CFAI 4- Financial Reporting and Analysis Flashcards
The ability to meet short-term obligations is generally referred to as …..,
and the ability to meet long-term obligations is generally referred to as ……..
The ability to meet short-term obligations is generally referred to as liquidity, and the ability to meet long-term obligations is generally referred to as solvency. Cash flow in any given period is not, however, a complete measure of performance for that period because, as shown in Example 1, a company may be obligated to make future cash payments as a result of a transaction that generates positive cash flow in the current period.
basic and diluted earnings per share on the face of the income statement.
Basic earnings per share is calculated using the weighted-average number of common (ordinary) shares that were actually outstanding during the period and the profit or loss attributable to the common shareowners.
Diluted earnings per share uses diluted shares—the number of shares that would hypothetically be outstanding if potentially dilutive claims on common shares (e.g., stock options or convertible bonds) were exercised or converted by their holders—and an appropriately adjusted profit or loss attributable to the common shareowners.
Financial Reporting Documents
Balance Sheet,
Statement of Comprehensive Income
(Income Statment; Other Compreensive Income)
The statement of changes in equity, variously called the “statement of changes in owners’ equity” or “statement of changes in shareholders’ equity,” primarily serves to report changes in the owners’ investment in the business over time.
Cash Flow Statment
Financial flexibility
is the ability of the company to react and adapt to financial adversities and opportunities.
Porque é que as Financial Notes são importantes?
IMPORTANTE PARA EXAME E VIDA BROW!
Porque nos dão uma ideia de como são calculados os financial statments. Para compararmos duas empresas os financial statments devem ter seguido as mesmas normas.
Overall, flexibility in accounting choices is necessary because, ideally, a company will select those policies, methods, and estimates that are allowable and most relevant and that fairly reflect the unique economic environment of the company’s business and industry. Flexibility can, however, create challenges for the analyst because the use of different policies, methods, and estimates reduces comparability across different companies’ financial statements. Comparability occurs when different companies’ information is measured and reported in a similar manner over time. Comparability helps the analyst identify and analyze the real economic differences across companies, rather than differences that arise solely from different accounting choices. Because comparability of financial statements is a critical requirement for objective financial analysis, an analyst should be aware of the potential for differences in accounting choices even when comparing two companies that use the same set of accounting standards.
.
MD&A como é que pode auxiliar um analista na hora de investir?
The management commentary or MD&A is a good starting place for understanding information in the financial statements. In particular, the forward-looking disclosures in an MD&A, such as those about planned capital expenditures, new store openings, or divestitures, can be useful in projecting a company’s future performance. However, the commentary is only one input for the analyst seeking an objective and independent perspective on a company’s performance and prospects.
Under international standards for auditing (ISAs), the objectives of an auditor in conducting an audit of financial statements are
- To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and
- To report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings.8
Quando são feitas auditorias às empresas a empresa que faz a auditoria emite uma opinião relativa ao conteúdo nos financial statment.
Os financial statment são classificados segundo 3 categorias….
An unqualified audit opinion states that the financial statements give a “true and fair view” (international) or are “fairly presented” (international and US) in accordance with applicable accounting standards. This is often referred to as a “clean” opinion and is the one that analysts would like to see in a financial report. There are several other types of opinions.
A qualified audit opinion is one in which there is some scope limitation or exception to accounting standards. Exceptions are described in the audit report with additional explanatory paragraphs so that the analyst can determine the importance of the exception.
An adverse audit opinion is issued when an auditor determines that the financial statements materially depart from accounting standards and are not fairly presented. An adverse opinion makes analysis of the financial statements easy: Do not bother analyzing these statements, because the company’s financial statements cannot be relied on.
“contra account.”
The estimated uncollectible amount is recorded in an account called allowance for bad debts. Because the effect of the allowance for bad debts account is to reduce the balance of the company’s accounts receivable, it is known as a “contra asset account.”
Any account that is offset or deducted from another account is called a “contra account.”
Endingretainedearnings
Endingretainedearnings
Assets
Equation (4a)
Endingretainedearnings=Beginningretainedearnings+ Netincome−Dividends
Or, substituting Equation 3 for Net income, equivalently:
Equation (4b)
Endingretainedearnings=Beginningretainedearnings+Revenues− Expenses−Dividends
This becomes the expanded accounting equation:
Equation (5a)
Assets = Liabilities + Contributed capital + Ending retained earnings
Or equivalently, substituting Equation 4b into Equation 5a, we can write:
Equation (5b)
Assets=Liabilities+Contributedcapital+Beginningretainedearnings+ Revenue−Expenses−Dividends
Accrual accounting
Accrual accounting requires that revenue be recorded when earned and that expenses be recorded when incurred, irrespective of when the related cash movements occur. The purpose of accrual entries is to report revenue and expense in the proper accounting period.
Accounting system:
Journal
Ledger
Trial Balance
Financial Statments
A journal is a document or computer file in which business transactions are recorded in the order in which they occur (chronological order). The general journal is the collection of all business transactions in an accounting system sorted by date. All accounting systems have a general journal to record all transactions. Some accounting systems also include special journals. For example, there may be one journal for recording sales transactions and another for recording inventory purchases.
A ledger is a document or computer file that shows all business transactions by account. Note that the general ledger, the core of every accounting system, contains all of the same entries as that posted to the general journal—the only difference is that the data are sorted by date in a journal and by account in the ledger. The general ledger is useful for reviewing all of the activity related to a single account. T-accounts, explained in Appendix 23, are representations of ledger accounts and are frequently used to describe or analyze accounting transactions.
A trial balance is a document that lists account balances at a particular point in time. Trial balances are typically prepared at the end of an accounting period as a first step in producing financial statements. A key difference between a trial balance and a ledger is that the trial balance shows only total ending balances. An initial trial balance assists in the identification of any adjusting entries that may be required. Once these adjusting entries are made, an adjusted trial balance can be prepared.
The financial statements, a final product of the accounting system, are prepared based on the account totals from an adjusted trial balance.
When, at the end of an accounting period, cash has not been paid with respect to an expense that has been incurred, the business should then record:
A.an accrued expense, an asset.
B.a prepaid expense, an asset.
C.an accrued expense, a liability.
- B is correct. Payment of expenses in advance is called a prepaid expense which is classified as an asset.
- C is correct. When an expense is incurred and no cash has been paid, expenses are increased and a liability (“accrued expense”) is established for the same amount.
When, at the end of an accounting period, cash has been paid with respect to an expense, the business should then record:
A.an accrued expense, an asset.
B.a prepaid expense, an asset.
C.an accrued expense, a liability.
•C is correct. When an expense is incurred and no cash has been paid, expenses are increased and a liability (“accrued expense”) is established for the same amount.
Long Term Contracts can be divided in accounting by
Under the percentage-of-completion method, in each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total
p.e: 50% of the cost on the first year means 50% of the revenue
Under the completed contract method, the company does not report any income until the contract is substantially finished (the remaining costs and potential risks are insignificant in amount), although provision should be made for expected losses. Billings and costs are accumulated on the balance sheet rather than flowing through the income statement.
UNDER IFRS and GAAP
Year 1. Under IFRS, Kolenda would recognize $3 million cost of construction, $3 million revenue, and thus $0 income. Under US GAAP, Kolenda would recognize $0 cost of construction, $0 revenue, and thus $0 income. The $3 million expenditure would be reported as an increase in the inventory account “construction in progress” and a decrease in cash.
Year 2. Under IFRS, Kolenda would recognize $2.4 million cost of construction, $2.4 million revenue, and thus $0 income. Under US GAAP, Kolenda would recognize $0 cost of construction, $0 revenue, and thus $0 income. The $2.4 million expenditures would be reported as an increase in the inventory account “construction in progress” and a decrease in cash.
Year 3. Under IFRS, Kolenda would recognize the $0.6 million cost of construction incurred in the period. Because the contract has been completed and the outcome is now measurable, the company would recognize the remaining $4.6 million revenue on the contract, and thus $4 million income. Under US GAAP, because the contract has been completed, Kolenda would recognize the total contract revenue (i.e., $10 million). Kolenda would recognize $6 million cost of construction and thus $4 million income. The inventory account “construction in progress” would be eliminated.
Installment Sales
sales in which proceeds are to be paid in installments over an extended period. For installment sales, IFRS separate the installments into the sale price, which is the discounted present value of the installment payments, and an interest component. Revenue attributable to the sale price is recognized at the date of sale, and revenue attributable to the interest component is recognized over time.
Under US GAAP, when the seller has completed the significant activities in the earnings process and is either assured of collecting the selling price or able to estimate amounts that will not be collected, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions.22 When those two conditions are not fully met, under US GAAP some of the profit is deferred. Two of the methods may be appropriate in these limited circumstances and relate to the amount of profit to be recognized each year from the transaction: the installment method and the cost recovery method. Under the installment method, the portion of the total profit of the sale that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash. Under the cost recovery method, the seller does not report any profit until the cash amounts paid by the buyer—including principal and interest on any financing from the seller—are greater than all the seller’s costs of the property. Note that the cost recovery method is similar to the revenue recognition method under international standards, described above, when the outcome of a contract cannot be measured reliably (although the term cost recovery method is not used in the international standard).
Expense Recognition
2 methods
Matching principle- as despesas que se podem relacionar diretamente com as vendas são declaradas no mesmo período que os revenue. p.e. Cost of goods
Period Costs- as despesas que não se podem relacionar diretamente com as vendas feitas são declaradas no período em que incorrem. (p.e. admistrative expenses)
Under US GAAP what can u consider an operating activitie?
Under US GAAP, operating activities generally involve producing and delivering goods and providing services and include all transactions and other events that are not defined as investing or financing activities
Specifically, under IFRS, interest and dividends received can be shown either as operating or as investing on the statement of cash flows, while under US GAAP interest and dividends received are shown as operating cash flows. Under IFRS, interest and dividends paid can be shown either as operating or as financing on the statement of cash flows, while under US GAAP, interest paid is shown as operating and dividends paid are shown as financing.)
Complex capital structure vs simple capital structure?
When a company has issued any financial instruments that are potentially convertible into common stock, it is said to have a complex capital structure. Examples of financial instruments that are potentially convertible into common stock include convertible bonds, convertible preferred stock, employee stock options, and warrants.48 If a company’s capital structure does not include such potentially convertible financial instruments, it is said to have a simple capital structure.
Diluted EPS vs Basic EPS
The distinction between simple versus complex capital structure is relevant to the calculation of EPS because financial instruments that are potentially convertible into common stock could, as a result of conversion or exercise, potentially dilute (i.e., decrease) EPS. Information about such a potential dilution is valuable to a company’s current and potential shareholders; therefore, accounting standards require companies to disclose what their EPS would be if all dilutive financial instruments were converted into common stock. The EPS that would result if all dilutive financial instruments were converted is called diluted EPS. In contrast, basic EPS is calculated using the reported earnings available to common shareholders of the parent company and the weighted average number of shares outstanding.
BasicEPS=
Netincome−PreferreddividendsWeightedaveragenumberofsharesoutstanding
The weighted average number of shares outstanding is a time weighting of common shares outstanding. For example, assume a company began the year with 2,000,000 common shares outstanding and repurchased 100,000 common shares on 1 July. The weighted average number of common shares outstanding would be the sum of 2,000,000 shares × 1/2 year + 1,900,000 shares × 1/2 year, or 1,950,000 shares. So the company would use 1,950,000 shares as the weighted average number of shares in calculating its basic EPS.
It is possible that some potentially convertible securities could be antidilutive
what is that?
By antidilutive means that basic EPS could be lower than diluted EPS.
Analysis of the income statment methods
Common Size analysis:
Neste método de análise colocamos os income statment lado a lado e calculamos os rácios para apreender de onde poderão vir as discrepâncias. Mais usado para comparar empresas do mesmo sector.
Income Statment ratios:
Profit Margin : net income/revenue,
gross profit margin….
Comparar indicadores e o porque dos indicadores subirem de ano para ano ou descerem.. mais profit? menos revenue? sustentável? etc…
Standard Setting Bodies Vs Regulatory Authorities
Standard Setting Bodies definem as regras que as regulatory authorities por sua vez vão legislar.
Objectives of securities Regulation
Protecting Investors
Ensuring that markets are fair, efficient and transparent
Reducing systemic risk
Neutrality of information in the financial statements most closely contributes to which qualitative characteristic?
A.Relevance.
B.Understandability.
C.Faithful representation.
C is correct. The fundamental qualitative characteristic of faithful representation is contributed to by completeness, neutrality, and freedom from error.
Standard Setting approach
Multi step format
Single step format
Multi step presents gross profit it is most common in manufacturing and merchandise companies.
Single step não representa o gross profit.
Qualitative Characteristics of financial reporting
RELEVANT FAITHFUL are the most important 2 comparability verifiability timeliness understandability
Financial statments assumptions
Accrued accounting
Going concern
Frameworks to be effective must be:
Transparent
Consistent
Comprehensive
6.2. Barriers to a Single Coherent Framework
- Valuation: As discussed, various bases for measuring the value of assets and liabilities exist, such as historical cost, current cost, fair value, realizable value, and present value. Historical cost valuation, under which an asset’s value is its initial cost, requires minimal judgment. In contrast, other valuation approaches, such as fair value, require considerable judgment but can provide more relevant information.
- Standard-Setting Approach: Financial reporting standards can be established based on 1) principles, 2) rules, or 3) a combination of principles and rules (sometimes referred to as “objectives oriented”). A principles-based approach provides a broad financial reporting framework with little specific guidance on how to report a particular element or transaction. Such principles-based approaches require the preparers of financial reports and auditors to exercise considerable judgment in financial reporting. In contrast, a rules-based approach establishes specific rules for each element or transaction. Rules-based approaches are characterized by a list of yes-or-no rules, specific numerical tests for classifying certain transactions (known as “bright line tests”), exceptions, and alternative treatments. Some suggest that rules are created in response to preparers’ needs for specific guidance in implementing principles, so even standards that begin purely as principles evolve into a combination of principles and rules. The third alternative, an objectives-oriented approach, combines the other two approaches by including both a framework of principles and appropriate levels of implementation guidance. The common conceptual framework is likely to be more objectives oriented.
- Measurement: The balance sheet presents elements at a point in time, whereas the income statement reflects changes during a period of time. Because these statements are related, standards regarding one of the statements have an effect on the other statement. Financial reporting standards can be established taking an “asset/liability” approach, which gives preference to proper valuation of the balance sheet, or a “revenue/expense” approach that focuses more on the income statement. This conflict can result in one statement being reported in a theoretically sound manner, but the other statement reflecting less relevant information. In recent years, standard setters have predominantly used an asset/liability approach.
During 2009, Argo Company sold 10 acres of prime commercial zoned land to a builder for $5,000,000. The builder gave Argo a $1,000,000 down payment and will pay the remaining balance of $4,000,000 to Argo in 2010. Argo purchased the land in 2002 for $2,000,000. Using the installment method, how much profit will Argo report for 2009?
A.$600,000.
B.$1,000,000.
C.$3,000,000.
A is correct. The installment method apportions the cash receipt between cost recovered and profit using the ratio of profit to sales value (i.e., $3,000,000 ÷ $5,000,000 = 60 percent). Argo will, therefore, recognize $600,000 in profit for 2009 ($1,000,000 cash received × 60 percent).
Fairplay had the following information related to the sale of its products during 2009, which was its first year of business:
Revenue$1,000,000Returns of goods sold$100,000Cash collected$800,000Cost of goods sold$700,000
Under the accrual basis of accounting, how much net revenue would be reported on Fairplay’s 2009 income statement?
A.$200,000.
B.$900,000.
C.$1,000,000.
B is correct. Net revenue is revenue for goods sold during the period less any returns and allowances, or $1,000,000 minus $100,000 = $900,000.
•For 2009, Flamingo Products had net income of $1,000,000. At 1 January 2009, there were 1,000,000 shares outstanding. On 1 July 2009, the company issued 100,000 new shares for $20 per share. The company paid $200,000 in dividends to common shareholders. What is Flamingo’s basic earnings per share for 2009?
A.$0.80.
B.$0.91.
C.$0.95.
•C is correct. The weighted average number of shares outstanding for 2009 is 1,050,000. Basic earnings per share would be $1,000,000 divided by 1,050,000, or $0.95.
•Cell Services Inc. (CSI) had 1,000,000 average shares outstanding during all of 2009. During 2009, CSI also had 10,000 options outstanding with exercise prices of $10 each. The average stock price of CSI during 2009 was $15. For purposes of computing diluted earnings per share, how many shares would be used in the denominator?
A.1,003,333.
B.1,006,667.
C.1,010,000.
•A is correct. With stock options, the treasury stock method must be used. Under that method, the company would receive $100,000 (10,000 × $10) and would repurchase 6,667 shares ($100,000/$15). The shares for the denominator would be:
Shares outstanding1,000,000Options exercises10,000Treasury shares purchased(6,667)Denominator1,003,333
working capital
The excess of current assets over current liabilities.
The level of working capital tells analysts something about the ability of an entity to meet liabilities as they fall due. Although adequate working capital is essential, working capital should not be too large because funds may be tied up that could be used more productively elsewhere.
Current Assets
Among the current assets’ required line items are cash and cash equivalents, trade and other receivables, inventories, and financial assets (with short maturities).
2 methods to price inventories
- Standard cost, which should take into account the normal levels of materials, labor, and actual capacity. The standard cost should be reviewed regularly to ensure that it approximates actual costs.
- The retail method in which the sales value is reduced by the gross margin to calculate cost. An average gross margin percentage should be used for each homogeneous group of items. In addition, the impact of marked-down prices should be taken into consideration.
deferred income/revenue
liability
arises when a company receives payment in advance of delivery of the goods and services associated with the payment. The company has an obligation either to provide the goods or services or to return the cash received.
.
Recoverable amount:
The higher of an asset’s fair value less cost to sell, and its value in use.
- Fair value less cost to sell: The amount obtainable in a sale of the asset in an arms-length transaction between knowledgeable willing parties, less the costs of the sale.
- Value in use: The present value of the future cash flows expected to be derived from the asset.
Models to price property in accounting
Cost Model Historical cost - depreciation
Fair value The amount obtainable in a sale of the asset in an arms-length transaction between knowledgeable willing parties, less the costs of the sale.
Why companies get bought for more than the fair value and there is goodwill?
Economic Goodwill vs Accounting Goodwill
First, as noted, certain items not recognized in a company’s own financial statements (e.g., its reputation, established distribution system, trained employees) have value.
Second, a target company’s expenditures in research and development may not have resulted in a separately identifiable asset that meets the criteria for recognition but nonetheless may have created some value.
Third, part of the value of an acquisition may arise from strategic positioning versus a competitor or from perceived synergies.
Analysts should distinguish between accounting goodwill and economic goodwill. Economic goodwill is based on the economic performance of the entity, whereas accounting goodwill is based on accounting standards and is reported only in the case of acquisitions. Economic goodwill is important to analysts and investors, and it is not necessarily reflected on the balance sheet. Instead, economic goodwill is reflected in the stock price (at least in theory). Some financial statement users believe that goodwill should not be listed on the balance sheet, because it cannot be sold separately from the entity. These financial statement users believe that only assets that can be separately identified and sold should be reflected on the balance sheet. Other financial statement users analyze goodwill and any subsequent impairment charges to assess management’s performance on prior acquisitions.
Financial Assets na contabilidade das empresas são medidos pelo
justo valor na maioria dos casos,
só são medidos pelo custo quando são held to maturity , titulos não cotados em que não se consegue estimar fair value e empréstimos a outras empresas.
Treasury shares
Shares in the company that have been repurchased by the company and are held as treasury shares, rather than being cancelled. The company is able to sell (reissue) these shares. A company may repurchase its shares when management considers the shares undervalued, needs shares to fulfill employees’ stock options, or wants to limit the effects of dilution from various employee stock compensation plans. A purchase of treasury shares reduces shareholders’ equity by the amount of the acquisition cost and reduces the number of total shares outstanding. If treasury shares are subsequently reissued, a company does not recognize any gain or loss from the reissuance on the income statement. Treasury shares are non-voting and do not receive any dividends declared by the company.
Money received from customers for products to be delivered in the future is recorded as:
A.revenue and an asset.
B.an asset and a liability.
C.revenue and a liability.
B is correct. The cash received from customers represents an asset. The obligation to provide a product in the future is a liability called “unearned income” or “unearned revenue.” As the product is delivered, revenue will be recognized and the liability will be reduced.
Differences between IFRS and GAAP on CF
IFRS is more flexible.
Classification of cash flows:
◾Interest receivedOperating or investingOperating
◾Interest paidOperating or financingOperating
◾Dividends receivedOperating or investingOperating
◾Dividends paidOperating or financingFinancing
◾Bank overdraftsConsidered part of cash equivalentsNot considered part of cash and cash equivalents and classified as financing
◾Taxes paidGenerally operating, but a portion can be allocated to investing or financing if it can be specifically identified with these categories OperatingFormat of statementDirect or indirect; direct is encouragedDirect or indirect; direct is encouraged. A reconciliation of net income to cash flow from operating activities must be provided regardless of method used
Direct and Indirect Methods for Reporting Cash Flow from Operating Activities
The direct method shows the specific cash inflows and outflows that result in reported cash flow from operating activities. It shows each cash inflow and outflow related to a company’s cash receipts and disbursements. In other words, the direct method eliminates any impact of accruals and shows only cash receipts and cash payments. The primary argument in favor of the direct method is that it provides information on the specific sources of operating cash receipts and payments. This is in contrast to the indirect method, which shows only the net result of these receipts and payments. Just as information on the specific sources of revenues and expenses is more useful than knowing only the net result—net income—the analyst gets additional information from a direct-format cash flow statement. The additional information is useful in understanding historical performance and in predicting future operating cash flows.
The indirect method shows how cash flow from operations can be obtained from reported net income as the result of a series of adjustments. The indirect format begins with net income. To reconcile net income with operating cash flow, adjustments are made for non-cash items, for non-operating items, and for the net changes in operating accruals. The main argument for the indirect approach is that it shows the reasons for differences between net income and operating cash flows. (However, the differences between net income and operating cash flows are equally visible on an indirect-format cash flow statement and in the supplementary reconciliation required under US GAAP if the company uses the direct method.) Another argument for the indirect method is that it mirrors a forecasting approach that begins by forecasting future income and then derives cash flows by adjusting for changes in balance sheet accounts that occur because of the timing differences between accrual and cash accounting.
Como conciliar Balance Sheet com income statment para calcular CF statment?
p.e.
Initial Account Receivables (Balanc 0)+ Revenues (Inc Stat)- Cash collected from customers (CF)= Ending Acc receiv (Balanc 1)
Blue Bayou, a fictitious advertising company, reported revenues of $50 million, total expenses of $35 million, and net income of $15 million in the most recent year. If accounts receivable decreased by $12 million, how much cash did the company receive from customers?
A.$38 million.
B.$50 million.
C.$62 million.
C is correct. Revenues of $50 million plus the decrease in accounts receivable of $12 million equals $62 million cash received from customers. The decrease in accounts receivable means that the company received more in cash than the amount of revenue it reported.
Orange Beverages Plc., a fictitious manufacturer of tropical drinks, reported cost of goods sold for the year of $100 million. Total assets increased by $55 million, but inventory declined by $6 million. Total liabilities increased by $45 million, but accounts payable decreased by $2 million. How much cash did the company pay to its suppliers during the year?
A.$96 million.
B.$104 million.
C.$108 million.
A is correct. Cost of goods sold of $100 million less the decrease in inventory of $6 million equals purchases from suppliers of $94 million. The decrease in accounts payable of $2 million means that the company paid $96 million in cash ($94 million plus $2 million).
Black Ice, a fictitious sportswear manufacturer, reported other operating expenses of $30 million. Prepaid insurance expense increased by $4 million, and accrued utilities payable decreased by $7 million. Insurance and utilities are the only two components of other operating expenses. How much cash did the company pay in other operating expenses?
A.$19 million.
B.$33 million.
C.$41 million.
C is correct. Other operating expenses of $30 million plus the increase in prepaid insurance expense of $4 million plus the decrease in accrued utilities payable of $7 million equals $41 million.
Copper, Inc., a fictitious brewery and restaurant chain, reported a gain on the sale of equipment of $12 million. In addition, the company’s income statement shows depreciation expense of $8 million and the cash flow statement shows capital expenditure of $15 million, all of which was for the purchase of new equipment.
Balance sheet item
12/31/2009
12/31/2010
Change
Equipment$100 million$109 million$9 millionAccumulated depreciation—equipment$30 million$36 million$6 million
Using the above information from the comparative balance sheets, how much cash did the company receive from the equipment sale?
A.$12 million.
B.$16 million.
C.$18 million.
Solution:
B is correct. Selling price (cash inflow) minus book value equals gain or loss on sale; therefore, gain or loss on sale plus book value equals selling price (cash inflow). The amount of gain is given, $12 million. To calculate the book value of the equipment sold, find the historical cost of the equipment and the accumulated depreciation on the equipment.
◾Beginning balance of equipment of $100 million plus equipment purchased of $15 million minus ending balance of equipment of $109 million equals historical cost of equipment sold, or $6 million.
◾Beginning accumulated depreciation on equipment of $30 million plus depreciation expense for the year of $8 million minus ending balance of accumulated depreciation of $36 million equals accumulated depreciation on the equipment sold, or $2 million.
◾Therefore, the book value of the equipment sold was $6 million minus $2 million, or $4 million.
◾Because the gain on the sale of equipment was $12 million, the amount of cash received must have been $16 million.
Net income vs Operating CF
Operating CF what to consider
Turning to the operating section, the analysts should examine the most significant determinants of operating cash flow. Companies need cash for use in operations (for example, to hold receivables and inventory and to pay employees and suppliers) and receive cash from operating activities (for example, payments from customers). Under the indirect method, the increases and decreases in receivables, inventory, payables, and so on can be examined to determine whether the company is using or generating cash in operations and why. It is also useful to compare operating cash flow with net income. For a mature company, because net income includes non-cash expenses (depreciation and amortisation), it is expected and desirable that operating cash flow exceeds net income. The relationship between net income and operating cash flow is also an indicator of earnings quality. If a company has large net income but poor operating cash flow, it may be a sign of poor earnings quality. The company may be making aggressive accounting choices to increase net income but not be generating cash for its business. You should also examine the variability of both earnings and cash flow and consider the impact of this variability on the company’s risk as well as the ability to forecast future cash flows for valuation purposes. In summary:
◾What are the major determinants of operating cash flow?
◾Is operating cash flow higher or lower than net income? Why?
◾How consistent are operating cash flows?
Investing CF
What you should see on it?
Within the investing section, you should evaluate each line item. Each line item represents either a source or use of cash. This enables you to understand where the cash is being spent (or received). This section will tell you how much cash is being invested for the future in property, plant, and equipment; how much is used to acquire entire companies; and how much is put aside in liquid investments, such as stocks and bonds. It will also tell you how much cash is being raised by selling these types of assets. If the company is making major capital investments, you should consider where the cash is coming from to cover these investments (e.g., is the cash coming from excess operating cash flow or from the financing activities described in Step 4). If assets are being sold, it is important to determine why and to assess the effects on the company.
Financing CF
What you should see on it?
Within the financing section, you should examine each line item to understand whether the company is raising capital or repaying capital and what the nature of its capital sources are. If the company is borrowing each year, you should consider when repayment may be required. This section will also present dividend payments and repurchases of stock that are alternative means of returning capital to owners. It is important to assess why capital is being raised or repaid.
We now provide an example of a cash flow statement evaluation.
Common Size analysis units expressed
Common size analysis is usefull in CF analysis:
This method is also useful to the analyst in forecasting future cash flows because individual items in the common-size statement (e.g., depreciation, fixed capital expenditures, debt borrowing, and repayment) are expressed as a percentage of net revenue. Thus, once the analyst has forecast revenue, the common-size statement provides a basis for forecasting cash flows for those items with an expected relation to net revenue.
In common-size analysis of a company’s income statement, each income and expense line item is expressed as a percentage of net revenues (net sales). For the common-size balance sheet, each asset, liability, and equity line item is expressed as a percentage of total assets. For the common-size cash flow statement, there are two alternative approaches. The first approach is to express each line item of cash inflow (outflow) as a percentage of total inflows (outflows) of cash, and the second approach is to express each line item as a percentage of net revenue.
An analyst gathered the following information from a company’s 2010 financial statements (in $ millions):
Balances as of Year Ended 31 December
2009
2010
Retained earnings120145Accounts receivable3843Inventory4548Accounts payable3629
In 2010, the company declared and paid cash dividends of $10 million and recorded depreciation expense in the amount of $25 million. The company considers dividends paid a financing activity. The company’s 2010 cash flow from operations (in $ millions) was closest to
A.25.
B.45.
C.75.
B is correct. All dollar amounts are in millions. Net income (NI) for 2010 is $35. This amount is the increase in retained earnings, $25, plus the dividends paid, $10. Depreciation of $25 is added back to net income, and the increases in accounts receivable, $5, and in inventory, $3, are subtracted from net income because they are uses of cash. The decrease in accounts payable is also a use of cash and, therefore, a subtraction from net income. Thus, cash flow from operations is $25 + $10 + $25 – $5 – $3 – $7 = $45.
Cash flows from taxes on income must be separately disclosed under:
A.IFRS only.
B.US GAAP only.
C.both IFRS and US GAAP.
C is correct. Taxes on income are required to be separately disclosed under IFRS and US GAAP. The disclosure may be in the cash flow statement or elsewhere.
Green Glory Corp., a garden supply wholesaler, reported cost of goods sold for the year of $80 million. Total assets increased by $55 million, including an increase of $5 million in inventory. Total liabilities increased by $45 million, including an increase of $2 million in accounts payable. The cash paid by the company to its suppliers is most likely closest to:
A.$73 million.
B.$77 million.
C.$83 million.
C is correct. Cost of goods sold of $80 million plus the increase in inventory of $5 million equals purchases from suppliers of $85 million. The increase in accounts payable of $2 million means that the company paid $83 million in cash ($85 million minus $2 million) to its suppliers.
An analyst gathered the following information from a company’s 2010 financial statements (in $ millions):
Balances as of Year Ended 31 December
2009
2010 Retained earnings 120 145 Accounts receivable 38 43 Inventory 45 48 Accounts payable 36 29
In 2010, the company declared and paid cash dividends of $10 million and recorded depreciation expense in the amount of $25 million. The company considers dividends paid a financing activity. The company’s 2010 cash flow from operations (in $ millions) was closest to
A.25.
B.45.
C.75.
B is correct. All dollar amounts are in millions. Net income (NI) for 2010 is $35. This amount is the increase in retained earnings, $25, plus the dividends paid, $10. Depreciation of $25 is added back to net income, and the increases in accounts receivable, $5, and in inventory, $3, are subtracted from net income because they are uses of cash. The decrease in accounts payable is also a use of cash and, therefore, a subtraction from net income. Thus, cash flow from operations is $25 + $10 + $25 – $5 – $3 – $7 = $45.
Silverago Incorporated, an international metals company, reported a loss on the sale of equipment of $2 million in 2010. In addition, the company’s income statement shows depreciation expense of $8 million and the cash flow statement shows capital expenditure of $10 million, all of which was for the purchase of new equipment. Using the following information from the comparative balance sheets, how much cash did the company receive from the equipment sale?
Balance Sheet Item
12/31/2009
12/31/2010
Change
Equipment $100 M $105M $5M
Acc Depreciat$40M $46M $6 M
A.$1 million.
B.$2 million.
C.$3 million.
A is correct. Selling price (cash inflow) minus book value equals gain or loss on sale; therefore, gain or loss on sale plus book value equals selling price (cash inflow). The amount of loss is given—$2 million. To calculate the book value of the equipment sold, find the historical cost of the equipment and the accumulated depreciation on the equipment.
◾Beginning balance of equipment of $100 million plus equipment purchased of $10 million minus ending balance of equipment of $105 million equals the historical cost of equipment sold, or $5 million.
◾Beginning accumulated depreciation of $40 million plus depreciation expense for the year of $8 million minus ending balance of accumulated depreciation of $46 million equals accumulated depreciation on the equipment sold, or $2 million.
◾Therefore, the book value of the equipment sold was $5 million minus $2 million, or $3 million.
◾Because the loss on the sale of equipment was $2 million, the amount of cash received must have been $1 million.
Equity analysis vs Credit Analysis
In this 2 types of analysis what is the main focus on each one?
Equity analysis usually places a greater emphasis on growth, whereas credit analysis usually places a greater emphasis on risks
Financial Statement Analysis Framework
Quais são as 6 fases para o processo de análise?
1- Articulate the purpose and context of the analysis
2- collect input data
3- process data
4- analyze/interpret the processed data
5- Develop and communicate conclusions and recommendations
6- follow up
A vertical5 common-size balance sheet
e horizontal common size balance sheet?
A vertical só tem um período enquanto que a horizontal tem mais períodos para comparar.
Trend Analysis
o que é?
When looking at financial statements and ratios, trends in the data, whether they are improving or deteriorating, are as important as the current absolute or relative levels. Trend analysis provides important information regarding historical performance and growth and, given a sufficiently long history of accurate seasonal information, can be of great assistance as a planning and forecasting tool for management and analysts
As another example, consider the following year-over-year percentage changes for a hypothetical company:
Revenue+20%
Net income+25%
Operating cash flow–10%
Total assets+30%
o que podemos à partida analisar desta empresa?
Net income is growing faster than revenue, which indicates increasing profitability. However, the analyst would need to determine whether the faster growth in net income resulted from continuing operations or from non-operating, non-recurring items. In addition, the 10 percent decline in operating cash flow despite increasing revenue and net income clearly warrants further investigation because it could indicate a problem with earnings quality (perhaps aggressive reporting of revenue). Lastly, the fact that assets have grown faster than revenue indicates the company’s efficiency may be declining. The analyst should examine the composition of the increase in assets and the reasons for the changes.
Common Ratios used in financial analysis categories:
Activity ratios measure how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory.
Liquidity ratios measure the company’s ability to meet its short-term obligations.
Solvency ratios measure a company’s ability to meet long-term obligations. Subsets of these ratios are also known as “leverage” and “long-term debt” ratios.
Profitability ratios measure the company’s ability to generate profits from its resources (assets).
Valuation ratios measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specified claim (e.g., a share or ownership of the enterprise).
O que é a Análise de Dupont?
É a decomposição do ROE nas suas três vertentes e posterior análise para saber o que afeta os resultados.
Pelas fórmulas é facilmente deduzido que:
ROE = ROA × Leverage
A company can improve its ROE by improving ROA or making more effective use of leverage. Consistent with the definition given earlier, leverage is measured as average total assets divided by average shareholders’ equity. If a company had no leverage (no liabilities), its leverage ratio would equal 1.0 and ROE would exactly equal ROA.
As tres componentes do ROE é a Margem o volume de vendas e a leverage
ROE = Net profit margin × Total asset turnover × Leverage
Net profit margin - Netincome/Revenue (profitability)
Total Asset Turnover - Revenue/Averagetotalassets (efficiency)
Leverage - Averagetotalassets/Averageshareholders’equity (alavancagem)
Taxa de crescimento sustentável de uma empresa é..?
Taxa de retenção * ROE
Como interpretar P/B ?
Another price-based ratio that facilitates useful comparisons of companies’ stock prices is price to book value, or P/B, which is the ratio of price to book value per share. This ratio is often interpreted as an indicator of market judgment about the relationship between a company’s required rate of return and its actual rate of return. Assuming that book values reflect the fair values of the assets, a price to book ratio of one can be interpreted as an indicator that the company’s future returns are expected to be exactly equal to the returns required by the market. A ratio greater than one would indicate that the future profitability of the company is expected to exceed the required rate of return, and values of this ratio less than one indicate that the company is not expected to earn excess returns.1
Estudos que relacionam os rácios com a qualidade crediticia das empresas.
One of the earliest studies examined individual ratios to assess their ability to predict failure of a company up to five years in advance. Beaver (1967) found that six ratios could correctly predict company failure one year in advance 90 percent of the time and five years in advance at least 65 percent of the time. The ratios found effective by Beaver were cash flow to total debt, ROA, total debt to total assets, working capital to total assets, the current ratio, and the no-credit interval ratio (the length of time a company could go without borrowing). Altman (1968) and Altman, Haldeman, and Narayanan (1977) found that financial ratios could be combined in an effective model for predicting bankruptcy. Altman’s initial work involved creation of a Z-score that was able to correctly predict financial distress. The Z-score was computed as
Z= 1.2 × (Current assets – Current liabilities)/Total assets + 1.4 × (Retained earnings/Total assets) + 3.3 × (EBIT/Total assets) + 0.6 × (Market value of stock/Book value of liabilities) + 1.0 × (Sales/Total assets)
In his initial study, a Z-score of lower than 1.81 predicted failure and the model was able to accurately classify 95 percent of companies studied into a failure group and a non-failure group. The original model was designed for manufacturing companies. Subsequent refinements to the models allow for other company types and time periods. Generally, the variables found to be useful in prediction include profitability ratios, coverage ratios, liquidity ratios, capitalization ratios, and earnings variability (Altman 2000).
A empresa deve reportar como disclosure o facto de mais de X% das suas vendas estarem dependentes de um cliente, sendo que X é :
10%
Periodical vs Perpetual Inventory system
Companies typically record changes to inventory in one of two ways. Under a periodic inventory system, a company determines the quantity of inventory on hand periodically. Purchases are recorded in a purchases account. The total of purchases and beginning inventory is the amount of goods available for sale during the period. The ending inventory amount is subtracted from the goods available for sale to arrive at the cost of sales. The quantity of goods in ending inventory is usually obtained or verified through a physical count of the units in inventory. Under a perpetual inventory system, changes in the inventory account are continuously updated. Purchases and sales of goods are recorded directly in inventory as they occur.
The use of periodic versus perpetual inventory systems will arrive at the same values for cost of sales and ending inventory using the specific identification and FIFO methods of inventory valuation. The choice of system, however, will potentially affect the ending inventory and cost of sales when either the LIFO or weighted average cost method is used. Example 3 illustrates the impact of the choice of system under LIFO.
Three ratios often used to evaluate the efficiency and effectiveness of inventory management
are inventory turnover, days of inventory on hand (DOH), and gross profit margin.12
The total cost of inventories comprises ….
comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Storage costs of finished inventory and abnormal costs due to waste are typically treated as expenses in the period in which they occurred.
Liquidity Ratios
Current Ratio
This ratio expresses current assets in relation to current liabilities. A higher ratio indicates a higher level of liquidity (i.e., a greater ability to meet short-term obligations). A current ratio of 1.0 would indicate that the book value of its current assets exactly equals the book value of its current liabilities.
A lower ratio indicates less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short-term obligations. Liquidity affects the company’s capacity to take on debt. The current ratio implicitly assumes that inventories and accounts receivable are indeed liquid (which is presumably not the case when related turnover ratios are low).
Quick Ratio
The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets (sometimes referred to as “quick assets”) in relation to current liabilities. Like the current ratio, a higher quick ratio indicates greater liquidity.
The quick ratio reflects the fact that certain current assets—such as prepaid expenses, some taxes, and employee-related prepayments—represent costs of the current period that have been paid in advance and cannot usually be converted back into cash. This ratio also reflects the fact that inventory might not be easily and quickly converted into cash, and furthermore, that a company would probably not be able to sell all of its inventory for an amount equal to its carrying value, especially if it were required to sell the inventory quickly. In situations where inventories are illiquid (as indicated, for example, by low inventory turnover ratios), the quick ratio may be a better indicator of liquidity than is the current ratio.
Cash Ratio
The cash ratio normally represents a reliable measure of an entity’s liquidity in a crisis situation. Only highly marketable short-term investments and cash are included. In a general market crisis, the fair value of marketable securities could decrease significantly as a result of market factors, in which case even this ratio might not provide reliable information.
Defensive Interval Ratio
This ratio measures how long the company can continue to pay its expenses from its existing liquid assets without receiving any additional cash inflow. A defensive interval ratio of 50 would indicate that the company can continue to pay its operating expenses for 50 days before running out of quick assets, assuming no additional cash inflows. A higher defensive interval ratio indicates greater liquidity. If a company’s defensive interval ratio is very low relative to peer companies or to the company’s own history, the analyst would want to ascertain whether there is sufficient cash inflow expected to mitigate the low defensive interval ratio.
Cash Conversion Cycle (Net Operating Cycle)
This metric indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash. In the typical course of events, a merchandising company acquires inventory on credit, incurring accounts payable. The company then sells that inventory on credit, increasing accounts receivable. Afterwards, it pays out cash to settle its accounts payable, and it collects cash in settlement of its accounts receivable. The time between the outlay of cash and the collection of cash is called the “cash conversion cycle.” A shorter cash conversion cycle indicates greater liquidity. A short cash conversion cycle implies that the company only needs to finance its inventory and accounts receivable for a short period of time. A longer cash conversion cycle indicates lower liquidity; it implies that the company must finance its inventory and accounts receivable for a longer period of time, possibly indicating a need for a higher level of capital to fund current assets. Example 9 demonstrates the advantages of a short cash conversion cycle as well as how a company’s business strategies are reflected in financial ratios.
In order to assess a company’s ability to fulfill its long-term obligations, an analyst would most likely examine:
A.activity ratios.
B.liquidity ratios.
C.solvency ratios.
C is correct. Solvency ratios are used to evaluate the ability of a company to meet its long-term obligations. An analyst is more likely to use activity ratios to evaluate how efficiently a company uses its assets. An analyst is more likely to use liquidity ratios to evaluate the ability of a company to meet its short-term obligations.
Which of the following ratios would be most useful in determining a company’s ability to cover its lease and interest payments?
A.ROA.
B.Total asset turnover.
C.Fixed charge coverage.
C is correct. The fixed charge coverage ratio is a coverage ratio that relates known fixed charges or obligations to a measure of operating profit or cash flow generated by the company. Coverage ratios, a category of solvency ratios, measure the ability of a company to cover its payments related to debt and leases.
An analyst observes a decrease in a company’s inventory turnover. Which of the following would most likely explain this trend?
A.The company installed a new inventory management system, allowing more efficient inventory management.
B.Due to problems with obsolescent inventory last year, the company wrote off a large amount of its inventory at the beginning of the period.
C.The company installed a new inventory management system but experienced some operational difficulties resulting in duplicate orders being placed with suppliers.
C is correct. The company’s problems with its inventory management system causing duplicate orders would likely result in a higher amount of inventory and would, therefore, result in a decrease in inventory turnover. A more efficient inventory management system and a write off of inventory at the beginning of the period would both likely decrease the average inventory for the period (the denominator of the inventory turnover ratio), thus increasing the ratio rather than decreasing it.
Which of the following would best explain an increase in receivables turnover?
A.The company adopted new credit policies last year and began offering credit to customers with weak credit histories.
B.Due to problems with an error in its old credit scoring system, the company had accumulated a substantial amount of uncollectible accounts and wrote off a large amount of its receivables.
C.To match the terms offered by its closest competitor, the company adopted new payment terms now requiring net payment within 30 days rather than 15 days, which had been its previous requirement.
B is correct. A write off of receivables would decrease the average amount of accounts receivable (the denominator of the receivables turnover ratio), thus increasing this ratio. Customers with weaker credit are more likely to make payments more slowly or to pose collection difficulties, which would likely increase the average amount of accounts receivable and thus decrease receivables turnover. Longer payment terms would likely increase the average amount of accounts receivable and thus decrease receivables turnover.
Brown Corporation had average days of sales outstanding of 19 days in the most recent fiscal year. Brown wants to improve its credit policies and collection practices and decrease its collection period in the next fiscal year to match the industry average of 15 days. Credit sales in the most recent fiscal year were $300 million, and Brown expects credit sales to increase to $390 million in the next fiscal year. To achieve Brown’s goal of decreasing the collection period, the change in the average accounts receivable balance that must occur is closest to:
A.+$0.41 million.
B.–$0.41 million.
C.–$1.22 million.
A is correct. The average accounts receivable balances (actual and desired) must be calculated to determine the desired change. The average accounts receivable balance can be calculated as an average day’s credit sales times the DSO. For the most recent fiscal year, the average accounts receivable balance is $15.62 million [= ($300,000,000/365) × 19]. The desired average accounts receivable balance for the next fiscal year is $16.03 million (= ($390,000,000/365) × 15). This is an increase of $0.41 million (= 16.03 million – 15.62 million). An alternative approach is to calculate the turnover and divide sales by turnover to determine the average accounts receivable balance. Turnover equals 365 divided by DSO. Turnover is 19.21 (= 365/19) for the most recent fiscal year and is targeted to be 24.33 (= 365/15) for the next fiscal year. The average accounts receivable balances are $15.62 million (= $300,000,000/19.21), and $16.03 million (= $390,000,000/24.33). The change is an increase in receivables of $0.41 million
The company’s total assets at year-end FY9 were GBP 3,500 million. Which of the following choices best describes reasonable conclusions an analyst might make about the company’s efficiency?
A.Comparing FY14 with FY10, the company’s efficiency improved, as indicated by a total asset turnover ratio of 0.86 compared with 0.64.
B.Comparing FY14 with FY10, the company’s efficiency deteriorated, as indicated by its current ratio.
C.Comparing FY14 with FY10, the company’s efficiency deteriorated due to asset growth faster than turnover revenue growth.
C is correct. The company’s efficiency deteriorated, as indicated by the decline in its total asset turnover ratio from 1.11 {= 4,390/[(4,384 + 3,500)/2]} for FY10 to 0.87 {= 11,366/[(12,250 + 13,799)/2]} for FY14. The decline in the total asset turnover ratio resulted from an increase in average total assets from GBP3,942 [= (4,384 + 3,500)/2] for FY10 to GBP13,024.5 for FY14, an increase of 230 percent, compared with an increase in revenue from GBP4,390 in FY10 to GBP11,366 in FY14, an increase of only 159 percent. The current ratio is not an indicator of efficiency.
Which of the following choices best describes reasonable conclusions an analyst might make about the company’s solvency?
A.Comparing FY14 with FY10, the company’s solvency improved, as indicated by an increase in its debt-to-assets ratio from 0.14 to 0.27.
B.Comparing FY14 with FY10, the company’s solvency deteriorated, as indicated by a decrease in interest coverage from 10.6 to 8.4.
B is correct. Comparing FY14 with FY10, the company’s solvency deteriorated, as indicated by a decrease in interest coverage from 10.6 (= 844/80) in FY10 to 8.4 (= 1,579/188) in FY14. The debt-to-asset ratio increased from 0.14 (= 602/4,384) in FY10 to 0.27 (= 3,707/13,799) in FY14. This is also indicative of deteriorating solvency. In isolation, the amount of profits does not provide enough information to assess solvency.
Which of the following choices best describes reasonable conclusions an analyst might make about the company’s liquidity?
A.Comparing FY14 with FY10, the company’s liquidity improved, as indicated by an increase in its debt-to-assets ratio from 0.14 to 0.27.
B.Comparing FY14 with FY10, the company’s liquidity deteriorated, as indicated by a decrease in interest coverage from 10.6 to 8.4.
C.Comparing FY14 with FY10, the company’s liquidity improved, as indicated by an increase in its current ratio from 0.71 to 0.75.
C is correct. Comparing FY14 with FY10, the company’s liquidity improved, as indicated by an increase in its current ratio from 0.71 [= (316 + 558)/1,223] in FY10 to 0.75 [= (682 + 1,634)/3,108] in FY14. Note, however, comparing only current investments with the level of current liabilities shows a decline in liquidity from 0.26 (= 316/1,223) in FY10 to 0.22 (= 682/3,108) in FY14. Debt-to-assets ratio and interest coverage are measures of solvency not liquidity.
An analyst compiles the following data for a company:
FY13
FY14
FY15 ROE 19.8% 20.0% 22.0% Return on total assets8.1% 8.0% 7.9% Total asset turnover 2.0 2.0 2.1
Based only on the information above, the most appropriate conclusion is that, over the period FY13 to FY15, the company’s:
A.net profit margin and financial leverage have decreased.
B.net profit margin and financial leverage have increased.
C.net profit margin has decreased but its financial leverage has increased.
C is correct. The company’s net profit margin has decreased and its financial leverage has increased. ROA = Net profit margin × Total asset turnover. ROA decreased over the period despite the increase in total asset turnover; therefore, the net profit margin must have decreased.
What does the P/E ratio measure?
A.The “multiple” that the stock market places on a company’s EPS.
B.The relationship between dividends and market prices.
C.The earnings for one common share of stock.
A is correct. The P/E ratio measures the “multiple” that the stock market places on a company’s EPS.
Inventory cost is least likely to include:
A.production-related storage costs.
B.costs incurred as a result of normal waste of materials.
C.transportation costs of shipping inventory to customers.
C is correct. Transportation costs incurred to ship inventory to customers are an expense and may not be capitalized in inventory. (Transportation costs incurred to bring inventory to the business location can be capitalized in inventory.) Storage costs required as part of production, as well as costs incurred as a result of normal waste of materials, can be capitalized in inventory. (Costs incurred as a result of abnormal waste must be expensed.)
Carrying inventory at a value above its historical cost would most likely be permitted if:
A.the inventory was held by a producer of agricultural products.
B.financial statements were prepared using US GAAP.
C.the change resulted from a reversal of a previous write-down.
•A is correct. IFRS allow the inventories of producers and dealers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products to be carried at net realisable value even if above historical cost. (US GAAP treatment is similar.)
Eric’s Used Book Store prepares its financial statements in accordance with IFRS. Inventory was purchased for £1 million and later marked down to £550,000. One of the books, however, was later discovered to be a rare collectible item, and the inventory is now worth an estimated £3 million. The inventory is most likely reported on the balance sheet at:
A.£550,000.
B.£1,000,000.
C.£3,000,000.
•B is correct. Under IFRS, the reversal of write-downs is required if net realisable value increases. The inventory will be reported on the balance sheet at £1,000,000. The inventory is reported at the lower of cost or net realisable value. Under US GAAP, inventory is carried at the lower of cost or market value. After a write-down, a new cost basis is determined and additional revisions may only reduce the value further. The reversal of write-downs is not permitted.
Zimt AG started business in 2007 and uses the FIFO method. During 2007, it purchased 45,000 units of inventory at €10 each and sold 40,000 units for €20 each. In 2008, it purchased another 50,000 units at €11 each and sold 45,000 units for €22 each. Its 2008 ending inventory balance (€ thousands) was closest to:
A.€105.
B.€109.
C.€110.
•C is correct. Zimt uses the FIFO method, and thus the first 5,000 units sold in 2008 depleted the 2007 inventory. Of the inventory purchased in 2008, 40,000 units were sold and 10,000 remain, valued at €11 each, for a total of €110,000.
Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices, the cost of sales reported by:
A.Zimt is too low.
B.Nutmeg is too low.
C.Nutmeg is too high.
•A is correct. Zimt uses the FIFO method, so its cost of sales represents units purchased at a (no longer available) lower price. Nutmeg uses the LIFO method, so its cost of sales is approximately equal to the current replacement cost of inventory.
Like many technology companies, TechnoTools operates in an environment of declining prices. Its reported profits will tend to be highest if it accounts for inventory using the:
A.FIFO method.
B.LIFO method.
C.weighted average cost method.
B is correct. In a declining price environment, the newest inventory is the lowest-cost inventory. In such circumstances, using the LIFO method (selling the newer, cheaper inventory first) will result in lower cost of sales and higher profit.
Zimt AG wrote down the value of its inventory in 2007 and reversed the write-down in 2008. Compared to the ratios that would have been calculated if the write-down had never occurred, Zimt’s reported 2007:
A.current ratio was too high.
B.gross margin was too high.
C.inventory turnover was too high.
•C is correct. The write-down reduced the value of inventory and increased cost of sales in 2007. The higher numerator and lower denominator mean that the inventory turnover ratio as reported was too high. Gross margin and the current ratio were both too low.
Zimt AG wrote down the value of its inventory in 2007 and reversed the write-down in 2008. Compared to the results the company would have reported if the write-down had never occurred, Zimt’s reported 2008:
A.profit was overstated.
B.cash flow from operations was overstated.
C.year-end inventory balance was overstated.
•A is correct. The reversal of the write-down shifted cost of sales from 2008 to 2007. The 2007 cost of sales was higher because of the write-down, and the 2008 cost of sales was lower because of the reversal of the write-down. As a result, the reported 2008 profits were overstated. Inventory balance in 2008 is the same because the write-down and reversal cancel each other out. Cash flow from operations is not affected by the non-cash write-down, but the higher profits in 2008 likely resulted in higher taxes and thus lower cash flow from operations.
Compared to a company that uses the FIFO method, during periods of rising prices a company that uses the LIFO method will most likely appear more:
A.liquid.
B.efficient.
C.profitable.
•B is correct. LIFO will result in lower inventory and higher cost of sales. Gross margin (a profitability ratio) will be lower, the current ratio (a liquidity ratio) will be lower, and inventory turnover (an efficiency ratio) will be higher.
Nutmeg, Inc. uses the LIFO method to account for inventory. During years in which inventory unit costs are generally rising and in which the company purchases more inventory than it sells to customers, its reported gross profit margin will most likely be:
A.lower than it would be if the company used the FIFO method.
B.higher than it would be if the company used the FIFO method.
C.about the same as it would be if the company used the FIFO method.
A is correct. LIFO will result in lower inventory and higher cost of sales in periods of rising costs compared to FIFO. Consequently, LIFO results in a lower gross profit margin than FIFO.
Carey Company adheres to US GAAP, whereas Jonathan Company adheres to IFRS. It is least likely that:
A.Carey has reversed an inventory write-down.
B.Jonathan has reversed an inventory write-down.
C.Jonathan and Carey both use the FIFO inventory accounting method.
A is correct. US GAAP do not permit inventory write-downs to be reversed.
What is the most likely justification for Century Chocolate’s choice of inventory valuation method for its finished goods?
A.It is the preferred method under IFRS.
B.It allocates the same per unit cost to both cost of sales and inventory.
C.Ending inventory reflects the cost of goods purchased most recently.
C is correct. The carrying amount of inventories under FIFO will more closely reflect current replacement values because inventories are assumed to consist of the most recently purchased items. FIFO is an acceptable, but not preferred, method under IFRS. Weighted average cost, not FIFO, is the cost formula that allocates the same per unit cost to both cost of sales and inventory.
Annan’s statement regarding the perpetual and periodic inventory systems is most significant when which of the following costing systems is used?
A.LIFO.
B.FIFO.
C.Specific identification.
A is correct. The carrying amount of the ending inventory may differ because the perpetual system will apply LIFO continuously throughout the year, liquidating layers as sales are made. Under the periodic system, the sales will start from the last layer in the year. Under FIFO, the sales will occur from the same layers regardless of whether a perpetual or periodic system is used. Specific identification identifies the actual products sold and remaining in inventory, and there will be no difference under a perpetual or periodic system.
A noção de expense e capitalization para fixed assets é importante. Todos os custos para colocar um equipamento operacional, como reforços do chão para, equipa para colocar o equipamento devems ser considerados como…?
devem ser capitalizados visto que tudo o que é custo necessário para colocar a máquina a funcionar é considerado como custo capitalizado e não é reconhecida de imediato a despesa, contudo se também contratasse uma equipa para a manutenção já seria despesa porque não é necessária para começar a funcionar.
BILDA S.A., a hypothetical company, borrows €1,000,000 at an interest rate of 10 percent per year on 1 January 2010 to finance the construction of a factory that will have a useful life of 40 years. Construction is completed after two years, during which time the company earns €20,000 by temporarily investing the loan proceeds.
- What is the amount of interest that will be capitalized under IFRS, and how would that amount differ from the amount that would be capitalized under US GAAP?
- Where will the capitalized borrowing cost appear on the company’s financial statements?
Solution to 1:
The total amount of interest paid on the loan during construction is €200,000 (= €1,000,000 × 10% × 2 years). Under IFRS, the amount of borrowing cost eligible for capitalization is reduced by the €20,000 interest income from temporarily investing the loan proceeds, so the amount to be capitalized is €180,000. Under US GAAP, the amount to be capitalized is €200,000.
Solution to 2:
The capitalized borrowing costs will appear on the company’s balance sheet as a component of property, plant, and equipment. In the years prior to completion of construction, the interest paid will appear on the statement of cash flows as an investment activity. Over time, as the property is depreciated, the capitalized interest component is part of subsequent years’ depreciation expense on the company’s income statement.
Revaluation Model vs Cost Model
Can both be used in IFRS and US GAAP?
What are the differences between both?
IFRS allow companies to value long-lived assets either under a cost model at historical cost minus accumulated depreciation or amortization or under a revaluation model at fair value. In contrast, US accounting standards require the cost model be used. A key difference between the two models is that the cost model allows only decreases in the values of long-lived assets compared with historical costs but the revaluation model may result in increases in the values of long-lived assets to amounts greater than historical costs.
Impairement under IFRS and under US GAAP
In contrast with depreciation and amortization charges, which serve to allocate the depreciable cost of a long-lived asset over its useful life, impairment charges reflect an unanticipated decline in the value of an asset. Both IFRS and US GAAP require companies to write down the carrying amount of impaired assets. Impairment reversals are permitted under IFRS but not under US GAAP.
Under US GAAP long term assets held for sale can reverse impairement losses
Sussex, a hypothetical manufacturing company in the United Kingdom, has a machine it uses to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The company has assembled the following information with respect to the machine:
Carrying amount£18,000
Undiscounted expected future cash flows£19,000
Present value of expected future cash flows£16,000
Fair value if sold£17,000
Costs to sell£2,000
- Under IFRS, what would the company report for the machine?
- Under US GAAP, what would the company report for the machine?
Solution to 1:
Under IFRS, the company would compare the carrying amount (£18,000) with the higher of its fair value less costs to sell (£15,000) and its value in use (£16,000). The carrying amount exceeds the value in use, the higher of the two amounts, by £2,000. The machine would be written down to the recoverable amount of £16,000, and a loss of £2,000 would be reported in the income statement. The carrying amount of the machine is now £16,000. A new depreciation schedule based on the carrying amount of £16,000 would be developed.
Solution to 2:
Under US GAAP, the carrying amount (£18,000) is compared with the undiscounted expected future cash flows (£19,000). The carrying amount is less than the undiscounted expected future cash flows, so the carrying amount is considered recoverable. The machine would continue to be carried at £18,000, and no loss would be reported.
Se uma empresa comprar um edificio XPTO e para isso tiver que contrair um empréstimo? O que deve a empresa capitalizar após a aquisição?
Companies must capitalize interest costs associated with acquiring or constructing an asset that requires a long period of time to prepare for its intended use.
Including capitalized interest in the calculation of interest coverage ratios provides a better assessment of a company’s solvency.
BAURU, S.A., a Brazilian corporation, borrows capital from a local bank to finance the construction of its manufacturing plant. The loan has the following conditions:
Borrowing date1 January 2009Amount borrowed500 million Brazilian real (BRL)Annual interest rate14 percentTerm of the loan3 yearsPayment methodAnnual payment of interest only. Principal amortization is due at the end of the loan term.
The construction of the plant takes two years, during which time BAURU earned BRL 10 million by temporarily investing the loan proceeds. Which of the following is the amount of interest related to the plant construction (in BRL million) that can be capitalized in BAURU’s balance sheet?
A•130.
B•140.
C•210.
A is correct. Borrowing costs can be capitalized under IFRS until the tangible asset is ready for use. Also, under IFRS, income earned on temporarily investing the borrowed monies decreases the amount of borrowing costs eligible for capitalization. Therefore, Total capitalized interest = (500 million × 14% × 2 years) – 10 million = 130 million.
BAURU, S.A., a Brazilian corporation, borrows capital from a local bank to finance the construction of its manufacturing plant. The loan has the following conditions:
Borrowing date1 January 2009Amount borrowed500 million Brazilian real (BRL)Annual interest rate14 percentTerm of the loan3 yearsPayment methodAnnual payment of interest only. Principal amortization is due at the end of the loan term.
The construction of the plant takes two years, during which time BAURU earned BRL 10 million by temporarily investing the loan proceeds. Which of the following is the amount of interest related to the plant construction (in BRL million) that can be capitalized in BAURU’s balance sheet?
A.130.
B.140.
C.210.
A is correct. Borrowing costs can be capitalized under IFRS until the tangible asset is ready for use. Also, under IFRS, income earned on temporarily investing the borrowed monies decreases the amount of borrowing costs eligible for capitalization. Therefore, Total capitalized interest = (500 million × 14% × 2 years) – 10 million = 130 million.
Which of the following will cause a company to show a lower amount of amortization of intangible assets in the first year after acquisition?
A.A higher residual value.
B.A higher amortization rate.
C.A shorter useful life.
A is correct. A higher residual value results in a lower total depreciable cost and, therefore, a lower amount of amortization in the first year after acquisition (and every year after that).
MARU S.A. de C.V., a Mexican corporation that follows IFRS, has elected to use the revaluation model for its property, plant, and equipment. One of MARU’s machines was purchased for 2,500,000 Mexican pesos (MXN) at the beginning of the fiscal year ended 31 March 2010. As of 31 March 2010, the machine has a fair value of MXN 3,000,000. Should MARU show a profit for the revaluation of the machine?
A.Yes.
B.No, because this revaluation is recorded directly in equity.
C.No, because value increases resulting from revaluation can never be recognized as a profit
B is correct. In this case, the value increase brought about by the revaluation should be recorded directly in equity. The reason is that under IFRS, an increase in value brought about by a revaluation can only be recognized as a profit to the extent that it reverses a revaluation decrease of the same asset previously recognized in the income statement.
An analyst is studying the impairment of the manufacturing equipment of WLP Corp., a UK-based corporation that follows IFRS. He gathers the following information about the equipment:
Fair value£16,800,000Costs to sell£800,000Value in use£14,500,000Net carrying amount£19,100,000
The amount of the impairment loss on WLP Corp.’s income statement related to its manufacturing equipment is closest to:
A.£2,300,000.
B.£3,100,000.
C.£4,600,000.
B is correct. The impairment loss equals £3,100,000.
Impairment = max(Recoverable amount; Value in use) – Net carrying amount
= max(16,800,000 – 800,000; 14,500,000) – 19,100,000
= –3,100,000.
CROCO S.p.A sells an intangible asset with a historical acquisition cost of €12 million and an accumulated depreciation of €2 million and reports a loss on the sale of €3.2 million. Which of the following amounts is most likely the sale price of the asset?
A.€6.8 million
B.€8.8 million
C.€13.2 million
A is correct. Gain or loss on the sale = Sale proceeds – Carrying amount. Rearranging this equation, Sale proceeds = Carrying amount + Gain or loss on sale. Thus, Sale price = (12 million – 2 million) + (–3.2 million) = 6.8 million.
According to IFRS, all of the following pieces of information about property, plant, and equipment must be disclosed in a company’s financial statements and footnotes except for:
A.useful lives.
B.acquisition dates.
C.amount of disposals.
B is correct. IFRS do not require acquisition dates to be disclosed.
According to IFRS, all of the following pieces of information about intangible assets must be disclosed in a company’s financial statements and footnotes except for:
A.fair value.
B.impairment loss.
C.amortization rate.
A is correct. IFRS do not require fair value of intangible assets to be disclosed.
If a company uses the fair value model to value investment property, changes in the fair value of the asset are least likely to affect:
A.net income.
B.net operating income.
C.other comprehensive income.
C is correct. When a company uses the fair value model to value investment property, changes in the fair value of the property are reported in the income statement—not in other comprehensive income.
A company is most likely to:
A.use a fair value model for some investment property and a cost model for other investment property.
B.change from the fair value model when transactions on comparable properties become less frequent.
C.change from the fair value model when the company transfers investment property to property, plant, and equipment.
C is correct. A company will change from the fair value model to either the cost model or revaluation model when the company transfers investment property to property, plant, and equipment.
BAURU, S.A., a Brazilian corporation, borrows capital from a local bank to finance the construction of its manufacturing plant. The loan has the following conditions:
Borrowing date1 January 2009Amount borrowed500 million Brazilian real (BRL)Annual interest rate14 percentTerm of the loan3 yearsPayment methodAnnual payment of interest only. Principal amortization is due at the end of the loan term.
The construction of the plant takes two years, during which time BAURU earned BRL 10 million by temporarily investing the loan proceeds. Which of the following is the amount of interest related to the plant construction (in BRL million) that can be capitalized in BAURU’s balance sheet?
A.130.
B.140.
C.210.
A is correct. Borrowing costs can be capitalized under IFRS until the tangible asset is ready for use. Also, under IFRS, income earned on temporarily investing the borrowed monies decreases the amount of borrowing costs eligible for capitalization. Therefore, Total capitalized interest = (500 million × 14% × 2 years) – 10 million = 130 million.
Which of the following will cause a company to show a lower amount of amortization of intangible assets in the first year after acquisition?
A.A higher residual value.
B.A higher amortization rate.
C.A shorter useful life.
A is correct. A higher residual value results in a lower total depreciable cost and, therefore, a lower amount of amortization in the first year after acquisition (and every year after that).
MARU S.A. de C.V., a Mexican corporation that follows IFRS, has elected to use the revaluation model for its property, plant, and equipment. One of MARU’s machines was purchased for 2,500,000 Mexican pesos (MXN) at the beginning of the fiscal year ended 31 March 2010. As of 31 March 2010, the machine has a fair value of MXN 3,000,000. Should MARU show a profit for the revaluation of the machine?
A.Yes.
B.No, because this revaluation is recorded directly in equity.
C.No, because value increases resulting from revaluation can never be recognized as a profit
B is correct. In this case, the value increase brought about by the revaluation should be recorded directly in equity. The reason is that under IFRS, an increase in value brought about by a revaluation can only be recognized as a profit to the extent that it reverses a revaluation decrease of the same asset previously recognized in the income statement.
An analyst is studying the impairment of the manufacturing equipment of WLP Corp., a UK-based corporation that follows IFRS. He gathers the following information about the equipment:
Fair value£16,800,000Costs to sell£800,000Value in use£14,500,000Net carrying amount£19,100,000
The amount of the impairment loss on WLP Corp.’s income statement related to its manufacturing equipment is closest to:
A.£2,300,000.
B.£3,100,000.
C.£4,600,000.
B is correct. The impairment loss equals £3,100,000.
Impairment = max(Recoverable amount; Value in use) – Net carrying amount
= max(16,800,000 – 800,000; 14,500,000) – 19,100,000
= –3,100,000.
CROCO S.p.A sells an intangible asset with a historical acquisition cost of €12 million and an accumulated depreciation of €2 million and reports a loss on the sale of €3.2 million. Which of the following amounts is most likely the sale price of the asset?
A.€6.8 million
B.€8.8 million
C.€13.2 million
A is correct. Gain or loss on the sale = Sale proceeds – Carrying amount. Rearranging this equation, Sale proceeds = Carrying amount + Gain or loss on sale. Thus, Sale price = (12 million – 2 million) + (–3.2 million) = 6.8 million.
According to IFRS, all of the following pieces of information about property, plant, and equipment must be disclosed in a company’s financial statements and footnotes except for:
A.useful lives.
B.acquisition dates.
C.amount of disposals.
B is correct. IFRS do not require acquisition dates to be disclosed.
According to IFRS, all of the following pieces of information about intangible assets must be disclosed in a company’s financial statements and footnotes except for:
A.fair value.
B.impairment loss.
C.amortization rate.
A is correct. IFRS do not require fair value of intangible assets to be disclosed.
If a company uses the fair value model to value investment property, changes in the fair value of the asset are least likely to affect:
A.net income.
B.net operating income.
C.other comprehensive income.
C is correct. When a company uses the fair value model to value investment property, changes in the fair value of the property are reported in the income statement—not in other comprehensive income.
A company is most likely to:
A.use a fair value model for some investment property and a cost model for other investment property.
B.change from the fair value model when transactions on comparable properties become less frequent.
C.change from the fair value model when the company transfers investment property to property, plant, and equipment.
C is correct. A company will change from the fair value model to either the cost model or revaluation model when the company transfers investment property to property, plant, and equipment.
Tax Base of an asset vs carrying amount of an asset.
The tax base of an asset or liability is the amount at which the asset or liability is valued for tax purposes, whereas the carrying amount is the amount at which the asset or liability is valued according to accounting principles.3 Differences between the tax base and the carrying amount also result in differences between accounting profit and taxable income. These differences can carry through to future periods. For example, a tax loss carry forward occurs when a company experiences a loss in the current period that may be used to reduce future taxable income. The company’s tax expense on its income statement must not only reflect the taxes payable based on taxable income, but also the effect of these differences.
r.
differences between accounting profit and taxable income can occur in several ways, including:
- Revenues and expenses may be recognized in one period for accounting purposes and a different period for tax purposes;
- Specific revenues and expenses may be either recognized for accounting purposes and not for tax purposes; or not recognized for accounting purposes but recognized for tax purposes;
- The carrying amount and tax base of assets and/or liabilities may differ;
- The deductibility of gains and losses of assets and liabilities may vary for accounting and income tax purposes;
- Subject to tax rules, tax losses of prior years might be used to reduce taxable income in later years, resulting in differences in accounting and taxable income (tax loss carryforward); and
- Adjustments of reported financial data from prior years might not be recognized equally for accounting and tax purposes or might be recognized in different periods.
Tax Base vs Carrying amount
As mentioned in Section 2, temporary differences arise from a difference in the tax base and carrying amount of assets and liabilities. The tax base of an asset or liability is the amount attributed to the asset or liability for tax purposes, whereas the carrying amount is based on accounting principles. Such a difference is considered temporary if it is expected that the taxes will be recovered or payable at a future date.
Using the straight-line method of depreciation for reporting purposes and accelerated depreciation for tax purposes would most likely result in a:
A.valuation allowance.
B.deferred tax asset.
C.temporary difference.
C is correct. Because the differences between tax and financial accounting will correct over time, the resulting deferred tax liability, for which the expense was charged to the income statement but the tax authority has not yet been paid, will be a temporary difference. A valuation allowance would only arise if there was doubt over the company’s ability to earn sufficient income in the future to require paying the tax.
Income tax expense reported on a company’s income statement equals taxes payable, plus the net increase in:
A.deferred tax assets and deferred tax liabilities.
B.deferred tax assets, less the net increase in deferred tax liabilities.
C.deferred tax liabilities, less the net increase in deferred tax assets.
C is correct. Higher reported tax expense relative to taxes paid will increase the deferred tax liability, whereas lower reported tax expense relative to taxes paid increases the deferred tax asset.
Analysts should treat deferred tax liabilities that are expected to reverse as:
A.equity.
B.liabilities.
C.neither liabilities nor equity.
B is correct. If the liability is expected to reverse (and thus require a cash tax payment) the deferred tax represents a future liability.
Deferred tax liabilities should be treated as equity when:
A.they are not expected to reverse.
B.the timing of tax payments is uncertain.
C.the amount of tax payments is uncertain.
A is correct. If the liability will not reverse, there will be no required tax payment in the future and the “liability” should be treated as equity.
When accounting standards require recognition of an expense that is not permitted under tax laws, the result is a:
A.deferred tax liability.
B.temporary difference.
C.permanent difference.
C is correct. Accounting items that are not deductible for tax purposes will not be reversed and thus result in permanent differences.
When certain expenditures result in tax credits that directly reduce taxes, the company will most likely record:
A.a deferred tax asset.
B.a deferred tax liability.
C.no deferred tax asset or liability.
C is correct. Tax credits that directly reduce taxes are a permanent difference, and permanent differences do not give rise to deferred tax.
When accounting standards require an asset to be expensed immediately but tax rules require the item to be capitalized and amortized, the company will most likely record:
A.a deferred tax asset.
B.a deferred tax liability.
C.no deferred tax asset or liability.
A is correct. The capitalization will result in an asset with a positive tax base and zero carrying value. The amortization means the difference is temporary. Because there is a temporary difference on an asset resulting in a higher tax base than carrying value, a deferred tax asset is created.
A company incurs a capital expenditure that may be amortized over five years for accounting purposes, but over four years for tax purposes. The company will most likely record:
A.a deferred tax asset.
B.a deferred tax liability.
C.no deferred tax asset or liability.
B is correct. The difference is temporary, and the tax base will be lower (because of more rapid amortization) than the carrying value of the asset. The result will be a deferred tax liability.
Zimt AG presents its financial statements in accordance with US GAAP. In 2007, Zimt discloses a valuation allowance of $1,101 against total deferred tax assets of $19,201. In 2006, Zimt disclosed a valuation allowance of $1,325 against total deferred tax assets of $17,325. The change in the valuation allowance most likely indicates that Zimt’s:
A.deferred tax liabilities were reduced in 2007.
B.expectations of future earning power has increased.
C.expectations of future earning power has decreased.
B is correct. The valuation allowance is taken against deferred tax assets to represent uncertainty that future taxable income will be sufficient to fully utilize the assets. By decreasing the allowance, Zimt is signaling greater likelihood that future earnings will be offset by the deferred tax asset.
Cinnamon, Inc. recorded a total deferred tax asset in 2007 of $12,301, offset by a $12,301 valuation allowance. Cinnamon most likely:
A.fully utilized the deferred tax asset in 2007.
B.has an equal amount of deferred tax assets and deferred tax liabilities.
C.expects not to earn any taxable income before the deferred tax asset expires.
C is correct. The valuation allowance is taken when the company will “more likely than not” fail to earn sufficient income to offset the deferred tax asset. Because the valuation allowance equals the asset, by extension the company expects no taxable income prior to the expiration of the deferred tax assets.
What is a synthetic lease?
A lease that is structured to provide a company with the tax benefits of ownership while not requiring the asset to be reflected on the company’s financial statements is known as a synthetic lease.
Examples of situations that would normally lead to a lease being classified as a finance lease include the following
- The lease transfers ownership of the asset to the lessee by the end of the lease term.
- The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.
- The lease term is for the major part of the economic life of the asset, even if the title is not transferred.
- At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
- The leased assets are of such a specialized nature that only the lessee can use them without major modifications.
Although accounting for leases under US GAAP is guided by a similar principle of the transfer of benefits and risks, US GAAP is more prescriptive in its criteria for classifying capital and operating leases. Four criteria are specified to identify when a lease is a capital lease:
- Ownership of the leased asset transfers to the lessee at the end of the lease.
- The lease contains an option for the lessee to purchase the leased asset cheaply (bargain purchase option).
- The lease term is 75 percent or more of the useful life of the leased asset.
- The present value of lease payments is 90 percent or more of the fair value of the leased asset.
From the lessor’s perspective, US GAAP distinguishes between types of capital leases. There are two main types of capital leases from a lessor’s perspective:
1) direct financing leases, and 2) sales-type leases
Under US GAAP, a direct financing lease results when the present value of lease payments (and thus the amount recorded as a lease receivable) equals the carrying value of the leased asset. Because there is no “profit” on the asset itself, the lessor is essentially providing financing to the lessee and the revenues earned by the lessor are financing in nature (i.e., interest revenue). If, however, the present value of lease payments (and thus the amount recorded as a lease receivable) exceeds the carrying amount of the leased asset, the lease is treated as a sales-type lease.
Debt Covenants, Affirmative and Negative
Affirmative - exige que a empresa cumpra certos rácios ou valores.
Negative - proibe a empresa de fazer certas coisas. (ex. aprovar um novo projecto ou distribuir dividendos)
Two types of pension plans are defined contribution plans and defined benefits plans.
In a defined contribution plan, the amount of contribution into the plan is specified (i.e., defined) and the amount of pension that is ultimately paid by the plan (received by the retiree) depends on the performance of the plan’s assets. In a defined benefit plan, the amount of pension that is ultimately paid by the plan (received by the retiree) is defined, usually according to a benefit formula.
At the time of issue of 4.50% coupon bonds, the effective interest rate was 5.00%. The bonds were most likely issued at:
A.par.
B.a discount.
C.a premium.
B is correct. The effective interest rate is greater than the coupon rate and the bonds will be issued at a discount.
Oil Exploration LLC paid $45,000 in printing, legal fees, commissions, and other costs associated with its recent bond issue. It is most likely to record these costs on its financial statements as:
A.an asset under US GAAP and reduction of the carrying value of the debt under IFRS.
B.a liability under US GAAP and reduction of the carrying value of the debt under IFRS.
C.a cash outflow from investing activities under both US GAAP and IFRS.
A is correct. Under US GAAP, expenses incurred when issuing bonds are generally recorded as an asset and amortised to the related expense (legal, etc.) over the life of the bonds. Under IFRS, they are included in the measurement of the liability. The related cash flows are financing activities.
On 1 January 2010, Elegant Fragrances Company issues £1,000,000 face value, five-year bonds with annual interest payments of £55,000 to be paid each 31 December. The market interest rate is 6.0 percent. Using the effective interest rate method of amortisation, Elegant Fragrances is most likely to record:
A.an interest expense of £55,000 on its 2010 income statement.
B.a liability of £982,674 on the 31 December 2010 balance sheet.
C.a £58,736 cash outflow from operating activity on the 2010 statement of cash flows.
B is correct. The bonds will be issued at a discount because the market interest rate is higher than the stated rate. Discounting the future payments to their present value indicates that at the time of issue, the company will record £978,938 as both a liability and a cash inflow from financing activities. Interest expense in 2010 is £58,736 (£978,938 times 6.0 percent). During the year, the company will pay cash of £55,000 related to the interest payment, but interest expense on the income statement will also reflect £3,736 related to amortisation of the initial discount (£58,736 interest expense less the £55,000 interest payment). Thus, the value of the liability at 31 December 2010 will reflect the initial value (£978,938) plus the amortised discount (£3,736), for a total of £982,674. The cash outflow of £55,000 may be presented as either an operating or financing activity under IFRS.
Consolidated Enterprises issues €10 million face value, five-year bonds with a coupon rate of 6.5 percent. At the time of issuance, the market interest rate is 6.0 percent. Using the effective interest rate method of amortisation, the carrying value after one year will be closest to:
A.€10.17 million.
B.€10.21 million.
C.€10.28 million.
A is correct. The coupon rate on the bonds is higher than the market rate, which indicates that the bonds will be issued at a premium. Taking the present value of each payment indicates an issue date value of €10,210,618. The interest expense is determined by multiplying the carrying amount at the beginning of the period (€10,210,618) by the market interest rate at the time of issue (6.0 percent) for an interest expense of €612,637. The value after one year will equal the beginning value less the amount of the premium amortised to date, which is the difference between the amount paid (€650,000) and the expense accrued (€612,637) or €37,363. €10,210,618 – €37,363 = €10,173,255 or €10.17 million.
The management of Bank EZ repurchases its own bonds in the open market. They pay €6.5 million for bonds with a face value of €10.0 million and a carrying value of €9.8 million. The bank will most likely report:
A.other comprehensive income of €3.3 million.
B.other comprehensive income of €3.5 million.
C.a gain of €3.3 million on the income statement.
C is correct. A gain of €3.3 million (carrying amount less amount paid) will be reported on the income statement.
Innovative Inventions, Inc. needs to raise €10 million. If the company chooses to issue zero-coupon bonds, its debt-to-equity ratio will most likely:
A.rise as the maturity date approaches.
B.decline as the maturity date approaches.
C.remain constant throughout the life of the bond.
A is correct. The value of the liability for zero-coupon bonds increases as the discount is amortised over time. Furthermore, the amortised interest will reduce earnings at an increasing rate over time as the value of the liability increases. Higher relative debt and lower relative equity (through retained earnings) will cause the debt-to-equity ratio to increase as the zero-coupon bonds approach maturity.
Fairmont Golf issued fixed rate debt when interest rates were 6 percent. Rates have since risen to 7 percent. Using only the carrying amount (based on historical cost) reported on the balance sheet to analyze the company’s financial position would most likely cause an analyst to:
A.overestimate Fairmont’s economic liabilities.
B.underestimate Fairmont’s economic liabilities.
C.underestimate Fairmont’s interest coverage ratio.
A is correct. When interest rates rise, bonds decline in value. Thus, the carrying amount of the bonds being carried on the balance sheet is higher than the market value. The company could repurchase the bonds for less than the carrying amount, so the economic liabilities are overestimated. Because the bonds are issued at a fixed rate, there is no effect on interest coverage.
Compared to using a finance lease, a lessee that makes use of an operating lease will most likely report higher:
A.debt.
B.rent expense.
C.cash flow from operating activity.
B is correct. An operating lease is not recorded on the balance sheet (debt is lower), and lease payments are entirely categorised as rent (interest expense is lower.) Because the rent expense is an operating outflow but principal repayments are financing cash flows, the operating lease will result in lower cash flow from operating activity.
Under US GAAP, a lessor’s reported revenues at lease inception will be highest if the lease is classified as:
A.a sales-type lease.
B.an operating lease.
C.a direct financing lease.
A is correct. A sales-type lease treats the lease as a sale of the asset, and revenue is recorded at the time of sale equal to the present value of future lease payments. Under a direct financing lease, only interest income is reported as earned. Under an operating lease, revenue from rent is reported when collected.
A lessor will record interest income if a lease is classified as:
A.a capital lease.
B.an operating lease.
C.either a capital or an operating lease.
A is correct. A portion of the payments for capital leases, either direct financing or sales-type, is reported as interest income. With an operating lease, all revenue is recorded as rental revenue.
Penben Corporation has a defined benefit pension plan. At 31 December, its pension obligation is €10 million and pension assets are €9 million. Under either IFRS or US GAAP, the reporting on the balance sheet would be closest to which of the following?
A.€10 million is shown as a liability, and €9 million appears as an asset.
B.€1 million is shown as a net pension obligation.
C.Pension assets and obligations are not required to be shown on the balance sheet but only disclosed in footnotes.
B is correct. The company will report a net pension obligation of €1 million equal to the pension obligation (€10 million) less the plan assets (€9 million).
Biased reporting Agressive Choices vs Conservative Choices
Choices are deemed to be “aggressive” if they increase a company’s reported performance and financial position in the current period. The choice can increase the amount of revenues, earnings, and/or operating cash flow reported in the period or decrease the amount of expenses reported in the period and/or the amount of debt reported on the balance sheet. Aggressive choices may decrease the company’s reported performance and financial position in later periods. In contrast, choices are deemed “conservative” if they decrease a company’s reported performance and financial position in the current period. Conservative choices may decrease the amount of revenues, earnings, and/or operating cash flow reported in the period or increase the amount of expenses reported in the period and/or the amount of debt reported on the balance sheet. Conservative choices may increase the company’s reported performance and financial position in later periods.
The SEC intended that the definition of non-GAAP financial measure capture all measures that have the effect of depicting either
- a measure of performance that differs from that presented in the financial statements, such as income or loss before taxes or net income or loss, as calculated in accordance with GAAP; or
- a measure of liquidity that differs from cash flow or cash flow from operations computed in accordance with GAAP.19
Projecting profit margins into the future on the basis of past results would be most reliable when the company:
A.is in the commodities business.
B.operates in a single business segment.
C.is a large, diversified company operating in mature industries.
C is correct. For a large, diversified company, margin changes in different business segments may offset each other. Furthermore, margins are most likely to be stable in mature industries.
Galambos Corporation had an average receivables collection period of 19 days in 2003. Galambos has stated that it wants to decrease its collection period in 2004 to match the industry average of 15 days. Credit sales in 2003 were $300 million, and analysts expect credit sales to increase to $400 million in 2004. To achieve the company’s goal of decreasing the collection period, the change in the average accounts receivable balance from 2003 to 2004 that must occur is closest to:
A.–$420,000.
B.$420,000.
C.$836,000.
C is correct. Accounts receivable turnover is equal to 365/19 (collection period in days) = 19.2 for 2003 and needs to equal 365/15 = 24.3 in 2004 for Galambos to meet its goal. Sales/turnover equals the accounts receivable balance. For 2003, $300,000,000/19.2 = $15,625,000, and for 2004, $400,000,000/24.3 = $16,460,905. The difference of $835,905 is the increase in receivables needed for Galambos to achieve its goal.
•In a comprehensive financial analysis, financial statements should be:
A.used as reported without adjustment.
B.adjusted after completing ratio analysis.
C.adjusted for differences in accounting standards, such as international financial reporting standards and US generally accepted accounting principles.
C is correct. Survivorship bias exists when companies that merge or go bankrupt are dropped from the database and only surviving companies remain. Look-ahead bias involves using updated financial information in back-testing that would not have been available at the time the decision was made. Back-testing involves testing models in prior periods and is not, itself, a bias.
•When comparing financial statements prepared under IFRS with those prepared under US GAAP, analysts may need to make adjustments related to:
A.realized losses.
B.unrealized gains and losses for trading securities.
C.unrealized gains and losses for available-for-sale securities.
C is correct. Financial statements should be adjusted for differences in accounting standards (as well as accounting and operating choices). These adjustments should be made prior to common-size and ratio analysis.
An analyst gathered the following data for a company ($ millions):
31 Dec 2000 31 Dec 2001 Gross investment in fixed assets $2.8 $2.8 Accumulated depreciation $1.2 $1.6
The average age and average depreciable life of the company’s fixed assets at the end of 2001 are closest to:
Average Age Average Depreciable Life A 1.75 years 7 years B 1.75 years 14 years C 4.00 years 7 years
C is correct. The company made no additions to or deletions from the fixed asset account during the year, so depreciation expense is equal to the difference in accumulated depreciation at the beginning of the year and the end of the year, or $0.4 million. Average age is equal to accumulated depreciation/depreciation expense, or $1.6/$0.4 = 4 years. Average depreciable life is equal to ending gross investment/depreciation expense = $2.8/$0.4 = 7 years.
To compute tangible book value, an analyst would
A.add goodwill to stockholders’ equity.
B.add all intangible assets to stockholders’ equity.
C.subtract all intangible assets from stockholders’ equity.
C is correct. Tangible book value removes all intangible assets, including goodwill, from the balance sheet.
•Which of the following is an off-balance-sheet financing technique? The use of
A.capital leases.
B.operating leases.
C.the last in, first out inventory method.
B is correct. Operating leases can be used as an off-balance-sheet financing technique because neither the asset nor liability appears on the balance sheet. Inventory and capital leases are reported on the balance sheet.
•To better evaluate the solvency of a company, an analyst would most likely add to total liabilities
A.the present value of future capital lease payments.
B.the total amount of future operating lease payments.
C.the present value of future operating lease payments.
C is correct. The present value of future operating lease payments would be added to total assets and total liabilities.
When comparing financial statements prepared under IFRS with those prepared under US GAAP, analysts may need to make adjustments related to:
A.realized losses.
B.unrealized gains and losses for trading securities.
C.unrealized gains and losses for available-for-sale securities
C is correct. IFRS makes a distinction between unrealized gains and losses on available-for-sale debt securities that arise as a result of exchange rate movements and requires these changes in value to be recognized in the income statement, whereas US GAAP does not make this distinction.
