Equity Valuation: Models from Leading Investment Banks

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From Accounting to Economics – Part I

Based on the concepts of accrual accounting, to arrive at profit, one includes all of the costs with the revenues incurred for the relevant period, regardless of whether the costs (revenues) involved a cash outlay (inflow) in the period or not. While accrual accounting helps us to understand the matching period between revenues and expenses, management discretion over accrual periods (when the matching occurs) gives it a creative opportunity to improve appearances at the expense of economics. Actual cash outlays frequently occur in different periods than the accrual treatment, resulting in a volatile rift between accounting “profits” and actual cash flow.

In addition to management discretion on accruals, management discretion for creative financing influences the accounting of assets. For example, under certain conditions, the cost of leasing an asset is a direct expense whereas under other conditions it is first capitalized on the balance sheet and then amortized over some period. The accounting for leases affects how the asset flows through the income statement (influencing earnings) and resides on the balance sheet (influencing both assets and debt). Furthermore, when the financing of an asset is debt based (lease or loan), the interest expense explicitly reflects the cost to the firm required by the debt providers. On the other hand, if the asset purchase is with equity (cash), there is no explicit cost to the firm of a required return ...