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Financial reporting and analysis

Business activities can be classified into three groups: operating activities, investing activities and financing activities companies classify transaction into common accounts that are components of the five financial statement elements: assets, liabilities, equity, revenue, and expense.

T-Account
DebitCredit
Balance Sheet
AssetsLiabilities
Owners' Equity

Basic formula

$$Assets = Liabilities + Owners'\ equity$$

$$Assets = Liabilities + Contributed\ capital + Ending\ retained\ earnings$$

contributed capital: 投入资本

$$Owners'\ equity = Contributed\ capital + Retained\ earnings$$

$$Revenue - Expenses = Net\ income$$

$$Ending\ retained\ earings = Beginning\ retained\ earnings + Net\ income - Dividends$$

  • assets: economic resources of a company
    • non-current assets:
      • intangible assets including goodwill
      • property, plant, and equipment
      • investment property
      • investments in joint ventures and associates
    • current assets:
      • inventories
      • trade and other receivables
      • cash and cash equivalents
  • liabilities: creditors' claims on the resources
  • owners' equity: residual claim on those resources;
  • expense: outflows of economic resources or increases in liabilities

financial statement

  • Balance sheet
  • Income statement
  • statement of cash flow
  • statement of owners' equity

Accrual accounting(权责发生制)

  • unearned revenue(or deferred revenue) 预收账款，已收款，权利义务并为交割
  • unbilled revenue(accrued revenue): arises when a company earns revenue prior to receiving cash but has not yet recognized the revenue at the end of an accounting period. 应计收入，权利义务已交割，但收入未到账
  • prepaid expense
  • accrued expense: arise when a company incures expenses that have not yet been paid as of the end of an accounting period

valuation adjustments

financial statements and supplementary information

  • balance sheet
  • statement of comprehensive income
  • statement of changes in equity
  • cash flow statement
  • financial notes and supplementary schedules: note disclosures include information about the following:
    • financial instruments and risks arising from financial instruments
    • commitments and contingencies
    • legal proceedings
    • related-party transactions
    • subsequent events (events that occur after the balance sheet date)
    • business acquisitions and disposals
    • operating segments' performance
  • management commentary of management's discussion and analysis (MD & A) publicly held companies typically include a section in their annual reports where management discusses a variety of issues of concern, including:
    • the nature of the business
    • past results
    • future outlook
  • auditor's reports financial statements presented in companies' annual reports are generally required to be audited (examined) by an independent accounting firm in accordance with specified auditing standards. The independent auditor then provides a written opinion on the financial statements. under ISAs, the objectives of an auditor in conducting an audit of financial statements are:
    1. to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement
    2. to report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor's findings.

classification

  • classified balance sheet: a balance sheet organized so as to group together the various assets and liabilities into subcategories (e.g., current and non-current)
  • liquidity based presentation: a liquidity-based presentation rather than a current/non-current presentation, is used when such a presentation provides information that is reliable and more relevant. With a liquidity-based presentation, all assets and liabilities are presented broadly in order of liquidity.

accounting systems

flow of information in an accounting system

  • general ledger(总分类账): collection of all business transactions sorted by account in an accounting system
  • general journal(普通日记账): collection of all business activities sorted by date

Journal entries and adjusting entries -> General ledger and T-accounts -> Trial balance and adjusted trial balance -> Financial statements

Financial reporting standards

  • International Accounting Standards Board (IASB): the independent standard-setting body of the IFRS (International Financial Reporting Standards) Foundation. Under IAS No.1, a complete set of financial statements includes:
    • statement of financial position
    • statement of comprehensive income
    • statement of changes in equity
    • statement of cash flows
    • notes comprising a summary of significant accounting policies
    • other explanatory information
  • US Financial Accounting Standards Board (FASB): established US GAAP (generally accepted accounting practices)

objective of financial reporting

To provide financial information in making decisions.

measurement of financial statement elements

  • historical cost: in reference to assets, the amount paid to purchase an asset, including any costs of acquisition and/or preparation; with liabilities, the amount of proceeds received in exchange in issuing the liability.
  • amortised cost: the historical cost (initially recognized cost) of an asset, adjusted for amortization and impairment.
  • current cost: the amount of cash or cash equivalents that would have to be paid to buy the same or an equivalent asset today.
  • realizabel value: the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal
  • present value: the present discounted value of future cash flow
  • the amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's-length transaction.

the measurement of performance are income and expense the measurement of financial position are assets, liabilities and equity

income statements

  • grouping by nature: with reference to the presentation of expenses in an income statement, the grouping together of expenses by similar nature, e.g., all depreciation

  • grouping by function: with reference to the presentation of expense in an income statement, the grouping together of expenses serving the same function, e.g., all items that are costs of goods sold.

  • installment method: with respect to revenue recognition, a method that specifies that the portion of the total profit of the sale that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash.

  • cost recovery method: a method of revenue recognition in which the seller does not report any profit until the cash amounts paid by the buyer -- including principal and interest on any financing from the seller -- are greater than all the seller's costs for the merchandise sold.

The securities and exchange commission (SEC)

The following are some of the more common information sources used by analysts

  • securities offerings registration statement
  • Forms 10-K, 20-F, and 40-F
  • Annual Report
  • Proxy statement/Form DEF-14A
  • Forms 10-Q and 6-K

miscellaneous

  • A core objective of the IOSCO is to ensure that the markets are fair, efficient, and transparent. The other core objectives are to reduce, not eliminate, systematic risk and to protect investors, not all users of financial statements.
  • Rules-based, principles-based, and objectives-oriented approaches are recognized approaches to standard-setting.
  • other summary see page 137

revenue recognition

income: income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

general principles

IFRS specifies the revenue from the sale of goods is to be recognized when the following conditions are satisfied:

  • the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
  • the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
  • the amount of revenue can be measured reliably;
  • it is probable that the economic benefits associated with the transaction will flow to the entity;
  • the costs incurred or to be incurred in respect of the transaction can be measured reliably.

US GAAP specify that revenue should be recognized when it is "realized or realizable and earned" with following lists:

  • there is evidence of an arrangement between buyer and seller.
  • the product has been delivered, or the service has been rendered.
  • the price is determined, or determinable.
  • the seller is reasonably sure of collecting money.

revenue recognition in special cases

before transaction after transaction
the percentage-of-completion method is used the installment method and cost recovery method are appropriate

down payment: 首付

  • install method: the portion of the total profit of the sale that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash.
  • cost recovery method: the seller does not report any profit until the cash amounts paid by the buyer-including principal and interest on any financing from the seller-are greater than all the seller's costs for merchandise sold.

inventory costing methods

Method Description COGS when prices are rising Ending Inventory when prices are rising
FIFO first in, first out Lowest Highest
LIFO last in, first out Highest Lowest
Weighted average cost --- Middle Middle

LIFO is prohibited under IFRS

depreciation expense recognition

  • straight-line method: (cost - residual)/useful life
  • double declining method: 2*(cost - accumulated depreciation)/useful life

Non-recurring item

  • discounted operations: is one that management has decided to dispose of, but either has not yet done so, or has disposed of in the current year after the operation had generated income or losses.
  • continuing operations

Basic EPS

$$Basic\ EPS = \frac{Net\ income - Preferred\ dividends}{Weighted\ average\ number\ of\ share\ outstanding}$$

the weighted average number of shares outstanding is a time weighting of common shares outstanding. weighted average numbers = [T1 * out1 +(T2-T1) * (out2+out1) + (T3-T2) * (out3+out2+out1)+...+(T_N-T_{N-1})*(outN+...+out1)]/(TN)

diluted EPS when a company has convertible preferred stock outstanding

$Diluted\ EPS = \frac{(Net\ income)}{(Weighted\ average\ number\ of\ shares\ outstanding + New\ common\ shares\ that\ would\ have\ been\ issued\ at\ conversion)}$

diluted EPS when a company has convertible debt outstanding

$Diluted\ EPS = \frac{(Net\ income + After\ tax\ interest\ on\ convertible\ debt - Preferred\ dividends)}{(Weighted\ average\ number\ of\ shares\ outstanding + Additional\ common\ shares\ that\ would\ have\ been\ issued\ at\ conversion)}$

diluted EPS when a company has option outstanding

$Diluted\ EPS = \frac{(Net\ income - Preferred\ dividends)}{(Weighted\ average\ number\ of\ shares\ outstanding + (New\ shares\ that\ would\ have\ been\ issued\ at\ option\ exercise - Shares\ that\ could\ have\ been\ purchased\ with\ cash\ received\ upon\ exercise) \times (Proportion\ of\ year\ during\ which\ the\ financial\ instruments\ were\ outstanding)}$

Income statement ratios

$$Net\ profit\ margin = \frac{Net\ income}{Revenue}$$ $$Gross\ profit\ margin = \frac{Gross\ profit}{Revenue}$$

miscellaneous

  • expenses may be categorized by either nature of function:
    • expense by function: COGS;
    • expense by nature: tax expense/ interest expense
  • net revenue is revenue for goods sold during the period less any returns and allowances
  • for long term:
    • percentage-of-complete method: both for US GAAP & IFRS when outcome can be measured reliably
    • completed contract method is used under US GAAP when outcome cannot be measured reliably
    • cost recovery method is used under IFRS when outcome cannot be measure reliably

understanding balance sheets

current and non-current classification

  • current assets include cash and other assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater.
    • cash and cash equivalents
    • marketable securities
    • accounts receivable
    • inventories following techniques can be used for measurement of the cost:
      • standard cost
      • retail method: sales value is reduced by the gross margin to calculate cost
    • other current assets
  • current liabilities are obligations that will be satisfied within one year or operating cycle.
    • accounts payable
    • notes payable and current portion of long-term debt
    • deferred income or unearned earning
  • non-current assets will not be converted into cash or used up within one year or operating cycle.
    • property, plant and equipment (PP&E)
      • recoverable amount: the higher of an asset's fair value less cost, and its value in use
      • fair value less cost
      • value in use: the present value of the future cash flows expected to be derived from the assets
    • investment property
    • intangible assets
    • good will
    • financial assets
      • derivatives
      • held-to-maturity
      • held for trading
      • available-for-sale
  • non-current liabilities
    • long-term financial liabilities
    • deferred tax liabilities
  • current assets minus current liabilities equals working capital
  • equity: note the value of share in the statement is the book value instead of the market value
    • contributed capital
    • preferred shares
    • treasury shares
    • retained earning (留存收益)
    • accumulated other comprehensive income
    • non-controlling interest (or minority interest): 非控制权益; refers to owners of the remaining shares of the subsidiary that are not owned by the parent.

common size analysis

  • vertical common-size analysis
  • cross sectional common-size analysis

balance sheet ratio

liquidity ratios

ratio calculation indicates
current ratio current asset / current liabilities ability to meet current liabilities
quick ratio (cash+marketable securities + receivables) / current liabilities ability to meet current liabilities more
cash ratios (cash+marketable securities) / current liabilities most

solvency ratios

ratio calculation indicates
long-term debt-to-equity long-term debt / total equity financial risk and financial leverage
debt-to-equity total debt / total equity ditto
total debt total debt / total assets ditto
financial leverage total assets / total equity ditto

miscellaneous

  • accrued liabilities: 应计费用
  • impairment write-downs: reduction in equity

understanding cash flow statements

classification of cash flows and non-cash activities

  • operating activities (CFO)

    • such as selling inventory and providing services, dealing securities or trading securities
      • for financial assets classified as trading securities, unrealized gains and losses are reported on the income statement and flow to shareholders' equity as part of retained earnings.
      • for financial assets classified as available for sale, unrealized gains and losses are not recorded on the income statement and instead are part of other comprehensive income. Accumulated other comprehensive income is a component of Shareholders' equity.
      • for financial assets classified as held to maturity, are measured at amortised cost. Gains and losses are recognized only when realized.

  • investing activities (CFI)

    • include purchasing and selling long-term assets and other investments.

  • financing activities (CFF)

    • including obtaining or repaying capital, such as equity and long-term debt.

  • operating cash flow + investing cash flow + financing cash flow = change in cash balances

  • changing in cash balance + beginning cash balance = ending cash balance

The steps in calculating CFO under the indirect method can be summarized as follows:

  1. begin with net income
  2. subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land)
  3. add back all noncash charges to income (such as depreciation and amortization) and subtract all noncash components of revenue
  4. add or subtract changes to balance sheet operating accounts as follows
  • increase in the operating asset accounts (uses of cash) are subtracted, while decreases are added
  • increase in the operating liability accounts (sources of cash) are added, while decreases are subtracted.

adjustments to net income using the indirect method

addition

  • non-cash items
    • depreciation expense of tangible assets
    • amortization expense of intangible assets
    • depletion expense of natural resources
    • amortization of bond discount
  • non-operating losses
    • loss on sale or write-down of assets
    • loss on retirement of debt
    • loss on investments accounted for under the equity method
  • increase in deferred income tax liability
  • changes in working capital resulting from accruing higher amounts for expenses than the amounts of cash payments or lower amounts for revenues than the amounts of cash receipts
    • decrease in current operating assets (e.g. accounts receivable, inventory, and prepaid expenses)
    • increase in current operating liabilities (e.g. accounts payable and accrued expense liabilities)

subtraction

  • non-cash items (e.g. amortization of bond premium)
  • non-operating items
    • gain on sale of assets
    • gain on retirement of debt
    • income on investments accounted for under the equity method
  • decrease in deferred income tax liability
  • changes in working capital resulting from accruing lower amounts for expenses than the amounts of cash payments or higher amounts for revenues than for cash receipts
    • increase in current operating assets (e.g. accounts receivable, inventory, and prepaid expenses)
    • decrease in current operating liabilities (e.g. accounts payable and accrued expense liabilities)

free cash flow to the firm (FCFF) and free cash flow to equity (FCFE)

FCFF = NI + NCC + Int(1 - Tax rate) - FCInv - WCInv where: NI = Net income NCC = Non-cash charges (such as depreciation) Int = Interest expense FCInv = Capital expenditures (fixed capital) WCInv = Working capital expenditures

FCFF = CFO + Int(1 - Tax rate) - FCInv

Free cash flow to equity is the cash flow that would be available for distribution to common shareholders. FCFE can be calculated as follows:

FCFE = CFO - FCInv + net borrowing

cash flow ratio

performance ratios calculation what it measures
cash flow to revenue CFO/net revenue operating cash generated per dollar of revenue
cash return on assets CFO/avg total assets operating cash generated per dollar of asset investment
cash return on equity CFO/avg shareholders' equity operating cash generated per dollar of owner investment
cash to income CFO/operating income cash generating ability of operations
cash flow per share (CFO - Preferred dividends)/(Number of common shares outstanding)
coverage ratios calculation what it measures
Debt coverage CFO/ total debt Financial risk and financial leverage
Interest coverage EBIT/Interest paid Ability to meet interest obligation
Reinvestment CFO/Cash paid for long-term assets Ability to acquire assets with operating cash flow
Debt payment CFO/Cash paid for long-term debt repayment Ability to pay debts with operating cash flows
Dividend payment CFO/Dividends paid Ability to pay dividends with operating cash flows
Investing and financing CFO/Cash outflows for investing and financing activities Ability to acquire assets, pay debts, and make distributions to owners

Financial Analysis Technique

An effective analysis encompasses both computations and interpretations.

Ratio Analysis

Net profit margin = Net income/Revenue

return on assets (ROA) = operating income/ avg total assets

financial ratios

  • activity ratios: also know as asset utilization ratios or operating efficiency ratios receivables(rcv) turnover (TO) = annual sales/avg receivables days of sales outstanding (DSO) = 365/rcv TO, which is avg number of days it takes for the customer to pay their bills inventory TO = COGS/avg inv days of inv on hand (DOH)= 365/inv TO payable TO = purchases/avg trade payables days of payables = 365/payable TO total asset TO = revenue/avg total assets fixed asset TO = revenue/avg net fixed assets working capital TO = revenue/avg working capital, how effectively a company is using its working capital

  • liquidity ratios current ratio = current assets/current liabilities quick ratio = (cash+short-term marketable investment+receivables)/current liabilities cash ratio = (cash+short-term marketable investments)/current liabilities defensive interval ratio = (cash+short-term marketable investments+receivables)/(daily cash expenditures) cash conversion cycle = DOH + DSO - Number of days of payables

  • solvency ratios: refers to a company's ability to fulfill its long-term debt obligations

    • debt ratios debt-to-assets ratio = total debt/total assets debt-to-capital ratio = total debt/(total debt+total shareholders' equity) debt-to-equity ratio = total debt/total shareholders' equity financial leverage ratio = average total assets/avg total equity
    • coverage ratios interest coverage = EBIT/Interest payments fixed charge coverage = (EBIT+lease payments)/(Interest payments+lease payments)

  • profitability ratios

    • return on sales gross profit margin = gross profit/revenue operating profit margin = operating income/revenue pretax margin = EBT(earning before tax but after interest)/revenue net profit margin = net income/revenue
    • return on investment operating ROA = operating income/avg total assets ROA = Net income/avg total assets return on total capital = EBIT/short-and long-term debt and equity ROE = Net income/avg total equity return on common equity = (Net income - preferred dividends)/avg common equity

  • valuation ratios P/E = price per share / earnings per share P/CF = price per share / cash flow per share P/S = price per share / sales per share P/BV = price per share / Book value per share

  • dividend-related quantities dividend payout ratio is ratio of cash dividends paid to earnings for a period retention rate = 1 - payout ratio The coefficient of variation for a variable is its standard deviation divided by its expected value.

    • CV sales = std of sales/ mean sales
    • CV operating income = std of operating income/ mean operating income
    • CV net income = std of net income/ mean net income

DuPont Analysis: the decomposition of ROE

ROE = NI/avg shareholders' equity = NI/avg total assets * avg total assets/avg shareholders' equity ROE = ROA * Leverage

ROE = NI/revenue * revenue/avg total assets * avg total assets/avg shareholders' equity ROE = Net profit margin * total asset TO * leverage

ROE = NI/EBT * EBT/EBIT * EBIT/revenue * revenue/avg total assets * avg total assets/avg shareholders' equity ROE = Tax burden * Interest burden * EBIT margin * Total asset TO * Leverage

Common-Size Analysis

Common-size analysis involves expressing financial data, including entire financial statements, in relation to a single financial statement item, or base.

  • vertical common-size balance sheet, dividing each item by the same period's total assets and expressing the results as percentages, highlights the composition of the balance sheet.

  • horizontal common-size balance sheet, computing change in percentage terms of each balance sheet item from prior year or by a base year, highlights changes.

  • cross-sectional analysis: compares a specific metric among a group of companies

  • trend analysis

Graphic analysis

regression analysis

credit analysis

credit risk is the risk of loss

model building and forecasting

  • sensitivity analysis
  • scenario analysis
  • simulation

inventories

COGS = beginning inventory + purchases - ending inventory

product cost:

  • purchase cost less trade discounts and rebates
  • conversion costs including labor and overhead (经常费用， 管理费用)
  • other cost necessary to bing inventory to its present location and condition

period cost, some costs are expensed in the period incurred, not capitalized:

  • abnormal waste of materials, labor, or overhead
  • storage costs (unless required as part of production)
  • administrative overhead
  • selling cost

different inventory valuation methods

  • specific identification
  • first-in, first out COGS will be understated compared to current cost
  • weighted average cost
  • last-in, first-out (LIFO is not allowed under IFRS) in an inflationary environment, LIFO ending inventory is less than current cost.

periodic versus perpetual inventory systems

In periodic inventory system, inventory values and COGS are determined at the end of the accounting period. In a perpetual inventory system, inventory values and COGS are updated continuously.

For the FIFO and specific identification method, ending inventory and values and COGS are the same whether a periodic or perpetual system is used. However, periodic and perpetual inventory system can produce different values under LIFO and weighted average cost method.

Convert a company's reported financial statement from LIFO to FIFO for purpose of comparison

These four relations hold when prices have been rising over the relevant period:

  1. LIFO inventory < FIFO inventory
  2. LIFO COGS > FIFO COGS
  3. LIFO net income < FIFO net income
  4. LIFO tax < FIFO tax

FIFO COGS = LIFO COGS - (ending LIFO reserve - beginning LIFO reserve) FIFO NI = LIFO NI + (ending LIFO reserve - beginning LIFO reserve)*(1-Tax rate) FIFO RE (Retained earning) = LIFO RE + ending LIFO reserve *(1-Tax rate)

Effect on Ratios

  • Profitability: LIFO -> higher COGS -> lower earnings -> lower profitability
  • Liquidity: LIFO -> lower inventory -> lower current asset(inv) -> lower liquidity(use current asset) -> unaffected quick ratio
  • Activity: LIFO -> lower inventory & higher COGS -> higher inventory TO -> lower days of inventory on hand
  • solvency: LIFO -> lower inventory -> lower total assets -> lower stockholders' equity -> higher debt ratio

describe the measurement of inventory at the lower of cost and net realizable value

net realizable value = expected sales prices - estimated selling costs and completion costs under IFRS, inventory is the lower of cost and net realizable value. If the NRV < cost of inventory, the inventory is "write down" to NRV and the loss is recognized in the income statement. If there is a subsequent recovery in value, the inventory can be "written up" and the gain is recognized in the income statement by reducing COGS by the amount of the recovery.

under GAAP, inventory is the lower of cost or market. Market is usually equal to replacement cost, but cannot be greater than net realizable value (NRV) or less than NRV minus a normal profit margin, that is $$Market = replacement\ cost \in [NRV - normal\ profit\ margin, NRV]$$

miscellaneous

IFRS allow the inventories of producers and dealers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products to be carried at net realizable value even if above historical cost. GAAP similar. Under IFRS, reversal of write-down is required if net realizable value increases. The reversal of write-down is not permitted under GAAP.

Long-lived assets

Long-lived tangible assets, referred to as property, plant, and equipment and sometimes as fixed assets, include land, buildings, furniture and fixtures, machinery and vehicle; example of long-lived intangible assets include patents and trademarks; financial assets include investments in equity or debt securities issued by other companies.

As a general rule, an expenditure that is expected to provide a future economic benefit over multiple accounting periods is capitalized; however, if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed in the period incurred.

depreciation and amortization

  • carrying book value: net value on the balance sheet
  • historical cost: also known as gross investment in the asset

depreciation method

  • straight-line method depreciation expense = (original cost - salvage value)/depreciable life
  • accelerated methods DDB depreciation in year x = 2/depreciable life in years*book value at beginning of year x
  • units-of-production method units-of-production depreciation = (original -salvage value)/life in output units * output units in the period

miscellaneous

  • only cost necessary for the machine to be ready to use can be capitalized.
  • Under IFRS, income earned on temporarily investing the borrowed monies decreases the amount of borrowing costs eligible for capitalization.
  • value increase brought about by the revaluation should be recorded directly in equity.
  • Impairment = max(Fair value - costs to sell, value in use) - net carrying amount
  • according to IFRS, all of the following pieces of information about PP&E must be disclosed in a company's financial statements and footnotes except for acquisition dates
  • according to IFRS, all of the following pieces of information about intangible assets must be disclosed in a company's financial statements and footnotes except for fair values
  • when a company uses the fair value model to value investment property, changes in the fair value of the property are reported in the income statement -- not in the other comprehensive income.
  • a company will change from the fair value model to either the cost model or revaluation model when the company transfers investment property to PP&E.

income taxes

  • taxable income
  • taxes payable
  • income tax paid
  • tax loss carryforward: a current or past loss that can be used to reduce taxable income. can result in a deferred tax asset.
  • tax base: net amount of an asset or liability used for tax reporting purpose.

financial reporting terminology

  • income tax expense. Expense recognized in the income statement that includes taxes payable and changes in deferred tax assets and liabilities (DTA and DTL):

income tax expense = taxes payable + Delta DTL - Delta DTA

  • deferred tax liabilities: balance sheet amounts that result from an excess of income tax expense over taxes payable that are expected to result in future cash outflows.
  • deferred tax assets: balance sheet amounts that result from an excess of taxes payable over income tax expense that are expected to be recovered from future operations. Can also result from tax loss carryforwards.

deferred tax liabilities are expected to reverse as liabilities while as equity when they are not expected to reverse. When both timing and amount of tax payments are uncertain, should treat it as neither liabilities nor equity.

temporary and permanent differences between taxable and accounting profit

permanent difference are difference between tax and financial reporting of revenue that will not be reversed at some future date. These differences do not give rise to deferred tax.

  • income or expense items not allowed by tax legislation, and
  • tax credits for some expenditures that directly reduce taxes
  • effective tax rate = income tax expense/pretax income

taxable temporary differences result in expected future taxable income deductible temporary differences result in expected future tax deduction tax credits that directly reduce taxes are a permanent difference

valuation allowance is a contra account that reduces the DTA value on the balance sheet. Increasing the valuation allowance will increase income tax expense and reduce earnings. If circumstances change, the DTA can be revalued upward by decreasing the valuation allowance, which would increase earnings.

non-current (long-term) liabilities

income statement/balance sheet impact of issuing a bond

issued at par issued at a premium issued at a discount
market rate=coupon rate market rate < coupon rate market rate > coupon rate
interest = coupon rate*face value=cash paid interest=cash paid-amortization of premium interest = cash paid + amortization
interest is constant interest decreases interest increases

Under US GAAP, expenses incurred such as print fee... when issuing bonds are generally recorded as an asset and amortized to the related expense over the life of bonds. Under IFRS, they are included in the measurement of the liability. The related cash flow are financing activities.

a gain will be recorded on the income statement when carrying amount greater than paid cash of the purchase of a bond

debt covenants

  • affirmative covenants: borrowers promises to do certain things
  • negative covenants: borrowers promises to refrain from certain activities that might adversely affect its ability to repay the outstanding debt, such as:
    • increasing dividends or repurchasing shares
    • issuing more debt
    • engaging in mergers and acquisitions

lease

  • finance lease
  • operating lease
Item Finance Lease Operating Lease
Assets Higher Lower
Liabilities Higher Lower
NI (early years) Lower Higher
NI (later years) Higher Lower
Total NI Same Same
EBIT (operating income) Higher Lower
CFO Higher Lower
CFF Lower Higher
Total cash flow Same Same
Current ratio (CA/CL) Lower Higher
Working Capital (CA - CL) Lower Higher
Asset TO (Revenue/Asset) Lower Higher
Return on asset (NI/Asset), early Lower Higher
Return on equity (NI/SE), early Lower Higher
Debt/Asset Higher Lower
Debt/Equity Higher Lower

leasing can have certain benefits:

  • less costly financing
  • reduced risk of obsolescence
  • less restrictive provisions
  • off-balance-sheet financing
  • tax reporting advantage

financial statement

  • balance sheet: finance lease results in a reported asset and a liability. TO ratio that use total/fixed assets in denominators lower; return on assets lower; leverage ratios higher such as debt-to-assets and debt-to-equity because of reported liability; current ratio and working capital lower
  • income statement: as to finance, EBIT will be higher; total expense over the life of a lease will be same; in early years of a finance lease, the interest expense is higher, so NI will be lower in early years
  • cash flow statement: total cash flow is unaffected; as to finance lease, CFF is lower and CFO is higher

disclosure

The lessee will disclose

  • the future obligation by maturity of its operating leases.
  • The future obligations by maturity, leased assets, and lease liabilities will be shown for finance leases.

defined contribution and defined benefit pension plans

  • defined contribution plan: firm's contribution can includes years of service, the employee's age, compensation, profitability, or even a percentage of the employee's contribution. Make no promise regarding the future value of the plan assets. The investment decisions are left to the employee, who takes all of the investment risk.

  • defined benefit plan: the firm promises to make periodic payments to employees after retirement, which is usually based on

  • The company will report a net pension obligation equal to the pension obligation less the plan assets

financial reporting quality

conservative and aggressive accounting

Aggressive Conservative
tend to increase reported earnings or improve the financial position for the current period tend to decrease the company's reported earnings and financial position for the current period
capitalizing current period costs expensing current period costs
longer estimates of the lives of depreciable assets shorter estimates of the lives of depreciable assets
higher estimates of salvage values lower estimates of salvage values
straight line depreciation accelerated depreciation
delayed recognition of impairments early recognition of impairments
less accrual of reserves for bad debt more accrual of reserves for bad debt
smaller valuation allowances on deferred tax assets larger valuation allowances on deferred tax assets

Conservative choices may decrease the amount of revenues, earnings, and/or operating cash flow reported in the current period and increase those amounts in later periods.

  • 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 ,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 audit opinion of a company's financial report is most likely intended to assure that financial information is presented fairly.

  • If a company uses a non-GAAP financial measure in an SEC filing, it is required to provide the most directly comparable GAAP measure with equivalent prominence in the filing. In addition, the company is required to provide a reconciliation between the non-GAAP measure and the equivalent GAAP measure.

  • At the top of the quality spectrum of financial reports are reports that conform to GAAP, are decision useful, and have earnings that are sustainable and offer adequate returns. In other words, these reports have both high financial reporting quality and high earnings quality.

  • When calculating solvency ratios, analysts should estimate the present value of operating lease obligations and add it to the firm's liabilities.