FINANCIAL ACCOUNTING – notes from QBank

SS7: Introduction

Financial Statement Analysis: An Introduction ( Reading 29 )

Financial Reporting Mechanics ( Reading 30 )
Financial Reporting Standards ( Reading 31 )

Using the information in a company’s financial statements to make economic decisions is financial analysis, not
financial reporting.

Some supplementary schedules are not audited whereas footnotes are audited

The MD&A provides an assessment of the financial performance and condition of the company from the perspective of
the company and is required by the SEC. It includes many areas including such items as discontinued operations,
extraordinary items, and other unusual or infrequent events. The MD&A is typically not audited. The statement of
comprehensive income reports the change in equity from transactions and from non-owner sources.

The statements that the financial information was prepared according to GAAP should be included in the regular part
of the auditors' report and not as an explanatory paragraph

Proxy statements are issued to shareholders when there are matters that require a shareholder vote. These
statements, which are also filed with the SEC and available from EDGAR, are a good source of information about the
election of (and qualifications of) board members, compensation, management qualifications, and the issuance of
stock options.

Corporate reports and press releases are written by management and are often viewed as public relations or sales
materials.

Framework

The financial statement analysis framework consists of six steps:

1. State the objective and context.
2. Gather data.
3. Process the data.
4. Analyze and interpret the data.
5. Report the conclusions or recommendations.
6. Update the analysis.

The financial statement analysis framework consists of six steps:

1. State the objective and context. Determine what questions the analysis is meant to answer, the form in which it
needs to be presented, and what resources and how much time are available to perform the analysis.

2. Gather data. Acquire the company’s financial statements and other relevant data on its industry and the economy.
Ask questions of the company’s management, suppliers, and customers, and visit company sites.

3. Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios. Prepare exhibits
such as graphs and common-size balance sheets.

4. Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide what
conclusions or recommendations the information supports.

5. Report the conclusions or recommendations. Prepare a report and communicate it to its intended audience. Be sure
the report and its dissemination comply with the Code and Standards that relate to investment analysis and
recommendations.

6. Update the analysis. Repeat these steps periodically and change the conclusions or recommendations when
necessary.

Financial Reporting

The role of financial statement analysis is to use the information in a company’s financial statements, along with other
relevant information, to make economic decisions.

Financial Reporting Mechanics ( Reading 30 )

Accumulated depreciation is a contra-asset account to the asset account property, plant & equipment. Treasury stock
is a contra-equity account to common stock or additional paid-in capital.

Keeping the accounting equation in balance requires double-entry accounting, in which a transaction has to be
recorded in at least two accounts.

The down payment will increase cash (an asset) and unearned revenue (a liability). Revenues (and thus retained
earnings and owner’s equity) will not increase because the car has not been delivered.

furniture store acquires a set of chairs for $750 cash and sells them for $1000 cash. These transactions are most
likely to affect which accounts?

Assets, revenue, expenses, owners' equity - an increase in cost of goods sold (expenses)

Accruals fall into four categories:

1. Unearned revenue.
2. Accrued revenue.
3. Prepaid expenses.
4. Accrued expenses. Wages payable are a common example of an accrued expense

Accruals require an accounting entry when the earliest event occurs (paying or receiving cash, providing a good or
service, or incurring an expense) and one or more offsetting entries as the exchange is completed.

Calculating Net Income

Ending equity – Beginning Equity + dividends – stockholder investments

ACCOUNTING NOTES FROM VIDEO

Purpose of Accounting
1. Equity investments
2. M&A
3. Subsidieary
4. PE VC
5. Creditworthiness
6. Extending credit
7. Examine compliance with convenants
8. Assign debt rating
9. Value security – research
10. Forecasting earnings CFLO

MD&A is unaudited
Statement of Comprehensive Income  unrealized gains and losses
Revenue = Net Sales – less warranties

Assets – Liabilities = Net Assets or Net Worth

Paid in cap + Other Paid in Cap ($amt over par) = Contributed Capital

Audit Report
- Unqualified (no problems)
- Qualified (limitations and exceptions)
- Disclaimer of opinion (failed to make opinion)

LIABILITIES
Liability Provision: is an estimated liability (e.g. tax expense)
Financial Liabilities: pension or leases
Minorith Interest – the amount of subsidiary not owned
Unearned Revenue – is also a liability

Debits & Credits

Debit is good in the Balance Sheet

Recognition IFRS – includes “probable” flow of benefit – GAAP does not have “probable”
No statement of Comprehensive Income

Minority interest shown on both B/S and I/S

Where there is no framework – IFRS but, not GAAP

GAAP biz vs non biz

IASB – going concern + accruals
FASB – going concern is not well-developed

IASB – no hierarachy
FASB – hierarchy

FASB – asset revaluation not allowed

Both acknowledge Fair Value

Measurement
- Both are focusing more on B/S standard as opposed to revenue/expense

Reporting Mechanics

Chart of Accounts
5 financial statement Elements
Assets, Liabilities , equity, rev, expenses

Flow of info
Entries > general ledger (all transactions by date
Ledger > sor by account
Trial Balance
Financial statements

Net Income = Change in RE + dividends – Stk investments

Sh. Equity = Beginning RE + Net Income + Stock Investments – dividends

Use of GAPP mentioned in Auditors Report not in MD&A

SEC Registration Documents

10K – annjual filing of bbsiness, financial disclosures, legal proceedings, and management
20F, 40F – annual for foreign companies
Annual report – not required by SEC
10Q and 6K – interim reports. Non-U.S. is 6K
S1 – New Sale of securities
DEF 14A – proxy
8K – material events
144 – unregistered sale of securities
F – foreign company
Form 3,4,5 – beneficial ownership of securities – initial statement, changes, annual report

Convergence – universal acceptance of standards

Timelieness refers to relevance

Qualitative Characteristics
1. Understandability
2. Comparability
3. Relevance (both IASB and FASB)
4. Reliability (faithful representation, substance over form, neutrality, prudence, completeness) (both IASB and
 FASB)

Requirements IAS No. 1

Balance Sheet
Income Statement
Statement of Changes in Eqity
Cash Flow Statement
Notes

Fundamentals in preparation of financial statements

Fair presentation
Going concern
Accural basis
Consistency
Materiality

Presentation Requirements

Aggregation – group similar items together

No offsetting –
Classified Balance Sheet – distinguish between current and non-current assets
Minimum information on Financial Statements
Minimum information on notes
Comparative information

Characteristics of a Coherent System

Transparancy
Comprehensive
Consistent

Standard Seting
- Principle based (broad – IFRS)
- Rule based (specific)
- Objective based (combination – FASB)

Company Disclosure

- Footnotes and MD&A

- Which policies are discussed
- Which policies required management to make estimates
- Any changes over previous period

Likely impact of new standards

- Does or doesn’t apply
- Still evaluating
- Conclude materiality impact

FINANCIAL STATEMENT ANALYSIS

Describe the components of the income statement and construct an income statement using the alternative
presentation formats of that statement.

Interest earned on the CD is recognized as interest income. The gain on the sale of treasury stock is not reported on
the income statement but is relected on the statement of changes in stockholders’ equity and on the balance sheet.
The sale proceeds simply increase equity and increase cash.

Gains and losses result from, transactions that are not a part of the firm’s normal business operations. Expenses are
amounts that are incurred to generate revenue; thus, expenses result from the firm’s ongoing operations. Both are
included on the income statement.
Demonstrate specific revenue recognition applications (including accounting for long-term contracts,
installment sales, barter transactions, and gross and net reporting of revenue).

Under the accrual concept, revenue is recognized when the earnings process is completed (earned) and ultimate
realization (cash receipt) is assured.

Revenue may be recorded as production occurs (% of completion), at completion of production, and at the time of
sale.

Percentage of Completion:

Costs incurred to date

Total cost of project

% of completion X contract amt (revenue recognition)

Gross profit = revenue recognized – costs incurred to date

The percentage-of-completion method is appropriate when payment is assured when dealing with the U.S.
government, and cost and price estimates are assumed reliable due to the ongoing and routine nature of the
contract.

total costs incurred to total estimated cost.

Completed Contract Method

The completed contract method compared to the percentage-of-completion method will result in lower net income
since revenue is recognized later. Hence, retained earnings will also be lower than the percentage-of-completion
method. Short-term and costs and revenue cannot be estimated.

Losses are recognized when occurred

In accounting for long-term construction contracts, the percentage-of-completion method is preferable to the
completed contract method when estimates of the costs to complete and the extent of progress toward completion are
reasonably dependable.
When a reliable estimate of costs exists, use percentage of completion
When a reliable estimate of costs do NOT exist, use completed contract

Net construction-in-progress
Take % of construction completed minus progress billings

Net Advanced Billing:

Gross billings minus cash collection

The installment sales method

recognizes revenue and associated cost of goods sold only when cash is received. Gross profit (sales - cost of goods
sold) reflects the proportion of cash received. Based on gross profit.

The cost recovery method

is similar to the installment sales method but is more conservative. Sales are recognized when cash is received, but
no gross profit is recognized until all of the cost of goods sold is collected.

Discuss the general principles of expense recognition, such as the matching principle, specific expense
recognition applications (including depreciation of longterm assets and inventory methods), and the
implications of expense recognition principles for financial analysis.

The LIFO conformity rule in the U.S. requires firms to use LIFO for their financial statements if they use LIFO for
income tax purposes.

Demonstrate the depreciation of long-term assets using each approved method, and amortization of
intangibles.
DDB

Year 1: (2/n) X (Cost)

Year 2: (2/n) X (Cost – Previous year depreciation)

Distinguish between the operating and nonoperating components of the income statement.

dividends paid to the preferred shareholders be reported as a nonoperating component of net income
Dividends paid to preferred shareholders do not affect net income.

Discuss the financial reporting treatment and analysis of nonrecurring items (including discontinued
operations, extraordinary items, and unusual or infrequent items), and changes in accounting standards.

Extraordinary items are unusual and infrequent, reported below the line separate from income from continuing
operations on the income statement, and would include such items as: foreign government confiscation, earthquake
damages, losses from volcanic eruptions, etc.

Changes in accounting estimates are not treated the same as changes in principles. Changes in principles are treated
retrospectively, whereas changes in accounting estimates are accounted for in the current and future periods. There is
one exception to this; changes in depreciation methods are treated as changes in estimates

Pro forma effects must be disclosed for all prior income statements disclosed in the financial report. Firms are not
required to provide forward-looking forecasts of results.

The gain on the sale of a subsidiary is an unusual or infrequent item.

The results of a discontinued segment are reported below the line, net of tax (after tax).

A change in the salvage value of an asset is a change in accounting estimate, which does not apply retrospectively.

Components of earnings per share.

Simple capital structure vs. Complex capital structure

Basic EPs:

Net income – preferred dividends

Weighted avg number of common shares outstanding

Number of preferred shares is irrelevant

Common dividends are irrelevant

The company repurchases 20,000 of its own common shares on July 1.  use X Number of months first before
anything. – Its how long they were active for.

The following data pertains to the McGuire Company:

 Net income equals $15,000

 5,000 shares of common stock issued on January 1st
 10 percent stock dividend issued on June 1st
 1000 shares of common stock were repurchased on July 1st
 1000 shares of 10 percent, par $100 preferred stock each convertible into 8 shares of common were
outstanding the whole year

What is the company’s basic earnings per share (EPS)?

Number of average shares:

1/1 5,500 shares issued (includes 10% stock dividend on 6/1) x 12 = 66,000
7/1 1,000 shares repurchased x6 months = -6,000

= 60,000

60,000 shares/12 months = 5,000 average shares

Preferred dividends = ($10)($1000) = $10,000

Basic EPS = [$15,000(NI) – $10,000(preferred dividends)]/5,000 shares = $5,000/5,000 shares = $1/share

Stock dividends, repurchases  multiply by 12 depending on number of months remaining. Then divide all by 12.

Stock splits – adjust retroactively – even effects share repurchases occurring before it e.g. share purchase amount
doubles.

Stock dividends  multiply all share numbers prior to the stock dividend by the dividend amount.

Dilutive EPS

Preferred dividends must be added back – cancels out and just use Net Income
Convertible bonds – interest expense is multiplied by (1-tx rate) – must be added back (interest saving)

Securities must be dilutive

First calculate Basic EPS then test each security individually
Then decide whether or not to include

Convertible preferreds  if dilutive, take out the dividend in the numerator because the prfds become common and
pay no dividend.
Differentiate between preferred shares and convertible preferreds

Bond interest is not included in EPS calculation

‘Always be conscience of month. If security is issued in middle of year must factor in annualized weight.

Treasury Stock Method

Options/Warrants X Exercise Price divided by avg. market price

The option or warrant must be “in-the-money”

Comprehensive Income
includes all transactions that affect stockholders’ equity except transactions with shareholders.

Available-for-sale securities are reported on the balance sheet at fair value. The unrealized gains and losses bypass
the income statement and are reported as a component of stockholders’ equity as a part of other comprehensive
income.

Comprehensive income includes all transactions that affect shareholders’ equity except transactions with
shareholders. Thus, any transaction that affects net income would also affect comprehensive income. Since the
inventory write-down is included in net income, it is part of comprehensive income. The acquisition of treasury stock is
a transaction with shareholders; thus, it is not a part of comprehensive income.

Revenue $100,000
Cost of goods sold 40,000
Operating expenses 20,000
Unrealized gain from foreign currency translation 5,000
Unrealized loss on cash flow hedging derivatives 3,000
Dividends paid to common shareholders 7,500
Realized gain on sale of equipment 1,000
Net income is equal to $41,000 ($100,000 revenue – $40,000 COGS – $20,000 operating expenses + $1,000 realized
gain on sale of equipment). Comprehensive income includes all transactions that affect stockholders’ equity except
transactions with shareholders. Comprehensive income includes net income, unrealized gains and losses from
available-for-sales securities, unrealized gains and losses from cash flow hedging derivatives, and gains and losses
from foreign currency translation. Thus, comprehensive income is equal to $43,000 ($41,000 net income + $5,000
unrealized gain from foreign currency translation – $3,000 unrealized loss from cash flow hedging derivatives).
Dividends paid is a transaction with shareholders and is not included in comprehensive income.

Unrealized foreign currency translation gains and losses are not reported in the income statement; thus, retained
earnings are unaffected. However, unrealized foreign currency gains and losses are included in comprehensive
income. Comprehensive income includes all changes in equity except those that result from transactions with
shareholders. So, the translation gain increases stockholders’ equity by increasing comprehensive income.

BALANCE SHEET

The account format follows the traditional ledger account, assets on the left hand side and liabilities and equity on the
right hand side. With a report format, the assets, liabilities, and equity are presented in a single column.

The recognition of bad debt expense has no effect on liabilities, current revenues are reduced by the expected amount
of uncollectable accounts. Bad debt expense reduces net income and reduces assets. The recognition of expected
warranty expense decreases net income (following the matching principle), and since it is not currently paid (doesn’t
reduce assets) it creates or increases a liability at the time of sale.

Shareholder’s equity
Treasury stock = deduct from Sh. Holders EQ. because this represents a retirement or shares outstanding.
Comprehensive loss reduces Sh. Holders Eq.

When a firm recognizes revenue before cash is collected, equity increases (retained earnings) and assets increase
(accounts receivable). Liabilities would not be affected.

Current Assets
Includes inventory

Inventory – recorded at lower of cost and net-realizable value

Equipment – at historical cost

Liabilities

Accrued expenses – short-term and included in current liabilities

A current liability is expected to be settled within one year or operating cycle, whichever is greater.

Equipment is reported in the balance sheet at historical cost less accumulated depreciation. Inventory is reported in
the balance sheet at the lower of cost or market.

Acquired copyrights and patents are intangible assets that can be separately identified. Identifiable intangible assets
are amortized over their useful lives.

Goodwill = Purchase price minus net assets of target

Goodwill is not amortized.

Goodwill developed internally is expensed and shown on Income Statement

Acquisition of a patent is recorded as goodwill on Balance Sheet

If equity = 40%, Debt/Equity Ratio: debt must = 60%, thus 60/40 = 1.5

Reporting assets and liabilities at fair value is known as marketing-to-market.

Investment Securities

Trading Available-for-Sale Held-to-Maturity

Balance Sheet Fair Value Fair Value Amortized cost
Income Statement Dividends Dividends Interest
Interest Interest Realized gains/losses
Realized gains/losses Realized gains/losses
Unrealized gains/losses Unrealized gains/losses

All reflected in Retained recorded in Other

Earnings Comprehensive Income

Ratios

Current ratio
Quick Ratio (Acid ratio)
Cash ratio

Financial leverage ratio

Comparing ratios of competitors – cross-sectional comparison

STATEMENT OF CASHFLOWS

IFRS GAAP

Interest received Operating or Investing Operating

Interest paid Operating or financing Operating
Dividends received Operating or Investing Operating
Dividends paid Operating or financing Financing

When “paying”  financing

IFRS is more flexible

Gains or losses on sale of subsidiary will be found in cash flow from investments.

Purchase of equipment would reduce CFI

No cash is involved in a stock split: shares are exchanged for shares.

Direct Method vs. Indirect Method

Direct Method – don’t deduct depreciation because it is not a cash outlay

Direct Method
(all from B/S)
Cash collections = revenues – (AR1 – AR0)
Cash inputs = -COGS – increase in inventory + increase in accounts payable.

CFF
Change in LT Debt + change in equity – dividends paid

Cash payment of dividends CFF -$30

Sale of equipment CFI +$10
Net income CFO +$25
Purchase of land CFI -$15
Increase in accounts payable CFO +$20
Sale of preferred stock CFF +$25
Increase in deferred taxes CFO +$5
Profit on sale of equipment CFO -$15

The gain on the equipment sale ($500,000) would be subtracted out of cash flow from operations (CFO).
WHY????

Average age and average depreciable life of assets

Remaining useful life: Gross Investment – Accumulated depreciation / depreciation exp

Average age (in years): Accumulated depreciation / Depreciation expense

Relative Age - Average age (in %): Accumulated depreciation / Total PPE

Average depreciable life: Total PPE / depreciation expense

Company B’s assets are mostly depreciated. Therefore, depreciation expense will be lower and if all other aspects
are similar, the earnings and taxes for Company B will be higher.

ANALYSIS OF LONG-LIVED ASSETS: DEPRECIATION

Impairment

Cashflow No effect
PPE on B/S (Assets) Decrease

Deferred tax liabilities Decrease

(depreciation is less on financial
statements than that of tax return)

Stockholder’s equity (retained Decrease

earnings)

Current Net Income, ROA, ROE Decrease

Future net income, ROA, ROE Increase

Future depreciation expense Decrease

Asset turnover ratio Increase

Debt-to-equity ratio Increase

A permanently impaired asset must be written down to the present value of its future cash flows.

The asset’s carrying value = asset cost – accumulated depreciation

An impaired value write-down reduces net income for accounting purposes, but not for tax purposes until the asset is
sold or disposed of.

Write-down amount X (1 – tx rate) = increase in deferred tax asset

Environmental Damage

SFAS 143 makes it clear that any future expenditure that is required for environmental remediation be recorded as a
liability according to the present value of its expected cost at time of acquisition.
depreciation will be higher;
net profit margin lower because of depreciation
times interest earned will be lower because of higher interest expense
accretion of liability

Liability values are accreted in a manner similar to interest for bond amortization. The liability grows until it matches
expected cost of disposal at the end of the asset's life.

ANALYSIS OF INCOME TAXES

The difference between income tax expense and taxes payable is a: deferred income tax expense

Taxes payable are the taxes due to the government and are determined by taxable income and the tax rate. Note that
pretax income is income before tax expense and is used for financial reporting.

Income tax expense is defined as expense resulting from current period pretax income. It includes taxes payable and
deferred income tax expense.

Over the useful life of the asset:

Total depreciation, total taxable (and pre-tax) income, and total taxes payable (income tax expense) are all equal.

Deferred Tax Assets: Warranty expenses and tax-loss carry-forwards

Liability of Accounting for Deferred Taxes

When analyzing a company's financial leverage, deferred tax liabilities are best classified as: a liability or equity,
depending on the company's “financial performance”

If timing differences that give rise to a deferred tax liability are not expected to reverse then the deferred tax:

Deferred Tax as Liability or Equity

If reversal future of deferred tax liability is unlikely, then deferred tax liabilities should be treated as equity.
If reversal is uncertain, or financial statement depreciation is deemed inadequate, then ignore altogether.

Consider on a case-by-case basis

Deferred taxes are calculated by multiplying the temporary differences by the current tax rate

Income tax expense = Taxes payable - Change in Deferred tax asset + Change in Deferred tax liability.

Differences in taxable and pretax incomes that will reverse in future years result in deferred tax assets and liabilities

Summary:

Tax liability reverse in future  liability

Tax liability does not reverse  equity
Not sure  ignore
Case-by-case analysis
Depends on “financial performance” of company e.g. growth of firm, operations, tax laws
Why equity? Same side of accounting equation.

Valuation Allowance:

Valuation allowance is a reserve against deferred tax assets based on the likelihood that those assets will not be
realized.

Contra account against deferred assets

Must be greater than 50% probability of unrecoverability.

If a firm is unlikely to have future taxable income, it would be unlikely to ever use its deferred tax assets, and therefore
must record a valuation allowance.

An analyst should review company’s performance to see that deferred tax assets will be realized.

temporary and permanent items

Permanent = change in effective tax rate

Temporary = deferred tax asset or liabilities (which then can lead to lower or higher current and future taxes payable)

Examples

Temporary
Current liabilities Using installment sales for taxes and sales method for
pretax income.
LT Liabilities Tax liability from using DDB on tax reporting and SL
depreciation for the financial statements
Current Assets Warranty expenses on financial statements are DTA but
not deductible on tax returns until claims are paid.
LT Assets Post-retirement benefits on I/S is greater than that
allowed on tax returns.
Stockholder’s Equity Marketable securities are deferred tax adjustments to
equity

Available for sale securities’ market value changes are

reported as adjustments to shareholder’s equity. The
taxes that would be payable are recorded as an offset to
this unrealized gain adjustment.

Permanent

Tax exempt interst income

Tax credits

Differences in statutory and marginal tax rate – due to things like tax credits

Deferred Tax and the Tax Rate

Income tax expense = taxes payable + (change in DTL – change in DTA)

DTL increases the tax expense
DTA decreases the tax expense

Statutory vs. Effective Tax Rates

1. Effective tax rate = tax expense / pre-tax income

Alternative tax rates:

1. taxes payable (from tax return) / pretax income (from f/s)

2. income tax paid (from tax return) / pretax income (from f/s)

Low effective tax rates may indicate management earnings manipulation.

If sales occur but, part of money received in year 2, attribute a proportionate amount of tax to year 2 as
deferred tax liability. i.e. rent expense

Calculating income tax expense

- deduct any tax deductible items from pre-tax income then multiply by tax rate

Overstating warranty expense  fall in pretax income  fall in income tax expense
Income tax expense < taxes payable

Taxable income  tax reporting

Pretax income  financial statements

An analyst gathered the following information about a company:

 Taxable income = $100,000

 Pretax income = $120,000
 Current tax rate = 20 %
 Tax rate when the reversal occurs will be 10 %

What is the company's tax expense?

A) $22,000.
B) $24,000.
C) $10,000.
D) $12,000.

Click for Answer and Explanation

Deferred tax liability = (120,000-100,000) * 0.1 = 2,000

Tax expense = current tax rate * taxable income + deferred tax liability

0.2 * 100,000 + 2,000 = 22,000

If pretax income (F/S) > taxable income (tax report)  DTA **************why?

DTL is cumulative  2003, 2004, 2005  2005’s DTL is the sum of all years.

Calculate adjustment to DTL – tax change

Interpret a deferred tax footnote disclosure that reconciles the effective and statutory tax rates.

a tax holiday is usually a temporary exemption from having to pay taxes in some tax jurisdiction. Because of the
temporary nature, the key issue for the analyst is to determine when the holiday will terminate, and how the
termination will affect taxes payable in the future.

If the foreign subsidiary income tax rate is the normal statutory rate, then the effect should be viewed as continuous

Ignore sporadic tax items

Analyze disclosures relating to, and the effect of, deferred taxes on a company's financial statements and
financial ratios.

Deferred tax assets and liabilities must be separated between current and noncurrent accounts?????????????????

Effective tax rate = Income tax expense / pretax income

Income tax expense = Effective tax rate * pretax income

Compare and contrast a company's deferred tax items and effective tax rate reconciliation (1) between reporting
periods and (2) with the comparable items reported by other companies.

Analysis of the Effective Tax Rate

 1. Use the information in the management analysis and discussion (MD&A).
2. Recommended that the analyst seek additional information from the management if needed
3. The analysis of trends and forecasting should include all continuous items
4. The forecast should include expected changes in legislation related to corporate taxation.

Causes for differences in Statutory and Effective Tax Rates:

Permanent tax differences such as tax credits, tax-exempt income, non-deductible expenses, and tax differences
between capital gains and operating income give rise to differences in the effective and statutory tax rates.

FINANCING LIABILITIES

ALWAYS FROM PERSPECTIVE OF ISSUER

Zero-coupon
- PMT = 0 on calculator
- Calculate PV for discount

As bond premium is amortized, interest expense will be successively lower each period, thus increasing earnings over
the life of the bond.

Coupon = PMT (on calculator)

Market rate = I/Y (on calculator)

Premium Bonds
- Amortize premium – interest decreases over time
- Liability decreases over time
- Increase by (Liability + market rate X liability)

Interest expense = cash paid – amoritization

CFO – Understated (lower interest expense)

CFF – Overstated (the premium or the proceeds not of par value)

Coupon Payment
- Outflow from CFO
- From issuer perspective  paying the coupon as an interest expense
ALWAYS START WITH PV CALCULATION

- Total interest expense = (coupons + principal) – PV calculation

Calculate future year interest expense

- Calculate year 1 interest expense
- PV X mkt rate
- Intereset expense – interest paid
- Difference  add as carrying value of bond for year 2
Discount zero /coupon bond

CFO  O/S (b/c interest expense is too low)

PV of interest payments  FV = 0 (for calculation)

Unamortized discount = FV – PV

In year 1: interest expense – coupon

Change in discount
(FV – PV) – unamortized discount in year 1
= balance

Liability = (par)(coupon) => PMT

Liability + [(mkt rate)(liability) – PMT]]
Zero-coupon
- Cash interest = 0
- Interest is paid at maturity
- O/S CFO – is most extreme of all debt types
Debt-to-capital

= D / D+E

Gains on exchangeable bonds = increase equity

Disclosures
All B/S disclosures in Footnotes

PV of Future Bond payments discounted @ market rate

Advantages of Different Debt Types

1. Commodity-linked Bonds
- Linked to commodity, interest coupon
- Hedging strategy
- Issued by producer
- Fixed becomes variable cost
- Stabilizes earnings
2. CB vs BW
- CB interest is lower than BW (why?)
- BW equity is higher than CB (b/c of warrants that act like equity)

CB = BW = Zero = Variable  debt

BW  increase in equity

Variable Rate Debt

- Good for lenders short term rates change
- If rates increase while they lent out at lower rates

Changing Market Interest Rates

- No effect on BVs of debt issued at mkt rate.

- Does not affect coupon
- Affects mkt rates of debt
- As interest rates increase, good for issuers previously at lower interst rates – cost of borrow increases

Retiring Debt Prior to Maturity

- Analyst should offset ganins/losses with new debt if old debt is retired
- i.e. retired debt does not equal BV of liabilities on the B/S
- if interest rates fall, retired debt and gains are realized
Callable bonds
- retire usually at premium
- can realize gain, but, F/S loss can occur

Retiring debt: analyst should ignore any gains and losses.

Non-callable debt
Buy t-bills equal to the remaining liability = non-callable debt
Not allowerd under both U.S. Gaap and international

Debt Covenants
- in footnotes

perpetual debt – treated as equity

LEASES AND OFF-BALANCE SHEET DEBT

Capital lease
- title transferred
- bargin purchase ption (purchase < mkt pr)
- lease time > 75% of assets economic life
- PV lease payments > 90% of fair value of assets
- interest rate used to calculate PV is the lower of: lease borrowing cost, implied in contract

Otherwise the lease is an operating lease

Operating vs. Capital Lease

- Short-term need
- Re-sell asset (lessor has ability to re-sell at terminal)
- Lessee does not want to re-sell
- Lessor mkt power – increase lease price
- Non-specialized – office space
- Risk reduction – risk with holding expensive equipment

Capital vs. Operating

The entire amount is recorded at the outset for a capital lease

The amount recorded initially by the lessee as a liability will equal the present value of the minimum lease payments at
the beginning of the lease

Op = rental
Capital = purchase

In early years, capitalized income < operating income.

In later years, capitalized income > operating income.
BUT income will increase over the entire period.

-During the life of an operating lease the rent expense equals the lease payment
-During the life of a capital lease the lease payment is separated into interest expense and principal payments.
-Asset turnover is higher with an operating lease than a capital lease.

Lease shown as liability and and asset on B/S

Most incentives favor operating lease

1. Lessor > lease > depreciation > lower taxes

2. No asset + liability
- ROA – assets fall so ROA falls
- D /E – lower because operating leases do not account as liability on B/S
3. ROIC is lower and may be tied to mgt compensation

Capital lease = sale fopr accouting purposes

Advantage = total expenses increase = tax savings

CFO increase vs. operating lease

Capital vs. Operating on F/S and Ratios

Capital Lease Operating Lease

Interest expense $3,000 Rental expense $6,000
Depreciation expense $4,167
Total: $7,167 Total: $6,000

 Present value (PV) of lease payments at 12 percent is $25,000.

 The leased asset is depreciated straight line over 6 years.
  The lease payment is $6,000.
 The first payment of $6,000 is to be paid at the end of the year.

Opeating lease – treating as rental

Capital lease - asset (leasehold) + liability (leasehold) = PV of lease pmts
- interest expense affects income and CFO

Interest expense = PV of lease (or booked liability) * interest rate

Capital lease expenses = interest cost + depreciation expense

In capital leases, there is only interest expense and principal repayment. Rental expense is only charged when the
lease is an operating lease.

Principal repayment = lease pmt – lease expense

If asked to calculate 5 year lease at end of year 1 then n=4

The present value of the leased assets is booked to fixed assets, but the present value is not an investing cash flow
because no cash moved through the company. The transaction is reported as a note to the statement of cash flows.

Calculation: Scwhwer question: if 1 payment is made at beginning – just deduct it from figures – down payment.

There are two components of lease obligation, current and noncurrent, reported as liabilities for a capital lease. The
current component is the principal portion of the lease payment to be made in the following year.

the lessee has bond covenants (e.g., debt-to-equity ratio) relating to its financial policies that it must follow, it is best to
have an operating lease due to the fact that the operating lease will keep the asset off of the balance sheet resulting in
less liabilities.

Cash flow from financing is reduced by the rest of the capital lease payment which is the principal part of the payment.

Cash flow from investing is not affected by a lease being either a capital or an operating lease

In the first years of a capital lease the firm's debt to equity ratio will be greater than if the firm had used an operating
lease.
cash flow from operations is reduced by a lower amount than under an operating lease

The classification of a lease as a capital lease creates an asset, a debt obligation, financing cash flows (amortization
of the loan), and operating cash flows (interest expense).

Assets = liabilities

Liability
Lease pmt – interest pmt
Principal repayment (CFF)

Income Statement
Interst expense = income
Depreciation expense

Off B/S Financing – b/c does not affect liabilities

Total income is same for both

Because depreciation + interest expense = total lease pmts

Capital lease
CFO increases b/c no lease payments are made
CFF decrease b/c amortized pmt of principal is cash change to CFF
From the lessor’s standpoint, sales and revenue recognition occur earlier when leases are treated as capital, and not
operating leases, which enhances profitability and turnover ratios. Net cash flow is the same under either method.

Analyst should recalculate off B/S activities

Take or pay
Through-put off-take is a liability but is off B/S  disclosed in footnotes

Should add back to asset and liability on B/S to calculate ratios

Sale of receivables
- Recorded as a sale
- A/R falls and CFO increases
- CFF instead of CFO
- With recourse: guaranteed collection
- A/R should be adjusted upward as the fall in A/R is artificial

Finance Subsidiaries
- If parent owns less than 50% of subsidiary it does nto recognize liabilities
- Analyst should apply proportionately – add back assets and liabilities
JVs and affiliates
- Guarantees (debt) – should add back proportionately
Commodity-linked Bonds
- Changes in values should be reflected (remember that interest expense is variable)
Sales-type leases and Direct Financing (Types of Capital Leases)

Sales-type
- Dealer
- Recognize as sale (income) immediately
- Profit increases
- Profit = PV minimum lease payments – cost
Direct financing
- Not a dealer
- No profit recognition at inception
- Profit = periodic interest revenue
- Implicit rate???
Accoutning for Sales-type Lease

1. Sale recorded as PV of lease pmts

2. Cogs = cost – salvage
3. Profit recorded on income statement
4. CFO increases
5. CFI cash outflow
6. Net cashflow = 0

Periodic transactions
- Interest income = CFI
- Ending balance = salvage value which is a CFI inflow
Direct Financing Type
- Only profit = interest income
- Net income falls
- R/E falls
- Equity falls
- Total profit equal to sales-type lease
Sale of receivables and no transfer of risk
The cash flow statement needs to be adjusted by reducing the cash flow from operations and increasing the cash
flows from financing by the amount of receivables sold. The total cash flows over the life of the receivables and cash
flows from investing are not affected.

In a take-or-pay contract, the purchasing firm commits to buying a minimum quantity of an input over a specified
period of time

The parent company is not required to consolidate the statements of the financial subsidiary if it owns less than 50%
of the subsidiary.
FINANCIAL ANALYSIS TECHNIQUES

Evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial
performance.
highest gross profit margin percentage since it is selling a customized product and does not compete primarily based
on price.

AIM b: Prepare a basic projection of a company’s future net income and cash flow.
2007 inventory turnover was 5 (365 / 73 days in inventory). Given inventory turnover and COGS, 2007 average
inventory was $20 million ($100 million COGS / 5 inventory turnover). 2008 inventory turnover is expected to be 7.3
(365 / 50 days in inventory). Given expected inventory turnover, 2008 average inventory is $17 million ($124.1 million
COGS / 7.3 expected inventory turnover). To achieve 50 days of inventory on hand, average inventory must decline $3
million ($20 million 2007 average inventory – $17 million 2008 expected inventory).

Using the EBITDA coverage (EBITDA / Interest expense) to measure leverage tolerance

Retained cash flow divided by total debt is one of several measures that can be used.

Margin stability is desirable from the lender’s perspective for both floating-rate and fixed-rate debt.

Product and geographic diversification should lower credit risk

higher the assets-to-equity ratio, the higher the leverage

EBITDA margin is a measure of operational efficiency. EBITDA / Interest expense is a measure of the tolerance for
leverage. The adjustment involves capitalizing the operating lease. As a result, the lease payment is added back to
EBITDA. Adjusted EBITDA margin is 25.0% [($6,125,000 EBIT + $1,675,000 deprecation and amortization +
$1,000,000 lease payment) / $35,200,000 revenues].

Company A should be adjusted for the operating lease liability and the related assets; however, adding the present
value of the lease payments to both assets and liabilities does not change equity (book value). Thus, Company A’s
adjusted P/B ratio is 2.17 = [$26 price / ($6,000 million equity / $500 million shares)]. Company B’s inventory should
be adjusted back to FIFO by adding the LIFO reserve to both assets and equity. Thus, Company B’s P/B ratio is 2.06
= $22.50 / [($7,500 million equity + $700 million LIFO reserve) / 750 million shares].

Sales/Total Assets, or Total Asset Turnover is a measure of operating efficiency, not operating profitability

Total Debt Ratio

= total assets – equity  total debt
Total debt / total assets

If payables period increase  cash conversion cycle lengthens

Dupont ROE
Use average assets and equity when given

P/E ratio is easy to manipulate because earnings are based on the numerous estimates and judgments of accrual
accounting

Two firms may have the same amount of earnings but the number of shares outstanding may differ significantly

INTERNATIONAL STANDARDS COVERGENCE

Under IFRS, the recovery is reported in the income statement to the extent that the previous downward adjustment
(loss) was reported in net income. Otherwise, the increase in value is reported as an adjustment to equity.
Negative goodwill is not reported on the balance sheet; rather, the excess of fair value over the price paid in an
acquisition is recognized as a gain in the income statement.

Construction contacts
Under IFRS, when total cost cannot be reliably estimated, revenue is recognized to the extent that recovering contract
costs is probable – equal to cost of construction.

Marketable Securities
Available-for-sale securities are reported on the balance sheet at fair value and any unrealized gains and losses
bypass the income statement and are reported as an adjustment to equity. Thus, a decrease in fair value will result in
a higher ROA ratio (lower assets). Trading securities are also reported on the balance sheet at fair value; however, the
unrealized gains and losses are recognized in the income statement. Therefore, an increase in fair value will result in
higher ROA. In this case, both the numerator and denominator are higher; however, since the ratio is less than one,
the percentage change of the numerator is greater than the percentage change of the denominator, so the ratio will
increase

Increasing the value of the patent on the balance sheet will increase assets and thus decrease the total asset turnover
ratio (higher denominator). Increasing the value of the patent will also increase equity, otherwise, the balance sheet
equation would not balance. Increasing equity will result in lower ROE (higher denominator). The increase in the value
of the patent is not recognized in the income statement unless it is reversing a previously recognized write-down.

QUANTITATIVE METHODS

More precisely, they are nominal risk-free rates rather than real risk-free rates since they contain a premium for
expected inflation.

Required interest rate

Nominal risk-free rate
+ default risk
+ liquidity risk
+ maturity risk

EAR effective annual rate

- considers periodic compounding
- (1 + r)n – 1

nominal, stated, and stated annual rates are all the same thing.

There is an upper limit to the EAR as the frequency of compounding increases. In the limit, with continuous
compounding the EAR = eAPR –1. Hence, the EAR increases at a decreasing rate.

annual percentage rate (APR) – doesn’t change with increase compounding

The continuously compounded rate = er − 1

enter [0.09] [2nd] [ex]

An investor invested $10,000 into an account five years ago. Today, the account value is $18,682. What is the
investor's annual rate of return on a continuously compounded basis?

ln(18,682/10,000) = 0.6250/5 = 12.50%

Or:
(18,682/10,000)1/5 = 1.133143
ln(1.133143) = 12.4995%

Annuities

PMT = 0

Ordinary Annuity – payment at end of period

Annuity Due – payment at beginning of period

The present value of the ordinary annuity is less than an annuity due.
Annuity Due Calculation
PV of first $1,000 = $1,000
PV of next 9 payments at 10% = 5,759.02
Sum of payments = $6,759.02

[2nd] [BGN] [2nd] [SET] [clear]

If annuity pmt begins in 3 years from today find the PV of lump sum beginning 3 years ahead then discount back that
PV 2 years. Year 3 payment equals the PV of the lump sum

AIM d, (Part 3): Calculate and interpret a perpetuity (PV only).

PVperpetuity = PMT / interest rate

AIM d, (Part 4): Calculate and interpret a series of uneven cash flows

Simply calculate each year’s PV of cashflow separately and sum them.

N = 4; I/Y = 12; PMT = 0; PV = -2,000; CPT → FV = -3,147.04

N = 3; I/Y = 12; PMT = 0; PV = -3,000; CPT → FV = -4,214.78
N = 2; I/Y = 12; PMT = 0; PV = 6,000; CPT → FV = 7,526.40
N = 1; I/Y = 12; PMT = 0; PV = 25,000; CPT → FV = 28,000.00
N = 0; I/Y = 12; PMT = 0; PV = 30,000; CPT → FV = 30,000.00

Sum the cash flows: $58,164.58.

AIM e: Draw a time line, specify a time index, and solve time value of money applications (for example,
mortgages and savings for college tuition or retirement).

Loan amortization

Loan PMT includes both interest and principal PMTs.

PMTs will be equal every year.
Principal beginning balances each year = reduced by principal repayment (principal repay = PMT – interest pmt)
Interest component = interest rate X beginning balance

Interest component decreases over time

Principal component increases over time
Total PMT is same.

If given monthly payment question and asked for implied annual interest rate  X12

CAGR

Ending Value 1/n

Begin Value

DISCOUNTED CASHFLOW APPLICATIONS

IRR and NPV calculations  use CF function

The financial manager at Genesis Company is looking into the purchase of an apartment complex for $550,000. Net
after-tax cash flows are expected to be $65,000 for each of the next five years, then drop to $50,000 for four years.
Genesis’ required rate of return is 9% on projects of this nature. After nine years, Genesis Company expects to sell the
property for after-tax proceeds of $300,000. What is the internal rate of return (IRR) and net present value (NPV) on
this project?

CF0 = -$550,000; CF1 = $65,000; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1.

Although the rate of return is positive, the IRR is less than the required rate of 9%. Hence, the NPV is negative.

Williams Warehousing currently has a warehouse lease that calls for five annual payments of $120,000. The
warehouse owner, who needs cash, is offering Williams a deal wherein Williams will pay $200,000 this year and then
pay only $80,000 each of the remaining 4 years. (Assume that all lease payments are made at the beginning of the
year.) Should Williams Warehousing accept the offer if its required rate of return is 9%, and why?
The present value of the current lease is $508,766.38, while the present value of the lease being offered is
$459,177.59; a savings of 49,589. Alternatively, the present value of the extra $40,000 at the beginning of each of the
next 4 years is $129,589 which is $49,589 more than the extra $80,000 added to the payment today.*****************

The internal rate of return (IRR) method and net present value (NPV) method of project selection will always provide
the same accept or reject decision when projects are independent

IRR and NPV criteria can give conflicting decisions for mutually exclusive projects

The IRR method assumes cash flows are reinvested at the investment’s internal rate of return;
The NPV method assumes cash flows are reinvested at the opportunity cost of capital (discount rate)

Non-normal cash flow patterns may result in multiple IRRs

10 3/8 treasury note for 103 11/32  10.375% X 1000 = coupon payment

Money-weighted vs Time-weighted Returns

Money-weighted returns: It is the IRR of a portfolio, taking into account all of the cash inflows and outflows

money-weighted return will be biased upward if the funds are invested just prior to a period of favorable performance
and will be biased downward if funds are invested just prior to a period of relatively unfavorable performance. The
opposite will be true for cash outflows.

1.1247% = 0.011247