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Financial Accounting

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Submitted By jenny7317312000
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University of Melbourne
DEPARTMENT OF ACCOUNTING
SEMESTER 1, 2014
 SUBJECT CODE: ACCT 90013 SUBJECT NAME: FINANCIAL ACCOUNTING

Student Declaration
I / we declare that: 1. This submission is our own work
 2. The submission is based on our own research and analysis 3. All sources are documented in the assignment
 4. All participants contributed equally to this joint submission
Student number 1 2 3 4 594130 644502 579471 517355 Signature Jie Yang Anqi Li Xi Zhao Lei Fu Date 6 May 2014 6 May 2014 6 May 2014 6 May 2014

Part A This session mainly discuss the assumptions made to estimate the share price using Ohlson’s model. Detailed calculations are shown in appendix. Firm Value = Net Assets as at date of valuation ± Expected PV of Abnormal Earnings i.e. ������������������ = ������������������ + ������������ = ������������������ + PV (Actual Future Earnings – Expected Normal Earnings) = ������������������ + PV (ROE × Opening BV – CoC × Opening BV) It is assumed that reported total comprehensive income, $2373m, is quoted by some investors. Alternatively, some other investors would make adjustment according to their evaluation of the quality of items that contribute to this year’s earnings. Gain on disposal seems to be a once-off item, the figure is quite consistent for the past 4 years, so it is reasonable to assume that the gain would persist in the future. However, the investment in associates should be taken out because the profit/loss fluctuated a lot over the past 4 years. Also, the gain from foreign translation is the result of the decline of exchange rate in 2013 and the high figure is not likely to persist, and thus should be excluded. Reported earnings NI2013 BV2012 BV2013 2373 25627 26022 Adjusted earnings 2314.6 25198 25602

ROE and dividend payout ratio are assumed to continue for 5 years because according to the 2013 annual report, the corporate plans and business forecasts of Wesfarmers are developed with a five-year outlook (Wesfarmers, 2013). Reported earnings ROEt=NIt÷ t-1 BV ROE2013 K2013 BV2014 BV2015 Adjusted earnings

9.26% 9.19% Dividend payout ratio kt=Dividendt÷ t NI 83.86% 85.98% BVt=BVt-1× [1+ROE× (1-k)] 26410.90 26805.62 25931.80 26265.86

BV2016 BV2017

27206.23 27612.84

26604.21 26946.93

To calculate cost of capital, both quoted and estimated beta are used. The quoted beta from Reuters is 0.78. The estimated beta derived from daily returns data during observation period, from 15th August to 14th November 2013, for Wesfarmers and the S&P/ASX300 index (Yahoo, 2013) is 0.811. It is assumed that market became aware of the results on 15th August 2013 when key financial figures were available in Full-Year Results Briefing, instead of 26th September, the date of official release of Annual Report on ASX. And a 3-month period is allowed as listing companies released their annual report during this period. The risk-free rate is assumed to be 3.366%, the average yield of Australian 5-year government bond during the observation period (Fusion Media Limited, 2014). According to a research, risk premium for Australia in specific year of 2013 is 6% (KPMG, 2013). Calculations of estimated share price based on different assumptions about earnings and beta are shown as follow. Reported earnings Adjusted earnings Quoted β Estimated β Quoted β Estimated β 0.78 0.81 0.78 0.81 CAPM:E(Ri,j) = Rf × Rj) + βj×E (Rm,t) (18.05% 8.23% 8.05% 8.23% Expected abnormal earnings: AEt=(ROE-CoC) × t-1 BV 315.85 320.57 325.36 330.22 267.29 271.28 275.34 279.45 291.77 295.53 299.34 303.19 244.00 247.14 250.33 253.55 256.82 991.54

β CoC AE2014 AE2015 AE2016 AE2017

AE2018 PV of AE PA2013

335.15 283.63 307.10 1294.80 1090.32 1191.56 PA=PV of AE+BV2013

27316.8 27112.32 26793.56 26593.54 Estimated share price=PA÷ of shares outstanding no. Estimated share price $23.61 $23.43 $23.15 $22.98

Part B (a) Market efficiency In Leighton Holdings’ case, whether the market is efficient depends on whether the share price is correctly responding to the abnormal earnings. Due to the lack of sufficient information to quantify the theoretical responding change in share price, both possibilities are discussed. If the $1.03 decline in share price was correctly reacting to Leighton’s underperformance compared to market expectation, the market is efficient. Under Market Efficiency Theory, the share price should reflect all information that is publicly known about the share (Fama, 1970). Therefore, if it is an efficient market, the following public information would have been interpreted and priced correctly. 1. Investors can interpret the quality of earnings appropriately. The gain from assets disposal was a one-time gain and seemed hardly to persist into the future. 2. Investors can properly evaluate the negative impact imposed by the tough macroeconomic condition, including the downturn of construction market and the competitive market environment, which leads to loss of contract. 3. Investors can assess Leighton’s decisions and performance properly including investment decisions and profitability in terms of cost management. According to Bayes Theorem, when the annual report was released, these rational risk-averse investors revised their prediction combining their prior knowledge formed from the above information and new information about earnings to make the appropriate response. If the decline in share price is an inappropriate respond to the underperformance, either over-reacting or under-reacting, the market is inefficient. As Verma, Baklaci and Soydermir (2008) pointed out, some irrational individual investors or noise traders could misprice stock prices by way of unpredictable changes in their sentiments. So the possible explanations relating to Behavioral Finance Theory are stated as follows.

1.

Overconfident investors would overestimate the precision of information collected by themselves, resulting in prediction errors (Kufepaksi, 2010). If investors were overconfident about the evidence for Leighton’s satisfying performance in the future, they would tend to under-react to the negative abnormal earnings reported and the share price decreases less than it should be, vice versa.

2.

Overreliance on stereotypes could lead investors to make decisions that violate Bayes Theorem (Chen, Kim, Nofsinger, Rui, 2007). Because of the representativeness bias, irrational investors probably overweighed the negative information mentioned in Article 1 and magnified the negative impact in the future, which can lead to a more significant decline in share price.

3.

As suggested in Prospect theory, loss aversion might lead to over-reacting to Leighton’s underperformance. So when profit below expectation was reported, investors tend to over-react and sell stocks, resulting in a larger decline in share price.

(b) Extent of adoption of fair value accounting Similarly to purchased goodwill, self-developed goodwill is associated with intangibles such as research and development (R&D), advanced management, reputation, etc. (Scott, 2012). Nevertheless, there is a recognition lag in identifying the cost of self-developed goodwill, since no related costinducing transactions exist to support the valuation and they are not disclosed in financial statements under current accounting standards as well. For example, a typical type self-developed goodwill is R&D. Lev and Sougiannis (1996) suggest that R&D expenditures contribute to a firm’s future earnings, but neither detailed spending on each R&D project or potential benefits brought about is fully informative for investors (Scott 2012). Therefore, fair value accounting practice seems reasonable. Either market valuation or value-in-use is recognised as fair value accounting, which provides more relevant but less reliable information than historical cost accounting. Market value is the fair value of an asset if it is marked to a fully efficient and complete market, while value-in-use is referred to as the present value of expected future cash flows generated by the asset. Particularly, the expected future

cash flows should be estimated by the manager of a company, potentially involving manager bias and estimation error. Investors probably use either approach to valuing a firm in an efficient market, whereas value-in-use is superior if the market is inefficient where the market value seems neither reliable nor relevant. To verify decision usefulness of a measurement approach, both reliability and relevance should be considered. However, in the real world, investors always confront trade-offs between them, which is the same situation in measuring the value of self-developed goodwill. Fair valuation applied by the investors based on market estimates is more reliable but less relevant for decision making. As mentioned above, investors lack knowledge about the cost and future benefits associate with self-developed goodwill (Scott 2012). If the market is efficient, all information relating to self-developed goodwill is informative for investors. Hence, if the cost of self-developed goodwill is capitalised to the market, investors are directly informed with the fair value which is more reliable. For example, if Leighton’s self-developed goodwill such as R&D projects is marked to market, investors obtain an opportunity to recognise potential profitability associated. It is reasonable that the price of Leighton share will increase to reflect market estimate. By contrast, managers have more inside information regarding self-developed goodwill. To take an example of R&D, they are better informed about investment in each project and outcome of that project, although the resulted contribution to the firm’s profitability is uncertain. According to the assumption of Lev and Zarowin (1990), the firm is likely to capitalise the costs of successful R&D projects but immediately write off the costs incurred by the unsuccessful ones. That means, the value-in-use measure based on manager estimation is more relevant but less reliable for decision making. Suppose that Leighton manager decided to invest in R&D projects to improve its productivity efficiency along with dramatic decrease in the pipeline of work under the tough economic circumstance. The current value of R&D projects estimated by the manager is likely to give more relevant

information for investors attributed to their inside information. However, if a market is not completely efficient, investors are less informative and asymmetry information exists between investors and managers. Besides, the R&D expenditures would not be disclosed in the financial statements until the results come out, then the manager’s manipulation on reported costs of R&D projects is opportunistic. As a result, the value of R&D given by value-in-use measure is exposed to both estimation error and manager bias, which imposes a negative impact on information reliability.

Reference Chen, G., Kim, K.A., Nofsinger, J.R. & Rui, O.M. (2007). Trading Performance, Disposition Effect, Overconfidence, Representativeness Bias, and Experience of Emerging Market Investors. Journal of Behavioral Decision Making, 20, 425–451. Fama, E.F. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance, 25(2), 313-416. Fusion Media Limited. (2014). Australia 5-Year Bond Yield. Retrieved from http://www.investing.com/rates-bonds/australia-5-year-bond-yield-historical-data. KPMG. (2013). Valuation Practices Survey 2013. Retrieved from http://www.kpmg.com/au/en/issuesandinsights/articlespublications/valuation-practicessurvey/pages/valuation-practices-survey-2013.aspx. Kufepaksi, M. (2010). The Effect of the Quality of Information on Overconfident Decision: The Evidence of Self Deception in Indonesian Capital Market, a Case Study in an Experimental Setting. International Journal of Management and Innovation, 2(1), 51-65. Lev, B., P. Zarowin. (1999). The boundaries of financial reporting and how to extend them. Journal of Accounting Research, 37, 353-385. Lev, B., T. Sougiannis. (1996). The capitalization, amortization and value-relevance of R&D. Journal of Accounting and Economics, 2, 107-138. Scott, W. R. (2012). Financial Accounting Theory. 6th Edition, Toronto: Pearson/Prentice-Hall. Verma, R., Baklaci, H. & Soydemir, G. (2008). The Impact of Rational and Irrational Sentiments of Individual and Institutional Investors on DJIA and S&P500 Index Returns. Applied Financial Economics, 18, 1303–1317. Wesfarmers. (2013). Wesfarmers Annual Report 2013. Retrieved from https://www.wesfarmers.com.au/document/cat_view/10-about/26-corporate-governance.html. Yahoo. (2013). S&P/ASX 300 Historical Prices. Retrieved from https://au.finance.yahoo.com/q/hp?s=%5EAXKO&a=08&b=1&c=2013&d=08&e=30&f=2013 &g=d. Yahoo. (2013). Wesfarmers Ltd Historical Prices. Retrieved from https://au.finance.yahoo.com/q/hp?s=WES.AX&a=08&b=01&c=2013&d=08&e=30&f=2013&g =d.

Appendix Firm value could be estimated by using Ohlson’s model as below. Firm Value = Net Assets as at date of valuation ± Expected PV of Abnormal Earnings i.e. ������������������ = ������������������ + ������������ = ������������������ + PV (Actual Future Earnings – Expected Normal Earnings) = ������������������ + PV (ROE × Opening BV – CoC × Opening BV) where ������������������ : Firm Value at time t ������������������ : Book Value of the firm at time t ������������ : PV of Expected Abnormal Earnings  Reported Earnings We need to extract information from the Annual Report of Wesfarmers Ltd for the financial year end 30 June 2013 (p. 97, 98) under the assumption that reported total comprehensive income is quoted by some investors. Net Income for 2013($m) Book Value at 30 June 2012($m) Book Value at 30 June 2013($m) ������������2013 = $2,373 ������������2012 = $25,627 ������������2013 = $26,022

1. Find the expected book value for the next five years According to the annual report for 2013, Wesfarmers has developed a five-year outlook for its corporate plan and business forecast. Hence, we need to find end-of-year book values for 2013 to 2017. Firstly, we assume that ROE and Dividend Payout Ratio are constant for the five years. Then, find ROE on opening book value. ������������������ ������������������������������������ ������������ $2,373 ������������������2013 = ������������������������������������������ ������������ = ������������2013 = $25,627 = 0.0926 = 9.26% From the Annual Report of Wesfarmers Ltd for the financial year end 30 June 2013 (p. 121), total declared and paid dividends ($m) for 2013 is $1,990 including $1,099 final franked dividend and $891 interim franked dividends. ������������������������������ ������������������������������������������������������ $1,990 So, Dividend Payout Ratio for 2013 is k = ������������������ ������������������������������������ = $2,373 = 0.8386 = 83.86% We need to project end-of-year book values based on the following relation. ������������������ = ������������������−1 + (������������������ − ������������ ) Substitute ������������ = ������ × ������������������ ������������������ = ������������������−1 + (������������������ − ������ × ������������������ ) = ������������������−1 + ������������������ (1 − ������) ������������ Since ROE = , NI = ROE × BV. ������������ Substitute ������������������ = ������������������ × ������������������−1 ������������������ = ������������������−1 + ������������������ (1 − ������) = ������������������−1 + ������������������ × ������������������−1 (1 − ������) = ������������������−1 (1 + ������������������(1 − ������)) ������������2014 = ������������2013 (1 + ������������������(1 − ������)) = 26,022(1 + 0.0926(1 − 0.8386)) = 26,022 × 1.015 = 26,410.90 ������������2015 = 26,410.90(1 + 0.0926(1 − 0.8386)) = 26,410.90 × 1.015 = 26,805.62 ������������2016 = 26,805.62(1 + 0.0926(1 − 0.8386)) = 26,805.62 × 1.015 = 27,206.23 ������������2017 = 27,206.23(1 + 0.0926(1 − 0.8386)) = 27,206.23 × 1.015 = 27,612.84
2012

2. Calculate the expected abnormal earnings and estimated value per share Expected Abnormal Earnings = Actual Future Earnings – Expected Normal Earnings = ROE × Opening BV – CoC × Opening BV

i.e. ������������������ = (������������������ − ������������������) × ������������������−1 To calculate abnormal earnings of each year, it is necessary to capture expected normal earnings based on CAPM. ������(������������,������ ) = ������������ (1 − ������������ ) + ������������ ������(������������,������ ) where ������(������������,������ ): Rate of return demanded by the market for Wesfarmers share (i.e. firm’s Cost of Capital) ������(������������,������ ): ������������ + Market Risk Premium Under our assumption, risk-free rate of interest is 3.366% and market risk premium is 6%, therefore expected annual rate of return on the market portfolio is ������(������������,������ ) = 0.03366 + 0.06 = 0.09366 = 9.37% Using quoted ������ From Reuters, the quoted β for Wesfarmers share is 0.78. ������(������������,������ ) = ������������ (1 − ������������ ) + ������������ ������(������������,������ ) = 0.03366(1 − 0.78) + 0.78 × 0.0937 = 0.0805 = 8.05% Assume that this 8.05% Cost of Capital will stay constant for the next 5 years, we could calculate expected abnormal earnings for year 2014 to 2018. ������������2014 = (������������������ − ������������������) × ������������2013 = (0.0926−0.0805)×26,022 = 315.85 ������������2015 = (������������������ − ������������������) × ������������2014 = (0.0926−0.0805)×26,410.90 = 320.57 ������������2016 = (������������������ − ������������������) × ������������2015 = (0.0926−0.0805)×26,805.62 = 325.36 ������������2017 = (������������������ − ������������������) × ������������2016 = (0.0926−0.0805)×27,206.23 = 330.22 ������������2018 = (������������������ − ������������������) × ������������2017 = (0.0926−0.0805)×27,612.84 = 335.15 PV of Expected Abnormal Earnings is calculated at the Cost of Capital 8.05%. 315.85 320.57 325.36 330.22 335.15 ������2013 = + + + + = 1,294.80 2 3 4 1.0805 1.0805 1.0805 1.0805 1.08055 ������������2013 = ������������2013 + ������2013 = 26,022 + 1,294.80 = 27,316.80 = $27,316,800,000 From the annual report (p. 182), the number of ordinary shares on issue at 30 June 2013 is 1,157,194,000. ������������ $27,316,800,000 Estimated value per share = ������������.������������ ������ℎ������������������������2013 = 1,157,194,000 = $������������. ������������ ������������������������������������������������������������������ Using estimated ������ Assume that market became aware of the financial results of Wesfarmers Ltd’s 2013 annual report on 15th August 2013, and ������ is estimated based on daily returns for the observation period from 15th August to 14th November. By applying the estimated formula ������ =
������������������(������������ ,������������ ) ������������������(������������ )

, the estimated ������ is 0.81

which is used to capture Cost of Capital according to the CAPM. ������(������������,������ ) = ������������ (1 − ������������ ) + ������������ ������(������������,������ ) = 0.03366(1 − 0.81) + 0.81 × 0.0937 = 0.0823 = 8.23% Under the assumption of the constant Cost of Capital 8.23% using estimated ������ for the next five years, each year’s expected abnormal earnings are obtained. ������������2014 = (������������������ − ������������������) × ������������2013 = (0.0926−0.0823)×26,022 = 267.29 ������������2015 = (������������������ − ������������������) × ������������2014 = (0.0926−0.0823)×26,410.90 = 271.28 ������������2016 = (������������������ − ������������������) × ������������2015 = (0.0926−0.0823)×26,805.62 = 275.34 ������������2017 = (������������������ − ������������������) × ������������2016 = (0.0926−0.0823)×27,206.23 = 279.45 ������������2018 = (������������������ − ������������������) × ������������2017 = (0.0926−0.0823)×27,612.84 = 283.63 PV of Expected Abnormal Earnings is calculated at the Cost of Capital 8.23%. 267.29 271.28 275.34 279.45 283.63 ������2013 = + + + + = 1,090.32 2 3 4 1.0823 1.0823 1.0823 1.0823 1.08235

������������2013 = ������������2013 + ������2013 = 26,022 + 1,090.32 = 27,112.32 = $27,112,320,000 From the annual report (p. 182), the number of ordinary shares on issue at 30 June 2013 is 1,157,194,000. ������������ $27,112,320,000 Estimated value per share = ������������.������������ ������ℎ������������������������2013 = 1,157,194,000 = $������������. ������������ ������������������������������������������������������������������  Adjusted Earnings We assume that net income for 2013 is adjusted to exclude both investment in associates and foreign currency translation reserve, because the impact of either component is unlikely to be persistent. The adjustment is shown in below two tables.

Meanwhile, it is noticeable that investment in associates affects the book values of firm from Wesfarmers Ltd’s 2013 annual report (p.98), so adjustments are displayed in the table.

Under the assumption of adjusted earnings, we need the following information to estimate the firm value. Net Income for 2013($m) ������������2013 = $2,314.60

Book Value at 30 June 2012($m) Book Value at 30 June 2013($m)

������������2012 = $25,198 ������������2013 = $25,602

1. Find the expected book value for the next five years Use the same formula as above, we could calculate ROE and Dividend Payout ratio, which are assumed to be constant for the next five years. ������������������ ������������������������������������ ������������ $2,314.60 ������������������2013 = ������������������������������������������ ������������ = ������������2013 = $25,198 = 0.0919 = 9.19%
2012

Dividend Payout Ratio for 2013 is k =

������������������������������ ������������������������������������������������������ ������������������ ������������������������������������

Then, capture end-of-year book values for 2014 to 2017. ������������������ = ������������������−1 (1 + ������������������(1 − ������)) ������������2014 = ������������2013 (1 + ������������������(1 − ������)) = 25,602(1 + 0.0919(1 − 0.8598)) = 25,602 × 1.013 = 25,931.80 ������������2015 = 25,931.80(1 + 0.0919(1 − 0.8598)) = 25,931.80 × 1.013 = 26,265.86 ������������2016 = 26,265.86(1 + 0.0919(1 − 0.8598)) = 26,265.86 × 1.013 = 26,604.21 ������������2017 = 26,604.21(1 + 0.0919(1 − 0.8598)) = 26,604.21 × 1.013 = 26,946.93 2. Calculate the expected abnormal earnings and estimated value per share Using quoted ������ As mentioned above, the constant return of return demanded by the market for Wesfarmers share is 8.05% for the quoted β (0.78). Expected abnormal earnings for year 2014 to 2018 are calculated as below. ������������������ = (������������������ − ������������������) × ������������������−1 ������������2014 = (������������������ − ������������������) × ������������2013 = (0.0919−0.0805)×25,602= 291.77 ������������2015 = (������������������ − ������������������) × ������������2014 = (0.0919−0.0805)×25,931.80 = 295.53 ������������2016 = (������������������ − ������������������) × ������������2015 = (0.0919−0.0805)×26,265.86 = 299.34 ������������2017 = (������������������ − ������������������) × ������������2016 = (0.0919−0.0805)×26,604.21 = 303.19 ������������2018 = (������������������ − ������������������) × ������������2017 = (0.0919−0.0805)×26,946.93 = 307.10 PV of Expected Abnormal Earnings is calculated at the Cost of Capital 8.05%. 291.77 295.53 299.34 303.19 307.10 ������2013 = + + + + = 1,191.56 1.0805 1.08052 1.08053 1.8054 1.08055 ������������2013 = ������������2013 + ������2013 = 25,602 + 1,191.56 = 26,793.56 = $26,793,560,000 From the annual report (p. 182), the number of ordinary shares on issue at 30 June 2013 is 1,157,194,000. ������������ $26,793,560,000 Estimated value per share = ������������.������������ ������ℎ������������������������2013 = 1,157,194,000 = $������������. ������������ ������������������������������������������������������������������ Using estimated ������ Estimated ������ is 0.81 by using daily returns for the observation period from 15th August to 14th November, and the obtained Cost of Capital is 8.23% for the next five years and expected abnormal earnings are calculated. ������������2014 = (������������������ − ������������������) × ������������2013 = (0.0919−0.0823)×25,602 = 244.00 ������������2015 = (������������������ − ������������������) × ������������2014 = (0.0919−0.0823)×25,931.80 = 247.14 ������������2016 = (������������������ − ������������������) × ������������2015 = (0.0919−0.0823)×26,265.86 = 250.33 ������������2017 = (������������������ − ������������������) × ������������2016 = (0.0919−0.0823)×26,604.21 = 253.55 ������������2018 = (������������������ − ������������������) × ������������2017 = (0.0919−0.0823)×26,946.93 = 256.82 PV of Expected Abnormal Earnings is calculated at the Cost of Capital 8.23%. 244.00 247.14 250.33 253.55 256.82 ������2013 = + + + + = 991.54 2 3 4 1.0823 1.0823 1.0823 1.0823 1.08235

= $2,314.60 = 0.8598 = 85.98%

$1,990

������������2013 = ������������2013 + ������2013 = 25,602 + 991.54 = 26,593.54 = $26,593,540,000 From the annual report (p. 182), the number of ordinary shares on issue at 30 June 2013 is 1,157,194,000. ������������ $26,593,540,000 Estimated value per share = ������������.������������ ������ℎ������������������������2013 = 1,157,194,000 = $������������. ������������ ������������������������������������������������������������������

It is obvious that estimated share price using either quoted ������ or estimated ������ has been much lower than the actual share price on 15th November 2013 ($43.29) after adjusting earnings.

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