have three different buckets or three different level. Level one is the kind of the best level. Level one assets are traded in active market and therefore should be valued at their market price. So what is level one? Let's assume you have stocks and bonds that are traded in the open market, like Apple, Microsoft, Walmart. That's easy. You have level one data. Therefore, you have the best, you have the best fair value. Therefore, you can mark your assets, financial assets and financial liabilities to market. Level two assets that are not actively traded. Here, you are looking at assets. You cannot loop them up on the internet or in the Wall Street Journal, but their value may be still estimated, use it observable market data on similar assets. For example, if you have a building in a certain city and you want to value it, well, well, if a similar building in that city was sold, that building is comparable, then you would say the fair value of my building should be the same as that building because it was sold recently. What I'm looking at is now is I'm using comparable data. I'm using some observable market on similar comparable asset. These assets can be marked to a matrix of comparable securities. Or if you were talking about securities, you'd say my security is similar to that other security that's traded on the market. Therefore, the value of my securities should be that much. Level three is the most complicated one and it's the hardest to value. Here, you don't have any active market. You don't have any similar assets. It's difficult to identify other assets that are similar enough to serve as a benchmark for their market value. One has to resort to pricing model to estimate their intrinsic value. And we learn about intrinsic value. Basically, we can estimate the cash flow, discount the cash flow, so on and so forth. So rather than mark to market, these values are often called mark to model, which is basically you are using a model, although they are also disproportionately known as mark to make believe. Simply put, when you do a model, basically you're taking cash flow and you're discounting the cash flow based on certain interest rate. So you are doing two estimates. You're estimating the cash flow and you are choosing an arbitrary rate. As these estimates are prone to manipulation by creative use of model imports, of course they are. But since 2012, firms had been required to disclose more about methods and assumption. So if you're using level three, you are using level three, you have to explain clearly how you came up with these figures. So now anyone can see how you are coming up with these figures and to describe sensitivity to their valuation estimate. So you would say this is my figure, but let's assume I am wrong by 10%. Here's what the figure would be. Or if I am conservative, you don't have to say if you're conservative, but if you are wrong, you want to say like, what's the worst case scenario? For quality of earnings and accounting practices, I will have a separate recording because this session has many subtopics and I believe it deserves a session by itself. As always, I'm going to ask you to like this recording, share it and please visit my website, farhatlectures.com. If not for anything, is to find out what your university scored on the CPA exam. As always, if you're studying for your CPA exam, don't shortchange yourself. My supplemental material will not replace yours, it will be in addition to yours and will be an excellent edition. Good luck, stay safe and study hard.