Assignment

On
Syllabus Summary

Course Title: Financial Statement Analysis and Valuation

Course Code: F-401

Submitted to
Md. Sajib Hossain
Assistant Professor
Department of Finance
Faculty of Business Studies
University of Dhaka

Submitted by
Susoma Pauria
Section: B
ID No: 23-312
Department of Finance
Faculty of Business Studies
University of Dhaka

Date of Submission: 7th July, 2020

READING 26: LONG-LIVED ASSETS
Understanding the reporting of long-lived assets at inception requires distinguishing between
expenditures that are capitalized and those that are expensed. Once a long-lived asset is
recognized, it is reported under the cost model at its historical cost less accumulated depreciation
(amortization) and less any impairment or under the revaluation model at its fair value. IFRS
permit the use of either the cost model or the revaluation model, whereas US GAAP require the
use of the cost model. Key points include the following:

■ Expenditures related to long-lived assets are capitalized as part of the cost of assets if they are
expected to provide future benefits, typically beyond one year. Otherwise, expenditures related
to long-lived assets are expensed as incurred.

■ Although capitalizing expenditures, rather than expensing them, results in higher reported
profitability in the initial year, it results in lower profitability in subsequent years; however, if a
company continues to purchase similar or increasing amounts of assets each year, the
profitability-enhancing effect of capitalization continues.

■ Companies must capitalize interest costs associated with acquiring or constructing an asset that
requires a long period of time to prepare for its intended use.

■ IFRS require research costs be expensed but allow all development costs (not only software
development costs) to be capitalized under certain conditions. Generally, US accounting
standards require that research and development costs be expensed; however, certain costs
related to software development are required to be capitalized.

■ When one company acquires another company, the transaction is accounted for using the
acquisition method of accounting in which the company identified as the acquirer allocates the
purchase price to each asset acquired (and each liability assumed) on the basis of its fair value.
Under acquisition accounting, if the purchase price of an acquisition exceeds the sum of the
amounts that can be allocated to individual identifiable assets and liabilities, the excess is
recorded as goodwill.

■ The capitalized costs of long-lived tangible assets and of intangible assets with finite useful
lives are allocated to expense in subsequent periods over their useful lives. For tangible assets,
this process is referred to as depreciation, and for intangible assets, it is referred to as
amortization.

■ Methods of calculating depreciation or amortization expense include the straight-line method,

in which the cost of an asset is allocated to expense in equal amounts each year over its useful
life; accelerated methods, in which the allocation of cost is greater in earlier years; and the units-
of-production method, in which the allocation of cost corresponds to the actual use of an asset in
a particular period.
■ Estimates required for depreciation and amortization calculations include the useful life of the
equipment (or its total lifetime productive capacity) 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.

■ IFRS permit 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.

■ In contrast with depreciation and amortization charges, which serve to allocate the cost of a
long-lived asset over its useful life, impairment charges reflect an unexpected decline in the fair
value of an asset to an amount lower than its carrying amount.

■ Long-lived assets reclassified as held for sale cease to be depreciated or amortized. Long-lived
assets to be disposed of other than by a sale (e.g., by abandonment, exchange for another asset,
or distribution to owners in a spin-off) are classified as held for use until disposal. Thus, they
continue to be depreciated and tested for impairment.
READING 28: NON- CURRENT (LONG-TERM) LIABILITIES
Non-current liabilities arise from different sources of financing and different types of creditors.
Bonds are a common source of financing from debt markets. Key points in accounting and
reporting of non-current liabilities include the following:

■ Future cash payments on bonds usually include periodic interest payments (made at the stated
interest rate or coupon rate) and the principal amount at maturity.

■ When the market rate of interest equals the coupon rate for the bonds, the bonds will sell at
par. When the market rate of interest is higher than the bonds’ coupon rate, the bonds will sell at
a discount. When the market rate of interest is lower than the bonds’ coupon rate, the bonds will
sell at a premium.

■ Companies are required to disclose the fair value of financial liabilities, including debt.
Although permitted to do so, few companies opt to report debt at fair values on the balance sheet.
Summary 521

■ Two types of pension plans are defined contribution plans and defined benefits plans. In a
defined contribution plan, the amount of contribution into the plan is specified (i.e., defined) and
the amount of pension that is ultimately paid by the plan (received by the retiree) depends on the
performance of the plan’s assets. In a defined benefit plan, the amount of pension that is
ultimately paid by the plan (received by the retiree) is defined, usually according to a benefit
formula.

■ Under a defined contribution pension plan, the cash payment made into the plan is recognised
as pension expense.

■ 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. An
underfunded defined benefit pension plan is shown as a non-current liability.

■ Under IFRS, the change in the defined benefit plan net asset or liability is recognized as a cost
of the period, with two components of the change (service cost and net interest expense or
income) recognized in profit and loss and one component (measurements) of the change
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 with three components of the change (current service costs, interest
expense on the beginning pension obligation, and expected return on plan assets) recognized in
profit and loss and two components (past service costs and actuarial gains and losses) typically
recognized in other comprehensive income.
READING 29: FINANCIAL REPORTING QUALITY
Financial reporting quality varies across companies. The ability to assess the quality of a
company’s financial reporting is an important skill for analysts. Indications of low-quality
financial reporting can prompt an analyst to maintain heightened skepticism when reading a
company’s reports, to review disclosures critically when undertaking financial statement
analysis, and to incorporate appropriate adjustments in assessments of past performance and
forecasts of future performance.

■ Financial reporting quality can be thought of as spanning a continuum from the highest
(containing information that is relevant, correct, complete, and unbiased) to the lowest
(containing information that is not just biased or incomplete but possibly pure fabrication).

■ Reporting quality, the focus of this reading, 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. Quality earnings are
regarded as being sustainable, providing a sound platform for forecasts.

■ 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 expenses for the
period and/or the amount of debt reported on the balance sheet.

■ Conservatism in financial reports can result from either (1) accounting standards that
specifically require a conservative treatment of a transaction or an event or (2) judgments made
by managers when applying accounting standards that result in conservative results.

■ 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 issuance of low-quality financial reports include a cultural
environment that result in fewer or less transparent financial disclosures, book/tax conformity
that shifts emphasis toward legal compliance and away from fair presentation, and limited capital
markets regulation.

■ Managers’ considerable flexibility in choosing their companies’ 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, estimated realizability of
deferred tax assets, depreciation method, estimated salvage value of depreciable assets, and
estimated useful life of depreciable assets.

■ Cash from operations is a metric of interest to investors that can be enhanced by operating
choices, such as stretching accounts payable, and potentially by classification choices.
READING 30: APPLICATIONS OF FINANCIAL STATEMENT ANALYSIS
This reading described selected applications of financial statement analysis, including the
evaluation of past financial performance, the projection of future financial performance, the
assessment of credit risk, and the screening of potential equity investments. In addition, the
reading introduced analyst adjustments to reported financials. In all cases, the analyst needs to
have a good understanding of the financial reporting standards under which the financial
statements were prepared. Because standards evolve over time, analysts must stay current in
order to make good investment decisions. The main points in the reading are as follows:

■ Evaluating a company’s historical performance addresses not only what happened but also the
causes behind the company’s performance and how the performance reflects the company’s
strategy.

■ The projection of a company’s future net income and cash flow often begins with a top-down
sales forecast in which the analyst forecasts industry sales and the company’s market share. By
projecting profit margins or expenses and the level of investment in working and fixed capital
needed to support projected sales, the analyst can forecast net income and cash flow.

■ Projections of future performance are needed for discounted cash flow valuation of equity and
are often needed in credit analysis to assess a borrower’s ability to repay interest and principal of
a debt obligation.

■ Credit analysis uses financial statement analysis to evaluate credit-relevant factors, including
tolerance for leverage, operational stability, and margin stability.

■ When ratios constructed from financial statement data and market data are used to screen for
potential equity investments, fundamental decisions include which metrics to use as screens, how
many metrics to include, what values of those metrics to use as cutoff points, and what weighting
to give each metric.

■ Analyst adjustments to a company’s reported financial statements are sometimes necessary

(e.g., when comparing companies that use different accounting methods or assumptions).
Adjustments can include those related to investments; inventory; property, plant, and equipment;
and goodwill.
READING 28: FREE CASH FLOW VALUATION
Discounted cash flow models are widely used by analysts to value companies.

■ Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are the cash flows
available to, respectively, all of the investors in the company and to common stockholders.

■ Analysts like to use free cash flow (either FCFF or FCFE) as the return:

● If the company is not paying dividends;

● If the company pays dividends but the dividends paid differ significantly from the company’s
capacity to pay dividends;

● If free cash flows align with profitability within a reasonable forecast period with which the
analyst is comfortable; or

● If the investor takes a control perspective.

■ The FCFF valuation approach estimates the value of the firm as the present value of future
FCFF discounted at the weighted average cost of capital

The value of equity is the value of the firm minus the value of the firm’s debt:

Equity Value = Firm value – Market value of debt

Dividing the total value of equity by the number of outstanding shares gives the value per share.

■ FCFF and FCFE are frequently calculated by starting with net income:

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

FCFE = NI + NCC – FCInv – WCInv + Net borrowing

■ FCFF and FCFE are related to each other as follows:

FCFE = FCFF – Int(1 – Tax rate) + Net borrowing

■ FCFF and FCFE can be calculated by starting from cash flow from operations:

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

FCFE = CFO – FCInv + Net borrowing

■ FCFF can also be calculated from EBIT or EBITDA:

FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv

FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv

FCFE can then be found by using FCFE = FCFF – Int(1 – Tax rate) + Net borrowing.

■ Finding CFO, FCFF, and FCFE may require careful interpretation of corporate financial
statements. In some cases, the needed information may not be transparent.

■ Earnings components such as net income, EBIT, EBITDA, and CFO should not be used as
cash flow measures to value a firm. These earnings components either double- count or ignore
parts of the cash flow stream.

■ FCFF or FCFE valuation expressions can be easily adapted to accommodate complicated

capital structures, such as those that include preferred stock.

■ One common two- stage model assumes a constant growth rate in each stage, and a second
common model assumes declining growth in Stage 1 followed by a long- run sustainable growth
rate in Stage 2.

■ To forecast FCFF and FCFE, analysts build a variety of models of varying complexity. A
common approach is to forecast sales, with profitability, investments, and financing derived from
changes in sales.

■ Three- stage models are often considered to be good approximations for cash flow streams
that, in reality, fluctuate from year to year.