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.
What must management estimate during acquisitions?
The fair value of acquired assets.
How does dampening the value of acquired assets affect depreciation charges?
It lowers depreciation charges, increasing reported operating profit.
What is goodwill in the context of acquisitions?
The difference between the purchase price and the fair value of identifiable assets.
What is the impact of overestimating goodwill on future financial results?
It may require an impairment charge, negatively affecting future period results.
What is the primary role of financial reporting?
To provide information about a company’s performance and financial position.
Who benefits from a company’s financial reports?
Owners, management, investors, banks, public institutions, customers, employees, and counterparties.
What specific information does financial reporting provide?
Information about the company’s performance, financial situation, and changes in its financial situation.
How do financial reporting requirements differ by company size?
Larger companies have more stringent requirements due to their greater impact on society and the economy.
Why is reliable and truthful financial reporting important?
It enables stakeholders to make informed economic decisions.
What is the purpose of financial statement analysis?
To evaluate a company’s past, current, and potential performance and financial position.
Who benefits from financial statement analysis?
Investors, banks, and other stakeholders.
What information do financial statements provide according to International Accounting Standards 1.9?
Information about assets, liabilities, equity, income and expenses, contributions, distributions, and cash flows.
What are the key components of financial statements?
Balance sheet, statement of comprehensive income, statement of changes in equity, and statement of cash flows.
What are the two main financial statement frameworks?
International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (U.S. GAAP)
What is another name for the balance sheet?
The statement of financial position or the statement of financial condition.
What does the balance sheet show?
The current financial situation of the company, including assets, liabilities, and owner’s equity.
According to IFRS, what defines an asset?
A resource controlled by the company from past events, expected to bring future economic benefits.
What is owners’ equity?
The excess of assets over liabilities, following the basic accounting equation: assets = liabilities + owners’ equity.
Basic Accounting Equation?
Assets (A) = Liabilities (L) + Equity (E)
Owner’s Equity Equation?
Equity (E) = Contributed Capital (C) + Retained Earnings (RE)
What Contributed Capital means?
This represents the money that shareholders have invested in the company.
What Retained Earnings means?
These are the cumulative profits that the company has retained and not distributed as dividends.
What is comprehensive income?
It includes all items affecting owners’ equity apart from shareholder transactions.
How can comprehensive income be presented under IFRS?
As a single statement or split into an income statement and a statement of comprehensive income.
What does the income statement show?
It shows items used to calculate net income, including revenues and expenses.
What is other comprehensive income?
Items affecting owners’ equity not included in net income and not resulting from shareholder transactions.
What makes up total comprehensive income?
Net income from the income statement plus other comprehensive income.
What is the Income Statement (Basic) equation?
Net Income (NI) = Revenue (R) + Other Income (OI) - Expenses (E) = Income (I) - Expenses (E)
How do you calculate retained earnings at the end of a period?
Retained Earnings (End of Period) = Retained Earnings (Beginning of Period) + Net Income (NI) - Dividends.
What must be subtracted from the sum of beginning retained earnings and net income, to generate the Retained Earning (End of Period)?
Subtract Dividends.
What is the formula for the expanded accounting equation?
Assets (A) = Liabilities (L) + Contributed Capital (C) + Retained Earnings (End of Period) (REend).
How does the expanded accounting equation provide a more detailed view?
By breaking down owner’s equity into contributed capital and retained earnings, offering a clearer picture of a company’s financial position.
What happens if a company’s expenses exceed its revenue?
The company incurs a net loss.
How is the income statement reported?
On a consolidated basis, including the income and expenses of subsidiaries.
What are the two types of earnings per share (EPS) found at the bottom of the income statement?
Basic Earnings Per Share (EPS) and Diluted Earnings Per Share (EPS).
What is Earnings Per Share (EPS)?
EPS is the ratio of a company’s net income attributable to ordinary shareholders to the weighted average number of ordinary shares outstanding.
Why is EPS an important financial metric?
EPS measures the profitability of a company on a per-share basis, helping investors assess the company’s performance and compare it with others.
What is the formula for Basic Earnings Per Share (EPS)?
Basic EPS = (NetIncome(NI) − PreferredDividends) / WeightedAverageNumberofOrdinarySharesOutstanding
What adjustments are made to net income in Basic EPS calculation?
Net income is adjusted by subtracting any preferred dividends before dividing by the weighted average number of ordinary shares outstanding.
Why are preferred dividends subtracted from net income in Basic EPS calculation?
Preferred dividends are subtracted because EPS measures the income available to ordinary shareholders.
What is the formula for Diluted Earnings Per Share (EPS)?
Diluted EPS = (NetIncome(NI) − PreferredDividends) / WeightedAverageNumberofOrdinarySharesOutstanding+DilutivePotentialShares
What are dilutive potential shares?
Dilutive potential shares include any instruments (e.g., stock options, warrants) that could be converted into ordinary shares, increasing the total number of shares outstanding.
Why is diluted EPS often lower than basic EPS?
Diluted EPS accounts for the potential increase in shares outstanding, which can dilute the earnings per share.
What does the cash flow statement show?
The actual money flowing in and out of a company from operating, investing, and financial activities.
How are cash flows categorized?
Operating activities, investing activities, and financial activities
Why is classifying cash flows sometimes difficult?
Due to differences between IFRS and U.S. GAAP and variations across industries.
What is financial flexibility?
A company’s ability to adapt to changes in its financial situation and exploit opportunities or react to adversities
What are cash flows from operating activities related to?
Everyday business operations that influence the value of net income.
What do cash flows from investing activities represent?
Operations related to the acquisition or disposal of long-term assets.
What are cash flows from financing activities related to?
The acquisition or repayment of capital used to finance the company’s operations.
What is an optimal cash flow pattern for a growing company?
Positive cash flow from operating activities, negative cash flow from investing activities, and positive cash flow from financing activities.
What is an optimal cash flow pattern for a declining company?
Negative cash flow from operating activities;Positive or stable cash flow from investing activities;Negative cash flow from financing activities:
What are the two methods of preparing the cash flow statement from operating activities?
The direct method and the indirect method.
How does the direct method report cash flows from operating activities?
By listing all inflows and outflows of cash and summing them up.
How does the indirect method report cash flows from operating activities?
By starting with net income and adjusting for all relevant non-cash flows or excluded cash flows.
Which method is usually preferred by companies for operating activities?
The indirect method, as it gives a better view of the company’s operations.
Which method is used for reporting cash flows from investing and financing activities?
The direct method.
What does the statement of changes in equity show?
It shows how equity changes over time.
What are the main components of equity?
Paid-in capital, retained earnings, and minority interests and reserves.
How is paid-in capital generated?
From the issuance of equity.
What are retained earnings?
Profits that have not been distributed as dividends.
What factors can affect the amount of equity at the end of a period?
Issuance or redemption of shares, retained earnings, profits or losses, and dividends.
What is another common name for Paid-In Capital?
Contributed Capital;
What term is sometimes used to describe the funds received from shareholders in exchange for stock?
Issued Capital.
What do financial notes (footnotes) provide in a financial report?
Detailed and contextual information essential for understanding the numbers in financial statements.
Why are footnotes considered the essence of financial statements?
They contain the core information needed to interpret the numbers and amounts included in the statements.
What basic information is typically included in financial notes?
Dates of the fiscal year, units of measure, financial standards, methods and estimates, accounting policies, laws and regulations, related-party transactions, and business acquisitions.
How do footnotes help analysts?
They provide the necessary context to draw reasonable conclusions related to the numbers in the financial statements.
Why are financial notes an integral part of a financial report?
They offer important and detailed information left out of the core statements for clarity.
What does the Management Discussion & Analysis (MD&A) section provide?
Insights from management on the company’s performance, trends, and future prospects.
Why is MD&A included in annual financial reports?
It is often a requirement for public companies to provide detailed management commentary.
What types of information should MD&A disclose according to the SEC?
Favorable and unfavorable trends, significant events, uncertainties, effects of inflation, other material events, off-balance-sheet obligations, and contractual commitments.
Why are accounting policies included in MD&A?
To explain policies that require management to make subjective judgments materially affecting the presented financial results.
How do requirements for MD&A vary?
They differ by country and jurisdiction, depending on local regulations.
What is the role of an audit report?
To provide reasonable assurance that financial statements are fairly presented and comply with accounting standards.
What are the three generally required paragraphs in an audit report?
Introductory paragraph, scope paragraph, and opinion paragraph.
What must auditors in the USA also express an opinion on under the Sarbanes-Oxley Act (SOX)?
The company’s internal control systems.
What does an unqualified audit opinion mean?
Financial statements give a true and fair view and comply with accounting standards.
What does a qualified audit opinion indicate?
There are some limitations or exceptions to accounting standards, detailed in the report.
What is an adverse audit opinion?
means the financial statements do not give a true and fair view and materially deviate from standards.
What is a disclaimer of opinion?
The auditor refrains from expressing an opinion due to specific reasons.
What are some internal sources of information used by analysts?
Proxy statements, interim reports, company website, press releases, periodic earnings announcements, conference calls.
What do proxy statements provide?
Information about discussions and voting items before shareholder meetings.
Why are interim reports important for analysts?
They provide semiannual or quarterly updates, usually not audited.
What role does a company’s website play for analysts?
It serves as a source for official information and updates.
What are some external sources of information for analysts?
Information about the economy, industry, and peer companies.
Why do analysts compare information from peer companies?
To benchmark and assess the company’s performance relative to similar companies.
What is the primary purpose of the balance sheet?
To provide a snapshot of a company’s financial position at a specific point in time.
What do cash and cash equivalents represent on the balance sheet?
Highly liquid assets that are readily convertible to cash.
What is the significance of accounts receivable in the balance sheet?
It represents the money owed to the company by its customers for goods or services provided on credit.
Comprehensive Income Equation:
CI = NetIncome(NI) + OtherComprehensiveIncome(OCI)
Net Income Equation:
NI = Revenue(R) + OtherIncome(OI) − Expenses(E)
How can a comprehensive income statement be presented under IFRS?
As a single statement or split into two statements: the income statement and the statement of comprehensive income.
What does the income statement provide information about?
The financial performance over a period, including revenue, other income, and expenses, resulting in net income.
What is the main purpose of having an analysis framework for financial statements?
To ensure a consistent and coherent process for financial analysis.
What is the first step in the common analysis framework?
Stating the purpose of the analysis.
Why is gathering input data important in the analysis framework?
It collects all necessary information and data needed for analysis.
What does processing data involve in the analysis framework?
Organizing and preparing data for analysis.
What is the final step in the analysis framework for financial statements?
Reviewing findings periodically (follow-up).
What are expenses according to the IASB framework?
Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
What is another term for net income?
Net earnings or the bottom line.
What is the difference between revenue and income?
Revenue is the amount received for supplying goods or services, while income includes all increases in economic benefits during the period.
What are gains and losses, and how are they recorded?
Gains and losses are results from selling assets for more or less than their carrying amount, and they can be from both operating and non-operating activities.
How do gains differ from revenue?
Gains are from incidental transactions or events, while revenue is from the company’s main business activities.
What are other income items, and how are they included in the income statement?
Other income includes profits that may not occur in the ordinary course of business and are added to revenue in the income statement.
What role do expenses play in calculating net income?
Expenses are subtracted from revenues and other income to calculate net income.
Why is the income statement also referred to as the profit and loss statement?
Because it shows the company’s profit or loss over a specific period, detailing income and expenses.
Why are PP&E assets important on the balance sheet?
They are usually one of the largest positions and provide long-term economic benefits.
What valuation methods are allowed under IFRS for PP&E?
Cost model and revaluation model.
How does the cost model calculate carrying value?
Carrying Value = Historical Cost - Accumulated Depreciation and Depletion - Impairment.
What is the recoverable amount in impairment adjustment?
The higher of the asset’s fair value less costs to sell or its value in use (present value of future cash flows).
What is the historical cost of a PP&E asset?
Historical cost = Purchase price + delivery cost + any other costs to install or prepare assets for operation.
Under which accounting standards are reversals of impairment charges allowed?
Reversals of impairment charges are allowed under IFRS but not under U.S. GAAP.
What are intangible assets?
Non-physical assets derived from specific contractual or legal rights.
How are finite useful life intangible assets treated?
They are amortized and annually reassessed for their useful life designation.
What must be done for intangible assets with infinite useful life?
They are not amortized but must be annually tested for impairment.
How does IFRS treat internally generated intangible assets?
It distinguishes between research phase (expensed) and development phase (capitalized if criteria are met).
What is U.S. GAAP’s approach to internally generated intangible assets?
Generally prohibits recognition on the balance sheet, requiring related costs to be expensed.
How might management influence the cash flow statement?
By using certain techniques to make the operating cash flow appear better than it actually is.
How can management influence cash flow from operations through accounts payable?
By delaying the payment of accounts payable, extending the credit period beyond the reporting date.
What is the impact of delaying accounts payable on cash flow from operations?
It increases the cash flow from operations for the current period.
How does delaying accounts payable affect subsequent periods?
the cash outflow is reported in the subsequent period, potentially lowering cash flow from operations then.
Why might management choose to delay accounts payable
To improve the appearance of cash flow from operations in the current period.
How can misclassification of cash flows impact financial analysis?
It can create a misleading impression of the company’s financial performance and metrics.
What flexibility does IAS 7 provide for classifying cash flows?
It allows non-financial institutions to classify interest paid and interest/dividends received as operating, investing, or financing cash flows, and dividends paid as financing or operating cash flows.
What is the impact of misclassifying cash flows on operating cash flow?
It can artificially inflate or deflate the perceived cash flow from operations.
Why might management choose to misclassify cash flows?
To present a more favorable financial position or meet certain financial metrics.
How can shipment terms affect revenue recognition?
the timing of revenue recognition is influenced by shipment terms, as it dictates when control over the product is transferred.
What is channel stuffing and its potential impact?
Channel stuffing involves aggressive sales strategies, like significant discounts, to boost current period revenues. This can lead to substantial returns in subsequent periods or a drop in future demand.
Why is accurate estimation of customer returns important?
Over- or under-estimating the rate of customer returns affects the revenue recognized in the current period, potentially distorting the financial statements.
What are bill-and-hold transactions?
Bill-and-hold transactions occur when customers buy goods but request they be stored in the company’s warehouse until a later date, transforming inventory into sales that generate revenue, often involving falsified sales documents.
How does misestimating the useful economic life of assets affect financial reporting?
It impacts depreciation charges, potentially misleading financial comparisons with industry peers.
What is depreciation?
The allocation of the cost of a long-lived asset over its useful economic life.
How can management’s choice to capitalize or expense R&D costs impact financial reporting?
It can significantly affect the balance sheet and income statement, potentially presenting higher operating profits if costs are capitalized.
What is capitalization of costs?
Capitalization of costs involves recording expenses as assets on the balance sheet, spreading the expense over future periods.
Why might companies choose to capitalize R&D costs?
To demonstrate higher operating profits in the current period by deferring expenses.
What is the impact of expensing R&D costs in the current period?
Expensing R&D costs immediately reduces operating profits for the current period but reflects the actual expenses incurred.
How does capitalization of intangible assets affect the income statement?
It reduces current period expenses and increases operating profits, but the costs are amortized over future periods.
What are the three basic inventory cost methods?
FIFO (First In, First Out), LIFO (Last In, First Out), and weighted average cost basis.
How does the FIFO method affect inventory cost reporting?
FIFO assumes the oldest inventory items are sold first, which can impact the cost of goods sold and inventory valuation.
What is unique about the LIFO method in inventory cost reporting?
LIFO assumes the newest inventory items are sold first and is allowed only under U.S. GAAP.
What is the weighted average cost basis method?
It calculates an average cost for all inventory items, providing a different valuation approach.
How can the choice of inventory cost method influence financial results?
It affects the cost of goods sold and inventory valuation, allowing management to manage financial outcomes.
What are warranty reserves?
Provisions set aside to cover future warranty claims made by customers.
How can management’s discretion affect warranty reserves?
Management can choose to underestimate the reserves required, which may not reflect actual costs.
What is the impact of underestimating warranty reserves on financial reporting?
It decreases current period costs, artificially enhancing operating income.
Why might management be tempted to underestimate warranty reserves?
To benefit the operating income by decreasing reported expenses.
How does underestimating warranty reserves mislead financial analysis?
It presents a more favorable financial position than reality, potentially misleading analysts and investors about the company’s true financial health.
What are related-party transactions?
Transactions between companies within the same capital group or with individuals running the company, often at terms favorable to one side.
How can related-party transactions impact financial reporting?
They can be used to transfer profits or costs between companies, potentially masking the true financial performance.
Why might management engage in related-party transactions?
To cover up for mismanagement or to use private wealth to support the company’s financial position.
What is an example of using private wealth in related-party transactions?
The founder using personal funds to cover the company’s expenses or losses.
How do related-party transactions affect transparency?
They can obscure the true financial performance and condition of the company, making it difficult for analysts and investors to assess the company’s actual situation.
Why should analysts study revenue recognition policies and financial notes?
To check for premature or deferred revenue recognition and difficult-to-measure revenues, which could indicate manipulation.
What could abnormal revenue growth dynamics indicate?
Revenue growth not in line with the market and industry trends or competitor growth might suggest financial manipulation.
What does a rapid increase in accounts receivable versus revenue suggest?
It might indicate channel stuffing, where the company aggressively boosts sales to record higher revenues.
How can the days sales outstanding metric reveal issues?
If it grows faster than competitors’ metrics, it might indicate premature revenue recognition.
What does a lower asset turnover compared to competitors signify?
It might indicate overvalued assets, potential future write-downs, or inefficiency in converting investments into profit.
Why should analysts monitor inventory growth relative to revenue?
High inventory levels compared to revenue, especially if above market peers, might indicate unsold products and potential future write-downs or markdowns.
What does a decrease in the inventory turnover ratio suggest?
It may indicate that products are becoming obsolete and not selling as quickly.
Why is it important to review the method of accounting for inventory sales costs?
Changes in methods (e.g., FIFO, LIFO, weighted-average) might signal management’s attempt to alter financial results.
What is the significance of monitoring inventory methods under U.S. GAAP?
It helps identify potential manipulation in financial reporting, as different methods can impact profit and tax liabilities.
Why should analysts compare capitalization methods for long-lived assets?
To identify potential warning signs, such as material differences in accounting practices compared to competitors.
What might a significant discrepancy in capitalization methods indicate?
It could signal potential financial misrepresentation or differing accounting practices.
What specific aspect should be reviewed regarding long-lived assets?
The capitalization of interest costs, comparing the company’s methods with those of the market peers.
How can differences in capitalization methods impact financial reporting?
They can affect the reported value of assets and expenses, potentially leading to an inaccurate portrayal of the company’s financial health.
What does aggressive accrual accounting involve?
It involves manipulating the timing of revenue and expense recognition to present a more favorable financial position.
How can material differences between cash flow and net income affect financial analysis?
They can mislead analysts and investors about the company’s true financial health, potentially hiding underlying issues.
How can one-off, non-recurring transactions mislead financial analysis?
Recording these as operating profit can falsely boost results, giving an impression of sustainability that isn’t accurate.
How can an excessive focus on financial reporting limit a company’s future performance?
By potentially missing the true drivers of the company’s performance and focusing too much on non-GAAP measures.
Why is company culture important for analysts to consider
A culture demonstrating high motivation and ambition might lead to financial reporting manipulation, especially in competitive markets.
What are some typical warning signs analysts should watch for in business and accounting practices?
Aggressive depreciation assumptions, unusual seasonality in results, related-party transactions, one-off transactions recorded as operating profit, and significant differences in performance metrics compared to competitors.
What is the purpose of sensitivity analysis in financial modeling?
To examine how changes in particular assumptions about inputs affect the model’s outputs.
What are the three main techniques used in financial modeling to check sensitivity?
Sensitivity analysis (what-if analysis), scenario analysis, and simulation.
