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Review questions

Pages 582–586 deal with this issue.

Examples of different results and decisions: Valuations based on multiples like P/B, P/E. Credit rating decisions based on equity ratios, ROIC. Liquidation values based on a % of book values, EBIT in most cases, EVA for single years.

Example of same result (value) is valuations based on the DCF and EVA model.

Because both conservative and aggressive accounting affect numbers and ratios and create noise when comparing over time or with peers versus if faithful representation is used. Conservative accounting sometimes shows better ratios (e.g. ROIC and EVA for a single year) than aggressive accounting and vice versa.

Valuation: See pages 587–601 and include examples like when/how much revenue is recognised if used for forecasting, how FX is treated, the use of FIFO versus average cost for inventories, useful life and classification of restructuring charges, impairment and gains/losses. Further estimated future taxes might be estimated incorrectly. Most multiples will be significantly affected by accounting flexibility.

Credit analysis: See pages 601–608 and include examples like probability of default based on empirical peer analysis where analysis is affected if flexibility is used to improve credit ratios. Examples are changes in accounting policies, useful life, revaluation. Ultimate recovery based on % of book values to estimate liquidation values might be affected if the firm uses conservative versus aggressive accounting.

See pages 608–612. Most absolute performance measures are affected: If bonuses are based on revenues, EBIT or EBITDA both recognition (e.g. capitalisation of development cost, ) and measurement flexibility (e.g. measurement of provisions, useful life) would affect such numbers. However, EBIT or EBITDA is less affected if the firm is close to steady state.

Ratios like ROIC are more self-correcting. However, changes in accounting policies and non-capitalisation of expenses have an impact.

All reclassification in/out of bonus-qualifying numbers or ratios should be monitored carefully, i.e. classification of ‘non-recurring items’ if bonuses are measured excluding such items.