Financial Reporting

Question 1

Describe ROE and DuPont

Answer 1

Return on Equity = (NI/Average Equity)

DuPont Original
ROE = Net Profit Margin * Asset Turnover * Leverage (or equity multiplier)
(NI/Revenue) * (Revenue/Total Assets) * (Total Assets/Equity)

DuPont Extended: Breakout of Net Profit Margin into 3 ratios. Start at the bottom on income statement at net income, considering Tax and Interest. Look at operating profit separate from Tax and Interest.

NI/Revenue is broken out into 3 ratios:
EBIT Margin * Interest Burden * Tax Burden
(EBIT/Revenue) * (EBT/EBIT) * (NI/EBT) *
(Revenue/Total Assets) * (Total Assets/Equity)

EBIT Margin * Interest Burden * Tax Burden * Asset Turnover * Leverage

Tax burden = 1 – effective tax rate

Question 2

Double Declining Depreciation Method

Answer 2

Double-declining balance (DDB), an accelerated depreciation method:

DDBdepreciationinyearx =

2/depreciablelifeinyears *
bookvalueatbeginningofyear x

Question 3

Trade Payable and Trade Receivable

Answer 3

AKA Accounts Payable and Accounts Receivable

Question 4

Interest Coverage Ratio

Answer 4

EBIT / INT EXP

Higher interest coverage means greater ability to cover required interest and lease payments.

Question 5

LIFO vs FIFO when prices rise: Inventory, COGS, Net Income, tax

Answer 5

These four relations hold when prices have been rising over the relevant period:

LIFO inventory < FIFO inventory.

LIFO COGS > FIFO COGS.

LIFO net income < FIFO net income. (lower retained earnings)

LIFO tax < FIFO tax.

Question 6

What adjustments need to be made to the balance sheet for LIFO reserve

Answer 6

LIFO Reserve is the amount by which LIFO inventory is less than FIFO inventory.

add the LIFO reserve to LIFO inventory on the balance sheet. This gives you FIFO ending inventory.

net income increases by the increase in the LIFO reserve multiplied by (1 - tax rate)

after-tax profit = LIFO after-tax profit + (change in LIFO reserve)(1 − t)

increase the retained earnings component of shareholders’ equity by the LIFO reserve.

Question 7

As it relates to LIFO, COGS FIFO

Answer 7

COGS FIFO = COGS LIFO - (ending LIFO reserve - beginning LIFO reserve)

Question 8

Diluted Shares - Treasury Stock Method

Answer 8

The treasury stock method assumes that the funds received by the company from the exercise of the options would be used to hypothetically purchase shares of the company’s common stock in the market at the average market price.

Question 9

Basic EPS

Answer 9

= net income - pref divd / weighted average shares of common

Note: divd to common shareholders is not included in EPS calc. So if it’s part of the question ignore it.

Question 10

deferred tax asset vs liability

Answer 10

Tax reporting shows what you paid in taxes, while financial reporting shows what you should have paid. If you paid less than you should have you have a tax liability. If you paid more than you should have you have a tax asset. Also, you must look at tax payable under tax reporting vs tax expense under financial reporting

Note: if tax assets or liability is expected to reverse, than it hits assets or liability. If not, it hits equity.

Question 11

CFO Indirect Method - Steps

Answer 11

Step 1 - Start with Net Income
Step 2 - Subtract gains or add losses resulting from financing or investing cash flows (i.e. sale of land)
Step 3 - add back all non-cash charges to income (i.e. depreciation and amortization). and subtract all noncash components of revenue. Include impairments, write-offs, write-downs, provisions (warranty, restructuring, legal), deferred tax
Step 4 - Add or subtract changes in balance sheet items
- an increase in an asset is a use of Cash (-)
- an increase in a liability is a source of Cash (+)
- YOU DO NOT ACCOUNT FOR CHANGE IN CASH

Question 12

CFO - which sections of the balance sheet are typically used

Answer 12

With a few exceptions, operating activities relate to the firm’s current assets and current liabilities.

Question 13

What happens to deferred tax assets/liabilities when the tax rate increases?

Answer 13

An increase in the tax rate increases the value of both deferred tax assets and deferred tax liabilities to reflect the future tax rate.

Question 14

Skip

Answer 14

Skip

Question 15

When are financial markests considered operationally efficient?

Answer 15

When transaction costs are low

Question 16

When are financial markets considered informationally efficient

Answer 16

when prices reflect new info quickly

Question 17

when are financial markets allocationally efficient

Answer 17

when resources are allocated to their most productive uses.

Question 18

Calc Margin Call Price

Answer 18

original price × [(1 - initial margin) / (1 - maintenance margin)]

Remember that the initial margin is in the numerator by thinking as “initial” as being first.

Question 19

Inventory Turnover

Answer 19

COGS / average inventory

Question 20

Free Cash Flow to Firm ( FCFF)

Answer 20

FCFF = Cash flow from operations + interest net of taxes - net capital expenditures

int net of taxes = (interest expense * (1 - t))

Question 21

LIFO Liquidation

Answer 21

For a firm that uses the LIFO inventory cost method, a LIFO liquidation occurs if: the quantity of inventory decreases during a reporting period. In an increasing price environment this results in older, lower costs being included in COGS for the period.

Question 22

Impairment under IFRS

Answer 22

Tested for impairment annually.

Asset is impaired if Carrying Value (original cost minus depreciation) exceeds the recoverable value.

Recoverable Value is the greater of its fair value less any selling costs and its value in use. The value in use is the present value of its future cash flow stream from continued use.

Question 23

Impairments Under US GAAP

Answer 23

tested for impairment only when events and circumstances indicate the firm may not be able to recover the carrying value through future use.

Recoverability. An asset is considered impaired if the carrying value (original cost less accumulated depreciation) is greater than the asset’s future undiscounted cash flow stream.

The recoverable amount of an asset is defined as “the higher of its fair value less costs to sell and its value in use.” Value in use is a discounted measure of expected future cash flows. Under US GAAP, assessing recoverability is separate from measuring the impairment loss. An asset’s carrying amount is considered not recoverable when it exceeds the undiscounted expected future cash flows. If the asset’s carrying amount is considered not recoverable, the impairment loss is measured as the difference between the asset’s fair value and carrying amount.

Question 24

Cash Ratio

Answer 24

Cash + Marketable Securities / Current Liabilities

Question 25

deferred tax calc difference

Answer 25

The deferred tax liability is equal to the tax rate × temporary difference between the Financial reporting and Tax reporting #.

step 1 calc the carrying value (subtract accumulated depreciation) for Financial and Tax reporting.

step 2 - take the difference and multiply it by the tax rate.

Question 26

Describe a firm’s primary source of liquidity

Answer 26

A company’s primary sources of liquidity are the sources of cash it uses in its normal day-to-day operations : selling goods and services, collecting receivables, and generating cash from other sources such as short-term investments.

increasing cash flow management efficiency is a primary source of liquidity.

increasing bank lines of credit is a primary source of liquidity.

Question 27

Describe a firm’s secondary source of liquidity

Answer 27

Secondary sources of liquidity include liquidating short-term or long-lived assets, negotiating debt agreements (i.e., renegotiating), or filing for bankruptcy and reorganizing the company.

Question 28

Financial Statement Analysis Framework

Answer 28

1 - State purpose and context of analysis
2 - Collect Data
3 - Process Data
4 - Analyze/interpret data
5 - state conclusion
6 - follow up

Question 29

Free cashflow to the firm

Answer 29

Free cash flow to the firm can be computed as operating cash flows plus after-tax interest expense less capital expenditures.

Question 30

Tax Expense calc

Answer 30

Income tax expense = income tax payable (the tax rate * taxable income) + the increase in the deferred tax liabilities.

Question 31

Total Comprehensive Income and Comprehensive Income

Answer 31

DOES NOT INCLUDE DIVDs

Total comprehensive income = Net income + Other comprehensive income

Other Comprehensive Income

• gains/losses on available for sale securities
• Foreign currency translation gains and losses.
• Adjustments for minimum pension liability.
• Unrealized gains and losses from cash flow hedging derivatives.
• Unrealized gains and losses from available-for-sale securities.

Question 32

Derecognition of an Asset

Answer 32

If asset is sold, the asset is removed from the balance sheet and the difference between the sale proceeds and the carrying value reported as a gain or loss in the income statement.

If a long-lived asset is abandoned, the treatment is similar to a sale, except there are no proceeds. In this case, the carrying value of the asset is removed from the balance sheet and a loss of that amount is recognized in the income statement.

Question 33

Percentage of Completion Method - reliable estimate

Answer 33

Used for GAAP and IFRS when outcome of project can be reliably estimated.

The percentage of completion is measured by the total cost incurred to date divided by the total expected cost of the project. That % is applied to revenue of the project to calculate period revenue and profit

Question 34

Unreliable estimate of project cost - IFRS vs GAAP

Answer 34

Under IFRS, revenue is recognized to the extent of contract costs, costs are expensed when incurred, and profit is recognized only at completion.

Under GAAP, the completed contract method must be used. Rev, exp and profit are recognized when project is complete

If a loss is expected, the loss is recognized immediately.

Question 35

Installment Sales

Answer 35

Under U.S. GAAP, if collectibility is certain, revenue is recognized at the time of sale using the normal revenue recognition criteria. If collectibility cannot be reasonably estimated, the installment method is used. If collectibility is highly uncertain, the cost recovery method is used.

Under the installment method, profit is recognized as cash is collected. Profit is equal to the cash collected during the period multiplied by the total expected profit as a percentage of sales. Under the cost recovery method, profit is recognized only when cash collected exceeds costs incurred