ACCT3302

Financial Statement Analysis

Lecture 1: Introduction to Financial Statement Analysis

Why are Financial Statements Important?

- Investors cannot properly judge the opportunities and risks of investment alternatives without it
- Financial statements are the first and often best source of information about a company’s past performance,
current health, and future prospects
- Financial statements provide information about a company’s economic wealth and changes in that wealth
- Uses:
- Analytical tool
- Management report card
- Early warning signal
- Basis for prediction
- Measure of accountability

Accounting is Not an Exact Science

- Some financial statement items (i.e., cash) are measured with a high degree of precision and reliability
- Other financial statement items (i.e., product warranty liabilities) are judgemental and uncertain in their
measurement because they are derived from estimates of future events
- Investors and others should not accept the numbers in financial statements at face value
- Must:
- Understand financial reporting standards
- Recognise that management can shape information
- Distinguish between reliable and judgemental information

Economics of Accounting Information

- Functions (of Financial Statements):

- Information Asymmetry – financial statement information provides a way for company management
to transfer information about business activities to people outside the company
- Contract Efficiency – financial statement information is often included in contracts between the
company and other parties

Demand for and Supply of Accounting Information

- Demand for financial statements stems from their value as a source of information about company
performance, financial condition, and resource stewardship
- Supply of financial statements is guided by the costs of producing and disseminating it and the benefits it will
provide to the company

Users of Financial Statements

- Shareholders and Investors – investment decisions; proxy contests

- Equity Investors – to form opinions about the value of a company and its stock
- Analysts – as the basis for recommendations to equity investors and creditors
- Auditors – to help design more effective audits
- Managers and Employees – performance assessment; compensation contracts; company-sponsored pension
plans
- Lenders (Creditors) and Suppliers – lending decisions; covenant compliance
- Customers – seller’s health; repeat purchases; warranties and support
- Government and Regulators – mandatory reporting; taxing authorities; regulated industries
Fundamental Concepts of Financial Reporting

- Primary Characteristics
- Relevant Information – helps users form more accurate predictions about the future or allows them
to better understand how past economic events have affected the business
 Predictive Value – information improves the decision maker’s ability to forecast the future
outcome of past or present events
 Confirmatory Value – information confirms or alters the decision maker’s earlier beliefs
 Materiality – omission or misstatement of the information could influence the decisions that
financial statement users make about a specific reporting entity
- Faithful Representation – actually depicts the underlying economic event
 Completeness – can be false or misleading if information is omitted
 Neutrality – information cannot be selected to favour one set of interested parties over
another
 Free from Material Error – some minimum level of accuracy is also necessary for an estimate
to be a faithful representation of an economic event
- Enhancing (Qualitative) Characteristics
- Comparability – allows analysts to identify the real economic similarities in and differences between
underlying economic events because those similarities or differences are not obscured by accounting
methods or disclosure practices
- Verifiability – independent measurers should get similar results when using the same yardstick;
financial information that lacks verifiability is less reliable for decision purposes
- Timeliness – information is available to decisions makers while it is still fresh and capable of
influencing their decisions
- Understandability – meaning of information is able to be understood and comprehended by users
 Lecture 2: Accrual Accounting and Income Determination

Key Concepts and Practices that Govern the Measurement of Income

- Under accrual accounting:

- Revenues are recorded (recognised) when the seller has performed a service or conveyed an asset to
the buyer which entitles the seller to the benefits represented by the revenues, and the value to be
received for that service or asset is reasonably assured and can be measured with a high degree of
reliability
- Expenses are expired costs or assets that are used up in producing those produce revenues
 Expense recognition is tied to revenue recognition – commonly referred to as the “matching
principle”
 Expenses are recorded in the same accounting period in which the related revenues are
recognised

Cash Flow vs Accrual Income Measurement

- Accrual accounting decouples measured earnings (i.e., revenues minus expenses) from the amount of cash
generated from operations
- Accrual accounting revenues generally do not correspond to cash receipts for the period, nor do
accrual expenses always correspond to cash outlays for the period
- Accrual accounting can produce large discrepancies between measured earnings and the amount of
cash generated from operations (cash-basis earnings)
- Accrual accounting better matches economic benefit with economic effort, thereby producing a measure of
operating performance – accrual earnings – that provides a more realistic picture of past economic activities
- Many believe that accrual accounting numbers also provide a better basis for predicting future performance
of an enterprise

Articulation of Income Statement and Balance Sheet

- Two things happen when income is recognised in the financial statements:

- Owners’ equity is increased by the amount of the income
- Net assets (i.e., gross assets minus gross liabilities) are increased by an identical amount
- Thus, there are two identical ways of thinking about income recognition:
- Assets – Liabilities = Owners’ Equity
- Income increases net assets = Income (revenues minus expenses) increases owners’ equity
- Net asset valuation and income determination are interrelated

Revenue Recognition

- Recently, the FASB and IASB issued a join pronouncement that revamped the standards for revenue
recognition
- The new standard replaced a patchwork of rules, many of which were industry-specific, with a single
framework for when revenue is to be recognised

Expense Recognition

- Once revenue for a period has been determined, the next step in determining income is to accumulate and
record the costs associated with generating the revenue
- There are two types of costs associated with generating revenue:
- Traceable costs are easily traced to the revenue earned
- Period costs are also clearly important in generating revenue, but their contribution to a specific sale
is difficult, if not impossible, to quantify
Traceable Costs

- Matching process – traceable costs are recognised in expense in the same period as the corresponding
revenue is recognised
- Product costs – costs of physically producing a good; often constitute a large portion of the traceable costs;
also include manufacturing overhead (factory maintenance, insurance, depreciation etc.)
- It is difficult to associate overhead costs with specific units of production
- Generally allocated to inventory costs (and thus expensed as part of cost of goods sold) on some
rational basis

Income Statement Format and Classification

- Virtually all decision models in modern corporate finance are based on expected future cash flows
- Financial reporting seeks to satisfy users’ needs by providing financial information in a format that gives
users reliable and representative baseline numbers for generating their own forecasts of future cash flows
- The income statement separates earnings into two components:
- Continuing operations – “sustainable” or likely to be repeated in future reporting periods
- Discontinued operations – “transitory”

Discontinued Operations

- Transactions related to certain operations the firm intends to discontinue or has already discontinued are
separated from other income statement items
- Discontinued operations will not generate future operating cash flows
- Classification on income statement:
- The operating results of discontinued operations are excluded from continuing operations in the
current period when the decision to discontinue was made
- In addition, they are excluded from continuing operations in any prior years for which comparative
data are provided
- Net income for those prior years are the same as originally reported; the amounts removed from
continuing operations are reclassified to discontinued operations

Discontinued Operations – Criteria

- The component of an entity must comprise operations and cash flows that can be clearly distinguished from
the rest of the entity
- If the component has been disposed of:
 It is treated as a discontinued operation if the disposal represents a strategic shift that has
(or will have) a major effect on an entity’s operations and financial results
- If the component has not yet been disposed of:
 It must first be determined whether it is classified as held for sale
 If the component is deemed to be held for sale, then it also must meet the strategic shift
criterion to be given discontinued operations treatment

Held for Sale

- A disposal group is considered held for sale if the following 6 conditions are met:
- Management has committed to a plan to sell the component
- The component is available for immediate sale in its present condition subject only to terms that are
usual and customary
- An active program to locate a buyer has been initiated, as have all other necessary actions
- The sale is probable, and is expected to be completed within 1 year (subject to certain exceptions)
- The component is being actively marketed at a reasonable price
- It is unlikely that significant changes will be made to the disposal plan or that it will be withdrawn
Amounts Reported when Disposal Group has been Sold

- When the discontinued component is sold before the end of the reporting period, companies report 2
elements as part of discontinued operations:
- Operating income or loss (that is, revenue minus expenses) from operating the component from the
beginning of the reporting period to the disposal date, net of related tax effects
- Gain or loss on disposal computed as the net sale price minus book value of net assets disposed of,
net of related tax effects

Amounts Reported when Disposal Group is Considered “Held for Sale”

- If a component becomes a discontinued operation in a reporting period but has not been sold by the end of
the period, the income effects of the discontinued operates are reported in 2 elements:
- Operating income or less (that is, revenue minus expenses) from operating the component, net of
tax effects
- An impairment loss (net of tax effects) if the book value of the net assets in the disposal group is
more than the net assets’ fair value minus cost to sell

Reporting as Net of Tax Effects

- “Net of tax” treatment is called intraperiod income tax allocation

- The income (loss) from operating the discontinued component is reported net of tax effects
- Any gain (loss) from disposal or impairment are reported net of tax effects
- Intraperiod income tax allocation matches the income tax burden or benefit with the item giving rise to it

Reporting Accounting Changes

- Consistency – using the same accounting methods to describe similar economic events from period to period
- Enhances decision usefulness by allowing users to identify trends or turning points in a company’s
performance over time
- Changing accounting methods:
- Firms sometimes voluntarily switch accounting methods or revise estimates because the alternative
method or estimate better reflects the firm’s underlying economics
- Accounting standards-setting bodies frequently issue new standards requiring companies to change
accounting methods (mandatory)
- When firms change accounting methods, it raises questions about transition methods

Types of Accounting Changes

Change in Accounting Principle

- U.S. GAAP requires firms to use the retrospective approach (unless it is impractible to do so or a new
standard specifies some other transition method)
- Prior years’ financial statements are revised to reflect the impact of the accounting principle change
(as if the new principle had been used since the company’s inception)
- A journal entry is made to adjust all account balance sheet accounts as of the beginning of the
current year to what their balances would have been had the new method always been used
 The entry typically requires an adjustment to the firm’s beginning Retained Earnings balance
to reflect the cumulative effect of the accounting principle change on all prior periods’
reported income
- In some cases, it is impractible to apply a change in accounting principle retrospectively

Change in Accounting Estimates

- Estimates are used extensively in accounting:

- Uncollectible receivables
- Inventory obsolescence
- Service lives and salvage values of depreciable assets
- Warranty obligations
- Changes in accounting estimates come about because new information indicates the previous estimate is no
longer valid
- When accounting estimates are changed, prior year income is never adjusted
- Prospective approach – instead, the income effects of the changed estimates are accounted for the
in the period of the change and in future periods if the change affects both

Change in Estimate Effected by Change in Principle

- In some cases, a change in accounting estimate results from a change in accounting principle
- Changes in accounting estimates that result from a change in accounting principle are accounted for as a
change in estimate

Change in Reporting Entity

- A change in reporting entity occurs when the entities comprised by the financial statements change:
- Consolidated or combined statements are replacing statements of individual entities
- There is a change in the subsidiaries to be consolidated or combined
 A business combination accounted for under the acquisition method is specifically excluded
from the definition of a change in reporting entity
- Requirements
- When a change in reporting entity occurs, comparative financial statements for prior years must be
restated to reflect the new reporting entity as if it had been in existence during all the years
presented
- The effect of the change on income, net income, other comprehensive income, and any related per
share amounts are disclosed for all periods presented

Earnings Management

- Applying the criteria for revenue and expense recognition still leaves room for considerable latitude and
judgement
- Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that
mask the company’s underlying performance
- Some managers have even resorted to outright financial fraud (relatively rare)
- Earnings management has become increasingly common because of pressure to meet analysts’ earnings
forecasts
- The representational faithfulness and predictive usefulness of the resultant accounting numbers may then
be compromised
Popular Earnings Management Devices: “Big Bath” Restructuring Charges

- “Big bath” restructuring charges are taken in an effort to “clean up” company balance sheets; managers
have often taken excessive restructuring write-offs and overstated estimated charges for future expenditure
- The restructuring charges and liability reserves are sometimes reversed in future years to boost net
income in those years
- The FASB now requires that a liability must actually have been incurred before recording a liability
and taking an associated restructuring charge
- Because of the subjectivity of restructuring charges and the ability to take charges by writing down
assets, overstatement of restructuring charges cannot be completely eliminated

Popular Earnings Management Devices: “Cookie Jar Reserves”

- Miscellaneous “cookie jar reserves” are recorded for bad debts, loan losses, warranty costs, and reserves for
various future expenditure related to corporate restructuring
- Some companies use unrealistic assumptions to arrive at these estimated charges
- The overreserve in good times and cut back on estimated charges, or reverse previous charges, in
bad times
- A convenient income smoothing device
 One critique of IFRS is that it might offer more opportunities for “cookie jar reserves” accrual
accounting than U.S. GAAP

Popular Earnings Management Devices: Intentional Errors and Misstated Estimates

- Companies make intentional errors deemed to be “immaterial” and intentional bias in estimates
- Materiality thresholds are another way of using financial reporting flexibility to inflate earnings
- A series of “immaterial” errors spread across several accounts can, in the aggregate, have a material
effect on earnings
- Management can often intentionally misstate estimates
- Estimates abound in accrual accounting
- Management can often shade these estimates in one direction or the other to achieve a desired
earnings target

Popular Earnings Management Devices: Revenue Recognition Abuses

- Under existing GAAP, revenue may be recognised when it has been earned and is realised or realisable
- The SEC says revenue is earned (critical event) and realised (measurability) when all of the following are met:
- Pervasive evidence of an exchange agreement exists
- Delivery has occurred or services have been rendered
- The seller’s price to the buyer is fixed or determinable
- Collectability is reasonably assured
- SEC Staff Accounting Bulletin (SAB) No. 104 illustrates troublesome areas of revenue recognition

Revenue Recognition Abuses: SAB No. 104 Examples

- Goods shipped on consignment – no revenue can be recognised at delivery

- Sales with delayed delivery – seller can’t recognise revenue until delivery, except certain buy and hold
transactions
- Goods sold on lay-away – postpone revenue recognition until merchandise is delivered to customer
- Non-refundable up-front fees – earned as services are delivered over the full term of service engagement
- Gross vs net basis for internet resellers – revenue should be recognised on a “net” basis as commissions
revenue
- Capacity swaps – revenue should be recognised over time as the capacity is brought on line and used by
customers
Accounting Errors and Irregularities

- Accounting errors and “irregularities” can occur for several reasons:

- Simple oversight
- Misapplication of GAAP (especially where judgement is required)
- Intentional attempts to exploit the flexibility in GAAP
- Outright financial fraud
- Several parties are charged with discovering accounting errors and irregularities
- The company’s internal audit staff and audit committee
- External auditors
- SEC staff surveillance of filings

Price Periods Adjustments

- Once discovered, accounting errors and irregularities must be corrected and disclosed
- Material errors discovered after the year in which the error is made are corrected through a prior period
adjustment
- This adjustment results in a change to the beginning Retained Earnings balance (for the year the
error is detected) and correction of related asset or liability balances
- Previous years’ financial statements that are presented for comparative purposes are retroactively
restated to reflect the specific accounts that are corrected
- The impact of the error on current and prior periods reported net income is disclosed in the notes to
the financial statements

Earnings Per Share

- Basic EPS uses the weighted-average number of commons shares outstanding for the period
- Income available to common shareholders divided by weighted-average common shares outstanding
- Diluted EPS reflects what Basic EPS would have been if all potentially dilutive (i.e., EPS reducing) securities
were converted into common shares

Comprehensive Income and Other Comprehensive Income

- Comprehensive income is the change in equity that occurs from transactions or events from non-owner
sources
- Most of the items included in comprehensive income results from completed or closed transactions with
outside parties
- Closed transactions are those whose ultimate payoffs result from events that have already occurred
and whose dollar flows can be predicted fairly accurately
- All items of comprehensive income are categorised as net income or other comprehensive income (OCI)
- An item of comprehensive income is considered part of net income unless GAAP specifically
designates it as part of OCI
- When it is part of OCI, no gain or loss is reported in net income; instead, the gain or loss is included
in OCI for the year
- U.S. GAAP requires firms to report comprehensive income in a statement that is displayed with equal
prominence to other financial statements
- Firms are permitted to display the components of other comprehensive income in a:
- Single-statement format
 Net income and other comprehensive income are both presented and their sum,
comprehensive income, is the bottom line
- Two-statement format
 A traditional income statement is followed immediately on the next page of the report by a
statement of comprehensive income that begins with net income and shows the individual
other comprehensive income components, followed by comprehensive income
Global Vantage Point

- U.S. GAAP and IFRS for OCI differ in many respects

- IFRS allows more opportunities for managers to change the balance sheet valuation of certain assets
even when managers have no intention to sell or dispose of these assets
- IFRS allows managers to revalue property, plant, and equipment to an appraised fair value
periodically
- With regards to defined benefit pension plans, both U.S. GAAP and IFRS require companies to report
actuarial valuation changes in OCI each period; however, IFRS does not require firms periodically to
recategorize (“recycle”) a portion of these OCI changes into periodic net income
- Under IFRS, entities are required to group items within OCI based on whether they will be
reclassified subsequently into net income (“recycled”)
 Lecture 3: Revenue Recognition

AASB 15 Revenue Recognition

- Main issue in accounting for revenue is in determining when the revenue is to be recognised
- AASB 15 will apply to all contracts with customers, except for contracts covered by other Standards, such as
leases, insurance and financial instruments
- What is required?
- AASB 15 stipulates how and when revenue is recorded, requiring entities to provide users of
financial statements with more information and reporting disclosures

The Five-Step Revenue Recognition Model

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. Recognise revenue when (or as) the entity satisfies a performance obligation

Step 1: Identify the Contract(s) with a Customer

- All of the following conditions must be met for a firm to account for a contract with a customer:
- All parties to the contract have approved the contract and are legally obligated to perform their
obligations under the contract
- Each party’s rights regarding the goods or services being exchanged can be identified
- Payment terms can be identified
- The contract has commercial substance
- Collection is probable
- If neither party has yet performed under the contract and both parties have the right to cancel the contract
without penalty, then for purposes of the revenue recognition standard, no contract exists.

Collectability vs Price Concessions

- If a firm believes it will not ultimately receive the full, stated contract price, judgement may be necessary to
determine if the shortfall is due to a collectability problem or a price concession
- i.e., a hospital immediately treats an uninsured patient in the emergency room; later, the hospital
determines the patient is uninsured and does not expect to collect in full
- Initially, the hospital cannot determine that the patient is committed to perform its obligation
- Therefore, no revenue may yet be recognised
- Hospital will reassess whether a contract can be identified as circumstances change

Consideration Received before a Contract Exists

- Sometimes, a payment is received before a contract can be identified – revenue may be recognised when (1)
the consideration is non-refundable and (2) any of the following events has occurred:
- There are no remaining obligations to transfer goods or services to the customer
- The contract has been terminated
- The entity has transferred the goods or services to which the consideration received relates, and it
has no further obligation to transfer goods or services
- Any discrepancy between when the payment is received and when the obligation(s) is (are) satisfied would
be considered a significant financing component (Step 2 of the model)
Step 2: Identify the Performance Obligations in the Contract

- At the inception of a contract, a firm must determine its performance obligations

- Each performance obligation is a promise to provide goods or services
- Judgement may be required to determine if:
- The elements of a set of promised goods or services are distinct from one another, and therefore
constitute separate performance obligations, or
- They are not distinct
- Factors that indicate 2 or more promises to transfer goods or services are not separately identifiable include:
- The entity provides a significant service of integrating the goods or services with other goods or
services promised in the contract
- One or more of the goods or services significantly modifies or is significantly modified by other goods
or services promised in the contract
- The goods or services are highly interdependent or interrelated

Warranties
- Warranties provide repair services for goods sold to a customer
- Warranties can serve 2 purposes:
- They can be used to assure the customer that the product it is purchasing is free of defect at the
time of the purchase; such defects cannot always be detected immediately
- They act as a sort of insurance policy against future repair and maintenance costs
- A warranty is considered a separate performance obligation if:
- The customer has the option to purchase the warranty separately, or
- The warranty provides services beyond what is required to assure the product is free of defects at
the time of sale
- The cost of providing the warranty is estimated and expensed in the period in which revenue is recognised
for the good whose quality it assures
- Warranties that provide services beyond assuring the product is defect-free at the time of sale are separate
performance obligations
- Answers to the following questions will be useful in distinguishing between an assurance warranty and a
warranty providing additional services
- Is the warranty required by law?
- What is the length of the warranty?
- What are the services required under the warranty?

Step 3: Determine the Transaction Price

- The transaction price:

- Is the amount of consideration the firm expects to be entitled to receive
- Excludes amounts collected on behalf of third parties, such as for sales taxes
- Non-cash consideration is to be valued at fair value
- The transaction price may have both fixed and variable components

Assessing Whether the Firm is a Principal or an Agent

- For transactions involving more than 2 parties, a firm may need to determine whether it is a(n):
- Principal (providing goods or services) – a firm is considered a principal if it obtains control of the
goods or services and then transfers that control to another party
- Agent (facilitating the sale of goods or services by another party)
- The principal-agent determination affects whether a firm recognises revenue on a gross or a net basis
- A principal recognises revenue for the gross amount paid by the customer and reports as an expense
its cost of goods sold
- An agent reports revenue only for the net amount retained (i.e., its commission)
- The principal-agent determination also affects the timing of the revenue recognition:
- An agent may recognise revenue when its performance obligation to the principal is satisfied
- A principal may not recognise revenue until the goods or services promised to the end customer
have been transferred
Right of Return
- A right of return exists when the customer is entitled to a full or partial refund, a credit against amounts
owed, or another product in exchange (unless it is only for another product that is essentially the same)
- In these situations, the amount the firm will be entitled to collect depends on the extent to which customers
exercise their rights to refunds
- When a right of refund exists, the variable consideration analysis is applied
- i.e., a retailed sells goods at a selling price of $10,000 (and a $8,000 cost); customers have a right of
return within 30 days
 The store estimates that 4% of the units sold will be returned
 Revenue recognised in the period is 96% * 10,000 = 9,600
 Journal entry:
 DR Cash 10,000
 CR Sales Revenue 9,600
 CR Refund Liability 400
 Cost of goods sold is only recognised on the portion of the total sale for which revenue has
been recognised
 Cost of goods sold is 96% * 8,000 = 7,680
 DR COGS 7,680
 DR Inventory recovery asset 320
 CR Inventory 8,000

Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract

- The allocation of the transaction price should be based on the standalone prices for the goods and services
comprising each performance obligation
- When the sum of the standalone prices is not equal to the total consideration = the allocation of the
consideration should be based on the proportion of the sum of the standalone prices represented by
each performance obligation
- Standalone prices are straightforward when the goods and services in the contract are also sold separately;
otherwise, estimates must be made using a(n):
- Adjusted market approach
- Expected cost plus margin approach
- Residual approach

Step 5: Recognise Revenue when (or as) the Entity Satisfies a Performance Obligation

- A performance obligation is considered satisfied when control over the goods and services that comprise the
performance obligation is transferred to the customer
- Control has transferred when:
- The customer has a legal obligation to pay the firm
- The customer has legal title (in the case of goods)
- The customer has physical possession (in the case of goods)
- The customer is subject to the risks and rewards generally associated with ownership
- The customer has indicated its acceptance of the goods and services
- These are indicators of control; no single item above is decisive
Licenses
- Some transactions involving intellectual property represent a sale of intellectual property, whereas others
represent licenses
- The approach to be used for revenue recognition depends on whether the transaction is considered a sale or
a license
- If the transaction represents a sale, then it is treated like any other sale and the five-step model is
applied to determine the point in time that sales revenue may be recognised
- If the transaction is a license, then revenue recognition may be entirely at the inception of the
license or over time during the period of the license, depending on the circumstances
- First, the firm must determine whether the transaction is a sale, or a license, of intellectual property
- If the customer’s right to use the intellectual property is somehow limited, for example by time or
geographic area, then the contract is a license
- If the customer’s use of the property is unlimited, the contract is a sale
- If a contract is determined to be a license, then the firm must determine if the license is a distinct
performance obligation
- If it is not distinct, the firm applies the five-step model for a combined bundle that represents a
single performance obligation
- If it is distinct, then the firm must assess whether the customer has a right to access the firm’s
intellectual property

Consignment Arrangements
- A consignment arrangement exists when a firm delivers goods to another party but retains control over
them
- The purpose of the arrangement is typically to facilitate a sale to a third party
- Indicators that a consignment agreement exists are as follows:
- The firm transferring possession of the product still controls it until some event occurs, such as the
sale of the product to a third party
- The firm transferring possession of the product has the right to require the product to be returned
or transferred elsewhere
- The entity that has received the product is not obligated to pay for it (unless it is sold)

Bill-and-Hold Arrangements
- A bill-and-hold arrangement exists when the firm bills a customer for goods but retains physical
- Revenue is recognised when control is transferred to the customer; all of the following criteria must be met:
- The reason for the bill-and-hold arrangement is substantive
- The product is identified separately as belonging to the customer
- The product is ready for physical transfer to the customer
- The firm does not have the ability to use the product itself or to transfer it to another customer
- If any of the criteria are not met, the customer has not yet obtained control and the seller may not recognise
revenue

Long-Term Construction Projects; Percentage-of-Completion Method

- Long-term construction projects are generally undertaken only after a buyer has been found and has
obligated itself contractually
- When that is the case:
- The cost of the project can be reasonably estimated, and collection is reasonably certain, perhaps
because of progress payments that are made as construction progresses, and
- The percentage-of-completion method is permitted under rules in effect through 2017
- Percentage-of-completion method – revenue is recognised in proportion of “work done” each period
- In some cases, it is not possible to determine expected costs with a high degree of reliability
- In these situations, the completed-contract method is used instead
- The completed-contract method postpones recognition of income until the project is completed
 Lecture 4: Statement of the Balance Sheet and Statement of Cash Flows

Balance Sheet

Assets = Liabilities + Equity

- Assets
- Current Assets – cash and other assets expected to be converted to cash within 12 months (or with
the operating cycle, if longer)
 Measurement Base – lower of cost or net realisable value
- Non-Current Assets – all other assets
 Measurement Base – historical cost minus accumulated depreciation (except that fair
market value, if lower, is used when “impaired”)
- Liabilities
- Current Liabilities – liabilities expected to be settled within 12 months (or with the operating cycle, if
longer)
 Measurement Base – amount due at maturity or historical cost
- Non-Current Liabilities – all other liabilities
 Measurement Base – discounted present value of the future cash flows
- Equity
- Common/Preferred Stock – the par value of shares issued and outstanding
 Measurement Base – historical par value
- Additional Paid-in Capital – the amount in excess of par value paid to the firm when its shares were
originally issued
 Measurement Base – historical cost
- Retained Earnings – the cumulative earnings less cumulative dividend distributions of the company
since its inception
 Measurement Base – combinations of different measurement bases

Analytical Insights: Understanding the Nature of a Firm’s Business

- Common-Size Balance Sheet

- Presents each item as a percentage of total assets
- Allows an analyst to compare companies in a way that factors out differences between balance
sheet amounts due solely to differences in company size
- The number and percentages tell a story about the company, its industry, its strategies, and its
performance

International Differences in Balance Sheet Presentation

- GAAP Format (i.e., US) – assets listed from most to least liquid
- Current Assets + Non-Current Assets = Current Liabilities + Non-Current Liabilities + Equity
- IFRS Format (i.e., UK and Australia) – allows ordering from least to most liquid
- Non-Current Assets + Current Assets – Non-Current Liabilities – Current Liabilities = Equity

Statement of Cash Flows

- Because cash flows and accrual earnings can differ dramatically, firms must present a statement of cash
flows in addition to an income statement and a balance sheet
- The cash flow statement explains the causes for year-to-year changes in cash and cash equivalents
Structure of Cash Flow Statement

- Cash Flow from Operating Activities – comprises the increase or decrease in cash arising from the firm’s
profit-making activities
- Cash Flow from Investing Activities – comprises the decrease in cash resulting from investments made in
productive assets or securities, as well as the increases in cash when such investments are liquidated
- Cash Flow from Financing Activities – comprises changes in cash due to transactions related to the financing
of the business, such as the issuance or repurchase of debt or equity securities and the payment of dividends
- Change in Cash and Cash Equivalents – the amount by which cash and cash equivalents changed from one
balance sheet date to the next

- NB – although interest payments actually are due to financing activities, US GAAP includes interest payments
in operating cash flows

Cash Flows from Operating Activities

- 2 Methods:
- Direct Method – the operating section presents cash transactions related to the determination of
net income
- Indirect Method – the operating section begins with net income and then presents all the reasons
why and amounts by which cash flow from operations differs from net income
- Amount is the same under the 2 methods
- Both US GAAP and IFRS encourage, but do not require, the use of the direct method

Cash Flow Statement and Financial Statement Articulation

- A complete statement of cash flows explains the changes in every balance sheet account during the period,
not just cash
- Algebraically, the balance sheet equation is used as follows:
- Assets = Liabilities + Stockholders’ Equity
- Cash + Non-Cash Assets = Liabilities + Stockholders’ Equity
- Cash = Liabilities - Non-Cash Assets + Stockholders’ Equity
- Δ Cash = Δ Liabilities - Δ Non-Cash Assets + Δ Stockholders’ Equity
- As such, every line item of a cash flow statement relates to a change in one or more balance sheet accounts
other than cash
- Analysing why each account changed provides each component of the cash flow statement

Deriving Cash Flow Information

- Beginning Balance Sheet – Income Statement – Cash Flow Statement – Ending Balance Sheet
- You can always derive any one financial statement from information available in the other three financial
statements
Deriving Cash Flows from Operations: Indirect Approach

Notes to Financial Statements

- Notes are an integral part of companies’ financial reports

- Notes allow financial statement users to more thoroughly understand and interpret the numbers presented
in the body of the financial statements
- 3 important notes that are typically found in companies’ financial reports
- Summary of significant accounting policies
- Disclosures of important subsequent events
- Related-party transactions

Subsequent Events

- Events or transactions that have a significant effect on a company’s financial position or results of operations
sometimes occur after the close of its fiscal year-end, but before the financial statements are issued
- Disclosure of these subsequent events is required if they are material and are likely to influence investors’
appraisal of the risk and return prospect of the reporting entity
- Examples include:
- Loss of a major customer
- A business combination
- Issuance of debt or equity securities
- A catastrophic loss
 Lecture 5: Essentials of Financial Statement Analysis

Financial Analysis Tools and Approaches

- Financial Analysis Tools

- Cause-of-change analysis
- Common-size statements
- Trend statements
- Financial ratios
- Basic Approaches
- Time-series analysis – helps identify trends for a single company or business unit
- Cross-sectional analysis – helps identify similarities and differences across companies or business
units at a single point in time
- Benchmark comparison – industry norms or predetermined

Financial Statement Analysis and Accounting Quality

- Analysts use financial statement information to see more clearly the economic activities and condition of a
company and its prospects
- However, financial statements do not always provide a complete and faithful picture of a company’s
activities and condition

Getting Behind the Numbers at Whole Food Market

Cause-of-Change Analysis

- One way to quantify the components of change is with a “cause-of-change analysis”, which shows the effects
of individual changes on the change in net income

Whole Foods Market: Cause-of-Change Analysis 2015 vs 2012

Common-Size Statements

- Financial analysts use common-size and trend statements of net income to help spot changes in a company’s
cost structure and profit performance
- Common-size income statements recast each statement item as a percentage of sales
- Common-size income statements show how much of each sales dollar the company spent on
operating expenses and other business costs and how much of each sales dollar hit the bottom line
as profit
- Common-size balance sheets recast each statement item as a percentage of total assets
Financial Ratios and Profitability Analysis

EBI
ROA=
Average assets
=
EBI
Operating Profit Margin=
Sales
x
Sales
Asset Turnover =
Average assets

- EBI – earnings before interest

- Average assets – average book value of total assets

- Before computing ROA, analysts may adjust the company’s reported earnings and asset figures, which fall
into 3 broad categories:
- Adjustments aimed at isolating a company’s sustainable profits by removing nonrecurring items
from reported income
- An adjustment that eliminates after-tax interest expense from the profit calculation so that
profitability comparisons over time or across companies are not affected by differences in financial
structure
- Adjustments for distortions related to accounting quality concerns

Whole Foods Market: Return on Asset

- Before ROA is computed, adjustments are made to reported earnings each year to eliminate interest
expense, net of its related tax savings (here, interest expense is immaterial)

How Can a Company Increase ROA?

- A company can increase ROA in just 2 ways (see above formula):

- Increase the profit margin
- Increase the intensity of asset utilisation (turnover rate)

Whole Foods Market: ROA Decomposition

ROA and Competitive Advantage: Grocery Industry

- Competition works to drive down ROA towards the competitive floor – that is, the rate of return that would
be earned in the economist’s “perfectly competitive” industry
- Companies that consistently earn an ROA above the floor are said to have a competitive advantage
- However, a high ROA stimulates more competition which can lead to an eventual erosion of profitability and
advantage

- The ROAs of Whole Foods (WFM), SUPERVALU, and Fresh Market (TFM) are above the curve, indicating
ROAs above the industry average
- Weis Markets (WMK) is just below the industry average ROA, due to its lower turnover
- Smart & Final Stores (SFS) is the lowest of the five companies shown on both margin and turnover, resulting
in a 3.3% ROA that lags well behind the industry average

Key Strategies for Achieving Superior Performance

- 2 key strategies for achieving superior performance in any business

- Product and service differentiation
 Focuses on “unique” products or services to gain brand loyalty and attractive margins
 People are willing to pay premium prices for things they value and can’t get elsewhere
 Differentiation can take several forms
- Low-cost leadership
 Focuses on operating efficiencies, which permit the company to under-price the
competition, achieve high sales volume, and still make a profit on each sale
 Companies can attain a low-cost position in various ways

Return on Common Equity

- Return on Common Equity (ROCE) – measures a company’s performance in using capital provided by
common shareholders to generate earnings
- ROCE explicitly considers how the company finances its assets
- Interest charged on loans, and dividends declared on preferred stock, are both subtracted in arriving
at net income available to common shareholders

Return on Common Equity and Financial Leverage

- ROCE is affected by both ROA and the degree of financial leverage employed by the company
- For companies with more financial leverage, the ups and downs in ROA are exaggerated:
 When ROA is low at a highly levered firm, ROCE will be very low, perhaps even negative
 When ROA is high at a highly levered firm, ROCE will be very high
- In contrast, ROCE is not much more volatile than ROA for firms that do not employ much financial
leverage
Components of ROCE

ROCE=Net income available ¿ common shareholders ¿

Average common shareholder s ' equity
=
EBI
ROA=
Average assets
x
Common earningsleverage=Net income available ¿ common shareholders ¿
EBI
x
Average assets
Asset Turnover =
Average common shareholder s' equity

Liquidity, Solvency, and Credit Analysis: Credit Risk

- Credit risk – the risk of non-payment by the borrower

- The lender risks losing interest payments and loan principal
- A borrower’s ability to repay debt is driven by its capacity to generate cash from operations, asset classes, or
external financial markets
- Numerous and interrelated risks influence a company’s ability to generate cash

Liquidity, Solvency, and Credit Analysis: Balancing Cash Sources and Needs

Short-Term Liquidity Ratios

- Liquidity Ratios

Current assets
Current ratio=
Current liabilities

Cash+ Marketable securities + Receivables

Quick ratio=
Current liabilities

- Activity Ratios

Net credit sales

Accounts receivable turnover=
Average accounts receivable

Cost of goods sold

Inventory turnover =
Average inventory

Inventory purchases
Accounts payable turnover =
Average accounts payable
Liquidity Analysis: Credit Risk Analysis: Short-Term Liquidity

- Even through both the current ratio have been falling, Whole Foods generates strong and predictable
operating cash flows
- Working capital activity ratios are essentially unchanged
- Payments to suppliers occurred about 10 days after inventory was purchased but it took about 22 days (17.2
+ 4.9) to generate a sale and collect cash from credit customers; this misalignment of operating cash flows is
unlikely to cause concerns

Long-Term Solvency Ratios

- Debt Ratios

Long term debt

Long term debt ¿ assets=
Total assets

Long term debt

Long term debt ¿ tangible assets=
Total tangible assets

- Coverage Ratios

Operatingincomes before taxes∧interest

Interest coverage=
Interest expense

Operating cash flow ¿ total liabilities=Cash flow ¿ continuing operations ¿

Average current liabilities +long term debt

Long-Term Solvency

- An interest coverage ratio below 1 indicates that earnings are not even sufficient to pay interest
requirements

- Rite Aid’s interest coverage ratio has grown over the period
- Rite Aid’s cash flow coverage ratio and operating cash flow to total liabilities ratio also increased over the
period
Cash Flow Analysis

- Although a company’s earnings are important, an analysis of its cash flows is central to credit evaluations
and lending decisions
- Cash Flow from Operating Activities
- Generating cash from operations is essential to any company’s long-term economic viability
- Cash Flow from Investing Activities
- Changes in a company’s capital expenditures or fixed asset sales over time must be analysed
carefully because they have implications for the company’s future operating cash flows
- Cash Flow from Financing Activities
- Determining the optimal debt level involves a trade-off between two competing economic forces –
taxes and costs of financial distress

Financial Ratios and Default Risk

- A firm default when it fails to make principal or interest payments

- Lenders can then:
- Adjust the loan payment schedule
- Increase the interest rate and require loan collateral
- Seek to have the firm declared insolvent
- Financial ratios play two roles in credit analysis
- They help quantify the borrower’s credit risk before the loan is granted
- Once granted, they serve as an early warning device for increased credit risk