Financial Statement Analysis Flashcards
Role of Financial Statement Analysis
> Using information in a company’s financial statements to make economic decisions.
Evaluating a company’s past performance and current financial position to form opinions about a firm’s ability to make profits and generate cash flows.
Balance Sheet (aka the statement of financial position or statement of financial condition)
Reports the firm’s financial position at a point in time. The balance sheet consists of three elements:
> Assets (resources controlled by the firm)
> Liabilities (amounts owed to lenders and other creditors)
> Owners’ equity (also shareholders’ equity, shareholders’ funds, or net assets) - (the residual interest in the net assets of an entity that remains after deducting its liabilities from its assets).
Accounting equation
Assets = Liabilites + Equity
Capital Structure of a firm:
The proportions of liabilities and equity used to finance a company
The statement of comprehensive income
Comprehensive income represents the changes to owners’ equity that originate from non-owner sources and traditional income. This includes:
- adjustments made to the prices of securities held for sale by the firm and/or derivatives used to hedge such positions, foreign currency exchange rate changes, and adjustments to pension liabilities.
Comprehensive income and how it is accounted for will usually appear in the footnotes to a company’s financial statements.
The income statement (also known as the statement of operations or the profit and loss statement)
reports on the financial performance of the firm over a period of time. The elements of the income statement include revenues, expenses, and gains and losses.
The statement of changes in equity
reports the amounts and sources of changes in equity investors’ investment in the firm over a period of time.
The statement of cash flows
reports the company’s cash receipts and payments
Three types of cash flows:
> Operating cash flows include the cash effects of transactions that involve the normal business of the firm.
Investing cash flows are those resulting from the acquisition or sale of property, plant, and equipment; of a subsidiary or segment; of securities; and of investments in other firms.
Financing cash flows are those resulting from issuance or retirement of the firm’s debt and equity securities and include dividends paid to stockholders.
What is the significance of the accruals process:
Earnings do not equal cash.
As revenues/expenses are recorded when a transaction occurs, not when payment is received or made.
Retained earnings
Earnings that are reinvested in the company and not distributed to shareholders
Financial statement notes
include disclosures that provide further details about the information summarized in the financial statements. Footnotes allow users to improve their assessments of the amount, timing, and uncertainty of the estimates reported in the financial statements.
Management’s commentary (Management’s Discussion and Analysis (MD&A))
Discusses the nature of the business, the management’s objectives, the company’s past performance, the performance measures used, and the company’s key relationships, resources, and risks.
Analysts must be aware that some parts of management’s commentary may be unaudited.
unqualified / unmodified / clean opinion
indicates that the auditor believes the statements are free from material omissions and errors.
qualified opinion
indicated the statements make exceptions to the accounting principles and an explanation is given.
adverse opinion
if the statements are not presented fairly or are materially nonconforming with accounting standards
disclaimer of opinion
If the auditor is unable to express an opinion (e.g., in the case of a scope limitation)
modified opinion
Any opinion other than unqualified
Proxy statements
issued to shareholders when there are matters that require a shareholder vote.
‘Goring Concern’ assumption
The assumption that the company will continue operating for the foreseeable future.
Internal controls
The processes by which the company ensures that it presents accurate financial statements and to prevent fraud.
Which audit opinion do shareholders want on the financial statements
Unqualified opinion
How are auditors appointed?
By the shareholders to review the financial statements of the company
Where are the Securities and Exchange Commission (SEC) filings available from and what do they contain?
EDGAR (Electronic Data Gathering, Analysis and Retrieval System)
Form 8-K: which a company must file to report events such as acquisitions and disposals of major assets or changes in its management or corporate governance.
Forms 10-K and 10-Q: annual and quarterly financial statements
Key Audit Matters / Critical Audit Matters
The auditor will outline areas of complication/risk and accounting choices made that are relevant to the reader.
The financial statement analysis framework consists of six steps:
Step 1: State the objective and context.
Step 2: Gather data.
Step 3: Process the data.
Step 4: Analyze and interpret the data.
Step 5: Report the conclusions or recommendations.
Step 6: Update the analysis.
Two fundamental characteristics that make financial information useful:
- Relevance
- Faithful representation
Four characteristics that enhance relevance and faithful representation:
- Comparability
- Verifiability
- Timeliness
- Understandability
When should an item be ‘recognized’ in its financial statement?
If a future economic benefit from the item is probable and the item’s value can be measured.
What do the amounts at which items are reported in the financial statement elements depend on?
Their measurement base.
This includes historical cost, amortized cost, current cost, net realizable value, present value and fair value.
Accrual Accounting
Financial statements should reflect transactions at the time they occur - not when cash changes hands.
Going concern
Assumption that company will continue to exist for the foreseeable future
International Accounting Standard (IAS) requires from financial statements (5):
- Balance Sheet
- Statement of Comprehensive Income
- Cash flow statement
- Statement of changes in owner’s equity
- Explanatory notes and summary of accounting policies
The objective of financial reporting, according to the IASB framework, is to:
to provide information about the firm to current and potential investors that is useful for making decisions about investing in or lending to the firm. (LOS 16.a)
International Accounting Standard (IAS) No. 1
According to IAS No. 1, financial statements must be presented at least annually
Required financial statements, according to International Accounting Standard (IAS) No. 1, include a(n):
balance sheet and explanatory notes.
Income equation:
net income = revenues - expenses
net income = income (+gains) - expenses (+losses)
How is net revenue calculated:
Revenue - adjustments for estimated returns and allowances
Principles-based approach to revenue recognition:
A firm should recognize revenue when it has transferred a good or service to a customer.
Five step process to recognizing revenue:
- Identify the contract with the customer
- Identify the distinct performance obligations in the contract.
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when the entity satisfies the performance obligation.
A ‘distinct’ good or service
Meets the following criteria:
- The customer benefits from the good/service on its own or combined with other resources that are readily available.
- The promise to transfer the good/service can be identified separately from any other promises.
For long-term contracts, how can revenue be recognised?
On a firm’s ‘progress toward’ completing the performance obligation.
This can be measured on the input side (% of completion costs incurred) and the output side (engineering milestones / % of output achieved to date)
What is the effect of capitalising the expenses involved in securing long-term contracts?
To decrease the reported expenses on the income statement, increasing reported profitability during the contract period.
Are depreciation expenses and interest expenses included or excluded from operating expenses in the income statement?
Depreciation expenses: Included
Interest Expenses: Excluded (this is a financing cost)
Period costs
Expenses that cannot be tied to revenue generation e.g. admin costs
Which inventory calculation method is prohibited under IFRS?
LIFO
Amortization:
Allocation of the cost of an intangible asset over its useful life.
Amortization expense should match the proportion of the asset’s economic benefits used during the period. Intangible assets with indefinite lives (e.g. goodwill) are not amortized.
Discontinued Operations
An operation in which management has decided to dispose of, but either hasn’t yet or has in the current year after the operation has generated income/losses.
Analysts should exclude discontinued operations when forecasting future earnings.
Prior-period adjustment
A correction of an accounting error made in previous financial statements. This requires retrospective application.
Which element of the accounting equation represents a residual claim?
Owner’s equity - a residual claim on the business
Deferred/unearned revenue
Cash received prior to revenue being recognised
This is a liability until the promised goods are provided.
Unbilled (accrued) revenue
When a revenue has been recognised but no billing has occurred and no cash has been received.
This is an asset.
Prepaid expense
Payment of expenses in advance. This is an asset.
Double-declining balance method
(2 / useful life) ( cost - accumulated depreciation)
for Y1 the equation is (2/useful life)(cost)
How are gains/losses on sales of operating assets and depreciation expenses displayed on the income statement?
These are reported pre-tax, above income from continuing operations.
Accrual basis (matching principle)
Match costs against associated revenues (e.g. inventory, depreciation)
(based on transactions not cash)
Period expenses
Expenditures that less directly match the timing of revenues (e.g. admin costs)
Impairments
When the fair value of the asset is lower than the carrying value of the asset.
This reduction in value is seen on the balance sheet.
How is inventory held/recorded?
At the lower of cost and net realisable value (NRV)
Discontinued Operations
Operations that the management have decided to dispose of but:
- has not done so yet, or
- did so in the current year after it generated profit or loss
It is reported net of taxes (unlike infrequent/unusual events) after net income from continuing operations (below the line)
Operating / Non-operating income
Income received from activities that are core to the operation of the company and visa versa.
This can depend on the company e.g. financial and non-financial companies.
Weighted average no. of common shares
when calculating basic EPS
Weighted by the portion of the year the shares were outstanding.
Stock dividend
The % distribution of additional shares to each shareholder proportional to the number of shares (*% by number of shares)
How do cash dividends impact EPS
It doesn’t
Other comprehensive income:
- Foreign currency translation gains and losses.
- Adjustments for minimum pension liability.
- Unrealized gains and losses from cash flow hedging derivatives.
- Unrealized gains and losses from available-for-sale securities.
Trading securities
Debt securities that a firm owns, but intends to sell.
Reported on income statement and balance sheet at fair value.
Held-to-maturity securities
Debt securities the firm does not intend to sell prior to maturity.
Reported as amortized cost on the balance sheet (not fair value) and not reported on income statement or other comprehensive income.
Available-for-sale securities
Debt securities that are not expected to be held to maturity or sold in the near term.
Reported as other comprehensive income at fair value. Any unrealised gains/losses reported on income statement.
Classified balance sheet
groups together similar items
useful when assessing liquidity
Liquidity-based balance sheet
presents assets/liabilities in order of liquidity
How should the proceeds received from the advance sale of tickets to a sporting event be treated by the seller, assuming the tickets are nonrefundable?
Revenue is deferred until the sporting event is held.
Even though the tickets are nonrefundable, the seller is still obligated to hold the event.
Accounting goodwill
Goodwill as a result of past acquisitions
Economic goodwill
Goodwill as a result of expected future performance
Treasury stock method
when calculating diluted number of shares with warrants
Step 1: Determine the number of common shares created if the warrants are exercised
Step 2: Calculate the cash inflow if the warrants are exercised
Step 3: Calculate the number of shares that can be purchased with these funds using the average market price
Step 4: Calculate the net increase in common shares outstanding from the exercise of the warrants
Step 5: Add the net increase in common shares from the exercise of the warrants to the number of common shares outstanding for the entire year
Effect of Dividends paid to shareholders
reduce owners’ equity but not net income.
Operating cycle
Time taken to produce/purchase inventory, sell the product and collect cash
Current assets
- Cash and cash equivalents
- Marketable securities
- Accounts receivable
- Inventories
Standard costing
A method of measuring inventory costs - using predetermined costs to goods produced.
Retail method
A method of measuring inventory costs - using retail prices and subtracting gross profits to determine the cost.
Other current assets
Amounts that may not be material if shown separately and are combined together
e.g. prepaid expenses
Current liabilities
- Accounts payable
- Notes payable and current portion of long-term debt
- Accrued liabilities
- Unearned revenue
Historical cost
Purchase price + any additional costs getting product ready for use
Impact of manipulating net income upwards by allocating more of the acquisition price to goodwill and less to the identifiable asset
Less depreciation and amortization expenses, and higher net income
Difference between ‘comprehensive income’ and ‘accumulated other comprehensive income’
Comprehensive income is an income measure over a period of time. It includes net income and other comprehensive income for the period.
Accumulated other comprehensive income does not include net income but is a component of stockholders’ equity at a point in time.
Current ratio
current assets / current liabilities
Quick ratio (acid test)
( current assets - inventory ) / current liabilities
( cash + marketable securities + receivables ) / current liabilities
Cash ratio
( cash + marketable securities ) / current liabilities
Long-term debt-to-equity
long-term debt / total equity
total debt-to-equity
total debt / total equity
total debt ratio
total debt / total assets
financial leverage
total assets / total equity
limitations of balance sheet ratio analysis:
- Differences in accounting standards and estimates.
- Firms operate in different industries.
- Interpretation of ratios requires significant judgement.
- Balance sheet data is only measured at a single point in time.
Treasury stock
Shares that are held by the company and restricted to the public.
Retained earnings
Net income since inception - dividends paid out
Noncontrolling/minority interest
Portion of a subsidiary’s balance sheet not owned by the parent company (but controlled by the parent)
Issued share capital
shares offered for sale to the public
Outstanding share capital
shares held by shareholder’s (excluding treasury stock)
Total stockholder’s equity
common/preferred stock + retained earnings + accumulated other comprehensive income
Par value
The stated/nominal value assigned to the stock. No relationship to market value.
The amount the corporation receives from the issuance of common stock is equal to the par value plus the additional paid-in-capital (proceeds in excess of par).
What is the appropriate measurement basis for equipment used in the manufacturing process?
Equipment is reported in the balance sheet at historical cost less accumulated depreciation.
Calculating goodwill
proceeds - fair value of net assets
Liquidity-based presentation of a balance sheet is most likely to be used by a:
The liquidity-based format of balance sheet presentation is most common in the banking industry.
The balance sheet is most likely to provide an analyst with information about a firm’s:
solvency
An analyst can use the balance sheet to assess a firm’s solvency and liquidity. Operating profitability can be assessed by examining the income statement. Information on a firm’s investing and financing activities appears in a firm’s statement of cash flows.
Under IFRS, how do firms report an investment in the equity securities of another company
Under IFRS, firms have an irrevocable choice at the time of purchase to report equity securities at fair value through other comprehensive income. If not, this is reported at fair value through profit and loss.
Working capital (accounting)
current assets - current liabilities
common size analysis when viewing a balance sheet
balance sheet item / total assets
Cash flow from operating activities
transactions that affect a firm’s net income
inflows:
- cash collected from customers
- interest/dividends received
- sales proceeds from trading activities
outflows:
- cash paid to employees and suppliers
- cash paid for other expenses
- acquisition of trading securities
- interest paid on debt or leases
- taxes paid
Cash flow from investing activities
acquisitions/disposals of long-term assets
inflows:
- sales proceeds from fixed assets
- sales proceeds from debt/equity investments
- principal received from loans made to others
outflows:
- acquisition of fixed assets
- acquisition of debt and equity investments
- loans made to others
Cash flow from financing activities
transactions that affect a firm’s capital structure
inflows:
- principal amounts of debt issued
- proceeds from issuing stock
outflows:
- principal paid on debt or leases
- payments to reacquire stock
- dividends paid to shareholders
Dividends / Interest paid received on cash flow statement (IFRS or GAAP)
GAAP
- interest received/paid: operating activity
- dividends received: operating activity
- dividends paid: financing activity
IFRS
- interest/dividends received: operating or investing activity
- interest/dividends paid: operating or financing activity
Taxes paid / bank overdraft on cash flow statement (IFRS and GAAP)
GAAP
- taxes paid: operating activity
- bank overdraft: financing activity
IFRS
- taxes paid: operating activity or investing + financing activity
- bank overdraft: part of cash equiv.
(Period end) accounts receivable =
Beginning accounts receivable + sales - cash collections
Relationship between changes in assets and changes in cash flows
Asset account ↑ Cash ↓
Relationship between liabilities and cash flows
Liabilities ↑ Cash ↑
Effect of depreciation on cash flows
None - it is not a cash flow (non-cash charge through income statement)
Affect of deferred tax liability on cash flows
None
Working Capital (Indirect method)
current assets - (cash + investments) + current liabilities - (debt instruments + dividends payable)
Cash dividends paid
Dividends declared - Δ Dividends payable
Dividends declared
Net income - Δ retained earnings
Cash collections
net sales - Δ accounts receivable + Δ advances from customers (unearned revenues)
Cash paid for inputs (suppliers)
cost of goods sold - Δ inventory + Δ accounts payable
Cash interest
interest expense + Δ interest payable
Free cash flow
a measure of cash that is available for discretionary purposes.
This is the cash flow that is available once the firm has covered its capital expenditures. This is a fundamental cash flow measure and is often used for valuation. There are several measures of free cash flow. Two of the more common measures are free cash flow to the firm and free cash flow to equity.
Free cash flow to the firm (FCFF)
cash available to all investors, both equity owners and debt holders.
FCFF = NI + NCC + [Interest paid × (1 − tax rate)] − FCInv − WCInv FCFF = CFO + [Interest paid × (1 − tax rate)] − FCInv
Free cash flow to equity (FCFE)
cash flow that would be available for distribution to common shareholders
FCFE = CFO − FCInv + net borrowing FCFE = FCFF – [interest paid × (1 – tax rate)] + net borrowing
cash flow-to-revenue ratio
measures the amount of operating cash flow generated for each dollar of revenue.
CFO / net revenue
cash return-on-assets ratio
measures the return of operating cash flow attributed to all providers of capital.
CFO / avg. total assets
cash return-on-equity ratio
measures the return of operating cash flow attributed to shareholders.
CFO / avg. total equity
cash-to-income ratio
measures the ability to generate cash from firm operations.
CFO / operating income
Cash flow per share
a variation of basic earnings per share measured by using CFO instead of net income.
( CFO - pref. dividends ) / weighted avg. no. of common shares
debt coverage ratio
measures financial risk and leverage.
CFO / total debt
interest coverage ratio
measures the firm’s ability to meet its interest obligations.
( CFO + interest paid + taxes paid ) / interest paid
EBIT / interest payments
reinvestment ratio
measures the firm’s ability to acquire long-term assets with operating cash flow.
CFO / cash paid for long-term assets
debt payment ratio
measures the firm’s ability to satisfy long-term debt with operating cash flow.
CFO / cash long-term debt repayment
dividend payment ratio
measures the firm’s ability to make dividend payments from operating cash flow.
CFO / dividends paid
investing and financing ratio
measures the firm’s ability to purchase assets, satisfy debts, and pay dividends.
CFO / cash outflows from investing/financing activities
Activity ratios (asset utilisation / operating efficiency ratios )
measures efficiency of everyday tasks
Liquidity ratios
measures ability to meet short-term liabilities
Solvency ratios
measures ability to meet long-term obligations
Profitability ratios
measures ability to generate profitable sales from asset base
Valuation ratios
measures quantity of asset or flow associated with an ownership claim
receivables turnover
annual sales / average receivables
days of sales outstanding / average collection period
365 / receivables turnover
inventory turnover
cost of goods sold / average inventory
days of inventory on hand / average inventory processing period
365 / inventory turnover
payables turnover
a measure of the use of trade credit by the firm
purchases / average trade payables
Ending inventory
beginning inventory + purchases - cost of goods sold
number of days of payables / payables payment period
365 / payables turnover ratio
total asset turnover
The effectiveness of the firm’s use of its total assets to create revenue
revenue / average total assets
Fixed asset turnover
revenue / average net fixed assets
Working capital turnover
revenue / average working capital
defence interval
indicates the number of days of average cash expenditures the firm could pay with its current liquid assets
( current assets - inventory ) / avg. daily expenditure
Cash conversion cycle
time taken to turn the firm’s cash investment in inventory to cash, in the form of collections from the sales of that inventory.
days sales outstanding + days of inventory on hand - number of days of payables
debt-to-capital
Debt / assets
total debt / total debt + total equity
debt-to-assets
total debt / total assets
fixed charge coverage
( earnings before interest and taxes + lease payments ) / ( interest payments + lease payments )
net profit margin
net income / revenue
operating profit margin
operating income / revenue
operating income
gross profit - operating costs
pretax margin
earnings before tax but after interest / revenue
net profit margin
net income / revenue
return on assets
net income / average total assets
operating return on assets
operating income (EBIT) / avg. total assets
return on total capital
EBIT / ( short + long-term debt + equity )
return on equity
net income / avg. total equity
return on common equity
( net income - pref. div ) / avg. common equity
Three point DuPont Analysis
ROE = Net Income / Equity
= Net Income / Revenues (operating profit margin)
* Revenues / Equity (EQ turnover)
=
*Net Income / Revenues (operating profit margin)
* Revenues / Total Assets (asset turnover)
* Total Assets / EQ (leverage ratio)
Five point DuPont Analysis
Net Income / Revenues (operating profit margin) =
EBIT / Revenues (operating profit margin) *
EBT / EBIT (interest burden) *
NI / EBIT (tax burden (= 1 - t))
∴
ROE = tax burden * interest burden * EBIT margin * asset turnover * financial leverage
dividend payout ratio
common dividend / ( net income - pref. div )
retention rate
( Earnings available to common shares - common dividend ) / Earnings available to common shares
net income - pref. div = earnings available to common shares
sustainable growth rate (g)
retention rate (b) * ROE
b = 1 - dividend payout ratio
Coefficient of sales ratio
s.d. of sales / mean sales
Coefficient of operating income
s.d. of operating income / mean operating income
Coefficient of net income
s.d. of net income / mean net income
Altman’s Z score
a regression based approach that predicts the chances of bankruptcy - a score of < 1.8 indicates a high chance
a business segment
- a portion of a larger company that accounts for more than 10% of the company’s revenues, assets or income
- is distinguishable from the company’s other lines of business in terms of risk and return
segment margin
segment profit / segment revenue
segment asset turnover
segment revenue / segment assets
segment ROA
segment profit / segment assets
segment debt ratio
segment liabilities / segment assets
COGS
COGS = beginning inventory + purchases - ending inventory
ending inventory
beginning inventory + purchases - COGS
‘capitilized’
recorded in balance sheet
Inventory costs included in balance sheet
‘product costs’
- purchase cost
- conversion/manufacturing costs making it product fit
‘period costs’ are not included
- selling costs
- abnormal waste of materials
- administrative overheads
Under which inventory cost flow assumption does inventory on the balance sheet best approximate its current cost?
FIFO - ending inventory is made up of the most recent purchases, thereby providing a closer approximation of current cost.
Specific identification
Each unit sold is matched with the unit’s actual cost.
Appropriate when inventory items are not interchangeable and is used by firms with a low number of distinguishable items such as jewellery stores.
periodic inventory system
inventory values and COGS are determined at the end of the accounting period
perpetual inventory system
inventory values and COGS are updated continuously
LIFO reserve
LIFO inventory - FIFO inventory
FIFO Inventory
LIFO Inventory + LIFO reserve
FIFO cash
LIFO cash - (LIFO reserve * t)
FIFO equity (R/E)
LIFO equity + (LIFO reserve * (1-t))
FIFO COGS
LIFO COGS - 𐤃 in LIFO Reserve
FIFO taxes
LIFO taxes + ( 𐤃 in LIFO reserve * t)
FIFO Net Income
LIFO net income + ( 𐤃 in LIFO reserve * (1-t))
LIFO liquidation
Occurs when goods sold exceed goods replaced. Older (lower cost under LIFO) inventory goods are sold. COGS ↓
COGS needs to be adjusted back up by converting to FIFO.
market value of inventory (under US GAAP)
for LIFO or retail cost method companies
The current replacement cost
Upper limit: NRV
Lower Limit: NRV - normal profit margin
What type of firms can report inventory above cost?
commodity-like products (inventory reported at NRV)
Under LIFO and increasing prices, what happens to profitability ratios?
COGS ↑, profitability ratios ↓
Under LIFO and increasing prices, what is the impact on liquidity ratios?
COGS ↑, Inventory value ↓, Current Assets ↓, liquidity ratios ↓
Under LIFO, and increasing prices, what is the impact on activity ratios?
COGS ↑, inventory value ↓, inventory turnover ↑, days of inventory on hand ↓, activity ratios ↓
Under LIFO, and increasing prices, what is the impact on leverage ratios?
COGS ↑, Inventory value ↓, Current Assets ↓, Equity ↓, debt / equity ↑, leverage ratios ↑
From an analyst’s point of view, which accounting methods are preferable for income statements and balance sheets?
Income: LIFO
B/S: FIFO
Historic cost
purchase price + installation costs + transport costs
Accumulated depreciation
cumul. depreciation that has past through the income statement
book/carrying/balance sheet value
historic cost - accum. depreciation
methods of depreciation:
straight line: equal amount each period
accelerated (DDB): higher in early years, lower in later years
units of production: expense is based on usage rather than time (manual calc.)
Component Depreciation
depreciating an asset based on the separate useful lives of its individual components (required under IFRS)
How are R+D costs recorded?
US GAAP: R+D expensed as incurred
IFRS: R expensed, D capitalised
how are indefinite-lived intangible assets recorded?
reported on the balance sheet indefinitely unless they are impaired
Revaluation model (permitted under IFRS) for reporting long-lived assets
permits assets to be reported at fair value if an active market
Impairments of long-lived assets (IFRS)
book/carrying value > recoverable amount
Asset is written down to recoverable amount and the loss is reflected on the income statement.
The recoverable amount is GREATER of ‘fair value - selling cost’ and ‘value of use’ (PV of future cash values)
Loss reversal allowed up to original loss
Impairments of long-lived assets (US GAAP)
- Identify impairment: book value > estimated future undiscounted cash flows
- Loss recognition: write down asset to its fair value (or discounted value of future cash flows if fair value is unknown) - loss recognised in income statement.
Loss reversal prohibited for ‘held-for-use’ assets.
assets held-for-use and assets held-for-sale
assets held-for-use are depreciated on the balance sheet
assets held-for-sale are tested for impairment
(loss reversals allowed up to the original loss under both IFRS and US GAAP)
Derecognition of a long-lived asset
When a long-lived asset is sold/exchanged or abandoned.
Sold:
- carrying value removed from balance sheet
- cash or new asset added to balance sheet
- gain/loss reported on income statement
Abandoned:
- carrying value removed from balance sheet
- any loss reported on income statement
According to U.S. GAAP, an asset is impaired when:
when the firm cannot recover the carrying value. Under U.S. GAAP, recoverability is tested based on undiscounted future cash flows.
Disclosure measurements
- Basis for measurement (usually historical cost)
- Gross carrying value of each class of asset
- Accumulated depreciation/amortization
- Title restrictions/assets pledged as collateral
- Any impairment losses/reversals and circumstances
- Any revaluations (IFRS only)
Why calculating the average age of fixed assets is useful?
- Older assets can be identified
- Analysts can estimate the timing of major capital expenditures and future financing requirments.
Estimated age of fixed asset
accumulated depreciation / annual depreciation
Estimated useful life of fixed asset
historical cost / annual depreciation
Estimated remaining life
Net PPE / annual depreciation
Assumptions of using Fixed Asset Disclosures to estimate the life of fixed assets
- Straight-line method
- 0 salvage value
Investment Property (IFRS only)
Owned for purpose of rental income/capital appreciation. Can be valued under the ‘Cost Model’ or ‘Fair Value Model’.
Cost model: historic cost - accum. depreciation
Fair value model: all changes in value taken to the income statement
Component depreciation is required under:
IFRS, but not U.S. GAAP.
IFRS requires firms to use component depreciation, which refers to depreciating the identifiable components of an asset separately. U.S. GAAP permits component depreciation but does not require it.
When is a standard PP&E asset tested for impairment (under US GAAP)
- when events and circumstances indicate the firm may not recover its carrying value through future use
- if the asset is reclassified from held-for-use to held-for-sale.
When is a standard PP&E asset tested for impairment (under IFRS)
annually
Under U.S. GAAP, an asset is considered impaired if its book value is:
greater than the sum of the estimated undiscounted future cash flows from its use and disposal.
Tax loss carry-forward
A current or past loss that can be used to reduce taxable income (thus, taxes payable) in the future. Can result in a deferred tax asset.
Tax base
Net amount of an asset or liability used for tax reporting purposes.
Accounting profit
Pretax financial income based on financial accounting standards. Also known as income before tax and earnings before tax.
Income tax expense (companies)
Expense recognized in the income statement that includes taxes payable and changes in deferred tax.
taxes payable + Δ deferred tax liabilities (DTL) − Δ deferred tax assets (DTA)
Deferred tax liabilities.
Tax deduction > Accounting expense
carrying value > tax base of asset
(too little tax paid - pay more later)
Taxable income is smaller than profit before tax. We pay less tax today and more tax going forward
Deferred tax assets
Tax deduction < Accounting expense
carrying value < tax base of asset
(too much tax paid - pay less later)
Taxable income is greater than profit before tax. We pay more tax today and less tax going forward.
Valuation allowance
Reduction of deferred tax assets based on the likelihood the assets will not be realized (reversal of DTA not worth it)
US GAAP: DTA - Valuation Allowance (disclosed in footnotes)
IFRS: DTA - VA shown (VA not disclosed in footnotes)
Carrying value
Net balance sheet value of an asset or liability.
Permanent differences in tax and financial reporting
Differences between tax and financial reporting that will not reverse in the future (do not cause deferred tax)
- Tax exempt income (appears in accounts but not in tax returns) e.g. interest on municipal securities
- Non-deductible expenses e.g. entertaining clients
- Tax credits
Result: effective tax rate (income tax expense / pre-tax income) ≠ statutory rate
Temporary difference in tax and financial reporting
A difference between the tax base and the carrying value of an asset or liability that will result in either taxable amounts or deductible amounts in the future. Several examples of how temporary differences arise are presented later in this review
Tax base of an B/S asset
Amount that will pass through future tax returns
the amount depreciation that goes through future years
carrying value > tax base of an asset
deferred tax liability
carrying value < tax base of an asset
deferred tax asset
Tax base of an B/S liability
carrying value - tax base of an B/S asset
Tax base of revenue received in advance
carrying value - revenue not taxed in future
If a deferred tax liability is expected to reverse in the future, how are they described?
as a liability
If a deferred tax liability is NOT expected to reverse in the future, how are they described?
as an asset
tax expense
tax payable + ( Δ DTL - Δ DTA )
Deferred tax payable with business combinations (e.g. subsidiaries, JVs, Associates)
- No deferred tax on goodwill
- Deferred tax paid on fair value adjustments of assets and liabilities acquired
- DTL - earnings and dividends differences (unless the reversal is unlikely (US GAAP), or unless parent controls the dividend policy of the subsidiary (IFRS))
main difference between permanent and temporary timing difference with regards to deferred tax
temporary timing differences cause deferred tax, permanent difference
Impact of increasing/decreasing the valuation allowance on net income
VA ↑ Income ↓
VA ↓ Income ↑
Key differences between IFRS and US GAAP with regards to treatment of income taxes:
- Revaluations of PP&E and intangibles only in IFRS. DTL/DTA offset against OCI.
- Undistributed profits from subsidiaries, associates and joint ventures (no DTL needed under US GAAP if reversal unlikely in future).
IFRS has a two step process: parent control of dividends and non-reversal - Valuation allowance disclosed only in US GAAP. IFRS just reports the netted DTA.
According to U.S. GAAP, the coupon payment on a bond is reported as:
an operating cash outflow.
Using the effective interest rate method, the reported interest expense of a bond issued at a premium will
decrease over the term of the bond.
Interest expense is based on the book value of the bond. As the premium is amortized, the book value of the bond decreases until it reaches face value.
When is a bond issued at a discount?
when the coupon rate < market rate
ending book value of a bond
beginning book value + interest expense - coupon payment
Issuance costs and how these are treated by IFRS/US GAAP
costs incurred at time of issuance for legal fees, underwriting costs etc.
(IFRS/US GAAP)These costs are deducted from the initial bond liability. Effective interest rate ↑ PV of future cash flows ↓
Under US GAAP, issuance costs can be treated as a pre-paid expense.
Effects of interest changes
- If debt is reported at amortized value (as opposed to fair value) the value of the debt is not affected.
Debt derecognition
Gain/loss if bonds are redeemed prior to maturity:
- repurchase price < carrying value -> GAIN
- repurchase price > carrying value -> LOSS
- Unamortized issuance costs reduce gain or increase loss (US GAAP)
- Noted in MD&A, footnotes
Bond covenants
Restrictions placed on borrower to protect lender
- a violation leads to a technical default
Affirmative covenants (bonds)
Borrower agrees to make timely payments
Negative covenants (bonds)
Borrower refrains from paying dividends and repurchasing shares, engaging in mergers and acquisitions or issuing more debt
interest expense (when issuing a bond)
market rate at issue * b/s value of liability at bgn of period
Conditions of a lease, the contract must:
- refer to a specific asset
- Give the lessee (eg tenant) the asset’s economic benefits during the term of the contract
- Give the lessee (eg tenant) the right to determine how to use the asset during the term of the contract
Conditions of finance lease (5)
Any of following:
- transferral of ownership to lessee
- lessee has option to buy and expects to exercise it
- term of lease is most of asset’s useful life
- PV of lease payments ≥ fair value of asset
- Lessor has no alternative use for asset
Leases less than 1 yr and leases of ‘low value’
reported as expenses
Operating leases
non-finance lease
Lessee Reporting on b/s: IFRS/US GAAP
IFRS
‘right-of-use’ asset = ‘lease liability’
= PV of lease payments on b/s (discounted at lease/borrowing rate)
US GAAP
only different is that the right-of-use asset (for operating leases) is amortized by the decrease in the lease liability each period (not straight-line)
Initial liability of a bond (appears in b/s)
Issue price (PV of future cash flows)
Effective interest rate of a bond
The discount rate (IRR) that equates PV of future cash flows
interest expense of a bond
book value * effective interest rate
coupon + amortization discount - amortization premium
cash flow implications of issuing a bond
CFO ↓ (coupon interest)
CFF ↑ (proceeds at issuance)
CFF ↓ (principal paid at maturity)
When is a bond issued at a discount
market interest rate (YTM) > coupon rate
- Initial liability = issue price (less than face value)
- Liability INCREASES over time as discount is amortized
When is a bond issued at a premium
market interest rate (YTM) < coupon rate
- Initial liability = issue price (greater than face value)
- Liability DECREASES over time as premium is amortizes
- Face value is repaid at maturity (borrower keeps premium)
‘Effective interest method’ of amortizing a bond issued at a premium/discount
(required for IFRS, preferred by US GAAP)
Interest expense = YTM at maturity * beginning b/s liability
amortization of premium/discount = coupon interest - interest expense
‘Straight line Amortization’ of a bond issued at a premium/discount
(permitted under US GAAP)
Interest expense = coupon +/- amortization
Annual Amortization = discount/years or premium/years
Impact of lessee reporting on cash flows
- Principal: CFF outflow
- Interest: CFO outflow (US GAAP), CFO/CFF (IFRS)
Reporting of DC pension plans
I/S: pension expense = employer’s contribution
B/S: no future obligation to report as a liability (unless not when not yet paid)
Reporting of DB pension plans
Asset > liability (PBO/PVDBO) = net pension asset (over-funded plan)
Asset < liability (PBO/PVDBO) = net pension liability (under-funded plan)
Employer’s pool of assets is used to pay off the liability of the pension.
B/S: assets-liability (funded status)
What type of liabilities are considered as ‘debt’?
interest-bearing liabilities
Earnings quality high if they are:
- sustainable
- provide adequate investor returns
aggressive accounting
accounting choices increase current period earnings and financial position
conservative accounting
accounting choices decrease current period earnings and financial position
‘smoothing earnings’
conservative accounting choices when earnings are high and aggressive choices when earnings are low.
motivations for low-quality reporting
- meet/exceed benchmark EPS
- increase compensation/reputation
- increase stock price
- avoid violating debt covenants
- improve view of company by investors/suppliers/customers
opportunities for low-quality financial reporting:
- weak internal controls
- inadequate board oversight
- range of acceptable treatments within GAAP
- minimal consequences of inappropriate choices
Govt. regulation to prevent poor financial reporting quality
- securities registration (IOSCO - ESMA/SEC)
- disclosure/auditing requirements
- mgmt commentary, review of business, principal risks and uncertainties
- mgmt responsibility for reporting
- enforcement: fines/suspension etc
Non-GAAP accounting measures to present accounts
- SEC: non-GAAP measure and link to GAAP measure stated
- IFRS: non-GAAP measures defined alongside an explanation for their use - link to GAAP measure
bill and hold transaction
the customer buys the goods and receives an invoice but requests that the firm keep the goods at their location for a period of time.
The use of fictitious bill-and-hold transactions can increase earnings in the current period by recognizing revenue for goods that are actually still in inventory.
channel stuffing
e.g. accelerating deliveries to distributors or sending customers unordered merchandise
accounts receivable as a percentage of revenues ↑
receivables turnover ratio ↓
days of sales outstanding ↑
Payables would not be affected.
barter transactions
exchanging goods/services for other goods/services (no money exchanged)
Four general characteristics of credit analysis
- Scale and diversification
- Operational Efficiency
- Margin Stability
- Leverage
Projections of net income and cash flows are typically based on what assumptions
COGS, operating expenses, and noncash working capital remain a constant percentage of sales
The problem with using financial statement ratios to screen for stocks to include in a portfolio is that:
specific industries are often over-represented.
Inventory cost method in tax returns - same must be used in financial statements
.
Inventory revaluations under IFRS and US GAAP
Under IFRS, inventory is measured at the lower of cost or net realizable value. Inventory that has been written down can later be revalued upward if its net realizable value recovers, but only to the extent that reverses the writedown (i.e., no higher than cost).
Under U.S. GAAP, inventory that has been written down may not be revalued upward.
How are deferred tax assets and deferred tax liabilities are classified on the balance sheet under IFRS/US GAAP
IFRS: non-current items
US GAAP: current/non-current items
