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
Capitalisation vs. Expensing - table picture
Some differences in classification - Cash Flows - IFRS vs US GAAP
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)
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”
The PAT margin can be decomposed using a multiplicative approach:
Liquidity Ratios
Financial leverage ratio - Assess degree of debt utilisation
Debt payback ratio
Interest coverage ratio
Banks - Avg. Return and Cost
