Financial Statement Analysis & Managerial Accounting PDF

lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – Goodwill is the excess of the cost of an acquired company over the sum of the FMV of its idenable assets less the liabilies 5- Accounng for goodwill – In the previous example, assume that: • A acq...

lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – Goodwill is the excess of the cost of an acquired company over the sum of the FMV of its idenable assets less the liabilies 5- Accounng 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 tabulaon 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 addional element about this conversaon about purchasing, acquiring and accounng for goodwill refers to the possibility of A not buying 100% of B (As we assumed), but only a (relevant) poron 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 idened and disclosed in some way. Just to see how it is disclosed: In the Balance Sheet, in the Equity secon we have total Equity aributable to the shareholder of the parent company and non-controlling interest, so basically the Equity is split in two components: the Equity aributable to the parent company and the Equity aributable to the shareholder of B who is sll 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 Accounng UCSC | Marna Marazzi When we started talking about goodwill, we said that company A was invesng in B (this is in the rst place an investment of A in B, so we have to consolidate A + B), but this is not the only situaon when a company can invest in the so-called intercorporate investment; a company can invest in nancial 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 situaon of merges and acquision, 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 consolidaon (one single legal enty regardless the accounng disncon – “as if it were a single company”). OWNERSHIP BETWEEN 20% AND 50% (Financial Investment) If we buy Equity (which is not M&A, but acquision), 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 aliaon gets a lile more ght (because the representave of the Board of Director of a will have to be present in the shareholding meeng of B): this aliaon is what is very roughly dened as operang when A owns from 20% to 50% of the shares of B (it has power to inuence the decisions of B) and it is called aliaon. A is saying that it has an investment in B: how do we represent this power of inuence, 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 queson is: do we have to match the market price in this case (because this is nancial investment, it is dierent from PPE because they are not traded every day). For this specic situaon we may want to match the market price because these are idenable items, so we have to nd 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 nd ourselves in this situaon, instead of looking at the lisng 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 prots) 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 prot and deduct the % of the dividends. So, any change in the Equity of B gets replicated in A proporonally. 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 inuence. Available for sale or trading securies: the dierence is the intent, so available for sale means that the intenon 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 lisng on the stock and report that amount on the Balance Sheet. We record this increase or decrease in the Balance Sheet under the “investment” secon, 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 nancial statements. – Although both companies remain separate legal enes, the nancial posion 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 Accounng UCSC | Marna Marazzi – – – The preparaon of consolidated nancial statements entails the pooling of revenues and expenses, assets and liabilies of all legal enes belonging to the consolidaon perimeter. Homogeneity checks refer to: • Separate enes nancial statements closing dates • Accounng principles, if dierent re-statement is required • Currency adopted, if dierent the funconal currency conversion id required • Format of nancial statements. Intercompany transacons need to be eliminated. Typical accounng items that emerge in consolidaon are minority and goodwill interest. INVESTMENTS AND INTERNATIONAL OPERATIONS Investments: an overview Shares: – Investor: enty that owns share of a corporaon – Investee: enty that issues the share Bonds – Investor: enty that owns the bonds of the corporaon – Debtor: enty 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 expiraon 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 dierent impact on accounng in a dierent to be presented in the Balance Sheet. TRADING SECURITIES – Short-term investments in marketable securies (because the intent is to speculate) – Next-most-liquid asset aer cash – Reported immediately aer 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 eect as a revenue, i.e., it will increase equity • Unrealized gain because the company may not yet have sold any securies HELD-TO-MATURITY BONDS – Reported at amorzed cost – Interest received semi-annually – Usually issued in $1,000 denominaons – 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 Accounng UCSC | Marna Marazzi • Market rate < face rate  premium BONDS – Major investors are nancial instuons – Investor intends to hold for < 1 year  available-for-sale – Investor intends to hold unl maturity  held-to-maturity – Traded on the open market (public companies) LITTLE WRAP UP If a company decides to make an investment in nancial assets, how do we dierenate a nancial 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 meeng, but we exert a certain inuence, which can be small and limited or very high, so this idea that when a company invests in Equity can exert an inuence make the accountants think how to represent this inuence in the body of the statement. So, if we concentrate on Equity, we will have dierent ways of represenng the inuence going from very lile to very high: - Very high inuence (more than 50%): the way to represent the nancial investment into another company is M&A, and so consolidaon, which means that we put together all the categories of B with the homogeneous categories of the mother/parent company - Lighter inuence: the accounng method to present the investment in another company (called aliated) is called Equity method - Very lile inuence: in this case there are 2 alternaves, which are available-for-sale investment (make an investment without the intenon to sell it) and trading securies (make an investment with the specic intenon to sell it) and in these 2 cases the investment is reported in the nancial 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 unl maturity. In the case of purchase of a bond with the intent to hold it unl maturity the criterium used to represent this investment is amorzed cost. Who is making the decision of what is what? This decision is important since it has a good impact on the nance 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 liabilies The Conceptual Framework denes liability as Obligaons seled through oulow of resources embodying economic benet There are two kinds of liabilies: a. If short-term  current liability b. If long-term  non-current liability and this classicaon is based on the nancial criterium, that is to say when the obligaon that is underlying the liability is actually expiring or when the obligaon needs to be seled through the oulow of resources embodying economic benets (typically, but not necessarily cash ow). Current Liabilies 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 Accounng UCSC | Marna Marazzi – – – – – – – – – Accrued liabilies 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 liabilies (company pays a salary to the employee but is also obliged to pay a percentage of the salary to INPS, for example, for social contribuon) Sales tax payable (=VAT payable) Tax payable Provisions Notes payable – Short term Debt – Current poron of long-term debts Provisions Provisions (fondi for future expenses and risks) of uncertain me and amount – warranes – Liabilies of uncertain ming 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, Conngent Assets and Conngent Liabilies – 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 Conngent liabilies – A potenal liability that depends on the future outcome of past events (they originate in the past and we may see them in the future) • Possible obligaon to be conrmed by a future event • Present obligaon that may/may not require oulow of resources • Reliable esmate of amount of present obligaon cannot be made – Examples: future liabilies that may arise due to lawsuits, tax disputes, or alleged violaons of environmental protecon laws – Either: accrue (supposed to have a tax ligaon that we don’t know how it is going to end, but the IRS has already computed the value of taxaon + ne that they are asking because of miscalculaon, so in that case we want to be very prudent and we put it under conngent 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 nancial statements), or neither. – Can be overlooked when creang 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 reporng) long-term liabilies Reporng 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 beer 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 liabilies, we talk about obligaons, that are what we owe to other enes and therefore if we have to value the obligaon, we need to take into account the me value of money. One example of long-term obligaon that is listed under the liability side (long-term but also has a poron 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 Accounng UCSC | Marna Marazzi Some vocabulary about bonds: • The maturity of the bond is the expiraon of the bond, so the me 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 uctuates in general, and specically from company to company So, the market rate is volale, while the nominal (or coupon) rate is xed for all the life of the bond. – Aects the pricing of bonds (valuaon 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 (eecve interest rate) We know that we have to report bonds at the net present value of the bond since it is a long-term obligaon (being a long-term obligaon 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 dierence, 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 obligaon? The assumpon 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 ow (what is this obligaon implying to us), and the cash ow is set up of 2 components: 1. The rst 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 mulply 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 mes. So, we have to report these two ows at present value, and we so have to decide when the present value is (could be present value at me 0, at me 1, etc …). With regards to the rst cash ow (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 obligaon is in 5 years but today this obligaon 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 Accounng UCSC | Marna Marazzi With regard to the second ow, we have the same problem as before, that is to know what is worth today ten payments delayed in ve 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 ve years and then ten semiannual payments, so the value of the bond today is the value discounted of this capital payment in ve years (face value payment at maturity) and the ten consecuve payments over ve years’ me 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 invesng it in another investment). The present value can be computed at me 0, and this is called the proceed from issuance or it can be computed at each point in me and at each point in me of course the present value would adjust (so if we are at issuance we say ve years and ten payments, but if we are posioned at me 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 – Liabilies are classied in: • Short-term and long-term depending on expiraon date • Denite or un-denite in the amount • Certain or conngent – Liabilies are reported at their nominal value if they are short-term, of denite amount and certain – Liabilies are reported at their present value if they are long-term, of denite amount and certain – Liabilies of undene amount need to be esmated – Conngent liabilies 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 obligaon we are dealing with is we have to do two things: – Idenfy the future cash oulow that the obligaon implies – Discount this cash ow 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 eecve 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 specic 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 dierent (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 amorze the discount on bond or the premium on bond, and in any case this amorzaon which applies both to the discount and the premium follows the eecve interest rate method, that is to say amorzaon is determined using the algebraical sum of the interest expense and the cash payment (that is the amount that we have to use to amorze 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 Accounng UCSC | Marna Marazzi Denion and purposes The Statement of Cash Flow provides a thorough explanaon of the change occurred in a rm’s cash* (cash and cash equivalents) balance during the enre accounng period. Cash inows and oulows are grouped according to the type of acvity that generate them: – Operaons: cash inows and oulows concerned with ordinary funconing of the enterprise – Invesng: cash inows and oulows concerned with transacons to acquire or to dispose of long-lived assets – Financing: cash inows and oulows concerned with geng cash or repaying debt We could create a Cash Flow Statement simply looking at the cash column and labelling each cash inow and oulow as cash ow from operaon, from invesng or from nancing (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 me 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 waing 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 inow and oulow and so at some point both statements are referred to ow value (revenues is a ow value and expenses is a ow value, cash inow and cash oulow are both ow values). Somebody wondered why we don’t reconcile the income posion to the cash posion, so why don’t we nd a way to start with income and then idenfy which poron of that income is also cash ow (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 ow and the earnings ow are not coinciding). So, the Cash Flow Statement prepared using the indirect method suggests an answer to this queson: it is the reconciliaon of income posion to cash posion. Preparaon of Cash Flow Statement - indirect method 1. The beginning: the Balance Sheet equaon ASSET = LIABILITY + EQUITY 2. The connuaon: the re-classicaon of the Balance Sheet equaon Cash + Non-cash Current assets + Long-lived Assets = Current Liabilies + Long-term Liabilies + Capital + Retained Earnings (Net Income – Dividends) 3. The focus on the cash: the “arrangement” of the Balance Sheet equaon Cash = Net Income – Non-cash Current Assets + Current Liabilies – Long-lived assets + Long-term Liabilies + Capital – Dividends 4. The change in cash: stac to dynamic Balance Sheet equaon Change in cash equal to change in all the other items, so Δ +/- Cash = – Net Income ** - Δ +/- Non-cash Current Assets + Δ +/- Current Liabilies (**Δ Retained Earnings = Net Income – Dividends) Cash ow from operaons – - Δ +/- Long-lived Assets Cash ow from invesng – + Δ +/- Long-term Liabilies + Δ +/- Capital – Dividends ** Cash ow from nancing 17 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi Net Cash Flow This means that  we want to observe the cash ow we can look at the cash ow changes on the le side (and this is what we were doing when preparing the cash ow for the transacon analysis) or, because this is an equaon that balances, we can look at the right side of the equaon 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 equaon because if we look at the right side of the equaon the rst input is income, and this allows to reconcile the income posion to the cash posion. 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 subcontracng 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 ew 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 ow 5 35 2 0 1 0 Non-cash current Assets Current Liabilies When we have 100 in Revenues, this doesn’t mean that we collected all the Revenues and we can also have exisng Accounts Receivables that we may end up collecng during the period, so in order to say which poron of the Revenues is cash collecon 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 poron 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 potenal collecon from customers is 110, but we are le 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 oulows. The complicaon comes from this: Net Income is our input in the rst secon, but we have to determine Cash Flow from Operaons. Do we include in Net Income items that are Non-operang? Because if we want to reconcile the boom of the Income Statement to the rst secon, which is Cash Flow from Operaon we say that everything that we write there as Cash Flow from Operaons has to be related to operaons. Adjustments: 1. So, basically one complicaon is to exclude Non-operang items, which means that if they are already computed in the calculaon of Net Income we have: – Add back them if they are Expenses (Non-operang) – Subtract them If they are Revenues (Non-operang) 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 Accounng UCSC | Marna 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 Depreciaon, Amorzaon, Impairment of Goodwill (they are examples that are considered in the calculaon of Net Income, but for any reason will ever convert into cash). 3. Third adjustment is due to the fact that we have me lags between the Revenue and the Expense item and the actual cash ow, so here we have to: – Add the changes in Current Liabilies – 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 equaon). Example: When we depreciate an item we always have to think about what happens: we include the Depreciaon Expense in Retained Earnings and we deduct the depreciaon either straight from the Long-lived assets or we add it to Accumulated Depreciaon, but in any case, the book value of the Long-lived Asset aer the applicaon of depreciaon is reducing. When we say that we take into account, if we start with Cash Flow from Operaon, that this depreciaon will never convert into cash oulow and adjust, it means that we are basically rewinding or redoing this transacon pung a + in the Retained Earnings’ column in order to exclude the depreciaon, but if we do that we have to balance this transacon and so we have also to add back the depreciaon 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 accounng doesn’t get changed because of this – this are all extra accounng adjustments, but they are needed otherwise the numbers don’t come up right. Adjusng in this case (Depreciaon) means that it will aect both the Cash Flow from Operaons and the Cash Flow from Invesng (Long-lived Assets are in the Cash ow from Invesng) 19 Downloaded by Chiara Davoli ([email protected])