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Subject 5. Analyst Adjustments to Reported Financials
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-statement-analysis-applications
Analysts' adjustments to a company's reported financial statements are sometimes necessary (e.g., when comparing companies that use different accounting methods or assumptions). A balance-focused framework for analyst adjustments is presented in the textbook.

Investments Adjustments

Different categories of investment securities have different treatments regarding unrealized holding gains and losses. Depending on management's intention, investment securities can be classified as:

  • Trading securities. Any unrealized gains and losses are recognized on the income statement as part of the net income.
  • Available-for-sale securities. Any unrealized gains and losses are recognized on the balance sheet as part of other comprehensive income.

Adjustments may be needed to facilitate the comparison of two otherwise comparable companies that have significant differences in the classification of investments.

Inventory Adjustments

IAS No.2 does not permit the use of LIFO. If a company not reporting under IFRS uses LIFO but another company uses FIFO, comparison of the two companies may be difficult. Reading 29 [Inventories] illustrates how to make an inventory adjustment and its impact.

Property, Plant and Equipment

Companies may choose different depreciation methods (e.g., a straight-line method or an accelerated method) and accounting estimates (e.g., salvage value or useful life) related to depreciation. Disclosures required for depreciation often do not facilitate specific adjustments. Analysts may evaluate the relationships between various depreciation-related items (e.g., gross PPE, accumulated depreciation, depreciation expense, cash flows for capital expenditure, and asset disposals).

  • Relative Age (in %) = Accumulated Depreciation / Ending Gross Investment. This equation suggests how much of the useful life of the company's overall asset base has passed.
  • Average Depreciable Life = Ending Gross Investment / Depreciation Expense.
  • Average Age (in years) = Accumulated Depreciation / Depreciation Expense. This equation indicates how many years' worth of depreciation expense has already been recognized.

The above three indicators are discussed in Reading 30 [Long-Lived Assets].

  • The ratio of Net PPE / Depreciation Expense suggests how many years of useful life remain for a company's overall asset base.
  • CapEx / (Gross PPE + CapEx) signifies what percentage of the asset base is being renewed through new capital investment.
  • CapEx / Asset Disposal indicates the growth of the asset base.

Goodwill

Goodwill is recorded as an asset if one company purchases another for a price that is more than the fair value of the assets acquired. Internally generated goodwill is not recorded on the balance sheet. Adjustments are needed to compare two otherwise comparable companies when one has a recorded goodwill asset. The textbook provides an excellent example of the ratio comparisons for goodwill.

Off-Balance-Sheet Financing

This topic is covered in Reading 32 [Non-current (Long-term) Liabilities].
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