[财会/金融考试]CFA_Financial_Reporting2

[财会/金融考试]CFA_Financial_Reporting2 Financial Reporting and AnalysisReading 29 Financial Statement Analysis: An Introduction 1.Introduction 2.Scope of financial statement analysis 1)Definition a)Role of financial reporting •To provide information about their performance, financial position, and changes in financial position that is useful to a wide range of users in making economic decisions. •Also used for forecasting financial position and performance. •Including profitability and cash flow generating ability. oProfit represents the excess of the prices at which goods or services are sold over all the costs of providing those goods and services. oCash flow is used to maintain the operation of company. Thus a better generating ability indicates more flexibility in funding needed investment and business opportunities. Cash flow is also the source of returns to providers of capital. oProfit provides useful information about future (and past) cash flows. •The current financial position of a company can be measured by comparing the resources controlled by the company in relation to the claims against those resources. b)Cash flow related •Liquidity oThe ability to meet short-term obligations. •Solvency oThe ability to meet long-term obligations. 3.Major Financial statements and other information sources 1)Financial statements and supplementary information a)Definition •Key financial statements oIncome statement ,Company’s performance over a period of time. oBalance sheet ,Finical position at a given point in time. oStatement of cash flows ,Company’s performance over a period of time. oStatement of changes in owners’ equity ,Additional information regarding the changes in a company’s financial position. b)Income statement •Definition oThe income statement presents information on the financial results of a company’s business activities over a period of time. oNet income (net earnings, net profit or net loss) ,Revenue minus all costs (expenses). oRevenue , oThe income statement is sometimes referred to as a statement of operations or profit and loss (P&L) statement. oBe careful about time order in the income statement. oEBIT (operation income) ,Earnings before interest and taxes. ,Revenue –operating costs and expenses. oEarnings per share ,Represents the net income divided by the number of shares of stock outstanding during the period. ,Basic earnings per share •It uses the weighted-average number of common shares that were actually outstanding during the period. , Diluted earnings per share (worst case senario) •It uses diluted shares – the number of shares that would be outstanding if potentially dilutive claims on shares (e.g. stock options) were exercised by their holders. •Companies present their basic and diluted earnings per share on the face of the income statement. c)Balance sheet •Balance sheet (statement of financial position, or statement of financial condition) oAbout net come, whether profitable over time, financial position compared with other companies. oIt presents a company’s current financial position by disclosing resources the company controls (assets) and what it owes (liabilities) at a specific point in time. •Owner’s equity (partners’ capital or shareholders’ equity) oIt represents the excess of assets over liabilities. oOwners’ equity = Assets – Liabilities. •Assets = Liabilities + Owners’ equity. oThe total amount for assets must balance to the combined total amounts for liabilities and owners’ equity. d)Statement of cash flows •Statement of cash flows oAbout liquidity, solvency, financial position relative to the industry. oVital to long-term success as it represents the financial flexibility by disclosing the sources and uses of cash. •Financial flexibility oAbility to react and adapt to financial adversities and opportunities.•Three ways to classify cash flows oOperating activities ,They involve transactions that enter into the determination of net income and are primarily activities that comprise the day- to-day business functions of a company. oInvesting activities ,They are those activities associated with the acquisition and disposal of long-term assets, such as equipment. oFinancing activities ,Activities related to obtaining or repaying capital to be used in the business. •Different perspectives of income statement and cash flow oIncome is reported when earned, not necessarily when cash is received. oThe statement of cash flows presents another aspect of performance: the ability of a company to generate cash flow from running its business. ,Ideally, the analyst would like to see that the primary source cash flow is from operating activities (as opposed to investing or financing activities). •The summation of the net cash flows from operating, investing and financing activities and the effect of exchange rates on cash equals the net change in cash during the fiscal year. e)Statement of changes in owners’ equity •Statement of changes in owners’ equity oIt primarily serves to report changes in the owners’ investment in the business over time and assists the analyst in understanding the changes in financial position reflected on the balance sheet. f)Financial notes and supplementary schedules •Financial notes and supplemental schedules provide explanatory information about the following: oBusiness acquisitions and disposals; oCommitments and contingencies; oLegal proceeding; oStock option and other employee benefit plans; oRelated-party transactions; oSignificant customers; oSubsequent events; oBusiness and geographic segments; and oQuarterly financial data. •Footnotes oThey contain information about the methods and assumptions used to prepare the financial statements. •Comparability of financial statements is triticale requirement for objective financial analysis. oIt occurs when information is measured and reported in a similar manner over time and for different companies. oIFRS ,International financial reporting standards. oUnited States sets forth standard. ,Set by FASB oU.S. GAAP ,Generally accepted accounting principles oThese two standards have differences. oEven within each of these sets of standard there can be choices for management to make that can reduce comparability between companies. , Both standards allow the use of alternative accounting methods. ,Some principles require the use of estimates and assumptions in measuring performance and financial condition. •Depreciation oThe allocation of the cost in a systematic manner over the life of the equipment. •A company’s accounting policies (methods, estimates and assumptions) are generally presented in the notes to the financial statements. oNote ,It contains a summary of significant accounting policies reveals. g)Management’s discussion and analysis •Management’s discussion and analysis (MD&A) oIn it, management must highlight any favorable or unfavorable trends and identify significant events and uncertainties that affect the company’s liquidity, capital resources, and results of operations. oIt must provide inflation, changing prices, or other material events and uncertainties that may cause the future operating results and financial condition to materially depart from the current reported financial information. ,Critical accounting policies that require management to make subjective judgments and that have significant impact on reported financial results. h)Auditor’s reports •Financial statements presented in company annual financial reports are often required to be audited (examined) by an independent accounting firm that then expresses an opinion on the financial statement. •Standard for audit also varies. •Independent audit provides reasonable (not absolute) assurance that the financial statements are fairly (not absolute accurate) presented, meaning that there is a high degree of probability that the audited financial statements are free from material error, fraud, or illegal acts that have a direct effect on the financial statements. •The standard independent audit report for a publicly traded company normally has several paragraphs under both the international and U.S. auditing standards. oIntroductory ,It describes the financial statements that were audited and responsibilities of both management and the independent auditor. oScope ,It describes the nature of the audit process and provides the basis for the auditor’s expression about reasonable assurance on the fairness of the financial statements. oOpinion ,It expresses the auditor’s opinion on t he fairness of the audited financial statements. ,unqualified audit opinion •It states that the financial statements give a “true and fair view” or “fairly presented” in accordance with applicable accounting standards. •“Clean” opinion which is welcomed by analysts. ,Qualified •There is some limitation or exception to accounting standards. ,Adverse •It occurs when the financial statements materially depart from accounting standards and are not fairly presented. •It implies that this statement is not reliable oDisclaimer of opinion ,It occurs when the auditors are unable to issue an opinion.•In U.S., the auditors must also express an opinion on the company’s internal control system. oThe internal control system that is designed to ensure the company’s process for generating financial reports is sound. oU.S. rules increase management’s responsibility for demonstrating that the company’s internal controls are effective. oPublic traded companies in U.S. are now required by securities regulators to ,Accept responsibility for the effectiveness of internal control; ,Evaluate the internal control using suitable control criterion; ,Support the evaluation with competent evidence; and ,Provide a report on internal control. oOn the report of internal control: ,State that it is management’s responsibility to establish and maintain adequate internal control; ,Identify management’s assessment of the effectiveness of company’s internal control over financial reporting as of the end of the most recent year, including a statement as to whether internal control over financial reporting is effective; ,Include a statement that the company’s auditors have issued an attestation report on management’s assessment; and ,Certify that the company’s financial statements are fairly presented. 2)Other sources of information a)Interim reports •Semiannually or quarterly. •It generally presents the four key financial statements and footnotes but are not audited, which a update of information since the last annual report. b)Proxy statement •To whoever can put a vote at the company’s annual meeting of shareholders.•It provides useful information regarding management and director compensation and company stock performance and discloses any potential conflicts of interest that may exist between management, the board, and shareholders. •Remembered as decision and cost between proxy and principles. c)Current information on website and press as a part of conference call. d)External sources regarding the economy, the industry, the company, and peer (comparable) companies. 4.Financial statement analysis framework 1)Articulate the purpose and context of analysis a)Well defined analysis tasks. •It requires little decision making by the analyst. b)Other tasks. •The purpose of an analysis guides further decisions about the approach, the tools, the data sources, the format in which to report results of the analysis, and the relative importance of different aspects of the analysis. •What conclusion, for what question, and supporting what decision. •Defining the context. oAudience oWhat is the end product oTime frame oResources and their constraints. oPredefinition. c)Compiling the specific questions to be answered by the analysis. 2)Collect data a)Obtaining an understanding of the company’s business, financial performance, and financial position (including trends over time and in comparison with peer companies). •For historical analyses, financial statement data alone are adequate in some cases. But for further conclusion, more information is usually needed.b)The information on the economy and industry is necessary to understand the environment in which the company operates. The “top-down” approach: • Gain an understanding of the macroeconomic environment, such as prospects for growth in economy and inflation; •Analyze the prospects of the industry in which the subject company operates based on the expected macroeconomic environment, and; •Determine the prospects for the company in the expected industry and macroeconomic environments. 3)Process data a)Reading and evaluating financial statements for each company subject to analysis. •Reading the footnotes and understanding what accounting standards have been used, and what operating decisions have been made that affect reported financial statements. b)Making any needed adjustments to the financial statements to facilitate comparison, when the unadjusted statements of the subject companies reflect differences in accounting standards, accounting choices, or operating decisions. •Commonly used databases do not make such analyst adjustments. c)Preparing or collecting common-size financial statement data. •Those data scale themselves to directly reflect percentages or changes and financial ratios. •On the basis of that, analysts can evaluate a company’s relative profitability, leverage, efficiency, and valuation in relation to past results and/or peers’ results. 4)Analyze/ Interpret the processed data a)It is a critical step. b)Several answers to their questions •The answer to a specific financial analysis question is seldom the numerical answer alone: •The answer to the analytical question relies on the interpretation which further supports a conclusion or recommendation. 5)Develop and communicate conclusions/recommendations a)The appropriate format will vary by analytical task, by institution or by audience.6)Follow up a)The process doesn’t end with the report. b)Usually need periodic review to see whether the original conclusion turns out to be right. And further modification evaluation if needed. Reading 30- Financial Reporting Mechanics 1.Introduction 1)Learning the process from this perspective will enable an analyst to grasp the critical concepts without being overwhelmed by the detailed technical skills required by the accountants. 2.The classification of business activities 1)Three classifications a)Operating activities •Activities that are part of the day-to-day business functioning of an entity. •Including taking deposits and making loans by a bank. b)Investing activities •Activities associated with acquisition and disposal of long-term assets. •Also including purchase or sale of an office building, a retail store, or a factory. c)Financing activities •Activities related to obtaining or repaying capital. •The two primary sources for such funds are owners or creditors. 2)Properties a)Ideally, an analyst would prefer that most of a company’s profits (and cash flow) come from its operating activities. b)Not all transactions fit neatly in this framework for purposes of financial statement presentation. 3.Accounts and financial statements 1)Definitions a)Interpretation of business activities •Business activities resulting in transactions are reflected in the broad groupings of financial statement elements: Assets, Liabilities, Owners’ Equity, Revenue, and Expenses. oInternational Financial Reporting Standards use the term “income” to include revenue and gains. o Gains/Losses ,They arise from secondary or peripheral activities rather than from a company’s primary business activities. oIn U.S. GAAP, also including gains and losses. oIn this reading, gains and revenue will be aggregated in revenue, and all losses and expenses will be aggregated in expenses. •Assets oEconomic resources of a company. •Liabilities oCreditors’ claims on the resources of a company; •Owners’ equity/shareholders’ equity/ partners’ capital/net assets/equity/net worth/net book value oResidual claim on those resources. •Revenues oInflows of economic resources to the company. •Expenses oOutflows of economic resources or increases in liabilities. 2)Financial statement elements and accounts a)Accounts •Individual records of increases and decreases in a specific asset, liability, component of owners’ equity, revenue, or expense. •For financial statements, amounts recorded in every individual account are summarized and grouped appropriately within a financial statement element.•Accounts are varies for different companies with different operating activities.•A company’s challenge is to establish accounts and account groupings that provide meaningful summarization of voluminous data but retain enough detail to facilitate decision making and preparation of the financial statements. b)Chart of accounts •Generally, the chart of accounts is far more detailed than the information presented in financial statements. c)Certain accounts are used to offset other accounts •Account receivable (trade accounts receivable or trade receivables) oTo record the amounts it is owed by its customers. (e.g. on credits)•Allowance for bad debts oIn connection with its receivables, a company often expects some amount of uncollectible accounts and, therefore, records an estimate of the amount that may not be collected. oIt deduces account receivable, so it is a “contra asset account”.•Contra account oAny account that is offset or deducted from another account. oCommon contra asset accounts include: , allowance for bad debts, ,accumulated depreciation •an offset to property, plant, and equipment reflecting the amount of the cost of property, plant, and equipment that has been allocated to current and previous accounting periods. ,Sales returns and allowances •An offset of revenue reflecting any cash refunds, credits on account, and discounts from sales prices given to customers who purchased defective un unsatisfactory items. d)Current and noncurrent assets. •Noncurrent assets oAssets that are expected to benefit the company over an extended period of time (usually more than one year). •Current assets oAssets that are expected to be consumed or converted into cash in the near future, typically one year or less. oInventories ,Unsold units of product on hand (sometimes referred to as inventory stock). oTrade receivables (commercial receivables or accounts receivable) ,Amounts customers owe the company for products that have been sold as well as amounts that may be due from suppliers (such as for returns of merchandise). oOther receivables ,Represent amounts owed to the company from parties other than customers. oCash ,Refers to cash on hand and in the bank. oCash equivalents ,Very liquid short-term investments, usually maturing in 90 days or less. •The presentation of assets of current or noncurrent will vary from industry to industry and form country to country. 3)Accounting equations a)Balance sheet •It presents a company’s financial position at a particular point in time.•It provides a listing of a company’s assets and the claims on those assets (liabilities and equity claims). •Basic accounting equation oAssets = Liabilities + Owners’ equity •Owners’ equity is the residual claim of the owners (i.e. the owners’ remaining claim on the company’s assets after the liabilities are deducted). oAssets –Liabilities = Owners’ equity. •Owners’ equity at a given date can be further classified by its origin: capital contributed by owners, and earnings retained in the business up to the date. o Owners’ equity =Contributed capital +Retained earnings. ,Capital received from investors for stock, equal to capital stock plus contributed capital. ,Contributed capital is the same with “common shares”, “common stock”, “members’ capital”, “partners’ capital”, etc. oOwners’ equity section of a company’s balance sheet ay include other terms, such as treasury stock or other comprehensive income. ,Comprehensive income includes all income of the company. ,Items that are not included in that is called other comprehensive income. b)Income statement •It presents the performance of a business for a specific period of time.•Revenue- expense =Net income (loss) oOther terms are sued synonymously with revenue, including sales and turnover (in U.K.). Other terms used synonymously with net income include net profit and net earnings. oRevenue and expenses generally relate to providing goods or services in a company’s primary business activities. •Variance between balance sheet and income statement. oA balance sheet can be referred to as a “statement of financial position” or some similar term that indicates it contains balances (financial position) at a point in time. oIncome statements can be titled “statement of operations” , “statement of income”, ”statement of profit and loss”, or other similar term showing that it reflects the company’s operating activity for a period of time. oThese two are linked together through the retained earnings component of owners’ equity. ,Ending retained earnings = Beginning retained earnings + Net income – Dividends ,Ending retained earnings = Beginning retained earnings + Revenues - Expenses – Dividends oRetained earning ,It represents the earnings that are retained by the company – in other words, the amount not distributed as dividends to owners. ,It is a component of owners’ equity and links the “as of” balance sheet equation with the “activity” equation of the income statement. ,Assets = Liabilities + Contributed capital+ Ending retained earnings ,Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends oIn the simplified definition here, we can see that the net income is the change of the assets, and particularly, relative to the change of owners’ equity. And in the equations of retained earnings, we can find net income, this is the essential of the linkage. c)Statement of retained earnings •It shows the linkage between the balance sheet and income statement.•Double-entry accounting oUsed to describe the accounting process that every recorded transaction affects at least two accounts in order to keep the equation in balance implied by the basic accounting equation reflected in the balance sheet. oBut with each transaction, the accounting equation remains in balance, which is a fundamental accounting concept. 4.The account process 1)An illustration 2)The accounting records a)Accounting system •If the owners want to evaluate the business, then the record system is needed to track each activities and to address three objectives: oIdentify those activities requiring further action. (e.g. collection of outstanding receivable balances) oAssess the profitability of the operations over the month. oEvaluate the current financial position of the company (such as cash on hand). •An accounting system will translate the company’s business activities into usable financial records. •The accounting equation provides a basis for setting up this system. (Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends ). b)In assessing the financial impact of each event and converting these events into accounting transactions, the following steps are taken: •Identify which accounts are affected, by what amount, and whether the accounts are increased or decreased (assets, liability or owners’ equity).•Determine the element type for each account identified in Step 1 (e.g. cash is an asset) and where it fits in the basic accounting equation. Rely on the economic characteristics of the account and the basic definitions of the elements to make this determination. •Using the information from Steps 1 and 2, enter the amounts in the appropriate column of the spreadsheet. •Verify that the accounting equation is still in balance. •At any point in time, basic financial statement can be prepared based on the subtotals in each column. c)Unclassified balance sheet •The one that doesn’t show subtotals for current assets and current liabilities.•Assets are simply listed in order of liquidity; and liabilities are listed in the order in which they are expected to be satisfied (or paid off). d)Definitions •Depreciation oTerm for the process of spreading the cost of equipments over multiple periods. •Unearned fees (unearned revenue) oThe cash that got but recorded as liability, to indicate that they need more operations (in future) to let it to be the assets. •Cost of goods sold oCataloged as expense, it is the cost of goods. e)Something need to notice •If something paid is worth in several periods, then it is included in assets (e.g. prepaid rent which is reflected as an expense over time). Otherwise, it will be in expense. •Retained earnings are the key to link income statement and balance sheet by revenue, expense, and dividend. •Companies may make adjustments to correct erroneous entries or to update inventory balance to reflect a physical count. •From the income statement, we can determine that the business was profitable for the period. The balance sheet presents the financial position. 3)Financial statements a)Definitions •Direct format oThe format that refers to the operating cash section appearing simply as operating cash receipts less operating cash disbursements.•Indirect format oThe format that begins with net income and shows adjustments to derive operating cash flow. b)Three statements •Balance sheet oThis statement provides information bout a company’s financial position at a point in time. oIt shows an entity’s assets, liabilities, and owners’ equity at a particular date. oLess significant accounts can be grouped into a single line item.•Income statement oThis statement provides information about a company’s profitability over a period of time. oIt shows the amount of revenue, expense, and resulting net income or loss during a period of time. oLess significant accounts can be grouped into a single line item.•Statement of cash flows oIt provides information about a company’s cash flows over a period of time. oIt shows a company’s cash inflows (receipts) and outflows (payments) during the period, which are categorized according to three groups of business activities: operating, financing, and investing. •Statement of owners’ equity oIt provides information about the composition and changes in owners’ equity during a period of time. oA statement of retained earnings would report the changes in a company’s retained earnings during a period of time. c)Interrelationships among financial statements. •Owners’ equity in balance sheet is consistent with the statement of retained earnings. •Cash in balance sheet is consistent with the statement of cash flows.•In summary, the balance sheet provides information at a point in time (financial position), whereas the other statements provide useful information regarding the activity during a period of time (profitability, ash flow, and changes in owners’ equity). 5.Accruals and valuation adjustments 1)Accruals a)General explanation •Accrual accounting requires that revenue be recorded when earned and that expenses be recorded when incurred, irrespective of when the related cash movements occur. (no matter when the cash moves) •The purpose of accrual entries is to report revenue and expense in the proper accounting period. oCash movement and accounting recognition can occur at the same time. ,There is no need for accruals. oCash movement may occur before or after accounting recognition. ,Accruals are required. b)Four types of accrual entries •Unearned revenue (deferred revenue) oIt arises when a company receives cash prior to earning the revenue. oOriginating entry ,Record cash receipt and establish a liability. oAdjusting entry ,Reduce the liability while recoding revenue. oIn practice, a large amount of unearned revenue may cause some concern about a company’s ability to deliver on this future commitment. Conversely, a positive aspect is that increases in unearned revenue are an indicator of future revenues. •Unbilled revenue (accrued revenue) oIt arises when a company earns revenue prior to receiving cash but has not yet recognized the revenue at the end of an accounting period. oOriginating entry ,Record revenue and establish an asset. oAdjusting entry ,When billing occurs, reduce unbilled revenue and increase accounts receivable. When cash is collected, eliminate the receivable. oAccrued revenue specifically relates to end-of-period accruals, however, the concept is similar to any sale involving deferred receipt of cash. •Prepaid expenses oIt arises when a company makes a cash payment prior to recognizing an expense. oPrepaid expense are assets that will be subsequently expensed. oOriginating entry ,Record cash payment and establish an asset. oAdjusting entry ,Reduce the asset while recording expense. oIn practice, particularly in a valuation, one consideration is that prepaid assets typically have future value only as future operations transpire, unless they are refundable. •Accrued expenses oIt arises when a company incurs expenses that have not yet been paid as of the end of an accounting period. oThey result in liabilities that usually require future cash payments. oOriginating entry ,Establish a liability and record an expense to reflect the company’s position at the end of that period. oAdjusting entry ,Reduce the liability as cash is paid. oAccrued expenses specifically relate to end-of-period accruals. oAccounts payable ,Accounts payable are similar to accrued expenses in that they involve a transaction that occurs now but the cash payment is made later. ,Accounts payable is also a liability but often relates to the receipt of inventory (or perhaps services) as opposed to recording an immediate expense. ,Account payable should be listed separately from other accrued expenses on the balance sheet. •Overall, in practice, complex businesses require additional accruals that are theoretically similar to the four categories of accruals discussed above but which require considerable more judgment. oHow to allocate/distribute amount across periods. 2)Valuation adjustment a)Valuating adjustments are made to a company’s assets or liabilities, only where required by accounting standards, so that the accounting records reflect the current market value rather than the historical cost. b)Accounting regulations do not require all types of assets to be reported at their current market value. c)In summary where valuation adjustment entries are required for assets, the basic pattern is the following for increases in assets: •An asset is increased with the other side of the equation being a gain on the income statement or an increase to their comprehensive income. •Decrease: an asset is decreased with the other side of the equation being a loss on the income statement or a decrease to other comprehensive income. 6.Accounting systems 1)Flow of information in an accounting system a)Page 67 exhibit 11 b)General idea •Journal entries and adjusting entries oA journal is a document in which business transactions are recorded in the order in which they occur (chronological order). oJournal entries – recorded in journals – are dated, show the accounts affected, and the amounts, which includes explanations of authorization in necessary. oAdjusting journal entries, a subset of journal entries, are typically make at the end of an accounting period to record items such as accruals that are not yet reflected in the accounting system. •General ledger and T-accounts oA ledger is a document or computer file that shows all business transactions by account. oThe only difference from general journal is that the data are sorted by date in a journal and by account in the ledger. So ledger is useful for reviewing all of the activity related to a single account. oT-accounts, are representations of ledger accounts and are frequently used to describe or analyze accounting transactions. •Trial balance and adjusted trial balance oA trial balance is a document that lists account balances at a particular point in time, which are typically prepared at the end of an accounting period as a first step in producing financial statements. oA key difference between trial balance and a ledger is that the trial balance shows only total ending balances. •Financial statements oThey are prepared based on the account totals from an adjusted trial balance. 2)Debits and credits a)Traditionally, accounting systems have sued these terms to describe changes in an account resulting from the accounting processing of a transaction.b)Definition •Debits oThey record increases of asset and expense accounts or decreases in liability and owners’ equity accounts. •Credit oThey record increases in liability. Owners’ equity, and revenue accounts or decreases in asset accounts. c)Properties •In processing a transaction, the sum of debits equals then sum of credits, which is consistent with the accounting equation always remaining in balance. 7.Using financial statements in security analysis Analysts need to infer what transactions were recorded by examining the financial statements. 1)The use of judgment in accounts and entries a)Accruals and valuation entries require considerable judgment and thus create many of the limitations of the accounting model. b)An important first step in analyzing financial statements is identifying the types of accruals and valuation entries in an entity’s financial statements. •Most of them will be noted in the critical accounting policies/ estimates section of MD&A and in the significant accounting policies footnote, both found in the annual report. •The analyst need to be aware, that the manipulation of earnings and assets can take place within the context of satisfying the mechanical rules governing the recording of transactions. 2)Misrepresentations a)Most computer accounting systems will not allow a company to make one-sided entries, but an unscrupulous accountant could structure entries to achieve a desired result. b)There has to be another side to every entry is key in detecting inappropriate accounting because-usually in the course of “fixing” one account-there will be another account with a balance that does not make sense. c)Ratio analysis can assist in detecting suspect amounts in their accounts. d)The accounting equation can be used to detect likely accounts where aggressive or even fraudulent accounting may have occurred. Reading 31- Financial Reporting Standards 1.Introduction 1)Financial reporting standards determine the types and amounts of information that must be provided to investors and creditors so that they may make informed decisions. 2.The objective of financial reporting 1)The objective of financial reporting a)International accounting standard board (IASB) says •The objective of financial statements is to provide information about the financial position, performance, and changes in financial position of an entity; this information should be useful to wide range of users for the purpose of making economic decisions. b)Financial reporting standards try to limit the range of acceptable answers to ensure some measure of consistency in financial statements. c)The IASB and the U.S. Financial Accounting Standards Board (FASB) have developed similar financial reporting frameworks, both of which specify the overall objective and qualities of information to be provided. •Financial reports are not designed with only asset valuation, but also provide important inputs into the process of valuing the company or the securities of a company issues. 3.Financial reporting standard-setting bodies and regulatory authorities Generally, standard-setting bodies make the rules and regulatory authorities enforce the rules. 1)International accounting standards boards a)IASB is the standard-setting body responsible for developing international financial reporting and accounting standards, with four goals of: •To develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the world’s capital markets and other users make economic decisions. •To promote the use and rigorous application of those standards; •In fulfilling the objectives associated with 1, and 2, to take account of , as appropriate, the special needs of small and medium-sized entities and emerging economies; and •To bring about convergence of national accounting standards and international accounting standards and international financial reporting standards to high quality solutions. 2)International organization of securities commissions a)The IOSCO adopted a comprehensive set of objectives and principles of securities regulation, which is recognized as international benchmarks for all markets, with three core objectives of securities regulation: •Protecting investors; •Ensuring that markets are fair, efficient, and transparent; and •Reducing systematic risk. b)The IOSCO aims to assist in the uniform of regulation. 3)Capital markets regulation in Europe a)European Securities Committee (ESC) • It consists of high-level representatives of member states and advises the EC on securities policy issues. b)Committee of European Securities Regulators (CESR) •It is an independent advisory body composed of representatives of regulatory authorities of the member states. 4)Capital Markets Regulation in the U.S. (U.S.SEC) a)Significant securities-related legislation •Securities act of 1933 •Securities exchange act of 1934 oThis act created the SEC. •Sarbanes-Oxley act of 2002 oCreated the Public Company Accounting Oversight Board (PCAOB) ot oversee auditors. oIt strengthens corporate responsibility for financial reports. b)SEC filings: key sources of information for analysis •Electronic Data Gathering, Analysis, and Retrieval system. (EDGAR)•Securities Offering Registration Statement oThe 1933 act requires companies offering securities to file a registration statement. ,Disclosures about the securities being offered for sale ,The relationship of these new securities to the issuer’s other capital securities ,The information typically provided in the annual filings ,Recent audited financial statements ,Risk factors involved in the business. •Forms 10-K, 20-F, and 40-F oThere are forms that companies are required to file annually. ,10-K : U.S. registrants ,40-F: for certain Canadian registrants ,20-F: for all other non-U.S. registrants. oIncluding historical summary financial data, MD&A, and audited financial statement. •Annual report oIt is not a requirement. •Proxy Statement/Form DEF-14A oRequired prior to a shareholder meeting. •Forms 10-Q and 6_k oThese are forms that companies are required to submit for interim periods. c)Other filing •These forms sometimes contain the most interesting and timely information and may have significant valuation implications. •Form 8-K o“current report” •Form 144 oRule 144 permits limited sales of restricted securities without registration. •Form 3,4, and 5 oThese forms are required to report beneficial ownership of securities. oThese forms, along with 144, can be used to examine purchases and sales of securities by officers, directors, and other affiliates of the company. •Form 11-K oAnnual report of employee stock purchase, savings, and similar plans. 4.Convergence of global financial reporting standard 1)Ongoing barriers a)The move toward one global set of financial reporting standards has made the barriers to full convergence more apparent. •Standard-setting bodies and regulators can have differing views. •They may be influenced by strong industry lobbying groups and others that will be subject to these reporting standards. •Political pressure. 5.The international financial reporting standards framework 1)Objective a)The frameworks are designed to assist the IASB in developing standards and to instruct preparers of financial statements on the principles of financial statement construction. b)Fair presentation of the company’s financial position, its financial performance, and its cash flows. •For all users •For making economic decisions. 2)Qualitative Characteristics of financial statements a)Understandability •The information should be readily understandable by users who have a basic knowledge of business, economic activities, and accounting, and who have a willingness to study the information with reasonable diligence.b)Relevance •Whether the information influences economic decisions of users, helping them to evaluate past, present, and future events, or to confirm or correct their past evaluations. •Timely, and enough for assessing risk and opportunity. •Materiality oThe omission or misstatement of the information could make a difference to users’ decisions. •Reliability oReliable information also reflects economic reality, not just the legal form of a transaction or event. oFaithful representation ,Information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. oSubstance over form ,It is necessary that transactions and other events be accounted for and represented in accordance with their substance and economic reality and not merely their legal form. oNeutrality ,Information contained in the financial statements must be neutral – that is , free from bias. oPrudence ,Prudence is the inclusion of a degree of caution in making the estimates required under conditions of uncertainty. ,It does not allow the deliberate misstatement of elements in the financial statements in an attempt to conservative by providing for hidden reserves or excessive provisions. oCompleteness ,Financial statements must be complete within the bounds of materiality and cost. •Comparability oInformation should be presented in a consistent manner over time and in a consistent manner between entities to enable users to make significant comparisons. 3) Constraints on financial statement a)Necessity for trade-offs across the desirable characteristics. b)The cost of providing this information. c)What financial statements omit. •Financial statements, by necessity, omit information that is non-quantifiable. 4)The elements of financial statement a)Financial statements portray the financial effects of transactions and other events by grouping then into broad classes (elements) according to their economic characteristics. Measurement of the financial position: •Assets oResources controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. What company owns(e.g. inventory and equipment)•Liabilities oPresent obligations of an enterprise arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits. oWhat a company owes. •Equity oAssets less liabilities. oThe residual interest in the assets after subtracting the liabilities. Measurement of performance •Income oIncreases in economic benefits in the form of inflows or enhancements of assets, or decreases of liabilities that result in an increase in equity. (other than increases resulting from contributions by owners.) oIncluding both revenue and gains. ,Revenue •Income from ordinary activities of the enterprise. ,Gains •From ordinary activities or other activities •Expense oDecreases in economic benefits in the form of outflows or depletions of assets, or increases in liabilities that result in decreases in equity (other than decreases because of distributions to owners). b)Underlying Assumptions in financial statement •Accrual basis oFinancial statements aim to reflect transactions when they actually occur, not necessarily when cash movements occur. •Going concern oThe company will continue in business for the foreseeable future. oNo hush liquidation c)Recognition of financial statement elements •Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition. o It is probable that any future economic benefit associated with the item will flow to or from the enterprise, and oThe item has a cost or value that can be measured with reliability. d)Measurement of financial statement •Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement, whose bases are: •Historical cost oThe amount of cash or cash equivalents paid to purchase an asset, including any costs of acquisition and/or preparation. oTo liabilities, the amount of proceeds received in exchange for the obligation. •Current cost oThe amount of cash or cash equivalents that would have to be paid to buy the same or an equivalent asset today. oTo liabilities, the undiscounted amount of cash or cash equivalents that would be required to settle the obligation today. •Realizable (settlement) value oThe amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. oTo liabilities, called “settlement value”, undiscounted amount of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. •Present value oThe present discounted value of the future net cash inflows that the asset is expected to generate in the normal course of business. oTo liabilities, the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. •Fair value oThe amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction, which may involve either market measures or present value measures. 5)General Requirements for financial statements In International Accounting Standard (IAS) No.1 a)Required Financial statement •A balance sheet •An income statement •A statement of changes in equity showing either oAll changes in equity; or oChanges in equity other than those arising from transactions with equity-holders acting in their capacity as equity-holders.•A statement of cash flows; and •Notes comprising a summary of significant accounting policies and other explanatory notes. b)Fundamental principles underling the preparation of financial statement Relevant to the framwork •Fair presentation oFair presentation requires faithful representation of the effects of transactions, events and conditions in accordance with definitions and recognition criteria for assets, liabilities, income and expenses set out in Framework. •Going concern oUnless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. oIf not presented on a going concern basis, the fact and rationale should be disclosed. •Accrual basis oExcept for cash flow information. •Consistency oThe presentation and classification of items in financial statements are usually retained from one period to the next. oComparative information of prior periods is disclosed for all amounts reported in the financial statements, unless an IFRS requires or permits otherwise. •Materiality oOmissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. oAny material item shall be presented separately. c)Presentation requirement •Aggregation oEach material class of similar items is presented separately. oDissimilar items are presented separately unless they are immaterial.•No offsetting oAssets and liabilities, and income and expenses, are not offset unless required or permitted by an IFRS. •Classified balance sheet oThe balance sheet should distinguish between current and noncurrent assets, and between current and noncurrent liabilities unless a presentation based on liquidity provides more relevant and reliable information. (e.g. in the case of bank or similar financial institutions)•Minimum information on the face of the financial statements oIAS No.1 specifies the minimum line item disclosures on the face of, or in the notes to, the balance sheet, the income statement, and the statement of changes in equity. •Minimum information in the notes (or on the face of financial statement) oThe information must be provided in a systematic manner and cross- referenced from the face of the financial statements to the notes•Comparative information oFor all amounts reported in financial statement, comparative information should be provided for the previous period unless another standard requires or permits otherwise. 6.Comparison of IFRS with alternative reporting systems 1)U.S. GAAP a)U.S. GAAP Authoritative guidance •A “GAAP hierarchy” defines the sources of accounting principles and a framework for selecting the right principle. oFASB is working on a project to bring all authoritative guidance from these various sources into one set of authoritative literature called the “Codification”. •The top level of the hierarchy includes standards issued by the FASB. oThe literature referred to in the GAAP hierarchy that comprises U.S. GAAP is extensive. •As these standards have been developed over many years and by various bodies, they are more a patchwork than a cohesive framework. b)Role of the SEC in U.S.GAAP •U.S.GAAP is officially recognized as authoritative by the SEC, but the SEC retains the authority to establish standards—Staff Accounting Bulletins. c)Convergence of U.S.GAAP and IASB framework •The initial focus is on achieving the convergence of the frameworks and improving particular aspects of the framework dealing with objectives, qualitative characteristics, elements recognition, and measurement. d)Difference between IFRS and U.S. GAAP (FASB) frameworks •Purpose of the framework oFASB resides a lower level in the hierarchy. oUnder IFRS, management is expressly required to consider the frameworks if there is no standard or interpretation for that issue. The FASB doesn’t. •Objectives of financial statement oU.S. GAAP framework provides separate objectives for business entities versus non-business entities rather than one objective as in the IASB framework. •Underlying assumption oU.S.GAAP pays less attention to accrual and going concern assumption. •Qualitative characteristics oU.S.GAAP framework indentifies the same qualitative characteristics but also establishes a hierarchy of those characteristics. Relevance and reliability are considered primarily, and comparability secondarily. oUnderstandability is treated as a user-specific quality in the U.S.GAAP frameworks, is seen as a link between the characteristics of individual users and decision-specific qualities of information. FASB indicates that it cannot base its decisions on the specific circumstances of individual users. •Financial statement elements (definition, recognition, and measurement) oPerformance elements ,FASB includes three additional elements: gains, loss and comprehensive income. oFinancial position elements ,FASB defines the assets as a future economic benefit rather than the resource. ,Different meaning of probable. oRecognition of elements ,FASB does not discuss the term probable in tits recognition criteria. ,Different meaning of relevance. oMeasurement of elements ,FASB prohibits revaluations except for certain categories of financial instruments, which have to be carried at fair value. 2)Implications of other reporting systems a)Industry-specific financial reports – such as those required for banking or insurance companies – will continue to exist. 3)Reconciliation of financials prepared according to different standards.a)Reconciliation could provide additional useful information for security valuation.b)Given the length of reconciliation disclosure, a systematic method to quickly digest the information can be helpful. 7.Effective financial reporting framework 1)Characteristics of an effective financial reporting framework a)Transparency •Users should be able to see the underlying economics of the business.b)Comprehensiveness •Encompass the full spectrum of transactions that have financial consequences, for both existing and newly developed transactions. c)Consistency •Across companies and time periods. 2)Barriers to a single coherent framework a)Valuation •Historical cost valuation requires minimal judgment compared to other three. •Over time, both IASB and FASB recognized it may be more appropriate to measure certain elements using some fair value method in spite of the judgment required. •Fair value may be more relevant, whereas historical cost may be more reliable. b)Standard-setting approach •Principle-based oA broad financial reporting framework with little specific guidance on how to report a particular element or transaction. oRequire considerable judgment. •Rule-based oEstablishes specific rules for each element and transaction. oCharacterized by a list of yes-or-no rules, specific numerical tests for classifying certain transactions, exceptions, and alternative treatments. •Objective-oriented oCombines the other two approaches by including both a framework of principles and appropriate levels of implementation guidance.c)Measurement •Asset/liability v.s. revenue/expense (balance sheet v.s. income statement) •In recent years, asset/liability is more preferred. 8.Monitoring developments in financial reporting standards 1)Importance a)Analysts need to monitor ongoing developments in financial reporting and assess their implications for security analysis and valuation, for users’ perspective. 2)New products or types of transactions a)Dew products and new types of transactions can have unusual or unique elements to them such that no explicit guidance in the financial reporting standards exists. •Monitor business journals and the capital markets to identify such items. •Once new products, financial instruments, or structured transactions are identified, it is helpful to gain an understanding of the business purpose. •The financial reporting framework presented here is useful in evaluating the potential effect on financial statements even though a standard may not have been issued. 3)Evolving standard and the role of the CFA institute a)Changes in regulations can affect companies’ financial reports and evaluation. •This is particularly true if the financial reporting standards change to require more explicit identification of matters affecting asset/liability valuation or financial performance. b)The IASB and FASB have numerous major projects underway that will most likely result in new standards, so it is important to keep up to date on these evolving standards. •On their websites. •IASB and FASB seek input from the financial analysis community.•CFA issued a position paper titled A comprehensive Business Reporting Model: Financial Reporting for Investors. 4)Company disclosures a)Disclosures relating to critical significant accounting policies•Under both IFRS and U.S. GAAP, companies are required to disclose their accounting policies and estimates in the footnotes to the financial statements. oThis disclosure indicates the policies that management deems most important. oAlthough many policies are discussed in both MD&A and footnotes to the financial statements, there is typically a distinction between the two discussions. ,MD&A : require significant judgment ,Footnote: irrespective of whether judgment is required. oEssential questions about polices: ,What policies ,Whether cover all of the significant balances on FS. ,Which polices requiring significant estimates ,Changes oTwo items usually need significant judgment ,Revenue recognition ,Timing of reporting the related expenses. b)Disclosures regarding the impact of recently issued accounting standards.•Likely the future impact of recently issued accounting standards required by SEC in U.S. •IFRS requires similarly discussion about pending implementations of new standards and known or estimable information relevant to assessing the impact of the new standards. •The conclusion that a company can reach about a new standard include oThe standard does not apply; ,Helpful. oThe standard will have no material impact; ,Helpful. oManagement is still evaluating the impact; ,Indicating uncertainty. oThe impact of adoption is discussed. ,Disclosures indicating the expected impact provide the most meaningful information. Reading 32 – Understanding The Income Statement 1.Introduction 1)It is also called as the statement of operations or statement of earnings, “P&L” for profit and loss. 2.Components and format of the income statement 1)Revenue a)Definitions •Revenue/ Sales/turnover(in some countries) oIt refers to amounts charged for the delivery of goods and services in the ordinary activities of a business. •Net revenue oThe revenue number that is shown after adjustments (e.g., for estimated returns or for amounts unlikely to be collected). •Net income oIt includes gains and losses, which are asset inflows and outflows, respectively, not directly related to the ordinary activities of the business. •Subtotals that are significant to users. oSome are required by IFRS: ,Revenue, financial costs ,and tax expense, be separately stated on the face of the income statement. ,Headings and subtotals also required. ,Expenses should be grouped by their nature or function. oGross profit/gross margin ,When an income statement shows a gross profit subtotal, it is said to use a multi-step format rather than a single-step format. ,Gross profit is the amount of revenue available after subtracting the cost of delivering goods and services such as material and labor. ,Other expenses related to running the business are subtracted after gross profit. oOperating profit ,Operating profit further deducts operating expense such as selling, general, administrative, research, and development expenses. ,For some companies composed of a number of separate business segments, operating profit can be useful in evaluating the performance of the individual businesses, reflecting the reality that interest and tax expense are more relevant at the level of the overall company rather than an individual segment level. oMinority interest ,It represents the portion of income that belongs to minority shareholders of these consolidated subsidiaries, as opposed to the parent company. ,Consolidation •It means that they include all of the revenues and expenses of those subsidiaries even if they own less than 100 percent. b)Alternative format •Columns of years may list the most recent one to the leftmost or the rightmost. •Different in presentations of items, such as expenses. oPresentation of negative terms •Synonyms for net income oNet income, net earnings, net profit, the bottom line. oIt is the most relevant number to describe a company’s performance over a period of time. •Gross profit oFor goods companies, it is revenue minus the cost of the goods that were sold. oFor service companies, it is calculated as revenue minus the cost of services that were provided. •Operating profit oFor financial firms, interest expense would be included in operating expenses and subtracted in arriving at operating profit. oFor non-financial firms, interest expense would be subtracted after operating expenses because it related to non operating activities.•Footnotes to the financial statements are helpful in identifying differences in accounting policies, practices of particular company, and terminologies. 3.Revenue recognition 1)Definitions a)Income •Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. •IFRS use the term income to include revenue and gains. •Gains oThey arise from secondary or peripheral activities rather than from a company’s primary business activities. •Loss oThey arise from the secondary activities. •Gains and losses may be considered part of operating activities or may be considered part of non-operating activities. 2)General Principles a)It can occur independently of cash movements – an important concept!•Account receivable oRevenue is recognized when it is earned, so the company’s financial records reflect the same when it is made and a related accounts receivable – a fundamental principle. •Unearned revenue oWhen a company receives cash up front and actually delivers the product or service later, perhaps over a period of time, the company would record unearned revenue, which is then recognized as being earned over time. b)The basic revenue recognition principles promulgated by accounting regulators deal with the definition of “earned”. •IASB oThe entity has transferred to the buyer the significant risks and rewards of ownership of the goods; ,It occurs when goods are delivered to the buyer or when legal title to goods transfers. ,However, transfer of goods will not always result in the recognition of revenue. oThe entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; oThe amount of revenue can be measured reliably; oIt is probable that the economic benefits associated with the transaction will flow to the entity; and oThe costs incurred or be incurred in respect of the transaction can be measured reliably. •FASB oThere is evidence of an arrangement between buyer and seller. ,This would disallow the practice of recognizing revenue in a period by delivering the product just before the end of an accounting period and then completing a sales contract after the period end. oThe product has been delivered, or the service has been rendered. ,Preclude shipped products, but the ownership has not been passed to the buyer. oThe price is determined, or determinable. ,Preclude recognizing revenue on contingency. oThe seller is reasonably sure of collecting money. ,Preclude recognizing revenue when customer is unlikely to pay. c)Recognition of revenue for services defined by IASB •The amount of revenue can be measured reliably; •It is probable that the economic benefits associated with the transaction will flow to the entity; •The stage of completion of the transaction at the balance sheet date can be measured reliably; and •The costs incurred for the transaction and the costs to complete the transaction can be measured reliably. d)Companies must disclose their revenue recognition policies in the foot notes to their financial statements. 3)Revenue recognition in special cases a)Long-term contract •definition oLong-term contract is one that spans a number of accounting periods.•The way to determine revenue of each accounting period of long-term contract is : oPercentage-of-completion method defined by IAS. (discussed below) oU.S.GAAP generally accepts this basis and has a similar requirement. oIf a loss is incurred, then it is reported immediately, no matter what method used. •Percentage-of-completion method oThe revenue is recognized in the accounting periods in which the services are rendered. oIn each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. oContract costs for the period are expensed against the revenue, thus, net income or profit is reported each year as work is performed. oUnder IAS, if the outcome of the contract cannot be measured reliably, then revenue is only reported to the extent of contract costs incurred (if it is probable the costs will be recovered). Costs are expensed in the period incurred, and no profit would be reported until completion of the contract. oConstruction contracts also require the recognition of revenue on this basis. •Completed contract method oWhen the outcome of the contract cannot be measured reliably, U.S.GAAP uses this method oThe company does not report any revenue until the contract is finished, and it is also appropriate for other kind of contracts.•Comparison of those two methods oDisadvantages of Percentage-of-completion method ,Percentage-of-completion method results in revenue recognition sooner than the completed contract method and thus may be considered a less conservative approach. ,And because it relies on management’s estimate, it is less objective. oAdvantages of Percentage-of-completion method ,It results in better matching of revenue recognition with the accounting period in which it was earned. ,It is preferred for long-term contract when periodic outcomes can be measured reliably under both IAS and U.S.GAAP. b)Installment sales •definition oinstallment sales in which proceeds are to be paid in installments over an extended period. •installment sales for real estate oUnder normal conditions. sales of real estate are reported at the time of sale using the normal revenue recognition conditions. oIAS provides that in the case of real estate where the down payment and payments received do not provide sufficient evidence of the commitment of the buyer, revenue should only be reported to the extent cash is received. ,This is a conservative treatment because the reporting of revenue is deferred. oU.S.GAAP have similar provisions except that the full revenue is shown in the year of sale but some of the profit is deferred.•installment method othe portion of the total profit of the sale that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash. •cost recovery method oan appropriate alternative for many of the same situations as the installment method. othe seller does not report any profit until the cash amounts paid by the buyer-including principal and interest on any financing from the seller- are greater than all the seller’s costs of the property. c)Barter •Mostly used in e-commerce. •Barter transaction oThe exchange of goods and services that without common unit of exchange (that is, without money or cash equivalence). oRound-trip transactions ,The company’s revenue would be approximately equal to its expense, the net effect of the transaction would have no impact on net income or cash flow. However, the amount of revenue reported would be higher. oUnder IFRS, revenue from barter transactions must be measure based on the fair value of revenue from similar non-barter transactions with unrelated parties. oFASB states that revenue can be recognized at fair value only if a company has historically received cash payments for such services and can thus use this historical experience as a basis for determining fair value. d)Gross versus Net Reporting •Also involved in e-commerce. •U.S.GAAP indicates the approach should be based on the specific situation and provides guidance for determining when revenue should be reported gross versus net. oTo report gross revenues ,Gross revenue doesn’t subtract the cost of the goods purchased. ,The company is the primary obligor under the contract, bears inventory risk and credit risk; ,Can choose its supplier; ,Has reasonable latitude to establish price. oTo report net revenue ,It subtracts the cost of the goods purchased from the suppliers. ,All other conditions. ,Any one of above criteria is not satisfied. 4)implications of financial statement a)companies disclose their revenue recognition policies in the footnotes to their financial statement, often in the first note. b)the following aspects of a company’s revenue recognition policy are particularly relevant to financial analysis: •Whether a policy results in recognition of revenue sooner rather than later (sooner is less conservative); •To what extent a policy requires the company to make estimates.•comparing with other companies in the same industry to characterize the relative conservatism of a company’s policies and to qualitatively assess how differences in policies might affect financial ratios. 4.Expense recognition 1)definitions a)expenses •Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. •The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the enterprise. •Losses represent other items that meet the definition of expenses and may, or may not, arise in the course of the ordinary activities of the enterprise.•Losses include those resulting from disasters such as fire and flood. 2)General principles a)In general, a company recognizes expenses in the period that it consumes the economic benefits associated with the expenditure, or loses some previously recognized economic benefit. b)Marching principle/marching of costs with revenues •a company directly matches some expenses with associated revenues.•it requires that the company match the cost of goods sold with the revenues of the period. (the cost is respected to its own period) c)Period costs •expenditures that less directly match the timing of revenues, are reflected in the period when a company makes the expenditure or incurs the liability to pay. oe.g. administrative cost •other expenditures that also less directly match the timing of revenues relate more directly to future expected benefits; in this case, the expenditures are allocated systematically with the passage of time. oe.g. depreciation expenses. d)Specific identification method •It is not always possible to specifically identify which items were sold, so the accounting standards permit the assignment of inventory costs to costs of goods sold and to ending inventory using cost flow assumptions.•Under both IFRS and U.S.GAAP, companies may use either of two methods to assign costs oFirst In, First Out (FIFO) ,It is simply assumed that the age earliest items purchased were sold first oWeighted average cost method ,Simply averages the total available costs over the total available units. oLast In, First Out (LIFO) ,It is permitted under US.GAAP, but not IFRS. ,It is assumed that the most recent items purchased were sold first. 3)Issues in expense recognition a)Doubtful accounts •When a company sells its products or services on credit, it is likely that some customers will ultimately default on their obligations. •direct write-off method oThe company to wait until such time as a customer defaulted and only then recognize the loss. oIt is usually not consistent with generally accepted accounting principles. •Under matching principle, at the time revenue is recognized on a sale, a company is required to record an estimate of how much of the revenue will ultimately be uncollectible, which is not direct deduction of revenues. b)warranties •One possible approach would be for a company to wait until actual expenses are incurred under the warranty and to reflect the expense at that time.•Under the matching principle, a company is required to estimate the amount of future expenses resulting from its warranties, to recognize an estimated warranty expense in the period of the sale, and to update the expense as indicated by experience over the life of the warranty. c)Depreciation and amortization •Long-lived assets oThey are assets expected to provide economic benefits over a future period of time greater than one year. oThe costs of most long-lived assets are allocated over the period of time during which they provide economic benefits. oIntangible assets ,Assets lacing physical substance, such as trademarks.•Depreciation oThe process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits. oUsed most for physical long-lived assets such as plant and equipment. oAmortization ,Commonly applied to this process for intangible long-lived assets with a finite useful life. ,Systematic allocation of a premium or discount relative to the face value of a fixed-income security over the life of the security. oIAS, property, plant, and equipment, requires that the depreciable amount (cost less residual value) be allocated on a systematic basis over the remaining useful life of the asset. But it does not prescribe a method for computing. •Straight-line method oIt allocates evenly the cost of long-lived assets less estimated residual value over the estimated useful life of an asset. ,A plot the cost of the asset minus the cumulative amount of annual depreciation expense, if represented as a line graph over time, would be a straight line with a negative downward slope.oIt requires two significant estimates: ,The estimated useful life of an asset ,The estimated residual value (salvage value) of an asset. •Under IAS No.16, the amount that the company expects to receive upon sale of the asset at the end of its useful life. •Accelerated method of depreciation oThe timing of depreciation is accelerated. oUsed for the plant ad equipment that is expected to be used up faster in the early years. oDiminishing balance method ,Double declining balance depreciation •Depreciation with the acceleration factor of 200 percent (2 times of the percentage by the straight-line method). ,This rate is then applied to the remaining undepreciated balance of the asset each period (net book value). So the net book values are a geometric sequence. oCompanies often use a zero or small residual value, which creates problems for diminishing balance deprecation because the asset never fully depreciates. So in the last year, just let the net book value to the small residual value which is used as criteria. And a company often adopts a depreciation policy that combines the diminishing balance and straight-line methods, let’s say, switch to straight-line half way.oIt is sometimes referred to as a “conservative” accounting choice because it results in lower net income in the early years of assets use. •For intangible assets that must amortized (those with an identifiable useful life), the process is the same as for depreciation, only the name of the expense is different. oIf a pattern cannot be determined over the useful life, then the straight- line method should be used. oIn most cases under IAS and U.S.GAAP, amortized with no residual value. oGoodwill and intangible assets with indefinite life are not amortized. ,Goodwill in financial statements arises when a company is purchased for more than the fair value of the identifiable assets of the company 4)Implications for financial analysis a)A company’s estimates for doubtful accounts and/or for warranty expenses can affect its reported net income. Similarly, a company’s choice of depreciation or amortization method, estimates of assets’ useful lives, and estimates of assets’ residual values can affect reported net income. b)The analyst should understand the significant changes on expenses over accounting periods. c)The analyst should understand why two companies in the same industry use dramatically different estimates and methods for expenses. d)Information about a company’s accounting policies and significant estimates are described in the footnotes. e)When possible, the monetary effect of differences in expense recognition polices and estimates can facilitate comparisons. f)Even when the monetary effects of differences in policies and estimates cannot be calculated, it is generally possible to characterize the relative conservatism of the policies and estimates and, therefore, to qualitatively asses how such differences might affect reported expenses and thus financial ratios. 5.Nonrecurring items and non-operating items To assess a company’s future earnings, it is helpful to separate those prior years’ items that are less likely to continue from those that are less likely to continue. Discontinued items: •Discontinued operations •Extraordinary items (no longer permitted under IFRS). 1)Discontinued operations a)Both under IFRS and U.S.GAAP, discontinued component must be separable both physically and operationally. And they are usually eliminated in formulating expectations about a company’s future financial performance. 2)Extraordinary items a)IAS No.1 prohibits classification of any income or expense items as being extraordinary. b)Under U.S.GAAP, an extraordinary item is one that is both unusual in nature and infrequent in occurrence. c)Separately on the income statement, to show it is not part of operating activities, and are not expected to continue. d)Companies apply judgment to determine whether an item is extraordinary based on guidance from accounting standards. •Determining whether an item is infrequent in occurrence is based on expectations of whether it will occur again in the near future. oStandard setters offer specific guidance in some cases. ,E.g. an natural disaster is reasonably expected to be re-occur. oRequirement for classification: unusual and infrequent. 3)Unusual or infrequent items a)Items that do not meet the definition of extraordinary are shown as part of a company’s continuing operations. Items that are unusual or infrequent- but not both- cannot be shown as extraordinary. •E.g. costs to close plants and employee termination costs, gains and losses arising when a company sells an asset or part of a business for more or less than its carrying value are considered ordinary business. However, buying an asset or business less or more than the fair value is considered to be extraordinary. b)Highlighting the unusual or infrequent nature of these items assists an analyst in judging the likelihood that such items will reoccur. c)It is generally not advisable simply to ignore all unusual items. 4)Changes in accounting standards a)Retrospective application •It means that the financial statements for all fiscal years shown in a company’s financial report are presented as if the newly adopted accounting principle had been used throughout the entire period, and it is in footnotes. •It allows the financial statements in the report to be comparable. •In years prior to 2005, under both IFRS and U.S.GAAP, the cumulative effect of changes in accounting policies was typically shown at the bottom of the income of changes in the income statement in the year of changes instead of using Retrospective application. Analyst need to examine disclosers to ensure comparability caross companies. b)Changes in accounting estimates •Changes in accounting estimates are handled prospectively, with the change affecting the financial statement for the period of change and future periods. •No adjustments are made to prior statements, and the adjustment is not shown on the face of the income statement. Significant changes should be included in the disclosure and footnotes. c)Correction of an error for a prior period •Correction of an error for a prior period cannot be handled by adjust the current period income statement, but by restarting the financial statements (including the balance sheet, statement of owners’ equity, and statement of cash flows) for the prior periods presented in the current financial statements. •Footnote disclosures are required regarding the error. And they should be examined carefully because they may reveal weaknesses in the company’s accounting systems and financial controls. 5)Non-operating items: investing and financing activities a)Non-operating items are reported separately from operating income.b)Among non-operating items on the income statement (or accompany notes), non- financial service companies also disclose the interest expense on their debt securities, including amortization of any discount or premium, which is described in the financial footnotes. c)In practice, investing and financing activities may be disclosed on a net basis, with the components disclosed separately in the footnotes. d)For purposes of assessing a company’s future performance, the amount of financing expense will depend on the company’s financing policy (target capital structure) and borrowing costs. •For a non-financial company, a significant amount of financial income would typically warrant further exploration. •Reasoning about why companies invest on securities of other companies: oSimply investing excess cash in short-term securities to generate income higher than cash deposits, or o Is the company purchasing securities issued by other companies for strategic reasons, such as access to raw material supply or research. 6.Earnings per share Under IFRS, IAS, it requires the representation of EPS on the face of the income statement for net profit or loss and profit or loss from continuing operations. 1)Simple versus complex capital structure a)Introduction facts and definitions •A company’s capital is composed of its equity and debt. •Under IFRS, the types of equity for which EPS is presented are ordinary shares. •Ordinary shares oEquity shares that are subordinate to all other types of equity. oBasic ownership of the company ,The equity-holders who are paid last in a liquidation of the company and who benefit the most when the company does well. ,Under U.S.GAAP, this equity is referred to as common stock or common shares, reflecting U.S. language usage. b)Two structures •Complex structure oWhen a company has any securities that are potentially convertible into common stock, it is said to have a complex capital structure. (e.g. warrants) ,A warrant is a call option typically attached to securities issued by a company, such as bonds, which gives the holder the right to acquire the company’s stock from the company at a specified price within a specified time period. ,IFRS and U.S.GAAP standards regarding earnings per share apply equally to call options, warrants, and equivalent instruments. •Simple capital structure oCompany’s capital structure does not include securities that are potentially convertible into common stock. c)EPS and two structures •Any securities that are potentially convertible into common stock could, as a result of conversion, potentially dilute (i.e. decrease) EPS.•Diluted EPS oThe EPS that would result if all dilutive securities were converted.•Basic EPS oThe EPS that is calculated using the actual earnings available to common stock and the weighted average number of shares outstanding. •Companies are required to report both EPS. 2)Basic EPS a)Definition •It is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period.•The amount of income available to common shareholders is the amount of net income remaining after preferred dividends (if any) have been paid. b)Formulas and computations •BasicEPSNetincomePreferreddividendsWeightedaverage = - numberofsharesoutstanding oThe weighted average number of shares outstanding is a time weighting of common shares outstanding, and the methodology applies to calculating diluted EPS. •If the number of shares of common stock increases as result of a stock dividend, stock bonus, or a stock split (all three represent the receipt of additional shares by existing shareholders), the EPS calculation reflects the change retroactively to the beginning of the period. oThis means the number of outstanding is treated as if the events occurred at the beginning the accounting period, and affecting all the operations on stock. •Then, just calculate as the situation without these events, and apply the final effect to the result of that. • 3)Diluted EPS a)Diluted EPS when a company has convertible preferred stock outstanding•If-converted method oWhat EPS would have been if the convertible preferred securities had been converted at the beginning of the period. oIf such a conversion had been taken place, the company would not have paid preferred dividends and would have had more shares of common stock. oDilutedEPSNetincmeWeightedaveragenumberofshares = - outstandingNewcommonsharesthatwouldhavebeen+ issuedatconversion oNotice that it doesn’t subtract the preferred dividend, but adjusting by increase the total number of outstanding b)Diluted EPS when a company has convertible debt outstanding•If-converted method oWhat EPS would have been if the convertible debt had been had been converted at the beginning of the period. oIf such a conversion had taken place, the company would not have paid interest on the convertible debt and would have had more shares of common stock. •DilutedEPSNetincomeAftertaxinterestonconvertibledebt = +- - PreferreddividendsWeightedaveragenumberof sharesoutstandingNewcommonsharesthat+ couldhavebeen issuedatconversion oNotice that the tax might be on the avoided interest payment, which will decrease the amount of it. c)Diluted EPS when a company has stock options, warrants or their equivalents outstanding •Under U.S. GAAP, when a company has stock options, warrants, or their equivalents outstanding, the diluted EPS is calculated using the treasury stock method. •Treasury stock method oWhat EPS would have been if the options had been exercise and the company had used the proceeds to repurchase common stock. oNew shares added by carrying out the options, minus the number of stock purchased from the cash of carrying out the options.•DilutedEPSNetincomePreferreddividendsWeightedaverage = - numberofsharesoutstandingNewsharesthatcouldhavebeen + issuedatoptionexercise -Sharesthatcouldhavebeen purchasedwithcashreceiveduponexercise •Under IFRS, IAS No.33 requires a similar computation but doses not refer to it as the “treasury stock method”. oThe company is required to consider that any assumed proceeds are received from the issuance of new shares at the average market price for the period. d)Other issues with diluted EPS •Anti-dilutive oTheir inclusion in the computation would result in an EPS higher than the company’s basic EPS. oUnder accounting standards, anti-dilutive securities are not included in the calculation of diluted EPS. •In general, diluted EPS reflects maximum potential dilution. If the anti- dilutive occurs, then the company would have converted it at the first place to increase its stock price. • • 7.Analysis of the income statement 1)Common-size analysis of the income statement a)Common-size analysis of the income statement can be performed by stating each line item on the income statement as a percentage of revenue. •It facilitates comparison across time periods (time-series analysis) and across companies of different sizes (cross-sectional analysis). •This form can be distinguished as vertical common-size analysis. oHorizontal common-size analysis ,It states items in relation to a selected base year value.b)The common-size income statement also highlights differences in companies’ strategies. •An analyst would seek to understand the underlying reasons for the differences and their implications for the future performance of the companies. c)For most expenses, comparison the amount of sales is appropriate. •In the case of taxes, it is more meaningful to compare the amount of taxes with the amount of pretax income. •To project the companies’ future net income, an analyst would project the companies’ pretax income and apply an estimated effective tax rate determined in part by the historical tax rates. d)Vertical common-size analysis of the income statement is particularly useful in cross-sectional analysis – comparing companies with each other for a particular time period or comparing a company with industry or sector data. •Note that when compiling aggregate data such as this, some level of aggregation is necessary and less detail may be available than from peer company financial statements. And a individual company can be compared with industry or peer company data to evaluate its relative performance. • 2)Income statement ratios a)Net profit margin/ profit margin / return on sale •An indicator of profitability •NetprofitmarginNetincomeRevenue = •Higher implies higher profitability. •It could be found in common-size income statement. b)Gross profit margin •Another measure of profitability. •GrossprofitmarginGrossprofitRevenue = •Higher level implies higher profitability. •As it is gross, it just subtract the cost of manufactory and delivery of goods and services, then other operation cost may not calculated here.c)Net profit margin d)Operation margin •Operating income divided by revenue e)Pretax margin •Earnings before taxes and divided by revenue. • 8.Comprehensive income 1)Comprehensive income a)Definition •The change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. •It includes both net income and other revenue and expense items that are excluded from the net income calculation (other comprehensive income).b)In U.S.GAAP, four types of items are treated as other comprehensive income: •Foreign currency translation adjustments. oIn consolidating the financial statement of foreign subsidiaries. •Unrealized gains or losses on derivatives contracts accounted for as hedges. oHedge is treated as other comprehensive income and thus bypassed in the income statement. •Unrealized holding gains and losses on a certain category of investment securities, namely, available-for-sale securities. •Change in the funded status of a company’s defined benefit. oRecently changed. oAfter December 15 2006, the need of minimum pension liability adjustments is eliminated. oUnder the new standard, companies are required to recognize the overfunded or underfunded status of a defined benefit post-retirement plan as an asset or liability on their balance sheet. c)Whether to consider the holding gain/loss is depending on the categorization, which is relying on the usage of securities. •Trading securities oIf the company intends to actively trade the securities, then it should categorize the securities as trading securities and reflect the unrealized holding gains and losses in its income statement. •Available-for-sale securities oOther conditions from the above one. oBypass the income statement, and go directly to shareholders’ equity. oBut they are included in a company’s comprehensive income. d)SFAS allows companies to report comprehensive income at the bottom of the income statement, on a separate statement of comprehensive income, or as a column in the statement of shareholders’ equity; however, presentation alternatives are currently being reviewed by both U.S. and non-U.S. standard setters. • • • • •Reading 33- Understanding the balance sheet • • 1.Introduction 1)The balance sheet provides information on a company’s resources (assets) and its sources of capital (its equity and liabilities/debt). 2)Limitations of balance sheet, especially relating to how assets and liabilities are measured. •Liabilities and, sometimes, assets may not be recognized in a timely manner. •The use of historical costs rather than fair values to measure some items on the balance sheet means that adjustments needed to determine the real (economic) net worth of the company. • 2.Components and format of the balance sheet 1)Definition a)Balance sheet/ statement of financial position •It discloses what an entity owns and what it owes at a specific point in time.b)The financial position of an entity is described as following terms: •Assets oThey are resources controlled by the company as a result of past events and from which future economic benefits are expected to flow to the entity. •Liabilities oThey represent obligations of a company arising from past events, the settlement of which is expected to result in an outflow of economic benefits from the entity. •Equity oCommonly known as shareholders’ equity or owners’ equity, equity is determined by subtracting e liabilities from the assets of a company, giving rise to the accounting equation: A=L+E or A-L=E. oEquity can be viewed as a residual or balancing amount, taking assets and liabilities into account. c)Assets and liabilities arise as a result of business transactions. d)Assets and liabilities also arise from the accrual process, which means revenue and expenses reported on an accrual basis regardless of the period in which cash is received and paid. •Revenue reported on the income statement before cash is received; this results in accrued revenue or accounts receivable, which is an asset. oThis is ultimately reflected on the balance sheet as an increase in accounts receivable and an increase in retained earnings. •Cash received before revenue is to be reported on the income statement; this results in a deferred revenue or unearned revenue, which is a liability. •Expense reported on the income statement before cash is paid; this results in an accrued expense, which is a liability. oThis is reflected on the balance sheet as an increase in liabilities and a decrease in retained earnings. •Cash paid before an expense is to be reported on the income statement; this results in a deferred expense, also known as a “prepaid expense”, which is an asset. oOn the balance sheet, cash is reduced and prepaid assets are increased. • 2)Structure and components of the balance sheet a)Assets •Assets are generated either through purchase (investing), or generated through business activities (operating activities), or financing activities, such as issuance of debt. oThrough the analysis of the liabilities and equity of an entity, the analyst is able to determine how assets are acquired or funded. oFunding for the purchase may come from shareholders (financing activities) or from creditors (either through direct financing activities, or indirectly through the surplus generated through operating activities that may be funded by current liabilities/trade finance). •Assets are defined as resources controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. oSimpler definition: store of wealth. oIt is probable that any future economic benefit associated with the item will flow to the entity, and; oThe item has a cost or value that can be measured with reliability.•Value that are typically included in assets will include amount that have been spent but which have not been recorded as an expense on the income statement (as prepaid rent or inventories, etc.) because of the matching principle, or amounts that have been reported as earned on an income statement but which have not been received (e.g. account receivable). b)Liabilities •Liabilities (and equity capital )represent the ways in which the funds were raised to acquire the assets. •Liabilities are defined as probable future sacrifices of economic benefits arising from present obligations of an entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. oAmounts received but which have not been reported as revenues or income on an income statement and/or will have to be repaid. (e.g. notes payable) oAmounts that have been reported as expenses on an income statement but which have not been paid. (e.g. accounts payable, accruals, and taxes payable) c)Equity •Equity represents the portion belonging to the owners or shareholders of a business oEquity is the residual interest in the assets of an entity after deducting its liabilities, also referred to as net asset value: E=A-L. oEquity is increased by contributions by the owners or by profits (including gains) made during the year and is decreased by losses or withdrawals in the form of dividends. •The adequacy of equity capital is one of the key factors to be considered when the safety or soundness of a particular company is assessed. oIt is also the ultimate determinant of a company’s borrowing capacity. oIn practice, a company’s balance sheet cannot be expanded beyond a level determined by its equity capital without increasing the risk of financial distress to an unacceptable level; the availability of equity capital consequently determines the maximum level of assets.•The cost and amount of capital affect a company’s competitive position. oThe obligation to earn return on equity impacts the pricing of company products. oThe perspective of the market ,The issuance of debt requires public confidence which is established as the equity buffer. •The key purposes of equity capital are to provide stability and to absorb losses, thereby providing a measure of protection to creditors in the event of liquidation. oIt should be permanent. oIt should not impose mandatory fixed charges against earnings (in case of banks). oIt should allow for legal subordination to the rights of creditors.•The total amount of equity capital is of fundamental importance. oThe nature of the company ownership is also important – the identity of those owners who can directly influence the company’s strategic direction and risk management policies. • 3)Format of the balance sheet a)General definitions •Report format oAssets, liabilities, and equity are listed in a single column.•Account format oIt follows the pattern of the traditional general ledger accounts, with assets at the left and liabilities and equity at the right of a central dividing line. •Classified balance sheet oIf a company has many assets and liabilities, then we need to group together the various classes of them. oClassification is the term used to describe the grouping of accounts into subcategories. ,It most often distinguish between current and noncurrent assets/liabilities, or by financial and nonfinancial categories – all in order to provide information related to the liquidity of such assets or liabilities (albeit indirectly in many cases.) b)Current and noncurrent distinction •The balance sheet should distinguish between current and noncurrent assets.•The distinction is also an attempt at incorporating liquidity expectation into the structure of the balance sheet. •Current assets oAssets expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classified as current assets. ,It indicates a further decrease (usually within a year) in assets. oOperating cycle ,The amount of time that elapses between spending cash for inventory and supplies and collecting the cash from its sales to customers. ,When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be one year. oSome current assets are allocated to expenses immediately (e.g. inventory) when sales or cash transactions take place, whereas noncurrent assets are allocated over the useful lives of such assets. oIt tells us more about the operating activities and the operating capability of the entity. •Noncurrent assets/long-term assets oAssets not expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classified as noncurrent assets. oThey represent the infrastructure from which the entity operates and are not consumed or disposed in the current period. oLess-liquid investments made from a strategic or longer-term perspective. •Working capital oThe excess of current assets over current liabilities. oThe level of working capital tells about the ability of an entity to meet liabilities as they fall due. oWorking capital should not be too large because funds could be tied up that could be used more productively elsewhere. •Current liability oIt is a liability that satisfies any the following criteria: ,It is expected to be settled in the entity’s normal operating cycle. ,It is held primarily for the purpose of being traded. ,It is due to be settled within one year after the balance sheet. ,The entity does not have an unconditional right to defer settlement of the liability for at least one year after the balance sheet date. oFinancial liabilities are classified as current if they are due to be settled within one year after the balance sheet date, even if the original term was for a period longer than one year. oAll other liabilities are noncurrent liabilities. oIAS No.1 specifies that some current liabilities, such as trade payables and some accruals for employee and other operating costs, are part of the working capital used in the entity’s normal operating cycle, even though some of them will be settle d more than one year after the balance sheet date. •Noncurrent liability oThey include financial liabilities that provide financing on a long-term basis, and they are, therefore, not part of the working capital used in the entity’s normal operating cycle; neither are they due for settlement within one year after the balance sheet date. c)Liquidity-based presentation •IAS requires the use of the current/noncurrent format of presentation for the balance sheet, except when a presentation based on liquidity provides information that is reliable and is more relevant. •Entities such as banks are clearly candidates for such a liquidity-based presentation in their balance sheets. d)IFRS and U.S.GAAP balance sheet illustrations •Minority interest oIt represents the portion of consolidated subsidiaries owned by others. oUnder U.S.GAAP, it is usually located between or under liability and equity; under IFRS, it is located in the shareholders’ equity section. • 3.Measurement bases of assets and liabilities 1)General discussion a)The balance sheet under current standards is a mixed model: •Historical cost is more reliable, while current value (depends on fair value) is more useful for today’s decision making. •Some assets and liabilities can be more objectively valued in the marketplace than others. •Fair value oIt is the amount at which an asset could be exchanged or a liability settled, between knowledgeable willing parties in an arm’s length transaction. ,An arm’s length transaction •Transaction between two unrelated or affiliated (or based that assumption) parties. ,When the asset or liability trades regularly, its fair value is usually readily determinable from its market price (sometimes referred to as fair market value). •Historical cost oThe historical cost of an asset or liability is its cost or fair value at acquisition, including any costs of acquisition and/or preparation.•In limited circumstances other measurement bases are sometimes used, such as current cost (the cost to replace an asset) or present value (the present discounted value of future cash flows). b)How the reported measures of assets and liabilities on the balance sheet relate to economic reality and to each other. •Accounting polices •Analysts may need to make adjustments to balance sheet measures of assets and liabilities in assessing the investment potential or credit-worthiness of a company. c)For all of above reasons, the balance sheet value of total assets should not be accepted as an accurate measure of the total value of a company.•The balance sheet provides important information about the value of some assets and information about future cash flows but does not represent the value of the company as a whole. d)Once individual assets and liabilities are measured, additional decisions may be necessary as to how these measures are reflected on the balance sheet.•Accounting standards generally prohibit the offsetting of assets and liabilities other than in limited circumstances, instead, recording assets with corresponding items in liability, vice versa. oOffsetting allowed when it reflects the substance of the transaction or other events, or when in limited circumstances where there are restrictions on the availability of assets (e.g. pension plans). oDisclosing or measuring assets net of valuation allowance is not considered to be offsetting. e)According to IFRS, following information should on the balance sheet •Page 209 f)The notes to financial statements and management’s discussion and analysis are integral parts of U.S.GAAP and IFRS financial reporting processes. • 2)Current assets a)Categories of assets •Assets held primarily for trading •Assets expected to be realized within 12 months after the balance sheet date.•Cash or cash equivalents, unless restricted in use for at least 12 months.•Marketable securities oDebt or equity securities that are owned by a business, traded in a public market, and whose value can be determined from price information in a public market. (e.g. treasury bills, notes, bonds, and equity securities, such as common stocks and mutual fund shares)•Trade receivables oAllowance has to be made for bad debt expenses, reducing the gross receivables amount. •Inventories oIncluding finished goods and raw materials and work-in-process.•Other current assets oShort-term items not easily classifiable into the above categories. (e.g. prepaid expenses) b)Inventories •Inventories should be measured at the lower of cost or net realizable value.•Inventory costs comprise all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. •The cost of inventories excludes oAbnormal amounts of wasted materials, labor, and overheads; oStorage costs, unless they are necessary prior to a further process; oAdministrative overhead; and oSelling costs. •Net realizable value (NRV) oThe estimated selling price less then estimated costs of completion and costs necessary to make the sale. •Accounting standards allow different valuation methods. •The following techniques can be used to measure the cost of inventories if the resulting valuation amount approximates cost oStandard cost ,It should take into account the normal levels of materials, labor, and actual capacity. The standard cost should be reviewed regularly in order to ensure that it approximates actual costs. oRetail method ,Sale value is reduced by the gross margin to calculate cost. ,An average gross margin percentage should be used for each homogeneous group of items. ,The impact of market-down prices should be taken into consideration. c)Prepaid expenses •Prepaid expenses are normal operating expenses that have been paid in advance. •Generally, expenses are reported in the period in which they are incurred as opposed to when they are paid. • 3)Current liabilities a)Definition •Current liabilities are those liabilities that are expected to be settled in the entity’s normal operating cycle, held primarily for trading and due to be settled with 12 months after the balance sheet date. •Noncurrent interest-bearing liabilities to be settled within 12 months after the balance sheet date can be classified as noncurrent liabilities if: oThe original term of the liability is greater than 12 months; oIt is the intention to refinance or reschedule the obligation; or oThe agreement to refinance or reschedule the obligation is completed on or before the balance sheet date. b)Trade and other payable/ accounts payable •Accounts payable are amounts that a business owes its vendors for goods and services that were purchased from them but which have not yet been paid.c)Note payable •Notes payable are amounts owed by a business to creditors as a result of borrowings that are evidenced by a (short-term) loan agreement, which including bank loans and other current borrowings other than those arising from trade credit. •Notes payable may also appear in the long-term liability section of the balance sheet if they are due after one year or the operating cycle. d)Current portion of noncurrent borrowings •By convention, liabilities expected to be repaid or liquidated within one year or one operating cycle of the business, whichever is greater, are classified as current liabilities. e)Current tax payable •They are tax expenses that have been determined and recorded on a company’s income statement but which have not yet been paid. f)Accrued liabilities/accrued expenses •Accrued liabilities are expenses that have been reported on a company’s income statement but which have not yet been paid because there is no legal obligation to pay them as of the balance sheet date. •Common examples of accrued liabilities are accrued interest payable and accrued wages payable. g)Unearned revenue/deferred revenue •Unearned revenue is the collection of money in advance of delivery of the goods and services associated with the revenue. • 4)Tangible assets a)Tangible assets •They are long-term assets with physical substance that are used in company operations. •These noncurrent assets are carried at their historical cost less any accumulated depreciation or accumulated depletion. oHistorical cost generally consisting: vendor invoice cost, freight cost, and any other additional costs incurred to make the assets operable.•E.g. natural resources. If any of tangible assets are not used in company operations, they must be classified as investment assets. • 5)Intangible assets a)Definitions •Intangible assets are amounts paid by a company to acquire certain rights that are not represented by the possession of physical assets. oIdentifiable intangible can be acquired singly and is typically linked to specific rights or privileges having finite benefit periods. oUnidentifiable intangible cannot be acquired singly and typically possesses an indefinite benefit period. •Amortization and impairment principles oAmortized based on its best estimate of useful life for finite one. oImpairment annually but not amortized for infinite useful life ones. •The balance sheet and notes should disclose the gross carrying amount (book value) less accumulated amortization for each class of asset at the beginning and the end of the period. •Companies may also have intangible assets that are not recorded on their balance sheet. b)Specifically identifiable intangibles •Under IFRS, specifically identifiable intangible assets are nonfinancial assets without physical substance but which can be identified. •They are recognized if it is probable that future economic benefits will flow to the company and the cost of asset can be measured reliably. •Identifiable intangibles could be created or purchased by a company, and both IFRS and U.S.GAAP determine that the intangible assets reported on a balance sheet are only those intangibles that have been purchased or created.•IAS provides that for internally created intangible assets, the company must identify the research phase and the development phase. oIAS prohibits the capitalization of costs as intangible assets during the research phase. Instead, they should be on the income statement. oCost incurred in the development stage can be capitalized as intangible assets if certain criteria are met, including technological feasibility, the ability to use or sell the resulting asset, and the ability to complete the project. oAll other expenses related to the list on page 219 are expensed. •U.S.GAAP prohibits the capitalization as an asset of almost all research and development costs. All such costs usually be expensed. c)Goodwill •In a purchase acquisition, the excess of the cost of acquisition over the acquirer’s interest in the fair value of the identifiable assets and liabilities acquired is described as goodwill and is recognized as an asset.•Proponents of goodwill oPresent value of excess returns that a company is able to earn. oDetermining the present excess returns is analogous to determining the present value of future cash flows associated with other assets and projects. •Opponents of goodwill recognition oThe prices paid for acquisitions often turn out to be based on unrealistic expectations, thereby leading to future write-offs of goodwill. •Differences between accounting goodwill and economic goodwill oEconomic goodwill ,It is based on the economic performance of the entity. ,What should be concerned, but not on the balance sheet, instead, on stock price. oAccounting goodwill ,It is based on accounting standards and only reported for past acquisitions. •Under IFRS and U.S.GAAP, goodwill should be capitalized and tested for impairment (noncash expenses) annually, but not amortized. (infinite useful life) oIf goodwill is deemed to be impaired, it is charged against income in the current period, and reduces current earnings. oHowever, assets are also reduced, so some performance measures, such as return on assets, may actually increases in future period.•Under IFRS, the purchase method of accounting can be summarized by the following steps: oThe cost of acquisition is determined. oThe fair value of the acquiree’s assets is determined. oThe fair value of the acquiree’s liabilities and contingent liabilities is determined. oCalculate the goodwill arising from the purchase as follows: ,The book value of the acquirer’s assets and liabilities should be combined with the fair value adjustments of the acquiree’s assets, liabilities, and contingent liabilities. ,Any goodwill should be recognized as an asset in the combined entity’s balance sheet. •Adjustment between companies using different accounting methods. oComputing financial ratios using the balance sheet data that exclude goodwill oReviewing operating trends using data that exclude the amortization of goodwill or impairment to goodwill charges; and oEvaluating future business acquisitions by taking into account the purchase price paid relative to the net assets and earnings prospects of the acquired company. •IFRS requires disclosure of the factors that contributed to goodwill and a description of each intangible asset that was not recognized separately from goodwill. • 6)Financial instruments: financial assets and financial liabilities a)IAS define a financial instrument as a contract that gives rise to financial asset of one entity, and a financial liability or equity instrument of another entity.•Financial assets oBonds, notes payable, and similar instruments. oSome financial instruments may be classified as either an asset or la liability depending upon the contractual terms and current market conditions. ,Derivative •It is a financial instrument for which the value is derived based on some underlying factor (interest rate, exchange rate, commodity price, security price, or credit rating) and for which little or no initial investment is required. •Mark-to-market oMark-to-market fair value adjustments to financial assets and liabilities is the process whereby the value of most trading assets (e.g. those held for trading and that are available for sale) and trading liabilities are adjusted to reflect current fair value. oSuch adjustments are often made on a daily basis, and cumulative mark-to-market adjustment. •All financial assets and liabilities (including derivatives) should be recognized when the entity becomes a party to the contractual provisions of an instrument. oFor the purchase or sale of financial assets where market convention determines a fixed period between trade and settlement dates, the trade or settlement date can be used for recognition. oInterest normally accrued between trade and settlement dates, but mark-to-market adjustments are made regardless of whether the entity uses trade date or settlement date accounting, in which trade date is preferred. •Marketable securities such as stocks and bonds may be classified as trading, available for sale, and held to maturity. •In the case of marketable securities classified as either trading or available for sale, the investments are listed under assets at fair market value. oIn the case of available-for-sale securities, the unrealized gain is not included on the income statement; rather, it is deferred as part of other comprehensive income within owners’ equity. oIn the case of held-to-maturity securities, the unrealized gain is not reflected on either the balance sheet or income statement. •In the case of liabilities such as bonds issued by a company, these are normally reported at amortized cost on the balance sheet. oAny bond premium would be amortized for bonds issued at a premium. ,Premium: a charge paid in addition to normal payment. • 4.Equity •Equity is the residual claim on a company’s assets after subtracting liabilities. It represents the claim of the owner against the company, Equity includes funds directly invested in the company by the owners, as well as earning s that have been reinvested over time. Equity can also included items of gain or loss that are not yet recognized on the company’s income statement. • 1)Components of equity a)Potential components of that on balance sheet •Capital contributed by owners. oThrough the issuance of common stock and preferred stock ,Preferred stock : a hybrid security with some characteristics of debt, and it has rights that take precedence over the rights of common shareholders, including generally pertain to receipt of dividends, and receipt of assets if the company is liquidated. ,Preferred and common stock may or may not have bar values. •If exists, then must be disclosed in the stockholders’ equity section of balance sheet. ,The number of shares authorized, issued, and outstanding must be disclosed for each class of stock. •The number of authorized shares is the number of shares that may be sold by the company under its articles of incorporation. •Issued: number of shares that have been sold to investors. •Outstanding: number of shares of issued less repurchased (treasury stock) by the company. •Minority interest / non-controlling interest oEquity interests of minority shareholders in the subsidiary companies that have been consolidated by the parent company but that are not wholly owned by the parent company. •Retained earnings / retained deficit oAmounts that have been recognized as cumulatively earned in the company’s income statements but which have not been paid to the owners of the company through dividends. •Treasury stock / own shares repurchased oIt may occur when management considers the shares undervalued or when it wants to limit the effects of dilution from various employee stock compensation plans. ,It is a reduction of shareholders’ equity and a reduction of total shares outstanding. ,Nonvoting and do not receive dividends if declared by the company. •Accumulated comprehensive income / other reserves oIt has no effect on shareholders’ equity but is not derived from the income statement or through any company transactions in its own equity shares. b)FASB released SFAS No. 130 – reporting of comprehensive income.•Comprehensive income was included all changes in owners’ equity that resulted from transactions of the business entity with non-owners.•Comprehensive income = Net income + Other comprehensive income.•Other comprehensive income (OCI) is part of total comprehensive income but generally excluded from net income. oForeign currency translation adjustments, minimum pension liability adjustments, and unrealized gains or losses on available-for-sale investments. oOn No.133, net unrealized losses on derivatives were also include.•Three alternative formats that are allowed by SFAS No.130 for OCI and total comprehensive income oBelow the line for net income in a traditional income statement (as a combined statement of net income and comprehensive income) oIn a separate statement of comprehensive income that begins with the amount of net income for the year; or oIn a statement of changes in stockholders’ equity. •Under IFRS, the component changes are also reported in the statement of equity; however, it is not presently required that a comprehensive income amount be reported. • 2)Statement of changes in shareholders’ equity a)The statement of changes in shareholders’ equity reflects information about the increases to a company’s net assets or wealth, which must including following items: •About comprehensive income oUnrealized gains or losses on available-for-sale investments; oGains or losses from derivatives that qualify as net investment hedges or cash flow hedges; oMinimum pension liability adjustments from underfunded defined- benefit plans; and oForeign currency translation adjustments on foreign subsidiary. •Others oCapital transactions with owners and distributions to owners; oReconciliation of the balance of accumulated profit or loss (retained earnings) at the beginning and end of the year; and oReconciliation of the carrying amount of each class of equity capital, share premium (paid-in capital), and accumulated comprehensive income (reserve) at the beginning and end of the period. • 5.Uses and analysis of the balance sheet •It shows the trends of changes of size of a company, with proper adjustments. 1)Common-size analysis of the balance sheet a)Definition •Common-size analysis involves stating all balance sheet items as a percentage of total assets. b)Vertical common-size statements: •Comparing current balance sheet and prior-year balance sheet. •Comparing with other companies in the industry for a particular time. •It reveals the changes of composition proportion of every part of items in balance sheet. oIt is particularly useful in cross-sectional analysis. oSources of published data ,Annual statement studies. ,Almanac of business and industrial financial ratios c)Horizontal: •Only comparing current with prior-year’s. • 2)Balance sheet ratios a)Definition •In ratio analysis, the analyst may examine the level and trends of a ratio in relation to past values of the ratio for the company, therefore providing information on changes in the financial position of a company over time. •May also compare a ratio against the values of the ratio for comparable companies, therefore providing financial position of a company against other peer groups. •Balance sheet ratio are those involving balance sheet items only, which fall under the heading of liquidity ratios (measuring the company’s ability to meet its short-term obligations) or solvency ratios (measuring the company’s ability to meet long-term and other obligations). b)Value of financial statement •It enables the analyst to gain insights that can assist in making forward-looking projections. •Value of financial ratios oProvide insights into microeconomic relationship helpful to project earnings and free cash flow (to determine entity value and credit- worthiness). oProvide insights into a company’s financial flexibility (ability to obtain cash). ,Financial flexibility requires a company to possess financial strength (a level and trend o financial ratios that meet or exceed industry norms), lines of credit, or assts that can be easily used as a means of obtaining cash, either by their outright sale or by using them as collateral. oProvide a means of evaluating management ability. •Financial ratio analysis is limited by: oThe use of alternative accounting methods. ,FIFO or LIFO inventory valuation methods. ,Cost or equity methods of accounting for unconsolidated associates. ,Straight-line or accelerated consumption pattern methods of depreciation; ,Capitalized or operating lease treatment. oThe homogeneity of a company’s operating activities. oThe need to determine whether the results of the ratio analysis are mutually consistent. oThe need to use judgment. ,Key issue is whether a ratio for a company is within a reasonable range for an industry, which is determined by analyst. ,They cannot be used alone to directly value a company or determine its credit-worthiness. • • • •Reading 34 – Understanding The Cash Flow Statement • a.i.1.Introduction a.i.1.1)The cash flow statement provides information about cash receipts and cash payments during an accounting period, showing how these cash flows link the ending cash balance to the beginning balance shown on the company’s balance sheet.a)Contrasts with the accrual-based information from income statement.b)A reconciliation between those two provides when, where, and how a company is generating cash from its operating activities. c)A reconciliation of the beginning and ending cash on the balance sheet. • a.i.2.Components and format of the cash flow statement a.i.2.1)Classification of cash flows and noncash activities a)Cash flow categories •Operating activities oIt includes the company’s day-to-day activities that create revenues, such as selling inventory and providing services. oInclude cash receipts and payments related to securities held for dealing or trading purposes (as opposed to being held for investment). •Investing activities oInclude purchasing and selling investments. oExclude: ,Any securities investments considered cash equivalents (very short-term, highly liquid securities); ,Dealing or trading securities (held for trading), which is considered as operating activities for all companies. •Financing activities o Include obtaining or repaying capital, such as equity and long-term debt. oIndirect borrowing using accounts payable is not considered a financing activity, which is considered as operating activities instead.b)Under IFRS, there is some flexibility in reporting some items of cash flow, particularly interest and dividends. •For financial institution, interest and dividends are considered as operating activities; for others, interest is considered as investment, and dividend is considered as financing activity. c)Under U.S.GAAP, interest is reported as operating activities for all. Dividends received are reported as operating activities, and dividends paid are reported as financing activities. d)Non-cash investing and financing transactions. •A noncash transaction is any transaction that does not involve an inflow or outflow of cash. •Any significant noncash transaction is required to be disclosed, either in a separate note or a supplementary schedule to the cash flow statement. e)The following rules are used to make adjustments for changes in current assets and liabilities, operating items not providing or using cash and non-operating items. •Decrease in non-cash current assets are added to net income •Increase in non-cash current asset are subtracted from net income•Increase in current liabilities are added to net income •Decrease in current liabilities are subtracted from net income•Expenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that have no effect on cash flows in the period) •Revenues with no cash inflows are subtracted from net income•Non operating losses are added back to net income •Non operating gains are subtracted from net income a.i.2.2)A summary of differences between IFRS and U.S.GAAP a)The key differences are on page 254. •In short, the IASB allows more flexibility in the reporting of items such as interest paid or received and dividends paid or received, and in how income tax expense is classified. b)Major differences •Interest oU.S.GAAP classifies interest and dividends received from investments as operating activities, whereas IFRS allows companies to classify those items as either operating or investing cash flows. oU.S.GAAP classifies interest expense as an operating activity, even though principal amount of the debt issued is classified as a financing activity. •IFRS allows companies to classify interest expense as either an operating activity or a financing activity. •Dividend oU.S.GAAP classifies dividends paid to stockholders as a financing activity, whereas IFRS allows companies dividends paid as either an operating activity or a financing activity. •Tax oU.S.GAAP classifies all income tax expenses as an operating activity. IFRS also classifies income tax expense as an operating activity, unless the tax expense can be specifically identified with an investing or financing activity (e.g., the tax effect of the sale of a discontinued operation could be classified under investing activities). a.i.2.3)Direct and indirect cash flow formats for reporting operating cash flow a)Definitions •There are two acceptable formats for reporting cash flow from operations (also known as cash flow operating activities or operating cash flow) oCash flow from operations is defined as the net amount of cash provided from operating activities: direct and indirect methods. oAmount is identical under both methods. oPresentation format differs. , The presentation format of the cash flows from investing and financing is exactly the same. •Direct method oIt shows the specific cash inflows and outflows that result in reported cash flow from operating activities. oIt shows each cash inflow and outflow of cash receipts and cash payments, with adjustments to remove the effect of accruals. oThe primary argument in favor of the direct methods is that it provides information on specific sources of operating cash receipts and payments in contrast to the indirect method, which shows only the net result (net income) of these receipts and payments. •Indirect method oIt shows cash flow from operations can be obtained from reported net income as the result of a series of adjustment. oIt begins with net income from the income statement. To reconcile net income with operating cash flow, adjustments are made for noncash items, for non-operating items, and for the net changes in operating accruals (or cash-based transactions). oBecause net income = revenue – expenses. So we need adjustments for “cashed” revenue and “cashed” expenses. ,Expenses not involving cash outflows such as depreciation, deferred taxes, increased accounts payable which are added back. (As cash position does not change from those activities, but recorded in income statement to affect the net income) ,Cash outflows not recorded as expenses such as increases in inventory which are subtracted. ,Revenues not involving cash inflows such as increased accounts receivable, profit on sale of property which are subtracted. oAn increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income.oThe main argument for the indirect approach is that it shows the reasons for differences between net income and operating cash flows. ,It may be noted that the differences between net income and operating cash flows are equally visible on an indirect-format cash flow statement and in the supplementary reconciliation required if the company uses the direct method. oAnother argument is that it mirrors a forecasting approach that begins by forecasting future income and then derives cash flows adjusting for changes in balance sheet accounts that occur due to the timing differences between accrual and cash accounting. •Under IFRS, IAS No.7 encourages the use of the direct method but permits either. Same as under U.S.GAAP. oUnder FAS No.95, if the direct method is presented, footnote disclosure must also be provided of the indirect method; if the indirect method is presented, then no other additional files required. •Many users prefer the direct format, with indirect cash flows as supplementary disclosure. b)An indirect-format cash flow statement prepared under IFRS •Income tax expense provided on the income statement does not reflect the flow of cash due to prepaid and deferred items. •Interest and dividend paid are grouped together in financial activities. Under U.S.GAAP interest paid – or the reconciliation adjustment for the net changes in interest payable- must be reported in the operating section of the cash flow statement, and does not required to be in a separate line. •Dividends and interest received are listed in the investing activities section. Under U.S.GAAP, investment income received (or the reconciliation adjustment for the net change in investment income receivable) must be reported in the operating section. c)A direct-format cash flow statement prepared under IFRS • The cash received from customers, as well as other operating items, is clearly shown. d)Illustrations of cash flow statements prepared under U.S.GAAP •Whenever the direct method is used, FAS No.95 mandates a disclosure note and schedule that reconciles net income with the net cash flow from operating activities. •Whenever the indirect method is used, U.S.GAAP mandates a supplemental note that discloses how much cash was paid for interest and income taxes at the bottom of its cash flow statement. • a.i.3.The cash flow statement: linkages and preparation•The indirect format of cash flow statement demonstrates that changes in balance sheet accounts are an important factor in determining cash flows. • a.i.3.1)Linkages of the cash flow statement with the income statement and balance sheeta)Balance sheet •Assets = liability + owners’ equity •Cash is an asset. oThe beginning and ending balances of cash are shown on the balance sheets for the precious and current years, and the bottom of the cash flow statement reconciles beginning cash with ending cash. •In the case of cash held in foreign currencies, there would also be an impact from changes in exchange rates. oIt shows why the cash changes – operating, investing, and financing activities (as well as the impact of foreign currency translation). oThe beginning and ending of balance sheet values of cash and cash equivalents linked through the cash flow statement, which is similar to the linkage between balance sheet and income statement. ,The net income and dividends to the beginning and ending values of retained earnings in the owners’ equity section of the balance sheet. b)Income statement •A company’s operating activities are reported on an accrual basis in the income statement, and any differences between the accrual basis and the cash basis of accounting for an operating transaction result in an increase or decrease in some (usually) short-term asset or liability on the balance sheet.•A company’s investing activities typically relate to the long-term asset section of the balance sheet, and its financing activities typically relate to the equity and long-term debt sections of the balance sheet. oEach item on balance sheet is also related to the income statement and/or cash flow statement through the change in the beginning and ending balance. (As balance sheet represents the current financial position, and income statement is the performance over a period, as well as cash flow) • a.i.3.2)Steps in preparing the cash flow statement a)General discussion •The first step in preparing the cash flow statement is to determine the total cash flows from operating activities. •A conversion from indirect to direct is needed. b)Operating activities : direct method •Cash received from customers oAdjustments for account receivable. ,If accounts receivable increase during the year, (not accounts receivable exist) revenue on an accrual basis is higher than cash receipts from customers, and vice versa. ,As income statement using accrual method, so the revenue is included all the account receivable generated in the accounting period recorded in the statement. ,Cash received from customers/cash collected from customers/cash collection •Revenue – increase in accounts receivable = cash received from customers •Beginning accounts receivable + revenue – ending accounts receivable = cash collected from customers. ,Ending accounts receivable •Beginning accounts receivable + revenue – cash collected from customers = ending accounts receivable•Cash paid to suppliers oadjustments ,Purchases from suppliers / amount of inventory purchased •Purchases from suppliers = Cost of goods sold + increase in inventory ,Cash paid to suppliers •Cash paid to suppliers = Cost of goods sold + increase in inventory – increase in accounts payable •Cash paid to suppliers = Purchases from suppliers – increase in accounts payable ,Ending inventory •Ending inventory = beginning inventory + purchase from suppliers - cost of goods sold ,Ending account payable •Beginning accounts payable + purchase _ cash paid to suppliers ,If inventory increased during the year, then purchases during the year exceeded cost of goods sold, and vice versa. ,Once purchases have been determined, cash paid to suppliers can be calculated by adjusting purchases for the change in accounts payable. •Cash paid to employees oTo determine the cash paid to employees, it is necessary to adjust salary and wage expense by the net changes in salary and wage payable for the year. oCash paid to employees ,Cash paid to employees = Salary and wage expenses – increase in salary and wage payable oEnding salary and wages payable ,Ending salary and wages payable = beginning salary and wages payable + salary and wage expense – cash paid to employees •Cash paid for other operating expenses oTo determine the cash paid for other operating expenses, it is necessary to adjust the other operating expenses amount on the income statement by the net changes in prepaid expense and accrued expense liabilities for the year. oCash paid for other operating expenses , Cash paid for other operating expenses = other operating expenses – decrease in prepaid expenses – increase in other accrued liabilities. •Cash paid for interest oUnder U.S.GAAP, interest expenses are included in operating cash flow; under IFRS, where to put interest expenses has two options.oCash paid for interest ,Cash paid for interest = interest expenses + decrease in interest payable. ,Cash paid for interest = interest expenses + beginning interest payable – ending interest payable. •Cash paid for income tax oTo determine the cash paid for income taxes, it is necessary to adjust the income tax expense amount on the income statement by the net changes in taxes receivable, tax payable, and deferred income tax for the year. oIf tax receivable or deferred tax assets increase during the year, income tax on a cash basis will be lower than on an accrual basis, and vice versa. If taxes payable or deferred tax liabilities increase during the year, income tax expense on a cash basis will be higher than on an accrual basis, and vice versa. • c)Investing activities: direct method •The second and third steps in preparing the cash flow statement are to determine the total cash flows from investing activities and from financing activities. •This part is identical between direct and indirect methods.•Negative number means purchasing equipment, and the beginning and ending balance equipment numbers are get from the balance sheet. •Historical cost of equipment sold = beginning balance equipment (from balance sheet) + equipment purchased (from information note) – ending balance equipment (from balance sheet) •Accumulated depreciation on equipment sold = beginning balance accumulated depreciation (from balance sheet) + depreciation expense (from income statement) – ending balance accumulated depreciation (from balance sheet) •The historical cost information accumulated depreciation information (from balance sheet), and information from the income statement about the gain on the sale of equipment can be used to determine the cash received from the sale. oBook value of equipment sold = historical cost equipment sold – accumulated depreciation on equipment sold oCash received from sale of equipment = book value of equipment sold + gain on sale of equipment (from the income statement) • d)Financing activities : direct method •As with investing activities, financing activities are always presented using the direct method. •Long-term debt and common stock oThe change in long-term debt and common stock is based on the beginning and ending balance sheets. oPositive number means get money from those activities. •Dividends oEnding retained earnings = beginning retained earnings + net income – dividends. oDividends paid = beginning balance of retained earnings (from the balance sheet) + net income (from the income statement) – ending balance of retained earnings • e)Overall cash flow statement : direct method f)Overall cash flow statement : indirect method •To perform the reconciliation from net income (from income statement) to operating cash flow (only category that varies between two methods), net income is adjusted for the following: oAny non-operating activities oAny noncash expenses oChanges in operating working capital items. ,Include increases and decrease in the current operating asset and liability accounts. ,The changes in these accounts arise from applying accrual accounting. So, the adjustments for working capital are subtracting any increase in a current operating asset account from net income, and adding any net decrease to net income that generated by accrual method. For current operating liabilities, a net increase is added to net income while a net decrease is subtracted from net income. ,Detailed adjustments are on page 275. • a.i.3.3)Conversion of cash flows from the indirect to the direct methoda)Direct-form of cash flow statement is used to review trends in cash receipts and payments. b)Three steps of conversion. •Aggregate all revenue and all expenses. •Remove all noncash items from aggregated revenues and expenses and break out remaining items into relevant cash flow items. •Convert accrual amounts to cash flow amounts by adjusting for working capital changes. • a.i.4.Cash flow statement analysis a.i.4.1)Evaluation of sources and uses of cash a)Evaluation of cash flow statement should involve an overall assessment of the sources and uses of cash between the three main categories as well as an assessment of the main drivers of cash flow within each category, as following •Evaluate where the major sources and uses of cash flow are between operating, investing, and financing activities. •Evaluate the primary determinants of operating cash flow. •Evaluate the primary determinants of investing cash flow. •Evaluate the primary determinants of financing cash flow. b)Major sources of cash for a company can vary with its stage of growth. •For mature company, it is desirable to have the primary source of cash be operating activities over the long term. oIf a company has a good opportunity, then grows business or invests other fields, which is an investing activity. Otherwise, cash should return to capital providers, which is a financing activity. •For a new or growth stage company, operating cash flow may be negative for some period of time as it invests in inventory and receivables (extending credit to new customers) in order to grow the business in short term.•It is desirable that operating cash flows are sufficient to cover capital expenditures. •Summary oWhat are the major sources and uses of cash flow. oIs operating cash flow positive and sufficient to cover capital expenditures. c)Turing the operating section, the analysts should examine the most significant determinates of operating cash flow. •Under the indirect method, the increases and decrease in receivables, inventory, payables, and so on can be examined to determine whether the company is using or generating cash in operations and why. • It is also useful to compare operating cash flow with net income, and the relationship between those two is an indicator of ability of earning. oLarge net income with relatively less operating cash flow may imply a poor earning ability, and aggressive accounting choices.•For mature company, because net income includes noncash expenses (depreciation and amortization), it is desirable that operating cash flow exceeds net income. •Variability of both net income and operating cash flows, which related to risk and future cash flow forecasting. •Summary oWhat are the major determinants of operating cash flow? oIs operating cash flow higher or lower than net income? Why? oHow consistent are operating cash flow? d)Within the investing section, you should evaluate each line item.•Each line item represents either a source or use of cash. oThis enables you to understand where and how much the cash is being spent (or received) in future property, plant, and equipment; acquire entire companies; put aside in liquid investments, such as stocks and bonds. oHow much get from those things. •Where the cash comes from to cover those investments. e)Within the financing section, you should examine each line item to understand whether the company is raising capital or repaying capital and what the nature of its capital sources are. • a.i.4.2)Common-size analysis of the cash flow statement a)For the cash flow statement, there are two alternative approaches: percentage of total inflow (outflows) of cash, and percentage of net revenue. •For income statement, each income and expense line item is expressed as a percentage of net revenues (net sales). •For balance sheet, the percentage of total assets. b)Total cash inflow/total outflows method •Each of the cash inflows is expressed as a percentage of the total cash outflows. •Direct method: operating cash inflows and outflows are separately presented on the cash flow statement. •Indirect method: operating cash inflows and outflows are not separately presented, as they are “net” or adjustment from the net income.c)Net revenue common-size cash flow statement •Each line item in the cash flow statement is shown as a percentage of net revenue. •The common-size format makes it easier to see trends in cash flow rather than just looking at the total amount. •This method is also useful to the analyst in forecasting future cash flows because individual items in the common-size statement are expressed as a percentage of net revenue. Thus, once the analyst has forecast revenue, the common-size statement provides a basis for forecasting cash flows. • a.i.4.3)Free cash flow to the firm and free cash flow to equity a)Free cash flow •The excess of operating cash flow over capital expenditures.b)Free cash flow to the firm (FCFF) •FCFF is the cash flow available to the company’s suppliers of debt and equity capital after operating expenses (including income taxes) have been paid and necessary investments in working capital and fixed capital have been made. •FCFF computed from net income oFCFF =NI + NCC+ Int(1 – Tax rate) – FCInv – WCInv ,NI : net income ,NCC: noncash charges (such as depreciation and amortization) ,Int = interest expense ,FCInv = capital expenditures (fixed capital, such as equipment) ,WCInv = working capital expenditures •The reason for adding back interest is that FCFF is the cash flow available to the suppliers of debt capital as well as equity capital. •FCFF can also be computed from cash flow from operating activities: oFCFF = CFO +Int(1-Tax rate) – FCInv ,CFO represents cash flow from operating activities under U.S.GAAP or under IFRS where the company has chosen to place interest expense in operating activities. ,Under IFRS, if the company has placed interest and dividends received in investing activities, these should be added back to CFO to determine FCFF. ,If dividends paid were subtracted in the operating section, these should be added back to compute FCFF. c)Free cash flow to equity (FCFE) •FCFE is the cash flow available to the company’s common stockholders after all operating expenses and borrowing costs (principal and interest) have been paid and necessary investments in working capital and fixed capital have been made. •FCFE = CFO –FCInve – Net borrowing –Net debt repayment •Positive FCFE means that the company has an excess of operating cash flow over amounts needed for investments for the future and repayment of debt. This cash would be available for distribution to owners. • a.i.4.4)Cash flow ratios a)There several ratios based on cash flow from operating activities that are useful for comparisons to other companies in the same or different industry.b)These ratios generally fall into cash flow performance (profitability) ratios and cash flow coverage (solvency) ratios. c)On page 289 • • • • • •Reading 35 – Financial Analysis Techniques • • 1.Introduction 1)In essence, an analyst converts data into financial metrics and assist in decision making. a)How successfully has the company performed, relative to its own past performance and relative to its competitors? b)How is the company likely to perform in the future ? c)Based on expectations about future performance, what is the value of this company or the securities it issues? • 2)A primary source of data is a company’s financial reports, including the financial statements, footnotes, and MD&A. a)They contain the past performance and current financial condition.b)They lack some important non-financial information or future results forecasting. • 3)Equity analysis incorporates an owner’s perspective, either for valuation or performance evaluation. Credit analysis incorporates a creditor’s perspective.a)Both assess the entity’s ability to generate and grow earnings and cash flow, as well as any associated risks. b)Equity places emphasis on growth, and credit emphasis on risks. •This reflects the different fundamental of investments: the value of a company’s equity generally increases as the company’s earnings and cash flow increase, whereas the value of a company’s debt has an upper limit. • 2.The financial analysis process 1)The objectives of the financial analysis process a)Clarifying purpose and context: •Purpose of analysis, what question to answer •What level of detail will be needed to accomplish this purpose? •What data are available for the analysis? •What are the factors or relationships that will influence the analysis? •What are the analytical limitations, and will these limitations potentially impair the analysis? b)Selecting techniques (e.g. ratios). •General framework is on page 304 • 2)Distinguishing between computations and analysis a)Reasoning for the information collected •What aspects of performance are critical for this company to successfully compete in this industry? •How well did the company’s performance meet these critical aspects? (This is established through computation and comparison with appropriate benchmarks, such as the company’s own historical performance or competitors’ performance) •What were the key causes of this performance, and how does this performance reflect the company’s strategy? (This is established through analysis)b)Additional questions for forward looking analysis •What is the likely impact of an event or trend? (Established through interpretation of analysis) •What is the likely response of management to this trend? (Established through evaluation of quality of management and corporate governance.) •What is the likely impact of trends in the company, industry, and economy on future cash flows? (Established through assessment of corporate strategy and through forecasts.) •What are the recommendations of the analyst? (Established through interpretation and forecasting of results of analysis.) •What risks should be highlighted? (Established by an evaluation of major uncertainties in the forecast.) c)Communicating with writing report. •The purpose of the report, unless it is readily apparent; •Relevant aspects of the business context: oEconomic environment (country, macro economy, sector); oFinancial and other infrastructure (accounting, auditing, rating agencies); oLegal and regulatory environment (and any other material limitations on the company being analyzed); •Evaluation of corporate governance; •Assessment of financial and operational data; •Conclusions and recommendations (including risks and limitations to the analysis). d)An effective storyline and well-supported conclusions and recommendations are normally enhanced by using 3-10 years of data, as well as analytic techniques appropriate to the purpose of the report. • 3.Analysis tools and techniques •Evaluations require comparisons, which consists of cross-sectional analysis and time-series analysis. • 1)Ratios a)General discussion •Ratios express one quantity in relation to another (usually as a quotient). oResearch has found that financial statement ratios are effective in selecting investments and predicting financial distress. •Several aspects of ratio analysis are important to understand. oThe computed ratio is not “the answer”. ,Ratio is an indicator of some aspect of performance, only telling what has happened. ,Company size sometimes confers economies of scale, so the absolute amounts of net income and revenue are useful in financial analysis. ,Ratios reduce the effect of size, which enhances comparisons between companies and over time. oThe differences in accounting policies (across companies and across time) can distort ratios, and a meaningful comparison may, therefore, involve adjustments to the financial data. oNot all ratios are necessarily relevant to a particular analysis. oRatio analysis does not stop with computation, and interpretation of the result is essential. b)The universe of ratios •Formulas and even names of ratios often differ from analyst to analyst or form database to database. •But the different ratios may be used in practice and that certain industries have unique ratios tailored to the characteristics of the industry.•When facing a new ratio, the analyst should evaluate the numerator and denominator to assess what the ratio is attempting to measure and how it should be interpreted. •Return on assets (ROA) ratio. oThere are other ways of specifying this formula based on how assts are defined. oGenerally, using average would be appropriate. oA good general rule is that when an income statement or statement of cash flows number is in the numerator of a ratio and a balance sheet number is in the denominator (overtime/current), then an average should be sued for the denominator. If both are from balance sheet (current/current), then not need to be average. oOccasionally, there might need averages in ratios of items related to balance sheet. (e.g. ROE) •If an average is used, there is also judgment required as to what average should be used. c)Value, purpose and limitations of ratio analysis •Financial ratios provide insights into; oMicroeconomic relationships within a company that help analysts project earnings and free cash flow; oA company’s financial flexibility, or ability to obtain the cash required to grow and meet its obligations, even if unexpected circumstances develop; and oManagement’s ability •Limitations to ratio analysis oThe homogeneity of a company’s operating activities. oThe need to use judgment. ,A key issue is whether a ratio for a company is within a reasonable range, as ratio can not used to determine value or creditworthiness alone. oThe use of alternative accounting methods. Some important accounting considerations includes: ,FIFO, LIFO, or average cost inventory valuation methods (IFRS no longer allow LIFO); ,Cost or equity methods of accounting for unconsolidated affiliates; ,Straight line or accelerated methods of depreciation; and ,Capital or operating lease treatment. d)Source of ratios •Ratios may be computed using statements or from a database such as Bloomberg, Baseline, FactSet, or Thomson Reutuers. •Analysts should be aware that the underlying formulas may differ by vendor. oIt is a good practice to use the same source for data when comparing different companies or when evaluating the historical record of a single given company. •Systems are under development that collect financial data from regulatory filings and can automatically compute ratios. oThe eXtensibel Business Reporting Language (XBRL) •Analysts can compare a subject company to similar (peer) companies in these data bases or use aggregate industry data. oNon-public ,Annual statement studies • 2)Common-size analysis a)General discussion •Common-size analysis involves expressing financial data, including entire financial statements, in relation to a single financial statement item, or base.•Items used frequently as bases are total assets or revenue. b) Common-size analysis of balance sheet •A vertical common-size balance sheet (comparing in one reporting period), prepared by dividing each item on he balance sheet by the same period’s total assets and expressing the results as percentages, highlights the composition of the balance sheet. •A horizontal common-size balance sheet (comparing prior or future time periods or to a cross-sectional analysis), prepared by computing the increase or decreases in percentage terms of item form the prior year, highlights items that have changed unexpectedly or have unexpectedly remained unchanged. c)Common-size analysis of the income statement •A vertical common-size income statement divides each income statement item by revenue, or sometimes by total assets (especially in the case of financial institutions). oIf there are multiple revenue sources, a decomposition of revenue in percentage terms is useful. •The change of one item may results in changes of other items. d)Cross-sectional analysis •Cross-sectional analysis (sometimes called “relative analysis”) compares a specific metric for one company with the same metric for another company or group of companies, allowing comparisons even though the companies might be of significantly different sizes and/or operate in different currencies. e)Trend analysis •Trends in the data, whether they are improving or deteriorating, are as important as the current absolute or relative levels. oTrend analysis provides important information regarding historical performance and growth and, given a sufficiently long history of accurate seasonal information, can be of great assistance as a planning and forecasting tool for management and analysis. oA small percentage change could hide a significant currency change and vice versa,. •Another way to present data covering a period of time is to show each item in relation to the same item in a base year (i.e. a horizontal common-size balance sheet). oThis way of presentation highlights the significant changes.•An analysis of horizontal common-size balance sheets highlights structural changes that have occurred in a business. oAn examination of past trends is more valuable when the macroeconomic and competitive environments are relatively stable and when the analyst is reviewing a stable or mature business. oUnderstanding past trends is helpful in assessing whether these trends are likely to continue or if the trend is likely to change direction.•One measure of success is for a company to grow at a rate greater than the rate of the overall market in which it operates. oCompanies that grow slowly may find themselves unable to attract equity capital. Conversely, companies that grow too quickly may find that their administrative and management information systems cannot keep up with the rate of expansion. f)Relationships among financial statements •Trend data generated by a horizontal common-size analysis can be compared across financial statements. oIf revenue is growing more quickly than assts (from both horizontal common-sized income statement and balance sheet), the company may be increasing its efficiency (i.e., generating more revenue for every dollar invested in assets). oIf net income is growing faster than revenue, then it indicates increasing profitability. However, further analysis need to do to find out whether the increase is from continuing operations. •Decline in operating cash flow despite increasing net income and revenue increasing. •The fact that assets have grown faster than revenue indicates the company’s efficiency may be declining. •Analyst should examine the composition of the increase in assets and the reasons for the changes. • 3)The use of graphs as an analytical tool a)Graphs facilitate comparison of performance and financial structure over time, highlighting changes in significant aspects of business operations, and visual overview of trends. b)Choosing the appropriate graph to communicate the most significant conclusions of a financial analysis is a skill. •Pie graphs are most useful to communicate the composition of a total value. •Line graphs are useful when the focus is on the change in amount for a limited number of items over a relatively longer time period. •Stacked column graph can be useful to deal with the composition and amounts. • 4)Regression analysis a)Regression analysis can help identify relationships (or correlation) between variables. •Used to judge some characteristics, or for forecasting. b) Regression analysis facilitates identification of items or ratios that are not behaving as expected, given historical statistical relationships. • 4.Common ratios used in financial analysis 1)General discussion a)Net profit margin •Net income / sales •Indicator of profitability. b)Due to the large number of ratios, it is helpful to think about ratios in terms of broad categories based on what aspects of performance a ratio is intended to detect. •Common ratio categories include activity, liquidity, solvency, and profitability. •Activity oEfficiency of day-to-day tasks. •Liquidity oAbility to meet its short-term obligations •Solvency oAbility to meet long-term obligations. oSubsets of these ratios are “leverage” and “long-term debt” ratios •Profitability oAbility to generate profitable sales from its resources (assets). •Valuation oQuantity of an asset or flow (e.g. earnings) associated with ownership of a specific claim c)These categories are not mutually exclusive; some ratios are useful in measuring multiple aspects of the business. •In summary, analysts appropriately use certain ratios to evaluate multiple aspects of the business, and be aware of variations in industry practice in the calculation of financial ratios. • 2)Interpretation and context a)Financial ratios can only be interpreted in the context of other information, including benchmarks. •In general, compared with major competitors or prior periods.•The goal is to understand the underlying causes of divergence.•Each ratios that remain consistent require understanding because consistency can sometimes indicate accounting policies selected to smooth earnings.b)Analysts should evaluate financial ratios based on the following:•Company goals and strategy. •Industry norms (cross-sectional analysis) oCare to use industry norms ,Many ratios are industry specific, and not all ratios are important to all industries. ,Companies may have several different lines of business, and ratios should be examined by liens of business. ,Differences in accounting methods used by companies can distort financial ratios. ,Differences in corporate strategies can affect certain financial ratios. •Economic conditions oFor cyclical companies, financial ratios tend to improve when the economy is strong and weaken during recession. • 3)Activity ratios/Asset utilization ratios/Operating efficiency ratiosa)General discussion •Activity ratios are intend to measure how well a company manages various activities, particularly how efficiently it manages its various assets. •Indicators of ongoing operational performance, which is how effectively assets are used by a company for both working capital and longer-term assets.•Efficiency has a direct impact on liquidity. b)Calculation of activity ratios •On page 322 oInventory turnover = cost of goods sold / average inventory = #sold/#in inventory = “probability” to be sold of a product oDays of inventory on hand (DOH) = number of days in period / inventory turnover = #of total time * probability to not sold = how much average worth of inventory a company hold oReceivables turnover = revenue / average receivable oDays of sales outstanding (DSO) = number of days in period / receivables turnover oPayable turnover = purchase / average trade payables oNumber of days of payables = number of days in period / payable turnover oWorking capital turnover = revenue / average working capital oFixed asset turnover = revenue / average net fixed assets oTotal asset turnover = revenue / average total assets •Activity ratios measure how efficiently the company utilizes assets. • They generally combine information from the income statement (usually average) in the numerator and balance sheet items in the denominator (accumulated in period/current). oIf business is seasonal, then the time range for average may not annual. oThere can still be bias in using three or five data points, because the beginning and end of year occur at the same time of the year and are effectively double counted. oBecause the cost of goods sold measures the cost of inventory that has been sold, this ratio measures how many times per year the entire inventory was theoretically turned over, or sold. •Activity ratios can be computed for any annual or interim period, but care must be taken in the interpretation and comparison across periods. •In some cases, an analyst may want to know how many days of inventory are on hand at eh end of the year rather than the average for the year. oIn this case, it would be appropriate to use the year-end inventory balance in the computation rather than the average. oIf the value of item changes dramatically during the period, then it is may be more appropriate to use the recent average than overall average. c)Interpretation of activity ratios •Inventory turnover (and DOH) oIt indicates the resources (money) tied up in inventory (i.e., the carrying costs) and can, therefore, be used to indicate inventory management effectiveness. ,The higher, the lower DOH. ,In general, it (and DOH) should be benchmarked against industry norms. oA high inventory turnover ratio relative to industry norms might indicate highly effective inventory management. Alternatively, a high inventory turnover may indicate the company does not carry adequate inventory, so shortage could potentially hurt revenue. ,To assess which explanation is more likely, the analyst can compare the company’s revenue growth with that of the industry. ,Slow revenue growth with high turnover indicates the inadequate inventory levels. Otherwise, a greater inventory management efficiency. oA low inventory turnover ratio (and commensurately high DOH) relative to the rest of the industry could be an indicator of slow-moving inventory, and more information needed about comparing the sales growth with the industry. •Receivables turnover and DSO oThe number of DSO represents the elapsed time between a sale and cash collection, reflecting how fast the company collects cash from customers it offers credit. ,Revenue used here as a approximation as the credit sales information is not always available. oA relatively high receivables turnover ratio (and commensurately low DSO) might indicate highly efficient credit and collection. Alternatively, a high receivables turnover ratio could indicate that the company’s credit or collection policies are too stringent, suggesting the possibility of sales being lost to competitors offering more lenient terms. ,As with inventory management, comparison of the company’s sales growth relative to the industry can help to assess whether sales are being lost due to stringent credit policies. ,In addition, comparing the company’s estimates of uncollectible accounts receivable and actual credit losses with past experience and with peer companies can help assess whether low turnover reflects credit management issues. oCompanies of tern provide details of receivables aging (how much receivables have been outstanding by age). ,This can be sued along with DSO to understand trends in collection. •Payable turnover and number of days of payables oThe number of days payables reflects the average number of days and the company takes to pay its suppliers, and payables turnover ratio measures how many times per year the company theoretically pays off all its creditors. ,An implicit assumption is that the company makes all its purchases using credit. ,If the amount of purchase is not directly available, it can be computed as cost of goods sold plus ending inventory less beginning inventory. ,Alternatively, the cost the goods sold sometimes used as a approximation of purchase. oA payables turnover ratio that is high (low days payable) relative to the industry could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment discounts. ,An excessively low turnover ratio could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms. •If liquidity ratios indicate that the company has sufficient cash and other short-term assets to pay obligations, then they might be enjoying the favor of lenient supplier terms. •Working capital turnover oWorking capital is defined as current (expected to be consumed or converted into cash within one year) assets minus current liabilities.oWorking capital turnover indicates how efficiently the company generates revenue with its working capital. oA high working capital turnover ratio indicates greater efficiency (i.e., the company is generating a high level of revenues relative to working capital). oFor some companies, working capital can be near zero or negative, rendering this ratio incapable of being interpreted, then the following two would be more useful in those circumstances. •Fixed asset turnover oThis ratio measures how efficiently the company generates revenues from its investments in fixed assets. oGenerally, a higher fixed asset turnover ratio indicates more efficient use of fixed assets in generating revenue. oA low ratio can indicate inefficiency, a capital-intensive business environment, or a new business not yet operating at full capacity, in which case the analyst will not be able to link the ratio directly to efficiency. oIn addition, ratio can be affected by factors other than a company’s efficiency. ,Newer assets lead to a less ratio. ,The fixed assets ratio can be erratic because, although revenue may have a steady growth rate, increases in fixed assets may not follow a smooth pattern; so a change of ratio may not directly indicate a change of efficiency. •Total asset turnover oIt measures the company’s overall ability to generate revenues with a given level of assets. oA higher ratio indicates greater efficiency. Because this ratio includes both fixed and current assets, inefficient in one will distort overall interpretation. Therefore, it is helpful to analyze working capital and fixed asset turnover ratios separately. oA low asset turnover ratio can be an indicator of inefficiency or of relative capital intensity of the business. It also reflects strategic decisions by management. oWhen interpreting activity ratios, the analysts should examine not only the individual ratios but also the collection of relevant ratios to determine the overall efficiency of a company. • 4)Liquidity ratios a)General discussion •Focusing on cash flows, it measures a company’s ability to meet its short-term obligations. oIt measures how quickly assets are converted into cash. oIt measures the ability to pay off short-term obligation. oIn day-to-day operations, liquidity management is typically achieved through efficient use of assets. In the medium term, liquidity in the nonfinancial sector is also addressed by managing the structure of liabilities. •The level of liquidity needed differs from one industry to another, or the various points of time. oJudging whether a company has adequate liquidity requires analysis of its historical funding requirements, current liquidity position, anticipated future funding needs, and options for reducing funding needs or attracting additional funds (including actual and potential).•Larger companies are usually better able to control the level and composition of their liabilities than smaller companies. oMore easy to access capital funds, and thus less needs for liquidity buffer. •Contingent liabilities, such as letters of credit or financial guarantees, can also be relevant when assessing liquidity. oIn nonbanking sector, contingent liabilities (in footnotes) represent potential cash outflows, and when appropriate, should be included in an assessment of a company’s liquidity. oIn banking sector, contingent liabilities represent potentially significant cash outflows that are not dependent on the bank’s financial condition. ,A crisis can trigger a substantial increase in defaults and business bankruptcies that often accompany large cash outflows by contingent liabilities. b)Calculation of liquidity ratios •They use data from the ending balance sheet rather than average from the ending of the balance sheet. •The current, quick, and cash ratios reflect the company’s ability to pay current liabilities. oCurrent ratio = current assets / current liabilities. oQiuck ratio = (cash + short-term marketable investments + receivables) / current liabilities oCash ratio = (cash + short-term marketable investments) / current liabilities •The defensive interval ratio measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in. oDefensive interval ratio = (cash + short-term marketable investments + receivables) / daily cash expenditures oDaily cash expenditures is the total of cash expenditures for the period divided by the number of days in the period. ,Total cash expenditures are approximated by the summation of all expenses on the income statement. ,Summation of all cash expenditures minus the noncash expenditures (typically, taxes are not included). •Cash conversion cycle/Net operating cycle oA financial metric not in ratio form, measures the length of time required for a company to go from cash (invested in its operations) to cash received (as a result of its operations). ,It measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. ,During this period, the company needs to finance its investment in operations through other sources (i.e., through debt or equity). oCash conversion cycle = DOH + DSO - number of days of payables •(???????) why minus => in wikipedia by intervals c)Interpretation of liquidity ratios •Current ratio oIt expresses current assets (assets expected to be consumed or converted into cash within one year) in relation to current liabilities (liabilities falling due within one year). oA high value indicates a higher level of liquidity. oA lower ratio indicates less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short-term obligations. ,Liquidity affects the company’s capacity to take on debt. ,The current ratio implicitly assumes that inventories and accounts receivable are indeed liquid (which is presumably not the case when related turnover ratios are low). •Quick ratio oThe quick ratio is more conservative than the current ratio because it included only the more liquid current assets (sometimes referred to as “quick assets”) in relation to current liabilities. oA higher ratio indicates greater liquidity. oThe quick ratio reflects the fact that certain current assets – such as prepaid expenses, some taxes, and employee-related prepayments – represent costs of the current period that have been paid in advance and cannot usually be converted back into cash. oIt also reflects the fact that inventory might not be easily and quickly converted into cash, and a company may not be able to sell all of its inventory for an amount equal to its carrying value, especially if it were required to sell the inventory quickly. oIn situations where inventories are illiquid (e.g., by low inventory turnover), the quick ratio may be a better indicator of liquidity than the current ratio. •Cash ratio oIt normally represents a reliable measure of an individual entity’s liquidity in a crisis situation. oIn a general market crisis, the fair value of marketable securities could decreases significantly as a result of market factors, in which case even this ratio might not provide reliable information. •Defensive interval ratio oIt measures how long the company can continue to pay its expenses from its existing liquid assets without receiving any additional cash inflow. oA higher ratio indicates greater liquidity. •Cash conversion cycle / Net operating cycle oThis metric indicates the amount of time that elapses from the pint when a company invests in working capital until the point at which the company collects cash. oThe time between the outlay of cash and collection of cash is called the “cash conversion cycle”. oA shorter cash conversion cycle indicates greater liquidity • 5)Solvency ratios a)General discussion •Solvency refers to a company’s ability to fulfill its long-term debt obligations. oRelative amount of debt in the company’s capital structure and the adequacy of earnings and cash flow to cover interest expenses and other fixed charges (such as lease or rental payments) as they come due. •Analysts seek to understand a company’s used of debt for several main reasons. oOne reason is that the amount of debt in a company’s capital structure is important for assessing the company’s risk and return characteristics, specifically its financial leverage. ,Leverage is a magnifying effect that results from the use of fixed costs and can take two forms: operating leverage and financial leverage. ,Fixed costs are costs that stay the same within some range of activity. ,Operating leverage results from the use of fixed costs in conducting the company’s business, and it magnifies the effect of changes in sales on operating income. •The explanation is that: although variable costs will rise proportionally with revenue, fixed costs will not. ,When financing a firm, the use of debt constitutes financial leverage because interest payments are essentially fixed financing costs. Thus financial leverage tends to magnify the effect of changes in EBIT on returns flowing to equity-holder. •However, a higher level of debt in a company’s capital structure increases the risk of default and results in higher borrowing costs for the company to compensate the lenders for assuming greater credit risk. ,Analysts also need to be aware of the relationship between operating leverage and financial leverage. • Operating leverage can limit a company’s capacity to use financial leverage. oA company’s relative solvency is fundamental to valuation of its debt securities and its credit-worthiness. oUnderstanding a company’s use of debt can provide analysts with insight into the company’s future business prospects. b)Calculating of solvency ratios •Solvency ratios are primarily of two types: Debt ratios and coverage ratios. •Debt ratios oDebt-to-assets ratio/Total debt ratio = total debt / total assetsoDebt-to-capital ratio = total debt / (total debt + total shareholders’ equity) oDebt-to-equity ratio = total debt / total shareholders’ equityoTotal debt ,Here it means interest-bearing short-term and long-term debt, excluding liabilities such as accrued expenses and accounts payable. oFinancial leverage ratio = average total assets / average total equity •Coverage ratios oInterest coverage = EBIT / interest payments oFixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments) c)Interpretation of solvency ratios •Debt-to-assets ratio oIt measures the percentage of total assets financed with debt. oHigher debt means higher financial risk and thus weaker solvency.•Debt-to-capital ratio oIt measures the percentage of a company’s capital (debt plus equity) represented by debt. oHigher ratio generally means higher financial risk and thus indicates weaker solvency. •Debt-to-equity ratio oIt measures the amount of debt capital relative to equity capital. oHigher ratio indicates weaker solvency. oAlternative definitions of this ratio use the market value of stockholders’ equity rather than its book value (or use the market values of both stockholders’ equity and debt). •Financial leverage ratio / leverage ratio oIt measures the amount of total assets supported for each one money unit of equity. oUsed in DuPont decomposition of return on equity. •Interest coverage oIt measures the number of times a company’s EBIT could cover its interest payments. oA higher interest coverage ratio indicates stronger solvency.•Fixed charge coverage oIt relates fixed charges, or obligations, to the cash flow generated by the company. It measures the number of times of company’s earnings (before interest, taxes, and lease payments) can cover the company’s interest and lease payments. oA higher fixed charge coverage ratio implies stronger solvency, offering greater assurance that the company can service its debt from normal earnings. oThe ratio is sometimes used as an indication of the quality of the preferred dividend. oAn assumption sometimes made is that one-third of the lease payment amount represents interest on the lease obligation and that the rest is a repayment of principal on the obligation. The numerator is EBIT plus one-third of lease payments and the denominator is interest payments plus one-third of lease payments. • 6)Profitability ratios •Profitability reflects a company’s competitive position in the market, and by extension, the quality of its management (income statement). a)Calculation of profitability ratios •Profitability ratios measure the return earned by the company during a period.•Return on sales oThey express various subtotal on the income statement as a percentage of revenue. oEssentially, these ratios constitute part of a common-size income statement. oGross profit margin = gross profit / revenue oOperating profit margin = operating income / revenue oPertax margin = EBT (earnings before tax, but after interest) / revenueoNet profit margin = net income / revenue •Return on investment oThey measure income relative to assets, equity, or total capital employed by the company. oOperating ROA = operating income / average total assets oROA = net income / average total assets oReturn on total capital = EBIT / short- and long-term debt and equityoROE = net income / average total equity oReturn on common equity = (net income – preferred dividends) / average common equity ,Because preferred dividends are a return to preferred equity. b)Interpretation of profitability ratios •Gross profit margin oIt indicates the percentage of revenue available to cover operating and other expenditures. oHigher indicates some combination of higher product pricing and lower product costs. oIt related to competition (due to pricing and cost). •Operating profit margin oOperating profit is calculated as gross margin minus operating cost.oAn operating margin increasing faster than the gross margin can indicates improvements in controlling operating costs, such as administrative overheads. •Pertax margin/ Earnings before tax oPretax income is calculated as operating profit minus interest, so this ratio reflects the effects on profitability of leverage and other (non- operating) income and expenses. oIf a company’s pretax margin is rising primarily as a result of increasing non-operating income, the analyst should evaluate whether this increase reflects a deliberate change in a company’s business focus and, therefore, the likelihood that the increase will continue. •Net profit margin oNet profit is calculated as revenue minus all expenses. It includes both recurring and non-recurring items offers a better view of a company’s potential future profitability. •ROA oIt measures the return earned by a company on its assets. oThe higher the ratio, the more income is generated by a given level of assets. oThe problem with this computation is net income is the return to equity-holders, whereas assets are financed by both equity-holders and creditors. oAlternatively, some analysts computing ROA as : ROA = EBIT / average total assets. ,As noted, returns are measured prior to deducing interest on debt capital (i.e., as operating income or EBIT). ,This measure reflects the return on all assets invested in the company, whether financed with liabilities, debt, or equity.•Return on total capital oIt measures the profits a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity).•ROE oIt measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity. oBoth ROA and ROE are important measures of profitability. • 7)Integrated financial ratio analysis a)The overall ratio picture: examples b)DuPont analysis: the decomposition of ROE •It involves expressing the basic ratio as the product of component ratios. oEach component is a indicator of a distinct aspect of a company’s performance that affects ROE. •Decomposition ROE is useful in determining the reasons for changes in ROE over time for a given company and for differences in ROE for different companies in a given time period. oCould used to improve ROE oCould used to show why a company’s overall profitability, measured by ROE, is a function of its efficiency, operating profitability, and use of financial leverage. oIt shows the relationship between the various categories of ratios.•Analysts have developed several different methods of decomposing ROE, one of the mostly used is oROE = net income / average shareholders’ equity oROE = Netincomeaverageshareholders'equitynet = incomeaveragetotalassetsaveragetotalassetsaverage × shareholders'equityROAleverage=× ,In other words, ROE is a function of a company’s ROA and its use of financial leverage. ,If a company’s borrowing cost exceeds the marginal rate it can earn on investing, ROE would decline as leverage increased because the effect of borrowing would be to depress ROA. oROE = netincomerevenuerevenueaveragetotal × assetsaveragetotalassetsaverage× shareholders'equitynetprofitmarginassetturnover= × ×leverage ,Profitability (how much income a company derives per one money unit) × efficiency (how much revenue a company generates per one money unit of assets) × solvency (the total amount of a company’s assets relative to its equity capital) ,It also decomposes the ROA to be profitability and efficiency. ,ROE is a function of its net profit margin, efficiency, and leverage. oROE = netincomeEBTEBTEBITEBITrevenuerevenueaverage ××× totalassetsaveragetotalassetsaverage × shareholders'equitytaxburdeninterestburdenEBIT= × × marginassetsturnoverleverage × × ,Tax burden •effect of taxes on ROE (how much of a company’s pretax profits it gets to keep) •A higher tax burden means a higher pretax profits and lower tax rate. ,Interest burden •The effect of interest on ROE •Higher borrowing costs reduce ROE. ,EBIT margin •Effect of operating margin (if operating income is used in the numerator) or EBIT margin (if EBIT is used) on ROE, and effect of operating profitability. ,Asset turnover ratio •Overall efficiency of the company ,Financial leverage •The total amount of a company’s assets relative to its equity capital. ,The decomposition expresses a company’s ROE as a function of its tax rate, interest burden, operating profitability, efficiency, and leverage. oCould be decomposed into any combination of ratios discussed before, for certain purpose of analysis. • 5.Equity analysis 1)General discussion a)An application of financial analysis is valuing a security to assess its merits for inclusion or retention in a portfolio. b)Valuation process •Understanding the business and existing financial profile •Forecasting company performance •Selecting the appropriate valuation model •Converting forecasts to a valuation •Making the investment decision c)Fundamental equity analysis involves evaluation a company’s performance and valuing its equity in order to assess its relative attractiveness as an investment.• 2)Valuation ratios a)Calculation of valuation ratios and related quantities •The P/E ratio expresses the relationship between the price per share and the amount of earnings attributable to a single share. oHow much an investor in common stock pays per dollar of current earnings. oDue to the net income, the ratio can be sensitive to nonrecurring earnings or one-off earning events, and net income is more susceptible to manipulation. •Price to cash flow oParticularly in situations where earnings quality may be an issue (where net income may be manipulated). •EBITDA per share oBecause it is calculated using income before interest, taxes, and depreciation, and be used to eliminate the effect of different levels of fixed asset investment across companies. oFor comparison of companies in the same sector but at different stages of infrastructure maturity. •Price to sales oIt is calculated in a similar manner, and sometimes used as a comparative price metric when a company does not have positive net income. •Price to book value / or P/B o The ratio of stock price to book value per share. oIndicator of market judgment about the relationship between a company’s required rate of return and its actual rate of return. Assuming the book value is the fair value, then this ratio can be interpreted as an indicator that the company’s future returns are expected to be exactly equal to the returns required by the market. b)Interpretation of earning per share •EPS is the amount of earning attributable to each share of common stock. oIt doesn’t provide adequate information for comparison, as it consists of profitability and number of outstanding. •Basic EPS oIt provides information regarding the earnings attributable to each share of common stock. oThe weighted average number of shares outstanding during the period is first needed. ,It consists of the number of ordinary shares outstanding at the beginning of the period, adjusted by those bought back or issued during the period, multiplied by a time-weighting factor. •Diluted EPS oIt includes the effect of all the company’s securities whose conversion or exercise would result in a reduction of basic EPS; dilutive securities include convertible debt, convertible preferred, warrants, and options). oBoth basic and diluted EPS are required in the financial statement.oto calculate the diluted EPS, earnings are adjusted for the after-tax effects assuming conversion, and following adjustments are made to the withed number of shares: ,The weighted average number of shares for basic EPS, plus those that would be issued on conversion of all dilutive potential ordinary shares. •Potential ordinary shares are treated as dilutive when their conversion would decrease net profit per share from continuing ordinary operations. ,These shares are deemed to have been converted into ordinary shares at the beginning of the period or, if later, at the date of the issue of the shares. ,Options, warrants (and their equivalents), convertible instruments, contingently issuable shares, contracts that can be settled in ordinary shares or cash, purchased options and written put options should be considered. c)Dividend-related quantities •Dividend payout ratio oIt measures the percentage of earnings that the company pays out as dividends to shareholders. oThe amount of dividends per share tends to be relatively fixed because any reduction in dividends has been shown to result in a disproportionately large reduction in share price. Then the ratio tends to fluctuate with earnings. oSo the examination should be applied to a number of periods. •Retention rate oIt is the complement of the payout ratio, which is a percentage of earnings that a company retains. •Sustainable growth rate oIt is viewed as a function of its profitability (measure as ROE) and its ability to finance itself from internally generated funds (measured as the retention rate). oA higher ROE and a higher retention rate result in a higher sustainable growth rate. • 3)Industry-specific ratios a)On page 352 • 4)Research on ratio in equity analysis a)The end product of equity analysis is often a valuation and investment recommendation. b)Theoretical valuation models are useful in selecting ratios that would be useful in this process. c)Another common valuation method involves forecasts of future cash flow that are discounted back to the present. d)Trends in ratios can be useful in forecasting future earnings and cash flows. •Future growth expectations are a key component of all of these valuation models. e)The variability in ratios and common-size data can be useful in assessing risk, an important component of the required rate of return in valuation models. • 6.Credit analysis 1)General discussion a)Credit risk is the risk of loss caused by a counterparty’s or debtor’s failure to make a promised payment. •Credit analysis is the evaluation of credit risk. b)Credit analysis for specific types of debt often involves projections of period-by- period cash flows similar to projections make by equity analysts. •Equity analyst may discount the projected cash flows. •Credit analyst may use the projected cash flows to assess the likelihood of a company complying with its financial covenants. c)Credit analysis may relate to the borrower’s credit risk in a particular transaction or to its overall credit-worthiness. •Credit scoring, a statistical analysis of the determinants of credit default. •Credit rating, could be long-term or short-term, and is an indication of rating agency’s opinion of the credit-worthiness of a debt issuer with respect to a specific debt security or other obligation. • 2)The credit rating process a)The rating process involves both the analysis of a company’s financial reports as well as a broad assessment of a company’s operations. b)Process •Meeting with management to discuss. •Tours of major facilities, time permitting. •Meeting of a rating committee after considering factors that are include •Monitoring of publicly distributed rating. c)Ratios used •EBIT interest coverage = EBIT / Gross interest •EBITDA interest coverage = EBITDA / gross interest •Funds from operations to total debt = FFO (net income adjusted for non-cash items) / total debt •Free operating cash flow to total debt = CFO (adjusted) less capital expenditures / total debt •Total debt to EBITDA = total debt / EBITDA •Return on capital = EBIT / capital (average equity and short –term portions of debt, noncurrent deferred taxes, minority interest) •Total debt to total debt plus equity = total debt / total debt plus equity •(FFO = funds from operations) d)Before calculating ratios, rating agencies make certain adjustments to reported financials such as adjusting debt to included off-balance sheet debt in a company’s total debt. • 3)Research on ratios in credit analysis a)Ability to predict failure of a company up to 5 years •Cash flow to total debt, ROA, total debt to total assets, working capital to total assets, the current ratio, and no-credit interval ratio. b)Similar research has been performed on the ability of ratios to predict bond rating and bond yields. • 7.Business and geographic segments 1)IAS 14 requirements a)Segments •Subsidiary companies, operating units, or simply operations in different geographic areas. b)Under IAS 14, disclosures are required for reportable segments, whereas U.S.GAAP is similar but less detailed (such as segment liabilities) •The majority (>50%) of its revenue is earned externally, and •Its income from sales, segment result, or assets is greater than or equal to 10 percent of the appropriate total amount of all segments. c)Two types of segments •A business segment is a distinguishable component of a company that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments. •A geographical segment is a distinguishable component of a company that is engaged in providing products or services within a particular economic environment. •Differences between those two oFor external reporting purposes, they are distinguished to the BOD and CEO. oFor internal organization units which is not individual, they should be determined by BOD or CEO to be either one of those types, based on their assessment of which type of segment reflects the primary source of the company’s risks and returns. oUnder this standard, most entities would identify their business and geographical segments as the organizational units for which information is reported to the nonexecutive board of directors and senior management. d)Segment reporting •If the total revenue from external customers for all reportable segments combined is less than 75 percent of the total company revenue, additional reportable segments should be identified until the 75 percent level is reached. oSmall segments might be combined with other relative small segment groups or a significant segment. If they are not separately reported or combined, they are included as an unallocated reconciling item. •The company must identify a primary segment reporting format with the other segment used for the secondary reporting format. oThe company’s internal organization and management structure, and its system of internal financial reporting to the board of directors and CEO, are normally the basis for identifying the predominant source and nature of risks and differing rates of return. •The items that should be disclosed for primary, secondary and other segments is on page 358. • 2)Segment ratio a)Segment margin = segment profit / segment revenue •It measures the operating profitability of the segment relative to revenue.b)Segment turnover = segment revenue / segment assets •It measures the overall efficiency of the segment. c)Segment ROA = segment profit / segment assets •It measures the operating profitability relative to assets. d)Segment debt ratio = segment liabilities / segment assets •It measures the level of liabilities (solvency) of the segment. • 8.Model building and forecasting 1)Analysts use data about the economy, industry, and company with their judgment to arriving at forecasting. 2)Model building a)In addition to budgets, pro forma financial statements are widely used in financial forecasting. 3)Forecast examples a) Revenue forecasting •Budget expenses based on expected common-size data b)Forecasts of balance sheet and statement of cash flows •Expected ratio data, such as DSO. c)Forecasts are not limited to a single point estimate 4)Techniques a)Sensitivity analysis / “What if” analysis •It shows the range of possible outcomes as specific assumptions are changed; this could influence financing need or investment in fixed assets. b)Scenario analysis •It shows the changed in key financial quantities that result from given (economic) events, such as the loss of customers. •If the list of events is mutually exclusive and exhaustive and the events can be assigned probabilities, statistical methods could be used. c)Simulation •It is computer-generated sensitivity or scenario analysis based on probability models for the factors that drive outcomes. • • • • • •Reading 36 - Inventories • • • 1.Introduction 1)Merchandisers only have one type of inventory: finished goods inventory; manufactures have three types of inventory: raw materials, work-in-process and, finished goods through application of direct labor and factory overhead costs. a)Work-in-process •Started then conversion process from raw materials but have not yet been completed or “finished”. 2)An important consideration if calculating profits for these types of companies is measuring the cost of goods sold when inventory is sold to business customersa)IFRS allows companies complying with IFRS to opt from these three sanctioned method: specific identification, weighted average costs, and first-in, first-out.b)U.S.GAAP allows the same three methods, but also included LIFO. • 2.Inventory cost and inventory accounting methods 1)Determination of inventory cost a)Capitalized inventory costs •They comprise all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. •Company must also allocate to inventory a portion of fixed production overhead based on normal capacity levels, though any unallocated portion of the overhead is expensed when incurred. •IAS excludes from inventory cost all abnormal costs incurred due to waste of materials and abnormal waste incurred for labor and overhead conversion costs from the production process, any storage and all administrative overhead and selling costs. oThose excluded costs are treated as period costs. oU.S.GAAP has a similar system for this. b)Capitalizing inventory related costs defers their recognition as an expense in the income statement until the inventory is sold. •Any capitalization of costs that should otherwise be expensed will overstate profitability on the income statement (due to the inappropriate deferral of cost recognition) and create an overstated inventory value on the balance sheet. •Production overhead is calculated as capitalized as proportion of the total goods finished to the maximized (theoretical) amount, with the rest as period cost. • 2)Declines in inventory value a)IAS states the inventories shall be measured at the lower of cost and “net realizable value”. •Net realizable value oIt is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale. oIn the event that the value of inventory declines below the cost carried on the balance sheet (historical cost), a write-down (loss) must be recorded. oReversal (limited to the amount of the original write-down) is required for a subsequent increase in value of inventory previously written down. oThe amount of any write-down of inventories to net realizable value and all losses of inventories are recognized as an expense in the period the write-down or loss occurs. And the reversal is recognized as a reduction of that expense in the period in which the reversal occurs. b)In certain industries, inventories may be valued and recorded at amounts greater than their historical cost. •IAS allow agricultural and forest products, minerals and mineral products can be exceed their historical cost, that is, reversal is unbounded. oIn active market, using the market value for fair value; in non-active market, use the market-determined value (e.g., recent market transaction value). oA gain or loss from the change in fair value is included in the net profit or loss. •U.S.GAAP is broadly consistent with IFRS, in that the lower of cost and market is used to value inventories. oMarket value (fair value) is defined as being current replacement cost subject to an upper limit of net realizable value and a lower limit of net realizable less a normal profit margin. oReversal is prohibited, as a write-down creates a new cost basis. oSame treatment for inventories of agricultural and forest products and mineral ores. • 3)Inventory accounting methods a)IAS 2, the cost of inventories is generally assigned by using either the FIFO or withed average cost method. •Methods are not inter-changeable for specific projects, and costly goods. •Those are cost flow assumptions, whereas the specific identification method is not. •For inventories with a different nature or use, different cost formulas may be justified. •When inventories are sold, the carrying amount of the inventory is recognized as an expense according to the inventory cost flow formula. b)The choice of inventory method would not be much of an issue if inventory unit costs remained relatively constant from period to period. •This is because allocation of cost flow between cost of goods sold and inventory carrying value would be very similar under the specific identification, weighted average cost, and FIFO inventory method. c)General discussion about those methods • The specific identification method matches the physical flow of the specific inventory items sold to their actual historic cost. •Under the weighted average cost method, inventory value and inventory cost recognition determined by using a weighted average mix of the actual costs incurred for all inventory items available for sale. •The FIFO method assumes that companies sell their oldest purchased inventory units before selling the next oldest purchased inventory units, and so on. oEnding inventory will always consist of those units that have been most recently purchase and are valued at their historic purchase cost.• 4)Comparison of inventory accounting methods a)In an environment of rising inventory unit costs and constant or increasing inventory quantities, FIFO will allocate a lower amount of cost flow to cost of goods sold on the income statement and a greater amount of cost flow to the carrying value of inventory on the balance sheet. •The cost of goods sold will be lower •The book value of inventories will more closely reflect current replacement values. b)In an environment of declining inventory unit costs and constant or increasing inventory quantites (?????????) • • 3.Financial analysis of inventories 1)Inventory ratios a)Ratios •Many other ratios are also affected by the choice of inventory method, although less directly. b)Inventory turnover ratio •It indicates the resources tied up in inventory (the carrying costs) and can be used to evaluable inventory management effectiveness. •The higher the ratio, the shorter the period that inventory is held, and so the lower the number of days of inventory ratio. •In general, they should be benchmarked against industry norms.