FitchLearning Chartered Financial Analyst® Program Level I Phase 2 (2025) PDF

Knowledge | Skills | Conduct Chartered Financial Analyst® Program Level I Phase 2 (2025) Topics: Financial Statement Analysis i  Knowledge | Skills | Conduct Copyright © Fitch Learning Limited 2024 All rights reserved. No part of this publication may be...

Knowledge | Skills | Conduct Chartered Financial Analyst® Program Level I Phase 2 (2025) Topics: Financial Statement Analysis i  Knowledge | Skills | Conduct Copyright © Fitch Learning Limited 2024 All rights reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording or otherwise) without the prior permission of the copyright owner. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. While every effort has been made to ensure its accuracy, Fitch Learning Limited can accept no responsibility for loss occasioned to any person, acting or refraining from action as a result of any material in this publication. ii  Level I CFA Program Phase 2 Contents Financial Statement Analysis (FSA1) p1 Financial Statement Analysis (FSA2) p40 Financial Statement Analysis (FSA3) p82 Financial Statement Analysis (FSA4) p123 iii  Knowledge | Skills | Conduct CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Fitch Learning. CFA Institute, CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. iv  Level I CFA® Program Financial Statement Analysis (FSA1) Knowledge | Skills | Conduct 1 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 2: Analyzing Income Statements The candidate should be able to: a. Describe general principles of revenue recognition, specific revenue recognition applications, and implications of revenue recognition choices for financial analysis b. Describe general principles of expense recognition, specific expense recognition applications, implications of expense recognition choices for financial analysis and contrast costs that are capitalized versus those that are expensed in the period in which they are incurred c. Describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies d. Describe how earnings per share is calculated and calculate and interpret a company’s basic and diluted earnings per share for companies with simple and complex capital structures including those with antidilutive securities e. Evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement Knowledge | Skills | Conduct 2 Components and Format of the Income Statement Income Statement 2009 2010 2011 $’000 $’000 $’000 Net sales 100,000 110,000 150,000 Cost of goods sold 60,000 66,000 80,000 Gross profit 40,000 44,000 70,000 Selling expenses 20,000 22,000 30,000 General and administrative expenses 12,000 10,000 15,000 Operating income 8,000 12,000 25,000 Less: interest expense 6,500 6,500 6,500 Pretax income 1,500 5,500 18,500 Provision for income taxes 300 900 4,000 Income before minority interest 1,200 4,600 14,500 Minority interest 200 400 900 Net income 1,000 4,200 13,600 Knowledge | Skills | Conduct 3 Revenue Recognition Definition Terms used - Revenue, sales, turnover - Arises from a company’s primary business activities General principles Revenue recognition occurs independently of cash movements - E.g. goods sold on credit - Application of accruals principle If cash is received before goods are provided or services are delivered - Unearned revenue Conditions have to be met before revenue can be recognized in income statement Knowledge | Skills | Conduct 4 Revenue Recognition IASB definition “Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants” Illustration Credit sales $1,100,000 Return of goods sold $100,000 Cash collected $700,000 Cost of goods sold $600,000 Net revenue recognized = Credit sales - Return of goods sold Net revenue recognized = $1,100,000 - $100,000 = $1,000,000 Knowledge | Skills | Conduct 5 Revenue Recognition Accounting Standards Converged accounting standards issued by IASB and FASB in May 2014 introduce some basic changes to the principles of revenue recognition: Should enhance comparability Standards are effective from 1 January 2018 under IFRS and 15 December 2017 under US GAAP Core principle of the converged standard: “Revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects consideration to which entity expects to be entitled in an exchange for those goods or services” The standard applies five steps in recognizing revenue: Identify the contract(s) with a customer Identify the separate or distinct performance obligations in the contract Determine the transaction price Allocate the transaction price to the performance obligations in the contract Recognize revenue when (or as) the entity satisfies the performance obligation Knowledge | Skills | Conduct 6 Expense Recognition IASB definition Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants General principles Matching principle - Matching of costs with revenues E.g. revenue matched with cost of goods sold Period costs - If expenses cannot be directly matched with revenues then recognize in the period they are incurred E.g. administrative expenses Knowledge | Skills | Conduct 7 Earnings Per Share Importance Enables each shareholder to compute share of earnings - Aids comparison between companies Input into price/earnings ratio IASB and FASB require presentation on face of income statement Simple capital structure Basic EPS presented for ordinary shares (IFRS) or common stock (US) Net income - Preference dividends Basic EPS = Weighted average number of common shares Knowledge | Skills | Conduct 8 Earnings Per Share Basic EPS Determining the weighted average number of shares Not necessarily the number of shares outstanding at year end Stock issues/stock repurchases - Weighting of shares based on date of purchase/repurchase Stock splits/stock dividends - Treasury stock method Weighting is based on the shares already in existence Date of stock split/stock dividend is irrelevant Restatement of prior year EPS - Required for stock splits/stock dividends Knowledge | Skills | Conduct 9 Earnings Per Share Example 2: Basic EPS calculation Calculate basic EPS using the information provided below: Net income: $50,000 Dividends to preferred stockholders: $20,000 Dividends to common stockholders: $15,000 Common stock account: - 1 January: Shares outstanding at the beginning of the year 5,000 - 1 April: Shares issued 2,000 - 1 July: 10% stock dividend - 1 September: Shares repurchased 1,500 Knowledge | Skills | Conduct 10 Earnings Per Share Diluted Earnings Per Share Complex capital structure Company has securities potentially convertible into common stock - Convertible bonds - Convertible preferred stock - Employee stock options - Warrants Convertible securities could dilute, i.e. decrease, EPS Adjusted income available for common shares Diluted EPS =  Weighted no of common     + potential common shares  Each potentially dilutive issue treated separately - ‘Anti-dilutive’ issues are ignored in the calculation - Issue is dilutive, if dilutive EPS < basic EPS Knowledge | Skills | Conduct 11 Earnings Per Share Convertible debt ‘If-converted’ method - What would EPS have been if the convertible debt had been converted at the beginning of the period Company would have saved interest (post tax) Number of shares in issue would have increased Earnings = Net Income - Preference dividends + Convertible debt post tax interest SAVED Shares = Weighted average number of shares + Shares on conversion of debt Knowledge | Skills | Conduct 12 Earnings Per Share Example 3: Convertible debt Calculate basic and diluted EPS using the information provided below: Net income $23,120. Common stock 4,000 shares outstanding for the entire year. Preference stock 2,000 $100 10% shares outstanding for the entire year. Convertible bonds 120 $1,000 8% bonds issued during the previous year for $120,000. Each is convertible into 100 shares of common stock. Tax rate 40%. Knowledge | Skills | Conduct 13 Earnings Per Share Convertible preference stock ‘If-converted’ method - What would EPS have been if the convertible preference stock had been converted at the beginning of the period Company would have saved preference dividend - No tax effect Number of shares in issue would have increased Earnings = Net income - Preference dividends + Convertible preferred dividends SAVED Shares = Weighted average number of shares + Shares on conversion of preference stock Knowledge | Skills | Conduct 14 Earnings Per Share Example 4: Convertible preference stock Calculated basic and diluted EPS using the information provided below: Net income $23,120 Common stock 4,000 shares outstanding for the entire year Preference stock 2,000 $100 10% shares, each convertible into 20 shares of common stock, outstanding for the entire year Tax rate 40% Knowledge | Skills | Conduct 15 Earnings Per Share Dilutive stock options/warrants Treasury stock method - What would EPS have been if the options has been exercised and the company had used the proceeds to repurchase common stock? Company would have received cash (exercise price) Number of shares in issue due to exercise of options or warrants Company would have repurchased shares in the market Earnings = Net income - Preference dividends Shares Weighted average number of shares + Net increase in shares on exercise of options/warrants Knowledge | Skills | Conduct 16 Earnings Per Share Example 5: Options/warrants Calculate basic and diluted EPS using the information provided below: Net income $23,120 Common stock: 4,000 shares outstanding for the entire year Non-convertible preference stock: 2,000 $100 10% shares Stock options: 2,000 outstanding the entire year. Each converts into ten shares of common stock at $15/share The average market price of stock during the year was $20/share Tax rate: 40% Knowledge | Skills | Conduct 17 Earnings Per Share Antidilutive securities Inclusion of antidilutive securities results in an increased EPS figure Antidilutive securities are not included in the EPS calculation - Diluted EPS will be stated as same as basic EPS Only dilutive securities are included in the EPS calculation - Reflects maximum potential dilution Antidilutive securities are not to be used to offset dilutive securities Companies with more than one dilutive security Curriculum readings does not cover the method of calculating EPS when there is more than one dilutive security Knowledge | Skills | Conduct 18 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 4: Analyzing Statements of Cash Flows I The candidate should be able to: a. Describe how the cash flow statement is linked to the income statement and the balance sheet b. Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data c. Demonstrate the conversion of cash flows from the indirect to direct method d. Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP) Knowledge | Skills | Conduct 19 Components and Format of the Cash Flow Statement Organization of statement of cash flows Cash flows from operations (CFO) +/- Cash flow from investing (CFI) +/- Cash flow from financing (CFF) +/- Effect of exchange rate changes on cash = Change in cash account + Beginning period cash = Ending cash balance Knowledge | Skills | Conduct 20 Components and Format of the Cash Flow Statement International accounting differences US GAAP IAS GAAP Interest received CFO CFO or CFI Interest paid CFO CFO or CFF Dividends CFO CFO or CFI received Dividends paid CFF CFO or CFF Considered part of cash and cash Bank overdrafts CFF equivalents CFO but some can be allocated Taxes paid CFO to CFI/CFF if appropriate Direct or indirect, reconciliation of Format net income to CFO regardless of Direct or indirect method used Knowledge | Skills | Conduct 21 Components and Format of the Cash Flow Statement Cash Flows from Operations (CFO) Revenue Cost of goods sold Gross profit Selling general and admin expenses Income before interest and tax ( = EBIT) Financing costs Pre-tax earnings ( = EBT) Income tax expense Net income ( = EAT) Direct method CFO OR Indirect method CFO Knowledge | Skills | Conduct 22 Components and Format of the Cash Flow Statement Direct method Calculation of cash flows from operations (CFO) Step 1 Cash collections Step 2 - Cash inputs Step 3 - Other cash outflows = Cash flows from operations (CFO) Knowledge | Skills | Conduct 23 Components and Format of the Cash Flow Statement Indirect method Calculation of cash flows from operations (CFO) Net income + Non-cash expenses - Non-cash revenues + Decreases in accounts receivables/inventories - Increase in accounts receivables/inventories + Increase in accounts payable/tax payable/interest payable - Decrease in accounts payable/tax payable/interest payable - Gain on disposal of an asset + Loss on disposal of an asset = Cash flows from operations (CFO) Knowledge | Skills | Conduct 24 Components and Format of the Cash Flow Statement Example 1: Components of cash-flow statement Given the following data, compute the operating cash flows from customers $ Opening accounts receivable 118,000 Ending accounts receivable 133,000 Sales 1,200,000 A. 1,185,000 B. 1,200,000 C. 1,215,000 Knowledge | Skills | Conduct 25 Components and Format of the Cash Flow Statement Cash flow from investing calculations Gains and losses on disposal of assets - Included in net income in income statement - Gain = proceeds > Net book value - Loss = proceeds < Net book value - Remove from net income to calculate CFO Deduct a gain Add back a loss Proceeds - Include in CFI Proceeds from sale = Inflow (+ CFI) Purchase = Outflow (- CFI) Knowledge | Skills | Conduct 26 Components and Format of the Cash Flow Statement Example 2: Components of cash flow statement Given the following data, compute the cash flow from investing. $ Opening book value of assets 230,000 Ending book value of assets 180,000 Book value of assets disposed 30,000 Gain on sale of assets 15,000 Depreciation in period 100,000 A. +45,000 B. -80,000 C. -35,000 Knowledge | Skills | Conduct 27 Components and Format of the Cash Flow Statement Example 3: Cash flow calculation Given the following data and assuming US GAAP, what is the cash flow from operations. Net income $1,560 Depreciation $250 Increase in inventory $180 Increase in accounts payable $100 Profit on disposal of fixed assets $85 Dividends paid $230 Decrease in accounts receivable $110 A. $1,755 B. $1,840 C. $1,925 Knowledge | Skills | Conduct 28 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 5: Analyzing Statements of Cash Flows II The candidate should be able to: a. Analyze and interpret both reported and common-size cash flow statements b. Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios Knowledge | Skills | Conduct 29 Cash Flow Statement Analysis Free cash flow Excess of operating cash flow over capital expenditure Free cash flow to the firm (FCFF) Cash available to the company’s suppliers of debt and equity capital FCFF = NI + NCC + Int(1 - Tax rate) - FCInv - WCInv Where: NI = Net income NCC = Non-cash charges Int = Interest expense FCInv = Capital expenditures WCInv = Working capital expenditures FCFF = CFO + Int(1 - Tax rate) - FCInv Knowledge | Skills | Conduct 30 Cash Flow Statement Analysis Free cash flow to equity (FCFE) Cash available to the company’s common stockholders after repayment of debt (principal and interest) FCFE = CFO - FCInv - Net debt repayment Debt repayments exceed receipts of borrowed funds FCFE = CFO - FCInv + Net borrowing Receipts of borrowed funds exceed debt repayments Knowledge | Skills | Conduct 31  Solutions to Examples Knowledge | Skills | Conduct 32 Earnings Per Share Solution 2: Basic EPS calculation Net income - Preference dividends Basic EPS = Weighted average number of common shares Net income less preference dividends = $50,000 - $20,000 = $30,000 Weighted average shares: 5,000 x 1.1 x (12 / 12) = 5,500 +2,000 x 1.1 x (9 / 12) = 1,650 - 1,500 x (4 /12) = (500) 6,650 $30,000 / 6,650 = $4.51 Using the treasury stock method the stock dividend is assumed to occur at the beginning of the year (although it occurred in July). This is the method adopted by the accounting standard setters. Knowledge | Skills | Conduct 33 Earnings Per Share Solution 3: Convertible debt Basic EPS = Net income - Preference dividends / Weighted average number of shares Basic EPS = $23,120 - $20,000 / 4,000 = $0.78 Diluted EPS Earnings - Net Income - Preference dividends = $23,120 - $20,000 - + Convertible debt post tax interest SAVED + [(0.08 x $120,000) x (1 - 0.40) Shares - Weighted average number of shares = 4,000 - + Shares on conversion of debt + 12,000 Diluted EPS = $8,880 / 16,000 = $0.555 $0.555 < $0.78 therefore the convertible debt is dilutive and diluted EPS will be shown as $0.555 Knowledge | Skills | Conduct 34 Earnings Per Share Solution 4: Convertible preference stock Basic EPS = Net income - Preference dividends / Weighted average number of shares Basic EPS = $23,120 - $20,000 / 4,000 = $0.78 Diluted EPS Earnings - Net Income - Preference dividends = $23,120 - $20,000 - + Convertible preference dividends saved + $20,000 Shares - Weighted average number of shares = 4,000 - + Shares on conversion of preference stock + 40,000 Diluted EPS = $23,120 / 44,000= $0.525 $0.525 < $0.78 therefore the convertible preference stock is dilutive and diluted EPS will be shown as $0.525 Knowledge | Skills | Conduct 35 Earnings Per Share Solution 5: Options/warrants Basic EPS as in previous examples = $0.78 Calculate number of dilutive shares from exercise of options - Number of shares issued assuming all options are exercised = 2,000 x 10 = 20,000 shares - Proceeds generated from exercise of options = 2,000 x 10 x $15 = $300,000 - Amount of shares that could repurchased using proceeds = $300,000 / $20 = 15,000 shares - Amount of ‘dilutive’ shares = 20,000 issued shares - 15,000 repurchased = 5,000 shares Diluted EPS = $23,120 - $20,000 / ( 4,000 + 5,000) = $0.34667 Alternatively use the following formula to calculate number of dilutive shares: - (Average price - Exercise price / Average price) x Number of shares issued = ($20 - $15 / $20) x 20,000 = 5,000 dilutive shares Knowledge | Skills | Conduct 36 Components and Format of the Cash Flow Statement Solution 1: Components of cash flow statement Given the following data, compute the operating cash flows from customers $ Opening accounts receivable 118,000 Ending accounts receivable 133,000 Sales 1,200,000 1,185,000 Alternative calculation Revenue - Increase in receivables = Cash flow from customers $1.2m - $15,000 = $1,185,000 Knowledge | Skills | Conduct 37 Components and Format of the Cash Flow Statement Solution 2: Components of cash flow statement Given the following data, compute the cash flow from investing $ Opening book value of assets 230,000 Depreciation in period (100,000) Book value of assets disposed (30,000) 100,000 Ending book value of assets 180,000 Assets purchased 80,000 Cash proceeds: Book value of assets sold 30,000 Add gain on sale 15,000 45,000 Net outflow ($80,000 outflow less $45,000 inflow) 35,000 Knowledge | Skills | Conduct 38 Components and Format of the Cash Flow Statement Solution 3: Cash flow calculation Given the following data and assuming US GAAP, what is the cash flow from operations. Net income $1,560 $1,560 Depreciation $250 + $250 Increase in inventory $180 - $180 Increase in accounts payable $100 + $100 Profit on disposal of fixed assets $85 - $85 Dividends paid $230 N/A Decrease in accounts receivable $110 + $110 Cash flow from operations Option A - $1,755 Knowledge | Skills | Conduct 39  Level I CFA® Program Financial Statement Analysis (FSA2) Knowledge | Skills | Conduct 40 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 3: Financial Analysis Techniques The candidate should be able to: a. Describe tools and techniques used in financial analysis, including their uses and limitations b. Calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios c. Describe the relationships among ratios and evaluate a company using ratio analysis d. Demonstrate the application of the DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components e. Describe the uses of industry-specific ratios used in financial analysis f. Describe how ratio analysis and other techniques can be used to model and forecast earnings g. Describe how ratio analysis and other techniques can be used to model and forecast earnings Knowledge | Skills | Conduct 41 Common Ratios Used in Financial Analysis Classification of ratios Measures how efficiently a company performs Activity day-to-day tasks Measures the company’s ability to pay short- Liquidity term obligations Measures the company’s ability to pay long- Solvency term obligations Measures the company’s ability to generate Profitability profitable sales from its resources Measures the quantity of an asset or earnings Valuation associated with ownership of a share Knowledge | Skills | Conduct 42 Common Ratios Used in Financial Analysis Activity ratios Cost of goods sold Inventory turnover = Average inventory Net sales Receivables turnover = Average receivables Purchases Payables turnover = Average payables Inventory processing (days of inventory on hand (DOH)), payables payment and receivables collection (days of sales outstanding (DSO)) is a company’s cash conversion cycle 365 = ' Turnover' Knowledge | Skills | Conduct 43 Common Ratios Used in Financial Analysis Activity ratios ୅୴ୣ୰ୟ୥ୣ ୧୬୴ୣ୬୲୭୰୷ Days of inventory on hand (DOH) = ൈ 365 େ୭ୱ୲ ୭୤ ୥୭୭ୢୱ ୱ୭୪ୢ ୅୴ୣ୰ୟ୥ୣ ୰ୣୡୣ୧୴ୟୠ୪ୣୱ Days of sales outstanding (DSO) = ൈ 365 ୒ୣ୲ ୱୟ୪ୣୱ ୅୴ୣ୰ୟ୥ୣ ୮ୟ୷ୟୠ୪ୣୱ Days of payables ൌ x 365 ୔୳୰ୡ୦ୟୱୣୱ Cash conversion cycle = DOH + DSO − Payable days Knowledge | Skills | Conduct 44 Common Ratios Used in Financial Analysis Example 3.1: Turnover Calculate inventory turnover, receivables turnover, payables turnover and the inventory processing period for the following two businesses. Identify which is most likely a book publisher and which is most likely a training firm? Business 1 (US$) Business 2 (US$) Sales $2,400,000 $2,400,000 Opening inventory $120,000 $25,000 Purchases $1,100,000 $1,200,000 Ending inventory $180,000 $25,000 Cost of goods sold $1,040,000 $1,200,000 Average receivables $800,000 $200,000 Average payables $100,000 $400,000 Average inventory $150,000 $25,000 Knowledge | Skills | Conduct 45 Common Ratios Used in Financial Analysis Operational activity ratios Revenue Fixed asset turnover = Average net fixed assets Revenue Total asset turnover = Average total assets Revenue Working capital turnover = Average working capital Knowledge | Skills | Conduct 46 Common Ratios Used in Financial Analysis Liquidity ratios Current assets Current ratio = Current liabilities Cash + Marketable securities + Receivables Quick ratio = Current liabilities Cash + Marketable securities Cash ratio = Current liabilities Cash + Marketable securities + Receivable s Defensive interval ratio = Daily cash expenditure Cash conversion cycle = DOH + DSO − Payable days Knowledge | Skills | Conduct 47 Common Ratios Used in Financial Analysis Solvency ratios – debt ratios Debt - to - assets = Total interest - Bearing debt Total assets Total interest - Bearing debt Debt - to - capital = Total interest - Bearing debt + Total equity Total interest - Bearing debt Debt - to - equity = Total equity Average total assets Financial leverage ratio = Average total equity Total debt Debt - to - EBITDA = EBITDA Knowledge | Skills | Conduct 48 Common Ratios Used in Financial Analysis Solvency ratios – coverage ratios EBIT Interest cover = Interest payments EBIT + Lease payments Fixed charge cover = Interest payments + Lease payments Knowledge | Skills | Conduct 49 Common Ratios Used in Financial Analysis Profitability ratios Gross profit Gross profit margin = Revenue Operating income Operating profit margin = Revenue EBT Pretax margin = Revenue Net income Net profit margin = Revenue Knowledge | Skills | Conduct 50 Common Ratios Used in Financial Analysis Profitability ratios Operating income Operating ROA = Average total assets Net income Return on Assets(ROA) = Average total assets EBIT Return on total capital = Short - term and long - term debt and equity Net income (EAT) Return on equity (ROE) = Average total equity Net income - preferred dividends Return on common equity = Average common equity Knowledge | Skills | Conduct 51 Common Ratios Used in Financial Analysis Basic DuPont decomposition of ROE Net income ROE = Average shareholders' equity ROE = ROA x Leverage Net income Average total assets = x Average total assets Average shareholders' equity Knowledge | Skills | Conduct 52 Common Ratios Used in Financial Analysis Basic DuPont decomposition of ROE EAT Revenue Assets Return on total equity = x x Revenue Assets Equity Net profit margin Asset turnover Leverage Knowledge | Skills | Conduct 53 Common Ratios Used in Financial Analysis Extended DuPont decomposition of ROE EAT EBT EBIT REVENUE ASSETS ROE = x x x x EBT EBIT Revenue Assets Equity Tax burden Interest burden EBIT margin Asset turnover Leverage Knowledge | Skills | Conduct 54 Common Ratios Used in Financial Analysis Example 3.2: DuPont A company’s sales are $1,000,000, assets are $800,000 and net income is $120,000. Given that the company’s debt-to-assets is 50%, what is the return on equity? A. 15% B. 20% C. 30% Knowledge | Skills | Conduct 55 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 6: Analysis of Inventories The candidate should be able to: a. Describe the measurement of inventory at the lower of cost and net realisable value and its implications for financial statements and ratios b. Calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods c. Describe the presentation and disclosures relating to inventories and explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information Knowledge | Skills | Conduct 56 Cost of Inventories Cost of sales Calculation: Cost of sales = Beginning inventory (BI) + Purchases (P) - Ending inventory (EI) Effect of misstatement on balance sheet and income statement - Ending inventory too high Assets overstated, cost of sales understated, profit overstated - Ending inventory too low Assets understated, cost of sales overstated, profit understated Knowledge | Skills | Conduct 57 Inventory Valuation Methods Methods Identify the items sold in the period U.S. GAAP - Specific identification E.g. Expensive items that can easily be separately identified - Weighted average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) Oldest goods are sold first Newest goods are sold first Cost of sales reflects oldest Cost of sales reflects most prices, relatively understated recent prices, relatively overstated Ending inventory is Ending inventory is based on current prices based on oldest prices IFRS - Does not allow LIFO to be used, due to distortion of balance sheet Knowledge | Skills | Conduct 58 Inventory Valuation Methods Example 6.1: FIFO/LIFO/Weighted Average Cost Consider the following inventory data: 1 January Beginning inventory 4 units @ $2/unit $8 10 January - Purchases 6 units @ $3/unit $18 20 January - Purchases 10 units @ $5/unit $50 Units sold at end of 14 units @ $10/unit $140 January Calculate cost of sales, ending inventory, and gross profit using: FIFO LIFO Weighted average cost Knowledge | Skills | Conduct 59 Inventory Valuation Methods Solution 6.1: FIFO/LIFO/Weighted Average Cost FIFO - Oldest items sold first Revenue 14 units $10 $140 Beginning inventory 4 units $2 $8 Plus: Purchases 6 units $3 $18 10 units $5 $50 20 units $76 Less: Ending inventory Cost of sales Gross profit Knowledge | Skills | Conduct 60 Inventory Valuation Methods Solution 6.1: FIFO/LIFO/Weighted Average Cost (cont.) LIFO - Newest items sold first Revenue 14 units $10 $140 Beginning inventory 4 units $2 $8 Plus: Purchases 6 units $3 $18 10 units $5 $50 20 units $76 Less: Ending inventory Cost of sales Gross profit Knowledge | Skills | Conduct 61 Inventory Valuation Methods Solution 6.1: FIFO/LIFO/Weighted Average Cost (cont.) Weighted average cost Revenue 14 units $10 $140 Beginning inventory 4 units $2 $8 Plus: Purchases 6 units $3 $18 10 units $5 $50 20 units $76 Less: Ending inventory Cost of sales Gross profit Knowledge | Skills | Conduct 62 Inventory Valuation Methods Solution 6.1: FIFO/LIFO/Weighted Average Cost (cont.) Summary Cost of sales Ending inventory Gross profit FIFO $46 $30 $94 LIFO $62 $14 $78 Weighted average cost $53 $22.8 $86.8 Knowledge | Skills | Conduct 63 Inventory Valuation Methods Comparison of inventory valuation methods Where prices are rising and inventory quantity is stable or rising LIFO inventory < FIFO inventory LIFO cost of sales > FIFO cost of sales LIFO income < FIFO income Financial analysis Stable prices - Little difference between the methods Prices are rising, or there are more mature businesses - Analysts will need to take more care - Balance sheet FIFO inventory values resemble current cost or market value LIFO inventory values resemble out-of-date costs - Income statement LIFO profit measured using current cost (understated) FIFO profit measure using old costs (overstated) Knowledge | Skills | Conduct 64 The LIFO Method LIFO reserve Under US GAAP, companies using the LIFO method must disclose in the notes or the balance sheet, the amount of the LIFO reserve LIFO Reserve is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if FIFO was used FIFO inventory = LIFO inventory + LIFO reserve Retained earnings (FIFO) = Retained earnings (LIFO) + LIFO reserve x (1 - Tax rate) FIFO cost of goods sold = LIFO COGS - Change in LIFO reserve FIFO net income = LIFO net income + Change in LIFO reserve x (1 - Tax rate) Knowledge | Skills | Conduct 65 The LIFO Method Example 6.2: LIFO to FIFO Adjust from LIFO to FIFO - Year end LIFO inventory: $14,000 - Year end LIFO reserve: $10,000 - Previous year’s LIFO reserve: $8,000 - LIFO COGS: $40,000 - After tax income: $2,400 - Income tax rate: 40% Estimate inventory, COGS, net income, and change in retained earnings on a FIFO basis Knowledge | Skills | Conduct 66 Inventory Valuation Methods Inventory liquidation Occurs when number of items sold > items purchased - E.g. a company running down its inventory levels LIFO income > FIFO income - LIFO cost of sales < FIFO cost of sales - Due to ‘low cost’ LIFO items being included in cost of sales Example 6.3: Inventory liquidation Use the data from the previous example (below). Assume in the next period one item is sold from inventory at a price of $10 Number of units in inventory Valuation FIFO 6 units @ $5 $30 4 units @ $2 LIFO 2 units @ $3 $14 Knowledge | Skills | Conduct 67 Inventory Valuation Methods Solution 6.3: Inventory liquidation Use the data from the previous example, as shown below. Assume that one item is sold from inventory at a price of $10 in the next period Number of units in inventory Valuation FIFO 6 units @ $5 $30 4 units @ $2 LIFO 2 units @ $3 $14 FIFO LIFO Revenue 1 unit $10 Revenue 1 unit $10 Cost of Cost of sales sales Gross Gross profit profit Knowledge | Skills | Conduct 68 Measurement of Inventory Value IFRS Lower of cost and net realizable value (NRV) - Estimated selling price less costs required to make the sale Inventory write-down required - Balance sheet value > NRV - Inventory reduced to NRV - Impairment expense deducted in income statement Assets reduced, equity (retained earnings) reduced Impairments can be reversed U.S. GAAP Lower of cost and net realizable value (NRV) Exceptions – Inventories under LIFO and retail inventory methods - Lower of cost and market value Market value (fair value) - Upper limit: Cannot exceed NRV - Lower limit: NRV - Normal profit margin Reversal of impairment not permitted Knowledge | Skills | Conduct 69 Measurement of Inventory Value Example 6.4: Measurement of inventory value Pinnacle Products manufactures picnic tables. Inventory was valued at $7.2m in the balance sheet in 20X8 before any impairment. 20X8 inventory impairment = $0.3m. In 20X9 the circumstances that led to the write down ceased. 20X9 fair value = $8m. What were the income effects in 20X8 and 20X9 if Pinnacle Products prepares its accounts using IFRS or U.S. GAAP? Knowledge | Skills | Conduct 70 Evaluation of Inventory Management Inventory ratios In periods of rising prices and stable or increasing inventory levels FIFO LIFO Inventory Higher Lower Shareholder equity Higher Lower Earnings Higher Lower Pre-tax cash flow Same Same After-tax cash flow Lower Higher Profit margins (Profit / Revenue) Higher Lower Asset turnover (Revenue / Lower Higher Assets) Current ratio (CA / CL) Higher Lower Debt to equity (Debt / Equity) Lower Higher Knowledge | Skills | Conduct 71  Solutions to Examples Knowledge | Skills | Conduct 72 Common Ratios Used in Financial Analysis Solution 3.1: Turnover Business 1 (US$) Business 2 (US$) Inventory Cost of sales / $1,040,000 / $150,000 = $1,200,000 / $25,000 = turnover Average inventory 6.93x 48x Inventory 365 / Inventory processing 365 / 6.93 = 52.6 days 365 / 48 = 7.6 days turnover period (DOH) Net sales / Receivables $2,400,000 / 200,000 = Average $2,400,000 / $800,000 = 3x turnover 12x receivables Receivables 365 / Receivables collection 365 / 3 = 121.7 days 365 / 12 = 30.4 days turnover (DOS) Payables Purchases / $1,200,000 / $400,000 = $1,100,000 / $100,000 = 11x turnover Average payables 3x Payables 365 / Payables 365 / 11 = 33.2 days 365 / 3 = 121.7 days payment period turnover Knowledge | Skills | Conduct 73 Common Ratios Used in Financial Analysis Solution 3.2: DuPont A company’s sales are $1,000,000, assets are $800,000 and net income is $120,000. Given that the company’s debt-to-assets is 50%, what is the return on equity? A. 15% B. 20% C. 30% Return on equity = Net margin x Asset turnover x Financial leverage Return on equity = 120,000/1,000,000 x 1,000,000/800,000 x Financial leverage Financial leverage = Assets/Equity, so if debt-to-assets = 50% then equity-to-assets = 50 which means assets/equity = 1/0.5 = 2 Return on equity = 120,000/1,000,000 x 1,000,000/800,000 x 2 = 30% Answer is C Knowledge | Skills | Conduct 74 Inventory Valuation Methods Solution 6.1: FIFO/LIFO/Weighted average cost FIFO - Oldest items sold first Revenue 14 units $10 $140 Beginning inventory 4 units $2 $8 Plus: Purchases 6 units $3 $18 10 units $5 $50 20 units $76 Less: Ending inventory -6 units $5 -$30 Cost of sales 14 units -$46 Gross profit $94 Knowledge | Skills | Conduct 75 Inventory Valuation Methods Solution 6.1: FIFO/LIFO/Weighted average cost (cont.) LIFO - Newest items sold first Revenue 14 units $10 $140 Beginning inventory 4 units $2 $8 Plus: Purchases 6 units $3 $18 10 units $5 $50 20 units $76 Less: Ending inventory -4 units $2 -$8 -2 units $3 -$6 Cost of sales 14 units -$62 Gross profit $78 Knowledge | Skills | Conduct 76 Inventory Valuation Methods Solution 6.1: FIFO/LIFO/Weighted average cost (cont.) Weighted average cost Revenue 14 units $10 $140 Beginning inventory 4 units $2 $8 Plus: Purchases 6 units $3 $18 10 units $5 $50 20 units $76 Less: Ending inventory -6 units $3.80 -$22.8 Cost of sales 14 units -$53.2 Gross profit $86.8 Knowledge | Skills | Conduct 77 Inventory Valuation Methods Solution 6.1: FIFO/LIFO/Weighted average cost (cont.) Summary Ending Cost of sales Gross profit inventory $46 $30 $94 FIFO $62 $14 $78 LIFO Weighted average $53 $22.8 $86.8 cost Knowledge | Skills | Conduct 78 The LIFO Method Solution 6.2: LIFO to FIFO FIFO inventory = LIFO inventory plus LIFO reserve = $14,000 + $10,000 = $24,000 FIFO COGS = LIFO COGS - Change in LIFO reserve = $40,000 - (10,000 - 8,000) = $38,000 FIFO net income = LIFO net income plus change in LIFO reserve post tax = $2,400 + (10,000 - 8,000) (1 - 0.40) = $3,600 Change in retained earnings = LIFO reserve x (1 - Tax rate) = $10,000 x (1 - 0.40) = $6,000 Knowledge | Skills | Conduct 79 Inventory Valuation Methods Solution 6.3: Inventory liquidation Use the data from the previous example, as shown below. Assume that one item is sold from inventory at a price of $10 in the next period. Number of units in inventory Valuation FIFO 6 units @$5 $30 LIFO 4 units @ $2 2 units @ $3 $14 FIFO LIFO Revenue 1 unit $10 Revenue 1 unit $10 Cost of 1 unit @ $5 Cost of 1 unit @ $3 sales $5 sales $3 Gross $5 Gross $7 profit profit Knowledge | Skills | Conduct 80 Measurement of Inventory Value Solution 6.4: Measurement of inventory value U.S. GAAP - 20X8 inventory valued at $7.2m - $0.3m = $6.9m - 20X9 inventory $6.9m Reversal of impairment not permitted under U.S. GAAP IFRS - 20X8 inventory valued at $7.2m - $0.3m = $6.9m - 20X9 inventory $7.2m Reversal of impairment permitted under IFRS Inventory cannot be revalued above original cost Knowledge | Skills | Conduct 81  Level I CFA® Program Financial Statement Analysis (FSA3) Knowledge | Skills | Conduct 82 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 1: Introduction to Financial Statement Analysis The candidate should be able to: a. Describe the steps in the financial statement analysis framework b. Describe the roles of financial statement analysis c. Describe the importance of regulatory filings, financial statement notes and supplementary information, management’s commentary, and audit reports d. Describe implications for financial analysis of alternative financial reporting systems and the importance of monitoring developments in financial reporting standards e. Describe information sources that analysts use in financial statement analysis besides annual and interim financial reports Knowledge | Skills | Conduct 83 Scope of Financial Statement Analysis The role of financial reporting Provide information Company performance Financial position Changes in financial position Useful to a wide range of users in making economic decisions The role of financial statement analysis Analyze financial reports and other information Evaluate - Past, current and prospective performance and financial position of a company Purpose - Making investment, credit, and other economic decisions Knowledge | Skills | Conduct 84 Scope of Financial Statement Analysis Evaluating a Deciding whether Evaluating equity Evaluating a subsidiary or to make a investment for merger or operating division venture capital or inclusion in a acquisition of a parent other private portfolio candidate company equity investment Valuing a security Determining Examples of economic for making an credit-worthiness decisions investment of a company recommendation Assigning a debt Examining Forecasting Extending credit rating to a compliance with future net income to a customer company or bond debt covenants and cash flow issues Knowledge | Skills | Conduct 85 Scope of Financial Statement Analysis Analysis of performance Assessment of profitability and cash flow generating ability Profitability - Earn a profit from delivering goods and services Cash flow - Cash is needed to pay employees, suppliers etc. - Essential to continue as a going concern - Positive cash flow leads to funding flexibility Liquidity - Ability to meet short-term obligations Solvency - Ability to meet long-term obligations Knowledge | Skills | Conduct 86 Other Information Sources Auditor’s reports Examination by an independent accounting firm - Express an opinion on the truth and fairness of the financial statements International standards - International Auditing and Assurance Standards Board (IAASB) of International Federation of Accountants (IFAC) US standards - Public Company Accounting Oversight Board (PCAOB) - Sarbanes-Oxley Act Audit report - Provides reasonable assurance financial statements are fairly presented High degree of probability statements are free from material error, fraud, or illegal acts Knowledge | Skills | Conduct 87 Other Information Sources Independent audit report Provides unqualified audit opinion (clean opinion) True and fair view (IFRS) Fairly presented (IFRS and US) Adverse opinion - Financial statements materially depart from accounting standards - Not fairly presented - No point in performing any financial analysis - Statements cannot be relied on Disclaimer of opinion - Auditors are unable to have an opinion for some reason E.g. destruction of accounting records Sarbanes-Oxley - Auditors must express an opinion on internal control system Knowledge | Skills | Conduct 88 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 3: Analyzing Balance Sheets The candidate should be able to: a. Explain the financial reporting and disclosures related to intangible assets b. Explain the financial reporting and disclosures related to goodwill c. Explain the financial reporting and disclosures related to financial instruments d. Explain the financial reporting and disclosures related to non-current liabilities e. Ealculate and interpret common-size balance sheets and related financial ratios Knowledge | Skills | Conduct 89 Components and Format of the Balance Sheet Balance sheet format 20X1 Current assets - Cash and cash equivalents 2,100,000 - Inventories 300,000 - Trade and other receivables 150,000 - Prepaid expenses 120,000 - Financial assets 550,000 - Deferred tax assets 120,000 Non-current assets - Plant, property and equipment 4,500,000 - Investment property 1,400,000 - Intangible assets 350,000 - Assets held for sale 130,000 Total assets 9,720,000 Knowledge | Skills | Conduct 90 Components and Format of the Balance Sheet Balance sheet format 20X1 Current liabilities - Notes payable 1,350,000 - Trade and other payables 450,000 - Current income tax liability 150,000 - Provisions 120,000 - Accrued and other current liabilities 550,000 Non-current liabilities - Long-term debt 2,300,000 - Deferred income tax 430,000 - Post-employment benefit liabilities 210,000 Equity - Capital and reserves 3,940,000 - Minority interest 220,000 Total liabilities and equity 9,720,000 Knowledge | Skills | Conduct 91 Measurement Bases of Assets Historic cost Reliable and objectively determined measurement base Fair value Users may prefer to know what the asset can be sold for May be difficult to estimate a current value Current model Mixed model using both historic and fair values Balance sheet is not a statement of corporate value Knowledge | Skills | Conduct 92 Measurement Bases of Assets Note that ALL realised gains/losses go through the Income Statement. The FOCUS of this slide is on UNREALISED gains/losses. Measured at Cost or Measured at Fair Value Measured at Fair Value Amortized Cost through Other through Profit and Loss Comprehensive Income Debt securities that ‘Available-for-sale’ debt All equity securities unless are to be held to securities (US GAAP) investment gives the maturity Debt where the investor significant Loans and notes business model involves influence (US GAAP only) receivable both collecting interest Trading debt securities Unquoted equity and principal and selling (US GAAP only) instruments the security (IFRS only) Securities not assigned to Note: Known as Equity investments for either of the other two ‘Held-to-maturity’ which the company categories, or investments under US GAAP irrevocably elects this for which the company measurement at irrevocably elects this acquisition (IFRS only) measurement at acquisition (IFRS only) Knowledge | Skills | Conduct 93 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 2: Analyzing Income Statements (Revisited) The candidate should be able to: a. Describe general principles of revenue recognition, specific revenue recognition applications, and implications of revenue recognition choices for financial analysis b. Describe general principles of expense recognition, specific expense recognition applications, implications of expense recognition choices for financial analysis and contrast costs that are capitalized versus those that are expensed in the period in which they are incurred c. Describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies d. Describe how earnings per share is calculated and calculate and interpret a company’s basic and diluted earnings per share for companies with simple and complex capital structures including those with antidilutive securities e. Evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement Knowledge | Skills | Conduct 94 Acquisition of Long-Lived Assets Long-lived assets Accounting for property, plant and equipment (PPE) - Tangible assets - Economic life longer than one year - Intended to be held for company’s own use - Recorded on balance sheet at cost Accounting for intangible assets - Depends on how the asset was acquired Capitalize vs. expensing Capitalize - Include an asset on balance sheet Expense - Include as a cost of the period in income statement - E.g., include in cost of sales, general, and administration Knowledge | Skills | Conduct 95 Acquisition of Long-Lived Assets Capitalizing Year of expenditure - Increases assets, as asset is recognized on balance sheet - Reduces investing cash flow (CFI) Subsequent years - Depreciation/amortization expense reduces profit No impact on cash flow - Reduces value of asset in balance sheet Expensing Expensed if expenditure does not meet asset recognition criteria Reduces net income Reduces operating cash flow (CFO) No asset recorded on balance sheet Lower net income in current year No effect on financial statements in later years Knowledge | Skills | Conduct 96 Acquisition of Long-Lived Assets Example: Capitalizing vs. expensing Two firms Asset Inc. and Expense Inc. are identical in all respects. Both have $5,000 of cash and equity at the start of year 1. During this 3-year period: They both generated $7,500 of cash revenue and $2,500 of cash expenses per year They both purchased $4,500 of equipment at start of year 1 Expense Inc. takes this equipment purchase as an expense in year 1. Asset Inc. capitalizes the amount and then depreciates it to a zero salvage value over three years. Neither firm pays tax. Knowledge | Skills | Conduct 97 Acquisition of Long-Lived Assets Asset Inc. capitalize the asset and Expense Inc. charge expense to net depreciate income in Year 1 Year 1 2 3 Year 1 2 3 Revenue 7,500 7,500 7,500 Revenue 7,500 7,500 7,500 Cash 2,500 2,500 2,500 Cash 7,000 2,500 2,500 expenses expenses Depreciation 1,500 1,500 1,500 Depreciation Profit 3,500 3,500 3,500 Profit 500 5,000 5,000 CFO 5,000 5,000 5,000 CFO 500 5,000 5,000 CFI -4,500 0 0 CFI 0 0 0 Cash flow 500 5,000 5,000 Cash flow 500 5,000 5,000 Knowledge | Skills | Conduct 98 Acquisition of Long-Lived Assets Companies constructing their own assets All costs incurred in bringing the asset to its present location and condition are capitalized - I.e., the cost of the asset and the freight costs borne by the purchaser - Includes capitalization of interest expense associated with construction of assets Capitalization of interest costs Required by both US and IFRS GAAP Interest rate - Based on existing borrowings - Borrowing specifically incurred for constructing the asset Interest - Capitalized during construction only and added to asset cost - Reduced for interest earned on borrowings invested (IFRS only) - Depreciated over the life of the asset Knowledge | Skills | Conduct 99 Acquisition of Long-Lived Assets Example 1: Capitalization of interest A construction company has been constructing a head office over two years. The expected life of the building is 50 years and the cost of the building is $2,000,000. Borrowing to finance construction is $2,000,000 @ 10%. During construction, the company earns $10,000 on proceeds invested Calculate the total interest payable during construction Calculate interest capitalized during the years - U.S. GAAP - IFRS Calculate the depreciation expense on a straight-line basis - U.S. GAAP - IFRS Knowledge | Skills | Conduct 100 Acquisition of Long-Lived Assets Issues for analyst Capitalized interest is included in CFI - Normally interest payments are included in CFO (U.S. GAAP) or CFO/CFF (IFRS) Analyst should consider adjusting cash flow for this treatment Analyst should restate interest coverage ratios - Earnings before interest and tax/interest expense - Increase interest expense to include capitalized interest - Will result in lower interest coverage ratios - Better assessment of solvency of company Knowledge | Skills | Conduct 101 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 7: Analysis of Long-Term Assets The candidate should be able to: a. Compare the financial reporting of the following types of intangible assets: purchased, internally developed, and acquired in a business combination b. Explain and evaluate how impairment and derecognition of property, plant, and equipment and intangible assets affect the financial statements and ratios c. Analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets Knowledge | Skills | Conduct 102 Acquisition of Long-Lived Assets Intangible assets Assets that lack physical substance - E.g. patents, copyrights, franchises, brands, and trademarks IFRS criteria for recognition on balance sheet Identifiable - Capable of being separated from the entity or - Arising from legal or contractual rights Under the control of the company Expected to generate future economic benefits Probable that future economic benefits will flow to the company Cost of the asset can be reliably measured Goodwill Only arises when one company purchases another - Acquisition price > fair value of net identifiable assets acquired Knowledge | Skills | Conduct 103 Acquisition of Long-Lived Assets Intangible assets purchased in situations other than business combinations E.g. buying a patent Treated like acquiring long-lived tangible assets - Recorded at fair value (purchase price) when acquired Analyst should focus on understanding the type of asset acquired - Valuation is often a very subjective process Intangible assets developed internally Generally expensed when incurred - E.g. research costs (IFRS), R&D (U.S. GAAP) Exceptions - Development costs under IFRS if certain criteria are met - Software costs (U.S. GAAP) Software for sale Software intended to be used internally Knowledge | Skills | Conduct 104 Acquisition of Long-Lived Assets Analysis Expensing development costs - Results in lower net income in current period - If current period development expenses > amortization Will continue to result in lower net income Typically happens when development costs are increasing Organic growth vs. acquisition - Companies that have developed intangibles internally will have a smaller balance sheet - Differences in strategy can affect financial ratios Cash flow statement - Costs expensed will be included in CFO - Capitalized costs will be included in CFI Knowledge | Skills | Conduct 105 Acquisition of Long-Lived Assets Intangible assets acquired in a business combination One company acquires another - Accounted for using acquisition method - Allocate purchase price to each asset acquired - Excess of purchase price over fair value of assets acquired Goodwill Cannot be identified separately from business as a whole Knowledge | Skills | Conduct 106 Derecognition Definition Remove an asset from financial statements - E.g. asset is sold, exchanged, abandoned or distributed to existing shareholders Calculation of gain/loss on sale Proceeds - Carrying value in balance sheet (NBV) Proceeds > NBV = Gain Proceeds < NBV = Loss Gain/loss on disposal - Disclosed in income statement Component of other gains and losses or Separate line item if material Further detail in MD&A or footnotes Cash flow statement Net income + Loss on disposal - Gain on disposal = CFO - Proceeds (not gain or loss) included in CFI Knowledge | Skills | Conduct 107 Derecognition Other disposal methods Abandonment or exchange for another asset - Classified as ‘held for use’ until disposal - Depreciation and amortization is still charged Exchange - Derecognize old asset and recognize new asset Fair value of new asset > Net book value of asset given up = Gain Fair value of new asset < Net book value of asset given up = Loss Knowledge | Skills | Conduct 108 The Revaluation Model Long-lived assets Alternative to cost method for accounting for long-lived assets Not allowed under U.S. GAAP Asset value is increased to fair value on balance sheet - Uses market values rather than historic cost IFRS - Can use cost model for some assets and revaluation model for others - Must apply revaluation model to all assets within a particular class Avoids selective revaluation E.g. land, land and buildings, machinery, office equipment - Can be used for intangible assets Only if an active market for the asset exists - Increase in asset value is included in revaluation surplus in equity Gain is not recognized in income statement Knowledge | Skills | Conduct 109 The Revaluation Model Analyst considerations Upward revaluations will increase assets and equity - Improve leverage ratios such as debt/equity - Reduce return measures such as ROA or ROE Knowledge | Skills | Conduct 110 Impairment of Assets Impairments Reflect an unanticipated decline in the value of the asset Impairment of property, plant, and equipment No annual impairment review required Company needs to assess whether there are indications of impairment - E.g. evidence of obsolescence, decline in demand for products, or technological advancements Impairment reduces asset value on balance sheet Reduces net income in income statement No effect on cash flow statement Knowledge | Skills | Conduct 111 Impairment of Assets Impairments Required by both U.S. GAAP and IFRS Generally this means that the: - Carrying amount in balance sheet > Recoverable amount U.S. GAAP – Impairment if: - Carrying amount in balance sheet > Recoverable amount * - If impaired write down to: Fair value IFRS – Impairment if: - Carrying amount in balance sheet > Recoverable amount ** - If impaired write down to: Recoverable amount * Undiscounted expected future cash flows ** Higher of fair value less costs to sell and value in use (PV of expected future cash flows) Knowledge | Skills | Conduct 112 Impairment of Assets Calculation of impairment loss Example 1: Impairment expense PTS Inc. has collected the following data on a piece of business equipment. Carrying amount $80,000 Undiscounted expected future cash flows $100,000 PV of expected future cash flows $75,816 Fair value if sold $77,000 Selling costs $3,000 What would the impairment expense be under U.S. GAAP? What would the impairment expense be under IFRS? Knowledge | Skills | Conduct 113 Impairment of Assets Intangible assets with a finite life As for PPE, not tested annually for impairment Indication of possible impairment - Significant decrease in market price or significant adverse change in legal or economic factors Calculation of loss is the same as for PPE Intangible with indefinite lives No amortization charged during life of asset Annual impairment review Impairment - Carrying amount > Fair value Long-lived assets held for sale Assets management intend to sell or distribute to existing shareholders Not depreciated or amortized Tested for impairment when assets are reclassified Knowledge | Skills | Conduct 114 Impairment of Assets Reversals of impairments of long-lived assets Asset’s recoverable amount could increase in later years IFRS allows reversal of impairment U.S. GAAP - Assets held for use Reversals not permitted - Assets held for sale Reversals permitted Knowledge | Skills | Conduct 115 Impairment of Assets Example 2: Impairment of assets 20X5 - JSX Inc. purchased land for $100m 20X6 - Revalued to $150m when the company switched to the revaluation model 20X7 - Fair value = $80m due to a chemical spill 20X8 - Fair value = $160m after successful clean-up operation Calculate balance sheet values and income statement expense under both IFRS and U.S. GAAP Knowledge | Skills | Conduct 116 Impairment of Assets Solution 2: Impairment of assets 20X5 20X6 20X7 20X8 IFRS $m $m $m $m Balance sheet value 100 Revaluation surplus (equity) n/a Impairment expense n/a U.S. GAAP Balance sheet value 100 Revaluation surplus n/a Impairment expense n/a Knowledge | Skills | Conduct 117 Impairment of Assets U.S. GAAP IFRS Reversal of impairment of inventory Not allowed Permitted Reversal of impairment of Not allowed Permitted long-lived assets held for use Reversal of impairment of Permitted Permitted long-lived assets held for sale Reversal of impairment of intangible assets other than Not allowed Permitted goodwill Reversal of impairment of goodwill Not allowed Not allowed Revaluation of long-lived assets Not allowed Permitted Revaluation of goodwill Not allowed Not allowed Knowledge | Skills | Conduct 118  Solutions to Examples Knowledge | Skills | Conduct 119 Acquisition of Long-Lived Assets Solution 1: Capitalization of interest Calculate the total interest payable - $2m x 10% pa x 2 years = $400,000 Calculate interest capitalized during the year - U.S. GAAP Interest capitalized = $200,000 pa Cost of asset = $2m + $0.4m = $2.4m - IFRS The interest proceeds from investment of borrowings is deducted from amount of interest capitalized $400,000 - $10,000 = $390,000 Cost of asset = $2m + $0.39m = $2.39m Calculate the depreciation expense on a straight-line basis - U.S. GAAP $2.4m / 50 years = $48,000 - IFRS $2.39m / 50 years = $47,800 Knowledge | Skills | Conduct 120 Impairment of Assets Solution 1: Impairment expense U.S. GAAP - Carry value in balance sheet < Undiscounted cash flows - $80,000 < $100,000 - There is no impairment adjustment required as the future cash flows are in excess of carrying value IFRS - Carry value in balance sheet > Discounted cash flows - $80,000 > $75,816 - Asset value will be reduced by $4,184 ($80,000 - $75,816) - Income statement will have an expense of $4,184 Note: Discounted cash flows ($75,816) > Fair value less costs to sell ($77,000 - $3,000) Knowledge | Skills | Conduct 121 Impairment of Assets Solution 2: Impairment of assets IFRS 20X5 20X6 20X7 20X8 $m $m $m $m Balance sheet value 100 150 80 160 Revaluation surplus n/a 150 - 100 = 50 50 - 50 = 0 160 - 100 = 60 (equity) Impairment expense n/a n/a 20 Reversal -20 U.S. GAAP Balance sheet value 100 100 80 80 Revaluation surplus n/a n/a n/a n/a Impairment expense n/a n/a 20 No reversal Knowledge | Skills | Conduct 122  Level I CFA® Program Financial Statement Analysis (FSA4) Knowledge | Skills | Conduct 123 Coverage TOPIC – FINANCIAL STATEMENT ANALYSIS Learning Module 1: Analysis of Income Taxes The candidate should be able to: a. Contrast accounting profit, taxable income, taxes payable, and income tax expense and temporary versus permanent differences between accounting profit and taxable income b. Explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis c. Calculate, interpret, and contrast an issuer’s effective tax rate, statutory tax rate, and cash tax rate d. Analyze disclosures relating to deferred tax items and the effective tax rate reconciliation and explain how information included in these disclosures affects a company’s financial statements and financial ratios Knowledge | Skills | Conduct 124 Differences Between Accounting Profit and Taxable Income Terminology used in accounting for income taxes Accounting profit - Based on accounting standards - Pre-tax income or income before taxes Taxable income - Income subject to income taxes under tax law of jurisdiction - Basis for income tax payable Taxable income x Statutory income tax rate Income taxes owed or payable Income tax expense in income statement - Income taxes payable - Changes in deferred tax assets/liabilities (deferred tax expense) Income tax paid - Actual amount paid for income taxes - Reduces income tax liability in balance sheet Knowledge | Skills | Conduct 125 Differences Between Accounting Profit and Taxable Income Differences between accounting profit and taxable income Tax authorities have different rules for the recognition of income and expense compared to accounting standard setters Results in differences between pre-tax income and taxable income Permanent differences Income or expenses are included in either pre-tax income or taxable income but not both - Income or expense items not allowed by tax legislation - E.g. tax-exempt municipal bond interest - Tax credits for expenditure that reduces taxes No adjustment required to income tax expense Effective tax rate (ETR) ETR = Income tax expense / Pre-tax income Affected by permanent differences and different national statutory tax rates Knowledge | Skills | Conduct 126 Differences Between Accounting Profit and Taxable Income $ Pre-tax income from income statement X Add non tax-deductible expenditure, i.e. X depreciation Less tax exempt income -X Less tax allowances -X Taxable income X Income tax payable: Taxable income x Statutory rate X Knowledge | Skills | Conduct 127 Differences Between Accounting Profit and Taxable Income Example 1: Income taxes X Inc. has pre-tax income for the year of $10m. The statutory rate of tax is 30%. Pre-tax income includes municipal bond interest of $1m, which is tax-exempt income. Calculate: Taxable income Income taxes owed Income tax expense Effective tax rate Knowledge | Skills | Conduct 128 Differences Between Accounting Profit and Taxable Income Temporary differences between accounting profit and taxable income Income or expenses are included in both pre-tax income and taxable income but in different periods Revenues and expenses may be recognized in one period for accounting purposes and a different period for tax purposes - E.g. warranty expense recognized on an accruals basis for accounting purposes and cash basis for tax purposes Carrying amount and tax base of asset and/or liabilities may differ - E.g. accounting depreciation methods vs. tax depreciation methods Net book value vs. tax base See Clayton example later Deductibility of gains and losses of assets and liabilities may vary for accounting and income tax purposes - E.g. impairments are not recognized for tax purposes until asset is disposed of Tax losses from prior year might be used to reduce taxable income in later years Knowledge | Skills | Conduct 129 Differences Between Accounting Profit and Taxable Income Deferred tax liabilities (DTL) Pre-tax income > Taxable income - Difference due to a temporary timing difference - E.g. tax authorities calculate a depreciation allowance using double-declining balance with the company using straight-line depreciation in income statement Deferred tax assets (DTA) Pre-tax income < Taxable income E.g. accounting expenses not being recognized for tax purposes such as warranty expense E.g. losses deducted from taxable income in later periods Knowledge | Skills | Conduct 130 Differences Between Accounting Profit and Taxable Income Tax in income statement Income tax expense in the income statement comprises of two elements - Income taxes owed Based on taxable income Current tax payable - Deferred tax expense Based on temporary timing differences Tax due on temporary timing differences at some point in the future Knowledge | Skills | Conduct 131 Differences Between Accounting Profit and Taxable Income Calculation of deferred tax expense Income tax = Income taxes + Deferred tax Deferred tax - expense payable liability ending liability beginning Income tax = Income taxes Deferred tax Deferred tax asset - + expense owed asset ending beginning Recognition of DTL/increase in DTL - Increase in deferred tax expense - Decrease in net income Recognition of DTA/increase in DTA - Decrease in deferred tax expense - Increase in net income Knowledge | Skills | Conduct 132 Differences Between Accounting Profit and Taxable Income Example: Deferred tax liability method Clayton Inc. purchased an asset at $9,000 with an estimated useful life of three years and a salvage value of $nil. Depreciation is calculated using the straight line method. IRS depreciation is $5,000 and $4,000 in years one and two respectively. Clayton has EBITDA $10,000 in each year. Statutory income tax rate is 40%. Show income statement for the next three years: No deferred tax Accounting for deferred tax Knowledge | Skills | Conduct 133 Differences Between Accounting Profit and Taxable Income Solution: Deferred tax liability method Net book value vs. tax base Total Year 1 Year 2 Year 3 allowances $ $ $ Cost 9,000 9,000 9,000 Less accumulated depreciation -3,000 -6,000 -9,000 9,000 Net book value of asset in balance sheet 6,000 3,000 0 Cost 9,000 9,000 9,000 Less cumulative tax allowances -5,000 -9,000 -9,000 9,000 Tax base 4,000 0 0 Difference between net book value and 2,000 3,000 0 tax base The total depreciation and tax allowances are the same over the life of the asset