JuiceNotes TM

- By FinTree

eBook 4
Financial Reporting
and Analysis

CFA® Level 1 JuiceNotesTM 2017

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 Financial Statement Analysis: An Introduction
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LOS a Roles of financial reporting and financial statement analysis

Financial reporting - Provide a variety of users with useful information about a
company’s performance (Income statement) and financial
position (Balance sheet)

Financial statement Use the data from financial statements to support

analysis - economic decisions

LOS b
Comprehensive Income Statement of Cash flow
Balance sheet
income statement changes in equity statement

Aka statement of Reports all changes Aka statement of Reports the Reports the
financial position in equity except for operations / profit amounts and company’s cash
shareholder and loss statement sources of changes receipts and
Reports the firm’s transactions (eg. in equity owners’ payments
financial position at issuing stock, Reports the firm’s investment in the
a point in time paying dividends financial firm over a period Operating cash
etc.) performance over a of time. flows - Inflows and
Assets - Resources period of time outflows of
controlled by firm US GAAP - Firms transactions that
can choose to Revenues - Inflows are firm’s ordinary
Liabilities -
Amounts owed to
lenders and other
creditors
report
comprehensive
income in
statement of e
from firm’s ordinary
course of business

Expenses -
course of business

Investing cash
flows - Inflows and
re
shareholders’ Outflows from outflows resulting
Equity - Residual equity firm’s ordinary from the acquisition
interest in net course of business or sale of firm’s
assets assets
Other income -
Fundamental Gains that may or Financing cash
accounting may not arise in flows - Inflows and
equation - ordinary course of outflows resulting
nT

Assets = Liabilities business from issuance or

+ Equity retirement of firm’s
Income statement debt and equity
+ Other securities and
comprehensive dividends paid
income =
Comprehensive
income
Fi

LOS c Financial statement notes Management’s commentary

Aka footnotes Aka management’s report,
operating and financial review
Important information about and management’s discussion
accounting methods, estimates and analysis (MD&A)
and assumptions is disclosed
Contains an overview of the
company and important
information (eg. business
trends, liquidity etc.)
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LOS d Audit
ª It is an independent review of an entity’s financial statements
ª Conducted by public accountants
ª To provide an opinion on fairness and reliability of financial statements
ª Auditor examines the company’s accounting and internal control systems,
confirms assets and liabilities, and tries to determine the financial statements are
free of any material errors
ª Unqualified opinion (Clean opinion) - Issued when financial statements are free
from material omissions and errors
ª Qualified opinion - Issued when financial statements deviate from accounting
principles
ª Adverse opinion - Issued when financial statements are not presented fairly or are
materially nonconforming with accounting standards
ª Disclaimer of opinion - Issued when auditor is unable to express an opinion
ª Company’s management is responsible for maintaining an effective internal
control system to ensure the accuracy of its financial statements, not the auditor

LOS e Information sources that analysts use in financial statement analysis

Ê Form 8-K - Filed when there is

Ê Quarterly and semiannual reports
acquisition or disposals of major
Ê Proxy statements
asset or changes in its
Ê Press releases
management or corporate
Ê Corporate reports
governance
Ê Earnings guidance
Ê Information on industry and peer
companies from external sources
such as trade journals, statistical
reporting services, and
government agencies
e Ê Form 10-K - Filing of annual
financial statements

Ê Form 10-Q - Filing of quarterly

re
financial statements

LOS f Financial statement analysis framework

ΠState the objective of the analysis
 Gather data
Ž Process the data
nT

 Analyze and interpret the data

 Report the conclusions or recommendations
‘ Update the analysis
Fi
 Financial Reporting Mechanics
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LOS a Classification of business activities

Operating activities - Firm’s ordinary course of business (producing and
selling goods and services)

Investing activities - Buying or selling long-term assets (PPE or land)

Financing activities - Issuing/redeeming debt, issuing/repurchasing
common stock or paying cash dividend

LOS b Financial statement elements, accounts and classification of accounts

Elements - Assets, liabilities, equity, revenues and expenses
Accounts - Specific records within each element
Chart of accounts is a detailed list of the accounts that
make up the five financial statement elements
Contra accounts are used for entries that offset some
part of the value of another account (Eg. Machinery and
accumulated depreciation)

Assets Liabilities Equity Revenues Expenses

Ÿ Cash Ÿ AP e Ÿ COGS
re
Ÿ AR Ÿ Unearned Ÿ SGA
Ÿ Capital
Ÿ PPE revenue expenses
Ÿ Retained Ÿ Sales
Ÿ Deferred tax Ÿ Deferred tax Ÿ Depreciation
earnings Ÿ Gains
asset liability and
Ÿ Other Ÿ Investment
Ÿ Investment Ÿ Unearned amortization
comprehensi income
in affiliates revenue Ÿ Interest and
ve income
Ÿ Intangibles Ÿ Long-term tax expense
debt
nT

LOS c Accounting equation

Basic form Expanded form

Assets = Equity + Liabilities Assets = Contributed capital (No. of shares × FV)

Fi

+ Retained earnings (beginning)

+ Revenue
− Expenses
− Dividend
+ Liabilities
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LOS d Accounting system
Double entry accounting - Transactions are recorded in at least two accounts
To hold “Assets = Equity + Liabilities” true, double entry
accounting is required

If one Asset Another asset Or Equity or Liability

If one Liability Asset Or Equity or another Liability

LOS e Accrual accounting

As per accrual accounting, revenues and expenses must be recorded when
earned and incurred whether or not the cash has actually been received or paid

Unearned revenue Accrued revenue Prepaid expenses Accrued expenses

Cash is received before Sale is made first, cash Cash is paid ahead of Firm owes cash for
making sale is received later time expenses

Cash é Revenue é Cash ê Expenses é

Liability (Un. Rev.) é Asset (A/c Rec.) é Asset (Pre. Exp.) é Liability (Accr. Exp.) é

After making sale,

Revenue é
Liability (Un. Rev.) ê
After firm receives
cash,

Asset (A/c Rec.) ê

e
When exp is incurred

Asset (Pre. Exp.) ê

Expenses é
After firm pays cash,

Liability (Accr. Exp.) ê

re
LOS f Relationship between Balance sheet and other financial statements
è Balance sheet shows company’s financial position at a point in time

è Changes in balance sheet accounts during an accounting period are reflected

nT

in the income statement, cash flow statement and statement of owners’ equity

LOS g Flow of information in accounting system

Balance sheet
Initial trial Adjusted
General journal General ledger
balance trial balance
Income statement
Fi

LOS g Use of results of accounting process in security analysis

ª Since financial reporting requires choices of method, judgment, and estimates,
an analyst must understand the accounting process used to produce the financial
statements in order to understand the results for the period
 Financial Reporting Standards
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LOS a Objective of Importance of financial

financial statements reporting standards

Provide current and potential They are designed to ensure that

investors and creditors with useful financial statements of different
information about firm’s financial firms are comparable to one another.
performance and position They are needed to provide
consistency by narrowing the range
of acceptable responses

LOS b Standard setting bodies ª Professional organizations of accountants and

auditors that establish financial reporting standards
ª Two primary standard-setting bodies -
Ÿ Financial Accounting Standards Board (FASB) -
US GAAP
Ÿ International Accounting Standards Board
(IASB) - IFRS

Regulatory authorities Government agencies that enforce compliance with

financial reporting standards. Eg. SEC - US, FSA - UK

International Organization 3 objectives;

of Securities Commissions ª Protect investors
(IOSCO)

e
ª Ensure the fairness, efficiency, and transparency
of markets
ª Reduce systemic risk
re
SEC forms

S-1 10-K 10-Q DEF-14A 8-K 144 3, 4, 5

Registration Annual filing Quarterly Proxy Material When Beneficial

nT

statement filing statement events such company ownership of

filed prior to firm’s annual as asset issues securities by a
the sale of report is not Do not have acquisition securities to company’s
new a substitute to be audited and disposal, qualified officers and
securities to for 10-K changes in buyers directors
the public management
or corporate
governance
Fi

etc.

LOS c Global convergence of accounting standards

Barriers to developing one universally accepted set of financial reporting standards include
differences of opinion among standard-setting bodies and regulatory authorities from
different countries. There are also political pressures from business groups and others who
will be affected by changes in reporting standards
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LOS d International Accounting Standards Board’s (IASB) conceptual framework
Objective to provide financial information that is useful in making decisions for resource
providers and users of financial statements

Two fundamental characteristics of financial statements:

Œ Relevance - Information in financial statements can influence users’ economic decisions

Information should have predictive value, confirmatory value or both
Materiality is an aspect of relevance

 Faithful representation - Information is complete, neutral and free from error

Four characteristics that enhance relevance and faithful representation

ΠComparability - Presentation should be consistent among firms and across time periods
 Verifiability - Different observers using same method must arrive at same result
Ž Timeliness - Information must be available to economic decision maker in time
 Understandability - Users with a basic knowledge of business and accounting and who
make a reasonable effort to study the financial statements should be
able to understand information presented in the statements.

Two underlying assumptions of financial statements

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

Constraints e
Going concern - Company will continue to exist for the foreseeable future
re
ΠCost-benefit tradeoff - Benefits the user gains from the information should be greater
than the cost of presenting it

 Information such as reputation, brand loyalty, capacity for innovation, etc. cannot be
captured directly in financial statements

LOS e General requirements for financial statements under IFRS

nT

ª Required financial statements - Balance sheet, comprehensive income statement,

cash flow statement, statement of changes in owners’ equity, and footnotes

ª Features for preparing financial statements - Fair presentation, going concern,

accrual accounting, consistency, materiality, aggregation, no offsetting, reporting
frequency, comparative information
Fi

ª Structure and content of financial statements:

Ÿ Classified balance sheet - Showing current and noncurrent assets and

liabilities
Ÿ Minimum information - On the face of each financial statement and in
the notes
Ÿ Comparative information - Information for prior periods should be included
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LOS f Financial reporting standards under IFRS and US GAAP

IFRS US GAAP
ª Standards issued by the IASB ª Standards issued by the FASB
ª Financial performance - Income ª Financial performance -
and expenses Revenues, expenses, gains,
ª Asset - Resource from which a losses and comprehensive
future economic benefit is income
expected to flow ª Asset - Future economic benefit
ª Upward valuation is allowed ª FASB does not allow the
under IASB upward valuation of most
assets

Reconciliation is no longer required for IFRS firms, who have their shares listed in the United States

LOS g Coherent financial reporting framework

è It is one that fits together logically

è It should exhibit transparency, comprehensiveness and consistency

è It has barriers such as valuation, standard setting and measurement

LOS h
è e
Implications of financial analysis of different financial reporting systems

An analyst must be aware of evolving financial reporting standards,

new products and innovations that generate new types of transactions
re
è He must also monitor company disclosures for significant accounting
standards and estimates

LOS i Disclosures of significant accounting policies

nT

Under IFRS and US GAAP, companies must disclose their accounting policies and estimates
in the footnotes and MD&A

Public companies are also required to disclose the likely impact of recently
issued accounting standards on their financial statements

Disclosure of likely impact

Fi

No material Impact
No impact
impact quantified
or
Impact yet to be
evaluated
or
Uncertain
 Understanding Income Statements
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LOS a 1 Presentation format of income statement

Revenue/Sales/Turnover 1000
COGS 400

Gross Profit 600

SGA expenses 200

EBITDA (Cash operating profit) 400

Depreciation & amortization 100
EBIT (Operating profit) 300
Interest 100
EBT 200
Taxes 100
EAT/PAT/Net Profit/Bottomline 100

2 Expense classification

Based on
nature
Based on
function
e 3 Minority interest

Parent company reports pro rata share of

re
the subsidiary’s income not owned by it as
minority interest

Eg. Combining Eg. COGS, it consists of It is subtracted in arriving at net income

depreciation expense costs associated with because the parent company reports all of
of manufacturing and manufacturing subsidiary’s revenue and expense
administration as one (function of business)
expense
nT

LOS b & c Accrual accounting - Revenues and expenses must be recorded when earned
and incurred whether or not the cash has actually been
received or paid

Eg. Salary expense - $60,000 Consulting income - $100,000

Fi

Scenario Scenario Scenario Scenario Scenario Scenario

A B C A B C

Cash paid/received $60,000 $70,000 $50,000 $100,000 $120,000 $80,000

Expense/income $60,000 $60,000 $60,000 $100,000 $100,000 $100,000
Asset/Liability - $10,000 $10,000 - $20,000 $20,000

Prepaid Outstanding Accrued Account

salary salary income receivable
 Revenue recognition
Long term contracts

Profit Loss

Outcome can be Outcome can not be

reliably measured reliably measured

IFRS US GAAP

% completion Revenue = Cost Completed Recognize loss

method in both contract method immediately in both
IFRS and US GAAP IFRS and US GAAP

Installment sales

Collectibility is Collectibility can not Collectibility is

certain be reliably estimated uncertain

IFRS US GAAP

Normal revenue Recognize sales Cost recovery

recognition at t0 (PV of future Installment sales method
installments)

Installment sales - Under IFRS, PV of the installment payments is recognized at the time of sale.
Difference between installment payments and the discounted PV is recognized as interest over time

Barter transactions - Revenue is recognized only if fair value can be estimated

Revenue reporting

Gross Net

Sales and COGS are Only the difference

reported separately in sales and cost is
reported
Should be used by
the firm who is Should be used by
primary obligor the firm who is an
under the contract agent

Eg. Airline company Eg. Ticket agent

LOS d Key aspects of the converged accounting standards
Five-step process for ΠIdentify the contract with a customer
recognizing revenue -  Identify the performance obligations in the contract
Ž Determine the transaction price
 Allocate the transaction price to the performance obligations in the contract
 Recognize revenue when the entity satisfies a performance obligation

LOS e Expense recognition

Under accrual accounting, expense recognition is based on matching principle where
expenses to generate revenue are recognized in the same period as revenue

1 Inventory

First In Last In Weighted

First Out First Out average

COGS - First COGS - Recent COGS - Between

purchases purchases FIFO and LIFO

Ending inventory - Ending inventory - Ending inventory -

Recent purchases First purchases Between FIFO and
LIFO
Appropriate for Appropriate for
inventory that has inventory that does Makes no
a limited shelf life not deteriorate assumption about
with age physical flow of
Eg. Food products inventory
company Eg. Coal distributor
will sell coal off the
top of the pile

ª If a firm can identify exactly which items were sold and which items remain in inventory,
it can use the specific identification method

ª LIFO is allowed under US GAAP, but not under IFRS

ª Under inflationary environment;

Ÿ LIFO COGS > FIFO COGS
Ÿ LIFO inventory < FIFO inventory

2 Depreciation

ª In early years of asset’s life;

Ÿ SML deprc. < DDB deprc.
Straight-line Accelerated
Ÿ Net income (SML) > Net income (DDB)

Cost − Residual value Double declining balance ª In later years;

Useful life Ÿ SML deprc. > DDB deprc.
Op. Book value
x 2 Ÿ Net income (SML) < Net income (DDB)
Useful life
Equal amount of
depreciation each year Depreciation ends once ª However total depreciation over the life of
the estimated residual the asset is same under both the methods
value has been reached
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3 Amortization 4 Bad debts and Warranty

ª It is allocation of cost of intangible These expenses must be recognized in the year

asset over its useful life they are estimated rather than in a later period

ª Most firms use the straight-line method

ª Intangible assets with indefinite lives

are not amortized, they are tested for
impairment at least annually (Eg. goodwill)

LOS f Discontinued operations, unusual or infrequent

items and changes in accounting policies

Discontinued operations - Income or loss from discontinued operations is

reported separately in the income statement, net
of tax, after income from continuing operations
Unusual or infrequent items - These events are either unusual in nature or
infrequent in occurrence (Eg. impairments,
write-offs etc.)

Included in income from continuing operations

Reported before tax

Changes in accounting policies -

e
Change in accounting principle - Eg. changing
from LIFO to FIFO. Requires retrospective
application (Except changing to LIFO)
Change in accounting estimate - Change in
re
estimated useful life of asset. Applied
prospectively

LOS g Operating and non-operating income

Operating income - Generated from the firm’s normal business operations

nT

For a financial firm, income from investing and financing activities is classified as
operating income since its business operations include investing in and financing securities

LOS h & i Earnings per share (EPS)

ª It is reported only for shares of common stock

Fi

ª Simple capital structure - Does not contain potentially dilutive securities

ª Complex capital structure - Contains potentially dilutive securities such as convertible debt, warrants etc.

ª A firm with complex capital structure must report both basic and diluted EPS
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Basic and diluted EPS
Eg. PAT = 500,000 Preferred dividend = 80,000 No. of convertible preferred stock = 20,000
No. of equity shares as on 1st Jan = 40,000
20,000 shares issued on 1st Apr
Stock dividend declared on 1st May (20%)
Share repurchase on 1st July (15,000)
Stock split on 1st Sep (3:2)

Weighted average number of common shares outstanding -

Jan 1 40,000 x 1.2 x 1.5 x 12/12 72,000

Apr 1 20,000 x 1.2 x 1.5 x 9/12 27,000

July 1 (15,000) x 1.5 x 6/12 (11,250)

87,750

PAT − Preferred dividend

Basic EPS = Wt. avg. no. of common shares

500,000 − 80,000
= 87,750

= 4.786
e
PAT + Interest (1 − Tax rate)
re
Diluted EPS = Wt. avg. no. of common shares + Shares from conversion

500,000
= 87,750 + 20,000

= 4.64
nT

Dilutive security - A security that would decrease the EPS if exercised i.e.
converted to common stock

Antidilutive security - A security that would increase the EPS if exercised i.e.
converted to common stock

LOS j Common-size income statement

Fi

Vertical common-size income statement expresses each item as a percentage of revenue.

i.e Revenue = 100% and rest other items as its percentage

Allows time-series and cross-sectional analysis

Tax expense is more meaningful when expressed as a percentage of pretax income

(Effective tax rate)
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LOS k Margin ratios

Gross profit Net profit

margin margin

Gross profit = Sales − COGS Net profit = GP − Expenses

Gross profit Net profit

GP margin = NP margin =
Sales Sales
Can be increased by raising prices Can be increased by raising prices
or reducing production costs or reducing expenses

LOS l & m Comprehensive income

Comprehensive income = Net income + Other comprehensive income

It is a more inclusive measure that includes all changes in equity
except for owner contributions and distributions
Other comprehensive income - Ÿ Foreign currency translation gains and losses
Ÿ Pension obligation adjustments
Ÿ Unrealized gains and losses from cash flow
hedging derivatives
Ÿ Unrealized gains and losses from available-

e
for-sale securities
re
nT
Fi
 Understanding Balance Sheet
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LOS a Elements of balance sheet

Assets Liabilities Equity

Resources controlled as Obligations as a result of

a result of past past events that are The owners’ residual
transactions that are expected to require an interest in the assets
expected to provide outflow of economic after deducting the
future economic benefits resources liabilities

LOS b Uses and limitations of the balance sheet in financial analysis

Ê It can be used to assess a firm’s liquidity, solvency,

and ability to make distributions to shareholders
Ê Liquidity - Ability to meet short-term
Ê Balance sheet assets, liabilities, and equity should obligations
not be interpreted as market value or intrinsic value
Ê Solvency - Ability to meet long-term
Ê Some assets and liabilities are difficult to quantify
and are not reported on the balance sheet
e obligations
re
LOS c Alternative formats of balance sheet presentation

Classified Liquidity-based
balance sheet format
nT

Reporting assets and liabilities Reporting assets and liabilities

as current/non-current in order of liquidity

Useful in evaluating liquidity Used in the banking industry

Required under both IFRS and Allowed only under IFRS if the
US GAAP presentation is more relevant
Fi

and reliable

LOS d Current Current Noncurrent Noncurrent

assets liabilities assets liabilities

Assets expected to Assets that do not Liabilities that do not

Liabilities that firm meet the definition meet the definition
be used up or
expects to satisfy in of current assets. of current liabilities.
converted to cash in
less than one year or They provide They provide
less than one year or
one operating cycle, information about information about
one operating cycle,
whichever is greater firm’s investing firm’s long-term
whichever is greater
activities financing activities
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LOS e Different types of assets and liabilities

1 Current assets

Cash and cash Marketable Accounts

Inventories Other
equivalents securities receivable

Goods held for

These are
sale to customers
amounts that may
Cash equivalents These are traded These represent or used in
not be material if
are short-term, in a public market amounts owed to manufacture of
shown separately
highly liquid and whose value the firm by goods to be
financial assets can be readily customers sold
Items are
that are readily determined combined into a
convertible to Reported at net Reported at the
single amount
cash Eg. Equity realizable value lower of cost or
securities, bonds by estimating bad net realizable
Eg. Prepaid
Eg. Commercial etc. debt expense value (IFRS) or
expenses and
paper, T-bills the lower of cost
deferred tax
or market
assets
(US GAAP)

ª Manufacturing firms separately report inventories of raw materials, work-in-process

and finished goods
ª All costs necessary to bring the inventory to its present location and condition are
included in the cost of inventory

and overhead to goods produced

e
ª Standard costing - Involves assigning predetermined amounts of materials, labor

ª Retail method - Inventory is measured at retail prices and gross profit is subtracted
to determine the cost
re
ª Net realizable value (NRV) = Selling price − Selling costs
ª Market = Range - (NRV − NP margin) to NRV
ª Inventory can be written down and written back up under IFRS
ª Under US GAAP inventory can be written down but can not be written back up

2 Current liabilities
nT

Accounts payable Amounts the firm owes to suppliers

Notes payable Obligations in the form of promissory
notes owed to creditors and lenders
Current portion of long-term debt It is the principal portion of debt due within one
year or operating cycle, whichever is greater
Accrued liabilities Firm owes cash for expenses. Eg. taxes payable,
wages payable etc.
Fi

Unearned revenue Cash is received before making sale. Eg.

subscription received for magazines
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3 Non-current assets
Property, plant and equipment (PPE)

ª Tangible assets used in the production of goods and services

ª Includes land and buildings, machinery and equipment, furniture, and natural resources
ª IFRS - Cost model or revaluation model
ª US GAAP - Only cost model
ª Land is not depreciated because it has an indefinite life
ª Historical cost = Purchase price + Cost necessary to get the asset ready for use
ª Under cost model, PP&E must be tested for impairment
ª Impairment - Recoverable amount < Carrying value
ª Recoverable amount - NRV or Value in use whichever is greater (IFRS)
ª Value in use - PV of asset’s future CFs
ª If impaired, the asset is written down to its recoverable amount and loss is recognized
in income statement
ª Loss recovery is allowed under IFRS, but not under US GAAP
ª Under revaluation model - Fair value

Investment property - IFRS - Assets that generate rental income or capital appreciation
Can be reported at amortized cost or fair value
US GAAP - No specific definition

Intangible assets Measurement base for internally

created intangible assets

Identifiable Unidentifiable
e IFRS US GAAP
re
Can be acquired Cannot be acquired
separately separately and may Research cost - Research cost -
have an unlimited life Expensed Expensed
Eg. Patent
Eg. Goodwill Development cost - Development cost -
Amortized and tested Capitalized Expensed
nT

for impairment Not amortized, but are

tested for impairment Exception - Software
at least annually costs. These are
treated the same
way as under IFRS
Measurement base for purchased assets - Same as PPE

Goodwill - Purchase price of business − Fair value of net identifiable assets acquired
Fi

It is not amortized but must be tested for impairment at least annually

Internally generated goodwill is expensed as incurred
Economic goodwill - Expected future performance of the firm
Accounting goodwill - Result of past acquisitions
 Securities

Held-to-maturity Trading securities Available-for-sale

Reported at amortized cost Reported at fair value Reported at fair value

Acquired with the intent to Acquired with the intent to These are not expected to
be held to maturity profit over the near term be held to maturity or
traded in the near term

Unrealized gains and losses Unrealized gains and Unrealized gains and losses
are ignored losses are recognized in are reported in other
the income statement comprehensive income

Realized gains/losses are always taken to Income Statement

4 Non-current liabilities

Long-term financial liabilities These include bank loans, notes payable, bonds
payable and derivatives
If they are not issued at face value, they are
reported at amortized cost

Deferred tax liabilities These are amounts of income tax payable in future
as a result of temporary differences

LOS f Components of shareholders’ equity

Owners’ equity

Contributed Preferred Minority Retained Accumulated

(Treasury stock)
capital stock interest earnings OCI

Includes all
Has certain Pro rata share changes in
Cumulative Stock that is
Amount rights and of the equity from
undistributed reacquired by
contributed by privileges not subsidiary’s sources other
earnings of the the firm but not
common possessed by income not than net income
firm since yet retired
shareholders common owned by & transactions
inception
shareholders parent company with
shareholders

Owners’ equity - Residual interest in the assets after deducting liabilities

LOS g Common-size balance sheet

Vertical common-size balance sheet expresses each item as a percentage of total assets. i.e
Assets = 100% and rest other items as its percentage

Allows time-series and cross-sectional analysis

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LOS h Liquidity Solvency
ratios ratios

Measure firm’s ability to satisfy Measure firm’s ability to satisfy

its short-term obligations its long-term obligations

Current ratio, Quick ratio, Cash Debt-to-equity ratio, Debt ratio,

ratio Financial leverage ratio

e
re
nT
Fi
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Understanding Cash flow Statements

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LOS a Categories of Cash Flow

CFO CFI CFF

Cash Flow from Operating Cash Flow from Investing Cash Flow from Financing
activities activities activities

Inflows and outflows Inflows and outflows Inflows and outflows

generated from normal resulting from acquisition resulting from
business operations or disposal of long-term transactions affecting
assets firm’s capital structure
Eg. Cash paid to creditors,
cash collected from Eg. Acquisition of PPE, Eg. Proceeds from issuing
debtors etc. Sale proceeds from debt shares, payment of
investment dividend

LOS b Reporting of non-cash investing and financing activities

ª They are not reported in the cash flow statement since they do not result in

e
inflows or outflows of cash

ª However they must be disclosed in the footnotes

re
LOS c Cash flow statement IFRS Vs. US GAAP

Cash flow item IFRS US GAAP

Dividends paid CFO/CFF CFF

nT

Dividends received CFO/CFI CFO

Interest paid CFO/CFF CFO

Interest received CFO/CFI CFO

Taxes CFO/CFI/CFF CFO

Fi

LOS d Direct and indirect method of presenting CFO

Direct method Indirect method
Cash collected from customers 100,000 Net income 15,000
Cash paid to suppliers (60,000) Adjustments :
Cash paid for operating expenses (25,000) Depreciation 2,000
Taxes paid (5,000) Income tax payable 2,000
Interest income (4,000)
CFO 10,000
Working capital changes (5,000)
CFO 10,000
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LOS e Relation of CF statement to income statement and balance sheet
CFO - Relate to current assets and current liabilities
CFI - Relate to non-current assets
CFF - Relate to non-current liabilities and equity

LOS f Computation of CFs using income statement and balance sheet data
Eg.
Opening AR = 10,000 Opening AP = 30,000

Credit Credit
55,000 60,000
sales purchases

65,000 90,000

Cash received = 50,000 Ending AR = 15,000 Cash Paid = 65,000 Ending AP = 25,000

Opening interest payable = 50,000 Opening tax payable = 25,000

15,000

65,000
Interest
expense

e 5,000
Tax
expense

30,000
re
Cash paid = 10,000 Ending interest Cash Paid = 15,000 Ending tax
payable = 55,000 payable = 15,000

CFO using indirect method - Net income

nT

+ Non cash charges (NCC)

+/− Transactions related to
CFI and CFF
+/− Working capital changes

Cash Flow from Operating activities

Fi

LOS g Converting cash flows from the indirect method to direct method
Indirect cash flow statement can be converted to a direct cash flow statement by
adjusting each income statement account for changes in associated balance sheet
accounts and by eliminating noncash and non-operating items

LOS h Common-size cash flow statements

A common-size cash flow statement shows each item as a percentage of revenue or shows each
cash inflow as a percentage of total inflows and each outflow as a percentage of total outflows
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LOS i FCFF, FCFE and Cash flow ratios

FCFF FCFE
ª FCFF = NI + NCC + [Int. x (1 − t)] ª FCFE = CFO ± Fixed capital investment
± Fixed & working capital ± Net borrowing
investment
ª FCFE = FCFF − [Int. × (1 − t)] ± Net
ª FCFF = CFO + [Int. x (1 – t)] ± borrowing
Fixed capital investment
ª It is the cash available only for equity
ª It is the cash available to all investors, owners
both equity owners and debt holders

Ratios
Performance
1
ratios

è CF to revenue - CFO/Net revenue

è Cash return on assets - CFO/Avg assets

e
è Cash return on equity - CFO/Avg. equity

è Cash to income - CFO/Operating income

re
è CFPS - CFO − Preferred dividend/Wt. avg. no. of shares

Coverage
2
ratios

Debt coverage - CFO/Total debt

nT

è Interest coverage - CFO + Int. paid + Taxes paid/Int. paid

è Reinvestment ratio - CFO/Cash paid for long term assets

è Debt payment - CFO/Long term debt payment

è Dividend payment - CFO/Dividend paid

Fi

è Investing and financing - CFO/CFF and CFI outflows

 Financial Analysis Techniques
LOS a Tools and techniques used in financial analysis

Ratio Common-Size Regression Graphical

Analysis Analysis Analysis Analysis

Ÿ Ratios must be Ÿ Vertical common- Ÿ Used to identify Ÿ Stacked column

viewed relative to size - Stated as a relationships graph
one another % of sales between variables
(income Ÿ Line graph
Ÿ Require statement) or as a Ÿ Results are used
adjustments when % of total assets for forecasting
different for balance sheets
companies use
different Ÿ Horizontal
accounting common-size -
treatments Each item is
presented as a
Ÿ Difficult to find percentage of its
comparable value in base year
industry ratios
when a company
operates in
multiple industries

Ÿ Requires a range
of acceptable
values

LOS b Ratios
1 Activity ratios

Accounts receivable turnover ratio (ARTR) Avg. collection period (days of sales outstanding)
Credit sales 365
Avg. AR ARTR
Higher the better Lower the better
Inventory turnover ratio (ITR) No. of days in inventory (days of inventory on hand)
COGS 365
Avg. inventory ITR
Higher the better Lower the better

Accounts payable turnover ratio (APTR) No. of days in payables (days of inventory on hand)
Purchases 365
Avg. AP APTR
Lower the better Higher the better
Asset turnover ratio Working capital turnover ratio
Sales Sales
Avg. assets Avg. Working capital
Higher the better Higher the better
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2 Liquidity ratios

Current ratio Quick ratio (Acid-test ratio)

Current assets Cash + Marketable securities + AR
Current liabilities Current liabilities

Cash ratio Defensive interval ratio

Cash + Marketable securities Cash + Marketable securities + AR
Current liabilities Avg. daily expenses

Cash conversion cycle - No. of days in inventory + No. of days in AR − No. of days in AP

3 Solvency ratios

Debt-to-equity ratio Debt-to-capital ratio

Debt Debt
Equity Debt + Equity

Debt-to-assets ratio Financial leverage ratio

Debt Assets
Assets Equity

Interest coverage ratio

EBIT
Interest
e Fixed charge coverage ratio
EBIT + Lease
Interest + Lease
re
4 Profitability ratios

Net profit margin Gross profit margin

Net income Gross profit
Sales Sales
nT

Operating profit margin Pretax margin

EBIT EBT
Sales Sales

Return on assets Operating return on assets

NP NP + Int. (1 - t) EBIT
Or
Avg. assets Avg. assets Avg. assets
Fi

Return on total capital Return on equity (ROE)

EBIT NP
Avg. total capital Avg. equity

Return on common equity

NP − Preferred dividend
Avg. common equity
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LOS c Evaluation of company using ratio analysis
Analyst should use an appropriate combination of different ratios to
evaluate a company over time

LOS d DuPont analysis

Return on equity (ROE)

Net profit Asset Financial

margin turnover leverage ratio

Net profit Sales Avg. assets

Sales Avg. assets Equity

Tax burden Interest

EBIT margin
ratio burden ratio

Net profit
EBT
EBT
EBIT
EBIT
Sales
e
re
LOS e Ratios used in equity analysis and credit analysis
Equity analysis - P/E ratio, P/CF ratio, P/Sales ratio, P/BV ratio and
Basic and Diluted EPS
Credit analysis - Interest coverage ratio, Return on capital, Debt-to-
Asset ratio and CF-to-Debt ratio
nT

LOS f Segment reporting

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

ª Both US GAAP and IFRS require companies to report segment data

Fi

LOS g Use of ratio analysis in modeling and forecasting earnings

Ratio analysis can be used to construct pro forma financial statements that provide
estimates of financial statement items for one or more future periods

Three methods of examining the variability of financial outcomes around point estimates;
ª Sensitivity analysis - Based on “what if” questions
ª Scenario analysis - Based on specific scenarios
ª Simulation - Computer based technique to generate distribution of values
 Inventories
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LOS a Costs included in Costs recognized as

inventory expense
ª Purchase cost ª Abnormal loss
ª Conversion cost ª Storage cost (Except where
ª Other costs necessary to it is considered as a part of
bring the inventory to its manufacturing process)
present location and ª Administration costs
condition ª Selling costs

LOS b Inventory valuation methods

First In Last In Weighted

First Out First Out average

COGS - First COGS - Recent COGS - Between

purchases purchases FIFO and LIFO

Ending inventory -
Recent purchases
e
Ending inventory -
First purchases
Ending inventory -
Between FIFO and
LIFO
re
Appropriate for Appropriate for
inventory that has inventory that does Makes no
a limited shelf life not deteriorate assumption about
with age physical flow of
Eg. Food products inventory
company Eg. Coal distributor
will sell coal off the
top of the pile
nT

ª If a firm can identify exactly which items were sold and which items remain in inventory,
it can use the specific identification method

ª LIFO is allowed under US GAAP, but not under IFRS

ª Under inflationary environment;

Ÿ LIFO COGS > FIFO COGS
Fi

Ÿ LIFO inventory < FIFO inventory

LOS c Perpetual inventory system Periodic inventory system

Inventory and COGS are updated Inventory and COGS are determined at the
continuously end of the accounting period
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Eg. Date Quantity Cost per unit
January 30 10 10
March 30 10 20
April 30 10 30
May 30 10 40

Sales on April 10 = 10 Q @ 50 = 500

COGS

Last In Weighted First In

First Out average First Out

Perpetual Periodic Perpetual Periodic Perpetual Periodic

10 × 20 10 × 40 (10 × 10) Weighted 10 × 10 10 × 10

= 200 = 400 + (10 × 20) average = 25 = 100 = 100
= 300
COGS = 10 × 25
Cost per unit =250
= 300/20 = 15

COGS = 15 × 10
=150
e
re
LOS d Impact of inflation and deflation on financial statements
Environment LIFO Weighted FIFO
average
Inflationary COGS Ç COGS (Between) COGS È

Closing inventory È Closing inventory Closing inventory Ç

nT

(Between)
Deflationary COGS È COGS (Between) COGS Ç

Closing inventory
Closing inventory Ç Closing inventory È
(Between)

Impact on ratios
Fi

Particulars LIFO FIFO

Inflationary Deflationary Inflationary Deflationary
GP ratio È Ç Ç È

Working capital È Ç Ç È

Current ratio È Ç Ç È

Inventory turnover Ç È È Ç

Debt-equity ratio Ç È È Ç
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LOS e & f LIFO reserve
A firm that reports under LIFO must also report a LIFO reserve
LIFO reserve = FIFO inventory − LIFO inventory

Year Particulars LIFO FIFO LIFO reserve

1 Purchases 5,000 5,000
− COGS 1,500 1,000 500
Cl. inventory 3,500 4,000 500

2 Op. inventory 3,500 4,000

− COGS 2,500 1,500 1,000
Cl. inventory 1,000 2,500 1,500

3 Op. inventory 1,000 2,500

− COGS 1,000 300 700
Cl. inventory 0 2,200 2,200

Ç LIFO reserve = LIFO COGS − FIFO COGS

e
Closing LIFO reserve = Opening LIFO reserve + Ç in LIFO reserve

LIFO liquidation
re
Year Particulars LIFO FIFO LIFO reserve

1 Purchases (10 @ 10) 300 300

and (10 @ 20)
− COGS (Sold 10Q) 200 100 100
Cl. inventory 100 200 100
nT

2 Op. inventory 100 200

Purchases (10 @ 30) 300 300

− COGS (Sold 10Q) 300 200 100

Fi

Cl. inventory 100 300 200

3 Op. inventory 100 300

− COGS (Sold 10Q) 100 300 (200)

Cl. inventory 0 0 0

LIFO liquidation occurs when a LIFO firm’s inventory quantities decline

It results in higher profit margins and higher income taxes

 Conversion of LIFO financials to FIFO

Income statement Balance sheet

COGS decreases by Inventory increases by

Ç in LIFO reserve LIFO reserve
Taxes increase by Cash decreases by
Ç in LIFO reserve x Tax rate Closing LIFO reserve x Tax rate

PAT increases by Reserves increase by

Ç in LIFO reserve x (1 - t) Closing LIFO reserve x (1 - t)

LOS g Inventory measurement

IFRS Eg. Cost - 100 US GAAP

Selling price - 90
Selling cost - 10
Replacement cost - 95
NP margin - 20 Cost vs. Lower of market or
Cost vs. Net realizable value
replacement cost

Cost = 100 Cost = 100

Replacement cost = 95
NRV = SP − SC = 80
NRV − NP margin NRV

Since NRV < Cost, inventory

will be valued at 80 80 − 20 = 60 80

Since replacement cost (95) is

beyond NRV (80), inventory
must be valued at 80

Inventory write-up is allowed

Inventory write-up is not
only to the extent of previous
allowed
writedown

ª In ceratin industries inventory can be shown above historical cost in both IFRS and US
GAAP - agricultural and forest products, mineral ores and precious metals

Implications of inventory writedown

Inventory È COGS Ç GP & NP È Taxes È Cash Ç

LOS h Impact on ROE and ROA

% decrease in net income > % decrease in assets or equity

As a result, both ROA and ROE are decreased

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LOS i Inventory disclosures

Ê Cost flow method (FIFO,LIFO etc.)

Ê Carrying value of inventory
Ê Carrying value of inventories reported at fair value less selling costs
Ê COGS
Ê Amount of inventory writedown
Ê Reversals of inventory writedown
Ê Carrying value of inventories pledged as collateral

LOS j Issues that analysts should consider when examining a

company’s inventory disclosures
è Finished goods inventory is increasing but raw materials and work-in-progress are
decreasing, indicates decreasing demand and potential future inventory writedowns

è Raw materials and work-in-progress are decreasing, indicates increasing demand

and higher earnings

è Finished goods inventory is increasing but there is no proportionate increase in

sales, indicates decreasing demand or inventory obsolescence.

LOS k Evaluation using inventory turnover

ª Low ITR - Slow-moving or obsolete inventory

e
ª High ITR with low sales growth - Inadequate inventory levels and lost sales

ª High ITR with high sales growth - Reflects greater efficiency

re
LOS l Analysis of companies that use different
inventory methods
An analyst must adjust the financial statements to reflect same inventory costing
methods for both firms
nT
Fi
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Long-Lived Assets © 2017 FinTree Education Pvt. Ltd.

LOS a Capitalized costs Expensed costs

Expenditure that is expected to If the future economic benefit is

provide a future economic benefit unlikely or highly uncertain,
is capitalized expenditure is expensed

Recorded as an asset in B/S Recorded as an expense in I/S

Interest that accrues during the Interest paid after construction

construction period is capitalized period is expensed

If capitalized (as compared with ‘if expensed’);

ª Assets are higher

ª Profit in first year is higher

ª Profits in later years are lower

ª There is less volatility

LOS b
Intangible assets
e
Intangible assets
Measurement base for internally
created intangible assets
re
Identifiable Unidentifiable
IFRS US GAAP

Can be acquired Cannot be acquired

separately separately and may Research cost - Research cost -
nT

have an unlimited life Expensed Expensed

Eg. Patent
Eg. Goodwill Development cost - Development cost -
Amortized and tested Capitalized Expensed
for impairment Not amortized, but are
tested for impairment Exception - Software
at least annually costs. These are
treated the same
way as under IFRS
Measurement base for purchased assets - Same as PPE
Fi

Goodwill - Purchase price of business − Fair value of net identifiable assets acquired
It is not amortized but must be tested for impairment at least annually
Internally generated goodwill is expensed as incurred
Economic goodwill - Expected future performance of the firm
Accounting goodwill - Result of past acquisitions
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LOS c Impact of capitalization on various ratios

Particulars Increase/decrease

Total assets Ç
Total liabilities No change

Equity (1st year) Ç

Equity (Subsequent yrs.) Ç
Net income (1st year) Ç
Net income (Subsequent yrs.) È
CFO Ç
CFI È
CFF No change

Total CF No change

Interest coverage (EBIT/Int.) Ç

Interest coverage (Subsequent yrs.) È
Debt-equity ratio (D/E)

e È
re
LOS d Depreciation methods

Straight line Double declining Units of production

method balance method method
nT

Cost − Residual value Op. book value Deprc. per unit =

× 2
Useful life Useful life
Cost − Residual value
Equal amount of Depreciation ends once Total no. of units
depreciation each year the estimated residual
value has been reached Total depreciation =
Deprc. per unit x units
produced
Fi

Component depreciation - Depreciating components of asset separately (Eg. in case of

building - flooring, roof, walls etc. are depreciated separately)

IFRS - Component depreciation is required

US GAAP - Component depreciation is allowed (not required) but is seldom used

Economic depreciation - Actual decline in the value of the asset

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LOS e Impact of depreciation related assumptions

As compared to SLM, using DDB method results in;

Higher depreciation
Lower net income
Lower ROA and ROE
There is no impact on CF

Estimating lower salvage value (residual value) or less useful life results in
higher depreciation

LOS f & g Amortization methods

Ê Amortization is same as depreciation of tangible assets

Ê Intangible assets with finite lives are amortized over their useful lives
Ê These methods are same as depreciation i.e. SLM, DDB and UOP
Ê Choice of amortization method affects expenses, assets, equity and
financial ratios just the same way the choice of depreciation does

LOS h Revaluation model

ª Cost model - Long-lived assets are also reported at depreciated cost
ª Revaluation model - Long-lived asset are reported at fair value

e
ª Revaluation model is permitted only under IFRS

ª Revaluation can be used if active market exists for the asset

re
ª Reporting - Balance sheet - Fair value, OCI - Gain, Income statement - Loss

Eg. Asset’s FV - 100 120 70

Gain = 20 Loss = 50
(Reported in OCI as
revaluation surplus)
nT

20 30
(Reported in OCI) (Reported in I/S)
(Loss is reversed)

Asset’s FV - 100 80 150

Loss = 20 Gain = 70
(Reported in I/S)
Fi

20 50
(Reported in I/S) (Reported in OCI)
(Loss is reversed)

LOS i Impairement of PPE and intangible assets

ª Depreciation - Systematic reduction in the value of asset
ª Impairment - One time reduction because of significant decline in
the market value of asset
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Impairment

IFRS US GAAP

Carrying value (CV) vs. Determine if impairment is

Recoverable amount required

Recoverable amount is higher of ;

ΠIf CV > Total of undisounted CFs
ΠNRV or, then,
 Value in use (PV of future CFs)
 Impairment =
Impairment = CV − FV or PV of future CFs
CV − Recoverable amount

ª Under US GAAP impairment can not be reversed

ª Under IFRS impairment can be reversed but only to the extent of previous carrying value

Long-lived assets held for sale

PPE
Held for use
e
Reclassified as
PPE
Held for sale
re
è Tested for impairment
è No longer depreciated

ª For long-lived assets held for sale, loss can be reversed under both IFRS and US GAAP

LOS j Derecognition of PPE

nT

PPE is sold PPE is exchanged PPE is abandoned

Asset is removed New asset is Asset is removed

from the B/S recorded at FV from the B/S
Fi

Gain/loss is Gain/loss is Loss is reported in

reported in I/S computed by I/S
comparing CV and
FV of asset given
up or acquired
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LOS k Impact of impairment, revaluation and
derecognition on ratios

Impairment Revaluation Derecognition

PAT, assets, equity Upward revaluation In case of loss PAT

and ROE and ROA will increase assets and assets will
will decrease and equity decrease

Subsequent periods; Debt-to-assets and In case of gain PAT

PAT and ROE and debt-to-equity will and assets will
ROA will increase decrease increase

LOS l Required disclosures

ª Carrying values for each class of asset

ª Accumulated depreciation and amortization
ª Title restrictions and assets pledged as collateral
ª For impaired assets, loss amount and circumstances that caused the loss
ª For revalued assets (IFRS only), the revaluation date, how fair value
was determined, and the carrying value using the historical cost model

LOS m
e
Three useful calculations for analysts
re
Average age of Total useful life Remaining useful
asset of asset life of asset

Accumulated depreciation Net block

Annual deprc. expense Annual deprc. expense
Gross block
Annual deprc. expense
More accurate for firms Total useful life of asset
nT

that use SLM − Average age of asset

LOS n Investment PPE

Ÿ Property held for rental income, earning capital appreciation or both (Only under IFRS)
Ÿ US GAAP does not distinguish investment PPE from other long-lived assets
Ÿ IFRS allows use of cost model or fair value model
Ÿ Fair value model is similar to revaluation model except gains are also taken to I/S
Fi

LOS o & p Lease

ª It is a contractual arrangement whereby the lessor (owner of the asset) allows lessee to
use the asset for a specified period of time in return for periodic payments

ª Operating lease - Lessee pays periodic lease payments which are recognized as rental
expense in the income statement

ª Finance lease (capital lease) - Lessee recognizes both depreciation and interest expense
(same as purchasing the asset with debt)
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IFRS US GAAP
A lease is finance lease if,

ΠPV of lease payments > 90% of

Lease is determined by the
total value of asset
economic substance of the
 Lease tenure > 75% of life of
transaction
asset
Ž Bargain purchase
 Title transfer to the lessee at the
end of lease perod

Accounting for operating lease Accounting for operating lease

(books of lessee) (books of lessor)

è No asset è Asset remains on B/S

è No liability è Record depreciation
è Lease payment - Operating expense è Lease income - Operating or non-
and outflow under CFO operating income and inflow under
CFO/CFI

Accounting for capital lease Accounting for capital lease

(books of lessee)

è Asset is created equal to PV of

future lease payments e (books of lessor)

è Lease receivable (asset) is created

equal to the PV of lease payments
re
è Liability is created at same value of è Interest income - Operating or non-
asset operating income and inflow under
è Depreciation and interest expense CFO
is recorded in I/S è Principal portion - Lease receivable
è Liability is amortized as principal is is decreased and inflow is recorded
repaid in every installment under CFI
nT

Ÿ Value of asset and liability at to and tn will be same but not necessarily same between to and tn
Ÿ Principal portion of current year is current liability
Ÿ Compared to operating lease, expenditure in capital lease would be more in first few years
and less in last years
Ÿ Capital lease (in the books of lessor) can be either sale type lease or direct financing lease
Ÿ Sale type lease - Lessor is a manufacturer or dealer. Gross profit is recorded
Ÿ Direct financing lease - Lessor is only offering financing in the form of lease. No GP is
recorded
Fi

Impact on ratios in capital lease (as against operating lease)

Income statement items Higher/lower Ratios Higher/lower

NP (earlier years) È Operating profit Ç

NP (subsequent years) Ç Asset turnover È
EBIT (earlier years) Ç Debt-equity (D/E) Ç
EBIT (subsequent years) Ç Current ratio È
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Balance sheet items Higher/lower

Total assets Ç
Total liabilities Ç
Current liabilities Ç
Equity È
CFO Ç
CFI Same

CFF È

e
re
nT
Fi
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Income Taxes © 2017 FinTree Education Pvt. Ltd.

LOS a Taxable income Income subject to tax based on the tax return (tax book)
Taxes payable Tax liability caused by taxable income
Tax base Net amount of an asset or liability as per the tax book

Income tax expense Expense recognized in the income statement

Deferred tax asset (DTA) Asset that results when tax payable > tax expense
Deferred tax liability (DTL) Liability that results when tax payable < tax expense
Valuation allowance Contra account for DTA. If DTA is not expected to
reverse, valuation allowance is created

LOS b, c & d DTA and DTL

These are created due to temporary differences between taxes payable
(tax return) and tax expense (income statement)
Eg. Rate of depreciation for A/c purpose - 25% Rate of depreciation for tax purpose - 50%
Tax rate - 40%

Accounting book Tax return

Year Sales Depriciation PBT Tax Year Sales Depriciation PBT Tax DTL

2
100

100
25

25
75

75
expense

30

30
1

2
e
100

100
50

50
50

50
payable

20

20
10

10+10 = 20
re
3 100 25 75 30 3 100 - 100 40 10+10-10 = 10

4 100 25 75 30 4 100 - 100 40 10+10-10-10 = 0

ª In year 3 and year 4, there is reduction in DTL which is called as reversal of DTL

ª Total amount of depreciation over 4 years is same in both the books

nT

ª Income tax expense = Taxes payable + Ç in DTL + È in DTA − È in DTL − Ç in DTA

Carrying value Tax base

Value of asset or liability as per Value of asset or liability as per

Fi

accounting book tax book

ª For assets - If Tax base Ç º Depreciation È º Profit Ç º Taxes Ç º DTA

ª For assets - If Tax base È º Depreciation Ç º Profit È º Taxes È º DTL

Unless otherwise mentioned, tax base for provision related liabilities will always be zero
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DTA DTL

Accounting Accounting
Tax return Tax return
book book

Tax expense Tax payable Tax expense Tax payable

is lower is higher is higher is lower

Profit is Profit is Profit is Profit is

lower higher higher lower

Sales Expenses Sales Expenses Sales Expenses Sales Expenses

are are are are are are are are
lower higher higher lower higher lower lower higher

DTA is created when;

ΠRevenues are taxable before they are recorded in I/S
 Expenses are recognized in I/S before they are tax deductible
Ž Tax loss carryforwards are available

DTL is created when;

e
ΠRevenues are recognized in I/S before they are recognized in tax return
 Expenses are tax deductible before they are recognized in I/S
re
LOS e Impact of tax rate changes on a company’s financial statements and ratios
When tax rate increases, both DTA and DTL increase proportionately

When tax rate decreases, both DTA and DTL decrease proportionately
nT

LOS f Temporary difference Permanent difference

Difference between tax base and Difference between taxable
carrying value that will reverse in income and pretax income that
future will not reverse in the future

Temporary differences create Permanent differences do not

DTAs or DTLs create DTAs or DTLs
Fi

It causes effective tax rate to

differ from statutory tax rate

LOS g Valuation allowance

è It is a contra account that reduces DTA
è If DTA is not expected to reverse, valuation allowance is created
è Increasing the valuation allowance will increase income tax expense and reduce earnings
è If circumstances change, the net DTA can be increased by decreasing the valuation
allowance. This would result in higher earnings
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LOS h Recognition and measurement of current and deferred tax items

Measurement of deferred tax items depends on the tax rate expected to be in force when the
underlying temporary difference reverses
If DTL is not expected to reverse it should be treated as a part of equity for analytical purpose

LOS i Disclosures relating to deferred tax items

and the effective tax rate reconciliation
ª Deferred tax liabilities
ª Deferred tax assets
ª Valuation allowance
ª Net change in valuation allowance
ª Tax loss carryforwards
ª Current-year tax effect of each type of temporary difference
ª Components of income tax expense

LOS j Differences between IFRS and US GAAP

ª US GAAP - DTA/DTL is classified as current or noncurrent based on classification of

underlying asset or liability

ª IFRS - DTA/DTL is netted and classified as noncurrent

e
re
nT
Fi
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Long Term Liabilities © 2017 FinTree Education Pvt. Ltd.

LOS a & b Recognition and measurement of bonds

MV of bond is PV of future CFs discounted at current YTM (Yield-to-maturity)

BV of bond liability is PV of future CFs discounted at YTM on the date of issuance

Discount bond Par bond Premium bond

Discount bond

Eg. 4
FV = 1000 Bond liability(BL)
1000
Coupon rate = 10%
Maturity = 4 yrs.
YTM = 20% 2
847
3
916
69
100 e
84
100
184
Discount amortized at tn = BLtn − BLtn−1

Coupon amount = FV x coupon rate

re
1 58 169
789 100 Interest expense =
0 48 158 Disc. amortized + Coupon amount or
741 100 BLtn x YTM
148

ª Liability will increase every year

nT

ª Interest expense will increase every year

ª Interest expense > Coupon amount

Par bond
Eg. Bond liability(BL)
Fi

FV = 1000
0 1 2 3 4 Coupon amount = FV x coupon rate
Coupon rate = 10%
Maturity = 4 yrs. 1000 1000 1000 1000 1000 Interest expense =
YTM = 10% 100 100 100 100 100 Coupon amount or BLtn x YTM

100 100 100 100 100

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Premium bond

Eg. 0
FV = 1000 Bond liability(BL)
1177
Coupon rate = 10% 1
Maturity = 4 yrs. 1136 Discount amortized at tn = BLtn − Bltn−1
YTM = 5% (41) 2
100 1092
Coupon amount = FV x coupon rate
59 (44) 3
100 1047 Interest expense =
56 (45) 4 Coupon amount − Prem. amortized or
100 1000 BLtn x YTM
55 (47)
100
53

ª Liability will decrease every year

ª Interest expense will decrease every year

ª Interest expense < Coupon amount

Issuance cost

IFRS
e US GAAP
re
Initial bond liability on B/S is
reduced by the amount of
It is capitalized and amortized
issuance cost
as an expense in I/S over the
term of the bond
Increases bond’s effective
interest rate
nT

Reporting of debt
Under IFRS and US GAAP there is irrevocable option to report debt at fair value. Under this
option, gains and losses that result from changes in bonds’ YTM are reported in the I/S

LOS e Derecognition of debt

Fi

If bonds are redeemed before maturity, gain or loss is recognized equal to the difference between
the redemption price and book value of bond liability

Under US GAAP remaining unamortized bond issuance costs must also be written off and included in
the gain/loss calculation. No write-off is necessary under IFRS because issuance costs are already
included in book value of bond liability
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LOS d Debt covenants

è These are restrictions on borrower that protect the bondholders’ interests

è They reduce default risk and borrowing costs

Affirmative covenants Negative covenants

Promises to do certain things. Eg. - Promises to refrain from certain

activities Eg. -
Make timely payments of principal
and interest Restrictions on dividend payments

Maintain ratios in specified levels Restriction on issuance of new debt

Maintain collateral in working order Restriction on disposal of assets

LOS e Presentation of and disclosures relating to debt

ª Portion that is due within the next year is reported as a current liability

ª More details about long-term debt such as maturity, conversion features,

restrictions, assets pledged etc. are disclosed in the footnotes

LOS f
e
Motivations for leasing an assets
Less expensive financing
re
ª
ª Reduced risk of obsolescence of asset
ª Less restrictive provisions
ª Off-balance-sheet financing (operating lease)
ª Tax reporting advantages (synthetic lease)

Synthetic lease - Lease is treated as capital lease for tax purposes

and operating lease for accounting purposes
nT

LOS g & h Lease

IFRS US GAAP
A lease is finance lease if,
Fi

ΠPV of lease payments > 90% of

Lease is determined by the
total value of asset
economic substance of the
 Lease tenure > 75% of life of
transaction
asset
Ž Bargain purchase
 Title transfer to the lessee at the
end of lease perod
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Accounting for operating lease Accounting for operating lease

(books of lessee) (books of lessor)

è No asset è Asset remains on B/S

è No liability è Record depreciation
è Lease payment - Operating expense è Lease income - Operating or non-
and outflow under CFO operating income and inflow under
CFO/CFI

Accounting for capital lease Accounting for capital lease

(books of lessee) (books of lessor)

è Asset is created equal to PV of è Lease receivable (asset) is created

future lease payments equal to the PV of lease payments
è Liability is created at same value of è Interest income - Operating or non-
asset operating income and inflow under
è Depreciation and interest expense CFO
is recorded in I/S è Principal portion - Lease receivable
è Liability is amortized as principal is is decreased and inflow is recorded
repaid in every installment under CFI

Ÿ Value of asset and liability at to and tn will be same but not necessarily same between to and tn

e
Ÿ Principal portion of current year is current liability
Ÿ Compared to operating lease, expenditure in capital lease would be more in first few years
and less in last years
Ÿ Capital lease (in the books of lessor) can be either sale type lease or direct financing lease
re
Ÿ Sale type lease - Lessor is a manufacturer or dealer. Gross profit is recorded
Ÿ Direct financing lease - Lessor is only offering financing in the form of lease. No GP is
recorded

Impact on ratios in capital lease (as against operating lease)

nT

Income statement items Higher/lower

Balance sheet items Higher/lower
NP (earlier years) È
NP (subsequent years) Ç
Total assets Ç

EBIT (earlier years) Ç

Total liabilities Ç

EBIT (subsequent years) Ç

Current liabilities Ç
Fi

Equity È
Ratios Higher/lower CFO Ç

Operating profit Ç CFI Same

Asset turnover È CFF È

Debt-equity (D/E) Ç
Current ratio È
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LOS i Disclosures relating to finance and operating leases
è General description of the lease

è Nature, timing and amount of payments to be paid or received in each of

the next five years. Lease payments after five years can be aggregated

è Amount of lease revenue and expense reported in I/S for each period

è Amounts receivable and unearned revenues from lease arrangements

è Restrictions imposed by lease agreements

LOS j Defined contribution Defined benefit

pension plan pension plan

Employer and employee both contribute Only employer contributes to a

an amount to employee’s retirement fund to provide benefits to the
account each period employee

Contribution may be based on years of Benefit is usually based on employee’s

service, employee’s compensation, his age years of service and his compensation
or even a percentage of his contribution

Firm makes no promise to employee

e near retirement

Firm promises to make periodic payments

re
regarding the future value of plan assets to employee after retirement

The investment decisions are left to the Since employee’s future benefit is defined,
employee who assumes all investment risk employer assumes the investment risk
nT

No asset, no liability Asset - Plan assets

Contributions are expensed Liability - Pension benefit obligation (PBO)
Subject to multiple assumptions

Under both IFRS and US GAAP, net amount

is reported on B/S
Fi

Defined benefit pension plan

IFRS US GAAP

I/S - (Pension expense) I/S - (Pension expense)

Service costs and interest income/expense Current service cost, interest
income/expense and expected return
OCI - (Remeasurements)
Actuarial gains/losses and difference b/w OCI - (Remeasurements)
actual return and expected return Actuarial gains/losses and past service costs

Discount rate = Expected return Discount rate ≠ Expected return

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Under IFRS:
Overfunded plan = Net interest income
Underfunded plan = Net interest expense
Under US GAAP:
Interest expense is reported separately
Expected income is reported separately

LOS k Leverage ratios

Debt-to-equity ratio Debt-to-capital ratio

Debt Debt
Equity Debt + Equity

Debt-to-assets ratio Financial leverage ratio

Debt Assets
Assets Equity

Coverage ratios
Interest coverage ratio Fixed charge coverage ratio
EBIT EBIT + Lease
Interest Interest + Lease

e
re
nT
Fi
 Financial Reporting Quality
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LOS a
Financial reporting Quality of reported
quality results
Refers to characteristics of a firm’s Refers to the level and
financial statements sustainability of a firm’s earnings,
CFs and B/S items
High quality financial reporting must
be decision useful It should help investors earn
adequate and sustainable return in
Two characteristics - future periods
relevance and faithful representation

LOS b Spectrum for assessing financial reporting quality

{
ΠSustainable earnings

 Low earning quality

Reporting is
GAAP compliant
Ž Low earning quality and biased estimates

Reporting is non
GAAP compliant
{ e
 Earnings is actively managed

 True representation

‘ Fictitious transactions
re
LOS c
Aggressive Conservative
accounting accounting
Ÿ Increases company’s reported Ÿ Decreases reported earnings. Eg :
nT

earnings. Eg :
Ÿ Expensing current period costs
Ÿ Capitalizing current period costs Ÿ Shorter estimate of useful life of
Ÿ Longer estimate of useful life of asset
asset Ÿ Lower estimate of salvage value
Ÿ Higher estimate of salvage value Ÿ Using accelerated depreciation
Ÿ Using SLM
Fi

LOS d Motivations for firm managers to issue low-quality financial reports

ª Pressure to meet or exceed earnings targets

ª Career considerations

ª Increasing their compensation

ª Improving perceptions of the firm among customers and suppliers

ª Meeting terms of debt covenants

LOS e Conditions where managers issue low-quality financial reports
When managers have motivations, opportunities, and rationalizations
Opportunities ;
Weak internal controls
BoDs don’t provide adequate oversight
Wide ranges of acceptable accounting treatments

LOS f Mechanisms that discipline financial reporting quality

ª Mechanisms that help to discipline financial reporting quality include regulation, auditing and
private contracts
ª Securities regulations typically require ;
Ÿ Registration process for issuance of publicly traded securities
Ÿ Specific disclosure and reporting requirements
Ÿ Independent audit of financial reports
Ÿ MD&A
Ÿ Review process for newly registered securities and periodic reviews after registration

LOS g Presentation choices that could be used to

influence an analyst’s opinion
Firms sometimes report accounting measures that are not defined or
required under GAAP. Such non-GAAP measures typically exclude some items
in order to make the firm’s performance look better than it would using
measures defined and required by GAAP

LOS h Accounting methods used to manage earnings, CF and B/S items

ª Revenue recognition choices such as shipping terms (FOB shipping
point versus FOB destination), accelerating shipments (channel
stuffing), and bill-and-hold transactions

ª Estimates of reserves for uncollectible accounts or warranty expenses

ª Valuation allowances on deferred tax assets

ª Depreciation methods, estimates of useful lives and salvage values,

and recognition of impairments

ª Inventory cost flow methods

ª Capitalization of expenses

ª Related-party transactions

LOS i Warning signs for detecting manipulation in financial statements

è Changes in revenue recognition methods, or lack of transparency about revenue recognition

è Decrease in ARTR, ITR and Asset-turnover ratio

è Barter or related-party transactions

è PAT not supported by operating cash flows

è Capitalization decisions, depreciation methods, useful lives, salvage values not in line with
comparable firms
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è Frequent appearance of nonrecurring items

è Emphasis on non-GAAP measures, minimal information and disclosure in financial reports

e
re
nT
Fi
 Financial Statement Analysis : Applications
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LOS a How a company’s strategy is reflected in past financial performance

Analyst can evaluate trends in the ratios, as well as their levels

Differences between its financial ratios and those of its competitors or industry
average ratios can reveal important aspects of its business strategy

LOS b Projected net income and cash flow

Net income can be projected by forecasting sales growth and using estimates
of profit margins

CFs can be projected by forecasting increases in working capital, fixed assets

and issuance/repayments of debt and issuance or repurchase of stock

LOS c Creditworthiness of a firm

Three Cs
Œ Character - Management’s professional reputation and the firm’s history of debt repayment
 Collateral - Reduces lender risk
Ž Capacity to repay - Requires close examination of the firm’s financial statements and ratios

Indicators of a firm’s creditworthiness

Œ

Ž

Scale and diversification
Operational efficiency
Margin stability
Use of financial leverage e
re
LOS d Use of financial statement analysis in
screening for potential equity investments
Potentially attractive equity investments can be identified by screening a universe
of stocks, using minimum or maximum values of one or more ratios
nT

Screening involves which (and how many) ratios to use, what minimum or
maximum values to use, and how much importance to give each ratio

LOS e Adjustments in financial statements for comparability

Since different companies use different accounting methods, analyst must adjust the
financial statements to compare them with each other
Fi

Eg. LIFO financials can be converted to FIFO financials by adding LIFO reserve to FIFO
inventory

PV of operating lease obligations should be added to firm’s liabilities for analytical purposes