International Financial Accounting

Asset = (Liabilities + Equity) -> ways to finance an Asset

• Assets = Cash, Machinery, Buildings

• Liabilities -> everything company owes to Creditors

  • 2 types => short-term; current liabilities & long-term; non current liabilities (Accounts payable)

  • The interest on a loan (non-current liability) is a current liability.

• Equity -> Residual Claim of the Owners against the Asset

  • Paid-in Capital: Investor provide Resources (Cash) and recieved Shares of the Company (They become owners/shareholders) {Happens when the company issues common stocks}

  • Retained Earnings: Savings of a Company (They grow Retained Earnings to buy new assets) 3 types

    • Revenue: Income generated from business operations (selling produced good or service) using Assets -> revenue ⬆️ = net income ⬆️ = retained earnings ⬆️ = equity ⬆️

    • Expenses: Costs the business incurred while producing the good or service (salaries…) all the costs necessary to increase assets -> expenses ⬆️ = net income ⬇️ = retained earnings ⬇️ = equity ⬇️

    • Dividends: Distributions of a portion of a company's earnings to its shareholders part of the profits that are returned to the owners of the company later on as a reward for investing in the company and is the opposite of paid in capital -> dividends ⬆️ = net income ⬇️ = retained earnings ⬇️ = equity ⬇️

Assets

Liabilities

Equity

Common Stock (ownership with voting rights)

Preffered Stock (ownership without voting rights)

Treasury Stock (Shares that were issued and later reacquired by the company)

Retained Earnings

Presentation of Financial Statements

• Piurpose of Financial Statements: Decision Usefulness

• Financial Statement shall fairly present the financial position, performance and cash flow of an entity

• Components of IFRS Financial Statements

  • Income Statement (P&L)

  • Statement of Changes in Equity

  • Balance Sheet

  • Statement of Cash Flow

  • Notes

  • Management Report (Voluntary)

• A company should report least favorable numbers when oppurtunity presents itself

• Never overstate assets or net income

• Anticipate no gains

• Provide for probable losses

  
  

Value

• attaching financial and monetary value of an asset

Historical Cost

• The original amount of money paid for an asset

  • Value can be reduced over time according to useful life (resulting in carrying amount)

  • this method looks at original purchase price of an asset, backward looking & objective

  • may not reflect the current market value

Replacement Cost

• The Amount of money required to buy the same asset today

  • This can be the cost of buying the asset new, second.-hand or a variant which does the same thing

  • this method estimates costs to replace asset today considering current market conditions.

  • useful for assets subject to rapid change

Net Realizable Value

• The Amount of Money that can be obtained from selling the asset in the current condition, after deducting selling expenses.

  • It reflects the asset’s current market value

Net Present Value

• Known as economic value: it refers to the current value of the future benefits expected from using the asset

  • NPV = [CF₁ / (1+r)¹] + [CF₂ / (1+r)²] + ... + [CFₙ / (1+r)ⁿ] - Initial Investment

-> No single best method for valuing assets

-> different valualtion methods for different purposes

-> It aims to provide realistic and current assesment of an asset’s worth

specifies how an entity should measure fair value and disclose information but not when fair value should be used

• Definition

  • Fair Value is the Price that would be recieved to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date.

• Price

  • Market Based measurement, not entity specific

  • Market-Based Exit Price

    • The price at which the company can sekk the asset often equal zo entry price but can differ in cases like forced sales.

• Transaction

  • orderly transaction is assumed to take place either in principal market or in the absence of it in the most advantageous market

• Framework

  • IFRS 13 requires disclosure about fair value measurement to ensure transparency

  • Measurement considers condition,location, restrictions on sale or use

Valuation techniques used to measure fair value shall maximize the use of relevant observable inputs and minimize the use of unobservable inputs

• Level 1

  • Quotes prices in active markets for identical assets or liabilities. Most reliable

    • If shares are quotes 100€ at the NYSE the fair value of shares is 100€ per share

• Level 2

  • Inputs other than quotes prices that are observable for the asset or liability (directly or indirectly)

    • If similar bonds are quotes at 95€ per bond and adjustments for credit risks result in 3e increase the fair value of the bond is 98€ per bond

• Level 3

  • Unobservable inputs used when observable inouts are unavailable. Reflects assumptions of market participants

    • Company projects future cash flows from an investment and discounts them appropriately, if the present value is 500k then the fair value of the investment is 500k

Market Approach

• Utilizes prices and other relevant data generated by market transactions involving identical or comparable assets or liabilities

Current Replacement Cost Approach

• Reflects the amount that would be required currently to replace the service capacity of the asset

Income Approach

• Converts future amounts to a single current (discounted) amount

HCA records assets & liabilities at their original purchase price adjusted for dpreciation/amortization

FVA measures assets and liabilities at their current market value providing more relevant information for decision making

-> The choice between the 2 affect investment choices, management decisions and economic activities

-> FV is market specific which can be controversial when comparing entities

-> FVA is more relevant and less conservative and reliable

-> Shareholders may prefer FV

-> Tax authorities & Creditors might not

IAS 16 (PP&E)

• Allows Entities to revalue their PP&E to FV

• The revaluation surplus is recognized in OCI and accumulated equity under revaluation surplus

IAS 38 (Intangible Assets)

• Permits revaluation of intangible assets to FV provided there is an active market.

• Revaluation Surplus is recognized in OCI and accumulated equity

IAS 40 (Investment Property)

• Entities can choose to measure investment property at FV

• changes recogized in the P&L: provides direct reflection of market conditions in the F/S

IAS 41 (Agriculture)

• Reqiures biological and agriculturaal assets to be measured at current FV with changes recognized in P&L reflecting real time value of agrecultural assets

IAS 39/IFRS 9 (Financial Instruments)

• Finanical Instrunts classified as FV through Profit or Loss (FVTPL) are measured at FV with changes recognized in P&L

  • If i buy a share at the beginning of the month for 100€ and at the end of the month it is worth 130 the increase 30€ goes into the P&L as profit

IAS 36 (Impairement of Assets)

• Requires Entitites to test assets for impairement and measure the recoverable amount

• Which is the higher of FV less costs of disposal and Value in use (you take the higher)

• Impairement losses are recognized in P&L

  • A machines carrying amount is 1000€.

  • calculate

    FV less costs of disposal	Value in use
    Selling price today: 750€ costs to sell: 50€	Expected Future Cash Flow (discounted) 820€
    FV less costs of disposal 800€	820€

  • Pick the higher Value: Recoverable amount 820€

  • Compare with Carrying amount

    1000€-820€= 180€

  • 180€ impairement loss is recorded in the P&L

Entities must asses at each reporting date wheter there is any indication that an asset may be impaired

• Definition

  • additional irregular write-off wher the carrying value of an asset is lowered to its recoverable amount.

  • represents unusual/extra rwductions in asset values

  • if the reason for impairement is removed, impairement loss must be reversed (except for goodwill:

• Internal Sources

  • Significant decline in assets market value

  • Significant changes in the tech/legal environment

  • Carrying amount of the entity exceeds its market capitalization

  • Increase in market interest rates affecting discount rates and decreasing value in use

• External Sources

  • Physical damage to assst

  • Significant changes within the entity making the asset obsolete

• Scope:

  • PP&E (IAS 16)

  • Intangible Assets (IAS 38)

  • Goodwill (IFRS 3)

  • Investments (IAS 27, IAS 28, IAS31)

• Carrying Amount

  • Th amount at which an asset is recognized after dedcuting any accumulated depreciation and accumated impairement loss

• Recoverabe Amount

  • The higher of an asset’s FV less costs of disposal and its value in use.

  • often higher for non current assets than FV

• Value in Use

  • The PV of future Cash flows expected to be derived from an asset or cash generating unit (CGU)

  • Entity specific and often determined using the weighted average cost of capital

• Cash Generating Unit

  • The smalles identifiable group of assets that generates cash inflows largely independent of other assets

An impairement loss is recognised immediately in profit or loss (as expense) unless asset is carried at a revalued amount under another standard

Other than goodwill must be reversed when there has been a change in estimates used to determine asset’s recoverable amount since last impairement loss was recognized

multiplied with the used years => Accumulated depreciation

Carrying Amount

Asset Cost - Accumulated Depreciation

Depends on whether the gains and lossea are realized or unrealized

Realized Gains and Losses:

• when asset is sold

• recognized in P&L

  • selling stock for more than purchase price

Unrealized Gains and Losses:

• Occur due to changes in the FV of an asset still held

• Recognized based on asset type

  • Investment Properties: unrealized gains and losses are recognized before EBIT

  • Financial Instruments: unrealized gains and losses may be recognized in P&L or OCI depending on classification

recognized as expense in income statement under impairement loss.

Reversal of impairement Loss:

recognized in the income statement, limited to the amount that would’ve been the carrying amount

recognized as a gain under Reversal of impairement losses

An Asset is a resources conttrolled by the entity as a result of past events and from which future economic benefits are expected

Fair Recognition Criteria

• probable that any future economic benefit associated with asset will flow to/from entity

• The asset has a cost/value that can be measured with reliability

• Repairs/Maintanance cost are expensed as incurred and immediately recognized in the income statement

• when asset is first recognized it is recorded at its cost

• after intial rcognition can be measured using differen models

Key factor: Intention of the owner or the intended use of th asset

Current Assets:

• expected to be realized in, intended for sale/consumption in entity’s normal operating cycle

• held primarly for trading

• expected to be realized within 12 months after reporting period

• It is cash/cash equivalent unless restricted from being exchanged/used to settle a liability for at least 12 months after reporting period

• expected tp be converted into cash/used up within the entity’s normal operating cycle

• Need to meet any of the criteria (IAS 2)

  • Invntories that are held for sale in ordinary course of business

  • Items that are currently being produced for future sale (work in progress)

  • Materials/supplies that will be consumed in the production process/ in the renderin services

-> Accurate valuation of inventories is crucial for determining COGS

-> Additionally the closing inventory vlaue is siginificant for the balanace sheet

applies to all invetories except

• work in progress under construction contracts (IAS 11)

• financial instruments (IFRS 9)

• biological assets related to agricultural activity (IAS 41)

1. Unit Cost

Each actual physical unit is tracked

1. FIFO

2. Weighted Average

after each purchase, average cost of the inventory on hand is computed

1. Consistency

• provides consistent cost per unit

• usefull for companies with large volumes of similar inverntory

1. Smoothig Effect

• Smooths out price fluctuations over the period

• easier to manage and report inventory costs

1. Applicability

• suitable where inventory items are indistinguishable from one another

Shall be measure at the lower of cost and

Net realizable Value (NRV)

• Definition

  • Amount of money that could be obtained from selling inventories in the ordinary course of business

• Explanantion

  • Deduct the estimated costs of completion/estimated costs neessary to mae the sale

    • retailer has seasonal clothing expected to sell for 50€ per item; if the cost of clothing it 45€ & the estimated costs to sell is 10€

    • NRV (50-10 =40€)

    • since NRV lower than cost inventory is written down to 40€

-> Under current IFRS and IAS 2 inventory should be measured a the lower of cost and NRV on an item-by-item basis .

-> Grouping items can sometimes be appropriate to ensure precision IAS 2 emphasizes the item-by-item approach

Costs of Purchase

• Purchase price

• Import duties and taxes

• Transport costs

• Less: Discounts

Costs of Conversion (labor costs)

• Direct Costs: Costs directly related to the units of production

Costs of Conversion (depreciation, MOH)

• Fixed Production Overheads: Indirect costs that remain constant regardelss of production volume

Costs of Conversion ( VC {costs of indirect material})

• Variable Production Overhead: indriiect costs that vary directly with production volume

• Purchase price

• Brokerage commisions

• Survey and legal fees

• Property Tax

• Titel Transfer fee

• Costs of clering the land

• Costs of removing old buildings

Land is not depreciable

• EXCEPTION: land where firms harvest natural resources

• Land improvements (Fences, signs…) are depreciated

• Purchase Price

• Transportation charges

• Purchase commission

• Sales Taxes

• Insurance while in transit

• Installation and testing costs

• Architectural fees

• Building permits

• Contractor charges

• Payment for material, labor and overhead

  
  

• Purchase price

• Costs to renovate the building for use

• If a loan is necessary to obtain funds for acquiring an asset, the interest costs can be argued as part of the asset’s cost

• Borrowing costs generally refer to interest costs and treated as a periodic expense (recognized on a time period)

• Capitalization is required if certain conditions are met

  • adding the cost to the asset’s carrying amount instead of expensing immediately

• Borrowing costs directly attributable to the acquisiton, construction or production of a qualifying asset are capitalized. Other borrowing costs are recognized as an expense.

• Assets that take a substantial amount of time to prepare for their intended use/ sale

• Borrowing Costs directly fromy attributable to the acquisiton of qualifying assets are those that would have been avoided if the expenditure on the qualifying asset had not been made

  • Borrowing Cost is the interest you pay on the loan you took to build the the building; if it weren’t for the Building i wouldn’t have gotten the oan and not paid interest ( Interest is a Borrowing Cost and can be capitalized)

• Capitalization of borrowing costs should cease when substantially all activities necessary to prepare the qualifying asset for its intended use or sale are complete

Calculate Capitalized Borrowing Costs

• Revaluation Frequency

Revaluations must be made with suffcient regularity to ensure that the carrying amount does not differ materially from the FV at the end of the reporting period

• Revaluation Surplus

Any increase in the asset’s carrying amount as a result of revaluation is credited to equity under the heading (revaluation surplus)

• Challenges

The revaluation model is often seen as complicated and is not frequently used

Can lead to extra depreciation and deviates from the historical cost principle

• Have reached the end of their estimated life

• If still useful, an entity will continue using it

• Report book value on the balance sheet (1€)

• Record no more depreciation

• Assets are never reported below their residual value

Property held to earn rentals or for capital appreciation

• intially measured at cost, including transaction costs such as professional fees for legal services and property transfer taxes

• after intial recognition entity chooses between FV model and Cost model

• chosen method must be applied consistently to all of the entity’s investment properties

Difference Non-Current asset & Investment

Patents

• Grants made by government to inventor of a product/process bestowing exclusive rights to produce and sell upto 20 years

  -> Amortized over useful life

Copyrights

• Exclusive rights to reproduce/sell creative item

• Protection to firm/individual for life of creator + 70 years

  -> -> Amortized over useful life

Registered Trademark

• Distinctive Identifications of manufactured product or of a service (name,sign, slogan, logo, emblem)

• Economic life depends on its estimated length of use

  -> Amortized over useful life

Franchises and Licenses

• Legal contracts that allow the buyer the right to sell a product/service in accordance with specified conditions

• capitalize up-front franchise fee

  -> Amortized over useful life

  -> Franchise agreement lenghts vary from one year to perpetuity

Goodwill

• unique type of intangible asset that arises in the context of business combinations

• represent future economic benefits arising from assets that are not capable of being individually identified and separately recognized

  -> excess of the amount paid for an acquired company over FV of its identifiable net assets

  -> Acquiring Company

  Goodwill is only recorded by the acquiring company

  -> Non-Amortizable

  must be reviewed for impairement based on circumstances

• It will exist inherently in a business & is always present

• value difficult to determine

• Accounting Goodwill (IFRS 3)

GENERALLY NOT recognized

• Brands, Customer Lists

-> Reason

• Costs cannot be clearly separated from running the business

• Future benefits cannot be measured reliably

GENERALLY NOT recognized

• Brands, Customer Lists

-> Reason

• Costs cannot be clearly separated from running the business

• Future benefits cannot be measured reliably

• recognize assets and liabilities with a term of more than 12 months unless underlying asset is low value

• eliminates distinction between operating and finance leases

• ensuring all leases are represented

Recognition at commencement date

• Right-of-Use asset

  • represents lessee’s right to use ujnderlying asset

    -> goes into balance sheet

• Lease liability

  • represents the lesee’s obligation to make lease payments

    -> goes into balance sheet

Subsequent measurement

• Depreciation and impairement

  • RoU is depreciated over the shorter useful life or lease term

  • also asses for impairement according to IAS 36

• Interest expense

  • Interest expense is recognized on the lease liability usiing interest rate

Accounting Journal Entries Lessee

Intial Recognition

DR: Right of use asset

CR: Lease liability

CR: Cash upfront payment

CR: Cash initial direct costs

CR:Lease incentives recieved

Subsequent Measurement

The amount recognised as provision should be the best estimate of an expenditure required to settle the present obligation at the end of reporting period

Best Estimate

• The amount the entity would rationally pay to settle the obligation/transfer it to third party

  • using past data to predict future costs

  • Consulting experts to estimate cost

Expected Value

• used for large populations of items

• for single items, most likely outcome is used

  • Asigning probabilities to different outcomes & calculating the weighted average

  • Evaluating different scenarios and selecting most probable one

-> provisions should be reviewed at the end of th reporting period and adjusted to reflect currnt best estimate

-> if no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation provison will be reversed

-> if the effect of time value fo money is material, provision should be discounted to its PV using discount rate

• Reversal Entry

  • DR: Provision for Decommissioning

  • CR: P&L

restates income statement in terms of cash reciept and disbursment.

-> shows actual cash in and outflows related to income generating process

-> requires detailed records

Steps to prepare CF using DM

1. Cash recipt from Customers

2. Cash payment to suppliers and employees

3. Cash payment for other operating expenses

4. Cash payment for interest and tax

starts with the accrual net income and adjusts itr to arrive at the net cash from operating activities.

-> more commonly used

Information needed for Preperation

• Current Income Statement

  • to know net income and non-cash expenses

• Current Balance Sheet

  • identify changes in assets and liabilities

• Immediate Past Balance Sheet

  • compare and determine changes in working capital

• Changes in Long-Term Assets and Liabilities

  • to adjust for non-operating activities

• Changes in Equity

  • to account for financing activities

Steps to Prepare CF using indirect methos

1. Begin with Net income from income statement

   • Net income is derived from accrual basis of accounting, which includes non-cash items

   • adjustments necessary to convert to cash basis

2. Adjust for Non-Cash items

   • Add back non-cash expenses such as depreciation, amortization, impairement

   • subtract deferred revenue (doesn’t represent actual CF in that period)

     -> Non-Cash expenses reduce net income but do not involve actual CF so needed to be added back

3. Adjust for Gains and Losses

   • Gains for non-operating activites increase net income but don’t represent cash inflows from operating activities

     -> subtract gains

   • Losses from non-operating activites decrease net income but don’t represent cash outflows from operating activities

     -> add losses

4. Adjust for changes in current assets

   • Changes in currents assets reflect timing differences between revenue recognition and cash receipts

   • increase in current assets: use of cash

     -> subtract increases

   • decrease in current asstes: source of cash

     -> add decreases

5. Indirect Methos (operating Cash Flow)

   • increase in current liability

     -> add increases

   • decrease in current liability

     -> add decrease

6. Accounts payable (operating CF)

   • Purchase of inventory

     • increase inventory and accounts payable but doesnt affect net income

   • Recognition of COGS

     • occurs when inventory is sold reducing net income

   • CF adjustment

     • increase in accounts payable is added back to net income to reflect the cash conserved by delaying payments.

     • not reflected in net income

     -> add increase in accounts payable to net income

7. Accrued liabilities

   expenses that have been incurred but not yet pais

   • CF adjustment

     • when they increase company has incurred expenses but not yet paid

       -> increases net income

     • when they decrease company has paid incurred expenses

       -> decreases net income

These acitivities result in changes in the size and composition of the quity capital and borrowings of an entity

-> discovers if company is responsibly taking on or repaying debts or if its manipulating its stock price

Cash in

• Proceeds from issuing shared or debt to raise capital

Cash out

• Repayment of debt, repurchase of shares and payment of devidends

positive CFF

-> means more cash was raised than paid => growth

-> consistent positive CFF could indicate heavy reliance on external financing

negative CFF

-> could indicate healthy debt repayment

-> or strained liquidity

1. Evaluate Solvency and Liquidity

   • provides insights into company’s liquidity position

   • by analyzing CF firm can decided if it can cover short-term obligations and maintain operational efficiency

2. Evaluate Management decisions

   • analyzing past CF offers window into management’s impact on CF

   • stakholders can identify trends in cash management

   • understand if company generates sufficient cash from operations

3. Asses ability to Pay Debts and Dividends

   • helps in determining company’s capacityto meet financial obligations and distribute dividends

   • reassures investors about company’s financial health

1. Inability to compare similar companies

   • Terms of sale and purchase may differ

   • different accounting techniques used within companies makes comparison hard

2. Not useful for forecasting future CF

   • future CF could not conform to past CF because of shifting economic conditions

3. Lack of Focus and profitability

   • CF Statement will not present the net income of a company for accounting period as it does not include non-cash items

-> Use of accounting techniques to produce financial reports that may paint a picture of a company’s business activities and financial position that benefits the company

Can be legitimate within IFRS limits

-> Legitimate (using flexibility within IFRS)

• Accrual-based adjustments such as provisions

• Revenue recognition timing

• Fair value measurements

-> Illegitimate (violating IFRS practices and misrepresent the company’s financial position)

• Fictious revenue

• Improper expense deferral

• Manipulating estimates

• Off-balance sheet financing

Incentives

Perfromance Based Compensation

-> they have to meet targets which are tied to bonuses/stock options

Debt Covenants

-> Companies may do it to avoid breaching debt convenants (rules you have to follow when you get a loan)-> could lead to penalties/increased borrowing costs

Regulatory Compliance

-> Avoiding regulatory scrutiny/penalitis by presenting a favorable financial position

Opportunities

Shareholder

• High Earnings

• Stable earnings

• earnings expectations

-> Share prices react to earnings

-> Volatile Earnings = drop in share prices

Debtholder

• Safety

• Assurance the company can repay debt

• Compliance with debt convenants

If reported earnings fall

-> financial ratios worsen

-> debt convenants may be breached

-> loans can become immediately repayable

Government/Regulators

• wants tax revenue

• compliance with laws

• Financial stability

-> High earnings -> higher taxes

-> very low earnings-> regulatory scrutiny/intervention

Employees/Unions

• Job security

• Stable company performance

• Ability to pay wages and pensions

If earnings look poor

-> Fear of layoffs

-> wage pressure

-> Labor disputes

Accounting Standard Quality

• IFRS tries reducing flexibility

• More comparability between companies

Institutional environment

• Strength of Enforcement

• Legal system

• Risk of penalities

Company and board characteristics

-> about internal governance

• Board of directors

• Independence of Board members

• Oversight of Management

-> strong board challenges management decisions

-> questions estimates and assumptions

Audit quality

-> refers to

• How independent auditor is

• How strict the audit procedure is

• How much risk the auditor is willing to tolerate

-> matters because High Quality Auditors

• Scrutinizes estimates

• Challenges assumptions

  • Require evidence for judgement

Real Transactions

-> influence earnings by changing what the company actually does

1. Overproduction

Exisiting Costs

• factory rent

• Machinery

• Permanent Productivity Staff

-> Accounting spreads these fixed costs over the number of units produced

-> if managers decide to produce more units than demand requires

• fixed costs are divided over more units

• cost per unit becomes lower

• cost of good sold per unit decreases

-> Nothing fake happens but

• inventory builds up

• cash may worsen

• future write-downs may occur

1. Cutting discretionary spending

Expenses that not legally required, can be postponed or reduced

• R&D

• Marketing

• Advertising

-> if managers decide to cut or delay these

• expenses decrease immediately

• profits increase immediately

Accounting Methods

-> Nothing changes in the business accounting treatment changes

1. Revenue Recognition

depends on judgement about

• when a performance obligation is satisfied

• whether revenue should be recognized now or later

-> recognizing revenue realier increases current profits

-> recognizing revenue later reduces profits

Cash is unchanged

Customer is unchanged

1. Depreciation Methods

An Asset costs the same and provides same economic benefits

-> Depreciaiton

• straight-line

• accelarated

-> Different Methods change

• Expense timing

• Change reported profit in each period

-> Early years: lower depreciation -> higher profit

-> Later years: higher depreciation-> lower profit

Accounting Estimates

-> judgement based numbers NOT OBSERVABLE FACTS

-> Most powerful and sensitive mechanism

-> Numbers depend on expectations

1. Provisions

Estimates of future losses or obligations

• Doubtful debts

• Inventory obsolescence

• Warranty Claims

If management estimates

-> higher provisions -> higher expense -> lower profit

-> lower provisions -> lower expense -> higher profit

Managers can

• increasse provisions in good years

• realease in bad years

-> shifts profit between periods without changing cash

-> how hidden reserves are created

1. Impairement of assets

Reuires estimating

• future cash flows

• discount rates

• recoverable amounts

(all of which involve only judgement)

If management is optimistic

-> no impairement -> higher profit

If Management is pessimistic

-> large impairement -> lower profit

Managers can choose when to recognize impairements

• delay

• take big losses in bad years

specific earnings management technique

-> intentionally record higher expenses than necessary in good years so profits look lower than they are

-> created hidden reserves

Later in bad years managers:

-> reduce those reserves

-> record lower expenses

=> makes profits look better than they are in bad period

Which is why it is calles smoothing earnings

1. Equity investors (existing and potential)

-> return on investment

-> safety of investment

what they look at

• Profitability

• Growth trends

• Leverage ( too much debt -> too high risk)

1. Loasn creditors (existing and potential)

-> Security for loans

-> Profitability

-> Cash Flow

what they look at

• Liquidity ratios

• Leverage ratios

• Interest coverage

1. Employees (exisiting and potential)

-> Profitability

-> Cash Flow

-> Job Security

what they look at

• Long-term profitability

• Cash Flow from operations

• Debt levels (high debt = risk of restructuring)

1. Analysts

-> comprehensive financial data

what they look at

• All financial statements and notes

• Ratios, trends, segment reporting

1. Supplier

-> Creditworthiness

-> Continuity of business

what they look at

• Liquidity

• Short-term solvency

• Stability indicators

1. Customer

-> Reliable supply

-> Business continuity

what they look at

• overall financial health

• long-term solvency

• stability indicators

1. Government

-> Taxation

-> Economic decision making

what they look at

• Profits

• Transfer pricing

• Compliance disclosures

1. General Public

-> Financial Health

-> Community Impact

what they look at

• Overall performance

• Sustainability report

• Risk disclosure

1. Competitors

-> Benchmarking

-> Competitive analysis

what they look at

• Margins

• Efficiency Ratios

• Segment Data

1. Horizontal

2. Vertical

3. Ratio Analysis

Study of percentage chanfe in comparative FS over different periods

-> Trend identification

spot consistent growth/decline

-> Unusual Changes

find big movements that might be problematic

-> Expectation comparison

compare actual change eo expected change to asses performance

Formula

Amount of Change = Later Period -Earlier Period

Percentage Change = (Amount of Change/Earlier “Base”Period Amount) * 100

specialized form of horizontal analysis looks how number/ratios/percentage change over time

-> Long term perspective

consistent patterns/anamalies over time

-> Performance evaluation

evaluate management strategies over time

-> Forecasting

perdict future performance using historical data

Formula

1. Identify base period amount

Choose a base year and set it to 100%

1. Convert later years into a % of the base

Trend Percentage = (Subsequent Period Amount/ Base Period Amount) * 100

Common Size Analysis shows each item as a percentage of the base amount

-> Comparison with competing company

-> Standardization

removes size effect

Base amounts

• Income Sheet -> Net sales

• Balance Sheet -> Total Assets

Formula

Vertical Analysis Percentage = (FS Item Amount / Base Amount) *100

-> differences in business characteristics must be considered when interpreting

-> breaking up the business into more homogeneous sub-total/segments

matters because

-> understanding the operating model

see how different parts operate

-> Assesing risk and returns

-> Identifying opportunities and threats

highlight what each part faces

How do you do it?

1. Determine Segments

2. Evaluate each segment with metrics

• revenue growth

• profit margins

• return on assets

Ratio Analysis = relationship amog FS Items to assess:

• Perfromance

• Efficiency

• Liquidity

• Financial Health

Answers 3 sets of questions

1. Financial performance and liquidity

• How succesfull is the business

• Is it making reasonable profit

• Is it utilizing assets to the fullest

1. Leverage & Liquidity

• Can the business meet financial commitments

• Can it pay its debts

• Is it liquid

1. Investment potential

• Is is a suitable investment for shareholder

• Would return be greater elsewhere

• Is it a good investment

Gross Profit margin

% of the revenue exceeding COGS

Formula

Gross Profit Margin = (Gross Profit/ Net Sales) * 100

-> above 40% considered good (varies)

Net Profit Margin

Indicates how much of each revenue dollar is profit

Formula

Net Profit Margin = (Net Income / Net Sales) * 100

-> above 10% considered good (varies)

ROA 1

Return on Assets

-> How effectively assets generate net income

Formula

ROA 1 = (Net income / Total assets) *100

ROA 2

-> Efficiency using assets to generate profit plus cost of debt

Formula

ROA 2 = (Net Income + Interest Expense) / Total Asstes * 100

-> focuses on operating performance regardless of debt because it adds back interest

-> useful for asset-utilization efficiency regardless of financing decisions

ROE

Return generated on shareholder’s equity

Formula

ROE = (Net Income/ Shareholder’s Equity) * 100

-> useful for comparing companies with different capital structures because it reflects net profitability to equity

Inventory Turnover

-> How often inventory is sold and replaced

Formula

Inventory Turnover = COGS / Average inventory

Asset Turnover

-> How efficiently assets generate sales

Formula

Asset Turnover = Net sales / Total Assets

above 1 usually good

Day’s Recievable

-> how many days on average the company waits to get paid after making a sale

Formula

Day’s Recievable = 365/ (Sales/ Recievables)

high value = takes longer to collect

Day’s Invetories

-> how many days on average inventory sits in storage bfore being sold

Formula

Day’s Inventory = 365 / (COGS/ Average Inventory)

high value:

• inventory sits longer before being sold

• can also be interpreted as efficient inventory management/ strong sales

ability to meet short term obligations

Current Ratio

Formula

Current Ratio = Current Assets / Current Liabilities

Quick Ratio

-> excludes inventory

Formula

Quick Ratio = (Current Assets- Inventory) / Current Liabilities

Cash Ratio

-> Cash only strenght

Formula

Cash Ratio = (Cash + Cash Equivalent) /Current Liabilities

Cash equivalents

-> can be converted into cash quickyl

-> low risk of loosing value

• tresury bills

• short term deposits (3month maturity)

Working Capital

Formula

Working Capital = Current Assets - Current Liabilities

-> Positive working capital is cosidered good

Leverage = debt financing / debt pressure

Debt-to-Equity Ratio

Formula

Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity

Interest Coverage Ratio

-> Ability to cover interest with EBIT

Formula

Interest Coverage Ratio = EBIT / Interest Expense

ratio above 1 (even over 3) considered good

Debt Ratio

-> Proportion of assets financed with debt

Formula

Debt Ratio = Total Liabilities / Total Assets

Dividend Payout Ratio

-> Proportion of earnings paid out

Formula

Dividend Payout = (Annual Dividend per Share/ Earnings per Share) * 100

Dividend Yield

Return from dividends relative to price

Formula

Dividend Yield = (Annual Dividend per Share / Price per Share) * 100

developed as in internal management tool to better understand what drives ROE

1. Profit Margin

Formula

Profit Margin Ratio = ( Net Income / Net Sales) * 100

-> How much profit company makes per unit sold

• high margin -> good cost control

• low margin -> high costs or competitive pressure

1. Asset Turnover

Formula

Asset Turnover Ratio = (Net Sales/ Total) * 100

-> How efficiently the company uses its assets to generate sales

• high turnover -> assets are used

• low turnover -> assets sit idle or underused

Financial Leverage

Formula

Financial Leverage Ratio = (Total Assets/ Sharegolders Equity) * 100

-> how much of the company’s assets are financed by equity versus debt

• Assets much larger than equity -> lots of debt

• Assets close to equity -> little debt

Combined Dupont formula

ROE = Profit Margin * Asset Turnover * Financial Leverage

=> ROE = (Net Income/ Net Sales) * (Net Sales /Total Assets) * (Total Assets/ Shareholder’s Equity)

Key Warning

increase in ROE should come frm increase in pprfit margins or asset turnovers (meaning compay becomes more profitable) not because they borrowed more ( increase in Financial Levergae)

1. Historical cost accounting

may not reflect current market value

1. Industry and business characteristics

normal ratios differ between industries

1. Non-Monetary factors

Ratios don’t capture qualitative factors

• product/service quality

• customer satisfaction

• brand value