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.
