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CFA English > Session 7&8&9 > Flashcards

Session 7&8&9 Flashcards

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1
Q

Provisions

A

an estimated liability, based on prudence concept we should provide for expenses as soon as they are foreseeable
(we put the expense in the income statement and make a liability in the balance sheet)

*tax expenses in companies’ balance sheets are provisions because you don’t actually know the exact amount of tax that you are going to pay year end

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2
Q

Accrued liability

A

for when we have used a good or service but we have not been invoiced yet

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3
Q

Deferred tax liabilities

A

flip side of deferred tax assets, for some reason we pay less tax now but we’re gonna pay more tax in the future

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4
Q

Current tax liabilities

A

the provision of what we believe we owe the tax authorities based on this year’s profits

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5
Q

Unearned revenue

A

the customer paid us we have not yet met the criteria to record it in our income statement

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6
Q

Capital at par value

A

(Equity)
issue 100 shares at 1$ par value –> 100$ capital at par

*any additional gains from issuing would go to additional paid in capital account (share premium account)

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7
Q

Retained earnings

A

accumulated amount of reinvested earnings since the company set up

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8
Q

Other comprehensive income

A

(equity)

some strange gains and losses that couldn’t come in income statement so are added to equity directly

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9
Q

Noncontrolling (minority) interest

A

(equity)
**under US GAAP it used to be treated as mezzanine financing but now it’s considered owner’s equity in both GAAP and IFRS.

When a parent has legal control of a subsidiary, the parent consolidates the subsidiary’s financial results with its own. Ownership of > 50% of the subsidiary’s voting common stock generally implies legal control. so you add 100% of assets and liabilities but you do not own 100% of the company. so by minority interest account we show the minority share of net assets added by consolidation

***consolidated balance sheets show what you control not what you own

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10
Q

Treasury stocks

A

(equity)
shares that company has purchased itself, so it reduces owners equity

*this is debit balance account of equity

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11
Q

Sources of revenue in income statement

A
  1. Sales- of products/services (turnover)
  2. Gains: realized when we dispose of our long lived assets (intangible/ PP&E/ Investments) if sold higher than balance sheet value.
  3. Investment income: dividends, capital gains and losses
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12
Q

Expenses in income statement

A
  1. Cost of goods sold
  2. SQ&A (selling, general and admin)
  3. Depreciation/ amortization: the cost we release over time for PP&E/Intangibles
  4. Interest
  5. Tax expense
  6. Losses
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13
Q

Accounting equations (3)

A
  1. revenue - expenses = net income
  2. assets = liabilities + owners’ equity
  3. owners’ equity = contributed capital + retained earnings
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14
Q

Contributed capital

A

capital at par value + additional paid in capital

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15
Q

Accrual accounting vs cash acounting

A

in accrual accounting we record transactions when they’re made not when the cash is paid or received, but in cash accounting everything is recorded when cash is transferred.

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16
Q

Accruals and valuation adjustments

A

we often tend to make these at year end:

  1. bad/doubtful debts: we know some of our debtors will default, we should estimate this at year end and reduce it from accounts receivable (decrease assets and retained earning through expense)
  2. prepaid expenses (assets)
  3. unbilled (accrued) revenue (asset)
  4. impairments/writedowns (asset)
  5. mark to market (asset- for passive investments): availablle for sale/ trading securities
  6. accrued expenses: expenses we know we’ve made but not yet received an invoice (liability- like cell phone bill!)
  7. unearned (deferred) revenue: we’ve been paid but not completed the earning’s process
  8. provisions: any uncertainties regarding expenses should be put through the income statement and also as a liability. (e.g. legal suits that are not yet finalized)
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17
Q

Accounting system flow

A
  1. Journal entries (double entry- debit/credit) –>
  2. Ledger T accounts for each account that is seen on the balance sheet: put together all debits and credits to find the balancing figure (Trial)–>
  3. Trial balance: list of all carried forward figures. –>
  4. Journal adjustments: adding accruals!- year end adjustments. –>
  5. Adjusted trial balance –>
  6. Financial statements
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18
Q

Statements and security analysis

A
  • before using an statement to analyze securities an analyst should know that financial statements include several estimates and judgments, so before using, analyst should make sure that he finds those estimates and judgements fair and correct.
  • analyst should review MD&A and footnotes
  • Misrepresentation: being balances doesn’t mean being correct
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19
Q

Income statement names!

A

Statement of operations
Statement of earnings
Earnings statement
Profit and loss statement

Rev - Exp = net income (earnings)

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20
Q

Net revenue

A

Revenue less adjustments for estimated returns and allowances (discounts)

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21
Q

IASB requirements for revenue recognition

A
  1. risk and reward of ownership transferred
  2. no continuing control or management over the good sold
  3. reliable revenue measurement
  4. probable flow of economic benefits in future
  5. cost of provided product can be measured reliably
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22
Q

IASB requirements for revenue recognition for servises

A
  1. when the outcome can be measured reliably, revenue will be recognized by reference to the stage of completion.
  2. outcome can be measured reliably if:
    * amount of revenue can be measured
    * probable flow of economic benefits
    * stage of completion can be measured
    * cost incurred and remaining cost to complete can be measured.
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23
Q

FASB and SEC requirements for revenue recognition

A

FASB: revenue should be recognized when it is realizable (customer likely to pay) and earned (after the completion).

SEC additional guidance:

  1. evidence of an arrangement between buyer and seller.
  2. completion of the earnings process, firm has delivered product or service
  3. price is determined.
  4. assurance of payment, able to estimate probability of payment.
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24
Q

Revenue recognition methods

A
  1. Sales basis method: used when goos or service is provided at time of sale, and there’s a high payment probability (cash or credit)
    * *Exceptions (Long term/ construction contracts):
  2. Percentage of completion method
  3. Completed contract method (GAAP): all of the expense and revenue and profit is recognized at the last year.
    * ** in IFRS it’s possible to report revenue but no profit, so we match sales rev to the cost incurred on that project in one year and they will offset.
    - —-
  4. Installment sales method (GAAP)
  5. Cost recovery method (most extreme)
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25
Q

Percentage of completion method

A

used for LT projects under contract, with reliable estimates of revenues, costs, and completion time (same in IFRS and GAAP)
**we bring in the revenue in accordance to our costs in that year

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26
Q

Completed contract method

A

used for LT projects with no contract, or unreliable estimates of revenue or costs, revenue and expenses are not recognized until project is completed because we cannot estimate and don’t know if there will be any profits!
*** in IFRS it’s possible to report revenue but no profit, so we match sales rev to the cost incurred on that project in one year and they will offset.

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27
Q

Installment sales method

A

*installment sales: a firm finances a sale and payments are expected to be received over an extended period.
used when firm cannot estimate likelihood of collection, but cost of goods/services is known, revenue and profit are based on percentage of cash collected.
**we bring in the costs(known) in accordance to cash collected.

***in IFRS present value of the installment payments is recognized at the time of sale and the difference between installment payments and the discounted PV is recognized as interest over time

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28
Q

Cost recovery method

A

used when cost of goods/services is unknown and firm cannot estimate the likelihood of collection, only recognize profit after all costs are recovered.
means we should match all revenues to incurred costs until all of costs are covered and then we can recognize profits.

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29
Q

Barter transactions

A

exchange of goods or services between two parties (no exchange of cash)

  • IFRS: Revenue = fair value of similar non barter transactions with unrelated parties.
  • GAAP: Revenue = fair value only if the company has received cash payments for such services historically (otherwise record sale at carrying value of assets)
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30
Q

Gross vs Net reporting

A

Net reporting is usually used for internet based merchandising companies that sell product but never hold in inventory, actually they act as agents. so they just report the “Net Sale” like it’s their commission. (instead of entering 100 and 80, we just enter 20)

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31
Q

US GAAP requirements for gross reporting

A
  1. company is primary obligator
  2. bears inventory risk
  3. bears credit risk
  4. can choose supplier.
  5. has latitude to set price

**if criteria are not met, then company is acting as an agent –> NET

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32
Q

Expense recognition method

A
  1. accrual basis - matching principle: match costs against associated revenues. (inventory, depreciation/amortization, warranty expense, …)
  2. period expenses: expenditure that less directly match the timing of revenues (e.g. admin costs- straight line deep) : match them against the period of use
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33
Q

COGC

A

beginning inventory + purchases - ending inventory

*should be matched with items sold and revenue over the period

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34
Q

Depreciation expenses

A

match depreciation to asset’s decrease in value over time.
asset’s decrease in value can have different forms, so we have different methods for depreciation. (use of relevant methods is a must in IFRS but not in GAAP)

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35
Q

Amortization expenses

A

depreciation of intangible assets (e.g., patents, royalty agreements, …)

  • *if the earnings pattern cannot be established use straight line.
  • *IFRS and GAAP firms both typically amortize straight line with no residual value.
  • *goodwill not amortized, checked annually for impairment
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36
Q

Impairments

A

when the fair value of an asset has fallen below it’s carrying value

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37
Q

Write off

A

an expense account, when we cannot sell our inventory it’s not an asset by definition, so it should be wiped from assets and booked as an expense in income statement.

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38
Q

Write down

A

an expense account, when the net realizable value (sale price minus costs of selling) of inventory has fallen below it’s cost, we should write down inventory to it’s recoverable amount, and that write down goes in income statement as an expense.

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39
Q

Unusual OR infrequent items (expense)

A

these items are above the line (pretax, gross of tax):

  1. gain/loss from disposal of a business segment or assets
  2. gain/loss from sale of investment in subsidiary
  3. provisions for environmental remediation (we expect to be fined)
  4. impairments/ write offs/ write downs/ restructuring (costs of a division)
  5. integration expense for recently acquired business
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40
Q

Handling of discontinued operations in income statement

A

operations that management has decided to dispose of but (1) has not done so yet or (2) did so in current year (mid year) after it generated profit or loss - also assets, operations and financing activities must be physically and operationally distinct from firm in order to be a discontinued operation

**only the net of profit is reported net of taxes after net income from continuing operations (below the line)

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41
Q

Extraordinary items

A
  • only in GAAP, prohibited in IFRS
  • items that are both unusual and infrequent.
  • reported net of taxes after net income from continuing operations (below the line)

Includes:

  1. losses from expropriation of assets (mosadere)
  2. gains and losses from early retirement of debt (when judged to be both unusual and infrequent)
  3. uninsured losses from natural disasters
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42
Q

Accounting changes

A
  1. change in accounting principle (lifo to fifo, or change depreciation method) –> Retrospective application: under both IFRS and GAAP prior years’ data should be adjusted due to this change as well
  2. change in accounting estimate (change in the estimated life of an depreciable asset) –>
    * does not require restatement of prior period earnings, but should be disclosed in foot notes
    * *these changes typically do not affect cash flow
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43
Q

Non-operating items in income statement

A

*depends on the nature of the firm

things like interest, dividends, gains/losses are not operational for non financial companys

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44
Q

Potentially dilutive securities

A

anything that company has in issue that could be converted to new shares at a later date

employee stock option
warrants
convertible debt
convertible preferred stock

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45
Q

Simple capital structure

A

structure of a firm with no potentially dilutive securities

–> these firms report only basic EPS

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46
Q

Complex capital structure

A

structure of a firm with potentially dilutive securities

–> these firms must report both basic and diluted EPS (if ALL of the potentially dilutive securities gets exercised)

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47
Q

Dilutive vs anti-dilutive securities

A
  1. decrease EPS if exercised

2. increase EPS if exercised

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48
Q

Calculating basic EPS

A

(Net income - preferred dividends) / weighted average number of common stock in issuance during the period

wighted average … : if no new purchase or buyback was done during the period, it will be the number of shares held at the beginning of year (or end of year)

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49
Q

Diluted earnings per share

A

too long!

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50
Q

Checking for dilution

A

*Conv. pfd: is pfd. dividends/ pfd shares

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51
Q

Dilutive stock options- treasury stock model

A
  1. calculate number of common shares created if options are exercised.
  2. calculate cash received from exercise
  3. calculate number of shares that can be purchased at the average market price with exercise proceeds.
  4. calculate net increase in common shares outstanding
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52
Q

Vertical common-size income statements

A

instead of monetary and absolute terms, we use relative figures so that we can compare different firms with different sizes.

*every item in the income statement will be shown as a percentage of sales.

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53
Q

Statement of comprehensive income

A

comprehensive income = net income + other comprehensive income

  • *it shows all of the change to stockholders’ equity that is not directly related to transactions with stockholders (new issues/ buybacks/ dividends) wether they’re realized or unrealized –> all of the gains and losses wether they’re in income statement or wether they’ve gone directly into stockholders’ equity, it means change in these items of balance sheet:
    1. foreign currency translation adjustment
    2. minimum pension liability adjustment
    3. unrealized gains or losses on derivatives contracts accounted for as hedges
    4. unrealized gains and losses on available for sale securities
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54
Q

Balance sheet analysis uses

A

Assessing liquidity (short term), solvency (long term) and ability to make distributions to shareholders.

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55
Q

Balance sheet analysis limitations

A
  1. mixed measurement conventions: historic cost/ amortized cost (bonds to par, …) / fair value
  2. fair values may change after balance sheet date
  3. off balance sheet assets and liabilities: like what happens whit operating leases.
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56
Q

Fair value

A

market value

or value is use (we valuate it ourselves based on future cash flows)

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57
Q

Inventory value

A

IFRS: lower of cost or net realizable value
GAAP: lower of cost or market

  • market: replacement cost, cannot be more than NRV or less than NRV minus a normal profit margin- in either case we will use NRV or NRV minus profit
  • cost: all standard costs bringing inventory to it’s current condition and location (so not including storage, admin and selling costs)
  • NRV: estimated selling price - estimated cost of completion- selling costs
  • **in case of subsequent recovery in value after a write down:
    1. IFRS: can write up only to the extent that a previous write down to NRV was recorded.
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58
Q

Depletion

A

like depreciation but for natural resources.

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59
Q

Depreciation and depletion effect

A

book value of assets will be:

  1. historical cost less accumulated depreciation or depletion, unless asset values are impaired (GAAP and IFRS)
  2. fair value less any accumulated depreciation (IFRS)
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60
Q

Asset types

A 
current 
non current/ long term:
tangible
intangible: identifiable, unidentifiable
investment
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61
Q

Intangible asset criteria

A

may only be recognized if they can be measured reliably. e.g., a company can only add its brand name value if it had bought it in the market and there’s a transaction value, so no internally generated intangibles!

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62
Q

Expensed Items

A

Internally generated brands, mastheads, publishing titles, customer lists, etc.
start up costs
training costs
admin overhead
advertising and promotion
R&D (in IFRS development can be an asset)
…

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63
Q

Marketable securities

A

classification of securities based on company’s intent with regard to eventual sale:
*held to maturity securities: debt securities held to maturity/ carried at cost (amortized cost)

  • available for sale securities: may be sold to satisfy company needs/ debt or equity/ current or not/ carried on balance sheet at market value/
  • trading securities: acquired for the purpose of selling in the near term/ carried in the balance sheet as current assets at market value
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64
Q

Held to maturity securities- Income Statement

A

income and realized gains/losses on disposal:
if purchased at discount: coupon +amortization of the discount

if purchased at premium: coupon - amortization of the premium

  • *held to maturity securities should not be disposed of prior to maturity (there’re penalties!)
  • **so if we do indeed hold to maturity there’s no gain or loss in the income statement.
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65
Q

Available for sale securities- Income statement

A

like HTM- one of comprehensive income items

**trading securities go through income statement, not directly to stockholders’ equity

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66
Q

Fair value assets and liabilities

A

Financial assets: trading securities/ AFS securities/ derivatives/ assets with fair value exposure hedged by derivatives.

Financial liabilities: derivatives/ non derivative investments with fair value exposure hedged by derivatives

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67
Q

Current liability

A

satisfies any of the following 4 criteria:

  1. expected to be settled in the entity’s normal operating cycle on in less than a year
  2. held primarily for the purpose of being traded
  3. the entity does not have a right to defer settlement for >12 months.
  • current portion of long term debt is a current liability, it’s a ling term loan that currently is in its last year
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68
Q

Common size balance sheet

A

each value is converted to percentage of total assets

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69
Q

Liquidity ratios

A
  1. current ratio = current assets/ current liabilities
  2. quick ratio = current assets - inventory / current liabilities
  3. cash ratio = cash + marketable securities / current liabilities
  4. defensive interval = cash + marketable securities / daily cash expenditure
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70
Q

Solvency ratios

A
  1. Long term debt to equity = total long term debt/ total equity
    * * total long term debt is all liabilities due after 12 months
  2. debt to equity = total debt/ total equity
    * *total debt is all of long term liabilities plus any interest bearing current liabilities.
  3. debt to capital: total debt/ total debt + total shareholders’ equity
  4. debt to assets = total debt/ total assets
  5. financial leverage = total assets/ total equity
  6. interest coverage: EBIT/ Interest payments (Total)
    * *cash flow ratio: CFO+ interest+ tax (cash based version of EBIT!) / interest paid (IFRS: if interest paid was treated as CFF, no addition is required)
  7. fixed charge coverage: EBIT + lease payments/ interest payments + lease payments
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71
Q

Cash flow statement

A

reconciles last year’s balance sheet’s cash and cash equivalents figure with this years
Operating cash flows (CFO)
Investment cash flows (CFI)
Financing cash flows

  • in IFRS dividend payments go under CFO but in GAAP goes under financing cash flow
  • trading securities go under CFO because if a firm has trading securities, then it’s likely a financial firm and these are it’s operations
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72
Q

Direct vs indirect cash flow statement

A

*Only CFO
Direct: identify actual cash inflows and outflows. (better for analysis because gives cash flows by function)

Indirect: begin with income and adjust that for changes in assets and liabilities. (increase in assets: deduct, increase in liability: add)
- useful because it makes a link between cash flow and net income.

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73
Q

Indirect cash flow method steps

A
  1. start with net income
  2. adjust net income for changes in assets and liabilities. (only OPERATING accounts)
  3. eliminate depreciation and amortization by adding them back (they’ve been deducted in arriving at net income but are non cash expenses)
  4. eliminate gains on disposal by deducting them and losses on disposal by adding them back (even if cash item, these are CFI, not CFO)
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74
Q

Calculating CFI

A

CFI = investment in assets (cash) - cash received on asset sales
**by assets we mean investment related assets (long term)

*to calculate cash received on sales:
gain/loss + gross asset value - accumulated depreciation
= gain/loss + net book value

**masalan agar ye zamin befrushim, gross asset value mice meghdari ke az account land am shode, estehlakesham meghdarie ke az contra accounte estehlake zamin kam shode.

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75
Q

Calculating CFF

A

CFF = increase in debt + increase in common stock - cash dividends paid
=(net borrowings - principal amounts paid) + (new equity issued - share repurchases - cash dividends paid(in IFRS?))

  • to calculate cash dividends paid:
    1) dividends declared = net income + beginning retained earning - ending retained earning
    2) dividends declared - change in dividends payable = cash dividend paid
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76
Q

Putting the cash flow statement together

A

CFO + CFI + CFF = net increase in cash

new cash balance = last year’s cash balance + net increase in cash

*it’s a reconciliation (making compatible) between this year and last year’s cash figures

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77
Q

Convert an indirect statement to a direct statement of cash flows

A

a direct statements is like an indirect, the same method is applied but instead of using the net income figure, we go through all income statement figures one by one and adjust base on related accounts.

  1. take each income statement item in turn (e.g., sales)
  2. identify related accounts from balance sheet (e.g., accounts receivable)
  3. calculate the change in the balance sheet item during period (ending balance - opening)
  4. apply the rule:
    increase in asset: deduct
    increase in liability: add
    decrease in an asset: add
    decrease in a liability: deduct
  5. adjust the income statement amount by the change in the balance sheet
  6. tick off the items dealt with in both the income statement and balance sheet
  7. move to the next item
  8. ignore depreciation/amortization and gains/losses of assets as these are non cash on non CFO
  9. continue until all items included in net income have been addressed.
  10. total up the amounts and you have CFO
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78
Q

Cash flow statement benefits

A

Benefits for the analyst:

  • do regular operations generate enough cash to sustain the business?
  • is enough cash generated to pay off maturing debt.
  • highlights the need for additional finance
  • ability to meet unexpected obligations
  • the flexibility to take advantage of new business opportunities.
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79
Q

Cash flow statement analysis- all/CFO

A
  1. analyze the major sources and uses of cash flow (CFO, CFI, CFF): where are the major sources and uses?/ is CFO positive and sufficient to cover capex (capital expenditure) –> if not it indicates we have to raise cash through debt or equity (CFF) or sales of assets (CFI)
  2. Analyze CFO: what are the major determinants of CFO (direct method)?/ is CFO higher or lower than net income? (if it’s too much lower, means we’ve generated earnings through accruals process not backed by cash so we get poor quality earnings)/ how consistent is CFO over time? (more stable, less risk)
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80
Q

Cash flow statement analysis- CFI/CFF

A
  1. Analyze CFI: what is cash being spent on? (PPE means organic growth, acquiring other companies means growth through M&A, … - should be consistent with MD&A)
  2. Analyze CFF: how is company financing CFI and CFO? is the company raising or returning capital? what dividends are being returned to owners?
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81
Q

Common size cash flow statements

A

two approaches:
1. each item as a % of sales (net revenue?), it’s useful because if we can forecast future sales, then we can forecast cash flows

  1. show each inflow as a percentage of total inflows, and each outflow by the percentage of total outflows.
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82
Q

Free cash flow (FCF)

to firm/ to equity holders

A
  • cash available for discretionary uses, remaining cash after capex that could be distributed between providers of finance.
  • frequently used to value firms

to firm: (before any distribution to debt or equity holders)
FCFF = NI + NCC - WCInv + Int(1-tax rate) - FCInv = CFO + Int(1-T) - FCInv

*NI= net income
*NCC: non cash charges- depreciation and amortization
*Int: interest expense
*FCInv: fixed capital investment (net capital expenditures= capital spending - sales of assets)
*WCInv: working capital investment
——
to equity holders: (before any distribution to equity holders but after distribution to debt holders)
FCFE = CFO - FCInv + net debt increase

  • net debt increase: debt issued - debt repaid
  • *we can value the firm using FCFF, and we can find the theoretical value of firms equity by forecasting FCFE
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83
Q

Capital expenditure

A

investing in the firm

capex

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84
Q

Cash flow performance ratios

A
  • cash flow to revenue = CFO/ net revenue (like net profit margin)
  • cash return on assets = CFO/ avg total assets (how is the firm using it’s asset base to generate cash flows)
  • cash return on equity = CFO/ avg equity
  • cash to income = CFO/ operating income (close to 1 means our operating earnings is of high quality)
  • cash flow per share = CFO-pref div / #common stock (—IFRS: if dividends paid were treated as CFO, they must be added back)
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85
Q

Cash flow coverage ratios

A
  1. debt coverage: CFO/ total debt
  2. interest coverage: CFO+ interest+ tax (cash based version of EBIT!) / interest paid (IFRS: if interest paid was treated as CFF, no addition is required)
  3. reinvestment = CFO/ cash paid for long term assets
  4. debt payment = CFO/ cash paid for long term debt repayment
  5. dividend payment = CFO/ dividends paid
  6. Investing and financing = CFO/ cash outflows for CFI & CFF
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86
Q

Horizontal common size statements

A

each line shown as a relative to some base year, facilitates trend (time series) analysis

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87
Q

Limitations of financial ratios

A
  1. not useful in isolation from the same ratio in other firms or other times
  2. must be viewed relative to other ratios, should look at the big picture and how all ratios move together
  3. different accounting treatments can make problems when comparing
  4. finding comparable industry ratios for companies that operate in multiple industries and represent consolidated statements
  5. determining the target or comparison value requires some range of acceptable values
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88
Q

Categories of ratios

A
  1. Activity: efficiency of day to day tasks/operations
  2. Liquidity: ability to meet short term liabilities
  3. Solvency: ability to meet long term obligations
  4. Profitability: ability to generate profitable sales from asset base
    Valuation: quantity of asset or flow associated with an ownership claim
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89
Q

Ratio analysis context

A
  1. company goals and strategy (MD&A) –> are ratios backing these up?
  2. Industry norms- compare ratios with them (there are limitations)
  3. economic conditions: stage of the business cycle will affect our expectations from the ratios
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90
Q

Pure vs mixed ratios

A

pure: gets both its numerator and denominator from the same statement –> both numbers from latest statement
mixed –> income statement figure comes from the latest statement but we use average value of the previous and current statement for balance sheet item

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91
Q

Inventory turnover

A

-activity ratio

COGC/ average inventory

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92
Q

Days of inventory on hand (DOH)

A

-activity ratio
365/ Inventory turnover

tells the length of time between receiving of raw materials and sales of finished goods

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93
Q

Receivables turnover

A

-activity ratio

revenue/ average receivables

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94
Q

Days of sales outstanding (DSO)

A

-activity ratio
365/ receivables turnover

*length of time between selling a finished good and collect the money

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95
Q

Payables turnover

A

-activity ratio

purchases/ average trade payables

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96
Q

Number of days of payables

A

-activity ratio
365/ payables turnover

*the length of time between receiving raw materials into our warehouse and paying our suppliers

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97
Q

Working capital turnover

A

-activity ratio
revenue/ average working capital

*how efficient is the firm using its working capital to generate sales

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98
Q

Working capital

A

current assets - current liabilities

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99
Q

Fixed asset turnover**

A

-activity ratio
revenue/ average net fixed assets (net of accumulated depreciation = balance sheet carrying value)

*how efficient is the firm using its fixed assets to generate sales

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100
Q

Total asset turnover

A

-activity ratio

revenue/ average total assets

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101
Q

Current ratio

A

-liquidity ratios
current assets/ current liabilities

*if lower than 1, it could mean some liquidity problems

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102
Q

Quick ratio

A

-liquidity ratios
cash + short term marketable securities +receivables / current liabilities

*it says inventory isn’t particularly liquid and should be deducted.

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103
Q

Cash ratio

A

-liquidity ratios
cash + short term marketable securities / current liabilities

*even purer than quick ratio, really liquid

104
Q

Defensive interval ratio

A

-liquidity ratios
cash + short term marketable investments + receivables / daily cash expenditure

*how long the company could survive if it didn’t have access to any new cash or investments, how long the company could operate using it’s existing cash investments and accounts receivable

105
Q

Cash conversion cycle

A

DOH + DSO - No. of days payables

if positive –> cash is leaving the company long before we receive it from our customers SOO the cash conversion cycle needs to be financed

  • a company with a current ratio lower than 1 and positive cash conversion cycle would probably have long term liquidity problems
  • supermarkets have lower than 1 current ratios but they have also a very different cash conversion cycle, this is often negative for them, so they can use the cash conversion cycle to finance the rest of the business and support their current ratio that is less than 1
106
Q

Solvency roots

A

Earnings variability: the volatility of our net income, our profit after tax
contributors:
1. business risk: variability in EBIT, Sales volatility and operating leverage
2. financial leverage

107
Q

Total debt

A

current and long term interest bearing liabilities.

another view: all long term plus current interest bearing

108
Q

Debt to assets ratio

A

-solvency ratio
total debt/ total assets

*typically debt should be a smaller percentage of assets, assets should cover debt

109
Q

Debt to capital ratio

A

-solvency ratio
total debt/ total debt + total shareholders’ equity

*shows the percentage of debt financing within our capital structure

110
Q

Debt to equity ratio

A

-solvency ratio

Total debt/ total shareholders’ equity

111
Q

Financial leverage ratio

A

-solvency ratio
Average total assets/ average total equity

*it’s a pure ratio, so why average?–> industry standard, and sometimes we calculate without averaging as well

112
Q

Interest coverage

A

-solvency ratio
EBIT/ Interest payments (Total)

*it’s a safety ratio, looking at how safely are you making your interest payments

113
Q

Fixed charge coverage

A

-solvency ratio
EBIT + lease payments/ interest payments + lease payments

*takes interest coverage ratio further and says interest is not the only fixed charge we should cover, so it adds leases

114
Q

Gross profit margin

A

-profitability ratio
gross profit/ revenue

*gross profit= sales - COGS

115
Q

Gross profit margin

A

-profitability ratio
operating income/ revenue

*problem: there’s no real definition of operating profit(income)
operating income = gross profit - operating costs
approximation: EBIT
**EBIT also contains non operating items (dividends received and gains and losses on investment securities)

116
Q

Pretax margin

A

-profitability ratio

Earnings before tax but after interest/ revenue

117
Q

Net profit margin

A

-profitability ratio
net income/ revenue

*most of return on sales profitability ratios are on the face of the common size income statement!

118
Q

Return on assets (ROA)

A

-profitability ratio
net income/ average total assets

*not good! net income only belongs to shareholders (it’s a levered measure) but is being divided by total assets which is financed by both equity and debt

it can be solved to a degree by using this alternative ratio:

ROA: net income + interest expense(1-T) (pre levered) / average total assets.

119
Q

Operating ROA

A 
-profitability ratio
operating income (or EBIT) / average total assets
120
Q

Inventory equation

A

beg inv + purchases - end inv = COGS

matching concept

121
Q

Inventory costs

A
  1. Product costs: capitalized as inventory, costs relate to getting the inventory to it’s state, and LOCATION–> purchase, labor, overhead,…
  2. Period costs: expensed when incurred–> abnormal costs, storage, selling and administrative costs
122
Q

Inventory cost flow methods

A
  1. FIFO: Highest ending inventory and lowest COGS (due to inflation)
  2. LIFO (No IFRS): lowest ending inventory and highest COGS
  3. AVCO: averaging
  4. Specific identification

**LIFO better for income statement and FIFO better for balance sheet (for each criterion, the one that shows more recent figures is better)

123
Q

Inventory Systems

A
  1. Periodic: Inventory and COGS are determined at the end of the period. –> beg inv +purchases - end inv = COGS
  2. Perpetual system: as each sales occurs, inventory on the balance sheet goes down and COGS goes up, for each purchase inventory goes up. –> no purchase account needed

**the inventory system only affects the LIFO and avco methods.

124
Q

Return on total capital

A

-profitability ratio

EBIT/ short + long term debt (total debt)+ equity

125
Q

Return on equity (ROE)

A

-profitability ratio

net income/ average total equity

126
Q

Return on common equity

A

-profitability ratio

net income - pref. div / average common equity

127
Q

DuPant analysis** (2,3)

A
  • an integrated ratio analysis method
  • takes ROE and explains why it’c changing year on year

stage1: ROE
* ROE: net income/ equity (average)

stage2: ROE = ROA* Financial leverage ratio
*ROA: net income/ total asset (av)
*finlev: total assets/ Equity (av)
explains that change in ROE is because of the return we generate on our assets or is it because of a change in our capital structure

stage3: ROE= net profit margin* Equity turnover = net profit margin* asset turnover* leverage
*net profit margin: net income/ revenue
*asset turnover: revenue/ total assets
*leverage: total assets/ equity (av)
explains that change in ROE is because of the change in profit margin or the sales we generate on our assets or is it because of a change in our capital structure

128
Q

DuPant analysis** (5)

A

ROE = EBIT (operating) margin* Interest burden* tax burden* asset turnover* leverage
EBIT margin = EBIT/ revenue
Interest burden = EBT/ EBIT
Tax burden = net income/ EBT

in the change in ROE because our operating margins have changed? is it because a change in interest? are we bearing more tax? ……

*tax burden = 1- effective tax rate

129
Q

Ratios for equity (valuation) analysis

**valuation ratios

A
  1. P/E: price per share/ earnings per share
  2. P/Cf: price per share/ cash flow (of operations or free CF to equity holders) per share
    * earnings can be manipulated because they come from the income statement which is accruals driven but it’s much harder to manipulate cash flow
  3. P/S: price per share/ sales per share
    * if earnings and CF are negative maybe we want to consider this
  4. P/BV: price per share/ book value per share
  5. basic and diluted EPS
130
Q

Per share quantities

A 
basic EPS
diluted EPS
cash flow per share
EBITDA per share
dividends per share
131
Q

Dividend related quantites

A 
dividend payout ratio = 1-b
retention rate (b)
132
Q

Sustainable growth rate

A

b*ROE

133
Q

Business risk ratios

A
  1. Coefficient of variation of operating income (approx EBIT)
  2. Coefficient of variation of net income
  3. Coefficient of variation of revenue(sales)
134
Q

Credit rating ratios

Credit analysis

A
  1. interest coverage ratios
  2. return on capital
  3. debt to assets ratios
  4. various measures of cash flow to total debt
135
Q

Segment reporting

A
  • ratio analysis has problems regarding conglomerates.
  • reportable segment: 50% of its revenue from sales external to the firm AND at least 10% of a firm’s revenue, earnings or assets. –> limited financial statements will be reported. (rev, EBIT, assets, liabilities (IFRS), capex, depreciation and amortization)
136
Q

Segment ratios

A
  1. Segment margin: S profit/ S revenue
  2. Segment asset turnover: S revenue/ S assets
  3. Segment ROA: S profit/ S assets
  4. Segment debt ratio (only IFRS): S liabilities/ S assets
137
Q

Long lived asset

A

asset held for continuing use not resell

138
Q

Capitalizing vs expensing

A

costs can either be capitalized as an asset on the balance sheet or immediately expensed in the income statement.

  • capitalizing involves depreciating or amortizing the asset’s cost over it’s useful life.
  • expensing results in an immediate reduction of net income

–> capitalize if there is a future economic benefit
Immediately expense if the future benefit is unlikely or highly uncertain

139
Q

Releasing costs

A

if we believe a certain cost will have future benefits we capitalize it and put it on the balance sheet, then by the matching principle we will release the cost to the income statement (match with revenues) which will be done in two ways, depreciation and amortization

140
Q

Cost vs Expense

A

cost is more inclusive, a cost could be an expense or an asset

141
Q

Software development costs

A
  1. for sale: expensed as incurred until technological feasibility is reached, after that can be capitalized (both IFRS & GAAP)
  2. for internal use: Same as for sale (IFRS)– Capitalize all (GAAP)
142
Q

Historic cost

A

purchase price + installation costs + transport costs

143
Q

Net book value

A

= carrying value - balance sheet value

=historic cost - accumulated dep

144
Q

Economic depreciation

A

decline in market value of the asset because we held it rather than sell it
*accounting dep may not equal economic dep

145
Q

Depreciation methods

A
  1. straight line: SL= C-S/ T
  2. accelerated (double declining balance): DDB= net book value* (2/T)
  3. units of production. (based on usage rather than time): UOP= (C-S)*(units produced/total capacity)

*IFRS requires a method that matches the actual revenue trend, in GAAP there’s no difference

146
Q

Component depreciation

A

involves depreciating an asset based on the separate useful lives of the asset’s individual components (e.g., building–> roof, walls, elevator, carpeting, …)

  • under IFRS: required
  • under GAAP: permitted
147
Q

Amortizing

A

identical to depreciation but for intangibles– estimating useful life is harder–

  • intangibles with finite life: amortize/ pattern should match consumption of benefits (both IFRS & GAAP)
  • indefinite life: no amortization/ periodic impairment review
148
Q

Asset revaluation

A
  • GAAP: no revaluation- depreciated historic cost is used
  • IFRS: you can choose between depreciated historic cost or fair value (revaluation)- can even use different approaches for different assets
149
Q

Revaluation below historic cost

A
  • balance sheet asset reduced to fair market value
  • loss taken to income statement
  • subsequent reversals of value recognized in income statement up to original loss
  • increase in value above original cost taken to equity (a comprehensive income item)
150
Q

Revaluation above historic cost

A
  • balance sheet asset increased to fair market value

* gain taken directly to equity (a comprehensive income item)

151
Q

Impairment of long lived assets (PPE & Intangibles)- IFRS

A
  1. annually assess indications of impairment (decline in market value, change in physical condition, …)
  2. asset is impaired when book value > recoverable amount
  3. if impaired, write down asset to recoverable amount and recognize loss in the income statement
  4. loss reversal is allowed up to the original loss, anything above that wont be shown.

**Recoverable amount= greater of value in use and fair value less selling costs

152
Q

Recoverable amount of an asset

A

the greater of fair value less selling costs and value in use

*value in use: present value of future cash flows

**obviously both figures are wildly subjective!

153
Q

Impairment of long lived assets (PPE & Intangibles)- GAAP

A

2 steps:

  1. identification of impairment: asset is impaired when book value > asset’s estimated future undiscounted cash flows.
  2. loss recognition: if impaired, write down asset to fair value (or discounted value of future cash flows if fair value is unknown), recognize loss in I/S
  • loss reversal is prohibited for assets held for use
  • impairments are lower in GAAP, because it doesn’t subtract the selling cost.
154
Q

Impairment of long lived assets - assets held for sale

A

both IFRS & GAAP:

  1. asset tested for impairment when transferred from held for use to held for sale.
  2. depreciation expense is no longer recognized
  3. asset is impaired if book value > net realizable value (fair value - selling costs)
  4. if impaired, write down asset to NRV
  5. loss reversals are allowed up to the original loss under IFRS and GAAP
155
Q

Disposal of long lived assets (derecognition)

A

Sales proceeds - carrying value –> gain/loss in I/S

156
Q

Investment property

A

IFRS only:

  • property owned for the purpose of earning rental income and/or capital appreciation
  • valued at cost or fair value (in fair value model, changes in value are taken to income statement, not comprehensive income)
157
Q

Tax accounting

A

Accounting methods that focus on taxes rather than the appearance of public financial statements. Tax accounting is governed by the Internal Revenue Code which dictates the specific rules that companies and individuals must follow when preparing their tax returns. Tax principles often differ from Generally Accepted Accounting Principles.

  • it’s modified cash accounting, sth between cash accounting and accrual accounting because accrual accounting entails so much subjectivity and cannot be accepted for tax purposes. –> causes temporary time differences.
158
Q

Valuation allowance

A

if we believe that we won’t be profitable enough in the future to use deferred tax assets, we net those assets against valuation allowance. (amount of DTAs that probably wont be used)

  • valuation allowance is a contra asset account like accumulated depreciation, is used for inventory write downs as well
  • increasing the valuation allowance will increase income tax expense and reduce earnings
159
Q

DTAs & DTLs

A

both are presented on the balance sheet, not netted.

  • IFRS: DTL and DTA always non current
  • GAAP: DTL and DTA current and non current depending on reversal (??)
160
Q

Accounting vs taxable profit

A
  1. revenues and expenses recognized in different periods for accounts and tax (e.g., we should estimate and account for warranty expenses at the time of sales under the accruals method, but in tax, it will be added when occurred)
  2. carrying values of assets and liabilities may differ from tax base (value of assets and liabilities under tax approach) e.g., depreciation is subjective and not allowed in the tax returns so tax authorities take out accounting depreciation and replace it their own version of depreciation.
  3. specific revenues and expenses not recognized for tax or accounting purposes (like tax exempt revenues and expenses –> permanent timing differences)
  4. tax loss carryforwards.
  5. gains and losses from asset disposals are calculated differently for tax and financial statements, for tax it’s just sales price compared to purchase price
161
Q

Tax loss carryforward

A

if you have negative taxable income in a year, you can roll that forward to offset against future taxable incomes.
*it results in a deferred tax asset equal to the loss times tax rate

162
Q

Deferred tax causes

A

DTL: temp timing difference –> tax deduction > accounting expense –> taxable income paying less today but should pay more in future –> an increase in liabilities.

DTA: …

163
Q

Tax base- for asset

A

tax base of asset = amount deductible for tax purposes in future periods as economic benefits are realized– assets value for tax purposes

  • tax base may not equal carrying value
  • above differences come from temp timing differences
  • difference between carrying value and tax base times tax rate gives us DTA or DTL (the net balance)
  • tax base and carrying value will be the same for non taxable benefits (permanent differences)

*when an asset is sold, the TAXABLE gain or loss on the sale is equal to the sale price minus the assets tax base

164
Q

Tax base- for liability

A

a liability’s tax base = the carrying value of the liability minus any amounts that will be deductible on the tax return in the future.

*the tax base of revenue received in advance is the carrying value minus the amount of revenue that will not be taxed in the future.– typically it equals carrying value so tax base would be zero, because tax authorities tax at the time of the receipt of cash, so no tax in future

165
Q

financial statement effects of debt issuance

A
  • balance sheet: create a liability equal to proceeds received. (proceeds received minus issuance cost under IFRS) –> changes every year due to amortization
  • income statement: interest expense = beginning of period book value (PV of future cash flows)* market rate at the time of issuance (book value changes/ interest expense can be more or less than coupon amount because it entails both coupon and amortization)
  • cash flow: CFO reduced by coupon interest paid/ CFF increased by proceeds at issuance/ CFF decreased by principal paid at maturity
166
Q

Amortization of premium/discount

A

methods:

  1. Effective interest method: difference between coupon payment and interest expense is amortized each period. (required under IFRS, preferred under GAAP)
  2. straight line method: annual amortization is discount/years or premium/years so interest expense will be calculated this way: coupon +/- amortization (permitted under GAAP)
167
Q

Bond issuance costs

A

IFRS:

  • deducted from initial bond liability
  • results in lower liability and higher effective interest rate.

GAAP:

  • shown on balance sheet as a prepaid expense (asset!)
  • very controversial because this asset does not provide future economic benefits.
  • amortized over the bond’s life.
168
Q

Effect of changing interest rates on bonds

A

once debt is issued, firms report the book value (not market value) of debt, so changes in interest rate do not affect balance sheet or income statement.
change in interest rate causes a difference between carrying and fair values.

**exception: liabilities hedged with derivatives (fair value hedges)

169
Q

Debt extinguishment

A

carrying value - repurchase price –> gain/loss

in GAAP unamortized issuance costs should also be subtracted.

170
Q

Capital lease

A

GAAP: capital lease if any of these criteria meet:

  1. asset transferred to the lessee at the end of the lease.
  2. a bargain purchase option exists (the lessee has the right to buy the asset under it’s fair value at the end of the lease)
  3. the lease period is at least 75% of the asset’s economic life.
  4. the PV of the lease payments >= 90% of the leased asset’s fair value

IFRS: treat as finance lease if substantially all rights and risks of ownership are transferred (no quantitative criteria)

171
Q

Operating lease

A

A contract that allows for the use of an asset, but does not convey rights of ownership of the asset. An operating lease is not capitalized; it is accounted for as a rental expense in what is known as “off balance sheet financing.” For the lessor, the asset being leased is accounted for as an asset and is depreciated as such. Operating leases have tax incentives and do not result in assets or liabilities being recorded on the lessee’s balance sheet, which can improve the lessee’s financial ratios.

172
Q

Synthetic lease

A

An operating lease that is structured in a way so that it is not recorded as a liability on the balance sheet. Instead, it is considered to be an expense on the income statement.
?? what’s the difference with operating leases?

173
Q

Treatment of finance (capital) lease

A

treat as if leased asset was purchased with debt.

  • lower of fair value or PV of future lease payments is reported as a balance sheet asset and liability
  • depreciation on asset (life of LEASE and no salvage value because it’s for the lessor
  • interest expense on liability
  • lease payment like amortizing debt
  • *interest expense part of the payment is CFO and the amortizing part is CFF

**asset and liability only need to be equal at the beginning and the end.

174
Q

Lessor financial reporting

A

Operating lease:

  • lessor reports leased asset on balance sheet.
  • recognize lease payments as rental income.
  • recognize depreciation expense on asset

Finance lease:

  • lessor reports lease receivables on balance sheet.
  • recognize lease payments as part interest revenue and part return of capital (reducing assets).
  • treat as either sales type lease or direct financing lease
175
Q

Sales type lease (financing)

A

lessor is typically a manufacturer or dealer of the leased equipment. (normally sells these items) –> so actually the are selling and also providing the finance for the customer.

**PV of lease payments > carrying value of leased asset –> a gross profit (goes through income statement) is recognized at the beginning — interest revenue is recognized over lease term.

**a lease receivable is created at the inception of the lease, equal to the PV of the lease payments, lease payments are part interest income (CFO) and part principal reduction (CFI)

176
Q

Direct financing lease

A

lessor is not a manufacturer or dealer of the leased equipment. (the economic substance is that they’re a finance company not seller)

**PV of lease payments = carrying value of leased asset. –> no gross profit is recognized at lease inception. — lessor recognizes interest revenue over lease term.

**a lease receivable is created at the inception of the lease, equal to the PV of the lease payments, lease payments are part interest income (CFO) and part principal reduction (CFI)

177
Q

Defined contribution plan

A

A retirement plan in which a certain amount or percentage of money is set aside each year BY THE COMPANY for the benefit of the employee. There are restrictions as to when and how you can withdraw these funds without penalties.
There is no way to know how much the plan will ultimately give the employee upon retiring. The amount contributed is fixed, but the benefit is not.

*the employee assumes the investment risk

178
Q

Defined benefit plan

A

An employer-sponsored retirement plan where employee benefits are sorted out based on a formula using factors such as salary history and duration of employment. Investment risk and portfolio management are entirely under the control of the company. There are also restrictions on when and how you can withdraw these funds without penalties.

**the employer assumes the investment risk

179
Q

Defined contribution plan reporting

A

-straightforward reporting
Income:
*pension expense = employer’s contribution

Balance sheet:

  • no future obligation to report as a liability!
  • decrease in cash or current liability if not paid by fiscal year end(?)
180
Q

Defined benefit plan reporting

A

-much more complicated reporting
Balance sheet:
*plan assets net pension liability (underfunded plan)
*plan assets> ESTIMATED future obligation –> net pension asset (overfunded plan)

*PV of future payments to the employees should be calculated so we should ESTIMATE future compensation levels, employee turnover, avg retirement age and …

181
Q

Incentives for income management

A

Over report earnings:

  • meet analysts’ expectation (improve ratios)
  • meet debt covenants
  • improve incentive based compensation!

Under report earnings:

  • obtain trade relief
  • negotiate lower payments for contingent consideration (buying a firm at a price based on future performance)
  • negotiate concessions from unions. (wage, employee levels, …)
182
Q

Motivation for manipulation of assets

A

*Overstate assets/ understate liabilities (improve leverage and liquidity ratios)

*Understate assets
Improve return on assets/ asset turnover
Decrease solvency- negotiate concessions from creditors/ employees
Report higher goodwill on acquisition (goodwill doesn’t get amortized and doesn’t affect income statement in the future)

183
Q

Signs of low quality earnings

A
  1. selecting alternative methods that don’t reflect the economic substance. e.g., inventory valuation or depreciation methods
  2. using loopholes and bright line criteria to report legal rather than economic substance. e.g., operating vs finance leases
  3. using unrealistic accounting estimates and assumptions. e.g., economic lives and residual value of PP&E
  4. stretching an accounting rule to achieve a desired result rather than economic substance. e.g., past non consolidation SPEs.
  5. fraudulent financial accounting (zero quality of earnings). e.g., capitalization of operating expenses
184
Q

The fraud triangle

A
  1. incentive or pressure
  2. opportunities
  3. ability to rationalize behaviour
185
Q

Incentives/pressures for fraud

A
  1. economic, industry or entity operating conditions (declining margins, market saturation, demand decline, negative CF, …)
  2. pressure on management from third parties (analyst/investor/creditor expectations, exchange listing requirements, debt covenants, …)
  3. directors’ personal financial position threatened. (interest in company, bonuses, stock options, debt guarantee, …)
186
Q

Opportunities for fraud

A
  1. nature of industry or entity’s operations (significant related party transactions, power over suppliers/customers, significant level of estimation in accounting, international operations, operating in tax havens)
  2. ineffective monitoring of management (domination of management by a single person or group, ineffective audit committee or board)
  3. complex or unstable organizational structure
  4. high turnover of key people
  5. insufficient internal controls (accounting, IT, audit, …)
187
Q

Rationalization of fraud

A

alarming attitudes/ justifications/ rationalizations:

  • no enforcement of ethical values
  • non financial managers involved in selection of accounting principles/estimates
  • excessive focus on stock price/ earnings trends
  • committing to unrealistic forecasts
  • focus on tax reduction
  • attempts to justify inappropriate accounting policy based on materiality
  • strained relationship with auditors
188
Q

SEC improper practice

A

under these four categories SEC forces companies to redo their accounts:

  1. improper revenue recognition
  2. improper expense recognition (cost capitalizing)
  3. improper accounting of business combinations (acquisition, merger, …)
  4. other accounting and reporting issues
189
Q

Warning signs in statements

A
  1. aggressive revenue recognition.
  2. divergence of CFO and earnings.
  3. growth of revenue out of line with peers.
  4. growth in inventory out of line with peers/stock holding days increasing
  5. classification of nonrecurring or non-operating items as revenue (use to mask sales decline)
  6. deferral of expenses (capitalization)
  7. excessive use of operating leases
  8. classification of losses and expenses as extraordinary or nonrecurring
  9. LIFO liquidation
  10. gross/operating margins out of line with peers
  11. useful economic lives (the higher, the lower the dep, the higher the revenue)
  12. aggressive pension assumptions
  13. fourth quarter earnings surprises
  14. equity accounting/ unconsolidated SPEs
  15. off balance sheet financing
190
Q

Aggressive revenue recognition

A
  • bill and hold: invoice the customer and record an earning before sending the product (sales criteria not met)
  • sales type lease instead of direct financing- they accelerate revenues
  • recording revenues before earnings activities are complete (delivery, completion of all contract terms)
  • using swaps and barter agreements to generate sales
191
Q

Divergence of CFO and earnings

A
  • positive earnings, negative cash flows (earnings backed by accruals not cash)
  • CFO/NI less than 1
  • CFO/NI declining
192
Q

LIFO liquidation

A

a firm using LIFO can reduce stock levels so an old and probably low COGC will be released from B/S and go through I/S so margins will be artificially boosted. (look for changes in LIFO reserve)

193
Q

Shenanigans on cash flow statement

A

Although total cash flow is difficult to manipulate, management may try to manipulate operating cash flow
-example: classifying financing transactions as operating activities. (analysts usually perceive CFO as more sustainable, so management might try to improve it at the cost of CFI and CFF)

194
Q

Motivations for creative CF reporting

A
  1. higher share price
  2. lower borrowing cost
  3. higher incentive compensation for management
195
Q

Ways of manipulating cash flow

A
  1. stretching out payables- not sustainable, this year or another the company should pay it (one indicator is that days’ sales payable (DSP) will be increasing)
  2. financing of payables (borrow to pay AP)–> manipulates timing of cash flows, we’ve delayed our payment but CF shows that we paid it right away, and later, we paid some debt!
  3. securitization of accounts receivable: company sells notes or accounts payable, CFO increase is accelerated!
  4. issuance of stock options: less cash outflow compared to cash compensation/ also provides tax savings
  5. buybacks to offset dilution: company’s usually buyback shares before stock option exercises to offset dilution of the shares, so 4 & 5 together will result in a CFF inflow and a CFF outflow but the difference is actually part of employee compensation! (GAAP treats as CFF but analyst should classify as CFO)
196
Q

Projecting future performance

A
  1. linear regression between GDP and industry sales
  2. forecast GDP
  3. consider expected change of firm’s market share.
  4. calculate expected firm sales
  5. use historical margins for stable firms (usually EBITDA/sales because it’s more constant over time)
    * nonrecurring items should be removed from EBITDA for each past year
    * historical margins are not relevant to new, volatile or high fixed cost industries. (fixed costs don’t vary in line with sale)
197
Q

Forecasting net income and cash flow

A

after estimating future sales:

  1. make assumptions about working capital, fixed assets, COGC, and SG&A as proportions of sales
  2. estimate interest rates for saving/borrowing, tax rate, and dividends.
  3. project net income and cash flow based on assumptions.

**projections of net income and cash flows are typically based on assumptions that cost of goods sold , operating expenses and non cash working capital remain a constant percentage of sales.

198
Q

Credit risk analysis

A

ability of issuer to meet interest and principal repayment on schedule, the focus of this analysis is on cash flow forecasts.

*4C: character/ capacity/ collateral/ covenants

199
Q

Credit scoring

A

credit rating agencies employ formulas that are weighted averages of several specific accounting ratios and business characteristics

  1. scale and diversification
  2. operational efficiency
  3. margin stability
  4. leverage
200
Q

Equity investment screening

A

-Screening: application of a set of criteria to reduce a set of investments to a smaller subset having desired characteristics, involves comparing ratios to min/max values.

  • growth investors: focus on earnings growth
  • value investors: focus on low share price in relation to earnings or assets
  • market oriented: neither value or growth focused
201
Q

Analyst adjustments

A

in order to compare two firms, analyst should:

  1. adjust financial statements for differences in accounting choices (e.g., LIFO/FIFO, accelerated/ straight line dep, revenue recognition criteria, …)
  2. adjust financial statements for differences in accounting standards (e.g., IFRS vs GAAP)

1–> investment types (held to maturity, available for sale,…) inventory/ PP&E (dep, life, salvage, revaluation under IFRS)/ goodwill/ off balance sheet financing

202
Q

Auditor report

A

opinion on statements’ fairness and reliability.

  1. unqualified: free from material error
  2. qualified: this report notes exceptions to accounting principles observed.
  3. adverse: statements are not presented fairly
  4. disclaimer of opinion: unable to express an opinion
203
Q

Accrued vs unearned revenue (expense)

A

accrued rev: did the job, not paid yet
unearned rev: got paid, cannot enter as rev yet

accrued expense: job was done, not billed yet
prepaid expense: already paid, job not done yet

204
Q

Accumulated depreciation account

A

contra asset account. contra to PPE

205
Q

Allowance for bad debts accounts

A

contra asset account. contra to accounts receivable

206
Q

Fundamental characteristics of financial statements

A

relevance

faithful representation

207
Q

Enhancing characteristics of financial statements

A

enhance relevant and faithful representation:

  1. comparability: statement presentation should be consistent among firms and time periods.
  2. verifiability: independent observers, using the same methods, obtain similar results
  3. timeliness: information is available before it gets outdated and useless
  4. understandability: not too complicated!
208
Q

underlying assumptions of financial statements

A

accrual accounting

going concern: assumes the company will continue to exist for the foreseeable future.

209
Q

Definition of assets

A

IASB: a resource from which a future economic benefit is expected

FASB: probable future economic benefit.

210
Q

Coherent financial reporting- definition and barriers

A

coherent reporting framework should exhibit:

  1. transparency
  2. comprehensiveness
  3. consistency

barriers:

  1. issues of valuation
  2. standard setting
  3. measurement
211
Q

Aggressive revenue recognition

A
  • percentage of completion more aggressive than completed contract
  • installment cost more aggressive than cost recovery

using an aggressive method will inflate current period earnings and perhaps overall earnings.

212
Q

Months!

A 
January: 31
February: 28
March: 31
April: 30
---
May: 31
June: 30
July: 31
August: 31
---
September: 30
October: 31
November: 30
December: 31
213
Q

Comprehensive income items

A
  1. net income
  2. foreign currency translation gains and losses
  3. adjustments for minimum pension liability
  4. unrealized gains and losses from cash flow hedging activities
  5. unrealized gains and losses from available for sale securities.

*AFSs are recorded in the balance sheet at fair value so changes in their values while it’s not cashed yet is an unrealized gain or loss which is a comprehensive income item, under IFRS other long lived assets can also be reported at fair value, and the same thing happens with unrealized gains and losses.

214
Q

Expenses classified by nature/function

A
  • nature: like income taxes, grouped together because they’re related by nature
  • function: COGC, different expenses but have same function
215
Q

Classified balance sheet

Liquidity based balance sheet

A
  • grouped into current and con current

* present assets and liabilities in the order of liquidity

216
Q

Unrealized gains and losses for trading securities and derivatives

A

unlike AFS, they come in income statement

217
Q

Accrued Liability

Unearned revenue

A
  • expenses that have been recognized in the income statement but not yet contractually due
  • cash collected in advance of providing goods and services.—» no revenue is recognized.
218
Q

Owners’ equity includes:

A
  1. contributed capital
  2. preferred stock
  3. treasury stock
  4. retained earnings
  5. non controlling interest
  6. accumulated other comprehensive income (comprehensive income includes net income and is for a period but this is the accumulation of other comprehensive income items over time from the beginning)

*statement of changes in stockholders’ equity summarizes the transactions during a period that increase or decrease equity, including transactions with shareholders (which don’t come in comprehensive income, like dividends paid, stock repurchases, …)

219
Q

Goodwill

A

excess of purchase price over the FAIR value of the IDENTIFIABLE NET assets.

  • Identifiable: goodwill itself is not identifiable
  • Net: assets minus liabilities.

*if the purchase price is less than fair value of the identifiable net assets, the difference is immediately recognized as a gain in the acquirer’s income statement.

220
Q

Direct cash flow method steps

A
  • for CFO
  • shows cash payments and cash receipts over the period!
  1. cash collections from customers- sales adjusted for changes in receivables and unearned revenue. (***payables is for cash paid for inputs).
  2. cash paid for inputs- COGC adjusted for changes in inventory and accounts payable
  3. cash operating expenses- SG&A adjusted for changes in related accrued liabilities or prepaid expenses.
  4. cash interest paid- interest expense adjusted for the change in interest payable
  5. cash taxes paid- income tax expense adjusted for changes in taxes payable and changes in deferred tax assets and liabilities.
221
Q

(Inventory) period costs

A

like abnormal waste, STORAGE costs, administrative costs and selling costs are expensed as occurred.

222
Q

LIFO vs FIFO

A

LIFO cost of sales and FIFO inventory values better represent economic reality (replacement cost)

223
Q

Cash flow and depreciation method

A

depreciation method doesn’t affect cash flow because tax depreciation is unaffected by the choice of method for financial reporting.

224
Q

Revaluation effects of income statement

A
  1. if the first revaluation resulted in a loss, the initial loss would be recognized in the income statement and any subsequent gain would be recognized in the income statement only to the extent of the previously reported loss. revaluation gains beyond the initial loss bypass the income statement and are recognized in shareholders’ equity as a revaluation surplus.
  2. if the initial revaluation resulted in a gain, the initial gain would bypass the income statement and be reported as a revaluation surplus in shareholders’ equity, later revaluation losses would first reduce the revaluation surplus and after that will go into income statement
225
Q

Capitalized interest

A

interest cost incurred during construction of an asset for internal use, or in some instances for resale, is capitalized. the capitalized interest is added to asset’s value and depreciated over the life of the asset.

  • it’s a CFI outflow
  • in this case the interest coverage ratio would be higher because of a lower denominator, so some analysts prefer to add the capitalized interest to the expensed interest and then calculate ratio because anyway it’s something the company should pay on due dates.
226
Q

Change in depreciation estimate

A

we use the net book value at the time of change and treat the remaining period like a new one, net book value- salvage value- and time to maturity (remaining life)

227
Q

Investment assets

A

IFRS: held for the purpose of rental income or capital appreciation.
*can be recorded using a cost model or a fair value model, but the chosen method should be used for all investment properties.

GAAP: no difference between investment property and other long lived assets.

228
Q

Deferred tax terminology

A
  1. taxable income: income subject to tax based on the tax return. (tax return financial reporting)
  2. accounting profit: PRETAX INCOME from the income statement based on financial accounting standards.
  3. deferred tax assets: taxes payable > income tax expense
  4. deferred tax liabilities: taxes payable
229
Q

Deferred tax liabilities analysis

A

deferred tax liabilities are expected to reverse because they are caused by temporary differences and result in future cash outflows when the taxes are paid, in this case we treat them as liability.

but if they are (or a part of them) not going to reverse in future, they (or that part) should be omitted from liabilities and added to equities for ANALYSIS purposes

230
Q

Depreciable equipment tax base

A

the cost of equipment is 100,000, accounting depreciation is 10,000 in 10 years and based of tax return depreciation is 20,000 for 5 years.

at the end of first year, tax base is 80,000 and the carrying value is 90,000 so a DTL equal to 10,000(tax rate) is created to account for the timing difference.

231
Q

R&D tax base

A

75,000 cost of R&D is expensed in the income statement but is capitalized in the tax return with a 3 year straight line amortization.

at the end of first year: tax base: 50,000- carrying value: 0- DTA: 50,000(tax rate)

232
Q

Accounts receivable tax base

A

gross receivables totaling 20,000 are outstanding at year-end. because collection is uncertain, the firm recognizes bad debt expense of 1,500$ in the income statement . for tax purposes, bad debt expense cannot be deducted until the receivables are deemed worthless. so at the end of year we have 20,000 tax base and 18,500 carrying value, again a DTA is resulted.

233
Q

Unearned revenue tax base

A

the carrying value of the liability minus the amount of revenue that will not be taxed in the future.

for a 10,000 revenue received in advance, that carrying value is 10,000 but the tax return is 0, because non of this amount is going to be taxed in the future, because in tax return when we receive cash we should pay the tax even if revenue is not recognized at that time so the tax is fully paid at the beginning.
*a DTA is created.

234
Q

Warranty liability tax base

A

???

  • accounting: 5000- estimation
  • tax return: NOT DEDUCTIBLE until the warranty work is actually performed.
  • the warranty work will be performed next year.

–> 0

235
Q

Impact of tax rate changes on DTA and DTL

A

increase in t –> increase in both DTL and DTA, these accounts are adjusted to reflect the new tax rate, because this is the rate expected to be in force when the associated reversals occur.

236
Q

Permanent difference (tax)

A
  • a different between taxable income and pretax income that will not reverse in the future.
  • do not make DTA or DTL
  • can be caused by revenue that is not taxable, expenses that are not deductible, …
237
Q

Effective tax rate

A

?
differs from statutory tax rate when there are permanent differences.

=income tax expense/ pretax income

  • reconciliation of this difference is useful in analysis
238
Q

Income tax expense relation with pretax income

A

Income tax expense is not equal to pretax income* statutory tax rate. income tax expense is equal to taxes payable adjusted for changes in DTA and DTL so in there are changes in those accounts that are not because of the difference between pretax income and taxable income, like a change in tax rates, income tax expense would not be equal to pretax income times statutory tax rate.

239
Q

Bond redeemed befor maturity

A

a gain or loss is recognized equal to the difference between the redemption price and the carrying value.

GAAP–> any remaining unamortized bond issuance costs must also be written off and included in the gain or loss calculation.

240
Q

Long term debt footnotes

A

useful for determining the timing and amount of future cash outflows.

includes a discussion of nature of the liabilities, maturity dates, stated and effective interest rates, call provisions, restrictions imposed by holders, ….

**under leases also lots of things should be disclosed!

241
Q

Pension

A

a form of deferred compensation earned over time through employee service, so it’s a long term liability for the firm.

242
Q

Change in net pension asset/liability- overview

*all related to defined profit

A

the change is recognized in financial statements each year, some components of the total change are included in net income and others are recorded as other comprehensive income.

243
Q

Change in NPA/NPL- IFRS

*all related to defined profit

A

three components make up the change:

  1. service costs
  2. net interest expense or income
  3. remeasurements

*1 and 2 are income statement items and 3 is a comprehensive income

244
Q

Service cost

A

PV of additional benefits earned by an employee over the year

245
Q

Net interest expense (or income)

A

the beginning value of the net pension liability (or asset) multiplied by the discount rate assumed when determining the present value of the pension obligation.
*the discount rate is chosen by management but should reflect the yield of a highly rated corporate bond.

246
Q

Remeasurements

A

these include a)actuarial gains or losses and the b) difference between the actual return on plan assets and the return included in net interest expense or income. under IFRS remeasurements are not amortized to the income statement over time.

**Actuarial gains and losses can occur when changes are made to the assumptions on which a company bases its estimated pension obligation (e.g., employee turnover, mortality rates, retirement ages, compensation increases). The actual return on plan assets would likely differ from the amount included in the net interest expense or income, which is calculated using a rate reflective of a high-quality corporate bond yield; plan assets are typically allocated across various asset classes, including equity as well as bonds.

247
Q

Past service costs

A

retroactive benefits awarded to employees when a plan is initiated or amended.

248
Q

Change in NPA/NPL- GAAP

*all related to defined profit

A

five components make up the change:

  1. service costs
  2. net interest expense or income
  3. expected return on plan assets (a positive expected return decreases pension expense)
  4. past service costs
  5. actuarial gains/losses

*1 and 2 and 3 are income statement items and 4 and 5 are comprehensive income

249
Q

Change in NPA/NPL- manufacturing companies

A

in these companies, under either IFRS or GAAP, pension expense is allocated to inventory and COGC for employees who provide direct labor to production, and to salary or administrative expense for other employees. as a result, pension expense does not appear separately on the income statement for manufacturing companies. an analyst must examine the financial statement notes to find the details of these companies’ pension expense.

250
Q

Change in market interest after debt issuance- analytical view

A

it doesn’t affect anything on financial statements but anyway the price of the bond is decreased. for analytical purposes adjusting the bond liability to its economic value could be done for a better view.

251
Q

Coupon payment under GAAP

A

fully CFO

252
Q

Operating lease- effects on solvency analysis

A

operating leases are off balance sheet but the lease payments are actually long term obligations, so the analyst should estimate the PV of operating lease obligations and add it to the firm’s liabilities and assets.

*debt ratios should include liabilities for both capital leases and operating leases.

253
Q

Analyst adjustments to facilitate comparison

A

when companies use different accounting methods or estimates in areas such as inventory accounting, depreciation, capitalization and off balance sheet financing (4) analyst must adjust the financial statements for comparability. (also changes should apply when comparing firms from different standards.

254
Q

LIFO reserve

A

all LIFO firms must report- can be used to adjust LIFO COGC and inventory to their FIFO equivalent values.

  • to adjust inventory use the LIFO reserve of that year and to adjust COGC use the change of LIFO reserve from last year to this year.
255
Q

Long lived assets that are reclassified as being held for sale

A

will not be depreciated anymore.

*long lived assets that are to be abandoned or exchanged are classified as held for use until disposal and continue to be depreciated.

CFA English (10 decks)

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