Financial Statement Analysis

Vertical financial statement

% of sales for income statement and total assets for balance sheet.

Dividend payout ratio (important for exam)

(Can also be DPS/ EPS)...

Units of production depreciation method

(Cost - salvage value)*Units Used/ Total Capacity. Expense is based on usage rather than time.

CFF (Indirect)

(Dividends payable included here). Might have to do Net Y - dividends declared to get retained earnings and work out dividends declared. Then the difference between declared and payable is actual paid. · Change in debt. · Change in common stock · Cash dividends paid

Fixed charge coverage

(EBIT + Lease Payments)/(Interest Payments + Lease Payments)

Weighted average number of shares

(Old shares*stock dividend*proportion of the year). Adjust old shares so they have been affected by stock dividend*.

Non-controlling minority interest

(Recorded in Balance Sheet as shareholder's equity). Subsidiaries: when we own less than 100% of voting share capital. Minority shareholders' pro-rata share of the net assets (equity) of a subsidiary that is not wholly owned by the parent. Does not really belong to equity holders - more like piece of debt (owed to minority shareholders). (But include for CFA exam).

Different methods for inventory expense recognition

(Split up into COGS and remaining inventory). · Specific identification e.g. auto dealer has records. · First-in, first-out (FIFO): the first item purchased is assumed to be the first item sold. COGS assigned to first bought then last bought. Appropriate for inventory with limited shelf life. · Last-in, first-out (LIFO): last item purchased assumed to be last sold. Most recently purchased inventory = COGS, cost of earlier purchases assigned to ending inventory. Appropriate for inventory that does not deteriorate. (Coal distributor - top of pile). Popular in USA because of income tax benefits: inflationary environment, LIFO results in higher cost of goods sold, which results in lower taxable income and, therefore, lower income taxes. · Weighted average cost: no assumption about the physical flow of the inventory. It is popular because of its ease of use. Cost per unit calculated by dividing cost of available goods by total units available, and this average cost is used to determine both cost of goods sold and ending inventory. Average cost results in cost of goods sold and ending inventory values between those of LIFO and FIFO. Example: 200 chairs at $10 per chair = $2,000. 300 chairs at $20 per chair = $6,000 Total number of chairs = 500 Weighted Average Cost Cost of a chair: $8,000 divided by 500 = $16/chair Cost of Goods Sold: $16 x 100 = $1,600 Remaining Inventory: $16 x 400 = $6,400

Defensive interval

(cash + marketable securities + receivables) / average daily expenditures

straight line depreciation

(cost - residual value)/ useful life. Cost equals gross PP&E (no D&A deduction). Equal amount of expense each period. Often used for financial reporting purposes. (Although IFRS requires depreciation method that matches earnings potential of asset).

Return on common equity

(net income - preferred dividends) / average common equity

periodic inventory system

(smaller companies) purchases go to income statement. At YE, compute ending inventory and take out of income statement and into the balance sheet.

Analysis of deferred tax disclosures

-Be aware of differences in tax reconciliation between periods -Available-for-sale marketable securities: unrealised gains and losses straight to stockholder's equity. SO when create DTL, doesn't sit as a liability but instead nets off against gains and losses directly in stockholder's equity. -Overseas subsidiaries paying tax at lower rate = benefit.

Effect on bond issuance on CF statement

-CFO is reduced by coupon interest (part of day to day operations). -CFF is increased by proceeds at issuance and decrease by principal when paid back at maturity

Fixed asset disclosure requirements

-IFRS: basis for measurement - can either use cost or revaluation model (GAAP is cost only). -Carrying value for each class of asset (land, buildings, vehicles, machinery, fixtures and fittings). -Accumulated D&A. (Running total of depreciation that has passed through income statement). -Title restrictions (prevents you from selling asset) and assets pledged as collateral. -For impaired assets, the loss amount and circumstances. -For evaluated assets (IFRS only), revaluation date, how fair value determined, carrying value using historical cost model.

Bond issued at a discount

-Liability increases over time as the discount is amortised. So that at maturity it is par value. Face amount (including discount) is repaid at maturity. So no gain or loss. -Book value is equal to PV of reaming cash flows discounted at market rate of issuance. -Interest expense on IS increases over time as the book value increases to face amount.

Examples of permanent differences

-Non deductible expenses (gone through accounts but through tax e.g. entertainment expenses). -Tax credits for some expenditures )often acquiring PP&E - given credit by government to reduce tax bill to promote new investment). Result: effective tax rate does not equal statutory tax rate.

SEC Requirements for MD&A

1) Effects of inflation and changing prices if material. 2) Impact of off-balance-sheet obligations and contractual obligations such as purchase commitments. 2) Accounting policies that require significant judgment by management. 3) Forward-looking expenditures and divestitures.

Types of auditor opinion

1) Unqualified opinion: (also known as an unmodified or clean opinion) indicates that the auditor believes the statements are free from material omissions and errors. 2) Qualified opinion: if the statements make any exceptions to the accounting principles. 3) Adverse opinion: if the statements are not presented fairly or are materially nonconforming with accounting standards. 4) Disclaimer of opinion: if auditor is unable to express an opinion - e.g. in the case of scope limitation.

Process for recognising revenue

1. Identify the contract(s) with a customer. 2. Identify the separate or distinct performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation.

Common size CF statement - how to do it?

2 Approaches: 1) Show each item as % of net revenue. 2) Show each inflow/ outflow as a percentage of total inflows/ outflows. Useful for trend analysis (time series) and forecasting future cash flow (% of revenue).

Calculator: depreciation

2nd, 4 for depreciation. 2nd enter to change depreciation type. DB = 200 is double declining balance. RBV = net book value. RDV = remaining depreciation value.

How to use calculator for discount/ premium bonds

2nd, then PV on calculator. Will give P1 - what year are we interested from? For year 2, 2 then enter, then down arrow to get P2 - to end of what period? Down to get balance gives you liability at end of Y2. Down again gives PRN (Y2 amortisation). Down again gives interest expense.

Days of inventory on hand

365/ inventory turnover

Number of days of payables

365/ payables turnover ratio

Days of sales outstanding

365/ receivables turnover

Average collection period

365/accounts receivable turnover

Segment reporting

A business segment is a portion of a larger company that accounts for more than 10% of the company's revenues, assets, or income, and is distinguishable from the company's other lines of business in terms of the risk and return characteristics of the segment.

14A

A company can issue securities to certain qualified buyers without registering the securities with the SEC but must notify the SEC that it intends to do so.

What must be done when an incorrect accounting method is used?

A correction of an accounting error made in previous financial statements is reported as a prior-period adjustment and requires retrospective application. Prior-period results are restated. Disclosure of the nature of any significant prior-period adjustment and its effect on net income is also required.

Liquidity Ratios

Ability to satisfy short term liabilities. Although all three ratios measure the firm's ability to pay current liabilities, they should be considered collectively. For example, assume Firm A has a higher current ratio but a lower quick ratio as compared to Firm B. This is the result of higher inventory as compared to Firm B. The quick ratio (also known as the acid-test ratio) (inventory might be harder to turn around) is calculated by excluding inventory from current assets. Similar analysis can be performed by comparing the quick ratio and the cash ratio. The cash ratio is calculated by excluding inventory and receivables. *Current ratio needs to be looked at in conjunction with cash conversion cycle*

Standard Costing

Accounting method that assigns costs to cost objects at predetermined amounts. (Used to measure inventory costs). (Done after using either LIFO/ FIFO/ Weighted Average/ Specific Cost Method).

Financial Reporting Terminology

Accounting profit. Pretax financial income based on financial accounting standards. Also known as income before tax and earnings before tax. Income tax expense. Expense recognized in the income statement that includes taxes payable and changes in deferred taxincome tax expense = taxes payable + ΔDTL − ΔDTA. Deferred tax liabilities. Balance sheet amounts that result from an excess of income tax expense over taxes payable that are expected to result in future cash outflows. (Paying less tax now but will pay more in the future). Deferred tax assets. Balance sheet amounts that result from an excess of taxes payable over income tax expense that are expected to be recovered from future operations. Can also result from tax loss carryforwards. (Paying more tax now but will pay less in the future). Valuation allowance. Reduction of deferred tax assets based on the likelihood the assets will not be realized. (US GAAP). If don't have sufficient future profits cannot have benefit from DTA.

Two primary assumptions that underlie preparation of financial statements

Accrual accounting and going concern.

What form of liability can taxes payable be considered?

Accrued liability. Expenses that have been recognized in the income statement but are not yet contractually due.

How debt and equity and their dividends/ interest are split up in different CF statements.

Acquisition of debt and equity investments (other than trading securities) and loans made to others are reported as investing activities; however, the income from these investments (interest and dividends received) is reported as an operating activity. Also, note that principal amounts borrowed from others are reported as financing activities; however, the interest paid is reported as an operating activity. Finally, note that dividends paid to the firm's shareholders are financing activities.

8-K Reports

Acquisitions/ disposals of major assets/ changes in management/ changes in corporate governance. (Must be filed within 4 days of major business event).

Why is the revaluation/ fair value model rarely used in practice?

Active market for assets must exist.

Additional paid-in capital

Additional paid-in capital is the amount paid for share capital above its par value. Additional paid-in capital is recorded on a company's balance sheet under the stockholders' equity section. The account for the additional paid-in capital is created every time when a company issues new shares to or repurchases its shares from shareholders.

Defined benefit plan reporting:

Agreeing to make fixed payments on retirement. Therefore a liability. PV of payments earns to date discounted from retirement date to present date. Called PBO (GAAP), PVBO (IFRS). Also an asset because employer pays into assets to pay liability on retirement of employees. BS: Plan assets: asset > liability means a net pension asset. Plan liability: asset < liability means a net pension liability Estimated liability based on salaries, employee turnover, average retirement age, life expectancies, appropriate discount rate.

What do you do with taxes and interest paid for the indirect method?

Already calculated for net income so leave.

Permanent differences

Also permanent differences: tax disallowable expenses such as client entertainment. Do not create DTAs/ DTLs but mean that effective tax (tax expense/ EBT) is different to statutory tax (tax payable to tax authorities).

Important point to remember when using ratios in Dupont analysis

Always use averages for balance sheet figures even if you have a 'pure' ratio.

What is usually the balance sheet value of a debt liability?

Amortised value - not market/ fair value so changes in market interest rates do not affect amortised value (carrying value) of firm debt. (Although IFRS and US GAAP give firms an irrevocable option to report debt at fair value).

Tax base of an asset

Amount deductible for tax purposes in future periods as economic benefits are realised. (Amount of asset that is going to be expensed through future tax returns). So can be remaining depreciation that has to be expensed. Tax base might not equal accounting carrying value due to cumulative differences. Differences = timing (temporary). Difference between carrying value and tax base x tax rate = DTA/ DTL. CV > TB = DTL CV < TB = DTA

What should analysts do to goodwill when computing ratios?

Analysts should eliminate goodwill from the balance sheet and goodwill impairment charges from the income statement for comparability. Also, analysts should evaluate future acquisitions in terms of the price paid relative to the earning power of the acquired assets.

10-K

Annual (not exactly the same as annual report). Includes information about the business and its management, audited financial statements and disclosures, and disclosures about legal matters involving the firm. Equivalent SEC forms for foreign issuers in the U.S. markets are Form 40-F for Canadian companies and Form 20-F for other foreign issuers.

How to record a gain when you sell land?

Asset purchases and sales are considered investing activity so recorded investing section of the cash flow statement. However, you record the gain in the operating section. Specifically, in the investing section you retire the asset by recording the total amount of sale proceeds you received for the asset. The amount that exceeds the asset's net value gets subtracted out in the operating section because that section will have already reflected the gain in net income from the income statement. Say your construction company owns a forklift. Your balance sheet shows an original value of $15,000 and accumulated depreciation of $10,000. Thus, the net book value for the forklift shown on your balance sheet is $5,000. You sell the forklift for $7,000. To record this transaction, you show proceeds from the sale of the forklift of $7,000 under investing activity. Under operating activity, you deduct gain on the sale of the forklift of $2,000, because the $2,000 from the gain on sale is already included in the net income shown at the top of the operating section. The net increase in cash from this transaction is $7,000. Gain is already included in income so you don't want to count it twice.

What do we assume with cost flow methods?

Assuming rising prices and constant and increasing inventory levels. (

How are unlisted equity investments/ loans and notes receivable recorded on the balance sheet?

At historical cost.

What are retained earnings?

At the end of each accounting period, the net income of the firm (less any dividends declared) is added to stockholders' equity through an account known as retained earnings. Therefore, any transaction that affects the income statement (net income) will also affect stockholders' equity.

Consequence of making a sale on credit

Bad debt: uncertain future costs arising as a consequence of making sales. The firms are required to estimate the bad debt expense and record these estimated expenses when the products are sold (matching principle). Basically estimate % of credit sales not paid off based on historical data. Similar principle for warranty.

Long term contracts revenue recognition

Based on a firm's progress toward completing a performance obligation. Progress toward completion can be measured from the input side (e.g., using the percentage of completion costs incurred as of the statement date). Progress can also be measured from the output side, using engineering milestones or percentage of the total output delivered to date.

What to do when asset held for use is now going to be sold?

Become assets held for sale. Tested for impairment when this is the case. (For US GAAP and IFRS). Depreciation expense no longer recognised. Asset is impaired if book value > NRV (fair value - selling costs). Loss reversals allowed up to original loss for both IFRS and US GAAP.

Indirect Method

Begin with net income (which includes all non-cash charges) and make necessary adjustments to get operating cash flow. (Shortcut). Strip out cash items. Get less information on how company generates and uses cash. Basically transforms accrual to cash accounting. I.e. accounts receivable would be an increase in assets for accrual but here it is non cash so we subtract. Add back non-cash expense also.

Forms 3, 4, 5

Beneficial ownership of securities by a company's officers and directors. Analysts can use these filings to learn about purchases and sales of company securities by corporate insiders.

What to do if convertible bonds are dilutive?

Bonds' after-tax interest expense is not considered an interest expense for diluted EPS. Hence, interest expense multiplied by (1 - the tax rate) must be added back to the numerator. (No longer paying debt interest if converted so add back to numerator). (Interest tax deductible, but acting as though conversion has happened so no longer getting this benefit - add back, reduces income).

Equivalence between 50% stock dividend and 3-for-2 stock split

Both result in 3 'new' shares for every 2 'old' shares.

Effect of subsidiaries on deferred taxes

Bring in 100% of earnings of subsidiaries regardless of amount of ownership. Associates: bring in your shares of earnings, same with JVs. Recognition of earnings in accounts and dividends in tax returns. Unless company distributes all earnings through dividends - will have a timing difference. IFRS: DTL unless parent controls timing of reversal (and subsidiary's dividend policy) and unlikely that they will ever distribute all earnings through dividend so timing difference unlikely to reverse.

How are mortgages recorded for indirect method?

CFF

Where is a change in notes payable recorded?

CFF (also liabilities on balance sheet).

Where is cash dividend paid recorded?

CFF - no logic to this. (Cash dividends/ interest received and cash interest paid in CFO). Maybe because it is a capital structure decision to pay dividends?

How are receiving cash dividends recorded for indirect method?

CFO - cash inflow.

Easier way to lay out indirect method

CFO = NI + Non-cash charges - working capital investment (current assets adjustment and current liabilities adjustment). Where NCC = depreciation - gain on sale of land + deferred tax liability.

Difference for the direct and indirect method for different cash flows:

CFO is calculated differently, but the result is the same under both methods. The calculation of CFI and CFF is identical under both methods.

Difference between direct and indirect method?

CFO under the direct method can be computed using a combination of the income statement and a statement of cash flows prepared under the indirect method. Adjust income statement amount by change in balance sheet amount to get CF. Tick off items dealt with and move onto next ones. Ignore depreciation/ amortization and gains/ losses on the disposal of assets as these are non-cash or non-CFO items. (Not the same as the indirect method because net income already includes them so have to remove).

Why can LIFO liquidations be a warning sign?

COGS reflects the lower costs of items acquired in past periods, which increases current period earnings. (Not sustainable - will run out of old costs).

What can a firm do at the time of a security purchase under IFRS?

Can (irrevocably) choose to: · Account for an equity security as measured at fair value through other comprehensive income (take unrealized gains straight to shareholder equity) · Account for any security as measured at fair value through profit and loss (on income statement) Not possible under US GAAP.

De-recognition of long-lived assets

Can no longer sit in balance sheet. Carrying value removed from PP&E.

Analysing and interpreting disclosures

Can use disclosures to estimate the average age of fixed assets and the average depreciable life of fixed assets. Identify: -Firms with older, inefficient assets -Need for major Capex -Inflated earnings from the use of older assets with low depreciation (3 useful equations, assuming SL depreciation and 0 salvage value).

Capitalise or expense the cost to get machine to current location?

Capitalise

Examples of direct method

Cash collections = net sales (net income section) - change in accounts receivable + change in advances from customers (indirect method statement of CFs section). Cash paid for inputs = - COGS (negative figure since an expense) - change in inventory + change in accounts payable. Cash interest = interest expense + change in interest payable. Cash paid to employees: Operating expense (wages) - decrease in salaries payable. (Advances: customer has paid you but you are yet to complete sale. (Liability).)

Analysts should examine disclosures showing (deferred taxes)

Changes in DTLs by source/ category e.g. excess of tax over book depreciation - DBB (150) i tax returns. Impairments generally result in a deferred tax asset since the write-down is recognized immediately in the income statement, but the deduction on the tax return is generally not allowed until the asset is sold or disposed of. Change in DTAs by source/ category e.g. write down of inventory. Change in valuation allowance.

Treasury Stock

Companies buyback and hold equity in their company. Stockholder's equity goes down. Can be reissued at a later date. Lose voting rights (obviously) and dividends (obviously).

CFO

Consists of the inflows and outflows of cash resulting from transactions that affect a firm's net income. Trading securities recorded here - since unrealized gains/ losses affect net income (unlike available for sale securities). Also, part of core business operations - financial institutions.

Do you capitalise or expense interest expense on funds spent constructing a capital asset?

Constructing own tangible assets e.g. building... might borrow to construct... interest on borrowings to finance can be added to the cost of the asset. (Deemed as part of the cost of the asset - not expensed). Capitalised as part of: · The asset's value on the balance sheet (self-use) (i.e. interest added here) · The asset's value in inventory (for sale to others) (i.e. The capitalized interest will be expensed as part of the cost of goods sold when the asset is sold).

What is a simple capital structure?

Contains no potentially dilutive securities. A simple capital structure contains only common stock, nonconvertible debt, and nonconvertible preferred stock.

What is a complex capital structure?

Contains potentially dilutive securities such as options, warrants, or convertible securities.

What to do if convertible preferred stock is dilutive?

Convertible preferred dividends must be added to earnings available to common shareholders. (No longer paying preferred dividend if converted so add back to numerator).

Inventories are required to be valued at the lower of...

Cost or net realizable value (or "market" under U.S. GAAP). FIFO and average cost are two of the inventory cost flow assumptions among which a firm has a choice.

What methods can be used to report intangibles?

Cost or revaluation (like PP&E) although the revaluation model can only be used if an active market for the intangible asset exists. Under U.S. GAAP, only the cost model is allowed.

Effect of redeeming bonds on financial statements?

Creates gain or loss recorded in income from continuing operations. Unamortised issuance costs (GAAP) offset/ increase.

Something to remember if the current ratio is greater than one.

Current ratio = current assets / current liabilities. If CR is > 1, then if CA and CL both fall, the overall ratio will increase. (Think of the decrease in percentage, not absolute terms).

Bill and hold transaction

Customer buys the goods and receives an invoice but requests that the firm keep the goods at their location for a period of time. The use of fictitious bill-and-hold transactions can increase earnings in the current period by recognizing revenue for goods that are actually still in inventory.

What is the kay to high quality financial reporting

Decision-useful the key - can use to make economic decisions (because they reflect economic reality).

Method for accelerated depreciation

Declining balance method (DBB) applies a constant rate of depreciation to an asset's (declining) book value each year. Most common double-declining balance (DDB) - applies 2X straight line rate. (2/useful life)*(cost - accumulated depreciation) *Do not depreciate below salvage value* Higher expense in the early years and lower expense in the later years.

How to treat issuance costs of debt (IFRS)

Deduct from initial bonds liability -results in higher YTM. So proceeds minus issuance costs.

Deferred tax impact on balance sheet and income statement

Deferred taxes are a liability. So an increase would mean adding onto net income (indirect method). Also impacts income statement - through provision for taxes (increases by equivalent amount). But deferred tax is not a CF, so must be adjusted. (Not sure this needs to be that complicated).

Contract revision - when to treat as new contract or extension?

Depends on whether goods and services to be provided are distinct from those already transferred.

Timing differences

Differences include timing differences (accrual vs cash accounting and differences in reporting methods and estimates). Same amount going through tax returns and financial accounts but in different periods - leading to DTLs or DTAs. E.g. Tax returns use accelerated depreciation (150 DB) compare to normal SL.

If assets are antidilutive then

Diluted EPS = basic EPS.

How do you tell if something is (anti)dilutive?

Dilutive decreases EPS, anti-dilutive increases.

Authorised share capital

Disclosed in footnotes. Number of shares that could be issued. E.g. Stock exchanges may require companies to have a minimum amount of authorized share capital as a requirement of being listed on the exchange. For example, the London Stock Exchange (LSE) requires that a public limited company (PLC) have at least £700,000 of authorized share capital to be listed. If issued < authorised, can issue more shares without going to shareholders and requesting them to increase authorised capital.

8-K

Discloses material events including significant asset acquisitions and disposals, changes in management or corporate governance, or matters related to its accountants, its financial statements, or the markets in which its securities trade.

How to treat a physically and operationally distinct division that is currently for sale?

Discontinued operation. The income from the division is reported net of tax below income from continuing operations. Gains and losses on sales of operating assets, as well as depreciation expense, are reported pretax, above income from continuing operations.

General CF statement analysis

Do regular operations generate enough cash to sustain the business? (CFO). Is enough cash generated to pay off maturing debt? Need for additional finance? CFO < CFI < CFF. Then CFO insufficient to finance CFI and CFF so need to raise more finance. Ability to meet unexpected obligations? CFO means you can deal with downturns. Flexibility to take advantage of new opportunities? Healthy CFO helps here.

How to account for debt retired through issuance of common stock in the indirect method?

Don't include because non cash transaction.

Other income and expenses

Don't occur during the normal course of business operation. For example, a Bread Distributor does not normally earn income from rental property or interest from investments.

COGS for LIFO and FIFO*

Don't use EI*

What is the difference between bad debt expense and doubtful accounts?

Doubtful accounts represents an estimate of the amount of receivables that a company does not expect to collect. It is subtracted from the accounts receivable balance, which is usually reported net of doubtful accounts on the balance sheet (NRV). Bad debt expense is an estimate of the uncollectible accounts for the current accounting period. It is reported on the income statement.

Tax base of a liability

E.g. Warrant. Carrying value of the liability minus any amounts that will be deductible on the tax return in the future. All or nothing instead of gradual with tax base of an asset. CV > TB = DTA CV < TB = DTL Warranty expensed all in one go so amount you will pay in the future = to CV. Difference = timing.

Interest Coverage Ratio

EBIT / interest payments

Differences between EBIT and Operating Income

EBIT often used as a proxy but there can be key differences: operating income does not include non-operating income, non-operating expenses, or other income.

Return on total capital

EBIT/Average Total Capital

Horizontal financial statement

Each line shown relative to some base year.

Why are cashflow statements useful? What are they?

Earnings - not CFs are recorded in net income because of the accrual concept. However, this does not tell us about the source of the cash - the main reason why companies go out of business (can't pay liabilities) - reason why CFO is most important. They reconcile last year's balance sheet cash with this year's balance sheet cash.

For financial statement quality, distinguish between

Earnings and reporting quality

Effective interest rate

Effective interest rate: the discount rate (IRR) that equates PV of future CFs (coupon payments and par value) with the issue price. (If no issue costs, IRR = YTM, but if discount issue costs from face value, have higher IRR/ discount rate). Interest expense = YTM at issuance X beginning balance sheet liability. Difference between coupon interest and interest expense is amortisation premium or discount. Required under IFRS, preferred under US GAAP.

Free-on-board

Either at the shipping point (the firm's loading dock) or FOB at the destination (the customer's location).

Defined contribution

Employer agrees to pay fixed percentage of salary. IS: Pension expense = employer's contribution. (Just like salary). BS: No future obligation to report as a liability (no obligation on retirement to pay you). If paid, decrease in cash If not paid (but are due to do so), increase in current liability for that year.

What is goodwill?

Excess of purchase price over the fair value of the identifiable net assets (assets minus liabilities) acquired in a business acquisition. Can be synergies, brand loyalty.

Current asset adjustments for the indirect method for CFO

Exclude cash (because this is what we are trying to show the change in) and investments (CFI) - but would include trading securities (CFO). Current liability adjustments: exclude debt (CFF) and dividends payable (CFF).

Capitalise or expense staff training?

Expense as not certain that staff training will lead to future benefit. Also future benefit cannot be restricted to firm as staff can leave.

GAAP method for reporting internal intangible costs

Expensed - such as R&D costs.

Do you expense or capitalise internally developed intangible assets?

Expenses as incurred usually, except for R&D and software development costs.

What is a vertical common-size income statement?

Expresses each category of the income statement as a percentage of revenue. Allows for better comparison over time (time-series analysis) and across firms (cross-sectional analysis). In most cases, expressing expenses as a percentage of revenue is appropriate. One exception is income tax expense. Tax expense is more meaningful when expressed as a percentage of pretax income. The result is known as the effective tax rate. (Literally just because tax charged based on income, not revenue).

Main points for intangible assets

External/ internal: With some exceptions, costs to create intangible assets are expensed as incurred. Important exceptions are research and development costs (under IFRS) and software development costs. External depends on purchased in acquisition/ purchased outright. Identifiable/ unidentifiable: can it be separated from, and controlled by, the firm (and consequently bought or sold separately?). Can capitalise identifiable but unidentifiable is different. Usual example is goodwill, where internally generated is expensed but externally generated (in acquisition) is tested for impairment. Infinite-lived/ finite-lived: infinite means you test for impairment at least annually and finite lived you can amortise. Purchased in acquisition/ purchased outright: like tangible assets, an intangible asset purchased is recorded on the balance sheet at cost, typically fair value at acquisition. If the intangible asset is purchased as part of a group, the total purchase price is allocated to each asset on the basis of its fair value. Any remaining amount of the purchase price is recorded as goodwill (acquisition method).

Which methods of inventory expense recognitions are allowed where?

FIFO and average cost are permitted under both U.S. GAAP and IFRS. LIFO is allowed under U.S. GAAP but is prohibited under IFRS.

IAS general features for preparing financial statements

Fair presentation. Going concern. Accrual accounting. Consistency. Materiality. Aggregation. No offsetting. Reporting frequency. Comparative information.

S-1

Filed prior to the sale of new securities to the public. The registration statement includes audited financial statements, risk assessment, underwriter identification, and the estimated amount and use of the offering proceeds.

Accrual accounting

Financial statements should reflect transactions at the time they actually occur, not necessarily when cash is paid.

When to amortize intangible assets?

Finite-lived intangible assets are amortized over their useful lives and tested for impairment in the same way as PP&E. Intangible assets with indefinite lives are not amortized, but are tested for impairment at least annually.

Capitalizing vs expensing

Fixed asset, then depreciated. Consumption over a longer period of time.

Where are noncash investing and financing activities reported?

Footnote in statement of CFs - not recorded in CFs because not an actual inflow or outflow of cash. Examples: -If a firm acquires real estate with financing provided by the seller, the firm has made an investing and financing decision. This transaction is the equivalent of borrowing the purchase price. However, since no cash is involved in the transaction, it is not reported as an investing and financing activity in the cash flow statement. -Exchange of debt for equity. Such an exchange results in a reduction of debt and an increase in equity. However, since no cash is involved in the transaction, it is not reported as a financing activity in the cash flow statement. Other examples: -Stock dividend: literally extra stock, not cash. -Purchases of assets via issuance of debt/ equity. -Assets acquired under capital leases. (Increase liability but no CF changes hand). No CF changes hand is the key.

What must you report for a segment?

For primary segments, must report revenue (internal and external), operating profit (EBIT), assets, liabilities (IFRS only), capex, D&A. (Footnote disclosure).

FCF (CFA Definition)

Free cash flow is a measure of cash that is available for discretionary purposes. This is the cash flow that is available once the firm has covered its capital expenditures.

Inventory write up

Gain is recognized in the income statement by reducing COGS by the amount of the recovery. Because inventory is valued at the lower of cost or net realizable value, inventory cannot be written up by more than it was previously written down.

Financial Accounting Standards Board (FASB) accounting principles

Generally Accepted Accounting Principles (GAAP) US. (Private organisation).

How is goodwill created internally recorded?

Goodwill developed internally is expensed as incurred. Goodwill 'generated' as part of an acquisition is externally generated so is capitalised.

What is a classified balance sheet?

Groups companies assets into current and long-term assets and liabilities. Both IFRS and GAAP require this but IFRS allows for liquidity-based format: (order of liquidity) often used in banking.

Impact of depreciation method on financial statements

Growing firm is adding to PP&E. Effect on BS cancels out at end of asset's life since it = salvage value for both methods.

Modified cash accounting

Halfway between cash and accruals accounting: Accounting financial statements presented to shareholders and then statements used for tax purposes. Accounting: applies accrual and matching concepts. But this leads to estimates and judgements but tax authorities do not like this.

Preferred stock

Has no voting rights but receives dividend that is a fixed percentage of its par value. I.e. closer to debt than equity. For example, perpetual preferred stock that is non-redeemable is considered equity. However, preferred stock that calls for mandatory redemption in fixed amounts is considered a financial liability (debt). It is subtracted from Net Income when calculating (any) EPS since it is not available to common stock holders.

Inventory disclosure (footnotes)

Have to disclose LIFO reserve.

Effect of LIFO on inventory turnover

Higher - but lower days of inventory on hand (days of inventory).

What happens with increasing prices and FIFO?

Higher inventory value than LIFO. Both assets and equity (through higher retained earnings) are greater than for LIFO, resulting in lower leverage ratios. (No impact on debt).

Why is GAAP R&D reporting an example of conservatism?

Higher standard of verification for revenue and profit than for expenses and accrual of liabilities.

What are key audit matters (international) or critical matter reports (US)

Highlight accounting choices that are of greatest significance and require judgement from management.

CF statement analysis (CFF)

How is the company financing CFI and CFO? Is the company raising or repaying capital? What dividends are being returned to owners?

When deciding how to recognise different assets, look at...

How they are recorded on balance sheet, if and how unrealised gains and losses are recorded, where dividend/ interest/ realised gains or losses are recorded (all in income statement).

Software developed for sale

IFRS and U.S. GAAP: expensed until technological feasibility is established - this requires judgement (once feasible, will bring future benefits). Software developed for internal use: IFRS - same as software developed for sale. U.S. GAAP - capitalise all software development costs.

What if NRV recovers to above cost?

IFRS can reverse it. GAAP worried about moving profit between years. (Balance sheet inventory increases and then add back expense (gain) in income statement).

US GAAP vs IFRS Cash Flows

IFRS has more flexibility. GAAP more prescriptive. For CFO or CFI decision, decide whether that activity is part of your core operations or not. E.g. interest received from a bank.

GAAP: Held to maturity securities - what is IFRS equivalent + explain

IFRS: Securities measured at amortized cost. Amortized cost is equal to the original issue price minus any principal payments, plus any amortized discount or minus any amortized premium, minus any impairment losses. This is recorded in the balance sheet - not fair value. Unrealised gains or lossess (based off market value) are ignored. Interest income = Coupon + amortized discount or coupon - amortized premium. (recorded on income statement - like for all securities). So if bought at discount, spread over the life of the bond and treat it as interest. If bought at premium, spread over the life of the bond and reduce interest. Realized gains/ losses on disposal - should not really be getting rid of debt securities. Intention and ability to hold through to maturity (would be on income statement). (If you do sell, 'taint' your held to maturity securities which means you won't be able to use this classification going forwards).

GAAP: Available-for-sale securities - what is IFRS equivalent + explain

IFRS: Securities measured at fair value through other comprehensive income. Debt securities that are not expected to be held to maturity or traded in the near term. Intend to collect interest payments but sell prior to maturity. Reported on the balance sheet at fair value. So if fair value increases, will lead to unrealized gain (and vice versa). However, any unrealized gains and losses are not recognized in the income statement, but are reported in other comprehensive income as a part of shareholders' equity. Interest income still reported in income statement. (Still coupon + amortized discount / - amortized premium).

GAAP: Trading securities - what is IFRS equivalent + explain

IFRS: Securities measured at fair value through profit and loss. Debt securities acquired with the intent to sell them over the near term. Also equity and derivative securities. Fair value on balance sheet. Unrealised gains or losses are reported on the income statement. Dividend income (or interest - same amortization calculation) and realized gains and losses to income statement (like all other securities).

How can PP&E be reported?

IFRS: cost model or revaluation model, GAAP: cost model only.

When and how to impair an asset? (US GAAP)

Identification of impairment: book value > asset's estimated future un-discounted CFs. (Subjective). Loss recognition: if impaired, write down asset to fair value (no deduction of selling costs unlike IFRS) (or use discounted value of future CFs if fair value unknown - this is basically value in use for IFRS but just use different terminology) recognise loss in income statement. Loss reversal prohibited for assets held for use. (Can be used to manipulate earnings). An asset is impaired when the firm cannot recover the carrying value. Under U.S. GAAP, recoverability is tested based on undiscounted future cash flows.

Direct Method

Identify actual cash inflows and outflows (e.g. collections from customers, amounts paid to suppliers).

IFRS method for reporting internal intangible costs

Identify the research stage (discovery of new scientific or technical knowledge) and the development stage (using research results to plan or design products). Expense costs incurred during the research stage but can capitalize costs incurred during the development stage.

How and when to write down inventory?

If NRV falls below cost - write down. Reduce value from cost to NRV and expense in income statement. (If write down big, treated as unusual item).

What is the point of Dupont analysis?

If ROE has changed - why? Take it and split into further ratios.

How to check if warrants/ options are dilutive?

If average price > strike, would like to exercise so will be dilutive. Again, just pretending that we are exercising now.

Main criteria for expensing

If benefits beyond one period are unlikely or highly uncertain.

When and how to impair an asset? (IFRS).

If carrying value exceeds the recoverable amount. Under IFRS, the recoverable amount of an asset is the greater of fair value less any selling costs, or the asset's value in use. Value in use is the present value of the asset's future cash flow stream. If impaired, the asset is written down to its recoverable amount and a loss is recognized in the income statement. Loss recoveries are allowed under IFRS but not under U.S. GAAP.

Unearned revenue

If cash is received before good is delivered - a liability (unearned revenue) is created to offset the asset increase (cash).

How to check if convertible preferred shares are dilutive?

If dividends/ new shares < basic EPS, then dilutive.

How does a change in accounts payable affect cash collections?

If does not - accounts payable result from a firm's purchases from its suppliers.

How to check if convertible debt is dilutive?

If interest*(1-t)/ new shares < basic EPS, then dilutive.

What does it mean if there is a declining inventory turnover ratio?

If this goes down, days of inventory on hand goes up - could be that producing items and not being able to sell them (would be coupled with increase in finished goods).

What do we ignore in the direct method?

Ignore depreciation (next line in income statement). Don't start with net income so can ignore. Ignore gains or losses from asset disposals.

How to treat issuance costs of debt (GAAP)

Included as an asset (prepaid expense) Amortised over bonds life (but not really an asset so controversial).

Accumulated other comprehensive income

Includes all changes in stockholders' equity except for transactions recognized in the income statement (net income) and transactions with shareholders, such as issuing stock, reacquiring stock, and paying dividends.

Where are dividend, interest income and realised gains and losses recognised for all securities?

Income statement. (Where interest income is coupon + amortised discount/ premium).

Gains and Losses

Increase (gains) or decrease (losses) of economic benefits. Gains and losses may or may not result from ordinary business activities. E.g. a firm might sell surplus equipment used in its manufacturing operation that is no longer needed. The difference between the sales price and book value is reported as a gain or loss on the income statement. Reported in non-operating income section.

CFI

Inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments. Available for sale securities and held to maturity securities recorded here (not trading securities).

CFF

Inflows and outflows of cash resulting from transactions affecting a firm's capital structure. I.e. debt and equity. Principal payments for debt through CFF but interest through CFO.

How to amortize goodwill

Intangible assets with indefinite lives (e.g., goodwill) are not amortized. However, they must be tested for impairment at least annually. If the asset value is impaired, an expense equal to the impairment amount is recognized on the income statement.

What expense does a financial firm have included in operating expenses that a non-financial frim does not?

Interest expenses.

International Accounting Standards Board (IASB) accounting principles

International Financial Reporting Standards (IFRS) outside of the US.

perpetual inventory system

Inventory and COGS continuously updated as each sale occurs. No purchases account needed.

CFI (Indirect)

Investment in assets (cash spent) - cash received on asset sales. E.g. Land, PP&E, goodwill. Net PP&E = costs - accumulated depreciation. (Can happen in exam).

Component depreciation

Involves depreciating an asset based on the separate useful lives of its individual components. Required under IFRS Permitted under US GAAP but rarely used since not an obligation Example: office building consisting roof, walls, elevator, HVAC... Again, total depreciation will be identical but timing will differ.

Changing an accounting estimate:

Is reported prospectively

FCFE

Is the cash flow that would be available for distribution to common shareholders. (post-levered i.e. after payments and receipts to debt holders). Not a problem that CFO includes interest payments because this is post levered. FCFE can be calculated as follows: FCFE = CFO − FCInv + net borrowing where: CFO = cash flow from operations FCInv = fixed capital investment (net capital expenditures) net borrowing = debt issued - debt repaid

Outstanding shares

Issued shares less shares that have been reacquired by the firm (i.e., treasury stock).

How does total depreciation change under the three main methods?

It does not - all that changes is timing.

Linkages between balance sheet and CFs

It is helpful to understand how transactions affect each balance sheet account. For example, accounts receivable are increased by sales and decreased by cash collections. We can summarize this relationship as follows: Beginning accounts receivable +Sales -Cash collections =Ending accounts receivable Knowing three of the four variables, we can solve for the fourth. For example, if beginning accounts receivable are €10,000, ending accounts receivable are €15,000, and sales are €68,000, then cash collections must equal €63,000.

Revenue should only be recognised when

It is highly probable that it won't be reversed.

LIFO liquidation

It occurs when a company that uses the last-in, first-out (LIFO) inventory costing method liquidates its older LIFO inventory. A LIFO liquidation occurs when current sales exceed purchases, resulting in the liquidation of any inventory not sold in a previous period.

What makes and asset current?

It will be used within on year or within the operating cycle (days required for a business to receive inventory, sell the inventory, and collect cash from the sale).

Hi, what does "internally generated goodwill is expensed as incurred" mean? I understand that R&D can be expensed but conceptually expensing goodwill does not make sense to me.

Just means that, for example, if I build a product line that is worth 2 million and has net assets at fair value of 1 million, all the expenses of developing the product line have been expensed and no asset for the 2 million - 1 million is recorded on the balance sheet. Where as if I purchased the subsidiary from another company instead I would record the difference between purchase cost of 2 mill and 1 mill of net assets = 1 mill would be recorded as goodwill.

What do management have to do if they use non GAAP IFRS measures?

Justify.

How to remember Dupont Analysis

Leverage slides down for each line. For calculations e.g. ROE = Net Profit Margin x Total Asset Turnover x Leverage.

Bond issued at a premium

Liability decreases over time as premium is amortised. Book value equal to PV of remaining CFs discounted at the market rate of issuance. Face amount is repaid at maturity (borrower keeps premium). Interest expense decreases over time as BV declines to face amount.

What is important about retained earnings?

Linkage between income statement and balance sheet. Based of that year's net income - dividend.

How to value inventory for all firms under IFRS but not LIFO GAAP

Lower of cost and net realisable value. Cost for inventory: cost of bringing the inventory to its current location and condition. Excludes abnormal costs, storage costs (only include for finished goods*), admin overheads and selling costs. NRV = estimated selling price - estimated cost of completion - selling costs. For finished goods, can ignore estimated cost of completion. Whereas work in progress, what you could sell finished goods for minus estimated cost of completion (work in progress to finished goods) and selling costs.

US GAAP LIFO Inventory valuation

Lower of cost or market. Market is current replacement cost subject to upper limit NRV, lower limit (NRV - normal profit margin). (Market is usually equal to replacement cost). Think of lower of cost or market, where "market" cannot be outside a range of values. The range is from net realizable value minus a normal profit margin, to net realizable value. So the size of the range is the normal profit margin. "Net" means sales price less selling and completion costs. So work out market then see if it is higher or lower than cost.

CF statement analysis (CFO)

Major source better to come from CFO. Sufficient to cover capex, debt and unexpected investment opportunities. (Need direct method to analyze). Is CFO higher or lower than net income? Earnings quality: better if backed by cash. So if net income and CFO similar, better. If Net income not generated by cash - lots must come from accruals. Accruals automatically reverse at some point in the future. How consistent is CFO? Lower variation means more sustainable, volatility is uncertain.

What interest rate is used for accounting purposes on discount/ premium bonds?

Market rate when bond issued - don't worry about yield fluctuating in market place.

Difference between market value and fair value

Market value fluctuates more

Price to Book Ratio

Market value of a firms equity divided by the book value of it's shareholder's equity.

What should a balance sheet not be interpreted as?

Market/ intrinsic value - since the BS can be calculated in different ways: historical, amortised, fair value. Even if reported at fair value, may have changed since then.

Deferred tax from fair value adjustment?

May arise. Adjust BS items from historic to fair value when acquire company. May not be recognised in tax returns, resulting in DTAs/ DTLs.

Change in tax rates

Meant to be created at the tax rate at the time of the reversal. But we don't know what that is. So use current tax rate. Therefore making an assumption that it will be the same at the time of reversal.

Retail Method

Measure inventory at retail prices and then subtract gross profit in order to determine cost. (Done after using either LIFO/ FIFO/ Weighted Average/ Specific Cost Method).

Operating leverage

Measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is (EBIT). Operating leverage is used to calculate a company's break-even point and help set appropriate selling prices to cover all costs and generate a profit. Companies with high operating leverage must cover a larger amount of fixed costs each month regardless of whether they sell any units of product. Low-operating-leverage companies may have high costs that vary directly with their sales but have lower fixed costs to cover each month. The more profit a company can squeeze out of the same amount of fixed assets, the higher its operating leverage. The benefits of high operating leverage can be immense. Companies with high operating leverage can make more money from each additional sale if they don't have to increase costs to produce more sales. (If have more variable costs, will tend to move with sales - giving you a less volatile EBIT. Counterintuitive but lower operating leverage company will have less volatile EBIT, whereas firm with high operating leverage will have more volatile EBIT).

Solvency Ratios

Measure the firm's ability to satisfy its long-term obligations. All four ratios measure solvency but they should be considered collectively. For example, Firm A might have a higher long-term debt-to-equity ratio but a lower total debt-to-equity ratio as compared to Firm B. This is an indication that Firm B is utilizing more short-term debt to finance itself. When calculating solvency ratios, debt is considered to be any interest-bearing obligation. On the other hand, the financial leverage ratio captures the impact of all obligations, both interest bearing and non-interest bearing.

5 stage Dupont

Might want more information on why profit margin is changing.

What is comprehensive income?

More inclusive measure that includes all changes in equity except for owner contributions and distributions. That is, comprehensive income is the sum of net income and other comprehensive income (OCI). Under both U.S. GAAP and IFRS, other comprehensive income includes transactions that are not included in net income, such as: 1) Foreign currency translation gains and losses. 2) Adjustments for minimum pension liability. 3) Unrealized gains and losses from cash flow hedging derivatives. 4) Unrealized gains and losses from available-for-sale securities.

What must be done to past income statements if operations are discontinued?

Must be restated, separating the income or loss from the discontinued operations.

Main criteria for capitalising a cost

Needs to lead to higher future benefits. (The whole goal is to match cost of asset to the benefit it generates). If benefits extend over multiple periods, amount can include additional costs to prepare the asset for use.

Return on equity

Net Income/ Average Total Equity

Where would the write off of obsolete equipment be recorded?

No CF impact. Reduce the current value to zero on your balance sheet. Add the write off amount to your depreciation costs on the profit and loss.

Deferred tax from goodwill?

No deferred tax on goodwill or goodwill impairment. So impairments also wouldn't change anything because we didn't create a deferred tax in the first place.

Are market options dilutive?

No, only employee stock options are.

How are gains and losses from disposal of land recorded on the cash flow statement?

Non-cash, so they are not. Proceeds from disposal price vs carrying value (cost - accumulated depreciation) value. So accounting gain or loss - not a cash flow.

Constraints of financial reporting

Non-quantifiable information about a company (its reputation, brand loyalty, capacity for innovation, etc.) cannot be captured directly in financial statements.

What is the difference between using periodic and perpetual for FIFO?

None

Role of the International Organization of Securities Commissions (IOSCO)

Not a regulatory body but 'regulates' 95% of the world's financial markets - by making regulation and enforcement more uniform globally.

Period costs

Not all expenses can be directly tied to revenue generation, such as administrative costs. Expensed in the period incurred.

How to amortize goodwill?

Not amortized but must be tested for impairment at least annually. If impaired, goodwill is reduced and a loss is recognized in the income statement. The impairment loss does not affect cash flow. As long as goodwill is not impaired, it can remain on the balance sheet indefinitely.

Adjusting CFO for FCF calculations

Not necessary to adjust for non-cash charges and changes in working capital when starting with CFO.

What does it mean if total asset turnover is decreasing

Not using assets efficiently to generate revenues.

Consolidated statements

Occurs when a firm has a controlling interest in a subsidiary. Earnings of both firms are included on the income statement. In this case, the share (proportion) of the subsidiary's income not owned by the parent is reported in parent's income statement as the noncontrolling interest (also known as minority interest or minority owners' interest). The noncontrolling interest is subtracted from the consolidated total income to get the net income of the parent company.

Discontinued operations

One that management has decided to dispose of, but either has not yet done so, or has disposed of in the current year after the operation had generated income or losses - must be physically and operationally distinct from the rest of the firm. They are reported on the income statement as a separate entry from continuing operations.

Retention rate (important for exam)

Or just 1 - dividend payout ratio

Channel stuffing

Overloading a distribution channel with more goods than would normally be sold during a period - In periods where high earnings are expected, management may wish to delay recognition of revenue to the next period and hold or delay customer shipments to achieve this.

(Fair value) Revaluation Model

PP&E is carried at its depreciated cost, but at each revaluation date, the balance sheet value is adjusted to fair value. Between revaluation dates, depreciation is recorded for the asset. (Then compare fair value to carrying value). Asset value is depreciated between revaluation dates and set to fair value at each revaluation date. Reflected in shareholder's equity. E.g. if revalue upwards, will have a higher carrying value which leads to more depreciation in the income statement. (The model makes it possible for the values of long-lived assets to increase to amounts that are higher than their historical costs).

Issue price of a bond

PV of future cash flows discounted at the market rate of interest at issuance).

Important implication of impairment

Past earnings have been overstated due to insufficient depreciation.

FCFF

Pre-levered measure. Before any distributions to debt or equity holders. So it is the cash available to all investors, both equity owners and debt holders. FCFF can be calculated by starting with either net income or operating cash flow. FCFF = NI + NCC − WCInv + [Int × (1 − tax rate)] − FCInv (NI + NCC - WCInv = CFO using indirect method). where: NI = net income NCC = noncash charges (depreciation and amortization) Int = cash interest paid (cash interest paid, net of tax, is added back to net income. This is because FCFF is the cash flow available to stockholders and debt holders. Since interest is paid to (and therefore "available to") the debt holders, it must be included in FCFF). FCInv = fixed capital investment (net capital expenditures) (not same as CFI). WCInv = working capital investment ((current assets adjustment and current liabilities adjustment). Because pre levered - add back interest (not paying back) but have to remove tax shield. To get net interest.

How to calculate diluted EPS

Pretend everything has been converted (even though this could happen whenever).

How to distinguish between costs that can included in inventory (capitalised on the balance sheet) and those that cannot and must be expensed?

Product costs are capitalised: (because inventories are assets that provide future economic benefits. When inventories are sold, these benefits are realized. This delays expense recogniiton until inventory is used). · Purchase cost less discounts and rebates (overall cash price to buy materials etc) · Conversion costs including labour and overheads (production not administrative) · Other costs necessary to bring inventory to its current location (transportation) Period costs are expensed when incurred: (not directly linked to revenue generation). May also be post finished goods. · Abnormal waste · Storage costs of raw materials (unless required in production process). · SG&A

Sarbanes Oxley Act

Prohibits a company's external auditor from providing certain additional paid services to the company, to avoid the conflict of interest involved and to promote auditor independence. The act requires a company's executive management to certify that the financial statements are presented fairly and to include a statement about the effectiveness of the company's internal controls of financial reporting. Additionally, the external auditor must provide a statement confirming the effectiveness of the company's internal controls.

IASB objective of financial reporting

Provide information about the firm to current and potential investors. (Financial performance and position). (Private organisation).

DEF-14A

Proxy statement for a shareholder vote.

Differences between realised and unrealised gains:

Realized gains are listed on the income statement, while unrealized gains are listed under an equity account known as accumulated other comprehensive income (e.g. available-for-sale), which records unrealized gains and losses. This account may be added to the end of the income statement (which results in comprehensive income), but is clearly marked as such and is not incorporated into the income statement.

What does it mean if receivables turnover is decreasing

Receivables turnover is decreasing over multiple periods. (Revenues/ average accounts receivable). Days sales outstanding goes up. Problem collecting the cash? Increasing revenues by selling to customers who cannot pay.

Accounts Receivable

Recognition of revenue not dependent on receiving cash. If sales are made on credit, this can be recognised as revenue (accounts receivable on balance sheet).

Matching principle

Recognize expenses in the same period as the revenues they help to generate. The matching concept, or matching principle, is not an alternative to accrual accounting, but rather a fundamental element of it.

Balance of financial reporting

Reporting standards ensure that transactions are reported by firms similarly. However, standards must remain flexible and allow discretion to management to properly describe the economics of the firm.

Changing an accounting principle

Requires retrospective application; that is, all prior period financial statements currently presented are restated to reflect the change.

Scope limitation

Restriction on an audit that is caused by the client, issues beyond the control of the client, or other events that do not allow the auditor to complete all aspects of his or her audit procedures. Examples of events causing a scope limitation are the disappearance of relevant evidentiary matter and the client's restriction on contact with customers to confirm the existence of accounts receivable.

Why do DTAs and DTLs come about?

Revenues and expenses recognised in different periods for accounts and tax e.g. warranty expenses. Accounted at time of sale in accrual processes. Warranty is insurance but have to estimate its cost at time of sale. Tax authorities do not allow you to deduct these since they are an estimate. So have to wait until it is actually incurred to put in tax returns.

Net Income

Revenues − ordinary expenses + other income − other expense + gains − losses

Exchanged assets

Sales proceeds = fair value.

IFRS classification of major types of marketable securities

Same as GAAP just explained differently: 1) Securities measured at fair value through profit and loss (corresponds to trading securities under U.S. GAAP). 2) Securities measured at fair value through other comprehensive income (corresponds to available-for-sale under U.S. GAAP). 3) Securities measured at amortized cost (corresponds to held-to-maturity under U.S. GAAP).

Abandoned assets

Same calculation but sales proceeds = 0. So loss would be the whole carrying value.

What to do with subsequent expenditure - capitalise or expense?

Same criteria, can have an asset you initially capitalise but then subsequent expenditures that do not provide benefits beyond one year are expensed. (if cost increase life of asset that brings future benefits beyond one period, can capitalise it).

Where is income or loss from discontinued operations reported?

Separately in the income statement, net of tax, after income from continuing operations.

Where are non-operating transactions reported?

Separately in the income statement. For non-financial firms, this may be investment income and financing expenses.

How net income can be manipulated upwards through goodwill

Since goodwill is not amortized, firms can manipulate net income upward by allocating more of the acquisition price to goodwill and less to the identifiable assets. The result is less depreciation and amortization expense, resulting in higher net income.

Asset revaluation of two periods

Split up into asset, income statement and balance sheet.

Par value

Stated or legal value (usually a small amount like $0.01). Par value has no relationship to fair value. Some common shares are even issued without a par value. When par value exists, it is reported separately in stockholders' equity. In that case, the total proceeds from issuing an equity security (capital contributed by owners) are the par value of the issued shares plus "additional paid-in capital." E.g. par value = $1. Issue new share for $2.50 (additional paid-in capital), Cash goes up by $2.50. Stockholder's equity (Capital contributed by owners): $1 + $2.50.

The financial statement analysis framework:

Step 1: State the objective and context. Step 2: Gather data. Step 3: Process the data. Step 4: Analyze and interpret the data. Step 5: Report the conclusions or recommendations. Step 6: Update the analysis.

Different types of business combinations

Subsidiaries (entities that we control). Joint ventures (shared control). Associates (entities that we don't control but have significant influence over).

What do you do with gains/ profit on the disposal/ sale of assets with the indirect method?

Subtract gains. Proceeds from the sale of fixed assets are an investing cash flow. Since gains are a portion of such proceeds, we need to subtract them from net income in calculating CFO under the indirect method. Conversely, a loss would be added back to net income in calculating CFO under the indirect method.

Changing from DBB to SL or vice versa - change in accounting principle or estimate?

Surprisingly, deemed to be an estimate.

Stretching payables

Taking longer to pay suppliers increases operating cash flows

What can profit margin be split into?

Tax burden, interest burden and EBIT margin (DuPont analysis).

How can depreciation create a DTL?

Tax deduction > accounting expense. E.g. depreciation. Greater in tax returns initially. Means that taxable income (what you get after tax deduction) is smaller than profit before tax. So pay less tax today and more in the future. Tax base can be depreciation that is expensed in subsequent years. Accelerated depreciation can affect net income and EPS negatively even though underlying EBITDA is smooth... so tax payable is adjusted with DTL/ DTA to be a smooth tax expense. DTL can vary across years as depreciation changes. (Tax return depreciation - accounting depreciation) = timing difference. Times tax rate = change in DTL. (Goes through income statement). (CV - TB)*Tax rate = DTL.

Terminology from tax return:

Taxable income. Income subject to tax based on the tax return. Taxes payable. The tax liability caused by taxable income. This is also known as current tax expense, but do not confuse this with income tax expense (see below). Income tax paid. The actual cash flow for income taxes including payments or refunds from other years. Tax loss carryforward. A current or past loss that can be used to reduce taxable income (thus, taxes payable) in the future. Can result in a deferred tax asset. Tax base. Net amount of an asset or liability used for tax reporting purposes.

An analyst is comparing a firm to its competitors. The firm has a deferred tax liability that results from accelerated depreciation for tax purposes. The firm is expected to continue to grow in the foreseeable future. How should the liability be treated for analysis purposes?

The DTL is not expected to reverse in the foreseeable future because a growing firm is expected to continue to increase its investment in depreciable assets, and accelerated depreciation for tax on the newly acquired assets delays the reversal of the DTL. The liability should be treated as equity at its full value.

What is depreciation and what are the names for different assets?

The allocation of cost over an asset's life is known as depreciation (tangible assets), depletion (natural resources), or amortization (intangible assets).

What is the difference between fair value and carrying value?

The carrying value, or book value, is an asset value based on the company's balance sheet, which takes the cost of the asset and subtracts its depreciation over time. The fair value of an asset is usually determined by the market and agreed upon by a willing buyer and seller, and it can fluctuate often.

Qualitative characteristics that make financial information useful. +4 qualities that enhance (According to IFRS)

The fundamental characteristics of financial statements are relevance and faithful representation. The enhancing characteristics include comparability, verifiability, timeliness, and understandability.

Where are actual gains and losses recognised when a security is sold?

The income statement

Statement of Comprehensive Income

The statement of comprehensive income reports all changes in equity except for shareholder transactions (e.g., issuing stock, repurchasing stock, and paying dividends). Not the same as the income statement.

If warrants/ options are antidilutive then

The warrants in this case are antidilutive. The average price per share of $15 is less than the exercise price of $20. The year-end price per share is not relevant. The denominator consists of only the common stock for basic EPS.

Financial statement effect of writing down inventory IFRS

The write-down in inventory value from cost to net realizable value is reported on the income statement either as an addition to cost of sales or as a separate line item, not as other comprehensive income.

Relationship between liabilities and changes in cash flows:

There is a direct relationship between changes in liabilities and changes in cash flow. In other words, an increase in a liability account is a source of cash, and a decrease in a liability is a use of cash. (I.e. decrease in liability means you have paid it off).

Relationship between changes in assets and changes in cash flows:

There is an inverse relationship between changes in assets and changes in cash flows. In other words, an increase in an asset account is a use of cash, and a decrease in an asset account is a source of cash. Makes sense intuitively e.g. accounts receivable - don't actually receive cash in real life and with accounts payable hold onto cash. (Only assets inverse to what you would think).

Why are preferred shares subtracted in the Basic EPS calculation?

They are not paid to common shareholders.

How are deferred tax assets and liabilities recorded on the cash flow statement

They are not since they are non-cash.

What must be done to costs to secure a long-term contract?

They must be capitalised - recorded as an asset on the balance sheet. So instead of expensed in the first year - put as an asset then amortised.

Modified retrospective application

This application does not require restatement of prior-period statements; however, beginning values of affected accounts are adjusted for the cumulative effects of the change.

Phaseout period

Time between the measurement period and the actual disposal date

Internal sales

To other group companies

External sales

To third parties

What is Net Realisable Value (NRV) and give an example of a component of the balance sheet it is used for:

Total amount of money an asset might generate upon its sale, less a reasonable estimate of the costs, fees, and taxes associated with that sale or disposal. So accounts receivable is recorded at net realisable value since doubtful accounts are taken into account.

Trick Question

Total stockholders' equity consists of common stock of $550,000, preferred stock of $175,000, retained earnings of $893,000, and accumulated other comprehensive income of $46,000, for a total of $1,664,000. The $30,000 unrealized gain from the investment in Beta is already included in accumulated other comprehensive income. (LOS 18.f)

Could you theoretically have an external, identifiable, infinite lived intangible asset purchased in a business acquisition for instance?

Trademark that was purchased and is renewable forever at a nominal fee.

US GAAP classification of major types of marketable securities

Trading securities, available for sale, held to maturity.

10-Q

U.S. firms are required to file this form quarterly, with updated financial statements (unlike Form 10-K, these statements do not have to be audited) and disclosures about certain events such as significant legal proceedings or changes in accounting policy. Non-U.S. companies are typically required to file the equivalent Form 6-K semiannually.

Valuation allowance effect on deferred taxes

US GAAP valuation allowance: full DTA shown, offset by valuation allowance (contra account - nets against figure on BS). Show the two in the footnotes - IFRS do not (just show smaller DTA). Valuation allowance can be used to manipulate income: -Increasing allowance will decrease income. Lower DTA net on BS and lower expense on IS which reduces NI. Deemed to be an operating expense. But very subjective - how do we know what proportion of DTA we won't be able to use? So not allowed on tax returns.

When can inventory valuation be above cost?

Under IFRS and GAAP, allowed in some industries - usually related to commodities. · Reported at NRV, if active market exists - use quoted market price, otherwise recent market transactions. (Even if NRV > Cost). · Unrealised gains/ losses recognised in the income statement and affect inventory, assets, equity, net income and related ratios. Similar to trading securities - recording at fair value in balance sheet so have to adjust in income statement (gains/ losses).

How to capitalise net amount (IFRS)

Under IFRS, capitalised interest is reduced by any income on borrowings invested temporarily. E.g. borrow 100m but only spend 20m, in t1. Can capitalise interest on the 100m loan however, IFRS says you can take the remaining 80m (not yet used) that is likely to be invested and generate investment income (so investing cash not yet used offsets interest on amount borrowed).

Investment Property

Under IFRS, investment property includes assets that generate rental income or capital appreciation. U.S. GAAP does not have a specific definition of investment property. Under IFRS, investment property can either be reported at amortized cost (just like PP&E) or fair value (revaluation). Under the fair value model, any change in fair value is recognized in the income statement.

Cost model (US GAAP)

Under this model, PP&E other than land (does not depreciate) is reported at amortized cost (historical cost minus accumulated depreciation, amortization, depletion, and impairment losses). Historical cost includes the purchase price plus any cost necessary to get the asset ready for use, such as delivery and installation costs. PP&E must be tested for impairment. (PP&E can be valued through the revaluation method under IFRS).

Segment profit

Use EBIT

What to do if options/ warrants are dilutive?

Use the treasury stock method to calculate the number of shares used in the denominator. Assumes that the funds received by the company from the exercise of the options would be used to hypothetically purchase shares of the company's common stock in the market at the average market price (from POV of firm, issue new shares but receive money from them). The net increase in the number of shares outstanding (the adjustment to the denominator) is the number of shares created by exercising the options less the number of shares hypothetically repurchased with the proceeds of exercise. If average price > strike, then dilutive.

LIFO Reserve

Used to convert LIFO balance sheet and income statement to FIFO for comparison. (Simply difference between EI LIFO and FIFO). Allows analyst to convert from LIFO to FIFO easily. Inventory is less under LIFO.

Tip for ratios to get days of x...

Usually inverse * 365 days.

Business risk

Variability of EBIT

Financial risk

Variability of EPS (or net income) from fixed interest costs of debt financing.

How can a warrant* create a DTA?

Warrant not expensed immediately. Tax deduction is smaller than accounting expense. Taxable income is greater than PBT so pay more tax today and less in the future. Warranty liability. At year-end, a firm estimates that $5,000 of warranty expense will be required on goods already sold. On the tax return, warranty expense is not deductible until the warranty work is actually performed. The warranty work will be performed next year. The carrying value of the warranty liability is $5,000. The tax base is equal to the carrying value minus the amount deductible in the future. Thus, the warranty liability has a tax base of zero ($5,000 carrying value - $5,000 warranty expense deductible in the future). Delayed recognition of this expense for tax results in a deferred tax asset.

CF statement analysis (CFI)

What is the cash being spent on? Is the company investing in PP&E? Organic growth strategy. What acquisitions have been made? M&A based strategy.

Capital contributed by owners

What they pay for shares when first issued i.e. total value of a company's equity purchased by investors directly from a company. In other words, it indicates the total amount of money that the shareholders paid to a company to acquire their stakes in it. (Not market value). We just see issued (not authorised). Common stock at par + additional paid-in capital.

'Uncertainties'

When a material loss is probable but cannot be reasonably estimated - can be going concern assumption (assumption that firm will continue to operate for the foreseeable future, valuation of asset values or litigation.'

When is LIFO more accurate?

When prices are rising, LIFO more accurate - reflects current costs. But LIFO provides artificially low value for ending inventory - older purchase prices. Good for IS but not BS.

Measurement date

When the company develops a formal plan for disposing of an operation. On the measurement date, the company will accrue any estimated loss during the phaseout period and any estimated loss on the sale of the business. Any expected gain on the disposal cannot be reported until after the sale is completed.

How to depreciate land?

You don't - because it has an indefinite life. (So you don't use the revaluation or cost method as you would for other PP&E).

Any opinion other than qualified may be referred to as

a modified opinion.

Cash Conversion Cycle

age of inventory + age of receivables - age of payables. Expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales in the form of collection from inventory sales. Shorter than operating cycle (usually) as pay for inventory on day (91) (days payable) and then convert to cash. A decrease in the payables turnover would increase days payables, which would decrease (improve) the firm's cash conversion cycle.

financial leverage ratio

average total assets / average total equity

COGS

beginning inventory + purchases during year - ending inventory. Is purchase the same as what we paid to suppliers - no. Just because we purchased, does not mean we actually paid (could be credit). Hunt for liability on BS (accounts payable).

Quick ratio (Acid test)

cash + marketable securities + receivables / current liabilities. (Basically includes most current assets but not inventories - so can rewrite as: current assets - inventories/ current liabilities). Controversial because are receivables liquid?

Cash ratio

cash + marketable securities / current liabilities

Inventory turnover

cost of goods sold/average inventory

Current ratio

current assets / current liabilities

Operating cycle

days (age) of inventory + days (age) of receivables. In practise, means (61) days to sell inventory (on credit) and then (73) days to collect cash. I.e. the time it takes a company to buy goods, sell them and receive cash from the sale of said goods.

Capitalise or expense repair and maintenance vs rebuilding cost

expense (merely maintain existing life) vs capitalise if extending and bringing future benefit.

LIFO perpetual

literally match up sales to most recent purchases at that point in time then work out EI with whatever is left over.

Adjusted income available for common shares

net income - preferred dividends + divs on convertible preferred stock + after-tax interest on convertible debt

Return on Assets (ROA)

net income/average total assets but measure is a bit misleading, however, because interest is excluded from net income but total assets include debt as well as equity. Adding interest adjusted for tax back to net income puts the returns to both equity and debt holders in the numerator. The interest expense that should be added back is gross interest expense, not net interest expense (which is gross interest expense less interest income). So use net income + interest expense*(1 - tax rate)/ average total assets.

Operating Return on Assets

operating income (EBIT)/average total assets

Payables turnover

purchases/ average trade payables

Receivables Turnover

revenue / average receivables (or net annual credit sales/ average receivables).

Total Asset Turnover

revenue /average total assets

Fixed asset turnover

revenue/ average net fixed assets

Working capital turnover

revenue/ average working capital

Income Tax Expense

taxes payable + ΔDTL - ΔDTA

What inventory method will US firms usually choose?

under GAAP will usually choose to use LIFO as it gives them a lower tax figure. (Can't use LIFO under IFRS).

3 types of expenses

· Decreases in economic benefits during the accounting period in the form of outflows · Depletions of assets · Incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants.

Income statement LIFO adjustment

· FIFO COGS = LIFO COGS - Change in reserve (change because add BI and subtract EI) · FIFO Taxes = LIFO Taxes +(Change in reserve x t) Here change in reserve, whereas balance sheet is outright reserve.

Balance Sheet LIFO reserve adjustment

· FIFO Inventory = LIFO Inventory + LIFO Reserve · FIFO Cash = LIFO Cash - (Reserve x t) · FIFO Equity = LIFO Equity + [Reserve x (1 - t)] (Outright reserve, not change in reserve like for the income statement). Can't just adjust inventory (current assets) and not adjust cash and equity. Cash affected by tax. FIFO profits higher - which means more tax. So reduce BS cash by reserve (proxy for profit) times tax rate. Equity adjustment: to balance.