Friday, July 3, 2009

“This one is for you Prof”

Assume that you enter into a highly competitive environment, not sure of whether you belong to that place. Assume that there is a credible person, who takes pain to boost your morale in such a situation…Can you forget that person in life…My accounting professor ,the late Mr.Amanullah , is one such person who made me believe that i belong to that tough environment. He died a couple of days ago in a car accident, when he travelled from Delhi to Lucknow for a conference…

He managed to dedicate a majority of time for us in the first trimester..He handled quite a lot of additional sessions when students found accounting a hard nut to crack.And he was open to any doubts regarding the subject/personal counseling during any time…

This article is my humble dedication to you Prof…

When doing a Valuation, you need to do a lot of tinkering work in the Balance sheet before you can start using it. Here are some of them which are very crucial.Please bear in mind that Accounting was an area which was created for old age manufacturing companies. Though lot of accounting flexibility has been brought in for the new world companies, there are certainly some loopholes which can make the valuation totally different from the actual.Here are few of them.

R and D expense: When you deal with technology companies this is going to be a huge number.Technology companies classify Research and development activity as an expense. As per accounting norms expense should be matched with the benefit/revenue in the particular period. But the benefit of the R and D activity is going to accrue over a period through a breakthrough technology or a patent (in case of a pharma) or a new product in the market (FMCG).Hence this particular investment need not be expensed but has to be amortised over a period of time..The amortization period has to be in sync with the period over which the benefit is going to accrue. Same goes for advertising expense in the case of a marketing company whose spending is directed towards creating a brand.

Inventories /Depreciation policy: Be careful with the inventory/depreciation policy that the company follows..Companies could swing between different policies to make them look better under different situations .Basically a particular policy should economically justify the activity which they do. Delta Airlines extended its useful life in order to reduce its depreciation expense.As an analyst one should be sharp enough to observe this aberration (the industry was using a much lower useful life)..

Leases: Most of the FMCG/Airlines operate on leased assets .It makes a huge difference in terms of valuation whether you classify a lease as a financial lease or a operating lease..Most companies tend to classify their lease as a operating lease.This makes the impact of the lease item only to the income statement..But when we classify it as an financial lease then the there will be an asset/liability in the balance sheet and more often than not some of the crucial ratios like ROE, ROC are pulled down…

Underfunding of Pensions: Companies park a lot of their excess cash in pension accounts for the employees. Now the key thing to be noted is the interest rate earning assumption that the company has made for the Pensions. There could be an optimistic assumption regarding the interest rates .An analyst should observe the Pension interest rate assumption vis-à-vis other companies and need to adjust the balance sheet factor in a liability.

Onetime expenses/Divestures/restructuring expense: This item does not require any changes in the balance sheet/income statement as such.But while doing a valuation one needs to understand that this is not a recurring expense and need not be considered while valuation. Let me put in simple terms..Assume you bought a 10.Rs lottery and gained a crore out of it. Can you project this income over your life time.That is can you assume that you are going to invest 10.Rs year after year and you are going to earn 1 crore out of it.Distant possibility right…So in valuation we try to project only those items which are recurring in nature..Agreed that the above mentioned expense will be in tens of crores.But they are generally not considered because the value of a company will be in thousands of crores and one time activity of this magnitude will not affect the valuation of a company.

These are few of the accounting adjustments that need to be made before doing a valuation.If I could think of more, I’ll come up with another article on the same…

Me: Sir, I’m finding it hard to crack all other subjects except accounting
Mr.Amanullah: If you have cracked accounting, then certainly you have to be bright…You’ll definitely perform better in the other subjects as well.
True Prof, I was certainly bright…And you made me realize it!! I will not forget you in my life time…..

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