CH. 18 Performance Measures and EPS

Question 1

Name the different types of stakeholders interested in the interpretation of the financial reports? and what are their reasons?

• Management
• Employees
• Present and Potential Investors
• Lenders and suppliers
• Customers

Answer 1

• Management - Set Performance targets and use statements to compare performance to targets often with the view to achieving their bonuses.
• Employees - Concerns with job stability and future prospects.
• Present and Potential Investors - Assess if the investment is sound and generates acceptable returns, and help them to make decisions on further investment or dispose of.
• Lenders and suppliers - Creditworthiness of an entity
• Customers - if products or services purchase is consistent with personal ethical and moral expectations.

Question 2

What are the main Categories of Ratios?

Answer 2

• Profitability
• Efficiency
• Liquidity
• Investor
• Working Capital Management
• Financial Leverage

Question 3

What are the formulas for the following ratios and what do they show?

• R.O.C.E
• R.O.E
• Gross Profit Margin
• Operating Profit Margin
• Net Profit Margin

Answer 3

Question 4

What are the formulas for the following ratios and what do they show?

Efficiency Ratios

• Asset Turnover
• Total Asset Turnover
• Non-Current Asset Turnover

Answer 4

Question 5

What are the formulas for the following ratios and what do they show?

Investor Ratios

• EPS
• Price/Earnings Ratio
• Profit Retention Ratio
• Dividend Payout Rate
• Dividend Yield
• Dividend Cover

Answer 5

Question 6

What are the formulas for the following ratios and what do they show?

Liquidity Ratios

• Current Ratio
• Quick Ratio

Answer 6

Question 7

What are the formulas for the following ratios and what do they show?

Working Capital Management

• Debtor Days
• Creditor Days
• Inventory Holding Days
• Working Capital Cycle

Answer 7

Question 8

What are the formulas for the following ratios and what do they show?

Financial Leverage

• Gearing
• Interest Cover

Answer 8

Question 9

How do you calculate Basic Earnings Per Share?

Answer 9

Formula:

• *Profit or loss for the period attributable to equity shareholders**
• *The weighted average number of ordinary shares outstanding in the period**

= EPS

The Weighted Average number of shares is based on the number of shares issued on average on a monthly basis.

Example:

Calculate Basic EPS?

Profit attributable to shareholders: $555,000
Number of Shares Issued at 31/12/2020: 800,000
Number of Shares Issued at 31/12/2021: 1,000,000

Reporting date: 30/06/2021

Step 1

What is the weighted number of shares on the Reporting Date?

800,000 x 6/12 = 400,000
+
1,000,000 x 6/12 = 500,000

= 900,000 weighted average shares

Step 2

EPS Formula = $550,000/900,000 W.A.S = 61.1C

Question 10

What is Bonus Issue of shares?

How does it affect the eps?

How to calculate Basic EPS with a Bonus issue?

Answer 10

What is a Bonus issue?

A Bonus Issue of shares is a free issue of shares to the current owners of shares.

How does it affect the EPS?

• It does not affect earnings but does increase the total number of shares. Which is like reduce the price per share and the Earnings Per Share.
• For the Purpose of EPS, the bonus share issue is treated as if they have always been issued.

How to calculate EPS with a bonus issue?

• To calculate the new number of shares is to multiply the number of shares by the bonus fraction. ^{(make sure the fraction is top-heavy)}
• To restate the comparative of EPS it’s easily calculated by multiplying the eps by the inverse of the bonus fraction.

Example:

Profit

• ^20X8: $555,000 ^20X7: $460,000

Issued Shares

• ^{<strong>20X8:</strong>} 1,200,000^20X7:1,000,000

Bonus Issue:

• 1 New Share to Every 5 shares

Calculate the Basic EPS and the new Prior Comparative EPS?

Step 1 Calculate Bonus Fraction

5+1 = 6 Total number of shares after Bonus Issue
Fraction: 6/5

Step 2 Weighted average number of shares

1,000,000 X 6Months/12 Months X 6/5 = 600,000
1,200,000 X 6/12 = 600,000
= 1,200,000 weighted average shares

Step 3 Cal EPS

EPS = $550,000/1.2M Shares = 45.8c

Step 4 Calculate prior year

1st inverse the bonus fraction = 5/6

2nd multiply the prior eps with the inverse bonus = 46.06c X 5/6 = 38.3c

Question 11

What is Rights Issue of shares?

How does it affect the eps?

How to calculate Basic EPS with a Rights issue?

Answer 11

What is Rights Issue of shares?

A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. Usually at a discount.

So a rights issue has combined the characteristics of a bonus issue and a full price issue.

How does it affect the eps?

Similarly to bonus Issues, it does not affect the Earnings.

But the issue of the new shares does affect the weighted average of shares.

How to calculate Basic EPS with a Rights issue?

Step 1 - Calculate TERP Theoretical share price after the rights issue Value per share after the rights issue.

1. Calculate Total Market Cap before and after the rights Issue
   Shares before rights issue X Price = Market Cap
   Add New issued shares as a rights Issue X Price = Market Cap
   = Total Market Cap
2. Then divide the Total Market Cap / Total No. of shares after rights issue = TERP

Step 2 - Bonus Fraction

Market price per share before the rights issue
Divided by TERP

Step 3 - Weighted average number of shares Calculation

Step 4 Prior year adjustment EPS is Multiplied by the Inverse of the Bonus fraction.

Question 12

What are Diluted Earnings Per Share

What types of Instruments may dilute the shareholder’s interest/ownership?

How are they dealt with in the accounts?

Answer 12

Many companies issue convertible instruments, options and warrants that entitle their holders to purchase shares in the future at below the market price. When these shares are eventually issued, the interests/claim of ownership or to dividends rights of the original shareholders will be diluted.

The dilution occurs because these shares will have been issued below market price.

Shares and other instruments that may dilute the interests of the existing shareholders are called potential ordinary shares. Examples of potential ordinary shares include:

• – Debt and other instruments, including preference shares, that are convertible into ordinary shares
• – Share warrants and options (instruments that give the holder the right to purchase ordinary shares)
• – Employee plans that allow employees to receive ordinary shares as part of their remuneration and other share purchase plans
• – Contingently issuable shares (i.e. shares issuable if certain conditions are met).
• *Treated:**
• *Where there are dilutive potential ordinary shares in issue, the diluted EPS must be disclosed as well as the basic EPS.**

This provides relevant information to current and potential investors.

Affect on earnings -

• - When calculating diluted EPS, the profit used in the basic EPS calculation is adjusted for any expenses that would no longer be paid if the Convertible instrument were converted into shares, e.g. preference dividends, loan interest.

Affect on Shares -

• - When calculating diluted EPS, the weighted average number of shares used in the basic EPS calculation is adjusted for the conversion of the potential ordinary shares.

Question 13

What is the significance of EPS?

How is it limited as a performance measure?

and

Why should accountants be aware of this when considering accounting policy changes?

Answer 13

Significance

• The stock market places great emphasis on the earnings per share figure and the P/E ratio.
• It is used as a yardstick for investment decisions.
• IAS 33 sets out a standard method of calculating EPS, which enhances the comparability of the figure.

Performance:

• - An entity’s earnings are affected by its choice of accounting policies. Therefore, it may not always be appropriate to compare the EPS of different companies.
• - EPS does not take account of inflation. The apparent growth in earnings may not be true growth.
• - EPS does not provide predictive value. High earnings may be achieved at the expense of investment, which would have generated increased earnings in the future.
• - In theory, diluted EPS serves as a warning to equity shareholders that the return on their investment may fall in future periods. However, diluted EPS is based on current earnings rather than forecast earnings.
• - EPS is a measure of profitability but profitability is only one aspect of performance. Concentration on earnings per share and ‘the bottom line’ arguably detracts from other important aspects of an entity’s affairs, such as cash flow and stewardship of assets.

Question 14

How do you approach EPS Question?

Answer 14

Look at the issue/transaction and consider:

• What is the impact on Earnings? is there an increase, decrease, no impact?
• Share options issued = Earning will decrease.
• Shares issued to staff = No impact on E. Movement within equity.
• Convertible loans are converted = No Finance Costs. Earnings will increase (might have to think about tax implications).
• What is the impact on the number of Shares?
  
  • Share options issued = No Impact
  • Shares issued to staff = Increase in numbers
  • Convertible loans are converted = An increase in the number of shares.

Question 15

What is the impact of policies and estimates?

Answer 15

Accounting policies and estimates can significantly affect the view presented by financial statements, and the ratios computed by reference to them, without affecting an entity’s cash generation.

This is a particularly important issue when:

• accounting standards permit a choice, such as between a cost model or a fair value model
• judgement is needed in making accounting estimates, such as with depreciation, allowances and provisions
• there is no relevant accounting standard (although this is extremely rare).

Question 16

How is the statement of cash flows useful for stakeholder?

Answer 16

The usefulness of the statement of cash flows

A statement of cash flows provides information that is not available from the statement of financial position or the statement of profit or loss and other comprehensive income.

There are a number of reasons why it is useful for stakeholder analysis:

• Profits can be manipulated through the use of judgement or choice of a particular accounting policy whereas cash flows are objective and verifiable.
• Cash generated from operations is a useful indication of the quality of the profits generated by a business. Good quality profits will generate cash.
• Statements of cash flows provide valuable information to stakeholders on the financial adaptability of an entity.
• Cash flow information has some predictive value. It may assist stakeholders in making judgements

Question 17

Discuss the following additional performance measures?

• EBIT
• EBITDA
• Net Financial Debt
• Free Cash Flow

What are the benefits and Drawbacks of additional performance measures?

Answer 17

Users of financial statements are demanding more information. In response, many entities present additional performance measures (APMs) in their published many statements, such as:

• EBIT – earnings before interest and tax.
• EBITDA – Earnings before interest, tax, depreciation and amortisation.
• Net financial debt – gross debt less cash and cash equivalents and other financial assets.
• Free Cash Flow – cash flows from operating activities less capital expenditure.

Benefits
APMs can have many benefits, such as:

• Helping users of financial statements to evaluate an entity through the eyes of management.
• Enabling comparison between entities in the same sector or industry.
• Stripping out elements that are not relevant to current or future year operating performance.

Drawbacks

Presenting APMs in financial statements can create problems:

• An entity might calculate an APM in a different way year-on-year
• Two entities might calculate the same APM in a different way
• Entities often provide little information about how an APM is calculated or how it reconciles with the figures presented in the financial statements
• APMs might be selected and calculated so as to present an overly optimistic picture of an entity’s performance
• Too much information can be confusing to users of the financial statements
• Giving an APM undue prominence may mislead users of the financial statements into believing it is a requirement of IFRS Standards.

Question 18

Why is there a growing concern for the financial statements of Tech companies?

Hints-

SFP

SP/L

Answer 18

According to the Conceptual Framework

SFP - provides information about a company’s financial position
P/L - Information about a company’s financial performance.

However, there is growing concern that F.S produced under IFRS do not produce useful information with regards to tech companies (such as Amazon, Google, Facebook)

Statement of financial position

The carrying amounts of net assets in the SFP for a tech company tends to be significantly lower than its market capitalisation. (share price multiplied by the number of shares in issue).

Tech company financial statements underreport a significant amount of ‘value’. Reasons:

• • They have powerful and valuable brands. But In accordance with IAS 38 Intangible Assets, internally generated brands are not recognised on the SFP
• • Another reason is that operating assets used by many tech companies are not owned or leased by the company itself (such as the music available on Spotify, or the cars available to ride through the Uber app).

Tech companies benefit from these assets but they do not meet the criteria for recognition in the statement of financial position because they are controlled by other parties (such as record labels, or taxi drivers).
* A further reason is that many intangible assets developed and used by tech companies appreciate in value as they are used,(creation of data that can be used to generate profits) even though accounting standards may require them to be depreciated or amortised.

For example, each new user on a social media platform increases the benefits of the platform for existing users as well as increasing the advertising fees that the platform owner can charge.

Although there will be some incremental operating costs associated with new users (in relation to helping, support and regulating online behaviour), the growth is mainly driven by the assets already in place.

Statement of profit or loss

• Many tech companies are valued at billions of dollars even though they have historically made losses. When assessing economic performance, it would seem that investors increasingly look beyond the statement of profit or loss.
• Tech companies tend to incur high costs in the initial years after incorporation.
• However, once these costs are incurred, the further costs required to expand are lower in comparison (for example, companies that offer online services can expand by adding to server capacity, rather than by acquiring new premises).
• As such successful tech companies often report losses for many years but then high margins once established as a market leader.
• Therefore, at all stages in the lifecycle of a tech company, the P/L does not effectively match the revenues earned in the current period with the costs incurred to earn those revenues.
• This is not to argue that the statement of profit or loss is worthless to the analysis of performance. Investors are certainly interested in the revenue generated by a tech company – this is a good indicator of growth and market share.
• Furthermore, the share price of many tech companies rises significantly in the first period when a profit is recorded, indicating that markets attach some importance to this performance measure. It may be that profit generation indicates that the business has moved into a different stage in its lifecycle – away from high risk, capital demanding initial stage into a mature, less risky, cash generative stage.

Remedies
Due to the weaknesses identified above, tech companies may need to report other types of information to investors and lenders. This might be done via:

• Integrated reporting (covered later in this chapter)
• Online real-time reporting of key performance indicators (such as membership numbers, monetary spend per user etc.).

Question 19

What problems arise on over-relying on financial measures/statements?

and

Give examples of non-financial performance measures?

Answer 19

Problems arise from an over-reliance on financial performance indicators:

• They are normally calculated from historical financial information and provide limited information about future performance.
• They do not provide information about key issues that impact long-term success, such as customer satisfaction
• There are concerns about whether traditional financial reporting adequately reports the financial position and performance of tech companies
• They can be manipulated through accounting estimates or policy choices. Due to these limitations, analysis of non-financial performance measures is important. These measures are related to entity performance but are not expressed in monetary units.

Examples of non-financial performance measures include:

• Employee turnover
• Absentee rates
• Employee satisfaction
• Customer satisfaction
• Delivery times
• Brand awareness and brand loyalty.

Entities are not required to disclose non-financial performance measures. However, many choose to do so in their annual reports or as part of their integrated report.

Question 20

What is the impact of ethical, environmental and social factors on a business and its stakeholders?

Consider:-

Reporting

Link between ethical behaviour and profit

Answer 20

Many investors will not financially support entities that they perceive to be unethical or harmful to the environment. Some will only invest in entities that meet the very highest ethical standards, even if this means achieving a low overall return. Factors that may be of interest to investors include:

• Animal welfare – does the entity test its products on animals?
• Arms – does the entity, or any entities within its group, manufacture or supply weapons?
• Emissions – does the entity monitor and take steps to reduce harmful emissions, such as carbon dioxide?
• Energy – is the entity committed to using renewable energy?
• Marketing – does the entity use irresponsible or offensive marketing strategies?
• Remuneration – what is the gap between the highest and lowest paid employees?
• Supply chain management – are goods and services only purchased from entities that have high ethical standards?
• Tax – does the entity use tax avoidance schemes?
• Transparency – does the entity make enhanced disclosures about its social and environmental impact?
• Treatment of workers – are working conditions safe and humane?

Investors will prioritise these issues to different degrees.

Reporting

Entities often provide this information in additional reports, such as:

• Environmental reports
• Social reports
• Sustainability reports
• Integrated reports.

A range of nonfinancial reporting standards has been published in recent years to guide preparers of such reports.

Ethical behaviour and profit

• Entities that pay employees higher wages, or which reject tax avoidance schemes, are likely to have higher costs. Moreover, these entities may have to raise selling prices to compensate for higher costs, making their products and services less competitive. As a result, profit levels may fall.
• However, a strong ethical stance might attract ‘green’ investors and customers. Some entities are the subject of boycotts as a result of their perceived unethical stance.
• Moreover, an ethical business model may be more sustainable than one which prioritises short-term profits. As you can see, the relationship between ethics and profit is not straightforward.

Question 21

Name some of the Developments in Sustainability reporting?

Reasons why companies should seek it’s own sustainability goals?

Reporting standards and initiatives created?

How legislation is changing?

Answer 21

Developments in sustainability reporting

Sustainable development consists of balancing local and global efforts to meet basic human needs without destroying or degrading the natural environment.

Sustainable Development Goals (SDGs) are a range of 17 goals agreed by UN member states that include:

• no poverty
• zero hunger
• decent work
• reduced inequalities
• responsible production and consumption.

Some of these will only be achieved through the cooperation of industry.

Reasons why companies should set their own sustainable development goals:

• It is ethical
• Government funding will increasingly focus on sustainable businesses
• There will be a reduction in reputational and regulatory risk
• Sustainable products and services are a growth area
• Short-term, profit-based models are now less relevant for many investors.

Reporting standards and initiatives
It is vital for companies to carefully consider how to communicate their commitment to, and progress towards, SDGs. There are many reporting initiatives that can be used:

• The United Nations Global Compact (UNGC) is an initiative to support UN goals. It encourages entities to produce an annual Communication in Progress (COP) report, in which they describe the practical actions taken to implement UN principles in respect of human rights, labour, the environment, and anti-corruption.
• The Global Reporting Initiative (GRI) publishes the most widely used standards on sustainability reporting and disclosure. Using the GRI standards should mean that entities produce balanced reports that represent their positive and negative economic, environmental and social impacts. GRI principles encourage stakeholder engagement in order to ensure that their information needs are met.
• The International Integrated Reporting Council has published the International Integrated Reporting Framework.

Legislation

Many countries are introducing legislation on sustainability reporting:

• The Singapore Stock Exchange has made sustainability reporting mandatory for listed companies, on a ‘comply or explain’ basis.
• The European Union requires certain large companies to disclose non-financial information on employee diversity.

Although these are positive moves, the lack of an agreed set of standards causes significant diversity in how entities report sustainability issues.

Question 22

What is Integrated reporting?

Hints

Definition

IIRC & its role

The objective of the framework

Fundamental concepts in ir framework

Answer 22

Integrated reporting
What is the International Integrated Reporting Council?
The International Integrated Reporting Council (IIRC) was created to respond to the need for a concise, clear, comprehensive and comparable integrated reporting framework.

The IIRC define an integrated report (IR) as

“a concise communication about how an organisation’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term.’

The IIRC believe that integrated reporting will contribute towards a more stable economy and a more sustainable world.

What is the role of the IIRC? is to:

• Develop an overarching integrated reporting framework setting out the scope of integrated reporting and its key components
• Identify priority areas where additional work is needed and provide a plan for development
• Consider whether standards in this area should be voluntary or mandatory and facilitate collaboration between standard-setters and convergence in the standards needed to underpin integrated reporting; and
• Promote the adoption of integrated reporting by relevant regulators and report preparers.

The objective of the Framework

• • Establishes ‘guiding principles’ and ‘content elements’ that govern the overall content of an integrated report. This will help organisations to report their value creation in ways that are understandable and useful to the users.
• • Aimed at the private sector, although could be adapted for use by charities and the public sector.
• The key users of an integrated report are deemed to be the providers of financial capital. However, the report will also benefit employees, suppliers, customers, local communities and policymakers.
• The Framework is principles-based and therefore does not prescribe specific KPIs that must be disclosed. Senior management needs to use judgement to identify which issues are material. These decisions should be justified to the users of the report.
• Those charged with governance are not required to acknowledge their responsibility for the integrated report. It was felt that such disclosures might increase legal liability in some jurisdictions and therefore deter some companies from applying the IR Framework.
• Fundamental concepts in the IR framework*
• *An integrated report explains how an entity creates value over the short-, medium- and long-term. To this extent, a number of fundamental concepts underpin the IR framework. These are:**
• The capitals

The capitals are stocks of value that are inputs to an organisation’s business model. The capitals identified by the IR Framework are financial, manufactured, intellectual, human, social and relationship, and natural. (SHIN.FM)

The capitals will increase, decrease or be transformed through an organisation’s business activities.

Central to integrated reporting is the overall impact that a business has on the full range of capitals through its business model.

• The organisation’s business model

The business model is a business’ chosen system of inputs, business activities, outputs and outcomes that aims to create value over the short, medium and long term.

• An integrated report must identify key inputs, such as employees, or natural resources. It is important to explain how secure the availability, quality and affordability of components of natural capital are.
• At the centre of the business model is the conversion of inputs into outputs through business activities, such as planning, design, manufacturing and the provision of services.
• An integrated report must identify an organisation’s key outputs, such as products and services. There may be other outputs, such as chemical byproducts or waste. These need to be discussed within the business model disclosure if they are deemed to be material.
• Outcomes are defined as the consequences (positive and negative) for the capitals as a result of an organisation’s business activities and outputs. Outcomes can be internal (such as profits or employee morale) or external (impacts on the local environment).
• The creation of value over time.

Value is created over time and for a range of stakeholders. IR is based on the belief that the increasing financial capital (e.g. profit) at the expense of human capital (e.g. staff exploitation) is unlikely to maximize value in the longer term.

IR thus helps users to establish whether short-term value creation can be sustained into the medium- and long-term.

Question 23

What are the guiding principles and the contents of Integrated Reporting?

Answer 23

Guiding principles
The following Guiding Principles underpin the preparation of an integrated report.

• Strategic focus and future orientation – An integrated report should provide insight into the organisation’s strategy; how it enables the organisation to create value in the short, medium and long term; and its effects on the capitals.
• Connectivity of information – An integrated report should show a holistic picture of the factors that affect the organisation’s ability to create value.
• Stakeholder relationships – An integrated report should provide insight into the nature and quality of the organisation’s relationships with its stakeholders.
• Materiality – An integrated report should disclose information on matters that significantly affect the organisation’s ability to create value.
• Conciseness – An integrated report should be concise.
• Reliability and completeness – An integrated report should be balanced and free from material error.
• Consistency and comparability – The information in an integrated report should be comparable over time, and comparable with other entities.

The content of an integrated report

An integrated report should include all of the following content elements:

• Organisational overview and external environment – ‘What does the organisation do and what are the circumstances under which it operates?’
• Governance – ‘How does the organisation’s governance structure support its ability to create value in the short, medium and long term?’
• Opportunities and risks – ‘What are the specific opportunities and risks that affect the organisation’s ability to create value over the short, medium and long term, and how is the organisation dealing with them?’
• Strategy and resource allocation – ‘Where does the organisation want to go and how does it intend to get there?’
• Business model – ‘What is the organisation’s business model and to what extent is it resilient?’
• Performance – ‘To what extent has the organisation achieved its strategic objectives and what are its outcomes in terms of effects on the capitals?’
• Future outlook – ‘What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy, and what are the potential implications for its business model and future performance?’
• Basis of presentation –‘How does the organisation determine what matters to include in the integrated report and how are such matters quantified or evaluated?’

Including this content will help companies shift the focus of their reporting from historical financial performance to longer-term value creation.

Question 24

Describe a Non-Profit Entity?

The Objectives of a Non-Profit?

Assessing Performance in a non-profit?

Answer 24

A not-for-profit entity is one that does not carry on its activities for the purposes of profit or gain to particular persons and does not distribute its profits or assets to particular persons.
The main types of not-for-profit entity are:

•  clubs and societies
•  charities
•  public sector organisations (including central government, local government and National Health Service bodies).

The objectives of a not-for-profit entity

The main objective of public sector organisations is to provide services to the general public. Their long-term aim is normally to break even, rather than to generate a surplus.

Most public sector organisations aim to provide value for money, which is usually analysed into the three Es – economy, efficiency and effectiveness.

Other not-for-profit entities include charities, clubs and societies whose objective is to carry out the activities for which they were created.

Assessing performance in a not-for-profit entity
It can be difficult to monitor and evaluate the success of a not-for-profit organisation as the focus is not on a resultant profit as with a traditional business entity.

The success of the organisation should be measured against the key indicators that reflect the visions and values of the organisation. The strategic plan will identify the goals and the strategies that the organisation needs to adapt to achieve these goals.

The focus of analysis should be the measures of output, outcomes and their impact on what the charity is trying to achieve.