Financial Reporting And Analysis - Cfa Level Ii

Front 1

First In - First Out (FIFO)

Back 1

assumes that inventory items purchased or manufactured first are sold first

Front 2

Weighted Average Rate - Inventory

Back 2

assumes that the inventory items sold and those remaining in inventory are the same average age and cost

Front 3

Periodic Inventory System

Back 3

inventory values and costs of sales are determined at the end of the accounting period

Front 4

Perpetual Inventory System

Back 4

inventory values and cost of sales are continuously updated to reflect purchases and sales

Front 5

Last In - Last Out (LIFO)

Back 5

assumes that the inventory items purchased or manufactured most recently are sold first

Not allowed under IFRS

Front 6

Impact of inflation on Inventory - under LIFO

Back 6

Costs assigned to the units in ending inventory are lower than the costs assigned to the units sold

Result in higher COGS and lower inventory carrying amounts under LIFO

Causes GPMs and general profitability to be lower, which means incomes taxes are less (on less pretax profit) – this causes the net operating CF to be higher

BS will see lower inventory carrying amounts, resulting in lower reported current assets, WC and total assets

Front 7

Impact of deflation on Inventory

Back 7

costs assigned to the units in ending inventory are higher than the costs assigned to the units sold

Front 8

LIFO reserve

Back 8

is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used

FIFO inventory - LIFO inventory

Front 9

LIFO liquidation

Back 9

some of the older units held in inventory are assumed to have been sold

a decline in the LIFO reserve from the prior period may be indicative of LIFO liquidation

Will cause gross profits to increase unsustainably – on a one-time basis

Front 10

Net Realizable Value

Back 10

is the estimate selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale

Front 11

IFRS requirements for Inventory measurement

Back 11

IFRS requires that inventories be measured (and carried on the balance sheet) at the lower of cost and net realizable value – if inventory value falls below the carrying value, must be written down to net realizable value with the reduction in value recorded as an expense on the IS (within COGS or listed separately).

Upward reversal is limited to the original write down value.

Front 12

US GAAP requirements for Inventory measurement

Back 12

GAAP inventory is carried at the lower of cost or market value – and prohibits the reversal of write-downs.

Market value is defined as current replacement cost subject to upper and lower limits –

upper limit: market cannot exceed net realizable value

lower limit: net realizable value less a normal profit margin

any write down of inventory results in an expense on the IS reflected in COGS

Front 13

Issues to address/consider when examining inventory disclosures

Back 13

a. A significant increase in raw materials may signal that the company expects an increase in demand, whereas a significant increase in finished goods inventories while raw materials and work-in-progress decline, may signal a decrease in demand (potentially a future write down)

b. Compare the sales growth rate to the finished goods inventory growth rate

Front 14

IFRS definition/requirements of a long-lived asset (for acquisition purposes)

Back 14

future economic benefits must flow to the entity from the use of the asset and the cost of the item can be measured reliably

Front 15

Goodwill

Back 15

The amount by which the purchase price exceeds the sum of the accounts allocated to identifiable assets and liabilities

Front 16

Capitalizing Costs

Back 16

increases the amount of assets on the BS and appears as an investing cash outflow on the CF statement

a company allocates the capitalized amount over the asset’s useful life as a D&A expense (except land – which is not depreciated) – reducing the asset on the BS and recording an expense on the IS

D&A is a non-cash expense, so no impact on CF

Front 17

Expensing Costs

Back 17

no asset is recorded on the BS and therefore no D&A occurs in later periods

expensing lowers net income, which is reflected in lower retained earnings on the BS

An expensed item also appears as an operating cash outflow in the period it is made

No impact in subsequent periods – one and done with expensing

Front 18

Capitalizing vs. Expensing

Back 18

Expensing reduces net income in the first year, enabling higher profitability in subsequent years compared to capitalizing

SE will be higher in the first year when capitalizing, because higher profits result in higher retained earnings – but over the life of the asset, SE and NI will be the same between expensing and capitalizing

Front 19

When Capitalizing is Required

Back 19

Companies must capitalize interest costs when constructing a building to sell/own – this is recorded on the BS as the relevant long-lived asset –

If the asset is constructed for company use – capitalized interest is expensed over time as the property is depreciated, and recorded within D&A vs. interest expense

If the asset is constructed to sell – capitalized interest is recorded within inventory on the BS, and therefore expensed with COGS when the asset is sold

Capitalized interest appears as an investing cash outflow vs. expensing interest which reduces operating cash flow

Interest coverage ratio calculation should include both the capitalized portion and the expense portion

Front 20

Capitalizing "rules" for R&D between IFRS and GAAP

Back 20

IFRS requires that research be expensed rather than capitalized as an intangible asset – because in the research phase, a company cannot demonstrate that an intangible asset be created. In development phase, can capitalize costs as long as: technical feasibility is established and there is intent to use or sell upon completion

GAAP generally requires that R&D be expensed, with the exception of software development (after technical feasibility is established)

Front 21

Double Declining Depreciation

Back 21

results in higher depreciation in the earlier years, lower in the later years, impacting net income over the life of the asset

n/2 = depreciation expense each year, where n = beginning BV of the asset

Front 22

Straight Line Depreciation

Back 22

even depreciation over the life of the asset

Front 23

Units of Production Depreciation

Back 23

can result in variable depreciation expense; impacting net income over the life of the asset

Front 24

Impairment definition

Back 24

a charge reflecting an unanticipated decline in the value of an asset

are non-cash charges – reducing the carrying value on the BS and a one-time "hit" to net income

Front 25

Impairment measurement via IFRS

Back 25

Both IFRS and GAAP require the write down of the carrying amount of impaired assets, but upward reversals are only allowed IFRS

IFRS measures impairment as the excess of carrying over recoverable amount, where, recoverable value is the “higher of its fair value less costs to sell and its value in use”, and value in use is a discounted measure of expected future cash flows

Front 26

Impairment measurement via GAAP

Back 26

Both IFRS and GAAP require the write down of the carrying amount of impaired assets, only IFRS allows upward reversals

GAAP first assesses recoverability (not recoverable when the asset’s carrying amount exceeds the undiscounted expected future cash flows)

second – if not recoverable, the impairment loss is measured as the difference between the asset’s fair value and carrying amount

Front 27

Revaluation Model - for Impairment - only considered under IFRS

Back 27

Under revaluation, long-lived assets are reported at their fair value

Revaluation model is only an alternative under IFRS, otherwise historical cost model is used

Front 28

Historical Cost Model

Back 28

Historical cost less accumulated depreciation and adjusted for impairment

Front 29

Necessary Disclosure regarding Long-Lived Assets

Back 29

Disclosures should enable analysis of a company’s use of its assets, the average age of assets, and the remaining useful life of assets

Must also disclose the depreciation method used, gross carrying amount and the accumulated depreciation at the BSs dates for each class of PPE

Front 30

Lessor

Back 30

the owner of the asset

Front 31

Lessee

Back 31

the party seeking to use the asset

Front 32

Lease

Back 32

a form of financing to the lessee provided by the lessor in exchange for lease payments

certain leases are not reported as debt on the BS – therefore no interest expense or depreciation reported on the IS, but taxes may be higher

Front 33

Advantages of Leasing vs. Owning

Back 33

i. Can provide less costly financing with little to no down payment, and often at fixed rates
ii. Less restrictive provisions than other forms of borrowing
iii. Leases can reduce the risks of obsolescence, residual value, and disposition to the lessee because the lessee does not own the asset

Front 34

Synthetic Lease

Back 34

a lease structured to provide a company with the tax benefits of ownership while not requiring the asset to be reflected on the company’s financial statements

Front 35

Finance Lease

Back 35

equivalent to the purchase of some asset (lease to own)

i. Lessee will report interest expense and depreciation
ii. Lessor reports the sale of an asset and the lease as a receivable
iii. Reported debt and assets are higher and expenses are generally higher in the early years
iv. With a finance lease, only interest expense reduces CFFO while the portion of the lease payment that reduces the lease liability is a financing cash outflow = means a finance lease results in higher CFFO

Front 36

Operating Lease

Back 36

an agreement allowing the lessee to use the asset for a period of time (rental)

i. Lessee records a lease expense on the IS; no asset or liability is recorded on the BS
ii. Lessor continues to show the asset and its associated financing on the BS
iii. Lessees often prefer operating lease because of lower assets, debt, expenses, and therefore a higher ROA
iv. Lease payment under operating is fully reflected in CFFO
v. Results in higher profits in the early years, higher returns, and strong solvency position

Front 37

IFRS stance on lease accounting:

Back 37

IFRS stipulates that if most of the risks and rewards incidental to ownership are transferred to the lessee – must classify as a finance lease

Front 38

GAAP stance on lease accounting:

Back 38

GAAP says that if a lease meets one of the following four specifications – must report as a finance lease (finance lease is equivalent to the term capital lease)

1) ownership of the leased asset transfers to the lessee at the end of the lease
2) the lease contains the option for the lessee to purchase the leased asset cheaply
3) lease term is 75% or more of the useful life of the leased asset
4) the PV of lease payments is 90% or more of the fair value of the leased asset

Front 39

Direct Financing Lease

Back 39

when the PV of the lease payments (the recorded lease receivable) equals the carrying value of the leased asset

no profit in the asset, so deemed as financing provided by the lessor – lessor will report interest revenue

Front 40

Sales-type Lease

Back 40

the PV of lease payments exceeds the carrying value of the leases assets, the lease is treated as a sale

lessor will show a profit on the transaction in the year of inception and interest revenue over the life of the lease

Front 41

No Significant Influence/Control

Back 41

Investments in Financial Assets: the investee owns less than 20% and has no significant influence/control of operations

Types of Investments in financial assets include:

Held-to-maturity carried at cost (debt, changes in value are ignored unless impaired)

Held for trading carried at fair value – unrealized gains and losses are reported on the IS

Available-for-sale – carried at fair value – unrealized gains and losses are reported in other comprehensive income in the equity section of BS

IFRS and GAAP treat investments in financial assets the same

Front 42

Held-to-maturity

Back 42

Investment in financial asset - no significant influence, often a debt instrument in this classification

Carried at cost (debt) and changes in value are ignored unless impaired

Front 43

Held-for-trading

Back 43

Investment in financial asset - no significant influence

Carried at fair value – unrealized gains and losses are reported on the IS

Designated at Fair Value is treated the same as Held-for-Trading

Front 44

Available-for-sale

Back 44

Investment in financial asset - no significant influence

Carried at fair value – unrealized gains and losses are reported in other comprehensive income, in the equity section of BS

Front 45

Investment in associates

Back 45

Significant influence, but not control - may include representation on the board, participation in decision making process, material transactions between the investor and the investee, interchange of managerial personnel, technological dependency

investor can exert significant influence (but not control) (20-50%)

Front 46

Accounting for Investment in associates

Back 46

IFRS and GAAP require the equity method – requires a more objective basis for reporting investment income

a. investors must recognize income as earned rather than when dividends are received

b. investment is carried at cost + share of post-acquisition income, less dividends received

c. single line item on the BS and IS - be sure to reduce investment balance by depreciation of identifiable assets

Compared to the acquisition/business combination method, profit margins will be higher, but NI and SE will be the same

Front 47

Joint Ventures

Back 47

entities owned and operated by a small group of investors with shared common control

Front 48

Accounting for JVs: IFRS vs GAAP

Back 48

IFRS favors proportionate consolidation – requires the venturer’s share of the assets, liabilities, income, and expenses of the JV to be combined on a line-by-line basis with similar line items in the venturer’s financial statements; equity method is not permitted

GAAP requires the equity method accounting for JVs

Compared to the acquisition/business combinations method, profit margins will be higher, but NI and SE will be the same

Front 49

Business Combinations

Back 49

Significant influence + Control - includes investments in subsidiaries with +50% interest

GAAP distinguishes between a merger, acquisition, and consolidation; IFRS makes no distinction

Front 50

Merger (by GAAP)

Back 50

only one of the entities remains in existence; A + B = A

Front 51

Acquisition (by GAAP)

Back 51

each entity is an individual that maintains separate financial records; A + B=(A + B)

Front 52

Consolidation (by GAAP)

Back 52

a new legal entity is formed and none of the predecessor remains; A + B = C

Front 53

Accounting for Business Combinations

Back 53

GAAP and IFRS both require the acquisition method – fair value measurement for identifiable assets and liabilities acquired, and when the acquisition is less than 100%, IFRS allows the non-controlling interest to be measured at either is fair value (full goodwill) or as the proportionate share (partial goodwill). GAAP only allows full goodwill method

Post-combination BS will be the book value of the acquiring entity + the fair value of the acquired entity

Compared to the equity method, profit margins will be lower, but NI and SE will be the same

Front 54

Pooling of Interests Method OR Uniting of Interests (under IFRS)

Back 54

Is no longer allowed – where combined companies were portrayed as if they had always operated as a single economic entity (A and L were recorded at book value, and the pre-combination retained earnings were included in the BS of the combined companies)

Front 55

Goodwill

Back 55

the difference between the acquisition value and the fair value of the target’s identifiable net tangible and intangible assets

Goodwill is not amortized (considered to have an indefinite life), but instead tested for impairment annually – should impairment occur (one-step test under IFRS; two step test with GAAP), the loss is to be reported on the IS

Determine the difference between BV and Fair Value to appropriately amortize identifiable PP&E that was given "credit" in the purchase price, but had yet to be amortized

Front 56

Partial Goodwill

Back 56

the purchase price less the acquirer’s share of the fair value of identifiable tangible and intangible assets, liabilities, and contingent liabilities acquired

only an option under IFRS

under partial goodwill, companies will report lower total assets and non-controlling interests within SE, but no difference on the IS – therefore ratios like ROE and ROA would differ

Front 57

Full Goodwill

Back 57

is required under GAAP, an option under IFRS – where the acquired entity is considered as a whole (not just the acquirer’s share)

Front 58

Fair Value of Identifiable net assets

Back 58

Monetary assets - Monetary liabilities

Front 59

Special Purpose Entities (SPEs)

Back 59

enterprise created to accommodate specific needs of the sponsoring entity (financing mechanism to segregate certain activities and thereby reduce risk)

Front 60

Variable Interest Entities (VIEs)

Back 60

an entity that is financially controlled by one or more parties that do not hold a majority voting interest (real estate leases, or securitization of assets)

Front 61

Requirements of SPEs and VIEs

Back 61

Required to be consolidated by the entity which is expected to absorb the majority of the expected losses or receive the majority of the expected residual benefits

GAAP no longer allows qualified SPEs, now in line with IFRS

Front 62

Defined contribution plans

Back 62

the agreed upon amount is the pension expense, and the employer has no obligation to make payments beyond the agreed upon amount – employee bears all the risk

easily accounted for in the financial statements

Front 63

Defined benefit plans

Back 63

promises by the employer to pay a defined amount of pension in the future, based on age, years of service, compensation, etc.

requires companies to make actuarial assumptions: employee turnover, average retirement age, life expectancy after retirement

employer must estimate total costs of the benefits promised and then allocate these costs to the periods in which the employees provide the service (very different from when actual cash flow – or contributions into the plan and payments from the plan are made)

Under or over-funded plans are based on whether the amount of assets in the pension trust is greater or less than the estimated liability

Front 64

Other post-employment benefits

Back 64

promises by a company to pay benefits in the future, like life insurance premiums, or health care insurance for retirees – typically classified as DB plans

Front 65

Defined benefit pension obligation

Back 65

the PV of future benefits earned by employees for service provided to date; PVDBO under IFRS; PBO under GAAP

To determine future benefits, must make assumptions on future compensation increases and levels, discount rates, and expected vesting rate – if changes are made to these assumptions referred to as either an actuarial loss/gain (depending)

Net pension asset/liability is dependent on whether the pension obligation exceeds the pensions plan assets (underfunded – liability reported), or if the plan assets exceed the obligation (overfunded – asset reported)

Front 66

Net pension asset/liability

Back 66

is dependent on whether the pension obligation exceeds the pensions plan assets (underfunded – liability reported), or if the plan assets exceed the obligation (overfunded – asset reported)

the "funded status" under GAAP

Front 67

Actuarial loss/gain

Back 67

when changes are made to future benefits assumptions like: future compensation increases and levels, discount rates, and expected vesting rate

Front 68

Funded Status - IFRS

Back 68

Funded Status includes unrecognized past service costs + unrecognized actuarial gains/(losses) = net pension liability or asset under IFRS

Front 69

Funded Status - GAAP

Back 69

Funded Status = PV of defined benefit obligation – fair value of the plan assets

Front 70

Components of a company’s defined benefit pension expense

Back 70

Typically composed of five items: current service costs, interest expense accrued on the pension obligation, return on plan assets, past service costs, and actuarial gains/losses (everything but return on plan assets and actuarial gains, increases pension expense)

Reported in opex within GAAP and opex + interest expense under IFRS

Front 71

Impact of a defined benefit plan’s assumptions on the defined benefit obligation and periodic expense

Back 71

Employee turnover, length of service, and rate of increase in compensation levels, employee life expectancy post-employment, discount rate to calculate the PV of future payments, the expected return on pension assets

Increasing the discount rate will lower the pension obligation, and will typically lower pension expense on the IS due to a lower opening obligation and lower service costs

Increasing compensation growth will result in a higher obligation and higher service costs

Higher than expected return on plan assets will have no effect on the fair value of the plan assets reported on the BS, but will lower pension expense

Front 72

Impact on financial statements of adjustments for items of pension and other post-employment benefits that are reported in the NOTES to the financial statements rather than in the financial statements

Back 72

Notes disclosure often helps with making necessary adjustments for comparison purposes – companies disclose assumptions about discount rates, expected compensation increases, medical expense inflation, and expected return on plan assets

Comparing assumptions across companies can expose aggressive/conservative accounting, as well as, whether a company is being consistent internally

Other post-employment plans may disclose assumptions around health care inflation (or ultimate health care trend rate) – the time it takes to get to the ultimate rate as well

Front 73

Cash Flow impact from pension

Back 73

is the amount of contributions that the company makes to fund the plan, or for unfunded plans, the amount of benefits paid

This amount may be determined by country regulations (US has a required funded status)

If contributions exceed economic pension expense – should be seen as a reduction of the pension obligation (paying principal on a loan), while a contribution below the economic pension expense can be viewed as a source of financing

Excess or financing may be reported with CFF

Front 74

Economic pension

Back 74

is the actual expense incurred during the period vs. what is reported on the IS, including smoothing/amortization items

Front 75

Reported pension expense

Back 75

= current service costs + interest costs + expected return on plan assets

Front 76

Issues with share-based compensation accounting

Back 76

Requires no cash outlay, but is treated as an expense on the IS

Must determine the nature and extent of share-based compensation arrangements during the period

Must determine how the fair value of share-based compensation arrangement was determined

Must determine the effect of share-based compensation on the company’s income for the period and on its financial position

Front 77

Stock grants

Back 77

when employers grant stock to employees outright with restrictions, or contingent on performance – compensation expense is then based on the fair value of the stock on the grant date (generally the market value at grant date) and then allocated over the period benefited by the employee’s service (the service period)

Front 78

Restricted stock

Back 78

requires the employee to return the shares to the company if certain conditions are not met (often includes employment duration or performance-based) – and is reported at market value on the grant date allocated over the service period

Front 79

Performance shares

Back 79

likely have a predetermined value (not just based on the stock price) – accounted for in a similar manner, and on the grant date

Front 80

Stock Options reporting

Back 80

reported at fair value under both IFRS and GAAP (like grants) – fair value with stock options, however, is not just based on market value on the grant date, but is estimated, because stock options often differ in price from traded options

Front 81

Types of stock options valuation models

Back 81

Black-Scholes option pricing model

Binomial model

Both require the following inputs: exercise price, stock price volatility, estimated life of each award, estimated # of options that will be forfeited, dividend yield, and the RFR of interest (some of these inputs are known (grant date exercise price), some are highly subjective (volatility and life of stock options)

Front 82

What conditions will increase the estimated fair value of stock options, and therefore stock-based compensation expense

Back 82

Higher volatility
Longer estimated life
Higher RFR

A lower dividend yield will increase the estimated fair value/compensation expense

Front 83

Grant date

Back 83

the day the options are granted to the employees

Front 84

Service period

Back 84

the period between the grant date and the vesting date

Front 85

Vesting date

Back 85

the date that the employees can first exercise the stock options

if immediate, no service period, and therefore expense is recognized on the grant date, as opposed to being allocated over the service period

if conditional, an estimated service period is determined by the company

Front 86

Exercise date

Back 86

when employees actually exercise the options, converting them into stock

Front 87

Option expense impact on equity

Back 87

Option expense has no net impact on equity – reduces retained earnings with the offsetting entry from an increase in paid-in capital

Front 88

Phantom stock & Stock appreciation rights

Back 88

compensates the employee based on changes in the value of shares without requiring the employee to hold the shares (cash settled share based compensation) – while these are not dilutive to earnings, they do however require a cash outlay

Front 89

Presentation currency

Back 89

currency in which financial statement amounts are presented

Front 90

Functional currency

Back 90

currency of the primary economic environment in which an entity operates (the currency it generates and expends cash in)

In most cases the functional currency will be the same as the presentation currency

Front 91

Local currency

Back 91

currency of where operations are physically located

Often the presentation, functional, and local currency are all the same – but in the case of multinational companies with geographically diverse subsidiaries, or just transactions in other countries/currencies – reporting become a bit more complicated

Front 92

Transaction FX risk

Back 92

arises when the transaction date and the payment date differ

i.e. you may determine a purchase price on one date at a specific exchange rate, but then actually pay for the same asset at a different exchange rate later

Changes in value due to FX must be reported as a gain/loss on the IS

When BS reporting falls between transaction date and payment date, still required to report the gain/loss even though it is unrealized

Export sale => recorded as an account receivable => if FX strengthens = gain & vice versa

Import purchase => is an account payable => if FX strengthens = loss & vice versa

Where foreign currency transaction gains/losses are reported is unspecified – some place it in opex, some as a non-operating expense resulting in tough comparisons

Analysts should also be critical of unrealized gains/losses – as they have not occurred yet, but are simply reflecting a spot price at a point in time (BS date)

Front 93

Translation of FX

Back 93

when multinational companies have to translate foreign subsidiaries to report results at a specific point in time – this brings about what would be the appropriate FX rate to use for each line item
Two approaches are used:

either all A & L are translated at the current exchange rate (spot rate on the BS date)

OR only monetary A & L (cash and receivables (payables) that are to be received (paid) in a fixed number of currency units) are translated at current exchange rates, while non-monetary A&L (inventory, fixed assets, and intangibles, and non-monetary liabilities include deferred revenue, common stock) are translated at historical exchange rates

Front 94

Net asset/liability BS exposure

Back 94

when assets translated at the current exchange rate are greater than liabilities translated at the current exchange rate, the opposite for net liability BS exposure

Front 95

Current rate method

Back 95

USE this method: when a foreign entity has a functional currency that is DIFFERENT from the parent’s presentation currency

all A&L are translated at the current exchange rate – only generates a net asset BS exposure (when assets>liabilities, unless there is negative SE - unlikely)

i. All A&L are translated at the current exchange rate
ii. SE is translated at the historical exchange rate
iii. Rev & exp on IS are translated at an average exchange rate

Front 96

Temporal method

Back 96

USE this method: when a foreign entity has a functional currency that is the SAME as the parent’s presentation currency – the foreign entities financial statements must be translated to the parent’s presentation currency in the following manner:

only monetary A&L are translated at the current rate, while non-monetary A&L is
translated at the historical rate – could generate either a net asset BS exposure or a net liability BS exposure (when assets < liabilities)

i. Monetary A&L are translated at the current exchange rate
ii. Non-Monetary A&L measured at historical cost are translated at historical exchange rate, while nonmonetary A&L measured at current value are translated at the date when its current value was established
iii. SE is translated at the historical exchange rate
iv. Rev & exp on IS are translated at an average exchange rate
v. COGS (inventory), depreciation (fixed assets), and amortization (intangible assets) are translated at the exchange rates used to translate their related assets
vi. Remeasurement gains/losses are reported on the IS

Front 97

Temporal Process

Back 97

i. First translate the BS and determine retained earnings – what it needs to be to balance the BS

ii. Retained earnings under CURRENT & TEMPORAL = beginning balance + translated NI less dividends translated at the historical rate

iii. Then translate the IS and determine the needed gain/loss for NI less dividends to = needed retained earnings value

Front 98

Ratio impact between Temporal and Current

Back 98

CURRENT takes the accumulated translation adjustment and reports it as a separate component of equity

TEMPORAL takes the translation adjustment and reports is as a gain/loss in NI - this could result in significantly different NI under CURRENT vs TEMPORAL

Assets and equity could also be much larger under CURRENT – all of which will impact comparability of ratios

Receivables turnover is the only ratio that is the same under both methods

It is possible for a multinational corporation to report both a net translational gain/loss on the IS and a translation adjustment on the BS, if different foreign subsidiaries require different translation methods based on their functional currency in relation to the multinational’s presentation currency

Front 99

Clean-surplus accounting

Back 99

when all non-owner changes in SE (such as translation adjustments) are included in the determination of NI (this would naturally occur under the temporal method)

Front 100

Dirty-surplus accounting

Back 100

when some income items are reported as part of SE rather than as gains and losses on the IS (this would naturally occur under the current rate method)

Front 101

Hyper-inflationary definition

Back 101

a currency whose cumulative three year inflation rate exceeds 100%

Front 102

IFRS adjustment for hyper-inflationary environment

Back 102

when an entity is located in a highly inflationary economy, its functional currency becomes irrelevant, and for translation to the parent’s presentation currency, you must first restate financial for local inflation and then translate using the CURRENT RATE METHOD

To restate financials for local inflation, will need to restate non-monetary A&L along with SE in terms of the general price index at the BS date

If the exchange rate between two currencies changes by exactly the same % amount as the change in the general price index in the highly inflationary country than IFRS and GAAP adjustments will produce the same results

Front 103

GAAP adjustment for hyper-inflationary environment

Back 103

GAAP does not reinstate for local inflation, but instead requires the TEMPORAL METHOD to translate statements kept in a highly inflationary currency with a gain/loss related to translation adjustments reported in NI

If the exchange rate between two currencies changes by exactly the same % amount as the change in the general price index in the highly inflationary country than IFRS and GAAP adjustments will produce the same results

Front 104

Impact of inflation on Cash

Back 104

Holding cash and receivables during a period of inflation = purchasing power loss, whereas holding payables = a purchasing power gain

Front 105

Net Income definition

Back 105

Net income is after interest, taxes, extraordinary items, and after changes in accounting principles

Front 106

Operating Earnings

Back 106

are often used by companies to depict earnings excluding special items, discontinued operations, restructuring charges, etc

Front 107

Tenants of financial disclosure

Back 107

should be relevant, reflective, verifiable, neutral, comparable, complete, and understandable

SOX provides for more oversight of the auditing function, increased corporate financial disclosures, and improved corporate governance (MD&A, more events that trigger 8-Ks, and an adverse opinion with respect to a weakness in internal controls)

Front 108

Why is CFFO more reliable than trends in earnings?

Back 108

Follow the money – how does cash flow compare to income?

Cash flow is often more reliable than earnings because earnings may include non-cash income and expenses – items that are arbitrary

Differences between earnings and cash flows must be resolved over time

Front 109

Accounting treatment for derivatives being hedged:

Back 109

Exposure to changes in the value of assets and liabilities – the extent to which the hedge is not effective is recognized in the IS

Exposure to variable cash flows – the effective portion of the derivative’s gain or loss goes to comprehensive income (directly to SE, bypassing the IS), and then is recognized as a part of a gain/loss when the forecasted transaction affects earnings

Foreign currency exposure of investments in foreign corporations - any gain/loss is a part of comprehensive income (and SE, bypassing the IS)

Front 110

Cash-basis accounting

Back 110

only recording transactions that are attached to cash flows

Front 111

Accrual-basis accounting

Back 111

cash flow does not define when revenues and expenses are recorded, rather there is an earnings process that triggers the recognition of revenue and expenses – when a good or service has been provided to the customer

Revenues = increases in net assets that result from principal income-generating activity

Expenses = reductions in net assets associated with the creation of those revenues

Front 112

Persistence of accrual-accounting

Back 112

Accrual accounting is less persistent (more transitory) than the cash component of earnings, and despite the notion that accrual is superior to cash, the accrual component should receive a lower weighting than the cash component of earnings when evaluating a company’s performance

A lower weighting is suggested, given the subjectivity involved in the estimate of accruals – i.e. reasonably estimated the risk of default within account receivables

A lower weighting is not solely based on the potential for earnings management activity

Front 113

Management "opportunities" to intervene/manage earnings

Back 113

revenue recognition (provision for doubtful accounts, warranties…)

depreciation choices (useful lives, residual value, method)

inventory choices (cost flow assumptions, obsolescence estimates)

goodwill and other non-current asset choices (impairment tests)

taxes – valuation allowances

pension choices: return on plan asset estimate, wage growth, employee turnover, etc

stock option expenses, financial A/L valuation

Front 114

Management "incentive/motivation" to intervene/manage earnings

Back 114

Wanting earnings to have a positive reaction in the market

Management compensation is often tied to reported earnings

Debt covenants may cause management to strategically adjust earnings to remain compliant

Front 115

Mechanisms to dissuade earnings management

Back 115

external auditors and the prospect of anything but an unqualified opinion

internal auditors/audit committee, and the board

management certification of the financial statements (SOX)

class action lawsuits

regulatory actions

general market scrutiny

Front 116

Earnings Quality definition

Back 116

defined in terms of persistence and sustainability – the more persistent and sustainable an earnings level, the higher the earnings quality

The lower the accruals ratio, or the decline in the accruals ratios – the better quality!!

Front 117

Balance Sheet accruals ratio

Back 117

(chg in NOA) / Average NOA

Front 118

Net Operating Assets (NOA) =

Back 118

(total assets – cash) – (total liability – total debt)

Front 119

Cash Flow accruals ratio

Back 119

(NI – (CFO + CFI)) / Average NOA

Front 120

Mean reversion in Earnings

Back 120

earnings at extreme levels tend to revert back to normal levels – and will do so “faster” when earnings are largely comprised of accruals as opposed to cash flows

Front 121

Quality issues with revenue recognition:

Back 121

Large increases in AR or large decreases in unearned revenue - potential revenue quality issues

Large swings in the ratio of revenue to cash collected from customers – potential accelerated revenue recognition

ratio of revenue to cash collected from customers should be stable overtime

recognizing revenue early with bill and hold sales, lessor use of capital lease classification, or recording sales of equipment/software prior to installation – potential accelerated recognition in revenue to mask a decline in operating performance / growth

classifying non-operating income or gains as revenue – may mask a decline in operations

growth in revenue out of line with the industry or a large proportion of revenue occurs in the last quarter of the year for a non-seasonal business – may be aggressive reporting of sales

Front 122

Quality issues with expenses and losses recognition:

Back 122

Inconsistent reporting of operating revenues & expenses – opportunistic use of mgmt discretion

Classification of ordinary/recurring expenses as non-recurring – an attempt to mask a decline in operating performance

Non-conservative depreciation methods – may be to boost current results

Build-up of inventory – may indicate obsolete inventory or failure to write down

Front 123

Quality issues with balance sheet reporting:

Back 123

Lessee preference for operating lease classification – tends to reduce leverage ratios

Warning sign for upcoming impairment charge – when goodwill is reported on the BS, but the company’s market cap is less than the book value of equity

Common accounting abuse is capitalizing costs that should have been expensed by claiming they are non-current assets (typically within PP&E)

Front 124

Framework for the analysis of financial statements:

Back 124

Define the purpose and context of the analysis – debt/equity? Needs and concerns within the analysis? Proper institutional procedure?

Collect input data – financial statements, supplemental info, survey work, industry/economic data, mgmt discussions, conversations with suppliers, customers, competitors; company site visit

Process input data, as required, into analytically useful data – adjust financial statements? Common-size analysis? Ratios and graphs? Forecasts?

Analyze/interpret the data – determine the results

Develop and communicate conclusions and recommendations (within a written report) – provide the results publicly

Follow up – periodically repeat the above steps

Front 125

Potential financial reporting biases or choices that may affect quality and comparability of a companies' financial statements

Back 125

An analyst may make adjustments for lease classifications, the classification of warrant premiums, adjust for investment in associates, accounting changes over a period of time – attempting to neutralize the financials for a clear, stripped down view of the company

Evaluate where capex is spent compared to segment profitability and growth