Ift Study Notes Vol 3 PDF

2019 CFA® Exam Prep
IFT Study Notes
Volume 3
Financial Reporting and Analysis
This document should be read in conjunction with the corresponding reading in the 2019 Level I
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Financial Reporting and Analysis 2019 Level I Notes
Table of Contents
R21 Financial Statement Analysis ........................................................................................... 5

1. Introduction ...........................................................................................................................5
2. Scope of Financial Statement Analysis ................................................................................5
3. Major Financial Statements and Other Information Sources ............................................5
4. Financial Statement Analysis Framework ...........................................................................7
Summary........................................................................................................................................9
Practice Questions ......................................................................................................................11
R22 Financial Reporting Standards....................................................................................... 13

1. Introduction .........................................................................................................................13
2. The Objective of Financial Reporting.................................................................................13
3. Standard Setting Bodies and Regulatory Authorities .......................................................14
4. Convergence of Global Financial Reporting Standards ....................................................15
5. The International Financial Reporting Standards Framework .......................................15
6. Effective Financial Reporting .............................................................................................18
7. Comparison of IFRS with Alternative Reporting Systems ...............................................19
8. Monitoring Developments in Financial Reporting Standards .........................................19
Summary......................................................................................................................................20
R23 Understanding Income Statements ............................................................................... 29

1. Introduction .........................................................................................................................29
2. Components and Format of the Income Statement ..........................................................29
3. Revenue Recognition...........................................................................................................30
4. Expense Recognition ...........................................................................................................35
5. Non-Recurring Items and Non-Operating Items...............................................................37
6. Earnings per Share ..............................................................................................................39
7. Analysis of the Income Statement ......................................................................................41
8. Comprehensive Income ......................................................................................................42
Summary......................................................................................................................................44
R24 Understanding Balance Sheets ....................................................................................... 54
© IFT. All rights reserved 1

1. Introduction .........................................................................................................................54

2. Components and Format of the Balance Sheet .................................................................54
3. Current Assets and Current Liabilities ..............................................................................56
4. Non-Current Assets .............................................................................................................56
5. Non-Current Liabilities .......................................................................................................59
6. Equity....................................................................................................................................59
7. Analysis of the Balance Sheet .............................................................................................61
Summary......................................................................................................................................63
R25 Understanding Cash Flow Statements .......................................................................... 71

1. Introduction .........................................................................................................................71
2. Components and Format of the Cash Flow Statement .....................................................71
3. The Cash Flow Statement: Linkages and Preparation ......................................................74
4. Cash Flow Statement Analysis ............................................................................................79
Summary......................................................................................................................................83
R26 Financial Analysis Techniques ....................................................................................... 92

1. Introduction .........................................................................................................................92
2. The Financial Analysis Process ..........................................................................................92
3. Analytical Tools and Techniques .......................................................................................93
4. Common Ratios Used in Financial Analysis ......................................................................96
5. Equity Analysis ..................................................................................................................104
6. Credit Analysis ...................................................................................................................105
7. Business and Geographic Segments.................................................................................106
8. Model Building and Forecasting.......................................................................................106
Summary....................................................................................................................................108
Practice Questions ....................................................................................................................111
R27 Inventories ....................................................................................................................... 115
1. Introduction .......................................................................................................................115
2. Cost of Inventories.............................................................................................................115
3. Inventory Valuation Methods ...........................................................................................116
4. The LIFO Method ...............................................................................................................120

5. Inventory Method Changes ...............................................................................................123

6. Inventory Adjustments .....................................................................................................123
7. Evaluation of Inventory Management .............................................................................125
Summary....................................................................................................................................127
R28 Long Lived Assets ............................................................................................................ 137

1. Introduction .......................................................................................................................137
2. Acquisition of Long-Lived Assets .....................................................................................137
3. Depreciation and Amortization of Long-Lived Tangible Assets ....................................141
4. The Revaluation Model .....................................................................................................145
5. Impairment of Assets ........................................................................................................147
6. Derecognition ....................................................................................................................148
7. Presentation and Disclosures ...........................................................................................148
8. Investment Property .........................................................................................................149
9. Leasing................................................................................................................................149
Summary....................................................................................................................................153
R29 Income Taxes ................................................................................................................... 164

1. Introduction .......................................................................................................................164
2. Differences between Accounting Profit and Taxable Income ........................................164
3. Determining the Tax Base of Assets and Liabilities........................................................167
4. Temporary and Permanent Differences between Taxable and Accounting Profit ......169
5. Unused Tax Losses and Tax Credits .................................................................................170
6. Recognition and Measurement of Current and Deferred Tax........................................171
7. Presentation and Disclosure .............................................................................................173
8. Comparison of US GAAP and IFRS ....................................................................................174
Summary....................................................................................................................................175
R30 Non‐Current Liabilities .................................................................................................. 182

1. Introduction .......................................................................................................................182
2. Bonds Payable ....................................................................................................................182
3. Leases .................................................................................................................................190

4. Introduction to Pensions and Other Post-Employment Benefits ..................................198

5. Evaluating Solvency: Leverage and Coverage Ratios .....................................................200
Summary....................................................................................................................................201
R31 Financial Reporting Quality .......................................................................................... 209
1. Introduction .......................................................................................................................209
2. Conceptual Overview ........................................................................................................209
3. Context for Assessing Financial Reporting Quality ........................................................210
4. Detection of Financial Reporting Quality Issues .............................................................212
5. Conclusion ..........................................................................................................................220
Summary....................................................................................................................................222
R32 Financial Statement Analysis Applications ............................................................... 228

1. Introduction .......................................................................................................................228
2. Application: Evaluating Past Financial Performance .....................................................228
3. Application: Projecting Future Financial Performance ..................................................229
4. Application: Assessing Credit Risk ...................................................................................231
5. Application: Screening for Potential Equity Investments ..............................................231
6. Analyst Adjustments to Reported Financials ..................................................................232
Summary....................................................................................................................................236

R21 Financial Statement Analysis 2019 Level I Notes
R21 Financial Statement Analysis

1. Introduction
Financial analysis is the process of examining a company’s performance. For this purpose,
financial reports are one of the most important sources of information available to a
financial analyst. A financial analyst must have a strong understanding of the information
provided in a company’s financial reports, notes, and supplementary information.
2. Scope of Financial Statement Analysis
In order to understand financial analysis, we first need to understand the difference between
the roles of financial reporting and financial statement analysis.
Financial reporting
The role of financial reporting is to provide information about a company’s performance
(income statement and cash flow statement), financial position (balance sheet) and changes
in financial position (statement of changes in equity).
Financial statement analysis
The role of financial statement analysis is to use the financial reports prepared by firms and
combine them with other sources of information to decide if you can invest in the equity of
the firm or lend money to the firm.
3. Major Financial Statements and Other Information Sources
Instructor’s Note:
The financial statements mentioned below will be covered in a lot more detail in later
readings. At this stage, you simply need to understand the basics.
The major financial statements are the balance sheet, the income statement, the cash flow
statement, and the statement of changes in owners’ equity.
Balance sheet
The balance sheet reports the firm’s financial position at a specific point in time. It has the
following elements:
 Assets – What the company owns.
 Liabilities – What the company owes.
 Owners’ equity – What the shareholders of the company own.
The relationship between the elements can be shown as:
Assets = Liabilities + Owners’ equity
Income statement
The income statement reports the financial performance of the firm over a period of time. It

has the following elements:

 Revenues – Income generated by selling goods and services.
 Expenses – Costs incurred for producing goods and services.
 Net income – Resulting profit or loss.
The relationship between the elements can be shown as:
Net income = Revenues - Expenses
Cash flow statement
The cash flow statement reports the sources and uses of cash for the firm over a period of
time. It has the following elements:
 Operating cash flows – Cash flows from day-to-day activities.
 Investing cash flows - Cash flows associated with the acquisition and disposal of long-
term assets, such as property and equipment.
 Financing cash flows - Cash flows from activities related to obtaining or repaying
capital.
Statement of changes in owner’s equity
It reports the changes in the owners’ investment in the firm over time. It has the following
elements:
 Paid in capital – Amount raised from owners.
 Retained earnings – Firm’s profits that have been retained (i.e., not paid out as
dividends).
Along with these required financial statements (mentioned above), a company typically
provides additional information in its financial reports. This includes footnotes,
management’s commentary, and auditor’s report.
Footnotes
They provide additional details about the information presented in financial statements.
This includes important information about the accounting methods, estimates, and
assumptions. They also contain information regarding acquisitions and disposals,
commitments and contingencies, legal proceedings, employee stock options and other
benefits, related party transactions and business, and geographic segments.
Management’s commentary
It provides an assessment of the data reported in the financial statements from the
management’s perspective. Examples of content include trends and significant events
affecting the company’s operations, liquidity and capital resources, off-balance sheet
obligations, and planned capital expenditures.
Auditor’s report
An audit is an independent review of a firm’s financial statements. It enables the auditor to

express an opinion on the fairness and reliability of the financial reports. An audit report
can contain one of the following opinions:
 Unqualified Opinion - Reasonable assurance that financial statements are fairly
presented. (This is the opinion that you would like to see.)
 Qualified Opinion - Some misstatement or exception to accounting standards.
 Adverse Opinion - Financial statements are not presented fairly.
Other information sources
Apart from the above-mentioned sources, other information sources available for an analyst
are:
 Interim reports – Quarterly or semiannual reports prepared by the firm. These
reports are not audited.
 Proxy statements - Statements distributed to shareholders about matters that are to
be put to a vote.
 Press releases, conference calls, and websites – Firms often provide current
information via these media.
 External sources – Information about the economy, industry, and the firm’s
competitors.
4. Financial Statement Analysis Framework
A financial statement analysis framework recommended by the CFA Institute is summarized
in the figure below. The grey boxes represent phases of financial analysis while the white
boxes represent outputs from each phase.
Articulate the Purpose and Context of Analysis
In this step, we understand the purpose of the analysis. For example, an equity analyst
analyzes the financial reports in order to decide whether to invest in the stocks of the
company or not. On the other hand, a credit analyst looks at the company in a very different

light in order to judge whether it should be given a loan or not.

Next, the analyst defines the context which includes details such as the intended audience,
time frame, budget, and so on. Once the purpose and the context are defined, the analyst
compiles the specific questions to be answered by the analysis, decides on the content to be
prepared, and finalizes the timeline and the budget.
Collect Data
Next, the analyst collects data required to answer the questions compiled in the previous
step. The sources of data are financial reports and other information sources.
The output from this step includes organized financial statements, financial tables, and
completed questionnaires.
Process Data
After collecting data, the analyst processes the data using appropriate analytical tools. This
involves:
 Making any adjustments to the financial statements to facilitate comparison. For
example, adjustments will be required to compare a company using IFRS with a
company using US GAAP.
 Creating graphs, ratios, common-size statements, etc.
The output from this step includes adjusted financial statements, common-size statements,
ratios, graphs, and forecasts.
Analyze/Interpret the Processed Data
The next step is to interpret the processed data and come up with a decision. For example,
an equity analyst may come up with a buy, sell, or hold decision.
Develop and Communicate Conclusions/Recommendations
Next, the analyst communicates the conclusions or recommendations in the appropriate
format. For example, an equity analyst will prepare a research report and send it to his firm’s
clients.
Follow‐up
Conduct periodic reviews to check if the previous conclusions are still valid. Change the
conclusions/recommendations when necessary. For example, an equity analyst may send
quarterly updates on his initial buy, sell, or hold recommendation.


Summary
LO.a: Describe the roles of financial reporting and financial statement analysis.
The role of financial reporting is to provide information about a company’s performance
(income statement and cash flow statement), financial position (balance sheet) and changes
in financial position (statement of changes in equity).
The role of financial statement analysis is to use the financial reports prepared by firms and
combine them with other sources of information to decide if you can invest in the equity of
the firm or lend money to the firm.
LO.b: Describe the roles of the key financial statements (statement of financial
position, statement of comprehensive income, statement of changes in equity, and
statement of cash flows) in evaluating a company’s performance and financial
position.
The balance sheet reports the firm’s financial position at a specific point in time. It shows the
firm’s assets, liabilities, and owners’ equity.
The income statement reports the financial performance of the firm over a period of time. It
shows the firm’s revenues, expenses, and net income.
The cash flow statement reports the sources and uses of cash for the firm over a period of
time. It shows the firm’s operating, investing, and financing cash flows.
Statement of changes in owner’s equity reports the changes in the owners’ investment in the
firm over time. It shows the firm’s paid in capital and retained earnings.
LO.c: Describe the importance of financial statement notes and supplementary
information ‐ including disclosures of accounting policies, methods, and estimates ‐
and management’s commentary.
The notes (also called footnotes) are important as they disclose information about the
accounting policies, methods, and estimates used to prepare the financial statements. They
contain important information regarding acquisitions and disposals, commitments and
contingencies, legal proceedings, employee stock options and other benefits, related party
transactions and business, and geographic segments.
Management’s commentary comprises of subjective information where management is
presenting its view and interpretation of the data it has reported. Examples of content
include trends and significant events affecting the company’s operations, liquidity and
capital resources, off-balance sheet obligations, and planned capital expenditures.
LO.d: Describe the objective of audits of financial statements, the types of audit
reports, and the importance of effective internal controls.
An audit is an independent review of a firm’s financial statements. It enables the auditor to
express an opinion on the fairness and reliability of the financial reports. An audit report can

contain one of the following opinions:

 Unqualified Opinion - Reasonable assurance that financial statements are fairly
presented.
 Qualified Opinion - Some misstatement or exception to accounting standards.
 Adverse Opinion - Financial statements are not presented fairly.
Effective internal controls are important to ensure the accuracy of financial statements. A
firm’s management is responsible for maintaining an effective internal control system.
LO.e: Identify and describe information sources that analysts use in financial
statement analysis besides annual financial statements and supplementary
information.
Apart from the financial statements, other information sources available for an analyst are:
 Interim reports – Quarterly or semiannual reports prepared by the firm.
 Proxy statements - Statements distributed to shareholders about matters that are to
be put to a vote.
 Press releases, conference calls, and websites – Firms often provide current
information via these mediums.
 External sources – Information about the economy, industry, and the firm’s
competitors.
LO.f: Describe the steps in the financial statement analysis framework.
The financial statement analysis framework consists of the following six steps:
1. Define the purpose and context of the analysis.
 Define the purpose and context of the analysis based on your function, client
inputs, and organizational guidelines.
 Determine the time frame and the resources available for the task.
2. Collect data.
 Collect data from financial statements and other information sources.
3. Process the data.
 Make adjustments to financial statements.
 Create graphs, ratios, common-sizes statements, etc.
4. Analyze and interpret the data.
5. Develop and communicate conclusions and recommendations.
6. Follow up.
 Conduct periodic reviews to check if previous conclusions are still valid.

Practice Questions
1. Information regarding a company’s financial position, financial performance, and
changes in financial position is disclosed in which of the following process:
A. auditing.
B. financial statement analysis.
C. financial reporting.
2. A company’s financial position at a given time is best portrayed by:

A. balance sheet.
B. income statement.
C. cash flow statement.
3. Information regarding the accounting policies, estimates, and the methods used in
preparing the financial statements would be most likely found in the:
A. management’s discussion and analysis.
B. notes to financial statements.
C. auditor’s report.
4. When analyzing financial statements, the type of audit opinion that is most preferred is:
A. unqualified.
B. qualified.
C. adverse.
5. Which of the following would most likely provide information about election of board
members?
A. auditor’s report.
B. notes to financial statements.
C. proxy statement.
6. Ratios are an output of which step in the financial statement analysis framework?
A. Collect data.
B. Analyze and interpret data.
C. Process data.

Solutions

1. C is correct. In financial reporting, statements that include information regarding the
company’s financial position, financial performance, and changes in financial position are
published. In financial statement analysis, information disclosed in the financial
statements is evaluated.
2. A is correct. The balance sheet portrays the current financial position of the company at a
specific time. The income statement and cash flow statement portray the financial
performance of the company over a specific period of time.
3. B is correct. Information regarding the accounting policies, estimates, and the methods
used in preparing the financial statements is found in the notes to financial statements.
4. A is correct. An unqualified opinion is a clean opinion that represents that statements are
free from errors and are in accordance with accounting standards. A qualified opinion
represents any deviations from the accounting standards while an adverse opinion
represents that the statements are not represented in a fair manner.
5. C is correct. Matters, like election of board members, that require shareholder vote are
included in the proxy statement.
6. C is correct. The steps in the financial statement analysis framework are:

1. Articulate purpose and context of analysis.
2. Collect data.
3. Process data.
4. Analyze and interpret data.
5. Develop and communicate recommendations and conclusions.
6. Follow up.
Ratios are an output of the “process data” step. They then form an input to the “analyze
and interpret data” step.

R22 Financial Reporting Standards 2019 Level I Notes
R22 Financial Reporting Standards

1. Introduction
Financial reporting standards provide principles for preparing financial reports. They also
determine the types and amount of information that must be provided to users of financial
statements. There are several financial reporting standards but the most prominent ones are
the U.S. generally accepted accounting principles (US GAAP) and International Financial
Reporting Standards (IFRS). This reading focuses on the framework within which these
standards are created.
2. The Objective of Financial Reporting
The following paragraph is an excerpt from the Conceptual Framework for Financial
Reporting 2010 formulated by IASB:
‘The objective of general purpose financial reporting is to provide financial information
about the reporting entity that is useful to existing and potential investors, lenders and other
creditors in making decisions about providing resources to the entity.’
For the users of financial statements, financial reporting standards facilitate comparison
across companies (cross sectional analysis) and over time for a single company (time-series
analysis). The accounting standards must be flexible enough to recognize that differences
exist in the underlying economics between businesses. The financial transactions that
companies aim to disclose are often complex and often require accruals and estimates, both
of which necessitate judgment. Accordingly, the accounting standards must also be flexible
enough to achieve some consistency in these judgments.
Let us consider some simple examples. Suppose two companies buy similar equipment for
long-term use. One company expenses (shows the entire amount as an expense on the
income statement) and the other company capitalizes the cost of the equipment (creates an
asset on the balance sheet). For an analyst, this represents a challenge when comparing the
two companies. The different accounting treatment will lead to two very different income
statements and balance sheets for the two companies. Financial reporting standards address
such a challenge by creating accounting standards which ensure that both companies record
similar transactions in a similar manner. For example, the standards might require that both
companies create an asset on the balance sheet.
However, suppose one company will make extensive use of the equipment while the other
will not use it so extensively. How do financial reporting standards allow for such a
difference? The answer is that financial reporting standards retain some flexibility in giving
companies the discretion to decide on the estimated useful life of an asset. The cost of the
machine is then apportioned over this useful life as an expense – this expense is known as
depreciation. Financial standards allow companies to record different amounts of
depreciation every period based on the usage of the machines. For example, the company
that uses the asset extensively will show a higher depreciation expense each year for a

shorter number of years. Whereas, the company that uses the asset less extensively will
show a lower depreciation expense each year but for a longer number of years.
3. Standard‐Setting Bodies and Regulatory Authorities
Standard‐setting bodies
Standard-setting bodies are private sector organizations that help develop financial
reporting standards. The two important standard-setting bodies are:
 Financial Accounting Standards Board (FASB) – For the U.S. The standards developed
by FASB are called U.S. GAAP (Generally Accepted Accounting Principles).
 International Accounting Standards Board (IASB) – For the rest of the world. The
standards developed by IASB are called IFRS (International Financial Reporting
Standards).
Standard-setting bodies simply set the standards but they do not have the authority to
enforce the standards.
Desirable attributes of standard‐setting bodies
 Clearly define responsibilities of all parties involved.
 Observe high professional and ethical standards.
 Have adequate authority, resources and competencies.
 Have a clear and consistent process.
 Have a well-articulated framework for guidance.
 Seek inputs from stakeholders, but still operate independently.
 Should not succumb to pressure from external forces.
 Final decisions should be made in the public interest.
Regulatory Authorities
Regulatory authorities are government entities that have legal authority to enforce the
financial reporting standards. The two important regulatory authorities are:
 Securities and Exchange Commission (SEC) – For the U.S.
 Financial Services Authority (FSA) – For the UK
Regulatory authorities are also responsible for the regulation of capital markets under their
jurisdiction.
The International Organization of Securities Commission (IOSCO)
IOSCO is not a regulatory authority, but its members (such as the SEC) regulate a significant
portion of the world’s financial markets. (Think of it as an umbrella organization of
regulatory authorities). This organization has established objectives and principles to guide
securities and capital market regulation.

Core objectives
 Protect investors.
 Ensure fairness, efficiency, and transparency in markets.
 Reduce systemic risk.
Principles
 There should be full, accurate, and timely disclosure of financial results and risks.
 Financial statements should be of a high and internationally acceptable quality.
4. Convergence of Global Financial Reporting Standards
IFRS is in the process of being adopted in many countries. Other countries, the U.S. being the
major one, are maintaining their own standards but are working with the IASB to converge
their standards and IFRS. However, there are still challenges in full convergence (adoption of
a single set of global standards). The main challenges are as follows:
 Standard setting bodies and regulators can have different views.
 Resistance to change from industry lobbying groups.
 For convergence to be meaningful, standards need to be applied consistently and
there needs to be effective enforcement. Otherwise, a single set of standards may only
appear to exist while desirable attributes, such as comparability, may be lacking.
5. The International Financial Reporting Standards Framework
The IFRS has prepared a framework for the preparation and presentation of financial
reports. The framework is shown in the diagram below.

Objective of financial statements
At the center of the framework is the objective of financial statements. As per the IFRS
framework, the objective of financial statements is ‘to provide financial information about
the reporting entity that is useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity.’
Qualitative characteristics
Surrounding the objective are the desirable qualitative characteristics of financial
statements.
The two fundamental qualitative characteristics are:
 Relevance: Financial statements should be useful, both for making forecasts as well as
to evaluate past forecasts. They should be timely and sufficiently detailed and
important facts should not be omitted.
 Faithful representation: Information presented should be complete, neutral, and free
from errors.
The four supplementary qualitative characteristics are:
 Comparability: Financial statements should be consistent over time and across firms
to facilitate comparisons.
 Verifiability: Independent observers should be able to verify that information reflects
true economic reality.
 Timeliness: Information should be available in a timely manner.
 Understandability: Information should be presented in a simple manner, such that
even users with basic business knowledge can understand it.
Reporting elements
Surrounding the qualitative characteristics are the reporting elements used to present
information.
Elements related to measurement of financial position are:
 Assets
 Liabilities
 Equity
Elements related to measurement of financial performance are:
 Revenue
 Expenses
Below the reporting elements are the constraints faced and the assumptions made while
preparing financial statements.


Constraints
 Tradeoff between reliability and timeliness: If a firm tries to make statements that
have no errors and are highly reliable it will need a lot of time. Similarly, if a firm tries
to make statements in the least amount of time they will more errors and be less
reliable.
 Cost: The benefit that the users gain from using the reports should be more than the
cost of preparing the reports.
 Intangible aspects: Intangible information such as brand name and customer loyalty
cannot be captured directly in financial statements.
Assumptions
 Accrual basis: Revenue should be recognized when earned and expenses should be
recognized when incurred, irrespective of when the cash is actually paid.
 Going concern: Assumption that the company will continue operating for the
foreseeable future.
General Requirements for Financial Statements (IASB)
Required financial statements

The required financial statements are:
 Balance sheet.
 Income statement.
 Cash flow statement.
 Statement of changes in owners’ equity.
 Explanatory notes.
General features for preparing financial statements
The general features for preparing financial statements are:

 Fair presentation: Faithful representation of transactions.

 Going concern: Assume firm will continue to exist for the foreseeable future.
 Accrual basis: Recognize revenue when earned and expense when incurred.
 Materiality and aggregation: Important information should not be omitted. Similar
information should be grouped together.
 No offsetting: Assets and liabilities, and revenue and expenses should not be offset
against each other.
 Frequency of reporting: Prepare statements at least annually.
 Comparative information: Comparable information for prior periods should be
included.
 Consistency: Prepare reports in the same manner for every period.
Structure and content requirements
Firms should use the classified balance sheet structure (which shows current and non-
current assets and liabilities separately.) Certain minimum information must be presented in
the notes and on the face of the financial statements.
Convergence of Conceptual Framework
As more countries adopt IFRS, the need to consider other financial reporting systems will be
reduced. Nevertheless, analysts are likely to encounter financial statements that are
prepared on a basis other than IFRS. The most common among alternate frameworks is the
US GAAP. While there has been progress over the last decade, differences remain between
the two frameworks. Therefore, an analyst should be aware of these differences when
comparing financial reports based on the different frameworks.
6. Effective Financial Reporting
Characteristics of an Effective Financial Reporting Framework
The characteristics of an effective framework are:
 Transparency: This means that users should be able to see the underlying economics
of a business reflected clearly in the company’s financial statements.
 Comprehensiveness: A framework should cover the full spectrum of transactions that
have financial consequences.
 Consistency: Similar transactions should be measured and presented in a similar
manner across companies and time periods regardless of industry, company size,
geography, or other characteristics.
Barriers to a Single Coherent Framework
It is difficult to satisfy all three characteristics simultaneously. Different frameworks will
make different tradeoffs between the characteristics, thus creating a barrier to a single
coherent framework. Other areas of conflict include:
 Valuation: Various bases for measuring the value of assets and liabilities exist such as

historical cost and fair value. These require varying levels of judgment and can
provide different degrees of relevant information.
 Standard-setting approach: Standards can be principles based, rules based or a
combination of the two (called an ‘objectives-oriented’ approach). A principles-based
approach provides a broad framework with little specific guidance on how to report a
particular element or transaction. In contrast, a rules-based approach establishes
rules for each element or transaction. An objectives-oriented approach includes a
framework of principles and implementation guidelines.
 Measurement: Financial reporting standards can be established using an
asset/liability approach that gives preference to proper valuation of the balance
sheet, or a revenue/expense approach that focuses more on the income statement.
7. Comparison of IFRS with Alternative Reporting Systems
A significant percentage of listed companies use either IFRS or US GAAP. An analyst must be
cautious when comparing financial measures between companies reporting under IFRS and
companies reporting under US GAAP. If needed, specific adjustments need to be made to
achieve comparability.
US GAAP uses standards issued by FASB while IFRS uses standards issued by IASB. While the
two organizations are working towards convergence, significant differences still remain.
8. Monitoring Developments in Financial Reporting Standards
Analysts must be aware that reporting standards are evolving rapidly. They need to monitor
developments in financial reporting and assess their implications for security analysis and
valuation.
A financial analyst can remain aware of developments in financial reporting standards by
monitoring three sources:
 new products or transactions
 actions of standard setters and groups representing users of financial statements
 company’s disclosures regarding critical accounting policies and estimates.


Summary
LO.a: Describe the objective of financial statements and the importance of financial
reporting standards in security analysis and valuation.
The objective of financial statements is to provide useful information about a firm’s financial
performance to existing and potential investors, lenders, and other creditors.
Financial reporting standards ensure that there is consistency in the preparation of financial
reports. This ensures that financial reports of different firms are comparable to one another.
A firm’s management uses some estimates and assumptions to prepare financial reports.
Financial reporting standards ensure that the assumptions and estimates are within a
narrow reasonable range.
LO.b: Describe the roles and desirable attributes of financial reporting standard‐
setting bodies and regulatory authorities in establishing and enforcing reporting
standards, and describe the role of the International Organization of Securities
Commissions.
Standard Setting Bodies Regulatory Authorities
Private sector organizations. Government entities.
Self-regulated organizations. Country specific: SEC, FSA.
Set standards but do not have the authority Authority to enforce financial reporting
to enforce. requirements.
Board members are experienced Can overrule private sector standard-setting
accountants, auditors, analysts, and bodies and establish standards in their
academics. jurisdiction.
Major ones: FASB and IASB. Regulate capital markets in general.
The International Organization of Securities Commission (IOSCO) is not a regulatory
authority but its members (such as the SEC) regulate a significant portion of the world’s
financial markets. The following are the core objectives of IOSCO:
 Protect investors.
 Ensure fairness, efficiency, and transparency in markets.
 Reduce systematic risk.
LO.c: Describe the status of global convergence of accounting standards and ongoing
barriers to developing one universally accepted set of financial reporting standards.
IFRS is in the process of being adopted in many countries. The different standard setting
bodies are working with IASB to converge their standards with IFRS. The challenges in full
convergence are:
 Difference of opinion among standard-setting bodies and regulatory authorities from
different countries.
 Political pressure from industry lobbying groups that will be affected by the change.

LO.d: Describe the International Accounting Standards Board’s conceptual framework,

including the objective and qualitative characteristics of financial statements,
required reporting elements, and constraints and assumptions in preparing financial
statements.

LO.e: Describe the general requirements for financial statements under IFRS.
LO.f: Compare the key concepts of financial reporting standards under IFRS and U.S.
GAAP reporting systems.
Instructor note:
This LO is not very testable, since some of the differences mentioned in the table below are

old and no longer valid. The recent differences between IFRS and U.S.GAAP are covered in
much more detail in later readings.
U.S. GAAP uses standards issued by FASB while IFRS uses standards issued by IASB. The two
organizations are working towards convergence but still have some differences:
Differences FASB IASB
Performance Elements Includes revenue, expenses, Includes income and
gains, losses, and expenses.
comprehensive income.
Financial position Asset defined as future Asset defined as resource
elements economic benefit. from which future economic
benefit is expected to flow.
Recognition of Does not discuss the term IASB requires that it is
elements probable in its recognition probable that any future
criteria. economic benefit flow
to/from the entity.
Measurement of
Upward valuation not allowed. Upward valuation allowed.
elements

LO.g: Identify the characteristics of a coherent financial reporting framework and the
barriers to creating such a framework.
The characteristics of a coherent financial reporting framework are:
 Transparency
 Comprehensiveness
 Consistency
The barriers to a single coherent framework are differences in:
 Valuation
 Standard-setting approach
 Measurement
LO.h: Describe the implications for financial analysis of differing financial reporting
systems and the importance of monitoring developments in financial reporting
standards.
Analysts must be aware that reporting standards are evolving rapidly. They need to monitor
developments in financial reporting standards and assess their implications for security
analysis and valuation. To do this, an analyst can monitor three sources:
 New products or transactions in capital markets.
 Actions of standard-setting bodies.
 Company’s disclosures regarding critical accounting policies and estimates.

LO.i: Analyze the company disclosures of significant accounting policies.

Both IFRS and U.S. GAAP require companies to disclose their accounting policies and
estimates in the footnotes and management commentary. Companies are also required to
disclose the likely impact of recent changes in accounting standards on their financial
statements. These disclosures can alert analysts to significant changes that could affect
security valuation.

Practice Questions
1. Which of the following statements about the objective of financial statements is true?
Statement 1: “The objective of financial statements is to provide information about the
financial performance of an entity.”
Statement 2: “The objective of financial statements is to provide information about the
changes in the financial position of an entity.”
A. Statement 1.
B. Statement 2.
C. Both Statements 1 and 2.
2. Which of the following is the least desirable attribute of accounting standards board?
A. Is guided by a well-articulated framework.
B. Is funded by companies for which the standards are being developed.
C. Does not concede to external forces like political pressure.
3. Which of the following entities are currently responsible for developing International
Financial Reporting Standards (IFRS) and US Generally Accepted Principles (US GAAP)?
IFRS US GAAP
A. The International Accounting Standards The Financial Accounting Standards
Board (IASB) Board (FASB)
B. The Financial Services Authority (FSA) The Financial Accounting Standards
Board (FASB)
C. The International Accounting Standards The Securities and Exchange
Board (IASB) Commission (SEC)
4. Which of the following is the core objective of the International Organization of Securities
Commissions (IOSCO)?
A. Ensure that markets are fair, efficient and transparent.
B. Protect all the users of financial statement.
C. Eliminate systematic risk.
5. Which of the following statements is least accurate regarding the barriers to global
convergence of accounting standards?
A. Political pressure from entities impacted by the reporting standards change acts as a
barrier to global convergence of accounting standards.
B. Despite strong support from business groups, there are barriers to global
convergence of accounting standards.
C. Disagreement between national standard-setting and regulatory authorities acts as a
barrier to global convergence of accounting standards.

6. With respect to the IASB Conceptual Framework, which of the following are the
fundamental qualitative characteristics that make financial statements useful?
A. Relevance and faithful representation.
B. Verifiability and timeliness.
C. Comparability and understandability.
7. Which of the following reporting elements of financial statements are most closely
related to measurement of financial position and measurement of financial performance?
Financial Position Financial Performance
A. Expenses Assets
B. Income Liabilities
C. Equity Income
8. Which of the following statements regarding the primary assumptions that are used in
preparation of financial statements are most likely to be true?
Statement 1: “An entity should be regarded as a going concern, i.e., it will continue to
operate in the foreseeable future.”
Statement 2: “All the transactions should be recorded on an accrual basis, i.e., when the
transactions occur and not when the cash flows occur.”
A. Statement 1.
B. Statement 2.
C. Both Statements 1 and 2.
9. With respect to IAS No. 1, which of the following is not a required financial statement?
A. Statement of changes in income.
B. Statement of comprehensive income.
C. Statement of financial position.
10. Which of the following statements comparing FASB and IASB conceptual frameworks is
most accurate?
A. Both frameworks are fully converged.
B. The IASB framework lists income and expenses as performance elements, while the
FASB lists revenues, expenses, gains, loses, and comprehensive income.
C. The FASB allows for upward revaluation of most assets.
11. Which of the following is not a characteristic of a coherent financial reporting

framework?
A. Timeliness.
B. Transparency.
C. Consistency.

12. Which of the following disclosures regarding new accounting standards is most useful for
an analyst?
A. Management is still evaluating the impact.
B. The likely impact of adopting the accounting standards is discussed.
C. The adoption of the standard is likely to have no impact.

Solutions

1. C is correct. The objective of financial statements is to provide information about an
entity’s financial performance and changes in the financial position.
2. B is correct. For an accounting standards board to function properly, it should be

independent, should be guided by a well-articulated framework, should not concede to
external forces like political pressure, and should be adequately funded.
3. A is correct. Standard-setting bodies are responsible for developing the reporting

standards. The International Accounting Standards Board (IASB) is responsible for
developing the IFRS reporting standard while the Financial Accounting Standards Board
(FASB) is responsible for developing the US GAAP standard. Regulatory authorities
enforce compliance with the reporting standards. This includes the Securities and
Exchange Commission (SEC) in the US and the Financial Services Authority (FSA) in the
UK.
4. A is correct. The core objective of IOSCO is to ensure that markets are fair, efficient and
transparent, reduce systematic risk (not eliminate), and protect investors (not all users)
that use the financial statement.
5. B is correct. Barriers to global convergence of accounting standards include

disagreements between standard-setting bodies and regulatory authorities and political
pressure exerted by entities that are impacted by the reporting standards change. Global
convergence of accounting standards does not enjoy strong support from business
groups.
6. A is correct. The fundamental characteristics of financial statements are relevance and

faithful representation. The enhancing characteristics of financial statements are
verifiability, comparability, understandability, and timeliness.
7. C is correct. Reporting elements of financial statements related to measurement of

financial position are assets, liabilities, and equity. Reporting elements of financial
statements related to measurement of financial performance are income and expenses.
8. C is correct. The two primary assumptions that are used while preparing financial
statements are the accrual basis of accounting and the going concern assumption. In
accrual basis, transactions are recorded when the transactions occur and not when the
cash flows occur. The entity is assumed to be a going concern, i.e., it will continue its
operation in the foreseeable future.

9. A is correct. There is no statement of changes in income. The required financial

statements are statement of financial position, a statement of comprehensive income, a
statement of changes in equity, a statement of cash flows, and notes comprising a
summary of significant accounting policies and other explanatory information.
10. B is correct. The IASB and FASB frameworks are moving towards convergence but
differences still exist between them. The FASB does not allow upward revaluation of
most assets.
11. A is correct. The characteristic of a coherent framework are transparency,

comprehensiveness, and consistency. Timeliness is not a characteristic of a coherent
framework.
12. B is correct. The discussion on the likely impact would be most useful for an analyst.

R23 Understanding Income Statements 2019 Level I Notes
R23 Understanding Income Statements

1. Introduction
The income statement presents information on the financial results of a company’s business
activities over a period of time. It is also known as the ‘statement of operations’, ‘statement
of earnings’, or ‘profit and loss (P&L) statement’. The basic equation underlying the income
statement is:
Income - Expenses = Net Income
Equity analysts carefully analyze a company’s income statements for use in valuation models
while fixed-income analysts analyze income statements to measure a company’s debt
servicing ability.
2. Components and Format of the Income Statement
Components of the income statement
The components of an income statement are:
Revenues: Income generated from the sale of goods and services in the normal course of the
business. Net revenue is the total revenue minus products that were returned and amounts
that are unlikely to be collected.
Expenses: Costs incurred to generate revenues. They are grouped together by their nature or
function. For example,
 Costs of similar nature like depreciation of building and depreciation of equipment
are grouped together.
 Costs associated with the same function such as production (e.g. raw materials and
labor) are grouped together.
Gains and losses: Amounts generated from non-operating activities.
Net income: Net income can be calculated as Net income = Revenues – Expenses + Gains –
Losses.
Presentation formats
Income statements can be presented in the following two formats:
 Single-step: All revenues and all expenses are grouped together. There are no sub-
totals.
 Multi-step: It includes subtotals such as gross profit and operating profit.
The table below shows samples for both formats.
Multi‐step format Single‐step format
$ million 2015 2014 $ million 2015 2014
Sales 35,310 31,600 Sales 35,310 31,600
Cost of sales 10,300 9,060 Cost of sales 10,300 9,060

Gross Profit 25,010 22,540 Gain from sale of equipment 900 860
Administrative expenses 3,400 2,900
Gain from sale of equipment 900 860 Advertising expense 1,000 900
Administrative expenses 3,400 2,900 Depreciation 960 850
Advertising expense 1,000 900 Other expenses 6,500 6,100
Depreciation 960 850 Operating Income (EBIT) 14,050 12,650
Other expenses 6,500 6,100 Interest Expense 10 70
Operating Income (EBIT) 14,050 12,650 Profit before tax (EBT) 14,040 12,580
Interest Expense 10 70 Tax Expense 3,945 3,300
Profit before tax (EBT) 14,040 12,580
Tax Expense 3,945 3,300 Profit after tax 10,095 9,280
Profit after tax 10,095 9,280
3. Revenue Recognition
3.1. General Principles
Under the accrual method of accounting, revenue should be recognized when earned and not
necessarily when cash is received. Let us consider three simple examples to illustrate this
point.
 If a company sells goods for $100 cash in Period 1, can it recognize revenue in Period
1? The answer is yes. Revenue is recorded in the period it is earned, i.e., when goods
or services are delivered.
 What if the company sells goods on credit in Period 1 and expects to receive cash in
Period 2? Can revenue be recognized in Period 1? The answer is that revenue is
recorded in Period 1. In addition, since the goods are sold on credit, an asset called
accounts receivable is created.
 What if an advance payment is received in Period 1 but goods and services are to be
delivered in Period 2. When will the revenue be recognized? The revenue will be
recognized in Period 2 because that is when delivery of goods will take place. In this
case, the company will record a liability called unearned revenue when the advance
payment is received.
When is revenue recognized?
IFRS and US GAAP provide specific criteria for recognizing revenue. These are listed in the
following table.
Revenue recognition criteria under IFRS and US GAAP
IFRS US GAAP
• Amount of revenue can be measured • Price is determined or determinable.
reliably.
• It is probable that economic benefits
• Evidence of arrangement between
associated with the transaction will
buyer and seller.
flow to the entity.

• Stage of completion of the transaction • Product has been delivered or service

can be measured reliably. has been rendered.
• Transaction costs can also be measured • Recognize when “realized or
reliably. realizable and earned”.
• The entity no longer has any • Seller is reasonably sure of collecting
managerial involvement or effective money.
control over the goods sold.
Companies must disclose their revenue recognition policies in the notes to their financial
statements, and analysts should read these carefully to understand how and when a
company recognizes revenue.
3.2. Revenue Recognition in Special Cases
In this section, we will look at revenue recognition for long-term contracts, installment sales,
and barter transactions. We will also discuss gross versus net reporting.
Long‐term contracts
A long-term contract is one that extends beyond one accounting period. For example, the
construction of a building that takes five years. The revenue reorganization methods to be
used for long-term contracts are:
1. If cost and revenue can be reliably measured:
Both IFRS and U.S. GAAP require Percentage of completion method. The revenue to be
recognized in a year is given by:
Costs incurred in that year
Revenue recognized in a year Total revenue
Total cost of the project
Example
Company ABC has a contract to construct a building. This project will take 5 years to
complete. The expected total revenue from the project is $10 million and the expected total
cost is $8 million. In year 1, the cost incurred by the company was $2 million. In year 2, the
cost incurred by the company was $1 million. Using the percentage of completion method,
what amount of revenue will the company recognize in year 1 and year 2?
Solution:
$2 million
Revenue recognized in year 1 $10 million $2.5 million
$8 million
$1 million
Revenue recognized in year 2 $10 million $1.25 million
$8 million
2. If costs and revenues cannot be reliably measured:
IFRS states that revenue can be recognized to the extent of contract costs incurred.
Example

cost incurred by the company was $1 million. The costs and revenue cannot be reliably
measured and the company follows IFRS standards, what amount of revenue will the
company recognize in year 1 and year 2?
Solution:
Revenue recognized in year 1 $2 million
Revenue recognized in year 2 $1million
U.S. GAAP requires the ‘completed contract method' in which the company does not report
any income until the contract is complete.
Example
cost incurred by the company was $1 million. The costs and revenue cannot be reliably
measured and the company follows U.S. GAAP standards, what amount of revenue will the
company recognize in year 1 and year 2?
Solution:
Revenue recognized in year 1 $0 million
Revenue recognized in year 2 $0million
Installment Sales
In installment sales, the company finances a sale and the sales proceeds are paid in
installments over multiple accounting periods. For example, sale of an apartment in which
the customer will pay the sale price in installments over the next 10 years.
The revenue recognition methods to be used for installment sales are:
1. If the company is reasonably sure of collecting payments.
Separate installments into two components: Sales price (present value of installments) and
interest component. Revenue attributable to the sales price is recognized immediately, and
revenue attributable to the interest component is recognized over time, as and when the
payments come in.
2. If the collectability cannot be reasonably estimated.
The ‘installment method’ is used. The profit for a period is calculated as:
Cash collected in that period
Profit for a period Total profit
Total revenue
Example
Company ABC sold a property at a sales price $100,000. The cost of the property to the
company was $80,000. The buyer made a down payment of $25,000 in year 1. He will be

paying the remaining amount in installments over the next 10 years. For year 1, how much
profit can be recognized using the installment method?
Solution:
$25,000
Proift for year 1 $20,000 $5,000
$100,000
3. If the collectability is highly uncertain:
The ‘cost recovery method’ is used. Under this method, profits are recognized only when
the total cash collections exceed total costs.
Example
Company ABC sold a property at a sales price $100,000. The cost of the property to the
company was $80,000. The buyer made a down payment of $25,000 in year 1. He will be
paying the remaining amount in installments over the next 10 years. For year 1, how much
profit can be recognized using the cost recovery method?
Solution:
Profit for year 1 = $0.
Since the total cash collected ($25,000) did not exceed the total cost ($80,000), we cannot
recognize any profits in year 1.
Note: We can start recognizing profits only from year 8 onward; when the total cash
collected ($85,000) exceeds the total cost.
Cash collected till year 8: $85,000  Profit for year 8 = $5,000
Barter transaction
In a barter transaction, two parties exchange goods or services without any cash payment. A
‘round trip transaction’ is a special type of barter transaction in which the goods/services
exchanged are identical to each other.
The criteria for recognizing revenue from barter transactions under IFRS and US GAAP differ
as stated below:
 Under IFRS, revenue from barter transactions can be measured using the fair value
from a similar non-barter transaction with an unrelated party.
 Under U.S. GAAP, revenue can be recognized at fair value only if the firm has
historically received cash payments for such goods.
Gross versus net revenue reporting

Under gross revenue reporting, the selling firm reports sales revenue and cost of goods sold
separately. Whereas, under net revenue reporting, only the difference between sales and
cost of goods sold is reported. Though the profit reported is the same under both methods,

using gross reporting gives us higher reported sales.

Gross reporting can only be used if:
 The company is the primary obligor under the contract.
 The company bears inventory and credit risk.
 The company can choose its suppliers.
 The company has reasonable latitude to establish price.
For example, an airline company would use gross reporting for tickets sold, whereas a travel
agent who sells airline ticket for a commission will use net reporting.
3.3. Implications for Financial Analysis
Companies use a variety of revenue recognition methods; some might be more aggressive,
while others might be more conservative. In addition, a single company can use different
revenue recognition policies for different businesses. An analyst should be able to
characterize the relative conservatism of a company’s polices and also understand how the
differences in policies might impact financial ratios.
3.4. Revenue Recognition Accounting Standards Issued May 2014
In May 2014, the IASB and FASB issued converged standards for revenue recognition. The
standards take a principles-based approach to revenue recognition issues. The core principle
behind the converged standard is that revenue should be recognized to “depict the transfer
of promised goods or services to customers in an amount that reflects the consideration to
which the entity expects to be entitled in an exchange for those goods or services.”
According to the standard, the following five steps must be followed in order to recognize
revenue:
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
When revenue is recognized, a contract asset is added to the balance sheet. If an advance is
received but performance obligations have not been met, then a contract liability is added to
the seller’s balance sheet.
Treatment of related costs
Specific accounting treatment for related costs is summarized below:
 Incremental costs of obtaining a contract or fulfilling a contract must be capitalized.
 If incremental costs were expensed in the years before adopting the converged
standard, then the company’s profitability will appear higher under the converged
standards.

Disclosure requirements
The converged standard mandates the following disclosure requirements:
 Companies must disclose information about contracts with customers after
segregating them into different categories of contracts. The categories may be based
on the geographic region, the type of product, the type of customer, pricing terms, etc.
 Companies must disclose information related to revenue recognition. For example,
any change in judgments, remaining performance obligations, and transaction price
allotted to those obligations, and balances of contract-related assets and liabilities.
4. Expense Recognition
Expenses are ‘decreases in economic benefit during the accounting period in the form of
outflows or depletion of assets or incurrences of liabilities that result in decreases in equity.’
For example, if a company pays rent, its cash reduces and the rent is recognized as an
expense.
4.1. General Principles
Matching principle
The most important principle of expense recognition is the matching principle, under which
the expenses incurred to generate revenue are recognized in the same period as revenue.
For example, if some goods bought in the current year remain unsold at the end of the year,
they are not included in the cost of goods sold for the current year. If they are sold in the
next year, they will be included in the cost of goods sold for the next year.
Periodic costs
Expenses that cannot be tied directly to generation of revenues are called periodic costs.
They are expensed in the period incurred. For example, the rent paid for office premises are
simply expensed in the period for which the rent was paid.
Inventory methods
Accounting standards permit the use of following methods to assign inventory expenses:
 ‘First in, first out (FIFO)’ assumes that the earliest items purchased are sold first.
 ‘Last in, first out (LIFO)’ assumes that the most recent items purchased are sold first.
 ‘Weighted average cost’ averages total cost over total units available.
 ‘Specific identification’ identifies each item in the inventory and uses its historical
cost for calculating COGS, when the item is sold.
We will learn more about these inventory valuation methods in a later reading.


4.2. Issues in Expense Recognition

Some issues in expense recognition are:
Doubtful accounts
When sales are made on credit, there is a chance that some customers will default. There are
two methods of recognizing credit losses. The first one is to wait for a customer to default
and then recognize a loss. This is called the ‘direct write-off’ method. The second is to record
an estimate of credit losses (using historical data) at the time of revenue recognition. The
matching principle requires the use of the second method.
Warranties
When a company provides warranty, there is a chance that some defective product may need
to be replaced or repaired. There are two methods of recognizing warranty expense. The
first one is to recognize warranty expense when warranty is claimed. The second is to
estimate a warranty expense (using historical data) at the time of revenue recognition. The
matching principle requires the use of the second method.
Depreciation
It is the process of allocating costs of long-lived assets over the period during which the
assets are expected to provide economic benefits. The first method is called the straight-line
method, where we expense an equal amount of depreciation in each year of the asset’s useful
life. The second method is the declining balance method, where a greater proportion of
deprecation is allocated in the initial years and a lower proportion is allocated in later years.
Amortization
It is the process of allocating costs of intangible assets (a non-physical asset) over its useful
life. Intangible assets with identifiable useful lives (for example a patent that will expire in a
few years) are amortized evenly over their lives. Intangible assets with indefinite lives (for
example goodwill) are not amortized. They are tested for impairment annually. If the asset
value has come down an expense is recorded in the income statement to bring its value
down to the current value.
We will learn more about depreciation and amortization in a later reading.
4.3. Implications for Financial Analysis
A company’s estimates for doubtful accounts, warranty expenses, and depreciation amounts
can affect its net income. If a company’s policies result in early recognition of expenses, it can
be considered a conservative approach. On the other hand if a company’s polices delay the
recognition of expenses, it can be considered an aggressive approach. Using this as well as
other information contained in the footnotes or disclosures, an analyst can recognize
whether a company’s expense recognition policy is conservative or not. The analyst should

also recognize that it is possible that two companies in the same industry have very different
expense recognition policies.
5. Non‐Recurring Items and Non‐Operating Items
Analysts are generally trying to estimate and assess future earnings of a company. Hence,
reporting standards require firms to separate income and expense items that are likely to
continue in the future, from items that are not likely to continue. (You will be more
interested in items that will continue as compared to one-time items.)
5.1. Discontinued Operations
A discontinued operation is an operation which a company has disposed of or plans to
dispose of. Net income from discontinued operations is shown (as a separate line item on
the income statement) net of tax after net income from continuing operations.
5.2. Extraordinary Items
This is an item which is unusual and infrequent and is shown separately as a non-operating
item. IFRS prohibits classification of any income or expense as an extraordinary item.
However, this is allowed under US GAAP. Judgment of whether an item is unusual in nature
requires consideration of the company’s environment, including its industry and geography.
Determining whether an item is infrequent in occurrence is based on expectations of
whether it will occur again in the near future. For example, loss due to an earthquake would
be an extraordinary item, as it is both unusual in nature and infrequent in occurrence.
5.3. Unusual or Infrequent Items
Both IFRS and US GAAP allow recognition of items that are unusual or infrequent (but not
both). Examples include restructuring charges and gains/losses from sale of equipment.
These items are shown as part of a company’s continuing operations.
5.4. Changes in Accounting Policies
At times, new accounting standards may require companies to change accounting policies.
An example can be changing the inventory valuation method from last in, first out (LIFO) to
first in, first out (FIFO). Companies are allowed to adopt standards prospectively (in the
future) or retrospectively.
 Retrospective application means that the financial statements for previous years are
presented as if the newly adopted accounting principle had been used throughout the
period. A change in accounting policy is applied retrospectively. For example, if a
company shifts from LIFO valuation method to FIFO valuation method, this change will
require a retrospective application.
 Prospective application means that only the financial statements for the period of change
and for future periods are changed. Financial statements for previous years are not
changed. At times, new standards might require companies to change accounting
estimates such as the useful life of a depreciable asset. Changes in accounting estimates

are applied prospectively.

 Correction of an error for a prior period is another possible adjustment which requires a
restatement of the four major financial statements. If a company is making corrections
very often, this gives a negative signal and investors will avoid investing in such a
company.
5.5. Non‐Operating Items
Non-operating items are typically reported separately from operating income because they
are material and/or relevant to the understanding of the company’s financial performance.
Under IFRS, there is no definition of operating activities and companies need to use
judgment about which items can be classified as operating and non-operating.
Under US GAAP, operating activities generally involve producing and delivering goods and
providing services. All other transactions and events are defined as investing or financing
activities. For example, interest expense would be an operating item for a bank but would be
non-operating for a manufacturing firm.
In practice, investing and financing activities may be disclosed on a net basis. For example, a
manufacturing firm may report net interest expense (interest expense minus interest
revenue) in its income statement. The footnotes to the financial statements can provide
further disclosure about the net interest expense. The figure below shows a visual depiction
of an income statement for a manufacturing firm following US GAAP.
Revenue or Income
Operating Expenses
Cost of Goods Sold
SG&A
Depreciation
Unusual or Infrequent Items
Operating Income
Non‐Operating Expenses
Interest Expense
Extraordinary Items
EBT (continuing operations)
Taxes
NI (continuing operations)
Earnings from discontinued operations net of taxes
Net Earnings or Net Income


6. Earnings per Share

6.1. Simple versus Complex Capital Structure
Earnings per share (EPS) is a very important profitability measure. It depicts the earnings
per ordinary share. Some basic terminologies related to EPS are:
 Potentially dilutive securities: Securities that can be converted into ordinary shares
are called potentially dilutive securities. This includes convertible bonds, convertible
preferred stock, and employee stock options.
 Simple capital structure: If a company has no potentially dilutive securities it is said
to have a simple capital structure.
 Complex capital structure: If a company has potentially dilutive securities it is said to
have a complex capital structure.
 Dilutive securities: A potentially dilutive security that decreases EPS when exercised
is called a dilutive security.
 Antidilutive security: A potentially dilutive security that increases EPS when
exercised is called an antidilutive security.
6.2. Basic EPS
In this calculation we do not consider the effect of any potentially dilutive securities. Basic
EPS is calculated as:
Net income Preferred dividends
Basic EPS
Weighted average number of shares outstanding
Weighted average number of shares outstanding is the number of shares outstanding
during the year, weighted by the portion of the year they were outstanding. Stock splits and
stock dividends are applied retroactively to the beginning of the year, so the old shares are
converted to new shares for consistency.
Example
During 2001, Company ABC had a net income of $100,000. It paid $22,000 as dividends to its
preference shareholders and $12,000 as dividends to its common shareholders. The number
of common shares outstanding during 2001 was as follows:
Shares as of January 1, 2001: 10,000
Additional shares issue on July 1, 2001: 2,000
Calculate the basic EPS of the company for 2001.
Solution:
We had 10,000 shares outstanding for the first 6 months and 12,000 shares outstanding for
the last 6 months.
Therefore weighted average number of shares outstanding = 10,000 x 6/12 + 12,000 x 6/12
= 11,000 shares.

$100,000 $22,000
Basic EPS $8
11,000
Note: We ignore dividend paid to common shareholders.
6.3. Diluted EPS
In this calculation, we consider the effect of potentially dilutive securities. If a firm has a
complex capital structure it has to report both basic and diluted EPS. Diluted EPS is
calculated as:
Net Income After tax interest Preferred dividend convertible preferred dividends
Diluted EPS
Weighted Average Shares New shares if convertible debt is converted
For preference shares, we need to subtract preference share dividends from the numerator
and add new shares issued from conversion to the denominator.
Example
During 2001, Company ABC had a net income of $100,000. It paid $22,000 dividends to its
preference shareholders and $12,000 dividends to its common shareholders. It had 2,200
preference share and 11,000 common shares outstanding during 2001. Each preference
share is convertible into 2 shares of common stock. Calculate the diluted EPS for the
company.
Solution:
Number of common shares issued upon conversion = 2,200 x 2 = 4,400
NI conv debt int 1 t pref div conv pref div
Diluted EPS
Wt avg shares New shares issued
$100,000 0 $22,000 $22,000
Diluted EPS $6.5
11,000 4,400
For convertible bonds, we need to add the after tax interest cost savings to the numerator
and new shares issued from conversion to the denominator.
Example
During 2001, Company ABC had a net income of $100,000. The capital structure of the
company for 2001 was as follows:
11,000 common shares
1,000 convertible bonds with par value of $100 and 10% coupon; convertible to 5,000
shares
The tax rate of the company is 30%.
Calculate diluted EPS.
Solution:
Number of common shares issued upon conversion = 5,000

Interest payable on the bonds = 100 x $1,000 x 10% = $10,000

Diluted EPS
$100,000 $10,000 x 0.7 $0 $0
Diluted EPS $6.69
11,000 5,000
For stock options, we use the ‘Treasury Stock Method’, which assumes that the
hypothetical funds received by the company from the exercise of options are used to
purchase shares of the company’s common stock at the average market price over the
reporting period. Thus, the numerator is unchanged and the number of shares to be added to
the denominator = the number of shares created by exercising the options – number of
shares hypothetically repurchased with the proceeds of the exercise.
Example
During 2001, Company ABC had a net income of $100,000. It paid $22,000 dividends to its
preference shareholders and $12,000 dividends to its common shareholders. The capital
structure of the company for 2001 was as follows:
11,000 common shares
1,000 stock options outstanding, that have an exercise price of $20.
During 2001, the average market price for the company’s share was $25.
Calculate the diluted EPS.
Solution:
Number of common shares issued upon conversion = 1,000
Cash proceeds from the exercise of options = 1,000 x 20 = $20,000
Number of shares that can be purchased at the average market price with these funds =
$20,000/25 = 800
Net increase in common shares outstanding = 1,000 – 800 = 200
Diluted EPS
$100,000 $0 $22,000 $0
Diluted EPS $6.96
11,000 200
Assess each instrument individually and determine if it is dilutive or not. Only instruments
which are dilutive must be included in the diluted EPS calculation.
7. Analysis of the Income Statement
Common‐size income statement presents each line item on the income statement as a

percentage of revenue. This format standardizes the income statements and helps remove
the effects of company size. They are useful to comparisons across time periods and across
companies. The income statement is used to calculate income statement ratios to evaluate
a firm’s profitability. The commonly used ratios are:
Gross profit margin = Gross profit / Revenue
Operating profit margin = Operating profit / Revenue
Net profit margin = Net profit / Revenue
High margin ratios are desirable. A firm can increase its margins by either increasing selling
price or by lowering costs, or both.
An example of a common size income statement is shown below.
2001 % 2002 %
Revenue $100,000 100% $110,000 100%
Cost of goods sold $60,000 60% $65,000 59%
Gross profit $40,000 40% $45,000 41%
SG&A $10,000 10% $11,000 10%
Depreciation expense $10,000 10% $11,000 10%
Operating profit $20,000 20% $23,000 21%
Interest expense $5,000 5% $5,500 5%
Earnings before taxes $15,000 15% $17,500 16%
Taxes (10%) $1,500 1.5% $1,750 1.6%
Net income $13,500 13.5% $15,750 14.3%
Looking at the above common-size statement, we can conclude that, the profitability margins
of this company have improved in 2002 as compared to 2001.
8. Comprehensive Income
Other comprehensive income
Other comprehensive income includes transactions that are not included in net income. Four
types of items treated as other comprehensive income under both IFRS and U.S. GAAP are:
 Unrealized gain/losses from available for sale securities.
 Foreign currency translation adjustments.
 Unrealized gains/losses on derivative contracts used for hedging.
 Adjustments for minimum pension liability.
Instructors Note:
At Level I, you need to remember these four items; these are explained in detail at level II.
Comprehensive income
Comprehensive income is the sum of net income and other comprehensive income. It
measures all changes to equity apart from those resulting from transactions with

shareholders (For example, dividends paid and stocks repurchased are not included in
comprehensive income.)
Example
Company ABC’s beginning shareholder equity was $100 million; its net income for the year
was $10 million. Cash dividends of $2million were paid to shareholders during the year. The
company's actual ending shareholder equity is $113 million. Calculate OCI.
Solution:
Amount that has bypassed the income statement = OCI = $113 – ($100+$10-$2) = $5 million.


Summary
LO.a: Describe the components of the income statement and alternative presentation
formats of that statement.
The components of an income statement are:
 Revenue
 Expenses
 Gains and Losses
 Net income
There are two ways of presenting an income statement:
 Single step format - All revenues and all expenses are grouped together.
 Multi-step format - It includes subtotals such as gross profit and operating profit.
LO.b: Describe general principles of revenue recognition and accrual accounting,
specific revenue recognition applications (including accounting for long‐term
contracts, installment sales, barter transactions, gross and net reporting of revenue),
and implications of revenue recognition principles for financial analysis.
According to the accrual method of accounting, revenue is recognized when earned and
expenses are recognized when incurred.
Revenue recognition methods for long-term contracts are:
 If cost and revenue can be measured reliably, both IFRS and U.S. GAAP state that the
‘percentage-of-completion’ method should be used.
 If cost and revenues cannot be reliably measured, IFRS states that revenue can be
recognized to the extent of contract costs incurred, US GAAP says that the ‘completed
contract method’ must be used.
Revenue recognition methods for installment sales are:
 If collection of payments is certain, IFRS separates the installments into two
components: the sales price (recognized immediately) and an interest component
(recognized over time).
 If collection of payments cannot be reasonably estimated, use the ‘installment
method’.
 If collection of payments is highly uncertain, use the ‘cost recovery method’.
Barter transaction: Under IFRS, revenue from barter transactions can be measured using the
fair value from a similar non-barter transaction with an unrelated party. Under U.S. GAAP,
revenue can be recognized at fair value only if the firm has historically received cash
payments for such goods.
Gross revenue reporting shows sales and COGS separately, while net revenue reporting
shows only the difference between the sales and COGS.

An analyst should be able to characterize the relative conservatism of a company’s revenue

recognition polices and also determine how the differences in policies might impact financial
ratios.
LO.c: Calculate revenue given information that might influence the choice of revenue
recognition method.
Firms can use any revenue recognition technique provided there is a rationale behind their
choice. Firms using an aggressive revenue recognition method will most likely inflate the
earnings of the current period and later periods. For example, between the percentage
completion method and the completed contract method, the percentage completion method
is more aggressive. An analyst should consider the effects different revenue recognition
methods can have on the financial statements of a company.
LO.d: Describe key aspects of the converged accounting standards issued by the
International Accounting Standards Board and Financial Accounting Standards Board
in May 2014.
The converged standards have a five-step process to recognize revenue.
1. Identify the contract with a customer.
2. Identify the performance obligation in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligation in the contract.
5. Recognize revenue when the entity satisfies a performance obligation.
LO.e: Describe general principles of expense recognition, specific expense recognition
applications, and implications of expense recognition choices for financial analysis.
The most important principle of expense recognition is the matching principle, under which
the expenses incurred to generate revenue are recognized in the same period as revenue.
Expenses that cannot be tied directly to generation of revenues are called periodic costs.
They are expensed in the period incurred.
Inventory methods: Accounting standards permit the use of the following methods to assign
inventory expenses:
 FIFO
 LIFO
 Weighted average cost
 Specific identification
Some issues in expense recognition are:
 Doubtful accounts: Record an estimate of credit losses (using historical data) at the
time of revenue recognition.
 Warranties: Expense an estimated amount at the time of revenue recognition.
 Depreciation: It is the process of systematically allocating costs of long-lived assets

over the period during which the assets are expected to provide economic benefits.
Depreciation methods include:
o Straight line method.
o Declining balance method.
Using the above mentioned accounts and information contained in the footnotes or
disclosures, an analyst can recognize whether a company’s expense recognition policy is
conservative or not.
LO.f: Describe the financial reporting treatment and analysis of non‐recurring items
(including discontinued operations, unusual, or infrequent items) and changes in
accounting standards.
Net income from discontinued operations is shown net of tax after net income from
continuing operations.
An extraordinary item is an item that is unusual and infrequent and is shown separately as a
non-operating item. It is only allowed under U.S. GAAP.
Both IFRS and U.S. GAAP allow recognition of unusual or infrequent (but not both) items.
Changes in accounting policies can be adopted retrospectively (the financial statements for
all fiscal years are presented as if the newly adopted accounting principle had been used
throughout the period) or prospectively (only the financial statements for the period of
change and for future periods are changed).
LO.g: Distinguish between the operating and non‐operating components of the income
statement.
Non-operating items are typically reported separately from operating income because they
are material and/or relevant to the understanding of the company’s financial performance.
Under IFRS, there is no definition of operating activities so judgment is required to
distinguish between operating and non-operating income. Under U.S. GAAP, operating
activities generally involve producing and delivering goods and providing services. All other
activities are non-operating.
LO.h: Describe how earnings per share is calculated, and calculate and interpret a
company’s earnings per share (both basic and diluted earnings per share) for both
simple and complex capital structures.
When a company has simple capital structure, basic EPS is calculated using the formula:
Net Income Preferred dividends
Basic EPS
Weighted Average Number of Shares Outstanding
When a company has complex capital structure, diluted EPS is calculated using the formula:
Net Income After tax interest Preferred dividend convertible preferred dividends
Diluted EPS
Weighted Average Shares New shares if convertible debt is converted

LO.i: Distinguish between dilutive and antidilutive securities, and describe the
implications of each for the earnings per share calculation.
Dilutive securities are stock options, convertible debt, warrants, and convertible preferred
stock that decrease EPS when converted to common stock.
Antidilutive securities are stock options, convertible debt, warrants, and convertible
preferred stock that increase EPS when converted to common stock.
LO.j: Convert income statements to common‐size income statements.
Common-size analysis of the income statement can be performed by stating each line item
on the income statement as a percentage of revenue. Common-size statements facilitate
comparison across time periods as well as across companies because the standardization of
each line item removes the effect of size.
LO.k: Evaluate a company’s financial performance using common‐size income
statements and financial ratios based on the income statement.
Net profit margin is calculated as: Net Income / Sales. This indicates how much income a
company was able to generate for each dollar of revenue.
Gross profit margin is calculated as: Gross Profit / Sales. Where gross profit is calculated as
revenue minus cost of goods sold.
Operating profit margin is calculated as: Operating Profit/ Sales.
Analysts can use these profit margins to compare over time and with industry peers.
LO.l: Describe, calculate, and interpret comprehensive income.
Comprehensive income = Net income + other comprehensive income (OCI)
It measures all changes in equity except for owner contributions and distributions.
LO.m: Describe other comprehensive income, and identify major types of items
included in it.
Other comprehensive income includes transactions that are not included in net income. Four
types of items treated as other comprehensive income under both IFRS and U.S. GAAP are:
 Unrealized gain/losses from available-for-sale securities.
 Foreign currency translation adjustments.
 Unrealized gains/losses on derivative contracts used for hedging.
 Certain costs of a company’s defined benefit post-retirement plans.

Practice Questions
1. For a nonfinancial firm, which of the following would most likely be included in operating
expenses in the income statement?
A. Interest expense.
B. Depreciation expense.
C. Both interest expense and depreciation expense.
2. Which of the following is an example of expense classification by function?

A. Interest expense.
B. Tax expense.
C. Cost of goods sold.
3. At the beginning of 2015, Company ABC entered into a contract to build a building for the
government. The construction of the building will take four years. The following
information as of 31st December 2015 is available for the contract:
Total revenue according to the contract $90,000
Total expected costs $75,000
Cost incurred during 2015 $25,000
How much profit should ABC report for 2015 under the completed contract method and
the percentage-of-completion method?
Completed‐contract Percentage‐of‐completion
A. $0 $5,000
B. $30,000 $5,000
C. $0 $30,000
4. During 2015, Company XYZ sold a plot of land to a real-estate developer for $ 1,000,000.
The developer gave XYZ a down payment of $200,000 and will pay the remaining
$800,000 in 2016. XYZ had purchased the plot five years back for $400,000. How much
profit will XYZ report for 2015, under the cost recovery method and the installment sales
method?
Cost recovery method Installment sales method
A. $0 $120,000
B. $120,000 $200,000
C. $200,000 $600,000
5. According to the converged accounting standards issued by IASB and FASB, which of the
following is the first step in the revenue recognition process?
A. Determine the transaction price.
B. Identify the performance obligation.
C. Identify the contract.

6. Which inventory method is least likely permitted under IFRS?

A. First in, first out (FIFO).
B. Last in, first out (LIFO).
C. Weighted average.
7. A company performed the following inventory transactions in chronological order during

a year.
Purchase Sales
5 units at $3. 1 unit at $4.
3 units at $4. 4 units at $5.
10 units at $5. 7 units at 6.
If the inventory at the beginning of the year was 0. The company’s year-end inventory
according to FIFO and LIFO is:
FIFO LIFO
A. $30 $19
B. $19 $30
C. $30 $18
8. Which combination of depreciation methods and useful lives is most aggressive in the
year a depreciable asset is acquired?
A. Straight-line depreciation with a short useful life.
B. Straight-line depreciation with a long useful life.
C. Double declining balance depreciation with a short useful life.
9. At the beginning of the year, Company A purchased a new machine for its factory at a cost
of $60,000. The machine has an estimated useful life of 10 years and estimated residual
value of $5,000. How much depreciation will the company report for the first year using
the straight-line and double declining balance methods?
Straight‐line Double‐declining
A. $5,500 $11,000
B. $5,500 $12,000
C. $6,000 $6,500
10. A company following IFRS would most likely classify a loss from the destruction of
property in a fire as:
A. an extraordinary item.
B. continuing operations.
C. discontinued operations.
11. Retrospective restatement of all prior period financial statements is least likely required

for a change from:

A. FIFO to LIFO inventory valuation.
B. zero salvage value to positive salvage value.
C. Installment sales method to cost recovery method.
12. An analyst has gathered the following information about a company:

 Net income: $250,000.
 Average number of shares outstanding: 100,000.
 2,000, 8%, $1,000 face value bonds convertible into 15 shares each, outstanding at
the beginning of the year.
 The tax rate is 40%.
The company’s diluted EPS is closest to:
A. $2.2
B. $2.5
C. $2.8.

 100,000 average shares outstanding during the year.
 1,000 warrants outstanding with exercise price of $10
 The stock is selling at year end at $8.
 The average stock price during the year was $15.
How many shares should be used in calculating the company’s diluted EPS?
A. 100,000.
B. 100,333.
C. 101,000.
14. In a vertical common-size income statement, each category of the income statement is
expressed as a percentage of:
A. gross profit.
B. assets.
C. revenue.
15. Which of the following would be least likely included in comprehensive income?
A. Dividends paid to common shareholders.
B. Gains and loss from foreign currency translation.
C. Unrealized gains and losses from cash flow hedging derivatives.

Solutions

1. B is correct. Depreciation expense is included in operating expenses. Interest expense is
excluded from operating expenses because it is a financing cost.
2. C is correct. Cost of goods sold is a classification by function because it includes a number

of expenses related to the same function – the production of inventory. Interest expense
and tax expense represent classifications by nature.
3. A is correct. No profit would be reported in the first year under the completed-contract
method. Under the percentage-of-completion method, percentage of project completed =
$25,000/$75,000 = 33.33%. 33.33% of $90,000 = $30,000. $30,000 revenue - $25,000
cost = $5,000 profit.
4. A is correct. Under cash recovery method, the company will not recognize any profits
until the cash amount paid by the buyer exceeds its cost of $400,000. Under the
installment method reported profit = Cash received x profit percentage = $200,000 x
($1,000,000 – 400,000) / $1,000,000 = $120,000.
5. C is correct. Under the converged standards, the five steps in the revenue recognition
process are:
1. Identify the contract(s) with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognize revenue when (or as) the entity satisfies a performance obligation
6. B is correct. The last in, first out (LIFO) method is not permitted under IFRS. The other
two methods are permitted.
7. A is correct.
Total units sold = 1 + 4 + 7 = 12
Total units available for sale = 5 + 3 + 10 = 18
Units in ending inventory = 18 – 12 = 6
Under FIFO, the last six units would remain in the inventory. Therefore ending inventory
= 6 x $5 = $30.
Under LIFO, the first six units would remain in the inventory. Therefore ending inventory
= 5 x $3 + 1 x $4 = $19.
8. B is correct. This would result in the lowest amount of depreciation in the first year and
hence the highest amount of net income as compared to the other choices.

9. B is correct.
Cost residual value
Straight line depreciation expense
Useful life
= ($60,000 - $5,000)/10 = $5,500.
2
DDB depreciation cost accumulated depreciation
useful life
Double-declining balance depreciation would be $12,000 i.e. $60,000 × 20 percent (twice
the straight-line rate). The residual value is not subtracted from the initial book value to
calculate depreciation. However, the book value (carrying amount) of the asset will not
be reduced below the estimated residual value.
10. B is correct. A fire may be infrequent, but it would still be part of continuing operations.
IFRS do not permit classification of an item as extraordinary. Discontinued operations
relate to a decision to dispose of an operating division.
11. B is correct. Changes in accounting principle require retrospective restatement of all

prior-period financial statements. A change in the salvage value of an asset is a change in
accounting estimate, which does not apply retrospectively.
12. B is correct.
Net Income Preferred dividends
Basic EPS
weighted average number of common shares outstanding
Basic EPS = $250,000/100,000 = $2.5
Check if the convertible bonds are dilutive
NI Preferred dividends converible debt interest 1 t
Diluted EPS
wt avg common shares shares from conversion of conv. debt
convertible debt interest 1 t
convertible debt shares
Numerator impact = (2,000 x 1,000 x 0.08) x (1 – 0.4) = 96,000
Denominator impact = 2,000 x 15 = 30,000
Per share impact = 96,000 / 30,000 = $3.2
Since $3.2 is greater than the basic EPS of $2.5, the bonds are antidilutive. Thus diluted
EPS = Basic EPS = $2.5.

13. B is correct. Since the exercise price of the warrants is less than the average stock price,
the warrants are dilutive. The year-end stock price is not relevant. With warrants, the
treasury stock method is used. Under this method the company would receive 1,000 x
$10 = $10,000 and would repurchase $10,000/15 = 667 shares. Therefore, the number of
shares used in calculating the company’s EPS would be
Shares outstanding 100,000

Warrants exercised 1,000

Treasury shares purchased -667
Total 100,333
14. C is correct. In a vertical common-size income statement, each category of the income
statement is expressed as a percentage of revenue.
15. A is correct. Comprehensive income includes all changes to equity except transactions
with shareholders. Therefore, dividends paid to common shareholders are not included
in it.

R24 Understanding Balance Sheets 2019 Level I Notes
R24 Understanding Balance Sheets

1. Introduction
The balance sheet (also called the statement of financial position) provides information on a
company’s resources (assets) and its sources of capital (liabilities and equity). The basic
equation underlying the balance sheet is Assets = Liabilities + Equity. In this reading, we look
at the different components and presentation formats of the balance sheet, assets, and
liabilities in detail, and how to analyze a balance sheet.
2. Components and Format of the Balance Sheet
The balance sheet presents the financial position of a company on a particular date, in terms
of three elements: assets, liabilities, and equity.
 Assets (A) are what the company owns. They are the resources controlled by the
company as a result of past events and they are expected to provide future economic
benefits.
 Liabilities (L) are what the company owes. They represent the obligations of a
company arising from past events, the settlement of which is expected to result in an
outflow of economic benefits from the entity.
 Equity (E) represents the owners’ residual interest in the company’s assets after
deducting its liabilities. It is also known as shareholders’ equity. The accounting
equation for determining equity is: E = A – L
Limitations of the balance sheet in financial analysis
 Some assets and liabilities are measured based on historical cost while some are
measured based on current value. These differences can have significant impact on
reported figure.
 The value of an item reported on the balance sheet is the value at the end of the
reporting period. If we are analyzing the company at a later date, these values may
have changed.
 Some assets and liabilities are difficult to quantify and are not reported on the
balance sheet. For example, brand, customer loyalty, human capital, etc.
Presentation formats
A balance sheet may be presented as either a classified or a liquidity-based balance sheet.
Classified balance sheet
In this format, assets are separated into current assets and non-current assets. Similarly,
liabilities are separated into current liabilities and non-current liabilities. Both IFRS and U.S.
GAAP require this format.

Example:
Liquidity-based format
In this format, the assets and liabilities are presented in a decreasing order of liquidity. This
method is often used in the banking industry. Only IFRS permits this method.
Example:

3. Current Assets and Current Liabilities

3.1. Current Assets
Current assets are those assets that are expected to be used up or converted to cash within
one year or in one operating business cycle, whichever is greater.
A few examples of current assets are:
 Cash and Cash Equivalents – Highly liquid, low-risk securities with maturity less
than 90 days. They are reported at either fair value or amortized cost.
 Accounts receivable – Amount owed to a company for goods and services sold. They
are reported at net realizable value.
 Inventories – Items held for sale or to be used for manufacturing. Inventories are
measured at the lower of cost or net realizable value under IFRS, and at the lower of
cost or market under U.S. GAAP.
 Marketable securities – Liquid securities which are publically traded in market. For
example, bonds and stocks.
3.2. Current Liabilities
Current liabilities are those liabilities which are expected to be settled within one year or in
one operating business cycle, whichever is greater.
A few examples of current liabilities are:
 Accounts payable ‐ Amount that a company owes to its vendors for goods/services
purchased on credit.
 Notes payable - Amount to be paid by company for short-term borrowings like
commercial papers.
 Income taxes payable - Taxes recognized in the income statement but have not yet
been paid.
 Accrued expenses ‐ Expenses that have been recognized on a company’s income
statement but which have not yet been paid as of the balance sheet date.
 Unearned revenue ‐ Revenue for which cash has been collected but goods or
services are yet to be provided. For example, receipt of advance rent payments, will
fall under this category.
4. Non‐Current Assets
Instructor’s Note
This material will be covered in detail in the reading on Long-Lived Assets.
Non-current assets include all assets that cannot be classified as current assets. Some
common examples of non-current assets are discussed below:
4.1. Property, Plant, and Equipment
Property, plant, and equipment (PPE) are tangible assets that are used in the company’s

operations. They are expected to be used over more than one fiscal period. Examples of PPE
include land, machinery, equipment, etc. PPE is measured differently under IFRS and US
GAAP:
 IFRS permits companies to report PPE using either a cost model or a revaluation
model.
 US GAAP permits only the cost model for reporting PPE.
4.2. Investment Property
IFRS defines investment property as property that is not used in the regular operations of a
company. Instead, it is used to earn rental income or capital appreciation. US GAAP has no
separate definition for investment property. Similar to PPE, investment property is valued
using either the cost model or the fair value model.
4.3. Intangible Assets
These are long-term assets that lack physical substance. Examples include patents, licenses,
and trademarks. IFRS allows companies to report intangible assets using either a cost model
or a revaluation model. US GAAP allows only the cost model.
4.4. Goodwill
Goodwill is an unidentifiable intangible asset. It is created when one company is purchased
by another company. If the purchase price is greater than fair value at acquisition, then
goodwill is created in the acquirer’s balance sheet.
Let us consider a simple example. Company A buys Company T for $100 million. The book
value of Company T’s assets and liabilities are $125 million and $75 million respectively.
The fair value of Company T’s assets and liabilities are $160 million and $75 million
respectively. What is the goodwill? In this case, the purchase price is $100 million and the
net fair value is $160 - $75 million = $85 million. Hence, goodwill is ($100 million - $85
million) $15 million. Note that the book values of assets and liabilities are not used in the
goodwill calculation.
Under both IFRS and US GAAP, goodwill is capitalized (i.e., shown as an asset on the balance
sheet). Goodwill is not amortized but is tested for impairment annually. If goodwill is
impaired, it is written down and the impairment loss is shown on the income statement.
4.5. Financial Assets
IFRS defines a financial instrument as a contract that gives rise to a financial asset of one
company and a financial liability or equity instrument of another entity. Financial assets
include stocks and bonds, derivatives, loans and receivables.
Financial assets can be measured either at fair value or amortized cost. The measurement
basis depends on how financial asset is categorized. The major categories for financial assets
are:

 Held-to-Maturity: These are debt securities acquired with the intent to hold them till
maturity.
 Held-for-Trading: This category of asset is acquired primarily for the purpose of
selling in the near term and is likely to be held for only a short period of time.
 Available-for-sale: This category of asset is expected neither to be held till maturity
nor traded in the near term.
Note: The ‘available-for-sale’ classification no longer applies with the release of IFRS
9.
The table below shows which category of asset is measured at fair value or amortized cost.
In addition, it also summarizes where gains and losses associated with the financial asset are
recognized in the financial statements of the company.
Asset Category Treatment
Held-for-trading (HFT)  Measured at fair value.
 Unrealized gains shown on Income Statement.
Available-for-sale (AFS)  Measured at fair value.
 Unrealized gains/losses shown in other comprehensive
income (OCI).
Held-to-maturity  Measured at cost or amortized cost.
(HTM)  Unrealized gains not recorded anywhere.
Note: Under IFRS 9, the ‘available-for-sale’ classification no longer applies and the
unrealized gain is recognized in the income statement.
Realized gains for all categories are shown on the income statement of the company. An
important concept related to these assets is mark‐to‐market. It is the process whereby the
value of a financial instrument is adjusted to reflect current value based on market prices.
Let us illustrate the different accounting treatments for each of these categories through a
simple example.
Example
Company owners contribute $100,000, which is invested in a 20-year bond with a 5%
coupon paid semi-annually. After six months, the company receives the first coupon
payment of $2,500. At this stage, the market price has increased to $102,000. Show the
balance sheet and income statement treatment under each of the following categorizations:
HFT, AFS and HTM.
Solution:
The accounting treatment under the three categories is summarized below:
HFT AFS HTM
Balance Sheet
Cash $2,500 $2,500 $2,500

Cost of securities $100,000 $100,000 $100,000

Unrealized $2,000 $2,000
gains/losses
PIC $100,000 $100,000 $100,000
RE Up by $4,500 Up by $2,500 Up by $2,500
OCI Up by $2,000
Income Statement
Interest income $2,500 $2,500 $2,500
Unrealized gain $2,000
For HFT, unrealized gains and cash from coupon payments are shown on the asset side of
the balance sheet. On the equity side, paid-in capital remains the same at $100,000. Retained
earnings increase by $4,500 (sum of coupon payment of $2,500 and unrealized gain of
2,000). On the income statement unrealized gain of $2,000 and interest income of $2,500 is
recognized.
For AFS, the accounting treatment is the same as HFT except for unrealized gains. For AFS,
the unrealized gain is shown as part of other comprehensive income (OCI). It is not shown
on the income statement.
For HTM, the asset is valued at amortized cost. Therefore, the unrealized gain of $2,000 is
not shown on the balance sheet or income statement. Only the coupon payment of $2,500 is
shown on the balance sheet as cash and on the income statement as interest income.
5. Non‐Current Liabilities
All liabilities that are not classified as current are considered to be non-current or long-term
liabilities.
Long‐term financial liabilities - Include loans, notes and bonds payable. These are usually
reported at amortized cost on the balance sheet.
Deferred tax liabilities - Result from temporary timing difference between a company’s
taxable income and reported income. They are defined as the amounts of income taxes
payable in future periods in respect of taxable temporary differences.
6. Equity
Equity is the owners’ residual claim on a company’s assets after subtracting its liabilities.
6.1. Components of Equity
The six components of equity are:
 Contributed capital: Total amount paid in by common and preferred shareholders.
 Treasury shares: These are shares that have been repurchased by the company, but
not yet retired.

 Retained earnings: Cumulative income of firm since inception that has not been
distributed as dividends.
 Accumulated other comprehensive income: These include items which lead to
changes in equity but are not part of the income statement or from issuing stock,
reacquiring stock, and paying dividends.
 Non‐controlling interest (minority interest): It is the portion of a subsidiary not
owned by the parent company. For example, if a firm owns 80% of a subsidiary, then
it will report 20% of net assets of the subsidiary as minority interest.
6.2. Statement of Changes in Equity
The statement of changes in equity presents information about the increases or decreases in
a company’s equity over a period of time. IFRS requires the following information in the
statement of changes in equity:
 total comprehensive income for the period;
 the effects of any accounting changes that have been retrospectively applied to
previous periods;
 capital transactions with owners and distributions to owners; and
 reconciliation of the carrying amounts of each component of equity at the beginning
and end of the year.
U.S. GAAP requirement is for companies to provide an analysis of changes in each
component of equity as shown in the balance sheet.
Sample Statement of Changes in Stockholders’ Equity

7. Analysis of the Balance Sheet

Balance sheet analysis can help us evaluate a company’s liquidity and solvency. A balance
sheet can be used to analyze a company’s capital structure and ability to pay liabilities.
7.1. Common‐Size Analysis of the Balance Sheet
In a vertical common-size balance sheet, all balance sheet items are expressed as a
percentage of total assets. Common-size statements are useful in comparing a company’s
balance sheet composition over time (time-series analysis) and across companies in the
same industry. An example of a common-size balance sheet is shown in the figure below for
Everest Inc.
ASSETS 2015 2014
Cash and cash equivalents 10.81% 13.12%
Short-term marketable securities 1.24% 0.62%
Other financial assets 1.24% 1.21%
Accounts receivable 7.50% 4.80%
Inventory 25.32% 25.97%
Other current assets 3.37% 2.14%
Property, plant and equipment 38.76% 40.06%
Investment property 6.18% 6.22%
Intangible assets 0.22% 0.35%
Deferred tax assets 0.11% 0.08%
Goodwill 0.91% 1.09%
Long-term loans 4.32% 4.32%
Other non- current assets 0.03% 0.02%
Total 100.00% 100.00%
EQUITY and LIABILITIES
Short-term borrowing 0.46% 0%
Accounts payable 6.49% 6.22%
Accrued expenses 4.22% 3.38%
Deferred revenue 1.30% 1.21%
Other current liabilities 24.29% 24.42%
Long-term borrowings 0.23% 0.31%
Deferred tax liabilities 4.01% 4.20%
Other long-term liabilities 0.12% 0.13%
Stockholder's equity 58.88% 60.13%
Equity and Liabilities 100.00% 100.00%
7.2. Balance Sheet Ratios
Balance sheet ratios are those involving balance sheet items only. Liquidity ratios tell us
about a company’s ability to meet current liabilities, while solvency ratios tell us about a

company’s ability to meet long-term and other obligations. They also help us evaluate a
company’s financial risk and leverage. The following table summarizes some liquidity ratios.
The last column shows the relevant ratios for Everest Inc. for 2015.
Ratios for
Liquidity
Calculation Everest Inc. for
Ratios
2015
Current Current assets ÷ Current liabilities 1.35
Quick (acid (Cash + Marketable securities + Receivables) ÷ Current 0.53
test) liabilities
Cash (Cash + Marketable securities) ÷ Current liabilities 0.33
Solvency ratios help to evaluate:

 a company’s ability to meet long-term and other liabilities.
 a company’s financial risk and leverage. The following table summarizes some
solvency ratios:
Ratios for
Solvency Ratios Calculation Everest Inc. for
2015
Long-term debt- 0.004
Total long-term debt ÷ Total equity
to-equity
Debt-to-equity Total debt ÷ Total equity 0.012
Total debt-to- 0.007
Total debt ÷ Total assets
assets
Financial 1.69
Total assets ÷ Total equity
leverage
It is important for analysts to remember that ratio analysis requires judgment. For example,
current ratio is only a rough measure of liquidity. In addition, ratios are sensitive to end of
period financing and operating decisions that can potentially impact current asset and
current liability amounts. Analysts should also evaluate ratios in the context of a company’s
industry. This requires an examination of the entire operations of a company, its
competitors, and the external economic and industry setting.

Summary
LO.a: Describe the elements of the balance sheet: assets, liabilities, and equity.
 Assets are the resources controlled by the company as a result of past events and
from which future economic benefits are expected to flow to the entity.
 Liabilities are the obligations of a company arising from past events, the settlement of
which is expected to result in an outflow of economic benefits from the entity.
 Equity represents the owner’s residual interest in the company’s assets after
deducting its liabilities. E = A – L.
LO.b: Describe the uses and limitations of the balance sheet in financial analysis.
An understanding of the balance sheet enables an analyst to evaluate the liquidity, solvency,
and overall financial position of a company. However, the elements of a balance sheet cannot
be viewed as a measure of either the market or the intrinsic value of a company’s equity for
the following reasons:
 Some assets and liabilities are measured based on historical cost while some are
measured based on current value. These differences can have significant impact on
reported figure.
 The value of an item reported on the balance sheet is the value at the end of the
reporting period. If we are analyzing the company at a later date, these values may
have changed.
 Some assets and liabilities are difficult to quantify and are not reported on the
balance sheet. For example, brand, customer loyalty, human capital, etc.
LO.c: Describe alternative formats of balance sheet presentation.
There are two ways of presenting balance sheet:
Classified balance sheet: Firms report their current and non-current assets, and current and
non-current liabilities, separately. Both IFRS and U.S. GAAP require this format.
Liquidity-based format: The assets and liabilities are presented in the order of liquidity.
Under IFRS, firms can choose this method. This method is usually used by the banking
industry.
LO.d: Distinguish between current and non‐current assets, and current and non‐
current liabilities.
Current assets are assets held primarily for trading or expected to be sold, used up, or
otherwise realized in cash within one year or in one operating business cycle. Examples:
Cash and cash equivalents, marketable securities, trade receivables, inventories.
Non-current assets include all assets other than those classified as current assets. Examples:
Property, plant and equipment, investment property, intangible asset, goodwill, financial
assets.

Current liabilities are liabilities that are expected to be settled within one year or in one
operating business cycle. Examples: Accounts payable, notes payable, income tax payable,
accrued expense, deferred income.
Non-current liabilities include all liabilities that are not classified as current liabilities.
Examples: long-term financial liabilities, deferred tax liabilities.
LO.e: Describe different types of assets and liabilities and the measurement bases of
each.
Current assets:
 Cash equivalents are highly liquid, short-term investments that are very close to
maturity. They are reported at either fair value or amortized cost.
 Marketable securities are also financial assets and include publically traded debt and
equity instruments. Examples include treasury bills, notes, and bonds.
 Trade receivables are amounts owed to a company by its customers for products and
services already delivered. These are typically reported at net realizable value.
 Inventories are physical products that include raw materials, finished goods, and
work in process. Inventories are measured at the lower of cost or net realizable value
under IFRS, and at the lower of cost or market under U.S. GAAP.
Non-current assets:
 Property, plant, and equipment are tangible assets that are used in a company’s
operations and expected to be used over more than one fiscal period. IFRS permits
companies to report PPE using either a cost model or a revaluation model. U.S. GAAP
permits only the cost model.
 Investment property refers to property not used in the regular operations of a
company. This concept only exists under IFRS and it is valued using either the cost
model or the fair value model.
 Intangible assets are identifiable non-monetary assets without physical substance.
Under IFRS, the cost model or revaluation model can be used. U.S. GAAP permits only
the cost model. Internally created identifiable intangibles are expensed rather than
reported on the balance sheet under IFRS and U.S. GAAP.
 Goodwill arises when one company is purchased by another company. If the purchase
price is greater than fair value at acquisition, then goodwill is created in the
acquirer’s balance sheet. Under both IFRS and U.S. GAAP, accounting goodwill is
capitalized.
 Financial assets include investment securities, derivatives, loans, and receivables. The
following table summarizes measurement of different categories of financial assets:

Asset Category Treatment

Held-for-trading (HFT)  Measured at fair value.
 Unrealized gains shown on Income Statement.
Available-for-sale (AFS)  Measured at fair value.
 Unrealized gains/losses shown in other comprehensive
income (OCI).
Held-to-maturity (HTM)  Measured at cost or amortized cost.
 Unrealized gains not recorded anywhere.
Current Liabilities:
 Accounts payable is the amount that a company owes to its vendors.
 Notes payable include financial liabilities owed by a company to its creditors.
 Income taxes payable reflect taxes that have not yet been paid.
 Accrued expenses are expenses that have been recognized on a company’s income
statement but which have not yet been paid as of the balance sheet date.
 Deferred income arises when a company receives payment in advance of delivery of
the goods and services associated with the payment.
Non-Current Liabilities:
 Long-term financial liabilities include loans, notes, and bonds payable. These are
usually reported at amortized cost on the balance sheet.
 Deferred tax liabilities result from temporary timing difference between a company’s
taxable income and reported income. They are defined as the amounts of income
taxes payable in future periods in respect of taxable temporary differences.
LO.f: Describe the components of shareholders’ equity.
The six components of equity are:
 Contributed capital: The amount paid in by common shareholders.
 Preferred shares: These are classified as equity or financial liabilities depending on
their characteristics.
 Treasury shares: These are shares in the company that have been repurchased by the
company.
 Retained earnings: This is the cumulative amount of earnings recognized in the
company’s income statements which have not been paid to the owners of the
company as dividends.
 Accumulated other comprehensive income: This includes net income and other
comprehensive income which is not recognized as part of net income.
 Non-controlling interest (minority interest): It is the portion of a subsidiary not
owned by parent company.

LO.g: Analyze balance sheets and statements of changes in equity.

Balance sheet analysis can help us evaluate a company’s liquidity and solvency. The
statement of changes in equity presents information about the increases or decreases in a
company’s equity over a period. The balance sheet can be used to analyze a company’s
capital structure and ability to pay liabilities.
LO.h: Convert balance sheets to common‐size balance sheets and interpret common‐
size balance sheets.
In a common-size balance sheet, all balance sheet items are expressed as a percentage of
total assets. Common-size statements are useful in comparing a company’s balance sheet
composition over time and across companies in the same industry.
LO.i: Calculate and interpret liquidity and solvency ratios.
Balance sheet ratios are those involving balance sheet items only. Liquidity ratios tell us
about a company’s ability to meet current liabilities while solvency ratios tell us about a
company’s ability to meet long-term and other obligations. The following table summarizes
these ratios:
Liquidity Ratios Calculation

Current Current assets ÷ Current liabilities
(Cash + Marketable securities + Receivables) ÷ Current
Quick (acid test)
liabilities
Cash (Cash + Marketable securities) ÷ Current liabilities
Solvency Ratios Calculation
Long-term debt-to-equity Total long-term debt ÷ Total equity
Debt-to-equity Total debt ÷ Total equity
Total debt-to-assets Total debt ÷ Total assets
Financial leverage Total assets ÷ Total equity

Practice Questions
1. Resources controlled by a firm as a result of past transactions are:
A. assets.
B. liabilities.
C. equity.
2. Company A’s balance sheet distinguishes between current and non-current items and
presents a subtotal for current assets and liabilities. It is most likely a(n):
A. classified balance sheet.
B. unclassified balance sheet.
C. liquidity based balance sheet.

3. Which of the following is least likely a current asset?
A. Cash.
B. Inventories.
C. Good will.

4. Company B received money from customers for products to be delivered in the future. It
will record this transaction as:
A. revenue and asset.
B. revenue and liability.
C. an asset and a liability.

5. The carrying value of inventories reflects:
A. their current value.
B. their historical cost.
C. the lower of historical cost or net realizable value.

6. Company ABC has created goodwill in the market by an advertising campaign. The value
of this goodwill is estimated to be $1 million. Also, ABC recently purchased a patent from
a competitor for $500,000. Should ABC report the goodwill and patent on its balance
sheet?
Goodwill Patent
A. Yes Yes
B. Yes No
C. No Yes

7. Company A purchased company B for $10 million. Just before the acquisition date, B’s
balance sheet reported net assets of $8 million. Company A determined that fair value of
B’s net asset is $9 million. What amount of goodwill should A report on its balance sheet

as a result of this acquisition?

A. $0.
B. $1 million.
C. $2 million.

8. If a financial asset has been classified as ‘held-to-maturity’, how will an unrealized gain or
loss in the asset be reflected in shareholder’s equity?
A. It is not recognized.
B. It will flow through income into retained earnings.
C. It is a component of accumulated other comprehensive income.

9. A company bought back shares of its own stock to be held in treasury. This transaction
will reduce:
A. both assets and liabilities.
B. both assets and shareholders’ equity.
C. assets and increase shareholders’ equity.

10. In a vertical common-size balance sheet each category of the balance sheet is expressed
as a percentage of total:
A. assets.
B. equity.
C. revenue.

11. The most rigorous test of a company’s liquidity is its:
A. current ratio.
B. quick ratio.
C. cash ratio.

12. An investor is concerned about a company’s long-term solvency. He would most likely
examine its:
A. quick ratio.
B. return on equity.
C. debt-to-equity ratio.


Solutions

1. A is correct. Assets are resources controlled by a firm as a result of past transactions that
are expected to provide future economic benefits.
2. A is correct. A classified balance sheet is one that classifies assets and liabilities as
current or non-current and provides a subtotal for current assets and current liabilities.
A liquidity-based balance sheet broadly presents assets and liabilities in order of
liquidity.
3. C is correct. Goodwill is a long-term asset, and the others are all current assets.
4. C is correct. The cash received from customers represents an asset. The obligation to
provide a product in the future is a liability called “unearned revenue.” As the product is
delivered, revenue will be recognized and the liability will be reduced.
5. C is correct. Under IFRS, inventories are carried at historical cost unless the net realizable
value of the inventory is less. Under US GAAP, inventories are carried at the lower of cost
or market.
6. C is correct. Goodwill developed internally is not reported on the balance sheet, it is

expensed as incurred. Intangible assets that are purchased are reported on the balance
sheet.
7. B is correct. Good will = Purchase price – Fair value of net assets = $10 million - $ 9
million = $ 1 million.
8. A is correct. Financial assets classified as ‘held-to-maturity’ are measured at amortized

cost. Gains and losses are recognized only when realized.
9. B is correct. . Share repurchases reduce the company’s cash (an asset). Shareholders’
equity is reduced because there are fewer shares outstanding. Treasury stock is an offset
to owners’ equity.
10. A is correct. In a vertical common-size balance sheet each category of the balance sheet is
expressed as a percentage of assets.
11. C is correct. The cash ratio determines how much of a company’s near-term obligations
can be settled with existing amounts of cash and marketable securities. It is the most
rigorous among the three ratios.

Current assets
Current ratio
Current liabilities
Cash Marketable securities Receivables
Quick ratio
Current liabilities
Cash Marketable securities
Cash ratio
Current liabilities
12. C is correct. The debt-to-equity ratio, a solvency ratio, measures the firm’s ability to
satisfy its long-term obligations.

R25 Understanding Cash Flow Statements 2019 Level I Notes
R25 Understanding Cash Flow Statements

1. Introduction
The cash flow statement provides important information about a company’s cash receipts
and payments during an accounting period. It is a vital information source that assists users
to evaluate a company’s liquidity, solvency, and financial flexibility.
2. Components and Format of the Cash Flow Statement
2.1. Classification of Cash Flows and Non‐Cash Activities
Under both IFRS and US GAAP, cash flows are categorized as operating, investing, or
financing activities on the cash flow statement.
Operating activities: These are activities related to the normal operations of a company.
Examples include:
 Cash inflows such as cash collected from sales, commissions, royalties, etc.
 Cash outflows such as cash payments for inventory, salaries, and operating expenses.
 Cash payments and receipts related to trading securities (securities that are not
bought as investments).
Investing activities: These are activities associated with acquisition and disposal of long-
term assets. Examples include:
 Cash from sale of property, plant, and equipment.
 Cash spent to purchase property, plant, and equipment.
 Cash payments and receipts related to investment securities (not trading securities).
Financing activities: These are activities related to obtaining or repaying capital. Examples
include:
 Issuance or repurchase of a company’s own preferred or common stock.
 Issuance or repayment of debt.
 Dividend payments to shareholders.
Example
JFK Enterprises recorded the following for the year 2015:
Purchase of equipment $70,000
Gain from sale of van $8,000
Receipts from sale of van $18,000
Dividends paid on ordinary share capital $10,000
Interest and preference dividend paid $12,000
Salaries paid $40,000
What is the net cash flow from investing activities?
Solution:

We first need to identify cash flows associated with investing activities. These are the
purchase of equipment and the receipts from the sale of van. The gain from sale of van is not
a cash flow item. The remaining items pertain to either operating or financing cash flows.
Therefore, the net cash flow from investing activities is:
Net cash flow from investing activities = Purchase of equipment + Receipt from sale of van
Net cash flow from investing activities = -$70,000 + $18,000 = $52,000
Non‐cash transactions
A non-cash transaction is any transaction that does not involve an outflow or inflow of cash.
Significant non-cash transactions must be disclosed in either a footnote or a supplemental
schedule to the cash flow statement. Analysts should incorporate non-cash transactions into
the analysis of past and current performance and include their effects in estimating future
cash flows. An example of a non-cash transaction is the conversion of face value $1,000,000
convertible bonds to common stock.
2.2. A Summary of Differences between IFRS and US GAAP
The reporting of interest paid/received and dividends paid/received is different between
IFRS and US GAAP. The differences between the two standards are summarized in the table
below.
Cash flow IFRS US GAAP
Interest received Operating or investing Operating
Interest paid Operating or financing Operating
Dividends received Operating or investing Operating
Dividends paid Operating or financing Financing
In addition to the points made above, IFRS and US GAAP also have some differences with
respect to bank overdrafts, taxes paid, and the format of the cash flow statement. These are
outlined in the table below.
Cash Flow IFRS US GAAP
Bank overdrafts Considered part of cash Not considered part of cash
equivalents. equivalents and classified as
financing.
Taxes paid Generally categorized as Operating.
operating, but a portion can be
allocated to investing or
financing if it can be specifically
identified with these categories.

Format of statement Both direct and indirect formats Both direct and indirect
are allowed but the direct formats are allowed but the
format is encouraged. direct format is encouraged. A
reconciliation of net income to
cash flow from operating
activities must be provided
regardless of method used.
2.3. Direct and Indirect Methods for Reporting Cash Flow from Operating Activities
Under IFRS and US GAAP, there are two acceptable formats for reporting cash flow from
operating activities: indirect and direct.
 The indirect method shows how cash flow from operations can be obtained from
reported net income through a series of adjustments.
 The direct method shows the specific cash inflows and outflows that result in
reported cash flow from operating activities.
Indirect Format Sample
With the indirect method, we start with net income and make several adjustments for non-
cash, non-operating items to arrive at the cash flow from operations. Shown below is a
sample of the indirect format for a fictitious company called K2 Corp.
Net income 2,775
Depreciation 1,000
Gain on sale of equipment (200)
Increase in accounts receivable (150)
Increase in inventory (600)
Increase in pre-paid expenses (30)
Increase in accounts payable 300
Increase in wages payable 10
Increase in tax payable 5
Increase in other accrued liabilities 100
Decrease in interest payable (10)
Cash flow from operations 3,200
Direct Format Sample
In the direct format, we look at the specific cash inflows and outflows that resulted in cash
flow from operating activities. This method is encouraged by both IFRS and US GAAP.
Cash from customers 24,850
Cash paid to suppliers (10,300)
Cash paid to employees (7,990)

Cash paid for other operating expenses (1,930)

Cash paid for interest (510)
Cash paid for taxes (920)
Cash flow from operations 3,200
Notice that while the presentation formats are different, the cash flow from operations
number is the same under both methods.
3. The Cash Flow Statement: Linkages and Preparation
3.1. Linkages of the Cash Flow Statement with the Income Statement and Balance
Sheet
Link between the Cash Flow Statement and the Balance Sheet
Cash is an asset and is reported on the balance sheet. The cash flow statement explains the
change in cash during an accounting period. This can be illustrated through a simple
scenario. Assume that beginning cash is 1,100. This is reported on the balance sheet. The
cash flow statement will show the cash receipts and cash payments. For the scenario
presented below, the cash receipts equal 3,200 and the cash payments equal 3,300 which
means that the net change in cash is -100. This explains how the cash balance went from
1,100 at the start of the period to 1,000 at the end of the period.
Beginning Statement of Cash Flows for Year Ended Ending Balance
Balance Sheet 1 31 December 2015 Sheet at 31 Dec 2015
Jan 2015
Beginning Cash Plus: Cash Receipts Less: Cash Ending Cash
Payments
1,100 3,200 3,300 1,000
Link between Cash Flow Statement, Balance Sheet, and Income Statement
Let’s consider an example of how items on the balance sheet are related to the income
statement and the cash flow statement. Suppose the beginning accounts receivable is 200,
the revenue during the year is 5,000 and the cash collected from customers is 4,800. What is
the ending accounts receivables? The table below makes it easy to compute the missing
amount. We see that the ending accounts receivables will be 400.
Balance Sheet Income Statement of Cash Flows Balance Sheet
at 1 Jan 2015 Statement at 31 Dec 2015
Beginning A/R Plus: Less: Cash Collected from Ending A/R
Revenue Customers
200 5,000 4,800 400
This example clearly shows that receivables (balance sheet item), revenue (income

statement item) and cash collected from customers (cash flow item) are related as follows:
Ending receivables = Beginning receivables + Revenue – Cash collected from customers
3.2. Steps in Preparing the Cash Flow Statement
Only cash flow from operating activities is presented differently under the two methods.
Presentation of cash flow from investing activities and cash flow from financing activities is
the same under both methods.
Operating Cash Flow
Direct method:
In the direct method, we take each item from the income statement and convert it to its cash
equivalent by removing the impact of accrual accounting.
The rules to adjust are:
 Increase in assets is use of cash (-ve adjustment) and decrease in asset is source of
cash (+ve adjustment).
 Increase in liability is source of cash (+ve adjustment) and decrease in liability is use
of cash (-ve adjustment).
Cash collected from customers: Adjust sales for changes in accounts receivable and unearned
revenue.
Cash for inputs: Adjust COGS for changes in inventory and accounts payable.
Cash operating expenses: Adjust SG&A for changes in related accrued liabilities or prepaid
expenses.
Cash interest paid: Adjust interest expense for changes in interest payable.
Cash taxes paid: Adjust tax expense for changes in tax payable and changes in deferred tax
assets and liabilities.

Example
Consider a company that reported sales of $10 million. Accounts receivable for the year
went up from $2 million to $4 million. Unearned revenue went up from $1 million to $2
million. Calculate cash collected from customers.
Solution:
Δ Accounts receivable = $2 million. This is an asset and increase in asset is use of cash so –ve
adjustment.
Δ Unearned revenue = $1million. This is a liability and increase in liability is source of cash
so +ve adjustment.
Cash collected from customers = + $10 million - $2million + $1million = $9 million.

Example
Consider a company with COGS of $20 million for a particular period. During this period
inventory increased by $4 million and accounts payable went up by $2 million. Calculate the
cash paid for inputs.
Solution:
Δ Inventory = $4 million. This is an asset and increase in asset is use of cash so –ve
adjustment.
Δ Accounts payable = $2 million. This is a liability and increase in liability is source of cash so
+ve adjustment.
Cash paid for inputs = - $20 million - $4 million + $2 million = - $22 million
Indirect method:
Indirect method shows how cash flow from operations can be obtained from reported net
income as a result of a series of adjustments.
The steps are:
 Begin with net income.
 Add back all non-cash charges to income and subtract all non-cash components of
revenue (For example, add depreciation and amortization).
 Subtract any gains that resulted from financing or investing cash flows (For example,
gain on the sale of an equipment).
 Add or subtract changes to related balance sheet operating accounts.
 Decrease in operating assets (source of cash) should be added and increase in
operating assets (use of cash) should be subtracted.
 Similarly, increase in current liabilities (source of cash) should be added and decrease
in current liabilities (use of cash) should be subtracted.
Example
Consider a company with net income of $100 million in 2001. Depreciation expense is $10
million. Gain on sale of equipment is $4 million. Increase in A/R is $8 million. Increase in
A/P is $4 million. Increase in inventory is $10 million. Calculate CFO using the indirect
method.
Solution:
Net income +100
Add non-cash charges (depreciation) + 10
Less gain on sale of equipment -4
Less increase in A/R -8
Add increase in A/P +4
Less increase in inventory -10

Total 92
CFO = $ 92 million
Investing cash flows
CFI is calculated by examining the change in the gross asset account that results from
investing activities. Typically, this change results from purchases or sale of equipment (long-
term assets). To determine the cash inflow from the sale of equipment, we need to use the
expression shown below.
Cash from sale of equipment Historical cost of equipment sold
Accumulated depreciation on equipment sold
Gain on sale of equipment
where:
Historical cost of equipment sold beginning balance
equipment purchased
ending balance equipment
Accumulated depreciation begining balance accumulated depreciation
depreciation expense
Example
The balance sheet extract for Jackal Labs Ltd shows the machinery and accumulated
depreciation balances for the years 2011 and 2012.
2011 2012
Machinery (Gross) $80 million $91 million
Accumulated depreciation $25 million $31 million
Further information provided is as follows:
Gain on sale of machinery $1.5 million
Depreciation expense for 2012 $7 million
Capital expenditure on machinery $14 million
What is the cash received from sale of equipment?
Solution:
Cash from sale of machinery = historical cost of equipment sold – accumulated depreciation
on equipment sold + gain on sale of equipment
We know the gain is $1.5 million. Calculate the other components in the equation:
Historical cost of equipment sold = beginning balance + equipment purchased – ending
balance of equipment = 80 + 14 – 91 = $3 million
Accumulated depreciation on equipment sold = beginning value of depreciation +
depreciation expense – ending value of depreciation = 25 + 7– 31 = $1 million
Cash from sale of machinery = 3 – 1 + 1.5 = 3.5

Financing cash flows

Cash flow from financing activities refers to cash flows between the firm and the suppliers of
capital. Suppliers of capital include creditors, bondholders, and shareholders. Similar to
investing activities, the presentation of cash flows from financing activities is also identical
under both methods. The figure below summarizes the calculation of net cash flows from
creditors, bondholders, and shareholders.
It can be calculated using the following formulae:

(1) CFF = Net cash flow from creditors + Net cash flow from shareholders
(2) Net cash flow from creditors = New borrowings – Principal repaid
(3) Net cash flow from shareholders = New equity issued – Shares repurchased – Cash
dividends
Example
The following information is available about company ABC for 2001.
New borrowings $10 million
Principal repaid $5 million
New equity issued $5 million
Shares repurchased -
Dividends paid $2 million
Calculate CFF.
Solution:
Net cash flow from creditors = New borrowings – Principal repaid = 10 – 5 = $5 million
Net cash flow from shareholders = New equity issued – Shares repurchased – Cash dividends
= 5 – 0 -2 = $3 million
CFF = Net cash flow from creditors + Net cash flow from shareholders = 5 + 3 = $8 million
3.3. Conversion of Cash Flows from the Indirect Method to the Direct Method
Instructor’s note: The probability of getting tested on this topic on the exam is low.
The operating cash flow from indirect method can be converted to direct by using the three-
step process:

 Aggregate all the revenues and expenses.

 Remove all non-cash items from aggregated revenues and expenses and break up
remaining items into relevant cash flow items.
 Convert accrual amounts to cash flow amounts by adjusting for changes in
corresponding working accounts.
4. Cash Flow Statement Analysis
4.1. Evaluation of the Sources and Uses of Cash
Evaluation of the cash flow statement should involve the following:
 Evaluate where the major sources and uses of cash flow are between operating,
investing, and financing activities. Major sources of cash for a company can vary with
its stage of growth. For example, for a mature company it is expected that operating
activities are the primary source of cash flows. However, for all companies analysts
must analyze whether operating cash flows are positive and cover capital
expenditures.
 Evaluate the primary determinants of operating cash flow. Analysts should compare
operating cash flow with net income. If a company has large net income but poor
operating cash flow, it may be a sign of poor earnings quality. In addition, analysts
need to look at consistency of operating cash flows.
 Evaluate the primary determinants of investing cash flow. This is useful for letting the
analyst know how much is being invested for the future in property, plant, and
equipment and how much is put aside in liquid investments.
4.2. Common‐Size Analysis of the Statement of Cash Flows
In common-size analysis of a company’s cash flow statement, there are two alternative
approaches. In the first approach, we express each line item of cash inflow (outflow) as a
percentage of total inflows (outflows). An example of a common-size cash flow statement
using this approach is shown below for K2 Corp.
Inflows Actual % of Total Inflow
Net cash provided by operating activities 3,200 80 %
Sale of Equipment 800 20%
Total 4,000 100%
Outflows Actual % of Total Outflow

Purchase of equipment 1,500 36.58%
Retirement of long-term debt 500 12.19%
Retirement of common stock 325 7.9%
Dividend payments 1,775 43.29%
Total 4,100 100%
Net increase (decrease) in cash (100)

In the second approach, we express each line item as a percentage of revenue. An example of
such a statement is shown below for K2 Corp. In this example, we have assumed total
revenue is 10,000.
Cash flow Actual % of Total Revenue
Cash flow from operating activities
Net Income 4,000 40%
Depreciation expense 500 5%
Increase in accounts receivable (500) (5%)
Increase in inventory (1,000) (10%)
Decrease in prepaid expenses 1,000 10%
Increases in accounts payable 500 5%
Increases in accrued liabilities 500 5%
Net cash provided by operating activities 5,000 50%
Cash flow from investing activities

Cash received from sale of equipment 2,000 20%
Cash paid for purchase of equipment (5,000) (50%)
Net cash used for investing activities (3,000) (30%)

Cash flow from financing activities
Sale of bonds 1,000 10%
Cash dividends (2,000) (20%)
Net cash used for financing activities (1,000) (10%)
Net increase in cash 1,000 10%

The common-size cash flow statement makes it easier to see trends in cash flow rather than
just looking at the total amount. The second approach is useful for the analyst in forecasting
future cash flows.
4.3. Free Cash Flow to the Firm and Free Cash Flow to Equity
Free cash flow to firm (FCFF) is the cash flow available to all the suppliers of capital to a
company after all operating expenses have been paid and necessary investments in working
capital and fixed capital have been made. The suppliers of capital include both lenders (debt)
and equity shareholders (equity). This is illustrated in the figure below:

The formula for computing FCFF is:

FCFF NI NCC Int 1 Tax rate – FCInv – WCInv
where:
NI = Net Income
NCC = non-cash charges
Int = Interest expense
FCInv = Fixed capital investment/expenditures
WCInv = working capital expenditures
While FCFF indicates how much cash is available to all suppliers of capital, free cash flow to
equity (FCFE) is the cash flow available to the company’s stockholders after all operating
expenses and borrowing costs (principal and interest) have been paid and necessary
investments in working capital and fixed capital have been made. The formula for computing
FCFE is as follows:
FCFE CFO – FCInv Net borrowing
4.4. Cash Flow Ratios
There are several ratios useful for the analysis of the cash flow statement. These ratios
generally fall into cash flow performance (profitability) ratios and cash flow coverage
(solvency) ratios. The calculation and interpretation of these ratios are summarized in the
tables below.
Performance Calculation What It Measures
Ratios
Cash flow to CFO ÷ Net revenue Operating cash generated per dollar
revenue of revenue.
Cash return on CFO ÷ Average total assets Operating cash generated per dollar
assets of asset investment.
Cash return on CFO ÷ Average shareholders’ Operating cash generated per dollar
equity equity of owner investment.
Cash to income CFO ÷ Operating income Cash generating ability of
operations.
Cash flow per share (CFO – Preferred dividends) ÷ Operating cash flow on a per-share
Number of common shares basis.
outstanding
Coverage Ratios Calculation What It Measures

Debt coverage CFO ÷ Total debt Financial risk and financial
leverage.
Interest coverage (CFO + Interest paid + Taxes Ability to meet interest obligations.
paid) ÷ Interest paid

Reinvestment CFO ÷ Cash paid for long-term Ability to acquire assets with
assets operating cash flows.
Debt payment CFO ÷ Cash paid for long-term Ability to pay debts with operating
debt repayment cash flows.
Dividend payment CFO ÷ Dividends paid Ability to pay dividends with
operating cash flows.
Investing and CFO ÷ Cash outflows for Ability to acquire assets, pay debts,
financing investing and financing and make distributions to owners.
activities


Summary
LO.a: Compare cash flows from operating, investing, and financing activities and
classify cash flow items as relating to one of those three categories given a description
of the items.
Under both IFRS and U.S. GAAP, cash flows in the cash flow statement are categorized as:
 Operating activities: These are the company’s day-to-day activities that create
revenues such as selling inventory and providing services.
 Investing activities: These are activities associated with acquisition and disposal of
long-term assets.
 Financing activities: These are activities related to obtaining or repaying capital.
LO.b: Describe how non‐cash investing and financing activities are reported.
Non-cash investing and financing activities are not reported in cash flow statements. They
must be disclosed in either a footnote or a supplemental schedule to the cash flow statement.
LO.c: Contrast cash flow statements prepared under International Financial Reporting
Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Cash flow IFRS U.S. GAAP
Interest received Operating or investing Operating
Interest paid Operating or financing Operating
Dividends received Operating or investing Operating
Dividends paid Operating or financing Financing
LO.d: Distinguish between the direct and indirect methods of presenting cash from
operating activities and describe arguments in favor of each method.
In the direct method we take each item from the income statement and convert it to its cash
equivalent by removing the impact of accrual accounting. The main advantage of the direct
method is that it provides more information than the indirect method.
income through a series of adjustments. The main advantage of indirect method is that it
focuses on the differences between net income and operating cash flow.
LO.e: Describe how the cash flow statement is linked to the income statement and the
balance sheet.
Cash is an asset. The cash flow statement ultimately shows the change in cash during an
accounting period. The beginning and ending balances of cash are shown on the balance
sheet and the bottom of the cash flow statement reconciles beginning cash with ending cash.
Because a company’s operating activities are reported on an accrual basis in the income
statement, any differences between the accrual basis and cash basis for accounting result in

an increase or decrease in some asset or liability on the balance sheet.

LO.f: Describe the steps in the preparation of direct and indirect cash flow statements,
including how cash flows can be computed using income statement and balance sheet
data.
CFO can be computed using the direct method or the indirect method.
Direct method:
In the direct method, we take each item from the income statement and convert it to its cash
equivalent by removing the impact of accrual accounting.
The rules to adjust are:
 Increase in assets is use of cash (-ve adjustment) and decrease in asset is source of
cash (+ve adjustment).
 Increase in liability is source of cash (+ve adjustment) and decrease in liability is use
of cash (-ve adjustment).
Indirect method:
income as a result of a series of adjustments.
The steps are:
 Begin with net income.
 Add back all non-cash charges to income and subtract all non-cash components of
revenue (For example, add depreciation and amortization).
 Subtract any gains that resulted from financing or investing cash flows (For example,
gain on the sale of an equipment).
 Add or subtract changes to related balance sheet operating accounts.
 Decrease in operating assets (source of cash) should be added and increase in
operating assets (use of cash) should be subtracted.
 Similarly, increase in current liabilities (source of cash) should be added and decrease
in current liabilities (use of cash) should be subtracted.
CFI is calculated by determining changes in the gross asset account that result from the
purchase or sale of equipment.
CFF is the sum of net cash flows from creditors and net cash flows from shareholders.
LO.g: Convert cash flows from the indirect to direct method.
The operating cash flow from indirect method can be converted to direct by using the three-
step process:
 Aggregate all the revenues and expenses.
 Remove all non-cash items from aggregated revenues and expenses and break up
remaining items into relevant cash flow items.
 Convert accrual amounts to cash flow amounts by adjusting for working capital

changes.
LO.h: Analyze and interpret both reported and common‐size cash flow statements.
Operating cash flow
 A healthy firm should generate positive cash flows from operating activities. (This is
not applicable for startups).
 Positive operating cash flow generated by liquidating non-cash working capital items
(like liquidating inventory and receivables or increasing payables) is not sustainable.
 Earnings that are significantly greater than operating cash flows indicate that
aggressive accounting policies are being followed.
Investing cash flow
 Cash outflows can result from investments in property, plant and equipment, or other
assets.
 Increasing outflows is an indication of growth.
 Decreasing outflows may indicate a reduction of capital expenditure and reduction in
growth.
Financing cash flow
 Tells us if the company is generating cash by issuing debt or equity.
 Also tells us if the company is using cash to repay debt, reacquire stock, or pay
dividends.
Common-Size format
 There are two approaches:
o In the first approach, we express each line item of cash inflow (outflow) as a
percentage of total inflows (outflows).
o In the second approach, we express each line item as a percentage of revenue.
 Common-size cash flow statement makes it easier to identify trends in cash flows.
 It also helps us in forecasting future cash flows.
LO.i: Calculate and interpret free cash flow to the firm, free cash flow to equity, and
performance and coverage cash flow ratios.
FCFF = NI + NCC + Int (1 - Tax rate) – FCInv – WCInv
Or
FCFF = CFO + Int (1 - Tax rate) – FCInv
FCFE = CFO – FCInv + Net borrowing

Calculation What It Measures

Cash flow to revenue CFO ÷ Net revenue Operating cash generated
per dollar of revenue.
Cash return on assets CFO ÷ Average total assets Operating cash generated
per dollar of asset
Performance Ratios
investment.
Cash return on equity CFO ÷ Average Operating cash generated
shareholders’ equity per dollar of owner
investment.
Cash to income CFO ÷ Operating income Cash generating ability of
operations.
Cash flow per share (CFO – Preferred Operating cash flow on a
dividends) ÷ Number of per-share basis.
common shares
outstanding
Debt coverage CFO ÷ Total debt Financial risk and
financial leverage.
Interest coverage (CFO + Interest paid + Ability to meet interest
Taxes paid) ÷ Interest paid obligations.
Coverage Ratios
Reinvestment CFO ÷ Cash paid for long- Ability to acquire assets

term assets with operating cash flows.
Debt payment CFO ÷ Cash paid for long- Ability to pay debts with
term debt repayment operating cash flows.
Dividend payment CFO ÷ Dividends paid Ability to pay dividends
with operating cash flows.
Investing and CFO ÷ Cash outflows for Ability to acquire assets,
financing investing and financing pay debts, and make
activities distributions to owners.

Practice Questions
1. Sale of land would be classified as what type of activity on the cash flow statement?
A. Operating.
B. Investing.
C. Financing.
2. Issuing stocks would be classified as:

A. investing cash flow.
B. financing cash flow.
C. operating cash flow.
3. The conversion of face value $500,000 convertible bond for $500,000 of common stock
would most likely be reported as:
A. $500,000 investing cash inflow and outflow.
B. $500,000 financing cash outflow and inflow.
C. reported as supplementary information to cash flow statement.
4. Where is interest expense reported in the cash flow statement under U.S. GAAP and
IFRS?
U.S. GAAP IFRS
A. Operating or financing Financing
B. Operating Financing
C. Operating Operating or financing
5. Which of the following would be least likely reported under Cash flow from operations
under US GAAP?
A. Payment of interest.
B. Receipt of dividend.
C. Payment of dividend.
6. Which of the following can be presented using the indirect method under both IFRS and
US GAAP?
A. Cash flow from operations (CFO)
B. Cash flow from investing (CFI)
C. Cash flow from financing (CFF)
7. An analyst gathered the following information from a company’s 2015 financial

statements (in $ millions):
Year ended 31st Dec 2014 2015
Net Sales 24 25

Cost of goods sold 16 17

Accounts receivable 7 6
Inventory 3 4
Accounts payable 2 3
Based only on the information above, the cash received from the customers and the cash
paid to suppliers by the company in 2015 is closest to:
Cash received from customers Cash paid to suppliers
A. 26 17
B. 26 19
C. 25 17
8. Using the following information (in $ millions), calculate a firm’s cash flow from
operations (CFO).
Net income 100
Decrease in accounts receivable 21
Depreciation 30
Increase in inventory 12
Increase in accounts payable 9
Decrease in wages payable 7
Increase in deferred tax liabilities 13
Profit on sale of building 3
A. 130
B. 151
C. 178
9. An analyst gathered the following information about a company’s transactions during

2015.
 Purchased land for $60,000.
 Converted $100,000 worth of preferred shares to common shares.
 Received cash dividends of $15,000
 Paid cash dividends of $20,000.
 Paid off long-term bank borrowings of $25,000
Assuming the company follows US GAAP, its Cash flow from investing (CFI) and Cash
flow from financing (CFF) for 2015 would be:
CFI CFF
A. (60,000) (65,000)
B. (60,000) (45,000)
C. (40,000) (25,000)

10. In preparing a common-size cash flow statement, each item on the cash flow statement is
expressed as percentage of:
A. total assets.
B. total revenue.
C. total cash inflows.
11. The following selected data are available for a firm:

$ millions
Net income 40
Non-cash charges 12
Interest expense 2
Capital expenditures 15
Working capital expenditures 8
If the firm’s tax rate is 30%, the free cash flow to the firm (FCFF) is closest to:
A. $30.4 million.
B. $31.0 million.
C. $38.4 million.

Solutions
1. B is correct. The sale of land would be classified as an investing cash flow.
2. B is correct. Issuing stocks would be classified as financing cash flow.
3. C is correct. Non-cash transactions are not reported in the investing or financing sections
of the cash flow statement. If significant, they are reported as supplementary
information.
4. C is correct. Interest expense is always classified as an operating cash flow under US

GAAP but may be classified as either an operating or financing cash flow under IFRS.
5. C is correct. Payment of dividends is a financing activity under US GAAP. Payment of

interest and receipt of dividends are included in operating cash flows under US GAAP.
6. A is correct. CFO may be prepared under the indirect method. CFI and CFF are always
prepared under the direct method.
7. A is correct. Cash received from customers = Sales – Change in accounts receivable = 25 -

(6-7) = 26
Cash paid to suppliers = COGS + Change in inventory – Change in accounts payable = 17 +
(4-3) – (3-2) = 17
8. B is correct. CFO = Net income – profit from sale of building + depreciation + decrease in
accounts receivable – increase in inventory + increase in accounts payable – decrease in
wages payable + increase in deferred tax liabilities
= 100 – 3 + 30 + 21 – 12 +9 – 7 + 13 = 151
9. B is correct.
Purchased land for $60,000 – CFI Outflow
Converted $100,000 worth of preferred shares to common shares – Non-cash transaction
Received cash dividends of $15,000 – CFO inflow
Paid cash dividends of $20,000 – CFF outflow
Paid off long-term bank borrowings of $25,000 – CFF outflow
CFI = -60,000
CFF = -20,000 – 25,000 = -45,000
10. B is correct. The cash flow statement can be converted to common-size format by
showing each line item as a percentage of revenue.

11. A is correct. FCFF = Net income + Non-cash charges + interest expense * (1 – Tax rate) –
capital expenditures – working capital expenditures
FCFF = 40 + 12 + 2 *(1 – 0.3) – 15 – 8 = $30.4 million

R26 Financial Analysis Techniques 2019 Level I Notes
R26 Financial Analysis Techniques

1. Introduction
Financial analysis is a useful tool in evaluating a company’s performance and trends. The
primary source of data is the company’s annual reports, financial statements, and MD&A. An
analyst must be capable of using a company’s financial statements along with other
information such as economy/industry trends to make projections and reach valid
conclusions.
2. The Financial Analysis Process
Before beginning any financial analysis, an analyst must clarify the purpose and context of
why it is needed. Once the purpose is defined, an analyst can choose the right techniques for
the analysis. For example, the level of detail required for a substantial long-term investment
in equities will be higher than one needed for a short-term investment in fixed income.
2.1. The Objectives of the Financial Analysis Process
This reading focuses on steps 3 and 4 of the financial analysis framework in detail: how to
adjust financial statements, compute ratios, and produce graphs and forecasts. The
processed data is then analyzed to arrive at a conclusion.
Financial Analysis Framework
Phase Output of the phase
1. Define purpose and context based on Objective
the analyst’s function, client input, and Questions to be answered
organizational guidelines. Nature and content of report to be
provided
Timetable and budget
2. Collect data: financial statements, other Organized financial statements
financial data, industry/economic data, Financial tables
discussions with management, suppliers, Completed questionnaires
customers, and competitors.
3. Process data Adjusted financial statements
Common-size statements
Ratios and graphs
Forecasts
4. Analyze and interpret processed data Analytical results
5. Develop and communicate Report answering questions from phase 1
conclusions and recommendations Recommendation regarding the purpose
of the analysis
6. Follow‐up Updated recommendations


2.2. Distinguishing between Computation and Analysis

An effective analysis is not just a compilation of various pieces of information, tables, and
graphs. It includes both calculations and interpretations. For analyzing past performance, an
analyst computes several ratios, compares them against benchmarks, evaluates how the
company performed, and determines the reasons behind its good/bad performance.
Similarly, for a forward-looking analysis, an analyst must forecast and make
recommendations after analyzing trends, management quality, etc.
3. Analytical Tools and Techniques
Various tools and techniques such as ratios, common size analysis, graphs, and regression
analysis help in evaluating a company’s performance. Evaluations require comparisons, but
to make a meaningful comparison of a company’s performance, the data needs to be adjusted
first. An analyst can then compare a company’s performance to other companies at any point
in time (cross-section analysis) or its own performance over time (time-series analysis).
3.1. Ratios
A ratio is an indicator of some aspect of a company’s performance like profitability or
inventory management that tells us what happened, but not why it happened. Ratios help in
analyzing the current financial health of a company, evaluate its past performance, and
provide insights for future projections. Calculating ratios is straightforward, but interpreting
them is subjective.
Uses of ratio analysis
Ratios allow us to evaluate:
 operational efficiency.
 financial flexibility.
 changes in company/industry over time.
 company performance relative to industry.
Limitations of ratio analysis
Ratio analysis also has certain limitations. Some of the factors to consider include:
 Need to use judgment: An analyst must exercise judgment when interpreting ratios.
For example, a current ratio of 1.1 may not necessarily be good/bad unless viewed in
perspective of other companies/industry.
 Use of alternate accounting methods: Using alternate methods may require
adjustments before the ratios are comparable. For example, Company A might use the
LIFO method to measure inventory, while a comparable company might use the FIFO
method. Similarly, one company may use the straight line method of depreciation,
while another may use an accelerated method.
 Nature of a company’s business: Companies may have divisions operating in many
different industries. This can make it difficult to find comparable ratios.

 Consistency of results of ratio analysis: One set of ratios may indicate a problem,
while the other may indicate the problem is short term making the results
inconsistent.
3.2. Common‐Size Analysis
Common-size financial statements are used to compare the performance of different
companies within an industry or a company’s performance over time. Common size
statements are prepared by expressing every item in a financial statement as a percentage of
a base item.
Common‐Size Analysis of the Balance Sheet
There are two types of common-size balance sheets: vertical and horizontal.
Vertical common-size balance sheet
A vertical common-size balance sheet is prepared by dividing each item on the balance sheet
by the total assets for a period and expressed as a percentage. This highlights the
composition of the balance sheet.
Vertical common-size balance sheet account (in %) = ∗ 100
A simple common-size vertical balance sheet for Everest Inc. is shown below:
Vertical common‐size (partial) balance sheet for Everest Inc.
ASSETS 2015 2014
Cash and cash equivalents 10.81% 13.12%
Short-term marketable securities 1.24% 0.62%
Accounts receivable 7.50% 4.80%
Inventory 25.32% 25.97%
Other current assets 3.37% 2.14%
Property, plant, and equipment (PPE) 38.76% 40.06%
…………. …… …..
Other non- current assets 0.03% 0.02%
Total 100.00% 100.00%
EQUITY and LIABILITIES
Short-term borrowing 0.46% 0%
Deferred tax liabilities 4.01% 4.20%
….. … …
Stockholder's equity 58.88% 60.13%
Equity and Liabilities 100.00% 100.00%
Time‐Series Analysis
Trend analysis or time-series analysis provides information on historical performance and
growth. It indicates how a particular item is changing – whether it is improving or

deteriorating – relative to total assets over multiple periods. For the data given above, we
can observe that inventory decreased as a percentage of total assets in 2015, while accounts
receivable increased as a percentage of total assets.
Cross‐Sectional Analysis
The vertical common-size balance sheet can be used in cross-sectional analysis (also called
relative analysis) to compare a specific metric of one company with the same metric for
another company or companies for a single time period. As illustrated in the table below, this
method allows comparison across companies which might be of significantly different sizes
and/or operate in different currencies.
Everest Inc. Alps Corp.

2015 2015
Cash and cash equivalents 10.81% $3,500 9.00% €1,755.00
Short-term marketable securities 1.24% $400 4.00% €780.00
Accounts receivable 7.50% $2,430 5.20% €1,014.00
Inventory 25.32% $8,200 20.10% €3,919.50
Other non-current assets 0.03% $10 0.50% €97.50
Total Assets 100.00% $32,382 100.00% €19,500.00
This presentation makes it easy to see that Alps Corp. has lower receivables as a percentage
of total assets relative to Everest Inc. Alps Corp. also has lower inventory as a percentage of
total assets relative to Everest Inc.
Horizontal Common-Size Balance Sheet
In a horizontal common-size balance sheet, each balance sheet item is shown in relation to
the same item in a base year. Consider the following balance sheet excerpt for Everest Inc.:
2014 (base year) 2015
Cash and cash equivalents $3,800 $3,500
Short-term marketable securities $180 $400
Inventory $7,520 $8,200
The corresponding horizontal common size balance sheet will look like this:
2014 (base year) 2015
Cash and cash equivalents 1.0 0.9
Short-term marketable securities 1.0 2.2
Inventory 1.0 1.1
Notice that the base-year value for all balance sheet items is set to 1. This makes it easy to
see the percentage change in each item relative to the base year. For the data given above,
cash decreased by 10% and inventory increased by 10%. An analysis of horizontal common-
size balance sheets highlights structural changes that have occurred in a business.

Common‐size Analysis of the Income Statement

A vertical common-size income statement divides each income statement element by
revenue.
Vertical common-size income statement account (in %) = ∗ 100
Relationships among Financial Statements

Comparing the trend data of a horizontal common-size analysis across financial statements
will give some insight into a company’s financial standing. Consider the following percentage
changes for a company to identify some potential issues:
Revenue: +15%, Operating income: +15%, Operating cash flow: -10%, Inventory: +60%,
Receivables: +40%, Total assets: +30%
Some of the potential issues based on these numbers are:
 The assets are growing at a faster rate than revenue, which implies the company is
spending more than the sales it is able to generate.
 Operating cash flow is negative whereas operating income is +15%, indicating a
problem that the company is booking sales (accrual accounting) but has not realized
the cash yet.
 Similarly, when inventory and receivables grow at a much faster pace than sales, it
shows signs of poor inventory and receivables management.
3.3. The Use of Graphs as an Analytical Tool
Graphs can be considered an extension of the financial analysis. It is a pictorial
representation of the analysis done, be it ratio analysis or trend analysis. Analysts use
appropriate graphs such as line charts and bar graphs based on the type of data to be shown.
This helps in quick comparison of financial performance and structure over time.
3.4. Regression Analysis
Regression analysis, described in detail in Level II, is a statistical method of analyzing
relationships (correlations) between variables.
4. Common Ratios Used in Financial Analysis
A large number of ratios are used to measure various aspects of performance. Commonly
used financial ratios can be categorized as follows:
Category What they measure Example
Activity ratios Efficiency of a company in Revenue
performing its day-to-day Assets
operations.
Liquidity ratios A company’s ability to meet its short- Current assets
term obligations. Current liabilities

Solvency ratios A company’s ability to meet its long- Assets

term obligations. Equity
Profitability ratios A company’s ability to generate Net Income
profit from its resources. Assets
Valuation ratios Quantity of an asset or flow per Earnings
share. Number of shares
Single statement ratios: Note that for some ratios, the numerator and denominator are from
the same statement (Income statement, balance sheet, or cash flow statement). For example,
net profit margin (net income/sales) where both items are from the income statement.
Mixed ratios: For other ratios, the numerator is from one statement and the denominator is
from another statement. An example is the asset turnover ratio (sales/assets) where the
numerator is from the income statement and the denominator is from the balance sheet.
4.1. Interpretation and Context
As standalone numbers, the financial ratios of a company are not meaningful. The ratios are
usually industry specific. For instance, one cannot compare the ratios of Schlumberger with
that of Facebook. The financial ratios should be used to periodically evaluate a company’s
past performance (trend analysis) and its goals and strategy; how it fares against its peers in
the industry (cross-sectional analysis); and the effect of economic conditions on its business.
4.2. Activity Ratios
Activity ratios measure how efficiently a company manages its assets. They are also known
as asset utilization ratios or operating efficiency ratios. The activity ratios usually have an
element from the income statement in the numerator and one from the balance sheet in the
denominator. The average of the balance sheet element is generally taken because the
balance sheet only shows the value at the end of the period, whereas the income statement
measures what happened during the period.
Activity Ratios Formula Interpretation
Inventory turnover Cost of goods sold  Indicates how many times per period
Average inventory the entire inventory was sold.
 Measures the ability of a company to
sell its inventory.
 Higher number means greater
efficiency because inventory is kept
for a shorter period. It could also
mean insufficient inventory, which in
turn, might affect growth/ revenue.
Days of inventory Number of days in period  On an average, how many days of
on hand Inventory turnover inventory is kept on hand.

Receivables Revenue  Indicates how quickly a company

turnover Average receivables collects cash.
 More appropriate to use credit sales
instead of revenue but it is not readily
available.
 A higher number means greater
efficiency in credit and collection. It
could also mean stringent cash
collection policies are hurting
potential sales.
Days of sales Number of days in period  Elapsed time between credit sale and
outstanding Receivables turnover cash collection.
 Higher number means it takes a long
time to collect receivables.
Payables turnover Purchases  Indicates how quickly a company pays
Average trade payables suppliers.
 A high number means the company is
paying suppliers quickly and is
possibly not making use of credit
facilities.
 Low number may mean the company
is facing trouble making payments on
time and signal liquidity issues.
Number of days of Number of days in period  On an average, how many days it
payables Payables turnover takes to pay suppliers.
Working capital Revenue  Indicates how efficiently a company
turnover Average working capital generates revenue from working
capital.
 Working capital = current assets (CA)
– current liabilities (CL)
 Higher number means greater
efficiency. If CA = CL, then working
capital would be zero making the
ratio meaningless.

Fixed asset Revenue  Indicates how efficiently a company

turnover Average net fixed assets generates revenue from fixed assets.
 A higher number means efficient use
of fixed assets.
 A lower number may mean
inefficiency, or newer business
(higher carrying value on B/S), or a
capital-intensive business.
Total asset Revenue  Indicates how efficiently a company
turnover Average total assets generates revenue from total assets
(fixed + current assets).
 As with other turnover ratios, higher
number means efficiency.
Purchases = Cost of goods sold + Ending inventory – Beginning inventory
Instructor’s Note: How to remember the activity ratios
1. Name of the ratio indicates the balance sheet item. For example, in the receivables
turnover ratio, average receivables is the balance sheet item.
2. The income statement item is in the numerator.
3. Average value of the balance sheet item is in the denominator. An income statement
measures an item over a period but a balance sheet indicates values of items only at the end
of a period. So, analysts typically use the average value for balance sheet items.
4. Turnover ratios except inventory turnover and payables turnover use revenue in the
numerator. Inventory turnover uses cost of goods sold, while payables turnover uses
purchases.
Higher number for turnover ratios = greater efficiency
4.3. Liquidity Ratios
Liquidity ratios measure a company’s ability to meet short-term obligations. It also indicates
how quickly it turns assets into cash.
Liquidity Ratios
Current Current assets A higher number implies
ratio Current liabilities greater liquidity.
Quick ratio Cash marketable securities receivables A higher number implies
Current liabilities greater liquidity.
More conservative than
current ratio as only more
liquid current assets are
included.

Cash ratio Cash marketable securities This is the most

Current liabilities conservative liquidity ratio
and a good measure of a
company’s ability to handle
a crisis situation.
Defensive Cash marketable securities receivables Measures the number of
interval Daily cash expenditures days a company can operate
ratio before it runs out of cash.
A higher number implies
greater liquidity.
Cash Days of inventory on hand (DOH) + days of sales The time between cash paid
conversion outstanding (DSO) – number of days of payables (to suppliers) and cash
cycle (net collected (from customers).
operating A low number is better for
cycle) the company as it means
high liquidity.
A long cash conversion cycle
implies low liquidity
The example below for ABC Corp. illustrates the cash conversion cycle. The timeline for
various events is illustrated below:
4.4. Solvency Ratios

Solvency ratios measure a company’s ability to meet long-term obligations. In simple terms,
it provides information on how much debt the company has taken and if it is profitable
enough to pay the interest on debt in the long term. It has to be analyzed within an industry’s
perspective. Certain industries such as real estate use a higher level of leverage.

Solvency Ratios Formula Interpretation

Debt ratios
Debt-to-assets Total debt Measures the amount of debt
ratio Total assets in total assets.
Higher debt means low
solvency and higher risk. A
ratio of 0.5 implies 50% of
assets are financed with debt.
Debt-to-capital Total debt Measures the amount of debt
ratio Total debt Total shareholder’s equity as a percentage of capital (debt
+ shareholder’s equity).
Debt-to-equity Total debt Measures the amount of debt
ratio Total shareholder’s equity as a percentage of equity.
Financial Average total assets Measures the amount of assets
leverage ratio Average total equity per unit of equity.
A higher value means a
company is more leveraged.
Coverage ratios
Interest EBIT Measures the company’s
coverage ratio Interest payments ability to make interest
(also called payments (how many times
‘times interest the company can make
earned’ interest payments with its
EBIT).
Unlike the other solvency
ratios, a higher value for this
ratio is better as it means
stronger solvency.
Fixed charge EBIT lease payments Measures the ability of a
coverage ratio Interest payments lease payments company to pay interest on
debt.
Here, lease payments are
added to EBIT as they are an
obligation like interest
payments. Like the interest
coverage ratio, a higher value
for this ratio implies stronger
solvency.
Note that there are two categories of solvency ratios: debt (or leverage) ratios and coverage
ratios.

In general, a high debt (or leverage) ratio implies a high level of debt, high risk, and low
solvency. With coverage ratios, a high number is good because this indicates high income
relative to interest payments.
4.5. Profitability Ratios
Profitability ratio Formula Interpretation
Return on Sales
Gross profit margin Gross profit A higher value means higher
Revenue pricing and lower costs.
Operating profit Operating income Operating profit = gross
margin Revenue profit - operating costs.
A good sign if operating
profit margin grows at a
faster rate than gross profit
margin.
Pretax margin EBT EBT = operating profit -
Revenue interest related expenses.
Needs further analysis if
pretax income increases
only because of non-
operating income.
Net profit margin Net profit Net profit = revenue – all
Revenue expenses.
Return on Investment
Operating ROA Operating income For return, either net
Average total assets income or operating income
(EBIT) can be used.
Return on assets Net income For return, either net
(ROA) Average total assets income or operating income
(EBIT) can be used.
Return on total capital EBIT Like operating ROA, EBIT is
Debt equity used. Measures return on
capital before deducting
interest.
Return on equity Net income A very important measure
(ROE) Average total equity of return earned on equity
capital. Unlike return on
common equity, it includes
minority and preferred
equity.

Return on common Net income – preferred dividend Money available to common

equity Average common equity shareholders.
4.6. Integrated Financial Ratio Analysis
DuPont Analysis: The Decomposition of ROE
DuPont analysis decomposes a firm’s ROE to better analyze a firm’s performance.
Start with ROE
net income
ROE
equity
The traditional DuPont equation is
net income sales assets
ROE
sales assets equity
ROE net profit margin asset turnover leverage ratio
The extended DuPont equation is
net income EBT EBIT revenue total assets
ROE
EBT EBIT revenue total assets total equity
ROE tax burden interest burden EBIT margin asset turnover financial leverage
Example
The following data is available for a company:
2010 2011 2012
ROE 19% 20% 22%
ROA 8.1% 8% 7.9%
Total asset turnover 2 2 2.1
Based only on the information above, the most appropriate conclusion is that over the
period 2010 to 2012, the company’s:
A. Net profit margin and financial leverage have decreased.
B. Net profit margin and financial leverage have increased.
C. Net profit margin has decreased but its financial leverage has increased.
Solution:
A quick glance at the data says profitability is going up and asset turnover has slightly
increased from 2010 to 2012. ROA is going down from the second year.
First, break down ROE into: x = ROA x Leverage.
ROE is going up (first row). Since ROA is going down, leverage must increase for ROE to

increase. So A is incorrect.
Next, to determine if net profit margin increased or decreased, break down ROA
into x . Since or asset turnover is increasing, net profit margin has to
decrease for return on assets to decrease. So, the correct answer is C.
5. Equity Analysis
One of the most common applications of financial analysis is that of selecting stocks. An
equity analyst uses various tools (such as valuation ratios) before recommending a security
to be included in an equity portfolio. The valuation process consists of the following steps:
 Understanding the company’s business and existing financial profile.
 Forecasting the company’s performance, such as revenue projections.
 Selecting the appropriate valuation model.
 Converting forecasts to a valuation.
 Making the investment decision to buy or not to buy.
This section, in particular, focuses on the ratios used to value equity. Research has shown
that ratios are useful in forecasting earnings and stock returns. Note that this material is
covered in more detail in the equity segment of the curriculum.
5.1. Valuation Ratios
Valuation ratios aid in making investment decisions. They help us determine if a stock is
undervalued or overvalued.
Valuation Formula Interpretation
Ratio
P/E Price per share Most often used valuation measure. Prone to
Earnings per share earnings manipulation. Non-recurring earnings
may distort the ratio.
P/CF Price per share Less prone to manipulation than P/E.
Cash flow per share
P/S Price per share Used when net income is not positive.
Sales per share
P/BV Price per share An indicator of what the market perceives. A
Book value per share value greater than 1 means future rate of return
is higher than required rate of return.
Per‐share quantities
Basic EPS Net income minus preferred dividends
Weighted average number of ordinary shares outstanding

Diluted EPS Adjusted income

Weighted average number of ordinary shares outstanding
Cash flow per Cash flow from operations
share Weighted average number of shares outstanding
EBITDA per EBITDA
Dividends per Common declared dividends
Dividend‐related ratios
Dividend‐related formulae
Dividend Ratios Formula Interpretation
Dividend payout ratio Dividend Measures the percentage of
Earnings earnings a company pays out as
dividends to equity shareholders.
Retention rate 1 - payout rate Measures the percentage of
earnings a company retains.
Sustainable growth rate Retention rate x ROE Measures how much growth a
company is able to finance from
its internally generated funds. A
higher retention rate and ROE
result in higher sustainable
growth rate.
5.2. Industry‐Specific Ratios
Ratios serve as indicators of some aspect of a company’s performance and value. Aspects of
performance that are important in one industry may be irrelevant in another. These
differences are reflected through industry-specific ratios. For example, companies in the
retail industry may report same-store sales changes because in the retail industry it is
important to distinguish between growth that results from opening new stores and growth
that results from generating more sales at existing stores.
6. Credit Analysis
Credit risk is the risk that the borrower will default on a payment when it is due. For
example, if you are a bondholder, credit risk is the risk that the bond issuer will not pay you
the interest on time. Credit analysis is the evaluation of this credit risk. Just as ratio analysis
is useful in valuing equity, it can also be applied to analyze the creditworthiness of a
borrower. Some of the ratios commonly used in credit analysis are listed below:

Credit Analysis Ratio Formula Interpretation

EBIT interest coverage EBIT A high value implies good
Gross Interest credit quality.
EBITDA interest coverage EBITDA A high value implies good
Gross Interest credit quality.
Debt to EBITDA Total debt Low debt/EBITDA implies
EBITDA good credit quality.
Total debt to total debt plus Low total debt to total debt
Total debt
equity plus equity implies good
Total debt plus equity
credit quality.
7. Business and Geographic Segments
A business or geographic segment is a portion of a company that has risk and return
characteristics distinct from the rest of the company and accounts for more than 10% of the
company’s sales or assets. Companies are required to report some items for significant
segments separately.
Ratios can be computed for business segments to evaluate how units within a business are
performing. Some of the key segment ratios are listed below:
Ratio Formula Measures
Segment margin Segment profit Operating profitability relative to
Segment revenue revenue.
Segment turnover Segment revenue Overall efficiency of the segment.
Segment assets
Segment ROA Segment profit Operating profitability relative to
Segment assets assets.
Segment debt ratio Segment liabilities Solvency.
Segment assets
8. Model Building and Forecasting
Analysts use several methods to forecast future performance. One commonly used method is
to project sales and to combine the forecasted sales numbers with expected values for key
ratios. For example, by using sales numbers and gross profit margin, one can determine cost
of goods sold and gross profit. This method is particularly useful for mature companies with
stable margins.
Besides ratio analysis, techniques such as sensitivity analysis, scenario analysis, and
simulations are often used as part of the forecasting process.
 Scenario analysis shows a range of possible outcomes as specific assumptions or
input variables are changed.
 With scenario analysis, a number of different scenarios are defined and outcomes are

estimated for each outcome.

 Simulations involve the use of computer models and input variables which are based
on a pre-defined probability distribution.


Summary
LO.a: Describe tools and techniques used in financial analysis, including their uses and
limitations.
A ratio is an indicator of some aspect of a company’s performance like profitability or
inventory management.
Uses of ratio analysis Limitations of ratio analysis
 Evaluate operational efficiency and  An analyst must exercise judgment when
financial flexibility. interpreting ratios.
 Compare company performance  Use of alternate accounting methods may
relative to industry and peer require adjustments before the ratios are
companies. comparable.
 Compare across companies  Companies may have divisions operating in
irrespective of size and currency. many different industries. This can make it
difficult to find comparable ratios.
Common-size financial statements are used to compare the performance of different
companies within an industry or a company’s performance over time. The vertical common-
size balance sheet helps in cross-sectional and time-series analysis. An analysis of horizontal
common-size balance sheets highlights structural changes that have occurred in a business.
A graph is a pictorial representation of the analysis done, be it ratio analysis or trend
analysis. It helps in quick comparison of financial performance and structure over time.
Regression analysis is a statistical method of analyzing relationships (correlations) between
variables.
LO.b: Classify, calculate, and interpret activity, liquidity, solvency, profitability, and
valuation ratios.
Activity ratios measure the efficiency of a company’s operations, such as collection of
receivables or management of inventory. They include inventory turnover, days of inventory
on hand, receivables turnover, days of sales outstanding, payables turnover, number of days
of payables, working capital turnover, fixed asset turnover, and total asset turnover.
Liquidity ratios measure the ability of a company to meet short-term obligations. They
include the current ratio, quick ratio, cash ratio, and defensive interval ratio.
Solvency ratios measure the ability of a company to meet long-term obligations. They
include debt-to-assets ratio, debt-to-capital ratio, debt-to-equity ratio, financial leverage
ratio, interest coverage ratio and fixed charge coverage ratio.
Profitability ratios measure the ability of a company to generate profits from revenue and
assets. They include gross profit margin, operating profit margin, pretax margin, net profit
margin, ROA, return on total capital, ROE, and return on common equity.

Valuation ratios express the relation between the market value of a company or its equity.
They include EPS, P/E, P/B, and P/CF.
LO.c: Describe relationships among ratios and evaluate a company using ratio
analysis.
To evaluate the overall position and performance of a company, a single ratio or a single
category of ratios is not examined in isolation. The information from one ratio category can
be helpful in answering questions raised by another category and the most accurate overall
picture comes from integrating information from all sources.
LO.d: Demonstrate the application of DuPont analysis of return on equity, and
calculate and interpret effects of changes in its components.
The traditional DuPont equation is:
net income sales assets
ROE
sales assets equity
The extended DuPont equation is:
net income EBT EBIT revenue total assets
ROE
EBT EBIT revenue total assets total equity
LO.e: Calculate and interpret ratios used in equity analysis and credit analysis.
Ratios used in equity analysis include:
 P/E
 P/CF
 P/S
 P/BV
 Basic and diluted EPS
These ratios help to determine if a stock is overvalued or undervalued.
Ratios used in credit analysis include:
 Interest coverage ratios
 Return on capital
 Debt-to-assets ratio
 Cash flow to total debt
High coverage ratios would indicate good credit quality.
LO.f: Explain the requirements for segment reporting, and calculate and interpret
segment ratios.
A business or geographic segment is a portion of a company that has risk and return
characteristics distinct from the rest of the company and accounts for more than 10% of the
company’s sales or assets. Companies are required to report some items for significant

segments separately.
Ratios can be computed for business segments to evaluate how units within a business are
performing.
LO.g: Describe how ratio analysis and other techniques can be used to model and
forecast earnings.
Analysts often use common-size analysis and ratio analysis to prepare pro forma financial
statements. They forecast future sales and combine the forecasted sales numbers with
expected value for key ratios.

Practice Questions
1. An analyst compares a company’s financial results to other peer companies for the same
time period. He is most likely performing:
A. technical analysis.
B. time-series analysis.
C. cross-sectional analysis.
2. Which of the following is least likely a limitation of ratio analysis?

A. Ratios are not useful when viewed in isolation.
B. It is difficult to obtain data on comparable companies.
C. It is difficult to determine the range of acceptable values for a ratio.
3. In order to examine a company’s ability to meet its short-term obligation, an analyst

would most likely examine the:
A. Current ratio.
B. Debt-to-equity ratio.
C. Gross profit margin.
4. Company ABC’s purchases were $200,000 during the year. Its balance sheet shows an
average accounts payable balance of $10,000 and an average accounts receivable balance
of $20,000. ABC’s payables payment period is closest to:
A. 18 days.
B. 24 days.
C. 36 days.
5. Company ABC’s sales and gross profit during the year were $200,000 and $60,000
respectively. Its balance sheet shows an average inventory balance of $28,000. ABC’s
days of inventory on hand is closest to:
A. 35 days.
B. 53 days.
C. 73 days.
6. Company ABC’s payable turnover is 8 times, the receivable turnover is 9 times and the
inventory turnover is 6 times. ABC’s cash conversion cycle is closest to:
A. 38 days
B. 56 days.
C. 74 days.
7. Company ABC’s sales and COGS during the year were $100,000 and $40,000 respectively.
Its balance sheet shows total assets of $70,000 and an average inventory balance of

$10,000. ABC’s total asset turnover and gross margin are closest to:
Total asset turnover Gross margin
A. 1.43 60%
B. 1.58 40%
C. 1.65 50%
8. Company ABC has a net profit margin of 10%, a total asset turnover of 2 times, and a
financial leverage multiplier of 1.5 times. ABC’s return on equity is closest to:
A. 10%
B. 24%
C. 30%

 Operating profit margin = 12%
 Average tax rate = 30%
 Asset turnover ratio = 2 times
 Financial leverage multiplier = 1.5 times
 Interest burden = 0.6 times
The company’s ROE is closest to:
A. 12%.
B. 15%.
C. 18%.
10. Which of the following will least likely result in an increase in a company’s sustainable
growth rate?
A. Higher tax burden ratio.
B. Higher interest burden ratio.
C. Higher dividend payout ratio.
11. A decrease in which of the following ratios would be favorable for a creditor?
A. Interest coverage ratio.
B. Debt-to-total assets.
C. Return on assets.

Solutions

1. C is correct. Cross-sectional analysis is the comparison of companies with each other for
the same time period. Technical analysis uses price and volume data as the basis for
investment decisions. Time-series analysis is the comparison of financial data across
different time periods.
2. B is correct. Company and industry data is easily available through various public and
private sources. Options A and C are limitations of ratio analysis.
3. A is correct. Liquidity ratios like the current ratio indicate the firm’s ability to meet its
short-term obligations.
4. A is correct. Payables turnover = purchases/ average payables = $200,000/ $10,000 = 20

Payables payment period = 365/20 = 18.25 days.
5. C is correct. COGS = $200,000 - $60,000 = $140,000.

Inventory turnover = COGS / average inventory = $140,000/$28,000 = 5
Days of inventory on hand = 365/ inventory turnover = 365/5 = 73 days.
6. B is correct. Cash conversion cycle = Days of sales outstanding + Days of inventory on

hand – Number of days of payable = 365/9 + 365/6 – 356/8 = 55.76 days
7. A is correct.
Total asset turnover = Sales / Total assets = $100,000 / $70,000 = 1.43 times.
Gross profit = Sales – COGS = $100,000 - $40,000 = $60,000.
Gross margin = Gross profit / Sales = $60,000 / $100,000 = 60%.
8. C is correct.
Net income Sales Assets
Return on equity
Sales assets Equity
= 0.10 x 2 x 1.5 = 0.3 = 30%
9. B is correct.
Net income EBT EBIT Revenue Average assets
ROE
EBT EBIT Revenue average assets Equity
Tax burden = 1-tax rate = 1 – 0.3 = 0.7
ROE = 0.7 x 0.6 x 0.12 x 2 x 1.5 = 0.1512 = 15%
10. C is correct.
Sustainable growth rate = Retention ratio × ROE.

A higher dividend payout ratio means a lower retention ratio.

ROE = Tax burden × Interest burden × EBIT margin × Asset turnover × Leverage.
Higher tax burden and higher interest burden will increase ROE and hence increase the
sustainable growth rate.
11. B is correct. In general, a creditor would consider a decrease in debt to total assets as
favorable. A high debt-to-total assets ratio increases the risk of default. A decrease in
either interest coverage or return on assets is likely to be considered unfavorable.

R27 Inventories 2019 Level I Notes
R27 Inventories
1. Introduction
Inventories are assets held by a company to produce finished goods for sale. They are shown
as a current asset on the balance sheet; and can represent a significant part of the total
assets for many companies.
Manufacturing and merchandising companies (Ex: Nike, Caterpillar) generate sales and
profit through the sale of inventory. An important measure in calculating profits is cost of
goods sold, i.e., how much cost the company incurred from procuring raw materials to
converting it to a finished product, and finally selling it.
There is no universal inventory valuation method. IFRS and US GAAP allow different
identification methods to measure the cost of inventory such as specific identification,
weighted average cost, first in, first out, and last in, first out.
2. Cost of Inventories
When a company spends money on inventory, most of the costs are capitalized. Capitalizing
means creating an asset on the balance sheet. Inventory costs that are capitalized include:
 costs of purchase (this includes the purchase price, import and tax duties, transport
and handling costs).
 costs of conversion (costs such as labor, material, and overheads which are directly
related to converting raw materials to finished goods).
 costs necessary to bring inventories to their present location and condition (this will
include the cost of transporting goods to a showroom).
Costs that are expensed in the period incurred include:
 Abnormal costs arising due to wastage of material, labor, or other production inputs.
 Storage costs of final/finished goods.
 Administrative overheads.
 Selling costs.
 Unused portion of fixed production overhead.
 Transportation of finished goods to the customer.
Example
Kayvee Corporation manufactures high-end tractors. The inventory related costs are shown
below:
Raw materials $56,000
Direct labor $40,000
Abnormal wastage $6,000
Transportation of raw materials $10,000
Transportation of finished goods to showroom $1,000

Storage of finished product $18,000

Transport of finished product to customer $250
What value of inventory is recorded? Which costs are expensed?
Solution:
The value of inventory is based on the costs which are capitalized. These costs are raw
materials, direct labor, transportation of raw materials and transportation of finished goods
to showroom: $56,000 + $40,000 + $10,000 + $1,000 = $107,000. Abnormal wastage,
storage of finished product, and transport of finished product to customer are expensed in
the period incurred.
3. Inventory Valuation Methods
The four inventory valuation methods for accounting inventory are:
 Specific Identification
 FIFO (First In, First Out)
 Weighted Average Cost
 LIFO (Last In, First Out)
3.1. Specific Identification
Specific identification is used when:
 Items are unique in nature and not interchangeable.
 Cost of inventory is high.
 Every item in the inventory can be tracked individually.
Under specific identification, items are shown on the balance sheet at their actual costs.
Examples: Jewelry, expensive watches, highly valued art pieces, used cars, etc.
3.2. First In, First Out (FIFO)
Under First In, First Out:
 Oldest goods purchased or manufactured are assumed to be sold first.
 Newest goods purchased or manufactured remain in ending inventory.
 When prices are increasing or stable, cost assigned to items in inventory is higher
than the cost of items sold.
The following example illustrates how cost of goods sold and inventory are accounted for in
each period:
Assume you bought four pencils. The first two pencils were worth $1 each and the next two
pencils were worth $2 each. Before you start selling, your inventory consists of four pencils.
In period 1, you sell two pencils. The cost of pencils sold in period 1 is $2 (two pencils of $1

each). The pencils that were bought first are considered sold. Inventory at the end of period
1 is $4 and looks like this (2 pencils of $2 each):

As you could see, cost of pencils sold in period 1 was $2 (cheaper pencils bought initially)
whereas the cost of pencils in inventory was $4. In period 2, you again sell two pencils. The
cost of pencils sold in period 2 is $4. Inventory at the end of period 2 is 0.
Advantage of using FIFO is that it is less subject to manipulation. It results in higher income
when prices are increasing.
3.3. Weighted Average Cost
Under weighted average cost method, each item in inventory is valued using an average cost
of all items in the inventory.
Total cost of units available for sale
Weighted average cost
Total units available for sale
Let’s use the pencils example again to illustrate how inventory is calculated using the WAC
method.
Total cost of pencils available for sales = $6
Total number of pencils available for sale = 4
Weighted average cost per pencil = $6/4 = $1.5
WAC Method
Item WAC
Cost of 2 pencils sold in period 1 $3
Inventory for 2 pencils at the end of period 1 $3
Inventory at the end of period 2 $0
3.4. Last In, First Out (LIFO)
Under Last In, First Out method:
 The newest items purchased or manufactured are assumed to be sold first.
 Oldest goods purchased or manufactured remain in ending inventory.
 The cost of goods sold reflects the cost of goods purchased or manufactured recently;
the value of inventory reflects the cost of older goods purchased.
Let’s continue with the pencils example to see how inventory is accounted for in LIFO:
Unlike FIFO, at the end of period 1, LIFO inventory consists of the first two pencils:

LIFO Method
Item LIFO
Inventory for 2 pencils at the end of period 1 $2
Inventory at the end of period 2 $0
LIFO is not allowed under IFRS; it is allowed only under US GAAP. Companies use LIFO
during inflation to reduce taxes as cost of goods sold (COGS) is high.
3.5. Calculation of Cost of Sales, Gross Profit, and Ending Inventory
Based on the inventory valuation method used by a company, the allocation of inventory
costs between cost of goods sold on the income statement and inventory on the balance
sheet varies in periods of changing prices.
Continuing with the pencils example, assume each of the pencils was sold for $5. The table
below summarizes the cost of goods sold, inventory ending value, and gross profit under
each of the methods:
Inventory Accounting under Various Methods
Item FIFO (in $) LIFO (in $) WAC (in $)
COGS for period 1 2 4 3
Gross profit for period 1 8 6 7
Inventory at end of period 1 4 2 3
COGS for period 2 4 2 3
Gross profit for period 2 6 8 7
Inventory at end of period 2 0 0 0
Some points to be noted:
 The total gross profit and COGS for all the periods combined is the same under each of
the methods.
 As the prices of pencils were increasing, the ending inventory was highest and COGS
was lowest under FIFO.
 Similarly, the ending inventory was lowest and COGS was highest under LIFO.
Example
A company bought 400 generators at a price of $300 each on January 5. Out of these 300
generators were sold at a price of $450 each by the end of March. On April 10, 250 more
generators were bought at a price of $325 each. By May 31, 225 generators were sold at a
price of $500 each. For the period ending 30 June, what is the ending inventory using FIFO?
Solution:
Purchased 400

Sold (300)
Remainder as at March 2012 100
Purchased further 250
Sold (100 old+125 new) (225)
Remainder (new) 125
Therefore, inventory cost 125 x 325 = $40,625
3.6. Periodic versus Perpetual Inventory Systems
The two types of inventory systems used to keep track of changes in the inventory are:
 Periodic system
 Perpetual system
Periodic system
The company measures the quantity of inventory on hand periodically. It is not a continuous
process unlike the perpetual system. Purchases are recorded in a purchases account. Ending
inventory is determined through a physical count of the units in inventory.
Cost of goods sold (COGS) = Beginning Inventory + Purchases – Ending Inventory
The formula above can be rearranged to determine the value of any of the items. For
example:
Ending inventory = Beginning Inventory + Purchases - COGS
Perpetual system
As the name implies, inventory and COGS are continuously updated in this system. Purchases
and sale of units are directly recorded in the inventory as and when they occur.
Instructor’s Note
For Specific Identification and FIFO: Periodic and perpetual systems give the same values for
COGS and ending inventory.
For LIFO and WAC: Periodic and perpetual systems may give different values for COGS and
ending inventory.
3.7. Comparison of Inventory Valuation Methods
The allocation of total cost of goods available for sale to COGS and ending inventory varies
under different inventory valuation methods. The following table compares LIFO vs. FIFO for
different parameters when prices are rising and inventory levels are stable:

LIFO vs. FIFO with rising prices and stable inventory levels
LIFO FIFO
COGS Higher Lower
Taxes Lower Higher
Earnings before taxes (EBT) Lower Higher
Earnings after taxes (Net Income) Lower Higher
Ending inventory Lower Higher
Working capital (CA-CL) Lower Higher
Cash flow (after tax) Higher Lower
Weighted average costs provide results between FIFO and LIFO. Some tips for remembering
the table above are listed below:
1. Remember the pencils example of $1, $1, $2, and $2. Deducing the LIFO values from this
example for COGS, net income, and ending inventory becomes simpler.
2. FIFO is the opposite of LIFO.
3. Cash flow (after tax) is higher under LIFO as taxes paid are lower.
4. Companies following US GAAP prefer LIFO because the taxes paid are lower.
5. LIFO gives a better income statement and FIFO a better balance sheet as they reflect
economic reality or recent costs. Under LIFO, cost of goods sold in income statement
shows the most recent costs reflecting better quality. Similarly, under FIFO ending
inventory on the balance sheet shows the most recent costs, reflecting better quality.
4. The LIFO Method
LIFO is permitted under US GAAP, but not under IFRS. Under the LIFO conformity rule, the
US tax code requires that companies using the LIFO method for tax purposes must also use
the LIFO method for financial reporting. When prices are increasing, LIFO method will result
in higher COGS, lower profit, income tax expense, and net income. Due to lower taxes, the
LIFO method will also result in higher after-tax cash flow.
4.1. LIFO Reserve
The LIFO reserve is the difference between the reported LIFO inventory carrying amount
and the inventory amount that would have been reported if the FIFO method had been used
instead. The equation for LIFO reserve is given by:
LIFO reserve = FIFO inventory value – LIFO inventory value
US GAAP requires companies using the LIFO method to disclose the amount of the LIFO
reserve either in the notes to financial statements or in the balance sheet. An analyst can use
the disclosure to adjust a company’s COGS and ending inventory from LIFO to FIFO. This

makes it easier to compare the company’s performance with other companies that use FIFO.
The following formulas show how to make adjustments for inventory, COGS, and net income
from LIFO to FIFO:
FIFO inventory = LIFO inventory + LIFO reserve
FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve)
(The adjusted COGS is also impacted by inventory write-downs)
FIFO NI = LIFO NI + change in LIFO reserve (1 - T)
FIFO retained earnings = LIFO retained earnings + LIFO reserve (1 – T)
Example
Ace Inc. uses the LIFO method for reporting inventory. Excerpts from Ace’s financial
statements are given below:
All numbers in millions of USD 2014 2015
Ending inventory balance 100 110
LIFO reserve at the end of the year 10 15
Cost of sales 500 550
Net income 20 25
Net cash flow from operating 22 27
1. What inventory values would Ace report for 2015 if it had used the FIFO method instead
of the LIFO method?
Solution:
FIFO inventory = LIFO inventory + LIFO reserve = 110 + 15 = 125
2. What amount would Ace’s cost of goods sold for 2015 be if it had used the FIFO method
instead of the LIFO method?
Solution:
FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve) = 550 – (15 - 10) =
545
3. What net income (profit) would Ace report for 2015 if it had used the FIFO method
instead of the LIFO method? Assume tax rate 30%.
Solution:
FIFO NI = LIFO NI + change in LIFO reserve (1 - T) = 25 + 5 - (5 x 0.3) = 28.5
4. By what amount would net cash flow from operating activities change if Ace used the
FIFO method instead of the LIFO method?
Solution:

CFO CFO impact of the change on income taxes paid = 27 – 1.5 = 25.5
5. What is the tax savings that Ace has generated in 2015 by using the LIFO method instead
of the FIFO method? Assume last year tax rate 40%.
Solution:
Tax saving change in LIFO reserve x new tax rate last year LIFO x old tax rate = 5 x 0.3
+ 10 x 0.4 = 5.5
Listed below are some tips to remember the equations:
 In equations involving the balance sheet, such as FIFO inventory and FIFO retained
earnings, use LIFO reserve.
 In equations involving the income statement, such as FIFO COGS and FIFO NI, use change
in LIFO reserve.
 It can be confusing to figure out whether to add LIFO or subtract reserve. The intuitive
way is to think which value is lower: FIFO or LIFO. For instance, inventory value is higher
for FIFO as the last purchased units at higher prices are added to the inventory. So LIFO
reserve must be added to LIFO inventory to get the FIFO inventory.
 But FIFO COGS is lower, so a change in reserve must be subtracted from LIFO COGS to get
FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve).
 For FIFO, if COGS is lower, then net income and retained earnings must be higher. So,
LIFO reserve/change in reserve must be added to LIFO.
4.2. LIFO Liquidations
In periods of rising inventory, the carrying amount of inventory under FIFO will exceed the
carrying amount of inventory under LIFO. LIFO reserve is equal to the difference between
LIFO inventory and FIFO inventory. LIFO reserve may increase for two reasons:
 The number of inventory units manufactured or purchased exceeds the number of
units sold.
 Increasing difference between the older costs used to value inventory under LIFO and
the more recent costs used to value inventory under FIFO.
If a firm is liquidating its inventory or if the prices are declining, the LIFO reserve will
decline.
When the number of units sold in a period exceeds the number of units
purchased/manufactured, it is called LIFO liquidation. In LIFO liquidation, the costs from
older LIFO layers will flow to COGS and it can be used by the management to manipulate
earnings and margins. The gross profits increase because the older inventory carrying
amounts are used for COGS while sales are at current prices. An increase in gross profit
accompanied by a decrease in LIFO reserve must be used as a warning sign. LIFO liquidation
occurs for a number of reasons such as labor strikes, to reduce inventory during an

economic recession when demand is low, and earnings manipulation.

The consequences of LIFO liquidation are as follows:
 COGS does not reflect recent costs during periods of rising prices.
 Overstates net income.
 Higher taxable income and higher tax payments.
 Positive cash flow.
Analysts must make the following adjustments to account for LIFO liquidation:
 Net income must be lowered.
 COGS must be adjusted to reflect current prices for the replaced units.
Example
Company A uses LIFO and has an increasing LIFO reserve. Company B uses FIFO. Company C
uses LIFO and has a decreasing LIFO reserve. Which company’s COGS best reflect current
costs?
Solution:
Company A’s COGS best reflects current costs because it uses the LIFO method and has an
increasing LIFO reserve. Even though company C uses LIFO, it has a decreasing LIFO reserve,
which may be an indicator of LIFO liquidation. In that case, COGS will not reflect current
costs. Company B uses FIFO, hence its COGS reflects older costs.
5. Inventory Method Changes
Companies occasionally change their inventory valuation method. The change is acceptable
if it results in the financial statements providing reliable and more relevant information.
If the change is justified, then it must be applied retrospectively.
Analysts must carefully analyze why a company is actually changing the inventory valuation
method. Often, the company might be trying to reduce taxes or increase reported net income.
6. Inventory Adjustments
Holding inventory for a prolonged period results in the risk of spoilage, obsolescence, or
decline in prices, and the cost of inventory may not be recoverable in such circumstances.
We define some terms first before looking at the differences in how inventory is measured
under IFRS and GAAP.
Net realizable value: Estimated selling price under ordinary business conditions minus
estimated costs necessary to get the inventory in condition for sale. NRV is from a seller’s
perspective.
Net realizable value = estimated sales price – estimated selling costs
Market value: Current replacement cost subject to lower or upper limits. Market value has
upper limit of net realizable value and lower limit of NRV less a normal profit margin. Market

value is from a buyer’s perspective.

Market value limits = (NRV - normal profit margin, NRV)
The following table describes how inventory is measured under IFRS and GAAP:
Inventory measurement under IFRS and US GAAP
IFRS US GAAP
Lower of cost or net realizable value. Lower of cost or market value.
If NRV is less than the balance sheet cost, If cost exceeds market, inventory is
the inventory is “written down” to NRV. written down to market value on the
The loss in value is reflected in the income balance sheet and the loss is recognized.
statement in cost of goods sold.
Inventory write-down has a negative effect
on profitability, liquidity, and solvency
ratios and positive effect on activity ratios.
If value recovers subsequently, inventory If value recovers subsequently, no write up
can be written up and gain is recognized in is allowed. There is no reversal of write-
the income statement. The amount of gain downs. This may motivate companies not
is limited to loss previously recognized. to record inventory write-downs unless the
decline is permanent as it affects
profitability ratios.
Commodities and agricultural goods prices Commodities and agricultural goods prices
can be reported above historical cost. can be reported above historical cost.
An inventory write-down reduces both profit and carrying amount of inventory on the
balance sheet, which, in turn, affects the ratios. The following table shows the effect of
inventory write-downs on various financial ratios:
Ratio Effect Reason
Liquidity ratios
Current assets decrease due to lower
Current ratio Lower
inventory.
Activity ratios
COGS increases assuming inventory write-
downs are reported as part of cost of sales.
Average inventory decreases. Lower
Inventory turnover Higher inventory carrying amounts make it appear
as if the company is managing its inventory
effectively, but write-downs reflect poor
inventory management.
Days of inventory on hand Lower Inventory turnover is higher.
Profitability ratios

Net profit margin Lower Cost of sales is higher. Sales stay the same.
Gross profit margin Lower Cost of sales is higher. Sales stay the same.
Companies that use weighted average, specific identification, and FIFO are more likely to
have inventory write-downs than companies using the LIFO method.
7. Evaluation of Inventory Management
The efficiency and effectiveness of inventory management can be evaluated using the
following ratios:
 Inventory Turnover
 Days of Inventory on hand
 Gross Profit Margin
An analyst must understand that the choice of inventory valuation method can impact
several financial ratios and make comparisons between two firms difficult. He needs to be
particularly careful when comparing an IFRS and US GAAP firm.
7.1 Presentation and Disclosure
IFRS requires the following financial statement disclosures concerning inventory:
 The accounting policies used to measure inventory, including the cost formula.
 The total carrying amount of inventories and the carrying amount in classification
(for example, merchandise, raw materials, production supplies, work in progress, and
finished goods appropriate to entity).
 The carrying amount of inventories carried at fair value less costs to sell.
 The amount of inventories recognized as an expense in the period (cost of sales).
 The amount of any reversal of any write-down recognized as a reduction in cost of
sales in the period.
 What led to the reversal of a write-down in the inventories?
 Carrying amount of inventories pledged as a security for liabilities.
Disclosures under U.S. GAAP are similar to IFRS except that it does not permit reversal of
write down of inventories. In addition, any income from liquidation of LIFO inventory must
be disclosed.
7.2 Inventory Ratios
The choice of inventory valuation method impacts various components of the financial
statements such as cost of goods sold, net income, current assets, and total assets. As a result,
it affects the financial ratios containing these items. Analysts must consider the differences
in valuation methods when evaluating a company’s performance over time or in comparison
to other companies.
The table below summarizes the impact of valuation method on inventory-related ratios in
an inflationary environment:

Ratio Numerator Denominator Impact on ratio

Inventory Cost of goods sold is Average inventory is Higher under
turnover higher under LIFO. lower under LIFO. LIFO.
Days of inventory No. of days are the Higher under LIFO. Lower under
same. LIFO.
Total asset Revenue is the same. Lower average total Higher under
turnover assets under LIFO. LIFO.
Current ratio Ending inventory is Current liabilities are Lower under
lower under LIFO so the same. LIFO.
current assets are
lower.
Cash ratio Cash is higher under Current liabilities are Higher under
LIFO because taxes the same. LIFO.
are lower.
Gross profit Gross profit is lower Revenue is the same. Lower under
margin under LIFO as COGS LIFO.
is higher.
Return on assets Net income is lower Lower average total Lower under
under LIFO as COGS assets under LIFO. LIFO.
is higher.
Debt to equity Debt is the same. Lower equity under Higher under
LIFO. Equity = assets – LIFO.
liabilities. Total assets
under LIFO are lower
as ending inventory is
lower.
The ratios that are important in evaluating a company’s management of inventory are
inventory turnover, number of days of inventory, and gross profit margin. A high inventory
turnover implies that a company is utilizing inventory efficiently.


Summary
LO.a: Distinguish between costs included in inventories and costs recognized as
expenses in the period in which they are incurred.
Costs included in the inventory are:
 Cost of purchase.
 Cost of conversion.
 Fixed production overhead under normal operating capacity.
 Other costs necessary to bring the inventories to its present location and condition.
Costs that are recognized as expenses are:
 Storage costs of finished inventory.
 Abnormal costs due to waste.
 Administrative costs.
 Selling costs.
LO.b: Describe different inventory valuation methods (cost formulas).
The four inventory valuation methods are:
FIFO
 The cost of the first item purchased is assumed to be the cost of the first item sold.
 Ending inventory is based on the cost of the most recent purchases.
LIFO
 The cost of the last item purchased is assumed to be the cost of the first item sold.
 Ending inventory is based on the cost of the earliest purchases.
Weighted average cost
 Each item in the inventory is valued using an average cost of all items in the
inventory.
 COGS and inventory values are between their FIFO and LIFO values.
Specific identification
 Each unit sold is matched with the unit’s actual cost.
 This method is usually used for items that are unique in nature, for example, jewelry.
All four methods are permitted under U.S. GAAP. However, IFRS does not permit LIFO
method.
LO.c: Calculate and compare cost of sales, gross profit, and ending inventory using
different inventory valuation methods and using perpetual and periodic inventory
systems.
Suppose you bought 10 shirts for $1 each on 1st Jan and bought 5 shirts for $1.5 each on 15th
Jan. You sold 7 shirts for $2 each on 20th Jan. Inventory accounting under various methods is

as follows:
Item FIFO (in $) LIFO (in $) WAC (in $)
COGS for period 7*1=7 (5 * 1.5) + 2 = 9.5 (1.17 * 7) = 8.17
Gross profit for period (7 * 2) – 7 = 7 (7 * 2) – 9.5 = 4.5 (7 * 2) – 8.17 = 5.8
Inventory at end of period (5 * 1.5) + 3 = 10.5 8*1=8 8 * 1.17 = 9.33
Periodic system: The company measures the quantity of inventory on hand periodically.
Cost of goods sold (COGS) = Beginning Inventory + Purchases – Ending Inventory
Perpetual system: As the name implies, inventory and COGS are continuously updated in this
system. Purchases and sale of units are directly recorded in the inventory as and when they
occur.
Specific Identification and FIFO: Periodic and perpetual systems give the same values for
COGS and ending inventory.
LIFO and WAC: Periodic and perpetual systems may give different values for COGS and
ending inventory.
LO.d: Calculate and explain how inflation and deflation of inventory costs affect the
financial statements and ratios of companies that use different inventory valuation
methods.
The following table compares LIFO and FIFO when prices are rising and inventory levels are
stable. (We get the opposite effect during periods of falling prices)
LIFO vs. FIFO with rising prices and stable inventory levels
LIFO FIFO
COGS Higher Lower
Taxes Lower Higher
Earnings before taxes (EBT) Lower Higher
Earnings after taxes (Net Income) Lower Higher
Ending inventory Lower Higher
Working capital (CA-CL) Lower Higher
Cash flow (after tax) Higher Lower
For weighted average costs, all values will be between those for the LIFO and FIFO methods.
LO.e: Explain LIFO reserve and LIFO liquidation and their effects on financial
statements and ratios.
LIFO reserve = FIFO inventory value – LIFO inventory value
A LIFO liquidation occurs when a firm using LIFO sells more inventory during a period than
it produces/purchases. This results in an unsustainable increase in the gross profit margin
because the firm is tapping into old lower-cost inventory.

LO.f: Convert a company’s reported financial statements from LIFO to FIFO for
purposes of comparison.
FIFO inventory = LIFO inventory + LIFO reserve
FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve)
FIFO NI = LIFO NI + change in LIFO reserve (1 - T)
FIFO retained earnings = LIFO retained earnings + LIFO reserve (1 – T)
LO.g: Describe the measurement of inventory at the lower of cost and net realizable
value.
Net realizable value: It is calculated as estimated selling price under ordinary business
conditions minus estimated costs necessary to get the inventory in condition for sale.
Net realizable value = estimated sales price – estimated selling costs
Market value: It is the current replacement cost subject to lower or upper limits. Market
value has upper limit of net realizable value and lower limit of NRV less a normal profit
margin.
Market value limits = (NRV - normal profit margin, NRV)
Under IFRS, inventories are valued at the lower of cost or net realizable value. Inventory
write-ups are allowed but only to the extent a previous write-down to net realizable value
was recorded.
Under US GAAP, inventories are valued at lower of cost or market. If cost exceeds market,
inventory is written down. No subsequent write-ups are allowed.
LO.h: Describe implications of valuing inventory at net realizable value for financial
When inventory is written down from cost to net realizable value:
 It decreases inventory, assets, and equity.
 It increases asset turnover, debt to equity ratio, and the debt to assets ratio.
 It results in a loss on the income statement, which decreases net income, net profit
margin, return on assets, and return on equity.
LO.i: Describe the financial statement presentation of and disclosures relating to
inventories.
IFRS requires the following financial statement disclosures concerning inventory:
 The accounting policies used to measure inventory, including the cost formula.
 The total carrying amount of inventories and the carrying amount in classification.
 The carrying amount of inventories carried at fair value less costs to sell.
 The amount of inventories recognized as an expense in the period (cost of sales).
 The amount of any reversal of any write-down recognized as a reduction in cost of

sales in the period.

 What led to the reversal of a write-down in the inventories?
 Carrying amount of inventories pledged as a security for liabilities.
Disclosures under U.S. GAAP are similar to IFRS except that U.S. GAAP does not permit
reversal of write-down of inventories. In addition, any income from liquidation of LIFO
inventory must be disclosed.
LO.j: Explain issues that analysts should consider when examining a company’s
inventory disclosures and other sources of information.
 If finished goods inventory is increasing while raw material and work in progress
inventory is decreasing, then this may indicate decreasing demand for the product.
 If raw material and work in progress inventory is increasing, then this may indicate
increasing demand for the product.
 If finished goods inventory is increasing at a greater rate than increases in sales, then
this may indicate decreasing demand for the product.
LO.k: Calculate and compare ratios of companies, including companies that use
different inventory methods.
The table below summarizes the impact of valuation method on inventory-related ratios:
Ratio Numerator Denominator Impact on ratio
Inventory turnover Cost of goods sold is Average inventory is Higher under
higher under LIFO. lower under LIFO. LIFO.
Days of inventory No. of days are the Higher under LIFO. Lower under
same. LIFO.
Total asset Revenue is the same. Lower average total Higher under
turnover assets under LIFO. LIFO.
Current ratio Ending inventory is Current liabilities are Lower under
lower under LIFO so the same. LIFO.
current assets are
lower.
Gross profit Gross profit is lower Revenue is the same. Lower under
margin under LIFO as COGS LIFO.
is higher.
Return on assets Net income is lower Lower average total Lower under
under LIFO as COGS assets under LIFO. LIFO.
is higher.

Debt to equity Debt is the same. Lower equity under Higher under
LIFO. Equity = assets – LIFO.
liabilities. Total assets
under LIFO are lower
as ending inventory is
lower.
LO. l: Analyze and compare the financial statements of companies, including
companies that use different inventory methods.
Before comparing the financial statements of companies that use different inventory
methods, we need to adjust the statements so that they reflect the same inventory costing
methods.

Practice Questions
1. Which of the following costs is least likely included in a firm’s ending inventory?
A. Storage costs related to production.
B. Transportation cost incurred to bring inventory to the business location.
C. Costs incurred as a result of abnormal waste.
2. ABC Inc. reports under IFRS. Which inventory valuation method will the company least
likely use?
A. LIFO.
B. FIFO.
C. Specific identification.
3. The balance sheet inventory values will reflect the most recent costs if a company
accounts for inventory using the:
A. FIFO method.
B. LIFO method.
C. weighted average cost method.
4. Company A uses the FIFO method, and company B uses the LIFO method. Assuming
stable inventory quantities during periods of rising prices, the cost of goods sold
reported by:
A. company A would be higher.
B. company B would be higher.
C. both companies will be the same.
5. The information on a company’s inventory is given below:

- Opening inventory 0 units
- 1 purchase
st 50 units at $4/unit
- 2 purchase
nd 100 units at $4.5/unit
- 3 purchase
rd 120 units at $5/unit
- Total Sales 200 units at $6/unit
Using a periodic inventory system and the weighted average method, the ending
inventory value is closest to:
A. $324.
B. $366.
C. $395.
6. A company uses a periodic inventory system and calculates inventory and COGS at the
end of the year. The beginning of the year inventory of the company was 30 units at $2
per unit. During the year the company’s inventory purchases were

Quarter Units Purchased Cost per unit

1 50 $2
2 30 $2.5
3 25 $3
4 20 $4
The company sold a total of 70 units during the year. Its COGS for the year under FIFO
and LIFO are:
FIFO LIFO
A. $217.5 $140
B. $160 $196.5
C. $140 $217.5
7. Company A operates in an environment of falling prices. Its reported profits will tend to
be the highest if it accounts for inventory using the:
A. FIFO method.
B. LIFO method.
C. weighted average method.
8. During periods of rising prices, a LIFO liquidation will:

A. reduce cost of goods sold.
B. reduce gross margins.
C. increase LIFO reserve.
9. Company A accounts for inventory using the LIFO method. During the current period it
reported a COGS of $40,000 and an ending inventory of $15,000. Its LIFO reserve
decreased from $5,000 to $4,000 over the period. If the firm had reported using FIFO, its
COGS would have been:
A. $39,000.
B. $40,000.
C. $41,000.
10. The following information is available for a manufacturing company:

Cost of ending inventory computed using FIFO $1.5 million
Net realizable value $1.4 million
Current replacement cost $1.3 million
If the company uses International Financial Reporting Standards (IFRS), instead of U.S.
GAAP, its cost of goods sold ($ millions) is most likely:
A. the same.
B. 0.1 lower.
C. 0.1 higher.

11. Company A adheres to US GAAP whereas company B adheres to IFRS. It is most likely
that:
A. company A has reversed an inventory write-down.
B. company B has reversed an inventory write-down.
C. both companies use the LIFO inventory accounting method.
12. Company A uses LIFO method, company B uses FIFO method. During a period of rising
prices, as compared to company B, company A will most likely have a higher:
A. current ratio.
B. gross margin.
C. inventory turnover.
13. Compared to the industry average, a company has a high inventory turnover and lower
sales growth. The company is most likely:
A. managing its inventory efficiently.
B. losing sales by not carrying enough inventory.
C. has slow moving or obsolete inventory.

Solutions

1. C is correct. Costs incurred as a result of abnormal waste must be expensed.
2. A is correct. LIFO is not permitted under IFRS; it is only allowed under US GAAP.
3. A is correct. Under FIFO, ending inventory consists of items that were most recently
purchased. Therefore, balance sheet inventory values reflect the most recent costs.
4. B is correct. When prices are increasing and inventory quantities are stable or increasing,
LIFO results in higher COGS as compared to FIFO.
5. A is correct.
Ending Inventory Weighted Average Calculations
Units $/unit Total $
Purchase #1 50 $4 $200
Purchase #2 100 $4.5 $450
Purchase #3 120 $5 $600
Total available 270 $1,250
Average cost 1,250 ÷ 270 = $4.63
Ending inventory 270 – 200 = 70 units
Ending inventory value = 70 x $4.63 = $324.1
6. C is correct.
FIFO COGS:
30 units from beginning inventory x $2 per unit = $60.
40 units from Quarter 1 x $2 per unit = $80
Total = $140
LIFO COGS:
25 units from Quarter 2 x $2.5 per unit = $62.5
Total = $217.5
7. B is correct. In an environment of falling prices, the most recent inventory is the lowest-
cost inventory. Therefore, selling the newer, cheaper inventory first (LIFO) will result in
lower cost of sales and higher profit.
8. A is correct. When a LIFO liquidation occurs, older and lower-cost inventory is included
in the cost of goods sold. Thus, the cost of goods sold decreases.

9. C is correct.
FIFO COGS = LIFO COGS – change in LIFO reserve.
FIFO COGS = $40,000 – ($4,000 - $5,000) = $41,000.
10. B is correct. Under IFRS, the inventory would be written down to its net realizable value
($1.4 million), whereas under U.S. GAAP market is defined as current replacement cost
and hence would be written down to its current replacement cost ($1.3 million). The
smaller write-down under IFRS will reduce the amount charged to the cost of goods sold
as compared with U.S. GAAP, and result in a lower cost of goods sold of $0.1 million.
11. B is correct. US GAAP does not permit inventory write-downs to be reversed. LIFO is not
allowed under IFRS.
12. C is correct. During a period of rising prices, ending inventory under LIFO will be lower
than that of FIFO and cost of goods sold higher. Therefore, inventory turnover
(COGS/average inventory) will be higher.
13. B is correct. High inventory turnover combined with low sales growth indicates that the
company is not maintaining adequate inventory levels to meet sales.

R28 Long Lived Assets 2019 Level I Notes
R28 Long‐Lived Assets

1. Introduction
Long-lived assets are defined as those assets that are expected to provide future economic
benefits extending more than one year.
These assets include:
 Tangible assets also known as fixed assets or property, plant, and equipment.
Examples include land, buildings, furniture, machinery, etc.
 Intangible assets lack physical substance. Examples include patents, trademarks, etc.
 Financial assets include investments in equity or debt securities issued by other
companies.
There are two important questions in accounting for a long-lived asset:
 What cost should be shown on the balance sheet?
 How should this cost be allocated over the life of an asset?
2. Acquisition of Long‐Lived Assets
Upon acquisition, long-term tangible assets such as property, plant, and equipment are
recorded on the balance sheet at cost, which is the same as fair value. An asset’s cost might
include expenditures in addition to purchase price. The question is how should these costs
be treated – expensed or capitalized?
If the expenditure on an asset is expected to provide benefits beyond one year in the future,
the costs are usually capitalized. The costs are expensed if they are not expected to provide
benefits in future periods.
2.1. Property, Plant, and Equipment
Property, plant, and equipment are recorded at cost at acquisition. In addition to the
purchase price, the cost includes all expenditures necessary to get the asset ready for
intended use. For instance, readying the factory for installation of a machine is included in
the cost. But if any training is required for the staff to operate the machine, that is expensed
and not capitalized. Subsequent costs are capitalized if they are expected to provide benefits
beyond one year, otherwise they are expensed. Companies might have different approaches
towards expensing/capitalizing costs. An analyst should understand the impact of
expensing/capitalizing decisions on financial statements and ratios. All the capitalized costs
related to the long-lived assets are recorded in the balance sheet.
Example
Acme Inc. purchased a machine for $ 10,000. In addition, the following costs were incurred:
 $200 for delivery.
 $300 for installation.
 $100 to train staff on using the machine.

 $1,000 to reinforce floor to support machine.

 $500 to paint the factory.
1. Which costs will be capitalized and which will be expensed?
2. How will the treatment of these expenditures affect the company’s financial statements?
Solution to 1:
Capitalized amount = purchase price + costs that are involved in extending asset’s life or
getting it ready to use = $10,000 + $200 + $300 + $1000 = $11,500.
Training cost is expensed because if the trained staff leaves the company, then it doesn’t
provide a long-term benefit to the business. Expensed costs = $100 + $500 = $600.
Solution to 2:
Balance sheet: PP&E increases by $11,500 and cash decreases by $11,500.
Income statement: An expense of $600 towards training staff and painting. Also a
depreciation expense spread over the useful life of the asset appears on the income
statement.
Cash flow statement: CFI decreases by $11,500 and CFO decreases by $600.
2.2. Intangible Assets
Intangible assets lack physical substance. Classic examples include software, customer lists,
patents, copyrights, and trademarks. Accounting for an intangible asset depends on how it is
acquired.
Acquired in a Business Combination
This refers to a situation where one company buys another company and in the process,
acquires intangible assets.
 Both IFRS and US GAAP require the use of acquisition method in accounting for
business combinations. (This method will be studied in detail at Level II.)
 Under the acquisition method, identifiable intangible assets such as patents,
copyrights, and trademarks are recorded at their fair value.
 Goodwill is an intangible asset that cannot be identified separately. It is recorded
when one business acquires another business. If the purchase price exceeds the sum
of the fair value of the individual assets and liabilities of the acquired business, the
excess amount is recognized as goodwill. For example, Tan Hospitals Inc. acquires
Man Equipments Inc. for $100 million. The fair value of Man Equipments’ net assets
equal $95 million. In this case, the excess of $5 million will be recorded as goodwill.
Purchased in Situations Other than Business Combinations
This refers to a situation where an identifiable intangible asset is purchased. The identifiable

intangible asset is recorded at fair value.

Developed Internally
Costs to internally develop intangible assets are generally expensed when incurred, although
there are exceptions. The differences in whether the costs are capitalized or expensed affect
financial statement ratios as outlined below:
 Balance sheet: A company that develops intangible assets internally will expense
costs and record lower assets compared to a company that acquires such assets
through purchase.
 Statement of cash flows: The costs of internally developing intangible assets are
classified as operating cash flows, while the cost of acquiring intangible assets is
classified as investing cash flows.
For internally developed intangible assets, there are two phases: the research phase and the
development phase.
Research phase refers to the period during which commercial feasibility of an intangible
asset is yet to be established. It is defined as “original and planned investigation undertaken
with the prospect of gaining new scientific or technical knowledge and understanding.”
Development phase refers to the period during which the technical feasibility of completing
an intangible asset has been established with the intent of either using or selling the asset.
The treatment for the two phases varies slightly under IFRS and US GAAP as outlined below:
Under IFRS:
 Research costs are expensed.
 Development costs can be capitalized if technical feasibility and the intent to sell the
asset are established.
Under US GAAP:
 Both research and development costs are expensed, but there are exceptions for
software development.
 Software for sale: Costs incurred to develop a software product for sale are expensed
until the product’s feasibility is established, and capitalized after the product’s
feasibility has been established. Determining feasibility involves judgment.
 Software for internal use: All development costs should be capitalized.
Example
Acme Inc. starts an internal software development project on January 1, 2012. It incurs
expenditures of $10,000 per month during the fiscal year ended December 31, 2012. By
March 31, it is clear that the product will be developed successfully and will be used as
intended. How are the software development costs recorded before and after March 31
according to IFRS and US GAAP?

Solution:
IFRS: Under IFRS all costs are expensed until feasibility is established if the software is
developed for internal use. So, $30,000 (period from January 1 to March 31, 2012) is
expensed and $90,000 is capitalized (from April 1 to December 31, 2012).
U.S GAAP: The entire cost of $120,000 should be capitalized.
2.3. Capitalizing versus Expensing: Impact on Financial Statements and Ratios
Capitalizing: In general, when a company acquires a long-lived tangible or intangible asset,
its cost is capitalized if the asset is expected to provide economic benefits beyond a year. The
company records an asset in an amount equal to the acquisition cost plus any other cost to
get the asset ready for its intended use.
Capitalizing results in spreading the cost of acquiring an asset over a specified period of time
instead of immediately expensing it. All other costs to make the asset ready for intended use
are also capitalized. Capitalizing leads to higher profitability in the period when the asset is
purchased. The effect of capitalizing an expenditure on the financial statements is
summarized below:
Effect of capitalization on financial statements
Initially when an Balance sheet: non-current assets increase by the capitalized
expenditure is amount.
capitalized. Statement of cash flows: investing cash flow decreases.
Subsequent periods over Income statement: depreciation or amortization expense.
the asset’s useful life. Net income decreases.
Balance sheet: non-current assets (carrying value of the
asset) decreases.
Retained earnings decreases.
Equity decreases.
Expensing: The cost of an asset is expensed if it has uncertain or no impact on future
earnings and provides economic benefit only in the current period. Immediate recognition of
an asset’s cost as an expense on the income statement results in lower profitability in the
current period and higher profits in the future.
Effect of expensing on financial statements
When an expenditure is Income statement: Net income decreases by the after-tax
expensed. amount of the expenditure.
No depreciation/amortization expense.
Balance sheet: No asset is recorded.
Lower retained earnings due to lower net income.
Statement of cash flow: Operating cash flow decreases.
The table below summarizes the effects of capitalizing versus expensing on various financial

statement items.
Capitalizing Expensing
Total assets Higher Lower
Equity Higher Lower
Income variability Lower Higher
Net income (1st year) Higher Lower
Net income (later) Lower Higher
CFO Higher Lower
CFI Lower Higher
D/E Lower Higher
Interest coverage (initially) Higher Lower
Interest coverage (later) Lower Higher
ROA and ROE (initially) Higher Lower
ROA and ROE (later) Lower Higher
2.4. Capitalization of Interest Costs
When an asset requires a long period of time to get ready for its intended use, the interest
costs associated with constructing or acquiring the asset are capitalized. Capitalized interest
is reported as part of the asset’s cost on the balance sheet; in the future, it is reported as part
of the asset’s depreciation expense in the income statement.
For constructed assets, interest costs during construction are capitalized as part of the asset
cost
 Use rate on borrowing related to construction; if no construction debt is outstanding,
interest rate is based on existing unrelated debt.
 Capitalized interest is not reported as interest expense on I/S.
 IFRS: Interest on short-term lending offsets capitalized costs (not allowed in U.S.
GAAP).
Effect of Capitalized Interest on Financial Statements:
 Higher net income and greater interest coverage ratios during the period of
capitalization.
 Higher asset values and depreciation lead to lower net income, EBIT and interest
coverage ratio in the subsequent periods.
3. Depreciation and Amortization of Long‐Lived Tangible Assets
Under the cost model of reporting long-lived assets, the capitalized cost of a tangible
(intangible) long-lived asset is expensed through a process called depreciation
(amortization).
3.1. Depreciation Methods and Calculation of Depreciation Expense
Depreciation methods are:

 Straight‐line – The cost of an asset is evenly distributed over the asset’s useful life.
 Accelerated methods – A higher depreciation expense is recorded in the early years
and lower depreciation expense is recorded in the later years of an asset’s life.
 Units‐of‐production – Cost allocated is based on the actual use of an asset in a
particular period.
Formulae
Straight-line depreciation expense = depreciable cost / estimated useful life
DDB depreciation expense = 2 x straight-line rate x beginning book value
Units-of-Production depreciation expense per unit = depreciable cost/useful life in units
Carrying amount = historical cost – accumulated depreciation
Depreciable cost = historical cost – estimated residual value
Example
Consider three companies with names based on their depreciation method:
1. Straight Line (SL) Inc.
2. Double Declining Balance (DDB) Inc.
3. Units of Production (UOP) Inc.
Each company purchases identical equipment for 10,000 and makes similar assumptions;
estimated useful life = 4 years; residual value = 1,000; productive capacity = 1,000 units.
Production over 4 years is 400, 300, 200, and 100 respectively. Complete the table below for
each company.
Beginning Net Depreciation Accumulated Ending Net Book
Book Value Expense Depreciation Value
Year 1
Year 2
Year 3
Year 4
Solution:
Straight‐Line Method:
, – ,
Depreciation expense = = = 2,250
Straight-line Method
Year 1 10,000 2,250 2,250 7,750
Year 2 7,750 2,250 4,500 5,500
Year 3 5,500 2,250 6,750 3,250
Year 4 3,250 2,250 9,000 1,000

Double‐Declining Method (DDM)

The rate of depreciation in double-declining method (DDM) is twice that of straight-line
method. It is 25% for straight-line method (100% in 4 years = 25%). The rate of decline for
DDM is 50%. Depreciation expense for first year = 0.25 x 2 x 10,000 = 5,000 and so on for the
subsequent years. Once the net book value is equal to the residual value there is no further
depreciation.
Double-declining balance method
Year 1 10,000 5,000 5,000 5,000
Year 2 5,000 2,500 7,500 2,500
Year 3 2,500 1,250 8,750 1,250
Year 4 1,250 250 9,000 1,000
Units‐of‐Production Method:
Depreciable cost
Depreciation expense x Units produced in period
Useful life in units
,
Depreciation expense in first year = x 400 = 3,600
,
Note that we use the depreciable cost of 9,000 which is the original cost (10,000) minus the
residual value (1,000).
Units of production method
Year 1 10,000 3,600 3,600 6,400
Year 2 6,400 2,700 6,300 3,700
Year 3 3700 1,800 8,100 1,900
Year 4 1900 900 9,000 1,000
Some points to be noted:
 The beginning book value is the same for all the three methods.
 The total depreciation over 4 years for all three companies (or under three depreciation
methods) should be the same.
Impact of Depreciation Methods on Financial Statements
The choice of depreciation method affects the amounts reported for assets, operating and
net income, which in turn, affect the financial ratios. The relationships indicated in the table
below are for the early years of an asset’s life.

Straight‐ Accelerated Interpretation

Line (SL) (DDB)
Depreciation Lower Higher Compared to SL, the rate of depreciation for DDB
Expense is double, making the depreciation expense
higher in the initial years.
Net Income Higher Lower Compared to SL, depreciation expense is higher
in initial years for DDB making net income lower.
Assets Higher Lower Compared to SL, depreciation and accumulated
depreciation are higher for DDB making the net
book value of assets lower in the initial years.
Equity Higher Lower Equity = assets – liabilities. Liabilities are not
affected. Since assets are lower for DDB, equity is
also lower.
Return on Higher Lower Compared to SL, ROA for DDB is lower in earlier
Assets years because percentage impact on the
(NI/Assets) numerator (net income) is more than the
percentage impact on the denominator (assets).
Percentage impact on assets is lower because
equipment is generally a small percentage of
assets.
Return on Higher Lower Compared to SL, ROE for DDB is lower in earlier
Equity years because percentage impact on net income
is more than the percentage impact on equity.
Asset Lower Higher Revenue is not impacted by the choice of
Turnover depreciation method. Net book value of assets is
lower for the DDB method making asset turnover
higher.
Operating Higher Lower Revenue is not impacted. EBIT is lower for DDB
Profit in the initial years, which makes operating profit
Margin margin lower.
The above relationships are for the initial years of an asset. These reverse in the later years if
the firm’s capital expenditure declines.
Component Method of Depreciation
In this method, individual components or parts of an asset are depreciated separately at
different rates. For example, in an aircraft it may be prudent to depreciate engine, frame, and
interior furnishings separately.
 IFRS requires companies to use the component method of depreciation, i.e.,
depreciate each component separately.
 US GAAP allows component depreciation but the method is often not used in practice.

3.2. Amortization Methods and Calculation of Amortization Expense

Amortization is similar in concept to depreciation. The term amortization applies to
intangible assets, and term depreciation applies to tangible assets.
Amortization methods for intangible assets with finite lives are the same as those used in
depreciation:
 Straight-line
 Accelerated
 Units-of-production
The calculation of amortization expense is also similar to that of depreciation expense
(covered earlier).
4. The Revaluation Model
What we have seen so far is the cost model of accounting where an asset is recorded
originally at cost. This value is then depreciated every year. An alternative to cost model is
the revaluation model. Under the revaluation model, assets are revalued periodically. The
carrying value of an asset after revaluation becomes the fair value. The method is used when
the fair value of an asset can be easily determined and is subject to judgment.
IFRS permits the use of either the cost model or the revaluation model for the valuation and
reporting of long-lived assets, but the revaluation model is not allowed under US GAAP.
Impact of revaluation on financial statements
The impact of revaluation on financial statements depends on whether the revaluation
initially increased or decreased the asset class’ carrying amount. Let us consider both the
cases.
Downward revaluation
When a revaluation initially decreases the carrying amount of an asset:
 The decrease is recognized as loss in the income statement.
 Later, if the asset’s carrying amount increases, the increase is recognized as a gain on
the income statement to the extent that it reverses the revaluation decrease
previously recognized for the same asset class.
 Any increase in excess of the reversal amount will not be recognized in the income
statement, but will be recorded directly to equity as a revaluation surplus.
Upward revaluation
When a revaluation initially increases the carrying amount of the asset class:
 An increase in the carrying value of the asset class bypasses the income statement
and is recorded directly under equity as a revaluation surplus.
 A subsequent decrease in the carrying amount first decreases the revaluation surplus
and any excess beyond the reversal amount is recorded as a loss on the income

statement.
Example
Upward Corp, a hypothetical manufacturing company, has elected to use the revaluation
model for its machinery. Assume for simplicity that the company owns a single machine,
which it purchased for $20,000 on the first day of its fiscal period, and that the measurement
date occurs simultaneously with the company’s fiscal period end.
1. At the end of the first fiscal period after acquisition, assume that the fair value of the
machine is determined to be $22,000. How will the company’s financial statements
reflect the asset?
2. At the end of the second fiscal period after acquisition, assume that the fair value of the
reflect the asset?
Solution to 1:
At the end of the first fiscal period, the company’s balance sheet will show the asset at a
value of $22,000. The $2,000 increase in the value of the asset will appear in other
comprehensive income and be accumulated in equity under the heading of revaluation
surplus.
Note: Gains do not go through income statement and instead go directly to equity under
revaluation surplus. In case of loss, part of the decrease is shown as loss in income statement.
Solution to 2:
At the end of the second fiscal period, the company’s balance sheet will show the asset at a
value of $15,000. The total decrease in the carrying amount of the asset is $7,000 ($22,000 –
$15,000). Of the $7,000 decrease in the carrying amount, $2,000 will reduce the amount
previously accumulated in equity under the heading of revaluation surplus. This does not go
through the income statement. The other $5,000 will be shown as a loss on the income
statement.
Example
Downward Corp, a hypothetical manufacturing company, has elected to use the revaluation
model for its machinery. Assume for simplicity that the company owns a single machine,
which it purchased for $20,000 on the first day of its fiscal period, and that the measurement
date occurs simultaneously with the company’s fiscal period end.
1. At the end of the first fiscal period after acquisition, assume the fair value of the machine
is determined to be $15,000. How will the company’s financial statements reflect the
asset?
2. At the end of the second fiscal period after acquisition, assume the fair value of the


reflect the asset?
Solution to 1:
At the end of the first fiscal period, the company’s balance sheet will show the asset at a
value of $15,000. The $5,000 decrease in the value of the asset will appear as a loss on the
company’s income statement.
Solution to 2:
At the end of the second fiscal period, the company’s balance sheet will show the asset at a
value of $22,000. The total increase in the carrying amount of the asset is an increase of
$7,000 ($22,000 – $15,000). Of the $7,000 increase, $5,000 goes towards reversal of a
previously reported loss and will be reported as a gain on the income statement. The other
$2,000 will bypass profit or loss and be reported as other comprehensive income and be
accumulated in equity under the heading of revaluation surplus.
5. Impairment of Assets
Impairment charges reflect an unexpected decline in the fair value of an asset to an amount
lower than its carrying amount (Whereas depreciation and amortization charges allocate the
cost of a long-lived asset over its useful life.)
Under IFRS
 An asset is impaired when its carrying value exceeds the recoverable amount.
 The recoverable amount is the greater of (fair value less selling costs) and the
(present value of expected cash flows from the asset, i.e., the value in use).
 If impaired, the asset is written down to the recoverable amount.
 Subsequent loss recoveries are allowed, but they cannot exceed the historical cost.
Under US GAAP,
 An asset is impaired if its carrying value is greater than the asset’s undiscounted
future cash flows.
 If impaired, the asset is written down to the fair value.
 Subsequent loss recoveries are not allowed.
Impairments of assets result in losses in the income statement. However, they have no
impact on the cash flow.
Example
Given the following data, what is the reported value under IFRS and US GAAP:
 Carrying amount = $8,000
 Undiscounted expected future cash flows = $9,000
 Present value of expected future cash flows = $6,000
 Fair value if sold = $7,000

 Costs to sell = $200

Solution:
IFRS: Recoverable amount = greater of ($7,000 - $200, $ 6,000) = $6,800
Impairment loss = $8,000- $6,800 = $1,200
Write down the value of asset from $8,000 to $6,800 in the balance sheet and record a loss of
$1,200 in the income statement.
US GAAP: Is the asset impaired? No, since the carrying amount of $8,000 is less than the
undiscounted future cash flows of $9,000.
Other Impairment Scenarios
Impairment of Intangible Assets with Indefinite Lives: Intangible assets with infinite lives
such as goodwill are not amortized. They are carried on the balance sheet at historical cost,
but they are tested annually for impairment.
Impairment of Long–Lived Assets Held for Sale: A long-lived asset is reclassified as held for
sale, if the management does not intend to use it any more. For example, if a company owns
a machine with the intent of using it but now intends to sell it, then it should be reclassified
as held for sale. Held-for-sale assets are not depreciated or amortized. At the time of
reclassification, the asset should be tested for impairment and any impairment loss should
be recognized.
The impairment loss can be reversed under IFRS and US. GAAP if the value of the asset
recovers in the future. However, this reversal is limited to the original impairment loss.
Therefore, the carrying value of the asset after reversal cannot exceed the carrying value
before the impairment was recognized.
6. Derecognition
A company derecognizes an asset (i.e., removes it from the financial statements) when the
asset is disposed of or is expected to provide no future benefits from either use or disposal.
The three ways in which an asset can be derecognized (removed from a company’s financial
statements) are as follows:
 Selling the asset: The difference between the sales proceeds and the carrying value
of the asset is reported as a gain or loss on the income statement.
 Abandoning the asset: The carrying value of the asset is removed from the balance
sheet and a loss is recognized in that amount in the income statement.
 Exchanging the asset: The carrying value of the old asset is compared to the fair
value of the new asset and a gain or loss is reported.
7. Presentation and Disclosures
Under IFRS, for each class of property, plant, and equipment, a company must disclose the

measurement bases, the depreciation method, the useful lives (or, equivalently, the
depreciation rate) used, the gross carrying amount, the accumulated depreciation at the
beginning and end of the period, and a reconciliation of the carrying amount at the beginning
and end of the period.
Under U.S. GAAP, the requirements are less exhaustive. A company must disclose the
depreciation expense for the period, the balances of major classes of depreciable assets,
accumulated depreciation by major classes or in total, and a general description of the
depreciation method(s) used in computing depreciation expense with respect to the major
classes of depreciable assets.
8. Investment Property
Investment property is defined as property that is owned (or, in some cases, leased under a
finance lease) for the purpose of earning rentals, capital appreciation, or both.
Under IFRS, companies are allowed to value investment properties using either a cost model
or a fair value model. The cost model is identical to the cost model used for property, plant,
and equipment, but the fair value model differs from the revaluation model used for
property, plant, and equipment. Under the fair value model, all changes in the fair value of
investment property affect net income.
Under U.S. GAAP, investment properties are generally measured using the cost model.
9. Leasing
A lease is a contract between the lessor (owner of an asset) and another party seeking the
use of assets (lessee). Lessor is the owner of the leasing asset, while the lessee is the user of
the leasing asset. The lessor grants the right of use of the asset to lessee; the right to use
could be a long period such as 20 years or a short period such as a month. In exchange for
the right to use the asset, the user makes periodic payments to the owner.
9.1. The Lease versus Buy Decision
The advantages of leasing an asset instead of purchasing it are listed below:
 Less costly financing: they require little down payment, and are often at fixed interest
rates.
 Less restrictive provisions.
 Reduces the risk of obsolescence, residual value, and disposition to the lessee because
he does not own the asset.
 Off balance sheet financing: In case of operating lease, leased assets do not appear on
the balance sheet; activity ratios and return on assets look better.
 Tax reporting advantages: In the US, firms can create a synthetic lease but treat lease
as an ownership for tax purposes.

9.2. Finance versus Operating Leases

There are two types of leases: finance and operating.
A finance lease is equivalent to the purchase of some asset (lease to own) by the buyer
(lessee) that is directly financed by the seller (lessor). The criteria for classifying a lease as a
finance lease vary under IFRS and US GAAP as outlined below:
Under previous IFRS standards: If all risks and rewards are transferred to the lessee, then
the lease is classified as a finance lease.
Under new IFRS standards: All leases of more than 12 month duration have to be recognized
on the balance sheet by the lessee; lessees can no longer classify a lease as an operating
lease. The lessor can continue to classify its lease as operating or finance lease.
Under US GAAP: If a lease satisfies any of these four conditions, then it is classified as a
finance lease:
 Ownership of the leased asset transfers to lessee at the end of the lease.
 The lease contains an option for the lessee to purchase the lease asset cheaply
(bargain purchase option).
 The lease term is 75 percent or more of the useful life of the leased asset.
 The present value of lease payments is 90 percent or more of the fair value of the
leased asset.
Accounting for a Finance Lease from a Lessee Perspective
A finance lease is similar to borrowing money and buying an asset. Following are the entries
in the financial statements by a lessee:
At inception:
 The present value of future lease payments is recognized as an asset and as a liability
on the balance sheet.
In the subsequent periods:
 Balance sheet: The carrying value of the asset decreases as the asset is depreciated
every year. Liability is reduced by an amount equal to (lease payment – interest
expense).
 Income statement: There are two types of expenses in case of a finance lease:
depreciation expense and interest payment; both are recognized in the income
statement over the term of the lease. The depreciation expense is based on the
depreciation method being used. The interest expense = liability at the beginning of
the period * interest rate.
 Statement of cash flows: The portion of the lease payment relating to interest expense
reduces operating cash flows. The portion of the lease payment that reduces the lease
liability appears as a cash outflow in the financing section.

An operating lease is an agreement allowing the lessee to use the asset for a period of time,
essentially a rental.
How a lessee reports an operating lease:
At inception: No entry (either asset or liability) is recorded at the inception of the lease
because an operating lease is similar to renting an asset.
In the subsequent periods:
 Balance sheet: No entry is recorded.
 Income statement: Rent expense equal to the lease payment is recognized in the
income statement during the lease term.
 Statement of cash flows: The full lease payment is shown as an operating cash
outflow.
The table below summarizes the impact of lease accounting on financial statements for a
lessee:
Finance lease Operating lease
Assets Higher Lower
Liabilities (current and long term) Higher Lower
Net income (early years) Lower Higher
Net income (later years) Higher Lower
Total net income Same Same
EBIT (operating income) Higher Lower
Cash flow from operation Higher Lower
Cash flow from financing Lower Higher
Total cash flow Same Same
The table below summarizes the impact of lease accounting on financial ratios:
Finance Lease Operating Lease Comments
Current ratio Lower Higher Current liability is higher for
finance lease, so ratio is lower.
For operating lease, there is no
impact on current assets and
current liabilities.
Working capital Lower Higher
Asset turnover Lower Higher
Return on assets Lower Higher
(early years)
Return on equity Lower Higher
(early years)

Debt/assets Higher Lower The percentage increase in

numerator is higher than that
of denominator making the
ratio higher.
Debt/equity Higher Lower
The discussion so far has focused on the lessee’s perspective. We will now consider the
lessor’s perspective.
Accounting and Reporting by the Lessor
For an operating lease, the lessor retains the leased asset on its balance sheet. This asset is
depreciated over time. The lease revenue and the depreciation expense are shown on the
income statement.
If a lease is categorized as a finance lease, the asset is removed from the balance sheet of the
lessor and replaced by a lease receivable. The lease receivable is equal to the present value
of future payments. Under US GAAP, there can be two types of finance leases: 1) direct
financing leases and 2) sales type leases.
Direct Financing Lease
 When the present value of lease payments is equal to the carrying value of leased
asset, it is classified as a direct financing lease.
 The lessor earns only interest revenue. There is no profit earned in the transaction.
Sales-type Lease
 When the present value of lease payments is greater than the carrying value of the
leased asset, the lease is treated as a sales-type lease.
 A profit or loss is shown on the sale of the leased asset in the year of inception.
Subsequently, lessor earns interest revenue over the life of the lease.
Under IFRS, all finance leases are treated like sales-type leases. If the present value of lease
payments is equal to the carry amount of the leased asset the profit is zero.


Summary
LO.a: Distinguish between costs that are capitalized and costs that are expensed in the
period in which they are incurred.
If an asset is expected to provide benefits only for the current period, its cost is expensed on
the income statement for that period.
If an asset is expected to provide benefits over multiple periods, its cost is capitalized on the
balance sheet and spread over the life of the asset.
LO.b: Compare the financial reporting of the following types of intangible assets:
purchased, internally developed, acquired in a business combination.
Purchased intangible assets
 The cost of a finite-lived intangible asset is amortized over its useful life.
 Indefinite-lived intangible assets are not amortized. They are tested for impairment
at least annually.
Internally developed intangible assets
 Under IFRS, research costs are expensed but development costs may be capitalized.
 Under US GAAP, both research and development costs are expensed. (Except in the
case of software created for sale to others.)
Intangible assets acquired in a business combination
 Acquired intangible assets such as patents, copyrights, and trademarks are recorded
at their fair value; similar to long-lived tangible assets.
LO.c: Explain and evaluate how capitalizing versus expensing costs in the period in
which they are incurred affect financial statements and ratios.
Capitalizing Expensing
Total assets Higher Lower
Equity Higher Lower
Income variability Lower Higher
Net income (1st year) Higher Lower
Net income (later) Lower Higher
CFO Higher Lower
CFI Lower Higher
D/E Lower Higher
Interest coverage (initially) Higher Lower
Interest coverage (later) Lower Higher
ROA and ROE (initially) Higher Lower
ROA and ROE (later) Lower Higher
LO.d: Describe the different depreciation methods for property, plant, and equipment

and calculate depreciation expense.

Three types of depreciation are:
1. Straight-Line – The cost of an asset is distributed evenly over the asset’s useful life.
2. Accelerated methods – A commonly used accelerated method is the Double-Declining-
Balance method in which cost allocated is greater in the earlier years.
3. Units-of-Production – The allocation of cost is equal to the actual use of an asset in a
particular period.
Calculating depreciation expense
Carrying amount = historical cost – accumulated depreciation
Depreciable cost = historical cost – estimated residual value
Straight-line: depreciation expense = depreciable cost / estimated useful life
DDB: depreciation expense = 2 * straight-line rate * beginning book value
Units-of-Production: depreciation expense per unit = depreciable cost/useful life in units
LO.e: Describe how the choice of depreciation method and assumptions concerning
useful life and residual value affect depreciation expense, financial statements, and
ratios.
The effect of depreciation method on financial statements and ratios is summarized in the
table below.
Straight-Line (SL) Accelerated (DDB)
Depreciation Expense Lower Higher
Net Income Higher Lower
Assets Higher Lower
Equity Higher Lower
Return on Assets (NI/Assets) Higher Lower
Return on Equity Higher Lower
Asset Turnover Lower Higher
Operating Profit Margin Higher Lower
Assumptions concerning useful life and residual value:
 Estimates required for depreciation and amortization calculations include the useful
life of the equipment and its expected residual value at the end of that useful life.
 A longer useful life and higher expected residual value result in a smaller amount of
annual depreciation relative to a shorter useful life and lower expected residual value.
LO.f: Describe the different amortization methods for intangible assets with finite
lives and calculate amortization expense.
Amortization methods for intangible assets with finite lives are same as those used in
depreciation:
 Straight-line

 Accelerated
 Units-of-production
The calculation of amortization expense is also similar to that of depreciation expense
(covered earlier).
LO.g: Describe how the choice of amortization method and assumptions concerning
useful life and residual value affect amortization expense, financial statements, and
ratios.
The choice of amortization method affects expenses, assets, equity, and financial ratios in
exactly the same way as the choice of depreciation method does.
LO.h: Describe the revaluation model.
Under the revaluation model, carrying amounts are the fair values at the date of revaluation
less any consequent accumulated depreciation or amortization.
IFRS permits the use of either the cost model or the revaluation model for the valuation and
reporting of long-lived assets, but the revaluation model is not allowed under US GAAP.
If initial revaluation resulted in a loss
 The initial loss is recognized in the income statement and any subsequent gain is
recognized on the income statement only to the extent of the previously reported
loss.
 Revaluation gains beyond the initial loss do not flow through the income statement.
They are directly recognized in shareholder’s equity as a revaluation surplus.
If the initial revaluation resulted in a gain
 The initial gain would bypass the income statement and be reported directly as a
revaluation surplus.
 Any subsequent loss would then first reduce the revaluation surplus and later flow
into the income statement.
LO.i: Explain the impairment of property, plant, and equipment and intangible assets.
Under IFRS
 An asset is impaired when its carrying value exceeds the recoverable amount.
 The recoverable amount is the greater of (fair value less selling costs) and the present
(value of expected cash flows from the asset i.e. the value in use).
 If impaired, the asset is written down to the recoverable amount.
 Subsequent loss recoveries are allowed, but they cannot exceed the historical cost.
Under US GAAP,
 An asset is impaired if its carrying value is greater than the asset’s undiscounted
future cash flows.
 If impaired, the asset is written down to the fair value.

 Subsequent loss recoveries are not allowed.

LO.j: Explain the derecognition of property, plant, equipment, and intangible assets.
The three ways in which an asset can be derecognized (removed from a company’s financial
statements) are:
 Selling the asset: The difference between the sales proceeds and the carrying value of
the asset is reported as a gain or loss on the income statement.
 Abandoning the asset: The carrying value of the asset is removed from the balance
sheet and a loss is recognized in that amount in the income statement.
 Exchanging the asset: The carrying value of the old asset is compared to the fair value
of the new asset and a gain or loss is reported.
LO.k: Explain and evaluate how impairment, revaluation, and derecognition of
property, plant, equipment, and intangible assets affect financial statements and
ratios.
Impairment
When an asset is impaired the impact in that period is:
 The value of the asset is written down.
 Activity ratios such as sales/assets are higher.
 Income is lower due to impairment expense.
 Therefore, profitability ratios are lower.
 Cash flows are not impacted (ignoring taxes).
The impact in subsequent periods is:
 Higher income because of reduced depreciation expense.
 Therefore, profitability ratios are higher.
 Activity ratios such as sales/assets are higher.
Revaluation
 An upward revaluation will increase assets and equity.
 Therefore, debt to assets and debt to equity ratios are lower.
 A downward revaluation will have the opposite effects.
 The impact on net income and profitability ratios depend on whether the revaluation
is to a value above or below cost.
Derecognition
 This can result in either a gain or loss on the income statement.
 A loss will lead to lower net income and assets.
 A gain will lead to higher net income and assets.
LO.l: Describe the financial statement presentation of and disclosures relating to
property, plant, equipment, and intangible assets.

IFRS presentation guidelines

 For each class of property, plant, and equipment, a company must disclose the
measurement bases, the depreciation method, the useful lives, the gross carrying
amount and the accumulated depreciation at the beginning and end of the period, and
a reconciliation of the carrying amount at the beginning and end of the period.
 Each class of intangible assets must disclose whether useful lives are finite or infinite.
 Impairment losses and reversal of impairment losses recognized for every asset
during the period.
U.S. GAAP presentation guidelines
 A company must disclose the depreciation expense for the period, the balances of
major classes of depreciable assets, accumulated depreciation by major classes or in
total, and a general description of the depreciation method(s) used in computing
depreciating expense with respect to the major classes of depreciable assets.
LO.m: Analyze and interpret financial statement disclosures regarding property,
plant, equipment, and intangible assets
An analyst can use financial statement disclosures to calculate the following:
Average age = accumulated depreciation/ annual depreciation expense.
Total useful life = historical cost/ annual depreciation expense.
Remaining useful life = ending PP&E/ annual depreciation expense.
LO.n: Compare the financial reporting of investment property with that of property,
plant, and equipment.
Under IFRS, companies are allowed to value investment properties using either a cost model
or a fair value model. Cost model is similar to the cost model used for property, plant, and
equipment. Under the fair value model, all changes in the fair value of the asset affect net
income.
LO.o: Explain and evaluate how leasing rather than purchasing assets affects financial
When an asset is purchased through financing, both an asset and a liability is recorded on
the balance sheet.
When we use an operating lease to purchase an asset, no asset or liability is recorded on the
balance sheet; the full lease payment is reported as a rental expense on the income
statement.
LO.p: Explain and evaluate how finance leases and operating leases affect financial
statements and ratios from the perspective of both the lessor and the lessee.
Lessor (Entity lending the asset) perspective

Operating lease
 The asset remains on the balance sheet and is depreciated.
 The lease payments are recorded as rental income.
Finance lease
 The asset is removed from the balance sheet and replaced with a lease receivable.
 The interest portion of the lease payment is recorded as interest income and the
principal repayment portion decreases the lease receivable on the balance sheet.
Lessee (Entity using the asset) perspective
Operating lease
 No asset or liability is recorded on the balance sheet.
 The entire lease payment is reported as a rental expense on the income statement
and as an operating cash flow.
Finance lease
 The leased asset is recorded on the balance sheet and depreciated over its useful life.
The present value of the lease payment is recorded as a liability and amortized over
the term of the lease.
 The interest portion of the lease payment and the depreciation of the asset are
recorded as expenses on the income statement.
 The interest portion of the lease payment is recorded as an operating cash outflow
and the principal portion is recorded as a financing cash outflow.
Compared to an operating lease, a finance lease will result in less profit for the lessee in the
early years of the lease and greater profits in the later years.

Practice Questions
1. The cost of a purchased finite-lived intangible asset:
A. is amortized over its useful life.
B. is not amortized but is tested for impairment at least annually.
C. is expensed.
2. Company A expenses assets purchased, while company B capitalizes them. All else equal,
as compared to company B, company A will have:
A. smoother earnings.
B. higher asset turnover.
C. lower cash flow from investing.
3. An analyst gathered the following information about an equipment’s expected

production life and use. The equipment was purchased for $10,000 and is expected to
have 0 salvage value at the end of its useful life.
Year 1 Year 2 Year 3 Year 4 Year 5
Units produced 1,000 1,100 900 500 500
Compared with the units-of-production method of depreciation, if the straight-line
method is used to depreciate the equipment, the depreciation expense in Year 1 will most
likely be:
A. lower.
B. higher.
C. the same.
4. In the early years of an asset’s life, as compared to straight-line depreciation, accelerated

depreciation least likely results in:
A. higher depreciation expense.
B. lower retained earnings.
C. higher return on equity.
5. Which of the following will cause a company to show a higher amount of amortization of
intangible assets under the straight-line method?
A. A lower residual value.
B. A higher residual value.
C. A longer useful life.
6. Two years ago, Company ABC purchased machinery for $10,000. At the end of last year,
the fair value of the machinery was $9,000. The fair value of the machinery at the end of
the current year is $11,000. If the company uses the revaluation model, what amount

would be recognized in its net income this year?

A. $0.
B. $1,000.
C. $2,000.
7. Which of the following assets will most likely be tested for impairment at least annually?
A. Land.
B. A patent with a legal life of 20 years.
C. A trademark with an indefinite life.
8. An analyst gathered the following information about a manufacturing equipment of XYZ,

Inc.
Fair value $160,000
Costs to sell $8,000
Value in use $140,000
Net carrying amount $190,000
The amount of impairment loss on XYZ’s income statement related to this equipment is
closest to:
A. $26,000.
B. $34,000.
C. $38,000.
9. Company A follows IFRS. Which of the following disclosures about property, plant, and
equipment would least likely be found in its financial statements and footnotes?
A. Acquisition dates.
B. Useful lives.
C. Disposal amounts.
10. Company ABC sells an intangible asset with a historical acquisition cost of $10 million
and an accumulated depreciation of $1 million and reports a loss on the sale of $2
million. Which of the following amounts is most likely the sales price of the asset?
A. $7 million.
B. $8 million.
C. $9 million.
11. ABC Inc. reported end-of-year gross PP&E and accumulated depreciation of $200 million
and $60 million respectively. Its annual depreciation expense for the current year is $10
million. The estimated remaining useful life of ABC’s PP&E is closest to:
A. 6 years.
B. 14 years.
C. 20 years.

12. An investment property is most likely to:

A. earn rent.
B. be held for resale.
C. be used in the production of goods and services.

Solutions

1. A is correct. The cost of a purchased finite-lived intangible asset is amortized over its
useful life.
2. B is correct. Company A will have lower assets. Thus, asset turnover = revenue/average
assets will be higher for company A.
3. A is correct.
Straight-line method:
original cost salvage value
Depreciation expense
depreciable life
Depreciation expense = $10,000/5 = $2000.
Units of production method:
Output during period
Depreciation expense original cost salvage value
Total output
Depreciation expense = $10,000 x 1,000/4,000 = $2,500
4. C is correct. In the early years of an asset’s life, as compared to straight-line depreciation,

accelerated depreciation results in a lower return on equity.
5. A is correct. A lower residual value results in higher total depreciable cost and, therefore,
a higher amount of amortization in the first year after acquisition.
6. B is correct. Under the revaluation model, the company will report the asset on its
balance sheet at fair value. At the end of last year, a loss of $1,000 was recorded on the
income statement. If the asset subsequently recovers in value, then any recovery to the
extent of the loss is recorded in the income statement and the excess is recognized as a
revaluation surplus in shareholder’s equity. Therefore, at the end of the current year,
$1,000 will be recorded in the income statement and $1,000 would be recorded in
shareholder’s equity.
7. C is correct. Intangible assets with indefinite lives need to be tested for impairment at
least annually. PP&E (including land) and intangibles with finite lives are only tested if
there has been a significant change or other indication of impairment.
8. C is correct.
Impairment = max (Recoverable amount; Value in use) – Net carrying amount
Impairment = max ($160,000 - $8,000; $140,000) – 190,000
= -38,000

9. A is correct. IFRS do not require acquisition dates to be disclosed.
10. A is correct.
Gain or loss on sale = Sale proceeds – Carrying amount
= Sale proceeds – (Acquisition cost – accumulated depreciation)
Sale proceeds = Gain or loss on sale + (Acquisition cost – accumulated depreciation)
Sale proceeds = -$2 million + ($10 million - $1million) = $7 million
11. B is correct.
ending net PP&E
Remaining useful life
annual depreciation expense
Remaining useful life = ($200 - $60)/ $10 = 14 years.
12. A is correct. Investment property earns rent. Inventory is held for resale. Property, plant,
and equipment are used in the production of goods and services.

R29 Income Taxes 2019 Level I Notes
R29 Income Taxes

1. Introduction
One of the key concepts we will discuss in this reading is deferred tax assets and liabilities.
Deferred tax assets and liabilities are created because of differences between how and when
transactions are recognized for financial reporting purposes relative to tax reporting.
2. Differences between Accounting Profit and Taxable Income

Some common terms related to financial reporting are defined below:
 Accounting profit: It is also known as pretax income or earnings before tax (EBT) and
appears on the income statement. In simple terms, this is before taxes are calculated.
Accounting profit is based on accounting standards.
 Income tax expense: Tax expense, or tax benefit, appears on a company’s income
statement, which is created using financial reporting standards. It is calculated based
on the accounting profit (profit before tax) using a given tax rate.
 Carrying value: The net value of an asset or liability reported on the balance sheet
according to accounting principles.
Some common terms related to tax reporting are defined below:
 Taxable income: It is the portion of income that is subject to income taxes under the
tax laws where the company is operating.
 Income tax payable: Income tax payable is calculated on a company’s taxable income
using the applicable tax rate. This is the amount that is generally paid to the tax
authorities and it appears on the balance sheet. Since it results in a cash outflow,
firms minimize taxes payable by showing higher expenses and lower taxable income.
 Tax Base of an Asset: Tax base of an asset is the amount that will be deductible for tax
purposes in future periods as economic benefits are realized. It is used to calculate
tax payable and is analogous to the carrying amount (net book value) concept. Tax
base is the amount allocated to asset for tax purposes whereas carrying amount is
based on accounting principles.
Why are accounting profit and taxable income different?
Both report income before deducting tax expense, yet they are different because accounting
profit is based on accrual method of accounting (revenues reported when earned and
expenses when incurred). On the other hand, taxable income is usually based on cash-basis
accounting (revenue recognized when cash is collected and expense reported when cash is
paid).
Accounting profit and taxable income differ when:
 Revenues and expenses are recognized in one period for accounting purposes and a

different period for tax purposes.

 The carrying amount and tax base of assets/liabilities differ.
 Gain/loss of assets/liabilities in the income statement is different than tax return.
 Some revenues/expenses recognized in the income statement are not considered for
tax purposes.
The following table shows the distinction between accounting profit/ taxable income and
income tax expense/taxes payable.
Income Statement for Everest Inc. Tax Return for Everest Inc.
$ million 2011 2012 $ million 2011 2012
Revenue 100 100 Revenue 100 100
Cash Expenses 50 50 Cash Expenses 50 50
Depreciation (SL) 25 25 Depreciation (Acc) 40 10
Accounting profit 25 25 Taxable income 10 40
Income tax expense (40%) 10 10 Taxes payable (40%) 4 16
Profit after tax 15 15 Profit after tax 6 24
The following table summarizes the analogous financial and tax reporting terms:
Financial reporting Tax Reporting
Accounting profit Taxable income
Tax expense Income tax payable
Carrying amount Tax base
Deferred tax liabilities
Deferred tax liability (DTL) occurs when income tax expense (financial accounting) is
greater than income tax payable. It is a liability because we pay less tax now, thereby
creating a liability or an obligation to pay more in the future. Since the tax will be paid later,
it is deferred.
Such a situation can happen when:
 Revenue is recognized on income statement before being included on tax return
(accrued/unbilled revenue).
 Expenses are tax deductible before being recognized on income statement.
For example, in the sample income statement and tax return shown for Everest Inc, at the
end of 2011, the income tax expense (10) is greater than the income tax payable (4), hence a
DTL of 6 (10 - 4) will be recorded on the balance sheet. At the end of 2012, the DTL is
reversed and it increases taxes payable by 6.


Deferred Tax Assets

Deferred tax assets (DTA) arise when income tax payable is temporarily greater than income
tax expense. In other words, taxable income is higher than accounting profit. Since tax is paid
in advance, it is considered an asset; it can be viewed as a prepaid expense.
Such a situation can happen when:
 Revenue is taxed before being recognized on income statement (unearned revenue).
 Expense is recognized on the income statement before being tax deductible.
Consider the following income statement and tax return for Atlas Inc.
Income Statement for Atlas Inc. Tax Return for Atlas Inc.
$ million 2011 2012 $ million 2011 2012
Cash Expenses 50 50 Cash Expenses 50 50
Accounting profit 50 50 Taxable income 70 30
Income tax expense (40%) 20 20 Taxes payable (40%) 28 12
At the end of 2011, since the income tax payable (28) is greater than the income tax expense
(20), a DTA of 8 (28 - 20) will be recorded on the balance sheet. At the end of 2012, the DTA
is reversed and it brings down taxes payable by 8.
Any deferred tax asset or liability is the result of a temporary difference that is expected to
reverse in the future. Deferred tax liability reverses when taxes are paid in the future
resulting in cash outflows. Similarly, deferred tax asset reverses when tax benefits are
realized in the future resulting in lower cash outflows.
Under IFRS, deferred tax assets and liabilities are classified as non-current.
Under US GAAP, they are classified based on the classification of the respective asset or
liability.
Tax Base of an Asset
Asset tax base is the value of an asset according to tax rules and is used to calculate tax
payable. Asset tax base is analogous to carrying amount (net book value).
Example
An asset is purchased for 50 and is depreciated over two years. On the financial statements
the depreciation is 25 and 25. According to tax rules the depreciation is 40 and 10. Show the
carrying amount and tax base at T=0, T=1, and T=2.

Time period Carrying Amount (Financial Reporting) Tax Base (Tax reporting)
T=0 50 50
T=1 25 10
T=2 0 0
Link between Tax Base and DTL
Deferred tax liability = (Carrying amount – Tax base) x Tax rate
Assuming a 40% tax rate for the above example,
At T = 1: DTL = (25 - 10) x 0.4 = 6
At T = 2: DTL = (0 - 0) x 0.4 = 0
Instructor’s Note
If the carrying amount and tax base are the same then DTL is 0. If the carrying amount is
greater than the tax base, then there will be a deferred tax liability. If carrying amount is less
than the tax base, then there will be a deferred tax asset.
Both DTL and DTA should be measured at the tax rate which is expected to apply when the
liability is settled (reversed).
Link between Income Tax Expense, Tax Payable, and DTL
Income tax expense = Income tax payable + Change in net DTL
where net DTL = DTL – DTA and change in net DTL is the ending value of net DTL –
beginning value of net DTL.
Example
In 2015, the income tax payable for a certain company is 100. During the year, DTL increased
from 20 to 25 and DTA increased from 0 to 10. What is the provision for income tax in 2015?
Solution:
ITE = ITP + ∆DTL – ∆DTA = 100 + 5 – 10 = 95
3. Determining the Tax Base of Assets and Liabilities

3.1. Determining the Tax Base of an Asset
Asset tax base is the amount that will be deductible for tax purposes in future periods as the
economic benefits become realized.


Examples:
Item Carrying Tax Base Temporary
Amount Difference
An asset is purchased for 50; for year 1
depreciation = 25 on income statement and 40 for 25 10 15
tax purposes.
Capitalized development cost = 100 at the start of
the year. During the year 30 was amortized.
70 75 -5
For tax purposes only 25% amortization is
allowed.
Research cost for the year = 100; entire cost was
expensed. 0 80 -80
Tax rules require cost to be spread over 4 years.
Gross accounts receivable = 100
Provision for doubtful debt = 10%. 90 80 10
Tax authorities allow 20%.
3.2. Determining the Tax Base of a Liability
The tax base of a liability is the carrying amount of the liability less any amounts that will be
deductible for tax purposes in the future.
Example:
Item Carrying Tax Base Temporary
Amount Difference
Customer payments received in advance = 50
50 0 50
Amount is taxable.
Since the customer pays 50 in advance. A liability called unearned revenue is created on the
accounting side making the carrying amount of the liability to 50. On the tax side, 50 is
shown as revenue and taxes are paid for the same. So tax base is 0 and carrying amount is
50.
3.3. Changes in Income Tax Rates
The measurement of deferred tax assets/liabilities is based on current tax law. But, if there is
any subsequent change in tax laws or new income tax rates, then existing deferred tax assets
and liabilities must be adjusted to reflect those changes. When income tax rate changes,
deferred tax assets and liabilities are calculated based on the new tax rate.
Let us take an example to see what happens to DTL. Assume the carrying amount of an asset
is 25 and its tax base is 10. When the tax rate is decreased from 40% to 30%, the effect on
DTL is:

DTL old rate carrying amount – tax base x tax rate 25 10 x 0.4 6
DTL new rate 25 10 ∗ 0.3 4.5
DTL changes from 6 to 4.5.
Relationship between tax rate, DTL, and DTA
 Decrease in tax rate reduces both deferred tax liabilities and deferred tax assets.
 Increase in tax rate increases both deferred tax liabilities and deferred tax assets.
Example
Firm A has a net deferred tax liability. The government announces a decrease in the
statutory tax rate. Will this change benefit the income statement and balance sheet?
Solution:
If the government announces a decrease in the statutory tax rate, it will cause the net DTL to
decrease. A lower tax rate causes the tax expense to decrease and, consequently, the net
income and equity to increase.
4. Temporary and Permanent Differences between Taxable and

Accounting Profit
Permanent differences are differences between tax and financial reporting of revenue
(expenses) that will not be reversed at some future date. These differences do not give rise
to DTLs and DTAs. Examples include:
 Income or expense items not allowed by tax legislation. One example that leads to a
permanent difference is when a company incurs a penalty or fine on breaking a civil
or criminal law.
 Tax credits for some expenditures that directly reduce taxes.
As no deferred tax item is created for permanent differences, all permanent differences
result in a difference between the company’s effective tax rate and statutory tax rate.
Income tax expense
Reported effective tax rate
Pretax income
Example
In 2012, Acme’s provision for income tax was 20 against an EBT of 100. In the same year, the
tax payable was 25 and the taxable income was 110. What was Acme’s effective tax rate for
2012?
Solution:
Effective tax rate = 20/100 = 20%
Temporary differences between taxable and accounting profit arise from a difference
between the tax base and the carrying amount of assets and liabilities. DTLs and DTAs are

only created if there is temporary difference which is expected to reverse in the future.
Some examples of situations that lead to temporary differences in carrying amount and tax
base are listed below:
Temporary differences between carrying amount and tax base
Balance Carrying amount vs. DTL or DTA Example
Sheet Item Tax Base
Asset Carrying amount > Tax DTL Straight-line depreciation for
Base accounting profit. Accelerated
depreciation for taxable profit.
Asset Carrying amount < Tax DTA Research cost expensed for
Base accounting profit.
Amortized for tax.
Liability Carrying amount > Tax DTA Cash from customers before
Base revenue recognition.
Cash from customers is taxed.
Liability Carrying amount < Tax DTL
Base
Instructor’s Note
Remember the first relation for how a DTL is created for an asset. Everything else follows.
5. Unused Tax Losses and Tax Credits

Tax loss carry forward occurs when a company experiences a loss in the current period that
may be used to reduce future taxable income. Tax loss carry forward reduces the taxes paid
in future.
Let us take an example. Assume, in 2011 Acme Inc. records revenue of $500,000 and
operating expenses of $750,000. It pays taxes at the rate of 25%. The company’s net
operating income for 2011 was -$250,000. Since the net operating income was negative,
Acme would not pay any taxes for 2011. Now, assume in 2012, the company turns profitable
and records $500,000 of taxable income. Instead of paying a tax of 0.25 * 500,000 =
$125,000, the company may choose to use the tax loss carry forward of -250,000 this year.
This reduces the taxable income to 250,000 * 0.25 = $62,500.
Tax credit is the amount that a taxpayer can deduct from the tax owed. Governments may
grant a tax credit to promote a specific behavior. For example, to promote growth in the
rural areas the government may give tax credits encouraging companies to set up factories.
Deferred tax assets may arise from unused tax losses and tax credits.
Often, the tax loss carry forward and tax credits can be used only up to a certain time period

in the future. If the company expects to be profitable in the future periods like we saw for
Acme Inc. in 2012, it would be prudent to recognize tax loss carry forward. Instead, if it
anticipates losses in the future periods, recognizing tax loss carry forward would be
rendered useless.
IFRS allows recognition of unused tax losses and tax credits only to the extent that it is
probable that in the future there will be taxable income against which unused tax losses and
credits can be applied. Under US GAAP, a deferred tax asset is recognized in full but is
reduced by a valuation allowance if it is unlikely that the benefit will be realized.
A few guidelines to assess the probability a firm will be sufficiently profitable in the future
are listed below:
 If there is uncertainty as to the probability of future taxable benefits, a deferred tax
asset as a result of unused tax losses or credits is only recognized to the extent of the
available taxable temporary difference.
 Assess the probability that the entity will in fact generate future taxable profits before
the unused tax losses and/or credits expire pursuant to tax rules regarding the carry
forward of the unused tax losses.
 Determine whether the past tax losses were a result of specific circumstances that are
unlikely to be repeated.
 Discover if tax planning opportunities are available to the entity that will result in
future profits. These might include change in tax legislation that is phased in over
more than one financial period to the benefit of the entity.
Instructor’s Note
If a tax credit directly reduces taxes, a permanent difference is created between tax expense
and tax payable. A permanent difference does not lead to a deferred tax asset or liability. If a
tax credit reduces taxes presumably in future periods, then a deferred tax asset would have
been created. This is again assuming there is a probability for the company to be profitable
in the future.
6. Recognition and Measurement of Current and Deferred Tax

The amount of current tax payable or refundable from tax authorities is based on the
applicable tax rates at the balance sheet date. Deferred taxes should be measured at the tax
rate applicable when the asset is realized or the liability is settled. In short, the tax rate at the
time when the reversal in temporary difference (taxable income and profit before tax)
occurs.
Let’s illustrate the current tax and deferred tax concepts with the help of a simple example.
The tax applicable for Period 1 is 30% and the government has announced the tax for Period
2 will be reduced to 25%. Current tax will use 30% while deferred tax will be calculated

using 25%.
All unrecognized deferred tax assets and liabilities must be reassessed on the appropriate
balance sheet date and should be measured against their probable future economic benefit.
In the example above, at the end of period 1 the profitability in future, and beyond period 2,
must be assessed to see if DTA/DTL can be recognized.
Measurement of DTL
The treatment of deferred tax liability is discussed below:
 DTL should be classified as debt if the liability is expected to reverse in the future
when taxes are paid.
 If it is determined that a DTL will not be reversed, then DTL should be reduced and
the amount by which it is reduced should be treated as equity. There is no cash
outflow expected in the future. Assume for Period 1 in the example above there is a
DTL because of the different depreciation methods used for accounting and tax
reporting purposes. Also assume the company is expected to grow at a rate of 30% in
the foreseeable future, making the depreciation amounts higher with no reversal in
sight. In such cases, the liability will be treated as equity.
 If there is uncertainty about the timing and amount of tax payments, analysts should
treat DTLs as neither liabilities nor equity.
Measurement of DTA and Valuation Allowance
If it is determined that the DTA will not be realized because of insufficient future taxable
income to recover the tax asset, then the DTA must be reduced.
Under US GAAP, a DTA is reduced by creating a valuation allowance (a contra account). DTA
and net income decrease in the period in which a valuation allowance is established. DTA
can be revalued upward by decreasing the valuation allowance which would increase
earnings.
Instructor’s Note
For the exam, you may think of valuation allowance in terms of depreciation. When
depreciation expense goes up, net income comes down. Similarly, if valuation allowance goes
up, net income comes down. Depreciation is shown as an expense on the income statement.
Similarly, an increase in valuation allowance is shown as a loss on the income statement.
Example
Rocky Inc. a US-based company, reports the following information:
2014 2015
Deferred tax asset 100 100
Valuation allowance 25 20

Deferred tax asset, net of valuation allowance 75 80

Deferred tax liability 70 70
Net deferred tax asset 5 10
Tax rate 40% 40%
1. What does the decrease in valuation allowance imply about future profitability?
2. How does the reduction in valuation allowance impact income tax expense and net
income?
3. What is the impact on deferred taxes if the tax rate is reduced to 35%?
Solution to 1:
The decrease in valuation allowance implies that the company is more likely to benefit from
the deferred tax asset. This is probably because the company expects higher profitability in
the future.
Solution to 2:
The reduction in valuation allowance causes the tax expense to be lower and the net income
to be higher.
Solution to 3:
If the tax rate is reduced from 40% to 35% that reduces both the deferred tax asset and
deferred tax liability. Since the company has a net deferred tax asset, a reduction in the tax
rate will cause the net deferred tax asset to be lower. Consequently, the equity value will
also decrease.

Instructor’s Note
If the valuation allowance is equal to the deferred tax asset, this implies that a company
expects no taxable income prior to the expiration of the deferred tax asset.
When a company decreases the valuation allowance, it implies a higher probability that the
deferred tax asset will benefit the company.
7. Presentation and Disclosure

Key points of this section are listed below:
 Deferred tax assets and liabilities must be disclosed.
 Under IFRS, deferred tax assets or liabilities are classified as non-current.
 Under US GAAP, the classification (current versus non-current) is based on the
underlying asset or liability.
 The deferred tax asset and deferred tax liability amount should be shown on the
balance sheet. But, details of how we arrive at the number should be disclosed in the

footnotes.
Here is an example of what might be disclosed in the footnotes:
Deferred tax assets:
Accrued Expenses 10
Tax loss carry forward 11
Deferred tax assets 21
Valuation allowance -1
Net deferred tax asset 20
Deferred tax liabilities:
Depreciation 30
Retirement plans 15
Deferred tax liabilities 45
8. Comparison of US GAAP and IFRS

Note: This section is not very testable. Only the important points are highlighted below.
This section details the similarities and differences in the treatment of income taxes between
US GAAP and IFRS. Accounting treatment of income taxes under US GAAP and IFRS are
similar in most respects. Some notable differences include:
 Upward revaluation is prohibited under US GAAP. It is permitted under IFRS and the
deferred taxes are recognized as equity.
 Under IFRS, DTA/DTLs are classified as non-current on the balance sheet. Under US
GAAP, they are classified as current or non-current based on the classification of the
underlying asset or liability for financial reporting.
 Valuation allowance is used by US GAAP. Under IFRS, a DTA is recognized if it is probable
that the taxable profit in future will be sufficient enough to use the temporary difference.
Whereas under US GAAP, a deferred tax asset is recognized in full but reduced by
valuation allowance if it is likely that a deferred tax asset will not be realized.

Summary
LO.a: Describe the differences between accounting profit and taxable income, and
define key terms, including deferred tax assets, deferred tax liabilities, valuation
allowance, taxes payable, and income tax expense.
Accounting profit: This is the pretax income from the income statement. It is based on
accounting standards.
Taxable income: This is income subject to tax. It is based on the tax return.
Deferred tax assets: They are created when income tax payable is greater than income tax
expense, provided the difference is temporary and expected to reverse in future periods.
Deferred tax liabilities: They are created when income tax expense is greater than income
tax payable, provided the difference is temporary and expected to reverse in future periods.
Valuation allowance: It is a contra account to the DTA account. It is used to reduce DTA
based on the probability that future tax benefits will not be realized.
Taxes payable: It is a liability on the balance sheet calculated using taxable income.
Income tax expense: It is an expense recognized in the income statement, which includes
taxes payable and changes in deferred tax assets and liabilities.
Income Tax Expense = Income Tax Payable + ΔDTL - ΔDTA
LO.b: Explain how deferred tax liabilities and assets are created and the factors that
determine how a company’s deferred tax liabilities and assets should be treated for
the purposes of financial analysis.
Deferred tax liabilities are created when:
 Income tax expense is greater than taxes payable.
 This can occur if revenues are recognized on the income statement before being
included on the tax return (e.g. credit sales).
 Or expenses are tax deductible before they are recognized on the income statement.
Deferred tax assets are created when:
 Taxes payable are greater than income tax.
 This can occur if revenues are taxable before they are recognized in the income
statement (unearned revenue).
 Or when expenses are recognized in the income statement before they are tax
deductible.
If deferred tax liabilities are expected to reverse in the future they can be classified as
liabilities. If they are not expected to reverse in future, they can be classified as equity.
LO.c: Calculate the tax base of a company’s assets and liabilities.

Tax base of assets is the amount that will be deductible for tax purposes in future periods as
the economic benefits become realized. Suppose the capitalized development cost = 100 at
the start of the year. During the year, 30 was amortized. For tax purposes, only 25%
amortization is allowed. At the end of year, the carrying amount will be 70 (100-30) but tax
base will be 75 (100-25).
Tax base of a liability is the carrying amount of the liability less any amounts that will be
deducted for tax purposes in the future. Suppose the customer pays 50 in advance. A liability
called unearned revenue is created on the accounting side making the carrying amount of
the liability to 50. On the tax side, 50 is shown as revenue and taxes are paid for the same. So
tax base is 0 and carrying amount is 50.
LO.d: Calculate income tax expense, income taxes payable, deferred tax assets, and
deferred tax liabilities, and calculate and interpret the adjustment to the financial
statements related to a change in the income tax rate.
In the table below, what you see on the right is the actual tax paid and to the left is the
income tax expense. Tax paid at the end of 2011 is $4 which is less than the obligation to pay,
i.e., $10. Extra $6 in taxes which is not paid becomes the deferred tax liability; so, at the end
of 2011 DTL is 6. At the end of 2012, the total tax paid is 16 and the DTL of 6 from 2011
reverses to 0. (If tax paid is more than the obligation to pay, deferred tax asset is created.)
Accounting profit (Financial Reporting) Taxable Income ( Tax Reporting)
2011 2012 2011 2012
Cash expenses 50 50 Cash expenses 50 50
Depreciation (SL) 25 25 Depreciation 40 10
(Acc. Dep.)
Profit before tax 25 25 Taxable Income 10 40
Tax expense 10 10 Tax payable 4 16
LO.e: Evaluate the impact of tax rate changes on a company's financial statements and
ratios.
If there is any change in tax laws or new income tax rates, then existing deferred tax assets
and liabilities must be adjusted to reflect those changes.
Decrease in tax rate reduces both deferred tax liabilities and deferred tax assets.
Increase in tax rate increases both deferred tax liabilities and deferred tax assets.
LO.f: Distinguish between temporary and permanent differences in pretax accounting
income and taxable income.

Permanent differences => Effective tax rate ≠ Statutory Tax rate

Reported effective tax rate = Income tax expense/ Pretax Income
Temporary differences between carrying amount and tax base
Item Carrying amount vs. Tax DTL/DTA Example
Base
Asset Carrying amount > Tax Base DTL Straight-line depreciation for
accounting profit. Accelerated
depreciation for taxable profit.
Asset Carrying amount < Tax Base DTA Research cost expensed for
accounting profit.
Amortized for tax.
Liability Carrying amount > Tax Base DTA Cash from customers before
revenue recognition.
Cash from customers is taxed.
Liability Carrying amount < Tax Base DTL
LO.g: Describe the valuation allowance for deferred tax assets—when it is required
and what impact it has on financial statements.
If DTA will not be realized because of insufficient future taxable income to recover the tax
asset, then the DTA must be reduced. Under U.S. GAAP, a DTA is reduced by creating a
valuation allowance (a contra account). DTA and net income decrease in the period in which
a valuation allowance is established. DTA can be revalued upward by decreasing the
valuation allowance, which would increase earnings.
LO.h: Explain recognition and measurement of current and deferred tax items.
Deferred tax is created when there is a temporary difference between the earnings before
tax of a company and the taxable income. Deferred tax can take the form of an asset or a
liability. For instance, a different depreciation method can result in a deferred tax item.
LO.i: Analyze disclosures relating to deferred tax items and the effective tax rate
reconciliation, and explain how information included in these disclosures affects a
company’s financial statements and financial ratios.
Key points of presentation and disclosure are listed below:
 Deferred tax assets and liabilities must be disclosed.
 Under IFRS, deferred tax assets or liabilities are classified as non-current.
 Under U.S. GAAP, the classification (current versus non-current) is based on the
underlying asset or liability.
 The deferred tax asset and deferred tax liability amount should be shown on the
balance sheet. But, details of how we arrive at the number should be disclosed in the

footnotes.
LO.j: Identify the key provisions of and differences between income tax accounting
under IFRS and U.S. GAAP.
Accounting treatment of income taxes under U.S. GAAP and IFRS are similar in most
respects. Some notable differences include:
 Upward revaluation is prohibited under U.S. GAAP. It is permitted under IFRS and the
deferred taxes are recognized as equity.
 Under IFRS, DTA/DTLs are classified as non-current on the balance sheet. Under U.S.
GAAP, they are classified as current or non-current based on the classification of the
underlying asset or liability for financial reporting.
 Valuation allowance is used by U.S. GAAP. Under IFRS, a DTA is recognized if it is
probable that the taxable profit in future will be sufficient enough to use the
temporary difference. Whereas under U.S. GAAP, a deferred tax asset is recognized in
full but reduced by valuation allowance if it is likely that a deferred tax asset will not
be realized.

Practice Questions
1. In the current year, a company increased its deferred tax liability by $10,000. During the
year, the company most likely:
A. became entitled to a $10,000 tax refund.
B. had permanent differences between accounting profit and taxable income.
C. reported a higher accounting profit than taxable income.
2. Analysts should treat deferred tax liabilities that are not expected to reverse as:
A. equity.
B. liabilities.
C. neither equity nor liabilities.
3. During its first year of operations, a company generated a taxable income of -$20,000.
The current tax rate is 30%. Which of the following would be most likely reported on the
company’s balance sheet?
A. DTA of $6,000.
B. DTL of $6,000.
C. DTA of $20,000.
4. If the carrying value of an asset is lower than its tax base and a reversal is expected in
future:
A. a deferred tax asset is created.
B. a deferred tax liability is created.
C. neither a deferred tax asset nor a deferred tax liability is created.
5. A company incurs a capital expenditure that can be amortized over four years for
accounting purposes, but over three years for tax purposes. The company will most likely
record:
A. a deferred tax asset.
B. a deferred tax liability.
C. neither a deferred tax asset nor a deferred tax liability.
6. A company receives an advance payment from a customer that is immediately taxable.

This advance will not be recognized for accounting purposes until the company fulfils its
obligation. The company will most likely record:
A. a deferred tax asset.
B. a deferred tax liability.
C. neither a deferred tax asset nor a deferred tax liability.
7. The following information is available about a company:

(all figures in $ thousands) 2015 2014

Deferred tax assets 500 400
Deferred tax liabilities 350 300
Taxes payable 2000 1800
The company’s 2015 income tax expense (in thousands) is closest to:
A. $1,800.
B. $1,950.
C. $2,050.
8. A decrease in the tax rate causes the balance sheet value of a deferred tax asset to:
A. increase.
B. decrease.
C. remain unchanged.
9. A company incurred an accounting expense of $100,000 that cannot be deducted for

income tax purposes. This will most likely result in:
A. an increase in deferred tax assets.
B. an increase in deferred tax liabilities.
C. no change to deferred tax assets and liabilities.
10. Company ABC presents its financial statements in accordance with US GAAP. In 2015,
ABC reported a valuation allowance of $1,000 against total deferred tax assets of
$20,000. In 2014, ABC reported a valuation allowance of $1,200 against total deferred tax
assets of $18,000. Which of the following statements best describes the expected
earnings of the firm? Earnings are expected to:
A. increase.
B. decrease.
C. remain relatively stable.


Solutions
1. C is correct. Deferred tax liabilities represent taxes that have not yet been paid (because
of the lower taxable income) but have been recognized on the income statement
(because of the higher accounting profit).
2. A is correct. If the DTL will not reverse, there will be no required tax payment in the
future and the “liability” should be treated as equity. If the DTL is expected to reverse it is
treated as a liability. When both the amount and the timings of tax payments resulting
from a reversal of DTL are uncertain, it is excluded from both debt and equity.
3. A is correct. The tax loss carry-forward will result in a DTA, which is equal to loss
multiplied by the tax rate.
DTA = $20,000 x 30% = $6,000.
4. A is correct. If the carrying value of an asset is lower than its tax base a deferred tax asset
is created. Taxable income will be lower in future when the reversal happens.
5. B is correct. Because of more rapid amortization for tax purposes, the tax base will be
lower than the carrying value of the asset. The result will be a deferred tax liability.
6. A is correct. The advances represent a liability for the company. The tax base is equal to
the carrying value minus any amounts that will not be taxed in future. Since the advance
has already been taxed, the tax base of the advance is 0. The carrying value of the
liability exceeds the tax base. A deferred tax asset arises when the carrying value of a
liability exceeds its tax base.
7. B is correct.
Income tax expense = Taxes payable + Δ DTL – Δ DTA
Income tax expense = 2,000 + (350 - 300) – (500 - 400) = 1,950
8. B is correct. When a firm’s tax rate decreases, DTA and DTL both decrease to reflect the
new rate.
9. C is correct. Accounting expenses that are not deductible for tax purposes result in a
permanent difference, and thus do not give rise to deferred taxes.
10. A is correct. The valuation allowance is taken against deferred tax assets to represent
uncertainty that future taxable income will be sufficient to fully utilize the assets. By
decreasing the allowance, ABC is signaling greater likelihood that future earnings will be
offset by the deferred tax asset, i.e., the future earnings are expected to increase.

R30 Non-Current Liabilities 2019 Level I Notes
R30 Non‐Current Liabilities

1. Introduction
Non-current liabilities are long-term liabilities that are due after one year or more in the
future. They are on the right-hand side of the balance sheet. Common non-current liabilities
include bonds payable, notes payable, finance leases, pension liabilities, and deferred tax
liabilities. This reading focuses on bonds payable and leases.
2. Bonds Payable
2.1. Accounting for Bond Issuance
Bonds are contractual promises made by an entity to pay cash in the future to its lenders
(bondholders) in exchange for receiving cash in the present. In simple terms, bonds are a
form of long-term borrowing. The terms of a bond contract are defined in a document called
an indenture. Bonds usually make two types of payments: principal repayment (face value)
and periodic interest payments.
Some of the common terms associated with a bond are described below:
 Face value or par value: This is the amount of cash payable by the bond-issuing entity
to the bondholders when the bond matures.
 Coupon rate: This is the interest rate promised in the contract based on which
periodic interest payments are calculated.
 Coupon payment: The periodic interest payment is known as the coupon payment.
The coupon amount is based on the face value and the coupon rate. Consider a bond
with a face value of 1,000 which makes annual payments. If the coupon rate is 10%,
the annual coupon amount will be 10% of 1,000 = 100.
 Effective interest rate: It is the market interest rate (or the rate demanded by
investors) when a bond is issued. This rate is not documented on the bond indenture.
If the effective interest rate is equal to the coupon rate, a bond is issued at par value.
This scenario is illustrated below.
Relationship between coupon rate and effective interest rate
 A bond is issued at face value when coupon rate = effective interest rate.
 A bond is issued at a discount if coupon rate < effective interest rate.
 A bond is issued at a premium if coupon rate > effective interest rate.
We will now look at examples for each of the three cases.
Example (Bonds issued at face value)
The terms of a bond (issuer’s obligations) are given below:
Face value (par value) = 100
Issue Date = 1 January, 2016
Maturity Date = 31 December, 2018

Coupon rate = 10% paid annually

If the investor’s required return at issuance (effective interest rate) is 10%, then calculate
the sales proceeds. State how the bond issuance is reflected in the financial statements.
Solution:
Let us start with the cash flow which is illustrated below throughout the bond’s life:
The bond’s tenure is 3 years. The effective interest rate or the market interest rate is 10%.
The cash flow at the end of Year 1 is calculated as coupon rate * face value = 0.1 * 100 = 10.
Similarly, the cash flow at the end of Year 2 and Year 3 is also 10. At the end of Year 3 (bond’s
life), there is an additional cash flow of 100 equal to the face value of the bond.
To calculate the amount the investor pays now, the cash flows at the end of each period are
discounted at the required rate of return (effective interest rate) of 10%. Using a financial
calculator, calculate the present value as:
N = 3; I = 10; PMT = 10; FV = 100; CPT PV = 100.
I = 10 is the required rate of return. In this case, coupon rate = required rate of return.
The investor must pay the company 100 to earn 10% on the bond over 3 years.
Effect of bond issuance on the financial statements:
Balance sheet: Cash goes up by 100; Bond payable goes up by 100.
Cash flow statement: Issuance of the bond is shown as cash flow from financing.
Income statement: Initially, there is no effect on the income statement.
Example (Bonds issued at a discount)

Issue date = 1 January, 2016
When the bond is issued, the investor’s required return is 11%. What are the sales proceeds?
How is the issuance reflected in the financial statements?
Solution:
Let us understand why investors require a return of 11% here, which is higher than the
coupon rate. Investors demand a higher return if they perceive the company to be risky. The

cash flows are the same as in the previous example.
The present value can be calculated as:

N = 3; I = 11; PMT = 10; FV = 100; CPT PV = 97.56.
In order to receive a higher return, an investor pays less than the face value, in this case
97.56 compared to 100, to earn 11% return.
Balance sheet: Cash goes up by 97.56; Bond payable goes up by 97.56.
Cash flow statement: Cash inflow of 97.56. Issuance of the bond is shown as cash flow from
financing.

Example (Bonds issued at a premium)
When the bond is issued, the investor’s required return is 9%. What are the sales proceeds?
How is the issuance reflected in the financial statements?
Solution:
The cash flow is the same as in the previous two cases. Investors earn coupon amount based
on coupon rate. Since investors will receive a higher rate of return than the market rate,
they are willing to pay more.
N = 3; I = 9; PMT = 10; FV = 100; CPT PV = 102.53
Balance sheet: Cash goes up by 102.53; Bond payable goes up by 102.53.
Cash flow statement: Cash inflow of 102.53. Issuance of the bond is shown as cash flow from
financing.

2.2. Accounting for Bond Amortization, Interest Expense, and Interest Payments
In this section, we look at how the bond is shown on the balance sheet, and how the coupon
payments are accounted for.
Amortization of a Bond
When a bond is issued, most companies report the historical cost and amortize the
discount/premium over the life of the bond. The amortized cost is reported on the balance
sheet, which is the historical cost plus or minus the cumulative amortization.
Accounting Treatment for Bonds at Issuance
Initially, bonds are reported as a liability on the balance sheet. This amount on the balance
sheet is known as the carrying value or book value of the bond.
Under both IFRS and US GAAP the amount of sales proceeds minus issuance costs is reported
on the balance sheet.
Example (Amortizing a bond discount)
Terms of the bond are given below:
When the bond is issued, investors require a return of 11%. Show the following:
1. Interest Payments
2. Interest Expense
3. Reported Bond Value
How are the above numbers reflected in the financial statements?
Solution:
To identify if a bond was sold at par, premium, or discount, one needs to know the prevailing
market interest rate when the bond was issued. Since the market interest rate/required
return 11% is greater than the coupon rate, the bond was sold at a discount. Let us see how
the values for each item are arrived at for 2016:
Carrying amount = Present value of the bond or the amount the investor pays initially. We
calculated this to be 97.56 in the earlier example.
Interest expense = Carrying amount * required return = 97.56 * 0.11 = 10.73
Interest payment = Face value * coupon rate = 100 * 0.1 = 10
Amortization of discount = Interest expense – interest payment = 10.73 - 10 = 0.73
Carrying amount (end) = Beginning carrying amount + amortization of discount = 97.56 +

0.73 = 98.29
Year Carrying Interest Interest Amortization of Carrying
Amount Expense Payment Discount Amount
(Begin) (End)
2016 97.56 10.73 10 0.73 98.29
2017 98.29 10.81 10 0.81 99.10
2018 99.10 10.90 10 0.90 100.00
Effect on financial statements:
Balance Sheet: The carrying amount in the beginning for the bond is 97.56. At the end of Year
1, the liability is 98.29, 99.10 at the end of Year 2 and 100.00 at the end of Year 3.
Income Statement: The interest expense is shown in the income statement which is 10.73 for
Year 1, and 10.81 and 10.90 for the subsequent years. Though the actual interest paid is only
10, the required return of 11% should be shown on the income statement.
Cash Flow Statement: The actual cash flow for each year is 10. Under US GAAP, interest paid
must be classified as CFO. IFRS allows interest paid to be treated as either CFO or CFF.
Amortization of discount is a non-cash item. It only affects the taxable income.

Example (Amortizing a bond premium)
Terms of the bond are given below:
1. Interest Payments
2. Interest Expense
3. Reported Bond Value
Solution:
Since the required return is less than the coupon rate, the bond is sold at a premium. The
individual items are calculated the same way as for a discount bond.
Year Carrying Interest Interest Amortization Carrying

Amount Expense Payment of Premium Amount
(Begin) (End)
2016 102.53 9.23 10 -0.77 101.76
2017 101.76 9.16 10 -0.84 100.92

2018 100.92 9.08 10 -0.92 100.00

Based on the above example, we can infer the following points:
Bonds Issued at Par:
 Periodic interest expense is equal to the periodic interest payment to bondholders.
Bonds Issued at a Premium:
 Initially, the carrying amount of the bonds is greater than the face value and as the
premium is amortized, the carrying amount decreases to the face value.
 Interest expense will be less than the coupon payment.
 Interest expense = interest payment - amortization of premium
Bonds issued at a Discount:
 Initially, the carrying amount of the bonds is less than the face value and as the
discount is amortized, the carrying amount increases to the face value.
 Interest expense will be higher than the coupon payment.
 Interest expense = interest payment + amortization of discount
Amortization of a Zero‐Coupon Bond
A zero-coupon bond is a type of a discount bond that does not make any coupon or periodic
interest payments. A lump sum amount is paid on maturity which includes principal and the
accrued interest payments. Zero-coupon bonds are always issued at a discount to face value
i.e. at a price much lower than the par/face value of the bond.
Example (Amortizing a zero‐coupon bond)
Terms of the bond are described below:
No coupon payments are made.
1. Reported Bond Value.
2. Interest Expense.
Solution:
N = 3; I = 10; PMT = 0; FV = 100; CPT PV = 75.13

Year Carrying Interest Interest Amortization Carrying

Amount (Begin) Expense Payment of Discount Amount (End)
2016 75.13 7.51 0 7.51 82.64
2017 82.64 8.26 0 8.26 90.91
2018 90.91 9.09 0 9.09 100.00
Balance Sheet: The carrying amount is shown on the balance sheet.
Income Statement: The interest expense is shown on the income statement which is 7.51 for
year 1, and 8.26 and 9.09 for the subsequent years.
Cash Flow Statement: As there is no periodic interest payment, there is no cash flow.
Issuance Costs
A company incurs costs like underwriter’s fee, legal, commissions, etc. when it issues a bond.
Publicly sold debt is usually done through an underwriter, i.e., the company may sell the
bond issue to an underwriter who will then sell it to investors. US GAAP and IFRS treat the
issuance costs differently.
US GAAP: Issuance costs are shown as an asset which is amortized on a straight-line basis
over the life of the bond. In other words, under US GAAP, issuance costs are capitalized.
IFRS: Issuance costs reduce the carrying value of the debt.
Cash outflows are shown as a financing cash flow under both US GAAP and IFRS.
Miscellaneous Points
 Effective interest rate does not change during the life of the bond. For example,
assume the market rate when the bond is issued is 10%. Through the life of the bond,
the market interest rate may change but the effective interest rate is the market rate
when the bond was issued; in this example, it stays constant at 10% over the life of
the bond.
 Book value of the bond rises for a discount bond while it falls for a premium bond. In
our earlier examples, the book value of a discount bond increased from 97.56 to
100.00, while the book value of the premium bond fell from 102.53 to 100.00.
Two Methods of Amortization
There are two methods of amortizing the premium/discount of bonds:
 Effective interest method: Required under IFRS and preferred under US GAAP. What
we saw until now for amortization in all the examples was the effective interest
method. This method uses the market interest rate in effect when the bond was
issued to the current amortized cost of the bond to calculate the interest expense.
Amortization premium/discount = interest expense – interest payment
 Straight-line method: Under this method, amortization of premium or discount is

evenly distributed over the life of the bond. This is analogous to straight-line
depreciation of long-lived assets.
2.3. Current Market Rates and Fair Value Reporting Option
We have so far focused on reporting bonds at amortized historical costs. This method
reflects the market rate at the time the bonds were issued. When market rates change, the
bond’s fair value diverges from carrying value. When market rates decline, the fair value of a
bond with a fixed coupon rate increases, and vice versa.
Companies have been given the option to report financial liabilities at fair value. A company
selecting this option will report gains/losses when market rates increase/decrease.
2.4. Derecognition of Debt
Once bonds are issued, a company may leave the bonds outstanding until maturity or
redeem the bonds before maturity. If the bonds remain outstanding until maturity, the
company pays bondholders the face value of the bonds at maturity. However, if a company
decides to redeem (retire) bonds before maturity, a gain or loss is recognized which is
calculated as:
Gain or loss = Redemption price – Book value of the bond liability at the reacquisition date
If the redemption price is higher than book value, a loss will be reported. For example, if
redemption price = 1,020,000 and book value = 990,000, the loss will be 30,000. If the
redemption price is lower than the book value, a gain will be reported. A gain or loss on the
extinguishment of debt must be reported in the income statement as a separate line item, if
the amount is significant. The cash used to retire the debt is classified under financing cash
flow. Additional detail about the extinguished debt is provided in MD&A or notes to financial
statements.
Treatment of Bond Issuance Costs
IFRS: No write-off because issuance cost is included in book value of bond liability.
US GAAP: Unamortized bond issuance costs must be written off and included in gain/loss
calculations.
2.5. Debt Covenants
The terms of borrowing between investors and the company issuing the bond are defined in
a document called the bond indenture. Indenture often contains restrictions called debt
covenants. Covenants are restrictions imposed by the creditor (bondholder/lender) on the
issuer (borrower) to protect the creditor’s interest. The benefit of including debt covenants
is that they reduce the default risk for investors and lower the interest costs of borrowing for
the borrower.
Affirmative covenants require the borrower to take certain actions. For example, making
interest payments on time, maintaining a certain level of working capital, or that it will

maintain minimum acceptable financial ratios.

Negative covenants restrict the borrowing company’s actions. For example, the borrowing
company may not be allowed to take on additional debt, pay dividends, sell assets, or any
action that may affect the company’s ability to pay interest and principal to its investors.
Technical default occurs when the borrower violates a debt covenant (affirmative or
negative).
2.6. Presentation and Disclosure of Long‐Term Debt
The total amount of a company’s long-term debt (debt that is due after one year) is
combined into a single line item and shown under the non-current liabilities section of the
balance sheet. The portion of the long-term debt that is due within one year is shown as a
current liability. Additional information on a company’s debt is disclosed in the notes to
financial statements. They include:
 The nature of the liabilities.
 Maturity dates.
 Stated and effective interest rates.
 Call provisions and conversion privileges.
 Restrictions imposed by creditors.
 Assets pledged as security.
 Amount of debt maturing in each of the next five years.
In addition to this, MD&A provides other details about a company’s capital resources,
including debt financing and off-balance-sheet financing.
3. Leases
A lease is a contract between a lessor (owner) and a lessee (who wants to use the asset).
Below is a pictorial representation of what constitutes a lease. An asset’s owner is called a
lessor. The entity or person wishing to use the asset is called the lessee. The lessor allows the
lessee to use the asset for a pre-determined period. In return, the lessee makes periodic
payments to the lessor over the period for the right to use the asset. This period can be as
long as 20 years, or as short as a month.

3.1. Advantages of Leasing

A lease can be classified as an operating or finance (capital) lease. The accounting treatment
is different depending on how the lease is categorized. We will discuss in detail the
advantages of operating leases from both perspectives:
Advantages of Operating Leases
Lessee Perspective (using the asset) Lessor Perspective (owner of the asset)
Off‐balance‐sheet financing: No assets on Tax advantage: Lessor might have a tax
the balance sheet. Since money is not advantage by keeping asset on its balance
borrowed to purchase the asset, debt is sheet. This is because the depreciation
less. Less costly financing: lease requires expense will reduce taxes payables.
no initial down payment.
Less costly financing: Lessee typically pays Possibly more efficient for lessor to
less financing cost relative to purchasing maintain asset.
on credit.
Reduced risk of obsolescence: Assume a
company bought an earthmover and after
three years, a better earthmover comes
into market which makes the one it owns
obsolescent. Instead if it had leased the
asset, it could use the newer one after three
years.
Off-balance-sheet financing improves the
leverage ratios compared to borrowing the
funds to purchase the asset.
Tax reporting advantages: In the U.S., firms
can create a synthetic lease. Asset shown
on balance sheet for tax purposes. On the
financial reporting side, the asset is shown
as an operating lease. But, on the tax
reporting side, it is shown as an asset to
account for depreciation expense.
3.2. Finance (or Capital) Leases versus Operating Leases
There are two types of leases: finance lease and operating lease. The impact of the lease on
the financial statements is different based on the type of the lease. A finance lease is
equivalent to purchasing an asset whereas an operating lease is similar to renting an asset
for a certain period.
Finance Lease Criteria under IFRS:
A lease is classified as a finance lease if the risks and rewards of ownership of the asset are

transferred to the lessee.

Finance Lease Criteria under US GAAP:
A lease must be classified by lessee as a finance lease if any one of the following four criteria
is met:
 Ownership transfer: If the lease transfers ownership of the asset to the lessee by the
end of the lease term.
 Bargain purchase option: The lessee has an option to purchase the asset at a price
lower than the fair value.
 Lease term: If lease term is 75% or more of the useful life of the leased asset
 Minimum lease payment: If the present value of lease payments is 90% or more of the
fair value of leased asset.
If none of the above criteria are met, the lessor reports the lease as an operating lease.
Most companies prefer not showing the asset on their balance sheet. So a lessor prefers
finance leases as the asset goes from the lessor’s to the lessee’s balance sheet. Similarly, a
lessee prefers operating leases as the asset is not shown on the lessee’s balance sheet.
Note: A new IFRS standard for accounting for leases is applicable for financial years
beginning 1 January 2019. This standard requires lessees to record both finance and
operating leases in the same way. Both assets and liabilities associated with the lease have to
be shown on the lessee’s balance sheet.
Accounting and Reporting by Lessee
The table below describes how a finance and an operating lease are treated on the financial
statements for the lessee.
Lease accounting and reporting by Lessee
Operating Lease Finance Lease
Balance Sheet No entry on the balance sheet Equivalent to borrowing money
as it is like renting an asset. to buy an asset. At inception, the
Operating lease is an off- present value of future lease
balance-sheet transaction. payments is recognized as an
asset and related debt as a
liability.
Asset is depreciated; lease
payable is amortized.
Income Statement Rent expense equal to lease Interest expense = liability at the
payment. It would be an beginning of period * interest
operating expense. rate

Cash Flow Cash outflow shown in cash There are two components to a
Statement flow from operations. lease payment: interest and
principal.
Only the portion of the interest
expense reduces CFO.
Rest of the lease payment
reduces CFF.
Example (Initial recognition and measurement of finance lease)

Assume a company leases a machine on 1 January 2016 for 4 years and pays 100 at the start
of every year. The fair value is 350. Relevant interest rate is 10%. How should this lease be
categorized? What is the impact on the financial statements? Assume straight line
depreciation.
Solution:
Let us begin by drawing a timeline for the lease payments. Notice that in the case of a lease,
payments are generally made at the beginning of a period.
Present value of lease payments = 100 made in year 0 + present value of three lease
payments from year 1 to 3 = 100 + 249 = 349. This number exceeds 90% of the fair value
(350). Hence this is a finance lease.
Balance Sheet: At inception, the present value of lease payments is 348. An asset (machine)
of 348 and a liability (lease payable) of 348 are shown on the balance sheet. Over time the
asset is depreciated and liability is reduced as lease payments are made.
Cash flow statement: Lease payments are shown on the cash flow statement. The interest
component of the lease payment reduces CFO and the principal component of the lease
payment reduces CFF.
Income statement: The interest expense is shown on the income statement. The annual
interest expense = lease liability at the start of the year * lease rate. Depreciation expense is
also shown on the income statement.
The table below shows the carrying amount of the asset and the depreciation expense over
the four years.

Year Carrying amount Depreciation Accumulated Carrying Amount

(1 Jan) Expense Depreciation (31 Dec)
2016 348.69 87.17 87.17 261.52
2017 261.52 87.17 174.34 174.35
2018 174.35 87.17 261.51 87.18
2019 87.18 87.17 348.68 0.01
Let us walk through the table above for 2016 to understand how each figure is calculated
and presented.
Carrying value of asset on 1 Jan 2016 = present value of lease payments = 348.69
Depreciation expense:
The value of the asset at the end of four years becomes zero from the lessee’s perspective.
Straight-line depreciation over 4 years = 348.69/4 = 87.17. Hence, each year the
depreciation expense is 87.17.
Accumulated depreciation = depreciation expense for current year + accumulated
depreciation = 0 + 87.17 = 87.17.
Carrying amount of asset on 31 Dec 2016 = beginning carrying amount – depreciation
expense = 348.69 - 87.17 = 261.52.
The table below shows the carrying amount of the lease liability and the interest expense
over the four years.
Year Lease Lease Interest (at Reduction of Lease
liability payment 10%; accrued lease Liability
(1 Jan) (1 Jan) in previous liability (31 Dec)
year) (1 Jan)
2016 348.69 100.00 0.00 100.00 248.69
2017 248.69 100.00 24.87 75.13 173.56
2018 173.56 100.00 17.36 82.64 90.92
2019 90.92 100.00 9.09 90.91 0.01
Let us walk through the table above for 2016 and 2017 to understand how each figure is
calculated and presented.
Lease liability on 1 Jan 2016 = present value of lease payments = 348.69
Lease payment on 1 Jan 2016 = 100
Interest at 10% accrued in previous year:
In the 2016 row, we are showing the interest accrued in the previous year (2015). Since
the lease was initiated on 1 Jan 2016, the interest accrued in the previous year (2015) was
0.
Reduction of lease liability in 2016:
The first lease payment was on 1 Jan 2016. Since lease was initiated on the same day, no
interest has accrued. Hence the entire payment of 100 reduces the lease payable which
comes down from 348.69 to 248.69.
Lease liability on 1 Jan 2017: 248.69. This is the same as lease liability on 31 Dec 2016.

Lease payment on 1 Jan 2017 = 100.

Interest at 10% accrued in previous year:
In the 2017 row, we are showing the interest accrued in the previous year (2016). Lease
liability at the start of 2016 (after the first payment of 100) was 248.69. 10% of this
number is 24.87. This represents the accrued interest expense for 2016.
Reduction of lease liability in 2017:
The lease payment is 100 of which 24.87 represents interest expense. The remaining
amount (100 - 24.87 = 75.13) reduces the lease liability from 248.69 to 173.56.
Example (Operating lease vs. finance lease)
Assume a company leases a machine for 4 years and pays 100 at the start of every year. The
fair value of the machine is 340 and relevant interest rate is 10%. Show the total expense
under the two different categorizations.
Solution:
If the lease is categorized as an operating lease, then the entire lease payment of 100 is
treated as an expense. 100 is considered as CFO and there is no effect on the balance sheet.
Instead, if it is categorized as a finance lease, the expense consists of depreciation and
interest. This can be summed up as follows:
Operating Lease Finance Lease
Year Expense Depreciation Interest Total
2016 100 87.17 24.87 112.04
2017 100 87.17 17.36 104.53
2018 100 87.17 9.09 96.26
2019 100 87.17 0.00 87.17
Interpretations based on the above example:
Some meaningful deductions can be based on the table above. This will help you in solving
problems comparing the two types of leases.
 Overall expense in the initial years is higher for finance lease as interest expense is
higher. The lease liability is higher in the initial years making the interest expense
higher.
 Towards the end, interest expense becomes low as the lease liability becomes lower.
 Assets and debt are higher in the finance lease.
 Net income is higher in the initial years for operating lease as expense is lower.
The following table summarizes the impact of lease accounting for the lessee on the financial
statements. Instead of memorizing, remember the example we have seen above to deduce
what item is higher/lower in the initial and later years.

Item Finance Operating Interpretation

Lease Lease
Assets Higher Lower With finance lease, the leased machine is
shown as an asset, hence assets are higher.
Liabilities Higher Lower With finance lease, the lease payable makes
(Current and long long term liabilities higher. The current
term) portion of lease payable makes current
liabilities higher.
Net income (in the Lower Higher Lease expense for operating lease is lower
early years) than the total expense (interest expense +
depreciation expense) of a finance lease in
the initial years.
Net income (later Higher Lower Interest expense, and as a result the total
years) expense, comes down in the later years for
finance lease. Net income is higher for
finance lease.
Total net income Same Same Over the life of the lease, the total net
income is the same for both types of leases.
EBIT (operating Higher Lower Operating income is higher for finance lease
income) because only the depreciation part is
deducted. Whereas for operating lease, the
entire lease payment is considered an
operating expense. In the example above, it
was 87.17 for finance lease vs 100 for
operating lease.
Cash flow from Higher Lower Similarly, for CFO in the case of finance
operations lease; it is divided into interest expense and
principal amount. Only the interest expense
reduces CFO whereas in an operating lease,
the entire amount (100 in our example) is
treated as CFO.
Cash flow from Lower Higher The principal amount reduces CFF for
financing finance lease. No effect on CFF in the case of
an operating lease.
Total cash flow Same Same Total cash flow is the same for both types of
leases.
Accounting and Reporting by Lessor
Next, we move on to understanding the accounting and reporting of a lease from a lessor’s
perspective. The accounting for an operating lease is as follows:
 Lessor records revenue when earned. Revenue is the lease payment received on the

leased asset.
 Reports the leased asset on balance sheet.
 Records depreciation expense on the asset on the income statement. Since the asset is
on the lessor’s balance sheet, it has to be depreciated.
Under IFRS, the recognition of a finance lease is straightforward. If the lessee has classified
a lease as a finance lease, it is the same for a lessor as well i.e. all the risks and rewards of an
asset are transferred to the lessee. IFRS only allows a sales type lease.
Under US GAAP, a lease is classified as a finance (capital) lease or operating lease using the
same four recognition criteria as a lessee plus the additional revenue recognition criteria.
That is, the lessor must be reasonably assured of collecting lease payments. Further, US
GAAP classifies a finance (capital) lease into two:
 Direct finance lease
 Sales-type lease
To understand the distinction between the two types of finance (capital) leases, let us see
what happens when the lessor sells an asset. There are two possibilities:
 Present value of lease payments = carrying value of lease asset.
 Present value of lease payments > carrying value of lease asset.
Direct Finance Lease: The first possibility where the present value of lease payments is equal
to the carrying value of the lease asset. There is no profit made by selling the asset. Revenue
for the lessor is essentially the interest earned.
Sales-Type Lease: The second possibility where the present value of lease payments is
greater than the carrying value of leased asset is a sales-type lease. Here, the lessor sells the
asset to the lessee. There is a profit on sale and interest revenue on lease receivable
(financing on the sale). A profit on the transaction in the year of lease inception is shown.
Both types of capital leases have the same effect on the balance sheet. A lease receivable
equal to the present value of future lease payments is reported on the balance sheet and the
leased asset is removed. The carrying value of the asset is different for a direct financing and
sales-type lease. We will work through the same example we did for lessee to understand
accounting from a lessor’s perspective.
Example (Direct financing lease)
Assume you lease a machine for 4 years and receive 100 at the start of every year. Relevant
interest rate is 10%. What are the accounting entries assuming a direct financing lease?
Solution:
The figures in the table below would seem familiar from our earlier example for the lessee. It
is like a mirror image. Lease payable for the lessee becomes the lease receivable for the
lessor. Lease receivable on 1 January 2016 is the present value of future lease payments.
Lease payment consists of two parts: The principal part reduces the lease receivable. It

eventually reduces to 0 at the end of four years. Interest income for lessor is calculated in the
same way as interest expense for lessee.
Year Lease Lease Interest Income Reduction of Lease
Receivable Payment (at 10%; Lease Receivable
(1 Jan) Received accrued in Receivable (31 Dec)
(1 Jan) previous year) (1 Jan)
2016 348.69 100.00 0.00 100.00 248.69
2017 248.69 100.00 24.87 75.13 173.56
2018 173.56 100.00 17.36 82.64 90.92
2019 90.92 100.00 9.09 90.91 0.01
Disclosures for Finance and Operating Leases
Disclosures can help estimate the extent of a company’s off balance-sheet lease financing
through operating leases. Lessee and lessor are required to disclose information on financial
and operating leases in the financial statements or footnotes that address the following:
 Details of the lease agreement.
 Show payments to be made or received for the next five years and afterward.
 Lease expense or revenue reported in the income statement.
4. Introduction to Pensions and Other Post‐Employment Benefits
Instructor’s Note: Pensions are discussed in great detail at Level II.
One common post-employment benefit offered by companies to their employees is pension.
Pensions and other post-employment benefits give rise to non-current liabilities reported by
many companies. When companies promise its employees certain benefits after a certain
period of time, they are obligated to fulfill that promise.
The accounting treatment of pensions depends on the type of pension plan. There are
primarily two types of pension plans:
1. Defined contribution plan: Under this plan, a company contributes an agreed‐upon
amount to the plan. This contribution is recognized as a pension expense on the income
statement and an operating cash outflow. Since there is no future payout or obligation, no
liability is reported on the balance sheet. A liability is recognized on the balance sheet if
some prior agreed-upon amount is not paid by the end of the fiscal year.
2. Defined benefit plan: Under this plan, a company promises to pay a certain amount in
the future to the employees. The amount of future obligation is based on a lot of
assumptions such as retirement age of its employees, last drawn salary before
retirement, mortality rate, etc. For example, a company may promise an employee an
annual pension payment equal to 60% of his last salary at retirement, until death. The
pension obligation is the present value of future payments the company expects to make.
A company fulfills this obligation by setting up a pension fund (also known as plan
assets) and making payments to this fund. The ongoing pension obligations are paid from

this fund. The amount in the fund remains invested until it has to be paid to the retirees.
Disclosures for Defined Benefit Plans
Since the future obligation of defined benefit pension fund cannot be determined with
certainty, accounting is more complicated than the defined contribution plan. Listed below
are a few rules for you to remember for a defined benefit plan:
 If the fair value of plan assets > present value of estimated pension obligation, the
plan is overfunded (has a surplus). It is called net pension asset.
 If the present value of estimated pension obligation > fair value of plan assets, the
plan is underfunded. It is called net pension liability.
Under both IFRS and US GAAP, the net pension asset or liability is reported on the balance
sheet.
For each period, the change in net pension asset or liability is recognized either in profit or
loss or in other comprehensive income.
Under IFRS, the change in net pension asset or liability has three components:
 Employee service costs and past service costs: Recognized as pension expense in the
income statement.
 Service cost is the present value of the benefit earned by an employee for one additional
year of service. It is the sum of past service costs and present value of the increase in
pension benefit earned by working for one more year.
 Net interest expense or income accrued on the beginning net pension asset or
liability: Recognized as pension expense in the income statement.
 Net interest expense = net pension asset or liability x discount rate used to estimate the
present value of the pension obligation.
 Remeasurements: Recognized in other comprehensive income on the balance sheet.
 Remeasurements = actuarial gains and losses and the actual return on plan assets
minus the net interest expense or income.
Under US GAAP, the change in net pension asset or liability has five components:
 Employees’ service costs for the period.
 Interest expense accrued on the beginning pension obligation.
 Expected return on plan assets (this reduces the pension expense).
 Past service costs.
 Actuarial gains or losses.
The first three are recognized in profit and loss during the period incurred. Past service costs
and actuarial gains and losses are recognized in other comprehensive income in the period
they occur and later amortized into pension expense.
Example
On 31 Dec. 2012, a company has a pension obligation of 100 and pension assets are 90. What

will the company report on the balance sheet under IFRS and US GAAP?
Solution:
Funded status = pension assets – pension obligation = 90 – 100.
The company will report a net pension liability of 10.
5. Evaluating Solvency: Leverage and Coverage Ratios
Solvency ratios are used to measure a company’s ability to meet its long-term obligations,
including both principal and interest payments. There are two categories of solvency ratios:
leverage ratios and coverage ratios.
Leverage Ratios
Leverage ratios focus on the balance sheet and measure the extent to which a company uses
debt to finance its assets.
The commonly used leverage ratios are as follows:
Leverage Ratio Numerator Denominator
Debt-to-assets Total debt Total assets
Debt-to-capital Total debt Total debt + shareholders’ equity
Debt-to-equity Total debt Total shareholders’ equity
Financial leverage Average total assets Average total equity
These ratios provide information on how much debt a company has taken. A low leverage
ratio implies the company has low leverage and is well positioned to fulfill its debt
obligations. The ratios for a particular company should be interpreted in the context of the
industry in which it operates.
Coverage Ratios
Coverage ratios focus on the income statement and cash flow to measure a company’s ability
to service debt (make interest and other debt-related payments).
Coverage Ratios Numerator Denominator
Interest coverage EBIT Interest payments
Fixed charge coverage EBIT + lease payments Interest payments + lease payments
Unlike leverage ratios, higher values for coverage ratios are better, all else equal.


Summary
LO.a: Determine the initial recognition, initial measurement, and subsequent
measurement of bonds.
When a bond is issued, asset (cash) and liability (bonds payable) both increase by the bond
proceeds. The cash flow statement shows an inflow from financing activity.
The book value of a bond is calculated by discounting the future cash flows to present value
using market interest rate at the time of issuance. The payments of coupons are recorded as
cash outflow from financing activity on the cash flow statement.
 When coupon rate = effective interest rate: the bond is issued at face value.
 When coupon rate < effective interest rate: the bond is issued at a discount.
 When coupon rate > effective interest rate: the bond is issued at a premium.
The book value of a discount bond increases over time until it reaches face value at maturity.
The book value of a premium bond decreases over time until it reaches face value at
maturity.
LO.b: Describe the effective interest method and calculate interest expense,
amortization of bond discounts/premiums, and interest payments.
Under the effective interest rate method, interest expense = book value of the bond liability
at the beginning of the period x market interest rate at issuance. The interest expense
includes amortization of any discount or premium at issuance.
Premium Bond:
 The yield < coupon rate, therefore interest expense < coupon payment.
 The difference is subtracted from the bond liability on the balance sheet, which leads
to amortization of the premium.
Discount Bond:
 The yield > coupon rate, therefore interest expense > coupon payment.
 The difference is added to the bond liability on the balance sheet, which leads to
amortization of the discount.
LO.c: Explain the derecognition of debt.
If a company redeems bonds before maturity, it reports a gain or loss (which is computed as
the carrying amount of the bonds less the amount required to redeem the bonds).
Under US GAAP, any remaining unamortized bond issuance costs must also be written off
and included in the gain or loss calculation.
Under IFRS, write-off of issuance cost is not necessary because they are already included in
the book value of the bond liability.

LO.d: Describe the role of debt covenants in protecting creditors.

A bond indenture often includes restrictions on the issuer, called covenants, to protect the
bondholder’s interest. The benefit of including debt covenants is that they reduce the default
risk for investors and lower the interest costs of borrowing for the borrower. Affirmative
covenants require the borrower to take certain actions. Negative covenants place
restrictions on a company’s actions.
LO.e: Describe the financial statement presentation of and disclosures relating to debt.
The total amount of a company’s long-term debt (debt that is due after one year) is
combined into a single line item and shown under the non-current liabilities section of the
balance sheet. The portion of long-term debt that is due within one year is shown as a
current liability. Additional information on a company’s debt is disclosed in the notes to
financial statements.
LO.f: Explain motivations for leasing assets instead of purchasing them.
Compared to purchasing an asset, the advantages of leasing an asset are:
 Off-balance-sheet financing.
 Tax reporting advantage.
 Less costly financing.
 Reduced risk of obsolescence.
 Improved leverage ratios.
LO.g: Distinguish between a finance lease and an operating lease from the
perspectives of the lessor and the lessee.
Accounting standards require leases to be classified as either operating leases or finance
(capital) leases.
Under IFRS, leases are classified as finance leases when substantially all the risks and
rewards of legal ownership are transferred to the lessee. Otherwise, the lease is classified as
an operating lease.
Under U.S. GAAP, the lessee must classify a lease as a finance lease if any one of the following
criteria is met:
 Ownership of the asset is transferred to the lessee at the end of the lease period.
 A bargain purchase option exists.
 The lease term is for 75% or more of the asset’s useful life.
 Present value of lease payments is 90% or more of fair value of leased asset.
LO.h: Determine the initial recognition, initial measurement, and subsequent
measurement of finance leases.
Operating Lease:
 Initial measurement: No asset or liability reported. The balance sheet is unaffected.

 Subsequent measurement: Lease payments are recognized as expense in lessee’s

income statement.
 Cash flow: Lease payments are reported as operating cash outflows.
Finance Lease:
 Initial measurement: The lower of the present value of future lease payments or the
fair value of the leased asset is recognized as an asset and a liability on the lessee’s
balance sheet.
 Subsequent measurement: Finance lease payment consists of depreciation of the
asset and interest on the loan.
 Cash flow: The lease payment is split and reported as an operating cash outflow
(interest expense) and financing cash outflow (principal reduction).
LO.i: Compare the disclosures relating to finance and operating leases.
Required disclosures about finance leases and operating leases in the financial statements
include:
 A general description of the leasing arrangement.
 Restrictions imposed by the lease agreement.
 The nature, timing, and amount of payments to be paid in each of the next five years.
Lease payments after five years can be shown together.
 Amount of lease expense reported in the income statement for each period.
LO.j: Compare the presentation and disclosure of defined contribution and defined
benefit pension plans.
Defined Contribution Plans
 The amount of contribution into the plan is specified. However, the amount of
pension that is ultimately paid by the plan is not defined and it depends on the
performance of the plan’s assets.
 The cash payment made into the plan is recognized as pension expense on the income
statement.
Defined Benefit Plans
 The amount of pension that is ultimately paid by the plan is defined, usually
according to a benefit formula.
 Under both IFRS and US GAAP, companies must report the difference between the
defined benefit pension obligation and the pension assets as an asset or liability on
the balance sheet.
 Under IFRS, the change in the defined benefit plan net asset or liability is recognized
as a cost of the period. Two components of the change (service cost and net interest
expense or income) are recognized in the income statement and one component (re-
measurements) is recognized in other comprehensive income.
 Under US GAAP, the change in the defined benefit plan net asset or liability is also

recognized as a cost of the period. Three components of the change (current service
costs, interest expense on the beginning pension obligation, and expected return on
plan assets) are recognized in the income statement and two components (past
service costs and actuarial gains and losses) are recognized in other comprehensive
income.
LO.k: Calculate and interpret leverage and coverage ratios.
Leverage ratios focus on the balance sheet and measure the amount of debt financing
relative to equity financing.
Leverage Ratio Numerator Denominator
Debt-to-assets Total debt Total assets
Debt-to-capital Total debt Total debt + shareholders’ equity
Debt-to-equity Total debt Total shareholders’ equity
Financial leverage Average total assets Average total equity
Coverage ratios focus on the income statement and cash flows and measure the ability of a
company to cover its interest payments.
Coverage Ratios Numerator Denominator
Interest coverage EBIT Interest payments
Fixed charge coverage EBIT + lease payments Interest payments + lease payments

Practice Questions
1. At the time of issue of 6% coupon bonds, the effective interest rate was 5.5%. The bonds
were most likely issued at:
A. par.
B. a discount.
C. a premium.
2. Using the effective interest rate method, the reported interest expense of a bond issued
at discount will:
A. decrease over the term of the bond.
B. increase over the term of the bond.
C. remain unchanged over the term of the bond.
3. Company A raised $1 million by issuing zero-coupon bonds, its debt-to-equity ratio will
most likely:
A. rise over the term of the bond.
B. decline over the term of the bond.
C. remain constant over the term of the bond.
4. A firm issues $1 million bonds with a 5% coupon rate, 5-year maturity, and annual
interest payments when market interest rates are 6%. The discount amortized in the first
year will be closest to:
A. $6,583.69.
B. $7,472.58.
C. $8,361.47.
5. If a company reports a lease as an operating lease instead of a finance lease, it will most
likely report:
A. higher debt.
B. lower interest expense.
C. higher operating cash flow.
6. A lessor can record interest income if the lease is classified as:

A. a financing lease.
B. an operating lease.
C. either a finance lease or an operating lease.
7. At the beginning of 2015, XYZ Inc. enters a finance lease that requires four annual
payments of $15,000 each beginning on the first day of the lease. The lease interest rate
is 6%. The amount of interest expense that XYZ will report in 2015 is closest to:

A. $2,405.71
B. $3,305.71
C. $4,215.51
8. XYZ Inc has a defined benefit pension plan. At the end of 2015, its pension obligations
were $10 million and pension assets were $12 million. For 2015, XYZ’s balance sheet will
show:
A. $10 million as a liability and $12 million as an asset.
B. $2 million as a net pension liability.
C. $2 million as a net pension asset.
9. Company A has $1 million in total liabilities and $500,000 in shareholders’ equity. It also
has lease commitments over the next four years with a present value of $100,000. If the
lease commitments are treated as debt, the debt-to-total-capital ratio of the company is
closest to:
A. 0.67
B. 0.69
C. 0.71

Solutions

1. C is correct. Since coupon rate > market rate, the bond is issued at a premium.
2. B is correct. As the discount is amortized, the book value of the bond increases until it
reaches its face value. Since interest expense is based on the book value of a bond, it will
increase over the term of the bond.
3. A is correct. As discount is amortized over time, the value of the liability for zero-coupon
bonds increases. Also, the amortized interest will reduce earnings at an increasing rate
over time as the value of the liability increases. Higher relative debt and lower relative
equity (through retained earnings) will cause the debt-to-equity ratio to increase as the
zero-coupon bonds approach maturity.
4. B is correct.
Since coupon rate < market rate, the bonds will be issued at a discount. Discounting the
future payment to their present value indicates that at issuance the company will record
an initial book value of $957,876.36.
The interest expense in the first year = Market interest rate at issuance x book value =
957,876.36 x 6% = $57,472.58.
Discount amortized in first year = Interest expense – Coupon payment = $57,472.58 -
$50,000 = $7,472.58.
5. B is correct. An operating lease is not recorded on the balance sheet, therefore the debt is
lower. Lease payments are entirely categorized as rent, therefore interest expense is
lower. Because the rent expense is an operating outflow but principal repayments are
financing cash flows, the operating lease will result in lower cash flow from operating
activity.
6. A is correct. A part of the payments for finance leases is reported as interest income. For
an operating lease, all revenue is recorded as rental revenue.
7. A is correct.
The present value of the lease payments at inception is $55,095.18
(BGN mode: N = 4, I = 6, PMT = $15,000, FV = 0. CPT PV = -$55,095.18)
After the first payment is made the book value of the lease liability will reduce to
$55,095.18 - $15,000 = $40,095.18.
Interest expense for the first year = Book value of the lease x lease interest rate =
$2,405.71
8. C is correct. If the fair value of the plan assets is greater than the pension obligation, then

the firm will report a net pension asset.
9. B is correct.
total debt
Debt to total capital ratio
total debt total equity
Current debt-to-total-capital ratio = $1,000,000 / ($1,000,000 + $500,000) = 0.67.
If lease commitments are treated as debt, the total debt would increase to $1,100,000.
Post-adjustment debt-to-total capital ratio = $1,100,000/ ($1,100,000 + $500,000) = 0.69

R31 Financial Reporting Quality 2019 Level I Notes
R31 Financial Reporting Quality

1. Introduction
There are two main interrelated concepts that will be discussed in detail in this reading:
financial reporting quality and earnings quality.
2. Conceptual Overview
Financial reporting quality: High-quality financial reporting provides information that is
useful to analysts in assessing a company’s performance and prospects. They contain
information that is relevant, complete, neutral, and free from error.
High-quality reporting helps in making the right decision as it depicts the true economic
reality of a company for the reporting period. Low-quality financial reporting contains
inaccurate, misleading, or incomplete information.
Earnings quality: High-quality earnings result from activities that a company will likely be
able to sustain in the future and provide a sufficient return on the company’s investment. If
the return on investment is greater than the cost of funds, then it indicates high earnings
quality.
Sustainability is the key here. For example, assume a company uses accrual-based earnings
in a quarter. It has high accounts receivable and as a result reports high earnings, which is
not sustainable in the following quarters. This implies earnings quality is low.
Quality Spectrum of Financial Reports
Combining the two aspects – financial reporting quality and earnings quality, we get a
spectrum spanning from highest to lowest. Let us now look at the characteristics of
reporting/earnings quality as we move down along the spectrum as shown in the exhibit
below.

1. Reporting is GAAP compliant and decision useful. The earnings are also sustainable
and adequate.
2. Reporting is GAAP compliant and decision useful. However, earnings quality is low,
i.e., the earnings are not sustainable or adequate.
3. Reporting is GAAP compliant, but the reporting choices and estimates used while
preparing the reports are biased.
4. Reporting is GAAP compliant, but the amount of earnings is actively managed. The
intent is to increase/decrease/smooth reported earnings.
5. Reporting is not GAAP compliant, although the reports are based on the company’s
actual economic activities.
6. Reporting is not GAAP compliant and the reports contain numbers that are fictitious.
Differentiate between Conservative and Aggressive Accounting
The choice of accounting methods used can distort the economic reality. Unbiased financial
reporting is the ideal, but investors may prefer conservative accounting choices as a positive
surprise is acceptable. Whereas the management may prefer aggressive accounting choices.
Aggressive accounting: It refers to biased accounting choices that aim to improve the
reported earnings or financial position in the current period.
Conservative accounting: It refers to biased accounting choices that aim to decrease the
Some managers use aggressive accounting when earnings are below targets and
conservative accounting when earnings are above targets, to artificially smooth earnings.
When a company makes conservative choices, it implies that:
 revenue is recognized only when earned and when collections are reasonably certain.
 expenses/losses are recognized when probable.
 earnings will be understated in the current period.
3. Context for Assessing Financial Reporting Quality
3.1. Motivations
Managers may be motivated to issue financial reports that are not high quality in order to:
 mask poor performance.
 boost the stock price.
 increase personal compensation.
 avoid violation of debt covenants.
3.2. Conditions Conducive to Issuing Low‐Quality Financial Reports
The three conditions conducive for issuing low-quality financial reports are presented

below:
Opportunity: It can be the result of weak internal controls, ineffective board of directors, and
accounting standards that allow a range of choices.
Motivation: It can result from pressure to meet some criteria for some personal reasons.
Rationalization: It can result from justifying a wrong choice as seen in Enron’s case. Enron’s
CFO sought board approvals, legal and accounting opinions for misstated financial
statements.
3.3. Mechanisms that Discipline Financial Reporting Quality
Market Regulatory Authorities
Regulators in every country can play a key role in enforcing financial reporting quality.
Examples of regulatory authorities include:
 the SEC (Securities Exchange Commission).
 SEBI (Securities and Exchange Board of India).
 Securities and Futures Commission in Hong Kong.
These regulatory authorities are members of an international organization called the
International Organization of Securities Commissions (IOSCO), comprising 120 regulatory
authorities and 80 securities market participants like the stock exchanges.
The actual regulation, however, is enforced through each individual regulatory authority in a
country. The features of any regulatory regime such as the SEC that affect financial reporting
quality include the following:
 Registration requirements: Publicly traded companies must register securities before
offering securities for sale to the public. A registration document (often known as a
prospectus in an Initial Public Offering) contains current financial statements, future
prospects of the company, and securities being offered.
 Disclosure requirements: Publicly traded companies are required to make public
periodic reports such as financial statements.
 Auditing requirements: The financial statements must be audited by an independent
auditor that states the statements conform to the accounting standards.
 Management commentaries: Financial reports must include statements by the
management. Some regulators require a management report containing “(1) a fair

review of the issuer’s business, and (2) a description of the principal risks and
uncertainties facing the issuer.”
 Responsibility statements: Individuals responsible for company’s filings must issue a
statement explicitly acknowledging responsibility and correctness of the information
in the reports. Falsely certifying may be considered criminal offence and attract a jail
sentence.
 Regulatory review of filings: Regulators conduct reviews periodically to ensure that
the rules have been followed.
 Enforcement mechanisms: Regulators have the authority to enforce these rules,
without which the rules are of no significance. These powers include fines, barring
market participants, or bringing criminal charges.
Auditors
Financial statements of public companies must be audited by an independent auditor.
However, there are some drawbacks of audited opinion:
 It is based on information provided by the company.
 Only a sample is audited, which may not reveal misstatements.
 The intent of the auditor is not to detect fraud, but to ensure that the information is
presented fairly.
 The company being audited pays the audit fees. The auditor has an incentive to be
lenient to the company being audited in case of a conflict of interest; particularly if
the auditor’s firm provides additional services to the company.
Private Contracting
We have seen earlier that managers are motivated to manipulate earnings in order to avoid
violating debt covenants or triggers that may prompt investors to recover all or part of their
investment.
Consider an example where a company takes a loan from a bank; there is every incentive for
the company to dress up its financial reports to keep its cost of capital low. So it is in the best
interest of investors, such as the bank here, to monitor the quality of financial reports and
detect any misreporting.
4. Detection of Financial Reporting Quality Issues
Analysts must be able to understand the choices that companies make in financial reporting
while evaluating the overall quality of reports – both financial reporting quality and earnings
quality. There is no right or wrong choice. The intent of the management is what makes the
difference.
Choices exist both in how information is presented (financial reporting quality) and in how
financial results are calculated (earnings quality).
 Choices in presentation are often transparent.

 Choices in the calculation of financial results are more difficult to detect.

Ways to increase performance and financial position in the current period include the
following:
 Recognize revenue prematurely. Ex: a software services company recognizes revenue
before the services are delivered to a client. Revenue and earnings will be overstated
in the current period.
 Use nonrecurring transactions to increase profits. Ex: selling accounts receivable,
which increases earnings in an unsustainable manner.
 Defer expense to later periods. Ex: warranty expense for a sale that happened in this
period should be recognized now and not put off for later. Deferring understates
expense.
 Measure and report assets at higher values; and/or
 Measure and report liabilities at lower values. Equity will be overstated if assets are
higher and liabilities are lower.
Ways to increase performance and financial position in a later period include the following:
 Defer current income to a later period (save income for a rainy day); and/or
 Recognize future expenses in a current period; setting the table for improving future
performance. Ex: cookie jar reserve accounting. Higher expenses are reported in the
current period. This allows earnings in the later period to be overstated because
lower expenses are reported later.
4.1. Presentation Choices
 Companies may use “strange new metrics”. Metrics are set by a company or an industry,
and not by a standard-setting body. For example, website companies started using
metrics such as “eyeballs” or “stickiness” to measure user engagement and operating
performance; traditional valuation methods such as P/E could not justify their stock
prices.
 Companies may present “pro forma earnings”. These are earnings that are not prepared
in accordance with any standard such as US GAAP or IFRS. Analysts must be careful
about the assumptions made in the financial reports as they may be manipulated to make
the earnings look better. Ex: companies would exclude huge restructuring charges (to the
tune of $3-$7 billion) in performance presentation to make earnings look good to
investors.
 EBITDA is earnings before interest, taxes, depreciation, and amortization. It is often used
as a proxy for operating cash flow. EBITDA is used to compare companies as the expense
incurred for depreciation, amortization, and restructuring may vary with the choice of
accounting method. Companies may construct their own version of EBITDA by excluding
the following from net income:
o Rental payments for operating leases.

o Equity-based compensation, usually justified on the grounds that it is a non-cash

expense.
o Acquisition-related charges.
o Impairment charges for goodwill or other intangible assets.
o Impairment charges for long-lived assets.
o Litigation costs.
o Loss/gain on debt extinguishments.
 If companies are compared using EBITDA measure, then it must be ensured that the
companies calculate EBITDA in a similar manner and the same assumptions are made.
 IFRS requires a definition and explanation of any non-IFRS measures included in
financial reports.
 Similarly, if a company uses a non-GAAP financial measure, then it must also include the
closest GAAP measure with prominence. It must also explain why the non-GAAP measure
is a better choice to represent the company’s financial condition than the GAAP measure.
4.2. Accounting Choices and Estimates
In this section, we look at the accounting methods (choices and estimates) made by the
management for a desired outcome such as earnings growth or meeting the numbers.
How Choices Affect the Cash Flow Statement
A cash flow statement has three sections:
 Cash flow from operations (CFO): This is of most interest to investors. The CFO is
insulated from manipulation more than the income statement. For instance, if a large
part of the earnings is from accruals, then it should raise a red flag.
 Cash flow from investing (CFI)
 Cash flow from financing (CFF)
How the cash flow statement is manipulated:
 Misclassification of cash flows: Analyze the composition of CFO closely. For example,
if a certain cash outflow should be classified as part of CFO but is instead shown as
CFI, or if a cash inflow must be part of CFI but shown as CFO, then it indicates
manipulation.
 Payables management: Decrease in accounts payables is a use of cash. Consider the
following:

At the end of the period, the payables decrease to 90 which is a decrease in the
liability. It is the use of cash and decrease in CFO. Contrast this with the following if
a company wanted to manipulate the CFO. It could delay the payable by stretching
the credit period, which will increase the CFO by +50.
 Interest capitalization: This is due to the differences between interest payments and
interest costs. Assume a company takes a loan to construct a factory. It pays an
interest of 100,000 in a given period of which 70,000 is the interest expense (on the
income statement) and 30,000 is capitalized interest on the loan taken. The amount
that will show up as interest in CFO will be 70,000 and 30,000 in CFI.
 Flexibility in the classification of interest/dividends paid and received: Interest paid
and interest/dividends received may be classified as operating cash flow. Or interest
paid can be classified as a financing cash flow and interest/dividends received can be
classified as investing cash flows. Dividend paid may be classified as a financing cash
flow or cash flow from operating activities.
Analysts should:
 Examine the composition of the operations segment.
 Compare company’s cash generation with other companies in the industry; study
relationship between net income and CFO.
How Accounting Choices and Estimates Affect Earnings and Balance Sheets
This section identifies areas where choices affect financial reporting and the questions
analysts must ask to assess the quality of reporting.
Revenue Recognition
When evaluating a company’s revenue recognition practices, an analyst should ask the
following questions:
 How is the revenue recognized, upon shipment or upon delivery of goods?
 Is the company engaged in “channel stuffing” – the practice of overloading a
distribution channel with more product than it is normally capable of selling? For
example, a washing machine manufacturer pressurizes a retailer to sell more
machines through special discounts. The threat is that the retailer may return unsold
units.
 Does the company engage in bill-and-hold transactions? A company bills the
customer, recognizes revenue but does not ship the product.

 Does the company use rebates as part of its marketing approach? If so, how
significantly do the estimates of rebate fulfillment affect net revenues? And have any
unusual breaks with history occurred?
 Does the company separate its revenue arrangements into multiple deliverables of
goods or services?
Long-Lived Assets: Depreciation Policies
 Companies have a choice to use one of the three depreciation methods: Straight-line,
accelerated double-declining-balance method, or units-of-production method.
 Depreciation expense: Depends on the method used and the salvage value of the
assets being depreciated. We have seen the effect on operating margins and
depreciation expense in the earlier reading.
 Analysts must consider if the estimated life spans of the associated assets make sense,
or are they unusually low compared with others in the same industry? And if there
have been changes in depreciable lives that have a positive effect on current earnings.
Inventory Costing Method
Companies cannot arbitrarily switch between inventory costing methods once the policy
decision is made. For example, a cost flow assumption between FIFO vs. weighted average
cost can lead to different values for income statement and balance sheet items, and
eventually affect profitability. Let us take an example of a company that sells one good. There
are four pieces of that good whose costs are 1, 1, 2, and 2 respectively. If two pieces are sold
then, according to:
 FIFO: COGS = 2; Ending inventory = 4. FIFO understates cost and overstates ending
inventory.
 Weighted average cost: COGS = 3; Ending inventory = 3. The balance sheet is a mix of
old and new inventory costs. Understates inventory if costs are rising.
Analysts must examine the following:
 Does the company use a costing method that produces fair reporting results in view
of its environment? How do its inventory methods compare with others in its
industry? Are there differences that will make comparisons uneven if there are
unusual changes in inflation?
 Does the company use reserves for obsolescence in its inventory valuation? If so, are
they subject to unusual fluctuations that might indicate adjusting them to arrive at a
specified earnings result?
 If a company reports under US GAAP and uses last-in, first-out (LIFO) inventory
accounting, does LIFO liquidation (assumed sale of old, lower-cost layers of
inventory) occur through inventory reduction programs? This inventory reduction
may generate earnings without supporting cash flow, and management may
intentionally reduce the layers to produce specific earnings benefits.

Capitalization Policies of Intangible Assets

Another example of how choices affect both the balance sheet and income statement is in the
use of capitalization. If the payment benefits only the current period, then it must be
classified as an expense. If it will be used in future periods, then it must be capitalized.
 Does the company capitalize expenditures related to intangibles, such as software?
 Does its balance sheet show any R&D capitalized as a result of acquisitions?
 Or, if the company is an IFRS filer, has it capitalized any internally generated
development costs?
Goodwill
When a company acquires another company, and the acquiring company pays more than its
fair value, then goodwill is created. The fair value of the assets created is based on the
management’s estimate. The depreciable value of assets is kept low to lower the
depreciation expense, and the amount that cannot be allocated to specific assets is classified
as goodwill.
The initial value of the goodwill is objective. Over time, the value of goodwill is subjective.
Companies must test goodwill for impairment annually on a qualitative basis. The value of
the assets reported depends on the management’s intent; if the fair value of assets cannot be
recovered, the company must write-down goodwill. To avoid writing down goodwill, the
company may project a better future performance.
Allowance for Doubtful Accounts/Loan Loss Reserves
 Are additions to such allowances lower or higher than in the past? For example, if the
allowance for doubtful accounts must be 3% based on historical transactions, a
company can report 2% instead in order to boost earnings. Analysts must verify if the
allowances are justified.
 Does the collection experience justify any difference from historical provisioning?
 Is there a possibility that any lowering of the allowance may be the result of industry
difficulties along with the difficulty of meeting earnings expectations?
Related-Party Transactions
 Is the company engaged in transactions that disproportionately benefit members of
management? Does one company have control over another’s destiny through supply
contracts or other dealings?
 Do extensive dealings take place with non-public companies that are under
management control? If so, non-public companies could absorb losses (through
supply arrangements that are unfavorable to the private company) and make the
public company’s performance look good. This scenario may provide opportunities
for an owner to cash out.
Tax Asset Valuation Accounts
 Tax assets, if present, must be stated at the value at which management expects to

realize them, and an allowance must be set up to restate tax assets to the level
expected to eventually be converted into cash. Determining the allowance involves an
estimate of future operations and tax payments. Does the amount of the valuation
allowance seem reasonable, overly optimistic, or overly pessimistic? For example, if a
company records a DTA which expires in three years, analysts must analyze if a
company can become profitable within this period.
 Are there contradictions between the management commentary and the allowance
level, or the tax note and the allowance level? There cannot be an optimistic
management commentary and a fully reserved tax asset, or vice versa. One of them
has to be wrong.
 Look for changes in the tax asset valuation account. It may be 100% reserved at first,
and then “optimism” increases whenever an earnings boost is needed. Lowering the
reserve decreases tax expense and increases net income. If the valuation allowance is
lower, then DTA and net income increases.
4.3. Warning Signs
Warning signs of information manipulation in financial reports can be seen as manipulation
in:
 Biased revenue recognition.
 Biased expense recognition.
The bias may be with respect to:
 Timing of recognition: Deferring expenses by capitalizing.
 Location of recognition: Showing a loss in other comprehensive income instead of the
income statement.
Analysts must look at the following for warning signs:
 Pay attention to revenue. Examine the accounting policies note for a company’s revenue
recognition policies. Studies have shown that most manipulations relate to revenue
recognition; the largest number on the income statement.
o Does the company recognize revenue prematurely; revenue recognition upon
shipment of goods or bill-and-hold sales?
o Does the company engage in barter transactions?
o Are rebates offered? If yes, by how much, as these can affect revenue recognition?
o How will revenue be recognized for multiple-deliverable arrangements of goods and
services?
 Look at revenue relationships.
o Compare a company’s revenue growth with that of its competitors, industry, or the
economy. If the company outperforms, then there must be a justifiable performance
like superior management or product differentiation. If not, it should be a cause of
concern.

o Compare accounts receivable with revenue to see if it is increasing as a percentage of

revenue over the years. It may indicate relaxed credit terms or channel stuffing.
o Analyze asset turnover to see if the assets are efficiently used. If an asset turnover is
declining, then it indicates assets may be written down in the future.
 Pay attention to signals from inventories.
o Look at the growth in inventories relative to competitors and industry.
o Look at the inventory turnover ratio. If the ratio is declining, it may mean obsolescent
inventory.
o US GAAP allows use of LIFO for inventory accounting. If prices increase, analysts must
check to see that old inventory has not been passed through earnings (LIFO
liquidation) to boost net profits.
 Pay attention to capitalization policies and deferred costs.
o Compare a company’s accounting policy for capitalization of long-term assets,
interest costs, and handling of deferred costs with that of its competitors and the
industry. If only this company is capitalizing costs while others are expensing, then it
is a warning sign.
 Pay attention to the relationship of cash flow and net income.
o Construct a time series of cash flow from operations divided by net income. If the
ratio is consistently less than 1.0, then it indicates a problem with accrual accounts,
i.e., net income is shown higher than it should be.
Other Potential Warning Signs
Other areas that require further analysis include:
 Depreciation methods and useful lives.
 Fourth-quarter surprises: For non-seasonal businesses, over- or under-performance
in the fourth quarter of a year routinely is a red flag.
 Presence of related-party transactions: What is the intent behind related-party
transactions, often by founding members of a company?
 Non-operating income or one-time sales included in revenue: To mask declining
revenues, companies may include one-time gain as part of revenue. Ex: In 1997,
Trump Hotels included a one-time gain from a lease termination as part of revenue.
 Classification of expenses as non-recurring.
 Gross/operating margins out of line with competitors or industry.
 Younger companies with an unblemished record of meeting growth projections.
 Management has adopted a minimalist approach to disclosure: Is the management
withholding information from competitors?
 Management fixation on earnings reports.

5. Conclusion
 Financial reporting quality can be thought of as spanning a continuum.
 Reporting quality pertains to the information disclosed. High-quality reporting
represents the economic reality of the company’s activities during the reporting period
and the company’s financial condition at the end of the period.
 Results quality (commonly referred to as earnings quality) pertains to the earnings and
cash generated by the company’s actual economic activities and the resulting financial
condition, relative to expectations of current and future financial performance.
 An aspect of financial reporting quality is the degree to which accounting choices are
conservative or aggressive. “Aggressive” typically refers to choices that aim to enhance
the company’s reported performance and financial position by inflating the amount of
revenues, earnings, and/or operating cash flow reported in the period; or by decreasing
the amount of expenses reported in the period and/or the amount of debt reported on
the balance sheet.
 Conservatism in financial reports can result from either:
o Accounting standards that specifically require a conservative treatment of a
transaction or an event.
o Judgments necessarily made by managers when applying accounting standards that
result in more- or less-conservative results.
 Motivation: Managers may be motivated to issue less than high quality financial reports
in order to mask poor performance, to boost the stock price, to increase personal
compensation, and/or to avoid violation of debt covenants.
 Conditions that are conducive to the issue of low-quality financial reports include
cultural environment attributes that result in fewer or less transparent financial
disclosures, the book/tax conformity that shifts emphasis toward legal compliance and
away from fair presentation, and limited capital markets regulation.
 Mechanisms that discipline financial reporting quality include the free market and
incentives for companies to minimize cost of capital, auditors, contract provisions
specifically tailored to penalize misreporting, and enforcement by regulatory entities.
 Pro forma earnings (also commonly referred to as non-GAAP or non-IFRS earnings)
adjust earnings as reported on the income statement. Pro forma earnings that exclude
negative items are a hallmark of aggressive presentation choices.
 Companies are required to make additional disclosures when presenting any non-GAAP
or non-IFRS metric.
 Managers’ considerable flexibility in choosing their company’s accounting policies and in
formulating estimates provides opportunities for aggressive accounting.
 Examples of accounting choices that affect earnings and balance sheets include inventory
cost flow assumptions, estimates of uncollectible accounts receivable, estimates of how
much of deferred tax assets can be realized, depreciation method, estimated salvage
value of depreciable assets, and estimated useful life of depreciable assets.

 Cash from operations is a metric of interest for investors that can be enhanced by
operating choices, such as stretching accounts payable, and potentially by classification
choices.


Summary
LO.a: Distinguish between financial reporting quality and quality of reported results
(including quality of earnings, cash flow, and balance sheet items).
Reporting quality: It refers to the information disclosed in the firm’s financial statements.
High-quality reporting means that the financial statements are decision useful and represent
the economic reality of the company.
Results quality (earnings quality): It refers to the earnings and cash generated by the
company’s actual economic activities. High-quality earnings means that the earnings are
sustainable and are expected to continue in the future.
LO.b: Describe a spectrum for assessing financial reporting quality.
LO.c: Distinguish between conservative and aggressive accounting.

Aggressive accounting: It refers to biased accounting choices that aim to improve the
Conservative accounting: It refers to biased accounting choices that aim to decrease the
LO.d: Describe motivations that might cause management to issue financial reports
that are not high quality.
Managers may be motivated to issue financial reports that are not high quality in order to:
 mask poor performance.
 boost the stock price.
 increase personal compensation.
 avoid violation of debt covenants.
LO.e: Describe conditions that are conducive to issuing low‐quality, or even
fraudulent, financial reports.

Conditions that are conducive to issuing low-quality financial reports are:

Motivation: Covered above
Opportunity:
 Weak internal controls.
 Ineffective board of directors.
 Accounting standards that allow a range of choices.
Rationalization
 Ability to justify wrong choices to him/herself.
LO.f: Describe mechanisms that discipline financial reporting quality and the potential
imitations of those mechanisms.
Mechanisms that discipline financial reporting quality include:
 the free market and incentives for companies to minimize cost of capital.
 auditors.
 contract provisions specifically tailored to penalize misreporting.
 enforcement by regulatory entities.
LO.g: Describe presentation choices, including non‐GAAP measures that could be used
to influence an analyst’s opinion.
 Companies may use “strange new metrics”.
 Companies may present “pro forma earnings”.
 Companies may construct their own version of EBITDA by excluding:
o Rental payments for operating leases;
o Equity-based compensation, usually justified on the grounds that it is a non-cash
expense;
o Acquisition-related charges;
o Impairment charges for goodwill or other intangible assets;
o Impairment charges for long-lived assets;
o Litigation costs;
o Loss/gain on debt extinguishments.
 IFRS requires a definition and explanation of any non-IFRS measures included in
financial reports.
 If a company uses a non-GAAP financial measure, then it must also include the closest
GAAP measure with prominence. It must also explain why the non-GAAP measure is a
better choice to represent the company’s financial condition than the GAAP measure.
LO.h: Describe accounting methods (choices and estimates) that could be used to
manage earnings, cash flow, and balance sheet items.
Accounting methods (choices and estimates) that can be used to manage earnings and
balance sheet items are shipping terms, FIFO versus weighted cost, deferred tax assets,

depreciation methods, capitalization, and goodwill.

Cash flow statements can be manipulated by misclassification of cash flows (CFO, CFI, and
CFF), payables management, interest capitalization, and flexibility in the classification of
interest/dividends paid and received.
Choices that affect financial reporting are revenue recognition, long-lived assets
(depreciation policies), intangibles (capitalization policies), allowance for doubtful accounts,
inventory cost method, tax valuation accounts, goodwill, warranty reserves, and related
party transactions.
LO.i: Describe accounting warning signs and methods for detecting manipulation of
information in financial reports.
Warning signs of information manipulation in financial reports can be seen as manipulation
in:
 Biased revenue recognition.
 Biased expense recognition.
The bias may be with respect to:
 Timing of recognition: Deferring expenses by capitalizing.
 Location of recognition: Showing a loss in other comprehensive income instead of the
income statement.
Analysts must look at the following for warning signs:
 Pay attention to revenue.
 Look at revenue relationships.
 Pay attention to signals from inventories.
 Pay attention to capitalization policies and deferred costs.
 Pay attention to the relationship of cash flow and net income.
Other potential warning signs are:
 Depreciation methods and useful lives.
 Fourth-quarter surprises.
 Presence of related-party transactions.
 Non-operating income or one-time sales included in revenue. To mask declining
revenues, companies may include one-time gain as part of revenue.
 Classification of expenses as non-recurring.
 Gross/operating margins out of line with competitors or industry.
 Younger companies with an unblemished record of meeting growth projections.
 Management has adopted a minimalist approach to disclosure. Is the management
withholding information from competitors?
 Management fixation on earnings reports.

Practice Questions
1. Which of the following does an analyst require to correctly evaluate a company’s
historical performance?
A. High earnings quality.
B. High financial reporting quality.
C. Both high earnings quality and high financial reporting quality.
2. Financial reports that are considered to be of the lowest quality reflect:

A. fictitious events.
B. biased accounting choices.
C. departures from accounting principles.
3. If a particular accounting choice is considered conservative in nature, then the financial

performance for the current period would most likely:
A. be neutral.
B. exhibit an upward bias.
C. exhibit a downward bias.
4. Which of the following will least likely motivate managers to inflate earnings?
A. Reducing tax obligations.
B. Meeting analyst expectations.
C. Possibility of a bond covenant violation.
5. With respect to conditions that can result in low-quality financial reporting, ‘ineffective
board of directors’ is best described as a(n):
A. motivation.
B. opportunity.
C. rationalization.
6. The objective of audit of a company’s financial reports is to:

A. detect fraud.
B. reveal misstatements.
C. assure that financial information is presented fairly.
7. Under IFRS, a company using a nonstandard financial measure is least likely required to:
A. present the same measure for at least three prior periods.
B. provide a reconciliation of the nonstandard measure to a comparable standard
measure.
C. define and explain the relevance of the non-standard measure.

8. A company wishing to increase earnings in the current period may choose to:
A. decrease the useful life of depreciable assets.
B. increase the estimates of uncollectible accounts receivables.
C. classify a purchase as a capital expenditure rather than an expense.
9. A potential warning sign that the revenues of a firm are being recorded prematurely or
may even be fictitious is an unusual:
A. decrease in the firm’s payables turnover.
B. increase in the firm’s receivables turnover.
C. increase in the firm’s days of sales outstanding.

Solutions

1. B is correct. Financial reporting quality relates to the quality of the information contained
in financial reports. If financial reporting quality is low, the information provided is not
useful to evaluate the company’s performance.
Earnings quality relates to the earnings and cash generated by the company’s actual
economic activities and the resulting financial condition.
2. A is correct. Financial reports span a quality continuum from high to low based on
decision-usefulness and earnings quality. The lowest-quality reports portray fictitious
events, which may misrepresent the company’s performance.
3. C is correct. Conservative accounting choices tend to decrease the company’s reported

earnings and financial position for the current period. As a result, the financial
performance for the current period will most likely exhibit a downward bias.
4. A is correct. Reducing tax obligations would be a reason to understate earnings.
5. B is correct. ‘Ineffective board of directors’ is a condition that provides an opportunity for

low-quality financial reporting.
6. C is correct. The objective of an audit is to provide assurance that the company’s financial
reports are presented fairly. An audit is not typically intended to detect fraud. An audit is
based on sampling and it is possible that the sample might not reveal misstatements.
7. A is correct.
IFRS requires that firms using non-IFRS measures must
 Define and explain the relevance of such measures.
 Reconcile the differences between the non-IFRS measure and the most
comparable IFRS measure.
8. C is correct. This will lower the expenses and increase earnings.
9. C is correct. If a company’s days sales outstanding (DSO) is increasing unusually, this may
be a signal that revenues are being recorded prematurely or are even fictitious.

R32 Financial Statement Analysis Applications 2019 Level I Notes
R32 Financial Statement Analysis: Applications

1. Introduction
This reading brings us to the end of financial reporting and analysis. Think of this reading as
a practical application of steps outlined for a financial analysis framework (define purpose,
collect and process data, analyze and interpret, recommend and follow-up). Some of the
questions we will address over the next few sections are:
 What factors to consider when evaluating a company’s past financial performance?
 How to approach forecasting a company’s future net income and cash flow?
 How can a financial statement analysis be used to evaluate the credit quality of a fixed
income statement?
 How can it be used to identify potential equity investments?
 What adjustments do analysts need to make so that the financial ratio comparison
between companies is meaningful?
2. Application: Evaluating Past Financial Performance

Evaluating past performance helps analysts assess how the company performed and the
reasons behind its performance (why it performed the way it did). When studying a
company, some key analytical questions include the following:
 How and why have corporate measures of profitability, efficiency, liquidity, and
solvency changed over the period being analyzed?
 How do the level and trend in a company’s profitability, efficiency, liquidity, and
solvency compare with the corresponding results of other companies in the same
industry? What factors explain any differences?
 What aspects of performance are critical for a company to successfully compete in its
industry? How did the company perform relative to those critical performance
aspects?
 What is the company’s business strategy? Do the financials reflect the strategy?
To evaluate how a company performed, an analyst can process data by creating common-
size financial statements, calculating ratios, and analyzing industry-specific metrics. Some of
the factors an analyst must be aware of when evaluating financial performance are discussed
below:
Change in Company’s Strategy
The effect of a company’s strategy is reflected in its performance. Let us take the example of
Apple Inc.
 Apple was primarily a personal computer technology company until early 2000’s.
 The company’s strategy changed substantially between 2007 and 2010 and as a
result its product mix with the introduction of iPod, iPad and iPhone.

 The company wanted to become a pioneer in the personal interactive electronics space
by leveraging its unique ability to design and develop.
 The change in strategy is evident in its financial performance. In 2005, iPod became
Apple’s bestselling product. By 2009, iPhone became Apple’s most sold product. The
share of computers in sales continued to decline.
 When a company sells differentiated products, it can charge higher prices. Premium
prices lead to higher gross margins. Impact on operating profit margins, however, is
weaker relative to gross margins because a company has to spend on advertising and
research to support differentiated products.
Differences in Accounting Standards
When comparing the ratios of different companies, analysts must be aware of the accounting
standards, methods, and estimates used for reporting as they can have a significant impact
on the financial statements. Let us consider the example below where the ROE of three
companies reporting under different accounting standards are given. For comparison, they
are then converted to US GAAP.
ROE of three companies for a year (in %)
Mexican GAAP Brazilian GAAP US GAAP
Mexican company 52.69 211.12
Brazilian company -7.89 29.34
U.S. company 12.69
While the Mexican company reported the highest ROE under Mexican and US GAAP, the
Brazilian company turned profitable under US GAAP after posting a negative ROE. The table
illustrates why it is important to make adjustments to a common standard such as US GAAP
before comparing the financial ratios of companies.
This comparison only provides information about how a company performed. To understand
why it performed better or worse, analysts gather information from the management
commentary, MD&A, and industry sources such as consumer surveys. The results of a past
performance analysis set the ground for making recommendations.
3. Application: Projecting Future Financial Performance
To estimate the target price for a company’s stock, an analyst needs to forecast EPS. The
inputs for estimating EPS are future sales and profit. The steps usually followed for
projecting performance are illustrated below:

Notice that future income can be projected in two ways: by estimating expenses and by
forecasting future profit margins. The individual steps used to forecast sales and profit
margin are listed below:
Forecast Sales
Analysts often take a top-down approach to forecasting sales.
 Forecast expected GDP growth rate.
 Forecast expected industry sales based on historical relationship with GDP. For
example, based on historical data, an analyst may conclude that a 3% increase in GDP
corresponds to a 3% increase in industry sales.
 Forecast expected change in company’s market share, i.e., whether a company is
expected to gain, lose, or retain its market share over the forecasting period. Market
share projections may be based on historical data or forward-looking analysis.
 Forecast expected company sales by multiplying projected market share by projected
total industry sales.
Forecast Expenses
 Use historical margin for stable firms like Johnson & Johnson.
 For less stable firms like Facebook, estimate each expense item.
 Remove non-recurring items.
 Estimate interest expense based on the level of debt; estimate tax expense based on
the tax rate and the earnings before taxes.

Forecast Cash Flows

 Estimate changes in working capital.
 Estimate investment expenditures.
 Estimate dividend payments.
4. Application: Assessing Credit Risk

Another application of financial statement analysis is in assessing the credit risk of a
borrower. Credit risk is the risk that the borrower will fail to make the obligated interest and
principal payments. Credit analysis is the evaluation of credit risk. The purpose of credit
analysis is to determine whether a company will be able to service its debt (interest and
principal payments) on time. A credit analysis exercise is likely to include an evaluation of
the following:
 Profitability (net profit margin, operating margin, etc.)
 Cash flows and the variability of cash flows. If the cash flow is highly volatile, then it
becomes a concern.
 Business risk (low revenues and high expenses).
 Financial risk (high debt and low operating profit).
Let us take a look at how Moody’s assigns credit ratings for a company based on the
following groups of qualitative factors:
 Scale and diversification: Refers to a company’s sensitivity to adverse events that
affect debt-paying ability. Larger size and scale indicate prior success, and the
company’s ability to adapt to changing economic conditions.
 Tolerance for leverage: Refers to the borrower’s ability to service debt. Solvency
ratios are used to measure leverage. Free cash flow/debt: if this ratio is high, it is
good as it means debt is low.
 Operational efficiency: Refers to cost structure of a company. Companies with lower
costs are in a better position to handle adverse conditions. Low value for leverage
ratios such as debt/equity is good. High value for coverage ratios such as
EBIT/interest payments is good. Low value for debt/EBITDA is good as it indicates
operating income is sufficient to make debt payments.
 Margin stability: Refers to the volatility of profit margins in the past. The lower the
volatility of profit margins (the higher the stability), the lower the credit risk.
5. Application: Screening for Potential Equity Investments

Screening is a process to filter investments (for example stocks, bonds) based on a set of
criteria. The criteria may be a set of financial ratios, or other metrics such as dividends paid,
market capitalization, etc. One example of a stock screen is defined below.

Criterion Stocks Meeting Criterion

P/E < 15 100
Assets/Equity < 2 50
Dividends > 0 75
Meeting all three criteria collectively 25
The criteria are not limited to the factors mentioned above. It can be as detailed and as
specific as required based on the investment requirement. For example, if an analyst wants
to keep risk low, he might screen for companies with positive earnings and a low leverage
ratio (assets/equity). If he wants low P/E firms which are financially strong, he might use
criteria such as P/E less than 10, and debt/equity less than 0.2.
Types of Investors
Stock screens are used by both growth and value investors.
 Growth Investors: Focused on investing in high earnings growth companies. Screens
use criteria related to growth or momentum.
 Value Investors: Investors focused on paying a relatively low share price in relation to
earnings per share or book value per share (low P/E or low P/B). Screens use
valuation ratios as criteria.
 Market-oriented Investors: Intermediate category of investors who cannot be
classified as growth or value investors.
Back‐testing
Often, an analyst may be interested in finding how a portfolio based on a stock screen would
have performed historically. For instance, assume you go back 5 years and apply the same
stock screen to form a portfolio of stocks to see how much the portfolio would have earned
had the strategy been implemented. However, there are some limitations (biases) to this
approach:
 Survivorship bias: Companies that are no longer in operation (or delisted) will be
eliminated. The surviving companies appear to have performed better.
 Look-ahead bias: If companies have restated their financial statements, then there is a
mismatch between what the investor would have known at the time of the
investment decision and the information used now in back-testing.
 Data-snooping bias: The bias that may exist if excessive analysis is applied to the
same data set.
6. Analyst Adjustments to Reported Financials

When comparing ratios of companies using different accounting standards, adjustments may
be required. Before making adjustments, consider the following:
 Importance: Will any adjustments to an item materially affect the conclusion? For

example, inventory for a bank has minimal impact. So, will it matter if one bank uses
LIFO and the other FIFO?
 Body of standards: Is there a difference in accounting standards: IFRS, US GAAP or
home-country GAAP? What does it impact the most?
 Methods: Is there a difference in accounting methods used? For example, cash/accrual
based accounting, straight-line or accelerated depreciation, and LIFO/FIFO to
measure inventories.
 Estimates: Is there a difference in estimates used by companies? For example,
residual value or useful lives of similar assets by two companies.
Analyst Adjustments Related to Investments
Assume Company A classifies financial assets as “available for sale” and Company B classifies
similar assets as “trading” securities. Adjustments must be made to classification of
investments to facilitate comparison. Recall the following rules for classifying financial
assets from the reading on balance sheets:
Classification of Financial Assets
Classification Treatment
Measured at fair value through profit or Unrealized gains or losses reported in
loss: trading securities in US GAAP. income statement.
Measured at fair value through other Unrealized gains or losses recognized in
comprehensive income: available for sale equity.
(AFS) securities in US GAAP.
Analyst Adjustments for Inventory
Consider two companies reporting under US GAAP: one uses LIFO while the other uses FIFO.
Companies using LIFO are also required to report a LIFO reserve. When LIFO reserve is
added to LIFO inventory, we get inventory value under FIFO.
To make the results of the two companies comparable, the inventory values of the company
following LIFO must be adjusted to FIFO using the following formula:
FIFO Inventory = LIFO inventory + LIFO Reserve
Analyst Adjustments Related to Property, Plant, and Equipment
Any company’s management exercises considerable discretion when it comes to estimates
and accounting methods for depreciation. Depreciation expense can significantly impact the
net income of company and fixed assets on the balance sheet. So, it depends whether a
company is making aggressive or conservative estimates for the useful life and residual
value of its assets.
Specific adjustments are usually not made for depreciation when comparing two companies.

It is more of a qualitative factor. The table below is self-explanatory; it lists the relationships
between assets and depreciation as seen in the balance sheet and income statement.
Estimate Calculation
Number of years of useful life which have Accumulated depreciation/ gross PPE
passed.
Number of years of depreciation expense Accumulated depreciation/depreciation
which have been recognized. expense
How many years of useful life remain for Net PPE (net of accumulated
the company’s overall asset base? depreciation)/depreciation expense
Average life of the assets at installation. Gross PPE/depreciation expense
What percentage of the asset base is being Capital expenditure/ sum of gross PPE &
renewed through new capital investment? capital expenditure
Analyst Adjustments Related to Goodwill
Goodwill arises when one business acquires another business. If the purchase price exceeds
the sum of the fair value of the individual assets and liabilities of the acquired business, then
the excess amount is recognized as goodwill. Let us assume that companies A and B are
identical except that A has grown through acquisition and B has grown organically. What is
the impact on goodwill and on total assets?
The company that has grown through acquisition will record higher goodwill, assets, and
equity. Assets are higher for this company as they are capitalized and not expensed like the
organically growing company. The ratios based on asset values, including profitability ratios,
look better for the grown-by-acquisition company.
To make the two companies comparable, it is recommended to use tangible book value
which removes the effect of goodwill and other intangible assets (i.e.. subtract goodwill and
intangible assets from stockholder’s equity).
Analyst Adjustments Related to Off‐Balance‐Sheet Financing
There are certain liabilities that are not required to be reported on a company’s balance
sheet. A company’s financial statements must be adjusted to include off-balance-sheet
obligations such as operating lease payments as part of its liabilities to facilitate
comparisons as this affects ratios.
The Context
It is of primary concern to analysts when a company shows a finance (capital) lease as an
operating lease. If a lease transfers to the lessee most of the risks and rewards of ownership
of an asset, then it should be shown as a finance lease instead of an operating lease.
Accounting for it as an operating lease gives rise to off-balance-sheet financing which makes
the ratios look relatively good. An analyst might want to analyze the impact on assets,

liabilities and equity if a company’s operating leases were capitalized (i.e. finance leases).
The Adjustment
Compute the present value of operating lease payments. Let us assume the present value of
lease payments is 100.
Add this number (100) to the value of assets and liabilities.
The Impact:
Impact on solvency ratios: Consider the debt to assets ratio. When capitalized lease
obligation (present value of lease payments) is added to debt, the debt-to-assets ratio goes
up. Capitalizing leases has an adverse impact on the solvency ratio.
Impact on coverage ratios: Interest coverage ratio = EBIT/interest. When an operating lease
is capitalized, the denominator (interest) goes up. The numerator, EBIT, is adjusted by
adding back the operating lease expense and subtracting depreciation. Typically, the
percentage increase in the denominator (interest) is higher than the percentage change in
the numerator. Hence when operating leases are capitalized the interest coverage ratio
decreases.

Summary
LO.a: Evaluate a company’s past financial performance and explain how a company’s
strategy is reflected in past financial performance.
Evaluating a company’s past financial performance helps understand not only what
happened but also the reasons behind the company’s performance and how the performance
reflects the company’s strategy.
LO.b: Forecast a company’s future net income and cash flow.
A company’s future income and cash flows are projected by forecasting sales growth. Then
the analyst uses estimates of profit margins and level of investment in working and fixed
capital required to support projected sales, to calculate net income and cash flow.
LO.c: Describe the role of financial statement analysis in assessing the credit quality of
a potential debt investment.
Assessing credit risk includes:
 Ability of issuer to meet interest and principal repayment on schedule.
 Cash flow forecast.
 Variability of cash flows.
 Evaluation of business risk and financial risk.
Moody’s assigns credit ratings for a company based on the following broad factors:
 Size and scale (total revenue and operating profits).
 Business profile, revenue sustainability, and efficiency.
 Financial leverage and flexibility (leverage ratios, coverage ratios, Debt/EBITDA,
FCFF/Debt).
 Liquidity.
LO.d: Describe the use of financial statement analysis in screening for potential equity
investments.
Screening is a process to filter investments (for example stocks, bonds) based on a set of
criteria. The criteria may be a set of financial ratios, or other metrics such as dividends paid,
market capitalization, etc.
Types of Investors:
 Growth investors: Focused on investing in high earnings growth companies.
 Value investors: Focused on paying a relatively low share price in relation to EPS or
BVPS.
 Market-oriented investors: Intermediate category.
Back-testing: Evaluates how a portfolio based on a particular screen would have performed

historically. When back-testing:

 Survivorship bias exists if delisted companies are not considered.
 Look-ahead bias exists if the database includes financial data updated for
restatements; mismatch between what the investor would have actually known at the
time of the investment decision and the information used in back-testing.
 Data-snooping bias might exist if excessive analysis is applied to the same data set.
LO.e: Explain appropriate analyst adjustments to a company’s financial statements to
facilitate comparison with another company.
Sometimes it is necessary to adjust a company’s financial statements. For example, when
comparing companies that use different accounting methods or assumptions.
Adjustments include those related to:
 investments
 inventory
 property, plant, and equipment
 goodwill
 off-balance-sheet financing


Practice Questions
1. An analyst has gathered the following information.
Company A: A rapidly growing company that has made many acquisitions in the past.
Company B: A large, diversified company operating in mature industries.
Projecting profit margins into the future on the basis of past results would be most
reliable for:
A. company A.
B. company B.
C. both company A and company B.

2. While projecting a company’s future income and cash flows, an analyst is least likely to
assume a constant relationship between the company’s sales and its:
A. interest expenses.
B. cost of goods sold.
C. non-cash working capital.

3. Which of the following characteristics would credit analysts least likely prefer?
A. Small size and concentrated products.
B. Stable margins.
C. Low leverage.

4. Jeff Miller, equity manager, uses a stock screener with the following criteria: earnings
growth greater than the median earnings growth percentage and an ROE value higher
than the median ROE value. The stocks so selected would be most appropriate for
portfolios of:
A. growth investors.
B. value investors.
C. both growth and value investors.

5. Which of the following is a least appropriate adjustment to the financial statements of a
firm that uses operating leases to finance its plant and equipment?
A. Increase liabilities.
B. Increase long-lived assets.
C. Decrease shareholders’ equity.

Solutions

1. B is correct. Earnings of company B would be stable. Earnings of company A would be
very volatile.

2. A is correct. While projecting net income and cash flows we assume that cost of goods
sold, operating expenses, and non-cash working capital remain a constant percentage of
sales. By looking at the projections we then decide if additional borrowings are needed
during the forecast period. Then, if required, the analyst can increase the interest
expense accordingly.

3. A is correct. Larger scale and more diversification indicate better credit quality.

4. A is correct. Metrics such as earnings growth and momentum are aimed at selecting
growth companies; therefore, the portfolio is most appropriate for growth investors.

5. C is correct. The appropriate adjustment is to estimate the present value of the future
lease obligations and add it to the firm’s liabilities and long-lived assets.


2019 Level I Notes
Notes


2019 Level I Notes
Notes


Ift Study Notes Vol 3 PDF

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2019 CFA® Exam Prep

IFT Study Notes

© IFT. All rights reserved

Published in 2018 by IFT

Errata information can be found at: https://ift.world/errata

© IFT. All rights reserved

R21 Financial Statement Analysis ........................................................................................... 5

R22 Financial Reporting Standards....................................................................................... 13

R23 Understanding Income Statements ............................................................................... 29

R24 Understanding Balance Sheets ....................................................................................... 54

© IFT. All rights reserved 1

1. Introduction .........................................................................................................................54

R25 Understanding Cash Flow Statements .......................................................................... 71

R26 Financial Analysis Techniques ....................................................................................... 92

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5. Inventory Method Changes ...............................................................................................123

R28 Long Lived Assets ............................................................................................................ 137

R29 Income Taxes ................................................................................................................... 164

R30 Non‐Current Liabilities .................................................................................................. 182

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4. Introduction to Pensions and Other Post-Employment Benefits ..................................198

R32 Financial Statement Analysis Applications ............................................................... 228

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R21 Financial Statement Analysis

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has the following elements:

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Articulate the Purpose and Context of Analysis

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light in order to judge whether it should be given a loan or not.

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contain one of the following opinions:

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2. A company’s financial position at a given time is best portrayed by:

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6. C is correct. The steps in the financial statement analysis framework are:

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R22 Financial Reporting Standards

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Objective of financial statements

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Required financial statements

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 Fair presentation: Faithful representation of transactions.

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LO.d: Describe the International Accounting Standards Board’s conceptual framework,

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LO.i: Analyze the company disclosures of significant accounting policies.

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11. Which of the following is not a characteristic of a coherent financial reporting

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2. B is correct. For an accounting standards board to function properly, it should be

3. A is correct. Standard-setting bodies are responsible for developing the reporting

5. B is correct. Barriers to global convergence of accounting standards include

6. A is correct. The fundamental characteristics of financial statements are relevance and