CFA - FSA - Updated 010822

1
READING 15: INTRODUCTION TO

FINANCIAL STATEMENTS
ANALYSIS
2
READING 15: INTRODUCTION TO FINANCIAL

STATEMENTS ANALYSIS
Learning outcomes
15.a. Describe the roles of financial reporting and financial statement

analysis.
15.b. Describe the roles of financial statements in evaluating company’s
performance and financial position
15.c. Describe the importance of financial statement notes,
supplementary information and management’s commentary
15.d. Describe the objective of audits of financial statements, the types
of audit reports and the importance of effective internal controls
15.e. Identify & describe information sources that analyst use in FS

analysis besides annual financial statements & supplementary
information
15.f. Describe the steps in the financial statement analysis framework

3

STATEMENTS ANALYSIS
[LOS 15.a] Describe the roles of financial reporting and
financial statement analysis.
1. Role of financial reporting

Financial
Financial reporting
reporting Investors, creditors & analysis
The Economic
other interested
company decisions
parties
Financial reporting refers to the way companies show their financial performance
to investors, creditors and other interested parties by preparing and presenting
financial statements.
2. Role of financial statement analysis
Financial statement analysis is to use the information in a company’s financial

statements, along with other relevant information, to make economic decision.
Analysts use financial statement data to evaluate a company’s past performance
and current financial position to form opinions about the company ability to earn
profits and generate cash flow in the future.
4

STATEMENTS ANALYSIS
[LOS 15.b] Describe the roles of financial statements in
evaluating a company’s performance and financial position.
Types of financial statements
Statement of financial position (balance sheet)
Statement of comprehensive income
Statement of cash flows
Statement of changes in equity
Note: The accompanying required notes or footnotes (see

more in part III), are considered an integral part of a
complete set of financial statements.
5

STATEMENTS ANALYSIS
1. Role of statement of financial position
Report major classes & amount of assets (resources owned or controlled

by the firm), liabilities (external claims on those assets), and
stockholders’ equity (owners’ capital contributions and other internally
generated sources of capital) and their interrelationships at specific
point in time.
Basic equation of SOFP
Assets Liabilities Equity

6

STATEMENTS ANALYSIS
Example: Statement of financial position
Basic equation:
Total assets = Totals
liabilities + Equity
7

STATEMENTS ANALYSIS
2. Role of statement of comprehensive income (SOCI)
Report on performance of firm (result of its operating activities) on

account of revenues, expenses incurred, gains and loss in the period.
Some (not all) of the changes in assets, liabilities and equity of the firm
between two consecutive period can also explained.
Basic equation of SOCI
Net
Revenue Expenses
income
The statement of comprehensive income can be presented as a single

statement of comprehensive income or as 2 statements:
• Statement of profit or loss
• Statement of other comprehensive income
8

STATEMENTS ANALYSIS
Example: Statement of comprehensive income

loss (income statement)
Statement of profit or
income/ expense
contains realized
income/ expense
Statement of OCI
income contains
unrealized
9

STATEMENTS ANALYSIS
3. Role of statement of cash flow
Report cash receipts and payments in the reporting period, classified as

follows:
• Operating CF: cash from normal business activities
• Investing CF: cash from acquisition or sale of property, plant and
equipment; a subsidiary or segment; investments in other firms.
• Financing CF: cash from issuance or retirement of debt, equity
securities and dividends paid.
Basic equation of SOCF
Net cash Net cash in Net cash in Net cash in

in SOCF operating CF investing CF financing CF
10

STATEMENTS ANALYSIS
Example: Statement of cash flows
+ Net cash in financing CF

operating CF + Net cash in investing CF
Net Cash in SOCF = Net cash in
11

STATEMENTS ANALYSIS
Example: Profit versus Cash Flow

Sennett Designs (SD) sells furniture on a retail basis. SD began operations
during December 20X7:
• Sold furniture for €250,000 in cash.
• The furniture sold by SD was purchased on credit for €150,000 and
delivered by the supplier during December. The credit terms granted
by the supplier required SD to pay the €150,000 in January 20X8 for the
furniture it received during December.
• In addition to the purchase and sale of furniture, in December, SD paid
€20,000 in cash for rent and salaries.
1. How much is SD’s profit for December 20X7 if no other transactions
occurred?
2. How much is SD’s cash flow for December 20X7?
3. If SD purchases and sells exactly the same amount in January 20X8 as it
did in December 20X7 and under the same terms (receiving cash for the
sales and making purchases on credit that will be due in February), how
much will the company’s profit and cash flow be for the month of
January?
12

STATEMENTS ANALYSIS
Solution:
SD’s Profit versus Cash Flow for December 20X7
Profit Cash flow
Sale price €250,000 Cash from sale price €250,000
Cash paid for COGS

Cost of goods sold (€150,000) (recorded in Jan 0
20X8)
Rent and salaries (€20,000) Cash paid for Rent &

(€20,000)
expenses salaries expenses
SD’s profit for SD’s cash flow for

€80,000 €230,000
December 20X7 December 20X7
13

STATEMENTS ANALYSIS
Solution:
SD’s Profit versus Cash Flow for January 20X8
Profit Cash flow
Sale price €250,000 Cash from sale price €250,000
Cash paid for COGS

Cost of goods sold (€150,000) (for furniture (€150,000)
received in Dec 20X7)
Rent and salaries (€20,000) Cash paid for Rent &

(€20,000)
expenses salaries expenses
SD’s profit for SD’s cash flow for

€80,000 €80,000
January 20X8 January 20X8
14

STATEMENTS ANALYSIS
4. Role of statement of change in equity
• Report movement (increase and decrease) in components of owners’

equity
• Movement in shareholders' equity over an accounting period
comprises the following elements:
o Increase or decrease in retained earnings
o Increase or decrease in share capital reserves
o Increase or decrease in subscribed capital
Basic equation of SOCI
Opening Movement Closing

equity in equity equity
15

STATEMENTS ANALYSIS
Example: Statement of change in equity
Share Share Retained Revaluation Unrealized gain on

Total
capital premium earnings surplus FVOCI investments
Opening
$ $ $ $ $ $
Balance at 1/1/2020 700,000 - 500,560 - 34,850 1,235,410

Issue of new shares 100,000 50,000 - - - 150,000
Net income for the year - - 36,900 - - 36,900
Dividends paid during - - (60,000) - - (60,000)
the year
Revaluation gain on - - - 85,000 - 85,000
revaluation of fixed
assets
Movement
Unrealized loss on - - - - (14,050) (14,050)
FVOCI investments
Balance at 31/12/2020 800,000 50,000 477,460 85,000 20,800 1,433,260
Closing
16

STATEMENTS ANALYSIS
[LOS 15.c] Describe the importance of financial statement notes,
Importance of financial statement notes and
1.
supplementary information
The notes provide information that is essential to understanding the

information provided in the primary statements.
Information included in Financial statement notes:
• Discuss the basis of presentation such as the fiscal period covered by

the statements and the inclusion of consolidated entities.
• Provide information about accounting methods, assumptions, and
estimates used by management.
• Provide additional information on items such as business
acquisitions or disposals, legal actions, employee benefit plans,
contingencies and commitments, significant customers, sales to
related parties, and segments of the firm.
17

STATEMENTS ANALYSIS
Example: Financial statement notes – Basis of presentation

This note provide information about the basis of preparation
Saigon Beer – Alcohol - Beverage Corporation (SAB)

Notes to the consolidated financial statements
1. Basis of preparation
(a) Statement of compliance
These consolidated financial statements have been preparcd in accordance with
Vietnamese Accounting Standards, the Vietnamese Accounting System for
enterprises and the relevant statutory requirements applicable to financial
reporting.
(b) Basis of measurement
The consolidated financial statements, except for the consolidated statement of
cash flows, are prepared on the accrual basis using the historical cost concept. The
consolidated statement of cash flows is prepared using the indirect method.
(c) Annual accounting period
The annual accounting period of the Group is from 1 January to 31 December.
(d) Accounting and presentation currency
The Group's accounting currency is Vietnam Dong ("VND"), which is also the
currency used for consolidated financial statements presentation purpose.
18

STATEMENTS ANALYSIS
2. Importance of management’s commentary
• The management’s commentary (required under U.S. GAAP) highlights

important trends and events that affect a company’s liquidity, capital
resources, and operations.
• Management also discusses prospects for the upcoming year with
respect to inflation, future goals, material events, and uncertainties.
• The section must also discuss critical accounting policies that require
management to make subjective judgments and have a material
impact on the financial statements.
• Although it contains important information, analysts should bear in
mind that the MD&A section is not audited.
• It is also known as management’s report, operating & financial review
or management discussion and analysis (MD&A)
19

STATEMENTS ANALYSIS
2. Importance of management’s commentary
Requirement of management’s commentary

IFRS guidance recommends that US. GAAP requires that MD&A
MD&A address must
• The nature of the business • Highlight any favorable or
• Management’s objectives unfavorable trends
• The company’s past performance • Identify significant events and
• The performance measures used uncertainties that may affect the
• The company’s key relationships, company’s liquidity
resources and risk • Identify capital resources and
results of operations
• Discuss effects of inflation and
changing prices if material
• Discuss Impact of off-balance
sheet obligations & contractual
commitments.
• Discuss accounting policies that
require significant judgment by
management
• Forward-looking expenditures
and divestitures
20

STATEMENTS ANALYSIS
[LOS 15.d] Describe the objective of audits of FS, types of audit
reports and the importance of effective internal controls
1. Objective of audits of FS
Audit
Independent auditor Financial Statements
An audit is an independent review of an entity’s financial statements.

The objective of an audit are:
• Obtain reasonable assurance about whether the financial statements
as a whole are free from material misstatement
• Give opinion about accounting standards, estimates, assumption
applied
• Give opinion about the internal control system (only required by
GAAP)
• Report on the financial statements, and communicate as required by
the ISAs, in accordance with the auditor’s findings
(*) Materiality: Information is considered to be material if omission or
misstatement of the information could influence users’ decisions
21

STATEMENTS ANALYSIS
2. Types of audit reports
Types of audit reports
Unqualified audit report Qualified audit report

FS are free from material There is scope limitation or
omissions and errors exception to standards
Adverse audit report Disclaimer audit report

FS materially depart from Audit is unable to issue audit
accounting standards opinion
Note: An audit report must also contain a section called Key Audit
Matters or Critical Audit Matters, which highlights accounting choices
that are greatest significance to users of financial statements.
22

STATEMENTS ANALYSIS
3. Importance of effective internal controls
a. Definition of internal control
The internal control system is the company’s internal system that is

designed, among other things, to ensure that company’s process for
generating financial reports is sound (good)
Example: Internal control system for credit approval process
Sales Dept Management Credit Dept
Credit
Start
criteria
Sales order Credit check Pass
Review Account y
Receivable
n
Pass n
Note y
Internal Credit
report Credit approval End
control point
23

STATEMENTS ANALYSIS
3. Importance of effective internal controls
b. Requirement about internal control
Companies in the United States are now required to

• Explicitly accept responsibility for the effectiveness of internal control.
• Evaluate the effectiveness of internal control using suitable control
criteria
• Provide a report on internal control.
c. Importance of effective internal control
• Reduces the risk of asset loss

• Help ensure that plan information is complete and accurate, financial
statements are reliable, and the plan’s operations are conducted in
accordance with the provisions of applicable laws and regulations
→ Assure that the plan is achieving its financial reporting objectives.
American Institute of Certified Public Accountants (AICPA)
24

STATEMENTS ANALYSIS
[LOS 15.e] Information sources that analyst use in FS analysis
besides annual FS & supplementary information
The following describes some other information sources that analyst use in FS
analysis besides annual FS and supplementary information:
Interim report
Unaudited FS provided by the company semi-annually or quarterly
Proxy statements
Distributed to shareholders on matters at shareholder meetings, about:
 Board member and management
 Executive compensation
 Stock option
 Major shareholders
 Potential conflicts of interest between management, the board and
shareholder
Others
Information on the economy, industry and peer companies…
25

STATEMENTS ANALYSIS
[LOS 15.f] Describe the steps in the financial statement analysis
framework
Some are equity analysts want to evaluate potential investments in a

company’s equity securities as a basis for deciding whether a
prospective investment is attractive and what an appropriate purchase
price might be. This section presents a generic framework for financial
statement analysis that can be used in these various tasks
1. Articulation of 3. Data
2. Input data
purpose and processing
collection
context
5. Conclusion and
4. Data analysis/
6. Follow-up recommendation
interpretation
development
26

STATEMENTS ANALYSIS
framework
Step Input Output
1. • The nature of the • Statement of the

Articulate analyst’s function, such purpose or objective of
the purpose as evaluating an equity analysis.
and context or debt investment or • A list (written or
of issuing a credit rating. unwritten) of specific
the analysis • Communication with questions to be
client or supervisor on answered by the
needs and concerns. analysis.
• Institutional guidelines • Nature and content of
related to developing report to be provided.
specific work product • Timetable and budgeted
resources for
completion.
27

STATEMENTS ANALYSIS
framework
Step Input Output
2. Input • Financial statements, • Organized financial

data other financial data, statements.
collection questionnaires, and • Financial data tables.
industry/economic data. • Completed
• Discussions with questionnaires, if
management, suppliers, applicable..
customers, and
competitors.
• Company site visits (e.g.,
to production facilities
or retail stores).
3. Process Data from the previous • Adjusted financial

data phase. statements.
• Common- size
statements.
• Ratios and graphs.
• Forecasts.
28

STATEMENTS ANALYSIS
framework
Step Input Output
4. Analyze/ Input data as well as Analytical results

interpret the processed data.
processed data
5. Conclusion and • Analytical results • Analytical report

recommendation and previous answering questions
development reports. posed in Phase 1.
• Institutional • Recommendation
guidelines for regarding the purpose
published reports.. of the analysis, such
as whether to make
an investment or
grant credit.
6. Follow-up Information gathered Updated reports and

by periodically recommendations.
repeating above steps
29

STATEMENTS ANALYSIS
Practice questions
Learning outcome statements Exercises
15.a. Describe the roles of financial reporting and financial 1, 2

statement analysis.
15.b. Describe the roles of financial statements in evaluating 3

company’s performance and financial position
15.c. Describe the importance of financial statement notes, N/A

15.d. Describe the objective of audits of financial statements, the 4

types of audit reports and the importance of effective internal
controls
15.e. Identify & describe information sources that analyst use in 5

FS analysis besides annual financial statements & supplementary
information
15.f. Describe the steps in the financial statement analysis 6

framework
30

STATEMENTS ANALYSIS
Practice questions
1. Providing information about the performance and financial position

of companies so that users can make economic decisions best
describes the role of:
A Auditing.
B Financial reporting.
C Financial statement analysis.
2. The role of financial statement analysis is best described as:

A Providing information useful for making investment decisions.
B Evaluating a company for the purpose of making economic decisions.
C Using financial reports prepared by analysts to make economic
decisions.
3. The financial statement that would be most helpful to an analyst in

understanding the changes that have occurred in a company’s retained
earnings over a year is the statement of:
A. changes in equity.
B. financial position.
C. comprehensive income.
31

STATEMENTS ANALYSIS
Practice questions
4. What type of audit opinion is preferred when analyzing financial

statements?
A Qualified.
B Adverse.
C Unqualified.
5. Which of the following sources of information used by analysts is

found outside a company’s annual report?
A Auditor’s report
B Peer company analysis
C Management’s discussion and analysis
6. Which phase in the financial statement analysis framework is most

likely to involve producing updated reports and recommendations?
A Follow- up
B Analyze/interpret the processed data
C Develop and communicate conclusions and recommendations
32

STATEMENTS ANALYSIS
Practice questions
1. B is correct. This is the role of financial reporting. The role of financial

statement analysis is to evaluate the financial reports.
2. B is correct. The primary role of financial statement analysis is to use

financial reports prepared by companies to evaluate their past, current,
and potential performance and financial position for the purpose of
making investment, credit, and other economic decisions.
3. A is correct. The statement of changes in equity reports the changes in the

components of shareholders’ equity over the year, which would include
the retained earnings account.
B is incorrect. The statement of financial position (Balance Sheet) reports
a company’s financial position at a specific time.
C is incorrect. The statement of comprehensive income illustrates the
financial performance and results of operations of a particular company or
entity for a period of time.
4. C is correct. An unqualified opinion is a “clean” opinion and indicates that

the financial statements present the company’s performance and financial
position fairly in accordance with a specified set of accounting standards.
33

STATEMENTS ANALYSIS
Practice questions
5. B is correct. When performing financial statement analysis, analysts

should review all company sources of information as well as information
from external sources regarding the economy, the industry, the company,
and peer (comparable) companies.
6. A is correct. The follow- up phase involves gathering information and

repeating the analysis to determine whether it is necessary to update
reports and recommendations.
34
READING 16: FINANCIAL

REPORTING STANDARDS
35
READING 16: FINANCIAL REPORTING

STANDARDS
Learning outcomes
16.a. Describe the objective of financial reporting and the importance of

financial reporting standards in security analysis and valuation
16.b. Describe the roles of financial reporting standard-setting bodies
and regulatory authorities in establishing and enforcing reporting
standards
16.c. Describe the International Accounting Standards Board’s
conceptual framework
16.d. Describe general requirements for financial statements under
International Financial Reporting Standards (IFRS)
16.e. Describe implications for financial analysis of alternative financial

reporting systems and the importance of monitoring developments
in financial reporting standards
36

STANDARDS
[LOS 16.a] Describe the objective of financial reporting (FR) and
the importance of FR standards in security analysis & valuation
1. Describe the objective of financial reporting (FR)
The objective of financial reporting is to provide financial information

that is useful to users in:
• Making decisions (*) about providing resources to the reporting entity,
where those decisions relate to equity and debt instruments, or loans
or other forms of credit
• Influencing management’s actions that affect the use of the entity’s
economic resources
(*) decisions involve buying, selling, or holding equity and debt
instruments, and providing or setting loans and other forms of credit.
2. The importance of FR standards
Financial reporting requires policy choices and estimates. These choices

and estimates require judgements, which can vary from one preparer to
the next. Accordingly, standards are needed to ensure increased
consistency in these judgements.
37

STANDARDS
[LOS 16.b] The roles of FR standard-setting bodies & regulatory
authorities in establishing, enforcing reporting standards
Introduction of FR standard-setting bodies & regulatory
1.
authorities
Financial reporting standard- Regulatory Authorities

setting bodies
Private sector organizations of Governmental entities that have the
accountants and auditors that legal authority to enforce the
develop financial reporting rules, financial reporting requirements set
regulations, and accounting forth by the standard-setting bodies
standards
IASB FASB FSA (UK) SEC (US)
Member
Issue
of
IFRS US GAAP IOSCO (US)

38

STANDARDS
2. Role of FR standard-setting bodies (ISAB & FASB)
Bodies Role
International The IASB is the independent standard-setting body of the IFRS

Accounting Foundation. Its objectives are:
Standards • Develop and promote the use and adoption of a single set of
Board - ISAB high quality financial standards
• Ensure the standards result in transparent, comparable, and
decision-useful information while taking into account the
needs of a range of sizes and types of entities in diverse
economic settings
• Promote the convergence of national accounting standards
and IFRS.
Financial Financial Accounting Standards Board (“FASB”) develop US

Accounting Financial Accounting Standards. Its objective is:
Standards • Improve standards of financial reporting so that information
Board - FASB provided to users is useful for decision-making.
39

STANDARDS
2. Role of regulatory authorities
Bodies Role
International IOSCO is not a regulatory authority, but its members regulate a

Organization large portion of the world’s financial capital markets (including
of Securities SEC). Its core objectives are:
Commissions • Ensure that markets are fair, efficient and transparent.
- IOSCO • Reduce systematic risk
• Protect investors
U.S. SEC sets rules and regulations for any company issuing securities
Securities in the US or involved in the US capital market.
and
Exchange
Commission -
SEC
40

STANDARDS
[LOS 16.c] Describe the International Accounting Standards
Board’s conceptual framework
Introduction of International Accounting Standards
1.
Conceptual Framework consists of 3 following components:

• Qualitative characteristics of financial statements (2)
• Constraints on Financial Statements (3)
• Reporting Elements of financial statements (4)
2. Qualitative characteristics of financial statements
Relevance
Fundamental
Qualitative of financial
characteristics
Faithful representation
statements
Comparability
Verifiability
Enhancing
characteristics
Timeliness
Understandability
41

STANDARDS
2. Qualitative characteristics of financial statements (cont)
The Conceptual Framework identifies two fundamental qualitative

characteristics that make financial information useful: relevance and
faithful representation.
Predictable value: useful in making forecasts

Relevance
Confirmatory value: useful to evaluate past decisions or

Fundamental qualitative
forecasts
Materiality: Information is considered to be material if
characteristics
omission or misstatement of the information could

influence users’ decisions
Complete: All necessary information for users to
representation
understand the phenomenon is depicted

Faithful
Neutral: information is selected and presented without

bias
Free from error: No errors or omission in description. No
errors in producing financial information.
42

STANDARDS
Qualitative characteristics of financial statements
2.
(cont)
Comparability: Financial statement presentation should be consistent
among firms and across time periods.
Example: The profit of the company must be compared with the previous
years to see that there is an increase or decrease in it.
Enhancing qualitative characteristic
Verifiability: Independent observers, using the same methods, obtain

similar results.
Example: The profit of the company is considered to be verifiable when
there are specific proofs for the revenue and expense.
Timeliness: Information is available to decision-makers in times to be

capable of influencing their decisions.
Example: The information of the company’s profit should be given to users
in time.
Understandability: Users with a basic knowledge of business and

accounting should be able to readily understand the information the
statement present. Use full information should not be omitted
Example: When the accountant present the information of the company’s
profit, she should not use a lot of jargon and difficult phrasing.
43

STANDARDS
3. Constraints on Financial Statements
Benefit Does the cost of providing financial information

versus cost exceed the benefits derived from the information?
Omission of Intangible aspects (e.g., company reputation, brand

non- name, customer loyalty,
quantifiable and corporate culture) cannot be quantified and
information reflected in financial statements.
44

STANDARDS
4. Reporting Elements of financial statements
a. Elements in financial statements
Elements in financial statement of position
ASSET LIABILITY EQUITY

• Resource controlled • Present obligation of The residual interest in
by the entity as a the entity arise from the assets of the entity
result of past event. past events after deducting all its
• Arise future • To transfer an liabilities
economic benefits economic resource
from it.
45

STANDARDS
4. Reporting Elements of financial statements (cont)
a. Elements in financial statements
Elements of financial statement of profit or loss
INCOME EXPENSE
• Increase in economic benefits • Decrease in economic benefits
during the accounting period. during the accounting period.
• In the form of inflows (or • In the form of outflows (or
enhancements) of assets or depletions) of assets or
decrease of liabilities. incurrences of liabilities.
• Result in increase in equity (other • Result in decrease in equity
than increases relating to (other than decreases relating to
contributions from equity distributions to equity
participants.) participants.)
46

STANDARDS
b. Underlying Assumptions in Financial Statements
There are two underlying assumptions of financial statements:
Accrual • Requires that transactions should be recorded when

basis they actually occur, irrespective of when the related
exchange of cash occurs
• All activities are reported to the financial statements of
the periods to which they relate.
Going • Company will continue in operation for the foreseeable

concern future, no intention or need to liquidate the company in
the future.
• If those needs or intentions exist, the financial
statements shall be prepared on another basis..
47

STANDARDS
c. Recognition of financial statement elements
• Recognition means that an item is included in the balance sheet or

income statement.
• Recognition occurs if: the item meets the definition of an element
and satisfies the criteria for recognition.
• Recognition is appropriate if: it results in both relevant information
about assets, liabilities, equity, income and expenses and a faithful
representation of those items, because the aim is to provide
information that is useful to investors, lenders and other creditors.
48

STANDARDS
d. Measurement of Financial Statement Elements
Base Features
Historical • Assets:
costs o The amount of cash or cash equivalents paid to purchase an
asset, including any costs of acquisition and/or preparation.
o If the asset was not bought for cash, historical cost is the fair
value of whatever was given in order to buy the asset.
• Liabilities: the amount of proceeds received in exchange for
the obligation.
Current • Assets are carried at the amount of cash or cash equivalents

costs that would have to be paid if the same asset was acquired
currently.
• Liabilities: the undiscounted amount of cash or cash
equivalents that would be required to settle the obligation
currently.
Amortized Historical cost adjusted for amortization, depreciation, or

cost depletion and/or impairment
49

STANDARDS
d. Measurement of Financial Statement Elements (cont)
Realizable • Assets: the amount of cash or cash equivalents that could

(settlement) currently be obtained by selling the asset in an orderly
value disposal.
• Liabilities: the undiscounted amounts of cash or cash
equivalents expected to be paid to satisfy the liabilities in
the normal course of business.
Present value • Assets: the present discounted value of the future cash
inflows that the item is expected to generate in the normal
course of business.
• Liabilities: the present discounted value of the future net
cash outflows that are expected to be required to settle
the liabilities in the normal course of business.
Fair value An exit price, the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. This
may involve either market measures or present value
measures depending on the availability of information.
50

STANDARDS
[LOS 16.d] Describe general requirements for financial
statements under International Financial Reporting Standards
Required Financial Statements

• Statement of financial position (Balance sheet)
• Statement of comprehensive income (Income
statement + Statement of comprehensive income)
• Statement of change in equity
• Cash flow statement
• Notes
• In certain cases: Balance sheet from earliest
comparative period
General features (1) Structure and content (2)

• Fair presentation • Classified balance sheet
• Going concern • Minimum specified
• Accrual basis information on face
• Materiality and aggregation • Minimum specified note
• No offsetting disclosure
• Frequency of reporting • Comparative information
• Comparative information
• Consistency of presentation
51

STANDARDS
1. General features
Requirement Explanation
Fair Requires the faithful representation of the effects of

presentation transactions, other events and conditions in
accordance with the definitions & recognition criteria
for assets, liabilities, income and expenses set out in
the Framework
Going Financial statements are prepared on a going concern

concern basis unless management intends to liquidate the
entity or to cease trading,... If not going concern, the
fact and rationale should be disclosed
Accrual basis Financial statements (except for cash flow information)

are to be prepared using the accrual basis
Materiality • Each material class of similar items must be

and presented separately in the financial statements.
Aggregation • Dissimilar items may be aggregated only if they are
individually immaterial.
52

STANDARDS
1. General features
No offsetting Assets and liabilities, and income and expenses, may

not be offset unless required or permitted by IFRS.
Frequency of Financial statements must be prepared at least

reporting annually.
Comparative For all amounts reported in a financial statement,

information comparative information should be provided for the
previous period unless another standard requires or
permits otherwise
Consistency The presentation and classification of items in the

of financial statements shall be retained from one period
presentation to the next unless a change is justified either by a
change in circumstances or requirements of new IFRS.
53

STANDARDS
2. Structure and content requirements
Classified Requires the balance sheet to distinguish between

balance sheet current and non-current assets, between current and
non-current liabilities unless a presentation based on
liquidity (presented by bank, finance corp,..)
Minimum IAS 1 – Presentation of financial statement specifies

information on the minimum line item disclosures on the face of, or
the face of the in the notes to, the balance sheet, the income
FSs statement, and the statement of changes in equity.
Example: The SOFP shall include line items that
present the following amounts: property, plant and
equipment; investment property…
Minimum IAS 1 – Presentation of financial statement specifies

information in disclosures about information to be presented in the
the notes notes to financial statements. (*see the next slide)
Example: Disclose the amount of any cumulative
preference dividends not recognized
54

STANDARDS
2. Structure and content requirements
(*) Notes to financial statements requirements
Disclosure of • Measurement bases used in preparing financial statements

Accounting • Significant accounting policies used
Policies • Judgments made in applying accounting policies that have
the most significant effect on the FSs
Sources of Key assumptions about the future and other key sources of
Estimation estimation uncertainty that can cause significant risk of
Uncertainty material adjustment to the assets and liabilities within the
next year
Other • Information about capital & equity instruments

Disclosures • Dividends not recognized as a distribution during the period
• Description of the entity, including its domicile, legal form,
country of incorporation, and registered office or business
address
• Nature of operations and principal activities
• Name of parent and ultimate parent
55

STANDARDS
[LOS 16.e] Describe implications for financial analysis of
alternative financial reporting systems and the importance of
monitoring developments in financial reporting standards
There are still significant differences in financial reporting in the global
capital markets. Arguably, the most critical are the differences that exist
between IFRS and US GAAP
Criteria US GAAP IFRS
Developed by Financial Accounting International Accounting

Standard Board (FASB) Standard Board (IASB)
Based on Rules Principles
Inventory FIFO, LIFO & Weighted FIFO and Weighted

valuation Average Method Average Method
Extraordinary Shown at the bottom of Not segregated in the

the income statement income statement.
Development Treated as an expense Capitalized, only if certain

cost conditions are satisfied
Reversal of Prohibited Permissible, if specified

inventory conditions are met
56

STANDARDS
[LOS 16.e] Describe implications for financial analysis of
alternative financial reporting systems and the importance of
monitoring developments in financial reporting standards
1. New products or types of transactions
• Certain economic events have led to the development of new products

and new transactions.
• Analysts should evaluate companies’ financial reports to understand
new transactions or products being used and implemented. They can
also get more information from business journals, magazines, capital
markets, and company management.
• As products or transactions become more common in the industry,
it becomes imperative to understand their implications, usefulness, and
impact on cash flows.
2. Evolving standards and the role of CFA Institute
• Actions of standard-setting bodies, such as IASB and FASB, must be

monitored because changes in regulations and financial reporting
standards affect reported financial performance. A great deal of
information is presented on IASB and FASB websites.
• Investment decision-making can be improved by keeping track of
enacted and proposed changes.
57

STANDARDS
Practice questions
16.a. describe the objective of financial reporting and the Question 1

importance of financial reporting standards in security analysis
and valuation.
16.b. describe the roles of financial reporting standard-setting Question 2

bodies and regulatory authorities in establishing and enforcing
reporting standards
16.c. describe the International Accounting Standards Board’s Question 3-5

conceptual framework
16.d. describe general requirements for financial statements Question 2

under International Financial Reporting Standards (IFRS)
16.e. describe implications for financial analysis of alternative Question 6

financial reporting systems and the importance of monitoring
developments in financial reporting standards
58

STANDARDS
Practice questions
1. Which of the following is most likely not an objective of financial

statements?
A To provide information about the performance of an entity.
B To provide information about the financial position of an entity.
C To provide information about the users of an entity’s financial
statements.
2. US generally accepted accounting principles are currently developed by

which entity?
A The Securities and Exchange Commission.
B The Financial Accounting Standards Board.
C The Public Company Accounting Oversight Board.
3. The assumption that the effects of transactions and other events are
recognized when they occur, not when the cash flows occur, is called:
A relevance.
B accrual basis.
C going concern..
59

STANDARDS
Practice questions
4. Valuing assets at the amount of cash or equivalents paid or the fair value
of the consideration given to acquire them at the time of acquisition
most closely describes which measurement of financial statement
elements?
A Current cost.
B Historical cost.
C Realizable value.
5. The assumption that an entity will continue to operate for the

foreseeable future is called:
A accrual basis.
B comparability.
C going concern.
6. Which of the following disclosures regarding new accounting standards

provides the most meaningful information to an analyst?
A The impact of adoption is discussed.
B The standard will have no material impact.
C Management is still evaluating the impact.
60

STANDARDS
Practice questions
1. C is correct. Financial statements provide information, including information about
the entity’s financial position, performance, and changes in financial position, to
users. They do not typically provide information about users.
2. B is correct. The FASB is responsible for the Accounting Standards

Codification™, the single source of nongovernmental authoritative US generally
accepted accounting principles.
3. B is correct. Accrual basis reflects the effects of transactions and other events being
recognized when they occur, not when the cash flows. These effects are recorded
and reported in the financial statements of the periods to which they relate.
4. B is correct. Historical cost is the consideration paid to acquire an asset.
5. C is correct. The Conceptual Framework identifies two important underlying

assumptions of financial statements: accrual basis and going concern. Going concern
is the assumption that the entity will continue to operate for the foreseeable future.
Enterprises with the intent to liquidate or materially curtail operations would require
different information for a fair presentation.
6. A is correct. A discussion of the impact would be the most meaningful,

although B would also be useful.
61
READING 17: UNDERSTANDING

INCOME STATEMENT
62
READING 17: UNDERSTANDING INCOME

STATEMENT
Learning outcomes
17.a. Describe the components of the income statement and alternative

presentation formats of that statement
17.b. Describe general principles of revenue recognition and accounting
standards for revenue recognition
17.c. Calculate revenue given information that might influence the
choice of revenue recognition method
17.d. Describe general principles of expense recognition, specific
expense recognition applications, and implications of expense
recognition choices for financial analysis
17.e. Describe the financial reporting treatment and analysis of non-
recurring items (including discontinued operations, unusual or
infrequent items) and changes in accounting policies
17.f. Contrast operating and non- operating components of the income
statement
17.g. Describe how earnings per share is calculated and calculate and
interpret a company’s earnings per share for both simple &
complex capital structures
63

STATEMENT
Learning outcomes
17.h. Contrast dilutive and antidilutive securities and describe the

implications of each for the earnings per share calculation
17.i. Formulate income statements into common-size income
statements
17.j. Evaluate a company’s financial performance using common-size
income statements and financial ratios based on the income
statement
17.k. Describe, calculate, and interpret comprehensive income
17.l. Describe other comprehensive income and identify major types of

items included in it
64

STATEMENT
[LOS 17.a] describe the components of the income statement
and alternative presentation formats of that statement
1. Describe the components of the income statement
The income statement presents information on the financial results of a

company's activities over a period of time.
The income statement equation is:
1 Revenue 2 Expenses 3 Net Income
• Revenue generally refers to the amount charged for the delivery of goods or
services in the ordinary activities of a business.
• Net revenue is total revenue adjusted for product returns and amounts that
are unlikely to be collected.
Revenue – Adjustments for returns and allowance = Net revenue
• Expenses reflect outflows, depletions of assets, and incurrences of liabilities

in the course of the activities of a business.
• Expenses may be grouped and reported in different formats, subject to
some specific requirements.
65

STATEMENT
1. 1. Describe
Describe
the components
the components
of the income
of the income
statement
statement
1 Revenue 2 Expenses 3 Net Income
Net income is the “bottom line” of the income statement. It includes profits
earned from ordinary business activities as well as gains and losses from non-
operating activities.
Net income = Revenue - Expenses in the ordinary activities of the business
+ Other income - Other expenses + Gains - Losses
In addition to presenting the net income, income statements also present

subtotals, which are significant to users of financial statements.
Some subtotals are required by IFRS (especially non-
Subtotal net
* recurring items), while others are not explicitly required.
income
(see the next slide for more detail)
66

STATEMENT
Subtotal net income

There are two subtotals that are important to consider in the income statement
a. Gross margin (Gross profit)
Gross profit is the amount of revenue available after subtracting the costs of
delivering goods or services.
Gross margin = Net revenue – Cost of goods sold
Note:
• For manufacturing and merchandising companies:
Gross profit is calculated as revenue minus the cost of the goods that were sold.
• For service companies:
Gross profit is calculated as revenue minus the cost of services that were
provided.
Yes
Base on the occurance of gross margin, Multi-step format
there are two types of presentation of
income statement Single-step format
No
67

STATEMENT
Subtotal net income
b. Operating income (Operating profit)
Operating income represents the profit earned by a company from its ordinary
business activities before accounting for taxes and, in the case of nonfinancial
companies, before deducting interest expense
Operating income = Gross margin – Operating expenses
Note:
• For financial companies:
Interest expense would be included in operating expenses and subtracted in
arriving at operating profit because it relates to the operating activities for such
companies.
• Operating profit is sometimes referred to as EBIT (earnings before interest
and taxes).
The format of the income statement is not specified and the actual format varies
across companies. (see the next slides)
68

STATEMENT
2. Alternative presentation formats of that statement
Format 1: Multi-step format

Zynga Jelly Button Co.
Income Statement
For the year ended 31 December 2021
1 Revnues (also called “Sales”) or Net Revenue $100,000
2 Cost of goods sold (COGS) 75,000
* Gross profit 25,000
2 Operating expenses
Selling expenses 7,000
Administrative expenses 6,000
Total operating expenses 13,000
*
Operating income 12,000
1 2
Other expenses and income
Interest revenues 5,000
Gain on sale of investments 3,000
Interest expense (500)
* Loss from lawsuit (1,500)
Profit before tax 18,000
3 Income tax expense 3,600
69

STATEMENT
Format 2: Single-step format

Neowiz Hidea Co.
Income Statement
For the year ended 31 December 2021
1 Revenues & Gains
Sales revenues $100,000
Interest revenues 5,000
Gain on sales of assets 3,000
* Total revenues & gains 108,000
2 Expenses & Losses
Cost of goods sold 75,000
Commisions expense 5,000
Office supplies expense 3,500
Office equiptment expense 2,500
Adverstising expense 2,000
Interest expense 500
Loss from lawsuit 1,500
* Total expenses & losses 90,000
3 Net income 18,000
70

STATEMENT
Expenses can be grouped together by their nature or function.
Group by nature: Presenting expense from manufacturing and administration

together in one line of the income statement.
Group by function (Cost of sales method): Expenses would be grouping
together expenses into a category.
Expenses group by nature Expenses group by function
Revenue X Revenue X
Expenses: COGS (X)
• Purchases (X) Gross profit X
• Changes in inventory (X) Operating expense (X)
Depreciation expense (X) Operating income X
Rent expense (X) Other income X
Employee benefit expenses (X) Other expense (X)
Interest expenses (X) Income before taxes X
Income tax expense (X) Income tax expenses (X)
Profit after tax – Net income X Profit after tax – Net income X
71

STATEMENT
Components of the income statement
Revenue recognition - LOS 17.b - c
Revenue 1. General principle
2. Accounting Standards for Revenue Recognition
Expense recognition - LOS 17.d
1. General principle
Expenses 2. Issues in expense recognition
2.1 2.3
2.2
Doubtful Depreciation
Warranties
Accounts And amortization
Non-recurring items - LOS 17.e

Other
income/expense 1. 2. 3.
Infrequent or Discontinued Unusual or Change in
abnormal gain or Operations Infrequent Items accounting policy
loss
Non-operating items - LOS 17.f
72

STATEMENT
[LOS 17.b] describe general principles of revenue recognition
and accounting standards for revenue recognition
1. Introducing to income and revenue
Income is increases in economic benefits during the accounting period in the

form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity
participants.
Arise from a company’s ordinary Arise from secondary or peripheral

business activities activities
Revenue Gain
Refer to LOS 17.a.1 Refer to LOS 17.e - f
Example: for a restaurant, the sale of

Revenue recognition surplus restaurant equipment for more
Refer to LOS 17.b - c than its carrying value is referred to as a
gain rather than as revenue.
Note: Gains and losses may be considered part of operating activities (e.g., a loss
due to a decline in the value of inventory) or may be considered part of non-
operating activities (e.g., the sale of non-trading investments).
73

STATEMENT
2. General principles of revenue recognition
Accrual accounting principle

Revenue is recognized (reported on the income statement) when when the risk
and reward of ownership is transferred (this is often when the company delivery
goods or services).
Revenue recognition is that it can occur independently of cash movements
Credit sale Payment in advance

• Revenue recognized at the time of sale • A liability, unearned revenue, is
and an asset (accounts receivable) is created when the cash is received.
created on the balance sheet. • Revenue is recognized as the goods
• Cash received from customer to offset are transferred to the buyer.
the acconts receivable
Good transferred Cash received Cash received Good transferred

Debit AR (SOFP) Debit Cash Debit Cash Debit Unearned Revenue
Credit Revenue (SOPL) Credit AR Credit Unearned Credit Revenue
Revenue
74

STATEMENT
3. Accounting standards for revenue recognition
The core principle of the converged standard

Revenue should be recognized to “depict the transfer of promised goods or
services to customers in an amount that reflects the consideration to which the
entity expects to be entitled in an exchange for those goods or services.”
The follow five-steps process will be used to recognize revenue:
3.1. Identify the contract(s) with a customer

5 steps model to recognize revenue
3.2. Identify the separate or distinct performance obligations in the

contract
3.3. Determine the transaction price
3.4. Allocate the transaction price to the performance obligations in the

contract
3.5. Recognize revenue when (or as) the entity satisfies a performance
obligation
75

STATEMENT
3.1. Identify the contract(s) with a customer
Contract is an agreement that creates enforceable rights and obligations
The contracts with the customers must satisfy five criteria:

All parties have approved the contract and committed to perform their
respective obligations
Five criteria of contract
The entity can identify each party’s rights and obligations regarding the
goods or services to be transferred
The payment terms for the goods or services can be identified
The contract has commercial substance
It is probable* to collect consideration
(*) IFRS and U.S. GAAP use the same word (probable), but they apply a different
threshold for probable collectability:
• IFRS: “Probable” means more likely than not;
• US GAAP: “Probable” means likely to occur.
76

STATEMENT
3.2. Identify the separate or distinct performance obligations in the contract
A performance obligation is a promise to deliver a distinct good or service.
Promises to transfer goods/services

Seller PO1 PO2 … Buyer
A good or service (G/S) is distinct if both of the following

criteria are met: Each identified
• The customer can benefit from the good or service on performance
its own or combined with other resources that are obligation (PO) is
readily available. accounted for
• The promise to transfer the good or service can be separately
identified separately from any other promises.
If G/S are not distinct

Company would account for a single performance
obligation
77

STATEMENT
3.3. Determine the transaction price
The transaction price is the amount that the seller estimates it will receive in
exchange for transferring the good(s) or service(s) identified in the contract to
the buyer.
Promises to transfer goods/services

Seller Buyer
Transaction price (TP)
3.4. Allocate The transaction price is then allocated to

the transaction each identified performance obligation
price to the
performance
obligations in
the contract PO 1 PO 2 … PO n
78

STATEMENT
3. Accounting standards for revenue recognition (cont.)
3.4. Allocate the transaction price to the performance obligations in the

contract.
Transaction price must be allocated based on stand-alone price of each

performance obligation.
Example:
X Co sells the set top box by itself for $500 and charges monthly access to the
TV service without the set top box for $1,560 a year
Y Co signed a contract with X and has to pay a monthly fee of $160
(equivalent to $1,920 for a year). Y receives a cable TV set top box and access
to all the TV channels.
Standalone price Revenue
Box 500 1,920 x (500/2060)
Cable TV access 1,560 1,920 x (1,560/2060)
Total 2,060 1,920

79

STATEMENT
3. Accounting standards for revenue recognition (cont.)

3.5. Recognize revenue when (or as) the entity satisfies a performance
obligation.
• The entity will recognize revenue when it is able to satisfy the

performance obligation by transferring control to the customer.
• Factors to consider when assessing whether the customer has
obtained control of an asset at a point in time:
o Entity has a present right to payment
o Customer has legal title

o Customer has physical possession
o Customer has the significant risks and rewards of ownership
o Customer has accepted the asset
80

STATEMENT
[LOS 17.c] calculate revenue given information that might
influence the choice of revenue recognition method
The new converged accounting standards provide some examples of

appropriate revenue recognition under various scenarios. The following
summaries draw on these examples.
1. Long-term contract 2. Variable consideration

Consider revenue recognition in Consider revenue of contract with
case of long term contract the addition of a promised bonus
(contract is one that spans payment
multiple accounting periods)
3. Contract revisions 4. Acting as an agent

Consider revenue of contract in Consider revenue in case firm
case of contract modification as acting as an agent
an extension of the existing
contract or as a new contract
81

STATEMENT
1. Long-term contract
Consider expected loss/outcome on contract
The loss is reported immediately,

If loss is expected on contract
regardless of the method used
• IFRS and U.S. GAAP require the use of
the percentage-of-completion
Outcome of
method.
contract can
• The percentage-of-completion is
be reliably
equal to actual cost/estimated total
measured
If outcome is cost, or it can be determined by an
expected on engineering estimate
contract • IFRS requires revenue is only
Outcome of
reported to the extent of contract
contract
costs incurred
cannot be
• U.S. GAAP requires no revenue is
reliably
reported until the contract is finished
measured
(completed contract method)
82

STATEMENT
1. Long-term contract
Example: Long-term contract

A contractor agrees to build a warehouse for a price of $10 million and
estimates the total costs of construction at $8 million. Although there are
several identifiable components of the building, these components are
not separate deliverables, and the performance obligation is the
completed building. During the first year of construction, the builder
incurs $4 million of costs, 50% of the estimated total costs of completion.
cost incurred 4
Percentage of completion = = = 50%
total cost 8
Percentage of 50%
completion
Apply the percentage-of-completion method, we have:

Revenue recognized = Percentage of completion x total revenue
= 50% x $10 = $5 (million)
83

STATEMENT
2. Variable consideration
Principle: Performance bonus should be added in revenue if condition to

achieve bonus is highly probable.
Example: Variable consideration

Consider construction contract at prior example with the addition of a
promised bonus payment of $1 million if the building is completed in three
years.
• At the end of the first year, the contractor has some uncertainty about
whether he can complete building by the end of the third year
→ The builder does not consider the possible bonus as part of the transaction
price
→ Year 1 revenue is still $5 million (as the prior example)
• During the second year, the contractor incurred an additional $2 million in
costs and believes that the building will be finished in time.
→ The bonus is now included in the transaction price and becomes $11
($10+S1)
4+2
Percentage of =75%
8
completion
The total revenue to be recognized till the end of year 2= 0.75 × $11 = $8.25
Revenue recognized in year 2 = $8.25 – $5 = $3.25 (million)
84

STATEMENT
3. Contract revisions
Principle:
• Contract modification as an extension of the existing contract if the goods,
services to be provided are not distinct from those already transferred.
• Contract modification as a new contract if the goods, services to be provided
are distinct from those already transferred
Example: Contract revisions

Returning to our example, a contract revision requires installation of
refrigeration to provide cold storage in part of the warehouse; of which the
cost is $2m and revenue is $3m.
The goods and services to be provided are not distinct from those already
transferred
→ The contract revision should be considered an extension of the existing
contract
→ The total cost of the contract after revision = $8 + $2 = $10 (million)
→ The total revenue after revision = $11 + $3 = $14 (million)
6
Percentage of = 60%
10
completion
The total revenue to be recognized to date = 60% × $14 = $8.4 (million)
Revenue for the second year = $8.4 – $5 = $3.4 (million)
85

STATEMENT
4. Acting as an agent
Principle:
• Revenue of agent = Commission
• Revenue of principal = Gross amount of the consideration
Example: Acting as an agent

Consider a travel agent who arranges a first-class ticket for a customer
flying to Singapore.
• The ticket price is $10,000, made by nonrefundable payment at
purchase, and
• The travel agent receives a $1,000 commission on the sale.
The travel agent is not responsible for providing the flight and bears no
inventory or credit risk → she is acting as an agent.
→ The travel agent reports revenue equal to her commission of $1,000
If she was the principal, she would report revenue of $10,000, and an
expense of $9,000 for the ticket.
86

STATEMENT
[LOS 17.d] describe general principles of expense recognition,
specific expense recognition applications, and implications of
expense recognition choices for financial analysis
1. Describe general principles of expense recognition
Expenses are decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity
participants
Arise from a company’s ordinary Arise from secondary or peripheral

business activities activities
Expense Loss
Refer to LOS 17.a.1 Refer to LOS 17.e - f
87

STATEMENT
1. Describe general principles of expense recognition
EXPENDITURE RECOGNITION
Principle Issues
Matching concept Doubtful Accounts (i.e uncollectible

Expense matching with revenue (i.e accounts) required to record an
costs of goods sold) estimate of how much of the revenue
will be uncollectible and recognize the
Period Cost loss when customer defaulted
Expense made by company or incurred
the liability to pay in the period (i.e Warranties required to estimate and
administrative expense) recognize the amount of future
expenses resulting from its warranties,
and to be updated over the life of the
Expenditure relate to future expected warranty
benefits allocated systematically with the
passage of time (i.e depreciation expense) Choices of methods (i.e depreciation
method, …)
88

STATEMENT
2. Specific expense recognition applications
a. Inventory expense
• Under the matching principle, COGS will be matched against revenues

when these units are sold.
Example: At beginning of 20X8, Company X has 10,000 units of $25
each. In this year, Company X sold 9,000 units during 20X8 at a price of
$30 per unit. In this case, company X has
o Total revenue = $30 x 9,000 = $270,000
o COGS = $25 x 9,000 = $225,000
o We can conclude that COGS of $225,000 matches against revenues
of $270,000
• Cost of goods sold = Opening inventory + Purchased inventory –
Closing inventory
89

STATEMENT
a. Inventory expense
Ending inventory
Method Description COGS consists of
consists of
FIFO Cost of the

earliest items Most recent
First purchased
purchased flow purchases
to COGS first
LIFO Cost of the most

recent items Earliest
Last purchased
purchased flow purchases
to COGS first
WAC Averages total

Average cost of Average cost of
costs over total
all items all items
units available
Specific
Price of each units used
identification
90

STATEMENT
b. Uncollectible account (Doubtful expense)
• Account receivables arise from sales to customers who do not

immediately pay cash.
• There are always some customers who cannot or will not pay their
debts. The accounts owed by these customers are called uncollectible
accounts.
• Doubtful expenses are generally classified as a sales and general
administrative expense on the income statement.
• Under the matching principle, a company is required to estimate the
amount of doubtful expenses resulting from its sales.
• One possible approach to recognizing credit losses on customer
receivables would be for the company to wait until such time as a
customer defaulted and only then recognize the loss (direct write-off
method).
91

STATEMENT
c. Warranties expense
• Warranties expense related to expense that will be used to repair or

replace the product they sell, if the product proves deficient in some
respect that is covered under the terms of the warranty.
• Under the matching principle, a company is required to estimate the
amount of future expenses resulting from its warranties, to recognize
an estimated warranty expense in the period of the sale, and to
update the expense as indicated by experience over the life of the
warranty.
92

STATEMENT
d. Depreciation & Amortization expense (Reading 22 – Long Lived Asset)
• Depreciation/Amortization is the process of systematically allocating

costs of long-lived assets over the period during which the assets are
expected to provide economic benefits
• Depreciation is the term commonly applied to tangible assets
• Amortization is the term commonly applied to intangible assets
• Accumulated depreciation the total amount of depreciation
expenditure allocated to a particular asset since the asset was used
• There are 3 methods to calculate depreciation/amortization
o Straight-line depreciation method
o Accelerated depreciation method
o Double-declining balance method
93

STATEMENT
Implications of expense recognition choices for
3.
financial analysis
• Expense recognition requires a number of estimates. Since estimates
are involved, it is possible for firms to delay or accelerate the
recognition of expenses. Delayed expense recognition increases
current net income and is therefore more aggressive.
• Financial analysis should:
o Consider the underlying reasons for a change in an expense
estimate.
Ex: If a firm’s bad debt expense has recently decreased
→ Did the firm lower its expense estimate because its collection
experience improved, or was the expense decreased to manipulate
net income?
o Compare a firm’s estimates to those of other firms within the
firm’s industry.
Ex: If a firm’s warranty expense is significantly less than that of a
peer firm,
→ Is the lower warranty expense a result of higher quality
products, or is the firm’s expense recognition more aggressive than
that of the peer firm?
94

STATEMENT
[LOS 17.e] describe the financial reporting treatment and
analysis of non-recurring items & changes in accounting policies
It is helpful to disclose separately some items from prior years which are
not expected to continue in the future periods
Present in the income statement as a

separate component of income from
Unusual or continuing operations
infrequent items
Recognition under GAAP/IFRS
Recorded gross of tax
Present in the income statement as a

separate component after income from
Discontinued continuing operations
operations
Recorded net of tax
Change in
Restate prior-year income statement
accounting policies
Change in
Not restate prior-year income statement
accounting estimates
95

STATEMENT
Describe the financial reporting treatment and

1.
analysis of non-recurring items
a. Unusual or infrequent items
• Definition: Events are either unusual in nature or infrequent in

occurrence. Examples of items that could be considered unusual or
infrequent include:
o Gains or losses from the sale of assets or part of a business, if these
activities are not a firm’s ordinary operations.
o Impairments, write-offs, write-downs, and restructuring costs.
• Treatment: Unusual or infrequent items are included in income from
continuing operations and are reported before tax.
• Analytical implications: review to determine whether they truly
should be included when forecasting future firm earnings. Some
companies appear to be accident-prone and have “unusual or
infrequent” losses every year or every few year
96

STATEMENT

1.
analysis of non-recurring items
b. Discontinued operation
• Definition: Discontinued operation is the one that management has

decided to dispose of, but either has not yet done so, or has disposed
of in the current year after the operation had generated income or
losses.
• Treatment:
o To qualify, the assets, results of operations, and investing and
financing activities of a business segment must be separable from
those of the company.
o Any gains or disposal will not contribute to future income and cash
flows, and therefore can be reported only after disposal, that is -
when realized.
• Analytical implications: Analysts may exclude discontinued operations
when forecasting future earnings. The actual event of discontinuing a
business segment or selling assets may provide information about the
future cash flows of the firm, however.
97

STATEMENT

2.
analysis of changes in accounting policies
a. Change in accounting policies
• Definition: Change in accounting policies is change in specific

principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements. For example,
by changing its inventory costing method or capitalizing rather than
expensing specific purchases.
• Treatment: Retrospective application, prior-period financial
statements presented in a firm’s current financial statements must be
restated, applying the new policy to those statements as well as
future statements.
• Analytical implications: Prior-period adjustments usually involve new
accounting standards and does not typically affect cash flow. Analyst
should review changes in accounting policies to determine their
impact on future operating results.
98

STATEMENT

2.
analysis of changes in accounting policies
b. Change in accounting estimate
• Definition: Change in accounting estimate is the result of a change in

management’s judgment, usually due to new information
• Treatment: Prospective application, prior statements are not
restated, and the new policies are applied only to future financial
statements.
• Analytical implications: Accounting estimate changes typically do not
affect cash flow. Analyst should review changes in accounting
estimates to determine their impact on future operating results.
99

STATEMENT
[LOS 17.f] contrast operating and non-operating components of
the income statement
Operating activities Non-operating activities
Operating activities are those
Non-operating activities are ones
that generally involve producing
which do not belong to the
and delivering goods & providing
normal course of business.
services (normal course of
business)
Note: These non-operating items are reported separately from
operating items since they may affect financial analysis.
Special cases and accounting treatment for non-operating items
Cases Accounting treatment
Gain, loss on disposal of Recorded as an unusual or infrequent item, but

fixed assets still part of operating activities
Interest expense For non-financial service company: non-operating

Investment income For financial service company: operating
Restructuring charges Under US GAAP: operating items

Under IFRS: non-operating items
100

STATEMENT
[LOS 17.g-h] Understand and calculate earnings per share, basic
earnings per share and diluted earnings per share under specific
circumstances
1. Earnings per share: definition and disclosure
Earnings per share (EPS) refer to the share of net income of a company that
is owned by common shareholders only.
A company may have either a simple or complex capital structure:
Simple structures
Contains no potentially convertible securities
Report basic EPS (session 2)
Complex Structures
Contains potentially convertible securities (potentially convert into common stock)
Convertible securities, once converted, potentially dilute EPS (↓EPS)
Companies also have to disclose what their EPS would be if all dilutive securities
were converted into common stock, also called diluted EPS
101

STATEMENT
circumstances
Defining dilutive securities: deriving from economic meaning
The convertible securities give investors the right to convert the securities
into shares
If thẹ opportunity cost of If thẹ opportunity cost of converting

converting is small is large
Investors would rather convert Investors would rather not convert

into shares into shares
This would delute the EPS, the This does not delute the EPS, or we
company reports diluted EPS can say basic EPS = diluted EPS
These securities are dilutive These securities are antidilutive
Once we identify a security as “antidilutive”, it means that the opportunity cost

of converting this security is so large that the investors don’t want to convert it.
102

STATEMENT
circumstances
Defining dilutive securities: deriving from economic meaning
• Once we identify a security as “dilutive”, it means that the opportunity cost

of converting this security is small and therefore the investors want to
convert it. When converted, EPS is diluted (decreases).
• Once we identify a security as “antidilutive”, it means that the opportunity
cost of converting this security is too large that the investors don’t want to
convert it. If they do, the EPS increases.
If antidilutive securities are converted, they do not dilute the EPS, but they
increase it, this means that the interest that was supposed to belong to
convertible sharesholders is now spreaded widely to common shareholders.
The situation mentioned above is not beneficial for investors, which explains
why they never convert antidilutive securities .
103

STATEMENT
circumstances
2. Calculating basic earnings per share
The basic EPS calculation does not consider the effects of any dilutive
securities in the computation of EPS.
Net income − Preferred Dividends

Basic EPS =
Weighted average number of common shares
In which:
Weighted average number of common shares = Number of outstanding
ordinary shares x portion of the year they were outstanding
In basic EPS calculation, we will need to pay attention to 2 special cases

• New issue
• A stock split or stock dividend
Calculation of basic EPS in these two cases is specified in the next slide.
104

STATEMENT
circumstances
a. New issue
Example: Basic EPS calculation in case of new issue

For 2020, X Company has net income of $ 1,000,000. At 1 January 2020,
there were 1,000,000 shares outstanding. On 1 July 2020, the company
issued 100,000 new shares for $2 per share. The company paid $200,000
in dividends to common shareholders. What is X company’s basic EPS for
the year 2020.
Answer:
1,000,000 +100,000
01/01 01/07 31/12

• Weighted average number of common shares = 1,000,000 + 100,000 x
6/12 = 1,050,000
1,000,000
• Basic EPS = = 0.952
1,050,000
Shares issued enter into the computation from the date of issuance.
105

STATEMENT
[LOS 17.g] describe how earnings per share is calculated and
calculate and interpret a company’s earnings per share for both
simple & complex capital structures
b. Stock split/ stock dividend
• A stock dividend is the distribution of additional shares to each

shareholder in an amount proportional to their current number of
shares. Ex: If a 10% stock dividend is paid, the holder of 100 shares of
stock would receive 10 additional shares.
• A stock split refers to the division of each “old” share into a specific
number of “new” (post-split) shares.
Ex: The holder of 100 shares will have 200 shares after a 2-for-1 split or
150 shares after a 3-for-2 split.
106

STATEMENT
Example: Stock split

Johnson Company has 10,000 shares outstanding at the beginning of the
year. On April 1, Johnson issues 4,000 new shares. On July 1, Johnson
distributes a 10% stock dividend. On September 1, Johnson repurchases
3,000 shares. Calculate Johnson’s weighted average number of shares
outstanding for the year, for its reporting of basic earnings per share.
Calculate basic EPS of Johnson if Johnson Company has net income of
$10,000.
Answer in the next slide.
107

STATEMENT

Answer:
10,000 + 4,000 Dividend - 3,000
01/01 01/04 01/07 01/09 31/12
Will be adjusted by dividend effect Will not be adjusted by dividend effect

Adjusted shares outstanding = Original shares outstanding x ( 1 + stock
dividend rate)
Weighted number of common shares in Johnson
12 9 4
= (10,000 x + 4,000 x ) x 1.1 – 3000 x = 13,300 (shares)
12 12 12
Affected by the dividend effect Not affected by the dividend
effect
108

STATEMENT

Answer:
Net income − Preferred Dividends
Basic EPS of Johnson =
$10,000
= 13,300 = 0.75
• A stock split or stock dividend is applied to all shares outstanding

prior to the split or dividend and to the beginning-of-period
weighted average shares.
• A stock split or stock dividend adjustment is not applied to any
shares issued or repurchased after the split or dividend date.
109

STATEMENT
[LOS 17.h] contrast dilutive and antidilutive securities and
describe the implications of each for the earnings per share
calculation
2. Calculating diluted earnings per share
a. Diluted EPS calculation in case of convertible preferred stock
When a company has convertible preferred stock

Net income
Diluted EPS =
Weighted average New common share that
number of shares + would have been issue at
outstanding (WANOS) conversion
When is convertible stock antidilutive?
Once convertible preferred stock is converted, the investors give up the

fixed preferred dividends, and get the benefits of holding common
shares.
If the preferred dividends are high → thẹ opportunity cost of converting

is large → the investors do not convert the convertible preferred stock,
and it is antidilutive
110

STATEMENT
calculation
When is the convertible stock antidilutive?
In practice:
• If diluted EPS < Basic EPS → convertible preferred stock is dilutive
→ diluted EPS takes the calculated value
• If diluted EPS > Basic EPS → convertible preferred stock is anti-dilutive
→ diluted EPS is equal to basic EPS
• Quick way to check whether convertible preferred stock is diluted or anti-
preferred dividend
diluted: If < basic EPS → convertible preferred
convert pref common shares
is dilutive and vice versa.
111

STATEMENT
calculation
Example: EPS with convertible preferred stock

During 20X6, ZZZ reported net income of $4,350,000 and had 2,000,000
shares of common stock outstanding for the entire year. ZZZ’s 7%,
$5,000,000 par value preferred stock is convertible into common stock at
a conversion rate of 1.1 shares for every $10 of par value. Compute
diluted EPS.
Solution:
Step 1: Calculate basic EPS
4,350,000 − 0.07 x $5,000,000
Basic EPS = = $2.00
2,000,000
Step 2: Calculate diluted EPS
Step 2.1. Compute convertible preferred stock
$5,000,000
Convertible preferred stock = x 1.1 = 550,000
$10
112

STATEMENT
calculation
Step 2.2. Compute diluted EPS

If the convertible preferred shares were converted to common stock,
there would be no preferred dividends paid. Therefore, you should add
back the convertible preferred dividends that had previously been
subtracted from net income in the numerator
$4,350,000
Diluted EPS = = $1.71
2,000,000 + 550,000
Step 3: Compare basic EPS with diluted EPS
Diluted EPS = $1.71 < Basic EPS = $2 → the preferred stock is dilutive
→ Diluted EPS = $1.71
7% x $5,000,000
Quick check dilutive: ($0.64) < basic EPS ($2.00)
550,000
→ Diluted EPS takes the calculated value.
113

STATEMENT
calculation
b. Diluted EPS calculation in case of convertible debt outstanding
When a company has convertible debt outstanding

Net income + After-tax interest on convertible debt –
Preferred dividends
Diluted EPS =
WANOS + Additional common shares that would have
been issued at conversion
When is convertible debt antidilutive?
Once convertible debt is converted, the investors give up the fixed

interest on the loan, and get the benefits of holding common shares.
If the interest are high → thẹ opportunity cost of converting is large

→ the investors do not convert the convertible debt, and it is antidilutive
114

STATEMENT
calculation
When is the convertible debt antidilutive?
In practice:
• If diluted EPS < Basic EPS → convertible debt is dilutive
→ diluted EPS takes the calculated value
• If diluted EPS > Basic EPS → convertible debt is anti-dilutive
→ diluted EPS is equal to basic EPS
• Quick way to check whether convertible debt outstanding is diluted or
anti-diluted:
convertible debt interest x (1 − tax rate)
If < basic EPS → convertible
convertible debt shares
debt outstanding is dilutive and vice versa
115

STATEMENT
calculation
Example: EPS with convertible debt

During 20X6, Y Corp had net income of $2,500,000 and 1,000,000 shares
of common stock outstanding for the entire year for basic EPS of $2.50.
During 20X5, Y issued 5% bonds of 2,000 at par of $1,000. Each of these
bonds is convertible to 120 shares of common stock. The tax rate is 30%.
Compute the 20X6 diluted EPS.
Solution:
• Additional common shares that would have been issued at conversion
= 2,000 x 120 = 240,000 shares
• After-tax interest on convertible debt = 2,000 x 1,000 x 5% x (1 – 30%)
= $70,000
$2,500,000 + $70,000
• Diluted EPS = = $2.07 < Basic EPS ($2.5)
1,000,000 + 240,000
→ Diluted EPS = $2.07
116

STATEMENT
calculation
c. Diluted EPS calculation in case of stock option, warrants
When a company has stock option, warrants

Net income – Preferred Dividends
Diluted EPS =
WANOS + (New share that would have been issue at
option exercise – Shares that could have
been purchase with cash received upon
exercise) x Proportion of the year during
which the financial instruments were
outstanding
When are stock option and warrant antidilutive?

Once stock option and warrant is converted, the investors buy common
shares at the exercise price.
If the exercise price is higher than market price → it is not beneficial for
investors to exercise the option → the option is not excercised, and it is
antidilutive
117

STATEMENT
calculation
When are stock option and warrant antidilutive?
• Market price > exercise price → the options and warrants are dilutive
and the dilutive EPS takes the calculated value.
• Market price < exercise price → the options and warrants are antidilutive
and the dilutive EPS = basic EPS.
118

STATEMENT
calculation
Example: EPS with stock option

During 20X6, X had net income of $1,200,000 and 500,000 shares of
common stock outstanding for the entire year. X has 100,000 stock options
outstanding the entire year. Each option allows its holder to purchase one
share of common stock at $15 per share. The average market price of X’s
common stock during 20X6 is $20 per share. Compute diluted EPS
Solution:
Market price > exercise price → the options and warrants are dilutive and
the dilutive EPS takes the calculated value.
• New share that would have been issue at option exercise = 100,000
• Shares that could have been purchase with cash received upon exercise =
$15 x 100,000/$20 = 75,000
$1,200,000
• Diluted EPS = = $2.29
500,000 + (100,000 − 75,000)
119

STATEMENT
[LOS 17.i] formulate income statements into common-size
income statements
Common-size income statement involves stating each line on the

income statement as a percentage of sales. Common-size statements
facilitate comparison of firms across time periods of different sizes.
Income Common
statement (I/S) size I/S
Sales 10,000,000 100%
Cost of sales 3,000,000 30%
Gross profit 7,000,000 70%
Selling, general and 1,000,000 10%

administrative expense
Research and development 2,000,000 20%
Advertising 2,000,000 20%
Operating profit 2,000,000 20%

120

STATEMENT
[LOS 17.j] evaluate a company’s financial performance using
common-size income statements and financial ratios based on
Gross profit margin
Gross profit
• Gross profit margin =
Revenue
• Gross profit margin can be increased by raising prices or reducing
production costs.
• Should be compared over time and with the firm’s industry peers
Net profit margin
Net income
• Net profit margin =
Revenue
• Net profit margin measures the profit generated after considering all
expenses
• Like gross profit margin, net profit margin should be compared over
time and with the firm’s industry peers.
121

STATEMENT
[LOS 17.k-j] Describe, calculate, and interpret comprehensive
income
1. Comprehensive income
• Under IFRS and GAAP, comprehensive income is the change in equity

during a period resulting from transactions and other events from non-
owner sources.
• Comprehensive income = net income (in P/L) + other comprehensive
income (OCI)
2. Other comprehensive income

Other comprehensive income include 4 types of income/expense:
Foreign currency translation adjustments. In consolidating the financial statements of
foreign subsidiaries, the effects of translating the subsidiaries’ balance sheet assets
and liabilities at current exchange rates are included as other comprehensive income
Unrealized gains or losses on derivatives contracts accounted for as hedges. Changes
in the fair value of derivatives are recorded each period, but these changes in value
for certain derivatives (those considered hedges) are treated as other comprehensive
income and thus bypass the income statement
Unrealized holding gains and losses on a certain category of investment securities,
namely, available-for-sale securities
Certain costs of a company’s defined benefit post-retirement plans that are not
recognized in the current period
122

STATEMENT
Practice questions
17.a. describe the components of the income statement and Question

alternative presentation formats of that statement 1,2,4
17.b. describe general principles of revenue recognition and N/A

accounting standards for revenue recognition
17.c. calculate revenue given information that might influence Question 3

the choice of revenue recognition method
17.d. describe general principles of expense recognition, specific Question 5

expense recognition applications, and implications of expense
recognition choices for financial analysis
17.e. describe the financial reporting treatment and analysis of N/A

non-recurring items (including discontinued operations, unusual
or infrequent items) and changes in accounting policies
17.f. contrast operating and non-operating components of the N/A

income statement
123

STATEMENT
Practice questions
17.g. describe how earnings per share is calculated and calculate Question 6
and interpret a company’s earnings per share for both simple &
complex capital structures
17.h. contrast dilutive and antidilutive securities and describe the Question 7
implications of each for the earnings per share calculation
17.i. formulate income statements into common-size income Question 8

statements
17.j. evaluate a company’s financial performance using common- N/A

size income statements and financial ratios based on the income
statement
17.k. describe, calculate, and interpret comprehensive income Question 9
17.l. describe other comprehensive income and identify major Question 10

types of items included in it
124

STATEMENT
Practice questions
1. An example of an expense classification by function is:

A tax expense.
B interest expense.
C cost of goods sold.
2. Denali Limited, a manufacturing company, had the following income

statement information:
Revenue $4,000,000
Cost of goods sold $3,000,000
Other operating expenses $500,000
Interest expense $100,000
Tax expense $120,000
Denali’s gross profit is equal to:
A $280,000.
B $500,000.
C $1,000,000.
125

STATEMENT
Practice questions
3. Apex Consignment sells items over the internet for individuals on a

consignment basis. Apex receives the items from the owner, lists
them for sale on the internet, and receives a 25 percent commission
for any items sold. Apex collects the full amount from the buyer and
pays the net amount after commission to the owner. Unsold items are
returned to the owner after 90 days. During 2009, Apex had the
following information:
• Total sales price of items sold during 2009 on consignment was
€2,000,000.
• Total commissions retained by Apex during 2009 for these items
was €500,000.
How much revenue should Apex report on its 2009 income
statement?
A €500,000.
B €2,000,000.
C €1,500,000.
126

STATEMENT
Practice questions
4. At the beginning of 2009, Glass Manufacturing purchased a new

machine for its assembly line at a cost of $600,000. The machine has
an estimated useful life of 10 years and estimated residual value of
$50,000. Under the straight- line method, how much depreciation
would Glass take in 2010 for financial reporting purposes?
A $55,000.
B $60,000.
C $65,000.
5. Under IFRS, a loss from the destruction of property in a fire would most
likely be classified as:
A continuing operations.
B discontinued operations.
C other comprehensive income..
127

STATEMENT
Practice questions
6. Laurelli Builders (LB) reported the following financial data for year-
end 31 December:
Common shares outstanding, 1 January 2,020,000
Common shares issued as stock dividend, 1 June 380,000
Warrants outstanding, 1 January 500,000
Net income $3,350,000
Preferred stock dividends paid $430,000
Common stock dividends paid $240,000
Which statement about the calculation of LB’s EPS is most accurate?
A LB’s basic EPS is $1.12.
B LB’s diluted EPS is equal to or less than its basic EPS.
C The weighted average number of shares outstanding is 2,210,000.
7. When calculating diluted EPS, which of the following securities in the

capital structure increases the weighted average number of common
shares outstanding without affecting net income available to common
shareholders?
A Stock options
B Convertible debt that is dilutive
C Convertible preferred stock that is dilutive
128

STATEMENT
Practice questions
8. Which statement is most accurate? A common size income

statement:
A restates each line item of the income statement as a percentage of
net income.
B allows an analyst to conduct cross-sectional analysis by removing
the effect of company size.
C standardizes each line item of the income statement but fails to
help an analyst identify differences in companies’ strategies.
9. When preparing an income statement, which of the following items

would most likely be classified as other comprehensive income?
A A foreign currency translation adjustment
B An unrealized gain on a security held for trading purposes
C A realized gain on a derivative contract not accounted for as a hedge
129

STATEMENT
Practice questions
10. Selected year-end financial statement data for Workhard are shown
below.
Beginning shareholders’ equity $475m
Ending shareholders’ equity $493m
Unrealized gain on available- for- sale securities 5m
Unrealized loss on derivatives accounted for as hedges –3m
Foreign currency translation gain on consolidation 2m
Dividends paid 1m
Net income 15m
Workhard’s comprehensive income for the year:

A is $18 million.
B is increased by the derivatives accounted for as hedges.
C includes $4 million in other comprehensive income.
130

STATEMENT
Practice answers
1. C is correct. Cost of goods sold is a classification by function. The other two

expenses represent classifications by nature.
2. C is correct. Gross margin is revenue minus cost of goods sold. Answer A represents
net income and B represents operating income.
3. A is correct. Apex is not the owner of the goods and should only report its net
commission as revenue.
4. A is correct. Straight- line depreciation would be ($600,000 – $50,000)/10 = $55,000
5. A is correct. A fire may be infrequent, but it would still be part of continuing

operations and reported in the profit and loss statement. Discontinued operations
relate to a decision to dispose of an operating division.
6. B is correct.
LB has warrants in its capital structure:
• If the exercise price is less than the weighted average market price during the
year, the effect of their conversion is to increase the weighted average
number of common shares outstanding, causing diluted EPS to be lower than
basic EPS.
• If the exercise price is equal to the weighted average market price, the number
of shares issued equals the number of shares repurchased. Therefore, the
weighted average number of common shares outstanding is not affected and
diluted EPS equals basic EPS.
131

STATEMENT
Practice answers
6. (cont)
• If the exercise price is greater than the weighted average market price, the
effect of their conversion is antidilutive. As such, they are not included in
the calculation of basic EPS.
→ B is true.
The weighted average number of shares outstanding = 2,020,000 + 380,000 =
2,400,000 → C is wrong.
LB’s basic EPS is = ($3,350,000 – $430,000)/(2,020,000 + 380,000) = $1.22 → A is
wrong.
(note: Stock dividends are treated as having been issued retroactively to the
beginning of the period)
7. A is correct.
• When a company has stock options outstanding, diluted EPS is calculated as
if the financial instruments had been exercised and the company had used
the proceeds from the exercise to repurchase as many shares possible at
the weighted average market price of common stock during the period.
→ As a result, the conversion of stock options increases the number of
common shares outstanding but has no effect on net income available to
common shareholders.
• The conversion of convertible debt increases the net income available to
common shareholders by the after- tax amount of interest expense saved.
• The conversion of convertible preferred shares increases the net income
available to common shareholders by the amount of preferred dividends
paid; the numerator becomes the net income.
132

STATEMENT
Practice answers
8. B is correct. Common size income statements facilitate comparison across time

periods (time- series analysis) and across companies (cross- sectional analysis) by
stating each line item of the income statement as a percentage of revenue.
The relative performance of different companies can be more easily assessed
because scaling the numbers removes the effect of size.
A is wrong. A common size income statement states each line item on the income
statement as a percentage of revenue.
C is wrong. The standardization of each line item makes a common size income
statement useful for identifying differences in companies’ strategies.
9. A is correct. Other comprehensive income includes items that affect shareholders’

equity but are not reflected in the company’s income statement. In consolidating
the financial statements of foreign subsidiaries, the effects of translating the
subsidiaries’ balance sheet assets and liabilities at current exchange rates are
included as other comprehensive income.
133

STATEMENT
Practice answers
10. C is correct. Comprehensive income includes both net income and other
comprehensive income.
Other comprehensive income = Unrealized gain on available- for- sale
securities – Unrealized loss on derivatives accounted for as hedges + Foreign
currency translation gain on consolidation
= $5 million – $3 million + $2 million
= $4 million
Alternatively,
Comprehensive income – Net income = Other comprehensive income
Comprehensive income = (Ending shareholders equity – Beginning share-
holders equity) + Dividends
= ($493 million – $475 million) + $1 million
= $18 million + $1 million = $19 million
Net income is $15 million so other comprehensive income is $4 million.
134

BALANCE SHEETS
135
READING 18: UNDERSTANDING BALANCE SHEET

Learning outcomes
18.a. Describe elements of the balance sheet: assets, liabilities, equity
18.b. Describe uses and limitations of balance sheet in financial analysis
18.c. Describe alternative formats of balance sheet presentation
18.d. Contrast current and non-current assets and current and non-
current liabilities
18.e. Describe different types of assets and liabilities and the
measurement bases of each
18.f. Describe the components of shareholders’ equity
18.g. Demonstrate the conversion of balance sheets to common-size

balance sheets and interpret common- size balance sheets
18.h. Calculate and interpret liquidity and solvency ratios

136

[LOS 18.a] Describe elements of the balance sheet: assets,
liabilities, equity
The balance sheet (also known as the statement of financial position or

statement of financial condition) reports the firm’s financial position at a
point in time.
Components of the balance sheet: assets, liabilities, and equity
Resources controlled Obligations as a result The owners’ residual

as a result of past of past events that are interest in the assets
transactions that are expected to require an after deducting the
expected to provide outflow of liabilities, sometimes
future economic economic resources. referred to as “net
benefits. assets.”
Basic equation of the balance sheet
The resources controlled How those resources were financed

by the company
137

[LOS 18.b] Describe uses and limitations of balance sheet in
financial analysis
1. Uses of balance sheet in financial analysis
Helps an analyst assess a company’s ability to:

• Pay for its near-term operating needs
• Meet future debt obligations
• Make distributions to owners
2. Limitations of balance sheet
The balance sheet amounts of equity (assets, net of liabilities) should not
be viewed as a measure of either the market or intrinsic value of a
company’s equity, for the following reasons:
1. The balance sheet is a mixed model with respect to measurement.
For example:
• Some assets and liabilities are measured based on historical cost.
• Some others are measured based on a fair value basis .
→ The measurement bases may have a significant effect on the amount
reported.
138

[LOS 18.b] Describe uses and limitations of balance sheet in
financial analysis
2. Limitations of balance sheet
The balance sheet amounts of equity (assets, net of liabilities) should not
be viewed as a measure of either the market or intrinsic value of a
company’s equity, for the following reasons:
2. The items measured at current value reflect the value that was current
at the end of the reporting period.
The values of those items obviously can change after the balance sheet is
prepared.
3. Important aspects of a company’s ability to generate future cash flows—

for example, its reputation and management skills—are not included in its
balance sheet.
The company’s ability to generate future cash flows primarily decides its
intrinsic value.
139

[LOS 18.c] Describe alternative formats of balance sheet
presentation
Format
Current and non-current

Liquidity-based presentation
classification
Current assets/liabilities All assets and liabilities are

items which is liquidated/ settled or presented broadly in order of
used up in less than 1 year or liquidity means that items with high
operating cycles liquidity will be sorted first and vice
versa.
(There is no separation between
Non current assets/liabilities current and non current
Items which are liquidated, settled or assets/liabilities)
used up in more than 1 year or
operating cycles
Which type of company should use liquidity-based rather than current

and non-current classification?
Answer: A liquidity-based presentation is often used if it provides reliable

and more relevant information → Often used by banks and financial
institutions.
140

presentation
As of 31 December
2017 2016
Example of Current and non-current classification format
Cash and cash equivalents €4,011 €3,702

Other financial assets 990 1,124
Trade and other receivables 5,899 5,924
Other non-financial assets 725 581
Tax assets 306 233
Total current assets 11,930 11,564
Total non-current assets 30,567 32,713
Total assets €54,428 €55,841
Total current liabilities 10,210 9,674
Total non-current liabilities 6,747 8,205
Total liabilities 16,958 17,880
Total equity 20,513 36,174
Total equity and liabilities €54,428 €55,841
141

presentation
As of 31 December
2017 2016
Assets
Example of Liquidity-based presentation format
Cash and balances at central banks $180,624 $128,009

Items in the course of collection from other
6,628 5,003
banks
Hong Kong Government certificates of
34,186 31,228
indebtedness
Trading assets 287,995 235,125
Derivatives 219,818 290,872
Loans and advances to banks 90,393 88,126
Loans and advances to customers 962,964 861,504
Reverse repurchase agreements – non-
201,553 160,974
trading
Financial investments 389,076 436,797
Goodwill and intangible assets 23,453 21,346
Deferred tax assets 4,676 6,163
Total assets $2,401,366 $2,265,147

142

[LOS 18.d] Contrast current and non-current assets and current
and non-current liabilities
Current assets Current liabilities
Cash and other assets that will likely Obligations that will be satisfied
be converted into cash or used up within one year or one operating
within one year or one operating cycle, whichever is greater.
cycle*, whichever is greater. More specifically, the criteria
includes:
• Settlement is expected during the
normal operating cycle.
• Settlement is expected within one
year.
• Held primarily for trading
purposes.
• No unconditional right to defer
settlement for more than 1 year
Operating cycle: the average amount of time that elapses between acquiring
inventory and collecting the cash from sales to customers.
Holding
inventory Cash’
Cash Acquiring inventory Goods Goods’ Sale (Cash’ > Cash)
Operating cycle
143

Operating cycle: the average amount of time that elapses between acquiring
inventory and collecting the cash from sales to customers.
1 year 1 year
Operating cycle Operating cycle
One year becomes the criteria for Operating cycle becomes the criteria
current assets/ liabilities for current assets/ liabilities
Most companies fall into this case This happens to tobacco, distillery,
construction industry, …
• Current assets - Current liabilities = Working capital.

• The level of working capital provides information about ability of an
entity to meet liabilities as they fall due.
144

Non current assets Non current liabilities
• Assets that will not be • Liabilities that do not meet

converted into cash or used up the criteria of current
within one year or operating liabilities.
cycle. • Noncurrent liabilities provide
• Noncurrent assets provide information about the firm’s
information about the firm’s long-term financing
investing activities, which activities.
form the foundation upon
which the firm operates.
145

[LOS 18.e] Describe different types of assets and liabilities and
the measurement bases of each
1. Current assets
Items Definition Measurement

Cash and Cash equivalents are highly liquid, • Amortized cost: historical cost
cash short-term investments that are so – amortization – impairment (if
equivalent close to maturity. any).
Examples: demand deposits with • Fair value: exit price, the price
the maturities less than three received to sell an asset or paid
months. to transfer a liability between
two market participants at the
measurement date.
• Both price are likely to be
immaterially different.
Marketable Marketable securities include Price information in a public
securities investments in debt or equity market.
securities that are traded in a public
market.
Examples: Treasury bills, notes,
bonds, common stock, mutual fund
Trade Trade (Account) receivables are • Net realizable value (≈ Fair
receivables amounts owed to a company by its value) = Original account
customers for products and services receivables minus allowance for
already delivered. bad debts.
• Allowance for bad debts is a
contra account.
146

1. Current assets (cont.)

• IFRS: Lower of cost and net
Inventories Inventories are physical products
realizable value.
(see more in that will eventually be sold to the
• US-GAAP: same as IFRS
Reading 21) company’s customers. In current
(without LIFO & Retail
form (finished goods) or as inputs
inventory methods) or Lower
to manufacture a final product
of Cost and Market value (LIFO
(raw materials & work-in-
& RIM).
process).
• COGS Valuation: FIFO,
Weighted average cost, LIFO
(US-GAAP only), specific
identification.
Prepaid Prepaid expenses are normal Prepaid expenses is recorded at
expense and operating expenses that have historical cost on balance sheet,
Others been paid in advance. and decrease in accordance with
Other current assets reflect items allocation to expenses.
that are not material enough to
require a separate line item.
147

2. Current liabilities
Trade Amounts that a company owes its vendors for

payables purchases of goods and services.
The company record
Owed by a company to creditors, including full net amount of
trade creditors and banks, through a formal contract to liabilities
Financial
agreement.
liabilities
Ex: bank loans, notes payable, commercial
paper, current portion of long-term liabilities.
Expenses that have been recognized on a Accrued expenses that
company’s income statement but which have have not been paid is
Accrued
not yet been paid as of the balance sheet date. recorded as a current
expenses
Ex: accrued interest payable, accrued warranty liabilities and decrease
costs, and accrued employee compensation when being paid.
Deferred Deferred income arises when a company Deferred income is
income receives payment in advance of delivery of the recorded as liabilities
(Unearned goods and services associated with the until goods/services is
revenue) payment. transferred. Then, the
Ex: lease payments, fees for servicing office company decrease
equipment, and payments for magazine deferred income and
subscriptions received at the beginning. record revenue for
those goods/services.
148

3. Non-current assets (see more in Reading 22)
Property, Tangible assets used in company • Cost model (IFRS and GAAP):
Plant, and operations and expected to be Carrying amount (CA) = Cost –
Equipment used in more than 1 fiscal periods. Accumulated depreciation –
(PPE) Impairment (if any).
• Revaluation model (IFRS only):
Fair value.
Investment Property used for purposes of • Cost model: Similar to PPE Cost
property earning rental income or capital model.
appreciation (or both). • Fair value model: Fair value but
difference between CA and Fair
value is recorded in PL (not OCI
like PPE).
Are identifiable non-monetary Cost model (IFRS and GAAP)
Intangible assets without physical substance. Revaluation model (IFRS) only
assets Examples: patents, licenses, and applied when there is an active
trademarks market for intangible asset trading.
149

3. Non-current assets (cont.)
Appear in business Goodwill = Cost of acquisition

combination, arising when - Acquirer’s interest in the fair
purchase price is greater than value of identifiable assets
Goodwill the acquirer’s interest in the and liabilities acquired.
fair value of the identifiable Goodwill is not amortized but
assets and liabilities acquired is tested for impairment at
least annually.
Contracts that give rise to both 3 categories (in US-GAAP):
a financial asset of one entity Held-to-maturity, Available-
Financial assets
and a financial liability or equity for-sale and Trading securities.
instrument of another entity
Deferred Tax Asset Income taxes incurred prior to ∆Deferred tax asset = Taxes
(see more in the time that the income tax payable – Income tax expense
Reading 23) expense will be recognized on
150

• Financial assets: Contracts that give rise to both a financial asset of one entity, and a
financial liability or equity instrument of another entity.
• Financial asset is important types of non-current assets.
Fair value Fair value

IFRS Categories Amortized cost
through OCI through P&L
US GAAP Available-for-sale Trading

Held-to-maturity
Categories Securities Securities
Measurement
Amortized cost Fair value Fair value
base
Initial Fair value + Fair value +

Only Fair value
measurement Transaction cost Transaction cost
Realized G/L Record in P/L Record in P/L Record in P/L
Unrealized G/L N/A Record in OCI Record in P/L

151

Example: Classification of investment securities

Triple D Corporation, a U.S. GAAP reporting firm, purchased a 6% bond, at
par, for $1,000,000 at the beginning of the year. Interest rates have
recently increased and the market value of the bond declined $20,000.
Determine the bond’s effect on Triple D’s financial statements under each
classification of securities.
Answer:
If the bond is classified as a held-to-maturity security, the bond is
reported on the balance sheet at $1,000,000. Interest income of $60,000
[$1,000,000 × 6%] is reported in the income statement.
If the bond is classified as a trading security, the bond is reported on the
balance sheet at $980,000. The $20,000 unrealized loss and $60,000 of
interest income are both recognized in the income statement.
If the bond is classified as an available-for-sale security, the bond is
reported on the balance sheet at $980,000. Interest income of $60,000 is
recognized in the income statement. The $20,000 unrealized loss is
reported as part of other comprehensive income.
152

4. Non-current liabilities
Long-term Long-term financial liabilities Fair value or amortized cost

financial include loans (i.e., borrowings Bond: At maturity, the amortized
liabilities from banks) and notes or cost of the bond (carrying amount)
(see more in bonds payable (i.e., fixed- will be equal to the face value of
Reading 22) income securities issued to the bond. Some cases could be
investors) reported as fair value.
Deferred tax Created when the amount of ∆Deferred tax liabilities = Income
liabilities income tax expense exceeds tax expense – Taxes payable.
(see more in the amount of taxes payable
Reading 23) recognized in the income
statement due to temporarily
timing difference
153

[LOS 18.f] Describe the components of shareholders’ equity
Capital
contributed
Retained Preferred
earnings shares
Shareholders’
equity
Accumulated Treasury
OCI shares
Non-
controlling
interest
154

1.
Describe capital contributed, preferred shares, treasury
shares
Criteria Capital contributed Preferred shares Treasury shares
Definition Amount contributed by Stock with certain Stock that has been
equity shareholders and rights & privileges reacquired by the
also known as issued not conferred by issuing firm but not
capital. common stock. yet retired.
Invest in firm Yes Yes No
Impact Increase equity Increase or Reduce equity

unchanged equity
Voting rights Has voting rights and Has no voting Has no voting rights
and Dividend receive dividends. rights and receive and does not
dividends at a receive dividends.
specified rate.
Measurement See more in the following slides Reduces

shareholders’
equity by the
amount of the cost
of repurchasing
155

1.
Describe capital contributed, preferred shares, treasury
shares (cont.)
Amount of capital contributed at par

Share capital
value of common stock (a stated or
contributed
(at par value)

Capital
legal value)
Share premium Share premium = Fair value of

(additional paid-in common stock – Par value of common
capital) stock
• A type of preferred stock shares that

Preferred shares
Non-redeemable do not include a callable feature.

• Consider as shareholder’s equity
• A type of preferred stock shares that

includes a callable feature.
Redeemable
• Consider as company’s financial
liability
Chart 1: Types of capital contributed and preferred shares

156

2. Describe retained earnings and OCI
Shareholders’ equity
Accumulated other
Retained earnings Other components comprehensive
income (OCI)
Net income OCI
Comprehensive income
Retained earnings. The cumulative Accumulated other comprehensive

amount of earnings recognized in income includes all changes in
the company’s income statements stockholders’ equity except for net
which have not been paid out to the income and transactions with
company’s owners as dividends. shareholders, such as issuing stock,
reacquiring stock, paying dividends.
157

3. Describe non-controlling interest
Non-controlling
owner
Parent 60% 40%

company Subsidiary company
Consolidated financial
statements
• Non-controlling interest just occurs in the consolidated financial

statements as an equity of group.
• Non-controlling interest (or minority interest) is the equity interests of
minority shareholders in the subsidiary companies that have been
consolidated by the parent (controlling) company but that are not
wholly owned by the parent company.
158

[LOS 18.g] Demonstrate the conversion of balance sheets to
common-size balance sheets and interpret common-size
balance sheets
• A vertical common-size balance sheet expresses each item of the balance
sheet as a percentage of total assets.
• The common-size format standardizes the balance sheet by eliminating the
effects of size.
• This allows for comparison over time (time-series analysis) and across firms
(cross-sectional analysis) – see below
Excerpt from common-size
Excerpt from balance sheet
balance sheet
East West East West
Cash 2,300 1,500 Cash 5.2% 10%
A/R 3,700 1,100 A/R 8.4% 7%
Inventory 5,500 900 Inventory 12.5% 6%
PPE 32,500 11,750 PPE 73.9% 77%
Total assets 44,000 15,250 Total assets 100% 100%
Current liabilities 10,000 1,000 Current liabilities 22.7% 6.6%

Long-term debt 26,000 5,000 Long-term debt 59.1% 32.8%
Total liabilities 36,000 6,000 Total liabilities 81.8% 39.3%
Equity 8,000 9,250 Equity 18.2% 60.7%
Total liabilities Total liabilities
44,000 15,250 100% 100%
and equity and equity
159

[LOS 18.h] Calculate and interpret liquidity and solvency ratios
1. Liquidity ratios
• Liquidity ratios measure the ability of a company to meet future short-term
financial obligations from current assets and, more importantly, cash flows.
• High liquidity ratio means that the entity has the ability to pay its current
liabilities and vice versa.
Ratios Formulas Indication
Reflects how many times a

Current Current assets company can pay its short-
Ratio Current liabilities term liabilities with its short-
term assets.

Cash + Marketable securities company can pay short-term
Quick
+ Receivables liabilities with short-term
Ratio
Current liabilities assets excluding company
inventories.

company can pay short-term
Cash Cash + Marketable securities
liabilities with short-term
Ratio Current liabilities assets excluding company
inventories and receivables.
160

[LOS 18.h] Calculate and interpret liquidity and solvency ratios
2. Solvency ratios
Solvency ratios measure a company's ability to meet long-term and other
obligations.
Ratios Formulas Indication
Measure of the degree to which a company is

Long-term Total long−term debt financing its operations through long-term
debt to debt versus equity.
Total equity
equity If the ratio is comparatively high, it implies
that a business is at greater risk of bankruptcy.
Measure of the degree to which a company is
Total debt financing its operations through debt versus
Debt to
equity.
equity Total equity
This ratio is often lower than 1. A ratio of 2.0
or higher is usually considered risky.
Shows the debt burden that a company has
Total debt
Total debt to bear. When a company has a high debt
Total assets ratio: high financial risk, can lose its liquidity.
Shows the portion of a company's assets that
Total assets is financed by stockholders equity rather
Financial
than by debt. If this ratio is low, it means the
leverage Total equity
company is not incurring excessive debt to
finance its assets.
161

Practice questions
18.a. Describe elements of the balance sheet: assets, liabilities, equity Question 1
18.b. Describe uses and limitations of balance sheet in financial analysis N/A
18.c. Describe alternative formats of balance sheet presentation Question 2,3
18.d. Contrast current and non-current assets and current and non-current N/A
liabilities
18.e. Describe different types of assets and liabilities and the Question 4, 5,
measurement bases of each 7, 8, 10
18.f. Describe the components of shareholders’ equity Question 11
18.g. Demonstrate the conversion of balance sheets to common- size N/A

balance sheets and interpret common- size balance sheets
18.h. Calculate and interpret liquidity and solvency ratios Question 6,9
162

Practice questions
1. Resources controlled by a company as a result of past events are:

A equity.
B assets.
C liabilities.
2. Distinguishing between current and non- current items on the balance

sheet and presenting a subtotal for current assets and liabilities is
referred to as:
A a classified balance sheet.
B an unclassified balance sheet.
C a liquidity- based balance sheet.
3. Which of the following is most likely classified as a current liability?

A Payment received for a product due to be delivered at least one
year after the balance sheet date
B Payments for merchandise due at least one year after the balance
sheet date but still within a normal operating cycle
C Payment on debt due in six months for which the company has the
unconditional right to defer settlement for at least one year after the
balance sheet date
163

Practice questions
4. The most likely costs included in both the cost of inventory and
property, plant, and equipment are:
A selling costs.
B storage costs.
C delivery costs.
5. The carrying value of inventories reflects:
A their historical cost.
B their current value.
C the lower of historical cost or net realizable value.
6. Defining total asset turnover as revenue divided by average total
assets, all else equal, impairment write-downs of long-lived assets
owned by a company will most likely result in an increase for that
company in:
A the debt- to- equity ratio but not the total asset turnover.
B the total asset turnover but not the debt- to- equity ratio.
C both the debt- to- equity ratio and the total asset turnover.
7. Money received from customers for products to be delivered in the
future is recorded as:
A revenue and an asset.
B an asset and a liability.
C revenue and a liability.
164

Practice questions
8. An example of a contra asset account is:

A depreciation expense.
B sales returns and allowances.
C allowance for doubtful accounts.
9. An investor concerned whether a company can meet its near-term

obligations is most likely to calculate the:
A current ratio.
B return on total capital.
C financial leverage ratio.
10. For financial assets classified as available for sale, how are unrealized
gains and losses reflected in shareholders’ equity?
A They are not recognized.
B They flow through retained earnings.
C They are a component of accumulated other comprehensive
income.
11. The non-controlling (minority) interest in consolidated subsidiaries is
presented on the balance sheet:
A as a long- term liability.
B separately, but as a part of shareholders’ equity.
C as a mezzanine item between liabilities and shareholders’ equity.
165

Practice answers
1. B is correct. Assets are resources controlled by a company as a result of

past events.
2. A is correct. A classified balance sheet is one that classifies assets and

liabilities as current or non-current and provides a subtotal for current
assets and current liabilities. A liquidity-based balance sheet broadly
presents assets and liabilities in order of liquidity.
3. B is correct. Payments due within one operating cycle of the business,

even if they will be settled more than one year after the balance sheet
date, are classified as current liabilities. Payment received in advance of
the delivery of a good or service creates an obligation or liability. If the
obligation is to be fulfilled at least one year after the balance sheet date, it
is recorded as a non- current liability, such as deferred revenue or
deferred income. Payments that the company has the unconditional right
to defer for at least one year after the balance sheet may be classified as
non-current liabilities.
4. C is correct. Both the cost of inventory and property, plant, and

equipment include delivery costs, or costs incurred in bringing them to the
location for use or resale.
166

Practice answers
5. C is correct. Under IFRS, inventories are carried at historical cost, unless

net realizable value of the inventory is less. Under US GAAP, inventories
are carried at the lower of cost or market.
6. C is correct. Impairment write- downs reduce equity in the denominator of

the debt- to-equity ratio but do not affect debt, so the debt-to-equity ratio
is expected to increase. Impairment write-downs reduce total assets but
do not affect revenue. Thus, total asset turnover is expected to increase.
7. B is correct. The cash received from customers represents an asset. The

obligation to provide a product in the future is a liability called “unearned
income” or “unearned revenue.” As the product is delivered, revenue will
be recognized and the liability will be reduced.
8. C is correct. A contra asset account is netted against (i.e., reduces) the

balance of an asset account. The allowance for doubtful accounts reduces
the balance of accounts receivable. Accumulated depreciation, not
depreciation expense, is a contra asset account. Sales returns and
allowances create a contra account that reduce sales, not an asset.
9. A is correct. The current ratio provides a comparison of assets that can be

turned into cash relatively quickly and liabilities that must be paid within
one year. The other ratios are more suited to longer- term concerns.
167

Practice answers
10. C is correct. For financial assets classified as available for sale, unrealized
gains and losses are not recorded on the income statement and instead
are part of other comprehensive income. Accumulated other
comprehensive income is a component of Shareholders’ equity.
11. B is correct. The non-controlling interest in consolidated subsidiaries is

shown separately as part of shareholders’ equity.
168

CASH FLOW STATEMENTS
169
READING 19: UNDERSTANDING CASH FLOW

STATEMENTS
Learning outcomes
19.a. Compare cash flows from operating, investing, and financing

activities and classify cash flow items as relating to one of those
three categories given a description of the items
19.b. Describe how non-cash investing and financing activities are

reported
19.c. Contrast cash flow statements prepared under International

Financial Reporting Standards (IFRS) and US generally accepted
accounting principles (US GAAP)
19.d. Compare and contrast the direct and indirect methods of

presenting cash from operating activities and describe arguments
in favor of each method
170

STATEMENTS
Learning outcomes
19.e. Describe how the cash flow statement is linked to the income
statement and the balance sheet
19.f. Describe the steps in the preparation of direct and indirect cash
flow statements, including how cash flows can be computed using
income statement and balance sheet data
19.g. Demonstrate the conversion of cash flows from the indirect to

direct method
19.h. Analyze and interpret both reported and common-size cash flow
statements
19.i. Calculate and interpret free cash flow to the firm, free cash flow to
equity, and performance and coverage cash flow ratios.
171

STATEMENTS
[LOS 19.a] Compare cash flows from operating, investing, and
financing activities and classify cash flow items as relating to
one of those three categories given a description of the items
1. Overview of cash flow statements
The cash flow (CF) statement provides information about a company’s

cash receipts and cash payments during an accounting period.
Transaction occurs Cash receipts/payments t
Recognize revenue/expense Recognize cash collected/paid

in the income statement in the CF statement
Accrual basis Cash basis

Income statement CF statement
Revenue Earned Received
Expense Incurred Paid
A firm with healthy sales and significant income on its income statement
might report low cash inflow if it can not collect its accounts receivable.
→ We need to analyze the CF statement to understand clearly about the
sources and uses of cash.
172

STATEMENTS
2. Operating, investing and financing activities
Cash receipts and cash payments during a period are classified in the
statement of cash flows into three different activities.
Operating activities Investing activities Financing activities
Consists of the inflows Consists of the inflows Consists of the inflows

and outflows of cash and outflows of cash and outflows of cash
resulting from resulting from the resulting from
transactions that affect acquisition or disposal transactions that affect
a firm’s net income. of long-term assets and a firm’s capital
certain investments. structure.
173

STATEMENTS
Cash inflows Cash outflows

Proceeds from sale of Payment of employee benefit
goods/services expense
Receipt from fees, Operating Purchase of inventories

commission and other activites
revenue Pay operating expenses
Sale of PPE, long-term Payment of taxes

invetsments
Investing
Principal receipt from loans activites Purchase of PPE, long-term
made to others investments
Loans made to others

Proceeds from issue of equity
shares
Financing
Proceeds from issue of Payment of the debts
activites
debts/bonds
Procurement of loans Payment of stock repurchase

174

STATEMENTS
Example 1: Net Cash Flow from Investing Activities

A company recorded the following in Year 1:
Proceeds from issuance of long-term debt € 300,000
Purchase of equipment € 200,000
Loss on sale of equipment € 70,000
Proceeds from sale of equipment € 120,000
Equity in earnings of affiliate € 10,000
On the Year 1 statement of cash flows, the company would report net
cash flow from investing activities closest to:
A. (€150,000).
B. (€80,000).
C. €200,000.
(Continue in the next slide)
175

STATEMENTS
Answer
Activities Affect Category Cash flow
Proceeds from issuance of the firm’s capital Financing

+ €300,000
long-term debt structure cash flow
the firm’s long-term Investing

Purchase of equipment − €200,000
assets cash flow
the firm’s net income

Loss on sale of equipment − − €70,000
but not the cash flow
Proceeds from sale of the firm’s long-term Investing

+ €120,000
equipment assets cash flow
the firm’s net income

Equity in earnings of affiliate − + €10,000
but not the cash flow
Net cash flow from investing − €80,000
→ B is correct
176

STATEMENTS
Example 2: Operating versus Financing Cash Flows

On 31 December 2018, a company issued a £30,000 180-day note at 8
percent and used the cash received to pay for inventory and issued
£110,000 long-term debt at 11 percent annually and used the cash
received to pay for new equipment.
Which of the following most accurately reflects the combined effect of
both transactions on the company’s cash flows for the year ended 31
December 2018 under IFRS? Cash flows from:
A. operations are unchanged.
B. financing increase £110,000.
C. operations decrease £30,000.
177

STATEMENTS
Answer
Activities Affect Category Cash flow
the firm’s net Operating

Purchase of inventory − £30,000
income cash flow
Issue short and long- the firm’s capital Financing

+ £140,000
term debts structure cash flow
the firm’s long- Investing

Purchase of equipment − £110,000
term assets cash flow
→ C is correct
178

STATEMENTS
[LOS 19.b] Describe how non-cash investing and financing
activities are reported
Some investing and financing activities do not flow through the statement
of cash flows because they don't require the use of cash, such as:
• Retiring debt securities by issuing equity securities to the lender.
• Converting preferred stock to common stock.
• Acquiring assets through a capital lease.
• Obtaining long-term assets by issuing notes payable to the seller.
• Exchanging one non-cash asset for another non-cash asset.
• The purchase of non-cash assets by issuing equity or debt securities
Any significant non-cash financing and investing activity is required to be

disclosed, either in a separate note or a supplementary schedule to the
cash flow statement because it may affect a company’s capital or asset
structures.
179

STATEMENTS
[LOS 19.c] Contrast cash flow statements prepared under
International Financial Reporting Standards (IFRS) and US
generally accepted accounting principles (US GAAP)
There are some differences in cash flow statements prepared under IFRS and US
GAAP that will be summarized below:
Items IFRS US GAAP
Interest received Operating or investing Operating
Interest paid Operating or financing Operating
Dividends received Operating or investing Operating
Dividends paid Operating or financing Financing
Bank overdraft Considered part of cash Classified as financing

equivalents rather than part of cash &
cash equivalents
Taxes paid Generally operating, but a portion Operating

can be allocated to investing or
financing if it can be specifically
identified with these categories
Direct or indirect; direct is encouraged.

Format of
A reconciliation of net income to cash flow from operating
statement
activities must be provided regardless of method used under US
(LOS 19.d)
GAAP
180

STATEMENTS
[LOS 19.d] Compare and contrast the direct and indirect
methods of presenting cash from operating activities and
describe arguments in favor of each method
There are two acceptable formats for reporting cash flow from operating activities:
direct and indirect method
Direct method Indirect method
Definition Shows the specific cash inflows Shows how cash flow from
and outflows that result in operations can be obtained from
reported cash flow from reported net income as the result of
operating activities a series of adjustments.
Begins with net income.
General Adjust each item in the income Adjust net income for all non-cash
principles statement to its cash equivalent items and net changes in the
operating working capital accounts.
Advantages More information and easily Show the reasons for differences
understood by the average between net income and operating
reader cash flows.
Who prefer? Mostly preferred by users of Mostly used by firm because easier
financial statements, particularly conversion from Income statement
analysts and commercial lenders and Balance Sheet.
Note that in 2 methods, presentation of cash flow from investing activities and
financing activities are similar. The distinguish between these methods only comes
from operating activities.
181

STATEMENTS
Illustration of direct and indirect method in reporting operating cash flows

1. Direct method
Adjust each item in the income statement to its cash equivalent.
Income statement Cash flow statement $’000
Revenue in cash Cash receipts from customers 10,150
COGS & administrative Cash paid to suppliers &

(7,600)
expenses in cash employees
EBIT Cash generated from operations 2,550
Interest expense Interest paid (270)
Income tax expense Income taxes paid (900)
Net income Operating cash flows 1,380
Excerpt from direct cash flow statement

182

STATEMENTS
2. Indirect method
Adjust net income (Profit before taxation) for all non-cash items and net changes in
the operating working capital accounts to calculate operating cash flows.
Cash flow statement $’000

Profit before taxation 3,350
Depreciation 450
Investment income (500)
3,700
Increase in trade & other receivables (500)
Decrease in inventories 1,090
Decrease in trade payables (1,740)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)
Operating cash flows 1,380
Excerpt from indirect cash flow statement

183

STATEMENTS
[LOS 19.e] Describe how the cash flow statement is linked to
the income statement and the balance sheet
Equity Cash flow statement Equity
Non-current (3) (3) Non-current

liabilities Financing cash flow liabilities
(3) (3)
Non-current assets Non-current assets
Investing cash flow
Current liabilities Current liabilities
(2) Operating cash flow (2)
Other current assets Other current assets
(1) (1)
Cash Net change in cash Cash
Accrual and cash basis
Accrual and cash basis
Balance sheet Balance sheet

differences
differences
(Beginning) Income statement (Ending)
Revenue
Expense
Net income
184

STATEMENTS
(1)
The statement of cash flows ultimately shows the net change in cash
during an accounting period.
→ The bottom of the cash flow statement reconciles beginning with
ending cash balances on the balance sheets.
Beginning Statement of Cash Flows for Ending Balance

Balance Sheet at Year Ended 31 Sheet at 31
31 December 20X9 December 20X9
December 20X8
Plus: Cash receipts (from

Beginning cash operating, investing, and Ending cash
financing activities)
Less: Cash payments (for

operating, investing, and
financing activities)
Net change in cash

185

STATEMENTS
(2)
Any differences between the accrual basis in the income statement and the
cash basis in the cash flow statement of accounting for an operating
transaction result in an increase or decrease in some (usually) short-term
asset or liability on the balance sheet.
Beginning balance Income statement Cash Flows Ending balance

sheet at 31 for Year Ended 31 statement for sheet at 31
December December 20X9 Year Ended 31 December
20X8 December 20X9 20X9
Beginning Minus: Cash
Ending accounts
accounts Plus: Revenues collected from
receivable
receivable customers
Beginning Minus: Cash paid Ending accounts
Plus: Purchase
accounts payable to suppliers payable
Accrual basis Cash basis

(3)
• A company’s investing activities typically relate to the long-term asset
section of the balance sheet
• A company’s financing activities typically relate to the equity and long-
term debt sections of the balance sheet.
186

STATEMENTS
[LOS 19.f] Describe the steps in the preparation of direct and
indirect cash flow statements, including how cash flows can be
computed using income statement and balance sheet data
1. Direct method
Principle for operating cash flow: Adjust each item in the income statement to its
cash equivalent by +/- changes in the corresponding balance sheet accounts.
(+) Cash collected from customers (1.1)
Operating Cash Flows
(−) Cash paid to suppliers (1.2)

(−) Cash paid to employees (1.3)
(−) Cash paid for other operating expenses (1.4)
(+) Cash received from interest/dividend – note that this can appear in
operating or investing activities under IFRS (1.5,6)
(−) Cash paid for interest/dividend – note that this can appear in operating
or financing activities under IFRS (1.5,6)
(−) Cash paid for income taxes (1.7)
(+) Cash receipt from sales of assets (1.8)
Cash Flows
Investing
(−) Cash payment for purchase assets (1.9)

(+) Cash receipts from sales of financial instrument of other entities (1.10)
(−) Cash payment to acquire financial instrument of other entities (1.11)
(+) Cash receipts from share issuance (1.12)
Cash flows
Financing
(+) Cash receipts from new borrowings

(−) Cash payment of principal repayment of borrowings
187

STATEMENTS
Using information from the income statement and balance sheet in Figure
1 to illustrate the steps in the preparing of direct cash flow statement.
Figure 1: Income statement and balance sheet ($ millions)

Income statement (31/12/2018) 2018
Revenue (net) 23,598
Cost of goods sold (11,456)
Gross profit 12,142
Salary and wage expense (4,123)
Depreciation expense (1,052)
Other operating expenses (3,577)
Operating profit 3,390
Gain on sale of equipment 205
Income before tax 3,349
Income tax expense (1,139)
Net income 2,210
188

STATEMENTS
Balance sheet (31/12) 2018 2017 Net changes
Cash 1,011 1,163 (152)
Accounts receivable 1,012 957 55
Inventory 3,984 3,277 707
Prepaid expenses 155 178 (23)
Total current assets 6,162 5,575 587
Land 510 510 0
Buildings 3,680 3,680 0
Equipment (*) 8,798 8,555 243
Less: accumulated depreciation (3,443) (2,891) (552)
Total long-term assets 9,545 9,854 (309)
Total assets 15,707 15,429 278
(*) During 2018, Acme purchased new equipment for a total cost of $1,300.
No items impacted retained earnings other than net income and dividends
189

STATEMENTS
Balance sheet (31/12) (cont) 2018 2017 Net changes

Accounts payable 3,588 3,325 263
Salary and wage payable 85 75 10
Interest payable 62 74 (12)
Income tax payable 55 50 5
Other accrued liabilities 1,126 1,104 22
Total current liabilities 4,916 4,628 288
Long-term debt 3,075 3,575 (500)
Common stock 3,750 4,350 (600)
Retained earnings 3,966 2,876 1,090
Total liabilities and equity 15,707 15,429 278
190

STATEMENTS
1. Direct method
1.1. Cash collected from customers
Basis formula: Beginning account receivables

+ Revenue
– Cash collected from customers
Ending account receivables
Cash collected from customers

= Revenue – (Ending account receivables – Beginning account receivables)
(= Revenue – increase in accounts receivable
Or = Revenue + decrease in accounts receivable)
From Figure 1:
Cash collected from customers = 23,598 − 55 = 23,543
191

STATEMENTS
1. Direct method
1.2. Cash paid to suppliers
We need to calculate the amount of inventory purchased and then

calculate the amount paid for it.
Basis formula: Beginning inventory Beginning account payables

+ Purchase + Purchase
– COGS – Cash paid to suppliers
Ending inventory Ending account payables
Cash paid to suppliers

= COGS + (Ending inventory – Beginning inventory) – (Ending account
payables – Beginning account payables)
From Figure 1:
Cash paid to suppliers = 11,456 + (3,984 – 3,277) – (3,588 – 3,325) = 11,900
192

STATEMENTS
1. Direct method
1.3. Cash paid to employees
Basis formula: Beginning salary and wages payable

+ Salary and wages expense
– Cash paid to employees
Ending salary and wages payable
Cash paid to employees

= Salary and wages expense – (Ending salary and wages payable –
Beginning salary and wages payable)
(= Salary and wages expense – increase in salary and wages payable
Or = Salary and wages expense + decrease in salary and wages payable)
From
From Figure
Figure 1:
1:
Cash paid
Cash paid to
to employees
employees == $4,123
4,123 ––10
10==4,113
$4,113
193

STATEMENTS
1. Direct method
1.4. Cash paid for other operating expenses

We need to adjust the other operating expenses amount on the income
statement by the net changes in prepaid expenses and accrued expense
liabilities for the year to calculate cash paid for other operating expense .
Basis formula: Beginning accrued expense – Beginning prepaid expense
+ Other operating expense
– Cash paid for other operating expense
Ending accrued expense – Ending prepaid expense
Cash paid for other operating expense

= Other operating expenses + (Ending prepaid expense – Beginning prepaid
expense) – (Ending accrued expense – Beginning accrued expense)
From Figure 1:
Cash paid for other operating expenses = 3,577 + (155 –178) – (1,126 –1,104)
= 3,532
194

STATEMENTS
1. Direct method
1.5. Cash paid for/received from interest
Basis formula:
Beginning interest payable Beginning interest receivable
+ Interest expense + Interest income
– Cash paid for interest – Cash received from interest
Ending interest payable Ending interest receivable
Cash paid for interest Cash received from interest

= Interest expense – (Ending interest = Interest income – (Ending interest
payable – Beginning interest receivable – Beginning interest
payable) receivable)
From Figure 1:
Cash paid for interest = 246 – (62 – 74) = 258
195

STATEMENTS
1. Direct method
1.6. Cash paid for/received from dividend
Basis formula:
Beginning retained earnings Beginning dividend receivable
+ Net income + Dividend income
– Cash paid for dividend – Cash received from dividend
Ending retained earnings Ending dividend receivable
Cash paid for dividend Cash received from dividend

= Net income – (Ending retained = Dividend income – (Ending
earnings – Beginning retained dividend receivable – Beginning
earnings) dividend receivable)
From Figure 1:
Cash paid for dividend = 2,210 – (3,966 – 2,876) = 1,120
196

STATEMENTS
1. Direct method
1.7. Cash paid for income taxes
We need to adjust the income tax expense amount on the income statement by the
net changes in taxes payable, taxes receivable, and deferred income taxes for the
year.
Basis formula: Beginning tax payables + Beginning deferred tax liability
– Beginning deferred tax asset
+ Income tax expenses
– Cash paid for income taxes
Ending tax payables + Ending deferred tax liability
– Ending deferred tax asset
Cash paid for income taxes

= Income tax expenses – (Ending tax payables – Beginning tax payables ) + (Ending
deferred tax asset – Beginning deferred tax asset ) – (Ending deferred tax liability –
Beginning deferred tax liability)
From Figure 1:
Cash paid for income taxes = 1,139 – (55 – 50) = 1,134
197

STATEMENTS
1. Direct method
1.8. Cash receipt from sales of assets

We need to calculate the historical cost of the equipment sold and accumulated
depreciation as well as the gain/loss on the sale of equipment to calculate the cash
receipt from sales of assets.
Beginning balance equipment Beginning balance accumulated depreciation
+ Equipment purchased + Depreciation expense
– Ending balance equipment – Ending balance accumulated depreciation
Historical cost of asset sold Accumulated depreciation on asset sold
Cash receipt from sale of asset

= Historical cost of asset sold – Accumulated depreciation on asset sold + Gain/ – Loss
on the sale of asset
= Equipment purchased – (Ending equipment – Beginning equipment) – Depreciation
expense + (Ending accumulated depreciation – Beginning accumulated depreciation)
+ Gain/ – Loss on the sale of asset
From Figure 1:
Historical cost of asset sold = 8,555 + 1,300 – 8,798 = 1,057
Accumulated depreciation on asset sold = 2,891 + 1,052 – 3,443 = 500
→ Cash receipt from sale of asset = 1,057 – 500 + 205 = 762
198

STATEMENTS
1. Direct method
1.9. Cash payment for purchase of assets
Cash payment for purchase of assets

= Purchase price – Remained amount payable to acquire assets
1.10. Cash receipts from sales of financial instrument of other entities
Cash receipts from sales of financial instrument of other entities

= Sales price – Remained amount receivables to sales of financial instrument
1.11. Cash payment to acquire financial instrument of other entities
Cash payment to acquire financial instrument of other entities

= Purchase price – Remained amount payable to acquire financial instrument
1.12. Cash receipts from share issuance
Cash receipts from share issuance

= Number of shares x Market price of share
199

STATEMENTS
1. Direct method
Summary: Cash flow under direct method (from Figure 1)
Cash flow statement (31/12/2018) – direct method 2018
Cash received from customers 23,543
Cash paid to suppliers (11,900)
Cash paid to employees (4,113)
Cash paid for other operating expenses (3,532)
Cash paid for interest (258)
Cash paid for income tax (1,134)
Net cash provided by operating activities 2,606
Cash received from sale of equipment 762
Cash paid for purchase of equipment (1,300)
Net cash used for investing activities (538)
Cash paid to retire long-term debt (500)
Cash paid to retire common stock (600)
Cash paid for dividends (1,120)
Net cash used for financing activities (2,220)
Net increase (decrease) in cash (152)
Equal to the net decrease in cash balance in the balance sheet.

200

STATEMENTS
2. Indirect method
Indirect method is the alternative approach to reporting cash from

operating activities.
Principle for operating cash flow: Adjust net income for the following:
• any non-operating activities
• any non-cash expenses
• changes in operating working capital items (*)
(*) Changes in working capital accounts include increases and decreases

in the current operating asset and liability accounts, arising from
difference in accrual and cash accounting.
• Any increase in a current operating asset account is subtracted from
net income and a net decrease is added to net income.
For example, an increase in account receivables means you have
recognized revenue higher than cash received → need to be subtracted
from net income
• Similar explanation for any changes in a current operating liability
account.
201

STATEMENTS
2. Indirect method
Some type of items that need to be adjusted from Net income.
Additions Subtractions
• Depreciation/amortization of Amortization of bond premium
Non-cash
fixed assets
items
• Amortization of bond discount
• Loss on sale or write-off of assets • Gain on sale of assets
Non-
• Loss on retirement of debt • Gain on retirement of debt
operating
• Loss on investments accounted • Gain on investment accounted
items
under equity method under equity method
• Decrease in current operating • Increase in current operating
Change in
assets (*) assets
working
• Increase in current operating • Decrease in current operating
capital
liabilities (**) liabilities
• Increase in deferred income tax • Decrease in deferred income
Deferred liability tax liability.
taxes • Decrease in deferred income tax • Increase in deferred income
asset tax asset.
(*) Current operating assets: accounts receivable, inventory, and prepaid expenses
(**) Current operating liabilities: accounts payable and accrued expense liabilities
202

STATEMENTS
2. Indirect method
From Figure 1
Income
Non-cash items Depreciation 1,052 statement
Non-operating Income
Gain on sale of equipment 205 statement
items
Increase in accounts receivable 55 Balance sheet
Increase in accounts inventory 707 Balance sheet
Decrease in prepaid expenses 23 Balance sheet
Change in Increase in accounts payable 263 Balance sheet

working capital Increase in salary and wage payable 10 Balance sheet
Decrease in interest payable 12 Balance sheet
Increase in income tax payable 5 Balance sheet
Increase in other accrued liabilities 22 Balance sheet
203

STATEMENTS
2. Indirect method
Operating cash flow under indirect method (from Figure 1)

Cash flow statement (31/12/2018) – indirect method 2018
Net income 2,210
Depreciation expense 1,052
Gain on sale of equipment (205)
Increase in accounts receivable (55)
Increase in inventory (707)
Decrease in prepaid expenses 23
Increase in accounts payable 263
Increase in salary and wage payable 10
Decrease in interest payable (12)
Increase in income tax payable 5
Increase in other accrued liabilities 22
Investing and financing cash flows under direct and indirect method are the same.
204

STATEMENTS
[LOS 19.g] Demonstrate the conversion of cash flows from the
indirect to direct method
If a direct-format statement is not available, cash flows from operating
activities reported under the indirect method can be converted to the
direct method, shown in three-step process below:
Step 1 Disaggregating net income into total

Aggregate all revenue and all revenues and total expenses:
expenses. • Total revenues
• Total expenses
Step 2 • Deduct non-operating and non-cash

Remove all non-operating revenue items
and non-cash items from • Deduct non-cash expense items
aggregated revenues and • Break down the adjusted expenses into
expenses and break out cash outflow items:
remaining items into relevant o Cost of goods sold
cash flow items. o Salary and wage expenses
o Other operating expenses
o Interest expense
o Income tax expense
205

STATEMENTS
Step 3 • Cash received from customers

Convert accrual amounts to (converted from revenue – LOS 19.f –
cash flow amounts by 1.1)
adjusting for working capital • Cash paid to suppliers (converted from
changes COGS – LOS 19.f – 1.2)
• Cash paid to employees (converted
from salary and wage expenses – LOS
19.f – 1.3)
• Cash paid for other operating expenses
(converted from other operating
expenses – LOS 19.f – 1.4)
• Cash paid for interest (converted from
interest expense – LOS 19.f – 1.5)
• Cash paid for income tax (converted
from income tax expense – LOS 19.f –
1.7)
206

STATEMENTS
Example 3: Conversion of indirect cash flow to the direct cash flow

We will use these information from Figure 1 to convert indirect cash flow
to the direct cash flow as below:
Income statement (31/12) 2018 Indirect cash flow (31/12) 2018

Revenue (net) 23,598 Net income 2,210
Cost of goods sold (11,456) Depreciation expense 1,052
Gain on sale of equipment (205)
Gross profit 12,142
Increase in accounts receivable (55)
Salary and wage expense (4,123)
Increase in inventory (707)
Depreciation expense (1,052) Decrease in prepaid expenses 23
Other operating expenses (3,577) Increase in accounts payable 263
Operating profit 3,390 Increase in salary and wage
10
Gain on sale of equipment 205 payable
Decrease in interest payable (12)
Increase in income tax payable 5
Income before tax 3,349
Increase in other accrued
Income tax expense (1,139) 22
liabilities
Net income 2,210 Net operating cash flow 2,606
207

STATEMENTS
Answer:
Step 1: Aggregate all revenue and all expenses.
Income statement (31/12) 2018
Revenue (net) 23,598
Cost of goods sold (11,456)
Total revenue
Gross profit 12,142
= 23,598 + 205
Salary and wage expense (4,123) = 23,803
Depreciation expense (1,052)
Other operating expenses (3,577)
Operating profit 3,390
Total expenses
Gain on sale of equipment 205 = 11,456 + 4,123 + 1,052
Interest expense (246) + 3,577 + 246 + 1,139
Income before tax 3,349 = 21,593
Income tax expense (1,139)
Net income 2,210
208

STATEMENTS

Step 2: Remove all non-operating and non-cash items from aggregated
revenues and expenses and break out remaining items into relevant cash
flow items.
Income statement (31/12) 2018
Total revenue 23,803
Less: gain on sale of equipment (205)
Total revenue less non-operating items 23,598
Total expenses 21,593
Less: depreciation expense (1,052)
Total expenses less non-cash items 20,541
Include:
Cost of goods sold 11,456
Salary and wage expense 4,123
Other operating expenses 3,577
Income tax expense 1,139
209

STATEMENTS

Step 3: Convert accrual amounts to cash flow amounts by adjusting for
working capital changes
Cash received from = Revenue − increase in account 23,543

customers receivables = 23,598 − 55
Cash paid to suppliers = COGS + increase in inventory − increase (11,900)
in account payables
= 11,456 + 707 – 263
Cash paid to employees Salary and wage expense − Increase in (4,113)
salary and wage payable
= 4,123− 10
Cash paid for other = Other operating expenses − Decrease in (3,532)
operating expenses prepaid expenses − Increase in other
accrued liabilities
= 3,577 − 23 − 22
Cash paid for interest = Interest expense + Decrease in interest (258)
payable = 246 + 12
Cash paid for income tax = Income tax expense − Increase in (1,134)
income tax payable = 1,139 − 5
210

STATEMENTS
[LOS 19.h] Analyze and interpret both reported and common-
size cash flow statements
The analysis of a company’s cash flows can provide useful information for
understanding a company’s business and earnings and for predicting its
future cash flows.
Tools and techniques for analyzing the statement of cash flows
Calculation of free
Evaluation of the
Common-size cash flow measures
Sources and Uses of
analysis (2) and cash flow ratios
Cash (1)
(LOS 19.i)
211

STATEMENTS
1. Evaluation of the Sources and Uses of Cash
1.1. Evaluate the major sources and uses of cash flow: operating,
investing or financing cash flow
Financing activities Short term: operating cash

New and flow may be negative.
is the main source
growth
and investing
stage
activities is the Long term: operating cash flow
company
main use of cash must be the primary source.
Used in investing activities

(use of cash)
Mature Operating cash flow
company is the main source
Used in financing activities
(use of cash)
What are the major sources Is operating cash flow positive

and uses of cash flow? and sufficient to cover capital
expenditures?
212

STATEMENTS
1.2. Evaluate the primary determinants of operating cash flow
What are the major determinants of operating cash flow?

Under the indirect method, the increases and decreases in receivables,
inventory, payables, and so on can be examined to determine whether
the company is using or generating cash in operations and why.
Is operating cash flow higher or lower than net income? Why?

Non-cash and non-operating items can be examined to determine
whether operating cash flow is higher or lower than net income
→ evaluate the earning quality.
How consistent are operating cash flows?

Examine the variability of both earnings and cash flow and consider the
impact of this variability on the company’s risk as well as the ability to
forecast future cash flows for valuation purposes.
213

STATEMENTS
1.3. Evaluate the primary determinants of investing cash flow

Where is the cash being spent?
Within the investing section, you should evaluate each line item representing either
a source or use of cash.
How much cash is being invested: for PPE, liquid investments, M&A.
Where is cash come from to cover the investments (from operating or

financing cash flow)?
How much is cash raised by selling assets?

Potential effect on the company?
1.4. Evaluate the primary determinants of financing cash flow
What is the nature of capital sources? When is the repayment?

Within the financing section, you should examine each line item to understand
whether the company is raising capital or repaying capital.
• If the company is borrowing each year, you should consider when repayment
may be required.
• This section will also present dividend payments and repurchases of stock that
are alternative means of returning capital to owners.
214

STATEMENTS
2. Common-size analysis
Common-size cash flow statement
1st approach
2nd approach
The total cash inflows/outflows
The net revenue method
method
a. Based on direct method of Based on indirect method of

operating cash flow operating cash flow
b. Based on indirect method of

operating cash flow
215

STATEMENTS
1st approach: Each line item of cash inflow (outflow) is expressed as a percentage of
total inflows (outflows) of cash.
a. Common-size statement is based on a cash flow statement using the direct
method of presenting operating cash flows.
Operating cash inflows and outflows are separately presented on the cash flow
statement → each of these operating inflows (outflows) as a percentage of total
inflows (outflows). (Illustration 1)
Illustration 1
Inflow Cash flow (CF) Common size CF
Cash receipts from customers $23,543 96.86%
Cash from sale of equipment 762 3.14%
Total $24,305 100.00%
Outflows
Cash paid to suppliers $13,400 54.79%
Cash paid to employee 5,613 22.59%
Cash interest payments 790 3.23%
Cash taxes 1,134 4.64%
Cash for purchase of equipment 1,300 5.32%
Retirement of long-term debt and stock 1,100 4.49%
Dividend payments 1,120 4.58%
Total $24,457 100.00%
216

STATEMENTS
1st approach: Each line item of cash inflow (outflow) is expressed as a percentage of
total inflows (outflows) of cash.
b. Common-size statement is based on a cash flow statement using the indirect
method of presenting operating cash flows.
Operating cash inflows and outflows are not separately presented on the cash flow
statement
→ the common-size cash flow statement shows only the net operating cash flow
(net cash provided by or used in operating activities) as a percentage of total
inflows or outflows, depending on whether the net amount was a cash inflow or
outflow (Illustration 2)
Illustration 2
Inflows Cash flow (CF) Common size CF
Net operating cash flow $2,606 77.38%
Cash from sale of equipment 762 22.62%
Total $3,368 100.00%
Outflows
Purchase of equipment $1,300 36.93%
Retirement of long-term debt 500 14.20%
Retirement of common stock 600 17.05%
Dividend payments 1,120 31.82%
Total $3,520 100.00%
217

STATEMENTS
2nd approach: Each line item in the cash flow statement is shown as a
percentage of net revenue.
• Common-size statement is based on a cash flow statement using the

indirect method of presenting operating cash flows.
• Each line item of the reconciliation between net income and net
operating cash flows is expressed as a percentage of net revenue.
Illustration 3
Assume that net revenue is $23,598.
Operating cash flow Cash flow (CF) % of Net revenue

Net income $2,210 9.37%
Depreciation expense 1,052 4.46%
Increase in accounts receivable (155) (0.66)%
Increase in inventory (707) (3.00)%
Increase in accounts payable 186 0.79%
Increase in salary and wage payable 20 0.08%
Net operating cash flow $2,606 11.04%
218

STATEMENTS
Implications of common-size analysis

• The common-size format makes it easier to see trends in cash flow
rather than just looking at the total amount → useful to the analyst in
forecasting future cash flows.
• The common-size statement provides a basis for forecasting cash flows
for those items with an expected relation to forecasted net revenue.
219

STATEMENTS
[LOS 19.i] Calculate and interpret free cash flow to the firm, free
cash flow to equity, performance and coverage cash flow ratios
1. Calculate and interpret free cash flow
Free cash low is a measure of cash that is available for discretionary purposes.
• This is the cash flow that is available once the firm has covered its capital
expenditures (CAPEX)
• This is a fundamental cash flow measure and is often used for valuation.
Two of the more common measures are set out below.
Term Definition Computation
Free cash Cash flow available to the company’s • FCFF = CFO – net CAPEX (*) +
flow to suppliers of debt and equity after all Interest x (1 – tax rate)
firm operating expense have been paid and • FCFF = net income + non cash
(FCFF) necessary investment has been made charges + [Int × (1 − tax rate)]
− net CAPEX − working capital
investment
Free cash FCFE is cash flow available to the FCFE = CFO – net CAPEX + Net
flow to company’s common stockholders borrowing
equity after all operating expenses and (net borrowing = debt issued –
(FCFE) borrowing costs have been paid, debt repaid)
necessary investments in working (*) net CAPEX = fixed capital
capital and fixed capital have been investment
made
220

STATEMENTS
2. Calculate and interpret performance ratios
Performance Ratios Calculation Meaning

Cash flow to revenue CFO / Net revenue Operating cash generated
per dollar of revenue
Cash return on CFO / Average total assets Operating cash generated
assets per dollar of asset
investment
Cash return on CFO / Average Operating cash generated
equity shareholders' equity per dollar of owner
investment
Cash to income CFO / Operating income Cash generating ability of
operations
Cash flow per share (CFO - Preferred Operating cash flow on a
dividends) / number of per- share basis
common shares
outstanding
Measure a company's profitability, performance, and financial strength

by using cash flow statement
221

STATEMENTS
3. Calculate and interpret coverage cash flow ratios
Coverage Ratios Calculation Meaning

Debt coverage CFO / Total debt Financial risk and financial
leverage
Interest coverage (CFO + Interest Paid + Taxes Ability to meet interest
paid) / Interest paid obligations
Reinvestment CFO / Cash paid for long- Ability to acquire assets with
term assets operating cash flows
Debt payment CFO / Cash paid for long- Ability to pay debt with
term debt repayment operating cash flows
Dividend payment CFO / Dividends paid Ability to pay dividends with
operating cash flows
Investing and financing CFO / Cash outflows for Ability to acquire assets, pay
investing and financing debts, and make distributions
activities to owners
222

STATEMENTS
Practice questions
19.a. compare cash flows from operating, investing, and Question 1

financing activities and classify cash flow items as relating to one
of those three categories given a description of the items
19.b. describe how non-cash investing & financing activities are Question 3
reported
19.c. contrast cash flow statements prepared under IFRS and US Question 4
GAAP
19.d. Compare, contrast the direct & indirect methods of Question 2

presenting cash from operating activities & describe arguments in
favor of each method
19.e. describe how the cash flow statement is linked to the N/A
income statement and the balance sheet
19.f. describe the steps in the preparation of direct and indirect Question 5 -
cash flow statements, including how cash flows can be computed 9
using income statement and balance sheet data
223

STATEMENTS
Practice questions
19.g. demonstrate the conversion of cash flows from the indirect N/A
to direct method
19.h. analyze and interpret both reported and common-size cash Question 10
flow statements
19.i. calculate and interpret free cash flow to the firm, free cash Question 11
flow to equity, and performance and coverage cash flow ratios
224

STATEMENTS
Practice questions
1. The sale of a building for cash would be classified as what type of

activity on the cash flow statement?
A Operating.
B Investing.
C Financing.
2. A benefit of using the direct method rather than the indirect method
when reporting operating cash flows is that the direct method:
A mirrors a forecasting approach.
B is easier and less costly.
C provides specific information on the sources of operating cash flows.
3. A company recently engaged in a non-cash transaction that

significantly affected its property, plant, and equipment. The
transaction is:
A reported under the investing section of the cash flow statement.
B reported differently in cash flow from operations under the direct
and indirect methods.
C disclosed as a separate note or in a supplementary schedule to the
cash flow statement.
225

STATEMENTS
Practice questions
4. Which of the following is an example of a financing activity on the cash

flow statement under US GAAP?
A Payment of interest.
B Receipt of dividends.
C Payment of dividends.
5. Mabel Corporation (MC) reported accounts receivable of $66 million

at the end of its second fiscal quarter. MC had revenues of $72 million
for its third fiscal quarter and reported accounts receivable of
$55 million at the end of its third fiscal quarter. Based on this
information, the amount of cash MC collected from customers during
the third fiscal quarter is:
A $61 million.
B $72 million.
C $83 million.
6. When computing net cash flow from operating activities using the
indirect method, an addition to net income is most likely to occur
when there is a:
A gain on the sale of an asset.
B loss on the retirement of debt.
C decrease in a deferred tax liability.
226

STATEMENTS
Practice questions
7. Golden Cumulus Corp., a commodities trading company, reported

interest expense of $19 million and taxes of $6 million. Interest payable
increased by $3 million, and taxes payable decreased by $4 million over
the period. How much cash did the company pay for interest and taxes?
A $22 million for interest and $10 million for taxes.
B $16 million for interest and $2 million for taxes.
C $16 million for interest and $10 million for taxes.
8. Purple Fleur S.A., a retailer of floral products, reported cost of goods

sold for the year of $75 million. Total assets increased by $55 million,
but inventory declined by $6 million. Total liabilities increased by
$45 million, and accounts payable increased by $2 million. The cash
paid by the company to its suppliers is most likely closest to:
A $67 million.
B $79 million.
C $83 million.
227

STATEMENTS
Practice questions
9. Silverago Incorporated, an international metals company, reported a

loss on the sale of equipment of $2 million in 2018. In addition, the
company’s income statement shows depreciation expense of $8 million
and the cash flow statement shows capital expenditure of $10 million,
all of which was for the purchase of new equipment. Using the
following information from the comparative balance sheets, how much
cash did the company receive from the equipment sale?
Balance Sheet Item 12/31/2017 12/31/2018 Change
Equipment $100 million $105 million $5 million
Accumulated $40 million $46 million $6 million

depreciation—
equipment
A $1 million.
B $2 million.
C $3 million.
228

STATEMENTS
Practice questions
10. Which is an appropriate method of preparing a common-size cash flow

statement?
A Show each item of revenue and expense as a percentage of net
revenue.
B Show each line item on the cash flow statement as a percentage of
net revenue.
C Show each line item on the cash flow statement as a percentage of
total cash outflows.
11. Which of the following is an appropriate method of computing free

cash flow to the firm?
A Add operating cash flows to capital expenditures and deduct after-
tax interest payments.
B Add operating cash flows to after- tax interest payments and deduct
capital expenditures.
C Deduct both after- tax interest payments and capital expenditures
from operating cash flows.
229

STATEMENTS
Practice answers
1. B is correct. Purchases and sales of long-term assets are considered

investing activities. Note that if the transaction had involved the exchange
of a building for other than cash (for example, for another building,
common stock of another company, or a long-term note receivable), it
would have been considered a significant non- cash activity.
2. C is correct. The primary argument in favor of the direct method is that it

provides information on the specific sources of operating cash receipts
and payments. Arguments for the indirect method include that it mirrors a
forecasting approach and it is easier and less costly
3. C is correct. Because no cash is involved in non-cash transactions, these

transactions are not incorporated in the cash flow statement. However,
non-cash transactions that significantly affect capital or asset structures
are required to be disclosed either in a separate note or a supplementary
schedule to the cash flow statement.
4. C is correct. Payment of dividends is a financing activity under US GAAP.

Payment of interest and receipt of dividends are included in operating
cash flows under US GAAP.
230

STATEMENTS
Practice answers
5. C is correct.
Cash collected from customers = Revenue – (Closing in account
receivables – Opening in account receivables)
= $72 million + $66 million – $55 million = $83 million.
6. B is correct. An addition to net income is made when there is a loss on the

retirement of debt, which is a non-operating loss. Gain on the sale of an
asset & decrease in deferred tax liability are both subtracted from net
income.
7. C is correct.
Cash interest payments = Interest expense – (Closing interest payables –
Opening interest payables) = $19 - $3 = $16
Taxes paid = Income taxes – (Closing in tax payables – Opening in tax
payables) – (Closing in deferred taxes –Opening in deferred taxes) = $6 – (-
$4) = $10
8 A is correct.
Cash paid to supplier = COGS + (Closing inventory – Opening inventory) –
(Closing in account payables – Opening in account payables)
= $75 + (-$6) – ($2) = $67
231

STATEMENTS
Practice answers
9. A is correct.
Selling price (cash inflow) minus book value equals gain or loss on sale;
therefore, gain or loss on sale plus book value equals selling price (cash
inflow). The amount of loss is given—$2 million. To calculate the book
value of the equipment sold, find the historical cost of the equipment and
the accumulated depreciation on the equipment.
• Historical cost of equipment sold = Beginning balance of equipment +
equipment purchased – ending balance of equipment = $100 + $10 -
$105 = $5
• Accumulated depreciation on the equipment sold = Beginning
accumulated depreciation + depreciation expense - ending balance of
accumulated depreciation = $40 + $8 - $46 = $2
Cash receipts from disposal of assets = (Historical cost – Accumulated

depreciation) +/- Gain/Loss from disposal = $5 - $2 -$2 = $1
232

STATEMENTS
Practice answers
10. B is correct. An appropriate method to prepare a common- size cash flow

statement is to show each line item on the cash flow statement as a
percentage of net revenue. An alternative way to prepare a statement of
cash flows is to show each item of cash inflow as a percentage of total
inflows and each item of cash outflows as a percentage of total outflows.
11. B is correct. Free cash flow to the firm can be computed as operating cash
flows plus after- tax interest expense less capital expenditures.
233

ANALYSIS TECHNIQUES
234
READING 20: FINANCIAL ANALYSIS

TECHNIQUES
Learning outcomes
20.a. Describe tools and techniques used in financial analysis, including

their uses and limitations
20.b. Identify, calculate, and interpret activity, liquidity, solvency,

profitability, and valuation ratios
20.c. Describe relationships among ratios and evaluate a company using

ratio analysis
20.d. Demonstrate the application of DuPont analysis of return on equity

and calculate and interpret effects of changes in its components
20.e. Calculate and interpret ratios used in equity analysis and credit
analysis
20.f. Explain the requirements for segment reporting and calculate and
interpret segment ratios
20.g. Describe how ratio analysis and other techniques can be used to
model and forecast earnings
235

TECHNIQUES
[LOS 20.a] Describe tools and techniques used in financial
analysis, including their uses and limitations
1.
Ratio
Analysis
2.
4.
Tools and Common-
Regression
techniques Size
analysis
Analysis
3.
Graphical
Analysis
236

TECHNIQUES
1. Ratio analysis
The following table describes usage and limitations of each technique
Techniques Usage Limitations

• Project future earnings and • Financial ratios are not useful
cash flow. when viewed in isolation.
• Evaluate a firm’s flexibility • Comparisons are made more
• Assess management’s difficult by different accounting
performance. treatments.
• Evaluate changes in the • It is difficult to find comparable
Ratio firm and industry over industry ratios
Analysis time. • Conclusions cannot be made by
• Compare the firm with calculating a single ratio.
industry competitors. • Determining the target or
comparison value for a ratio is
difficult, requiring some range
of acceptable values.
237

TECHNIQUES
Example: Ratio analysis
Company A FY2016 FY2017

Revenue 232,724 237,275
Gross profit 23,212 25,361
Net income (4,901) 2,797
Company B FY2016 FY2017

Revenue 43,035 45,350
Gross profit 6,105 6,272
Net income 530 (127)
By ratio analysis, we can determine

• Which company is larger based on the amount of revenue, in US$,
reported in fiscal year 2016, 2017
• Which company had the higher revenue growth from FY2016 to
FY2017
• Profitability of companies (assessed by comparing the amount of gross
profit to revenue and the amount of net income to revenue)
238

TECHNIQUES
2. Common-Size Analysis
• Allow the analyst to more • Does not facilitate the

easily compare performance decision-making process
across firms and for a single due to the lack of any
firm overtime approved standard
• Common-size balance sheet benchmark
expresses all balance sheet • Fails to convey proper
accounts as a percentage of records during seasonal
total assets. fluctuations in various
Common-Size
• Common-size income components of sales,
Analysis
statement expresses all assets liabilities
income statement items as a • Does not help to ascertain
percentage of sales. the Current ratio, Liquid
• Common-size cash flow ratio, Capital gearing ratio
statements expresses all cash etc. which are applied in
flows as a percentage of total testing liquidity and
cash flows or a percentage of solvency position of a
net revenue method firm.
239

TECHNIQUES
2. Common-Size Analysis
Example: Graphical analysis
Items IS Common size IS

Sales 10,000,000 100%
Cost of sales 3,000,000 30%
Gross profit 7,000,000 70%
Selling, general and administrative
1,000,000 10%
expense
Research and development 2,000,000 20%
Advertising 2,000,000 20%
Operating profit 2,000,000 20%
By common-size analysis, we can

• Certainly point the analyst in the right direction
• Ask relevant questions in assessing the company’s operating performance
over the period, and evaluating its prospects going forward.
240

TECHNIQUES
3. Graphical Analysis
• Comparison of performance and financial
• Require
structure over time, highlighting changes in
additional
significant aspects of business operations.
written or verbal
• Provide the analyst (and management) with
Graphical explanation;
a visual overview of risk trends in a
Analysis • Can be easily
business.
manipulated to
• Communicate the analyst’s conclusions
give false
regarding financial condition and risk
impressions
management aspects
4. Regression Analysis
• Identify relationships between
• It involves very lengthy and
variables
complicated procedure of
Regression • Providing a basis for forecasting
calculations and analysis
analysis • Identification of items or ratios
• Strict assumptions of
that are not behaving as
regression model can be
expected, given historical
violated
statistical relationships.
241

TECHNIQUES
Example: Graphical analysis
Change in trade payables, cash and lease obligations

of company X in 4 year-period
15000
10000
5000
0
20X4 20X5 20X6 20X7
Trade payables Cash Lease obligations
Stacked column graph (a type of graphic analysis) shows the changes in

items from year to year in graphical form.
242

TECHNIQUES
[LOS 20.b] Identify, calculate, and interpret activity, liquidity,
solvency, profitability, and valuation ratios
Type Usage
1. Activity ratio Measure how well a company manages various activities,

particularly how efficiently it manages its various assets.
2. Liquidity Liquidity measures how quickly assets are converted into

ratio cash. Liquidity ratios also measure the ability to pay off
short-term obligations.
3. Solvency Solvency refers to a company’s ability to fulfill its long-

ratio term debt obligations.
4. Profitability Measure the company’s to generate profits from revenue

ratio and assets.
5. Valuation Sales per share, earnings per share, and price to cash flow
per share are examples of ratios used in comparing the
relative valuation of companies.
243

TECHNIQUES
1. Activity ratios
Activity
Usage/Calculation/Interpretation
ratios
• Usage: The number of DSO represents the elapsed time

between a sale and cash collection, reflecting how fast the
company collects cash from customers.
• Calculation:
Revenue
o Receivables turnover =
Average receivables
Receivables 365
Turnover and o DSO =
Receivable turnover
days of sales • Interpretation:
outstanding o A high receivables turnover might indicate that the
(DSO) company’s credit collection are highly efficient or result
from overly stringent credit or collection policies, which
can hurt sales if competitors offer more lenient credit
terms to customers and vice versa
o A high DSO means that the company’s credit collection
are highly inefficient.
244

TECHNIQUES
1. Activity ratios
Activity ratios Usage/Calculation/Interpretation

• Usage: The number of days of payables reflects the average
number of days the company takes to pay its suppliers, and
the payables turnover ratio measures how many times per
year the company theoretically pays off all its creditors.
• Calculation:
Purchase
o Payables turnover =
Average payables
Payables 365
o Number of days of payables =
Turnover and Payables turnover
the Number • Interpretation:
of Days of o A high payables turnover might indicate that the
Payables company is not making full use of available credit
facilities and repaying creditors too soon or company
making payments early to avail early payment discounts
o A high number of days of payables means that the
company is having trouble in making payments on time,
or alternatively, exploitation of lenient supplier terms
245

TECHNIQUES
1. Activity ratios

• Usage: Indicate inventory management effectiveness. A
higher inventory turnover ratio implies a shorter period
that inventory is held, and thus a lower DOH.
• Calculation:
COGS
o Inventories turnover =
Average inventories
Inventory 365
turnover and o DOH =
Inventories turnover
days of • Interpretation:
inventory on o A high inventory turnover ratio relative to industry
hand (DOH) norms might indicate highly effective management or
the company does not hold adequate inventory levels,
which can hurt sales in case shortages arise and vice
versa
o A high DOH means that company uses inventory
inefficiently and is struggling to clear its stock.
246

TECHNIQUES
1. Activity ratios
• Usage: Indicates how efficiently the company generates revenue

with its working capital
Working Capital • Calculation: WCT = Revenue
Turnover (WCT) Average working capital
• Interpretation: A high working capital turnover ratio indicates higher
operating efficiency
• Usage: Measures how efficiently the company generates revenues

from its investments in fixed assets
Fixed Asset Revenue
• Calculation: FA turnover =
Turnover Average net FA
• Interpretation: A high ratio indicates more efficient use of fixed
assets in generating revenue
• Usage: Measures the company’s overall ability to generate revenues

with a given level of assets
Total Asset Revenue
• Calculation: TA turnover = Average TA
Turnover
• Interpretation: A high ratio indicates more efficient use of total
assets in generating revenue
247

TECHNIQUES
2. Liquidity ratios
Liquidity
ratios
• Usage: Expresses current assets in relation to current liabilities. A
higher ratio indicates a higher level of liquidity
Current assets
Current ratio • Calculation: Current ratio =
Current liabilities
• Interpretation: A high current ratio is desirable because it indicates a
higher level of liquidity
• Usage: Expresses “quick” assets in relation to current liabilities. Quick
assets excludes items in current assets that cannot be converted into
cash such as inventory, prepaid expenses, taxes…
Quick ratio • Calculation:
Cash + Short−term investment + Receivables
Quick ratio =
Current liabilities
• Interpretation: A high quick ratio indicates greater liquidity.
• Usage: Represents a reliable measure of an entity’s liquidity in a crisis
situation. Only highly marketable short-term investments and cash are
included
Cash ratio Cash+Short−term investment
• Calculation: Cash ratio =
Current liabilities
• Interpretation: A high cash ratio is desirable as it indicates greater
liquidity
248

TECHNIQUES
2. Liquidity ratios
Liquidity
ratios
• Usage: Measures how long the company can continue to pay its expenses
from its existing liquid assets without receiving any additional cash inflow.
Defensive • Calculation:
Cash + Short−term investment
interval
ratio Defensive interval ratio = +Daily
Short−term receivables
cash expenditures
• Interpretation: A high defensive interval ratio is desirable as it indicates
greater liquidity
• Usage: Indicates the amount of time that elapses from the point when a
company invests in working capital until the point at which the company
Cash
collects cash
conversion
• Calculation: Cash conversion cycle = DOH + DSO – Number of days of
cycle
payables
• Interpretation: A short cycle is desirable, as it indicates greater liquidity
249

TECHNIQUES
3. Solvency ratios
Solvency ratios Usage/Calculation/Interpretation
• Usage: Measures the percentage of total assets financed with debt.

Total debts
Debt-to-asset • Calculation: Debt-to-asset ratio = Total assets
ratio
• Interpretation: A high ratio is undesirable because it implies higher
financial risk and a weaker solvency position
• Usage: Measures the percentage of a company’s capital (debt plus

equity) represented by debt.
• Calculation:
Debt-to-capital Total debts
ratio Debt-to-capital = Total debts + Total shareholder′s equity
• Interpretation: A high ratio is undesirable and indicates higher

financial risk
• Usage: Measures the amount of debt capital relative to equity
capital.
• Calculation:
Debt-to-equity Total debts
ratio Debt-to-equity = Total shareholder′s equity
• Interpretation: A high ratio is undesirable and indicates higher

financial risk
250

TECHNIQUES
3. Solvency ratios
Solvency ratios Usage/Calculation/Interpretation

• Usage: Measures the amount of total assets supported for each one
money unit of equity.
Financial Average total assets
• Calculation: Financial leverage ratio =
leverage ratio Average total equity
• Interpretation: A higher the leverage ratio, the more leveraged
(dependent on debt for finance) the company.
• Usage: Measures the number of times a company’s EBIT (earnings
before interest and tax) could cover its interest payments.
Interest EBIT
• Calculation: Interest coverage = Interest payments
coverage ratio
• Interpretation: A higher ratio provides assurance that the company
can service its debt from operating earnings
• Usage: Measures the number of times a company’s earnings can
cover the company’s interest and lease payments.
• Calculation:
Fixed charge EBIT+Lease payments
coverage Fixed charge coverage = Interest+Lease payment
ratios
• Interpretation: A higher ratio suggests that the company is
comfortably placed to service its debt and make lease payments from
the earnings it generates from operations
Note: In this reading, total debt is the sum of interest-bearing short-term and long-term debt.
251

TECHNIQUES
4. Profitability ratios
Before moving on to any profitability ratios, you should be familiar with a few
terms, such as gross profit, operating profit, net profit, and so on. These are
linked in the income statement as follows:
Net sales
- Cost of goods sold
= Gross profit
- Operating expense
= Operating profit (EBIT)
- Interest
= Earnings before tax (EBT)
- Taxes
= Earnings after tax (EAT)
+/- Below the line items
= Net income
- Preferred dividends
= Income available to common shareholders
252

TECHNIQUES
Profit ratios Usage/Calculation/Interpretation

• Usage: Indicates the percentage of revenue available to
cover operating and other expenses and to generate profit.
Gross profit
Gross profit • Calculation: Gross profit margin =
Revenue
margin • Interpretation: A high gross profit margin can be a explain
by high product prices (reflected in high revenues) and low
product costs (reflected in low COGS).
• Usage: Indicate the company’s ability to control operating
costs, such as administrative overheads.
Operating income
• Calculation: Operating profit margin =
Revenue
• Interpretation:
Operating o An operating profit margin that is increasing at a higher
profit margin rate than the gross profit margin indicates that the
company has successfully controlled operating costs.
o A decreasing operating profit margin when gross profit
margins are rising indicates that the company is not
efficiently controlling operating expenses.
253

TECHNIQUES
• Usage: Reflects the effects on profitability of leverage

and other (non-operating) income and expenses
EBT (earnings before tax)
• Calculation: Pretax margin =
Revenue
Pretax • Interpretation: If a company’s pretax margin is rising
margin primarily due to higher non-operating income, the
analyst should evaluate whether this source of income
will continue to bring in significant earnings going
forward.
• Usage: Shows how much profit a company makes for

every dollar it generates in revenue.
Net income
Net profit • Calculation: Net profit margin =
Revenue
margin • Interpretation: A low net profit margin indicates a low
margin of safety. It alerts analysts to the risk that a
decline in the company’s sales revenue will lower profits
or even result in a net loss
254

TECHNIQUES
• Usage: Measures the return earned by a company on its assets.

Net income
Return on • Calculation: ROA =
Average total assets
asset (ROA) • Interpretation: The higher the ROA, the greater the income
generated by the company given its total assets.
• Usage: Measures the profits a company earns on all of the

Return on capital that it employs (long/short-term debt and equity)
EBIT
total capital • Calculation: Return on total capital =
Average total capital
(ROTC) • Interpretation: The higher the ROTC, the greater the EBIT
generated by the company given its total capital.
• Usage: Measures the return earned by a company on its equity

capital, including minority equity, preferred equity, and common
Return on equity
Net income
equity (ROE) • Calculation: ROE =
Average total equity
• Interpretation: A high ROE indicates a more efficient usage of
equity capital.
255

TECHNIQUES
[LOS 20.c] Describe relationships among ratios and evaluate a
company using ratio analysis
Illustration: Combining ratios

Ratios can also be combined and evaluated as a group to better
understand how they fit together and how efficiency and leverage are tied
to profitability. For example:
Fiscal year 10 9 8
Current 2.1 1.9 1.6

ratio
Quick ratio 0.8 0.9 1.0
• The ratios present a contradictory picture of the company’s liquidity.

Based on the increase in its current ratio from 1.6 to 2.1, the company
appears to have strong and improving liquidity;
• However, based on the decline of the quick ratio from 1.0 to 0.8, its
liquidity appears to be deteriorating.
• Because both ratios have exactly the same denominator, current
liabilities, the difference must be the result of changes in some
asset that is included in the current ratio but not in the quick ratio
(e.g., inventories).
256

TECHNIQUES
[LOS 20.d] Demonstrate the application of DuPont analysis of
return on equity and calculate and interpret effects of changes
in its components
DuPont system is used to break-down return on equity (ROE) into

component ratios.
Decomposing ROE into its components through DuPont analysis has the
following uses:
• It facilitates a meaningful evaluation of the different aspects of the
company’s performance that affect reported ROE.
• It helps in determining the reasons for changes in ROE over time for a
given company.
• It also helps us understand the reasons for differences in ROE for
different companies over a given time period.
• It can direct management to areas that it should focus on to improve
ROE.
• It shows the relationship between the various categories of ratios and
how they all influence the return that owners realize on their
investment
257

TECHNIQUES
in its components
Two-Way DuPont Decomposition
Net income
ROE =
Net income Average total assets
= x
Average total assets Average shareholder′s equity
x Financial
= ROA
Leverage
Three-Way DuPont Decomposition
Net income
ROE =
Net income Revenue Average total assets
= x x
Revenue Average total assets Average shareholder′ s
equity
Net profit Asset Financial
= x x
margin turnover Leverage
258

TECHNIQUES
in its components
Five-Way DuPont Decomposition
Net income
ROE =
Equity
Net income EBT EBIT Revenue Average TA
= x x x x
EBT EBIT Revenue Average TA Average shareholders′
equity
= Tax Interest EBIT Total asset Financial
x x x x
burden burden margin turnover Leverage
• The tax burden ratio equals one minus the average tax rate. It basically
measures the proportion of its pretax profits that a company gets to keep. A
higher tax burden ratio implies that the company can keep a higher
percentage of its pretax profits.
• The interest burden ratio captures the effect of interest expense on ROE.
High borrowing costs reduce ROE. As interest expense rises, EBT will fall as a
percentage of EBIT, the interest burden ratio will fall, and ROE will also fall.
• The EBIT margin captures the effect of operating profitability on ROE.
• We already know that the asset turnover ratio is an indicator of the overall
efficiency of the company, while the leverage ratio measures the total value
of a company’s assets relative to its equity capital.
259

TECHNIQUES
in its components
Summary of ROE Decomposition
Return on Average Shareholders’ Equity or ROE
Return on assets (ROA) Leverage
Net profit Total assets

margin turnover
Interest Tax EBIT

burden burden margin
260

TECHNIQUES
in its components
Example: Five-Way DuPont Decomposition
2011 2010 2009
ROE 9.47% 15.00% 24.31%
Tax burden 64,86% 59.37% 63.24%
Interest burden 92.58% 92.45% 92.74%
EBIT margin 8.63% 10.41% 13.24%
Asset turnover 0.85 1.21 1.47
Leverage 2.15 2.17 2.13

Based on this information, comment on the negative trend in the
company’s ROE.
261

TECHNIQUES
in its components
Example: Five-Way DuPont Decomposition
Solution:
The following conclusions may be drawn from the given information:
• The tax burden ratio has varied with no obvious trend over the years.
The recent increase in tax burden ratio (from 59.37% in 2010 to 64.85%
in 2011) indicates that taxes declined as a percentage of pre-tax profits.
Average tax rates may have declined as a result of (1) new legislation or
(2) greater revenue generated in lower tax jurisdictions.
• The interest burden ratio remained fairly constant over the period,
which suggests that the company’s capital structure has remained fairly
constant.
• The EBIT margin declined over the period, indicating that the company’s
operations were less profitable.
• The company’s asset turnover declined over the period, which suggests
that the company is becoming increasingly inefficient.
• The financial leverage ratio remained fairly constant over the period,
which is consistent with the stable interest burden ratio.
Overall, the decline in the company’s ROE is mainly caused by a decline in
the EBIT margin (profitability) and asset turnover (efficiency).
262

TECHNIQUES
[LOS 20.e] Calculate and interpret ratios used in equity analysis
and credit analysis
1. Equity analysis
a. Valuation ratios
Ratios Meaning
(P/E) It basically tells us how much a share of common

Price per share stock is currently worth per dollar of earnings of the
Earnings per share company.
Cash flow is less subject to manipulation by

(P/CF)
Price per share management than earnings. Thus, P/CF ratios can be
used to compare companies with different degrees of
Cash flow per share accounting aggressiveness
• Sales are generally less subject to distortion or

(P/S) manipulation than are other fundamentals.
Price per share
• The ratio is used when a company does not have
Sales per share
positive net income.
(P/BV) Book value per share is more stable than EPS, P/BV
Price per share may be more meaningful than P/E when EPS is
Book value per share abnormally high or low, or is highly variable.
263

TECHNIQUES
and credit analysis
1. Equity analysis
b. Per-share quantities
Net income −Preferred Dividends

outstanding during the period
Basic EPS
Where, Weighted average number of ordinary shares
= Number of outstanding ordinary shares x Time
Earnings per share (EPS)
weighting factor
Adjusted net income available to common shares

outstanding during the period + number of potential
dilutive securities convert to common share
Diluted EPS • Dilutive securities include convertible debt and
convertible preferred stock, options & warrants.
• Net income available to common shares is increased
by the after-tax interest savings on any dilutive debt
securities and by the dividends on any dilutive
convertible preferred stock  Adjusted net income
264

TECHNIQUES
and credit analysis
1. Equity analysis
b. Per-share quantities (cont.)
Term Definition Calculation
The percentage of earnings that

Dividend DPR = (Total dividends/
the company pays out as
payout rate Net income) x 100%
dividends to shareholders
Retention The percentage of earnings that

1 – dividend payout rate
rate a company retains.
Sustainable A company’s sustainable growth

growth rate rate is viewed as a function of its SGR (g) = retention rate x
profitability (measured as ROE) ROE = (1 – dividend
and its ability to finance itself payout rate) x ROE
from internally generated funds
(measured as the retention rate)
265

TECHNIQUES
and credit analysis
1. Equity analysis
c. Business risk
Coefficient Calculation
Coefficient of variation Standard deviation of operating income

of operating income Average operating income
Coefficient of variation Standard deviation of net income

of net income Average net income
Coefficient of variation Standard deviation of revenue

.
of revenues Average revenue
266

TECHNIQUES
and credit analysis
1. Equity analysis
c. Financial sector ratios
Various components of capital

Capital adequacy ratio
Various measures such as risk−weighted assets,
(of banks) (CAR)
market risk exposure
Monetary reserve Reserves held at central bank

requirement Specified deposit liabilities
Liquid asset Approved "readily marketable" securities

.
requirement pecified deposit liabilities
Net interest income

Net interest margin
Total interest−earning assets
267

TECHNIQUES
and credit analysis
2. Credit analysis
Credit analysis is the evaluation of credit risk which is the risk of loss caused
by a counterparty’s or debtor’s failure to make a promised payment. The
following ratios can be used to evaluate credit risk of company
EBITDA interest coverage EBITDA/Interest expense
FFO (Funds from operations)

FFO/Total debt
to debt
Free operating cash flow to [CFO (adjusted) – Capital expenditure]/Total

debt debt
EBIT margin EBIT/Total revenues
EBITDA margin EBITDA/Total revenues
Debt to EBITDA Total debt/EBITDA
EBIT/ Average beginning-of-year and

Return on capital
end-of-year capital
268

TECHNIQUES
[LOS 20.f] Explain the requirements for segment reporting and
calculate and interpret segment ratios
Business segment: a portion of a larger company that accounts for more than 10% of
company’s revenue or assets, and can be distinguisable from the company’s other
lines of business in terms of risk and return characteristics of the segment.
Geographic segment: identified when meeting the criteria above, the geographic unit
has a business environment that is different from that of other segments or
remainder of the comapny’s business.
Segment
Usage/Calculation
ratios
Segment • Usage: Measures operating profitability relative to sales

Segment profit (loss)
margin • Calculation:
Segment revenue
• Usage: Measures overall efficiency means how much revenue is

Segment generated per dollar of assets
turnover Segment revenue
• Calculation: Segment assets
Segment • Usage: Measures operating profitability related to assets.

Segment profit (loss)
ROA • Calculation: Segment assets
Segment • Usage: Measures solvency of the segment.

Segment liabilities
debt ratio • Calculation: Segment assets
269

TECHNIQUES
[LOS 20.g] Describe how ratio analysis and other techniques can
be used to model and forecast earnings
The results of financial analysis provide valuable inputs into forecasts of future
earnings and cash flow. An analyst can build a model to forecast future
performance of a company. Techniques that can be used include:
Techniques Feature
Shows the range of possible outcomes as underlying

Sensitivity Analysis assumptions are altered. (e.g., what will be the net
income if more debt is issued?)
This type of analysis shows the changes in key financial

quantities that result from given (economic) events,
Scenario Analysis
such as the loss of customers, the loss of a supply
source, or a catastrophic event.
• This is computer-generated sensitivity or scenario

analysis based on probability models for the
factors that drive outcomes.
Monte Carlo • Each event or possible outcome is assigned a
Simulation probability.
• Multiple scenarios are then run using the
probability factors assigned to the possible values
of a variable.
270

TECHNIQUES
Practice questions
20.a. describe tools and techniques used in financial analysis, N/A

including their uses and limitations
20.b. identify, calculate, and interpret activity, liquidity, solvency, Question 1-5
profitability, and valuation ratios
20.c. describe relationships among ratios and evaluate a N/A

company using ratio analysis
20.d. demonstrate the application of DuPont analysis of return on N/A

equity and calculate and interpret effects of changes in its
components
20.e. calculate and interpret ratios used in equity analysis and Question 6
credit analysis
20.f. explain the requirements for segment reporting and N/A

calculate and interpret segment ratios
20.g. describe how ratio analysis and other techniques can be Question 7
used to model and forecast earnings
271

TECHNIQUES
Practice questions
1. In order to assess a company’s ability to fulfill its long-term obligations,

an analyst would most likely examine:
A activity ratios.
B liquidity ratios.
C solvency ratios.
2. An analyst is evaluating the solvency and liquidity of Apex Manufacturing

and has collected the following data (in millions of euro):.
FY 5 FY4 FY3
Total debt 2,000 1,900 1,750
Total equity 4,000 4,500 5,000
Which of the following would be the analyst’s most likely conclusion?

A The company is becoming increasingly less solvent, as evidenced by
the increase in its debt-to-equity ratio from 0.35 to 0.50 from FY3 to FY5.
B The company is becoming less liquid, as evidenced by the increase in
its debt- to- equity ratio from 0.35 to 0.50 from FY3 to FY5.
C The company is becoming increasingly more liquid, as evidenced by
the increase in its debt- to- equity ratio from 0.35 to 0.50 from FY3 to FY5.
272

TECHNIQUES
Practice questions
3. An analyst observes a decrease in a company’s inventory turnover.

Which of the following would most likely explain this trend?
A The company installed a new inventory management system,
allowing more efficient inventory management.
B Due to problems with obsolescent inventory last year, the company
wrote off a large amount of its inventory at the beginning of the period.
C The company installed a new inventory management system but
experienced some operational difficulties resulting in duplicate orders
being placed with suppliers.
4. Brown Corporation had average days of sales outstanding of 19 days in

the most recent fiscal year. Brown wants to improve its credit policies
and collection practices and decrease its collection period in the next
fiscal year to match the industry average of 15 days. Credit sales in the
most recent fiscal year were $300 million, and Brown expects credit
sales to increase to $390 million in the next fiscal year. To achieve
Brown’s goal of decreasing the collection period, the change in the
average accounts receivable balance that must occur is closest to:
A +$0.41 million.
B –$0.41 million.
C –$1.22 million.
273

TECHNIQUES
Practice questions
5. Assuming no changes in other variables, which of the following would

decrease ROA?
A A decrease in the effective tax rate.
B A decrease in interest expense.
C An increase in average assets.
6. What does the P/E ratio measure?

A The “multiple” that the stock market places on a company’s EPS.
B The relationship between dividends and market prices.
C The earnings for one common share of stock.
7. When developing forecasts, analysts should most likely:

A develop possibilities relying exclusively on the results of financial
analysis.
B use the results of financial analysis, analysis of other information,
and judgment.
C aim to develop extremely precise forecasts using the results of
financial analysis.
274

TECHNIQUES
Practice answers
1. C is correct. Solvency ratios are used to evaluate the ability of a company

to meet its long-term obligations. An analyst is more likely to use activity
ratios to evaluate how efficiently a company uses its assets. An analyst is
more likely to use liquidity ratios to evaluate the ability of a company to
meet its short-term obligations.
2. A is correct. The company is becoming increasingly less solvent, as

evidenced by its debt- to- equity ratio increasing from 0.35 to 0.50 from
FY3 to FY5. The amount of a company’s debt and equity do not provide
direct information about the company’s liquidity position.
Debt to equity:
FY5: 2,000/4,000 = 0.5000
FY4: 1,900/4,500 = 0.4222
FY3: 1,750/5,000 = 0.3500
3. C is correct. The company’s problems with its inventory management

system causing duplicate orders would likely result in a higher amount of
inventory and would, therefore, result in a decrease in inventory turnover.
A more efficient inventory management system and a write off of
inventory at the beginning of the period would both likely decrease the
average inventory for the period (the denominator of the inventory
turnover ratio), thus increasing the ratio rather than decreasing it.
275

TECHNIQUES
Practice answers
4. A is correct. The average accounts receivable balances (actual and

desired) must be calculated to determine the desired change. The average
accounts receivable balance can be calculated as an average day’s credit
sales times the DSO. For the most recent fiscal year, the average accounts
receivable balance is $15.62 million [= ($300,000,000/365) × 19]. The
desired average accounts receivable balance for the next fiscal year is
$16.03 million (= ($390,000,000/365) × 15). This is an increase of
$0.41 million (= 16.03 million – 15.62 million).
5. C is correct. Assuming no changes in other variables, an increase in

average assets (an increase in the denominator) would decrease ROA. A
decrease in either the effective tax rate or interest expense, assuming no
changes in other variables, would increase ROA.
6. A is correct. The P/E ratio measures the “multiple” that the stock market
places on a company’s EPS.
7. B is correct. The results of an analyst’s financial analysis are integral to the

process of developing forecasts, along with the analysis of other
information and judgment of the analysts. Forecasts are not limited to a
single point estimate but should involve a range of possibilities.
276
READING 21: INVENTORIES

277

Learning outcomes
21.a. Contrast costs included in inventories and costs recognized as

expenses in the period in which they are incurred.
21.b. Describe different inventory valuation methods (cost formulas)
21.c. Calculate and compare cost of sales, gross profit, and ending
inventory using different inventory valuation methods and using
perpetual and periodic inventory systems
21.e. Explain LIFO reserve and LIFO liquidation and their effects on
financial statements and ratios
21.g. Describe the measurement of inventory at the lower of cost and

net realizable value
21.h. Describe implications of valuing inventory at net realizable value

for financial statements and ratios
21.i. Describe the financial statement presentation of and disclosures

relating to inventories
We incorporates Los 21.d in the curriculum into los 21.c, and los 21.f to los 21.e
278

Learning outcomes
21.j. Explain issues that analysts should consider when examining a

company’s inventory disclosures and other sources of information
21.k. Calculate and compare ratios of companies, including companies

that use different inventory methods
21.l. Analyze and compare the financial statements of companies,

including companies that use different inventory methods
279

[LOS 21.a] Contrast costs included in inventories & costs
recognized as expenses in the period in which they are incurred
1. Definition, categories of inventories and costs
INVENTORIES
• Assets are held for sale in the ordinary course of business
• Assets are in the process of production for such sale; or
• Assets are in the form of materials or supplies to be consumed in the
production process or in the rendering of services.
CATEGORIES COSTING
(see more in the next slide)
• Raw materials: materials or
substances used in the primary • Costing that will be capitalized
production or manufacturing in inventory asset
of goods • Costing that will be recognized
• Work-in-progress: Inventories in expenses
have started the conversion
process from raw materials but
are not yet finished goods
ready for sale
• Finished goods: goods ready
for sale
280

Contrast costs included in inventories & costs recognized as

2.
expense
Capitalized costs Expensed costs
Purchase price
+ Import duties, taxes, insurance fee
+ Other costs directly attributable goods
Cost of
(Transport, handling..)
purchase • Abnormal costs from
- Trade discounts
- Other rebates that reduce costs of material wastage.
purchase • Abnormal costs of labor
or wastage of other
production inputs.
Direct cost: Costs directly related to the • Storage costs that are
units of production, eg direct labor not a part of the normal
Cost of
production process.
conversion
Overheads cost: • Administrative
• Fixed production overheads expenses, selling and
• Variable production overheads marketing costs
Incurred in bringing the inventories to their

Other cost
present location & condition.
281

Example: Identification of inventory cost

ABC Company manufactures a single product. Various costs incurred during
the year 2009 are listed here:
Cost of raw materials $12,000,000
Direct labor conversion costs $25,000,000
Production overheads $5,000,000
Freight charges for raw materials $2,000,000
Storage costs for finished goods $800,000
Abnormal wastage $80,000
Freight charges for finished goods $100,000
1. What costs should be included in inventory for 2009?
2. What costs should be expensed during 2009?
282

Solution:
Capitalized costs Expensed costs
• Cost of raw material = Storage costs

12,000,000 are not part of Storage costs for
Costs of
• Freight-in charges for the normal finished goods =
purchase
raw materials = production 800,000
2,000,000 process
• Direct labor Abnormal costs

Abnormal
conversion costs = wastage = 80,000
Costs of
25,000,000
conversion Freight charges
• Production overhead
Selling cost for finished goods
= 5,000,000
=100,000
Total = $44,000,000 Total = $980,000

283

[LOS 21.b] Describe different inventory valuation methods (cost
formulas)
1. Introduction to 4 inventory valuation methods
There are 4 different methods of inventory valuation that are applied in

IFRS and US GAAP:
• Specific identification method
• First in first out (FIFO)
• Last in first out (LIFO)
• Weighted average cost
Note that, just US GAAP accept LIFO method while IFRS does NOT accept
LIFO methods.
• A company must use the same inventory valuation method for all
items that have a similar nature and use.
• For items with a different nature or use, a different inventory
valuation method can be used.
• Change in inventory valuation method is change in accounting policy
and must be adjusted retrospectively.
284

formulas)
2 Weighted average cost (WAC)
Beginning inventory Purchases
4 5 5 8 8 8 9 9 = 56
First in Weighted Last in
average cost
7 7 7 7 7 7 7 7
Goods available for sale
Cost of sales = 14
7 7
Ending inventory = 42
7 7 7 7 7 7
• The cost of an item of inventory is calculated by taking the average of

all inventory held
• Applied on such inventories which are interchangeable
285

formulas)
3 First in first out (FIFO)

First in Last in
4 5 5 8 8 8 9 9
First out
Cost of sales = 9
4 5
5 8 8 8 9 9
• The first items of inventory received are assumed to be the first ones
sold.
• The cost of closing inventory is the cost of the most recent purchases
of inventory
286

formulas)
4 Last in first out (LIFO)

First in Last in
4 5 5 8 8 8 9 9
First out
Cost of sales = 18
9 9
4 5 5 8 8 8
• The last items of inventory received are assumed to be the first ones
sold.
• The cost of closing inventory is the cost of the earliest purchases of
inventory
287

formulas)
5 Specific identification method
First in 4 5 5 8 8 8 9 9 Last in
Specific identification
Cost of sales = 13
5 8
4 5 8 8 9 9
• The cost of sales and the cost of ending inventory reflect the actual
costs incurred to purchase.
• Applied on such inventories which are not interchangeable or
individually distinguishable & of high value or for goods or services
produced and segregated for specific projects make the sale.
288

formulas)
6 Inventory valuation methods comparison
WAC FIFO LIFO Specific ID
COGS is COGS is COGS is COGS reflects actual

composed of composed of composed of costs incurred to
units valued at units valued at units valued at purchase or
average prices oldest prices most recent manufacture the
prices specific units
that have been sold
over the period.
Ending Ending Ending Ending inventory

inventory is inventory is inventory is reflects actual costs
composed of composed of composed of incurred to purchase
units valued at units valued at units valued at or manufacture the
average most recent oldest prices specific units that
prices. prices still remain in
inventory at the end of
the period
289

[LOS 21.c] Calculate and compare cost of sales, gross profit, and
ending inventory using different inventory valuation methods
and using perpetual and periodic inventory systems
Calculate and compare COS, gross profit, and ending
1.
inventory using different inventory valuation methods
Gross profit
Number of Sale price of

Sales
goods sale each goods
Beginning Ending
Cost of sales Purchases
inventories inventories
Costs of
Number of
each
inventory
inventory
Rely on
Inventory valuation methods

Specific
WAC FIFO LIFO
identification
290

1.
Example: cost of sales, gross profit and ending inventory balances under
4 valuation methods
Global Sales, Inc. (GSI) is a hypothetical Dubai-based distributor of
consumer products, including bars of luxury soap. The soap is sold by the
kilogram.
• GSI began operations in 20X8, during which it purchased and received
following order:
o Initially, 100,000 kg of soap at 110 dirham (AED)/kg,
o Then, 200,000 kg of soap at 100 AED/kg.
o Finally, 300,000 kg of soap at 90 AED/kg.
• GSI stores its soap in its warehouse so that soap from each shipment
received is readily identifiable.
• GSI sold 520,000 kg of soap at 240 AED/kg.
o 100,000 kg from the first shipment received.
o 180,000 kg of the second shipment received.
o 240,000 kg of the final shipment received.
What are the reported cost of sales, gross profit and ending inventory
balances for 20X8 under 4 valuation methods?
291

1.
Solution: Units are measured in thousand (‘000)
Step 1: Calculate the COGS using different inventory valuation methods
WAC FIFO LIFO Specific
Beginning Value = 0 in all 4 methods (per question)
Purchase Value = Quantity x Price = 100 x 110 + 200 x 100 + 300 x 90 = 58,000
QxP1 V QxP2 V QxP3 V Q1xP4 + Q2xP5 V

Ending
80x97 7,760 80x90 7,200 80x110 8,800 20x100 + 60x90 7,400
COGS 50,240 50,800 49,200 50,600

• P1: Price of inventory in Weighted average cost = [(100,000 × 110) + (200,000 × 100) + (300,000 ×
90)]/600,000 ≈ 97 AED
• P2: Value at most recent inventory , in this case it is value of goods in final shipment received = 90
• P3: Value at oldest inventory, in this case it is value of goods in first shipment received = 110
• P4, P5: Value of specified inventory in, in this case P5 = value of goods in third shipment received
and P4 = value of goods in second shipment received.
• Q: Total number of inventory at the end,
o Q1: Number of specified inventory in second shipment at the end
o Q2: Number of specified inventory in third shipment at the end
292

1.
Solution (continued):
WAC FIFO LIFO Specific
Sale Sale = 520 x 240 = 124,800 AED in all 4 methods
COGS 50,240 50,800 49,200 50,600
Gross profit 74,560 74,000 75,600 74,200

293

Explain how inflation and deflation of inventory costs
2.
affect the financial statements and ratios
In this section, we will determine effect of inflation (increase in price) and deflation
(decrease in price) on COS, gross profit and ending inventory (refer to LOS 21.d in
curriculum CFA)
FIFO when declining price LIFO when declining price

First in Last in First in Last in
10 9 8 7 6 10 9 8 7 6
First out
First out
Cost of sales = 19 Cost of sales = 13
10 9 7 6
Ending inventory = 21 Ending inventory = 27
8 7 6 10 9 8
294

2.
In case of declining price (deflation) period

Ending inventory FIFO < Ending inventory LIFO because:
Ending inventory FIFO = Value of the most recent inventories < Value of the oldest
inventories = Ending inventory LIFO
Ending inventory FIFO < Ending inventory LIFO
COGS FIFO > COGS LIFO
Net profit FIFO < Net profit LIFO
Assets FIFO < Assets LIFO Equity FIFO < Equity LIFO
By contrast, in case of rising price (inflation period) , If entity uses LIFO method, it
will have lower total assets as well as lower total equity compare to FIFO
295

2.
We have summarized table about the effect of changing price on valuation
inventory methods
Ending Gross/Net
Methods COGS Assets Equity
inventory profit
Increasing cost or inflation
FIFO Lower Higher Higher Higher Higher
LIFO Higher Lower Lower Lower Lower
Declining cost or deflation
FIFO Higher Lower Lower Lower Lower
LIFO Lower Higher Higher Higher Higher

296

3 Perpetual and periodic inventory systems
Perpetual system: Value of inventory as well as COGS will be continuously updated

after each transaction sale/purchase. The ending inventory could be compared with
physical count to find the difference.
Update ending
Update purchase Update COGS inventory by
by transaction by transaction transaction
Beginning inventory Purchase COGS
Ending inventory
Beginning Purchase Sales Ending
COGS
Beginning inventory Purchase Ending inventory

Update purchase NOT update COGS Update ending
by transaction by transaction. inventory at the
Calculate at the end of period by
end of period. physical count
Periodic system: Value of inventory and COGS will be updated at the end of period
after physical counting inventory
297

[LOS 21.e] Explain LIFO reserve and LIFO liquidation and their
effects on financial statements and ratios
1 LIFO reserve
For companies using the LIFO method, US GAAP requires disclosure the
amount of the LIFO reserve in the notes to the financial statements or
on the balance sheet.
The LIFO reserve is the difference between the inventory balance shown
on the balance sheet and the amount that would have been reported
had the firm used FIFO. That is:
LIFO reserve = Inventory FIFO - Inventory LIFO
To compare companies using LIFO with companies not using LIFO

298

2 Converting FS components from LIFO to FIFO
Difference in COGS FIFO = COGS LIFO - Change in LIFO reserve

inventory value
COGS Explanation for formula:

COGS FIFO = Beginning inventory FIFO + Purchase –
Ending inventory FIFO
Net incomes
 COGS FIFO = (Beginning inventory LIFO + LIFO
reserve beginning) + Purchase – (Ending inventory
Retained earnings
LIFO + LIFO reserve ending)
(RE)
 COGS FIFO = (Beginning inventory LIFO + Purchase
Deffered tax
– Ending inventory LIFO) – (LIFO reserve ending –
liabilities LIFO reserve beginning)
 COGS FIFO = COGS LIFO - Change in LIFO reserve
299

Difference in Net income FIFO = Net income LIFO + Change in LIFO

inventory value
reserve x (1 - Tax rate)
Sales revenue FIFO = Sales revenue LIFO

Net incomes
COGS FIFO = COGS LIFO - Change in LIFO
Retained earnings reserve
(RE)
EBTFIFO = EBTLIFO + Change in LIFO reserve
Deffered tax
liabilities
Net income FIFO = Net income LIFO +
Change in LIFO reserve x (1 - Tax rate)
Taking account of tax effect

300

Difference in REFIFO = RELIFO + LIFO reserve x (1 - Tax rate)

inventory value
Net income FIFO REFIFO

Net incomes
Retained Net income LIFO RELIFO

earnings (RE)
Deffered tax Change in LIFO

liabilities LIFO reserve
reserve
x (1 - Tax rate)
x (1 - Tax rate)
LIFO reserve is equivalent to accumulated

changes in LIFO reserve
301

Difference in DTLFIFO = DTLLIFO + LIFO reserve x tax rate

inventory value
Change in
EBTFIFO EBTLIFO
Net incomes LIFO reserve
Retained earnings Change in

(RE) Tax payable Tax payable LIFO reserve
FIFO LIFO
x Tax rate
Deffered tax
liabilities (DTL)
Incomes Tax Expense
LIFO reserve
DTLFIFO DTLLIFO
x tax rate
302

3 LIFO liquidation
Assumption
LIFO liquidations may arise in periods of rising inventory unit costs
Definition: LIFO liquidation occurs when a firm using LIFO sells more
inventory during a period than it produces → The COGS figure no longer
reflects the current cost of inventory sold, and leads to higher but not
stable profit.
Assume rising prices, consider company A under 2 scenarios:
1 It produces 2 items in a year 2 No items are produced
Beginning inventory Produced Beginning inventory
Last in Last in
6 7 8 9 10 6 7 8
First out
First out
Higher COGS Lower COGS
Cost of sales = 19 Cost of sales = 15
9 10 7 8
No longer
Ending inventory = 21 COGS reflects Ending inventory = 6 reflects the
the current cost current cost of
6 7 8 6
of inventory sold inventory sold
303

3 LIFO liquidations
• Indication: A decline in the LIFO reserve from the prior period may be
indicative of LIFO liquidation.
• Reasons that lead to LIFO liquidation:
o Reasons outside the management control: Labour strikes at a
supplier → company has reduce inventory levels.
o Reasons arising from the management control:
 Economic recession or declining customer demand → company
choose to reduce existing inventory levels rather than invest in
new inventory
 Earnings management: The company intentionally reducing
inventory quantities and liquidating older layers of LIFO
inventory to inflate earnings.
• Analytical implication: If LIFO layers of inventory are temporarily

depleted and not replaced by fiscal year-end, LIFO liquidation will
occur resulting in unsustainable higher gross profits.
→ We should review the LIFO reserve footnote disclosures to determine
if LIFO liquidation has occurred.
304

3 LIFO liquidations
Example: LIFO liquidations

At the beginning of 20X7, Big 4 Manufacturing Company had 400 units of
inventory for the fiscal year 20X6 as follows:
Purchased Number of
Cost Per Unit Total Cost
month units
October 120 $10 $1,200
November 140 $11 $1,540
December 140 $12 $1,680
Total 400 - $4,420
Big 4 reports inventory under LIFO. Due to a strike, no units were

produced during 20X7. During 20X7, Big 4 sold 280 units. In the absence
of the strike, Big 4 would have had a cost of $14 for each unit
produced. Compute the extra profit that resulted from the inventory
liquidation.
305

3 LIFO liquidations
Solution:
We calculate the COGS under 2 scenarios:
1. The strike did not occurred and the company produced 280 items, the
amount of goods that it sold in 20X7
2. The strike occurred and no items were produced in the year
1 In the absent of the strike 2 The strike occurred
Beginning inventory Produced Beginning inventory
Last in Last in
120x10 140x11 140x12 280x14 120x10 140x11 140x12
First out
First out
Higher COGS Lower COGS
Cost of sales = 3,920 Cost of sales = 3,220
280x14 140x11 140x12
Ending inventory = 4,420 Ending inventory = 1,200
120x10 140x11 140x12 120x10
Due to the LIFO liquidation, COGS was lower by $700 ($3,920 – $3,220);
thus, pretax profit was higher by $700.
306

4 Effects on ratios
In the case of rising prices:

• COGS FIFO < COGS LIFO
• Inventory FIFO > Inventory LIFO
→ This leads to the following effects on Profitability, liquidity, activity and
solvency ratios.
Type Effect
COGS FIFO < COGS LIFO  higher earnings  higher profitability.

Profitability For example, reducing COGS  higher gross, operating, and
net profit margins under FIFO
Inventory FIFO > Inventory LIFO  higher current ratio 

Liquidity
Working capital is higher under FIFO
COGS FIFO < COGS LIFO and Inventory FIFO > Inventory LIFO 
lower inventory turnover (COGS / average inventory) and
Activity
higher days of inventory on hand (365 / inventory turnover)
under FIFO
Inventory FIFO > Inventory LIFO  higher total assets  higher

Solvency in stockholders’ equity (assets - liabilities)  lower debt ratio
and the debt-to-equity ratio under FIFO
307

The conversion of a company’s reported financial

5.
statements from LIFO to FIFO for purposes of comparison
Principles to convert among different inventory valuation method, under
IFRS and US GAAP:
IFRS US. GAAP
• Retrospectively for change from

• Retrospectively for changes in LIFO to another method.
inventory valuation methods. • Prospectively for change from
another method to LIFO.
Differences in inventory valuation methods should be considered when

comparing a company’s performance with that of its industry or those of
its competitors.
308

[LOS 21.g] Describe the measurement of inventory at the lower
of cost and net realizable value
1 Describe the measurement of inventory under IFRS and US GAAP
Under IFRS, value of inventory should be recorded at lower value between cost
and Net realizable value (NRV)
Inventory Cost = Historical cost

Lower
value of NRV = Selling price – Completion cost & Selling cost
Under US GAAP, value of inventory should be recorded by 2 principles:
For inventories measured using LIFO and retail inventory methods
Cost = Historical cost

Lower
Inventory of
value Market value = Mid value of (NRV – normal profit margin;
Replacement cost; NRV)
For inventories measured using other methods, the principle is consistent with IFRS
Inventory Cost = Historical cost

Lower
value of NRV = Selling price – Completion cost & Selling cost
• The value of inventory is lower than cost, or we can say that inventory is “written
down”
• Recognize an expense = Cost – NRV (or Market value) in the I/S
309

Example: Inventory written down

Zoom, Inc., sells digital cameras. Per-unit cost information pertaining to
Zoom’s inventory is as follows:
Original cost $210
Estimated selling price $225
Estimated selling costs $22
Net realizable value $203
Replacement cost $197
Normal profit margin $12
What are the per-unit carrying values of Zoom’s inventory using lower
of cost or NRV and lower of cost or market?
310

Example: Inventory written down

Solution:
• IFRS:
Inventory Lower Cost = Historical cost = $210

value of NRV = $203
o The inventory is written down to the NRV = $203

o The $7 decrease in value ($203 net realizable value − $210 original
cost) is reported in the income statement.
• US GAAP:
Lower Cost = Historical cost = $210

Inventory of Market value = Mid value of (NRV – normal profit
value margin; Replacement cost; NRV) = Mid value of
($191; $197; $203) = $197
o The inventory is written down to $197

o The $13 loss ($197 replacement cost – $210 original cost) is reported
in the income statement.
311

2 Effect of writing down the value of inventory
This is what happens when we write down the value of inventory
Effect of written down

Items/ ratios
This year Next year
Ending Inventory Lower No effect
COGS Higher due to lower Lower due to lower

ending inventory beginning inventory
(this year ending
inventory)
Gross/net profit Lower Higher
Inventory Higher Lower

turnover ratio
Total assets Higher Lower

turnover ratio
312

3 Reversal of value of inventory
In each subsequent period, a new assessment of net realizable value is

made.
• Under IFRS: Reversal is required for a subsequent increase in value of
inventory previously written down; and recognize a gain on the I/S.
• Under US. GAAP: Reversal is not allowed.
Note: The increase in value that can be recognized is limited to the total
write-down that had previously been recorded
Write-down Reversal
Ending Inventory Lower Higher
Assets Lower Higher
COGS Higher Lower
Gross/net profit Lower Higher
Retained earnings Lower Higher
Effects on ratio:
Profitability, Solvency, Total assets turnover, inventory turnover
313

3 Reversal of value of inventory
Example: Inventory reversal

Using the similar information from above example.
Assume that in the year after the write-down in the previous example, net
realizable value and replacement cost both increase by $10. What is the impact of
the recovery under IFRS, and under U.S. GAAP if lower of cost or market is used?
Solution:
IFRS
The year of write-down The following year
Historical cost $210 $210
NRV $203 $213
Inventory value Lower($203; $210) = $203 Lower($210; $213) = $210 →

Write down from $210 to inventory reversal to the
$203 amount written down = $210
Effect on I/S Loss of $7 on the I/S Gain of $7 on the I/S
US GAAP
No recovery is permitted, so there is no change on the financial statements.

314

[LOS 21.h] Describe implications of valuing inventory at net
realizable value for financial statements and ratios
Type of Ratio Impact from inventory value Effect on Ratio
• Net profit margins

• COGS increases  profit
(net profit/revenue)
decrease Lower
• Gross profit margins
• Revenue remain the same
(gross profit/revenue)
• Profit decrease  Equity

• Debt-to-equity
decrease
(total debt/total equity)
• Lower inventory  Assets Higher
• Debt ratio
decrease
(total debt/total asset)
• Debt remain the same
• Lower inventory  Current

Current ratio
assets decrease
(Current asset/Current Lower
• Current liability remain the
liability)
same
Inventory turnover • COGS increases

Higher
(COGS/Average inventory) • Average inventory decreases
Total asset turnover • Revenue remain the same

Higher
(revenue/total assets) • Total assets decrease
315

[LOS 21.i] Describe the financial statement presentation of and
disclosures relating to inventories
Accounting policies applied
Carrying amount, classified as separate

components
Carrying amount of items recognized at NRV
IFRS
Written-down amount recognized as
Presentation &
expenses in the period
disclosure
The circumstances or events that led to the
reversal and amount of reversal in the period
Carrying amount of inventories pledged as

securities for liabilities
Cost of inventories recognized as expense

(COGS)
US GAAP Very similar to the disclosures above, but exclude

Presentation & that requirements for reversal, and add disclosures
disclosure of significant estimates and material amounts.
316

[LOS 21.j] Explain issues that analysts should consider when
examining a company’s inventory disclosures and other sources
of information
Inventory is an important asset of a company, the following three ratios should
be used when examining a company’s inventory.
Days of inventory on hand can be calculated as days in the period

divided by inventory turnover.
Average inventory
Number of days of inventory = × Number of days
Cost of good sold
Inventory turnover measures how fast a company moves its inventory

through the system.
Cost of goods sold
Inventory turnover =
Average inventory
If a company has a higher inventory turnover ratio and a lower number of days
of inventory than the industry average, it could mean one of three things:
• It could indicate that the company is more efficient in inventory
management, as fewer resources are tied up in inventory.
• It could also suggest that the company does not carry enough inventory at
any point in time, which could hurt sales.
• It could also mean that the company might have written down the value of
its inventory.
317

of information
Gross profit margin indicates the percentage of sales being contributed

to net income as opposed to covering the cost of sales
Gross profit
Gross profit margin =
Sales revenue
• Firms in relatively competitive industries have lower gross profit margins.
• Firms selling luxury products tend to have lower volumes and higher gross
profit margins.
• Firms selling luxury products are likely to have lower inventory turnover
ratios.
Example: Inventory analysis

The following information relates to Atlas Inc. for the years 2007 and
2008
2007 2008
Inventory turnover ratio 6.71 6.11
Number of days of inventory 54.4 days 59.7 days
Gross profit margin 24.8% 27.3%

318

of information
Example: Inventory analysis (cont)

Rely on above information, Comment on the changes in Atlas’s financial
statement ratios from 2007 to 2008.
Solution:
• The inventory turnover ratio declined (from 6.71 in 20X7 to 6.11 in
20X8) and the number of days of inventory increased (from 54.4 days
to 59.7 days).
→ The company has been less efficient in managing its inventory in
2008 as compared to 2007.
• The gross profit margin improved by 2.5% from 24.8% in 2007 to 27.3%
in 2008.
→ The company did well in managing its cost of goods sold or that a
company can make a reasonable profit on sales.
319

LOS 21.k: Calculate and compare ratios of companies, including
companies that use different inventory methods
The following table will show the comparison between LIFO and FIFO with
Rising Prices and Stable Inventory Levels
Effect on Effect on
Type of Ratio Effect on Ratio
Numerator Denominator
Net and Gross Income is lower under LIFO Sales remain the Lower under
profit margins because COGS is higher same LIFO
Debt-to-equity Lower equity and Higher under

Same debt levels
& Debt ratio assets under LIFO LIFO
Current assets are lower Lower under

Current liabilities
Current ratio under LIFO because ending LIFO
are the same
inventory is lower
Quick assets are higher Current liabilities

Higher under
Quick ratio under LIFO as a result of are the same
LIFO
lower taxes paid
Inventory Average inventory Higher under

COGS is higher under LIFO
turnover is lower under LIFO LIFO
Total asset Lower total assets Higher under

Sales are the same
turnover under LIFO LIFO
320

[LOS 21.l] Analyze and compare the financial statements of
companies, including companies that use different inventory
methods
1 Income statement and statement of cash flow
SOCI SOCF
Methods Gross
Tax expense Net income CF from
profit
(1) (2) operating (3)
(LOS 21c)
LIFO Lower Lower Lower Higher
FIFO Higher Higher Higher Lower
Explanation of trends in items:

• In LOS 21c, we have Gross profit FIFO > Gross profit LIFO
Gross profit FIFO - other expense > Gross profit LIFO - other expense
EBTFIFO > EBTLIFO and Net income FIFO > Net income LIFO (2)
Tax expense FIFO > Tax expense LIFO (1)
• In LOS 21c, we have Ending inventory FIFO > Ending inventory LIFO
While Beginning inventory FIFO = Beginning inventory LIFO
 Increase in inventory FIFO > Increase in inventory LIFO
 Cash flow from operating FIFO < Cash flow from operating LIFO (3)
321

[LOS 21.l] Analyze and compare the financial statements of
companies, including companies that use different inventory
methods
2 Balance sheet
SOFP
Total
Methods Ending Working Retained
assets Owner’s
inventory capital earnings
(LOS equity (6)
(LOS 21c) (4) (5)
21e)
LIFO Lower Lower Lower Lower Lower
FIFO Higher Higher Higher Higher Higher
Explanation of trends in items:

• Working capital = Current assets – Current liabilities
Ending inventory FIFO > Ending inventory LIFO
 Current assets FIFO > Current assets LIFO
 Working capital FIFO > Working capital LIFO (4)
• Net income FIFO > Net income LIFO
 Retained earnings FIFO > Retained earnings LIFO (5)
 Owner’s equity FIFO > Owner’s equity LIFO (6)
322

Practice questions
21.a. Contrast costs included in inventories and costs recognized Question 1

as expenses in the period in which they are incurred.
21.b. Describe different inventory valuation methods (cost Question 4

formulas)
21.c. Calculate and compare cost of sales, gross profit, and N/A
21.d. Calculate and explain how inflation and deflation of Question 6

inventory costs affect the financial statements and ratios of
companies that use different inventory valuation methods
21.e. Explain LIFO reserve and LIFO liquidation and their effects Question 3, 8
on financial statements and ratios
21.f. Demonstrate the conversion of a company’s reported Question 7

financial statements from LIFO to FIFO for purposes of
comparison
21.g. Describe the measurement of inventory at the lower of cost Question 5

and net realizable value
323

Practice questions
21h. Describe implications of valuing inventory at net realizable N/A

value for financial statements and ratios
21i. Describe the financial statement presentation of and N/A

disclosures relating to inventories
21j. Explain issues that analysts should consider when examining Question 2
a company’s inventory disclosures and other sources of
information
21k. Calculate and compare ratios of companies, including N/A

companies that use different inventory methods
21l. Analyze and compare the financial statements of companies, N/A

including companies that use different inventory methods
324

Practice questions
1. Inventory cost is least likely to include:

A production-related storage costs.
B costs incurred as a result of normal waste of materials.
C transportation costs of shipping inventory to customers.
2. During periods of rising inventory unit costs, a company using the FIFO
method rather than the LIFO method will report a lower:
A current ratio.
B inventory turnover.
C gross profit margin.
3. A company using the LIFO method reports the following in £:

2018 2017
COGS 50,800 48,500
Ending inventories 10,550 10,000
LIFO reserve 4,320 2,600
Cost of goods sold for 2018 under the FIFO method is closest to:
A £48,530.
B £49,080.
C £52,520.
325

Practice questions
4. Eric’s Used Book Store prepares its financial statements in accordance
with IFRS. Inventory was purchased for £1 million and later marked
down to £550,000. One of the books, however, was later discovered to
be a rare collectible item, and the inventory is now worth an estimated
£3 million. The inventory is most likely reported on the balance sheet
at:
A £550,000.
B £1,000,000.
C £3,000,000.
5. Fernando’s Pasta purchased inventory and later wrote it down. The

current net realisable value is higher than the value when written down.
Fernando’s inventory balance will most likely be:
A higher if it complies with IFRS.
B higher if it complies with US GAAP.
C the same under US GAAP and IFRS..
6. Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method.
Compared to the cost of replacing the inventory, during periods of
rising prices the ending inventory balance reported by (assume the
company use a periodic inventory system):
A Zimt is too high.
B Nutmeg is too low.
C Nutmeg is too high.
326

Practice questions
7. Compared with a company that uses the FIFO method, during a period
of rising unit inventory costs, a company using the LIFO method will
most likely appear
more:
A liquid.
B efficient.
C profitable.
8. Bangor Company discloses that its LIFO reserve was $625,000 at the
end of the previous year and $675,000 at the end of the current year.
For the current year, beginning inventory was $2,350,000 and ending
inventory was $2,525,000. The firm’s tax rate is 30%. What would
Bangor’s ending inventory have been using FIFO?
A $2,575,000.
B $2,997,500.
C $3,200,000.
327

Practice answer
1. C is correct. Transportation costs incurred to ship inventory to customers
are an expense and may not be capitalized in inventory. (Transportation
costs incurred to bring inventory to the business location can be
capitalized in inventory.) Storage costs required as part of production, as
well as costs incurred as a result of normal waste of materials, can be
capitalized in inventory. (Costs incurred as a result of abnormal waste
must be expensed.).
2. B is correct. During a period of rising inventory costs, a company using the

FIFO method will allocate a lower amount to cost of goods sold and a
higher amount to ending inventory as compared with the LIFO method.
The inventory turnover ratio is the ratio of cost of sales to ending
inventory. A company using the FIFO method will produce a lower
inventory turnover ratio as compared with the LIFO method. The current
ratio (current assets/current liabilities) and the gross profit margin [gross
profit/sales = (sales less cost of goods sold)/sales] will be higher under the
FIFO method than under the LIFO method in periods of rising inventory
unit costs.
3. B is correct. The adjusted COGS under the FIFO method is equal to COGS
under the LIFO method less the increase in LIFO reserve:
COGS (FIFO) = COGS (LIFO) – Increase in LIFO reserve
COGS (FIFO) = £50,800 – (£4,320 – £2,600)
COGS (FIFO) = £49,080
328

Practice answers
4. B is correct. Under IFRS, the reversal of write- downs is required if net

realisable value increases. The inventory will be reported on the balance
sheet at £1,000,000. The inventory is reported at the lower of cost or net
realisable value. Under US GAAP, inventory is carried at the lower of cost
or market value. After a write- down, a new cost basis is determined and
additional revisions may only reduce the value further. The reversal of
write-downs is not permitted.
5. A is correct. IFRS require the reversal of inventory write- downs if net

realisable values increase; US GAAP do not permit the reversal of write-
downs.
6. B is correct. Nutmeg uses the LIFO method, and thus some of the
inventory on the balance sheet was purchased at a (no longer available)
lower price. Zimt uses the FIFO method, so the carrying value on the
balance sheet represents the most recently purchased units and thus
approximates the current replacement cost.
7. B is correct. During a period of rising inventory prices, a company using
the LIFO method will have higher cost of cost of goods sold and lower
inventory compared with a company using the FIFO method. The
inventory turnover ratio will be higher for the company using the LIFO
method, thus making it appear more efficient. Current assets and gross
profit margin will be lower for the company using the LIFO method, thus
making it appear less liquid and less profitable.
329

Practice answers
8. C is correct. FIFO inventory = LIFO inventory + LIFO reserve = $2,525,000 +
$675,000 = $3,200,000.
330
READING 22: LONG-LIVED

ASSETS
331
READING 22: LONG-LIVED ASSETS

Learning outcomes
22.a. Identify and contrast costs that are capitalized and costs that are expensed in
the period in which they are incurred
22.b. Explain and evaluate how capitalizing versus expensing costs in the period in
which they are incurred affects financial statements and ratios
22.c. Definition classification and recognition of long-lived assets
22.d. Measurement of long-lived assets
22.e. Depreciation and amortization of long-lived assets
22.f. Impairment and derecognition of long-lived assets
22.g. Describe the financial statement presentation of and disclosures relating to

property, plant, and equipment and intangible assets.
22.h. Analyze and interpret financial statement disclosures regarding property,

plant, and equipment and intangible assets
22.i. Compare the compare the financial reporting of investment property with
that of property, plant, and equipment.
We changed the LOS order that is presented in Curriculum and Schweser Notes
332

[LOS 22.a] Identify and contrast costs that are capitalized and
costs that are expensed in the period in which they are
incurred
When a company makes an expenditure
Capitalize the cost as an asset on Expense the cost in the income

the balance sheet if it is expected to statement if it is expected to
provide future economic benefits provide economic benefits in only
over multiple accounting periods. the current period. (*)
In LOS 22.a and LOS 22.b we are going to address two questions about
expensed costs and capitalized costs, which is:
1. [LOS 22.a] What is the accounting treatment of capitalized costs and
expensed costs?
2. [LOS 22.b] What is the effect of capitalizing versus expensing costs on
financial statements and ratios?
333

incurred
1. Accounting treatment of capitalized costs and expensed costs
Capitalized Costs Expensed Costs
• A capitalized cost is recognized • Current period pretax income

as a noncurrent asset on the is reduced by the amount of
balance sheet. the expenditure
• The associated cash outflow is • The associated cash outflow is
listed under investing activities classified under operating
(CFI) on the statement of cash activities (CFO) on the
flows. statement of cash flows.
• In subsequent periods, the • No related asset is recognized
capitalized amount is allocated on the balance sheet, so no
(expensed) over the asset’s related depreciation or
useful life as depreciation amortization charges are
expense (for tangible assets) incurred in future periods.
or amortization expense (for
intangible assets with finite
lives).
See example in the next slide. See example in the next slide.
334

incurred
1. Accounting treatment of capitalized costs and expensed costs
Example
Capitalized Costs Expensed Costs
Company A bought an equipment that Company B incurred a $15m

costs $15m and it was expected to maintenance expense of an equipment
bring benefit in the next periods. It and decided that the expense was
estimates the useful life to be 3 years expected to provide economic benefits
and the salvage value to be zero. A uses in only the current period.
the straight line depreciation method. Therefore, B expenses the entire
Treatment: amount of $15m in the 1st year.
• Capitalized as a non-current asset on Treatment:
the B/S. • The company expenses the entire
Non-current asset: ↑$15m cost of the assets of $15m in year
• The expense is allocated over 3 1.
years as depreciation expense.
Year 1 2 3 Year 1 2 3
Expense (depreciation) $5 $5 $5 Expense $15 $0 $0

335

incurred
2. Capitalizing interest expense
• When a firm constructs an asset for its own use or, in

limited circumstances, for resale, the interest that
Accounting accrues during the construction period is capitalized as a
treatment part of the asset’s cost.
• The treatment of construction interest is similar under
U.S. GAAP and IFRS.
Once construction interest is capitalized, the interest cost is
allocated to the income statement through depreciation
Effect on I/S
expense (if the asset is held for use), or COGS (if the asset is
held for sale).
Effect on Capitalized interest is reported in the cash flow statement
statement of as an outflow from investing activities.
cashflow
• Both capitalized and expensed interest should be used

Analytical when calculating interest coverage ratios.
implication • Any depreciation of capitalized interest on the income
statement should be added back when calculating
income measures.
336

[LOS 22.b] Explain and evaluate how capitalizing versus
expensing costs in the period in which they are incurred
affects financial statements and ratios
Continue with the example in LOS 22.a, we will demonstrate a shortened version of
financial statements of company A and B to see the difference between the effects of
capitalized and expensed costs. Assume that both company have a gross profit of $50
each year over three years and the tax rate is equal to 0%. A and B both pay no dividends
during that 3-year period. The beginning balance of retained earning (RE) is $0.
Company A Company B
(Capitalized Costs) (Expensed Costs)
Year 1 2 3 1 2 3
Effect on Cost $15 $15 $15 $0 $0 $0
asset (BS) Accumulated Dep. ($5) ($10) ($15) $0 $0 $0
Long-lived assets (CA) $10 $5 $0 $0 $0 $0
Effect on Year 1 2 3 1 2 3
income Expense ↑ $5 ↑ $5 ↑ $5 ↑ $15 $0 $0
(PL) Net income impact ↓ $5 ↓ $5 ↓ $5 ↓ $15 No impact
Year 1 2 3 1 2 3
Effect on RE impact ↓ $5 ↓ $5 ↓ $5 ↓ $15 No impact
equity Net income $45 $45 $45 $35 $50 $50
RE balance $45 $90 $135 $35 $85 $135
Year 1 2 3 1 2 3
Effect on ($15)
CFO $0 $0 $0 $0 $0
cash flow
CFI ($15) $0 $0 $0 $0 $0
337

1. Effect on Financial Statements
A recognized greater asset compared to B.

Effect on → Capitalization results in higher asset compared to immediately
asset (BS) expensing in the period that the expense is capitalized, and it continues
to be higher in the subsequent years.
• A allocated the expense in 3 years and only recognized $5 in the first

year,
• B recognized the total amount of the expense in the first year ($15)
Effect on
→ Capitalizing an expenditure could:
income
• delays the recognition of an expense into the income statement.
(PL)
• makes the net income higher in the period that it is capitalized, but in
the subsequent periods, it will report lower net income compared to
intermediate expensing.
When capitalizing the expenditure, retained earnings (equity) are higher

Effect on
in the period that the expense is capitalized, and it continues to be
equity
higher in the subsequent years.
Effect on Capitalizing an expenditure will result in higher operating cash flow and
equity lower investing cash flow compared to expensing.
338

6. Effect on financial ratio
Profitability ratio
As mentioned before, if a company capitalizes costs, compared to
immediately expensing:
First year Subsequent years
Net income higher lower

Assets higher higher
Owner’s equity higher higher
ROE (*) higher lower
ROA (*) higher lower
Net income Net income

(*) ROA = ROE =
Assets Equity
339

Solvency ratio
Debt the same the same

Owner’s equity higher higher
Debt-to-equity (*) lower lower
Debt-to-asset (*) lower lower
Debt Debt-to-equity ratio = Debt

(*) Debt-to-asset ratio = Equity
Assets
340

Solvency ratio
EBIT higher lower

Interest expense lower higher
Interest coverage (*) higher lower
EBIT
(*) Interest coverage =
Interest expense
341

Activity ratio
First year Subsequent year
Revenue the same the same

Total asset turnover (*) lower lower
Revenue
(*) Total asset turnover =
Average total asset
342

[LOS 22.c] Definition classification and recognition of long-
lived assets
Long-lived assets
Tangible assets Intangible assets

Long-term assets that Long-term assets that lack physical substance and
have physical substance. include items that involve exclusive rights such as
patents, copyrights, and trademarks.
Example: Land, plant,
machinery, equipment Intangible assets can be classified as:
• Intangible asset with a finite life
• Intangible asset with an indefinite life
Or
• Identifiable intangible assets (*)
• Unidentifiable intangible assets (**)
(*) Identifiable intangible assets

• They must be identifiable.
• They must be under the company’s control.
• They must be expected to earn future economic benefits.
(**) Unidentifiable intangible asset
One that cannot be purchased separately and may have an indefinite life
(goodwill).
343

lived assets
1. Tangible assets
a. Tangible assets acquired through an exchange
If the fair value of the If the fair value of the

acquired asset can be acquired asset cannot be
determined determined
On balance • Remove the carrying • Remove the carrying

sheet amount of the asset given amount of the asset given
up from noncurrent assets up from noncurrent assets
on the balance sheet. on the balance sheet.
• Add the fair value of the • Add the fair value of the
asset acquired. asset given up.
On income If the fair value of the asset No gain or loss is recognized.

statement acquired is greater/lower
than the value of the asset
given up, a gain/loss is
recorded on the income
statement.
344

lived assets
1. Tangible assets
b. Tangible assets acquired through purchase
Expenditures Capitalized Expensed
The purchase price x
Expenses other than the purchase price

(e.g., costs of shipping and installation and
x
other costs necessary to prepare the
asset for its intended use)
Subsequent expenses that are expected to

x
provide economic benefits beyond one year
Subsequent expenses that are not expected

to provide economic benefits beyond one x
year (e.g. repair costs)
Expenditures that extend an asset’s useful

x
life
345

lived assets
2. Intangible assets
a. Intangible Assets Created Internally
Treatment under IFRS
Expenditure Capitalized Expensed
On research phase (*) x
On development phase (**) x
(*) The research phase of an internal project refers to the period during which
a company cannot demonstrate that an intangible asset is being created.
(**) The development phase of an internal project refers to the period during
which a company can apply the research findings to a plan or design for
production.
There are some criteria to recognize a period as a development phase:
• A demonstration of the technical feasibility of completing the intangible
asset
• The intent to use or sell the asset.
346

lived assets
Treatment under US GAAP
Both research and development costs are generally expensed as incurred.

There is an exception for costs related to software development.
Software for sale
When the product’s technological

x
feasibility has not been established
When the product’s technological

x
feasibility has been established
347

lived assets
Treatment under US GAAP
Exception about software (continued)

Software for internal use
When it is not probable that the project will

be completed and that the software will be x
used as intended
When it is probable that the project will be

completed and that the software will be used x
as intended
Note: The logic in the treatment of software development costs under U.S.
GAAP is similar to the treatment of all costs of internally developed intangible
assets under IFRS.
348

lived assets
b. Purchased Intangible Assets
Intangible assets purchased Intangible assets purchased as a

individually group
Capitalized – The assets are recorded Capitalized – The assets are recorded
on the balance sheet at cost, on the balance sheet after allocating
typically its fair value at acquisition. the purchase price to each asset on
the basis of its fair value.
(See the example below)
Example:
AFS Co., a manufacturing company buys a group of intangible assets which
consists of A, B and C, with a purchase price of $30 million. The fair value of
them is correspondingly $7, $8, and $9 million. How will these assets be
recorded on the company’s balance sheet?
349

lived assets
b. Purchased Intangible Assets
Example (cont):
As stated above, the total purchase price is allocated to each asset on the basis
of its fair value. Thus, the intangible assets are recored on the B/S at:
purchase price
carrying amount =
sum of fair value
30
A is recorded on the B/S at: x 7 = 8.75 ($ mil)
7+8+9
30
B is recorded on the B/S at: x 8 = 10 ($ mil)
7+8+9
30
C is recorded on the B/S at: x 9 = 11.25 ($ mil)
7+8+9
350

lived assets
c. Intangible Assets Obtained in a Business Combination

The acquisition method is used to record intangible assets obtained in a
business combination. Under such method, the purchase price is allocated to
the identifiable assets and liabilities of the acquired firm on the basis of fair
value. Any remaining amount of the purchase price is recorded as goodwill.
Illustration: Intangible Assets obtained when A acquires B
1 Classification of the acquiree company’s assets (Company B)
Identifiable assets Unidentifiable assets
2 Calculating goodwill
B’s Net assets = B’s Identifiable assets - B’s Liability

Goodwill = Purchase price - B’s Net assets
3 Record the acquiree’s assets on the acquirer’s balance sheet
On A’s balance sheet

• Record B’s asset at fair value
• Record B’s liability at fair value
• Record a goodwill calculated in step 2.
351

[LOS 22.d] Measurement of long-lived assets
Herein this part 2 primary models to measure long-lived assets are introduced:
• Cost model (required under both US GAAP and IFRS)
• Revaluation model (only permitted under IFRS)
Cost model Revaluation model
Carrying value Carrying value
= =
Original cost Fair value
- -
Accumulated depreciation Accumulated depreciation
- -
Impairment charges Impairment charges
352

1. Cost model
Cost model is the model where the carrying amount of an asset equals
its historical cost minus accumulated depreciation/ amortization:
Carrying amount = Original cost – Accumulated depreciation (*) –

Impairment charges
(*)
• The accumulated year-end depreciation equals total depreciation
charged against the asset till the end of the current period.
• Depreciation charge depends on the depreciation method (more
detailed in LOS 22.d)
353

1. Cost model
Example: An asset is purchased by company A at a cost of $10.

The company uses the straight-line depreciation method,
salvage value is equal to 0 and the useful life of the asset is 5
years. What is the carrying amount of the asset at the end of
year 2, assumed that there is no impairment charges?
Answer:
The accumulated year-end depreciation equals total depreciation
charged against the asset till the end of the current period.
Year 1 Year 2 Year 3 Year 4 Year 5
Cost 10 10 10 10 10
Depreciation (2) (2) (2) (2) (2)

Accumulated
(2) (4) (6) (8) (10)
depreciation
Carrying value 8 6 4 2 0
354

2. Revaluation model
Initial measurement Subsequent measurement
test
Use the cost model Use the cost model
or revaluation model
• Under the revaluation model, the carrying amount of an asset is

reported at its fair value on the date of revaluation minus any
subsequent accumulated depreciation and subsequent impairment.
• Revaluation model is only allowed under IFRS.
Carrying amount = Fair value – Accumulated depreciation

– Impairment charges
Important: In the scope of CFA Curriculum:

For revaluation model only, to simplify, we assume that there is no
depreciation, amortization or impairment during the life of the long-lived
assets.
355

a. The case of gain in the initial revaluation
Initial revaluation (1) Subsequent revaluation (2)
Fair value > CA (initial gain) • Fair value > CA (subsequent gain)
Fair value Fair value
Carrying amount Revaluation RS↑

surplus ↑ Carrrying amount
CA ↑, RS ↑
• Asset: Carrying amount (CA) ↑ • Fair value < CA (subsequent loss)
• Equity: Revaluation surplus (RS) ↑ o Loss < the previous gain:
Fair value
Carrrying amount
CA ↓, RS ↓
o Loss > the previous gain:
Fair value
loss No RS
Carrrying amount
CA ↓, RS = 0, P&L loss
356

b. The case of loss in the initial revaluation
Initial revaluation (1) Subsequent revaluation (2)
Fair value < CA (Initial loss) • Fair value < CA (subsequent loss)
Fair value
Fair value loss Loss ↑
Carrying amount Carrying amount

CA ↓, loss ↑
• Asset: Carrying amount ↓
• P&L: Recognize a loss on the I/S • Fair value > CA (subsequent gain)
o Gain < the previous loss:
Fair value
Carrying amount Gain

CA ↑, gain on I/S
o Gain > the previous loss:
Fair value
RS ↑
Carrying amount Gain
CA ↑, gain on I/S till initial loss, RS ↑

357

c. Ilustration of the revaluation model
Example: Illustration of the revaluation model

A company purchases an asset for $10,000. After one year, it determines
that the value of the asset is $8,000 and another year later it determines
that the fair value of the asset is $15,000. Assuming that the company
follows the revaluation model to report this asset, describe the financial
statement impact of the revaluation in Year 1 and Year 2.
We present the answer in the next slide.
358

c. Ilustration of the revaluation model
Example: Illustration of the revaluation model (cont)

Initial revaluation (1) Subsequent measurement (2)
Fair value ($8,000) < Carrying • Fair value ($15,000) > Carrying
amount ($10,000) → initial loss: amount ($8,000) → subsequent
$8,000 gain
Loss = $2,000
• Gain = $15,000 - $8,000 =
$7,000 > Previous loss ($2,000)
$10,000 $15,000
• Carrying amount of the asset ↓,
becomes $8000 RS ↑
$8,000 $2,000
• Recognize a loss on the I/S, loss = $5000
$2,000 o PnL gain = $2,000

o Revaluation surplus ↑ $5,000
($7,000 - $2,000)
o Carrying amount of the asset ↑,
becomes $15,000
359

d. Evaluate how asset’s upward revaluation affect financial statement

and ratios
Carrying amount of Revaluation surplus Depreciation expense

the asset ↑ ↑ ↑
Asset↑ Equity ↑ Profit ↓
D/A and D/E ↓ ROA, ROE ↓

360

[LOS 22.e] Depreciation and amortization of long-lived assets
Depreciation Methods and Calculation of Depreciation

1.
Expense
a. Depreciation Methods
Straight-Line Depreciation
Under the straight-line method, the cost of the asset is allocated evenly
across its estimated useful life.
Depreciable cost
Depreciation expense =
Depreciable life
Original cost − Salvage value
=
Depreciable life
The residual value is the estimated amount that will be received from
disposal of the asset at the end of its useful life.
(Refer to the example presented in [LOS 22.c] Measurement of long-
lived assets, session 1. Cost model)
361


1.
Expense
Accelerated Depreciation
• Under accelerated depreciation methods, the allocation of
depreciable cost is greater in the early years of the asset’s use.
• One often-used accelerated depreciation method is the double-
declining balance (DDB) method:
Double declining balance depreciation expense in year x
Beginning book value
= ×2
Depreciable life
• Note that:
o Salvage value is not in the formula for double-declining balance
depreciation.
o Once the carrying (book) value of the asset reaches the salvage
value, no additional depreciation expense is recognized.
362


1.
Expense
Example: Illustration of calculating double declining balance

depreciation expense
Company A purchases an identical piece of manufacturing equipment
for use in their operations. The cost of the equipment is $3,000, the
estimated salvage value is $200, and the useful life of the equipment is 4
years. Calculate each company’s beginning net book value, annual
depreciation expense, end-of-year accumulated depreciation, and
ending net book value for each year.
Answer:
Double declining balance depreciation expense in year x
Beginning book value
= ×2
Depreciable life
Therefore, depreciation charges:
Year 1 = $3,000/4 x 2 = $1,500;
Year 2 = ($3000 - $1,500)/4 x 2 = $750
Year 3 = ($3000 - $1500 - $750)/4 x 2 = $375
Year 4 = ($3000 - $1500 - $750 - $375)/4 x 2 = $187.50
363

1.
Expense

depreciation expense (cont)
3. Beginning book
2. Adding up value minus
depreciation till the end depreciation expense
1. Use the formula
of the current period (3) = (4)-(1)
Beginning Depreciation Expense $ (1) Accumulated Ending Net

Net Book Depreciation $ Book Value $
Value $ (4) (2) (3)
Year 1 3,000 1,500 = (2/4) x $3,000 1,500 1,500
Year 2 1,500 750 = (2/4) x $1,500 2,250 750
Year 3 750 375 = (2/4) x $750 2,625 375
Year 4 375 187.5 = (2/4) x $375 2,812.5 187.5
Year 4 375 175 = 375 - 200 2,800 200

adjusted
Explain in the next slide

364

1.
Expense

depreciation expense (cont)
If depreciation charge of year 4 is $187.50, the year-end carrying amount

would be $187.50 < salvage value ($200) → We have to adjust the
depreciation expense.
→ The amount of depreciation charged should be:
Beginning book value of year 4 ($3000 - $1500 - $750 - $375 = $375) –
Salvage value = $375 - $200 = $175
365

1.
Expense
Units-of-production method
Depreciation under the units-of-production method is based on usage
rather than time. Depreciation expense is higher in periods of high
usage.
Units-of-production depreciation expense

Original cost −salvage value
= × Output in the period
Life in outputs unit
366

1.
Expense
Component Depreciation
• IFRS requires firms to depreciate the components of an asset
separately, thereby requiring useful life estimates for each
component.
For example, a building is made up of a roof, walls, flooring, electrical
systems, etc. → The useful life of each component is estimated and
depreciation expense is computed separately for each. See the example
below.
Example: Illustrating the calculation of component depreciation

expense
Global Airlines purchased a new airplane with an all-inclusive cost of $50
million, in which $47 million is the cost of aircraft component and $3 is
the cost of the interior. The useful life of the two is 30 years and 15
years, respectively, and assume that the salvage value is equal to zero.
Calculate depreciation expense in year 1 using the straight-line method,
assuming the interior is a separate component.
367

1.
Expense
Example: Illustrating the calculation of component depreciation

expense
• Depreciation expense of aircraft component in year 1:
Depreciable cost 47
Depreciation expense = = = 1.56 (mil $)
Depreciable life 30
• Depreciation expense of the interior component in year 1:
Depreciable cost 3
Depreciation expense = = = 0.2 (mil $)
Depreciable life 15
→ Year 1 depreciation expense = Depreciation expense of aircraft

component in year 1 + Depreciation expense of the interior component
in year 1 = 1.56 + 0.2 = 1.76 ($ mil)
368

1.
Expense
Depreciation method:
In the early years of an asset’s life, compared to straight-line
depreciation, using an accelerated depreciation method will result in:
First year Subsequent year
Net income lower higher

Assets lower higher
Owner’s equity lower higher
Sales the same the same
ROE lower higher
ROA lower higher
Asset turnover higher lower

ratio
369

Amortization methods for intangible assets with finite
2.
lives and calculate amortization expense
a. Amortization Methods
Intangible assets with finite Intangible assets with indefinite

useful lives useful life (*)
Being amortized like the Not being amortized

depreciation of tangible assets.
The same method:

straight-line, accelerated, and
units-of-production
(*) An intangible asset is considered to have an indefinite useful life

when there is “no foreseeable limit to the period over which the asset
is expected to generate net cash inflows” for the company.
Imagine that we have an intangible asset with a specific expiration

date, but it can be renewed at minimal cost, should we amortize this
asset?
370

Amortization methods for intangible assets with finite
2.
lives and calculate amortization expense
a. Amortization Methods
Imagine that we have an intangible asset with an a specific

expiration date (a license that will expire in 5 years) but it can be
renewed at minimal cost, should we amortize this asset?
Answer: The answer is no, because in this case we consider the asset to
have indefinite useful life, so we do not amortize it.
Read the example of Calculating amortization expense, LOS 22.f 2022
Schweser Notes, page 174).
b. The choice of amortization method and assumptions
The same as what was presented in session 1.b. The choice of

depreciation method and assumptions of this LOS.
371

[LOS 22.f] Impairment and derecognition of long-lived assets
1. Impairment of long-lived assets
a. Definition of impairment and effect of impairment on financial

statement
Definition: An impairment charge is made to reflect the unexpected

decline in the fair value of an asset.
Effects on a company’s financial statements:
• The carrying value of the asset decreases.
• Net income decreases by the amount of impairment loss.
• Impairment does not affect cash flows because it is a noncash charge.
b. Impairment of Property, Plant, and Equipment
Assessing whether there are indications of

impairment periodically.
When are the
assets tested
There is no indication There is indication of
for
of impairment impairment
impairment?
Not test for impairment Test for impairment

372

b. Impairment of Property, Plant, and Equipment (cont.)

When are the Indications of impairment include evidence of obsolescence,
assets tested for decrease in demand for the asset’s output, and technological
impairment? advancements.
IFRS
Impairment happens when
Recoverable amount < Carrying amount
max
Testing for fair value - value in use = the discounted value of future
impairment costs to sell cash flows expected from the asset
US GAAP
Recoverable amount =
undiscounted expected Carrying amount
future cash flows
<
IFRS US GAAP
Impairment loss = asset’s
Impairment loss
Impairment loss = carrying amount - fair value (or
(↓ asset, ↓ profit)
carrying amount - the the discounted value of future
recoverable amount cash flows, if fair value is not
known)
373

Example: Asset impairment

Information related to equipment owned by Brownfield Company
follows:
Original cost: $900,000
Accumulated depreciation to date: $100,000
Expected future cash flows: $795,000
Fair value: $790,000
Value in use: $785,000
Selling costs: $30,000
Assuming Brownfield will continue to use the equipment, test the asset
for impairment under both IFRS and US GAAP.
Answer:
Carrying amount = Original cost − Accumulated depreciation = $900,000
- $100,000 = $800,000
374


Answer:
Carrying amount = original cost − accumulated depreciation
= $900,000 - $100,000 = $800,000
Under IFRS
Recoverable amount Carrying amount
= $785,000
< = $800,000
→ the asset is impaired
max
fair value - costs to sell value in use
= $790,000 - $30,000 = $785,000
→ Impairment loss = Carrying amount - recoverable amount = $15,000
→ On the financial statement:
o The asset is written down to recoverable amount = $785,000
o Recognise a loss = $15,000 on income statement
Under US GAAP
Recoverable amount = → the asset

Carrying amount
undiscounted expected future < = $800,000 is impaired
cash flows = $795,000
→ Impairment loss = Carrying amount - fair value = $800,000 - $790,000 = $10,000
→ On the financial statement:
o The asset is written down to fair value = $790,000
o Recognise a loss = $10,000 on income statement
375

c. Impairment of Intangible Assets with a Finite Life (same as PPE)
d. Impairment of Long-Lived Assets Held for Sale (same as PPE)
A long-lived (non-current) asset is reclassified as held

Definition for sale rather than held for use when management’s
intent is to sell it and its sale is highly probable.
When are the assets Tested at the time of reclassification.

tested for impairment?
e. Reversals of Impairments of Long-Lived Assets
Under IFRS Under US GAAP

• Recoverable amount of an asset • Assets held for use: no reversal
of any type increases allowed
→ Impairment losses can be • Assets held for sale: if the fair
reversed. value increases after an
• The value of the asset can not be impairment loss, the loss can be
reversed to a value greater than reversed
the previous carrying amount.
• Reversal increases reported
profits.
376

f. Evaluate how impairment affect financial statements and ratios
The period the impairment happens The period after the impairment
Loss on I/S ↑ CA of the asset ↓ Depreciation ↓ CA of the asset ↓
Profit ↓ Asset ↓ Profit ↑ Asset ↓
Equity ↓ Equity ↓
ROA, ROE ↓ ROA, ROE ↑
The judgment required in determining asset impairments gives management

considerable discretion about the timing and amounts of impairment charges.
→ The chance for them to manipulate earnings.
• Delay recognizing an impairment loss until a period of relatively high earnings →
Smooth earnings
• Take more impairment charges in periods when earnings will be poor due to
external factors, or when new managements take over the company → The
resulting low earnings might not be perceived as the “fault” of management
377

2. Derecognition of long-lived assets
• A company derecognizes or removes an asset from its financial

statements when the asset is disposed of or is not expected to
provide any future economic benefits from use or disposal.
• Derecognition occurs when assets are sold, exchanged, or
abandoned.
a. When an asset is sold
BS & PL
• The asset is removed from the balance sheet and gain/loss is
recognized in the income statement.
Gain/Loss on asset disposal = Selling price - Carrying or book value of asset
• The gain or loss is usually reported in the income statement as a part

of other gains and losses, or reported separately if material.
CF
• Gains and losses on disposal of fixed assets can also be found on the
cash flow statement if prepared using the indirect method.
• The amount of proceeds from sale are included in cash flow from
investing activities.
378

2. Deregonition of long-lived assets
b. When an asset is retired or abandoned
BS & PL
• The carrying value of the asset is removed from the balance sheet.
• A loss of that amount is recognized in the income statement.
CF
• The company does not receive any cash.
c. When an asset is exchanged for another asset
Refer to session 1.a. Tangible assets acquired through an exchange, LOS

22.c Recognition of long-lived assets.
379

[LOS 22.g] Describe the financial statement presentation of
and disclosures relating to property, plant, and equipment
and intangible assets.
1. Disclosure of PPE
IFRS US GAAP
Basic disclosure
Basic disclosure
• The measurement bases used.
• The balances of major
• The depreciation method used.
classes of depreciable assets.
• Useful lives (or depreciation rate).
• General description of
• Accumulated depreciation at the
depreciation methods used
beginning and end of the period.
for major classes or
• Restrictions on title.
depreciable assets.
• Pledges of property as security.
• Depreciation expense for the
• Contractual agreements to acquire
period.
PP&E.
• Accumulated depreciation by
For impaired assets
major classes or in total.
• Amounts of impairment losses and
For impaired assets
reversals by asset class.
• A description of the impaired
• Where the losses and loss reversals are
asset.
recognized in the income statement.
• Circumstances that caused
• Circumstances that caused the
the impairment.
impairment loss or reversal.
• How fair value was
If the revaluation model is used
determined.
• The date of revaluation
• The amount of loss.
• Details of fair value determination.
• Where the loss is recognized
• The carrying amount under the cost
in the income statement.
model.
380

[LOS 22.g] Describe the financial statement presentation of
and disclosures relating to property, plant, and equipment
and intangible assets.
2. Disclosure of Intangible assets
IFRS US GAAP
• Same as PPE • Same as PPE

• In addition, the firm must disclose • In addition, the firm must provide
whether the useful lives are finite an estimate of amortization
or indefinite. expense for the next five years.
381

[LOS 22.h] Analyze and interpret financial statement
disclosures regarding property, plant, and equipment and
intangible assets
1. Calculation
Gross fixed assets (cost) = Accumulated depreciation + Net fixed assets (book value)
divide both sides of this equation by annual depreciation expense
Gross fixed assets Accumulated depreciation Net fixed assets

= +
Annual depreciation expense Annual depreciation expense Annual depreciation expense
Estimated useful or
Average age of asset Remaining useful life
depreciable life
2. Interpretation of the calculation

Help identify older, obsolete assets that might make the firm’s operations less efficient
(forecast future cash flows, identify major capital expenditures replacement).
Estimated useful life
Younger assets → More
efficient, more competitive Low average age High remaining useful life
Estimated useful life

Older assets → Less efficient,
Low remaining
less competitive, have to raise High average age
useful life
cash to replace the old assets
in the near future
382

[LOS 22.i] Compare the financial reporting of investment
property with that of property, plant, and equipment.
IFRS defines investment property as property that is owned (or
leased under a finance lease) for the purpose of earning rentals or
Definition capital appreciation or both.
US GAAP does not distinguish investment property from other
kinds of long-lived assets.
Investment property is not owner occupied, nor is it used for
Feature
producing the company’s products and services.
Cost model Fair value model

Similar to the cost Similar to revaluation model except
model used for the way net income is affected.
Measurement property, plant, and • FV > Carrying amount → Gain on
equipment. I/S (instead of recognizing
revaluation surplus in the
revaluation model)
Companies must disclose which model they have used (cost or

fair value) to value the property.
Cost model Fair value model
• Similar to those It must make additional disclosures
Disclosure required for PP&E. regarding how it has determined
• Further, the fair fair value and reconcile beginning
value of the and ending carrying amounts of
property should also investment property.
be disclosed.
383

Practice questions
22.a. Identify and contrast costs that are capitalized and costs that N/A
are expensed in the period in which they are incurred
22.b. Explain and evaluate how capitalizing versus expensing costs in N/A
the period in which they are incurred affects financial
statements and ratios
22.c. Definition, classification and recognition of long-lived assets 1, 3
22.d. Measurement of long-lived assets 2, 6
22.e. Depreciation and amortization of long-lived assets 2, 4, 5
22.f. Impairment and derecognition of long-lived assets 2, 7
22.g. Describe the financial statement presentation of and disclosures N/A

relating to property, plant, and equipment and intangible
assets.
22.h. Analyze and interpret financial statement disclosures regarding N/A

property, plant, and equipment and intangible assets
22.i. Compare the compare the financial reporting of investment 8

property with that of property, plant, and equipment.
384

Practice questions
1. JOOVI Inc. has recently purchased and installed a new machine for its
manufacturing plant. The company incurred the following costs:
Purchase price $12,980
Freight and insurance $1,200
Installation $700
Testing $100
Maintenance staff training costs $500
The total cost of the machine to be shown on JOOVI’s balance sheet is

closest to:
A. $14,180.
B. $14,980.
C. $15,480.
2. Intangible assets with finite useful lives mostly differ from intangible
assets with infinite useful lives with respect to accounting treatment
of:
A. revaluation.
B. impairment.
C. amortization.
385

Practice questions
3. Under US GAAP, when assets are acquired in a business combination,

goodwill most likely arises from:
A. contractual or legal rights.
B. assets that can be separated from the acquired company.
C. assets that are neither tangible nor identifiable intangible assets.
4. A company purchases a piece of equipment for €1,500. The
equipment is expected to have a useful life of five years and no
residual value. In the first year of use, the units of production are
expected to be 15% of the equipment’s lifetime production capacity
and the equipment is expected to generate €1,500 of revenue and
incur €500 of cash expenses.
The depreciation method yielding the lowest operating profit on the
equipment in the first year of use is:
A. straight line.
B. units of production.
C. double-declining balance.
5. A company is comparing straight-line and double-declining balance
amortization methods for a non-renewable six-year license, acquired
for €600,000. The difference between the Year 4 ending net book
values using the two methods is closest to:
A. €81,400.
B. €118,600.
C. €200,000.
386

Practice questions
6. MARU S.A. de C.V., a Mexican corporation that follows IFRS, has

elected to use the revaluation model for its property, plant, and
equipment. One of MARU’s machines was purchased for 2,500,000
Mexican pesos (MXN) at the beginning of the fiscal year ended 31
March 2010. As of 31 March 2010, the machine has a fair value of
MXN 3,000,000. Should MARU show a profit for the revaluation of
the machine?
A. Yes.
B. No, because this revaluation is recorded directly in equity.
C. No, because value increases resulting from revaluation can never be
recognized as a profit.
7. Under IFRS, an impairment loss on a property, plant, and equipment

asset is measured as the excess of the carrying amount over the
asset’s:
A. fair value.
B. recoverable amount.
C. undiscounted expected future cash flows.
8. Investment property is most likely to:
A. earn rent.
B. be held for resale.
C. be used in the production of goods and services.
387

Practice questions
1. B is correct. Only costs necessary for the machine to be ready to use can
be capitalized. Therefore, Total capitalized costs = 12,980 + 1,200 + 700
+ 100 = $14,980.
2. C is correct. An intangible asset with a finite useful life is amortized,

whereas an intangible asset with an indefinite useful life is not.
3. C is correct. Under both International Financial Reporting Standards
(IFRS) and US GAAP, if an item is acquired in a business combination
and cannot be recognized as a tangible asset or identifiable intangible
asset, it is recognized as goodwill. Under US GAAP, assets arising from
contractual or legal rights and assets that can be separated from the
acquired company are recognized separately from goodwill.
4. C is correct. The operating income or earnings before interest and taxes

will be lowest for the method that results in the highest depreciation
expense. The double-declining balance method results in the highest
depreciation expense in the first year of use.
Depreciation expense:
Straight line = €1,500/5 = €300.
Double-declining balance = €1,500 × 0.40 = €600.
Units of production = €1,500 × 0.15 = €225.
388

Practice questions
5. A is correct. As shown in the following calculations, at the end of Year
4, the difference between the net book values calculated using
straight-line versus double-declining balance is closest to €81,400.
• Net book value end of Year 4 using straight-line method = €600,000
– [4 × (€600,000/6)] = €200,000.
• Net book value end of Year 4 using double-declining balance
method = €600,000 (1 – 33.33%)^4 ≈ €118,600.
6. B is correct. In this case, the value increase brought about by the
revaluation should be recorded directly in equity. The reason is that
under IFRS, an increase in value brought about by a revaluation can only
be recognized as a profit to the extent that it reverses a revaluation
decrease of the same asset previously recognized in the income
statement.
7. B is correct. Under IFRS, an impairment loss is measured as the excess of
the carrying amount over the asset’s recoverable amount. The
recoverable amount is the higher of the asset’s fair value less costs to
sell and its value in use. Value in use is a discounted measure of
expected future cash flows. Under US GAAP, assessing recoverability is
separate from measuring the impairment loss. If the asset’s carrying
amount exceeds its undiscounted expected future cash flows,
the asset’s carrying amount is considered unrecoverable and the
impairment loss is measured as the excess of the carrying amount over
the asset’s fair value.
389

Practice questions
8. A is correct. Investment property earns rent. Inventory is held for

resale, and property, plant, and equipment are used in the production
of goods and services.
390
READING 23: INCOME TAXES

391

Learning outcomes
23.a. Describe the differences between accounting profit and taxable income
23.b. Illustrating the effect of temporary difference and the creation of

deferred tax liability, deferred tax asset, and deferred tax expense
23.c. The effect of permanent difference on the taxable income, income tax
expense, and the effective tax rate
23.d. Definition of deferred tax asset, deferred tax liability, tax base of assets
and liabilities
23.e. Calculate income tax expense, income taxes payable, deferred tax assets
and deferred tax liabilities
23.f. Evaluate the effect of tax rate changes on a company’s financial
statements and ratios
23.g. Describe the valuation allowance for deferred tax assets when it is
required and what effect it has on financial statements
23.h. Explain recognition and measurement of current and deferred tax items
23.i. Analyze disclosures relating to deferred tax items and the effective tax
rate reconciliation and explain how information included in these
disclosures affects a company’s financial statements and financial ratios
23.k. Identify the key provisions of and differences between income tax
accounting under IFRS and US. GAAP
392

WARM-UP: Financial accounting and tax accounting
Let’s begin with an illustrative example for income taxes
For accounting
For tax purposes
purposes
Revenue 100 100
Disposal of a car 20 20
Selling experimental products 0 10
Purchase without
0 (20)
supporting documents
Manufacturing cost (10) (10)
Profit 110 100
Profit for tax purpose is also (see the next slide) Profit for accounting purpose is
called taxable income also called accounting profit
393

WARM-UP: Financial accounting and tax accounting
Difference between the recognition of revenue and expense for tax and
accounting purposes may result in taxable income differing from accounting
profit. As a result, the amount of income tax expense recognized in the
income statement may differ from the tax payable to the tax authorities.
Recognition of revenue Recognition of revenue &

& expense for tax v expense for accounting
Taxable income Accounting profit
Taxable income x Tax rate + Deferred tax expense = Tax expense

394

Illustration I: Defining basic background for income taxes
For the current and the 4 following accounting years, company A recognises
a total revenue of $500, and it incurs the following expenditure:
• Purchase a machine for $100 and it estimates the useful life of the
machine is five years. However, under the tax scheme for that machine,
the tax authority only accepts the useful life of four years.
• Advertising expense of $100 each year in 5 years.
• Entertainment expenses of $20 each year for the current 5 years.
The tax rate is 20%.
The learning outcomes that we are going to get via working on this
illustration includes:
a. Describe the differences between accounting profit and taxable income
b. The effect of temporary difference and the creation of deferred tax
liability, deferred tax asset, and deferred tax expense
c. The effect of permanent difference on the taxable income, income tax
expense, and the effective tax rate
We approach this illustration under two cases:

Case 1: The entertainment expense is recognizable under tax law
Case 2: The entertainment expense is unrecognizable under tax law
395

Illustration I: Defining basic background for income taxes

Table 1.1
Year 0 1 2 3 4 5
Cost 100 100 100 100 100 100
Dep. Tax (25) (25) (25) (25)
Accounting (20) (20) (20) (20) (20)
CA Tax 75 50 25 0 0
Accounting 80 60 40 20 0
Temporary difference 5 10 15 20 0
DTL (Tem Diff *20%) 0 1 2 3 4 0
Table 1.2 +1 +1
Accounting profit Accounting base Tax base profit

(for financial reporting) profit (for tax) (for tax)
Revenue 500 500 500 500 500 500
Depreciation expense (20) (20) (20) (20) (25) (25)
Advertising expense (100) (100) (100) (100) (100) (100)
Entertainment expenses
(20) (20) (20) (20) (20) (20)
(Per diff)
Profit before tax 360 360
Tax expenses (72) (72)
Taxable profit 355 355
Income tax payable
(71) (71)
(20%)
Deferred tax expense (1) (1)
Net profit 288 288
396

[LOS 23.a] Describe the differences between accounting profit and
taxable income

We see that there is difference between the recognition of expense for
tax and accounting purposes, let’s look at Company A, year 1:
Expense For financial reporting (I) For tax purpose (III)
Depreciation expense $100/5 = $20 $100/4 = 25
This leads to the difference between accounting profit ($360) and the
taxable income ($355) recognized in year 1
The difference between income tax expense ($72) and income tax payable
($71)
Conclusion: Difference between the recognition of revenue and expense

for tax and accounting purposes may result in taxable income differing
from accounting profit. As a result, the amount of income tax expense
recognized in the income statement may differ from the tax payable to
the tax authorities.
397

[LOS 23.b] Illustrating the effect of temporary difference and the
creation of deferred tax liability, deferred tax asset, and deferred
tax expense
Difference in recognition of revenue

and expense for tax and accounting
purposes
Permanent Temporary
difference difference
(refer to LOS 23c) (refer to LOS 23b)
Deferred tax Deferred tax

asset liability
Change in Deferred tax asset/liab.

Taxable income
(between accounting periods)
× Tax rate
Deferred tax
Tax payable Tax expense
expense
398

tax expense
1. Definition of temporary difference
Tax (25) (25) (25) (25)

Accounting (20) (20) (20) (20) (20)
Difference -5 -5 -5 -5 20
Depreciation expense
• For each year from year 1 to year 4, depreciation charge for tax purpose is
higher than accounting treatment. ($25 each year and $20 each year,
respectively)
• However, the total impacts on the pre-tax income are the same between
two perspective (total impact = $25x4 for tax purpose = $20x5 for
accounting purpose)
The difference in taxable income and accounting profit is expected to reverse
in the future.
This is temporary difference (PnL approach)
A temporary difference refers to a difference between taxable income and

accounting profit, that is expected to reverse in the future.
399

tax expense
The creation of DTL/DTL at the existence of temporary

2.
difference
approach
Temporary
P&L
Accounting profit difference in Taxable income

pre-tax income
Recorded in Deferred tax Tax

Tax payable
P&L expense expense
This approach
Balance sheet ( B/S) approach
is popularly Change in Deferred tax asset, Deferred

used tax asset/liability is charged to P&L
statement (∆DTA or ∆DTL)
Recorded
Deferred tax asset/liability
in BS
Temporary
Carrying amount
difference in Tax base
of asset/liability account balance
400

tax expense
The creation of DTL/DTL at the existence of temporary
2.
difference
a. P&L approach

In the first 4 years, the depreciation expense under tax ($25) is greater than
depreciation expense under accounting ($20), the taxable income is then
lower than the accounting profit.
→ The company receives tax relief, which means that its tax payment is
deferred till the following years (lower tax payable for the current years).
→ To be specific, the amount of tax that is deferred each year is:
Deferred tax expense = (Accounting profit – taxable income) x tax rate
= ($25-$20) x 20% = $1
Which equals $1 x 4 = $4 in total for the first 4 years.
However, in year 5, when the depreciation expense under accounting ($20) is

greater than depreciation expense under tax law ($0), the taxable income is
then higher ($20 higher), so the tax payable is also higher
Deferred tax expense =($0 - $20) x 20% = -$4
→ The company is charged additional tax, so the difference is only temporary.
Year 0 1 2 3 4 5
Expense recognized - $1 $1 $1 $1 -$4
401

tax expense
a. Balance sheet approach

Now that the temporary difference occurs on an asset, here we introduce the definition
of “tax base of an asset”
Tax base of assets is the amount that will be deducted (expensed) on the tax return
in the future as the economic benefits of the assets are realized.
Now we will illustrate this definition, in case 1:
By the end of year 1, temporary difference of $5 shows that:
• Carrying amount = $80 → An amount of $80 expense will be allocated in the
future
• Tax base = $75 → Under tax law, an amount of $75 expense will be allocated in
the future, lower expense means higher profit and more tax payable.
 The temporary difference results in tax being payable in the future, a liability
(which is named deferred tax liability – DTL) is recorded:
 DTL = (carrying amount – tax base) x tax rate = $5 x 20% = $1.
The increase in the DTL balance (from $0 to $1) is recorded as an deferred tax
expense.
Deferred tax expense in year 1 = $1
The relationship between tax expense, tax payable and deferred tax expense in year
1 is shown as:
Deferred tax expense
Tax expense $72 = (Change in deferred tax
$1 + Tax payable $71
liability)
402

tax expense
c. The relationship between P&L and balance sheet approach
To investigate the relationship between PnL and balance sheet approach, let’s take
a closer look into the DTL and deferred tax expense recognized in the next years.
Continue with case 1
Notice: The table 1.1 shows us that the change in temporary difference in
account balance is equal to temporary difference in pre-tax income.
By the end of year 2, the company has a temporary difference of $10, which
includes the $5 brought forward from year 1, plus the additional difference of
$5 arising in year 2.
• A liability is therefore recorded equal to (Carrying amount – tax base) x tax
rate = $10 x 20% = $2.
• Since there was a liability of $1 recorded at the end of year 1, $1 arising in
DTL (the change in DTL in comparison with year 1) is recorded as an
deferred tax expense: ↑ deferred tax expense $1, and ↑ DTL $1
Use the same logic for year 3, 4 and 5, we can summarize the relationship between
Deferred tax expense (PnL approach) and DTL (balance sheet approach) as the table
presented in the next slide.
403

tax expense
4. The relationship between PnL and balance sheet approach
DTL and deferred tax expense recognized in the 5 years:
Year 0 1 2 3 4 5
DTL $0 $1 $2 $3 $4 $0
Deferred tax expense
- $1 $1 $1 $1 $(4)
recognized
• Under balance sheet approach, the difference is shown as a liability

account (DTL) whose balance is accumulated as we recognize expense
each year
• Under P&L approach, the difference in depreciation expense hit the
taxable income directly, so each year we recognize an expense (= ∆DTL).
In short, under the P&L approach, the difference is represented as expenses

(∆DTL), and these expenses are accumulated over the years under a liability
account – known as DTL (deferred tax liability) – represented under the
balance sheet approach.
Note: The treatment for deferred tax asset (DTA) is the same as the
treatments for DTL mentioned above.
404

[LOS 23.c] The effect of permanent difference on the taxable
income, income tax expense, and the effective tax rate

Table 2.1
Year 0 1 2 3 4 5
Cost 100 100 100 100 100 100
Dep. Tax (25) (25) (25) (25)
Accounting (20) (20) (20) (20) (20)
CA Tax 75 50 25 0 0
Accounting 80 60 40 20 0
Temporary difference 5 10 15 20 0
DTL (Tem Diff *20%) 0 1 2 3 4 0
Table 2.2 +1 +1
(I) Accounting profit (II) Accounting base (III) Tax base
(for financial reporting) profit (for tax) profit (for tax)
Revenue 500 500 500 500 500 500
Depreciation expense (20) (20) (20) (20) (25) (25)
Advertising expense (100) (100) (100) (100) (100) (100)
Entertainment expenses
(20) (20) 0 0 0 0
(Per diff)
Profit before tax 360 360
Tax expenses (76) (76)
Taxable profit 375 375
Income tax payable
(75) (75)
(20%)
Deferred tax expense (1) (1)
Net profit 284 284
405

1. The definition of permanent difference
Entertainment expense
• Under financial reporting purpose, we recognize entertainment
expense of $20 per year in 5 years.
• Under tax purpose, because we have no supporting document for
these expense, no entertainment expense is recorded.
• The total impact (in 5 years) is different, $20x5 for financial reporting
and $0 for tax purpose, and we can say, the difference is not going to
reverse in the future.
This is permanent difference
Permanent difference Temporary difference
A temporary difference refers to a

A permanent difference is a
difference between taxable
difference between taxable
income and accounting profit,
income and accounting profit that
that is expected to reverse in the
will not reverse in the future.
future.
406

1. The effect of permanent difference
For the treatment of temporary difference, after using the same approach as what we
did in Case 1, we find out that the temporary difference takes the same effect – and
leads to the recognition of $1 deferred tax expense.
But now, the relationship between tax expense, tax payable and deferred tax expense
in year 1 is shown as:
Tax expense $76 = Deferred tax expense $1 + Tax payable $75
Recall that in case 1, without permanent difference, we have:

Tax expense $72 = Deferred tax expense $1 + Tax payable $71
• The effect of permanent difference is a increase of $4 on tax expense ($76 - $72)

and tax payable ($75 - $71);
• This effect is caused by an increase of $20 in taxable income ($375 - $355), which
arises from the difference in recognition of entertainment expense under
accounting and tax.
As opposed to temporary difference, which is represented under DTL/DTA and

deferred tax expense, permanent difference “hit” the taxable income directly, and
causes a difference between accounting profit and taxable income that can not be
reversed in the future.
407

1. The effect of permanent difference
Without permanent difference

Tax expense $72 = Change in deferred $1 + Tax payable $71
tax liability
With permanent difference
Tax expense $76 = Change in deferred $1 + Tax payable $75
tax liability
Tax expense ($76) > accounting profit x tax rate ($72)

tax expense
→ = effective tax rate (21.11%) > statutory tax rate (20%)
accounting profit
Permanent difference leads to the difference between effective tax rate and
statutory tax rate.
408

[LOS 23.d] Deferred tax asset, deferred tax liability, tax base of assets
and liabilities
1. Definition of deferred tax asset/ liability
Deferred tax liability Deferred tax asset
The amounts of income taxes The amounts of income taxes

payable in future periods recoverable in future periods
409

[LOS 23.d] Deferred tax asset, deferred tax liability, tax base of assets
and liabilities
2. How deferred tax assets and liabilities are created
a. DTA/DTL arising from the temporary difference that occurs on an asset
Tax base of assets is the amount that will be deducted (expensed) on the tax
return in the future as the economic benefits of the assets are realized.
Carrying amount > tax base (refer

Carrying amount < tax base
to illustration I)
The expense deducted in the future The expense deducted in the future
for accounting profit > The expense for accounting profit < The expense
deducted in the future for taxable deducted in the future for taxable
income income
Future accounting profit < Future Future accounting profit > Future
taxable income taxable income
Future tax expense < Future tax Future tax expense > Future tax
payable payable
We have to pay more tax in the We have to pay less tax in the
future → Deferred tax liability future → Deferred tax asset
410

[LOS 23.d] Explain how deferred tax liabilities and assets are created,
calculate deferred tax liabilities and assets using balance sheet
approach
b. DTA/DTL arising from the temporary difference that occurs on an liability
• Tax base of liabilities = the carrying value of the liabilities – amounts

that will be deductible on the tax return in the future.
• Tax base of revenue received in advance = the carrying value – amount
of revenue that will not be taxed in the future
Example 1: Warranty liability

Company B makes an estimation of $5,000 warranty expenses for goods
sold. But on the tax point of view, warranty expense is not deductible
until warranty work is performed.
Discussion
• Carrying amount of warranty liability = $5000
• Note that for tax purpose, warranty expense is only recognized when
it actually occurs → amounts that will be deductible on the tax return
in the future = $5000
→ Tax base = Carrying amount - amounts that will be deductible on
the tax return in the future = $5000 - $5000 = $0
411

approach
Example 1: Warranty liability

Company B makes an estimation of $5,000 warranty expenses for goods
sold. But on the tax point of view, warranty expense is not deductible
until warranty work is performed.
Discussion (cont)
Let’s look at the temporary difference
• Carrying amount of warranty liability = $5000, this means that $5000
is expensed now.
• Tax base = $0, this means that $5000 would be expensed in the future
and therefore leads to lower taxable income and lower tax payable
(in the future)
→ We recognize a deferred tax asset.
412

approach
Carrying amount > tax base (refer

Carrying amount < tax base
to example 1)
The expense deducted in the future The expense deducted in the future
for accounting profit < The expense for accounting profit > The expense
deducted in the future for taxable deducted in the future for taxable
income income
Future accounting profit > Future Future accounting profit < Future
taxable income taxable income
Future tax expense > Future tax Future tax expense < Future tax
payable payable
We have to pay less tax in the We have to pay more tax in the
future → Deferred tax asset future → Deferred tax liability
413

approach
From our discussion above, we can also summarize the way DTL/DTA is
created as follows:
Temporary differences
Deductible temporary
Taxable temporary differences
differences
Assets: Carrying amount > Tax base Assets: Carrying amount < Tax base
Liabilities: Carrying amount < Tax base Liabilities: Carrying amount > Tax base
Expected to result in future taxable Expected to provide tax deductions

income in the future
Deferred tax liability (DTL) Deferred tax asset (DTA)

Tax to pay in the future Tax saving in the future
414

[LOS 23.e] Calculate income tax expense, income taxes
payable, deferred tax assets and deferred tax liabilities
Calculate income tax expense, income taxes payable,

1.
deferred tax assets and deferred tax liability
Here we recall the key formula that we have alreading illustrated at Illustration 1
Items Calculation
Income tax payable Taxable income x Tax rate
Taxes payable + Deferred tax expense

Income tax expense
Taxes payable + ΔDTL − ΔDTA
Deferred tax Temporary difference x Tax rate
liability/asset = |Carrying amount – Tax base| x Tax rate
• Refer to Illustration 1 to see how to calculate Income tax payable and

income tax expense
• Read example 2 and 3 in the next slides to see how to calculate tax base,
DTL and DTA
415

payable, deferred tax assets and deferred tax liabilities and
Practicing on calculating tax base of assets and liabilities,
2.
DTA and DTL
Example 2: Determining the Tax Base of an Asset
The following information pertains to Entiguan Sports, a hypothetical
developer of products used to treat sports-related injuries. (The treatment of
items for accounting and tax purposes is based on hypothetical accounting and
tax standards and is not specific to a particular jurisdiction.)
1. Dividends receivable: On its balance sheet, Entiguan Sports reports
dividends of €1 million receivable from a subsidiary. Dividends are not
taxable.
2. Development costs: Entiguan Sports capitalized development costs of €3
million during the year. Entiguan amortized €500,000 of this amount during
the year. For tax purposes amortization of 25 percent per year is allowed.
3. Research costs: Entiguan incurred €500,000 in research costs, which were all
expensed in the current fiscal year for financial reporting purposes. Assume
that applicable tax legislation requires research costs to be expensed over a
four-year period rather than all in one year.
4. Accounts receivable: Included on the income statement of Entiguan Sports
is a provision for doubtful debt of €125,000. The accounts receivable amount
reflected on the balance sheet, after taking the provision into account,
amounts to €1,500,000. The tax authorities allow a deduction of 25 percent of
the gross amount for doubtful debt.
Calculate the tax base and carrying amount for each item, and the DTL/DTA
that arises, suppose that the tax rate is 25%
416

2.
DTA and DTL
Example 2: Determining the Tax Base of an Asset
Solution:
1. Dividends receivable:
• For financial reporting: Carrying amount = €1,000,000
• For tax purpose: Tax base = €1,000,000 (recorded as cash)
• Notice: €1,000,000 dividend received is recognized as dividend income on
financial statement, but it is not reflected as income when calculating the
taxable income.
→ This constitutes a €1,000,000 difference between accounting profit and
taxable income, that can not be reversed.
→ Constitutes a permanent difference, and its effect is a decrease of
€1,000,000 x 25% = €250,000 on tax expense (as tax payable decreases
€250,000).
2. Development costs:
• For financial reporting, depreciation in year 1 = €500,000
Carrying Amount = €3,000,000 - €500,000 = €2,500,000
• For tax, depreciation in year 1 = €3,000,000 x 25% = €750,000
Tax base = €3,000,000 - €750,000 = €2,250,000
This is an asset, and Carrying Amount > Tax base
→ Recognise a deferred tax liability = (€2,500,000 - €2,250,000) x 25% =
€62,500
417

2.
DTA and DTL
Example 2: Determining the Tax Base of an asset
Solution:
3. Research costs:
• For financial reporting, the research cost is expensed immediately → no
asset on the balance sheet is recorded. Carrying amount = 0
• For tax, research costs are required to be expensed over a four-year
period → The amount incurred this year is €500,000/4 = €125,000
→ Tax base = The amount deductible in the future = €500,000 - €125,000
= €375,000
This is an asset, and Carrying Amount < Tax base
→ Recognize a deferred tax asset = (€375,000 – 0) x 25% = €93,750
4. Accounts receivable:
• For financial reporting, carrying amount of account receivable =
€1,500,000
• For tax, we need to make a deduction of 25 percent of the gross amount
for doubtful debt → Tax base of account receivable = €1,500,000 +
€125,000 - [25% × (€1,500,000 + €125,000)] = €1,218,750
This is an asset, and Carrying Amount > Tax base
→ Recognise a deferred tax liability = (€1,500,000 - €1,218,750) x 25%
= €70,312.5
418

[LOS
[LOS 23.e]
23.d] Calculate
Calculae theincome
tax basetaxofexpense, income
a company’s taxes
assets and
liabilities
2.
DTA and DTL
Example 2: Determining the Tax Base of an asset
Solution:
Carrying Tax base Temporary Will result in

amount (€) (€) difference (€) DTA/DTL
1. Dividends
1,000,000 1,000,000 0 Permanent difference
receivable
2. Development
2,500,000 2,250,000 250,000 DTL = €62,500
costs
3. Research
0 375,000 375,000 DTA = €93,750
costs
4. Accounts
1,500,000 1,218,750 281,250 DTL = €70,312.5
receivable
419

2.
DTA and DTL
Example 3: Determining the Tax Base of a Liability
The following information pertains to the hypothetical company Entiguan Sports
for the fiscal year -end. The treatment of items for accounting and tax purposes
is based on fictitious accounting and tax standards and is not specific to a
particular jurisdiction.
1. Donations: Entiguan Sports made donations of €100,000 in the current fiscal
year. The donations were expensed for financial reporting purposes, but are not
tax deductible based on applicable tax legislation.
2. Interest received in advance: Entiguan Sports received in advance interest of
€300,000. The interest is taxed because tax authorities recognize the interest to
accrue to the company (part of taxable income) on the date of receipt.
3. Rent received in advance: Entiguan recognized €10 million for rent received in
advance from a lessee for an unused warehouse building. Rent received in
advance is deferred for accounting purposes but taxed on a cash basis.
4. Loan: Entiguan Sports secured a long-term loan for €550,000 in the current
fiscal year. Interest is charged at 13.5 percent per annum and is payable at the
end of each fiscal year.
Calculate the tax base and carrying amount for each item.
420

2.
DTA and DTL
Solution:
1. Donations:
• For financial reporting, the donations are expensed immediately → no
asset or liability on the balance sheet is recorded. Carrying amount = 0
• For tax, donations are not allowed to be deducted for tax purposes
→ Tax base = CA - amount to be deducted in the future = €0
• Notice: €100,000 is expensed under financial accounting, while it is not
deductible under tax law.
→ This constitutes a €100,000 difference between accounting profit and
taxable income, that can not be reversed.
→ Constitutes a permanent difference, and its effect is a decrease of
€100,000 x 25% = €25,000 on taxable income.
2. Interest received in advance
• For accounting purposes, the interest income received in advance is a
balance sheet liability. Carrying amount = €300,000
• For tax, the interest is taxed on the date of receipt, therefore
$300,000 is included in the taxable this year
→ Tax base of revenue received in advance = the carrying value –
amount of revenue that will not be taxed in the future
= €300,000 - €300,000 = 0
421

2.
DTA and DTL
Solution:
2. Interest received in advance (cont.)
This is a liability, and carrying amount > tax base
→ Recognize a deferred tax asset = (€300,000 – 0)x25% = €75,000
3. Rent received in advance
We use the same logic as Interest received in advance:
Carrying amount = €10,000,000
Tax base = €0
→ Recognize a deferred tax asset = (€10,000,000 – 0)x25% = €2,500,000
4. Loan
• Loan
o For accounting purpose, Carrying amount of the loan = €550,000
o For tax, tax base of the loan = €550,000
Carrying amount = tax base → no DTL/DTA
• Interest payment
o For accounting purpose, the interest is immediately expensed, so
carrying amount = 0
o For tax, tax base = CA - amount to be deducted in the future
=0–0=0
Carrying amount = tax base → no DTL/DTA
422

2.
DTA and DTL
Solution:
Carrying Tax base Temporary Will result in

amount (€) (€) difference (€) DTA/DTL
1. Donations 0 0 0 Permanent
difference
2. Interest received €300,000 0 €300,000 DTA = €75,000

in advance
3. Rent received in €10,000,00 0 €10,000,000 DTA = €250,000

advance 0
4. Loan 0 0 0 No difference
Interest paid 0 0 0 No difference

423

[LOS 23.f] Evaluate the effect of tax rate changes on a
company’s financial statements and ratios
Evaluate the effect of tax rate change on a company’s
1.
financial statements
When tax rate decrease, the following items will be effected. We use the same
logic for the case in which tax rate increases.
Tax rate decrease
Deferred tax assets Or Deferred tax liabilities

decrease decrease
Change in deferred tax Change in deferred tax

assets decrease liabilities decrease
= Tax payable +
Income tax expense Income tax expense
ΔDTL − ΔDTA
increases decreases
Net income decreases Net income increases
Retained earnings Retained earnings

decrease increase
Shareholder’s equity Shareholder’s equity

decrease increase
424

1.
Example 4: Effect of tax rate change on a company’s financial statements

A firm owns equipment and bad debt that will be shown below. (The tax
rate is 40%)
Items Carrying value Tax base Deferred tax asset/ liability

(‘000) (‘000) (‘000)
Equipment $200 $160 DTL = $16 [=($200 - $160) ×

40%]
Bad debt 0 $10 DTA = $4 [(=$10 – 0) x 40%]

expense
Calculate the effect on the firm’s income tax expense if the tax rate
decreases to 30%.
425

1.
Solution:
Items Carrying Tax base Deferred tax asset/ Deferred tax asset/
value (‘000) liability (tax rate = liability (tax rate =
(‘000) 40%) (‘000) 30%) (‘000)
Equipment $200 $160 DTL = $16 DTL = $12

[=($200 - $160) × [=($200 - $160) ×
40%] 30%]
Bad debt 0 $10 DTA = $4 DTA = $3

expense [($10 – 0) x 40%] [($10 – 0) x 30%]
• Deferred tax liability decreases by $4,000 ($16,000 reported DTL - $12,000

adjusted DTL).
• Deferred tax asset decreases by $1,000 ($4,000 reported DTA - $3,000
adjusted DTA).
Using the income tax equation, we can see that income tax expense decreases
by $3,000 (income tax expense = taxes payable + ∆DTL - ∆DTA).
426

2. Evaluate the effect of tax rate change on a company’s ratios
Again we assume that the tax rate is decrease, the following ratios will be
effected
Ratios Effect
Long term Debt to • Decrease in deferred tax asset → Decrease in equity →

Equity ratio Increase in long term debt to equity
Long−term debt • Decrease in deferred tax liability → Increase in equity →
( )
Total equity Decrease in long term debt to equity
• Decrease in deferred tax asset → Decrease in equity →

Debt to equity ratio Increase in long term debt to equity
Total debt
(Total equity) • Decrease in deferred tax liability → Increase in equity →
Decrease in long term debt to equity
Total debt ratio • Decrease in deferred tax asset → Decrease in asset

Total debt → Increase in total debt ratio
( )
Total asset • Decrease in deferred tax liability → Increase in asset
→ Decrease in total debt ratio
• Decrease in deferred tax asset → Decrease in asset &

Financial leverage equity → Increase in financial leverage
Average total asset
(Average total equity) • Decrease in deferred tax liability → Increase in asset &
equity → Decrease in financial leverage
427

[LOS 23.g] Describe the valuation allowance for deferred tax
assets when it is required and what effect it has on financial
statements
1. Describe the valuation allowance for deferred tax assets
• Deferred tax assets are assessed at each balance sheet date to determine the
likelihood of sufficient future taxable income to recover the tax assets. (Without
future taxable income, a Deferred tax assets is worthless)
• Under U.S. GAAP, DTA are reduced by creating a contra-asset account known as the
valuation allowance.
More likely to recover Not require valuation allowance

Sufficient future taxable income is more
likely to recover the tax assets or not ?
(>50%) account
Example: If a company has order backlogs or existing contracts which are

expected to generate future taxable income, a valuation allowance might not
be necessary.
More likely to not recover Require valuation allowance account
Example: If a company has cumulative losses over the past few years or a
history of inability to use tax loss carry forwards, then the company would
need to use a valuation allowance
428

[LOS 23.g] Describe the valuation allowance for deferred tax
assets when it is required and what effect it has on financial
statements
2. Effect of valuation allowance on financial statements
Valuation allowance increases Valuation allowance decreases
Deferred tax asset decreases Deferred tax asset increases
Change in deferred tax asset

Change in deferred tax asset increases
decreases
Income tax expense increases Income tax expense decreases
Net income decreases Net income increases
Retained earnings decreases Retained earnings increases
Shareholder’s equity decreases Shareholder’s equity increases

429

[LOS 23.h] Explain recognition and measurement of current
and deferred tax items
1. Recognition of unused tax losses and tax credits
Tax losses: A tax loss (tax loss carryforward) is a provision that allows
a taxpayer to move a tax loss to future years to offset a profit.
Tax credit: A tax credit is an amount of money that taxpayers can
subtract directly from taxes owed to their government.
These two reduce the amount of

taxable income in the future
IFRS and US GAAP allow the creation of a deferred tax asset in the case
of tax losses and tax credits. The recognition is specified below:
IFRS US GAAP
IFRS allows the recognition of A deferred tax asset
unused tax losses and tax credits is recognized in full but is then
only to the extent reduced by a valuation allowance
that it is probable that in the if it is more likely than not that
future there will be taxable some or all of the deferred tax
income against which the asset will not be realized.
unused tax losses and credits can
be applied
430

1. Recognition of unused tax losses and tax credits
The existence of tax losses may indicate that the entity cannot reasonably be
expected to generate sufficient future taxable income
→ there are concerns about the uncertainty of future taxable profits
→ in this case, we follow these criteria:
• Taxable temporary differences are available to offset deferred tax payable
• Assess the probability that the entity will in fact generate future taxable
profits before the unused tax losses and/or credits expire (*)
• Verify that the above is with the same tax authority and based on the same
taxable entity
• Determine whether the past tax losses were a result of specific
circumstances that are unlikely to be repeated
• Discover if tax planning opportunities are available to the entity that will
result in future profits. (**)
(*) Taxable profit → DTA (**)

opportunity
+
Unused tax loss profit
Loss loss loss loss loss

Before adding the effect of unused tax loss, Illustration for tax planning
we assess the probability of taxable profit
to decide whether to recognize a DTA.
431

2. Recognition of deferred tax charged directly to equity
Recognition of deferred tax items
Recognition of deferred tax items in Recognition of deferred tax items in

profit or loss other comprehensive income and not
→ Deferred Tax effect on equity effect on net income
through effect on net income (see → Deferred Tax charged directly to
more in previous LOS) equity
The following are example of deferred tax charged directly to equity:

• Revaluation of property, plant, and equipment (revaluations are not permissible
under US GAAP);
• Long- term investments at fair value;
• Changes in accounting policies;
• Errors corrected against the opening balance of retained earnings;
• Initial recognition of an equity component related to complex financial instruments;
and
• Exchange rate differences arising from the currency translation procedures for
foreign operations.
432

[LOS 23.i] Analyze disclosures relating to deferred tax items
and the effective tax rate reconciliation and explain how
information included in these disclosures affects a company’s
financial statements and financial ratios
Analyzing disclosures relating deferred tax items and the
1.
effective tax rate reconciliation
a. Analyzing disclosures relating deferred tax items
Details on the source of the temporary differences that cause the deferred
tax assets and liabilities reported.
Typically, the following deferred tax information is disclosed:
• Deferred tax liabilities, deferred tax assets, any valuation allowance, and
the net change in the valuation allowance over the period.
• Any unrecognized deferred tax liability for undistributed earnings of
subsidiaries and joint ventures.
• Current-year tax effect of each type of temporary difference.
• Components of income tax expense.
• Reconciliation of reported income tax expense and the tax expense
based on the statutory rate.
• Tax loss carry forwards and credits.
433

Analyzing disclosures relating deferred tax items and the
1.
effective tax rate reconciliation
b. The effective tax rate reconciliation
Some firms’ reported income tax expense differs from the amount based
on the statutory income tax rate. Thus, firm need explain the differences
between:
• The statutory rate tax (the tax rate of the jurisdiction where the firm
operates)
Income tax expense
• The effective tax rate (= )
Pretax income
The differences are generally the result of:
• Different tax rates in different tax jurisdictions (countries).
• Permanent tax differences: tax credits, tax-exempt income, nondeductible
expenses, and tax differences between capital gains and operating income.
• Changes in tax rates and legislation.
• Deferred taxes provided on the reinvested earnings of foreign and unconsolidated
domestic affiliates.
• Tax holidays in some countries (watch for special conditions such as termination
dates for the holiday or a requirement to pay the accumulated taxes at some point
in the future)
434

Explain how information included in these disclosures
2.
affects a company’s FS and financial ratios
Example 5: Analyzing deferred tax item disclosures

Use the table below to explain why income tax expense has exceeded taxes payable
over the last three years. Also explain the effect of the change in the valuation
allowance on WCCO’s earnings for 20X5
20X5 ($) 20X4 ($) 20X3 ($)
Employee benefits 278 310 290
Internal tax loss carry forwards 101 93 115
Valuation allowance (24) (57) (64)
Deferred tax asset 355 346 341
Property, plant and equipment 452 361 320
Unrealized gain on available for sale securities 67 44 23
Deferred tax liability 519 405 343
Deferred income taxes 164 59 2

435

Example 5: Analyzing deferred tax item disclosures

Solution:
Explain why income tax expense has exceeded taxes payable over the last three
years
• The company’s deferred tax asset balance = international tax loss carry forwards +
employee benefits (most likely pension and other post-retirement benefits) –
valuation allowance.
• The company’s deferred tax liability balance = property, plant, and equipment (most
likely from using accelerated depreciation methods for tax purposes and straight-
line on the financial statements) + unrealized gains on securities classified as
available-for-sale (because the unrealized gain is not taxable until realized).
• Income tax expense = taxes payable + deferred income tax expense
= taxes payable + ∆deferred tax liabilities – ∆deferred tax assets
Because deferred tax liabilities have been growing faster than deferred tax assets,
deferred income tax expense has been positive, resulting in income tax expense
being higher than taxes payable.
Explain the effect of the change in the valuation allowance on WCCO’s earnings for
20X5
• Management decreased the valuation allowance by $33 million in 20X5  a
reduction in deferred income tax expense and an increase in reported earnings for
20X5
436

Example 6: Analyzing the tax rate reconciliation

Analyze the trend in effective tax rates over the three years shown in NDC Co by using
following information:
20X3 20X4 20X5
Statutory U.S. federal income tax rate 35% 35% 35%
State income taxes, net of related federal 2.1% 2.2% 2.3%

income tax benefit
Benefits and taxes related to foreign (6.5%) (6.3%) (2.7%)

operations
Tax rate changes 0% 0% (2%)
Property, plant and equipment 0% (3%) 0%
Special items (1.6%) 8.7% 2.5%
Other, net 0.8% 0.7% (1.4%)
Effective income tax rates 29.8% 37.3% 33.7%

437

Example 6: Analyzing the tax rate reconciliation (cont)

Solution:
• The effective tax rate is upward trending over the 3-year period.
Contributing to the upward trend is
o An increase in the state income tax rate and
o A decrease in benefits related to taxes on foreign income.
• In 20X4, taxes created by special items are increased significant and
partially offset the decrease in taxes created by sale of PPE.
• In 20X3 and 20X5, the special items and the other items also offset each
other. The fact that the special items and other items are so volatile over
the 3-year period suggests that it will be difficult for an analyst to
forecast the effective tax rate for NDC for the foreseeable future
without additional information. This volatility also reduces comparability
with other firms.
438

[LOS 23.j] Identify the key provisions of and differences
between income tax accounting under IFRS and US. GAAP
• Accounting for income taxes under U.S. GAAP and IFRS is similar in most
respects.
• However, there are some differences. The following table is a summary of a
few of the more important differences.
IFRS GAAP
Revaluation of fixed Deferred taxes are recognized No applicable, no

assets and in equity revaluation allowed
intangible asset
Undistributed profit Deferred taxes are recognized • No deferred taxes for

from an investment unless the parent is able to foreign subsidiary that
in a subsidiary control the distribution of meet the indefinite
profit and it is probable the reversal criterion
temporary difference will • No deferred taxes for
reverse in the future domestic subsidiary if
the amounts are tax free
Undistributed profit Deferred taxes are recognized No deferred taxes for joint
from an investment unless the parent is able to venture that meet the
in a joint venture control the distribution of indefinite reversal criterion
profit and it is probable the
temporary difference will
reverse in the future
439

[LOS 23.j] Identify the key provisions of and differences
between income tax accounting under IFRS and US. GAAP
IFRS GAAP
Undistributed Deferred taxes are Deferred taxes are

profit from an recognized unless the recognized from
investment in an investor is able to control temporary differences
associate firm the sharing of profit and it
is probable the temporary
difference will not reverse
in the future
Deferred tax asset Recognized if probable that Recognized in full and

recognition sufficient taxable profit will then reduced if “more
be available to recover the likely than not” that
tax asset some or all of the tax
asset will not be
realized
Tax rate used to Enacted or substantively Enacted tax rate only

measure deferred enacted tax rate
taxes
440

Practice questions
23.a. Describe the differences between accounting profit and N/A

taxable income and define key terms
23.b. Explain how deferred tax liabilities and assets are created Question 1, 2
and the factors that determine how a company’s deferred tax
liabilities and assets should be treated for the purposes of
financial analysis
23.c. Calculate the tax base of a company’s assets and liabilities Question 3
23.d. Calculate income tax expense, income taxes payable, Question 4, 5

deferred tax assets and deferred tax liabilities and Calculate and
interpret the adjustment to the financial statements related to a
change in the income tax rate
23.e. Evaluate the effect of tax rate changes on a company’s N/A

financial statements and ratios
23.f. Identify and contrast temporary versus permanent N/A

differences in pre-tax accounting income and taxable income
441

Practice questions
23.g. Describe the valuation allowance for deferred tax assets Question 6
when it is required and what effect it has on financial statements
23.h. Explain recognition and measurement of current and N/A

deferred tax items
23.i. Analyze disclosures relating to deferred tax items and the N/A
effective tax rate reconciliation and explain how information
included in these disclosures affects a company’s financial
statements and financial ratios
23.j. Identify the key provisions of and differences between N/A

income tax accounting under IFRS and US. GAAP
442

Practice questions
1. Using the straight-line method of depreciation for reporting purposes

and accelerated depreciation for tax purposes would most likely result
in a:
A valuation allowance.
B deferred tax asset.
C temporary difference.
2. Income tax expense reported on a company’s income statement equals

taxes payable, plus the net increase in:
A deferred tax assets and deferred tax liabilities.
B deferred tax assets, less the net increase in deferred tax liabilities.
C deferred tax liabilities, less the net increase in deferred tax assets
3. The author of a new textbook received a $100,000 advance from the

publisher this year. $40,000 of income taxes were paid on the advance
when received. The textbook will not be finished until next year.
Determine the tax basis of the advance at the end of this year.
A $0.
B $40,000.
C $100,000
443

Practice questions
4. A firm acquires an asset for $120,000 with a 4-year useful life and no
salvage value. The asset will generate $50,000 of cash flow for all four
years. The tax rate is 40% each year
The firm will depreciate the asset over three years on a straight-line
(SL) basis for tax purposes and over four years on a SL basis for financial
reporting purposes. Taxable income in year 1 is:
A $6,000.
B $10,000.
C $20,000
5. A firm acquires an asset for $120,000 with a 4-year useful life and no
salvage value. The asset will generate $50,000 of cash flow for all four
years. The tax rate is 40% each year
The firm will depreciate the asset over three years on a straight-line
(SL) basis for tax purposes and over four years on a SL basis for
financial reporting purposes. Pretax income in year 4 is:
A $6,000.
B $10,000.
C $20,000
444

Practice questions
6. A company has following information:

Year ended 30 June Year 1 Year 2 Year 3
Expected federal income ($112,000) $768,000 $685,000

tax expense
Expenses not deductible $357,000 $32,000 $51,000

for income tax purposes
State income taxes, net $132,000 $22,000 $100,000

of federal benefit
Change in valuation ($150,000) ($766,000) ($754,000)

allowance for deferred
tax assets
Income tax expense $227,000 $56,000 $82,000
Over the three years presented, changes in the valuation allowance

for deferred tax assets were most likely indicative of:
A decreased prospect for future profitability.
B increased prospects for future profitability.
C assets being carried at a higher value than their tax base
445

Practice answers
1. C is correct. Because the differences between tax and financial accounting

will correct over time, the resulting deferred tax liability, for which the
expense was charged to the income statement but the tax authority has
not yet been paid, will be a temporary difference. A valuation allowance
would only arise if there was doubt over the company’s ability to earn
sufficient income in the future to require paying the tax.
2. C is correct. Higher reported tax expense relative to taxes paid will

increase the deferred tax liability, whereas lower reported tax expense
relative to taxes paid increases the deferred tax asset.
3. A For revenue received in advance, the tax base is equal to the carrying
value minus any amounts that will not be taxed in the future. Since the
advance has already been taxed, $100,000 will not be taxed in the future.
Thus, the textbook advance liability has a tax base of $0 ($100,000
carrying value – $100,000 revenue not taxed in the future)
4. B Annual depreciation expense for tax purposes is ($120,000 cost – $0

salvage value) / 3 years = $40,000. Taxable income is $50,000 – $40,000 =
$10,000.
446

Practice answers
5. C Annual depreciation expense for financial purposes is ($120,000 cost –

$0 salvage value) / 4 years = $30,000. Pretax income is $50,000 – $30,000
= $20,000
6. B is correct. Over the three-year period, changes in the valuation

allowance reduced cumulative income taxes by $1,670,000 (= 766,000 +
754,000 + 150,000). The reductions to the valuation allowance were a
result of the company being “more likely than not” to earn sufficient
taxable income to offset the deferred tax assets.
447
READING 24: NON-CURRENT

(LONG-TERM) LIABILITIES
448
READING 24: NON-CURRENT (LONG-TERM)

LIABILITIES
Learning outcomes
Bonds
24.a. Determine the initial recognition and initial measurement

of bonds
24.b. Determine the subsequent recognition of bonds using the

effective interest method and calculate interest expense,
amortization of bond discounts/premiums, and interest
payments
24.c. Explain the derecognition of debt
24.d. Describe the role of debt covenants in protecting creditors
24.e. Describe the financial statement presentation of and

disclosures relating to debt
449

LIABILITIES
Learning outcomes
Leases
24.f. Explain motivations for leasing assets instead of purchasing

them
24.g. Explain the financial reporting of leases from a lessee’s

perspective
24.h. Explain the financial reporting of leases from a lessor’s

perspective
Pensions and evaluating solvency
24.i. Compare the presentation and disclosure of defined

contribution and defined benefit pension plans
24.j. Calculate and interpret leverage and coverage ratios

450

LIABILITIES
[LOS 24.a] Determine the initial recognition and initial
measurement of bonds
1. Bond Terminology
A bond is a contractual promise between a borrower (the bond issuer)

and a lender (the bondholder) that obligates the bond issuer to make
payments to the bondholder over the term of the bond.
Two types of payments are involved:
• Periodic interest payments
• Repayment of principal at maturity
Face or Par The amount of principal that will be paid to the bondholder at
value maturity and is used to calculate the coupon payments.
Coupon The interest rate stated in the bond that is used to calculate
rate the coupon payments and is typically fixed for the term of
bonds.
Coupon The periodic interest payments to the bondholders and are

payments calculated by multiplying the face value by the coupon rate
451

LIABILITIES
1. Bond Terminology
Effective • The market rate of interest that is used to value the bond
rate of and depends on the bond’s risks as well as the structure of
interest interest rates and the timing of the bond’s cash flows.
• The market rate will likely change over the bond’s life,
which changes the bond’s market value as well.
The • Known as the book value or the carrying value of the bond,
balance equals to the present value (PV) of its remaining cash flows
sheet (coupon payments and par value), discounted at the market
liability rate of interest at issuance.
• At maturity, the liability will equal the face value of the
bond.
Interest Reported in the income statement and is calculated by

expense multiplying the book value of the bond liability at the
beginning of the period by the market rate of interest of the
bond at issuance.
452

LIABILITIES
1. Bond Terminology
At the date of issuance, the market rate can be the same as or

different than the coupon rate:
Market rate > Market rate = Market rate <

coupon rate coupon rate coupon rate
the bond is a the bond is a par the bond is a

discount bond bond (priced at face premium bond
(priced below par). value) (priced above par).
453

LIABILITIES
1. Bond Terminology
Example 1: Discount, Premium and Par bond

On December 31, 20X2, a company issued a 3-year, 10% annual coupon
bond with a face value of $100, assuming the bond was issued at a market
rate of interest (r) of:
a. 9%.
b. 10%
c. 11%
Answer:
Coupon payment each period = 10% × $100 = $10
Issuance date 31 Dec 20X3 31 Dec 20X4 31 Dec 20X5
a. PV = $102.531 $10 $10 $10 + $100 = $110

b. PV = $100
c. PV = $97.556
454

LIABILITIES
1. Bond Terminology
Example 1: Discount, Premium and Par bond

Answer:
a. The market rate of 9% < the coupon rate of 10% → the bond is issued at
premium.
The bond proceeds = the book value at issuance = $102.531 > Par
(N = 3, PMT = 10, FV = 100, I/Y = 9, CPT → PV = - 102.531)
b. The market rate of 10% = the coupon rate of 10% → the bond is issued
at Par.
The bond proceeds = the book value at issuance = Par = $100
c. The market rate of 11% > the coupon rate of 10% the bond is issued at
discount.
The bond proceeds = the book value at issuance = $97.556 < Par
(N = 3, PMT = 10, FV = 100, I/Y = 11, CPT → PV = - 97.556)
455

LIABILITIES
2. Initial recognition of bond issued
(Continue with example 1)
Par bond Premium bond Discount bond
Assets and Liabilities increase by the bond proceeds

Balance
sheet Bond proceeds Bond proceeds Bond proceeds
= $100 = $102.531 = $97.556
Income
No effect
statement
The issued proceeds are reported as a cash inflow

Cash flow from financing (CFF)
statement
CFF = +$100 CFF = +$102.531 CFF = +$97.556
456

LIABILITIES
[LOS 24.b] Determine the subsequent measurement of bonds
using the effective interest method: calculate interest
expense, amortization of bond discounts/premiums, and
interest payments
1. Effective interest method
Premium bond
PV ($102.531) – Total premium amortization in 3 years (2.531) = Par ($100)
Market rate < coupon rate → interest expense < the coupon payment
→ premium amortization each year = coupon payment – interest expense
Discount bond
PV ($97.556) + Total discount amortization in 3 years (2.444) = Par ($100)
Market rate > coupon rate → interest expense > the coupon payment
→ discount amortization each year = interest expense – coupon payment
457

LIABILITIES
interest payments
Zero-coupon bond
• Zero-coupon bonds, known as pure-discount bonds have no

periodic coupon payments.
• The effects of zero-coupon bonds on the financial statements
are the same as any discount bonds but with larger impact due
to larger discount.
458

LIABILITIES
interest payments
Example 2: Effective interest method

Consider discount and premium bonds in the Example 1
459

LIABILITIES
interest payments
Answer:
Premium bond ( r = 9%) Discount bond (r = 11%)
Bond Liability
20X3 20X4 20X5 20X3 20X4 20X5
Beginning
$102.531 $101.759 $100.917 $97.556 $98.287 $99.099
book value (1)
Interest
expense (2) = $9.228 $9.158 $9.083 $10.731 $10.812 $10.901
(1) × r
decreases over time increases over time
Coupon
payments (3) $10 $10 $10 $10 $10 $10
= $10
Ending book
value
$101.759 $100.917 $100 $98.287 $99.099 $100
= (1) – (3) +
(2) decreases over time increases over time
460

LIABILITIES
interest payments
2. Periodic recognition of bond issued
Balance The book value of The premium is The discount is

sheet bond liability will not amortized → the book amortized → the
change over the term value of bond liability book value of bond
of the bond decreases until it liability increases
reaches the Par until it reaches the
Par
Income Interest expense = market rate at issuance × the book value of bond
statement liability at beginning of each period
• Interest expense = • Interest expense < • Interest expense >

coupon payment coupon payment coupon payment
• Interest expense is • Interest expense • Interest expense
constant decreases over time increases over time
Cash flow The coupon payments are reported as cash outflow from operating
statement (CFO) under U.S.GAAP and cash outflow from operating (CFO) or
financing (CFF) under IFRS
461

LIABILITIES
interest payments
3. Maturity recognition of bond issued
Balance sheet Remove the bond issued
Income statement –
Cash flow Principle repayment (face value) of the bond is

statement reported as a cash outflow from financing (CFF)
462

LIABILITIES
interest payments
4. Issuance cost
Issuance cost involves legal and accounting fees, printing costs,

sales commissions, and other fees incurred when bond is issued.
U.S. GAAP IFRS
• Issuance costs are expensed in the measurement of the liability

and decrease the initial bond liability on the balance sheet and
increase the bond’s effective interest rate.
• Issuance costs are reported as an outflow of CFF.
U.S.GAAP still
• Permits to capitalize these
costs (deferred charge); and
• Allocated to the income
statement on a straight-line
basis.
463

LIABILITIES
interest payments
4. Issuance cost
Example 3: Expense the issuance cost (for IFRS and U.S.GAAP)

A premium bond issued is similar in the example 1, with the issuance cost
of $6.
Answer:
PV = $102.531 $10 $10 $10 + $100 = $110

Issuance cost = $6 is deducted from the bond liability at issuance.
The initial bond liability is reduced by $6 = $102.531 - $6 = $96.531
→ The bond’s effective interest rate = 11.43%
N = 3, PMT = 10, PV = -96.531, FV = 100, CPT → I/Y = 11.43% higher than
the market rate of 9% at issuance.
(continue in the next slide)
464

LIABILITIES
interest payments
4. Issuance cost
Example 3: Expense the issuance cost (for IFRS and U.S.GAAP)
Year 1 Year 2 Year 3
Asset Cash ↓ $6
Cash flow: CFF outflow $6
Beginning book value $102.531 - $6 =

$97.564 $98.716
(1) $96.531

$11.033 $11.152 $11.283
Liability: = (1) × 11.43%
Bond
liability Coupon payment
$10 $10 $10
= $10
Ending book value (3)

$97.564 $98.716 $100
= (1) – (3) + (2)
Income statement No effect of issuance cost

465

LIABILITIES
interest payments
4. Issuance cost
Example 4: Capitalize the issuance cost (only for U.S.GAAP)

A premium bond issued is similar in the example 1, with the issuance cost
of $6.
Answer:
PV = $102.531 $10 $10 $10 + $100 = $110

Issuance cost = $6 is allocated equally in the income statement
(continue in the next slide)

466

LIABILITIES
interest payments
4. Issuance cost
Example 4: Capitalize the issuance cost (only for U.S.GAAP)

Income Liability &
Asset Cash flow statement Equity
Cash Prepaid CFF outflow Expense Owner

expense equity
Year 1 ↓ $6 ↑ $4 $6 ↑ $2 ↓ $2
Year 2 – ↓ $2 ↑ $2 ↓ $2
Year 3 – ↓ $2 ↑ $2 ↓ $2
Issuance cost is
allocated equally in
467

LIABILITIES
interest payments
5. Fair value reporting option
Under effective interest rate method, the book value of the bond is based
on the market rate at issuance → If market interest rates fluctuate → the
actual value of the firm’s debt deviates from its reported book value:
Market rates rise Market rates fall
Book value > fair value of debt Book value < fair value of debt
Overstate the firm’s leverage Understate the firm’s leverage

level level
Companies have the option to report financial liabilities at fair value.
Gains and losses that result from changes in bonds’ market yields are
reported in the income statement.
468

LIABILITIES
[LOS 24.c] Explain the derecognition of debt
A firm may redeem the bond before maturity due to some reasons:
When bonds are redeemed before maturity, a gain or loss is recognized
by subtracting the redemption price from the book value of the bond
liability at the reacquisition date.
Example 5: Redeem bond before maturity

A 3-year bond was redeemed in the end of the 2nd year at the price of
$1,042. The book value of the bond at the end of the 2nd year is $1,037.
The company will recognize a loss of $5 ($1,037 carrying value - $1,042
redemption price).
At the end of 2nd year
Assets Cash ↓ = $1,042
Liability & Equity Bond liability ↓ = $1,037

Owner equity ↓= $5
Income statement Loss ↑= $5
Cash flow statement CFF outflow = $1,042

469

LIABILITIES
[LOS 24.d] Describe the role of debt covenants in protecting
creditors
Debt covenants are restrictions imposed by the lender on borrower to

protect the lender’s position.
Affirmative covenants Negative covenants
The borrower must: The borrower must not:

• Make timely payments of • Increasing dividends or
principal and interest. repurchasing shares.
• Maintain certain ratios (such • Issuing more debt.
as the current, debt-to-equity, • Engaging in mergers and
and interest coverage ratios) in acquisitions
accordance with specified
level.
• Maintain collateral, if any, in
working order.
If the borrower violates a covenant → technical default → the

bondholder can demand immediate repayment of principle.
470

LIABILITIES
[LOS 24.e] Describe the financial statement presentation of
and disclosures relating to debt
• Firm will often report all of their outstanding long-term debt

on a single line on the balance sheet.
• The portion of long - term debt that has due date < 1 year is
reported on a current liability.
• More details about the long - term debt is disclosed in the
footnotes, including:
o The nature of the liabilities.
o Maturity dates.
o Stated and effective interest rates.
o Call provisions and conversion privileges.
o Restrictions imposed by creditors.
o Assets pledged as security.
o The amount of debt maturing in each of the next 5 years.

471

LIABILITIES
[LOS 24.f] Explain motivations for leasing assets instead of
purchasing them
A lease is a contract between the owner of the asset (lessor) and

another party that wants to use the asset (lessee). The lessee
gains the right to use the asset for a period of time in return for
periodic lease payments.
The right to use the asset

Lessor Lessee
Lease payments
Three requirements for a lease contract
• It must refer to a specific asset.

• It must give the lessee effectively all the asset’s economic
benefits during the term of the lease.
• It must give the lessee the right to determine how to use the
asset during the term of the lease.
472

LIABILITIES
[LOS 24.f] Explain motivations for leasing assets instead of
purchasing them
The advantages of leasing rather than purchasing an asset
• Less initial cash outflow: a lease only requires a small down

payments
• Less costly financing: a lease is effectively secured by the leased
asset if the lessee defaults → the interest rate implicit in a
lease contract < the interest rate would be on a loan to
purchase the asset.
• Less risk of obsolescence: At the end of a lease, the lessee often
returns the leased asset to the lessor and therefore does not
bear the risk of an unexpected decline in the asset’s end-of-
lease value.
473

LIABILITIES
[LOS 24.g] Explain the financial reporting of leases from a
lessee’s perspective
1. Types of lease
Finance lease Operating lease
Transferred substantially all the Does not transferred substancially all
benefits and risks of ownership to the the benefits and risks of ownership to
lessee. the lessee.
2. Classifications for Lessee and Lessor
Lessee Lessor
IFRS US GAAP IFRS/US GAAP

Short lease term (12 Finance lease Finance lease
months)
Or Operating lease Operating lease
Low value (up to Five conditions for a lease to be classified as a finance lease
$5,000) • Ownership of the leased asset transfers to the lessee.
• The lessee has an option to buy the asset and is expected
Y to exercise it.
Y/N Exemption
N • The lease is for most of the asset’s useful life.
• The present value of the lease payments is greater than
Lease or equal to the asset’s fair value.
(same finance lease) • The lessor has no other use for the asset.
474

LIABILITIES
3. Accounting for lease under IFRS and U.S.GAAP
Example 6: Accounting lease for lessee

Affordable Company leases a machine for its own use for 2 years
with annual payments of $60,000. The interest rate implicit in
the lease is 6%. How will the lease be reported by the lessee if
it’s classified as a finance lease (lease under IFRS) and as an
operating lease under U.S.GAAP?
475

LIABILITIES

The present value of lease payments = $110,000:
(N = 2; I/Y = 6%; PMT = - $60,000; FV = 0; CPT → PV = $110,000)
Note: The table below is lease accounting under U.S.GAAP. The lease under IFRS is
the same as the finance lease under U.S.GAAP.
Balance sheet Finance lease Operating lease
Year 0 1 2 0 1 2
Beginning lease liability (1) 110 56.6 110 56.6

6.6 3.4 6.6 3.4
(1)*6%
Lease payment (3) (60) (60) (60) (60)

Principal repayment (4)
(53.4) (56.6) (53.4) (56.6)
(3)-(2)
Ending lease liability (5)
110 56.6 0 110 56.6 0
(1)-(4)
Ending ROU asset 110 55(*) 0 110 56.6(**) 0
(*) Amortization = 110/2 = 55 => ending balance = 110 - 55 = 55
(**) Amortization = principal repayment = 53.4 => ending balance = 110 - 53.4 = 56.6
476

LIABILITIES

Answer: (cont.)
Income statement Finance lease Operating lease
Year Total 1 2 Total 1 2
Interest expenses 10 6.6 3.4
Amortization expenses 110 55 55

Lease expenses 120 60 60
Total expenses 120 61.6 58.4 120 60 60
Cash flow statement Finance lease Operating lease
CFO outflow 10 6.6 3.4 120 60 60
CFF outflow 110 53.4 56.6

477

LIABILITIES
Lease (IFRS) and Finance lease (US.GAAP) Operating lease

Summary
(as borrowing and buy) (U.S.GAAP)
• Right-of-use asset = PV of future lease Record as finance

payments (at lease inception) lease. But the right-of-
ROU Assets
• Straight-line amortization of right-of-use use asset is not
asset - Cost model (after the inception) straight-line
amortized:
Lease • Lease liability = PV of future lease o Amortization =
liability payments (at lease inception) reduction of lease

• Reduction of lease liability from lease liability
payment each period - Amortized cost
(after the inception)
Income • Interest expense on lease liability Rental expense = Lease

statement • Amortization expense on leased asset payment
Interest expense = CFO/CFF outflow under Lease payments = CFO

Cash flow IFRS and CFO outflow under U.S.GAAP outflow
statement
Reduction of lease liability = CFF outflow
478

LIABILITIES
[LOS 24.h] Explain the financial reporting of leases from a
lessor’s perspective
Example 7: Accounting lease for lessor

A lease contract as in Example 6. How the lessor report it?
Answer:
The present value of lease payments:
N = 2; I/Y = 6%; PMT = - $60,000; FV = 0; CPT → PV = $110,000
The accounting for lessors is substantially identical under IFRS and US
GAAP:
Operating lease: lease payments are simply reported as lease income in
the P&L and CFO inflow over the period.
Finance lease: Lessors under US GAAP recognize finance leases as either
“sales-type” or “direct financing” lease:
• Sale-type lease: PV of lease payments (sales) > the book value of
leased asset (COGS)
• Direct financing lease: PV of lease payments = the book value of
leased asset
In this example, assume that the book value of leased asset is $80,000
→ sale-type lease.
479

LIABILITIES
Answer:
Balance sheet
(Remove leased asset) (Retain leased asset)
Year 0 1 2 0 1 2
Beginning lease receivable (1) 110 56.6
Interest income (2)

6.6 3.4
(1)*6%
Lease payment received (3) (60) (60) No effect

Principal repayment received
(53.4) (56.6)
(4) = (3)-(2)
Ending lease receivable (5)
110 56.6 0
(1)-(4)
Ending leased asset (removed) (80) 80 40(*) 0
Liability No effect No effect
Equity 30 No effect
(*) Amortization = 80/2 = 40 => ending balance = 80 - 40 = 40

480

LIABILITIES
Answer (cont):
Income statement
Year Total 1 2 Total 1 2
Interest income 10 6.6 3.4
Sales 110
COGS (80)
Gain 30
Lease revenue 60 60
Depreciation expense (40) (40)

Cash flow statement
CFO inflow 60 60 60 60
481

LIABILITIES
Summary
(as sell and lending) (no lending)
• Remove assets (at lease inception) • Retain assets (at lease

• Lease receivables = PV of future inception)
lease payments (at lease inception) • Depreciation on leased
Assets • Reduction of lease receivable from assets (after the inception).
lease lease payment received each
period - Amortized cost (after the
inception).
Liability – –
• Interest income on lease • Lease revenue = lease

receivables payment
Income
• Gain/Loss = PV of future lease • Depreciation expense on
statement
payments (sales) – book value of leased assets
leased asset (COGS)
Cash flow
Lease payments = CFO inflow Lease payments = CFO inflow
statement
482

LIABILITIES
[LOS 24.i] Compare the presentation and disclosure of
defined contribution and defined benefit pension plans
Defined contribution plans Defined benefit plans
Definition Pension plans in which the Pension plans in which the

employee and the company company contributes into
is required to contribute the plan and promises to
and invest a certain of funds pay future benefits to the
into the plan. However, the employee during
company makes no promise retirement.
to the employee regarding
the future value of the plan
assets.
Contribution Amount is defined each Depends on current period

from period. estimate and investment
employer performance of assets.
483

LIABILITIES
Defined contribution plans Defined benefit plans
Amount of Depends on investment Based on plan’s formula:

future performance of plan’s assets the firm promises to make
benefit to periodic payments to
employee employees after retirement
Investment The employees The employers

risk goes to
Example An employee periodically The firm contributes a plan

contributed 5% of basic and makes a commitment
salary, this amount is that the employee might
matched by the employer. earn a retirement benefit of
But the employee’s future 2% of her final salary for
benefit is not specified. each year of service.
484

LIABILITIES
1. Accounting for Defined contribution plans
Balance sheet • Records a decrease in cash.

• If the agreed-upon amount is not
deposited into the plan during a
particular period → the outstanding
amount is recognized as a liability.
Income statement Employer’s contribution is reported as

pension expense
Cash flow statement Employer’s contribution is reported as CFO

outflow
485

LIABILITIES
2. Accounting for Defined benefit plans
Pension benefit = a% × final salary at retirement × number of years of

services.
Example 8: Employee’s pension benefit (Firm’s pension payments)

Consider a company that determines annual pension benefit of each
employee during retirement as 2% × final salary at retirement × number
of years of services. A retiree who served the company for 20 years and
had a final salary at retirement of $200,000 . What is the amount of
pension benefit employee will receive each period after the retirement?
486

LIABILITIES
Example 8: Employee’s pension benefit (Firm’s pension payments)
Answer
A retiree who served the company for 20 years and had a final salary at
retirement of $200,000 would, under the terms of this defined-benefit
plan, be entitled to an annual pension payment of 0.02 x $200,000 x 20 =
$80,000 each year during her retirement until her death.
0 1 … 19 20 21 22 …
$200,000 $80,000 $80,000 $80,000
Final salary at
retirement
487

LIABILITIES
Pension obligation allocated over the Pension expense

= PV of annual Included in COGS/
pension payment years of services SG&A in the P&L
Assumption to determine the pension obligation:

• Expected salary at date of retirement.
• Number of years the employee is expected to live after
retirement.
• The discount rate (typically assumed to be the high-quality
corporate bond yield).
488

LIABILITIES
Example 9: Pension obligation

An employee is eligible to participate in the company’s defined-benefit
pension plan. Under the plan, he is promised an annual payment of 2% of
his final salary for each year of service. The pension benefit will be paid at
the end of each year. The final annual salary is 50,000.
The discount rate is 8%.
The employee will work for 25 years.
The employee will live for 15 years after retirement and receive 15 annual
pension benefit payments.
489

LIABILITIES
Example 9: Pension obligation

Answer:
At the end of the 1st year of service, the employee’s annual pension
benefit = 2% × $50,000 × 1 = $1,000 per year from retirement until death.
Step 1: The PV of payments on the retirement date = $8,560
(I/Y = 8, PMT = 1,000, N = 15, FV = 0, CPT → PV = -8,560)
Step 2: At the end of the 1st year of employment, the PV of the annuity
that begins in 24 years = The pension obligation (PBO) of the first year =
$8,560/(1.08^24) = $1,350.
0 1 2 24 25 26 39 40
PBO $1,000 $1,000 $1,000

= 1,350 $8,560
Step 2 Step 1
490

LIABILITIES
The change in the pension obligation (Additional reading)
Beginning value of pension obligation
Under IFRS Under U.S.GAAP
+ Current service costs + Current service costs
+ Net interest expense + Interest costs
+ Actuarial losses + Actuarial losses change in net

pension
– Net interest income + Past service costs
liability/asset
– Actuarial gains – Actuarial gains
– Actual return on – Expected return on plan

plan asset asset
Ending value of pension obligation

491

LIABILITIES
Recognized as Under IFRS Under U.S.GAAP
Current service costs = present value of the increase in pension

benefit earned by the employee as a result of providing one more
year of service to the company
Net interest expense/income = Interest costs: the company

beginning net pension does not pay out service costs
Pension expense liability/asset × discount rate earned by the employee over
(in P&L) used to estimate the pension the year until retirement
obligation
Expected return on plan asset:

This is an explicit assumption
for the expected long-term
rate of return on plan assets
492

LIABILITIES
Recognized as Under IFRS Under U.S.GAAP
Actuarial losses/gains: arise when changes are made in any of

the assumptions used to estimate the company’s pension
obligation (e.g., mortality rates, life expectancy, rate of
Other compensation increase, and retirement age)
comprehensive
income Actual return on plan assets Past service costs: retroactive
less any return included in the benefits awarded to employees
net interest expense or when a plan is initiated or
income. amended
493

LIABILITIES
Fair value of plan asset – Pension obligation

= Net pension asset/liability
Balance sheet • The fair value of plan assets > the pension
obligation → the plan has a surplus → reflect a
net pension asset.
• The fair value of plan assets < the pension
obligation → the plan has a deficit → reflect a
net pension liability.
Income The change in net pension liability/asset is

statement recognized either in profit and loss or in other
comprehensive income.
494

LIABILITIES
Example 10: Change in pension obligation and Net pension

asset/liability
Continue with the pension plan for an employee as in the Example 9.
Answer
At the end of the 2nd year of service, the employee’s annual pension
benefit = 2% × $50,000 × 2 = $2,000 per year from retirement until death.
Step 1: The PV of payments on the retirement date = $17,119
(I/Y = 8, PMT = 2,000, N = 15, FV = 0, CPT → PV = -17,119)
Step 2: At the end of the 2nd year of employment, the PV of the annuity
that begins in 23 years = The pension obligation (PBO) of the 2nd year
= $17,119/(1.08^23) = $2,916.
0 1 2 24 25 26 39 40
PBO PBO $2,000 $2,000 $2,000

= $1,350 = $2,916 $17,119
Step 2 Step 1
495

LIABILITIES
Example 10: Change in pension obligation and Net pension

asset/liability
Answer
During the 2nd year of service, the PBO increased $1,566. The increase is a
result of current service cost and interest cost as follows:
1st PBO = $1,350
+ Current service cost = $1,458 (PV of 15 payments of $1,000 ($2000 –
$1000) starting in 23 years)
+ Interest cost = $108 (= $1,350 × 8%)
2nd PBO = $2,916
If the fair value of the plan assets at the end of 2nd year = $2,000
→ report a net pension liability = $2,916 - $2,000 = $916
496

LIABILITIES
[LOS 24.j] Calculate and interpret leverage and coverage
ratios
Solvency ratios to measure a firm’s ability to satisfy its long-term
obligation.
1. Leverage ratios 2. Coverage ratios
• Focus on balance sheet • Focus on income statement

• Measure relative amount • Measure the sufficiency of
of debt in the firm’s capital earnings to repay interest
and other fixed charges
when due.
497

LIABILITIES
ratios
1. Leverage ratios
• Debt-to-assets ratio = total debt / total assets
Measures the percentage of total assets financed with debt
The higher the ratio, the higher the financial risk and → the weaker the
solvency
• Debt-to-capital ratio = total debt / (total debt + total equity)
Measures the percentage of total capital financed with debt. It is
different from debt-to-asset ratio by the non-interest-bearing liabilities
The higher the ratio → the weaker the solvency
• Debt-to-equity ratio = total debt / total equity.
Measures the amount of debt financing relative to the firm’s equity
base.
The higher the ratio → the weaker the solvency
• Financial leverage ratio = average total assets / average total equity.
Measure of leverage used in the DuPont formula
The higher the financial leverage ratio, the more leveraged the company
in the sense of using debt and other liabilities to finance assets.
498

LIABILITIES
ratios
2. Coverage ratios
• Interest coverage = EBIT / interest payments
Measures the number of times a company’s EBIT could cover its interest
payments.
The higher interest coverage ratio, the stronger solvency → greater
assurance that the company can service its debt from operating
earnings
• Fixed charge coverage = (EBIT + lease payments) / (interest payments +
lease payments).
Measures the number of times a company’s earnings (before interest,
taxes, and lease payments) can cover the company’s interest and lease
payments.
Fixed charge coverage is more meaningful for firms that engage in
significant operating leases
499

LIABILITIES
ratios
Example 11: Leverage ratios and coverage ratios
BT Group data:
31-Mar-X8 31-Mar-X7
Short-term borrowings 2,281 2,632
Long-term debt 11,994 10,081
Total shareholders' equity 10,304 8,335
Total assets 42,759 42,372
EBIT 3,381 3,167
Interest expense 776 817
1. Comment on any changes in the calculated leverage ratios from

year-to-year.
2. Comment on any changes in the interest coverage ratio from
year to year.
500

LIABILITIES
ratios
Answer:
31-Mar-X8 31-Mar-X7
Debt-to-assets (2,281 + 11,994)/42,759 (2,632 + 10,081)/42,372

= 33.4% = 30%
Debt-to-capital (2,281 + 11,994)/(2,281 + (2,632 + 10,081)/(2,632 +

11,994 + 10,304) 10,081 + 8,335)
= 58.1% = 60.4%
Debt-to-equity (2,281 + 11,994)/10,304 (2,632 + 10,081)/8,335

= 1.39 = 1.53
Interest coverage 3,381/776 = 4.36 3,167/817 = 3.88

ratio
Debt-to-assets ratio increased, while its debt-to-capital and debt-to-equity ratios

both decrease: The decrease in debt-to-capital and debt-to-equity ratios resulted
primarily from the company’s increase in total equity and indicate stronger
solvency.
Interest coverage ratios increased from 2017 to 2018 → an improvement in
solvency. The company has sufficient operating earnings to cover interest payments.
501

LIABILITIES
Practice exercises
24.a. Determine the initial recognition, initial measurement and Question 1

subsequent measurement of bonds –2
24.b. Describe the effective interest method and calculate interest Question 3
expense, amortization of bond discounts/premiums, and interest –5
payments
24.c. Explain the derecognition of debt Question 6
24.d. Describe the role of debt covenants in protecting creditors Question 7
24.e. Describe the financial statement presentation of and Question 8

disclosures relating to debt
24.f. Explain motivations for leasing assets instead of purchasing Question 9

them
24.g. Explain the financial reporting of leases from a lessee’s Question 10

perspective - 11
502

LIABILITIES
Practice exercises
24.h. Explain the financial reporting of leases from a lessor’s Question 12 –

perspective 13
24.i. Compare the presentation and disclosure of defined Question 14

contribution and defined benefit pension plans
24.j. Calculate and interpret leverage and coverage ratios Question 15

503

LIABILITIES
Practice exercises
1. A company issues €1 million of bonds at face value. When the bonds are
issued, the company will record a:
A. cash inflow from investing activities.
B. cash inflow from financing activities.
C. cash inflow from operating activities.
2. At the time of issue of 4.50% coupon bonds, the effective interest rate
was 5.00%. The bonds were most likely issued at:
A. par.
B. a discount.
C. a premium.
3. Oil Exploration LLC paid $45,000 in printing, legal fees, commissions, and
other costs associated with its recent bond issue. It is most likely to
record these costs on its financial statements as:
A. an asset under US GAAP and reduction of the carrying value of the
debt under IFRS.
B. a liability under US GAAP and reduction of the carrying value of the
debt under IFRS.
C. a cash outflow from investing activities under both US GAAP and
IFRS.
504

LIABILITIES
Practice exercises
4. Midland Brands issues three-year bonds dated 1 January 2015 with a face
value of $5,000,000. The market interest rate on bonds of comparable
risk and term is 3%. If the bonds pay 2.5% annually on 31 December,
bonds payable when issued are most likely reported as closest to:
A. $4,929,285.
B. $5,000,000.
C. $5,071,401
5. On 1 January 2010, Elegant Fragrances Company issues £1,000,000 face

value, five-year bonds with annual interest payments of £55,000 to be
paid each 31 December. The market interest rate is 6.0 percent. Using the
effective interest rate method of amortization, Elegant Fragrances is most
likely to record:
A. an interest expense of £55,000 on its 2010 income statement.
B. a liability of £982,674 on the 31 December 2010 balance sheet.
C. a £58,736 cash outflow from operating activity on the 2010
statement of cash flows
505

LIABILITIES
Practice exercises
6. The management of Bank EZ repurchases its own bonds in the open

market. They pay €6.5 million for bonds with a face value of €10.0million
and a carrying value of €9.8 million. The bank will most likely report:
A. other comprehensive income of €3.3 million.
B. other comprehensive income of €3.5 million.
C. a gain of €3.3 million on the income statement.
7. Which of the following is an example of an affirmative debt covenant?

The borrower is:
A. prohibited from entering into mergers.
B. prevented from issuing excessive additional debt.
C. required to perform regular maintenance on equipment pledged as
collateral
8. Regarding a company’s debt obligations, which of the following is most

likely presented on the balance sheet?
A. Effective interest rate
B. Maturity dates for debt obligations
C. The portion of long-term debt due in the next 12 months
506

LIABILITIES
Practice exercises
9. Compared to purchasing a long-lived asset using debt financing, leasing

the asset most likely:
A. is more costly to the lessee.
B. requires a greater initial cash outflow from the lessee.
C. allows the lessee to avoid the risk of obsolescence.
10. Beginning with fiscal year 2019, for leases with a term longer than one
year, lessees report a right-to-use asset and a lease liability on the
balance sheet:
A. only for finance leases.
B. only for operating leases.
C. for both finance and operating leases.
11. A company enters into a finance lease agreement to acquire the use of
an asset for three years with lease payments of €19,000,000 starting next
year. The leased asset has a fair market value of €49,000,000 and the
present value of the lease payments is €47,250,188. Based on this
information, the value of the lease liability reported on the company’s
balance sheet at lease inception is closest to:
A. €47,250,188.
B. €49,000,000.
C. €57,000,000.
507

LIABILITIES
Practice exercises
12. Under US GAAP, a lessor’s reported revenues at lease inception will be

highest if the lease is classified as:
A. a sales-type lease.
B. an operating lease.
C. a direct financing lease
13. For a lessor, the leased asset appears on the balance sheet and
continues to be depreciated when the lease is classified as:
A. a finance lease.
B. a sales-type lease.
C. an operating lease.
14. Penben Corporation has a defined benefit pension plan. At 31

December, its pension obligation is €10 million and pension assets are
€9 million. Under either IFRS or US GAAP, the reporting on the balance
sheet would be closest to which of the following?
A. €10 million is shown as a liability, and €9 million appears as an
asset.
B. €1 million is shown as a net pension obligation.
C. Pension assets and obligations are not required to be shown on
the balance sheet but only disclosed in footnotes.
508

LIABILITIES
Practice exercises
15. The following presents selected financial information for a company:
$ Millions
Short-term borrowing 4,231
Current portion of long-term interest-bearing debt 29
Long-term interest-bearing debt 925
Average shareholders’ equity 18,752
Average total assets 45,981
The financial leverage ratio is closest to:

A. 0.113
B. 0.277
C. 2.452
509

LIABILITIES
Practice exercises
Answer
1. B is correct. The company receives €1 million in cash from investors at the
time the bonds are issued, which is recorded as a financing activity
2. B is correct. The effective interest rate is greater than the coupon rate and
the bonds will be issued at a discount.
3. A is correct.
• Under US GAAP, expenses incurred when issuing bonds (issuance cost)
are generally recorded as an asset and amortized to the related expense
(legal, etc.) over the life of the bonds.
• Under IFRS, they are included in the measurement of the liability.
• The related cash flows are financing activities.
4. A is correct. The bonds payable reported at issue is equal to the sales

proceeds = $4,929,285
Coupon payments each period = 2.5% × $5,000,000 = $125,000
I/Y = 3; N = 3; PMT = 125,000; FV = 5,000,000; CPT→ PV = -4,929,285
1 Jan 2015 31 Dec 2015 31 Dec 2016 31 Dec 2017
PV = $4,929,285 $125,000 $125,000 $5,125,000

510

LIABILITIES
Practice exercises
5. B is correct. Book value of bond liability is equal to the present value of the
remaining future cash flow.
At the beginning of 2010, book value of bond = £978,938 and it is also a
cash inflow from financing in 2010
Interest expense in 2010 = £978,938 × 6% = £58,736
2010
Beginning book value (1) £978,938
Interest expense (2) = (1) × 6% £58,736

Bond liability
Coupon payments (3) = £55,000 £55,000
Ending book value = (1) – (3) + (2) £982,674
Income statement Interest expense £58,736
Cash flow CFF inflow £978,938

511

LIABILITIES
Practice exercises
6. C is correct. A gain of €3.3 million (carrying amount less amount paid) will
be reported on the income statement.
7. C is correct.
• Affirmative covenants require certain actions of the borrower. Requiring
the company to perform regular maintenance on equipment pledged as
collateral is an example of an affirmative covenant because it requires
the company to do something.
• Negative covenants require that the borrower not take certain actions.
Prohibiting the borrower from entering into mergers and preventing the
borrower from issuing excessive additional debt are examples of
negative covenants.
8. C is correct. The non-current liabilities section of the balance sheet usually

includes: a single line item of the total amount of a company’s long-term
debt due after 1 year → the current liabilities section shows the portion of
a company’s long-term debt due in the next 12 months.
• Notes to the financial statements generally present the stated and
effective interest rates and maturity dates for a company’s debt
obligations
512

LIABILITIES
Practice exercises
9. C is correct. At the end of a lease, the lessee often returns the leased asset
to the lessor → does not bear the risk of an unexpected decline in the
asset’s end-of-lease value → the interest rate implicit in a lease contract
may be less than the interest rate on a loan to purchase the asset.
• The terms of a lease may not require all the covenants typically included
in loan agreements or bond indenture.
10. C is correct. Beginning with fiscal year 2019, lessees report a right-of-use
asset and a lease liability for all leases longer than one year. An exception
under IFRS exists for leases when the underlying asset is of low value.
11. A is correct. Under the revised reporting standards under IFRS and U.S.
GAAP, a lessee must recognize an asset and a lease liability at inception of
each of its leases (with an exception for short-term leases):
→ The lessee reports a “right-of-use” (ROU) asset and a lease liability = the
present value of fixed lease payments on its balance sheet → the company
will record a lease liability on the balance sheet of €47,250,188.
513

LIABILITIES
Practice exercises
12. A is correct. A sales-type lease treats the lease as a sale of the asset, and
revenue is recorded at the time of sale equal to the value of the leased
asset. Under a direct financing lease, only interest income is reported as
earned. Under an operating lease, revenue from lease receipts is reported
when collected.
13. C is correct. When a lease is classified as an operating lease, the underlying

asset remains on the lessor’s balance sheet. The lessor will record a
depreciation expense that reduces the asset’s value over time
14. B is correct. The company will report a net pension obligation of €1 million
equal to the pension obligation (€10 million) less the plan assets
(€9 million).
15. C is correct. The financial leverage ratio is calculated as follows:

(Average total assets/average total shareholder’s equity)
= 45,981/18,752 = 2.452
514

REPORTING QUALITY
515

QUALITY
Learning outcomes
25.a. Compare and contrast financial reporting quality with the quality of
reported results (including quality of earnings, cash flow, and balance
sheet items).
25.b. Describe a spectrum for assessing financial reporting quality.
25.c. Explain the difference between conservative and aggressive accounting.
25.d. Describe motivations that might cause management to issue financial

reports that are not high quality.
25.e. Describe conditions that are conducive to issuing low-quality, or even
fraudulent, financial reports.
25.f. Describe mechanisms that discipline financial reporting quality and the
potential limitations of those mechanisms.
25.g. Describe presentation choices, including non-GAAP measures, that could be
used to influence an analyst’s opinion.
25.h. Describe accounting methods (choices and estimates) that could be used to
manage earnings, cash flow, and balance sheet items.
25.i. Describe accounting warning signs and methods for detecting manipulation
of information in financial reports.
516

QUALITY
[LOS 25.a] Compare and contrast financial reporting quality
with the quality of reported results (including quality of
earnings, cash flow, and balance sheet items).
1. Financial reporting quality
High quality financial reporting must be decision useful
Relevance Faithful representation

Relevance refers to the fact Faithful representation
that information presented in encompasses the qualities of
the financial statements is completeness, neutrality, and
useful to users of financial the absence of errors.
statements in making
decisions.
Relevant information must
also be material in that
knowledge of it would likely
affect the decisions of users
of financial statements.
517

QUALITY
2. Quality of earnings
Earning quality can be judged based on the sustainability of the

earnings as well as on their level
Sustainability Level of earnings

Sustainability can be The importance of the level
evaluated by determining the of earnings is that reported
proportion of reported earnings must be high
earnings that can be enough to sustain the
expected to continue in the company’s operations and
future. existence.
(Ex. Earnings from core (ROE > required rate of
business,… ) return, …)
518

QUALITY
Financial Reporting Quality
Low High
HIGH financial reporting

Earnings (Results) Quality
quality enables assessment.

High
LOW financial reporting HIGH earnings quality
quality impedes increases company value.
assessment of earnings
quality and impedes
valuation. HIGH financial reporting
quality enables assessment.
Low
LOW earnings quality
decreases company value.
519

QUALITY
[LOS 25.b] Describe a spectrum for assessing financial reporting
quality.
Highest • Compliant with GAAP
quality • Earnings are sustainable and adequate.
• Compliant with GAAP
• Earnings quality is low (earnings are not
sustainable or not adequate).
Quality spectrum
• Compliant with GAAP

• Earnings quality is low and reporting choices and
estimates are biased.
• Compliant with GAAP,
• Amount of earnings is actively managed to
increase, decrease, or smooth reported earnings.
• Not compliant with GAAP
• The numbers presented are based on the
company’s actual economic activities.
Worst • Not compliant and includes numbers that are

quality essentially fictitious or fraudulent.
520

QUALITY
[LOS 25.c] Explain the difference between conservative and
aggressive accounting.
Types of bias
Aggressive choice Conservative choice *
Increase the company’s Decrease the company’s

reported performance and reported performance and
financial position in current financial position and increase
period and decrease earnings future period earnings.
in future periods.
Example: Accounting bias
Aggressive Conservative
Capitalize current period cost Expense current period cost

(period cost ↓ ⟹ net income ↑) (period cost ↑ ⟹ net income ↓)
Straight line depreciation Accelerated depreciation

(early-stage depreciation expense (early-stage depreciation expense
↓ ⟹ net income ↑) ↑ ⟹ net income ↓)
521

QUALITY
(*) Conservative choice
Conservatism should not be seen as “good”. Conservative bias

can also be considered as a deviation from neutral reporting or
faithful representation.
Drawbacks of conservatism Benefits of conservatism
Conservatism directly • Reducing the possibility

conflicts with the concept of of litigation.
Neutrality ⇒ biased • Reducing current period
estimates of assets, liabilities, tax liability.
and earnings. • Protecting the interests of
those who have less
complete information.
522

QUALITY
3. Typical examples of accounting bias
Involves employing conservative assumptions to

understate performance when the company is
Earnings actually doing well and then using aggressive
smoothing assumptions when the company is not doing as well.
(Cookie jar reserve accounting is also a case of
earnings smoothing)
Unbiased
Earning
Conservative choice effect Earning
Earnings
smoothing
Aggressive choice effect
Low earning period High earning period Time

523

QUALITY
3. Typical examples of accounting bias
This refers to the strategy of manipulating a

Big bath
company’s income statement to make poor results
behavior
look even worse.
Unbiased
Earning
Aggressive choice effect Earning
Big bath
bias
Conservative choice effect
Low earning period High earning period Time

524

QUALITY
[LOS 25.d,e] Describe motivations, conditions that are
conducive to issuing low-quality, or even fraudulent, financial
reports.
In assessing financial reporting quality, it is important to consider:
1. Whether the reporting 2. Whether a company’s management may be

environment is conducive motivated to issue financial reports that are not
to misreporting ? of high quality ?
Opportunity Motivation Rationalization
• The company has • Mask poor performance Story to justify

weak internal controls • Boost the stock price breaking the
• The board of directors • Increase personal rules.
provides inadequate compensation
oversight • Avoid violation of debt
• Applicable accounting covenants
standards provide a • Increase the probability of
large range of exceeding next period’s
acceptable accounting forecasts
treatments • Meat or beat expectations
525

QUALITY
[LOS 25.f] Describe mechanisms that discipline financial
reporting quality and the potential limitations of those
mechanisms.
1. Markets
Financial 2.
4. Private
reporting Regulatory
contract
quality authorities
3. Auditors
526

QUALITY
mechanisms.
1. Markets
Companies compete for capital, and the cost of capital is directly related
to the level of perceived risk ⟹ aim to provide high-quality financial
reports to minimize their long-term cost of capital.
2. Regulatory authorities
Typical regulatory requirement
• A registration process for the issuance of new publicly traded
securities.
• Specific disclosure and reporting requirements, including periodic
financial statements and accompanying notes.
• A statement of financial condition made by management.
• A signed statement by the person responsible for the preparation of
the financial reports.
• A review process for newly registered securities and periodic
reviews after registration.
Enforcement actions
• Fines
• Suspension of participation
527

QUALITY
mechanisms.
3. Auditors
While public companies are required to have their financial statements

audited by an independent auditor, private companies also obtain audit
opinions regarding their financial statements, either voluntarily or to
meet requirements imposed by providers of capital.
(*) An unqualified or “clean” audit opinion is not a guarantee that no
fraud has occurred but only offers reasonable assurance that the
financial reports
4. Private contract
The counterparties to private contracts with the firm have an incentive

to see that the firm produces high-quality financial reports → source of
discipline on financial reporting quality.
528

QUALITY
[LOS 25.g] Describe presentation choices, including non-GAAP
measures, that could be used to influence an analyst’s opinion.
Companies that report non-GAAP measures are
1.
required to:
• Display the most comparable GAAP measure with equal
prominence
• Provide an explanation by management as to why the non-
GAAP measure is thought to be useful.
• Reconcile the differences between the non-GAAP measure
and the most comparable GAAP measure.
• Disclose other purposes for which the firm uses the non-
GAAP measure.
• Include, in any non-GAAP measure, any items that are likely
to recur in the future, even those treated as nonrecurring,
unusual, or infrequent in the financial statements.
2. IFRS require that firms using non-IFRS measures to:

• Define and explain the relevance of such non-IFRS measures.
• Reconcile the differences between the non-IFRS measure
and the most comparable IFRS measure.
529

QUALITY
[LOS 25.h] Describe accounting methods (choices and
estimates) that could be used to manage earnings, cash flow,
and balance sheet items.
1. Revenue recognition
2. Estimates of credit losses
3. Valuation allowance
4. Depreciation methods and estimates

Accounting
choices and 5. Amortization and impairment
estimates
6. Inventory method
7. Capitalization
8. Related-party transactions
9. Other cash flow effects

530

QUALITY
Free-on-board (FOB)
• FOB at the shipping point ⟹ revenue is recognized
aggressively and earlier.
• FOB at the destination ⟹ revenue is recognized in
later period.
Channel stuffing
• In low earning period, firm overload a distribution
1. Revenue
channel with more goods than would normally be
recognition sold during a period ⟹ higher current revenue ⟹
lower future revenue.
• In high earnings period, firm delays recognition of
revenue to the next period and hold or delay
customer shipments ⟹ lower current revenue.
Bill-and-hold transaction
The firm sells the goods but still keep it at their location
⟹ at the end of that period, inventory is still high ⟹ low
COGS ⟹ company recognizes high net income and assets
531

QUALITY
• ↓ in the allowance for bad debt ⟹ ↑ net receivables

2. Estimates
on the balance sheet, ↓ expenses ⟹ ↑ net income.
of credit
• ↑ in the allowance for bad debt ⟹ ↓ net receivables
losses
on the balance sheet,↑ expenses ⟹ ↓ net income.
Valuation allowance reduces the carrying value of a

deferred tax asset based.
• ↑ a valuation allowance ⟹ ↓ the net deferred tax
3. Valuation asset on the balance sheet ⟹ ↓ net income for the
allowance period
• ↓ a valuation allowance ⟹ ↑ the net deferred tax
asset on the balance sheet ⟹ ↑ net income for the
period
532

QUALITY
Depreciation methods, Estimates of the useful life
4. Depreciation
of a depreciable asset and its salvage value upon
methods and
disposal can affect expenses, and net income. (LOS
estimates
22.e – SAPP’s slides version)
By ignoring or delaying recognition of an
5. Amortization impairment charge for goodwill, management can
and impairment increase earnings in the current period. (LOS 22.e
and LOS 22.f – SAPP’s slides version)
Choice between FIFO, LIFO and weighted-average

6. Inventory
inventory costing methods will affect COGS, gross
method
profit, gross margin, and earnings (LOS 21.l)
Any expense that can be capitalized creates an

asset on the balance sheet, and the impact of the
expense on net income can be spread over many
7. Capitalization
years.
Capitalization also affects cash flow
classifications.(LOS 22.b)
533

QUALITY
If a public firm does business with a supplier that is

8. Related- private and controlled by management, adjusting the
party price of goods supplied can shift profits either to or
transactions from the private company to manage the earnings
reported by the public company.
The ability under IFRS to classify interest and dividends

paid as either CFO or CFF, and interest and dividends
9. Other cash received as either CFO or CFI, gives management an
flow effects additional way to manage reported operating cash
flow.
(LOS 19.a)
534

QUALITY
[LOS 25.i] Describe accounting warning signs and methods for
detecting manipulation of information in financial reports.
List of several warning signs
Related to Capitalization Policies and Deferred Costs

• Capitalization decisions, depreciation methods, useful lives,
salvage values out of line with comparable firms
Related to the Relationship between Cash Flow and Income
• Net income not supported by operating cash flows
• Revenue growth out of line with comparable firms, changes
in revenue recognition methods, or lack of transparency
about revenue recognition
Other Potential Warning Signs
• Decreases over time in turnover ratios (receivables,
inventory, total asset)
• Fourth-quarter earnings patterns not caused by seasonality
• Frequent appearance of nonrecurring items
• Bill-and-hold, barter, or related-party transactions
• Emphasis on non-GAAP measures, minimal information and
disclosure in financial reports
535

QUALITY
Practice questions
25.a. Compare and contrast financial reporting quality with the 4

quality of reported results (including quality of earnings, cash
flow, and balance sheet items).
25.b. Describe a spectrum for assessing financial reporting quality. 6
25.c. Explain the difference between conservative and aggressive 2, 3

accounting.
25.d. Describe motivations that might cause management to issue 7

financial reports that are not high quality.
25.e. Describe conditions that are conducive to issuing low- 5

quality, or even fraudulent, financial reports.
25.f. Describe mechanisms that discipline financial reporting 9

quality and the potential limitations of those mechanisms.
536

QUALITY
Practice questions
25.g. Describe presentation choices, including non-GAAP 8

measures, that could be used to influence an analyst’s opinion.
25.h. Describe accounting methods (choices and estimates) that 10

could be used to manage earnings, cash flow, and balance sheet
items.
25.i. Describe accounting warning signs and methods for 1

detecting manipulation of information in financial reports.
537

QUALITY
Practice questions
1. Which of the following would most likely signal that a company may
be using aggressive accrual accounting policies to shift current
expenses to later periods?
“Over the last five-year period, the ratio of cash flow to net income
has…”:
A. increased each year.
B. decreased each year.
C. fluctuated from year to year.
2. Which of the following is most likely to be considered a potential
benefit of accounting conservatism?
A. A reduction in litigation costs
B. Less biased financial reporting
C. An increase in current period reported performance
3. Which of the following is most likely to reflect conservative

accounting choices?
A. Decreased reported earnings in later periods
B. Increased reported earnings in the period under review
C. Increased debt reported on the balance sheet at the end of the
current period
538

QUALITY
Practice questions
4. To properly assess a company’s past performance, an analyst

requires:
A. high earnings quality.
B. high financial reporting quality.
C. both high earnings quality and high financial reporting quality.
5. Which of the following best describes an opportunity for
management to issue low-quality financial reports?
A. Ineffective board of directors
B. Pressure to achieve some performance level
C. Corporate concerns about financing in the future
6. Which attribute of financial reports would most likely be evaluated as
optimal in the financial reporting spectrum?
A. Conservative accounting choices
B. Sustainable and adequate returns
C. Emphasized pro forma earnings measures
7. Which of the following concerns would most likely motivate a
manager to make conservative accounting choices?
A. Attention to future career opportunities
B. Expected weakening in the business environment
C. Debt covenant violation risk in the current period
539

QUALITY
Practice questions
8. Earnings that result from non-recurring activities most likely indicate:

A. lower-quality earnings.
B. biased accounting choices.
C. lower-quality financial reporting.
9. If a company uses a non-GAAP financial measure in an SEC filing, then
the company must:
A. give more prominence to the non-GAAP measure if it is used in
earnings releases.
B. provide a reconciliation of the non-GAAP measure and equivalent
GAAP measure.
C. exclude charges requiring cash settlement from any non-GAAP
liquidity measures.
10. Which technique most likely increases the cash flow provided by
operations?
A. Stretching the accounts payable credit period
B. Applying all non-cash discount amortization against interest
capitalized
C. Shifting classification of interest paid from financing to operating
cash flows
540

QUALITY
Practice questions
1. B is correct. If the ratio of cash flow to net income for a company is

consistently below 1 or has declined repeatedly over time, this may be a signal
of manipulation of information in financial reports through aggressive accrual
accounting
2. A is correct. Conservatism reduces the possibility of litigation and, by
extension, litigation costs. Rarely, if ever, is a company sued because it
understated good news or overstated bad news. Accounting conservatism is a
type of bias in financial reporting that decreases a company’s reported
performance. Conservatism directly conflicts with the characteristic of neutrality.
3. C is correct. Accounting choices are considered conservative if they decrease
the company’s reported performance and financial position in the period under
review. Conservative choices may increase the amount of debt reported on the
balance sheet. They may decrease the revenues, earnings, and/or operating cash
flow reported for the period and increase those amounts in later periods.
4. B is correct. Financial reporting quality pertains to the quality of the
information contained in financial reports. If financial reporting quality is low,
the information provided is of little use in assessing the company’s performance.
Financial reporting quality is distinguishable from earnings quality, which
pertains to the earnings and cash generated by the company’s actual economic
activities and the resulting financial condition.
541

QUALITY
Practice questions
5. A is correct. Opportunities to issue low-quality financial reports include

internal conditions, such as an ineffective board of directors, and external
conditions, such as accounting standards that provide scope for divergent
choices. Pressure to achieve a certain level of performance and corporate
concerns about future financing are examples of motivations to issue low-
quality financial reports. Typically, three conditions exist when low-quality
financial reports are issued: opportunity, motivation, and rationalization.
6. B is correct. At the top of the quality spectrum of financial reports are
reports that conform to GAAP, are decision useful, and have earnings that
are sustainable and offer adequate returns. In other words, these reports
have both high financial reporting quality and high earnings quality.
7. B is correct. Managers may be motivated to understate earnings in the
reporting period and increase the probability of meeting or exceeding the
next period’s earnings target.
8. A is correct. Earnings that result from non-recurring activities are
unsustainable. Unsustainable earnings are an example of lower-quality
earnings. Recognizing earnings that result from non-recurring activities is
neither a biased accounting choice nor indicative of lower quality financial
reporting because it faithfully represents economic events.
542

QUALITY
Practice questions
9. B is correct. If a company uses a non-GAAP financial measure in an SEC
filing, it is required to provide the most directly comparable GAAP measure
with equivalent prominence in the filing. In addition, the company is
required to provide a reconciliation between the non-GAAP measure and
the equivalent GAAP measure. Similarly, IFRS require that any non-IFRS
measures included in financial reports must be defined and their potential
relevance explained. The non-IFRS measures must be reconciled with IFRS
measures.
10. A is correct. Managers can temporarily show a higher cash flow from
operations by stretching the accounts payable credit period. In other words,
the managers delay payments until the next accounting period. Applying all
noncash discount amortization against interest capitalized causes reported
interest expenses and operating cash outflow to be higher, resulting in a
lower cash flow provided by operations. Shifting the classification of
interest paid from financing to operating cash flows lowers the cash flow
provided by operations.
543
READING 26: APPLICATIONS OF

FINANCIAL STATEMENT ANALYSIS
544
READING 26: APPLICATIONS OF FINANCIAL

STATEMENT ANALYSIS
Learning outcomes
26.a. Evaluate a company’s past Financial performance and

explain how a company’s strategy is reflected in past
financial performance.
26.b. Demonstrate how to forecast a company’s future net

income and cash flow.
26.c. Describe the role of financial statement analysis in

assessing the credit quality of a potential debt
investment.
26.d. Describe the use of financial statement analysis in

screening for potential equity investments.
26.e. Explain appropriate analyst adjustments to a company’s

financial statements to facilitate comparison with another
company.
545

STATEMENT ANALYSIS
[LOS 26.a] Evaluate a company’s past Financial performance
and explain how a company’s strategy is reflected in past
Financial analysis
Adressing
How well the company The reasons behind its

performed over the period performance
Financial analysis should focus on:

• Important changes that have occurred in corporate measures of
profitability, efficiency, liquidity, and solvency and the reasons behind
these changes.
• Comparisons of the company’s financial ratios with others from the
same industry and the reasons behind any differences.
• Examination of performance aspects that are critical for a company to
successfully compete in the industry and an evaluation of the
company’s performance on these fronts relative to its competitors’.
• The company’s business model and strategy and how they influence its
operating performance.
546

STATEMENT ANALYSIS
[LOS 26.a] Evaluate a company’s past Financial performance
and explain how a company’s strategy is reflected in past
Example: A firm’s strategy and its financial performance

Low cost airlines like Southwest focus on generating profits through high
volumes with low margins. Others, like Silverjet (an exclusively business
class airline) cater to high end customers only.
→ While Silverjet sales volume (in units) would be significantly lower
than Southwest’s, Silverjet gross margin should be higher as it offers a
premium service.
547

STATEMENT ANALYSIS
LOS 26.b: Demonstrate how to forecast a company’s future net
1. Sales forecast
“Top down” approach: GDP growth → growth of

industry sales (Use regression models) → firm sales
(market share analysis).
2. Using model to forecast net income from revenue

A simple forecasting model: use historical average,
trend-adjusted measure of profitability of operating
margin, EBT margin, or net margin to forcast
earnings.
Complex forecasting models: each item on an
income statement and balance sheet can be
estimated based on separate assumptions
548

STATEMENT ANALYSIS
LOS 26.b: Demonstrate how to forecast a company’s future net
Make assumptions about future sources and uses

3.
of cash
Assumptions should be made on:
• Required increases in working capital.
• Capital expenditures on new fixed assets.
• Repayment and issuance of debt.
• Repurchase and issuance of stock (equity).
4. Forecast Cash flow
Forecast cash flow based on assumptions made in

step 3.
549

STATEMENT ANALYSIS
LOS 26.c: Describe the role of financial statement analysis in
assessing the credit quality of a potential debt investment.
1. Credit risk
Credit risk is the risk of loss from a counterparty or debtor’s

failure to make a promised payment.
2. Credit analysis
Credit analysis involves evaluation of the 4 “Cs” of a company.
Character refers to the quality of management
Collateral refers to the assets pledged to secure a loan.
refers to the ability of the issuer to fulfill its

Capacity
obligations.
are limitations and restrictions on the

Covenants
activities of issuers.
550

STATEMENT ANALYSIS
LOS 26.c: Describe the role of financial statement analysis in
assessing the credit quality of a potential debt investment.
3. Credit analysis considerations

Credit rating agencies such as Moody’s and Standard and Poor’s
employ formulas that are essentially weighted averages of
several specific accounting ratios and business characteristics.
Scale and diversification: Larger companies enjoy

significant leverage in negotiations with suppliers
and lenders ⇒ lower credit risk.
Operational efficiency: Firms that have higher

The types return on their assets ⇒ lower credit risk.
of items
considered Margin stability: high profit margins indicate a
higher probability of repayment ⇒ low credit risk.
Leverage: High ratios of free cash flow to total

debt and to interest expense ⇒ low credit risk.
551

STATEMENT ANALYSIS
LOS 26.d: Describe the use of financial statement analysis in
1. Definition of screening
Screening is the process of filtering a set of potential investments
into a smaller set (that exhibits certain desirable characteristics)
by applying a set of criteria.
Top-down analysis Bottom-up analysis
involves identifying attractive involves selecting specific
geographical and industry segments, investments within a specific
and then choosing the most investment universe.
attractive investments from them.
2. Applications of screening
Screens can be used by growth investors (focused on investing in
high earnings-growth companies), value investors (focused on
paying a relatively low share price in relation to earnings or assets
per share), and market-oriented investors (who cannot be
categorized as growth or value investors).
552

STATEMENT ANALYSIS
2. Applications of screening
Securities
Screening
Value investors set screens

Growth investors set
like a higher-than-average
screens like increasing
return on equity (ROE) and
earnings growth and/or
a lower-than-average P/E
momentum.
ratio
Potential investment portfolio
3. Limitations of screening
Equity screens will likely include and exclude many or all of the
firms in particular industries.
553

STATEMENT ANALYSIS
4. Backtesting
Using a specific set of criteria to screen historical data to determine

how portfolios based on those criteria would have performed.
Limitations
Survivorship bias: If the database used in backtesting eliminates

companies that cease to exist because of a merger or bankruptcy, then
the remaining companies collectively will appear to have performed
better.
Look-ahead bias: If a database includes financial data updated for

restatements, there is a mismatch between what investors would have
actually known at the time of the investment decision and the
information used in backtesting.
Data-snooping bias: If researchers build models based on previous

researchers’ findings, then using the same database to test the model is
not actually a test.
554

STATEMENT ANALYSIS
LOS 26.e: Explain appropriate analyst adjustments to a
company’s financial statements to facilitate comparison with
another company.
Company uses different Financial Analysts need to make

accounting method or statements items adjustments to facilitate
estimate key accounting becomes comparisons
inputs differently incomparable
1. Adjustments related to investments
Securities are recorded as held-for-trading, available-for-sale, held-to-

maturity. these differences in classifications lead to significant differences
in reported net income or balance sheet asset values → adjust net income
and assets
2. Adjustments related to inventory
Firm using LIFO → higher cost of goods sold, lower income, and lower
inventory (when costs are rising) → adjust LIFO cost of goods and
inventory to their FIFO-equivalent values using LIFO reserve
555

STATEMENT ANALYSIS
another company.
3. Adjustments related to property, plant, and equipment
Differences between depreciation methods, estimates of useful lives, and estimates

of salvage values → significant differences in reported income and balance sheet
asset values → adjustment should be made.
Gross fixed assets = Accumulated depreciation + Net fixed assets
Gross fixed assets Accumulated depreciation Net fixed assets

= +
Annual depreciation expense Annual depreciation expense Annual depreciation expense
Estimated useful or
Average age of asset Remaining useful life
depreciable life
Comparing average ages and useful lives of assets within an

industry may reveal differences in firms’ future capital spending needs.
Example: A firm that is aggressive in using higher estimates of useful asset lives or
asset salvage values will report lower annual depreciation expense and higher net
income, compared to a more conservative firm that uses lower estimates of useful
lives or salvage values.
556

STATEMENT ANALYSIS
another company.
4. Adjustments related to goodwill
For companies that has grown through acquisition of some business

units, analysts must remove the inflating effect of goodwill on book
value and rely on the price to-tangible book value ratio to make
comparisons.
Two adjustments should be made on goodwill:
• Goodwill should be subtracted from assets when calculating
financial ratios
• Any income statement expense from impairment of goodwill in the
current period should be reversed, increasing reported net income.
557

STATEMENT ANALYSIS
Practice questions
26.a. Evaluate a company’s past Financial performance and

explain how a company’s strategy is reflected in past financial N/A
performance..
26.b. Demonstrate how to forecast a company’s future net income

6
and cash flow.
26.c. Describe the role of financial statement analysis in assessing

1
the credit quality of a potential debt investment.
26.d. Describe the use of financial statement analysis in screening

3
for potential equity investments.
26.e. Explain appropriate analyst adjustments to a company’s

financial statements to facilitate comparison with another 2, 4, 5
company.
558

STATEMENT ANALYSIS
Practice questions
1. Credit analysts are likely to consider which of the following in making
a rating recommendation?
A. Business risk but not financial risk
B. Financial risk but not business risk
C. Both business risk and financial risk
2. To compute tangible book value, an analyst would:
A. add goodwill to stockholders’ equity.
B. add all intangible assets to stockholders’ equity.
C. subtract all intangible assets from stockholders’ equity.
3. When a database eliminates companies that cease to exist because of
a merger or bankruptcy, this can result in:
A. look-ahead bias.
B. back-testing bias.
C. survivorship bias.
4. An analyst is evaluating the balance sheet of a US company that uses
last in, first out (LIFO) accounting for inventory. The analyst collects the
following data:
559

STATEMENT ANALYSIS
Practice questions
4. 31 Dec 05 31 Dec 06
Inventory reported
$500,000 $600,000
on balance sheet
LIFO reserve $ 50,000 $70,000
Average tax rate 30% 30%
After adjusting the amounts to convert to the first in, first out (FIFO)
method, inventory at 31 December 2006 would be closest to:
A. $600,000.
B. $620,000.
C. $670,000.
5. An analyst gathered the following data for a company ($ millions):
31 Dec 2000 31 Dec 2001
Gross investment in fixed
$2.8 $2.8
assets
Accumulated depreciation $1.2 $1.6
The average age and average depreciable life of the company’s fixed
assets at the end of 2001 are closest to:
560

STATEMENT ANALYSIS
Practice questions
Average Age Average Depreciable Life
A. 1.75 years 7 years
B. 1.75 years 14 years
C. 4.00 years 7 years
6. Projecting profit margins into the future on the basis of past results
would be most reliable when the company:
A. is in the commodities business.
B. operates in a single business segment.
C. is a large, diversified company operating in mature industries.
561

STATEMENT ANALYSIS
Practice questions
1. C is correct. Credit analysts consider both business risk and financial
risk.
2. C is correct. Tangible book value removes all intangible assets, including
goodwill, from the balance sheet.
3. C is correct. Survivorship bias exists when companies that merge or go
bankrupt are dropped from the database and only surviving companies
remain. Look-ahead bias involves using updated financial information in
back-testing that would not have been available at the time the
decision was made. Backtesting involves testing models in prior periods
and is not, itself, a bias.
4. C is correct. To convert LIFO inventory to FIFO inventory, the entire LIFO
reserve must be added back: $600,000 + $70,000 = $670,000.
5. C is correct. The company made no additions to or deletions from the
fixed asset account during the year, so depreciation expense is equal to
the difference in accumulated depreciation at the beginning of the year
and the end of the year, or $0.4 million. Average age is equal to
accumulated depreciation/depreciation expense, or $1.6/$0.4 = 4
years. Average depreciable life is equal to ending gross
investment/depreciation expense = $2.8/$0.4 = 7 years.
6. C is correct. For a large, diversified company, margin changes in
different business segments may offset each other. Furthermore,
margins are most likely to be stable in mature industries.
56
2
Thanks for your watching!

CFA - FSA - Updated 010822

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFA - FSA - Updated 010822

Uploaded by

Copyright:

Available Formats

1

READING 15: INTRODUCTION TO

READING 15: INTRODUCTION TO FINANCIAL

15.a. Describe the roles of financial reporting and financial statement

15.e. Identify & describe information sources that analyst use in FS

15.f. Describe the steps in the financial statement analysis framework

READING 15: INTRODUCTION TO FINANCIAL

1. Role of financial reporting

2. Role of financial statement analysis

Financial statement analysis is to use the information in a company’s financial

READING 15: INTRODUCTION TO FINANCIAL

Statement of financial position (balance sheet)

Statement of comprehensive income

Statement of cash flows

Statement of changes in equity

Note: The accompanying required notes or footnotes (see

READING 15: INTRODUCTION TO FINANCIAL

1. Role of statement of financial position

Report major classes & amount of assets (resources owned or controlled

Basic equation of SOFP

Assets Liabilities Equity

READING 15: INTRODUCTION TO FINANCIAL

Example: Statement of financial position

READING 15: INTRODUCTION TO FINANCIAL

2. Role of statement of comprehensive income (SOCI)

Report on performance of firm (result of its operating activities) on

Basic equation of SOCI

The statement of comprehensive income can be presented as a single

READING 15: INTRODUCTION TO FINANCIAL

Example: Statement of comprehensive income

READING 15: INTRODUCTION TO FINANCIAL

3. Role of statement of cash flow

Report cash receipts and payments in the reporting period, classified as

Basic equation of SOCF

Net cash Net cash in Net cash in Net cash in

READING 15: INTRODUCTION TO FINANCIAL

+ Net cash in financing CF

READING 15: INTRODUCTION TO FINANCIAL

Example: Profit versus Cash Flow

READING 15: INTRODUCTION TO FINANCIAL

Sale price €250,000 Cash from sale price €250,000

Cash paid for COGS

Rent and salaries (€20,000) Cash paid for Rent &

SD’s profit for SD’s cash flow for

READING 15: INTRODUCTION TO FINANCIAL

Profit Cash flow

Sale price €250,000 Cash from sale price €250,000

Cash paid for COGS

Rent and salaries (€20,000) Cash paid for Rent &

SD’s profit for SD’s cash flow for

READING 15: INTRODUCTION TO FINANCIAL

4. Role of statement of change in equity

• Report movement (increase and decrease) in components of owners’

Basic equation of SOCI

Opening Movement Closing

READING 15: INTRODUCTION TO FINANCIAL

Example: Statement of change in equity

Share Share Retained Revaluation Unrealized gain on

Balance at 1/1/2020 700,000 - 500,560 - 34,850 1,235,410

Balance at 31/12/2020 800,000 50,000 477,460 85,000 20,800 1,433,260

READING 15: INTRODUCTION TO FINANCIAL

The notes provide information that is essential to understanding the

Information included in Financial statement notes: