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Review questions

In principle all stakeholders are potential users of financial statements. In the text book we focus on three stakeholders: Equity-oriented stakeholders, debt capital oriented stakeholders and compensation oriented stakeholders.

There are four valuation approaches available:

  • Present value approach
  • Relative valuation approach (multiples)
  • Asset based approach
  • Contingent claim valuation approach (real option)

No. Data requirements deviate across valuation approaches. For instance, a present value approach requires estimates of the earnings potential of a firm. Thus, when predicting the future earnings potential of a firm, analysts will strive to ensure that historical data are based on unchanged accounting policies; i.e. similar accounting practice across time. This ensures that any observed trend is caused by underlying changes in operations rather than by changes in accounting policies.

Valuation based on a relative value approach (multiples) requires a comparison of two or more firms’ earnings (for earnings based multiples). This implies that the accounting practice should (ideally) be similar across firms.

The asset based approach requires that assets and liabilities are measured at market values (fair values), since value based on this approach is calculated as the proceeds from selling all assets and settling the liabilities.

The contingent claim valuation approach (real options) is not discussed in the book.

Methods for estimating the probability of default include ratio analysis, credit rating, statistical models and forecasting (value at risk analyses).

A credit evaluation also includes an estimate of the ultimate recovery. The ultimate recovery is usually estimated as the value of the security and collaterals plus creditor liquidation dividends.

No, data requirement deviates across the different approaches available for credit analysis. For instance, credit rating models typically compare financial ratios across firms. This implies that the accounting practice should (ideally) be similar across firms. The forecasting approach requires estimates of the earnings potential of a firm. Thus, when predicting the future earnings potential of a firm, analysts will strive to ensure that historical data are based on unchanged accounting policies; i.e. similar accounting practice across time.

Choice of performance measure

Choice of performance standard

Choice of pay to performance relation:

  • Linearity between performance and pay
  • Lump-sum bonuses
  • A minimum and maximum bonus

Accounting issues

Theme 1 discusses Accounting Data available for financial statement analysis

Theme 2 analyses profitability, growth and risk

Theme 3 focuses on decision making with an emphasis on a) forecasting, b) cost of capital, c) firm valuation, d) credit analysis and e) evaluation of management performance (design of an accounting based incentive plans for executives)

Theme 4 discusses and analyses the concept of accounting flexibility and adjustments needed to analyse financial statements