1. Financial Statement Analysis Flashcards
Which methods we can use to valuate Property, plant, and equipment valuation method?
IFRS: cost model or revaluation model
U.S. GAAP cost model only
which asset is not subject to depreciation?
Land is not subject to depreciation.
What is the premise behind the classification of PP&E or PPE?
The major premise behind the classification is that the company foresees that those assets will be used in operation and will generate economic benefits for the period beyond 1 year.
When the impairment occuors?
Impairment adjustment arises when the recoverable amount is lower than the carrying value of the PP&E asset on the balance sheet.
How the recoverable of an asset is defined?
he recoverable amount is defined as the amount that is the higher of:
1° the asset’s fair value less costs to sale
and;
2 ° The asset’s value in use (present value of the future cash flows to be generated by the asset).
In which system are reversals impairment are allowed?
Reversals to the impartirment charges are allowed under IFRS, but not under U.S GAAP
What is the Goodwill and when it happens?
Goodwill – arises during the corporate merger & acquisition processes when the price paid for the company acquired is higher than the net fair value of identifiable and measurable assets and liabilities
Why the Goodwill is necessary?
It is necessary, because there are components that build the value of the target company, but are not appropriately represented by the carrying values of assets and liabilities reported within the balance sheet. Usually, this value is built by a well-known brand, customer base, non-capitalized research and development costs, as well as the value coming from the expected synergies when acquiring and target companies are combined.
What are the types of Goodwill
1° Accounting goodwill, based on accounting standards.
2° Economic goodwill, based on the economic performance of the company which should be reflected (in theory) in the stock value.
Is the Goodwill subject to amortization?
No, it is not subject to amortization but nbeeds to be annually tested for impairment.
Which system requeire companies to capitalize Goodwill within the balance sheet?
Both IFRS and U.S. GAAP require companies to capitalize goodwill within the balance sheet.
What is the process to measure Goodwill when a company acquires another?
The process to measure goodwill when one company acquires another can be summarized in the following steps:
1° Purchase price paid by the acquirer is established.
2° Fair value of identifiable assets is netted by the fair value of identifiable liabilities (both regular and contingent liabilities are taken into consideration).
3° Goodwill is the difference between the purchase price and fair value of net assets calculated in step 2.
Why Goodwill can be subjective?
Because goodwill is not a separately identifiable asset and its valuation might be subjective, analysts and investors do have opposing views on whether such an asset should be recognized in the balance sheet.
What is bargain purchase?
There are situations, where the price paid to acquire another company is lower than the fair value of net assets – it is called bargain purchase. The profit from such a transaction is recognized in the income statement.
Can the Goodwill be exclude in the balance sheet?
No, it can not. However, because it subjective, the analyst sometimes adjust the balance sheet to exclude goodwill when valuing the firm or calculating financial ratios.
What the acronym “DTA” means?
It means Deferred tax asset (DTA)
When the Deferred Tax Asset happens?
It arises due to differences between tax calculated for the net income using tax regulation and accounting regulation.
When we should recognize DTA?
We recognize DTA in the situations when the actual tax paid to the governmental authorities exceeds the tax due calculated using the accounting methods.
What is the main drive in DTA?
The timing difference. Certain business activities are recorded as income/cost faster for accounting purposes than tax purposes, e.g., due to the application of the accrual accounting method
What the company needs to do in order to recognize the DTA in the balance sheet?
To recognize DTA in the balance sheet, the company needs to expect to generate a taxable income in the subsequent periods, which will allow the company to deduct the ‘overpaid’ taxes.
What is the Long-Term Financial Liabilities?
Long-term liabilities represent the amounts that the company is due to its lenders and finance providers beyond a period of 1 year. Usually, it consists of long-term loans provided by the banks and debt/bonds issued to finance investments and business growth.
What method is applied to measure the Long-Term Liabilities?
Typically, long-term liabilities are reported and measured using the amortized cost method (for details please see the financial instruments section above). However, we need to bear in mind that certain financial liabilities might be recorded using the fair value method. This includes derivatives (which represent liability) or debt held for trading.
Which Long-Term Liabilities should be recorded using the Fair Value Method?
Derivatives Because it represent liability or debt held for trading.
What the acronym “DTL” means?
It means Deferred Tax Liability (DTL)
What is the main recognition drive to DTL?
The mechanism is the same as in the DTA and recognition is usually driven by the timing difference in the recognition of certain business events (different recognition periods for tax and accounting purposes).
When the DTL happens?
It happens when the tax that the company pays now according to the tax rules is lower than what is derived from the application of the accounting standards and it means that there will be a higher tax amount due in the future to level the difference.
What is the typical example given to explain when the DTL occuors?
A typical example is using the double depreciation method for tax purposes and the straight-line depreciation method for accounting purposes. As the double depreciation method usually means higher depreciation charges recognized in the income statement (in the first years of the asset life) in comparison with the straight-line method, income for tax purposes will be lower than the one calculated for accounting purposes.
Which items do the Non-Current Assets include?
Non-current assets include property, plant, and equipment (PPE), investment property, intangible assets, goodwill, financial assets, and deferred tax asset (DTA).
Which items do the Non-Current Assets include?
Non-current liabilities include long-term financial liabilities and deferred tax liabilities (DTL).
What PPE means and what is used for?
Property, plant, and equipment (PPE) is composed of all the assets that the company uses for its day-to-day operation and are expected to provide economic benefits in the long term. PP&E mainly represents buildings, land, manufacturing plants and vehicles used for the production, and delivery of products or services.
What are investment property assets?
Investment property includes assets that are held by the company to invest and generate profits either due to growth in the value of the asset or from the regular cash flows. Investment property is valued using either the cost model or the fair value model.
What the Intangible assets are?
Intangible assets are identifiable non-monetary assets that do not have a physical form such as royalties, trademarks, licenses, patents, or other legal rights.
What methods we could use to evalute intangible assets?
IFRS allow companies to value intangible assets using the cost model or the revaluation model, while U.S. GAAP allows the cost model only.
What we need to do if we are evaluting a intangible asset with infinite useful life?
We should annually test it for impairment.
What we need to do if we are evaluting a intangible asset with finite useful life?
We should amortize it on a systematic basis
What are the procedures for recognizing intangible assets under IFRS?
For IFRS, the company needs to distinguish the costs spent on the research phase (which generally are not capitalized) and the development phase (such costs are capitalized providing the asset meets certain criteria).
Why the common-size analysis is hepful?
This method is helpful because it allows tracking the changes in the balance sheet composition across peer companies. It also allows an easy and insightful time-series analysis.
What are the procedures for recognizing intangible assets under U.S GAAP?
Under U.S. GAAP, costs spent on internally generated intangibles are expensed.
What is the Common-Size Analysis?
A common-size analysis is based on the premise of analyzing the balance sheet in relative rather than absolute terms. The analyst needs to present each component of the balance sheet as a percentage of the total assets.
What is the difference between solvency and liquidity?
The primary difference between liquidity and solvency lies within the time frame against which we assess the risk of not being able to meet obligations. Liquidity refers to the inability to settle debts in the short term, while solvency refers to a long-term time frame.
What is the supplement of the common-size analysis?
Thebalance sheet ratios analysis. Balance sheet ratios show us the relationships between individual assets and liabilities positions that are not visible under the common-size analysis
Which ratios are presented in balance sheet ratio analysis?
- Liquidity Ratios
- Solvency Ratios
What is the Current Ratio Formula?
CR = current assets / current liabilities
What is the formula for Quick Ratio (Acid-Test Ratio)?
QR= (cash + marketable securities + receivables) / current liabilities
What is the Acid-Test Ratio?
This is the same as Quick Ratio
What is the formula for Cash Ratio?
cash ratio = (cash + marketable securities) / current liabilities
which indices made up Liquidity Ratios?
1° Current Ratio;
2° Quick Ratio Or Acid-Test Ratio;
3° Cash Ratio;
which indices made up Solvency Ratios?
1° Long-Term Debt-To-Equity Ratio;
2° Debt-To-Equity Ratio;
3° Total Debt Ratio
What is the main similarity between IFRS and U.S. GAAP in terms of income tax expense?
Both IFRS and U.S. GAAP recognize income tax expense based on taxable profit (or loss) for the period.
How do IFRS and U.S. GAAP differ in recognizing deferred tax assets?
Under IFRS, deferred tax assets are recognized if it is probable that future taxable profit will be available. U.S. GAAP requires a “more likely than not” criterion, meaning there’s a greater than 50% chance that the deferred tax asset will be realized.
What are deferred taxes and how are they treated under IFRS and U.S. GAAP?
Deferred taxes represent the future tax consequences of temporary differences between the carrying amount of an asset or liability and its tax base. Both IFRS and U.S. GAAP recognize deferred taxes, but they may differ in the specific recognition and measurement criteria.
Can you explain a specific case where deferred tax assets cannot be recognized under IFRS?
Under IFRS, deferred tax assets cannot be recognized if the asset arises from the initial recognition of goodwill or an asset/liability in a transaction that is not a business combination and, at the time of the transaction, affects neither accounting profit nor taxable profit (loss).
What is the approach to deferred tax liabilities under U.S. GAAP?
U.S. GAAP generally requires the recognition of deferred tax liabilities for all taxable temporary differences, except in cases where specific exemptions apply, such as the initial recognition of goodwi
How does U.S. GAAP treat deferred tax assets in terms of valuation allowances?
Under U.S. GAAP, a valuation allowance is recognized if it is more likely than not that some portion or all of the deferred tax assets will not be realized.
What is the treatment of deferred tax liabilities under IFRS?
Under IFRS, deferred tax liabilities are recognized for all taxable temporary differences, except for specific exemptions such as the initial recognition of goodwill.
How do IFRS and U.S. GAAP differ in the treatment of revaluation of assets?
Under IFRS, deferred tax liabilities are recognized on revalued assets. Under U.S. GAAP, revaluation of assets is not permitted, so there is no need to recognize deferred tax liabilities on revalued assets.
Explain the treatment of deferred taxes on undistributed profits under IFRS.
Under IFRS, deferred taxes are recognized on undistributed profits of subsidiaries, joint ventures, and associates unless the parent, investor, or venturer can control the timing of the reversal and it is probable that the temporary difference will not reverse in the foreseeable future.
How are deferred tax assets and liabilities presented on the balance sheet under IFRS and U.S. GAAP?
Under IFRS, deferred tax assets and liabilities are always classified as non-current. Under U.S. GAAP, deferred tax assets and liabilities are classified as non-current.
What is a temporary difference, and how is it recognized under IFRS and U.S. GAAP?
A temporary difference is the difference between the tax base of an asset or liability and its carrying amount in the financial statements. Both IFRS and U.S. GAAP recognize deferred tax assets and liabilities for temporary differences, but the recognition criteria and measurement may differ.
What are the three key conditions for low-quality reporting?
Opportunity, motivation, and rationalization
What creates the opportunity for low-quality reporting?
Weak internal controls, poor governance, and vague accounting standards.
What drives the motivation for low-quality reporting?
Personal gains linked to remuneration or reputation.
What is rationalization in the context of low-quality reporting?
A profit-seeking company culture that justifies manipulative practices.
Why is recognizing these risks important for market participants and analysts?
To mitigate and maintain financial reporting quality.
Why is trust important in competitive markets for companies seeking investment?
Trust decreases investment risk and helps companies source cheaper capital.
What role does high-quality financial reporting play for investors?
It builds trust and reduces investment risk.
How does high-quality reporting affect the cost of capital for a company?
It lowers the cost of capital by increasing investor confidence.
Why do companies compete for investors’ money?
To secure necessary funding for their operations and growth.
What happens when investors have high trust in a company’s reporting?
The company can access capital at a lower cost.
Why were market regulatory authorities established?
To provide guidance and enforce high-quality financial reporting.
Name some key market regulatory authorities in the European and US markets.
ESMA (EU), FCA (UK), and SEC (US).
What are some key measures implemented by regulatory authorities for financial reporting?
Registration, disclosure, auditing, management commentaries, responsibility statements, regulatory review, and enforcement mechanisms.
What is the role of the International Organization of Securities Commissions (IOSCO)?
To provide global guidance on financial reporting with approx. 120 securities regulators and 80 market participants as members.
How do regulatory authorities enforce compliance in financial reporting?
Through penalties, fines, license revocations, and legal proceedings for violations.
What is the primary role of independent external auditors?
To ensure financial statements represent the true and unbiased performance of companies.
What does an unqualified opinion from an auditor represent?
That the financial report complies with GAAP and fairly presents the company’s performance.
What are some limitations of the auditing process?
Reliance on company-provided materials, audit focus on compliance rather than fraud detection, and potential conflicts of interest.
How can conflicts of interest between a company and its auditor arise?
The company chooses and pays the auditor, risking bias to maintain the client relationship.
Why is understanding the scope and limitations of auditors’ work important for analysts?
To accurately assess the quality of financial statements and make informed decisions.
How do banks and capital providers influence financial reporting through private contracting?
By setting strict requirements and demanding frequent, high-quality performance reports.
What is the role of legally binding contractual provisions for capital investors?
To allow them to withdraw funds if performance reporting is unsatisfactory.
Why do companies need to adhere to the requirements set by lenders?
To ensure compliance with debt covenants and maintain access to capital.
How do private contracting mechanisms help discipline companies?
By ensuring fair and accurate performance reporting to meet lenders’ and investors’ standards.
What impact does private contracting have on a company’s financial reporting quality?
It enforces high standards and accountability in financial reporting.
How can management influence analysts’ perception using presentation methods?
By employing non-GAAP measures and adjusting standard metrics.
What is “adjusted-EBITDA” and why do companies use it?
A modified version of EBITDA excluding certain costs to inflate performance metrics.
What requirements do regulatory authorities set for non-GAAP measures?
Reconciliation to GAAP measures, detailed definitions, explanations, and limitations on smoothing metrics.
How can management influence revenue recognition through shipment terms?
By selecting favorable incoterms that affect the timing of control transfer over goods.
What impact does the choice of incoterms have on revenue recognition?
It determines when revenue is recognized based on the timing of control transfer.
How can premature revenue recognition be achieved through incoterms?
By selecting incoterms that transfer control at the warehouse departure.
How can deferring revenue recognition be achieved through incoterms?
By choosing incoterms that transfer control upon delivery to the customer.
Why is the selection of incoterms significant for financial reporting?
It impacts the timing and accuracy of revenue recognition, affecting financial statements.
How does the FIFO method impact inventory valuation?
It recognizes the cost of goods sold at the oldest inventory prices, reflecting current market conditions in remaining inventory.
How does the weighted average cost method work?
It averages the cost of inventory, blending old and recent prices weighted by volume.
Why is the choice of inventory valuation method important?
It affects the company’s revenues, costs, and balance sheet.
What is the impact of selecting an inventory cost method on financial performance?
It can significantly alter reported revenues, costs, and balance sheet values.
How does management influence financial performance through estimates?
By adjusting provisions for potential customer returns.
Under what accounting method is customer return estimation required?
Accrual accounting.
What is the impact of decreasing the estimate of goods returned on operating profit?
It temporarily increases the reported operating profit.
Why might management be tempted to adjust return estimates?
To meet performance targets and gain bonuses.
What is the risk of misestimating customer returns?
It can distort the true financial performance and mislead stakeholders.
What is a deferred tax asset (DTA)?
A tax benefit from a loss that can reduce future tax obligations.
How is the value of a DTA determined?
Based on the likelihood of generating enough future operating profit to utilize the DTA.
What role does the valuation allowance play in DTA accounting?
It reduces the DTA value if future profit generation is uncertain.
How can management influence reported performance through DTA?
By misjudging or misvaluing the valuation allowance.
Why should analysts independently assess the DTA?
To ensure accurate financial forecasting and understand the DTA’s impact on financial statements.
What are the three depreciation methods a company can choose?
Straight-line basis, accelerated method, and activity-based method.
What does the straight-line method assume?
Equal depreciation charge in each period.
How does the accelerated method (double-declining balance) differ from the straight-line method?
It allows higher depreciation charges during the first years of the asset’s life.
What determines depreciation in the activity-based method?
The actual usage of the asset over time.
How can management influence depreciation charges and reported profits?
By choosing a depreciation method and estimating a high salvage value to recognize less depreciation early on, resulting in higher profits.
What can management do with payments covering expenses for multiple periods?
Capitalize them as assets if they contribute to profits over multiple periods.
How does capitalizing payments affect the current period’s financial performance?
It reduces the recognized costs, thus increasing reported profits.
What must management assess when deciding to capitalize payments?
The portion of the payment attributable to the current period and the extent linked to future periods.
Why might management choose to capitalize a higher share of payments?
To positively impact short-term profits by reducing current period costs.
What is the effect of capitalizing expenses on a company’s profits?
It increases the company’s short-term profits by deferring costs to future periods.
