FSA (legacy, full module) Flashcards
What are the objectives of financial reporting standards?
To determine the types and amounts of information that must be provided to users of financial reports by providing principles for preparing them
What is the goal of the IASB?
The objective of the International Accounting Standards Board (IASB) is to provide useful financial information to users who make decisions (invest, lend to, work for, extend credit) regarding the corporate entity in question. It aims to promote convergence of all reporting standards, because finance is global
Why is it important to understand financial reporting standards when it comes to security analysis and valuation?
Because judgements and estimates are used in forming the information that makes up financial reports
What are the two kinds of bodies involved in financial reporting standards?
Standard setting bodies (private, usually not for profit, i.e., the IASB, FASB) and regulatory bodies (public/government entities, i.e., the SEC)
What financial reporting standard does the IASB set?
IFRS
What financial reporting standard does FASB set?
US GAAP
What is the difference in roles between the two kinds of financial reporting standards bodies?
Standard setting bodies set the standards (i.e., IASB, FASB set IFRS and GAAP), regulatory bodies (i.e., SEC) recognise, require, and enforce them
What is the IOSCO?
The International Organisation of Securities Commissions establishes principles and objectives that guide regulation. Thus they do not control regulation directly. It is not a regulatory body in itself but rather a collective of regulators across different markets.
What are the 3 core objectives of the IOSCO’s financial reporting regulation?
- Protect investors
- Ensure markets are fair, efficient, and transparent
- Reduce systemic risk
What companies must report to the SEC?
Any company that issues securities in the US, whether domiciled in the US or not, must submit filings to the SEC in a standardised format through EDGAR (Electronic Document Gathering Access and Retrieval)
What is the IASB’s conceptual framework?
To provide useful financial info for making decisions about providing resources (i.e., financing) to the entity
What are the two fundamental characteristics and 4 enhancing characteristics the IASB’s conceptual framework seeks to promote in info in financial reports?
Fundamentally the info must be:
1. Relevant: it would affect or make a difference in the info user’s decision
2. Faithful representation: complete, neutral (without bias), free from error
Enhancing characteristics:
1. Comparability: all standards consistent across all companies
2. Verifiability: if there are any estimates involved in the info the company must disclose the methodology used in the notes
3. Timeliness: information available before becoming an investor in the company
4. Understandability: info is clear and concise if you have accounting knowledge
What are the constraints associated with standardised financial reporting outlined in the IASB’s conceptual framework?
The cost of providing the information in the financial statement should not outweigh the benefits
What two properties may be traded off when preparing a standardised financial report?
Timeliness and verifiability
What elements are associated in the measurement of financial position of an entity in FR?
- Assets: an economic resource controlled by an entity (owned)
- Liabilities: obligation of the entity to transfer an economic resource (owed)
- Equity: Assets less liabilities
What elements of a financial report are measurements of performance of an entity?
- Income: Increases in assets and/or decreases in liabilities that result in increases in equity (revenues, plus gains)
- Expenses: Decreases in assets and/or increases in liabilities that result in decreases in equity (costs, plus losses)
What are the two assumptions that underlie financial reporting?
- Accrual accounting: costs are matched to the revenue produced from them, whether or not the costs are incurred during that period. Revenue is recognised as it is earned
- Going concern: the company will continue to operate indefinitely. This is important because fire sale value of a company’s assets if it is going bankrupt is lower
What are the six monetary amounts recognised and measured?
- Historical cost: amount originally paid
- Amortised cost: historical coss less depreciation or amortisation
- Current cost: amount required today for replacement of a given asset
- Realisable value: amount that is realisable for the sale of an asset (known as the settlement value for a liability)
- Present value: discounted value of future net cash inflows
- Fair value: the amount that would be realised in the sale of an asset, in normal markets (may be higher than realisable value in bad markets)
What is the difference between realisable value and present value of an asset?
Realisable value is the amount a company would be able to get if it sold an asset now. Fair value is that would be realised in a sale under normal market conditions. During a market rout or financial crisis, the realisable value of an asset may be lower than its fair value
What are the five components generally required of a financial statement?
- Statement of financial position (the balance sheet)
- Statement of comprehensive income (can either be a single statement, or an income statement plus a statement of comprehensive income)
- Statement of changes in equity
- Statement of cash flows
- Notes to the financial statement
What are the four general features of financial statements?
- Fair presentation: must represent the effects of a company’s transactions faithfully (i.e., unless an expense is capitalised it is listed when it is incurred, and not improperly spread out)
- Going concern: assumes company will continue to operate into the future
- Accrual basis: Matching principle + revenue recognised when it is earned, not before or after!
- Materiality & aggregation: aggregate similar items ie advertising across all countries aggregated into one line, but dissimilar items are listed separately. Note depreciation items can be listed separately since they will depreciate differently
What financial reporting standard does the CFA course take the perspective of?
IFRS. The FRA course will point out where US GAAP differs from IFRS but does not teach from a US GAAP perspective
How regular are financial statements?
Audited statements are at least once a year (audited by a US govt body). Unaudited statements are periodic, typically quarterly
What is the order of a statement of financial position?
The statement of financial position (or balance sheet) usually places assets first (debit entries), then liabilities second (credit entries), then the statement of equity. However, within assets and liabilities the ordering may differn, as the IFRS specifies the categories but not the order. Some companies will list them most liquid to least liquid, others the other way around
What is the accounting identity?
Assets = Liabilities + Owner’s Equity.
Assets = resource the company controls
Liabilities = obligations to lenders and creditors
Owner’s equity = excess of assets over liabilities
What is the time period of a balance sheet?
A balance sheet is a snapshot of a company at a point in time. By contrast the income/cash flow statement are a picture of a company OVER a period of time. A balance sheet will list a particular day (i.e. December 31st), the income/cashflow statement will list a period (i.e., December 1st-31st)
Why is the time period of a cashflow statement important when comparing to a balance sheet?
We must modify the information on the cashflow statement to be compatible, typically using averages, since a balance sheet is a snapshot pf one point in time whereas a cashflow statement is over a period of time
What are the different orders of an income statement and a statement of comprehensive income?
An income statement starts with revenues and flows all the way down to net income. A statement of comprehensive income starts with net income and then adds in all the other components of income, to end with total comprehensive income
If a parent owns 55% of a company, how would it present income from this company?
It would start by taking ALL of the revenues of the subsidiary, and then have a line item removing the part of net income which belongs to minority interest. This is known as reporting income on a consolidated basis. This applies where any parent owns more than 50% of a given company.
What is the difference between revenue and income?
Revenue is money earned from the business’ primary activites (what it is in business to do), income adds in money earned incidentally (currency exchange, investments)
What does other comprehensive income include?
Any money earned which is not listed on the income statement, and is not gained from selling more stock. This could include unrealised gains or losses, foreign currency translations, and gains and losses in the pension fund
What is the equation for total comprehensive income?
TCI = net income + other comprehensive income
What is contained in the statement of changes in owner’s equity?
This part of the balance sheet lists out different equity accounts (i.e., paid-in capital, retained earnings, accumulated other comprehensive income). It shows how those accounts changed over the year: what the balance at the beginning was, plus gains, minus losses, and the ending balance.
What is the most important financial statement?
The cash flow statement
What formula describes what the income statement does?
Revenue less expenses = net income
What two forms of income statement can be presented under IFRS and US GAAP standards?
A single statement of comprehensive income with a separate section for P&L, or an income statement followed by a statement of comprehensive income
What are the components of the income statement?
Revenue - the first line. Amounts charged for goods and services during the ordinary activity of the business. It is reported as a net figure, less returns, rebates, and discounts
Expenses - outflows (whether or not they actually flowed out during that particular time period), depletion of assets, and incurrences of liabilities AS PART OF ORDINARY COURSE OF THE BUSINESS (therefore excludes investment losses and incidental losses). Expenses may be grouped by either nature or function
What are the two ways that expenses can be grouped on the income statement?
- By nature, e.g. depreciation
- By function, e.g. Cost of Goods Sold, Raw Material, Direct Labour, Manufacturing Overhead, Sales & General Administrative Expenses
Note that if we group by function, some of the depreciation may be part of each function (spread out)
Why are gains and losses listed separately from expenses on the income statement?
Gains and losses account for gains and losses on sales of assets, and unrealised gains and losses on financial assets, held and traded not as part of the businesses main operations. I.e., a banana smoothie business may choose to retain part of its earnings each year and invest it in stocks. The gains and losses for those stocks would be listed in these parts of the income statement
Why is the income statement broken into multiple steps?
So that potential lenders, creditors, and investors can judge the efficiency of each part of the business
What are the steps of the multi-step income statement?
Revenue - COGS (cost of generating those sales) - Operating Expenses - Income from associates & discontinued operations - Interest - Taxes = Net income
What is the difference between gross profit and gross margin?
Gross profit is expressed in currency, gross margin is expressed as a percentage
What is the formula for EBIT?
Revenue - COGS - Operating Expenses - Income from Associates - Income from discontinued operations
Does operating profit contain non-operating income and expenses?
It actually depends, sometimes it does sometimes it doesn’t! This can make it hard to estimate the profitability of the underlying business. For that reason, sometimes we may prefer net income
Is the bottom line net income or operating income?
Net income (or net income margin)
How is revenue recognised in an income statement?
Revenue is recognised on an accrual basis. This means it is recognised not necessarily at the time the payment is actually received.
How does recognition of revenue change for an item sold when it gets delivered?
Payment before delivery is counted as unearned revenue. Payment after delivery is counted as accounts receivable. The delivery itself does not change how it is recognised, but rather, the relation between payment and the delivery
What are the five steps of the revenue recognition process:
- Identify what the contract established with the customer is (you give me consideration i.e. money, I give you a washing machine)
- Identify the separate/distinct performance obligations in the contract (you pay for a washing machine, and you pay for installation)
- Determine the transaction price (£200 total)
- Allocate the price to the performance obligations (£150 allocated to the actual washing machine, £50 to installation)
- Recognise revenue when a performance obligation is satisfied (the customer bought the washing machine but it has not been installed yet; in this case the £50 allocated to installation is not counted on the income statement
What is a contract according to accounting standards?
An agreement between parties that establishes obligations and rights (i.e., delivery of goods and services for payment). A contract only exists if collectability is more likely than not to occur, i.e., >50% likely. Note that in questionable situations IFRS is more likely than GAAP to recognise a contract with low likelihood
How do we determine whether performance obligations are singular (and taken as one performance obligation) or distinct?
A performance obligation is distinct when a customer can benefit from it on its own. If I receive a washing machine but also pay for installation bundled with it, these are actually two separate performance obligations. This is because I could choose to get someone else to install it
What five conditions are required for a performance obligation to be satisfied?
- Company has a right to payment
- Customer has legal title
- Customer has physical possession
- Customer has significant risks and rewards of ownership
- Customer has accepted the asset
What forms can expenses on an income statement take according to the IASB?
- Outflows
- DEPLETION of assets
- Incurrences of liabilities (expenses, plus losses)
All of them result in a decrease in equity.
All expenses are defined as decreases in economic benefits
What is the matching principle?
Costs are matched to revenues generated as a result of those costs.
- Product costs are defined as Cost of Goods Sold, and are directly related to earning revenues. These must be listed alongside revenues related regardless of the payment dates (whether past or future)
- Period costs are things like admin expenses and depreciation. These are related to operations and are incurred regardless of how much product is sold. Thus they are recorded within the period and do not need to be matched.
What is the difference between expense recognition for tax purposes and for financial statements?
You are not allowed to record expected expenses for tax purposes, only when you know they are going to occur. Thus the direct write-off method is used for tax purposes (only writing off actual costs), and take charges of bad debt only when actual default occrs
What is the difference between depreciation and amortisation?
Both depreciation and amortisation are methods by which the costs of long-lived assets are allocated over the period of time during which it provides economic benefits.
However, depreciation applies to physical assets (buildings, equipment), whereas amortisation applies to intangible assets (copyright, patents)
What are the two methods of determining depreciation and amortisation?
- The cost model
- The revaluation model
What is the shape of the depreciation curve implied by the cost model?
Flat. The cost model takes salvage value away from cost, and divides this figure by useful life. Thus the value of the asset is said to reduce by the same steady rate each year until the end of its useful life to the company
In what contexts might the revaluation model of depreciation be more useful than the cost model?
For assets which depreciate most rapidly in the first year (i.e., cars). Revaluation model specifies that the carrying value of an asset equals its fair value. Howevern this model is not permitted under US GAAP
What does it mean for assets to be depreciated separately?
Assets which have different useful lives cannot be taken together as having the same depreciation. For example, if I have a machine with 3 components, a frame which needs to be replaced every 20 years, a hinge which needs to be replaced every 5 years, and a drill bit which needs to be replaced every 3, these components must be treated as having separate depreciation rates
What pattern of depreciation does the IFRS require?
The IFRS requires that the choice of depreciation match the asset’s pattern of use. If there is no pattern, then the straight line method should be used. It also requires salvage value to be reevaluated each year
Why is it important to read the notes of financial statements on depreciation?
All the assumptions going in to estimating depreciation will be listed in the notes. How these assumptions are made can have a big effect on the profitability of the company, according to the financial statement. Extending the expected life of the assets and increasing their salvage value, as struggling airlines did in the 1990s, can make your company look a lot more profitable
Why might faulty depreciation estimates not matter?
If everyone in the industry is using the same faulty depreciation estimation methods, then comparability is preserved between the companies. We can see which stand out and which fall behind
What is the conservative method to expense recognition?
The conservative method is where we recognise or make decisions where a greater value is written off the worth of an asset in its earlier years. For example, when forming a financial statement the accelerated method of depreciation would be a means of implementing the conservative method
What is the formula for the accelerated method of calculating depreciation?
Calculate the straight line rate, then double it. For each of the remaining years re-calculate the straight line rate with the value in the previous year as the starting value. Double it again. Continue until the value goes below salvage value, and simply take this as the value for all remaining periods
Why might low salvage values be a problem when recognising depreciation?
If the salvage value is too low the asset may never fully depreciate, if the double declining (accelerated) method is used. For this reason, a hybrid method of depreciation is used whereby double declining is used for the first half of the asset’s life and straight-line during the second
How is depreciation recorded for tax purposes?
There is a specific formula for depreciation specified by the tax code for every different kind of asset
When comparing two companies with different methods of recognising depreciation how might net income be affected?
Companies with different methods of recognising depreciation will have different net incomes, all else being equal. A company using straight line depreciation, for example, will have higher net income in the early years of purchasing its assets and lower net income in the later years. A company using double declining depreciation will have higher net income in the later years of purchasing its assets. This is because the double declining method entails faster initial depreciation and slower later depreciation of assets
How is amortisation recognised?
Usually through the straight line method. For assets with indefinite lives, i.e., goodwill, there is no amortisation, but the value is tested annually for impairment
How are non-operating items reported on the income statement?
After we take gross profit and remove operating expenses, we arrive at operating income. After this line we will find non-operating gains/income, and non-operating losses/ expenses, which are reported discretely
What might non-operating income consist of?
Typically amounts earned through investing and financing activities
What might non-operating losses consist of?
Typically, interest expense
How do we standardise an income statement for comparability?
We use common size analysis. We take sales as 100%, and then COGS, gross profit (sales - COGS), R&D, Advertising, Operating profit (sales less these costs) are expressed as percentages too. Taxes are shown separately. This creates comparability when looking at COGS for example across years and companies very quickly
What dooes gross profit margin tell us?
- How effective a company is purchasing at the best prices
- How efficient they are at the manufacturing process (absorption costing)
- Margins shrinking over time indicate increased competitive pressure, driving prices down and causing margin compression
What does operating profit margin tell us?
- Effectiveness at running the business (independent of purchasing and manufacturing)
- Larger operating profit margins indicate a larger company that benefits from economies of scale. A large company is able to buy and act in bulk which helps it save money in operations
What does net income margin tell us?
Overall effectiveness of a company at making money
What is Other Comprehensive Income?
An item added to the comprehensive income statement on top of income to create total comprehensive income. It will include thinks like foreign currency translation adjustments, and unrealised gains and losses on certain financial assets, along with a few other things not part of CFA level 1. These changes are not really income so cannot be counted as such as part of the main income statement, but do have an effect on equity, and so therefore must be accounted for separately within the other comprehensive income category
What is the definition of an asset?
A resource owned by a company as a result of past events. Future economic benefits must be expected to flow from the resource. If no benefits are expected to flow in future it cannot be counted as an asset. The item must have a cost or value that can be measured reliably
What is the definition of a liability?
What a company owes. An obligation ofa company as a result of past events. Future outflows of economic benefits must be expected. Thus if there are no longer future outflows of economic benefits expected the item cannot be counted as a liability any longer. The item must have a cost or value that can be measured reliably
Is equity equivalent to market value?
No! Equity must equal assets less liabilities, hence the name “balance sheet”. Equity is equivalent to book value, which is not the same as market value, or is it the same as intrinsic value
What are the limitations of a balance sheet?
- A balance sheet is a snapshot of a point in time, even though the true balances change each day, The snapshot is only available periodically.
- BS mixes cost and values of items (historical cost, adjusted historical cost, and fair value at a point in time). It is therefore a mixed model with respect to measurement
- Some aspects of a company’s ability to generate future cash flows are not included on the US (Income Statement and Cashflow Statement are far more useful for valuation)
What are the uses of a balance sheet?
A balance sheet is best used to assess the ability of a company meet short term liabilities (liquidity) and its solvency. If equity is greater than zero this indicates solvency. If equity is less than zero the company can be considered INSOLVENT
What is the distinction between current and non current on a balance sheet?
Under GAAP, assets and liabilities are sorted into current and non current. Current means that the asset is expected to be sold, used up, or converted to cash over an operating cycle (unless a longer one is justified). For a liability current means it is expected to be SETTLED within the current cycle. Non-current assets represent the infrastructure from which the company operates, and is not expected to be used, sold up ort converted to cash within on year. Non-current liabilities are all thsoe not expected to be settled in one operating cycle
What is working capital?
Current assets less current liabilities. Working capital measures the ability of a company to meet liabilities as they fall due
Why might banks not follow a current/non-current division of assets and liabilities as required under GAAP?
If the company uses IFRS accounting in its financial statement it may list assets and liabilities in order of liquidity without the current/non current assets divisoin. However, it is not required to do this by IFRS either. It will only do this if it feels this is the best choice for reflecting the operations in the most relevant or informative way. Typically banks may do this
What are the different items that could be counted as current assets?
- Cash
- Cash equivalents (short term investments made for less than 90 days, typically US T-bills that mature in less than 90 days which are quoted at discount (i.e., 99.25) and mature at par value i.e. 100 after 90 days). Note these must be reported at fair value (exit price not entry price)
- Marketable securiites. i.e., equity and debt securities that TRADE in public markets
- Trade receivables: amounts owed to a company by its customers for g/s already delivered. You have to estimate bad debts i.e., people that won’t pay you and take this off. This is known as reporting at NET REALISABLE VALUE
How do you calculate trade receivables?
Amounts owed to a company by customers for g/s ALREADY DELIVERED less allowance for default accounts (customers that you think won’t pay you). The allowance for default accounts is known as a “contra” account. The amount for allowance was reported in the notes
What factors affect percentage of trade receivables uncollectible?
- Changes in credit terms
- Changes in risk management policies
- Quality of customers
- Changes in estimates
What important factors that affect trade receivables are reported in the notes?
- Allowance for bad debts
- Length of time a receivable has been outstanding
- Concentration of credit crisk: all the customers that owe it money in terms of % of accounts receivable it represents.
How are bad debt recorded on the balance sheet?
The allowance for bad debt is netted against the asset accounts receivable (because it is a contra asset account). Let’s say that we have an allowance of $1500 for bad debt and an account of $500 decides it’s not paying. However all other accounts pay. We would reduce the accounts receivable by $500 based on the non payment, AND reduce the allowance for doubtful accounts (DA) by $500. We DO NOT increase the allowance by $500 because we have already given the allowance
What factors might affect a company’s allowance for doubtful accounts?
- Improvement in credit quality of the company’s existing customers
- Improvement in the overall economy
- Stricter credit policies, i.e. refusing less creditworthy customers or asking for additional financial backing
- Stricter risk management (i.e., buying more insurance for non paying customers)
What items count as current liabilities?
- Trade payables: owed to vendors for the purchase of goods & services
- Bank loans, notes payable, and current portion of long term debt (this means the portion of debt the entity expects to pay within that operating cycle)
- Accrued expenses. These are different from payables. Payables are directly owed for taking g/s from a seller. Accrued expenses are expected to be incurred within the operating cycle but have not yet been paid, i.e., wages
- Deferred income or unearned revenue. This is payment for g/s received before delivery is made. This applies to subscriptions particularly. Costco may charge a yearly subscription but the revenue earned by buying 1Y subscription may actually contractually entail access to the warehouse beyond the current operating cycle (say, one quarter). Thus, it is deferred to the relevant cycle
What is PPE?
Property plant and equipment. This is a non-current asset. Under GAAP or IFRS we can record it via the cost model.
- This entails taking the purchase price, including delivering and installation (i.e., the historical cost).
- We then less accumulated depreciation, except for when it comes to land (which doesn’t depreciate)
- We take off impairment when the recoverable amount is less than the carrying value. The loss then goes on the income statement. Under IFRS this is reversible, under GAAP it is not. Recoverable amount is the higher of (fair value less costs to sell) or (value in use). If the higher of the two is still less than the carrying value, then you have an impairment
What is investment property under IFRS?
It is a kind of property which is non-operating (not used for company operations, but perhaps is simply rented out for income).
This is a category of non-current assets, and is unique to IFRS
You can use either the cost model or fair value, but you have to use fair value across the whole class (not just those that are going up in value!)
Changes in value from period to period show up as a gain or loss on the income statement
What are deferred tax assets?
A non-current asset on the balance sheet.
Deferred tax assets are recorded when income tax payable for tax purposes is more than income tax expense for reporting expenses
Sometimes tax payable for tax purposes is higher, sometimes lower, in the long run they smooth out
We use deferred tax assets to record the temporary difference
What are the components of shareholder’s equity?
- Capital contributed by owners
- Preferred shares
- Treasury shares
How is capital contributed by owners recorded?
There are two sub accounts, par value and paid in capital. If common stock has no par value then there will just be one number of no par value.
Let’s say a company has decided the par value of the common stock is $1. If it sells 1m shares for a total of $10m, then there will be $1m in the par value acount ad $9m in the paid-in capital account for a total of $10m
The number of shares authorised, issued, and outstanding listed as well.
- Authorised = shares the company is allowed to sell
- Issued = shares the company has sold
- outstanding = shares issued and repurchased (which counts as treasury stock for the company), but not cancelled
What two forms can preferred shares take?
Based on their characteristics, preferred shares can be classified eiher as equity or debt.
- They will be classified as equity if perpetual and non-redeemable
They will be classified as debt if they have a mandatory redemption requirement, at a fixed amount, at a future date
What are treasury shares?
Shares that have been repurchased by the comapny, but not cancelled.
- If they were cancelled the value of the remaining stock would increase by the appropriate amount
- Treasury shares may be resold. However, if they are resold they just affect the par value and the paid-in capital. Proceeds from the sale do not create a gain or loss.
- Shares may be repurchased if the company feels the shares are undervalued, to fulfil options, or to limit dilution from a convertible security
- Treasury shares do not have voting rights, and there are no dividends.
- Treasury shares are called a contra-equity account. It reduces shareholder’s equity by the dollar amount of the repurchase
What are retained earnings?
Counts the cumulative amount of earnings the company generated not paid to owners.
What is accumulated other comprehensive income?
AOCI is gains or losses not recognised in the income statement historically plus any OCI generated during the year
What is non-controlling interest?
Also known as minority interest. This is the equity interest of minority shareholders in a subsidiary of a company that have been consolidated into the balance sheet but not wholly owned. A parent which owns >50% of a subsidiary report 100% of the liability but not 100% of the equity. Thus non-controlling interest is added to the equity section to make the balance sheet balance.
How can we determine from a balance sheet the history of acquisitions by a company?
If there is goodwill and no minority interest it would mean the company has bought other entities in the past, but has bought 100% of those entities. Is there is no goodwill or minority interest, it means it has never made an acquisition. If there is goodwill and minority interest, it means the company has bought other entities in the past, and has not bought 100% of those entities
What does a cashflow statement do?
It converts the accrual-based income statement to a cash-based statement. It provides a reconciliation between beginning and ending cash balances.
What are the 3 sections of a CFS?
- Cash flow from operations (CFO). Day to day activities.
- Cash flow from investing (CFI). Purchase or sale of long term assets and other investors.
- Cash flow from financing (CFF). Obtaining and repaying capital from shareholders and creditors.
What could constitute inflows and outflows for CFO?
Inflows:
- Increase in liabilities (if you borrow money
- Decrease in assets (accounts receivable becomes cash when your customer pays)
- Cash sales (including sales of dealing or trading securities if this is the primary activity of your business)
Outflows:
- Decreases in liabilities
- Increases in assets
- Cash payments for expenses (including purchases of dealing/trading securities if this is the primary activity of your business
What counts as a long term asset for CFI purposes on the cashflow statement?
Property Plant and Equipment
Intangible assets
Long term and short term investments in equity or debt
- (however, this excludes cash equivalents. It also excludes dealing and trading securities if this is the primary activity of your business)
Why might a loss be recorded on the balance sheet but not on the cashdlow statement?
If an asset i.e., equipment is sold for less than expected. There is a loss, because the asset was valued at more than it was sold for. However, it is a non-cash loss. Therefore it does not show up on the cashflow statement. Only the gain in cash from the proceeds of the sale would show up. This is because the cashflow statement is a cash-based statement and not accrual-based unlike the balance sheet
How are non-cash financing and investing activities reported on the CFS?
Simple rule: if no cash was involved there is no reporting on the CFS.
Barter is not recorded, dividends paid as stock is not recorded, conversion of convertible securities is not recorded
If significant any non cash transaction is required to be disclosed in the CFS notes
What are the two formats for reporting CFO on a CFS?
- Direct method.
- Convert revenue from accrual to cash
- Convert COGS from accrual to cash
- Continue for every item. Hence why it’s called the direct method.
- By the time you get to net income on the IS, you’re done
Pro: provides information on the specific sources of operating cash receipts and payments
- Indirect method
- STARTS with net income
- Adjust NI for non cash items, non operating items, and changes in working capital accounts from accrual accounting
Pro: Uses changes in the accounts on the balance sheet. Is therefore easier to see. You can reconstruct the CFS from the balance sheet. Is therefore easier for many to see
Both result in the same CFO number, but the presentation differs
The presentation of CFI and CFF are the same under both IFRS and GAAP regardless of how CFO is presented
How do you identify the format of a CFS?
On an indirect CFS the first line will be net income
On a direct CFS the first line will be cash provided by operations or cash collected from customers (or similar)
What are the differences between how IFRS and US GAAP classify cash flows?
For the most part companies will elect to classify interest received, paid, and dividends received as operating, and dividends paid as financing activity under IFRS. However, they can elect to choose either operating or investing/financing. Under US GAAP this pattern of classification is mandatory.
However they differ on bank overdrafts. IFRS considers an overdraft to be a cash equivalent (so your cash goes negative). US GAAP considers bank overdrafts to be classified as financing.
Taxes paid are always classified as operating by US GAAP. They are GENERALLY classified as operating under IFRS, but a portion can be allocated to investing or financing if it can be specifically identified with these categories of activity. Meaning that if you can separate out tax paid on income from dividends or capital gains etc.. However usually income from investing activities is small compared to ops, and if not the question would be what is the primary activity of the business now. Thus it doesn’t seem to make sense to reclassify as the work needed would have largely IMMATERIAL consequences to the reader (potential lender or investor)
Does US GAAP require a direct or indirect format CFS?
Both are permitted. Direct is encouraged. However, if you provide a direct format CFS you must also provide a “reconciliation of NI from CFO regardless of method used”, which is an indirect format CFS in itself. Therefore US GAAP usually just provide indirect alone anyway.
With IFRS companies have the choice but usually choose to provide indirect to be comparable to US GAAP companies
What are the two types of business relevant for understanding inventores in FSA?
- Companies that buy inventory from others and sell it
These companies primarily just pay for inventory. - Companies that make their own products
These companies must spend on things like:
- Direct labour
- Overhead of manufacturing facilities
- Raw materials
What is a dead cost?
The dead cost is everything it costs to get an item to where it needs to be in your warehouse. This includes price, duties, taxes, insurance, and delivery costs (less discounts and rebates). Once the item gets to the floor of your warehouse you cannot add anything to inventory costs. These are allCOSTS OF PURCHASE
What are conversion costs?
Raw materials, direct labour, indirect labour, direct and indirect manufacturing overhead. These are all PRODUCT COSTS, along with costs of purchase. These conversion costs are most relevant to companies that manufacture their own products (manufacturers). Conversion costs ends when the good lands in the FINISHED GOODS warehouse. All cost absorption ends when the inventory hits the finished goods inventory warehouse floor, whether the company is a manufacturer or simply buys inventory
What are non-inventoriable costs?
- Abnormal costs from material wastage, labour, or wastage of other production inputs
- Storage costs not part of the “normal” production process
- Administrative overhead and selling expenses
All these are known as period costs.
Period costs are only recorded in the income statement!
What is a cost formula?
Inventory valuation method used under IFRS
What is a cost flow assumption?
Inventory valuation method used under GAAP
What are the IFRS/GAAP methods for inventory valuation?
- Specific identification
- Typically used for non interchangeable items
- COGS and ending inventory (EI) reflect actual costs
- Matches physical flow with ACTUAL costs
Con: this doesn’t work well for a high volume business with a wide range of slightly different prices
- FIFO First In First Out
- Oldest units sold first go to COGS
- Newest units end up in inventory
- Intentionally disregards might be the actual flow of goods
- Since prices tend to increase due to inflation over time, the newer units in inventory tend to be higher values and COGS tends to be lower since those oldest units were cheaper - Weighted average cost AVCO
- Costs allocated evenly across all units for sale regardless of when it came into inventory
- COGS + EI -> units valued at average prices - LIFO Last In First Out (GAAP only)
- Direct opposite of FIFO
- Newest units sold first go to COGS
- Oldest units are put to inventory and ending inventory
- This means lower EI vs FIFO and higher COGS
- LIFO companies will have higher asset values and lower gross margins and net income compared to FIFO companies
- LIFO and FIFO are the dominant inventory methods
What is the difference between periodic and perpetual inventory systems?
Periodic involves periodically calculating inventory on hand ie once per week or once per month
Perpetual involves continuously updating the inventory on hand (has become absolutely dominant since computerisation)
Why might it be inappropriate to use a specific identification inventory cost flow method?
In cases where prices of inventory differ but the product is the same the company could manipulate its margins by choosing which inventory to send to customers. They could send the cheapest-bought inventory to customers to increase margins or most expensive inventory to decrease margins (and smooth margin fluctuations)
Why might a company repeatedly change its inventory valuation method?
To chase higher gross profit. However few auditors of any quality would allow that
Why might gross profit differ when total cost of goods avaliable for sale AND revenue from sales are the same for two companies?
It may be because the two companies use different inventory valuation methods, which lead to different recorded cost of sales and ending inventory. It’s important to check what method they use to ensure comparability. Different accounting methods doesn’t mean one company is better run or more profitable than another
What inventory cost flow method results in the lowest gross income? (EBIT or net income)
LIFO will result in lower gross income if unit costs are increasing over time, and FIFO will result in lower gross income if unit costs are decreasing over time. This is because the COGS under LIFO reflects the price of the most recently bought units
Which inventory cost flow method results in highest asset value? (NI, EBIT)
FIFO results in highest asset value if unit costs are increasing, and LIFO results in highest asset value if unit costs are decreasing. This is because FIFO keeps the most recently finished goods in inventory
Why does the average cost inventory cost flow method not reflect replacement value necessarily?
Average cost may reflect earlier lower or higher prices of acquiring inventory, rather than current prices
Why does LIFO result in higher inventory turnover?
When unit cost is increasing LIFO results in higher turnover because the cost of sales increases but the inventory value does not increase as quickly. LIFO would result in lower inventory turnover if unit costs were decreasing, all else being equal
If a company uses LIFO for tax purposes, what inventory cost flow method will they use for reporting?
Companies are required to use the same inventory cost flow method both for tax purposes and external reporting. However, for internal reporting they may use FIFO or AVCO for internal reporting, because it may lead to better pricing decisions
Why might a company elect to use LIFO for tax purposes?
Using LIFO decreases tax incidence when prices are increasing. LIFO results in higher COGS than FIFO, and lower EBT than FIFO, and therefore lower tax expense (as well as lower net income after taxes)
Why might a tech company use FIFO?
When prices are decreasing FIFO will decrease tax incidence. This is because COGS will be higher (goods sold will be costed at earlier, higher prices) and thus Earnings Before Tax will be lower. In the tech industry prices are generally decreasing.
Why would using FIFO for internal reporting lead to better pricing decisions?
The ending inventory when using FIFO will be closer to current replacement cost (since the sold units are costed for COGS at the earlier price levels)
How do you convert between LIFO and FIFO accounting when valuing ending inventory?
For companies that use LIFO, GAAP requires the LIFO reserve to be reported in the notes. This is the difference between reported LIFO inventory carrying amount and the carrying amount if FIFO was used.
FIFO(ending inventory) = LIFO (ending inventory) + LIFO reserve
Typically the LIFO reserve > 0
LIFO reserve is a cumulative balance.
How do you convert between COGS measured under LIFO inventory cost flow method to COGS according to FIFO?
COGS(FIFO) = COGS(LIFO) - (LIFO Reserve End - LIFO Reserve Beginning)
Begin with LIFO reserve from the end of the current period and subtract LIFO reserve from end of last period. The remaining number we then subtract from the LIFO COGS figure. This gives us FIFO COGS.
We do this because COGS is only for this period and we only need LIFO reserve change OVER the period not the total cumulative amount
Why would LIFO reserve increase over time?
- If prices are rising AND
- If quantities being added to inventory are greater or the same as quantities being sold
LIFO reserve can decrease over time with rising prices if quantities being sold are greater than quantities being added to inventory
What would IFRS say about a company reporting unver LIFO?
Trick question! IFRS does not allow reporting under LIFO. Only GAAP does. GAAP requires that companies using LIFO report the LIFO Reserve to allow comparability to FIFO companies through 1-2 easy calculations
What is a LIFO Liquidation?
A LIFO liquidation occurs when the quantity of units sold is greater than quantity of units added to inventory, for a LIFO method reporting company.
A LIFO liquidation is when some of the older units of inventory (called LIFO Layers) are sold
If costs have been increasing over time, and a LIFO liquidation occurs, those units will have very low COGS relative to other items sold.
- This leads to lower gross margins
However, a LIFO Liquidation is a one-time event, and does not reflect sustainable margins.
What indicator can point to a LIFO liquidation?
A decline in LIFO Reserve reported on the financial statement may be evidence of a LIFO liquidation.
However, decreasing prices can cause LIFO Reserve to decrease WITHOUT any LIFO Liquidation
What period does LIFO apply to?
Only the current financial reporting period (e.g., one year).
A company cannot match COGS from 10 years ago to a sale today unless it has run down its inventory beyond inventory accrued in the current period
NOTE: not entirely sure about this
What information would you need to calculate COGS under FIFO for two periods (years)?
If you do not have COGS under the First In First Out inventory cost flow method for those two periods, you would need COGS calculated through the Last In First Out method for those two periods plus the period before. You would take FIFO COGS and subtract the change in LIFO reserve year over year for each one. For the earlier period being calculated you would therefore need the LIFO reserve from the year before to calculate change into that next year
Why would inventory be adjusted even if not sold?
Inventory may be unrecoverable due to spoilage, obsolescence (ie technology), or declines in selling prices (making it unprofitable to sell)
What is Net Realisable Value for inventory?
Realisable value is estimated selling price (in the ordinary course of business), less estimated costs to make the sale, and estimated costs to get inventory into condition for sale.
What does the IFRS say about how to adjust inventory value when it is no longer sellable?
Inventory shall be measured at the lower of cost or net realisable value (NRV)
What happens if the value of inventory drops below the carrying value (value previously recorded on the balance sheet)?
If the value of inventory decreases there needs to be a corresponding cost entry. It can go to one of two places. It can either be charged to COGS, or it can be reported separately.
Often unless the writedown is very signficant and the company doesn’t want to hurt its gross margins, the company will charge it to COGS.
What are two reasons why a company might want to report inventory writedowns separately from COGS?
- If the inventory writedown is very large and unusual the company might not want to affect its gross margins by charging it to COGS
- Including the writedown in inventory as a “less inventory writedown” line makes it easier to modify the value ie if the writedown later turns out to be overstated
What happens if inventory value recovers from a previous write-down?
A reversal is recorded. However, the reveral is limited to the original write-down. It will result in a reduction to COGS under IFRS.
GAAP says that a reversal cannot be recorded. As such, companies using GAAP are less likely to write-down inventory than IFRS companies
How is an inventory write-down recorded according to GAAP?
When using LIFO (or retail inventory methods): the lower of cost or market.
Market value equals current replacement costs. The lower bound is NRV less the normal profit margin. The upper bound is NRV
When using FIFO or AVCO: the method is the same as IFRS, except there are no reversals under GAAP
What are the effects of an inventory writedown?
- Lowers profitability: has a negative effect on profitability, meaning lower retained earnings and shareholder earnings, meaning higher debt to equity, making it look like you’re more highly leveraged. This decreases liquidity and solvency ratios
- Lowers carrying amount of inventory: this therefore has a positive effect on activity ratios, like inventory turnover and asset turnover
What four kinds of business have inventory measured at NRV at all times according to both IFRS and GAAP?
Agriculture
Forest products
Minerals
Commodity brokers
In these cases NRV is defined as full value less costs to sell and complete.
full value equals market value, if active market ecists
Else most recent transaction price is taken
For these businesses changes in inventory are treated as profit and loss in the period of change regardless of whether the movement is up and down.
This is because in these industries the success of the business is closely linked to the value of the commodities at any given time
What are the upper and lower bounds for an IFRS write-down of inventory?
The upper bound is market value (which equals net realisable value)
The lower bound is net realisable value less a normal profit margin.
An IFRS write-down must therefore revalue the inventory as greater than or equal to net realisable value less a normal profit margin, and less than market value.
Under GAAP and IFRS where would a recovery of inventory value be recorded?
For IFRS, on the income statement. Usually, in cost of sales (COGS) both the write-down and recovery are recorded, for both standards.
However, GAAP does not allow recovery of inventory value once written down
Why might an inventory writedown affect US GAAP companies more than European companies?
Under GAAP companies are not allowed to use FIFO, under IFRS they are. Thus US GAAP companies are more likely to use LIFO. Under FIFO a company will charge its higher COGS to sales and have a lower inventory value. Under LIFO a company will charge its lower COGS inventory to sales and have a higher inventory value. LIFO therefore already uses conservatively presented inventory carrying amounts and so is less likely to record write-downs.
Furthermore IFRS companies are allowed to record recovery of inventory value making write downs more palatable and frequently used.
The end effect is that an IFRS company is more likely to perform an inventory write down and a US GAAP company less so.
What are the 8 aspects of the presentation of inventory required to be disclosed?
Under IFRS and GAAP:
- Accounting policy used (FIFO, LIFO, AVCO etc)
- Total carrying amount of inventory, plus any classifications (Raw Materials, Work in Process, Finished Goods Inventory)
- Total amount of inventory carried at (Fair Value less costs to sell)
- COGS
- Any write-downs
- Any reversals (obviously not for GAAP)
- Event that led to the reversal (ditto)
- Carrying amount of inventory pledged as collateral for liabilities
+ for GAAP:
- Any material amount of income resulting from a LIFO liquidation
What are the three critical ratios used for evaluating inventory management?
- Inventory turnover (COGS / avg inventory)
- Days of inventory On Hand (DOH) 365/inventory turnover
- Gross Profit Margin (gross profit/revenue)
2 is a derivative of the inventory turnover ratio so could be eliminated
How would you interpret a high inventory turnover and a low DOH?
- It could be evidence of highly effective inventory management. Having a low inventory at any given time is highly effective working capital management
- It could also evidence inadequate inventory levels (lost sales as a result of not being in stock etc)
- It could even evidence inventory write-downs, through the denominator effect
How would you interpret whether high inventory turnover plus low DOH evidences highly effective inventory management or inadequate inventory levels?
Check inventory turnover, and the sales growth vs the rest of the industry.
- A higher turnover plus slower growth than the mean supports the inadequate inventory thesis
- Few writedowns plus above average growth supports the effective inventory management thesis
What does low inventory turnover plus high DOH versus the industry suggest?
It would indicate the presence of slow moving or obsolete inventory (which was not being sold!)
What would a non-mean gross margin indicate?
Gross margins are affected by competition, type of product sold, and inventory management
- Depressed gross margins indicate intensifying competition. The reverse is true too
- High gross margins could indicate a company focuses only on high margin products (for example, specialist products for which they have a wide economic moat ie ASML, TSMC)
- Above average gross margins could indicate highly effective working capital management
What would high Raw Materials cost plus high Work In Process value indicate?
This may signal rising demand. It will ramp up production thus spend more on inputs
What does high Finished Goods Inventory value plus low Raw Materials value and low Work In Progress value indicate?
This may signal a decrease in demand. The company may lower production (as inventory is piling up) and spend less on inputs
How are assest treated when acquired on the balance sheet?
- Tangible assets are capitalised on the balance sheet at cost
- Intangible assets are capitalised on the balance sheet at cost, IF ACQUIRED. If they have been developed internally we don’t capitalise them on the balance sheet
However there is more to the cost than just the invoice price
What is PPE?
Property, Plant and Equipment. This pretty much covers every tangible asset that the company would have. It is therefore usually the highest value item on the balance sheet.
How is the value of PPE recorded when acquired?
If PPE has been acquired through exchange it is recorded at Fair Value (the Fair Value of the asset given up in exchange). This applies unless the Fair Value of the ASSET ACQUIRED is more evident.
If there is no Fair Value, then use the carrying amount of the asset given up
If the PPE is acquired through purchase, it is recorded at cost plus all expenses necessary to get the asset ready for its indended use.
Subsequent costs are included as part of the carrying cost of the asset, IF the asset is expected to provide benefits beyond one year. Otherwise, they are expensed
In short, when PPE is acquired through purchase, if it is expected to provide benefits for more than 1yr, it is capitalised; it is expensed if not.
Let’s say that a company acquires a new maching. They spend £10k on the purchase price including taxes, £200 on delivery, £400 for installation and testing, and £500 to train staff on maintaining the machine. They also spend £900 to reinforce the factory floor to accomodate the machine’s weight, and £2000 to repair the factory roof (extending life by 5yrs) and £1000 to paint the exterior of the factory and offices for maintenance reasons (does not extend use or improve usability).
Total: £15 000 cash outflows
Which expenditures will be capitalised and which will be expensed?
These will be capitalised:
£10k purchase price incl taxes
£200 on delivery
£400 on installation and testing
£900 to accomodate the weight of the machine
£2000 to repair factory roof (not related to machine but is extending life of an existing asset)
Total: £13500 capitalised
These will be expensed:
£500 to train staff on maintenance of machine (not related to INSTALLATION of the machine)
£1000 on painting (does NOT extend useful life of the factory or offices)
Total: £1500 expensed
Grand total: £15 000 cash outflows
How is PPE recorded when gained through construction?
All costs of construction PLUS borrowing costs.
Note that IFRS states that if interest is earned on borrowed finds, this lowers the cost of borrowing (ie if you borrow £100k at a 5% interest rate but earn 2% interest on the balance before you spend it this counts again cost of borrowing rather than counting as a profit).
In GAAP the 2% would be recorded as income on the income statement
If the company is in the business of constructing PPE to sell (ie a householder), constructing PPE is equivalent to adding goods to inventory. However this only applies to PPE construction costs THAT CAN BE CAPITALISED.
Interest expenses are therefore recorded on inventory. Then when the sale is made they move to COGS on the income statement.
If the company is constructing PPE to use, interest is recorded as part of PPE. Then it is recorded as depreciation on the income statement/
This also only applies for PPE construction that can be capitalised.
In both cases interest paid is recorded as a cash outflow within the investing section.
How do US GAAP and IFRS differ when it comes to recording the cost of PPE construction?
If the PPE construction involves borrowing, then any interest earned on the borrowed amount by the borrower (borrowing company) will be counted AGAINST the interest paid on the loan according to IFRS. The amount capitalised on the balance sheet will therefore be lowered by the difference between interest paid and interest earned on the borrowed amount.
Under GAAP, interest earned on the borrowed amount is NOT counted against interest paid on the loan, and the full amount is therefore capitalised. This results in a higher balance on the balance sheet. The interest earned is recorded on the income statement as INCOME, therefore raising income.
As such the effect of this practical divergence will be significant when interest rates are high, and insignificant when low
What are the different effects on the FS of a company of capitalising PPE versus expensing PPE-related expenses?
When capitalised the outflows will:
- Increase the amount of non current assets
- Reduce Cash Flow for Investors
When expensed the outflows will:
- Decrease current assets
- Have a negative effect on Net Income
- Have a negative effect on Retained Earnings
- Have a negative effect on Equity
The readings like to say that expensing decreases net income, retained earnings, and equity. However, MM likes to simply say that it has a negative effect. This is because NI, retained income and equity can be rising (due to increased sales for example) even whilst large amounts are being expensed.
How do IFRS and GAAP record depreciation of long-lived assets?
Both IFRS and GAAP use the cost model. This means that the capitalised COSTS of long-lived assets and intangible assets with finite useful lives are allocated to subsequent periods.
- Depreciation applies to tangible assets
- Amortisation applies to intangible assets
What is carrying cost?
Carrying cost is equivalent to historical cost less accumulated depreciation/amortisation.
Carrying cost applies to long-lived assets, like PPE
What is one difference between IFRS and GAAP when it comes to reporting the value of long-lived assets?
Under IFRS a company may use the REVALUATION MODEL to value assets. This means that long-lived assets can be reported at FAIR VALUE rather than under the cost model
What are the different methods for recording depreciation of long-lived assets?
- Straight line.
Depreciation = (original cost - salvage value) / useful life - Accelerated depreciation
E.g. double declining:
Depreciation = 2 x (original cost, or value in last period - salvage value) / useful life - Units of Production. Based on proportion of production during a period (i.e. number of units produced) versus productive capacity over useful lifetime.
Depreciation expense = Depreciable Cost x (Period Production / Capacity)
How is deprecation recorded for tax purposes?
Some countries require that depreciation is recorded in the same way for both tax and reporting purposes.
However, other countries do not have this requirement. This can give rise to a deferred tax expense.
What assumptions and estimates are required to calculate deferred taxes?
- Knowledge of the depreciation method
- Knowledge of the useful like
- Knowledge of the salvage value
IFRS requires annual review of the estimates
What is the component method of depreciation?
A depreciation method REQUIRED under IFRS, and ALLOWED (but rarely used) under GAAP.
This is where each component is depreciated separately.
I.e., some moving parts which have shorter lives have to be depreciated more steeply.
Non-moving parts with longer lives might be depreciated more slowly than the aggregate depreciation.
What is impairment?
Impairment is an unanticipated decline in the value of an asset.
IFRS and GAAP both require a write down of the carrying amount.
ONLY IFRS allows a reversal of an impairment write-down.
How does a company ascertain when impairment of PPE has occured?
When it comes to PPE, an assessment of INDICATIONS of impairment is required during every reporting period (ie annually).
If there are no indications, then no test of impairment will be carried out.
If there is a positive indication of impairment, then the recoverable amount should be measured.
PPE is considered impaired if the carrying amount is determined to be greater than the recoverable amount.
What is the effect of positively determining that impairment of PPE has occurred?
- The carrying value of the PPE asset will decrease
- The impairment charge will subsequently reduce net income
- There is NO EFFECT on cash flows, since impairment is a NON-CASH charge
What models of long-lived asset value reporting typically subject PPE to the option of declaring impairment?
Typically the cost model of reporting.
Under the component model of reporting assets are declared at fair value, and so value is periodically reassessed. Value can decline WITHOUT reporting impairment OR declaring depreciation.
How do you determine recoverable amount for PPE when you have determined that impairment has occured under IFRS?
The recoverable amount will be the higher of:
- Fair Value less costs to sell
- Value-In-Use (which equals the present value of expected cash flows)
How do you assess recoverability under GAAP?
If the carrying amount is greater than the UNDISCOUNTED future cash flows (ie just the sum of future cash flows), then the asset is considered impaired.
The impairment charge is just the carrying amount, less the fair value.
Unlike IFRS, you do NOT remove costs to sell
How are intangible long-lived assets treated?
If they are intangibles with a finite life, they are treated the SAME as PPE.
If they are intangible assets with an indefinite life, they MUST be tested annually for impairment (not just look for indications)
How is a long-lived asset that is expected to be sold treated?
If the intent is to sell the asset, AND the sale is highly probable, then the asset is reclassified as HELD-FOR-SALE
When the asset is reclassified as held-for-sale, it is tested for impairment (not just checked for indications)
What reversals of impairment of long-lived assets are allowed and what amounts?
IFRS allows reversals of impairment, EVEN if held for sale, but ONLY to the extent of the original impairment charge.
GAAP DOES NOT permit reversals when the long-lived asset is held-for-use.
HOWEVER, GAAP DOES allow reverals if the asset is held-for-SALE
What is derecognition?
When an asset is disposed of or not expected to provide any future benefits. If the asset is not expected to provide any future benefits, then it is NO LONGER an asset.
Thus it is removed from FINANCIAL STATEMENTS.
How is the disposal of a long lived asset via sale recorded on the financial statement, and where does it show up?
- The gain or loss on disposal is recorded on the income statement
- The sales process are shown on the cash flow to investors
- The carrying cost is shown on the balance sheet
Gain or loss on disposal = sales proceeds - carrying cost
How is an asset derecognition recorded when it is disposed of through means other than sale?
If the asset is disposed of through means other than sale, it is reclassified as “held-for-use until disposal” and continues to be depreciated, until it is disposed of.
Retired or abandoned (can apply to a patent):
- The total assets are reduced by the carrying amount.
- A loss is recorded on the income statement
Exchange:
- Recorded at the fair value of the asset GIVEN UP
- Unless the fair value of the asset acquired is MORE EVIDENT
Spun-off:
- If a unit of the company is separated into a new entity
- In this case, the shareholders receive PROPORTIONAL shares
- All assets of the new entity are removed from the balance sheet of the parent
What long-lived assets are subject to amortisation?
- Long lived assets
- With definite lives.
This might include:
- Acquired customer list
- Acquired patent/copyright with a specific expiration date
- Acquired licence with a specific expiration date and no right to renew
The acceptable methods for dealing with amortisation are exactly THE SAME as for depreciation
What numbers do we need to properly record amortisation on the balance sheet?
- Original cost
- Useful life
- Salvage value
We also need to know/choose an amoritsation method
What is the revaluation model?
- IFRS only
- List the carrying amount of the long lived asset at fair value
- Therefore carrying amounts = FV at date of revaluation less any subsequent depreciation or amortisation
We depreciate/amortise the asset because we have to get the cost paid for the asset to the income statement over a period of time (even if we use fair value)
Revaluation may result in both decreases and increases in value (beyond historical cost)
- Can be used only if FV can be measured reliably
- Can be used for some classes of assets along with the cost model for others, but most be applied to all assets within that class.
Overall, revaluation is rarely used
What happens when according to the revaluation model a long-lived asset goes below or above initial cost?
Revaluation below cost leads to a loss on the Income Statement
- If cost recovers, a reversal may be recorded up to the initial cost only.
- This is recorded as a gain on the Income Statement
- Any excess above cost upon revaluation goes to the “Revaluation Surplus” account in equity.
- On the Income Statement, it is recorded as part of Other Comprehensive Income
When there is simply a revaluation above cost, it flows to OCI and is also recorded in the Revaluation Surplus account on the balance sheet under equity.
- Any reversals after this will lead to the Revaluation Surplus being reduced first
- Any further losses once the Revaluation Surplus is 0 leads to a loss on the Income Statement
What are the impacts of revaluations of long lived assets?
Upward revaluations (greater than initial cost) lead to increased assets and equity
- This leads to a reduced leverage ratio
- This is because the leverage ratio equals average total assets over average shareholder equity
- Assets equal liabilities plus equity, so assets are typically greater than equity alone
- Thus the leverage ratio is always above 1
- Upward revaluations therefore bring the leverage ratio TOWARDS 1, because you are adding an equal amount to the numerator and denominator
Downward revaluations (below initial cost) lead to decreased assets and equity
- They reduce profitability (return on assets, return on equity) in the year of revaluation
- This is because return on assets is ( net income / total assets).
- Net Income tends to be much smaller than total assets, so removing an equal amount from the numerator and denominator will bring return on assets further away from 1
- HOWEVER, you have a lower base of assets and equity going forward, so all else being equal if net income remains the same it will look like you have a boost to ROA and ROE in the subsequent years
What causes an upward revaluation of a long-lived asset under the IFRS revaluation model?
- Increased operating capacity or
- Increased cash flow potential
Likewise, in the inverse, downward revaluation of a long-lived asset is typically caused by DECREASED operating capacity or decreased cash flow potential
Assets are worth the present value of all future cash flows. If something happens to an asset that increases capacity for production or allows it to generate even more cash flow this will change its value.
a. What would the effect of a revaluation of a shoemaking machine owned by an IFRS-compliant shoe production company in the next period after it was bought, from £100,000 to £120,000 be?
b. If in the next period after, if the machine was revalued at £90,000, what would the effect be?
a. The revaluation would increase total assets for the company under the property plant and equipment line on the balance sheet.
- Thus equity increases on the balance sheet, and will sit under the Revaluation Surplus account
- The £20,000 gain in the value of the shoemaking machine would be recorded on the Income Statement under Other Comprehensive Income
- This would decrease the leverage ratio
b. If the shoemaking machine is then revalued:
- The Revaluation Surplus account in equity on the balance sheet is reduced to 0 first, account for £20,000 of the loss between periods
- This affects only the Balance Sheet
- Then, the last £10,000 is recorded as a loss on the Income Statement
- Since Net Income gets added to equity on the Balance Sheet through Retained Earnings, £10,000 less will be added to Retained Earnings
- This would decrease profitability in the current period (return on assets and return on equity).
- However in subsequent periods there may be a boost to ROA and ROE because there will be a lower asset base (denominator effect)
When an asset is revalued below intial cost and then in the next period revalued ABOVE initial cost, how is the gain recorded on the financial statements?
The downward revaluation:
- Recorded as a loss on the company’s income statement
- The loss on the income statement finds its way to net income
- Net income adds to retained earnings
- Retained earnings is less by the amount equivalent to the loss on the revalued asset
- This results has a negative effect on equity, hence balancing the balancing the balance sheet
The upward valuation up to initial cost:
- Reported as a gain on the income statement
The upward valuation portion beyond initial cost:
- Bypasses profit or loss
- Reported as Other Comprehensive Income
- Accumualted in equity under the heading of Revaluation Surplus
What is investment property?
IFRS defines investment property as property that is owned (or leased under a finance lease) for the purpose of earning rent, capital appreciation, or both.
- The property must not be owner occupied
- The property must not be used for producing other goods and services
GAAP also allows investment property, but does not call it as such.
How is investment property treated by IFRS?
IFRS stipulates that investment property may be valued using the cost model, or the fair value model.
Under the cost model, investment property is treated the same as PPE assets.
Under the fair value model, ALL changes in value impact net income, UNLIKE the revaluation model where any changes ABOVE initial calue ONLY impact other comprehensive income
FV model may only be used if reliable estimstes of FR are attainable continuously
The company must use ONE model for all investment properties
If FV is used, it must continue to be used UNTIL disposition or reclassification, EVEN if FV assessment becomes difficult.
How is an asset treated when reclassified from investment property to owner-occupied or inventory?
If it is valued at cost, there is no change in cost (since this is already the method used!)
If it was valued at fair value as an investment property, the fair value becomes the new carrying cost when reclassified
How is an asset treated when it is reclassified from owner-occupied to investment property?
If investment property is valued according to a fair value model, then the reclassification is treated like a revaluation. When the asset is reclassified, the difference between Fair Value and Carrying Cost is treated like a revaluation. I.e., flows to the appropriate parts of the income statement or balance sheet depending on the carrying cost
How is an asset treated if reclassified from inventory to investment property?
If investment property is valued at Fair Value, the difference between Fair Value and Carrying Cost is recorded as Profit/Loss
- This is because if the asset started as inventory, we are in the business of buyng and selling property. Thus the difference is really part of our profit or loss
Where is investment property found on the balance sheet?
Under IFRS, investment property is treated as a SEPARATE LINE ITEM on the Balance Sheet
- There is also disclosure of whether cost or fair value valuation model is used, how it is determined, and a reconciliation of beginning and ending values
GAAP has no specific definition of investment property
However, GAAP companies CAN STILL HAVE investment properties.
They just use the cost model to value them.
What is the tax base?
The amount attributed to the asset or liability for tax purposes (i.e., the balance sheet that we would see for tax purposes)
In the case of assets: the tax base is the amount that will be deductible for tax purposes in future periods
In the case of liabilities: the tax base is the carrying amount of the liability, less any amounts that will be deductible for tax purposes, i.e., amounts that will NOT be taxed in the future.
I.e., for accounting purposes we categorise unearned revenue as a liability. For tax purposes we cannot, because the money has not actually been earned in that period. Therefore we do not include it in the tax base
What is a deferred tax liability?
Accounting for FS purposes and accounting for tax purposes differ, thus the taxable assets and liabilities (tax base) can differ from the reported amounts in the FS.
A deferred tax liability (DTL) is where tax is expected to be owed in a future period but is not payable in the current period. So for example, if we have signed contracts to receive revenue in a future period, we might report this as unearned revenue on the FS under assets. However, for tax purposes this amount is not part of the tax base because it has not been received yet. We know that we will have to pay tax on this future inflow in a later period. Thus the deferred tax liability will be the temporary difference between the carrying amount on the FS and the tax base, multiplied by the tax rate.
What is a deferred tax asset (DTA)?
When tax that pertains to activity in future periods according to the matching principle employed on the FS is paid in the current period.
How do we determine whether there is a DTA or DTL?
If the tax base is greater than the carrying amount, a Deferred Tax Asset is created.
If the tax base is less than the carrying amount, a Deferred Tax Liability is created.
What iss the impact of a DTL?
A DTL results in lower taxable income, because the tax expense (according to the matching principle) is greater than the tax paid. Tax Payable is less than Income Tax Expenditure.
An increase in DTL results in an increase in total liabilities.
SInce Income Tax Expense = Tax Payable + Change in Deferred Tax Liabilities:
Increase in DTL leads to lower Net Income, lower Retained Earnings, and lower equity
Decrease in DTL leads to higher Net Income, higher Retained Earnings, and higher equity
What is the impact when a DTA arises?
DTA arising causes higher taxable income, because tax expense is less than tax paid. Tax Payable is greater than Income Tax Expenditure.
An increaase in DTA increases total assets.
Since ITE = TP - change in DTA:
Increase in DTA increases net income, retained earnings, and equity
Decrease in DTA decreases net income, retained earnings, and equity
What happens if a tax rate increases to DTA and DTL?
DTA and DTL increase if tax rate increases. It increases the tax multiple
What happens to tax payments implied by DTL when tax rate decreases?
Tax payments lower
What happens to future tax benefits when DTA decreases?
Future tax benefits are reduced
What happens if DTA > DTL?
This means there are net tax assets. This means the BS benefits if the tax rate increases
What happens if DTL > DTA?
This means there are net tax liabilities/ This means the income statement benefits if the tax rate increases.
Would a business prefer DTA > DTL or DTA < DTL?
A business will prefer to defer tax payments if it expects tax rates to drop in future, and prefer to pay tax in advance if it expects tax rates to increase in future.
When DTA > DTL there are net tax assets. This is preferable when the business expects the tax rate to increase.
When DTL > DTA there are net tax liabilities. This is preferable when the business expects the tax rate to decrease.
What is the effect of net tax assets and net tax liabilities on the IS and BS?
The Income Statement benefits regardless of net tax assets or net tax liabilities, when the tax rate drops. Thus from an IS perspective it is agnostic to net tax assets or liabilities and benefits primarily and most significantly from lower tax rates. Thus ultimately a business will always want lower tax rates.
The Balance Sheet benefits from net tax assets when taxes go up, and benefits from net tax liabilities when taxes go down.
As such there is a double benefit (to both IS and BS) when taxes go down and the company has net tax liabilities.
What is the formula for determining Income Tax Expense?
ITE = Tax Payable + change in Deferred Tax Liabilities - change in Deferred Tax Assets
What happens if tax rates increase to liabilities, assets, income tax expense, and equity?
If there is a net deferred tax liability:
- Liabilities increase
- Income tax expenses increase
- Equity decreases
If there is a net deferred tax asset:
- Assets increase
- Income tax expenses decrease
- Equity increases
What happens if tax rates decrease to liabilities, assets, income tax expense, and equity?
If there is a deferred tax liability:
- Liabilities decrease
- Income tax expenditure decreases
- Equity increases
If there is a deferred tax asset:
- Assets decrease
- Income tax expenditure increases
- Equity decreases
What is a temporary difference of recognition when it comes to income taxes?
A temporary difference of recognition is when the carrying amount is not equal to the tax base for an asset of liability. However, this difference does not remain over the life of the asset or liability.
For example, let’s say that a company buys some new energy efficient equipment for $50,000, but uses a $10,000 government grant in order to purchase it. The company will record the value of the asset at $42,000, because this is the amount paid for it. However, for tax purposes the value (tax base) will be $50,000, because this is the value of the expense which can be counted against profits when paying tax.
This difference is still temporary because both the carrying value and tax base will depreciate to zero.
In the case of a temporary difference of recognition, a company cannot record a deferred tax asset or deferred tax liability.
What is an unused tax lost or unused tax credit?
If a company reports a loss in one period it can carry forward this loss to successive periods to lower its tax exposure.
If a company loses £1m in Year 1, and £2m in Year 2, but earns £3m in Year 3, it could count its losses in Y1 and Y2 against earnings on Y3.
In this case (-1-2+3) = 0, so the company would pay no taxes.
In some jurisdictions, the carry forward period is 3 years, in others 7.
What do IFRS and GAAP say about unused tax credits?
IFRS stipulates that unused tax credits may only be recognised to the extent of probable future taxable income
GAAP unused tax credits to be recognised in full, and reduced through a valuation allowance if unlikely to be realised
Do deferred tax liabilties and assets apply to revaluations?
No!
If an asset is revalued above its original undepreciated/amortised carrying amount, the proportion that exceeds the original value is not part of deferred tax liability or asset calculations.
You can calculate the amount you need to remove from an incorrectly calculated DTA /DTL by multiplying the tax rate by the revaluation credit and subtracting this from the sum
How are DTA and DTL accounted for when determining book value?
DTA and DTL are not subject to discounting to ascertain present value (even though they are expected to be earned/paid at some future date)
Under IFRS:
All DTA and DTL balances must be evaluated at each balance sheet date to ensure that they will be recovered.
The balance is then reduced directly to its recoverable amount
Under GAAP:
DTAs are reduced through a contra-asset account called “valuation allowance”.
An increase in valuation allowance reduces DTA, increases ITE, and results in lower NI, retained earnings, and shareholder equity.
If conditions changed, previous reductions can be reversed under GAAP
What does it mean for a bond to be issued at par?
This means the bond is issued with a coupon equal to the market rate. By contrast, a bond can also be issued at a discount (coupon less than market rate) or at a premium (coupon greater than market rate).
The market rate at the time of issuance is defined as the “effective interest rate”: the borrowing rate that is the basis of the company’s interest expense.
So in other words when a bond is issued at par, its coupon is equivalent to the company’s borrowing rate on its loans.
How are proceeds from bond issuance categorised?
Proceeds from bond issuance are categorised as a cash inflow on the income statement within Cash Flow from Financing. However the amount recorded is not the total face value of the bonds but the amount actually raised. Thus if the amount actually raised is 90m USD but the face value of all the bonds sold is 100m USD, it is the 90m USD that is recorded.
How is interest expense on bonds recorded?
Interest expense recorded equals the coupon payment plus the amortisation of the discount (if issued at a discount) or minus the amortisation of the discount (if issued at a premium). Interest expense is therefore not solely the interest rate on the bond.
Thus note that if a bond is issued at a premium the interest expense will be lower than the coupon payment!
How is the price of a corporate bond determined after initial sale?
Matrix pricing is often used to determine price because corporate bonds are rarely traded after initial sale, with the majority of investors adopting a buy and hold strategy
What are the two methods of amortising a bond premium or discount after issue?
- The effective interest rate method (required under IFRS and preferred under GAAP)
This involves determining the interest expense by multiplying the carrying amount by the market rate in effect at issuance
Interest expense = Carrying amount x Market rate in effect at issuance
The interest expense calculated less the coupon equals the amortisation amount.
Interest expense - coupon = amortisation amount
2.The straight line method (an option under GAAP only)
This is where the discount or premium is evenly amortised over the life of the bond.
Amortisation applies rather than depreciation because the discount/premium is a non-cash item. The amortisation is therefore added back to Net Income in Cash Flow from Operations
How does presentation of interest payments on the cash flow statement differ between reporting standards?
In IFRS it can be classed as either an operating or financing outflow.
In GAAP it can only be classed as an operating outflow
Both of these classifications pertain only to the interests payment directly associated with the coupon payments.
How do you calculate amortisation of a bond issued at a discount using effective interest rate method over a timeseries until maturity?
Effective market interest rate is 7%
Coupon is 6%
- Face value minus sale value
- Difference multiplied by 7%
This gives you the interest EXPENSE - Multiply face value by coupon rate
This gives you interest PAYMENT - Interest expense less interest payment
This gives you AMORTISATION of the discount - Add amortisation of the discount to carrying amount at the beginning of the year
This gives you the carrying amount for th end of the year
When the bond reaches maturity carrying amount will equal face value.
What is the difference between interest expense and interest payment for bonds?
Interest expense includes amortisation of the premium or discount at which the bond was issued.
Interest payment is simply the cash outflow from the company attributable to covering the cost of debt
In what situation will interest expense be less than interest payment?
When a company issues a bond at a premium. This will usually occur if it pays a coupon above the effective market rate
In what situation will interest expense be greater than interest payment?
When a company issues a bond at a discount. This will usually occur if it pays a coupon below the effective market rate
What is the fair value reporting option?
A reporting option for companies. This is where non-current liabilities are reported at fair value. It is typically selected by financial institutions.
Under GAAP liabilities can be reported simply through the fair value option
Under IFRS financial liabilities must be designated as financial liabilities at fair value THROUGH profit or loss.
When rates increase companies using the fair value method will report gains, since liabilities will decrease.
When rates decrease, companies using the fair value method will report losses, since liabilities will increase
However, both IFRS and GAAP also require fair value disclosures even if they are not reported on the BS at FV
Why is fair value disclosure of non-current liabilities required even if they are not reported on the balance sheet at fair value?
When rates drop, the carrying value will understate leverage levels.
When rates rise, the carrying value will overstate leverage levels
How do changes in fair value flow to the financial statements?
Changes in fair value due to changing interest rates will flow to the income statement
Changes in fair value due to changing credit quality will flow to Other Comprehensive Income
What is the derecognition of debt?
When debt is taken off the balance sheet, either when the debt is paid off (ie a bond reaching maturity) or when the company buys the debt back on the open market
What happens when debt is derecognised at maturity?
Bonds payable are reduced to zero
There is a cash outflow equivalent to the face value, which is displayed on Cash Flows for Financing on the CFS
Cash is reduced by the face value
How do we evaluate a company’s past financial performance and explain its strategy using a financial statement?
- Look at levels of and changes in performance measures and critical success factors.
- Check the alignment of strategy and results. I.e., if the goal of the company is to be a luxury or specialist maker (high purchase cost, lower volummes high margin, high marketing and R&D costs) then the volume and margins displayed on the financial statement must reflect that. A low-cost provider would see high volume, low margin.
- Compare across companies and within the company (evolution of all the measures over time)
- Once you have the “what”, adopt the preschooler method and ask “why” for ever metrics.
- The metrics are the “what”, the virtue of a financial analyst uncaptured by software is understanding the “why”. This is the critical skill to develop
What would we expect to see on the financial statement of a technology leader?
- Short product cycles: short lead time between product development and being on the market. This means they are able to adapt rapidly to changes in consumer sentiment, market trends, and emerging technologies they can use as inputs
- High inventory turnover. If they are developing rapidly they don’t want to keep old inventory around for long, they should want to get rid of it
- High R&D costs. Developing cutting edge technology will require lots of R&D spending
How would you forecast a company’s net income and cash flow using the top down approach?
The top down approach involves forecasting sales.
- Begin with the economy’s GDP forecast, X
- Add in the premium (or discount) for the industry’s growth rate, A
Industry growth rate - Determine the company’s growth rate based on market share. The company will either retain, gain, or lose market share. If it retains market share company growth rate will be equal to industry growth rate. If it loses market share it will be lower, if it gains market share it will be higher.
- Estimate income and cash flow.
We can do this either by assuming these will remain at historical levels, or looking for trends in the ratios (gross margin, operating margin) and extrapolating these forward. - Create separate forecasts for expense items, based on some relationship with sales or a stated company strategy
- Forecast cash flows.
Assume the ratio of non-cash working capital to sales remains constant (so increased sales will require increased working capital)
Forecast what we need to reinvest back in the business (capex)
Forecast what our cash flow from financing will be (raising money from issuing equity and/or debt)
What would forecasting the future cashflows of a company help with in terms of managing the company?
Forecasting future cash flows (along with capex, working capital, opex needs etc) can help companies to predict when they will have financing needs. As the company grows the cash generated by operations less all their expenses and taxes may not be nenough to finance their growth. Thus they will take out loans or issue bonds or equity to cover their needs
It can also help a company to determine the sustainability of their business model
How would one assess the credit quality of a company?
There are the 4Cs of credit:
- Character: quality of management
- Capacity: ability to pay
- Collateral: assessing the assets pledged
- Covenants: limitations or restrictions
Capacity is by far the most important.
Character is at the bottom in terms of importance
A company with lower credit risk is one with:
- more revenue sources
- stable or sustainable margins
- higher ratios of Free Cash Flow to Debt, and Free Cash Flow to interest payments
What is screening?
Quickly filtering a set of potential investment into a smaller set that meet certain criteria.
Within this there is also backtesting. Backtesting involves applying the methodology used to select securities to the past and seeing how that set has performed over time
There are limits to screening:
- When screening with ratios for example, they are not adjusted for differences in accounting standards (GAAP vs IFRS)
- Backtesting may not be relevant for future periods. Mark Meldrum thinks that in order to be very good at financial analysis you need to find companies that are emerging; that have a new product that they are able to earn sustainable and healthy margins on. Thus he doesn’t like backtesting
What adjustments might you want to make in order to more accurately compare companies than the screening method would allow?
- Look at investments
Investments can be classified as either “available for sale”, and placed in other comprehensive income, or “trading”, and placed on the income statement. - Look at inventory
- Separate out companes that use the LIFO method from FIFO method, and standardise them to one method - Look at long-lived assets
- Assess methods used to determine values, depreciation, and amortisation. Determine whether the estimates they have given are accurate or reasonable - Look at goodwill
- A company with internal growth will have no goodwill, whereas a company that grows through M&A will have goodwill on its balance sheet
- In order to deal with this just use tangible book value (exclude intangibles). This will create more comparability.
What are the steps in the financial statement analysis framework?
- Determine the context and purpose of the analysis (why are you doing this? Are you assessing an investment, or assigning a credit rating?)
- Collect data.
Look at the financial statements, have discussions with management, and conduct company site visits. - Process data
Look at ratios, growth rates, common size the statements (set everything as ratios i.e. take sales as 100%), and use statistical tools. - Analyse and interpret data. Draw conclusions and recommendations by asking the “why” questions.
- Develop and communicate conclusions. Produce an analyst report. Make sure to separate fact from opinion. Do not state forecasts as fact (use language like “expect” and “anticipate”)
- Follow up.
Update your conclusions regularly as markets change.
What different aspects of the financial ststement will you look at depending on your motivations for financial statement analysis?
If you are assigning a credit rating, you will focus on the cash flow statement
If you are assessing profitability, i.e., as an equity investor, you will be more interested in the ratios foudn on the income statement
When you are assigning credit ratings, you will be interested in processing the data by creating ratios for cash flows versus debt, and interest coverage.
When you are assembling a portfolio of growth stocks, you will be interested in looking at attempting to predict future growth rates
What is the role of financial statement analysis?
To evaluate the PERFORMANCE (1) and financial POSITION (2) of a company for the purpose of making ECONOMIC DECISIONS (3)
- Performance is evidenced by the income statement. We can look at past performance ie 5 years back, as well as current performance. We may be able to also use it to predict potential performance.
- Position is evidenced by the balance sheet.
- The economic decisions made might be
- Investment decisions: making an equity investment for a portfolio. Valuing the underlying value of a company in order to make a recommendation. VC/PE investment
- Credit: deciding wihether to make a loan. Assigning a debt rating
- Other: deciding whether to or performing due diligence on a merger or acquisition
Why are financial statement notes and supplementary information important?
These notes can be extensive: you could get 150+ pages vs 15 pages of primary footnotes.
Pretty much every line of the balance sheet and income statement will have notes.
You will get a footnote on the major accounting policies, which is huge for comparability (different profit for the year can be a result)
Subsequent events can tell you things that happened between the cutoff date (end of period) and the final filing date, which could be quite important (esp given that the end of year statement is unlikely to be released before March/April)
Footnotes also include CONTRACTUAL OBLIGATIONS and OFF-BALANCE SHEET ITEMS. There might be items there that are not on the balance sheet.
The supplementary schedules also include information on business and geographic segment reporting. This discloses key line items by geography and operating segment (what part of the company they refer to). A company which derives 90% of its revenue from a stable but growing segment is good, one which derives 90% from an unstable and shrinking segment not so much. The supplementary schedules help us to separate out the financials for each business line.
What can we find in the management’s commentary on a financial statement?
The management’s commentary is also known as the MD&A. It is included in the 10-K and the 10-Q. It is unaudited (except in Germany), which is important to pay attention to.
The IASB framework for “decision useful management commentary” is as follows:
- The nature of the business
- Management objectives and strategies
- Significant resources, risks, relationships (significant events or uncertainties like prices and inflation)
- Results of operations (including favourable and unfavourable trends)
- Critical performance measures. (often ignoring GAAP standards)
However this is just guidance so not obligatory. Often the management commentary can be useful because it talks about top management strategy, but can also be fictitious
Why should we pay attention to audit reports of financial statements?
The audit reports can give us insight into potential areas where the company may have misstated certain items in the financial statements. They provide us third-party reassurance that the financial statements are likely to be materially correct. The language in the definition of the auditor’s responsibilities is deliberately vague: the auditor’s review is not supposed to provide total reassurance, but rather, give us a clear indication that the majority of the data is correct, insofar as it would substantively impact investment decisions.
An auditor can also in some cases attach comments even when they present the report as unqualified (the financial statement needs no changes to be correct) to highlight areas where certain figures may have involved challenging, subjective, or complex estimations. As a financial analyst we may or may not need to pay attention to these. Subjective estimates of revenue or free cash flow, for example, would be important to an investor. Other items may not be as important
What is IOSCO?
The International Organisation of Securities Commissions. It helps establish universal regulatory standards that help investors to access global capital markets, because finance is global
What are the principles that guide IOSCO?
There are 10 categories of entities which have their own principles.
The FSA reading picks out 2 principles for issuers that relate directly to financial reporting.
- FULL, ACCURATE, and TIMELY disclosure of what RISKS, RESULTS, and other MATERIAL information an investor might want to know.
- Accounting standards used must be of HIGH and INTERNATIONALLY ACCEPTED quality (either IFRS or GAAP)
What is the SEC?
The US regulatory body for publicy listed companies.
It was established in 1933 through the Securities Act to give fundamental rules on the registration process that issuers must go through.
Through the Securities Exchange Act in 1934 it was empowered
Sarbanes-Oxley of 2002 clamped down on the auditors of publicly listed companies to require greater independence, and those companies’ internal controls (in the wake of the WorldCom, Enron, and Tyco scandals)
What SEC filings are required for listed companies?
- Securites offerings registration statement
- The annually submitted 10-K, 20-F, and 40-F forms
- The annual report
- The proxy statement / form the DEF-14A (shareholders must receive a DEF-14A before each shareholder meeting)
- The 10-Q (reports on a quarterly basis) and 6-K (for many non-US companise)
- The 8-K, when there are major material changes between quarterly statements (i.e., an acquisition or disposal)
- Forms 3,4,5, and 144 cover beneficial ownership: ownership by directors, other companies, and anyone over 10%. This can give you information about an income takeover.
- The 11-K form on employee stock compensation (which will give you info about what shares are issues, and what shares will be issued which could have a big impact on diluted EPS)
What are the characteristics of regulatory filings in the EU?
- Some member states regulate their own capital markets, however others regulate at the collective EU level
- Consolidated accounts of EU-listed companies must use IFRS
- Securities are regulated by the European Securities Committee (ESC) and the European Securities and Market Authority (ESMA)
What is the definition of an operating segment?
- Must generate revenue, or at least have expenses
- Discrete data: you must be able to separate data on revenue etc. from this part of the business from other business
- Must make up at least 10% of revenue, assets, OR profit (or losses)
- All reported segments must add up to 75% of external (?) revenue. If they do not, we ignore the prior 10% rule and find more segments until we can make up the 75%.
Financials for each operating segment must be disclosed in the supplementary information with the financial statement. This helps investors better assess risk
What are the four different outcomes of an audit report?
The audit report may either say unmodified (unqualified, clean) or modified.
If it is modified it may be either qualified, adverse, or have “disclaimer” status.
99.99% of audit reports are issued as “unmodified”. If it is modified it will cause market panic so companies will often inform the market in advance.
Qualified means the accounts are mostly okay, but with some issues. I.e., if there is one set of records that cannot be reconciled (a warehouse burns down with one set inside)
Adverse means not okay, there is an issue with more than one set of records, there has been material misstatement (i.e. the company says it has $4bn worth of property, I say it’s work $5). The auditor fundamentally disagrees with the presentation of the financials.
Disclaimer means that the auditor can’t express an opinion (i.e., the company won’t release its records, no matter how long you get the interns to camp outside).
What are the 5 key differences between US GAAP and IFRS?
- US GAAP is based on rules, IFRS is based on principles
- Interest paid to the company is treated as Cash Flows from Operating Activities under US GAAP, but can be classed as either this or Cash Flows from Financing Activities under IFRS
- Inventory valuation can be performed under FIFO, LIFO, or the weighted average method under GAAP. Under IFRS, only FIFO or the weighted average method are allowed
- Development costs are treated as an expense under US GAAP. Under IFRS, they can be capitalised if certain conditions are satisfied.
- Reversal of inventory write-down is prohibited under US GAAP, but permissible under certain conditions in IFRS
New products or types of transactions may not have specific guidance under either, especially under the GAAP rules-based system
IFRS is dominant outside the US and has helped global convergence
What other information sources may be used beyond FS?
- Issuer sources: earnings calls, presentations, press releases
- Public third party: industry whitepapers analyst reports, social media
- Proprietary third-party: Bloomberg/CapitalIQ, analyst reports from banks, industry-specific sources
- Proprietary primary research: surveys, conversations, and product comparisons
Ratios an input into which step in the financial statement analysis framework?
Analyse/interpret the processed data
Which phase in the financial statement analysis framework is most likely to involve producing updated reports and recommendations?
Follow-up
Which of the following best describes the role of financial statement analysis?
A. To provide information about a company’s performance
B. To provide information about a company’s changes in financial position
C. To form expectations about a company’s future performance and financial performance
C. To form expectations about a company’s future performance and financial performance
What is the primary role of FSA best described as?
A. Providing information useful for making investment decisions
B. Evaluating a company for the purpose of making economic decisions
C. Using financial reports prepared by analysts to make economic decisions
B. Evaluating a company for the purpose of making economic decisions
What entity develops the International Finance Reporting Standards?
The International Accounting Standards Board
US GAAP are currently developed by who?
The Financial Accounting Standards Board
A key objective of the International Organisation of Securities Commissions is to:
A. Eliminate systemic risk
B. Protect users of financial statements
C. Ensure that markets are fair, efficient, and transparent
C. Ensure that markets are fair, efficient, and transparent
Which of the following describes most accurately why financial statements notes are required?
A. Permit flexibility in statement preparation
B. Standardise financial reporting across companies
C. Provide information necessary to understand the financial statements
C. Provide information necessary to understand the financial statements
Where are accoutning policies, methods, and estimates used in preparing financial statements more likely to be found?
A. Notes to the financial statements
B. Management commentary
C. Auditor’s report
A. Notes to the financial statements
Where is information about management and director compensation most likely to be found?
A. Auditor’s report
B. Proxy statement
C. Earnings release
B. Proxy statement
Where will a company’s objectives, strategies, and significant risks most likely be found?
A. Notes to the financial statements
B. Auditor’s report
C. Management commentary
C. Management commentary
If an auditor determines that a company’s financial statements are prepared in accordance with applicable accounting standards except with respect to inventory reporting, this is most likely to result in an audit opinion that is:
A. Unqualified
B. Qualified
C. Adverse
B. Qualified
An independent audit report is most likely to provide:
A. A qualified opinion with respect to the transparency of the financial statements
B. Reasonable assurance that the financial statements are fairly presented
C. A qualified opinion with respect to the transparency of the financial statements
B. Reasonable assurance that the financial statements are fairly presented
Interim financial reports released by a company are mostly likely to be:
A. Unqualified
B. Unaudited
C. Monthly
B. Unaudited
Which of the following sources of information is found outside a company’s annual report, but still used by analysts?
A. Management discussion and analysis
B. Auditor’s report
C. Peer company analysis
C. Peer company analysis
What are the five criteria that go into revenue recognition?
Revenue is recognised (i.e., put in the accounts) when earned (when the risks and rewards of ownership are transferred to the consumer)
However, there are five aspects to this definition:
1. Identify contract with the customer
2. Identify separate or distinct performance obligations
3. Determine the fransaction price (and allocate it to separate parts to distinct obligations)
4. Allocate the price to performance obligations
5. Recognise revenue when entity satisfies a performance obligation
When identifying contract with the customer, collectibility has to be probable
- Under IFRS, it has to be more likely than not
- Under US GAAP, it has to be likely to occur
What constitutes satisfaction of a performance obligation?
When the control of the good or service is transferred to the customer
- Entity (company) has present right to payment
- Customer has legal title
- Customer has physical possession
- Customer has significant risks and rewards of ownership
- Customer has accepted the good or service
What is bill and hold?
An arrangement which allows revenue to be recognised as earned if the customer has not received the product. For many years companies manipulated accounts by pretending some of their inventory was bill and hold. Thus there are strict standards for satisfaction of the four criteria of bill and hold:
- The reason for the bill and hold arrangement must be substantive (e.g., the customer has requested the arrangement)
- The product must be identified separately as belonging to the customer
- The product currently must be ready for physical transfer to the customer
- The entity cannot have the ability to use the product or to direct it to another customer
What are the principles of expense recognition?
We recognise expenses in the period in which economic benefits associated with the expenditure are consumed
OR when a previously recognised economic benefit is lost
There are three models of expense recognition:
1. Matching (place Cost of Goods Sold for inventory in relation to sales)
2. Expesed as incurring (for period costs like admin and payroll)
3. Capitalisation and subsequent depreciation (tangible assets) or amortisation (intangible assets)
How is interest treated when paid to finance construction or acquisiton of assets that take a long time to get ready (i.e., financing a factory)?
All companies are requires to capitalise (place on the balance sheet) interest costs associated with accruing or constructing such long lead time assets (stretching over accounting periods). The interest costs thus become part of the cost of the asset.
If the asset is for the company’s own use, it is placed on the balance sheet as a long-lived asset. You will never see the interest expense as interest on the income statement as an analyst. It will get to the income statement through depreciation. Because it counts as an investing flow (you’re capitalising a set of expenses), it does get to the cash flow statement, but under Cash Flow from Investing
If the asset is for sale, it is placed on the balance sheet as inventory. The interest expense does get to the income statement, but through cost of sales i.e., when it’s sold. While you are building the asset/inventory, it is an investing flow, so it is on the CFS under Cash Flow from Investing
How can the treatment of interest costs for constructing or acquiring long-lived assets that take a long time to get ready be affected by the classification of these interest costs on the FS?
When attempting to understand the interest coverage (particularly when assessing the credit worthiness of a company) if you only pay attention to the income statement you will miss some of the interest being paid. This is because some of the interest will not flow to the income staement as interest but as depreciation (if the LLA is for the company’s own use) or as cost of sales (if the LLA is for sale).
Thus the interest coverage ratio will be OVERSTATED
What is the best way to assess interest coverage from a FS?
If we find interest expense on the income statement we will not capture interest paid to acquire or construct long-lived assets that require multiple accounting periods to get ready.
Therefore we should look at the Interest Paid line in the income statement rather than Interest Expense
The other problem is that EBIT also includes some of the interest expense associated with constructing or acquiring long-lived assets for own use over multiple periods (since EBIT is post- depreciation amortisation). Thus we have to add amortisation (and depreciation?) of deferred financing costs to EBIT on the numerator to get a more accurate picture of the ratio:
Interest coverage without capitalised interest = EBIT / Interest Expense (from income statement)
Interest coverage with capitalised interest = (EBIT + Amortisation of deferred financing costs) / (Interest Expense + Capitalised Interest)
How can the exclusion of capitalised interest from net cash provided by operating activities affect how we interpret operating cash flows?
When capitalised interest increases between periods it may nix increases in net cash provided by operating activities, meaning that cash flow from operations could actually be decreasing. Likewise net cash provided by operating activities may look like it’s decreasing, but operating cash flow may in fact be increasing, if capitalised interest is decreasing.
This former scenario may occur if a company is investing more heavily in developing internally used long-lived assets (which can be a good thing), and the latter scenario can occur if a company is investing less in developing internally used long-lived assets (which can be a bad thing and stymie future growth).
Thus only taking operating cash flow can cause companies which are sacrificing future growth for present cash flow from operations look favourable, even if these are suboptimal long term investments.
How are software development costs capitalised?
Software development costs can only be capitalised after a product’s feasibility is established. This is obviously a matter of judgement.
Up until the feasibility is established, all the software development costs are expensed.
Given the major impact capitalising versus expensing has on the financial statements establishing feasibility is a huge deal.
Microsoft says for example that it establishes feasibility shortly before the products are released to the public
What does it mean to have an aggressive approach to expense recognition?
As an analyst, you can generally judge expense recognition as having either conservative or aggressive bias.
The earlier you recognise expenses, the more conservative you’re being.
For example, if a company thinks that an asset will only last a year, and places the whole expense in that financial period, that would be a conservative approach.
By contrast an aggressive approach might try to eke the cost out over multiple years.
Other factors which can be imbued with a conservative or aggressive expensing bias are:
- Uncollectable debts as a % of sales (compare year on year: amount set ASIDE to cover uncollectable debts should not fluctuate without reason)
- Warranty expenses as a % of sales (compare across companies)
- Useful lives of assets (compare across companies)
How should an analyst determine whether a company has adopted an aggressive or conservative bias to expense recognition within its financial statements?
Analysts may look to:
- Comparisons year on year. Every company needs to set some money aside to cover uncollectable debts. The amount you set aside should not vary wildly year on year unless there is a specific reason. If it is this would suggest aggressive expense recognition
- Comparisons between companies. Two companies in the same industry you would expect to have a similar percentage of uncollectable debts.
What are unusual or infrequent items?
These are expenses unlikely to repeat or reoccur in future.
Income statements tell us about the past. Removing items less likely to repeat will help us to create better forecasts.
Therefore it makes sense to separate out these “unusual and infrequent items” from others
IFRS requires that income or expenses that is material or relevant to understanding performance is disclosed separately
US GAAP states that material items that are unusual or infrequent or both are shown as part of continuing operations but disclosed separately
Examples of unusual or infrequent items might include restructuring charges or the sale of a business
What is the specific definition of a discontinued operation?
An operation that has been disposed of, or where there is an established plan to dispose of a component operation
Do IFRS and US GAAP require disclosure of discontinued operations?
Yes, both require separate disclosure.
The component of the business that has or is being discontinued must be separable, both physically and operationally.
Results are presented on a net basis at the bottom of the income statement
Assets and liabilities are shown on the balance sheet as held for sale
How should financial statements deal with changes in accounting POLICIES versus changes in accounting ESTIMATES?
- When it comes to changes in a company’s accounting policy, they must implement both retrospective and prospective changes
- This means that when publishing a new financial statement they must show how the results and reporting for prior year would be calculated using the new policy (for comparability)
- However, they don’t need to go back to every person they emailed the original report to
Do changes in scope and exchange rates require disclosure?
No, there are no required disclosures for either of those aspects (which MM has a problem with since impacts can be significant)
How is EPS calculated?
EPS based on net profit and net profit from continuing ops must be disclosed on the face of the IS
Per share refers to ordinary shares under IFRS and common stock or shares under US GAAP (though this is a minor point as these are interchangeable terms)
Any capital structure is considered complex if it has financial instruments that are convertible into common stock (convertible bonds, convertible preferred shares, employee stock options, warrants)
These instruments all have capacity to dilute EPS
What is diluted EPS?
Both ordinary and diluted earnings per share must be disclosed on the face of the income statement within the FS.
Non-diluted EPS excludes potential impact of stock options on increasing the pool of shares. Diluted EPS includes this impact fully
What financial instruments are potentially convertible into common stock?
Convertible bonds
Convertible preferred shares
Employee stock options
Warrants
All have the potential to dilute EPS by increasing the number of shares (without increasing earnings in concert)
What is a complex capital structure?
Any capital structure which possesses financial instruments that are potentially convertible into common stock
A complex capital structure necesstiates the calculation of both diluted and undiluted earnings per share and introduces some uncertainty into the potential future value of shares
How is diluted EPS calculated
Assume all dilutive instruments are converted or exercised
Exclude all anti-dilutive instruments (don’t consider them at all in the calc)
Otherwise we just make two adjustments to the ordinary EPS calculation
So the ordinary EPS calculation is :
(Income available to shareholders - Preferred Dividends)
_____________________________________
(Weighed average no. of shares outstanding)
On the numerator, we add savings from conversion. On the denominator, we add shares issued on conversion or exercise (dilutive)
Convertible preferred stock has the effect of adding the convertible preferred dividend onto the numerator, and shares issued on conversion on the denominator. The preferred dividend is the higher dividend earned on preferred shares (which would be earned if convertible preferred stock is exercised)
Convertible debt securities has the effect of adding interest x (1 - tax rate) to the numerator, and shares issued on conversion to the denominator. This is because interest is tax deductible so we need a multiplier
Dilutive EPS should ALWAYS be lower than basic, else you’ve calculated it wrong! This might be due to including anti dilutive securities
What is the formula for EPS?
(Income available to shareholders - Preferred Dividends)
_____________________________________
(Weighed average no. of shares outstanding)
- You cannot simply take no. of shares at start of year or year end
Weighted avg no of shares = number of shares outstanding within a specific period x duration of that period as fraction of the year + all other numbers of shares plus durations calculated similarly
- Income available to shareholders = Net Income only if there are no preferred shares outstanding.
Income available to shareholders = Net Income - preferred dividends
- For outstanding stock options and warrants calculate diluted EPS using the Treasury Stock Method (US GAAP)
Options or warrants exercise entails no savings so we only add net shares issued using the TSM to the denominator
- Assume all dilutive options/warrants have been exercised
- Assume company uses exercise proceeds (money employees pay to exercise options) to repurchase as pany shares as possible at the avg market price for the period
- Add net number of shares to the denominator of basic EPS
IFRS uses a similar method with no name but the same result
What is income available to shareholders?
Income available to shareholders = Net Income - preferred dividends
NI = Income available to shareholders if there are no preferred shares outstanding
How do EPS calculations deal with stock splits?
Assume that the shares issued at the beginning of the year
This is to aid comparability
Otherwise it would look like EPS halved
What are net margin and gross margin?
Net margin = net income / sales
Gross margin = gross profit / sales
Calculate the common size ratios
Sales: 938,343
COGS: 324,203
Gross profit: 614,140
SGIA: 350,411
R&D: 140,289
Advertising: 27,460
Operating profit: 95,980
You tell me!
Under IFRS, income includes increases in economic benefits from:
A. Increases in liabilities not related to owners’ contributions
B. Enhancements of assets (not related to owners’ contributions)
C. Increases in owners’ equity related to owners’ contributions
C. Increases in owners’ equity related to owners’ contributions
How is net revenue calculated?
Gross revenue less returns of goods sold and rebates
How does a consignment business record revenue?
It records revenue as commission, as it is not the principal owner of what it sells (it sells on behalf of its clients and does not own inventory)
A company previously expensed the incremental costs of obtaining a contract. All else being equal, adopting the May 2014 IASB and FASB converged accounting standards on revenue recognition makes a company’s profitability initially appear:
A. Lower
B. Unchanged
C. Higher
C. Higher
This adoption of converged accounting standards will result in use of the matching principle. The cost will be capitalised instead of expensed since it is a cost of generating revenue. Thus it will not come off profitability aand so profitability will appear higher
Under IFRS, a loss from the destruction of a property in a fire would most likely be classified as:
A. Continuing operations
B. Discontinued operations
C. Other comprehensive income
A. Continuing operations
There is no suggestion that the destruction of the property represents a discontinuation of an operation.
It cannot be under OCI since it’s not one of the select group of things that go in here (derivatives and hedging gains and losses)
A company chooses to change an accounting policy. This change requires that, if practical, the company restate its financial statements for:
A. All prior periods
B. Current and future periods
C. Prior periods shown in a report
C. Prior periods shown in a report
Restating for all prior periods is a bit much
There must be a restatement of at least one past period so B cannot be correct
For 2009, Flamingo Products had net income of USD 1m. At 1 Jan 209, there were 1m shares outstanding. On 1 Jul 2009 the company issued 100k new shares for USD20 per share. The company paid USD 200k in dividends to common shareholders.
What is Flamingo’s basic earnings per share for 2009?
A. USD 0.8
B. USD 0.91
C. USD 0.95
C. USD 0.95
A company with no debt or convertible securities issued publicly traded common stock three times during the current discal year. Under both IFRS and US GAAP, the company’s:
A. Basic EPS equals its diluted EPS
B. Capital structure is considered complex at year-end
C. Basic EPS is calculated by using a simple average number of shares outstanding
A. Basic EPS equals its diluted EPS
For its fiscal year end, Sublyme Corporation reported net income of USD 200m and a weighted average of 50m common shares outstanding. There are 2m convertible preferred shares outstanding that paid an annual dividend of USD5. Each preferred share is convertible into two shares of the common stock. The diluted EPS is closest to:
A. USD 3.52
B. USD 3.65
C. USD 3.70
C. USD 3.70
For its fiscal year end, CWC reported net income of 12m and a weighted avg of 2m common shares outstanding.
The company paid 800k in preferred dviidends and had 100k options outstanding, with an avg exercise price of 20USD. CWC’s market price over the year averaged 25 per share. CWC’s diluted EPS is closest to:
A. USD 5.33
B. USD 5.54
C. USD 5.94
B. USD 5.54
Cell services (CSI) had 1m avg shares outstanding during all of 2009. During 2009, CSI also had 10k options outstanding with exercise price of 10USD each. The average stock price of CSI during 2009 was 15USD. For purposes of computing diluted earnings per share, how many shares would be used in the denominator?
A. 1,003,333
B. 1,006,667
C. 1,010,000
A. 1,003,333
When calculating diluted EPS, which of the following securities in the capital structure increases the weighted avg no of common shares outstanding without affecting net income available to common shareholders?
A. Stock options
B. Convertible debt that is dilutive
C. Convertible preferred stock that is dilutive
A. Stock options
Which statement is most accurate: a common size income statement:
A. Restates each line item of the income statement as a percentage of net income
B. Allows an anayst to conduct cross-sectional analysis by removing the effect of a company’s size
C. Standardises each line item of the income statement but fails to help an analyst identify differences in companies’ strategies
B. Allows an anayst to conduct cross-sectional analysis by removing the effect of a company’s size
Not A because relative to revenue
Not C because can indeed help to identify company strategy ie specialist or luxury (high margin) or high volume low margins
What are intangible assets?
Intangible assets are:
1. Identifiable: can buy them without buying anything else (this doesn’t apply to goodwill for example)
2. Non monetary:
3. Without physical substance:
Useful life may either be finite or indefinite
Patents, licences, and customer lists fit these
How are intangible assets recognised under IFRS and US GAAP?
Under IFRS they can be recognised through either the cost or revaluation models
Under US GAAP they may only be recognised using the cost model
Useful life may be either finite or indefinite
Finite: amortised over useful economic life
Review annually
Can experience impairment as for PPE
(if value drops below assessed value it can be charged to the income statement)
Look for indications of impairment with finite intangibles before you test for impairment
Indefinite: no amortisation
Annual review of assumptions, and test for impairment
More strict full test of impairment every year with indefinite intangibles
When are intangible assets recognised on the balance sheet?
Most internally created intangibles do not make it onto the financial statements. An intangible must satisfy the following to feature on the balance sheet:
- If there is a probable future economic benefit
- Cost can be measured reliably
Internally created intangibles (brands, customer lists, training costs, advertising):
Under IFRS:
- Research costs (seeking knowledge) expensed
- Development costs (design and testing) are capitalised if certain criteria are met, such as feasibility, profitability, and completion of development
Under US GAAP:
- Expense both research and development
Purchased intangibles may be capitalised if they arise from a contractual or legal right (patents) OR can be sold separately
How do wary analysts treat intangibles?
Financial analysts will often view intangible assets with caution
Some may even exclude intangibles, to create a new tangible book value
This will reduce assets and reduce equity on the balance sheet
It will entail adding back amortisation and impairment to pretax income on the income statement
How are internally created intangibles created if their cost cannot be measured reliably?
Internally created intangibles like brands, customer lists, training costs and advertising are expensed if their costs cannot be measured reliably.
Most internally created intangibles therefore end up being expensed, especially under US GAAP.
US GAAP states that both researched and development must be expensed, whereas IFRS states that development costs may be capitalised if certain criteria regarding feasibility, profitability, and completion are met
By contrast a large firm like Nestle will actually feature the value of brands on their balance sheet because these have been purchased. Nestle’s own internally developed brand/s you will not see
What is goodwill?
Goodwill arises on acquisition of one company by another.
“Internally generated goodwill is not recognised” - i.e., is not a thing
It is calculated as the excess purchase price above fair value of identifiable assets and liabilities.
It represents the value of the company that is not recognised on the balance sheet. This can include things like reputation, human capital (staff skills), intangible assets that have not been recorded (like promising but unfinished research), and strategic value (i.e., future operating cost savings from a merger).
Goodwill must be capitalised and tested annually for impairment.
Analysts may exclude goodwill from the balance sheet and exclude impairment charges from the income statement in order to understand better the value of a company if they think the price paid was unreasonable.
When an acquisition occurs how is goodwill calculated?
When the acquisiton occurs there is a big task, because analysts must go through the whole company and attempt to determine what has been excluded from the company’s balance sheet because it was internally generated.
Since the company will be sold many assets become recognised.
For example, when you acquire the company you are doing so BECAUSE of things like customer lists which may be valuable. Thus these have to be assessed at fair value.
These assets have to be valued at fair value rather than cost during the process. You cannot simply find value on the balance sheet. You have to restate at fair value every item.
Goodwill equals the difference between the sum of the fair value of all the assets and liabilities, and the price paid.
However goodwill can be tricky because companies may get into an overzealous bidding war leading to large goodwill
How might strategic value impact an acquisition?
Strategic value can be something like:
- The presence of the target company within a specific geography you’re looking to expand into. That makes it much more valuable to you than to someone else who already has a presence there
- A process or machine that might save you costs in future
Thus this will contribute to greater value paid for the company by the acquirer, and a greater excess of value paid over fair value of all assets that can be recognised
What might impairment of goodwill indicate about a company?
If a company records substantial impairment of goodwill it likely indicates that it has a track record of overpaying for acquisitions
What is the definition of a financial instrument?
A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another
What are the three methods by which financial instruments can be measured on the FS?
There are three methods for measuring financial instruments in both US GAAP and IFRS. They have different names but are the same 3 methods
These methods are fair value (profit and loss), fair value (other comprehensive income), and amortised cost.
In short, fair value (profit and loss) means that fluctuations in value will flow to the income statement, potentially creating extra noise in the company’s earnings.
Under fair value (other comprehensive income) these fluctuations will be separated out from the main activities of the business. However, there are strict requirements for when and for what purpose this method can be used. The model must be to collect cash flows from the asset (if it’s debt) and then sell the asset. Under IFRS only equity may be classed here if the company makes an irrevocable election at purchase not to trade the asset (collecting dividends).
Under the amortised cost model the business model must be to hold the asset to maturity, because the fluctuations in the value of the asset are not going to be seen anywhere on the income statement.
The cash flows from the asset must be on specified dates and consist of principal and interest only (ie it has to be a debt financial instrument). One case where this might be applicable is if a company has future liabilities and is purchasing assets in an attempt to match these liabilities to cash flow from the assets (ie for paying pensions).
What are the conditions for selecting the 3 methods of measuring financial instruments on the FS?
IFRS amortised cost method / US GAAP Held to Maturity:
- Cash flows must be on specified dates and consist of principal and interest only
- Business model is to hold the asset to maturity
IFRS fair value through OCI / US GAAP Avaliable for Sale:
- Business model is to collect cash flows and sell the asset
- Equity can be included only if an irrevocable election is made at purchase to record it here (cannot change method)
IFRS fair value through P&L / US GAAP “trading” debt and all equity:
- Financial instruments not placed into the other 2 categories
Or if an irrevocable election made at purchase to classify the asset here
A 5% semi-annual coupon bond is purchased for 10m EUR at par. In six months the fair value is 10.2m EUR. How would this be measured on the financial statement in under the FV OCI method?
Income statement for 1st Jan - 30th Jun
Interest income = 250k
Unrealised gain = 0
Impact on P&L = 250k
Balance sheet as of 30th Jun
Assets: Cash and cash equivalents: 250k
Cost of securities: 10m
Unrealised gains on securities: 200k
Liabilities: N/A
Equity: Paid in capital: 10m
Retained earnings: 250k
Accumulated OCI: 200k
Total: 10.45m EUR
A 3% semi-annual coupon bond is purchased for 50m EUR at par. In six months the fair value is 51m EUR. How would this be measured on the financial statement in under the amortised cost method?
IS for 1st Jan-30th June:
Interest income: 750k EUR
Unrealised gains: 0
Impact on P&L: 750k
Balance sheet as of 30th June:
Assets:
Cash and cash equivalents: 750k
Cost of securities: 50m
Unrealised gains on securities: 0
Total: 50.75m EUR
Liabilities:
N/A
Equity:
Paid in Capital: 50m EUR
Retained earnings: 750k EUR
Accumulated OCI: 0
Total: 50.75m EUR
Change in value of the bond is not recorded, as you can see
A 6% semi-annual coupon bond is purchased for 20m EUR at par. In six months the fair value is 19m EUR. How would this be measured on the financial statement under the FV P&L method?
IS for 1st Jan-30th June:
Interest income: 600k EUR
Unrealised gains: -1m EUR
Impact on P&L: -400k EUR
Balance sheet as of 30th June:
Assets:
Cash and cash equivalents: 600k
Cost of securities: 20m
Unrealised gains on securities: -1m
Total: 19.6m EUR
Liabilities:
N/A
Equity:
Paid in Capital: 20m EUR
Retained earnings: -400k EUR
Accumulated OCI: 0
Total: 19.6m EUR
How are non-current liabilities recorded?
Long term liabilities are recorded accounting to amortised cost. The expections are:
- Those held for trading (ie bonds bought and sold)
- Derivatives
- Non-derivatives that are hedged by derivatives (i.e., a forex receivable plus a forward contract)
Deferred tax liabilities: These result from temporary timing differences.
E.g. accelerated depreciation is used for tax purposes whereas straight line may be used in accounts.
How do you create common size balance sheets?
We apply the same method as for common size for the income statement.
In a vertical common size analysis every line is stated as a percentage of total assets.
This will show % of total assets as cash, % inventory for example
How do you calculate the liquidity ratio?
There are actually 3 liquidity ratios.
- Current = current assets / current liabilities
- Quick ratio or acid test = (cash + marketable securities + receivables) / current liabilities
- Cash liquidity ratio: (Cash + marketable securities) / current liabilities
What is the definition of a liquidity ratio?
A ratio which can be used to assess the ability of a company to meet short-term obligations
How do you calculate the solvency ratio?
There are actually four solvency ratios.
Long term debt to equity = total long term debt / total equity
Debt to equity = total debt / total equity
Total debt = total debt / total assets
Financial leverage = total assets / total equity.
What is the definition of the solvency ratio?
A ratio which can be used to rapidly assess the ability of a company to meet long-term obligations.
What is the disadvantage of using the current liquidity ratio?
Current ratio is current assets over current liabilities.
However it may include assets which CANNOT be rapidly sold
For example, a housebuilder might include sand in its current assets, but this sand is not readily marketable. It has to be used to make cement to build a house and then sold as part of the house. Thus it has little short-term value
Thus we may want to exclude these to see whether a company could meet its short-term obligations quickly (in a stressful situation)
The quick ratio may be a better measure. It is:
cash + marketable securities + receivables
____________________________________________
current liabilities
Why might the liquidity ratios be not comparable across industries?
Service sector companies or those that do not carry inventory generally speakng might have low liquidity ratios, whereas those which carry a lot of inventory i.e., manufacturing, would typically have very high liquidity ratios. Intra-industry comparisons are much more telling than inter-industry comparisons
What is the difference between the debt-to-equity solvency ratio and the total debt solvency ratio?
Both have total debt in the numerator, but debt-to-equity has total equity in the denominator. By contrast, total debt solvency ratio has total assets in the denominator
How do the balance sheet and income statement relate to the cash flow statement?
We can work out the line items on the CFS from the BS and IS.
For example:
- If there was a purchase of inventory on credit on the balance sheet it would result in +100 inventory and +100 accounts payable, but no revenue or cost of sales on income statement or cash flow from operations on the CFS
If a company bought 100 worth of inventory on 5th May and then at the end of the month paid it off how would this be reported on the FS?
- On the balance sheet the initial purchase would result in +100 to inventory and +100 to accounts payable
- On the income statement there would be nothing in revenue or cost of sales
- On the CFS cashflow from operations would record nothing
- By the end of the month there would be -100 from accounts payable on the balance sheet as the inventory would be paid for. There would also be -100 cash
- The income statement would record nothing
- There would be -100 in cash flow from operations in the CFS
How would the sale of 600 worth of inventory on credit to a purchaser be recorded on the financial statements?
Since the purchase was made on credit there would initially be +600 to accounts receivable, and -600 to accounts payable on the balance sheet.
On the income statement the sale of the inventory would count as revenue on the IS as the IS uses accrual accounting. Thus there would be +600 to revenue. Whatever it costed to produce or acquire that inventory would also be recorded alongside in cost of sales, as per the matching principle. Nothing would be recorded as of yet on the cash flow statement.
When the customer pays for the purchase, this would result in -600 from accounts receivable and +600 in cash on the balance sheet.
The income statement would record nothing as the sale and cost of sale has already been recorded.
The cash flow statement however would finally record the cash collected as +600 in cash flow from operations
Why might cash flow from operations be significantly lower than revenue recorded on the income statement in a given accounting period?
Cash flow from operations, part of hte cash flow statement, records only cash actually recieved. Thus a company might make a significant amount of sales in a given period but not receive payment WITHIN that period. Since the income statement employs accrual accounting (transactions recorded when they are accrued regardless of the payment date), the income statement would still see that income show up in the revenue line. However, it would not hit CFO.
Some sectors more than others might particularly be affected by this characteristic.
Revenue accrued but without cash collected yet shows up on the balance sheet within accounts receivable.
When these purchases from the clients have been paid the amount is subtracted from accounts receivable and added to cash on the balance sheet
My company manufactures orange juice, and at the start of the year owns 400k USD worth of orange juice pressing equipment. I take depreciation through double declining method over a 10 year lifespan reducing to a 60k disposal value, charging at the end of the year.
Midway through the year, we decide to buy a further 80k worth of equipment to make our bottling process better. However, bottling equipment wears out quickly, so we take 25% of the cost as annual depreciation.
How would this be recorded in the financial statements?
PPE shows up as 400k on the balance sheet at the beginning of the year. No depreciation expense on the IS according to the question setup, and no cash flow from investments on the CFS.
The midyear FS would show +80k to PPE on the balance sheet thanks to the bottling equipment purchase, and -80k cash on the BS to pay for it. Depreciation expense still 0 because we are charging it yearly. Cash flow for investments on the CFS records -80k.
The end of year FS records the accumulated depreciation as 88k. This is (25% x 80k) + (2*(400k-60k)/10).
This 88k adds to accumulated depreciation on the balance sheet, and to depreciation expense on the IS. There is no charge to CFI on the CFS since it is a non-cash charge
My startup borrows 200k from a lender in March. In September it repays the loan plus 8% interest. How would this be recorded on the FS?
- When the company takes out the loan it adds +200k to cash and +200k to loans (liabilities) on the balance sheet. It does not record interest expense on the income statement. It records +200k cash flow from financing on the cash flow statement.
- When the company repays the loan in September it pays back principal plus the interest. It was not specified whether this was an annual interest rate so let us assume not. 8% of the 200k is 16k so in total 216k is paid back.
- Therefore -216k cash is recorded on the balance sheet and -200k in the loans section
- +16k interest expense is recorded on the income statement, to balance the difference between the -216k cash and -200k in the loans section on the balance sheet
- there is a -16k charge in cash flow from financing OR cash flow from operations (there is a choice dep on accounting standards), and a -200k charge in cash flow from financing
My company agrees to manufacture a custom volleyball net for a customer for 500. On 1st October the customer makes a downpayment of 200 cash. On 30th November the equipment is delivered and the remaining balance paid.
How would this be recorded in the FS?
When the company agrees to manufacture the volleyball net there is no impact on the FS since it is just an agreement
On the 1st October FS, the +200 downpayment is added to the CFS in cash flow from operations
This also results in +200 in cash on the balance sheet and +300 in deferred revenue, also on the BS.
On the 30th Nov FS, +300 is added to cash and -300 to deferred revenue on the BS. +500 is added to revenue on the income statement. +300 is added to cash flow from operations on the statement of cash flows.
The downpayment cannot be recorded on the income statement on the 1st Oct financial statements even though it does show up on the cashflow statement because the company has not yet met the obligation to the customer to manufacture the volleyball net. The company would have to give the 200 cash back if the world came to a stop on that day. The revenue is not yet EARNED.
What is the least popular method of constructing cash flow from operations using the income statement and balance sheet?
The direct method.
The direct method takes every line on the income statement and converts it into cash.
So for the revenue line for example we take revenue from the income statement (i.e., 24 000) and deduct the increase in accounts receivable (i.e., 3 000). This is the short way.
The long way:
- Check the balance sheet. Find accounts receivable at the start of the year (i.e., 2000)
- Check the income statement. Find revenue for the full year i.e, 24 000
- Customers previously owed us 2 000, and I collected 24 000. Thus in total they owe us 26 000.
- Then go back to the balance sheet. Check accounts receivable at the end of the year. i.e., 5 000.
- Subtract accounts receivable at the end of the year from the sum. 26 000 - 5 000 = 21 000
Thus I received 21 000 in cash.
How would I calculate cash paid to suppliers using the direct method and the long way?
- BS inventory 3 399 in 2015, 4 433 in 2016
- Accounts payable 1 122 in 2015, 343 in 2016
- Cost of goods sold 9 996 in 2016
Take the increase in inventory between years away from cost of goods sold:
Cost of goods sold = 9 966
Increase in inventory = (4 433 - 3 399) = 1 034
Purchases from suppliers = 9 966 + 1 034 = 11 000
Change in accounts payable = 343 - 1 122 = -779
Cash paid to suppliers = 11 779
As accounts payable decrease it means we paid more during this year than the amount of supplies we received
Why can I simply take opening inventory away from ending inventory and add to COGS on the income statement to calculate purchases from suppliers when constructing a cashflow statement from a balance sheet and income statement?
Cost of Goods Sold for the cash flow statement equals purchases plus opening inventory less ending inventory
How do I calculate cash paid to employees to produce a cash flow statement using the direct method? Usingn the direct method
- Take the increase (decrease) in salary and wages payable between periods from the B/S
4000-3000=1000 - Take the salary and wages expense for the current period from the I/S
3400 - Minus the increase (decrease) in salary and wages payable from the salary and wages expense
3400-1000=2400
This equals cash paid to employees
=2400
How to calculate cash paid for interest from the balance sheet and income statement? Using the direct method
Take the change in interest payable from the balance sheet
2016: 446
2017: 664
Change = +218
Take the interest expense from the income statement
2017: 5 522
Minus the change from the interest expense (add if the change is negative because it’s a double minus)
5 522 - 218 = 5 304
Cash paid for interest = 5 304
How do you calculate cash paid for income tax from the balance sheet and income statement? Using the direct method
Calculate the difference in income tax payable on the balance sheet between this period and the last
443-221 = 222
Find income tax expense for the current period on the income statement
5 599
Minus the difference from income tax expense
5 599 - 222 = 5 377
Cash paid for income tax = 5 377
Why do we have to add the amortisation of a bond discount back to net income to calculate cashflows?
Net income is the top line of a cash flow statement constructed through the indirect method, which is the most commonly used.
However net income includes non-cash items, as well as changes in operating working capital items.
The amortisation of a bond discount is a way of spreading the additional cost attributable to a bond that my company has issued if it sells below par.
Since I collect less principal than the face value of the bond during the bond sale, I will have to pay back more when it matures than I have actually received (even excluding the coupon payments I have to make)
The difference between the discounted selling price and face value will be amortised until maturity.
It is thus a non-cash item and must be ADDED BACK to net income to find cash flow from operations
What items have to be added back to net income to find cash flow from operations?
- Depreciation and amortisation expense
- Depletion expense of natural resources
- Amortisation of bond discount (a negative number, so we add it back)
- Loss on sale of assets
- Writedown of assets
- Loss on retirement of debt
- Loss on investments (under the equity method)
- Increase in deferred income tax liability
- Decrease in current operating assets (accounts receivable, inventory,
- Increase in current operating liabilities (accounts payable, accruals)
Also note that several subtractions have to be made.
This method of starting from net income and making adjustments is known as the indirect method
What subtractions have to be made from net income to arrive at cash flow from operations?
- Amortisation of bond premia
- Gain on sale of assets
- Gain on retirement of debt
- Income from investments (under the equity method, i.e., if you have
significant influence over another entity, e.g., 20% equity share or more or less if you licence technology that is important to the company) - Decrease in deferred income tax liability
- Increase in current operating assets
- Decrease in current operating liabilities
Note that additions have to be made as well
Calculate net cash provided by operating activities:
I/S 2020
Revenue 22 550
COGS 12 550
Salary and wage expense 2 000
Depreciation expense 1 500
Other operating expenses 3 000
Other revenues:
Gain on sale of equipment: 250
Interest expense: (500)
Income tax expense: 1 000
Net income: 2 250
B/S 2019, 2020
AR: 200, 300
Inventory: 3 000, 3 500
Prepaid expenses: 100, 50
Land: 600, 700
Buildings: 400, 300
Equipment: 900, 800
Less: accumulated depreciation: 200, 300
Total assets: 5 000, 5350
AP: 1 000, 1 200
Salary and wages payable: 20, 70
Interest payable: 70, 60
Income tax payable: 90, 100
Other accrued liabilities: 1 300, 1 100
Net income: 2 250
+ depreciation expense: 1500
- gain on sale of equipment: 250
- change in AR: (300 - 200 = 100)
- change in inventory: (3 500 - 3 000 = 500)
+ change in accounts payable: (1 200 - 1 000 = 200)
+ change in salary and wages payable: (70 - 20 = 50)
+ change in other accrued liabilities: (1 100 - 1 300 = -200)
+ change in interest payable: (60 - 70 = -10)
+ change in income tax payable: (100 - 90 = 10)
2250 + 1500 - 250 - 100 - 500 + 200 + 50 - 200 - 10 + 10
Net cash provided by operating activities: 2 950
How do we convert indirect to direct cashflow from operations?
- Disaggregate NI into revenue and expenses
- Remove non-operating and non-cash items
- Convert accruals-based revenue and expenses into cash flows by adjusting for changes in working capital amounts
What are the primary components of cash flow from investing activities?
Cash flows from purchase of PPE (Property, Plant & Equipment)
When a PPE purchase is made cash spent on additions is an outflow from investing activities
When a PPE sale is made cash received from disposals is an inflow from investing activities.
However net PPE also changes due to depreciation, which is not a cash flow. Hence depreciation must be removed to get from the balance sheet to cash flow statement
How do you adjust PPE for the cashflow statement to remove depreciation?
Purchases and sales of PPE entail cash outflows and inflows from investing activites. They appear on cash flow from investing activities (CFI) on the CFS.
If historic cost and depreciation are diven separately:
- Beginning historic cost PPE + additions - historic cost of disposals = ending historic cost PPE
- Beginning accumulated depreciation - accumulated depreciation of disposals + depreciation expense = ending accumulated depreciation
If we are only given net PPE:
Beginning net PPE + additions - Net Book Value of disposals - depreciation expense = ending net PPE
How do you calculate cash flow from investing activities starting from beginning net PPE?
- Take beginning net PPE i.e., 10 000
- Add PPE additions i.e., 3 500
- Subtract depreciation expense i.e., 2 250
- Subtract ending net PPE i.e., 10 200
- This gives you net book value of disposals
We add net book value of disposals to gain on sale from the income statement to find proceeds from PPE sale
How do we find cash flows from sources of finance?
Change in long-term debt between periods equals cash paid to retire long-term debt
Change in common stock equals cash paid to retire common stock
These are the debt and equity components of net cash used for financing activities. We also need to find cash paid for dividends by calculating the difference between beginning and ending retained earnings and finding the part of net income which has “gone missing” (paid as dividends)
How do we calculate cash paid for dividends?
Beginning retained earnings plus net income less dividends equals ending retained earnings.
So: beginning retained earnings plus net income less ending retained earnings equals dividends paid.
We can add cash paid for dividends to cash paid to retire long-term debt and cash paid to retire common stock to find net cash used for financing activities
What are the differences between how US GAAP and IFRS classify interest, dividends, bank overdrafts and taxes paid on the cash flow statement?
US GAAP placed interest received, interest paid, and dividends recieved in Cash Flow from Operations (CFO).
Dividends paid are placed in Cash Flow from Financing (CFF).
Bank overdrafts are treated as part of cash.
Taxes paid are part of CFO.
IFRS offers the choice for interest received and dividends received between CFO and Cash Flow from Investing activities (CFI).
Interest paid and dividends paid can be classified as either CFO or CFF.
Bank overdrafts count as CFF under IFRS.
Taxes paid can be CFO, CFI, or CFF under IFRS! You would do this to attribute taxes specifically to investing, financing, and operating activities
How must a cash flow statement be formatted?
For US GAAP either direct or indirect cash flow statement can be used, with direct encouraged.
A reconciliation of net income to CFO (basically an indirect) must be provided.
For IFRS direct or indirect can be used, with direct encouraged. No reconciliation is required
Why does IFRS CFS comparison across multiple different companies give more work to analysts?
Whereas US GAAP specifies a classification order for interest paid and received and dividends paid and received, IFRS offers choices. For example, dividends paid can fall under either CFO or CFF.
This means that as an analyst you will have to check where things are.
It also should prompt extra caution because it gives companies the ability to manipulate
How do you calculate CFO based on change in retained earnings, accounts receivable, inventory, dividends, and depreciation, if you are not given net income?
Net income = increase in retained earnings + cash dividends paid
If dividends paid are considered a financing activity:
Net income - change in accounts receivable - change in inventory + change in accounts payable + depreciation = CFO
The Chinese book corp. reported COGS for the year of 300m. Total assets increased by 200m, including 20m increase in inventory. Total liabilities increased by 150m, including an increase of 10m in accounts payable. The cash paid by the company and its suppliers is most likely what figure?
300 - 20 + 10 = 290m
COGS - increase in inventory + increase in accounts payable = cash paid to suppliers
What does evaluation of the CFS involve?
- Assessment of sources and uses of cash in CFO, CFI, and CFF
- Assessment of the main DRIVERS of cash flow in CFO, CFI, CFF
What are the major sources and uses of cash?
If it’s a mature company, we would expect operating activities to be the primary source of cash.
CFO can be used in either investing (if profitable opportunities exist) or financing (if no profitable opportunities exist) activities
New/growth stage companies are likely to see CFO negative for a period, but must eventually turn positive bc cannot last indefinitely
In the long run we want to see CFO to cover capital expenditure (ie PPE and intangibles) and to grow
What are the main drivers of CFO?
Is the company generating cash on a daily basis?
- Impacted by movements in receivables, inventories, and payables.
- We can compare CFO to net income to assess earnings quality. We want to see sales turning into cash as quick as possible rather than a buildup of receivables.
- By contrast some companies see accounts payable as an indirect course of finance. Buying supplies and not paying suppliers is effectively a free source of borrowing. OFC not suitable for covering long term liabilities
- What we don’t want to see is NI high and rising and CFO low and falling. That indicates low earnings quality.
Another thing we look at is if we are turning earnings into cash. This indicates profit sustainability.
In the long run we want to see CFO greater than net income due to non-cash charges (ie due to depreciation expense).
If Net income is greater than CFO this indicates poor earnings quality.
How do we identify the drivers of CFI cash flows
We must analyse each line as either a source or use of cash.
- Ask is the company using cash to invest in PPE, make acquisitions, or invest in liquid assets? In the long run we want to see PPE covered by CFO, because you cannot cover the costs of your operation only through financing.
- Ask what sources of cash are being used to cover investments, excess CFO, CFF or sales of assets (CFI)?
How do we analyse the main drivers of cash flows to CFF?
We must determine whether the company is raising capital or repaying capital.
- If the company is consistently raising capital: when is repayment required?
This is especially true when we consider credit cycles. An easy credit environment can prompt companies to borrow year after year; but when things turn and credit becomes much more expensive this can endanger the profitability of their operation
- CFF will also include dividends payments, so a high dividend will (usually) entail large outflows from CFF, unless a choice is made under IFRS otherwise
When analysing a common size cash flow statement what warning signs or things of note might we want to look out for?
- Generally speaking, comparisons between companies within the same industry or within one company across several years are useful
- The trend in % for depreciation and amortisation in the CFO section should roughly track capital expenditure on the CFF section
- A sustainable business model should see cash generated by operating activities greater than net income
What is FCF?
CFO - capital expenditures = Free Cash Flow (FCF)
There are two kinds:
1. Free cash flow to the firm (FCFF): FCF available to both debt and equity investors after operating expenses and taxes are paid
2. Free cash flow to equity (FCFE): FCF available to equity investors after borrowing costs have been paid
How do we calculate FCF?
FCFF = Net Income + Non-Cash Charges - Working Capital Investment - Fixed Capital Investment + (Interest x (1-t))
FCFE = Net Income + Non-Cash Charges - Working Capital Investment - Fixed Capital Investment + Net Borrowings - Net Repayment
Non cash charges: depreciation is the classic example
Working capital investment: changes in receivables, inventory, payables (all the changes we made to NI to get to CFO in the indirect method)
Fixed capital investment: a net figure, PPE spending less PPE disposals
We add back interest to find what free cash flow we have BEFORE we pay interest in the case of FCFF
Interest has a tax shield because it’s tax deductible hence we have to adjust for lack of tax.
In the case of FCFE we do not add back interest since we are happy it is post-interest. However we do add back net borrowings (cash we received from providers of debt) and less net repayment (cash repaid to providers of debt).
Which tax rate should we use to calculate FCFF?
If we are given both statutory and marginal, we should use marginal.
We use the tax rate as a (1-t) multiplier on the interest when we add back interest to NI whilst calculating FCF.
What is the relationship between CFF and FCFF?
FCFF = CFO + Interest x (1 - t) - Net Fixed Capital Investment
This is because CFO = NI + Non-Cash Charges - Working Capital Investment (Inventory, Receivables, Payables) under the indirect method
Please note that under IFRS, interest paid can fall under cash flows from financing (CFF), and thus will not be included in cash flows from operations (CFO). In this case, interest does not need to be added back.
What is the relationship between FCFE and CFO?
FCFE = CFO - Fixed Capital Investment + Net Borrowing (- Net Debt Repayment)
Please note that the accounting standards used might require interest paid from this to arrive at FCFE, if it has not already been counted within CFO.
Please note that under IFRS, interest paid on debt may fall under CFF (cash flows from financing) rather than CFO (cash flows from operations). Thus it wouldn’t have been deducted yet.
In this case, interest paid x (1- tax rate) would be deducted
FCFE = CFO - FCinv + net borrowing - i(1-t)
Why might we prefer cash-based performance ratios over net income based performance ratios?
Cash based performance ratios are harder to manipulate
Since net income takes account of depreciation and amortisation these things can be reduced to boost net income.
Cash based performance ratios can also be more appropriate for measuring the underlying property they intend to
For example, net income to debt is inadequate compare to cash flow to debt because net income does not help to pay the bills, cash does.
What are the five key cash-based performance ratios?
- Cash flow to revenue. Measures operating cash generated per unit of revenue. CFO / net revenue
- Cash return on assets. Measures operating cash generated per dollar of asset investment. CFO / average total assets
- Cash return on equity. Measures operating cash generated per dollar of owner investment. CFO / average shareholder’s equity
- Cash to income. Measures cash generating ability of operations. CFO / operating income
- Cash flow per share. Measures operating cash flow on a per-share basis. (CFO - preferred dividends) / number of common shares outstanding
What are the six key cash-based coverage ratios?
- Debt coverage. Measures financial risk and financial leverage. CFO / total debt
- Interest coverage. Measures ability to meet interest obligations. (CFO + Interest paid + Taxes paid) / Interest paid
- Reinvestment. Measures ability to acquire assets with operating cash flows. CFO / Cash paid for long-term assets
- Debt payment. Measures ability to pay debts with operating cash flows. CFO / Cash paid for long-term debt repayment.
- Dividend payment. Measures ability to pay dividends with operating cash flows. CFO / Dividends paid
- Investing and financing. Measures ability to acquire assets, pay debts, and make distributions to owners. CFO / Cash outflows for investing and financing activities
Company A has a rising cash flow to revenue ratio and stable cash return on assets ratio over periods. Company B has declining cash flow to revenue ratio and a declining cash return on assets.
What conclusions might we form when comparing the two companies?
Without any additional information, what we can gleam is:
- Company A is increasing its cash-generating ability from revenues
- Company A is not changing its proportion of investment of cash into assets
- Company B is delivering less cash per unit of revenues
- Company B is changing its proportion of investments of cash into assets
There might be several reasons:
- Company A might have decreasing revenue but retaining or expanding its higher margin business lines. In this case we might see cash flow to revenue increase but cash flow in dollar terms remain stable or decrease.
- Company A might simply be increasingly more efficient at generating cash than company B. This could indicate it has greater pricing power and a wider economic moat, good things for a company.
- Company B might be in a growth phase. It may be increasing its revenue but investing heavily in assets to fuel expansion. This would decrease cash flows, even if revenue is increasing. As such the dollar value of cash flows might be increasing or remaining stable or decreasing. We can’t tell only from a ratio
- Company B might also be holding its cash in investments or financial instruments. In this case it would not show up as cash
We would need to look at assets on the balance sheet over periods, income on the income statement, and cash flow from investing to determine what is happening.
One appropriate method of preparing a common-size cash flow statement is to show each line item:
A. Of revenue and expense as a percentage of net revenue
B. On the cash flow statement as a percentage of net revenue
C. On the cash flow statement as a percentage of total cash outflows
B. On the cash flow statement as a percentage of net revenue
It’s not A because revenue and expense are on the income statement not the CFS
It’s not C because you don’t show the inflow as a percentage of cash outflows
Which of the follow is an appropriate method of computing FCF to the firm?
A. Add operating cash flows to capital expenditures and deduct after-tax interest payments
B. Add operating cash flows to after-tax interest payments and deduct capital expenditures
C. Deduct both after-tax interest payments and capital expenditures from operating cash flows
Free cash flow to the firm is what I have before I pay everyone (debt, equity).
I deduct what it costs to run my business (capital expenditures) and add back parts of net income associated with paying everyone (so I add back interest expense x 1 - tax)
Thus the answer is B
The first step in cash flow statement analysis should be:
A. Evaluate consistency of cash flows
B. Determine operating cash flow drivers
C. Identify the major sources and uses of cash
Before we start studying the cash flows we need to understand what they are. We cannot do this until we identify the sources and uses of cash.
Thus the answer is C.
An analyst has calculated a ratio using as the numerator the sum of operating cash flow, interest, and taxes and as the denominator the amount of interest. What is this ratio, what does it measure, and what does it indicate?
A. This ratio is an interest coverage ratio, measuring a company’s ability to meet its interest obligations and indicating a company’s solvency
B. This ratio is an effective tax ratio, measuring the amount of a company’s operating cash flow used for taxes and indicating a company’s efficiency in tax management
C. This ratio is an operating profitability ratio, measuring the operating cash flows generated accounting for taxes and interest and indicating a company’s liquidity
This ratio has interest on the denominator. Therefore it must be related to ability to pay interest. Hence it measures solvency: higher ratio means lower risk and means I can pay back interest more comfortably.
Hence the answer is A
What does IFRS say about valuing inventory by cost and net realisable value?
Inventory must be valued at the lower of cost and net realisable value
If NRV is less than cost, this counts as a write-down. The write-down must be charged to the income statement
Subsequent increases in NRV are recognised, and will reduce the cost of sales in the income statement. This is known as a reversal.
Be careful: it can only be reversed up to cost.
There are no reversals under US GAAP. Once inventory is written down, it is written down.
What happens when we write down inventory to our ratios?
- We reduce current and total assets on the balance sheet
- We increase expenses, which results in lower net income and lower equity
Therefore the impact on our ratios is:
- Solvency ratios i.e., debt/equity: has a negative effect. Results in a decrease in equity
- Liquidity ratios, i.e., current assets/current liabilities: has a negative effect. Results in a decrease in current assets. Note that quick and cash ratio not affected by write-down because don’t include inventory
- Profitability ratios i.e., net profit / revenue : has a negative effect. Results in a decrease in net income (though not cash flow)
- Activity ratios, i.e., COGS/average inventory: has a positive effect. Results in a decrease in assets but an increase in COGS.
What might an increase in activity ratios indicate with no other signs of business growth?
An inventory write-down has occured
For example, COGS goes up in a write down and average inventory value goes down
Thus there is a double effect leading to an increase in activity ratios
Why does an inventory write-down lead to an asymmetric effect to the numerator and denominator of ROE?
ROE (Return on Equity) = Net Income / Average Total Equity.
A write-down will result in an equal amount being deducted from net income (charged through higher COGS) and average total equity (since assets decrease).
However NI is usually much smaller than average total equity.
Thus subtracting an equal amount from top and bottom will have a much greater proportional effect on the top, changing the fraction and rapidly eroding return on equity.
What is the shorthand for understanding how LIFO and FIFO inventory valuation methods are impacted by inflation or deflation?
FIFO: newest items go on the balance sheet, oldest items go on the income statement
LIFO: oldest items go on the balance sheet, newest items go on the income statement
Thus under inflation, FIFO results in higher inventory, higher profits, and higher taxes
Under deflation, LIFO results in higher inventory, higher profits, and higher taxes
Carrying inventory at a value above its historical cost would most liekly be permitted if:
A. the inventory was held by a producer of agricultural products
B. Financial statements were prepared using US GAAP
C. The change resulted from a reversal of a previous write-down
A. the inventory was held by a producer of agricultural products
Commodity-like goods can be held at net realisable value
Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices, the cost of sales reported by:
A. Zimt is too low
B. Nutmeg is too low
C. Nutmeg is too high
A. Zimt is too low
FIFO = the oldest inventory stays on the balance sheet
Compared to using the weighted average cost method to account for inventory, during a period in which prices are rising, the current ratio of a company using the FIFO method would most likely be:
A. Lower
B. Higher
C. Dependent upon the interaction with accounts payable
B. Higher
FIFO: balance sheet shows up to date inventory which is more expensive
Current ratio = current assets / current liabilities
Current assets will increase, so current ratio will increase
How do we convert LIFO to FIFO on a financial statement?
Take away the change in the LIFO reserve (which should be provided on the financial statement) from the COGS.
Which group of ratios uaually appears more favourable with an inventory write-down?
A. Activity ratios
B. Solvency ratios
C. Profitability ratios
A. Activity ratios
During periods of rising inventory unit costs, a company using the FIFO method rather than the LIFO method will report a lower:
A. Current ratio
B. Inventory turnover
C. Gross profit margin
B. Inventory turnover
What is the definition of an intangible asset:
- Non-monetary (must be held to generate revenue)
- Lacks physical substance (the substantive part of a patent is not the paper it’s written on)
IFRS definition criteria (is it an intangible?):
1. Must be identifiable. You must be able to sell it separately from the company (goodwill doesn’t count)
2. Must be under control of the company. Likely needs a contractual right
3. Must be expected to generate future economic benefits
IFRS recognition criteria (can we put it on a balance sheet?):
1. Probable that the expected future economic benefits will flow to the company
2. Cost of the asset can be RELIABLY measured (the essence of everything here)
How can intangibles be acquired?
Intangible assets can be:
- Purchased
- Developed internally
- Acquired in a business combination
However if it is developed internally it must be expensed as incurred (the exception being development spending which can be capitalised). This is because it is hard to say exactly what the cost of working on it was.
Purchased intangibles have a clear value.
If acquired in a business combination part of the purchase price can be allocated
How are intangibles recorded in the financial statements?
Purchased intangibles are recorded on the balance sheet at fair value (we assume that cost is the fair value)
Expenses related to intangibles developed internally are expensed as incurred (unless it is development in which case the expenses can be capitalised)
Intangibles acquired in a business combination must meet certain criteria in order to be placed on the balance sheet. Under IFRS they must meet the standard intangibles definition and recognition criteria. Under US GAAP the intangible must arise either from a contractual or legal right OR can be separated from the company.
During the business purchase the price will be allocated to identifiable assets and liabilities at fair value, including the intangibles where applicable.
Why might goodwill be overstated in an acquisition?
Identifiable assets are amortised over their useful life, whereas goodwill is not and has an indefinite life. Identifying assets in an acquisition thus creates an expense. Hence the acquirer may have an incentive to under-recognise identifiable assets and overstate goodwill.
The good news is that goodwill is checked annually for impairment, so if it has been overstated massively then it may become impaired. An impairment charge hits the income statement anyway, which creates a check on this dynamic
What is the impairment test?
The impairment test is used for long-lived assets (property, plant and equipment) to determine whether they have become impaired.
IFRS (one step test):
An asset is impaired if the carrying value on the balance sheet is greater than the recoverable amount.
The recoverable amount is defined as the higher of:
- value in use
- fair value less costs to sell
US GAAP (two step)
1. If undiscounted cash flows from use are less than the carrying value, the asset is impaired. ( You cannot exit step 1 with a number: it is a yes/no)
2. If impaired, calculate the amount of impairment as:
Carrying Value - Fair Value
These rules apply to both PPE and intangible assets.
However intangibles are reviewed annually for impairment no matter what
What is the impact of an impairment charge on accounts?
PPE, total assets, and equity go down
Net income goes down
Cash flows unaffected
How are long-lived assets held for sale treated in terms of impairment?
Long-lived assets can be classified as held-for-sale if
- Management’s intent is to sell
- Sale is highly probable
Tested for impairment when the asset is classified as held-for sale.
If the carrying value is greater than fair value less costs to sell, we must recognise an impairment cost.
Held for sale assets are not depreciated or amortised.
What happens if after recording an impairment, the recoverable amount recovers?
Under IFRS, you reverse whatever you did.
You credit the income stataement (I/S)
You increase the asset carrying value to its original amount (B/S)
Held-for use OR held-for-sale losses can be reversed.
Under US GAAP, only held-for-sale (a very small number of cases) can reverse impairment. The foundational view is otherwise that impairment cannot be reversed.
Tax authorities do not care about impairment. Reversal of impairment will affect your deferred tax credit/liability. However impairment is not considered an expense by the tax authorities in the first place so is largely ignored
What is the impact of reversal of impairments on the accounts of a company?
Long lived assets, total assets, and equity increase
Expenses decrease, so net income increases
Note reversal of impairment is not a cash flow, so the cash flow statement is not impacted.
When would we derecognise an asset?
- When an asset no longer provides economic benefit (ie its sale has been banned by the govt)
- When you sell an asset
If the sale of an asset is highly probable, we move it to held-for-sale
What happens when we sell an asset to the accounts?
Proceeds from sale are recorded on the cash flow from investing on the cash flow statement.
The cash is added to assets on the balance sheet.
The net book value is removed from the balance sheet. This results in a decrease in assets.
The gain is recorded on the income statement, within other gains and losses. It is recorded on a separate line if it is a material disposal i.e., significant enough for investors to need to know about it
The gain on the sale would be used to adjust net income to cash flow from operations
The proceeds from sale would be zero if the asset was abandoned rather than sold.
When we swap assets how it is recorded?
The carrying value is removed, and replaced with the fair value of the asset acquired.
There are three options for how to arrive at fair value.
- Fair value of the asset given up (we assume that the trade is equitable)
- The fair value of the asset acquired is used if it is “more evident” (i.e., more easy to calculate, if my asset was a specialised piece of machinery or something very complicated)
- If it’s very difficult to calculate the value of either asset, we use carrying value of the asset removed
This results in zero gain or loss to the exchange
What factors must be disclosed along with the FS when it comes to valuing and identifying long-term assets? (excluding impairment)
Under IFRS:
1. Measurement basis (historic cost/fair value)
2. Depreciation method (straight line, declining balance, etc.)
3. Gross carrying amount (at the start and end of period)
4. Accumulated depreciation (at the start and end of period)
5. Depreciation expense for the period
6. Reconciliation of the carrying amount, from beginning to end of the period
7. Major classes of assets
8. Justification of indefinite lives for intangibles
9. Restrictions on title, pledges as security
10. Contractual agreements to acquire PPE
11. Revaluation model: Date of revaluation, Details of fair value calculation, Carrying amount under cost model, Revaluation surplus
Under US GAAP:
1. Everything in IFRS
2. Plus estimated amortisation expense for the next 5years
3. Less revaluation (because not allowed)
Note, if a company uses the function of expense method for income statement, depreciation expense is shown separately (on the face of the income statement)
Note it’s not too important to memorise all these but rather understand how they’re used
What factors must be disclosed along with the FS when it comes to valuing and identifying long-term assets on the matter of impairment?
Under IFRS:
Amount of impairment losses
Circumstances leading to impairment
Amount of impairment losses reversed
Circumstances leading to reversal
Where impairment losses are recognised
Under US GAAP:
Everything under IFRS
Plus the method of determining fair value
Less reversals disclosures for held-for-use assets, since reversals are only allowed for held-for-sale
What ratios can long-term assets disclosures on the FS be used to calculate?
- Fixed asset furnover: total revenue / average net fixed assets
- Asset age ratios:
Estimated total useful life = historic cost / annual depreciation expense
Estimated age of assets = accumulated depreciation / annual depreciation expense
These last two assume no salvage value and the use of straight line depreciation
We can then calculate when our assets will need to be replaced on average by finding:
estimated total useful life - estimated age of assets
What would a high fixed asset turnover and a high estimated age of assets imply about a company?
It appears that the company is using its asset base efficiently.
However there may be a major capex program coming up.
The assets being used may be very old.
They may have to be replaced in order to keep the business running
Why is it useful to exclude land from PPE when calculating asset activity ratios?
Land is not depreciated so it distorts your simplistic asset activity ratios
What does capital expenditure greater than annual depreciation expense entail?
It suggests that a company is investing more in its assets than is being worn out each year. This should give you comfort that (provided that the overall business is profitable) the business model is sustainable RE maintenance of asset base
What would be the most likely effect in the following period if a company were to switch from straight line to accelerated depreciation for both financial and tax reporting?
A. Net profit margin would increase
B. Total asset turnover would decrease
C. Cash flow from operating activities would increase
C. Cash flow from operating activities would increase
Net profit margin would decrease due to higher depreciation charge
Total asset turnover would increase as revenue would remain constant but assets (the denominator) would decrease
Total cash flow would remain the same, so it would appear that C is not correct either.
However, charging more depreciation would decrease profits and thus result in lower tax. Hence, cash flow from operating activities specifically would be higher
How is a lease defined?
A contrac that conveys the right to use an asset for a period of time in exchange for consideration
The lessee pays consideration and uses an asset (i.e., a manufacturer leasing a warehouse)
The lessor receives consideration for the use of an asset (i.e., an investment property company)
The contract must:
1. Identify a specific underlying asset (i.e., must specify you can use a specific truck, not any truck)
2. Give the customer the right to obtain largely all of the economic benefits from the asset over the contract term (only you are using the truck)
3. Give the customer, not the supplier, the ability to direct how and for what objective the underlying asset is used (you can do what you want with the truck)
What are the advantages to leasing?
- Less cash required up front (some leases require a lease premium but most do not
- We don’t see the liability on a balance sheet despite being very economically similar. This decreases leverage
- Lower ‘finance’ cost than some loans. The asset acts as an security. The company will come and take back the leased asset if you don’t pay. Thus it will be cheaper than an unsecured loan
- Convenience and lower risks of ownership: you can swap the asset back for a newer model rather than being stuck with it,
- From the lessor (asset owner) perspective, it widens the market for customers, to those who might not be able to pay upfront for it
- For the lessor, they will receive an income stream over the lease term
How do accounting standards get around the problem of companies using leases to hide borrowing?
Leases can be classified either as operating or finance.
Operating leases resemble a rental agreement. I.e., like hiring a car to drive around on holiday.
Finance leases resemble the purchase of an asset. In substance, it looks like you’re buying the asset with finance.
It is up to the accountants to decide the classification, not the person that takes out the lease.
When is a lease classified as finance?
When it resembles the purchase of an asset.
If it meets any of the following criteria it qualifies:
- 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. I.e., you are allowed to purchase the asset for a dollar after 3yrs
- The lease term is for a major part of the asset’s useful life. I.e., if once your lease is over the asset will be worthless
- The present value of the sum of the lease payments equals or exceeds substantially all the fair value of the asset
- The underlying asset has no alternative use to the lessor. i.e., it is there to be leased
Thus, the majority of leases are going to be finance
In what cases do you not need to apply lease accounting?
- Under both GAAP and IFRS, if the term of the lease is less than 12mths
- Under IFRS only, if the value of the asset is less than 5000USD when new (confusing because priced in USD!)
How are operating and finance leases accounted for under IFRS?
Operating and finance leases are treated identically under IFRS.The lease liability is amortised using the effective interest rate method (similar to bond accounting, except amortising to 0 instead of to par value)
When you sign the lease, you put a right of use (ROU) asset on the balance sheet. The value is calculated at the present value.
You can calculate the discount rate from the lease, or estimate a secured borrowing rate (since the lease is similar to a liability)
The PV is amortised (usually straight line) over the life of the lease
You ALSO on the balance sheet recognise a liability, since in substance it is like buying an asset and finance it.
You put in the present value of future lease payments
At inception there is no impact on equity.
Going forward we obviously will start charging expenses which will impact equity, but at the outset no.
We place interest expense on the income statement during the life of the asset, as well as amortisation expense.
Note these will be two separate lines. Amortisation expense will be part of EBIT and reduce EBIT. Interest expense will not - interest expense comes after EBIT
The amount of the lease payments which goes to principal repayment goes to CFF
The amount of the lease payments which does to interest payment goes to either CFO most of the time, or CFF (since this is IFRS)
How would you summarise how leases are treated under IFRS?
- Bring in an asset
- Bring in an equal and opposite liability
- The asset is amortised straight line
- The liability uses the effective interest method
True for both operating and financing leases.
Why does the asset value of a lease on the balance sheet not equal the lease liability (under IFRS)?
The amount we are charging as amortisation (which is calculated straight-line) is not equal to the liability expense (which is charged using the effective interest rate method)
How are leases accounted for under US GAAP?
Finance leases are treated identically to IFRS
Operating leases are treated differently:
- The present value of future lease payments goes onto the balance sheet as a right-of-use asset (amortised as lease payment less interest)
- The lease liability goes onto the balance sheet as the present value of future lease payments (amortised using the effective interest rate method)
- During the life of the lease, the lease is recognised as the lease expense on the income statement on one line. It is equal to lease payment less interest. This is also equivalent to the theoretical principal payment. Thus the value of the liability and the right of use asset track each other and remain equal to each other over the life of the lease, unlike a financial lease
- It arrives on the cash flow statement in CFO during the life as the least directly as the lease payment.
The discount rate used to calculate present value of future lease payments for the balance sheet is either the implicit rate calculated from the lease itself, or an estimated secured borrowing rate
What impact does the classification of a lease as a finance lease have on the incomme statement over the life of the lease compared to classification as an operating lease have under US GAAP rules?
A financial lease will start off with a high total interest expense and then it will gradually fall below the evenly amortised lease expense. This means at the start of the lease equity will be lower than if the lease had been classified as an operating lease. Equity will converge to the same point regardless of classification because it is the exact same lease that has been taken out in both cases. However, equity will decline more slowly toward the end of the life of the lease when classified as a finance lease.
This is because for a financial lease, as the liability fallls the interest charge falls, like a conventional liability.
What impact does the classification of a lease as a finance lease have on the cash flow statement over the life of the lease compared to classification as an operating lease have under US GAAP rules?
Total impact on the cash flow statement will be the same
If it is an operating lease, we charge the straight line amortisation of the present value of the total lease payments to CFO as an outflow
Under a finance lease, the value is split. Interest is going to CFO (no choice since this is US GAAP).
The principal amount goes to CFF.
An operating lease therefore has a much higher impact on CFO than if it is a finance lease (as we would expect: match cash flow from operations to operating leases).
How does classification of a lease as operating rather than finance affect EBITDA margin?
EBITDA margin = EBITDA/revenue
Operating expenses reduce EBITDA. Operating leases charge the whole amount of the lease to the income statement through lease expense. EBITDA is before interest and amortisation, which is how the finance lease would recognise the lease, so operating leases will comparatively decrease EBITDA margin
How does classification of a lease as operating rather than finance affect asset turnover during the life of the lease?
Firstly, this question must pertain to US GAAP since IFRS treats operating and finance leases in the same way.
Asset turnover = revenue / assets
With a finance lease the asset value is always lower than under operating.
This is because in the operating lease we amortise the asset using interest, as opposed to straight line which is higher.
Thus asset turnover will be higher under finance lease classification, ceteris paribus
How will cash flow per share be affected by a finance lease classification as opposed to an operating lease classification?
Analysts typically use CFO as a measure of cashflow per share because it is seen as a more robust measure than net income per share if you have accruals accounting concerns.
Operating lease treatment hammers CFO with a large cash charge, whereas finance lease treatment is more kind. Thus CFO will be lower when using operating lease and so cash flow per share will be lower.
At the end of the lease they are equivalent - this only applies to the life of the lease.
What are the two terms used by IFRS to describe a finance lease from the lessor side?
Either
- Sales-type finance lease (if leasing is incidental to your business)
- Direct financing (if leasing is the main part of your business)
However there is “no material impact” for analysts on the difference so it is not included in the curriculum
How is a finance lease treated on the lessor side by IFRS and GAAP?
IFRS and GAAP are pleasingly similar in treatment. The main difference is between finance lease and operating lease.
At inception, a finance lease creates a lease receivable asset. This is a mirror image of the lessee liability.
It equals present value of the future lease payments, the discount rate being the implicit rate.
This asset is reduced by payments using the effective interest method.
At the same time, we derecognise the leased asset during its life by removing it from the balance sheet. This is because we are effectively transmuting the asset into a receivable
On the income statement, the difference between value of the leased asset and present value of future lease payments arrives on the income statement as a gain or loss on inception.
During the life of the lease, interest income (using the effective interest method) arrives on the income statement. Or, if leasing is the primary businss activity, it will be classified as revenue.
Cash flow during the life of the lease appears in CFO
How is an operating lease treated on the lessor side by IFRS and GAAP?
IFRS and US GAAP are pleasingly similar.
The difference is between opearting and finance lease.
An operating lease is essentially treated as a rental agreement.
The leased asset is retained and NOT removed from the balance sheet at the inception of the lease.
During the life of the lease, it is recognsied as lease revenue on the income statement through the straight line method. This means if we receive equal cash payments we just bring this in directly every year. If it is a variable amount each year we take present value of future lease payments and smooth it by putting it in straight line
Cash flow during the life of the lease appears in CFO.
How are salaries, bonuses, and health and life insurance premia recorded?
Salaries, bonuses, and health and life insurance premia usually vest (appear in the FS) immediately or shortly after the grant date (i.e., when they give you the salary on a monthly or weekly basis)
They are reported as an expense in the period in which they vest.
How are pensions recorded?
Defined contribution pension plans, defined benefit pension plans, and share based compensation are deferred: Employees may earn compensation in the current period, but receive in future periods. The amount may be based on future variables like final salary and stock price.
For a defined contribution plan specifically, the company pays into the plan but has no further obligation.
The payment is thus recorded as an expense in the period.
For a defined benefit plan, the company promises a VALUE of future benefits to be paid in retirement: e.g., annual payment during retirement until death is equal to
(Number of Years Service / 60) x Final Salary
There are a lot of assumptions going into this: how long are you going to live? What will your final salary be? How long will you work at the company?
This is great news for an employee, but a big risk for the employer. Hence companies don’t tend to use this anymore, but there are big historic plans still in company accounts that can represent a big % of assets and liabilities on the BS.
The present value of the future obligation is recorded as a liability at PV. Discounted by the yield on a high quality corporate bond (low risk). The assumptiosn used and discount rate you’re using significantly affect the obligation.
The company holds in a separate legal entity the assets used to fund the obligation. This is a pension trust fund. The company makes payments into the fund which are invested until needed.
The fund makes pension payments when required.
The company reports a net pension liability or net pension asset on the balance sheet depending on whether the PV of the future obligation is greater or lesser than the fair value of the plan assets.
What would the effect of rising corporate bond yields have on a net pension liability attributed to a defined benefit plan?
A defined benefit plan may create a liability if the fair value of the plan assets held in the pension trust fund (a separate legal entity) is less than the present value of the future obligation.
However, the discount rate used to calculate the present value is the yield on a high quality corporate bond.
Thus, when corporate bond yields rise, the present value decreases.
A decreasing present value will shrink the deficit and thus the net pension liability. A large enough move (i.e., as a result of rapid central bank rate hikes) nay result even in a net pension asset due to a surplus.
Thus the company would theoretically find it easier to meet the pensions obligations given its current base of assets, and ceteris paribus this would increase the book value (assets less liabilities) of a company.
How might inflation increase the book value of a company thorugh its defined benefit plan pensions obligations?
High inflation rates may trigger interest rate hikes from the Central Bank. This would thus increase the yield on corporate bonds by the change plus the risk premium. Since the present value of future obligation for DB pension plans is calculated using a discount rate equal to the yield on a high quality corporate bond, the risk-free rate (set by the Central Bank) has a substantive impact on the value of the future obligation.
As such, if inflation rises and rates rise, the liability attributable to future pensions payments will decrease. Thus the book value of a company, which is assets less liabilities, will increase.
How is the net pension asset / liability recognised under IFRS?
The change in the net pension asset / liabiltiy over the year is recognised in either the income statement or OCI. The split differs between IFRS and US GAAP.
What goes on the income statement:
- Service cost: the increase in present value of the benefit earned by the employee in the year
- Also: past service costs resulting from changes in plan rules. I.e., a union negotiates a change in the calculated pension payout resulting in a jump in service cost
- Net interest expense or income: change in the PV of the net pension or asset liability due to the passage of time. I.e., when the average time unti the pension pays out increases or decreases
What goes into OCI:
What OCI causes remeasurements.
- Actuarial gains or losses from changes in ASSUMPTIONS (e.g. average service life, salary increases, etc.)
- Difference between the actual return on assets and return included in interest (P&L). This is because the pension asset or liability is the difference between Assets x Discount Rate and Liability x Discount Rate
The idea is that changes in assumptions are choppy. They represent noise that does not reflect the actual cost of the defined benefit plans. Over time, they should even out. Thus, they fall in OCI.
By contrast service costs are supposed to include things that change smoothly over time, as more people join the company or the average age of the worker changes.
How is the net pension asset / liability recognised under US GAAP?
On the income statement is placed:
1. Service Cost: Present Value increase in the benefit earned by the employee in the year
2. Interest Expense: Interest accrued on beginning plan obligation using the discount rate
3. Expected Return on Assets: The return plan assets would have generated using the EXPECTED rate of return
The expected rate of return is not necessarily the discount rate, unlike under IFRS. The expected return on assets may be amortised into the income statement over the future service period of the employees
Under IFRS interest and expected return on assets are combined into one line, by contrast
In OCI is placed:
Actuarial gains and losses (not called remeasurements), which are gains and losses
1. On the obligation (as for IFRS)
2. Or actual return on assets less expected return on assets (since this latter part falls into the income statement)
What is the logic behind share-based compensation?
The ain is to align employee interests with those of the shareholders.
However, we might be sceptical that this works though.
How many employees are going to come to work determined to work harder so that in five years their share price might be slightly higher than it might have been, and they could sell these shares for a bit more than they otherwise could?
Share-based compensation potentially involves no cash outlaw, but
- is a form of compensation expense
- has the potential to dilute earnings per share
- may be cash settled (cash compensation linked to share performance)
- may causeC-suite to be risk averse (don’t want to hurt the stock price) OR take excessive risks.I.e., granting call options, right to buy a share at a particular price. These have limited downside, but unlimited upside, if the shares go far above the call price.
What is a stock grant?
A compensation expense based on the fair value of stock on the grant date.
The expense is recognised over the plan’s vesting schedule (spread out).
Outright stock grants are those allocated over a service period (i.e., 3 years). If it doesn’t specify a service period, it typically means it is just allocated over the current period.
Restricted stock grants are allocated over the service period, but related to performance. It could be your performance, more likely it will be the company’s performance.
What are stock options?
Share-basd employee compensation where the compensation is based on the fair value of the option on the grant date.
A valuation model is required (i.e., Black Scholes, Binomial) to determine the fair value.
Because even if there are options traded on the company on public markets, employee options are a very different beast from traded options.
Accounting standards do not specify a particular valuation model, but do require that it:
1. Be consistent with fair value measurement
2. Be based on established principles of financial economic theory
3. Reflect all substantive characteristics of the award. I.e., if dependent on events that will occur after the grant date, wait until those facts are known.
What are the key valuation inputs for stock options?
- Exercise price (higher the price the lower the value of the option, since the employee will have to pay more to buy the stock!)
- Stock price volatility (increases the value of options: bigger upside, limited downside)
- Estimated life of the award (how long is it until the options can be exercised)
- Estimated number of options that will be forefeited (some people may leave the company before the options vest)
- Dividend yield (higher dividend equals higher option value)
- Risk-free interest rate (higher the risk-free rate the lower the value of a call option)
This is also covered in the derivatives module
How do we account for stock options?
Timeline is:
1. Grant date, when the option is given
2. Vesting date, when the option is earned
3. Exercise date
Our job is to calculate the fair value of the option at the grant date. We spread the compensation expense over the service period. It therefore reduces net income.
The service period is the time between the grant date and the vesting date.
The price at exercise date is considered irrelevant to the compensation expense.
The compensation expense is recognised over the service period.
It adds to additional paid-in capital (which is part of equity) to balance out the compensation expense on the balance sheet
However, there is NO NET IMPACT on equity!
On the date they are actually exercised we do not recalculate. We just record the cash paid to us by the employee, and add it to additional paid-in capital
How do we account for stock appreciation rights?
Stock appreciation rights are another name for cash-settled share compensation.
They offer a reward to an employee for increases in share price, WITHOUT issuing shares
There is limited potential to induce risk aversion therefore
The fair value of the SAR is allocated as an expense over the service period.
SARs may also track phantom stock, for companies that haven’t actually issued shares but are able to calculate the company value
What is required to be disclosed by the lessee participating in a business lease?
- The carrying amount of a Right Of Use asset at the end of period (grouped by asset class)
- Total cash outflow for leases
- Interest expense on lease liabilities
- Depreciation charges for Right Of Use assets (grouped by asset class)
- Additions to Right of Use assets
Plus maturity and qualitative analysis of the lease liabilities and activities. This includes:
- Nature of the lessee’s leasing activities
- Future cash outflows to which the lessee is potentially exposed (that are not in liabilities). This is because lease payments are binding and so are as important as knowing the debt that a company has
- Restrictions or covenants imposed by leases
- Sale and leaseback transactions (a classic way of raising cash, and way of decreasing management admin)
What is required to be disclosed by a lessor participating in a finance lease?
- Amount of selling profit or loss
- Finance income on the net investment in the lease
- Income relating to variable lease payments (i.e. those dependent on contingencies that may change going forward), not included in measurement of the lease
- Qualitative and quantitative explanation of significant changes in the carryong amount of the net investment
- Maturity analysis of lease payments receivable. This is the undiscounted cash flows for Y1 to Y5 individually, and for years beyond the total
Plus:
6. Qualitative and quantitative information about leasing activities (is it a leasing company? How dependent is it on leasing?)
7. If it is a leasing company, how the lessor manages risks associated with rights it retains in underlying leased assets. (how do we know the lessees are not ruining the assets we are leasing them?)
What is required to be disclosed by a lessee participating in an operating lease?
- Lease income
- Income relating to variable lease payments not baseds on an index or rate
- Disaggregated information about each class of property, plant and equipment subject to operating leases
- Maturity analysis of lease payments receivable. This is the undiscounted cash flows for Y1 to Y5 individually, and for years beyond the total.
Plus:
6. Qualitative and quantitative information about leasing activities
What are the disclosures requires for postemployment plans?
For defined contribution pension plans, the amount must be recognised in the income statement for the period.
For defined benefit pension plans, we must disclose:
1. The characteristics and risks
2. Identify and explain the amounts shown in the financial statements
3. Describe how the plan may affect the amount, timing and uncertainty of the entity’s future cash flows
In addition, speciifc disclosures required include:
4. Nature of benefits provided, regulatory framework, governance, risks
5. Reconciliation of the opening net position to the closing net position
6. Composition of plan assets by category (i.e., asset class)
7. Indications of the effect of the plan on the entity’s future cash flows
8. Sensitivity analysis showing how changes in assumptions (ie., discount rate, future salary increases) would impact the financial statements
What disclosures are required on share-based compensation?
A description of each TYPE of share-based payment arrangement, including vesting requirements, the maximum term of the options, and the method of settlement.
For options, we must state:
- The number outstanding at the start of period
- Granted during period
- Forefeited during period
- Exercised during period
- Expired during period
- Outstanding at the end of the period
- Exercisable at the end of the period
For other equity instrument granted during the period, we must state:
- The number, and their weighted average fair value
- How fair value was measured
Which of the following is a potential drawback of compensating employees with stock options?
A. May make employees adverse to risk
B. May make employees seek more risk
C. Both of the above are potential drawbacks
C. Both of the above are potential drawbacks
They don’t want to risk losing any value the option has
Options are also asymmetric: they may also take on more risk when the option is out of the money getting it into the money.
So both are right
Assume XYZ Company discloses the following information in its Stock Compensation note: As of 31st December 2021, we had USD630 million of unrecognised compensation cost related to nonvested stock-based compensation awards granted under our plan. We expect to recognise this cost over a weighted average of 3.2 years as a stock-based compensation expense. What is the expected compensation expense in 2025?
A. USD 39m
B. USD 197m
C. USD 630m
2025 takes the tail end of that weighted average 3.2 years, so we divide 630m/3.2 and then multiply by 0.2 years
For leases with a term longer than one year, leases report a right-to-use asset and a lease liability on the balance sheet:
A. Only for finance leases
B. Only for operating leases
C. For both finance and operating leases
C. For both finance and operating leases
Under the new rules for IFRS.
(If equal to or more than 5000USD)
Note, assume the question is asking about IFRS unless otherwise stated.
Under US GAAP, a lessor’s reported revenues at lease inception will be highest if the lease is classified as:
A, A sales-type lease
B. An operating lease
C. A direct financing lease
A. A sales-type lease
An operating lease involves keeping the asset and depreciating it.
A direct financing lease and a sales-type lease are both financing leases.
However, for a direct financing lease, all of your revenue is interest.
For a sales-type lease, you take profit on sale (which would boost revenues)
note this isn’t covered in any detail on the curriculum
Under US GAAP, a lessee’s accounting for a long-term finance lease after inception will include:
A. Recognising a single lease expense
B. Recording depreciation expense on the right-of-use asset
C. Increasing the balance of the lease liability by a portion of the lease payment
B. Recording depreciation expense on the right-of-use asset
For a financing lease we do not recognise a single expense.
We decrease the lease liability by paying it off over time, so C is not correct.
B is correct because we record a finance lease as interest and amortisation of the right of use asset on the income statement.
What is accounting profit defined as?
AKA pretax income
Reported on the income statement
Based on accounting standards
Taxable income is income subject to income taxes under relevant tax laws
Accounting profit and taxable income are likely to be different either due to temp or permanent differences
What is the carrying amount?
The amount at which an asset or liabiltiy is recorded in the FS
What is income tax paid?
CASH amount paid
Reduces income tax payable
What is income tax payable?
Based on taxable income
Appears on the balance sheet
An “outstanding” item in my terminology.
In the sense that it is reduced when income tax paid is recorded (a cash amount paid toward taxes)
What is the cause of temporary differences between accounting profit and taxable income?
Timing differences i.e., due to the matching principle, slower depreciation on the accounts
This may cause carrying value of the asset to be greater than the tax base (which creates deferred tax liability). This is a taxable temporary difference.
or less than the asset base (which creates deferred tax asset). This is a deductible temporary difference.
What happens if there are permanent differences between carrying value and tax base?
Permanent differences do not result in a taxable or deductible temporary difference
This will be due to differences in accounting standards and not just timing of how events are recorded
This entails that the company tax rate is not equal to the statutory tax rate.
If it is only a temporary difference company tax rate will equal statutory
When certain expenditures result in tax credits that direct reduce taxes, the company will most likely record:
A. DTA
B. DTL
C. No DTA or DTL
C. No DTA or DTL.
The tax credits are never going to hit the accounts, because they are permanent. Thus it does not constitute a temporary difference.
How do DTAs and DTLs result from assets and liabilities?
For assets, when carrying value > tax base this created DTL on the balance sheet
When carrying value < tax base, this creates DTA on the balance sheet
For LIABILITIES, when carrying value > tax base this results in DTA on the BS
When carrying value < tax base, this results in DTL on the BS
How do we find DTA and DTL and where do they appear on the FS?
Temporary difference in value of assets or liabilities x tax rate = DTA or DTL on the BS
Income statement sees a DT charge or credit: the change in DTL or DTA during the year
What is the valuation allowance when it comes to DTA or DTL?
We should only recognise a DTA if we expect to be able to realise the economic benefit of it.
Although we might be able to benefit from a DTA if we will profit in future, if the company is not likely to profit in future then the DTA will not necessarily provide an economic benefit (since taxes are only paid when the firm profits)
If this is in doubt, for an existing DTA, under IFRS we write down the DTA. This might not be a full writedown but be something like 50%.
Under US GAAP we create a valuation allowance to offset DTA.
As an analogy we might add depreciation to PPE to bring it down to a net value. The same occurs under GAAP for DTA.
Analysts should treat deferred tax liabilities that are expected to reverse as:
A. Equity
B. Liabilities
C. Neither liabilities nor equity
B. Liabilities
This is a very obvious question!
There might be a case where DTL keeps building because a company keeps buying more and more assets and is expected to pay back progressively more tax in future.
In this case, we would remove the liability and instead include it as equity
What is the statutory tax rate?
The corporate income tax rate in the country in which the country is DOMICILED
What is the effective tax rate?
An accounting ratio:
Reported income tax expense / Pre-tex income
This is useful for forecasting net income
What is the cash tax rate?
An accounting ratio:
Tax paid in cash in period / Pre-tax income
Useful for forecasting cashflow
Why is the statutory tax rate not usually equal to the effective tax rate?
It may be due to several factors:
1. Tax credits (a permanent difference)
2. Expenses not deductible for tax purposes (a permanent difference)
- Adjustments to previous years
- Witholding taxes on dividends
- Activity outside country of domicile
Effective tax rate consistently lower the statutory rate or competitors’ rate is not unusual.
Tax avoidance gets a lot of press, but there is a lot of scope for tax PLANNING before you get to tax avoidance. Hence a well versed company can navigate tax laws in efficient ways
However as an analyst we SHOULD adjust for big one-offs.
In fact analysts often take a “normalised” operating income. This involves removing special items and income counted in NI from companies we own >=20% of (since we don’t actually receive this income). Though we don’t see this in L1
What reconciliation is used to explain tax expense?
A reconciliation is used to detail the difference between what your tax expense would have been at the statutory rate and the tax actually paid
Line items might include:
- Tax provision at the statutory rate
- Foreign tax differential
- Change in valuation allowance
- Change in unrecognised tax benefits
- Tax credits
- Noncontrolling investment transactions
- Other
- Income tax (provision) benefit
If EBT is higher than taxable income what item is used to balance the balance sheet?
A deferred tax liability
If EBT is lower than taxable income what item is used to balance the balance sheet?
A deferred tax asset
If my earnings before tax and taxable income are equal, do I have a deferred tax asset or deferred tax liability?
You could actually have both or neither.
If there is EBT and taxable income across multiple categories (e.g., depreciation, unearned revenue) but a mismatch for each one (which is possible and indeed proably common) then you could have both DTAs and DTLs. But they could also match in which case there would be neither a DTL nor a DTA
What tax mismatches lead to a DTL?
- Earnings Before Tax greater than Taxable Income
-Income Tax Expense greater than Tax Payable - Carrying Value greater than Tax Base
How can we figure out whether a DTL or DTA exists?
We can draw out a diagram.
On the left side (in order) go EBT, Income Tax Expense, and Carrying Value
On the right side go Taxable Income, and Tax Base
The left side is the debit side, right side is the credit side
Left side is financial reporting, right side is taxation
When the arrow points right, it is pointing to the credit side. A credit side is a liability, so we have a deferred tax liability.
When the arrow points left, it is pointing to the debit side. A debt is an asset, so we have a deferred tax asset.
EBT > Tax Inc
ITE > TP
Carrying Value > Tax Base
All generate a DTL
This also works in inverse (generates a DTA) and with negative numbers
What is a tax base?
The value of an asset in accounting for tax purposes which is taxable.
When we record an entry for tax purposes we do not use the term “carrying value” but “tax base” instead
In early 2009 Sanborn Company must pay the tax authority £80,000 on the income it earned in 2008. This amount was recorded on the company’s 31st Deccember 2008 financial statement as:
A. Taxes Payable
B. Income Tax Expense
C. A Deferred Tax Liability
A. Taxes Payable
Analysts should treat deferred tax liabilities that are expected to reverse as:
A. Equity
B. Liabilities
C. Neither liabilities nor equity
B. Liabilities
Sony reports its PPE at $500m for financial reporting purposes, but the asset class has a tax base of $480m. Given a tax rate of 30%, this situation results in a:
A. $6,000 DTA
B. $20,000 DTL
C. $6,000 DTL
C. $6,000 DTL
Which statement is false?
A. All DTA / DTL are noncurrent under IFRS
B. DTA / DTL may be either current or noncurrent under US GAAP
C. All DTA / DTL are current under IFRS
C. All DTA / DTL are current under IFRS
IFRS treats DTA and DTL as noncurrent because if they are adjusted once a year, the idea is they are not going to be paid within the next 12 months
Research costs of $50m are expensed in the current year for financial reporting purposes but for tax purposes, this amount must be claimed over 2 years. This will result in:
A. Tax base < Carrying value
B. Tax base > Carrying value
C. The creation of a DTL account
B. Tax base > Carrying value
We would find 0 on our balance sheet for our research costs in assets because they are simply expensed. If we spread research costs over 2 years this implies that we would have to capitalise them.
thus for financial reporting purposes there is 0 in assets whereas for tax reporting there is $25m in assets.
Thus tax base is greater than carrying value
Donations made of $1m in the current period to various charities are only 75% deductible for tax reporting purposes. This will set up a:
A. DTA
B. DTL
C. Neither a DTA nor a DTL
C. Neither a DTA nor a DTL
This is a permanent difference
With respect to an increase in the statutory tax rates within a jurisdiction, reporting companies would experience:
A. An increase in their DTL and a decrease in their DTA
B. A decrease in their DTL and an increase in their DTA
C. An increase in both their DTA and DTL
C. An increase in both their DTA and DTL
Because the multiplier for both sides goes up
A company reports current DTA of $45k, non-current DTA of $100k, current DTL of $32k, and noncurrent DTL of $55k. What is the effect on the net tax position of a 7% decrease in tax rates?
A. An increase in tax benefits of $4060
B. A decrease in tax benefits of $4060
C. A decrease in tax benefits of $3,150
B. A decrease in tax benefits of $4060
Total DTA = $145k
Total DTL = $87k
145 - 87 = 58
58 x 0.07 = $4060
Tax credits would have the following effect on deferred taxes:
A. A tax credit reduces the balance in the DTL
B. A tax credit increases the balance in the DTA
C. A tax credit has no effect on deferred taxes
C. A tax credit has no effect on deferred taxes
Tax credit comes after tax payable. It is counted against the amount you owe, rather than modifying income or expenses
What are the six levels of the assessment spectrum to determine financial reporting quality?
- Generally accepted accounting principles, decision-useful, sustainable earnings
- GAAP and decision-useful (perhaps not sustainable earnings)
- GAAP (perhaps involves biased accounting choices)
- GAAP with intentional earnings management (“intentional choices that create biased financial reports)
- Non-compliant accounting (incorrect treatment or categorisation of transactions)
- Fictitious transactions (making stuff up)
Note GAAP here does not refer to US GAAP but just accounting principles used which have wide acceptance
Why might investors prefer conservative reporting choices?
Positive surprises are acceptable
What are the benefits for conservative financial reporting quality?
- Gives protection for lenders taking on risk (who have asymmetric information)
- Reduces chance of litigation (can’t be sued for overstating profits)
- Reduces chances of regulators or politicians catching heat
- In some countries, taxable income = accounting income. Thus there is a benefit to being conservative (you pay fewer taxes)
What motivations might an otherwise well-meaning human being have to inflluence financial reports?
- Mask poor performance
- Meet or beat analyst expectations (public companies face constant pressure to keep their earnings at a certain level and may get into a toxic cycle of always trying to meet the next analyst expecations at the cost of long-term growth)
- Manipulate compensation
A study concluded that only companies which are highly leveraged and unprofitable meddle with financial reports to avoid debt covenant violations, i.e., those that are already in a pickle, so this is largely an irrelevant motive
What is the fraud triangle?
Conditions conducive to financial mischief!
- Opportunity (i.e., poor internal controls)
- Pressure/motivation (i.e., incentives)
- Rationalisation (i.e., everyone agreed it was a good idea)
What mechanisms provide financial reporting discipline?
- Markets. Companies compete for capital, meaning its cost is a function of perceived risk
- Regulatory authorities: SEC in the US and IOSCO globally
- Auditors: Provide an independent opiion. However, there are limitations: their sampling may be quite narrow (they won’t look at every single thing) and their independence can be questionable, especially since the board chooses them.
After Arthur Anderson moves were made to separate audit and consulting arms as well, because the auditor was doing far far more than just auditing - Private contracting: loan ageements and convenants. Raising capital that puts controls in place. This motivates manipulation by the company but also close monitoring by the lenders
What is non-GAAP earnings?
Earnings figures a company will present using their own rules.
They might argue that GAAP does not accurately reflect the characteristics of the business.
However there is absolutely no common standard.
Non-GAAP earnings are also known as pro -forma earnings
What is excluded from pro-forma earnings?
Rental payments for leases (which creates EBITDAR)
Equity based compensation, since it’s not a cash charge
Acquisiton-related charges, since they are one offs
Impairment charges, since they are not cash
Litigation costs, since they are typically a long way off
Loss or gain on extinguishment of debt, since they are not cash
Loan covenants may also exclude these from earnings according to the preference of the lender
How should non-GAAP measures be presented?
The SEC states that the non-GAAP and GAAP measures must be displayed side by side with equal prominence, and you must reconcile one to the other
Management must justify its reasoning for believing it is useful.
Management must disclose additioal purposes, if material, for which it is used
THe IFRS says:
- Definition and explanation of non-IFRS measures must be given
- A reconciliation to the IFRS measure must be provided
- Management must explain why it is relevant
How should non-GAAP measures be calculated?
Non-GAAP measures must exclude charges that require cash settlementfrom liquidity measures
Measures that eliminate non-recurring itsems cannot exclude items very likely to re-occur (ie you cannot class something as a one-off that is not a one-off)
Who recognises the point at which risks and rewards are transferred from seller to customer?
Trick question - it depends on the agreement between them. You have such thing as “free on board” shipping whereby the customer owns it by the time it leaves for delivery.
What are some methods of earnings management on the income statement and balance sheet?
- Altering timing of revenue recognition
- Channel stuffing: offering deep discounts at the quarter end (or sending goods without orders)
- Bill and hold: goods sold but held by the seller. It’s easy to start fabricating these
- Revenue arrangement: managing allocation of revenue to performance obligations
- Rebates: managing the recognition of the rebate allowance
- Inventory cost flow assumption: FIFO vs weighted average vs LIFO choice
- Managing allowance for uncollectible receivables
- Deferred tax assets: bring forward tax losses, manage recognition of valuation allowance
- Depreciation method: manage salvage value, depreciation method, useful expected life
- Capitalisation vs expensing: incorrectly capitalise or expense costs
- Acquisition or goodwill: underestimate the fair value of acquired assets
- Capitalising intangibles: manage the timing of recognition, i.e., development costs
- Warranty reserves: manage allowance for warranty expenses matched to revenue
- Related party transactions: undertake transactions with RELATED parties at favourable rates
What are the methods of earnings management for the cash flow statement?
Cash flow from operations is closely scrutinised from investments
Accruals based earnings on the IS that don’t turn into cash flow may indicate shenanigans.
the CFS is more insulated from managerial manipulation than earnings, but still not immune to it.
- Accounts payable: one can delay payment of suppliers to increase CFO
- Capitalising interest: interest incurred in relation to the construction of assets can be classified as CFI
- IFRS choices:
- Interest received: CFO/CFI
- Dividends received: CFO/CFI
- Interest paid: CFO/CFF
- Dividends paid: CFO/CFF
Put the inflows in CFO, outflows if CFF if you want to manipulate
What are the warning signs that earnings have been managed on the BS and IS in terms of revenue?
“The choices management makes to achieved desired results leave a trail, like tracks in sand or snow”
Revenue:
- Look at the accounting policies note for FOB shipping, bill-and-hold, barter transactions, rebates, and multiple deliveries
- Look at revenue relationships: revenue growth vs competitors, industry, and the broader economy. Check accounts receivable vs revenue trend. Look at asset turnover.
What are two warnings signs that the earnings on the cash flow statement have been managed?
Ratio of cash flow to net income:
1. Consistently trending apart, or
2. Consistently below a value of 1
What are the warning signs that earnings have been managed on the BS and IS in terms of inventory?
Inventory:
- Look at inventory renationships like trend, inventory turnover ratio, or LIFO usage when in US GAAP
What are the warning signs that earnings have been managed on the BS and IS in terms of capitalisation policies?
Capitalisation policies:
- Compare capitalisation policies versus competitors and industry practice in the accounting policies note
What are the further warning signs that earnings have been managed?
- PPE disclosures: depreciation methods and useful expected lives are unrealistic
- 4th quarter results show consistent positive surprises
- Relataed party disclosures may show some unusual patterns
- When non-operating income (i.e., sale of a division) is included in revenue, this is a huge warning sign. we might detect this if the company discloses a sale of part of the business but it does not appear in non operating income
- Non-recurring expenses: repetition of non-recurring expenses that makes no sense
- Ratio analysis: If ratios are superior to competitors, why is this?
What are the risk factors associated with potential earnings manipulation and low financial reporting quality?
- Young companies with stellar history maturing
- Minimalist disclosures by management
- Management fixated with earnings
- Company culture
- Restructuring charges
- Acquisition focus
Earnings that result from non-recurring activities most likely indicate:
A. Lower-quality earnings
B. Biased accounting choices
C. Lower-quality financial reporting
A. Lower-quality earnings
Which technique most likely increases the cash flow provided by operations?
A. Stretching the accounts payable credit period
B. Applying all non-cash discount amortisation against interest capitalised
C. Shifting classificatoin of interest paid from financing to operating cash flows
A. Stretching the accounts payable credit period
Which of the following is an indication that a company may be recognising revenue prematurely? Relative to its competitors, the company’s
A. Asset turnover is decreasing
B. Receivables turnover is increasing
C. Days sales outstanding is increasing
C. Days sales outstanding is increasing
Which of the following would most likely signal that a company may be using aggressive accrual accounting policies to shift current expenses to later periods? Over the last five-year period, the ratio of cash flow to net income has:
A. Increased each year
B. Decreased each year
C. Fluctuated from year to year
B. Decreased each year
You will attempt to boost net income which is the denominator
Why use ratio analysis?
- Ratios help with comparability, removing size, currency as factors and assist in identification of trends
- Ratios highlight relationships between financial accounts and from one point in time to another
- Ratios are not the answer, however: they are indicative, and require interpretation
- Ratios are at the mercy of GAAP: accounting policies can distort ratios, and they may need adjusting to common GAAP
- Ratios have no standard form: it’s up to the analyst how to use them and how to calculate them. Ratios useful in one industry may not be useful in another
What are the limitations of using ratio analysis?
- It may be difficult to find comparable firms for multi division companies
2.Conflicting ratios like liquidity and solvency are similar - Ratios always require extensive judgement and interpretation to be useful
- Accounting policies can limit the usefulness and comparability of ratios
What are the vertical common size ratios?
- BS: percentage of total assets
- IS: Percentage of revenue (NI/Revenue)
- CFS: Percentage of revenue or % cash inflow/outflow
What is a horizontal common size ratio?
Every line item is expressed as a percentage of the same item from a base year
I.e., inventory in 2019 might be set as 100, with 2020 recording 110, 2021 105, 2022, 116, 2023 130 etc.
What is an activity ratio?
Measures efficiency of operations. How well you use your assets to generate profits
I.e., if you can generate 70m of revenue from 5USD of assets you are doing much better than someone who generates 70m of revenue from 100m of assets.
However we have to be careful: different industries will be different. Some industries may be much more capital intensive than others. It’s best to compare to industry peers to get useful comparisons
What is a liquidity ratio?
A ratio used to assess the ability of a company to meet its short term obligations, i.e., paying for inventory and paying down short-term debt. An example of this is the current ratio. There are several!
What is a solvency ratio?
A solvency ratio measures the ability of a company to meet its LONG term obligations. Often this comes down to debt vs equity
What is a profitability ratio?
A profitabiltiy ratio is somethign used to measure the ability of a company to generate profits from its resources. This is one of the most common sets of ratios used by financial analysts.
A typical example is net margin. gross margin, or operating margin
Why is context important when interpreting ratios?
- Ratios are a social animal: they lose their value in isolation
It’s important to compare prior periods, industry norms, competitors, and company goals - We must view ratios in the context of economic conditions. Bad numbers are more reasonable in a bad economy. They are less reasonable in a good economy
What are the turnover activity ratios?
Activity ratios measure asset utilisation and operating efficiency.
There are nine ratios we can group together into three sets, turnover and days, and assets, to make them easier to learn:
TURNOVER RATIOS
These are always:
income statement/ average balance sheet
- Inventory turnover: COGS / Average Inventory
- Receivables turnover: Revenue / Average Receivables
- Payables turnover: COGS / Average Payables
We usually take the most recent income statement figure, and an average balance sheet figure across the period we’re assessing (i.e., 3 years).
This is because the income statement captures income for the whole year, whereas the balance sheet is a snapshot of a point in time. Adding something large to the BS at the very end of the year may distort it
What are the days activity ratios?
Activity ratios measure asset utilisation and operating efficiency.
There are nine ratios we can group together into two sets, turnover and days, and assets, to make them easier to learn:
DAYS RATIOS
Number of days in period / turnover ratio
We convert between activity ratios and days ratios by dividing 365 by the turnover.
Days of inventory on hand (DOH) = number of days in period / inventory turnover
Days of sales outstanding (DSO) = number of days in period / receivables turnover
Number of days of payables = number of days in period / inventory turnover
What potential discrepancies are there between how different analysts will calculate turnover activity ratios?
There may be some doubt about how payables turnover should be calculated. Some vendors will break expenses down into payables. Otherwise we have to proxy using COGS.
Simialrly, receivables turnover would ideally separate out receivables from revenue, but often this information isn’t available, so we simply proxy by using revenue on the numerator
What might a high inventory turnover indicate?
If days of inventory on hand is low versus the industry or inventory turnover over the period is high v the industry, it could indicate:
- Efficient inventory management
- Inadequate inventory levels to sate demand
Check revenue growth to tell. If low DOH plus strong revenue growth this is a positive sign and points to 1.
Otherwise there could be another reason. A sudden drop in inventory could also indicate inventory obsolescence, i.e., I just had to throw a lot of old stock away because I wasn’t pushing it out effectively or overbought
What would high receivables turnover indicate?
High receivables turnover would entail low days of sales outstanding. I collect from my customers very quickly. This could indicate two things:
- Efficient debt collection, or
- Credit terms too stringent
We could tell which by looking at revenue growth and receivables aging.
A good way of tempting customers to buy from you might be to allow them to pay more slowly. This could drive revenue growth. Perhaps my receivables turnover is high because I am being too strict with my credit terms, leading to missed revenues (of people who can’t pay quite as quickly).
What would a high payables turnover indicate?
High payables turnover means you are paying your suppliers very quickly. Number of days of periods would thus be low.
This could indicate one of two things:
1. Not making use of credit terms. Maybe I could be more lax with payments (without taking fines or getting in trouble)
2. Taking early payment discounts. Perhaps they give me a 2% discount for paying within 10 days.
To determine which of the two is correct, we should look at liquidity. If payable turnover is high and I have lots of cash it would indicate I am taking advantage of those early payment discounts.
If turnover keeps decreasing and my cash is very low it’s a warning sign that I don’t have enough liquidity to operate my business.
What are the asset activity ratios?
Activity ratios measure asset utilisation and operating efficiency.
There are nine ratios we can group together into two sets, turnover and days, and assets, to make them easier to learn:
ASSET ACTIVITY RATIOS:
Working capital turnover:
Revenue / Average Working Capital
- Dollars of revenue per dollar of WC
- High means greater efficiency
- Industry is important
Fixed asset turnover:
Revenue / average net fixed assets
- Dollars of revenue per dollar of fixed capital or
- High means greater efficiency
- Low could mean inefficient, capital intensive business, new business not at full capacity, or new assets acquired
Total asset turnover:
Revenue / average total assets
- Same as above
Turnover actually means something different here. It’s not to do with inventory but just turnover as in revenue.
How are the five liquidity ratios calculated?
Current ratio = current assets / current liabilities
Quick ratio = (cash + short-term marketable investments + receivables) / current liabilities
Cash ratio = (cash + short term marketable investments) / current liabilities
Defensive interval ratio: (cash + short term marketable investments + receivables) / daily cash expenditure
Cash conversion cycle, aka net operating cycle: days of inventory on hand + days of sales outstanding - number of days of payables
How do you interpret liquidity ratios?
Liquidity ratios such as the current, quick, or cash ratio capture ability to meet short term obligations
Higher value means higher liquidity
Lower implies reliance on cash flow from operations or outside financing
The cash ratio in particular measures ability to withstand a crisis (esp in an economic downturn)
What does the defensive interval ratio measure?
How defensive a company is.
Holding cash on the balance sheet rather than investing it costs a company money.
Defensive interval ratio is cash + short term marketable investments + receivables over daily cash expenditure.
It shows how long a company can pay its daily cash expenditures using existing liquid assets.
Higher = more defensive. More reluctant to part with cash and more able to withstand issues or shocks
What does the cash conversion cycle measure?
AKA net operating cycle
Days of inventory on hand (DOH) + Days of sales outstanding (DSO) - number of days of payables
It measures the time between paying for goods from suppliers and collecting cash from customers, with selling the finished product inbetween
The longer the cash conversion cycle is the more your business will cost to finance, because it costs money to not have money
How might the cash conversion cycle differ across different industries?
A cash conversion cycle might be very short or even negative for a retailer like a supermarket.
They might receive cash from customers even before they pay for the products!
However they have very low margins. They race around the cash conversion cycle, collecting a very small amount each time.
By contrast something like a high-end jewellery store might have a crawling cash conversion cycle, but very high margins. Jewellery might sit in their store for months after they pay suppliers, but when they sell a piece, they might earn 50% of the purchase price as operating profit.
What is the advantage of a negative cash conversion cycle?
A negative cash conversion cycle is where the company receives cash from buyers before it pays suppliers
By contrast, a positive cash conversion cycle would mean the company has to wait between paying for its inputs and receiving cash from buyers for its product
If the company has a positive cash conversion cycle, it must pay for the working capital required to purchase the inputs, which involves a financing cost
If the company has a zero cash conversion cycle there would be no financing cost, since they don’t need to really hold cash on their balance sheet, and if they have a negative cash conversion cycle the opposite actually happens.
The company can receive cash from the buyers, and then invest it for the period until they are required to pay suppliers.
This additional investment income can boost
It also indicates the company has market power and can dictate the credit terms for buying its inputs
What might high number of days of payables but lots of cash on the balance sheet indicate?
A country is able to dictate favourable credit terms thanks to oligopsony or monopsony status (in econ terms).
If the balance sheet was weak in terms of cash balance we might think that the company was struggling to pay its suppliers, which is a bad sign for the sustainability of the business.
However in the case that the balance sheet is very strong and they have plenty of cash on hand it indicates that the company is deliberately not paying its suppliers.
Since the suppliers would be pretty reluctant to get into such a situation it must be because the company is a highly desirable buyer, perhaps because they dominate the market for this particular product
What does a solvency ratio measure?
Ability to fulfil long term debt obligations
Specifically, debt based solvency ratios measure the relative ampunt of debt in the capital structure
And coverage based solvency ratios measure adequacy of earnings and cash flow to cover interest expenses and other fixed charges.
These are important, because OPERATING leverage may limit the company’s ability to make use of long-term financial leverage
How is total debt calculated in the FS Level 1 module?
Total debt = Sum of INTEREST-BEARING short-term and long-term debt
Note that this excludes accrued expenses, accounts payable, and leases
What is interest coverage used for?
Determining the terms of debt covenants
it is calculated as EBIT / interest payments
A higher fixed charge coverage ratio indicates greater solvency
What is fixed charge coverage used for?
it is used to measure the QUALITY of preferred dividends.
It is calculates as:
(EBIT + Lease Payments)
_________________________
(Interest Payments + Lease Payments)
A higher fixed charge coverage ratio indicates greater solvency
What are the four leverage based solvency ratios?
Debt to assets (total debt ratio): Total Debt / Total Assets
% of total assets financed with debt
Debt to capital ratio: Total Debt / (Total Debt + Total Shareholder Equity)
% of capital represented by debt
Debt to equity ratio: Total Debt / Total Shareholder Equity
Amount of debt relative to equity
Financial leverage ratio: Average Total Assets / Average Total Equity
Average
The average is used here unlike the others. This is because this ratio is used later in another module to calculate DuPont analysis
Often in practice we actually use year end total assets and total equity
Debt to ebitda ratio: total debt / ebitda
OR net debt / ebitda
Net debt = total debt - (cash + marketable securities)
This measures how many years it would take to repay debt based on EBITDA
What are the four return on sales ratios?
Gross profit margin: gross profit/revenue
Operating profit margin: operating income / revenue
Pretax margin: EBT / revenue
Net profit margin (which we can use this for DuPont): net income / revenue
These are return on sales revenues, that compare income to revenue.
They measure returns earned during a period
They are also part of a common size income statement (proportional
What are the five return on investment ratios?
Operating return on assets: operating income / average total assest
Return on assets: net income / average total assets
Return on invested capital: Ebit(1-1) / average total st & lt debt and equity
Return on equity: net income / average total equity
Return on common equity: (net income - preferred dividends) / average common equity
How do we perform basic DuPont analysis?
We multiply return on assets (net income/average total assets) by leverage (average total assets/average shareholders’ equity).
We can also cancel out the avg total assets term to simply arrive at the formula
ROE = net income / average sh’s equity
What is more interesting than ROE in itself is what drives ROE.
- Is it high leverage (are we borrowing a lot and therefore using our sh’s equity efficiently)?
- Is it high return on assets (are we making high quality investments)?
- Is it both?
What is the overconfidence behavioural bias?
The unwarranted faith in one’s own ability
This is more common when making CONTRARIAN predictions
Mitigation strategies include sharing, reviewing insights, widening the confidence intervals you provide, and using scenario analysis to consider a wider range of possibilities
What is the five-part or extended DuPont analysis?
We take our three-part breakdown and then we break down net income / revenue even further.
The easiest way to imagine this is to start at the bottom of the income statement and start to work our way up.
So at the bottom is net income. Just above this is tax. What comes above? Earnings before Tax. So we put this in the bottom of the ratio. Net income / EBT. What is in net income but not EBT? Tax. So this is the tax burden.
Then we look at the next line. What is above EBT? It’s interest. What is the figure that takes EBT and excludes interest? Earnings before interest AND tax. So we put EBIT at the bottom of the next.
EBT / EBIT. What is in EBT but not EBIT? Interest. So this is the interest burden.
Then we arrive at the third ratio. What are we on? EBIT. So we add EBIT to the top. Then we have EBIT / Revenue. This is our last one in the expansion. What is this about? It’s about the EBIT margin on revenue. So this is just called the EBIT margin.
Tax burden x interest burden x EBIT margin x total asset turnover x leverage = return on equity
This kind of decomposition can help us see what changes in return on equity are caused by
What is a sensitivity analysis?
Creating a range of possible outlines based on how specific assumptions are changed
Contrast this to scenario analysis, where change results from total differences in the business landscape
What is a scenario analysis in models & forecasting?
Where one attempts to predict outcomes for a business resulting from large changes in the economic bacgkround.
Both mutually exclusive and exhaustive events can be assigned.
Probabilities, the mean/median scenario, and outputs can be derived.
I.e., I might envisage the economy to be in one of three phases next year: boom, recession, or slow steady growth.
I might assign a 20% probability to the first 2 and a 60% probability to the last
Based on that I can calculate how it might impact my business
What is a simulation in models & forecasting?
A computer-generated sensitivity or scenario analysis based on probability models for different input factors. I.e., a Monte Carlo simulation
What is the illusion of control?
This is a behavioural factor which may lead experts to make forecasting errors, ie a behavioural bias
The illusion of control is “overestimation of ability to control what cannot be controlled”
This can lead to overly complex models, and leads to diminishing marginal returns
Mitigation involves focusing on the most important variables and discarding the others
What is conservatism bias?
Conservatism bias is a behavioural bias that leads financial analysis and experts to make forecasting errors.
It is related to anchoring and adjustment.
Conservatism bias is defined as “maintaining prior views of forecasts by inadequately incorporating new information”.
Mitigation involves regular review, and more flexible models
What is representativeness bias?
Classifying information based on past experiences and KNOWN classificaitons
This involves base rate neglect
We can contrast the “inside view” to the “outside view”. The outside view will consider the base rate.
Mitigation strategies involve considering the base rate and making adjustments
What is confirmation bias?
The tendency to seek and notice information that confirms prior belief. This leads experts to persistently make forecasting errors.
Mitigation strategies include deliberately seeking opinions that differ
What are Porter’s Five Forces?
Factors that help assess relative profit potential of a company, including whether there are prospects for high or low sales growth, and forecasting what the margins might look like. It largely boils down to competitive advantage:
- Threat of substitutes
- Rivalry
- Bargaining power of suppliers
- Bargaining power of buyers
- Threat of new entrants
What are the impacts of inflation and deflation on a company?
The impact differs from company to company, affecting both revenues and expenses.
The key question for the analyst is: can the company pass on higher input prices to customers?
Key factors include industry structure.
For example, the US beer market is an oligopoly, with AB InBev holding 50% market share.
The customer base is fragmented, meaning that prices can generally rise and fall with input costs. There is high pass-through ability.
By contrast, the European beer market is differnet. Beer is distributed through a concentrated customer base (buyers like supermarkets), and there is no single dominant brewer. Changes in European beer prices thus average 100 basis points less than inflation.
This is known as elasticity. During inflation, increasing prices can have a negative impact if demand is elastic, and will have little impact if demand is inelastic.
During deflation, dropping prices may benefit volume in the short run (if demand is elastic), until competitors react, but will likely have minimal effect if demand is inelastic
What can companies with limited ability to pass through changing input costs to customers do to deal with inflation and deflation?
- They may be able to use long-term price-fixed forward contracts to lock in a certain prior known price. This will also delay the inflation impact. Example: airlines, who might see 50% of their cost base as fuel costs, might purchase forward contracts for kerosene
- Consider industry specific factors i.e., agriculture is deeply affected by the weather. Attempt to find supply that is not affected by these risks
- A company might want to pursue vertical integration to offset inflation. Ownership of parts higher up the value chain means that if prices rise you are also able to sell to other customers from that part higher up the value chain and take in some of the profits - or supply to your business lower down the value chain at preferential or even loss-leading rates
- Availability of substitutes. They might want to think whether they can diversify their supply and look to other countries for inputs
How can businesses offset unforeseen or inflated expenses to do with inflation?
As a financial analyst looking at a business, businesses will tend to decrease discretionary spending when raw material costs rise. They may have to spend less on advertising costs and research and development to make more room in the budget for raw materials.
Of course thinking long term, cutting back on these things might hurt your growth
What factors affect the choice of time horizon when using an explicit forecast horizon to assess a company?
- The style of investing strategy for which the security is being considered. If the stated investment horizon is 3-5 years, this equates to 33-20% average annual turnover for securities.
- The cyclicality of the industry. Forecasts should be long enough to reach the expected mid cycle sales or profitability level (i.e., mining, consumer cyclical)
- Company specific factors. Given a recent acquisition or restructuring time is needed to realise the full impact and resume typical or representative operations, even if it has already been 2-3 years since in some cases
- Employer’s preferences.
What factors must be considered when using longer-term predictions to assess the quality of a company’s earnings?
- You must ensure that you are using normalised earnings or free cash flow (mid-cycle)
- You must ensure that you are not including unusual or temporary factors (positive or negative impact) in your predictions. You must therefore understand the cycle, account for acquisitions and restructuring
- Often you would attempt to calculate a long-term trend using historical data, i.e., using regression analysis
What factors must you consider when using terminal value estimation to determine the quality and company’s earnings into the future? (i.e., DCF)
- You must calculate present value of future free cash flows
- You must predict what that FCF is going to do in perpetuity. Is it going to hit the historical rate? Above? Below? It might be below if it’s a mature business that has previously had good cash flows.
- Inflection points and economic disruption can be critical in making, adjusting, and understanding forecasts. Remember, widen your confidence intervals. Include what might happen in the case of major disruption
