CFA Level 1 Exam- Accounting

Financing Cash Flows

are determined by measuring the cash flows ocurring between the firm and its suppliers of capital -CF's between the firm and creditors result from new borrowings (positive CFF) and debt principal repayments (negative CFF) -interest paid is technically a cash flow to creditors but it is included in CFO under US GAAP -cash between firm and its shareholders occur when equity is issued, shares are repurchased, or dividends are paid

stock dividend

distribution of additional shares to each shareholder in an amount proportional to their current # of shares proportional ownership in the company is unchanged

stock split

division of each old share into a specific number of new shares. proportional ownership in the company is unchanges

amortized cost

historical cost adjusted for depreciation, amortization, depletion, and impairment

working capital turnover ratio

how effectively a company is using its working capital =revenue / average working capital -working capital is current assets minus current liabilities -utilization of working capital in terms of dollars of sales per dollar of working capital

operating profitability ratios

how goos is mgmt at turning their efforts into profits? compare sales to profits gross profits = net sales minus COGS operating profits = EBIT net income = earnings after taxes but BEFORE dividends total capital = LT debt + ST debt + common and preferred stock total capital = total assets

Activity Ratios

Asset Utilization/Turnover/operating efficiency ratios -Indicate how well a firm utilizes/manages various assets such as inventory and fixed assets EX: receivables turnover

Basic EPS Equation

(Net Income - Preferred Dividends) / Weighted number of common shares outstanding weighted avg # of common shares is the number of shares outstanding during the year, weighted by portion of the year they were outstanding

Diluted EPS Equation

(net income - preferred dividends) + (convertible preferred dividends) + (convertible debt interest)(1-t) / (weighted avg shares) + (shares from conversion of preferred shares) + (shares from conversion of convertible debt) + (shares issuable from stock options)

Key takeaways of cash flow activities

*Note that the 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) are reported as an operating activity *principal amounts borrowed from others are financing activity; but the interest paid is reported as an operating activity *dividends paid to firms shareholders is a financing activity US GAAP: dividends RECEIVED are operating cash flows, and dividends PAID are financing activities Page 110

free cash flow to the firm (FCFF)

-Cash available to ALL investors, both equity owners and debt holders -start with either net income or operating cash flow FCFF = Net Income + noncash charges (aka Dep/Amort) + [interest expense * (1-t)] - Fixed Capital Investment (AKA Net Capex) - Working Capital Investment OR FCFF = CFO + [Int * (1-t)] -Fixed Capital Investment (Net Capex) -not necessary to adjust for noncash charges and net working capital since CFO already makes the adjustment

Disclosure of Deferred Tax Information

-DTL, DTA, valuation allowance and net change in valuation allowance -unrecognized DTL for undistributed earnings of subsidiaries -current year tax effect of each type of temporary difference -components of income tax expense -reconciliation of reported income tax expense and tax expense based on statutory rate -tax loss carryforwards and credits

disclosure of finance and operating leases

-general description of lease -nature, timing, amount of payments to be paid or received in next 5 yrs (5 > aggregated) -lease revenue and expense amount reported on income statement -receivable amount and unearned revenues from lease arrangements -restrictions imposed by lease agreements

liquidity ratio effects from inventory methods

-LIFO results in lower inventory values on the BS. -Inventory, a current asset, is lower under LIFO than FIFO. Working capital is lower as well. -quick ratio is unaffected since inventory is excluded from the numerator

Off-Balance Sheet Financing: financial statement adjustments

-To estimate PV of operating lease liabilities, use ratio of PV of capital lease to sum of the future payments -make an assumption about timing of operating lease payments beyond five years and calculate a discount rate to use when calculating PV of op lease payments -further in future payments are made, the lower the discount rates

deferred tax items

-a DTL results from using accelerated depreciation for tax purposes and a straight line depreciation for financial statements -impairments result in a DTA since the writedown is recognized immediately in the income statement but the deduction on the tax return is not allowed until the asset is sold or disposed -restructuring creates a DTA because the costs are recognized for financial reporting when announced, but not deducted for tax purposes until actually paid. -in US, firms that use LIFO for financial statements are required to use LIFO for taxes so no temporary differences result. But in places where this is not the case, temporary differences can result from choice of inventory cost flow method -post-employment benefits and deferred compensation are recognized on FS when earned by employee but not deducted for tax purposes until actually paid. DTA results -a deferred tax adjustment is made to SE to reflect the future tax impact of unrealized gains/losses on available for sale securities that are taken directly to equity. NO DTL is added to BS for future tax liability when g/l are realized

declining balance depreciation method

-aka diminishing balance method applies a constant rate of depreciation to an assets declining book value each year -double-declining balance: applies two times the straight line rate to the declining balance DDB= (2 / useful life)(cost minus accumulated depreciation) -once the book value of the asset reaches its salvage value, no additional depreciation expense is recognized

statement of changes in stockholders equity

-all transactions that increase or decrease equity accounts -shareholder transactions and beginning/ending balance of capital stock, additional-paid-in capital, retained earnings, and accumulated other comprehensive income -includes components such as unrealized g/l of available for sale, cash flow hedges, minimum pension, and translation adjustment

Impairment under IFRS

-annually asses impairment of assets value -asset is impaired when its carrying value (original less accum dep) exceeds the recoverable amount -recoverable amount: the greater of its fair value less selling costs and value in use -value in use: PV of future cash flow stream -assets value must be written down on the BS to the recoverable amount -impairment loss: excess carrying value over recoverable amount is recognized in the income statement -IFRS allows a reversal of loss if asset recovers in future -loss reversal is limited to the original impairment loss -carrying value of asset after the reversal cannot exceed the carrying value before the impairment loss was recognized

Reporting inventory above historical cost is permitted under IFRS and US GAAP

-applies primarily to producers and dealers of commodity products such as agricultural and forest, mineral ores, and precious metals -inventory is reported at NRV and any unrealized gains/losses from changing market prices are recognized in the income statement -if active market, quoted market price is used to value the inventory

authorized, issued, outstanding shares

-authorized shares: number of shares that may be sold under the firms articles of incorporation -issued shares: number of shares that have actually been sold to shareholders -outstanding shares: issued shares minus shares that have been required by the firm (treasury stock)

IFRS long-lived asset disclosure

-basis for measurement (usually historical cost) -useful lives or depreciation rate -gross carrying value and accum. depreciation -reconciliation of carrying amounts from beginning to end of the period also disclose: -title restrictions and assets pledged as collateral -agreements to acquire PPE in the future if revaluation model was used: -revaluation date -how fair value was determined -carrying value using historical cost model intangible asset disclosure: similar to PPE except have to disclose whether finite or indefinite impaired assets: -losses and reversals by asset class -where losses and reversals are recognized on the income statement -circumstances that cause loss or reversal

forecasting future net income and cash flow

-begins with a forecast of future sales -to forecast cash flows, needs to be assumptions -increases in working capital, capital expenditures on new fixed assets, issuance/repayments of debt and repurchasing stock

capitalizing vs expensing effects on operating cash flow

-capitalized expenditure is usually reported in CF statement as outflow from investing -if expensed, expenditure is reported as outflow from operating activities. -capitalizing an expenditure results in higher CFO and lower investing cash flow compared to expensing -total cash will be the same assuming no tax differences -depreciation form capital expenditure is a noncash expense that does not affect CFO

capitalizing vs expensing effects on net income

-capitalizing an expenditure delays the recognition of an expense in the income statement -periods where expenditures are capitalized, the firm will report higher net income compared to immediately expensing -In subsequent periods, firm reports lower net income compared to expensing since asset expenditure is allocated to IS via depreciation -over the life of an asset, total net income is identical whether the assets cost is capitalized or expensed. Timing of expense recognition in the IS is the only difference

unearned revenue (CL)

-deferred revenue is cash collected in advance of providing goods and services -cash asset goes up when paid and so does unearned revenue liability that reduces as goods are delivered and revenue is recognized

Notes to acctg shenanigans

-delaying payments to suppliers is a source of CFO not CFF but it is not sustainable bc supplies will eventually refuse to supply credit -cash received from securitizing receivables is an operating activity -cash received from borrowing against accts receivable is a financing activity

US GAAP disclosures for long lived assets

-depreciation expense by period -balances of major classes of assets by nature and function (land, improvements, buildings, machinery) -accumulated depreciation by asset class or in total -general description of depreciation methods intangible asset disclosure is similar to PPE except firm must provide estimation of amortization expense for next 5 yrs impaired assets: -description of impaired asset -circumstances that caused impairment -how fair value was determined -amount of loss -where is loss recognized on income statement

Balance Sheet Liability of a Bond

-equal to the PV of its remaining cash flows (coupon payments and FV), discounted at the market rate of interest at ISSUANCE. At maturity the liability will be equal to the face value of the bond. -AKA book or carrying value of the bond

Balance sheet effects of operating and finance leases

-finance results in reporting an asset and a liability -turnover ratios and ROA using assets in denominators will be lower for a finance lease compared to operating -Important: leverage ratios (debt to assets and debt to equity) will be higher with finance compared to operating because of the reported liability -principal repayment due within the next year is reported as current liability on lessee's BS which reduces current ratio and working capital -operating leases are also called off balance sheet financing activities because the liability does not appear on lessees balance sheet

Bad Debt Expense and Warranty expense recognition

-firm sells goods on credit or provides warranty to customer, matching principle requires firm to estimate bad debt expense/warranty expense. Firm is recognizing expense in period of sale, rather than later period

Interest Coverage Ratio

-firms ability to repay its debt obligations =EBIT / Interest Payment -lower this ratio, more likely the firm will have difficulty meeting debt payments

Inventories (CA)

-goods held for sale to customers or used in manufacture of goods sold -costs are purchase, conversion, and other costs to bring inventory to present condition -costs excluded: abnormal waste of material, labor, and overhead, storage costs, administrative, selling costsw

redeeming bonds

-happens before maturity because: interest rates have fallen, surplus cash, or issuance of equity made it possible. -when redeemed before maturity, a gain or loss is recognized by subtracting redemption price from book value of bond liability at reacquisition date -carrying value > than redemption price = gain -US GAAP says any remaining unamortized bond issuance costs must be written off and included in gain or loss calculation -no write off is necessary under IFRS cause issuance costs are accounted for in book value of bond liability already -gain/loss from redemption is reported in IS as part of continuing operations -redemption price is outflow from financing activities

Effect of inventory valuation method choice on gross profit

-higher COGS under LIFO will result in lower gross profit and net income compared to FIFO -Deflationary periods and stable or increasing quantities: LIFO COGS will be lower and LIFO ending inventory will be higher. FIGURE 2 PAGE 187 -not necessarily about newer inventory its about the COSTS

inventory changes

-if change cost flow method, has to be made retrospecitvely by changing prior years financial statements by recasting based on new method -adjustments to retained earnings -IFRS: firm must demonstrate the change will provide more reliable/relevant information -US GAAP: firm must explain why the change in cost flow method is preferable *LIFO: change is applied prospectively with no adjustments made to the prior periods -carrying value of inventory under old method becomes first layer of inventory under LIFO in period of change

Transfers to or from investment property

-if cost model, carryin amount does not changed when transferred Fair value *from owner occupied to investment property: treat as revaluation; recognize gain only if reverses a previous loss that was recognized *from inventory to investment property: recognize gain or loss if fair value is different from carrying amount *from investment property to owner occupied/inventory: fair value of asset at date of transfer will be its cost under new classification

trading securities

-intent to profit over near term -BS at fair value -unrealized gains (holding period g/l) and losses on IS before sold -derivatives treated same as trading securities

Number of Days Payables

-inverse of payables turnover ratio * 365 -payables payments period =(average accounts or trade payables/purchases) *365 OR =365/payables turnover *if turnover ratios are for a quarter rather than a year, the number of days in the quarter should be divided by quarterly turnover ratios in order to get the days form of these ratios

available-for-sale securities

-investment securities not expected to be held to maturity or sold in the near term. -They are reported on the balance sheet at fair value -unrealized gains and losses (changes in fair value before sold) are not reported in the income statement but reported directly in stockholders equity as a component of other comprehensive income -Under IFRS: firms can choose to report certain long-lived assets at fair value rather than historical cost so the changes in fair value are also included in other comprehensive income -dividends received for A-F-S securities and realized gain on sale of land are already included in net income -dividends paid and reacquisition of common stock are shareholder transactions, so they are not included in comprehensive income

Issuance Costs

-involves legal/acctg fees, printing costs, sales comissions -US GAAP: issuance costs are capitalized as an asset (deferred charge) and allocated to the IS as an expense over the bonds term -IFRS: initial bond liability on BS is reduced by amount of issuance costs, increasing bonds effective interest rate (unamortized discount). -under both: bond issuance costs are netted against bond proceeds and reported on cash flow statement as a financing cash flow

LIFO-last in, first out

-item purchased last is assumed to be the item first sold -cost of inventory most recently purchased is assigned to the COGS of the period -cost of beginning inventory and earlier purchases are assigned to ending inventory -used with inventory that does not deteriorate with age -ex: coal *income tax benefits: rising prices=higher LIFO COGS=lower taxable income=lower income taxes -inflationary environment, LIFO COGS will be higher than FIFO COGS, and earnings will be lower. -Lower earnings = lower income taxes, which increases cash flow. -ending inventory on BS uses earliest costs, so inflationary environments mean ending inventory is less than current cost -income tax advantage: lower reported earnings result in higher cash flow from operations

Impairment under US GAAP

-only tested for impairment when events indicate firm may not be able to recover the carrying value through future use -recoverability test: an asset is impaired if carrying value (original minus accum dep) is greater than the assets FUTURE UNDISCOUNTED CASH FLOW -if impaired, the assets value is written down to fair value on the balance sheet and a loss, equal to excess of carrying value over fair value of asset (OR discounted value of Future cash flows if fair value is not known) is recognized on the IS -LOSS RECOVERIES ARE NOT PERMITTED -impairment loss for intangibles with indefinite lives are recognized when the carrying value amount exceeds fair value

Property, Plant, and Equipment (Non-Current Asset)

-land, buildings, machinery, equipment, furniture, natural resources IFRS vs US GAAP Treatment of PPE: -IFRS: reported using cost model or revaluation model -US GAAP: ONLY the cost model

benefits of leasing

-less costly financing (no down payment) -reduced risk of obsolescence: asset returned to lessor -less restrictive provisions -off-balance sheet financing: operating leases do NOT result in a balance sheet liability -tax reporting advantages

limitations of ratio analysis BS

-limited by differences in acctg standards/estimates b/w firms -lack of homogeneity as many firms operate in different industries -significant judgement -only measured at a single point in time b

Free Cash Flow

-measure of cash available for discretionary purposes. Cash flow available once the firm has covered its capital expenditures. -FCFF -FCFE

Fixed Charge Coverage Ratio

-measures companies ability to meet its obligations =(EBIT + Lease payments) / (interest payments + lease payments) -typically for airline companies

Identifiable Intangible Assets under IFRS

-must be capable of being separated from the firm or arise from a contractual or legal right -controlled by the firm -expected to provide future economic benefits *future economic benefits must be probable and assets cost reliably measured

Notes about deferred tax assets/liabilities and valuation

-neither deferred tax assets nor deferred tax liabilities are carried on the balance sheet at their discounted present values -deferred tax assets are assessed at each balance sheet date to determine the likelihood of future taxable income to recover the tax assets

Indirect Method

-net income is converted to OCF by making adjustments for transactions that affect net income but are NOT cash transactions -eliminating noncash expenses (depr. and amort -eliminated nonoperating items (gains and losses) -eliminating changes in balance sheet accts resulting from accrual acctg -starts with net income -advantage: focuses on differences in net income and operating cash flow

issuance of stock options

-no cash flow effects at time of employee stock options given to employee because they are non cash -CFO is greater than it would have been if cash compensation were paid instead -when exercised, issuing firm gets a tax deduction decreasing cash taxes payable in that period

Bonds issued at Discount or Premium

-non equal coupon and issuance rates result in proceeds received not equal to par value. these are premium and discount bonds -discount bond: if market rate is grater than coupon rate the proceeds received will be less than par value. Investors pay less than FV because of the lower coupon rate -premium bond: if coupon rate is greater than bonds yield then the bond price and the proceeds recieved will be greater than FV

Period Costs

-not all inventory costs are capitalized; some are expensed in the period incurred and these are known as period costs: 1. abnormal waste of materials, labor, or overhead 2. storage costs (unless required as part of production) 3. administrative overhead 4. selling costs

Fraud Triangle (3 conditions present when fraud occurs)

-not all need to be present when fraud occurs 1. incentive/pressure: motive exists to commit fraud -meeting earnings bc compensation is tied to stock price 2. opportunity: exists when weakness in internal controls 3. attitudes or rationalization: mindset that fraudulent behavior is justified

Limitations of ratios

-not useful when viewed in isolation -only informative when compared to other firms or historical performance of the company -different acctg treatments make comparisons difficult -hard to find comparable ratios when analyzing companies operating in multiple industries -conclusions cannot be made by a single ratio. Should always be viewed relative to one another

notes payable and current portion of long-term debt (CL)

-obligations in form of promissionary notes owed to creditors -current portion of LT debt is the principal portion of debt due within one year or operating cycle, whichever is greater

Amortization of intangible assets

-only intangible assets with finite lives are amortized over useful lives. -methods are same as depreciation -total amount of amortization is same under all methods -timing of expense in the income statement is only difference -intangible assets with indefinite lives are no amortized, but tested for impairment annually -good will is not amortized -trademarks that have specific expiration dates, but can be renewed at minimal cost are NOT amortized

preferred stock

-paid dividends at a percentage of par value -priority claim over common shareholders in the event of liquidation

Cost of Sales, EI, and Gross Profit using different inventory valuation methods

-periods of stable prices, all three cost flow methods will yield the same results for inventory, COGS, and gross profit -trending prices yield different results for different methods

structure and content of financial statements

-present a classified balance sheet showing current and non current assets and liabilities -minimum information is required on the face of each financial statement and in the notes -BS: cash/equivalents, PPE, inventories -IS: revenue, p/l, tax expense, and finance costs -comparative info: for prior periods should be included

reporting debt on financial statements

-report outstanding LT debt on single line of BS -portion due within next year = current liability -footnote disclosure: nature of liabilities, maturity dates, stated and effective rates, call provisions, restrictions, collateral -also found and MD&A

Standard costing vs retail method to measure inventory

-standard costing: assigning predetermined amounts of materials, labor, and overhead to goods produced. -retail method: measure inventory at retail prices and then subtract gross profit in order to determine cost

Dividends

-total dividends on a firm-wide basis are called dividends declared -neither EPS or net income are reduced by payment of common stock dividends -Net income minus dividends declared is called retained earnings -rate of return on resources is measured as the return on equity capital or ROE -proportion of earnings reinvested is known as the retention rate

accounts receiveable (CA)

-trade receivables -amounts owed to firm by customers for goods/services sold on credit -Reported at their Net Realizable Value, which is based on bad debt expense -bad debt expense increases the allowance for doubtful accounts (contra asset acct) -contra asset account is used to reduce the value of its controlling account -Net Realizable Value = gross receivables less the allowance for doubtful accounts is equal to the amount the firm expects to collect. -if receivable is written off- both gross receivables and allowance account are reduced

Steps for calculating CFO with indirect method

1. Begin with Net Income 2. Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land) 3. Add back all noncash charges to income (deprec. and amort) and subtract all noncash components of revenue 4. Add or subtract changes to balance sheet operating accounts -increases in operating asset accounts (use of cash) are subtracted, while decreases (sources of cash) are added -increases in operating liability accounts (sources of cash) are added, while decreases (uses of cash) are subtracted look at example on page 120

cash collections from customers (when converting from indirect to direct cash flow statement

1. Begin with net sales from the income statement 2. subtract (add) any increase (decrease) in the accounts receivable balance as reported in the indirect method -if the company has sold more on credit than has been collected from customers, accounts receivable will increase and cash collections will be less than net sales 3. Add (subtract) an increase (decrease) in unearned revenue. Unearned revenue includes cash advances from customers. Cash received before services have yet to be delivered needs to be added to net sales net sales, accounts receivable, unearned revenue

key points when preparing direct and indirect cash flow statements

1. CFO is calculated differently, but the result is the same under both methods 2. calculation of CFI and CFF is the same under both methods 3. Inverse relationship between changes in ASSETS and changes in CASH FLOWS -an increase in an asset account is a use of cash (negative cash outflow) and a decrease in an asset is a source of cash (positive cash inflow) 4. Direct relationship between changes in liabilities and changes in cash flow. An increase in a liability is a source of cash (positive cash inflow) and a decrease in a liability is a use of cash (negative cash outflow)

features for preparing financial statements

1. Fair presentation: faithfully representing 2. Going concern basis: firm will continue to exist 3. Accrual basis 4. Consistency: prior periods disclosed for comparison 5. Materiality: free of misstatements 6. Aggregation of similar items and separation of dissimilar items 7. No offsetting: 8. Reporting Frequency: atleast annually 9. Comparative information: from prior periods

differences in FASB and IASB

1. The IASB lists income and expenses as elements related to performance, while the FASB includes revenues, expenses, gains, losses, and comprehensive income 2. The FASB defines an asset as a future economic benefit, but the IASB defines it as a resources from which future economic benefit is expected to flow -FASB uses probable in definition of A and L -FASB does not allow upward valuation of most assets

Incentives and Pressures: 4 risk factors leading to fraudulent reporting

1. Threats to financial stability or profitability as a result of economic, industry, or firm conditions 2. Excessive 3rd party pressures on management -stock exchange listing requirements, debt repayments 3. Personal net worth of MGMT or BOD is threatened -significant financial interest in firm, personal guarantees of firms debt 4. Excessive pressure on MGMT or operating personnel to meet financial goals, including sales and profitability targets`

common acctg warning signs for low quality earnings

1. aggressive revenue recognition: recognizing too soon 2. different growth rates of CFO and earnings by recognizing revenue soon and delaying expenses 3. Abnormal sales growth compared to economy, peers 4. abnormal inventory growth compared to sales 5. boost revenue with nonoperating income and nonrecurring gains 6. delaying expense recognition 7. abnormal use of operating leases by lessees 8. hide expenses by classifying as extraordinary or nonrecurring 9. LIFO liquidations 10. abnormal gross or operating margin comparisons 11. extending useful life of LT assets 12. aggressive pension assumptions 13. year end surprises 14. off balance sheet special purpose entities

cash payments to suppliers

1. begin with COGS as reported in the income statement 2. add back any depreciation/amortization to COGS 3. reduce (increase) COGS by any increase (decrease) in the accounts payable balance reported in the indirect method 4. Add (subtract) any increase (decrease) in the inventory balance as disclosed in the indirect method. Increases in inventory are not included in COGS but represent the purchase of inputs, so they increase cash paid to suppliers 5. subtract an inventory write-off that occured. Reduces inventory and increases COGS. COGS, deprec/amort, accounts payable, inventory, inventory write-off

Attitudes and Rationalizations: risk factors to commit fraud

1. inappropriate ethical standards 2.known history of law violations by MGMT and BOD 3. mgmt obsesses to raise stock price 4. materiality excuse to justify questionable acctg 5. strained relationship b/w mgmt and auditor

Opportunities: 4 risk factors to commit fraud

1. nature of firms industry or operations -operations that occur internationally where businesses practices differ 2. Ineffective management monitoring as a result of: -mgmt being dominated by small group/single person -ineffective oversight of BOD by audit committee 3. A complex or unstable organizational structure -who is in control?, unusual legal entities 4. Deficient internal controls -inadequate monitoring

formulas of weighted average acctg ratios

1. scale and diversification: larger companies and those with a wider variety of product lines and geographic diversification are better credit risks 2. operational efficiency: op. ROA and margins, EBITDA. Greater vertical diversification, high op efficiency is associated with better debt ratings 3. margin stability: stable relevant profit margins prove higher probability of repayment 4. Leverage: ratios of op earnings, EBITDA, FCF to interest expense or total debt. Greater earnings in relation to their debt and interest risk are better quality

activities that result in a low quality of earnings

1. selecting acceptable acctg principles that misrepresent the economics of the transaction -ex: choosing units of production method instead of straight line or accelerated in periods when the other methods are more appropriate. accelerates earnings to early years 2. structuring transactions to achieve desired outcome -structuring lease to avoid capital lease resulting in lower liabilities, ratios, and fixed asses 3. using aggressive or unrealistic estimates and assumptions -higher live of asset or higher salvage to lower deprec. 4. exploiting intent of an acctg principle -separate purpose entities

financial statement analysis framework: six steps

1. state the objective and context -questions seeking to answer, presentation, resources 2. gather the data -acquire FS, talk to MGMT, suppliers, and customers 3. process the data -adjust FS, calculate ratios, graphs, common-size BS 4. analyze/interpret the data -use data to answer 1st step questions 5. report the conclusions or recommendations -prepare report, communicate to audience, 6. update the analysis -periodically repeat steps, and change conclusions when necessary

standard auditors opinion

1. whereas the FS are prepared by MGMT and are its responsibility, the auditor has performed an independent review 2. providing reasonable assurance that the FS contain no material errors 3. auditor is satisfied that statements were prepared in accordance with accepted acctg principles and there are reasonable estimates.

International Organization of Securities Commissions

3 objectives of financial market regulation 1. protect investors 2. ensure the fairness, efficiency, and transparency of markets 3. reduce systemic risk

cash conversion cycle

= (days sales outstanding) + (days of inventory on hand) minus the number of days of payables -amount of time it takes to turn the firms cash investment in inventory back into cash, in the form of collections from the sales of that inventory -high cash conversion cycles are undesirable

Receivables Turnover

= Annual Sales / average receivables *when a ratio compares a balance sheet account with an income or cash flow item, the BALANCE SHEET item will be the average of the account instead of simply the year end balance

financial leverage ratio

=average total assets / average total equity

gross profit margin

=gross profit / revenue -GP can be increased by raising prices or reducing costs

net profit margin

=net income / revenue -concerned if too low. only based on net income from continued operations (forget about discontinued operations below this).

Operating return on assets

=operating income / average total assets OR =EBIT / average total assets -includes both taxes and interest in the numerator

debt-to-assets ratio

=total debt / total assets

debt-to-capital ratio

=total debt / total debt + total shareholders equity capital is equal to all short-term and long-term debt + preferred stock and equity

Inventory Turnover

A measure of a firms efficiency with respect to its processing and inventory management inventory turnover = COGS / Avg Inventory

Periodic vs Perpetual Inventory Systems

A periodic system matches the total purchases for the month with the total withdrawals of inventory units for the month -Perpetual system matches each unit withdrawn with the immediately preceding purchases

Accounting Profit

Acctg profit: pretax financial income based on financial acctg standards (income before tax or earnings before tax)

5 ratios used in analysis

Activity, Liquidity, Solvency, Profitability, and Valuation Ratios

Notes on 5 way dupont

An increase in interest expense ad a proportion of EBIT will increase the interest burden (aka decreases the interest burden ratio) -lower ratio indicates a higher burden -increases in either the tax burden or the interest burden (decreases in the ratio) will decrease ROE. -in general, high profit margins, leverage, and asset turnover will lead to high levels of ROE. But this version of the formula shows that more leverage does NOT always lead to ROEAs leverage rises, so does the interest burden, hence positive effects of levverage can be offset by the higher interest payments that accompany the debt. Higher taxes will always lead to lower levels of ROE

Tax rate effects on financial statements and ratios

An increase in the tax rate will increase both deferred tax liabilities and deferred tax assets. A decrease in the tax rate will decrease both deferred tax liabilities and deferred tax assets -if there is an increase (decrease) in the tax rate, when previously deferred income is recognized for tax, the tax due will be higher (lower), and when expense items previously reported in the financial statements are recognized for tax, the benefit will be greater (less) -changes in the tax rate will affect income tax expense in the current period

Bonds issued at Par

At Par, the yield is equal to coupon rate -PV of coupon payments + PV of face amount is equal to par value -on BS, a/l increase by bond proceeds (face value). Book value of bond will NOT change over time -On income statement, interest expense for the period is equal to the coupon payment because the yield at issuance and coupon rate are the same -cash flow statement, issue proceeds are reported as cash inflow from FINANCING activities and coupon payments are reported as cash outflows from operating activities under US GAAP and either CFO or CFF outflows under IFRS -Repayment of FV at maturity is reported as a cash outflow from financing activities

Fair Value Bond Reporting

BV of bond liability is based on market yield at issuance. If this does not change, bond represents fair value. If yield changes, balance sheet liability is no longer equal to fair value -increase in yield decreases fair value of bond liability -decrease in yield increases fair value of bond liability -changes in yield diverge between book value and fair value both IFRS and US GAAP give firms irrevocable option to report debt at fair value. -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 -decreasing bond liability on BS to market value increases equity and decreases debt-to-assets and debt-to-equity ratios. page 263 and 264

units of production method of depeciation

Based on usage rather than time -depreciation expense is higher in periods of high usage ((Original cost minus salvage value) / life in output units))*output units in the period

Original Approach

Begin with ROE: Net Income / Equity -average or year end values can be used Multiply ROE by (revenue/revenue) ROE = (Net Income/Revenue) * (Revenue/Equity) = (profit margin) * (equity turnover) Multiply ROE by (assets/assets) ROE = (net income/revenue) * (sales/assets) * (assets/equity) ROE = (Net Profit Margin)*(asset turnover)*(leverage ratio) *for exam: remember net income/sales * sales/assets =ROA

Impairment of PPE and Intangible Assets

Both IFRS and US GAAP require firms to write down impaired assets by recognizing a loss on the income statement

Liquidity Ratios

analyzing the ability to pay short-term obligations as they come due

current assets and non current assets

CA: cash and other assets converted into cash or used within one year or operating cycle -op cycle: time it takes to produce/purchase inventory, sell the product, and collect the cash. NCA: will not be converted into cash or used up within one year or operating cycle. Firms investing activities

current liabilities and noncurrent liabilities

CL: obligations will be satisfied within one year or operating cycle, whichever is greater. -settlement is expected during normal operating cycle -settlement expected within 1 year -held primarily for trading purposes -no unconditional right to defer settlement for more than 1 year *current assets - current liabilities = working capital NCL: firms long term financing actibities

capitalizing vs expensing effects on shareholders equity

Capitalization results in higher net income in expenditure period so it also results in higher SE because retained earnings are greater. Assets are greater and liabilities are unaffected. As cost is allocated to IS, net income, retained earnings, and shareholders equity will be reduced -if expenses, retained earnings and SE will reflect entire reduction in net income

COGS

Cost of Goods Sold; Cost of Sales -relates to the beginning balance of inventory, purchases, and the ending balance of inventoryr COGS = beginning inventory + purchases - ending inventory OR Ending Inventory = beginning inventory + purchases - COGS -manufacturing firms report inventory using raw materials, work in process, and finished goods

Software development costs

Costs incurred to develop software for sale to others are expensed as incurred until the products technological feasibility has been established, after which costs are capitalized under both IFRS and US GAAP. -Under IFRS, treatment is the same whether the software is developed for sale or for a firms own use -US GAAP: all research and development costs are capitalized when a firm develops software for its own use. *Under IFRS, treatment is the same regardless if the software is developed for sale or for a firms own use

Income Statement effects of operating and finance leases

EBIT will be higher for companies that use finance leases relative to using operating leases -with op lease, entire lease payment is an operating expense, while for finance, only depreciation of leased asset (not interest portion) is treated as operating expense -total expense will be same for both -however in early years the finance lease interest expense is higher and net income is lower compared to later years when it is higher than op leases

Pretax Margin

EBT = EBIT - interest =EBT / Revenue

internally created intangible assets

EX: R&D costs are expenses as incurred under US GAAP. IFRS says a firm must identify the research stage (discovery of new scientific or technical knowledge) and the development stage (using research to plan or design products). Firm must expense costs incurred during research stage BUT can capitalize costs incurred during development stage

other current assets (CA)

EX: prepaid expenses (operating costs paid in advance) and deferred tax assets(result of temporary differences between financial reporting and tax reporting income)

Investing Cash Flows

Examine the change in the gross asset accounts that result from investing activities: PPE, intangible assets, and investment securities *accum depreciation and amortization are ignored (bc. noncash) -if calculating cash paid for new asset, determine whether old assets were sold Cash paid for new asset = ending gross assets + gross cost of old assets sold minus beginning gross assets OR beginning gross assets + cash paid for new asset - gross cost of assets sold = ending gross assets cash from asset sold = book value of the asset + gain (or minus loss) -cash from sale of land = decrease in the asset + gain on sale

FIFO, LIFO, Weight Avg under both US GAAP and IFRS

FIFO and AVG COST are permitted under both US GAAP and IFRS *LIFO is allowed under US GAAP, BUT NOT UNDER IFRS -No LIFO for IFRS US GAAP-FIFO, LIFO, AVG IFRS-FIFO, AVG

Finite vs infinite intangibles

Finites: amortized over useful lives and tested for impairment in same way as PPE Infinites: not amortized but tested for impairment annually

Form 10-K

annual filing includes info about the business and its management, audited FS and disclosures, and disclosures about legal matters

Qualitative characteristics of financial statements

Fundamental 1. relevance -info. can influence users economic decisions. Predictive value, confirmatory value. Materiality is an aspect of relevance 2. faithful representation -information that is faithfully representative is complete, neutral, and free from error Enhancing: 3. comparability -consistant among firms and across time periods 4. verifiability -independent observers using the same methods=same results 5. timeliness -info is available to decision makers before the info is stale 6. understandability -users with basic knowledge of business and acctg should be able to readily understand the info the statements present

Sustainable growth rate, retention rate, and dividend payout ratio

G= RR x ROE retention rate = (net income available to common minus dividends declared) / net income available to common =1- dividend payout ratio dividend payout = dividends declared/net income available to common =DPS/EPS

Solvency Ratios

Give analyst information on firms financial leverage and ability to meet its longer-term obligations as they come due -debt ratios based on balance sheet and coverage ratios based on the income statement

other intangible assets

IFRS firms revalue intangibles upward but thats not permitted under US GAAP since revaluations that do not reverse previous impairment and go to equity, analysts can reduce intangible asset values (therby equity) to adjust

component depreciation

IFRS requires firms to depreciate the components of an asset separately, so there is useful estimates for each component -useful life of each component is estimated and depreciation expense is computed separately for each

Investment Property

IFRS: assets that generate rental income or capital appreciation US GAAP: no definition IFRS: reported at amortized cost or fair value (fair value model = change in fair value recognized on the IS)

Lessor's perspective IFRS vs US GAAP

IFRS: classification is same as lessees; if all rights and risks of ownership are transferred to lessee, the lease is treated as a finance lease, otherwise its operating US GAAP: if any one of capital lease criteria is met, and collecting of payments is certain, and lessor has completed performance, should be a finance lease *with operating lease, lessor recognizes rental income and reports/depreciates leased asset on balance sheet *with capital finance lease, lessor removes leased asset from BS and replaces it with a lease investment account: lease receivable

reporting investment property compared to PPE

IFRS: cost model or fair value model when valuing investment property, if a fair value for the property can be established reliably -cost model is same as for PPE -different for revaluation model -PPE Revluation above historical cost is recognized as revaluation surplus in SE -investment property revaluation above historical cost is recognized as a gain on the income statement

IFRS vs GAAP Inventory Treatment

IFRS: inventories reported at lower of cost or NRV -NRV = selling price less any completion and disposal (selling) costs US GAAP: inventories reported at lower of cost or market -Market = replacement cost; market cannot be greater than NRV or less than NRV minus normal profit margin *IF NRV OR MARKET ARE LESS THAN CARRYING VALUE, THE INVENTORY IS WRITTEN DOWN AND A LOSS IS RECOGNIZED ON THE INCOME STATEMENT -IFRS: If there is recovery value, inventory can be written back up -US GAAP: no write up allowed; firm reports higher profit when the inventory is sold

Net Realizable Value

IFRS: inventory is reported on the BS at the lower of cost or net realizable value NRV = expected sales price minus the estimated selling costs and completion costs *if NRV is less than the BS value of inventory, the inventory is written down to NRV and the loss is recognized in the income statement *if there is 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. -inventory cannot be written up by more than it was previously written down since inventory is valued at the lower of cost or NRV -write up and write downs are done through a contra asset account called valuation allowance account *carrying value cannot exceed the original cost

Lessees perspective (IFRS)

IFRS: lease classification determined by economic substance. If all rights/risks of ownership are transferred to lessee, the lease is treated as a finance lease circumstances required to be treated as a finance lease: 1. title to leased asset is transferred to lessee at end of lease 2. lessee can purchase leased asset for a price significantly lower than fair value of asset in future 3. lease term covers a large portion of assets life 4. PV of lease payments is = to fair value of leased asset 5. only lessee can use asset without significant modifications

Firm cannot reliably measure outcome of the project

IFRS: revenue is recognize to the extent of costs, costs are expensed when incurred, and profit is only recognized at completion GAAP: completed contract method

Tips to dupont analysis

If ROE is relatively low, it must be that atleast one of the following is true: 1. company has poor profit margin 2. company has poor asset turnover 3. company has too little leverage

Specific Identification

If a firm can identify which items were sold and which items remain in inventory ex; auto dealer records each vehicle sold or in inventory by its identification number -each unit sold is matched with the unit's actual cost -appropriate when inventory items are not interchangeable and is commonly used by firms with a small number of costly and easily distinguishable items like jewelry -good for special items as well

noncontrolling interest/minority interest

If a firm has controlling interest in a subsidiary, the pro rata share of the subsidiarys income not owned by the parent is reported in the parents income statement. The noncontrolling interest is subtracted in arriving at net income because the parent is reporting all of the subsidiarys revenue and expense -minority shareholders pro-rate share of net assets of subsidiary thats not wholly owned by the parent

Long-Lived Assets held for sale

If a firm reclassifies a long-lived asset from held for use to held for sale, the asset is tested for impairment -held for sale asset is impaired if its carrying value exceeds its net realizable value (fair value less selling costs) -impaired asset is written down to NRV and loss is recognized on income statement -held for sale assets can be reversed under both IFRS and US GAAP. -carrying value of asset after reversal cannot exceed carrying value before impairment

Operating Lease for Lessor

If lease is treated as an op lease, the lessor simply recognizes the lease payment as rental income. In addition, the lessor will keep the leased asset on its BS and depreciate it over its useful life -total income over life of the lease is the same for operating lease and direct financing lease -in early years of lease, income reported from direct financing lease is higher than the income reported from the operating lease cash flow from operations: total cash flow is the same for an operating lease and a direct financing lease. CFO is higher with operating lease. With direct financing, lease payment is separated into interest for CFO and principal for CFI *lessee perspective: principal is a financing outflow *lessor perspective: principal is return of capital invested so its an investing inflow

disclaimer of opinion

auditor is unable to express an opinion

Average Collection Period (Days of Sales Outstanding)

Inverse of the receivables turnover * 365 -Avg number of days it takes for the company's customers to pay their bills days of sales outstanding=(Average Receivables / Annual Sales) * 365 OR days of sales outstanding = 365 / receivables turnover

Discontinued Operations (non-recurring item)

Is one that mgmt decided to dispose of, either has done it or not yet, or has disposed of in current year after losses. -should be physically and operationally distinct from the rest of the firm -measurement date: date when company develops a formal plan for disposing of an operation -phaseout period: time between the measurement period and actual disposal date -loss from this is reported separately in the IS, net of tax, after income from CONTINUING OPERATIONS -past IS must be restated -expected gain on disposal cannot be reported until after the sale is completed *do not affect net income of CONTINUING OPERATIONS. Discontinued operations should be excluded by the analyst when forecasting future earnings

inventory accounting differences: financial statement adjustments

LIFO Reserve can be used to adjust LIFO COGS and inventory to FIFO equivalents -add LIFO reserve to current assets to fix to FIFO since EI is MORE for FIFO -subtract differences in LIFO reserves and then subtract the answer from FIFO COGS since it would be lower -subtracting reserves makes FIFO COGS smaller *assumes rising costs -To adjust LIFO to FIFO, add LIFO reserve to inventories on balance sheet and subtract CHANGE in LIFO reserve from COGS on the income statement -balance sheet is cumulative (use full reserve) -income statement is most recent period (use change for the period in reserve

Profitability ratio effects from inventory methods

LIFO produces higher COGS on IS and results in lower earnings. Profitability measures including COGS will be lower under LIFO

Solvency ratio effects from inventory methods

LIFO results in lower total assets compared to FIFO because LIFO inventory is lower. Lower total assets under LIFO result in lower SE (assets minus liabilities).

inverse relationship between turnover ratios and days on hand

Low inventory turnover will result in high days of inventory on hand and vice versa. In either case, the inventory measures should be compared to industry averages -high inventory turnover also indicates write downs have ocurred

carrying (book) value

Net value of an asset or liability on the balance sheet. *for PPE, carrying value equals historical cost minus accumulated depreciation

Ending Cash Balance

OCF + ICF + FCF = Change in Cash Balance + Beginning Cash Balance = Ending Cash Balance

Unidentifiable intangible asset

One that cannot be purchased separately and may have an indefinite life (good will) *not all intangible assets are reported on the balance sheet

US GAAP

PENSION EXPENSE 1. Service costs 2. net interest expense 3. expected return on plan assets (positive decreases expense) OTHER COMPREHENSIVE INCOME 1. past service costs (benefits awarded to employees when a plan is initiated or amended) 2. actuarial gains and losses *amortized to pension expense *pension expense does not appear separately on IS for manufacturing companies that allocate it to COGS or SG&A

IFRS treatment for pension plans

PENSION EXPENSE 1. service costs: PV of additional benefits earned by an employee over the yr 2. net interest expense/income: beginning value of net pension liability (asset) multiplied by discount rate assumed when determining PV of pension obligation OTHER COMPREHENSIVE INCOME 3. re-measurements: actuarial g/l and difference between actual return on plan assets and return included in net interest expense or income (not amortized to income statement over time)

Revaluation Model

PPE is reported at fair value less any accumulated depreciation -changes in fair value are reflected in SE

cost model of PPE (aka amortized cost)

PPE other than land is reported at amortized cost (historical minus accumulated depreciation) -PPE must also be tested for impairment

Profitability Ratios

Provide information on how well the company generates operating profits and net profits from its sales -measure overall performance of the firm relative to revenues, assets, equity, and capital

Return on Assets

ROA = Net income / average total assets -misleading because interest is excluded from net income but total assets include both debt and equity SO ROA = (net income + interest expense(1-t)) / Avg total assets

Valuation Ratios

Sales per share, earnings per share, and price to cash flow per share are examples comparing relative valuation of company's

Extended (5-way) Dupont Equation

Takes net profit margin and breaks it down further. ROE = (Net Income/EBT) * (EBT/EBIT) * (EBIT/Revenue)*(revenue/total assets)*(total asset/total equity) net income/EBT = tax burden and is equal to (1-tax rate) EBT/EBIT = interest burden EBIT/Revenue = EBIT Margin ROE=tax burden * interest burden * EBIT Margin * total asset turnover*financial leverage

Tax return Terminology

Taxable Income: Income subject to tax based on tax return Taxes Payable: tax liability on the BS caused by taxable income. Also known as current tax expense, but do not confused with income tax expense Income taxes paid: 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/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

Installment sales IFRS

The discounted PV of the installment payments is recognized AT THE TIME OF SALE. The difference between the installment payments and the discounted PV is recognized as interest over time. If the outcome cannot be reliably measured, revenue recognition under IFRS is similar to cost recovery method

horizontal common-size balance sheet/income statement

The divisor is the first-year values so they are standardized by 1

Effective Rate of Interest of a Bond

The interest rate that equates the PV of the future cash flows of the bond to the issue price -market rate of interest required by bondholders and depends on the bonds risks, structure of IR, and timing of bonds cash flows. -market rate changes over the bonds life

coherent financial reporting framework

Transparency: full disclosure and fair presentation reveal the underlying economics of the company Comprehensiveness: all transactions should be part of the framework Consistency: similar transactions in similar ways

Extraordinary Item

U.S. GAAP says its a material transaction or event that is both unusual AND infrequent in occurrence EX: losses from expropriation of assets -g/l from early retirement of debt -uninsured losses from natural disasters -reported separately on IS, net of tax, after income from continuing operations IFRS does NOT allow these items to be separated from operating results on the IS

Form 10-Q

U.S. firms should file this quarterly with updated financial statements that do not have to be audited. Disclosures about certain events in legal or accounting policies.

Market inventory valuation

US GAAP reports inventory on BS 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 *market cannot be outside a range of values *Size of the range is the normal profit margin -if cost exceeds market, inventory is written down to market on the balance sheet and a loss is recognized on the income statement -NO WRITE UP IS ALLOWED UNDER US GAAP IF THERE IS SUBSEQUENT RECOVERY IN VALUE

IFRS vs US GAAP Cash Flow Statements

US GAAP: -dividends paid to firms shareholders are reported as FINANCING activities -interest paid is reported as operating activities -interest received from investments is also an operating activity IFRS (more flexible): -interest and dividends received may be classified as operating OR investing activities -dividends paid to company's shareholders and interest paid on company's debt may be classified as operating OR financing activities *US GAAP says all taxes paid are reported as operating activities, even taxes related to investing and financing transactions *IFRS says income taxes are reported as operating activities unless the expense is associated with an investing or financing activity

disclosure of direct vs indirect

US GAAP: direct method presentation must also disclose the adjustments necessary to reconcile net income to OCF (the disclosure is the same info that is presented in an indirect method statement). -payments for interest/taxes can be reported in cash flow statement or disclosed in the footnotes IFRS: reconciliation is not required under IFRS -payments for interest and taxes must be disclosed separately in the cash flow statement under both direct/indirect methods

Valuation Allowance

US GAAP: if it is 50% probability or more that some or all of DTA will NOT be realized to cover the tax asset, then the DTA must be reduced by a valuation allowance -it is a contra asset account that reduces the net balance sheet value of the DTA -increasing the valuation allowance will decrease net balance sheet DTA, increase income tax expense and decrease net income -net DTA can be increased by decreasing the valuation allowance which would result in higher earnings -an increase (decrease) in the valuation allowance will decrease (increase) earnings, mgmt can manipulate earnings by changing valuation allowance -a valuation account is only used for deferred tax assets -US GAAP: DTA and DTL appear separately on the balance sheet and are typically not netted

Revaluation Model of Long-Lived Assets

US GAAP: most long-lived assets are reported on the BS at depreciated cost (original cost less accum dep. and any impairment charges) -no fair value alternative for asset reporting under US GAAP IFRS: most long-lived assets are also reported at depreciated cost (cost model). IFRS alternative is 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 estimated. -must choose same treatment for similar assets -initial revaluation to fair value below historical cost results in a loss reported in the income statement which decreases net income and SE -upward revaluation reflects an increase in fair value which is reported as a gain on the IS to the extent that it reverses a previously reported loss from revaluation to fair value -Any increase in an assets value above historical cost is not reported as a gain on the income statement, rather its reported as a component of SE in a REVALUATION SURPLUS account -subsequent declines in an assets value first reduce the surplus and then result in a loss reported on the IS to the extent that an assets fair value decreases below its historical cost *under revaluation model, a firm does not recognize depreciation expense on an asset, instead it revalues it downward if its fair value decreases with use or age

Balance Sheet Measurement of Bonds

When a bond is issued, assets and liabilities bot initially increase by the bond proceeds -any point in time the BV of bond liability will equal the PV of the remaining future cash flows (coupons and FV) discounted at bonds yield at issuance -interest expense and book value of a bond liability are calculated using bond yield at time of ISSUANCE and NOT todays yield -premium bond is reported on BS at more than its face value. As premium is amortized/reduced the BV of the bond liability will decrease until it reaches face value at maturity -discount bond is reported on BS at less than FV. As discount is amortized, the book value of the bond liability will increase until it reaches FV at maturity

Ending Inventory differences in methods

When prices are rising or falling, FIFO provides the most useful measure of ending inventory -the purchase costs can be viewed as better approximation of current cost -LIFO ending inventory is based on older costs that may differ significantly from economic value

percentage of completion method for IFRS and US GAAP for long term contracts

When the outcome of a LT contract CAN be reliably estimated, this method is used under both IFRS and GAAP. Percentage of completion is measured by the total cost incurred to date divided by the total expected cost of the project.

Reporting by lessor

a capital lease under US GAAP is either: 1. a sales-type lease: if PV of lease payments exceeds carrying value of the assets 2. direct financing lease: if PV of lease payments is equal to the carrying value IFRS does not distinguish between sales type and direct financing

Form 144

a company can issue securities to certain qualified buyers without registering the securities to the SEC

permanent differences

a difference between taxable income and pretax income that will not reverse in the future -do not create deferred tax assets or deferred tax liabilities -caused by revenue thats not taxable, expenses that are not deductible, or tax credits that result in a direct reduction in taxes -will cause the firms effective tax rate to differ from the statutory tax rate

installment sale

a firm finances a sale and payments are expected to be received over an extended period. -If collectibility is certain, revenue is recognized at the time of sale using the normal revenue recognition criteria. -if collectibility cannot be reasonably estimated, use the installment method -highly uncertain, use the cost recovery method

lease

a lease is a contractual arrangement whereby the lessor, the owner of the asset, allows the lessee to use the asset for a specified period of time in return for periodic interest payments leases are either finance (capital) leases or operating leases

finance (capital) lease

a purchase of an asset that is financed with debt -at inception, the lessee will add equal amounts to both assets and liabilities on the balance sheet. Over the lease term, the lessee will recognize depreciation expense on the asset and interest expense on the liability

assumptions of financial statements

accrual accounting vs going concern: -accrual: FS 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 -benefit users gain from using FS should outweigh cost of presenting it and brand loyalty, capacity, reputation cannot be captured from FS

Intangible assets obtained in a business combination

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 is recorded as good will which is unidentifiable. 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

affirmative covenants vs negative covenants

affirmative: borrower promises to do certain things: -make timely payment of principal and interest -maintain certain ratios with specific levels -maintain collateral negative: borrower promises to refrain from certain activities that might adversely affect ability to repay outstanding debt: -increasing dividends or repurchase shares -issuing more debt -engaging in M&A

Number of days of inventory

aka average inventory processing period or days of inventory on hand -inverse of inventory turnover * 365 # days of inventory = Avg Inventory / COGS *365 OR # days of inventory = 365 / inventory turnover

Amortization

allocation of the cost of an intangible asset over its useful life. Typically straight line method is used -indefinite lives such as goodwill are not amortized. Must be tested for impairment annually though. -if impaired, expense equal to amount of impairment is recognized on IS

gross profit

amount that remains after the direct costs of producing a product or service are subtracted from revenue

tax base vs carrying value

amount that will be deducted (expensed) on the tax return in the future as the economic benefits of the asset are realized carrying value is the value of the asset reported on the financial statements net of depreciation/amortization

deferred tax liabilities

amounts of income taxes payable in future periods as a result of taxable temporary differences -created when amount of income tax expense recognized in the income statement is greater than taxes payable EX: a firm uses an accelerated depreciation method for tax purposes and straight line for financial reporting

impairment for PPE

an asset is impaired if its carrying value exceeds the recoverable amount IFRS: recoverable amount = the greater of fair value minus any selling costs, or the assets value in use -value in use is the present value of an assets future cash flow stream -if impaired, the asset is written down to its recoverable amount and a loss is recognized on the IS under IFRS but not under US GAAP

acctg equation

assets = liabilities + contributed capital + ending retained earnings *ending retained earnings: beginning retained earnings + revenues - expenses - dividends assets = liabilities + contributed capital + beginning retained earnings + revenues - expenses - dividends

Deregonition

assets are sold, exchanged, or abandoned sold: asset removed from BS and difference b/w sale proceeds and carrying value is reported as a gain or loss on the IS -gain or loss is reported on IS as part of other gains or losses abandoned: similar to sale except no proceeds. carrying value is removed from BS and a loss is recognized on the income statement exchanged: g/l is computed by comparing carrying value of old asset with fair value of old asset or new asset. carrying value of old asset is removed from balance sheet and new asset is recorded at its fair value

financial statement elements

assets, liabilities, SE, revenue, expenses accounts are specific records within each element where each transaction is enterest

Balance Sheet elements

assets-resources controlled as a result of past transactions that are expected to provide future economic benefits liabilities-obligations as a result of past events that are expected to provide future economic benefits equity-owners residual interest in the assets after deducting the liabilities (net assets)

required financial statements

balance sheet (financial position) statement of comprehensive income statement of cash flow statement of changes in owners equity explanatory notes: summary of acctg policies

beginning accounts receivable

beginning accounts receivable + sales - cash collections = ending accounts receivable

Forms 3,4,5

beneficial ownership of securities by a companies officers or directors. Purchase and sale of company insider securities

Direct vs Indirect methods

both are permitted under US GAAP and IFRS -use of direct method is encouraged -difference relates to the presentation of Operating Cash Flow -presentation of cash flows from investing and financing activities is exactly the same under both methods

Balance sheet presentation under US GAAP and IFRS

both require firms to separately report their current assets and non current assets and current and non current liabilities (classified balance sheet to evaluate liquidity) -IFRS: firms can choose to use a liquidity based format if the presentation is more relevant and reliable. This presents assets and liabilities in order of liquidity

interest expense reported in the income statement

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

capitalize vs expense costs

capitalize cost as an asset on the balance sheet or expense the cost in the income statement in the period incurred -an expenditure that is expected to provide future economic benefits over multiple acctg periods is capitalized -if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed in the period incurred -a capitalized expenditure 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 (goodwill), the cost is then allocated to the income statement over the life of the asset as depreciation/amortization expenses -If expenditure is immediately expensed, pretax income is reduced by the amount of the expenditure -once there is a capitalized asset, subsequent expenditures that provide more future economic benefits are also capitalized -expenditures that sustain usefulness of the asset are expensed when incurred. -capitalize includes costs necessary to get the asset ready for use -training costs are not necessary to get the asset ready for use

capitalizing vs expensing effects on financial ratios

capitalizing results in higher initial assets and equity compared to expensing. so debt-to-assets and debt-to-equity ratios are lower (larger denominators) with capitalization -initially results in higher ROA and ROE bc of higher net income in first year. Later years they will be lower because net income is reduced by depreciation expense -expensing: ROA and ROW will be lower in first year and higher in later years

liability tax base

carrying value of the liability minus any amounts that will be deductible on the tax return in the future -the tax base of revenue received in advance is carrying value minus the amount of revenue that will not be taxed in the future -on tax return, revenue received in advance is taxable when collected

unearned revenue, prepaid expense

cash changes hands first and revenue or expense is recorded later.

Free Cash Flow to Equity (FCFE)

cash flow that would be available for distribution to common shareholders FCFE = CFO -Net Capex + net borrowing *net borrowing = debt issued - debt repaid *if net borrowing is negative (debt repaid exceeds debt issued) we would subtract net borrowing from the calculation *if firms that follow IFRS have subtracted dividends paid in calculating CFO, dividends must be added back in the calculation

cash ratio

cash ratio = (cash + marketable securities) / current liabilities

assets/economic resources

cash, cash equivalents, accts receivable, inventory, financial assets, prepaid expenses, PPE, investment in affiliates, deferred tax assets, intangible assets

change in acctg principle

change from GAAP or IFRS method to another ex: change in inventory acctg from LIFO to FIFO -retrospective application: all of the prior period FS currently presented are restated to reflect the change

prior-period adjustment

change from incorrect acctg method to one acceptable under GAAP or IFRS, or correcting acctg error made in previous FS -adjustments are made by restating results for all prior periods presented in the current FS -disclosure of nature and effect on NI is also required -errors or acctg standards and dont effect CF

other comprehensive income

changes resulting from foreign currency translation exposure, pension adjustments, unrealized gains and losses

3 C's of credit analysis

character: MGMTS professional reputation and history of debt repayment collateral: ability to pledge collateral reduces lender risk capacity: capacity to repay

Investments in securities: financial statement adjustments

classification of a firms investment securities affects how changes in their values are recorded and can effect reported earnings/assets -unrealized gains and losses differences between held for trading, held for maturity, and held for sale securities EX: IFRS says unrealized g/l on available for sale debt from exchange rates are recorded in income statement -Since they are not for US GAAP, analyst should subtract from net income in IFRS or add to net income for GAAP

unqualified opinion

clean opinion by auditor believing the statements are free from material omissions and errors

Form 8-K

companies must file this form to disclose material events including significant asset acquisitions and disposals, changes in management or corporate governance

Quick ways to figure out if dilutive

compare answers to basic EPS -convertible debt =convertible debt interest (1-t) / convertible debt shares -preferred stock =preferred dividend / number of shares -stock options =((Avg Mkt Price - Exercise Price) / Avg MKT Price))* N

accumulated comprehensive income vs comprehensive income

comprehensive income: income measure over a perod of time including net income and other comprehensive income for the period accumulated other comprehensive income: does not include net income but is a component of SE at a point in come. All changes in SE except for transactions recognized in the income statement and transactions with shareholders (stock issuance, reaquiring stock, and paying dividends)

cash flow from investing activities (CFI)

consists of inflows/outflows of cash resulting from the acquisition or disposal of LT assets and certain investments inflows: sale proceeds from fixed assets, sale proceeds from debt/equity investments, principal received from loans made to others outflows: acquisition of fixed assets, acquisition of debt and equity investments, loans made to others

cash flow from financing activities (CFF)

consists of the inflows and outflows resulting from transactions affecting a firms capital structure inflows: principal amounts of debt issued, proceeds from issuing stock outflows: principal paid on debt, payments to reacquire stock, and dividends paid to shareholders

cash flow from operating activities (CFO)

consists of the inflows/outflows of cash resulting from transactions that affect the firms net income inflows: cash collected from customers, interest/dividends received, sale proceeds from trading securities outflows: cash paid to employees/suppliers, cash paid for other expenses, acquisition of trading securities, interest/taxes paid

deferred tax assets (CA)

created when the amount of taxes payable exceeds the amount of income tax expense recognized on the income statement -can occur when expenses or losses are recognized in the IS before they are tax deductible

capitalized interest

constructing assets for own uses or resale, the interest that accrues is capitalized as part of the assets cost (similar under US GAAP and IFRS) -Under IFRS, income earned by temporarily investing borrowed funds reduces the interest eligible for capitalization. There is no such reduction of capitalized interest under US GAAP -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 asset is held for use or COGS if asset is held for sale -generally capitalized interest is reported in investing activities while interest expense is reported as operating activity outflow -in year of expenditure, capitalizing interest results in lower interest expense compared to expensing. This results in a higher interest coverage ratio bc of the denominator when interest is capitalized

simple capital structure

contains no potentially dilutive securities. Only common stock, nonconvertible debt, and nonconvertible preferred stock

complex capital structure

contains potentially dilutive securities such as options, warrants, or convertible securities -this structure has to report both basic and diluted EPS

stockholders equity

contributed capital, preferred stock, treasury stock, retained earnings, non-controlling interest, and other comprehensive income -contributed capital is the amount contributed by the common shareholders

securitizing accounts receivable

convert accts receivable to cash by borrowing against receivables or selling/securitizing the receivables -firm borrows with receivables as collateral, inflow of cash is financing activity -securitized: transfers them to a special purpose entity and pools receivables together -inflow of cash is CFO because its reported as sale (accelerates CFO in current period -can get gains from differences in book value and fair value and affect earnings

Depreciation Expense Recognition

cost of long-lived assets must be matched with revenues -depreciation=tangible -depletion=natural resources -amortization=intangible

Product Costs

costs included in inventory are similar under IFRS and US GAAP. They are called product costs that are capitalized in the Inventories account on the balance sheet and include: 1. purchase cost less trade discounts and rebates 2. conversion costs including labor and overhead 3. other costs necessary to bring the inventory to its present location and condition -capitalizing inventory costs as an asset means expense recognition is DELAYED until inventory is sold and revenue is recognized

Acctg for intangible assets created internally

costs to create intangible assets are expensed as incurred (with some exceptions)

Deferred Tax Liabilities

created when income tax expense on the INCOME STATEMENT is greater than taxes payable on the tax return due to temporary differences occur when: -revenues (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 -expected to reverse and result in future cash outflows when taxes are paid -mostly from different depreciation methods used on tax return and income statement

Deferred Tax assets

created when taxes payable on the tax return is greater than the income statement tax expense due to temporary differences results from: 1. revenues/gains are taxable before they are recognized in the income statement 2. expenses/losses are recognized in the income statement before they are tax deductible 3. tax loss carryforwards are available to reduce future taxable income -expected to provide future tax savings -post employment benefits, warrant expenses, and tax loss carryforwards are typical causes of deferred tax assets

Liabilities

creditor claims on the company's resources -accts payable, trade payables, financial liabilities, unearned revenue, income taxes payable, long term debt, deferred tax liabilities

retained earnings

cumulative earnings that have not been paid out to shareholders as dividends

current ratio

current ratio = current assets/ current liabilities -higher current ratio means more likely the company will be able to pay its short-term bills -less than 1 means company has negative working capital (CA-CL)

held-to-maturity securities

debt securities acquired with the intent to be held to maturity and are measured at their amortized cost amortized cost = original price minus any principal payments + amortized discount or minus any amortized premium minus impairment losses

temporary difference

difference b/w tax base and carrying value of asset or liability that will result in either taxable amounts or deductible amounts in the future

permanent difference

difference b/w taxable income (tax return) and pretax income (IS) that will not reverse in the future

temporary differences

difference between the tax base and the carrying value of an asset or liability that will result in taxable amounts or deductible amounts in the future -DTA or DTL is created taxable temporary differences: result in expected future taxable income deductible temporary differences: result in expected future tax deductions

common-size BALANCE SHEET

each item of balance sheet as percentage of total assets -eliminates size affect

Direct Method

each line item of the accrual-based income statement is converted into cash receipts or cash payments -converts an accrual based income statement into a cash basis income statement -begins with cash inflows from customers and then deducts cash outflows for purchases, operating expenses, interest, and taxes -advantage: presents firms operating cash receipts and payments, while indirect only shows net result -when using direct method ignore depreciation expense because it is a noncash charge

total asset turnover

effectiveness of the firms use of its total assets to create revenue = Revenue / Avg total assets

initial trial balance

end of period, initial trial balance is prepared that shows the balances in each account

contra accounts

entries that offset some part of the value of another account

straight line depreciation

equal amount of depreciation expense each period -early years, this method will result in lower depreciation expense compared to the accelerated method -later years, this method will will result in higher expense and lower net income compared to accelerated method =(original cost minus salvage value) / useful life

operating lease

essentially a rental agreement. No asset or liability is reported by lessee and periodic lease payments are recognized as rental expense in the income statement

Goodwill

excess of the purchase price over the fair value of the identifiable net assets (A minus L) acquired in a business acquisition. If examining balance sheet to calculate goodwill, make sure the values are FAIR VALUE and do not include the goodwill since it is unidentifiable. We are focused only on identifiable assets. Remember NET ASSETS (A minus L) -in the case of a lower purchase price than fair value, the difference is immediately recognized as a gain on the acquirer's income statement -if impaired, goodwill is reduced and a loss is recognized on the IS -goodwill developed internally is expensed as incurred

Repurchasing stock to offset dilution

exercising stock options dilutes shares bc higher stock price relative to exercise = more shares issued by the firm and lower EPS cash from exercise of option and outflow of cash from share repurchase are financing activities and the tax benefit increases CFO

Grouping of expenses

expenses are grouped together by their nature or their function Nature: presenting all depreciation expense from manufacturing and administration together on one line Function: combining all costs associated with manufacturing (RM, depreciation, and labor) as COGS

Accrued liabilities (expenses) (CL)

expenses recognized in the IS but not contractually due ex: taxes payable, interest payable, wages payable, and accrued warranty expense -expense incurred but not yet paid

Period Costs

expenses that cannot be tied to revenue generation: administrative costs, are expenses in the period incurred

Matching principle: expense recognition

expenses to generate revenue are recognized in the same period as the revenue Ex: inventory purchased in Q4 of 2012 and sold in Q1 of 2013 -both revenue and expenses (COGS) are recognized in Q1 2013 when the inventory was sold

common size cash flow statement

express each line item as a percentage of revenue -inflow of cash as a % of total cash inflows -outflow of cash as a % of total cash outflows

common-size income statement (vertical)

expresses each category of the IS as a percentage of revenue -eliminates the effect of size

marketable securities (CA)

financial assets traded in a public market -t-bills, notes, bonds, and equities

Mark-to-Market securities

financial instruments measured at fair value: 1. trading securities 2. available-for-sale securities 3. derivatives ***DIVIDEND AND INTEREST INCOME AND REALIZED GAINS AND LOSSES (ACTUAL GAINS AND LOSSES WHEN SOLD) ARE RECOGNIZED IN THE INCOME STATEMENT -different from UNREALIZED gains and losses Example page 95

accrued expenses

firm owes cash for expenses incurred. Expenses increase and a liabilitiy for accrued expenses increases as well. liability decreases when the firm pays cash to satisfy it -ex: wages payable

prepaid expense

firm pays cash ahead of time for an anticipated expense. cash (an asset) decreases and prepaid expense (also an asset) increases. Prepaid expense then decreases and expenses increase when the expense is actually incurred. -renting in a mall

defined benefit plan

firm promises to make periodic payments to employees AFTER retirement -future benefit is defined so the employer assumes the investment risk -Ex: 2% of 20 years of work with a final salary of 100K would earn someone 40K each year after retirement until death -employer contributes to a trust that manages the assets to generate payments due -more difficult reporting because of estimating value of future obligations

Unearned revenue

firm receives cash before it provides a good or service to customers. Cash increases and so does the liabilitity "unearned revenue" by the same amount. When firm provides good, revenue increases and liability decreases Ex; Magazine subscription

Differences in depreciation methods: financial statement adjustments

firms using higher estimates of useful asset lives and salvage values will report lower depreciation expense and higher net income compared to an opposite conservative firm. average age of firms assets: accum depreciation from BS / depreciation expense on balance sheet average useful life: (gross PPE / depreciation expense) average remaining useful life: (net PPE / depreciation expense)

FIFO-first in, first out

first item purchased is the first one sold -cost of inventory acquired first (beginning inventory) is used to calculate COGS -cost of most recent purchases is used for ending inventory -used for food products that will sell oldest inventory first to keep inventory on hand freshis that ending inventory is valued based on most recent purchases which reflects current cost best -advantage of FIFO -In an inflationary environment, COGS will be understated compared to current cost so EARNINGS will be overstated

financial statement notes

footnotes: disclosures provide further details about the info. summarized in the financial statements. -discuss basis of presentation such as fiscal period/consolidated entities -info. on acctg methods, assumptions, and estimates -acquisitions/disposals, legal actions, employee benefit plans, contingencies, commitments, sales

pension

form of deferred compensation earned over time through employee service defined contribution vs defined benefit plans

Inventory Disclosures

found in the financial statement footnotes. required inventory disclosures are similar under US GAAP and IFRS and include: - cost flow method used (LIFO vs FIFO etc) -total carrying value of inventory classified by RM, WIP, and FG -carrying value reported at fair value less selling costs -COGS recognized as an expense during the period -Amount of inventory write downs during the period -reversals of inventory write downs -carrying value of inventories used as collateral

regulatory authorities

government agencies that have the legal authority to enforce compliance with financial reporting standards -SEC and FSA in U.K. established by national governments

Gross and net reporting of revenue

gross revenue reporting: selling firm reports sales revenue and COGS separately. net revenue: difference in sales and cost is reported US GAAP criteria for gross revenue reporting: -firm must be primary obligor under the contract -bear inventory risk and credit risk -be able to choose its supplier -have reasonable latitude to establish the price

Gross Profit differences in methods

higher COGS in LIFO results in lower gross profit

identifiable vs unidentifiable intangible assets

identifiable: can be acquired separately or at the result of rights or privileges conveyed by owner (patents, trademarks, copyrights). unidentifiable: cannot be acquired separately and may have an unlimited life (goodwill) IFRS: identifiable intangibles that are purchased can be reported on the BS using a cost or revaluation model just like for PPE US GAAP: only cost model

net pension asset or net pension liability (defined benefit plan)

if the fair value of the plans assets is greater than the estimated pension obligation, the plan is OVERFUNDED and the sponsoring firm records a net pension asset on the balance sheet -if the fair value of the plans assets is less than the pension obligation, the plan is underfunded and the firm records a net pension liability

KEY notes about affects of leases

in sum, on page 272: all ratios are worse when the lease is capitalized. The only improvements from a finance lease are higher EBIT (because interest is not calculated in getting to EBIT), higher CFO (because principal repayment is CFF), and higher net income in later years (because interest plus depreciation is less than lease payment in later years *interest payments are an operating cash flow but not considered an operating expenditure so they are not subtracted in calculating EBIT *adding equal amounts to assets and liabilities will increase debt-assets-ratio. since assets are typically larger than debt, numerator increases by greater proportion than denominator so it increases the ratio *current ratio and working capital: current year principal amortization for a finance lease is added to current liabilities, but there is no increase in current assets because the asset is long lived, making the current ratio lower for a finance lease

long-term financial liabilities (non-current liabilities)

include bank loans, notes payable, bonds payable, and derivatives -if not issued at face, typically reported on BS at amortized cost -Fair value: held for trading liabilities, derivative liabilities, and exposure hedged by derivatives

comprehensive income/other comprehensive income

includes all changes in equity except for owner contributions and distributions -sum of net income and other comprehensive income Other comprehensive income includes transactions not included in net income: -foreign currency translation gains and losses -adjustments for minimum pension liability -unrealized gains and losses from cash flow hedging derivatives -unrealized gains and losses from available-for-sale securities

Income Tax Expense

income tax expense: expense recognized in the income statement that includes taxes payable AND changes in deferred tax assets and liabilities income tax expense = taxes payable + change in DTL - change in DTA

defense interval ratio

indicates number of days of average cash expenditures the firm could pay with its current liquid assets =(cash + marketable securities + receivables) / average daily expenditures -expenditures include cash expenses for COGS, SG&A, and R&D.

effective interest rate method

interest expense includes amortization of any discount or premium -it is equal to book value of bond liability at beginning of period multiplied by bonds yield at interest -this method is required under IFRS to amortize discount or premium -US GAAP, effective interest rate method is preferred but straight line method is allowed if results are not materially different (straight line is similar to depreciation where amortization is equal each period). -coupon interest is paid in cash and amortization is a noncash item -cash flow statement under indirect method means net income has to be adjusted to remove effects of amortization of discount/premium to calculate CFO

Discount Bond

interest expense is greater than coupon payment (yield > coupon rate). Difference between interest expense and coupon payment is amortization of the discount. Amortization is added to bond liability on BS so interest expense will increase over time as bond liability increases.

Premium Bond

interest expense is less than coupon payment (yield < coupon rate). The difference between interest expense and coupon payment is amortization of the premium. This is subtracted each period from bond liability on BS and interest expense will decrease over time as bond liability decreases

Activity ratio effects from inventory methods

inventory turnover is higher for firms using LIFO. COGS is valued at more recent higher costs (high numerator) while inventory is older lower costs (a lower denominator) Higher turnover will result in lower days of inventory on hand

Periodic Inventory System

inventory values and COGS are determined at the end of the accounting period -no detailed records of inventory are maintained; 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 COGAS -To calculate COGS, ending inventory is subtracted from COGAS

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 -for FIFO and specific identification methods, ending inventory and COGS are the same whether a periodic or perpetual system is used because FIFO values are the same regardless of subsequent purchases -However, periodic and perpetual inventory systems can produce different values for inventory and COGS under the LIFO and weighted average cost methods

amortized cost

issue price minus any principal payments + amortized discount or minus amortized premium

proxy statements

issued to shareholders when there are matters that require a shareholder vote -info about election of board members, compensation, management qualifications, and issuance of stock options

Dilluted EPS explanation

its a "what if" value -the lowest possible EPS that could have been reported if all firm securities that can be converted into common stock, and would decrease basic EPS if they had been, were converted

Lessees Perspective (US GAAP)

lessee must treat a lease as a finance lease if ANY of the criteria are met: 1. title to leased asset is transferred to lessee at end of lease 2. bargain purchase option: permits lessee to purchase leased asset for a price significantly lower than fair market value of asset at some future date 3. lease period is 75% or more of the assets economic life 4. PV of lease payments is 90% or more of fair value of leased asset *a lease not meeting any of these criteria is an operating lease

useful lives and salvage values

longer estimated useful life decreases annual depreciation and increases reported net income -higher salvage value will decrease depreciation and increase net income -lower salvage value increases depreciation and decreases net income -change in estimate is applied to book value and depreciation is calculated going forward using the new estimate

zero-coupon bonds

make no periodic interest payments. Pure discount bond. Issued at a discount from par and annual interest is implied but not explicitly paid. Actual interest payment is included in the face value paid at maturity. effects on FS are same as any discount bond, but impact is large because the discount is larger

solvency ratios

measure firms ability to satisfy its long-term obligations long-term debt-to-equity ratio: =long-term debt / total equity total debt to equity ratio =total debt / total equity debt ratio =total debt / total assets financial leverage ratio =total assets / total equity debt-to-capital ratio = total debt / (total debt + total equity)

liquidity ratios

measure firms ability to satisfy its short-term obligations: current ratio = current assets/ current liabilities quick ratio (acid test excludes inventory) = (cash + marketable securities + receivables )/ current liabilities cash ratio = (cash + marketable securities) / current liabilities

debt-to-equity ratio

measure of a firms use of fixed-cost financing sources =total debt / total shareholders equity -total debt is calculated different for everyone -rule of thumb: long-term debt + interest bearing short term debt

Payables Turnover

measure of the use of trade credit by the firm Payables Turnover = Purchases / Avg Trade or Accounts Payable Purchases = Ending Inventory -Beginning Inventory + COGS

valuation

measurement bases for valuation that require little judgement, such as historical cost, may be less relevant than a basis like fair value that requires more judgement

Cash-to-income-ratio (performance)

measures ability to generate cash from firm operations =CFO / operatine income

cash flow-to-revenue ratio (performance)

measures amount of operating cash flow generated for each dollar of revenue =CFO / net revenue

debt coverage ratio (coverage)

measures financial risk and leaverage =CFO/total debt

reinvestment ratio

measures firms ability to acquire long-term assets with operating cash flow =CFO/cash paid for long-term assets

dividend payment ratio

measures firms ability to make dividend payments from operating cash flow =CFO/dividends paid

investing and financing ratio

measures firms ability to purchase assets, satisfy debts, and pay dividends =CFO/cash outflows from investing and financing activities

debt payment ratio

measures firms ability to satisfy long-term debt with op. cash flow =CFO/cash long term debt repayment

cash-return-on-equity (performance)

measures return of operating cash flow attributed to shareholders =CFO / Avg Total Equity

interest coverage ratio

measures the firms ability to meet its interest obligations =(CFO +interest paid + taxes paid) / interest paid

cash return-on-assets ratio (performance)

measures the return of operating cash flow attributed to all providers of capital =CFO / Avg Total Assets

Cash Flow from Financing Equation

net cash flow from creditors = new borrowings - principal amounts repaid net cash flow from shareholders = new equity issued - share repurchases - cash dividends paid cash dividends: -dividends declared + increase in dividends payable dividends declared = beginning retained earnings + net income - ending retained earnings total cash flow = CFO + CFI + CFF

Net income

net income = revenues - ordinary expenses + other income - other expense + gains - losses

Weighted Avg cost inventory method

no assumption about the physical flow of inventory -cost per unit is calculated by dividing COGAS / Total units available -COGS: avg cost per unit is multiplied by the number of units sold -COGAS: beginning inventory + purchases -this avg cost results in COGS and EI inbetween FIFO and LIFO

direct financing lease (US GAAP) for lessor (finance lease)

no gross profit recognized by lessor at inception not usually a manufacturer or dealer financing function rather than sales function because of equal carrying value and PV of future cash flows -inception: remove asset from balance sheet, lease receivable of same amount. As payments are received, principal portion reduces receivable -income statement: lessor recognizes interest income over term of the lease(lease receivable multiplied by rate) -cash flow statement: interest portion is inflow from op activities and principal reduction is inflow from investing

operating vs non operating

nonfinancial firm: non operating transactions result from investment income and financing expenses -ex: dividends/interest from investment in other firms. the g/l is not part of a firms normal business operations -financial firm investment and financing expenses are considered operating activities.

vertical common-size statements

normalize BS's and IS's and allow the analyst to more easily compare performance across firms and for a single firm over time vertical size balance sheet and income statement put accounts divided by total assets and total sales respectively

available-for-sale securities

not expected to be held to maturity or traded in the near term. -reported on BS at fair value -UNLIKE trading securities that show unrealized G/L on the income statement, available-for-sale securities unrealized G/L are not reported on the income statement -INSTEAD they are reported in other comprehensive income as part of SE -Think dividends

noncash investing and financing activities

not reported on CF statement since they do not result in inflows or outflows of cash EX: acquiring real estate with financing provided by the seller results in an investing and financing decision but no cash is involved EX: exchange of debt for equity with no cash is not reported as a financing activity *disclose in footnote

cash flow statement effects of operating and finance leases

op lease- rent expense reduces cash flow from operations -finance lease-only interest expense portion reduces CFO and repayment of principal reduces CF from financing SO...CFO is higher for finance leases since not the whole portion is allocated to it but CF from financing is lower compared to operating leases

reporting by lessee

operating lease: at inception, balance sheet is unaffected. No asset or liability is reported by lessee. during term, rent expense equal to lease payment is recognized in lessee's income statement -cash flow statement: lease payment is reported as an outflow from operating activities finance lease: at inception, the lower of PV of future minimum lease payments or fair value of leased asset is recognized as both an asset and as a liability on lessees balance sheet -over lease term, asset is depreciated in the IS and interest expense is recognized -interest expense is equal to lease liability at beginning period multiplied by lease interest rate -finance lease: interest rate used by lessee is lower of incremental borrowing rate and implicit rate -cash flow statement: lease payment is separated into interest and principal payments -US GAAP: interest paid is reported as outflow from operating activities and principal as financing IFRS: choose to report interest paid as operating or financing -principal repayment amount each period is equal to lease payment minus interest expense for the period

historical cost

original purchase price of the asset including installation and transportation costs aka gross investment in the asset

expenses

outflows of economic resources: COGS, SG&A, depreciation, amortization, tax expense, interest expense, losses

MGMT overstates/understates income

overstates because: -meet earnings expectations -remain in compliance with lending covenants -receive higher incentive compensation understates because: -obtain trade relief in form of quotas or protective tariffs -negotiate favorable terms from creditors -negotiate labor union contracts -also motivate to manage the balance sheet (overstate/understate earnings to appear more solvent or less solvent) -enhance performance ratios -reporting cash flow wrong

owners equity

owners residual claim on a firms resources -capital (common stock) -additional paid in capital -retained earnings -other comprehensive income *includes capital contributed by the firms owners and the cumulative earnings the firm has retained

standard setting

principles-based: relies on a broad framework (IFRS) rules-based: specific guidance about how to classify transactions (US GAAP) objectives-oriented: blends the first two

additional paid in capital

proceeds from common stock sales in excess of par value -share repurchases that the company has made are represented in the contra asset account called treasury stock

internal controls

processes where the company ensures that it presents accurate financial statements -US Gaap requires auditor express opinion on firm internal controls

standard-setting bodies

professional org. of accountants and auditors that establish financial reporting standards -standard setting bodies: FASB and IASM -U.S. = GAAP -Outside U.S.= IFRS

income statement

profit and loss or operations. performance over a period of time -revenues, expenses, gains and losses. -other income includes gains that may not arise in the ordinary course of business IFRS: Income statement can be combined with other comprehensive income and presented as a single statement of comprehensive income or separately GAAP: same for gaap but firms can also choose to report comprehensive income in the statement of SE

installment method

profit is recognized as CASH IS COLLECTED. -Profit is equal to the cash collected during the period multiplied by the total expected profit as a percentage of sales -real estate

cost recovery method

profit is recognized only when cash collected exceeds cost incurred

measurement

properly valuing the changes between elements at a point and time or between points in time -asset liability approach -revenue expense approach

Financial Reporting

provide financial info. about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Decisions are buying, selling, or holding debt and equity, loans or credit

cash flow statement

provides information beyond that available from the income statement, which is based on accrual, rather than cash accounting: -info about company's cash receipts and payments -info about operating, investing, and financing activities -understanding of impact of accrual acctg events on CF's -use to determine if regular operations generate enough cash to sustain business -enough cash to pay off existing debts -determine if firm needs additional financing -items from cash flow statement come from 1. income statement items 2. changes in balance sheet accounts

historical cost PPE

purchase price plus any cost necessary to get the asset ready for use, such as delivery and installation costs

Purchased Intangible Assets

purchased from another party is initially recorded on balance sheet at cost, typically fair value -purchased as a group, total purchase price is allocated to each asset on the basis of fair value -financial statement effects of capitalizing intangibles is the same as capitalizing other expenditures

quick ratio

quick ratio (acid test excludes inventory) = (cash + marketable securities + receivables )/ current liabilities -does not include inventory -higher quick ratio means more likely the company will be able to pay its short-term bills

Return on total capital (ROTC)

ratio of net income before interest and taxes to total capital ROTC= EBIT / Avg total capital -total capital includes short and long term debt, preferred equity, and common equity

Return on equity (ROE) and return on common equity

ratio of net income to average total equity (including preferred stock) ROE = net income / avg total equity return on common equity = (net income - preferred dividends/ (avg common equity)

operating profit margin

ratio of operating profit (gross profit less SG&A) to sales =op income / revenue OR EBIT / Revenue -some analysts prefer to calculate op. profit margin by adding back depreciation and amortization to arrive at EBITDA

Journal Entries

record every transaction, and show which accts are changed and by what amounts. A listing of all journal entries in order of their dates is called the general journal

valuation allowance

reduction of deferred tax assets based on the likelihood the assets will not be realized

Form S-1

registration statement filed prior to the sale of new securities to the public.

Managements commentary

report, operating/financial review, and management discussion and analysis -discuss nature of the business, past performance, and future outlook -SEC says public companies in US discuss trends, events and uncertainty affecting liquidity, capital, and operations -inflation, off-balance sheet obligations, acctg policies, forward spending expenditures and divestitures

reported income tax differences

reported income tax differs from amount based on statutory income tax rate as a result of: -different tax rates in different jurisdictions -permanent tax differences -changes in tax rates and legislation -deferred taxes provided on the reinvested earnings of foreign and unconsolidated domestic affiliates -tax holidays in some countries

statement of comprehensive income

reports all changes in equity except for shareholder transactions (stock issuance, repurchases, and dividends)

statement of changes in equity

reports the amounts and sources of changes in equity investors investment in the firm over a period of time

statement of cash flows

reports the companys cash receipts and payments operating: cash effects of normal business transactions investing: acquisition or sale of PPE, subsidiary,securities financing: issuance or retirement of the firms debt and equity securities and dividends paid out

revenues

represent inflows of economic resources: sales, gains, investment income(interest and dividend income)

accruals

require an acctg entry when the earliest event occurs (paying, receiving cash,m or providing a good service/incurring an expense). -accrued revenue/expense, the revenue or expense is recorded first and cash later.

R&D Costs under IFRS for Intangibles

research costs aimed at discovery of new scientific or technical knowledge are EXPENSED AS INCURRED -development costs may be capitalized. They are incurred to translate research findings into a plan or design of a new product or process US GAAP: both research and development costs are expensed as incurred. One exception is software development costs

debt covenants

restrictions imposed by lender on the borrower to protect lenders position -affirmative or negative covenants

change in acctg estimate

result of a change in mgmts judgement, due to new info. ex: changing the useful life of an asset bc of new info. -does not require restatement of prior FS -do not affect CF

defined contribution plan

retirement plan where the firm contributes a sum each period to the employees retirement account -based on factors: years of service, employees age, compensation, profitability *no promise to employee of future value of plan assets -employee has investment decisions and assumes all the risk -pension expense is simply equal to the employers contribution -no future obligation to report on balance sheet as a liability

US GAAP barter transactions

revenue from barter transactions can be recognized at fair value only if firm has historically received cash payments for such goods and services and can use this historical experience to determine fair value, otherwise revenue is recorded at carrying value of asset surrendered

IFRS Barter transactions

revenue from barter transactions must be based on the fair value of revenue from similar nonbarter transactions with unrelated parties

FASB revenue recognition policies

revenue is recognize on IS when: 1. realized, 2. earned -there is evidence of an arrangement b/w the buyer and seller -product has been delivered or service rendered -price is determined or determinable -seller is reasonably sure of collecting money

IASB Revenue recognition policies

revenue is recognized from the sale of goods when: 1. the risk and reward of ownership is transferred 2. no control or mgmt over the goods sold 3. revenue can be reliably measured 4. probable flow of economic benefits 5. cost can be reliably measured For services rendered, recognize revenue when: 1. amount of revenue can be reliably measured 2. probable flow of economic benefits 3. stage of completion can be measured 4. cost incurred and cost of completion can be reliably measured

accrual accounting

revenues and expenses are not always recorded at the same time that cash payments are made. revenue should be recorded when the firm earns it and expenses recorded as the firm incurs them, regardless of whether cash has actually been paid 4 categories: 1. unearned revenue 2. accrued revenue 3. prepaid expenses 4. accrued expenses

Cost of goods sold differences in methods

rising prices cause higher LIFO COGS than FIFO COGS falling prices LIFO COGS will be lower than FIFO COGS -since LIFO is based on most recent purchases, LIFO produces a better approximation of current cost in the income statement -weighted average prices are in the middle of FIFO and LIFO

round-trip transaction

sale of goods to one party with the simultaneous purchase of almost identical goods from the same party

cash/cash equivalents (CA)

short-term, highly liquid investments readily convertible to cash and near maturity. -T-bills, commercial paper and MMF reported on BS at amortized cost or fair value

Accrued revenue

the firm provides goods before it receives cash payment. Revenue increases and accounts receiveable increases. When the customer pays cash, accts receivable decreases Ex: is manufacturers selling to stores on account

general ledger

sorts the entries in the general journal account

accelerated depreciation

speeds up recognition of depreciation expense to recognize more in the early years of an assets life and less expense in the later years of its life -total expense will be the same as if the straight line depreciation were used -lower net income in early years of assets life and higher net income in later years compared to straight line method

stacked column graph and line graph

stacked bar graph -shows changes in items from year to year in graphical form

Expenses as incurred under both US GAAP and IFRS

start-up and training costs administrative overhead advertising and promotion costs relocation and reorganization costs termination costs

balance sheet

statement of financial position or condition. at a point in time assets: resources controlled by firm liabilities: amounts owed to lenders or creditors equity: residual interest in the net assets of an entity after deducting liabilities A = L + SE

adverse opinion

statements are not presented fairly or are materially nonconforming with acctg standards

qualified opinion

statements make any exceptions to the acctg principles the auditor explains these

statutory rate vs effective tax rate

statutory: tax rate of the jurisdiction where the firm operates effective tax rate: derived from the income statement ETR = income tax expense / pre tax income

Treasury stock method

stock options and warrants are only dilutive when their exercise prices are less than the average market price of the stock -assumes funds received from exercise of options would be used to purchase shares of the company's common stock at avg mkt price -the adjustment to the denominator is the number of shares created by exercising the option minus the number of shares repurchased with the proceeds of the exercise

dilutive securities

stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock -dilutive preferred stock: the convertible preferred dividends must be added to earnings available to common shareholders -convertible dilutive bonds: bonds after tax interest expense is not considered an interest expense for dilutive EPS. Interest expense is multiplied by (1-Tax) and added back to numerator -if dilutive EPS is greater than basic EPS then the bonds are antidilutive and you would use the basic EPS instead

antidilutive securities

stock options, warrants, convertible debt, or convertible preferred stock that would increase EPS if exercised or converted to common stock

treasury stock

stocks been reacquired by issuing firm but not retired. -reduces SE -no voting rights, no dividends, not an investment in firm

operating profit

subtracting operating expenses such as SGA from gross profit nonfinancial firms: op profit is profit before financing costs, income taxes, and non operating items

Ratio analysis

used to: -project future earnings and cash flow -evaluate a firms flexibility -assess managements performance -evaluate changes in the firm or industry over time -compare firm with competitors

stretching accounts payable

supplier transactions tend to be CFO. Delaying payments to suppliers can increase CFO. Delaying payment = no cost financing Days sales in payables: (accts payable / COGS) * number of days Note: earlier this was calculated by dividing 365 by accounts payable turnover (purchases divided by average accounts payable) -can be accomplished by having arrangement with third party (financial institution) to manage timing of CFO -third party pays accts payable and now firm has short term debt -outflow of cash to pay short term debt is financing rather than operating -delay of outflow

effective tax rate

tax expense as a percentage of pretax income

Taxes Payable vs income tax expense

taxes payable: taxes actually due to the government income tax expense: reported in the income statement and reflects taxes payable plus deferred income tax expense

fair value

the amount at which two parties in an arms length transaction would exchange the asset

realizable value

the amount for which the firm could sell the asset

historical cost

the amount originally paid for the asset

current cost

the amount the firm would have to pay today for the same asset

present value

the discounted value of the assets expected future cash flows

accounts payable (CL)

trade payables are amounts the firm owes to suppliers for goods/services purchased on credit

backtesting

using a specific set of criteria to screen historical data to determine how portfolios based on those criteria would have performed

sales type lease (US GAAP) for lessor (finance lease)

treated as if the lessor sold the asset for the PV of the lease payments and provided a loan to the buyer in the same amount -manufacturer/dealer bc cost of leased asset is less than fair value -at inception, lessor recognizes a sale equal to PV of lease payments, and COGS equal to carrying value of asset (difference is gross profit) -Asset is removed from balance sheet and lease receivable is created equal to PV of lease payments -as payments are received, principal portion of payment reduces the receivable and interest portion(lease receivable at beginning of period * interest rate) is recognized as interest income -on cash flow statement the interest portion of lease payment is reported as inflow of op activities, principal reduction is an inflow from investing activities

Goodwill: financial statement adjustment

two companies w/identical assets: one has grown through acquisition of some business units -tangibles acquired are valued at fair value rather than historical minus depreciation -identifiable intangibles: valued at acquiring costs rather than not being included on BS assets -Goodwill is shown on balance sheet other has grown internally show different balance sheet items for same assets good will should be subtracted from assets when calculating ratios IS expense from impairment of goodwill in current period should be reversed, increasing the reported net income -remove when doing P/b ratio

barter transaction

two parties exchange goods/services without cash payment

Unusual or infrequent items

unusual in nature or infrequent in occurrence but NOT both Ex: g/l from sale of assets or part of a business -impairments, write-offs, write-downs, and restructuring costs -INCLUDED in the income from continuing operations and are reported before tax -affect net income unlike discontinued operations

Dupont system of analysis

used to analyze return on equity. Analysts see the impact of leverage, profit margins, and turnover on shareholder returns -original three part approach, and extended five part approach

Regression Analysis

used to identify relationships between variables -typically used in forecasting

Fixed asset turnover ratio

utilization of fixed assets =Revenue / Avg net fixed assets (net of accumulated depreciation

barriers to creating a coherent reporting framework

valuation standard setting measurement

cash flow per share (performance)

variation of basic EPS measured using CFO instead of net income =(CFO - preferred dividends) / weighted avg # of common shares

form DEF-14A

when a company prepares a proxy statement for its shareholders prior to the annual meeting or shareholder vote, it also files this statement to the SEC

derecognition of debt

when bonds mature no gain or loss is recognized by issuer. At maturity, the book value of a bond liability and face value are the same because of amortization -cash outflow to repay bond is a financing cash outflow

dilutive securities in the equation

when the firm has dilutive securities outstanding, the denominator is the basic EPS denominator adjusted for the equivalent number of common shares that would be created by the conversion of all dilutive securities outstanding. -Diluted stock options or warrants increase the number of common shares outstanding in the denominator but make no adjustment to the numerator like convertible bonds and preferred stock do