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CFA Lvl 1 > Financial Statement Analysis > Flashcards

Financial Statement Analysis Flashcards

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1
Q

Role of Financial Statement Analysis

A

> 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.

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2
Q

Balance Sheet (aka the statement of financial position or statement of financial condition)

A

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).

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3
Q

Accounting equation

A

Assets = Liabilites + Equity

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4
Q

Capital Structure of a firm:

A

The proportions of liabilities and equity used to finance a company

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5
Q

The statement of comprehensive income

A

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.

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6
Q

The income statement (also known as the statement of operations or the profit and loss statement)

A

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.

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7
Q

The statement of changes in equity

A

reports the amounts and sources of changes in equity investors’ investment in the firm over a period of time.

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8
Q

The statement of cash flows

A

reports the company’s cash receipts and payments

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9
Q

Three types of cash flows:

A

> 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.

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10
Q

What is the significance of the accruals process:

A

Earnings do not equal cash.

As revenues/expenses are recorded when a transaction occurs, not when payment is received or made.

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11
Q

Retained earnings

A

Earnings that are reinvested in the company and not distributed to shareholders

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12
Q

Financial statement notes

A

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.

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13
Q

Management’s commentary (Management’s Discussion and Analysis (MD&A))

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.

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14
Q

unqualified / unmodified / clean opinion

A

indicates that the auditor believes the statements are free from material omissions and errors.

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15
Q

qualified opinion

A

indicated the statements make exceptions to the accounting principles and an explanation is given.

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16
Q

adverse opinion

A

if the statements are not presented fairly or are materially nonconforming with accounting standards

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17
Q

disclaimer of opinion

A

If the auditor is unable to express an opinion (e.g., in the case of a scope limitation)

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18
Q

modified opinion

A

Any opinion other than unqualified

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19
Q

Proxy statements

A

issued to shareholders when there are matters that require a shareholder vote.

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20
Q

‘Goring Concern’ assumption

A

The assumption that the company will continue operating for the foreseeable future.

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21
Q

Internal controls

A

The processes by which the company ensures that it presents accurate financial statements and to prevent fraud.

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22
Q

Which audit opinion do shareholders want on the financial statements

A

Unqualified opinion

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23
Q

How are auditors appointed?

A

By the shareholders to review the financial statements of the company

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24
Q

Where are the Securities and Exchange Commission (SEC) filings available from and what do they contain?

A

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

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25
Q

Key Audit Matters / Critical Audit Matters

A

The auditor will outline areas of complication/risk and accounting choices made that are relevant to the reader.

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26
Q

The financial statement analysis framework consists of six steps:

A

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.

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27
Q

Two fundamental characteristics that make financial information useful:

A
  • Relevance

- Faithful representation

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28
Q

Four characteristics that enhance relevance and faithful representation:

A
  • Comparability
  • Verifiability
  • Timeliness
  • Understandability
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29
Q

When should an item be ‘recognized’ in its financial statement?

A

If a future economic benefit from the item is probable and the item’s value can be measured.

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30
Q

What do the amounts at which items are reported in the financial statement elements depend on?

A

Their measurement base.

This includes historical cost, amortized cost, current cost, net realizable value, present value and fair value.

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31
Q

Accrual Accounting

A

Financial statements should reflect transactions at the time they occur - not when cash changes hands.

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32
Q

Going concern

A

Assumption that company will continue to exist for the foreseeable future

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33
Q

International Accounting Standard (IAS) requires from financial statements (5):

A
  • Balance Sheet
  • Statement of Comprehensive Income
  • Cash flow statement
  • Statement of changes in owner’s equity
  • Explanatory notes and summary of accounting policies
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34
Q

The objective of financial reporting, according to the IASB framework, is to:

A

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)

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35
Q

International Accounting Standard (IAS) No. 1

A

According to IAS No. 1, financial statements must be presented at least annually

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36
Q

Required financial statements, according to International Accounting Standard (IAS) No. 1, include a(n):

A

balance sheet and explanatory notes.

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37
Q

Income equation:

A

net income = revenues - expenses

net income = income (+gains) - expenses (+losses)

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38
Q

How is net revenue calculated:

A

Revenue - adjustments for estimated returns and allowances

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39
Q

Principles-based approach to revenue recognition:

A

A firm should recognize revenue when it has transferred a good or service to a customer.

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40
Q

Five step process to recognizing revenue:

A
  1. Identify the contract with the customer
  2. Identify the 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 the entity satisfies the performance obligation.
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41
Q

A ‘distinct’ good or service

A

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.
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42
Q

For long-term contracts, how can revenue be recognised?

A

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)

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43
Q

What is the effect of capitalising the expenses involved in securing long-term contracts?

A

To decrease the reported expenses on the income statement, increasing reported profitability during the contract period.

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44
Q

Are depreciation expenses and interest expenses included or excluded from operating expenses in the income statement?

A

Depreciation expenses: Included

Interest Expenses: Excluded (this is a financing cost)

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45
Q

Period costs

A

Expenses that cannot be tied to revenue generation e.g. admin costs

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46
Q

Which inventory calculation method is prohibited under IFRS?

A

LIFO

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47
Q

Amortization:

A

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.

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48
Q

Discontinued Operations

A

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.

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49
Q

Prior-period adjustment

A

A correction of an accounting error made in previous financial statements. This requires retrospective application.

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50
Q

Which element of the accounting equation represents a residual claim?

A

Owner’s equity - a residual claim on the business

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51
Q

Deferred/unearned revenue

A

Cash received prior to revenue being recognised

This is a liability until the promised goods are provided.

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52
Q

Unbilled (accrued) revenue

A

When a revenue has been recognised but no billing has occurred and no cash has been received.

This is an asset.

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53
Q

Prepaid expense

A

Payment of expenses in advance. This is an asset.

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54
Q

Double-declining balance method

A

(2 / useful life) ( cost - accumulated depreciation)

for Y1 the equation is (2/useful life)(cost)

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55
Q

How are gains/losses on sales of operating assets and depreciation expenses displayed on the income statement?

A

These are reported pre-tax, above income from continuing operations.

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56
Q

Accrual basis (matching principle)

A

Match costs against associated revenues (e.g. inventory, depreciation)

(based on transactions not cash)

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57
Q

Period expenses

A

Expenditures that less directly match the timing of revenues (e.g. admin costs)

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58
Q

Impairments

A

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.

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59
Q

How is inventory held/recorded?

A

At the lower of cost and net realisable value (NRV)

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60
Q

Discontinued Operations

A

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)

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61
Q

Operating / Non-operating income

A

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.

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62
Q

Weighted average no. of common shares

when calculating basic EPS

A

Weighted by the portion of the year the shares were outstanding.

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63
Q

Stock dividend

A

The % distribution of additional shares to each shareholder proportional to the number of shares (*% by number of shares)

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64
Q

How do cash dividends impact EPS

A

It doesn’t

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65
Q

Other comprehensive income:

A
  • 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.
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66
Q

Trading securities

A

Debt securities that a firm owns, but intends to sell.

Reported on income statement and balance sheet at fair value.

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67
Q

Held-to-maturity securities

A

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.

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68
Q

Available-for-sale securities

A

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.

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69
Q

Classified balance sheet

A

groups together similar items

useful when assessing liquidity

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70
Q

Liquidity-based balance sheet

A

presents assets/liabilities in order of liquidity

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71
Q

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?

A

Revenue is deferred until the sporting event is held.

Even though the tickets are nonrefundable, the seller is still obligated to hold the event.

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72
Q

Accounting goodwill

A

Goodwill as a result of past acquisitions

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73
Q

Economic goodwill

A

Goodwill as a result of expected future performance

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74
Q

Treasury stock method

when calculating diluted number of shares with warrants

A

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

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75
Q

Effect of Dividends paid to shareholders

A

reduce owners’ equity but not net income.

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76
Q

Operating cycle

A

Time taken to produce/purchase inventory, sell the product and collect cash

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77
Q

Current assets

A
  • Cash and cash equivalents
  • Marketable securities
  • Accounts receivable
  • Inventories
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78
Q

Standard costing

A

A method of measuring inventory costs - using predetermined costs to goods produced.

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79
Q

Retail method

A

A method of measuring inventory costs - using retail prices and subtracting gross profits to determine the cost.

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80
Q

Other current assets

A

Amounts that may not be material if shown separately and are combined together

e.g. prepaid expenses

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81
Q

Current liabilities

A
  • Accounts payable
  • Notes payable and current portion of long-term debt
  • Accrued liabilities
  • Unearned revenue
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82
Q

Historical cost

A

Purchase price + any additional costs getting product ready for use

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83
Q

Impact of manipulating net income upwards by allocating more of the acquisition price to goodwill and less to the identifiable asset

A

Less depreciation and amortization expenses, and higher net income

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84
Q

Difference between ‘comprehensive income’ and ‘accumulated other comprehensive income’

A

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.

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85
Q

Current ratio

A

current assets / current liabilities

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86
Q

Quick ratio (acid test)

A

( current assets - inventory ) / current liabilities

( cash + marketable securities + receivables ) / current liabilities

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87
Q

Cash ratio

A

( cash + marketable securities ) / current liabilities

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88
Q

Long-term debt-to-equity

A

long-term debt / total equity

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89
Q

total debt-to-equity

A

total debt / total equity

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90
Q

total debt ratio

A

total debt / total assets

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91
Q

financial leverage

A

total assets / total equity

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92
Q

limitations of balance sheet ratio analysis:

A
  • 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.
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93
Q

Treasury stock

A

Shares that are held by the company and restricted to the public.

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94
Q

Retained earnings

A

Net income since inception - dividends paid out

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95
Q

Noncontrolling/minority interest

A

Portion of a subsidiary’s balance sheet not owned by the parent company (but controlled by the parent)

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96
Q

Issued share capital

A

shares offered for sale to the public

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97
Q

Outstanding share capital

A

shares held by shareholder’s (excluding treasury stock)

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98
Q

Total stockholder’s equity

A

common/preferred stock + retained earnings + accumulated other comprehensive income

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99
Q

Par value

A

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).

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100
Q

What is the appropriate measurement basis for equipment used in the manufacturing process?

A

Equipment is reported in the balance sheet at historical cost less accumulated depreciation.

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101
Q

Calculating goodwill

A

proceeds - fair value of net assets

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102
Q

Liquidity-based presentation of a balance sheet is most likely to be used by a:

A

The liquidity-based format of balance sheet presentation is most common in the banking industry.

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103
Q

The balance sheet is most likely to provide an analyst with information about a firm’s:

A

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.

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104
Q

Under IFRS, how do firms report an investment in the equity securities of another company

A

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.

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105
Q

Working capital (accounting)

A

current assets - current liabilities

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106
Q

common size analysis when viewing a balance sheet

A

balance sheet item / total assets

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107
Q

Cash flow from operating activities

A

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
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108
Q

Cash flow from investing activities

A

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
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109
Q

Cash flow from financing activities

A

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
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110
Q

Dividends / Interest paid received on cash flow statement (IFRS or GAAP)

A

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
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111
Q

Taxes paid / bank overdraft on cash flow statement (IFRS and GAAP)

A

GAAP

  • taxes paid: operating activity
  • bank overdraft: financing activity

IFRS

  • taxes paid: operating activity or investing + financing activity
  • bank overdraft: part of cash equiv.
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112
Q

(Period end) accounts receivable =

A

Beginning accounts receivable + sales - cash collections

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113
Q

Relationship between changes in assets and changes in cash flows

A

Asset account ↑ Cash ↓

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114
Q

Relationship between liabilities and cash flows

A

Liabilities ↑ Cash ↑

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115
Q

Effect of depreciation on cash flows

A

None - it is not a cash flow (non-cash charge through income statement)

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116
Q

Affect of deferred tax liability on cash flows

A

None

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117
Q

Working Capital (Indirect method)

A

current assets - (cash + investments) + current liabilities - (debt instruments + dividends payable)

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118
Q

Cash dividends paid

A

Dividends declared - Δ Dividends payable

119
Q

Dividends declared

A

Net income - Δ retained earnings

120
Q

Cash collections

A

net sales - Δ accounts receivable + Δ advances from customers (unearned revenues)

121
Q

Cash paid for inputs (suppliers)

A

cost of goods sold - Δ inventory + Δ accounts payable

122
Q

Cash interest

A

interest expense + Δ interest payable

123
Q

Free cash flow

A

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.

124
Q

Free cash flow to the firm (FCFF)

A

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
125
Q

Free cash flow to equity (FCFE)

A

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
126
Q

cash flow-to-revenue ratio

A

measures the amount of operating cash flow generated for each dollar of revenue.

CFO / net revenue

127
Q

cash return-on-assets ratio

A

measures the return of operating cash flow attributed to all providers of capital.

CFO / avg. total assets

128
Q

cash return-on-equity ratio

A

measures the return of operating cash flow attributed to shareholders.

CFO / avg. total equity

129
Q

cash-to-income ratio

A

measures the ability to generate cash from firm operations.

CFO / operating income

130
Q

Cash flow per share

A

a variation of basic earnings per share measured by using CFO instead of net income.

( CFO - pref. dividends ) / weighted avg. no. of common shares

131
Q

debt coverage ratio

A

measures financial risk and leverage.

CFO / total debt

132
Q

interest coverage ratio

A

measures the firm’s ability to meet its interest obligations.

( CFO + interest paid + taxes paid ) / interest paid

EBIT / interest payments

133
Q

reinvestment ratio

A

measures the firm’s ability to acquire long-term assets with operating cash flow.

CFO / cash paid for long-term assets

134
Q

debt payment ratio

A

measures the firm’s ability to satisfy long-term debt with operating cash flow.

CFO / cash long-term debt repayment

135
Q

dividend payment ratio

A

measures the firm’s ability to make dividend payments from operating cash flow.

CFO / dividends paid

136
Q

investing and financing ratio

A

measures the firm’s ability to purchase assets, satisfy debts, and pay dividends.

CFO / cash outflows from investing/financing activities

137
Q

Activity ratios (asset utilisation / operating efficiency ratios )

A

measures efficiency of everyday tasks

138
Q

Liquidity ratios

A

measures ability to meet short-term liabilities

139
Q

Solvency ratios

A

measures ability to meet long-term obligations

140
Q

Profitability ratios

A

measures ability to generate profitable sales from asset base

141
Q

Valuation ratios

A

measures quantity of asset or flow associated with an ownership claim

142
Q

receivables turnover

A

annual sales / average receivables

143
Q

days of sales outstanding / average collection period

A

365 / receivables turnover

144
Q

inventory turnover

A

cost of goods sold / average inventory

145
Q

days of inventory on hand / average inventory processing period

A

365 / inventory turnover

146
Q

payables turnover

A

a measure of the use of trade credit by the firm

purchases / average trade payables

147
Q

Ending inventory

A

beginning inventory + purchases - cost of goods sold

148
Q

number of days of payables / payables payment period

A

365 / payables turnover ratio

149
Q

total asset turnover

A

The effectiveness of the firm’s use of its total assets to create revenue

revenue / average total assets

150
Q

Fixed asset turnover

A

revenue / average net fixed assets

151
Q

Working capital turnover

A

revenue / average working capital

152
Q

defence interval

A

indicates the number of days of average cash expenditures the firm could pay with its current liquid assets

( current assets - inventory ) / avg. daily expenditure

153
Q

Cash conversion cycle

A

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

154
Q

debt-to-capital

A

Debt / assets

total debt / total debt + total equity

155
Q

debt-to-assets

A

total debt / total assets

156
Q

fixed charge coverage

A

( earnings before interest and taxes + lease payments ) / ( interest payments + lease payments )

157
Q

net profit margin

A

net income / revenue

158
Q

operating profit margin

A

operating income / revenue

159
Q

operating income

A

gross profit - operating costs

160
Q

pretax margin

A

earnings before tax but after interest / revenue

161
Q

net profit margin

A

net income / revenue

162
Q

return on assets

A

net income / average total assets

163
Q

operating return on assets

A

operating income (EBIT) / avg. total assets

164
Q

return on total capital

A

EBIT / ( short + long-term debt + equity )

165
Q

return on equity

A

net income / avg. total equity

166
Q

return on common equity

A

( net income - pref. div ) / avg. common equity

167
Q

Three point DuPont Analysis

A

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)

168
Q

Five point DuPont Analysis

A

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

169
Q

dividend payout ratio

A

common dividend / ( net income - pref. div )

170
Q

retention rate

A

( Earnings available to common shares - common dividend ) / Earnings available to common shares

net income - pref. div = earnings available to common shares

171
Q

sustainable growth rate (g)

A

retention rate (b) * ROE

b = 1 - dividend payout ratio

172
Q

Coefficient of sales ratio

A

s.d. of sales / mean sales

173
Q

Coefficient of operating income

A

s.d. of operating income / mean operating income

174
Q

Coefficient of net income

A

s.d. of net income / mean net income

175
Q

Altman’s Z score

A

a regression based approach that predicts the chances of bankruptcy - a score of < 1.8 indicates a high chance

176
Q

a business segment

A
  • 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
177
Q

segment margin

A

segment profit / segment revenue

178
Q

segment asset turnover

A

segment revenue / segment assets

179
Q

segment ROA

A

segment profit / segment assets

180
Q

segment debt ratio

A

segment liabilities / segment assets

181
Q

COGS

A

COGS = beginning inventory + purchases - ending inventory

182
Q

ending inventory

A

beginning inventory + purchases - COGS

183
Q

‘capitilized’

A

recorded in balance sheet

184
Q

Inventory costs included in balance sheet

A

‘product costs’

  • purchase cost
  • conversion/manufacturing costs making it product fit

‘period costs’ are not included

  • selling costs
  • abnormal waste of materials
  • administrative overheads
185
Q

Under which inventory cost flow assumption does inventory on the balance sheet best approximate its current cost?

A

FIFO - ending inventory is made up of the most recent purchases, thereby providing a closer approximation of current cost.

186
Q

Specific identification

A

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.

187
Q

periodic inventory system

A

inventory values and COGS are determined at the end of the accounting period

188
Q

perpetual inventory system

A

inventory values and COGS are updated continuously

189
Q

LIFO reserve

A

LIFO inventory - FIFO inventory

190
Q

FIFO Inventory

A

LIFO Inventory + LIFO reserve

191
Q

FIFO cash

A

LIFO cash - (LIFO reserve * t)

192
Q

FIFO equity (R/E)

A

LIFO equity + (LIFO reserve * (1-t))

193
Q

FIFO COGS

A

LIFO COGS - 𐤃 in LIFO Reserve

194
Q

FIFO taxes

A

LIFO taxes + ( 𐤃 in LIFO reserve * t)

195
Q

FIFO Net Income

A

LIFO net income + ( 𐤃 in LIFO reserve * (1-t))

196
Q

LIFO liquidation

A

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.

197
Q

market value of inventory (under US GAAP)

for LIFO or retail cost method companies

A

The current replacement cost

Upper limit: NRV
Lower Limit: NRV - normal profit margin

198
Q

What type of firms can report inventory above cost?

A

commodity-like products (inventory reported at NRV)

199
Q

Under LIFO and increasing prices, what happens to profitability ratios?

A

COGS ↑, profitability ratios ↓

200
Q

Under LIFO and increasing prices, what is the impact on liquidity ratios?

A

COGS ↑, Inventory value ↓, Current Assets ↓, liquidity ratios ↓

201
Q

Under LIFO, and increasing prices, what is the impact on activity ratios?

A

COGS ↑, inventory value ↓, inventory turnover ↑, days of inventory on hand ↓, activity ratios ↓

202
Q

Under LIFO, and increasing prices, what is the impact on leverage ratios?

A

COGS ↑, Inventory value ↓, Current Assets ↓, Equity ↓, debt / equity ↑, leverage ratios ↑

203
Q

From an analyst’s point of view, which accounting methods are preferable for income statements and balance sheets?

A

Income: LIFO

B/S: FIFO

204
Q

Historic cost

A

purchase price + installation costs + transport costs

205
Q

Accumulated depreciation

A

cumul. depreciation that has past through the income statement

206
Q

book/carrying/balance sheet value

A

historic cost - accum. depreciation

207
Q

methods of depreciation:

A

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.)

208
Q

Component Depreciation

A

depreciating an asset based on the separate useful lives of its individual components (required under IFRS)

209
Q

How are R+D costs recorded?

A

US GAAP: R+D expensed as incurred

IFRS: R expensed, D capitalised

210
Q

how are indefinite-lived intangible assets recorded?

A

reported on the balance sheet indefinitely unless they are impaired

211
Q

Revaluation model (permitted under IFRS) for reporting long-lived assets

A

permits assets to be reported at fair value if an active market

212
Q

Impairments of long-lived assets (IFRS)

A

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

213
Q

Impairments of long-lived assets (US GAAP)

A
  1. Identify impairment: book value > estimated future undiscounted cash flows
  2. 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.

214
Q

assets held-for-use and assets held-for-sale

A

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)

215
Q

Derecognition of a long-lived asset

A

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
216
Q

According to U.S. GAAP, an asset is impaired when:

A

when the firm cannot recover the carrying value. Under U.S. GAAP, recoverability is tested based on undiscounted future cash flows.

217
Q

Disclosure measurements

A
  • 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)
218
Q

Why calculating the average age of fixed assets is useful?

A
  • Older assets can be identified

- Analysts can estimate the timing of major capital expenditures and future financing requirments.

219
Q

Estimated age of fixed asset

A

accumulated depreciation / annual depreciation

220
Q

Estimated useful life of fixed asset

A

historical cost / annual depreciation

221
Q

Estimated remaining life

A

Net PPE / annual depreciation

222
Q

Assumptions of using Fixed Asset Disclosures to estimate the life of fixed assets

A
  • Straight-line method

- 0 salvage value

223
Q

Investment Property (IFRS only)

A

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

224
Q

Component depreciation is required under:

A

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.

225
Q

When is a standard PP&E asset tested for impairment (under US GAAP)

A
  • 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.
226
Q

When is a standard PP&E asset tested for impairment (under IFRS)

A

annually

227
Q

Under U.S. GAAP, an asset is considered impaired if its book value is:

A

greater than the sum of the estimated undiscounted future cash flows from its use and disposal.

228
Q

Tax loss carry-forward

A

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.

229
Q

Tax base

A

Net amount of an asset or liability used for tax reporting purposes.

230
Q

Accounting profit

A

Pretax financial income based on financial accounting standards. Also known as income before tax and earnings before tax.

231
Q

Income tax expense (companies)

A

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)

232
Q

Deferred tax liabilities.

A

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

233
Q

Deferred tax assets

A

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.

234
Q

Valuation allowance

A

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)

235
Q

Carrying value

A

Net balance sheet value of an asset or liability.

236
Q

Permanent differences in tax and financial reporting

A

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

237
Q

Temporary difference in tax and financial reporting

A

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

238
Q

Tax base of an B/S asset

A

Amount that will pass through future tax returns

the amount depreciation that goes through future years

239
Q

carrying value > tax base of an asset

A

deferred tax liability

240
Q

carrying value < tax base of an asset

A

deferred tax asset

241
Q

Tax base of an B/S liability

A

carrying value - tax base of an B/S asset

242
Q

Tax base of revenue received in advance

A

carrying value - revenue not taxed in future

243
Q

If a deferred tax liability is expected to reverse in the future, how are they described?

A

as a liability

244
Q

If a deferred tax liability is NOT expected to reverse in the future, how are they described?

A

as an asset

245
Q

tax expense

A

tax payable + ( Δ DTL - Δ DTA )

246
Q

Deferred tax payable with business combinations (e.g. subsidiaries, JVs, Associates)

A
  • 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))
247
Q

main difference between permanent and temporary timing difference with regards to deferred tax

A

temporary timing differences cause deferred tax, permanent difference

248
Q

Impact of increasing/decreasing the valuation allowance on net income

A

VA ↑ Income ↓

VA ↓ Income ↑

249
Q

Key differences between IFRS and US GAAP with regards to treatment of income taxes:

A
  • 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.
250
Q

According to U.S. GAAP, the coupon payment on a bond is reported as:

A

an operating cash outflow.

251
Q

Using the effective interest rate method, the reported interest expense of a bond issued at a premium will

A

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.

252
Q

When is a bond issued at a discount?

A

when the coupon rate < market rate

253
Q

ending book value of a bond

A

beginning book value + interest expense - coupon payment

254
Q

Issuance costs and how these are treated by IFRS/US GAAP

A

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.

255
Q

Effects of interest changes

A
  • If debt is reported at amortized value (as opposed to fair value) the value of the debt is not affected.
256
Q

Debt derecognition

A

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
257
Q

Bond covenants

A

Restrictions placed on borrower to protect lender

- a violation leads to a technical default

258
Q

Affirmative covenants (bonds)

A

Borrower agrees to make timely payments

259
Q

Negative covenants (bonds)

A

Borrower refrains from paying dividends and repurchasing shares, engaging in mergers and acquisitions or issuing more debt

260
Q

interest expense (when issuing a bond)

A

market rate at issue * b/s value of liability at bgn of period

261
Q

Conditions of a lease, the contract must:

A
  • 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
262
Q

Conditions of finance lease (5)

A

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
263
Q

Leases less than 1 yr and leases of ‘low value’

A

reported as expenses

264
Q

Operating leases

A

non-finance lease

265
Q

Lessee Reporting on b/s: IFRS/US GAAP

A

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)

266
Q

Initial liability of a bond (appears in b/s)

A

Issue price (PV of future cash flows)

267
Q

Effective interest rate of a bond

A

The discount rate (IRR) that equates PV of future cash flows

268
Q

interest expense of a bond

A

book value * effective interest rate

coupon + amortization discount - amortization premium

269
Q

cash flow implications of issuing a bond

A

CFO ↓ (coupon interest)
CFF ↑ (proceeds at issuance)
CFF ↓ (principal paid at maturity)

270
Q

When is a bond issued at a discount

A

market interest rate (YTM) > coupon rate

  • Initial liability = issue price (less than face value)
  • Liability INCREASES over time as discount is amortized
271
Q

When is a bond issued at a premium

A

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)
272
Q

‘Effective interest method’ of amortizing a bond issued at a premium/discount

(required for IFRS, preferred by US GAAP)

A

Interest expense = YTM at maturity * beginning b/s liability

amortization of premium/discount = coupon interest - interest expense

273
Q

‘Straight line Amortization’ of a bond issued at a premium/discount

(permitted under US GAAP)

A

Interest expense = coupon +/- amortization

Annual Amortization = discount/years or premium/years

274
Q

Impact of lessee reporting on cash flows

A
  • Principal: CFF outflow

- Interest: CFO outflow (US GAAP), CFO/CFF (IFRS)

275
Q

Reporting of DC pension plans

A

I/S: pension expense = employer’s contribution

B/S: no future obligation to report as a liability (unless not when not yet paid)

276
Q

Reporting of DB pension plans

A

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)

277
Q

What type of liabilities are considered as ‘debt’?

A

interest-bearing liabilities

278
Q

Earnings quality high if they are:

A
  • sustainable

- provide adequate investor returns

279
Q

aggressive accounting

A

accounting choices increase current period earnings and financial position

280
Q

conservative accounting

A

accounting choices decrease current period earnings and financial position

281
Q

‘smoothing earnings’

A

conservative accounting choices when earnings are high and aggressive choices when earnings are low.

282
Q

motivations for low-quality reporting

A
  • meet/exceed benchmark EPS
  • increase compensation/reputation
  • increase stock price
  • avoid violating debt covenants
  • improve view of company by investors/suppliers/customers
283
Q

opportunities for low-quality financial reporting:

A
  • weak internal controls
  • inadequate board oversight
  • range of acceptable treatments within GAAP
  • minimal consequences of inappropriate choices
284
Q

Govt. regulation to prevent poor financial reporting quality

A
  • 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
285
Q

Non-GAAP accounting measures to present accounts

A
  • 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

286
Q

bill and hold transaction

A

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.

287
Q

channel stuffing

A

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.

288
Q

barter transactions

A

exchanging goods/services for other goods/services (no money exchanged)

289
Q

Four general characteristics of credit analysis

A
  1. Scale and diversification
  2. Operational Efficiency
  3. Margin Stability
  4. Leverage
290
Q

Projections of net income and cash flows are typically based on what assumptions

A

COGS, operating expenses, and noncash working capital remain a constant percentage of sales

291
Q

The problem with using financial statement ratios to screen for stocks to include in a portfolio is that:

A

specific industries are often over-represented.

292
Q

Inventory cost method in tax returns - same must be used in financial statements

A

.

293
Q

Inventory revaluations under IFRS and US GAAP

A

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.

294
Q

How are deferred tax assets and deferred tax liabilities are classified on the balance sheet under IFRS/US GAAP

A

IFRS: non-current items

US GAAP: current/non-current items

CFA Lvl 1 (10 decks)

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