Accounting Analysis: Accounting Adjustments PDF

Updated version on Nov 7th, 2024 Ch4. Accounting Analysis: Accounting Adjustments Instructor: Hung-Kun Chen 2024/10/17 Department of Information and Finance Management National Taipei University of Technology  Topics Covered Analyze elements of the balan...

Updated version on Nov 7th, 2024 Ch4. Accounting Analysis: Accounting Adjustments Instructor: Hung-Kun Chen 2024/10/17 Department of Information and Finance Management National Taipei University of Technology  Topics Covered Analyze elements of the balance sheet for possible distortions (扭曲) that allows the analyst to better understand the economic substance of a firm’s transactions and financial position. The most common accounting distortions: – Sources of asset value distortions – Sources of liability value distortions – A brief introduction to equity distortions 2  Recognition of Assets Assets are defined as resources with probable future benefits. Asset distortions (資產扭曲) may generally arise from ambiguities about: – Who owns or controls the economic resource? – Can economic benefits be measured with reasonable certainty? – Have fair values of assets declined below book values? – Are fair value estimates accurate? 3  Recognition of Assets: Who Owns/Controls Resources? (1/2) Some types of transactions make it difficult to assess the ownership of an asset. – A resource that a firm leases (租賃) lessor (出租人/leasing firm) or lessee (承租人/the firm) – A customer receivable with a bank customers or banks – A firm owns 49 percent of another firm’s ordinary shares (普通股) all of investment assets of the firm or only the investment assets it legal owns 4  Recognition of Assets: Who Owns/Controls Resources? (2/2) Leaving discretion to managers is better than imposing detailed and mechanical rules: – Mechanical rules (i.e., rule-based approach) help to establish economic ownership with noise or induce managers to structure transactions. – Principles-based approach increase managers’ reporting discretion. Ex: IFRS 10 requires that firm A reports all the assets of firm B on its balance sheet when firm A has the power to govern activities of firm B that affect firm A’s returns on its investment 5  Recognition of Assets: Uncertain Economic Benefits? Which types of resources firm can record as assets and which it cannot. – Expensing research outlays (費用化研究支出) – Capitalizing development outlays (資本化開發 支出) if the products have been delivered IFRS Standards require the immediate expensing of some resource outflows that may have future economic benefits, such as research expenditures. 6  Recognition of Assets: Fair Value of Assets? Must report any impairment loss for assets – An asset is impaired (減損) when its fair value falls below its book value. – Considerable judgment is involved in determining whether the value of an asset is impaired, and the amount of the impairment, assets may be misstated. – Information of assets impairment might be incomplete: Firms can combine a set of assets in one unit. The impairment of one asset (in the same unit) may offset surplus of another. 7  Recognition of Assets: Estimate Assets Accurately? Firms can use “revaluation method” to adjust the book value of assets toward fair value Asset revaluation (資產重估) will affect a firm’s earnings (why?) Managers can bias fair value estimates used in, for example, accounting for goodwill (商譽) or financial instruments (金融工具). – IFRS 3: Business combination – IFRS 9: Financial instruments 8 IFRS 3: Business Combination (1/2) Business Combination = Mergers & Acquisitions (M&As/合併與收購) Record the amount that acquisition costs (併 購成本) exceeds the fair value of the acquired net assets as goodwill (商譽) – IFRS 3 requires testing the amount of goodwill for impairment regularly rather than amortizing it. – Overstate goodwill can reduce future depreciation, but may not increase the goodwill impairment regularly (why?) 9 IFRS 3: Business Combination (2/2) Suppose Firm A pays $25 billion for Firm B (or Firm A acquires Firm B by $25 billion). Firm A’ Balance Sheet Firm B’ Balance Sheet NWC 30 40 Debt NWC 9 10 Debt FA 70 60 Equity FA 11 10 Equity 100 100 20 20 Firm AB’s Balance Sheet NWC 39 50 Debt = 60 + 10 + 5 FA 81 75 Equity Goodwill 5 125 125 10  IFRS 9: Financial Instruments Stocks or bonds are financial instruments IFRS 9 requires to recognize equity investment (股權投資) and debt investment (債權投資) held for trading at their fair value (公平價值) The task of determining fair value is delegated to management, leading to some biases – overstate assets: not to recognize an impairment – understate assets by taking a bath (資產減損): reduce (increase) future expenses (earnings) 11  Asset Distortions Asset overstatement (高估) arises when managers have incentives to inflate earnings Asset understatement (低估) arises when – managers have incentive to deflate earnings during good times – managers decide to take a bath in a bad year – implementing some accounting rules – managers have incentive to understate liabilities 12  Overstated Assets Incentives to inflate (膨脹) reported earnings can result in overstated assets. Some of the most common forms include: – Understated depreciation/amortization of non- current assets (低估非流動資產折舊/攤提) – Delayed write-downs of current or non-current assets (流動或非流動資產減損之遞延認列) – Understatement of allowances (低估備抵) – Accelerated recognition of revenues (加速認列營 業收入) 13  Understated Assets Incentives to deflate (縮減) reported earnings can result in understated assets. Some of the most common forms include: – Key intangible assets off-balance sheet (資產負債 表外主要無形資產) – Overstated allowances (高估備抵項目) – Discounted receivables off-balance sheet (資產負 債表外應收帳款折現) 14 Over- or Understated Depreciation for non-Current Assets For depreciable non-current assets, managers can choose – Estimate of asset lives (資產使用年限估計) – Salvage values (殘值) – Amortization schedules (攤銷時程表) This way influences both book value of assets and earnings, especially for firms in heavy asset businesses, e.g., airlines, utilities, and IC manufacturing (why?). 15  Lufthansa Airline’s Cases Lufthansa, the German national airline, reported it depreciated its aircraft over 20 years on a straight- line basis, with an estimated residual value of 5% of initial cost. Corporate tax rate is 25%. Aircraft’s depreciation rate: 4.75% (=[1-0.05]/20) of the initial cost is higher than its competitors. Peers’ depreciation rate is: 3.8% (=[1-0.05]/25), which assumes 25 years asset life. Acquired €1,004 million net new aircraft in 2020 What will you do for adjustment? 16  Example #1: Depreciation (1/8) Key steps in adjusting depreciation are: – Step 1: Determine the average asset age: Accumulated depreciation × Depreciable life Depreciable cost – Step 2: Calculate the asset adjustment: ∆Depreciation rate × Average age × Initial cost – Step 3: Calculate the depreciation adjustment: ∆Depreciation rate × Initial cost Depreciation adjustments should take purchases or disposals of new assets into account. 17  Example #1: Depreciation (2/8) Step 1: The average age of Lufthansa’s aircraft (€ millions unless otherwise noted) Aircraft cost, 1/1/2020 €32,945 Reported Depreciable cost €31,298 Cost × (1 – 0.05) Accumulated depreciation, 1/1/2020 €16,698 Reported Accumulated depreciation/Depreciable cost 53.4% Depreciable life 20 years Reported Average age of aircraft 10.67 years 20 × 0.5335 years €16,698 20 20 0.5335 ≅ 10.67 €31,298 18  Example #1: Depreciation (3/8) Step 2: Asset adjustment Depreciation rates [1 – old residual value (%)]/old asset life (years) 4.75% [100% – 5%]/20y [1 – new residual value (%)]/new asset life (years) 3.80% [100% – 5%]/25y New depreciation Rate – Old depreciation rate -0.95% Asset adjustment = −∆Depreciation rate × Average age × Initial cost = −(−0.95%) × 10.67 years × €32,945 ≅ €3,339 million 19  Example #1: Depreciation (4/8) Step 3: Depreciation adjustment Depreciation rates [1 – old residual value (%)]/old asset life (years) 4.75% [100% – 5%]/20y [1 – new residual value (%)]/new asset life (years) 3.80% [100% – 5%]/25y New depreciation Rate – Old depreciation rate -0.95% Depreciation adjustment = ∆Depreciation rate × Initial cost of average assets = −0.95% × [€32,945 + (1,004/2)] ≅ −€318 million 20  Example #1: Depreciation (5/8) Asset and depreciation adjustments influence both balance sheet and income statement – Accumulated depreciation → asset & liabilities – Depreciation expense → profit or loss & tax – Both are associated with shareholders’ equity Balance Sheet Income Statement Assets: Liabilities: Revenues Non-current Deferred tax - Cost of sales tangible assets liability Pre-tax profit Equity: Shareholders’ - Tax expense equity Profit or loss 21  Example #1: Depreciation (6/8) Impacts due to the asset adjustment between 2019 and 2020 – Increase non-current tangible assets: €3,339 million – Increase deferred tax liability: €835 million (= €3,339 × 0.25) – Increase shareholders’ equity: €2,504 million (= €3,339 – €835 or €3,339 × 0.75) 22  Example #1: Depreciation (7/8) Impacts due to the depreciation adjustment in 2020 – Increase non-current tangible assets: €318 million – Increase deferred tax liability / tax expense: €79.5 million (= €318 × 0.25) – Increase shareholders’ equity: €238.5 million (= €318 – €79.5 or €318 × 0.75) – Decrease cost of sales (i.e., depreciation): €318 million 23  Example #1: Depreciation (8/8) Adjustments Adjustments Dec 31, 2019 Dec 31, 2020 (€ millions) Assets Liabilities Assets Liabilities Balance sheet Non-current tangible assets +3,339 +3,339 +318 Deferred tax liability +835 +835 +79.5 Shareholders’ equity +2,504 +2,504 +238.5 Income statement Cost of sales -318 Tax expense +79.5 Profit or loss +238.5 24 Quick Idea: Deferred Tax Liability Deferred tax liability (遞延所得稅負債) – taxes that are owed but are not due to be paid until a future date. – amount of income tax payable in future periods in respect of taxable temporary differences (IAS 12). – future taxable income (應稅收入) will be higher compared to financial accounting income. – Ex: a reduction of “cost of sales” leads to an increase in pre-tax income and thus tax expense 25  Leased Assets Off-Balance Sheet Before 2019, firms record their lease assets: – Finance lease method: recorded the asset and an offsetting lease liability on its balance sheet – Operating lease method: recognized the lease payment as an expense when it occurred, keeping the leased asset off its balance IFRS 16 requires that a firm leasing an asset recognizes a lease asset (租賃資產) and a lease liability (租賃負債) on its balance sheet 26  Key Intangible Assets Off-Balance Sheet (1/2) Intangible assets (無形資產): R&D, software development outlays, and brands and membership bases created through advertising and promotions. Expensing or capitalization research outlays? – Expensing (費用化): record research outlays on income statement, but not balance sheet – Capitalizing (資本化): record research outlays on balance sheet and recognize depreciation expense on income statement for years 27  Key Intangible Assets Off-Balance Sheet (2/2) Expensing intangibles has two implications: – Omission of intangible assets from the balance sheet inflates measured rates of return on capital, e.g., return on assets at pharmaceutical firms. – Immediately expensing outlays for intangibles makes it difficult to judge operating performance. Omission of intangibles’ solutions: – Correct the forecasting of long-term rate of returns – Capitalizing intangibles and amortize them. 28  Sanofi’s Case Sanofi is one of the largest pharmaceutical companies (製藥公司) in the world. Sanofi does not capitalize most of its R&Ds because of uncertainty of new products. Will you capitalize all of Sanofi’s research and development and to amortize the intangible assets? 29  Example #2: Intangible Assets (1/8) Key steps in capitalizing off-balance intangible assets (資本化表外無形資產) are: – Determine the economic useful life: L – Calculate the capitalized proportion of year i i +1 expenditure: 1− 2 × Expenditurei L – Calculate the asset capitalization adjustment: ∑0−(L−1) Expenditurei 30  Example #2: Intangible Assets (2/8) Sanofi’s R&D asset, assuming an expected life of 5 years: Proportion Proportion R&D capitalized Asset capitalized Asset Year outlay 31/12/19 31/12/19 31/12/20 31/12/20 2020 €5,529m (1 – [1/5 × 0.5]) €4,976m 2019 6,018 (1 – [1/5 × 0.5]) €5,416m (1 – [1/5 × 1.5]) 4,213 2018 5,894 (1 – [1/5 × 1.5]) 4,126 (1 – [1/5 × 2.5]) 2,947 2017 5,472 (1 – [1/5 × 2.5]) 2,736 (1 – [1/5 × 3.5]) 1,642 2016 5,172 (1 – [1/5 × 3.5]) 1,552 (1 – [1/5 × 4.5]) 517 2015 5,082 (1 – [1/5 × 4.5]) 508 Total €14,338m €14,295m 31  Example #2: Intangible Assets (3/8) Key steps in calculating amortization of capitalized intangible assets (資本化無形資產攤提) are: – Determine the economic useful life: L – Calculate the currently amortized proportion of year i expenditure: 1 For i ≠ 0 and i ≠ -L: × Expenditurei L 1 1 For i = 0 and i = -L: × × Expenditurei 2 L – Calculate the amortization adjustment: ∑0−L Amortization of expenditurei 32  Example #2: Intangible Assets (4/8) Sanofi’s R&D amortization, assuming an expected life of 5 years: Proportion Proportion R&D amortized in Expense in amortized in Expense in Year outlay 2019 2019 2020 2020 2020 €5,529m 1/5 × 0.5 €553m 2019 6,018 1/5 × 0.5 €602m 1/5 1,204 2018 5,894 1/5 1,179 1/5 1,179 2017 5,472 1/5 1,094 1/5 1,094 2016 5,172 1/5 1,034 1/5 1,034 2015 5,082 1/5 1,016 1/5 × 0.5 508 2014 4,667 1/5 × 0.5 467 Total €5,392m €5,572m 33  Example #2: Intangible Assets (5/8) Capitalizing intangible assets influence both balance sheet and income statement – Non-current intangible assets → asset & liabilities – R&D & depreciation → profit or loss & tax – Profit or loss → shareholders’ equity Balance Sheet Income Statement Assets: Liabilities: Revenues Non-current Deferred tax - Cost of sales intangible liability assets Pre-tax profit Equity: Shareholders’ - Tax expense equity Profit or loss 34  Example #2: Intangible Assets (6/8) Impacts due to the capitalizing intangibles – Increase in non-current intangible assets: 2019: €14,338 million 2020: €14,295 million – Increase in deferred tax liability (tax = 32%): 2019: €4,588 million ( €14,338 × 0.32) 2020: €4,574 million ( €14,295 × 0.32) – Increase in shareholders’ equity: 2019: €9,750 million ( €14,338 × [1 0.32]) 2020: €9,271 million ( €14,295 × [1 0.32]) 35  Example #2: Intangible Assets (7/8) Impacts due to the capitalizing intangibles – Decrease in R&D expense: €6,018 million (2019); €5,529 million (2020) – Increase in depreciation expense: €5,392 million (2019); €5,572 million (2020) – Pre-tax profit: +€626 (2019); €43 (2020) – Tax expense (Corporate tax = 32%): 2019: +€200 million ( €626 × 0.32) 2020: €14 million ( €43 × 0.32) 36  Example #2: Intangible Assets (8/8) Adjustments Adjustments Dec 31, 2019 Dec 31, 2020 (€ millions) Assets Liabilities Assets Liabilities Balance sheet Non-current intangible assets +14,338 +14,295 Deferred tax liability +4,588 +4,574 Shareholders’ equity +9,750 +9,721 Income statement Other operating expense Decrease in R&D exp. → -6,018 -5,529 Increase in Dep. exp. → +5,392 +5,572 Pre-tax profit +626 -43 Tax expense (tax = 32%) +200 -14 Profit or loss +426 -29 37  Accelerated Recognition of Revenues Managers have incentives to accelerate (加速) the recognition of revenues by overstating: – earnings (盈餘) – trade/account receivables (應收帳款) Manager’s compensation packages are related to the firm’s earnings. 38  Burford Capital plc’s Case (1/2) Burford is a firm that provides funding to parties involved in litigation, receiving a claim on the case’s outcome in exchange for its investment in a litigation case: – Estimate the fair value of each claim and record as a “capital provision asset” (資本準備資產) on balance sheet – Capital provision asset is accounted for 80% of the firm’s total assets in 2020. 39  Burford Capital plc’s Case (2/2) – Burford revalued a claim by $90 million and recognize revenues, increasing Burford’s operating profit by close to 50%. – The claim was that of investment company Petersen against the Argentinian government and the Argentinian oil company YPF for damages incurred due to Argentina’s nationalization (國有 化) of YPE’s shares in 2012. Petersen sought $1 billion compensation for losing these shares. What will you do for adjustment? 40  Example #3: Revenues (1/4) Derecognize revenues influence both income statement and balance sheet – Revenues → cost of sales, tax, & profit or loss – Revenues & cost of sales → assets – Assets → deferred tax liability & equity Balance Sheet Income Statement Assets: Liabilities: Revenues Current/non- Deferred tax - Cost of sales current assets liability Pre-tax profit Equity: Shareholders’ - Tax expense equity Profit or loss 41  Example #3: Revenues (2/4) Key steps in correcting revenues are: – Revenue (labeled “capital provision income”) decreases by $90 million. – Other current/non-current assets (labeled “capital provision asset”) decreases by $90 million. – Cost of sales declines to reflect the reduction in revenues and other current/non-current assets (prepaid expense) increases by the same amount Cost adj. = 1 Average gross margin × Revenue adj. – Costs of sales equal zero in this case (why?). 42  Example #3: Revenues (3/4) Decline in revenues would result in offsetting decrease in pre-tax income, and thus: – Decrease in tax expense: $5.4 million ( $90 0 × 0.06) – Decrease in deferred tax liability: $5.4 million – Decrease in profit or loss: $84.6 million ( $90 0 × [1 0.06]) – Decrease in shareholders’ equity: $84.6 million 43  Example #3: Revenues (4/4) Adjustments ($ millions) Assets Liabilities Balance sheet Other current/non-current assets (i.e., capital provison asset) -90.0 Other current/non-current assets (i.e. prepaid expense) +0.0 Deferred tax liability -5.4 Shareholders’ equity -84.6 Income statement Renenue -90 Cost of sales +0.0 Pre-tax profit -90 - Tax expense (tax = 6%) -5.4 Profit or loss -84.6 44 Other Revenue Recognition Issues Analyze the revenue recognition from complex contracts (複雜契約) with its customers – Contracts often include distinct performance obligations (履約義務), e.g., hardware maintenance (硬體維護). MUST separate splitting transaction price and performance obligations – Contracts can be a longer period. For example, building construction often takes years. Revenue recognition relies on the project’s progress 45  Revenue Recognition from Long-term Contracts (1/3) Contract liability (合約責任/合約負債): – Cash or other considerations received for goods or services that the firm will deliver in the future. – Reflect collected but unearned (delayed) revenues. Step 1: Recognize revenues for delivered goods or services but will receive payment in a future period has two ways: – Trade receivable (應收帳款), if the firm’s right to payment is unconditional. 46  Revenue Recognition from Long-term Contracts (2/3) – Contract asset (合約資產), if the firm’s right to payment is conditional on delivering future service/products – Contract assets reflect earned but accelerated revenues – Ex: Suppose Deutsche Telekom (DT) sells a €500 smartphone with a 12-month subscription. The customer pays €200 within 14 days after the contract date and €50 monthly, conditional on DT providing voice and data services. 47  Revenue Recognition from Long-term Contracts (3/3) DT recognizes a €200 trade receivable and a €300 contract asset to account for the sale of the smartphone. DT transfers one-twelfth of the contract asset to trade receivables each time a monthly subscription fee becomes billable. Step 2: Amortize contract costs (合約成本) against the recognized revenue – Contract costs: capitalized costs that the firm has incurred to fulfill a contract, e.g., direct labor costs for the contract delivered. 48  Vestas Wind Systems’ Case (1/2) Vestas, a firm specializing in developing, manufacturing, and installing wind turbines and power plants. – Recognize revenues based on the contracts’ completion rate 49  Vestas Wind Systems’ Case (2/2) Change in contract assets in fiscal year 2020 (€ millions) 2020 Beginning balance 528 Increase (revenues recognized) 422 Transfers to receivables (billings made) -221 Other changes (e.g., exchange rate adjustment) 46 Profit or loss 775 If there is significant uncertainty about the remaining risk of Vestas’s contract, what will you do for adjustment? 50  Example #4: Revenues (1/6) Key steps in correcting revenues due to “contract assets” at the end of fiscal year 2019: – Derecognize the contract assets: €528 million – Derecognize the contract costs (assume gross margin=15%): €449 million ( €528 × [1 0.15]) – Adjust equity and the deferred tax liability in 2019 to offset the difference between the derecognized contracts assets and the increased contracts costs Deferred tax liability: €17 million ( €79 × 0.22) Equity: €62 million ( €79 × [1 0.22]) 51  Example #4: Revenues (2/6) Key steps in correcting revenues due to “contract assets” at the end of fiscal year 2020: – Derecognize the revenues: €422 million – Derecognize the cost of sales: €359 million ( €422 × [1 0.15]) – Net effect on other current assets: €63 million Contract assets decrease by €422 million Contract costs increase by €359 million ( €422 × [1 0.15]) 52  Example #4: Revenues (3/6) Key steps in correcting revenues due to “transfers to receivables” at the end of fiscal year 2020: – Recognize the revenues: €221 million – Recognize the cost of sales: €188 million ( €221 × [1 0.15]) – Net effect on other current assets: +€33 million Contract assets increase by €221 million Contract costs decrease by €188 million ( €221 × [1 0.15]) 53  Example #4: Revenues (4/6) Other steps in correcting revenues in 2020: – Derecognize “other change in contract assets”: Other current assets (contract assets): €46 million Shareholders’ equity: €46 million – Net effect on pre-tax profit: Recognized revenue – Derecognized revenue €221 €188) €422 €359)= €30 million – Tax expense and deferred tax liability (tax rate = 22%): €30 × 0.22= €6.6 €7 million – Profit or loss: €30) €7)= €23 million 54  Example #4: Revenues (5/6) Adjustments Adjustments Dec 31, 2019 Dec 31, 2020 (€ millions) Assets Liabilities Assets Liabilities Balance sheet Other current assets (contract -528 -528 assets) -422 Reduce revenue +221 Adj. 2019 -46 Other current assets (contract +449 +449 costs) Recognize revenue +359 -188 Deferred tax liability -17 -17 Tax expense → -7 Shareholders’ equity -62 -62 Other changes in contract assets → -46 Profit or loss → -23 55  Example #4: Revenues (6/6) Adjustments Adjustments Dec 31, 2019 Dec 31, 2020 (€ millions) Income statement Revenue -422 +221 Cost of sales -359 +188 Pro-tax proft -30 Tax expense (tax = 22%) -7 Profit or loss -23 56  Delayed Write-Downs of Non-current Assets (1/2) Must recognize “impairment” for non-current assets if its fair value falls below book value. – Lacking of secondhand markets for non-current assets or the markets are illiquid. Intangible assets: goodwill (商譽) Tangible assets: aircraft in the airline industry – Managers use reporting judgment to delay write- downs on the balance sheet and avoid showing impairment changes in the income statement (why?). 57  Delayed Write-Downs of Non-current Assets (2/2) Warning signs of impairments in non-current assets: – Declining non-current asset turnover (= net sales/non-current assets, 非流動資產週轉率) – Declines in return on assets to levels lower than the weighted average cost of capital – Write-downs by other firms in the same industry – Overpayment for or unsuccessful integration of key acquisitions (收購) 58  Renault’s Case (1/2) Renault (雷諾汽車) invested 43.7% stake in Nissan (日產汽車), as of year end of 2020 – Renault cannot control Nissan's major financial and operating decisions – Renault used the “equity method” (權益法) to account for tis investment in Nissan Use initial cost of Nissan’s shares to recognize the investment on the balance sheet and periodically adjust the investment’s book value for Renault’s shares in Nissan’s profit or loss and dividends received. 59  Renault’s Case (2/2) Key accounting numbers in Renault: – Book value of the investment in Nissan: €16,618 million (13% of Renault’s balance sheet total) – Goodwill (商譽): €723 million – Market value of the investment in Nissan: €8,110 million, which is €8 billion less than its book value Will you recognize an impairment on the investment? 60  Example #5: Delayed Recognize Impairment (1/2) Key steps in recognizing non-current assets impairment are (tax rate = 32%): – Reduce non-current assets and increase non- recurring expense (非經常性費用) by €8,508 million ( €16,618 €8,110) – Reduce deferred tax liability and tax expense: €2,723 million ( €8,508 0.32) – Reduce shareholders’ equity and profit or loss: €5,785 million ( €8,508 €2,723)) 61 Example #5: Delayed Recognize Impairment (2/2) Adjustments (€ millions) Assets Liabilities Balance sheet Non-current assets -8,508 Deferred tax liability -2,723 Shareholders’ equity -5,785 Income statement Non-recurring expense +8,508 Tax expense (tax = 6%) -2,723 Profit or loss -5,785 62  Delayed Write-downs of Current Assets Any write-downs of current assets will trigger a reduction of earnings. – Trade/account receivable (應收帳款) – Inventory (存貨) Warning signs for delays in current asset write-downs: – Growing days’ inventory and days’ receivable – Write-downs by competitors – Business downturns for a firm’s major customers 63  Imtech’s Case Imtech, a Dutch industrial services company Potential deterioration of the quality of Imtech’s trade receivables – Average number of days’ receivables (應收帳款 週轉天數) increased from 147 days to 232 days – Days’ receivables for other firms are stable. What will you do for the adjustment? 64  Example #6: Receivable (1/3) Imtech’s receivables (應收帳款) information: – Current receivables (June 2012): €2,197 million – Total revenues (June 2012): €5,436 million – Trade/account receivable days: 148 days (€2,197 / [€5,436 / 365]) Key steps in correcting receivables are: – Assume the normal days of receivables is 123 days, the normal receivables in terms of the revenues is: €1,832 million ( €5,436 [123/365]) 65  Example #6: Receivable (2/3) Key steps in correcting receivables are (cont.): – Adjustment in receivables: €365 million ( €2,197 €1,832) – Reduce receivables and increase non-recurring expense (非經常性費用) by €365 million – Reduce deferred tax liability and tax expense (tax rate = 28.1%): €103 million ( €365 0.281) – Reduce shareholders’ equity and profit or loss: €262 million ( €365 €103)) 66 Example #6: Receivable (3/3) Adjustments (€ millions) Assets Liabilities Balance sheet Receivables -365 Deferred tax liability -103 Shareholders’ equity -262 Income statement Non-recurring expense +365 Tax expense (tax = 28.1%) -103 Profit or loss -262 67  Allowances Allowances (備抵項目): Expected customer defaults on trade receivables or loans – allowance for doubtful accounts (備抵呆帳) – allowance for bad debt (備抵壞帳) Some warning sings – Growing trade/account receivable days – Business downturns for a firm’s major clients – Growing loan delinquencies (貸款拖欠) 68  Société Générale’s Case Société Générale (SG), French banking and insurance company. SG’s allowances are: Gross loans Allowances for loan Allowances/Gross Year (€ millions) losses (€ millions) loans (%) 2017 496,288 13,649 2.75 2018 531,516 11,673 2.20 2019 530,075 10,976 2.07 2020 529,738 11,962 2.26 – Suppose the allowance over gross loans is 2.2% (2019) and 3.0% (2020) rather than 2.07% and 2.26%, what should we do for adjustment? 69  Example #7: Loan Losses Allowances (1/7) Gross loans Allowances for loan Allowances/Gross Year (€ millions) losses (€ millions) loans (%) 2017 496,288 13,649 2.75 2018 531,516 11,673 2.20 2019 530,075 10,976 2.07 → 2.2% 2020 529,738 11,962 2.26 → 3.0% Adjust loan losses allowance based on the updated allowances to gross loans ratios: – 2019: €11,662 €530,075 0.022 – 2020: €15,892 €529,738 0.03 70  Example #7: Loan Losses Allowances (2/7) Allowances for loan losses (€ million) Dec 31, 2020 Dec 31, 2019 Dec 31, 2018 Balance at beginning of year 10,976 11,673 13,649 Provision for/(recovery of) loan losses 2,951 1,204 970 Write-offs (1,691) (1,858) (2,130) Other changes (e.g., exchange rates) (274) (43) (816) Balance at end of year 11,962 10,976 11,673 → 15,896 →11,662 Correct the loan losses allowance: – 2019: €686 million ( €10,976 €11,662) – 2020: €3,930 million ( €11,962 €15,896) What else? 71  Example #7: Loan Losses Allowances (3/7) Decrease deferred tax liability (tax rate = 32%) – 2019: €220 million ( €686 0.32) – 2020: €1,258 million ( €3,930 0.32) Decrease shareholders’ equity – 2019: €466 million ( €686 1 0.32 ) – 2020: €2,672 million ( €3,930 1 0.32 ) 72  Example #7: Loan Losses Allowances (4/7) Allowances for loan losses (€ million) Dec 31, 2020 Dec 31, 2019 Dec 31, 2018 Balance at beginning of year 10,976 11,673 13,649 Provision for/(recovery of) loan losses 2,951 1,204 970 Write-offs (1,691) (1,858) (2,130) Other changes (e.g., exchange rates) (274) → (291) (43) (816) Balance at end of year 11,962 10,976 11,673 → 15,896 →11,662 Estimate “other changes,” which is a proportion of new balance of the loan losses allowance: €291 million ( 274/10,976] 11,662) Reduce other changes: €17 million 73  Example #7: Loan Losses Allowances (5/7) Allowances for loan losses (€ million) Dec 31, 2020 Dec 31, 2019 Dec 31, 2018 Balance at beginning of year 10,976 11,673 13,649 Provision for/(recovery of) loan losses 2,951→ 6,212 1,204 970 Write-offs (1,691) (1,858) (2,130) Other changes (e.g., exchange rates) (274) → (291) (43) (816) Balance at end of year 11,962 10,976 11,673 → 15,896 →11,662 Estimate provision for loan losses (貸款損失 準備) by assuming new balance for each components: €6,212 million ( €15,892 [€11,662 €1,691 €291]) Increase the provision: €3,261 million 74  Example #7: Loan Losses Allowances (6/7) The adjustment of provision for loan losses (+€3,261) will influence income statement in 2020: – Increase provision for loan losses (i.e., operating expense): €3,261 million – Decrease tax expense: €1,044 million ( €3,261 0.32) – Decrease profit or loss: €2,217 million ( €3,261 €1,044 ) 75  Example #7: Loan Losses Allowances (7/7) Adjustments Adjustments Dec 31, 2019 Dec 31, 2020 (€ millions) Assets Liabilities Assets Liabilities Balance sheet Net loans -686 -3,930 Deferred tax liability -220 -1,258 Shareholders’ equity -466 -2,672 Income statement Operating expenses +3,261 Tax expense -1,044 Profit or loss -2,217 76  Understated Allowances and Overstated Tax Credits When a firm reports a loss in its tax statement, it does not receive an immediate tax refund, but becomes a tax loss carryforward – Record a deferred tax asset (遞延所得稅資產) for a tax loss carryforward (稅損退算和結轉) – Tax loss carryforward can offset against future taxable profits, increasing profit or loss – Tax loss carryforward is valuable only when the firm has a positive profit. 77  Quick Idea: Deferred Tax Asset Deferred tax asset (遞延所得稅資產) – opposite of a deferred tax liability – overpayment or advance payment of taxes – future taxable income (應稅收入) will be lower compared to financial accounting income – Ex: if firms has a net operating loss (NOL) that is carried forward to future income tax returns, that NOL will reduce taxable income in future years compared to financial accounting income. 78  Spyker’s Case (1/2) Spyker, a Dutch manufacturer of exclusive cars, had been loss-making. The company reported the following losses carried forward and deferred tax assets (遞延所得稅資產): (€ thousands) Dec 31, 2005 Dec 31, 2004 Total loss carried forward 19,822 15,687 Tax rate 29.6% 34.5% = Calculated deffered tax 5,867 5,412 Allowance -1,467 -3,058 Recognized deferred tax asset 4,400 2,354 79  Spyker’s Case (2/2) (€ thousands) Dec 31, 2005 Dec 31, 2004 Total loss carried forward 19,822 15,687 Tax rate 29.6% 34.5% = Calculated deffered tax 5,867 100% 5,412 100% Allowance -1,467 25% -3,058 56.5% Recognized deferred tax asset 4,400 2,354 Estimate the allowance lower in 2005 than in 2004 because management expected an increase in spiker’s future profitability If the firm’s future profitability is not positive, what should we do for adjustment? 80  Example #8: Allowances (1/2) Must increase its allowance to 56.5%, and thus increase the deferred tax asset: +€1,848 thousands (= €5,867 0.565 0.25 ) Reduce shareholders’ equity and profit or loss: €1,848 thousands 81 Example #8: Allowances (2/2) Adjustments (€ thousands) Assets Liabilities Balance sheet Deferred tax liability -1,848 Shareholders’ equity -1,848 Income statement Tax expense +1,848 Profit or loss -1,848 82  Recognition of Liabilities Liabilities (負債) are defined as economic obligations that arise from benefits received in the past, have the optional of being require to be met, and cannot be feasibly avoided. Liability distortions (負債扭曲) arise because there is ambiguity about: – whether the firm has really incurred an obligation – whether the firm can measure the obligation 83  Has an Obligation been Incurred? Most liabilities have little ambiguity about whether there is an incurred obligation, with some exceptions: – If a firm announces a plan to restructure its business by laying off employees, has it made a commitment that is recording a liability? – If a software firm receives cash from its customers for a five-year software license, should the firm report the full cash inflow as revenues? 84  Can the Obligation be Measured? Many liabilities specify the amount/timing of obligation precisely, e.g., bonds or bank loans. Obligations with amount/timing uncertainties: – Responsible for an environmental clean-up – Post-employment benefits (rely on mortality rate & future inflation rate) – Future warranty and insurance on products 85  Liability Distortions (1/2) Liabilities are likely to be understated Understated liabilities may arise from: – Incentives to overstate earnings or the strength of financial position (誇大盈餘或財務實力). – Difficulties in estimating the amount of future financial commitments (未來財務承諾). 86  Liability Distortions (2/2) The most common forms of liability understatement: – Understate deferred revenues (低估遞延收入) or recognize revenue aggressively Deferred revenues (also known as unearned revenues or contract liabilities): has received cash but has yet to provide the product or service – Understate provisions (低估備抵) – Understate post-employment benefit obligations (低估退休福利負債) 87  MicroStrategy’s Case In March 2000, MicroStrategy, a software company, conceded that it had incorrectly overstated revenues on contracts that involved significant future customization and consulting by $54.4 million. Cost of sales (or license revenues) is 3% of its revenue. Corporate tax rate is 35%. Must restate its financial statements for 1999. 88 Example #9: Deferred Revenue (1/2) Reduce revenue and increase deferred revenue (in other current liabilities) by $54.4 million – Reduce cost of sales: $1.6 million ( $54.4 0.03) – Increase prepaid expense (預付費用) in other current assets: +$1.6 million – Reduce tax expense and deferred tax liability: $18.5 million ( $54.4 1.6 0.35) – Reduce profit or loss: $34.4 million ( $54.4 $1.6 $18.5 ) 89 Example #9: Deferred Revenue (2/2) Adjustments ($ millions) Assets Liabilities Balance sheet Other current assets +1.6 Other current liabilies +54.5 Deferred tax liability -18.5 Shareholders’ equity -34.4 Income statement Revenue -54.5 Cost of sales -1.6 Tax expense (tax = 6%) -18.5 Profit or loss -34.4 90  Provisions Understated Two examples for uncertain liabilities: – obligation to clean up polluted production sites – warranty coverage for product sold. MUST recognize provision (備抵項目) on its balance sheet for such uncertain liabilities, if – the obligation will lead to future outflow of cash – has no or little discretion to avoid the obligation – can make a reliable estimate of the obligation 91  Volkswagen’s Case (1/2) Volkswagen, a car manufacturer, was suffering from lawsuits due to the manipulation of car emissions tests. At the end of fiscal year 2020, Volkswagen recognized: – On-balance sheet provision: €1.9 billion – Off-balance sheet contingent liability: €4.2 billion – Contingent liability (或有負債): a potential liability may occur in the future, such as pending lawsuits or granting product warranties. 92  Volkswagen’s Case (2/2) After consultation with legal experts, financial analyst concludes: – The present value of expected future damages and settlements (discounted Volkswagen’s borrowing rate: 1.5%): €4 billion – Corporate tax rate is 30%. What should you do for adjustment? 93  Example #10: Provisions (1/3) Recognize an additional liability (i.e., provision): €2.1 billion ( €4 €1.9) – Decline deferred tax liability: €0.63 billion (= €2.1 0.3) – Decline shareholders’ equity: €1.47 billion (= €2.1 1 0.3 ) – Because the non-current provision is a discounted liability, the provision would increase as interest accrues (應計利息) in 2021. 94  Example #10: Provisions (2/3) Additional liability in 2021 = additional liability in 2020 + Interest accrues – Interest accrues (應計利息): €31.5 million (= €2.1 bil 0.015) – Decline tax expense and deferred tax liability: €9.5 million (= €31.5 0.3) – Decline profit or loss and shareholders’ equity: €22 million (= €31.5 1 0.3 ) 95  Example #10: Provisions (3/3) Adjustments Adjustments Dec 31, 2020 Dec 31, 2021 (€ millions) Assets Liabilities Assets Liabilities Balance sheet Non-current debt +21,000 +21,000 +31.5 Deferred tax liability -630 -630 Shareholders’ equity -14,700 -14,700 -22 Income statement Interest expense +31.5 Tax expense (tax = 32%) -9.5 Profit or loss -22 96  Post-employment Benefit Obligations Understated Pension benefits or post-employment benefits (退休福利) Managers MUST estimate and report the present value of the commitments to post- employment plans – Require judgement: future wage and benefit rates, worker attrition rates (員工流失率), and the expected lives of retirees (退休人員預期壽命). – Must adjust its post-employment obligations to reflect some factors 97  Factors Affecting the Adjustment of Pension Benefit Plans (1/2) Current service cost: benefit plans provide higher benefits for each additional year of service with the company. Interest cost: Multiplying the obligation (i.e., benefit plans) at the beginning of the year with the discount rate. Actuarial gains and losses: Review assumptions used to estimate the present value of pension benefit and adjust it if inappropriate 98  Factors Affecting the Adjustment of Pension Benefit Plans (2/2) Past service cost: It happens due to any change of pension benefit plans. Benefits paid: Firms reduce plan commitment as the plan makes payment to retirees each year. Other: change in foreign exchange rates (匯 率), changes in consolidation (合併), plan curtailments (計畫縮減), and plan settlements (計畫結算). 99  Carlsberg’s Case (1/3) Carlsberg’s post-employment benefit obligation (DKK million) December 31, 2020 December 31, 2019 Benefit obligation at beginning of year 13,771 12,239 Current service cost 223 199 Interest cost 160 256 Actuarial (gains)/losses 733 1,354 Benefits paid -608 -594 Other (e.g. Foreign exchange adjustments) -691 317 Balance obligation at end of year 13,588 ← ← ← 13,771 1.3% decrease 100  Carlsberg’s Case (2/3) Carlsberg’s post-employment benefit assets – Increase due to new employee contributions – Increase/decrease due to plan investments (DKK million) December 31, 2020 December 31, 2019 Fair value of plan assets at beginning of year 10,472 9,331 Actual return on plan assets 850 906 Interest costContributions to plans 182 225 Benefits paid -504 -486 Other (e.g. Foreign exchange adjustments) -346 496 Fair value of plan assets at end of year 10,654 ← ← ← 10,472 1.7% increase 101  Carlsberg’s Case (3/3) Unfunded obligation to employees: DDK2.93 billion ( 13,588 10,654) Pension benefits’ assumptions in 2020 – Future salaries will grow at 1.2% – Discount rate: 0.6% (1.3% in 2019) Suppose analyst decided to: – Increase Carlsberg’s discount rate by 0.5%, which decreases the post-employment obligation by DKK1.1 billion 102  Example #11: Post-employment Benefit Obligations The adjustments to Carlsberg’s 2020 balance sheet by decreasing the post-employment obligation by DDK1.1 billion. Adjustments (DDK billions) Assets Liabilities Balance sheet Long-term debt -1.1 Deferred tax liability +0.23 Shareholders’ equity +0.87 103  Equity Distortions Equity is the residual claim (剩餘求償) on a firm’s assets held by stockholders. Factors affecting equity distortions – Since Assets = Liabilities + Equity, distortions in assets and/or liabilities lead to distortions in equity. – Contingent claims (或有請求權) on their net assets that a firm provides to outside stakeholders employee stock options (員工股票權選擇) conversion options on convertible bonds (可轉換債券) 104  Quick Idea: Contingent Claims Contingent claims (或有請求權) are so named because there is only a payoff under certain contingencies. – Contingent claims’ future payoff depends on the value of another underlying asset (標的資產), or on the realization of some uncertain future event. – The nature of contingent claims needs to be considered to reduce any possible bias in the financial statements. 105 Contingent Claims: Two Examples Employee stock options give a firm’s employees the right to purchase a certain number of shares at a predetermined price (i.e., exercise or strike price/執行價格) – Provide managers with incentives to maximize shareholder value and make it easier to attract talented managers. (why?) Convertible bonds (CBs) give their holders the right to purchase a certain number of shares in exchange for their fixed claim. 106  Impact of Contingent Claims on Financial Reporting The economic cost of contingent claims – Although contingent claims do not involve cash flows for the firm, the potential exercise of the option dilutes current shareholders’ equity Include an expense reflecting the value of the contingent claims to the recipients – Employee stock options (員工股票選擇權) – Convertible bonds (可轉換債券/可轉換公司債) 107 Record the Cost of Employee Stock Options Accurately (1/2) Record an expense for stock option compensation using fair value method, such as Black-Scholes option pricing model – Expenses such value over the vesting period (歸 屬期/等待期) Vesting periods specify the time schedule and amounts of employer-contributed cash or assets that employees may gain access to gradually. – B-S model is highly sensitive to management’s assumptions about model parameters (模型參數) 108 Record the Cost of Employee Stock Options Accurately (2/2) – B-S model is highly sensitive to management’s assumptions about model parameters (模型參數) stock price volatility (股價波動性), the price of the underlying asset, the strike price of the option, the time until the expiration of the option, the risk-free interest rate, and dividend yield (股票殖利率) Understate the stock option expense by – Understate the expected future stock price volatility – Overstate the expected future dividend yield 109  Record CBs Expense (1/3) Separate the debt from the equity component of convertible bonds Convertible bonds = Straight bonds (普通債 券) + right to purchase a certain number of shares – When exercising the right (option), the straight bonds automatically disappear 110  Record CBs Expense (2/3) Straight bonds: Estimate the fair value (公平 價值) of the bonds, assuming the bonds had no conversion option – The present value of the future fixed payments on the bonds, depending on: Fixed payments on the bonds Discount rate: the firm’s effective interest rate (有效利 率) on the nonconvertible bonds Right to purchase equity: Proceeds of the CBs minus the fair value of the debt component. 111  Record CBs Expense (3/3) Economic cost of the conversion option – Interest expense on the bonds based on the effective interest rate on nonconvertible bonds Understate the convertible bonds’ equity component and effective interest expense by – Understate the effective interest rate on nonconvertible bonds (why?) – Assume y = effective interest rate, the discount rate 𝑪𝒐𝒖𝒑𝒐𝒏 𝑪𝒐𝒖𝒑𝒐𝒏 𝑪𝒐𝒖𝒑𝒐𝒏 𝑷𝒂𝒓 𝐁𝐨𝐧𝐝 𝐏𝐫𝐢𝐜𝐞 ⋯ 𝟏 𝒚 𝟏 𝟏 𝒚 𝟐 𝟏 𝒚 𝒕 112 Concluding Comments Recasting financial statements is an important step to facilitate comparability among analyzed financial statements. Analysts should focus on evaluating and adjusting accounting measures that describe the firms’ key strategic value drivers. It is important to keep in mind that many accounting adjustments will be estimates. 113