Transparency & Global Markets Exam 1

discounted cash flow method

an approach to company valuation that forecasts free cash flows by discounting future cash inflows to the present and subtracting capital expenditures necessary to realize benefits

multiples approach

an approach to company valuation which uses comparable companies to estimate the value of a company of interest

profitability

ability of a company to generate profits from resources

asset management

how effectively the company performs tasks such as collection of receivables and inventory management

liquidity

ability of a company to meet short-term obligations

solvency

ability of a company to meet long-term obligations

valuation

amount an investor is willing to pay for one unit of a financial metric (e.g., earnings)

return on assets (ROA)

return before we compensate debt/equity holders

P/E ratio, overvalued, growth

a high ___________ suggests that a company’s stock price may be high relative to earnings and possibly ___________, however this metric is limited because it does not take ___________ into account

consolidation

a process necessary for companies with controlling interest where assets and liabilities are put on the controlling company’s balance sheet and invested equity is eliminated

• internal corporate governance (BOD, internal audit)

• periodic financial reporting (external audit, gaap reporting)

• external regulations (government, stock exchange requirements, etc)

how do shareholders'/debt holders monitor companies?

external auditor

• an outside accountant, completely independent of the business, who evaluates the controls to ensure that the financial statements are presented fairly in accordance with GAAP

• reports to an audit commitee

audit committee

A subcommittee of the board of directors that is responsible for overseeing both the internal audit function and the annual financial statement audit by independent CPAs.

public company accounting oversight board (PCAOB)

sets auditing standards for US listed issuers

international auditing and assurance standards board (IAASB)

works to improve uniformity of auditing practices throughout the world

international forum of independant audit regulators (IFIAR)

provides a forum for independent audit regulators to share among each other their knowledge and experiences, with a focus on inspections of auditors and audit firms

adverse selection

• a situation where one party of a transaction has more information than the other and is in a position to conceal relevant facts to benefit

• this may cause high quality participants from leaving the market since we never know who is lying (and nobody wants to pay full price)

securities and exchange commission (SEC)

monitors the stock market and enforces laws regulating the sale of stocks and bonds

• majority of BOD must be independent

• audit, compensation, and monitoring committees

• internal audit function

• voting rights for shareholders

what are the new york stock exchange requirements?

• legal system (common law vs. code law)

• who provides financing

• inflation

• political/economic links

where do we see differences in accounting across countries?

american depository receipt (ADR)

a method for non-US companies to access the US stock market where a US investor owns the right to the stock but not the stock itself

reporting entity

a circumscribed area of economic activity where economic activities can be distinguished from other entities and financial reporting is of faithful representation and helps in decision-making

• understanding the business model

• tax implications (Tax avoidance structure)

• hidden debt/risks

what are 3 reasons that we analyze reporting structures?

special purpose entity (SPE)

often referred to as a “paper” company, meaning it exists on paper, but has no independent operations

enron prepay transaction

• a complex financial structure composed of enron, an SPE, and JP Morgan used to hide debt

• created loan of gas/oil that would be passed off as sales despite the goods ultimately ending back in enron’s hands

• a lump sum of cash was paid from JP Morgan to the SPE, then to enron, essentially functioning as debt, but being recognized as a sale

voting interest entity model

controlling interests determined through voting rights (% ownership in stock)

variable interest entity model (VIE)

• controlling interests determined based on who has the power and who is affected by costs and benefits

• created to broadly capture all types of company arrangements (ex. synthetic lease)

synthetic lease

a lease that is structured to provide a company with the tax benefits of ownership while not requiring the asset to be reflected on the company's financial statements

variability

another word for risk, especially in the context of an investment or business structure

variable entities

those that absorb risk, especially in the context of an investment or business structure

variable interest

contractual, ownership, or other monetary interests that change with the fair value of the entity’s net assets (ex. default risk, common stock, guarantees, options, etc.)

options

contract between two parties that gives the buyer the right, but not the obligation, to purchase or sell something at a later date at a price agreed upon today

call option

the option to buy

put option

the option to sell

long position

person buying the option

short position

person writing the option and who has the obligation to buy/sell upon exercise

strike/exercise price

the price for an option that is agreed to

premium

the amount paid to purchase an option

greater than

in a call option, the stock price is __________ exercise price

less than

in a put option, the stock price is __________ exercise price

convertible debt (preferred stock)

a type of option written by a company where debtholders have the option to convert debt to stock → this is essentially debt + a call option

redeemable preferred stock

• stock that permits a corporation to buy back the preferred stock at some future date

• this can be a call option for the company, put option for preferred stockholders, mandatory repurchase, etc.

common law

• a system where legal decisions are largely derived from judicial precedents set in previous cases

• tends to have more specific accounting law set by non-legislative organizations

code law

• a legal system where laws are primarily based on a comprehensive set of written statutes or codes

• tends to have a more general accounting law

anglo-saxon accounting model

• an accounting model aimed towards meeting needs of large numbers of investors and creditors

• influenced mostly by the UK and US

continental european accounting model

• an accounting model aimed towards providing information for taxation and government planning

• influenced by code law countries where banks served as primary lenders instead of debt/equity holders

• providing incentives for the BOD and managers to act in interest of the company and shareholders

• facilitating monitoring

name 2 links between auditing and corporate governance

corporate governance

• the way in which a corporation is structured and the effect that structure has on the corporation's behavior

• highly influenced by the role and independence of auditors, monitoring committee, accounting model, and type of law

• power to direct

• obligation to receive benefits of absorb loss

what are the determinants of consolidation for a VIE under gaap?

• power through voting rights

if not:

• power to direct activities

• right to gains/losses

• power to affect variable return

what are the determinants of consolidation under IFRS?