CFA-FRA-R15-26-updated 0110122

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READING 15: INTRODUCTION TO

FINANCIAL STATEMENTS
ANALYSIS
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READING 15: INTRODUCTION TO FINANCIAL

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

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

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

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STATEMENTS ANALYSIS
[LOS 15.a] Describe the roles of financial reporting and
financial statement analysis.
1. Role of financial reporting
Financial
Financial reporting
reporting Investors, creditors & analysis
The Economic
other interested
company decisions
parties
Financial reporting refers to the way companies show their financial performance to
investors, creditors and other interested parties by preparing and presenting
financial statements.
2. Role of financial statement analysis
Financial statement analysis is to use the information in a company’s financial

statements, along with other relevant information, to make economic decision.
Analysts use financial statement data to evaluate a company’s past performance
and current financial position to form opinions about the company ability to earn
profits and generate cash flow in the future.
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STATEMENTS ANALYSIS
[LOS 15.b] Describe the roles of financial statements in
evaluating a company’s performance and financial position.
Statement of financial position (balance sheet)

Types of financial
statements
Statement of comprehensive income
Statement of cash flows
Statement of changes in equity
Note: The accompanying required notes or footnotes (see

more in part III), are considered an integral part of a
complete set of financial statements.
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STATEMENTS ANALYSIS
1. Role of statement of financial position
Report major classes & amount of assets (resources owned or controlled

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

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STATEMENTS ANALYSIS
Example: Statement of financial position
Basic equation:
Total assets = Totals
liabilities + Equity
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STATEMENTS ANALYSIS
2. Role of statement of comprehensive income (SOCI)
Report on performance of firm (result of its operating activities) on

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

statement of comprehensive income or as 2 statements:
• Statement of profit or loss
• Statement of other comprehensive income
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STATEMENTS ANALYSIS
Example: Statement of comprehensive income

loss (income statement)
Statement of profit or
income/ expense
contains realized
income/ expense
Statement of OCI
income contains
unrealized
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STATEMENTS ANALYSIS
3. Role of statement of cash flow
Report cash receipts and payments in the reporting period, classified as

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

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

operating CF + Net cash in investing CF
Net Cash in SOCF = Net cash in
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STATEMENTS ANALYSIS
Example: Profit versus Cash Flow

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

Cost of goods sold (€150,000) (recorded in Jan 0
20X8)
Rent and salaries (€20,000) Cash paid for Rent & (€20,000)
expenses salaries expenses
SD’s profit for SD’s cash flow for

€80,000 €230,000
December 20X7 December 20X7
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STATEMENTS ANALYSIS
Solution:
SD’s Profit versus Cash Flow for January 20X8
Profit Cash flow
Sale price €250,000 Cash from sale price €250,000
Cash paid for COGS

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

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

€80,000 €80,000
January 20X8 January 20X8
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STATEMENTS ANALYSIS
4. Role of statement of change in equity
• Report movement (increase and decrease) in components of owners’

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

equity in equity equity
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STATEMENTS ANALYSIS
Example: Statement of change in equity
Opening
Movement
Closing
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STATEMENTS ANALYSIS
[LOS 15.c] Describe the importance of financial statement notes,
Importance of financial statement notes and
1.
supplementary information
The notes provide information that is essential to understanding the

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

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

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

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

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

IFRS guidance recommends that US. GAAP requires that MD&A
MD&A address must
• The nature of the business • Highlight any favorable or
• Management’s objectives unfavorable trends
• The company’s past performance • Identify significant events and
• The performance measures used uncertainties that may affect the
• The company’s key relationships, company’s liquidity
resources and risk • Identify capital resources and
results of operations
• Discuss effects of inflation and
changing prices if material
• Discuss Impact of off-balance
sheet obligations & contractual
commitments.
• Discuss accounting policies that
require significant judgment by
management
• Forward-looking expenditures
and divestitures
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STATEMENTS ANALYSIS
[LOS 15.d] Describe the objective of audits of FS, types of audit
reports and the importance of effective internal controls
1. Objective of audits of FS
Audit
Independent auditor Financial Statements
An audit is an independent review of an entity’s financial statements.

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

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

FS materially depart from Audit is unable to issue audit
accounting standards opinion
Note: An audit report must also contain a section called Key Audit
Matters or Critical Audit Matters, which highlights accounting choices
that are greatest significance to users of financial statements.
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STATEMENTS ANALYSIS
3. Importance of effective internal controls
a. Definition of internal control
The internal control system is the company’s internal system that is

designed, among other things, to ensure that company’s process for
generating financial reports is sound (good)
Example: Internal control system for credit approval process
Sales Dept Management Credit Dept
Credit
Start
criteria
Sales order Credit check Pass
Review Account y
Receivable
n
Pass n
Note y
Internal Credit
report Credit approval End
control point
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STATEMENTS ANALYSIS
3. Importance of effective internal controls
b. Requirement about internal control
Companies in the United States are now required to

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

• Help ensure that plan information is complete and accurate, financial
statements are reliable, and the plan’s operations are conducted in
accordance with the provisions of applicable laws and regulations
Assure that the plan is achieving its financial reporting objectives.
American Institute of Certified Public Accountants (AICPA)
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STATEMENTS ANALYSIS
[LOS 15.e] Information sources that analyst use in FS analysis
besides annual FS & supplementary information
The following describes some other information sources that analyst use in FS
analysis besides annual FS and supplementary information:
Interim report
Unaudited FS provided by the company semi-annually or quarterly
Proxy statements
Distributed to shareholders on matters at shareholder meetings, about:
 Board member and management
 Executive compensation
 Stock option
 Major shareholders
 Potential conflicts of interest between management, the board and
shareholder
Others
Information on the economy, industry and peer companies…
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STATEMENTS ANALYSIS
[LOS 15.f] Describe the steps in the financial statement analysis
framework
Some are equity analysts want to evaluate potential investments in a

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

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

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

data phase. statements.
• Common- size
statements.
• Ratios and graphs.
• Forecasts.
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STATEMENTS ANALYSIS
framework
Step Input Output
4. Analyze/ Input data as well as Analytical results

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

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

by periodically recommendations.
repeating above steps
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STATEMENTS ANALYSIS
Practice questions
Learning outcome statements Exercises

15a. Describe the roles of financial reporting and financial Question 1
statement analysis.
15b. Describe the roles of financial statements in evaluating a Question 2
company’s performance and financial position
15c. Describe the importance of financial statement notes, Question 3
15d. Describe the objective of audits of financial statements, the Question 4
types of audit reports and the importance of effective internal
controls
15e. Identify & describe information sources that analyst use in FS Question 5
analysis besides annual financial statements & supplementary
information
15f. Describe the steps in the financial statement analysis Question 6
framework
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STATEMENTS ANALYSIS
Practice questions
Providing information about the performance and financial position of

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

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

3
understanding the changes that have occurred in a company’s retained
earnings over a year is the statement of:
A. changes in equity.
B. financial position.
C. comprehensive income.
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STATEMENTS ANALYSIS
Practice questions
4 What type of audit opinion is preferred when analyzing financial

statements?
A Qualified.
B Adverse.
C Unqualified.
5
Which of the following sources of information used by analysts is
found outside a company’s annual report?
A Auditor’s report
B Peer company analysis
C Management’s discussion and analysis
6 Which phase in the financial statement analysis framework is most likely

to involve producing updated reports and recommendations?
A Follow- up
B Analyze/interpret the processed data
C Develop and communicate conclusions and recommendations
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STATEMENTS ANALYSIS
Practice questions
1. B is correct. This is the role of financial reporting. The role of financial

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

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

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

the financial statements present the company’s performance and financial
position fairly in accordance with a specified set of accounting standards.
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STATEMENTS ANALYSIS
Practice questions
5. B is correct. When performing financial statement analysis, analysts should

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

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

REPORTING STANDARDS
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READING 16: FINANCIAL REPORTING

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

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

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

framework
16.d. Describe general requirements for financial statements under
International Financial Reporting Standards (IFRS)
16.e. describe implications for financial analysis of alternative financial

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

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

and estimates require judgements, which can vary from one preparer to
the next. Accordingly, standards are needed to ensure increased
consistency in these judgements.
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STANDARDS
[LOS 16.b] The roles of FR standard-setting bodies & regulatory
authorities in establishing, enforcing reporting standards
Introduction of FR standard-setting bodies & regulatory
1.
authorities
Financial reporting standard- Regulatory Authorities

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

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STANDARDS
2. Role of FR standard-setting bodies (ISAB & FASB)
Bodies Role
International The IASB is the independent standard-setting body of the IFRS
Accounting Foundation. Its objectives are:
Standards • Develop and promote the use and adoption of a single set of
Board - ISAB high quality financial standards
• Ensure the standards result in transparent, comparable, and
decision-useful information while taking into account the
needs of a range of sizes and types of entities in diverse
economic settings
• Promote the convergence of national accounting standards
and IFRS.
Financial Financial Accounting Standards Board (“FASB”) develop US
Accounting Financial Accounting Standards. Its objective is:
Standards • Improve standards of financial reporting so that information
Board - FASB provided to users is useful for decision-making.
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STANDARDS
2. Role of regulatory authorities
Bodies Role
International IOSCO is not a regulatory authority, but its members regulate a
Organization large portion of the world’s financial capital markets (including
of Securities SEC). Its core objectives are:
Commissions • Ensure that markets are fair, efficient and transparent.
- IOSCO • Reduce systematic risk
• Protect investors
U.S. SEC sets rules and regulations for any company issuing securities
Securities in the US or involved in the US capital market.
and
Exchange
Commission -
SEC
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STANDARDS
[LOS 16.c] Describe the International Accounting Standards
Board’s conceptual framework
Introduction of International Accounting Standards
1.
Conceptual Framework consists of 3 following components:

• Qualitative characteristics of financial statements (2)
• Constraints on Financial Statements (3)
• Reporting Elements of financial statements (4)
2. Qualitative characteristics of financial statements
Relevance
Fundamental
qualitative
Qualitative of financial
Faithful representation
statements
Comparability
Verifiability
Enhancing qualitative
Timeliness
Understandability
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STANDARDS
2. Qualitative characteristics of financial statements (cont)
The Conceptual Framework identifies two fundamental qualitative

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

Relevance
Confirmatory value: useful to evaluate past decisions or

forecasts
Fundamental qualitative
Materiality: Information is considered to be material if

characteristics
omission or misstatement of the information could

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

Faithful
Neutral: information is selected and presented without

bias
Free from error: No errors or omission in description. No
errors in producing financial information.
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STANDARDS
Qualitative characteristics of financial statements (cont)
2.
Comparability: Financial statement presentation should be consistent among

firms and across time periods.
Example: The profit of the company must be compared with the previous
years to see that there is an increase or decrease in it.
Enhancing qualitative characteristic
Verifiability: Independent observers, using the same methods, obtain similar

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

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

should be able to readily understand the information the statement present.
Use full information should not be omitted
Example: When the accountant present the information of the company’s
profit, she should not use a lot of jargon and difficult phrasing.
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STANDARDS
3. Constraints on Financial Statements
Benefit Does the cost of providing financial information

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

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

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

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

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

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

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

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

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

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

STANDARDS
d. Measurement of Financial Statement Elements
Base Features
Historical • Assets:
costs o The amount of cash or cash equivalents paid to purchase an
asset, including any costs of acquisition and/or preparation.
o If the asset was not bought for cash, historical cost is the fair
value of whatever was given in order to buy the asset.
• Liabilities: the amount of proceeds received in exchange for the
obligation.
Current • Assets are carried at the amount of cash or cash equivalents
costs that would have to be paid if the same asset was acquired
currently.
• Liabilities: the undiscounted amount of cash or cash
equivalents that would be required to settle the obligation
currently.
Amortized Historical cost adjusted for amortization, depreciation, or
cost depletion and/or impairment
49

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

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

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

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

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

STANDARDS
1. General features
Requirement Explanation
Fair Requires the faithful representation of the effects of
presentation transactions, other events and conditions in
accordance with the definitions & recognition criteria
for assets, liabilities, income and expenses set out in
the Framework
Going Financial statements are prepared on a going concern

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

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

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

STANDARDS
1. General features
No offsetting Assets and liabilities, and income and expenses, may
not be offset unless required or permitted by IFRS.
Frequency of Financial statements must be prepared at least
reporting annually.
Comparative For all amounts reported in a financial statement,

information comparative information should be provided for the
previous period unless another standard requires or
permits otherwise
Consistency The presentation and classification of items in the
of financial statements shall be retained from one period
presentation to the next unless a change is justified either by a
change in circumstances or requirements of new IFRS.
53

STANDARDS
2. Structure and content requirements
Classified Requires the balance sheet to distinguish between
balance sheet current and non-current assets, between current and
non-current liabilities unless a presentation based on
liquidity (presented by bank, finance corp,..)
Minimum IAS 1 – Presentation of financial statement specifies
information on the minimum line item disclosures on the face of, or
the face of the in the notes to, the balance sheet, the income
FSs statement, and the statement of changes in equity.
Example: The SOFP shall include line items that
present the following amounts: property, plant and
equipment; investment property…
Minimum IAS 1 – Presentation of financial statement specifies
information in disclosures about information to be presented in the
the notes notes to financial statements. (*see the next slide)
Example: Disclose the amount of any cumulative
preference dividends not recognized
54

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

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

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

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

Developed by Financial Accounting International Accounting
Standard Board (FASB) Standard Board (IASB)
Based on Rules Principles
Inventory FIFO, LIFO & Weighted FIFO and Weighted
valuation Average Method Average Method
Extraordinary Shown at the bottom of Not segregated in the
the income statement income statement.
Development Treated as an expense Capitalized, only if certain
cost conditions are satisfied
Reversal of Prohibited Permissible, if specified
inventory conditions are met
56

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

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

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

STANDARDS
Practice questions

16a. describe the objective of financial reporting and the Question 1
importance of financial reporting standards in security analysis
and valuation.
16b. describe the roles of financial reporting standard-setting Question 2
bodies and regulatory authorities in establishing and enforcing
reporting standards
16c. describe the International Accounting Standards Board’s Question 3-5
conceptual framework
16d. describe general requirements for financial statements Question 2
under International Financial Reporting Standards (IFRS)
16e. describe implications for financial analysis of alternative Question 6
financial reporting systems and the importance of monitoring
developments in financial reporting standards
58

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

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

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

STANDARDS
Practice questions
4 Valuing assets at the amount of cash or equivalents paid or the fair value
of the consideration given to acquire them at the time of acquisition
most closely describes which measurement of financial statement
elements?
A Current cost.
B Historical cost.
C Realizable value.
5 The assumption that the effects of transactions and other events are
recognized when they occur, not when the cash flows occur, is called:
A relevance.
B accrual basis.
C going concern.
6 Which of the following disclosures regarding new accounting standards

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

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

Codification™, the single source of nongovernmental authoritative US
generally accepted accounting principles.
3. B is correct. Accrual basis reflects the effects of transactions and other

events being recognized when they occur, not when the cash flows. These
effects are recorded and reported in the financial statements of the
periods to which they relate.
4. B is correct. Historical cost is the consideration paid to acquire an asset.
5. B is correct. Accrual basis reflects the effects of transactions and other

events being recognized when they occur, not when the cash flows. These
effects are recorded and reported in the financial statements of the
periods to which they relate
6. A is correct. A discussion of the impact would be the most meaningful,

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

INCOME STATEMENT
62
READING 17: UNDERSTANDING INCOME

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

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

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

implications of each for the earnings per share calculation
17.i. formulate income statements into common-size income statements

17.j. evaluate a company’s financial performance using common-size
income statements and financial ratios based on the income statement
17.k. describe, calculate, and interpret comprehensive income
17.l. describe other comprehensive income and identify major types of

items included in it
64

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

company's activities over a period of time. The format of the income
statement is not specified and the actual format varies across companies.
Here are 3 components in income statement
Revenue Expenses Net income
Revenue
• Amount reported from the sale of goods and services in the normal
course of business
• Net revenue = Revenue – Adjustments for returns and allowance
Expense
• Amount incurred to generate revenue, reflect outflows, depletions of
assets, and incurrences of liabilities in the course of the activities of a
business
• Expenses are group by function (COGS) or nature (Depreciation)
65

STATEMENT
Income is increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity
participants.
Arise from a company’s ordinary Arise from secondary or peripheral

business activities activities
Revenue Gain
Refer to LOS 17.a.1 Refer to LOS 17.e - f
66

STATEMENT

(cont.)
Income
• Income = Revenue + Gain (refer to the previous slide)
• Net income = Revenue + other income + gain – expenses – other
expenses – loss;
• Gains and losses are increases and decreases in economic benefits,
respectively, which may not arise in the ordinary activities of the
business;
• IS showed gross profit (gross margin): Multi-step format. Not showed:
single-step format.
Example of Gain/loss, other income and other expenses
For example, for a manufacturing company:

• If it sells its products, these transactions are reported as revenue
• If it sells surplus land that is not needed, the transaction is reported as
a gain or a loss because it arises from non-recuring items. G/L = selling
price – carrying value
• Interest expense (income) or income tax benefit (loss) can be
recognized as other expense/ income
67

STATEMENT
2. Alternative presentation forms of income statement
Expenses can be grouped together by their nature or function.
• Group by nature: Presenting all depreciation expense from
manufacturing and administration together in one line of the income
statement is an example of grouping by nature.
• Group by function: Combining all costs associated with manufacturing
(e.g., raw materials, depreciation, labor, etc.) as cost of goods sold is an
example of grouping by function. As known as cost of sales method
Expenses group by nature Expenses group by function
Figure 1: Two different format of income statement

68

STATEMENT
Income statement with cost of sales method is more popular. So, in this
section, we will study components of income statement with this format
Cost of goods sold
The amount paid for merchandise sold, or the cost to manufacture
products that were sold, during an accounting period.
Gross (profit) margin
• Gross margin = Net revenue – Cost of goods sold
• Management is interested in both the amount of gross margin; and the
percentage of gross margin (gross margin/net sales).
Operating expenses
• Expenses other than the cost of goods sold that are incurred in running
a business
• These expenses are grouped into categories: selling expenses, general
and administrative expenses, and other incomes and expenses.
Operating income
• It represents the income from a company's normal, or main, business
• Operating income = Gross margin – Operating expenses
69

STATEMENT
3. Describe the components of the income statement (cont.)
Other income and expense

• Not part of a company's operating activities, include:
o Incomes or expenses from investments (e.g., dividends and interest).
o Interest and other expenses from borrowing.

o Any other income or expense not related to the company's normal
business operations
Income before taxes
Income before taxes = Operating income + Other income – Other expense
Income taxes
• Represent the expense for federal, state, and local taxes on corporate
income.
• Income taxes = Income before taxes x Tax rate
Net income
• Net income = Income before taxes - income taxes
o It represents the amount of business earnings that accrue to
stockholders.
o It is the amount transferred to retained earnings from all income
generating activities during the year.

o It is often used to determine whether a business has been operating
successfully.
70

STATEMENT
3. Describe the components of the income statement (cont.)
Example: Income statement for company ABC for fiscal years ending
2019
$ million 2019
Net revenue 3,000,000
Cost of goods sold (500,000)
Gross margin 2,500,000
Operating expenses (300,000)
Other revenue (expense) 100,000
Income before income taxes 2,300,000
Taxes (460,000)
Net income 1,840,000

71

STATEMENT
[LOS 17.b] describe general principles of revenue recognition
and accounting standards for revenue recognition
1. Describe general principles of revenue recognition
General principle: Revenue is generally recognized when it is (1) realized or realizable,

and (2) earned. The general rule for revenue recognition are set out below:
2. Accounting standards for revenue recognition
Revenue recognition is not

dependent on receiving cash
payment
Sale made on credit

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

transferred) Debit Cash (SOFP) Debit Cash (SOFP) Debit Unearned
Debit AR (SOFP) Credit AR (SOFP) Credit Unearned Revenue (SOFP)
Credit Revenue (SOPL) Revenue (SOFP) Credit Revenue (SOFP)
72

STATEMENT
2. Accounting standards for revenue recognition (cont.)
The core principle of the converged standard is that revenue should be

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

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

contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in

the contract.
5. Recognize revenue when (or as) the entity satisfies a

performance obligation.
73

STATEMENT
a. Identify the contract(s) with a customer
• Contract is an agreement that creates enforceable rights and

obligations
• The contracts with the customers must satisfy 5 following criteria
All parties have approved the contract and committed to perform

their respective obligations
Criteria of contract
The entity can identify each party’s rights and obligations

regarding the goods or services to be transferred
The payment terms for the goods or services can be identified
The contract has commercial substance
It is probable to collect consideration

74

STATEMENT
b. Identify the separate or distinct performance obligations in the

contract.
A performance obligation is a promise to deliver a distinct good or

service. A “distinct” good or service is one that meets the following
criteria:
• The customer can benefit from the good or service on its own or
combined with other resources that are readily available.
• The promise to transfer the good or service can be identified
separately from any other promises.
Example:
Stark plc is contracted to provide office equipment as well as technical
support for the customer. The customer agrees to pay more money for
the technical support.
• Customer can receive benefit from office equipment or technical
support
• Customer agrees to pay office equipment and technical support
separately  The good or service is separately identifiable  Distinct
goods/services.
75

STATEMENT
c. Determine transaction price
A transaction price is the amount a firm expects to receive from a customer in

exchange for transferring a good or service to the customer
d. Allocate the transaction price to the performance obligations in the contract.
Transaction price must be allocated based on stand-alone price of each

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

76

STATEMENT
e. Recognize revenue when (or as) the entity satisfies a performance

obligation.
• The entity will recognize revenue when it is able to satisfy the
performance obligation by transferring control to the customer.
• Factors to consider when assessing whether the customer has obtained
control of an asset at a point in time:
o Entity has a present right to payment
o Customer has legal title

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

77

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

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

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

Consider revenue of contract in Consider revenue in case firm
case of contract modification as acting as an agent
an extension of the existing
contract or as a new contract
78

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

If loss is expected on contract
regardless of the method used
• IFRS and U.S. GAAP require the use of
the percentage-of-completion
Outcome of
method.
contract can
• The percentage-of-completion is
be reliably
equal to actual cost/estimated total
measured
If outcome is cost, or it can be determined by an
expected on engineering estimate
contract • IFRS requires revenue is only reported
Outcome of
to the extent of contract costs
contract
incurred
cannot be
• U.S. GAAP requires no revenue is
reliably
reported until the contract is finished
measured
(completed contract method)
79

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

A contractor agrees to build a warehouse for a price of $10 million and
estimates the total costs of construction at $8 million. Although there are
several identifiable components of the building, these components are
not separate deliverables, and the performance obligation is the
completed building.
• During the first year of construction, the builder incurs $4 million of
costs (50% of the estimated total costs of completion)
• Based on this expenditure and a belief that the percentage of costs
incurred represents an appropriate measure of progress towards
completing the performance obligation, the builder recognizes $5
million (50% of the transaction price of $10 million) as revenue for the
year (the percentage-of-completion method)
80

STATEMENT
2. Variable consideration
Principle:
Performance bonus should be added in revenue if condition to achieve
bonus is highly probable.
Example: Variable consideration
Consider construction contract at prior example with the addition of a
promised bonus payment of $1 million if the building is completed in three
years.
• At the end of the first year, the contractor has some uncertainty about
whether he can complete building by the end of the third year  The
builder does not consider the possible bonus as part of the transaction
price  Year 1 revenue is still $5 million (like prior example)
• During the second year of construction, the contractor incurred an
additional $2 million in costs and the contractor believe that the building
will be finished in time.
The percentage of total costs incurred over the first two years is 75%
[($4m+ $2m)/$8m]. The total revenue to be recognized to date, with the
bonus payment included in transaction value, is $8.25m (0.75 × $11m)
 $3.25 million (= $8.25 million – $5 million) of revenue will be
recognized in year 2.
81

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

Returning to our example, a contract revision requires installation of refrigeration to
provide cold storage in part of the warehouse. In this case, the contract revision should
be considered an extension of the existing contract because the goods and services to
be provided are not distinct from those already transferred.
The contractor agrees to the revisions during the second year of construction and
believes they will increase his costs by $2m (from $8m to $10m). The transaction
value is increased by $3m (from $11m to $14m)
As before, the contractor has incurred $6 million in costs through the end of the
second year. Now the percentage of the contract obligations completed to be $6m/
$10m = 60%. The total revenue to be recognized to date is $8.4m (60% × $14m).
Revenue for the second year is $3.4 million (= $8.4 million – $5 million)
82

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

Consider a travel agent who arranges a first-class ticket for a customer
flying to Singapore.
• The ticket price is $10,000, made by nonrefundable payment at purchase,
and
• The travel agent receives a $1,000 commission on the sale.
The travel agent is not responsible for providing the flight and bears no
inventory or credit risk  she is acting as an agent. Because she is an
agent, rather than a principal, she should report revenue equal to her
commission of $1,000, the net amount of the sale. If she were a principal in
the transaction, she would report revenue of $10,000, the gross amount of
the sale, and an expense of $9,000 for the ticket.
83

STATEMENT
[LOS 17.d] describe general principles of expense recognition,
specific expense recognition applications, and implications of
expense recognition choices for financial analysis
1. Describe general principles of expense recognition
EXPENDITURE RECOGNITION
Principle Issues
Matching concept Doubtful Accounts (i.e uncollectible

Expense matching with revenue (i.e costs accounts) required to record an estimate
of goods sold) of how much of the revenue will be
uncollectible and recognize the loss
Period Cost when customer defaulted
Expense made by company or incurred the
liability to pay in the period (i.e Warranties required to estimate and
administrative expense) recognize the amount of future expenses
resulting from its warranties, and to be
updated over the life of the warranty
Expenditure relate to future expected
benefits allocated systematically with the
passage of time (i.e depreciation expense) Choices of methods (i.e depreciation
method
84

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

when these units are sold.
Example: At beginning of 20X8, Company X has 10,000 units of $25
each. In this year, Company X sold 9,000 units during 20X8 at a price of
$30 per unit. In this case, company X has
o Total revenue = $30 x 9,000 = $270,000
o COGS = $25 x 9,000 = $225,000
o We can conclude that COGS of $225,000 matches against revenues
of $270,000
• Cost of goods sold = Opening inventory + Purchased inventory – Closing
inventory
85

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

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

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

costs over total Average cost of Average cost of
units available all items all items
Specific
identification Price of each units used
86

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

immediately pay cash.
• There are always some customers who cannot or will not pay their
debts. The accounts owed by these customers are called uncollectible
accounts.
• Doubtful expenses are generally classified as a sales and general
administrative expense on the income statement.
• Under the matching principle, a company is required to estimate the
amount of doubtful expenses resulting from its sales.
• One possible approach to recognizing credit losses on customer
receivables would be for the company to wait until such time as a
customer defaulted and only then recognize the loss (direct write-off
method).
87

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

replace the product they sell, if the product proves deficient in some
respect that is covered under the terms of the warranty.
• Under the matching principle, a company is required to estimate the
amount of future expenses resulting from its warranties, to recognize
an estimated warranty expense in the period of the sale, and to
update the expense as indicated by experience over the life of the
warranty.
88

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

costs of long-lived assets over the period during which the assets are
expected to provide economic benefits
• Depreciation is the term commonly applied to tangible assets
• Amortization is the term commonly applied to intangible assets
• Accumulated depreciation the total amount of depreciation
expenditure allocated to a particular asset since the asset was used
• There are 3 methods to calculate depreciation/amortization
o Straight-line depreciation method
o Accelerated depreciation method
o Double-declining balance method
89

STATEMENT
Implications of expense recognition choices for
3.
financial analysis
• Expense recognition requires a number of estimates. Since estimates
are involved, it is possible for firms to delay or accelerate the
recognition of expenses. Delayed expense recognition increases
current net income and is therefore more aggressive.
• Financial analysis should:
o Consider the underlying reasons for a change in an expense
estimate.
Ex: If a firm’s bad debt expense has recently decreased
id the firm lower its expense estimate because its collection
experience improved, or was the expense decreased to manipulate
net income?
o Compare a firm’s estimates to those of other firms within the
firm’s industry.
Ex: If a firm’s warranty expense is significantly less than that of a
peer firm,
Is the lower warranty expense a result of higher quality products, or
is the firm’s expense recognition more aggressive than that of the
peer firm?
90

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

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

separate component of income from
Discontinued continuing operations
operations
Recorded net of tax
Change in accounting
Restate prior-year income statement
policies
Change in accounting
Not restate prior-year income statement
estimates
91

STATEMENT
Describe the financial reporting treatment and

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

occurrence. Examples of items that could be considered unusual or
infrequent include:
o Gains or losses from the sale of assets or part of a business, if these
activities are not a firm’s ordinary operations.
o Impairments, write-offs, write-downs, and restructuring costs.
• Treatment: Unusual or infrequent items are included in income from
continuing operations and are reported before tax.
• Analytical implications: review to determine whether they truly
should be included when forecasting future firm earnings. Some
companies appear to be accident-prone and have “unusual or
infrequent” losses every year or every few year
92

STATEMENT

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

decided to dispose of, but either has not yet done so, or has disposed
of in the current year after the operation had generated income or
losses.
• Treatment:
o To qualify, the assets, results of operations, and investing and
financing activities of a business segment must be separable from
those of the company.
o Any gains or disposal will not contribute to future income and cash
flows, and therefore can be reported only after disposal, that is -
when realized.
• Analytical implications: Analysts may exclude discontinued operations
when forecasting future earnings. The actual event of discontinuing a
business segment or selling assets may provide information about the
future cash flows of the firm, however.
93

STATEMENT

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

principles, bases, conventions, rules and practices adopted by an entity
in preparing and presenting financial statements. For example, by
changing its inventory costing method or capitalizing rather than
expensing specific purchases.
• Treatment: Retrospective application, prior-period financial
statements presented in a firm’s current financial statements must be
restated, applying the new policy to those statements as well as future
statements.
• Analytical implications: Prior-period adjustments usually involve new
accounting standards and does not typically affect cash flow. Analyst
should review changes in accounting policies to determine their
impact on future operating results.
94

STATEMENT

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

management’s judgment, usually due to new information
• Treatment: Prospective application, prior statements are not
restated, and the new policies are applied only to future financial
statements.
• Analytical implications: Accounting estimate changes typically do not
affect cash flow. Analyst should review changes in accounting
estimates to determine their impact on future operating results.
95

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

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

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

Under IFRS: non-operating items
96

STATEMENT
[LOS 17.g-h] Understand and calculate earnings per share, basic
earnings per share and diluted earnings per share under specific
circumstances
Earnings per share, simple capital structure and
1.
complex capital structure
• Earnings per share refer to the share of net income of a company that
is owned by common shareholders only. EPS is reported only for
shares of common stock.
• However, many companies’ capital structure is complex, which means
it includes not only common stock, but also potentially dilutive
securities. In this case we report two types of EPS, specified below.
Simple structures Complex Structures
• Contains no potentially dilutive • Contains potentially dilutive *

securities common stock only) securities (potentially convert
• Report only basic EPS into common stock)
• Report both basic and diluted
EPS. If diluted EPS > Basic EPS
 Diluted EPS is Basic EPS
(*) Potentially dilutive securities: convertible bonds, convertible preferred stock,

employee stock options, and warrants
97

STATEMENT
circumstances
2. Calculating basic earnings per share
The basic EPS calculation does not consider the effects of any dilutive
securities in the computation of EPS.
Basic EPS =
In which:
Weighted average number of common shares = Number of outstanding
ordinary shares x portion of the year they were outstanding
In basic EPS calculation, we will need to pay attention to 2 special cases

• New issue
• A stock split or stock dividend
Calculation of basic EPS in these two cases is specified in the next slide.
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STATEMENT
circumstances
a. New issue
Example: Basic EPS calculation in case of new issue

For 2020, X Company has net income of $ 1,000,000. At 1 January 2020,
there were 1,000,000 shares outstanding. On 1 July 2020, the company
issued 100,000 new shares for $2 per share. The company paid $200,000
in dividends to common shareholders. What is X company’s basic EPS for
the year 2020.
Solution:
• Weighted average number of common shares = 1,000,000 + 100,000 x
6/12 = 1,050,000
• Basic EPS = = 0.952
99

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

shareholder in an amount proportional to their current number of
shares. Ex: If a 10% stock dividend is paid, the holder of 100 shares of
stock would receive 10 additional shares.
• A stock split refers to the division of each “old” share into a specific
number of “new” (post-split) shares.
Ex: The holder of 100 shares will have 200 shares after a 2-for-1 split or
150 shares after a 3-for-2 split.
• A stock split or stock dividend will make the weighted average number
of common share increase to the time of split/ dividend
implementation.
• Stock split or stock dividend, regardless of whether it arises at any time
in the period, must be calculated on the first day of the reporting year.
100

STATEMENT
Example: Stock split

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

Answer:
10,000 + 4,000 Dividend - 3,000
1 Jan 1 Apr 1 July 1 Sep 31 Dec
Will be adjusted by dividend Will not be adjusted by

effect dividend effect
Adjusted shares outstanding = Original shares outstanding x ( 1 + stock
dividend rate)
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STATEMENT

Answer:
• Weighted number of common shares from 1 Jan to 31 Mar (3 months) =
3/12 x 10,000 x (1 + 10%) = 2,750 (shares)
• Weighted number of common shares from 1 Apr to 31 Aug (5 months) =
5/12 x 14,000 x (1 + 10%) = 6,417 (shares)
• Weighted number of common shares from 1 Sep to 31 Dec (4 months) =
4/12 x [14,000 x (1 + 10%) – 3,000] = 4,133 (shares)
Unaffected
by dividend
 Weighted number of common shares in Johnson = 13,300 (shares)
Basic EPS of Johnson =
= = 0.75
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STATEMENT
[LOS 17.h] contrast dilutive and antidilutive securities and
describe the implications of each for the earnings per share
calculation
2. Calculating diluted earnings per share
Before calculating diluted EPS, it is necessary to understand the following

terms:
• Dilutive securities are stock options, warrants, convertible debt, or
convertible preferred stock that would decrease EPS if exercised or
converted to common stock.
• Antidilutive securities are stock options, warrants, convertible debt, or
convertible preferred stock that would increase EPS if exercised or
converted to common stock.
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STATEMENT
calculation
a. Diluted EPS calculation in case of convertible preferred stock
When a company has convertible preferred stock

Net income
Diluted EPS =
Weighted average New common share that
number of shares + would have been issue at
outstanding (WANOS) conversion
• If diluted EPS < Basic EPS  convertible preferred stock is dilutive 
diluted EPS takes the calculated value
• If diluted EPS > Basic EPS  convertible preferred stock is anti-dilutive
 diluted EPS is equal to basic EPS
• Quick way to check whether convertible preferred stock is diluted or
anti-diluted: If < basic EPS  convertible preferred is dilutive and vice
versa.
105

STATEMENT
calculation
Example: EPS with convertible preferred stock

During 20X6, ZZZ reported net income of $4,350,000 and had 2,000,000
shares of common stock outstanding for the entire year. ZZZ’s 7%,
$5,000,000 par value preferred stock is convertible into common stock at
a conversion rate of 1.1 shares for every $10 of par value. Compute
diluted EPS.
Solution:
Step 1: Calculate basic EPS
Basic EPS = = $2.00
Step 2: Calculate diluted EPS
Step 2.1. Compute convertible preferred stock
Convertible preferred stock = x 1.1 = 500,000
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STATEMENT
calculation
Step 2.2. Compute diluted EPS

If the convertible preferred shares were converted to common stock,
there would be no preferred dividends paid. Therefore, you should add
back the convertible preferred dividends that had previously been
subtracted from net income in the numerator
Diluted EPS = = $1.71
Step 3: Compare basic EPS with diluted EPS
Diluted EPS = $1.71 < Basic EPS = $2  the preferred stock is dilutive
 Diluted EPS = $1.71
Quick check dilutive: < basic EPS = $2.00

107

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

Net income + After-tax interest on convertible debt –
Preferred dividends
Diluted EPS =
WANOS + Additional common shares that would have
been issued at conversion
• Note about basic EPS and diluted EPS is the same as the case of
convertible preferred stock.
• Quick way to check whether convertible debt outstanding is diluted or
anti-diluted:
If < basic EPS  convertible debt outstanding is dilutive and vice
versa
108

STATEMENT
calculation
b. Diluted EPS calculation in case of convertible debt outstanding
Example: EPS with convertible debt

During 20X6, Y Corp had net income of $2,500,000 and 1,000,000 shares
of common stock outstanding for the entire year for basic EPS of $2.50.
During 20X5, Y issued 5% bonds of 2,000 at par of $1,000. Each of these
bonds is convertible to 120 shares of common stock. The tax rate is 30%.
Compute the 20X6 diluted EPS.
Solution:
• Additional common shares that would have been issued at conversion
= 2,000 x 120 = 240,000 shares
• After-tax interest on convertible debt = 2,000 x 1,000 x 5% x (1 – 30%) =
$70,000
• Diluted EPS = = $2.07 < Basic EPS (2.5)
 Diluted EPS = $2.07
109

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

Net income – Preferred Dividends
Diluted EPS =
WANOS + (New share that would have been issue at option
exercise – Shares that could have been purchase
with cash received upon exercise) x Proportion of
the year
• Note about basic EPS and diluted EPS is the same as the case of convertible
preferred stock.
110

STATEMENT
calculation
Quick way to check whether stock options and warrants are diluted or anti-diluted:
Stock options and warrants are dilutive only when their exercise prices are less
than the average market price of the stock over the year. If the options or warrants
are dilutive, use the treasury stock method to calculate the number of shares used
in the denominator:
AMP = Average market price over the year

EP = exercise price of the options or warrants
N = Number of common shares that the options and warrants can be converted
into
111

STATEMENT
calculation
Example: EPS with stock option

During 20X6, X had net income of $1,200,000 and 500,000 shares of
common stock outstanding for the entire year. X has 100,000 stock options
outstanding the entire year. Each option allows its holder to purchase one
share of common stock at $15 per share. The average market price of X’s
common stock during 20X6 is $20 per share. Compute diluted EPS
Solution:
Step 1: Basic EPS = $1,200,000/500,000 = $2.4
Step 2: Diluted EPS
• New share that would have been issue at option exercise = 100,000
• Shares that could have been purchase with cash received upon exercise =
$15 x 100,000/$20 = 75,000
• Diluted EPS = = $2.29 < Basic EPS
Diluted EPS = $2.29
112

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

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

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

113

STATEMENT
[LOS 17.j] evaluate a company’s financial performance using
common-size income statements and financial ratios based on
Gross profit margin
• Gross profit margin =

• Gross profit margin can be increased by raising prices or reducing
production costs.
• Should be compared over time and with the firm’s industry peers
Net profit margin
• Net profit margin =

• Net profit margin measures the profit generated after considering all
expenses
• Like gross profit margin, net profit margin should be compared over
time and with the firm’s industry peers.
114

STATEMENT
[LOS 17.k] describe, calculate, and interpret comprehensive
income
1. Comprehensive income
• Under IFRS and GAPP, comprehensive income is the change in equity

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

Other comprehensive income include 4 types of income/expense:
Foreign currency translation adjustments. In consolidating the financial statements of
foreign subsidiaries, the effects of translating the subsidiaries’ balance sheet assets and
liabilities at current exchange rates are included as other comprehensive income
Unrealized gains or losses on derivatives contracts accounted for as hedges. Changes
in the fair value of derivatives are recorded each period, but these changes in value for
certain derivatives (those considered hedges) are treated as other comprehensive
income and thus bypass the income statement
Unrealized holding gains and losses on a certain category of investment securities,
namely, available-for-sale securities
Certain costs of a company’s defined benefit post-retirement plans that are not
recognized in the current period
115

STATEMENT
Practice questions

17a. describe the components of the income statement and Question
alternative presentation formats of that statement 1,2,4
17b. describe general principles of revenue recognition and N/A
accounting standards for revenue recognition
17c. calculate revenue given information that might influence the Question 3
choice of revenue recognition method
17d. describe general principles of expense recognition, specific Question 5
expense recognition applications, and implications of expense
recognition choices for financial analysis
17e. describe the financial reporting treatment and analysis of N/A
non-recurring items (including discontinued operations, unusual
or infrequent items) and changes in accounting policies
17f. contrast operating and non-operating components of the N/A
income statement
116

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

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

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

types of items included in it
117

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

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

statement information:
Revenue $4,000,000
Cost of goods sold $3,000,000
Other operating expenses $500,000
Interest expense $100,000
Tax expense $120,000
Denali’s gross profit is equal to:
A $280,000.
B $500,000.
C $1,000,000.
118

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

consignment basis. Apex receives the items from the owner, lists them
for sale on the internet, and receives a 25 percent commission for any
items sold. Apex collects the full amount from the buyer and pays the
net amount after commission to the owner. Unsold items are returned
to the owner after 90 days. During 2009, Apex had the following
information:
• Total sales price of items sold during 2009 on consignment was
€2,000,000.
• Total commissions retained by Apex during 2009 for these items was
€500,000.
How much revenue should Apex report on its 2009 income statement?
A €500,000.
B €2,000,000.
C €1,500,000.
119

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

machine for its assembly line at a cost of $600,000. The machine has
an estimated useful life of 10 years and estimated residual value of
$50,000. Under the straight- line method, how much depreciation
would Glass take in 2010 for financial reporting purposes?
A $55,000.
B $60,000.
C $65,000.
5 Under IFRS, a loss from the destruction of property in a fire would most
likely be classified as:
A continuing operations.
B discontinued operations.
C other comprehensive income..
120

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

capital structure increases the weighted average number of common
shares outstanding without affecting net income available to common
shareholders?
A Stock options
B Convertible debt that is dilutive
C Convertible preferred stock that is dilutive
121

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

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

would most likely be classified as other comprehensive income?
A A foreign currency translation adjustment
B An unrealized gain on a security held for trading purposes
C A realized gain on a derivative contract not accounted for as a hedge
122

STATEMENT
Practice questions
10 Selected year-end financial statement data for Workhard are shown

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

A is $18 million.
B is increased by the derivatives accounted for as hedges.
C includes $4 million in other comprehensive income.
123

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

operations and reported in the profit and loss statement. Discontinued operations
relate to a decision to dispose of an operating division.
6. B is correct.
LB has warrants in its capital structure:
• If the exercise price is less than the weighted average market price during the
year, the effect of their conversion is to increase the weighted average number of
common shares outstanding, causing diluted EPS to be lower than basic EPS.
• If the exercise price is equal to the weighted average market price, the number of
shares issued equals the number of shares repurchased. Therefore, the weighted
average number of common shares outstanding is not affected and diluted EPS
equals basic EPS.
124

STATEMENT
Practice answers
6. (cont)
• If the exercise price is greater than the weighted average market price, the effect
of their conversion is antidilutive. As such, they are not included in the
calculation of basic EPS.
B is true.
The weighted average number of shares outstanding = 2,020,000 + 380,000 =
2,400,000 C is wrong.
LB’s basic EPS is = ($3,350,000 – $430,000)/(2,020,000 + 380,000) = $1.22 A is wrong.
(note: Stock dividends are treated as having been issued retroactively to the
beginning of the period)
7. A is correct.
• When a company has stock options outstanding, diluted EPS is calculated as if the
financial instruments had been exercised and the company had used the proceeds
from the exercise to repurchase as many shares possible at the weighted average
market price of common stock during the period.
As a result, the conversion of stock options increases the number of common
shares outstanding but has no effect on net income available to common
shareholders.
• The conversion of convertible debt increases the net income available to common
shareholders by the after- tax amount of interest expense saved.
• The conversion of convertible preferred shares increases the net income available
to common shareholders by the amount of preferred dividends paid; the
numerator becomes the net income.
125

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

equity but are not reflected in the company’s income statement. In consolidating the
financial statements of foreign subsidiaries, the effects of translating the subsidiaries’
balance sheet assets and liabilities at current exchange rates are included as other
comprehensive income.
126

STATEMENT
Practice answers
10. C is correct. Comprehensive income includes both net income and other
Other comprehensive income = Unrealized gain on available- for- sale
securities – Unrealized loss on derivatives accounted for as hedges + Foreign currency
translation gain on consolidation
= $5 million – $3 million + $2 million
= $4 million
Alternatively,
Comprehensive income – Net income = Other comprehensive income
Comprehensive income = (Ending shareholders equity – Beginning share-
holders equity) + Dividends
= ($493 million – $475 million) + $1 million
= $18 million + $1 million = $19 million
Net income is $15 million so other comprehensive income is $4 million.
127

BALANCE SHEETS
128
READING 18: UNDERSTANDING BALANCE SHEET

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

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

129

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

financial position or statement of financial condition) reports the firm’s
financial position at a point in time. It helps to assess a company’s
ability to pay near-term operating needs (liquidity), meet future debt
obligations (solvency) & ability to make distributions to owners
Elements of balance sheet
ASSETS RESOURCES
Assets Liabilities Equity
Resources controlled Obligations as a result The owners’ residual

as a result of past of past events that are interest in the assets
transactions that are expected to require an after deducting the
expected to provide outflow of liabilities.
future economic economic resources sometimes refer to
benefits equity as “net
assets.”
130

[LOS 18.b] Describe uses and limitations of balance sheet in
financial analysis
1. Describe uses of balance sheet in financial analysis
Used to assess a firm’s liquidity, solvency, and ability to make

distributions to shareholders
2. Limitations of balance sheet
The balance sheet has many limitations, especially relating to the

measurement of assets and liabilities.
• The balance sheet elements (assets, liabilities, and equity) should not
be interpreted as market value or intrinsic value, because they are
measured at various measurement base. It implies that the financial
analyst must make numerous adjustments to determine the economic
net worth of the company.
• There are a number of assets and liabilities that do not appear on the
balance sheet but certainly have value. For example, the value of a
firm’s employees and reputation is not reported on the balance sheet.
131

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

Liquidity-based presentation
classification
Current assets/liabilities
items which is liquidated/ settled or
used up in less than 1 year or All assets and liabilities are
operating cycles presented broadly in order of
liquidity means that items with
high liquidity will be sorted first
Non current assets/liabilities and vice versa
Items which are liquidated, settled
or used up in more than 1 year or
operating cycles
Which type of company should use liquidity-based

rather than current and non-current classification?
132

[LOS 18.c] Describe alternative formats of balance sheet
presentation
Current and non-current classification
Liquidity-based presentation
Figure 1: Formats of balance sheet presentation

133

[LOS 18.d] contrast current and non-current assets and current
and non-current liabilities
Current assets Current liabilities

• Cash and other assets that will likely be Obligations that will be satisfied within
converted into cash or used up within one year or one operating cycle,
one year or one operating cycle, whichever is greater. Following criteria is
whichever is greater. considered current:
• Operating cycle is the time it takes to • Settlement is expected during the
produce or purchase inventory, sell the normal operating cycle.
product, and collect the cash • Settlement is expected within one year.
• Current assets - current liabilities = • Held primarily for trading purposes.
working capital. • No unconditional right to defer
• The level of working capital provides settlement for more than 1 year
information about ability of an entity to
meet liabilities as they fall due.
Non current assets Non current liabilities

Assets that will not be converted into cash Liabilities that do not meet the criteria of
or used up within one year or operating current liabilities
cycle
134

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

Cash and cash Cash equivalents are highly liquid, • Amortized cost: historical cost –
equivalent short-term investments that are so amortization – impairment (if
close to maturity. any)
Examples: demand deposits with the • Fair value: exit price, the price
maturities less than three months. received to sell an asset or paid
to transfer a liability between
two market participants at the
measurement date.
• Both price are likely to be
immaterially different.
Marketable Marketable securities include Price information in a public

securities investments in debt or equity market.
(see more in securities that are traded in a public
financial market.
assets) Examples: treasury bills, notes,
bonds, common stock, mutual fund
Trade Trade (Account) receivables are • Net realizable value (Fair value)
receivables amounts owed to a company by its Original account receivables
customers for products and services minus allowance for bad debts.
already delivered. • Contra account: recognized bad
debts.
135

1. Current assets (cont.)

IFRS: Lower of cost and net
Inventories Inventories are physical products •
realizable value.
(see more in that will eventually be sold to the US-GAAP: same IFRS (without
reading 21) company’s customers. In current • LIFO & Retail inventory
form (finished goods) or as inputs methods) OR Lower of Cost and
to manufacture a final product
Market value (LIFO & RIM)
(raw materials & work-in-process)
• COGS Valuation: FIFO, Weighted
average Cost, LIFO (US-GAAP
only), specific identification
Prepaid Prepaid expenses are normal Prepaid expenses is recorded at

expense and operating expenses that have been historical cost on balance sheet,
Others paid in advance. and decrease in accordance with
Other current assets reflect items allocation to expenses.
that are not material enough to
require a separate line item
136

1. Current assets (cont.)
Example: Analysis of Accounts Receivable

1 Based on the balance sheet excerpt for Apple Inc. in Exhibit 5, what
percentage of its total accounts receivable in 2017 and 2016 does Apple
estimate will be uncollectible?
2 In general, how does the amount of allowance for doubtful accounts
relate to bad debt expense?
3 In general, what are some factors that could cause a company’s
allowance for doubtful accounts to decrease?
137

Solution:
1.($ millions) The percentage of 2017 accounts receivable estimated to be
uncollectible is 0.32 percent, calculated as $58/($17,874 + $58). Note that the
$17,874 is net of the $58 allowance, so the gross amount of accounts
receivable is determined by adding the allowance to the net amount. The
percentage of 2016 accounts receivable estimated to be uncollectible is 0.34
percent [$53/($15,754 + $53)].
2. Bad debt expense is an expense of the period, based on a company’s
estimate of the percentage of credit sales in the period, for which cash will
ultimately not be collected. The allowance for bad debts is a contra asset
account, which is netted against the asset accounts receivable. To record the
estimated bad debts, a company recognizes a bad debt expense (which affects
net income) and increases the balance in the allowance for doubtful accounts
by the same amount. To record the write off of a particular account receivable,
a company reduces the balance in the allowance for doubtful accounts and
reduces the balance in accounts receivable by the same amount.
138

3. In general, a decrease in a company’s allowance for doubtful accounts in

absolute terms could be caused by a decrease in the amount of credit sales.
Some factors that could cause a company’s allowance for doubtful accounts to
decrease as a percentage of accounts receivable include the following:
• Improvements in the credit quality of the company’s existing customers
(whether driven by a customer-specific improvement or by an improvement
in the overall economy);
• Stricter credit policies (for example, refusing to allow less creditworthy
customers to make credit purchases and instead requiring them to pay
cash, to provide collateral, or to provide some additional form of financial
backing); and/or
• Stricter risk management policies (for example, buying more insurance
against potential defaults).
In addition to the business factors noted above, because the allowance is based
on management’s estimates of collectability, management can potentially bias
these estimates to manipulate reported earnings. For example, a management
team aiming to increase reported income could intentionally over-estimate
collectability and under-estimate the bad debt expense for a period.
Conversely, in a period of good earnings, management could under-estimate
collectability and over-estimate the bad debt expense with the intent of
reversing the bias in a period of poorer earnings.
139

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

payables purchases of goods and services.
The company record full
Owed by a company to creditors, including trade net amount of contract
creditors and banks, through a formal to liabilities
Financial agreement.
liabilities
Ex: bank loans, notes payable, commercial paper,
current portion of long-term liabilities.
Expenses that have been recognized on a Accrued expenses that
company’s income statement but which have not have not been paid is
Accrued
expenses yet been paid as of the balance sheet date. recorded as a current
Ex: accrued interest payable, accrued warranty liabilities and decrease
costs, and accrued employee compensation when being paid.
Deferred Deferred income arises when a company Deferred income is
income receives payment in advance of delivery of the recorded as liabilities
(unearned goods and services associated with the payment. until goods/services is
income) Ex: lease payments, fees for servicing office transferred. Then, the
equipment, and payments for magazine company decrease
subscriptions received at the beginning. deferred income and
record revenue for
those goods/services.
140

3. Non-current assets (see more in reading 22)

Property Plant Tangible assets used in • Cost model (IFRS and GAAP):
and Equipment company operations and Carrying amount (CA) = Cost –
(PPE) expected to be used in more Accumulated depreciation
than 1 fiscal periods. • Revaluation model (IFRS only): Fair
value
Investment Property used for purposes of • Cost model: Similar to PPE Cost
property earning rental or capital model: Similar to PPE
appreciation (or both). • Fair value model: Fair value but
difference between CA and Fair
value is recorded in PL not OCI like
PPE
Are identifiable non-monetary Cost model (IFRS and GAAP)

assets without physical Revaluation model (IFRS) only applied
Intangible substance. when there is an active market for
assets Examples: patents, licenses, intangible asset trading.
and trademarks
141

3. Non-current assets (cont.)

Appear in business combination, Cost of acquisition - Acquirer’s
arising when purchase price is interest in the fair value of
greater than the acquirer’s identifiable assets and liabilities
Goodwill interest in the fair value of the acquired.
identifiable assets and liabilities Goodwill is not amortized but
acquired tested for impairment
Contracts that give rise to both a 3 categories (in US-GAAP): Held

financial asset of one entity and to maturity, available for sale
Financial assets a financial liability or equity and trading debt securities
instrument of another entity
Deferred Tax Asset Income taxes incurred prior to Deferred tax asset = Taxes
(see more in the time that the income tax payable – Income tax expense
reading 23) expense will be recognized on
142

3. Non-current assets (cont.)
• Financial assets: Contracts that give rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.
• Financial asset is important types of non-current assets
IFRS Categories Amortized cost Fair value Fair value

through OCI through P&L
US GAAP Held to Maturity Available for sale Trading Debt

Categories Debt Securities Securities
Measurement Amortized cost Fair value Fair value

base
Initial Fair value + Fair value + Only Fair value

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

143

4. Non-current liabilities

Long-term Long-term financial Fair value or amortized cost
financial liabilities include loans (i.e., Bond: At maturity, the amortized
liabilities borrowings from banks) and cost of the bond (carrying
(see more in notes or bonds payable (i.e., amount) will be equal to the face
reading 22) fixed-income securities value of the bond. Some cases
issued to investors) could be reported as fair value.
Deferred tax Created when the amount Deferred tax liabilities = Income
liabilities of income tax expense tax expense – Taxes payable
(see more in exceeds the amount of
reading 23) taxes payable recognized in
the income statement due
to temporarily timing
difference
144

[LOS 18.f] Describe the components of shareholders’ equity
Capital
contributed
Retained Preferred
earnings shares
Shareholders’
equity
Accumulated Treasury
OCI shares
Non-
controlling
interest
145

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

unchanged equity
Voting rights has voting rights and has no voting rights has no voting rights
and Dividend receive dividends and receive dividends and does not
at a specified rate receive dividends
Measurement See more in following slide Reduces

shareholders’
equity by the
amount of the cost
of repurchasing
146

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

Share capital
contributed
value of common stock (a stated or

(at par value)
Capital
legal value)
Share premium
Fair value of common stock – Par value
(additional paid-in
of common stock
capital)
• A type of preferred stock shares that

Non-redeemable do not include a callable feature.
Preferred shares
• Consider as shareholder’s equity
• A type of preferred stock shares that

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

147

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

amount of earnings recognized in comprehensive income includes all
the company’s income statements changes in stockholders’ equity
which have not been paid to the except for net income and
owners of company as dividends. transactions with shareholders,
such as issuing stock, reacquiring
stock, paying dividends.
148

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

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

statements as an equity of group
• Non-controlling interest (or minority interest). The equity interests of
minority shareholders in the subsidiary companies that have been
consolidated by the parent (controlling) company but that are not
wholly owned by the parent company.
149

[LOS 18.g] demonstrate the conversion of balance sheets to
common-size balance sheets and interpret common-size
balance sheets
• A vertical common-size balance sheet expresses each item of the balance
sheet as a percentage of total assets.
• The common-size format standardizes the balance sheet by eliminating the
effects of size.
• This allows for comparison over time (time-series analysis) and across firms
(cross-sectional analysis) – see below
Excerpt from common-size
Excerpt from balance sheet
balance sheet
Figure 2: Excerpt from balance sheet and common-size balance

sheets in two companies East and West
150

[LOS 18.g] demonstrate the conversion of balance sheets to
common-size balance sheets and interpret common-size
balance sheets
The following information can be concluded from common-size balance
sheets:
• East’s investment in current assets of 26.1% (5.2% + 8.4% + 12.5%) of total
assets is slightly higher than West’s current assets of 23% (10% + 7% + 6%).
However, East’s current liabilities of 22.7% of total assets are significantly
higher than West’s current liabilities of 6.6%. Thus, East is less liquid and may
have more difficulty paying its current obligations when due.
• A closer look at current assets reveals that East reports less cash as a
percentage of assets than West. In fact, East does not have enough cash to
satisfy its current liabilities without selling more inventory and collecting
receivables. East’s inventories of 12.5% of total assets are higher than West’s
inventories of 6%. Carrying higher inventories may be an indication of
inventory obsolescence. Further analysis of inventory is necessary.
• Not only are East’s current liabilities higher than West’s, but East’s long-term
debt of 59.1% of total assets is much greater than West’s long-term debt of
32.8%. Thus, East may have trouble satisfying its long-term obligations since
its capital structure consists of more debt.
151

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

Ratio company can pay its short-term
liabilities with its short-term
assets
Quick Reflects how many times a

Ratio company can pay short-term
liabilities with short-term assets
excluding company inventories
Cash Reflects how many times a

Ratio company can pay short-term
liabilities with short-term assets
excluding company inventories
and receivables
152

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

term financing its operations through long-term
debt to debt versus equity.
Equity The ratio is comparatively high, it implies
that a business is at greater risk of bankruptcy
Debt to Measure of the degree to which a company is

equity financing its operations through debt versus
equity.
This ratio is often lower than 1. A ratio of 2.0
or higher is usually considered risky.
Total Shows the debt burden that a company has to

debt bear. When a company has a high debt ratio:
high financial risk, can lose its liquidity.
Financial Shows the portion of a company's assets that

Leverage is financed by stockholders equity rather than
by debt. If this ratio is low, it means the
company is not incurring excessive debt to
finance its assets.
153

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

balance sheets and interpret common- size balance sheets
18h. calculate and interpret liquidity and solvency ratios Question 6,9
154

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

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

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

A Payment received for a product due to be delivered at least one
year after the balance sheet date
B Payments for merchandise due at least one year after the balance
sheet date but still within a normal operating cycle
C Payment on debt due in six months for which the company has the
unconditional right to defer settlement for at least one year after the
balance sheet date
155

Practice questions
4 The most likely costs included in both the cost of inventory and
property, plant, and equipment are:
A selling costs.
B storage costs.
C delivery costs.
5 The carrying value of inventories reflects:

A their historical cost.
B their current value.
C the lower of historical cost or net realizable value.
6 Defining total asset turnover as revenue divided by average total

assets, all else equal, impairment write-downs of long-lived assets
owned by a company will most likely result in an increase for that
company in:
A the debt- to- equity ratio but not the total asset turnover.
B the total asset turnover but not the debt- to- equity ratio.
C both the debt- to- equity ratio and the total asset turnover.
156

Practice questions
7 Money received from customers for products to be delivered in the

future is recorded as:
A revenue and an asset.
B an asset and a liability.
C revenue and a liability.
8 An example of a contra asset account is:

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

obligations is most likely to calculate the:
A current ratio.
B return on total capital.
C financial leverage ratio.
157

Practice questions
10 For financial assets classified as available for sale, how are unrealized
gains and losses reflected in shareholders’ equity?
A They are not recognized.
B They flow through retained earnings.
C They are a component of accumulated other comprehensive
income.
11 The non-controlling (minority) interest in consolidated subsidiaries is

presented on the balance sheet:
A as a long- term liability.
B separately, but as a part of shareholders’ equity.
C as a mezzanine item between liabilities and shareholders’ equity.
158

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

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

liabilities as current or non-current and provides a subtotal for current
assets and current liabilities. A liquidity-based balance sheet broadly
presents assets and liabilities in order of liquidity.
3. B is correct. Payments due within one operating cycle of the business, even
if they will be settled more than one year after the balance sheet date, are
classified as current liabilities. Payment received in advance of the delivery
of a good or service creates an obligation or liability. If the obligation is to
be fulfilled at least one year after the balance sheet date, it is recorded as a
non- current liability, such as deferred revenue or deferred income.
Payments that the company has the unconditional right to defer for at
least one year after the balance sheet may be classified as non-current
liabilities.
4. C is correct. Both the cost of inventory and property, plant, and equipment
include delivery costs, or costs incurred in bringing them to the location for
use or resale.
159

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

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

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

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

balance of an asset account. The allowance for doubtful accounts reduces
the balance of accounts receivable. Accumulated depreciation, not
depreciation expense, is a contra asset account. Sales returns and
allowances create a contra account that reduce sales, not an asset.
160

Practice answers
9. A is correct. The current ratio provides a comparison of assets that can be

turned into cash relatively quickly and liabilities that must be paid within
one year. The other ratios are more suited to longer- term concerns.
10. C is correct. For financial assets classified as available for sale, unrealized
gains and losses are not recorded on the income statement and instead
are part of other comprehensive income. Accumulated other
comprehensive income is a component of Shareholders’ equity.
11. B is correct. The non-controlling interest in consolidated subsidiaries is

shown separately as part of shareholders’ equity.
161

CASH FLOW STATEMENTS
162
READING 19: UNDERSTANDING CASH FLOW

STATEMENTS
Learning outcomes
19.a. compare cash flows from operating, investing, and financing activities
and classify cash flow items as relating to one of those three categories
given a description of the items
19.b. describe how non- cash investing and financing activities are reported
19.c. contrast cash flow statements prepared under International Financial

Reporting Standards (IFRS) and US generally accepted accounting principles
(US GAAP)
19.d. compare and contrast the direct and indirect methods of presenting
cash from operating activities and describe arguments in favor of each
method
19.e. describe how the cash flow statement is linked to the income
statement and the balance sheet
163

STATEMENTS
Learning outcomes
19.f. describe the steps in the preparation of direct and indirect cash flow
statements, including how cash flows can be computed using income
statement and balance sheet data
19.g. demonstrate the conversion of cash flows from the indirect to direct
method
19.h. analyze and interpret both reported and common-size cash flow
statements
19.i. calculate and interpret free cash flow to the firm, free cash flow to
equity, and performance and coverage cash flow ratios
164

STATEMENTS
[LOS 19.a] compare cash flows from operating, investing, and
financing activities and classify cash flow items as relating to
one of those three categories given a description of the items
1. Overview about cash flow statements
The cash flow statement provides information about a company’s cash receipts and cash
payments during an accounting period
Information-based in cash flow Information-based in Income

statement statement
Cash-based information: Accrual-based information:
Revenue is recorded when Revenue or expenses are recorded
company received payment from when a transaction occurs rather
customer, expenses is recorded than when payment is received or
when company paid payment to made.
customer
Although income is an important measure of the results of a company’s activities, cash flow
is also essential. As an extreme illustration, a hypothetical company that makes all sales on
account, without regard to whether it will ever collect its accounts receivable, would report
healthy sales on its income statement and might well report significant income; however,
with zero cash inflow, the company would not survive.
165

STATEMENTS
LOS 19.a: compare cash flows from operating, investing, and
2. Operating, investing and financing activities
Cash receipts and cash payments during a period are classified in the statement of cash
flows into three different activities
Operating activities Investing activities Financing activities
Consists of the inflows Consists of the inflows Consists of the inflows

and outflows of cash and outflows of cash and outflows of cash
resulting from resulting from the resulting from
transactions that affect acquisition or disposal of transactions affecting a
a firm’s net income long-lived assets and firm’s capital structure
certain investments
Example: Example: Example:

• Cash collected from • Sale proceeds from • Proceeds from issuing
customers (inflow) fixed assets (inflow) stock (inflow)
• Cash paid for • Principal received from • Principal amounts of
inventory (outflow) loans made to other debt issued (inflow)
• Taxes paid (outflow) (inflow) • Stock Repurchase
• Acquisition of trading • Loan made to others (outflow)
securities (outflows)… (outflow)
166

STATEMENTS
Example: Net Cash Flow from Investing Activities

A company recorded the following in Year 1:
Proceeds from issuance of long-term debt € 300,000
Purchase of equipment € 200,000
Loss on sale of equipment € 70,000
Proceeds from sale of equipment € 120,000
Equity in earnings of affiliate € 10,000
On the Year 1 statement of cash flows, the company would report net
cash flow from investing activities closest to:
A. (€150,000).
B. (€80,000).
C. €200,000.
167

STATEMENTS
Solution:
B is correct. The only two items that would affect the investing section are
the purchase of equipment and the proceeds from sale of equipment:
(€200,000) + €120,000 = (€80,000). The loss on sale of equipment and the
equity in earnings of affiliate affect net income but are not cash flows. The
issuance of debt is a financing cash flow.
168

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

if a company purchases $200,000 of land by issuing a long-term bond,
this transaction is a non-cash one, as it does not involve direct outlays of
cash. Therefore, it is excluded from the statement of cash flows. These
types of transactions should be disclosed in:
• A separate schedule as part of the statement of cash flows or
• The footnotes to the financial statements.
169

STATEMENTS
[LOS 19.c] Contrast cash flow statements prepared under IFRS
and US GAAP
There are some differences in cash flow statements prepared under IFRS and
US GAAP that will be set out below:
Items IFRS US GAPP
Interest received Operating or investing Operating
Interest paid Operating or financing Operating
Dividends received Operating or investing Operating
Bank overdraft Considered part of cash classified as financing

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

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

Format of A reconciliation of net income to cash flow from operating
statement activities must be provided regardless of method used under US
GAAP
170

STATEMENTS
[LOS 19.d] compare and contrast the direct and indirect
methods of presenting cash from operating activities and
describe arguments in favor of each method
There are two methods of converting the income statement from an accrual
basis to a cash basis.
Direct method Indirect method
Definition Shows the specific cash inflows Shows how cash flow from
and outflows that result in operations can be obtained from
reported cash flow from reported net income as the result of
operating activities a series of adjustments.
Begins with net income.
General It adjusts each item in the Calculation of net cash flow of

principles income statement to its cash operating activities from net income
equivalent (profit before taxation) by adjusting
net income for all non-cash items
and net changes in the operating
working capital accounts.
Advantages More information and easily Mostly used by firm because easier
understood by the average conversion from Income statement
reader and Balance Sheet.
171

STATEMENTS
[LOS 19.d] compare and contrast the direct and indirect
methods of presenting cash from operating activities and
describe arguments in favor of each method
Note that in 2 methods, presentation of cash flow from investing activities and
financing activities are similar. The distinguish between these methods only
comes from operating activities.
Excerpt from direct cash flow Excerpt from indirect cash flow
statement statement
Figure 1: Excerpt from operating activities in cash flow statement

in two methods direct and indirect
172

STATEMENTS
[LOS 19.e] describe how the cash flow statement is linked to the
income statement and the balance sheet
1. Operating activities
Cash is an asset. The statement of cash flows ultimately shows the change in
cash during an accounting period. The beginning and ending balances of cash
are shown on the company’s balance sheets for the previous and current years,
and the bottom of the cash flow statement reconciles beginning cash with
ending cash. The relationship, stated in general terms, is as shown below.
CFO + CFI + CFF = Change in cash = Year-end cash balance – Beginning-of-
year cash balance
Beginning Balance Statement of Cash Flows for Year Ending Balance
Sheet at 31 Ended 31 December 20X9 Sheet at 31
December 20X8 December 20X9
Beginning cash Plus: Cash receipts (from operating, Ending cash

investing, and financing activities)
Less: Cash payments (for operating,
investing, and financing activities)
173

STATEMENTS
1. Operating activities
The current assets and current liabilities sections of the balance sheet typically
reflect a company’s operating decisions and activities. Because a company’s
operating activities are reported on an accrual basis in the income statement,
any differences between the accrual basis and the cash basis of accounting for
an operating transaction result in an increase or decrease in some (usually)
short-term asset or liability on the balance sheet.
With receivable, if revenue reported using accrual accounting is higher than the
cash actually collected, the result will typically be an increase in accounts
receivable.
Beginning accounts receivable + Revenues - Cash received from
customers = Ending accounts receivable
Beginning balance Income statement Cash Flows Ending balance

sheet at 31 for Year Ended 31 statement for sheet at 31
December December 20X9 Year Ended 31 December
20X8 December 20X9 20X9
Beginning Plus: Revenues Minus: Cash Equals: Ending
accounts collected from accounts
receivable customers receivable
174

STATEMENTS
2. Investing and financing activities
• Investing activities typically relate to the long-term asset section of the
balance sheet.
• Financing activities typically relate to the equity and long-term debt sections
of the balance sheet.
175

STATEMENTS
[LOS 19.f] describe the steps in the preparation of direct and
indirect cash flow statements, including how cash flows can be
computed using income statement and balance sheet data
Describe the steps in the preparation of direct cash flow
1.
statements
Take each item from Income Statement and convert to its cash equivalent by +/- changes
in the corresponding Balance sheet accounts
(+) Cash collected from customers (1)
(-) Cash paid to suppliers (2)
Operating Cash Flows
(-) Cash paid to employees (3)

(-) Cash of other operating expenses (4)
(+) Cash interest/dividend receipt – note that this can appear in operating or
investing activities under IFRS (5,6)
(-) Cash interest/dividend payments – note that this can appear in operating or
financing activities under IFRS (5,6)
(-) Cash taxes (7)
(+) Cash receipts from disposal of assets (8)
Cash Flows
Investing
(-) Cash payment to acquire assets (9)

(+) Cash receipts from sales of financial instrument of other entities (10)
(-) Cash payment to acquire financial instrument of other entities (11)
Cash Flows
(+) Cash receipts from issue of shares

Financing
(+) Cash receipts from new borrowings

(-) Cash payment of principal repayment of borrowings
176

STATEMENTS
LOS 19.f: describe the steps in the preparation of direct and
1.
statements
Formulas for cash from activities
1. Cash collected from customers
From basis formula: Opening account receivables + Revenue – Cash collected from
customers = Closing account receivables
Cash collected from Revenue – (Ending in account receivables – Beginning in
customers = account receivables)
2. Cash paid to suppliers
• Beginning inventory + Purchase – COGS = Ending inventory
• Beginning account payables + Purchase – Cash paid to suppliers = Ending account
payables
COGS + (Ending inventory – Beginning inventory) –
Cash paid to suppliers = (Ending in account payables – Beginning in account
payables)
3. Cash paid to employees
From basis formula: Opening S & W payables + S & W expense – Cash paid to employee =
Closing S & W payables
Cash paid to = Salary & wage expense – (Ending S & W payable –

employees Beginning S & W payable)
177

STATEMENTS
Describe the steps in the preparation of direct cash
1.
flow statements
Example: Calculation of cash paid to suppliers

Orange Beverages Plc., a fictitious manufacturer of tropical drinks, reported cost of goods
sold for the year of $100 million. Total assets increased by $55 million, but inventory
declined by $6 million. Total liabilities increased by $45 million, but accounts payable
decreased by $2 million. How much cash did the company pay to its suppliers during the
year?
A $96 million.
B $104 million.
C $108 million.
178

STATEMENTS
Describe the steps in the preparation of direct cash
1.
flow statements
Example: Calculation of cash paid to suppliers

Answer:
Cash pay to suppliers = COGS + (Closing inventory – Opening inventory) – (Closing in
account payables – Opening in account payables)
• Inventory declined by $6 million  Closing inventory – Opening inventory = - 6m
• Accounts payable decreased by $2 million  (Closing in account payables – Opening in
account payables) = -2m
 Cash pay to suppliers = $100m + (-6m) - (-2m) = $96m  A
179

STATEMENTS
1.
statements
4. Cash paid for other operating expenses
From basis formula: Opening prepaid expense + Opening accrued expense + Other
operating expense – Cash of other operating expense = Closing prepaid expense + Closing
accrued expense
Other operating expenses + (Ending prepaid expense –
Cash paid for other = Beginning prepaid expense ) - (Ending accrued expense –
operating expenses
Beginning accrued expense)
5. Cash interest payments/receipts
From basis formula: Beginning interest payables/receivables + Interest expense/income –
Cash interest payments/receipts = Ending interest payables/receivables
Cash interest payments = Interest expense – (Ending interest payables – Beginning
interest payables)
Interest income – (Ending interest receivables –
Cash interest receipts = Beginning interest receivables)
6. Cash dividend payments/receipts
From basis formula: Beginning retained earnings + Net income – Dividends = Ending
retained earnings
Cash dividend payments = Beginning retained earnings + Net income - Ending

retained earnings
Dividend income – (Ending dividend receivables –
Cash dividend receipts =
Beginning dividend receivables)
180

STATEMENTS
1.
statements
7. Cash taxes
From basis formula: Beginning tax payables + Beginning deferred tax + Income taxes – cash
taxes = Ending tax payables + Ending deferred tax
Income taxes – (Ending tax payable-Beginning tax payable)
Cash taxes paid =
– (Ending deferred tax – Beginning deferred tax)
8. Cash receipts from disposal of assets
Cash receipts from disposal – Carrying amount = Gain/loss from disposal
Carrying amount = Historical cost – Accumulated depreciation
Cash receipts from [Historical cost (*) – Accumulated depreciation(**)] +/-
disposal of assets = Gain/Loss from disposal
9. Cash payment to acquire assets
Purchase price – Remained amount payable
Cash payment to acquire assets =
to acquire assets
10. Cash receipts from sales of financial instrument of other entities
Cash receipts from sales of financial Sales price – Remained amount receivables
=
instrument of other entities to sales of financial instrument
12. Cash payment to acquire financial instrument of other entities
Cash payment to acquire financial Purchase price – Remained amount payable
=
instrument of other entities to acquire financial instrument
181

STATEMENTS
Describe the steps in the preparation of indirect cash
2.
flow statements
4 steps to prepare indirect cash flow (operating activities only)
• Step 1: Begin with net income.
• Step 2: Add or subtract changes to balance sheet operating accounts as follows:
o Increases in the operating asset accounts (uses of cash) are subtracted, while
decreases (sources of cash) are added.
o Increases in the operating liability accounts (sources of cash) are added, while
decreases (uses of cash) are subtracted.
• Step 3: Add back all non-cash charges to income (such as depreciation and amortization)
and subtract all non-cash components of revenue.
• Step 4: Subtract gains or add losses that resulted from financing or investing cash flows
(such as gains from sale of land).
Operating cash flow = Net income (+/-) Change working capital accounts (+/-) Non-cash
items (+/-) Non-operating gain/loss
Explanation for the principle in step 2, 3 and 4
Step 2: Increase in asset items means less cash – for example, you have spent cash on
buying inventory. Similar explanation for other asset and liability items.
Step 3: Non-cash expenses/revenue are deducted/added in arriving at the profit figure in
the income statement. Therefore, it makes sense to add/subtract it by adding it back.
Step 4: By the same logic in step 3, a gain/loss on a resulted from financing or investing
cash flows needs to be subtracted/added back.
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STATEMENTS
Describe the steps in the preparation of indirect cash
2.
flow statements
Some type of items that need to be adjusted
Items Addition Subtraction
• Depreciation/amortization of Amortization of bond premium
Non-cash fixed assets
items • Depletion of natural resources
• Amortization of bond discount
• Loss on sale or write-off assets • Gain on sale of assets
Non-operating • Loss on retirement of debt • Gain on retirement of debt
items • Loss on investments accounted • Gain on investment accounted
under equity method under equity method
Increase in deferred tax liabilityDecrease in deferred income tax
Deferred taxes liability
Resulting from accrued expense > Resulting from accrued expense <
cash payment or accrued revenue < cash payment or accrued revenue >
cash receipt cash receipt
Change in • Decrease in current operating • Increase in current operating
working assets assets
capital • Increase in current operating • Decrease in current operating
liabilities liabilities
183

STATEMENTS
Example: Indirect cash flow

Based on the following information for Pinkerly Inc., what are the total
adjustments that the company would make to net income in order to
derive operating cash flow?
A. Add $5 million.
B. Add $21 million.
C. Subtract $9 million.
184

STATEMENTS
Example: Indirect cash flow
Answer:
A is correct.
To derive operating cash flow, the company would make the following
adjustments to net income:
• Add depreciation (a non-cash expense) of $7 million;
• Add the decrease in inventory of $3 million;
• Add the increase in accounts payable of $10 million;
• Subtract the increase in accounts receivable of $15 million.
Total additions of $20 million and total subtractions of $15 million
result in net total additions of $5 million.
185

STATEMENTS
[LOS 19.g] demonstrate the conversion of cash flows from the
indirect to direct method
Conversion of Cash Flows from the Indirect to the Direct Method
Although the indirect method is most commonly used by companies, the analyst can
generally convert it to the direct format by following a simple three-step process.
• Step 1: Aggregate all revenue and all expenses.
o Aggregate all operating and non-operating revenues and gains such as sales and
gains from sale of assets.
o Aggregate all operating and non-operating expenses such as wages,
depreciation, interest, and taxes.
• Step 2: Remove all non-cash items from aggregated revenues and expenses and
break out remaining items into relevant cash flow items.
o Deduct non-cash revenue items such as gain on sales of assets from total
revenue.
o Deduct non-cash expense items such as depreciation from total expenses.
o Break down the adjusted expenses into cash outflow items, such as cost of
goods sold, wages, interest expense, and tax expense.
• Step 3: Convert accrual amounts to cash flow amounts by adjusting for working
capital changes.
o Convert revenue into cash receipts from customers by adjusting for accounts
receivable and unearned revenue.
o Convert COGS into cash payments to suppliers by adjusting for inventory and
accounts payable.
o Convert wages, interest, and tax expenses into cash amounts by adjusting for
wages payable, interest payable, taxes payable, and deferred taxes.
186

STATEMENTS
Example: Conversion of Cash collect from customers from the
indirect to the direct:
The income statement and operating cash flows using the indirect methods for
ABC Company are presented below. We will use these information to convert
indirect cash flow to the direct cash flow.
187

STATEMENTS
indirect to the direct:
Answer:
Step 1: Aggregate all revenue and all expenses:
Total revenues (23,000 + 200) $23,200
Total expenses (11,500 + 8,500 + 300 + 1,400) $21,700
Net income $1,500
Step 2: Remove all noncash items from aggregated revenues and
expenses:
Total revenue less non-cash item revenues: $23,000
(23,200 - 200)
Total expenses less non-cash item expenses: $20,700
(21,700 - 1,000)
Break out remaining items into relevant cash flow items:
Cost of goods sold $11,500
Salary and wage expenses $4,000
Other operating expenses $3,500
Interest expense $300
Income tax expense $1,400
Total $20,700
188

STATEMENTS
indirect to the direct
Answer: (cont.)
Step 3: Convert accrual amounts to cash flow amounts by adjusting
for working capital changes:
Items Amount
Cash received from customers (23,000 – 50) $22,950
Cash paid to suppliers (-11,500 – 650 + 200) ($11,950)
Cash paid to employees (-4,000 + 10) ($3,990)
Cash paid for other operating expenses ($3,250)
(-3,500 + 150 + 100)
Cash paid for interest ($325)
( -300 - 25)
Cash paid for income tax (-1,400 + 15) ($1,385)
CFO $2,050
All the calculations above are made via the formulas listed in LOS 19f.
189

STATEMENTS
[LOS 19.h] analyze and interpret both reported and common-
size cash flow statements
1. Analyze and interpret reported cash flow statement
Evaluation of the cash flow statement should involve an overall assessment of the
sources that will present, as follows:
• What are the major sources and uses of cash
Evaluate the major
flow?
sources and uses of
• Is operating cash flow positive & sufficient to
cash flow
cover capital expenditures
• What are the major determinants of operating
Steps in evaluating cash flows
Evaluate the primary cash flow?

determinants of • Is operating cash flow higher or lower than net
operating CF income? Why?
• How consistent are operating cash flows?
• Where is the cash being spent?
Evaluate the primary • How much is being invested, where are the
determinants of sources to cover those investment?
investing CF • How much is raised by selling assets? Potential
effect on the company?
• Whether the company is raising capital or
Evaluate the primary
repaying debt? When is the repayment?
determinants of
• What is the nature of the company’s capital
financing CF
sources?
190

STATEMENTS
2. Analyze and interpret common-size cash flow statement
For the common-size cash flow statement, there are two alternative
approaches.
• The first approach is to express each line item of cash inflow (outflow) as
a percentage of total inflows (outflows) of cash (figure 2)
• The second approach is to express each line item as a percentage of net
revenue (figure 3)
Outflows Cash flow (CF) Common

size CF
Cash paid to suppliers $12,000 69.36%
Cash paid to employee $4,000 23.12%
Cash interest payments $300 1.74%
Cash taxes $1,000 5.78%
Total $17,300 100%
Figure 2: Total flow common-size cash flow statement

191

STATEMENTS
2. Analyze and interpret common-size cash flow statement
Assume that company X has net revenue of $24,000. The following figure will show
common-size cash flow of company X
Common size
Cash flow from operating activities Cash flow (CF) CF
Net income $2,000 8.33%
Depreciation expense $1,000 4.17%
Gain on sale of equipment ($300) (1.25%)
Increase in accounts receivable ($60) (0.25%)
Increase in inventory (700) (2.92%)
Increase in accounts payable 240 1%
Increase in income tax payable 100 0.42%
Net cash provided by operating activities 2280 9.5%
Figure 3: Net revenue common-size cash flow statement

192

STATEMENTS
[LOS 19.i] calculate and interpret free cash flow to the firm, free
cash flow to equity, and performance & coverage cash flow ratios
1. Calculate and interpret free cash flow
Free cash low is a measure of cash that is available for discretionary purposes.
• This is the cash flow that is available once the firm has covered its capital
expenditures (CAPEX)
• This is a fundamental cash flow measure and is often used for valuation.
Two of the more common measures are set out below.
Term Definition Computation

Free cash Cash flow available to the company’s • FCFF = CFO – net CAPEX (*) +
flow to firm suppliers of debt and equity after all Interest x (1 – tax rate)
operating expense have been paid and • FCFF = net income + non cash
necessary investment has been made charges + [Int × (1 − tax rate)]
− net CAPEX − working capital
investment
Free cash FCFE is cash flow available to the FCFE = CFO – net CAPEX + Net
flow to company’s common stockholders after all borrowing
equity operating expenses and borrowing costs (net borrowing = debt issued –
have been paid, necessary investments in debt repaid)
working capital and fixed capital have
been made
(*) net CAPEX = fixed capital
investment
193

STATEMENTS
2. Calculate and interpret performance ratios
The cash flow statement may also be used in financial ratios measuring a company's
profitability, performance, and financial strength.
Performance
Ratios Calculation Meaning
Cash flow to CFO / Net revenue Operating cash generated per

revenue dollar of revenue
Cash return on CFO / Average total assets Operating cash generated per
assets dollar of asset investment
Cash return on CFO / average shareholders' equity Operating cash generated per
equity dollar of owner investment
Cash to income CFO / Operating income Cash generating ability of
operations
Cash flow per (CFO - Preferred dividends) / number Operating cash flow on a per-
share of common shares outstanding share basis
194

STATEMENTS
3. Calculate and interpret coverage cash flow ratios
Coverage Ratios Calculation Meaning
Debt coverage CFO / Total debt Financial risk and financial leverage
Interest coverage(CFO + Interest Paid + Taxes Ability to meet interest obligations

paid) / Interest paid
Reinvestment CFO / Cash paid for long-term Ability to acquire assets with
assets operating cash flows
Debt payment CFO / Cash paid for long-term Ability to pay debt with operating
debt repayment cash flows
Dividend payment CFO / Dividends paid Ability to pay dividends with
operating cash flows
Investing and CFO / Cash outflows for Ability to acquire assets, pay debts,
financing investing and financing activities and make distributions to owners
195

STATEMENTS
Practice questions
19a. compare cash flows from operating, investing, and financing activities Question 1
and classify cash flow items as relating to one of those three categories
given a description of the items
19b. describe how non-cash investing & financing activities are reported Question 3
19c. contrast cash flow statements prepared under IFRS and US GAAP Question 4
19d. Compare, contrast the direct & indirect methods of presenting cash Question 2
from operating activities & describe arguments in favor of each method
19e. describe how the cash flow statement is linked to the income N/A
statement and the balance sheet
19f. describe the steps in the preparation of direct and indirect cash flow Question 5 - 9
statements, including how cash flows can be computed using income
statement and balance sheet data
196

STATEMENTS
Practice questions
19g. demonstrate the conversion of cash flows from the indirect to direct N/A
method
19h. analyze and interpret both reported and common-size cash flow Question 10
statements
19i. calculate and interpret free cash flow to the firm, free cash flow to Question 11
equity, and performance and coverage cash flow ratios
197

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

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

significantly affected its property, plant, and equipment. The
transaction is:
A reported under the investing section of the cash flow statement.
B reported differently in cash flow from operations under the direct
and indirect methods.
C disclosed as a separate note or in a supplementary schedule to the
cash flow statement.
198

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

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

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

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

sold for the year of $75 million. Total assets increased by $55 million,
but inventory declined by $6 million. Total liabilities increased by
$45 million, and accounts payable increased by $2 million. The cash
paid by the company to its suppliers is most likely closest to:
A $67 million.
B $79 million.
C $83 million.
200

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

9
loss on the sale of equipment of $2 million in 2018. In addition, the
company’s income statement shows depreciation expense of
$8 million and the cash flow statement shows capital expenditure of
$10 million, all of which was for the purchase of new equipment.
Using the following information from the comparative balance
sheets, how much cash did the company receive from the equipment
sale?
Balance Sheet Item 12/31/2017 12/31/2018 Change
Equipment $100 million $105 million $5 million
Accumulated $40 million $46 million $6 million

depreciation—
equipment
A $1 million.
B $2 million.
C $3 million.
201

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

10 statement?
A Show each item of revenue and expense as a percentage of net
revenue.
B Show each line item on the cash flow statement as a percentage of
net revenue.
C Show each line item on the cash flow statement as a percentage of
total cash outflows.
1
Which of the following is an appropriate method of computing free cash
1
flow to the firm?
A Add operating cash flows to capital expenditures and deduct after-
tax interest payments.
B Add operating cash flows to after- tax interest payments and deduct
capital expenditures.
C Deduct both after- tax interest payments and capital expenditures
from operating cash flows.
202

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

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

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

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

Payment of interest and receipt of dividends are included in operating cash
flows under US GAAP.
203

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

retirement of debt, which is a non-operating loss. Gain on the sale of an
asset & decrease in deferred tax liability are both subtracted from net
income.
7. C is correct.
Cash interest payments = Interest expense – (Closing interest payables –
Opening interest payables) = $19 - $3 = $16
Taxes paid = Income taxes – (Closing in tax payables – Opening in tax
payables) – (Closing in deferred taxes –Opening in deferred taxes) = $6 – (-
$4) = $10
8 A is correct.
Cash paid to supplier = COGS + (Closing inventory – Opening inventory) –
(Closing in account payables – Opening in account payables)
= $75 + (-$6) – ($2) = $67
204

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

depreciation) +/- Gain/Loss from disposal = $5 - $2 -$2 = $1
205

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

statement is to show each line item on the cash flow statement as a
percentage of net revenue. An alternative way to prepare a statement of
cash flows is to show each item of cash inflow as a percentage of total
inflows and each item of cash outflows as a percentage of total outflows.
11. B is correct. Free cash flow to the firm can be computed as operating cash
flows plus after- tax interest expense less capital expenditures.
206

ANALYSIS TECHNIQUES
207
READING 20: FINANCIAL ANALYSIS

TECHNIQUES
Learning outcomes
20a. describe tools and techniques used in financial analysis, including their
uses and limitations
20b. identify, calculate, and interpret activity, liquidity, solvency, profitability,

and valuation ratios
20c. describe relationships among ratios and evaluate a company using

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

calculate and interpret effects of changes in its components
20e. calculate and interpret ratios used in equity analysis and credit analysis
20f. explain the requirements for segment reporting and calculate and interpret
segment ratios
20g. describe how ratio analysis and other techniques can be used to model and
forecast earnings
208

TECHNIQUES
LOS 20.a: describe tools and techniques used in financial
analysis, including their uses and limitations
Ratio
Analysis
Common-
Regression Tools and
Size
analysis techniques
Analysis
Graphical
Analysis
209

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

Ratio • Project future earnings and • Financial ratios are not useful
Analysis cash flow. when viewed in isolation.
• Evaluate a firm’s flexibility • Comparisons are made more
• Assess management’s difficult by different accounting
performance. treatments.
• Evaluate changes in the • It is difficult to find comparable
firm and industry over industry ratios
time. • Conclusions cannot be made by
• Compare the firm with calculating a single ratio.
industry competitors. • Determining the target or
comparison value for a ratio is
difficult, requiring some range
of acceptable values.
210

TECHNIQUES
Company A FY2016 FY2017
Revenue 232,724 237,275
Gross profit 23,212 25,361
Net income (4,901) 2,797
Company B FY2016 FY2017
Revenue 43,035 45,350
Gross profit 6,105 6,272
Net income 530 (127)
By ratio analysis, we can determine

• Which company is larger based on the amount of revenue, in US$,
reported in fiscal year 2016, 2017
• Which company had the higher revenue growth from FY2016 to FY2017
• Profitability of companies (assessed by comparing the amount of gross
profit to revenue and the amount of net income to revenue)
211

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

Analysis easily compare performance decision-making process
across firms and for a single due to the lack of any
firm overtime approved standard
• Common-size balance sheet benchmark
expresses all balance sheet • Fails to convey proper
accounts as a percentage of records during seasonal
total assets. fluctuations in various
• Common-size income components of sales,
statement expresses all assets liabilities
income statement items as a • Does not help to ascertain
percentage of sales. the Current ratio, Liquid
• Common-size cash flow ratio, Capital gearing ratio
statements expresses all cash etc. which are applied in
flows as a percentage of total testing liquidity and
cash flows or a percentage of solvency position of a
net revenue method firm.
212

TECHNIQUES
2. Common-Size Analysis
IS Common size IS
Sales 10,000,000 100%
Cost of sales 3,000,000 30%
Gross profit 7,000,000 70%
Selling, general and administrative 1,000,000 10%
expense
Research and development 2,000,000 20%
Advertising 2,000,000 20%
Operating profit 2,000,000 20%
By common-size analysis, we can certainly point the analyst in the right
direction and prompt us to ask relevant questions in assessing the company’s
operating performance over the period, and evaluating its prospects going
forward.
213

TECHNIQUES
3. Graphical Analysis
Graphical • Comparison of performance and financial • Require
Analysis structure over time, highlighting changes in additional
significant aspects of business operations. written or verbal
• Provide the analyst (and management) with explanation;
a visual overview of risk trends in a • Can be easily
business. manipulated to
• Communicate the analyst’s conclusions give false
regarding financial condition and risk impressions
management aspects
4. Regression Analysis
Regression • Identify relationships between • It involves very lengthy
analysis variables and complicated
• Providing a basis for forecasting procedure of calculations
• Identification of items or ratios and analysis
that are not behaving as expected, • Strict assumptions of
given historical statistical regression model can be
relationships. violated
214

TECHNIQUES
Change in trade payables, cash and lease obligations

of company X in 4 year-period
14000
12000
10000
8000
6000
4000
2000
0
20X4 20X5 20X6 20X7
Trade payables Cash Lease obligations
Stacked column graph (a type of graphic analysis) shows the changes in items
from year to year in graphical form.
215

TECHNIQUES
By Regression Analysis, we can determine the relationships between items.

216

TECHNIQUES
LOS 20.b: identify, calculate, and interpret activity, liquidity,
solvency, profitability, and valuation ratios
Type Use
1. Activity ratio Measure how well a company manages various activities,
particularly how efficiently it manages its various assets.
2. Liquidity ratio Liquidity measures how quickly assets are converted into cash.
Liquidity ratios also measure the ability to pay off short-term
obligations.
3. Solvency ratio Solvency refers to a company’s ability to fulfill its long-term
debt obligations.
4. Profitability Measure the company’s to generate profits from revenue and
ratio assets.
5. Valuation Sales per share, earnings per share, and price to cash flow per
share are examples of ratios used in comparing the relative
valuation of companies.
217

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

between a sale and cash collection, reflecting how fast the
company collects cash from customers.
• Calculation:
o Receivables turnover =
Receivables o DSO =
Turnover and
days of sales • Interpretation:
outstanding o A high receivables turnover might indicate that the
(DSO) company’s credit collection are highly efficient or result
from overly stringent credit or collection policies, which
can hurt sales if competitors offer more lenient credit
terms to customers and vice versa
o A high DSO means that the company’s credit collection
are highly inefficient.
218

TECHNIQUES
1. Activity ratios
• Usage: The number of days of payables reflects the average

number of days the company takes to pay its suppliers, and
the payables turnover ratio measures how many times per
year the company theoretically pays off all its creditors.
• Calculation:
Payables o Payables turnover =
Turnover and o Number of days of payables =
the Number of • Interpretation:
Days of o A high payables turnover might indicate that the
Payables
company is not making full use of available credit
facilities and repaying creditors too soon or company
making payments early to avail early payment discounts
o A high number of days of payables means that the
company repaying creditors too soon
219

TECHNIQUES
1. Activity ratios
• Usage: Indicate inventory management effectiveness. A

higher inventory turnover ratio implies a shorter period that
inventory is held, and thus a lower DOH.
• Calculation:
o Inventories turnover =
Inventory
turnover and o DOH =
days of • Interpretation:
inventory on o A high inventory turnover ratio relative to industry norms
hand (DOH) might indicate highly effective management or the
company does not hold adequate inventory levels, which
can hurt sales in case shortages arise and vice versa
o A high DOH means that company uses inventory
inefficiently and is struggling to clear its stock.
220

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

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

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

revenues with a given level of assets
Total Asset
Turnover • Calculation: TA turnover =
• Interpretation: A high ratio indicates more efficient use of
total assets in generating revenue
221

TECHNIQUES
2. Liquidity ratios
Liquidity
Usage/Calculation/Interpretation
ratios
• Usage: Expresses current assets in relation to current
Current liabilities. A higher ratio indicates a higher level of liquidity
ratio • Calculation: Current ratio =
• Interpretation: A high current ratio is desirable because it
indicates a higher level of liquidity
• Usage: Expresses “quick” assets in relation to current

liabilities. Quick assets excludes items in current assets that
cannot be converted into cash such as inventory, prepaid
Quick ratio expenses, taxes…
• Calculation: Quick ratio =
• Interpretation: A high quick ratio indicates greater liquidity.
222

TECHNIQUES
2. Liquidity ratios
Liquidity
ratios Usage/Calculation/Interpretation
• Usage: Represents a reliable measure of an entity’s liquidity in a crisis

situation. Only highly marketable short-term investments and cash are
Cash ratio included
• Calculation: Cash ratio =
• Interpretation: A high cash ratio is desirable as it indicates greater
liquidity
• Usage: Measures how long the company can continue to pay its
expenses from its existing liquid assets without receiving any additional
cash inflow.
Defensive Calculation:
interval ratio •
Defensive interval ratio =
• Interpretation: A high defensive interval ratio is desirable as it indicates
greater liquidity
• Usage: Indicates the amount of time that elapses from the point when a
Cash company invests in working capital until the point at which the company
collects cash
conversion
cycle • Calculation: Cash conversion cycle = DOH + DOS – Number of days of
payables
• Interpretation: A short cycle is desirable, as it indicates greater liquidity
223

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

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

(debt plus equity) represented by debt.
Debt-to-capital • Calculation:
ratio Debt-to-capital =
• Interpretation: A high ratio is undesirable and indicates
higher financial risk
• Usage: Measures the amount of debt capital relative to

equity capital.
Debt-to-equity • Calculation:
ratio Debt-to-equity =
• Interpretation: A high ratio is undesirable and indicates
higher financial risk
224

TECHNIQUES
3. Solvency ratios
Solvency ratios Usage/Calculation/Interpretation
• Usage: Measures the amount of total assets supported for each one
money unit of equity.
Financial
leverage ratio • Calculation: Financial leverage ratio =
• Interpretation: A higher the leverage ratio, the more leveraged
(dependent on debt for finance) the company.
• Usage: Measures the number of times a company’s EBIT (earnings

before interest and tax) could cover its interest payments.
Interest coverage Calculation: Interest coverage =
ratio •
• Interpretation: A higher ratio provides assurance that the company
can service its debt from operating earnings
• Usage: Measures the number of times a company’s earnings can

cover the company’s interest and lease payments.
Fixed charge • Calculation:
Fixed charge coverage =
coverage ratios
• Interpretation: A higher ratio suggests that the company is
comfortably placed to service its debt and make lease payments from
the earnings it generates from operations
225

TECHNIQUES
4. Profitability ratios
Before moving on to any profitability ratios, you should be familiar with a few
terms, such as gross profit, operating profit, net profit, and so on. These are
linked in the income statement as follows:
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TECHNIQUES
4. Profitability ratios
Profit ratios Usage/Calculation/Interpretation
• Usage: Indicates the percentage of revenue available to

cover operating and other expenses and to generate profit.
Gross profit • Calculation: Gross profit margin =
margin • Interpretation: A high gross profit margin can be a explain
by high product prices (reflected in high revenues) and low
product costs (reflected in low COGS).
• Usage: Indicate the company’s ability to control operating

costs, such as administrative overheads.
• Calculation: Operating profit margin =
• Interpretation:
Operating o An operating profit margin that is increasing at a higher
profit margin rate than the gross profit margin indicates that the
company has successfully controlled operating costs.
o A decreasing operating profit margin when gross profit
margins are rising indicates that the company is not
efficiently controlling operating expenses.
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TECHNIQUES
• Usage: Reflects the effects on profitability of leverage

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

every dollar it generates in revenue.
Net profit • Calculation: Net profit margin =
margin • Interpretation: A low net profit margin indicates a low
margin of safety. It alerts analysts to the risk that a
decline in the company’s sales revenue will lower profits
or even result in a net loss
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TECHNIQUES
• Usage: Measures the return earned by a company on its

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

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

equity capital, including minority equity, preferred equity,
Return on and common equity
equity (ROE) • Calculation: ROE =
• Interpretation: A high ROE indicates a more efficient usage
of equity capital.
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TECHNIQUES
LOS 20.c: describe relationships among ratios and evaluate a
company using ratio analysis
Ratios can also be combined and evaluated as a group to better
understand how they fit together and how efficiency and leverage are tied
to profitability. For example:
Fiscal year 10 9 8
Current 2.1 1.9 1.6

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

Based on the increase in its current ratio from 1.6 to 2.1, the company
appears to have strong and improving liquidity;
• However, based on the decline of the quick ratio from 1.0 to 0.8, its
liquidity appears to be deteriorating.
• Because both ratios have exactly the same denominator, current
liabilities, the difference must be the result of changes in some asset
that is included in the current ratio but not in the quick ratio (e.g.,
inventories).
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TECHNIQUES
LOS 20.d: demonstrate the application of DuPont analysis of
return on equity and calculate and interpret effects of changes
in its components
DuPont system is used to break-down return on equity (ROE) into
component ratios. Decomposing ROE into its components through DuPont
analysis has the following uses:
• It facilitates a meaningful evaluation of the different aspects of the
company’s performance that affect reported ROE.
• It helps in determining the reasons for changes in ROE over time for a
given company.
• It also helps us understand the reasons for differences in ROE for different
companies over a given time period.
• It can direct management to areas that it should focus on to improve ROE.
• It shows the relationship between the various categories of ratios and
how they all influence the return that owners realize on their investment
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TECHNIQUES
in its components
Two-Way DuPont Decomposition
ROE =
= x
=
x Financial
ROA
Leverage
Three-Way DuPont Decomposition
ROE =
= x x
=
Net profit Asset Financial

x x
margin turnover Leverage
232

TECHNIQUES
in its components
Five-Way DuPont Decomposition
ROE =
= x x x x
=
Tax Interest EBIT Total asset Financial

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

margin turnover
Interest Tax EBIT

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

company’s ROE.
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TECHNIQUES
in its components
Solution:
The following conclusions may be drawn from the given information:
• The tax burden ratio has varied with no obvious trend over the
years. The recent increase in tax burden ratio (from 59.37% in 2010
to 64.85% in 2011) indicates that taxes declined as a percentage of
pre-tax profits. Average tax rates may have declined as a result of
(1) new legislation or (2) greater revenue generated in lower tax
jurisdictions.
• The interest burden ratio remained fairly constant over the period,
which suggests that the company’s capital structure has remained
fairly constant.
• The EBIT margin declined over the period, indicating that the
company’s operations were less profitable.
• The company’s asset turnover declined over the period, which
suggests that the company is becoming increasingly inefficient.
• The financial leverage ratio remained fairly constant over the
period, which is consistent with the stable interest burden ratio.
Overall, the decline in the company’s ROE is mainly caused by a
decline in the EBIT margin (profitability) and asset turnover
(efficiency).
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TECHNIQUES
LOS 20.e: calculate and interpret ratios used in equity analysis
and credit analysis
Equity analysis: Valuation ratios
Analysts need to evaluate a company's performance in order to value a security.
One of their valuation methods is the use of valuation ratios.
Ratios Meaning
It basically tells us how much a share of common stock

(P/E)
is currently worth per dollar of earnings of the
company.
Cash flow is less subject to manipulation by

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

(P/S) manipulation than are other fundamentals.
• The ratio is used when a company does not have
positive net income.
Book value per share is more stable than EPS, P/BV

(P/BV) may be more meaningful than P/E when EPS is
abnormally high or low, or is highly variable.
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TECHNIQUES
and credit analysis
Equity analysis: Per-share quantities
Beside valuation ratios, per-share quantities are used to evaluate a company's
performance in order to value a security. First, we discuss about EPS
Basic EPS Where, Weighted average number of ordinary shares

= Number of outstanding ordinary shares x Time
weighting factor
Earnings per share (EPS)
• Dilutive securities include convertible debt and

convertible preferred stock, options & warrants.
Diluted EPS • is increased by the after-tax interest savings on any
dilutive debt securities and by the dividends on any
dilutive convertible preferred stock  Adjusted net
income
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TECHNIQUES
and credit analysis
Equity analysis: Per-share quantities (continued)
Next in per-share quantities section, we discuss the interpretation of the
dividend-related quantities
Term Definition Calculation
The percentage of earnings that

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

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

growth rate rate is viewed as a function of its
profitability (measured as ROE) SGR (g) = retention rate x
and its ability to finance itself ROE = (1 – dividend
from internally generated funds payout rate) x ROE
(measured as the retention rate)
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TECHNIQUES
and credit analysis
Equity analysis: Business risk
The standard deviation of revenue, standard deviation of operating income,
and the standard deviation of net income are all indicators of the variation in
and the uncertainty about a firm’s performance. Since they all depend on
the size of the firm to a great extent, analysts employ a size-adjusted
measure of variation. The coefficient of variation for a variable is its standard
deviation divided by its expected value.
Coefficient Calculation
Coefficient of variation
of operating income
of net income
.
of revenues
240

TECHNIQUES
and credit analysis
Equity analysis: Financial sector ratios
Regulated industries especially in the financial sector often are required to comply
with specific regulatory ratios. For example, the banking sector’s liquidity and cash
reserve ratios provide an indication of banking liquidity and reflect monetary and
regulatory requirements. Banking capital adequacy requirements attempt to relate
banks’ solvency requirements directly to their specific levels of risk exposure.
Capital adequacy
(of banks)
Monetary reserve
requirement
Liquid asset
requirement .
Net interest margin

241

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

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

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

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

margin • Calculation:
Segment • Usage: Measures overall efficiency means how much revenue is

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

ROA • Calculation:
Segment • Usage: Measures solvency of the segment.

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

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

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

analysis based on probability models for the
factors that drive outcomes.
Monte Carlo • Each event or possible outcome is assigned a
Simulation probability.
• Multiple scenarios are then run using the
probability factors assigned to the possible values
of a variable.
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TECHNIQUES
Practice questions
20a. describe tools and techniques used in financial analysis, N/A

including their uses and limitations
20b. identify, calculate, and interpret activity, liquidity, solvency, Question 1-5
profitability, and valuation ratios
20c. describe relationships among ratios and evaluate a company N/A
using ratio analysis
20d. demonstrate the application of DuPont analysis of return on N/A
equity and calculate and interpret effects of changes in its
components
20e. calculate and interpret ratios used in equity analysis and Question 6
credit analysis
20f. explain the requirements for segment reporting and calculate N/A
and interpret segment ratios
20g. describe how ratio analysis and other techniques can be Question 7
used to model and forecast earnings
245

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

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

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

A The company is becoming increasingly less solvent, as evidenced by the
increase in its debt-to-equity ratio from 0.35 to 0.50 from FY3 to FY5.
B The company is becoming less liquid, as evidenced by the increase in its
debt- to- equity ratio from 0.35 to 0.50 from FY3 to FY5.
C The company is becoming increasingly more liquid, as evidenced by the
increase in its debt- to- equity ratio from 0.35 to 0.50 from FY3 to FY5.
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TECHNIQUES
Practice questions
3 An analyst observes a decrease in a company’s inventory turnover.

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

the most recent fiscal year. Brown wants to improve its credit policies
and collection practices and decrease its collection period in the next
fiscal year to match the industry average of 15 days. Credit sales in the
most recent fiscal year were $300 million, and Brown expects credit
sales to increase to $390 million in the next fiscal year. To achieve
Brown’s goal of decreasing the collection period, the change in the
average accounts receivable balance that must occur is closest to:
A +$0.41 million.
B –$0.41 million.
C –$1.22 million.
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TECHNIQUES
Practice questions
5 Assuming no changes in other variables, which of the following would

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

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

A develop possibilities relying exclusively on the results of financial
analysis.
B use the results of financial analysis, analysis of other information,
and judgment.
C aim to develop extremely precise forecasts using the results of
financial analysis.
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TECHNIQUES
Practice answers
1. C is correct. Solvency ratios are used to evaluate the ability of a company
to meet its long-term obligations. An analyst is more likely to use activity
ratios to evaluate how efficiently a company uses its assets. An analyst is
more likely to use liquidity ratios to evaluate the ability of a company to
meet its short-term obligations.
2. A is correct. The company is becoming increasingly less solvent, as
evidenced by its debt- to- equity ratio increasing from 0.35 to 0.50 from
FY3 to FY5. The amount of a company’s debt and equity do not provide
direct information about the company’s liquidity position.
Debt to equity:
FY5: 2,000/4,000 = 0.5000
FY4: 1,900/4,500 = 0.4222
FY3: 1,750/5,000 = 0.3500
3. C is correct. The company’s problems with its inventory management
system causing duplicate orders would likely result in a higher amount of
inventory and would, therefore, result in a decrease in inventory turnover.
A more efficient inventory management system and a write off of
inventory at the beginning of the period would both likely decrease the
average inventory for the period (the denominator of the inventory
turnover ratio), thus increasing the ratio rather than decreasing it.
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TECHNIQUES
Practice answers
4. A is correct. The average accounts receivable balances (actual and desired)
must be calculated to determine the desired change. The average accounts
receivable balance can be calculated as an average day’s credit sales times
the DSO. For the most recent fiscal year, the average accounts receivable
balance is $15.62 million [= ($300,000,000/365) × 19]. The desired average
accounts receivable balance for the next fiscal year is $16.03 million (=
($390,000,000/365) × 15). This is an increase of $0.41 million (=
16.03 million – 15.62 million).
5. C is correct. Assuming no changes in other variables, an increase in average
assets (an increase in the denominator) would decrease ROA. A decrease
in either the effective tax rate or interest expense, assuming no changes in
other variables, would increase ROA.
6. A is correct. The P/E ratio measures the “multiple” that the stock market
places on a company’s EPS.
7. B is correct. The results of an analyst’s financial analysis are integral to the
process of developing forecasts, along with the analysis of other
information and judgment of the analysts. Forecasts are not limited to a
single point estimate but should involve a range of possibilities.
250
READING 21: INVENTORIES

251

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

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

21.i. describe the financial statement presentation of and disclosures

relating to inventories
We incorporates Los 21.d in the curriculum into los 21.c, and los 21.f to los 21.e
252

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

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

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

including companies that use different inventory methods
253

[LOS 21.a] Contrast costs included in inventories & costs
recognized as expenses in the period in which they are incurred
1. Definition, categories of inventories and costs
INVENTORIES
• Assets are held for sale in the ordinary course of business
• Assets are in the process of production for such sale; or
• Assets are in the form of materials or supplies to be consumed in the
production process or in the rendering of services.
CATEGORIES COSTING (see more in the next

• Raw materials: materials or slide)
substances used in the primary • Costing that will be capitalized
production or manufacturing of in inventory asset
goods • Costing that will be recognized
• Work-in-progress: Inventories in expenses
have started the conversion
process from raw materials but
are not yet finished goods ready
for sale
• Finished goods: goods ready for
sale
254

Contrast costs included in inventories & costs recognized as

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

Other cost
present location & condition.
255

Example: Identification of inventory cost

ABC Company manufactures a single product. Various costs incurred during
the year 2009 are listed here:
Cost of raw materials $12,000,000
Direct labor conversion costs $25,000,000
Production overheads $5,000,000
Freight charges for raw materials $2,000,000
Storage costs for finished goods $800,000
Abnormal wastage $80,000
Freight charges for finished goods $100,000
1. What costs should be included in inventory for 2009?
2. What costs should be expensed during 2009?
256

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

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

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

257

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

IFRS and US GAAP:
• Specific identification method
• First in first out (FIFO)
• Last in first out (LIFO)
• Weighted average cost
Note that, just US GAAP accept LIFO method while IFRS does NOT accept
LIFO methods.
• A company must use the same inventory valuation method for all
items that have a similar nature and use.
• For items with a different nature or use, a different inventory
valuation method can be used.
• Change in inventory valuation method is change in accounting policy
and must be adjusted retrospectively.
258

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

all inventory held
• Applied on such inventories which are interchangeable
259

formulas)
3 First in first out (FIFO)

First in Last in
4 5 5 8 8 8 9 9
First out
Cost of sales = 9
4 5
5 8 8 8 9 9
• The first items of inventory received are assumed to be the first ones
sold.
• The cost of closing inventory is the cost of the most recent purchases
of inventory
260

formulas)
4 Last in first out (LIFO)

First in Last in
4 5 5 8 8 8 9 9
First out
Cost of sales = 18
9 9
4 5 5 8 8 8
• The last items of inventory received are assumed to be the first ones
sold.
• The cost of closing inventory is the cost of the earliest purchases of
inventory
261

formulas)
5 Specific identification method
First in 4 5 5 8 8 8 9 9 Last in
Specific identification
Cost of sales = 13
5 8
4 5 8 8 9 9
• The cost of sales and the cost of ending inventory reflect the actual
costs incurred to purchase
• Applied on such inventories which are not interchangeable or
individually distinguishable & of high value or for goods or services
produced and segregated for specific projects make the sale.
262

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

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

inventory is inventory is inventory is reflects actual costs
composed of composed of composed of incurred to purchase or
units valued at units valued at units valued at manufacture the
average prices. most recent oldest prices specific units that
prices still remain in
inventory at the end of
the period
263

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

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

Specific
WAC FIFO LIFO
identification
264

1.
Example: cost of sales, gross profit and ending inventory balances under
4 valuation methods
Global Sales, Inc. (GSI) is a hypothetical Dubai-based distributor of
consumer products, including bars of luxury soap. The soap is sold by the
kilogram.
• GSI began operations in 20X8, during which it purchased and received
following order:
o Initially, 100,000 kg of soap at 110 dirham (AED)/kg,
o Then, 200,000 kg of soap at 100 AED/kg.
o Finally, 300,000 kg of soap at 90 AED/kg.
• GSI stores its soap in its warehouse so that soap from each shipment
received is readily identifiable.
• GSI sold 520,000 kg of soap at 240 AED/kg.
o 100,000 kg from the first shipment received.
o 180,000 kg of the second shipment received.
o 240,000 kg of the final shipment received.
What are the reported cost of sales, gross profit and ending inventory
balances for 20X8 under 4 valuation methods?
265

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

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

• P1: Price of inventory in Weighted average cost = [(100,000 × 110) + (200,000 × 100) + (300,000 ×
90)]/600,000 ≈ 97 AED
• P2: Value at most recent inventory , in this case it is value of goods in final shipment received = 90
• P3: Value at oldest inventory, in this case it is value of goods in first shipment received = 110
• P4, P5: Value of specified inventory in, in this case P5 = value of goods in third shipment received and
P4 = value of goods in second shipment received.
• Q: Total number of inventory at the end,
o Q1: Number of specified inventory in second shipment at the end
o Q2: Number of specified inventory in third shipment at the end
266

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

267

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

First in Last in First in Last in
10 9 8 7 6 10 9 8 7 6
First out
First out
Cost of sales = 19 Cost of sales = 13
10 9 7 6
Ending inventory = 21 Ending inventory = 27
8 7 6 10 9 8
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2.
In case of declining price (deflation) period

Ending inventory FIFO < Ending inventory LIFO because:
Ending inventory FIFO = Value of the most recent inventories < Value of the oldest
inventories = Ending inventory LIFO
Ending inventory FIFO < Ending inventory LIFO
COGS FIFO > COGS LIFO
Net profit FIFO < Net profit LIFO
Assets FIFO < Assets LIFO Equity FIFO < Equity LIFO
By contrast, in case of rising price (inflation period) , If entity uses LIFO method, it
will have lower total assets as well as lower total equity compare to FIFO
269

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

270

3 Perpetual and periodic inventory systems
Perpetual system: Value of inventory as well as COGS will be continuously updated after
each transaction sale/purchase. The ending inventory could be compared with physical
count to find the difference.
Update ending
Update purchase Update COGS inventory by
by transaction by transaction transaction
Beginning inventory Purchase COGS
Ending inventory
Beginning Purchase Sales Ending
COGS
Beginning inventory Purchase Ending inventory

Update purchase NOT update COGS Update ending
by transaction by transaction. inventory at the end
Calculate at the of period by physical
end of period. count
Periodic system: Value of inventory and COGS will be updated at the end of period after
physical counting inventory
271

[LOS 21.e] Explain LIFO reserve and LIFO liquidation and their
effects on financial statements and ratios
1 LIFO reserve
For companies using the LIFO method, US GAAP requires disclosure the
amount of the LIFO reserve in the notes to the financial statements or on
the balance sheet.
The LIFO reserve is the difference between the inventory balance

shown on the balance sheet and the amount that would have been
reported had the firm used FIFO. That is:
LIFO reserve = Inventory FIFO - Inventory LIFO
To compare companies using LIFO with companies not using LIFO

272

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

inventory value
COGS Explanation for formula:

COGS FIFO = Beginning inventory FIFO + Purchase –
Ending inventory FIFO
Net incomes
 COGS FIFO = (Beginning inventory LIFO + LIFO
Retained earnings reserve beginning) + Purchase – (Ending inventory
(RE) LIFO + LIFO reserve ending)
 COGS FIFO = (Beginning inventory LIFO + Purchase

Deffered tax – Ending inventory LIFO) – (LIFO reserve ending –
liabilities
LIFO reserve beginning)
 COGS FIFO = COGS LIFO - Change in LIFO reserve
273

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

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

Net incomes
COGS FIFO = COGS LIFO - Change in LIFO
Retained earnings reserve
(RE)
EBTFIFO = EBTLIFO + Change in LIFO reserve
Deffered tax
liabilities
Net income FIFO = Net income LIFO + Change
in LIFO reserve x (1 - Tax rate)
Taking account of tax effect
274

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

inventory value
Net income FIFO REFIFO

Net incomes
Retained Net income LIFO RELIFO

earnings (RE)
Deffered tax Change in LIFO

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

changes in LIFO reserve
275

Difference in DTLFIFO = DTLLIFO + LIFO reserve x tax rate

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

(RE) Tax payable Tax payable LIFO reserve
FIFO LIFO
x Tax rate
Deffered tax
liabilities (DTL)
Incomes Tax Expense
LIFO reserve
DTLFIFO DTLLIFO
x tax rate
276

3 LIFO liquidations
Assumption
LIFO liquidations may arise in periods of rising inventory unit costs
Definition: LIFO liquidations occur when a firm using LIFO sells more
inventory during a period than it produces The COGS figure no longer
reflects the current cost of inventory sold, and leads to higher but not
stable profit.
Assume rising prices, consider company A under 2 scenarios:
1 It produces 2 items in a year 2 No items are produced
Beginning inventory Produced Beginning inventory
Last in Last in
6 7 8 9 10 6 7 8
First out
First out
Higher COGS Lower COGS
Cost of sales = 19 Cost of sales = 15
9 10 7 8
No longer
Ending inventory = 21 COGS reflects the Ending inventory = 6 reflects the
current cost of current cost of
6 7 8 6
inventory sold inventory sold
277

3 LIFO liquidations
• Indication: A decline in the LIFO reserve from the prior period may be
indicative of LIFO liquidation.
• Reasons that lead to LIFO liquidation:
o Reasons outside the management control: Labour strikes at a
supplier company has reduce inventory levels.

o Reasons arising from the management control:
 Economic recession or declining customer demand company
choose to reduce existing inventory levels rather than invest in
new inventory
 Earnings management: The company intentionally reducing
inventory quantities and liquidating older layers of LIFO
inventory to inflate earnings.
• Analytical implication: If LIFO layers of inventory are temporarily

depleted and not replaced by fiscal year-end, LIFO liquidation will
occur resulting in unsustainable higher gross profits.
We should review the LIFO reserve footnote disclosures to determine if
LIFO liquidation has occurred.
278

3 LIFO liquidations
Example: LIFO liquidations

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

produced during 20X7. During 20X7, Big 4 sold 280 units. In the absence
of the strike, Big 4 would have had a cost of $14 for each unit
produced. Compute the extra profit that resulted from the inventory
liquidation.
279

3 LIFO liquidations
Solution:
We calculate the COGS under 2 scenarios:
1. The strike did not occurred and the company produced 280 items, the
amount of goods that it sold in 20X7
2. The strike occurred and no items were produced in the year
1 In the absent of the strike 2 The strike occurred
Beginning inventory Produced Beginning inventory
Last in Last in
120x10 140x11 140x12 280x14 120x10 140x11 140x12
First out
First out
Higher COGS Lower COGS
Cost of sales = 3,920 Cost of sales = 3,320
280x14 140x11 140x12
Ending inventory = 4,420 Ending inventory = 1,200
120x10 140x11 140x12 120x10
Due to the LIFO liquidation, COGS was lower by $700 ($3,920 – $3,220);
thus, pretax profit was higher by $700.
280

3 LIFO liquidations
Solution:
We calculate the COGS under 2 scenarios:
1. The strike occurred and no items were produced in the year
2. The strike did not occurred and the company produced 280 items, the
amount of goods that it sold in 20X7
The strike occurred In the absent of the strike
Beginning 120x10+140x11+ 140x12 = 4,420
Purchase Value = Q x P = 0 Value = Q x P = 280 x 14 = 3,920
Σ PxQ V Σ PxQ V
Ending
120x10 1,200 120x10+140x11+ 140x12 4,420
COGS 3,220 3,920
Due to the LIFO liquidation, COGS was lower by $700 ($3,920 – $3,220); thus,
pretax profit was higher by $700.
The higher profit is unsustainable because Big 4 will need to produce units at
the new higher cost in future periods.
281

4 Effects on ratios
In the case of rising prices:

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

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

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

Solvency stockholders’ equity (assets - liabilities)  lower debt ratio
and the debt-to-equity ratio under FIFO
282

The conversion of a company’s reported financial

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

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

comparing a company’s performance with that of its industry or those of
its competitors.
283

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

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

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

Lower of
value NRV = Selling price – Completion cost & Selling cost
• The value of inventory is lower than cost, or we can say that inventory is “written
down”
• Recognize an expense = Cost – NRV (or Market value) in the I/S
284

Example: Inventory written down

Zoom, Inc., sells digital cameras. Per-unit cost information pertaining to
Zoom’s inventory is as follows:
Original cost $210
Estimated selling price $225
Estimated selling costs $22
Net realizable value $203
Replacement cost $197
Normal profit margin $12
What are the per-unit carrying values of Zoom’s inventory using lower
of cost or NRV and lower of cost or market?
285

Example: Inventory written down

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

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

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

Inventory of Market value = Mid value of (NRV – normal profit
value margin; Replacement cost; NRV) = Mid value of
($191; $197; $203) = $197
o The inventory is written down to $197
o The $13 loss ($197 replacement cost – $210 original cost) is reported
in the income statement.
286

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

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

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

turnover ratio
Total assets Higher Lower

turnover ratio
287

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

made.
• Under IFRS: Reversal is required for a subsequent increase in value of
inventory previously written down; and recognize a gain on the I/S.
• Under US. GAAP: Reversal is not allowed.
Note: The increase in value that can be recognized is limited to the total write-
down that had previously been recorded
Write-down Reversal
Ending Inventory Lower Higher
Assets Lower Higher
COGS Higher Lower
Gross/net profit Lower Higher
Retained earnings Lower Higher
Effects on ratio:
Profitability, Solvency, Total assets turnover, inventory turnover
288

4 Reversal of value of inventory
Example: Inventory reversal

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

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

289

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

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

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

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

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

(revenue/total assets) • Total assets decrease
290

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

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

securities for liabilities
Cost of inventories recognized as expense

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

Presentation & that requirements for reversal, and add disclosures
disclosure of significant estimates and material amounts.
291

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

by inventory turnover.
Number of days of inventory =
Inventory turnover measures how fast a company moves its inventory

through the system.
Inventory turnover =
If a company has a higher inventory turnover ratio and a lower number of days
of inventory than the industry average, it could mean one of three things:
• It could indicate that the company is more efficient in inventory
management, as fewer resources are tied up in inventory.
• It could also suggest that the company does not carry enough inventory at
any point in time, which could hurt sales.
• It could also mean that the company might have written down the value of
its inventory.
292

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

net income as opposed to covering the cost of sales
Gross profit margin =
• Firms in relatively competitive industries have lower gross profit margins.

• Firms selling luxury products tend to have lower volumes and higher gross
profit margins.
• Firms selling luxury products are likely to have lower inventory turnover
ratios.
Example: Inventory analysis

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

293

of information
Example: Inventory analysis (cont)

Rely on above information, Comment on the changes in Atlas’s financial
statement ratios from 2007 to 2008.
Solution:
• The inventory turnover ratio declined (from 6.71 in 20X7 to 6.11 in
20X8) and the number of days of inventory increased (from 54.4 days
to 59.7 days).
The company has been less efficient in managing its inventory in 2008
as compared to 2007.
• The gross profit margin improved by 2.5% from 24.8% in 2007 to 27.3%
in 2008.
The company did well in managing its cost of goods sold or that a
company can make a reasonable profit on sales.
294

LOS 21.k: calculate and compare ratios of companies, including
companies that use different inventory methods
The following table will show the comparison between LIFO and FIFO with
Rising Prices and Stable Inventory Levels
Effect on Effect on Effect on

Type of Ratio Numerator Denominator Ratio
Net and Gross Income is lower under LIFO Sales remain the Lower under
profit margins because COGS is higher same LIFO
Debt-to-equity & Same debt levels Lower equity and Higher under
Debt ratio assets under LIFO LIFO
Current assets are lower Lower under

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

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

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

Sales are the same
turnover LIFO LIFO
295

[LOS 21.l] analyze and compare the financial statements of
companies, including companies that use different inventory
methods
1 Income statement and statement of cash flow
SOCI SOCF
Methods Gross Tax expense Net income CF from

profit
(1) (2) operating (3)
(LOS 21c)
LIFO Lower Lower Lower Higher
FIFO Higher Higher Higher Lower
Explanation of trends in items:

• In LOS 21c, we have Gross profit FIFO > Gross profit LIFO
Gross profit FIFO - other expense > Gross profit LIFO - other expense
EBTFIFO > EBTLIFO and Net income FIFO > Net income LIFO (2)
Tax expense FIFO > Tax expense LIFO (1)
• In LOS 21c, we have Ending inventory FIFO > Ending inventory LIFO
While Beginning inventory FIFO = Beginning inventory LIFO
 Increase in inventory FIFO > Increase in inventory LIFO
 Cash flow from operating FIFO < Cash flow from operating LIFO (3)
296

[LOS 21.l] analyze and compare the financial statements of
companies, including companies that use different inventory
methods
2 Balance sheet
SOFP
Methods Ending Working Total Retained

Owner’s
inventory capital assets earnings equity (6)
(LOS 21c) (4) (LOS 21e) (5)
LIFO Lower Lower Lower Lower Lower
FIFO Higher Higher Higher Higher Higher
Explanation of trends in items:

• Working capital = Current assets – Current liabilities
Ending inventory FIFO > Ending inventory LIFO
 Current assets FIFO > Current assets LIFO
 Working capital FIFO > Working capital LIFO (4)
• Net income FIFO > Net income LIFO
 Retained earnings FIFO > Retained earnings LIFO (5)
 Owner’s equity FIFO > Owner’s equity LIFO (6)
297

Practice questions
21a. Contrast costs included in inventories and costs recognized Question 1
as expenses in the period in which they are incurred.
21b. Describe different inventory valuation methods (cost Question 4
formulas)
21c. Calculate and compare cost of sales, gross profit, and ending N/A
inventory using different inventory valuation methods and using
perpetual and periodic inventory systems
21d. Calculate and explain how inflation and deflation of Question 6
inventory costs affect the financial statements and ratios of
companies that use different inventory valuation methods
21e. Explain LIFO reserve and LIFO liquidation and their effects on Question 3, 8
21f. demonstrate the conversion of a company’s reported Question 7
financial statements from LIFO to FIFO for purposes of
comparison
21g. describe the measurement of inventory at the lower of cost Question 5
and net realizable value
298

Practice questions
21h. describe implications of valuing inventory at net realizable N/A
value for financial statements and ratios
21i. describe the financial statement presentation of and N/A
disclosures relating to inventories
21j. explain issues that analysts should consider when examining Question 2
a company’s inventory disclosures and other sources of
information
21k. calculate and compare ratios of companies, including N/A
companies that use different inventory methods
21l. analyze and compare the financial statements of companies, N/A
including companies that use different inventory methods
299

Practice questions
1 Inventory cost is least likely to include:

A production-related storage costs.
B costs incurred as a result of normal waste of materials.
C transportation costs of shipping inventory to customers.
2 During periods of rising inventory unit costs, a company using the FIFO
method rather than the LIFO method will report a lower:
A current ratio.
B inventory turnover.
C gross profit margin.
3 A company using the LIFO method reports the following in £:

2007 2008
COGS 50,800 48,500
Ending inventories 10,550 10,000
LIFO reserve 4,320 2,600
Cost of goods sold for 2018 under the FIFO method is closest to:
A £48,530.
B £49,080.
C £52,520.
300

Practice questions
4 Eric’s Used Book Store prepares its financial statements in accordance
with IFRS. Inventory was purchased for £1 million and later marked
down to £550,000. One of the books, however, was later discovered to
be a rare collectible item, and the inventory is now worth an estimated
£3 million. The inventory is most likely reported on the balance sheet
at:
A £550,000.
B £1,000,000.
C £3,000,000.
5 Fernando’s Pasta purchased inventory and later wrote it down. The
current net realisable value is higher than the value when written down.
Fernando’s inventory balance will most likely be:
A higher if it complies with IFRS.
B higher if it complies with US GAAP.
C the same under US GAAP and IFRS..
6 Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method.
Compared to the cost of replacing the inventory, during periods of rising
prices the ending inventory balance reported by (assume the company
use a periodic inventory system):
A Zimt is too high.
B Nutmeg is too low.
C Nutmeg is too high.
301

Practice questions
7 Compared with a company that uses the FIFO method, during a period
of rising unit inventory costs, a company using the LIFO method will
most likely appear
more:
A liquid.
B efficient.
C profitable.
8 Bangor Company discloses that its LIFO reserve was $625,000 at the
end of the previous year and $675,000 at the end of the current year.
For the current year, beginning inventory was $2,350,000 and ending
inventory was $2,525,000. The firm’s tax rate is 30%. What would
Bangor’s ending inventory have been using FIFO?
A. $2,575,000.
B. $2,997,500.
C. $3,200,000.
302

Practice answer
1. C is correct. Transportation costs incurred to ship inventory to customers
are an expense and may not be capitalized in inventory. (Transportation
costs incurred to bring inventory to the business location can be
capitalized in inventory.) Storage costs required as part of production, as
well as costs incurred as a result of normal waste of materials, can be
capitalized in inventory. (Costs incurred as a result of abnormal waste must
be expensed.).
2. B is correct. During a period of rising inventory costs, a company using the
FIFO method will allocate a lower amount to cost of goods sold and a
higher amount to ending inventory as compared with the LIFO method.
The inventory turnover ratio is the ratio of cost of sales to ending
inventory. A company using the FIFO method will produce a lower
inventory turnover ratio as compared with the LIFO method. The current
ratio (current assets/current liabilities) and the gross profit margin [gross
profit/sales = (sales less cost of goods sold)/sales] will be higher under the
FIFO method than under the LIFO method in periods of rising inventory
unit costs.
3. B is correct. The adjusted COGS under the FIFO method is equal to COGS
under the LIFO method less the increase in LIFO reserve:
COGS (FIFO) = COGS (LIFO) – Increase in LIFO reserve
COGS (FIFO) = £50,800 – (£4,320 – £2,600)
COGS (FIFO) = £49,080
303
READING 18: UNDERSTANDING BALANCE

SHEET
Practice answers
4. B is correct. Under IFRS, the reversal of write- downs is required if net
realisable value increases. The inventory will be reported on the balance
sheet at £1,000,000. The inventory is reported at the lower of cost or net
realisable value. Under US GAAP, inventory is carried at the lower of cost
or market value. After a write- down, a new cost basis is determined and
additional revisions may only reduce the value further. The reversal of
write-downs is not permitted.
5. A is correct. IFRS require the reversal of inventory write- downs if net

realisable values increase; US GAAP do not permit the reversal of write-
downs.
6. B is correct. Nutmeg uses the LIFO method, and thus some of the
inventory on the balance sheet was purchased at a (no longer available)
lower price. Zimt uses the FIFO method, so the carrying value on the
balance sheet represents the most recently purchased units and thus
approximates the current replacement cost.
304
READING 18: UNDERSTANDING BALANCE

SHEET
Practice answers
7. B is correct. During a period of rising inventory prices, a company using the
LIFO method will have higher cost of cost of goods sold and lower
inventory compared with a company using the FIFO method. The
inventory turnover ratio will be higher for the company using the LIFO
method, thus making it appear more efficient. Current assets and gross
profit margin will be lower for the company using the LIFO method, thus
making it appear less liquid and less profitable.
8. C is correct. FIFO inventory = LIFO inventory + LIFO reserve = $2,525,000 +

$675,000 = $3,200,000.
305
READING 22: LONG-LIVED

ASSETS
306
READING 22: LONG-LIVED ASSETS

Learning outcomes
22.a. identify and contrast costs that are capitalised and costs that are expensed in
the period in which they are incurred
22.b. explain and evaluate how capitalising versus expensing costs in the period in
which they are incurred affects financial statements and ratios
22.c. Definition and classification of long-lived assets
22.d. Measurement of long-lived assets
22.e. Impairment and derecognition of long-lived assets
22.f. Depreciation and amortization of long-lived assets
22.g. Describe the financial statement presentation of and disclosures relating to

property, plant, and equipment and intangible assets.
22.h. Analyze and interpret financial statement disclosures regarding property, plant,
and equipment and intangible assets
22.i. Compare the compare the financial reporting of investment property with that
of property, plant, and equipment.
We changed the LOS order that is presented in Curriculum and Schweser Notes
307

LOS 22.a: Identify and contrast costs that are capitalised and
costs that are expensed in the period in which they are
incurred
When a company makes an expenditure
Capitalize the cost as an asset Expense the cost in the

on the balance sheet if it is income statement if it is
expected to provide a future expected to provide economic
economic benefit over multiple benefits in only the current
accounting periods. period. (*)
In Los 22a and los 22b we are going to address two questions
about expensed costs and capitalized costs, which is:
1. Los 22a: What is the accounting treatment of capitalized costs
and expensed costs?
2. Los 22b: What is the effect of capitalizing versus expensing on
308

incurred
1. Accounting treatment of capitalized costs and expensed costs
Capitalized Costs Expensed Costs
• A capitalized cost is recognized • Current period pretax income

as a noncurrent asset on the is reduced by the amount of
balance sheet. the expenditure
• The associated cash outflow is • The associated cash outflow is
listed under investing activities classified under operating
(CFI) on the statement of cash activities (CFO) on the
flows. statement of cash flows.
• In subsequent periods, the • No related asset is recognized
capitalized amount is allocated on the balance sheet, so no
(expensed) over the asset’s related depreciation or
useful life as depreciation amortization charges are
expense (for tangible assets) or incurred in future periods.
amortization expense (for
intangible assets with finite
lives).
See example in the next slide. See example in the next slide.
309

incurred
1. Accounting treatment of capitalized costs and expensed costs
Example
Capitalized Costs Expensed Costs
Company A bought an equipment that Company B incurred a $15m

costs $15m and it is expected to bring maintenance expense of an equipment
benefit in the next periods. It estimates and decided that the expense is
the useful life to be 3 years and the expected to provide economic benefits
salvage value to be zero. A uses the in only the current period.
straight line depreciation method. Therefore, it expense the entire
Treatment: amount of $15m in the 1st year.
• Capitalise a non-current asset in the Treatment:
B/S. • The company expenses the entire
Non-current asset: $15m cost of the assets of $15m in year
• The expense is allocated over 3 1.
years as depreciation expense.
Year 1 2 3 Year 1 2 3
Expense (depreciation ) $5 $5 $5 Expense $15 $0 $0

310

incurred
2. Capitalising Interest expense
• When a firm constructs an asset for its own use or, in

limited circumstances, for resale, the interest that
Accounting accrues during the construction period is capitalized as a
treatment part of the asset’s cost.
• The treatment of construction interest is similar under
U.S. GAAP and IFRS.
Once construction interest is capitalized, the interest cost is

Effect on I/S allocated to the income statement through depreciation
expense (if the asset is held for use), or COGS (if the asset is
held for sale).
Effect on Capitalized interest is reported in the cash flow statement as
statement of an outflow from investing activities
cashflow
• Both capitalized and expensed interest should be used

Analytical when calculating interest coverage ratios.
• Any depreciation of capitalized interest on the income
implication
statement should be added back when calculating
income measures
311

LOS 22.b: Explain and evaluate how capitalising versus
expensing costs in the period in which they are incurred
affects financial statements and ratios
Continue with the example in Los 22.a, we will demonstrate a shorted version of financial
statements of company A and B to see the difference between the effects of capitalized and
expensed costs. Assume that both company have a gross profit of $50 each year over three
years and the tax rate is equal to 0%. A and B both pay no dividends during that 3-year
period. The beginning balance of retained earning (RE) is $0.
Company A Company B
(Capitalized Costs) (Expensed Costs)
Year 1 2 3 1 2 3
Cost $15 $15 $15 $0 $0 $0
Effect on
asset (BS) Accumulated Dep. ($5) ($10) ($15) $0 $0 $0
Long-lived assets (CA) $10 $5 $0 $0 $0 $0
Year 1 2 3 1 2 3
Effect on
income Expense $5 $5 $5 $0 $0 $0
(PL) Net income impact $5 $5 $5 $15 No impact
Year 1 2 3 1 2 3
Effect on RE impact $5 $5 $5 $15 No impact
equity Net income $45 $45 $45 $35 $50 $50
RE balance $45 $90 $135 $35 $85 $135
Year 1 2 3 1 2 3
Effect on CFO $0 $0 $0 ($15) $0 $0
cash flow
CFI ($15) $0 $0 $0 $0 $0
312

1. Effect on Financial Statements
A recognized greater asset compared to B.

Effect on Capitalization results in higher asset compared to immediately expensing
asset (BS) in the period that the expense is capitalized, and it continues to be higher
in the subsequent years.
• A allocated the expense in 3 years and only recognized $5 in the first

year,
• B recognized the total amount of the expense in the first year ($15)
Effect on
Capitalizing an expenditure could:
income
• delays the recognition of an expense into the income statement.
(PL)
• makes the net income higher in the period that it is capitalized, but in
the subsequent periods, it will report lower net income compared to
intermediate expensing.
When capitalizing the expenditure, retained earnings (equity) are higher

Effect on
in the period that the expense is capitalized, and it continues to be higher
equity
in the subsequent years.
Effect on Capitalizing an expenditure will result in higher operating cash flow and
equity lower investing cash flow compared to expensing.
313

6. Effect on financial ratio
Profitability ratio
As mentioned before, if a company capitalizes costs, compared to
immediately expensing:
First year Subsequent years
Net income higher lower

Assets higher higher
Owner’s equity higher higher
ROE (*) higher lower
ROA (*) higher lower
(*) ROA = ROE =

314

Solvency ratio
Debt the same the same

Owner’s equity higher higher
Debt-to-equity (*) lower lower
Debt-to-asset (*) lower lower
(*) Debt-to-asset ratio = Debt-to-equity ratio =

315

Solvency ratio
EBIT higher lower

Interest expense lower higher
Interest coverage (*) higher lower
(*) Interest coverage =

316

LOS 22.b: Explain and evaluate how capitalizing versus
Activity ratio
First year Subsequent year
Revenue the same the same

Total asset turnover (*) lower lower
(*) Total asset turnover =

317

LOS 22.c: Definition and classification of long-lived assets
Long-lived assets
Tangible assets Intangible assets

Long-term assets Long-term assets that lack physical substance
that have physical and include items that involve exclusive rights
substance. such as patents, copyrights, and trademarks.
Example: Land, Intangible assets can be classified as:
plant, machinery, • Intangible asset with a finite life
equipment • Intangible asset with an indefinite life
Or
• Identifiable intangible assets (*)
• Unidentifiable intangible assets (**)
(*) Identifiable intangible assets
• They must be identifiable.
• They must be under the company’s control.
• They must be expected to earn future economic benefits.
(**) Unidentifiable intangible asset
One that cannot be purchased separately and may have an indefinite
life (goodwill).
318

LOS 22.c: Recognition of long-lived assets
1. Tangible assets
a. Tangible assets acquired through an exchange
If the fair value of the If the fair value of the

acquired asset can be acquired asset cannot be
determined determined
• Remove the carrying • Remove the carrying

amount of the asset given amount of the asset given
On balance up from noncurrent assets up from noncurrent assets
sheet on the balance sheet on the balance sheet
• Add the fair value of the • Add the fair value of the
asset acquired asset given up
• If the fair value of the asset • No gain or loss is

acquired is greater/lower recognized.
On income than the value of the asset • No gain or loss is
statement given up, a gain/loss is recognized.
recorded on the income
statement.
319

1. Tangible assets
b. Tangible assets acquired through purchase
Expenditures Capitalized Expensed
The purchase price x
Expenses other than the purchase price x

(e.g., costs of shipping and installation and
other costs necessary to prepare the
asset for its intended use)
Subsequent expenses that are expected x

to provide economic benefits beyond
one year
Subsequent expenses that are not x

expected to provide economic benefits
beyond one year (e.g. repair costs)
Expenditures that extend an asset’s x

useful life
320

2. Intangible assets
a. Intangible Assets Created Internally
Treatment under IFRS
Expenditure Capitalized Expensed
On research phase (*) x

On development phase (**) x
(*) The research phase of an internal project refers to the period during which a
company cannot demonstrate that an intangible asset is being created.
(**) The development phase of an internal project refers to the period during
which a company can apply the research findings to a plan or design for
production.
There are some criteria to recognize a period as the development phase:
• A demonstration of the technical feasibility of completing the intangible
asset
• The intent to use or sell the asset.
321

Treatment under US GAAP
Both research and development costs are generally expensed as

incurred.
There is an exception for costs related to software development.
Software for sale

When the product’s technological
feasibility has not been established x
When the product’s technological

feasibility has been established x
322

Treatment under US GAAP
Exception about software (continued)

Software for internal use

When it is not probable that the project
will be completed and that the software x
will be used as intended
When it is probable that the project will
be completed and that the software will x
be used as intended
Note: The logic in the treatment of software development costs under U.S.
GAAP is similar to the treatment of all costs of internally developed intangible
assets under IFRS.
323

b. Purchased Intangible Assets
Intangible assets purchased Intangible assets purchased as a

individually group
Capitalized – The assets are Capitalized - The assets are

recorded on the balance sheet at recorded on the balance sheet
cost. after allocating the purchase
price to each asset on the basis
of its fair value.
(See the example below)
Example:
AFS Co., a manufacturing company buys a group of intangible assets which
consists of A, B and C, with a purchase price of $30 million. The fair value of
them is correspondingly $7, $8, and $9 million. How will these assets be
recorded on the company’s balance sheet?
324

b. Purchased Intangible Assets
Example (cont):
As stated above, the total purchase price is allocated to each asset on the basis
of its fair value.
A is recorded on the B/S at:
= 8.75 ($ mil)
B is recorded on the B/S at: = 10 ($ mil)
B is recorded on the B/S at: = 11.25 ($ mil)
325

c. Intangible Assets Obtained in a Business Combination
The acquisition method is used to record intangible assets obtained in

a business combination.
the purchase price is allocated to the identifiable assets
Illustration: Intangible Assets obtained when A acquires B
1 Classification of the acquiree company’s assets (Company B)
Identifiable assets Unidentifiable assets
2 Calculating goodwill
B’s net assets = B’s identifiable assets - B’s Liability
Goodwill = purchase price - B’s net assets
3 Record the acquiree’s assets on the acquirer’s balance sheet
On A’s balance sheet

• Record B’s asset at fair value
• Record B’s liability at fair value
• Record a goodwill calculated in step 2.
326

LOS 22.d: Measurement of long-lived assets
Herein this part 2 primary models to measure long-lived assets are
introduced:
• Cost model (required under both US GAAP and IFRS)
• Revaluation model (only permitted under IFRS)
Cost model Revaluation model
Carrying value Carrying value

= =
Original cost Fair value
- -
accumulated depreciation accumulated depreciation
- -
Impairment charges Impairment charges
327

1. Cost model
Cost model is the model where the carrying amount of an asset

equals its historical cost minus accumulated depreciation/
amortization:
Carrying amount = original cost – accumulated

depreciation (*) – impairment charges
(*)
• The accumulated year-end depreciation equals total
depreciation charged against the asset till the end of the
current period.
• Depreciation charge depends on the depreciation method
(Specialized in LOS d)
328

1. Cost model
Example: An asset is purchased by company A at a cost of $10.

The company uses the straight-line depreciation method, salvage
value is equal to 0 and the useful life of the asset is 5 years. What
is the carrying amount of the asset at the end of year 2, assumed
that there is no impairment charges?
Answer:
The accumulated year-end depreciation equals total depreciation
charged against the asset till the end of the current period.
Year 1 Year 2 Year 3 Year 4 Year 5
Cost 10 10 10 10 10
Depreciation (2) (2) (2) (2) (2)

Accumulated
(2) (4) (6) (8) (10)
depreciation
Carrying value 8 6 4 2 0
329

2. Revaluation model
Initial measurement Subsequent measurement
test
Use the cost model
Use the cost model
or revaluation model
• Under the revaluation model, the carrying amount of an

asset is reported at its fair value on the date of revaluation
minus any subsequent accumulated depreciation and
subsequent impairment.
• Revaluation model is only allowed under IFRS.
Carrying amount = fair value – accumulated depreciation

– impairment charges
Important: In the scope of CFA Curriculum:

For revaluation model only, to simplify, we assume that there is no
depreciation, amortization or impairment during the life of the long-lived
assets.
330

a. The case of gain in the initial revaluation
Initial revaluation (1) Subsequent revaluation (2)
Fair value > CA (initial gain) • Fair value > CA (subsequent gain)
Fair value Fair value
Carrying amount Revaluation RS

surplus Carrrying amount
CA , RS
• Asset: Carrying amount (CA) • Fair value < CA (subsequent loss)
• Equity: Revaluation surplus (RS) o Loss < the previous gain:
Fair value
Carrrying amount
CA , RS
o Loss > the previous gain:
Fair value
loss No RS
Carrrying amount
CA , RS = 0, P&L loss
331

b. The case of loss in the initial revaluation
Initial revaluation (1) Subsequent revaluation (2)
Fair value < CA (Initial loss) • Fair value < CA (subsequent loss)
Fair value
Fair value loss Loss
Carrying amount Carrying amount

CA , loss
• Asset: Carrying amount
• P&L: Recognize a loss on the I/S • Fair value > CA (subsequent gain)
o Gain < the previous loss:
Fair value
Carrying amount Gain

CA, gain on I/S
o Gain > the previous loss:
Fair value
RS
Carrying amount Gain
CA, gain on I/S till initial loss, RS

332

c. Ilustration of the revaluation model
Example: Illustration of the revaluation model

A company purchases an asset for $10,000. After one year, it determines
that the value of the asset is $8,000 and another year later it determines
that the fair value of the asset is $15,000. Assuming that the company
follows the revaluation model to report this asset, describe the financial
statement impact of the revaluation in Year 1 and Year 2.
We present the answer in the next slide.
333

c. Ilustration of the revaluation model
Example: Illustration of the revaluation model (cont)
Initial revaluation (1) Subsequent measurement (2)
Fair value ($8,000) < carrying • Fair value ($15,000) > carrying
amount ($10,000) initial loss: amount ($8,000) subsequent
$8,000 gain
Loss = $2,000
• Gain = $15,000 - $8,000 =
$7,000 > previous loss ($2,000)
$10,000 $15,000
• Carrying amount of the asset
becomes $8000 RS
$8,000 $2,000 $5000
• Recognize a loss on the I/S, loss =
$2,000 o PnL gain = $2,000
o Revaluation surplus $5,000
($7,000-$2,000)
o , becomes $15,000
334

d. Evaluate how asset’s upward revaluation affect financial statement and

ratios
• The period in which an asset is revaluated upward
Carrying amount of the asset Revaluation surplus
Asset Equity
Lower leverage ratios, D/A and D/E
• The period after the upward revaluation
Asset Depreciation expense Equity
Profit
ROA, ROE
335

LOS 22.e: Depreciation and amortization of long-lived assets
Depreciation Methods and Calculation of Depreciation
1. Expense
a. Depreciation Methods
Straight-Line Depreciation
Under the straight-line method, the cost of the asset is allocated evenly
across its estimated useful life.
Depreciation expense =
The residual value is the estimated amount that will be received from
disposal of the asset at the end of its useful life.
(Refer to the example presented in LOS 22.c: Measurement of long-lived
assets, session 1. Cost model)
336


1. Expense
Accelerated Depreciation
• Under accelerated depreciation methods, the allocation of depreciable
cost is greater in the early years of the asset’s use.
• One often-used accelerated depreciation method is the double-
declining balance (DDB) method:
Double declining balance depreciation in year x
= x Beginning book value
• Note that:
o Salvage value is not in the formula for double-declining balance
depreciation.
o Once the carrying (book) value of the asset reaches the salvage
value, no additional depreciation expense is recognized.

337

1. Expense
Example: Illustration of calculating double declining balance

depreciation expense
Company A purchases an identical piece of manufacturing equipment for
use in their operations. The cost of the equipment is $3,000, the
estimated salvage value is $200, and the useful life of the equipment is 4
years. Calculate each company’s beginning net book value, annual
depreciation expense, end-of-year accumulated depreciation, and ending
net book value for each year.
Answer:
Double declining balance depreciation in year x
= x Beginning book value
Therefore, depreciation charges:
Year 1 = (2/4) x $3,000 = $1,500;
Year 2 = (2/4) x ($3000 - $1,500) = $750
Year 3 = (2/4) x ($3000 - $1500 - $750) = $375
Year 4 = (2/4) x ($3000 - $1500 - $750 - $375) = $187.50
If depreciation charge of year 4 is $187.50, the year-end carrying amount would be
$187.50 < salvage value ($200) We have to adjust depreciation expense.
The amount of depreciation charged should be: beginning book value of year 4
($3000 - $1500 - $750 - $375 = $375) – salvage value = $375 - $200 = $175
338

1. Expense
Example: Illustration of calculating double declining balance

depreciation expense (cont)
3. Beginning book
2. Adding up value minus
depreciation till the end depreciation expense
1. Use the formula
of the current period (3) = (4)-(1)
Beginning Depreciation Expense $ Accumulated Ending Net

Net Book (1) Depreciation $ Book Value $
Value $ (4) (2) (3)
Year 1 3,000 1,500 = (2/4) x $3,000 1,500 1,500
Year 2 1,500 750 = (2/4) x $1,500 2,250 750
Year 3 750 375 = (2/4) x $750 2,625 375
Year 4 375 175 = 375 - 200 2,800 200
4. Balancing figure
339

1. Expense
Units-of-production method
Depreciation under the units-of-production method is based on usage
rather than time. Depreciation expense is higher in periods of high usage.
Units-of-production depreciation
=
340


1. Expense
Component Depreciation
• IFRS requires firms to depreciate the components of an asset
separately, thereby requiring useful life estimates for each component.
For example, a building is made up of a roof, walls, flooring, electrical
systems,… the useful life of each component is estimated and
depreciation expense is computed separately for each. See the example
below.
Example: Illustrating the calculation of component depreciation

expense
Global Airlines purchased a new airplane with an all-inclusive cost of $50
million, in which $47 million is the cost of aircraft component and $3 is
the cost of the interior. The useful life of the two is 30 years and 15 years,
respectively, and assume that the salvage value is equal to zero. Calculate
depreciation expense in year 1 using the straight-line method, assuming
the interior is a separate component.
341


1. Expense
Example: Illustrating the calculation of component depreciation

expense
• Depreciation expense of aircraft component in year 1:
Depreciation expense = = = 1.56 (mil $)
• Depreciation expense of the interior component in year 1:
Depreciation expense = = = 0.2 (mil $)
Year 1 depreciation expense = Depreciation expense of aircraft

component in year 1 + Depreciation expense of the interior component
in year 1 = 1.56 + 0.2 = 1.76 ($ mil)
342

1. Expense
b. The choice of depreciation method and assumptions
Depreciation method:
In the early years of an asset’s life, compared to straight-line
depreciation, using an accelerated depreciation method will result in:
First year Subsequent year
Net income lower higher
Assets lower higher
Owner’s equity lower higher
Sales the same the same
ROE lower higher
ROA lower higher
Asset turnover higher lower

ratio
343

Amortisation methods for intangible assets with finite
2. lives and calculate amortization expense
a. Amortization Methods
Intangible assets with finite Intangible assets with indefinite

useful lives useful life (*)
Being amortized like the Not being amortized

depreciation of tangible assets.
The same method:

straight-line, accelerated, and
units-of-production
(*) An intangible asset is considered to have an indefinite useful life when

there is “no foreseeable limit to the period over which the asset is
expected to generate net cash inflows” for the company.
? Imagine that we have an intangible asset with an a specific

expiration date, but it can be renewed at minimal cost, should we
amortise this asset?
344

Amortisation methods for intangible assets with finite
2. lives and calculate amortization expense
a. Amortization Methods
Imagine that we have an intangible asset with an a specific

? expiration date (a license that will expire in 5 years) but it can be
renewed at minimal cost, should we amortise this asset?
Answer: The answer is no, because in this case we consider the asset to
have indefinite useful life, so we do not amortise it.
Read the example of Calculating amortization expense, LOS 22.f 2022
SchweserNotes, page 174).
b. The choice of amortization method and assumptions
The same as what was presented in session 1.b. The choice of

depreciation method and assumptions of this LOS.
345

LOS 22.f: Impairment and derecognition of long-lived assets
1. Impairment of long-lived assets
a. Definition of impairment and effect of impairment on financial

statement
Definition: An impairment charge is made to reflect the unexpected

decline in the fair value of an asset.
Effects on a company’s financial statements:
• The carrying value of the asset decreases.
• Net income decreases by the amount of impairment loss.
• Impairment does not affect cash flows, because it is a noncash charge.
b. Impairment of Property, Plant, and Equipment
Assessing whether there are indications of

impairment periodically.
When are the
assets tested
There is no indication of There is indication of
for
impairment impairment
impairment?
Not test for impairment Test for impairment

346

b. Impairment of Property, Plant, and Equipment (cont)

When are the Indications of impairment include evidence of obsolescence,
assets tested for decrease in demand for the asset’s output, and technological
impairment? advancements.
IFRS
Impairment happens when
Recoverable amount < Carrying amount
max
Testing for fair value - costs value in use = the discounted value of future
impairment to sell cash flows expected from the asset
US GAAP
Recoverable amount =
undiscounted expected Carrying amount
future cash flows
<
IFRS US GAAP
Impairment loss = asset’s
Impairment loss Impairment loss = carrying amount - fair value (or
(asset, profit) carrying amount - the the discounted value of future
recoverable amount cash flows, if fair value is not
known)
347

Example: Asset impairment

Information related to equipment owned by Brownfield Company
follows:
Original cost: $900,000
Accumulated depreciation to date: $100,000
Expected future cash flows: $795,000
Fair value: $790,000
Value in use: $785,000
Selling costs: $30,000
Assuming Brownfield will continue to use the equipment, test the asset
for impairment under both IFRS and US. GAAP.
Answer:
Carrying amount = original cost − accumulated depreciation = $900,000
- $100,000 = $800,000
348


Answer:
Carrying amount = original cost − accumulated depreciation
= $900,000 - $100,000 = $800,000
Under IFRS
Recoverable amount Carrying amount
= $785,000 < = $800,000
the asset is impaired
max
fair value - costs to sell value in use
= $790,000 - $30,000 = $785,000
Impairment loss = Carrying amount - recoverable amount = $15,000
On the financial statement:
o The asset is written down to recoverable amount = $785,000
o Recognise a loss = $15,000 on income statement
Under US GAAP
Recoverable amount = the asset

Carrying amount
undiscounted expected future < = $800,000 is impaired
cash flows = $795,000
Impairment loss = Carrying amount - fair value = $10,000
On the financial statement:
o The asset is written down to fair value = $790,000
o Recognise a loss = $10,000 on income statement
349

c. Impairment of Intangible Assets with a Finite Life (same as PPE)
d. Impairment of Long-Lived Assets Held for Sale (same as PPE)
When are the These assets are tested for impairment when they are
assets tested categorized as held-for-sale, which means that it is no longer
for in use and management intends to sell it.
impairment? (no depreciation charge after classification)
e. Reversals of Impairments of Long-Lived Assets
Under IFRS Under US GAAP

• Recoverable amount of an asset • Assets held for use: no reversal
of any type increases allowed
impairment losses can be • Assets held for sale: if the fair
reversed. value increases after an
• The value of the asset can not be impairment loss, the loss can be
reversed to a value greater than reversed
the previous carrying amount.
• Reversal increases reported
profits.
350

f. Evaluate how impairment affect financial statements and ratios
The period the impairment happens The period after the impairment
Loss on I/S CA of the asset Depreciation CA of the asset
Profit Asset Profit Asset
Equity Equity
ROA, ROE ROA, ROE
The judgment required in determining asset impairments gives management

considerable discretion about the timing and amounts of impairment charges. the
chance for them to manipulate earnings.
• Delaying recognizing an impairment loss until a period of relatively high earnings
smooth earnings
• Take more impairment charges in periods when earnings will be poor due to
external factors, or when new managements take over the company the
resulting low earnings might not be perceived as the “fault” of management
351

2. Deregonition of long-lived assets
• A company derecognizes or removes an asset from its financial

statements when the asset is disposed of or is not expected to provide
any future economic benefits from use or disposal.
• Derecognition occurs when assets are sold, exchanged, or abandoned.
a. When an asset is sold
BS & PL
• The asset is removed from the balance sheet and gain/loss is
recognized in the income statement.
Gain/(loss)on asset disposal = Selling price - Carrying or book value of asset
• The gain or loss is usually reported in the income statement as a part
of other gains and losses, or reported separately if material.
CF
• Gains and losses on disposal of fixed assets can also be found on the
cash flow statement if prepared using the indirect method.
• The amount of proceeds from sale are included in cash flow from
investing activities.
352

2. Deregonition of long-lived assets
b. When an asset is retired or abandoned
BS & PL
• The carrying value of the asset is removed from the balance sheet.
• A loss of that amount is recognized in the income statement.
CF
• The company does not receive any cash.
c. When an asset is exchanged for another asset
Refer to session 1.a. Tangible assets acquired through an exchange, Los

22.c Recognition of long-lived assets.
353

LOS 22.g: Describe the financial statement presentation of
and disclosures relating to property, plant, and equipment
and intangible assets.
1. Disclosure of PPE
IFRS US GAAP
Basic disclosure Basic disclosure
• The measurement bases used. • The balances of major classes
• The depreciation method used. of depreciable assets.
• Useful lives (or depreciation rate). • General description of
• Accumulated depreciation at the depreciation methods used
beginning and end of the period. for major classes or
• Restrictions on title. depreciable assets.
• Pledges of property as security. • Depreciation expense for the
• Contractual agreements to acquire PP&E. period.
For impaired assets • Accumulated depreciation by
• Amounts of impairment losses and major classes or in total.
reversals by asset class. For impaired assets
• Where the losses and loss reversals are • A description of the impaired
recognized in the income statement. asset.
• Circumstances that caused the • Circumstances that caused
impairment loss or reversal. the impairment.
If the revaluation model is used • How fair value was
• The date of revaluation determined.
• Details of fair value determination. • The amount of loss.
• The carrying amount under the cost • Where the loss is recognized
model. in the income statement.
354

LOS 22.g: Describe the financial statement presentation of
and disclosures relating to property, plant, and equipment
and intangible assets.
2. Disclosure of Intangible assets
IFRS US GAAP
• Same as PPE • Same as PPE

• In addition, the firm must disclose • In addition, the firm must provide
whether the useful lives are finite or an estimate of amortization
indefinite. expense for the next five years.
355

LOS 22.h: Analyze and interpret financial statement
disclosures regarding property, plant, and equipment and
intangible assets
1. Calculation
Gross fixed assets (cost) = Accumulated depreciation + Net fixed assets (book value)
divide both sides of this equation by annual depreciation expense
= +
Estimated useful or
Average age of asset Remaining useful life
depreciable life
2. Interpretation of the calculation

Help identify older, obsolete assets that might make the firm’s operations less efficient
(forecast future cash flows, identify major capital expenditures replacement)
Estimated useful life
Younger assets more
Low average age High remaining useful life
efficient, more competitive
Older assets less efficient, Estimated useful life

less competitive, have to
Low remaining
raise cash to replace the High average age
old assets in the near useful life
future
356

LOS 22.i: Compare the financial reporting of investment
property with that of property, plant, and equipment.
IFRS defines investment property as property that is owned (or
leased under a finance lease) for the purpose of earning rentals or
Definition capital appreciation or both.
U.S. GAAP does not distinguish investment property from other
kinds of long-lived assets.
Investment property is not owner occupied, nor is it used for
Feature
producing the company’s products and services.
Cost model Fair value model
Similar to the cost Similar to revaluation model except

model used for the way net income is affected.
Measurement property, plant, and • FV > carrying amount gain on
equipment I/S (instead of recognizing
revaluation surplus in the
revaluation model)
Companies must disclose which model they have used (cost or
fair value) to value the property.
Cost model Fair value model
• Similar to those It must make additional disclosures
Disclosure required for PP&E. regarding how it has determined
• Further, the fair fair value and reconcile beginning
value of the property and ending carrying amounts of
should also be investment property.
disclosed
357
READING 23: INCOME TAXES

358

Learning outcomes
23.a. Describe the differences between accounting profit and taxable income and
define key terms
23.b. Identify and contrast temporary versus permanent differences in pre-tax
accounting income and taxable income
23.c. 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
23.d. Calculate the tax base of a company’s assets and liabilities
23.e. 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
23.f. Evaluate the effect of tax rate changes on a company’s financial statements and
ratios
23.g. Describe the valuation allowance for deferred tax assets when it is required
and what effect it has on financial statements
23.h. Explain recognition and measurement of current and deferred tax items
23.i. Analyze disclosures relating to deferred tax items and the effective tax rate
reconciliation and explain how information included in these disclosures affects a
company’s financial statements and financial ratios
23.j. Identify the key provisions of and differences between income tax accounting
under IFRS and US. GAAP
359

[LOS 23.a] Describe the differences between accounting profit
and taxable income and define key terms
1. Describe the differences between accounting profit and

taxable income
Let’s begin with an illustrative example for income taxes
For accounting
For tax purposes
purposes
Revenue 100 100
Disposal of a car 20 20
Selling experimental products 0 10
Purchase without
0 (20)
supporting documents
Manufacturing cost (10) (10)
Profit 110 100
Profit for tax purpose is also called (see the next slide) Profit for accounting purpose is
taxable income also called accounting profit
360


taxable income
Difference between the recognition of revenue and expense for tax and
accounting purposes may result in taxable income differing from accounting
profit. As a result, the amount of income tax expense recognized in the
income statement may differ from the tax payable to the tax authorities.
Recognition of revenue & Recognition of revenue &

v
expense for tax expense for accounting
Taxable income Accounting profit
Income tax expense

Tax payable
recognized
361


taxable income
Note: In actuality, to calculate taxable income for tax purposes, we start from
accounting profit with some adjustments for taxable (or non-taxable) incomes
and deductible (or non-deductible) expenses.
Accounting profit 100
Other taxable income -
Non-taxable Income (10) (Selling experimental products)
(Purchase without supporting

Non-deductible expense 20
documents)
Deductible expense -
Taxable income 110

362

2. Key terminologies
Tax return terminologies
Taxable income Income subject to tax based on tax return
Current tax return liability resulting from the current period

Taxes payable
taxable income
Income tax paid Actual cash flows for income taxes, including
payments/refunds for other years
Tax loss carried Taxable loss used to reduce future taxable income
forward
Tax base Net amount of an asset or liability used for tax reporting
purposes
Pretax income Income before income tax expense
Income tax Expense recognized in the income statement that include taxes
expense payables and changes in deferred tax assets and liabilities
363

2. Key terminologies
Financial reporting terminology
Deferred tax BS amounts that result from an excess of income tax

expense over taxes payable that are expected to result in
liabilities
future cash outflows
Deferred tax BS amounts that result from an excess of taxes payable over
income tax expense that are expected to be recovered from
assets
future operation
Valuation Reduction of deferred tax assets based on the likelihood the

allowance asset will not be realized
Carrying value Net balance sheet value of asset or liability
Permanent Difference between taxable income and pretax income that

difference will not reverse in future
Difference between the tax base and the carrying value of

Temporary an asset of liability that will result in either taxable amounts
difference
or deductible amounts in the future
364

3. How income tax expense works
Accounting profit
Difference between
Other taxable income carrying amount and tax base
of assets and liabilities
Non-taxable items
Permanent Temporary
difference difference
(refer to LOS 23b) (refer to LOS 23b)
Non-deductible expense
Deductible expense Deferred tax Deferred tax

asset liability
Change in Deferred tax asset/lia

Taxable income
(between accounting periods)
× Tax rate
Deferred tax
Tax payable Tax expense
expense
365

[LOS 23.b] Identify and contrast temporary versus permanent
differences in pre-tax accounting income and taxable income
Identify and contrast temporary differences and
1.
permanent differences
Difference between accounting base and tax base
Temporary different Permanent different
Temporary difference* Permanent difference
A temporary difference refers to a A permanent difference is a

difference between taxable difference between taxable
income and accounting profit, income and accounting profit
that is expected to reverse in the that will not reverse in the future.
future.
(*) Refer to LOS.23d to understand what is tax base.

366

Identify and contrast temporary differences and permanent
1. differences
Example: Temporary difference

The company purchases a machine for $100 and it estimates the useful life of the machine is
five years. However, under the tax scheme for that machine, the tax authority only accepts
the useful life of four years. In this case, the temporary difference is incurred.
Depreciation Impact on pre-tax income

($) ($)
Year 1 (20)  20
Year 2 (20)  20
Accounting Year 3 (20)  20
perspective Year 4 (20)  100
Year 5 (20)  20
 20
Year 1 (25)  2,500

Year 2 (25)  2,500
Tax perspective Year 3 (25)  2,500
Year 4 (25)  100
Year 5 0  2,500
0
For each year from year 1 to year 4, depreciation charge for tax purpose is higher than
accounting treatment. However, the total impacts on the pre-tax income is the same
between two perspective, on the other hand, that is expected to reverse in the future.
367

Identify and contrast temporary differences and permanent
1. differences
Example: Permanent difference

The company purchases a machine for $10,000 and it estimates the useful life of the
machine is five years. However, under the tax scheme for that machine, the tax authority
only accepts for the cost of machine is capped at $6,000. In this case, the permanent
difference is incurred.
Depreciation Impact on pre-tax income
($) ($)
Year 1 (2,000)  2,000

Year 2 (2,000)  2,000
Accounting Year 3 (2,000)  2,000
perspective Year 4 (2,000)  10,000
Year 5 (2,000)  2,000
 2,000
Year 1 (1,200)  1,200

Year 2 (1,200)  1,200
Tax perspective Year 3 (1,200)  1,200
Year 4 (1,200)  6,000
Year 5 (1,200)  1,200
 1,200
For each year from year 1 to year 4, depreciation charge for tax purposes is higher than
accounting treatment. However, the total impacts on the pre-tax income under accounting
perspective is always higher than tax perspective, that leads to creating a permanent
difference for depreciation charge.
368

2. Determine the temporary difference
Accounting Deductible
P&L approach
expenses expenses
Temporary
Accounting profit difference in Taxable income
pre-tax income
Recorded in Deferred tax

Tax payable Tax expense
P&L expense
This approach
Balance sheet ( B/S) approach
Change in Deferred tax asset, Deferred

is popularly
tax asset/liability is charged to P&L
used to
statement (DTA or DTL)
calculate
Recorded
Deferred tax asset/liability
in BS
Temporary
Carrying amount
difference in Tax base
of asset/liability account balance
369

Back to the example for temporary difference above:

• Accounting perspective
Year 1 2 3 4 5
CA opening 100 80 60 40 20
Depreciation 20 20 20 20 20
CA ending 80 60 40 20 0
Effects on accounting profit 20 20 20 20 20
• Tax perspective
Year 1 2 3 4 5
CA opening 100 75 50 25 0
Depreciation 25 25 25 25 0
CA ending (tax base) 75 50 25 0 0
Effects on Taxable income 25 25 25 25 0

370

• P&L approach
Year 1 2 3 4 5
Accounting profit 20 20 20 20 20
Taxable income 25 25 25 25 0
Temporary difference in 5 5 5 5 -20

pre-tax income
Deferred tax expense 1 1 1 1 -4
• In the first 4 years, the depreciation expense under tax is greater than
depreciation expense under accounting, the taxable income is then lower than the
accounting profit.
The company receives tax relief, which means that its tax payment is deferred till
the next years.
To be specific, the amount of tax that is deferred each year in the first 4 years is:
(Accounting profit – taxable income) x tax rate.
• However, in year 5, when the depreciation expense under accounting is greater
than depreciation expense under tax law, the taxable income is then higher
the company is charged additional tax, so the difference is only temporary.
371

• Balance sheet approach

Year 0 1 2 3 4 5
CA ending 100 80 60 40 20 0
CA ending (tax base) 100 75 50 25 0 0
Temporary difference 0 5 10 15 20 0
in account balance
(1)
DTL (2) 0 1 2 3 4 0
Change in DTL (DTL ) - 1 1 1 1 -4
Deferred tax expense - 1 1 1 1 -4
(1) The change in temporary difference in account balance is equal to temporary

difference in pre-tax income.
(2) By the end of year 1, temporary difference shows that:
• Under accounting, an amount of $80 expense will be allocated in the future
• Under tax law, an amount of $75 expense will be allocated in the future, lower
expense means higher profit and more tax payable.
 The temporary difference results in tax being payable in the future, a liability is
recorded = (carrying amount – tax base) x tax rate = $5 x 20% = $1.
372

• Balance sheet approach

Year 0 1 2 3 4 5
CA ending 100 80 60 40 20 0
CA ending (tax base) 100 75 50 25 0 0
Temporary difference 0 5 10 15 20 0
in account balance
(1)
DTL (2) 0 1 2 3 4 0
Change in DTL (DTL ) - 1 1 1 1 -4

Deferred tax expense - 1 1 1 1 -4
(1) The change in temporary difference in account balance is equal to temporary

difference in pre-tax income.
(2) By the end of year 2, the company has a temporary difference of $10, which
includes the $5 brought forward from year 1, plus the additional difference of $5
arising in year 2.
• A liability is therefore recorded equal to (Carrying amount – tax base) x tax rate
= $10 x 20% = $2.
• Since there was a liability of $1 recorded at the end of year 1, $1 arising in DTL
(the change in DTL in comparison with year 1) that is recorded as an deferred
tax expense: deferred tax expense $1, and DTL $1
373

• Relationship between PnL approach and B/S approach
Year 0 1 2 3 4 5
B/S approach DTL recognized (balance) 0 1 2 3 4 0
DTL ending - DTL opening = DTL 2 - 1 = 1

DTL - 1 1 1 1 -4
P&L approach Expense recognized - 1 1 1 1 -4
• Under balance sheet approach, the difference is shown as a liability account

whose balance is accumulated as we recognize expense each year (+/- DTL).
• Under P&L approach, the difference in depreciation expense hit the taxable
income directly, so each year we recognize an expense.
In short, under the P&L approach, the difference is represented as expenses
(DTL), and these expenses are accumulated over the years under a liability
account – known as DTL (deferred tax liability) – represented under the balance
sheet approach.
Note: The treatment for deferred tax asset (DTA) is the same as the treatments for
DTL mentioned above.
374

Taxable temporary differences and Deductible temporary
3.
differences
Temporary differences can be divided into two categories:
Temporary differences
Taxable temporary differences Deductible temporary differences
Assets: Carrying amount > Tax base Assets: Carrying amount < Tax base
Liabilities: Carrying amount < Tax base Liabilities: Carrying amount > Tax base
Expected to result in future taxable Expected to provide tax deductions in

income the future
Deferred tax liability (DTL) Deferred tax asset (DTA)

Tax to pay in the future Tax saving in the future
375

[LOS 23.c] Explain how deferred tax liabilities and assets are
created and how a company’s deferred tax liabilities and
assets should be treated for the purposes of financial analysis
Temporary differences
Deferred tax liability Deferred tax asset
The amounts of income taxes The amounts of income taxes

payable in future periods recoverable in future periods
• Revenue (or gains) are taxable

• Revenue (or gains) are recognized
before they are recognized in the
in the income statement before
income statement
they are included on the tax return
• Expenses (or losses) are
Occur if
due to temporary difference

recognized in the income
• Expense (or loss) are tax
statement before they are tax-
deductible before they are
deductible
recognized in the income
• Tax loss carried forward are
statement
available
376

[LOS 23.d] Calculate the tax base of a company’s assets and
liabilities
1. Calculate the tax base of company’s assets
Tax base of assets

Tax base of assets is the amount that will be deducted (expensed) on the
tax return in the future as the economic benefits of the assets are
realized.
Example: Depreciable equipment

Equipment with historical cost of $100,000, useful life of 10 years. However,
under the tax authorities scheme, the useful life is only 5 years.
Accounting Tax perspective
perspective
Original cost $100,000 $100,000

Depreciation ($10,000) ($20,000)
Carrying amount/Tax base $90,000 $80,000
 Temporary difference = $90,000 - $80,000 = $10,000

377

liabilities
Example: Determining the Tax Base of an asset
The following information pertains to Entiguan Sports, a hypothetical developer of
products used to treat sports-related injuries. (The treatment of items for
accounting and tax purposes is based on hypothetical accounting and tax standards
and is not specific to a particular jurisdiction.)
1. Dividends receivable: On its balance sheet, Entiguan Sports reports dividends of
€1 million receivable from a subsidiary. Dividends are not taxable.
2. Development costs: Entiguan Sports capitalized development costs of €3 million
during the year. Entiguan amortized €500,000 of this amount during the year. For
tax purposes amortization of 25 percent per year is allowed.
3. Research costs: Entiguan incurred €500,000 in research costs, which were all
expensed in the current fiscal year for financial reporting purposes. Assume that
applicable tax legislation requires research costs to be expensed over a four-year
period rather than all in one year.
4. Accounts receivable: Included on the income statement of Entiguan Sports is a
provision for doubtful debt of €125,000. The accounts receivable amount reflected
on the balance sheet, after taking the provision into account, amounts to
€1,500,000. The tax authorities allow a deduction of 25 percent of the gross amount
for doubtful debt.
Required: Calculate the tax base and carrying amount for each item.
378

liabilities
Solution:
Carrying amount Temporary
(€) Tax base (€) difference (€)
1. Dividends receivable 1,000,000 1,000,000 0
2. Development costs 2,500,000 2,250,000 250,000
3. Research costs 0 375,000 (375,000)
4. Accounts receivable 1,500,000 1,218,750 281,250
1. Dividends receivable: Although the dividends received are economic benefits from the
subsidiary, we are assuming that dividends are not taxable. Therefore, the carrying amount
equals the tax base for dividends receivable.
2. Development costs: We assume that development costs will generate economic benefits
for Entiguan Sports  it may be included as an asset on the balance sheet for the purposes
of this example. The amortization allowed by the tax authorities exceeds the amortization
accounted for based on accounting rules.
Accounting perspective Tax perspective
Original cost €3,000,000 €3,000,000

Depreciation (€500,000) (€750,000)
Carrying amount/Tax base €2,500,000 €2,250,000
379

liabilities
3. Research costs:
Carrying amount/Tax base €0 €375,000

(€500,000 -€500,000/4)
The carrying amount is €0 because the full amount has been expensed for financial
reporting purposes in the year in which it was incurred. Therefore, there would not have
been a balance sheet item “Research costs” for tax purposes, and only a proportion may be
deducted in the current fiscal year. The tax base of the asset is (€500,000 - €500,000/4) =
€375,000.
4. Accounts receivable: The economic benefits that should have been received from
accounts receivable have already been included in revenues included in the calculation of
the taxable income when the sales occurred. Because the receipt of a portion of the
accounts receivable is doubtful, the provision is allowed. The provision, based on tax
legislation, results in a greater amount allowed in the current fiscal year than would be the
case under accounting principles.
Carrying amount/Tax base €1,500,000 €1,218,750
(€1,500,000 + €125,000) - [25% × (€1,500,000 + €125,000)]

380

liabilities
2. Calculate the tax base of company’s liabilities
Tax base of liabilities

• Tax base of liabilities = the carrying value of the liabilities – amounts
that will be deductible on the tax return in the future.
• Tax base of revenue received in advance = the carrying value – amount
of revenue that will not be taxed in the future
Example: Warranty liability

Estimation of warranty expenses of $5,000 for goods sold.
Accounting Tax perspective
perspective
Carrying amount/Tax base $5,000 $0
On Tax point of view: Warranty is not deductible until warranty work is

performed, so Tax base = $0
 Temporary difference = $5,000
381

liabilities
Example: Determining the Tax Base of a Liability
The following information pertains to the hypothetical company Entiguan
Sports for the fiscal year -end. The treatment of items for accounting and tax
purposes is based on fictitious accounting and tax standards and is not specific
to a particular jurisdiction.
1. Donations: Entiguan Sports made donations of €100,000 in the current fiscal
year. The donations were expensed for financial reporting purposes, but are not
tax deductible based on applicable tax legislation.
2. Interest received in advance: Entiguan Sports received in advance interest of
€300,000. The interest is taxed because tax authorities recognize the interest to
accrue to the company (part of taxable income) on the date of receipt.
3. Rent received in advance: Entiguan recognized €10 million for rent received
in advance from a lessee for an unused warehouse building. Rent received in
advance is deferred for accounting purposes but taxed on a cash basis.
4. Loan: Entiguan Sports secured a long-term loan for €550,000 in the current
fiscal year. Interest is charged at 13.5 percent per annum and is payable at the
end of each fiscal year.
Required: Calculate the tax base and carrying amount for each item.
382

liabilities
Solution:
Carrying amount Tax base (€) Temporary

(€) difference (€)
1. Donations 0 0 0
2. Interest received in 300,000 0 300,000

advance
3. Rent received in advance 10,000,000 0 (10,000,000)
4. Loan 0 0 0
Interest paid 0 0 0
1. Donations: The amount of €100,000 was immediately expensed on Entiguan’s income

statement; therefore, the carrying amount is €0. Tax legislation does not allow donations to
be deducted for tax purposes,
 The tax base of the donations equals the carrying amount.
383

liabilities
2. Interest received in advance:
Carrying amount/Tax base €300,000 €0
For accounting purposes, Interest received in advance is included in the financial period in
which it is deemed to have been earned. For this reason, the interest income received in
advance is a balance sheet liability. It was not included on the income statement because
the income relates to a future financial year.
For tax purposes, interest is deemed to accrue to the company on the date of receipt. For
tax purposes, it is thus irrelevant whether it is for the current or a future accounting period;
it must be included in taxable income in the financial year received. Because the full
€300,000 is included in taxable income in the current fiscal year, the tax base is €300,000 -
300,000 = €0.
3. Rent received in advance: The result is similar to interest received in advance. The
carrying amount of rent received in advance would be €10,000,000 while the tax base is €0.
4. Loan: Repayment of the loan has no tax implications. The repayment of the capital
amount does not constitute an income or expense. The interest paid is included as an
expense in the calculation of taxable income as well as accounting income. Therefore, the
tax base and carrying amount is €0.
384

[LOS 23.e] Calculate income tax expense, income taxes
payable, deferred tax assets and deferred tax liabilities and
Calculate and interpret the adjustment to the financial
Calculate income tax expense, income taxes payable,
1.
deferred tax assets and deferred tax liability
Items Calculation
Income tax payable Taxable income x Tax rate
Income tax expense Taxes payable + ΔDTL − ΔDTA
Deferred tax liability/asset Temporary difference x Tax rate
Example: Deferred tax assets

Consider warranty guarantees and associated expenses. Pretax income (financial reporting)
includes an accrual for warranty expense, but warranty cost is not deductible for taxable
income until the firm has made actual expenditures to meet warranty claims. Suppose:
• A firm has sales of $5,000 for each of two years.
• Warranty expense will be 2% of annual sales ($100).
• The actual expenditure of $200 to meet all warranty claims was not made until the
second year.
• Assume a tax rate of 40%.
Required: Calculate the firm’s income tax expense, taxes payable, and deferred tax assets
for year 1 and year 2
385

Solution:
For tax reporting and financial reporting, taxable income and taxes payable for two years
are:
Financial Reporting-Warranty Tax Reporting- Warranty
Expense Expense
Year 1 Year2 Year 1 Year 2
Revenue $5,000 $5,000 $5,000 $5,000
Warranty expense $100 $100 0 $200
Taxable income $4,900 $4,900 $5,000 $4,800
Taxes payable $1,960 $1,960 $2,000 $1,920
Net income $2,940 $2,940 $3,000 $2,880

386

In year 1,
• The firm reports $1,960 of tax expense in the income statement, but $2,000 of taxes
payable are reported on the tax return  taxes payable are initially higher than tax
expense and the $40 difference is reported on the balance sheet by creating a DTA.
• The carrying value of the warranty liability is $100 (the warranty expense has been
recognized in the income statement but it has not been paid), and the tax base of the
liability is 0 (the warranty expense has not been recognized on the tax return)  we get
the balance of the DTA of $40 [($100 carrying value - zero tax base) × 40%].
We can reconcile income tax expense and taxes payable with the change in the DTA. In this
example, the DTA increased $40 (from zero to $40) during year 1. Thus, income tax
expense in year 1 is $1,960 ($2,000 taxes payable – $40 increase in the DTA).
In year 2,
The firm recognizes $1,960 of tax expense in the income statement but only $1,920 is
reported on the tax return (taxes payable). The $40 deferred tax asset recognized at the
end of year 1 has reversed as a result of the warranty expense recognition on the tax
return. So, in year 2, income tax expense is $1,960 ($1,920 taxes payable + $40 decrease in
DTA).
387

2.
statements related to change in the income tax rate
Back to some formula about deferred asset and deferred tax liability
Deferred tax asset/liability = Temporary difference x Tax rate
From above formulas we know that when tax rate change, deferred tax
asset/liability will be adjusted. If tax rates decrease:
• Deferred tax asset will decrease  Decrease in value toward the offset
of future tax payments to the tax authorities.
• Deferred tax liability will decrease  Decrease in value off future tax
payments to the tax authorities.
Income tax expense = Taxes payable + ΔDTL − ΔDTA
Due to the relationship between income tax expense and deferred tax
asset/ liability (above formula), the decrease in the DTL would result in
lower income tax expense and the decrease in the DTA would result in
higher income tax expense
388

[LOS 23.f] Evaluate the effect of tax rate changes on a
company’s financial statements and ratios
Evaluate the effect of tax rate change on a company’s financial
1.
statements
When tax rate decrease, the following items will be effected. We use the same logic
for the case in which tax rate increases.
Tax rate decrease
Change in deferred tax Change in deferred tax

assets decrease Or liabilities decrease
Change in deferred tax Change in deferred tax

assets decrease liabilities decrease
Income tax expense = Tax payable + ΔDTL Income tax expense

increase − ΔDTA decrease
Net income decrease Net income increase
Retained earnings
Retained earnings increase
decrease
Shareholder’s equity Shareholder’s equity

decrease increase
389

Evaluate the effect of tax rate change on a company’s
1.
financial statements
Example:
A firm owns equipment and bad debt that will be shown below. (The tax
rate is 40%)
Items Carrying Tax base Deferred tax asset/
value (‘000) liability (‘000)
(‘000)
Equipment $200 $160 DTL = $16 [=($200 - $160)

× 40%]
Bad debt 0 $10 DTA = $4 [(=$10 – 0) x 40%]

expense
Calculate the effect on the firm’s income tax expense if the tax rate
decreases to 30%.
390

1.
financial statements
Solution:
Items Carrying Tax Deferred tax Deferred tax

value base asset/ liability asset/ liability
(‘000) (‘000) (tax rate = 40%) (tax rate = 30%)
(‘000) (‘000)
Equipment $200 $160 DTL = $16 DTL = $12

[=($200 - $160) × [=($200 - $160) ×
40%] 30%]
Bad debt 0 $10 DTA = $4 DTA = $3

expense [($10 – 0) x 40%] [($10 – 0) x 30%]
• Deferred tax liability decreases by $4,000 ($16,000 reported DTL - $12,000

adjusted DTL).
• Deferred tax asset decreases by $1,000 ($4,000 reported DTA - $3,000 adjusted
DTA).
Using the income tax equation, we can see that income tax expense decreases by
$3,000 (income tax expense = taxes payable + ∆DTL - ∆DTA).
391

2.
ratios
Again we assume that the tax rate is decrease, the following ratios will be effected
Ratios Effect
• Decrease in deferred tax asset  Decrease in equity 

Long term Debt to Increase in long term debt to equity
Equity ratio • Decrease in deferred tax liability  Increase in equity
()
 Decrease in long term debt to equity
• Decrease in equity  Increase in long term debt to

Debt to equity ratio equity
() • Increase in equity and decrease in deferred tax liability
 Decrease in long term debt to equity
• Decrease in total assets (deferred tax asset)  Increase

Total debt ratio in total debt
() • Decrease in total liabilities (deferred tax liability) 
Decrease in total debt
• Decrease in equity and decrease in deferred tax asset

Financial leverage  Increase in financial leverage
()
• Increase in equity  Decrease in financial leverage
392

[LOS 23.g] Describe the valuation allowance for deferred tax
assets when it is required and what effect it has on financial
statements
1. Describe the valuation allowance for deferred tax assets
• Deferred tax assets are assessed at each balance sheet date to determine the likelihood
of sufficient future taxable income to recover the tax assets. (Without future taxable
income, a Deferred tax assets is worthless)
• Under U.S. GAAP, DTA are reduced by creating a contra-asset account known as the
valuation allowance.
More likely to recover Not require valuation allowance

Sufficient future taxable income is more
(>50%) account
likely to recover the tax assets or not ?
Example: If a company has order backlogs or existing contracts which are

expected to generate future taxable income, a valuation allowance might not
be necessary.
More likely to not recover Require Valuation allowance account
Example: If a company has cumulative losses over the past few years or a
history of inability to use tax loss carry forwards, then the company would
need to use a valuation allowance
393

[LOS 23.g] Describe the valuation allowance for deferred tax
assets when it is required and what effect it has on financial
statements
2. Effect of valuation allowance on financial statements
Valuation allowance increases Valuation allowance decrease
Deferred tax asset decreases Deferred tax asset increase
Change in deferred tax asset Change in deferred tax asset

increases decreases
Income tax expense increases Income tax expense decreases
Net income decreases Net income increases
Retained earnings decreases Retained earnings increases
Shareholder’s equity decreases Shareholder’s equity increases

394

[LOS 23.h] Explain recognition and measurement of current
and deferred tax items
1. Recognition of unused tax losses and tax credits
Tax losses: A tax loss (tax loss carryforward) is a provision that allows
a taxpayer to move a tax loss to future years to offset a profit.
Tax credit: A tax credit is an amount of money that taxpayers can
subtract directly from taxes owed to their government.
These two reduce the amount of

taxable income in the future
IFRS and US GAAP allow the creation of a deferred tax asset in the
case of tax losses and tax credits. The recognition is specified below:
IFRS US GAAP
IFRS allows the recognition of A deferred tax asset
unused tax losses and tax is recognized in full but is then
credits only to the extent reduced by a valuation
that it is probable that in the allowance if it is more likely
future there will be taxable than not that some or all of the
income against which the deferred tax asset will not be
unused tax losses and credits realized.
can be applied
395

1. Recognition of unused tax losses and tax credits
The existence of tax losses may indicate that the entity cannot reasonably be
expected to generate sufficient future taxable income
there are concerns about the uncertainty of future taxable profits
in this case, we follow these criteria:
• Taxable temporary differences are available to offset deferred tax payable
• Assess the probability that the entity will in fact generate future taxable
profits before the unused tax losses and/or credits expire (*)
• Verify that the above is with the same tax authority and based on the
same taxable entity
• Determine whether the past tax losses were a result of specific
circumstances that are unlikely to be repeated
• Discover if tax planning opportunities are available to the entity that will
result in future profits. (**)
(*) Taxable profit

+
→DTA (**)
opportunity
Unused tax loss profit
Loss loss loss loss loss

Before adding the effect of unused tax loss, Illustration for tax planning
we assess the probability of taxable profit to
decide whether to recognize a DTA.
396

2. Recognition of deferred tax charged directly to equity
Recognition of deferred tax items
Recognition of deferred tax items in Recognition of deferred tax items in

profit or loss other comprehensive income and
 Deferred Tax effect on equity not effect on net income
through effect on net income (see  Deferred Tax Charged Directly to
more in previous LOS) Equity
The following are example of deferred tax charged directly to equity:

• Revaluation of property, plant, and equipment (revaluations are not permissible
under US GAAP);
• Long- term investments at fair value;
• Changes in accounting policies;
• Errors corrected against the opening balance of retained earnings;
• Initial recognition of an equity component related to complex financial
instruments; and
• Exchange rate differences arising from the currency translation procedures for
foreign operations.
397

[LOS 23.i] Analyze disclosures relating to deferred tax items
and the effective tax rate reconciliation and explain how
information included in these disclosures affects a company’s
financial statements and financial ratios
Analyzing disclosures relating deferred tax items and the
1.
effective tax rate reconciliation
a. Analyzing disclosures relating deferred tax items
Details on the source of the temporary differences that cause the deferred
tax assets and liabilities reported.
Typically, the following deferred tax information is disclosed:
• Deferred tax liabilities, deferred tax assets, any valuation allowance, and
the net change in the valuation allowance over the period.
• Any unrecognized deferred tax liability for undistributed earnings of
subsidiaries and joint ventures.
• Current-year tax effect of each type of temporary difference.
• Components of income tax expense.
• Reconciliation of reported income tax expense and the tax expense based
on the statutory rate.
• Tax loss carry forwards and credits.
398

Analyzing disclosures relating deferred tax items and the
1.
effective tax rate reconciliation
b. The effective tax rate reconciliation
Some firms’ reported income tax expense differs from the amount based
on the statutory income tax rate. Thus, firm need explain the differences
between:
• The statutory rate tax (the tax rate of the jurisdiction where the firm
operates)
• The effective tax rate (=)
The differences are generally the result of:
• Different tax rates in different tax jurisdictions (countries).
• Permanent tax differences: tax credits, tax-exempt income, nondeductible expenses,
and tax differences between capital gains and operating income.
• Changes in tax rates and legislation.
• Deferred taxes provided on the reinvested earnings of foreign and unconsolidated
domestic affiliates.
• Tax holidays in some countries (watch for special conditions such as termination
dates for the holiday or a requirement to pay the accumulated taxes at some point in
the future)
399

Explain how information included in these disclosures
2.
affects a company’s FS and financial ratios
Example: Analyzing deferred tax item disclosures

Use the table below to explain why income tax expense has exceeded taxes payable over
the last three years. Also explain the effect of the change in the valuation allowance on
WCCO’s earnings for 20X5
20X5 ($) 20X4 ($) 20X3 ($)
Employee benefits 278 310 290
Internal tax loss carry forwards 101 93 115
Valuation allowance (24) (57) (64)
Deferred tax asset 355 346 341
Property, plant and equipment 452 361 320
Unrealized gain on available for sale securities 67 44 23
Deferred tax liability 519 405 343
Deferred income taxes 164 59 2

400

Example: Analyzing deferred tax item disclosures

Solution:
Explain why income tax expense has exceeded taxes payable over the last three years
• The company’s deferred tax asset balance = international tax loss carry forwards +
employee benefits (most likely pension and other post-retirement benefits) – valuation
allowance.
• The company’s deferred tax liability balance = property, plant, and equipment (most likely
from using accelerated depreciation methods for tax purposes and straight-line on the
financial statements) + unrealized gains on securities classified as available-for-sale
(because the unrealized gain is not taxable until realized).
• Income tax expense = taxes payable + deferred income tax expense
= taxes payable + ∆deferred tax liabilities – ∆deferred tax assets
Because deferred tax liabilities have been growing faster than deferred tax assets,
deferred income tax expense has been positive, resulting in income tax expense being
higher than taxes payable.
Explain the effect of the change in the valuation allowance on WCCO’s earnings for 20X5
• Management decreased the valuation allowance by $33 million in 20X5  a reduction in
deferred income tax expense and an increase in reported earnings for 20X5
401

Example: Analyzing the tax rate reconciliation

Analyze the trend in effective tax rates over the three years shown in NDC Co by using
following information:
20X3 20X4 20X5
Statutory U.S. federal income tax rate 35% 35% 35%
State income taxes, net of related federal 2.1% 2.2% 2.3%

income tax benefit
Benefits and taxes related to foreign (6.5%) (6.3%) (2.7%)

operations
Tax rate changes 0% 0% (2%)
Property, plant and equipment 0% (3%) 0%
Special items (1.6%) 8.7% 2.5%
Other, net 0.8% 0.7% (1.4%)
Effective income tax rates 29.8% 37.3% 33.7%

402

Example: Analyzing the tax rate reconciliation (cont)

Solution:
• The effective tax rate is upward trending over the 3-year period. Contributing
to the upward trend is
o An increase in the state income tax rate and
o A decrease in benefits related to taxes on foreign income.
• In 20X4, taxes created by special items are increased significant and partially
offset the decrease in taxes created by sale of PPE.
• In 20X3 and 20X5, the special items and the other items also offset each
other. The fact that the special items and other items are so volatile over the
3-year period suggests that it will be difficult for an analyst to forecast the
effective tax rate for NDC for the foreseeable future without additional
information. This volatility also reduces comparability with other firms.
403

[LOS 23.j] Identify the key provisions of and differences
between income tax accounting under IFRS and US. GAAP
Accounting for income taxes under U.S. GAAP and IFRS is similar in most respects.
However, there are some differences. The following table is a summary of a few of the
more important differences.
IFRS GAAP
Revaluation of fixed Deferred taxes are recognized in No applicable, no

assets and equity revaluation allowed
intangible asset
Undistributed profit Deferred taxes are recognized • No deferred taxes for

from an investment unless the parent is able to foreign subsidiary that
in a subsidiary control the distribution of profit meet the indefinite
and it is probable the reversal criterion
temporary difference will • No deferred taxes for
reverse in the future domestic subsidiary if the
amounts are tax free
Undistributed profit Deferred taxes are recognized No deferred taxes for joint
from an investment unless the parent is able to venture that meet the
in a joint venture control the distribution of profit indefinite reversal criterion
and it is probable the
temporary difference will
reverse in the future
404

[LOS 23.j] Identify the key provisions of and differences
between income tax accounting under IFRS and US. GAAP
IFRS GAAP
Undistributed profit Deferred taxes are recognized Deferred taxes are

from an investment unless the investor is able to recognized from temporary
in an associate firm control the sharing of profit differences
and it is probable the
temporary difference will not
reverse in the future
Deferred tax asset Recognized in full and then Recognized if probable that
recognition reduced if “more likely than sufficient taxable profit will
not” that some or all of the tax be available to recover the
asset will not be realized tax asset
Tax rate used to Enacted tax rate only Enacted or substantively

measure deferred enacted tax rate
taxes
405

Practice questions

23.a. Describe the differences between accounting profit and N/A
taxable income and define key terms
23.b. Explain how deferred tax liabilities and assets are created Question 1, 2
and the factors that determine how a company’s deferred tax
liabilities and assets should be treated for the purposes of
financial analysis
23.c. Calculate the tax base of a company’s assets and liabilities Question 3
23.d. Calculate income tax expense, income taxes payable, Question 4, 5

deferred tax assets and deferred tax liabilities and Calculate and
interpret the adjustment to the financial statements related to a
change in the income tax rate
23.e. Evaluate the effect of tax rate changes on a company’s N/A

23.f. Identify and contrast temporary versus permanent N/A
406

Practice questions

23.g. Describe the valuation allowance for deferred tax assets Question 6
when it is required and what effect it has on financial statements
23.h. Explain recognition and measurement of current and N/A
deferred tax items
23.i. Analyze disclosures relating to deferred tax items and the N/A
effective tax rate reconciliation and explain how information
included in these disclosures affects a company’s financial
statements and financial ratios
23.j. Identify the key provisions of and differences between N/A
income tax accounting under IFRS and US. GAAP
407

Practice questions
1 Using the straight-line method of depreciation for reporting purposes

and accelerated depreciation for tax purposes would most likely result
in a:
A valuation allowance.
B deferred tax asset.
C temporary difference.
2 Income tax expense reported on a company’s income statement equals

taxes payable, plus the net increase in:
A deferred tax assets and deferred tax liabilities.
B deferred tax assets, less the net increase in deferred tax liabilities.
C deferred tax liabilities, less the net increase in deferred tax assets
3 The author of a new textbook received a $100,000 advance from the

publisher this year. $40,000 of income taxes were paid on the advance
when received. The textbook will not be finished until next year.
Determine the tax basis of the advance at the end of this year.
A $0.
B $40,000.
C $100,000
408

Practice questions
4 A firm acquires an asset for $120,000 with a 4-year useful life and no
salvage value. The asset will generate $50,000 of cash flow for all four
years. The tax rate is 40% each year
The firm will depreciate the asset over three years on a straight-line (SL)
basis for tax purposes and over four years on a SL basis for financial
reporting purposes. Taxable income in year 1 is:
A $6,000.
B $10,000.
C $20,000
5 A firm acquires an asset for $120,000 with a 4-year useful life and no
salvage value. The asset will generate $50,000 of cash flow for all four
years. The tax rate is 40% each year
The firm will depreciate the asset over three years on a straight-line (SL)
basis for tax purposes and over four years on a SL basis for financial
reporting purposes. Pretax income in year 4 is:
A $4,000.
B $6,000.
C $8,000
409

Practice questions
6 A company has following information:

Year ended 30 June Year 1 Year 2 Year 3
Expected federal income ($112,000) $768,000 $685,000

tax expense
Expenses not deductible $357,000 $32,000 $51,000

for income tax purposes
State income taxes, net $132,000 $22,000 $100,000

of federal benefit
Change in valuation ($150,000) ($766,000) ($754,000)

allowance for deferred
tax assets
Income tax expense $227,000 $56,000 $82,000
Over the three years presented, changes in the valuation allowance for
deferred tax assets were most likely indicative of:
A decreased prospect for future profitability.
B increased prospects for future profitability.
C assets being carried at a higher value than their tax base
410

Practice answers
1. C is correct. Because the differences between tax and financial accounting
will correct over time, the resulting deferred tax liability, for which the
expense was charged to the income statement but the tax authority has
not yet been paid, will be a temporary difference. A valuation allowance
would only arise if there was doubt over the company’s ability to earn
sufficient income in the future to require paying the tax.
2. C is correct. Higher reported tax expense relative to taxes paid will increase
the deferred tax liability, whereas lower reported tax expense relative to
taxes paid increases the deferred tax asset.
3. A For revenue received in advance, the tax base is equal to the carrying
value minus any amounts that will not be taxed in the future. Since the
advance has already been taxed, $100,000 will not be taxed in the future.
Thus, the textbook advance liability has a tax base of $0 ($100,000 carrying
value – $100,000 revenue not taxed in the future)
4. B Annual depreciation expense for tax purposes is ($120,000 cost – $0
salvage value) / 3 years = $40,000. Taxable income is $50,000 – $40,000 =
$10,000.
411

Practice answers
5. C Annual depreciation expense for financial purposes is ($120,000 cost –
$0 salvage value) / 4 years = $30,000. Pretax income is $50,000 – $30,000
= $20,000
6. B is correct. Over the three-year period, changes in the valuation
allowance reduced cumulative income taxes by $1,670,000 (= 766,000 +
754,000 + 150,000). The reductions to the valuation allowance were a
result of the company being “more likely than not” to earn sufficient
taxable income to offset the deferred tax assets.
412
READING 24: NON-CURRENT

(LONG-TERM) LIABILITIES
413
READING 24: NON-CURRENT (LONG-TERM)

LIABILITIES
Learning outcomes
Bonds
24.a. Determine the initial recognition and initial measurement of

bonds
24.b. Determine the subsequent recognition of bonds using the

effective interest method and calculate interest expense,
amortization of bond discounts/premiums, and interest payments
24.c. Explain the derecognition of debt
24.d. Describe the role of debt covenants in protecting creditors
24.e. Describe the financial statement presentation of and

disclosures relating to debt
414

LIABILITIES
Learning outcomes
Leases
24.f. Explain motivations for leasing assets instead of purchasing

them
24.g. Explain the financial reporting of leases from a lessee’s

perspective
24.h. Explain the financial reporting of leases from a lessor’s

perspective
Pensions and evaluating solvency
24.i. Compare the presentation and disclosure of defined

contribution and defined benefit pension plans
24.j. Calculate and interpret leverage and coverage ratios

415

LIABILITIES
LOS 24.a: Determine the initial recognition and initial
measurement of bonds
1. Bond Terminology
A bond is a contractual promise between a borrower (the bond issuer)

and a lender (the bondholder) that obligates the bond issuer to make
payments to the bondholder over the term of the bond.
Two types of payments are involved:
• Periodic interest payments
• Repayment of principle at maturity
Face or Par The amount of principal that will be paid to the bondholder at
value maturity and is used to calculate the coupon payments.
Coupon The interest rate stated in the bond that is used to calculate
rate the coupon payments and is typically fixed for the term of
bonds.
Coupon The periodic interest payments to the bondholders and are

payments calculated by multiplying the face value by the coupon rate
416

LIABILITIES
1. Bond Terminology
Effective • The market rate of interest that is used to value the bond
rate of and depends on the bond’s risks as well as the structure of
interest interest rates and the timing of the bond’s cash flows.
• The market rate will likely change over the bond’s life, which
changes the bond’s market value as well.
The • Known as the book value or the carrying value of the bond,
balance equals to the present value (PV) of its remaining cash flows
sheet (coupon payments and par value), discounted at the market
liability rate of interest at issuance.
• At maturity, the liability will equal the face value of the
bond.
Interest Reported in the income statement and is calculated by

expense multiplying the book value of the bond liability at the
beginning of the period by the market rate of interest of the
bond at issuance.
417

LIABILITIES
1. Bond Terminology
At the date of issuance, the market rate can be the same as or

different than the coupon rate:
Market rate > Market rate = Market rate <
coupon rate coupon rate coupon rate
the bond is a the bond is a par the bond is a

discount bond bond (priced at face premium bond
(priced below par). value) (priced above par).
418

LIABILITIES
1. Bond Terminology
Example 1: Discount, Premium and Par bond

On December 31, 20X2, a company issued a 3-year, 10% annual coupon
bond with a face value of $100, assuming the bond was issued at a market
rate of interest (r) of:
a. 9%.
b. 10%
c. 11%
Answer:
Coupon payment each period = 10% × $100 = $10
Issuance date 31 Dec 20X3 31 Dec 20X4 31 Dec 20X5
a. PV = $102.531 $10 $10 $10 + $100 = $110

b. PV = $100
c. PV = $97.556
(Continue in the next slide)
419

LIABILITIES
1. Bond Terminology
Example 1: Discount, Premium and Par bond

Answer:
a. The market rate of 9% < the coupon rate of 10% → the bond is issued at
premium.
The bond proceeds = the book value at issuance = $102.531 > Par
(N = 3, PMT = 10, FV = 100, I/Y = 9, CPT → PV = - 102.531)
b. The market rate of 10% = the coupon rate of 10% → the bond is issued
at Par.
The bond proceeds = the book value at issuance = Par = $100
c. The market rate of 11% > the coupon rate of 10% the bond is issued at
discount.
The bond proceeds = the book value at issuance = $97.556 < Par
(N = 3, PMT = 10, FV = 100, I/Y = 11, CPT → PV = - 97.556)
420

LIABILITIES
2. Initial recognition of bond issued
(Continue with example 1)
Par bond Premium bond Discount bond

Assets and Liabilities increase by the bond proceeds
Balance
sheet Bond proceeds Bond proceeds Bond proceeds
= $100 = $102.531 = $97.556
Income
statement No effect
The issued proceeds are reported as a cash inflow

Cash flow from financing (CFF)
statement
CFF = +$100 CFF = +$102.531 CFF = +$97.556
421

LIABILITIES
LOS 24.b: Determine the subsequent measurement of bonds
using the effective interest method: calculate interest
expense, amortization of bond discounts/premiums, and
interest payments
1. Effective interest method
Premium bond
PV ($102.531) – Total premium amortization in 3 years (2.531) = Par ($100)
Market rate < coupon rate → interest expense < the coupon payment
→ premium amortization each year = coupon payment – interest expense
Discount bond
PV ($97.556) + Total discount amortization in 3 years (2.444) = Par ($100)
Market rate > coupon rate → interest expense > the coupon payment
→ discount amortization each year = interest expense – coupon payment
422

LIABILITIES
interest payments
Zero-coupon bond
• Zero-coupon bonds, known as pure-discount bonds have no

periodic coupon payments.
• The effects of zero-coupon bonds on the financial statements
are the same as any discount bonds but with larger impact due
to larger discount.
423

LIABILITIES
interest payments
Example 2: Effective interest method

Consider discount and premium bonds in the Example 1
424

LIABILITIES
interest payments
Answer:
Premium bond ( r = 9%) Discount bond (r = 11%)
Bond Liability
20X3 20X4 20X5 20X3 20X4 20X5
Beginning
book value (1) $102.531 $101.759 $100.917 $97.556 $98.287 $99.099
Interest
expense (2) = $9.228 $9.158 $9.083 $10.731 $10.812 $10.901
(1) × r
decreases over time increases over time
Coupon
payments (3) $10 $10 $10 $10 $10 $10
= $10
Ending book
value
= (1) – (3) + $101.759 $100.917 $100 $98.287 $99.099 $100
(2)
decreases over time increases over time
425

LIABILITIES
interest payments
2. Periodic recognition of bond issued
Balance The book value of The premium is The discount is

sheet bond liability will not amortized → the book amortized → the
change over the term value of bond liability book value of bond
of the bond decreases until it liability increases
reaches the Par until it reaches the
Par
Income Interest expense = market rate at issuance × the book value of bond
statement liability at beginning of each period
• Interest expense = • Interest expense < • Interest expense >

coupon payment coupon payment coupon payment
• Interest expense is • Interest expense • Interest expense
constant decreases over time increases over time
Cash flow The coupon payments are reported as cash outflow from operating (CFO)
statement under U.S.GAAP and cash outflow from operating (CFO) or financing
(CFF) under IFRS
426

LIABILITIES
interest payments
3. Maturity recognition of bond issued
Balance sheet Remove the bond issued
Income statement –
Cash flow Principle repayment (face value) of the bond is

statement reported as a cash outflow from financing (CFF)
427

LIABILITIES
interest payments
4. Issuance cost
Issuance cost involves legal and accounting fees, printing costs,

sales commissions, and other fees incurred when bond is issued.
U.S. GAAP IFRS
• Issuance costs are expensed in the measurement of the liability

and decrease the initial bond liability on the balance sheet and
increase the bond’s effective interest rate.
• Issuance costs are reported as an outflow of CFF.
U.S.GAAP still
• Permits to capitalize these
costs (deferred charge); and
• Allocated to the income
statement on a straight-line
basis.
428

LIABILITIES
interest payments
4. Issuance cost
Example 3: Expense the issuance cost (for IFRS and U.S.GAAP)

A premium bond issued is similar in the example 1, with the issuance cost
of $6.
Answer:
PV = $102.531 $10 $10 $10 + $100 = $110

Issuance cost = $6 is deducted from the bond liability at issuance.
The initial bond liability is reduced by $6 = $102.531 - $6 = $96.531
→ The bond’s effective interest rate = 11.43%
N = 3, PMT = 10, PV = -96.531, FV = 100, CPT → I/Y = 11.43% higher than
the market rate of 9% at issuance.
(continue in the next slide)
429

LIABILITIES
interest payments
4. Issuance cost
Example 3: Expense the issuance cost (for IFRS and U.S.GAAP)

Year 1 Year 2 Year 3
Asset Cash ↓ $6
Cash flow: CFF outflow $6
Beginning book value $102.531 - $6 =

$97.564 $98.716
(1) $96.531
Interest expense (2) =

$11.033 $11.152 $11.283
Liability: (1) × 11.43%
Bond
liability Coupon payment
$10 $10 $10
= $10
Ending book value (3)

$97.564 $98.716 $100
= (1) – (3) + (2)
Income statement No effect of issuance cost

430

LIABILITIES
interest payments
4. Issuance cost
Example 4: Capitalize the issuance cost (only for U.S.GAAP)

A premium bond issued is similar in the example 1, with the issuance cost
of $6.
Answer:
PV = $102.531 $10 $10 $10 + $100 = $110

Issuance cost = $6 is allocated equally in the income statement

431

LIABILITIES
interest payments
4. Issuance cost
Example 4: Capitalize the issuance cost (only for U.S.GAAP)

Income Liability &
Asset Cash flow statement Equity
Cash Prepaid CFF outflow Expense Owner
expense equity
Year 1 ↓ $6 ↑ $4 $6 ↑ $2 ↓ $2
Year 2 – ↓ $2 ↑ $2 ↓ $2
Year 3 – ↓ $2 ↑ $2 ↓ $2
Issuance cost is
allocated equally in
432

LIABILITIES
interest payments
5. Fair value reporting option
Under effective interest rate method, the book value of the bond is based
on the market rate at issuance → If market interest rates fluctuate → the
actual value of the firm’s debt deviates from its reported book value:
Market rates rise Market rates fall
Book value > fair value of debt Book value < fair value of debt
Overstate the firm’s leverage Understate the firm’s leverage

level level
Companies have the option to report financial liabilities at fair value.
Gains and losses that result from changes in bonds’ market yields are
reported in the income statement.
433

LIABILITIES
LOS 24.c: Explain the derecognition of debt
A firm may redeem the bond before maturity due to some reasons:
When bonds are redeemed before maturity, a gain or loss is recognized by
subtracting the redemption price from the book value of the bond liability
at the reacquisition date.
Example 5: Redeem bond before maturity

A 3-year bond was redeemed in the end of the 2 nd year at the price of
$1,042. The book value of the bond at the end of the 2 nd year is $1,037.
The company will recognize a loss of $5 ($1,037 carrying value - $1,042
redemption price)
At the end of 2nd year
Assets Cash ↓ = $1,042
Liability & Equity Bond liability ↓ = $1,037

Owner equity ↓= $5
434

LIABILITIES
LOS 24.d: Describe the role of debt covenants in protecting
creditors
Debt covenants are restrictions imposed by the lender on borrower to

protect the lender’s position.
Affirmative covenants Negative covenants
The borrower must: The borrower must not:

• Make timely payments of • Increasing dividends or
principal and interest. repurchasing shares.
• Maintain certain ratios (such • Issuing more debt.
as the current, debt-to-equity, • Engaging in mergers and
and interest coverage ratios) in acquisitions
accordance with specified
level.
• Maintain collateral, if any, in
working order.
If the borrower violates a covenant → technical default → the

bondholder can demand immediate repayment of principle
435

LIABILITIES
LOS 24.e: Describe the financial statement presentation of
and disclosures relating to debt
• Firm will often report all of their outstanding long-term debt

on a single line on the balance sheet.
• The portion of long - term debt that has due date < 1 year is
reported on a current liability
• More details about the long - term debt is disclosed in the
footnotes, including:
o
The nature of the liabilities.
o
Maturity dates.
o
Stated and effective interest rates.
o
Call provisions and conversion privileges.
o
Restrictions imposed by creditors.
o
Assets pledged as security.
o
The amount of debt maturing in each of the next 5 years
436

LIABILITIES
LOS 24.f: Explain motivations for leasing assets instead of
purchasing them
A lease is a contract between the owner of the asset (lessor) and

another party that wants to use the asset (lessee). The lessee
gains the right to use the asset for a period of time in return for
periodic lease payments.
The right to use the asset

Lessor Lessee
Lease payments
Three requirements for a lease contract
• It must refer to a specific asset.

• It must give the lessee effectively all the asset’s economic
benefits during the term of the lease.
• It must give the lessee the right to determine how to use the
asset during the term of the lease.
437

LIABILITIES
LOS 24.f: Explain motivations for leasing assets instead of
purchasing them
The advantages of leasing rather than purchasing an asset
• Less initial cash outflow: a lease only requires a small down

payments
• Less costly financing: a lease is effectively secured by the leased
asset if the lessee defaults → the interest rate implicit in a lease
contract < the interest rate would be on a loan to purchase the
asset.
• Less risk of obsolescence: At the end of a lease, the lessee often
returns the leased asset to the lessor and therefore does not
bear the risk of an unexpected decline in the asset’s end-of-
lease value.
438

LIABILITIES
LOS 24.g: Explain the financial reporting of leases from a
lessee’s perspective
1. Types of lease
Finance lease Operating lease
Transferred substantially all the Does not transferred substancially all
benefits and risks of ownership to the the benefits and risks of ownership to
lessee. the lessee.
2. Classifications for Lessee and Lessor
Lessee Lessor
IFRS US GAAP IFRS/US GAAP
Short lease term (12 Finance lease Finance lease
months)
Or Operating lease Operating lease
Low value (up to Five conditions for a lease to be classified as a finance lease
$5,000) • Ownership of the leased asset transfers to the lessee.
• The lessee has an option to buy the asset and is expected
Y to exercise it.
Y/N Exemption
N • The lease is for most of the asset’s useful life.
• The present value of the lease payments is greater than or
Lease equal to the asset’s fair value.
(same finance lease) • The lessor has no other use for the asset.
439

LIABILITIES
3. Accounting for lease under IFRS and U.S.GAAP
Example 6: Accounting lease for lessee

Affordable Company leases a machine for its own use for 2 years
with annual payments of $60,000. The interest rate implicit in the
lease is 6%. How will the lease be reported by the lessee if it’s
classified as a finance lease? As an operating lease under
U.S.GAAP?
440

LIABILITIES

Answer:
The present value of lease payments = $110,000:
(N = 2; I/Y = 6%; PMT = - $60,000; FV = 0; CPT → PV = $110,000)
Balance sheet Finance lease Operating lease

Year 0 1 2 0 1 2
Beginning lease liability (1) 110 56.6 110 56.6
Interest expense (2)

(1)*6% 6.6 3.4 6.6 3.4
Lease payment (3) (60) (60) (60) (60)
Principal repayment (4)

(53.4) (56.6) (53.4) (56.6)
(3)-(2)
Ending lease liability (5) 110 56.6 0

(1)-(4) 110 56.6 0
Ending ROU asset 110 55(*) 0 110 56.6(**) 0
(*) Amortization = 110/2 = 55 => ending balance = 110 - 55 = 55

(**) Amortization = principal repayment = 53.4 => ending balance = 110 - 53.4 = 56.6
441

LIABILITIES

Answer: (cont.)
Income statement Finance lease Operating lease

Year Total 1 2 Total 1 2
Interest expenses 10 6.6 3.4
Amortization expenses 110 55 55

Lease expenses 120 60 60
Total expenses 120 61.6 58.4 120 60 60
Cash flow statement Finance lease Operating lease
CFO outflow 10 6.6 3.4 120 60 60
CFF outflow 110 53.4 56.6

442

LIABILITIES

Lease (IFRS) and Finance lease (US.GAAP) Operating lease
Summary (as borrowing and buy) (U.S.GAAP)
• Right-of-use asset = PV of future lease Record as finance

payments (at lease inception) lease. But the right-of-
ROU Assets • Straight-line amortization of right-of-use use asset is not
asset - Cost model (after the inception) straight-line amortized:
o Amortization =
reduction of lease
Lease • Lease liability = PV of future lease liability
liability payments (at lease inception)
• Reduction of lease liability from lease
payment each period - Amortized cost
(after the inception)
Income • Interest expense on lease liability Rental expense = Lease

statement • Amortization expense on leased asset payment
Interest expense = CFO/CFF outflow under Lease payments = CFO

Cash flow IFRS and CFO outflow under U.S.GAAP outflow
statement
Reduction of lease liability = CFF outflow
443

LIABILITIES
LOS 24.h: Explain the financial reporting of leases from a
lessor’s perspective
Example 7: Accounting lease for lessor

A lease contract as in Example 6. How the lessor report it?
Answer:
The present value of lease payments:
N = 2; I/Y = 6%; PMT = - $60,000; FV = 0; CPT → PV = $110,000
The accounting for lessors is substantially identical under IFRS and US
GAAP:
Operating lease: lease payments are simply reported as lease income in
the P&L and CFO inflow over the period.
Finance lease: Lessors under US GAAP recognize finance leases as either
“sales-type” or “direct financing” lease:
• Sale-type lease: PV of lease payments (sales) > the book value of
leased asset (COGS)
• Direct financing lease: PV of lease payments = the book value of
leased asset
444

LIABILITIES
Answer:
Balance sheet
(Remove leased asset) (Retain leased asset)
Year 0 1 2 0 1 2
Beginning lease receivable (1) 110 56.6
Interest income (2) 6.6 3.4

(1)*6%
Lease payment received (3) (60) (60) No effect

Principal repayment received
(4) = (3)-(2) (53.4) (56.6)
Ending lease receivable (5)

(1)-(4) 110 56.6 0
Ending leased asset (removed) (80) 110 55(*) 0
Liability No effect No effect
Equity 30 No effect
(*) Amortization = 110/2 = 55 => ending balance = 110 - 55 = 55

445

LIABILITIES
Answer (cont):
Income statement
Year Total 1 2 Total 1 2
Interest income 10 6.6 3.4
Sales 110
COGS (80)
Gain 30
Lease revenue 60 60
Depreciation expense (55) (55)

Cash flow statement
CFO inflow 60 60 60 60
446

LIABILITIES
Summary (as sell and lending) (no lending)
• Remove assets (at lease inception) • Retain assets (at lease

• Lease receivables = PV of future inception)
lease payments (at lease inception) • Depreciation on leased
• Reduction of lease receivable from assets (after the inception).
Assets lease lease payment received each
period - Amortized cost (after the
inception).
Liability – –
• Interest income on lease • Lease revenue = lease

receivables payment
Income • Gain/Loss = PV of future lease • Depreciation expense on
statement payments (sales) – book value of leased assets
leased asset (COGS)
Lease payments = CFO inflow Lease payments = CFO inflow

Cash flow
statement
447

LIABILITIES
LOS 24.i: Compare the presentation and disclosure of defined
Defined contribution Defined benefit plans
plans
Definition Pension plans in which Pension plans in which

the employee and the the company contributes
company is required to into the plan and
contribute and invest a promises to pay future
certain of funds into the benefits to the
plan. However, the employee during
company makes no retirement.
promise to the employee
regarding the future
value of the plan assets.
Contribution Amount is defined each Depends on current

from period. period estimate and
employer investment performance
of assets.
448

LIABILITIES
Defined contribution Defined benefit plans
plans
Amount of Depends on investment Based on plan’s formula:

future performance of plan’s the firm promises to
benefit to assets make periodic payments
employee to employees after
retirement
Investment The employees The employers

risk goes to
Example An employee periodically The firm contributes a

contributed 5% of basic plan and makes a
salary, this amount is commitment that the
matched by the employee might earn a
employer. But the retirement benefit of 2%
employee’s future benefit of her final salary for
is not specified. each year of service.
449

LIABILITIES
1. Accounting for Defined contribution plans
Balance sheet • Records a decrease in cash.

• If the agreed-upon amount is not
deposited into the plan during a
particular period → the outstanding
amount is recognized as a liability.
Income statement Employer’s contribution is reported as

pension expense
Cash flow statement Employer’s contribution is reported as CFO

outflow
450

LIABILITIES
2. Accounting for Defined benefit plans
Pension benefit = a% × final salary at retirement × number of years of

services.
Example 8: Employee’s pension benefit (Firm’s pension payments)

Consider a company that determines annual pension benefit of each
employee during retirement as 2% × final salary at retirement × number
of years of services. A retiree who served the company for 20 years and
had a final salary at retirement of $200,000 . What is the amount of
pension benefit employee will receive each period after the retirement?
451

LIABILITIES
Example 8: Employee’s pension benefit (Firm’s pension payments)
Answer
A retiree who served the company for 20 years and had a final salary at
retirement of $200,000 would, under the terms of this defined-benefit
plan, be entitled to an annual pension payment of 0.02 x $200,000 x 20 =
$80,000 each year during her retirement until her death.
0 1 … 19 20 21 22 …
$200,000 $80,000 $80,000 $80,000
Final salary at
retirement
452

LIABILITIES
Pension obligation allocated over the Pension expense

= PV of annual Included in COGS/
pension payment years of services SG&A in the P&L
Assumption to determine the pension obligation:

• Expected salary at date of retirement.
• Number of years the employee is expected to live after
retirement.
• The discount rate (typically assumed to be the high-quality
corporate bond yield).
453

LIABILITIES
Example 9: Pension obligation

An employee is eligible to participate in the company’s defined-benefit
pension plan. Under the plan, he is promised an annual payment of 2% of
his final salary for each year of service. The pension benefit will be paid at
the end of each year. The final annual salary is 50,000. The fair value of
plan assets in the first year of employment is $2,140.
The discount rate is 8%.
The employee will work for 25 years.
The employee will live for 15 years after retirement and receive 15 annual
pension benefit payments.
454

LIABILITIES
Example 9: Pension obligation

Answer:
At the end of the 1st year of service, the employee’s annual pension
benefit = 2% × $50,000 × 1 = $1,000 per year from retirement until death.
Step 1: The PV of payments on the retirement date = $8,560
(I/Y = 8, PMT = 1,000, N = 15, FV = 0, CPT → PV = -8,560)
Step 2: At the end of the 1st year of employment, the PV of the annuity
that begins in 24 years = The pension obligation (PBO) of the first year =
$8,560/(1.08^24) = $1,350.
0 1 2 24 25 26 39 40
PBO $1,000 $1,000 $1,000

= 1,350 $8,560
Step 2 Step 1
455

LIABILITIES
The change in the pension obligation (Additional reading)

Beginning value of pension obligation
Under IFRS Under U.S.GAAP
+ Current service costs + Current service costs
+ Net interest expense + Interest costs
+ Actuarial losses + Actuarial losses

change in net
– Net interest income + Past service costs pension
liability/asset
– Actuarial gains – Actuarial gains
– Actual return on – Expected return on plan

plan asset asset
Ending value of pension obligation

456

LIABILITIES
Recognized as Under IFRS Under U.S.GAAP
Current service costs = present value of the increase in pension

benefit earned by the employee as a result of providing one more
year of service to the company
Net interest expense/income = Interest costs: the company

beginning net pension does not pay out service costs
liability/asset × discount rate earned by the employee over
Pension expense used to estimate the pension the year until retirement
in profit and loss obligation
Expected return on plan asset:

This is an explicit assumption
for the expected long-term rate
of return on plan assets
457

LIABILITIES
Recognized as Under IFRS Under U.S.GAAP
Actuarial losses/gains: arise when changes are made in any of the

assumptions used to estimate the company’s pension obligation
(e.g., mortality rates, life expectancy, rate of compensation
increase, and retirement age)
Other
comprehensive
income in profit Actual return on plan asset: Past service costs: retroactive
and loss return which are gained from benefits awarded to employees
investing in a wide variety of when a plan is initiated or
asset classes including equity amended
instruments
458

LIABILITIES
Fair value of plan asset – Pension obligation

= Net pension asset/liability
Balance sheet • The fair value of plan assets > the pension
obligation → the plan has a surplus → reflect a
net pension asset.
• The fair value of plan assets < the pension
obligation → the plan has a deficit → reflect a
net pension liability.
Income The change in net pension liability/asset is

statement recognized either in profit and loss or in other
459

LIABILITIES
Example 10: Change in pension obligation and Net pension

asset/liability
Continue with the pension plan for an employee as in the Example 9.
Answer
At the end of the 2nd year of service, the employee’s annual pension
benefit = 2% × $50,000 × 2 = $2,000 per year from retirement until death.
Step 1: The PV of payments on the retirement date = $17,119
(I/Y = 8, PMT = 2,000, N = 15, FV = 0, CPT → PV = -17,119)
Step 2: At the end of the 2nd year of employment, the PV of the annuity
that begins in 23 years = The pension obligation (PBO) of the 2nd year
= $17,119/(1.08^23) = $2,916.
0 1 2 24 25 26 39 40
PBO PBO $2,000 $2,000 $2,000

= $1,350 = $2,916 $17,119
Step 2 Step 1
460

LIABILITIES
Example 10: Change in pension obligation and Net pension

asset/liability
Answer
During the 2nd year of service, the PBO increased $1,566. The increase is a
result of current service cost and interest cost as follows:
1st PBO = $1,350
+ Current service cost = $1,458 (PV of 15 payments of $1,000 ($2000 –
$1000) starting in 23 years)
+ Interest cost = $108 (= $1,350 × 8%)
2nd PBO = $2,916
If the fair value of the plan assets at the end of 2 nd year = $2,000
→ report a net pension liability = $2,916 - $2,000 = $916
461

LIABILITIES
LOS 24.j: Calculate and interpret leverage and coverage ratios
Solvency ratios to measure a firm’s ability to satisfy its long-term

obligation.
1. Leverage ratios 2. Coverage ratios
• Focus on balance sheet • Focus on income statement

• Measure relative amount • Measure the sufficiency of
of debt in the firm’s capital earnings to repay interest
and other fixed charges when
due.
462

LIABILITIES
1. Leverage ratios
• Debt-to-assets ratio = total debt / total assets

Measures the percentage of total assets financed with debt
The higher the ratio, the higher the financial risk and → the weaker the
solvency
• Debt-to-capital ratio = total debt / (total debt + total equity)
Measures the percentage of total capital financed with debt. It is
different from debt-to-asset ratio by the non-interest-bearing liabilities
The higher the ratio → the weaker the solvency
• Debt-to-equity ratio = total debt / total equity.
Measures the amount of debt financing relative to the firm’s equity base.
The higher the ratio → the weaker the solvency
• Financial leverage ratio = average total assets / average total equity.
Measure of leverage used in the DuPont formula
The higher the financial leverage ratio, the more leveraged the company
in the sense of using debt and other liabilities to finance assets.
463

LIABILITIES
2. Coverage ratios
• Interest coverage = EBIT / interest payments

Measures the number of times a company’s EBIT could cover its interest
payments.
The higher interest coverage ratio, the stronger solvency → greater
assurance that the company can service its debt from operating earnings
• Fixed charge coverage = (EBIT + lease payments) / (interest payments +
lease payments).
Measures the number of times a company’s earnings (before interest,
taxes, and lease payments) can cover the company’s interest and lease
payments.
Fixed charge coverage is more meaningful for firms that engage in
significant operating leases
464

LIABILITIES
Example 11: Leverage ratios and coverage ratios

BT Group data:
31-Mar-X8 31-Mar-X7
Short-term borrowings 2,281 2,632
Long-term debt 11,994 10,081
Total shareholders' equity 10,304 8,335
Total assets 42,759 42,372
EBIT 3,381 3,167
Interest expense 776 817
1. Comment on any changes in the calculated leverage ratios from

year-to-year.
2. Comment on any changes in the interest coverage ratio from
year to year
465

LIABILITIES
Answer:
31-Mar-X8 31-Mar-X7
Debt-to-assets (2,281 + 11,994)/42,759 (2,632 + 10,081)/42,372

= 33.4% = 30%
Debt-to-capital (2,281 + 11,994)/(2,281 + (2,632 + 10,081)/(2,632 +

11,994 + 10,304) 10,081 + 8,335)
= 58.1% = 60.4%
Debt-to-equity (2,281 + 11,994)/10,304 (2,632 + 10,081)/8,335

= 1.39 = 1.53
Interest coverage 3,381/776 = 4.36 3,167/817 = 3.88

ratio
Debt-to-assets ratio increased, while its debt-to-capital and debt-to-equity ratios both
decrease: The decrease in debt-to-capital and debt-to-equity ratios resulted primarily
from the company’s increase in total equity and indicate stronger solvency.
Interest coverage ratios increased from 2017 to 2018 → an improvement in solvency.
The company has sufficient operating earnings to cover interest payments.
466
Practice questions
467

LIABILITIES
Practice exercises
19a. Determine the initial recognition, initial Question 1

measurement and subsequent measurement of –2
bonds
19b. Describe the effective interest method and Question 3

calculate interest expense, amortization of bond –5
discounts/premiums, and interest payments
19c. Explain the derecognition of debt Question 6

19d. Describe the role of debt covenants in Question 7
protecting creditors
19e. Describe the financial statement presentation of Question 8

and disclosures relating to debt
468

LIABILITIES
Practice exercises
19f. Explain motivations for leasing assets instead of Question 9

purchasing them
19g. Explain the financial reporting of leases from a Question 10

lessee’s perspective - 11
19h. Explain the financial reporting of leases from a Question 12

lessor’s perspective – 13
19i. Compare the presentation and disclosure of Question 14

defined contribution and defined benefit pension
plans
19j. Calculate and interpret leverage and coverage Question 15

ratios
469

LIABILITIES
Practice exercises
1. A company issues €1 million of bonds at face value. When the bonds are
issued, the company will record a:
A. cash inflow from investing activities.
B. cash inflow from financing activities.
C. cash inflow from operating activities.
2. At the time of issue of 4.50% coupon bonds, the effective interest rate was
5.00%. The bonds were most likely issued at:
A. par.
B. a discount.
C. a premium.
3. Oil Exploration LLC paid $45,000 in printing, legal fees, commissions, and
other costs associated with its recent bond issue. It is most likely to record
these costs on its financial statements as:
A. an asset under US GAAP and reduction of the carrying value of the
debt under IFRS.
B. a liability under US GAAP and reduction of the carrying value of the
debt under IFRS.
C. a cash outflow from investing activities under both US GAAP and IFRS.
470

LIABILITIES
Practice exercises
4. Midland Brands issues three-year bonds dated 1 January 2015 with a face
value of $5,000,000. The market interest rate on bonds of comparable risk
and term is 3%. If the bonds pay 2.5% annually on 31 December, bonds
payable when issued are most likely reported as closest to:
A. $4,929,285.
B. $5,000,000.
C. $5,071,401
5. On 1 January 2010, Elegant Fragrances Company issues £1,000,000 face

value, five-year bonds with annual interest payments of £55,000 to be paid
each 31 December. The market interest rate is 6.0 percent. Using the
effective interest rate method of amortization, Elegant Fragrances is most
likely to record:
A. an interest expense of £55,000 on its 2010 income statement.
B. a liability of £982,674 on the 31 December 2010 balance sheet.
C. a £58,736 cash outflow from operating activity on the 2010 statement
of cash flows
471

LIABILITIES
Practice exercises
6. The management of Bank EZ repurchases its own bonds in the open market.
They pay €6.5 million for bonds with a face value of €10.0 million and a
carrying value of €9.8 million. The bank will most likely report:
A. other comprehensive income of €3.3 million.
B. other comprehensive income of €3.5 million.
C. a gain of €3.3 million on the income statement.
7. Which of the following is an example of an affirmative debt covenant? The

borrower is:
A. prohibited from entering into mergers.
B. prevented from issuing excessive additional debt.
C. required to perform regular maintenance on equipment pledged as
collateral
8. Regarding a company’s debt obligations, which of the following is most likely

presented on the balance sheet?
A. Effective interest rate
B. Maturity dates for debt obligations
C. The portion of long-term debt due in the next 12 months
472

LIABILITIES
Practice exercises
9. Compared to purchasing a long-lived asset using debt financing, leasing the
asset most likely:
A. is more costly to the lessee.
B. requires a greater initial cash outflow from the lessee.
C. allows the lessee to avoid the risk of obsolescence.
10. Beginning with fiscal year 2019, for leases with a term longer than one year,
lessees report a right-to-use asset and a lease liability on the balance sheet:
A. only for finance leases.
B. only for operating leases.
C. for both finance and operating leases.
11. A company enters into a finance lease agreement to acquire the use of an
asset for three years with lease payments of €19,000,000 starting next year.
The leased asset has a fair market value of €49,000,000 and the present
value of the lease payments is €47,250,188. Based on this information, the
value of the lease liability reported on the company’s balance sheet at lease
inception is closest to:
A. €47,250,188.
B. €49,000,000.
C. €57,000,000.
473

LIABILITIES
Practice exercises
12. Under US GAAP, a lessor’s reported revenues at lease inception will be

highest if the lease is classified as:
A. a sales-type lease.
B. an operating lease.
C. a direct financing lease
13. For a lessor, the leased asset appears on the balance sheet and continues to
be depreciated when the lease is classified as:
A. a finance lease.
B. a sales-type lease.
C. an operating lease.
14. Penben Corporation has a defined benefit pension plan. At 31 December, its
pension obligation is €10 million and pension assets are €9 million. Under
either IFRS or US GAAP, the reporting on the balance sheet would be closest
to which of the following?
A. €10 million is shown as a liability, and €9 million appears as an asset.
B. €1 million is shown as a net pension obligation.
C. Pension assets and obligations are not required to be shown on the
balance sheet but only disclosed in footnotes.
474

LIABILITIES
Practice exercises
15. The following presents selected financial information for a company:
$ Millions
Short-term borrowing 4,231
Current portion of long-term interest-bearing debt 29
Long-term interest-bearing debt 925

Average shareholders’ equity 18,752
Average
The total
financial assetsratio is closest to:
leverage 45,981
A. 0.113
B. 0.277
C. 2.452
475

LIABILITIES
Practice exercises
Answer
1. B is correct. The company receives €1 million in cash from investors at the
time the bonds are issued, which is recorded as a financing activity
2. B is correct. The effective interest rate is greater than the coupon rate and
the bonds will be issued at a discount.
3. A is correct.
• Under US GAAP, expenses incurred when issuing bonds (issuance cost)
are generally recorded as an asset and amortized to the related expense
(legal, etc.) over the life of the bonds.
• Under IFRS, they are included in the measurement of the liability.
• The related cash flows are financing activities.
4. A is correct. The bonds payable reported at issue is equal to the sales

proceeds = $4,929,285
Coupon payments each period = 2.5% × $5,000,000 = $125,000
I/Y = 3; N = 3; PMT = 125,000; FV = 5,000,000; CPT→ PV = -4,929,285
1 Jan 2015 31 Dec 2015 31 Dec 2016 31 Dec 2017
PV = $4,929,285 $125,000 $125,000 $5,125,000

476

LIABILITIES
Practice exercises
5. B is correct. Book value of bond liability is equal to the present value of the
remaining future cash flow.
At the beginning of 2010, book value of bond = £978,938 and it is also a
cash inflow from financing in 2010
Interest expense in 2010 = £978,938 × 6% = £58,736
2010
Beginning book value (1) £978,938
Interest expense (2) = (1) × 6% £58,736

Bond liability
Coupon payments (3) = £55,000 £55,000
Ending book value = (1) – (3) + (2) £982,674
Income statement Interest expense £58,736
Cash flow CFF inflow £978,938

477

LIABILITIES
Practice exercises
6. C is correct. A gain of €3.3 million (carrying amount less amount paid) will
be reported on the income statement.
7. C is correct.
• Affirmative covenants require certain actions of the borrower. Requiring
the company to perform regular maintenance on equipment pledged as
collateral is an example of an affirmative covenant because it requires
the company to do something.
• Negative covenants require that the borrower not take certain actions.
Prohibiting the borrower from entering into mergers and preventing the
borrower from issuing excessive additional debt are examples of negative
covenants.
8. C is correct. The non-current liabilities section of the balance sheet usually

includes: a single line item of the total amount of a company’s long-term
debt due after 1 year → the current liabilities section shows the portion of
a company’s long-term debt due in the next 12 months.
• Notes to the financial statements generally present the stated and
effective interest rates and maturity dates for a company’s debt
obligations
478

LIABILITIES
Practice exercises
9. C is correct. At the end of a lease, the lessee often returns the leased asset
to the lessor → does not bear the risk of an unexpected decline in the
asset’s end-of-lease value → the interest rate implicit in a lease contract
may be less than the interest rate on a loan to purchase the asset.
• The terms of a lease may not require all the covenants typically included
in loan agreements or bond indenture.
10. C is correct. Beginning with fiscal year 2019, lessees report a right-of-use
asset and a lease liability for all leases longer than one year. An exception
under IFRS exists for leases when the underlying asset is of low value.
11. A is correct. Under the revised reporting standards under IFRS and U.S.
GAAP, a lessee must recognize an asset and a lease liability at inception of
each of its leases (with an exception for short-term leases):
→ The lessee reports a “right-of-use” (ROU) asset and a lease liability = the
present value of fixed lease payments on its balance sheet → the company
will record a lease liability on the balance sheet of €47,250,188.
479

LIABILITIES
Practice exercises
12. A is correct. A sales-type lease treats the lease as a sale of the asset, and
revenue is recorded at the time of sale equal to the value of the leased
asset. Under a direct financing lease, only interest income is reported as
earned. Under an operating lease, revenue from lease receipts is reported
when collected.
13. C is correct. When a lease is classified as an operating lease, the underlying

asset remains on the lessor’s balance sheet. The lessor will record a
depreciation expense that reduces the asset’s value over time
14. B is correct. The company will report a net pension obligation of €1 million
equal to the pension obligation (€10 million) less the plan assets
(€9 million).
15. C is correct. The financial leverage ratio is calculated as follows:

(Average total assets/average total shareholder’s equity)
= 45,981/18,752 = 2.452
480
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481

REPORTING QUALITY
482

QUALITY
Learning outcomes
LOS 25.a: Compare and contrast financial reporting quality with the quality of reported
results (including quality of earnings, cash flow, and balance sheet items).
LOS 25.b: Describe a spectrum for assessing financial reporting quality.
LOS 25.c: Explain the difference between conservative and aggressive accounting.
LOS 25.d: Describe motivations that might cause management to issue financial reports
that are not high quality.
LOS 25.e: Describe conditions that are conducive to issuing low-quality, or even
fraudulent, financial reports.
LOS 25.f: Describe mechanisms that discipline financial reporting quality and the potential
limitations of those mechanisms.
LOS 25.g: Describe presentation choices, including non-GAAP measures, that could be
used to influence an analyst’s opinion.
LOS 25.h: Describe accounting methods (choices and estimates) that could be used to
manage earnings, cash flow, and balance sheet items.
LOS 25.i: Describe accounting warning signs and methods for detecting manipulation of
information in financial reports.
483

QUALITY
LOS 25.a: Compare and contrast financial reporting quality with
the quality of reported results (including quality of earnings,
cash flow, and balance sheet items).
1. Financial reporting quality
High quality financial reporting must be decision useful
Relevance Faithful representation

Relevance refers to the fact Faithful representation
that information presented in encompasses the qualities of
the financial statements is completeness, neutrality, and
useful to users of financial the absence of errors.
statements in making
decisions.
Relevant information must
also be material in that
knowledge of it would likely
affect the decisions of users of
financial statements.
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QUALITY
2. Quality of earnings
Earning quality can be judged based on the sustainability of the
earnings as well as on their level
Sustainability Level of earnings

Sustainability can be The importance of the level of
evaluated by determining the earnings is that reported
proportion of reported earnings must be high enough
earnings that can be expected to sustain the company’s
to continue in the future. operations and existence.
(Ex. Earnings from core (ROE > required rate of return,
business,… ) …)
485

QUALITY
Financial Reporting Quality
Low High
HIGH financial reporting

quality enables
Earnings (Results) Quality
High assessment.
LOW financial HIGH earnings quality
reporting increases company value.
quality impedes
assessment of
earnings quality and
impedes valuation. HIGH financial reporting
quality enables
Low assessment.
LOW earnings quality
decreases company value.
486

QUALITY
LOS 25.b: Describe a spectrum for assessing financial reporting
quality.
Highest • Compliant with GAAP
quality • Earnings are sustainable and adequate.
• Compliant with GAAP
• Earnings quality is low (earnings are not sustainable
or not adequate).
Quality spectrum
• Compliant with GAAP

• Earnings quality is low and reporting choices and
estimates are biased.
• Compliant with GAAP,
• Amount of earnings is actively managed to
increase, decrease, or smooth reported earnings.
• Not compliant with GAAP
• The numbers presented are based on the company’s
actual economic activities.
Worst • Not compliant and includes numbers that are
quality essentially fictitious or fraudulent.
487

QUALITY
LOS 25.c: Explain the difference between conservative and
aggressive accounting.
Types of bias
Aggressive choice Conservative choice *
Increase the company’s Decrease the company’s

reported performance and reported performance and
financial position in current financial position and increase
period and decrease earnings future period earnings
in future periods
Example: Accounting bias

Aggressive Conservative
Capitalize current period cost Expense current period cost
(period cost net income (period cost net income
Straight line depreciation Accelerated depreciation

(early-stage depreciation expense (early-stage depreciation expense
net income ) net income )
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QUALITY
(*) Conservative choice
Conservatism should not be seen as “good”. Conservative bias

can also be considered as a deviation from neutral reporting or
faithful representation.
Drawbacks of conservatism Benefits of conservatism
Conservatism directly • Reducing the possibility of

conflicts with the concept of litigation.
Neutrality biased estimates • Reducing current period
of assets, liabilities, and tax liability.
earnings. • Protecting the interests of
those who have less
complete information.
489

QUALITY
3. Typical examples of accounting bias
Involves employing conservative assumptions to
understate performance when the company is actually
Earnings doing well and then using aggressive assumptions
smoothing when the company is not doing as well.
(Cookie jar reserve accounting is also a case of
earnings smoothing)
Unbiased
Earning
Conservative choice effect Earning
Earnings
smoothing
Aggressive choice effect
Low earning period High earning period Time

490

QUALITY
3. Typical examples of accounting bias
This refers to the strategy of manipulating a

Big bath
company’s income statement to make poor results
behavior
look even worse.
Unbiased
Earning
Aggressive choice effect Earning
Big bath
bias
Conservative choice effect
Low earning period High earning period Time

491

QUALITY
LOS 25.d,e: Describe motivations, conditions that are conducive
to issuing low-quality, or even fraudulent, financial reports.
In assessing financial reporting quality, it is important to consider:
1. Whether the reporting 2. Whether a company’s

environment is conducive management may be motivated to issue
to misreporting ? financial reports that are not of high quality ?
Opportunity Motivation Rationalization
• The company has • Mask poor performance Story to justify

weak internal controls • Boost the stock price breaking the
• The board of directors • Increase personal rules.
provides inadequate compensation
oversight • Avoid violation of debt
• Applicable accounting covenants
standards provide a • Increase the probability of
large range of exceeding next period’s
acceptable accounting forecasts
treatments • Meat or beat expectations,
492

QUALITY
LOS 25.f: Describe mechanisms that discipline financial
reporting quality and the potential limitations of those
mechanisms.
1. Markets
Financial 2.
4. Private
reporting Regulatory
contract
quality authorities
3. Auditors
493

QUALITY
mechanisms.
1. Markets
Companies compete for capital, and the cost of capital is directly related
to the level of perceived risk aim to provide high-quality financial
reports to minimize their long-term cost of capital.
2. Regulatory authorities
Typical regulatory requirement
• A registration process for the issuance of new publicly traded
securities.
• Specific disclosure and reporting requirements, including periodic
financial statements and accompanying notes.
• A statement of financial condition made by management.
• A signed statement by the person responsible for the preparation of
the financial reports.
• A review process for newly registered securities and periodic reviews
after registration.
Enforcement actions
• Fines
• Suspension of participation
494

QUALITY
mechanisms.
3. Auditors
While public companies are required to have their financial statements

audited by an independent auditor, private companies also obtain audit
opinions regarding their financial statements, either voluntarily or to
meet requirements imposed by providers of capital.
(*) An unqualified or “clean” audit opinion is not a guarantee that no
fraud has occurred but only offers reasonable assurance that the
financial reports
4. Private contract
The counterparties to private contracts with the firm have an incentive

to see that the firm produces high-quality financial reports → source of
discipline on financial reporting quality.
495

QUALITY
LOS 25.g: Describe presentation choices, including non-GAAP
measures, that could be used to influence an analyst’s opinion.
Companies that report non-GAAP measures are
1. required to:
• Display the most comparable GAAP measure with equal
prominence
• Provide an explanation by management as to why the non-
GAAP measure is thought to be useful.
• Reconcile the differences between the non-GAAP measure
and the most comparable GAAP measure.
• Disclose other purposes for which the firm uses the non-
GAAP measure.
• Include, in any non-GAAP measure, any items that are likely
to recur in the future, even those treated as nonrecurring,
unusual, or infrequent in the financial statements.
2. IFRS require that firms using non-IFRS measures to:

• Define and explain the relevance of such non-IFRS measures.
• Reconcile the differences between the non-IFRS measure and
the most comparable IFRS measure.
496

QUALITY
LOS 25.h: Describe accounting methods (choices and estimates)
that could be used to manage earnings, cash flow, and balance
sheet items.
Revenue recognition (1)

Estimates of credit losses (2)
Valuation allowance (3)
Depreciation methods and estimates (4)
Accounting
choices and Amortization and impairment (5)
estimates
Inventory method (6)
Capitalization (7)
Related-party transactions (8)
Other cash flow effects (9)

497

QUALITY
sheet items.
Free-on-board (FOB)
• FOB at the shipping point revenue is recognized
aggressively and earlier.
• FOB at the destination revenue is recognized in later
period.
Channel stuffing
• In low earning period, firm overload a distribution
channel with more goods than would normally be
1. Revenue
sold during a period higher current revenue lower
recognition
future revenue.
• In high earnings period, firmdelays recognition of
revenue to the next period and hold or delay
customer shipments lower current revenue.
Bill-and-hold transaction
The firm sells the goods but still keep it at their location
at the end of that period, inventory is still high low COGS
company recognizes high net income and assets
498

QUALITY
sheet items.
• in the allowance for bad debt net receivables on

(2) Estimates
the balance sheet, expenses net income.
of credit
• in the allowance for bad debt net receivables on the
losses
balance sheet, expenses net income.
Valuation allowance reduces the carrying value of a

deferred tax asset based.
(3) Valuation • a valuation allowance the net deferred tax asset on
allowance the balance sheet net income for the period
• a valuation allowance the net deferred tax asset on
the balance sheet net income for the period
499

QUALITY
sheet items.
Depreciation methods, Estimates of the useful life
(4) Depreciation
of a depreciable asset and its salvage value upon
methods and
disposal can affect expenses, and net income. (LOS
estimates
22.e – SAPP’s slides version)
By ignoring or delaying recognition of an
(5) Amortization impairment charge for goodwill, management can
and impairment increase earnings in the current period. (LOS 22.e
and LOS 22.f – SAPP’s slides version)
Choice between FIFO, LIFO and weighted-average

(6) Inventory
inventory costing methods will affect COGS, gross
method
profit, gross margin, and earnings (LOS 21.l)
Any expense that can be capitalized creates an

asset on the balance sheet, and the impact of the
expense on net income can be spread over many
(7) Capitalization
years.
Capitalization also affects cash flow classifications.
(LOS 22.b)
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QUALITY
sheet items.
If a public firm does business with a supplier that is

(8) Related- private and controlled by management, adjusting the
party price of goods supplied can shift profits either to or
transactions from the private company to manage the earnings
reported by the public company.
The ability under IFRS to classify interest and dividends

paid as either CFO or CFF, and interest and dividends
(9) Other cash
received as either CFO or CFI, gives management an
flow effects
additional way to manage reported operating cash flow.
(LOS 19.a)
501

QUALITY
LOS 25.i: Describe accounting warning signs and methods for
detecting manipulation of information in financial reports.
List of several warning signs
Related to Capitalization Policies and Deferred Costs

• Capitalization decisions, depreciation methods, useful lives,
salvage values out of line with comparable firms
Related to the Relationship between Cash Flow and Income
• Net income not supported by operating cash flows
• Revenue growth out of line with comparable firms, changes in
revenue recognition methods, or lack of transparency about
revenue recognition
Other Potential Warning Signs
• Decreases over time in turnover ratios (receivables, inventory,
total asset)
• Fourth-quarter earnings patterns not caused by seasonality
• Frequent appearance of nonrecurring items
• Bill-and-hold, barter, or related-party transactions
• Emphasis on non-GAAP measures, minimal information and
disclosure in financial reports
502

QUALITY
Practice questions
LOS 25.a: Compare and contrast financial reporting

quality with the quality of reported results (including
4
quality of earnings, cash flow, and balance sheet
items).
LOS 25.b: Describe a spectrum for assessing financial

6
reporting quality.
LOS 25.c: Explain the difference between conservative

2,3
and aggressive accounting.
LOS 25.d: Describe motivations that might cause

management to issue financial reports that are not 7
high quality.
503

QUALITY
Practice questions
LOS 25.e: Describe conditions that are conducive to

issuing low-quality, or even fraudulent, financial 5
reports.
reporting quality and the potential limitations of those 9
mechanisms.
LOS 25.g: Describe presentation choices, including non-
GAAP measures, that could be used to influence an 8
analyst’s opinion.
LOS 25.h: Describe accounting methods (choices and
estimates) that could be used to manage earnings, cash 10
flow, and balance sheet items.
LOS 25.i: Describe accounting warning signs and
methods for detecting manipulation of information in 1
financial reports.
504

QUALITY
Practice questions
1 Which of the following would most likely signal that a

company may be using aggressive accrual accounting policies
to shift current expenses to later periods?
Over the last five-year period, the ratio of cash flow to net
income has:
A increased each year.
B decreased each year.
C fluctuated from year to year.
2
Which of the following is most likely to be considered a
potential benefit of accounting conservatism?
A A reduction in litigation costs
B Less biased financial reporting
C An increase in current period reported performance
3 Which of the following is most likely to reflect conservative
accounting choices?
A Decreased reported earnings in later periods
B Increased reported earnings in the period under review
C Increased debt reported on the balance sheet at the end of
the current period
505

QUALITY
Practice questions
4 To properly assess a company’s past performance, an analyst

requires:
A high earnings quality.
B high financial reporting quality.
C both high earnings quality and high financial reporting
quality.
5
Which of the following best describes an opportunity for
management to issue low-quality financial reports?
A Ineffective board of directors
B Pressure to achieve some performance level
C Corporate concerns about financing in the future
6 Which attribute of financial reports would most likely be

evaluated as optimal in the financial reporting spectrum?
A Conservative accounting choices
B Sustainable and adequate returns
C Emphasized pro forma earnings measures
506

QUALITY
Practice questions
7 Which of the following concerns would most likely motivate a

manager to make conservative accounting choices?
A Attention to future career opportunities
B Expected weakening in the business environment
C Debt covenant violation risk in the current period
8 Earnings that result from non-recurring activities most likely

indicate:
A lower-quality earnings.
B biased accounting choices.
C lower-quality financial reporting.
9 If a company uses a non-GAAP financial measure in an SEC
filing, then the company must:
A give more prominence to the non-GAAP measure if it is used
in earnings releases.
B provide a reconciliation of the non-GAAP measure and
equivalent GAAP measure.
C exclude charges requiring cash settlement from any non-
GAAP liquidity measures.
507

QUALITY
Practice questions
10 Which technique most likely increases the cash flow provided

by operations?
A Stretching the accounts payable credit period
B Applying all non-cash discount amortization against interest
capitalized
C Shifting classification of interest paid from financing to
operating cash flows
508

QUALITY
Practice questions
1. B is correct. If the ratio of cash flow to net income for a company

is consistently below 1 or has declined repeatedly over time, this
may be a signal of manipulation of information in financial reports
through aggressive accrual accounting
2. A is correct. Conservatism reduces the possibility of litigation and,
by extension, litigation costs. Rarely, if ever, is a company sued
because it understated good news or overstated bad news.
Accounting conservatism is a type of bias in financial reporting that
decreases a company’s reported performance. Conservatism
directly conflicts with the characteristic of neutrality.
3. C is correct. Accounting choices are considered conservative if
they decrease the company’s reported performance and financial
position in the period under review. Conservative choices may
increase the amount of debt reported on the balance sheet. They
may decrease the revenues, earnings, and/or operating cash flow
reported for the period and increase those amounts in later periods.
509

QUALITY
Practice questions
4. B is correct. Financial reporting quality pertains to the quality of

the information contained in financial reports. If financial reporting
quality is low, the information provided is of little use in assessing
the company’s performance. Financial reporting quality is
distinguishable from earnings quality, which pertains to the earnings
and cash generated by the company’s actual economic
activities and the resulting financial condition.
5. A is correct. Opportunities to issue low-quality financial reports

include internal conditions, such as an ineffective board of directors,
and external conditions, such as accounting standards that provide
scope for divergent choices. Pressure to achieve a certain level of
performance and corporate concerns about future financing are
examples of motivations to issue low-quality financial
reports. Typically, three conditions exist when low-quality financial
reports are issued: opportunity, motivation, and rationalization.
510

QUALITY
Practice questions
6. B is correct. At the top of the quality spectrum of financial reports

are reports that conform to GAAP, are decision useful, and have
earnings that are sustainable and offer adequate returns. In other
words, these reports have both high financial reporting quality and
high earnings quality.
7. B is correct. Managers may be motivated to understate earnings

in the reporting period and increase the probability of meeting or
exceeding the next period’s earnings target.
8. A is correct. Earnings that result from non-recurring activities are

unsustainable. Unsustainable earnings are an example of lower-
quality earnings. Recognizing earnings that result from non-
recurring activities is neither a biased accounting choice nor
indicative of lower quality financial reporting because it faithfully
represents economic events.
511

QUALITY
Practice questions
9. B is correct. If a company uses a non-GAAP financial measure in

an SEC filing, it is required to provide the most directly comparable
GAAP measure with equivalent prominence in the filing. In addition,
the company is required to provide a reconciliation between the
non-GAAP measure and the equivalent GAAP measure. Similarly,
IFRS require that any non-IFRS measures included in financial
reports must be defined and their potential relevance explained.
The non-IFRS measures must be reconciled with IFRS measures.
10. A is correct. Managers can temporarily show a higher cash flow

from operations by stretching the accounts payable credit period. In
other words, the managers delay payments until the next
accounting period. Applying all noncash discount amortization
against interest capitalized causes reported interest expenses and
operating cash outflow to be higher, resulting in a lower cash flow
provided by operations. Shifting the classification of interest paid
from financing to operating cash flows lowers the cash flow
provided by operations.
512
READING 26: APPLICATIONS OF

FINANCIAL STATEMENT ANALYSIS
513
READING 26: APPLICATIONS OF FINANCIAL

STATEMENT ANALYSIS
Learning outcomes
LOS 26.a: Evaluate a company’s past Financial performance

and explain how a company’s strategy is reflected in past
financial performance.
LOS 26.b: Demonstrate how to forecast a company’s future

net income and cash flow.
LOS 26.c: Describe the role of financial statement analysis in

assessing the credit quality of a potential debt investment.
LOS 26.d: Describe the use of financial statement analysis in

screening for potential equity investments.
LOS 26.e: Explain appropriate analyst adjustments to a

company’s financial statements to facilitate comparison with
another company.
514

STATEMENT ANALYSIS
LOS 26.a: Evaluate a company’s past Financial performance and
explain how a company’s strategy is reflected in past financial
performance.
Financial analysis
Adressing
How well the company The reasons behind its

performed over the period performance
Financial analysis should focus on:

• Important changes that have occurred in corporate measures of profitability,
efficiency, liquidity, and solvency and the reasons behind these changes.
• Comparisons of the company’s financial ratios with others from the same industry
and the reasons behind any differences.
• Examination of performance aspects that are critical for a company to successfully
compete in the industry and an evaluation of the company’s performance on these
fronts relative to its competitors’.
• The company’s business model and strategy and how they influence its operating
performance.
515

STATEMENT ANALYSIS
LOS 26.a: Evaluate a company’s past Financial performance and
explain how a company’s strategy is reflected in past financial
performance.
Example: A firm’s strategy and its financial performance

Low cost airlines like Southwest focus on generating profits through high
volumes with low margins. Others, like Silverjet (an exclusively business
class airline) cater to high end customers only.
→ While Silverjet sales volume (in units) would be significantly lower
than Southwest’s, Silverjet gross margin should be higher as it offers a
premium service.
516

STATEMENT ANALYSIS
LOS 26.b: Demonstrate how to forecast a company’s future net
income and cash flow.
1. Sales forecast
“Top down” approach: GDP growth → growth of

industry sales (Use regression models) → firm sales
(market share analysis).
2. Using model to forecast net income from revenue

A simple forecasting model: use historical average,
trend-adjusted measure of profitability of operating
margin, EBT margin, or net margin to forcast
earnings.
Complex forecasting models: each item on an
income statement and balance sheet can be
estimated based on separate assumptions
517

STATEMENT ANALYSIS
LOS 26.b: Demonstrate how to forecast a company’s future net
income and cash flow.
Make assumptions about future sources and uses

3.
of cash
Assumptions should be made on:
• Required increases in working capital.
• Capital expenditures on new fixed assets.
• Repayment and issuance of debt.
• Repurchase and issuance of stock (equity).
4. Forecast Cash flow
Forecast cash flow based on assumptions made in

step 3.
518

STATEMENT ANALYSIS
1. Credit risk
Credit risk is the risk of loss from a counterparty or debtor’s

failure to make a promised payment.
2. Credit analysis
Credit analysis involves evaluation of the 4 “Cs” of a company.
Character refers to the quality of management
Collateral refers to the assets pledged to secure a loan.
refers to the ability of the issuer to fulfill its

Capacity
obligations.
are limitations and restrictions on the

Covenants
activities of issuers.
519

STATEMENT ANALYSIS
3. Credit analysis considerations

Credit rating agencies such as Moody’s and Standard and Poor’s
employ formulas that are essentially weighted averages of several
specific accounting ratios and business characteristics.
Scale and diversification: Larger companies enjoy

significant leverage in negotiations with suppliers
and lenders lower credit risk.
Operational efficiency: Firms that have higher

The types return on their assets ⇒ lower credit risk.
of items
considered Margin stability: high profit margins indicate a
higher probability of repayment ⇒ low credit risk.
Leverage: High ratios of free cash flow to total

debt and to interest expense ⇒ low credit risk.
520

STATEMENT ANALYSIS
1. Definition of screening
Screening is the process of filtering a set of potential investments
into a smaller set (that exhibits certain desirable characteristics)
by applying a set of criteria.
Top-down analysis involves Bottom-up analysis involves
identifying attractive selecting specific investments
geographical and industry within a specific investment
segments, and then choosing universe.
the most attractive investments
from them.
2. Applications of screening
Screens can be used by growth investors (focused on investing in
high earnings-growth companies), value investors (focused on
paying a relatively low share price in relation to earnings or assets
per share), and market-oriented investors (who cannot be
categorized as growth or value investors).
521

STATEMENT ANALYSIS
2. Applications of screening
Securities
Screening
Value investors set screens

Growth investors set
like a higher-than-average
screens like increasing
return on equity (ROE) and a
earnings growth and/or
lower-than-average P/E
momentum.
ratio
Potential investment portfolio
3. Limits of screening
Equity screens will likely include and exclude many or all of the
firms in particular industries.
522

STATEMENT ANALYSIS
4. Backtesting
Using a specific set of criteria to screen historical data to determine

how portfolios based on those criteria would have performed.
Limitations
Survivorship bias Look-ahead bias Data-snooping bias

If the database used If a database includes If researchers build
in backtesting financial data models based on
eliminates updated for previous
companies that restatements, there researchers’
cease to exist is a mismatch findings, then using
because of a merger between what the same database
or bankruptcy, then investors would have to test the model is
the remaining actually known at the not actually a test.
companies time of the
collectively will investment decision
appear to have and the information
performed better. used in backtesting.
523

STATEMENT ANALYSIS
another company.
Company uses different Financial Analysts need to make

accounting method or statements items adjustments to facilitate
estimate key accounting becomes comparisons
inputs differently incomparable
1. Adjustments related to investments
Securities are recorded as held-for-trading, available-for-sale, held-to-

maturity. these differences in classifications lead to significant differences
in reported net income or balance sheet asset values → adjust net income
and assets
2. Adjustments related to inventory
Firm using LIFO → higher cost of goods sold, lower income, and lower
inventory (when costs are rising) → adjust LIFO cost of goods and inventory
to their FIFO-equivalent values using LIFO reserve
524

STATEMENT ANALYSIS
another company.
3. Adjustments related to property, plant, and equipment
Differences between depreciation methods, estimates of useful lives, and estimates of

salvage values → significant differences in reported income and balance sheet asset
values → adjustment should be made.
Gross fixed assets = Accumulated depreciation + Net fixed assets
= +
Estimated useful or
Average age of asset Remaining useful life
depreciable life
Comparing average ages and useful lives of assets within an
industry may reveal differences in firms’ future capital spending needs.
Ex. A firm that is aggressive in using higher estimates of useful asset lives or asset
salvage values will report lower annual depreciation expense and higher net income,
compared to a more conservative firm that uses lower estimates of useful lives or
salvage values.
525

STATEMENT ANALYSIS
another company.
4. Adjustments related to goodwill
For companies that has grown through acquisition of some business

units, analysts must remove the inflating effect of goodwill on book value
and rely on the price to-tangible book value ratio to make comparisons.
Two adjustments should be made on goodwill:
• Goodwill should be subtracted from assets when calculating financial
ratios
• Any income statement expense from impairment of goodwill in the
current period should be reversed, increasing reported net income.
526

STATEMENT ANALYSIS
Practice questions
Learning outcome statements Questions
LOS 26.a: Evaluate a company’s past Financial

performance and explain how a company’s strategy
is reflected in past financial performance..
LOS 26.b: Demonstrate how to forecast a company’s

6
future net income and cash flow.
LOS 26.c: Describe the role of financial statement

analysis in assessing the credit quality of a potential 1
debt investment.
LOS 26.d: Describe the use of financial statement
analysis in screening for potential equity 3
investments.
LOS 26.e: Explain appropriate analyst adjustments to

a company’s financial statements to facilitate 2,4,5
comparison with another company.
527

STATEMENT ANALYSIS
Practice questions
1 Credit analysts are likely to consider which of the following in making a

rating recommendation?
A Business risk but not financial risk
B Financial risk but not business risk
C Both business risk and financial risk
2 To compute tangible book value, an analyst would:

A add goodwill to stockholders’ equity.
B add all intangible assets to stockholders’ equity.
C subtract all intangible assets from stockholders’ equity.
3 When a database eliminates companies that cease to exist because of

a merger or bankruptcy, this can result in:
A look-ahead bias.
B back-testing bias.
C survivorship bias.
528

STATEMENT ANALYSIS
Practice questions
4 An analyst is evaluating the balance sheet of a US company that uses

last in, first out (LIFO) accounting for inventory. The analyst collects the
following data:
31 Dec 05 31 Dec 06
Inventory reported
$500,000 $600,000
on balance sheet
LIFO reserve $ 50,000 $70,000
Average tax rate 30% 30%
After adjusting the amounts to convert to the first in, first out (FIFO)
method, inventory at 31 December 2006 would be closest to:
A $600,000.
B $620,000.
C $670,000.
529

STATEMENT ANALYSIS
Practice questions
5 An analyst gathered the following data for a company ($ millions):

31 Dec 2000 31 Dec 2001
Gross investment in fixed
$2.8 $2.8
assets
Accumulated depreciation $1.2 $1.6
The average age and average depreciable life of the company’s fixed
assets at the end of 2001 are closest to:
Average Age Average Depreciable Life
A 1.75 years 7 years
B 1.75 years 14 years
C 4.00 years 7 years
6 Projecting profit margins into the future on the basis of past results
would be most reliable when the company:
A is in the commodities business.
B operates in a single business segment.
C is a large, diversified company operating in mature industries.
530

STATEMENT ANALYSIS
Practice questions
1. C is correct. Credit analysts consider both business risk and financial risk.
2. C is correct. Tangible book value removes all intangible assets, including
goodwill, from the balance sheet.
3. C is correct. Survivorship bias exists when companies that merge or go
bankrupt are dropped from the database and only surviving companies
remain. Look-ahead bias involves using updated financial information in
back-testing that would not have been available at the time the decision
was made. Backtesting involves testing models in prior periods and is not,
itself, a bias.
4. C is correct. To convert LIFO inventory to FIFO inventory, the entire LIFO
reserve must be added back: $600,000 + $70,000 = $670,000.
5. C is correct. The company made no additions to or deletions from the
fixed asset account during the year, so depreciation expense is equal to
the difference in accumulated depreciation at the beginning of the year
and the end of the year, or $0.4 million. Average age is equal to
accumulated depreciation/depreciation expense, or $1.6/$0.4 = 4 years.
Average depreciable life is equal to ending gross investment/depreciation
expense = $2.8/$0.4 = 7 years.
6. C is correct. For a large, diversified company, margin changes in different
business segments may offset each other. Furthermore, margins are most
likely to be stable in mature industries.
531

STATEMENT ANALYSIS
Practice questions
1. C is correct. Credit analysts consider both business risk and financial risk.
2. C is correct. Tangible book value removes all intangible assets, including
goodwill, from the balance sheet.
3. C is correct. Survivorship bias exists when companies that merge or go
bankrupt are dropped from the database and only surviving companies
remain. Look-ahead bias involves using updated financial information in
back-testing that would not have been available at the time the decision
was made. Backtesting involves testing models in prior periods and is not,
itself, a bias.
4. C is correct. To convert LIFO inventory to FIFO inventory, the entire LIFO
reserve must be added back: $600,000 + $70,000 = $670,000.
5. C is correct. The company made no additions to or deletions from the
fixed asset account during the year, so depreciation expense is equal to
the difference in accumulated depreciation at the beginning of the year
and the end of the year, or $0.4 million. Average age is equal to
accumulated depreciation/depreciation expense, or $1.6/$0.4 = 4 years.
Average depreciable life is equal to ending gross investment/depreciation
expense = $2.8/$0.4 = 7 years.
53
2
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READING 15: INTRODUCTION TO

READING 15: INTRODUCTION TO FINANCIAL

15.a. Describe the roles of financial reporting and financial statement

15.e. Identify & describe information sources that analyst use in FS

15.f. Describe the steps in the financial statement analysis framework

READING 15: INTRODUCTION TO FINANCIAL

2. Role of financial statement analysis

Financial statement analysis is to use the information in a company’s financial

READING 15: INTRODUCTION TO FINANCIAL

Statement of financial position (balance sheet)

Statement of comprehensive income

Statement of cash flows

Statement of changes in equity

Note: The accompanying required notes or footnotes (see

READING 15: INTRODUCTION TO FINANCIAL

1. Role of statement of financial position

Report major classes & amount of assets (resources owned or controlled

Basic equation of SOFP

Assets Liabilities Equity

READING 15: INTRODUCTION TO FINANCIAL

Example: Statement of financial position

READING 15: INTRODUCTION TO FINANCIAL

2. Role of statement of comprehensive income (SOCI)

Report on performance of firm (result of its operating activities) on

Basic equation of SOCI

The statement of comprehensive income can be presented as a single

READING 15: INTRODUCTION TO FINANCIAL

Example: Statement of comprehensive income

READING 15: INTRODUCTION TO FINANCIAL

3. Role of statement of cash flow

Report cash receipts and payments in the reporting period, classified as

Basic equation of SOCF

Net cash Net cash in Net cash in Net cash in

READING 15: INTRODUCTION TO FINANCIAL

+ Net cash in financing CF

READING 15: INTRODUCTION TO FINANCIAL

Example: Profit versus Cash Flow

READING 15: INTRODUCTION TO FINANCIAL

Sale price €250,000 Cash from sale price €250,000

Cash paid for COGS

SD’s profit for SD’s cash flow for

READING 15: INTRODUCTION TO FINANCIAL

Profit Cash flow

Sale price €250,000 Cash from sale price €250,000

Cash paid for COGS

Rent and salaries (€20,000) Cash paid for Rent &

SD’s profit for SD’s cash flow for

READING 15: INTRODUCTION TO FINANCIAL

4. Role of statement of change in equity

• Report movement (increase and decrease) in components of owners’

o Increase or decrease in subscribed capital

Basic equation of SOCI

Opening Movement Closing

READING 15: INTRODUCTION TO FINANCIAL

Example: Statement of change in equity

READING 15: INTRODUCTION TO FINANCIAL

The notes provide information that is essential to understanding the

Information included in Financial statement notes:

• Discuss the basis of presentation such as the fiscal period covered by

READING 15: INTRODUCTION TO FINANCIAL

Example: Financial statement notes – Basis of presentation

Saigon Beer – Alcohol - Beverage Corporation (SAB)