Financial Statement Analysis & Equity Investement PDF

Book 3: Financial Statement Analysis and Equity Investments SchweserNotes™ 2024 Level I CFA® SCHWESERNOTES™ 2024 LEVEL I CFA® BOOK 3: FINANCIAL STATEMENT ANALYSIS AND EQUITY INVESTMENTS ©2023 Kaplan, Inc. All rights reserved. Published in 2023 by Kaplan, Inc. ISBN: 978-...

Book 3: Financial Statement Analysis and Equity Investments SchweserNotes™ 2024 Level I CFA® SCHWESERNOTES™ 2024 LEVEL I CFA® BOOK 3: FINANCIAL STATEMENT ANALYSIS AND EQUITY INVESTMENTS ©2023 Kaplan, Inc. All rights reserved. Published in 2023 by Kaplan, Inc. ISBN: 978-1-0788-3539-8 These materials may not be copied without written permission from the author. The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics. Your assistance in pursuing potential violators of this law is greatly appreciated. Required CFA Institute Disclaimer: “Kaplan Schweser is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create/use updated materials every year and this is validated by CFA Institute. 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The authors of the referenced readings have not endorsed or sponsored these study tools. CONTENTS Learning Outcome Statements (LOS) FINANCIAL STATEMENT ANALYSIS READING 29 Introduction to Financial Statement Analysis Module 29.1: Financial Statement Roles Key Concepts Answer Key for Module Quizzes READING 30 Analyzing Income Statements Module 30.1: Revenue Recognition Module 30.2: Expense Recognition Module 30.3: Nonrecurring Items Module 30.4: Earnings Per Share Module 30.5: Ratios and Common-Size Income Statements Key Concepts Answer Key for Module Quizzes READING 31 Analyzing Balance Sheets Module 31.1: Intangible Assets and Marketable Securities Module 31.2: Common-Size Balance Sheets Key Concepts Answer Key for Module Quizzes READING 32 Analyzing Statements of Cash Flows I Module 32.1: Cash Flow Introduction and Direct Method CFO Module 32.2: Indirect Method CFO Module 32.3: Investing and Financing Cash Flows and IFRS/U.S. GAAP Differences Key Concepts Answer Key for Module Quizzes READING 33 Analyzing Statements of Cash Flows II Module 33.1: Analyzing Statements of Cash Flows II Key Concepts Answer Key for Module Quizzes READING 34 Analysis of Inventories Introduction Module 34.1: Inventory Measurement Module 34.2: Inflation Impact on FIFO and LIFO Module 34.3: Presentation and Disclosure Key Concepts Answer Key for Module Quizzes READING 35 Analysis of Long-Term Assets Introduction Module 35.1: Intangible Long-Lived Assets Module 35.2: Impairment and Derecognition Module 35.3: Long-Term Asset Disclosures Key Concepts Answer Key for Module Quizzes READING 36 Topics in Long-Term Liabilities and Equity Module 36.1: Leases Module 36.2: Deferred Compensation and Disclosures Key Concepts Answer Key for Module Quizzes READING 37 Analysis of Income Taxes Introduction Module 37.1: Differences Between Accounting Profit and Taxable Income Module 37.2: Deferred Tax Assets and Liabilities Module 37.3: Tax Rates and Disclosures Key Concepts Answer Key for Module Quizzes READING 38 Financial Reporting Quality Module 38.1: Reporting Quality Module 38.2: Accounting Choices and Estimates Module 38.3: Warning Signs Key Concepts Answer Key for Module Quizzes READING 39 Financial Analysis Techniques Introduction Module 39.1: Introduction to Financial Ratios Module 39.2: Financial Ratios, Part 1  Module 39.3: Financial Ratios, Part 2 Module 39.4: DuPont Analysis Module 39.5: Industry-Specific Financial Ratios Key Concepts Answer Key for Module Quizzes READING 40 Introduction to Financial Statement Modeling Module 40.1: Financial Statement Modeling Key Concepts Answer Key for Module Quiz Topic Quiz: Financial Statement Analysis EQUITY INVESTMENTS READING 41 Market Organization and Structure Module 41.1: Markets, Assets, and Intermediaries Module 41.2: Positions and Leverage Module 41.3: Order Execution and Validity Key Concepts Answer Key for Module Quizzes READING 42 Security Market Indexes Module 42.1: Index Weighting Methods Module 42.2: Uses and Types of Indexes Key Concepts Answer Key for Module Quizzes READING 43 Market Efficiency Module 43.1: Market Efficiency Key Concepts Answer Key for Module Quiz READING 44 Overview of Equity Securities Module 44.1: Types of Equity Investments Module 44.2: Foreign Equities and Equity Risk Key Concepts Answer Key for Module Quizzes READING 45 Company Analysis: Past and Present Module 45.1: Company Research Reports Module 45.2: Revenue, Profitability, and Capital Key Concepts Answer Key for Module Quizzes READING 46 Industry and Competitive Analysis Module 46.1: Industry Analysis Module 46.2: Industry Structure and Competitive Positioning Key Concepts Answer Key for Module Quizzes READING 47 Company Analysis: Forecasting Module 47.1: Forecasting in Company Analysis Key Concepts Answer Key for Module Quizzes READING 48 Equity Valuation: Concepts and Basic Tools Module 48.1: Dividends, Splits, and Repurchases Module 48.2: Dividend Discount Models Module 48.3: Relative Valuation Measures Key Concepts Answer Key for Module Quizzes Topic Quiz: Equity Investments Formulas Index LEARNING OUTCOME STATEMENTS (LOS) 29. 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. 30. 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. 31. 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. calculate and interpret common-size balance sheets and related financial ratios. 32. 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). 33. 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. 34. 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. 35. 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. 36. Topics in Long-Term Liabilities and Equity The candidate should be able to: a. explain the financial reporting of leases from the perspectives of lessors and lessees. b. explain the financial reporting of defined contribution, defined benefit, and stock-based compensation plans. c. describe the financial statement presentation of and disclosures relating to long-term liabilities and share-based compensation. 37. 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. 38. Financial Reporting Quality The candidate should be able to: a. compare financial reporting quality with the quality of reported results (including quality of earnings, cash flow, and balance sheet items). b. describe a spectrum for assessing financial reporting quality. c. explain the difference between conservative and aggressive accounting. d. describe motivations that might cause management to issue financial reports that are not high quality and conditions that are conducive to issuing low-quality, or even fraudulent, financial reports. e. describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms. f. describe presentation choices, including non-GAAP measures, that could be used to influence an analyst’s opinion. g. describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items. h. describe accounting warning signs and methods for detecting manipulation of information in financial reports. 39. 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, and profitability ratios. c. describe relationships among ratios and evaluate a company using ratio analysis. d. demonstrate the application of DuPont analysis of return on equity and calculate and interpret 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. 40. Introduction to Financial Statement Modeling  The candidate should be able to: a. demonstrate the development of a sales-based pro forma company model. b. explain how behavioral factors affect analyst forecasts and recommend remedial actions for analyst biases. c. explain how the competitive position of a company based on a Porter’s five forces analysis affects prices and costs. d. explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation. e. explain considerations in the choice of an explicit forecast horizon and an analyst’s choices in developing projections beyond the short-term forecast horizon. 41. Market Organization and Structure The candidate should be able to: a. explain the main functions of the financial system. b. describe classifications of assets and markets. c. describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes. d. describe types of financial intermediaries and services that they provide. e. compare positions an investor can take in an asset. f. calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call. g. compare execution, validity, and clearing instructions. h. compare market orders with limit orders. i. define primary and secondary markets and explain how secondary markets support primary markets. j. describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets. k. describe characteristics of a well-functioning financial system. l. describe objectives of market regulation. 42. Security Market Indexes The candidate should be able to: a. describe a security market index. b. calculate and interpret the value, price return, and total return of an index. c. describe the choices and issues in index construction and management. d. compare the different weighting methods used in index construction. e. calculate and analyze the value and return of an index given its weighting method. f. describe rebalancing and reconstitution of an index. g. describe uses of security market indexes. h. describe types of equity indexes. i. compare types of security market indexes. j. describe types of fixed-income indexes. k. describe indexes representing alternative investments. 43. Market Efficiency The candidate should be able to: a. describe market efficiency and related concepts, including their importance to investment practitioners. b. contrast market value and intrinsic value. c. explain factors that affect a market’s efficiency. d. contrast weak-form, semi-strong-form, and strong-form market efficiency. e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management. f. describe market anomalies. g. describe behavioral finance and its potential relevance to understanding market anomalies. 44. Overview of Equity Securities The candidate should be able to: a. describe characteristics of types of equity securities.  b. describe differences in voting rights and other ownership characteristics among different equity classes. c. compare and contrast public and private equity securities. d. describe methods for investing in non-domestic equity securities. e. compare the risk and return characteristics of different types of equity securities. f. explain the role of equity securities in the financing of a company’s assets. g. contrast the market value and book value of equity securities. h. compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return. 45. Company Analysis: Past and Present The candidate should be able to: a. describe the elements that should be covered in a thorough company research report. b. determine a company’s business model. c. evaluate a company’s revenue and revenue drivers, including pricing power. d. evaluate a company’s operating profitability and working capital using key measures. e. evaluate a company’s capital investments and capital structure. 46. Industry and Competitive Analysis The candidate should be able to: a. describe the purposes of, and steps involved in, industry and competitive analysis. b. describe industry classification methods and compare methods by which companies can be grouped. c. determine an industry’s size, growth characteristics, profitability, and market share trends. d. analyze an industry’s structure and external influences using Porter’s Five Forces and PESTLE frameworks. e. evaluate the competitive strategy and position of a company. 47. Company Analysis: Forecasting The candidate should be able to: a. explain principles and approaches to forecasting a company’s financial results and position. b. explain approaches to forecasting a company’s revenues. c. explain approaches to forecasting a company’s operating expenses and working capital. d. explain approaches to forecasting a company’s capital investments and capital structure. e. describe the use of scenario analysis in forecasting. 48. Equity Valuation: Concepts and Basic Tools The candidate should be able to: a. evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market. b. describe major categories of equity valuation models. c. describe regular cash dividends, extra dividends, stock dividends, stock splits, reverse stock splits, and share repurchases. d. describe dividend payment chronology. e. explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models. f. explain advantages and disadvantages of each category of valuation model. g. calculate the intrinsic value of a non-callable, non-convertible preferred stock. h. calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate. i. identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate. j. explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables. k. calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value. l. describe enterprise value multiples and their use in estimating equity value. m. describe asset-based valuation models and their use in estimating equity value. READING 29 INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS MODULE 29.1: FINANCIAL STATEMENT ROLES LOS 29.a: Describe the steps in the financial statement analysis framework. Video covering this content is available online. The financial statement analysis framework1 sets out a generic set of steps for analysts to apply to a multitude of objectives when analyzing debt issues, equity securities, and corporate actions. The framework consists of six steps: Step 1: State the objective and context. Determine what questions the analysis seeks to answer, the form in which this information needs to be presented, and what resources and how much time are available to perform the analysis. Step 2: Gather data. Acquire the company’s financial statements and other relevant data on its industry and the economy. Ask questions of the company’s management, suppliers, and customers, and visit company sites. Step 3: Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios and perform statistical analysis. Prepare exhibits such as graphs and common-size balance sheets. Step 4: Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports. Step 5: Report the conclusions or recommendations. Prepare a report and communicate it to its intended audience. Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations. Step 6: Update the analysis. Repeat these steps periodically, and change the conclusions or recommendations when necessary. LOS 29.b: Describe the roles of financial statement analysis. Financial reporting refers to the way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements. The role of financial statement analysis is to use the information in a company’s financial statements, along with other relevant information, to make economic decisions. Examples of such decisions include whether to invest in the company’s securities or recommend them to investors, whether to extend trade or bank credit to the company, and assigning credit ratings to a company’s debt. Analysts use financial statement data to evaluate a company’s past performance and current financial position to form opinions about the company’s ability to earn profits and generate cash flow in the future. As part of this process, analysts will identify risk factors that affect the company’s future profitability and position. PROFESSOR’S NOTE This reading deals with financial analysis for external users. Management also performs financial analysis in making everyday decisions. However, management may rely on internal financial information that is likely maintained in a different format and unavailable to external users. LOS 29.c: Describe the importance of regulatory filings, financial statement notes and supplementary information, management’s commentary, and audit reports. Standard-setting bodies are professional organizations of accountants and auditors that establish financial reporting standards. Regulatory authorities are government agencies that have the legal authority to enforce compliance with financial reporting standards. The two primary standard-setting bodies are the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). In the United States, the FASB sets forth the U.S. Generally Accepted Accounting Principles (U.S. GAAP). Outside the United States, the IASB establishes the International Financial Reporting Standards (IFRS). Other national standard-setting bodies exist as well. Some of the older IASB standards are referred to as the International Accounting Standards (IAS). Regulatory authorities, such as the Securities and Exchange Commission (SEC) in the United States and the Financial Conduct Authority in the United Kingdom, are established by national governments. Most national authorities belong to the International Organization of Securities Commissions (IOSCO). Together, the members of IOSCO regulate more than 95% of the world’s financial markets. IOSCO is not a regulatory body, but its members work together to improve cross-border cooperation and make national regulations and enforcement more uniform around the world. The IOSCO Objectives and Principles of Securities Regulation are based on three main objectives: 1. Protecting investors 2. Ensuring markets are fair, efficient, and transparent 3. Reducing systemic risk IOSCO requires issuers to provide full, accurate, and timely disclosure of financial results, risk, and other information used in the decision-making process. It also requires accounting standards that are used to prepare financial statements to be of a high standard and internationally accepted. The SEC’s requirements for financial reporting by U.S. companies are shown in Figure 29.1 as an example of reporting requirements. The SEC has the responsibility of enforcing the Sarbanes-Oxley Act of 2002. The act prohibits a company’s external auditor from providing certain additional paid services to the company, to avoid the conflict of interest involved, and to promote auditor independence. The act requires a company’s executive management to certify that the financial statements are presented fairly and to include a statement about the effectiveness of the company’s internal controls of financial reporting. Additionally, the external auditor must provide a statement confirming the effectiveness of the company’s internal controls. Proxy statements are issued to shareholders when there are matters that require a shareholder vote. These statements, which are also filed with the SEC, are a good source of information about the election of (and qualifications of) board members, compensation, management qualifications, and the issuance of stock options. In the European Union (EU), each member state has its own securities regulations, but all countries in the EU are required to report using IFRS. The European Commission also has established the European Securities Commission, which advises the European Commission on securities regulation issues, and the European Securities and Market Authority (ESMA), which coordinates regulation within the EU. Financial statement notes (footnotes) include disclosures that provide further details about the information summarized in the financial statements. Footnotes allow users to improve their assessments of the amount, timing, and uncertainty of the estimates reported in the financial statements. Footnotes do the following: They discuss the basis of presentation such as the fiscal period covered by the statements, whether IFRS or U.S. GAAP is adhered to, and the inclusion of consolidated entities. They provide information about accounting methods, assumptions, and estimates used by management. They provide additional information on information included in the primary financial statements and items such as business acquisitions or disposals, legal actions, employee benefit plans, contingencies and commitments, significant customers, related party transactions, position and performance of segments of the firm, and significant post balance sheet events. They are audited along with the primary financial statements. Figure 29.1: SEC Required Filings Both U.S. GAAP and IFRS require companies to report segment data, but the required disclosure items are only a subset of the required disclosures for the company as a whole. Nonetheless, an analyst can prepare a more detailed analysis and forecast by examining the performance of business or geographic segments separately. Segment profit margins, asset utilization (turnover), and return on assets can be very useful in gaining a clear picture of a firm’s overall operations. For forecasting, growth rates of segment revenues and profits can be used to estimate future sales and profits and to determine the changes in company characteristics over time. A business segment (operating segment) is a portion of a larger company that accounts for more than 10% of the company’s revenues, assets, or income. An operating segment should be distinguishable from the company’s other lines of business in terms of the risk and return characteristics of the segment. Segments reported should account for a minimum of 75% of the firm’s external sales. The following must be disclosed for each segment within the financial statement notes: Revenue (external and between segments) A measure of profit or loss A measure of assets and liabilities  Interest (revenue and expense) Acquisitions of PP&E and intangibles Depreciation and amortization Other noncash expenses Income tax expense Share of equity-accounted investments results Geographic segments are also identified when they meet the size criterion given previously and the geographic unit has a business environment that is different from that of other segments or the remainder of the company’s business. For example, in its 2016 annual report, Boeing described its business segments as follows:2 We are organized based on the products and services we offer. We operate in five principal segments: – Commercial Airplanes – Our Defense, Space & Security (BDS) business comprises three segments: Boeing Military Aircraft (BMA) Network & Space Systems (N&SS) Global Services & Support (GS&S) – Boeing Capital (BCC) Management commentary (also known as management report, operating and financial review, or management discussion and analysis [MD&A]) is one of the most useful sections of an annual report. IFRS guidance recommends that management commentary address the nature of the business, management’s objectives, the company’s past performance, the performance measures used, and the company’s key relationships, resources, and risks. Analysts must be aware that some parts of management commentary may be unaudited. For publicly held firms in the United States, the SEC requires management commentary to discuss trends and identify significant events and uncertainties that affect the firm’s liquidity, capital resources, and results of operations. Management must also discuss the following: Effects of inflation and changing prices, if material Impact of off-balance-sheet obligations and contractual obligations, such as purchase commitments Accounting policies that require significant judgment by management Forward-looking expenditures and divestitures An audit is an independent review of an entity’s financial statements. Public accountants conduct audits and examine the financial reports and supporting records. The objective of an audit is to enable the auditor to provide an opinion on the fairness and reliability of the financial statements. The independent certified public accounting firm employed by the board of directors is responsible for seeing that the financial statements conform to the applicable accounting standards. The auditor examines the company’s accounting and internal control systems, confirms assets and liabilities, and generally tries to determine that there are no material errors in the financial statements. The auditor’s report is an important source of information. The standard auditor’s opinion contains three parts and states the following: 1. Whereas the financial statements are prepared by management and are its responsibility, the auditor has performed an independent review. 2. Generally accepted auditing standards were followed, thus providing reasonable assurance that the financial statements contain no material errors. 3. The auditor is satisfied that the statements were prepared in accordance with accepted accounting principles and that the principles chosen and estimates made are reasonable. The auditor’s report must also contain additional explanation when accounting methods have not been used consistently between periods. An unqualified opinion (also known as an unmodified opinion or clean opinion) indicates that the auditor believes the statements are free from material omissions and errors. If the statements make any exceptions to the accounting principles, the auditor may issue a qualified opinion and explain these exceptions in the audit report. The auditor can issue an adverse opinion if the statements are not presented fairly or are materially nonconforming with accounting standards. If the auditor is unable to express an opinion (e.g., in the case of a scope limitation), a disclaimer of opinion is issued. Any opinion other than unqualified is sometimes referred to as a modified opinion. The auditor’s opinion will also contain an explanatory paragraph when a material loss is probable, but the amount cannot be reasonably estimated. These uncertainties may relate to the going concern assumption (the assumption that the firm will continue to operate for the foreseeable future), to the valuation or realization of asset values, or to litigation. This type of disclosure may be a signal of serious problems and may call for close examination by the analyst. Internal controls are the processes by which the company ensures that it presents accurate financial statements. Internal controls are the responsibility of management. For publicly traded firms in the United States, the auditor must express an opinion on the firm’s internal controls. The auditor can provide this opinion separately, or as the fourth element of the standard opinion. An audit report must also contain a section communicating key audit matters (international reports) or critical audit matters (U.S.), which highlights accounting choices that are of greatest significance to users of financial statements. These would include accounting choices that require significant management judgments and estimates, how significant transactions during a period were accounted for, or choices that the auditor finds especially challenging or subjective—and which, therefore, have a significant likelihood of being misstated. LOS 29.d: Describe implications for financial analysis of alternative financial reporting systems and the importance of monitoring developments in financial reporting standards. While the IASB and FASB work together to harmonize changes to accounting standards, some significant differences between IFRS and U.S. GAAP still exist. Some major differences are outlined in Figure 29.2, but additional differences will be encountered in subsequent modules. Figure 29.2: Significant Differences Between IFRS and U.S. GAAP The existence of differences between the two sets of standards require the analyst to exercise caution when making comparisons between firms operating in different jurisdictions. As financial reporting standards continue to evolve, analysts need to monitor how these developments will affect the financial statements they use. An analyst should be aware of new products and innovations in the financial markets that generate new types of transactions. These might not fall neatly into the existing financial reporting standards. Analysts can use the financial reporting framework as a guide for evaluating what effect new products or transactions might have on financial statements. To keep up to date on the evolving standards, an analyst can monitor professional journals and other sources, such as the IASB (www.ifrs.org) and FASB (www.fasb.org) websites. CFA Institute produces position papers on financial reporting issues through the CFA Institute Centre for Financial Market Integrity. Finally, analysts must monitor company disclosures for significant accounting standards and estimates. LOS 29.e: Describe information sources that analysts use in financial statement analysis besides annual and interim financial reports. As well as regulated information provided by issuers in filings and financial statements, an analyst can also use additional information sources: Issuer sources: – Earnings calls. Targeted at investors, analysts, and members of the media, earnings calls include presentations by the company’s management and the opportunity for question-and-answer sessions. Firms often provide earnings  guidance before they release their financial statements. After an earnings announcement, senior management may hold a conference call to answer questions and provide information to complement their regulatory filings. – Ad hoc presentations and events that are similar in format to an earnings call – Press releases focusing on major events relevant to the company – Communications with management, investor relations, and company personnel Analysts should note that these additional sources of information provided by issuers are unlikely to have been audited. Public third-party sources: – Free industry reports, whitepapers, and trade journals – Government agency-produced economic and industry statistics – Generalized and industry-specific media sources – Social media Proprietary third-party sources: – Analyst reports – Reports from data platforms such as Bloomberg, Wind, and FactSet – Reports from industry-specific agencies and consultancies Proprietary primary research: – Studies commissioned by the analyst – Hands-on experience with the company’s products or services – Data and advice of technical specialists employed by the analyst An analyst should also review pertinent information on economic conditions and the company’s industry and compare the company to its competitors. The necessary information can be acquired from trade journals, statistical reporting services, and government agencies. MODULE QUIZ 29.1 1. Which of the following statements least accurately describes a role of financial statement analysis? A. Use the information in financial statements to make economic decisions. B. Provide reasonable assurance that the financial statements are free of material errors. C. Evaluate an entity’s financial position and past performance to form opinions about its future ability to earn profits and generate cash flow. 2. Information about accounting estimates, assumptions, and methods chosen for reporting is most likely found in: A. the auditor’s opinion. B. financial statement notes. C. management discussion and analysis. 3. If an auditor finds that a company’s financial statements have made a specific exception to applicable accounting principles, she is most likely to issue a: A. dissenting opinion. B. cautionary note. C. qualified opinion.  4. Information about elections of members to a company’s board of directors is most likely found in: A. a 10-Q filing. B. a proxy statement. C. footnotes to the financial statements. 5. Which of these steps is least likely to be a part of the financial statement analysis framework? A. State the purpose and context of the analysis. B. Determine whether the company’s securities are suitable for the client. C. Adjust the financial statement data and compare the company to its industry peers. 6. Which of the following is least likely to be a part of segment disclosure? A. Segment sales. B. Segment cost of goods sold. C. Segment earnings. 7. Which of the following sources of information is most likely to be classified as a proprietary third-party source? A. Research reports prepared by analysts. B. Trade journals. C. Statistics produced by government agencies. KEY CONCEPTS LOS 29.a The framework for financial analysis has six steps: 1. State the objective of the analysis. 2. Gather data. 3. Process the data. 4. Analyze and interpret the data. 5. Report the conclusions or recommendations. 6. Update the analysis. LOS 29.b The role of financial reporting is to provide various users with useful information about a company’s performance and financial position. The role of financial statement analysis is to use the data from financial statements to support economic decisions. LOS 29.c Standard-setting bodies are private sector organizations that establish financial reporting standards. The two primary standard-setting bodies are the International Accounting Standards Board (IASB) and, in the United States, the Financial Accounting Standards Board (FASB). Regulatory authorities are government agencies that enforce compliance with financial reporting standards. Regulatory authorities include the Securities and Exchange Commission (SEC) in the United States and the Financial Conduct Authority in the United Kingdom. Many national regulatory authorities belong to the International Organization of Securities Commissions (IOSCO). Important information about accounting methods, estimates, and assumptions is disclosed in the footnotes to the financial statements and supplementary schedules. These disclosures also contain information about segment results, commitments and contingencies, legal proceedings, acquisitions or divestitures, issuance of stock options, and details of employee benefit plans. Management commentary (management discussion and analysis) contains an overview of the company and important information about business trends, future capital needs, liquidity, significant events, and significant choices of accounting methods requiring management judgment. The objective of audits of financial statements is to provide an opinion on the statements’ fairness and reliability. The auditor’s opinion gives evidence of an independent review of the financial statements that verifies that appropriate accounting principles were used, that standard auditing procedures were used to establish reasonable assurance that the statements contain no material errors, and that management’s report on the company’s internal controls has been reviewed. An auditor can issue an unqualified (clean) opinion if the statements are free from material omissions and errors, a qualified opinion that notes any exceptions to accounting principles, an adverse opinion if the statements are not presented fairly in the auditor’s opinion, or a disclaimer of opinion if the auditor is unable to express an opinion. A company’s management is responsible for maintaining an effective internal control system to ensure the accuracy of its financial statements. LOS 29.d Reporting standards are designed to ensure that different firms’ statements are comparable to one another and to narrow the range of reasonable estimates on which financial statements are based. This aids users of the financial statements who rely on them for information about the company’s activities, profitability, and creditworthiness. An analyst needs to be aware of differences between IFRS and U.S. GAAP when comparing companies in different jurisdictions. An analyst should be aware of evolving financial reporting standards and new products and innovations that generate new types of transactions. LOS 29.e Along with the annual financial statements, important information sources for an analyst include a company’s quarterly and semiannual reports, proxy statements, press releases, and earnings guidance, as well as information on the industry and peer companies from external sources. ANSWER KEY FOR MODULE QUIZZES Module Quiz 29.1 1. B This statement describes the role of an auditor, rather than the role of an analyst. The other responses describe the role of financial statement analysis. (LOS 29.b) 2. B Information about accounting methods and estimates is contained in the footnotes to the financial statements. (LOS 29.c) 3. C An auditor will issue a qualified opinion if the financial statements make any exceptions to applicable accounting standards and will explain the effect of these exceptions in the auditor’s report. (LOS 29.c) 4. B Proxy statements contain information related to matters that come before shareholders for a vote, such as elections of board members. (LOS 29.c) 5. B Determining the suitability of an investment for a client is not one of the six steps in the financial statement analysis framework. The analyst would only perform this function if he also had an advisory relationship with the client. Stating the objective and processing the data are two of the six steps in the framework. The others are gathering the data, analyzing the data, updating the analysis, and reporting the conclusions. (LOS 29.a) 6. B Firms are not required to provide detailed financial statements for segments that would include line items such as cost of goods sold, but the following should be disclosed in the segment data: Revenue (external and between segments) A measure of profit or loss A measure of assets and liabilities Interest (revenue and expense) Acquisitions of PP&E and intangibles Depreciation and amortization Other noncash expenses Income tax expense Share of equity-accounted investments results (LOS 29.c) 7. A Research reports provided by analysts are rarely in the public domain. Trade journals and government statistics are available publicly. (LOS 29.e) 1 Hennie van Greuning and Sonja Brajovic Bratanovic, Analyzing and Managing Banking Risk: Framework for Assessing Corporate Governance and Financial Risk, International Bank for Reconstruction and Development, April 2003, p. 300. 2 Boeing, The Boeing Company 2016 Annual Report (USA: 2017), https://s2.q4cdn.com/661678649/files/doc_financials/annual/2016/2016-Annual-Report.pdf. READING 30 ANALYZING INCOME STATEMENTS MODULE 30.1: REVENUE RECOGNITION LOS 30.a: Describe general principles of revenue recognition, specific revenue recognition applications, and implications of Video covering revenue recognition choices for financial analysis. this content is available online. In a sale of goods where the goods or services are exchanged for cash and returns are not allowed, the recognition of revenue is straightforward: it is recognized at the time of the exchange. The recognition of revenue is not, however, dependent on receiving cash payment. If a sale of goods is made on credit, revenue can be recognized at the time of sale—and an asset, accounts receivable, is created on the balance sheet. As a general rule, revenue is recognized in the period in which it is earned, which may not necessarily be the same as the period in which cash is collected from the customer. Revenue is reported net of any returns and allowances in the income statement (e.g., estimated warranty provisions and customer discounts). If payment for the goods is received before the transfer of the goods or services, a liability, unearned revenue, is created when the cash is received (offsetting the increase in the asset cash). Revenue is recognized as the goods are transferred to the buyer. As an example, consider a magazine subscription. When the subscription is purchased, an unearned revenue liability is created, and as magazine issues are delivered, revenue is recorded and the liability is decreased. Converged standards under IFRS and U.S. GAAP take a principles-based approach to revenue recognition issues. The central principle is that a firm should recognize revenue when it has transferred a good or service to a customer. This is consistent with the familiar accrual accounting principle that revenue should be recognized when earned. The converged standards identify a five-step process1 for recognizing revenue: 1. Identify the contract(s) with a customer. 2. Identify the separate or distinct performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation. The standard defines a contract as an agreement between two or more parties that specifies their obligations and rights. Collectability must be probable for a contract to exist, but probable is defined differently under IFRS and U.S. GAAP, so an identical activity could still be accounted for differently by IFRS and U.S. GAAP reporting firms. A performance obligation is a promise to deliver a distinct good or service. A distinct good or service is one that meets the following criteria: The customer can benefit from the good or service on its own or combined with other resources that are readily available. The promise to transfer the good or service can be identified separately from any other promises. A transaction price is the amount a firm expects to receive from a customer in exchange for transferring a good or service to the customer. A transaction price is usually a fixed amount, but it can also be variable (e.g., if it includes a bonus for early delivery). A firm should recognize revenue only when it is highly probable that it will not have to reverse it. For example, a firm may need to recognize a liability for a refund obligation (and an offsetting asset for the right to returned goods) if revenue from a sale cannot be estimated reliably. A firm recognizes revenue when the performance obligation is satisfied by transferring the control of the good or service from seller to buyer. Indicators that the customer has obtained control include physical possession by the customer, acceptance of the good or service by the customer, the customer taking on risk and benefits of ownership, the customer holding legal title, and the seller having a right of payment. For long-term contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation over a period of time. Progress toward completion can be measured from the input side (e.g., using the percentage of completion costs incurred as of the statement date). Progress can also be measured from the output side, using engineering milestones or the percentage of total output delivered to date. A performance obligation is satisfied over a period of time if any of the following three criteria are met: 1. The customer receives and benefits from the good or service over time as the supplier meets the obligations of the contract (e.g., service and maintenance contracts). 2. The supplier enhances an existing asset or creates a new asset that the customer controls over the period in which the asset is created or enhanced. 3. The asset has no alternative use for the supplier, and the supplier has the right to enforce payment for work completed to date (e.g., constructing equipment specific to the needs of a single customer). The costs to secure a long-term contract, such as sales commissions, must be capitalized; that is, the expense for these costs is spread over the life of the contract. The following summarizes some examples from IFRS 15 of appropriate revenue recognition under various circumstances. EXAMPLE: Revenue recognition 1. Performance obligation and progress toward completion (long-term contracts) A contractor agrees to build a warehouse for a price of $10 million and estimates the total costs of construction at $8 million. Although there are several identifiable components of the building (site preparation, foundation, electrical components, roof, etc.), these components are not separate deliverables, and the performance obligation is the completed building. During the first year of construction, the builder incurs $4 million of costs, 50% of the estimated total costs of completion. Based on this expenditure and a belief that the percentage of costs incurred represents an appropriate measure of progress toward completing the performance obligation, the builder recognizes $5 million (50% of the transaction price of $10 million) as revenue for the year. During the second year of construction, the contractor incurred an additional $2 million in costs. The percentage of total costs incurred over the first two years is now ($4 million + $2 million) / $8 million = 75%. The total revenue to be recognized to date is 0.75 × $10 million = $7.5 million. Because $5 million of revenue had been recognized in Year 1, $2.5 million (= $7.5 million – $5 million) of revenue will be recognized in Year 2. This treatment is consistent with the percentage of completion method previously in use, although the new standards do not call it that. 2. Acting as an agent Consider a travel agent who arranges a first-class ticket for a customer flying to Singapore. The ticket price is $10,000, made by nonrefundable payment at purchase, and the travel agent receives a $1,000 commission on the sale. Because the travel agent is not responsible for providing the flight and bears no inventory or credit risk, they are acting as an agent. Because they are an agent, rather than a principal, they should report revenue equal to their commission of $1,000, the net amount of the sale. If they were a principal in the transaction, they would report revenue of $10,000, the gross amount of the sale, and an expense of $9,000 for the ticket. Note that while gross profit is the same ($1,000) regardless of selling as a principal or agent, the gross profit margin is very different. If treated as a principal, the margin would be $1,000 / $10,000 = 10%, but as an agent, the margin would be $1,000 / $1,000 = 100%. 3. Franchising and licensing Consider a fast food company that both operates restaurants and grants franchisees rights to operate restaurants using its brand name under license, and supplies franchisees with some products used in daily operations. As well as charging a license fee, the company also receives a royalty fee of 2% of the franchisee’s turnover. Accounting standards require revenue to be split into  categories that have similar characteristics (nature, amounts, timings, and risk factors). The fast food company would disaggregate revenue into these categories: – Revenue from company-owned restaurants – Franchise royalties and fees – Revenue from supplies to franchises (equipment and food materials) Franchise fees often grant the franchisee the right to operate over numerous periods and would initially be treated as deferred revenue. Subsequently, it would be amortized to revenue in the income statement over the life of the franchise contract period. Royalty fees would be included periodically in the franchisor’s accounts when they become contractually payable by the franchisee under the terms of the contract. 4. Service versus license Consider a software supplier that allows customers to purchase a license and install the software on their own machines, or subscribe to a cloud-based solution with access over the internet. If customers purchase a license and install the software on their own systems, IFRS allows for two treatments: a. The software supplier will report revenue over the life of the contract. Criteria: The software supplier will continue to update and enhance the software over the term of the license. Customers will be exposed to potential benefits or negative impacts from updates and enhancements. Updates and enhancements do not result in a transfer of goods or services. b. The software supplier will report revenue at the outset of the contract. Criteria: The license grants the customer the right to use the software as it exists at the start of the contract (“sold as is”). A separate contract exists for enhancements and updates to the software. The revenue for support services will be recognized when provided (typically over the life of the contract). If customers access the software without taking physical possession of the software (i.e., cloud-based access), the contract is for a service, and revenue should be recognized over the life of the contract. 5. Bill-and-hold agreements Bill-and-hold agreements are a type of sales agreement that involves the customer paying for goods ahead of shipping. Typically, when a customer pays ahead of delivery, the revenue is treated as deferred, but revenue may be recorded before shipping if the supplier can demonstrate that its performance obligations are complete and the customer has control over the good. IFRS criteria include the following: the customer asked for the arrangement, the  goods are identified as belonging to the customer, the goods are complete and ready for transfer to the customer, and the goods cannot be redirected to another customer. Required disclosures under the converged standards include the following: Contracts with customers by category Assets and liabilities related to contracts, including balances and changes Outstanding performance obligations and the transaction prices allocated to them Management judgments used to determine the amount and timing of revenue recognition, including any changes to those judgments MODULE QUIZ 30.1 1. The first step in the revenue recognition process is to: A. determine the price. B. identify the contract. C. identify the obligations. 2. A contractor agrees to build a bridge for a total price of $10 million. The project is expected to take four years to complete, at a total cost of $6.5 million. After Year 1, costs of $2.5 million have been incurred, and a further $1 million in costs are incurred in Year 2. The client pays $2 million in each of the first two years. The amount of revenue the contractor should recognize in Year 2 is closest to: A. $1.54 million. B. $2.00 million. C. $5.38 million. 3. A realtor sells one of its client’s houses for $1.4 million, earning a commission of 3%. The costs to the realtor associated with the sale are $15,000. What is the realtor’s gross profit for this transaction? A. $27,000. B. $42,000. C. $1,385,000. MODULE 30.2: EXPENSE RECOGNITION LOS 30.b: Describe general principles of expense recognition, specific expense recognition applications, implications of Video covering expense recognition choices for financial analysis and contrast this content is available online. costs that are capitalized versus those that are expensed in the period in which they are incurred. Expenses are subtracted from revenue to calculate net income. According to the IASB, expenses are 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.2 If the financial statements were prepared on a cash basis, neither revenue recognition nor expense recognition would be an issue. The firm would simply recognize cash received as revenue and cash payments as expense. Under the accrual method of accounting, expense recognition is in the period in which the economic benefits of the expenditure are consumed. Three different methods are used to achieve this: the matching principle, expensing as incurred, and capitalization. Using the matching principle, expenses to generate revenue are recognized in the same period as the revenue. Inventory provides a good example. Assume that inventory is purchased during the fourth quarter of one year and sold during the first quarter of the following year. Using the matching principle, both the revenue and the expense (cost of goods sold) are recognized in the first quarter of the second year, when the inventory is sold—not the period in which the inventory was purchased. Another example are goods that are sold with a warranty period. The estimated cost of repairing or replacing faulty goods under the warranty must be estimated and deducted from revenue at the time of sale, rather than when the actual costs are incurred. Capitalization is an application of the matching principle whereby costs are initially capitalized as assets on the balance sheet and then expensed, using depreciation or amortization, to the income statement over the asset’s life as its benefits are consumed. Property, plant, and equipment (PP&E) and intangible assets with finite lives are examples of this. Not all expenses can be directly tied to revenue generation. These costs are known as period costs. Period costs, such as administrative costs, are expensed in the period incurred. For example, if a firm has occupied a leased premise, one year’s worth of rent should be expensed to the income statement regardless of whether the rent has been paid. An accounting policy that recognizes expenses later rather than sooner is seen as aggressive, while a policy that recognizes expenses earlier is conservative. Expensing is, therefore, more conservative than capitalization. EXAMPLE: Inventory and the matching principle Imagine a trading company that simply buys and resells goods. If the firm had 100 units of sales during the accounting period, we would expect to see cost of goods sold reflect 100 units of cost if we apply the matching principle. If the firm had 20 units of beginning inventory at the start of the year and purchased a further 90 units, the total number of units available for sale would be 110. The matching concept, therefore, requires the company to remove 10 units that are unsold from the income statement and store them in the balance sheet as a current asset (ending inventory). These 10 units will become the next period’s beginning inventory. Matching Cost of Goods Sold to the Number of Units Sold Assume the firm had the following transactions in the period: In addition, assume the beginning inventory of 20 units had an associated cost of $400. The company has identified that of its 10 units of ending inventory, 8 units relate to Purchase 4, and 2 units relate to Purchase 3. This approach ensures that the company matches the 100 units of sales with 100 units of cost. The $296 of ending inventory will be a current asset in the company’s balance sheet. PROFESSOR’S NOTE This example used the specific identification method to compute the cost of ending inventory. This method is typically used if a firm can identify exactly which items were sold and which items remain in  inventory (e.g., an auto dealer records each vehicle sold or in inventory by its identification number). If the specific cost of each item remaining in ending inventory at period-end cannot be identified, the company will rely on one of three cost flow methodologies to assign cost. The three methods are first-in, first-out (FIFO); last-in, first-out (LIFO); and the weighted average cost method. We will discuss these methods in more detail in our reading on Analysis of Inventories. Capitalization vs. Expensing When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance sheet or expense the cost in the income statement in the period incurred. As a general rule, an expenditure that is expected to provide a future economic benefit over multiple accounting periods is capitalized; however, if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed in the period incurred. An expenditure that is capitalized is initially recorded as an asset on the balance sheet at cost, which is typically its fair value at acquisition plus any costs necessary to prepare the asset for use. Except for land and intangible assets with indefinite lives (such as acquisition goodwill), the cost is then allocated to the income statement over the life of the asset as depreciation expense (for tangible assets), depletion (for natural resources), or amortization expense (for intangible assets with finite lives). Depreciation, depletion, and amortization reduce the carrying value (net book value) of the asset in the balance sheet, and the expense reduces net income in the income statement. Alternatively, if an expenditure is immediately expensed, current-period pretax income is reduced by the amount of the expenditure. Once an asset is capitalized, subsequent related expenditures that provide more future economic benefits (e.g., rebuilding the asset) are also capitalized. Subsequent expenditures that merely sustain the usefulness of the asset (e.g., regular maintenance) are expensed when incurred. EXAMPLE: Capitalizing vs. expensing Northwood Corp. purchased new equipment to be used in its manufacturing plant. The cost of the equipment was $250,000, including $5,000 freight and $12,000 of taxes. In addition to the equipment cost, Northwood paid $10,000 to install the equipment and $7,500 to train its employees to use the equipment. Over the asset’s life, Northwood paid $35,000 for repairs and maintenance. At the end of five years, Northwood extended the life of the asset by rebuilding the equipment’s motors at a cost of $85,000. What amounts should be capitalized on Northwood’s balance sheet, and what amounts should be expensed in the period incurred? Answer: Northwood should capitalize all costs that provide future economic benefits, including the costs that are necessary to get the asset ready for use. Rebuilding the equipment’s motors extended its life; thus, it increased its future benefits. Costs that do not provide future economic benefits are expensed in the period incurred. The initial training costs are not necessary to get the asset ready for use. Rather, the training costs are necessary to get the employees ready to use the asset. Thus, the training costs are immediately expensed. Repair and maintenance costs are operating expenditures that do not extend the life of the equipment. EXAMPLE: Impact of capitalization on financial statements Chair Ltd. was incorporated at the start of the year with the issuance of £40,000 of shares paid in full. The company immediately purchased new equipment to be used in the production process. The machinery cost £12,000 with an estimated useful economic life of four years and no salvage value. The equipment is depreciated using straight-line methodology in the accounts, and we will assume the accounting depreciation is tax deductible. Chair has no other assets and liabilities except cash and PP&E. Assume Chair has revenue of £30,000 per year and an operating profit margin of 40% before considering the impact of the equipment purchase. Chair is subject to a tax rate of 30% and pays no dividends. Compare and contrast the impact on the financial statement if the cost of equipment is capitalized versus expensed. Answer: Income Statement: Capitalization of Equipment Cost Income Statement: Expensing of Equipment Cost Capitalization spreads the expense of the equipment in the income statement over the life of the asset. Expensing results in the full cost of the equipment passing through the income statement in the first year, but none in subsequent years; in turn, this causes net income to be lower in the first year, but higher in the subsequent years. Capitalization results in less volatility of earnings when compared to expensing. Balance Sheet: Capitalization of Equipment Cost Balance Sheet: Expensing of Equipment Cost In the earlier years, total assets and equity are higher if the firm capitalizes costs. This results from including the carrying value of the asset (its cost less accumulated depreciation) in the balance sheet. Equity is higher in Year 1 under capitalization due to higher net income, and therefore, higher retained earnings. These differences narrow over the asset’s life until they are identical at the end. This convergence is caused by two factors: 1. The carrying value of the asset decreases as it is depreciated under the capitalization approach. 2. Although net income is lower in Year 1 if the cost is expensed, it is higher in all the subsequent years. Cash Flow Statement: Capitalization of Equipment Cost We can state operating cash flow as net income plus noncash charges less working capital investment. The only noncash charge in this example is depreciation. Working capital investment is assumed to be zero in this example. Cash Flow Statement: Expensing of Equipment Cost Capitalization requires the investment in equipment to be treated as a cash outflow from investing activities, while expensing treats the cost of equipment as a cash outflow from operating activities. The reason total cash flow differs under the two approaches is that the full tax benefit of the cost is recognized in Year 1 with expensing, while it is spread over the life of the asset under capitalization. At the end of the asset’s life, total cash is identical for both approaches. Financial statement ratios: Capitalization vs. expensing  Total asset turnover (sales / average total assets) is lower if costs are capitalized due to higher balance sheet assets. As the asset’s carrying value declines over time and retained earnings converge under the two approaches, the difference in total asset turnover between the two approaches declines. Net profit margin (net income / sales) is higher in Year 1 if the costs are capitalized because the income statement contains depreciation of £3,000 compared to the full cost of £12,000 if costs are expensed. In subsequent years, expensing will give higher margins as depreciation continues to pass through the income statement when using capitalization, while no cost passes through the income statement after Year 1 if the cost was expensed. Return on equity (net income / average stockholders’ equity) is higher in Year 1 if the cost is capitalized, but lower in subsequent years when compared to expensing. Again, this is due to the impact on net income of depreciation under capitalization versus the one-off charge to the income statement when expensing. The preceding example demonstrates how the decision to capitalize or expense a cost reduces comparability among companies. Capitalization increases net income, ROE, and CFO in Year 1 at the expense of decreased values in subsequent years. Analysts should take care to identify different accounting treatments of significant expenditures when comparing companies or industries. Figure 30.1 summarizes the impacts of capitalizing versus expensing. Figure 30.1: Financial Statement Effects The example considered a one-off decision to capitalize or expense. If a company continues to capitalize rather than expense cost in future periods, the profit- enhancing effects of capitalization will continue, provided the capitalized costs in each period exceed depreciation expense. Capitalized Interest When a firm constructs an asset for its own use or, in limited circumstances, for resale, the interest that accrues during the construction period is capitalized as a part of the asset’s cost. The reasons for capitalizing interest are to accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset. The treatment of construction interest is similar under U.S. GAAP and IFRS. Capitalized interest is not reported in the income statement as interest expense. Once construction interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for use) or COGS (if the asset is held for sale). Capitalizing interest results in it being reported in the cash flow statement as an outflow from investing activities. This contrasts with the usual treatment of interest paid, which is reported as an outflow from operating activities under U.S. GAAP and can be an operating or financing outflow under IFRS. For an analyst, both capitalized and expensed interest should be used when calculating interest coverage ratios to get a clearer picture of the company’s solvency. Analysts should also adjust income by adding back any depreciation of capitalized interest. EXAMPLE: Capitalization of interest Willock AG is a German company specializing in large infrastructure projects. Due to the highly specialized nature of some equipment, Willock constructs equipment that it will use in projects. In the current period, Willock reports EBIT of €160 million and an interest expense of €80 million. Footnote disclosures reveal €20 million of interest has been capitalized in assets in the course of construction in the year, and that depreciation resulting from interest capitalized on assets constructed in prior years that are now in use was €10 million. Calculate the interest coverage ratio before and after adjusting for capitalized interest. Answer: Additional depreciation in the income statement due to the capitalization of financing costs during the construction phase is reversed for assets that are now in use, increasing EBIT. Interest capitalized in the current period for equipment in the course of construction is added to interest expense.  EXAMPLE: Cash flow treatment of capitalized interest Continuing the previous example, Willock reported CFO of €70 million and CFI of -€50 million. Willock includes interest paid within its computation of CFO, with the exception of capitalized interest on the construction of equipment. Assuming all interest has been paid by year-end and ignoring any tax implications, what was the impact of interest capitalization on CFO and CFI? Answer: €20 million interest was capitalized. Had this been expensed instead, CFI would have been €20 million higher, or –€30 million, and CFO would have been €20 million lower, or €50 million. No adjustment for depreciation is required as it is a noncash charge. Research and Development Costs With some exceptions, costs to create intangible assets are expensed as incurred. Important exceptions are research and development costs (under IFRS) and software development costs. Under IFRS, research costs, which are costs aimed at the discovery of new scientific or technical knowledge and understanding, are expensed as incurred. However, development costs may be capitalized. Development costs are incurred to translate research findings into a plan or design of a new product or process. To recognize an intangible asset in development, a firm must show that it can complete the asset and intends to use or sell the completed asset, among other criteria. Under U.S. GAAP, both research and development costs are generally expensed as incurred. However, the costs of creating software for sale to others are treated in a manner similar to the treatment of research and development costs under IFRS. Costs incurred to develop software for sale to others are expensed as incurred until the product’s technological feasibility has been established, after which the costs of developing a salable product are capitalized. To make the financial statements comparable for a company that capitalizes development costs with one that expenses such costs, the income statement should be adjusted to include development costs as an expense, and any current amortization of development cost capitalized in the past should be removed. In the balance sheet, capitalized development costs should be removed, resulting in lower assets and equity. Adjusting the cash flow statement will require capitalized costs to be removed from CFI and included in CFO, which will decrease CFO. Bad Debt Expense and Warranty Expense Recognition If a firm sells goods or services on credit or provides a warranty to the customer, the matching principle requires the firm to estimate bad debt expense or warranty expense. To do so, the firm recognizes the expense in the period of the sale, rather than a later period. Implications for Financial Analysis Like revenue recognition, expense recognition requires numerous estimates. Because estimates are involved, it is possible for firms to delay or accelerate the recognition of expenses. Delayed expense recognition increases current net income and is, therefore, more aggressive. Analysts must consider the underlying reasons for a change in an expense estimate. If a firm decreases its bad debt expense, was it because its collection experience improved, or was it to manipulate net income? Analysts should also compare a firm’s estimates to those of other firms in its industry. If a firm’s warranty expense is significantly less than that of a peer firm, is that a result of higher quality products, or is the firm’s expense recognition more aggressive than that of the peer firm? Firms disclose their accounting policies and significant estimates in the financial statement footnotes and in the management discussion and analysis (MD&A) section of the annual report. MODULE QUIZ 30.2 1. If a company purchases an asset with future economic benefits that are highly uncertain, the company should: A. expense the purchase. B. use straight-line depreciation. C. use an accelerated depreciation method. 2. The cost of an intangible asset is most likely to be amortized if the asset has a(n): A. finite life and was purchased. B. finite life and was created internally. C. indefinite life and was acquired in a business combination. 3. Red Company immediately expenses its development costs, while Black Company capitalizes its development costs. All else equal, Red Company will: A. show smoother reported earnings than Black Company. B. report higher operating cash flow than Black Company. C. report higher asset turnover than Black Company. MODULE 30.3: NONRECURRING ITEMS LOS 30.c: Describe the financial reporting treatment and analysis of non-recurring items (including discontinued Video covering operations, unusual or infrequent items) and changes in this content is available online. accounting policies. The definition of unusual or infrequent items is obvious—these events are either unusual in nature or infrequent in occurrence and are material (significant enough to affect the opinions of financial statement users). Examples of items that could be considered unusual or infrequent include the following: Gains or losses from the sale of assets or part of a business, if these activities are not a firm’s ordinary operations Impairments, write-offs, and write-downs Restructuring costs Unusual or infrequent items are included in income from continuing operations and are reported before tax. Analysts should review unusual or infrequent items to determine whether they truly should be excluded when forecasting a firm’s earnings. Some companies appear to be accident-prone and have “unusual or infrequent” losses every year or every few years. A discontinued operation is one that management has decided to dispose of, but either has not yet done so, or has disposed of in the current year after the operation had generated income or losses. To be accounted for as a discontinued operation, the business must be physically and operationally distinct from the rest of the firm, in terms of assets, operations, and investing and financing activities. The date when the company develops a formal plan for disposing of an operation is referred to as the measurement date, and the time between the measurement period and the actual disposal date is referred to as the phaseout period. Any income or loss from discontinued operations is reported separately in the income statement, net of tax, after income from continuing operations. Any past income statements presented must be restated, separating the income or loss from the discontinued operations. On the measurement date, the company will accrue any estimated loss during the phaseout period, and any estimated loss on the sale of the business. Any expected gain on the disposal cannot be reported until after the sale is completed. Analysis of discontinued operations is straightforward: They do not affect net income from continuing operations. For this reason, analysts should exclude discontinued operations when forecasting future earnings. However, the actual event of discontinuing a business segment or selling assets may provide information about the future cash flows of the firm. Changes in Accounting Policies and Estimates Accounting changes include changes in accounting policies, changes in accounting estimates, and prior-period adjustments. Such changes may require either retrospective application or prospective application. With retrospective application, any prior-period financial statements presented in a firm’s current financial statements must be restated, applying the new policy to those statements as well as future statements. Retrospective application enhances the comparability of the financial statements over time. With prospective application, prior statements are not restated, and the new policies are applied only to future financial statements. Standard-setting bodies, at times, issue a change in accounting policy. Sometimes, a firm may change which accounting policy it applies, for example, by changing its inventory costing method or capitalizing rather than expensing specific purchases. Unless it is impractical, changes in accounting policies require retrospective application. In the recent change to revenue recognition standards, firms were given the option of modified retrospective application. This application does not require restatement of prior-period statements; however, beginning values of affected accounts are adjusted for the cumulative effects of the change. Generally, a change in accounting estimate is the result of a change in management’s judgment, usually due to new information. For example, management may change the estimated useful life of an asset because new information indicates that the asset has a longer or shorter life than originally expected. Changes in accounting estimates are applied prospectively and do not require the restatement of prior financial statements. Accounting estimate changes typically do not affect cash flow. An analyst should review changes in accounting estimates to determine their impact on future operating results. Sometimes, a change from an incorrect accounting method to one that is acceptable under GAAP or IFRS is required. A correction of an accounting error made in previous financial statements is reported as a prior-period adjustment and requires retrospective application. Prior-period results are restated. Disclosure of the nature of any significant prior-period adjustment and its effect on net income is also required. Prior-period adjustments usually involve errors or new accounting standards and do not typically affect cash flow. Analysts should review adjustments carefully because errors may indicate weaknesses in the firm’s internal controls. Changes in Scope and Exchange Rates Accounting standards do not require firms to disclose the impact on their financial statements of changes in scope or exchange rates, but analysts must be alert to their effects. In this context, “changes in scope” refer to how acquiring another company affects the size of the combined entity. Mergers and acquisitions can dramatically reduce comparability of company financial statements before and after the acquisition date. If a company conducts overseas trade or owns overseas subsidiaries, fluctuating exchange rates can affect its financial statements because overseas sales and purchases and the income statements of overseas subsidiaries need to be converted to the company’s reporting currency. PROFESSOR’S NOTE The Level II CFA curriculum addresses accounting and analysis of business combinations and foreign currency translation. MODULE QUIZ 30.3 1. Changing an accounting estimate: A. is reported prospectively. B. requires restatement of all prior-period statements presented in the current financial statements. C. is reported by adjusting the beginning balance of retained earnings for the cumulative effect of the change. 2. Which of the following transactions would most likely be reported below income from continuing operations, net of tax? A. Gain or loss from the sale of equipment used in a firm’s manufacturing operation. B. A change from the accelerated method of depreciation to the straight-line method. C. The operating income of a physically and operationally distinct division that is currently for sale, but not yet sold.  3. Which of the following statements about nonrecurring items is least accurate? A. Discontinued operations are reported net of taxes, at the bottom of the income statement before net income. B. Unusual or infrequent items are reported before taxes, above net income from continuing operations. C. A change in accounting principle is reported in the income statement net of taxes, before net income. MODULE 30.4: EARNINGS PER SHARE LOS 30.d: Describe how earnings per share is calculated and calculate and interpret a company’s basic and diluted earnings Video covering per share for companies with simple and complex capital this content is structures including those with antidilutive securities. available online. Earnings per share (EPS) is one of the most commonly used corporate profitability performance measures for publicly traded firms (nonpublic companies are not required to report EPS data). EPS is reported only for shares of common stock (also known as ordinary stock). A company may have either a simple or complex capital structure: A simple capital structure is one that contains no potentially dilutive securities. A simple capital structure contains only common stock, nonconvertible debt, and nonconvertible preferred stock. A complex capital structure contains potentially dilutive securities such as employee stock options, warrants, or convertible securities. All firms with complex capital structures must report both basic and diluted EPS. Firms with simple capital structures report only basic EPS. Basic EPS The basic EPS calculation does not consider the effects of any dilutive securities in the computation of EPS: The current year’s preferred dividends are subtracted from net income because EPS refers to the per-share earnings available to common shareholders. Net income minus preferred dividends is the income available to common stockholders. Common stock dividends are not subtracted from net income because they are a part of the net income available to common shareholders. The weighted average number of common shares is the number of shares outstanding during the year, weighted by the portion of the year they were outstanding. Effect of Stock Dividends and Stock Splits A stock dividend is the distribution of additional shares to each shareholder in an amount proportional to their current number of shares. If a 10% stock dividend is paid, the holder of 100 shares of stock would receive 10 additional shares. A stock split refers to the division of each “old” share into a specific number of “new” (post-split) shares. The holder of 100 shares will have 200 shares after a 2-for- 1 split, or 150 shares after a 3-for-2 split. The important thing to remember is that each shareholder’s proportional ownership in the company is unchanged by either of these events. Each shareholder has more shares but the same percentage of the total shares outstanding. For calculating EPS, we apply stock dividends and splits retroactively to the beginning of the year, to all shares before the date of the corporate event. Prior years’ weighted average number of common shares is also adjusted as if the stock split or stock dividend had occurred in the prior period, to prevent EPS from appearing to decline when these actions are largely cosmetic. PROFESSOR’S NOTE For our purposes here, a stock dividend and a stock split are two ways of doing the same thing. For example, a 50% stock dividend and a 3-for-2 stock split both result in three “new” shares for every two “old” shares. The following are key things to know about calculating weighted average shares outstanding: The weighting system is days outstanding divided by the number of days in a year, but on the exam, the monthly approximation method will probably be used. Shares issued enter into the computation from the date of issuance. Reacquired shares are excluded from the computation from the date of reacquisition. Shares sold or issued in a purchase of assets are included from the date of issuance. A stock split or stock dividend is applied to all shares outstanding before the split or dividend and to the beginning-of-period weighted average shares. A stock split or stock dividend adjustment is not applied to any shares issued or repurchased after the split or dividend date. EXAMPLE: Weighted average shares outstanding Johnson Company has 10,000 shares outstanding at the beginning of the year. On April 1, Johnson issues 4,000 new shares. On July 1, Johnson distributes a 10% stock dividend. On September 1, Johnson repurchases 3,000 shares. Calculate Johnson’s weighted average number of shares outstanding for the year, for its reporting of basic earnings per share. Answer: Shares outstanding are weighted by the portion of the year that the shares were outstanding. Any shares that were outstanding before the 10% stock dividend must be adjusted for it. Transactions that occur after the stock dividend do not need to be adjusted. PROFESSOR’S NOTE  Think of the shares before the stock dividend as “old” shares and shares after the stock dividend as “new” shares that each represent ownership of a smaller portion of the company (in this example, 10/11ths of that of an old [pre-stock dividend] share). The weighted average number of shares for the year will be in new shares. EXAMPLE: Basic earnings per share Johnson Company has net income of $10,000, paid $1,000 cash dividends to its preferred shareholders, and paid $1,750 cash dividends to its common shareholders. Calculate Johnson’s basic EPS using the weighted average number of shares from the previous example. Answer: PROFESSOR’S NOTE Remember, the payment of a cash dividend on common shares is not considered in the calculation of EPS. Diluted EPS Before calculating diluted EPS, it is necessary to understand the following terms: Dilutive securities are stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock. Antidilutive securities are stock options, warrants, convertible debt, or convertible preferred stock that would increase EPS if exercised or converted to common stock. We apply the “if converted” method to examine the impact of potentially dilutive securities. This looks at what EPS would have been if the securities were converted at the start of the accounting period, regardless of whether they can actually be converted during the period. The numerator of the basic EPS equation contains income available to common shareholders (net income less preferred dividends). In the case of diluted EPS, if there are dilutive securities, the numerator must be adjusted as follows: If convertible preferred stock is dilutive (meaning EPS will decrease if it is converted to common stock), the convertible preferred dividends must be added  to earnings available to common shareholders. If convertible bonds are dilutive, then the bonds’ after-tax interest expense is not considered an interest expense for diluted EPS. Hence, interest expense multiplied by (1 - the tax rate) must be added back to the numerator. PROFESSOR’S NOTE Interest paid on bonds is typically tax deductible for the firm. If convertible bonds are converted to stock, the firm saves the interest cost but loses the tax deduction. Thus, only the after-tax interest savings are added back to income available to common shareholders. The basic EPS denominator is the weighted average number of shares. When the firm has dilutive securities outstanding, the denominator is adjusted for the equivalent number of common shares that would be created by the conversion of all dilutive securities outstanding (convertible bonds, convertible preferred shares, warrants, and options), with each one considered separately to determine if it is dilutive. If a dilutive security was issued during the year, the increase in the weighted average number of shares for diluted EPS is based on only the portion of the year the dilutive security was outstanding. Dilutive stock options or warrants increase the number of common shares outstanding in the denominator for diluted EPS. There is no adjustment to the numerator. The diluted EPS equation is: The effect of conversion to common shares is included in the calculation of diluted EPS for a given security only if it is, in fact, dilutive. If a firm has more than one potentially dilutive security outstanding, each potentially dilutive security must be examined separately to determine if it is actually dilutive (i.e., would reduce EPS if converted to common stock). EXAMPLE: EPS with convertible preferred stock During 20X6, ZZZ Corp. reported net income of $4.35 million and had 2 million shares of common stock outstanding for the entire year. ZZZ’s 7%, $5 million par value preferred stock is convertible into common stock at a conversion rate of 1.1 shares for every $10 of par value. Calculate basic and diluted EPS. Answer: Step 1: Calculate 20X6 basic EPS: Step 2: Calculate diluted EPS: Compute the increase in common stock outstanding if the preferred stock is converted to common stock at the beginning of 20X6: ($5,000,000 / $10) × 1.1 = 550,000 shares. If the convertible preferred shares were converted to common stock, there would be no preferred dividends paid. Therefore, you should add back the convertible preferred dividends that had previously been subtracted from net income in the numerator. Compute diluted EPS as if the convertible preferred stock were converted into common stock: Check to see if diluted EPS is less than basic EPS ($1.71 < $2.00). If the answer is yes, the preferred stock is dilutive and must be included in diluted EPS as computed previously. If the answer is no, the preferred stock is antidilutive, and conversion effects are not included in diluted EPS. A quick way to check whether convertible preferred stock is dilutive is to divide the preferred dividend by the number of shares that will be created if the preferred stock is converted. For ZZZ: Because this is less than basic EPS, the convertible preferred is dilutive. EXAMPLE: EPS with convertible debt During 20X6, YYY Corp. had earnings available to common shareholders of $2.5 million and had 1 million shares of common stock outstanding for the entire year, for basic EPS of $2.50. During 20X5, YYY issued 2,000, $1,000 par, 5% bonds for $2 million (issued at par). Each of these bonds is convertible to 120 shares of common stock. The tax rate is 30%. Calculate the 20X6 diluted EPS. Answer: Compute the increase in common stock outstanding if the convertible debt is converted to common stock at the beginning of 20X6: shares issuable for debt conversion = (2,000)(120) = 240,000 shares  If the convertible debt is considered converted to common stock at the beginning of 20X6, then there would be no interest expense related to the convertible debt. Therefore, it is necessary to increase YYY’s after-tax net income for the after-tax effect of the decrease in interest expense: increase in income = [(2,000)($1,000)(0.05)] (1 − 0.30) = $70,000 Compute diluted EPS as if the convertible debt were common stock: Check to make sure that diluted EPS is less than basic EPS ($2.07 < $2.50). If diluted EPS is more than the basic EPS, the convertible bonds are antidilutive and should not be treated as common stock in computing diluted EPS. A quick way to determine whether the convertible debt is dilutive is to calculate its per share impact: If this per share amount is greater than basic EPS, the convertible debt is antidilutive, and the effects of conversion should not be included when calculating diluted EPS. If this per share amount is less than basic EPS, the convertible debt is dilutive, an