2022 Li Fra

Last Revised: 05/03/2021
MarkMeldrum.com
Level I - Financial Reporting and Analysis
Readings Page
(PREREQ.) Financial Reporting Mechanics 2
Introduction to Financial Statement Analysis 6
Financial Reporting Standards 11
Understanding Income Statements 17
Understanding Balance Statements 27
Understanding Cash Flow Statements 35
Financial Analysis Techniques 43
Inventories 53
Long-Lived Assets 61
Income Taxes 73
Non-Current (Long-Term) Liabilities 81
Financial Reporting Quality 91
Applications of Financial Statement Analysis 103
Reviews 107
This document should be used in conjunction with the corresponding readings in the 2022 Level I CFA® Program curriculum.
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(PREREQ. 1)
Financial Reporting Mechanics
Business Activity Classification
3 categories
1) Operating activities day-to-day business activities
(Rev., exp., Taxes, AR, Inv., AP)
2) Investing activities acquisition/disposal of non-current

assets
(CAPEX, Investment)
3) Financing activities obtaining/repaying capital

(debt, equity)
Elements & Accounts
5 financial statement Elements

Assets Liabilities Equity Revenues Expenses
| | | | |
economic creditor’s claims residual inflow of outflow of
resources on those claim economic economic
- Current -resources
Current resources resources
- Non-current - Non-current
Accounts (sum up the balances within elements)

· Cash · Acts. Pay. · Paid-in-Capital · Sales · Depn.
· Inventory · Accrued Exp. · Ret. Earn · Admin Exp.
· Acts. Rec.
Contra-accounts (decreased the balance within Elements)

· Dep. · Returns &
· All for D.A. Allowances
Accounting Equations
B.S. A= L + E Basic Accounting Equation

owner’s equity
A – L = E - residual claim shareholder equity
net assets
= Contributed + Retained net worth
Capital Earnings net book value
net profit
I.S. Revenues – Expenses = Net Income (loss)
(incl. gains) (incl. losses) net earnings
Statement of:
· Operations
· Income
· Profit & Loss
B.S. and I.S. linked by:

End. Ret. Earn. = Beg. Ret. Earn. + NI – Dividends
= Beg. Ret. Earn. + Rev. – Exp. – Dividends
A = L + Cont. Cap. + End. Ret. Earn.
= L + Cont. Cap. + Beg. Ret. Earn. + Rev. – Exp. – Dividends
Statement of Retained Earnings

e.g. Rev. $350
Beg. Ret. Earn. 90 Total Assets?
Exp. 280 = 120 + 75 + (90 + 350 – 280 - 25)
Div. 25 = 195 + 135
Liabilities 120 = 330
Cont. Cap. 75
Recording Process
based on double-entry accounting

(every transaction affects at least 2 accounts
such that debits = credits)
Financial Statements can be prepared at any time since the accounts
will always be in balance
reconciles cash balance

first line
B.S I.S CF. S
Net Income
Ret. = NI – Div.
Earn.
Accruals & Valuation
- based on ‘matching principle’

· Rev./Exp. recognized in the period in which they occur
regardless of when cash changes hands
Unearned Rev. get paid before delivery of good/service

(liability) i.e. book a flight in Jan. for March
Accrued Rev. not yet billed

(asset) i.e. lawyers
Prepaid Expense paid for but not yet used

(asset) i.e. Property Tax for the full year
Accrued Exp. incurred but not yet billed

(liability) i.e. Payday Quarter end Payday
| | |
Accrued exp.
all transactions are recorded at historical cost

certain items must be shown at market values
result in valuation adjustments to assets/liabilities
(gains/losses)
Information Flow
4 stages 1) Journal entries (and adjusting entries)

2) General ledger
3) Trial Balance
4) Financial Statements
Using Statements
· adjustments may need to be made

reflect items not reported
reconcile IFRS/GAAP
reconcile actg. policies
· assessments of reasonableness of judgements and estimates

| |
· never underestimate extent accruals useful life
of blatant misrepresentation valuations salvage value
and manipulation warranty claims
notes to fin. st.

MD & A
Introduction to Financial Statement Analysis
a. describe the roles of financial reporting and financial statement analysis;
b. describe the roles of the statement of financial position, statement of

comprehensive income, statement of changes in equity, and statement of cash
flows in evaluating a company’s performance and financial position;
c. describe the importance of financial statement notes and supplementary

information – including disclosures of accounting policies, methods, and
estimates – and management’s commentary;
d. describe the objective of audits of financial statements, the types of audit

reports, and the importance of effective internal controls;
e. identify and describe information sources that analysts use in financial

statement analysis besides annual financial statements and supplementary
information;
f. describe the steps in the financial statement analysis framework.

Financial Statement Analysis

Page 1
Role of Financial Statements provide information
LOS a
financial performance - describe
financial position
changes in financial position
Role of financial statement analysis
1) make economic decisions
· invest · lend · acquire
2) make assessments
· ratings · valuation
- examine current and past performance in order to form

an expectation of future performance
(profits, cash flow, assets, liabilities, equity)
capital structure
Page 2
Primary Financial Statements/ · periodic (unaudited) LOS b
· annual (audited) - describe
- prepared in accordance with applicable accounting standards

IFRS
1) Balance Sheet (Statement of Financial Position)
Assets = Liabilities + Owner’s Equity (accounting
equation)
resources the obligations to excess of
company controls lenders/creditors assets over liabilities
Assets Liabilities
Current Assets most Current Liabilities
IFRS specifies
liquid
categories but
Non-Current Liabilities
not format
Long-Lived Assets least
ordering by
liquid Equity liquidity may
Total Assets $ Total L + E $ differ
for a point in time

Page 3
2) Income Statement (Statement of Comprehensive LOS b
Income) - describe
single statement
· IFRS
2 statements Income St. consolidated
St. of C.I. (begins with N.I.) ( > 50%)
covers a period of time
Income – Expenses = Net Income/loss expressed as
Basic and
(Revenue + Other Income) Diluted EPS
Other Comprehensive Income (OCI): all items that impact
owner’s equity but are not the results of
transactions with shareowners · unrealized gains/losses
· foreign currency translations
NI + OCI = TCI
· pension actuarial g/L
3) Statement of Changes in Owner’s Equity/
· for each equity account : Beg. balance + Inc. – Dec. = Ending
(paid-in capital, retained earnings, etc.) balance
Page 4
4) Cash Flow Statement
LOS b
Sources and uses of cash from: Operations - CFO - describe
Investing
Financing
Financial Notes/(footnotes) LOS c

- describe
- needed to understand statements
actg. policies, methods, estimates
acquisitions, disposals · provides info
commitments & contingencies about (almost)
legal proceedings every line item in
subsequent events the statements
related-party transactions · facilitates comparison
segment performance between IFRS and
U.S. GAAP
Page 5
Management Discussion & Analysis (MD&A) – unaudited LOS c
IFRS · nature of business - describe
· mgmt. objectives and strategies
· significant resources, risks, relationships
· results of operations
· critical performance measures
liquidity
required by SEC · important trends/events that affect capital resources
· results of operations operations
· off-balance sheet obligations

· prospects for inflation, goals, material events
· critical actg. policies that require subjective
judgements
Page 6
Audits/
LOS d
· Objectives (under International Standards for Auditing) - describe
1) obtain reasonable assurance that statements are free
from material misstatement
2) report on the fin. st. + communicate findings
Auditor’s report
Types of Audit reports/opinions:
unmodified 1) unqualified (clean): statements presented fairly in
accordance with actg. standards
2) qualified: presented fairly with some exceptions
modified
3) adverse: not presented fairly
4) Disclaimer of opinion: auditor is not able to issue an
opinion
U.S. Sarbanes-Oxley · auditors must express an opinion on the
company’s internal control systems
ensures the reliability of processes

used in preparing fin. st.
Page 7
· audit report also includes LOS d
· Key Audit Matters (International) - describe
- issues the auditor considers most important
(higher risk of misstatement, significant mgmt. judgment)
· Critical Audit Matters (U.S.)
- issues that involve ‘especially challenging, subjective or
complex auditor judgment’
LOS e
Other Sources of Information/
- identify
· Interim reports quarterly statements
- describe
· Proxy statements matters that require shareholder vote
plus/ · mgmt. compensation
· stock performance
· Company websites · Conference calls economic
· Press releases · External sources industry
peers
Page 8
1) Determine the purpose and context of the analysis LOS f
- describe
2) Collect data – financial statements
- discussions with management
- company site visits
3) Process Data – ratios

- growth rates
- common-size statements
- statistical tools
4) Analyze/Interpret the Data – conclusions/recommendations
5) Develop/Communicate Conclusions – analyst report

(must distinguish between opinion and fact)
6) Follow-up
Financial Reporting Standards
a. describe the objective of financial reporting and the importance of financial

reporting standards in security analysis and valuation;
b. describe the roles of financial reporting standard-setting bodies and

regulatory authorities in establishing and enforcing reporting standards;
c. describe the International Accounting Standards Board’s conceptual

framework, including qualitative characteristics of financial reports,
constraints on financial reports, and required reporting elements;
d. describe general requirements for financial statements under International

Financial Reporting Standards (IFRS);
e. describe implications for financial analysis of alternative financial reporting

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

Page 1
Accounting Standards provide principles for preparing
LOS a
financial reports and determine the types and - describe
amounts of information that must be provided to users
IASB – International Accounting Standards Board: objective of

financial reporting is to provide financial information that
is useful to users in making decisions about providing resources
to the entity
invest, lend, work for, extend credit, etc.
Since financial reporting requires the use of judgments (estimates),

Standards try to limit the range of judgment to increase
consistency
Page 2
Standard Setting Bodies vs. Regulatory Authorities LOS b
e.g./ IASB/FASB e.g. SEC - describe
- private sector SROs that - recognize, require and
set standards enforce standards
Accounting Standards Boards/ - typically independent, private, not-for-profit

orgs.
1/ IASB standard setting body for IFRS
principle objective develop/promote the use and adoption of
a single set of standards transparent
comparable information
decision-useful
+ promote convergence of
standards
2/ FASB standard setting body for U.S. GAAP

Page 3
· Regulatory Authorities/ gov’t. entities with legal authority LOS b
to enforce requirements - describe
1/ IOSCO – International Organization of Securities Commissions

- made up of the regulators of different markets
- do not develop the regulations, but establish objectives/
principles to guide regulation
protect investors
3 core objectives of regulation ensure that markets are fair,
reduce systemic risk efficient and
transparent
2/ SEC – Securities and Exchange Commission (U.S.)
- any company issuing securities in the U.S. is subject to
the rules/regulations of the SEC
- companies must submit filings to comply (standardized forms)
electronically - EDGAR
Page 4
· Regulatory Authorities/ LOS b
2/ SEC – Securities and Exchange Commission (U.S.) - describe
· submission examples: · Securities Offering Registration Statement
· 10-k (20-F, 40-F) annual audited statements
· DEF – 14/A proxy statement
· 10–Q (6–k) quarterly unaudited statements
· 8-k material events e.g. M&A, disposals,
mgmt. changes, etc.
· 3, 4, 5 beneficial ownership
· 144 sale of restricted securities
· 11-k ESOP report
3/ Europe - IFRS
- regulation rests with each member state
ESC – European Securities Commission consist of

member
ESMA – European Securities and Market Authority
states
- advise EU
Page 5
Conceptual Framework/ LOS c
objective provide financial information useful in - describe
making decisions about providing resources to the entity
· Qualitative characteristics of financial reports/

Fundamental
1/ Relevance – info. is relevant if it would affect or make a difference
- material info. is relevant in user’s decisions
omission/misstatement could influence user’s decisions

2/ Faithful representation – info. is complete, neutral, free from error
Enhancing without bias
· Comparability
· Verifiability - involves trade offs estimates are not verifiable
· Timeliness available prior to making a decision
· Understandability clear and concise presentation
Page 6
Conceptual Framework/
LOS c
· Constraints/ Cost of providing information – benefits should - describe
(example #2) outweigh costs
· Elements/ measurement of financial position

1/ Assets – an economic resource controlled by the entity (what a
company owns)
2/ Liabilities – an obligation of the entity to transfer an
economic resource (what a company owes)
3/ Equity – Assets – Liabilities
- measurement of performance
4/ Income – increases in assets, decreases in liabilities that result in
increases in equity (revenue + gains)
5/ Expenses – decreases in assets, increases in liabilities that result in
decreases in equity (costs + losses)
Page 7
Conceptual Framework/ LOS c
· Underlying Assumptions/ - describe
1/ Accrual accounting – matching principle, revenue recognized as
2/ Going concern – company will continue to operate earned
· Measurement of Elements – monetary amounts to recognize

· historical cost – amount originally paid
· amortized cost – historical cost – Dep./Am.
· current cost – amount required today for replacement
· realizable value – amount realized from a sale of an asset
- called ‘settlement’ value for a liability
· present value – discounted value of future net cash inflows
· fair value – amount realized in a sale (normal markets)
Page 8
General Requirements/ LOS d
1/ Required Financial Statements/ - describe
· Statement of financial position Balance Sheet
· Statement of Comprehensive Income single statement or/
· Statement of changes in Equity IS + comp. Inc.
· Statement of cash flows
· Notes to financial statements
2/ General features of financial statements/

· fair presentation – faithful representation of the effects of
transactions
· going concern – unless intention is different
· accrual basis – matching principle, revenue recognized when earned
· materiality & aggregation – similar items are aggregated, presented
separately from dissimilar items
Page 9
General Requirements/ LOS d
2/ General features of financial statements/ - describe
· no offsetting assets & liabilities should not be used
Revenue & expenses to offset each other
· frequency of reporting at least annually audited
· comparative information should be presented for prior periods
e.g. BS–2 yrs. IS/CI–3 yrs.
· consistency items presented and classified in the same manner
in every period
3/ Structure and content requirements/

· Balance Sheet current/non-current assets/liabilities should be
shown separately
· Minimum info. on the face of the financial statements
· Minimum info. in the Notes (exhibit 2)
· Comparative info. as above
Page 10
2 major standards: IFRS vs. GAAP LOS e
- describe
not fully converged
- analysts must be aware of areas where standards have not
converged
modifying statements for comparability may not
always be possible
- must be aware of standards development, know where
caution is warranted
1/ new products & types of transactions – standards may not yet exist
2/ actions of standard–setting bodies – iasb.org and fasb.org
3/ company disclosures regarding critical actg. policies – companies will

discuss the impact of pending standards changes
Understanding Income Statements
a. describe the components of the income statement and alternative presentation

formats of that statement;
b. describe general principle of revenue recognition and accounting standards for

revenue recognition;
c. calculate revenue given information that might influence the choice of revenue
recognition method;
d. describe general principles of expense recognition, specific expense recognition

applications, and implications of expense recognition choices for financial
analysis;
e. describe the financial reporting treatment and analysis of non-recurring items

(including discontinued operations, unusual or infrequent items) and changes in
accounting policies;
f. contrast operating and non-operating components of the income statement;
g. describe how earnings per share is calculated and calculate and interpret a
company’s earnings per share (both basic and diluted earnings per share) for both
simple and complex capital structures;
h. contrast dilutive and antidilutive securities and describe the implications of each
for the earnings per share calculation;
i. formulate income statements to common-size income statements;
j. evaluate a company’s financial performance using common-size income

statements and financial ratios based on the income statement;
k. describe, calculate, and interpret comprehensive income;
l. describe other comprehensive income and identify major types of items included
in it.
- presents a company’s financial results over a period of time LOS a

-describe
Revenue – expenses = Net Income Pg-1
· IFRS/GAAP may be presented as a separate statement (IS) followed

by a Statement of Comprehensive Income (CI)
or/ a single statement of CI with a separate section for P/L
Components of the IS/
Revenue (net) – first line amounts charged for g/s in the ordinary
activities of the business
reported as a ‘net’ figure (i.e. less estimated
returns, rebates, discounts, etc…)
Expenses – outflows, depletion of assets, incurrences of liabilities in the

ordinary course of the business
- may be grouped by nature or function
Components of the IS/ LOS a

-describe
Expenses grouping by nature e.g. depreciation
Pg-2
function e.g. COGS – RM, DL, MOH
SG & A – DL, OH
Gains/Losses typically non-operating e.g. gain/loss on sale of assets
unrealized gain/loss on financial
assets
Multi-step IS: Gross Profit/Margin Rev. $ 100%
($) (%) - COGS ($) x %
Profit $ (100 - x)% - margin
Operating Profit/Margin Gross profit - not affected by

- may or may not include - Operating Exp. capital structure
non-operating Inc./Exp.
- income from associates
- discontinued operations
(EBIT – 1 – T = NI)
Net Income/Margin bottom line
Revenue Recognition/ LOS b

-describe
accrual basis – revenue is recognized when it is earned
Pg-3
- may or may not be at the same time payment is received
- payment after delivery Accounts Receivable
- payment before delivery Unearned Revenue
· Accounting Standards/ IASB/FASB

core principle rev. recognized to reflect the transfer of g/s
to customers in an amount that reflects the
consideration to be received
5 Steps:
1/ Identify the contract(s) with a customer
2/ Identify the separate/distinct performance obligations in the contract
3/ Determine the transaction price
4/ Allocate the price to the performance obligations
5/ Recognize revenue when a performance obl. is satisfied
LOS b
Revenue Recognition/
-describe
· Accounting Standards/ contract – agreement between parties Pg-4
- establishes obligations and rights
(e.g. delivery of g/s for payment)
- contract only exists if collectability is probable
IFRS: more likely than not GAAP: likely to occur
- performance obligations
distinct g/s customer can benefit from it on its own
promise to transfer g/s can be separated
from other g/s in contract
- obligation satisfied, and revenue recognized, when:

1/ company has a right to payment
2/ customer has legal title
3/ customer has physical possession
4/ customer has significant risks/rewards of ownership
5/ customer has accepted the asset (Exhibit #5)
LOSc - calculate
LOS d
Expense Recognition/
-describe
IASB/ · expenses are decreases in economic benefits in the Pg-5
form of: · outflows expenses
· depletion of assets +
· incurrences of liabilities losses
that result in decreases in equity
· General Principle/ · matching principle (concept) matching costs with

- product costs COGS – directly related to Revenue revenues
- period costs Admin, Depreciation related to operations
regardless of the level of Revenue
COGS depends on the inventory method adopted (more on this in the

FIFO – first-in, first-out reading: Inventories)
LIFO – last-in, first-out
(Example #1, #2)
Weighted average – average cost
Expense Recognition/ LOS d

-describe
· Doubtful accounts – matching principle estimate amount that
Pg-6
- expensed on IS would be uncollectible (typically derived from
for reporting purposes past exp.)
- direct write-off method (tax purposes)

- take charge only when default occurs
· Warranties – estimate expense based on level of sales and past exp.

- expensed on IS for reporting purposes
· Depreciation/Amortization – costs of long-lived assets are allocated over

the period of time during which they provide economic benefits
(except for land and intangibles with indefinite lives)
- physical assets Depreciation (building, equipment)
- Intangible assets Amortization (copyright, patent)
LOS d
-describe
· Depreciation/Amortization – 2 methods under IFRS Pg-7
(not widely
1/ Cost model 2/ Revaluation model
used)
IS/ IS/ − /
−
.= ( − )
BS/ = − . . BS/ =
· IFRS requires each component of not permitted under GAAP

an asset to be depreciated separately
· also requires an annual review of salvage
value and useful life
- choice of depreciation method should match the asset’s pattern of use
· Straight-Line (S.L.) no pattern then use S.L.

− estimate
estimate (Example #3)
LOS d
-describe
· Depreciation/Amortization Pg-8
· Accelerated methods - greater proportion of the cost to early yrs.
- referred to as
e.g. 2x declining (example #4)
conservative
Dep. exp. Early years 2x > S.L. higher NI with S.L.
Later years 2x < S.L. higher NI with 2x
· amortization typically S.L.
indefinite lives (e.g. Goodwill), no amortization but tested
annually for impairment
Implications choice of methods and estimates will affect Net Income
and thus, comparability (found in Notes of Statements)
- are changes valid?
- are differences valid?
Non-recurring items/ less likely to continue in the future LOS e

-describe
1/ Discontinued operations Pg-9
(IFRS/GAAP specify a separate line item for D.O.)
- on disposal or the establishment of a disposal plan for one
of its component operations
- reported on a separate line item
2/ Unusual or Infrequent Items - if material and/or relevant to

understanding, should be disclosed separately
- shown as part of continuing operations, but presented on a
separate line item (e.g. Other Operating Income (Expense))
(Exhibit #8)
3/ Changes in Accounting Policy
- new standards prospective – going forward ( estimates)
retrospectively – for all statements as if the
standard always applied
correction of a
past error
- preserves comparability ( policies)
Non-Operating Items/ LOS f

-distinguish
Pg-10
− .
=
typically + Non-operating gains/Inc. typically amounts earned
reported - Non-operating losses/Exp. through investing or
separately financing activities
may be disclosed on a ‘Net’ basis
e.g. Net Interest Expense = Interest Expense – Interest Inc.
Earnings per share (EPS)/ LOS g

IFRS/GAAP – require the presentation of EPS -describe
-calculate
on the face of the IS (below NI)
-interpret
· Simple vs. Complex Capital Structure: Pg-11
- EPS reported for ordinary or common shares - subordinate to
(IFRS) (GAAP) all other capital
securities
- if a company has convertible securities (pref. sh., debt), said to have a
complex structure
potentially dilutive
(NI – Pref. Div.)

=
company #
must
report Diluted EPS what EPS would be if all dilutive
securities were converted
+ Basic and Diluted EPS from continuing operations
LOS g
Earnings per share (EPS)/
-describe
− -calculate
=
# -interpret
time Pg-12
e.g./ weighting
Jan. 1 2M outstanding
( )+ ( . )= .
July 1 -100k repurchase
- stock splits, stock dividends reflected in beginning share count

(example #6, 7, 8)
Diluted EPS – simple structure: Basic = Diluted
a) convertible preferred shares/ use of ‘if-converted’ method (as of

Numerator higher – no pref. Div. beginning of period)
2 effects
Denominator higher – more common shares
= (example #9)
. . #
+
LOS g
Earnings per share (EPS)/
-describe
Diluted EPS b) Convertible Debt – also uses ‘if-converted’ method -calculate
-interpret
+ − . − . .
= Pg-13
. .#
+ (example #10)
GAAP
c) Stock options, warrants – treasury stock method
similar for IFRS
have a strike price company collects the strike price, uses the
proceeds to buy shares, only the difference = new shares
− . . weighted by time
= options/warrants were
. .# + . .
outstanding
- if issued prior to period,
(example #11, 12) full amount
- if issued during period,
time weighted
Anti-dilutive/ - conversion would result in an EPS LOS h

-distinguish
higher than Basic EPS
-describe
IFRS/GAAP such securities are not included in
Pg-14
the calculation of Diluted EPS
Diluted EPS ≤ Basic EPS (Example #13)
· Changes in EPS
changes in numerator NI, Pref. Div.
buybacks
changes in denominator w.a. # shares
secondary offerings
conversions
Common size analysis/ LOS i

-convert
Sales 100%
Pg-15
- COGS x %
· each line as a
= gross profit (100 - x) % gross margin %’age of Revenue
- SG & A - y1%
- R & D - y2%
- Advertising - y3%
= Operating profit (100% - x% - y1% - y2% - y3%) - op. profit margin
- Taxes - T% . not Sales (effective tax rate)
= Net Income = NI% - net income margin
· removes size effect

· facilitate comparison across time periods (time series analysis)
· facilitate comparison across companies (cross sectional analysis)
(Exhibit #15, 16)
LOS j
Ratios/
-evaluate
· = Pg-16
- measures effectiveness at manufacturing or purchasing
- lower margins over time = competitive pressures
· =
- measures effectiveness at operations
- higher margins as size grows = economies of scale
· =
- measures overall effectiveness
(Exhibit #17)
LOS k, l
Comprehensive Income
-describe
OCI – Other Comprehensive Income -calculate
TCI – Total Comprehensive Income – change in -interpret
equity during a period resulting from transactions Pg-17
(IFRS/GAAP) and other events, other than those changes resulting
from transactions with owners

TCI = NI + 0CI
other revenue/expense items NOT included in NI
e.g./ · foreign currency translation adjustments
· unrealized g/L on derivatives accounted for as hedges
· unrealized g/L on certain financial assets (AFS GAAP,
· certain DBPP costs FVOCI IFRS)
+ IFRS revaluation model results
(Example #14)
Understanding Balance Statements
a. describe the elements of the balance sheet: assets, liabilities, and equity;
b. describe uses and limitations of the balance sheet in financial analysis;
c. describe alternative formats of balance sheet presentation;
d. contrast current and non-current assets and current and non-current liabilities;
e. describe different types of assets and liabilities and the measurement bases of
each;
f. describe the components of shareholders’ equity;
g. demonstrate the conversion of balance sheets to common-size balance sheets

and interpret common-size balance sheets;
h. calculate and interpret liquidity and solvency ratios.

Understanding Balance Sheets
LOS a
Components and format/ Assets = Liabilities + Owner’s Equity
-describe
- the accounting equation Pg-1
Assets are financed by Debt or Equity

(A) = (L) + (E)
· Assets (what a company owns)

resources owned by a company as a result of past events
future economic benefits are expected to flow
· Liabilities (what a company owes)

obligations of a company as a result of past events
future outflows of economic benefits expected
· Equity Assets – Liabilities (equity = book value) equity ≠ market value

≠ intrinsic value
Note: for an item to be recognized as A or L, a future economic benefit

flowing to or from the entity must be probable and the item has a
cost or value that can be measured reliably (Exhibit #1, #2)
Uses and Limitations/ LOS b

-describe
· BS is at a point in time changes each day, however info Pg-2
is only available periodically
· BS mixes costs and values of items mixed model with

respect to measurement
· historical cost
· adjusted historical cost
· fair value but only at a point in time
· aspects of a company’s ability to generate future cash flows

are not included on the B.S. (IS, CFS, far more useful for valuation)
· BS useful for assessing the entity’s Liquidity & Solvency

Equity > 0
ability to meet - ability to
short-term liabilities meet LTD
Alternative formats/ LOS c, d

-describe
1/ current/non-current classification – both IFRS & GAAP
-distinguish
- referred to as a ‘classified’ balance sheet Pg-3
Assets: Current expected to be sold, used up, or converted to cash over
an operating cycle (1yr unless longer is justified)
cash-to-cash cycle
Non-current represent the infrastructure from which the company
- not expected to be sold, used up, or converted operates
to cash in one Yr.
Liabilities: current – expected to be settled in one operating cycle (1yr

Non-current – all others unless longer is justified)
Current assets – current liabilities = Working Capital (measures ability to

meet liabilities as they fall due)
2/ Liquidity-based presentation – all A/L are presented in order of liquidity

- can be used under IFRS if it is more relevant
or informative (exhibit #3)
LOS e
· Current Assets/ certain specific line items, if material,
-describe
should be shown Pg-4
1/ Cash/Cash equivalents highly liquid, short-term investments (<90 days)
- financial assets reported at amortized cost or fair value
exit price
2/ Marketable securities – equity/debt securities that trade in public
- financial assets markets
3/ Trade Receivables – amounts owed to a company by its customers for

g/s already delivered
- financial assets reported at net realizable value (amt. owed less
AR bad debts est.)
- Allowance for D.A. – called a ‘contra’ account
net AR amount reported on B.S. additions become Bad Debts Exp.
on IS.
amt. for All. for D.A. reported in the Notes
· Current Assets/ LOS e

3/ Trade Receivables - % uncollectible affected by: -describe
Pg-5
· changes in credit terms · Quality of customers
· changes in risk mgmt. policies. · Changes in estimates
- age refers to length of time a receivable has been outstanding

- Concentration of credit risk reported in Notes (example #1)
4/ Inventories – physical products that will eventually be sold
IFRS measured at lower of cost or net realizable value
est. Selling price – est. costs of

completion-selling costs
GAAP same as IFRS
LIFO or retail inventory methods measured at lower of cost or
market value
NRV
- normal ≤ current replacement cost ≤ NRV
profit margin
LOS e
· Current Assets/
-describe
4/ Inventories – when NRV or market value < inventory carrying costs, Pg-6
difference is written down charged to COGS
can be later reversed with IFRS, not with GAAP

- when inventory is sold COGS is increased, Inventory value is decreased
5/ Other current assets not material enough for a separate line item
disclosed in the Notes
e.g./ Prepaid expenses operating expenses that have been paid for
in advance
· Current Liabilities/
1/ Trade Payables – owed to vendors for the purchase of g/s
2/ Bank Loans
financial
Notes Payable
liabilities
Current portion of LTD
LOS e
· Current Liabilities/
-describe
3/ Accrued expenses – expenses incurred but not yet paid Pg-7
4/ Deferred income/Unearned revenue – payment for g/s received
before delivery is made
· Non-current assets/
1/ Property, Plant & Equipment (PPE) – tangible assets used in operations
GAAP/IFRS cost model IFRS Revaluation model
historical cost purchase price, delivery, installation

- Accum. Dep except land
- Impairment recoverable amount < carrying value – loss goes on IS
= net PPE - presented as a net amount (IFRS – reversible,
GAAP–no)
terms: Recoverable amount higher of (FV – costs to sell) & (value in use)
amount obtainable in an PV of future CFs

arm’s length transaction
· Non-current assets/ LOS e

-describe
2/ Investment Property – non-operating property (IFRS only)
Pg-8
- cost model or fair value (must apply to whole class)
changes from period-to-period = g/L on IS
3/ Intangible Assets – identifiable, non-monetary assets without physical

substance
means it can be acquired singly
(e.g. patents, licences, trademarks)
IFRS on BS if future economic benefits will flow to the company and
the cost of the asset can be measured reliably
IFRS – cost model or revaluation
GAAP – cost model only when an active market exists for the asset
Cost - Amortization – Impairment (definite life only)

life
- indefinite life tested annually
impair.
- notes useful lives, amortization rates/methods, past impairments
- internally developed intangible assets typically not recognizes on B.S.
· Non-current assets/ (IFRS) LOS e

3/ Intangible Assets – internally generated -describe
Pg-9
costs during research phase expensed
not for costs during development phase may be capitalized
GAAP (technologically feasible, able to use or sell asset, able to
complete the project) (example #3)
GAAP/IFRS acquired intangible on the BS.
4/ Goodwill excess over fair value of acquiring another company

- purchase price is allocated to FV of all A and L (requires judgment)
- if purchase price > net identifiable assets, rest is goodwill
called accounting goodwill

IFRS/GAAP – Goodwill listed on BS, not amortized,
but is tested for impairment annually
- if purchase price < net identifiable assets called bargain purchase

- difference recognized as a gain on IS
· Non-current assets/ LOS e

4/ Goodwill impact typically removed for analysis -describe
Pg-10
value of assets reduced, net income adjusted for any
Impairment charges (example #4)
5/ Financial assets – debt and equity of other companies (or governments)

- reported at either fair value or amortized cost
debt only
IFRS – amortized cost - debt only – objective is to hold to maturity

(called ‘held to maturity’ under GAAP)
IFRS FVPL or FVOCI (debt or equity)

called ‘available for sale’ under GAAP – debt only
(called ‘held for trading’ under GAAP) (exhibit #11)
- all income (interest/dividends) goes to IS (IFRS/GAAP)

LOS e
· Non-current assets/
-describe
6/ Deferred Tax Assets income tax payable for tax purposes
Pg-11
is more than income tax expense for reporting purposes
- temporary differences
· Non-current liabilities/
1/ Long-term financial liabilities Loans, notes, bonds
- reported at amortized cost
e.g./ bonds issued at 97.50 ($10M maturity value)

Bonds Payable = $9,750,000
- each YR the bonds are amortized towards $10M
2/ Deferred Tax Liabilities – income tax payable for tax purposes

is less than income tax expense for reporting purposes
- temporary differences
Equity/ par value

LOS f
-describe
1/ Capital contributed by owners paid-in-capital Pg-12
# of shares – authorized – allowed to sell
- issued – sold
- outstanding – issued – repurchased (Treasury Stock)
2/ Preferred Shares – based on characteristics, may be classified as

· Equity – perpetual, non-redeemable
· Debt – mandatory redemption at a fixed amount at a
future date
3/ Treasury Shares – shares that have been repurchased but not cancelled
- may be resold (no gain/loss involved)
non-voting
- done if a) shares undervalued
no dividends
b) to fulfill options
c) limit dilution
- reduces Sh. Eq. by $ amount of repurchase

LOS f
Equity/
-describe
4/ Retained Earnings – cumulative amount of earnings not Pg-13
paid to owners
5/ AOCI – Accumulated Other Comprehensive Income – gains/losses not

recognized in IS = +
6/ Non-Controlling Interest (minority interest) – the equity interests of
minority shareholders in the subsidiaries that have been
consolidated but are not wholly owned (Exhibit 14/15)
Statement of Changes in Equity/ itemizes changes in each equity

account over a period of time
IFRS requires · TCI · capital transactions or
· retrospective effect distributions with owners
of policy changes · component carrying amounts
reconciliation
GAAP reconciliation of each equity
account on the BS. (Exhibit #16)
Common Size BS/ LOS g

Total Assets = 100% all asset accounts listed as a -convert
%’age of TA -interpret
· Since A = L + E common size statements list all accounts as a Pg-14
%’age of Total Assets (Exhibit #17)
- current assets vs. non-current assets measures asset intensiveness

- current L. vs. non-current L. should align with assets
- Debt vs. Equity capital structure
LOS h
Liquidity Solvency -calculate
-interpret
= −
= . .
ability
+ + − − = ability to
= to meet
meet LTD
CL =
+
= = . .
Understanding Cash Flow Statements
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;
b. describe how non-cash investing and financing activities are reported;
c. contrast cash flow statements prepared under International Financial

Reporting Standards (IFRS) and US generally accepted accounting
principles (US GAAP);
d. compare and contrast the direct and indirect methods of presenting cash
from operating activities and describe arguments in favor of each method;
e. describe how the cash flow statement is linked to the income statement and
the balance sheet;
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;
g. demonstrate the conversion of cash flows from the indirect to direct method;
h. analyze and interpret both reported and common-size cash flow statements;
i. calculate and interpret free cash flow to the firm, free cash flow to equity,
and performance and coverage cash flow ratios.
LOS a
CFS → converts the accrual-based income statement to a
-compare
cash-based statement -classify
- provides a reconciliation between beginning and ending cash Pg-1
balances
- Components and format of the CFS/
1/ Cash flow from operations (CFO) - day-to-day activities

inflows → increases in liabilities, decreases in assets, cash
sales (sales of dealing/trading securities)
outflows → decreases in liabilities, increases in assets, cash payments
for expenses (purchase of dealing/trading securities)
2/ Cash flow from investing (CFI) - purchase/sale of long-term assets

and other investments
PPE, intangible assets
LT/ST investments in equity /debt
- excludes cash equivalents and dealing/trading securities
LOS a
3/ Cash flow from financing (CFF) - obtaining and -compare
repaying capital shareholders -classify
creditors Pg-2
inflows → selling stock, borrowing
outflows → share repurchases, loan repayments example #1
→ Non-cash investing/financing activities LOS b

-describe
- simple rule → no cash, no CFS reporting
(e.g. barter, stock dividends, conversion of convertible securities)
- if significant, any non-cash transaction is required example #2
to be disclosed in the Notes to the CFS
LOS c
-contrast
Pg-3
LOS d
2 acceptable formats for reporting CFO (IFRS/GAAP) -distinguish
1/ Direct method will result in same CFO, -describe
Pg-4
2/ Indirect method only presentation differs
- presentation of CFI/CFF sections are the same under IFRS/GAAP

regardless of how CFO is presented
→ Direct Method: IS items that are reported on an accrual basis are
converted to a cash basis
+/ provides information on the specific sources of operating cash
receipts and payments
→ Indirect Method: New Income is adjusted for the non-cash items,
non-operating items, and changes in working capital
accounts from accrual accounting
+/ shows the reason for differences between net income & CFO
exhibit #2, #3
→ Linkages with the IS & BS/ CFO + CFI + CFF = Cash LOS e, f
-describe
Casht - Casht-1 = Cash
Pg-5
• Operating activities: Direct method
- start with Revenue on IS, adjust for cash next acct.,
same process
ARbeg + Revenue - Cash rec. from customers = ARend asset acct.
beg. BS IS End BS
Revenue - AR = Cash collected from customers (example #3)
APbeg + Purchases - Cash paid to suppliers = APend
beg. BS. COGS + Invend - Invbeg End BS.
IS BS BS
COGS + Inv - AP = Cash Paid to suppliers (example #4)
→ linkages with the IS & BS/ LOS e, f

-describe
Cash paid to employees = Salary/Wages exp - Wages Payable Pg-6
Cash paid for the other Op.Ex. = Op.Ex. + Prepaid Exp - Acc.Liab.
Cash paid for Interest = Int.exp - Interest Payable (example #5)
Cash paid for Income Tax = Income Tax Exp - Income Tax Payable
→ Putting it together: CFO
cash received from customers 23,543 Rev
cash paid to suppliers (11,900) - COGS
cash paid to employees (4,113) - wages
cash paid for Other Op.Ex. (3,532) - Op.Ex = EBIT
cash paid for Interest (258) - Interest = EBT
cash paid for Taxes (1,134) - Taxes = NI
net cash from operations 2,606
→ Linkages with the IS & BS/ LOS e, f

-describe
Investing activities: CAPEX → Notes
+ = outflow Pg-7
Financial Investments
- = inflow
→ if gains/losses appear on IS due to disposal of assets:
PPEbeg + CAPEX - PPEend = historical cost of PPE sold (1)
BS Notes BS
AccumDepbeg + Dep.Exp. - AccumDepend = Accum.Dep on PPE sold (2)
1-2 = BV of PPE
BS BS BS
sold
1-2 + gain on sale = cash from sale of PPE
IS (example #6)
LOS e, f
→ Linkages with the IS & BS/
+ = inflow (new borrowing) -describe
Financing activities: LTD
- = outflow (repayments) Pg-8
Dividends paid = Net Income - Ret.Earnings

• Recap: ↑ Asset accts. ↓ Asset accts.
↓ Liability accts. ↑ Liability accts.
use of cash source of cash
CFO - changes in Current A/L accounts (except Cash/Cash Equiv.)

CFI - changes in Non-Current Asset accounts
CFF - changes in Non-Current Liability accounts
→ Linkages with the IS & BS/ LOS e, f

Operating activities: Indirect Method -describe
Pg-9
- begin with Net Income
Add: non-cash charges → Dep./Am./Depletion

non-operating losses → disposal of assets, unrealized losses
↑ DTL
WC accounts → ↓ assets, ↑ liabilities
Less: non-cash items → am. of bond premium (e.g.)

non-operating gains → disposal of assets, unrealized gains
↓ DTL
WC accounts → ↑ assets, ↓ liabilities (Exhibit #10)
(Example #7)
LOS g
-convert
Pg-10
converting
from Indirect
to Direct
1. Evaluate major sources and uses of cash: LOS h

-analyze
will vary with stage of growth -interpret
• early stage → CFO < 0 Pg-11
• late stage → CFO > CFI + CFF
2. Operating cash flow: CFO > NI

should be the major source of cash
- indicator of earnings quality
3. Cash flow from Investing: - sources and uses of cash

- CFO > CAPEX
- if CFI > 0, what is being sold, and why?
4. Cash flow from financing: - raising or repaying capital?
No investment opportunities?
- repurchase of shares
Deliver capital gains?
LOS h
- common size cash flow statement: -analyze
2 approaches/ -interpret
Pg-12
1/ each line of inflow/outflow as a %’age of total inflow/outflow
(exhibit #14)
2/ express each line item as percentage of Net Revenue
(exhibit #15)
- easier to see trends in cash flow
- easier to forecast cash flow as Revenue is forecast
1/ FCFF - free cash flow to the firm: LOS i

FCFF = NI + NCC + Int(1-t) - FCInv - WCInv -calculate
-interpret
net non-cash net working capital

income charges CAPEX investment
FCFF = CFO + Int(1-t) - FCInv → + (Int + Div Rec.)

- if in CFI
only if interest paid was included in CFO with IFRS
1/ FCFF - free cash flow to the firm: LOS i

IFRS → Div. paid in CFO? then add back -calculate
-interpret
2/ FCFE - free cash flow to equity Pg-13
FCFE = FCFF - Int(1-t) + Net Borrowings
or = CFO - FCInv + Net Borrowings
→ Cash Flow Ratios/ Performance Ratios
Cash flow to Revenue - operating cash per $ of

revenue
Cash return on assets . - operating cash per $ of

assets
Cash to Income . . - cash generating ability

of operations
Cash return on equity . . - operating cash per $ of

Sh. Equity
Cash flow per share ( − . )

#
→ Cash Flow Ratios/ Coverage Ratios LOS i

-calculate
-interpret
Debt Coverage - financial risk &
Pg-14
financial leverage
Interest Coverage ( + . + ) - ability to meet
interest obligations
Reinvestment . . . - ability to acquire
assets with CFO
Debt payment - ability to pay debts
with CFO
Dividend payment - ability to pay dividends
with CFO
Investing and ( ) - ability to acquire assets,
+
Financing pay debts and make
distributions to owners
Financial Analysis Techniques
a. describe tools and techniques used in financial analysis, including their uses
and limitations;
b. identify, calculate, and interpret activity, liquidity, solvency, profitability,

and valuation ratios;
c. describe relationships among ratios and evaluate a company using ratio

analysis;
d. demonstrate the application of DuPont analysis of return on equity and

calculate and interpret effects of changes in its components;
e. calculate and interpret ratios used in equity analysis and credit analysis;
f. explain the requirements for segment reporting and calculate and interpret
segment ratios;
g. describe how ratio analysis and other techniques can be used to model and
forecast earnings.
Tools & Techniques/ LOS a

1/ Ratios: express one quantity in relation to another (percentage or -describe
Pg-1
- highlight microeconomic relationships proportion)
within a company
- just an indicator – tells us what, not why
- differences in accounting policies can distort ratios
- adjustments will be required
- output requires interpretation
list
· no standard formulas + ratios can be industry specific
names
use of averages has no standard either
- typically when using flow and stock variables in
the same ratio, use an average for the stock variable

-describe
1/ Ratios: - value · evaluate past performance Pg-2
· assess current financial position
· aids in forecasting future results
· evaluate management ability
· make industry/competitor comparisons
- limitations: · difficult to find comparisons for multi-divisional companies

· inconsistencies among ratio types
e.g. poor liquidity, good solvency
· requires judgment
- ratio is not a credit rating, not a value
and not a recommendation
· different accounting policies
- the need for adjustments

-describe
1/ Ratios: sources: · data directly from financial statements Pg-3
· vendor data bases (Bloomberg, Compustat, FactSet)
- provide access to many years of historical data
Note: ratio formulas may differ by vendor
· XBRL – extensible Business Reporting Language
2/ Common-size analysis already introduced

vertical common-size as already introduced
horizontal common-size each line item is expressed as a
percent of the same line item from some base yr.
e.g./
2010 2011 2012 2013
100 110 121 145
LOS a
Tools & Techniques/
-describe
· Cross-sectional analysis – also called relative analysis Pg-4
- compares a specific metric from one company with
the same metric from another company or group of companies
· Trend analysis – important historical information that may highlight

improving or deteriorating trends
- use of horizontal common-size statements
- trends within a line item, or deviations of trends
between statements (e.g. growth in AR vs. growth in Revenue)
3/ Graphs – provide a visual overview
4/ Regression analysis – identify relationships or correlations among

variables (e.g. Sales to GDP)
LOS b
Ratios/
-classify
Categories: -calculate
Activity ratios – how efficiently a company performs -interpret
day-to-day tasks Pg-5
Liquidity ratios – measures ability to meet s.t. obligations
Solvency ratios – measures ability to meet L.T. obligations
Profitability – measures the ability to generate profit from resources
Valuation – quantity of an asset or flow associated with ownership
- must be interpreted in context of:

1/ company goals and strategy
2/ industry norms
3/ economic conditions
LOS b
Ratios/
-classify
1/ Activity ratios - aka – asset utilization ratios -calculate
- operating efficiency ratios -interpret
· indicators of ongoing operational performance Pg-6
· efficient mgmt. of both working capital and longer term assets

- averages should cover one year
- ratios should be expressed annually
· Inventory turnover COGS/Avg. Inv. - higher turnover implies

· Days of Inventory on hand (DOH) 365/Inv. turnover low DOH
more effective inv. mgmt.

· higher turnover vs. industry (?)
inadequate inventory levels
· Receivables turnover Revenue/Avg. AR - high turnover
· Days of Sales outstanding (DSO) 365/Rec. turnover = low DSO
· higher turnover vs. industry efficient collection

(?)
stringent credit policies
LOS b
Ratios/ -classify
1/ Activity ratios -calculate
· Payables turnover Purchases/Avg. AP -interpret
· Number of Days of Payables 365/Payables turnover Pg-7
- assumption is that the company makes all its purchases

using credit
not taking advantage of full credit terms
- high turnover vs. industry
taking discounts
· Working Capital turnover Revenue/Avg. WC.

higher indicates
· Fixed Asset Turnover Revenue/Avg. Net Fixed Assets
greater efficiency
· Total Asset Turnover Revenue/Avg. Total Assets
2/ Liquidity Ratios – measures how quickly assets are converted into cash
- also measure ability to pay off short-term obligations
Ratios/ LOS b
2/ Liquidity Ratios – level of liquidity needed differs by industry -classify
-calculate
- if a company has access to funding sources or
-interpret
capital markets, can operate at lower levels of liquidity Pg-8
- ratios typically use ending BS values instead of averages
· Current ratio CA/CL - higher ratio indicates

higher level of liquidity
· Quick ratio (Cash + s.t. Mkt. Sec. + AR)/CL
- companies with large and
· Cash ratio (Cash + s.t. Mkt. Sec.)/CL
stable cash flows can have
lower levels of liquidity
· Defensive Interval Ratio (Cash + s.t. Mkt.Sec. + AR)/Daily cash expenditures

- measures how long a company can pay its daily cash expenditures
with only existing liquid assets
Ratios/ LOS b
-classify
2/ Liquidity Ratios
-calculate
· Cash conversion cycle DOH + DSO – Number of days of Payables
-interpret
- shorter cycle = higher liquidity (lower WC financing costs) Pg-9
3/ Solvency Ratios – measures amount of debt in capital structure plus

adequacy of earnings and cash flow to cover interest expense
+ lease or rental payments as they come due
debt = financial leverage a company with high
level of fixed assets = operating leverage operating leverage may
be limited in their use
Debt Ratios/ of financial leverage
· Debt-to-assets = Total Debt/Total assets Total Debt = interest
· Debt-to-capital = Total Debt/Total Debt + Sh. Equity bearing st + LT Debt
LOS b
Ratios/ -classify
3/ Solvency Ratios -calculate
Debt Ratios/ -interpret
Pg-10
· Debt-to-Equity = Total Debt/Total Sh. Equity
· Financial leverage ratio = Avg. total assets/Avg. total equity Dupont
(period-end TA/ period-end TE) - typically
· Debt-to-EBITDA = Total Debt/EBITDA – measures how many years it
would take to repay total debt based on EBITDA
Coverage Ratios/
· Interest Coverage = EBIT/Interest payments (aka ‘times interest earned’)
· Fixed charge coverage = (EBIT + Lease payments)/(Interest + Lease payments)
- sometimes used as an indication of the
quality of the pref. Div.
- higher coverage ratios imply stronger solvency
Ratios/ LOS b
-classify
4/ Profitability Ratios
-calculate
· Return on Sales/ - common-size IS ratios -interpret
· gross profit margin gross profit/Revenue – higher GM Pg-11
indicate higher selling prices and/or lower
product costs
- level of GM inversely related to competitive pressure
· operating profit margin operating profit/Revenue – measures control
over operating costs
· pre-tax margin EBT/Revenue – measures the effect on profitability
of leverage and other non-operating items
· net profit margin net income/Revenue
Return on Investment/
· operating ROA Operating Income/Avg. total assets
Income available to all suppliers of capital
LOS b
Ratios/
-classify
4/ Profitability Ratios -calculate
Return on Investment/ -interpret
· ROA Net Income/Avg. total assets Pg-12
- or [Net Income + Int. Exp. (1-Tx)]/Avg. total assets
· Return on total capital EBIT/(Avg. st + LT Debt) + Avg. Equity]
· ROE Net Income /Avg. total equity
minority, preferred + common equity

· Return on common equity = (Net Income – Pref. Div.)/Avg. common equity
LOS c
-describe
- examples 6 to 14
LOS d
Dupont analysis Decomposition of ROE -demonstrate
-calculate
= . . -interpret
Pg-13
.
= . × . .
( = × )
. .
= . × . × . . .
( = × × )
profitability efficiency solvency
. .
= × × .× . × . . .
( = × × × × )
(1-T)
Example #16
LOS e
Equity Analysis/ -calculate
· Valuation ratios: Price per share -interpret
Pg-14
EPS CF/sh. Sales/sh. BVPS
- per share − . economic when NI < 0

quantities
. .# . result CFO < 0
Accounting result (PE ratio)

plus
· EBITDA/sh. and Dividends/sh.
· Dividend Payout Ratio (DPR) = ./

· Retention rate (b) = 1 – DPR
· sustainable growth rate (g) = b × ROE
· ability to finance growth from

internally generated funds
LOS e
Equity Analysis/
-calculate
· Industry–specific ratios Ex. #19 -interpret
Credit Analysis/ - the evaluation of credit risk Pg-15
risk of loss due to non-payment

· EBITDA interest coverage = EBITDA/Interest expense
· FFO-to-debt (funds from operations) = FFO/total debt · any debt
· Free CFO-to-debt = (CFO-CAPEX)/total debt is usually adjusted
· EBIT margin = EBIT/Revenue to include leases
- earnings are
· EBITDA margin = EBITDA/Revenue
typically from
· Debt-to-EBITDA = total debt/EBITDA
‘continuing operations’
· Return on capital = EBIT/Avg. capital
LOS f
Segment Reporting/
-explain
· IFRS/GAAP segment information required -calculate
- operating segment · generates revenues, creates expenses -interpret
· results are regularly reviewed by mgmt. Pg-16
· discrete financial information is available
- if a segment represents more than 10% of:

Σ op. segments revenue, profits or assets
- reportable segment info: · factors used to identify segments

· products/services sold by segment
· profit/loss
· total assets/liabilities · Dep./Amort.
· segment revenue · other non-cash exp.
· interest exp./rev. · income tax exp.
· CAPEX
LOS f
Segment Reporting/
-explain
· segment ratios/ -calculate
· segment margin = (Seg. Pr./LS.)/Seg. Rev. -interpret
· segment turnover = Seg. Rev./Seg. assets Pg-17
· segment ROA = (Seg. Pr./LS.)/Seg. assets
· segment debt ratio = Seg. Liabilities/Seg. assets
LOS g
· past trends
-describe
· relationships between IS & BS ratios
· forecasts of growth
- sensitivity
analysis what if? models Pro-forma
- scenario given events Statements
analysis
- Simulation – based on Future financial
probability models performance
range
of possibilities
Inventories
a. contrast costs included in inventories and costs recognised as expenses in the

period in which they are incurred;
b. describe different inventory valuation methods (cost formulas);
c. calculate and compare cost of sales, gross profit, and ending inventory using
different inventory valuation methods and using perpetual and periodic
inventory systems;
d. calculate and explain how inflation and deflation of inventory costs affect the
financial statements and ratios of companies that use different inventory
valuation methods;
e. explain LIFO reserve and LIFO liquidation and their effects on financial
statements and ratios;
f. demonstrate the conversion of a company’s reported financial statements from

LIFO to FIFO for purposes of comparison;
g. describe the measurement of inventory at the lower of cost and net realisable
value;
h. describe implications of valuing inventory at net realisable value for financial

statements and ratios;
i. describe the financial statement presentation of and disclosures relating to

inventories;
j. explain issues that analysts should consider when examining a company’s

inventory disclosures and other sources of information;
k. calculate and compare ratios of companies, including companies that use

different inventory methods;
l. analyze and compare the financial statements of companies, including

companies that use different inventory methods.
Inventories
Cost of Inventories/ LOS a

IFRS/GAAP: inventoriable costs -distinguish
Pg-1
• costs of purchase (price, duties, taxes, insurance, delivery)
less (discounts, rebates)
• conversion cost (RM, Direct/Indirect Labor, Direct/Indirect MOH)
- all cost absorption ends when the inventory hits the FGI warehouse floor
→ Balance Sheet → Income Statement
- when acquired or - when sold
⇒
converted
IFRS/GAAP: non-inventoriable costs

- abnormal costs from material wastage, labor or wastage of other
production inputs
- storage costs not part of ‘normal’ production process
(go to IS) - administrative overhead and selling expenses (Example #1)
Inventory Valuation Methods/ LOS b

-describe
IFRS → cost formulas
Pg-2
GAAP → cost flow assumptions
- same inventory valuation method must be used for all items that
have a similar nature and use (items with a different nature can use
a different method)
- Beginning Inventory + Purchases - Ending Inventory = COGS
how inventory is valued affects

⇒ COGS
IFRS/GAAP methods/
1/ Specific Identification
- typically used for non-interchangeable items
- COGS and Ending Inventory (EI) reflect actual costs
- matches physical flow with actual costs
2/ FIFO - first-in, first-out
- oldest units sold first → COGS
- newest units in Inventory → EI
LOS b
Inventory Valuation Methods/ -describe
IFRS/GAAP methods/ Pg-3
3/ Weighted-average cost → costs allocated evenly across all
units for sale
• COGS + EI → units valued at average prices
GAAP only/
4/ LIFO - last-in, first-out → newest units sold first → COGS
⇒
→ oldest units in Inventory → EI
→ periods of rising prices: LIFO → higher COGS vs FIFO LOS c

-calculate
→ lower EI vs FIFO
-interpret
- periodic inventory system - inventory on hand calculated periodically
- perpetual inventory system - inventory account updated continuously
- under both, COGS & EI will be the same for FIFO example #2, #3
and specific id (not for LIFO or w.a.)
LOS d
- constant or increasing inventory levels:
-calculate
A) if unit costs are increasing -explain
COGS: LIFO > AVCO > FIFO → LIFO → lower gross income (EBIT, NI) Pg-4
EI: FIFO > AVCO > LIFO → FIFO → higher asset value
LIFO → COGS more closely reflects current replacement value

FIFO → EI
B) if unit costs are decreasing

COGS: FIFO > AVCO > LIFO → FIFO → lower profitability
⇒
EI: LIFO > AVCO > FIFO → LIFO → higher asset values
example #4
P LIFO P P
LIFO
COGS COGS
EI COGS FIFO
EI EI
EI EI
COGS EI
FIFO LIFO
COGS FIFO COGS
t t t
LIFO Method/ LOS e, f

-explain
- recall, when prices are increasing, LIFO will have
(IS) higher COGS vs FIFO, lower EBT vs FIFO and -convert
Pg-5
lower tax expense, and lower NI
(BS) → EI will be lower vs FIFO, lower - WC

- total assets
- retained earnings, lower Sh. Eq.
⇒
(CFS) → CFO higher due to lower taxes
- if a company is in an industry characterized by decreasing prices, doubtful

they would elect to use LIFO for tax purposes (and thus reporting purposes)
- many companies will use LIFO for tax purposes and external reporting
(required: if LIFOtax, then LIFOreporting) and FIFO or AVCO for internal
reporting → better pricing decisions
LOS e, f
LIFO Reserve/
-explain
- for companies that use LIFO, GAAP requires the -convert
“LIFO Reserve’ be reported in the notes Pg-6
LIFO Reserve → difference between reported LIFO inventory carrying

amount and the carrying amount if FIFO was used
i.e. FIFOEI - LIFOEI → earliest cost
most recent cost ⇒

- typically LR Reserve > 0 → LR is a cumulative balance
• FIFOEI = LIFOEI + LR adjust LIFO Inventory and COGS

• COGSFIFO = COGSLIFO - (LRend - LRbeg) to be comparable with FIFO
• LIFO Liquidation → LR may increase over time if:

• prices are rising
• quantities added to inventory > quantities sold
LOS e, f
LIFO Reserve/
-explain
• LIFO Liquidation -convert
→ quantity of units sold > quantity of units added to inventory Pg-7
- then company experiences a LIFO liquidation
some of the older units in

inventory are sold (called LIFO layers)
→ So: if costs have been increasing over

⇒ time, and a LIFO liquidation occurs,
those units will have very low COGS relative to other items
sold → larger gross margins
one-time event → not sustainable

- a decline in LR may be evidence of a LIFO liquidation
decreasing prices can cause LR to decrease

without any LR Liquidation (example #5)
Inventory Adjustments/ LOS g, h

-describe
- cost of inventory may not be recoverable due to spoilage,
Pg-8
obsolescence, or declines in selling prices
IFRS/ inventories shall be measured at the lower of cost or

net realizable value
- estimated selling price (in the ordinary course of business)

⇒
- estimated costs to make the sale
- estimated costs to get inventory into condition for sale
- if value of inventory drops below carrying value

1/ inventory written down to NRV
- typically through a ‘Inventory Valuation Allowance’ acct.
2/ Write-down charged to COGS or reported separately

LOS g, h
Inventory Adjustments/
-describe
IFRS/ - if inventory subsequently recovers its value from a Pg-9
previous write-down → a reversal is recorded
- limited to original write down

- results in a reduction to COGS
GAAP/ LIFO or retail inventory methods: lower of cost or market

• market - current replacement
⇒ costs
lower bound upper bound = NRV

= NRV - normal (as defined
profit margin under IFRS)
- write down charged to COGS (non-reversible)
- since LIFO inventory has oldest costs, least likely to have
write-downs
FIFO/AVCO → same as IFRS → but no reversals
Inventory Adjustments/ LOS g, h

-describe
• Effects of write-down:
Pg-10
lowers profitability → negative effect on profitability,
liquidity, solvency ratios
lowers carrying amount of Inventory → has a positive effect
on activity ratios
e.g./ Inventory turnover, asset turnover
→ Agriculture, forest-products, minerals,

⇒ commodity brokers (IFRS/GAAP)
measured at NRV
- changes in Inventory, up or down, FV - costs to sell & complete

treated as P/L in the period
of change - MV - if active market exists
- most recent transaction price else
(example 7/8)
Presentation and Disclosure/ IFRS/GAAP LOS i

-describe
a) accounting policy used (e.g. FIFO, LIFO, etc.)
Pg-11
b) total carrying amount of inventory + any classifications
(RM, WIP, FGI)
c) total amount of inventory carried at (FV - costs to sell)
d) COGS ⇒
e) any write-downs
f) any reversals
obviously not for GAAP
g) event that lead to the reversal
h) carrying amount of inventory pledged as collateral for liabilities
+ GAAP/ → any material amount of income resulting from a LIFO Liquidation
Inventory Ratios/ LOS j

-explain
3 critical ratios for inventory mgmt. evaluation:
Pg-12
Inventory turnover - COGS/Avg. Inventory
directly impacted by
DOH = 365/Inventory turnover
a company’s choice of
Gross Profit Margin = gross profit/Revenue inventory valuation
- Interpretation method
Highly effective
e.g. high turnover (any ratio with COGS
inventory⇒mgmt.
or Inventory in num.
+ Inadequate inventory
or den.)
low DOH levels/lost sales
Inventory write-downs
→ check inventory turnover and Sales growth vs industry
- higher turnover, slower growth - supports inadequate inventory
- few write-downs, higher growth - supports eff. inv. mgmt.
Inventory Ratios/ LOS j

- low turnover + high DOH vs industry -explain
→ indicator of slow-moving/obsolete inventory Pg-13
- gross margins → affected by competition, type of product sold, and

inventory management
⇒
→ high RM/WIP → may signal rising demand
→ high FGI, low RM/WIP → may signal a decrease in demand
etc….
LOS k, l
example 9, 10
-calculate
-compare
-analyze
Long-Lived Assets
a. identify and contrast costs that are capitalized and costs that are expensed in the
period in which they are incurred;
b. compare the financial reporting of the following types of intangible assets:

purchased, internally developed, acquired in a business combination;
c. explain and evaluate how capitalizing versus expensing costs in the period in
which they are incurred affects financial statements and ratios;
d. describe the different depreciation methods for property, plant, and equipment and
calculate depreciation expense;
e. describe how the choice of depreciation method and assumptions concerning

useful life and residual value affect depreciation expense, financial statements, and
ratios;
f. describe the different amortization methods of intangible assets with finite lives
and calculate amortization expense;
g. describe how the choice of amortization method and assumptions concerning

useful life and residual value affect amortization expense, financial statements,
and ratios;
h. describe the revaluation model;
i. explain the impairment of property, plant, and equipment and intangible assets;
j. explain the derecognition of property, plant, and equipment and intangible assets;
k. explain and evaluate how impairment, revaluation, and derecognition of property,

plant, and equipment and intangible assets affect financial statements and ratios;
l. describe the financial statement presentation of and disclosures relating to

property, plant, and equipment and intangible assets;
m. analyze and interpret financial statement disclosures regarding property, plant, and
equipment and intangible assets;
n. compare the financial reporting of investment property with that of property, plant,
and equipment.
Long-Lived Assets
- provide economic benefits over a future period of time LOS a

-distinguish
· Acquisition/ Pg-1
- tangible assets capitalize on BS at cost
- intangible assets if acquire, capitalize on BS at cost
PPE/ - through exchange recorded at fair value

FV of asset given up (unless FV of
asset acquired is more evident)
- if no FV, use carrying amount of asset given up
- through purchase recorded at cost + all expenses necessary to

get the asset ready for its intended use
- subsequent costs included as part of carrying cost of
asset if expected to provide benefits beyond 1 YR.
(expensed if not) (example #1)
LOS a
PPE/ - through construction -distinguish
- all costs of construction + borrowing costs Pg-2
* IFRS only if interest is earned on

borrowed funds, lowers cost of borrowing
interest flows (if capitalized)
interest paid
- constructing an item to sell Inventory, then COGS
as a cash outflow
- constructing an asset to use PPE, then Depreciation
in Investing section
(example #2)
when capitalized when expensed
· non-current assets ↑ · current assets ↓
· CFI ↓ · net income negative
· retained earnings effect
· equity
LOS b
Intangible Assets/ - lack physical substance -compare
(e.g. patents, copyrights, trademarks, franchises) Pg-3
IFRS/ - must be 1) identifiable (i.e. capable of being separated

from the company or arising from
contractual or legal rights)
2) under the control of the company
3) expected to generate future economic benefits
+ 4) probable that future economic benefits will flow to the company
5) cost of asset can be reliably measured
A/ Purchased: (not part of business combination)

- same as tangible assets
- if acquired as a group, purchase price is allocated to each asset
on the basis of FV.
Intangible Assets/ LOS b

-compare
B/ Developed Internally: generally expensed when incurred
Pg-4
lower asset values vs. acquiring

lower current period NI vs. acquiring
lower CFO, higher CFI vs. acquiring
IFRS/ - research costs expensed

technically feasible
- development costs capitalize if:
intent to use or sell
GAAP/ R&D both expensed
exception: software development expensed until
technological feasibility demonstrated then capitalized (Ex. #3)
C/ Acquired in a Business Combination:

- acquirer allocated purchase price to the net identifiable
assets on the basis of FV
- if purchase price > FV of new assets excess called Goodwill
Intangible Assets/ LOS b

-compare
C/ Acquired in a Business Combination: Pg-5
IFRS recognized as an intangible asset if it meets the
definition of an intangible
GAAP must be an asset arising from contractual or legal rights
or/ an item that can be separated from the acquired company
1/ Capitalizing vs. Expensing directly to IS in the period LOS c

BS first expensed to IS over time -explain
-evaluate
(recognition) (Dep./Amort.)
lower EBT
non-cash expenses lower taxes
BS effect CFO – no effect
CFI effect
IS effect
in subsequent periods
(example #4)
1/ Capitalizing vs. Expensing LOS c

-explain
First YR. capitalizing = higher Net Income vs. expensing
-evaluate
= lower NI in subsequent periods vs. Pg-6
expensing
- for a company growing its asset base, if CAPEX > Dep. exp., profitability
enhancing aspects of capitalizing (in the early years) continues
(example #5)
Note: capitalizing results in higher CFO than by expensing

possibility for company to capitalize items that
should be expensed
2) Capitalization of Interest Costs/

- company’s interest cost can appear on B.S. if capitalized
Inventory Long-Lived asset
2) Capitalization of Interest Costs/ LOS c

-explain
- reduces CFI, not CFO
-evaluate
- when calculating Interest Coverage ratios both expensed and Pg-7
capitalized interest should be used
- if a company is depreciating interest that has been capitalized in a
prior period income should be adjusted to eliminate the effect of that
depreciation (for the Coverage Ratio)
(example #6)
3) Capitalization of Internal Development Costs

de-capitalize for comparison purposes
- include capitalized amount as expense on IS
- exclude any amortization of previous development cost from IS
- exclude capitalized costs (lower assets and equity)
- decrease CFO, increase CFI
Depreciation/ LOS d, e
-describe
IFRS/GAAP cost model capitalized costs of long-lived
-calculate
tangible assets and intangible assets with finite Pg-8
useful lives are allocated to subsequent
periods Depreciation (tangible assets)
Amortization (intangible assets)
Carrying cost = Historical cost – Accum. Dep./Amort.
IFRS only Revaluation model long-lived assets reported at FV
Methods/ choice of method affects amounts reported on financial st.
1/ Straight-line
−
.=
- cost of asset is allocated evenly over the assets

useful life
LOS d, e
Methods/
-describe
2/ Accelerated Depreciation – Dep. greater in earlier yrs. Pg-9
e.g. Double-Declining (2x)
Dep. exp. = %’age of carrying amount
e.g. 10 yr. useful life s.t. would be 10%/yr.

2x = 20%
- depreciated down to salvage value
3/ Units-of-Production – based on proportion of production during a
period vs. productive capacity over useful life
. .= ×
- example #8
LOS d, e
some countries Dep. method must be the same for both -describe
tax and reporting purposes Pg-10
other countries Dep. methods can differ between reporting

and tax gives rise to deferred taxes
Assumptions/estimates required
Dep. method
Useful life IFRS requires annual review of
Salvage value estimates
Component method of Depreciation – required under IFRS

allowed under GAAP (rarely used)
- separately depreciate components
of an asset when the component’s cost is significant in relation
to total cost and/or with different useful lives
(example #9)
LOS f, g
Amortization/ - definite lives only
-describe
acceptable methods same as tangible assets Pg-11
(e.g. acquired customer list, acquired patent or copyright
with a specific expiration date, an acquired license with a
specific expiration date and no right to renew, etc.)
need: Amortization method, original cost, useful life, salvage value
Revaluation model (IFRS only)

LOS h
list the carrying amount of assets at FV -describe
carrying amounts = FV at date of revaluation less any
subsequent Dep./Amort.
- may result in both decreases and increases in value (to greater
than historical cost)
LOS h, k
Revaluation model (IFRS only) -describe
- only used if fair value can be measured reliably -evaluate
Pg-12
can be used, for some classes of assets and cost model for others
must be applied to all assets within a class

- overall: rarely used
Revaluation below cost loss to IS

- if cost recovers, reversal back up to cost only gain on IS
- any excess about cost OCI
adds to a ‘Revaluation Surplus’
account in Equity
Revaluation above cost OCI
- adds to Revaluation Surplus account
- any reversals Revaluation Surplus reduced first
- any excess below loss on IS
Revaluation model (IFRS only) LOS h, k

-describe
- upward revaluations increase assets and equity
-evaluate
(> cost) · reduces leverage ratio Pg-13
- downward revaluations reduce profitability
(< cost) - ROA, ROE ↓ in year of revaluation
- but lower asset/equity base boost ROA and
ROE in subsequent years
- typically it is the increased operating capacity/cash flow potential that
causes an upward revaluation
(examples 11/12)
LOS i, k
Impairment/ - an unanticipated decline in the value of an asset
-explain
IFRS/GAAP require a write down of the carrying amount -evaluate
(reversals allowed with IFRS only) Pg-14
PPE/ - at each reporting period, assessment of indications of impairment

(annually) (not a test of impairment)
- no indication no test
positive indication recoverable amount should be measured
PPE impaired if carrying amount > recoverable amount
- carrying value of asset decreases
- impairment charge reduces net income
- no effect on cash flows (non-cash charge)
Impairment/ LOS i, k
-explain
PPE/ IFRS recoverable amount
-evaluate
- higher of: · FV less costs to sell Pg-15
· Value-in-use (PV of expected cash flows)
GAAP assessing recoverability

- if carrying amount > undiscounted future cash flows
- then impaired
impairment charge = carrying amount – FV
(example #13, 14)
Intangible Assets with Finite Life same treatment as PPE

Intangible Assets with Indefinite Life MUST be tested annually for
impairment
Long-Lived Assets held-for-Sale if intent is to sell and a sale is highly
probable, reclassified as held-for-sale
- tested for impairment on reclassification
Impairment/ LOS i, k
Reversals: IFRS allows even if held-for-sale, only to the -explain
extent of the original impairment charge -evaluate
Pg-16
GAAP held-for-use no reversals
held-for-sale permitted
Derecognition/ - when an asset is disposed of or is not LOS j, k
expected to provide any future benefits -explain
-evaluate
- removed from financial statements
1/ Sale
/
= − (example #15)
CFI BS
IS
2/ Other than Sale (abandoned, exchanged, spun-off)

- reclassified as ‘held-for-use until disposal’
- continue to be depreciated
LOS j, k
Derecognition/
-explain
2/ Other than Sale -evaluate
· retired/abandoned – assets reduced by carrying amt. Pg-17
- loss recorded on IS (if c > 0)
· exchanged covered in LOS a
· spin-off unit of company is separated into new entity
shareholders receive proportional shares
all assets of new entity are removed from the
balance sheet of parent
Presentation and Disclosures/ - Tangibles LOS l

GAPP/ · Dep. exp. for the period -describe
· balances of major classes of depreciable assets + accum. Dep.

by major class
· Dep. method by major class
Presentation and Disclosures/ - Tangibles LOS l

-describe
IFRS/ · measurement bases (cost, FV)
Pg-18
· Dep. method used
· useful life (or Dep. rate)
· Accum. Dep. – beg. + end of period, + gross carrying amt.
· Beg./end carrying amount reconciliation
+ · restrictions on, and pledges of PPE

· contractual agreements to acquire PPE
- if revaluation model used date, details of FV, C, and amt. of revaluation
Intangibles
GAPP – gross carrying amt. in total and by major class
- accum. Amort. by major class
- estimated Amort. exp. for next 5 years
Presentation and Disclosures/ Intangibles LOS l

-describe
IFRS/ finite life: · useful life (or Amort. rate)
Pg-19
· Amort. method
· gross carrying amount
· Accum. Amort. – beg + end
· where included on the IS
· Reconciliation of carrying amt. (beg. to end)
Indefinite life: why indefinite
+ · restrictions, pledges, contractual agreements to purchase
- if revaluation used same as tangible
Impairments/ GAAP · description of impaired asset

· events/conditions that led to impairment
· method of FV determination
· amount of loss
· where the loss is recognized
LOS l
Presentation and Disclosures/ Impairments -describe
IFRS/ · amount of loss and any reversals in the period Pg-20
and where on the IS
· main classes of assets affected
· events/conditions that led to these losses/reversals
LOS m
example 16 (leave for you)
-analyze
Ratios/ -interpret
= higher = better
.
. .
: = +
. . . . . .
estimated useful Average age remaining useful

life or depreciable life of assets life
- older a company’s assets, shorter their remaining life, more CAPEX will be
needed to maintain productive capacity (helps forecast future CFI)
Investment Property/ LOS n

-compare
IFRS property that is owned (or leased under a finance lease)
Pg-21
for the purpose of earning rent or capital appreciation
- not owner-occupied (or both)
- not used for producing g/s
- may be valued using

1/ cost model – same as for PPE
2/ fair value model - all changes impact NI (unlike revaluation model)
- may only be used if reliable estimates of FV
are attainable (continuously)
- company must use one model for all investment properties
- if FV is used, must be used until disposition or reclassification
- even if FV assessment becomes difficult
Investment Property/ LOS n

-compare
Reclassifications:
Pg-22
from to if valued at then
Inv. Prop. owner-occupied cost no change in C
or inventory
FV FV = new C
owner-occupied Inv. Prop. FV (Inv. P) FV – C treated
like a revaluation
Inventory Inv. Prop. FV (Inv. P) FV–C recognized
as p/L
- Inv. Prop. reported as a separate line item on the BS

- plus disclosure of cost or FV model · how determined
· reconcile beg
GAAP no specific definition of Investment Property end
- use cost model
Income Taxes
a. describe the differences between accounting profit and taxable income and
define key terms, including deferred tax assets, deferred tax liabilities,
valuation allowances, taxes payable, and income tax expense;
b. explain how deferred tax liabilities and assets are created and the factors that
determine how a company’s deferred tax liabilities and assets should be
treated for the purposes of financial analysis;
c. calculate the tax base of a company’s assets and liabilities;
d. calculate income tax expense, income taxes payable, 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;
e. evaluate the effect of tax rate changes on a company’s financial statements

and ratios;
f. identify and contrast temporary and permanent differences in pre-tax

accounting income and taxable income;
g. describe the valuation allowance for deferred tax assets – when it is required
and what effect it has on financial statements;
h. explain recognition and measurement of current and deferred tax items;
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;
j. identify the key provisions of and differences between income tax

accounting under International Financial Reporting Standards (IFRS) and
US generally accepted accounting principles (GAAP).
Income Taxes
LOS a
Financial Statements vs Tax Returns
-describe
• Income Before Taxes Taxable Income -define
(accounting standards) (tax laws) Pg-1
Less: Income Tax Expense Less: Income Tax Payable

(or benefit) (or recoverable)
(reported on IS) (reported on BS)
R < T - creates a deferred

tax asset (DTA)
R > T - creates a deferred
tax liability
Income Tax Expense = Income Tax Payable (CR)
(DR) + deferred tax accounts
- accounting profit may not equal taxable income due to:

• temporary differences in the recognition of Rev./Exp.
or permanent differences
LOS a
- if R < T, then Income Tax Expense < Taxes Payable
-describe
- a DTA is created -define
Pg-2
- Valuation Allowance → a contra DTA account
- a reserve created against a DTA based on the likelihood of
realizing the DTA in future accounting periods
(e.g. carryforwards expire, changes in tax laws that restrict future
use of deductible temporary differences)
• Income Tax Paid → actual amount paid for taxes

→ reduces Income Tax Payable liability (in CFO)
• Tax base → amount at which an asset or liability is valued for tax purposes
(TB)
• Carrying amount → amount at which an asset or liability is valued according

(C) to accounting principles
- differences between TB & C lead to differences between R & T
• DTA → represent taxes that have been paid but LOS b

-explain
not yet recognized on the IS
Pg-3
• DTL → represent taxes recognized on the IS that have not
required payment yet for tax purposes
- arise when accounting standards and tax authorities recognize the timing of
revenues and expenses differently
→ timing differences result in ‘temporary differences’
- DTA/DTL must meet the definition of an asset or liability to be recognized

on the BS
- if an existing DTA/DTL ceases to meet the definition of an asset or liability:
IFRS → amount will be reversed
GAAP → valuation allowance is established
(Example #1)
Recall: A = L + E LOS b
-explain
DTA/DTL: DR CR Pg-4
for assets for liabilities

if C < TB → DTA C < TB → DTL
C > TB → DTL C > TB → DTA
Income Tax Exp. = Income Tax Payable + DTA/ DTL

DR CR
if: DR > CR → need a - DTA or + DTL
(CR) (CR)
or (sum of DTA & DTL) = CR
DR < CR → need a + DTA or - DTL

(DR) (DR)
or (sum of DTA & DTL) = DR
→ Tax Base/ LOS c

- the amount attributed to the asset or liability -calculate
for tax purposes (i.e. the BS would be for tax purposes) Pg-5
• Asset/ - the amount that will be deductible for tax purposes in

future periods (Example #2)
• Liability/ - the carrying amount of the liability less any amounts that
will be deductible for tax purposes (i.e. amounts that will
not be taxed in the future)
(Unearned Revenue for example)
(example #3)
LOS d
→ DTL arises: higher tax expenses
-calculate
lower tax revenue -interpret
= lower taxable income Pg-6
TP < ITE
- an increase/decrease in DTL increases/decreases Total Liabilities

Since ITE = TP + DTL increase in DTL → NI ↓, Ret. Earn ↓, Equity ↓
decrease in DTL → NI ↑, Ret. Earn ↑, Equity ↑
→ DTA arises: lower tax expense

higher tax revenue TP > ITE
= higher taxable income
- an increase/decrease in DTA increases/decreases Total Assets

Since ITE = TP - DTA increase in DTA → NI ↑, Ret. Earn ↑, Equity ↑
decrease in DTA → NI ↓, Ret. Earn ↓, Equity ↓
→ Changes in Tax Rates/ LOS d, e

-calculate
- if tax rates increase, DTA & DTL both increase
-interpret
decrease decrease -evaluate
- lower DTL reduces future tax payments Pg-7
- lower DTA reduces future tax benefits
e.g.
YR 3 YR 2 YR 1
C 14000 16000 18000 - assume tax rate changes
TB 11429 14286 17143 to 25% in YR 3
C > TB 2571 1714 857 DTL = 2571 × .25 = 643
DTL 771 514 257 (129 lower)
(tax rate = 30%)
→ if DTA > DTL → net tax assets → BS benefits when taxes ↑

DTA < DTL → net tax liability → BS benefits when taxes ↓
- however, IS benefits with tax rates ↓
LOS d, e
→ Changes in Tax Rates/
-calculate
ITE = TP + DTL - DTA -interpret
• if a company has: -evaluate
net DTL - tax rates ↓ = L ↓, ITE ↓, Equity ↑ Pg-8
net DTA - tax rates ↓ = A ↓, ITE ↑, Equity ↓
net DTL - tax rates ↑ = L ↑, ITE ↑, Equity ↓
net DTA - tax rates ↑ = A ↑, ITE ↓, Equity ↑
→ temporary differences → arise from a difference between LOS f

TB and C of A/L that is expected to reverse itself at -distinguish
some future date (e.g. Dep)
→ Permanent differences - income/expense items that can be recognized

for reporting purposes but not under tax laws
- will not be reversed at some future date (no DTA/DTL)
Permanent difference examples: LOS f

-distinguish
non-taxable revenue (gov’t grants)
Pg-9
non-tax deductible expenses (fines, penalties)
tax credits for some expenses
• results in differences between effective and statutory tax rates
. =
−
Casset > TBasset
• taxable temporary difference → DTL
Cliab < TBliab
Casset < TBasset
• deductible temporary difference → DTA
Cliab > TBliab
- must be a reasonable expectation of future profits
LOS f
→ temporary differences at recognition
-distinguish
→ C ≠ TB for asset or liability Pg-10
→ company cannot recognize DTA/DTL unless initial
recognition was a business combination
e.g. gov’t grant for purchase of energy efficient equipment
grant = 8,000 equipment = 50,000
C = 42,000 but TB = 50,000 → C ≠ B → but difference is still temporary

→ both will depreciate asset to $0
• Unused tax losses/credits

IFRS → may only be recognized to the extent of probable future taxable
income
GAAP → recognized in full and reduced through a valuation allowance if
unlikely to be realized
→ Valuation Allowance LOS g

-describe
• DTA/DTL → neither is discounted to PV to ascertain book
Pg-11
value (even though they are related to temporary
differences expected to be recovered (DTA) or
settled (DTL) at some future date
- all DTA/DTL balances must be evaluated at each balance sheet date to

ensure that they will be recovered
C = expected recoverable amount
GAAP → DTAs are reduced through a contra-asset account called

‘Valuation Allowance’
- increase in Val. All. → reduce DTA
→ increase ITE
→ lower NI, Ret. Earn, Sh. Equity
- if conditions change, previous reductions can be reversed
- IFRS/GAAP → recognition of DTL and current income tax should be LOS h

-explain
treated similarly to the asset or liability that gave rise
Pg-12
to the DTL or ITE
e.g./
revaluation of → OCI any resulting DTL
property above ‘Revaluation Surplus’ or ITE should be
cost Account treated the same
way
but Depreciation → IS expense
(example #5)
→ Presentation and Disclosure/ LOS i, j

- all DTAs/DTLs are offset and presented as a single line item -analyze
for DTA and a single line item for DTL -explain
-identify
- footnotes → reconciliation of DTA/DTL account balances with
Pg-13
components making up that balance
- DTA/DTL → noncurrent status
- numerical reconciliation between tax expense and EBT × stat. tax rate
• GAAP → same thing using %’age or $ amounts

• reconciliation of tax expense attributable to continuing operations to
EBT from cont. ops × federal stat. tax rate
+ IFRS → reconciliation between average effective tax rate and the

applicable tax rate
Non-Current (Long-Term) Liabilities
a. determine the initial recognition, initial measurement and subsequent

measurement of bonds;
b. describe the effective interest method and calculate interest expense,

amortization of bond discounts/premiums, and interest payments;
c. explain the derecognition of debt;
d. describe the role of debt covenants in protecting creditors;
e. describe the financial statement presentation of and disclosures relating to

debt;
f. explain motivations for leasing assets instead of purchasing them;
g. explain the financial reporting of leases from a lessee’s perspective;
h. explain the financial reporting of leases from a lessor’s perspective;
i. compare the presentation and disclosure of defined contribution and defined

benefit pension plans;
j. calculate and interpret leverage and coverage ratios.

Bonds Payable/ Page 1

LOS a
· Initial recognition and measurement
- determine
- bonds can be issued · at par coupon = market rate
· at a premium coupon > market rate
· at a discount coupon < market rate
the market rate at the time of issuance is the ‘effective

interest rate’ or borrowing rate that is the basis of
the company’s interest expense
· CFF proceeds from bond issuance as a cash inflow

· BS liability = proceeds from bond issuance
· IS Interest expense = coupon PMT (if issued at par)
= coupon PMT + amort. of discount (issued at a

discount)
= coupon PMT – amort. of premium (issued at a
premium)
Bonds Payable/ Page 2

· Initial recognition and measurement LOS a
- determine
· Issuance costs IFRS/GAAP included in the measurement
of the liability
- liability for ‘Bonds Payable’ reflect net proceeds
from issuance (i.e. less issuing fees)
e.g./ $1M face value, 5% coupon, 5-YR bond
1/ market rate = 5% issued at par proceeds = face value

BS/ Cash ↑1M CFS/
Bonds Payable ↑1M CFF inflow of 1M
n= 5
2/ market rate = 6% issued at a discount proceeds = $957,876 PMT = 50,000
BS/ Cash ↑ 957,876 CFS/ FV = 1,000,000
Bonds Payable ↑ 957,876 CFF inflow of 957,876 =
CPT PV
Page 3
Bonds Payable/
LOS a
· Initial recognition and measurement - determine
e.g./ $1M face value, 5% coupon, 5-YR bond
3/ market rate = 4% issued at a premium proceeds = $1,044,518

BS/ Cash ↑ 1,044,518 CFS/ n= 5
Bonds Payable ↑ 1,044,518 CFF inflow of 1,044,518 PMT = 50,000

FV = 1,000,000
amount of ‘Bonds Payable’ on the BS = carrying amount =
- premiums/discounts are amortized over life of bond CPT PV
- discount bonds Bonds Payable increases each period typically done

towards par (Int. Exp. > coupon PMT) if the intention
- premium bonds Bonds Payable decreases each period is to retain the
towards par (Int. Exp. < coupon PMT) debt until it
matures
or/ Companies can report bonds at their current fair value
Amortization of Bond Premium/Discount/ Page 4

LOS b
- 2 methods for amortizing:
- describe
1/ effective interest rate method - calculate
- required under IFRS, preferred under GAAP
Interest expense = Carrying amount × market rate in effect
at issuance
| − |=
2/ straight-line method evenly amortizes the discount/premium
over the life of the bond
example #3 Discount example #4 Premium
Interest payments on CFS can differ:

IFRS operating or financing outflow
coupon PMTs only
GAAP operating outflow
- amortization non-cash item added back to NI in CFO
Page 5
Fair Value Reporting Option/ LOS b
· companies can report financial liabilities at FV - describe
· IFRS designated as financial liabilities at fair value - calculate
through profit or loss
· GAAP liabilities under the fair value option
- when rates ↑, report gains since L ↓

- when rates ↓, report losses since L ↑
IFRS/GAAP require fair value disclosures even if they are not reported
on the BS at FV (should consider the effect of FV on
leverage ratios vs. using amortized cost)
· when rates drop, C understates leverage levels

· when rates rise, C overstates leverage levels
FV changes due to changing interest rates FV to the IS

changing credit quality FV to OCI
Page 6
Derecognition of Debt/ LOS c
- explain
· at maturity: Bonds Payable reduced to zero
CFF cash outflow = face value
Cash reduced by face value
· before maturity: called or purchased

Bonds Payable reduced to zero
Gain/Loss on retirement of Debt Cash payment – C
IS
CFO gain deducted from NI, loss added to NI
CFF Cash payment = cash outflow
example #6
Debt Covenants/ Page 7

LOS d
- protect bondholders to the extent that they lower
- explain
the risk to creditors
· affirmative covenants what the company will do

e.g. maintain certain ratios
perform regular maintenance on assets
· negative covenants what the company will not do

e.g. no dividends
- violating a debt covenant = breach

LOS e
Liabilities - describe
Current portion due within 12 months
Non-Current Bonds Payable (single line item with all
LTD issues)
Page 8
Footnotes/ LOS e
· stated and effective interest rates - describe
· maturity dates
· restrictions imposed by creditors
· pledged collateral
· scheduled repayments over next 5-years
Page 9
Leases - contracts that convey the right to use an asset
LOS f
for a period of time - explain
Lessor - party who grants the right to use the asset
Leasee - party who uses the asset
- for a contract to be a lease, it must:

1/ identify a specific asset(s)
2/ give the customer the right to obtain largely all the
economic benefits from the asset for the contract term
3/ give the customer the ability to direct how and for what
objective the asset is used
- a lease allows the leasee to obtain the benefits of the asset
without purchasing it (a form of financing)
Advantages/ less cash up front, little if any downpayment

cost effective a form of secured borrowing, interest
rate typically lower than an unsecured loan
Page 10
Advantages/ convenience - may contain less restrictive LOS f
provisions that other forms of borrowing - explain
- reduces lessee’s risk of exposure to obsolescence
- for lessor increasing the market for its product by offering financing
earning interest over the term of the loan
Lease Classification/
finance lease resembles a purchase
criteria: 1/ lease transfers ownership of the asset to the leasee
(any one 2/ has an option to purchase, reasonably certain to do so
can be met) 3/ lease term is for major part of asset’s life
4/ PV(lease payments) = most of or more of FV(asset)
5/ asset has no alternative use to the lessor
operating lease all others example #10

Page 11
Financial Reporting/ - if term is < 12 mos. (IFRS/GAAP) LOS g
or < $5k (IFRS only), can expense the lease - explain
Leasse Accounting - IFRS/

- all leases treated the same
Inception: Lease Liability = PV(payments) using the rate in
Right of Use Asset (ROU) the lease
Over-time: Lease Liability reduced by each payment net of interest

ROU asset amortized, straight-line
Journal entries/
IS Interest Exp. DR
BS Lease Liab. DR
will not be equal
Cash CR
∴ ROU asset ≠ Lease
Liability
IS Amort. Exp. DR
after initial recognition
BS ROU Asset CR
Ex #11
Principal repayment - CFF outflow, Int. exp. operating or financing
Page 12
Leasse Accounting - US GAAP/ LOS g
finance lease identical to IFRS - explain
operating lease:
At inception Lease Liability reduced by principal pmts. over time
ROU asset amortized over time
- but: amortization = principal
∴ IS Int. exp. + amort. exp. = lease pmt.

BS ROU asset will always equal Lease Liability
- entire payment CFO outflow (no separation of interest)
LOS h
Lessor Accounting - IFRS/GAAP
- explain
Finance lease: Inception
BS Lease Receivable = PV(pmts.) (use interest rate
BS de-recognizes the leased asset in lease)
IS gain or loss on derecognition
Page 13
Lessor Accounting - IFRS/GAAP LOS h
BS Lease Rec. reduced by principal only - explain
IS Interest Income (reported as revenue if this is the
Lessor’s primary business)
CFO entire payment received
Operating Lease: asset is NOT removed from BS

- Lessor continues to own and depreciate it
IS - no interest is recognized
- full payment is revenue (CFO)
∴ Revenue = lease payments

- Depreciation expense Ex #13
Page 14
Pension Plans/ - pension reporting/accounting depends LOS i
on the type of plan - compare
1/ Defined Contribution – company contributes an agreed upon

amount into the plan
- the agreed-upon amount is the pension expense (IS)
- operating cash outflow
- cash decreases by amount of payment
2/ Defined Benefit – company makes promises to pay future benefits

based on years of service
- company estimates future amounts to be paid and discounts
those to a present value pension liability
- company makes contributions to the plan (fund) and
invests
- company assumes investment performance risk
Page 15
Pension Plans/
LOS i
2/ Defined Benefit – typically funded through a separate - compare
legal entity
BS/ if FVassets > Pension Obligation surplus
- report a Net Pension Asset
else Net Pension Liability
IS/ net pension asset/liability reported as profit/loss or in OCI

pension expense
IFRS/ 3 components
1/ employee service costs (IS) – PV of increase in benefits as a
result of one more year of service (or as a result of
plan changes to reflect past service)
2/ Net Interest expense/income (IS)

(net pension asset/liability) × discount rate
Page 16
Pension Plans/ LOS i
2/ Defined Benefit - compare
3/ Remeasurements (OCI) – actuarial gains/losses (result from

changes in assumptions)
- actual return on plan assets – expected return on
plan assets
GAAP 5 components
1/ employee service costs (IS)
2/ Interest expense on beg. balance of pension obligation (IS)
3/ Expected return on plan assets (IS)
4/ Past service costs (OCI)

subsequently amortized to pension exp.
5/ Actuarial gains/losses (OCI)
Page 17
Evaluating Solvency/
LOS j
1/ Leverage Ratios - calculate
- interpret
− − =
− − = ( + . .)
− − = . .
.
= . . .
2/ Coverage Ratios
=
( + )
=
+
Financial Reporting Quality
a. compare and contrast financial reporting quality and quality of reported

results (including quality of earnings, cash flow, and balance sheet items);
b. describe a spectrum for assessing financial reporting quality;
c. explain the difference between conservative and aggressive accounting;
d. describe motivations that might cause management to issue financial reports

that are not high quality;
e. describe conditions that are conductive to issuing low-quality, or even

fraudulent, financial reports;
f. describe mechanisms that discipline financial reporting quality and the

potential limitations of those mechanisms;
g. describe presentation choices, including non-GAAP measures, that could be

used to influence an analyst’s opinion;
h. describe accounting methods (choices and estimates) that could be used to

manage earnings, cash flow, and balance sheet items;
i. describe accounting warning signs and methods for detecting manipulation

of information in financial reports.
Quality
- financial reporting quality LOS a

-distinguish
- refers to the usefulness of information contained
in the report (relevant, faithful representation)
- quality of reported results

- pertains to the earnings and cash generated by
the company’s core economic activities
+ resulting financial condition
- sustainable earnings
- adequate ROI
- without reporting quality, quality of reported results questionable
GAAP, decision-useful, sustainable, adequate returns LOS b, c

-describe
- high quality reporting: -distinguish
· conform to actg. standards
· adhere to all characteristics of decision-useful info.
- relevant
- faithful representation (complete, neutral,
· meet enhancing characteristics free from error)
- comparability
- verifiability
- timeliness
- understandability
GAAP, decision-useful, sustainable, adequate returns LOS b, c

-describe
- high quality earnings: -distinguish
· adequate returns
- exceeds cost of capital
- meets/exceeds expected return
· increase company value
GAAP, decision-useful, sustainable?
- high quality reporting, but low earnings quality

· company is not expected to earn some ROI in the future
or/ - negative economic profit
Within GAAP, but biased actg. choices LOS b, c

-describe
- low reporting quality, unable to assess earnings quality -distinguish
· unbiased choices are ideal
biased: a) Aggressive – increase reported fin. performance

& fin. position in the current period
revenues
· increase reported earnings
operating cash flows
expenses
· decrease reported
debt
Within GAAP, but biased actg. choices LOS b, c

-describe
biased: b) Conservative – decrease reported financial performance -distinguish
& fin. position in the current period
revenues
· usually leads - decrease reported earnings
to improved reported operating cash flows
fin. perf. in later expenses
periods - increase reported
debt
c) Earnings smoothing – understatement of earnings volatility
use conservative assumptions when the co. is doing well, aggressive
assumptions when the co. is doing poorly
LOS b, c
Within GAAP, but biased actg. choices
-describe
- biased presentation -distinguish
- obscures unfavourable information
- highlights favourable information
i.e. emphasizing non-GAAP measures (i.e. non-GAAP EPS)
· Typically poor reporting quality comes with poor earnings quality

(or poor internal controls)
Within GAAP, but Earnings Management
making intentional choices or

taking deliberate action to influence
reported earnings and their interpretation
Within GAAP, but Earnings Management LOS b, c

-describe
(intentional)
-distinguish
defer expenses until next period
· real actions
Capitalize aggressively
warranty exp.
· accounting choices (change estimates)
product returns
bad debts, etc…
Departures from GAAP – Noncompliant Actg.

WorldCom
Departures from GAAP - Fictitious Transactions

Parmalat
Conservatism
LOS b, c
- Conceptual Framework supports neutrality
-describe
But/ conservatively biased standards remain and to different -distinguish
degrees (i.e. IFRS vs. US GAAP)
Benefits: reduces possibility of litigation

bonds ‘price in’ higher risk
may offer ‘tax’ cash outflow benefits
· application of any standard requires judgement, even if it is

inherently neutral
· Bias disguised as conservatism
1) Big bath behavior
2) Cookie jar reserves
Low Quality Reporting
· is mgmt. motivated to issue low quality reports? LOS d

-describe
(incentives, pressures)
- mask poor performance

- meet/beat analyst forecasts or mgmt. forecasts
- increases stock price and mgmt. compensation
(through options)
equity market effects – credibility, stock price
trade effects – company reputation (customers, suppliers)
- mgmt. career reputation
- avoid debt covenant violations
- mgmt./BOD. financial interests
- conditions conducive to issuing low quality reports LOS e

-describe
typically Opportunity – poor internal controls/mgmt. override
referred to - ineffective BOD
as the
Motivation – personal/corporate reasons
‘fraud
triangle’ Rationalization – get through a tough time then undo
- protect the stock price
Quality Mechanisms
LOS f
1) Markets – risk ‘priced in’
-describe
- better quality reporting, lower perceived risk
lower cost of capital
2) Regulatory Authorities
Registration requirements – before public offering
Disclosure requirements – ongoing, post-IPO
Audit reg. – annual
Mgmt. commentaries – desc. of risks, rev. of bus.
Responsibility statements – mgmt., BOD
- explicitly acknowledge resp.
Regulatory review of filings
Enforcement mechanisms – fines, suspensions, charges
3) Auditors – opinions – public – required LOS f

-describe
- private – may be a condition of financing
Limitations/ · opinion is based on info. prepared by the company

· audits are based on samples
· ‘expectations gap’ – auditors verify fair presentation,
not look for fraud
· auditor is the customer in a competitive marketplace
4) Private Contracting – covenants motivate manipulation which motivates

greater monitoring
Presentation Choices
Pro-forma vs. GAAP - strict guidelines LOS g

no universal guidelines -describe
- company uses discretion in calculating pro-forma

earnings including/excluding items depending on
estimated relevance
exclude: dep./amort., restructuring/merger costs, one-time charges
Pro-forma not fraudulent or dishonest

- excluded items are still reported, but just not included
in earnings
Differ from company to company
LOS g
EBITDA – eliminates impact of dep./amort. and restructuring charges
-describe
adjusted EBITDA – excludes more items
· OP leases EBITDAR
· equity-based compensation, acquisition-related charges,
impairment charges for intangibles & long-lived assets,
litigation costs, loss/gain on debt extinguishment
GAAP/ - if a non-GAAP financial measure is used:

- must display most directly comparable GAAP measure
with equal prominence
LOS g
GAAP/ - must provide a reconciliation of the non-GAAP measure
-describe
with GAAP
- explain why non-GAAP measure is more useful
IFRS – similar requirements
Groupon – excellent example

- treated online marketing expenses as
acquisition costs (of getting a new subscriber)
- review that example
Methods
LOS h
· Revenue Recognition FOB source or
-describe
FOB destination
source rev. & profit recognized sooner

- channel stuffing – end of Q discounts to
encourage purchase
- shipping without order
destination rev. & profit recognized later

- earnings smoothing
Reduced Allowance for Sales Returns

- easy to justify, difficult to question
LOS h
Bill-and-Hold transactions
-describe
- customer orders mid-August for Oct 15 shipping
- Sept 30 - Q-end reclassifies end-of-period
inventory as sold, but held
changes in estimates of rebate fulfillment
Allocation across multiple deliverables
equip./service equip./service
80% 20% 90% 10%
- not very visible – disclosures?

- deferred revenue?
LOS h
Depreciation Policies, Long-Lived Assets -describe
- changes in useful life, salvage value
Capitalization Policies relating to Intangibles

- versus expensing
- acquisitions – use low FV to value assets
- lower Dep. going forward
- higher goodwill (not amortized)
- goodwill – not acknowledging impairment
Inventory cost methods – resources for obsolescence

- LIFO liquidation (inflationary periods)
LOS h
Deferred Tax Assets & Valuation Accounts
-describe
- must be a reasonable expectation of recovery
(i.e. positive earnings in the future)
- contradiction between mgmt. commentary &
valuation allowance
Warranty Reserves
Related Party Transactions – used to absorb losses (esp. if private)
Choices that affect Cash Flow Statement

- stretching out payables
- misclassifying cash flows
- taking full advantage of allowable flexibility
Warning Signs
Revenue: LOS i
· allowing FOB source & ‘Bill-and-Hold’ -describe
· significant barter transactions

· low rebate estimates
· shifts in proportions related to multiple deliverables
· out of line revenue growth (vs. comp., vs. industry)
· increasing AR as %’age of sales
(channel stuffing, fictitious sales)
· unusual changes in the trend of AR turnover
· insufficient provision for Doubtful Acts.
· asset turnover .
.
· Inventories – higher growth rate vs. Sales LOS i

-describe
- LIFO liquidations
· Capitalizing when others expense
· Net Income persistently higher than CFO – aggressive accrual policies

red flag
1.0
.
· Others – estimates for dep./amort. out of line
- fourth quarter revisions (auditor reversals)
- related party transactions
- non-operating income/one-time sales included in Rev.
LOS i
Others – classifying an expense as non-recurring
-describe
(inflate Op. Inc.)
- gross/Op. Inc. margins out-of-line
- long records of meeting growth projections
- minimal disclosure
- fixation on reported earnings
Also: Culture – CEO on BOD

- weak/unqualified audit committee
Restructuring/impairment charges – spring-load future results
M&A orientation – opportunity to revalue assets and liabilities
Applications of Financial Statement Analysis
a. evaluate a company’s past financial performance and explain how a

company’s strategy is reflected in past financial performance;
b. demonstrate how to forecast a company’s future net income and cash flow;
c. describe the role of financial statement analysis in assessing the credit

quality of a potential debt investment;
d. describe the use of financial statement analysis in screening for potential

equity investments;
e. explain appropriate analyst adjustments to a company’s financial statements

to facilitate comparison with another company.
Strategy/Performance
LOS a
What?
-evaluate
- levels of and -explain
changes in:
time series The Preschooler
Performance method:
Measures Within Why?
& Why?
Critical Success Across WHY? Why?
Factors
Why?
Cross-sectional WHY?
Alignment of
Strategy and
results
Strategy: LOS a
Low cost provider - high volume, low margin -evaluate
-explain
Superior quality lower volumes, higher margins
Niche market - higher marketing/R&D costs
Technology leader - short product cycles, high inventory turnover,

high R&D costs
Net Income/Cash Flow
Top-Down Approach forecast Sales LOS b

-forecast
- begin with economy’s GDP forecast (x)
- Y = + β1X (Y = industry growth rate)
- Company growth rate based on market share analysis
- retain → co. growth rate = industry
- gain > industry
- lose < industry
now estimate income/cash flow
- historical levels/trends in ratios
- gross m./op. m etc…
- separate forecasts for expense items LOS b

- based on some relationship with sales or stated company -forecast
strategy
- forecast cash flows

- assume non-cash WC/Sales constant
- required increases in WC
- CAPEX
- CFF - debt, equity
Assumptions
First-year sales $100
Annual sales growth 20%
COGS as a percentage of sales 30%
Operating expenses as a percentage of sales 55%
Tax rate 30%
Noncash working capital as a percentage of sales 70%
Annual investment in fixed capital as a percentage of sales 5%
Beginning noncash working capital $75
Beginning cash $10
Assessing Credit Quality

LOS c
- 4 C’s of credit
-describe
1) Character - quality of mgmt.
2) Capacity - ability to pay
3) Collateral - assets pledged
4) Covenants - limitations/restrictions
Lower Risk:
- more revenue sources

- stable/sustainable margins
- higher
, .
Screening
- filtering a set of potential investments into a smaller set that LOS d

-describe
meet certain criteria
- backtesting - applies securities selected to historical data
Limits/ when screening with ratios, they are not adjusted for GAAP vs IFRS
back-testing may not be relevant for future periods
Adjustments
- Investments LOS e
-explain
- classified as either ‘available for sale’ - OCI
‘trading’ - IS
- Inventory
- LIFO vs FIFO
- Long-Lived Assets
- methods & estimates
- Goodwill
- company with internal growth vs company growth by M&A
- use tangible book value
- Off-Balance Sheet Financing

- operating vs. financing
Financial Statement Analysis: An Introduction
· primary purpose of financial reports: 21-1
· provide information and data about

a company’s financial position
profitability
performance
cash flows
· Basic statements/
· Statement of financial position (balance sheet)
· Statement of comprehensive income
- single statement
Income Statement
or - two statements
St. of Comp. Inc.
· Statement of changes in equity
· Statement of cash flows
21-2
· Balance Sheet/ - at a point in time
assets – resources controlled

- liabilities – what is owed providers of
= equity - residual claim on assets capital
- a.k.a. net assets
· Income Statement/ - over a period of time
Revenue + other income

- (Expenses + losses)
= Net Income
· Statement of Comprehensive Income/

- all items that change owner’s equity
except transactions with owners
21-3
· Statement of changes in equity/
- reconciles beg. balances with ending balances
· Statement of cash flows – operating

- investing
- financing
· Notes to the Financial Statements/

- methods, estimates, assumptions
· MD&A – not audited, additional information

· unqualified
· Audit/ - annual statements only · qualified
fair presentation · adverse
- opinion on
internal controls · disclaimer of
opinion
21-4
· financial statement analysis framework/
- purpose
- collect data
- process data
- analyze/interpret
- communicate conclusions
- follow up

Review - 1
LOS a/ objective of financial reporting - provide financial info.
that is useful to users in making decisions about
providing resources to the entity
financial reporting standards – provide principles for preparing
financial reports
- determine types/amounts of info. to provide
LOS b/ IFRS IASB, US GAAP FASB Standard setting bodies

- private sector SROs that set standards
Regulatory Authorities SEC gov’t. entities with legal authority
to enforce requirements
LOS c/ Fundamental Characteristics

1/ Relevance - material info. is relevant
2/ Faithful presentation – info. is complete, neutral, free from error
Review - 2
LOS c/ enhancing characteristics
· comparability
· verifiability - tradeoffs estimates are not verifiable
· timeliness - available prior to making a decision
· understandability - clear/concise presentation
Constraints costs Assets

Elements financial position Liabilities
Equity
Income – revenue + gains
measurement of performance
Expenses – costs + losses
Underlying Assumptions
1/ Accrual accounting – matching principle
2/ Going concern – company will continue to operate
Measurement of Elements - historical cost, amortized cost,

current cost, realizable value, present value, fair value
Review - 3
LOS d/ Required Statements
Statement of Financial Position – Balance Sheet
Comprehensive Income – single statement or
Changes in Equity IS + Comp. Inc.
Cash Flows
Notes to Financial Statements
General Features: fair presentation/going concern/accrual basis

similar items aggregated
materiality and aggregation
material items on a separate
no offsetting line
frequency of reporting – at least annually
BS–2 yrs.
comparative info. – prior period presentation
IS/CFS–3 yrs.
consistency
LOS e/ 2 major standards IFRS and US GAAP

have not converged
LOS a/ presents financial results over a period of time Pg-1

may be presented as 1/ a single St. of Comp. Inc.
2/ an IS + St. of Comp. Inc.
Components: Revenue (net) ordinary activities

Expenses grouped by nature (e.g. Dep.) or function (COGS, SG&A)
Gains/losses typically non-operating
Multi-step IS/ Rev.

- COGS
gross profit % = gross margin
- Operating Exp.
Operating profit % = operating margin
or EBIT not affected by capital structure
- 1
EBT
- T
Net Income % = Net Income margin
LOS b/ accrual basis – recognized when earned Pg-2
1/ Identify contracts - only exist if collectability is probable

2/ Identify distinct performance
obligations (POs) – customer can benefit from it on its own
3/ Determine price
4/ Allocate price to POs 1/ company has right to
5/ Recognize revenue when POs – satisfied when payment
satisfied 2/ customer has legal title
LOS d/ - matching principle 3/ + physical possession
· product costs COGS 4/ + risks/rewards of
· period costs Admin., Dep. ownership
5/ customer has accepted
- COGS depends on Inventory method the g/s
- Allowance for Doubtful Accounts – estimate
- Warranty Expense - estimate
LOS d/ Depreciation/Amortization Pg-3

IFRS cost model - each component must be Dep. separately
- choice of Dep. method - straight-line, units of
production, accelerated methods
Revaluation carrying value = fair value (not permitted
FV gain/loss on IS under GAAP)
- intangibles with indefinite lives no amortization
· Choice of methods affects comparability
LOS e/ 1/ Discontinued operations separate line item

2/ Unusual/infrequent items if material, disclose separately
(shown as continuing operations)
3/ Change in Accounting Policy
prospective ( estimates)
- new standards
retrospective ( policies)
LOS f/ Operating Income Pg-4

+ Non-op. gains/Inc. typically earned through investing or
- Non-op. losses/Inc. financing activities
- typically reported separately
LOS g/ EPS required on the IS
− . .
=
. .#
Diluted EPS what EPS would be if all dilutive securities

were converted (if converted method)
- as of beg. of period
+ Basic & Diluted from continuing operations
a) Convertible pref.: =
. . # +
+ ( )− . .
b) Convertible debt: =
. . # +
Pg-5
LOS g/ c/ stock options, warrants – treasury stock method
- collect strike price, buy shares, create what is needed
− . .
=
. .# + . .#
LOS h/
Anti-dilutive if conversion results in higher EPS
Diluted EPS = Basic EPS
LOS i/ Sales = 100%
- all else as a % of Sales (Revenue)
- removes size effect
- facilitates comparison across time & companies
LOS j/
gross profit margin - measures effectiveness
at manufacturing/purchasing
. Op. profit margin - measures effectiveness at
operations
NI Margin
Pg-6
LOS k, l/ OCI – Other Comprehensive Income
- other rev./exp. items NOT included in NI
TCI = NI + 0CI
e.g./
foreign currency translation adjustments
unrealized g/L on certain financial investments
Understanding Balance Sheets

Pg-1
A= L + E
resources how those resources

controlled were financed
· IFRS/GAAP
assets - sold, used up, or converted to cash < 1yr
Current (or 1 operating cycle)
liabilities – settled < 1yr
Non-Current – assets/liabilities – anything not current
- classified B.S. – separate current & non-current A & L

- liquidity-based presentation – all A & L presented in order of liquidity
· Working Capital = CA - CL
Current Assets/ Pg-2

· Cash/Cash Equivalents – financial assets - reported at either
FV or amortized cost
· Marketable Securities – financial assets hist. cost
+/- amort. or impairment
· Trade Receivables - net realizable value (NRV)
[Allowance for Doubtful Accounts contra acct]
· Inventories – IFRS: lower of cost or Net Realizable Value
NRV – selling price – costs to sell
- GAAP: lower of cost or market
current replacement cost

NRV
upper
market
lower
NRV – normal profit
· IFRS/GAAP – if NRV/market < carrying cost write-down (IS)

Current Assets/ Pg-3
IFRS – reversals of previous write-downs allowed

· Inventories
GAAP – reversals not allowed
· Other CA – notes disclosure

· Deferred Tax Assets – Tax Payable > Tax Expense
(filing) (reporting)
Current Liabilities/
· Trade Payables
· Notes Payable < 1yr
· Accrued Expenses
· Deferred Revenue
Pg-4
Non-Current Assets/
· Property, Plant & Equipment (PPE) – tangible assets

cost model (GAAP only)
IFRS
revaluation model
(on IS)
· cost model: historical cost – Dep. – Impairments
recoverable < carrying

· revaluation model
FV – Dep greater of
FV – costs to sell
(IS or equity)
Value in use (PV of CFs)
· Investment Property (IFRS) - reversals – IFRS only
· cost or FV
Non-Current Assets/ Pg-5

IFRS: cost or revaluation model
· Intangible Assets
GAAP: cost only when active market
- finite life – amortized

- impairment rules same as PPE
- infinite life – no amortization
- tested annually for impairment
- internally generated – IFRS/GAAP – expensed
· Goodwill excess of purchase price over FV of assets
· Financial Assets · held-to-maturity – amortized cost

(debt only)
· held-for-trading – FV IS
· available-for-sale – FV OCI
Pg-6
Non-Current Liabilities/
· Financial Liabilities
· Deferred Tax Liabilities
Equity
· Contributed Capital
· Preferred Shares
· Treasury Shares – contra acct.
· Retained Earnings
· Accumulated OCI
· Non-Controlling Interest – contra acct.
Statement of Changes in Equity/

Analysis of B.S./ Pg-7
· common size Total Assets = 100%

Total L + E = 100%
· ratios: liquidity – current, quick, cash
solvency - , , Total Debt, Financial leverage
[ + . + ] =
=
[ + . ] =
=
Pg-1
3 Sections
Direct
Operating - day-to-day activities
Indirect
- CA & CL accts (except cash)
Investing - long-term assets and other investments
Financing - obtaining & repaying capital (D&E)
IFRS /
Investing
GAAP
Received
Operating - all operating
Interest
Paid
Financing except Div. paid
Dividends
Received Operating financing
Investing
Beg. Cash + Cash inflows - Cash outflows = Ending Cash Pg-2

(Jan 1) (Op., Inv, Fin) (Op., Inv, Fin) (Dec 31)
- generally/
Beg. acct balance + Additions - Subtractions = End. Acct. balance
knowing any 3 solves the 4th
Direct Method/ - each line item on the IS is converted to cash

e.g./ Revenue cash collected
Beg AR + Rev - Cash collected = End. AR
known known known

(BS) (IS) (BS)
Pg-3
Cash paid to suppliers/
Beg AP + Purchases - Cash PMTs = End AP.
(BS) (BS)
Beg Inv + Purchases - COGS = End Inv.
(BS) (IS) (BS)
Cash paid to employees/

Beg Wages Payable + Wages Exp - Cash paid = End Wages Payable
(BS) (IS) (BS)
prepaid
Other Expenses/
accrued
Other Exp - dec. in prepaids - Inc. in accruals = Cash paid
Indirect Method/ (CFO) Pg-4
Net Income
+ NCC - add-back non-cash charges
+ Non-Operating Exp. - add back non-op charges
- Non-Operating Inc. - less non-op Inc.
+/- WC accts.
in out i.e. End AR = 50

assets - + Beg AR = 100
liabilities + - ( AR = -50) inflow
Analysis
- calculate sources and uses of cash (just look)
inflows 100% each line item as

common size
outflows 100% a %’age
each line item a %’age of net revenue
Pg-5
Free Cash Flow to the Firm/
FCFF = NI + NCC + Int(1-t) - FCInv - WCInv
= CFO + Int(1-t) - FCInv
Free Cash Flow to Equity/
FCFE = CFO - FCInv + Net Borrowing
Cash Flow Ratios/
Performance Coverage
CFO/Rev Debt Cov. - CF0/Total Debt
CFO/Avg. TA Int. Cov. -
( . )
.
CFO/Avg. E - cash return to equity
Reinvestment - CFO/CAPEX
CFO/Op. Inc. - cash to income
Debt PMT. - CFO/repayments
( . ) Div PMT. - CFO/Div. PMTs
CF/Sh. -
# Inv $ Fin. - CFO/(CFF + CFI)
Framework/ 1. Articulate the purpose and context of the analysis Pg-1

2. Collect input data
common size
3. Process data
ratios interpretation
forecasts
4. Analyze/Interpret
5. Develop/Communicate conclusions
6. Follow-up
Why?/ - guiding question difference between computation

and analysis
far more important

Ratios/ - focus on likely impact
of changes – achieving compatibility (IFRS vs. GAAP)
Pg-2
Ratios/ · if IS or CF acct. is a numerator & BS
acct. is a denominator use avg. ( . + )
· activity (efficiency)
· liquidity – short-term obligations compare with
performance · solvency - long-term obligations · major competitors
· profitability · across time
· valuation
Activity/
Inventory Turnover = COGS/Avg. Inv. Receivables Turnover = Revenue/Avg. AR
Days of Inventory Days of Sales

on Hand (DOH) = 365/Inv. Turnover outstanding = 365/Rec. Turnover
Pg-3
Activity/
Payables Turnover = Purchases/Avg. AP
Number of Days of Payables = 365/Payables Turnover
Working Capital Turnover Rev./Avg. WC.
Fixed Asset Turnover Rev./Avg. Net FA
Total Asset Turnover Rev./Avg. TA
Liquidity/
Current Ratio = CA/CL
Quick Ratio = (Cash + Mkt. Sec. + Rec.)/CL
Cash Ratio = (Cash + Mkt. Sec.)/CL
Defensive Interval Ratio = (Cash + Mkt. Sec. + Rec.)/Daily Cash Exp.
Pg-4
Liquidity/
Cash Conversion Cycle DOH + DSO – Days Payable
Solvency/ operating leverage – the use of fixed costs in the business

financial leverage – the use of debt in the capital structure
Debt-to-Assets = Total Debt/Total Assets

Debt-to-Capital = Total Debt/(Total D. + Total E.)
Debt-to-Equity = Total Debt/Total Sh. Equity
Financial Leverage Ratio = Avg. TA/Avg. total E.
Interest Coverage Ratio = EBIT/Int. exp.

Fixed charge coverage = (EBIT + Lease PMTs)/(Int. exp. + Lease PMTs)
Pg-5
Profitability/
Gross Profit Margin Gross profit/Rev.
Op. Profit Margin Op. Pr./Rev. Return on
Pre-tax Margin EBT/Rev. Sales
Net Profit Margin Net Income/Rev.
Operating ROA = Op. Inc./Avg. TA

ROA Net Inc./Avg. TA
return on
Return on Total Capital EBIT/(Total D + E) investment
ROE NI/Avg. Total E.
Return on Common Equity = NI – Pref. Div./Avg. Common E.
Dupont Analysis: Decomposition of ROE Pg-6
= . . .
.
= . × . . . ( × )
. .
= . × . × . . .
× ×
. .
= × × .× . × . . .
× × × ×
Valuation/ Pg-7
P/E = Price/EPS
P/CF = Price/(CF/sh)
P/S = Price/(Sales/sh)
P/BV = Price/(BV/sh)
Basic EPS = (Net Inc. – Pref. Div.)/w. avg. # shares

Diluted EPS = (Adj. NI after conversion)/w. avg. # shares + new
CF/sh. = CFO/w. avg. # shares
EBITDA/sh. = EBITDA/w. avg. # shares
Div./sh. = Common Div./w. avg. # shares
Valuation/ Pg-8
DPR = Divs./Net Income

RR = 1 – DPR
Sustainable g = RR × ROE
Credit Analysis/ · coverage EBIT

EBITDA Int. Cov.
FFO
· liquidity/solvency
Segment Reporting/ · minimum disclosures Notes

· segment ratios
Model Building/Forecasting/ · sensitivity analysis

· scenario analysis
· simulation
Inventories
Pg-1
IFRS/GAAP all costs up to finished goods
NO: storage of finished inventory
abnormal waste in conversion Exp → IS
admin/selling
raw materials
- Manufacturing
work-in-process
finished goods → merchandising Company
IFRS/GAAP specific identification - for non-interchangeable items

average cost
FIFO → higher Inv., lower COGS
LIFO - GAAP only → lower Inv, higher COGS
when prices are rising
• Periodic amt of Inventory on hand determined periodically Pg-2

Beg Inv. + Purchases = Inventory available for Sale
less: periodic Inventory count (end Inv)
Perpetual continuous = COGS
• spec. id & FIFO - no difference
• LIFO & avg. cost will have a difference
IFRS/ - lower of cost & NRV (FV - costs to get it ready for sale)
- if NRV < C : write-down → exp → IS
- reversals allowed (to the extent
GAAP/ - lower of cost or market of the write-down)
NRV – Normal - reduce COGS
< Current replacement cost < NRV
profit margin
• Write-downs IS COGS - no reversals

• commodity producers (ag., mining, forest) Pg-3
- carried at NRV (FV - costs to sell/complete)

gains/losses IS
Presentation/Disclosure:
• inventory valuation method
• carrying amt. (amt. carried at NRV as well)
• COGS
• write-downs
• amt. pledged as security
IFRS/ - reversals & why

Changes/ IFRS - yes - retrospective
GAAP - more difficult, but yes - retrospective
Pg-4
Ratios/ Inventory Turnover =
.
DOH = . .
Gross Profit Margin = ( − )
Heavy Focus: effect on other Ratios

current
Inventory - asset
total
COGS - profitability ratios
equity ratios (Retained Earnings)

Pg-5
LIFO/ LIFO for tax, then LIFO for reporting
COGS more closely reflect current replacement costs
- rising prices/ IS = higher - COGS

lower - gross profit, op. profit, tax exp., NI
BS = lower - End. Inv., WC, TA, RE, Sh. Eq
CFS - higher CFO
LIFO Reserve/ - GAAP disclosure requirement

- diff. between reported LIFO Inv. & what FIFO Inv. would be
(FIFO Inv. C. amt. - LIFO Inv. C. amt.)
Pg-6
LIFO Reserve/
B.S. LIFO Inv
+ LIFO Reserve
= FIFO equivalent
IS. LIFO COGS

- if LR increased
- (LRend - LRbeg)
- COGS reduced
LIFO Liquidation/
- EBIT increased
- when # units sold > # units made/purchased - Tax Increased by LR(t)
Units in < Units in - CFO reduced
End Inv. Beg Inv.
- if prices have been ↑, gross margins ↑ than normal

Long-Lived Assets
· tangible · intangible · Financial Pg-1
only these (L2 CFA)
does not
· capitalized (recorded as assets) versus expensed meet asset
recognition
costs allocated to exp. over useful life
criteria
assets ↑ NI ↓
CFI ↓ over-time assets ↓
Property, Plant & Equipment/

- recorded at cost + all costs up to ‘intended use’
(purchasing) - subsequent costs added to asset value if
they provide benefits > 1yr. (else exp.)
if being
(constructing) - borrowing costs capitalized (PPE or inventory) sold
· IFRS – interest earned on borrowed funds ↓ bor. costs
· GAAP – interest income
Int. payments CFI outflow
- all capitalized interest should be included in Pg-2
Int. Exp. for ratio analysis

1) identifiable (company separation)
Intangible Assets/
2) under control of company
IFRS – identifiable intangibles
3) generate future benefits
- how acquired/ +
future benefits probable
Purchased (not a Bus. Comb.)
+
CFI - FV when acquired (price paid)
costs can be measured reliably
outflow (allocated to each asset)
Developed Internally
- generally expensed as incurred – (CFO outflow)
- no associated asset
Pg-3
IFRS – all R expensed, some D can be capitalized
- R&D
GAAP - all expensed
if technically feasible &
except some software intend to sell or use
Acquired in a Bus. Comb.
- acquisition method – acquirer allocates purchase price
to each asset acquired FV
IFRS/ all tangible and - if purchase price > i = asset1,

identifiable intangibles asset2…
GAAP/ all tangible and Goodwill

‘contractual & separable’
intangibles
Pg-4
Depreciation/Amortization
IFRS allowed all tangible and ‘finite life’

· cost model
GAAP required intangibles costs allocated
· revaluation model – IFRS only over useful life
FV - accum. Dep./Amort.
- methods/
− . .
straight-line expensed evenly
accelerated greater costs in earlier yrs. – dep. down to S.V.
units-of-production actual use of an asset – dep. down to S.V.
- method need not be the same for tax as for reporting

- gives rise to DTA/DTL
· IFRS requires component method of Dep. – major components of an asset
· GAAP allows Dep. separately
Depreciation/Amortization Pg-5
- same methods as Dep.
- finite lives only
Revaluation model/ IFRS only (not required, but permitted) (rarely used)
asset
: FV (as of date of revaluation) – Subsequent Dep.
on BS
can be > original cost
cost or revaluation must be applied to the ‘class’ of asset
for intangibles as well only if active mkt. exists
· if FV < original C. loss IS [FV > C. reval. surplus]

- reversal to extent of original loss → IS
excess revaluation surplus acct. in equity section
Pg-6
Impairment/ - an unanticipated decline in value
- GAAP/IFRS – require write-down
reversals allowed
FV – costs to sell
IFRS/ C > recoverable amount higher
Value in use = PV(CFs)
GAAP/ C > FV – only when C. is determined to be
unrecoverable (C > Σ undisc. CF) – test
PPE – only if evidence of impairment

- reduce asset C, loss IS
IFRS: C – recov. amt. = loss
GAAP: C – FV = loss
Impairment/ Pg-7
Intangibles w/ Finite Life
- same as for tangible assets
Intangibles w/ Indefinite Lives

- tested annually for impairment
Long-Lived Assets Held-for-Sale
an asset no longer used and being sold

- revalued & reclassified, impairment taken then
Reversals
(even on Held-for-Sale)
IFRS only
GAAP – no! GAAP - yes!!
Pg-8
Derecognition/ - an asset is disposed of or provides no future
benefits from use or disposal
Sale of Long-Lived Asset
− = ⇒
Other than Sale

- held for use until disposed – Dep. Exp. continues
$0 – C = loss IS
- exchanged/
− = ⇒
typically equal
Presentation & Disclosures/ Pg-9

IFRS/ · measurement bases GAPP/ · dep. exp.
· dep. method · C of assets
· useful lives · accum. dep.
· gross carrying amt. · dep. method
· accum. dep. (beg. & end)
· reconciliation of C (beg. & end)
- if revaluation model used details - date, FV, FV-C

- intangibles - finite life GAPP/ · amort. exp.
- infinite life C · gross C
- Impairments amt. & reversals · accum. amort.
where on FS · est. amort. exp.
why next 5 years
Pg-10
Investment Property/
IFRS – property owned for income or cap. appr.
- cost or FV
all changes IS
GAAP – no definition of Inv. Prop.
- cost model
- reclassifications Inv. Prop. owner occupied

cost cost
FV FV
Owner occupied Inv. Prop. (FV)

cost FV treated as a revaluation
Inventory Inv. Prop. (FV)

cost FV gain/loss IS
Income Taxes
Pg-1
- accounting profit = EBT
- taxable income = portion of income subject to tax
Actg. profit may not equal Taxable Income
Income Tax Expense = Income Tax Payable +/- (DTA/DTL)
(IS) (BS) (BS)
if: Actg. Profit < Taxable Income = DTA (R<T)

ITE < ITP (excess paid)
if: Actg. Profit > Taxable Income = DTL (R>T)
ITE > ITP (deficit paid)
expense cash
CFO/ NI
tax Tax Base: amt at which A/L is
+ ITE
adjustments valued for tax purposes
- ITP
Carrying Amt: actg. principles
Pg-2
• Rev/Exp recognition differences
temporary or permanent
• C. vs. TB. Differences
DTA/ taxes that have been paid (or loss carry forward)
but not yet recognized on IS result of temp.
DTL/ ITE (reporting) > ITP (regulatory) differences
IFRS DTA/DTL = non-current

GAAP DTA/DTL = current/non-current depending on the classification
of the underlying A/L
- if past DTA/DTL doubtful

IFRS - reversal
GAAP - valuation allowance
Pg-3
Determining Tax Base/ - at each BS date, compare
BS (actg. standards) - BS (tax purposes) = difference
R > T = DTA (diff × t)
R < T = DTL (diff × t)
Journal Entry * For liabilities …

DR CR
Reverse it for Assets
Income Tax Expense $
Income Tax Payable $
Either of: decr. in DTA/inc. in DTL $ → ITE > ITP
inc. in DTA/decr. in DTL $ → ITE < ITP
Tax Base/ - amt. on BS for A/L assuming the tax return was the IS
- tax return reflects jurisdictional tax legislation
Changes in Tax Rates/ Pg-4

- existing DTA/DTL must be adjusted to new tax rate
gains/losses IS
- if new rates > old rates DTA & DTL ↑

- if new rates < old rates DTA & DTL ↓
Temporary vs. Permanent Differences/
will be reversed will not reverse results in difference between

at some future point effective & statutory tax rates
BS C vs TB ± ( / )
A C > TB DTL . = =
A C < TB DTA
L C > TB DTA
L C < TB DTL
Pg-5
Presentation & Disclosure/
- no offsetting of DTA/DTL
- current/non-current → IFRS
GAAP
- reconciliation of Tax Payable and Tax Expense
LOS a/ Initial recognition – market rate at time of issuance Review - 1
called ‘effective interest rate’ (YTM)
Cash ↑ Proceeds Financing cash inflow ↑ proceeds

Bonds Payable ↑ Proceeds
Interest expense = eff. int. rate × carrying value of bond

Interest payment = coupon rate × face value of bond
Amortization = Int. pmt. – Int. exp. for premium
Int. exp. – Int. pmt. for discount
- premiums/discounts are amortized over the life of the bond
Discount bonds Bonds Payable increases each period (Int. exp. > Int. pd.)
Premium bonds Bonds Payable decreases each period (Int. exp. < Int. pd.)
- Companies can also report Bonds Payable at FV

· FV IS
Review - 2
LOS b/ 2 methods of amortization
1/ straight-line constant amount each period
2/ effective interest rate – required under IFRS, preferred under GAAP

- increasing amortization each period
Int. exp. = carrying amount × eff. int. rate

Amort. = |Int exp. – Coupon|
Cash Flow Statement: IFRS op. or fin.

interest paid
GAAP op.
- amortization added back to NI in CFO
LOS c/
Bonds Payable ↓ to 0 Bonds Payable ↓ to 0
Cash reduced by face value gain/loss on IS
cash outflow financing cash ↓ by cash payment
payment = fin. outflow
at maturity
before maturity
Review - 3
LOS d/ Affirmative covenants – what the company will do
Negative covenants – what the company will not do
LOS e/ Current Liabilities current portion of LTD due within next 12 mos.
Non-current Bonds Payable (single line item)
- Footnotes Bond detail (eff. int. rate, maturity, restrictions, pledged
assets, etc.)
LOS f/ less cash up front, little if any downpayment
lower financing costs vs. unsecured loan (+ less restrictive provisions)
hedge against obsolescence
Lessor - support for sales + interest income
LOS g/ IFRS/GAAP all leases asset + liability on balance sheet

at inception: right of use = lease liability
asset = PV(pmts.)
IFRS: IS Interest expense + Amortization of ROU

BS ROU ↓, Lease Liability ↓ by (pmt. - interest)
CFF Principal payment
LOS g/ GAAP Review - 4
1/ Financing lease same as IFRS
2/ Operating lease at inception:

Lease Liability - reduced by principal pmts. over time
ROU Asset amortized over time (amort. = principal)
IS Amort. Exp. + Interest Exp. = PMT.
BS ROU asset will always equal lease liability
CFO outflow entire payment
LOS h/ Lessor Accounting - IFRS/GAAP

Finance Lease: Inception
BS Lease Receivable = PV(pmts.) (de-recognize asset)
- ongoing: IS - gain or loss
BS Lease Rec. reduced by principal only
IS Interest Income
CFO entire payment received
- Operating - asset is NOT removed from BS
- Lessor continues to own and depreciate it
Review - 5
LOS h/ IS - no interest is recognized
- full payment is revenue (CF0)
LOS i/ Defined Contribution contribution = Pension Expense (CFO)

Defined Benefit company makes contributions to a plan
FVassets > Pension Obligation surplus
- net pension asset, else liability
IFRS/ 1/ employee service costs

reported on IS
2/ Net interest exp./income
(net pension A/L × discount rate)
3/ Remeasurements OCI
- changes in assumptions, actual return on plan assets
- expected return
GAAP/ employee service costs + Int. on beg. pension obligation

+ expected return on plan assets IS
Review - 6
LOS i/ GAAP/ Past service costs + remeasurements OCI
LOS j/
Leverage Solvency
- Debt-to-Assets . . - Interest
coverage
- Capital
( + .)
- Equity .+ .
. .
. . . - financial - fixed charge coverage
leverage
ratio
Financial Reporting Quality
- financial reporting quality - usefulness of info. Pg-1
vs.
- quality of reported results - earnings & cash generated
(sustainable earnings, adequate ROE)
no reporting quality? quality of reported results questionable
Categories/ GAAP, decision-useful, sustainable & adequate returns
high quality reporting quality of results
- relevant + comparability
- faithful/rep. verifiability
timeliness
understandability
ad. ret.
GAAP, decision-useful, not so much sustainable
low earnings quality
Pg-2
a) aggressive
↑ fin. perf. in current period
↑ (Rev., Earn, CFO) ↓ (Exp. Debt)
GAAP, biased choices
b) conservative
↓ fin. perf. in current per.
or ↑ fin. perf. in later ↓ (Rev., Earn, CFO) ↑ (Exp. Debt)
periods
c) earnings smoothing
- understating earnings volatility
GAAP, biased presentation
e.g./ emphasizing non-GAAP measures
real actions
Within GAAP, but earnings Mgmt.
actg. choices
Departures from GAAP – noncompliant actg.
Departures from GAAP - fictitious transactions
Low Quality Reports/ Pg-3

poor perf.
mgmt. motive meet/beat forecasts
compensation
reputation
avoid debt violations
poor internal controls
conditions conducive/ 1) Opportunity
ineffective BOD
2) Motivation
get through this Q
3) Rationalization protect stock price
Quality Mechanisms/ counter balancing forces
Markets (lower perceived risk, lower WACC)
Regulatory Authorities
Pg-4
Quality Mechanisms/
info. prepared by mgmt.
Auditors (limitations however)
only verify fair presentation
Private Contracting
price
- covenants motivate manipulation, thus motivate
greater monitoring
Presentation Choices/
pro-forma - no universal guidelines - company uses discretion in
GAAP – strict guidelines reporting earnings
e.g. EBITDA vs. adjusted EBITDA

- removes even
- removes dep./amort.
more
+ restructuring charges
price
display comparable GAAP measure
- if a non-GAAP measure used
with equal prominence
price
Presentation Choices/ Pg-5

- reconciliation of non-GAAP & GAAP measures
- why non-GAAP used
(GAAP & IFRS similar requirements)
Actg. choices for F.S. mgmt./ (Channel stuffing)
Rev. Recog. - FOB source – recog. rev. sooner

- FOB destination – recog. rev. later (smoothing)
- reduce ‘Allowance for Returns’
- Bill & Hold
- lower est. of rebate fulfillment
- allocation across multiple deliverables
e.g./ 80/20 vs. 90/10

now later now later
Pg-6
Actg. choices for F.S. mgmt./
useful lives
Depreciation Policies
salvage values
Capitalization Policies of Intangibles - vs. expensing
- lower FV in
Inventory Cost Method
acquisitions
Warranty Reserves
Related Party Transactions

stretching payables
Choices that affect CFO misclassifying CFs

2022 Li Fra

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Level I - Financial Reporting and Analysis

Introduction to Financial Statement Analysis 6

Financial Reporting Standards 11

Understanding Income Statements 17

Understanding Balance Statements 27

Understanding Cash Flow Statements 35

Financial Analysis Techniques 43

Non-Current (Long-Term) Liabilities 81

Financial Reporting Quality 91

Applications of Financial Statement Analysis 103

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Business Activity Classification

2) Investing activities acquisition/disposal of non-current

3) Financing activities obtaining/repaying capital

Elements & Accounts

5 financial statement Elements

Accounts (sum up the balances within elements)

Contra-accounts (decreased the balance within Elements)

B.S. A= L + E Basic Accounting Equation

B.S. and I.S. linked by:

Statement of Retained Earnings

based on double-entry accounting

reconciles cash balance

B.S I.S CF. S

Accruals & Valuation

- based on ‘matching principle’

Unearned Rev. get paid before delivery of good/service

Accrued Rev. not yet billed

Prepaid Expense paid for but not yet used

Accrued Exp. incurred but not yet billed

all transactions are recorded at historical cost

4 stages 1) Journal entries (and adjusting entries)

· adjustments may need to be made

· assessments of reasonableness of judgements and estimates

notes to fin. st.

Introduction to Financial Statement Analysis

a. describe the roles of financial reporting and financial statement analysis;

b. describe the roles of the statement of financial position, statement of

c. describe the importance of financial statement notes and supplementary

d. describe the objective of audits of financial statements, the types of audit

e. identify and describe information sources that analysts use in financial

f. describe the steps in the financial statement analysis framework.

Financial Statement Analysis

- examine current and past performance in order to form

- prepared in accordance with applicable accounting standards

for a point in time

Financial Notes/(footnotes) LOS c

· off-balance sheet obligations

ensures the reliability of processes

3) Process Data – ratios

4) Analyze/Interpret the Data – conclusions/recommendations

5) Develop/Communicate Conclusions – analyst report

Financial Reporting Standards

a. describe the objective of financial reporting and the importance of financial

b. describe the roles of financial reporting standard-setting bodies and

c. describe the International Accounting Standards Board’s conceptual

d. describe general requirements for financial statements under International

e. describe implications for financial analysis of alternative financial reporting

Financial Reporting Standards

IASB – International Accounting Standards Board: objective of

Since financial reporting requires the use of judgments (estimates),