Financial statements Flashcards

Question

Expense Recognition IASB definition

Answer 1

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)

Answer 2

“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.”

Answer 3

* 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

Answer 4

sales - increase in accounts receivable

Answer 5

* 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

Answer 6

* 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

Answer 7

= Beginning inventory (BI) + Purchases (P) - Ending inventory (EI)

Answer 8

- 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

Answer 9

LIFO to be used, due to distortion of balance sheet

Answer 10

* 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

Answer 11

= LIFO inventory + LIFO reserve

Answer 12

= Retained earnings (LIFO) + LIFO reserve x (1 - Tax rate)

Answer 13

= LIFO COGS - Change in LIFO reserve

Answer 14

= LIFO net income + Change in LIFO reserve x (1 - Tax rate)

Answer 15

* Occurs when number of items sold > items purchased - E.g. a company running down its inventory levels

Answer 16

- LIFO income > FIFO income - LIFO cost of sales < FIFO cost of sales - Due to ‘low cost’ LIFO items being included in cost of sales

Answer 17

* 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

Answer 18

* 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

Answer 19

- 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

Answer 20

- 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

Answer 21

- 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

Answer 22

* 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

Answer 23

* 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

Answer 24

* 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

Answer 25

CFO is higher

Answer 26

Depreciation expense = (Cost - Estimated residual salvagevalue )/ Useful life (UEL)

Answer 27

Depreciation expense = Constant % x Undepreciated cost Constant % = 2 / Useful life Undepreciated cost = Cost - Accumulated depreciation

Answer 28

be reduced below residual salvage value

Answer 29

Depreciation expense = (Cost − Salvage value) x (Units produced in the year/Total units to be produced)

Answer 30

* 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

Answer 31

* 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

Answer 32

- 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

Answer 33

INVESTMENT PROPERTY GENRALLY MEASURED USING THE COST MODEL

Answer 34

* 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

Answer 35

permanent differences and different national tax rates income tax expense / pre-tax income

Answer 36

* 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

Answer 37

* 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

Answer 38

* 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

Answer 39

DTL: Increase in DT expense DTA: Decrease in DT expense

Answer 40

DTL: Decrease in DT expense DTA: Increase in DT expense

Answer 41

* 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

Answer 42

* 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

Answer 43

DTA * Arise when a company makes losses * Potentially reduce taxable income in future years - Represent economic asset

Answer 44

* Deductions against taxable income resulting from expenditure * E.g. research and development tax credits

Answer 45

* 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

Answer 46

Asset: Carrying amount > tax base : DTL Asset: Carrying amount < tax base : DTA Liability: Carrying amount > tax base : DTA Liability: Carrying amount < tax base : DTL

Answer 47

* 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

Answer 48

* DTLs that are unlikely to reverse - E.g. quasi-permanent timing differences from tax allowances - Remove from DTL - Add back to equity

Answer 49

Opening book value - book value of disposal - depreciation + purchases

Answer 50

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

Answer 51

> carrying amount - fair value fair value is the higher of value in use and market value less costs to sell

Answer 52

both CFO (the interest expense) and CFF (the reduction in the lease liability)

Answer 53

> to be tested for impairment annually. > must be tested for impairment if there are indications of impairment such as decline in demand or obsolescence.

Answer 54

carrying value or fair value - cost to sell if its lower than carrying value

Answer 55

the likelihood that deferred tax assets may not be realized

Answer 56

Income tax expense - change in deferred tax liability

Answer 57

if taxable income is more than pretax income and this will reverse in future.

Answer 58

when taxable income is less than pretax income and this will reverse in future

Answer 59

with sales when economies of scale are present

Answer 60

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

Answer 61

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

Answer 62

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

Answer 63

Source: Data from previous step Output: Adjusted financial statements Common-size statements Ratios and graphs Forecasts

Answer 64

Source: Input data as well as processed data Output: Analytical results

Answer 65

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

Answer 66

Source: Information gathered by periodically repeating above steps Output: Updated reports and recommendations

Answer 67

Provide information * Company performance * Financial position * Changes in financial position * Useful to a wide range of users in making economic decisions

Answer 68

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

Answer 69

* 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

Answer 70

* 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

Answer 71

* 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

Answer 72

* 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

Answer 73

* 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

Answer 74

* Form 8-K - Current report announcing major events * Acquisitions or disposals of corporate assets, changes in securities and trading markets etc. * 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

Answer 75

European Securities Committee(ESC) European Securities and Markets Authority (ESMA)

Answer 76

* High-level representatives of member states * Advises European Commission on securities policy issues

Answer 77

* Independent advisory body consisting of representatives of national regulators from individual EU countries

Answer 78

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

Answer 79

* 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

Answer 80

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

Answer 81

* 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

Answer 82

* 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.

Answer 83

Rules Principles

Answer 84

FIFO, LIFO, weighted average method FIFO and weighted average method

Answer 85

Shown below tax Not segregated in the income statement

Answer 86

Treated as an expense Capitalized if conditions are met

Answer 87

Prohibited Permissible if certain conditions are met

Answer 88

- If expenses cannot be directly matched with revenues then recognize in the period they are incurred * E.g. administrative expenses

Answer 89

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

Answer 90

* 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

Answer 91

* 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

Answer 92

* 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

Answer 93

* 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

Answer 94

* Business disposes of or establishes a plan to dispose of a distinct operation * Profits or losses should be disclosed separately on the income statement

Answer 95

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

Answer 96

* 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

Answer 97

* 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

Answer 98

* 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

Answer 99

* 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

Answer 100

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

Answer 101

* ‘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

Answer 102

* ‘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

Answer 103

* 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

Answer 104

* 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

Answer 105

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

Answer 106

* 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

Answer 107

* ‘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)

Answer 108

* 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)

Answer 109

Calculation of cash flows from operations (CFO) Cash collections - Cash inputs - Other cash outflows = Cash flows from operations (CFO)

Answer 110

sales - increase in Accounts receivable

Answer 111

* 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)

Answer 112

Opening assets + purchase - depreciation - disposals at NB

Answer 113

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

Answer 114

- Express each cash flow line item as % of total inflows (outflows) - Express each cash flow line item as % of net revenue

Answer 115

* Excess of operating cash flow over capital expenditure

Answer 116

* 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

Answer 117

> NOT FOR PREFERENCE STOCKHOLDERS FCFE = CFO - FCInv - Net debt repayment or FCFE = CFO - FCInv + Net borrowing

Answer 118

Debt repayments > receipts of borrowed funds

Answer 119

* 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

Answer 120

LIFO inventory < FIFO inventory LIFO cost of sales > FIFO cost of sales LIFO income < FIFO income

Answer 121

* 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)

Answer 122

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

Answer 123

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

Answer 124

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

Answer 125

* 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

Answer 126

* Only arises when one company purchases another - Acquisition price > fair value of net identifiable assets acquired

Answer 127

* 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

Answer 128

* 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

Answer 129

* 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

Answer 130

* 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

Answer 131

- Disclosed in income statement * Component of other gains and losses or * Separate line item if material * Further detail in MD&A or footnotes

Answer 132

Proceeds (not gain or loss) included in CFI

Answer 133

* 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

Answer 134

* Upward revaluations will increase assets and equity - Improve leverage ratios such as debt/equity - Reduce return measures such as ROA or ROE

Answer 135

* 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

Answer 136

* 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

Answer 137

* 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

Answer 138

* No amortization charged during life of asset * Annual impairment review * Impairment - Carrying amount > Fair value * Can't reverse impairment

Answer 139

* 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

Answer 140

* 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

Answer 141

Not allowed Not allowed Permitted Not allowed Not allowed Not allowed Not allowed

Answer 142

Permitted Permitted Permitted Permitted Not allowed Permitted Not allowed

Answer 143

* 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

Answer 144

* Can provide less costly financing with little, if any, cash required upfront * Reduces lessee’s exposure to obsolescence, residual value and disposal

Answer 145

* 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

Answer 146

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.

Answer 147

* 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

Answer 148

* Cash flow statement - Interest portion of lease payment = -CFO (US) or -CFO / CFF (IFRS) - Principal payment = -CFF (reduction of lease liability - payment - interest expense)

Answer 149

* Income statement - Lease expense * Cash flow statement - Lease payment = CFO * Note: CFO is lower when using operating leases

Answer 150

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

Answer 151

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

Answer 152

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

Answer 153

* 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

Answer 154

- 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

Answer 155

- Company contributes an agreed defined amount into the plan Income statement - Pension expense Cash flow statement - Operating cash flow Balance sheet - No impact

Answer 156

* 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

Answer 157

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

Answer 158

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

Answer 159

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

Answer 160

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

Answer 161

- 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)

Answer 162

- 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

Answer 163

* 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

Answer 164

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

Answer 165

is to provide the user of the financial statement with information to assess the amount, timing and uncertainty of cash flows associated with leases

Answer 166

- 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

Answer 167

- 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

Answer 168

- 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)

Answer 169

- 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.

Answer 170

- 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

Answer 171

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

Answer 172

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

Answer 173

* 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

Answer 174

* 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

Answer 175

* 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)

Answer 176

Decrease Increase

Answer 177

Increase Decrease

Answer 178

Lower forecast profits in future Higher forecast profits in future

Answer 179

> 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

Answer 180

> 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

Answer 181

* 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

Answer 182

* 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

Answer 183

* 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

Answer 184

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

Answer 185

* 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

Answer 186

* 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

Answer 187

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

Answer 188

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

Answer 189

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

Answer 190

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.

Answer 191

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.

Answer 192

1. Market 2. Market Regulatory authorities 3. Auditors 4. Private contracting

Answer 193

* 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

Answer 194

* 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

Answer 195

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?

Answer 196

* 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?

Answer 197

* 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?

Answer 198

* 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?

Answer 199

* 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?

Answer 200

* 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

Answer 201

* 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?

Answer 202

* 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

Answer 203

* 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

Answer 204

* 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

Answer 205

* 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

Answer 206

* 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

Answer 207

* 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

Answer 208

* 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

Answer 209

* 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

Answer 210

* 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

Answer 211

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

Answer 212

* 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)

Answer 213

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

Answer 214

- Compare a specific ratio with the same ratio for another company or group of companies * Can be done on a common-size basis

Answer 215

- 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

Answer 216

- 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

Answer 217

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

Answer 218

Inventory turnover (COGs/ Avg Inventory) Receivables turnover (Net sales / Avg receivables) Payables turnover (Purchases / Avg payables)

Answer 219

Fixed asset turnover (Rev/ Avg net fixed assets) Total asset turnover (Rev / Avg assets) Working capital turnover (Rev / Avg working capital)

Answer 220

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

Answer 221

* 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

Answer 222

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

Answer 223

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

Answer 224

ROE = EAT / Rev * Rev / Assets * Assets / Equity ROE = net profit margin * asset turnover * financial lev

Answer 225

ROE = (EAT/EBT)* (EBT/ EBIT) * (EBIT/ Rev) *(Rev / Assets) * (Assets / Equity) ROE = tax burden * interest burden * EBIT margin * asset turnover * financial lev

Answer 226

* 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

Answer 227

* 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

Answer 228

- 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.

Answer 229

- 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)

Answer 230

Combines elements of top-down and bottom-up approaches

Answer 231

Consider macroeconomic factors first – for example, inflation or industry specific costs – then make assumptions about how these would impact the company

Answer 232

Consider company level factors first – for example, segment level margins, historical growth rate of costs and margin levels or cost of delivering specific products

Answer 233

* 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

Answer 234

if cogs increases more relative to sales then margin falls more so cogs hedged from price input rises

Answer 235

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)

Answer 236

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

Answer 237

* 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

Answer 238

- Geographic location - Business type

Answer 239

- 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).

Answer 240

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

Answer 241

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.

Answer 242

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?”

Answer 243

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

Answer 244

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

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* 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”).

Answer 246

* 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

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1. 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 2. 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 4. Bargaining power of buyers > Bargaining leverage and price sensitivity 5. Bargaining power of suppliers > Number of suppliers, size of suppliers, ability to increase costs of inputs

Answer 248

* 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.

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* 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.

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* 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.

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* 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.

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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.

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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

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are short term (less than one year) under IFRS and US GAAP or low in value under IFRS only

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this tends to be real GDP (inflation removed), as opposed to nominal GDP (not adjusted for inflation)

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The undiscounted value of the expected future cash flows.

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The carrying amount of right of use assets. Total cash outflow for leases

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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.

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the estimated amortization expense for the next five fiscal years

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treated as an expense, even when no cash is exchanged based on the fair value of the grant.

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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

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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.

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enacted > IFRS in contrast allows for the possibility that further approvals are needed to enact the laws.

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recognized as a reduction in cost of sales

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price stability

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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.

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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.

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The plans are unfunded and employees pay pensions to retired employees from their own financial resources.

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favors FIFO as inventory will represent up to date costs. favors LIFO as cost of sales will reflect current costs.

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Start-of-year capital contributed + additional shares issued + initial retained earnings + net income - dividend paid

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should be written off within 20 years but subject to an impairment review.

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What the estimated amortization expense for the next five fiscal years will be

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why it is considered to have an indefinite life must be disclosed. a company must disclose where amortization is included on the income statement.

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= Cost of goods sold + Increase in inventory – Increase in accounts payable

Answer 275

Beginning interest payable + Interest expense – Cash paid for interest.