Reporting and Financial Statement Analysis PDF

Reporting and financial statement analysis Introduction The accounting is the collection and the organization of data and, basing on its purpose, can be dived in: - Management accounting, for internal use (mainly managerial) - Financial accounting, published in the form of financial reports...

Reporting and financial statement analysis Introduction The accounting is the collection and the organization of data and, basing on its purpose, can be dived in: - Management accounting, for internal use (mainly managerial) - Financial accounting, published in the form of financial reports, is useful to all the stakeholders Talking instead of the different kinds of companies, these can be divided in: - Unlimited companies, where the shareholders have the whole responsibility and, basically, if the company is not able to pay, the owners have to respond with their own assets - Limited companies, where their responsibility is limited to the invested amount. These can, in turn, be divided in: o Private limited companies o Public limited companies 01, Financial reporting basics Why is the regulation of financial reporting so crucial? This can be explained by several different factors that combined can explain the main reason: by one side we have the important increase of companies manged by professional managers (which are generally able to manage the numbers as they like) and, linked to this, we have the increasing trend of link their compensation to the performances of the company, obliging also them to respond, in case of errors, with their bonus received (for example in Coca-Cola, the fixed compensation for top managers is $1, all the remaining is linked to performances). But how can the shareholders understand whether the company is doing well? Through financial reporting, which assume a role of financial information communicator. Since 1970s, because of the increasing trend of globalisation, the need to put together companies that operate in different countries and give to the possible investors the possibility to compare companies were perceived. At today known as IASB (International Accounting Standard Board), able to create a unique common regulation. Their goal were been reached in 2001 through the publication of IFRS (International Financial Reporting Standards). These regulation were mainly useful for providing financial information useful in decision-making, which can be principally divided in three: 1. Buying, selling or holding equity and debt instruments 2. Providing or settling loans and other forms of credit 3. Exercising rights to vote. As understandable, these information are useful to almost every stakeholder, directly or indirectly linked to the company (starting from the shareholders, but also the creditors, the employees, the competitors and even the customers). 1 02, From harmonization to IFRS accounting standards The annual report is mandatorily required by the law. As, said before, the need of an international harmonization were perceived since the start of globalization but, exactly, why? - In 1960s and 1970s because of the cross border investments of US companies in Europe - In 1980s and 1990s because of the investments of European and US companies in Asia and, contemporary, because of the gradual deregulation of the financial and capital markets in many countries. Already in 1973, therefore, the IASC (International Accounting Standard Committee) was established. It was a group in which experts from several different countries explained the differences in accounting standards. At that time, however, they hadn’t any type of authority. In 1989, however, having received the power to create a sort of common language, the exposure draft E32 has been published. In 2005, the EU (and many other countries followed this idea but, however, not the US) obliged the listed companies to comply with IFRS. At today, the IFS are called IFRS and the IASC is divided in: - IASB (International Accounting Standards Board), whose members are responsible in the development of high-quality global accounting standards - ISSB (International Sustainability Standards Board), whose focus is about the sustainability reporting (at today the companies are also required to produce this report). In conclusion, the IFRS is doing, without any doubt, a great work in converge all the world in a unique standard, but there are some negative aspects to consider: - IASB is a private organization still based in London and most of their employees are from the US → the accounting standards lean on the American-Anglo-Saxon culture (both mainly market-based) - The role of EFRAG (European Financial Reporting Advisory Group) which assumes a predominant position because of their role in publishing the IFRS statement, which otherwise could not be applicable by judges in Europe - The problems with the emerging economies (mainly with the Islamic countries) due to the high costs required to companies for producing a financial report compliant to IFRS. 03, The IASB conceptual framework CAPEX → the capital expenditure to finance some long term operating investment. Guidance → the expectations of the results at the end of the year, it is updated quarterly. On the left, the model followed by the company in presenting the financial statement. 2  How can the net income increase? It can clearly be a real net income (so a positive difference between revenues and expenses), but it can also be due by an injection of the shareholders. In IFRS, moreover, Et1-Et0=NI+∆ equity reserves (in a few words, it remind to consider also the increase in equity reserves as part of the equity). This, however, depends on the source that has generated the gain: - If the source do not belong to the company productive structure (such as a real estate investment or some financial instruments held just for trading), the gain (or loss) is recorded directly in the income statement - If the source is, instead, part of the core business, the gain (or loss) has to pass to the equity reserves. The Net Income is so important because is the first direct link between income statement and balance sheet. All the financial statement reporting is based on two main fundamental principles: - Going concern principle (basically the supposition that the company will last for ever), which, primarily, allows to amortize the durable goods. In case there could exist some doubts about this principle, these must be indicated in the financial statement and, in the worst scenarios, preparers should even adopt a different reporting perspective. - Accrual principle, allows the recognition of revenues (increases in assets or decreases in liabilities) and expenses (decreases in assets or increases in liabilities) through two minor principles: o Realization principle, it allows to consider revenues all those products that are able to generate future cash flows in a reliable way. Two examples: ▪ Some products sold, but paid through cash receivables (that will expire in the next year) ▪ 10€ Moncler share bought in the market, valued at 31st December 15€ o Matching principle, basically it states that the expenses should be recorded in the same period as the revenues they are related to. o In addition to these, the conservatism principle act in two opposite ways in revenues and expenses: ▪ Revenues (an therefore profits) should be recorded only if certain (generally it happens with the deliver of the good or the execution of the service) ▪ Expenses (and therefore losses) should be recognized even if they are just likely Always talking about recognition and derecognition, this time with assets, it can happen in two different ways: 3  - Historical cost, the original cost at which the asset entered in the balance sheet - Fair value, the current amount of the asset An example: I buy and sell shoes and I have purchased some shoes at 100€, with the prevision of selling them at 120€. Following historical cost, the value that I should record is 100, while following fair value, this should be 120. Generally speaking, financial advisors are much more interested in fair value, because it is more actual. Alternatively to fair value and historical cost, there exist other two methods that can be used to evaluate an asset: - Value in use, the value of the future cash flows that the asset is expected to generate (or the liability expected to incur) - Current cost, how much should I spend today to replace that asset or to settle that liability Another important concept is, instead, the financial capital maintenance (when the company can affirm to have realized a profit?). This can be assessed in three ways: 1. Nominal, a profit is realized when the amount of net assets at the end of the period is higher that the amount at the beginning of the period 2. Real, restating both initial and final values in units of the same purchasing power, this method allows to consider inflation 3. Physical, only after having replaced or maintained all the physical assets, the profit can be recognized. A resuming example: Let us assume that a company begins with: - Capital stock of €100 - Cash of €100. At the beginning of the year, one item of inventory is bought for €100. The item of inventory is sold at the end of the year for €150, its replacement cost at that time is €120 and general inflation throughout the year is 10 per cent → 04, Fair value In general, we can say that using historical value, the results are much less volatile, while with fair value are more realistic. The regulation about fair value is contained in IFRS 13 which also states that estimations always assume a transaction between market participants, not taking into account transaction costs. In evaluating, moreover, there is a sort of hierarchy: - Level 1, consider only prices quoted in active markets for identical assets or liabilities - Level 2, consider also quoted prices for similar assets and non active markets (or non quoted prices) 4  - Level 3, establish a model based on the assumptions that a market participant would use in order to price the asset or the liability. In IFRS 13 are also listed all the cases where FV is mandatory (the so called benchmark treatment, or BT) and where the company can freely choose whether to use it or historical cost (the so called alternative treatment, or AT): Financial instruments (BT or AT) Other financial assets and liabilities (BT) Real estate investments (AT) Biological assets and agricultural Share-based payments (BT) products (BT) Business acquisitions (BT) Intangible assets (AT) Properties, plants and equipment (AT) In all the other non listed cases, it is mandatory to use historical cost instead. And for non current assets (financial instruments)? Here, FV is generally used when there is the need to show a financial situation more positive then how it effectively is (for example to cover a loss). And, since the values keep changing constantly, how can we record the variation in order to offset the situation? It can happen in two ways: - If variations are linked to activities of the core business, these are compensated with an equity reserve (when the value of the assets increases also the equity increases and vice versa) - If these are not, they can be directly compensated with net income. In conclusion, there are several pros and cons of fair value: the pros are for sure the currentness of the evaluation and therefore the possibility to compute the effective performance of the company, in addition to, the possibility to compare all the inputs (if those would be all measured with it). The main cons are, instead, the volatility of the evaluation and the evaluation asymmetry due to the fact that some items are measured with FV and others with HC. Exercise Raw material bought 1.000 paid in cash. At 31/12/23 60% of raw materials are still inventories, 40% are used to produce finished goods. Other costs: employees cost 100, energy 100 and amortization 100. All finished goods are sold, generating a revenue of 1.500, cash in march 2024. Question: represent the activity in the fin stat. 5 05, Presentation and layouts of financial statements Each financial statement is composed by different documents. The balance sheet is used to set out the financial position of a business, here are listed all the resources (assets) and all the economical obligations of the firm within outside parties (claims). But how can a resource be recognized? This shall guarantee these four requirements: 1. A probable future benefit 2. An exclusive right to control it 3. The property must derive from a past transaction 4. The asset must be measurable in monetary terms The claims, instead, can be divided in equity and liabilities (obligations through others). In term of time, however, all assets and liabilities can be divided in: - Current (usually expiring within 12 months) - Non-current The income statement, instead, has the purpose of computing and reporting the amount of profit (or loss) generated by the company over a given period. Here are listed all the inflows (revenues) and outflows (expenses) of economic benefits. These two documents are linked through the profit (or loss), which represent the final result of the income statement and it’s also inserted in the equity part of the balance sheet. Last but not least, the cash flow statement. This document is able to measure and report the company’s ability to generate cash (or cash equivalents, that are short-terms that can be cashed almost immediately) and understand how this is used from the company. This, in fact, is divided in three different types of activities: operating, investing and financing. 06, Management accounting numbers The company can choose, at least in part, how to manage earnings. This can happen for many several reasons: - Incentives driven by the contract with shareholders, trying to show them a better situation than how it really is, such as avoiding small losses, producing a steady stream of increase earnings (showing also a low level of volatility) or meeting earnings targets and benchmarks - Incentives driven by debt contracts, in order to avoid violation of debt covenants, get favourable credit ratings and so on - Linked to the management compensation (such as bonus or incentives) - Other disparate motivations, such as the competitive pressure, the union negotiations and the employees or to provide the impression to be a reliable supplier. Talking about earning management, this can happen in three main ways: 1. Accounting policy choices, depreciation method, inventory valuation, capitalization of certain expenditures and valuation method (as said before, choosing between FV and HC) 6  2. Accounting estimates, such as bad debt allowances (the amount netted off from trade receivables), the choice of residual value and the useful life and impairment 3. Real decisions, such as the deferral of investments, the sale of an asset or the overproduction aiming to lower the production costs. All these interventions, however, preview in the long run a reversal effect. Talking about financial statements and companies, however, there are some numbers, information and strategies that the company could not be able to explain just through the standard presentation of the financial statement. A clear example is Groupon that, during their IPO in 2011, announced “we don’t measure ourselves in conventional ways”. To solve these problems but, at the same time, forbid the exploitation of this reason with the purpose of present misleading information to the investors, the SEC intervened with two specific regulations: - Regulation G, an anti-fraud provision that applies to all corporate communications - Item 10(e), which regulate the preparation of an official document filed with the SEC. Others NON-GAAP measures are the EBITDA, EBIT, NFP and so on. 07, Introduction to financial statement analysis (FSA) As said before, the information that can be provided through an analysis of the financial statement are crucial for almost every subject involved in the life of a company (obviously starting from investors and owners, but as much as lenders, government and competitors, secondarily also customers, employees and the public). An analysis of financial statement, in fact, can provide information about the performances of the firm, crucial to understand its strength and weaknesses. These are so useful because are almost the only way to consider the company in their entire allowing also a quite easy but at the same time really reliable (being numbers and, thus, quite objective) method. The analysis can be divided in three sub-categories: 1. Liquidity, the ability of the company to repay short-term debts 2. Solvency, the capital robustness of the company (and so the grade of dependency from creditors). These value is the one that guarantee the survival of a company in case of crisis. 3. Profitability, the ability to produce profit, in relation to the invested capital. The FSA takes more importance when compared with some others financial statements. Depending on what these other FS are, we can face: 1. An horizontal analysis, that analyse a firm over time, taking in consideration financial statements from different years 2. A vertical analysis, compare the financial statement with those of competitors. When a company operates in different business areas, can be useful also to adopt a segmental analysis. An important value for investors is the required rate of return (or WAAC). 08, Reformulating balance sheet and income statement 7 The reformulated balance sheet sort both assets and liabilities with a criteria of cashable speediness (from fastest to slowest). It, consequently, will assume a similar aspect: Here we assume that all the inventories are short term and, therefore, we include them entirely in the financial gross working capital (all the assets cashable within 12 months). This value is also important in assessing the liquidity of the company because, subtracting the current liabilities, we can compute the financial net working capital (FNWC), which however, should be as little as possible (it just has to guarantee a low level of liquidity risk index, but having it high is considered a waste of money that could be invested better. The business structure balance sheet is another crucial document, because consider just the core business activities. This type of balance sheet allows to compute a lot on analysis: Net invested capital (NIC), is the total on the left side and represent the total amount of net funds invested in the operating activity Operating net working capital (ONWC), represent the financial requirement coming from the operating cycle, useful to obtain information about liquidity and efficiency Net financial position (NFP), which establishes the level of risk of the whole activity Information about both operating and financing activities Let’s talk now about the income statement with a business structure: this allows, mainly, to compute important considerations about the EBITDA (Earning Before Interests, Taxes, Depreciation and Amortization, widely used to evaluate for companies evaluations and in M&A) and the EBIT (Earning Before Interests and Taxes, represent the gross result of the operating activity). 09, Tangible assets Definition of asset: A present economic resource (a right that has potential to produce economic benefits) controlled by the entity as a result of past events. These are ruled by four different accounting standards: 8  - IAS 16, Property, plant and - IAS 40, Investment properties equipment (PPE) - IAS 41, Agricultural activities - IAS 17, Leasing Now let’s see each of them in the specific. IAS 16, Property, Plant and Equipment (PPE) includes all those assets expected to be used more than one year for production, rental or administrative purposes. These, to be recognized as effective PPE, must have a reliable measurable cost and be expected to generate an economic benefit in the future. Clearly, being pluriannual, these has to be amortized and it is possible, moreover, to add all the subsequent cost to the amortizable quota (thanks to IAS 23 about borrowing costs): 1. Import duties and non-refundable purchase taxes 2. Any cost required for bring the asset to working conditions 3. The estimated cost for dismantling. Let’s see a practical example: A company is constructing a new production facility. The following costs have been incurred: Greens are the recognized as part of PPE, reds are not. - Site preparation costs € 15.000 - Architects’ fees € 8.000 - Legal fees € 4.000 - Purchase of site € 120.000 - Construction costs € 580.000 - Costs incurred to relocate employees to the new facility € 12.000 - Administration costs € 2.000 For the subsequent measurement, moreover, the company can choose between two different ways: 1. The cost model, the initial cost less any accumulated depreciation and any accumulated impairment loss 2. The revaluation model, the fair value applied to PPE. If the item’s value increase, this can be recorded in two different ways: a. If previously depreciated, in profit or loss with an opposite sign (in order to reduce the previous depreciation) b. Otherwise in revaluation surplus. Also the depreciation can be calculated in two ways: on-time based or based on the activity level. IAS 40, Investment properties are all those assets held by the company with the only purpose of earn rental or, more generally, for a capital appreciation 9 IAS 41, Agricultural activities are about the management by an entity of the biological transformation of living animals or plants with sale purposes or conversion into agricultural products. 10, Tangible assets According to IFRS 38, an intangible asset is a non-monetary asset without physical substance. Are included in this definition patents, brands, trademarks, copyrights and software licences. To be recognized as intangible asset, an item must satisfy both the definition and the recognition criteria: - Definition, it has to be identifiable, controllable and represent a future economic benefit - Recognition criteria, more strict, states that the expected future economic benefit shall be probable to flow to the entity and the cost must be measured reliably. At this point, we have to do a little detailed study on R&D costs: research costs can never be capitalized, while development costs yes, but have to proof these six points: 1. The technical feasibility of completing the intangible asset 2. The intention to complete it 3. The ability to use or sell it 4. How this will generate future probable economic benefits: the existence, therefore, of a market for that intangible assets or, if the intention is to use if internally, the usefulness to the entity 5. The availability of adequate technical and financial resources to complete the development 6. The possibility to measure reliably the relative expenditure As for the tangible assets, these can be evaluated through: - Cost model (generally their residual value is zero, unless there is a third party interested to purchase it at the end of its useful life or there exist an active market) - Revaluation model. This, however, can be applied if and only if the item is part of an active market Intangible assets can, moreover, be with an indefinite useful life (clearly no depreciation). Here IAS 36 is applied, which imposes to carry out at least annually an impairment test. Let’s conclude with an easy exercise: A pharmaceutical company developed over the years a new drug against high blood pressure. Recently they received approval to commercialize the drug from the regulatory authorities. They also obtained patent protection and now have a patent for this new drug for the next ten years. The pharmaceutical company incurred the following costs during the research and development process which led to the marketable drug: labour costs in the research process for molecules €60,000; materials and labour used in the research on possible molecules that could be further developed into drugs €130,000; materials and labour costs in the 10 development of one molecule into a promising drug for blood pressure control €200,000; costs incurred during the testing process on humans €80,000; costs incurred to obtain recognition with the regulatory authorities €20,000. - How will this drug and the related costs be accounted for at the initial recognition of the intangible asset? - If the pharmaceutical company uses the cost model subsequently to initial valuation, what will be recorded after the initial recognition in the books of the pharmaceutical company? Answers: Only costs in the development phase can be capitalized, so only 300,000 (200,000 of blood pressure control+80,000 for testing process on human+20,000 for the recognition with the regular authorities). It has a finite a live, and will be amortized over a period of 10 years → 30,000 amortization costs each year. 11