Financial statements Flashcards
Treasury stock
> cost of shares bought back by the share issuer over time
it is a contra account
change in comprehensive income
net income + oher comprehensive income
Cash flows from investing
sale of property and equipment
and the purchase of property
and equipment
fundamental characteristics of useful information
relevance and faithful representation
enhancing characteristics
comparability, verifiability, timeliness and understandability
information provided by companies in registration statements
> disclosures about the securities being offered for sale;
the relationship of these new securities to the issuer’s other capital securities;
the information typically provided in the annual filings;
recent audited financial statements;
and risk factors involved in the business.
The European Union (EU) agreed to adopt IFRS for EU listed companies from
2005
The IASB and FASB
standard-setting bodies
fundamental principle that financial statements
> Materiality : free from misstatements and omissions that could influence the decisions of an investor.
Going concern : firm will continue to operate into the foreseeable future and not go into liquidation.
Consistency: presented and classified in a similar manner from one period to the next. Prior periods should be disclosed for comparative purposes.
assumption in a set of financial statements according to the IASB Conceptual Framework:
Going concern - the assumption that the company will continue in business for the foreseeable future
Accrual accounting - the financial statements should reflect transactions in the period when they occur
not required by IAS 1
director’s report
Disclaimer of Opinion
auditors are unable to issue an opinion
adverse opinion
when financial statements materially depart from accounting standards and are not fairly presented
unqualified audit report
when the auditors are of the opinion that the financial position and performance of the company is presented fairly
objective of financial reporting
> provide financial information
that is useful to:
users in making decisions about providing resources to the reporting entity,
where those decisions relate
to equity and debt instruments, or loans or other forms of credit, and in
influencing management’s actions that affect the use of the entity’s economic resources.
International Accounting Standards Board (IASB) objectives
- Develop and promote the use and adoption of a single set of high quality financial standards
- transparent, comparable, and decision-useful information while taking into account sizes and types of entities in diverse economic settings
- Promote convergence of the national accounting standards and IFRS
SEC will often issue
bulletins to reflect their views regarding accounting practices
constraints of financial reporting
benefit vs cost
omission of non-quantifiable info
Alternative measurement bases
- Historical cost
- How much it cost in the past
- Amortized cost
- Historical cost adjusted for depreciation/amortization/depletion/impairment
- Current cost
- How much it would cost today
- Realizable (settlement) value
- How much an asset could be sold for
- Present value
- Present discounted value of future net cash inflows from
an asset - Fair value
- Market value or present value
sum of net cash flows
net change in cash
IASB definition of revenue recognition
“Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants”
converged accounting standards issued by IASB and FASB in May 2014 introduce some basic changes to the principles of revenue recognition:
- Should enhance comparability
- Standards are effective from 1 January 2018 under IFRS and 15 December 2017 under US
GAAP
Core principle of the converged standard:
“Revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects consideration to which entity expects to be entitled in an exchange for those goods or services”
The standard applies five steps in recognizing revenue:
- Identify the contract(s) with a customer
- Identify the separate or distinct performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the entity satisfies the performance obligation
Expense Recognition
IASB definition
Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (e.g. dividends)
Comprehensive Income Definition
“the change in equity of a business enterprise during a
period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.”
Comprehensive Income components
- Net income
- Other revenue and expense items excluded from net income
- Foreign currency translation adjustments
- Changes in the funded status of a company’s defined benefit post-retirement plan
- Unrealized gains/losses on derivatives for hedging purposes
- Unrealized gains/losses on available-for-sale securities
(under US GAAP)
trading securities: unrealised gains and losses go on the income statement
cash collected from customers
sales - increase in accounts receivable
Direct method cash flows
- Eliminates impact of accruals
- Shows only cash receipts and cash payments
- Provides information on specific sources of operating cash receipts and cash payments
‒ Preferred by analysts and commercial lenders
‒ Recommended by CFA Institute - IASB/FASB encourage use of
direct method
Indirect method cash flows
- Starts with net income
- Shows only net result of operating
cash receipts and payments - Shows reasons for differences
between net income and
operating cash flows - Mirrors forecasting approach
Cost of sales
= Beginning inventory (BI) + Purchases (P) - Ending inventory (EI)
IFRS/U.S. GAAP
Cost of inventory
- All costs of purchase
- Purchase price, import duties, insurance, and handling costs, freight costs inwards, raw material
- Costs of conversion
- Direct labor, fixed, and variable overhead costs
- Other costs incurred
> bringing inventories to present location and condition - Exclude:
- Abnormal costs from waste of materials, labor, or
other production, location costs - Admin, overhead and selling costs
- Treat as expense and recognize in income statement when incurred
- Otherwise inventory is overstated, profit overstated
IFRS - Does not allow
LIFO to be used, due to distortion of balance sheet
Periodic vs. perpetual inventory systems
- Periodic system
- Company determines inventory levels periodically
- Ending inventory is subtracted from goods available for sale to calculate cost of sales
- Perpetual system
- Changes in inventory are continuously updated
- Purchases and sales are recorded directly as they occur
- May result in different values for cost of sales and closing inventory when weighted average cost and LIFO methods are used
- Same result if using FIFO
FIFO inventory
= LIFO inventory + LIFO reserve
Retained earnings (FIFO)
= Retained earnings (LIFO) + LIFO reserve x (1 - Tax rate)
FIFO cost of goods sold
= LIFO COGS - Change in LIFO reserve
FIFO net income
= LIFO net income + Change in LIFO reserve x (1 - Tax rate)
Inventory liquidation
- Occurs when number of items sold > items purchased
- E.g. a company running down its inventory levels
Inventory val method (regardless of price direction)
- LIFO income > FIFO income
- LIFO cost of sales < FIFO cost of sales
- Due to ‘low cost’ LIFO items being included in cost of sales
Measurement of Inventory Value
IFRS
- Lower of cost and net realizable value (NRV)
- Estimated selling price less costs required to make the sale
- Inventory write-down required
- Balance sheet value > NRV
- Inventory reduced to NRV
- Impairment expense deducted in income statement
- Assets reduced, equity (retained earnings) reduced
- Impairments can be reversed
Measurement of Inventory Value
U.S. GAAP
- Lower of cost and net realizable value (NRV)
- Exceptions – Inventories under LIFO and retail inventory methods
- Lower of cost and market value
- Market value (fair value)
- Upper limit: Cannot exceed NRV
- Lower limit: NRV - Normal profit margin
- Reversal of impairment not permitted
Measurement of Inventory Value
Presentation and disclosure :* IFRS requirements
- Disclosure requirements
- Accounting policies including cost formula used
- Total carrying amount of inventories by classification
- Raw materials, WIP, finished goods etc.
- Carrying amount of inventories carried at fair value less costs to sell
- Cost of sales
- Amount of any write-downs of inventories recognized as an expense
- Amount of any reversal of impairment
- Circumstances or events leading to reversals and impairments
- Carrying amount of inventories pledged as security for liabilities
Changes in inventory valuation method
* IFRS
- Change in accounting policy
- Only acceptable if company provides reliable and more relevant information
- Historical information is restated for all accounting periods
- Reflected in beginning balance of retained earnings
- Enhances comparability of financial statements over time
Changes in inventory valuation method
* U.S. GAAP
- Explain why new method is superior and preferable
- From LIFO to another method
- Restate inventory and retained earnings retrospectively
- From another method to LIFO
- Change on a prospective basis (don’t change opening balances)
- US tax regulations may restrict changes in inventory valuation methods
Long-lived assets
- Accounting for property, plant and equipment (PPE)
- Tangible assets
- Economic life longer than one year
- Intended to be held for company’s own use
- Recorded on balance sheet at cost
- Accounting for intangible assets
- Depends on how the asset was acquired
Capitalizing
- Year of expenditure
- Increases assets, as asset is recognized on balance sheet
- Reduces investing cash flow (CFI)
- Subsequent years
- Depreciation/amortization expense reduces profit
- No impact on cash flow
- Reduces value of asset in balance sheet
Expensing
- Expensed if expenditure does not meet asset recognition criteria
- Reduces net income
- Reduces operating cash flow (CFO)
- No asset recorded on balance sheet
- Lower net income in current year
- No effect on financial statements in later years
prefer asset capitalization to expensing because
CFO is higher
Depreciation methods
* Straight line
Depreciation expense = (Cost - Estimated residual salvagevalue )/ Useful life (UEL)
Accelerated methods
- Allocation of cost is greater in earlier years
- Double declining balance
Depreciation expense = Constant % x Undepreciated cost
Constant % = 2 / Useful life
Undepreciated cost = Cost - Accumulated depreciation
Net book value cannot
be reduced below residual salvage value
Units-of-production method
- Allocation of cost corresponds to actual use of an asset in a particular period
Depreciation expense = (Cost − Salvage value) x
(Units produced in the year/Total units to be produced)
Long-lived assets
* Alternative to cost method for accounting for long-lived assets
- Not allowed under U.S. GAAP
- Asset value is increased to fair value on balance sheet
- Uses market values rather than historic cost
- IFRS
- Can use cost model for some assets and revaluation model for others
- Must apply revaluation model to all assets within a particular class
- Avoids selective revaluation
- E.g. land, land and buildings, machinery, office equipment
- Can be used for intangible assets
- Only if an active market for the asset exists
- Increase in asset value is included in revaluation surplus in equity
- Gain is not recognized in income statement
Investment property
- U.S. GAAP
- Investment property is generally measured using the cost model
- Defined as property that is owned for the purposes of capital appreciation and/or earning rental yield
- property that is leased under a finance lease
Investment property - IFRS
- Firms are allowed to value investment property using one of the two following methods:
- Cost model: Same as the cost model used for property, plant and equipment (PP&E)
- Fair value model: Different from the revaluation model used for PP&E (if chosen must be used for all property)
- Under this model, all changes in the fair value of investment property affect net income
Investment property - us gaap
INVESTMENT PROPERTY GENRALLY MEASURED USING THE COST MODEL
Permanent differences between accounting profit and taxable income
- Income or expenses are included in either pre-tax income or taxable income but not both
- Income or expense items not allowed by tax legislation
- E.g. tax-exempt municipal bond interest
- Tax credits for expenditure that reduces taxes
- No adjustment required to income tax expense
effective tax rate affected by
permanent differences and different national tax rates
income tax expense / pre-tax income
Temporary differences between accounting profit and taxable income
- Income or expenses are included in both pre-tax income and taxable income but
in different periods - Revenues and expenses may be recognized in one period for
accounting purposes and a different period for tax purposes - E.g. warranty expense recognized on an accruals basis for
accounting purposes and cash basis for tax purposes - Carrying amount and tax base of asset and/or liabilities may differ
- E.g. accounting depreciation methods vs. tax depreciation methods
- Net book value vs. tax base
- See Clayton example later
- Deductibility of gains and losses of assets and liabilities may vary for accounting and income tax purposes
- E.g. impairments are not recognized for tax purposes until asset
is disposed of - Tax losses from prior year might be used to reduce taxable income in
later years
Deferred tax liabilities (DTL)
- Pre-tax income > Taxable income
- Difference due to a temporary timing difference
- E.g. tax authorities calculate a depreciation allowance using double-declining balance
with the company using straight-line depreciation in income statement
> ETR low
Deferred tax assets (DTA)
- Pre-tax income < Taxable income
- E.g. accounting expenses not being recognized for tax purposes such as warranty
expense - E.g. losses deducted from taxable income in later periods
> ETR high
Increase in rates =
DTL: Increase in DT expense
DTA: Decrease in DT expense
Decrease in rates =
DTL: Decrease in DT expense
DTA: Increase in DT expense
U.S. GAAP tax losses
- Recognize a deferred tax asset
- Recognize a valuation allowance for the extent that the losses cannot be deducted in future
- Doubts about future profitability
- DTA – valuation allowance shown in balance sheet
IFRS tax losses
- Different treatment to U.S. GAAP
- Asset is created only to the extent that it is probable that there will be sufficient future taxable income to offset the losses
tax losses
DTA
* Arise when a company makes losses
* Potentially reduce taxable income in future years
- Represent economic asset
Tax credits
- Deductions against taxable income resulting from expenditure
- E.g. research and development tax credits
Analyst considerations where there are tax losses
- Determine whether the losses were due to one-off circumstances or whether they
will recur - Contact the tax authority to discover the extent to which tax losses expire or are
transferable - Assess the recoverability of any tax losses
Balance sheet item / Carrying amount vs. tax base / DTA/DTL
Asset: Carrying amount > tax base : DTL
Asset: Carrying amount < tax base : DTA
Liability: Carrying amount > tax base : DTA
Liability: Carrying amount < tax base : DTL
Recognition of tax charged directly to equity
- IFRS and U.S. GAAP require that tax be treated on same basis as underlying
asset - Deferred tax taken directly to equity
- Examples:
- Revaluation of PPE (IFRS only)
- Long-term investments at fair value
- Changes in accounting policies and prior period errors
- Exchange rate differences for foreign operations
Reversal of DTLs
- DTLs that are unlikely to reverse
- E.g. quasi-permanent timing differences from tax allowances
- Remove from DTL
- Add back to equity
Ending book value
Opening book value - book value of disposal - depreciation + purchases
If unquoted equity has no reliable measure of fair market value (thinly traded)
then the investor has no choice but to use cost as a proxy for fair value. This is true for both US GAAP and IFRS
IFRS : impairment should be the difference
> carrying amount - fair value
fair value is the higher of value in use and market value less costs to sell
US GAAP finance lease the lease payment is allocated
both CFO (the interest expense) and CFF (the reduction in the lease liability)
Intangible assets with indefinite lives are required
Intangible assets with a finite life, along with tangible assets such as PP&E
> to be tested for impairment annually.
must be tested for impairment if there are indications of impairment such as decline in demand or obsolescence.
long lived asset is sold, any profit or loss is most likely to be relative to
carrying value
or
fair value - cost to sell if its lower than carrying value
Valuation allowance
the likelihood that deferred tax assets may not be realized
income tax expense comprises two elements:
- Actual taxes due
- Deferred tax expense
Income tax expense - change in deferred tax liability
A deferred tax asset occurs
if taxable income is more than pretax income and this will reverse in future.
A deferred tax liability occurs
when taxable income is less than pretax income and this will reverse in future
operating and gross profit margins tend to be positively correlated
with sales when economies of scale are present
Financial Statement Analysis Framework
Phases
Step 1 Articulate the purpose and context of analysis
Step 2 Collect all relevant data
Step 3 Process data
Step 4 Analyze results of data processing
Step 5 Conclude recommendation and communicate this
Step 6 Follow-up
- Purpose and
context of the
analysis
Source :
Nature of analyst’s function such as issuing a credit rating
Communication with client or supervisor
Institutional guidelines for developing specific product
Output:
Statement of purpose or objective of analysis
A list of specific questions to be answered by analysis
Nature and content of report
Timetable and budget
- Collect data
Source:
Financial statements, other financial data, questionnaires, industry and other economic data
Discussions with management, suppliers, customers and
competitors
Company site visits
Output :
Organized financial statements
Financial data tables
Completed questionnaires
- Process data
Source:
Data from previous step
Output:
Adjusted financial statements
Common-size statements
Ratios and graphs
Forecasts
- Analyze results of
data processing
Source:
Input data as well as processed data
Output:
Analytical results
- Conclude recommendation and communicate
this
Source :
Analytical results and previous reports
Institutional guidelines for published reports
Output:
Analytical report answering questions posed in phase 1
Recommendations regarding the purpose of the analysis
- Follow-up
Source:
Information gathered by periodically repeating
above steps
Output:
Updated reports and recommendations
The role of financial reporting
Provide information
* Company performance
* Financial position
* Changes in financial position
* Useful to a wide range of users in making economic decisions
The role of financial statement analysis
Analyze financial reports and other information
* Evaluate
- Past, current and prospective performance and financial position of a company
* Purpose
- Making investment, credit, and other economic decisions
Analysis of performance
- Assessment of profitability and cash flow generating ability
- Profitability
- Earn a profit from delivering goods and services
- Cash flow
- Cash is needed to pay employees, suppliers etc.
- Essential to continue as a going concern
- Positive cash flow leads to funding flexibility
- Liquidity
- Ability to meet short-term obligations
- Solvency
- Ability to meet long-term obligations
Regulatory authorities
- Requirement to prepare financial reports in accordance with specified accounting
standards is the responsibility of regulatory authorities - Regulatory authorities are governmental entities with the legal authority to enforce financial reporting requirements over entities that participate in the capital markets
within their jurisdiction
IFRS or USGAAP if multinationals
International Organization of Securities Commissions (IOSCO)
- Global organization; ordinary members e.g. SEC, associate members and affiliate members regulating more than 95% of world capital markets
- Three core objectives of securities regulation:
- Protecting investors
- Ensuring markets are fair, efficient and transparent
- Reducing systemic risk
- Assists in the goal of uniform regulation as well as cross-border co-operation in combating violations of securities and derivatives law
Securities Exchange Commission (SEC)
- Any company involved in US capital markets subject to SEC rules and regulations
- SEC is an ordinary member of IOSCO
- Securities Act of 1933
- Specifies financial and other information to be sent to investors when securities are sold
- Requires initial registration of all public issues
- Securities Exchange Act of 1934
- Act that created the SEC
- Sarbanes-Oxley Act of 2002
- Created Public Company Accounting Oversight Board (PCAOB), Strengthens corporate responsibility for financial reports
- Executive management to report on the effectiveness of the company’s internal controls over financial reporting along with an external audit of the management’s assessment
SEC filings useful for analysts
- Securities Offerings Registration Statement (required by securities act of 1933)
- Filed when offering securities
- Information depends on size and nature of offering
- Forms 10-K (US), 20-F (non-US) and 40-F (Canadian but US listed)
- Required to file annually
- Comprehensive information regarding the company’s business, including financial statements
- Annual Report
- Not required by SEC
- More of a marketing document
- Considerable overlap with previous forms
- Proxy Statement/Form DEF-14A
- Allows shareholders to appoint a proxy
- Contains shareholder resolutions
- Forms 10-Q (US) and 6-K (Non-US)
- Interim periods
Other filings in between filing listed on previous slide
- Form 8-K
- Current report announcing major events
- Acquisitions or disposals of corporate assets, changes in
securities and trading markets etc.
- Acquisitions or disposals of corporate assets, changes in
- Form 144 (unregistered private sales)
- Notice of proposed sales of restricted securities
- Rule 144 permits limited sales of restricted securities without registration
- Forms 3,4 and 5 (initial, changes, annual report)
- Report beneficial ownership of securities by directors and
stockholders holding more than 10% of share capital - Forms 11-K
- Annual report of employee stock purchase, savings and
similar plans
Capital market regulation in Europe
European Securities Committee(ESC)
European Securities and Markets Authority (ESMA)
European Securities Committee(ESC)
- High-level representatives of member states
- Advises European Commission on securities policy issues
European Securities and Markets Authority (ESMA)
- Independent advisory body consisting of representatives of national regulators from individual EU countries
Major Financial Statements and Other Information
Sources
Financial notes and supplementary schedules
* Provides explanatory information
- Business acquisitions/disposals, legal proceedings, stock option plans and related-party transactions
Footnotes
* Information about methods and assumptions used to prepare financial statements
- Aids comparability of financial statements between companies
* Required for complete presentation in conformity with US GAAP and IFRS
Management discussion and analysis (MD&A)
* Required by US GAAP for publicly held companies
* Highlight favorable or unfavorable trends
* Identify significant events and uncertainties
- Affect liquidity, capital, resources and results of operations
* Provide information about effects of inflation, changing prices or useful life, residual life and other material events
* Discuss critical accounting policies requiring subjective judgments
* Similar report required by IFRS
Auditor’s reports
- Examination by an independent accounting firm
- Express an opinion on the truth and fairness of the financial statements
- International standards
- International Auditing and Assurance Standards Board (IAASB) of International Federation of Accountants (IFAC)
- US standards
- Public Company Accounting Oversight Board (PCAOB)
- Sarbanes-Oxley Act
- Audit report
- Provides reasonable assurance financial statements are
fairly presented- High degree of probability statements are free from material error, fraud, or illegal acts
Independent audit report
Provides unqualified audit opinion (clean opinion)
True and fair view (IFRS)
Fairly presented (IFRS and US)
* Adverse opinion
- Financial statements materially depart from accounting standards
- Not fairly presented
- No point in performing any financial analysis
- Statements cannot be relied on
* Disclaimer of opinion
- Auditors are unable to have an opinion for some reason
* E.g. destruction of accounting records
* Sarbanes-Oxley
- Auditors must express an opinion on internal control system
Key Audit Matters (IFRS) and Critical Audit Matters (US)
For listed companies there needs to be a discussion of Key/Critical Audit Matters
- Key Audit Matters – issues that the auditor considers to be most important, such as those that have a higher risk of misstatement, involve significant management
judgment, or report the effects of significant transactions during the period - Critical Audit Matters – issues that involve “especially challenging, subjective, or complex auditor judgment” and similarly include areas with higher risk of misstatement or involving significant management judgment and estimates
Other sources of information
- Issuer sources
- Earnings calls
- Presentations and events
- Press releases
- Public third-party sources
- Free industry whitepapers or analyst reports from a consultancy
- Economic or industry indicators from governments and other
- General news outlet, social media
- Proprietary third-party sources
- Analyst reports and communications, including from the
sell side or analysts and creditrating agencies - Reports and data from platforms such as Bloomberg, Wind, and FactSet
- Proprietary primary research
- Surveys, conversations, product comparisons, and other studies commissioned by the analyst or conducted directly.
Key differences between US GAAP and IFRS
Developed by
FASB
IASB
Key differences between US GAAP and IFRS
Based on
Rules
Principles
Key differences between US GAAP and IFRS
Inventory valuation
FIFO, LIFO, weighted average method
FIFO and weighted average method
Key differences between US GAAP and IFRS
Extraordinary items (not
applicable since Dec 2015)
Shown below tax
Not segregated in the income statement
Key differences between US GAAP and IFRS
Development costs
Treated as an expense
Capitalized if conditions are met
Key differences between US GAAP and IFRS
Reversal of inventory
Prohibited
Permissible if certain conditions are met
Period costs
- If expenses cannot be directly matched with revenues then recognize in the period they are incurred
- E.g. administrative expenses
Issues in expense recognition
Doubtful accounts
* Direct write-off method (not appropriate)
- Recognize loss when the customer defaults
- Not consistent with GAAP
* Provisions for doubtful debts are consistent with matching principle
Warranties
* Company will pay for repairs to faulty products
- May incur costs in future
* At the time of sale (expense on I/S + create liability)
- Recognize a provision for estimated warranty costs
- Consistent with matching principle
Depreciation
Companies constructing their own assets
- All costs incurred in bringing the asset to its present location and condition are capitalized
- I.e., the cost of the asset and the freight costs borne by the purchaser
- Includes capitalization of interest expense associated with construction of assets
Capitalization of interest costs
- Required by both US and IFRS GAAP
- Interest rate
- Based on existing borrowings
- Borrowing specifically incurred for constructing the asset
- Interest
- Capitalized during construction only and added to asset cost
- Reduced for interest earned on borrowings invested (IFRS only)
- Depreciated over the life of the asset
Issues for analyst
- Capitalized interest is included in CFI
- Normally interest payments are included in CFO (U.S. GAAP) or CFO/CFF (IFRS)
- Analyst should consider adjusting cash flow for this treatment
- Analyst should restate interest coverage ratios
- Earnings before interest and tax/interest expense
- Increase interest expense to include capitalized interest
- Will result in lower interest coverage ratios
- Better assessment of solvency of company
- Reported separately as part of income from continuing operations
- Examples:
- Gains or losses on disposal of a portion of a business segment
- Restructuring costs
- Asset impairments
- Analysts will need to form a view on recurrence of these items
- Not advisable to just ignore all unusual items
Discontinued operations
- Business disposes of or establishes a plan to dispose of a distinct
operation - Profits or losses should be disclosed separately on the income statement
Accounting changes
Changes in estimates
* E.g. changes in the useful life of an asset
* Affects period of change and future accounting periods
* No prior year restatement
Changes in principles
* US GAAP and IFRS require restatement of prior periods
* Retrospective application
- Financial statements for all fiscal years shown in a company’s financial report are presented as if the newly adopted accounting principle had been
used throughout the entire period
Changes only applied to new transactions
* No adjustment required
Prior period adjustments
- Error in prior period
- Report adjustment in period new information available
- Restate prior year’s numbers reported in this year’s accounts
- No special recognition on income statement/balance sheet
Non-operating items
- Interest income and expense, dividend receipts tend to be disclosed separately (for non-financial services companies) as non-operating items
- Gains and losses on asset disposals will be shown separately as non-operating items
Earnings Per Share
- IASB and FASB require presentation on face of income statement
Simple capital structure - Basic EPS presented for ordinary shares (IFRS) or common stock (US)
(net income - preference div ) / weighted average number of common shares
Determining the weighted average number of shares
- Not necessarily the number of shares outstanding at year end
- Stock issues/stock repurchases
- Weighting of shares based on date of purchase/repurchase
- Stock splits/stock dividends
- Treasury stock method
- Weighting is based on the shares already in existence
- Date of stock split/stock dividend is irrelevant
- Restatement of prior year EPS
- Required for stock splits/stock dividends
Diluted Earnings Per Share
Complex capital structure
* Company has securities potentially convertible into common stock
- Convertible bonds
- Convertible preferred stock
- Employee stock options
- Warrants
* Convertible securities could dilute, i.e. decrease, EPS
Diluted EPS = Adj income available for common shares / (Weighted no of common + potential common shares)
* Each potentially dilutive issue treated separately
- ‘Anti-dilutive’ issues are ignored in the calculation
- Issue is dilutive, if dilutive EPS < basic EPS
Convertible debt
- ‘If-converted’ method
- What would EPS have been if the convertible debt had been converted at the beginning of the period
- Company would have saved interest (post tax)
- Number of shares in issue would have increased
Earnings
= Net Income - Preference dividends
+ Convertible debt post tax interest SAVED
Shares
= Weighted average number of shares
+ Shares on conversion of debt
Convertible preference stock
- ‘If-converted’ method
- What would EPS have been if the convertible preference stock had been converted at the beginning of the period
- Company would have saved preference dividend
- No tax effect
- Number of shares in issue would have increased
Earnings
= Net income / Weighted average number of shares
+ Shares on conversion of preference stock
Dilutive stock options/warrants
- Treasury stock method
- What would EPS have been if the options has been exercised and the company had used the proceeds to repurchase common stock?
- Company would have received cash (exercise price)
- Number of shares in issue due to exercise of options
or warrants - Company would have repurchased shares in the market
Earnings
= Net income - Preference dividends
Shares
Weighted average number of shares
+ Net increase in shares on exercise of options/warrants
Antidilutive securities
- Inclusion of antidilutive securities results in an increased EPS figure
- Antidilutive securities are not included in the EPS calculation
- Diluted EPS will be stated as same as basic EPS
- Only dilutive securities are included in the EPS calculation
- Reflects maximum potential dilution
- Antidilutive securities are not to be used to offset dilutive securities
Measurement Bases of Assets
Historic cost
* Reliable and objectively determined measurement base
Fair value
* Users may prefer to know what the asset can be sold for
* May be difficult to estimate a current value
Current model
* Mixed model using both historic and fair values
* Balance sheet is not a statement of corporate value
Measured at Cost or Amortized Cost
UNREALISED gains/losses
- Debt securities that are to be held to maturity
- Loans and notes receivable
- Unquoted equity instruments
- Note: Known as ‘Held-to-maturity’ under US GAAP
Measured at Fair Value through Other Comprehensive Income
UNREALISED gains/losses
- ‘Available-for-sale’ debt securities (US GAAP)
- Debt where the business model involves both collecting interest and principal and selling the security (IFRS only) (not held to maturity otherwise measured at amortized cost)
- Equity investments for which the company
irrevocably elects this measurement at acquisition (IFRS only)
Measured at Fair Value through Profit and Loss
UNREALISED gains/losses
- All equity securities unless investment gives the
investor significant influence (US GAAP only) - Trading debt securities (US GAAP only)
- Securities not assigned to either of the other two
categories, or investments for which the company
irrevocably elects this measurement at acquisition (IFRS only)
Direct method
* Calculation of cash flows from operations (CFO)
Calculation of cash flows from operations (CFO)
Cash collections
- Cash inputs
- Other cash outflows
= Cash flows from operations (CFO)
cash collected form customers
sales - increase in Accounts receivable
Cash flow from investing calculations
- Gains and losses on disposal of assets
- Included in net income in income statement
- Gain = proceeds > Net book value
- Loss = proceeds < Net book value
- Remove from net income to calculate CFO
- Deduct a gain
- Add back a loss
- Proceeds
- Include in CFI
- Proceeds from sale = Inflow (+ CFI)
- Purchase = Outflow (- CFI)
( CFI ) Ending assets
Opening assets + purchase - depreciation - disposals at NB
Conversion of cash flows from indirect to direct method
* Three-step conversion process:
Step 1 : Disaggregate all net income into revenue and expenses
Step 2 : Remove all non-cash items from aggregated revenues and expenses and break out all remaining items into relevant cash-flow items
Step 3 : Convert accrual amounts to cash flow amounts by adjusting for working capital changes
=== CASH COLLECTED = REV. - INCR IN ACCOUNTS RECEIV
Common-size cash flow statements
* Two alternative approaches
- Express each cash flow line item as % of total inflows (outflows)
- Express each cash flow line item as % of net revenue
Free cash flow
- Excess of operating cash flow over capital expenditure
Free cash flow to the firm (FCFF)
- Cash available to the company’s suppliers of debt and equity capital
FCFF = NI + NCC + Int(1 - Tax rate) - FCInv - WCInv
Where:
NI = Net income
NCC = Non-cash charges
Int = Interest expense / PAID
FCInv = Capital expenditures
WCInv = Working capital expenditures
FCFF = CFO + Int(1 - Tax rate) - FCInv
Free cash flow to equity (FCFE)
* Cash available to the company’s common stockholders after repayment of debt (principal and interest)
> NOT FOR PREFERENCE STOCKHOLDERS
FCFE = CFO - FCInv - Net debt repayment
or
FCFE = CFO - FCInv + Net borrowing
Net debt repayment
Debt repayments > receipts of borrowed funds
Periodic vs. perpetual inventory systems
- Periodic system
- Company determines inventory levels periodically
- Ending inventory is subtracted from goods available for sale to calculate cost of sales
- Perpetual system
- Changes in inventory are continuously updated
- Purchases and sales are recorded directly as they occur
- May result in different values for cost of sales and closing inventory when weighted average cost and LIFO methods are used
- Same result if using FIFO
Comparison of inventory valuation methods
Where prices are rising and inventory quantity is stable or rising
LIFO inventory < FIFO inventory
LIFO cost of sales > FIFO cost of sales
LIFO income < FIFO income
Comparison of inventory valuation methods
Financial analysis
- Stable prices
- Little difference between the methods
- Prices are rising, or there are more mature businesses
- Analysts will need to take more care:
- Balance sheet
- FIFO inventory values resemble current cost or market value
- LIFO inventory values resemble out-of-date costs
- Income statement:
- LIFO profit measured using current cost (understated)
- FIFO profit measure using old costs (overstated)
Measurement of Inventory Value
IFRS
IFRS
* Lower of cost and net realizable value (NRV)
- Estimated selling price less costs required to make the sale
* Inventory write-down required
- Balance sheet value > NRV
- Inventory reduced to NRV
- Impairment expense deducted in income statement
* Assets reduced, equity (retained earnings) reduced
* Impairments can be reversed
Measurement of Inventory Value
U.S. GAAP
U.S. GAAP
* Lower of cost and net realizable value (NRV)
* Exceptions – Inventories under LIFO and retail inventory methods
- Lower of cost and market value
* Market value (fair value)
- Upper limit: Cannot exceed NRV
- Lower limit: NRV - Normal profit margin
* Reversal of impairment not permitted
Presentation and disclosure
* IFRS requirements
Disclosure requirements
* Accounting policies including cost formula used
* Total carrying amount of inventories by classification
- Raw materials, WIP, finished goods etc.
* Carrying amount of inventories carried at fair value less costs to sell
* Cost of sales
* Amount of any write-downs of inventories recognized as an expense
* Amount of any reversal of impairment
* Circumstances or events leading to reversals and impairments
* Carrying amount of inventories pledged as security for liabilities
IFRS criteria for recognition on balance sheet
- Identifiable
- Capable of being separated from the entity or
- Arising from legal or contractual rights
- Under the control of the company
- Expected to generate future economic benefits
- Probable that future economic benefits will flow to the company
- Cost of the asset can be reliably measured
Goodwill
- Only arises when one company purchases another
- Acquisition price > fair value of net identifiable assets acquired
Analysis
- Expensing development costs (US GAAP)
- Results in lower net income in current period
- If current period development expenses > amortization
- Will continue to result in lower net income
- Typically happens when development costs are increasing
- Organic growth vs. acquisition
- Companies that have developed intangibles internally will have a smaller balance sheet
- Differences in strategy can affect financial ratios (ROA, Asset Turn)
- Cash flow statement
- Costs expensed will be included in CFO
- Capitalized costs will be included in CFI
Intangible assets purchased in situations other than business combinations
- E.g. buying a patent
- Treated like acquiring long-lived tangible assets
- Recorded at fair value (purchase price) when acquired
- Analyst should focus on understanding the type of asset acquired
- Valuation is often a very subjective process
Intangible assets developed internally
- Generally expensed when incurred
- E.g. research costs (IFRS), R&D (U.S. GAAP)
- Exceptions
- Development costs under IFRS if certain criteria are met (will be capitalized given that a feasibility study is conducted)
- Software costs (U.S. GAAP)
- Software for sale
- Software intended to be used internally
Intangible assets acquired in a business combination
- One company acquires another
- Accounted for using acquisition method
- Allocate purchase price to each asset acquired
- Excess of purchase price over fair value of assets acquired
- Goodwill
- Cannot be identified separately from business as a whole
Gain/loss on disposal
- Disclosed in income statement
- Component of other gains and losses or
- Separate line item if material
- Further detail in MD&A or footnotes
Proceeds on disposal
Proceeds (not gain or loss) included in CFI
Other disposal methods
- Abandonment or exchange for another asset
- Classified as ‘held for use’ until disposal
- Depreciation and amortization is still charged
- Exchange
- Derecognize old asset and recognize new asset
Through I/S :
Fair value of new asset > Net book value of asset given up = Gain
Fair value of new asset < Net book value of asset given up = Loss
Analyst considerations
- Upward revaluations will increase assets and equity
- Improve leverage ratios such as debt/equity
- Reduce return measures such as ROA or ROE
Impairments
- Reflect an unanticipated decline in the value of the asset (NON-CASH CHARGE)
Impairment of property, plant, and equipment - No annual impairment review required
- Company needs to assess whether there are indications of impairment
- E.g. evidence of obsolescence, decline in demand for products, or technological advancements
- Impairment reduces asset value on balance sheet
- Reduces net income in income statement (impairment expense)
- No effect on cash flow statement
Impairments
> no effect on CFO
> Recognised immediately
Accumulated impairment losses and amortization – (Accumulated impairment losses and amortization+ Exchange movements + Amortization charge for year + Net Additions (Disposals))
or
Beginning accumulated depr + expense - end accumulated depr
- Required by both U.S. GAAP and IFRS
- Generally this means that the:
- Carrying amount in balance sheet > Recoverable amount
- U.S. GAAP – Impairment if:
- Carrying amount in balance sheet > Undiscounted expected future cash flows
- If impaired write down to: Fair value
- IFRS – Impairment if:
- Carrying amount in balance sheet > Higher of fair value less costs to sell and value in use (PV of expected future cash flows)
- If impaired write down to: Recoverable amount
Intangible assets with a finite life
- As for PPE, not tested annually for impairment
- Indication of possible impairment
- Significant decrease in market price or significant adverse change in legal or economic factors
- Calculation of loss is the same as for PPE
Intangible with indefinite lives
- No amortization charged during life of asset
- Annual impairment review
- Impairment
- Carrying amount > Fair value
- Can’t reverse impairment
Long-lived assets held for sale
- test for impairment when held for use changes to held for sale
- Assets management intend to sell or distribute to existing shareholders
- Not depreciated or amortized
- Tested for impairment when assets are reclassified
Reversals of impairments of long-lived assets
- Asset’s recoverable amount could increase in later years
- IFRS allows reversal of impairment
- U.S. GAAP
- Assets held for use
- Reversals not permitted
- Assets held for sale
- Reversals permitted
- Assets held for use
US GAAP :
Reversal of impairment of inventory
Reversal of impairment of long-lived assets held for use
Reversal of impairment of long-lived assets held for sale
Reversal of impairment of intangible assets other than
goodwill
Reversal of impairment of goodwill
Revaluation of long-lived assets
Revaluation of goodwill
Not allowed
Not allowed
Permitted
Not allowed
Not allowed
Not allowed
Not allowed
IFRS:
Reversal of impairment of inventory
Reversal of impairment of long-lived assets held for use
Reversal of impairment of long-lived assets held for sale
Reversal of impairment of intangible assets other than
goodwill
Reversal of impairment of goodwill
Revaluation of long-lived assets
Revaluation of goodwill
Permitted
Permitted
Permitted
Permitted
Not allowed
Permitted
Not allowed
Leases
Definition
- A lease is a contract between the owner of an asset (lessor) and another party who wishes to use the asset (lessee)
- In exchange for use of the asset, the lessee makes payments to the lessor
- Strictly, for a contract to be a lease, it must
- Identify a specific underlying asset
- Give the customer the right to obtain largely all of the economic benefits from the asset
over the contract term - Give the customer, not the supplier, the ability to direct how and for what objective the
underlying asset is used - Form of financing provided by lessor allowing lessee to purchase the use of the
asset
Leases
Advantages
- Can provide less costly financing with little, if any, cash required upfront
- Reduces lessee’s exposure to obsolescence, residual value and disposal
Leases
IFRS and US GAAP criteria for identifying a finance lease
- A lease is a finance lease under both IFRS and US GAAP if any of the below criteria are met:
- The lease transfers ownership of the underlying asset to the lessee
- The lessee has an option to purchase the underlying asset and is reasonably certain it will do so
- The lease term is the major part of the asset’s useful life
- The present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the asset
- The underlying asset has no alternative use to the lessor
IFRS (Finance leases) and US GAAP (Finance and operating leases)
Most leases are recognized on balance sheet *
* At inception recognize a lease asset (right-of-use asset) and a lease liability *
- Lease asset = Lease liability = PV of fixed lease payments
* After inception
- IFRS – report amortization expense on the ‘right-of-use’ asset, interest expense (CFO) and reduce lease liability (CFF)
- US GAAP – categorize as a finance lease or operating lease
* Finance lease – report amortization expense on the ‘right-of-use’ asset, interest expense (CFO) and reduce lease liability (CFF)
* Operating lease – recognize a single lease expense and, in any given year, reduce lease asset and lease liability by the same amount (but diff amounts every year)
* Not required for short term leases (under a year) for IFRS and US GAAP or where the leased asset is low in value which means up to $5,000 (IFRS only) – record lease payment as an expense when paid on a straight line basis.
Note: These exceptions are not allowed for lessors.
Accounting for a finance lease (IFRS and US GAAP)
- Amortized cost method
- Same method as accounting for bonds (but value has to be 0)
- Recognize asset and liability on balance sheet
- Present value of lease payments
- Income statement expense
- Amortization of asset
- Interest expense = Opening Liability x Effective Interest rate
- Balance sheet
- Assuming payments made at the end of the year
+ PV of lease payments or opening liability
+ Add interest expense (Opening liability x Interest rate)
- Less lease payments paid in period -X
= closing lease liability in balance sheet
Accounting for a finance lease
- Cash flow statement
- Interest portion of lease payment = -CFO (US) or -CFO / CFF (IFRS)
- Principal payment = -CFF (reduction of lease liability - payment - interest expense)
Accounting for an operating lease
- Income statement
- Lease expense
- Cash flow statement
- Lease payment = CFO
- Note: CFO is lower when using operating leases
Lessor Accounting for Leases
Operating lease
Balance sheet
* Retains asset on
balance sheet
Income statement
* Reports lease income
* Reports depreciation expense on leased asset
Statement of cash flows
* Lease payments received CFO
Lessor Accounting for Leases
Finance lease
Sales-type*
- US terminology
Balance sheet
* Removes asset from balance sheet
* Recognize lease receivable (PV of payments)
Income statement
* Reports interest revenue on lease receivable
* Report revenue, COGS and profit at inception
Statement of cash flows
* Lease payments received CFO
Lessor Accounting for Leases
Finance lease
Direct financing*
- US terminology
Balance sheet
* Removes asset from balance sheet
* Recognize lease asset
Income statement
* Reports interest revenue on lease receivable
Statement of cash flows
* Lease payments received CFO
Employee Remuneration
- Employee Compensation
- The salary component of compensation provides for the liquidity needs of an employee
- Bonuses, generally in the form of cash, motivate and reward employees for short- or long-term performance or goal achievement by linking pay to performance
- Non-monetary benefits, such as health and life insurance premiums, housing, and vehicles, may be provided to facilitate employees performing their jobs
- Salary, bonuses, and non-monetary benefits tend to vest (i.e., employee earns the right to the consideration) immediately or shortly after their grant date
- Companies report a compensation expense on the income statement in the period in which compensation vests, and a cash outflow or accrued compensation liability (a current liability) is recognised in the balance sheet
Employee Remuneration
* Deferred Compensation
- Vests over time and can provide valuable retirement savings and financial upside to
employees and often serve as an effective retention and stakeholder alignment tool for
employers
Defined contribution plan:
- Company contributes an agreed defined amount into the plan
Income statement - Pension expense
Cash flow statement - Operating cash flow
Balance sheet - No impact
Defined benefit plan
- Company promises to pay future benefits to employee during retirement
- Balance sheet (net pension position)
- Recognize asset/liability representing surplus/deficit of pension scheme
Surplus / (Deficit) = Plan assets (fair market value) - PV of pension obligations
Pension expense – income statement for IFRS
Reported pension expense:
+ Employees’ Current Service Costs (PV of another year of work)
+/- Employees’ Past service costs
+/- Net Interest Expense/Income
= Pension expense
Net Interest Expense = Opening Net Pension Liability x Discount rate
OCI impact:
* Actuarial gains/losses are not recognized in the income statement but instead are
shown within OCI in the balance sheet
* The actual return on plan assets less any return included in the net interest
expense or income is also shown within OCI in the balance sheet
* IFRS refers to this OCI account as ‘remeasurements’
+ Employees’ Current Service Costs
+/- Employees’ Past service costs
+/- Net Interest Expense/Income
= Pension expense
Pension expense – income statement for US GAAP
Reported pension expense
+ Employees’ Current Service Costs (PV of another year of work)
+ Interest cost [ open oblig. liabi * DR - open plan assets * exp return]
- Expected return on plan assets
+/- Amortization of actuarial losses/gains
+/- Amortization of past/prior service cost
= Pension expense
Financial Reporting for Share-Based Compensation
Advantages
* Aligns managers’ interests with those of the shareholders
* Motivates employees
* No initial cash outlay required
Disadvantages
* Managers may have limited influence over the company’s stock price, so it may not provide the desired incentive
* Increased stock ownership may lead managers to take on low-risk projects for fear of a stock price decline
* Alternatively, it may lead to excessive risks, as stock options only pay out if stock prices rise above the strike
* If granted to employees, existing shareholders’ ownership is diluted
Accounting for share-based compensation
Reported at fair value under US GAAP and IFRS
Disclosures required (US GAAP and IFRS)
* Nature and extent of share-based compensation arrangements
* How fair value was determined
* Effect on income and financial position
Two common forms of share-based compensation:
1. Stock grants
2. Stock options
Stock grants
- A company can grant stock to employees:
- Outright (no restriction)
- With restrictions, e.g. employees must stay with the company for a certain time period
- Contingent upon performance
- The compensation expense is equal to the fair value (usually market value) of the shares issued at the grant date
- The compensation expense is allocated over the employee service period (vesting period)
Stock options
- Both US GAAP and IFRS require the compensation expense to be reported at fair value using a suitable option pricing model that is:
- Consistent with fair value measurement
- Based on established principles of financial economic theory
- Reflective of all substantive characteristics of the award
Grant date: Date that options are granted to the employee
Vesting date: Date that employees can first exercise stock options
Exercise date: Date that employees exercise the options
Service period: Period between grant date and vesting date
- The compensation expense is usually measured on the grant date, if both the number of shares and option price are known
- If the value of options depends on events after the grant date, then the compensation expense is measured on the exercise date
Other Types of Share-Based Compensation
- Can compensate employees on changes in share value without requiring
employees to hold the shares - These are accounted for in a similar fashion to other share-based compensation –
valued at fair value and the compensation expense is allocated over the service
period of employees: - Stock Appreciation Rights (SARs)
- Employee compensation based on increases in stock price
- Phantom stock
- Differ from SARs in that compensation is based on hypothetical stock, e.g. a business unit within a
company that is not publicly traded
- Stock Appreciation Rights (SARs)
- Employee compensation based on increases in stock price
Advantages
* Motivates employees
* Aligns with shareholders’ interests
* Limited downside risk, but unlimited upside potential, like stock options
* Shareholder ownership is not diluted
Disadvantages
* Requires current period cash outflows
Presentation and Disclosure of Leases
* Both IFRS and US GAAP indicate that the objective of lease disclosure
is to provide the user of the financial statement with information to
assess the amount,
timing
and uncertainty of cash flows associated with leases
- Lessee Disclosure (IFRS 16)
- The carrying amount of right of use assets and the end of the reporting period by class of
underlying asset; - Total cash outflow for leases;
- Interest expense on lease liabilities;
- Depreciation charges for right-of-use assets by class of underlying asset; and
- Additions to right of use assets
- Lessor Disclosure (IFRS 16): At a minimum, lessors should disclose;
- For finance leases: (capitalised)
- The amount of selling profit or loss; and
- Finance income on the net investment in the lease; and income relating to variable lease payments not included in the measurement of the lease;
- For operating leases, lease income with separate disclosure for income relating to variable lease payments not based on an index or rate
Presentation and Disclosure of Postemployment Plans
* IAS 19 defines the following objectives for issuers’ disclosures of their defined benefit pension plans:
- Explain the characteristics of its defined benefit plans and risks associated with them;
- Identify and explain the amounts in its financial statements arising from its defined benefit plans (i.e., the net pension asset or liability); and
- Describe how its defined benefit plans may affect the amount, timing and uncertainty of the entity’s future cash flows (e.g. increase employers contribution to reduce plan deficit)
- IAS 19 is principles-based, giving issuers discretion in how best to achieve the disclosure objectives
- However, several specific prescriptions, requiring issuers to make disclosures, such as the following:
- Nature of benefits provided, the regulatory framework in which the plan operates, governance of the plan, and risks to which the plan exposes the entity;
- Reconciliation from the opening balance to the closing balance of the net pension asset or liability, with separate reconciliations for plan assets and the present value of the
defined benefit obligation, showing service costs, interest income or expense, remeasurements, past service costs, contributions to the plan, and other components of
the change; - Sensitivity analysis showing how changes in significant assumptions (such as the discount rate used to measure the defined benefit pension obligation) would affect the
amounts reported on the financial statements; - Composition of plan assets by category, such as equity securities, fixed-income securities, and real estate; and
- Indications of the effect of the defined benefit pension plans on the entity’s future cash flows.
Presentation and Disclosure of Share-Based Compensation
* IFRS 2, required disclosures include the following:
- A description of each type of share-based payment arrangement, including its general terms and conditions, such as vesting requirements, the maximum term of options
granted and the method of settlement (i.e., cash or equity) - Details about the number and weighted average exercises price of options, including:
- The number outstanding at the beginning of the period,
- Granted during the period,
- Forfeited during the period,
- Exercised during the period,
- Expired during the period,
- Outstanding at the end of the period, and
- Exercisable at the end of the period.
- For other equity instruments granted during the period (i.e., other than share options), the number and weighted average fair value of those equity instruments at the measurement date, and information on how that fair value was measured
Differences Between Accounting Profit and Taxable
Income
Pre-tax income from income statement
Add non tax-deductible expenditure, i.e. depreciation
Less tax exempt income
Less tax allowances
Taxable income
Income tax payable: Taxable income x Statutory rate
Calculation of deferred tax expense
Income tax expense= Income taxes payable + Deferred tax liability ending - Deferred tax liability beginning
Income tax expense= Income taxes owed - Deferred tax asset ending + Deferred tax asset beginning
Tax in income statement
- Income tax expense in the income statement comprises of two elements
- Income taxes owed
- Based on taxable income
- Current tax payable
- Deferred tax expense
- Based on temporary timing differences
- Tax due on temporary timing differences at some point in the future
Calculation of deferred tax expense
- Recognition of DTL/increase in DTL
- Increase in deferred tax expense
- Decrease in net income
- Recognition of DTA/increase in DTA
- Decrease in deferred tax expense
- Increase in net income
Expenses qualifying for a tax deduction in a later period
- Some expenses do not immediately qualify for a tax deduction
- Warranty expense
- Provision created and expense deducted in year of sale (accruals basis)
- Tax deduction given when warranty expenses paid (cash basis)
Effect on deferred tax asset in balance sheet:
Increasing valuation
allowance &
Decreasing valuation
allowance
Decrease
Increase
Effect on deferred tax expense in income statement
Increasing valuation
allowance &
Decreasing valuation
allowance
Increase
Decrease
Reason
Increasing valuation
allowance &
Decreasing valuation
allowance
Lower forecast profits in future
Higher forecast profits in future
Recognition and measurement of current and deferred tax
> Recognition of tax charged directly to equity
IFRS and US GAAP require that tax be treated on same basis as underlying asset
Deferred tax taken directly to equity
Examples:
Reval of PPE (IFRS only)
Long-term investments at fair value (AFS)
Change in accounting policies and prior period errors
Exchange rate differences for foreign operations
Reversal of DTLs
DTLs that are unlikely to reverse ( temp becoming perm)
E.g. quasi-permanent timing differences from tax
allowances
remove from DTL
add back to equity
What is quality?
> Reporting Quality means the financial reports are decision-useful. They are transparent and accurately reflect economic reality.
- being GAAP compliant is a necessary but not a sufficient condition
* Earnings Quality means the profits and cash generated by the actual economic activities are sustainable and provide a level of return sufficient to cover the firm’s cost of capital.
* It is possible to have one but not the other
* In reality there is a spectrum relating to quality, ranging from being fully GAAP compliant and decision-useful with sustainable earnings all the way down to nonGAAP compliant with fraudulent and fictitious transactions designed to hide a
non-sustainable situation
Quality Spectrum of Financial Reports
from Better to Poorer
- GAAP, decision-useful, sustainable, and adequate returns
- GAAP, decision-useful, but sustainable?
− Low “earnings quality” - Within GAAP, but biased choices
- Within GAAP, but “Earnings Management”
− Real earnings management
− Accounting earnings management - Departures from GAAP
- Fictitious transactions
GAAP, decision-useful, sustainable, and adequate returns
- High-quality financial reports
- Conform to the GAAP of the jurisdiction, e.g. IFRS, US GAAP, or other home-country GAAP
- Also, embody the characteristics of decision-useful information as defined in the Conceptual Framework
- Relevance and faithful representation
- High-quality earnings
- Adequate level of return on investment from sustainable company activities that exceed the cost of investment
- Sustainable earnings with high returns contribute to higher valuation of a company and its securities
GAAP, decision-useful, but sustainable?
- High-quality financial reports
- Conform to the GAAP of the jurisdiction, e.g. IFRS, US GAAP, or other home-country GAAP
- Also, embody the characteristics of decision-useful information as defined in the Conceptual Framework
- Relevance and faithful representation
- Low-quality earnings
- Loss making company or earnings don’t provide adequate returns on investment
- Possibly earnings generated from non-recurring activities
Within GAAP, but biased choices
Biased choices result in financial reports that lack faithful economic representation and hence weakens the financial reporting quality
- “Aggressive” choices
- Increase current period’s performance and financial position
- May decrease the reported financial performance and position in later periods
- “Conservative” choices
- Decrease current period’s performance and financial position
- May increase the reported financial performance and position in later periods
- Earnings smoothing
- Understatement of earnings volatility
- Can result from conservative choices to understate earnings when performing well and aggressive choices when performing poorly
- Bias in the context of how information is reported, e.g. disclose information in a way that obscures unfavorable information and/or emphasizes favorable information
Within GAAP, but “Earnings Management”
- Earnings management (EM) is the process of making intentional choices in order to create biased financial reports
- A blurred line exists between being bias and EM is primarily based upon intent
- The discussion on EM is the same as being bias identified on the previous slide
Departures from GAAP
* Considered to be low-quality
* Earnings quality is difficult or impossible to assess
Fabricated reports
* Portraying fictitious events
Aggressive choices
* Increase current period’s performance and financial position
* May decrease the reported financial performance and position in later periods therefore raising a sustainability issue
Conservative choices
* Decrease current period’s performance and financial position
* May not be a sustainability issue because conservative choices may increase the reported financial performance and position in later periods
Conservatism in accounting
* Revenues are recognized once verifiable and legally enforceable receivable has been granted and that losses need not be recognized until it becomes “probable” that an actual loss will be incurred
* The Conceptual Framework supports neutrality of information. The asymmetric nature of conservatism conflicts directly with neutrality
* Despite the above, many conservative accounting standards remain
Motivations to issue financial reports that are not high-quality:
- To mask poor performance, such as sub-standard profitability or loss of market
share - To exceed analyst or management forecast expectations
- Career concerns and incentive compensation may motivate accounting choices
Conditions conducive to issuing low-quality financial reports
Typically three conditions exist when low-quality financial reports are issued:
* Opportunity:
- Internal conditions: poor internal controls, ineffective board members
- External conditions: Accounting standards providing scope for divergent choices, minimal
consequences for inappropriate choices
* Motivation – to meet criteria for personal reasons such as a bonus
* Rationalization – concern about the choices made is often alleviated by
rationalization
Mechanisms that discipline financial reporting quality:
1. Markets
companies and nations compete for capital. The cost of this capital is dependent on the perceived level of risk (e.g. the risk of low-quality accounts being produced). There is an incentive to produce high-quality accounts to keep the long-term cost of capital low
Mechanisms that discipline financial reporting quality:
2. Market Regulatory Authorities
regulations and regulators that establish and enforce rules play a key role in high-quality financial reporting.
The International Organization of Securities Commissions (IOSCO) is the global standard setter for the securities sector. IOSCO’s membership includes around:
120 securities regulators (e.g. Securities Exchange Commission in the US) and
80 other securities market participants such as stock exchanges.
- Typical features of a regulatory regime affecting the quality of financial reporting quality include:
* Registration requirements
* Disclosure requirements
* Auditing requirements
* Management commentaries
* Responsibility statements
* Regulatory review of filings
* Enforcement mechanisms
Mechanisms that discipline financial reporting quality:
3. Auditors
audit opinions provide users of the financial statements with some assurance that the accounts meet the relevant set of accounting standards, and present the company’s information fairly
- Limitations of the audit process:
* The audit opinion is based on a review of information prepared by the company. A review of information will not definitively uncover misstatements.
* The audit is based on sampling and might not reveal misstatements.
* An “expectations gap” may exist between the auditor’s role and the public expectations of auditors.
An audit has the primary object to ensure financial statements are fairly presented, not to detect fraud.
* The company being audited pays the audit fees, often established through a competitive process. There is a chance an auditor may show leniency in the audit process.
Mechanisms that discipline financial reporting quality:
4. Private Contracting
loan agreements or investment contracts can serve as
mechanisms to discipline financial reporting quality
- Loan covenants are often in place on such contracts. Parties with the contractual arrangement have an incentive to make sure the financial reporting is of high-quality.
- However, avoidance of debt covenant violation is a potential motivation for managers to inflate earning hence contributing to low-quality financial reporting.
Mechanisms that discipline financial reporting quality:
- Market
- Market Regulatory authorities
- Auditors
- Private contracting
Presentation choices of financial information
- Non-GAAP earnings measures, such as earnings before interest, taxes, depreciation and amortization (EBITDA) are often used by investors to try to make inter-company comparisons on a consistent basis
- EBITDA is widely viewed as eliminating ‘noisy’ reporting signals introduced by different accounting methods used by companies for depreciation, amortization of intangible assets, and restructuring charges
- Some companies may construct and report their own versions of EBITDA, often referred to as “Adjusted EBITDA”
- If a company uses a non-GAAP financial measure several caveats are often required by regulation e.g. SEC and IFRS. These include:
- Display the most directly comparable GAAP measure along with a reconciliation of one measure to the other
- Explanation by management why the non-GAAP measure is relevant to the user of the financial reports
Revenue Recognition - Analyst Concerns
- How is revenue recognised? Upon shipment or delivery?
- Growth in revenues out of sync with economy, industry, or peer companies and with growth in receivables
- Unusual allowances for sales returns relative to history?
- Do the sales outstanding indicate any potential collection
issues? - Does the company engage in any “bill-and-hold” transactions
- Does the company separate its revenue arrangements? E.g. use of deferred revenue
Long-lived assets: - - Analyst Concerns
Depreciation policies
* Are estimates of useful life reasonable?
* Straight-line vs. accelerated methods
* Do recent asset write-downs suggest that asset lives may need to be reconsidered?
Intangibles: Capitalization
policies - - Analyst Concerns
- What expenditure on intangibles has been capitalised?
- What are the company’s capitalization policies in comparison to peers?
- Are the policies for amortization used by the company reasonable?
Allowance for doubtful accounts/loan loss
reserves - Analyst Concerns
- What is the recent trend on such allowances? Have there been any significant changes?
- Are they being lowered to meet earning expectations or are they justified?
Inventory cost methods- Analyst Concerns
- How does the company’s costing methods compare with the rest of the industry?
- Are reserves being used for obsolescence in inventory valuation? Is there an indication that they are being used to manipulate earnings?
- FIFO vs. LIFO fundamentally impacts reported profits and inventory values
- Is LIFO liquidation occurring?
Tax asset valuation accounts- Analyst Concerns
- Tax assets should be recorded at an amount the management feel they should be able to realize them. A valuation allowance must be used to re-state the tax asset to a level expected to be converted into cash. This can be a very subjective process?
- Look for changes in the valuation allowance. Lowering of the reserve will reduce expenses and boost net income. Are they justified?
Goodwill- Analyst Concerns
- It would be wise for an analyst to review the annual impairment test process used by the company. The process of measuring the fair value of reporting units (US GAAP) or cash-generating units (IFRS) are based on subjective estimates
Warranty reserves- Analyst Concerns
- Have the reserve amounts for warranties changed recently?
Are they justifiable? Do the costs charged against the reserve
suggest issues in the quality of the product being sold?
Related-party transactions- Analyst Concerns
- Are there any company transactions that disproportionately
benefit members of management? Does one company exert
control other another’s destiny through supply contracts? - Are dealings with non-public companies taking place? It’s
possible the non-public company could absorb losses to make
the public company look better
Cash flow statement- Analyst Concerns
- An analysis of the composition of cash flows from operations (CFO) is important
− E.g. stretching out accounts payable is a source of cash. But, did a payment of cash to suppliers occur the day after the year-end balance sheet and hence flatter the CFO for the period? An analyst may conclude that economically the accounts payable did not increase by the reported amount - Analysing the composition of CFO in comparison to industry norms will be useful in picking up red flags
- Reconcile the net income of the company to CFO. Is there
a fundamental departure that would question earnings quality? - Are there misclassifications of operating cash out flows to areas like cash flows from investing (CFI) or cash flows from financing (CFF)? This would artificially boost CFO
− E.g. capitalisation of interest costs on borrowings used to construct assets held for use (such as property, plant and equipment). This process directs cash paid in interest on loans used to finance construction as CFI rather than CFO
Revenue - Analytical procedures
- Examine the footnotes to identify the company’s revenue recognition policies, e.g. barter transactions, bill-and-hold, evidence of rebate programs
- Look at revenue relationships:
− Is revenue growth out of line with peers/economy?
− Compare accounts receivables with revenues over time, e.g. changes in days sales outstanding (DSO) or receivables turnover - Examine asset turnover. Enables an analysis of managers’ asset allocation choices. If it is persistently declining it may be a sign of future asset write-downs particularly in areas such as goodwill
Inventory signals - Analytical procedures
- Identify inventory relationships:
− Compare growth of inventory with benchmarks. Is a growth in
inventory linked to growth in sales? If not, is it a result of poor
inventory management? Possibly a sign of obsolescence signalling an impending inventory write-down
− Calculate inventory turnover ratio. A declining ratio could indicate obsolescence issues that should be recognized
− Are there signs of LIFO liquidation for US GAAP companies using LIFO? This could artificially boost gross, operating and net profits
Capitalisation policies - Analytical procedures
- Examine the relevant accounting footnotes for policies used
− If one company in an industry is capitalizing a particular cost whilst the others are expensing, this outlier company may identify a possible red flag
Cash flow vs. Net Income - Analytical procedures
- If current NI is higher then CFO this could indicate aggressive accrual accounting policies have shifted current expenses to later periods
- Construct a time series of cash generated by operations divided by NI. If the ratio consistently drops below one this could be identified as a possible red flag
Other potential warning signs - Analytical procedures
- Depreciation methods and useful lives. Compare policies used to peers
- Fourth-quarter surprises
- Presence of related-party transactions
- Non-operating income or one-time sales included in revenue
- Classification of expenses as “non-recurring”
- Gross/operating margins out of industry norms
warnings signals. The following
are a few considerations:
- Young companies with an untainted record of meeting growth projections
- How long can the projection continue as a company matures? Management may seek to use unconventional means to continue the trend
- Management have adopted a minimalist approach to disclosure
- Management fixation on the earnings report in detriment to other key drivers of value such as cash flows. Could also be identified by a fixation of non-GAAP measures of performance, e.g. adjusted EBITDA
Objectives of Financial Analysis Process
- Before starting financial analysis clarify:
- Purpose of the analysis
- Level of detail required
- Available data
- Factors or relationships which will influence analysis
- Analytical limitations that could impair analysis
- Next stage:
- Select techniques (ratios)
- Use framework
- Effective analysis
- Includes both computations and interpretations
Ratios
Purpose
* Useful means of expressing relationships in financial accounts
* Indicator of an aspect of a company’s performance
Aspects
* Reduce the effect of size, enhancing comparison between companies
* Differences in accounting policies can distort ratios
- Meaningful comparison may involve adjustment
* Not all ratios are relevant to a particular type of analysis
* Interpretation of the ratio is as important as computation
Value, purposes and limitations of ratio analysis
- Value
- Provides insights into:
- Microeconomic relationships within a firm
- Firm’s financial flexibility
- Management’s ability
- Limitations
- Homogeneity of a company’s operating activities
- Need to determine if the results of the analysis are consistent
- Need to use judgment
- Use of alternative accounting methods
- First-in, first-out (FIFO) vs. last-in, first-out (LIFO)
- Straight line or accelerated methods of depreciation
- Capital or operating leases (not applicable under IFRS)
Purpose
* Common-size
Common-size balance sheet
- Highlights composition of the balance sheet
- Comparison between time periods highlights change in composition
* Common-size income statement
- Revenue can be analyzed between different sources
* Shows change in business mix
* Highlights changes in the cost structure
Cross-sectional analysis
* Definition
- Compare a specific ratio with the same ratio for another company
or group of companies - Can be done on a common-size basis
Trend analysis
* Importance
- Analyst should review trends in ratios as well as absolute and relative levels
- E.g., balance sheet data over a five-year period
- Provides information about historical performance and growth
- Helps as a planning and forecasting tool
Use of graphs as an analytical tool`
- Facilitate comparisons of performance and financial structure over time
- Highlight changes in significant aspects of the business
- Provide visual overviews of risk trends in a business
- Can also be used to communicate an analyst’s conclusions
Classification of ratios:
Activity
Liquidity
Solvency
Profitability
Valuation
Measures how efficiently a company performs day-to-day tasks
Measures the company’s ability to pay shortterm obligations
Measures the company’s ability to pay longterm obligations
Measures the company’s ability to generate
profitable sales from its resources
Measures the quantity of an asset or earnings
associated with ownership of a share
Activity ratios
Inventory turnover (COGs/ Avg Inventory)
Receivables turnover (Net sales / Avg receivables)
Payables turnover (Purchases / Avg payables)
Operational activity ratios
Fixed asset turnover (Rev/ Avg net fixed assets)
Total asset turnover (Rev / Avg assets)
Working capital turnover (Rev / Avg working capital)
Liquidity ratios
Current ratio = Current assets / current liabilities
Quick ratio = Cash + Marketable securities + Receivable / current liabilities
Cash ratio = Cash + Marketable securities / current liabilities
Defensive interval ratio = Cash + Marketable securities + Receivable / daily cash expenditure
Cash conversion cycle= DOH + DSO − days Payable
Solvency ratios
- Analysis of use of debt by a company
- Useful in assessing a company’s risk and return characteristics
- E.g. financial leverage
- Financial leverage
- Debt is a fixed cost
- % change in EBT > % change in EBIT
- Increase returns to equity holders
- Higher level of debt
- Increased risk of default
- Higher borrowing costs
- Company’s relative solvency
- Fundamental to valuation of debt securities and credit-worthiness
- Provide insight about company’s future business prospects
- Signals management’s beliefs about company’s future
Solvency ratios – debt ratios
Debt-to-assets = Total interest - Bearing debt / total assets
Debt-to-capital = Total interest - Bearing debt / Total interest - Bearing debt + Total equity
Debt-to-equity= Total interest - Bearing debt / Equity
Financial leverage ratio = Avg total assets / Avg total equity
Debt-to-EBITDA = Total debt / EBITDA
Interest cover = EBIT / Interest payments
Fixed charge overhead = EBIT + lease payments / Interest payments + Lease payments
Profitability ratios
Gross profit margin = Gross profit / Rev
Operating profit margin = Operating income / Rev
Pretax margin = EBT / Rev
Net profit margin = NI / Rev
Operational ROA = operating income / avg total assets
ROA = NI / avg total assets
Return on total capital = EBIT / short term and long term debt-to-equity
Return on equity = NI / avg total equity
Return on common equity = NI - preferred div / avg total equity
Basic DuPont decomposition of ROE
ROE = EAT / Rev * Rev / Assets * Assets / Equity
ROE = net profit margin * asset turnover * financial lev
Extended DuPont decomposition of ROE
ROE = (EAT/EBT)* (EBT/ EBIT) * (EBIT/ Rev) *(Rev / Assets) * (Assets / Equity)
ROE = tax burden * interest burden * EBIT margin * asset turnover * financial lev
Forecast
- Analysts often need to forecast future financial performance
- Include data from industry, economy, company, common-size and ratio analysis
- Judgment is integral to this process
- Analyst can create an ‘earnings model’ to forecast future performance
Forecasting techniques
- Sensitivity analysis
- Shows range of outcomes if specific assumptions are changed
- Scenario analysis
- Shows key changes in financial results from economic events
- Simulation
- Computer-generated sensitivity or scenario analysis based on
probability
Top-down revenue modelling
- Growth relative to GDP approach
1. First, forecast the nominal GDP growth rate.
2. Next, assess how a company growth rate will compare with nominal GDP growth.
3. Analysts can use real GDP forecast to project volumes and inflation forecast to project prices . - Market growth and market share approach
1. First, forecast the growth of a given market.
2. Next, assess current market share of a company and how it is projected to change.
3. If there is a predictable relationship between market revenue and GDP, regression
analysis can be used.
Bottom up revenue modelling
- Time series forecasts using historical growth rates or time series analysis
- Returns based measures using balance sheet values (for example, bank interest
revenue ≈ loan value x average interest rate) - Capacity based measures (for example, using existing store sales growth vs new store sales growth)
Hybrid revenue modelling
Combines elements of top-down and bottom-up approaches
Top-down assessment of operating costs
Consider macroeconomic factors first – for example, inflation or industry specific
costs – then make assumptions about how these would impact the company
Bottom-up assessment of operating costs
Consider company level factors first – for example, segment level margins,
historical growth rate of costs and margin levels or cost of delivering specific
products
Economies of scale
- Variable costs can be modelled as a percentage of revenue
- Analysts pay particular attention to fixed costs (sg&a) – high fixed costs can indicate
possible economies of scale - If operating margins correlate positively with sales, this gives evidence of
economies of scale in an industry
gross margin and cogs
if cogs increases more relative to sales then margin falls more
so cogs hedged from price input rises
Income Statement - Operating Costs - Modelling
SG&A Expenses
There is less of a direct relationship between SG&A (periodic cost) and sales than between COGS (matched cost) and sales
- Some expenses within SG&A will be more closely correlated with sales than others
* Selling & distribution expenses are variable and may vary with sales
* Overheads and R&D may not vary much with sales but may vary slowly over time (HR cost, IT support, Head office)
Income Statement - Non-operating Costs – Financing
Costs
Financing costs refer to:
- Interest income (BS cash + investments) (most significant for financial companies such as banks); and
- Interest expenses (depends on the level of debt (BS) and interest rates) – commonly
presented net of interest income
Important factors for an analyst to consider include:
- The capital structure of the company (debt level)
- Interest rates
Income Statement - Non-operating Costs – Financing expenses
- Driven by the level of debt and interest rates
- Disclosure about the debt maturity profile will help forecast to what extent new
debt will be required
Corporate income tax is primarily impacted by:
- Geographic location
- Business type
Three main forms of tax rate:
- Statutory tax rate – corporate tax rate in a country where company is domiciled
- Differences between statutory tax rate and the effective tax rate can arise due to tax credits, withholding tax on dividends or adjustments to previous years or expenses not deductible for tax purposes
- Effective tax rate
– calculated as reported income tax expense/pre-tax income - Difference between cash tax rand reported tax - function of difference between financial accounting standards and tax laws
- Difference between cash tax and reported tax – reflected as tax asset or deferred tax liability
- Cash tax rate
– calculated as: tax actually paid/pre-tax income
If a company operates in various countries, the effective tax rate is a blend of tax
rates in relation to profit generated in each country.
A special purpose entity (SPE) can reduce the effective tax rate, but risk may
increase (tax laws might change).
Balance Sheet Modelling
Working capital projections
- analysts can use historical efficiency ratios and project recent performance or historical average to persist (change in WC)
- or analysts may have a specific view on future working capital (top down or bottom up approach)
Net PP&E and intangible assets (open NBV - Dep - Disposals + Purchase = Net Book Value)
- net PP&E and intangible assets mainly change due to depreciation / amortisation and capital expenditures
Depreciation and amortisation forecasts
- forecasts generally based on historical depreciation, management disclosures and levels of long term assets
Capital expenditure – comprises:
- Maintenance capital expenditure: sustains the current business (generally higher than depreciation due to inflation)
- Growth capital expenditure: grows the business
- forecasts are driven by analyst views of revenue growth and business model
Leverage ratios
- Debt to capital, debt to equity & debt to EBITDA can be used to project future debt and equity levels
Return On Invested Capital (ROIC)
Net Operating Profit less adjusted tax (NOPLAT) / Invested capital
> invested capital is usually defined as operating assets less operating
liabilities
> A better measure of performance than ROE since it is unaffected by the degree of
financial leverage.
> A similar measure is return on capital employed (ROCE) which is essentially
ROIC before tax. Useful when comparing the difference companies in different tax
jurisdictions.
Behavioural Finance and Analyst Forecasts –
Overconfidence Bias
Overconfidence bias in analyst forecasts
* Analysts are more confident when making contrarian predictions.
To mitigate overconfidence bias:
* Analysts should record, share and review their forecasts regularly.
* Analysts should identify both correct and incorrect forecasts made
- goal is to recognise high forecast error rates
* Scenario analysis can generate different forecast scenarios by asking: “Where
could I have been wrong & by how much?”
Behavioural Finance and Analyst Forecasts – Illusion
of Control Illusion of control bias in analyst forecasts
Illusion of control bias in analyst forecasts
* Analysts may overestimate their ability to increase forecast accuracy by:
- Acquiring more information and opinions from experts; and by
- Creating more granular and complex models
Although additional information, opinions and more granular and complex models
can improve forecasting accuracy there are diminishing marginal returns
To mitigate illusion of control bias:
* Analysts can restrict model variables to those regularly disclosed by the company
- Models should focus on the most important and impactful variables
- Analysts should only speak to people with unique or significant perspectives
Behavioural Finance and Analyst Forecasts –
Conservatism Bias
Conservatism bias can lead an analyst to maintain their prior forecasts by
inadequately incorporating new information
- Analysts with this bias most often fail to update forecast after receiving negative
information
- Analysts may also fail to sufficiently incorporate positive information
“Anchoring and adjustment” is another name for conservatism bias – adjustments
made in the light of new information tend to be too small
To mitigate conservatism bias:
- Analyst forecasts and models can be regularly reviewed by an investment team
- Flexible models with fewer variables can be developed to allow easier changes of
assumptions
Behavioural Finance and Analyst Forecasts –
Representativeness Bias
- A tendency to classify information based on past events.
- An analyst may see new information as being representative of something they
have already experienced, even if it is very different.
Base rate neglect
* Base rate neglect is a common representativeness bias for analysts, where the
incidence of an event occurring in the larger population (the “outside view”) is
ignored, in favour of the situation specific incidence of the occurrence (the “inside
view”).
Behavioural Finance and Analyst Forecasts –
Confirmation Bias
- An analyst suffering from confirmation bias will tend to look for information which
confirms their prior beliefs (such as forecasts already made) and undervalue or
ignore information that contradicts their prior beliefs (such as evidence that their
forecast was inaccurate). - Confirmation bias is closely related to overconfidence and representativeness
biases - Confirmation bias can be mitigated by:
- Looking at research from analysts with a different opinion on the stock being analysed
- Seeking perspectives of colleagues who have no emotional or economic stake in the
security being analysed
Impact of Competitive Factors in Prices and Costs
- Threat of new entrants: Ease of entry and exit
> Economies of scale, capital requirements, regulation, brand
identity, high switching costs, government policy, retaliation,
absolute cost advantages - Rivalry among existing
competitors
>Number of competitors, strength of competition, industry growth,
brand identity, exit barriers
3.Threat of substitutes
> Buyer’s propensity to switch, switching costs
- Bargaining power of buyers
> Bargaining leverage and price sensitivity - Bargaining power of suppliers
> Number of suppliers, size of suppliers, ability to increase costs of inputs
Forecasting
Inflation and deflation
- Changing price levels can significantly affect the accuracy of forecasts.
- The impact of inflation on future company performance will vary from company to
company due to difference in competitive advantage and industry structure. - If the product’s demand is relatively price inelastic, then its revenues will benefit
from inflation. - Cost inflation will depend upon the scope for substituting alternative inputs.
- Analysing international companies means adjusting for the geographic mix of its
operations when incorporating inflation predictions. - Foreign exchange rate movements can also be a source of price changes.
Forecasting
Technological developments
- Assumptions need to be made about the impact of such developments
- Will this just cannibalize existing products or will it create a new segment in the market?
- It is important to analyse such developments using scenario and sensitivity
analysis.
Long-term forecasting
- The choice of forecast time horizon depends upon:
- Investment strategy for which the stock is being considered.
- Cyclicality of the industry – horizon needs to be long enough to allow the company to
reach a level of sales and profitability that is consistent with mid-cycle, i.e. normalized
earnings. - Analyst’s own preferences.
- Company specific factors – might be necessary to extend the horizon period to allow
temporary/unusual factors to be adjusted for so that we have a better idea of the level of normalized earnings. - Terminal value
- Take care when using historical valuation guidelines. Past multiples may not always be consistent with future multiples.
- Long term growth rate is always difficult to estimate.
- Regulations and technological change can dramatically impact terminal values.
Building a model
- Start with forecasting sales: Top-down vs. bottom-up vs. hybrid
- Revenue will be a function of price changes, volume and foreign exchange estimates
- May apply different assumptions to different segments of revenue
- Once we have forecasted the income statement, we can move onto the balance
sheet and then finally the cash flow statement.
A deficit in the current account will most likely be offset by:
A surplus in the capital account and a surplus in the financial account
The sum of the three accounts (current account, capital account and financial account) must be zero.
P/E =
P/E = Div payout / (required rate of return - growth rate)
P/E = Div payout / [(RR + IP + RP) - (ROE)(retention rate)] where RR is real return; IP is inflation premium and RP is market risk premium
operating leases can be used as an off-balance-sheet financing technique if they
are short term (less than one year) under IFRS and US GAAP or low in value under IFRS only
regression analysis is often used to find the historical relationship between industry sales and a macroeconomic factor such as GDP,
this tends to be real GDP (inflation removed), as opposed to nominal GDP (not adjusted for inflation)
Under US GAAP, an impairment loss on PPE is measured as the excess of the carrying amount over
The undiscounted value of the expected future cash flows.
When a company has foreign assets or liabilities, the historical exchange rate, (for the functional currency), applying when the assets or liabilities were acquired may differ from the exchange rate at the balance sheet date, (that is measured in the tax reporting currency). Under what accounting standards is this most likely to give rise to any change in deferred tax?
IFRS
IFRS 16, lessee disclosures must include
The carrying amount of right of use assets.
Total cash outflow for leases
In the early years, capital leases have lower net income since the total of the two expenses (amortization and interest expense) will be higher than the lease payment
US GAAP : Capital leases and operating leases have the same liabilities during the life of the lease.
estimated average total useful life
adding the estimates of the average remaining useful life and the average age of the assets
average age of the assets : accumulated depreciation / depreciation expense
average remaining useful life of the asset base : net property, plant, and equipment/ annual depreciation expense.
US GAAP, companies are required to disclose (long-lived intangible assets)
the estimated amortization expense for the next five fiscal years
Share-based compensation
treated as an expense, even when no cash is exchanged based on the fair value of the grant.
Beginning with fiscal year 2019, lessees report
a right-of-use asset and a lease liability for all leases longer than one year.
An exception under IFRS exists for leases when the underlying asset is of low value
Lessor accounting for an operating lease under US GAAP is similar to that under IFRS:
Over the lease term, the lessor recognizes lease receipts as income and recognizes related costs, including depreciation of the leased asset, as expenses. Under IFRS, at inception of a finance lease—not an operating lease—the lessor derecognizes the underlying leased asset and recognizes a lease asset comprising the lease receivable and relevant residual value. Further, an IFRS-reporting lessor will recognize selling profit at the beginning of all leases that are not classified as operating leases. In contrast, a US GAAP–reporting lessor will recognize selling profit only on sales-type leases at the beginning of the lease term.
US GAAP is most likely to require tax rates and tax laws to have been
enacted
> IFRS in contrast allows for the possibility that further approvals are needed to enact the laws.
Which accounting standards are most likely to require deferred tax in relation on temporary differences arising from investments in domestic subsidiaries or joint ventures, after 1992 but not before 1992 ?
US GAAP
The reversal of a prior fiscal year inventory write-down is:
recognized as a reduction in cost of sales
overarching objective of a central bank is most likely to maintain
price stability
Research
is defined as original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. The research phase of an internal project refers to the period during which a company cannot demonstrate that an intangible asset is being created—for example, the search for alternative materials or systems to use in a production process.
leases most of its long-lived assets under operating leases.
A high ROA is a good indicator that a company may be using operating leases, this would artificially lower leverage and assets, and therefore inflate performance ratios.
What is notable about the major defined benefit plans in Germany
The plans are unfunded and employees pay pensions to retired employees from their own financial resources.
Balance sheet analysis
Income statement analysis
favors FIFO as inventory will represent up to date costs.
favors LIFO as cost of sales will reflect current costs.
End-of year owners’ equity =
Start-of-year capital contributed + additional shares issued + initial retained earnings + net income - dividend paid
US GAAP : patented products
should be written off within 20 years but subject to an impairment review.
Which of the following disclosures about intangible assets is required under US GAAP?
What the estimated amortization expense for the next five fiscal years will be
under IFRS, for each class of intangible assets,
why it is considered to have an indefinite life must be disclosed.
a company must disclose where amortization is included on the income statement.
Cash paid to suppliers
= Cost of goods sold + Increase in inventory – Increase in accounts payable
Ending interest payable =
Beginning interest payable + Interest expense – Cash paid for interest.
