Analysis of Financial Statements Flashcards
Matching concept
When we recognize revenue, we also recognize expenses in this period - including e.g. warranty expenses, etc. (generally)
Over 40% of SEC enforcement actions on accounting issues deal with revenue recognition - correct?
Yes
How can you classify revenue?
Subset of income - wealth creation due to the normal operating activities of a firm - e.g. for British airways, selling/buying planes would be income, not revenue
McDonalds - how do they account?
Define themselves as a restaurant - not a real estate firm (even though they make a lot of profits from real estate)
When is revenue recognized?
When it is earned by providing the service
When does the long-term construction industry (highways, shipbuilding, etc) recognize revenues?
Production phase
When do agricultural goods get recognized?
Completion of production
In the past - how did the situation look like - why change the rules?
2 broad standards in IFRS: IAS 11 & 18
US: 140 different pieces of guidance (industry-specific & conceptually inconsistent)
Two simple principles:
- Revenue is earned once a “performance obligation” is satisfied under the terms of the customer contract
- Revenue must be allocated to the different performance obligations inherent in the customer contract and recognized separately
When does revenue get recognized for most retail and manufacturing industries?
Sale of good or service
When does revenue get recognized for real estate development?
Cash collection
Revenue is recognized during production when:
- a specific customer is identified and a price is agreed on
- a significant portion of the services has been performed and the expected costs of future services can be reliably estimated, and
- an assessment of the customer’s credit standing permits an estimate of the amount of cash that will be collected.
- Used for long term contracts
- Percentage-of-completion method
- Now ONLY allowed for service contracts
Ongoing/bundled services - revenue recognition
Telecoms example (1. phone, 2. mobile service, 3. financing) –> needs to be unbundled
Bill and hold - revenue recognition
Normally you wait until customer takes possession
Old system in construction: Percentage of completion - now
Milestones - performance obligations
When should an asset be capitalized?
When the asset meets the asset recognition criteria:
1. The value of the benefits are quantifiable
2. The entity has acquired the right to use the resource as a result of past transactions
Expedia with bookings vs Coca Cola with bottles
Risk of loss - treated as principle? Transaction on gross basis? - for Expedia, only middlemen; for Coca Cola, e.g. Coop accounts at full price
What do most accounting issues relate to?
- revenue recognition policy (40% SEC), 2. overly aggressively expensing (expensing capitalization, etc.)
Cost to capitalise
All costs necessary to acquire the asset and make it ready for use - for self-constructed assets: capitalize entire construction cost, including interest on debt incurred to finance the construction (required US, permitted IFRS)
Additional costs during company’s operation - expense or capitalize?
- If the expenditures restore or maintain an asset: expense them.
- If the expenditures (1) increase the useful life of the asset, (2) reduce operating costs, or (3) increase the productivity/output: capitalise them and depreciate
over the remaining useful life
Why do assets get depreciated?
Matching concept - Depreciation is a process of cost allocation, not asset valuation
Does land get depreciated?
No
Depreciation involves three estimates of future events:
– Expected useful life of the asset
– Expected salvage value
– Depreciation pattern which will reflect the asset’s declining
service potential – depreciation method
Accelerated Depreciation
Double declining: Annual Depreciation = Asset Remaining Cost2 Straight Line
Rate
Sum-of-years’ digits: Annual Depreciation = (Asset Cost – Salvage Value)*Years
Remaining/Sum of all Years
Units of Production - depreciation method
Annual Depreciation/ Unit= (Asset Cost – Salvage Value)/Number of Output Units
Double declining depreciation method
Annual Depreciation = Asset Remaining Cost2 Straight Line Rate
Sum-of-years’ digits depreciation method:
Annual Depreciation = (Asset Cost – Salvage Value)*Years Remaining/Sum of all Years
How do changes in the allocation method get treated?
Differently under US and International GAAP:
– International –> change is applied prospectively.
– US –> change is applied retroactively:
* Go back and ‘redepreciate’ the asset under the new method
* Depreciation for current & future years computed under new method, assuming that this method has been used throughout
* Cumulative difference in depreciation b/w the two methods is charged to current years profits (Cumulative Effect of Accounting Change)
Disclosure of Fixed Assets IFRS vs US
IFRS more detailed information about acquisitions, disposals, depreciation etc.
Administrative related depreciation – Depreciation on the corporate headquarters, retail stores, etc. - where is this normally included?
– This is NOT included in cost of sales, but rather is treated as an SG&A (Selling, General & Administrative) expense
– Sometimes this is separately disclosed (or combined with
Amortisation expense), but not always
How is depreciation for natural resources (e.g. oil and gas, minerals, gold, and silver) called?
Depletion
How do we determine the cost of natural resources? How should expenditures for site acquisition, exploration, development, and restoration be treated?
- Use the concept of cost allocation as with other fixed assets. In this case, it is called depletion rather than depreciation.
- Estimate the physical potential of the natural resource, i.e. the depletion base
- Periodic depletion is based on the ratio of units extracted during the period to total estimated units available.
Repairs and Maintenance - how to account for them?
- Repairs include the cost of restoring an asset’s service
potential after breakdowns or other damage. - Maintenance includes routine costs such as cleaning
or adjusting.
–> Both types of costs are an immediate expense
When/how to capitalise expenses?
- Unlike repairs and maintenance costs:
- The improvement cost is added to the original cost of the asset
- And it should be depreciated over the remaining useful life of the asset because improvements change the asset’s service potential
Changes in Asset Values: Revaluations and Impairments - US GAAP and IFRS
- US GAAP: Increases in value CANNOT be recognised until the asset is sold - assets cannot be revalued upwards - substantial decreases in value (asset impairment) must be
recognised immediately - conservatism - IFRS: Assets must written down if impaired - Upwards revaluations permitted (but not mandated)
Revaluations - US GAAP and IFRS
Not allowed under US GAAP
Allowed under International GAAP:
* Revaluations must be done consistently across asset
groups
* Revaluations are need to be performed frequently – Because of this most companies stopped revaluing their assets
Accounting for Asset Revaluations - IFRS - Upon Revaluation
– Increase the cost of the asset to the revalued amount
– Eliminate the accumulated depreciation
– The increase in value (“gain”) is put in a special equity account called “revaluation reserve”
Accounting for Asset Revaluations - IFRS - After Revaluation - Subsequent periods
– Depreciate the asset based on the revalued amount (hence, depreciation expense increases)
– Transfer an amount from the revaluation reserve directly to Retained Profits to offset the ‘extra’ depreciation expense
– Do NOT recognise any gains or losses on the P&L
Accounting for Revaluations – Sale
- Eliminate the fixed asset and accumulated depreciation.
Record any cash received and calculate the amount of
gain/loss (difference b/w cash and net book value) – Same as normal asset sales - Transfer the remaining balance in the revaluation
reserve (for that asset) directly to Retained Profits – This does NOT go through the P&L – Eliminates revaluation reserve
US GAAP - impairments
- Eliminate Accumulated Depreciation
- Decrease Fixed Asset ‘cost’ to Impaired amount
- Loss goes to P&L
- Permanent
International GAAP - impairments
- Impairment increases Accumulated Depreciation
- Loss goes to P&L
- Reversals are possible (but more difficult for goodwill)
- Revalued Assets –> First revalue asset downwards & reduce the revaluation reserve (no P&L effect).
Impairments under US GAAP - steps
- Step 1 – Estimate the sum of undiscounted cash flows of operating units and compare it to the carrying amount of the operating unit. If the sum of undiscounted cash flows is lower than the carrying amount, an impairment loss must be recognized.
- Step 2 - The impairment loss is equal to the difference between the carrying amount and the present value of cash flows (fair value).
- After recognizing an impairment loss, the new carrying amount becomes the new cost basis (no reversal of losses).
Impairments under International GAAP
- Impairment testing for each cash-generating unit, whenever there are specified indications for impairment (e.g., market-to-book below one).
- Whenever there are indications for impairment, a recoverable amount must be measured – The larger between present value of cash flows (Value-in-Use) and net selling price (Exit Value).
- An impairment loss is recognized in the Income Statement.
- An impairment loss may be reversed. Impairments of goodwill may be reversed only when the circumstances that caused the impairment no longer exist.
Arguments for capitalisation of interest cost
- Interests similar to other costs
- Better matching
- Better comparability between own construction
and purchases
Arguments against capitalisation of interest costs
- Arbitrary allocation of borrowing costs
- Costs affected by source of financing
Capitalisation of interest or borrowing
costs - US vs UK vs IAS GAAP
- UK GAAP - FRS 15: Option to companies, should apply policy consistently, only actual interest expense on separate borrowings for construction
- US GAAP - SFAS 34: Mandatory capitalisation, interest expense on separate borrowings for construction. If no
separate borrowing, weighted borrowing costs applied to
expenditures incurred on construction - IAS GAAP – IAS 23: Mandatory capitalisation, should apply policy consistently; Interest expense on separate borrowings for construction. If no separate borrowing, weighted borrowing costs applied to expenditures incurred on construction
Capitalisation should begin when the following three conditions are present (all GAAPs)
– Expenditures for the asset must have been made; and
– Activities that are necessary to get the asset ready for its intended use are
in progress; and
– Interest cost is being incurred.
Capitalisation of borrowing costs:
Capitalisation period (under all GAAPs)
- Interest capitalized in a year cannot be more than the interest incurred in that year.
- Interest capitalisation should cease when the asset is “substantially complete” and ready for use.
- For financial analysis, better to treat borrowing costs as an expense as true interest expense may otherwise be understated.
Adjustments for Reversing the Effect of
Capitalisation
- Capitalised interest should be added to interest expense in P&L
- Depreciation expense in P&L should be reduced by the amount that relates to depreciation of previously capitalised interest.
- NBV of capitalised interest on assets sold during the year should be added to profit (loss) on disposal of fixed assets in P&L
- NBV of capitalised interest (i.e. capitalised interest less accumulated depreciation of capitalised interest) should be excluded from NBV of assets.
- Reduce deferred tax liability by NBV of capitalised interest * Marginal tax rate.
- “NBV of capitalised interest *(1-Marginal tax rate)” should be deducted from Shareholder’s funds.
An expenditure should be capitalised (i.e., shown as an asset) if it meets the asset recognition criteria:
- The value of the benefit is quantifiable,
- The entity has acquired the right to use the resource as a result of past transactions
Intangible Fixed Assets - IAS …
Definition: “identifiable non-monetary assets without physical substance” (IAS 38).
Capitalisation vs. Expensing - table picture
Intangibles: General rule for recognition
- Internally generated intangible assets are (generally) not able (or less able) to be recognized by firms (ie offbalance sheet).
- Acquired intangible assets, including intangibles acquired in business combinations, are generally recognised (ie
on-balance sheet).
Research and Development costs - capitalization?
IFRS only
Internally Generated Intangibles - US GAAP
- Generally not recognised (all costs expensed); Exceptions:
- Software – Capitalise (and amortise) expenditures once ‘technological feasibility’ is established (over three years, linear) – Stop when product is available for general release
- Website Development – Expense costs during planning stage – Capitalise (& amortise) costs during website’s application & and infrastructure development stages – Expense costs incurred during operation stage
Internally Generated Intangibles - International GAAP
- Research Costs are always expensed
- Development Costs are capitalised (and amortised) – Intent to & technical feasibility of completing the asset – Ability to use/sell asset – How the asset will generate a future economic benefit
- Software & Website Development – Similar to US
Acquired Intangibles - Subsequent measurement – US GAAP
- Revaluation NOT allowed
- Amortise asset over useful life
- If intangible has an indefinite life do NOT amortise – Test annually for impairment (Goodwill)
Acquired Intangibles - Subsequent measurement – International GAAP
- Revaluations allowed, but must be based on price in an active market (rare) – Revaluations must be regularly performed (annually in general)
- Amortise asset over useful life (20 year max, rebuttable)
Intangible revaluations
Can only revalue intangible assets if they are traded on an active market.
Almost all intangibles fail to meet this requirement, but there are
a few which qualify: Taxi licenses in major cities, carbon credits, and crypto currencies
Crypto Asset Accounting
- Financial asset -> only if it meets the definition of a financial asset (e.g. stablecoin like USD Coin)
- Inventory -> only if the entity holding the crypto currency is a broker/dealer
- Intangible asset -> if the crypto asset isn’t a financial asset or inventory, this is the only other option (most crypto assets end up here)
Crypto Asset Accounting – US GAAP
- Similar to IFRS, most crypto assets are treated as intangible assets.
- HOWEVER under current US GAAP you can NOT revalue intangibles
- –> historical cost – You must test for impairment – Any impairment can NOT be reversed
Crypto Asset Accounting - IFRS
- Most crypto assets are treated as intangible assets – Account for the asset at its market value – Increases in value go to comprehensive income, decreases in value through the income statement
Acquired Intangibles – Patents
- Costs associated with patent applications, legal fees and document preparation are capitalized
- All R&D costs associated with new ideas that will (hopefully) eventually be patented are expensed!
- Shorter of useful life or legal life of patent is used in the amortization calculation (usually straight-line method)
- In general, the patents you are likely to see recorded are those purchased from other entities. Why?
Acquired Intangibles – Brands
IFRS and US GAAP both allow firm’s to recognize and value acquired intangibles, including Brands.
How do we separate and value Brands?
- With great difficulty and subjectivity…
- Cost-based approaches
- Market-based approaches
- Economic use or income-based approaches
- Formulary approaches
Finite vs Indefinite useful life - International accounting treatment
- Intangible assets with finite useful live - capitalised and amortised
- Intangibles assets with indefinite useful lives – capitalised and reviewed for impairment
- Purchased goodwill – capitalised and reviewed annually for impairment
Accounting for Goodwill
Goodwill is considered to have a uncertian life (i.e. indefiniteuseful life) and is not amortized; it is periodically tested for
impairment -> this impairment testing is different than impairment testing of other intangibles
Two alternatives permitted for the presentation of Cash Flows from Operations (CFO) section:
- Direct Method: presents cash flows as gross receipts minus gross payments arrive at net cash flow from operations.
- Indirect Method: starts with net income or EBIT (from income statement) and adjusts for non-cash items –> arrive at net cash flow from operations.
Some differences in classification - Cash Flows - IFRS vs US GAAP
Growing discrepancy between net income
and CFO can signal:
- Premature recognition of revenues
- Undervaluation of liabilities
- Overcapitalisation of costs
- BUT, need to take into account a company’s life cycle (Growth vs. Maturity)
IAS 10 Events after the reporting period
- For all annual periods beginning on or after 1 January 2005
- Provide guidance on events that happen after the end of the reporting period but before authorised for issue by directors
- Examples given by IAS 10 are: Settlement of outstanding court case, finalization of bonuses, discovery of fraud or errors, information about recovery of an asset (e.g. NRV of inventory)
IAS 10 - non-adjusting events
- occurring after the end of the
reporting period - Disclosure may be necessary providing details of the nature of the event and estimate of financial effect
- Examples: Major purchase or disposal of assets, destruction of assets caused by a fire, announcement of a major restructuring plan, significant fluctuation in exchange rates, changes in tax rates
IAS 10 - adjusting/non-adjusting events - dividends
- If declared after the end of the reporting period they do not meet definition of a liability
- Should be disclosed in notes to financial statements
Are events which occur after the authorisation date recognised or disclosed in the financial statements?
No
Non-Current Assets Held for Sale - which IFRS?
IFRS 5
IFRS 5
Classify a non-current asset, or disposal group, as held for sale when the entity no longer intends to use the asset as part of its ongoing business and instead intends to sell it.
Non-Current Assets Held for Sale - conditions
- Available for immediate sale in present condition
- Sale highly probable
- Sale completed within one year of the date of classification
- Does NOT apply if the entity decides to abandon, rather than sell, the asset
- Does apply if the entity intends to distribute the asset to the owners – IFRIC 17 – Minor difference, assets are measured at fair value less costs to distribute (instead of costs to sell)
Non-current assets held for sale - Accounting on BS
- Carry at lower of carrying amount and the fair value less costs to sell
- May result in an impairment loss if fair value less costs to sell is below current carrying amount.
- Do NOT depreciate the asset(s)
- Present the asset(s) separately in the statement of financial position
Non-current assets held for sale - upon sale/disposal, how is any difference between the current carrying amount and the disposal proceeds treated?
As a loss or gain (under IAS 16 – PP&E) – NOT as an adjustment to any prior impairment
Non-current assets held for sale - valuation using the revaluation model
If measuring the asset using the revaluation model, assets classified as held for sale should be revalued immediately PRIOR to the reclassification. – Once reclassified, deduct the costs to sell and recognise an impairment loss.
Non-current assets held for sale - no longer meets specific recognition requirements
- reclassify the assets as non-current assets
- Measure assets as the lower of:
- (1) the carrying amount that would have existed if the assets were never classified as held for sale
- (2) The recoverable amount
- If individual assets and/or liabilities within a disposal group no longer meet the specific requirements
- (1) Remove the specific assets and/or liabilities
- (2) Keep the group (as long as it still qualifies)
Return on Equity
Decomposition of ROE
- first part profitability measure
- second part activity measure
- third part captures leverage (in the UK among older people called gearing)
Decomposition of ROE - “DuPont analysis”
Gross profit margin reflects, among other things:
- Mark-up policy
- Cost efficiency
The PAT margin can be decomposed using a multiplicative approach:
Non-recurring Income/Expense - examples
restructuring charges, impairments, legal expenses, gains/losses on asset sales
Inventory T/O
- Cost of Sales / Av. Inventory
- For manufacturing companies, use finished goods inventory in the calculation of inventory turnover
- Affected by: Relations with suppliers, Production process and type of business, Cost flow assumptions (e.g. FIFO and LIFO)
Trade Debtors T/O
- Sales / Av. Trade Debtors
- Measures and reflects on the ability of the firm to transform sales to cash
- Affected by: Credit policy, Estimates of bad debt, VAT
Trade Creditors T/O
- Purchases / Av. Trade Creditors
- Measures the ability of the firm to extract credit from its suppliers
- Purchases = C.O.S. + ∆Inventory (since C.O.S. = beginning inventory + purchases – ending inventory)
- Alternatively (for manufacturing companies) use: C.O.S. / Av. Trade Creditors
Fixed Assets T/O and Total Assets T/O
- Fixed Assets T/O = Sales/ Av. Fixed Assets
- Measures sales generation per one pound of fixed assets
- Total Assets T/O = Sales/ Av. Total Assets
- Affected by capital intensity of the production process, stage of the firm’s life cycle
Credit risks are typically divided into:
– Business risks
– Financial risks
and is often summarized by using:
– Credit ratings, or
– Credit scores
Liquidity Ratios
Interest Coverage
- PBIT/ Interest expenses
- CFO before interest payments and tax payments/Interest payments
Debt:
Financial debt (bank loans, bonds, commercial paper etc) + All interest bearing instruments (though some financing arrangements (e.g. leasing) escape this simple
rule) + preferred shares +
leases on the balance sheet (i.e., financial leases)
A simple ratio to assess the financing mix is:
Assets / Equity
Financial leverage ratio - Assess degree of debt utilisation
Debt payback ratio
Interest coverage ratio
Common-size Balance Sheet
- Express line items as a percentage of total assets e.g., [fixed assets / total assets] x 100
- This technique is useful for * looking at financial structure (industry variations) * Comparing across firms with different size * Comparing across firms in different countries
Banks - Balance Sheet: Assets - classification
Assets not broken up into current and long term
Instead categorized functionally
– Cash
– Investments, Government securities
– Loans of different kinds
– Property
Banks - Balance Sheet: Liabilities - classification
Not broken up into current and long term
Instead categorized functionally
– Deposits (of different kinds)
– Federal Funds Borrowed
– Long Term Debt
Banks - Balance Sheet: Equity
- Instead of D/E ratio, banks analyzed in terms of capital adequacy, i.e. equity as a % of total assets
- For this calculation, assets are “risk-adjusted” as some assets are safer and don’t need the backing of equity
- Different calculations of capital: - Tier 1 Capital (sh. equity) has to be at least 4% - Tier 1 + Tier 2 Capital (reserves, hybrid instruments, some unsecured debt) has to be at least 8%, but Tier 2 cannot exceed Tier 1 (Basel II)
- Basel III (currently scheduled for January 2022) will increase
these requirements and add 2 additional capital requirements, e.g. Tier 1 increased to 6% - Focus on “Accumulated Other Comprehensive Income” - May include unrealized gains/losses on investments - Changes reflect unrealized or realized gains/losses in that year
Banks - Income Statement: Breakdown:
- 4 categories:
- Interest Income – income from loans, etc.
- Interest Expense – interest paid to depositers - These 2 are usually netted to arrive at Net Interest Income - Lower rates are good, higher rates are bad, as borrowing rates are more
sensitive than returns from assets lent out. - Non-Interest Income – fees, commissions, trading gains, etc.
- Non-Interest Expense – salaries, pensions, admin costs, infrastructure costs, etc.
Banks - Cash Flow Statement:
- Operations section is small
- Investing and Financing sections highlight the real “operations”
- Generation of New Loans, Repayments` of Old Loans
- Changes in Borrowing, Deposits
2 main risks facing financial institutions:
- Interest Rate Risk
- Credit Risk - Captured by the loan-loss provision
Banks frequently have a significant amount of contingent assets and liabilities - what are examples
- Loan commitments – a promise to loan up to a certain amount to a customer under certain terms. Not an asset until the funds are actually provided.
- Letters of credit and other guarantees
- Loans sold with recourse
- Derivative securities
Banks - Earning Assets Ratio
- Earning Assets / Total Assets
- Large number => more assets are being used productively. Number usually around 80-90%
- Include all assets that generate income that would be classified as interest income – Loans – Deposits – Derivatives – Govt Securities
- Exclude cash or at least some portion of cash
Banks - Avg. Return and Cost
Banks - Expense Ratio
Non-Interest Expense / Total Revenues
Loan Loss Coverage Ratio
- (Pre-Tax Income + Provision for Loan Losses) / Actual Charge-offs
- Measures extent to which pre-tax income and provisions cover the actual losses
- Charge-offs are net of actual recoveries from previously written off loans
- One can also compare the provision to the actual charge-off
CAMEL(S) Analysis
- Framework for analyzing the strength of a bank - Used extensively by regulators, bank rating agencies as well as in developmental banking
- Capital adequacy
- Asset quality
- Management effectiveness
- Earnings
- Liquidity
- Sensitivity to interest/market risk
What causes difference in tax expense based on accounting profit and that based on taxable income?
- Standard-setters aim for financial statements to reflect the underlying economics of a business and so allow managerial discretion
- Tax rules are the product of political and social objectives
and attempt to minimize discretion
Pre-tax income as reported in the financial statements
is determined using… (which framework/regulation)
GAAP
Effective tax rate
Tax expense divided by pre-tax income
Permanent Differences - taxable income
- Certain revenue items on the income statement for ‘book’
purposes are never taxable; Example: Interest earned on municipal bonds (US) - Certain expense items on the ‘book’ income statement
are never deductible for tax purposes; Example: Fines imposed by the government
The Liability Method - how to compute DTAs and DTLs
- Compare the ‘book value’ of assets and liabilities on the financial accounting books to the tax books. Compute ‘deferred tax assets’ and ‘deferred tax liabilities’ based on differences in book values using future tax rates (shown shortly)
- When tax rates change, this method can cause firms to revalue their deferred tax assets, and thus they might have a shock to their earnings stream
Temporary Differences - Taxes
- Items that are deducted in calculating taxable income before they are recognized as a financial expense. (Usually generate deferred tax liabilities): Example: Insurance Prepayments.
- Items that are recognized as a financial accounting expense before they are deducted in calculating taxable income. (Usually generate deferred tax assets); Example: Warranty Expense
Current and deferred tax are recognised directly in
profit or loss for the period except where the tax arises
from:
- A transaction that is accounted for directly in other comprehensive income (e.g., due to pensions, revaluations)
- A business combination
Loss Carryforwards and Carrybacks
- When a company has loss for tax purposes, the firm
can elect to do one of two things: - Carry back: Set off the tax-loss against profits in prior years (In US, companies can set off their tax loss against profits in prior 2 years. In UK, this is restricted to 1 year)
- Carry forward: Set off the tax-loss against profits in future years (In US, companies can set off their tax loss against profits in next 20 years. In UK, there is no time limit for carry forwards)
Manager of company expects to be able to only use $0.5m of the $2.0m loss carry-forward in the future - IFRS & US GAAP treatment
- IFRS: Deferred tax assets are recognized only to the extent
these benefits are likely to be realized in the future (i.e.,
here only $0.5m) - US GAAP: If DTAs are not likely to be realized in the future then a “valuation allowance” has to be created
US GAAP - Valuation Allowance - if not all the loss carry-forward can be used
- If it is “more likely than not” that a deferred tax assets will not be realized in the future, then a valuation allowance (a contra-asset account, similar to provisions for doubtful debt) has to be recorded
- To a large extent, decision on timing and amount of valuation allowance is a management judgement (subject to approval by the company’s auditors)
- The entry for valuation allowance would be to create a provision account called “valuation allowance” and charge this amount to the Income statement
- Like any other provision, valuation allowance affects the net asset value and the net income, but does not affect the cash flows
How can a valuation allowance be used to smooth earnings?
In good years (when earnings are unusually high) increase the valuation allowance. This increases the income tax expense and so reduces current income.
Increase: Income tax expense
Decrease: DTA through increasing the valuation allowance (contra asset)
What if DTAs or DTLs will not reverse in the future?
Then they are not an asset or liability and should be treated as part of equity for purposes of analysis. In this case,
- Deferred tax assets should be seen as reducing shareholder
equity
– Deferred tax liabilities should be seen as increasing equity
Where is it set out which segments and what information must be disclosed for operating segment reporting?
IFRS 8
Identified based on internal reports used for assessment
of performance
– identify segments the same way that the company does internally
(by product line, by geography, etc.)
– Only concerned with operating segments
– E.g. the head office is not an operating segment
– Applies even if a potential segment only sells products or services
internally to other parts of the entity
– If a part of the business does not earn revenues itself, it is not
considered to be an operating segment.
Which segments MUST be reported?
- A segment must be reported if the following tests result in a percentage of 10% or more: () Segmental revenue as a percentage of all segment revenue (include internal sales) () Segment profit or loss as a percentage of the greater of: Total segment profit, excluding any segment that reported a loss; Total segment loss, excluding any segment that reported a profit
- If a segment does not meet these tests then the company
can still voluntarily report it as a segment - If a segment was separately reported in the prior period it
should continue to be reported - Even if it fails to meet the 10% tests - If a segment is reportable for the first time that segment
should also be separately reported for the previous period - Threshold test: – Separately identified segments must comprise AT LEAST 75% of the entity’s (or group’s) EXTERNAL revenue – If not, then additional segments need to be reported even if they fail to meet the 10% tests.
What information has to be reported for each segment?
- Disclosure of general information required (type of products and services for each segment)
- Measure of profit or loss, liabilities, and total assets should be disclosed for each reportable segment
- Liabilities and total assets only required if this information is provided for internal reporting purposes.
- Under US GAAP (SFAS 131), liabilities are not required to be disclosed even if provided for internal reporting purposes
Discontinued operations: IFRS 5
- Disclosure is required about discontinued operations i.e. a component of an entity that either has been disposed of or is classified as held for sale.
- The component should represent a separate major business line or geographical area of the entity’s operations.
- The effective closure of the component should be part of a single plan.
- Should represent a separate major business line or geographical area of the entity’s operations
- Prior periods: Should be restated to reflect all operations that have been discontinued
- Discontinued Operations - no adjustments for events
occurring after the end of the reporting period.
GAAP liability recognition
- Liability recognition tests mirror asset tests.
- IAS 37, liability recognised if: – a present obligation exists as a result of a past event – a probable outflow of resources will be required to settle the obligation – a reliable estimate can be made of the amount of the obligation
- Recognize at value of minimum obligation
- In IFRS, liabilities are discounted
- Mostly, liabilities are known, contractual, uncontroversial.
- The challenge is when liability is large and uncertain in outcome. These liabilities require provision based on an estimate. Important cases: – pension liabilities – deferred tax liabilities
Classifications of Accounting Liabilities by Degree of Certainty
When is a past event an obligating event?
If the entity has no realistic alternative to settling the obligation created by the event
► Obligation may be legal or constructive
► Legal obligation derives from contract or law - the explicit or implicit terms of a contract, or from legislation or other law
► Constructive obligation: “by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.”
► Therefore, avoidable expenditures are not liabilities,
for example: restructuring provisions recognized only if there’s an obligation
What is a contingent liability?
- a possible obligation (that arises from past events) whose existence depends on uncertain future events not wholly within the control of the entity; or an actual obligation but either not probable that an outflow of resources will be required or amount cannot be measured reliably.
- Contingent liabilities should be disclosed, unless the
possibility of an outflow of economic resources is remote.
[IAS 37.86] - Similarly, the related party standard [IAS 24] requires disclosure of guarantees to associates. But again disclosure may be avoided on the grounds of economic insignificance.
- For safety, need to approach the company directly to confirm the existence of equity pledges.
Asset retirement obligations
- IAS 37 regulates provisions for asset retirement obligations
- ‘The discount rate should be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability.’
How to Account for Bonds?
Two valuation approaches for firms’ issued debt securities:
(1) Historical (Amortized) cost: use the original values and compute costs and benefits based on market rates at inception of the debt.
(2) Mark-to-market: Adjust to fair or market value at each reporting date, i.e. FVO (IFRS 9)** (e.g. Netflix)
Majority of firms tend to use amortized cost method, also
referred to as effective interest rate method. (our focus)
Accounting for Bonds at Issuance
- Increase cash by bond proceeds (i.e., bond price)
- Increase “Bonds payable” (liability) by face value
- The difference between (a) and (b) should (i) if positive, i.e. bond issued at premium, go to “Premium on bonds” (a liability account) (ii) if negative, i.e. bond issued at discount, go to “Discount on bonds” (a contra liability account)
Accounting for Bonds After Issuance
- Decrease P&L a/c by interest expense = market interest rate at issuance (called effective interest rate) times net book value of the bond.
- Decrease cash by interest paid = coupon rate multiplied by face value
- Decrease “Premium” or “Discount” account by the difference between (a) and (b)
- Cash flows are often at a different rate than the economic flows – accounting is based on economic flows
- In the P&L, we actually want to show the “usage” of the bond (the interest expense) rather than the actual cash outflow (interest paid).
- For example, if the bond is issued at a discount the actual expense of the year is the coupon PLUS part of the discount – i.e., we need to “amortize” the discount.
- The accounting principle behind this: accrual/matching
Bonds - Difference between the cash interest payment and the interest expense - Amortization
Coupon - Disclosure: Cash Flow Statement impacts
- Cash Flow Impacts:
- Coupon (interest) payments disclosed in CFO (US GAAP) or CFI (permitted under IFRS)
- Proceeds from issuance of new debt and repayment of principal disclosed in CFI
Accounting of more complex debt instruments..
- Foreign currency Bonds/Notes (presented in Fair Value)
- Interest rate swaps (presented in Fair Value)
- Payment-in-kind Bonds (interest “payments” added to principal)
- Convertible debt (e.g. Tesla) - Bond / Note can be converted into predetermined amount of equity shares. Has both a liability and an equity component (IFRS requires separation of the elements in financials)
Can assets and liabilities be offset?
- Fundamental GAAP principle says that assets and liabilities cannot be offset, except where permitted by a standard
- Financial assets and financial liabilities are netted where there is a legally enforceable right to offset. For example: – pensions assets and liabilities in same fund can be netted, but two funds, one in surplus, one in deficit cannot – deferred tax assets and liabilities cannot be netted
Netting, off-balance sheet financing
- In ‘asset financing’, borrowing is linked to a specific asset. If one can be offset or netted against the other, that gives off-balance sheet financing
*Principal mechanisms of off-balance sheet financing have been – operating leasing – securitization – non-consolidation
Reasons why an item may not be shown on balance sheet
- Items presented in “net” rather than “gross”
- Items represent future commitments rather than present liabilities
Off Balance Sheet Activities - 1. Leases, 2. Securitisation, 3. “Sale and Leaseback” - questions to ask for understanding whether to show transaction in balance sheet or otherwise off-balance-sheet
- Leases – Is it a genuine lease or a transaction that is equivalent to borrowing money and purchasing the asset?
- Securitisation – Sell securities whose payoffs are tied to a specific future source of revenues? – Is it a form of financing or is it a genuine sale of future revenues? – If it is a form of financing, show transaction in balance sheet otherwise, off-balance-sheet
- “Sale and Leaseback” – Is it a form of financing or a genuine sale of asset? – If former, show transaction in balance sheet.
Off Balance Sheet Activities - which are included?
- Leases
- Securitisation
- “Sale and Leaseback”
- Associates
- Sale with Repurchase agreement (Repo)
- Special Purpose Vehicles and similar structures
Classification of Leases: US GAAP old
Classification of Leases: IAS old
Accounting for Leases: Operating Lease
Under an operating lease the lessee will only record an annual rent expense - rental expense should be recognized on a straight-line basis unless another basis is more representative of the time pattern of benefits from the leased property.
Accounting for Leases: Capital Lease
The lessee will record an asset and a liability at the inception of the
lease. The asset will be depreciated over the lease term and the liability
will be treated as any other loan. This implies that the P&L will include
depreciation in the operating profit. It will also include the imputed
interest cost as part of the interest expense
Current ratio and quick ratio - impact from capital leases
Current ratio and quick ratio will be lower under capital lease because of the inclusion of the current portion of the lease liability under “Current liabilities”
Accounting for Leases: Capital Lease - end of each year
Operating Lease Adjustments – Method 1
Operating Lease Adjustments – Method 2
Leases - Estimating Implicit Interest Rate
- For US companies, the implicit interest rate for leases can be estimated from disclosures relating to capital leases or from disclosures relating to debt.
- For European Companies, the estimation of implicit interest rate is relatively easier. Since, for finance leases, IAS 17 requires the MLP in the following year as well as present value of the MLP in the following year to be disclosed, the implicit discount rate can be worked out directly from these figures.
New Lease Standards – IFRS 16
New Lease Standards – IFRS 16 - for Lessors:
New Lease Standards – US GAAP
Sale and Leaseback Accounting - Old
Sale and Leaseback Accounting - New
Accounting - Repurchase transactions (repo agreements)
Post-Lehman, additional disclosures on repo window
dressing.
Special Purpose Entities - purpose and legal form
Special Purpose Entities - characteristics and design
Special Purpose Entities - US GAAP and IFRS
- Consolidation of “Variable Interest Entities” (VIE) required if
- investor is exposed, or has rights, to variable returns from
its involvement with a VIE; ANDhas the ability to affect those returns through its power over the investee
Investment (financial) - definition
An asset that is characterised by its ability to generate future economic benefits in the form of distributions and/or appreciation in value - Investments in common and preferred shares, bonds, or other securities
Minority Passive Investments - 3 Types:
Terminology: US GAAP vs IFRS for Minority Passive Investments
Minority Passive Investments - 3 Types - Accounting
How is a debt Investment gonna be accounted for?
Available-for-sale-security, except classified as something else at time of buying - very difficult to reclassify afterwards
Minority Passive Investments - Classification/Accounting, broadly speaking:
- Debt: Investment can be carried at fair value (with changes in value going to Other Comprehensive Income) or historical amortized cost
- Debt and equity: investment is carried at fair value with changes in value going to P&L
Fair value change of minority passive investments if not held for trading purposes: OCI vs P&L - GAAP vs IFRS
Under IFRS (but not US GAAP): if the investment is not held for trading purposes, changes in the fair value of equity investments may be charged to OCI (need to designate the security as FVOCI at acquisition date and cannot reclassify)
Minority Passive Investments - where can you put Equity
Investments and Debt Investments?
Minority Passive Investments - what to do with transaction costs?
- Available-for-sale and Held-to-maturity securities: include transaction costs
- Trading securities: EXCLUDE transaction costs
Minority Passive Investments: Financial Reporting - Summary
Passive Investments in Securities: Basic Accounting Issues - Investment < 20% of Shares O/S (No Significant Influence)
Current Rules for structured entities
An entity that has been designed so that voting or similar rights are NOT the dominant factor in deciding who controls the entity - IFRS 12.
– Identify control by looking at the substance of the relationship, e.g. substance over legal form
– Looking for situations where the structured entity acts as if on ‘autopilot’ or is ‘brain dead’
– Frequently control exists NOT through voting power but rather through the predetermination of the activities of the structured entity
–> Look at corporate charter, etc
Does the investor control the investee?
(*) IFRS 10 provides a definition of control that’s comprises three elements
– Power over an investee;
– Exposure or rights to variable returns from an investee; and
– Ability to use power to affect the reporting entity’s returns
(*) Explicitly states that an investor can control an investee with less than 50% of the voting rights and provides guidance on assessing control in such cases
Minority Active Investments - IFRS vs US GAAP - “potential voting rights” when determining control?
IFRS includes the “potential voting rights” when determining control, whereas US GAAP does not.
IFRS 11 Joint Arrangements
- Sets out accounting requirements in relation to interests in joint ventures
- Joint arrangement – An arrangement of which two or more parties have joint
control – i.e a similar scope as for joint ventures under IAS 31 - Investor who does not share joint control – Account for as an investment or an associate
- Contractual arrangement – Principal factor in determining whether a joint venture
relationship exists - Does not apply where the venturer is a venture capital organisation
- The joint venture interest is owned by a mutual fund or unit trust
- Any company or division which is acquired but will be subsequently sold IFRS 5 Non-current assets held for sale and discontinued operations
The Two Forms of Joint Arrangement
Joint ventures - features and accounting
- Must be a separate entity
- Joint venturers have rights to the NET assets of the arrangement
- Equity method of accounting same as Investment in Associates (next example)
Current status for goodwill accounting (US GAAP and IFRS):
- Show as an intangible asset
- Do not amortise
- Subject it to annual impairment reviews
Calculation of Minority Interest - the parent company has the choice (available on a
transaction by transaction basis) to measure noncontrolling interests (NCI) either at:
- fair value (sometimes called the full goodwill method)
- the NCI’s proportionate share of net assets of the acquire (sometimes call the partial goodwill method)
