on 11-Nov-2016 (Fri)

Financial Notes and Supplementary Schedules

Financial footnotes are an integral part of financial statements. They provide information about the accounting methods, assumptions and estimates used by management to develop the data reported in the financial statements. They provide additional disclosure in such areas as fixed assets, inventory methods, income taxes, pensions, debt, contingencies such as lawsuits, sales to related parties, etc. They are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements.

Supplementary Schedules: In some cases additional information about the assets and liabilities of a company is provided as supplementary data outside the financial statements. Examples include oil and gas reserves reported by oil and gas companies, the impact of changing prices, sales revenue, operating income, and other information for major business segments. Some of the supplementary data is unaudited.

Management Discussion and Analysis (MD&A)

This requires management to discuss specific issues on the financial statements, and to assess the company's current financial condition, liquidity, and its planned capital expenditure for the next year. An analyst should look for specific concise disclosure as well as consistency with footnote disclosure.

Note that the MD&A section is not audited and is for public companies only.

Auditor's Reports

See next subject for details.

Other Sources of Information

• Interim reports. Publicly held companies must file form 10-Q (interim report) on a quarterly basis. It is far less detailed than annual financial statements, as it contains unaudited basic financial statements, unaudited footnotes to financial statements, and management discussion and analysis.

• Proxy statements. An analyst should look for litigation, executive compensation, and related-party transactions, known as proxy statements. Proxy statements should be considered an integral part of the financial report, and they may contain special compensation "perks" for officers and directors, as well as lawsuits and other contingent obligations facing the company.

• Companies' websites, press releases, and conference calls.

The auditor (an independent certified public accountant) is responsible for seeing that the financial statements issued comply with generally accepted accounting principles. In contrast, the company's management is responsible for the preparation of the financial statements. The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable. The auditor also examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.

An auditor's report (also called the auditor's opinion) is issued as part of a company's audited financial report. It tells the end-user the following:

• Whether the financial statements are presented in accordance with generally accepted accounting principles.
• It identifies those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
• Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

An auditor's report is considered an essential tool when reporting financial information to end-users, particularly in business. Since many third-party users prefer or even require financial information to be certified by an independent external auditor, many auditees rely on auditor reports to certify their information in order to attract investors, obtain loans, and improve public appearance. Some have even stated that financial information without an auditor's report is "essentially worthless" for investing purposes.

The Types of Audit Reports

There are four common types of auditor's reports, each one representing a different situation encountered during the auditor's work. The four reports are as follows:

• An unqualified opinion report is issued by an auditor when the financial statements presented are free of material misstatements and are in accordance with GAAP, which, in other words, means that the company's financial condition, position, and operations are fairly presented in the financial statements. It is the best type of report an auditee may receive from an external auditor. It is regarded by many as the equivalent of a "clean bill of health" to a patient, which has led many to call it the "clean opinion."
• A qualified opinion report is issued when the auditor encountered one or two situations that did not comply with generally accepted accounting principles; however, the rest of the financial statements are fairly presented. This type of opinion is very similar to an unqualified or "clean opinion," but the report states that the financial statements are fairly presented with a certain exception which is otherwise misstated.
• An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and generally do not comply with GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained to assess the auditee's financial position and results of operations is materially incorrect, unreliable, and inaccurate.

• A disclaimer of opinion, commonly referred to simply as a disclaimer, is issued when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit a company but could not complete the work due to various reasons and does not issue an opinion.

Auditor's Report on In...

The financial statement analysis framework provides steps that can be followed in any financial statement analysis project, including the following:

• Articulate the purpose and context of the analysis.
  What is the purpose of the analysis? Evaluating an equity or debt investment? Or issuing a credit rating?
  The context needs to be defined clearly too: Who is the intended audience? What is the nature and content of the final report? What is the time frame? What is the budget?

• Collect input data.
  Gather a company's financial data from financial statements and other sources described in Subject c (other financial information sources). Also gather information on the economy and industry to understand the environment in which the company operates.

• Process data.
  Compute ratios or growth rates, prepare common-size financial statements, create charts, perform statistical analyses, make adjustments to financial statements, etc.

• Analyze / interpret the processed data.
  Interpret the output to support a conclusion (e.g., a buy decision).

• Develop and communicate conclusions and recommendations.
  Communicate the conclusion or recommendation in an appropriate format.

• Follow up.
  Periodic review is required to determine if the original conclusions and recommendations are still valid.

Business activities can be classified into three groups:

• Operating activities involve those activities conducted in the course of running a business. These activities determine net income and changes in the working capital account (accounts receivable, inventory, and accounts payable). Examples:
  • Selling goods and services
  • Employing managers and workers
  • Buying goods and services
  • Paying taxes

• Investing activities are those associated with spending funds to begin and continue operations. In general, these activities affect the long-term asset items on the balance sheet. Examples:
  • Buying resources such as land, buildings, and equipment needed in the operation of the business.
  • Selling these resources when no longer needed.
  Selling land, buildings, and equipment is associated with investing activities, even though it results in a cash inflow, because it involves resources used to begin and continue operations.

• Financing activities are related to obtaining or repaying capital. In general, these activities affect the debt and the equity items on the balance sheet. Examples:
  • Issuing stock
  • Paying dividends to stockholders
  • Obtaining loans from creditors
  • Repaying amounts plus interest to creditors
  Payments of dividends and interest are associated with financing activities, even though they involve cash outflows, because they are necessary to obtain funding.

In Reading 27 [Understanding the Cash Flow Statement] a more detailed discussion of different business activities and their impact on cash flows will be provided.

An account is a label used for recording and reporting a quantity of almost anything. It is the:

• Means by which management keeps track of the effects of transactions.
• Basic storage unit for accounting data.

A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income, and Expenses.

Assets

Assets are economic resources controlled by a company that are expected to benefit future operations.

• An asset is usually listed on the balance sheet.
• It has a normal or usual balance of debit (i.e., asset account amounts appear on the left side of a ledger).

It is important to understand that in an accounting sense an asset is not the same as ownership. In accounting, ownership is described by the term "equity."

Types of Assets

• Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.
• Long-term investments are often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
• Property, plants, and equipment are properties of a durable nature used in the regular operations of a business. With the exception of land, most assets are either depreciable (such as a building) or consumable. The accumulated depreciation account is a contra-asset account used to total the depreciation expense to date on the asset.
• Intangible assets lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) as an expense over 5 to 40 years.

Liabilities

Liabilities are the financial obligations that the company must fulfill in the future. They are typically fulfilled by cash payment. They represent the source of financing provided to a company by its creditors.

Types of Liabilities

• Current liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: notes payable, accounts payable, accrued items (e.g., accrued warranty costs, compensation, and benefits), income taxes payable, current maturities of long-term debt, etc.
• Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities.

Owners' Equity

Equity represents the source of financing provided to the company by the owners.

Owners' Equity = Contributed Capital + Retained Earnings

Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.

• Contributed capital is the amount invested in the busines

...

Assets reported on the balance sheet are either purchased by the company or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the company. This fundamental accounting relationship provides the basis for recording all transactions in financial reporting and is expressed as the balance sheet equation:

Assets (A) = Liabilities (L) + Owners' equity (E)

This equation is the foundation for the double-entry bookkeeping system because there are two or more accounts affected by every transaction.

If the equation is rearranged:

Assets - Liabilities = Owners' equity

The above equation shows that the owners' equity is the residual claim of the owners. It is the amount left over after liabilities are deducted from assets.

Owners' equity at a given date can be further classified by its origin: capital provided by owners, and earnings retained in the business up to that date.

Owners' equity = Contributed capital + Retained earnings

Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.

Revenue - Expenses = Net income (loss)

Net income is informally called the "bottom line" because it is typically found on the last line of a company's income statement.

Balance sheets and income statements are interrelated through the retained earnings component of owners' equity.

Ending retained earnings = Beginning retained earnings + Net income - Dividends

The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:

Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue - Expenses - Dividends

• Dividends and expenses decrease owners' equity.
• Revenues increase owners' equity.

Because dividends and expenses are deductions from owners' equity, move them to the left side of the equation:

The following illustrates how the business transactions of ABC Realty are recorded in a simplified accounting system.

1. Owners' Investments - Invested $50,000 in business in exchange for 5,000 shares of $10 par value stock.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land	Building		A/P	Common Stock	Retained Earnings
1	$50,000							$50,000
A = $50,000							L + OE = $50,000
Notice A = L + SE is always in balance.

2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for $25,000.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land	Building		A/P	Common Stock	Retained Earnings
1	$50,000							$50,000
2	-35,000			$10,000	$25,000			$50,000
bal	$15,000			$10,000	$25,000			$50,000
A = $50,000							L + OE = $50,000
This transaction only affects one side of the accounting equation: assets. Whenever a transaction affects only one side of the accounting equation, both assets and liabilities and owners' equity remain unchanged.

3. Purchase of Assets by Incurring a Liability - Purchased office supplies for $500 on credit.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land

...

Under strict cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.

Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.

Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.

• A balance sheet must list all assets and liabilities at the end of the accounting period.
• An income statement must list all revenues and expenses applicable to the accounting period.

Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.

The four basic types of adjusting entries are:

• Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.

• Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.

• Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).

• Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.

In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.

• If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
• If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other com

...

Here are financial statements based on previous transactions for ABC Realty.

It is important for an analyst to understand the flow of information through a financial reporting system.

1. Journal entries and adjusting entries

Journalizing is the process of chronologically recording transactions.

• General journal is the simplest and most flexible.
• A separate journal entry records each transaction.
• Useful for obtaining detailed information regarding a particular transaction.

2. General ledger and T-accounts

The items entered in a general journal must be transferred to the general ledger. This procedure, posting, is part of the summarizing and classifying process. The general ledger contains all the same entries as those posted to the general journal; the only difference is that the data are sorted by date in the journal and by account in the ledger.

There is a separate T-account for each item in the ledger. A T-account appears as follows:

3. Trial balance and adjusted trial balance

A trial balance is a list of all open accounts in the general ledger and their balances.

• For every amount debited, an equal amount must be credited.
• The total of debits and credits for all the T-accounts must be equal.
• A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
• It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

4. Finance statements

The financial statements can be prepared from the adjusted trial balance.

Financial statements are the primary information that firms publish about themselves, and investors and creditors are the primary users of financial statements. Analysts, who work for investors and creditors, may need to make adjustments to reflect items not reported in the statements or assess the reasonableness of managements' judgments. For example, an important first step in analyzing financial statements is identifying the types of accruals and valuation entries in a company's financial statements.

Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.

For example, companies may improperly record costs as assets rather than as expenses and amortize the assets over future periods. The goal is to impress shareholders and bankers with higher profits. Consider advertising expenses, which should be charged against income immediately. Certain companies, particularly those selling memberships to customers (e.g., health clubs and Internet access providers), aggressively capitalize these costs and spread them over several periods.

Companies may amortize long-term assets too slowly. Slow depreciation or amortization keeps assets on the balance sheet longer, resulting in a higher net worth. With slow amortization, expenses are lower and profits are higher.

An awareness of the reporting framework underlying financial reports can assist in security valuation and other financial analysis. This framework describes the objectives of financial reporting, desirable characteristics for financial reports, the elements of financial reports, and the underlying assumptions and constraints of financial reporting. An understanding of the framework that is broader than knowledge of a particular set of rules offers an analyst a basis from which to infer the proper financial reporting, and thus security valuation implications, of any financial statement element transaction.

The objective of financial reporting:

• The objective of financial statements is to provide information about a company's financial position, performance, and any changes in financial position; this information should be useful to a wide range of end-users for the purpose of making economic decisions.
• Financial reporting requires policy choices and estimates. These choices and estimates require judgment, which can vary from one preparer to the next. Accordingly, standards are needed to attempt to ensure some type of consistency in these judgments.

Private sector standard-setting bodies and regulatory authorities play significant but different roles in the standard-setting process. In general, standard-setting bodies make the rules and regulatory authorities enforce the rules. However, regulators typically retain legal authority to establish financial reporting standards in their jurisdictions.

International Accounting Standards Board (IASB)

This is essentially the international equivalent of the Financial Accounting Standards Board (FASB).

• It was preceded by the International Accounting Standards Committee (IASC), which was established in 1973.
• It is comprised of 14 members (12 full-time, 2 part-time); seven members are liaisons with a national board.
• It works toward harmonization of international accounting standards.
• The standard development process is open.
• Standards are principles-based.
• Since the establishment of the IASB, the focus is on global standard-setting rather than harmonization per se.

International Organization of Securities Commissions (IOSCO)

This is essentially the international equivalent of the U.S. Securities and Exchange Commission (SEC).

• It works to achieve improved market regulation internationally.
• It works to facilitate cross-border listings.
• It advocates for the development and adoption of a single set of high-quality accounting standards.

Financial Accounting Standards Board (FASB)

The FASB is a non-governmental body that sets accounting standards for all companies issuing audited financial statements. All FASB pronouncements are considered authoritative; new FASB statements immediately become part of GAAP.

U.S. Securities and Exchange Commission (SEC)

In the U.S., the form and content of the financial statements of companies whose securities are publicly traded are governed by the SEC through its regulation S-X. Although the SEC has delegated much of this responsibility to the FASB, it frequently adds its own requirements. The SEC functions as a highly effective enforcement mechanism for standards promulgated in the private sector.

Audited financial statements, related footnotes, and supplementary data are presented in both annual reports sent to stockholders and those filed with the SEC. These filings often contain other valuable information not presented in stockholder reports.

Convergence of Global Financial Reporting Standards

As capital markets become more international in scope, the need for global accounting standards and the demand for multiple listings has grown. The IASB and FASB, along with other standard-setters, are working to achieve convergence of financial reporting standards.

Pros:

• Expedite the integration of global capital markets and make the cross-listing of securities easier.
• Facilitate international mergers and acquisitions.
• Reduce investor uncertainty and the cost of capital.
• Reduce financial reporting costs.
• Allow for easy adoption of high-quality standards by developing countries.

Cons:

• Significant differences in standards currently exist.
• The political cost of eliminating differences.
• Overcoming nationalism and traditions.
• Will cause "standards overload" for some firms.
• Diverse standards for diverse places are acceptable.

The IFRS Framework sets forth the concepts that underlie the preparation and presentation of financial statements for external end-users, provides further guidance on the elements from which financial statements are constructed, and discusses the concepts of capital and capital maintenance.

Objectives of Financial Statements

The Framework identifies the central objective of financial statements as providing information about a company that is useful in making economic decisions. Financial statements prepared for this purpose will meet the needs of most end-users. Users generally want information about a company's financial performance, financial position, cash flows, and ability to adapt to changes in the economic environment in which it operates.

The Framework identifies end-users as investors and potential investors, employees, lenders, suppliers, creditors, customers, governments, and the public at large.

Qualitative Characteristics of Financial Statements

The Framework prescribes a number of qualitative characteristics of financial statements. The key characteristics are relevance and reliability. Preparers can face a dilemma in satisfying both criteria at once. For example, information about the outcome of a lawsuit may be relevant, but the financial impact cannot be measured reliably.

Financial information is relevant if it has the capacity to influence an end-user's economic decisions. Relevant information will help users evaluate the past, present, and most importantly, future events in a company.

To be reliable, financial information must represent faithfully the effects of the transactions and events that it reflects. The true impact of transactions and events can be compromised by the difficulty of measuring transactions reliably.

• Financial information faithfully represents transactions and events when accounted for in accordance with their substance and economic realityand not merely their legal form. Commonly, a legal agreement will purport that a company has "sold" assets to a third party. However, an analysis of the substance of the arrangement indicates that the company retains control over the future economic benefits and risks embodied in the asset, and should continue to recognize it on its own balance sheet.
• Financial information is reliable if it is free from material error and is complete. Information is material if its omission or misstatement could influence decisions that end-users make on the basis of the financial statements. Information is reliable when it is neutral or free from bias and prudence. A degree of prudence when preparing financial information enhances its reliability. However, a company should not use prudence as the basis for the recognition of, for example, excessive provisions.

Financial information must be easily understandable in addition to being relevant and reliable. Preparers should assume that end-users have a reasonable knowledge of business and economic activities, and an ability to comprehend complex financial matters.

End-users must be able to compare a company's financial statements through time in order to identify trends in financial performance (comparability). Hence, policies on recognition, measurement, and disclosure must be applied consistently over time. Where a company changes its accounting for the recognition or measurement of transactions, it should disclose the change in the Basis of Accounting section of its financial statements and follow the guidance set out in IFRS.

The application of qualitative characteristics and accounting standards usually results in financial statements that show a true and fair view, or fairly present a company's financial position and performance.

The Elements of Financial Statements

The Framework outlines definition and recognition criteria fo...

The objective of IAS No. 1 is to prescribe the basis for the presentation of general-purpose financial statements, to ensure comparability both with the company's financial statements of previous periods and with the financial statements of other entities. To achieve this objective, this Standard sets out overall requirements for the presentation of financial statements, guidelines for their structure, and minimum requirements for their content.

Components of Financial Statements

A complete set of financial statements comprises:

• a balance sheet
• an income statement
• a statement of changes in equity showing either:
  • all changes in equity, or
  • changes in equity other than those arising from transactions with equity-holders acting in their capacity as equity-holders

• a cash flow statement
• notes, comprising a summary of significant accounting policies and other explanatory notes

Fundamental Principles Underlying the Preparation of Financial Statements

A company whose financial statements comply with IFRS shall make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with IFRS unless they comply with all the requirements of IFRS.

Underlying principles:

• Fair presentation. Financial statements shall present fairly the financial position, financial performance, and cash flows of a company. In virtually all circumstances, a fair presentation is achieved by compliance with applicable IFRS.

• Going concern. A business is presumed to be a going concern. If management has significant concerns about the company's ability to continue as a going concern, the uncertainties must be disclosed.

• Accrual basis. IAS No. 1 requires that a company prepare its financial statements, except for cash flow information, using the accrual basis of accounting.

• Consistency. The presentation and classification of items in the financial statements shall be retained from one period to the next unless a change is justified either by a change in circumstances or requirements of new IFRS.

• Materiality and Aggregation. Each material class of similar items must be presented separately in the financial statements. Dissimilar items may be aggregated only if they are individually immaterial.

Presentation requirements:

• No offsetting. Assets and liabilities, and income and expenses, may not be offset unless required or permitted by IFRS.

• Classified balance sheet. A business must normally present a classified balance sheet, separating current and non-current assets and liabilities. Only if a presentation based on liquidity provides information that is reliable and more relevant may the current/non-current split be omitted.

• Minimum information on the face of the financial statements. IAS 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. IAS No. 1 specifies disclosures about information to be presented in the financial statements.

• Comparative information. Comparative information shall be disclosed in respect of the previous period for all amounts reported in the financial statements, both on the face of financial statements and in notes.

A significant number of the world's listed companies report under either IFRS or U.S. GAAP. Although these standards are moving toward convergence, there are still significant differences in the framework and individual standards. Frequently, companies provide reconciliations and disclosures regarding the significant differences between reporting bases. These reconciliations can be reviewed to identify significant items that could affect security valuation.

The income statement presents information on the financial results of a company's activities over a period of time. The format of the income statement is not specified by U.S. GAAP and the actual format varies across companies.

Here are common components:

• Sales or revenue: amount charged for the delivery of goods or services.
  • Follows the revenue recognition rule: Revenue is recognized even though cash may not be collected until the following accounting period.
  • Net sales = gross sales - sales returns and allowances - discounts.
  • Amount of sales and trends in net sales over time are used to analyze a company's progress.

• Cost of goods sold is the amount paid for merchandise sold, or the cost to manufacture products that were sold, during an accounting period.

• Gross margin = net sales - costs of goods sold. Also called gross profit.
  Management is interested in both:
  • The amount of gross margin; and
  • The percentage of gross margin (gross margin/net sales).
  Both are useful in planning business operations.

• Operating expenses are expenses other than the cost of goods sold that are incurred in running a business.
  • These expenses are grouped into categories: selling expenses, general and administrative expenses, and other revenues and expenses.
  • Careful planning and control of operating expenses can improve a company's profitability.

• Income from operations (also called operating income) is the difference between gross margin and operating expenses. It represents the income from a company's normal, or main, business. It is used to compare the profitability of companies or divisions within a company.

• Other revenues and expenses are not part of a company's operating activities. These include:
  • Revenues or expenses from investments (e.g., dividends and interest).
  • Interest and other expenses from borrowing.
  • Any other revenue or expense not related to the company's normal business operations.
  They are also called non-operating revenues and expenses.

• Income before income taxes is the amount a company has earned from all activities - operating and non-operating - before taking into account the amount of income taxes the company incurred.
  This is used to compare the profitability of two or more companies or divisions within a company. Comparisons are made before income taxes are deducted because companies may be subject to different income tax rates.

• Income taxes (also called provision for income taxes) represent the expense for federal, state, and local taxes on corporate income.
  The income taxes account is shown as a separate item on the income statement. Tax rates are substantial (usually 15-38%) and have a significant effect on business decisions. Most other types of taxes are shown among operating expenses.

• Net income is what remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and income taxes are deducted. It is the final figure, or "bottom line," of the income statement.
  Net income = Income before income taxes - income taxes
  Net income is an important performance measure.
  • It represents the amount of business earnings that accrue to stockholders.
  • It is the amount transferred to retained earnings from all income generating activities during the year.
  • It is often used to determine whether a business has been operating successfully.

The...

There are two revenue and expense recognition issues when accrual accounting is used to prepare financial statements:

• Timing: when should revenue and expense be recognized?
• Measurement: how much revenue and expense should be recognized?

Revenue is generally recognized when it is (1) realized or realizable, and (2) earned.

The general rule for revenue recognition includes the "concept of realization." Two conditions must be met for revenue recognition to take place:

1. Completion of the earnings process

The company must have provided all or virtually all the goods or services for which it is to be paid, and it must be possible to measure the total expected cost of providing the goods or services. No remaining significant contingent obligation should exist. This condition is not met if the company has the obligation to provide future services (such as warranty protection) but cannot estimate the associated expenses.

2. Assurance of payment

The quantification of cash or assets expected to be received for the goods or services provided must be reliable.

These conditions are typically met at the time of sale, but there are many exceptions, which will be discussed next.

In limited circumstances, specific revenue recognition methods may be applicable.

Long-term Contracts

A long-term contract is one that spans multiple accounting periods. How should a company apportion the revenue earned under a long-term contract to each accounting period?

• If the outcome of a long-term contract can be reliably measured, both IFRS and U.S. GAAP require the use of the percentage-of-completion method.
• If the outcome of a long-term contract can NOT be reliably measured:
  • Under IFRS, revenue is only reported to the extent of contract costs incurred. Costs are expensed in the period incurred.
  • Under U.S. GAAP, no revenue is reported until the contract is finished. This is called the completed contract method.

• If a loss is expected on a contract, the loss is reported immediately, regardless of the method used.

Percentage-of-completion

Revenues and expenses are recognized each period in proportion to the work completed. This is used for a long-term project if all of the following conditions are met:

• There is a contract.
• There are reliable estimates of revenues, costs, and progress towards completion.
• The buyer can be expected to pay the full contract price on schedule.

It recognizes profit corresponding to the percentage of cost incurred to total estimated costs associated with long-term construction contracts. It is the preferred method because it provides a better measure of operating activities and a more informative disclosure of the status of incomplete contracts. It also facilitates the forecast of future performance and cash flows. This method highlights the relationship among the income statement (revenues), the balance sheet (resulting receivables), and the cash flow statement (current collections).

The percentage-of-completion is equal to actual cost/estimated total cost, or it can be determined by an engineering estimate. Using the first approach:

• Percent completed = Costs incurred to date / Most recent estimate of total costs.
• Revenue to be recognized to-date = Percent complete x Estimated total revenue.
• Current period revenue = Revenue to be recognized to date - revenue recognized in prior periods.

To date, the most recent estimate of the total cost is used in computing the progress toward completion. It means that if cost estimates are revised as the project progresses, that effect is recognized in the period in which the change is made. Costs and revenues of prior periods are not restated.

Completed Contract

This method does not recognize revenue and expense until the contract is completed and the title is transferred. All profits are recognized when the contract is completed. The completed contract method is used when:

• There is no contract; or
• Estimates of revenues, costs, or progress towards completion are unreliable; or
• The ability to collect revenues from the buyer is uncertain.

This method is more conservative than the percentage-of-completion method. Analysts may need to rely on the statement of cash flows to assess the contribution of long-term contracts to a company's profitability.

Installment Sales

This method is used if the costs to provide goods or services are known but the collectability of sales proceeds cannot be reasonably determined. It recognizes both revenue and the associated cost of goods sold only when cash is received. Gross profit (sales - costs of goods sold) reflects the proportion of cash received. This method is sometimes used to report income from sales of noncurrent assets and real estate transactions.

Cost Recovery

This method is similar to the installment sales method but is more conservative. It ...

In May 2014, the IASB and FASB each issued a converged standard for revenue recognition. The standards are effective for reporting periods beginning after 1 January 2017 under IFRS and 15 December 2016 under U.S. GAAP.

Key aspects of the converged accounting standards:

The core principle of the new standard is for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration (that is, payment) to which the company expects to be entitled in exchange for those goods or services.

Companies under contract to provide goods or services to a customer will be required to follow a five-step process to recognize revenue:

1. Identify contract(s) with a customer
2. Identify the separate performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the separate performance obligations
5. Recognize revenue when the entity satisfies each performance obligation

There is new guidance on whether revenue should be recognized at a point in time or over time. The standard provides detailed guidance on various issues such as identifying distinct performance obligations, accounting for contract modifications, and accounting for the time value of money. Detailed implementation guidance is included on topics such as sales with a right of return, customer options for additional goods or services, etc. The standard also introduces new guidance on costs of fulfilling and obtaining a contract and specifying the circumstances in which such costs should be capitalized. Costs that do not meet the criteria must be expensed when incurred.

The standard introduces new, increased requirements for disclosure of revenue in a reporter's financial statements.

If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).

The matching principle states that operating performance can be measured only if related revenues and expenses are accounted for during the same period ("let the expense follow the revenues"). Expenses are recognized not when wages are paid, when the work is performed, or when a product is produced, but when the work (service) or the product actually makes its contribution to revenue. Thus, expense recognition is tied to revenue recognition.

Expenses incurred to generate revenues must be matched against those revenues in the time periods when the revenues are recognized.

• If the revenues are recognized in the current period, the associated expenses should be recognized in the current period and appear in the income statement.
• If revenues are expected to be recognized in future periods, the associated expenses are capitalized (appearing on the balance sheet of the current period as an asset). When the revenues are recognized in future periods, the asset is converted to expenses in those periods.

The problem of expense recognition is as complex as that of revenue recognition. For costs that are not directly related to revenues, accountants must develop a "rational and systematic" allocation policy that will approximate the matching principle. However, matching permits certain costs to be deferred and treated as assets on the balance sheet when in fact these costs may not have future benefits. If abused, this principle permits the balance sheet to become a "dumping ground" for unmatched costs.

The Matching of Inventory Costs with Revenues

Please refer to Reading 29 [Inventories] for details.

Some issues in expense recognition:

Doubtful Accounts

Account receivables arise from sales to customers who do not immediately pay cash. There are always some customers who cannot or will not pay their debts. The accounts owed by these customers are called uncollected accounts. Therefore, accounts receivables are valued and reported at net realizable value - the net amount expected to be received in cash, which is not necessarily the amount legally receivable. The chief problem in recording uncollectible accounts receivable is establishing the time at which to record the loss.

Under the direct write-off method, uncollectible accounts are charged to expense in the period that they are determined to be worthless. No entry is made until a specific account has definitely been established as uncollectible. This method is easy and convenient to apply. However, it usually does not match costs with revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet.

Advocates of the allowance method believe that bad debt expense should be recorded in the same period as the sale to obtain a proper matching of expenses and revenues and to achieve a proper carrying value for accounts receivable. In practice, the estimate of bad debt is made either on the percentage-of-sales basis (income statement approach) or outstanding-receivables basis (balance sheet approach).

Warranties

Warranty costs are a classic example of a loss contingency. Although the future cost amount, due date, and customer are not known for certain, a liability is probable and should be recognized if it can be reasonably estimated.

Depreciation and Amortization

Please refer to Reading 30 [Long-Lived Assets] for details.

Financial Analysis Implications

In expense recognition, choice of method (i.e., the depreciation method and the inventory method) as well as estimates (i.e., uncollectible accounts, warranty expenses, assets' useful life, and salvage value) affect a company's reported income. An analyst should identify differences in companies' expense-recognition methods and adjust r...

The goal of analyzing an income statement is to derive an effective indicator to predict future earnings and cash flows. Net income includes the impact of non-recurring items, which are transitory or random in nature. Therefore, net income is not the best indicator of future income. Recurring pre-tax income from continuing operations represents the company's sustainable income and therefore should be the primary focus of analysis.

Segregating the results of recurring operations from those of non-recurring items facilitates the forecasting of future earnings and cash flows. Generally, analysts should exclude items that are non-recurring in nature when predicting a company's future earnings and cash flows. However, this does not mean that every non-recurring item in the income statement should be ignored. Management tends to label many items in the income statement as "non-recurring," especially those that reduce reported income. For the purpose of analysis, an important issue is to assess whether non-recurring items are really "non-recurring," regardless of their accounting labels.

There are four types of non-recurring items in an income statement.

1. Discontinued operations

Discontinued operations are not a component of persistent or recurring net income from continuing operations. To qualify, the assets, results of operations, and investing and financing activities of a business segment must be separable from those of the company. The separation must be possible physically and operationally, and for financial reporting purposes. Any gains or disposal will not contribute to future income and cash flows, and therefore can be reported only after disposal, that is - when realized.

• Subsidiaries and investees also qualify as separate components.
• Disposal of a portion of a business component does not qualify as discontinued operations. Instead, this is recorded as an unusual or infrequent item.

2. Extraordinary items

Extraordinary items are BOTH unusual in nature AND infrequent in occurrence, and material in amount. They must be reported separately (below the line) net of income tax.

Common examples are:

• Expropriations by foreign governments.
• Uninsured losses from earthquakes, eruptions, and tornadoes.

Note that gains and losses from the early retirement of debt used to be treated as extraordinary items; SFAS No. 145 now requires them to be treated as part of continuing operations.

3. Unusual or infrequent items

These are either unusual in nature OR infrequent in occurrence but not both. They may be disclosed separately (as a single-line item) as a component of income from continuing operations. They are reported pre-tax in the income statement and appear "above the line," while the other three categories are reported on an after-tax basis and "below the line" and excluded from net income from continuing operations.

Common examples are:

• Gains or losses from disposal of a portion of a business segment.
• Gains or losses from sales of assets or investments in affiliates or subsidiaries.
• Provisions for environmental remediation.
• Impairment, write-offs, write-downs, and restructuring costs (such as those costs related to the integration of acquired companies).

4. Changes in accounting principles

Changes in accounting principles, such as from LIFO to another inventory method or from the percentage-of-completion method to the completed-contract method, can be either voluntary changes or changes mandated by new accounting standards. They are reported in the same manner as extraordinary items and discontinued operations. The cumulative impact on prior period earnings should be reported as a separate line item on the income statement on...

Earnings per share (EPS) is a measure that is widely used to evaluate the profitability of a company.

A company's capital structure is simple if it consists of only common stock or includes no potential common stock that upon conversion or exercise could dilute earnings per common share. Companies with simple capital structures only need to report basic EPS.

A complex capital structure contains securities that could have a dilutive effect on earnings per common share. Dilutive securities are securities that, upon conversion or exercise, could dilute earnings per share. These securities include options, warrants, convertible bonds, and preferred stocks.

Companies with complex capital structures must report both basic EPS and diluted EPS. Calculation of diluted EPS under a complex capital structure allows investors to see the adverse impact on EPS if all diluted securities are converted into common stock.

Basic EPS

To calculate EPS in a simple capital structure:

The current year's preferred dividends are subtracted from net income because EPS refers to earnings available to the common shareholder. Common stock dividends are not subtracted from net income.

Since the number of common shares outstanding may change over the year, the weighted average is used to compute EPS. The weighted average number of common shares is the number of shares outstanding during the year weighted by the portion of the year they were outstanding. Analysts need to find the equivalent number of whole shares outstanding for the year.

Three steps are used to compute the weighted average number of common shares outstanding:

• Identify the beginning balance of common shares and changes in the common shares during the year.
• For each change in the common shares:
  • Compute the number of shares outstanding after each change in the common shares. Issuance of new shares increases the number of shares outstanding. Repurchase of shares reduces the number of shares outstanding.
  • Weight the shares outstanding by the portion of the year between this change and next change: weight = days outstanding / 365 = months outstanding / 12

• Sum up to compute the weighted average number of common shares outstanding.

Stock Dividends and Splits

In computing the weighted average number of shares, stock dividends and stock splits are only changes in the units of measurement, not changes in the ownership of earnings. A stock dividend or split does not change the shareholders' total investment (i.e., it means more pieces of paper for shareholders).

When a stock dividend or split occurs, computation of the weighted average number of shares requires restatement of the shares outstanding before the stock dividend or split. It is not weighted by the portion of the year after the stock dividend or split occurred.

Specifically, before starting the three steps of computing the weighted average, the following numbers should be restated to reflect the effects of the stock dividend/split:

• The beginning balance of shares outstanding;
• All share issuance or purchase prior to the stock dividend or split.
• No restatement should be made for shares issued or purchased after the date of the stock dividend or split.

If a stock dividend or split occurs after the end of the year but before the financial statements are issued, the weighted average number of shares outstanding for the year (and any other years presented in comparative form) must be restated.

Example

1. 01/01/15 - 100...

Common-Size Analysis of the Income Statement

This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques].

Income Statement Ratios

The following operating profitability ratios measure the rates of profit on sales (profit margins).

• Net Profit Margin shows how much profit is generated on every dollar of sales.
  
  Net income is earnings after tax but before dividends (EBIT - interest - taxes). It should be based on earnings from the company's continuing operation because the analysis is to forecast the company's future performance. Thus analysts should not consider earnings from discontinued operations, gains or losses from the sale of discontinued operations, and non-recurring income or expenses.

• Gross Profit Margin equals percent of sales available after deducting cost of goods sold.
  
  This percentage is available to cover selling, general and administrative costs, and also earn a profit. It indicates the basic cost structure of a company and shows the company's cost-price position. Comparing this ratio with the industry average over time shows the company's relative profitability within the industry.
  • A declining gross profit may indicate increasing costs of production or declining prices.
  • The ratio can be affected by changes in the company's product mix: a change toward items with higher (lower) margin raises (reduces) the gross profit margin.
  • A small change in gross profit can result in a much larger change in profit margin if the company has high fixed costs.

Comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation.

Comprehensive income is the sum of net income and other items that must bypass the income statement because they have not been realized, including items like an unrealized holding gain or loss from available-for-sale securities and foreign currency translation gains or losses. These items are not part of net income, yet are important enough to be included in comprehensive income, giving the user a bigger, more comprehensive picture of the organization as a whole.

The following table is from the Statement of Stockholders' Equity section of the 3M's 2001 annual report.

This section describes the composition of comprehensive income. It begins with net income and then includes those items affecting stockholders' equity that do not flow through the income statement. For 3M, these items include:

• Cumulative translation adjustment.
• Minimum pension liability adjustment.
• Unrealized gains (losses) on available-for-sale investments.
• Unrealized gains (losses) on derivative investments.

FASB has taken the position that income for a period should be all-inclusive comprehensive income. Comprehensive income may be reported on an income statement or separate statement, but is usually reported on a statement of stockholders' equity.

The starting place for analyzing a company is typically the balance sheet. Think of the balance sheet as a photo of the business at a specific point in time. It presents the assets, liabilities, and equity ownership of a company as of a specific date.

• Assets are the economic resources controlled by the company.
• Liabilities are the financial obligations that the company must fulfill in the future. Liabilities are typically fulfilled by payment of cash. They represent the source of financing provided to the company by the creditors.
• Equity ownership is the owner's investments and the total earnings retained from the commencement of the company. Equity represents the source of financing provided to the company by the owners.

The balance sheet provides users, such as creditors and investors, with information regarding the sources of finance available for projects and infrastructure. At the same time, it normally provides information about the future earnings capacity of a company's assets as well as an indication of cash flow implicit in the receivables and inventories.

The balance sheet has many limitations, especially relating to the measurement of assets and liabilities. The lack of timely recognition of liabilities and, sometimes, assets, coupled with historical costs as opposed to fair value accounting for all items on the balance sheet, implies that the financial analyst must make numerous adjustments to determine the economic net worth of the company.

The analyst must understand the components, structure, and format of the balance sheet in order to evaluate the liquidity, solvency, and overall financial position of a company.

Balance Sheet Format

Balance sheet accounts are classified so that similar items are grouped together to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.

The table below indicates the general format of balance sheet presentation:

This format is referred to as the account format, which 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. A report format balance sheet lists assets, liabilities, and equity in a single column.

Balance Sheet Components

Current Assets

These are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. The operating cycle is the average time between the acquisition of materials and supplies and the realization of cash through sales of the product for which the materials and supplies were acquired. The cycle operates from cash through inventory, production, and receivables back to cash. Where there are several operating cycles within one year, the one-year period is used. If the operating cycle is more than one year, the longer period is used.

Long-Term Investments

Often referred to simply as investments, these are to be held for many years and are not acquired with the intention of disposing of them in the near future.

• Investments in securities such as bonds, common stock, or long-term notes that management does not intend to sell within one year.
• Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
• Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund. The cash surrender value of life insurance is included here.
• Investments in non-consolidated subsidiaries or affiliated companies.

...

Asset and liability values reported on a balance sheet may be measured on the basis of fair value or historical cost. Historical cost values may be quite different from economic values. The balance sheet must be evaluated critically in light of accounting policies applied in order to answer the question of how the values relate to economic reality and to each other.

Current Assets

Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section are:

• Cash. Valued at its stated value. Cash restricted for purpose other than payment of current obligations or for use in current operations should be excluded from the current asset section.
• Marketable securities. Valued at cost or lower of cost and market value.
• Accounts receivables. Amounts owed to the company by its customers for goods and services delivered. Valued at the estimated amount collectible.
• Inventories. Products that will be sold in the normal course of business. They should be measured at the lower of cost or net realizable value. Refer to Reading 29 [Inventories] for details.
• Pre-paid expenses. These are expenditures already made for benefits (usually services) to be received within one year or the operating cycle, whichever is longer. Typical examples are pre-paid rent, advertising, taxes, insurance policies, and office or operating supplies. They are reported at the amount of un-expired or unconsumed cost.

Current Liabilities

Current liabilities are typically paid from current assets or by incurring new short-term liabilities. They are not reported in any consistent order. A typical order is: accounts payable, notes payable, accrued items (e.g., accrued warranty costs, compensation and benefits), income taxes payable, current maturities of long-term debt, unearned revenue, etc.

Tangible Assets

These are carried at their historical cost less any accumulated depreciation or accumulated depletion. See Reading 30 [Long-Lived Assets] for details.

Intangible Assets

Intangible assets are long-term assets that have no physical substance but have a value based on rights or privileges that belong to their owner. Generally, identifiable intangible assets are recorded only when purchased (at acquisition costs). The cost of internally developed identifiable intangible assets is typically expensed when incurred. For example, R&D costs are not in themselves intangible assets. They should be treated as revenue expenditures and charged to expense in the period in which they are incurred. One exception is that IFRS allows costs in the development stage to be capitalized if certain criteria (including technological feasibility) are met.

A company should assess whether the useful life of an intangible asset is finite or infinite and, if finite, the length of its life. The straight-line method is typically used for amortization.

Goodwill is an example of an unidentifiable intangible asset which cannot be acquired singly and typically possesses an indefinite benefit period. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill.

Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth.

Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally hig...

Financial instruments are contracts that give rise to both a financial asset of one company and a financial liability of another company. Financial instruments come in a variety of forms which include derivatives, hedges, and marketable securities.

Measured at fair market value:

Financial assets:

• Financial assets held for trading.
• Available-for-sale financial assets.
• Derivatives (whether stand-alone or embedded in non-derivative instruments).
• Non-derivative instruments with fair value exposures hedged by derivatives.

Financial liabilities:

• Derivatives.
• Financial liabilities held for trading.
• Non-derivative instruments with fair value exposures hedged by derivatives.

Measured at cost or amortized cost:

Financial assets:

• Unlisted instruments (there is no reliable valuation measure).
• Held-to-maturity investments (bonds).
• Loans and receivables.

Financial liabilities:

• All other liabilities (such as bonds payable or notes payable).

Accounting for Gains and Losses on Marketable Securities

• Held-to-maturity securities. Debt securities that management intends to hold to their maturity dates. At year-end, they are reported at cost adjusted for the effect of interest (debit the securities account and credit the interest income account) and unrealized holding gains and losses are not recognized.

• Trading securities. Debt and equity securities bought and held mainly for sale in the short term to generate income on price changes. At year-end, they are reported at their fair market value. Any unrealized holding gains or losses are recognized on the company's income statement as part of net income. When they are sold, the realized gains or losses will also appear on the income statement. Realized gains and losses are not affected by any unrealized gains or losses recognized before.

• Available-for-sale securities. Debt and equity securities not classified as held-to-maturity or trading securities. Unrealized gains and losses are reported as part of other comprehensive income (in contrast, the unrealized gains or losses of trading securities are reported in the income statement as part of net income). Other than that, they are accounted for in the same way as trading securities.

Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to severe pulmonary hypertension.

If infant is vigorous and crying immediately after birth, suctioning the mouth and nares is not necessarily recommended in the presence of meconium

If infant is depressed at birth, tracheal intubation and suctioning of meconium from the lower airway should be done.

Equity is a residual value of assets which the owner has claim to after satisfying other claims on the assets (liabilities). There are five potential components that comprise the owner's equity section of the balance sheet:

• Contributed capital. The amount of money which has been invested in the business by the owners. This includes preferred stocks and common stocks. Common stock is recorded at par value with the remaining amount invested contained in additional paid-in capital.

• Minority interest.

• Retained earnings. These are the total earnings of the company since its inception less all dividends paid out.

• Treasury stock. This is a company's own stock that has
  • Already been fully issued and was outstanding;
  • Been reacquired by the company; and
  • Not been retired.
  It decreases stockholder's equity and total shares outstanding.

• Accumulated comprehensive income. This includes items such as the minimum liability recognized for under-funded pension plans, market value changes in non-current investments, and the cumulative effect of foreign exchange rate changes. Refer to Reading 25 [Understanding the Income Statement] for details.

Statement of Changes in Shareholders' Equity

This statement reflects information about increases or decreases to a company's net assets or wealth. It reveals much more about the year's stockholders' equity transactions than the statement of retained earnings.

• The statement of shareholders' equity is a financial statement that summarizes changes that occurred during the accounting period in components of the stockholders' equity section of the balance sheet. For example, it includes capital transactions with owners (e.g., issuing shares) and distributions to owners (i.e., dividends).
• The shareholders' equity section of the balance sheet lists the items in contributed capital and retained earnings on the balance sheet date.

Common-Size Analysis of Balance Sheets

This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques].

Balance Sheet Ratios

Liquidity ratios measure the ability of a company to meet future short-term financial obligations from current assets and, more importantly, cash flows. Each of the following ratios takes a slightly different view of cash or near-cash items.

• Current Ratio is a measure of the number of dollars of current assets available to meet current obligations. It is the best-known liquidity measure. A current ratio of less than 1 indicates the company has negative working capital.
  

• Quick Ratio (Acid-Test Ratio) eliminates less liquid assets, such as inventory and pre-paid expenses, from the current ratio. If inventory is not moving, the quick ratio is a better indicator of cash and near-cash items that will be available to meet current obligations.
  

• Cash Ratio is the most conservative liquidity ratio, determined by eliminating receivables from the quick ratio. As with the elimination of inventory in the quick ratio, there is no guarantee that the receivables will be collected.
  

Solvency ratios measure a company's ability to meet long-term and other obligations.

• Long-Term Debt-Equity Ratio is an indicator of the degree of protection available to the creditors in the event of insolvency of a company. Higher debt-equity ratio indicates higher financial risk.
  

• Debt-Equity Ratio includes short-term debt in the numerator.
  
  The total debt includes all liabilities, including non-interest-bearing debt such as accounts payables, accrued expenses, and deferred taxes. This ratio is especially useful in analyzing a company with substantial financing from short-term borrowing.

• Total Debt Ratio =

• Financial Leverage Ratio =

Financial statement analysis aims to investigate a company's financial condition and operating performance. Using financial ratios helps to examine relationships among individual data items from financial statements. Although ratios by themselves cannot answer questions, they can help analysts ask the right questions in financial statement analysis. As analytical tools, ratios are attractive because they are simple and convenient. However, ratios are only as good as the data upon which they are based and the information with which they are compared.

Fr...

The cash flow statement provides important information about a company's cash receipts and cash payments during an accounting period as well as information about a company's operating, investing and financing activities. Although the income statement provides a measure of a company's success, cash and cash flow are also vital to a company's long-term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the company's liquidity, solvency, and financial flexibility.

Cash receipts and cash payments during a period are classified in the statement of cash flows into three different activities:

Operating Activities

These involve the cash effects of transactions that enter into the determination of net income and changes in the working capital accounts (accounts receivable, inventory, and accounts payable). Cash flows from operating activities (CFOs) reflect the company's ability to generate sufficient cash from its continuing operations. CFOs are derived by converting the income statement from an accrual basis to a cash basis. For most companies, positive operating cash flows are essential for long-run survival.

The major operating cash flows are (1) cash received from customers, (2) cash paid to suppliers and employees, (3) interest and dividends received, (4) interest paid, and (5) income taxes paid.

Special items to note:

• Interest and dividend revenue, and interest expenses, are considered operating activities, but dividends paid are considered financing activities. Note that interest expense is reported on the income statement while dividends flow through the retained earnings statement.
  Remember that an interest/dividend item is an operating activity if it appears on the income statement. For example, payments of dividends do not appear on the income statement, and thus are not classified as operating activities.

• All income taxes are considered operating activities, even if some arise from financing or investing.

• Indirect borrowing using accounts payable is not considered a financing activity - such borrowing would be classified as an operating activity.

Investing Activities

These include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plants, and equipment. In general, these items relate to the long-term asset items on the balance sheet. Investing cash flows reflect how a company plans its expansions.

Examples are:

• Sale or purchase of property, plant and equipment.
• Investments in joint ventures and affiliates and long-term investments in securities.
• Loans to other entities or collection of loans from other entities.

Financing Activities

These involve liability and owner's equity items, and include:

• Obtaining capital from owners and providing them with a return on (and a return of) their investments.
• Borrowing money from creditors and repaying the amounts borrowed.

In general, the items in this section relate to the debt and the equity items on the balance sheet. Financing cash flows reflect how the company plans to finance its expansion and reward its owners.

Examples:

• Dividends paid to stockholders (not interest paid to creditors!). Note that the cash outflow caused by dividends is determined by dividends paid, not dividends declared. Dividends paid are not reflected in the retained earnings account. The amount is provided in the supplementary information.
• Issue or repurchase of the company's stocks.
• Issue or retirement of long-term debt (including the current portion of long-term debt).

Purchase of debt and equity securities fro...

The beginning and ending cash balances on the statement of cash flows tie directly to the Cash and Cash Equivalents accounts listed on the balance sheets at the beginning and end of the accounting period.

Net income differs from net operating cash flows for several reasons.

• One reason is non-cash expenses, such as depreciation and the amortization of intangible assets. These expenses, which require no cash outlays, reduce net income but do not affect net cash flows.
• Another reason is the many timing differences existing between the recognition of revenue and expense and the occurrence of the underlying cash flows.
• Finally, non-operating gains and losses enter into the determination of net income, but the related cash flows are classified as investing or financing activities, not operating activities.

There are two methods of converting the income statement from an accrual basis to a cash basis. Companies can use either the direct or the indirect method for reporting their operating cash flow.

• The direct method discloses operating cash inflows by source (e.g., cash received from customers, cash received from investment income) and operating cash outflows by use (e.g., cash paid to suppliers, cash paid for interest) in the operating activities section of the cash flow statement.
  • It adjusts each item in the income statement to its cash equivalent.
  • It shows operating cash receipts and payments. More cash flow information can be obtained and it is more easily understood by the average reader.

• The indirect method reconciles net income to net cash flow from operating activities by adjusting net income for all non-cash items and the net changes in the operating working capital accounts.
  • It shows why net income and operating cash flows differ.
  • It is used by most companies.

• The direct and indirect methods are alternative formats for reporting net cash flows from operating activities. Both methods produce the same net figure (dollar amount of operating cash flow).

• Under IFRS and U.S. GAAP, both the direct and indirect methods are acceptable for financial reporting purposes. However, the direct method discloses more information about a company. Partly because companies want to limit information disclosed, the indirect method is more commonly used.

• The reporting of investing and financing activities is the same for both direct and indirect methods. Only the reporting of CFO is different.

Direct Method

Under the direct method, the statement of cash flows reports net cash flows from operations as major classes of operating cash receipts and cash disbursements. This method converts each item on the income statement to its cash equivalent. The net cash flows from operations are determined by the difference between cash receipts and cash disbursements.

Assume that Bismark Company has the following balance sheet and income statement information:

Additional information:

• Receivables relate to sales and accounts payable relates to cost of goods sold.
• Depreciation of $5,000 and pre-paid expense both relate to selling and administrative expenses.

Direct Method:

• Cash sales: sales on the accrual basis are $242,000. Since the receivables have decreased by $8,000, the ca

...

Evaluation of the Sources and Uses of Cash

Analysts should assess the sources and uses of cash between the three main categories and investigate what factors drive the change of cash flow within each category. For example, if operating cash flow is growing, does that indicate success as the result of increasing sales or expense reductions? Are working capital investments increasing or decreasing? Is the company dependent on external financing? Answers to questions like these are critical for analysts and can help form a foundation for evaluating the financial health of an industry or company.

Please refer to the textbook for specific examples.

Common-Size Analysis of the Statement of Cash Flows

This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques].

Free Cash Flow to the Firm and Free Cash Flow to Equity

From an analyst's point of view, cash flows from operation activities have two major drawbacks:

• CFO does not include charges for the use of long-lived assets. Recall that depreciation is added back to net income in arriving at CFO.
• CFO does not include cash outlays for replacing old equipment.

Free Cash Flow (FCF) is intended to measure the cash available to a company for discretionary uses after making all required cash outlays. It accounts for capital expenditures and dividend payments, which are essential to the ongoing nature of the business.

The basic definition is cash from operations less the amount of capital expenditures required to maintain the company's present productive capacity.

Free cash flow = CFO - capital expenditure

Free Cash Flow to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital investment, and WC investment.

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv

• NI: Net income available to common shareholders. It is the company's earnings after interest, taxes and preferred dividends.
• NCC: Net non-cash charges. These represent depreciation and other non-cash charges minus non-cash gains. The add-back of net non-cash expenses is usually positive, because depreciation is a major part of total expenses for most companies.
• Int (1 - Tax rate): After-tax interest expense. Add this back to net income because:
  • FCFF is the cash flow available for distribution among all suppliers of capital, including debt-holders, and
  • Interest expense net of the related tax savings was deducted in arriving at net income.
  The add-back is after-tax, because the discount rate in the FCFF model (WACC) is also calculated on an after-tax basis.
• FCInv: Investment in fixed capital. It equals capital expenditures for PP&E minus sales of fixed assets.
• WCInv: Investment in working capital. It equals the increase in short-term operating assets net of operating liabilities.

Example

Quinton is evaluating Proust Company for 2014. Quinton has gathered the following information (in millions):

• Net income: $250
• Interest expense: $50
• Depreciation: $130
• Investment in working capital: $20
• Investment in fixed capital: $100
• Tax rate: 30%
• Net borrowing: $180
• Proust has launched a new product in the market. It has capitalized $200 as an intangible asset out of a product launch expense of $240.
• During the year, Proust has written down restructuring non-cash charges amounting to $30.
• The tax treatment of all non-cash items is the same as that of other items in the books. There are no differed taxes incurred.

Calculate the FCFF for Proust for the year.

Solution

NCC = Depreci...

Financial analysis techniques are useful in summarizing financial reporting data and evaluating the performance and financial position of companies. The results of financial techniques provide important inputs into security valuation.

Ratios

Ratios express one quantity in relation to another. As analytical tools, ratios are attractive because they are simple and convenient. They can provide a profile of a company, its economic characteristics and competitive strategies, and its unique operating, financial, and investment characteristics.

Ratio analysis is essential to comprehensive financial analysis. However, analysts should understand the following aspects when dealing with ratios:

• A ratio is not "the answer." A ratio is an indicator of some aspect of a company's performance in the past. It does not reveal why things are as they are. Also, a single ratio by itself is not likely to be very useful. For example, a current ratio of 2:1 may be viewed as satisfactory. If, however, the industry average is 3:1, such a conclusion may be questionable.
• Differences in accounting policies can distort ratios (e.g., inventory valuation, depreciation methods).
• Not all ratios are necessarily relevant to a particular analysis. Analysts should know the questions for which they want to find answers and know the questions that particular ratios can help answer.
• Ratio analysis does not stop with computation; interpretation of the result is also important.

Limitations: There are a significant number of estimates and subjective information that go into financial statements and therefore it is imperative that the analyst understands the numbers before calculating and relying on ratio analyses based on these numbers. An analyst needs to ask questions like:

• How homogeneous is the company? Are the ratios comparable between divisions within a company? It is critical to derive comparable industry ratios. However, many companies have multiple lines of business, making it difficult to identify the appropriate industry to use in comparing companies. Companies are required to provide segmented information that allows the user to see the impact of various segments on the overall company.

• Are the results of the ratio analysis consistent? An analyst needs to look at several ratios in conjunction in order to form a sensible conclusion. The total portfolio of the company should be used instead of only one set of ratios. A company must be viewed along all these lines since the company may have strengths and/or weaknesses in different areas. For example, a highly profitable company may have very poor short-term liquidity.

• Is the ratio within a reasonable range for the industry? Analysts must look at a range of values for a particular ratio because a ratio can be too high or too low.

• Are alternative companies' accounting treatments comparable? In comparsons companies, even within the same industry, companies may be using different accounting treatments and/or different estimates to capture the same event. Companies can use different estimates to calculate depreciation or bad debt expenses. Companies can use different inventory methods and may have operating versus capital leases in the financial statements. All of these accounting choices and estimates affect financial statements. Alternative treatments can cause a difference in results for the same events, especially when dealing with non-U.S. companies.

Common-size Analysis

Raw numbers hide relevant information that percentages frequently unveil. Common-size statements normalize balance sheet, income statement, and cash flow statement items to allow easier comparison of different-sized companies. They reduce all the dollar am...

The ratios presented in the textbook are neither exclusive nor uniquely "correct." The definition of many ratios is not standardized and may vary from analyst to analyst, textbook to textbook, and annual report to annual report. The analyst's primary focus should be the relationships indicated by the ratios, not the details of their calculations.

Activity Ratios

A company's operating activities require investments in both short-term (inventory and accounts receivable) and long-term (property, plant, and equipment) assets. Activity ratios describe the relationship between the company's level of operations (usually defined as sales) and the assets needed to sustain operating activities. They measure how well a company manages its various assets.

• Receivables turnover measures the liquidity of the receivables - that is, how quickly receivables are collected or turn over. The lower the turnover ratio, the more time it takes for a company to collect on a sale and the longer before a sale becomes cash.
  
  This ratio provides a better level of detail than the current or quick ratio. A company could have a favorable current or quick ratio, but if the receivables turn over very slowly, these ratios would not be a good measure of liquidity. The same applies for the inventory turnover below.
  This ratio also implies an average collection period (the number of days it takes for the company's customers to pay their bills):
  
  Remember, as with all ratios, these ratios are industry specific. The nature of the industry dictates a higher or lower receivables or inventory turnover. For receivables turnover, analysts don't want to derive too much from the norm, since a low number indicates slow-paying customers that cause capital to be tied up in receivables and bad debt and a high number indicates overly stringent credit terms that hurt sales. If a company's credit policy is 30 days and the days of sales outstanding is 45 days, then the credit policy needs to be reviewed.

• Inventory turnover measures how fast the company moves its inventory through the system. The lower the turnover ratio, the longer the time between when the good is produced or purchased and when it is sold.
  
  An abnormally high inventory turnover and a short processing time could mean inadequate inventory, which could lead to outages, backorders, and slow delivery to customers, adversely affecting sales. An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory.
  

• Payable turnover measures the length of time a company has to pay its current liabilities to suppliers. This ratio examines the use of trade credit. The longer the time, the better it is for the company, since it is an interest-free loan and offsets the lack of cash from receivables and inventory turnovers.
  
  The following measures the number of days it tak

...

The breakdown of ROE into component ratios to assess the impact of those ratios is generally referred to as the DuPont Model.

Traditional DuPont equation:

• ROE = net income / common equity
• ROE = (net income / net sales) x (net sales / common equity). Therefore, ROE = (net profit margin) x (equity turnover).
• ROE = (net income / net sales) x (net sales / total assets) x (total assets / common equity)

Each of these components impacts the overall return to shareholders. An increase in profit margin, asset turnover, or leverage can all increase the return. There is a downside as well. If a company loses money in any year, the asset turnover or financial leverage multiplies this loss effect.

This implies that to improve its return on equity, a company should become more:

• Profitable (increase net profit margin, e.g., pricing and expense control).
• Efficient (increase total asset turnover, e.g., efficiency of asset use).
• Leveraged (increase its financial leverage ratio).

A company's over- or underperformance on ROA is due to one or both of these causes, or "drivers."

The extended DuPont model takes the above three factors and incorporates the effect of taxes and interest based on the level of financial leverage. It takes the profit margin and backs up to see the effect of interest and taxes on the overall return to shareholders. Therefore the extended model starts with EBIT (Earnings Before Interest and Taxes) rather than net income.

• EAT = EBT (1 - t), where t is the company's average tax rate. Substituting EBT(1 - t) for EAT in the expanded ROE equation gives us ROE = (EBT / sales)(sales / assets)(assets / equity)(1 - t).
• EBT = EBIT - I, where I equals the company's total interest expense. Substituting (EBIT - I) into the ROE equation for EBT gives us ROE = [(EBIT / sales)(sales / assets) - (interest expense / assets)] (assets / equity) (1 - t).
• Restated in accounting terms:
  ROE = [(operating profit margin) x (total asset turnover) - (interest expense rate)] x (financial leverage multiplier) x (tax retention rate)

High financial leverage does not always increase ROE; higher financial leverage will lead to a higher interest expense rate, which may offset the benefits of higher leverage.

This breakdown will help an analyst understand what happened to a company's ROE and why it happened.

Equity Analysis

Analysts need to evaluate a company's performance in order to value a security. One of their valuation methods is the use of valuation ratios.

Some common valuations ratios are:

• P/E: Price per share / Earnings per share.
  P/E is widely recognized and used by investors. Earning power is a chief driver of investment value, and EPS is perhaps the chief focus of security analysts' attention.

• P/CF: Price per share / Cash flow per share.
  Cash flow is less subject to manipulation by management than earnings. Thus, P/CF ratios can be used to compare companies with different degrees of accounting aggressiveness. Moreover, cash flow is generally more stable than earnings, so P/CF ratios are more stable than P/Es. When EPS is abnormally high, low, or volatile, P/CF ratios are more reliable than P/Es.

• P/S: Price per share / Sales per share.
  • Sales growth is the driving force for the growth of earnings and cash flows.
  • Sales are positive even when EPS is negative.
  • Sales are generally less subject to distortion or manipulation than are other fundamentals.

• P/BV: Price per share / Book value per share.
  Similarly, book value is generally positive even when EPS is negative. Since book value per share is more stable than EPS, P/B may be more meaningful than P/E when EPS is abnormally high or low, or is highly variable.

These price multiples and dividend-related quantities are discussed in more detail in Study Session 14 (Equity Analysis and Valuation).

Credit Analysis

Credit analysis is the evaluation of credit risk.

How does an analyst who has calculated a ratio know whether it represents good, bad, or indifferent credit quality? Somehow, the analyst must relate the ratio to the likelihood that a borrower will satisfy all scheduled interest and principal payments in full and on time. In practice, this is accomplished by testing financial ratios as predictors of the borrower's propensity not to pay (to default). For example, a company with high financial leverage is statistically more likely to default than one with low leverage, all other factors being equal. Similarly, high fixed-charge coverage implies less default risk than low coverage. After identifying the factors that create high default risk, the analyst can use ratios to rank all borrowers on a relative scale of propensity to default.

Many credit analysts conduct their ratio analyses within ranking frameworks established by their employers. In the securities field, bond ratings provide a structure for analysis. Credit rating agencies such as Moody's and Standard & Poor's use financial ratios when assigning a credit rating to a company's debt issues. For example, credit ratios used by Standard & Poor's include EBIT interest coverage, funds from operations to total debt, total debt to EBITDA, and total debt to total debt plus equity.

Much research has been performed on the ability of ratios to assess the credit risk of a company (including the risk of bankruptcy) and predict bond ratings and bond yields.

Segment Analysis

A company may be involved in many different businesses, may do business in many different geographic areas, or may have significant number of customers. It is difficult to analyze a company with multiple business lines because of the inherent differences in financial structures, risk characteristics, etc,. amount the different lines. Aggregation of financial results for all the lines tends to obscure the true picture.

A company must disclose information related to various subdivisions of its business.

• Under IAS 14 (Segment Reporting), disclosures are required for reportable segments.
• U.S. GAAP requirements are similar to IFRS but less det

...

The results of financial analysis provide valuable inputs into forecasts of future earnings and cash flow. An analyst can build a model to forecast future performance of a company. Techniques that can be used include:

• Sensitivity Analysis. This is the study of how the variation in the output of a model can be apportioned to different sources of variation. (e.g., what will be the net income if more debt is issued?)

• Scenario Analysis. This considers both the sensitivity of financial outcome to changes in key financial variables and the likely range of variable values. The least "reasonable" set of circumstances (low unit sales, high construction costs, etc.) and the most "reasonable" set are specified first. The financial outcomes under the bad and good conditions are then calculated and compared to the expected, or base-case, outcome. Even though there are an infinite number of possibilities, scenario analysis only considers a few discrete outcomes.

• Monte Carlo Simulation. This is a risk analysis technique in which a computer is used to simulate probable future events and thus estimate the profitability and risk of a project. Random values of input variables are generated on a computer. The mean of the target variable is computed to measure the expected value. Standard deviation (or coefficient of variation) is computed to measure risks.

There are two basic issues involved in inventory accounting:

1. Determine the cost of goods available for sale: Beginning Inventory + Purchases.

2. Allocate the cost of total inventory costs (cost of goods available for sale) between two components: COGS on the income statement and the ending inventory on the balance sheet. Note that COGS = (Beginning Inventory + Purchases) - Ending Inventory. The cost flow assumption to be adopted includes specific identification, average cost, FIFO, LIFO, etc. This issue will be discussed in subsequent subjects.

Determination of Inventory Cost

IFRS and SFAS No. 151 provide similar treatment of the determination of inventory costs.

The cost of inventories, capitalized inventory costs, includes all costs incurred in bringing the inventories to their present location and condition.

• It includes production costs, invoice price (net of discount), transportation costs, taxes, part of fixed production overhead, etc.
• It does not include all abnormal costs incurred due to waste of materials, abnormal waste incurred for labor and overhead conversion costs from the production process, any storage costs, or any administrative overhead and selling costs. These costs are typically expensed in the accounting period instead of being considered inventory costs.

In some cases, it's possible to specifically identify which inventory items have been sold and which remain. Using the specific identification method, the actual costs of the specific units sold are transferred from inventory to the cost of goods sold. (Debit Cost of Goods Sold; Credit Inventory.) This method achieves the proper matching of sales revenue and cost of goods sold when the individual units in the inventory are unique. However, the method becomes cumbersome and may produce misleading results if the inventory consists of homogeneous items. In most cases, companies may be unable to determine exactly which items are sold and which items remain in ending inventory.

The remaining three methods are referred to as cost flow assumptions under GAAP and cost formulas under IFRS. They should be applied only to an inventory of homogeneous items. The cost flow assumption may or may not reflect the physical flow of inventory.

Weighted Average Cost

Using the weighted average cost method, the average cost of all units in the inventory is computed and used in recording the cost of goods sold. This is the only method in which all units are assigned the same (average) per-unit cost.

• Average cost = (beginning inventory + purchases) / units available for sale
• Ending inventory = average cost x units of ending inventory
• COGS = cost of goods available for sale - ending inventory

FIFO

FIFO is the assumption that the first units purchased are the first units sold. Thus inventory is assumed to consist of the most recently purchased units. FIFO assigns current costs to inventory but older (and often lower) costs to the cost of goods sold.

LIFO

LIFO is the assumption that the most recently acquired goods are sold first. This method matches sales revenue with relatively current costs. In a period of inflation, LIFO usually results in lower reported profits and lower income taxes than the other methods. However, the oldest purchase costs are assigned to inventory, which may result in inventory becoming grossly understated in terms of current replacement costs.

LIFO is not allowed under IFRS. In the U.S., however, LIFO is used by approximately 36 percent of U.S. companies because of potential income tax savings.

Comparison of Inventory Accounting Methods

Inventory data is useful if it reflects the current cost of replacing the inventory. COGS data is useful if it reflects the current cost of replacing the inventory items to continue operations.

During periods of stable prices, all three methods will generate the same results for inventory, COGS, and earnings.

During periods of rising prices and stable or growing inventories, FIFO measures assets better (the most useful inventory data) but LIFO measures income better.

• Under LIFO, the cost of ending inventory is based on the earliest purchase prices, and thus is well below current replacement cost. For many firms using LIFO, the cost of inventory may be decades old and almost useless for analysis purposes. However, the cost of goods sold is based on the most recent purchase prices, and thus closely reflects current replacement costs. As a result, LIFO provides a better measurement of current income and future profitability.

• Under FIFO, the cost of ending inventory is based on the most recent purchase prices, and thus closely reflects current replacement cost. However, costs of goods sold are based on the earliest purchase prices, and this is well below the current replacement costs. The gain is actually holding gain or inventory profit. It is debatable whether this should be considered income; at least, analysts can say the underestimated COGS leads to inflated net income.

In an environment of declining inventory unit costs and constant or increasing inventory quantitie...

The perpetual inventory system updates inventory accounts after each purchase or sale. Inventory quantities are updated continuously. When there is a sale, inventory is reduced and COGS is calculated.

The periodic inventory system records inventory purchase or sale in the "Purchases" account. The "Inventory" account is updated on a periodic basis, at the end of each accounting period (e.g., monthly, quarterly). Cost of goods sold or cost of sale is computed from the ending inventory figure.

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each sale (perpetual) or whether you wait until the year is over (periodic).

With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the Inventory account and debited to the Cost of Goods Sold account. Since this is the perpetual system, we cannot wait until the end of the year to determine the last cost. An entry must be recorded at the time of the sale in order to reduce the Inventory account and increase the Cost of Goods Sold account.

If costs continue to rise throughout the entire year, perpetual LIFO will yield a lower cost of goods sold and a higher net income than periodic LIFO. Generally this means that periodic LIFO will result in lower income taxes than perpetual LIFO.

Example

Date....................................Units....Price
12.31.2008........Beginning Inventory....1.......85
1.1.2009..........Purchase...............1.......87
2.1.2009..........Purchase...............2.......89
6.1.2009..........Sales..................1.......89
12.1.2009.........Purchase...............1.......90

Under perpetual LIFO the following entry must be made at the time of the sale: $89 will be credited to Inventory and $89 will be debited from Cost of Goods Sold. If that was the only item sold during the year, at the end of the year the Cost of Goods Sold account will have a balance of $89 and the cost in the Inventory account will be $351 ($85 + $87 + $89 + $90).

Under periodic LIFO we assign the last cost of $90 to the one item that was sold. (If two items were sold, $90 would be assigned to the first item and $89 to the second item.) The remaining $350 is assigned to inventory. The $350 of inventory cost consists of $85 + $87 + $89 + $89. The $90 assigned to the item that was sold is permanently gone from inventory.

In the U.S., firms that use LIFO must report a LIFO reserve. The LIFO reserve is the difference between the inventory balance shown on the balance sheet and the amount that would have been reported had the firm used FIFO. That is:

Inventory_FIFO = Inventory_LIFO + LIFO Reserve

It represents the cumulative effect over time of ending inventory under LIFO vs. FIFO.

When adjusting COGS from LIFO to FIFO: COGS_FIFO = COGS_LIFO - Change in LIFO Reserve.

LIFO Liquidations

So far, discussions have been based on the assumptions of rising prices and stable or growing inventory quantity. As a result, the LIFO reserve increases over time. However, LIFO reserves can decline for either of the two reasons listed below. In either case, the COGS will be smaller and the reported income will be higher relative to what they would have been if the LIFO reserve had not declined. However, the implications of a decline in the LIFO reserve on financial analysis vary, depending on the reason for the decline.

• Liquidation of inventories. When a firm reduces its inventory, the old assets flow into income. The COGS figure no longer reflects the current cost of inventory sold. This is called LIFO liquidation. Gross profit margin will be abnormally high and unsustainable ("phantom" gross profits). To defer taxes indefinitely, purchases must always be greater than or equal to sales. A LIFO liquidation may signal that a company is entering an extended period of decline (and needs the "profit" to show as income). Analysts should exclude this profit from recurring earnings, as it is not operating in nature; the reported COGS should be restated by adding back the decline in the LIFO reserve to remove the artificial boost to net income.

• Price declines. The lower-cost current purchases enter reported LIFO COGS when purchase prices fall, reducing the cost differences between LIFO and FIFO ending inventories. As a result, the LIFO reserve declines. Such a decline is not considered a LIFO liquidation. Amounts on the balance sheet are still outdated but those on the income statement are still current. However, the tax benefits are lost under LIFO. For analytical purposes, no adjustment is required for declining prices, since price decreases are a normal business situation.

Under IFRS, inventories are reported at the lower of cost or net realizable value (NRV).

• If inventory declines in value below its original cost for whatever reason (obsolescence, price-level changes, damaged goods, etc.), the inventory should be written down to reflect this. If the NRV is lower than the cost, the ending inventory is written down to the NRV. The loss then is charged against revenues as an expense in the period in which the loss occurs, not in the period in which it is sold. However, if the NRV is higher than the cost, nothing is done. The increases in the value of the inventory are recognized only at the point of sale.
• A reversal (up to the amount of original write-down) is required if the inventory value goes up later.
• The amount of any reversal is recognized as a reduction in the cost of sales.
• This rule can be applied either directly to each inventory item, to each category, or to the total of the inventory. The most common practice is to price inventory on an item-by-item basis.

IFRS does not apply to the measurement of inventories held by producers of agricultural and forest products, mineral products, or commodity brokers and dealers. Their inventories are measured at net realizable value (above or below cost) in accordance with well-established practices in those industries.

Similarly, GAAP requires the use of the lower-of-cost-or-market valuation basis (LCM) for inventories, with market value defined as replacement cost. Reversal is prohibited, however. The LCM valuation basis follows the principle of conservatism (on both the balance sheet and income statement) since it recognizes losses or declines in market value as they occur, whereas increases are reported only when inventory is sold.

Here are some relevant terms:

• Net realizable value: Estimated selling price less estimated costs of completion necessary to make the sale.
• Historical cost: The cash equivalent price of goods or services at the date of acquisition.
• Market value (Replacement cost): The cost that would be required to replace an existing asset.
• Fair value: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Example

Historical cost: $5,000
Market cost: $2,000
Estimated selling price: $4,000
Estimated costs to complete sale: $1,000
Net realizable value: $4,000 - $1,000 = $3,000

• Inventory Valuation under IFRS: $3,000 (the lower of historical cost and NRV).
• Inventory Valuation under U.S. GAAP: $2,000 (the lower of historical cost and market cost).

Now assume NRV increases from $3,000 to $4,000 and the market cost increases from $2,000 to $3,000.

• Under IFRS, $1,000 of original write-down may be recovered to bring NRV up from $3,000 to $4,000. Note that reversals are limited to the amount of the original write-down ($2,000).
• Under U.S. GAAP, the value of inventory is $2,000 even though the new market value is $3,000. No adjustment is made and reversal is prohibited.

Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evaluation of a company's inventory management.

Presentation and Disclosure

Consistency of inventory accounting policy is required under both U.S. GAAP and IFRS. If a company changes an inventory accounting policy, the change must be justifiable and all financial statements accounted for retrospectively. The one exception is for a change to the LIFO method under U.S. GAAP; the change is accounted for prospectively and there is no retrospective adjustment to the financial statements.

Inventory Ratios

Inventory turnover measures how fast a company moves its inventory through the system.

This ratio can be used to measure how well a firm manages its inventories. The lower the ratio, the longer the time between when the good is produced or purchased and when it is sold.

• An abnormally high inventory turnover and a short processing time could mean either effective inventory management or inadequate inventory, which could lead to outages, backorders, and slow delivery to customers (which would adversely affect sales). Revenue growth should be compared with that of the industry to assess which explanation is more likely.
• An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory. Again, the analyst should compare the firm's revenue growth with that of the industry to assess the situation.

Financial Analysis: FIFO versus LIFO

The advantages of LIFO are:

• Matching. Current costs are matched against revenues and inventory profits are thereby reduced.
• Tax benefits. These are the major reason why LIFO has become popular. As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs. "Whatever is good for tax is good for financial reporting."
• Improved cash flow. This is related to tax benefits, because taxes must be paid in cash.
• Future earnings hedge. With LIFO, a company's future reported earnings will not be affected substantially by future price declines. Since the most recent inventory is sold first, there isn't much ending inventory sitting around at high prices, vulnerable to a price decline.

The disadvantages of LIFO:

• Reduced earnings. Many managers would just rather have higher reported profits than lower taxes. However, non-LIFO earnings are now highly suspect and may be severely penalized by Wall Street.
• Inventory understated. LIFO may have a distorting effect on a company's balance sheet. It makes the working capital position of the company appear worse than it really is.
• Physical flow. LIFO does not approximate the physical flow of the inventory items except in particular situations.
• Current cost income not measured. LIFO falls short of measuring current cost (replacement cost) income, though not as far as FIFO. Using replacement cost is referred to as the next-in, first-out method; it is not acceptable for purposes of inventory valuation.
• Inventory liquidation. If the base or layers of old costs are elim

...

The costs of acquiring resources that provide services over more than one operating cycle should be capitalized and carried as assets on the balance sheet. All costs incurred until an asset is ready for use must be capitalized, including the invoice price, applicable sales tax, freight and insurance costs incurred delivering equipment, and any installation costs. Costs of the long-lived asset should be allocated over current and future periods. In contrast, if these assets are expensed, their entire costs are written off as expense on the income statement in the current period.

Accounting rules on capitalization are not straightforward. As a result, management has considerable discretion in making decisions such as whether to capitalize or expense the cost of an asset, whether to include interest costs incurred during construction in the capitalized cost, and what types of costs to capitalize for intangible assets. The choice of capitalization or expensing affects the balance sheet, income and cash flow statements, and ratios both in the year the choice is made and over the life of the asset.

Here is a summary of the different effects of capitalization versus expensing:

• Income variability. Firms that capitalize costs and depreciate them over time show "smoother" patterns of reported income. Firms that expense those costs as incurred tend to have higher variability of net income.

• Profitability. In the early years expensing lowers profitability because the entire cost of the asset is expensed. In later years expensing results in higher net income because no more expense is charged in those years. This results in higher ROA and ROE because these expensing firms report lower assets and equity.

• CFO. The net cash flow remains the same, but the compositions of cash flows differ. Cash expenditures for capitalized assets are included in investing cash flows and are never classified as CFO. In contrast, cash expenditures for expensed outlays are included in CFOand are never classified as investing cash flows. Capitalization results in higher CFO but lower investing cash flows, and the cumulative difference increases over time.

• Leverage ratios. Capitalization firms have better (lower) debt-to-equity and debt-to-assets ratios, since they report higher assets and equities.

Under SFAS 34, interest is capitalized for certain assets and only if the firm is leveraged. Therefore, the carrying amount of a self-constructed asset depends on the firm's financial decisions. The capitalized interest cost is added to the value of the asset being constructed.

The amount of interest cost to be capitalized has two components:

• Any interest on borrowed funds made specifically to finance the construction of the asset. The interest rate applicable is the interest rate on each borrowing.
• The interest on other debt of the firm, up to the amount invested in the construction project. The interest rate applicable is the weighted-average interest rate on all outstanding debt not specifically borrowed for the asset under construction.

Therefore, the total interest cost incurred during the accounting period has two parts:

• Capitalized interest cost, which is reported as part of the asset on the balance sheet. Payments for capitalized interest cost are classified as an investing cash outflow and never as CFO.
• Other interest cost, which is charged to expense on the income statement. Payments for such non-capitalized interest cost are reported as CFO.

The total interest cost, along with the amount capitalized, must be disclosed as part of the notes to the financial statements.

Once the construction is complete, capitalized interest costs will be written off as part of depreciation over the useful life of the asset. From ...

Intangible assets are identifiable nonmonetary resources controlled by firms. Examples include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, property rights, and organization costs.

Accounting for the Acquisition of Long-Lived Intangible Assets

Accounting for an intangible asset depends on how it is acquired.

1. Intangible Assets Purchased in Situations Other than Business Combinations

These are accounted for at acquisition costs. "Cost" includes purchase price, legal fees, and other expenses that make the intangibles ready for use. For example, fees paid to obtain a license or franchise are capitalized. Another example: expenditures on patents and copyrights purchased from another party are capitalized. They are amortized over their remaining legal lives or 40 years, whichever is less. The straight-line method is typically used for amortization.

2. Intangible Assets Developed Internally

For internally generated intangible assets, it is difficult to measure costs, benefits, and economic lives. Generally, internally generated assets (such as costs of R&D, patents and copyrights, brands and trademarks, and advertising and secret processes) must be expensed in the period incurred.

One exception is research and development (R&D) expenditures which add risk to investment with uncertain future economic benefits. As a result, they must be expensed as incurred in most countries (including the U.S.). SFAS 86 requires that all R&D costs to establish the technological and/or economic feasibility of software must be expensed. Subsequent costs that are beyond the point of technological feasibility can - but don't have to - be capitalized as part of product inventory and amortized based on revenues or on a straight-line basis. The point of technological feasibility is the point when a software prototype has been proven to be technologically feasible, as evidenced by the existence of a working model of the software.

IFRS also requires research costs be expensed but allows development costs to be capitalized under certain conditions.

As you can see, managers have considerable discretion in making decisions, such as whether or when to capitalize these costs and by how much. For software development costs, one particular risk is that capitalized costs will not be realized and a future write-down may be needed.

If companies apply different approaches to capitalizing software development costs, adjustments can be made to make the two comparable.

3. Intangible Assets Acquired in a Business Combination

Business combinations are accomplished when one entity (investor) acquires "control" over the net assets of another entity. The transaction is accounted for using the purchase method of accounting, in which the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value.

Any excess of cost over fair value of net assets acquired is recorded as goodwill.

U.S. GAAP requires that in-process R&D (IPRD) of the target company should be expensed at the date of acquisition, which results in a large one-time charge. IFRS requires identifying IFRD as a separate asset with a finite life or including it as part of goodwill.

Amortizing Intangible Assets with Finite Useful Lives

An intangible asset with a finite useful life is amortized over its useful life. The estimates required for amortization calculations are: original valuation amount, residual value at the end of useful life, and the length of useful life.

Example

Torch, Inc. has developed a new device. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. The device has a useful life of 5 years. The legal life is 17 y...

For accountants, depreciation is an allocation process, not a valuation process. It is important for analysts to differentiate between accounting depreciation and economic depreciation. Two factors affect the computation of depreciation: depreciable cost (acquisition cost - salvage or residual value) and estimated useful life (depreciable life). Note that it is depreciable cost, not acquisition cost, that is allocated over the useful life of an asset.

The different depreciation methods are:

• Straight Line Depreciation (SLD)
  This is the dominant method in the U.S. and most countries worldwide. It is based on the assumption that depreciation depends solely on the passage of time. The amount of depreciation expense is computed as:
  
  If income is constant, SLD will cause the asset base to decline, causing ROA to increase over time. For assets whose benefit may decline over time, the matching principle supports using an accelerated depreciation method.

• Accelerated Depreciation Methods
  Accelerated depreciation methods are consistent with the matching principle because benefits from most depreciable assets are higher in the earlier years as the assets wear out. Therefore, more depreciation should be allocated to earlier years than to later years.
  Under the sum-of-the-years' digits (SYD) method, depreciation expense is based on a decreasing fraction of depreciable cost. The numerator decreases year by year but the denominator remains constant. As a result, this method applies higher depreciation expense in the early years and lower depreciation expense in later years.
  
  Where sum of years = (1 + 2 + 3 + ... + n) = n x (n + 1)/2, and years remaining = n - t + 1 (n: the estimated useful life. t: the index for current year).
  Double decline balance (DDB):
  
  Note that cost minus accumulated depreciation is the book value at the beginning of the year and that salvage value is not shown in the formula. For each year, however, depreciation is limited to the amount necessary to reduce book value to salvage value.
  With SYD and DDB methods, book value, net income, tax expense, and equity will be lower than with SLD in the earlier years of an asset's life. The percentage effect on net income is usually greater than the effects on assets and shareholders' equity. Consequently:
  • Profit margin is lower as net income is lower.
  • Asset turnover ratio is higher as assets are lower.
  • Debt-to-equity ratio is higher as equity is lower.
  • Return on assets ratio is lower; both net income and total assets are lower, but net income is lower by a larger percentage.
  • Return on equity ratio is lower; both net income and equity are lower, but net income is lower by a larger percentage.
  In later years the situation will reverse and income and book values will increase. This is true for individual assets. For a firm with stable or rising capital expenditures, however, the early-year impact of newly-acquired assets dominates. Therefore, an accelerated depreciation method will continuously result in lower reported earnings and tax expenses for these firms.

• Units of Production (UOP) and Service Hours Method
  This method assumes that d

...

Under U.S. accounting standards, it is compulsory to account for impairment in long-lived assets (downward revaluation). However, upward revaluation of long-lived assets to reflect fair market values is not allowed.

The balance sheet is more informative when assets and liabilities are stated at market value rather than historical cost. IASB and some other non-U.S. GAAP do permit upward revaluations. The purpose of a revaluation is to bring into the books the fair market value of long-lived assets.

• If an asset revaluation initially decreases the asset's carrying value, the decrease is recognized as a loss. Later, if there is an increase in the carrying value, the increase is recognized as a profit (up to the amount of the original decrease).
• If an asset revaluation initially increases its carrying value, the increase bypasses the income statement and goes to equity (revaluation surplus). Later, if there is a decrease, it first decreases the revaluation surplus, then goes to income.

Financial Statement Analysis Considerations

• The leverage motivation. An upward revaluation may improve a firm's leverage.
• Income manipulation. Revaluations are subjective in nature. For example, a downward revaluation will reduce ROE in the current period but make the firm more profitable in future years, since total assets and shareholders' equity will be lower.
• Revaluation has no impact on cash flows.
• What is the true value of the firm's long-lived assets? Why is the revaluation necessary? Who does the appraisal? How often is it done?

Sometimes a long-term asset may lose some of its revenue-generating ability prior to the end of its useful life. (e.g., a significant decrease in the market value, physical change, or use of the assets). If the carrying amount of the asset is determined not to be recoverable, an asset impairment occurs and the carrying value should be written down. The amount of the write-down is recorded as a loss.

GAAP and IFRS differ as to the methodology used to determine impairment.

The GAAP methodology of determining impairment uses a two-step recoverability test. Occurrence of an impairment differs from recognition of an impairment. An impairment, whether recognized in financial reports or not, occurs as long as an asset's carrying value cannot be fully recovered in the future. However, only impairments that meet certain conditions are recognized in financial reports. SFAS 121 provides a two-step process:

• Recoverability test. Impairment must be recognized when the carrying value of the assets exceeds the undiscounted future cash flows from their use and disposal.

• Loss measurement. The excess of the carrying amount over the fair value of the assets. If the fair value is not available, the present value of future cash flows discounted at the firm's incremental borrowing rate should be used. That is:
  Impairment Loss = Book Value - Either Fair Value or Present Value of Future Cash Flows

Conversely, IFRS methodology uses a one-step approach. This approach requires that impairment loss be calculated if "impairment indicators" exist. This approach does not rely on net undiscounted future cash flows and subsequent comparison to asset carrying value as required in GAAP methodology. In addition, the impairment loss is calculated as the amount by which the carrying amount of the asset exceeds it recoverable amount. The recoverable amount is the higher of the following: 1) fair value less cost to sell, or 2) value in use (i.e., the present value of future cash flows including disposal value).

Impairment of Intangible Assets

• Similar accounting treatment if the intangible asset has a finite life.
• Tested annually for impairment for an intangible asset with an indefinite life.

Among the most interesting intangible assets is goodwill. Goodwill is the present value of future earnings in excess of a normal return on net identifiable assets. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill.

Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth.

Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally high earnings. Analysts need to be aware of the possibility that the goodwill recognized by accountants may, in fact, represent overpayment for the acquired company. Since goodwill is inferred rather than computed directly, it will increase as the payment price increases. It is only after the passage of time that analysts will be able to evaluate the extent to which the purchase price was justified.

Under U.S. GAAP SFAS 142, goodwill is not amortized, but is tested annually for impairment. Goodwill impairment for each reporting unit should be tested in a two-step process at least once a year.

1. The fair value of a reporting unit is compared to its ...

For accounting purposes, an asset may be disposed of in three different ways. It may be:

• sold for cash
• exchanged for another asset
• abandoned

When plant assets are disposed of, depreciation should be recorded on the date of disposal. The cost is then removed from the asset account and the total recorded depreciation is removed from the accumulated depreciation account. Normally an asset's market value at the time of sale or disposal will most likely be different than the asset's book value (its original historical cost minus all accumulated depreciation on that asset). The sale of a plant asset at a price above or below book value results in a gain or loss to be reported in the income statement.

Because different depreciation methods are used for income tax purposes, the gain or loss reported on income tax returns may differ from that shown in the income statement. It is the gain or loss shown in the financial statement that is recorded in the company's general ledger accounts.

To illustrate each of these methods consider this. A machine was purchased on 1 January Year 1 for $1,000. The depreciation method was straight-line with a useful-life of 5 years and an estimated residual value of $200. On 31 July Year 3 the firm decides to dispose of the asset. The firm has a December year-end.

The first step irrespective of the method of disposal is to calculate the depreciation up to the date of sale:

Depreciation per year = (Cost - residual value) / Useful life = (1,000 - 200) / 5 = $160
Depreciation for year 1 = $160
Depreciation for year 2 = $160
Depreciation for year 3 = $93 (160 x 7/12)
Total: $413

Remember that the depreciation for year 3 is only for 7 months, as the asset is disposed of on 31 July Year 3.

Sale of Long-Lived Assets

The gain or loss on the sale of long-lived assets is computed as the sales proceeds minus the carrying value of the asset at the time of sale. Assume that the machinery is sold for cash in three scenarios:

a. Sold for $587 cash (Sale of machinery for carrying value)
Debit: Cash (B/S) $587
Debit: Accumulated depreciation (B/S) $413
Credit: Machinery (B/S) $1000

b. Sold for $600 cash (Sale of machinery for above carrying value)
Debit: Cash (B/S) $600
Debit: Accumulated depreciation (B/S) $413
Credit: Machinery (B/S) $1000
Credit: Profit on sale of machinery (I/S) $13

c. Sold for $500 cash (Sale of machinery for below carrying value)
Debit: Cash (B/S) $500
Debit: Accumulated depreciation (B/S) $413
Debit: Loss on sale of machinery (I/S) $87
Credit: Machinery (B/S) $1000

In summary, when disposing of an asset, entries are prepared to:

• eliminate the cost of the asset from the books.
• eliminate the accumulated depreciation from the books.
• record the proceeds on the sale. This is reported as cash from investing activities on the statement of cash flows.
• record the profit or loss on the sale (if applicable). This amount is excluded from net income when the indirect method is used to calculate cash flows from operating activities.

Exchange of Long-Lived Assets

If an asset is exchanged for another asset, the basic accounting is similar to the accounting for sales of plant assets for cash. If the trade-in allowance received is greater than the carrying value of the asset surrendered, there has been a gain. If the allowance is less, there has been a loss.

Level II will cover some special rules for recognizing these gains and losses, depending on the nature of the assets exchanged:

Abandoned

If an a...

Property, Plant, and Equipment (PP&E)

IAS 16 provides a long list of disclosure requirements for PP&E. For each class of PP&E, the financial statements must disclose the following:

• the measurement bases used for determining the gross carrying amount.
• the depreciation methods and rates or useful lives.
• the gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period.
• the detailed reconciliation of the carrying amount at the beginning and end of the period (showing, for example, additions, depreciation, impairment losses, revaluation information, foreign currency translation impacts, and so on).

U.S. GAAP require a company to disclose the depreciation expense for the period, the balances of assets, accumulated depreciation and a general description of the depreciation method(s) used.

Intangible Assets

IAS 38 provides a considerable set of disclosure requirements for intangible assets. For each class of intangibles, and distinguishing between internally generated and other assets, the financial statements must disclose:

• whether the useful lives are indefinite or finite and, if finite, the length of the useful lives or the amortization rates used.
• the amortization methods used for intangible assets with finite useful lives.
• the gross carrying amount and any accumulated amortization (aggregated with accumulated impairment losses) at the beginning and end of the period.
• the line item(s) of the statement of comprehensive income in which any amortization of intangible assets is included.
• detailed reconciliation of the carrying amount at the beginning and end of the period (showing, for example, additions, amortization, impairment losses, revaluation information, foreign currency translation impacts, and so on).

Under U.S. GAAP, a company is required to disclose the gross carrying amounts and accumulated amortization, the aggregated amortization expense for the period, and the estimated amortization expense for the next 5 years.

Impairment of Assets

As with most other standards, IAS 36 provides a long list of disclosure requirements. To begin with, for each class of assets, the financial statements must disclose:

• the amount of impairment losses and reversals recognized in profit or loss during the period and the line item(s) of the statement of comprehensive income in which those impairment losses and reversals are included.
• the amount of impairment losses and reversals on revalued assets recognized in other comprehensive income during the period.

U.S. GAAP require a company to disclose a description of the impaired asset, what caused impairment, the method of determining fair value, the amount of impairment loss, and where the loss is recognized on the financial statements.

Investment property is defined as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rental income, capital appreciation, or both.

Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model.

• The cost model is identical to the cost model used for property, plant, and equipment (PP&E).
• The fair value model differs from the revaluation model used for PP&E. All changes in the fair value of investment property affect income.

Under U.S. GAAP, there is no specific definition of investment property. Investment properties are generally measured using the cost model.

The computation of income taxes poses problems in financial reporting. The major problems arise because current period taxable income is measured using different rules than those used in accounting for pretax income.

Taxes are paid based on tax reporting, but from a financial reporting standpoint, the tax expense in the income statement (IS) is based on the matching principle and is computed on pretax accounting income. In order to achieve matching between taxes based on taxable income and taxes based on pretax income for accounting purposes, deferred tax entries are put through the accounting books.

The differences between the tax expense for tax and the accounting tax expense create deferred tax liabilities (credits) and deferred tax assets (debits or prepaid taxes).

Here are key terms based on tax return:

• Taxable income: Income subject to tax based on the tax code.

• Taxes payable: Tax return liability resulting from current period taxable income. (U.S.) SFAS 109 calls this "current tax expense or benefit."

• Income tax paid: Actual cash flow for income taxes, including payments (refunds) for other years.

• Tax loss carry forward: Tax return loss that can be used to reduce taxable income in future years.

• The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

Here are key terms based on financial reporting:

• Pretax income or accounting profit: Income before income tax expense.

• The carrying amount is the amount at which the asset or liability is valued according to accounting principles.

• Income tax expense: Expense resulting from current period pretax income; this includes taxes payable (from the tax return) and deferred income tax expense. It is reported in the income statement.

• Deferred income tax expense: Accrual of income tax expense expected to be paid (or recovered) in future years (difference between taxes payable and income tax expense). Under (U.S.) SAAS 109, this results from changes in deferred tax assets and liabilities.

• Deferred tax asset: Balance sheet item that results from a temporary excess of taxes payable over income taxes expense. It is expected to be recovered from future operations; it is not created if the excess is a permanent difference.

• Deferred tax liability: Balance sheet item that results from a temporary excess of income taxes expense over taxes payable. It is expected to result in future cash outflows; it is not created if the excess is a permanent difference.

• Valuation allowance: Reserve against deferred tax assets based on likelihood that those assets will be realized.

• Timing difference: The result of the tax return treatment (timing or amount) of a transaction that differs from the financial reporting treatment.

• Temporary difference: Difference between tax reporting and financial reporting that will affect taxable income when those differences reverse. This is similar to but slightly broader than timing difference. It also considers other events that result in differences between the tax bases of assets and liabilities and their carrying amounts in financial statements.

• Permanent difference: Differences between tax reporting and financial reporting that will not reverse in the future.

Tax reporting and financial reporting are based on two different sets of assumptions. This is particularly true in the U.S. because financial reporting does not have to conform to tax reporting, as it does in Japan, Germany, and Switzerland. Numerous items create differences between accounting profit and taxable income. As a result, the taxes payable for the period are often different from the tax expenses recognized in the financial statements.

In the U.S.:

• Tax reporting is based on the Internal Revenue Code (the tax code).
  • The modified cash basis of accounting is used in tax reporting to determine the periodic liability from currently taxable events.
  • Revenue and expense recognition methods used in tax reporting often differ from those used in financial reporting.

• Financial reporting is based on GAAP.
  • Accrual accounting is used in financial reporting to provide maximum information to allow evaluation of a firm's financial performance and cash flows.
  • Management is allowed to select revenue and expense recognition methods. A firm has a strong incentive to use methods that allow it to minimize taxable income.

Because of the differences between tax accounting and financial accounting, the financial statements may include tax liabilities or assets - allowances that have been made in the financial statements for taxes that have not yet been or have already been paid.

Deferred tax liabilities generally arise when tax relief is provided in advance of an accounting expense, or when income is accrued but not taxed until received. Deferred tax liabilities on an individual transaction are expected to be reversed when these liabilities are settled, causing future cash outflows.

A typical example is depreciation: a company uses the Accelerated Cost Recovery System for tax reporting but uses straight-line depreciation for financial reporting.

• Recall that taxes payable is calculated based on taxable income, and tax expense is calculated based on accounting profit.
• Lower depreciation expense in financial reporting results in accounting profit that is higher than taxable income, and tax expense that is higher than taxes payable.
• Deferred tax liabilities are thus created.

Deferred tax assets generally arise when tax relief is provided after an expense is deducted for accounting purposes. Deferred tax assets on an individual transaction are expected to be reversed when these assets are recovered, causing future cash inflows. Different treatments of warranty expenses in tax reporting and financial reporting are a common cause of deferred tax assets:

• For tax reporting, warranty expenses cannot be recognized until they have been incurred. For financial reporting, warranty expenses are recognized each year using accrual accounting, regardless of whether they are incurred or not.
• Lower warranty expense in tax reporting results in taxable income that is higher than accounting profit, and tax payable that is higher than tax expense.
• Deferred tax assets are thus created.

In the U.S., deferred tax assets/liabilities are classified on the balance sheet as current or non-current based on the classification of the underlying asset or liability. However, deferred tax assets/liabilities are always classified as non-current under IFRS.

A deferred tax item cannot be created if it is doubtful that the company will realize economic benefits in the future.

Example

A company purchases an asset for $1,000 at the beginning of Year 1. It depreciates the asset at 33% per annum (straight-line) for financial reporting. The tax depreciation is 50% per annum (straight-line). The pretax income and taxable income are $2,0...

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

The Tax Base of an Asset

An asset's tax base is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the asset's carrying amount. It is the amount that would be tax deductible if the asset was sold on the balance sheet date.

For example, a firm has total accounts receivable of $100,000. At the end of the year, management recognized a specific doubtful debt division of $3,000 for financial reporting. However, provisions for doubtful debts are not allowed for tax purposes in the firm's tax jurisdiction. A tax deduction is received when the receivable is written off as bad debt.

The carrying amount of the accounts receivable becomes $97,000. The tax base of the asset still remains $100,000. The firm has a deductible temporary difference of $3,000. Management should recognize a deferred tax asset in respect to the deductible temporary difference.

If the economic benefit will not be taxable, the tax base of the asset will be equal to the carrying amount of the asset. An example is dividends receivable from a subsidiary. If it is not taxable, the tax base and the carrying amount of the dividends receivable are equal.

The Tax Base of a Liability

The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes with respect to that liability in future periods.

• An unearned revenue item is treated as a liability for financial reporting but tax authorities often recognize it as taxable income. The tax base of such a liability is the carrying amount less any amount of the revenue that will not be taxable in the future. Examples are prepaid rent, prepaid subscriptions, etc.
• If an item has already been expensed, then its tax base and carrying amount are both zero. One example is interest paid on long-term loans.

Example

At the beginning of the year a firm received a lump sum of $5 million for rent from a lessee. The rent was for the use of an office building for the next 5 years. Local tax authorities require 70% of rent received in advance to be taxable income.

At the end of the year, $4 million should be treated as a liability for financial reporting purposes. That's the carrying amount. The tax base of the liability is $1.2 million (30% of $4 million) and $2.8 million should be treated as taxable income.

Changes in Income Tax Rates

When tax rates change, the deferred tax liability or asset has to be adjusted immediately to the new amount that is now expected, based upon the new expected tax consequences. The effect of this change in estimate will be included in the income from continuing operations.

The effect of an income tax rate increase:

• It raises deferred tax liabilities and thus increases tax expense.
• It raises deferred tax assets and thus decreases tax expense.
• If deferred tax liabilities exceed deferred tax assets, the net effect is to increase tax expense, and vice versa.

Numerous items create differences between accounting profit and taxable income. These differences can be divided into two types.

Permanent differences do not cause deferred tax liabilities or assets. These occur if a revenue or expense item:

• is recognized for tax reporting but never for financial reporting, or
• is recognized for financial reporting but never for tax reporting.

Therefore, permanent differences result from revenues and expenses that are reportable on either tax returns or in financial statements but not both. Permanent differences arise because the tax code excludes certain revenues from taxation and limits the deductibility of certain expenses.

• In the U.S., for example, interest income on tax-exempt bonds, premiums paid on officer's life insurance, and amortization of goodwill (in some cases) are included in financial statements but are never reported on tax returns.
• Similarly, certain dividends are not fully taxed, and tax or statutory depletion may exceed cost-based depletion reported in the financial statements.
• Tax credits are another type of permanent difference. Such credits directly reduce taxes payable and are different from tax deductions that reduce taxable income.

These differences are permanent because they will not reverse in future periods.

No deferred tax consequences are recognized for permanent differences; however, they result in a difference between the effective tax rate and the statutory tax rate that should be considered in the analysis of effective tax rates.

Example

A company owns a $50,000 municipal bond with a 4% coupon and has an effective tax rate of 50% and a statutory tax rate of 40%. Calculate the deferred tax created by this bond.

Solution

The bond does not result in deferred tax, as the difference it causes is a permanent difference that will not reverse. As a result, no deferred tax is recognized.

Temporary differences result in deferred tax liabilities or assets. Different depreciation methods or estimates used in tax reporting and financial reporting are a common cause of temporary differences.

There are two categories of temporary differences.

Taxable Temporary Differences (TTD)

• These will result in taxable amounts when an asset is recovered or a liability is settled.
• Hence, these result in deferred tax liabilities. This means the company will pay more tax in the future.

Items that give rise to taxable temporary differences are:

• Receivables resulting from sales.
• Prepaid expenses.
• Tax depreciation rates > accounting rates.
• Development costs capitalized and amortized.

Deductible Temporary Differences (DTD)

• These will result in deductible amounts when an asset is recovered or a liability is settled.
• Hence, these result in deferred tax assets. This means the company will pay less tax in the future.

Items that give rise to deductible temporary differences are:

• Accrued expenses.
• Unearned revenue.
• Tax depreciation rates < accounting rates.
• Tax losses.

Deferred tax assets and liabilities are re-assessed on each balance sheet date.

• They are measured against the criteria of probable future economic benefits.
• The tax rate used to calculate them should be the one that is expected to apply when the asset is realized or liability settled.
• They are not discounted to present value although they are related to amounts at some future date.

Valuation Allowance

Deferred tax assets are reduced by a valuation allowance to amounts that are "more likely than not" to be realized, taking into account all available positive and negative evidence about the future. For determining whether deferred tax assets must be reduced by a valuation allowance, all available positive and negative evidence must be considered. Information concerning recent pretax accounting earnings generally is critical. For example, if a firm has been recording material cumulative losses recently, it will be hard to justify a conclusion that tax credits can be realized in the near future. This will be evidence supporting the use of a valuation allowance ("negative evidence"). It is not necessary to quantify positive evidence for the conclusion that a valuation allowance is not required unless significant negative evidence exists. Where both positive and negative evidence exist, judgment must be used in evaluating what evidence is more persuasive. More weight should be given to objectively verifiable evidence.

Recognition of Current and Deferred Tax Charged Directly to Equity

A firm's deferred tax liability during an accounting period represents the portion of income tax expense that has not been paid. Therefore, from a pure accounting perspective, deferred tax liabilities are an accounting liability. However, from a financial analyst's perspective, whether deferred tax liabilities should be considered liabilities or not depends on whether they will reverse in the future. If they will, resulting in a cash outflow, then they should be treated as liabilities. If not, then they should be treated as equity! As deferred tax liabilities are created by temporary differences, reversal of a deferred tax liability depends on the reversal of the temporary difference that created it.

Changes in a firm's operations or tax law may result in deferred taxes that are never paid or recovered. For example, the use of accelerated depreciation methods for tax reporting creates a temporary difference. Normally, when there is less depreciation in later years, the deferred tax liability created by more depreciation in earlier years will be reversed. However, for firms with high growth rates, increased investments in fixed assets result in ever-increasing new deferred tax liabilities, which replace the reversing one. That is, a firm's growth may continually generate deferred tax liabilities. In this case, the deferred taxes are unlikely to be paid. Therefore, for such high-growth firms, deferred tax liabilities will not reverse and should be treated as equity.

Deferred tax liabilities are recorded at their stated value. Even if deferred taxes are eventually paid, payments typically occur far in the future. The present value of those payments is considerably lower than the stated amounts. Thus, the deferred tax liability should be discounted at an appropriate interest rate and the difference should be treated as equity.

In some cases, financial statement depreciation understates the value of economic depreciation. Instead, the accelerated depreciation in tax reporting is a better measure. Examples of such cases include equipment obsolescence due to technology innovation and rising price levels. Deferred tax liabilities are neither liabilities nor equity if they are not expected to reverse, and should be ignored by financial analysts.

• They are not liabilities since they will not reverse.
• They are not equity since adding the entire tax liabilities

...

Similarities

FAS 109 Accounting for Income Taxes and IAS 12 Income Taxes provide the guidance for income tax accounting under U.S. GAAP and IFRS, respectively. Both pronouncements require entities to account for both current tax effects and expected future tax consequences of events that have been recognized (that is, deferred taxes) using an asset and liability approach. Further, deferred taxes for temporary differences arising from non-deductible goodwill are not recorded under either approach and the tax effects of items directly accounted for as equity during the current year are also allocated directly to equity. Finally, neither principle permits the discounting of deferred taxes.

Significant Differences and Convergence

Below we discuss the significant differences in the current literature.

Tax basis:

• U.S. GAAP: Tax basis is a question of fact under the tax law. For most assets and liabilities there is no dispute on this amount; however, when uncertainty exists, it is determined in accordance with FIN 48 Accounting for Uncertainty in Income Taxes.
• IFRS: Tax basis is generally the amount deductible or taxable for tax purposes. The manner in which management intends to settle or recover a carrying amount affects the determination of tax basis.

Uncertain tax positions:

• U.S. GAAP: FIN 48 requires a two-step process, separating recognition from measurement. A benefit is recognized when it is "more likely than not" to be sustained based on the technical merits of the position. The amount of benefit to be recognized is based on the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement. Detection risk is precluded from being considered in the analysis.
• IFRS: There is no specific guidance; IAS 12 indicates tax assets/liabilities should be measured at the amount expected to be paid. In practice, the recognition principles on provisions and contingencies in IAS 37 are frequently applied. Practice varies regarding consideration of detection risk in the analysis.

Initial recognition exemption:

• U.S. GAAP: No similar exemption for non-recognition of deferred tax effects for certain assets or liabilities.
• IFRS: Deferred tax effects arising from the initial recognition of an asset or liability are not recognized when the amounts did not arise from a business combination and, upon occurrence, the transaction affects neither accounting nor taxable profit (for example, acquisition of nondeductible assets).

Recognition of deferred tax assets:

• U.S. GAAP: Recognized in full (except for certain outside basis differences), but valuation allowance reduces assets to the amount that is more likely than not to be realized.
• IFRS: Amounts are recognized only to the extent it is probable (similar to "more likely than not" under U.S. GAAP) that they will be realized.

Calculation of deferred asset or liability:

• U.S. GAAP: Enacted tax rates must be used.
• IFRS: Enacted or "substantively enacted" tax rates (as of the balance sheet date) must be used.

Classification of deferred tax assets and liabilities in balance sheet:

• U.S. GAAP: Current or non-current classification, based on the nature of the related asset or liability, is required.
• IFRS: All amounts are classified as non-current in the balance sheet.

Recognition of deferred tax liabilities from investments in subsidiaries or joint ventures (JVs) (often referred to as outside basis differences):

• U.S. GAAP: Recognition is not required for investment in foreign subsidiary or corporate JVs that are essentially permanent in duration, unless it becomes apparent that the difference will reverse

...