Business Analysis and Valuation: Using Financial Statements, Text and Cases 5th Edition by Krishna G

A second potential explanation is that human beings are subject to behavioral biases that lead them to make common mistakes. For example, most retail investors extrapolated performances at Enron, internet stocks, and mortgage backed securities to conclude that these would continue to be terrific investments. They poured money into these sectors and stocks and showed little interest in hearing from analysts, auditors, investment bankers, etc. who had a contrarian point of view. For example, at the height of the internet boom, Warren Buffet expressed concern about the sector but was dismissed as a dinosaur who didn’t understand the new economy. Less informed or less confident intermediaries would find it difficult to challenge the popular view of such hot markets or to judge when such hot markets would crash.
Given these problems, we will probably continue to have crises unless we can correct the fundamental conflicts of interest that pervade the industry and can figure out how to modify human behavior.
3. Accounting statements rarely report financial performance without error. List three types of errors that can arise in financial reporting.
Three types of potential errors in financial reporting include:
1.   error introduced by rigidity in accounting rules;
2.   random forecast errors; and
3.   systematic reporting choices made by corporate managers to achieve specific objectives.
Accounting Rules. Uniform accounting standards may introduce errors because they restrict management discretion of accounting choice, limiting the opportunity for managers’ superior knowledge to be represented through accounting choice. For example, SFAS No. 2 requires firms to expense all research and development expenditures when they are occurred. Note that some research expenditures have future economic value (thus, to be capitalized) while others do not (thus, to be expensed). SFAS No. 2 does not allow managers, who know the firm better than outsiders, to distinguish between the two types of expenditures. Uniform accounting rules may restrict managers’ discretion, forgo the opportunity to portray the economic reality of firm better and, thus, result in errors.
Forecast Errors. Random forecast errors may arise because managers cannot predict future consequences of current transactions perfectly. For example, when a firm sells products on credit, managers make an estimate of the proportion of receivables that will not be collected (allowance for doubtful accounts). Because managers do not have perfect foresight, actual defaults are likely to be different from estimated customer defaults, leading to a forecast error.
Managers’ Accounting Choices. Managers may introduce errors into financial reporting through their own accounting decisions. Managers have many incentives to exercise their accounting discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting. For example, many top managers receive bonus compensation if they exceed certain prespecified profit targets. This provides motivation for managers to choose accounting policies and estimates to maximize their expected compensation.
4. Joe Smith argues that “learning how to do business analysis and valuation using financial statements is not very useful, unless you are interested in becoming a financial analyst.” Comment.
Business analysis and valuation skills are useful not only for financial analysts but also for corporate managers and loan officers. Business analysis and valuation skills help corporate managers in several ways. First, by using business analysis for equity security valuation, corporate managers can assess whether the firm is properly valued by investors. With superior information on a firm’s strategies, corporate managers can perform their own equity security analysis and compare their estimated “fundamental value” of the firm with the current market price of share. If the firm is not properly valued by outside investors, corporate managers can help investors to understand the firm’s business strategy, accounting policies, and expected future performance, thereby ensuring that the stock price is not seriously undervalued.
Second, using business analysis for mergers and acquisitions, corporate managers (acquiring management) can identify a potential takeover target and assess how much value can be created through acquisition. Using business analysis, target management can also examine whether the acquirer’s offer is a reasonable one.
Loan officers can also benefit from business analysis, using it to assess the borrowing firm’s liquidity, solvency, and business risks. Business analysis techniques help loan officers to predict the likelihood of a borrowing firm’s financial distress. Commercial bankers with business analysis skills can examine whether or not to extend a loan to the borrowing firm, how the loan should be structured, and how it should be priced.