FINANCIAL STATEMENT ANALYSIS.pdf

lOMoARcPSD|11350337 Financial Statement Analysis Financial statement analysis and managerial accounting (Università Cattolica del Sacro Cuore) Studocu is not sponsored or endorsed by any college or university Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial State...

lOMoARcPSD|11350337 Financial Statement Analysis Financial statement analysis and managerial accounting (Università Cattolica del Sacro Cuore) Studocu is not sponsored or endorsed by any college or university Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi FINANCIAL STATEMENT ANALYSIS FUNDAMENTALS OF ACCOUNTING: A USERS’ PERSPECTIVE The annual report: a fundamental document An annual report is a financial document to report on company's activities throughout the past year, which is bigger than the financial statements and can go up to 600 pages or more – usually the more complex the company is, the more pages the annual report is composed of. If the company is listed, the company has to publish the annual report, since there might be people who want to know everything about the company or want to join the company; on the other hand, if the company is a familyowned business, there is no need to publish the annual report. Annual reports are intended to give shareholders (that are the owners of the company) and other interested people information about the company's activities and financial performance. Most jurisdictions require companies to prepare and disclose annual reports, and many require the annual report to be filed at the company's registry. The minimum content of the financial report depends on the legal status of the company, and it’s disciplined by the regulations in place where the legal entity is located. The voluntary disclosure of financial information in listed companies mainly is determined by financial communication choices or tactics. For listed companies the annual report includes specification of: – Financial result highlight – – – – – – Governance and ownership structure Discussion and analysis of recent economic events Financial Statements (Consolidated and separate entity parent company) • Balance sheet (or Statement of Financial Position) – shows the financial position on a given day • Income statement – shows the economic performance over a given period • Statement of cash flows – shows the financial performance over a given period Footnotes to explain elements of financial statements The report of independent auditors Statement of management responsibility for preparation of financial statements The main items of the annual report are: – Management report to the board of directors (address the board of directors in order to know what the business is about) – – – – Financial statements (numbers) Notes to the consolidated financial statements (the notes are important to know where the financial statements, that is the numbers, come from) Other disclosures Independent auditor’s report The notes to the consolidated financial statements are actually given because the number that come from the financial statements cannot be created out of the blue, but there are institutional frameworks that needs to be followed. The OIC (Organismo Italiano di Contabilità) is the accountancy body that is composed by professionals who work in the world of accounting and sets rules, which means that they formulate the accounting principles that apply, and especially sets standards in Italy for small national businesses. Standards are accounting principles that 1 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi apply, and they are needed in order to compare one company to another, otherwise the comparison would not be possible. But in order to compare companies at an international level there is another institution of setting, which is called IASB (International Accounting Standards Board), and is an independent, private-sector body that develops and approves IFRSs (so the accounting principle that it issues in order to assure comparability is called IFRS (International Financial Reporting Standard)). Another item of the annual report is the auditor’s report: the independent auditors are individuals who inspect and verify the accuracy of a company's financial records, so the auditor’s report is a compliance report, and it’s important to note that the company is in charge of paying for the auditor’s report. Public companies are required to use a public accounting firm for the conduct of an audit of their financial statements. At the end of the auditing process the auditing firm (or the independent auditor) issues an auditing report an opinion on the quality of financial measurement. THE THREE MAIN FINANCIAL STATEMENTS AND THEIR LINKS – Balance Sheet – – Income Statement Statement of Cash Flows The three main financial statements and their links: the Balance Sheet The main components of the Balance Sheet are: – Assets - economic resources of the firm that can be turned into cash – – Liabilities - economic obligations of the firm which will use cash Owners’ Equity - the residual interest in, or remaining claims against, the firm’s assets after deducting liabilities (rights of the owners). Generally, it reflects the amount of capital the owners invested plus any profit that the company generates that is subsequently reinvested in the company So, Assets and Liabilities are the elements that we record and recognize, while the equity is the difference between them. Owner’s equity is composed of Share Capital and Retained Earnings and is the result of their sum. The three main financial statements and their links: the Income Statement The main components of the Income Statement are: – Revenues - gross increases in Equity – Expenses - gross decreases in Equity – Net Income = Revenues – Expenses or net increase or decrease in the Equity • If Net Income > 0 there is a Profit • If Net Income < 0 there is a Loss The three main financial statements and their links: the Statement of Cash Flow The main components of the Statement of Cash Flow are: – Cash inflows - correspond to cash receipts (+) – Cash outflows - correspond to cash payments (-) These are the three most important financial statements, and they are telling a story to the users of these financial statements. They describe the financial performance of a company, so they describe its: – Profitability: a company is profitable when its revenues are higher than expenses, but it is also a way to broaden its Equity (if the company is profitable, it can feed its Retained Earnings and consequently its Equity) 2 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi – Credibility: the higher is the difference between the assets and the liabilities, the more solid the company is and there is a strong link between profitability and credibility because the more profitable the company is, the more solid it can become, and being soldi for a company means that it is able to meet long-term obligations. The liquidity production of a company tells whether the company has enough cash (not assets) to be able to meet the long-term obligations (liquidity is about “pure cash”) and it is associated with profitability because revenues sooner or later will become cash inflows and expenses will become cash outflows, and we say “sooner or later” because of the accrual principle, which is an accounting concept that requires transactions to be recorded in the time period in which they occur, regardless of when the actual cash flows for the transaction are received. So, according to the accrual system revenues are recognized only when the services or the goods are delivered. The statements are not always forced into a framework, but actually there are frameworks, formats that especially for listed companies are recurring. So, the framework, that is to say how we present assets and liabilities (etc.), the revenues and the expenses, the cash inflows and the cash outflows is more or less informative. The Balance Sheet presentation Before investing in any company, an investor can use the balance sheet to examine the following: – can the firm meet its financial obligations? – how much money has already been invested in this company? – is the company overly indebted? – what kind of assets has the company purchased with its financing? Typically, the balance sheet is represented in 2 sections, even though in the UK the Balance Sheet is typically organized into 1 section, so there is a list of assets and liabilities that combines. However, we will see a balance sheet represented in 2 sections and there are 2 criteria to classify assets and liabilities: the first criterium is liquidity, that is to say how fast the assets can be liquidated and when the liability is due, while the second one is the activity-related criterium 1- Liquidity: the criterium is related to the fact that there are assets and liabilities that can be liquidated within the year and others that cannot, therefore they are divided into: • Short Term or Current: assets that can be liquidated (=concerted into cash) in the short term (in operating cycle), typically one year and liabilities that are due within the operating cycle or within the year → Short Term Assets: Account Receivable, Inventory → Short Term Liabilities: Account Payable, Wages Payable, Interest Payable and all the payables within the year • Long Term or Non-Current: assets that are liquidated beyond the operating cycle and liabilities that are due beyond the operating cycle → Long Term Assets: Notes Receivable, Property, Plant and Equipment → Long Term Liabilities: Notes Payable, Loans, Bonds 2- Activity-related: this criterion refers to the fact that there are assets and liabilities that are related to the core business and others that are not (financing and investing) • Related to the operating cycle – Operating • Nonrelated to operating cycle – Non Operating → Investing activity → Financing activity 3 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi The first criterium of presenting assets and liabilities in the Balance Sheet, that is liquidity, is the criterium that is used to check the synchronization of the duration of the assets and the duration of the liabilities, because the assets are supposed to generate cash and the liabilities are supposed to absorb cash, so we want to see whether with the generation of cash (which is implicit) into the assets the company is able to cover the obligations and these timings are in some way synchronized. But there is also another way of looking at the assets and the liabilities of a company, which is the activity – related criterium, according to which assets and liabilities are spitted not based on the duration but based on the link that they have with pure operations (core business). The Income Statement presentation Before investing in any company, an investor can use the income statement to examine the following: – how much are sales? – what kind of expenses the company pays? – how is interesting the economic result compared with competitors? – is the operating income positive? The typical presentation of the income statement is a single section with multiple steps. Steps are intermediate results, and they are like paragraphs in the overall chapter that describes how the profit is generated. This is how a typical consolidated income statement is organized: 1. The first step calculates the gross profit, which tells what the difference between the revenues and the cost of goods sold is. 2. 3. 4. 5. However, when a company sells a product, it has to endure high advertising and promotional costs to keep the business alive The second step consists in calculating the contribution margin: once you subtract the advertising and promotional costs from the gross profit, you obtain the contribution margin, which contributes to cover all the other overheads The third step shows the operating result (operating profit), obtained by subtracting all the overheads from the contribution margin. The operating income is the company’s earnings from its core operations after it has deducted its cost of goods sold and its operating expenses. Operating income does not include interest expenses or other financing costs Then, as a fourth step, you have to consider the impact of financing and funding decisions (for example the interest expense), and if you subtract these expenses from the operating profit, you come to the profit before tax Eventually, by detracting the income tax expense from the profit before tax, you obtain the final profit for the period The number of steps depends on the narratives: if the company wants to organize your income statement with more details, it breaks it up in more steps and vice versa. The Statement of Cash Flow presentation Before investing in any company, an investor can use the cash flow statement to examine the following: – is this company able to pay interests, debts, dividends? – is this company able to generate cash for financing new investments? – how has the management used the cash generated by the company? In the cash flow statement, there are: – (+) cash inflows, which correspond to cash receipts – (-) cash outflows, which correspond to cash payments and these items explain why there is a change in cash balance over a period of time. Cash flows are classified according to three reasons why the cash balance might change: 4 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi – – – Cash flow from operations: cash inflows and outflows concerned with ordinary activities of the organization (related to the core business); you want this cash flow to be positive. Examples of cash flow from operations: • Collections from customers (+) • Cash payments to suppliers (-) • Cash payments to employees (-) • Tax payments (-) Cash flow from investing: cash inflows and outflows concerned with transactions to acquire or to dispose of long-lived assets; you expect this cash flow to be negative, because you expect a company to invest continuously. Examples of cash flow from investing: • Collections from sales of PPE or any long-term assets (+) • Payments on purchases of PPE or any long-term assets (-) Cash flow from financing: cash inflows and outflows concerned with transactions to get cash or to repay debts. Examples of cash flow from financing: • Borrowings of cash from creditors (+) • Issuance of debt securities (+) • Issuance of equity (+) • Repayments of loans (-) • Payments of dividends (-) and by summing these three cash flows together, what we obtain is the net cash flow. MAIN ASSETS EVALUATION PRINCIPLES We zoomed into the financial statements: the framework is the annual report and now we look at the numbers. When we look at the numbers we have these evaluation principles, so criteria, methods that are used to determine the value of Assets, Liabilities, and therefore the Equity. 1- The fundamental rules in assets evaluation – Accounting Standards represent a set of concepts and techniques that are used to identify, measure and communicate financial information about an economic unit to various users. – In particular, IFRSs are designed as a common global language for business affairs, so that company accounts are understandable and comparable across international boundaries. – Nevertheless, managers can exercise the so-called accounting discretion, that is the ability to make a judgment, a choice or a responsible decision, which ultimately impacts on the Financial Statements presentation. – Therefore, it is important to be aware of which are some of the main valuation issues that companies face during their day-by-day operations. – General principles applicable to the asset evaluation distinguish between: • Monetary assets, carry a fixed value in terms of currency units. They are stated as a fixed value in monetary terms even when macroeconomic factors such as inflation decrease the purchasing power of the currency. → Cash → Bank deposits → Trade receivables → Other receivables meant for settlement through cash → Investments in debt capital markets instruments • Non-monetary assets, conversely speaking, non-monetary assets are those that do not have a value determinable in exact money terms. 5 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi The value assets that are non-monetary change or fluctuate a lot over time and whose cash convertibility is limited. Therefore, these assets are not that liquid. Examples include property, plant & equipment, intangible assets (including goodwill), equity shares (some companies treat shares issued in foreign currency as monetary assets due to the absence of clear-cut directives), and Inventories. A non-monetary asset like plant & machinery can see its value decline as the technology becomes obsolete. Its value depends upon certain factors such as changes in technology, supply-demand factors, etc. These factors are not relevant when it comes to the valuation of monetary assets. The evaluation rules are different for monetary (fair value) o non-monetary assets (cost), but assets that can either be Monetary or Non-Monetary depending on circumstances. • Prepayments or advance payments can either be monetary or non-monetary, based on a contract with a third party (the party to which payment was made). If as per the contract, the pre-paid amount is non-refundable (which it usually is) or if there is no contract and the probability of getting the amount back is very low, then it should be treated as a nonmonetary asset. • Investments in preference shares shall be treated as monetary assets if there is a clause in the contract, by virtue of which, the redemption of preference shares has to be undertaken by the issuing entity after a certain time in the future. Otherwise, investments in preference shares will be treated as assets that are non-monetary. 2- Accounts receivable and allowance for bad debts – Accounts receivable are the amounts owed to a company by customers as a result of delivering goods or services and extending credit in the ordinary course of business and they are also known as trade receivables or simply receivables. They are valued at their net realizable value (what is used to value accounts receivable is the value for the sale that have not been collected yet, so revenues that have not been collected yet). – Uncollectible accounts (bad debts) are receivables determined to be uncollectible because debtors are unable or unwilling to pay their debts. They need to be deducted from accounts receivable gross. There are two basic ways to record uncollectible: • Specific write-off method : the receivables not paid are written off when they are recognized as uncollectible (example, in case of bankruptcy) → The specific write-off method assumes that all sales are fully collectible until proved otherwise (gross value equals the net realizable value of accounts receivable) • Allowance method: it estimates the portion of accounts receivable that are expected not to be collected → When an account is identified as uncollectible, that account is removed from the books and an expense is recorded and this method, which is used by companies that rarely experience bad debts, is called allowance method → The allowance method estimates the amount of uncollectible accounts to be matched to the related revenues and it allows to recognize bad debts during the proper period, before specific uncollectible accounts are identified in a subsequent period, thus improving the matching of revenues and expenses → The allowance method has two basic elements:  An estimate of the amounts that will ultimately be uncollectible 6 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi  A contra account, Allowance for Uncollectible Accounts, which contains the estimate and is deducted from Accounts Receivable → The allowance method is based on historical experience and the assumption that the current year is similar to prior years → The allowance is quantified directly as percentage of ending account receivable (sometimes differentiated based on the age of the overdue) or indirectly as a percentage of credit sales 3- Inventory evaluation and cost of goods sold – Inventories are measured at the lower of cost and net realisable value, which is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale – The cost of inventories includes all costs of purchase, costs of conversion (direct labour and production overhead) and other costs incurred in bringing the inventories to their present location and condition – Under the IFRS the cost of inventories is assigned by: • Specific identification of cost for items of inventory that are not ordinarily interchangeable • The first-in, first-out or weighted average cost formula for items that are ordinarily interchangeable (generally large quantities of individually insignificant items) – When inventories are sold, the carrying amount of those inventories is recognised as an expense in the period in which the related revenue is recognised – The amount of any write-down of inventories to net realisable value and all losses of inventories are recognised as an expense in the period the write-down or loss occurs 4- Fixed assets (tangible and intangible), depreciation and amortization – There are two main categories of fixed assets: • Tangible fixed assets, including PPE (property, plants and equipment), land, etc. – everything that is long lived, which means that ... and that it will generate cash flow beyond the current accounting period • Intangible assets, which have no physical form (like trademarks, patents, copyrights, ….) – According to the cost principle, acquired fixed assets should be recorded at their actual cost, also called historical cost – Remember that the cost of any asset, including fixed assets, is the sum of all the costs incurred to bring the asset to its intended use – For fixed assets, therefore, the typical items included in the cost are: • Purchase price • Applicable taxes • Purchase commission • Legal fees • Transportation charges • Insurance while the asset is in transit • Installation costs • Cost for testing the asset before it is used, etc. – At the end of the accounting period, firm record an expense related to the fact that during the same period they have used fixed assets, so they contributed to the revenue earned. – Depreciation is the process of allocating the cost of a fixed asset over the years of its useful life, that is over the years that the asset was used • Depreciation is an expense and a decrease in the asset value 7 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi • If, at the end of a given accounting period, the net book value of a fixed asset is higher than the recoverable value of the asset, firms are required to “impair” the asset, which means to record for an extraordinary loss of value (expense) • Remember that the cost is always the highest value at which an asset can be evaluated. This means that we cannot record a value higher than the cost we paid to acquire the asset (unless the revaluation model is used) – Amortization: intangible assets are rights or claims to expected benefits that tend to be contractual in nature rather than physical in nature. Examples are patents, copyrights, and franchises. The accounting for intangibles is much like that of tangible assets • Acquisition costs of intangibles may be: the cost of purchase, the fair value in a contribution in kind, the capitalized cost in case of capitalization of operating expenses • Intangibles are amortized using the straight-line method • Firms measure the depreciation based on: → Depreciable cost → Estimated useful life • Depreciable cost in most cases corresponds to the total cost of the asset (see before). When it is expected that some money from the sale of the asset at the end of its useful life will be gained, the depreciable cost equals the historical cost - (minus) the residual value • The estimated useful life is an estimate of how long the assets will be useful: this can be expressed in years, units of output or other measures • There are different methods to allocate the depreciable value to the periods of the asset’s useful life. The most common in practice are: → Straight-line method → Units-of-production method → Declining balance method (accelerated depreciation) 5- Take home – Non-monetary and monetary assets have different evaluation criteria: cost based and fair value based – Accounts receivables are valued at their net realizable value – Inventories are evaluated at the lower of cost (FIFO; LIFO; weighted average, specific identification) or market price – Fixed assets (tangible and intangible) are evaluated, respectively, at their depreciated or amortized cost INTRODUCTION TO CONSOLIDATION 1- Intercorporate investment and consolidation – When an investor has control over an investee company (over 50% ownership), it must prepare consolidated financial statements – The investor company is called the parent (buying company) – The investee company is called the subsidiary (target company) – Although both companies remain separate legal entities, the financial position and earnings reports of the parent are combined with those of the subsidiary, but since the parent company controls the subsidiary, it is required to produce consolidated statements 2- Acquisition – Assume two separate companies: • Company A: Assets of $650 million and Liabilities of $200 million 8 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi – – • Company B: Assets of $400 million and Liabilities of $187 million This means that the book value of Equity of company A of $450 million and the book value of Equity of company B of $213 million Company A purchases all of the outstanding stock of company B (B gives shares and A pays money to the shareholder of B) for $213 million in cash The journal entry on the books of A (in millions) will report an increase in Investment in B and a decrease in Cash for the same amount of 213, so the acquisition is reported as an investment (payment in cash) of company A in company B However, when we look at the consolidated account, we have to combine the assets and the liabilities of B into A: after the acquisition B will stay as a legal entity as it is, because B is still existing, but A will have a reduction in cash ($213 millions are gone to the shareholders of B) and there will be an investment in B 3- Consolidated financial statements Now the company has to prepare consolidated financial statements because now there is just one shareholder, that is all the shareholders of A, who want to know the whole “story”, so A + B, that means we have to combine the financial statements into a consolidated one. How do we combine A + B? In combining the amounts on the balance sheet, A must eliminate its investment account and the stockholders’ equity of B, which eliminates double-counting of the investment in B: After the acquisition A continues to use the equity method during the period and to prepare consolidated statements, P must eliminate: • Its investment account and the Shareholder’s Equity of the subsidiary on the consolidated balance sheet • Intercompany revenues and expenses on the income statement • Other intercompany transactions 4- Price not equal to book value Let’s now assume that all the acquired assets and liabilities are shown at their fair market value, so if the purchase price is more than the fair market value of the net asset, goodwill must be shown on the consolidated statement – When the acquiring company pays more than the book value of the acquired company’s net assets, consolidation requires a two-step adjustment: 1. All acquired assets and liabilities are shown at their fair market value (FMV) 2. If the purchase price > FMV of the net assets, goodwill must be shown on the consolidated balance sheet 9 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi – Goodwill is the excess of the cost of an acquired company over the sum of the FMV of its identifiable assets less the liabilities 5- Accounting for goodwill – In the previous example, assume that: • A acquired a 100% interest in B for $253 million rather than $213 million • A building with a book value of $20 million had a FMV of $35 million – The tabulation of the consolidated balance sheet is shown in the next exhibit – Goodwill = Price paid - Equity book value – FMV adjustments $253 million - $213 million- ($35 million-$20 million) = $25 million One additional element about this conversation about purchasing, acquiring and accounting for goodwill refers to the possibility of A not buying 100% of B (As we assumed), but only a (relevant) portion of it, so a will control B but there will be a residual part which will remains in the hands of the shareholder of B. If this is happening, once we consolidate A + B, there is an item, called “minority interests” or “interest of the non-controlling company” that needs to be identified and disclosed in some way. Just to see how it is disclosed: In the Balance Sheet, in the Equity section we have total Equity attributable to the shareholder of the parent company and non-controlling interest, so basically the Equity is split in two components: the Equity attributable to the parent company and the Equity attributable to the shareholder of B who is still there. As a result, there are two ways of looking at this company: A + B (total, regardless of who is owning this company) or just looking at what is owned by the parent company and what is owned by the former shareholder of B. And the same thing happens with Revenues and Expenses. 10 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi When we started talking about goodwill, we said that company A was investing in B (this is in the first place an investment of A in B, so we have to consolidate A + B), but this is not the only situation when a company can invest in the so-called intercorporate investment; a company can invest in financial investment. OWNERSHIP OF MORE THAN 50% (Equity Investment) The one that we have analyzed was an equity investment of A into B and this equity investment was because we had a situation of merges and acquisition, which means that company A in a very clear way wants to buy at least 50% of Equity since it wants to control B: so, it buys the equity and liquidates the shareholders of B (possibly all of them) and if this happens it means that A controls B and it represents this in the statement through the process of consolidation (one single legal entity regardless the accounting distinction – “as if it were a single company”). OWNERSHIP BETWEEN 20% AND 50% (Financial Investment) If we buy Equity (which is not M&A, but acquisition), we may end up saying “I’d like to work together with another company”, but if company A buys also the Equity of B (some, not all), then the affiliation gets a little more tight (because the representative of the Board of Director of a will have to be present in the shareholding meeting of B): this affiliation is what is very roughly defined as operating when A owns from 20% to 50% of the shares of B (it has power to influence the decisions of B) and it is called affiliation. A is saying that it has an investment in B: how do we represent this power of influence, this investment? Does this investment need to be reported as cost or at fair value? With Equity we have this doubt because this Equity (company B) may also be listed on the market and so the shares of B may go up or down, and so the question is: do we have to match the market price in this case (because this is financial investment, it is different from PPE because they are not traded every day). For this specific situation we may want to match the market price because these are identifiable items, so we have to find some ruled that needs to be followed to say that we want to match the market price. The rules that we are given are that if we find ourselves in this situation, instead of looking at the listing we use the so-called Equity Method, which in a very simple way says that we need to look at the investment in B and if this is to be reported at the end of the year, we have to make an adjustment: the investment in B increases (because the company reports profits) and decreases (because the company pays dividends). And if we have to report this in the company that owns a percentage of the other company (from 20% to 50%), we must report the % of the profit and deduct the % of the dividends. So, any change in the Equity of B gets replicated in A proportionally. OWNERSHIP OF LESS THAN 20% If company A doesn’t want to have a 20% but invests just to generate a return (less than 20%), so it is sure that it won’t exert any influence. Available for sale or trading securities: the difference is the intent, so available for sale means that the intention is to keep, while trading the idea is to do it for business. In both cases the way we report on the Balance Sheet is mark to market, which means that at the end of the year we must check which is the current listing on the stock and report that amount on the Balance Sheet. We record this increase or decrease in the Balance Sheet under the “investment” section, but we also have to record it in the Income Statement as “unrealized gain or loss”, under “other comprehensive income”. 6- Take home – When an investor has control over an investee company (over 50% ownership), it must prepare consolidated financial statements. – Although both companies remain separate legal entities, the financial position and earnings reports of the parent are combined with those of the subsidiary. 11 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi – – – The preparation of consolidated financial statements entails the pooling of revenues and expenses, assets and liabilities of all legal entities belonging to the consolidation perimeter. Homogeneity checks refer to: • Separate entities financial statements closing dates • Accounting principles, if different re-statement is required • Currency adopted, if different the functional currency conversion id required • Format of financial statements. Intercompany transactions need to be eliminated. Typical accounting items that emerge in consolidation are minority and goodwill interest. INVESTMENTS AND INTERNATIONAL OPERATIONS Investments: an overview Shares: – Investor: entity that owns share of a corporation – Investee: entity that issues the share Bonds – Investor: entity that owns the bonds of the corporation – Debtor: entity that issues the bonds Categories of Financial Asset Investments – Financial Assets: Short-term or long-term • Trading: bonds or share • Held-to-maturity: only bonds because shares don’t have an expiration date • Available-for-sale: bonds and shares – Investment in associates (and joint ventures): only shares – Investment in subsidiaries: only shares • Typically more than 50% ownership • Long-term investments and these categories are relevant because each one has got a different impact on accounting in a different to be presented in the Balance Sheet. TRADING SECURITIES – Short-term investments in marketable securities (because the intent is to speculate) – Next-most-liquid asset after cash – Reported immediately after cash and before receivables on the Balance Sheet – Reported at mark to market and we have unrealized gains or losses: • A gain has the same effect as a revenue, i.e., it will increase equity • Unrealized gain because the company may not yet have sold any securities HELD-TO-MATURITY BONDS – Reported at amortized cost – Interest received semi-annually – Usually issued in $1,000 denominations – Prices quoted as a percentage of par – Fluctuate with market interest rates • Market rate > face rate  discount 12 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi • Market rate < face rate  premium BONDS – Major investors are financial institutions – Investor intends to hold for < 1 year  available-for-sale – Investor intends to hold until maturity  held-to-maturity – Traded on the open market (public companies) LITTLE WRAP UP If a company decides to make an investment in financial assets, how do we differentiate a financial asset, in which categories? There are 2 categories: the debt and the Equity. Both earn a return, but in case of Equity we don’t knew ex ante what the return will be, while if it a debt we can determine ex ante which will be the return. If we have Equity not only, we go to the shareholder meeting, but we exert a certain influence, which can be small and limited or very high, so this idea that when a company invests in Equity can exert an influence make the accountants think how to represent this influence in the body of the statement. So, if we concentrate on Equity, we will have different ways of representing the influence going from very little to very high: - Very high influence (more than 50%): the way to represent the financial investment into another company is M&A, and so consolidation, which means that we put together all the categories of B with the homogeneous categories of the mother/parent company - Lighter influence: the accounting method to present the investment in another company (called affiliated) is called Equity method - Very little influence: in this case there are 2 alternatives, which are available-for-sale investment (make an investment without the intention to sell it) and trading securities (make an investment with the specific intention to sell it) and in these 2 cases the investment is reported in the financial statement of the acquiring company using mark to market criterium (or fair value) If we talk about bonds or debt, we don’t have the same categories: if we think about bonds, we have trading, we have available-for-sale and because bonds also have deadlines, we can also say that we buy the bond and hold it until maturity. In the case of purchase of a bond with the intent to hold it until maturity the criterium used to represent this investment is amortized cost. Who is making the decision of what is what? This decision is important since it has a good impact on the finance of the company, and CFO will probably make a proposal on how to classify the investments, but the Board of Directors is in charge of making this decision, and then there is an auditor who is in charge of checking this decision, because auditors know that this is a very sensible decision. MAIN LIABILITY EVALUATION PRINCIPLES Various type of liabilities The Conceptual Framework defines liability as Obligations settled through outflow of resources embodying economic benefit There are two kinds of liabilities: a. If short-term  current liability b. If long-term  non-current liability and this classification is based on the financial criterium, that is to say when the obligation that is underlying the liability is actually expiring or when the obligation needs to be settled through the outflow of resources embodying economic benefits (typically, but not necessarily cash flow). Current Liabilities of Known Amounts – Accounts payable (originated when somebody purchases something and doesn’t pay) 13 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi – – – – – – – – – Accrued liabilities or accrued expenses (when somebody uses resources which have not been built or invoiced or paid yet) Deposits Unearned revenues (somebody pays for a service which has not been delivered yet, so the cash comes in, but the service has not been delivered) Payroll-related liabilities (company pays a salary to the employee but is also obliged to pay a percentage of the salary to INPS, for example, for social contribution) Sales tax payable (=VAT payable) Tax payable Provisions Notes payable – Short term Debt – Current portion of long-term debts Provisions Provisions (fondi for future expenses and risks) of uncertain time and amount – warranties – Liabilities of uncertain timing and amount (we don’t know how much it will cost to repair and we don’t when this will happen) – Covered under IAS 37—Provisions, Contingent Assets and Contingent Liabilities – Examples include Warranty: companies may guarantee their products under a warranty – Matching principle demands the company records the warranty expense in the same period the business records sales revenue Contingent liabilities – A potential liability that depends on the future outcome of past events (they originate in the past and we may see them in the future) • Possible obligation to be confirmed by a future event • Present obligation that may/may not require outflow of resources • Reliable estimate of amount of present obligation cannot be made – Examples: future liabilities that may arise due to lawsuits, tax disputes, or alleged violations of environmental protection laws – Either: accrue (supposed to have a tax litigation that we don’t know how it is going to end, but the IRS has already computed the value of taxation + fine that they are asking because of miscalculation, so in that case we want to be very prudent and we put it under contingent liability and we put also the amount), disclose (means that we don’t put in the amount but we disclose it in the set of financial statements), or neither. – Can be overlooked when creating a Balance Sheet as they aren’t actual debts – Net income will be overstated if the company fails to accrue interest on liability Valuing (and reporting) long-term liabilities Reporting bonds – Time value of money: means that if we have €1 today and €1 in ten years is not the same thing, and it is better to have it today because in ten years this €1 invested today can become a higher value, so we have a present value, that is the value of the money today and a future value, which is the value of the money in the x amount of years When we talk about liabilities, we talk about obligations, that are what we owe to other entities and therefore if we have to value the obligation, we need to take into account the time value of money. One example of long-term obligation that is listed under the liability side (long-term but also has a portion on the short-term) are actually the bonds, which are a promise to repay a bond in a certain amount of year and also include a payment of a period interest. 14 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi Some vocabulary about bonds: • The maturity of the bond is the expiration of the bond, so the time when the bond holder will be refunded • The coupon rate: the coupon is the periodic payment of the interest, so the coupon rate is the rate of interest which is paid periodically to the bond holder • The nominal (or face) value of the bond is what will be paid back to the bond holder at maturity • The market interest rate means that there is an interest rate that is determined on the market every day and depends on many factors, such as depending on risk this market rate fluctuates in general, and specifically from company to company So, the market rate is volatile, while the nominal (or coupon) rate is fixed for all the life of the bond. – Affects the pricing of bonds (valuation of bonds) – Bond interest rates determine bond prices • Always sold at market price (bond’s present value) • Stated interest rate (coupon rate) • Market interest rate (effective interest rate) We know that we have to report bonds at the net present value of the bond since it is a long-term obligation (being a long-term obligation means that the criterium to report the value of the bond on the Balance Sheet is the present value). – Bonds may be issues at par, at discount, at premium and the two numbers that we compare to determine how the bond is issued are the proceeds from issuance of the bond (amount of money that the company will get when it issues then bond) vs the face value • At par: coupon rate = market rate  proceeds = face value (the promise that you make as a company that is issuing a bond to your bond holder is that you will pay on this loan an interest which is exactly equivalent to the market rate) • At discount: coupon rate < market rate  proceeds < face value (if you want to sell the bond, as a company, you have to give a discount, so you will say that today you will be giving me less money than expected to compensate this difference, because otherwise why should I buy your bond?) • At premium: coupon rate > market rate  proceeds > face value How do we compute the present value of the bond obligation? The assumption is that the bond is issued at par, the nominal value (or face value) is 1000, the coupon interest rate is 5% and also the market interest rate is 5% and we have a semiannual payment. What we have to do in order to compute the present value of this bond at issuance is to basically sketch out the cash flow (what is this obligation implying to us), and the cash flow is set up of 2 components: 1. The first component is the payment of 1000 at maturity 2. Several payments of equal amount every 6 month and to determine the equal amount that needs to be paid every six months we have to multiply 1000 for the coupon interest rate and divide it by 2 since it is a semiannual payment, so , so every 6 month we have to pay 25 and we have to pay 25 for 10 times. So, we have to report these two flows at present value, and we so have to decide when the present value is (could be present value at time 0, at time 1, etc …). With regards to the first cash flow (payment of 1000 at maturity) we know that the present value of 1000 will be less than 1000, so we discount the 1000 up to today (the obligation is in 5 years but today this obligation is worth less on a value term) and to know how much less we have to look at the market rate. 15 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi With regard to the second flow, we have the same problem as before, that is to know what is worth today ten payments delayed in five years, each one of 25, so it is the present value of an annuity (rendita) for ten periods at 5%. Basically, we have a payment in five years and then ten semiannual payments, so the value of the bond today is the value discounted of this capital payment in five years (face value payment at maturity) and the ten consecutive payments over five years’ time when the market would grant 5% on that amount of money (we have to think at what we are giving up lending this money and not investing it in another investment). The present value can be computed at time 0, and this is called the proceed from issuance or it can be computed at each point in time and at each point in time of course the present value would adjust (so if we are at issuance we say five years and ten payments, but if we are positioned at time 1 we say that the payment is in four years and the payments are not ten, but 8), this is why the value of the bond changes over the life of the bond. So, if we are issuing a bond at par, the present value at maturity is exactly the nominal value. Take home – Liabilities are classified in: • Short-term and long-term depending on expiration date • Definite or un-definite in the amount • Certain or contingent – Liabilities are reported at their nominal value if they are short-term, of definite amount and certain – Liabilities are reported at their present value if they are long-term, of definite amount and certain – Liabilities of undefine amount need to be estimated – Contingent liabilities are typically disclosed in the notes We have seen how to evaluate bonds, that is at net present value, which means whatever the long-term obligation we are dealing with is we have to do two things: – Identify the future cash outflow that the obligation implies – Discount this cash flow at present value and then we have to report this. With reference to bonds there are 4 issues / items that we need to consider: – Amount of money (cash) at issuance, which is called the proceeds (present value of the bond at issuance) and it can be equal, above of below the face value of the bond, and so we have bonds issued at par at premium or at discount – How do we determine the interest expense? It is determined using the effective market rate in place at issuance, so if the bond is issued at par the market rate is equal to the coupon rate (in this specific case the cash payment to the bond holder coincides with the interest expense), when the bond is issued at discount or at premium things are different (look at the table), but in any case the interest expense remains equal to the present value of the bond * market rate in place when we issue the bond – In case of issued at premium or bond issued at premium how do we amortize the discount on bond or the premium on bond, and in any case this amortization which applies both to the discount and the premium follows the effective interest rate method, that is to say amortization is determined using the algebraical sum of the interest expense and the cash payment (that is the amount that we have to use to amortize the discount or the premium) – What is the amount of payment that is due at maturity? The payment at maturity, regardless that it is premium, discount or par is always equal to the face value CASH FLOW STATEMENT PREPARATION 16 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi Definition and purposes The Statement of Cash Flow provides a thorough explanation of the change occurred in a firm’s cash* (cash and cash equivalents) balance during the entire accounting period. Cash inflows and outflows are grouped according to the type of activity that generate them: – Operations: cash inflows and outflows concerned with ordinary functioning of the enterprise – Investing: cash inflows and outflows concerned with transactions to acquire or to dispose of long-lived assets – Financing: cash inflows and outflows concerned with getting cash or repaying debt We could create a Cash Flow Statement simply looking at the cash column and labelling each cash inflow and outflow as cash flow from operation, from investing or from financing (direct method). The point is that this easy way to prepare the Cash Flow Statement is not what is implemented in 99,9% of the companies, since companies use another method called the indirect method. We need an indirect method because at some point in time somebody said that we have an income generated that is reported using the accrual basis ( accrual basis means that if we report revenues, we’re not waiting to get paid and if we report expenses we don’t wait to pay), so we start seeing that revenues and expenses deviate from cash inflow and outflow and so at some point both statements are referred to flow value (revenues is a flow value and expenses is a flow value, cash inflow and cash outflow are both flow values). Somebody wondered why we don’t reconcile the income position to the cash position, so why don’t we find a way to start with income and then identify which portion of that income is also cash flow (how is it possible that I have a income but no cash in hand or how is it possible that I have a loss but has money in hand? The cash flow and the earnings flow are not coinciding). So, the Cash Flow Statement prepared using the indirect method suggests an answer to this question: it is the reconciliation of income position to cash position. Preparation of Cash Flow Statement - indirect method 1. The beginning: the Balance Sheet equation ASSET = LIABILITY + EQUITY 2. The continuation: the re-classification of the Balance Sheet equation Cash + Non-cash Current assets + Long-lived Assets = Current Liabilities + Long-term Liabilities + Capital + Retained Earnings (Net Income – Dividends) 3. The focus on the cash: the “arrangement” of the Balance Sheet equation Cash = Net Income – Non-cash Current Assets + Current Liabilities – Long-lived assets + Long-term Liabilities + Capital – Dividends 4. The change in cash: static to dynamic Balance Sheet equation Change in cash equal to change in all the other items, so Δ +/- Cash = – Net Income ** - Δ +/- Non-cash Current Assets + Δ +/- Current Liabilities (**Δ Retained Earnings = Net Income – Dividends) Cash flow from operations – - Δ +/- Long-lived Assets Cash flow from investing – + Δ +/- Long-term Liabilities + Δ +/- Capital – Dividends ** Cash flow from financing 17 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi Net Cash Flow This means that fi we want to observe the cash flow we can look at the cash flow changes on the left side (and this is what we were doing when preparing the cash flow for the transaction analysis) or, because this is an equation that balances, we can look at the right side of the equation because it is equivalent to the straight, direct change in cash. 99,9% of companies use the indirect method, so to determine the change in cash they look at the right side of the equation because if we look at the right side of the equation the first input is income, and this allows to reconcile the income position to the cash position. Example: Assume year 1 Income Statement for a very simple service company that provides services for 100 and has got expenses for 60 (these are wages expenses because this company is providing clinic services and subcontracting to people). YEAR 1 YEAR 1 (beginning) YEAR 1 (end) Revenues 100 Accounts Receivable 1 0 Accounts Receivable Expenses 60 Wages Payable 5 Wages Payable Income 40 How much cash flew in this company over the period (what is the change of cash over the period)? + Income 40 Δ+ Accounts Receivable 10 Δ- Wages Payable Cash flow 5 35 2 0 1 0 Non-cash current Assets Current Liabilities When we have 100 in Revenues, this doesn’t mean that we collected all the Revenues and we can also have existing Accounts Receivables that we may end up collecting during the period, so in order to say which portion of the Revenues is cash collection from customers what we have to do is start saying we have Accounts Receivable at the beginning, we have sold during the period 100 but we may end up having Accounts Receivable at the end, which basically means take the portion of Income, Revenues, that is associated to Accounts Receivable and adjust for the change in Non-cash current Assets, in this case Accounts Receivable. In the example: the potential collection from customers is 110, but we are left with 20, which means we collected 90 (equal to Revenues – the change in Non-cash Current Assets). The same thing happens for Expenses, so similar procedure but in this case we talk about cash outflows. The complication comes from this: Net Income is our input in the first section, but we have to determine Cash Flow from Operations. Do we include in Net Income items that are Non-operating? Because if we want to reconcile the bottom of the Income Statement to the first section, which is Cash Flow from Operation we say that everything that we write there as Cash Flow from Operations has to be related to operations. Adjustments: 1. So, basically one complication is to exclude Non-operating items, which means that if they are already computed in the calculation of Net Income we have: – Add back them if they are Expenses (Non-operating) – Subtract them If they are Revenues (Non-operating) and one example are Gains or Losses on Sale of Equipment. 18 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi 2. The second adjustment is to exclude Non-monetary items: – Add back them if they are Expenses (Non-monetary) – Subtract them If they are Revenues (Non-monetary) and one example are Depreciation, Amortization, Impairment of Goodwill (they are examples that are considered in the calculation of Net Income, but for any reason will ever convert into cash). 3. Third adjustment is due to the fact that we have time lags between the Revenue and the Expense item and the actual cash flow, so here we have to: – Add the changes in Current Liabilities – Subtract the changes in Non-cash current Assets So, basically there are three types of items that we have to amend: we have seen the third one and now we have to see others. But we have to remember that excluding one item from Net Income implies that we have to do some other adjustments somewhere in the system to be able to balance the system, since this is a system that works with the double entry (Balance Sheet equation). Example: When we depreciate an item we always have to think about what happens: we include the Depreciation Expense in Retained Earnings and we deduct the depreciation either straight from the Long-lived assets or we add it to Accumulated Depreciation, but in any case, the book value of the Long-lived Asset after the application of depreciation is reducing. When we say that we take into account, if we start with Cash Flow from Operation, that this depreciation will never convert into cash outflow and adjust, it means that we are basically rewinding or redoing this transaction putting a + in the Retained Earnings’ column in order to exclude the depreciation, but if we do that we have to balance this transaction and so we have also to add back the depreciation to Long-lived Assets. This adjustment that we make to the Income and to the Long-lived Assets net are done using the doubleentry but don’t get journalized, so the accounting doesn’t get changed because of this – this are all extra accounting adjustments, but they are needed otherwise the numbers don’t come up right. Adjusting in this case (Depreciation) means that it will affect both the Cash Flow from Operations and the Cash Flow from Investing (Long-lived Assets are in the Cash fl