SESSION 1: ACCOUNTING FIRST

STEPS
Accounting for Finance
The Accountant’s Role

o In my view (and many accountants will disagree), it is the

role of accounting
o To check transactions and operations, as they occur
o To record them in a consistent manner
o To report the results in standardized form
o Much as accounting wants to makes itself more relevant
and central to businesses, it is not the role of accounting:
o Forecast the future, no matter how tempted.
o Value assets or operations.
o Bluntly put, an accountant is a historian, chronicling
events that have already occurred, not predicting the
future.

2
The Accounting Questions..

¨ What do you own? List out the assets that a business has
invested in, and how much it spent on those investments
and perhaps what these assets are worth today.
¨ What do you owe? Specify the contractual commitments
that a business has to meet, to stay in business. Simply
put, this should include all borrowings, but is not
restricted to those.
¨ How much money did you make? Measure the
profitability of the business, both with accounting
judgments on expenses, and based upon cash in and
cash out.

3
The Accounting Statements

! The balance sheet, which summarizes what a firm

owns and owes at a point in time, as well as an
estimate of what equity is worth (through
accounting eyes).
! The income statement, which reports on how much
a business earned in the period of analysis, while
providing detail on revenues and expenses.
! The statement of cash flows, which reports on cash
inflows and outflows to the firm during the period of
analysis and allows for a measure of cash earnings
(as opposed to accounting earnings) and cash flows.
4
1. Balance Sheet

5
 2. Income Statement

Item Explanation

Start with Revenues Accountant's estimate of the revenues/sales generated by

any transactions made the business during the period.

Net out Cost of Goods Sold Expenses associated with producing products or services that
represent top line sales
To get Gross Profit Production profitability

Includes selling, general and administrative and other

Net out Other Operating Expenses
expenses associated with operations, but not directly tied to
producing goods and services
To get Operating Profit Profitability of business

Net out Financial Expenses Expenses associated with the use of non-equity capital,
especially debt.
To get Taxable Income Income for equity investors, prior to taxes
Net out Taxes Taxes due on taxable income
To get Net Income Income for equity investors, after taxes

6
3. Statement of Cash Flows

7
The Interconnections

8
The Accounting Standards

q Accounting is a rule-driven process, and over time, those rules

have been formalized, especially for publicly traded companies.
This formalization is driven by two considerations:
q Standardization, to allow for comparisons across companies
q First principles, to ensure that earnings, asset value and cash flows
measure what they are supposed to measure.
q While accounting standards around the world remain different,
they have converged (for the most part) around two standards:
q GAAP (Generally Accepted Accounting Principles), representing rules
developed by FASB (Financial Accounting Standards Board) to cover US
financial reporting.
q IFRS (International Financial Reporting Standards), representing rules
developed by IASB (International Accounting Standards Board) for
companies listed globally, followed by about 90 countries as of 2020.

9
The Bottom Line

¨ The raw material that we use to do financial analysis

and valuation almost always takes the form of
accounting statements.
¨ Consequently, it behooves us all to understand how
accountants think (even if we disagree with them) in
putting these statements together.
¨ The challenge is that accounting thinking keeps
changing, as we move through time, and we have to
understand those changes (both the what and the
why), to keep up with them.

11
SESSION 2A: INCOME STATEMENT
COMPARISONS
Accounting for Finance
Income Statement: A Life Cycle Perspective

2
A Young Company: Peloton’s Income Statement
(2019) in its Prospectus

2
4

3
 A Growth Company: Netflix’s Income
Statement (2020)

1
2

4
 A Mature Company: Coca Cola (2019)

5
Revenue Breakdown for Coca Cola: By
Geography

1 2

6
An Aging Company: Toyota

1a

1b

7
Sector and Industry Differences

¨ The accounting standards that govern how

companies measure revenues and earnings may be
the same across companies, but there are some
sector-specific differences.
¤ For commodity companies, the differences often arise
from costs expended exploring for commodity reserves
and extracting the commodity from reserves.
¤ For financial service companies, the challenge often lies in
defining revenues and debt, since the latter is less a source
of capital and more raw material.

8
A Commodity Company: Total (France) in
2019

9
A Business Breakdown for Total

10
 A Financial Service Company: HSBC in
2019

11
 A Pharmaceutical Firm: Dr. Reddy’s in 2019

12
Bottom Line

¨ Much is made of the differences in accounting standards

around the world and across businesses, but the reality
is that accounting standards are converging across the
world, rather than diverging.
¨ While revenues come in different forms for different
companies and operating expenses take varied forms,
the end game with gross profit, operating and net
income remains the same, i.e., to measure profits are
different levels.
¨ In theory, you should be therefore able to compare these
numbers across companies, but in practice, accounting
inconsistencies in how the expenses get measured and
categorized can create problems.

13
SESSION 2: INCOME STATEMENTS
& PROFITABILITY MEASURES
Accounting for Finance
Measuring Income: Accrual versus Cash
Accounting
q In accrual accounting, you record transactions when they
occur, rather than when cash flows occur.
q Revenues are recorded when a product or service is sold, not
when the customer pays for that product or service.
q Expenses are recorded consistently, with the expenses
associated with producing the sold product or service shown in
the period, even though you may have spent the money in a
prior period or will not pay until a future period.
q In cash accounting, you record revenues when you get
paid for providing a product or service, and expenses
when you pay.
q Unless you are a small or personal business, you will
have to follow accrual accounting rules.

2
Classifying Expenses: Operating, Financing and
Capital Expenses
¨ Operating expenses are expenses associated with the
operations of the business. That includes not only the direct
costs of producing the product or service the firm sells, but
also other expenses associated with production, including S,
G & A expenses.
¨ Financing expenses are expenses associated with the use of
non-equity financing. Most often, this takes the form of
interest expenses on debt.
¨ Capital expenses are expenses that provide benefits over
many years. For a manufacturing company, these can take the
form of plant and equipment. For non-manufacturing
companies, they can take on less conventional and tangible
forms (and accounting has never been good at dealing with
these).

3
Everything has a place….

4
 Revisiting the Income Statement
Item Explanation

Start with Revenues Accountant's estimate of the revenues/sales generated by

any transactions made the business during the period.

Net out Cost of Goods Sold Expenses associated with producing products or services that
represent top line sales
To get Gross Profit Production profitability

Includes selling, general and administrative and other

Net out Other Operating Expenses
expenses associated with operations, but not directly tied to
producing goods and services
To get Operating Profit Profitability of business

Net out Financial Expenses Expenses associated with creating products or services that
represent top line sales
To get Taxable Income Income for equity investors, prior to taxes
Net out Taxes Taxes due on taxable income
To get Net Income Income for equity investors, after taxes

5
Revenue Recognition

¨ For many firms, revenue recognition is a simple process,

where once a product or service is sold, it is recorded as
revenues.
¨ For some firms, especially those that sell products or services
over many years, it becomes trickier, since the question of
how much of the revenue to record in the year of the sale
and how much in subsequent years becomes debatable.
¤ Under ASC 606: “The new model’s core principle for revenue
recognition is to “depict the transfer of promised goods or services to
customers in an amount that reflects the consideration to which the
entity expects to be entitled in exchange for those goods or services.”
¤ Thus, for a real estate developer working on a multi-year construction,
revenues should be recognized as construction progresses, and for a
software firm that enters in a contract over many years, performance
obligations will determine when revenues get recognized.

6
Revenue Breakdowns

¨ As companies enter multiple businesses and

different geographies, it is useful to know where
they generate their revenues.
¨ While the breakdown can sometimes by provided in
income statements, they are more likely to be part
of the footnotes to the financial statements:
¤ Companies generally break down revenues by geography,
though the degree of detail can vary.
¤ Companies also break down revenues by business
segment, though there is an element of subjectivity to the
segment categorization.

7
Operating Expenses: A Break Down

¨ COGS versus Other Operating Expenses: Operating

expenses are broadly broken down into expenses
directly related to producing the goods or services that
give rise to revenues, i.e. cost of goods sold, and
expenses that are related to operations, but which are
not as directly tied to revenues.
¤ The former are netted out from revenues to get to gross profits
¤ The latter get netted out of gross profits to get to operating
income
¨ Selling, General and Administrative Costs: In many
companies, the largest non-operating expense is S,G &A,
an amorphous item which can include everything but
the proverbial kitchen sink.

8
Depreciation: Accounting, Tax and
Economic Forms
• Economic depreciation reflects the loss in value (earning
power) in an asset, as it ages. It requires nuance, and will
vary across even the same type of assets, depending on
how it is used.
• Accounting depreciation is more mechanical and is
driven largely by the aging of the asset, with the
differences often being in whether it happens uniformly
over the life of the asset or is more accelerated.
• Tax depreciation reflects what the tax authorities will
allow as depreciation for purposes of computing taxable
income.

9
Financial Expenses

¨ The most common financial expense is interest expense on

debt, either in the form of bank loans or corporate bonds.
¨ As accountants classify other commitments (such as leases)
as debt, some of the interest expense is implicit, i.e., it is
calculated by accountants based upon their assessment of
the debt equivalent value of commitments and current
interest rates.
¨ In some companies, interest expenses are netted out against
interest income earned by the company on its cash holdings
and financial investments, and reported as a net interest
expense. If interest income exceeds interest expense, this
number will measure net interest income.

10
Income from non-operating investments

¨ Cash & Marketable Securities: Income earned on cash

holdings (which is invested in marketable securities, like
treasury bills and commercial paper in most companies)
will be reported either as a stand alone income or netted
against interest expenses.
¨ Cross holdings in other companies: The reporting can
vary depending upon the magnitude of your holding:
¤ When you hold a (small or minority) portion of another
company, the income from that holding will usually be reported
in the income statement.
¤ However, if you hold a majority stake of another company, you
will generally have to consolidate your financials. That will
require you to count 100% of the subsidiary’s revenues,
operating expenses and operating income as your own.

11
Extraordinary Income/ Expenses

¨ As the term implies, extraordinary income and expenses

are designed to capture what a company does not face
in the ordinary course of operations.
¨ Extraordinary items include
¤ One-time expense or gain from sale of assets or divisions
¤ Write offs or charges associated with past project, lawsuits or
fines
¤ Impairment of goodwill from acquisitions in the past
¨ If an item is truly extraordinary, it should show up
infrequently and the amount associated with it should
vary. If it shows up every year, it is not extraordinary,
even if switches signs (goes from profits in some years to
losses in others).

12
Pro-forma Accounting: Con game or
legitimate restatement?
¨ In recent years, companies have become creative in reporting
pro-forma financial statements.
¤ In some cases, they do so to correct for what they believe are
accounting inconsistencies.
¤ In other cases, they are motivated by the desire to increase their
profitability.
¨ As investors, you should never take pro-forma financials at
face value but devise your own smell test on what should be
added back and what should not to get to proforma income.
In general, there are two items you should focus the most
attention to:
¤ The movement of expenses from operating to capital, sometimes
merited, sometimes not.
¤ The removal of expenses because they are one time or extraordinary.

13
SESSION 3A: BALANCE SHEET
COMPARISONS
Accounting for Finance
Balance Sheet: A Life Cycle Perspective

2
A Young Company: Peloton’s Balance Sheet
(2019) in its Prospectus

3
A Growth Company: Netflix’s Balance
Sheet (2019)

4
A Mature Company: Coca Cola’s Balance
Sheet (2019)

5
 Coca Cola’s Debt in 2019

6
 Coca Cola’s Accounting Intangibles: Small-
bore?

7
 An Aging Company: Toyota’s Assets in
2020

8
 An Aging Company: Toyota’s Liabilities in
2020

9
Sector and Industry Differences

¨ As with income statements, there are differences in

what shows up on balance sheets in different
sectors, though the accounting standards governing
all companies may be the same.
¨ In particular, the divergences play out on both sides
of the balance sheet:
¤ On the asset side, it can show up in how much of the value
comes from tangible as opposed to intangible assets.
¤ For acquisitive companies, it can also show up as uniquely
accounting items like goodwill.

10
A Commodity Company: Total’s Assets in
2020

11
 A Commodity Company: Total’s Liabilities
in 2020

12
 A Financial Service Company: HSBC in
2019

13
 A Pharmaceutical Company: Dr. Reddy’s

14
Bottom Line

¨ A balance sheet is the financial statement that most reflects the

history of a company, since constructed correctly it is the
cumulated result of all of the company’s activities during its
existence.
¨ That said, there is disagreement even among accountants as to
what the history should reveal, with old-time accounting arguing
that it should reflect what the company has invested in its existing
assets, not what they are worth today, and fair-value accounting
arguing that it should reflect its current value.
¨ The end result is that balance sheets today are a mess, measuring
neither invested capital nor fair value. The most useful items on a
balance sheet now are
¤ Cash & marketable securities, since it is not subject to nuance
¤ Debt, since it measures closely what is owed (at least on interest bearing
liabilities)

15
SESSION 3: BALANCE SHEETS -
ASSETS OWNED & MONEY OWED
Accounting for Finance
The Balance Sheet: Dueling Views

q Record of capital invested: There are some (including

me) who believe that the main function of a balance
sheet is to record how much a business has invested in
its assets-in-place, i.e., the assets that allow for its
current operations to occur.
q Measure of current value: There is a large and perhaps
dominant school of thought among accountants, or at
least accounting rule writers, that a balance sheet should
reflect the value of the business today.
q Liquidation value: There is a third school, with lenders to
the firm among its primary members, who feel that a
balance should reflect what you would get for the assets
of the firm, if you liquidated them today.

2
Revisiting the Balance Sheet

3
Fixed and Current Assets

q The Old Way: If you are old enough to learned your

accounting two or three decades ago, the way you were
taught to value fixed and current assets was to show
them at original cost, net of accounting depreciation.
q The New Way: As accounting has increasingly adopted
the fair value standard, there has been a move to mark
assets to current market value.
q Divergent Effects: The difference in values that you get
for assets, using the two approaches, varies. It is
q Greater on older assets than on newer ones
q Greater on fixed assets than current assets

4
Financial Assets

¨ Financial assets can take the form of holdings of securities or part

ownership of other companies, private or public.
¨ With holdings of publicly traded securities, the movement to using
current market prices to mark up their values is almost complete.
¨ With equity ownership in other companies, the rules can vary
depending on
¤ Whether the stake is viewed as a majority stake (>50%) or a minority stake.
The former will lead to full consolidation (where 100% of the subsidiaries
revenues and operating income will be included in the parent company’s
financials, with the portion that is not owned shown as minority or non-
controlling interest on the liability side) and with the latter, the actual
stake will be shown as an asset.
¤ With a minority stake, whether it is held for trading or as a long-term
investment. With the former, the holding will be marked to market. With
the latter, it will be shown at book value terms.

5
Intangible Assets

¨ Big game: Accountants talk a big game when it

comes to intangible assets, and from that talk, you
would think that they have figured out how to value
the big intangibles (brand name, management
quality etc.).
¨ But different reality: In reality, accountants are
much better at valuing small-bore intangibles like
licenses and customer lists, where the earnings and
cash flows from the intangible are observable and
forecastable than they are at valuing the big
intangibles.

6
Goodwill: The Most Dangerous Intangible

¨ After all the talk of intangibles in accounting, it is telling

that the bulk of intangible assets on accounting balance
sheets across the world take the form of one item:
goodwill.
¨ Goodwill may sound good, but it is a plug variable that
signifies little.
¤ For goodwill to manifest itself on a balance sheet, a company
has to do an acquisition.
¤ When that acquisition occurs, goodwill is measured as the
difference between the price paid on the acquisition and the
target company’s asset value (dressed up book value).
¤ It shows up as an asset because without it in place, balance
sheets would not balance.

7
Goodwill Impairment: Valuable information or
Make-work-for-accountants?
¨ Old rules: For much of the last century, goodwill once created in an
acquisition, was written off on autopilot, often amortized over long
periods in equal installments.
¨ New Rules: In the late 1990s, both GAAP and IFRS rewrote the
rules, requiring accountants to revisit goodwill estimates each year,
and make judgments on whether the goodwill had been impaired
or not. To make that judgment, accountants would have to revisit
the target company valuations and decide whether the value had
increased (in which case goodwill would be left unchanged) or
decreased (and goodwill would be impaired).
¨ Is it informational? The rationale for this rule change was to
provide information to markets, but since goodwill impairments
are often based upon market pricing movements (in the sector)
and lag them by months and sometimes years, the effect of
goodwill impairments on stock prices has been negligible.

8
Current Liabilities

q Current liabilities can be broadly broken into three

groups:
q Non-interest-bearing liabilities, such as accounts payable and
supplier credit, which represent part of normal operations.
q Interest-bearing short-term borrowings such as commercial
paper, short term debt and the short term portion (<1 year) of
long term debt.
q Deferred salaries, taxes and other amounts due in the short
term.
q When computing non-cash working capital, we do not
include interest-bearing short term debt in the
calculation, moving it instead into the debt column.

9
Debt Due

¨ When companies borrow money, it can take three forms:

¤ Corporate bonds, represent debt raised from public markets
¤ Bank loans, debt raised from banks and other lending institiutions
¤ Lease debt, arising out of lease contracts requiring lease payments
in future years. Until 2019, only leases classified as capital leases
qualified, but since 2019, operating lease commitments are also
debt.
¨ The mark-to-market movement on the asset side of the
balance sheet has been muted on the liability side of the
balance sheet. Bank debt, for the most part, is recorded as
originally borrowed, and corporate bonds due, are for the
most part not marked to market.

10
Debt details

¨ While balance sheets are the repositories for total

debt due, broken down into current and long term,
there is additional information on debt in the
footnotes, for most companies.
¨ This additional information can be on two fronts:
¤ Individual debt due, with stated interest rates and
maturities.
¤ Additional features on the debt, including floating/fixed
and straight/convertible provisions.
¤ A consolidated table of when debt repayments come due,
by year.

11
Shareholder’s Equity

q Old ways: The shareholders’ equity in a business was a

reflection of its entire history, since it started with the
equity brought in to start the business, adds on equity
augmentations over time as well as the cumulation of
retained earnings.
q New ways: The shareholders’ equity in a business
reflects the jumbled mess of mark-to-market accounting,
with all of its contradictions.
q My cynical view: Old or new ways, shareholders’ equity
(or book equity) has little hope of ever being a measure
of the intrinsic value of equity in a business. This quixotic
quest on the part of accounting will do more damage
than good.

12
More on shareholders’ equity

¨ Par value: This is a throwback in time and should be ignored.

¨ Company Age: Since shareholders’ equity reflects a company’s
cumulated history of equity raises and retained earnings, young
companies will tend to have far less shareholders’ equity than older
companies, of equivalent market value.
¨ Capitalization effects: Since only capitalized expenses become part
of assets, shareholders’ equity can be skewed by accounting rules
and corporate actions on what is capitalized and what is expensed.
¨ Buyback effects: Both dividends and buybacks reduce shareholders’
equity, by reducing it, but the magnitude of buybacks makes their
effect more dramatic.
¨ Negative equity? There is no mathematical reason why
shareholders’ equity cannot become negative, either because a
company has lost money for an extended period or because of
large buyback/write off.

13
SESSION 4A: CASH FLOW
STATEMENT COMPARISONS
Accounting for Finance
Cash Flows: A Life Cycle Perspective

2
A Young Company: Peloton’s Cash Flow
Statement (2019) in its Prospectus

3
A Growth Company: Netflix’s Cash Flow
Statement (2020)

4
A Mature Company: Coca Cola’s Cash Flow
Statement

2
3

5
 An Aging Company: Toyota

6
Sector and Industry Differences

¨ The statement of cash flows is perhaps the most direct

of financial statements, since it is based upon cash flows
in and cash flows out. It is thus the one statement that
accounting game playing affects the least.
¨ While the objective of the statement might be explaining
why the cash balance changes, it is the repository for all
of the items needed to estimate cash flows.
¨ While it is not uncommon for income statements and
cash flows to send divergent messages about a firm’s
financial well being, consistent differences between the
two can be a indicator of accounting problems.

7
 A Commodity Company: Total in 2019

8
 A Financial Service Company: HSBC in
2019

9
A Pharmaceutical Firm: Dr. Reddy’s Lab in
2019

10
Bottom Line

¨ The statement of cash flows looks at cash flows through

the eyes of the equity investors in a business.
¤ Thus, if you are trying to compute cash flows to equity investors,
all of the information you will need should be on the statement.
¤ You should also be able to see what equity investors received as
cash flows.
¨ If your objective is to estimate cash flows, prior to debt
payments, you can start with the statement of cash flows
but you have to trace interest expenses (netted out to
get to net income) and add them back.

11
SESSION 4: CASH FLOW
STATEMENTS – CASH IN AND
CASH OUT
Accounting for Finance
The End Game with Cash Flows

q The surface level objective of a statement of cash flows is to

explain how much the cash balance of a business changed during a
period and why it changed.
q Embedded in the statement of cash flows, though, is other
information including:
q How much cash earnings the company had during the period, as
contrasted with accrual earnings (in income statements)
q How much and where the company reinvested cash during the period to
sustain and grow its business
q How much cash it raised from or returned to its debt and equity investors
q The statement of cash flows preserves the signs on cash flows, with
negative cash flows shown as minuses and positive cash flows as
pluses. It also looks at cash flows through the eyes of equity
investors in the company.

2
Revisiting the Cash Flow Statement

3
1. Cash flows from Operations

Change in non-cash working capital

4
The Working Capital Effect?

¨ Embedded in the cash flow from operations is the

change in working capital items, excluding cash
¤ Non-cash Working capital = Non-cash current assets – Non-debt
current liabilities
¤ An increase in non-cash working capital will decrease cash flows,
whereas a decrease in non-cash working capital will increase
cash flows.
¨ To the extent that non-cash working capital ties up cash
and capital, a firm with higher needs for that working
capital will have lower cash flows from operations, for
any given level of net income, than a firm with lower
needs.

5
2. Cash Flows from Investing

6
Operating or Non-operating Assets

q The investing activities section includes investments in both

operating and non-operating assets, except for investment in
liquid, close to riskless securities, which is treated as cash &
marketable securities.
q The investments into operating assets, whether internal (cap
ex, net of divestitures) or external (acquisitions of other
companies) are the engine that drives growth in the
operating line items (revenues, operating income etc.) Note
that acquisitions funded with stock will not show up here for
obvious reasons.
q The investments into non-operating assets create a separate
source of value, where the payoff will not show up in the
operating line items but below the operating income line, as
income from cross holdings or securities.

7
3. Cash flows from Financing

8
Debt Cash Flows

¨ While interest expenses show up in the operating cash

flow section, by reducing net income and showing up in
deferred taxes, debt repayments are part of the
financing section.
¨ To the extent that some or all of these debt repayments
are funded with debt issuances, the net effect on cash
flows can be neutralized or become positive.
¨ If total debt increases during a period, it will represent
a cash inflow, and if it decreases, it will be a cash
outflow. Companies that embark on plans to bring their
debt down (up) over time should therefore expect
these consequences.

9
Dividends and Buybacks

q Until the 1980s, the only cash flow that was received by
equity investors in publicly traded companies was dividends.
The effect of paying dividends is simple: it reduces the cash
balance at the company and increases the cash in the pockets
of every shareholder who receives dividends.
q Starting in the 1980s, US companies have returned increasing
amounts to their shareholders in the form of buybacks.
q The effect of buying back stock is exactly the same as paying dividends,
to the company, with cash leaving the company.
q For shareholders, though, the cash flow effect is disparate. Those
shareholders who sell their shares back get cash from the company,
and those that do not get no cash, but get a larger share of the equity
left in the company.
q Both dividends and buybacks reduce shareholder equity on the
balance sheet.

10
Potential Dividends (Free CF to Equity)

11
SESSION 5A: ACCOUNTING
INCONSISTENCY EXAMPLES
Accounting for Finance
1. Tax Rates

2
2. Non-debt Commitments

q In general, interest-bearing debt will show up on

balance sheets, though some of it may be included
in current liabilities (if due in less than a year) and
the rest as debt.
q There are other contractual commitments that have
historically not shown up on balance sheets, but
should be treated like debt.
q The most common of these commitments is
operating leases, but IFRS and GAAP have finally
made the ‘right’ decision and started including them
as debt in 2019.
3
A Retail Example: Nordstrom’s

Discounted at
4.7% 1

Treated as 5-year annuity of $227.2 m/year (=1136/5) starting in 2025

On the balance sheet in 2019

4
Consequences for the company

¨ Debt increases: The debt on the balance sheet is

augmented by the present value of lease commitments.
¨ A counter asset is created: Equivalent to the lease debt.
¨ Operating income changes, since you add back the
current year’s lease expense and reduce it by
depreciation. Net income does not or should not change.
¤ Interest expenses go up by the interest portion of the current
year’s lease payment.
¤ Depreciation is increased by the depreciation on the lease asset
(using the prior year’s value)
¨ Taxes and net income do not change, since you replace
one tax deductible expense (operating lease) with two
(interest and depreciation) of equivalent value.

5
 Another example: Netflix

6
3. Non-Physical Capital Expenses

¨ While accountants almost always treat investments in

physical assets as capital expenses and show them on the
balance sheet, they are inconsistent and unpredictable when
it comes to investments in non-physical assets.
¤ A pharmaceutical company that buys a patent from another one is
allowed to treat that expenditure as a capital expenditure, but one
that does R&D to arrive at the same result is not.
¤ A company reliant on human capital for its value is almost never
required to treat what it invests in human capital for the long term
(recruiting and training, for example) as capital expenditures.
¤ A subscriber/user based company that spends money acquiring users
or subscribers generally is not allowed to treat the money spent
acquiring customers as capital expenditures.

7
A Pharmaceutical Company Example

8
4. Stock Based Compensation

¨ Companies following IFRS and GAAP report the current

year’s stock- based compensation as an operating
expense, valuing both options and restricted stock at the
time of issuance.
¤ That said, the residue of past option grants will show up in the
footnotes of these companies, with relevant information on
remaining maturity and exercise price.
¤ The restricted stock units granted in past years will show up as
part of the discussion of share count.
¨ In both cases, companies will then try to reverse the
accounting charge, claiming it is non-cash in reporting
pro-forma or adjusted earnings.

9
 Options Outstanding… at Netflix

10
 And Adjusted EBITDA… at Peloton

11
Bottom Line

¨ Accounting statements are just raw material: In corporate finance and

valuation, financial statements are raw data that should be viewed as
accounting opinion and not fact.
¨ That you should mold to your own needs: To the extent that accounting
perspectives can be outdated or reflect a different set of priorities, you
should feel no qualms about redoing or reconstructing accounting
statements.
¨ But your choices will have consequences: That can have consequences for
how you measure profits, invested capital and even share count. The
company that you see will be closer to the truth than the company
described in accounting statements.
¨ Markets don’t follow (and are more sensible than) accountants: For the
most part, markets learn and move on faster than accountants do. Thus,
markets have been pricing in retailers, on the assumption that leases are
debt for decades, while accountants made the change in 2019.

12
SESSION 5: CLEANING UP
ACCOUNTING
Accounting for Finance
The Accountant’s Role

q Accountants like order and consistency, as can be seen in

their propensity to write rules.
q That said, much of accounting as practiced today was
developed in detail in the 20th century for the manufacturing
firms that dominated that century.
q As the center of economic gravity has shifted from
manufacturing to technology & service companies, and
corporate financial behavior has changed over time,
accountants have struggled with four key issues:
q Taxes, and the actions that companies take to avoid or delay paying
them.
q Managerial compensation in the form of equity (stock)
q Commitments that are contractual but are not debt
q Investments for long term benefits that are not in physical assets

2
1. Taxes: Dueling Tax Rates

1. Marginal tax rate: The marginal tax rate is the tax rate in the
statutory tax codes. Thus, in 2020, a US company should be
paying 21% of its taxable income in the US as federal taxes.
Since US companies now operate on a regional tax model,
the marginal tax rate for multinationals will reflect where
they make (or report to make) their taxable income.
2. Effective Tax Rate: The effective tax rate for a company
reflects the taxes and taxable income it reports in its income
statement, which is based on accrual accounting:
¤ Effective tax rate = Taxes/ Taxable Income
3. Cash Tax Rate: The cash tax rate for a company reflects the
taxes it actually pays on its taxable income.

3
Deferred Tax Assets & Liabilities

q For most companies, the effective tax rate will be lower than
the marginal tax rate, reflecting:
q Operations in countries with lower tax rates
q (Legal) Tax deferral and avoidance strategies
q When there are differences between what is expensed and
what is reported as taxable income between the reporting
and tax books, the resulting difference in taxes is reported as
a deferred tax liability (asset) if the company pays less (more)
in taxes on its tax books than it reports in its financial
statements.
q The logic for doing so is simple. The items that give rise to less
(more) taxes paid in the current period will reverse and result
in more (less) taxes paid in future periods.

4
Net Operating Losses & Carryforwards

¨ When a US company loses money, it is allowed to carry

those losses forward and use them to reduce taxes paid
in future years.
¤ Until the Tax Reform Act of 2017, the NOL could be carried back
two years and used to reduce taxes paid in prior years (as a tax
credit) and forward 20 years.
¤ The Tax Reform Act of 2017 removed the carry back provision
and allows losses to be carried forward indefinitely.
¨ When a company has losses that are over multiple years,
these losses are cumulated over time as a Net Operating
Loss (NOL) and should be disclosed in a company’s
financials.

5
2. Stock Based Compensation is an
Operating Expense…
q Companies have used stock-based compensation to
reward employees for decades for two reasons:
q To align the interests of employees & managers with those of
the shareholders
q To make up for the absence of cash (to provide compensation
packages that are competitive)
q Stock-based compensation primarily takes two forms:
q Options to buy the company’s stock (or invest in its equity) at a
fixed price for a specified period.
q Shares in the company, sometimes with restrictions on trading
on those shares (restricted shares)

6
What type of expense is it?

¨ No matter what the motive for providing stock-based

compensation (to align interests or to make up for lack of cash),
it is clearly a compensation expense.
¤ If a grant is large and occasional, and primarily driven by the desire to align
interests, there is an argument that it should be spread out over time.
¤ If a company uses stock-based compensation consistently, and more to
make up for its cash poor status than to align interests, it is an annual
expense.
¨ To expense stock-based compensation, you have to value of the
options or stock given to employees, at the time they are
granted.
¤ Until 2004, companies were allowed leeway to estimate the value of
option grants based upon exercise value at the time of the grant.
¤ After 2004, FAS 123 requires companies to value options based upon their
time premium (using option pricing models) and show that expense in the
year the options are granted.

7
Is it a cash flow?

q Now that options and restricted stock are treated

(correctly) as compensation, and expensed in the years
they are granted, the debate has shifted to the question
of whether they are non-cash expenses (like
depreciation), deserving of being added back to get to
cash flows.
q Most companies and analysts seem to have come down
on yes as the answer, and many companies add back
stock-based compensation to get to adjusted earnings.
q I disagree strongly. There is a fundamental difference
between a non-cash expense like depreciation, where
you pay nothing, and giving a share of equity (options or
shares) in lieu of cash.

8
3. Leases are debt

¨ The Essence of Debt: When you borrow money, you create contractual
obligations for the future, and a failure to meet them can put your
survival as a going concern at risk.
¨ Lease contracts: When you sign a lease contract, you create commitments
for the future, and a failure to meet these commitments will put your
survival at risk. Put simply, there is no reason (and there never has been)
to treat leases as debt.
¨ Accounting for leases: Until 2019, accountants disagreed and broke leases
down into two groups:
¤ Capital leases, where the lessee has effective ownership of the asset, is treated as
debt, with a counter asset.
¤ Operating leases, where the lessee has (temporary) use of the asset for a period,
were treated as operating expenses, with no debt or counter assets on the balance
sheet.
Starting in 2019, both GAAP and IFRS are requiring companies to treat all lease
commitments as debt, no matter how structured.

9
Capitalizing Leases

¨ The process of converting lease commitments to debt follows a simple

process, akin to how any bank debt or corporate bond can be valued.
¨ Here are the steps:
¤ Start with the contractual lease commitments for future years, by year.
¤ Compute the pre-tax cost of borrowing for the firm today, based upon its default
risk.
¤ Take the present value of lease commitments, using the pre-tax cost of debt as your
discount rate.
¨ The present value of lease commitments is treated as debt, with the same
value shown as a counter-asset.
¨ To complete the cycle, you compute interest expenses on the lease debt
and depreciation on the counter asset and bring them into your income
statement.
¤ Interest expense on lease debt = PV of lease commitments * Pre-tax cost of debt
¤ Depreciation on lease asset is computed using the life of the lease (as the life of the
asset) and the depreciation method chosen.

10
Other Contractual Commitments

¨ While accounting has (finally) come to terms with

treating leases as debt, there are a whole host of
contractual commitments that share the same
characteristics as leases, and require the same
treatment.
¨ Here are some examples:
1. Purchase commitments for many manufacturing firms
2. Content commitments at a streaming company (like
Netflix)
3. Player contracts for a sports team

11
4. R&D is a cap ex

¨ If the essence of a capital expenditure is that it is an expense

whose expected benefits are not just in the current period, but in
future periods, research and development (R&D) expenses clearly
fit the bill.
¨ That said, accounting rules around the world, for the most part,
require companies to expense R&D, using one of two rationale:
¤ The benefits of R&D are too uncertain. Consequently, they should be
expensed until the R&D is closer to commercial development.
¤ It is better to be conservative in estimating earnings.
¨ Neither justification makes sense.
¤ Uncertainty is never used with other types of capital expenditure (building
a factory to make a new and untested product) as the divining rod for
capital vs operating expenses.
¤ Accounting should deliver the most realistic estimate of earnings, not the
most conservative.

12
Capitalizing R&D

¨ To capitalize R&D, there are three steps:

¤ Step 1: Estimate an amortizable life for R&D by making your best
judgment on how long it takes, on average, for R&D to pay off (as
commercial success).
¤ Step 2: Collect R&D expenses from past years (going back as long as
the amortizable life). If your company has not been in existence for
that long, collect as many years as you can.
¤ Step 3: For each of the past years of R&D, estimate
n How much you will be amortizing this year
n How much of the R&D expense remains unamortized
¨ To complete the cycle, here are the last steps:
¤ Adjust earnings by adding back the current year’s R&D expense and
subtracting out the amortization of past years R&D
¤ Show the unamortized R&D as an asset, and show the same amount as
an increase in book equity.

13
Other Capital Investments

¨ There are other expenses that fit the R&D profile, i.e.,
expenses designed to create benefits over many years,
but since these investments are not in physical assets,
they are treated as operating expenses.
¨ Here are some examples:
¤ Advertising expenses by a consumer product company to build
up brand name
¤ Recruiting and training expenses by a consulting firm to build its
consulting practice
¤ Exploration costs for an oil company
¤ Customer acquisition costs for a subscriber or user based
company.

14
The Bottom Line: Trust, but verify…

¨ Accounting statements reflect not only an

“accounting” view of the company, but the burden
of accounting history and legacy rules.
¨ When analyzing a company, you should start with
accounting statements, but you should have no
qualms about changing, modifying or redoing them
to reflect what you are trying to do with the data in
those statements.

15
SESSION 6A: RATIO ANALYSIS
Accounting for Finance
Financial Ratios: A Life Cycle Perspective

2
1. Profitability Ratios

3
And analysis…

¨ Young to old: Young companies often have negative or

very low margins, for two reasons:
¤ They are still building up their revenues
¤ Some of their operating expenses are associated with future
growth, not current operations.
¨ Business Differences: High gross margin businesses have
the advantage: Companies like Coca Cola (brand name
consumer product) and Dr. Reddy’s Labs
(pharmaceutical) start with sky-high gross margins,
which then feed into high operating and net margins.
¨ Leverage Effects: Companies with high debt ratios can
have low net margins, while operating margins stay high.

4
2. Accounting Returns

5
Reflections of…

¨ Competitive Advantages: If accounting returns are fair

measure of true returns, they are the repository for
competitive advantages.
¤ Industries where barriers to entry are high or other competitive
advantages prevail should have higher returns on capital than
companies without these advantages.
¤ Companies with strong competitive advantages within an
industry should earn higher returns than their peer group.
¨ Accounting choices and inconsistencies: Accounting can
affect and sometimes skew returns:
¤ By misclassifying capital, operating and financial expenses
¤ By taking write offs to reflect mistakes made in the past.

6
3. Efficiency Ratios

7
The dark side of growth

¨ The growth trade off: Growth has a good side, insofar as

it lets a company scale up its operations, but it has a
dark side, which is that companies have to reinvest to
deliver that growth.
¨ Scaling up measure: Turnover ratios look at the link
between what a company has to reinvest, and how much
its revenues grow over time. Companies that are more
efficient on this measure will be able to grow revenues,
with less reinvestment.
¤ Young to old: The link between company age and turnover ratios
will vary across different business types, with older companies
becoming more efficient in some, and less in others.
¤ Accounting effects: The problems associated with accounting
choices and inconsistencies will affect turnover ratios as well.

8
4. Debt Ratios

9
Debt, the double edged sword

¨ Source of capital: Debt is a source of capital for a business,

just as equity is. There is nothing inherently good or bad
about it, but in most parts of the world, it is a trade off
between tax benefits that accrue to borrowing and distress
risk.
¨ Measurement choices: When comparing across companies,
you have to measure debt consistently across companies.
However, it is usually better to focus on
¤ Total debt, rather than a subset of debt
¤ Market value, rather than book value
¨ Gross vs Net Debt: While the rationale for netting cash out
from debt is impeccable, cash is a transient asset, here today
and can be gone tomorrow.

10
5. Coverage & Liquidity Ratios

11
And analysis…

¨ Safety in numbers: All else held equal, companies that

score higher on interest and fixed charge coverage ratios
should have more buffer than companies that score
lower.
¨ Normalization? That said, the ratios can be skewed by
year-to-year changes, especially in operating income and
debt repayments.
¤ For companies in volatile businesses, this can translate into big
swings in coverage ratios from good to bad years. The solution is
to use an average across time.
¤ For young companies, the coverage ratios can look bad, at least
as they start the growth process, but these companies can grow
operating income quickly to gain buffers.

12
Final Thoughts

¨ Less is more: If you decide to use financial ratios, less

is more. Choose the ratios that you want, rather
than create noise by computing multiple ratios.
¨ A means to an end: Ratios, by themselves, are just
numbers and mean nothing, unless you use them to
make judgments about what your company does
well or badly, and how this affects your perspective
for the company.
¨ Past versus future: While your ratios are in the past,
investing and corporate finance are about the
future.
13
SESSION 6: ACCOUNTING
FINANCIAL RATIOS –
PROFITABILITY MEASURES
Accounting for Finance
From Absolutes to Ratios

q Financial statements measure operations in absolute

terms, i.e., in dollars, rupees or reais, depending upon
the currency of denomination.
q Absolute measures are difficult, if not impossible, to
compare across companies, since bigger companies, all
else held constant, should have higher dollar profits and
carry more debt.
q Ratios scale absolute values to each other, and allow for:
q Comparisons across companies
q Comparisons across time
q Comparison to benchmarks

2
1. Profit Margins

3
Contribution & Gross Margins: The Costs
of Production
• Contribution margin measures the pure profits that you
generate with every marginal unit you sell, since it nets out
only the variable cost associated with producing that unit,
giving many software companies close to 100% contribution
margins.
• Gross margins are a close relative, providing a direct measure
of marginal profitability and an indirect measure of how
revenue increases flow into profits. To illustrate, Zoom, one of
the few stocks that has seen its value increase during the
crisis, reported a gross margin of 92% in 2019.
• Companies with high contribution and high gross margins
have much more profit potential, other things remaining
equal, than companies with low margins.

4
Operating Margins: Measures and
Implications
• Operating margins measure what is left after the other
operating expenses of the company, which cannot be
directly traced to individual unit sales, but are
nevertheless necessary for its operations.
• To the extent that these other operating costs (like
SG&A) are fixed (or more fixed) than the costs of
production, the difference between gross and operating
margins becomes a simple proxy for potential economies
of scale.
• Companies with high gross margins and low operating
margins should see operating profits (and margins)
improve much faster as they scale up than companies
where operating and gross margins are similar.

5
EBITDA Margin: Measures and
Implications
¨ The EBITDA is a rough measure of operating cash flows, rough
because it is before taxes and capital expenditures.
¨ Notwithstanding that, it remains a measure of the cash
generating capacity of a company, prior to discretionary
choices (on how much to reinvest and borrow) and is used by
¤ Lenders to determine whether the company can afford to borrow
money, since debt has to be paid before capital expenditures are
made.
¤ Equity investors to decide whether the entire business is fairly valued,
before it tries to expand its asset base.
¨ Companies with high EBITDA margins generate higher cash
flows per dollar of revenues and should be able to borrow
more than companies with lower EBITDA margins.

6
Net Margins: Measures and Implications

¨ Netting out taxes and interest expenses, and adding back

income from cash and cross holdings, yields net margin,
a measure of what equity investors get to keep out of
every dollar of revenues.
¨ It is a mixed and noisy measure, reflecting a company's
operating model, its tax liabilities and its financial
leverage (since debt creates interest expenses and
affects taxes), as well as non-operating assets.
¨ Companies with high net margins deliver more profits
for equity investors, in the aggregate, but perhaps not a
per share basis (if debt is the reason why net margins
are lower than operating margins).

7
A Life Cycle View of Margins

8
2. Accounting Returns

¨ With accounting returns, profits are scaled to measures of

investment in a project or business.
¨ Broadly speaking, there can be differences in how accounting
returns are measured based upon
¤ How profits are measured, i.e., to just equity investors (net income) or to
both debt and equity investors and whether profits are before or after
taxes. In most cases, it is accrual income that is the basis for returns.
¤ How investment is measured, i.e., investment made just by equity
investors or by debt and equity investors. In most cases, accounting
returns use the book value as the basis of investment measurement.
¤ With any measure of accounting return, you can get different values
depending upon timing, i.e., start of the period, end of the period or
average for invested capital.
¨ Consistency rule: A consistent measure of accounting return will
measure both profits and investment to the same group (equity or
capital).

9
Return on Equity

10
Return on Invested Capital

11
3. Efficiency Ratios

¨ Efficiency ratios measure the revenue payoff that

companies get from reinvesting back in their
businesses.
¨ Turnover ratios, with revenues in the numerator are
the most widely used measured of efficiency, though
the denominator can vary:
¤ Working Capital Turnover = Sales/ Non-cash Working
capital (or individual items of working capital, like
inventory or receivables)
¤ Asset Turnover = Sales/ Total Assets
¤ Capital Turnover = Sales/ Invested Capital

12
4. Measuring Financial Leverage

¨ Debt Ratios measure how much a company has

borrowed, relative to overall capital or to
earnings/cashflows.
¨ Debt can be scaled to overall capital or just to equity
¤ Debt to Capital = Debt/ (Debt + Equity): This is a measure of how
much of the capital in a company comes from debt.
¤ Debt to Equity = Debt/Equity: This is a close variant of debt to
capital, with debt stated as a percent of equity.
¨ Debt can also be measured relative to
earnings/cashflows:
¤ Debt to EBITDA = Debt/EBITDA: This measures how much debt a
company has relative to the cash it generates from operations,
before taxes and capital expenditures.

13
Variants on calculation

¨ What to include in debt

¤ Only long term debt
¤ All interest bearing debt
¤ Debt inclusive of commitments (like leases)
¨ Book or Market
¤ Book values for debt and equity (from balance sheet)
¤ Market values, measured as market cap for equity in a publicly
traded firm, and if doable, market value of debt
¨ Gross or Net
¤ Gross debt is all debt
¤ Net debt is all debt minus cash & marketable securities

14
5. Measuring Liquidity/ Credit Risk

¨ Coverage Ratios: These ratios measure how much buffer

or coverage a company has in meeting commitments.
¤ With interest coverage ratio, the commitment is interest
expenses, and it is scaled to operating income.
¤ With a fixed charge coverage ratio, the commitment is expanded
to include debt payments, and it is scaled to operating income +
fixed charges.
¨ Liquidity Ratios: These ratios measure how much
liquidity companies have, to cover near-term needs or
expenses:
¤ Current ratio, measure current assets relative to current
liabilities.
¤ Quick ratio, looks at only liquid current assets relative to current
liabilities. (Inventory is usually excluded.)

15