Topic 7: FINANCIAL REPORTING ISSUES External Audit

4 Types of Auditor’s opinion

 Managers, creditors and shareholders rely 1. Unqualified opinion
heavily on annual reports for information  When a unqualified opinion is rendered, it means
about a company. that in all material respects, the audited financial
 Historical Financial statements can be used to statements fairly present the financial position,
establish trends that, in turn, are useful for operating performance, and cash flows of a firm.
establishing reasonable assumptions that will 2. Qualified opinion
be used in financial forecasts.  A qualified opinion may be issued when there are
Financial statement, however, are vulnerable to scope limitations or when auditors believe that
window-dressing. material departures from GAAP are observed in
 Window-Dressing is a manipulation of some financial statement accounts.
financial statements to show more favourable  Except for the effect of these circumstances, the
results for the business. financial statements may still fairly present the
Why managers window-dress their financial financial position, operating performance and
statements: cash flow of the company. It is, however, should
 To support fund raising activities whether already serve as a warning signal to the analyst.
equity or debt. 3. Adverse opinion
 To improve their performance as managers.  An adverse opinion simply means that the
 To protect the value of their stock options. financial statements are not in conformity with
 To manage tax payments. general accepted accounting principles.
General Accepted Accounting Principles (GAAPs)  If an analyst finds out that the auditor’s opinion is
 Securities Regulation Code (SRC) Rule 68 adverse, he should not even bother to analyse the
defines generally accepted principles as: financial statement because they are not reliable.
“Accounting principles include not only accounting 4. Disclaimer of opinion
principles and practices but also the method of  It means that the auditor is not rendering an
applying them. Generally accepted accounting opinion on the fairness of the financial statement.
principles means accounting principles based on
pronouncements of recognized bodies involved in Window-Dressing of Financial Statements
setting accounting principles.” The following are the different possible ways by which
window-dressing of financial statement is done:
General Accepted Accounting Principles (GAAPs)  Overstatement of income
Greatest weight shall be given to their  Understatement of expenses and losses
pronouncements in the order listed below:  Overstatement of assets
1. Philippine Securities and Exchange  Understatement of liabilities
Commission  Improper classification of accounts
2. Accounting Standards Council (now Financial  Lack of adequate disclosures
Reporting Standards Council)  Income smoothing
3. Standards issued by International Accounting  Non-consolidation of subsidiaries
Standard Committee 1. Overstatement of Income
4. Accounting Principles and Practices for which Income includes both revenues and gains.
there is long history of acceptance and usage 2. Understatement of Expenses, Overstatement of
If there appears to be a conflict between any of the Assets, and Understatement of Liabilities
bodies listed above, the pronouncements of the first  Recognition of allowance for uncollectible
listed body shall be utilized. accounts
 GAAPs require the fair presentation of a  Recognition of impairment loss for inventories
company’s financial position, operating
 Depreciation of plant, property, and
performance, and its cash flow.
equipment (PPE)
 An analyst must be aware of the changes in
 Depreciation of investment properties
accounting principles, especially those related
 Recognition and reversal of impairment losses
to the biggest accounts in the financial
for PPE and investment properties
statements.
 Recognition of impairment losses on
investments in unlisted companies
 Amortization of intangible assets
 Provision for losses from existing legal cases
 Capitalizing operating expenses and losses
3. Improper Classification of Accounts
It is done to improve the liquidity of the company and
sometimes to improve the reported net income.
 Classifying non-current assets as current
assets and current liabilities as non-current
liabilities
 Certain balance sheet items, such as PPE can
be improperly classified as investment
properties and use the fair value approach for
its subsequent measurement.
4. Lack of Adequate Disclosure
 The notes to financial statements are integral
part of the financial position. An analyst
should read these notes because they provide
a substantial amount of information.
The following information is found in the notes to
financial statements:
1. General description about a company or
group of companies
2. Summary of significant accounting policies.
3. Breakdown of major financial statement
accounts
4. Recognition and reversal impairment of loss
5. Retirement or pension plans
6. Related party transactions
7. Commitment and contingency liabilities
8. Segment information
5. Income Smoothing
 Income smoothing is intended to present a
more stable operations for a company. This is
done by juggling expenses or income that are
well within the control of management.
6. Non-consolidation of Subsidiaries
 A parent company will generally exclude a
subsidiary from consolidated financial
statements, if such subsidiary will impair the
financial position and operating performance
of a group.
For the following reasons:
 Materiality
 Temporary control
 Planned disposal of a subsidiary

Limitations of Financial Statements

 An analyst should be aware that the balances
of some financial statement accounts are
result of management’s judgment and
estimates.
Topic 8: THE MACROECONOMIC ENVIRONMENT measured using the producers’ value added,
ANALYSIS that is, the value added by producing sectors
in the production process.
MACROECONOMIC ANALYSIS
Macroeconomics focuses on 2 main economic
variables:
 Aggregate Output
refers to the level of production in an economy.
Inasmuch as production creates employment, it also
serves as indicator of the income earned by the
citizens of the economy.
 Price Levels
is measured by Gross National Income (GNI) and
Gross Domestic Product (GDP).
Gross National Income (GNI) is the value of final
goods and services produced by the resources of an
economy.
Gross Domestic Product (GDP) is the value of final
goods and services produced within the economic
boundary.
Net Primary Income (NPI) is the difference between
GNI and GDP; which indicates the difference between
economic boundary and the income derived from the
resources of other countries within its economic
boundary
GNI = GDP +NPI
Activity:
How much is the Net Primary Income of a country
with the following data:
GDP= 500,500.00
GNI=489,765.00
Answer: NPI= 10,735.00

 In the Philippines, NPI includes the

remittances of overseas Filipino workers
which add significantly to the spending power
of consumers.
 As such, GNI measures the total income of
the Philippines economy.  In analyzing the performance of the economy
over time, economists use the value of the
 In contrast, GDP measures the income
output in “real terms”.
generated from employment within
Philippine territory.  Real Values of Output are computed using
Output of the economy can be divided into 2 prices that prevailed in a given year (also
components: referred to as the base year). By doing so, the
By Expenditures on output change in value is attributed solely to changes
in the volume of production.
 Total Expenditures is initially estimated as the
Aggregate Prices
sum of the value of final goods and services
spent in the domestic market and those in the  is commonly measured using the consumer price
export market. To estimate production, the index (CPI).
value of import is subtracted from the total  Consumer Price Index (CPI) measures the level of
value of expenditures. prices of a typical basket of consumer goods
Industrial Origin of Economy’s Production relative to those in a base year.
 The total Output of the Economy is estimated Inflation Rate
by adding up the output of the producing  Is the rate at which the average prices of goods
sectors of the economy. These outputs are increase over time.
 Inflation categories: 1. Market for Goods and Services
Headline Inflation the market for domestically produced goods and
 refers to the year-on-year increase in the CPI. It services. It refers to the exchange in products or
captures the changes in the cost of living based on services such as food. Cars, appliances, machineries,
the movements of prices (of all goods) in the transportation and communication.
basket of consumer goods. 4 components of Market for Goods and Services
Core Inflation  Consumption demand
 is the increase in prices of goods in the typical It satisfies the people’s basic needs such as food,
consumer basket excluding those with volatile clothing, education, health care, as well as higher
price movements due to mainly to supply shocks needs as leisure, entertainment, and so on.
(eg. Food and energy items)  Investment demand
Why can’t the government just print a lot of money It represents the demand to build productive capacity
to address poverty? in the economy (eg. Factories, machinery and
 When the supply of money in an economy equipment, roads and buildings, etc. )
increases rapidly without a corresponding  Government Demand
increase in goods and services, the purchasing It represents the largest single buyer of goods and
power of the currency decreases, leading to services. Government spending may be sued to
higher prices. Hyperinflation can erode the value “pump prime” or stimulate a weak economy.
of savings and create economic instability.  Net Exports
A broader measure of aggregate price is the Implicit It refer to the difference between exports and
Price Index of GDP (IPIFDP) or commonly referred as imports.
GDP deflator. Exports represent the purchase of domestic goods
 and services by foreigners.
 Imports represent that part of aggregate demand for
 It measures the level of prices of the goods and goods and services that are not locally produced.
services produced by an economy relative to
those in the base year. 2. Financial Assets Market
Is a venue for mobilizing funds by trading financial
assets like share of stock, treasury bills, commercial
papers, and of course cash itself.
2 Types of Instruments:
Debt Instruments are the less risky instrument; They
promised a fixed return and repayment of principal at
some future date.
Equity Securities: are more risky as they promise
neither. There are many variations of debt and equity
securities.
Indicators of changes in interest Rate:

ANALYTICAL FRAMEWORK:
Aggregate Demand and Aggregate Supply Model 3. Factor (or Input) Market
Model of Economy (3 Broad Markets) refers to the market for labor, capital, and other
inputs used in production. The availability of these
inputs, the level of technology of producers, and the
provision for infrastructure determine the cost of
production which, in turn, affect prices.
 Use: Real GDP per capita is particularly useful for
understanding changes in the standard of living over
time because it accounts for the impact of inflation. It
allows for a more accurate comparison of economic
output across different time periods.

Key Points:
 GDP per capita provides a straightforward
measure of average economic output per person
without considering changes in the price level.
 Real GDP per capita adjusts for inflation or
deflation, offering a more accurate reflection of
changes in the actual quantity of goods and
services produced per person.
Questions: Why it is important to understand and  Real GDP per capita is often used when comparing
create an Macroeconomic Environment Analysis in economic performance over different years to
Investment? account for the effects of inflation.
In summary, while GDP per capita gives a general idea
Economic Measures - Philippines of the average economic output per person, real GDP
• The GNI (gross national income) per capita in per capita is a more refined measure that considers
the Philippines is forecast to amount to US$3.94k in the impact of changing prices over time.
2023.
• The GDP (gross domestic product) per capita
in the Philippines is forecast to amount to US$3.71k in
2023.
• The GDP (gross domestic product) per capita
real in the Philippines is forecast to amount to
US$3.42k in 2023.
• The GNI (gross national income) in the
Philippines is forecast to amount to US$0.46tn in
2023.
• The GDP (gross domestic product) in the
Philippines is forecast to amount to US$0.44tn in
2023.
• The GDP (gross domestic product) real in the
Philippines is forecast to amount to US$0.40tn in 2023

GDP per Capita:

Definition: GDP per capita is a measure of the
economic output of a country per person. It is
calculated by dividing the total Gross Domestic
Product (GDP) of a country by its population.
Formula:
GDP per Capita=GDP/Population
Use: GDP per capita is a useful indicator to assess the
average standard of living in a country. However, it
does not account for changes in the price level over
time.

Real GDP per Capita:

Definition: Real GDP per capita adjusts the GDP per
capita figure for inflation or deflation, providing a
more accurate measure of the changes in the actual
quantity of goods and services produced per person.
Formula:
Real GDP per Capita=Real GDP/Population
Topic 9: THE INDUSTRY ANALYSIS homogeneity, numerous sellers and buyers, and
 Industry is defined as a firm or group of forms minimal price-setting power.
that produce similar types of goods and  The objectives of industry analysis is to
service. understand and predict the level of
 An analyst wishes to study banks, he could profitability of an industry.
examine the banking industry or the financial Implication and Limitations of Economic Concepts
services industry which could be further  In a perfect competitive industry, it is
classified as universal, commercial, savings assumed that entry into the industry is
and rural banking. absolutely free in the long run such that any
Types of Market Structure number of firms can enter an industry and
Monopolies manage to produce in exactly the same way
 These type of industries are characterized by and at exactly the same cost as the incumbent
a single firm that sells its output to many firms.
buyer.  In monopolies, ease of entry and/or exit is
 It is prevalent where the extent of capital restricted.
investment is so large and economies of scale  Investment Managers and Analysts cannot
are so significant that only one supplier can explain how industries evolve over time.
exist for a given market.
 Monopoly comes from the Greek prefix
mono-, which means "one," and pōlein, "to
sell. Example: Manila Waterworks and
Sewerage System
Oligopolies
 Industries that are characterized by a few
sellers supplier many buyers
 Oligopoly comes from the ancient
Greek oligo-, for "few," and pole, for
"merchant. Example: airline, cement,
petroleum, and fertilizer industries
Two (2) Types of Oligopolist The Five Forces Framework in Industry Analysis
1. Oligopolist may sell a product or services
which is identical (or almost identical) to what
is sold by others.
2. Oligopolist sells differentiated product
compare to its competitors
Monopolistic Competition
 In some cases, industries consist of a large
number of sellers which produce goods or
services that are differentiated from each
other.
 An industy in which may firms may offer
products or services that are similar (but not Generic Strategies
perfect) substitutes. 1. Overall Cost Leadership is a term used when a
 Examples: Restaurants, hair salons, company projects itself as the cheapest
household items, clothing, smartphones, manufacturer or provider of a particular product
Television services, and softdrinks. or commodity in a competition.
Perfect Competition 2. Differentiation strategy is an approach
 An industry that consist of many sellers and businesses develop by providing customers with
buyers dealing in a homogenous product. something unique, different and distinct from
 A theoretical market structure in which there items their competitors may offer in the
are no monopolies. marketplace.
 Examples: crop farming, the dairy industry, 3. Focus strategy is a business method companies
basic bread production, some technology use to identify and target specific market
markets with open-source elements, and segments or niches.
local farmers' markets. These examples
demonstrate key traits like product
 Generic Industry Environments and the Five Demand/Prices of Related Products
Forces Framework  The growth in demand for a product may be
 Demand Growth influenced by the demand for, and prices of
 Income Elasticity of Demand related products.
 Industry Life Cycle Downside Risk
 Demographic and Lifestyle Changes  The downside risk of a particular industry may
 Product Innovation be assessed by looking into the industry’s
 Demand/Prices of Related Products sensitivity to changes in macroeconomic
Downside Risk variables (eg. GDP growth, inflation, interest
MEANING; rates, foreign exchange rates, etc.) as well as
Demand Growth the factors which may be more specific to the
 The source of growth in the demand for an industry.
industry’s product and services may come Questions: Why creating Industry Analysis in
from the domestic market or the export important in Investment?
market, or both.

Income Elasticity of Demand

 Income elasticity of demand measures the
sensitivity of demand for a product or service
to changes in income. The demand for
products with high income elasticity tends to
increase faster with increasing consumer
incomes relative to other products.
 Ex. Automobiles, household appliances,
travel and recreation, luxury products.
Industry Life Cycle
 The industry life cycle model depicts changes
in growth rates in the demand for an
industry’s product through time.
Demographic and Lifestyle Changes
 The progress of urbanization in a country may
lead to changes in lifestyles which could
increase demand for certain products and
services.
Product Innovation
 Major product innovations and improvements
may stimulate rapid growth in demand.
 Ex. Electronic industry where sustained
innovations created new products for the
computer industry, telecommunications
sector, and household appliances industry.