Financial Reporting Analysis (Facts)

Question 1

What are the 4 Cost flow methods?

Answer 1

1) Specific identification
2) FIFO - First-in, First-out
3) Weighted average cost
4) LIFO - Last-in, First-out (GAAP only)

Question 2

What are the two ways companies record changes to inventory values?

Answer 2

1) Periodic - inventory value and COGS are calculated at the end of the accounting period
2) Perpetual - inventory values and COGS are calculated continuously

Question 3

What is the LIFO Reserve?

Answer 3

The difference between the reported LIFO inventory carrying amount and the inventory amount under FIFO.

FIFO Inv - LIFO Inv

Required to be disclosed in the notes to the financial statements or on the balance sheet.

Answer 4

1) LIFO reserve is added to inventory balance
2) The increase in LIFO Reserve (from reported period) is subtracted from COGS

Question 5

What is a LIFO liquidation?

Answer 5

Occurs when a LIFO firm’s inventory quantities are declining.

Older and lower costs are now included in COGSS and as a result profit margins will be higher with income taxes.

The LIFO liquidation must be disclosed in the footnotes.

Question 6

Can companies change inventory valuation methods?

Answer 6

Unders certain circumstances.

IFRS allows a change only if it “results in the financial statements providing reliable and more relevant information about the effects of the transactions, events, conditions on business entity’s financial position, financial performance, or cash flows”.

US GAAP are similar however require companies to thoroughly explain why the newly adopted method is superior and preferred to the old method.

Change is applied retrospectively.

Question 7

How does IFRS treat changes in inventory value?

Answer 7

Requires inventory to be measured at the i) lower of cost and ii) net realisable value (NRV).

Where NRV is the est. selling price less est. sale and preparation costs.

If NRV is < balance sheet cost the inventory is written down to NRV and loss is recognised in the income statement.

If recovery in value occurs inventory can be written up to the max amount of previously recognised losses and gain is recognised in the income statement.

Question 8

How does US GAAP treat changes in inventory value?

Answer 8

Requires inventory to be measured at the i) lower of cost and ii) market value.

Where Market is the replacement cost. Market however cannot exceed NRV or be lower than NRV less a normal profit margin.

If recovery in value occurs inventory cannot be written up.

Question 9

How can a company treat expenses in relation to long-lived assets?

Answer 9

If an expenditure is likely to provide a future economic benefit over multiple account periods than it is usually capitalised. If not benefit is likely or highly uncertain it is expensed.

1) Capitalise - initially recorded on the balance sheet at cost plus any costs necessary to prepare asset for use. Cost is then allocated to the income statement of the life of the asset as depreciation expense
2) Expensed - Current period Net Income is reduced by the after-tax amount of the expenditure

Holding all else constant, capitalising an expenditure enhances current profitability and increases reported cash flow from operations.

Question 10

What impact does capitalising have on Net Income?

Answer 10

Capitalising delays the recognition of expense so in the initial period NI will be higher. In subsequent periods NI will be lower than expensing due to the depreciation of the asset being recognised in the Income Statement.

Question 11

What impact does Capitalising an expense have on Shareholder’s equity?

Answer 11

NI will be higher due to capitalising so shareholder’s equity (retained earnings) will also be higher initially and then lower in the subsequent periods.

Question 12

What impact does capitalising an expense have on CFO?

Answer 12

Capitalising results in higher CFO and lower CFI.

Capitalised expenditures is usually reported as an outflow from investing activities.

Question 13

What impact does capitalising an expense have on Financial Ratios?

Answer 13

Capitalising results in higher assets and equity. Hence debt-to-assets and debt-to-equity ratios are lower.

Capitalising also results in higher ROA and ROE in the first year (lower in subsequent years)

Question 14

When are companies generally required to capitalise interest costs?

Answer 14

When acquiring or constructuing an asset for its own use or resale that requires a long period of time to get ready for it’s intended use.

The objective is to accurate measure the cost of the asset and match it with the revenues generated.

Question 15

How does a company determine the rate used on capitalised expenses?

Answer 15

Interest rate used is based on any debt specifically related to the construction of the asset or other existing unrelated borrowings.

Question 16

How is capitalised interested reported?

Answer 16

Income Statement - Capitalised interest is not reported in the income statement as an interest expense. It is allocated via depreciation of the asset or in COGS.

Cash flow statement - Capitalised interest is reported on the cash flow statement as an outflow from CFI while interest expense is reported as an outflow from CFO.

Question 17

What does the Interest Cover Ratio measure?

Answer 17

Measures a firm’s ability to make required interest payments on debt.

Capitalising expenses results in a lower interest expense and therefore higher NI - resulting in a higher interest cover ratio.

Including capitalised interest in the calculation of coverage ratios provides a better assessment of company’s solvency.

Question 18

What does IFRS & US GAAP require for capitalising/expensing internal development costs?

Answer 18

IFRS require expenditure on research be expensed until a project (moves to development) can meet a demonstration of technical feasibility (sale or internal use).

GAAP requires that research and development costs are expensed. An exception is certain costs related to software development which must be capitalised once feasibility has been established.

Question 19

What are the three types of depreciation methods?

Answer 19

1) Straight-line - Dominant method. Same amount each year is depreciated
2) Accelerated - More expense is recognised in the early years of an assets life
3) Units-of-production - Based on usage rather than time. Depreciable base (cost - est salvage value) of the asset is divided by the number of units expected to be produced over the assets life.

Total cost of depreciation is the same across all methods and firms can change the method is used. change is made prospectively.

Question 20

When has an impairment to a long-lived asset considered to have occured?

Answer 20

When the asset’s carrying amount is not recoverable and it exceeds fair value.

Question 21

How is an impairment loss measured under IFRS?

Answer 21

When the carrying (book) value (original cost - depreciation) is greater than the recoverable amount.

Where Recoverable amount is - 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.

Losses can be reversed up to original value.

Question 22

How is an impairment loss measured under US GAAP?

Answer 22

Two step process:

1) Recoverability is assessed - recoverability is not possible when the carrying value exceeds the undiscounted future cash flows.
2) Impairment loss is measured as the difference between the asset’s fair value and carrying amount.

Loss recoveries are not permitted

Question 23

What impact on financial statements does impairments have?

Answer 23

Impairments reduce the carrying amount of an asset on the balance sheet and reduce NI on the income statement (does not affect CFO).

1) Results in lower assets and equity (retain earnings)
2) ROA and ROE will be lower and Asset Turnover will be higher in the year of impairment.

Question 24

What are the benefits to leasing an asset?

Answer 24

i) Less costly financing (little or no down payment with fixed interest rate)
ii) Less restrictive contract clauses
iii) Reducation in the risk of obsolescence, residual value and disposition of the asset
iv) Some leases are not considered as debt on the financial statements

Question 25

What are the two types of leases?

Answer 25

1) Finance (capital) lease
- Purchase of an asset that is financed with debt
- Leasee adds equal amounts to assets and liabilities on the balance sheet. Asset is depreciated over the useful life
2) Operating lease
- Essentially forms a rental agreement
- Lease payments are recognised as rentral expense on the income statement

Leasees are required to disclose useful information about financing and operating leases in the financial statement footnotes (e.g. GAAP requires lease payments due for the next 5 years).

Question 26

How does IFRS classify a type of lease?

Answer 26

By determining the economic substance of the transaction. If all rights and risks of ownership are transferred to the leasee then it is treated as a finance lease.

Question 27

How does US GAAP classify a type of lease?

Answer 27

A lease is considered to be a finance lease if any of the follow are met:

1) TItle is transferred to the leasee at the end of period
2) A bargain purchase option exists (a provision that allows the purchase of the leased asset at a lower than fair market value in the future
3) Lease period is > 75% of asset’s economic life
4) Present value of lease payments is > 90% of the fair value of leased asset

Question 28

What is the reporting impact on financial statements for a Operating leasee?

Answer 28

At origination no entry is made. Rent expense is recognised in the income statement over the periods in use.

Rent expenses is reported as an outflow from operating activities on the cash flow statement.

Question 29

What is the reporting impact on financial statements for a Finance leasee?

Answer 29

At origination:

Balance sheet: Lower of i) Present value of future minimum lease payments or ii) Fair value of asset is recognised as an asset and liability

Subsequent periods:

Income Statement: Depreciation expense and interest expense is reported.

Cash Flow Statement: Lease payment is separated into interest expense and principal payments. GAAP requires interest expense to be reported as an outflow from CFO and principal from CFF. IFRS can choose interest expense as either an outflow from CFO or CFF.

Question 30

What is the reporting impact on financial statements for a Operating leasor?

Answer 30

Leasor recognises the lease payment as rental income while keeping the asset on this balance sheet and recognising depreciation over the asset’s life.

Question 31

What is the reporting impact on financial statements for an Finance Leasor?

Answer 31

US GAAP:

Two types of finance leases.

1) Sales-type lease
- PV of lease payments exceeds carrying value
- Treated as if the leasor sold the asset and provided financing to the buyer

At origination:

Leasor recognises a sale equal to the PV of lease payments and COGS equal to carrying value

Asset is removed from balance sheet and lease receivable is added equal to PV of lease payments

During use:

Leasor recognises interest revenue as the lease receivable multipled by the interest rate

Interest revnue portion is reported as an inflow from CFO and principal reduction is reported as inflow from CFI

2) Direct financing lease
- Lease payments are equal to carrying value

At origination

• Leasor removes asset from the balance sheet and adds a lease receivable

During use:

• Leasor recognises interest income on the income statement. The interest portion of the each lease payment is equal to the lease receivable times interest rate.
• The interest portion is reported as an inflow from CFO and principal portion as an inflow from CFI.

Question 32

What are the 4 types of Intercorporate investments?

Answer 32

1) Investments in financial assets (< 20% control)
2) Investments in associates (significant influence over operations of investee 20 - 50%)
3) Business combinations (control over the operations of investee > 50%)
4) Joint Ventures (joint control)

Question 33

How does US GAAP and IFRS classify investments in financial assets (four types)?

Answer 33

Debt Only:

1) Held-to-maturity (amortized cost, changes in value ignored unless deemed as impared)

Debt and Equity:

2) Held for trading (fair value, changes in value recognised in profit or loss)
3) Available-for-sale (fair value, changes in value recognised in equity)
4) Designated a fair value (fair value, changes in value recognised in profit or loss)

Question 34

What are the characteristics of Held-to-Maturity investments?

Answer 34

• Investments in debt assets with a fixed or determinable payments and fixed maturity
• Investor has the positive intent and ability to hold to maturity.
• They are recorded on the balance i) IFRS - fair value plus transaction costs. ii) GAAP - Cost including transaction costs.
• Interest income (coupons adj for amortization) are recognised in the income statement.
• HTM Investments are amortised cost each year however future changes in value are ignored
• Can be reclassifed to Available-for-sale if holder no longer intends to hold the security to maturity

Question 35

What are the characteristics of Held-for-Trading investments?

Answer 35

• Investments in debt or equity securities
• Usually held for trading profits in the short term
• Reported at fair value on the balance sheet
• Changes in value (realised or unrealised) are recognised in the income statement along with any dividends or interest payments

Question 36

What are the characteristics of Available-for-sale investments?

Answer 36

• Investments in debt and equity which is not classified as held-to-maturity or held for trading
• Reported at fair value plus transaction costs
• Changes in value are measured at fair value and any unrealised gains or losses are reported in Other Comprehensive Income
• Realised gains or losses are reported in the income statement.
• Note IFRS treats gains/losses from FX debt securities differently to GAAP. Exchange rate differences between periods are reported in the income statement.

Question 37

What are the characteristics of Designated at Fair Value investments?

Answer 37

• Investments that are intially designated at fair value have the option to report debt and equity securities that are otherwise treated as HTM or AFS.
• Unrealised gains/losses arising from changes in fair value and dividend or interest paymenst are recognised in the income statement

Question 38

How does IFRS handle reclassification of investments?

Answer 38

• Debt securities designated as AFS may be reclassified to HTM if a change in intention or ability has occured. When reclassified to HTM the security is remeasured at fair value and any previous gain or loss that was recognised in OCI is amortized to profit or loss over the remaining llfe of the security.
• Debt securities designated as HTM may be reclassified to AFS if a change in intention or ability has occured. When reclassified to AFS the security is remeasured at fair value with the difference between carrying amount (amortized cost) and fair value recognised in OCI
• Any financial asset classified as AFS may be reclassified at cost where no reliable measure of fair value and no evidence of impairment (rare).
• Securities that are designated at fair value are generally prohibited from reclassification

Question 39

How does US GAAP handle reclassification of investments?

Answer 39

• Allows reclassification of securities between all categories using the fair value of security at the date of transfer.
• Reclassification of securities out of HTM has implications for others securities of the same type.
• Treatment of unrealised gains or losses upon transfer depends on initial classification.
  i) HFT > AFS - Gains or losses are recognised in the income statement.
  ii) AFS > HFT - Cumulative gains and losses previously in OCI is recognised in income on date of transfer
  iii) HTM > AFS - unrealised gains and losses at date of transfer is recognised in OCI.
  iv) AFS > HTM - cumulative gains and losses previously in OCI is amortized over the remain life of the security as an adjustment of yield (as per premium or discount).

Question 40

When does IFRS consider an asset impaired?

Answer 40

When the carrying amount is expected to permanently exceed is recoverable amount.

For a debt security .

• Significant financial difficulty of the issuer
• Default or delinquency in interest or principal payments
• Borrower experiences financial difficulty and receives a concession from the lender as a result
• Probably a borrower will enter bankrupty

For a equity security

• Significant changes in the technological, market, economic and/or legal environments with an adverse affect on the investee
• Significant or prolonged decline in the fair value of an equity investment below its cost

Assets are tested at the end of each reporting period. Any security classified as fair value through profit / loss and HFT are already recognised in profit in loss.

Question 41

When does US GAAP consider an asset impaired?

Answer 41

When the carrying amount is expected to permanently exceed is recoverable amount.

• AFS and HTM is measured at each balance sheet date if any decline is permanent. Cost basis of the security is written down to its fair value (the new cost basis) and amount of write-down is treated as a realised loss and reported on the income statement.
• Subsequent increases in fair value are treated as unrealised gains and included in OCI (cost basis cannot be increased).

Question 42

What is mean by significant influence regarding Investments in Associates?

Answer 42

• Holding 20% to 50% of voting rights (directly or indirectly)
• Significant influence can be evidenced by
  i) Representation on the board of directors
  ii) Participation in the policy-making process
  iii) Material transactions between the investor and investee
  iv) Interchange of managerial personnel
  v) Technological dependency

Question 43

Which accounting method is used for Investments in Associates?

Answer 43

The Equity method - it reflects the economic reality of this relationship and provides a more objective basis for reporting investment income.

Question 44

How are Investment in Associates recorded with the Equity method?

Answer 44

• Recorded initially at cost
• Subsequent periods the carrying amount is increased (decreased) to recognise the investor’s proportionate share of investee’s earnings (losses). These are then reported in the income statement.
• Dividends and other distributions are treated as a return of capital and reduce the carrying amount of the investment. They are NOT reported in the investor’s income statement.
• One-line Consoliation. The investment is disclosed as a single separate line on the income statement and balance sheet (non-current assets).

Question 45

How to treat investment costs that exceed book value of the investee?

Answer 45

• PP&E is measured using either historical cost or fair value (less accum depreciation) - US GAAP historical only.
• When cost exceeds investor’s proportionate share of the investee’s book value
  i) Difference is first allocated to investee’s specific assets.
  ii) Differences are then amortized to the investor’s proportionate share of the investee’s profit or loss over the economic lives of the assets whose fair value exceeds book values.
• IFRS and US GAAP treat the difference as Goodwill (not amortised, reviewed for impairment on a regular basis) and is reported as part of the carrying amount on the investor’s sheet. .

Question 46

How is an investment treated for impairment using the equity method?

Answer 46

• If fair value of investment is below carrying value and deemed to be other than temporary an impairment must be recognised.
• IFRS requires objective evidence of impairment resulting from a loss event(s). Further that the loss event has an impact on the investment’s future cash flows.
• Goodwill is included in the carrying amount and is not separately tested for impairement.
• The impairment loss is recognised on the income statement and the carrying amount of the investment on the balance sheet is either reduced directly or via an allowance account.
• US GAAP considers that if fair value declines below its carrying value and the decline is permanent a loss is recognised on the income statement and carrying value of the investment is reduced to fair value.
• Neither allow reversal of impairment losses.

Question 47

What the two types of Transactions with Associates?

Answer 47

• Upstream: Sales from the associate to the investor. Sale is recognised immediately in the investee’s financial statements. Investor’s share of unrealised profits is included in equity income on the investor’s income statement.
• Downstream: Sales from the investor to the associate. Profit is recorded on the investor’s income statement, however, IFRS and GAAAP require the unearned profit (e.g. unsold goods) be eliminated to the extent of the investor’s interest in the associates.

Question 48

What accounting method is used for Joint Ventures?

Answer 48

• IFRS: Proportionate Consolidation
  i) Venturers share of assets, liabilities, income and expenses are combined on a line by line basis with similar items of the venturers financial statements.
• US GAAP: Equity method

Question 49

What are the 3 types of Joint Ventures under IFRS?

Answer 49

1) Jointly controlled operations - Venturers combined operations, resources and expertise to manufacture, market and distribute jointly a particular product. Each venturer recognises share of revenue generated and individual assets on own financial statements
2) Jointly controlled assets - Venturers jointly control or jointly own assets. Each recognises the share of income/expenses in it’s own accounting records and financial statements.
3) Jointly controlled entities - Predominant arrangement involving the establishment of a separate entity (with different interests for venturers). Entity operates independently however a contractual arrangement between venturers establishes joint control over the economic activity. IFRS recommends proportionate consolidations (permits equity method).

Question 50

How does US GAAP treat Joint Ventures?

Answer 50

• Refers only to a jointly controlled separate entity.
• Requires the use of the equity method
• Proportionate consolidation is generally not permitted except for unincorporated entities operating in certain industries.

Question 51

What accounting method is used for Business Combinations?

Answer 51

IFRS and US GAAP now require all business combinations be account for as acquisitions.

The acquisition method replaces the previously used purchase method.

Question 52

What are the 4 types of business combinations under US GAAP?

Answer 52

Merger:

Only a single entity remains (acquirer absorbs 100% of target company). Company A + Company B = Company A

Acquisition:

Entities remain in operation but is connected through a parent-subsidiary relationship. Each entity maintains separate financial statments and parent company provides consolidated statement (acquirer does not need 100% of target).

Consolidation:

A new legal entity is formed and neither of predecessor entities remain in existance.

Special Purpose Entities:

Created for a single purpose by a sponsoring company. Control is not usually baseed on voting control as equity investors do not normally have a sufficient amount at risk (subordinated financial support is needed). IFRS requires consolidation if sponsor retains control.

Question 53

How did the Pooling of Interests (Uniting of Interest) treat business combinations?

Answer 53

The combined companies were portrayed as if they had always operated as a single economic entity.

Assets and Liabilities were recorded at book values, and pre-combination retained earnings were included in the balance sheet of the combined companies.

Question 54

How does the Acquisition method treat business combinations?

Answer 54

It uses the fair value of the net assets acquired at the acquisition date.

It is usually equal to the consideration given by the acquiring firm. Direct costs (legal, valuation experts, consultants, etc) are expensed as incurred.

Question 55

What are the three major accounting issues that the acquisition method addresses?

Answer 55

1) Recognition and measurement of the assets and liabilities of the combined entities
2) Initial recognition and subsequent accounting for goodwill
3) Recognition and measurement of the non-controlling interest.

Question 56

How does the Acquisition method recognise and measure asset and liabilities of the combined entities?

Answer 56

1) Identifiable Assets and Liabilities

The acquirer measures the identifiable assets and liabilities of the acquiree at fair value as of the date of the acquisition.

2) Contingent Liabilities

Acquirer must recognise any contingent liability assumed in the acquisition if i) it is a present obligation and ii) it can be measured reliably.

3) Indemnification Assets

Acquirer must recognise an indemnification asset if the seller (acquiree) contractually indemnifies the acquier for the outcome of a contingency or an uncertainy related

4) Financial Assets and Liabilities

Acquirer can reclassify the financial assets and liabilities of the acquiree on the basis of the contractual terms, economic conditions, and the acquirer’s operating and accounting policies as they exist at the acquisition date.

Question 57

How does the Acquisition method recognise and measure Goodwill?

Answer 57

Under IFRS, goodwill is recognised as the fair value of the acquisition price less the acquirer’s share of all identifiable tangible and intangible assets, liabilities and contingent liabilities acquired (sometimes refered to as “partial goodwill”).

US GAAP considers the entity as a whole - Goodwill is recognised as the fair value of the acquisition less the fair value of the identifable net assets. IFRS permits this 100% percent goodwill under the “full goodwill” option on a transaction by transaction basis.

Question 58

What is the impact of the Acquisition Method on Financial Statements Post-acquisition?

Answer 58

Net income reflects the performance of the combined entity.

Amortisation and depreciation is based on historical cost of the acquirer’s assets and the fair value of the acquiree

Question 59

When is consolidation of financial statements required by IFRS and US GAAP?

Answer 59

IFRS - When one company has the ability to govern the financial operational policies of another company.

US GAAP - Uses a two component consolidation model.

i) Variable interst component - primary beneficiary of a Variable Interest Entity (VIE) is consolidate the VIE
ii) Voting interest (control)