Financial Reporting & Analysis

Balance Sheet Impact of Issuing a Bond

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Diluted EPS (formula)

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Financial Asset Measurement Bases-US GAAP

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Financial Statement Effects of Capitalizing vs. Expensing

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Income Statement Impact of Issuing a Bond

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LIFO and FIFO Diagram--Rising Prices and Growing Inventory Balances

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Sample Statement of Changes in Stockholders Equity

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US GAAP Cash Flow Classifications

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Effects of Depreciation Methods (Early Years or Fast-Growing Firm)

(See Picture) In the early years of an asset's life, compared to straight-line depreciation, using an accelerated depreciation method will result in higher depreciation expense and lower net income, total assets, and shareholders' equity. For a single long-lived asset, these effects reverse in the later years of its useful life. For a fast-growing firm, however, these effects will persist over time as long as the firm is acquiring more depreciable assets than it is derecognizing.

Tax Accounting Differences

(See Picture) LOS 27.j for more info

Lessor Reporting of Leases

(See Picture) LOS 28.h

Original DuPont Approach (ROE)

(See picture for formula) *Leverage ratio is sometimes called the "equity multiplier" **If ROE is relatively low, it must be that at least one of the following is true: The company has a poor profit margin, the company has poor asset turnover, or the firm has too little leverage ***Isn't a way to calculate ROE, but a way of decomposing ROE

Performance Ratios (Cash Flows)

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Coverage Ratios (Cash Flows)

(See picture for ratio formulas) *correction on interest coverage formula: taxes paid should be added not subtracted

Cash Flow Impact of Issuing a Bond

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Extended (5-Way) DuPont Equation

(see picture for formula) *Increases in either the tax burden or the interest burden (i.e., decrease in the ratios) will tend to decrease ROE **Note that in general, high profit margins, leverage, and asset turnover will lead to high levels of ROE. However, this version of the formula shows that more leverage does not always lead to higher ROE. As leverage rises, so does the interest burden. Hence, the positive effects of leverage can be offset by the higher interest payments that accompany more debt. Note that higher taxes will always lead to lower levels of ROE.

Transfers To or From Investment Property (Fair Value Model)

(see picture) LOS 26.n

Securities Regulations typically require:

- A registration process for the issuance of new publicly traded securities - Specific disclosure and reporting requirements, including periodic financial statements and accompanying notes - An independent audit of financial reports - A statement of financial condition (or mgmt commentary) made by mgmt - A signed statement by the person responsible for the preparation of the financial reports - A review process for newly registered securities and periodic reviews after registration

Financial Reporting Terminology (in terms of taxes)

- 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 tax assets and liabilities (DTA and DTL). Income tax expense = taxes payable + Change in DTL - Change in DTA. - 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 - 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 result from tax loss carryforwards. - VALUATION ALLOWANCE: Reduction of deferred tax assets based on the likelihood the assets will not be realized. - CARRYING VALUE: Net balance sheet value of an asset or liability - PERMANENT DIFFERENCE: A difference between taxable income (tax return) and pretax income (income statement) that will not reverse in the future. - TEMPORARY DIFFERENCE: A difference between the tax base and the carrying value of an asset or liability that will result in either taxable amounts or deductible amounts in the future.

Examples/Different Types of Current Liabilities

- Accounts Payable - Notes Payable and Current Portion of Long-Term Debt - Accrued Liabilities - Unearned Revenue

CFO under Indirect Method (And Steps for Calculating)

- Add depreciation back into net income - Subtract gains/add losses on the disposal of assets (b/c sale of fixed assets is an investing cash flow) - Changes in accounts receivable and accounts payable need to be added/subtracted from net income to reflect actual cash movements 1. Begin w/ net income 2. Add or subtract changes to balance sheet operating accounts 3. Add back all noncash charges to income (such as depreciation and amort) and subtract all noncash components of revenue 4. Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land)

Effects of a Write-Down of Inventory to Net Realizable Value on Financial Statements/Ratios

- As inventory is part of current assets, an inventory write-down decreases both current and total assets. - Current ratio (CA/CL) decreases. However the quick ratio is unaffected b/c inventories not included - Inventory turnover (COGS/average inventory) is increased, which decreases days' inventory on hand and the cash conversion cycle. - The decrease in total assets increases total asset turnover and increases the debt-to-assets ratio - Equity is decreased, increasing the debt-to-equity ratio - The increase in COGS reduces gross margin, operating margin, and net margin - The percentage decrease in net income can be expected to be greater than the percentage decrease assets or equity. As a result, both ROA and ROE are decreased.

Required Financial Statements (per the International Accounting Standard IAS)

- Balance Sheet (statement of financial position) - Statement of comprehensive income - Cash flow statement - Statement of changes in owner's equity - Explanatory notes, including a summary of accounting policies

Examples/Different Types of Current Assets

- Cash and Cash equivalents - Marketable Securities - Accounts Receivable - Inventories - Other Current Assets (Prepaid Expenses)

Common Components of Cash Flow (under Direct Method)

- Cash collected from customers, typically the main component of CFO - Cash used in the production of goods and services (cash inputs) - Cash operating expenses - Cash paid for interest - Cash paid for taxes *ignore depreciation under direct method, it will be added back under indirect method because it is subtracted from net income and needs to be added back

Limitations of Balance Sheet Ratio Analysis

- Comparisons w/ peer firms are limited by differences in accounting standards and estimates - Lack of homogeneity as many firms operate in different industries - Interpretation of ratios requires significant judgement - Balance sheet data are only measured at a single point in time

Features for Preparing Financial Statements

- Fair presentation - Going concern basis - Accrual basis - Consistency - Materiality - meaning the financial statements should be free of misstatements or omissions - Aggregation - of similar items and separation of dissimilar items - No offsetting of assets against liabilities or income against expenses unless a specific standard permits or requires it. - Reporting frequency must be at least annually - Comparative information for prior periods should be included unless a specific standard states otherwise

Advantages of Leasing (over purchasing an asset)

- LESS COSTLY FINANCING: the interest rate implicit in a lease contract may be less than the interest rate on a loan to purchase the asset, and typically no down payment is required. - LESS RESTRICTIVE PROVISIONS: compared to other borrowing (bank loans or bond issuance), the terms of a lease may be less restrictive. The lessor will typically not require the covenants that are included in most loan agreements or bond indentures. - LESS RISK OF OBSOLESCENCE: at the end of a lease, the lessee often returns the leased asset to the lessor and therefore does not bear the risk of an unexpected decline in the asset's end-of-lease value.

Structure and Content of Financial Statements

- Most entities should present a classified balance sheet showing current and noncurrent assets and liabilities - Min. Information is required on the face of each financial statement and in the notes. For example, the face of the balance sheet must show specific items such as cash and cash equivalents, plant, property and equipment, and inventories. Items listed on the face of comprehensive income statement must include revenue, profit or loss, tax expense, and finance costs, among others. - Comparative information for prior periods should be included unless a specific standard states otherwise

Examples/Different Types of Noncurrent Assets and Liabilities

- Property, Plant, and Equipment (PP&E) - Investment Property - Deferred Tax Assets

Tax Return Terminology

- 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 w/ income tax expense/ - 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.

Bond Terminology

- The FACE VALUE, aka MATURITY VALUE or PAR VALUE, is the amount of principal that will be paid to the bondholder at maturity. The face value is used to calculate the coupon payments. - The COUPON RATE is the interest rate stated in the bond that is used to calculate the coupon payments. - The COUPON PAYMENTS are the periodic interest payments to the bondholders and are calculated by multiplying the face value by the coupon rate. - The EFFECTIVE RATE OF INTEREST is the interest rate that equates the present value of the future cash flows of the bond and the issue price. The effective rate is the market rate of interest required by bondholders and depends on the bond's risks (e.g., default risk, liquidity risk), as well as the overall structure of interest rate and the timing of the bond's cash flows. *Do not confuse the market rate of interest with the coupon rate. The coupon rate is typically fixed for the term of the bond. The market rate of interest on a firm's bonds, however, will likely change over the bond's life, which changes the bond's market value as well. - The BALANCE SHEET LIABILITY of a bond is equal to the present value of its remaining cash flows of its remaining cash flows (coupon payments and face value), discounted at the market rate of interest at issuance. At maturity, the liability will equal the face value of the bond. The balance sheet liability is also known as the book value or carrying value of the bond. - The INTEREST EXPENSE reported in the income statement is calculated by multiplying the book value of the bond liability at the beginning of the period by the market rate of interest of the bond when it was issued.

Footnote Disclosures relating to debt

- The nature of the liabilities - maturity dates - stated and effective interest rates - call provisions and conversion privileges - restrictions imposed by creditors - assets pledged as security - the amount of debt maturing in each of the next five years

Differences between the treatment of an accounting item for TAX reporting and for FINANCIAL reporting occur when...

- The timing of revenue and expense recognition in the income statement and the tax return differ - Certain revenues and expenses are recognized in the income statement but never on the tax return or vice versa - Assets and/or liabilities have different carrying amounts and tax bases - Gain or loss recognition in the income statement differs from the tax return - Tax losses from prior periods may offset future taxable income - Financial statement adjustments may not affect the tax return or may be recognized in different periods

Things to know about the weighted average shares outstanding calculation

- The weighting system is days outstanding divided by the # of days in a year, but on the exam, the monthly approximation method will probably be used - Shares issued enter into the computation from the date of issuance - Reacquired shares are excluded from the computation from the date of reacquisition - Shares sold or issued in a purchase of assets are included from the date of issuance - A stock split or stock dividend is applied to all shares outstanding prior to the split or dividend and to the beginning-of-period weighted average shares. A stock split or stock dividend adjustment is not applied to any shares issued or repurchased after the split or dividend date.

Four Characteristics that enhance relevance and faithful representation (in financial reporting)

1. COMPARABILITY: Financial statement presentation should be consistent among firms and across time periods 2. VERIFIABILITY: Independent observers, using the same methods, obtain similar results 3. TIMELINESS: Information is available to decision makers before the information is stale 4. UNDERSTANDABILITY: Users w/ basic knowledge of business and accounting and who make a reasonable effort to study the financial statements should be able to readily understand the info the statements present. Useful info should not be omitted just b/c it is complicated.

LIFO compared to FIFO (when prices are rising)

1. LIFO inventory < FIFO inventory 2. LIFO COGS > FIFO COGS 3. LIFO net income < FIFO net income 4. LIFO tax < FIFO tax

Two Reasons why Average Age (of asset's) is useful

1. Older, less-efficient assets may make a firm less competitive 2. The average age of assets helps an analyst to estimate the timing of major capital expenditures and a firm's future financing requirements

Two Fundamental Characteristics that make financial information useful

1. RELEVANCE -> Financial statements are relevant if the information in them can influence users' economic decisions or affect users' evaluations of past events or forecasts of future events. To be relevant, info should have predictive value, confirmatory value (confirm prior expectations), or both. *Materiality 2. FAITHFUL REPRESENTATION -> Information that is faithfully representative is complete, neutral (absence of bias), and free from error

Credit Analysis/Quality Measurements

1. SCALE AND DIVERSIFICATION: Larger companies and those w/ a wider variety of product lines and greater diversification are better credit risks. 2. OPERATIONAL EFFICIENCY: Such items as operating ROA, operating margins, and EBITDA margins fall into this category. Along w/ greater vertical diversification, high operating efficiency is associated w/ better debt ratings. 3. MARGIN STABILITY: Stability of the relevant profitability margins indicates a higher probability of repayment (leads to a better debt rating and a lower interest rate). Highly variable operating results make lenders nervous 4. LEVERAGE: Ratios of operating earnings, EBITDA, or some measure of free cash flow to interest expense or total debt make up the most important part of the credit rating formula. Firms w/ greater earnings in relation to their debt and in relation to their interest expense are better credit risks.

Financial Statement Analysis Framework

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

Average Age (formula)

= accumulated dep. / annual dep. expense *more accurate for a firm that uses straight-line depreciation

Remaining Useful Life

= ending net PP&E / annual depreciation expense Net PP&E is equal to original cost (gross PP&E) minus accumulated depreciation

Total Useful Life (formula)

= historical cost / annual depreciation expense Historical cost is gross PP&E deducting accumulated depreciation.

Effective Tax Rate (formula)

= income tax expense/pretax income

Classified Balance Sheet

A balance sheet that separates current assets and noncurrent assets + current and noncurrent liabilities.

Redeem

A firm may choose to REDEEM bonds before maturity b/c interest rates have fallen, b/c the firm has generated surplus cash through operations, or b/c funds from the issuance of equity make it possible (and desirable). When bonds are redeemed before maturity, a gain or loss is recognized by subtracting the redemption price from the book value of the bond liability and the re-acquisition date. Redemption price > Carrying Value = Loss Redemption price < Carrying Value = Gain If the redeemed bonds' issuance costs were capitalized, any remaining unamortized costs must be written off and included in the gain or loss calculation. No separate entry is necessary if the issuance costs were accounted for in the initial bond liability, b/c in that case no separate asset representing unamortized issuance costs would have been created.

Performance Obligation

A promise to deliver a distinct good or service. A "distinct" good or service is one that meets the following criteria: - Customer can benefit from the good or service on its own or combined w/ other resources that are readily available - The promise to transfer the good or service can be identified separately from any other promises

Earnings Smoothing

Accomplished through adjustment of accrued liabilities that are based on management estimates. During periods of higher-than-expected earnings, management may employ a conservative bias by adjusting an accrued liability upward to reduce reported earnings for that period. This effectively allows deferral of the recognition of these earnings to a future period for which earnings are less than expected. In such a future period, the accrued liability is adjusted downward to increase reported earnings in that period, perhaps to meet market expectations.

Valuation Allowance

According to US GAAP, if it is more likely than not (greater than a 50% probability) that some or all of a DTA will not be realized (insufficient future taxable income to recover the tax asset), then the DTA must be reduced by a VALUATION ALLOWANCE. The valuation allowance is a contra account that reduces the net balance sheet value of the DTA. Increasing the valuation allowance will decrease the net balance sheet DTA, increasing income tax expense and decreasing net income. Under IFRS, a similar calculation is made but only the net amount of the DTA is presented on the balance sheet. The amount of the valuation allowance is not separately disclosed. If circumstances change, the net DTA can be increased by decreasing the valuation allowance. This would result in higher earnings.

Two Important underlying assumptions of financial statements

Accrual Accounting and Going Concern Accrual accounting means that financial statements should reflect transactions at the time they actually occur, not necessarily when cash is paid. Going concern assumes the company will continue to exist for the foreseeable future.

Effects of Converting LIFO to FIFO on Solvency Ratios

Adjusting to FIFO results in higher total assets because inventory is higher. Higher total assets under FIFO result in higher stockholders' equity (assets - liabilities). Because total assets and stockholders' equity are higher under FIFO, the debt ratio and debt-to-equity ratio are lower under FIFO compared to LIFO.

Transaction Price

Amount a firm expects to receive from a customer in exchange for transferring a good or service to the customer. A transaction price is usually a fixed amount but can be also be variable, for example, if it includes a bonus for early delivery.

Contributed Capital

Amount contributed by equity shareholders (issued capital)

Gross Profit

Amount that remains after the direct costs of producing a product or service are subtracted from revenue. Revenue - Cost of Goods Sold

Contract

An agreement between two or more parties that specifies their obligations and rights. *Collectability must be probable for a contract to exist, but "probable" is defined differently under IFRS and US GAAP

Impairments under US GAAP

An asset is tested for impairment only when events and circumstances indicate the firm may not be able to recover the carrying value through future use. Determining an impairment and calculating the loss potentially involves two steps. In the first step, the asset is tested for impairment by applying a RECOVERABILITY TEST. If the asset is impaired, the second step involves measuring the loss. RECOVERABILTIY -> An asset is considered impaired if the carrying value (original cost less accumulated depreciation) is greater than the asset's future undiscounted cash flow stream. B/c the recoverability test is based on estimates of future undiscounted cash flows, tests for impairment involve considerable management discretion. LOSS MEASUREMENT -> If impaired, the asset's value is written down to fair value on the balance sheet and a loss, equal to the excess of carrying value over the fair value of the asset (or the discounted value of its future cash flows if the fair value is known), is recognized in the income statement. Under US GAAP, loss recoveries are typically not permitted.

Value-at-Risk

An estimate of the dollar size of the loss that a firm will exceed only some specific percent of the time, over a specific period of time

Defensive Interval Ratio

Another measure of liquidity that indicates the number of days of average cash expenditures the firm could pay with its current assets Expenditures here include cash expenses for costs of goods, SG&A, and research and development. * If these items are taken from the income statement, noncash charges such as depreciation should be added back just as in the preparation of a statement of cash flows by the indirect method.

Declining Balance Method (DB)

Applies a constant rate of depreciation to an asset's (declining) book value each year. *is an accelerated depreciation method

Effects of Converting LIFO to FIFO on Profitability Ratios

As compared to FIFO, LIFO produces higher COGS in the income statement and results in lower earnings. Any profitability measure that includes COGS will be higher under FIFO. For example, reducing COGS will result in higher gross, operating, and net profit margins as compared to LIFO.

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. *AKA -> the undistributed earnings (net income) of the firm since inception, the cumulative earnings that have not been paid out to shareholders as dividends

Units-of-Production Method (Depreciation)

Based on usage rather than time. Depreciation expense is higher in periods of high usage. *The units-of-production method applied to natural resources is referred to as depletion.

COGS

COGS = beg. inventory + purchases - end. inventory or end. inventory = beg. inventory + purchases - COGS

Conservative vs Aggressive Accounting

CONSERVATIVE -> choices made w/in GAAP w/ respect to reported earnings that tend to decrease the company's reported earnings and financial position (on the balance sheet) for the current period. *Tends to increase future period earnings AGGRESSIVE -> choices that increase reported earnings or improve financial position for the current period. *Often leads to decreased earnings in future periods

Free Cash Flow to the Firm (FCFF)

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 can also be calculated from operating cash flow: FCFF = CFO + [Int x (1 - tax rate)] - FCInv

Free Cash Flow to Equity (FCFE)

Cash flow that would be available for distribution to common shareholders. FCFE = CFO - FCInv + net borrowing

Five-Step Process for Revenue Recognition

Central principle is that a firm should recognize revenue when it has transferred a good or service to a customer. 1. Identify the contract(s) w/ 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

Effects of Converting LIFO to FIFO on Liquidity Ratios

Compared to FIFO, LIFO results in a lower inventory value on the balance sheet. Because inventory (a current asset) is higher under FIFO, the current ratio, a popular measure of liquidity, is also higher under FIFO. Working capital is higher under FIFO as well, because current assets are higher.

Balance Sheet

Comprised of assets, liabilities, and owner's equity Accounting Equation: assets = liabilities + owner's equity

Bond

Contractual promise between a borrower (bond issuer) and a lender (the bondholder) that obligates the bond issuer to make payments to the bondholder over the term of the bond. *Typically, two types of payments are involved: (1) periodic interest payments, and (2) repayment of principal at maturity

Period Costs (inventory)

Costs expensed in the period incurred. They include: - Abnormal waste of materials, labor, or overhead - Storage costs (unless required as part of production) - Administrative overhead - Selling costs

Deferred Tax Liabilities

Created when income tax expense (income statement) is greater than taxes payable (tax return) due to temporary differences. Deferred tax liabilities occur when: - Revenues (or gains) are recognized in the income statement before they are included on the tax return due to temporary differences - Expenses (or losses) are tax deductible before they are recognized in the income statement Deferred tax liabilities are expected to reverse (i.e., they are caused by temporary differences) and result in future cash outflows when the taxes are paid. A deferred tax liability is most often created when an accelerated depreciation method is used on the tax return and straight-line depreciation is used on the income statement.

Deferred Tax Assets

Created when taxes payable (tax return) are greater than income tax expense (income statement) due to temporary differences. Deferred tax assets occur when: - Revenues (or gains) are taxable before they are recognized in the income statement - Expenses (or losses) are recognized in the income statement before they are tax deductible. - Tax loss carryforwards are available to reduce future taxable income Similar to deferred tax liabilities, deferred tax assets are expected to reverse through future operations. However, deferred tax assets are expected to provide future tax savings, while deferred tax liabilities are expected to result in future cash outflows. A firm that has taxable losses in excess of its taxable income can carry those excess losses forward and use them to reduce taxable income (and taxes) in future periods. Post-employment benefits, warranty expenses, and tax loss carryforwards are typical causes of deferred tax assets.

Working Capital

Current Assets minus Current Liabilities. *Not enough working capital may indicate liquidity problems. Too much working capital may indicate an inefficient use of assets

Dilutive vs. Antidilutive Securities

DILUTIVE -> Stock options, warrants, convertible debt or convertible preferred stock that would DECREASE EPS if exercised or converted to common stock ANTIDILUTIVE -> Stock options, warrants, convertible debt, or convertible preferred stock that would INCREASE EPS if exercised or converted to common stock

Trading Securities

Debt securities that a firm owns, but intends to sell, and any unrealized g/l during the period are reported on the income statement.

Available-for-Sale Securities

Debt securities that are not expected to be held to maturity or sold in the near term. Unrealized g/l on available-for-sale securities are reported as other comprehensive income, not on the income statement.

Held to Maturity

Debt securities the firm does not intend to sell prior to maturity. Securities classified as held to maturity are reported at amortized cost on the balance sheet (not fair value), Therefore, unrealized gains and losses are not reported on either the income statement or as other comprehensive income.

Permanent Difference (taxes)

Difference between taxable income and pretax income that will not reverse in the future. Permanent differences do not create deferred tax assets or deferred tax liabilities. Permanent differences can be caused by revenue that is not taxable, expenses that are not deductible, or tax credits that result in a direct reduction of taxes. Permanent differences will cause the firm's EFFECTIVE TAX RATE to differ from STATUTORY TAX RATE. The statutory rate is the tax rate of the jurisdiction where the firm operates. The effective tax rate is derived from the income statement.

Temporary Difference (tax)

Difference between the tax base and carrying value of an asset or liability that will result in taxable amounts or deductible amounts in the future. If the temporary difference is expected to reverse in the future and the balance sheet item is expected to provide future economic benefits, a DTA or DTL is created.

Two methods of presenting the Cash Flow Statement

Direct and Indirect methods. Both methods are permitted under US GAAP and IFRS. The use of the direct method, however, is encouraged by both standard setters. Regrettably, most firms use the indirect method. *The difference between the two methods relates to the presentation of cash flow from operating activities. The presentation of cash flows from investing and financing activities is exactly the same under both methods

Direct Method (Cash Flows)

Each line item of the accrual-based income statement is converted into cash receipts or cash payments. *recall that under the accrual method of accounting, the timing of revenue and expense recognition may differ from the timing of the related cash flows. Under cash-basis accounting, revenue and expense recognition occur when cash is received or paid. Simply stated, the direct method converts an accrual-basis income statement into a cash-basis income statement

Specific Identification Method (inventory cost methods)

Each unit sold is matched w/ the unit's actual cost. Specific identification is appropriate when inventory items are not interchangeable and is commonly used by firms w/ a small # of costly and easily distinguishable items, such as jewelry. Also appropriate for special orders or projects outside a firm's normal course of business.

Outstanding Shares

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

Common-Size Income Statement

Expresses each category of the income statement as a % of revenue. The common-size format standardizes the income statement by eliminating the effects of size. This allows for comparison of income statement items over time (time-series analysis) and across firms (cross-sectional analysis).

Vertical Common Size Balance Sheet

Expresses each item of the balance sheet as a percentage of total assets. Standardizes the balance sheet by eliminating the effects of size. This allows for comparison over time (time-series analysis) and across firms (cross-sectional analysis).

Primary Standard-Setting Bodies

Financial Accounting Standards Board (FASB) -> GAAP International Accounting Standards Board (IASB)

Mark-to-Market Accounting

Financial assets measured at fair value. Includes trading securities, available-for-sale securities, and derivatives

Long-term Financial Liabilities

Financial liabilities include bank loans, notes payable, bonds payable, and derivatives. If the financial liabilities are not issued at face amount, the liabilities are usually reported on the balance sheet at amortized cost. Amortized cost is equal to the issue price minus any principal payments, plus any amortized discount or minus any amortized premium. In some cases, financial liabilities are reported at fair value. Examples include held-for-trading liabilities such as a short position in a stock (which may be classified as a short-term liability), derivative liabilities, and non-derivative liabilities w/ exposures hedged by derivatives.

Impairments under IFRS

Firm must annually assess whether events or circumstances indicate an IMPAIRMENT of an asset's value has occurred. An asset is impaired when its carrying value (original cost less accumulated depreciation) exceeds the RECOVERABLE AMOUNT. The recoverable amount is the greater of its fair value less any selling costs and its VALUE IN USE. The value in use is the present value of its future cash flow stream from continued use. If impaired, the asset's value must be written down on the balance sheet to the recoverable amount. An impairment loss, equal to the excess of carrying value over the recoverable amount, is recognized in the income statement. Under IFRS, an impairment loss on an identifiable long-lived asset can be reversed if the asset's value recovers in the future. However, the loss reversal is limited to the original impairment loss.

Channel Stuffing

Firms can also manage the timing of revenue recognition by accelerating or delaying the shipment of goods. If additional revenue is required to meet targets, firms can offer discounts or special financing terms to increase orders in the current period, or ship goods to distributors without receiving an order. Overloading a distribution channel w/ more goods than would normally be sold during a period is referred to as CHANNEL STUFFING. 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.

FIFO (First-in, First-out) Method

First item purchased is assumed to be the first item sold. The cost of inventory acquired first (beg. inventory and early purchases) is used to calculate the cost of goods sold for the period. The cost of the most recent purchases is used to calculate ending inventory. *FIFO is the appropriate method for inventory that has a limited shelf life. For example, a food products company will sell its oldest inventory first to keep the inventory on hand fresh

Pension

Form of deferred compensation earned over time through employee service. The most common pension arrangements are defined contribution plans and defined benefit plans.

Goodwill

Goodwill is the excess of purchase price over the fair value of the identifiable net assets (assets minus liabilities) acquired in a business acquisition. Acquirers are often willing to pay more than fair value of the target's identifiable net assets because the target may have assets that are not reported on its balance sheet. For example, the target's reputation and customer loyalty certainly have value; however, the value is not quantifiable. Part of the acquisition may reflect perceived synergies from the business combination. For example, the acquirer may be able to eliminate duplicate facilities and reduce payroll as a result of the acquisition.

Regulatory Authorities

Government agencies that have the legal authority to enforce compliance with financial reporting standards

Measurement Bases

HISTORICAL COST -> amount originally paid for the asset AMORTIZED COST -> historical cost adjusted for depreciation, amortization, depletion, and impairment CURRENT COST -> the amount the firm would have to pay today for the same asset NET REALIZABLE VALUE -> estimated selling price of the asset in the normal course of business minus the selling costs PRESENT VALUE -> the discounted value of the asset's expected future cash flows FAIR VALUE -> price at which an asset could be sold, or a liability transferred, in an orderly transaction between willing parties

Preferred Stock

Has certain rights and privileges not conferred by common stock. For example, preferred shareholders are paid dividends at a specified rate, usually expressed as a percentage of par value, and have priority over the claims of the common shareholders in the event of liquidation. Preferred stock can be classified as debt or equity, depending on the terms. 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.

Sustainable Growth Rate

How fast the firm can grow without additional external equity issues while holding leverage constant g = RR x ROE

Identifiable vs. Unidentifiable Intangible Assets

IDENTIFIABLE -> Can be acquired separately or are the result of rights or privileges conveyed to their owner - Examples: patents, trademarks, copyrights UNIDENTIFIABLE -> Cannot be acquired separately and may have an unlimited life. - Examples: Goodwill

Cash Flow statements prepared under IFRS vs. US GAAP

IFRS - Allow more flexibility in the classification of cash flow - Interest and dividends received may be classified as either operating or investing activities - Dividends paid to company's shareholder and int paid on the company's debt may be classified as either operating or financing activities - Income taxes are reported as operating activities unless the expense is associated w/ an investing or financing transaction US GAAP - Dividends paid to the firm's shareholders are reported as financing activities while interest paid is reported in operating activities. - Interest received and dividends received from investments are also reported as operating activities - ALL TAXES paid are reported as operating activities, even taxes related to investing and financing transactions

Financial Reporting of Leases from Lessee's Perspective

IFRS -> Treated much like the purchase of a long-term asset financed by debt. An asset + liability, both equal to the present value of the promised lease payments, are reported on the balance sheet. The asset recorded on the balance sheet is not the leased asset itself, but the right to use the leased asset for the specified period *Short-term/low value leases = no balance sheet entry required US GAAP -> Finance lease vs. Operating lease. Leases in which benefits and risks of ownership have been substantially transferred to the lessee are classified as finance leases. Reported the same as IFRS. Operating (where benefits/risks have not been transferred to lessee) is the same, except the entire lease payment is recorded as a lease expense on the income statement; there is not separate interest expense reported. However, the principal portion of an operating lease payment is used to reduce the balance sheet lease liability.

Component Depreciation

IFRS requires firms to depreciate the components of an asset separately, thereby requiring useful life estimates for each component. For example, a building is made up of a roof, walls, flooring, electrical systems, plumbing, and many other components. Under COMPONENT DEPRECIATION, the useful life of each component is estimated and depreciation expense is computed separately for each. *Component depreciation is allowed under US GAAP but is seldom used

Impairment for Long-Lived Assets Held For Sale

If a firm intends to sell and asset, it's probable that the asset will be sold, and the asset is available for immediate sale, then it must be reclassified from held-for-use to held-for-sale. When a firm reclassifies an asset as held-for-sale, the asset is no longer depreciated or amortized. The held-for-sale asset is impaired if its carrying value exceeds its net realizable value (fair value less selling costs). If impaired, the asset is written down to net realizable value and the loss is recognized in the income statement. For long-lived assets held for sale, the loss can be reversed under IFRS and US GAAP if the value of the asset recovers in the future. However, the loss reversal is limited to the original impairment loss. Thus, the carrying value of the asset after reversal cannot exceed the carrying value before the impairment was recognized.

Revaluation Surplus (IFRS only)

If fair value at the first revaluation date is greater than the carrying value of the asset, the difference is recorded as REVALUATION SURPLUS, a component of equity, so net income is not affected.

Net Pension Asset or Net Pension Liability

If the fair value of the plan's (defined benefit plan) assets is greater than the estimated pension obligation, the plan is aid to be OVERFUNDED and the sponsoring firm records a net pension asset on its balance sheet. If the fair value of the plan's assets is less than the estimated pension obligation, the plan is UNDERFUNDED and the firm records a net pension liability.

Changing Inventory Cost Flow Methods

In most cases, change is made retrospectively; that is, the prior years' financial statements are recast based on the new cost flow method. The cumulative effect of the change is reported as an adjustment to the beginning retained earnings of the earliest year presented. Under IFRS, the firm must demonstrate that the change will provide reliable and more relevant information. Under US GAAP, the firm must explain why the change in cost flow method is preferable. An exception to retrospective application applies when a firm changes to LIFO from another cost flow method. In this case, the change is applied prospectively; no adjustments are made to the prior periods. W/ prospective application, the carrying value of inventory under the old method simply becomes the first layer of inventory under LIFO in the period of the change.

Current Assets

Include cash and other assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater. Operating Cycle -> time it takes to produce or purchase inventory, sell the product, and collect the cash *Usually presented in the order of their liquidity, w/ cash being the most liquid. Current assets reveal information about the operating activities of the firm.

Product Costs (inventory)

Include: - Purchase cost less trade discounts and rebates - Conversion (manufacturing) costs including labor and overhead - Other costs necessary to bring the inventory to its present location and condition *By capitalizing inventory cost as an asset, expense recognition is delayed until the inventory is sold and revenue is recognized.

Accumulated Other Comprehensive Income

Includes all changes in stockholders' equity except for transactions recognized in the income statement (net income) and transactions w/ shareholders, such as issuing stock, reacquiring stock, and paying dividends. ***Not to be confused w/ "comprehensive income." Comprehensive income is an income measure over a period of time. It includes net income and other comprehensive income for the period. Accumulated other comprehensive income does not include net income but is a component of stockholders' equity at a point in time.

Lease

Instead of purchasing an asset, a firm may choose to lease the asset. W/ a lease, a firm (the LESSEE) essentially purchases the right to use an asset from another firm (the LESSOR) for a specified period, which can range from a month to many years. The lessee makes periodic payments to the lessor for the use of the asset. Thus, a lease can be considered an alternative to financing the purchase of an asset.

Effective Interest Rate Method

Interest expense is equal to the book value of the bond liability at the beginning of the period, multiplied by the bond's yield at issuance. - For a premium bond, interest expense is less than the coupon payment (yield < coupon rate). The diff. between interest expense and the coupon payment is the amortization of the premium. The premium amort. is subtracted each period from the bond liability on the balance sheet. Thus, interest expense will decrease over time as the bond liability decreases. - For a discount bond, interest expense is greater than the coupon payment (yield > coupon rate). The diff. between interest expense and the coupon payment is the amortization of the discount. The amort. of the discount each period is added to the bond liability on the balance sheet. Therefore, interest expense will increase over time as the bond liability increases. *This method is required under IFRS. Under US GAAP, this is preferred, but straight-line depreciation is allowed if the results are not materially different.

Effects of Converting LIFO to FIFO on Activity Ratios

Inventory turnover (COGS/average inventory) is higher for firms that use LIFO compared to firms that use FIFO. Under LIFO, COGS is valued at more recent, higher costs (higher numerator), while inventory is valued at older, lower costs (lower denominator). Adjusting to FIFO values will result in lower turnover and higher days of inventory on hand (365/inventory turnover).

Periodic Inventory System

Inventory values and COGS are determined at the end of the accounting period. No detailed records of inventory are maintained; rather, inventory acquired during the period is reported in a Purchases account. At the end of the period, purchases are added to beginning inventory to arrive at cost of goods available for sale. To calculate COGS, ending inventory is subtracted from goods available for sale.

Perpetual Inventory System

Inventory values and COGS are updated continuously. Inventory purchased and sold is recorded directly in inventory when the transactions occur. Thus, a Purchases account is not necessary. *FIFO COGS and ending inventory will stay the same as periodic, LIFO COGS and ending inventory will be diff. than periodic under perpetual

Proxy Statements

Issued to shareholders when there are matters that require a shareholder vote

Issuance Costs (bonds)

Issuing a bond involves legal and accounting fees, printing costs, sales commissions, and other fees. Under IFRS and US GAAP, the initial bond liability on the balance sheet (the proceeds from issuing the bond) is reduced by the amount of issuance costs, increasing the bond's effective interest rate. In effect, issuance costs are treated as unamortized discount. Before 2016, under US GAAP, issuance costs were capitalized as an asset and allocated to the income statement over the life of the bond. Although the treatment of issuance costs has now converged, US GAAP still permits the earlier treatment. Under both US GAAP and IFRS, bond issuance costs (an outflow) are usually netted against the bond proceeds (an inflow) and reported on the cash flow statement as a financing cash flow.

DuPont System of Analysis

It uses basic algebra to break down ROE into a function of different ratios, so an analyst can see the impact of leverage profit margins, and turnover on shareholder returns. There are two variants of the DuPont system: the original three-part approach and the extended five-part system.

Liquidity vs. Solvency

LIQUIDITY -> Ability to meet short-term obligations SOLVENCY -> Ability to meet long-term obligations

LIFO (Last-in, First-out) Method

Last item purchased is assumed to be the first item sold. The cost of inventory most recently purchased is assigned to the cost of goods sold for the period. The costs of beginning inventory and earlier purchases are assigned to ending inventory. *LIFO is appropriate for inventory that does not deteriorate with age. For example, a coal distributor will sell coal off the top of the pile. *Popular in the US b/c of its income tax benefits. In an inflationary environment, LIFO results in higher COGS. Higher COGS results in lower taxable income and, therefore, lower income taxes. *Prohibited under IFRS, allowed under US GAAP

Cash Conversion Cycle

Length of time it takes to turn the firm's cash investment in inventory back into cash, in the form of collections from the sales of that inventory. The cash conversion cycle is computed from days sales outstanding, days of inventory on hand and number of days of payables

Operating Profitability Ratios

Look at how good management is at turning their efforts into profits. Operating ratios compare the top of the income statement (sales) to profits. The different ratios are designed to isolate specific costs See Picture for formulas

Financial Asset Classifications - IFRS

MEASURED AT AMORT COST -> debt securities w/ intent to hold until maturity, loans/notes receivable, unlisted equity securities if fair value cannot be determined reliably MEASURED AT FAIR VALUE THROUGH COMPREHENSIVE INCOME -> debt securities acquired w/ intent to collect interest but sell before maturity, equity securities only if this treatment is chosen at time of purchase MEASURED AT FAIR VALUE THROUGH PROFIT AND LOSS -> debt securities acquired w/ intent to sell in near term, equity securities (unless fair value through OCI is chosen at time of purchase), derivatives, any security not assigned to the other two categories, any security for which this treatment is chose at time of purchase

Zero-Coupon Bonds

Make no periodic interest payments. A zero-coupon bond, also known as a pure-discount bond, is issued at a discount from its par value and its annual interest expense is implied, but not explicitly paid. The actual interest payment is included in the face value that is paid at maturity. The effects of zero-coupon bonds on the financial statements are qualitatively the same as any discount bond, but the impact is larger b/c the discount is larger.

Weighted Average Cost Method (Expense recognition)

Makes no assumption about the physical flow of inventory. It is popular b/c of its ease of use. The cost per unit is calculated by dividing cost of available goods by total units available, and this average cost is used to determine both COGS and ending inventory. *Average cost results in COGS and ending inventory values between those of LIFO and FIFO.

Free Cash Flow

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. This is a fundamental cash flow measure and is often used for valuation. - Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE)

Liquidity Ratios

Measure the firm's ability to satisfy its short-term obligations as they come due. Current Ratio Quick Ratio Cash Ratio (see picture for formulas)

Solvency Ratios

Measure the firm's ability to satisfy long-term obligations. (See picture for formulas)

Comprehensive Income

More inclusive measure of income 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). Such as: 1. Foreign currency translation gains and losses 2. Adj. for minimum pension liability 3. Unrealized g/l from cash flow hedging derivatives 4. Unrealized g/l from available-for-sale securities

Accelerated Depreciation Method

Most assets generate more benefits in the early years of their economic life and fewer benefits in the later years. Speeds up the recognition of depreciation expense in a systematic way to recognize more depreciation expense in the early years of the asset's life and less depreciation expense in the later years of its life. *Total depreciation expense over the life of the asset will be the same as it would be if straight-line depreciation were used.

Operating vs. Non-Operating components of the Income Statement

NON-OPERATING -> May result from investment income and financing expenses. For ex, a nonfinancial firm may receive dividends and interest from investments in other firms. *For a financial firm, investment income and financing expenses are usually considered operating activities

Noncurrent Assets and Liabilities

NONCURRENT ASSETS -> Do not meet the definition of current assets b/c they will not be converted into cash or used up w/in one year or operating cycle. - Noncurrent assets provide information about the firm's investing activities, which form the foundation upon which the firm operates NONCURRENT LIABILITIES -> Do not meet the criteria of current liabilities. Noncurrent liabilities provide information about the firm's long-term financing activities.

Indirect Method (Cash Flows)

Net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. These adjustments include eliminating noncash expenses (e.g, depreciation and amortization), nonoperating items (e.g., gains and losses), and changes in balance sheet accounts resulting from accrual accounting events.

Intangible Assets

Non-monetary assets that lack physical substance. Securities are not considered intangible assets. Intangible assets are either identifiable or unidentifiable.

Noncash Investing and Financing Activities

Not reported in the cash flow statement since they do not result in inflows or outflows of cash. Noncash transactions must be disclosed in either a footnote or supplemental schedule to the cash flow statement. Analysts should be aware of the firm's noncash transactions, incorporate them into analysis of past and current performance, and include their effects in estimating future cash flows.

Issued Shares

Number of shares that have actually been sold to shareholders.

Authorized Shares

Number of shares that may be sold under the firm's articles of incorporation.

Cash Flow from Operating, Investing, and Financing Activities

OPERATING (CFO) -> Consists of the inflows and outflows of cash resulting from transactions that affect a firm's net income INVESTING (CFI) -> Consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments FINANCING (CFF) -> Consists of the inflows and outflows of cash resulting from transactions affecting a firm's capital structure

Current Liabilities

Obligations that will be satisfied w/in one year or one operating cycle, whichever is greater. More specifically, a liability that meets any of the following criteria is considered current: - Settlement is expected during the normal operating cycle - Settlement is expected w/in one year - Held primarily for trading purposes - There is not an unconditional right to defer settlement for more than one year

LIFO Liquidation

Occurs when a LIFO firm's inventory quantities decline. Older, lower costs are included in COGS compared to a situation in which inventory quantities are not declining. LIFO liquidation results in higher profit margins and higher income taxes compared to what they would be if inventory quantities were not declining. The extra profit reported w/ a LIFO liquidation inflates operating margins by recognizing historical inflationary gains from increasing inventory prices as income in the current period. Increases in profit margins from LIFO liquidation are not sustainable, however, because a firm cannot continue forever to sell existing inventory without replenishment. Mgmt could use a LIFO liquidation (draw down inventory) to artificially inflate current period earnings. Inventory declines can also be caused by events outside mgmt's control, such as strikers or materials shortages at a key supplier that make inventory reduction involuntary, or a decline in expected customer orders that results in a voluntary reduction in inventory to suit market conditions. **Regardless of the underlying reason for a LIFO liquidation, the resulting decrease in COGS will increase gross profits, pretax income, and net income. Decreased cash expenses (from not producing inventory) will increase operating cash flow, although higher income taxes on higher earnings will partially offset this increase in cash flows.

Derecognition

Occurs when assets are sold, exchanged, or abandoned. Gain or loss on a long-lived asset sold is usually reported in the income statement as a part of other gains and losses, or reported separately if material. Also, if the firm presents its cash flow statement using the indirect method, the gain or loss is removed from net income to compute cash flow from operations because the proceeds from selling a long-lived asset are an investing cash flow.

Free-On-Board

One example of how a firm's choices affect the timing of revenue recognition is the choice of where in the shipping process the customer actually takes title to the goods. A firm may choose terms with their customers of free-on-board (FOB) at the shipping point (the firm's loading dock) or FOB at the destination (the customer's location). Choosing terms of FOB at the shipping point will mean that revenue is recognized earlier compared to FOB at the destination.

Earnings Per Share (EPS)

One of the most commonly used corporate profitability measures for publicly-traded firms (nonpublic companies are not required to report EPS data). EPS is reported only for shares of common stock (also known as ordinary stock).

Discontinued Operations

One that mgmt has decided to dispose of, but has either not yet done so, or has disposed of in the current year after the operation had generated income or losses. Measurement date -> the date when the company develops a formal plan for disposing of an operation Phaseout period -> time between the measurement period and the actual disposal date *Analytical implications: Discontinued operations do not affect net income from continuing operations. Analysts may exclude discontinued operations when forecasting future earnings

Unearned Revenue

Payment for the goods is received prior to the transfer of the goods, a liability, UNEARNED REVENUE, is created when the cash is received (offsetting increase in the asset cash)

Cash Flows from Financing (CFF)

Positive CFF -> new borrowings Negative CFF -> debt principal repayments

Liquidity-Based Format (of balance sheet)

Presents assets and liabilities in the order of liquidity.

Internal Controls

Processes by which the company ensures that it presents accurate financial statements

Standard-Setting Bodies

Professional organizations of accountants and auditors that establish financial reporting standards

Retention Rate

Proportion of earnings reinvested RR = (net income available to common - dvds declared)/net income available to common = 1 - dividend payout ratio where: Dividend payout ratio = dividends declared/net income available to common

Profitability Ratios

Provide information on how well the company generates operating profits and net profits from its sales. See picture for formulas

Cash Flow Statement

Provides the following: - Information about a company's cash receipts and cash payments during an accounting period - Information about a company's operating, investing, and financing activities - An understanding of the impact of accrual accounting events on cash flows Provides information to assess firm's liquidity, solvency, and financial flexibility. An analyst can use statement of cash flows to determine whether: - Regular operations generate enough cash to sustain the business - Enough cash is generated to pay off existing debts as they mature - The firm is likely to need additional financing - Unexpected obligations can be met - The firm can take advantage of new business opportunities as they arise

Retrospective vs Prospective Application of Accounting Policy Changes

RETROSPECTIVE -> any prior-period financial statements presented in a firm's current financial statements must be re-stated, applying the new policy to those statements as well as future statements. *Enhances the comparability of financial statements over time PROSPECTIVE -> Prior statements are not restated, and the new policies are applied only to future financial statements

Net Profit Margin

Ratio of net income to revenue. Measures the profit generated after considering all expenses. Like gross profit margin, net profit margin should be compared over time and with the firm's industry peers.

Fair Value Reporting Option (bonds)

Recall that the book value of a bond liability is based on its market yield at issuance. So, as long as the bond's yield does not change, the bond liability represents fair (market) value. However, if the yield changes, the balance sheet liability is no longer equal to fair value. An INCREASE in the bond's yield will result in a DECREASE in the fair value of the bond liability. Conversely, a DECREASE in the bond's yield INCREASES its fair value. Changes in yield result in a divergence between the book value of the bond liability and the fair value of the bond. The fair value of the bond is the economic liability at a point in time. IFRS and US GAAP give firms the irrevocable option to report debt at fair value. Under this options, gains (decreases in bond liability) and losses (increases in bond liability) that result from changes in bonds' market yields are reported in the income statement. For analysis, the market value of a firm's debt may be more appropriate than its book value. For ex, a firm that issued a bond when interest rates were low is relatively better off when interest rates increase. This is b/c the firm could repurchase the bond at its now-lower market value. Decreasing the bond liability on the balance sheet to market value increases equity and decreases the debt-to-assets and debt-to-equity ratios. If interest rates have decreased since issuance, adjusting debt to its market value will have the opposite effects.

Straight-Line Depreciation

Recognizes an equal amount of depreciation expense each period. In the early years of an asset's life, the straight-line method will result in lower depreciation expense as compared to an accelerated method. Lower expense results in higher net income. In the later years, the effect is reversed.

Stock Split

Refers to the division of each "old" share into a specific number of "new" (post-split) shares.

Capital Adequecy

Refers to the ratio of some dollar measure of the risk, both operational and financial, of the firm to its equity capital.

Matching Principle

Requires that the expenses incurred to generate the revenue be recognized in the same accounting period as the revenue

Debt Covenants

Restrictions imposed by the lender on the borrower to protect the lender's position. Debt covenants can reduce default risk and thus reduce borrowing costs. The restrictions can be in the form of affirmative covenants or negative covenants.

Gains and Losses

Result in an increase (gains) or decrease (losses) in economic benefits. Gains and losses may or may not result from ordinary business activities. For example, 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.

Defined Contribution Plan

Retirement plan in which the firm contributes a sum each period to the employee's retirement account. The firm's contribution can be based on any number of factors, including years of service, the employee's age, compensation, profitability, or even a % of the employee's contribution. In any event, the firm makes no promise to the employee regarding the future value of the plan assets. The investment decisions are left to the employee, who assumes all of the investment risk. The financial reporting requirements for defined contribution plans are straightforward. Pension expense is simply equal to the employer's contribution. There is no future obligation to report on the balance sheet as a liability.

SEC Required Filings

SEC has the responsibility of enforcing Sarbanes-Oxley. Form S-1: Registration statement filed prior to the sale of new securities to the public Form 10-K: Required annual filing that includes information about the business and its management, audited financial statements and disclosures, and disclosures about legal matters involving the firm. Form 10-Q: US firms are required to file this quarterly, with updated financial statement (don't have to be audited) and disclosures about legal proceedings/changes in accounting policy. Form DEF-14A: When a company prepares a proxy statement for its shareholders prior to the annual meeting or other shareholder vote, it also files w/ SEC as this form. Form 8-K: Companies must file this form to disclose material events including significant asset acquisitions and disposals, changes in mgmt or corporate governance, or matters related to its accountants, financial statements or the markets in which its securities trade. Form 144: A company can issue securities to certain qualified buyers w/out registering w/ SEC but must notify SEC it intends to do so Forms 3, 4, and 5: involve beneficial ownership of securities by a company's officers and directors

Simple vs. Complex Capital Structure

SIMPLE -> One that contains no potentially dilutive securities. A simple capital structure contains only common stock, nonconvertible debt, and nonconvertible preferred stock. COMPLEX -> Contains potentially dilutive securities such as options, warrants, or convertible securities. ***All firms w/ complex structures must report both basic and diluted EPS. Firms w/ simple capital structures report only basic EPS.

Standard Costing vs Retail Method (measuring inventory costs)

STANDARD COSTING -> Often used by manufacturing firms, involves assigning predetermined amounts of materials, labor, and overhead to goods produced. RETAIL METHOD -> Measure inventory at retail prices and the subtract gross profit in order to determine cost

Accounts Receivable

Sale of goods is made on credit, revenue can be recognized at time of sale through ACCOUNTS RECEIVABLE (asset) on balance sheet.

Valuation Ratios

Sales per share, earnings per share, and price to cash flow per share are examples of ratios used in comparing the relative valuation of companies.

Examples of Regulatory Authorities

Securities and Exchange Commission (SEC) -> U.S. Financial Conduct Authority -> U.K. Most national authorities belong to the International Organization of Securities Commissions (IOSCO). The members of IOSCO regulate more thatn 95% of the world's financial markets

Converting Direct to Indirect (Cash Flows)

See LOS 23.g

Three methods of examining variability of financial outcomes around point estimates

Sensitivity analysis, Scenario analysis, Simulation

Major Sources and Uses of Cash (Cash Flows)

Sources and uses of cash change as the firm moves through its life cycle. For example, when a firm is in the early stages of growth, it may experience negative operating cash flow as it uses cash to finance increases in inventory and receivables. This negative operating cash flow is usually financed externally by issuing debt or equity securities. These sources of financing are not sustainable. - Eventually the firm must begin generating positive cash flow or the sources of external capital may no longer be available - Over the long term, successful firms must be able to generate operating cash flows that exceed capital expenditures and provide a return to debt and equity holders

Par Value

Stated or legal value of common stock. Has no relationship to fair value. Some common shares are even issued w/out 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 are the par value of the issued shares plus "additional paid-in capital."

Conceptual Framework for Financial Reporting

States the objective of financial reporting is to provide information about the firm to current and potential investors and creditors that is useful for making their decisions about investing in or lending to the firm. Financial reporting is not designed solely for valuation purposes; however, it does provide important inputs for valuation purposes

Treasury Stock Method

Stock options and warrants are dilutive only when their exercise prices are less than the average market price of the stock over the year. If the options or warrants are dilutive, use the treasury stock method to calculate the # of shares used in the denominator: - Treasury stock method 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. - The net increase in the # of shares outstanding (the adjustment to the denominator) is the # of shares created by exercising the options less the # of shares hypothetically repurchased w/ the proceeds of exercise.

Treasury Stock

Stock that has been reacquired by the issuing firm but not yet retired. Treasury stock reduces stockholders' equity. It does not represent an investment in the firm. Treasury stock has no voting rights and does not receive dividends.

Operating Profit

Subtracting operating expenses, such as selling, general, and admin expenses, from gross profits

Stretching payables

Taking longer to pay suppliers -> in effect, increasing operating cash flows

Sarbanes-Oxley Act of 2002

The 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.

Economic Depreciation

The actual decline in the value of the asset over the period.

Amortization

The allocation of the cost of an intangible asset (such as a franchise agreement) over its useful life. Amortization expense should match the proportion of the asset's economic benefits used during the period. Most firms use straight-line method to calculate annual amort expense for financial reporting, clac'ed exactly like straight-line depreciation. Intangible assets w/ indefinite lives (e.g., goodwill) are not amortized. However, they must be tested for impairment at least anually. If the asset value is impaired, an expense equal to the impairment amount is recognized on the income statement.

LIFO Reserve

The amount by which LIFO inventory is less than FIFO inventory. To make financial statements prepared under LIFO comparable to those of FIFO, an analyst must: 1. add the LIFO reserve to LIFO inventory on the balance sheet 2. increase the retained earnings component of shareholders' equity by the LIFO reserve When prices are increasing, a LIFO firm will pay less in taxes than it would pay under FIFO. For this reason, analysts often decrease a LIFO firm's cash by the tax rate times the LIFO reserve and increase its retained earnings by the LIFO reserve times (1 - tax rate) instead of the full LIFO reserve.

Weighted Average Cost (inventory cost methods)

The average cost per unit of inventory is computed by dividing the total cost of goods available for sale (beg. inventory + purchases) by the total quantity available for sale. To compute COGS, the average cost per unit is multiplied by the # of units sold. Similarly, to compute ending inventory, the average cost per unit is multiplied by the # of units that remain. During inflationary or deflationary periods, the weighted average cost method will produce an inventory value between those produced by FIFO and LIFO.

Basic EPS

The basic EPS calculation does not consider the effects of any dilutive securities in the computation of EPS. ***The current year's preferred dividends are subtracted from net income because EPS refers to the per-share earnings available to common shareholders. Net income minus preferred dividends is the income available to common stockholders. Common stock dividends are not subtracted from net income because they are a part of the net income available to common shareholders.

Technical Default

The bondholders can demand immediate repayment of principal if the firm violates a covenant

Bill-and-Hold Transaction

The 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. Revenue for future periods will be decreased as real customer orders for these bill-and-hold items are filled but not recognized in revenue, offsetting the previous overstatement of revenue.

Stock Dividend

The distribution of additional shares to each shareholder in an amount proportional to their current number of shares.

Defined Benefit Plan

The firm promises to make periodic payment to employees after retirement. The benefit is usually based on the employee's years of service and the employee's compensation at, or near, retirement. For example, an employee might earn a retirement benefit of 2% of her final salary for each year of service. Consequently, an employee w/ 20yrs of service and a final salary of $100k, would receive $40k ($100k x 2% x 20yrs) each year upon retirement until death. B/c the employee's future benefit is defined, the employer assumes the investment risk. A company that offers defined pension benefits typically funds the plan by contributing assets to a separate legal entity, usually a trust. The plan assets are managed to generate the income and principal growth necessary to pay the pension benefits as they come due.

Noncontrolling Interest (minority interest)

The minority shareholders' pro-rata share of the net assets (equity) of a subsidiary that is not wholly owned by the parent

Net Interest Margin

The performance of financial companies that lend funds is often summarized as the net interest margin, which is simply interest income divided by the firm's interest-earning assets.

Arguments in favor of Direct vs Indirect methods

The primary advantage of the direct method is that it presents the firm's operating cash receipts and payments, while the indirect method only presents the net result of these receipts and payments. Therefore, the direct method provides more information than the indirect method. This knowledge of past receipts and payments is useful in estimating future operating cash flows. The main advantage of the indirect method is that it focuses on the difference between net income and operating cash flow. This provides a useful link to the income statement when forecasting future operating cash flow. Analysts forecast net income and then derive operating cash flow by adjusting net income for the differences between accrual accounting and the cash basis of accounting. Under US GAAP, a direct method presentation must also disclose the adjustments necessary to reconcile net income to cash flow from operating activities. This disclosure is the same information that is presented in an indirect method cash flow statement. This reconciliation is not required under IFRS. Under IFRS, payments for interest and taxes must be disclosed separately in the cash flow statement under either method (direct or indirect). Under US GAAP, payments for interest and taxes can be reported in the cash flow statement or disclosed in the footnotes.

Financial Reporting Quality

The primary criterion for judging financial reporting quality is adherence to generally accepted accounting principles (GAAP) in the jurisdiction in which the firm operates. However, given that GAAP provides choices of methods, estimates, and specific treatment of many items, compliance w/ GAAP by itself does not necessarily result in financial reporting of the highest quality. High quality financial reporting must be DECISION USEFUL. Two characteristics of decision-useful financial reporting are RELEVANCE and FAITHFUL REPRESENTATION. Relevance -> information presented in financial statements is useful to users of financial statements in making decisions. must also be MATERIAL in that knowledge of it would likely affect the decisions of users of financial statements Faithful Representation -> encompasses the qualities of COMPLETENESS, NEUTRALITY, and the absence of errors.

Quality of Earnings

The quality of reported earnings (not the quality of earnings reports) can be judged based on the sustainability of the earnings as well as on their level. Sustainability can be evaluated by determining the proportion of reported earnings that can be expected to continue in the future. Increases in reported earnings resulting from changes in exchange rates or by sales of assets that have appreciated over many periods are not typically sustainable, whereas higher profits from increased efficiency or increasing market share would generally be considered sustainable.

Liquid Asset Requirement

The ratio of a bank's liquid assets to certain liabilities

Gross Profit Margin

The ratio of gross profit (revenue minus COGS) to revenue (sales). - Can be increased by raising prices or reducing production costs

Owners' Equity

The residual interest in assets that remains after subtracting an entity's liabilities. Includes contributed capital, preferred stock, treasury stock, retained earnings, non-controlling interest, and accumulated other comprehensive income

Noncontrolling Interest

The share of the subsidiary's income not owned by the parent that is reported in parent's income statement. *The noncontrolling interest is subtracted from the consolidated total income to get the net income of the parent company

Depreciation

The systematic allocation of an asset's cost over time. Two important terms are: - CARRYING (BOOK) VALUE. The net value of an asset or liability on the balance sheet. For property, plant, and equipment, carrying value equals historical cost minus accumulated depreciation. - HISTORICAL COST. The original purchase price of the asset including installation and transportation costs. Historical cost is also known as gross investment in the asset.

Modified Retrospective Application of accounting policy changes

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.

Activity Ratios

This category includes several ratios also referred to asset utilization or turnover ratios (e.g., inventory turnover, receivables turnover, and total assets turnover). They often give indications of how well a firm utilizes various assets such as inventory and fixed assets. See picture for formulas

Auditor Opinions

UNQUALIFIED -> statements are free from error QUALIFIED -> explains exceptions made to accounting principles ADVERSE -> statements are not presented fairly or are materially nonconforming w/ accounting standards DISCLAIMER -> unable to express an opinion

Property, Plant, and Equipment (PP&E)

Under IFRS, PP&E can be reported using the cost model or the revaluation model. Under US GAAP, only the cost model is allowed. COST MODEL -> PP&E other than land is reported at amortized cost (historical cost minus accumulated depreciation, amortization, depletion, and impairment losses). PP&E must be tested for impairment. - An asset is impaired if its carrying value exceeds the recoverable amount. Under the IFRS, 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: PV of the asset's future cash flow stream - Loss recoveries are allowed under IFRS but not under US GAAP HISTORICAL COST -> includes the purchase price plus any cost necessary to get the asset ready for use, such as delivery and installation costs.

Net Realizable Value NRV (in terms of inventory)

Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value. NET REALIZABLE VALUE is equal to the expected sales price less the estimated selling costs and completion costs. If net realizable value is less than the balance sheet value of inventory, the inventory is "written down" to net realizable value and the loss is recognized in the income statement. If there is a subsequent recovery in value, the inventory can be "written up" and the gain is recognized in the income statement by reducing COGS by the amount of the recovery. B/c 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.

Investment Property

Under IFRS, property that a firm owns for the purpose of collecting rental income, earning capital appreciation, or both, is classified as investment property. US GAAP does not distinguish investment property from other kinds of long-lived assets

IFRS (Fixed Asset) Disclosures

Under IFRS, the firm must disclose the following for each class of property, plant, and equipment (PP&E): - Basis for measurement (usually historical cost) - Useful lives or depreciation rate - Gross carrying value and accumulated depreciation - Reconciliation of carrying amounts from the beginning of the period to the end of the period The firm must also disclose: - Title restrictions and assets pledged as collateral - Agreements to acquire PP&E in the future If the revaluation (fair value) model is used, the firm must disclose: - the revaluation date - How fair value was determined - Carrying value using the historical cost model Under IFRS, the disclosure requirements for intangible assets are similar to those for PP&E, except that the firm must disclose whether the useful lives are finite or indefinite. For impaired assets, the firm must disclose: - Amounts of impairment losses and reversals by asset class - Where the losses and loss reversals are recognized in the income statement - Circumstances that caused the impairment loss or reversal

Lower of Cost or Market (in terms of inventory)

Under US GAAP, companies that use inventory cost methods other than LIFO or the retail method report inventories at the lower of cost or NRV. For companies using LIFO or the retail method, inventory is reported on the balance sheet at the lower of cost or market. Market is usually equal to replacement cost, but cannot be greater than NRV or less than NRV minus a normal profit margin. If replacement cost exceeds NRV, then market is NRV. If replacement cost is less than NRV minus a normal profit margin, then market is NRV minus a normal profit margin.

Revaluation Model

Under US GAAP, most long-lived assets are reported on the balance sheet at depreciated cost (original cost less accumulated depreciation and any impairment charges). There is no fair value alternative for asset reporting under US GAAP. Under IFRS, most long-lived assets are also reported at depreciated cost (the cost model). IFRS provides an alternative, the REVALUATION MODEL, that permits a long-lived asset to be reported at its fair value, as long as an active market exists for the asset so its fair value can be reliably (and somewhat objectively) estimated. Firms must choose the same treatment for similar assets so they cannot revalue only specific assets that are more likely to increase than decrease in value. The revaluation model is rarely used in practice by IFRS reporting firms.

US GAAP (Fixed Asset) Disclosures

Under US GAAP, the PP&E disclosures include: - Depreciation expense by period - Balances of major classes of assets by nature and function, such as land, improvements, buildings, machinery, and furniture - Accumulated depreciation by major classes or in total - General description of depreciation methods used Under US GAAP, the disclosure requirements for intangible assets are similar to those for PP&E. In addition, the firm must provide an estimate of amortization expense for the next five years. For impaired assets, the firm must disclose: - A description of the impaired asset - Circumstances that caused impairment - How fair value was determined - The amount of loss - Where the loss is recognized in the income statement

Acquisition Method (intangible assets obtained in a business combination)

Under the acquisition method, the purchase price is allocated to the identifiable assets and liabilities of the acquired firm on the basis of fair value. Any remaining amount of the purchase price is recorded as GOODWILL. Goodwill is said to be an unidentifiable asset that cannot be separated from the business itself. Only goodwill created in a business combination is capitalized on the balance sheet. The costs of any internally generated "goodwill" are expensed in the period incurred.

Specific Identification Method (Expense Recognition)

Used if a firm can identify exactly which items were sold and which items remain in inventory. For example, an auto dealer records each vehicle sold or in inventory by its identification number.

Contra Account

Used to reduce the value of its controlling account. EXAMPLE -> Allowance for doubtful accounts. Accounts receivable are reported at net realizable value, which is based on estimated bad debt expense. Bad debt expense increases the allowance for doubtful accounts. Accounts Receivable at net realizable value = gross receivables - allowance for doubtful accounts

Inventory Disclosures

Usually found in the financial statement footnotes, are useful in evaluating the firm's inventory management. The disclosures are also useful in making adjustments to facilitate comparisons with other firms in the industry. Required disclosures are similar under US GAAP and IFRS and include: - Cost flow method (LIFO, FIFO, etc.) used - Total carrying value of inventory, w/ carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate - The cost of inventory recognized as an expense (COGS) during the period - Amount of inventory write-downs during the period - Reversals of inventory write-downs during the period, including a discussion of the circumstances of reversal (IFRS only b/c US GAAP does not allow reversals) - Carrying value of inventories pledged as collateral

Affirmative Covenants

W/ AFFIRMATIVE COVENANTS, the borrower promises to do certain things, such as: - Make timely payments of principal and interest - Maintain certain ratios (such as the current, debt-to-equity, and interest coverage ratios) in accordance w/ specified levels - Maintain collateral, if any, in working order

Negative Covenants

W/ NEGATIVE COVENANTS, the borrow promises to refrain from certain activities that might adversely affect its ability to repay the outstanding debt, such as: - Increasing dividends or repurchasing shares - Issuing more debt - Engaging in mergers and acquisitions

Capitalized Interest

When a firm constructs an asset for its own use or, in limited circumstances, for resale, the interest that accrues during the construction period is capitalized as a part of the asset's cost. The reasons for capitalizing interest are to accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset. Treatment is similar under US GAAP and IFRS. Capitalized interest is not reported in the income statement as interest expense. Once construction interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for use), or COGS (if the asset is held for sale). Generally, capitalized interest is reported in the cash flow statement as an outflow from investing activities, while interest expense is reported as an outflow from operating activities under US GAAP. Note, however, that interest expense can be an operating, financing, or investing cash flow under IFRS. For an analyst, both capitalized and expensed interest should be used when calculating interest coverage ratios. Any depreciation of capitalized interest on the income statement should be added back when calculating income measures.

Consolidated (in terms of income statement)

When a firm has a controlling interest in a subsidiary; the earnings of both firms are included on the income statement

Capitalization vs. Expensing

When a firm makes an expenditure, it can either CAPITALIZE the cost as an asset on the balance sheet or EXPENSE the cost in the income statement in the period incurred. As a general rule, an expenditure that is expected to provide a future economic benefit over multiple accounting periods is capitalized; however, if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed in the period incurred. An expenditure that is capitalized is initially recorded as an asset on the balance sheet at cost, typically its fair value at acquisition plus any costs necessary to prepare the asset for use. Except for land and intangible assets with indefinite lives (such as acquisition goodwill), the cost is then allocated to the income statement over the life of the asset as depreciation expense (for tangible assets) or amortization expense (for intangible assets with finite lives).

Intangible Assets Created Internally

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. R&D costs: Under IFRS, RESEARCH COSTS, which are costs aimed at the discovery of new scientific or technical knowledge and understanding, are expensed as incurred. However, development costs may be capitalized. DEVELOPMENT COSTS are incurred to translate research findings into a plan or design of a new product or process. To recognize an intangible asset in development, a firm must show that it can complete the asset and intends to use or sell the completed asset. Under US GAAP, both R&D costs are generally expensed as incurred. However, creating software is treated like R&D under IFRS.

Business Segment

a portion of a larger company that accounts for more than 10% of the company's revenues or assets, and is distinguishable from the company's other lines of business in terms of the risk and return characteristics of the segment - Both US GAAP and IFRS require companies to report segment data, but the required disclosure items are only a subset of the required disclosures for the company as a whole.