Financial Reporting and Analysis Flashcards
What is the classification of business activities
■ Operating activities are those activities that are part of the day- to- day business
functioning of an entities
■ Investing activities are those activities associated with acquisition and disposal
of long- term assets.
■ Financing activities are those activities related to obtaining or repaying capital.
The two primary sources for such funds are owners (shareholders) or creditors
Where does ideally an analyst prefers that company’s profit comes from
operating activities.
What are Assets
assets are the
economic resources of a company
What are Liabilities
liabilities are the creditors’ claims on the resources of a company
What are owner equity
owners’ equity is the residual claim on those resources
What are Revenues
revenues
are inflows of economic resources to the company
What are Expenses
outflows of
economic resources or increases in liabilities
What are accounts
Accounts are
individual records of increases and decreases in a specific asset, liability, component
of owners’ equity, revenue, or expense.
What are allowance for bad debts
The estimated uncollectible amount is recorded in an account
What is a contra accounts
Any account that is offset or deducted from another account
Examples of contra accounts
Common contra accounts include
allowance for bad debts
accumulated depreciation
sales returns and allowances
What are non current assets
Non- current assets are assets that are expected to benefit the company over an
extended period of time (usually more than one year).
Current assets
are those that are expected to be consumed or converted into cash
in the near future, typically one year or less
Examples of currents assets
Inventory is the unsold units of product on hand (sometimes referred to as inventory stock).
Trade receivables (also referred
to as commercial receivables, or simply accounts receivable) are amounts customers
owe the company for products that have been sold as well as amounts that may be
due from suppliers (such as for returns of merchandise).
Other receivables represent
amounts owed to the company from parties other than customers.
Cash refers to cash
on hand
Cash equivalents are very liquid short- term investments, usually maturing in 90 days or
less.
The balance sheet
presents a company’s financial position at a particular point
in time. It provides a listing of a company’s assets and the claims on those assets
(liabilities and equity claims)
Formula for balance sheet
Assets = Liabilities + Owners’ equity
Formulas for Owners equity
Assets – Liabilities = Owners’ equity
Owners’ equity = Contributed capital + Retained earnings
income statement
presents the performance of a business for a specific period of time.
Revenue – Expenses = Net income (loss)
Formula
Ending retained earnings = Beginning retained earnings +Net income -Dividends
Expanded Assets Formula
Assets = Liabilities + Contributed capital + Ending retained earnings
or
Assets =Liabilities +Contributed capital +Beginning retained earnings
+Revenue- Expenses- Dividends
if no dividends present continue without it
statement of retained earnings
shows the linkage between the balance sheet
and income statement
Objectives Accounting System
■ Identify those activities requiring further action (e.g., collection of outstanding
receivable balances).
■ Assess the profitability of the operations over the month.
■ Evaluate the current financial position of the company (such as cash on hand).
Asset Accounts
Cash
Investments
Prepaid rent (cash paid for rent in advance of recognizing the expense)
Rent deposit (cash deposited with the landlord, but returnable to the company)
Office equipment
Inventory
Accounts receivable
Liability Accounts
Unearned fees (fees that have not been earned yet, even though cash has been received) Accounts payable (amounts owed to suppliers) Bank debt
Equity Accounts
Contributed capital
Retained earnings
Dividends
unclassified
balance sheet
one that does not show subtotals for current assets and current
liabilities. Assets are simply listed in order of liquidity (how quickly they are expected
to be converted into cash). Similarly, liabilities are listed in the order in which they
are expected to be satisfied (or paid off).
Depreciation
the term for the process of spreading this cost over
multiple periods
direct format
The format of the statement of cash flows presented here is known as the direct format, which refers to the operating cash section
appearing simply as operating cash receipts less operating cash disbursements.
indirect format
An
alternative format for the operating cash section, which begins with net income and
shows adjustments to derive operating cash flow,
Accrual
Accrual accounting requires that revenue be recorded when earned and that expenses
be recorded when incurred,
Unearned revenue (or deferred revenue)
arises when a company receives cash prior to earning the revenue.Liability
Unbilled revenue (or accrued revenue)
arises when a company earns revenue prior
to receiving cash but has not yet recognized the revenue at the end of an accounting
period.Asset
Prepaid expense
arises when a company makes a cash payment prior to recognizing an expense.Asset
Accrued expenses
arise when a company incurs expenses that have not yet been
paid as of the end of an accounting period. Accrued expenses result in liabilities
that usually require future cash payments Liability
Accounting System Flow
Journal entries and
adjusting entries
General ledger and
T- account
Trial balance and
adjusted trial
balance
Financial
statements
What’s the focus of financial analysis
a central focus of financial analysis is evaluating the company’s ability to
earn a return on its capital that is at least equal to the cost of that capital, to profitably
grow its operations, and to generate enough cash to meet obligations and pursue
opportunities.
Why is cash flow important
Cash flow is important because, ultimately, the company needs cash to pay
employees, suppliers, and others in order to continue as a going concern. A company
that generates positive cash flow from operations has more flexibility in funding needed
for investments and taking advantage of attractive business opportunities than an
otherwise comparable company without positive operating cash flow. Additionally,
a company needs cash to pay returns (interest and dividends) to providers of debt
and equity capital.
Liquidity
The ability to meet short- term obligations
Solvency
The ability to
meet long- term obligations is generally referred to as solvency.
When does companies prepare financial reports
Companies prepare financial reports at regular intervals (annually, semiannually,
and/or quarterly depending on the applicable regulatory requirements). Financial
reports include financial statements along with supplemental disclosures necessary
to assess the company’s financial position and periodic performance.
Do financial statements are audited by an independent accountant
Financial statements are almost always audited by independent accountants, who
provide an opinion on whether the financial statements present fairly the company’s
performance and financial position, in accordance with a specified, applicable set of
accounting standards and principles.
What’s the complete set of financial statements
A complete set of financial statements include a statement of financial position (i.e.,
a balance sheet), a statement of comprehensive income , a statement of changes in equity, and a statement of cash flows.
What does IFRS requires companies
IFRS require companies to present balance sheets that show current and non- current
assets and current and non- current liabilities as separate classifications. However, IFRS
do not prescribe a particular ordering or format, and the order in which companies
present their balance sheet items is largely a function of tradition.
Comprehensive Income
Comprehensive income includes all items that
impact owners’ equity but are not the result of transactions with shareowners. Some
of these items are included in the calculation of net income, and some are included
in other comprehensive income (OCI).
Statement of Changes in Equity
primarily serves to
report changes in the owners’ investment in the business over time. The basic components of owners’ equity are paid- in capital and retained earnings. Retained earnings
include the cumulative amount of the company’s profits that have been retained in
the company
Financial flexibility
is the ability of the company to react and
adapt to financial adversity and opportunities
Financial Notes and Supplementary Schedules
The notes (also sometimes referred to as footnotes) that accompany the four financial statements are required and are an integral part of the complete set of financial
statements. The notes provide information that is essential to understanding the information provided in the primary statements. The notes disclose the basis of preparation for the financial statements. The notes also disclose information about the accounting policies, methods, and
estimates used to prepare the financial statements.
Use of comparability
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.
Management Commentary or Management’s Discussion and Analysis
Publicly held companies typically include a section in their annual reports where
management discusses a variety of issues, including the nature of the business, past
results, and future outlook.
Who requires the Management Commentary
US Securities and Exchange
Commission (SEC) or the UK Financial Reporting Council (FRC).
Framework of Management Commentary
The framework identifies five content elements of a “decision- useful
management commentary:” 1) the nature of the business; 2) management’s objectives
and strategies; 3) the company’s significant resources, risks, and relationships; 4) results
of operations; and 5) critical performance measures
Overall Objective of an Auditor
A 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
B To report on the financial statements, and communicate as required by the
ISAs, in accordance with the auditor’s findings.
Can auditors provide an opinion with absolute accuracy
No,be based on estimates and assumptions.
How do you state 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.
How do you state a qualified audit opinion
A qualified audit opinion is one in which there is some scope limitation or
exception to accounting standards
How do you state an adverse audit opinion
An adverse audit opinion is issued when an auditor determines that
the financial statements materially depart from accounting standards and are not
fairly presented.
How do you state an disclaimer of opinion
Finally, a disclaimer of opinion occurs when, for some reason, such
as a scope limitation, the auditors are unable to issue an opinion.
Sarbanes-Oxley Act
the auditors must also express
an opinion on the company’s internal control systems. This information may be provided in a separate opinion or incorporated as a paragraph in the opinion related to
the financial statements. The internal control system is the company’s internal system
that is designed, among other things, to ensure that the company’s process for generating financial reports is sound.
Other sources of information provided
In addition, companies also provide information on management and director
compensation, company stock performance, and any potential conflicts of interest that
may exist between management, the board, and shareholders.
Interim Reports
Interim reports are also provided by the company either semiannually or quarterly,
depending on the applicable regulatory requirements. Interim reports generally present the four primary financial statements and condensed notes but are not audited.
These interim reports provide updated information on a company’s performance and
financial position since the last annual period
Other relevant current information
websites, in press
releases, and in conference calls with analysts and investors.
Purpose of Financial Statements
■ The primary purpose of financial reports is to provide information and data
about a company’s financial position and performance, including profitability
and cash flows
Balance Sheet
The balance sheet discloses what resources a company controls (assets) and
what it owes (liabilities) at a specific point in time. Owners’ equity represents
the net assets of the company; it is the owners’ residual interest in, or residual
claim on, the company’s assets after deducting its liabilities.
income statement
presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue and other income the company generated during
a period and what expenses, including losses, it incurred in connection with
generating that revenue and other income.
The financial statement analysis framework
● articulate the purpose and context of the analysis;
● collect input data;
● process data;
● analyze/interpret the processed data;
● develop and communicate conclusions and recommendations; and
● follow up
What’s the preferred audit Opinion
Qualified
Proxy Statement
The proxy statement provides details about management, their experience and qualifications.
Objective of Financial Reporting
the objective of financial reporting is to
provide financial information that is useful to users in making decisions about providing resources to the reporting entity, where those decisions relate to equity and
debt instruments, or loans or other forms of credit, and in influencing management’s
actions that affect the use of the entity’s economic resources.
Whats the two types of standards
some of which were quite comprehensive and complex (rules- based standards), and others that were more general (principles- based standards).
Accounting Standards Boards
Accounting standards boards exist in virtually every national market. These boards
are typically independent, private, not- for- profit organizations. There are certain
attributes that are typically common to these standard setters—the IASB and the
FASB
Regulatory Authorities
Regulatory authorities are governmental entities that have the legal authority to enforce financial reporting requirements and exert other controls over entities that participate in the capital markets
within their jurisdiction. Regulatory authorities may require that financial reports be
prepared in accordance with one specific set of accounting standards or may specify
acceptable accounting standards.
International Organization of Securities Commissions
the International Organization of Securities
Commissions (IOSCO) regulate a significant portion of the world’s financial capital
markets. This organization has established objectives and principles to guide securities
and capital market regulation. Formed in 1983 consists of ordinary members, associate members,
and affiliate members.
IOSCO’s comprehensive set of Objectives and Principles of Securities Regulation
■ protecting investors;
■ ensuring that markets are fair, efficient, and transparent; and
■ reducing systemic risk
IOSCO “Principle for Issuers”
■ There should be full, accurate, and timely disclosure of financial results, risk,
and other information which is material to investors’ decisions.
■ Accounting standards used by issuers to prepare financial statements should be
of a high and internationally acceptable quality
Most significant pieces of legislation in the US
■ Securities Act of 1933 (The 1933 Act): This act specifies the financial and
other significant information that investors must receive when securities are
sold, prohibits misrepresentations, and requires initial registration of all public
issuances of securities.
■ Securities Exchange Act of 1934 (The 1934 Act): This act created the SEC,
gave the SEC authority over all aspects of the securities industry, and empowered the SEC to require periodic reporting by companies with publicly traded
securities.
■ Sarbanes–Oxley Act of 2002: This act created the Public Company Accounting
Oversight Board (PCAOB) to oversee auditors. The SEC is responsible for
carrying out the requirements of the act and overseeing the PCAOB. The act
addresses auditor independence (it prohibits auditors from providing certain
non- audit services to the companies they audit); strengthens corporate responsibility for financial reports
Fillings used by analysts
■ Securities Offerings Registration Statement: The 1933 Act requires companies offering securities to file a registration statement. New issuers as well as
previously registered companies that are issuing new securities are required to
file these statements. Required information and the precise form vary depending upon the size and nature of the offering. Typically, required information
includes: 1) disclosures about the securities being offered for sale, 2) the relationship of these new securities to the issuer’s other capital securities, 3) the
information typically provided in the annual filings, 4) recent audited financial
statements, and 5) risk factors involved in the business.
■ Forms 10- K, 20- F, and 40- F: These are forms that companies are required
to file annually. Form 10- K is for US registrants, Form 40- F is for certain
Canadian registrants, and Form 20- F is for all other non- US registrants. These
forms require a comprehensive overview, including information concerning a
company’s business, financial disclosures, legal proceedings, and information
related to management. The financial disclosures include a historical summary of financial data (usually 10 years), management’s discussion and analysis
(MD&A) of the company’s financial condition and results of operations, and
audited financial statements.
■ Annual Report: In addition to the SEC’s annual filings (e.g., Form 10- K), most
companies prepare an annual report to shareholders. This is not a requirement
of the SEC. The annual report is usually viewed as one of the most significant
opportunities for a company to present itself to shareholders and other external parties; accordingly, it is often a highly polished marketing document with
photographs, an opening letter from the chief executive officer, financial data,
market segment information, research and development activities, and future
corporate goals. In contrast, the Form 10- K is a more legal type of document
with minimal marketing emphasis. Although the perspectives vary, there is considerable overlap between a company’s annual report and its Form 10- K. Some
companies elect to prepare just the Form 10- K or a document that integrates
both the 10- K and annual report.
■ Proxy Statement/Form DEF- 14A: The SEC requires that shareholders of a
company receive a proxy statement prior to a shareholder meeting. A proxy is
an authorization from the shareholder giving another party the right to cast its
vote. Shareholder meetings are held at least once a year, but any special meetings also require a proxy statement. Proxies, especially annual meeting proxies,
contain information that is often useful to financial analysts. Such information
typically includes proposals that require a shareholder vote, details of security
ownership by management and principal owners, biographical information on
directors, and disclosure of executive compensation. Proxy statement information is filed with the SEC as Form DEF- 14A
■ Forms 10- Q and 6- K: These are forms that companies are required to submit
for interim periods (quarterly for US companies on Form 10- Q, semiannually for many non- US companies on Form 6- K). The filing requires certain
financial information, including unaudited financial statements and a MD&A
for the interim period covered by the report. Additionally, if certain types of
non- recurring events—such as the adoption of a significant accounting policy,
commencement of significant litigation,
Other Forms
■ Form 8- K: In addition to filing annual and interim reports, SEC registrants
must report material corporate events on a more current basis. Form 8- K (6- K
for non- US registrants) is the “current report” companies must file with the
SEC to announce such major events as acquisitions or disposals of corporate assets, changes in securities and trading markets, matters related to accountants
and financial statements, corporate governance and management changes, and
Regulation FD disclosures
■ Forms 3, 4, 5 and 144: Forms 3, 4 and 5 are required to report beneficial
ownership of securities. These filings are required for any director or officer of
a registered company as well as beneficial owners of greater than 10 percent
of a class of registered equity securities. Form 3 is the initial statement, Form
4 reports changes, and Form 5 is the annual report. Form 14 is notice of the
proposed sale of restricted securities or securities held by an affiliate of the
issuer. These forms can be used to examine purchases and sales of securities
by officers, directors, and other affiliates of the company, who collectively are
regarded as corporate insiders.
■ Form 11- K: This is the annual report of employee stock purchase, savings, and
similar plans. It might be of interest to analysts for companies with significant
employee benefit plans because it contains more information than that disclosed in the company’s financial statemen
What are the two fundamental qualitative characteristics that make financial information useful
Relevance
: Information is relevant if it would potentially affect or make a differences in users’ decisions. The information can have predictive value (useful
in making forecasts), confirmatory value (useful to evaluate past decisions
or forecasts), or both. In other words, relevant information helps users of financial information to evaluate past, present, and future events, or to confirm
or correct their past evaluations in a decision- making context. Materiality:
Information is considered to be material if omission or misstatement of the
information could influence users’ decisions.
Faithful representation: Information that faithfully represents an economic
phenomenon that it purports to represent is ideally complete, neutral, and free
from error. Complete means that all information necessary to understand the
phenomenon is depicted. Neutral means that information is selected and presented without bias. In other words, the information is not presented in such a
manner as to bias the users’ decisions. Free from error means that there are no
errors of commission or omission in the description of the economic phenomenon, and that an appropriate process to arrive at the reported information was
selected and was adhered to without error. Faithful representation maximizes
the qualities of complete, neutral, and free from error to the extent possible.
What are the four enhancing qualitative characteristics
1 Comparability: Comparability allows users “to identify and understand similarities and differences of items.” Information presented in a consistent manner
over time and across entities enables users to make comparisons more easily
than information with variations in how similar economic phenomena are
represented.
2 Verifiability: Verifiability means that different knowledgeable and independent
observers would agree that the information presented faithfully represents the
economic phenomena it purports to represent.
3 Timeliness: Timely information is available to decision makers prior to their
making a decision.
4 Understandability: Clear and concise presentation of information enhances
understandability. Information should be prepared for and be understandable
by users who have a reasonable knowledge of business and economic activities,
and who are willing to study the information with diligence. Information that is
useful should not be excluded simply because it is difficult to understand and it
may be necessary for users to seek assistance to understand information about
complex economic phenomena.
What are the two Assumptions in Financial Statements
The use of “accrual accounting” assumes that financial statements should reflect
transactions in the period when they actually occur, not necessarily when cash movements occur
“Going concern” refers to the assumption that the company will continue in
business for the foreseeable future
Measurement of Financial Statement Elements
■ Historical cost: Historical cost is simply the amount of cash or cash equivalents
paid to purchase an asset, including any costs of acquisition and/or preparation.
If the asset was not bought for cash, historical cost is the fair value of whatever
was given in order to buy the asset. When referring to liabilities, the historical
cost basis of measurement means the amount of proceeds received in exchange
for the obligation.
■ Amortized cost: Historical cost adjusted for amortization, depreciation, or
depletion and/or impairment.
■ Current cost: In reference to assets, current cost is the amount of cash or cash
equivalents that would have to be paid to buy the same or an equivalent asset
today. In reference to liabilities, the current cost basis of measurement means
the undiscounted amount of cash or cash equivalents that would be required to
settle the obligation today.
■ Realizable (settlement) value: In reference to assets, realizable value is the
amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. For liabilities, the equivalent to realizable
value is called “settlement value”—that is, settlement value is the undiscounted
amount of cash or cash equivalents expected to be paid to satisfy the liabilities
in the normal course of business.
■ Present value (PV): For assets, present value is the present discounted value of
the future net cash inflows that the asset is expected to generate in the normal
course of business. For liabilities, present value is the present discounted value
of the future net cash outflows that are expected to be required to settle the
liabilities in the normal course of business.
■ Fair value: is defined as an exit price, the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. This may involve either market measures
or present value measures depending on the availability of information.
Required Financial Statements
• Statement of financial position (Balance sheet)
• Statement of comprehensive income (Single
statement or Income statement + Statement of
comprehensive income)
• Statement of changes in equity
• Statement of cash flows
• Notes, summarizing accounting policies and
disclosing other items
• In certain cases, Statement of financial position
from earliest comparative period
General Features
• Fair presentation Fair presentation requires the faithful representation of the effects
of transactions, other events and conditions in accordance with the
definitions and recognition criteria for assets, liabilities, income and
expenses
• Going concern Financial statements are prepared on a going concern basis
unless management either intends to liquidate the entity or to cease trading,
or has no realistic alternative but to do so. If not presented on a going concern
basis, the fact and rationale should be disclosed.
• Frequency of reporting Financial statements must be prepared at least annually.
• Comparative information : Financial statements must include comparative information from the previous period.
• Consistency of presentation The presentation and classification of items in the financial statements are usually retained from one period to the ne
• Accrual basis Financial statements (except for cash flow information) are to be
prepared using the accrual basis of accounting
• Materiality and aggregation Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions
that users make on the basis of the financial statements
• No offsetting Assets and liabilities, and income and expenses, are not offset
unless required or permitted by an IFRS
Structures and Content
• Classified balance sheet requires the balance
sheet to distinguish between current and non- current assets, and between current and non- current liabilities unless a presentation based on liquidity provides
more relevant and reliable information
• Minimum specified information on face specifies the
minimum line item disclosures on the face of, or in the notes to, the financial
statements
• Comparative information For all amounts reported in a financial statement,
comparative information should be provided for the previous period unless
another standard requires or permits otherwise.
disclosures
■ Minimum Information in the Notes (or on the face of financial statements):
specifies disclosures about information to be presented in the financial statements. This information must be provided in a systematic manner and cross-referenced from the face of the financial statements to the notes
How do you call an income statement that shows gross profit
it is said to use a multi- step format rather than a single- step format. Gross profit its said to be calculated as revenue minus the cost of the goods that were sold
operating profit
Operating profit results from
deducting operating expenses such as selling, general, administrative, and research
and development expenses from gross profit. Operating profit reflects a company’s
profits on its business activities before deducting taxes, and for non- financial companies, before deducting interest expense. can be called s EBIT (earnings before interest and
taxes). However, operating profit and EBIT are not necessarily the same
Revenue Recognition
Accounting standards for revenue
recognition became effective at the beginning
of 2018 and are nearly identical under IFRS and US GAAP. The revenue recognition
standards for IFRS and US GAAP (IFRS 15 and ASC Topic 606, respectively) were
issued in 2014 and resulted from an effort to achieve convergence, consistency, and
transparency in revenue recognition globally.
What is income
Income is increases in economic benefits during the accounting period in
the form of inflows or enhancements of assets or decreases of liabilities
that result in increases in equity, other than those relating to contributions
from equity participants.
What happens if a company receives cash in advance before delivering service
the company would record a liability for unearned revenue when the cash
is initially received, and revenue would be recognized as being earned over time as
products and services are delivered.
What are the five steps in recognizing revenue
1 Identify the contract(s) with a customer
2 Identify the separate or distinct performance obligations in the contract
3 Determine the transaction price
4 Allocate the transaction price to the performance obligations in the contract
5 Recognize revenue when (or as) the entity satisfies a performance obligation
when should revenue be recognized
Revenue is recognized when the obligation- satisfying transfer is made.
Revenue should only be recognized when it is highly probable that it will not be
subsequently reversed. This may result in the recording of a minimal amount of revenue upon sale when an estimate of total revenue is not reliable. The balance sheet
will be required to reflect the entire refund obligation as a liability and will include
an asset for the “right to returned goods” based on the carrying amount of inventory
less costs of recovery
EXPENSE RECOGNITION
expenses are “decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or
incurrences of liabilities that result in decreases in equity, other than those relating
to distributions to equity participants
matching principle
Under matching, a company
recognizes some expenses (e.g., cost of goods sold) when associated revenues are
recognized and thus, expenses and revenues are matched. Associated revenues and
expenses are those that result directly and jointly from the same transactions or events. Matching requires that a company recognizes cost of goods
sold in the same period as revenues from the sale of the goods
Issues in Expense Recognition
When a company sells its products or services on credit, it is likely that some customers will ultimately default on their obligations (i.e., fail to pay). At the time of the
sale, it is not known which customer will default. (If it were known that a particular
customer would ultimately default, presumably a company would not sell on credit
to that customer.)
Doubtful Accounts
One possible approach to recognizing credit losses on customer
receivables would be for the company to wait until such time as a customer defaulted
and only then recognize the loss (direct write- off method). Such an approach would
usually not be consistent with generally accepted accounting principles.
Under the matching principle, at the time revenue is recognized on a sale, a company is required to record an estimate of how much of the revenue will ultimately be
uncollectible
Warranties
At times, companies offer warranties on the products they sell. If the product proves
deficient in some respect that is covered under the terms of the warranty, the company
will incur an expense to repair or replace the product. At the time of sale, the company
does not know the amount of future expenses it will incur in connection with its warranties. One possible approach would be for a company to wait until actual expenses
are incurred under the warranty and to reflect the expense at that time. However, this
would not result in a matching of the expense with the associated revenue.
Under the matching principle, a company is required to estimate the amount of
future expenses resulting from its warranties, to recognize an estimated warranty
expense in the period of the sale, and to update the expense as indicated by experience
over the life of the warranty.
What are the two models for valuing property, plant and equipment
the cost model and the revaluation model.
Implications for Financial Analysis
A policy that results in recognition
of expenses later rather than sooner is considered less conservative.If, for example, a company shows a significant year- to- year change in its estimates
of uncollectible accounts as a percentage of sales, warranty expenses as a percentage
of sales, or estimated useful lives of assets, the analyst should seek to understand the
underlying reasons.
NON- RECURRING ITEMS AND NON- OPERATING
ITEMS
To assess a company’s future earnings, it is helpful to separate those prior years’
items of income and expense that are likely to continue in the future from those
items that are less likely to continue. Both IFRS and US GAAP specify that the results of discontinued operations should be reported separately from continuing operations.
Discontinued Operations
When a company disposes of or establishes a plan to dispose of one of its component
operations and will have no further involvement in the operation, the income statement reports separately the effect of this disposal as a “discontinued” operation under
both IFRS and US GAAP
Unusual or Infrequent Items
IFRS require that items of income or expense that are material and/or relevant to the
understanding of the entity’s financial performance should be disclosed separately. Under US GAAP, material items that are unusual or infrequent, and that are both as of reporting periods
beginning after December 15, 2015, are shown as part of a company’s continuing
operations but are presented separately
Changes in Accounting Policies
At times, standard setters issue new standards that require companies to change
accounting policies. Depending on the standard, companies may be permitted to
adopt the standards prospectively (in the future) or retrospectively (restate financial
statements as though the standard existed in the past).
What is Retrospective Application
Retrospective application means that the financial statements for all fiscal years
shown in a company’s financial report are presented as if the newly adopted accounting
principle had been used throughout the entire period. Notes to the financial statements
describe the change and explain the justification for the change. Because changes in
accounting principles are retrospectively applied, the financial statements that appear
within a financial report are comparable.
Possible adjustment
correction of an error for a prior period (e.g.,
in financial statements issued for an earlier year). This cannot be handled by simply
adjusting the current period income statement. Correction of an error for a prior
period is handled by restating the financial statements (including the balance sheet,
statement of owners’ equity, and cash flow statement) for the prior periods presented
in the current financial statements
Non- Operating Items
Non- operating items are typically reported separately from operating income because
they are material and/or relevant to the understanding of the entity’s financial performance. Under IFRS, there is no definition of operating activities, and companies
that choose to report operating income or the results of operating activities should
ensure that these represent activities that are normally regarded as operating. 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.
How can interest and dividends be shown
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.)
What’s an ordinary share
Under IFRS, the type of equity for which EPS is presented is referred to
as ordinary. Ordinary shares are those equity shares that are subordinate to all other
types of equity. The ordinary shareholders are basically the owners of the company—the
equity holders who are paid last in a liquidation of the company and who benefit the
most when the company does well. Under US GAAP, this ordinary equity is referred
to as common stock or common shares, reflecting US language usage
What happens when a company issues financial instruments that are convertible to stocks
it is said to have a complex capital structure
What happens when a company issues financial instruments that are not convertible to stocks
it is said to have a simple capital structure
Why is it important to know between a simple vs complex capital structure
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
What’s diluted EPS
The EPS that would result if all dilutive financial instruments
were converted is called diluted EPS
What’s basic EPS
Basic EPS is the amount of income available to common shareholders divided by the
weighted average number of common shares outstanding over a period. The amount
of income available to common shareholders is the amount of net income remaining
after preferred dividends (if any) have been paid
Diluted EPS,
is always equal to or less
than basic EPS. The sections below describe the effects of three types of potentially
dilutive financial instruments on diluted EPS: convertible preferred, convertible debt,
and employee stock options.
Diluted EPS When a Company Has Convertible Preferred Stock Outstanding
When a company has convertible preferred stock outstanding, diluted EPS is calculated using the if- converted method. The if- converted method is based on what
EPS would have been if the convertible preferred securities had been converted at the beginning of the period.
Diluted EPS When a Company Has Convertible Debt Outstanding
When a company has convertible debt outstanding, the diluted EPS calculation also
uses the if- converted method
Diluted EPS When a Company Has Stock Options, Warrants, or Their Equivalents
Outstanding
This method is called the treasury
stock method under US GAAP because companies typically hold repurchased shares
as treasury stock. The same method is used under IFRS but is not named
Common- Size Analysis of the Income Statement
Common- size analysis of the income statement can be performed by stating each line
item on the income statement as a percentage of revenue. Common- size statements
facilitate comparison across time periods (time series analysis) and across companies
(cross- sectional analysis) because the standardization of each line item removes the
effect of size
Vertical common- size analysis
Vertical common- size analysis of the income statement is particularly useful in
cross- sectional analysis—comparing companies with each other for a particular time
period or comparing a company with industry or sector data. The analyst could select
individual peer companies for comparison, use industry data from published sources,
or compile data from databases based on a selection of peer companies or broader
Net Profit
Net profit margin measures the amount of income that a company was able to generate for each dollar of revenue. A higher level of net profit margin indicates higher
profitability and is thus more desirable. Net profit margin can also be found directly
on the common- size income statement
gross profit margin
The gross profit margin measures the amount of gross profit that a company generated for each dollar of revenue. A higher level of gross profit margin indicates higher
profitability and thus is generally more desirable, although differences in gross profit
margins across companies reflect differences in companies’ strategies.
” Total comprehensive income
is “the change in equity during a period resulting from transaction
and other events, other than those changes resulting from transactions with owners
in their capacity as owners.
What includes in comprehensive income
Comprehensive income includes both net income and other revenue and expense
items that are excluded from the net income calculation (collectively referred to as
Other Comprehensive Income).
Types of Items treated as other comprehensive income
■ Foreign currency translation adjustments. In consolidating the financial statements of foreign subsidiaries, the effects of translating the subsidiaries’ balance
sheet assets and liabilities at current exchange rates are included as other comprehensive income.
■ Unrealized gains or losses on derivatives contracts accounted for as hedges.
Changes in the fair value of derivatives are recorded each period, but certain
changes in value are treated as other comprehensive income and thus bypass
the income statement.
■ Unrealized holding gains and losses on a certain category of investment securities, namely, available- for- sale debt securities under US GAAP and securities
designated as “fair value through other comprehensive income” under IFRS.
(Note: IFRS, but not US GAAP, also includes a category of equity investments
designated at fair value through other comprehensive income.)
■ Certain costs of a company’s defined benefit post- retirement plans that are not
recognized in the current period.
Under IFRS can companies reclassify other comprehensive income
under IFRS, companies are not permitted to reclassify
certain items of other comprehensive income to profit or loss, and companies must
present separately the items of other comprehensive income that will and will not be
reclassified subsequently to profit or loss.
trading securities
The trading securities category pertains
to a debt security that is acquired with the intent of selling it rather than holding it to collect the interest and principal payments. Also, under US GAAP, unrealized gains
and losses are reflected as other comprehensive income for debt securities designated
as available- for- sale securities. Available- for- sale debt securities are those not designated as either held- to- maturity or trading
Where under IFRS unrealized gains and losses are reflected in the income statement
Under IFRS, unrealized gains and losses are reflected in the income statement
for: (a) investments in equity investments, unless the company makes an irrevocable
election otherwise; and (b) debt securities, if the securities do not fall into the other
measurement categories or if the company makes an irrevocable election to show
gains and losses on the income statement. Referred as fair value through profit or loss
Components of income statement
revenue; cost of sales; sales,
general, and administrative expenses; other operating expenses; non- operating
income and expenses; gains and losses; non- recurring items; net income; and
EPS
How expenses may be grouped
either function or nature
Formula other comprehensive income
Comprehensive income – Net income = Other comprehensive income
Consolidation
means that they include all of the revenues and expenses of the subsidiaries even if they own less than 100 percent
How profitability will look under the converged standards
higher
Accelerated depreciation
conservative accounting choice
If company is agent report net
if owner report gross
MD&A Requirements
US GAAP
important trends/events that affect liquidity,capital resources
results of operations
off balance sheet obligations
prospects for inflation,goals,material events
critical activity polices that require subjective jugdements
IFRS
nature of business
MGMT objectives/strategies
significant resources,risk,relationships,results of operations
Working Capital
The excess of current assets over current liabilities
What is a classified balance sheet
A balance sheet with separately classified current and non- current assets and liabilities
What is a liquidity based presentation
A liquidity- based presentation, rather than a current/non- current presentation, is
used when such a presentation provides information that is reliable and more relevant.
With a liquidity- based presentation, all assets and liabilities are presented broadly in
order of liquidity.
Who uses an liquidity based presentation
Banks
Current Assets
Assets that are held primarily for the purpose of trading or that are expected to be
sold, used up, or otherwise realized in cash within one year or one operating cycle
of the business, whichever is greater, after the reporting period
Current Assets 1 ( Cash and Cash Equivalents)
Cash equivalents are highly liquid, short- term investments that are so close to maturity,
the risk is minimal that their value will change significantly with changes in interest
rates. Cash and cash equivalents are financial assets. Financial assets, in general, are
measured and reported at either amortised cost or fair value.
What’s fair value
Under IFRS and US GAAP, fair value is based on an exit price, the price
received to sell an asset or paid to transfer a liability in an orderly transaction between
two market participants at the measurement date.
Current Assets 2 Marketable Securities
Marketable securities are also financial assets and include investments in debt or
equity securities that are traded in a public market, and whose value can be determined from price information in a public market. Examples of marketable securities
include treasury bills, notes, bonds, and equity securities, such as common stocks and
mutual fund shares
Trade Receivables
Trade receivables, also referred to as accounts receivable, are another type of financial
asset. These are amounts owed to a company by its customers for products and services
already delivered. They are typically reported at net realizable value, an approximation
of fair value, based on estimates of collectability.
Current Assets 3 ( Inventories)
are physical products that will eventually be sold to the company’s customers, either in their current form (finished goods) or as inputs into a process to manufacture a final product (raw materials and work- in- process).
How are inventories measured under IFRS
the lower of cost and net realizable value (NRV) under
IFRS.
What comprises the cost of inventories
The cost of inventories comprises all costs of purchase, costs of conversion, and
other costs incurred in bringing the inventories to their present location and condition.
How is net realizable value calculated
is the estimated selling price less the estimated costs of completion and costs
necessary to complete the sale
How are inventories measured under US GAAP
inventories are also measured at the lower of cost and NRV unless they
are measured using the last- in, first- out (LIFO) or retail inventory methods. When
using LIFO or the retail inventory methods, inventories are measured at the lower
of cost or market value
What methods IFRS uses to calculate inventories
IFRS allows only the first- in, first- out (FIFO), weighted
average cost, and specific identification methods.The LIFO method is not allowed under IFRS
Other currents Assets ( Prepaid Expenses)
reflect items that are individually not
material enough to require a separate line item on the balance sheet and so are
aggregated into a single amount. Companies usually disclose the components of other
assets in a note to the financial statements.
Prepaid Expenses
Prepaid expenses are normal operating expenses that
have been paid in advance. Because expenses are recognized in the period in which
they are incurred—and not necessarily the period in which the payment is made—the
advance payment of a future expense creates an asset
How to put prepaid expenses in the balance sheet
Asset and liability
Current Liabilities
Current liabilities are those liabilities that are expected to be settled in the entity’s
normal operating cycle, held primarily for trading, or due to be settled within 12 months
after the balance sheet date
Current Liabilities ( Trade Payables)
Trade payables, also called accounts payable, are amounts that a company owes
its vendors for purchases of goods and services.
Current Liabilities ( Accrued Expenses)
are expenses that have been recognized on a company’s
income statement but not yet been paid as of the balance sheet date.common examples of accrued expenses are accrued interest
payable, accrued warranty costs, and accrued employee compensation
Current Liabilities ( Deferred Income)
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
Non-Current Assets ( Property,Plant,Equipment)
are tangible assets that are used in company
operations and expected to be used (provide economic benefits) over more than one
fiscal period.
How IFRS permits companies to report PPE
a cost model or a revaluation model
How US GAAP permits companies to report PPE
US GAAP permits only the cost model for reporting PPE
How a cost model works
Under the cost model, PPE is carried at amortised cost (historical cost less any
accumulated depreciation or accumulated depletion, and less any impairment losses).
How a historical model works
accumulated depreciation or accumulated depletion, and less any impairment losses).
Historical cost generally consists of an asset’s purchase price, plus its delivery cost,
and any other additional costs incurred to make the asset operable (such as costs to
install a machine).
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.
Non current assets (Investment Property)
used to earn rental income or capital appreciation (or both).
How IFRS reports investment property
cost model or a fair
value model.
Non Current Assets (Intangible assets)
are identifiable non- monetary assets without physical substance.
An identifiable asset can be acquired singly (can be separated from the entity) or is the
result of specific contractual or legal rights or privileges. Examples include patents,
licenses, and trademarks.
How IFRS reports intangible assets
report intangible assets using either a cost model or a
revaluation model.The revaluation model can only be selected when there is an active
market for an intangible asset
How US GAAP reports intangible assets
US GAAP permits only the cost model
Is it advisable to report a zero value to intangibles
not advisable; instead, an analyst should examine each listed intangible
and assess whether an adjustment should be made.
Examples of intangible assets that cant be recognized
These assets might include management skill, name recognition, a
good reputation,
Identifiable Intangible assets
Under IFRS, identifiable intangible assets are recognized on the balance sheet if it is
probable that future economic benefits will flow to the company and the cost of the asset
can be measured reliably
Non current Assets (Goodwill)
When one company acquires another, the purchase price is allocated to all the identifiable assets (tangible and intangible) and liabilities acquired, based on fair value. If the
purchase price is greater than the acquirer’s interest in the fair value of the identifiable
assets and liabilities acquired, the excess amount is recognized as an asset,
Economic Goodwill
Economic goodwill is based on the economic performance of the entity. 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
Accounting Goodwill
accounting goodwill is based on accounting standards and is reported only in the case
of acquisitions.
How is account good will capitalized
Goodwill is not amortised but is tested for impairment annually. If
goodwill is deemed to be impaired, an impairment loss is charged against income in
the current period. An impairment loss reduces current earnings. An impairment loss
also reduces total assets, so some performance measures, such as return on assets
(net income divided by average total assets), may actually increase in future periods.
An impairment loss is a non- cash item.
Accounting standards for recognizing goodwill
A The total cost to purchase the target company (the acquiree) is determined.
B The acquiree’s identifiable assets are measured at fair value. The acquiree’s
liabilities and contingent liabilities are measured at fair value. The difference
between the fair value of identifiable assets and the fair value of the liabilities
and contingent liabilities equals the net identifiable assets acquired.
C Goodwill arising from the purchase is the excess of a) the cost to purchase
the target company over b) the net identifiable assets acquired. Occasionally,
a transaction will involve the purchase of net identifiable assets with a value
greater than the cost to purchase. Such a transaction is called a “bargain purchase.”
Can recognition of goodwill affect companies financial ratios
■ excluding goodwill from balance sheet data used to compute financial ratios,
and
■ excluding goodwill impairment losses from income data used to examine operating trends.
Non current Assets (Financial Assets)
IFRS define a financial instrument as a contract that gives rise to a financial asset
of one entity, and a financial liability or equity instrument of another entity.
How financial instruments recognized
fair value or amortised cost
under US GAAP “Held to Maturity”
financial assets are subsequently measured at amortised cost if the
asset’s cash flows occur on specified dates and consist solely of principal and interest,
and if the business model is to hold the asset to maturity
What happens when an financial asset is sold
any realized gain or loss is reported on the income statement
under US GAAP “available- for- sale”
assets are measured at fair
value, with any unrealized holding gains or losses recognized in other comprehensive
income. However, unlike IFRS, the US GAAP category available- for- sale applies only
to debt securities a
under US GAAP”Trading debt securities”
, debt securities designated as trading securities are also measured at fair
value with unrealized holding gains or losses recognized in the income statement.
The trading securities category pertains to a debt security that is acquired with the
intent of selling it rather than holding it to collect the interest and principal payments.
Non current Assets ( Deferred Tax Assets)
Deferred tax assets may result when the actual income tax
payable based on income for tax purposes in a period exceeds the amount of income
tax expense based on the reported financial statement income due to temporary timing
differences.Deferred tax assets may also result from carrying forward unused tax losses and credits (these are not temporary timing differences). Deferred tax assets are only to be
recognized if there is an expectation that there will be taxable income in the future,
against which the temporary difference or carried forward tax losses or credits can
be applied to reduce taxes payable.
Non Current Liabilities(Long Term Financial Liabilities)
Typical long- term financial liabilities include loans (i.e., borrowings from banks) and
notes or bonds payable (i.e., fixed- income securities issued to investors). Liabilities
such as loans payable and bonds payable are usually reported at amortised cost on the
balance sheet
Non Current Liabilities ( Deferred Tax Liabilities)
Deferred tax liabilities result from temporary timing differences between a company’s
income as reported for tax purposes (taxable income) and income as reported for
financial statement purposes (reported income). Deferred tax liabilities result when
taxable income and the actual income tax payable in a period based on it is less than
the reported financial statement income before taxes and the income tax expense
based on it.
What is deferred tax liabilities
Deferred tax liabilities are defined as the amounts of income taxes payable
in future periods in respect of taxable temporary differences
Equity
Equity is the owners’ residual claim on a company’s assets after subtracting its liabilities.It represents the claim of the owner against the company. Equity includes
funds directly invested in the company by the owners, as well as earnings that have
been reinvested over time. Equity can also include items of gain or loss that are not
recognized on the company’s income statemen
Components of Equity
1 Capital contributed by owners (or common stock, or issued capital). The
amount contributed to the company by owners. Ownership of a corporation is
evidenced through the issuance of common shares
2 Preferred shares. Classified as equity or financial liabilities based upon their
characteristics rather than legal form. In contrast, preferred shares with mandatory redemption at a fixed amount at a future date are classified as financial
liabilities. Preferred shares have rights that take precedence over the rights of
common shareholders—rights that generally pertain to receipt of dividends and
receipt of assets if the company is liquidated..
3 Treasury shares (or treasury stock or own shares repurchased). 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.
4 Retained earnings. The cumulative amount of earnings recognized in the
company’s income statements which have not been paid to the owners of the
company as dividends.
5 Accumulated other comprehensive income (or other reserves). The cumulative amount of other comprehensive income or loss. The term comprehensive
income includes both a) net income, which is recognized on the income statement and is reflected in retained earnings, and b) other comprehensive income
which is not recognized as part of net income and is reflected in accumulated
other comprehensive income
6 Noncontrolling interest (or minority interest). The equity interests of minority
shareholders in the subsidiary companies that have been consolidated by the
parent (controlling) company but that are not wholly owned by the parent
company
Statement of Changes in Equity
The statement of changes in equity (or statement of shareholders’ equity) presents
information about the increases or decreases in a company’s equity over a period. I
What information IFRS requires in the statement of changes of equity
■ total comprehensive income for the period;
■ the effects of any accounting changes that have been retrospectively applied to
previous periods;
■ capital transactions with owners and distributions to owners; and
■ reconciliation of the carrying amounts of each component of equity at the
beginning and end of the year
Liquidity Ratios
Current,Quick,Cash
Solvency Ratios
Long term debt to equity
Debt to equity
Total Debt
Financial Leverage
Vertical common size analysis
states the items as percentages
financial assets classified as trading securities
Income statements
financial assets classified as available for sale
part of
other comprehensive income
What do repurchases of shares do
Share repurchases reduce the company’s cash (an asset).
Shareholders’ equity is reduced because there are fewer shares outstanding and
treasury stock is an offset to owners’ equity.
What ratio determines company’s near term obligation
Cash ratio
Cash Flow statement provides
information about a company’s cash receipts and
cash payments during an accounting period.
Operating Activities
include the company’s day- to- day activities that create
revenues, such as selling inventory and providing services, and other activities .Additionally, operating
activities include cash receipts and payments related to dealing securities or
trading securities
Investing Activities
include purchasing and selling long- term assets and other
investments. These long- term assets and other investments include property,
plant, and equipment; intangible assets; other long- term assets; and both long-term and short- term investments in the equity and debt
Financing Activities
include obtaining or repaying capital, such as equity
and long- term debt
Can companies engage in non cash transactions
Yes
IFRS Cash Flow Statements
■ Interest received: Operating or investing
■ Interest paid Operating or financing
■ Dividends received Operating or investing
■ Dividends paid Operating or financing
US GAAP Cash Flow Statements
■ Interest received : Operating
■ Interest paid Operating
■ Dividends received Operating
■ Dividends paid Financing
What are the two methods to report cash flow statements
Direct and Indirect
Direct Method
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.
Indirect Method
The indirect method shows how cash flow from operations can be obtained from
reported net income as the result of a series of adjustments. 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
How income and expenses are presented in an common size analysis
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).
How assets,liabilities and equity are presented in an common size analysis
For the common- size
balance sheet, each asset, liability, and equity line item is expressed as a percentage
of total assets.
How cash flow is presented in an common size analysis
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
Perfomance Ratios
Cash flow to revenue Cash return on assets Cash return on equity Cash to income Cash flow per share
Coverage Ratios
Debt coverage Interest coverage Reinvestment Debt payment Dividend payment Investing and financing
What includes in an evaluation of a cash flow statement
An evaluation of a cash flow statement should involve an assessment of the
sources and uses of cash and the main drivers of cash flow within each category
of activities.
What does a report might present
■ the purpose of the report, unless it is readily apparent;
■ relevant aspects of the business context:
● economic environment (country/region, macro economy, sector);
● financial and other infrastructure (accounting, auditing, rating agencies)
● legal and regulatory environment (and any other material limitations on the
company being analyzed);
■ evaluation of corporate governance and assessment of management strategy,
including the company’s competitive advantage(s);
■ assessment of financial and operational data, including key assumptions in the
analysis; and
■ conclusions and recommendations, including limitations of the analysis and
risks.
Limitations to ratio analysis
■ The heterogeneity or homogeneity of a company’s operating activities. Companies
may have divisions operating in many different industries. This can make it
difficult to find comparable industry ratios to use for comparison purposes.
■ The need to determine whether the results of the ratio analysis are consistent.
One set of ratios may indicate a problem, whereas another set may indicate that
the potential problem is only short term in nature.
■ The need to use judgment. A key issue is whether a ratio for a company is within
a reasonable range. Although financial ratios are used to help assess the growth
potential and risk of a company, they cannot be used alone to directly value
a company or its securities, or to determine its creditworthiness. The entire
■ The use of alternative accounting methods. Companies frequently have latitude
when choosing certain accounting methods. Ratios taken from financial statements that employ different accounting choices may not be comparable unless
adjustments are made. Some important accounting considerations include the
following:
what is vertical analysis
used to denote a common- size analysis using only one reporting period or
one base financial statement,
What is horizontal analysis
s refers to an analysis comparing a specific financial
statement with prior or future time periods or to a cross- sectional analysis of one company with another.
What does a graph provides to an analyst
facilitate comparison of performance and financial structure over time, highlighting changes in significant aspects of business operations. Provide the analyst (and management) with a visual overview of risk trends in a business.
Line graphs
Line graphs are useful when the focus is on the change in amount for a limited number of items over a relatively longer time period.
Pie graphs
In general, pie graphs are most useful to communicate
the composition of a total value (e.g., assets over a limited amount of time, say one or
two periods).
Stacked column graph
When the composition
and amounts, as well as their change over time, are all important,
Regression Analysis
help identify relationships (or correlation) between variables.
How to evaluate financial ratios
1 Company goals and strategy. Actual ratios can be compared with company
objectives to determine whether objectives are being attained and whether the
results are consistent with the company’s strategy
2 Industry norms (cross- sectional analysis). A company can be compared with
others in its industry by relating its financial ratios to industry norms or to a
subset of the companies in an industry. When industry norms are used to make
judgments, care must be taken because:
● Many ratios are industry specific, and not all ratios are important to all
industries.
● Companies may have several different lines of business. This will cause
aggregate financial ratios to be distorted. It is better to examine industryspecific ratios by lines of business.
● Differences in accounting methods used by companies can distort financial
ratios.
● Differences in corporate strategies can affect certain financial ratios.
3 Economic conditions. For cyclical companies, financial ratios tend to improve
when the economy is strong and weaken during recessions. Therefore, financial
ratios should be examined in light of the current phase of the business cycle..
Activity Ratios
Activity ratios are also known as asset utilization ratios or operating efficiency
ratios. This category is intended to measure how well a company manages various
activities, particularly how efficiently it manages its various assets. Activity ratios are
analyzed as indicators of ongoing operational performance—how effectively assets
are used by a company.
Inventory Turnover and DOH
Inventory turnover lies at the heart of operations for
many entities. It indicates the resources tied up in inventory (i.e., the carrying costs)
and can, therefore, be used to indicate inventory management effectiveness. High IT =effective management.High IT and Low DOH bad.LOW IT and high DOH = slow moving inventory
Receivables and DSO
The number of DSO represents the elapsed time
between a sale and cash collection, reflecting how fast the company collects cash from
customers to whom it offers credit High receivables and low DSO = highly efficient credit and collectibles
Payables Turnover and the Number of days of payables
The number of days of
payables reflects the average number of days the company takes to pay its suppliers,
and the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors.High payables and low days payables not making full use of available credit
Working Capital Turnover
Working capital turnover indicates how efficiently the company generates
revenue with its working capital.High = good, can be zero or negative depending companies
Fixed Asset Turnover
This ratio measures how efficiently the company generates
revenues from its investments in fixed assets.High ratio = good.Low ratio =bad.
Total Asset Turnover
The total asset turnover ratio measures the company’s overall
ability to generate revenues with a given level of assets.High ratio is good
Current Ratio
This ratio expresses current assets in relation to current liabilities. A
higher ratio indicates a higher level of liquidity
Quick Ratio
The quick ratio reflects the fact that certain current assets.represent costs of the
current period that have been paid in advance and cannot usually be converted back
into cash.
a higher quick ratio indicates
greater liquidity
Cash Ratio
The cash ratio normally represents a reliable measure of an entity’s
liquidity in a crisis situation.
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 higher defensive interval ratio indicates greater liquidity.
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.Shorter = better
Solvency Ratios
Ability to meet long term obligations
Debt- to- Assets Ratio
This ratio measures the percentage of total assets financed with
debt . Generally, higher debt means higher
financial risk and thus weaker solvency
Debt- to- Capital Ratio
The debt- to- capital ratio measures the percentage of a
company’s capital (debt plus equity) represented by debt. As with the previous ratio, a
higher ratio generally means higher financial risk and thus indicates weaker solvency.
Debt- to- Equity Ratio
The debt- to- equity ratio measures the amount of debt capital
relative to equity capital. Interpretation is similar to the preceding two ratios (i.e., a
higher ratio indicates weaker solvency)
Financial Leverage Ratio
measures
the amount of total assets supported for each one money unit of equity.The
higher the financial leverage ratio, the more leveraged the company is in the sense of
using debt and other liabilities to finance assets.
Debt- to- EBITDA Ratio
This ratio estimates how many years it would take to repay
total debt based on earnings before income taxes, depreciation and amortization
Interest Coverage
This ratio measures the number of times a company’s EBIT
could cover its interest payments. Thus, it is sometimes referred to as “times interest
earned.” A higher interest coverage ratio indicates stronger solvency, offering greater
assurance that the company can service its debt
Fixed Charge Coverage
This ratio relates fixed charges, or obligations, to the cash
flow generated by the company. It measures the number of times a company’s earnings
(before interest, taxes, and lease payments) can cover the company’s interest and lease payments.Similar to the interest coverage ratio, a higher fixed charge coverage ratio
implies stronger solvency, offering greater assurance that the company can service
its debt
Profitability Ratios
measure the return earned by the company during a period.
Gross Profit Margin
Gross profit margin indicates the percentage of revenue available to cover operating and other expenses and to generate profit. Higher gross profit
margin indicates some combination of higher product pricing and lower product costs
Operating Profit Margin
an operating profit margin increasing faster than the gross profit margin can
indicate improvements in controlling operating costs
Pretax Margin
The pretax margin reflects the effects on profitability of leverage and other
(non- operating) income and expenses. If a company’s pretax margin is increasing primarily as a result of increasing amounts of non- operating incom
Net Profit Margin
Generally, the net
income used in calculating the net profit margin is adjusted for non- recurring items
to offer a better view of a company’s potential future profitability.
ROA
ROA measures the return earned by a company on its assets. The higher the
ratio, the more income is generated by a given level of assets
Return on Total Capital
Return on total capital measures the profits a company earns
on all of the capital that it employs
ROE
ROE measures the return earned by a company on its equity capital, including
minority equity, preferred equity, and common equity
Decomposition of ROE
referred to as DuPont
analysis.The information gained can also be used by management to determine
which areas they should focus on to improve ROE. This decomposition will also show
why a company’s overall profitability, measured by ROE, is a function of its efficiency,
operating profitability, taxes, and use of financial leverage. DuPont analysis shows the
relationship between the various categories of ratios discussed in this reading and
how they all influence the return to the investment of the owners.
Equity Analysis
The valuation process has several
steps, including:
1 understanding the business and the existing financial profile
2 forecasting company performance
3 selecting the appropriate valuation model
4 converting forecasts to a valuation
5 making the investment decision
Valuation Ratio
Price to cash flow where earnings quality may be an issue
Price to sales is used when a company does not have a positive net income
Price to book value is a relationship between a companys required rate of return and its actual rate of return
Basic EPS
The difference in EPS does not reflect a
difference in profitability—the companies have identical profits and profitability. The
difference reflects only a different number of common shares outstanding
Dividend Related Quantities
Dividend Payout Ratio measures the percentage of earnings that the company pays out as dividends to shareholder.It fluctuates with earnings
Retention Rate
retention rate is the percentage of earnings that a company retains.
Sustainable Growth Rate
is viewed as a function of its profitability (measured as ROE) and its ability to finance itself from internally generated funds (measured as the retention rate).
Model building and Forecasting Techniques
■ Sensitivity analysis: Also known as “what if” analysis, sensitivity analysis
shows the range of possible outcomes as specific assumptions are changed; this
could, in turn, influence financing needs or investment in fixed assets
■ Scenario analysis: This type of analysis shows the changes in key financial
quantities that result from given (economic) events, such as the loss of customers, the loss of a supply source, or a catastrophic event. If the list of events
is mutually exclusive and exhaustive and the events can be assigned probabilities, the analyst can evaluate not only the range of outcomes but also standard
statistical measures such as the mean and median value for various quantities of
interest.
■ Simulation: This is computer- generated sensitivity or scenario analysis based
on probability models for the factors that drive outcomes. Each event or possible outcome is assigned a probability. Multiple scenarios are then run using the
probability factors assigned to the possible values of a variable.
What costs do the IFRS and US GAAP exclude
abnormal
costs incurred as a result of waste of materials, labor or other production conversion inputs, any storage costs (unless required as part of the production process),
and all administrative overhead and selling costs.
Inventory Valuation Methods under IFRS
specific identification; first- in, first- out (FIFO); and weighted average cost.
Inventory Valuation Methods under US GAAP
specific identification; first- in, first- out (FIFO); and weighted average cost; last in last out ( LIFO)
Specific Identification
The specific identification method is used for inventory items that are not ordinarily
interchangeable and for goods that have been produced and segregated for specific
projects. This method is also commonly used for expensive goods that are uniquely
identifiable. Under this method, the cost of sales and
the cost of ending inventory reflect the actual costs incurred to purchase (or manufacture) the items specifically identified as sold and the items specifically identified
as remaining in inventory
First- In, First- Out (FIFO)
the first units included in inventory are assumed to be the first units sold from
inventory. Therefore, cost of sales reflects the cost of goods in beginning inventory plus
the cost of items purchased (or manufactured) earliest in the accounting period, and
the value of ending inventory reflects the costs of goods purchased (or manufactured)
more recently. In periods of rising prices, the costs assigned to the units in ending
inventory are higher than the costs assigned to the units sold. Conversely, in periods
of declining prices, the costs assigned to the units in ending inventory are lower than
the costs assigned to the units sold.LOWER COGS AND HIGHER INVENTORY
Weighted Average Cost
Weighted average cost assigns the average cost of the goods available for sale (beginning
inventory plus purchase, conversion, and other costs) during the accounting period
to the units that are sold as well as to the units in ending inventory
Last- In, First- Out (LIFO)
the last units included in inventory are assumed to be the first units sold from inventory. Therefore, cost of sales reflects the cost of goods purchased (or manufactured)
more recently, and the value of ending inventory reflects the cost of older goods. In
periods of rising prices, the costs assigned to the units in ending inventory are lower
than the costs assigned to the units sold. Conversely, in periods of declining prices,
the costs assigned to the units in ending inventory are higher than the costs assigned
to the units sold.HIGHER COGS AND LOWER INVENTORY
Periodic Inventory System
Inventory on hand calculated periodiocally
Perpetual Inventory System
Inventory account updated continously
If prices are rising
COGS : LIFO>AVCO>FIFO
EI:FIFO>AVCO>LIFO
LIFO & AVCO understate EI
FIFO & AVCO understate COGS and profits
if prices are falling
COGS : FIFO>AVCO>LIFO
EI: LIFO>AVCO>FIFO
LIFO & AVCO overestimate EI
FIFO & AVCO overstate COGS and profits
LIFO Reserve
differences between internal inventory and LIFO
Why companies use LIFO
for tax purposes and external reporting
How companies use FIFO and AVCO
for internal reporting
US GAAP that use LIFO
must disclose beginning and ending balances for LIFO Reserves
LIFO liquidation
Increase in gross profit as a result of LIFO liquidation is phantom profit
Measurement of Inventory under IFRS
Lower of cost or net realizable value
IF NRV < Cost under IFRS
Inventory must be written down
loss recognized on Income Statement : COGS and expense
Inventory valuation allowance account may be used
Subsequent increase in NRV limited to amount in Allowance account
if NRV increases requires reversal
Measurement of Inventory under US GAAP
lower of cost or market(replacement value)
IF MARKET < COST
Inventory must be written down
Companies that uses Specific ID , FIFO or AVCO are more likely to incur write downs
reversals are prohibited
How is agriculture, forest products and mining measured
at NRV regardless of costs
If an active market exists for the product
the quoted price > NRV or most recent market transaction
How are inventory gains/losses recognized
Profit/loss in the period of change
Effects of inventory write down
- Profit
- Amount of inventory
Which ratios have a negative effect from inventory write down
profitability
liquidity
solvency
Which ratio has a positive effect from inventory write down
Activity
IFRS disclosures
activity policies used cost formulas used total carrying value value of inventories COGS for the period amount of any write downs amounts of any reversals description of why reversal carrying amount of inventory pledged as collateral for liabilities
US GAAP disclosures
activity policies used
cost formulas used
total carrying value
value of inventories
COGS for the period
carrying amount of inventory pledged as collateral for liabilities
any material income from LIFO liquidation
IFRS changes in valuation methods
Permitted if the changes enhances reliability of financial data
accounted for retrospectively
US GAAP changes in valuation methods
changing from LIFO :retrospective restatement of Income and Retained Earnings
changing to LIFO: prospective basis
Critical ratios for inventory management evaluation
Inventory Turnover
Days of inventory on hand
Gross profit margin
Lower under LIFO
gross margin
Current assets
Higher undo LIFO
Debt to equity
Quick ratio
Inventory turnover
Total asset turnover
Long Lived Assets
provides economic benefits over a future period of time > 1 year
Issues in Long Lived Assets
cost at acquisition allocation to expense over time subsequent costs incurred cost vs revaluation model unexpected declines in value classification with respect in tent derecognition
Capitalize
if the asset is expected to provide benefits for more than 1 year
What happens when you capitalize
- non current assets increase
- cash flow from investing activities decreases
What happens when you depreciate
- non current assets decrease
- net income decreases
- retained earnings decrease
- equity decreases
Expense
provides economic benefits in the current period only
What happens when expensed
- net income decreases by the entire after tax amount
- affects income statement
- no related assets recorded
- operating cash flow decreases
- no future periods effects
Effects of Expenses
-Lower net income in period of expensing but higher subsequent periods
Acquiring assets through an exchange
the amount to be capitalized is the fair value of asset capitalized
How this exchange affects Balance Sheet
carrying value of asset given up removed from assets and the fair value of asset is added
if FV > BV gain on Income Statement
FV< BV loss on Income Statement
FV unknown then FV = BV no gain or loss or no difference assets
Acquiring assets through purchase
You capitalize purchase cost + all expenditures necessary to get asset ready for its intended use
Subsequent expenditures related to Long lived assets are capitalized if
- they are expected to provide economic benefits beyond one year
- extends an asset useful life
Borrowing Costs
- Generally Capitalized
- Investing Cash Flow
IFRS Interest
- Capitalize Interest Expense
- Capitalize Earned Interest
US GAAP Interest
- Interest are expensed
- Interest Income
Intangible Assets
- finite life amortized over useful life
- indefinite life not amortized
Identifiable Assets under IFRS
- must be separable from the entity or arise from legal rights
- must be under the companies control
- must be expected to earn economic future benefits
Recognition criteria from Identifiable Assets
- probable that future benefits flow to the entity
- cost of asset can be reliably measured
Unidentifiable Assets
cannot be purchased separately and may have indefinite life
1 How to account for Intangible Assets by purchase
- Same as tangible asset
- recorded as fair value
- costs of acquisition are investing cash outflow
- if acquired as group purchase price is allocated to each asset
2 How to account for Intangible assets developed Internally
-costs generally expensed when incurred
Intangible Assets IFRS Developed Internally
- expense research
- may capitalize development costs but have to show technically feasibility and intend to use
Intangible Assets US GAAP Developed Internally
-expense both research and development
-except software
can be for sale once technical feasibility is established then capitalize
can be used for internal use
3.How to account Intangible assets acquired in a business
-using the accounting method
Purchase Price - Fair Value of net assets = Goodwill
IFRS if the acquired asset meet criteria then recorded as intangible else add to goodwill
US GAAP if asset can be separated from company or asset arises from contractual legal rights
Ratios affected by Capitalization
- Net Income present Higher
- Net present future yrs lower
- fixed asset turnover lower
- Total Assets higher
- Shareholders Equity Higher
- CFO higher
- CFI lower
- Income Variability Lower
- Debt/Equity lower
Ratios affected by Expensing
- Net Income present lower
- Net present future yrs higher
- Total Assets lower
- Shareholders Equity lower
- CFO lower
- CFI higher
- Income Variability higher
- Debt/Equity higher
Depreciation
Cost Model and Revaluation Model
Cost Model ( IFRS/GAAP)
- Capitalized costs allocated to future periods
- carrying cost = historical cost- accumulated dep/amort
Cost Model ( Straight Line Depreciation)
Cost of asset allocated evenly over estimated useful life
Cost Model(Accelerated Depreciation) or Declining Balance
-Depreciate expense greater in earlier years
Cost Model ( Units of Production)
-Depreciation based on proportion of production during a period vs productive capacity over useful life
Component Depreciation
IFRS requirement GAAP optional
Amortization
- same as tangible assets
- intangibles with finite life only
Revaluation Model
- allowed under IFRS only
- used only if fair vale can be measured reliably
- carrying amount increases
Devaluation
- Difference in price is counted as a loss in Income Statement
- Subsequent revaluation up to difference in price counted as a gain on Income Statement.
- Excess in equity goes to revaluation surplus account
Increase in Value
- Revaluation Surplus
- Devaluation surplus
- excess in equity goes to loss on Income Statement
Impairment
- an unanticipated decline in the value of an asset
- write down required IFRS/GAAP
- reversals allowed IFRS
- carrying value of assets decrease
- impairments charge reduces net income
- no effect on cash flows
IFRS Impairment
carrying amount > recoverable amount
- higher of FV-SC
- Value in use
US GAAP Impairment
carrying amount > Fair Value
-Carrying amount deemed unrecoverable
PPE Impairment IFRS
- Check for impairment
- Recoverable amount is to take the carrying amount vs the higher of FV-SC or PV of expected cash flows or recoverable amount Then the higher amount of those you subtract by the carrying amount then the difference is the loss and the higher amount is used as the recoverable amount
PPE Impairment US GAAP
- Check for impairment
- if the Carrying amount is less than the undiscounted expected future cash flows then use the amount of the carrying amount and no loss reported
- but if the carrying amount > undiscounted expected future cash flows then fair value would be written down and the loss is the FV-SC
Intangible Assets with Finite Life Impairment
-Only tested for impairment upon occurrence of significant adverse events
Intangible Assets with indefinite Life Impairment
-tested at least annually for impairment
Long Lived Assets Held For Sale
- transferred from PPE—> held for sale
- no longer in use —->intended for sale
- tested for impairment on reclassification
US GAAP Reversals
- assets held for use no reversals
- assets held for sale allowed
IFRS Reversals
- reversals allowed
- only to the extent of the original impairment loss
Derecognition
-When assets is disposed or not expected to provide future benefits
Derecognition Sale
gain/loss on disposal = sales proceeds - carrying cost
Derecognition other than sale
(abandoned,exchange,spun off)
- reclassified as held for use until disposal
- continue to depreciate
Retired/Abandoned
- assets reduced by carrying amount
- loss recorded on I.S
Exchanged
-the amount to be capitalized is the fair value of asset capitalized
Spun off
- separated into new entity
- parent shareholders receive proportional shares
- all assets of new entity are removed from the balance sheet of parent
Revaluation Increase in carrying value
- Total Assets and Shareholders Higher
- Financial Leverage ratio decreases
Revaluation decrease in Carrying value
- Total Assets and Net Income Lower
- ROA,ROE in yr 1 decrease but increase subsequent years
Impairment
- subjective judgements
- projecting future cash flows
- assessing fair values
Derecognition
- Loss = Total Assets, NI lower but CFI higher
- Gain = Total Assets ,NI and CFI higher
Disclosures Tangible IFRS
- measurement bases
- depreciation method used
- useful life
- accumulated depreciation
- amount of disposals
- restrictions, pledges of property
- contractual agreements
- if revaluation model used
Disclosures Tangibles US GAAP
- depreciation expense
- balances of major classes of depreciable assets
- accumulated depreciation by major classes
- depreciation method for major classes
Disclosures Intangibles IFRS
Finite
- useful life
- amortization method
- gross carrying amount
- accumulated amortization
- location on I.S
- Reconciliation of carrying amount
Indefinite
Why indefinite
-restrictions,plegdes,contractual agreements
-if revaluation model used
Disclosures Intangibles US GAAP
- Gross carrying amount in total and by major class
- accumulated amortisation by major classes
- aggregate amortisation for the period
- estimate amort expense for next 5 years
Disclosures Impairment IFRS
- amortisation of loss & reversal of loss in the period
- where are the losses and reversals are on the financial statements
- main classes of assets affected
- events/conditions that led to losses or reversals
Disclosures US GAAP
- description of the impaired asset
- events/conditions that led to the impairment
- method of fair value
- amount of loss
- where the loss is recognized
Disclosures Balance Sheet
reports the carrying value of the asset
Disclosures Income Statement
-depreciation expense may or may not appear separate
IFRS -to disclose depreciation expense depends if companies use nature or function of expense Under Nature(depreciation, purchases) Under Function(COGS,SG&A)
Disclosures Cash Flow Statement
- acquisition/disposal > CFI
- Indirect Method > adjustment of net income
Evaluation
Asset Age Ratio
Gross Fixed Assets/Dep expense = Accum Dep/Dep Expense + Net fixed Assets/Dep Expense
Avg remaining useful life = NET PPE/Dep expense
Gross fixed assets/Dep Expense = estimated useful life
Accum Dep/Dep exp = Average age of assets
Net fixed Assets/Dep Expense = Remaining useful life
Annual Capex/Dep Expense
if <100%
- replacing fixed assets at a rate slower than dep rate
- might indicate needed catch up investment
Investment Property
Property that is owned for leased under a finance for the purpose of earing rent or capital appreciation or both
- not owner occupied
- doesn’t provided goods and services
How Investment Property is valued
-Cost Model
-Fair Value Model
may use fair value if reliable estimates of FV are attainable
must use one model for all investment properties
How to use Fair Value
must be used until disposition or reclassification
Investment property to owner occupied or inventory
- Valued at cost then no change in carrying amount
- Valued at FV then FV new carrying amount
Owner Occupied to Investment Property
-Valued at FV then FV-C treated like revaluation
Inventory to Investment Property
-Valued at FV the FV-C recognized as profit/loss
How investment property is reported
As a separate line item on Balance Sheet
disclose whether FV or cost model
GAAP
- doesn’t specifies Investment property
- uses historical cost model
Financial Statements Taxes
- Income before Taxes
- Income Tax Expense
Tax Returns
-Taxable payable
Taxes a company must pay in the immediate future
-Income Tax Payable
Remember
IF reported > taxes creates an asset
IF reported < taxes creates a liability
How taxes are not the same
- Temporary differences in the recognition of expense and revenue
- permanent differences
When R
- creates Deterred Tax Asset
- creates Valuation Allowance thats reflects the probability of non use
- examples carryforwards expire
- changes in tax laws that restict future use of deductible temporary differences
What are Deferred Taxes
-Result from temporary differences in the recognition of expense and revenue for tax purposes versus reporting purposes
How IFRS classifies Deterred Taxes
Non-Current
How US GAAP classifies Deterred Taxes
Current or Non Current
Tax Base
the carrying value of an asset on the Balance Sheet created as if the tax return was our real income statement
Asset Tax Base
amount that will be expensed on future tax returns
Deferred Tax Liabilities Arises
- higher tax expenses + lower tax revenue = lower taxable income
- increase/decrease in DTL increases/decreases total liabilities
- NI lower and higher,retained earnings lower and higher and Shareholders Equity lower and higher
Deferred Tax Assets
- lower tax expenses +higher tax revenue = higher taxable income
- increase/decrease in DTA increases/decreases Total Assets
Change in Tax rates
- when income taxes rates change,balance in deferred tax accounts must be ajusted
- when tax rates rise balances in DT rise
- when tax rates fall balances in DT fall
gain in net DTL
reduction tax rates Liabilities drop ,ITE drop ,equity rises
gain in net DTA
reduction in tax rates assets drop,ITE increases,equity drops
loss in net DTL
increment in tax rates Liabilities rise,ITE rise,equity drops
loss in net DTA
increment in tax rates assets rise,ITE drops,equity rises
Temporary Difference
Difference between Carrying Amount and Tax Base
Permanent Difference
income/expense items that can be recognized on one statement and not the other
examples temporary
- Non taxable revenue
- Non tax deductible expenses
- Tax Credits
Example Permanent
No Deferred Taxes
Types of Temporary Differences
- Taxable Temporary Differences
- Deductible Temporary Differences
Tree Diagram
Assets if C>TB then DTL if TB>C then DTA
Liabilities if C>TB then DTA if TB>C then DTL
Temporary difference at recognition
company cant recognized DTA/DTL unless initial recognition was a business combination
Unused tax Losses/Credits IFRS
may only be recognized to the extent of probable future taxable income
Unused tax Losses/Credits GAAP
recognized in full and reduced through a valuation allowance if unlikely to be realized
Valuation Allowance
DTA must be evaluated at each balance sheet that will be recovered carrying value=expected recoverable amount
GAAP DTA reduced by contra account that is valuation allowance
Increase in valuation allowance
- reduces DTA
- Increases ITE
- lowers NI,Retained Earnings,Shareholderes Equity
Current Taxes
-based on tax rates applicable at the balance sheet date
Deferred taxes
measured at the rate that is expected to apply when they realized
Revaluation of property
goes to equity (revaluation surplus)
If expected to reverse
-liabiliities else equity
Bonds
Par Coupon = Market Value
Premium Coupon > Market Rate
Discount Coupon < Market Rate
Market Rate or effective rate
- at the time of issuance
- cant be changed
Sales Proceeds of a bond Face Value
- on the calculator put the years,interest as PMT ,bond value as FV,put interest per year and compute PV
- Calculate the interest payments
- Calculate the PV of each interest payments with its correspondent year,then add the PV of the interest payments
- Calculate the PV of the Face Value Payment of the bond
- Add the NPV of Interest and NPV of FV of bond to get the sales proceeds
Sales Proceeds Bond at a Discount and at a Premium
- Calculate the interest payments
- Calculate the PV of each interest payments with its correspondent year,then add the PV of the interest payments
- Calculate the PV of the Face Value Payment of the bond
- Add the NPV of Interest and NPV of FV of bond to get the sales proceeds
- Calculate the difference between the Face Value and total sales proceeds
How are issued bonds at a coupon rate of zero
At a discount to face value
-debt to equity rise
How IFRS and US GAAP include bond issuance costs
-included in the financing section netted against bond proceeds
US GAAP
expenses incurred when issuing bonds are assetsand amortised
Initial Recognition of Bonds
Bonds Proceeds at issuance
Contract of Bonds
Indenture
Measurement of Bonds IFRS
Measurement of Bonds US GAAP
-show these debt issuance costs as an asset (a deferred
charge), which was amortized on a straight- line basis to the relevant expense (e.g., legal
fees) over the life of the bonds.
-debt issuance costs are deducted
from the related debt liability. Companies reporting under US GAAP may still report
debt issuance costs for lines of credit as an asset because the SEC indicated that it
would not object to this treatment.
Methods of accounting for bonds
- Effective Interest Method
- Straight Line Method
Effective Interest Method
- Calculate Sales Proceedings
- Calculate Interest Payments
- Multiply Sales Proceedings and Interest rate to get Interest Expense
- Calculate Difference between Interest Expense and Interest Payment to get Amortization
- If Positive add to sales if negative substract
- With Carrying amount repeat process
Straight Line Method only for US GAAP
DIvide Amortization of Bond with years
then Interest payment less amortization to get annual interest expense
Current Market Reporting
Reporting bonds at amortised historical costs (reflects the market rate at the time the bonds were issued .As market interest rates change, the
bonds’ carrying amount diverges from the bonds’ fair market value.
Market rates decrease bond prices increase
market rates increase bond prices decrease
Can overestimate or understate leverage levels
Fair Value Reporting
Few Companies do it i.e. Financial Institutions
Rates Increase,report gains since Liabilities Drop
Rates Drop Report losses since Liabilities Increase
-disclose the fair value under IFRS and US GAAP
Derecognition at maturity
Pay the Face Value
Derecognition prior to maturity
-the bonds payable account is reduced by the carrying amount of the
redeemed bonds. The difference between the cash required to redeem the bonds and
the carrying amount of the bonds is a gain or loss on the extinguishment of debt.
Derecognition of Debt IFRS
. Under
IFRS, debt issuance costs are included in the measurement of the liability and are
thus part of its carrying amount.
Derecognition US GAAP
Under US GAAP, debt issuance costs are accounted
for separately from bonds payable and are amortized over the life of the bonds. Any
unamortized debt issuance costs must be written off at the time of redemption and
included in the gain or loss on debt extinguishment.
Covenants
-protect bondholders
-maintenance of pledged collateral
-restrictions on dividends
-meet certain working capital levels
-maximum levels of leverage
-protect benefit borrowers
-reduce default risk
-reduce borrowing costs
An affirmative covenant, also referred to as a positive covenant, is a promise that requires a party to adhere to specific terms of the agreement. It is the opposite of a negative covenant, which requires a party to avoid doing something.
Presentation/Disclosures
- stated effective interest rates
- maturity dates
- restrictions imposed by creditors
- pledged collateral
- scheduled repayments over next 5 years
Leasing
Contract between lessor and lessee
Advantages of Leasing
- Conserve Cash
- hedge against obsolescence
- fewer restrictions than borrowing
- tax advantages
Lessee Perspective US GAAP
- Classified as Financial Lease if
- ownership transfers to lessee at end of term
- bargain purchase option exists
- term>75% useful life
- PV or PMT at inception > 90% of FV
All IFRS leases, and US
GAAP finance leases Lessee
-On Balance Sheet must recognise a right of use asset and liability
-On Income Statement report Depreciation on ROU asset and Interest expense on ROU liability
-On Statement of Cash Flows a reduction of lease liability is a financing cash outlflow
Interest Portion is an operating or financing CF in IFRS on US GAAP is operating
US GAAP operating leases Lessee
-On Balance Sheet Recognise “right- of- use”
(ROU) asset and lease liability
-On Income Statement Report single lease
expense (a straight- line allocation of lease cost)
-On Statement of Cash Flows Entire cash payment is an operating cash outflow
short- term leases
and, under IFRS, leases
where leased asset is low
value Lessee
- On Balance Sheet No effect
- On Income Statement Report rent expense
- On Statement of Cash Flows Rent payment is operating cash outflow
IFRS and US GAAP operating lease Lessor
-On Balance Sheet Retain asset on balance
sheet
-On Income Statement Report lease income and
Report depreciation expense on leased asset
-On Statement of Cash Flows Lease payments received are an operating cash inflow
IFRS finance leases and US
GAAP sales- type leases Lessor
-On Balance Sheet Remove leased asset from
balance sheet and Recognise lease asset
(lease receivable and residual)
-On Income Statement Report interest revenue
on lease receivable
-On Statement of Cash Flows nterest portion of lease payment
received is either an operating or
investing cash inflow under IFRS
and an operating cash inflow under
US GAAP.
US GAAP direct financing
leases Lessor
-On Balance Sheet Remove leased asset from
balance sheet
Recognize lease receivable
-On Income Statement Report interest revenue
on lease receivable
-On Statement of Cash Flows Interest portion of lease payment received is an operating cash inflow
under US GAAP
Types of Pensions Plans
-defined contribution pension
plans
-defined benefit pension plans
Destined Contribution
- along with employee company contributes a destined amount into the plan
- company makes no commitment regarding future value of the plan
- investment decisions left to employees
- Employees bear all investment risk
IS Pension Expense
BS Cash loss
CFO loss
Defined Benefit
- company makes promises to pay future benefits
- 2% per years of service x avg of last 5 years gross salary
- After Retirement it becomes an annuity of future cash flows,find discount rate to take PV of benefits in the day of retirement
- Then take the PV of benefits as a FV to get PV of pension obligation present day
- Companies will know the amount of money to save for the retirement can comply with the annuity
- Assumptions of salary,day of death,discount rate
- Funded by separate legal entity
- Company assumes investment performance risk
Balance Sheet Defined Benefit
If FV > Pension Obligation ,surplus net pension asset
else net pension liability
Income Statement Defined Benefit
Net Pension Asset/Liability=Profit or loss or OCI
Pension Expense IFRS Components
- Employee service costs PV of increase in benefits as a result of one more year of service
- Net Interest Expense/Income Net pension asset/Liability X Discount rate
- Remeasurements actuarial gains/losses,actual reurn on plan assets
Pension Expense US GAAP Components
- Employee service costs IS
- Interest expense accrued IS
- Expected return on plan assets IS
- Past service costs OCI
- Actuarial Gains/losses OCI
Whats an underfunded defined benefit pension plan
Non current liability
If the fair value of the plan assets is less than the benefit obligation, there is a pension shortfall.
Financial reporting quality
refers to the usefulness of information contained in the report(relevant and faitful representation)
Earnings Quality
- pertains to the earnings and cash generated by the companys assets
- resulting financial condition
- sustainable earnings
- adequate ROI
- without reporting quality,earnings quality results questionable
1 GAAP, Decision-useful, sustainable, adequate returns
- high quality reporting
- conform to accounting standards
- adhere to characteristics of decision useful info such as relevant and faithful representation
- meet enhancing characteristics such as comparability, verifiability, timeliness, understandability
- adequate returns
- increase company value
2 GAAP ,Decision-useful ,sustainable ?
- high quality reporting but low earnings quality
- company not expected to earn ROI
- negative economic profit
3 Within GAAP but biased accounting choices
- low reporting quality ,unable to assess earnings quality
- biased presentation
- obscure unfavourable information
- highlights favourable information
- emphasizing NON GAAP measure
Biased : Aggressive
- increase reported financial performance and financial position in the current period
- increase reported revenues,earnings,CFO
- decrease reported expenses and debt
Biased : Conservative
- Decrease reported financial performance and position in the current period
- decrease reported revenues,earnings,CFO
- increase reported expenses and debt
- leads to improved performance in later periods
Biased : Earnings Smoothing
- understatement of earnings volatility
- Use conservative when co. is doing well
- Use Aggressive when doing bad
4 Within GAAP but Earnings Management
- making intentional choices or deliberate action to influence reported earnings
- deter expenses
- change estimates
Conservatism
-The Conceptual Framework supports neutrality of information
-application of any standard requires judgement even if its inherently neutral
-Research Costs Because the future benefit of research costs is uncertain at the time the costs are incurred
-Litigation Losses When it becomes “probable” that a cost will be incurred, both US GAAP and IFRS require expense recognition
-Insurance Recoverable Generally, a company that receives payment on an
insurance claim may not recognize a receivable until the insurance company acknowledges the validity of the claimed amount.
Benefits of Conservatism
-Given asymmetrical information, conservatism may protect the contracting
parties with less information and greater risk
-Conservatism reduces the possibility of litigation and, by extension, litigation
costs
-reducing the possibility that fault will be found with them if companies overstate earnings or assets
-e, companies can reduce the present
value of their tax payments by electing conservative accounting policies for certain types of events.
Bias disguised as conservatism
- Big Bath Behavior
- Cookie Jar Reserves
Contexts for Low Quality Reporting
- Motivations
- Mask poor performance
- meet or beat analyst forecasts or mgmt forecasts
- MGMT career repuation
- avoid debt covenants
- MGMT financial interest
Conditions conducive to issuing low quality reports
-Opportunity poor internal control ineffective BOD -Motivation personal/corporate reasons -Rationalization get through a tough time -protect stock price
Quality Mechanisms ; Markets
-better pricing qualtity reporting,lower perceived risk
Quality Mechanisms : Market Regulatory Authorities
- Registration Requirement
- Disclosure Requirements
- Auditory Requirements
- Management Commentaries
- Responsibility Statements
- Regulatory review of filings
- Enforcement mechanisms
Quality Mechanisms : Auditors
- Express reasonable assurance
- If company public audit is required
- if Private may be a condition of financing
Limitations of Auditors
- Opinion is based on info prepared by company
- audits are based on samples
- Expectations gap auditors verify fair presentation , not look for fraud
- auditor is an customer
Quality Mechanisms : Private Contracting
-Covenants motivate manipulation which motivates greater monitoring
Proforma Presentation
-company uses discretion in calculating proforma
earnings
-universal guidelines
-not fraudulent or dishonest
-excluded items are still reported but just not included in earnings
-differ from company to company
-excluded items are dep/amort ,restructuring/merger costs ,one time charges
Adjusted EBITDA
- excludes more items
- operating leases –>EBITDAR
- equity based compensation ,acquisition related charges ,impairment charges for long lived assets
GAAP and IFRS EBITDA
- if a non GAAP financial measure is used
- must display most directly comparable GAAP measure with equal prominence
- provide a reconciliation of the non gaap measure with GAAP
- explain why non GAAP measure is more useful
Methods : Revenue Recognition
- FOB source or Destination
- Source is revenue and profit recognized sooner
- channel stuffing
- Destination revenue and profit recognized later
- earnings smoothing
Bill and Hold Transactions
- holding the inventoy sold to a client
- changes in estimates of rebates fulfillment
- allocation across multiple deliverables
Methods Depreciation policies
-Changes in useful life ,salvage value
Methods Capitalization Policies
- goodwill not acknowledging impairment
- using low FV to value assets
- Lower Depreciation
Methods Inventory Cost Methods
- reserves for obsolescence
- LIFO liquidation
Methods Deferred Tax Assets & Valuation Accounts
-must be reasonable expectation of recovery
Choices that affect Cash Flow Statement
- stretching out payables
- misclassifying cash flows
- taking full advantage of allowable flexibility
Warnings Signs Revenue
- Allowing FOB source and Bill and Hold Transactions
- significant barter transactions
- low rebate estimates
- shifts in proportions related to multiple deliverables
- out of line revenue growth
- increasing AR as age of sales
- unusual changes in the trend of AR turnover
- insufficient provision for Doubtful account
Warnings Sings inventories
- Higher growth rate vs sales
- LIFO liquidations
- capitalizing when other expense
Warning Signs Other
- Net Income persistently higher than CFO(aggressive accrual policies)
- estimates for dep/amort out of line
- fourth quarter surprises
- related party transactions
- non operating income/one time sales
- inflating operating income
- gross/op margins out of line
- long records of meeting growth projections
- minimal disclosure
- fixation on reported earnings
Warning Signs Intangible
-Culture CEO on BOD weak/unqualified audit committee -Restructuring/impairment charges spring load future results -M&A orientation opportunity to revalue assets and liabilities
Top Down Approach
-Forecast Sales
-Begin with economys GDP forecast
-Company growth rate based on market share analysis
-Estimate income/cash flow by historical trends in ratios
-separate forecasts for expense items based with sales or stated company strategy
-forecast cash flows
CAPEX
4 C of Credit
-Character quality of mgmt. -Capacity ability to pay -Collateral Assets pledged -Covenants Limitations/Restrictions
Sources of Lower Risk
- More Revenue Sources
- Sustainable Sources
Screening
-Filtering a set of potential investments into a smaller set that meet certain criteria
