Book 2: FRA Flashcards
What is the COGS equation?
COGS = beginning inventory + purchases - ending inventory
What is the specific identification method?
An inventory cost formula where specific costs are attributed to identified items of inventory (each unit sold matched with units actually cost). Required for items that are not ordinarily interchangeable, or are produced and segregated for specific projects. (IAS 2.23)
What is the weighted average cost method?
An inventory cost formula where the cost of each item is determined from the weighted avg of the cost of similar items at the beginning of the period and the cost of similar items purchased or produced during the period (may be calculated on periodic [at end of period] or perpetual [as each additional shipment is received] basis). During inflation, will produce a value in-between LIFO and FIFO. (IAS 2.25)
Cost of goods AFS = Beginning inventory + purchases
Avg cost per unit = Cost of goods AFS / Quantity AFS
COGS = Avg cost per unit * Quantity sold
Ending inventory = Avg cost per unit * Quantity remaining
Under what cost formulas are ending inventory and COGS the same regardless of periodic or perpetual calculation?
FIFO and specific identification.
What is the LIFO reserve?
Difference between FIFO inventory and LIFO inventory.
LIFO reserve = FIFO inventory - LIFO inventory
FIFO inventory = LIFO inventory + LIFO reserve
How to convert from LIFO to FIFO?
1) FIFO inventory = LIFO inventory + LIFO reserve
If it’s avg inventory, just avg both the inventory and the reserve and add them together.
2) FIFO cash = LIFO cash - (LIFO reserve * tax rate)
This subtracts taxes on the LIFO reserve because LIFO firm pays lower taxes and therefore more CFO.
3) FIFO equity = LIFO equity + (LIFO reserve * (1 - tax rate))
This is because LIFO firm has higher COGS and therefore lower net income to go to RE.
4) FIFO COGS = LIFO COGS - (end LIFO reserve - beg LIFO reserve)
COGS is lower under FIFO.
5) FIFO net income = LIFO net income + [(end LIFO reserve - beg LIFO reserve) * (1 - tax rate)]
NI is higher under FIFO (because COGS is lower in an inflationary environment).
FIFO net income can also be arrived at by adjusting FIFO taxes (adding the tax on change in the reserve). ie:
FIFO taxes = LIFO taxes + [(end LIFO reserve - beg LIFO reserve) * tax rate)]
6) FIFO RE = LIFO RE + [LIFO reserve * (1 - tax rate)]
How to compute FIFO COGS or FIFO net income from a LIFO basis?
Change in LIFO reserve = ending LIFO reserve - beginning LIFO reserve
FIFO COGS = LIFO COGS - Charges included in COGS for inventory write-down - Change in LIFO reserve
COGS is lower under FIFO.
FIFO net income = LIFO net income + [(Change in LIFO reserve ) * (1 - tax rate)]
NI is higher under FIFO (because COGS is lower).
FIFO net income can also be arrived at by adjusting FIFO taxes (adding the tax on change in the reserve). ie:
FIFO taxes = LIFO taxes + [(end LIFO reserve - beg LIFO reserve) * tax rate)]
What’s LIFO liquidation?
When a firm’s LIFO inventory is declining, and therefore older, lower costs are now in COGS. This results in higher profit margins (lower COGS) and higher tax. These higher profit margins are artificial and unsustainable.
To adjust for this, should add the decline in the LIFO reserve (the difference between inventory at FIFO and LIFO) caused by a decline in inventory back to COGS. (note this is the opposite to computing FIFO COGS from LIFO, where the change in LIFO reserve is deducted from LIFO inventory).
What is the inventory valuation method under IFRS? US GAAP?
IFRS: lower of cost or net realisable value
Net realisable value is estimated selling price in ordinary course of business less the estimated costs of completion and estimated costs necessary to make the sale. (IAS 2.6)
Inventory can be written down if NRV is less than cost. NRV can also be written back up if there is a recovery in value, but the gain is limited to the amount previously recognised as a loss and can’t be written up above original cost. (IAS 2.33)
US GAAP: lower of cost or market
Market is usually replacement cost. Market cannot be greater than NRV, or less than NRV - normal profit margin. In effect, market is straddled by NRV and NRV - normal profit margin.
No write-up is allowed in US GAAP for subsequent recoveries in value.
What changes in inventory levels should an analyst be on the look out for?
An increase in raw materials or WIP may indicate an expected increase in demand.
Increased finished goods inventory while raw materials and WIP are decreasing may indicate decreasing demand.
Inventory turnover ratio
COGS / avg inventory
Gross profit margin
Gross profit / revenue
Net profit margin
Net income / revenue
Return on assets
Net income / avg assets
Days inventory on hand
365 / inventory turnover
inventory turnover = COGS / avg inventory
What’s the effect on net income and equity of capitalisation?
Delays recognition of expense to subsequent periods (via depreciation). Conversely, if a firm expenses in the current period, net income is reduced by the after-tax amount of the expenditure.
ie Capitalisation results in higher net income in first year and lower net income in subsequent years than expensing.
Over the life, total net income is identical.
Because it results in higher net income in the period, it also results in higher equity (retained earnings). This reduction is deferred to later periods (via depreciation).
What’s the effect on CFO of capitalisation?
A capitalised expenditure is usually an outflow from investing activities.
Conversely, if expensed, it’s reported as an outflow from operating activities.
So, capitalising results in higher CFO and lower CFI than expensing. Total CF is the same.
What’s the effect on ROA and ROE of capitalisation?
Capitalisation initially results in higher ROA and ROE because of higher net income in first year. Subsequently, ROA and ROE will be lower as net income is reduced by depreciation.
Expensing causes ROA and ROE to be lower in first year and higher in subsequent years. Though net income is lower in first year, it is higher in subsequent years (and assets/equity is lower) than if it was capitalised.
What interest rate is used to capitalise interest?
It is based on the debt specifically related to the construction of the asset. (IAS 23: actual borrowing costs incurred to extent entity borrows funds specifically).
If no construction-specific debt is oustanding, it is based on existing unrelated borrowings. Interest costs on general debt in excess of construction costs are expensed. (IAS 23: apply capitalisation rate to expenditures to extent entity borrows funds generally).
How is capitalised interest classified in CF statement?
Generally as outflow from CFI. Comparatively, regular interest expense is outflow from CFO.
What’s the interest coverage ratio and how does capitalisation affect it?
interest coverage ratio = EBIT / interest expense
Capitalisation initially results in higher ICR, because of lower interest expense.
In subsequent periods higher depreciation results in lower EBIT, so there is lower ICR.
ICR based on total interest expense (including capitalised interest) is considered a better measure of solvency by many.
How to adjust financial statement to reverse effect of capitalising interest?
1) Interest expense + capitalised interest in year
2) Total assets - capitalised interest + depreciation due to capitalised interest to date (which wouldn’t have happened)
3) Depreciation expense + depreciation due to capitalised interest
4) Subtract interest capitalised from CFO and add to CFI (capitalised interest is usually reported as an outflow from CFI)
How are internal development costs accounted for?
With some exceptions, they are expensed as incurred.
R&D:
IFRS: research costs are expensed as incurred, but development costs are capitalised.
GAAP: both research and development costs are expensed, with the exception of software development costs.
Software development costs (GAAP): expense until technological feasibility has been established, after which should capitalise. Also capitalise costs for software development for internal use.
Rememba: Capitalisation results in higher net income in first year and lower net income in subsequent years than expensing.
What’s the equation for straight-line depreciation?
depreciation expense = (original cost - salvage value) / depreciable life
What’s the equation for DDB depreciation?
DDB depreciation in year x = (2 / asset life in years) * book value at beginning of year x
Whats the equation for units-of-production method depreciation?
depreciable basis / number of units expected over life of asset
depreciable basis = original cost - salvage value
How is a change in depreciation method treated in IAS 8?
As a change in accounting estimate, and therefore put into effect in the current period and prospectively.
Entities can manage earnings through the choice of estimated lives and salvage values.
When must entities test non-financial assets for impairment?
IFRS: must annually assess whether there is indication impairment has occurred. If there is, then should test for impairment.
US GAAP: test for impairment only when events and circumstances indicate firm may not be able to recover the carrying value through future use.
How is a non-financial asset assessed for impairment?
IFRS: asset is impaired when carrying value exceeds the recoverable amount.
Recoverable amount is greater of “FV less selling costs” and “value in use”. Value in use is the PV of future CFs from continued use.
If impaired, asset is written down to recoverable amount and impairment loss is recognised.
In IFRS, loss may reverse.
US GAAP: two steps: determining recoverability and measuring the loss
Recoverability: asset impaired if carrying value is greater than undiscounted future CFs.
Loss measurement: if impaired, write down to FV (or discounted value of future CFs if FV is not known) and recognise impairment loss.
In US GAAP, loss may not reverse.
How is the impact of a revaluation in IAS 16 recognised in the income statement?
If initial revaluation caused carrying amount to INCREASE, recognise that increase in OCI and accumulated in equity as revaluation surplus (ie increases equity). Subsequent losses would reduce OCI to the extent of the gains.
If initial revaluation caused carrying amount to DECREASE, recognise that decrease in P&L. Subsequent gains would be recognised in P&L until they exceed the initial loss, at which point they are recognised in OCI and accumulated as revaluation surplus.
OCI
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COST
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P&L
What’s the equation for average age? Avg depreciable life? Remaining useful life?
Avg age = accumulated depreciation / annual depreciation expense
Avg depreciable life = end gross assets / annual depreciation expense
Remaining useful life = end net assets (net of accumulated depreciation) / annual depreciable expense
Compare annual capital expenditures to depreciation expense for indication of whether firm is replacing PP&E at same rate as assets are depreciating.
What is a finance lease? Operating lease?
Finance lease (capital lease in US GAAP): IFRS: transfers substantially all risks and rewards incidental to ownership
US GAAP: either
- title transferred to lessee at end
- bargain purchase option exists
- lease period is 75%+ of asset’s life
- PV of lease payments is 90%+ of FV of asset
In substance, a purchase of an asset that is financed with debt). Lessee adds equal amounts (lower of FV or the PV of lease payments) as asset and liability on its balance sheet, and over time recognises depreciation expense on asset and interest expense on liability.
Operating lease: any lease other than a finance lease (in substance, a rental arrangement). No asset or liability reported by the lessee, and periodic lease payments recognised as rental expense.
What are the benefits of leasing compared to traditional financing?
Less costly financing (no initial down payment)
Reduced risk of obsolescense (can return to lessor)
Less restrictive provisions (more flexibility in negotiations)
Off-balance-sheet financing (operating leases)
Tax reporting advantages (in US, synthetic lease whereby lease is treated as owned asset for tax purposes, and rental agreement for financial reporting)
What is the reporting by the lessee for a lease?
Operating lease: no entry at inception. Recognise rent expense equal to lease payment during term. Lease payment is outflow from CFO.
Finance lease: at inception the lower of the PV of future lease payments or FV is recognised as equal asset and liability by lessee. Over term, recognise depreciation expense on asset and interest expense on liability.
Total expense under finance lease = interest expense + depreciation.
Interest expense = lease liability at beginning of period * interest rate implicit in lease
The finance lease payment is separated into interest expense (CFO, or in IFRS CFO or CFF) and principal (CFF)
What are the financial statement effects of leasing?
Balance sheet: finance lease results in reported asset and liability, operating lease doesn’t.
Income statement:
Lessee: EBIT (operating income) is higher for finance lease than operating lease. With operating lease, the entire lease payment is an operating expense, whereas for finance lease only the depreciation expense (not the interest expense) is. Operating lease will show higher profits for lessee in early years, because lease expense is less than sum of interest and depreciation expense.
Lessor: EBIT is higher for direct financing lease than operating lease, because due to amortisation interest is higher in early years. This reverses in later years.
CF: total CF is unaffected.
Lessee: CFO is higher for operating lease and CFF is lower, because finance lease puts portion considered interest expense through CFO and principal portion (lease payment - interest expense) through CFF. For lessee, CFO is higher for operating, because full lease payment is treated as operating CF. For finance lease, only portion of lease payment relating to interest expense potentially reduces operating CFs.
Lessor: CFO is higher for operating lease than a direct financing lease. With a direct financing lease, the lease payment is separated into interest (inflow to CFO) and principal (lease payment - interest revenue) (inflow to CFI).
How to derive interest rate for lessee?
A lessee should recognise depreciation expense on asset and interest expense on liability (lower of FV or PV of lease payments).
Interest expense = lease liability at beginning of period * interest rate implicit in lease
Interest rate = IRR of future lease payments
CF0 = -PV of future lease payments
CF1 = CF in year 1
…
Then, can use NPV function to compute PV of operating lease payments discounted at the IRR.
CF0 = 0
CF1 = rent expense year 1
…
What is the reporting by the lessor for a lease?
Operating lease: recognise the lease payment as rental income, and keep the leased asset on the balance sheet (and recognise depreciation).
Finance lease: lessor should recognise as finance (capital) lease if finance lease criteria is met and (for US GAAP) the collectability of lease payments is reasonably certain and lessor has substantially completed performance
US GAAP distinguishes capital lease between:
Sales-type lease: If the PV of lease payments > carrying amount of asset. Treated as lessor sold asset and provided financing to buyer. Recognise sale equal to PV of lease payments, and COGS equal to carrying value of asset. Different is gross profit. Asset removed from BS and a lease receivable equal to PV of lease payments is created.
In substance, it’s as if lessor sold the asset for its fair market value and loaned the lessee the purchase price.
Direct financing lease: If the PV of lease payments = carrying value of asset. No gross profit is recognised at inception, rather lessor is providing financing to lessee. Asset removed from BS and a lease receivable equal to PV of lease payments is created.
On both finance leases the principal portion of payment reduces lease receivable, interest revenue is recognised equal to lease receivable at beginning of period * interest rate, and interest revenue portion is CFO inflow and principal portion (lease payment - interest income) is CFI inflow.
What are the tainting provisions for HTM assets?
When an entity’s actions cast doubt on its intention/ability to hold HTM assets to maturity, the use of amortised cost for HTM assets is precluded for a reasonable period of time. (IAS 39.AG20).
Consequently, no FA should be classified as HTM if, during current year or preceding 2 years, the entity has sold or reclassified more than an insignificant (in relation to the total) amount of HTM assets before maturity, other than those done:
- close enough to maturity or call date so that changes in market rate of interest did not have significant effect on FV;
- after substantially all original principal had been collected;
- due to an isolated non-recurring event beyond the holder’s control.
What are available-for-sale assets?
An FA is classified as AFS if it is designated as such or if it does not properly belong in one of the three other categories of FAs. In many respects it is therefore a ‘default’ classification. (IAS 39.9)
Assets that would otherwise be ‘loans and receivables’ may be designated as AFS at initial recognition.
AFS are measured at FV on each reporting date. Unrealised gains/losses is the difference between FV and carrying amount at that date. OCI is adjusted to reflect the cumulative unrealised gain or loss. The amount reported in OCI is net of taxes.
When AFS assets are derecognised, the cumulative amount in OCI is RECYCLED and reported as a reclassification adjustment on the statement of profit and loss.
Only forex gains and losses on AFS securities are recognised in P&L in IFRS. Under US GAAP, the total change in the fair value of AFS securities is in OCI.
Whats the difference between IFRS and US GAAP AFS measurement?
IFRS: Only forex gains and losses on AFS securities are recognised in P&L, any other unrealised gains and losses go through OCI
US GAAP: All unrealised gains and losses go through OCI
When can FIs be reclassified into or out of FVPL?
Generally FIs may NOT be reclassified into or out of FVPL. This is to impose discipline on entities. (IAS 39.50, BC73).
Eg, if an entity starts to trade an AFS portfolio, newly acquired investments will be FVPL, but the legacy portfolio will remain AFS.
There are certain exceptions if the FA is no longer being held for sale or repurchase in the near term:
- Can reclassify to loans and receivables if it meets definition and entity has intention and ability to hold it for foreseeable future or until maturity. (IAS 39.50D)
- Can reclassify to HTM or AFS in “rare circumstances”, which are not described. (IAS 39.50B).
It is prohibited for derivatives or FIs designated at FVPL on initial recognition to be reclassified.
When can FAs be reclassified between AFS and ‘loans and receivables’?
AFS to L&R: If FA would have met the definition of L&R and the entity has intention and ability to hold for foreseeable future or until maturity (IAS 39.50E).
L&R to AFS: IAS 39 neither requires nor prohibits this reclassification. EY thinks it is okay to do if applied consistently.
When can FAs be reclassified between HTM and AFS?
HTM to/from AFS are permitted. It depends on intention or ability to hold. (IAS 39.51)
If HTM tainting provisions are triggered, those remaining HTM assets should be reclassified to AFS.
When classifying from HTM to AFS, difference between AC and FV should be recognised as a gain/loss.
If it is no longer appropriate to classify an investment as HTM, it shall be reclassified as AFS and remeasured at FV, with difference between carrying amount and FV recognised in OCI.
How does US GAAP treat reclassification of FAs?
Allows reclassification of securities between all categories when justified.
