Financial Statements Flashcards
FS Introduction
Liquidity
This refers to the “closeness to cash” of the assets and liabilities of a company, or the ability to pay debts when they are due.
FS Introduction
Solvency
The companys ability to pay its debts as they fall due.
FS Introduction
Supplementary Schedules
Another source of financial info (not the same as the footnotes). These are extra unaudited figures produced by a company outside the FS such as an oil and gas reserves report.
FS Introduction
Management Discussion & Analysis (MD&A)
Definition
Issues included
Another source of information outside of the FS, for public companies only and not audited.
Requires management to discuss specific issues such as:
- Current financial condition
- Liquidity
- Planned Capital Expenditure for next year
FS Introduction
Audit
Disclaimer of Opinion
When the auditor was not able to complete their audit in order to produce an unqualified, qualified or adverse audit opinion.
FS Introduction
Audit
Sarbanes Oxley Requirement for internal controls
Name of the oversight body
Public Company Accounting Oversight Board (PCAOB).
PCAOB Auditing Standard #2 requires audit firms to present an additional disclosure regarding its assessment of the auditees internal controls over the financial reporting process.
FS Introduction
FS Analysis Framework
6 steps
- Articulate purpose and context: Decision to be made (eg evaluate an equity or credit rating), audience, time frame
- Collect input data
- Perform analysis (eg ratios)
- Analyse/interpret processed data
- Form conclusions
- Follow up: Monitor over time to see if conclusion changes
FS Introduction
Standard Setting Bodies
IASB - full name
Number of members - full & part time
Purpose
Principle or rule based focus
US version
International Accounting Standards Board
14 members (12 full time, 2 part time)
Purpose is the harmonisation of international accounting rules, via introducing global standards rather than direct harmonisation.
Principles based focus.
US version is Financial Accounting Standards Board (FASB).
FS Introduction
Standard Setting Bodies
IOSCI - full name
3 aims
US version
International Organisation of Securities Commissions.
- Work towards improved market regulation internationally
- Work to facillitate cross-border listings
- Advocates adoption of a single set of accounting standards
US version is the SEC
FS Introduction
Financial Reporting
IFRS Key qualitative characteristics
2 main ones (and sub-points)
2 secondary ones
- Relevant
- Reliable
- Represents substance and economic reality
- Free from material error
- Complete
Secondary:
- Easy to understand
- Comparability
FS Introduction
Financial Reporting
2 underlying assumptions
- Going Concern
- Accruals basis
FS Introduction
Financial Reporting
IAS 1: Purpose
Prescribes the basis for preparation of the companies financial statements to ensure comparability with prior periods and other companies.
FS Introduction
Financial Reporting
IAS 1 Components of Financial Statements
- Balance Sheet
- Income Statement
- Statement of Cash Flows
- SOCE showing either:
- all changes in equity
- all except transactions with equity holders acting in their capacity as equity holders
- Notes, including a summary of accounting policies
FS Introduction
Financial Reporting
IAS 1: Fundamental Principles
PGACM
- Fair presentation
- Going concern
- Accrual basis
- Consistency
- Materiality and aggregation
FS Introduction
Financial Reporting
IAS 1: Presentation Requirements
- No offsetting
- Classified balance sheet (C/NC)
- Minimum information on face of FS
- Minimum information in the notes
- Comparative information (ie PY numbers)
FS Introduction
Financial Reporting
3 characteristics of effective financial reporting frameworks
- Transparency
- Comprehensiveness (include all transactions)
- Consistency (similar transactions accounted for similarly, different transactions accounted for differently, thus aiding comparison)
FS Introduction
Financial Reporting
3 conflicts between financial reporting frameworks
- Valuation: some valuation approaches (non-historical cost) require significant judgement
- Rules based vs principals based
- Measurement:
- Assets/liabilities basis (income based on changes in net assets)
- Revenue/expense approach, relies on concepts like matching principle to determine profit
FS Introduction
Financial Reporting
Areas of attention for analysts relating to accounting standards
- New products or transactions types: May not be dealt with properly by existing standards/policies
- Evolving financial standards: Need to keep on top of evolution of standards
- Disclosures in notes: Companies may state some standards haven’t been applied, delayed adoption, changes in accounting policies
Income Statement
Revenue Recognition
When can revenue be recognised?
When it is:
- Realised or realisable, including that there is reasonable assurance of payment, and
- Earned, meaning goods or services have all or virtually all been provided
Income Statement
Revenue Recognition
Long-term contract revenue
IFRS vs US GAAP differences
If the outcome of the contract can be reliably measured then:
- Use percentage of completion
Otherwise:
- IFRS: Revenue = Costs incurred
- US GAAP: Revenue = 0, Costs = 0
If a loss is expected:
- Recognise the full loss immediately
Income Statement
Revenue Recognition
Long term contracting revenue
What is the completed contract method?
When is it used?
Conservative method where no revenue is recognised until contract is completed and title is transferred.
Used where:
- There is no contract,
- Estimates of revenues, costs and % of completion can’t be reliably estimated, or
- Ability to collect revenues is uncertain
Income Statement
Revenue Recognition
Installment Sales
Recognises revenue and associated cost of goods sold only when cash is received. Used if the cost to provide goods is known but collectability of revenue or sales proceeds can’t be determined.
Profit is recognised along with revenue since cost of sales is known.
For example real estate sales, it is hard to estimate what price you will sell new properties for.
Income Statement
Revenue Recognition
Cost Recovery method
Similar to but more conservative than sales installment method, for use when cost of sales is also difficult to estimate.
In this case revenue is recognised when cash is received, but no gross profit is recognised until all related costs have been collected.
Income Statement
Revenue Recognition
Barter Sales
Definition and treatment according to FASB
This is when companies exchange services, typical example is web companies exchanging advertising on each others websites. They may wish to recognise a large revenue and equal offsetting expense in the I/S.
FASB says this can only be done if a fair value can be determined based on the companies own historical realised cash for similar services, unrelated to barter transactions.
Income Statement
Revenue Recognition
Gross vs Net reporting
Definition and deciding factors
This is where a company acts as a middle-man to sell a product to a customer. They have the choice between recognising the full revenue and cost of the product, or just the difference (ie their commission on the sale).
Factors include whether they bear credit risk, have the choice to change supplier, have control over the end price or have inventory risk.
Income Statement
Expense Recognition
Doubtful accounts recognition
2 methods
The issue is how to recognise the cost of writing off unrecoverable receivables.
- Direct write off method: When each individual debt becomes irrecoverable write it off in full. Simple, but doesn’t match the cost with the revenue.
- Allowance method: Record bad debts in the period they relate to, in practise this means making an allowance of sales made (IS method) or receivables balance (BS method).
Cashflow Statement
US GAAP vs IFRS
Differences
US GAAP classifies interest and dividends received as CFO, interest paid as CFO and dividends paid as CFF.
IFRS offers a choice between CFO or CFI/CFF (for received/paid).
Cashflow Statement
Free Cash Flow
What is free cash flow?
FCF = CFO - capital expenditure
It measures the cash available to the company for discretionary spending, after the capex required to maintain the companies current operations is made.
Cashflow Statement
Free Cash Flow
Free Cash Flow to the Firm (FCFF) formula
(PAT method)
What does it represent?
FCFF = NI + NCC + int*(1-tax) - FCinv - WCinv
NI = Net Income (PAT)
NCC = Non-cash charges (eg depn.)
int = interest to bond holders, tax = tax rate
FCinv, WCinv = investment in fixed and working capital
It represents the total flow of cash to equity and bond holders.
Cashflow Statement
Free Cash Flow
FCFF formula (CFO method)
FCFF = CFO + int(1-tax) - FCinv
This is because CFO already takes into account movements in WCinv and NCC (non-cash charges)
Cashflow Statement
Free Cash Flow
Free Cash Flow to Equity (FCFE)
FCFE = FCFF + Net borrowing - Int(1-tax)
Note that net borrowing is NOT net debt, it is the amount borrowed in the year less the amount repaid (since cash borrowed from bondholders during the year is cash inflow to equity holders effectively).
Cashflow Statement
Cashflow Ratios
Typical cashflow performance ratios
Cash flow per share
Normal cashflow ratios are just CFO divided by the relevant balance (eg CFO/revenue, CFO/operating income).
For balance sheet items use the average of the balance (eg CFO/average fixed assets, CFO/average equity).
CF per share = (CFO - prefered divs)/# ordinary shares
** Cashflow Statement**
Free Cash Flow
Coverage Ratios
Debt, interest, reinvestment, debt payment, dividend and investing & financing.
Cashflow Coverage Ratios
Debt: CFO/total debt
Interest: (CFO + interest paid + taxes paid)/ interest paid
Reinvestment: CFO / cash spend on long term assets
Debt payment: CFO / cash spend on debt repayments
Dividends: CFO / divs paid
Investment & financing: CFO / cash paid for investing and financing activities (divs, bond interest, fixed assets etc)
Financial Analysis
Common Size Ratios
What are they?
I/S, BS and CF calcs
Common size ratios express financial statement balances as percentages of revenue (for IS), total assets (for BS) or for cashflow either total cash inflows, total outflows or revenue.
They allow comparison of companies regardless of their size.
Financial Analysis
Cross Sectional Analysis
Compares a company to its industry or a similar set of companies.
To be comparable they need to employ the same technology, be of similar size, appeal to similar customers etc.
Financial Analysis
Time series (trend) analysis
Compares a company to itself but over time.
Financial Analysis
Ratios
Activity Ratios
Receivables turnover, Inventory turnover, Payables turnover, Working Capital turnover, total asset turnover, fixed asset turnover.
Receivables Turnover = Revenue / Av. Receivables
days of sales outstanding = 365/receivables turnover
Inventory Turnover = COGS / Av. Inventory
Payables Turnover = Purchases / Av. Trade Payables
WC Turnover = Revenue / Av. WC
TA turnover = Revenue / Av. TA
FA turnover = Revenue / Av. Net FA
Financial Analysis
Ratios
Liquidity Ratios
Defensive Internal Ratio
Cash Conversion Cycle
Operating Cycle
Defensive Internal Ratio =
(Cash + Short-term investments + receivables) /
Daily Cash Expenditures
Cash conversion cycle = Net operating cycle =
Inventory days + receivables days - payable days
Operating cycle = Inventory days + receivable days
Financial Analysis
Ratios
Coverage Ratios
Interest Coverage
Fixed Charge Coverage
Interest Coverage = EBIT / interest expense
Fixed Charge Coverage =
(EBIT + lease payments) / (interest + lease payments)
Financial Analysis
Ratios
Return on Investment
ROA, Operating ROA, return on total capital,
ROE, return on common equity
ROA = net income / average total assets
Operating ROA = operating income / av tot assets
ROTC = EBIT / average total capital (debt+equity)
ROE = net income / average total equity
ROCE = (net income - pref divs) / av common equity
Financial Analysis
Ratios
DuPont Analysis
ROE = net income / average total equity
= net income / net sales *
net sales / total assets *
total assets / total equity
= profitability * efficiency * leverage
Financial Analysis
Ratios
Extended DuPont Model
Substitute EAT = (EBIT - I) * (1 - t) to get:
ROE = [(EBIT/sales)*(sales/assets) - (interest/assets)] *
(assets/equity) * (1 - t)
or, ROE = [(operating profit margin * efficiency) -
interest expense rate] * leverage * tax retention rate
Inventory
IFRS/US GAAP allowance of:
FIFO, LIFO, Av cost
All allowed under US GAAP, LIFO not allowed under IFRS.
30% of US companies use LIFO due to income tax savings.
Inventory
Periodic vs Perpetual inventory systems
Has an impact on LIFO.
If inventory is updated perpetually the cost of a good sold is based on the most recent purchase before the sale.
If it’s only updated periodically (eg at year end) the last purchases in the period will be used, therefore the cost of a good sold might be based on a purchase that took place after the sale occured.
This exacerbates the LIFO issue.
Inventory
Inventory Valuation
IFRS and US GAAP methods
Can write down of inventory values be reversed?
IFRS: Lower of cost and NRV. If written down to NRV and subsequently NRV rises, the charge can be reversed and inventory value brought back up.
US GAAP: Lower of Cost and Market (LCM). Mark down to market cost (replacement value) not NRV. Write offs CANNOT be reversed, instead you’ll realise a gain when you sell the inventory.
Long Term Assets
Depreciation Methods
Impact on tax and cash flow
Accronym for US tax method used for depreciation
Major assumption of the US tax method
Choice of depreciation has no impact on tax and consequently cash flow, since tax authorities decide the depreciation method to be used for the tax calcs.
US uses MACRS to determine depreciation in tax calculations.
Note MACRS assumes zero residual values.
Long Term Assets
Impairment
US GAAP methodology (test and impairment value)
IFRS method
US GAAP uses the recoverability test to decide whether to impair, which is whether carrying value is greater than undiscounted future cash flows.
Loss measurement is then based on FV if available, or discounted PV of future cashflows if not.
IFRS requires impairment loss to be calculated if “impairment indicators” exist, in which case recoverable amount is min(FV-CTS, VIU).
Long Term Assets
Impairment
Is goodwill amortised under US GAAP or IFRS
Method of testing for impairment
No goodwill impairment under either US GAAP or IFRS, use annual impairment tests instead.
Under US GAAP test annually for impairment by comparing carrying value of a reporting unit to its fair value. Then if CV is higher than FV for the unit, allocate FV’s to assets and liabilities of units as if acquired at that date in order to determine FV of the goodwill.
Long Term Assets
Impairments
Can impairments be reversed under IFRS/US GAAP?
Under IFRS impairment losses can be reversed, but not to exceed what the initial carrying amount adjusted for depreciation.
Under US GAAP it is permitted for HFS assets but not for assets in use.
Long Term Assets
Disclosures
IFRS/US GAAP differences
For PPE, Intangibles & impairments
IFRS has lists of disclosure requirements for each item.
US GAAP has less requirements including general descriptions of depn/amortisation/FV methods used and for intangibles the estimated amortisation expense for the next 5 years.
Long Term Assets
Investment Property
IFRS vs US GAAP differences
IFRS has special rules allowing valuation under the cost model or FV model.
US GAAP has no definition of investment property and it is measured using the cost model, the same as other long term assets.
Income Taxes
Deferred Tax
Are deferred tax assets and liabilities current or non-current?
Under IFRS always non-current.
Under US GAAP C or NC depending on the underlying asset of liability.
Income Taxes
Deferred Tax
Are deferred tax assets/liabilities discounted?
No
Income Taxes
Deferred Tax
What is a valuation allowance?
Under US GAAP this is an adjustment made to the deferred tax asset balance on the basis that less than the full deferred tax amount is likely to be recovered (usually due to poor financial performance).
Not necessary under IFRS since DTA/DTL only recognised if probable.
Income Taxes
Deferred Tax
When are deferred tax liabilities unlikely to be realised?
How should they be treated by analysts?
DTLs may be unlikely to be realised if:
- A high growth firm is continually investing in accelerated depreciation assets
- Tax policies are likely to change in the future
In such cases the PV of expected future cash payments relating to the DTL may be much lower than the DTL. So charge the difference between DTL and PV of cash payments to equity instead of profit.
Long Term Liabilities
Cash flow
How are cash flows from long term liability servicing split?
Coupon payments are split between CFO and CFF.
Normally it’s ok to allocate the coupon payment to CFO if the bond is to fund operations.
However if the issue is at a premium/discount this may be misleading. If issued at a premium part of the coupon payment is to pay back the premium, therefore classifying the coupon as CFO is misleading and it should be partially classified as CFF.
Long Term Liabilities
Leases
Criteria for recognition as capital lease (US GAAP)
Lessee designates as Capital if ANY of 4 conditions are met:
- Ownership transferred at end
- Bargain purchase option at end
- Lease term >75% of OEL
- PV of MLPs >= 90% of FV
For lessor need one of the 4 above AND both of:
- Collectability of lease payments is reasonably predictable
- No significant uncertainties regarding the amount of un-reimbursed costs yet to be incurred by the lessor
Long Term Liabilities
Leases
Sale-leaseback
When is this relevant?
What is the accounting treatment
Sale-leaseback treatment is relevant for capital leases under US GAAP where the asset was purchased from the leasee and leased back to them.
In this case the leasor recognises a gain of sales - cost of goods sold where:
sales = min(PV of MLPs, FV of asset)
COGS = cost of the asset - PV of residual value
And recognises an asset (net investment in lease) of PV of lease payments + PV of residual value.
Long Term Liabilities
Leases
Alternative to a sale-leaseback lease
Under US GAAP a capital lease is either sale-leaseback or direct financing lease.
IFRS doesn’t discriminate between them.
Financial Analysis
Credit Quality
Moody’s four factors for credit ratings
- Company profile - scale and diversification
- Financial policies - tolerance for leverage, this includes various solvency ratios
- Operational efficiency - ie operating leverage
- Margin stability - ie low volatility margins
What are the 10-k and 10-q forms?
These are forms which must be submitted by US firms to the SEC.
10-k is basically the annual return
10-q is a quarterly unaudited simple set of stats
US GAAP definition of “current”
(ie vs non-current)
The larger of one year and the length of the operating cycle.
So if operating cycle = 2 years, current defined as 2 years not 1 year
Valuation Methods for liabilities
Current Cost
Current Cost: The undiscounted amount of cash that would be required to settle the obligation today.
Proxy Statement
What is it?
Contents
The proxy statement is a document required by the SEC providing information useful to shareholders.
Includes information about directors, including their compensation.
Ratios
Current Ratio
Quick Ratio
Cash Ratio
(in order of items included)
Cash Ratio
(cash + cash eq.) / current liabilities
Quick Ratio
(cash + cash eq. + short inv. + accounts receivable) /
current liabilities
Current Ratio
current assets / current liabilities
EPS calculation
Weighted average # shares
Are stock dividends weighted based on date of issuance or for the full year?
Stock splits (and convention)?
Issuance of shares?
Stock dividends are considered to have been in issuance for the whole year regardless of when they were paid.
Stock splits and share issuances need to be adjusted on weighted average basis.
Convention for stock splits, 2 for 1 means 1 share split into 2, not getting an additional 2 shares for your 1.
EPS Calculation
Diluted EPS adjustments
How are unexercised options adjusted for?
Options adjustment: Increase # shares by,
options * intrinsic value / share price,
based on av. share price during the year.
EPS Calculation
Diluted EPS adjustments
Issue with convertible pref shares adjustment
For convertible bonds net income is increased by the fall in interest payable (adjusted for tax).
However pref share dividends aren’t included in net income. Therefore pref divs are subtracted from net income to get EPS and added back to get DEPS. So convertible pref dividends have NO NET IMPACT on DEPS.
Also note no tax is paid on pref dividends.
Net Sales
This is just revenue, means net of things like returns.
Intangible info required by IFRS but not US GAAP?
Does amortisation method need to be disclosed under US GAAP?
Does gross cost and accumulated amortisation need to be disclosed under US GAAP?
IFRS requires disclosure of whether useful lives are definite or indefinite, US GAAP does not.
US GAAP requires gross cost and accumulated amortisation to be disclosed, but NOT the amortisation method.
Biggest risk factor for manipulated accounts?
Opportunity
So poor internal controls are a bigger concern than a motivation such as directors compensation.
What is earnings quality?
Low quality earnings examples
Earnings quality reflects the degree of manipulation in the results of the company. High quality earnings reflect truly profitable performance and will result in future cash inflows.
An example of low quality earnings would be a manipulation of the accounts, for example recording revenue that the customer is not obliged to pay.
Long Term Asset
Definition
A long term asset in US GAAP means PPE.
Critical point is that it is used in operations, not for resale.
Also excludes investments.
Define Direct Financing Lease
Like a sale and leaseback, except there is no profit on sale.
i.e. PV of MLPs + PV of residual value = Cost
Treasury Stock Method
Treasury Stock
The treasury stock method is the way options/warrants are dealt with in diluted EPS (i.e. assume proceeds are invested back into purchase of stock).
Treasury stock is stock purchased by the company and held in treasury stock account (equity not asset account).
Extraordinary Items
What are they?
Which standards allow them?
Allowed under US GAAP but not IFRS.
Extraordinary items are both unusual in nature and infrequent in occurence. They are presented seperately in the income statement, net of tax.
Dividends
When do dividends hit the stats, paid or declared?
When they’re declared a liability and movement in equity is automatically recognised.
Then when paid the liability offsets cash movement and the movement in the cash flow statement appears.
Double Declining Depreciation method
Assume zero residual value.
At the start calculate a depreciation percentage based on 2/UEL (eg 10% for 20 years).
Reduce the balance by that percentage every year (so dollar amount reduces each year).
Classification of Current Liabilities
If a firm intends to refinance short term obligations on a long term basis, how are they accounted for?
If they can demonstrate the refinancing (eg by a post balance sheet event) they can classify the amount refinanced as a long term liability.
Capital/Operating Lease
What is the effect on earnings?
Over the whole life there is no net impact to earnings or tax.
However capital leases will have higher expense (lower earnings) in early years due to higher depreciation and interest costs, whilst operating leases have a stable cost over the whole life.
Difference between liquidity and solvency?
Liquidity is the ability to meet short-term obligations, solvency is the ability to meet long-term obligations.
Appropriate Retained Earnings
How do they work?
If you have some planned expenditure, you can shift some retained earnings into an “appropriated retained earnings” account.
If they are spent the expense is taken off appropraited retained earnings instead of retained earnings as normal.
If they are not spent the appropriate RE gets sent back to RE.
Capitalisation of costs incurred developing patents and copyrights, what is allowed?
Only legal costs when internally generated!
