Guidelines to Writing a Successful Finance Project

Initial Coverage Reports

This primer on project writing and the necessary approach to be taken consists of two basic sections. First, general writing styles and methods of logical argument are discussed. Second, the expectations, sequence and material to be included in the drafts (project sections) will be presented. I hope you find this useful. I will update this file as the course evolves.

To be completed(Moore drafts)

General writing and style guidelines

Grammar and sentence construction.

First, grammar and spelling do matter. Although finance is primarily a quantitative discipline, you are typically communicating ideas to numerically challenged customers. In the context of an initial coverage report or analyst recommendation, you are marketing an idea and selling your position.

Citation Analysis and Avoiding Plagiarism

You are working towards becoming industry experts with analytical capabilities. Part of this task involves researching the economy, industries and the firm. Clearly, you will be incorporating outside data and sources in order to form your opinions. This is expected. However, what I am most interested in is the opinions you form from putting together these researched sources. Hence, give credit to these researched inputs. Clearly identify your sources and the material you incorporate into your analysis. If you “cut and paste” material into your analysis, offset it, put quotes around it, and show the source used. You can save yourself from potential integrity questions by then writing up an analysis (your opinion) as to why this referenced material is important and relevant.

Business Report Writing Styles

Your job is to clearly communicate ideas and to convince the reader you have prepared something worthwhile. In every section (and sub-section) provide an introduction (what is it you will be doing and why is it important). Do not get trapped by buzz-words and do not assume a sophisticated reader. This means you need to provide, in simple language, what it is you are doing.

A good, clear writing style has a distinct flow and rhythm. Don’t write cumbersome multi-page paragraphs. A paragraph should contain one central idea. Don’t write one-page sentences. These are usually a bad compilation of multiple sentence fragments and run-ons.

Try the following (simple) writing format (I call it DDAC):

  • Define what you are doing in this section or paragraph (this, effectively is your introduction)
  • Discuss the topic or concept. This is where you convince the reader it is worth his (her) time to continue reading. What is it you are talking about? Why is it important (WDIC)? Take complex ideas and make them accessible to non-specialists.
  • Present your Analysis. This is where you connect the threads. Your analysis may consist of both quantitative presentation (where appropriate) and logical argumentation.
  • Draw a Conclusion. What does all of the above mean and what are the implications?

Logical Flow and Content Guidelines for Draft 1

  1. Minimum Citations and Research References
  1. 6 Wall Street Journal Articles and the 10-K’s of your company and its competitors.
  2. These can be firm specific WSJ articles, but also look at the bigger picture in terms of industry perspective and/or relevant economy or regulatory items.
  1. Firm and Industry (Competitor) overview.
  1. These are separate subsections
  2. Your focus is on business activities and structure; not stock price performance.
  3. Describe what the business does (in your own words), for example, where it competes, the nature of its products and product markets (who are the customers). Don’t waste a lot of time discussing stock price performance.
  4. It is up to you to identify relevant competitors (possibly from different industries). Part of your job is to demonstrate industry expertise and to convince the reader of your logical arguments.
  1. Industry Analysis and Classification(Five Forces Model)
  1. Start off by defining the model and introducing what it is (WDIC).
  2. Provide a summary table of your findings to set up the subsequent analysis.
  3. Remember, this is an industry analysis. Do not just discuss your company, but bring in examples and facts across the industry.
  4. Analysis of competition (introduce entire section)
  5. Rivalry among existing firms.

-Introduce why it is important (WDIC)

-Use (to the best of your ability) each of the elements in the appropriate table 2-2 “box” as separate subsections.

-Provide facts where possible, use logical argumentation grounded in the industry structure for other elements

-For example, industry growth can be measured as the percent change (year by year for five years) of industry sales (as you define the industry). Make the table and be sure to discuss it. In the retail industry, for example, you can also use same store sales and new store openings as measure of growth.

-Industry concentration (year by year for five years) can be measured as market share (percentage of annual industry sales).

-Economies of Scales can be represented, factually, by presenting total assets (how big do you have to be)

-Draw conclusions in each subsection (hi, low, or mixed) and explain implications. Finally, draw an overall conclusion.

  1. For the remaining “5-Forces”.

-Follow the same format and procedure. Use industry facts where available. Remember this is an industry analysis and not just the firm you are valuing. Your write-up should contain a balance of quantitative facts (where available) and information that you analyze in order to draw a logical industry conclusion that allows you to draw inferences (logical consequences).

  1. Finally, put it all together by drawing an overall conclusion (all 5 forces) that will allow you to classify the industry as being Hi competition (which leads to cost leadership), Low competition (leads to specialty product, differentiated product industries), or mixed. Also discuss the fragmentation of the industry (e.g. dominant high competition with segments, or small elements of specialty products, or, vice versa. You might title this subsection as “Overall Conclusions and Industry Classification”

Logical Flow Content Guidelines - Draft 2 – Accounting Analysis

  1. First, keep in mind the overall purpose of Draft 2 is to assess the quality and sufficiency of the financial Disclosure provided by the firm you are valuing. This involves an absolute judgment of the firm and a relative judgment as to how the firm’s disclosure quality compares to the benchmark competitors you identified.
  2. Basic Structure and Sequence of Draft 2.
  3. Start by identifying Key Accounting Policies
  1. Type 1 policies relate to Disclosure (broad sense) regarding the KSF’s identified at the industry level in Draft 1.

-What type of “stuff” do firms in this industry disclose as it relates to D1 KSF’s (relate to business activities that add value). Provide specific examples and discuss how this helps you evaluate value added activities.

-Type 1 KAP’s are industry specific. You would require different information to evaluate Apple than you would need for WalMart.

  1. Type 2 polices relate to potentially distortive items that you would be concerned about regardless of the firm or industry you are valuing.

-Type 2 items either allow firms a great deal of discretion or flexibility in measurement of accounting choice or the available GAAP is overly restrictive in measuring the economic consequences of business activities (R&D can be viewed as an investment in the future and not as an expense).

-Purpose of this sub-section is to identify the extent to which the firm is economically exposed to Type 2 areas. In other words, how big and important (materiality) are these items in providing the potential to affect your view of the firm.

-SomeType 2’s might require financial report restatements (Goodwill, R&D and Operating Leases). Other Type 2’s require analysis of “reasonableness” (pensions and FX risk management which involves FX exposure and Hedging).

-Provide facts (absolute and relative) as to the extent to which the Type 2’s are present and relevant.

  1. Assess the Degree of Potential Accounting Flexibility
  1. Regarding Type 1 KAP’s, this relates this relates to the different types of physical operating data that firms can voluntarily present so that Type 1 KAP’s can be used to assess KSF’s. The flexibility lies in firms’ choices to disclose or not disclose the items. Things like same store sales, unit commodity costs (cost per ton) or gallons and tones produced or sold are not required but are useful.
  2. Regarding Type 2 KAP’s, (the primary focus of this section) Demonstrate basic knowledge of the accounting issues surrounding the potentially distortive item. For example, what is the impact of choosing operating lease disclosure as opposed to capital leases; how much flexibility is there in impairing goodwill; does GAAP get in the way of measuring innovation by requiring R&D to be expensed (important for a differentiation firm); etc.
  1. Evaluate the Actual Accounting Strategy
  2. The focus of this section is to analyze the impact of the firm’s Type 2 KAP’s choice and exposure on the firm’s financial performance (existing/ potential impact) since these are potentially distortive items.
  3. Issues to address in this section include:
  • How conservative/aggressive is the company in reporting and measuring to the Type 2 Key Accounting Policies.
  • How conservative or aggressive is the company relative to its competitors.
  • Is this (are these) material and significant amounts?
  • How would alternative treatment affect financial reports?
  • Ratio of Goodwill to PPE; Percent of Operating income that would be lost when amortizing goodwill over 5 years.
  • Relationship between the present value of operating leases and Long-Term debt. Effect on credit-worthiness if operating leases were capitalized.
  • What percent of operating expense and sales is R&D. What would impact on financials be if R&D were capitalized and then “amortized” over 5 years?
  • How reasonable are pension plan assumptions (if a defined benefit plan)? Look at discount rates, growth rate in costs and plan assets. How do discount rate assumptions match interest rates over same time period? Is there disclosure regarding plan assets and the quality of these assets and their returns. A “stable” DB plan would be 10% Cash; 30% High Grade Debt; and 60% “safe” equity. A risky plan would have a large exposure to non-traditional investments such as resources (mines and forests), hedge funds and private equity funds.
  1. Evaluate the Quality of Disclosure
  1. The overall purpose of the section is for you to provide a well reasoned opinion regarding the absolute and relative usefulness of the financial disclosure provided by the firm you are valuing. In addition, you are expected to provide an opinion as to the degree of confidence you place on the financial performance presented by the firm.
  2. Qualitative Analysis of Disclosure Quality

-In this section, you provide an opinion as to the adequacy of the firm’s financial disclosure (absolute and relative). Areas to address include the degree to which the firm discloses operating data related to D1 KSF’s; the extent to which segment data is reported; the level of detail provided (as opposed to high levels of data aggregation; the quality of the Management discussion and Analysis section; the level of details and disclosure of assumptions in the footnotes. Make sure to provide fact, examples, and discuss how this helps you assess the business activities that add or destroy value.

  1. Quantitative Analysis of Earnings Quality

-The previous section (qualitative analysis) involved forming an opinion based upon your subjective criteria. This section (quantitative analysis) provides an objective assessment regarding the quality and “believability” of reported earnings. Your “mission” is to assess the credibility of reported revenues and expenses.

-You will be using forensic accounting techniques to determine whether or not the revenue functions and expense functions are supported by associated business activities (think of the “money merry-go-round”).

-The “context” of analysis for the revenue diagnostics screening ratios is to determine whether or not sales are supported by the associated transaction activities (there should be a relationship between sales and the cash collected from selling activities).

-Raw Form Analysis: This is a levels test. You would be concerned if there are unexplained increases in the raw ratio as this is a potential indication (not definitive proof) that revenues might be overstated. Clearly, the reverse (unexplained decreases) could lead to a concern that revenues were understated due to “big-bath” motivations by managers.

-Change Form Analysis: This is essentially a “first derivative” test. The changes represent the slope of a line. One would expect a positive relationship (positive first derivative) between the sales function and the inventory function. You job is to evaluate the “sign” not the magnitude of the ratio.

-Present both the raw and change form ratios on an absolute and relative basis (five years for the firm and its identified competitors. You can try to explain “strange” variations by firm specific activities that were disclosed or from industry effects and shifts. This is an opportunity to look for industry segmentation. If you observe segmentation, discuss it.

-At a minimum, graph the firm and its competitors relationships using “as-stated” data and then graph the ratio for the firm using your restated financial statement information (comment on differences between as-stated and re-stated. Restatement data will come from later analysis in this draft.

-Expense Manipulation Diagnostic Ratio Analysis: The “context” is to assess whether reported expenses are supported by associated business activities. The method of analysis is the same as the revenue diagnostics section. Your interpretation (for all expense ratios) is that (in raw form) unexplained decreases in the ratio can be a signal of under-stated expenses (leading to overstated earnings). Unexplained increases in expense ratios can be a signal of managers taking the “big-bath”. Change for ratios should also be positive in sign for the expense diagnostics.

-Please note that you will be more concerned as the number of outlier ratios occur. This is not definitive proof of manipulation, only indirect evidence. However, if 3 out of the five revenue or expense ratios are unexplained outliers, then you should be concerned as to the credibility of reported earnings.

5.Identify Potential “Red Flags”

  • Previous Quantitative Analysis Factors.
  • Asset Write-offs. 4th quarter adjustments. Related Party transactions; Special purpose entities
  • Are the potentially distortive items material in size relative to other financial statement measures as they relates to the Type 2 KAPs?
  • Use the establish criteria such as “when goodwill exceeds a specified percentage of PPE”, Operating Lease Criteria, Research and development. Provide tables in the body of the draft to show the magnitude.
  • Discuss the impact of the Type 2 items that are not subject to restatement (i.e. pensions and FX)
  1. Undo Accounting Distortions
  1. When distortive thresholds are exceeded, then you will have to restate the income statement and balance sheets (5 historical years).
  2. Prepare separate schedules for items such as Goodwill restatement, Operating Lease restatement, Research and Development restatement.
  3. Prepare a Trial Balance and an adjusted trial balance (debits and credits on both income statement and balance sheet accounts) for each of the five years (this can go in the appendix). There is no such thing as a balance sheet trial balance.
  4. Prepare adjusting entries that are consistent with the schedules created in Part B of the process.
  5. Once your trial balance is in balance, then prepare Restated income statements and Restated balance sheets.
  6. Write up an analysis as to how the restatements affect your view of the firm.

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