Financial Reporting and Analysis

The basic accounting equation is the relationship among the three balance sheet

 assets = liabilities + owners' equity 

Keeping the accounting equation in balance requires double-entry accounting, in which a transaction has to be recorded in at least two accounts. An increase in an asset account, for example, must he balanced by a decrease in another asset account or by an increase in a liability or owners equity account

Keeping the accounting equation in balance requires double-entry accounting, in which a transaction has to be recorded in at least two accounts. An increase in an asset account, for example, must he balanced by a decrease in another asset account or by an increase in a liability or owners equity account

Revenues and expenses are not always recorded at the same time that cash receipts and payments are made. The principle of accrual accounting requires that revenue is recorded when the firm earns it and expenses are recorded as the firm incurs them, regardless of whether cash has actually been paid.

Most assets are recorded on the financial statements at their historical costs. However, accounting standards require balance sheet values of certain assets to reflect their current marker values. Accounting entries that update these assets' values are called valuation adjustments.

Become Familiar with the Framework For International Financial Reporting Standards (IFRS), including qualitative characteristics, constraints and assumptions, and features for preparing financial statements. Be able to identify barriers to convergence of national accounting standards (such as U.S. GAAP) with IFRS key differences between the IFRS and U.S. GAAP frameworks1 and elements of and barriers to creating a coherent financial reporting network.

Reporting standards ensure that transactions are reported by firms similarly. However, standards must remain flexible and allow discretion to management to properly describe the economics of the firm. Financial reporting is not designed solely for valuation purposes; however, it does provide important inputs For valuation purposes.

Standard setting bodies are professional organizations of accountants and auditors that establish Financial reporting standards. Regulatory authorities are government agencies that have the legal authority to enforce compliance with financial reporting standards. The two primary standard-setting bodies are the Financial Accounting Sta nards Board

(FAS B) and the International Accounting Standards Board (lAS B). in the United States, the FASB sets forth Generally Accepted Accounting Principles (GAAP). Outside the United States, the IASB establishes international Financial Reporting Standards (1FRS). Other national standard-setting bodies exist as well. Many of them (including the FASB) are working toward convergence with IFRS. Some of the older IASB standards are referred to as International Accounting Standards (lAS).

A coherent financial reporting framework is one that is together logically. Such a framework should be transparent, comprehensive, and consistent.

• Transparency—FuIl disclosure and Fair presentation reveal the underlying economics of the company w the financial statement user.
• Comprehensiveness—All types of transactions that have financial implications should be part of the framework, including new types of transactions that emerge.
• Consistency—Similar transactions should be accounted for in similar ways across companies, geographic areas, and time periods.

Measurement—Another trade-off in financial reporting is between properly valuing the elements at one point in time (as on the balance sheet) and properly valuing the changes between points ¡n time (as on the income statement). An “asset/liability” approach, which standard setters have largely used, focuses on balance sheet valuation. A “revenue/expense” approach would rend to place more significance on the income statement.

The IASB and FASB frameworks are similar but are moving towards convergence. Some of the remaining differences are:

• The IASB Lists income and expenses as performance elements, while the FASB lists revenues, expenses, gains, losses, and comprehensive income.
• There are minor differences in the definition of assets. Also, the FASB uses the word probable when defining assets and liabilities.
• The FASB does not allow the upward revaluation of most assets.

Firms that list their shares in the United Stares but do not use U.S. GAAP or IFRS are required ro reconcile their financial statements with U.S. GAAP. For IFRS firms listing their shares in the United Stares, reconciliation is no longer required.

The income statement reports the revenues and expenses of the firm over a period of time. The income statement is sometimes referred to as the “statement of operations,” the “statement of earnings” or the “profit and loss statement.” The income statement equation is:

revenues — expenses net income

Revenue is recognized when earned and expenses are recognized when incurred.

Methods for accounting for long-term contracts include:

• Percentage-of-completion—recognizes revenue in proportion to costs incurred.
• Completed-contract----recognizes revenue only when the contract is complete.

Revenue recognition methods for installment sales are:

• Normal revenue recognition at time of sale if collectibility is reasonably assured.
• Installment sales method if collectibility cannot be reasonably estimated.
• Cost recovery method if collectibility is highly uncertain.

Revenue From barter transactions can only be recognized if its fair value can be estimated from historical data on similar non-barter transactions.

We will cover the method of revenue recognition for the following special cases in this lecture:

• Installment sales method if collectibility cannot be reasonably estimated.
• Cost recovery method if collectibility is highly uncertain.

A firm using a revenue recognition method that is aggressive will inflate current period earnings at a minimum and perhaps inflate overall earnings. .Because of the estimates involved, the percentage-of-completion method is more aggressive than the completed contract method. Also, the instalment method ¡s more aggressive than the cost recovery method.

The matching principle requires that firms match revenues recognized in a period with the expenses required to generate them. One application of the matching principle is seen in accounting for inventory, with cost of goods sold as the cost of units sold from inventory that are included in current-period revenue. Other costs, such as straight-line depreciation of fixed assets or administrative overhead, are period costs and are taken without regard to revenues generated during the period.

Results of discontinued operations are reported below income from continuing operations, net of tax, from the date the decision to dispose of the operations is made. These result arc segregated because they likely are non-recurring and do not affect future net income.

Operating income is generated from the firm's normal business operations. For a nonfinancial firm, income that results from investing or financing transactions is classified as non-operating income, while it is operating income for a financial firm since its business operations include investing in and financing securities.

A vertical common-size income statement expresses each item as a percentage of revenue. The common-size format standardizes the income statement by eliminating the effects of size. Common-size income statements are useful for trend analysis and for comparisons with peer firms

Transactions with shareholders, such as dividends paid and shares issued or repurchased, are not reported on the income statement.

Other comprehensive income includes other transactions that affect equity but do not Affects net income, including:

• Gains and losses from foreign currency translation.

• Pension obligation adjustments.

• Unrealized gains and losses from cash flow hedging derivatives.

• Unrealized gains and losses on available-for-sale securities.

The balance sheet can be used to assess a firm's 1iquidity solvency, and ability to make distributions to shareholders. From the firm's perspective, liquidity is the ability to meet short-term obligations and solvency is the ability to meet long-term obligations.

Both IFRS and U.S. GAAP require firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities. The current! noncurrent format is known as a classified balance sheet and is useful in evaluating liquidity. Under IFRS, firms can choose to use a liquidity-based format if the presentation is more relevant and reliable. Liquidity-based presentations, which are often used in the banking industry, present assets and liabilities in the order of liquidity.

Inventories are reported at the lower of cost or net realizable value (IFRS) or the Lower of cost or market (U.S. GAAP). Cost can be measured using standard costing or the retail method. Different cost flow assumptions can affect inventory values.

Current (noncurrent) liabilities are those the firm expects to satis1 in less than (more than) one year or the firm's operating cycle, whichever is greater.

Property, plant, and equipment (PP&E) can be reported using the cost model or the revaluation model under IFRS. Under U.S. GAAP, only (he cost model is allowed. PP&E is impaired if its carrying value exceeds the recoverable amount. Recoveries of impairment losses are allowed under IFRS but not U.S. GAAP.

Intangible assets created internally are expensed as incurred. Purchased intangibles are reported similar to PP&E. Under IFRS, research costs arc expensed as incurred and development costs are capitalized. Both research and development costs are expensed under U.S. GAAP.

Goodwill is the excess of purchase price over the fair value of the identifiable net assets (assets minus liabilities) acquired in a business acquisition. Goodwill is nor amortized but must be testedfor impairment at least annually.

Held-co-maturity securities are reported at amortized cost. Trading securities, available-for-sale securities, and derivatives are reported at Fair value. For trading securities and derivatives, unrealized gains and losses are recognized in the income statement. Unrealized gains and losses for available-for-sale securities are reported in equity (other comprehensive income).

Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accrued liabilities arc expenses that have been recognized in the income statement but are not yet contractually due. Unearned revenue is cash collected in advance of providing goods and services.

Financial liabilities not issued at face value, like bonds payable, are reported at amortized cost. Held-for-trading liabilities and derivative liabilities are reported at fair value.

Owners' equity includes:

• Contributed capital—the amount paid In by common shareholders.
• Preferred stock—capital stock chat has certain rights and privileges not possessed by the common shareholders. Classified as debt if mandatorily redeemable.
• Treasury stock—issued common stock that has been repurchased by the firm.
• Retained earnings—the cumulative undistributed earnings of the firm since inception.
• Noncontrolling (minority) interest—the portion of a subsidiary that is not owned by the parent
• Accumulated other comprehensive income—includes all changes to equity from sources other than net income and transactions with shareholders.

The statement of changes in stockholders' equity summarizes the transactions during a period that increase or decrease equity, including transactions with shareholders.

A vertical common-size balance sheet expresses each item of the balance sheet as a percentage of total assets. The common-size format standardizes the balance sheet by eliminating the effects of size. This allows for comparison over time (time-series analysis) and across firms (cross-sectional analysis).

Cash flow from operating activities (CFO) consists of the inflows and outflows of cash resulting from transactions that affect a firm's net income.

Cash flow from investing activities (CPI) consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments.

Cash flow from financing activities (CFF) consists of the inflows and outflows of cash resulting from transactions affecting a firm's capital structure, such as issuing or repaying debt and issuing or repurchasing stock.

Under U.S. GAAP, dividends paid are financing cash flows. Interest paid, interest received, and dividends received are operating cash flows. All taxes paid are operating cash flows.

Under IFRS, dividend paid and interest paid can be reported as either operating or financing cash flows. Interest received and dividends received can be reported as either operating or investing cash flows. Taxes paid arc operating cash flows unless they arise from an investing or financing transaction.

Under the direct method of presenting CFO, each line item of the accrual-based income statement is adjusted to get cash receipts or cash payments. The main advantage of the direct method is that it presents clearly the firm's operating cash receipts and payments.

Under the indirect method of presenting CFO, net income is adjusted for transactions that affect net income but do not affect operating cash flow, such as depreciation and gains or losses on asset sales and for changes in balance sheet items. The main advantage of the indirect method is that it focuses on the differences between net income and operating cash flow. This provides a useful link to the income statement when forecasting future operating cash flow.

An analyst should determine whether a company is generating positive operating cash flow over time that is greater than its capital spending needs and whether the company's accounting policies are causing reported earnings to diverge from operating cash flow.

A common-size cash flow statement shows each item as a percentage of revenue or shows each cash inflow as a percentage of total inflows and each outflow as a percentage of total outflows

Various tools and techniques are used to convert financial statement data into formats that facilitate analysis. These include ratio analysis, common-size analysis, graphical analysis, and regression analysis.

Ratios can be used to project earnings and future cash flow, evaluate a firm's flexibility, assess management's performance, evaluate changes in the firm and industry over time, and compare the firm with industry competitors. 

Vertical common-size data are stated as a percentage of sales for income statements or as a percentage of total assets for balance sheets. Horizontal common-size data present each item as a percentage of its value in a base year.

Activity ratios indicate how well a firm uses its assets. They include receivables turnover, days of sales outstanding, inventory turnover, days of inventory on hand, payables turnover, payables payment period, and turnover ratios For total assets, fixed assets, arid working capital.

Liquidity ratios indicate a firm's ability to meet its short-term obligations. They include the current, quick, and cash ratios, the defensive interval, and the cash conversion cycle.

Solvency ratios indicate a firm's ability to meet its long-term obligations. They include the debt-to-equity, debt-to-capital, debt- to-assets, financial leverage, interest coverage, and Axed charge coverage ratios.

Profitability ratios indicate how well a firm generates operating income and net income. They include net, gross, and operating profit margins pre-tax margin, return on assets, operating return on assets, return on total capital, return on total equity, and return on common equity.

Valuation ratios are used to compare the relative values of stocks. They include earnings per share and price-to-earnings, price-to-sales, price-to-book value, and price-to-cash-flow ratios.

All of the costs for inventory acquired or produced in the current period are added to beginning inventory value and then allocated either to cost of goods sold For the period or to ending inventory.

Period costs, such as abnormal waste, most storage costs, administrative costs and selling costs, are expensed as incurred.

Inventory cost flow methods:

FIFO: The cost of the first item purchased is the cost of the first item sold. Ending inventory is based on the cost of the most recent purchases, thereby approximating current cost.

LIFO: The cost of the last item purchased is the cost of the first item sold. Ending inventory is based on the cost of the earliest items purchased. LIFO is prohibited under IFRS.

Weighted average cost: COGS and inventory values are between their FIFO and LIFO values.

Specific identification: Each unit sold is matched with the unit's actual cost.

Under LIFO, cost of sales reflects the most recent purchase or production costs, and balance sheet inventory values reflect older out-dated costs.

Under FIFO, cost of sales reflects the oldest purchase or production costs for inventory, and balance sheet inventory values reflect the most recent costs.

Under the weighted average cost method, cost of sales and balance sheet inventory values are between those of LIFO and FIFO.

When purchase or production costs are risings LIFO cost of sales is higher than FIFO cost of sales, and LIFO gross profit is lower than FIFO gross profit as a result. LIFO inventory is lower than FIFO inventory.

When purchase or production costs arc Falling, LIFO cost of sales is lower than FIFO cost of sales, and LIFO gross profit is higher than FIFO gross profit as a result. LIFO inventory is higher that of FIFO inventory.

In either case, LIFO cost of sales and FIFO inventory values better represent economic reality (replacement costs).

Inventory turnover, days of inventory on hand, and gross profit margin can be used to evaluate the quality of a firm's inventory management.

Inventory turnover that is too low (high days of inventory on hand) may be an

indication of slow-moving or obsolete inventory.

High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled.

High inventory turnover together with high sales growth relative to the industry average suggests that high inventory turnover reflects greater efficiency rather than inadequate inventory.

When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance sheet or expense the cost in the income statement for the current period. Capitalizing results in higher assets, higher equity, and higher operating cash flow compared to expensing. Capitalizing also results in higher earnings in the first year and lower earnings in subsequent years as the asset is depreciated.

Interest incurred during construction of an asset is generally capitalized. The capitalized interest is added to the asset's value and depreciated over the life of the asset. Because the capitalized interest results in a higher interest coverage ratio (lower denominator), some analysts reverse the transaction and add the capitalized interest to interest expense for the period.

Depreciation methods:

Straight-line: Equal amount of expense each period.

Accelerated (declining balance): Greater depreciation expense in the early years and less depreciation expense in the later years of an asset's life.

Units-of-production: Expense based on usage rather than rime.

In the early years of an asset's life, accelerated depreciation results in higher depreciation expense, lower net income, and lower ROA and ROE compared to straight-line depreciation. Cash flow is the same assuming tax depreciation is unaffected by the choice of method For financial reporting.

Firms can reduce depreciation expense and increase net income by using longer useful lives and higher salvage values.

Under IFRS, firms have the option to revalue assets based on Fair value under the revaluation model. U.S. GAAP does not permit revaluation.

The impact of revaluation on the income statement depends on whether the initial revaluation resulted in a gain or loss. 1f the initial revaluation resulted in a loss (decrease in carrying value), the initial loss would be recognized in the income statement and any subsequent gain would be recognized in the income statement only to the extent of the previously reported loss. Revaluation gains beyond the initial loss bypass the income statement and are recognized in shareholders' equity as a revaluation surplus.

If the initial revaluation resulted in a gain (increase in carrying value), the initial gain would bypass the income statement and be reported as a revaluation surplus. Later revaluation losses would first reduce the revaluation surplus.

Financial accounting standards (IFRS and U.S. GAAP) are often different than income tax laws and regulations. As a result, the amount of income tax expense recognized in the income statements may differ from the actual taxes owed to the taxing authorities.

Temporary differences between earnings before taxes (financial statements) and taxable income (tax return) result in the creation of deferred tax assets or deferred tax liabilities.

Such differences can result From differences in depreciation methods or inventory costing methods (IFRS), impairment charges, restructuring costs, or post-employment benefits.