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Concepts

Description

Role of financial reporting

Introduction
Provide to variety of users useful information about the Company's performance and financial position

Role of FS analysis

Use FS data to support economic decisions

BS

Assets, Liabilities, OE at a point in time

PL

Results from business activities
Revenue, Cost from generating revenue, Profit/loss

Statement of Change in Equity

Amount and source of changes in OE

CF

Amount, source and use of cash

Footnotes and supplementary
schedule

Include:
- Information about the accounting method, estimates and assumptions;
- segments reults, commitments and contingencies, legal proceedings, acquisition and divestitures, issuance of stock options and details of employees
benefit plans

Management's commentary
(discussion and analysis)

Contains:
- Overview of the Company;
- Business trends, future capital needs, liquidity, significant events, significant choices of accounting method requiring management judgement
...

Ensure no material errors
Review the Company Internal Control

Audit opinion

-

Management responsibility

- Mantaining effective internal control
- Ensure accuracy of its FS

Other important information
sources

-

Financial analysis framework

1
...
Gather data (collect FS, other relevant data; interview management, suppliers, customers; site visit)
3
...
Analyze and interpret data (use data to answer questions in the first step)
5
...
Update the analysis (Repeat these steps periodically; change conclusion and recommendation when neccessary)

Unqualified (clean)
Qualified
Adverse opinion (presented not fairly or materially nonconforming with Accounting Standards)
Disclaimer of opinion (Unable to express opinion)

Quarterly/semiannually FS
Proxy statements
Press releases
Earning guidance
Industry information
Comparable companies

Financial Reporting Mechanics
Classification of business activities - Operating activities: Ordinary business;
- Investing activities: buying/disposing of long-term assets;
- Financing activities: Issue/Repay debt, issue/repurchase stock, pay cash interest/dividend
...


Link between BS, PL, CF and
change in OE

Changes in BS balance over a period are reflected in PL, CF, and change in OE

General journal

journal entries sorted by date

General ledger

journal entries sorted by account

Reason for understanding how to
produce FS

FR requires choice of method, judgement and estimate

Reporting standard

Financial Reporting Standards
- Ensure different firms' FS are comparable
- narrow the range of reasonable estimates
support users who rely on Fs for the Company's activities, profitability and creditworthiness

Standard-setting bodies

Private organisation that establish reporting standards
E
...
g: SEC (Securities and exchange commission - US); Financial Services Authority (FSA); and International Organisation of Securities Commissions (IOSCO)

Barrier for convergence to IFRS

- different opinion among standard-setting bodies and regulatory authorities
- political pressure from entities affected by changes

Features of FS

-

Reaining differences between US
GAAP and IFRS

IASB: lists income and expenses as elements related to performance
FASB: includes revenue, expenses, gains, losses and comprehensive income
...
Risk and reward of ownership is transferred
2
...
Revenue could be measured reliably
4
...
Costs could be measured reliably

Revenue recognition (sale of
goods) - IASB

Revenue recognition (service
rendered) - IASB

1
...
probable flow of economic benefits
3
...
cost incurred and cost of completion could be measured reliably

Revenue recognition (Sale of
goods and service rendered) FASB

FASB:
1
...

SEC:
2
...
Product has been delivered; or service has been rendered
3
...
Seller is reasonable sure of collecting money

Long-term contract

1
...
Costs are recognised when incrred
...
Completed contract method (US GAAP only - when outcome coulf not be reliably measured): Revenue, expenses and profit are rcognised at completion
** If loss is expected, loss must be recognised immediately**

Pros and Cons of percentage of
completion

Pros: Smoother earning; better matching of revenue and expenses
Cons: More aggressive since revene is recorded sooner; more subjective, since it requires estimates

Installment sales
(payments received over a period
of time)

US GAAP:
Certain collectibility: normal revenue recognition criteria
Collectibility could not be estimated reasonably: Installment method
...
Profit = cash collected x expected % profit
of sales
Highly uncertain collectiblility: Cost recovery method (profit is recorded after recovery all costs)
IFRS:
Certain collectibility: Discounted PV of installment payment is recorded as revenue at the time of sale
...


Barter transaction
(exchange of goods or services)

US GAAP:
revenue could be recognised at fair value if the Company has historically received cash payment for that goods/services and could use historical
experience to determined fair value

Gross revenue

IFRS:
revenue must be based on fair value from similar non-barter transactions with third parties
Sales revenue and COS are separated

Net revenue

Only report the difference between revenue and COS

Criteria for Gross revenue
reporting under US GAAP

- Be the primary obligator under the contract
- Bear the inventory risk and credit risk
- Be able to choose supplier
- Have reasonable latitude to establish the price

Consider when analysing revevnue - level of conservative of revenue recognition policies
- how much do the Company's policies rely on judgement and estimates
Converged standards for revenue
recognition

1
...
Identify the performance obligations in the contract(s)
3
...
Allocate transaction price to the performance obligations
5
...
Straight-line method: (Cost - residual value)/useful life
2
...
g: double declining balance)

Amortisation method

1
...
Indefinite lives (e
...

Impairment test would lead to Impairment loss and reversal of impairment loss (PL); or revaluation surplus (OCI)

Principle
Implication

Bad Debt / Warranty Expense
If a firm sell goods / services on credit → have to es mate bad debt / warranty expense in the period of sale
- Possible for Company to delay / accelarate the recognition of expenses by change in estimates → increase net income → more aggressive
- Should consider the reasons for change in estimates
- Should compare the Company's estimates with other comparable companies
...

Implication
Discontinued operations do not affect net income of continuing operations → should be excluded when forecating future earnings

Unusual / infrequent items

Unusual in nature (gains / losses from sale of assets or part of a business)
Infrequent in occurrence (Impairment, write-offs, write-downs, restructuring costs)
These items are included in the income from continuing operations

Implication

Should review to determine whether these items should be included when forecasting future earnings

Change in accounting policies

Changes in Accounting policies
IFRS ↔ GAAP
Require Retrospective application to enhance comparability

Change in accounting estimates
Implication

Prior-period adjustments

Change of management's judgement, due to new information
Could be applie prospecively, not require for restatement of prior Financial Statements
Do not affect cash flow
Sould be reviewed to determined the impact on future earnings
- Correction of accounting method
- Correction of accounting error
Require to disclose its effect on net income

Typre of EPS

EPS
Simple capital structure (no potentially dilutive securities) → Basic EPS
Complex capital structure (Potentially dilutive securities) → Basic EPS and Diluted EPS

Basic EPS

Do not consider the effecs of any dilutive securities

Basic EPS calculation

Basic EPS = (Net income - Preferred dividends) / Weighted avg
...
number of shares outstanding = No
...
g:
Net income: 10,000 USD
...
Common stock dividends: 1,750 USD
...
of share is 10,000
...

Weighted avg
...
82

Stock dividend

Distribute additional shares to shareholders in an amount proportional to theirs current number of shares

Stock split

Divide "old" share into a specific number of "new" shares

Basic EPS example
Dilutive securities
(treated as common stock when
calculating diluted EPS)

Net income: 10,000 USD
...
Common stock dividends: 1,750 USD
...


In which:
- exercise price > market price → not exercise → stock op ons and warrants are not dilutive → no share issuable from stock options
- exercise price < market price → exercise → stock op ons and warrants are dilutive → share issuable from stock op ons are calculated using treasury
stock method
Treasury stock method

Assumption: fund received from exercising stock options are used to repurchase common stocks @ market price
...

E
...
12
...
12
...
)
- Reduce production cost
Net profit margin
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =

𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑟𝑒𝑣𝑒𝑛𝑢𝑒

Net profit margin measure the profit after considering all expenses
Comprehensive income

Conprehensive income = Net income + Other Comprehensive income

Other comprehensive income

Include:
1
...
Adjustments for minimum pension liability
3
...
Unrealised gains / losses from available-for-sale securities (FV through OCI)

Implication

Firms could adjust transactions from net income to OCI or vice versa → must comparing comprehensive income when comparing financial performance
with other firms

Concepts
Definition

Balance sheet's elements

Description
Balance sheet
Disclose the firm's financial position at a point in time
...

Assets: resources controlled by the Company as a result of past events and from which future economic benefits are expected to flow to the Company
...

Equity: owner's residual interest in the Company's assets after deducting all liabilities
...
current value);
- Value of items measured at current value would change from reporting date to now;
- Factors that could not be reflected in balance sheet (reputation, management skills,
...


Current liabilities

Obligations that will be satisfied within one year / one operating cycle
...


Working capital

Working capital = Current assets - current liabilities
Working capital is too low: liquidity problem;
Working capital is too high: inefficient use of assets

Non-current assets

Do not meet the criteria of current assets
Provide information about the Company's investing activities

Non-current liabilities

Do not meet the criteria of current liabilities
Provide information about the Company's financing activities

Cash and cash equivalents

Current assets
Cash equivalents are:
- short-term, highly liquid investments;
- readily convertible to cash;
- near enough to maturity → insignificant interest rate risk
...
g: Treasure bills, commercial paper, money market funds
...
g: treasury bills, notes, bonds, equity securities

Accounts Receivable

Financial assets that represent amounts customers owe the firm for goods and services sold on credit
Present at net realisable value (AR - allowance for doubtful debts)
Firms are required to disclose significant concentrations of credit risk (customer, geographic, industry)

Implication

Receivable / sales → collection problems
Allowance for doubtful debt: relative to level of sales and growth rate
Firm could underestimate bad debt → Increasse earnings

Inventories

Goods held for sale or used in manufacture of goods to be sold
Invetories include: raw materials, WIP, finished goods
Cost of inventories:
- Include: Purchase cost, conversion costs, other costs neccessary to bring the inveontory to its presents location and condition
- Exclude: abnormal wate (labor, material, overhead), storage (unless neccessary as part of the production), admin
...
GAAP: Inventories are reported at the lower of cost or market (= replacement cost, but cannot be higher than net realisable value or (net realisable
value - normal profit margin))

Other current assets

Accounts Payable

Notes payable
Current portion of LT debt

Amounts immaterial if show separately
E
...
Reasons are: (1) expenses / losses are recognised before they are tax deductible (expenses
recorded but not yet paid); or (2) income is taxable before it is recorded in IS (unearned revenue)
...
g: interest expense, wage payable, accrued warranty payable, tax payable

Unearned revenue

Cash collected in advance of providing goods / services

Implication

Unearned revenue not require future cash outflow
Those revenue would be recognised in the future → may indicate future growth

Properties, plant and equipments

Cost model
(IFRS & US GAAP)

Non-current assets
Tangible assets used in the production of goods / services
Benefit for more than 01 year or 01 production cycle
E
...

Carrying value > recoverable amount → impair
Recoverable amount = FV - selling cost / or value in use
Loss recoveries: allowed under IFRS, not under US GAAP

Revaluation model
(IFRS only)

FV - accumulated depreciation

Investment property

Real estate that:
- generate rental income; or
- generate return on investment through future resale
Reported at amortised cost (like PPE) or fair value (gain/loss through PL)

Intangible assets

Non-monetary assets, with no physical substance

Identifiable intangible assets

Can be acquired separately, as right of privileges for owners
E
...
g: Goodwill

Treatment for other cost

IFRS
R&D

Startup & training cost

Research stage cost: expense
Development stage cost: intangible assets
Expensed as incurred

Administrative overhead Expensed as incurred
Adv & promotion cost

US GAAP

Expensed as incurred

Expensed as incurred

Expensed as incurred
Expensed as incurred
Expensed as incurred

Reloctaion &
reorganisation cost

Expensed as incurred

Expensed as incurred

Termination cost

Expensed as incurred

Expensed as incurred

Implication

Should consider value to firm of each intangible assets before making adjustments

Goodwill

purchase price - identifiable net assets acquired in a business acquisition
Reason: assets might not have quantifiable value reported on BS (reputation, customer loyalty, R&D)
synergies
Impairment test at least annually

Implication

Could manipulate net income by allocating more of acquisition price to goodwill → less depreciation
→ higher net income
When computing ration: eliminate goodwill and goodwill impairment charges
Evaluate future acquisition in terms of price paid / earning power of acquired assets

Financial instruments

Contracts, rise financial asset on one entity, and financial liability / equity instrument in another entity
Measure @:
- historical cost : unlisted equity investment; loan and receivables
- amortised cost : Held-to-maturities
- fair value: Trading securities, available-for-sale securities, derivatives

Held to maturities
(amortised cost)

debt securities
Intended to be held
Reported @ amortised cost (Calculated using PV)
Market value is ignored

Trading securities
Derivatives
(Fair value)

Debt and equity securities
Intend to profit over the near term
Reported @ FV
FVTPL

Available-for-sale securities

Debt and equity securities
Not expected to be held to maturity
Not expected to be traded in near term
Reported @ FV
FVTOCI

Long-term financial liabilities

Deferred tax liabilities

Non-current liabilities
Include: Bank loans, note payable, bond payable, derivatives
Reported @:
- Amortised cost (calculated using PV)
- FV (not usual - e
...

Vertical common-sized balance sheet

Vertical common-sized balance
sheet

Each item as % of total assets
Allow to:
- Comparision over time
- Comparision across firms

Balance sheet ratios

Compare balance sheet items only
Could be used to evaluate liquidity and solvency
Allow to:
- Comparision over time
- Comparision across firms

Balance sheet ratios

Limitations:
- Difference accounting standards and estimates → Lack of comparison
- Firms operate in different industries → lack of homogeneity
- Judgement when interpreting ratios
- BS data: single point in time
Liquidity ratios

Ability to meet ST obligations as they come to due
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =

𝐶𝑎𝑠ℎ 𝑟𝑎𝑡𝑖𝑜 =

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐶𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐶𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 − 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

These 3 ratios should be considered collectively

Solvency ratios

Ability to meet LT obligations as they come to due
𝐿𝑇 𝑑𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 =

𝐿𝑇 𝑑𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦

𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 =

𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 =

𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦

𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
These 4 ratios should be considered collectively
* Note:
- solvency ratios: debt are any interest bearing obligations
- financial leverage ratio: capture the impact of all obligations
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =

Concepts

Description

Cash flow statement

Cash Flow Statement
Ending cash balance = Opening cash balance + Change in cash balance
Change in cash balance = CFO + CFI + CFF

Cash flow from operating activities Cash received / paid for selling goods services
(CFO)
E
...
total assets

Cash return on equity

Operating cash generated per $1 of owner's investment
= CFO / Avg
...
Only useful when compare to other firms / historical performance
- Different accounting treatments → difficult for comparision
- Firm operates in multiple industry difficult to find comparable industry ratios
- Cannot make conclusion by calculating a single ratio
...

- Difficult to determine the target or comparison value → range of acceptable value is required
Note:
- ratios definition could vary widely → need to be consistent during analysis
- Reasonable value could differ among industries
Common-size analysis

Normalised BS and PL easier to compare vs other firms / historical performance overtime
- Vertical common-size BS: % of total assets
- Vertical common-size PL: % of sales
+ Show certain financial ratios (GP margin, OP margin, NP margin)
+ Useful for studying trends in costs and profit margins
+ Point analysis to the right direction to find out the circumstances that led to increase in NP margin, and effect on firm cash flow
- Horizontal BS and PL: all items of BS and PL are standardised to 1
...
Activities ratios: how well the firm utilises its various assets (e
...
: inventory, fixed assets, etc
...
Liquidity ratios: ability to pay ST obligations as they come to due
3
...
Profitability ratios: How well the firm generates OP, NP from its sales
5
...
of days for customers to pay their bills
𝐷𝑎𝑦𝑠 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 =

365
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Desirable: close to industry norm
Too high → customers too slow to pay → too much capital is tied up in assets
Too low → Too rigorous credit policies → decrease sale
Inventory turnover

Efficiency in processing and managing inventory
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝐶𝑂𝐺𝑆
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Days of inventory on hand
𝐷𝑎𝑦𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑜𝑛 ℎ𝑎𝑛𝑑 =

365
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Desirable: close to industry norm
Too high → too much capital is ed up in inventory / or obsolete inventory
Too low → Inadequate stock on hand
Payable turnover
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠

* Purchases = ending inventory - beginning inventory + COGS
Number of days of payables

Average time for the company to pay its bills
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 =

365
𝑃𝑎𝑦𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Might indicate liquidity problem
Total asset turnover

Effectiveness in using total assets to create revenue
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Desirable: close to industry norm
Too high → too few assets for poten al sales / or outdated assets
Too low → capital ed up in assets
Fixed asset turnover

Utilisation of fixed assets in creating revenue
𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

Desirable: close to industry norm
Too high → obsolete equipment / or might need to incur CAPEX in near future
Too low → capital ed up in assets / or using assets inefficiently
Working capital turnover

Effectively in using Working capital ($ of sales per $ of WC)
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Working capital = Current assets - Current liabilities
Desirable: close to industry norm
If low WC due to outstanding payables ≥ Inventory + receivables → WC turnover is very large, less informa ve
Liquidity ratios
Current ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Higher current ratio → more able to pay its ST obligations
Current ratio < 1 → WC < 0 → probable of liquidity crisis
Quick ratio
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =

𝐶𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Higher quick ratio → more able to pay its ST obligations
Cash ratio
𝐶𝑎𝑠ℎ 𝑟𝑎𝑡𝑖𝑜 =

𝐶𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Most conservative
Higher cash ratio → more able to pay its ST obligations
Defensive interval ratio

No
...

Extended 5-way approach
𝑅𝑂𝐸 =

𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝐸𝐵𝑇
𝐸𝐵𝐼𝑇
𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
=
×
×
×
×
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑞𝑢𝑖𝑡𝑦
𝐸𝐵𝑇
𝐸𝐵𝐼𝑇 𝑟𝑒𝑣𝑒𝑛𝑢 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑞𝑢𝑖𝑡𝑦
𝐸𝐵𝐼𝑇
𝑡𝑎𝑥
𝑎𝑠𝑠𝑒𝑡𝑠
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒
=
×
×
×
×
𝑚𝑎𝑟𝑔𝑖𝑛
𝑏𝑢𝑟𝑑𝑒𝑛
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝑏𝑢𝑟𝑑𝑒𝑛
𝑟𝑎𝑡𝑖𝑜

Low ROE because at least one of th following:
- Poor profit margin;
- Poor asset turnover;
- Too little leverage;
- High tax burden;
- High interest burden
...


Concepts

Description

Classification

Inventories
Merchandise firms: ready for sale inventory
Manufacturing firms: Raw materials, WIP, finished goods

Relationship between COGS and
inventory

Ending inventory = Beginning inventory + purchases - COGS

Capitalised / expensed inventory
cost

Capitalised:
- Purchase cost less discount and rebates
- Conversion cost (Labor, machine, overhead)
- Other cost necessary to bring the inventory to its present location and condition
Expensed:
- Abnormal waste of material, labor or overhead
- Storage cost (unless required as part of production)
- Admin overhead
- Selling costs

Value of inventory

Under IFRS:
- lower of cost or net realisable value;
- Net realisable value = Sale price - Selling costs
- If net realisable value < Cost → Writedown;
- Write-up is allowed
...


Affect of inventory writedown to
FS and ratio

1
...
Increase in asset turnover; Debt-to-quity ratio and Debt-to-assets ratio;
3
...


Type of inventory cost flow
method

1
...
FIFO: First in first out;
3
...
Weighted average cost: average cost per unit = total cost of goods available for sale ÷ total quantity avaiable for sale
...

US GAAP: firm must explain why the change is preferable
...


Perpetual / Periodic inventory
system

Period inventory system: value of inventory and COGS are determined at the end of the period;
Perpetual inventory system: value of inventory and COGS are updated continuously
...

Firms using LIFO also need to disclose:
- LIFO reserve (FIFO inventory - LIFO inventory)

LIFO liquidation

During inflationary period, inventory quantities decline → Older, lower cost inventories are included in COGS → Higher profit margin
This increase in profit margin is not sustainable, since the firm could not sell existing inventory without replenishment

Convert LIFO to FIFO

Comparison of firms' FS require adjustment into same costing method
Method:
1
...
FIFO COGS = LIFO COGS - (ending LIFO reserve - beginning LIFO reserve)
3
...
FIFO retained earnings = LIFO retained earnings + [LIFO reserve x (1- tax rate)]

Implication

- ↑ Finished goods ; ↓ Raw materials; ↓ WIP → ↓ demand, poten al future inventory writedown
- ↑ Raw materials, ↑ WIP
→ ↑ future demand, ↑ future earnings
- ↑ finished goods > ↑ sales
→ ↓ demand, or inventory obsolescence, poten al inventory writedown
...

- Subsequent recognition : expect to provide more future economic benefits
Expensed:
- Initial recognition : not expect to provide economic benefits for more than one period
...

*Training cost is not neccessary to get the aset ready to use (get the employees ready to use the asset)
Long-term assets that lack physical substance, including:
1
...
)
2
...
Indentifiable intangible assets:
- Capable of being separate from the firm / arise from a contractual of legal right;
- Controlled by the firm;
- Expected to provide future economic benefits
...
Unidentifiable intangible assets (goodwill):
- Cannot be purchased separately;
- May have indefinite life
...
fair value model)
- Useful life / depreciation rate
- Carrying value for each class of asset
- Accumulated depreciation / amortisation for each class of asset
- Reconciliation between beginning and ending carrying amount
- Title restriction; assets pledged as collateral
- Intangible assets: finite / indefinite useful life
- Impaired assets: The loss / reversal amount and the circumstances that cause the loss / reversal
- Revalued assets (IFRS only): revaluation date, how FV was determined, and the carrying value under historical cost model

Uses of disclosures
𝐴𝑣𝑔
...
Finance lease
Assets
Liabilities
Net income (in early years)
Net income (later years)
Total net income
EBIT
CFO
CFF
Total CF

Transfer to / from investment
property

Finance lease
↑
↑
↓
↑
same
↑
↑
↓
same

Operating lease
↓
↓
↑
↓
same
↓
↓
↑
same

Current ratio
↓
↑
Working capital
↓
↑
Asset turnover
↓
↑
ROA (in early years)
↓
↑
ROE (in early years)
↓
↑
Debt / Assets
↑
↓
Debt / Equity
↑
↓
Owner-occupied
→ Investment property
- Treat as revaluation (recognise gain if it reverse previously recognised loss)
Inventory
→ Investment property
- Recognise gain / loss if FV ≠ carrying amount
Investment property → Owner-occupied / Inventory - FV of asset @date of transfer→ cost under new classifica on

Concepts

Description
Income taxes

Taxable income

Income subject to tax based on tax return

Accounting profit

EBT from PL based on Financial accounting standard

Tax payable

Tax liability from tax return

Income tax expense

Expense recognised in PL
Income tax expense = Tax payable + ∆ DTL - ∆ DTA

Deferred tax assets

BS Assets value when tax payable > Income tax expense; difference is expected to reverse in the future
Arise when:
- Revenues are taxable before being recognised in PL (Deferred revenues / advance from customers)
- Expenses are recognised in PL before being deductible (Accrual expenses / Advance to suppliers)
- Tax loss carryforward
...
g: export revenue)
- Expense that is not deductible
- Tax credit → direct reduc on of tax

Temporary difference - Common
examples

- Using accelerated depreciation for tax purpose, and straight line depreciation for FR → DTL
- Impairments: asset writedown is recorded immediately in PL, but tax deduction is not allowed until the asset is sold / disposed → DTA
- Restructuring: Costs are recorded in PL when restructuring is announced, but not deducted until actually paid → DTA
- Choice of inventory cost-flow method → temporary difference
- Post-employment benefits and Deferred compensation: recorded in PL when earned by employee, but deducted when paid → DTA
- Unrealised gain / loss on available-for-sale marketable securities → Deferred tax adjustment for gain / loss taken directly into equity

Dislosure requirement

- Detailed source of temporary difference that cause DTA / DTL
- DTA, DTL, valuation allowance (if any), amd net change in valuation allowance in the period
- Unrecognised DTL for undistributed earnings of subsidiaries and JVs (if any)
- Current year tax effect of each type of temporary difference
- Component of income tax expense
- Reconciliation between income tax expense in PL and tax expense based in statutory rate
- Tax loss carryforwards and credits
...
US GAAP

Major difference
IFRS: allow upward revaluation → related effects on deferred tax are recorded in equity
...


Concepts
Book value of bond

Description
Non-current liabilities
Book value of bond = PV of remaining CF discounted @ market interest rate at issuance
Market interest rate @ issuance = coupon rate → issue at par → book value = face value
Market interest rate @ issuance > coupon rate → discount bond → book value < face value
Market interest rate @ issuance < coupon rate → premium bond → book value > face value

Interest expense of bond

Interest expense = beginning book value liability x bond's yield @ issuance
Bond issue @ par → interest expense = coupon payment
Premium bond → interest expense > coupon payment
Discount bond → interest expense < coupon payment

Bond's issuance cost

US
...
GAAP, written off remaining capitalised issuance cost → PL

Debt covenant

Restrictions of the bondholders on the borrower → ↓ default risk → protect bondholders
Affirmative covenant: Borrower promise to do certain things (make timely payments; maintain ratios and items of FS @ certain level; maintain collateral;
etc
...
)

Bond's disclosure requirement

- Outstanding of LT debt, and portion due within next year;
- Nature of the liabilities;
- Maturities date;
- Stated and effective interest rate;
- Call provisions and conversion priviledge;
- Restrictions;
- Assets pledged as security;
- Amount of debt maturing in each of the next 5 years
...
The firm make
no promise about the FV of the plan assets → Pension expense = the Company's contribution
Defined benefit plan: Retirement plan which the Company promises to make periodic payments to employees after retirement → Company must es mate
its obligation to employees
...
Follow US GAAP
2
...
Information also need to be material (knowledge of the
information would likely to affect the decisions of FS's users)
- Faithful representation: qualities of completeness, neutrality and absence of errors

Quality of Earnings

Characteristics of a firm's earnings:
1
...
g
...
Level of earnings: reported earnings must be high enough to sustain the company's operation and existence overtime

Spectrum for assessing FR quality

FR that are compliant with US GAAP, decision useful, and earnings are sustainable and adequate
↓
FR that are compliant with US GAAP, decision useful, but earnings quality is low (not sustainable or not adequate)
↓
FR that are compliant with US GAAP, but earnings quality is low (not sustainable or not adequate), and reported choices and estimates are biased
↓
FR that are compliant with US GAAP, but earnings is actively managed to increase, decrease or smooth
↓
FR that are not compliant with US GAAP, although the numbers presented are based on the company's actual economic activities
↓
FR that are not compliant with US GAAP, and includes fictitious/fraudulent numbers

Conservative accounting

Biased accounting choice, decrease the Company's earnings annd financial position

Aggressive accounting

Biased accounting choice, increase the Company's earnings annd financial position

Earning smoothing

Biased accounting choice, to smooth earnings overtime, because greater earning volatility tend to redce value of company's share

Condition for issuing low-quality
FS

1
...
Opprtunity
- weak IC
- BOD provide inadequate oversight
- Accounting standard provide a large range of acceptable accounting treatments
...

3
...
Regulation
...
Audit
...
Private contract
Non-US GAAP measure
- Display most comparable US GAAP measure
- Explain from management why the non-GAAP measure is
more useful
- Reconcile between non-GAAP measure and the most
comparable GAAP measure
- Disclose other purposes for using non-GAAP measure
- Include items that are likely to recur in the future (including
nonrecurring, unusual or infrequent item)

Non-IFRS measure
- Define and explain from management why the non-IFRS
measure is more useful/relevance
- Reconcile between non-IFRS measure and the most
comparable IFRS measure

Biased accounting choices and
estimates - Revenue recognition

Biased accounting choices and
estimates - Estimation of credit
losses

1
...
Offer discount/special financing term to increase order
3
...
Bill-and-hold
Underestimate of uncollectible receivable → Higher receivables, higher income
Overestimate of warranty reserve → higher income

Biased accounting choices and
estimates - Valuation allowance

Underestimate of valuation allowance → Higher DTA, higher income

Biased accounting choices and
estimates - Depreciation /
Amortisation method, estimates
and Impairment

1
...
straight line depreciation/amortisation
2
...
Longer useful life → decrease periodic deprecia on/amor sa on → increase net income in early years
4
...
Weighted average cost
*Rising price: FIFO COGS < weighted average cost COGS → FIFO earning > Weighted average cost COGS ;
FIFO inventory > weighted average cost inventory

Biased accounting choices and
estimates - Related-party
transactions

Adjusting price of goods supplied → shi profit between related par es

Biased accounting choices and
Expense could be capitalised into assets → impact of the expense on net income spread over many years
estimates - Expense capitalisation Expense capitalisation also impact CF
...

E
...
:
GM of Companies sell premium goods > GM of companies sell normal goods
R&D cost of Companies sell premium goods > R&D cost of companies sell normal goods
GM/OM of Companies sell premium goods > GM/OM of companies sell normal goods
Company improve EPS by cutting cost → OM, GM over me will reveal whether the company is able to implement the strategy, or sales have been suffered

Forecast future net income and
cash flow

1
...
Industry growth
...

- If firm's market share is expected to increase/decrease, firm's estimated sales = market share x estimated industry sales for the period
...
In simple forecasting model, earnings could be forecasted using historical average/trend-adjusted measure of profitability (OM, EBT margin, net
margin)
3
...
Multi-period forecast: use single estimate of sals growth at some point
5
...
Future interest expense should be adjusted for any increase in debt)

Credit analysis

1
...
Collateral: ability to pledge collateral → reduce lender's risk
3
...
Scale and diversification: Wider variety of product line, greater geographic diversification → be er credit risk
2
...
Margin stability: More stable profitability margin → higher probability of repayment → be er credit risk
4
...
Use multiple criteria, since single factor moght include firms with undesirable characteristics (e
...
: low P/E ratio → opera ng losses, decline sales, or high
leverage)
* might include/exclude many/all firms in particular industries
...
g
...
Back testing: using a specific set of criteria to assess historical performance → forecast future performance
...
age (remaining value / depreciation expense); avg
...
remaining useful life (net
book value / depreciation expense) → reveal in future capital spending needs compared to industry
Off-BS financing:
- Include operating lease in debt ratios
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑃𝑉 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑎𝑠𝑒 =

𝑃𝑉 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑙𝑒𝑎𝑠𝑒 × 𝑠𝑢𝑚 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑎𝑠𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑠𝑢𝑚 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑙𝑒𝑎𝑠𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠

Goodwill:
- Goodwill should be subtracted from assets when calculating financial ratios
- Goodwill impairment expense in current period should be reversed → increase earnings



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