CFA Level I

Financial statement & Analysis

Mona kaboli (PHD)

CFA Level I FR&A- VOLUME2

1. Introduction to financial statement(learning module 1)

2. Analyzing income statement(learning module 2)
3. Analyzing balance sheets(learning module 3)
4. Analyzing statement of cashflows1(learning module 4)
5. Analyzing statement of cashflows2(learning module 5)
6. Analysis of inventories(learning module 6)
7. Analysis of long-term assets(learning module 7)
8. Topics in long term liabilities and equity (learning module 8)

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CFA Level I FR&A- VOLUME3

1. Analysis of income taxes(learning module 1)

2. Financial reporting quality(learning module 2)
3. Financial analysis techniques(learning module 3)
4. Introduction financial statement modeling
(learning module 4)

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 Introduction to financial
statement analysis
• Describe the steps in financial analysis framework
• Describe the roles of financial statements analysis
• Describe the importance of regulatory filings, financial statement
notes and supplementary information, management’s commentary
and audit reports
• Describe implications for financial analyzing of alternative
financial reporting systems and developments in financial
reporting standards
• Describe information sources that analysts use in financial
segments analysis besides annual and interim financial reports

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The steps of Financial Reporting analyzing framework

“The objective of general purpose financial reporting is to

provide financial information about the reporting entity that
is useful to existing and potential investors, lenders, and
other creditor to the entity. Those decisions involve buying,
selling or holding equity and debt instruments, and
providing or settling loans and other forms of credit.”

4
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 Role of Financial Statement Analysis

■ Using the information in a company’s financial

statements, along with other relevant information, to
make economic decisions:
■ (e.g. evaluate securities, acquisitions, creditworthiness)
■ To evaluate a company’s past performance and current
financial position in order to form opinions about a firm’s
ability to earn profits and generate cash flow in the future

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Regulated sources of information

Regulatory authorities require publicly traded issuers to

prepare financial reports in IFRS and GAAP and most
of the exchanges are membered of the IOSCO.

The objectives of IOSCO are:

• Protecting investors

• Marketa are fair, efficient, transparent

• Reducing systematic risk

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Us securities and Exchange commission
US securities and exchange commission enforcement:

• Act of 1933 (investor must receive information about sold of registered securities)

• Act of 1934 (periodic reporting)

• Sarbanes Oxley act of 2022

(auditor independence and effectiveness of internal control)

• Form of 10k-20F-40F (US registration- Canadian registration- non-US

registration)

• Proxy statement(proposals that require shareholder vote)

• MD@A (nature of business, past result and outlook)

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Key Financial Statements

1. Income statement (statement of operations or the profit

and loss statement)
Summarizes events over a period:
■ Revenues are inflows from delivering or producing
goods, rendering services, or other activities that
constitute the entity's ongoing major or central
operations
■ Expenses are outflows from delivering or producing
goods or services that constitute the entity's ongoing
major or central operations
■ Other income includes gains and losses which may or
may not arise in ordinary course of business

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 Key Financial Statements

2. Statement of comprehensive income reports all

changes in equity except for shareholder transactions
3. Balance sheet - at a point in time
■ Assets = liabilities + owners' equity
■ Assets are the resources controlled by the firm
■ Liabilities are amounts owed to lenders and other
creditors
■ Owners 'equity is the residual interest in the net assets
of an entity that remains after deducting its liabilities

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Key Financial Statements

4. Cash flow statement reconciles beginning and ending

cash balance, splitting changes into three categories:
■ Operating cash flows(CFO)
■ Investing cash flows(CFI)
■ Financing cash flows(CFF)
5. Statement of changes in owners’ equity-
amounts and sources of changes in shareholders' equity
over the period

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Footnotes and Supplementary Schedules

■ Basis of presentation
■ Accounting methods and assumptions
■ Further information on amounts in primary statements
■ Business acquisitions/disposals
■ Contingencies
■ Legal proceedings
■ Stock options and benefit plans
■ Significant customers
■ Segment data
■ Quarterly data
■ Related-party transactions

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Management Discussion and Analysis

■ Nature of the business

■ Results from operations, business overview
■ Trends in sales and expenses
■ Capital resources and liquidity
■ Cash flow trends
■ Discussion of critical accounting choices
■ Effects of inflation, price changes, and uncertainties on
future results

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The Audit Report

■ Audit: Independent review of company's financial

statements
■ Reasonable assurance that financial statements are
free of material errors
■ Audit opinion:
Unqualified: "Clean" opinion Qualified:
Exceptions to accounting principles Adverse:
Statements not presented fairly Disclaimer of
opinion: Unable to form an opinion
■ Must provide opinion on company's internal controls
under U.S. GAAP

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Audit Report

1. Responsibility of management to prepare accounts

Independence of auditors

2. Properly prepared in accordance with relevant GAAP

Reasonable assurance that the statements are free from
material misstatement

3. Accounting principles and estimates chosen are reasonable

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Supplementary Sources of Information

■ Quarterly, semi-annual reports: Updates of major

financial statements and footnotes; SEC filings
■ Proxy statements: Issued when shareholder vote is
required; contain information on board elections,
management compensation, stock options
■ Corporate reports, press releases written by
management
■ Economic, industry data from trade journals, reporting
services, government agencies

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Accounting Standards

■ Financial Accounting Standards Board (FASB) U.S.

■ International Accounting Standards Board (IASB) most

other countries

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Comparison of IFRS with alternative financial reporting systems

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Financial Statements - Problem

Regarding the report of independent auditors under

U.S. GAAP, the audit report:
A. is unqualified if the auditors disagree with the firm on
the treatment of some items.
B. must provide an opinion on the firm's internal controls.
C. does not apply to the footnotes to the financial
statements.

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1. Which of the following statements least accurately describes a role of financial
statement analysis?
A. Use the information in financial statements to make economic decisions.
B. Provide reasonable assurance that the financial statements arc free of
material errors.
C. Evaluate an entity’s financial position and past performance to form
opinions about its future ability to earn profits and generate cash flow.

2. A firm’s financial position at a specific point in time is reported in the:

A. balance sheet.
B. income statement.
C. cash flow statement.

3. Information about accounting estimates, assumptions, and methods chosen for

reporting is most likely found in:
A. the auditor’s opinion.
B. financial statement notes.
C. Management’s Discussion and Analysis.
4. If an auditor finds that a company’s financial statements have made a specific
exception to applicable accounting principles, she is most likely to issue a:
A. dissenting opinion.
B. cautionary note.
C. qualified opinion.

5. Information about elections of members to a company’s Board of Directors is

most likely found in:
A. a 10-Q filing.
B. a proxy statement.
C. footnotes to the financial statements.

6. The financial statement that presents a shareholder’s residual claim on assets is:
A. Balance sheet
B. Income statement
C. Cash flow statement.
1. B This statement describes the role of an auditor, rather than the role of an analyst. The

other responses describe the role of financial statement analysis.

2. A The balance sheet reports a company's financial position as of a specific date. The
income statement, cash flow statement, and statement of changes in owners’ equity
show the company’s performance during a specific period.

3. B Information about accounting methods and estimates is contained in the footnotes to

the financial statements.

4. C An auditor will issue a qualified opinion if the financial statements make any exceptions
to applicable accounting standards and will explain the effect of these exceptions in the
auditor’s report.

5. B Proxy statements contain information related to matters that come before shareholders

for a vote, such as elections of board members.

6. A is correct. Owners equity is the residual interest that presents in balancesheet.

Learning module 2
analyzing Income Statements

40
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Income Statement

■ Alternative names:
Statement of operations Statement of
earnings Profit and loss statement
Revenue - Expenses = Net Income
■ IFRS: May combine with comprehensive income items
■ Two types:
■ Single step
■ Multi-step

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Income Statement

■ Revenues: Amounts reported from the sale of goods and

services in the normal course of business. Revenue less
adjustments for estimated returns and allowances is
known as net revenue.
■ Expenses: Amounts incurred to generate revenue and
include cost of goods sold, operating expenses, interest,
and taxes. Expenses are grouped together by their nature.
■ Gains and losses: Typically arise on the disposal of
long-lived assets.

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Multi-step Income Statement

Revenue
Cost of goods sold Gross profit

- Selling, general, and administrative expenses

Operating profit
Operating or
+ Other income and revenues non-operating?
- Financing costs +/- Unusual Analyze items
or infrequent items
Income before tax

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 Multi-step Income Statement
>

Income before tax

- Provision for income taxes M The line”

- Income from continuing operations +/- Income

from discontinued operations +/-
Extraordinary items All net of tax
Net income ”The bottom line”

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IASB Requirements for Revenue
Recognition (General Principles)

1. Risk and reward of ownership transferred

2. No continuing control or management over the good sold

3. Reliable revenue measurement

4. Probable flow of economic benefits
5. Cost can be measured reliably

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IASB Requirements for Revenue Recognition for Services

1. When the outcome can be measured reliably, revenue will

be recognized by reference to the stage of completion
2. Outcome can be measured reliably if:
■ Amount of revenue can be measured
■ Probable flow of economic benefits
■ Stage of completion can be measured
■ Cost incurred and remaining cost to complete can be
measured

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SEC Requirements for Revenue Recognition

"Revenue should be recognized when it is realizable

and earned" FASB
SEC additional guidance:
1. Evidence of an arrangement between buyer and seller

2. Completion of the earnings process, firm has delivered

product or service
3. Price is determined
4. Assurance of payment, able to estimate probability of
payment

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Revenue Recognition Methods
■ Sales-basis method-used when good or service is provided
at time of sale, cash, or credit with high payment
probability (majority of transactions)
Exceptions (construction contracts)
1. Percentage-of-completion method-used for L-T projects
under contract, with reliable estimates of revenues,
costs, and completion time
2. Completed-contract method (U.S. GAAP)-used for L-T
projects with no contract, or unreliable estimates of
revenue or costs; revenue and expenses are not
recognized until project is completed
(IFRS: Report revenue but no profit)

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Revenue Recognition Methods
Installment sale: A firm finances a sale and payments are
expected to be received over an extended period. If
collectability is certain, revenue is recognized at the time
of sale using the normal revenue recognition criteria.
3. Installment sales method (U.S. GAAP)-used when
firm cannot estimate likelihood of collection, but
cost of goods/services is known; revenue and profit
are based on percentage of cash collected
4. Cost recovery method used when cost of
goods/services is unknown and firm cannot estimate
the likelihood of collection; only recognize profit
after all costs are recovered

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Percentage-of-Completion Method

Ledesma Properties Ltd. has a contract to build a hotel for

$2,000,000 to be received in equal installments over 4 years.
A reliable estimate of total cost of this contract is
$1,600,000. During the first year, Ledesma incurred
$400,000 in cost. During the second year, $500,000 of costs
were incurred. The estimate of the project's total cost did not
change in the second year.

Calculate the revenue and profit to be recognized in each of

the first two years.

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Percentage-of-Completion Method
Cumulative revenue

Total costs to date

x Sales price X
Total project cost

Revenue recognized in prior years (X)

This period's revenue X
Costs incurred in period (X)
Profit recognized in period X

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Percentage-of-Completion Method Solution

Year 1: $2,000,000 x (400,000 / 1,600,000)

Revenue = $500,000
Profit = $500,000 - $400,000 = $100,000

Year 2: $2,000,000 x (900,000 / 1,600,000)

- $500,000
Revenue = $625,000
Profit = $625,000 - $500,000 = $125,000

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Completed-Contract Method

Revenue and expenses are not recognized until project is

completed

Example: Building a hotel for $40 million, cost to build is

$32 million; cost incurred in Year 1 is $6.4 million
Revenue = 0; expense = 0; income = 0

On completion/final year:
revenue = $40m; expenses = $32m; income = $8m

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IFRS: Long-term Contracts With Uncertain Outcome

Revenue and expenses are recognized over the project's life;

however, no profit is recorded until project is completed

Example: Building a hotel for €40 million, cost to build is

€32 million; cost incurred in Year 1 is €6.4 million
Revenue = 6.4m; expense = 6.4m; income = 0
On completion/final year:
Income = €8m

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Percentage-of-Completion (POC) vs. Completed
Contract (CC) Method

■ Net income is higher for POC because CC does not

recognize revenue until completion
t Net income ^ T Equity (until final year)
■ Income volatility is greater with CC method because
POC recognizes some revenue and income each year
instead of all at one time
■ Cash flowis the same for both (CF is unaffected by the
revenue recognition method used)

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New method for long term reve
recognition long term contract

Installment sale

Cost recovery method

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Installment Sales Method - Examples

■ During 20X0, Cook, Inc. sold $20,000 of inventory on

installment, with a cost of $10,000.

■ During 20X0 and 20X1, Cook collected $8,000 and

$12,000, respectively, of its receivables. Under the
installment method, what are the sales and gross profit to
be reported in each of the two years?

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Installment Sales Method - Solution

20X0 20X1
Sales 8,000 12,000
(6,000)
6,000

$8,000 $12,000 x $10,000

x $10,000
$20,000 $20,000

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Cost Recovery Method - Example

During 20X0, Cook, Inc. sold $20,000 of services, but the

cost of providing this service was unclear at the outset of the
contract. During 20X0 and 20X1, Cook collected $8,000 and
$12,000, respectively, of its receivables. The project was
completed during 20X1, at which time the company had
incurred total costs of $10,000.

Under the cost recovery method, what are the sales and
gross profit to be reported in each of the two years?

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Cost Recovery Method - Solution

20X0 20X1
Sales 8,000 12,000
Cost of sales (8,000) (2,°°°)
Gross profit 0 10,000

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Installment Sales: IFRS

■ Present value of the installment payments is recognized at

the time of sale
■ Difference between installment payments and the
discounted present value is recognized as interest over time
■ If outcome of the project cannot be estimated reliably,
revenue recognition under IFRS is similar to cost recovery
method

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Barter

■ Exchange of goods or services between two parties (no

exchange of cash)
■ A agrees to exchange inventory for a service provided by B
■ IFRS: Revenue = fair value of similar non-barter transactions
with unrelated parties
■ U.S. GAAP: Revenue = fair value only if the company has
received cash payments for such services historically
(otherwise record sale at carrying value of asset)

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 Gross vs. Net Reporting

■ Internet-based merchandising companies

■ Sell product but never hold in inventory
■ Arrangement for supplier to ship directly to end
customer
$ Sales commission
Revenue 100
w .£ $
Cost of good sold 80 Net sale 20
W Gross profit 20

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Gross vs. Net Reporting

U.S. GAAP: Report gross if company:

■ Is primary obligator
■ Bears inventory risk
■ Bears credit risk
■ Can choose supplier
■ Has latitude to set price

If criteria are not met, then company is acting as an agent:

report net

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Implications for Analysis

Review revenue recognition policies in footnotes:

■ Earlier revenue recognition-aggressive
■ Later revenue recognition-conservative
■ Consider estimates used in methods
■ Assess how different policies would affect financial ratios

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Expense Recognition
■ Accrual basis-matching principle
■ Match costs against associated revenues
■ Examples
■ Inventory
■ Depreciation/amortization
■ Warranty expense
■ Doubtful debt
■
expense Period expenses
■ Expenditures that less directly match the timing of
revenues (e.g., admin costs)

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Expense categories
■
functional : cost of good sold (COGS)

Nature: SG@A

Systematic: amortization- depreciation- deplation

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Depreciation Methods

Match depreciation to asset's decrease in value over time:

■ Truck cost $20,000, will run 100,000 miles-depreciate at
$0.20 per mile used
■ Oil tanker will last 25 years and then be sold for scrap-
use straight-line depreciation
■ DVDs purchased for rental decrease rapidly in value the
first year-use accelerated depreciation

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Amortization
■ Amortization of intangible assets (e.g., patents)
■ Spreading cost over life
■ If the earnings pattern cannot be established, use
straight line (IAS 38)
■ IFRS and U.S. GAAP firms both typically amortize
straight-line with no residual value
■ Goodwill not amortized-checked annually for
impairment

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What's the differences between
Cost and expenditure
■ capitalization versus expensing
■ capitalization of interest cost

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Accounting Changes

2. Change in accounting estimate (e.g., change in the

estimated useful life of a depreciable asset)
■ Does not require restatement of prior period
earnings
■ Disclosed in footnotes
■ Typically, changes do not affect cash flow

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Accounting Changes

Prior period adjustments

■ Correcting errors or changing from an incorrect
accounting method to one that is acceptable under GAAP
■ Typically requires restatement of prior period financial
statements
■ Must disclose the nature of the error and its effect on
net income

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Non-Operating Items

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 Simple vs. Complex Capital Structures

■ A simple capital structure contains no potentially dilutive

securities
■ Firm reports only basic EPS

■ A complex capital structure contains potentially dilutive

securities

■ Firm must report both basic and diluted EPS

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Dilutive vs. Antidilutive Securities
Potentially dilutive securities:
■ Stock options
■ Warrants
■ Convertible debt
■ Convertible preferred stock
■ Dilutive securities decrease EPS if exercised or
converted to common stock
■ Antidilutive securities increase EPS if exercised or
converted to common stock

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 Calculating Basic EPS

Basic Net income - preferred dividends

EPS Weighted average # common stock

■ Net income minus preferred dividends equals earnings

available to common stockholders
■ Note that common stock dividends are not subtracted
from net income

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Stock Dividends and Stock Splits

■ A 10% stock dividend increases shares outstanding by 10%

■ A 2-for-1 stock split increases shares outstanding by 100%
■ In calculating the weighted average shares outstanding, stock
dividends and splits are applied retroactively to the beginning
of the year, or the stock's issue date for new stock
■ Although weighted average shares are actually based on days,
the exam is likely to use months

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Calculating the Weighted-Average
Number of Shares Outstandin

1/1/X3 Shares outstanding 10,000

4/1/X3 Shares issued 4,000

7/1/X3 10% stock dividend

9/1/X3 Shares repurchased 3,000

Shares adjusted for the 10% dividend:

1/1/X3 Initial shares (x 1.1) 11,000

4/1/X3 Shared issued (x 1.1) 4,400

9/1/X3 Shares repurchased (no adj.) 3,000

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Calculating the Weighted-Average
Number of Shares Outstandin

Initial shares (11,000) (12 months) 132,000

Shares issued (4,400) (9 months) 39,600
Shares repurchased (3,000) (4 months) (12,000)
Total weighted shares 159,600
Weighted average shares outstanding 13,300
159,600 / 12

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Diluted Earnings Per Share
Include only if
Security is
dilutive
/
f convertible ^ f convertible ^
(net income - preferred dividends ) + preferred + debt (1 -1)
v dividend J v interest J
fweighted ^ f shares from ^ f shares from ^ f shares ^
average + conversion of + conversion of + issuable from
shares y Kconv .pfd shares y Kconv debt y Koptions /warrants y

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Checking for Dilution

■ Only those securities that would reduce EPS below

basic EPS if converted are used in the calculation of
diluted EPS

Conv. pfd: is dividends/new shares < basic?

Conv. debt: is interest (1 -1) / new shares < basic?
Options and warrants: is avg. price > ex. price?

If answer is yes, the security is dilutive

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Diluted EPS - Example
Earnings available to common,
year to 12/31 /X1 Common $4,000,000
stock Basic EPS 2,000,000 sh.
$2.00

$5,000,000 of 7% convertible preferred stock is outstanding

all year. The terms of conversion are that every $10 nominal
value of preferred stock can be converted to 1.1 common
shares.

Calculate fully diluted EPS for 20X1.

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Convertible Preferred Stock -Example

$
Earnings available to common
4,000,000
Add: Preferred dividend saved 350,000
4,350,000

No. of common stock shares if preferred shares were

converted: Outstanding all year 2,000,000
On conversion $5,000,000 / 10 x1.1 550,000

2,550,000

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Convertible Bonds - Example
Earnings available to common, year to 12/31/X1
$2,500,000
Common stock 1,000,000 sh.
Basic EPS $2.50
Tax rate 30%
$2,000,000 par value of 5% convertible bonds have been
outstanding all year. Each $ 1,000 par value convertible
bond can be converted to 120 common shares.

Calculate fully diluted EPS for 20X1.

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Diluted EPS - Convertible Bond - Example

$$
Earnings available to 2.500.000
100,000
common Add: Interest
(30,000)
saved Less: Tax @ 30%
70,000
2.570.000

No. of common shares if bonds were

converted: Outstanding 1,000,000
On conversion $2,000,000 / $1,000 x 120 240,000
1,240,000

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Dilutive Stock Options – Treasury Stock Method

Dilutive only when the exercise price is less than the

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

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Dilutive Employee Stock Options - Example

Earnings for equity in year to 31/Dec/X1 $1,200,000

Weighted average no. of common stock shares 500,000
Average price of common stock during year $20
Exercise price $15

Number of options outstanding in the year 100,000

Basic EPS $2.40

Calculate diluted EPS for 20X1.

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| Dilutive Stock Options - Example ^

Step 1 - Assume all options are exercised

Shares issued = 100,000
Step 2 - Calculate Cash Proceeds
Proceeds if all options exercised: 100,000 X$15 = $1,500,000
Step 3 - Calculate number of shares that can be bought at
average price
$1,500,000
$20 = 75,000 shares
Step 4 - Calculate Net Increase In Common Stock
Total shares needed 100,000
Shares "purchased" with proceeds 75,000
Number of new shares needed 25,000

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Dilutive Stock Options - Solution

$1,200,000
Diluted EPS: $2.29
525,000

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New method for calculating

Average share price - exercise price

Average share price

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Vertical Common-Size Income Statements

Income statement account Marketing expense

Sales Sales

■ Converts income statement to relative percentages

■ Useful for comparing entities of differing sizes
■ Compare % to strategy in MD&A
■ Time series or cross-section use
■ Gross and net profit margin are common-size ratios

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 Comprehensive Income
Comprehensive income =
Net income + Other comprehensive income
Net income from income statement X
A Foreign currency translation adjustment X/(X)
Comprehensive

A Minimum pension liability adjustment X/(X)

Income

A Unrealized gains or losses on derivatives X/(X)

Other

contracts accounted for as hedges A

Unrealized gains and losses on available
for sale securities X/(X)

Comprehensive income X

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 1. Expenses on the income statmens may be grouped by ?
A. Nature, but not by function
B. Function, but not by nature
C. Either function or nature

2. -Are income taxes and cost: of" goods sold examples of" expenses classified by nature or
classified by Function in the income statement?

Income TaXGif Cost oF goods sold

A. Nature Function
B. Function Nature
C. Function Function

3. Which of the Following is least likely a condition necessary For revenue recognition?
A. Cash has been collected.
B. The goods Have been delivered.
C. The price has been determined.

.
4. AAA. has a contract to build a building For $100,000 with an estimated time
to completion of three years. A reliable cost estimate for the project is
$60,000. In the first year of the project, AAA incurred costs totaling $24,000.
How much profit should AAA report at the end of the first year under the
percentage-of-completion method and the completed—contract method?
Percentage-of-completion Completed-con tract
A. $16,000 $O
B. $16,000 $40,000
C. S-40,000 $O
5- Which principle requires that cost of goods sold he recognized In the same
period in which the sale of the related inventory is recorded?
A. Going concern.
B. Certainty.
C. Matching.
6. Which of the following would least likely increase pretax income?
A. Decreasing the bad debt expense estimate.
B_ Increasing the useful life of an intangible asset.
C. Decreasing the residual value of a depreciable tangible asset.
7- Which of the following best describes the impact of
depreciating equipment with a useful life of 6 years using the
declining balance method as compared to the straight-line
method?
A. Total depreciation expense will be higher over the life of
the equipment.
B. Depreciation expense -will be higher in the first year.
C. Scrapping the equipment after five years will result in a
larger loss.
8. CC Corporation reported the following inventory transactions (in chronological order)

1 III
for the year:
Pttrchu.se Sules

40 units a.t $30 13 units at $35

20 Lin its at $40 35 units at $45
90 Lin its at $50 60 Li n its at $<50

Assuming inventory at the beginning of the year was zero, calculate the year-end inventory
using FIFO and LIFO.
FIFO LIFO
A. $5,220 $ 1,040
B. $2,1 OO $ 1 ,280
C. $2,1 OO $ 1 ,040

1 2.
9. At the beginning of the year, Triple W Corporation purchased a new piece of

1 III
equipment to be used in its manufacturing operation. The cost of the equipment
was $25,000. The equipment is expected to be used for 4 years and then sold for
$4,000. Depreciation expense to be reported for the second year using the double-
declining-balance method is closest to:
A. $5,250.
B. $6,250.
C. $7,000.
11 'Which of the following transactions would most likely be reported below income
from continuing operations, net of tax?
A. Gain or loss from the sale of equipment used in a firm’s manufacturing operation.
B. A change from the accelerated method of depreciation to the straight-line method.

C. The operating income of a physically and operationally distinct division that is currently for sale, but not yet sold.

12. Which of the following statements about nonrecurring items is least accurate?
A_ Gains from extraordinary items are reported net of taxes at the bottom of the income statement
before net income.
B. Unusual or infrequent items are reported before taxes above net income from continuing
operations.
C. A change in accounting principle is reported in the income statement net of taxes after extraordinary items and before
net income.
13. The Hall Corporation had 100.000 sharers of common stock outstanding at the
beginning of the year. Wall issued 30,000 shares of common stock: on May 1.
On July 1, the company issued a 10% stock: dividend. On September 1, Wall issued 1,000,
10% bonds, each convertible into 21 shares of common stock.. What is the weighted
average number of shares to be used in computing basic and diluted EPS, assuming the
convertible bonds arc dilutive?
Average shares, Average shares,
basic dilutive
A. 132,000 139,000
B. 132.000 1 -46,000
C. 139,000 1 -46,000
14 Given the following information, how many shares should he used in computing
diluted EPS?
• 300,000 shares outstanding.
• 1 00,000 warrants exercisable at $50 per share.
• Average share price is S5 5-
• Year-end share price is $60.
A. 9,091.
B. 90,909.
C. 309,091.

15. An analyst gathered the following information about a company!

• 1 00,000 common shares outstanding from the beginning of the year.
• Earnings of $ 125,000.
• 1,000, 7, $1,000 par bonds convertible into 25 shares each, outstanding as of
the beginning of the year.
• The tax rare is 40%.

The company’s diluted EPS is closest to:

A. SI-22.
B. SI.25.
C. SI-34.
16 An analyst has gathered the following information about a company:
• 50,000 common shares outstanding From the beginning of the year.
• 'Warrants outstanding all year on 50,000 shares, exercisable at $20 per share
• Stock is selling at year end For $25-
• The average price of the company’s stock For the year was $151 low
many shares should be used in calculating the company’s diluted EPS?
A. 16,667.
B. 50,000.
C. 66,667.
17 Which of the following transactions afreets owners’ equity but does not affect
net income?
A. Foreign currency translation gain.
B. Repaying the Face amount on a bond issued at par.
C. Dividends received from available-for-sale securities.

18 Which of the following is least likely to be included when calculating

comprehensive income?
A. Unrealized loss from cash flow hedging derivatives.
B. Unrealized gain from available-for-sale securities.
C. Dividends paid to common shareholders.
19. A vertical common-size income statement expresses each category of the
income statement as a percentage of:
A. assets.
B. gross profit.
C- revenue.

20 Which of the following would most likely result in higher gross profit
margin, assuming no fixed costs?
A. A 10% increase in the number of units sold.
B. A 5% decrease in production cost per unit.
C. A 7% decrease in administrative expenses.
Learning module 3-
analyzing Balance Sheets

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Balance Sheet Analysis

Uses of balance sheet analysis

■ Assessing liquidity, solvency, and ability to make
distributions to shareholders
Limitations
■ Mixed measurement conventions:
■ Historic cost
■ Amortized cost
■ Fair value
■ Fair values may change after balance sheet date
■ Off-balance-sheet assets and liabilities

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Balance Sheet Format

■ Report format
■ Assets, liabilities, and equity in a single column
■ Account format
■ Assets on the left
■ Liabilities and equity on the right
■ Classified balance sheet
■ Grouping of accounts into sub-categories:
■ Current vs. non-current
■ Financial vs. non-financial
■ Liquidity-based presentation (financial
institutions)
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Current Assets
■ Current assets include cash and other assets that will
likely be converted into cash or used up within one year
or one operating cycle, whichever is greater
■ The operating cycle is the time it takes to produce or
purchase inventory, sell the product, and collect the cash
■ Current assets presented in the order of liquidity
■ Current assets reveal information about the operating
activities/capacity of the firm

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Current Assets
■ Cash and cash equivalents: amortized cost or fair value
■ Marketable securities: amortized cost or fair value
■ Accounts receivable/trade receivables: net realizable
value
■ Inventories:
■ Raw materials, work in process, finished goods
■ Manufacturing (standardized costs)
■ Cost flow methodology (FIFO, Avco, LIFO)
■ Prepaid expenses: historic cost
■ Deferred tax assets: net of valuation allowance

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Noncurrent Assets
■ Assets held for continuing use within the business, not
resale
■ Assets not consumed or disposed of in the current
period
■ Represent the infrastructure from which the entity
operates
■ Provides information on the firm's investing activities

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Accounting for Long-Term Assets
Long-term assets convey benefits over time
■ Tangible assets (e.g., land, buildings, equipment, natural
resources)
■ Intangible assets (e.g., copyrights, patents, trademarks,
franchises, and goodwill)
■ Investment property (IFRS only)-generates
investment income or capital appreciation
Plant, property, and equipment recorded at purchase cost
including shipping and installation, or construction cost
including labor, materials, overhead, and interest

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Intangible Assets
■ Identifiable intangible
■ Can be acquired singularly, linked to rights and
privileges having finite benefit periods
■ Amortized over estimated useful life
■ Unidentifiable intangible
■ Cannot be acquired singularly and has indefinite
benefit period (e.g., goodwill)
■ Not amortized
■ Annual impairment review

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 Intangible Assets
■ May only be recognized if they can be measured reliably
■ Generally excludes internally generated intangibles-
subjectivity
■ Typical intangibles:
■ Purchased patents and copyrights
■ Purchased brands and trademarks
■ Purchased franchise and licence costs
■ Direct response advertising
■ Goodwill
■ Computer software development costs

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Expensed Items
■ Internally generated brands, mastheads,
■ publishing titles, customer lists, etc.
■ Start-up costs
■ Training costs
■ Administrative and general overhead
■ Advertising and promotion
■ Relocation and reorganization costs
■ Redundancy and termination costs
■ Research and development (Development may be
capitalized under IFRS)

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Goodwill

Goodwill is the difference between acquisition price and the

fair market value of the acquired firm's net assets
The additional amount paid represents the amount paid for
assets not recorded on the balance

Fair value
$ involves
Acquisition price X management
FMV net assets acquired (X) discretion -
Goodwill X goodwill is
not
amortized!
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Goodwill Analysis

■ Impairment indicates that goodwill often results from

overpayment to acquire entity
■ Remove the impact of goodwill from ratios
■ Remove goodwill from assets
■ Remove any impairment from income statement
■ Evaluate business acquisitions considering:
■ Purchase price
■ Net assets
■ Earnings prospects

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Financial Assets/Liabilities
■ Stocks
■ Bonds
■ Receivables
■ Notes receivable
■ Notes payable
■ Loans
■ Derivatives

122

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Fair Value Assets and Liabilities
Financial assets
■ Trading securities
■ Available-for-sale securities
■ Derivatives (standalone or embedded in a non-
derivative instrument)
■ Assets with fair value exposures hedged by derivatives
Financial liabilities
■ Derivatives
■ Non-derivative investments with fair value exposures
hedged by derivatives

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Cost or Amortized Cost
Financial assets
■ Unlisted instruments
■ Held-to-maturity investments
■ Loans
■ Receivables
Financial liabilities
■ All other liabilities (e.g. bonds, notes payable, etc.)
Amortized cost is equal to the original issue price minus any principal
payments, plus any amortized discount or minus any amortized premium,
minus any impairment losses.

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Marketable Securities
Classification of securities based on company’s intent with
regard to eventual sale:
Held-to- ■ Debt securities which the company intends to
hold to maturity Securities are carried at cost I/S
maturity
■ income and realized gains/(losses) on disposal
securities
■

■ May be sold to satisfy company needs

Available ■ Debt or equity
- ■ Current or non-current
■ Carried on balance sheet at market
for-sale
value
securities ■ Income statement unrealized G/L to
OCI

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Marketable Securities

Trading ■ Acquired for the purpose of selling in

the near term
securities
■ Carried on the balance sheet as current
assets at market value
■ Income statement includes dividends,
realized and unrealized gains/losses
■ Derivative instruments are treated as
trading securities

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Classification of Securities:

■ Dividends, interest, and realized gains always appear on

the income statement
■ Unrealized G/L only affect the income statement for
trading securities
■ Unrealized G/L are reflected on the balance sheet for
both trading and available-for-sale securities
■ Unrealized G/L on available-for-sale securities show up
as other comprehensive income, not on income statement

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Current Liabilities

Satisfies any of the following 4 criteria:

1. Expected to be settled in the entity's normal operating
cycle
2. Held primarily for the purpose of being traded
3. Is due to be settled <12 months from the balance sheet
date
4. The entity does not have a right to defer settlement for
>12 months
All other liabilities-noncurrent

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Current Liabilities

■ Accounts payable/trade payables

■ Notes payable
■ Current portion of long-term debt
■ Accrued liabilities
■ Taxes payable
■ Unearned revenue

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Components of Equity

■ Capital contributed by owners

■ Issued and authorized
■ Preferred stock (irredeemable)
■ Treasury stock (reduces equity)
■ Retained earnings
■ Noncontrolling (minority) interest
■ Accumulated other comprehensive income

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 Statement of Change in Stockholders’ Equity
Accumulated
Retained Other
Common Earnings (in Comprehensive Total
Stock thousands) Income (loss)
Beginning balance $49.134 $26.664 ($406) $75.492
Net income 6.994 6.994
Net unrealized loss on available- (40) (40)
for-sale securities
Net unrealized loss on cash flow (56) (56)
hedges
Adjustments to net pension (26) (26)
liability
Cumulative translation 42 42
adjustment
Comprehensive income 6,914
Issuance of common stock 1.282 1,282
Repurchases of common stock (6.200) (6,200)
Dividends (2,360) (2,360)
Ending balance $44.316 $31.298 ($486) $75.128

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Vertical Common-Size Income Statements

Balance sheet account

Inventory
Total assets
Total assets

Uses:
Comparisons over time (trend analysis)
Cross-sectional comparisons

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Liquidity Ratios

Current assets
Current ratio
Current
liabilities
Current assets —
Quick ratio
inventory Current
liabilities
Cash + marketable
Cash ratio
securities Current liabilities

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Solvency Ratios

Long-term debt Total long — term

to equity debt Total equity
Total debt
Debt to equity
Total equity

Total debt
Total debt
Total assets

Total assets
Financial leverage
Total equity

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1. Which of the following is most likely an essential characteristic of an asset?
A. An asset is tangible.
B. An asset is obtained at a cost.
C. An asset provides future benefits.

2 . Which of the following statements about analyzing the balance sheet is most
accurate?
A. The value of the firm’s reputation is reported on the balance sheet at amortized
cost.
B. Shareholders’ equity is equal to the intrinsic value of the firm.
C. The balance sheet can be used to measure the firm’s capital structure.
4. which of the following would most likely result in a current liability?
A. Possible warranty claims.

B. Future operating lease payments.

C. Estimated income taxes for the current year.

5. How should the proceeds received from the advance sale of rickets to a
sporting event be treated by the seller, assuming the tickets are
nonrefundablc?
A. . Unearned revenue is recognized to the extent that costs have been incurred.

B. Revenue is recognized to the extent that costs have been incurred.

C. Revenue is deferred until the sporting event is held.
6. A vertical common-size balance sheer expresses each category of the
balance sheet as a percentage of:
A. assets.
B. equity.
C. revenue.

7. Which of the following inventory valuation methods is required by the

accounting standard-setting bodies?
A. Lower of cost or net realizable value.
B. Weighted average cost.
C. First-in, first-out.

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8. SF Corporation has created employee goodwill by reorganizing its retirement
benefit package. An independent management consultant estimated the value
of the goodwill at $2 million. In addition, SF recently purchased a patent that
was developed by a competitor. The patent has an estimated useful life of five
years. Should SF report the goodwill and patent on its balance sheet?
Goodwill Patent
A. Yes No
B. No Yes
C. No No

9. At the beginning of the year, Parent Company purchased all 500,000 shares of
Sub Incorporated for $15 per share. Just before the acquisition date, Sub’s
balance sheet reported net assets of $6 million. Parent determined the fair
value of Subs property and equipment was $ 1 million higher than reported by
Sub. What amount of goodwill should Parent report as a result of its
acquisition of Sub?
A. $0.
B. $500,000.
C. $1,500,000.

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1. C An asset is a future economic benefit obtained or controlled as a result of past
transactions. Some assets are intangible (e.g., goodwill), and others may be donated.
2. C The balance sheet lists the firm’s assets, liabilities, and equity. The capital structure is
measured by the mix of debt and equity used to finance the business.
3. A A classified balance sheet groups together similar items (e.g., current and noncurrcnt
assets and liabilities) to arrive at significant subtotals.
4. C Estimated income taxes for the current year are likely reported as a current liability. To
recognize die warranty expense, it must be probable, not just possible. Future operating
lease payments are not reported on the balance sheet.
5. C The ticket revenue should not be recognized until it is earned. Even though the tickets
are nonrefundable, the seller is still obligated to hold the event.
6. A Each category of the balance sheet is expressed as a percentage of total assets.
7. A Inventories are required to be valued at the lower of cost or net realizable value (or
“market” under U.S. GAAP). FIFO and average cost are two of the inventory cost flow
assumptions among which a firm has a choice.
8. B Goodwill developed internally is expensed as incurred. The purchased patent is
reported
on the balance sheet.
9. B Purchase price of $7,500,000 [$15 per share x 500,000 shares] - fair value of net
assets of $7,000,000 [$6,000,000 book value + $ 1,000,000 increase in property and
equipmentj = goodwill of $500,000.
Learning 4,5-
analyzing
Statements of
cash flows

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Importance of Cash Flow Statement

Net income from accrual accounting does not tell us about

the sources and uses of cash to meet liabilities and
operating needs
The statement of cash flows has three components under
both IFRS and U.S. GAAP:

■ Cash provided or used by operating activities

■ Cash provided or used by investing activities

■ Cash provided or used in financing activities

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Operating Cash Flows (CFO)

$
Cash received from customers X
Cash dividends received X
Cash interest received X
Other cash income X
Payments to suppliers (X)
Cash expenses (wages, etc.) (X)
Cash interest paid (X)
Cash taxes paid (X)
CFO X/(X)

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Investing Cash Flows (CFI)

■ Purchases of property, plant, and equipment

■ Proceeds from sales of assets
■ Investments in joint ventures and affiliates
■ Payments for businesses acquired
■ Purchases and sales of intangibles
■ Purchases or sales of marketable securities Excludes:
❖ Trading securities (part of CFO)

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Financing Cash Flows

■ Issue and redemption of:

■ Common stock
■ Preferred stock
■ Treasury stock repurchases
■ Debt
■ Dividend payments (dividends rec'd CFO-U.S. GAAP)

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Non-Cash Investing and Financing Activities

■ Several types of transactions do not involve the payment

or receipt of cash and are not reflected in financing and
investing cash flows, but are disclosed in the footnotes or
other schedules
Non-cash financing and investing activities:
■ Converting debt or preferred into common equity
■ Assets acquired under capital leases
■ Purchase of assets via issuance of debt/equity
■ Exchanging one non-cash asset for another
■ Stock dividends

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 U.S. GAAP vs. IFRS

Interest received CFO CFO or CFI

Interest paid CFO CFO or CFF
Dividends received CFO CFO or CFI
Dividends paid CFF CFO or CFF
Taxes paid CFO CFO or CFI & CFF
Bank overdraft CFF *

* Considered part of cash and cash equivalents

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Statement of Cash Flow:
Direct vs. Indirect Method
Direct vs. indirect method refers only to the calculation of
CFO; the value of CFO is the same for both methods; CFI
and CFF are unaffected
■ Direct method: Identify actual cash inflows and
outflows (e.g., collections from customers, amounts paid to
suppliers)
■ Indirect method: Begin with net income and make
necessary adjustments to get operating cash flow

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Cash Inflows and Outflows
General rules regarding increases and decreases in balance
sheet items over time:
Increase Decrease
Assets outflow inflow
Liabilities & Equity inflow outflow

e.g.: An increase in AR or inventory uses cash

An increase in payables generates cash Adjust net

income for these changes (indirect)

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Indirect Method CFO
Steps
1. Start with net income
2. Adjust net income for changes in relevant balance sheet
items:
Increases in an asset:
deduct Increase in a
liability: add Decrease in
an asset: add Decrease in a
liability: deduct

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Indirect Method (continued)

3. Eliminate depreciation and amortization by adding them

back (they've been deducted in arriving at net income
but are non-cash expenses)

4. Eliminate gains on disposal by deducting them and losses

on disposal by adding them back (these are CFI, not
CFO)

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Calculating CFI

CFI =
investment in assets - cash received on asset sales

Net book value =

Gross PPE - accumulated depreciation

Gain (loss) on sale = sales price - net book value

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CFI - Problem
Last year Acme Corp. bought an asset for $72,000,
depreciation expense was $15,000, accumulated
depreciation increased by $5,000, and gross PPE increased
by $32,000. If a gain on an asset sold during the year was
$13,000, the sales proceeds on the asset sale were:
A. $30,000.
B. $43,000.
C. $48,000.

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Computing CFF

■ Change in debt
■ Change in common stock
■ Cash dividends paid

$ $
Net income X Dividends declared (X)
/••
Dividends declared (X) A Dividends payable X

Ain retained earnings X Cash paid (X)

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 Converting an Indirect Statement to a
Direct Statement of Cash Flows
Most firms use the indirect method, but the analyst may
want information on the cash flows by function; some
examples of this technique are:
Net sales - A accounts receivable + A advances from
customers = cash collections
Cost of goods sold -Ainventory + Aaccounts payable = cash
paid for inputs
Interest expense +Ainterest payable = cash interest

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 Direct Method From Indirect CFO

1. Take each income statement item in turn (e.g., sales)

2. Move to the balance sheet and identify asset and liability
accounts that relate to that income statement item-e.g.,
accounts receivable
3. Calculate the change in the balance sheet item during the
period (ending balance - opening
balance)
Increases in an asset:
4. Apply the rule: deduct Increase in a
liability: add Decrease in
an asset: add Decrease in a
liability: deduct
w w w. i r f i n a n c e . i r
Direct From Indirect CFO

5. Adjust the income statement amount by the change in

the balance sheet
6. Tick off the items dealt with in both the income
statement and balance sheet
7. Move to the next item on the income statement and
repeat
8. Ignore depreciation/amortization and gains/losses on
the disposal of assets as these are non-cash or non-CFO
items

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Direct From Indirect CFO

9. Keep moving down the income statement until all items

included in net income have been addressed applying
steps 1-8
10. Total up the amounts and you have CFO

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Cash Flow Statement Analysis

Do regular operations generate enough cash to sustain

the business?
Is enough cash is generated to pay off maturing debt?
The flexibility to take advantage of new business
opportunities

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Analysis

1. Analyze the major sources and uses of cash flow (CFO,

CFI, CFF)
■ Where are the major sources and uses?
■ Is CFO positive and sufficient to cover capex?
2. Analyze CFO
■ What are the major determinants of CFO?
■ Is CFO higher or lower than NI?
■ How consistent is CFO?

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Analysis
3. Analyze CFI
■ What is cash being spent on?
■ Is the company investing in PP&E?
■ What acquisitions have been made?
4. Analyze CFF
■ How is the company financing CFI and CFO?
■ Is the company raising or repaying capital?
■ What dividends are being returned to owners?

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Common Size Statements

Two Approaches

Show each item as Show each inflow as

a % of net a % of total inflows
revenue
Show each outflow as
a % of total outflows

Useful for:
Trend analysis (time series)
Forecasting future cash flows (% of net
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 Free Cash Flow (FCF)

■ FCF is cash available for discretionary uses

■ Frequently used to value firms

■ FCFF = NI + NCC - WClnv + Int (1-T) - FClnv

■ FCFF = CFO + Int (1-T) - FClnv

■ FCFE = CFO - FClnv + Net debt increase

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Cash Flow Performance Ratios

CFO
Cash flow to revenue Net revenue
CFO
Cash return on assets
Avg total assets

Cash return on equity CFO

Avg equity
CFO
Cash to income
Cash Flow Performance Ratios

CFO — pref
Cash flow to per share*
div # common
stock

*IFRS: If dividends paid

were treated as CFO,
they must be added back

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Cash Flow Coverage Ratios
CFO
Debt coverage
Total debt
CFO + interest + tax interest
Interest coverage*
paid
CFO
Reinvestment
Cash paid for long — term
assets
*IFRS: If interest paid
was treated as CFF, no
addition is required

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Cash Flow Coverage Ratios

CFO
Debt payment
Cash paid for long —
term debt repayment
CFO
Dividend payment
Dividends paid CFO
Investing and financing Cash outflow for CFI &
CFF

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Assuming U.S. GAAP, use the Following data, to answer Questions 2 through 4.

Net income $-45

Depreciation 75
'Faxes paid 25
Interest paid 5
Dividends paid 10
Cash received from sale oF company building -40
Issuance of preferred stock: 35
Repurchase oF common stock 30
Purchase oF machinery 20
Issuance oF bonds 50
Debt retired through issuance of common stock -45
Paid oil long-term bank, borrowings 1 5
Profit on sale oFbuilding 20

2. Cash flow from operations is:

A. $70.
B. $100.
C. $120.
3. Cash flow from investing activities is:
A. -$30.
B. $20.
C. $50.

4 Cash flow from financing activities is:

A. $30.
B. $55.
C. $75.
Sales $1,500
5. Given the following: Increase in inventory 100
Depreciation 150
Increase in accounts receivable 50

Decrease in accounts payable 70

After-tax profit margin 25%

Gain on sale of machinery $30

Cash flow from operations is:
A. $115.
B. $275.
C. $375.
6. Which of the following items is least likely considered a cash flow from financing
activity under U.S. GAAP?
A. Receipt of cash from the sale of bonds.
B. Payment of cash for dividends.
C. Payment of interest on debt.

7. Which of the following would be least likely to cause a change in investing cash flow?
A. The sale of a division of the company.
B. The purchase of new machinery.
C. An increase in depreciation expense.

8 Which of the following is least likely a change in cash flow from operations under
U.S. GAAP?
A. A decrease in notes payable.
B. An increase in interest expense.
C. An increase in accounts payable.
Where are dividends paid ro shareholders reported in the cash flow sraremcnr under
LJ.S. GAAP and IFRS?
FJ.S. GAAP IFRS
A. Operating or financing activities
Operating or financing activities Operating or
B. Financing activities financing activities Financing activities
C. Operating activities
Sales of inventory would h>e classified as:
A. operating cash flow.
B. investing cash flow.
C. financing cash flow.
Issuing bonds would t>e classified as:
A. investing cash flow.
B. financing cash flow.
C. no cash flow impact.

Sale of land would t»e classified as:

A. operating cash flow.
B. investing cash flow.
C. financing cash flow.

Under U.S. GAAP, taxes paid would he classified as:

A. operating cash flo-w.
B. financing cash flow.
C. no cash flow impact.
A.n increase in notes payable would be classified as:
A. investing cash flow.
B. financing cash flow.
C. no cash flow impact.
Under U.S. GAAP, interest paid would be classified as:
A. operating cash flow.
B. financing cash flow.
C. no cash flow impact.
Continental Corporation reported sales revenue of $150,000 for the
current year. If accounts receivable decreased $1 0,000 during the
year and accounts payable increased $4,000 during the year, cash
collections were:
A. $154,000.
B. $160,000.
C. $164,000.

The write-off of obsolete equipment would be

classified as:
A. operating cash flow.
B. investing cash flow.
C. no cash flow impact.
Sale of obsolete equipment would be classified as:
A. operating cash flow.
B. investing cash flow.
C. financing cash flow.
Under IFRS, interest expense would be classified as:
A. either operating cash flow or financing cash flow.
B. operating cash flow only.
C. financing cash flow only.
Depreciation expense would be classified as:
A. operating cash flow.
B. investing cash flow.
C. no cash flow impact.
Under X_T.S. GAAP, dividends received from investments would be classified as:
A. operating cash flow.
B. investing cash flow.
C2. financing cash flow.
Torval, Inc. retires debt securities by issuing equity securities. "This is considered
a:
A. cash flow front investing.
B. cash flow from financing.
C. noncash transaction.
Net income for Monique, Inc. for the year ended December 31, 20X7
was $78,000. Its accounts receivable balance at December 3 1, 20X7
was S 12 1.000, and this balance was $69,000 at December 31,
20X6. The accounts payable balance at December 31, 20X7 was
$72,000 and was $43,000 at December 3 1, 20X6. Depreciation for
20X7 was $ 12,000, and there was an unrealized gain of $15,000
included in 20X7 income from the change in value of trading
securities. Which of the following amounts represents Monique’s
cash flow from operations for 20X7?
A. $52,000.
B. $62,000.
C. $82,000.
CFI - Solution

Last year Acme Corp. bought an asset for $72,000,

depreciation expense was $15,000, accumulated
depreciation increased by $5,000, and gross PPE increased
by $32,000. If a gain on an asset sold during the year was
$13,000, the sales proceeds on the asset sale were:

B. $43,000.
72.000 - 32,000 = 40,000 Gross value (cost) of
asset
15.000 - 5,000 = 10,000 Accum. depreciation of
asset
40.000 - 10,000 = 30,000 Net book value of asset
30.000 + 13,000 = 43,000 Sale proceeds of asset
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Learning module 6-analysis of
inventories

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Inventory Equation

Beg. Inv + Purchases - COGS = End Inv

or
Beg. Inv + Purchases - End Inv = COGS

Beginning inventory (Bl) X

Purchases (P) X
Available for sale Ending X
inventory (EI) (X)
Cost of goods sold (COGS) X

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Inventory Costs

■ Product costs are capitalized as inventory

■ Purchase cost less discounts and rebates
■ Conversion costs including labor and overhead
■ Other costs necessary to bring the inventory to its
present location
■ Period costs are expensed when incurred
■ Abnormal waste
■ Storage costs (unless a required production cost)
■ Selling and administrative costs

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 Capitalization of Inventory Cost - Example

Units produced Raw materials 1,500,000

Direct labor $10,000,000
Manufacturing overhead $5,300,000
Freight-in to plant Storage $2,700,000
cost of finished goods $150,000
Abnormal waste $375,000
Administrative costs $200,000
$190,000

Assuming no abnormal waste is included in labor or

overhead, calculate the capitalized cost of one unit.

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Capitalization of Inventory- Example

Materials Labor cost $10,000,000

Manufacturing $5,300,000 Conversion
Cost
overhead Freight-in to $2,700,000
plant Total capitalized $150,000
cost Units produced $18,150,000
Cost per unit 1,500,000
$12.10

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 Inventory Cost Flow Methods
4 Methods Description Ending COGS
Inventory
FIFO EI most recent Highest Lowest
purchases
LIFO (No IFRS) EI oldest purchases Lowest Highest

AVCO Average cost of units Middle Middle

available
EI actual cost of
Specific specific items included
Identification in EI
Note: Assuming rising prices and constant
or increasing inventory

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 Inventory Cost Flow and Price Changes

■ When prices are rising (as in the example):

1. FIFO provides an artificially low value of COGS
while LIFO is more useful (reflects current costs)
2. LIFO provides an artificially low value of ending
inventory while FIFO is more useful (reflects current
costs)

■ When prices are declining, the reverse is true

■ With stable prices, all methods result in the same COGS
and ending inventory

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Inventory Systems

■ Periodic System
■ Inventory and COGS are determined at the end of
the period
■ Beg Inv + Purchases - End Inv =
■
COGS Perpetual System
■ Inventory and COGS are continuously updated as
each sale occurs
■ No purchases account needed

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 LIFO vs. FIFO Inflationary Environment

COGS Higher Lower

Income
EBT Lower Higher
Statement
Taxes Lower Higher
NI Lower Higher
Inv Lower Higher
Balance _
W/C Lower Higher
Sheet
R/E Lower Higher
Statement of Cash CFO Higher Lower
Flows

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LIFO Reserve

• The LIFO reserve is an account used to bridge

the gap between FIFO and LIFO costs, when a
company uses the FIFO method to track its
inventory but reports under the LIFO method
in the preparation of its financial statements.

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

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LIFO Reserve
• For comparison purposes, it is also necessary to convert the LIFO firm's

COGS to FIFO COGS. The difference between LIFO COGS and FIFO COGS

is equal to the change in the LIFO reserve for the period. To convert

COGS from LIFO to FIFO, simply subtract the change in the LIFO reserve:
FIFO COGS = LIFO COGS - (ending LIFO reserve - beginning LIFO reserve)
Assuming inflation, FIFO COGS is lower than LIFO COGS, so subtracting the
change in the LIFOreserve from LIFO COGS makes intuitive sense. When
prices are falling, we still subtract the change in the LIFO reserve to convert
from LIFO COGS to FIFO COGS. In this case, however, the change in the LIFO
reserve is negative and subtracting it will result in higher COGS. This again
makes sense. When prices are falling, FIFO COGS is greater than LIFO COGS.

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LIFO Reserve
Example: Converting ending Inventory and COGS from LIFO to
FIFO
Witz Company, which uses LIFO, reported end-of-year inventory
balances of $500 in 20X5 and $700 in 20X6. The LIFO reserve
was $200 for 20X5 and $300 for 20X6. COGS during 20X6 was
$3,000. Convert 20X6 ending inventory and COGS to a FIFO
basis.
Answer:
Inventory:

lnvF = lnvL + LIFO reserve = $700 +

$300 = $1,000 COGS:
C0GSF =COGSL-(ending LIFO reserve-beginning LIFO reserve)
= $3,000 - ($300 - $200) = $2,900
LIFO liquation happens

• In periods of rising inventory unit

costs,carring value of inventory under FIFO
will always exceed LIFO.
• When the number of the inventory units
manufactured or purchased exceed the unit
sold, the LIFO reserve may increase as the
result of the addition of new LIFO layers.

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LIFO Liquidation
• LIFO liquidation happens when a company uses
the LIFO method of inventory costing, and
then liquidates its older LIFO inventory. A LIFO
liquidation occurs if current sales are higher
than its purchase of inventory, which, as a
result, forces the company to liquidate any
inventory not sold in a previous period. This
liquidation causes a distortion in a company's
net operating income, because the lower-cost
inventory is recognized on its income
statement.

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LIFO Liquidation
Example: LIFO liquidation
At the beginning of 20X8, Big 4 Manufacturing Company had 560
units of inventory as follows:
Year Number of Cost Per
Purchased Units Unit Total Cost
20X4 120 510 $1,200
20X5 140 11 1,540
20X6 140 12 1,680
20X7 160 13 2.080
560 $6,500

Big 4 reports inventory under LIFO. Due to a strike, no units were

produced during 20X8. During 20X8, Big 4 sold 440 units. In the
absence of the strike, Big 4 would have had a cost of $14 for
each unit produced. Compute the extra profit that resulted from
the inventory liquidation.
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LIFO Liquidation
Answer:

Because of the LIFO liquidation, actual COGS was $5,300 as

follows: Units Cost
Beginning Inventory -+ 560 $6,500
Purchases — Ending 0-
- 0-
-

Inventory" 120 1.200 ($10 x 120 units)

^ GOGS (Actual) 440 $5,300

Had Big 4 replaced the 440 units sold, COGS would have been $6,160 as follows:
Units Cost
Beginning Inventory ■+ 560 $6,500
Purchases — Ending 440 6,160
Inventory = COGS (If ($14 x 440 units)
560 6.500
replaced) 440 $6,160

Due to the LIFO liquidation, COGS was lower by $860 ($6,160 -

$5,300); thus, pretax profit was higher by $860. The higher
profit is unsustainable because Big 4 will eventually run out of
inventory.
Inventory Valuation (IFRS)

Lower of cost and net realizable value

All costs of bringing the NRV

inventory to its current Estimated selling X
location and condition
price
Excludes:
■ Abnormal amounts Estimated cost of
■ Storage costs completion (X)
■ Admin overheads Selling costs (X)
■ Selling costs NRV X
Reversal of write-downs allowed

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Inventory Valuation (U.S. GAAP)

Lower of cost and market value

Same as IFRS
1T

Current replacement cost, subject to:

Upper Limit = NRV
Lower Limit = (NRV - normal profit
margin)
Reversal of write-downs prohibited

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Inventory Valuation
■ Under IFRS and U.S. GAAP, reporting inventory above
cost is permitted in some industries, primarily producers
and dealers of commodity-like products
■ Reported on the balance sheet at net realizable value
■ If active market exists, quoted market price is used;
otherwise, recent market transactions are used
■ Unrealized gains/losses recognized in the income
statement

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Inventory Disclosures

■ Cost flow method used (LIFO, FIFO, etc.)

■ Carrying value of inventory in total and by classification
(raw materials, work-in-process, and finished goods), if
appropriate
■ Carrying value of inventory reported at fair value less
■ selling costs
■ COGS for the period
■ Inventory write-downs for the period
■ Reversals of write-downs for the period (IFRS only)
■ Carrying value of pledged inventory

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Profitability Ratios and Inventory Method

■ As compared to FIFO, LIFO is a better measure of

economic cost in the income statement (COGS based on
recent prices)
■ Assuming inflation, LIFO produces:
■ Higher COGS
■ Lower gross profit
Lower
■ Lower operating profit Margins
■ Lower net profit

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 Liquidity Ratios and Inventory Method

■ As compared to LIFO, FIFO is a better representation of

economic cost on the balance sheet (inventory based on
recent prices)
■ Assuming inflation, FIFO produces:
■ Higher inventory balances
Higher
■ Higher current ratio
Current Assets
■ Higher working capital

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Activity Ratios and Inventory Method

■ LIFO COGS is based on recent prices and LIFO ending

inventory is based on historical prices
■ Assuming inflation, LIFO produces:
■ Higher inventory turnover (COGS / Avg. Inventory)
because of the higher numerator and lower
denominator
■ Lower days inventory on hand (365 / inventory
turnover) because of the higher denominator

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Leverage Ratios and Inventory Method

■ Assuming inflation, FIFO results in higher assets

(inventory reported at recent prices) and higher equity
(higher net income from lower COGS) as compared to
LIFO

■ Assuming inflation, FIFO produces lower leverage:

Lower debt-to-assets ratio Higher
Denominators
Lower debt-to-equity ratio

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Inventory Management Ratios

Cost of goods sold

Inventory turnover
Average inventory

Days inventory on 365

hand (DOH) Inventory turnover

Gross profit Gross profit

margin Revenue

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Inventory Management

Condition Possible Interpretation

Low turnover (high Slow-moving or
DOH) obsolete inventory

High turnover (low May be losing sales

DOH) with low sales from insufficient
growth relative to inventory levels
industry
High turnover (low Efficient
DOH) with sales growth inventory
at or above industry management
average
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Inventory Methods - Problem
For analytical purposes an analyst would prefer to use:

A. LIFO COGS and FIFO inventory.

B. FIFO COGS and FIFO inventory.

C. FIFO COGS and LIFO inventory.

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1. Which of the following is most likely included in a firm’s ending inventory?
A. Storage costs of finished goods.

1 III
B. Variable production overhead.
C. Selling and administrative costs.

2. Under which inventory cost flow assumption does inventory on the Balance

sheet best approximate its current cost?

A. First—in, first—out.
B. Weight average cost.

C. Last-in, first-out.

3- During the year, a firm’s inventory purchases were as follows:

Quarfer Units perches Cost per Unit Total
1 400 $3.30 $ 1,320
2 1 OO 3.60 360
3 200 3-90 780
4 50 4.20 2 10
750 $2,670

• The firm uses a periodic inventory system and calculates inventory and COGS at
the end of the year.
• Beginning inventory was 200 units at 53 per unit = $600.
• Sales for the year were 600 units.
 FIFO LIFO

1 III
A. S 1,920 $2,175

B. Si ,920 $1 ,850
C. 52,070 52,175

4. Which of the following most likely signals that a manufacturing company

expects demand for its product to increase?

A. Finished goods inventory growth rate higher than the sales growth rate
B. Higher unit volumes of work in progress and raw material inventories
C. Substantially higher finished goods, with lower raw materials and work
in process
 In periods of rising prices and stable inventory quantities, which of the
following best describes the effect on gross profit of using LIFO as compared
to using FIFO?
A. Lower.
B. Higher.
C. the same.

Kamp, Inc., sells specialized bicycle shots. At year-end, due to a sudden

increase in manufacturing costs, the replacement cost per pair of shoes is $55.
The original cost is $43, and the current selling price is $50. The normal profit
margin is 10% of the selling price, and the selling costs are S3 per pair.
According to U.S. GAAP which of the following amounts should each pair of
shoes be reported on Kamp’s year—end balance sheet?

.
A. $42.
B. $43.
C. $47.
B Variable production overhead is related to the production pi incurred.
A Under FIFO, ending inventory is made tip of the providing a closer
most recent

approximation of current cost-

FIFO COGS $3.00
$3-30
200 units from beginning $4.20 < S3.90
•400 units from 1st quarter x $3.60 $2 1 O 780
S3-30 360
_825

I IHO COGS $2,175

SO units from 41 ti quarter x 200 units from 3rd quarter ; 1 OO units from 2nd quarter
250 units from 1st quarter >

Compared to FIFO, COGS calculated under LIFO wi 11 be higher because the most
recent, higher cost units are assumed to he the first units sold. Higher C 'C It is under
LIFO will result in lower gross profit (revenue — COGS).
Market is equal to the replacement cost as long as replacement cost is within a specific range.
The upper bound is net realizable value (NRV) which is equal to the selling price ($50) less
selling costs ($3) for a NRV of $42. The lower hound is NRV ($42) less normal profit margin
(1096 of selling price = $5) for a net amount of $42. Because replacement cost is greater than
NRV ($42), market equals NRV ($42). Additionally, we have to use the lower of cost ($43) or
market ($42) principle, so the shoes should be recorded at a cost of $43.
"—I
Learning module-Long-Lived
Assets

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Capitalizing vs. Expensing: An Overview

■ Costs can either be capitalized as an asset on the

balance sheet or immediately expensed in the income
statement
■ Capitalizing involves depreciating or amortizing the
asset's cost over its useful life
■ Expensing results in an immediate reduction of net
income
■ General rule:
■ Capitalize if there is a future economic benefit
■ Immediately expense if the future benefit is unlikely
or highly uncertain

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Capitalizing vs. Expensing:An Overview

■ Capitalized cost includes expenditures necessary to

prepare the asset for use (e.g., freight, installation, taxes)

■ Subsequent related expenditures that provide more

benefits are capitalized (e.g., replacing the roof on a
building)

■ Costs that merely sustain the asset's usefulness are

immediately expensed (e.g., repair and maintenance)

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Capitalizing vs. Expensing:
Financial Statement Effects

Capitalize Expense
Assets & Equity Net Higher Lower
income (first year) Higher Lower
Net income (other years) Lower Higher
Income variability ROA & Lower Higher
ROE (first year) ROA & Higher Lower
ROE ( other years) Debt Lower Higher
ratio & Debt-to-equity CFO Lower Higher
CFI Higher Lower
Lower Higher

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Capitalizing Interest Costs
■ Interest incurred during construction is capitalized ("held-
for-use" assets and discrete projects)

■ Objective is to accurately measure the asset's cost and

better match cost with revenues

■ The interest rate is based (in order) on:

1. Project-specific debt
2. Unrelated debt

■ Interest expense on debt in excess of construction costs is

immediately expensed

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Capitalizing Interest Costs
■ Capitalized interest is reduced by income earned from
temporarily investing the debt proceeds (IFRS only)

■ Once construction is complete, capitalized interest is

depreciated in the income statement

■ Capitalizing interest costs results in higher interest

coverage ratio (lower denominator)
■ Many analysts add capitalized interest to interest
expense before calculating interest coverage
■ The result is a reduction in interest coverage (higher
denominator)

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 Capitalizing Expenses - Problem

Firm Aggressive capitalizes certain expenses that Firm

Conservative does not in year 20X0. In year 20X0,
compared to Firm Aggressive, Firm Conservative will most
likely have:
A. higher assets.
B. lower leverage ratios.
C. lower ROE.

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Intangible Assets

■ Intangible assets lack physical substance

■ Identifiable intangibles
■ Can be separated from, and controlled by, the firm
■ Expected to provide future benefits that are probable
and whose cost can be reliably measured
■ Unidentifiable intangibles cannot be separated from the
firm (e.g., goodwill)
■ Finite-lived intangibles are amortized over their useful
lives
■ Indefinite-lived intangibles are not amortized but tested
for impairment

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Intangible Assets
Internally developed intangibles expensed as incurred
Exception: R&D, software development costs
■ Research costs involve the discovery of new knowledge
and understanding
■ Development costs involve the translation of research
findings into a plan
IFRS: Research costs are expensed as incurred, but
development costs are capitalized
U.S. GAAP: Research and development costs are
expensed as incurred

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Intangible Assets

Software Development Costs

■ Software developed for sale
- IFRS & U.S. GAAP: Expensed as incurred until
technological feasibility is reached
■ Issue: Determining feasibility requires judgment

■ Software developed for internal use

■ IFRS: Same as software developed for sale
■ U.S. GAAP: Capitalize all software development
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Intangible Assets
Purchased Intangibles
■ Recorded at cost
■ When purchased as part of a group, price paid is allocated based on
fair value of each asset
Issue: Analyst usually more interested in type of asset than value
assigned (e.g., franchise rights may provide insight into future
performance)
Intangibles obtained in a business acquisition
■ Identifiable net assets recorded at fair value
■ Difference in purchase price and fair value of identifiable net assets
reported as goodwill

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Depreciation of Long-Lived Assets

Economic depreciation = decline in asset value

Analyst issue: Accounting depreciation may not
equal economic depreciation

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Depreciation Methods
Straight-tine
■ Equal amount of expense each period
■ Often used for financial reporting purposes

Accelerated (Double-declining balance)

■ Higher expense in the early years and lower expense in the later
years

Units-of-production
■ Expense is based on usage rather than time

Total depreciation expense is the same under all methods;

timing is the only difference!

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Depreciation Methods

Straight-line
SL = (Cost - Salvage Value) / Useful
Life
Double-declining balance
DDB = (Cost -Ace Depn) x(2 / useful Economic Life)
1_
NBV Do not depreciate below
salvage value!
Units-of-production
UOP = (Cost - Salvage Value) x (Units used / Total
capacity)

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Depreciation - Example
At the beginning of Year 1, a firm purchased a new machine
for £4,000. The machine has an estimated life of four years
or 1,000 units of production. The salvage value is estimated
at £500.

Assuming the firm produces 400 units in Year 2, calculate

depreciation expense for Year 2 using the following
methods:

1. Straight-line
2. Double-declining balance
3. Units-of-production

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Depreciation - Example

Straight-line
(£4,000 cost - 500 salvage) / 4 years = £875

Double-declining balance
Year 1 = (£4,000 cost - 0 Acc Dep) x2/4 = £2,000
Year 2 = (£4,000 cost - 2,000 Acc Dep) x 2/4 = £1,000

Units-of-production
(£4,000 cost - 500 salvage) x 400 units produced / 1,000
total units = £ 1,400

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 Impact of Depreciation Method on
Financial Statements

Straight-Line Accelerated
Depreciation expense Lower Higher
Net income Higher Lower
Assets Higher Lower
Equity Higher Lower
Return on assets Higher Lower
Return on equity Higher Lower
Turnover ratios Lower Higher
Cash flow Same Same
*Early years or growing firm

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 Estimates in Depreciation
Calculations

Changes in salvage value and useful life both represent

changes in accounting estimates, not changes in accounting
principle

■ Firm does not restate past income; change disclosed in

notes
■ Given longer useful life or higher salvage value,
depreciation is less, leading to increased EBIT, net
income, and ROE
■ Shorter life or lower salvage value has opposite effects

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Component Depreciation

Component depreciation involves depreciating an asset

based on the separate useful lives of the asset's individual
components
■ Required under IFRS
■ Permitted under U.S. GAAP but seldom used
Example: An office building consists of a roof, walls,
elevator, HVAC, carpeting, furniture, fixtures, etc.
Issue: The firm must estimate the useful lives of each
component and depreciate each separately

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Depreciation Methods - Problem

Accelerated depreciation methods:

A. lead to higher book values than does the straightline
method.
B. result in lower net income in early years, higher net
income in later years.
C. allocate larger portions of cost to later accounting
periods.

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Amortizing Intangibles
■ Process is identical to depreciation except estimating
useful lives is more complicated because of legal,
regulatory, and economic factors
■ Intangibles with finite lives
■ Amortize over useful life
■ Pattern should match consumption of benefits (use
straight-line, accelerated, or units-of-production)
■ Intangibles with indefinite lives
■ No amortization
■ Periodic impairment review

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Asset Revaluation
■ U.S. GAAP: Depreciated historic cost
■ IFRS choice: Depreciated historic cost or fair value
■ Revaluation below historic cost
■ B/S asset reduced to fair market value
■ Loss taken to income statement
■ Subsequent reversals of value recognized in income
statement up to original loss
■ Increase in value above original cost taken to equity
■ Revaluation above original cost
■ B/S asset increased to fair market value
■ Gain taken directly to equity

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Impairment of Long-Lived Assets
IFRS
■ Annually assess indications of impairment (e.g., decline
in market value or physical condition)
■ Asset is impaired when book value (historical cost - acc.
depreciation) > recoverable amount
■ Recoverable amount is greater of "fair value less selling
costs" and "value in use" (present value of future cash
flows)
■ If impaired, write down asset to recoverable amount and
recognize loss in the income statement
■ Loss reversal is allowed up to original loss

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Impairment of Long-Lived Assets

U.S. GAAP (2-step process)

Assess only when indication that book value may not be
recoverable through future use
1. Identification of impairment: Asset is impaired when
book value > asset's estimated future undiscounted cash
flows
2. Loss recognition: If impaired, write down asset to fair
value (or discounted value of future cash flows if fair
value unknown), recognize loss in I/S
Loss reversal prohibited for assets "held for use"

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Impairment of Long-Lived Assets

Assets Held for Sale (IFRS & U.S. GAAP)

■ Asset is tested for impairment when transferred from
"held for use" to "held for sale“
■ Depreciation expense no longer recognized
■ Asset is impaired if book value > net realizable value
(fair value - selling costs)
■ If impaired, write down asset to NRV
■ Loss reversals are allowed up to the original loss under
IFRS and U.S. GAAP

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Impairment - Example

Information related to machinery owned by Milano Company follows:

€
Original cost 500,000
Accumulated depreciation 350,000
Expected future cash flows 145,000
Fair value 140,000
Value in use 130,000
Selling costs 20,000

Assuming Milano continues to use the machinery in the future,

calculate the impairment loss, if any, under both IFRS and U.S. GAAP.

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 Impairment - Example
IFRS
Book value 150,000 (500,000-350,000)
- Recoverable amount 130,000 •* Greater of “value in
Impairment loss €20,000 use” and “fair value
less selling costs”
U.S. GAAP
1. Impairment identification
150 book value >145 expected future cash
flows
2. Loss measurement
Book value 150,000
- Fair value 140,000
Impairment loss €10,000
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 Impact of Impairment on Financial
Statements
■ Balance sheet: Reduces assets, liabilities (deferred
taxes), and stockholders' equity
■ Income statement: The loss decreases current period
income from continuing operations; in future years,
reduced depreciation results in higher net income
(potential earnings management)
■ Cash flow: Unaffected because the impairment is not
deductible for tax purposes-impairments are non-cash
charges
■ Disclosure: MD&A, footnotes

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Impact of Impairment on Ratios

■ Fixed asset and total asset turnover ratios increase due

to reduced assets

■ Debt-to-equity ratio increases due to reduced equity

■ Current year ROA and ROE decrease—% reduction

in net income > % reduction in assets/equity

■ Future ROA and ROE increase due to lower assets and

equity, higher net income with lower depreciation

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Impairment of Long-Lived Assets

Analysts should recognize that:

■ Past earnings have been overstated due to insufficient
depreciation
■ Management has some control over the timing of
impairment recognition and size of impairment losses
■ Impairments involve judgment-potential earnings
management

■ Consider revising earnings and cash flow forecasts

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 Disposal of Long-Lived Assets

Proceeds
Carrying
value
Gain/(loss)
■ Sales proceeds = zero for abandoned assets
■ Sales proceeds ; fair value if exchanged
■ Discussed in MD&A and/or footnotes
■ Classified as held-for-sale once sales process
commences
■ Held-for-sale at lower of carrying value or fair value
less sales costs

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Disclosure Requirements

Tangible and Intangible Assets

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

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Investment Property

■ IFRS only
■ Owned for the purpose of earning rental income and/or
capital appreciation
■ Valued at cost or fair value
■ Cost model-same as PP&E (i.e., depreciated cost)
■ Fair value model-changes in value taken to income
statement, not comprehensive income
■ Disclose: Fair value model or cost model
■ Fair value model: Determination of fair value
■ Cost model: Depreciation method, useful lives, fair
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1. Red Company immediately expenses its development costs ’while Black Company
capitalizes its development costs. .A.11 else equal, Red Company will:

1 III
A. show smoother reported earnings than Black. Company.
B. report higher operating cash flow than Black. Company.
C. report higher asset turnover than Black. Company.
2. which of the following statements about indefi nite-lived intangible assets is ?

A. They are amortized on a straight-line basis over a period nor to exceed -40
years.
B. They arc reported on the balance sheet indefinitely.
C. They never appear on the balance sheet unless they are internally developed.

3. In the early years of an asset’s life, a firm using the double-declining balance
method, as compared to a firm using srraighr-linc depreciation, will report lower:

A. depreciation expense.
B. operating cash flow.
C. retained earnings.
4. Bast Company purchased a new truck, at the beginning of this year for $30,000.
The truck has a useful life of eight years or 1 50,000 miles, and an estimated salvage value
of $3,000. If the trnclc is driven 16,500 miles this year, how much depreciation -will East
report under the double-declining balance (DDB) method and the units of production (UOP)
methods?
DDB UOP
A. $2,500 $2,920
B. $2,500 $3,300
C. $6,250 $2,920
5. Whicli of the following is l^etzst likely considered in determining the
useful life an intangible asset?
A. Initial cost.
B. Legal, regulatory, or contractual provisions.
C. Provisions for renewal or extension.
At the beginning of this year, Fair-weather Corp. incurred $200,000 of
6. research costs and $100,000 of development costs to create a new patent.
The patent is expected to have a useful Life of -40 years -with no salvage
value. Calculate the carrying value of the patent at the end of this year,
assuming Fair-weather follows US. GAAP.
A. SO.
B. $92,500.
G. $292,500.
Two years ago, Metcalf Corp. purchased machinery for
$800,000. At the end of last year, the machinery had a fair
value of $720,000. Assuming Metcalf uses the revaluation
model, what amount, if any, is recognized in Metcalf’s net
income this year if the machinery’s fair value is $810,000?

A. $0.
B. $80,000.
C. $90,000.
1- C As compared to a firm that capital i/x-.s its expenditures, a firm that
immediately expenses expenditures will report lower assets. Thus, asset
turnover (revenue / average assets) will he higher for the expensing firm
(lower denominator).
2- B Indefinite-lived intangible assets are not amortized; rather, they are
reported on the balance sheet indefinitely unless they arc impaired.
3- C In the early years, accelerated depreciation will result in higher
depreciation expense; thus, lower net income. Lower net income will
result in lower retained earnings.
4- A Double-declining balance = $30,000 book value x (278) = 57,500.
Units-of-production = ($30,000 cost — $3,000 salvage value) / 150,000
miles = $0.18 per mile.
16,500 miles driven x $0.18 per mile = $2,970.
5- A Initial cost has nothing to do with the useful life of an intangible asset.
6- A "Under U.S. GAAP, research and development costs are expensed as
incurred. Thus, the entire $300,000 of R&D is expensed this year. The
result is a zero carrying value.
7- B Under the revaluation method, Metcalf reports the equipment on the
balance sheet at fair value. At the end of last year, an $80,000 loss was
recognized (from $800,000 to $'720.OOO) in the income statement.
Any recovery is recognized in the income statement to the extent of the
loss. Any remainder is recognized in shareholders’ equity as revaluation
surplus. Thus, at the end of this year, an $80,000 gain is recognized in
the income statement, and a $10,000 revaluation surplus is recognized
in shareholders’ equity.
.
Learning module 8-
topics in Long-Term Liabilities and equity

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Reasons to Lease

Alternative to borrowing and purchasing asset

Advantages:
1. Short period of use
2. Cheaper financing (potentially)
3. No down payment
4. Fixed rates
5. May have fewer covenants
6. Less risk of obsolescence
7. Potential financial reporting adv (op
lease)
8. Tax advantages-synthetic leases
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Finance (Capital) vs. Operating Lease

U.S. GAAP: Treat as capital lease if any of the following

criteria are met:
1. Title to the leased asset is transferred to the lessee at
the end of the lease
2. A bargain purchase option exists
3. The lease period is at least 75% of the asset's
economic life
4. The PV of the lease payments >90% of the leased
asset's fair value

IFRS: Treat as finance lease if substantially all rights and

risks of ownership are transferred (no quantitative criteria)

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Treatment of Finance Lease

Treat as if leased asset were purchased with debt

■ Lower of fair value or PV of future lease payments is

reported as a balance sheet asset and liability

■ Asset is depreciated over time

■ Interest expense on liability is recognized

■ Lease payments treated like amortizing debt - each

payment is part interest and part principal

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Finance vs. Operating Lease

Financial Statement Operatin

Totals Finance g
Assets Higher Lower
Liabilities Higher Lower
Net income (early years) Lower Higher
Net income (later years) Higher Lower
Total Net Income Same Same
Cash flow from operations Higher Lower
Cash flow from financing Lower Higher
Total cash flow Same Same
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Leases - Problem

If Acme reports its lease of equipment as an operating lease

rather than as a capital lease the effect in the first year would
be to:
A. increase net income and decrease CFO
B. increase net income and CFO
C. decrease net income and increase CFO

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Lessor Financial Reporting
Operating Lease
■ Lessor reports leased asset on balance
sheet
■ Recognize lease payments as rental
income
■ Recognize depreciation expense on asset
Finance Lease
■ Lessor reports lease receivable on balance sheet
■ Recognize lease payments as part interest revenue
and part return of capital
■ Treat as either sales-type lease or direct financing
lease

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Sales-type Lease

■ Lessor is typically a manufacturer or dealer of the

leased equipment
■ PV of lease payments > Carrying value of leased
asset (termed a sales-type lease under U.S. GAAP)
■ At lease inception, lessor recognizes gross profit
■ Sales = PV of lease payments
■ COGS = Carrying value of the asset
■ Interest revenue recognized over lease term
■ Difference between interest revenue (CFO) and
payment reduces the lease receivable (CFI)

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Direct Financing Lease
■ Lessor is not the manufacturer or dealer of the leased
equipment (e.g., finance company)

■ PV of lease payments = carrying value of leased asset

■ No gross profit is recognized at lease inception

■ Lessor recognizes interest revenue over lease term

■ Difference between interest revenue (CFO) and lease
payment reduces the lease receivable (CFI)

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Direct Financing Lease - Example

Rowlands, Inc. leases a machine to Hall Company. The

lease qualifies as a finance lease. The terms of the lease are
three years at $10,000 p.a. Rowlands estimates that the
machine can be sold in three years for $5,000. The asset
cost $24,000.

N 3
Rate
Implicit in PMT $10,000 CPT I/Y = 19.897%
the Lease FV $5,000
PV ($24,000)

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Lease Disclosure

Lessees and lessors are required to disclose:

■ General description of leasing arrangements
■ Nature, timing, and payments to be paid or received
■ In each of the next 5 years
■ Aggregated payments beyond 5 years
■ Lease revenue and expense for each period presented in
the income statement
■ Amounts receivable and unearned revenues from leases
■ Restrictions imposed by lease arrangements

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Lease - Problem
Under I FRS a lessor would be most likely to recognize
depreciation expense related to a leased asset for a lease
classified as a(n):

A. operating lease
B. financing lease.
C. sales-type lease.

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Pensions
Defined Contribution Plan
■ Employer contributes specified sum each period
■ No guarantee of future benefits
■ Employee bears investment risk

Defined Benefit Plan

■ Employer promises specific payment stream beginning at
retirement
■ Contributions based on years of service, compensation at/near
retirement
■ Employer bears investment risk
■ Separate legal entity manages plan assets

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Defined Contribution Plan

Income Statement
■ Pension expense = employer's contribution

Balance Sheet
■ No future obligation to report as a liability
■ Decrease in cash, or current liability if not paid by fiscal
year-end

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Defined Benefit Plan Reporting
Balance Sheet
■ Plan assets < estimated obligation: Net pension liability
■ Plan assets > estimated obligation: Net pension asset

Firm must estimate PV of pension obligations based on:

■ Future compensation levels
■ Employee turnover
■ Average retirement age
■ Mortality rates
■ Appropriate discount rate

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Defined Benefit Plan Reporting
Change in net pension asset or liability during year
■ Service costs: PV of additional benefits earned
■ Past service costs: Retroactive benefits awarded when
plan is initiated or changed
■ Net interest expense/income: Beginning value x
assumed discount rate
■ Actuarial gains/losses: Changes in assumptions
■ Return on plan assets
Pension expense or other comprehensive income?
Different treatments under IFRS and U.S. GAAP

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 Defined Benefit Plan Reporting

Change in net pension asset/liability during period

IFRS Reporting U.S. GAAP Reporting

3) Remeasurements
• Actuarial
gains/losses Other comprehensive
Income
• Actual return -

expected return Not amortized

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Defined Benefit Plan Reporting

Manufacturing companies allocate pension expense

■ Inventory or cost of goods sold for employees who
provide direct labor to production
■ Salary and administrative expense for other
employees

Pension expense details are disclosed in the financial

statement notes

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Different compensation

Share base compensation

Stock grants
Stock options

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Solvency

■ Solvency measures the firm's ability to satisfy its long-

term obligations
■ Leverage ratios
■ Balance sheet focus of measuring the amount of debt
in the firm's capital structure
■ Coverage ratios
■ Income statement focus of measuring the sufficiency
of earnings to repay interest and other fixed charges

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 Leverage Ratios

Total debt = interest bearing

Total debt ratio
short-term and long-term debt

Debt-to-assets Total debt

ratio Total assets

Debt-to-capital Total debt

ratio Total debt + total
shareholders' equity
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 Leverage Ratios

Debt-to-equity Total debt

ratio Total shareholders'
equity

Financial Average total assets

leverage ratio Average total equity

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 Coverage Ratios

EBIT
Interest
Interest payments
coverage

EBIT + lease payment

Fixed charge Interest payment + lease
coverage payments

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■Westell fF Corporation is a hardware wholesaler. The following table shows selected, information
from Wes tclIfF’s most recent financial statements.

Accounts payable $360,000 $310,000

Notes payable 38 5,200 321,100
Current maturities of long-term debt 60,000 60,000
Accrued liabilities 90,800 117,600
Total current liabilities $896,000 $808,700
Long-term debt 740,000 800,000
Shareholders7 equity 727,600 588,700
Total liabilities and equity $2,363,600 $2,197,400
Partial Income Statement 20X9 20X8
Gross profit $610,500 $580,800
Administrative expense 187,000 177,200
Lease expense 24,000 22,800
Earnings before interest and taxes $399,500 $380,800
Interest expense $168,000 $116,100
Discuss WcstclifFs solvency u.sing the appropriate leverage and coverage ratios. Answer:
\X/hen evaluating solvency, accounts payable and accrued liabilities are not considered
debt. Debt only includes interest bearing obligations:

Notes payable 20X9 20X8

Current maturities of long-term debt Long- $385,200 $321,100
term debt Total debt 60,000 60,000
740,000 800,000
$1,18 5,200 $1,181,100
’West cliff's leverage and coverage ratios are calculated as follows:

Debt- to -assets 2009: 1,185,200 debt / 2,363,600 assets — 50.196

Debt-to-assets 2008: 1,181,100 debt / 2,197,400 assets = 53.796
Debt'to-equity 2009: 1,185,200 debt / 727,600 equity = 1.6 Debt-to-
equity 2008: 1,181,100 debt / 588,700 equity = 2.0
Debt-to-total capital 2009: 1,185,200 debt / 1,912,800 total capital = 62.096 Debt-to-total
capital 2008: 1,181,100 debt / 1,769,800 total capital — 66.796

(Note: Total capital = total debt +- shareholders’ equity.)

Interest coverage 200 9: 399,500 EBIT / 168,000 interest expense — 2.4 Interest
coverage 2008: 380,800 EBIT / 116,100 interest expense = 3.3

Fixed charge coverage 2009:

(399,500 EBIT + 24,000 lease payments) / (168,000 interest expense + 24,000 lease
payments) = 2.2

Fixed charge coverage 2008:

(380,800 EBIT -+- 22,800 lease payments) / (1 16,100 interest expense + 22,800 lease
payments) = 2.9
Leverage declined in 20X9 using all three measures, mainly as a result of an increase in
shareholders’ equity. On the other hand, both coverage ratios declined in 20X9 as a result of
higher interest expense. One possible explanation for the increase in Interest expense, given
lower leverage, is that interest rates are increasing.
Use the following data to answer Questions 1 through 8.
A firm issues a $10 million bond with a 6% coupon rate, 4-ycar maturity, and annual interest
payments when market interest rates are 294>-

1 III
1. The bond can be classified as a;
A. discount bond
B. par bond.
C. premium bond.
2. 'The annual coupon payments will eacb be:
A. $600,000.
B. $676,290.
C. $700,000.

3- Total of" all cash payments to the bondholders is;

A. $ 1 2,-400,000.
B. $12,738,721.
C. $12,800,000.

4. The initial book value of the bonds is;

A. $9.-400,000.
B. $0,66 1,220.
C . $10,000,000.
5. For the first period the interest expense is:
A. $600,000.
B. $676,290.
C. $700,000.

6. If the market rate changes to 8% and the bonds ate carried at amortized cost, the
booh, value of the bonds at the end of the first year will be;
A. $0,484,58 1.
B. $0,661,220.
C. $0,232,568.
7. The total interest expense reported by the issuer over the life of the bond will he:
A. $2,400,000.
B. $2,238,22 1.
C. $2,800,000.

8. For analytical purposes, what is the impact on the debt - torn arket rate of interest increases after
the bond is issued?
A. An increase.
B. A decrease.
C. No change.
9- Using the effective interest rate method, the reported interest expense of
a bond issued at a premium will:
A. , decrease over the term of the bond.
B. increase over the term of the bond.
C. remain unchanged over the term of the bond.
10- According to U.S. GAAP, the coupon payment on a bond is:
A. reported as an operating cash outflow.
B. reported as a financing cash outflow.
C. reported as part operating cash outflow and part financing cash
outflow.
11- At the beginning of 20X6, Cougar Corporation enters a finance lease
requiring five annual payments of $ 10,000 each beginning on the first day
of the lease. Assunring the lease interest rate is 8%, the anrount of interest
expense recognized by Cougar in 20X6 is closest to:
A. $2,6 50.
B. $3,194.
C. $3,450.
12- Which of the following is least likely to be disclosed in the financial
statements of a bond issuer?
A. The amount of debt that matures in each of the next five years.
B. Collateral pledged as security in the event of default.
C. I'hc market rate of interest on the balance sheet date.
13- As compared to purchasing an asset, which of the following is least likely an
incentive to structure a transaction as a finance lease?
A. At the end of the lease, the asset is returned to the lessor.
B. The terms of the lease terms can be negotiated to better meet each party’s needs.
C. The lease enhances the balance sheet by the lease liability.

14- At the end of last year, Maui Corporation’s assets and liabilities were as follows:

Total assets Accrued liabilities $98,500 $5,000 $12,000

Short-term debt Bonds payable $39,000

Maui’s debt-to-equity ratio is closest to:

A. 1.2
B. 1.3
C. 1.4
1.A
1- A - This bond is issued at a discount since the coupon race -e market race.
2. A
2- A - Coupon payment = (coupon rate x face value of bond) = 6% X S 10,000,000
3- A = $600,000.
4. B 3- A - Four coupon payments and the face value = ($600,000 x 4) + $10,000,000 =
5. B $ 12.400.000.
6. c;
4- B - The present value of a 4—year annuity of $000,000 plus a 4-year lump sum of
$10 million, all valued ar a discount rare of 24b. equals $0,061,220. Choice C can be
7. B
eliminated because the bond was issued at a discount.
8. B
Market interest rate x book, value = 24b x $0,001,220 = $020,200.

9. A
5- B - The new book value = beginning book value ♦ interest expense — coupon
paymenc = $0,001,220 + $020,200— $000,000 = $0,232,500. The interest expense
1 O. A was calculated in question 5. Alternatively, changing N from 4 to 3 and calculating the
11. A
PV •will yield the same result. The change in market rates •will not afreet amortized
costs.
Coupon payments + discount interest = coupon payments t (face value— issue value)
12. C
= $2,400,000 ($ 1 0,000,000 — $0,001 .220) = $2,238,22 1.
13. C An increase in the market rate will decrease the price of a bond. For analytical
purposes:, adjusting the bond liability to its economic value will result in a lower dcbt-
1 4. A to-cquity ratio (lower numerator and higher denominator).
Interest expense is based on the book value of the bond. As the premium is.

"—I
1.A

2. A

3- A amortized, the book value of the bond decreases until it reaches face value.
4. B
The actual coupon payment on a bond is reported as operating cash outflow under
5. B
U.S. GAAP.
6. c; At the inception of the lease, the present value of the lease payments is $43,121
(BGN mode: N — 5, I — 8, PMT — 10,000, FV — O, solve for PV). After the first
7. B payment is made, the balance of the lease liability is $43,12 1 — 10,000 principal
8. B payment = $33,121. Interest expense for the first year is $33,121 x 84b = $2,650.
The market rate on the balance sheet date is nor typically disclosed. The amount of
9. A debt principal scheduled to be repaid over the next five years and collateral pledged
(if any) arc generally included in rhe footnotes to the financial statements.
1 O. A
Operating leases enhance the balance sheet by excluding any lease liability. With a
11. A
finance lease, an asset and a liability are reported on the balance sheet as with
purchase made with debt.
12. C 14 – A- Because A — L ** H, shareholders’ equity is 98,500 assets — 5,000
accrued liabilities — 12,000 short-term debt — 39,000 bonds payable — $42,500.
13. C
Thus, debt-to-equity is (12,000 short-term debt -t~ 39,000 bonds payable) / 42.500
equity = 1.2. Only interestbearing liabilities arc considered debt. Accrued liabilities
1 4. A
are not interest bearing.

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Inventory Methods - Solution

For analytical purposes an analyst would prefer to use:

A. LIFO COGS and FIFO inventory.

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 Capitalizing Expenses - Solution

Firm Aggressive capitalizes certain expenses that Firm

Conservative does not in year 20X0. In year 20X0,
compared to Firm Aggressive, Firm Conservative will most
likely have:

C. lower ROE.

Expensing firm will have lower net income and lower

equity, but equity is typically greater than net income.

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 Depreciation Methods - Solution

Accelerated depreciation methods:

B. result in lower net income in early years, higher net

income in later years.

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Leases - Solution
If Acme reports its lease of equipment as an operating lease
rather than as a capital lease the effect in the first year would
be to:

A. Increase net income and decrease CFO

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Lease - Solution
Under IFRS a lessor would be most likely to recognize
depreciation expense related to a leased asset for a lease
classified as a(n):

A. operating lease

For a lessor, the leased asset remains on the balance sheet

and is depreciated over the lease term.

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Part2-learning module 1-
Analysis of income taxes

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 Income Tax Accounting

Tax Reporting $ Sources of Differences

Revenue 10,000 ■ Timing differences
Tax allowable costs (8,000) ■ Permanent differences
Taxable income 2,000
Tax payable @ 30% (600) Sources of Timing Differences
1,400 ■ Accrual vs. modified
cash accounting ■
Differences in reporting
Financial Accounting $
methods and estimates
Revenue 10,000
Accrual based costs (5,000)
Pre-tax income Tax @ 5,000 Income tax expense =
30% Taxes Payable +
(1,500)
ADeferred Tax
3,500

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Tax Terms From the Tax Return

■ Taxable income: Amount of income subject to taxes

■ Taxes payable: Actual tax liability for the current period
(based on taxable income)
■ Income tax paid: Actual cash flow for taxes
■ Tax loss carryforward: Current net taxable loss
available to reduce taxes in future years; can result in
deferred tax assets
■ Tax base: Net amount of asset or liability used for tax
reporting purposes

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Tax Terms for Financial Reporting

Accounting profit: Pre-tax financial income, earnings before

tax
Income tax expense: Tax on the income statement (includes
cash taxes and deferred taxes)
Tax payable + A DTL - A DTA
Deferred tax liability (DTL): Balance sheet item created
when taxes payable <income tax expense, due to temporary
differences
Deferred tax asset (DTA):Balance sheet item created when
taxes payable > income tax expense, due to temporary
differences

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 Tax Terms for Financial Reporting
(continued)
Valuation allowance: Reserve against deferred tax assets
that may not reverse in the future
Carrying value: Balance sheet value of an asset or liability

Note that both DTLs and DTAs are presented on the balance
sheet, not netted
IFRS: DTL and DTA always non-current
U.S. GAAP: DTL and DTA current and non-current
depending on reversal

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Differences: Accounting vs. Taxable
Profits
■ Revenues and expenses recognised in different periods
for accounts and tax (e.g., warranty expenses)
■ Carrying values of assets and liabilities may differ (e.g.,
depreciation)
■ Specific revenues and expenses not recognized for tax
or accounting purposes
■ Tax loss carryforwards
■ Gains and losses from asset disposals calculated
differently for tax and financial statements

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 Deferred Tax

Deferred Tax Liability Deferred Tax Asset

Tax Deduction > Tax Deduction <

Accounting Accounting
Expense Expense
The result is that taxable The result is that taxable
income is smaller than income is greater than
profit before tax and profit before tax and
hence we pay less tax hence we pay more tax
today and more tax in the today but will pay less tax
future in the future

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Deferred Tax Liabilities

Example of a deferred tax liability caused by using different

depreciation methods for taxes and for financial reporting

Tax Reporting Financial Reporting

Yr1 Yr1
Revenue 150 Revenue 150
Depreciation 1OO; Depreciation 50
Taxable income 50 Pre-tax income 100
Taxes payable 20; Tax expense 40

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Deferred Tax Liabilities (continued)

■ Tax expense ($40 on income statement) is greater than

taxes payable ($20 on tax return)
■ The $20 difference is a deferred tax liability that is
added to the DTL on the balance sheet
■ Under the liability method, the DTL is the tax due in
the future (based on enacted tax rates) when/if the
cumulative difference between taxable and pre-tax
income reverses

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Tax Bases

■ Tax Base of Asset = amount deductible for tax purposes

in future periods as economic benefits are realized
■ Tax base may not equal accounting carrying value due
to cumulative differences
■ Differences = temporary timing differences
■ Difference between carrying value xtax rate = DTA or
DTL
■ Non-taxable benefits: tax base and carrying value will
be the same (permanent differences)

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Tax Bases

■ A liability’s tax base = the carrying value of the

liability minus any amounts that will be deductible on the
tax return in the future
■ Differences = temporary timing differences

■ The tax base of revenue received in advance is the

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

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Deferred Tax Liability - Example

A firm acquires an asset for $21,000 with a 3-year useful

life and no salvage value. The asset will generate $16,000 of
annual revenue for three years. The tax rate is 30% and the
firm is allowed to depreciate the asset using DDB for tax
purposes but uses straight line in the accounts.

Compute the tax implications.

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 Deferred Tax Liability Solution

Tax Reporting
Year 1 2
$ $
Revenue 16,000 16,000
Depreciation (14,000) (4,667)
Taxable income 2,000 11,333
Tax payable @ (600) (3,400)
30% 1,400 7,933

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Deferred Tax Liability Solution

Financial Accounts 1 2 3
$ $ $
Revenue 16,000 16,000 16,000
Depreciation (7,000) (7,000) (7,000)
Pre-tax income 9,000 9,000 9,000
Tax expense @ 30% (2,700) (2,700) (2,700)
Net income 6,300 6,300 6,300

B/S DTL 2,100 1,400 0

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 Deferred Tax Liability Solution

1 2 3
$ $ $
Accounting Depn 7,000 7,000 7,000
Tax Return Depn (14,000) (4,667) (2,333)
Difference (7,000) 2,333 4,667
Tax Rate 30% 30% 30%
ADTL (2,100) 700 1,400
Tax Payable (600) (3,400) (4,100)
A DTL (2,100) 700 1,400
Tax Expense (2,700) (2,700) (2,700)

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Deferred Tax Liability Alternative

1 2 3
$ $ $
Tax base 7,000 2,333 0
Carrying value (14,000) (7,000) (0)
Difference (7,000) 4,667 0
Tax Rate 30% 30% 30%
DTL (2,100) (1,400) 0
Tax Payable (600) (3,400) (4,100)
A DTL (2,100) 700 1,400
Tax Expense (2,700) (2,700) (2,700)

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Liability Method for Deferred Taxes

■ DTAs and DTLs are based on differences that are

expected to reverse
■ DTA and DTL values are adjusted for changes in tax
rates for the period when differences are expected to
reverse
■ DTA adjusted with valuation allowance to reflect
probability that DTA will not be realized in future periods

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Effect of a Change in Tax Rate

When the tax rate decreases.

Deferred tax liability i Income tax expense i Deferred
tax asset i Income tax expense T
When the tax rate increases:
Deferred tax liability T Income tax expense T Deferred
tax asset T Income tax expense i tax expense = tax
payable + ADTL - ADTA Net effect depends on relative
sizes of DTL and DTA

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Effects of Tax Rate Change - Example

A firm acquires an asset for $24,000 with a 3-year useful

life and no salvage value. The asset will generate $20,000 of
annual revenue for three years. The firm is allowed to
depreciate the asset using DDB for tax purposes and straight
line in the accounts.

During Year 1 the tax rate is 40% but it will fall to 35% in
Year 2.

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 Deferred Tax - Tax Rate Change

Tax Reporting
Year 1 2 3
$ $ $
Revenue 20,000 20,000 20,000
Depreciation (16,000) (5,333) (2,667)
Taxable
income 4,000 14,667 17,333
Tax payable (1,600) (5,133) (6,067)
2,400 9,534 11,266

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 Deferred Tax - Tax Rate Change

Financial Reporting
1 2 3
$ $ $
Revenue 20,000 20,000 20,000
Depreciation (8,000) (8,000) (8,000)
Pre-tax income 12,000 12,000 12,000
Tax Expense (4,800) (3,800) (4,200)
PAT 7,200 8,200 7,800

B/S DTL 3,200 1,867 0

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 Deferred Tax - Tax Rate Change

1 2 3
Accounting Depn 8,000 8,000 8,000 Issue: Year 1
liability created
Tax Return Depn (16,000) (5,333) (2,667)
at 40% but
Difference (8,000) 2,669 5,333 reverses at 35%
Tax Rate 40% 35% 35% (8,000) x 40% =
Deferred Tax (3,200) 933 1,867 (3,200)

(8,000) x 35% =
Tax Payable (1,600) (5,133) (6,067)
(2,800)
Correction 400
Deferred Tax (3,200) 933 1,867 Difference =
Tax Expense (4,800) (3,800) (4,200) (400)

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 Tax Rate Change Alternative

1 2 3
Tax base 8,000 2,667 0
Carrying value (16,000) (8,000) (0)
Difference (8,000) (5,3337"0
Tax Rate 40% 35%35% _ _ _
DTL (3,200) (1,867) 0

Tax Payable (1,600) (5,133) (6,067)

ADTL (3,200_)_1333 _1,867_
Tax Expense (4,800) (3,800) (4,200)

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Example: Accounting effects of a change in a firm’s tax rate

A firm owns equipment with a carrying value of $200,000 and a tax base of $160,000 at
year-end. The tax rate is 40%. In this case, the firm will report a DTL of $16,000 [($200,000
carrying value - $160,000 tax base) x 40%]. The firm has recognized a bad debt expense of
$10,000 in its financial statements which is not yet deductible for tax purposes. The bad
debt expense created a DTA of $4,000 [($10,000 tax base - zero carrying value) x 40%].
Calculate the effect on the firm's income tax expense if the tax rate decreases to 30%.

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Answer:

As a result of the decrease in tax rate, the balance of the DTL is reduced to $12,000
[($200,000 carrying value - $160,000 tax base) x 30%]. Thus, due to the lower tax rate,
the change in the DTL is -$4,000 ($16,000 reported DTL - $12,000 adjusted DTL),

The balance of the DTA is reduced to $3,000 [($10,000 tax base - zero carrying value) x
30%]. Thus, due to the lower tax rate, the DTA decreases by $1,000 ($4,000 reported DTA
- $3,000 adjusted DTA).

Using the income tax equation, we can see that income tax expense decreases by $3,000
(income tax expense = taxes payable + A DTL - A DTA).

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Permanent Differences (not reversible)

Differences in tax and financial reporting that will not

reverse in the future
Don't cause deferred tax
■ Tax exempt income or non-deductible expenses
■ Tax credits for some expenditures
Result: effective tax rate ^statutory rate

Income tax expense

Pretax income

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 Valuation Allowance

■ A valuation allowance reduces a deferred tax asset

■ Is based on the likelihood that the asset will not be

realized (e.g., no taxable income expected)

■ Can be used to manipulate income: increasing the

valuation allowance will decrease income, decreasing the
allowance will increase income

■ May affect analysts' assumptions regarding future

earnings (earnings prospects)

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Comparison of Deferred Tax Items

Analyst should examine disclosures showing:

■ Change in DTLs by source/category (e.g., excess of
tax over book depreciation)
■ Change in DTAs by source/category (e.g.,
writedown of inventory)
■ Change in valuation allowance

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Required Deferred Tax Disclosures

■ Deferred tax liabilities / assets, any valuation

allowance, and net change in valuation allowance
■ Unrecognized deferred tax liability for undistributed
earnings of subsidiaries and joint ventures
■ Current-year tax effect of each type of temporary
difference
■ Components of income tax expense
■ Tax loss carryforwards and credits
■ Reconciliation of difference between income tax
expense as a % of pre-tax and statutory tax rate

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Disclosures About Deferred Tax Items

■ Be aware of differences in tax reconciliation between

periods

■ Consider the firm's growth rate and capital spending

levels when determining whether temporary differences
due to accelerated depreciation will reverse

■ Look for cumulative differences due to asset

impairments and post-retirement benefits

■ Restructuring charges can create a deferred tax asset

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 Analyst Treatment of Deferred Tax Liabilities

■ When differences are expected to reverse and result in

future tax payments, treat DTL as debt in calculating
leverage ratios

■ When differences are not expected to reverse and result in

future tax payments, treat DTL as equity in calculating
leverage ratios

■ When the amount and timing of future tax payments from

reversal is uncertain, exclude from both debt and
equity

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Key Differences IFRS and U.S. GAAP

Deferred tax differences

■ IFRS revaluation of PP&E and intangibles
■ Undistributed profits from subsidiaries, associates, joint
ventures
■ Deferred tax assets
■ IFRS recognized if probable recovery
■ U.S. GAAP full recognition reduced by valuation
allowance
■ Presentation
■ U.S. GAAP current and non-current
■ IFRS non-current

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 Deferred Taxes - Problem

A deferred tax asset would most likely be created by:

A. using straight line depreciation for financial

reporting and using an accelerated method for tax
returns.
B. differing treatment of warranty expenses for taxes
and for financial reporting.
C. utilizing an existing tax loss carryforward to reduce
a given year's taxes payable.

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1. Which of the following statements is most accurate? The difference between
taxes payable for the period and the tax expense recognized on the financial
statements results from differences:

A. in management control.
B. between basic and diluted earnings.
C. between financial and tax accounting.
2. Which of the following tax definitions is least accurate?
A. Taxable income is income based on the rules of the rax authorities.
B. Taxes payable are the amount due to the government.
C. Pretax income is income tax expense divided by one minus the statutory tax rate.

Use the following data to answer Questions 3 through 5>.

• A firm acquires an asset for $120,000 with a -4-year useful life and no salvage value.
• The asset will generate $50,000 of cash flow for all four years.
• The tax rate is 40% each year.
• The firm will depreciate the asset over three years on a straight-line (SI.) basis for tax
purposes and over four year’s on a SL basis for financial reporting purposes.
3. Taxable income in year 1 is:
A. $6,000.
B. $10,000.
C. $20,000.
 4. Taxes payable in year 1 are:
A. $4,000.
B. $6,000.
C. $8,000.

5. Pretax income in year 4 is:

A. $6,000.
B. $10,000.
C. $20,000.
6. Income tax expense in year 4 is:
A. $4,000.
B. $6,000.
C. $8,000.
7. Taxes payable in year 4 are:
A. $4,000.
B. $6,000.
C. $20,000.
8. At the end of year 2, the firms balance sheet will report a deferred tax:
A. asset of $4,000.
B. asset of $8,000.
C. liability of $8,000.
9. Suppose tax races rise during year 2 to 50%. At the end of year 2, the firm’s
balance sheet will show a deferred tax liability of:
A. $5,000.
B. $6,000.
C. SI 0,000.

10. A increase in the tax rate causes the balance sheet value of a deferred tax asset to:
A. decrease.
B. increase.
C. remain unchanged.

11. In its first year of operations, a firm produces taxable income of—Si 0,000. The
prevailing tax rate is 40%. The firm’s balance sheet will report a deferred tax:
A. asset of $4,000.
B. asset of S 1 0,000.
C. liability of $-4,000.
1 2. analyst is comparing a firm to its competitors. The firm has a deferred rax liability that results from
accelerated depreciation for tax purposes. The firm is expected to continue to grow in the
foreseeable future. How should the liability be treated, fox analysis purposes?
A. It should be treated as equity at its full value.
B. It should be treated as a liability' as its full value.
C. The present value should be treated as a liability with the remainder being treated as equity.

13. Which one of the following statements is most accuaeret? Under the liability method of accounting
for deferred taxes, a decrease in tbe tax rate at the beginning of tbe accounting period -will:
A. increase taxable income in tbe current period.
B. increase a deferred rax asset.
c. reduce a deferred tax liability.

14. ‘which reviewing a company, an analyst identifies a permanent difference between

taxable income and pretax income. "NX^bich of tbe following statements Tncfst
identifies tbe appropriate financial statement adjustment?
A. The amount of tbe tax implications of the difference should be added to the
deferred tax liabilities.
B. The present value of the amount of tbe tax implications of tbe difference should
he added to tbe deferred tax liabilities.
C. No financial statement adjustment is necessary.
 The difTerence between taxes payable for the period and the Tax expense recognised on the
financial stacemems results from differences between financial and rax accouming.
1. c Pretax income and income tax expense are not always lintc-ed because of temporarv and
permanent dlfferenoes.
2. C Annual depreciation expense for tax purposes is f $ 120,000 cost— $Q salvage vale,oj t 3 years
- $40,000. Taxable income is $ 50,000 — $40,000 = Si 0,000,
3- B
Taxes payable is taxable income x rax rare =■ $-10,0 00 x = $4,000. (XIte $10,000 tras
4.A calculated in question #3.)
Annual dcpreciatinn expense for financial purposes is 1 2 0,000 cost— $O salvage value)
5. c: 7 -4 years =■ $30,000. Pretax income is $50,000 — $30,000 = $20,0 00.
6. Because there hits been rto change In the tax me, income i;u>: expense is pretax income x tax
rate = $2-0.000 x -40(£f> = $8,000, (The $20,000 was calculated in question -#5.j
c Note that the asset was fully depreciated for ux purposes after year 3, so taxable income is $5
7. C 0,00 0. Taxes payable for year d = taxable income M ime = $50,000 x drlir:-t,
= $20,000.
s. c At the end of year 2, the tax base it $40,000 ($120,000 oast — 58 0,000 accmnubted tax
depreciation^ and the carrying value Is $0-0,000 (S 120,000 cost — S^0,000 accumulated
financial depreciation), Since the carrying value exceeds the tax base, a DTL of $3,0 00
9. C
[f$b0.QOO carrying value — $40,000 tarx base) x dOdb] is neptjrted.
10. D The deferred tax liability is now $ 10,0 00 [_f$C>0,00 0 carrying value — $40,000 rax base} x
11. A 50%].
If [AX rates increase, the balance sheer value of a deferred rax asset will also increase.
The tax loss carryforward results in a deferred tax asset cqtrzl to the loss multiplied by the rax
rate.
rate.
12. A The DTL is not expected to reverse in the foreseeable future because a growing firm
is
expected co continue to increase its investment in depreciable assets, and
accelerated
depreciation for tax on the newly acquired assets delays the reversal of the
DTI___The
liability should be created a* equity at its full value.
13. C IF the tax rate decreases, balance sheet DTX- and. D" 1 "A ate both teducel. Taxable
income:
■-5 unaffected.

14. C XN -O analyst adfus tmrnr is needed. If" a permanent difference- between taxable
income and pretax Income is identifiable, the difference will be reflected in the
firm’s effective tax

No analys adjustment

rate.
Learning module 2- Financial Reporting
Quality

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Motivation

Motivation: Over-report Earnings

■ Meet analysts' expectations
■ Meet debt covenants
■ Improve incentive
compensation
Motivation: Under-report Earnings
■ Obtain trade relief
■ Negotiate lower payments for contingent
consideration
■ Negotiate concessions from unions
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Motivation

Motivations: Manipulation of B/S

■ Overstate assets/understate liabilities
■ Improve leverage ratios
■ Improve liquidity ratios
■ Understate assets
■ Improve return on assets/asset turnover
■ Decrease solvency-negotiate concessions from
creditors/employees
■ Report higher goodwill on acquisition

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Signs of Low Quality Earnings

1. Selecting alternatives within GAAP that bias or distort

reported results
■ For example, inventory valuation, depreciation
2. Using loopholes or bright line criteria to report legal
rather than economic substance
■ For example, operating vs. finance leases
3. Using unrealistic or inappropriate accounting estimates
and assumptions
■ For example, economic lives and residual values of
PP&E

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Signs of Low Quality Earnings

4. Stretching an accounting rule to achieve a desired result

rather than economic substance
■ For example, past non-consolidation of SPEs

5. Fraudulent financial accounting (zero quality of

earnings)
■ For example, capitalization of operating expenses

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The Fraud Triangle

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Risk Factors: Incentives/Pressures

Economic, Industry, or Entity Operating Conditions

■ Degree of competition/market saturation, declining
margins
■ Vulnerability to rapid change: technology, interest rates,
product obsolescence
■ Significant declines in consumer demand
■ Operating losses-increasing bankruptcy,
foreclosure or hostile takeover
■ Recurring negative cash flows
■ Rapid growth or unusual profitability
■ New accounting/regulatory requirements

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Risk Factors: Incentives/Pressures

Pressure on Management from Third Parties

■ Expectations of profitability/trends from analysts,
institutional investors, significant creditors
■ Need to obtain additional financing (debt & equity) to
finance capex, R&D, etc.
■ Exchange listing requirements
■ Debt covenants
■ Impact on pending transactions: business transactions,
contract awards

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Risk Factors: Incentives/Pressures

Directors’ personal financial position threatened

■ Significant financial interests in entity
■ Significant contingent compensation (bonuses,
stock options)
■ Personal guarantee of entity’s debt

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 Risk Factors: Opportunities

Nature of the industry or entity’s Operations

■ Significant related-party transactions
■ Strong financial position, power over
customers/suppliers-non-arm's-length transactions
■ Accounting transactions dependent on significant
estimates, subjective judgements-difficult to corroborate
■ Highly unusual transactions-substance over form
■ International operations
■ Operations in tax haven jurisdictions

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 Risk Factors: Opportunities

Ineffective monitoring of management

■ Domination of management by a single person,
group, entity
■ Ineffective audit committee
■ Ineffective board of directors

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 Risk Factors: Opportunities

Complex or unstable organizational structure

■ Difficulty determining organizational structure
■ Difficulty determining controlling interests
■ Overly complex organizational structure/group structure
■ High turnover of management, key staff, professional
advisors, board members

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 Risk Factors: Opportunities

Insufficient internal controls

■ Inadequate monitoring of internal controls
■ High turnover of accounting, internal audit, or IT
staff
■ Ineffective accounting and IT systems

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Risk Factors: Rationalizations

Attitudes/Justifications/Rationalizations
■ Ineffective communication, support, and enforcement of
ethical values
■ Non-financial managers involved in selection of
accounting principles/estimates
■ History of violations
■ Excessive focus on stock price, earnings trends
■ Committing to analysts', investors', or creditors'
unrealistic/aggressive forecasts
■ Failure to correct known errors/breaches in a timely
fashion

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Risk Factors: Rationalizations

Attitudes/Justifications/Rationalizations
■ Focus on tax reduction
■ Attempts to justify inappropriate accounting policy
based on "materiality"
■ Strained relationship with auditors
■ Turnover of auditors
■ Disputes, disagreements
■ Unreasonable demands-time pressure
■ Attempts to limit informational access
■ Attempt to influence auditors' scope

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SEC Improper Practice

Identified four categories based on enforcement actions:

1. Improper revenue recognition
2. Improper expense recognition
3. Improper accounting of business combinations
4. Other accounting and reporting issues

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Warning Signs
1. Aggressive revenue recognition
■ Bill-and-hold
■ Sales type leases (lessee operating)
■ Recording revenue before earnings activities are
complete
■ Delivery of goods
■ Completion of all contract terms
■ Using swaps and barter agreements to generate sales

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Warning Signs
2. Divergence of CFO and earnings
■ Positive earnings, negative cash flows
■ CFO/NI less than 1 or declining trend

3. Growth of revenue out of line with peers

■ Quality of earnings
■ AR growing faster than revenues-indication of
nonexistent sales

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Warning Signs
4. Growth in inventory out of line with peers/stock
holding days increasing
■ Inventory management problems
■ Obsolete inventory
■ Overstatement of ending inventory

5. Classification of non-recurring or non-operating

items as revenue
■ May mask sales decline

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Warning Signs
6. Deferral of expenses
■ Capitalization of operating expenses

7. Excessive use of operating leases

■ Off-balance-sheet finance

8. Classification of losses and expenses as extraordinary

or non-recurring
■ Frequency of non-recurring items

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Warning Signs

9. LIFO liquidations
■ Firms using LIFO reducing stock levels
■ Review declines in LIFO reserve

10. Gross/operating margins out of line with peers

■ Indication of aggressive accounting policies
■ Overstatement of inventory
■ Capitalization of operating expenses

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 Warning Signs

11. Useful economic lives

■ Depreciation expense
■ Amortization expense

12. Aggressive pension assumptions

■ High discount rates
■ High expected returns
■ Low rates of compensation increase

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Warning Signs

13. 4th quarter earnings surprises

■ Unusually high revenues
■ Unusually low expenses
■ Not linked to seasonality
14. Equity accounting/unconsolidated SPEs
■ Netting of assets and liabilities
■ Uncommon for industry
15. Off-balance-sheet financing

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1. A firm reports net income of S4() million. The firm's financial statements disclose
in management’s discussion and analysis that $30 million of net income is
attributable to a gain on the sale of assets. Based only on this information, for this
period, the firm is best described as having high quality of:
A. financial reporting only.
B. both earnings and financial reporting.
C. neither earnings nor financial reporting.
2. Which of the following financial reports arc considered to be of be lowest quality?
financial reports that reflect:
A. unsustainable earnings.
3. biased accounting choices.
C. departures from accounting principles.
3. Financial reporting is most Ii kcly to be decision useful when management’s
accovinring choices are:
A. neutral.
B. aggressive.
C:. conservative.
4. WHich of be following is least likely to be a motivation to overreport earnings?
A. Reduce tax obligations.
B. Meet analyst expectations.
C. Remain in compliance with bond covenants.
5. NXfith respect to conditions tbat may lead to low-quality financial reporting,
ineffective internal controls are best described as a(n):
A. motivation.
B. opportunity.
C. rationalization.
6. A limitation on tbe effectiveness of auditing in ensuring financial reporting quality is
that:
A. detecting fraud is not the objective of audits.
B. public firms arc not required to obtain audit opinions.
C. auditors may only issue a qualified or unqualified opinion but do not explain why.

7. Under IFRS, a firm that presents a nonstandard financial measure is least likely required
to:
A. provide the same measure for at least two prior periods.
B. explain the reasons for presenting the nonstandard measure.
C. reconcile the nonstandard measure to a comparable standard measure.

8. For the current period, inappropriate capitalization is most likely ro:

A. overstate revenues.
B. understate liabilities.
C. understate expenses.
1. A Because a large proportion of net income is due to a one-time gain, this
period’s earnings are likely not sustainable and the firm may be said to have low
quality of earnings for the period, dear disclosure of this fact in the financial
statements suggests high quality of financial reporting.

2. C In the spectrum of financial reporting quality, financial reports that depart from
generally accepted accounting principles are considered to be of lower
quality than those that reflect biased accounting choices. Financial reports
that reflect unsustainable earnings, such as one-time gains, can still be of
high quality if they state the situation clearly.

3- A Financial reporting is most likely to be decision useful when accounting

choices are neutral. Either aggressive or conservative accounting choices
by management may be viewed as biases.

4. A Reducing tax obligations would be a reason to underreport

earnings. The other choices are motivations to overreport
earnings.
5- 13 Ineffective internal controls arc a condition that provides an opportunity for low-
quality
financial reporting.
6. A The objective of audits is to provide reasonable assurance that financial statements arc
presented fairly. A firm that is engaging in accounting fraud may deceive its auditor.
Regulators in most countries require publicly traded firms to obtain independent
audits of their financial statements. Auditors may issue a qualified opinion noting
certain aspects of financial statements that arc inconsistent with accounting
principles or an adverse opinion if they find that financial statements arc materially
misstated and do not conform with GAAP.

7. A IFRS require a firm that presents a nonstandard financial measure to reconcile that
measure to an IFRS measure and explain why the firm believes the
nonstandard measure is relevant to users of the financial statements. Presenting
the nonstandard measure for prior periods is not a requirement.

8. C Management may make inappropriate capitalization decisions to understate

expenses by creating balance sheet assets for items that should instead be
recognized as expenses in the current period, increasing net income in the
current period. Revenues and liabilities are unlikely to be affected by
capitalization decisions.
Learning module 3
Financial Statement Analysis
techniques

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20-Financial Analysis Techniques

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Interpreting Ratios

1. Cross-sectional analysis:

Comparison to industry norm or average

2. Time-series analysis (trend analysis):

Comparison to a company's past ratios

Ratios help the analyst identify the questions that
need answering

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Vertical Common-Size Statements

Income Statement

Income statement account Marketing expense

e.g., ■
Sales Sales

Balance Sheet

Balance sheet account Inventory

e.g., '
Total assets Total assets

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Horizontal Common-Size Statements

■ Each line shown as a relative to some base year

■ Facilitates trend analysis

Assets Year 1 Year 2 Year 3

Cash 1.0 1.2 1.1

Total 1.0 1.3 1.5

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Graphs

■ Facilitate comparisons over time

■ Performance
■ Financial structure
■ Communicate analyst conclusions
■ Types
■ Pie graph - composition of total value
■ Stacked column graph - composition of total value
over time
■ Line graph - change over time

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 Stacked Column Graph
4500 -
4000
3500
3000
2500
2000
1500
1000
500
0
20X4 20X5 20X6 20X7 20X8
■ Trade payable ■ Cash ■ Lease
obligations
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 Line Graph

2500
1600

1400
2000

1200

1000 1500

800
1000
600

400 500

200

0
0

—^Long-term notes —^Cash —^Lease obligations —^Trade payables

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 Limitations of Financial Ratios

■ Not useful in isolation - only valid when compared to

other firms or the company's historical performance
■ Different accounting treatments - particularly when
analyzing non-U.S. firms
■ Finding comparable industry ratios for companies
that operate in multiple industries (homogeneity of
operating activities)
■ All ratios must be viewed relative to one another
■ Determining the target or comparison value requires
some range of acceptable values

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Common-Size Income Statement

■ Expresses each income statement item as a percentage of

sales

■ Used to analyze changes in cost structure and profitability

■ Used for both cross-sectional and time-series analysis

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 Common-Size Income Statement

Example: Consider a common-size income statement that

reveals the following (selected items only):

Income statement item 20X7 20X8 Industry Avg.

COGS 58% 62% 60%
SG&A 18% 22% 18%
Net Income 9% 8% 10%

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Common-Size Income Statement

■ Increased COGS% suggests a lower selling price or

higher cost of material and labor

■ Increased SG&A% also suggests a lower selling price or

higher costs in this area

■ Lower net profit margin (net income as a % of sales)

reflects a lower selling price or higher expenses

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 Categories of Ratios

■ Activity _► Efficiency of day-to-day tasks/operations

■ Liquidity _► Ability to meet short-term liabilities

■ Solvency -► Ability to meet long-term obligations

■ Profitability_„ Ability to generate profitable sales from

asset base Valuation _ Quantity of asset
or flow associated with

an ownership claim
 Ratio Analysis Context

1. Company goals and strategy

2. Industry norms
■ Ratios may be industry specific
■ Multiple lines of business distort aggregate ratios
■ Differences in accounting methods
3. Economic conditions
■ Cyclical businesses and the stage of the business
cycle

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Ratio Analysis

Some general rules:

■ For ratios that use only income statement items, use the
values from the current income statement

■ For ratios using only balance sheet items, use the values
from the current balance sheet

■ For ratios using both income statement and balance

sheet items, use the value from the current income
statement and the average value for the balance sheet
item

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Activity Ratios

Inventory Cost of goods sold

turnover Average inventory
365
Days of inventory
on hand (DOH) Inventory turnover

Receivables Revenue
turnover Average receivables

Days of sales 365

outstanding Receivables
(DSO) turnover
Activity Ratios

Purchases
Payables turnover
Average trade
Number of payables 365
days of Payables turnover
payables
Working Revenue
capital
Average working capital
turnover
Working capital Current Current
assets liabilities

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Activity Ratios

Fixed asset Revenue

turnover Average net fixed assets

Net of accumulated
depreciation

Revenue
Total asset Average total assets
turnover

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Liquidity Ratios

Current assets
Current ratio
Current liabilities

Cash + short term

marketable securities +
Quick ratio _receivables_
Current liabilities
Cash + short term
marketable securities
Cash ratio Current liabilities

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Definitions: Liquidity Ratios

Cash + short term marketable

securities +
Defensive receivables
interval Daily cash expenditure
ratio
Day
s
DOH X
Cash
DSO X
conversion =
cycle No. of days of payables (X)
Cash conversion cycle X
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Cash Conversion Cycle

Raw materials arrive

Number of
days of
Production commences
payables

DOH Production complete Pay supplier

Goods sold Cash

conversion
DSO cycle
Cash collected
from customer

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Solvency

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Solvency Ratios

Total debt ratio Total debt = interest bearing

short-term and long-term debt

Debt-to-assets Total debt

ratio Total assets

Debt-to-capital Total debt

ratio Total debt + total
shareholders' equity

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 Solvency Ratios

Total debt
Debt-to-equity
Total shareholders'
ratio
equity

Financial Average total assets

leverage ratio Average total equity

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 Solvency Ratios

EBIT
Interest
Interest payments
coverage

Fixed charge EBIT + lease payments

coverage Interest payments + lease
payments

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 Profitability Ratios

Gross profit
Gross profit margin = Revenue
Operating income
Operating profit margin = Revenue
Operating income
Gross profit - operating costs
Approximation = EBIT
EBIT contains non-operating items (dividends rec'd and
gains and losses on investment securities)

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 Profitability Ratios

Earnings before tax but after interest

Pretax margin =
Revenue

Net income
Net profit margin
Revenue

Most of the retum-on-sales profitability ratios are on the

face of the common-size income statement

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 Profitability Ratios

Net income
Return on assets
ROA Average total assets

Net income + interest

Alternatively:
expense ( 1 — T)
Return on assets
Average total assets
ROA

Operating ROA Operating income

Average total assets

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 Profitability Ratios

EBIT
Return on total
capital Short—+ long-term debt +
equity

Return on equity Net income Average

ROE total equity

Return on Net income - pref. div

common equity Average common equity

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Integrated Financial Ratio Approach

■ Important to analyze all ratios collectively

■ Use information from one ratio category to answer

questions raised by another ratio

■ Classic example = DuPont analysis

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Integrated Financial Ratios

20X8 20X7 20X6

Current ratio 2.0 1.5 1.2
Quick ratio 0.5 0.8 1.0
20X8 20X7 20X6
DOH 60 50 30
DSO 20 30 40

What can you conclude about this firm's performance?

(Note that years are presented right-to-left)

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Integrated Financial Ratios

1. Current ratio up - Quick ratio down - Why?

2. DOH has increased - indicates rising inventory rather
than low cash
3. DSO decreasing - collecting cash from customers
sooner
4. Current and quick ratios indicate the collected cash is
being spent on inventory accumulation
5. Appears collections have been accelerated to make up
for poor inventory management

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DuPont System Analysis

Net income
ROE
Equity

Net income Total assets

x
Total assets Equity

ROA Financial leverage

ratio

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 DuPont System: Original Equation

Net income
ROE = Equity

Net income Revenue

x
Revenue Equity

Net income Revenue Total assets

Revenue x Total assets x Equity
t
Net profit margin Asset turnover Leverage

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DuPont System: Extended Equation

Net incomeRevenue Total assets

x x
Revenue Total assets Equity

x x
Revenue EBIT EBT
A

EBIT margin Interest burden Tax burden

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 DuPont System: Extended Equation

EBIT Interest Tax Asset

x Leverage
margin burden burden turnover

Operating
profit margin 1 - Effective Tax rate

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Per-Share Ratios for Valuation

P Price per share

E Earnings per share

P Price per share

CF Cash flow per share

P Price per share

S Sales per share

P Price per Share

BV Book value per share

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 Per-Share Quantities
NI — Pref div
Basic EPS Weighted avg#
ordinary shares

Income adjusted for dilutive

securities
Diluted EPS
Weighted avg shares
adjusted for dilution
Cash flow CFO
per share Weighted avg#
shares
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 Per-Share Quantities

EBITDA per EBITDA

share Avg# ordinary shares

Dividends Common dividend

per share Weighted avg#
common shares

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Dividend Related Quantities

Dividend Common dividend

payout ratio Net income — pref
l div
Net Income attributable to common shar

Net Income attributable to

common shares —
Retention common
rate (b) _dividend_
Net income attributable to
common shares
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 Dividend Related Quantities

Sustainable
b X ROE

Return on equity
1 - Dividend payout ratio

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 Sustainable Growth Rate - Problem

A firm has a dividend payout ratio of 35%, a net profit

margin of 10%, an asset turnover of 1.4, and an equity
multiplier leverage measure of 1.2. Estimate the firm's
sustainable growth rate.

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 Business Risk Ratios

Coefficient of Sd Operating income

variation of Mean Operating
operating
income
income
Coefficient of Sd Net income
variation of net Mean Net
income income
Coefficient of Sd Revenue
variation of Mean
revenue Revenue

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 Using Ratios for Equity Analysis

Research has found ratios (and changes in ratios) can be

useful in forecasting earnings and stock returns (valuation)

Some items useful in forecasting:

% change in: current ratio • quick ratio • inventory •
inventory turnover • inventory/total assets • sales •
depreciation • capex/assets • asset turnover •
depreciation/plant assets • total assets
ROE • A ROE • debt/equity • ROA • gross margin • working
capital/assets • dividends/cash flow • A dividend • % debt
repaid • operating ROA • pretax margin

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 Credit Ratings and Ratios

Assessing a company’s ability to service and repay its debt:

Interest coverage ratios
Return on capital Debt-
to-assets ratio
Other ratios focus on various measures of cash flow
to total debt

Note: Adjustments are made for off-balance-sheet debt

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 Segment Reporting

Reportable business or geographic segment:

50% of its revenue from sales external to the firm, and at
least 10% of a firm's revenue, earnings, or assets
■ For each segment, firm reports limited financial
statement information
■ For primary segments, must report: revenue
(internal and external), operating profit, assets,
liabilities (IFRS only), capex, depreciation and
amortization

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Definitions: Segment Ratios
Segment profit
Segment
Segment margin
revenue
Segment
Segment asset
turnover revenue
Segment assets
Segment ROA Segment
profit
Segment debt ratio Segment
(IFRS only) assets
Segment
liabilities
Segment assets
1. To study trends in a firm’s cost of goods sold (COGS), the analyst should
standardize the cost of goods sold numbers to a common-sized basis by
dividing COGS by:
A. assets.
B. sales.
C. net income.

2. Which of the following is least likely a limitation of financial ratios?

A. Data on comparable firms arc difficult to acquire.
B. Determining the target or comparison value For a ratio requires judgment.
C. Different accounting treatments require the analyst to adjust the data before
comparing ratios.
4.
An analyst who is interested in a company’s long-term solvency would most likely
examine the:
A. return on total capital.
B. defensive interval ratio.
C. fixed charge coverage ratio.
5.
RGB, Inc.’s purchases during the year were $100,000. The balance sheet shows an
average accounts payable balance of S 12,000. RGB’s payables payment period is
closest to:
A. 37 days.
B. 44 days.
C. 52 days.
6. RGB, Inc. has a gross profit of S-45,000 on sales of $150,000. The balance
sheet shows average total assets of $75,000 with an average inventory balance
of $ 1 5,000. RGB’s total asset turnover and inventory turnover are closest to:

Asset turnover Inventorv turnover

A. 7.00 times 2.00 times
B. 2.00 t imes 7.00 times
C. 0.50 times 0.33 times

7. If RGB, Inc. has annual sales of $100,000, average accounts payable of

$30,000, and average accounts receivable of $25,000, RGB’s receivables
turnover and average collection period are closest to:
Receivables turnover Average collection period
A. 2. 1 times 174 days
B. 3.3 times 111 days
C. 4.0 times 91days
8. A company’s current ratio is 1.9. If some of the accounts payable a re paid off from
the cash account, die:
A. ra n m era tor would decrease by a greater percentage than the denominator,
resulting in a lower current ratio.
B. denominator would decrease by a greater percentage than the numerator,
resulting in a higher current ratio.
C. numerator and denominator would decrease proportionally, leaving the current
ratio unchanged.

9. A company’s quick, ratio is 1.2. If inventory were purchased for cash, the:
A. numerator would decrease more than the denominator, resulting in a lower
quick, ratio.
B. denominator would decrease more than the numerator, resulting in a higher
current ratio.
C. numerator and denominator would decrease proportionally, leaving the current
ratio unchanged-

10. A11 other things held constant, which of the following transactions will increase a
firm’s current ratio if the ratio is greater than one?
A. Accounts receivable are collected and the funds received are deposited in the
firm’s cash account.
B. Fixed assets are purchased from the cash account.
C. Accounts payable are paid -with funds from the cash account.
11. RGB, Inc.’s receivable turnover is ten times, the inventory turnover is five times,
and the payables turnover is nine times. RGB’s cash conversion cycle is closest to;
A. 69 days.
B. 10-4 days.
C. 150 days.

12. RGB, Inc.’s income statement shows sales of $1,000, cost of goods sold of $400,
pre-interest operating expense of $300, and interest expense of $ 1 OO. RCUB’s
interest coverage ratio is closest to:
A. 2 times.
B.3 rimes.
C.4times

13. Return on equity using the traditional DuPont formula equals:

A. (net profit margin) (interest component) (solvency ratio).
B. (net profit margin) (total asset turnover) (tax retention rate).
C. (net profit margin) (total asset tumover) (financial leverage multiplier).
RGB, Inc. has a net profit margin of 12%, a total asset turnover of 1.2 times, and a
financial leverage multiplier of 1 .2 times. RGB’s return on equity is closest
to:
A. 12.0%.
B. 14.2%.
G. 17.3%.
B With a vertical common-size income statement, all income statement accounts are
divided by sales.
A Company and industry data are widely available from numerous private and public
sources. The other statements describe limitations of" financial ratios.

C Fixed charge coverage is a solvency ratio. Return on total capital is a measure of

profitability and the defensive interval ratio is a liquidity measure.

B payables turnover = (purchases / avg. AP) = 1 OO / 12 = 8.33 payables payment

period = 365 / 8.33 «* 43-8 days
B totalasset turnover = (sales / total assets) = 150 / 75 = 2 times
inventory turnover = (COGS / avg. inventory) = (150 — 45) (15 = 7 times
C receivables turnover = (S / avg. .AR) = 1 OO / 25 = 4 average collection period
- 365 / 4 = 91.25 days

B Current ratio = (cash + AR + inv) / AP*. IF cash and AP decrease by the same
amount and the current ratio is greater than 1 , then the denominator Falls faster
(in percentage terms) than the numerator, and the current ratio increases.
A Quick ratio — (cash A.R) / AP. IF cash decreases, the quick, ratio -will also
decrease. The denominator is unchanged.
C Current ratio = current assets / current liabilities. IF CR is > 1, then if CA and CL
both Fall, the overall ratio •will increase.
A.(365/10+365/5-365/9)=69 days
B. Interest coverage ratio= EBIT/I=(1000-400-300)/100=3 times

C.Return on equity=(net
income/sales)(sales/assets)(assets/equity)=(0.12)(1.2)(1.2)=0.1728=17.28
%
Learning module4-
Introduction to financial statement
modeling

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Evaluating Past Financial Performance

■ How have key ratios changed and why?

■ How do key ratios and trends compare with
competitors/industry?
■ What aspects of performance are critical for a
competitive advantage?
■ How did the company perform in these areas?
■ What is the company's business model and strategy-are
they reflected in key measures?

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 Projecting Performance

1. Forecast expected GDP growth

2. Forecast expected industry sales based on historical
relationship with GDP
3. Consider expected change of firm's market share
4. Forecast expected firm sales
5. Use historical margins for stable firms (gross,
operating, net) or individual forecast for each expense
item
■ Remove nonrecurring items
■ Historical margins are not relevant to new, volatile,
or high fixed cost industries
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 Forecasting Net Income and Cash
Flow

1. Spreadsheet can be developed based on the estimated

growth rate of sales
2. Make assumptions about working capital, fixed assets,
COGS, and SG&A as proportions of sales
3. Estimate interest rates for saving/borrowing, tax rate,
and dividends
4. Project net income and cash flow based on assumptions

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 Financial Forecasting Example

■ Sales expected to be $100 million in year 1 and increase

5% per year
■ COGS = 20% of sales
■ SG&A = 40% of sales
■ Interest income = 5% of cash (beg. year)
■ Tax rate = 30%
■ No dividends
■ Non-cash working capital = 70% of sales (beginning
non-cash working capital = $67 mil)
■ Fixed capital investment = 5% of sales

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Financial Forecast

($ mil.) Year 1 Year 2 Year 3

Sales 100 105 110
-COGS 20 21 22
-SG&A 40 42 44
+Interest 0 1 2
Pretax income 40 43 46
-Taxes 12 13 14
Net income 28 30 32

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 Financial Forecast (continued)

($ mil.) Beg. Year 1 Year 2 Year 3

Working capital 67 70 73 77
Net income 28 30 32

-Inv. In working cap. 3 3 4

-Inv. In fixed capital Change in 5 5 6

cash Beginning cash Ending 20 22 22

0 20 42
cash 0
20 "^ 42 " 64

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 Credit Risk

■ Ability of issuer to meet interest and principal

repayment on schedule ( capacity)
■ Cash flow forecast focus
■ Variability of cash flows
■ Character
■ Capacity
■ Collateral 4 Cs
■ Covenants

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 Credit Scoring

■ Credit rating agencies employ formulas that are weighted

averages of several specific accounting ratios and
business characteristics

1. Scale and diversification. Size, product diversification,

geographical diversification

2. Operational efficiency. Such items as operating ROA,

operating margins, and EBITDA margins fall into this
category, along with degree of vertical integration

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Credit Scoring

3. Margin stability. Stability of profitability margins

indicates a higher probability of repayment (leads to a
better debt rating and a lower cost of debt capital)

4. Leverage. Coverage ratios of operating earnings, EBITDA,

or some measure of free cash flow to interest expense or
total debt make up the most important part of the credit
rating formula

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 Equity Investment Screening

■ Screening: Application of a set of criteria to reduce a set of

investments to a smaller subset having desired characteristics
■ Involves comparing ratios to min/max values
Growth investors: Focus on earnings
growth
Value investors: Focus on low share
price in relation to
earnings or assets
Focus on dividend
Income oriented:
paying shares

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 Analyst Adjustments

■ Adjust financial statements for differences

in
accounting choices (e.g., LIFO/FIFO,
accelerated/straight line depreciation, revenue
recognition criteria)
■ Adjust financial statements for differences
in
accounting standards (e.g., IFRS vs. U.S. GAAP)

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 Analyst Adjustments

■ Required to ensure accounts are comparable before

calculating ratios
■ Investments
■ Held-to-maturity
■ Available-for-sale
■ Trading
■ e.g. IFRS AFS unrealized exchange rate gains/losses
taken to I/S but not in US GAAP; hence deduct/add to
make comparable

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 Analyst Adjustments
■ Inventory
■ FIFO/LIFO/AVCO
■ Property, plant, and equipment
■ Depreciation methods
■ Estimated lives
■ Salvage values
■ IFRS allows revaluation
■ Goodwill
■ Internally generated-not
capitalized
■ Purchased-capitalized

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 Analyst Adjustments

■ Off-balance-sheet finance
■ Finance leases vs. operating leases
■ Goodwill (to be excluded from assets when calculating
ratios)
■ Price to tangible book value (remove intangibles)
■ pre- and post-acquisition financial statements may lack
comparability

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Behavioral finance and analyst forecast

■ over confidence in forecasting

■ illusion of control
■ conservatism bias
■ representative bias
■ confirmation bias

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 Over confidence in forecasting
■ overconfidence bias occurs when people demonstrate
un warranted faith in their own abilities.
Studies have also suggested that individual are more confident
when making contrarian predictions that counter the consensus
and when forecasting what others do not expect.
To mitigate over confidence bias, analysts should record and
share their forecasts and review them regularly identifying both
the correct and incorrect forecast they have made.
Scenario analysis can help us to mitigate this bias by asking
where could I be wrong and by how much? An analyst can
generate different forecast scenarios.

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illusion of control
Actions in pursuit a bias linked to overconfidence, illusion
of control is a tendency to overestimate the ability to
control what can not controlled and fruitless actions in
pursuit of control.
Additional information and complexity in model
specification can improve accuracy, they are diminishing
marginal returns.
The amount of material information available for an
investment is finite and adding immaterial information will
mislead.

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Conservatism bias
A bias in which people maintain their prior views or
forecasts
By inadequately incorporating new information
representativeness bias.
This bias refers to tendency to classify information
based on past experiences and classification. The
classification producing
An incorrect understanding.

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Confirmation bias

The tendency to look for and notice what confirms

prior
Beliefs and ignore or under value whatever contradicts
them

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The impact of competitive factors in prices and costs

■ modeling inflation and deflation

■ the forecast horizon and long term forecasting

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The impact of competitive factors in price and cost
One of the tools that analyst can use to think about how
competition will affect financial results Michael porters
widely used five forces frame :
• Threaten of substitute
• Rivalry (competition)
• Bargaining power of suppliers
• Bargaining power of buyers
• Treat of new entrants

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Modeling inflation and deflation

Increase or decrease in the prices of goods and services

can significantly affect the accuracy of company future
revenue, profit, cash flow.
Some companies are better able to pass on price increases
for example, strong branding (COCOCOLA) or
proprietary technology (Apple)

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1- Projecting profit margins into the future on the basis of past results would
be most reliable when the company:
A. Is in the commodities business.
B. Operates in a single business segment.
C. Is a large, diversified company operating in mature industries.
2. Credit analysts are likely to consider which of the following in making a
rating recommendation:
A. Business risk but not financial risk.
B. financial risk but not business risk.
C. Both business risk and financial risk.

3. When a database eliminates companies that cease to exist because of a

merger or bankruptcy, this can result in:
A. Look ahead bias
B. Back testing bias
C. Survivorship bias
4. When comparing a US company that uses the LIFO method
;analysts should be aware that according to IFRS the LIFO
method of inventory:
A. Is never acceptable
B. Is always acceptable.
C. Is acceptable when applied to finished goods inventory only.

C. For a large , diversified company, margin changes in different

business segments may offset each other. Furthermore ,
marines are most likely to be stable in mature industries.