CFA 2020 - Level 1 SchweserNotes Book 3 (2) (1) - converted.pdf

 Average cost: Unit cost equals cost of goods available for sale divided by total units ava...

 Average cost: Unit cost equals cost of goods available for sale divided by total units available and is used for both COGS and inventory. KEY CONCEPTS Specific identification: Each item in inventory is identified and its historical cost is LOS 21.a used for calculating COGS when the item is sold. The income statement shows an entity’s revenues, expenses, gains and losses during a Intangible assets with limited lives should be amortized using a method that reflects the flow reporting period. over time of their economic benefits. Intangible assets with indefinite lives (e.g., goodwill) are not amortized. A multi-step income statement provides a subtotal for gross profit and a single step income statement does not. Expenses on the income statement can be grouped by the nature of the Users of financial data should analyze the reasons for any changes in estimates of expenses expense items or by their function, such as with expenses grouped into cost of goods sold. and compare these estimates with those of peer companies. LOS 21.b LOS 21.e Revenue is recognized when earned and expenses are recognized when incurred. Results of discontinued operations are reported below income from continuing operations, net of tax, from the date the decision to dispose of the operations is made. These results are Accounting standards identify a five-step process for recognizing revenue: segregated because they likely are non-recurring and do not affect future net income. 1. Identify the contract(s) with a customer. Unusual or infrequent items are reported before tax and above income from continuing 2. Identify the performance obligations in the contract. operations. An analyst should determine how “unusual” or “infrequent” these items really are 3. Determine the transaction price. for the company when estimating future earnings or firm value. 4. Allocate the transaction price to the performance obligations in the contract. Changes in accounting standards, changes in accounting methods applied, and corrections of 5. Recognize revenue when (or as) the entity satisfies a performance obligation. accounting errors require retrospective restatement of all prior-period financial statements included in the current statement. A change in an accounting estimate, however, is applied LOS 21.c prospectively (to subsequent periods) with no restatement of prior-period results. Information that can influence the choice of revenue recognition method includes progress LOS 21.f toward completion of a performance obligation, variable considerations and their likelihood of being earned, revisions to contracts, and whether the firm is acting as a principal or an Operating income is generated from the firm’s normal business operations. For a nonfinancial agent in a transaction. firm, income that results from investing or financing transactions is classified as non- operating income, while it is operating income for a financial firm since its business LOS 21.d operations include investing in and financing securities. The matching principle requires that firms match revenues recognized in a period with the LOS 21.g expenses required to generate them. One application of the matching principle is seen in accounting for inventory, with cost of goods sold as the cost of units sold from inventory that net income − preferred dividends are included in current-period revenue. Other costs, such as depreciation of fixed assets or basic EPS = weighted average number of common shares outstanding administrative overhead, are period costs and are taken without regard to revenues generated during the period. When a company has potentially dilutive securities, it must report diluted EPS. Depreciation methods: For any convertible preferred stock, convertible debt, warrants, or stock options that are Straight-line: Equal amount of depreciation expense in each year of the asset’s useful dilutive, the calculation of diluted EPS is: life. diluted EPS = Declining balance: Apply a constant rate of depreciation to the declining book value ⎡ ⎤ ⎡ ⎤ convertible convertible ]+⎢ preferred ⎥+ ⎢ ⎥(1–t) net preferred until book value equals residual value. [ – debt income dividends ⎣ dividends ⎦ ⎣ interest ⎦ Inventory valuation methods: ⎞ ⎛ shares from ⎞ ⎛ shares from ⎞ ⎛ ⎞ ⎛ weighted shares FIFO: Inventory reflects cost of most recent purchases, COGS reflects cost of oldest ⎜ average ⎟ +⎜ conversion of ⎟+⎜ conversion of ⎟+ ⎜ issuable from ⎟ ⎝ shares ⎠ ⎝ conv.pfd.shares ⎠ ⎝ conv.debt ⎠ ⎝ stock options ⎠ purchases. LIFO: COGS reflects cost of most recent purchases, inventory reflects cost of oldest LOS 21.h purchases. A dilutive security is one that, if converted to its common stock equivalent, would decrease EPS. An antidilutive security is one that would not reduce EPS if converted to its common stock equivalent. LOS 21.i KEY CONCEPTS A vertical common-size income statement expresses each item as a percentage of revenue. The common-size format standardizes the income statement by eliminating the effects of size. LOS 22.a Common-size income statements are useful for trend analysis and for comparisons with peer Assets are resources controlled as result of past transactions that are expected to provide firms. future economic benefits. Liabilities are obligations as a result of past events that are expected to require an outflow of economic resources. Equity is the owners’ residual interest LOS 21.j in the assets after deducting the liabilities. Common-size income statements are useful in examining a firm’s business strategies. A financial statement item should be recognized if a future economic benefit to or from the Two popular profitability ratios are gross profit margin (gross profit / revenue) and net profit firm is probable and the item’s value or cost can be measured reliably. margin (net income / revenue). A firm can often achieve higher profit margins by differentiating its products from the competition. LOS 22.b The balance sheet can be used to assess a firm’s liquidity, solvency, and ability to pay LOS 21.k dividends to shareholders. Comprehensive income is the sum of net income and other comprehensive income. It measures all changes to equity other than those from transactions with shareholders. Balance sheet assets, liabilities, and equity should not be interpreted as market value or intrinsic value. For most firms, the balance sheet consists of a mixture of values including LOS 21.l historical cost, amortized cost, and fair value. Transactions with shareholders, such as dividends paid and shares issued or repurchased, are Some assets and liabilities are difficult to quantify and are not reported on the balance sheet. not reported on the income statement. LOS 22.c Other comprehensive income includes other transactions that affect equity but do not affect net income, including: A classified balance sheet separately reports current and noncurrent assets and current and noncurrent liabilities. Alternatively, liquidity-based presentations, often used in the banking Gains and losses from foreign currency translation. industry, present assets and liabilities in order of liquidity. Pension obligation adjustments. LOS 22.d Unrealized gains and losses from cash flow hedging derivatives. Current (noncurrent) assets are those expected to be used up or converted to cash in less than Unrealized gains and losses on available-for-sale securities. (more than) one year or the firm’s operating cycle, whichever is greater. Current (noncurrent) liabilities are those the firm expects to satisfy in less than (more than) one year or the firm’s operating cycle, whichever is greater. LOS 22.e Cash equivalents are short-term, highly liquid financial assets that are readily convertible to cash. Their balance sheet values are generally close to identical using either amortized cost or fair value. Accounts receivable are reported at net realizable value by estimating bad debt expense. Inventories are reported at the lower of cost or net realizable value (IFRS) or the lower of cost or market (U.S. GAAP). Cost can be measured using standard costing or the retail method. Different cost flow assumptions can affect inventory values. Property, plant, and equipment (PP&E) can be reported using the cost model or the revaluation model under IFRS. Under U.S. GAAP, only the cost model is allowed. PP&E is impaired if its carrying value exceeds the recoverable amount. Recoveries of impairment losses are allowed under IFRS but not U.S. GAAP. Intangible assets created internally are expensed as incurred. Purchased intangibles are reported similar to PP&E. Under IFRS, research costs are expensed as incurred and development costs are capitalized. Both research and development costs are expensed under LOS 22.h U.S. GAAP. Balance sheet ratios, along with common-size analysis, can be used to evaluate a firm’s Goodwill is the excess of purchase price over the fair value of the identifiable net assets liquidity and solvency. Liquidity ratios measure the firm’s ability to satisfy its short-term (assets minus liabilities) acquired in a business acquisition. Goodwill is not amortized but obligations as they come due. Liquidity ratios include the current ratio, the quick ratio, and must be tested for impairment at least annually. the cash ratio. Under IFRS, debt securities acquired with intent hold them to maturity are measured at Solvency ratios measure the firm’s ability to satisfy its long-term obligations. Solvency ratios amortized cost. Debt securities acquired with the intent to collect interest payments but sell include the long-term debt-to-equity ratio, the total debt-to-equity ratio, the debt ratio, and the before maturity are measured at fair value through other comprehensive income. Debt financial leverage ratio. securities acquired with the intent to sell them in the near term, as well as equity securities and derivatives, are measured at fair value through profit and loss. IFRS permits firms to elect, irrevocably at the time of purchase, to measure equity securities at fair value through other comprehensive income, or any security at fair value through profit and loss. Under U.S. GAAP, held-to-maturity securities are reported at amortized cost. Trading securities, available-for-sale securities, and derivatives are reported at fair value. For trading securities and derivatives, unrealized gains and losses are recognized in the income statement. Unrealized gains and losses for available-for-sale securities are reported in equity (other comprehensive income). Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accrued liabilities are expenses that have been recognized in the income statement but are not yet contractually due. Unearned revenue is cash collected in advance of providing goods and services. Financial liabilities not issued at face value, like bonds payable, are reported at amortized cost. Held-for-trading liabilities and derivative liabilities are reported at fair value. LOS 22.f Owners’ equity includes: Contributed capital—the amount paid in by common shareholders. Preferred stock—capital stock that has certain rights and privileges not possessed by the common shareholders. Classified as debt if mandatorily redeemable. Treasury stock—issued common stock that has been repurchased by the firm. Retained earnings—the cumulative undistributed earnings of the firm since inception. Noncontrolling (minority) interest—the portion of a subsidiary that is not owned by the parent. Accumulated other comprehensive income—includes all changes to equity from sources other than net income and transactions with shareholders. The statement of changes in stockholders’ equity summarizes the transactions during a period that increase or decrease equity, including transactions with shareholders. LOS 22.g A vertical common-size balance sheet expresses each item of the balance sheet as a percentage of total assets. The common-size format standardizes the balance sheet by eliminating the effects of size. This allows for comparison over time (time-series analysis) and across firms (cross-sectional analysis).  Cash collections from customers—sales adjusted for changes in receivables and unearned revenue. KEY CONCEPTS Cash paid for inputs—COGS adjusted for changes in inventory and accounts payable. LOS 23.a Cash operating expenses—SG&A adjusted for changes in related accrued liabilities or Cash flow from operating activities (CFO) consists of the inflows and outflows of cash prepaid expenses. resulting from transactions that affect a firm’s net income. Cash interest paid—interest expense adjusted for the change in interest payable. Cash flow from investing activities (CFI) consists of the inflows and outflows of cash Cash taxes paid—income tax expense adjusted for changes in taxes payable and resulting from the acquisition or disposal of long-term assets and certain investments. changes in deferred tax assets and liabilities. The indirect method of calculating CFO begins with net income and adjusts it for gains or Cash flow from financing activities (CFF) consists of the inflows and outflows of cash losses related to investing or financing cash flows, noncash charges to income, and changes resulting from transactions affecting a firm’s capital structure, such as issuing or repaying in balance sheet operating items. debt and issuing or repurchasing stock. CFI is calculated by determining the changes in asset accounts that result from investing LOS 23.b activities. The cash flow from selling an asset is its book value plus any gain on the sale (or Noncash investing and financing activities, such as taking on debt to the seller of a purchased minus any loss on the sale). asset, are not reported in the cash flow statement but must be disclosed in the footnotes or a supplemental schedule. CFF is the sum of net cash flows from creditors (new borrowings minus principal repaid) and net cash flows from shareholders (new equity issued minus share repurchases minus cash LOS 23.c dividends paid). Under U.S. GAAP, dividends paid are financing cash flows. Interest paid, interest received, LOS 23.g and dividends received are operating cash flows. All taxes paid are operating cash flows. An indirect cash flow statement can be converted to a direct cash flow statement by adjusting Under IFRS, dividends paid and interest paid can be reported as either operating or financing each income statement account for changes in associated balance sheet accounts and by cash flows. Interest received and dividends received can be reported as either operating or eliminating noncash and non-operating items. investing cash flows. Taxes paid are operating cash flows unless they arise from an investing or financing transaction. LOS 23.h An analyst should determine whether a company is generating positive operating cash flow LOS 23.d over time that is greater than its capital spending needs and whether the company’s Under the direct method of presenting CFO, each line item of the accrual-based income accounting policies are causing reported earnings to diverge from operating cash flow. statement is adjusted to get cash receipts or cash payments. The main advantage of the direct method is that it presents clearly the firm’s operating cash receipts and payments. A common-size cash flow statement shows each item as a percentage of revenue or shows each cash inflow as a percentage of total inflows and each outflow as a percentage of total Under the indirect method of presenting CFO, net income is adjusted for transactions that outflows. affect net income but do not affect operating cash flow, such as depreciation and gains or losses on asset sales, and for changes in balance sheet items. The main advantage of the LOS 23.i indirect method is that it focuses on the differences between net income and operating cash Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners flow. This provides a useful link to the income statement when forecasting future operating and debt holders. cash flow. FCFF = net income + noncash charges + [cash interest paid × (1 − tax rate)] − fixed LOS 23.e capital investment − working capital investment. Operating activities typically relate to the firm’s current assets and current liabilities. FCFF = CFO + [cash interest paid × (1 − tax rate)] − fixed capital investment. Investing activities typically relate to noncurrent assets. Financing activities typically relate to Free cash flow to equity (FCFE) is the cash flow that is available for distribution to the noncurrent liabilities and equity. common shareholders after all obligations have been paid. Timing of revenue or expense recognition that differs from the receipt or payment of cash is FCFE = CFO − fixed capital investment + net borrowing reflected in changes in balance sheet accounts. Cash flow performance ratios, such as cash return on equity or on assets, and cash coverage LOS 23.f ratios, such as debt coverage or cash interest coverage, provide information about the firm’s The direct method of calculating CFO is to sum cash inflows and cash outflows for operating operating performance and financial strength. activities.  ROE = ( netEBT income ) ( EBIT EBT ) ( revenue EBIT ) ( total revenue assets ) ( total total assets equity ) KEY CONCEPTS LOS 24.e LOS 24.a Ratios used in equity analysis include price-to-earnings, price-to-cash flow, price-to-sales, Ratios can be used to project earnings and future cash flow, evaluate a firm’s flexibility, and price-to-book value ratios, and basic and diluted earnings per share. Other ratios are assess management’s performance, evaluate changes in the firm and industry over time, and relevant to specific industries such as retail and financial services. compare the firm with industry competitors. Credit analysis emphasizes interest coverage ratios, return on capital, debt-to-assets ratios, Vertical common-size data are stated as a percentage of sales for income statements or as a and cash flow to total debt. percentage of total assets for balance sheets. Horizontal common-size data present each item LOS 24.f as a percentage of its value in a base year. A business or geographic segment is a portion of a firm that has risk and return characteristics Ratio analysis has limitations. Ratios are not useful when viewed in isolation and require distinguishable from the rest of the firm and accounts for more than 10% of the firm’s sales adjustments when different companies use different accounting treatments. Comparable ratios or assets. may be hard to find for companies that operate in multiple industries. Ratios must be Firms are required to report some items for significant business and geographic segments. analyzed relative to one another, and determining the range of acceptable values for a ratio Profitability, leverage, and turnover ratios by segment can give the analyst a better can be difficult. understanding of the performance of the overall business. LOS 24.b LOS 24.g Activity ratios indicate how well a firm uses its assets. They include receivables turnover, Ratio analysis in conjunction with other techniques can be used to construct pro forma days of sales outstanding, inventory turnover, days of inventory on hand, payables turnover, financial statements based on a forecast of sales growth and assumptions about the relation of payables payment period, and turnover ratios for total assets, fixed assets, and working changes in key income statement and balance sheet items to growth of sales. capital. Liquidity ratios indicate a firm’s ability to meet its short-term obligations. They include the current, quick, and cash ratios, the defensive interval, and the cash conversion cycle. Solvency ratios indicate a firm’s ability to meet its long-term obligations. They include the debt-to-equity, debt-to-capital, debt-to-assets, financial leverage, interest coverage, and fixed charge coverage ratios. Profitability ratios indicate how well a firm generates operating income and net income. They include net, gross, and operating profit margins, pretax margin, return on assets, operating return on assets, return on total capital, return on total equity, and return on common equity. Valuation ratios are used to compare the relative values of stocks. They include earnings per share and price-to-earnings, price-to-sales, price-to-book value, and price-to-cash-flow ratios. LOS 24.c An analyst should use an appropriate combination of different ratios to evaluate a company over time and relative to comparable companies. The interpretation of an increase in ROE, for example, may be quite different for a firm that has significantly increased its financial leverage compared to one that has maintained or decreased its financial leverage. LOS 24.d Basic DuPont equation: ROE = ( net income ) ( sales ) ( assets ) sales assets equity Extended DuPont equation:  however, can produce different inventory values and COGS depending on whether a periodic or perpetual system is used. KEY CONCEPTS LOS 25.d LOS 25.a When prices are increasing and inventory quantities are stable or increasing: Costs included in inventory on the balance sheet include purchase cost, conversion costs, and LIFO results in: FIFO results in: other costs necessary to bring the inventory to its present location and condition. All of these higher COGS lower COGS costs for inventory acquired or produced in the current period are added to beginning lower gross profit higher gross profit inventory value and then allocated either to cost of goods sold for the period or to ending lower inventory balances higher inventory balances inventory. higher inventory turnover lower inventory turnover Period costs, such as abnormal waste, most storage costs, administrative costs, and selling When prices are decreasing and inventory quantities are stable or increasing: costs, are expensed as incurred. LIFO results in: FIFO results in: LOS 25.b lower COGS higher COGS Inventory cost flow methods: higher gross profit lower gross profit higher inventory balances lower inventory balances FIFO: The cost of the first item purchased is the cost of the first item sold. Ending lower inventory turnover higher inventory turnover inventory is based on the cost of the most recent purchases, thereby approximating current cost. The weighted average cost method results in values between those of LIFO and FIFO if prices are increasing or decreasing. LIFO: The cost of the last item purchased is the cost of the first item sold. Ending inventory is based on the cost of the earliest items purchased. LIFO is prohibited under LOS 25.e IFRS. A firm that reports under LIFO must disclose a LIFO reserve, which is the difference Weighted average cost: COGS and inventory values are between their FIFO and LIFO between LIFO inventory reported and inventory had the firm used the FIFO method. LIFO values. reserve will be positive during periods of rising inventory costs and negative during periods Specific identification: Each unit sold is matched with the unit’s actual cost. of falling inventory costs. LOS 25.c A LIFO liquidation occurs when a firm using LIFO sells more inventory during a period than it produces. During periods of rising prices, this drawdown in inventory reduces cost of goods Under LIFO, cost of sales reflects the most recent purchase or production costs, and balance sold because the lower cost of previously produced inventory is used, resulting in an sheet inventory values reflect older outdated costs. unsustainable increase in gross profit margin. Under FIFO, cost of sales reflects the oldest purchase or production costs for inventory, and LOS 25.f balance sheet inventory values reflect the most recent costs. To convert a firm’s financial statements from LIFO to what they would have been under Under the weighted average cost method, cost of sales and balance sheet inventory values are FIFO: between those of LIFO and FIFO. 1. Add the LIFO reserve to LIFO inventory. When purchase or production costs are rising, LIFO cost of sales is higher than FIFO cost of 2. Subtract the change in the LIFO reserve for the period from COGS. sales, and LIFO gross profit is lower than FIFO gross profit as a result. LIFO inventory is lower than FIFO inventory. 3. Decrease cash by LIFO reserve × tax rate. 4. Increase retained earnings (equity) by LIFO reserve × (1 − tax rate). When purchase or production costs are falling, LIFO cost of sales is lower than FIFO cost of sales, and LIFO gross profit is higher than FIFO gross profit as a result. LIFO inventory is LOS 25.g higher than FIFO inventory. Under IFRS, inventories are valued at the lower of cost or net realizable value. Inventory In either case, LIFO cost of sales and FIFO inventory values better represent economic reality write-ups are allowed, but only to the extent that a previous write-down to net realizable (replacement costs). value was recorded. In a periodic system, inventory values and COGS are determined at the end of the accounting Under U.S. GAAP, inventories are valued at the lower of cost or net realizable value for period. In a perpetual system, inventory values and COGS are updated continuously. companies using cost methods other than LIFO or the retail method. For companies using LIFO or the retail method, inventories are valued at the lower of cost or market. Market is In the case of FIFO and specific identification, ending inventory values and COGS are the usually equal to replacement cost but cannot exceed net realizable value or be less than net same whether a periodic or perpetual system is used. LIFO and weighted average cost, realizable value minus a normal profit margin. No subsequent write-up is allowed for any LOS 25.l company reporting under U.S. GAAP. Comparison of company financial statements may require statements to be adjusted to reflect LOS 25.h the same inventory costing methods for both firms, or for the subject firm and any industry or peer group of firms used for comparison. A write-down of inventory value from cost to net realizable value will: Decrease inventory, assets, and equity. Increase asset turnover, the debt to equity ratio and the debt to assets ratio. Result in a loss on the income statement, which will decrease net income and the net profit margin, as well as ROA and ROE for a typical firm. LOS 25.i Required inventory disclosures: The cost flow method (LIFO, FIFO, etc.) used. Total carrying value of inventory and carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate. Carrying value of inventories reported at fair value less selling costs. The cost of inventory recognized as an expense (COGS) during the period. Amount of inventory write-downs during the period. Reversals of inventory write-downs during the period (IFRS only because U.S. GAAP does not allow reversals). Carrying value of inventories pledged as collateral. LOS 25.j An analyst should examine inventory disclosures to determine whether: The finished goods category is growing while raw materials and goods in process are declining, which may indicate decreasing demand and potential future inventory write- downs. Raw materials and goods in process are increasing, which may indicate increasing future demand and higher earnings. Increases in finished goods are greater than increases in sales, which may indicate decreasing demand or inventory obsolescence and potential future inventory write- downs. LOS 25.k Inventory turnover, days of inventory on hand, and gross profit margin can be used to evaluate the quality of a firm’s inventory management. Inventory turnover that is too low (high days of inventory on hand) may be an indication of slow-moving or obsolete inventory. High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled. High inventory turnover together with high sales growth relative to the industry average suggests that high inventory turnover reflects greater efficiency rather than inadequate inventory.  original cost − salvage value depreciation expense = depreciable life KEY CONCEPTS Double-declining balance (DDB), an accelerated depreciation method: LOS 26.a When an asset is expected to provide benefits for only the current period, its cost is expensed DDB depreciation in year x = on the income statement for the period. If an asset is expected to provide benefits over multiple periods, it is capitalized rather than expensed. 2 × book value at beginning of year x depreciable life in years LOS 26.b The cost of a purchased finite-lived intangible asset is amortized over its useful life. Units of production method: Indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually. The cost of internally developed intangible assets is expensed. original cost − salvage value × output units used in the period life in output units Under IFRS, research costs are expensed but development costs may be capitalized. Under U.S. GAAP, both research and development costs are expensed as incurred, except in the IFRS requires component depreciation, in which significant parts of an asset are identified case of software created for sale to others. and depreciated separately. The acquisition method is used to account for assets acquired in a business combination. The LOS 26.e purchase price is allocated to the fair value of identifiable assets of the acquired firm less its In the early years of an asset’s life, accelerated depreciation results in higher depreciation liabilities. Any excess of the purchase price above the fair value of the acquired firm’s net expense, lower net income, and lower ROA and ROE compared to straight-line depreciation. assets is recorded as goodwill, an unidentifiable intangible asset that cannot be separated Cash flow is the same assuming tax depreciation is unaffected by the choice of method for from the business itself. financial reporting. LOS 26.c Firms can reduce depreciation expense and increase net income by using longer useful lives With capitalization, the asset value is put on the balance sheet and the cost is expensed and higher salvage values. through the income statement over the asset’s useful life through either depreciation or amortization. Compared to expensing the asset cost, capitalization results in: LOS 26.f Amortization methods for intangible assets with finite lives are the same as those for Lower expense and higher net income in period of acquisition, higher expense depreciation: straight line, accelerated, or units of production. Calculation of amortization (depreciation or amortization) and lower net income in each of the remaining years of expense for such assets is the same as with depreciation expense. the asset’s life. Higher assets and equity. LOS 26.g Lower CFI and higher CFO because the cost of a capitalized asset is classified as an The choice of amortization method will affect expenses, assets, equity, and financial ratios in investing cash outflow. exactly the same way that the choice of depreciation method will. Just as with the depreciation of tangible assets, increasing either the estimate of an asset’s useful life or the Higher ROE and ROA in the initial period, and lower ROE and ROA in subsequent estimate of its residual value will reduce annual amortization expense, which will increase net periods because net income is lower and both assets and equity are higher. income, assets, ROE, and ROA for a typical firm. Lower debt-to-assets and debt-to-equity ratios because assets and equity are higher. LOS 26.h LOS 26.d Under IFRS, firms have the option to revalue assets based on fair value under the revaluation Depreciation methods: model. U.S. GAAP does not permit revaluation. Straight-line: Equal amount of expense each period. The impact of revaluation on the income statement depends on whether the initial revaluation Accelerated (declining balance): Higher depreciation expense in the early years and resulted in a gain or loss. If the initial revaluation resulted in a loss (decrease in carrying lower depreciation expense in the later years of an asset’s life. value), the initial loss would be recognized in the income statement and any subsequent gain Units-of-production: Expense based on percentage usage rather than time. would be recognized in the income statement only to the extent of the previously reported loss. Revaluation gains beyond the initial loss bypass the income statement and are Straight-line method: recognized in shareholders’ equity as a revaluation surplus. original cost − salvage value If the initial revaluation resulted in a gain (increase in carrying value), the initial gain would Analysts can use disclosures of the historical cost, accumulated depreciation (amortization), bypass the income statement and be reported as a revaluation surplus. Later revaluation losses and annual depreciation (amortization) expense to estimate average age of assets, total useful would first reduce the revaluation surplus. life of assets, and remaining useful life of assets. These estimates are more accurate for firms that use straight-line depreciation. LOS 26.i Under IFRS, an asset is impaired when its carrying value exceeds the recoverable amount. accumulated depreciation Average age = The recoverable amount is the greater of fair value less selling costs and the value in use annual depreciation expense (present value of expected cash flows). If impaired, the asset is written down to the recoverable amount. Loss recoveries are permitted, but not above historical cost. historical cost Total useful life = annual depreciation expense Under U.S. GAAP, an asset is impaired if its carrying value is greater than the asset’s undiscounted future cash flows. If impaired, the asset is written down to fair value. ending net PP&E Subsequent recoveries are not allowed for assets held for use. Remaining useful life = annual depreciation expense Asset impairments result in losses in the income statement. Impairments have no impact on cash flow as they have no tax or other cash flow effects until disposal of the asset. LOS 26.n Under IFRS (but not U.S. GAAP), investment property is defined as property owned for the LOS 26.j purpose of earning rent, capital appreciation, or both. Firms can account for investment When a long-lived asset is sold, the difference between the sale proceeds and the carrying property using the cost model or the fair value model. Unlike the revaluation model for (book) value of the asset is reported as a gain or loss in the income statement. property, plant, and equipment, increases in the fair value of investment property above its When a long-lived asset is abandoned, the carrying value is removed from the balance sheet historical cost are recognized as gains on the income statement if the firm uses the fair value and a loss is recognized in that amount. model. If a long-lived asset is exchanged for another asset, a gain or loss is computed by comparing the carrying value of the old asset with fair value of the old asset (or fair value of the new asset if more clearly evident). LOS 26.k Impairment charges decrease net income, assets, and equity, which results in lower ROA and ROE and higher debt-to-equity and debt-to-assets ratios for a typical firm. Upward revaluation increases assets and equity, and thereby decreases debt-to-assets and debt-to-equity ratios. A downward revaluation has opposite effects. The effect on net income and related ratios depends on whether the revaluation is to a value above or below cost. Derecognition of assets can result in either a gain or loss on the income statement. A loss will reduce net income and assets, while a gain will increase net income and assets. LOS 26.l There are many differences in the disclosure requirements for tangible and intangible assets under IFRS and U.S. GAAP. However, firms are generally required to disclose: Carrying values for each class of asset. Accumulated depreciation and amortization. Title restrictions and assets pledged as collateral. For impaired assets, the loss amount and the circumstances that caused the loss. For revalued assets (IFRS only), the revaluation date, how fair value was determined, and the carrying value using the historical cost model. LOS 26.m  future taxable gains or losses when the liability is settled, the firm will recognize a deferred tax asset or liability to reflect this future tax or tax benefit. KEY CONCEPTS LOS 27.d LOS 27.a If taxable income is less than pretax income and the cause of the difference is expected to Deferred tax terminology: reverse in future years, a DTL is created. If taxable income is greater than pretax income and the difference is expected to reverse in future years, a DTA is created. Taxable income. Income subject to tax based on the tax return. Accounting profit. Pretax income from the income statement based on financial The balance of the DTA or DTL is equal to the difference between the tax base and the accounting standards. carrying value of the asset or liability, multiplied by the tax rate. Deferred tax assets. Balance sheet asset value that results when taxes payable (tax Income tax expense and taxes payable are related through the change in the DTA and the return) are greater than income tax expense (income statement) and the difference is change in the DTL: expected to reverse in future periods. income tax expense = taxes payable + ΔDTL − ΔDTA. Deferred tax liabilities. Balance sheet liability value that results when income tax expense (income statement) is greater than taxes payable (tax return) and the difference LOS 27.e is expected to reverse in future periods. When a firm’s income tax rate increases (decreases), deferred tax assets and deferred tax Valuation allowance. Reduction of deferred tax assets (contra account) based on the liabilities are both increased (decreased) to reflect the new rate. Changes in these values will likelihood that the future tax benefit will not be realized. also affect income tax expense. Taxes payable. The tax liability from the tax return. Note that this term also refers to a An increase in the tax rate will increase both a firm’s DTL and its income tax expense. A liability that appears on the balance sheet for taxes due but not yet paid. decrease in the tax rate will decrease both a firm’s DTL and its income tax expense. Income tax expense. Expense recognized in the income statement that includes taxes An increase in the tax rate will increase a firm’s DTA and decrease its income tax expense. A payable and changes in deferred tax assets and liabilities. decrease in the tax rate will decrease a firm’s DTA and increase its income tax expense. LOS 27.b LOS 27.f A deferred tax liability is created when income tax expense (income statement) is higher than A temporary difference is a difference between the tax base and the carrying value of an asset taxes payable (tax return). Deferred tax liabilities occur when revenues (or gains) are or liability that will result in taxable amounts or deductible amounts in the future. recognized in the income statement before they are taxable on the tax return, or expenses (or losses) are tax deductible before they are recognized in the income statement. A permanent difference is a difference between taxable income and pretax income that will not reverse in the future. Permanent differences do not create DTAs or DTLs. A deferred tax asset is created when taxes payable (tax return) are higher than income tax expense (income statement). Deferred tax assets are recorded when revenues (or gains) are LOS 27.g taxable before they are recognized in the income statement, when expenses (or losses) are If it is more likely than not that some or all of a DTA will not be realized (because of recognized in the income statement before they are tax deductible, or when tax loss insufficient future taxable income to recover the tax asset), then the DTA must be reduced by carryforwards are available to reduce future taxable income. a valuation allowance. The valuation allowance is a contra account that reduces the DTA Deferred tax liabilities that are not expected to reverse, typically because of expected value on the balance sheet. Increasing the valuation allowance will increase income tax expense and reduce earnings. If circumstances change, the DTA can be revalued upward by continued growth in capital expenditures, should be treated for analytical purposes as equity. If deferred tax liabilities are expected to reverse, they should be treated for analytical decreasing the valuation allowance, which would increase earnings. purposes as liabilities. LOS 27.h LOS 27.c Measurement of deferred tax items depends on the tax rate expected to be in force when the underlying temporary difference reverses. The applicable tax may depend on how the An asset’s tax base is its value for tax purposes. The tax base for a depreciable fixed asset is temporary difference will be settled (e.g., if a capital gains tax rate will apply). If a change its cost minus any depreciation or amortization previously taken on the tax return. When an that leads to a deferred tax item is taken directly to equity, such as an upward revaluation, the asset is sold, the taxable gain or loss on the sale is equal to the sale price minus the asset’s tax deferred tax item should also be taken directly to equity. base. A liability’s tax base is its value for tax purposes. When there is a difference between the LOS 27.i book value of a liability on a firm’s financial statements and its tax base that will result in Firms are required to reconcile their effective income tax rate with the applicable statutory rate in the country where the business is domiciled. Analyzing trends in individual reconciliation items can aid in understanding past earnings trends and in predicting future effective tax rates. Where adequate data is provided, they can also be helpful in predicting future earnings and cash flows or for adjusting financial ratios. KEY CONCEPTS LOS 27.j The accounting treatment of income taxes under U.S. GAAP and their treatment under IFRS LOS 28.a are similar in most respects. One major difference relates to the revaluation of fixed assets When a bond is issued, assets and liabilities both initially increase by the bond proceeds. At and intangible assets. U.S. GAAP prohibits upward revaluations, but they are permitted under any point in time, the book value of the bond liability is equal to the present value of the IFRS and any resulting effects on deferred tax are recognized in equity. remaining future cash flows (coupon payments and maturity value) discounted at the market rate of interest at issuance. The proceeds are reported in the cash flow statement as an inflow from financing activities. A premium bond (coupon rate > market yield at issuance) is reported on the balance sheet at a value greater than its face value. As the premium is amortized (reduced), the book value of the bond liability will decrease until it reaches its face value at maturity. A discount bond (market yield at issuance > coupon rate) is reported on the balance sheet at less than its face value. As the discount is amortized, the book value of the bond liability will increase until it reaches its face value at maturity. LOS 28.b Interest expense includes amortization of any discount or premium at issuance. Using the effective interest rate method, interest expense is equal to the book value of the bond liability at the beginning of the period multiplied by the bond’s yield at issuance. For a premium bond, interest expense is less than the coupon payment (yield < coupon rate). The difference between interest expense and the coupon payment is subtracted from the bond liability on the balance sheet. For a discount bond, interest expense is greater than the coupon payment (yield > coupon rate). The difference between interest expense and the coupon payment is added to the bond liability on the balance sheet. LOS 28.c When bonds are redeemed before maturity, a gain or loss is recognized equal to the difference between the redemption price and the carrying (book) value of the bond liability at the reacquisition date. LOS 28.d Debt covenants are restrictions on the borrower that protect the bondholders’ interests, thereby reducing both default risk and borrowing costs. Covenants can include restrictions on dividend payments and share repurchases; mergers and acquisitions; sale, leaseback, and disposal of certain assets; and issuance of new debt in the future. Other covenants require the firm to maintain ratios or financial statement items at specific levels. LOS 28.e The firm separately discloses details about its long-term debt in the footnotes. These disclosures are useful for determining the timing and amount of future cash outflows. The disclosures usually include a discussion of the nature of the liabilities, maturity dates, stated and effective interest rates, call provisions and conversion privileges, restrictions imposed by creditors, assets pledged as security, and the amount of debt maturing in each of the next five years. LOS 28.f Financial leverage ratio = average total assets / average total equity Advantages of leasing rather than purchasing an asset may include lower-cost financing, Coverage ratios, such as interest coverage and fixed charge coverage, focus on the income fewer restrictions, and less risk of obsolescence. statement. LOS 28.g Interest coverage = EBIT / interest payments Under IFRS, except for short-term leases, a lessee reports an asset and a liability on its Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments) balance sheet, both equal to the present value of the promised lease payments. The interest portion of each lease payment is reported as interest expense, while the principal-repayment portion of each payment reduces the lease liability. For short-term leases, rent expense is reported on the income statement and no balance sheet entries are required. Under U.S. GAAP, a lease is classified as a finance lease if the benefits and risks of ownership have been substantially transferred to the lessee, or as an operating lease otherwise. Reporting for a finance lease is the same as under IFRS. For an operating lease, the entire lease payment is recorded as a lease expense while the principal portion reduces the lease liability. LOS 28.h Under IFRS, there are two lease classifications for lessors, finance leases and operating leases. With a finance lease, the lessor removes the leased asset from its balance sheet and adds a lease receivable asset. The lessor reports the interest portion of the lease payments as income. For an operating lease, the lessor reports lease payments as income and depreciation and other costs as expenses. Under U.S. GAAP, lessor classifications for leases are sales-type, direct financing, or operating. A lease is sales-type if it meets the transfer of ownership criteria and collection of the lease payments is probable. A lease is direct financing if the transfer of ownership criteria are not met, a third party guarantees the residual value, and the lease payments plus the residual value at least equal the fair value of the asset. A lease that is neither sales-type nor direct financing is an operating lease LOS 28.i A firm reports a net pension liability on its balance sheet if the fair value of a defined benefit plan’s assets is less than the estimated pension obligation, or a net pension asset if the fair value of the plan’s assets is greater than the estimated pension obligation. The change in the net pension asset or liability is reflected in a firm’s comprehensive income each year. Pension expense for a defined contribution pension plan is equal to the employer’s contributions. LOS 28.j Analysts use solvency ratios to measure a firm’s ability to satisfy its long-term obligations. In evaluating solvency, analysts look at leverage ratios and coverage ratios. Leverage ratios, such as debt-to-assets, debt-to-capital, debt-to-equity, and the financial leverage ratio, focus on the balance sheet. Debt-to-assets ratio = total debt / total assets Debt-to-capital ratio = total debt / (total debt + total equity) Debt-to-equity ratio = total debt / total equity  Mechanisms that help to discipline financial reporting quality include regulation, auditing, and private contracts. Regulators typically require public companies to provide periodic KEY CONCEPTS financial statements and notes, including management commentary, and obtain independent audits. LOS 29.a Financial reporting quality refers to the characteristics of a firm’s financial statements. High- A clean audit opinion offers reasonable assurance that financial statements are free from quality financial reporting adheres to generally accepted accounting principles (GAAP) and is material errors but does not guarantee the absence of error or fraud. The fact that firms select decision useful in terms of relevance and faithful representation. and pay their auditors may limit the effectiveness of auditing to discipline financial reporting quality. Quality of reported results refers to the level and sustainability of a firm’s earnings, cash flows, and balance sheet items. High-quality earnings are high enough to provide the firm’s LOS 29.g investors with an adequate return and are sustainable in future periods. Firms may attempt to influence analysts’ valuations by presenting non-GAAP measures, such as earnings that exclude certain nonrecurring items. IFRS requires firms to define and explain LOS 29.b the relevance of any non-GAAP measures and reconcile them to the most comparable IFRS A spectrum for assessing financial reporting quality considers both the quality of a firm’s measure. Similar requirements apply to U.S. public firms. financial statements and the quality of its earnings. One such spectrum, from highest quality to lowest, is the following: LOS 29.h Accounting choices and estimates that can be used to manage earnings include: Reporting is compliant with GAAP and decision useful; earnings are sustainable and adequate. Revenue recognition choices such as shipping terms (FOB shipping point versus FOB Reporting is compliant and decision useful, but earnings quality is low. destination), accelerating shipments (channel stuffing), and bill-and-hold transactions. Reporting is compliant, but earnings quality is low and reporting choices and estimates Estimates of reserves for uncollectible accounts or warranty expenses. are biased. Valuation allowances on deferred tax assets. Reporting is compliant, but earnings are actively managed. Depreciation methods, estimates of useful lives and salvage values, and recognition of Reporting is not compliant, but the numbers presented are based on the company’s impairments. actual economic activities. Inventory cost flow methods. Reporting is not compliant and includes numbers that are fictitious or fraudulent. Capitalization of expenses. LOS 29.c Related-party transactions. Biased accounting choices that can be made within GAAP include conservative and LOS 29.i aggressive accounting. Conservative accounting choices tend to decrease the company’s Accounting warning signs that indicate a need for closer analysis may include: reported earnings and financial position for the current period. Aggressive accounting choices tend to increase reported earnings or improve the financial position for the current period. Revenue growth out of line with comparable firms, changes in revenue recognition methods, or lack of transparency about revenue recognition. Some managers employ conservative bias during periods when earnings are above target and Decreases over time in turnover ratios (receivables, inventory, total asset). aggressive bias during poor periods of below-target earnings to artificially smooth earnings. Bill-and-hold, barter, or related-party transactions. LOS 29.d Net income not supported by operating cash flows. Motivations for firm managers to issue low-quality financial reports may include pressure to Capitalization decisions, depreciation methods, useful lives, salvage values out of line meet or exceed earnings targets, career considerations, increasing their compensation, with comparable firms. improving perceptions of the firm among customers and suppliers, or meeting the terms of debt covenants. Fourth-quarter earnings patterns not caused by seasonality. Frequent appearance of nonrecurring items. LOS 29.e Emphasis on non-GAAP measures, minimal information and disclosure in financial Conditions that are often present when managers issue low-quality financial reports include reports. motivations, opportunities, and rationalizations. Weak internal controls, inadequate oversight by the board of directors, and wide ranges of acceptable accounting treatments are among the factors that may provide opportunities for low-quality reporting. LOS 29.f KEY CONCEPTS LOS 30.a Trends in a company’s financial ratios and differences between its financial ratios and those of its competitors or industry average ratios can reveal important aspects of its business strategy. LOS 30.b A company’s future income and cash flows can be projected by forecasting sales growth and using estimates of profit margins and the increases in working capital and fixed assets necessary to support the forecast sales growth. LOS 30.c Credit analysis uses a firm’s financial statements to assess its credit quality. Indicators of a firm’s creditworthiness include its scale and diversification, operational efficiency, margin stability, and use of financial leverage. LOS 30.d Potentially attractive equity investments can be identified by screening a universe of stocks, using minimum or maximum values of one or more ratios. Which (and how many) ratios to use, what minimum or maximum values to use, and how much importance to give each ratio all present challenges to the analyst. LOS 30.e When companies use different accounting methods or estimates relating to areas such as inventory accounting, depreciation, capitalization, and off-balance-sheet financing, analysts must adjust the financial statements for comparability. LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve. LIFO cost of goods sold can be adjusted to a FIFO basis by subtracting the change in the LIFO reserve. When calculating solvency ratios, analysts should estimate the present value of operating lease obligations and add it to the firm’s liabilities.