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CFA LEVEL 1 Exam 275 Questions with Verified Answer 2023,100% CORRECT

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CFA LEVEL 1 Exam 275 Questions with Verified Answer 2023 Financial Statement Analysis Framework - CORRECT ANSWER provides an overview of the methodology used by analysts to consistently analyze f... inancial statements 1. articulate the purpose and context of analysis 2. collecting data 3. process the data 4. analyzing and interpreting the processed data 5. develop/communicate conclusions and recommendations 6. follow up Scope of Financial Statement Analysis - CORRECT ANSWER - analysis is based on financial statements is performed by equity investors interested in valuation, lenders interested in liquidity, suppliers interested in future business, and analysts working to recommend security purchases, mergers, credit and lending, debt ratings, and forecasting Balance Sheet - Assets - CORRECT ANSWER - assets are items owned by a company that will benefit the company in the future - found on balance sheet; include current/noncurrent - required to be listed separately under IFRS - typically shown on balance sheet at historical cost Income Statement - Introduction - CORRECT ANSWER - reports revenues, expenses, and profit or loss for a company on a consolidated basis over a short period of time - revenues are matched with expenses incurred to earn the revenue, and the net result is a profit or a loss for the period - when the company reports on a consolidated basis, they include all companies they own in one income statement Statement of Changes in Equity (1) - CORRECT ANSWER - reconciles the balance in equity from the beginning of a period to the end of a period - equity is composed of paid-in capital, retained earnings, other comprehensive income, and minority interests - statement of changes in equity reconciles the beginning equity balance with the period-ending equity balance by analyzing the changes in the four components of equity Beginning equity +/- increase/decrease in paid-in capital + net income (or minus net loss) - dividends paid +/- changes in other comprehensive income +/- changes in minority interest Balance Sheet - Liabilities - CORRECT ANSWER - future obligations of a company, which may be monetary or non-monetary - include current/non-current liabilities - required to be listed separately under IFRS as a means of helping analysts in identifying threats to liquidity Financial Notes (footnotes) and Supplementary Schedules - CORRECT ANSWER - required part of the financial reports and contain essential information about the company's accounting policies, methods, and estimates, many of which are essential for analysis Statement of Comprehensive Income - CORRECT ANSWER - requirement under IFRS - comprised of both profit and loss for the period and other items affecting equity - presented as one or two statements, with one being the income statement - includes the traditional statement of operations and a second component presenting items that affect owners' equity but are not share transactions - component is called Other Comprehensive Income (OCI) - OCI reports certain gains and losses that bypass the income statement and end up as adjustments to owner's equity - OCI includes fair value changes, items reclassified to profit and loss, and other non-owner changes in equity - AOCI is included as a separate line item in the equity section * US GAAP allows corporations to present OCI as part of the statement of changes in equity as opposed to being part of the comprehensive income statements Management Discussion and Analysis - CORRECT ANSWER - provides readers with information needed to understand a company's financial condition, changes in financial condition, and results of operations 5 Elements 1. nature of the business 2. management's objectives and strategies 3. company's significant resources, risks, relationships 4. results of operations 5. critical performance measures Auditor's Reports - CORRECT ANSWER - performed by qualified, independent auditors - opinion is based on the audit procedures performed that are designed to provide reasonable assurance the statements fairly present the results of operations and financial condition of the company in accordance with applicable accounting standards - opinions may be unqualified, qualified, adverse, or disclaimed Introductory Paragraph - sets forth the statements to be audited and the responsibilities of both management to prepare the statements and auditors to audit the statement Scope Paragraph - describes the nature of the audit process and procedures that serve as a basis for the auditor's opinion Opinion Paragraph - states the auditor's opinion concerning if the statements fairly present the company's financial position and result of operations free of material misstatements in conformity with applicable accounting standards Auditor's Opinions - CORRECT ANSWER Unqualified Opinion - (most common) auditor found no material misstatement and believes the statements fairly reflect the results of operations and financial condition of the company, in compliance with applicable accounting standards Qualified Opinion - auditor found something material that does not comply with the applicable accounting standards; this exception doesn't invalidate the statement as a whole, though, and the auditor will explain the qualification in the audit report Adverse Opinion - the auditor found material misstatements of such an extent that the statements taken as a whole do not fairly represent the results of operations and financial condition in compliance with applicable accounting standards (really rare) Disclaimer of Opinion - auditor cannot complete the audit, not issuing an opinion; also rare *required under U.S. GAAP to express opinion on company's internal control system (not required under IFRS) Cash Flow Statement - Introduction - CORRECT ANSWER - reports the cash generated and expanded during a fiscal period - statement of cash flow differs from an income statement in that it converts all the transactions into cash changes within a time period - cash flows are important as it shows a company's ability to pay its short-term obligations (liquidity) and ability to pay its long-term obligations (solvency) - made up of operating activities, investing activities, financing activities, and supplemental activities - Indirect Method: starts with income statement and adjusts it to cash flow - Direct Method: (FASB preferred) provides information about cash flows from operations directly; sum of all cash flows then equal net cash increase or decrease from normal operations of the company Mechanics of Financial Reporting - Introduction - CORRECT ANSWER - financial statements are developed from the records within an accounting system that have recorded all transactions for a business over a period of time - they provide information to end users that will be used for decision making; they follow rules of balancing debits and credits, as well as ensuring that assets is equal to liabilities + equity; and then they often require adjusting entries to ensure the matching of revenues and associated expenses Chart of Accounts/Common Accounts - CORRECT ANSWER Chart of Accounts - large list of every account that will be needed for operation of the business, absorbing the details of every transaction during the accounting period, and in summation of those transactions Common Asset Accounts - cash/cash equivalents, accounts receivable, prepaid expenses, inventory, PPE, intangible assets Common Liability Accounts - accounts payable, unearned revenue, notes payable, bonds payable Common Equity Accounts - general capital, additional paid-in capital, retained earnings Contra Accounts - accounts in place to offset more common things (i.e. accumulated depreciation) Common Income Accounts - revenue/sales, gains, investment income Common Expense Accounts - COGS, selling expenses, administrative expenses, depreciation expense, interest expense, tax expense, losses Accounting Equations - CORRECT ANSWER Assets = Liabilities + Owner's Equity Revenue - Expenses = Net Income Statement of Retained Earnings - reports how net income or loss and the payment of dividends impact retained earnings, illustrating the relationships between the income statement and the balance sheet Beginning Retained Earnings + Net Income (- Net Loss) - Dividends Paid = Ending Retained Earnings Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Net Income - Dividends * equity as components such as retained earnings (cumulative net income) and paid-in capital; double-entry accounting ensures that the accounting equation holds Classification of Business Activities - CORRECT ANSWER Operating Activities - those arising from day-to-day operations Investing Activities - arise from buying and selling long-lived assets or purchasing investments in other companies Financing Activities - arise from raising and repaying capital The Accounting Process - CORRECT ANSWER Accounting System - used to record the transactions of the business and aid in the preparation of financial statements The Accounting Records - CORRECT ANSWER - process of entering transactions into an accounting system creates financial records for the company - the accounting equation can be used to evaluate business transactions for entering into the accounting system to create financial records Adjusting Entries - CORRECT ANSWER - are used to record transactions that do not necessarily involve cash but are an economic event for the company - often involve accruing expenses but not yet paid, revenues earnings but not yet received, interest earnings but not yet received, or interest due bt not yet paid - recording depreciation and the expiration of prepaid expenses are also adjusting entries Accruals and Valuation Adjustments - CORRECT ANSWER - accruals are vital to ensure the matching principle - changes in the value of trading securities must be reflected so that the financial statements represent a true value of the company's financial position, including what it owns Prepaids and Accruals - CORRECT ANSWER - unearned revenue or deferred revenue: liability when a customer pays for products or services in advanced - accrued revenue: revenue the company has earned, but not yet received payment for - prepaid expenses: assets when a bill is paid in advance of the service - accrued expenses: expenses that have not yet been paid Preparing Financial Statements from a Series of Entries - CORRECT ANSWER - accounting system will record transactions into accounts that relate to financial statement elements - proper recording throughout the year will ensure a balanced accounting equation - these accounts can then be totaled to provide information needed to prepare the financial statements Financial Statements - CORRECT ANSWER - income statement, balance sheet, statement of cash flows, statement of owners' equity, statement of retained earnings Inter-relationships among Financial Statements - CORRECT ANSWER - financial statements contain many interrelationships - an error in one statement will often impact some or all of the financial statements Accounting Systems - CORRECT ANSWER - the method which transforms the daily activity in the business into financial statements that provide an overall view of the business' financial status General Ledger and T-Accounts - CORRECT ANSWER - General Ledger: collection of individual T-accounts - T-accounts - each shows all the transactions affecting that one account, with the additions to the account listed on one side of the T-account and subtractions from the account listed on the other side of the T-account Objective of Financial Reporting - CORRECT ANSWER - to provide useful financial information about the entity to the users of the reports Standard-Setting Bodies and Regulatory Authorities - CORRECT ANSWER Standard-Setting Bodies: FASB, IASB Regulatory Authorities: SEC - accounting standards are created by private, standard-setting bodies with no legal authority to enforce those standards - regulatory agencies with enforcement powers generally recognize and enforce those standards - in case of disagreement between the standard-setting body and the regulatory agency, the regulatory agency rules Securities and Exchange Commission (SEC) - CORRECT ANSWER - responsible for capital markets of US; member of IOSCO, sets financial reporting standards to the FASB 3 major securities regulation acts: - 1933: details the financial and other information that must be shared with investors when securities are sold and public issuance's registered, specifically outlaws misrepresentation - 1934: gave SEC authority over securities industry and allowed them to require company financial reporting - 2002: regulates the audit industry, holds CEOs and CFOs personally responsible for the financial reporting, and highlights the importance of internal controls Forms required by SEC annually: 10-K (40-F for Canadian companies, 20-F for non-US), Annual Report, Form DEF-14A (Proxy) Financial Accounting Standards Board (FASB) - CORRECT ANSWER - organization that issues financial reporting standards in the US, by the authority of the SEC - issues generally accepted accounting principles (GAAP) in the Accounting Standards Codification (Codification) Capital Markets Regulation in Europe - CORRECT ANSWER - though each individual country has jurisdiction over their own capital markets, the European Union-listed companies follow European Union-endorsed standards - EU-listed companies follow IFRS rules - newly issued IFRS go through a review process within the EU structure to determine how much each new rule will apply to EU companies International Organization of Securities Commissions (IOSCO) - CORRECT ANSWER - made up of members from international securities commissions or similar agencies with regulatory authority - IOSCO issued a comprehensive set of Objective and Principles of Securities Regulations; main objectives are to protect investors, ensure markets are fair, efficient, and transparent, and to reduce systemic risk - IOSCO members regulate more than 90% of the world's financial markets Common Information Sources Used by Analysts - CORRECT ANSWER - an analyst has many common information sources to use to gather information, from the initial registration statement to the SEC-required 6-K, 10-K, and proxy statement - other sources of information include documents prepared by the company to report information to its shareholders Convergence of Global Financial Reporting Standards - CORRECT ANSWER - approximately 120 countries currently have adopted the Global Financial Reporting Standards, and many others are working toward convergence - consistent enforcement mechanisms in each country is key so all financial statements can be relied on equally Objective of Financial Reports - CORRECT ANSWER - to provide useful financial information to current or potential investors and/or creditors when trading or lending - information is evaluated to make decisions about lending money to the company, or whether or not to invest in the particular company - external users will look at the company's financial position, performance, and cash flow Qualitative Characteristics of Financial Reports - CORRECT ANSWER - relevance and faithful representation - enhanced characteristics include: comparability, verifiability, timeliness, understandability Constraints on Financial Reports - CORRECT ANSWER - constraints on financial reporting information are decision-making tools for which information to include/exclude - two pervasive constraints: materiality and cost - if the omission or misstatement of information can influence a user's decision, then the information is material - information would not be used if a cost to benefit analysis showed the cost was greater than the benefit gained Underlying Assumptions in Financial Statements - CORRECT ANSWER - Accrual Basis: refers to how transactions are recorded in financial statements - Going Concern: refers to the likelihood of a company staying in business General Requirements of Financial Statements - CORRECT ANSWER - IAS #1: requires a classified statement of financial position, a statement of comprehensive income, a statement of equity, a statement of cash flows, and financial statement notes - each must supply sufficient detail of both the current period and comparative information from the past for the user to understand the company's activity and position Elements of Financial Statements - CORRECT ANSWER - assets, liabilities, equity, income, and expense - assets: resources of value company owns - liabilities: debt obligations - equity: residual interest in the assets after liabilities are accounted for - income: increases in economic benefits - expenses: decreases to economic benefits Measurement of Financial Statement Elements - CORRECT ANSWER - Measurement: practice of giving a value to the elements of a financial statement - Current Cost: (replacement cost) amount needed to purchase an identical asset or settle the liability right now - Realizable Value (assets)/Settlement Value (liabilities) value assigned from selling or liquidating an asset or a liability to a third party that is not the fair market; common in bankruptcy - Present Value: involves a typical cash flow discounting based on the estimated cash flows the asset will produce or what payments are required to satisfy the liability - Fair Value: refers to a value decided between knowledgeable market participants, or some sort of market value (most difficult to determine) General Features of Financial Statements - CORRECT ANSWER - certain features must be included in a company's financial statements in order for the company to explicitly state in the notes that they are in compliance - the financial statements must be prepared at least annually in a fair and consistent manner, with accrual accounting, the going concern assumption, no offsetting, disclosure of material items, comparative information, and consistency Convergence of Conceptual Framework - CORRECT ANSWER - Convergence: idea of several accounting regulators working toward a common international set of standards - convergence of a conceptual framework for accounting is the process of FASB and IASB creating common accounting standards - these groups have thus far agreed that financial statements should include only relevant and honest information IFRS vs. US GAAP - CORRECT ANSWER Income Statements - IFRS-compliant: include all revenue and expenses but allow some items, such as unusual gains and losses, to bypass the income statement and flow directly to the statement of owner's equity in a statement of comprehensive income - GAAP-compliant: include all revenue, expenses, gains, and losses Valuing of Assets - IFRS: requires that assets provide some future economic benefit to the company to be considered assets - GAAP: allows recording of all assets at fair value at acquisition Revaluation - IFRS: allows for more liberal revaluation of assets - GAAP: only allow revaluation of assets in limited situations Barriers to a Single Coherent Framework - CORRECT ANSWER - financial reporting framework needs transparency which is full disclosure, fair presentation, and comprehensiveness Barriers to developing one coherent, global framework include the following: - conflicts in measurement - variations in valuation over a global market - choice in standard-setting approaches New Products of Types of Transactions - CORRECT ANSWER - new products or types of transactions arrive on a regular basis - they may result from economic events internal or external to the company, or they may be transactions the company has entered into - keeping up to date on new products or types of transactions allow for improved analytical skills Company Disclosures Regarding Changes in Accounting Policies - CORRECT ANSWER - accounting policies must be applied uniformly to maintain consistency in reporting - when a change in policy is made, it must be disclosed on a summary sheet or as a footnote - changes are generally applied retrospectively Company Disclosures Relating to Critical and Significant Accounting Policies - CORRECT ANSWER - when there are changes to how the elements of a financial statement are calculated, then a disclosure should be added to the report - critical and significant accounting policy changes are the ones where the deviation may be material to a user - Full Disclosure Principle: says that any information that affects the full understanding of a company's financial statements must be included with the financial statements - disclosures include: changes to accounting policies, assumptions made, judgments, framework used Evolving Standards and the Role of the CFA Institute - CORRECT ANSWER - changes in rules and regulations can affect the valuation and financial reporting of a company - CFA Institute actively follows regulatory bodies like the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), offering advocacy to both - CFA Institute advocates financial statements that are timely, consistent, comparable, and transparent Understanding Income Statements - Introduction - CORRECT ANSWER - income statement presents information on a company's revenues and expenses over a period of time - the difference is earnings, or profit/loss - both IFRS and GAAP allow the income statement and statement of comprehensive income to be presented in one section or separately, and both equity and fixed income analysts use income statement data Income Statement Components and Format - CORRECT ANSWER - income statement components include net revenue minus COGS, SG&A expenses to make operating income - from this, interest expense, depreciation expense, and tax expense are deducted for net income - there are many other potential elements, including gains and losses from non-operating items - expenses can be grouped by nature or function, and the income statement can be single-step or multi-step in format Basic EPS Calculation - CORRECT ANSWER - "common" = GAAP term, "ordinary" = IFRS term = (NI - P Dividends) / Weighted Average # of Shares Outstanding - the denominator of this is a time-weighted average and reflects the impact of share issuances, share repurchases, stock splits, and stock dividends Simple vs. Complex Capital Structure - CORRECT ANSWER - in a complex capital structure, some debt is convertible to new common (or ordinary) shares - potential dilution of earnings is accounted for in diluted EPS, which is lower than basic EPS - a simple capital structure is one without convertible debt Discontinued Operations - CORRECT ANSWER - must be separately stated on the income statement, allowing an analyst to disregard the impact on future financial performance Non-Operating Items - CORRECT ANSWER - non-operating items will vary depending on whether the company is a financial service - non-operating items should be stated separately on the income statement - analysts who observe a significant amount of non-operating income in a company's reports should investigate further before making an investment decision Diluted EPS and the If-Converted Method - CORRECT ANSWER - the if-converted method for calculating diluted EPS assumes the common shares had been exchanged for all convertible preferred stock at the start of the period - the diluted EPS value that results from this methodology must always be equal to, or less than, basic EPS Diluted EPS and the Treasury Stock Method - CORRECT ANSWER Treasury Stock Method - assumes the company uses that money to purchase treasury stock; treasury is not considered outstanding, so the purchase reduces weighted average number of shares outstanding - for a company that has stock options or warrants outstanding, diluted EPS is calculated using the treasury stock method by assuming that they were exercised as soon as they were issued, and the company used the proceeds to repurchase as many shares of common stock as possible at the average market price during the period Change in Accounting Policies - CORRECT ANSWER - will cause retrospective changes, meaning the company will have to restate the financial statements for previous years - changes in accounting policies may require companies to show past year financial statements based on the change in accounting policy; this is a retrospective application - in other cases when there is a change in an accounting estimate that impacts current and future years, that change can be presented prospectively Unusual or Infrequent Items - CORRECT ANSWER - IFRS requires separate disclosure of unusual or infrequent items that would affect understanding of a company's financial performance - items both unusual and infrequent used to be considered extraordinary items under US GAAP, but after December 15, 2015, that classification doesn't exist - extraordinary items were presented separately on the income statement, shown net of tax and below discontinued operations, to show that these items are not part of a company's operating activities and are not expected to occur on an ongoing basis Anti-dilutive Securities and Changes in EPS - CORRECT ANSWER Considerations with antidilutive securities: - potentially convertible securities are considered antidilutive if their inclusion in the diluted EPS calculation would result in an EPS figure HIGHER than the company's basic EPS - such as situation would violate both IFRS's and US GAAP's accounting standards - the effective of antidilutive securities' conversions must be excluded from the calculation of diluted EPS - a company is required to report both basic and diluted EPS when its capital structure consists of ordinary shares and warrants Common-Size Analysis of the Income Statement - CORRECT ANSWER - presents individual line items of a company's income statement as a % of sales General Principles of Revenue Recognition - CORRECT ANSWER - revenue is recognized when earned, meaning that the service is performed or the good is delivered, as long as some other conditions are met, such as expectation of payment - the timing of that payment is immaterial, however; it can be early, recorded as unearned revenue, or received late, to satisfy a receivable Percentage-of-Completion Method - CORRECT ANSWER - revenue can be recognized under a long-term contract by using the percentage-of-completion method, which recognizes revenue based on the stage of completion of a contract or as services are rendered - for each period, the company estimates the % of the contract that is complete, and reports that % of the total contract revenue in its income statement - if a loss is recorded, entire amount is recorded immediately *if outcome can't be measured reliably, use completed contract method under US GAAP; IFRS sees it too conservative, so it would only recognize revenue that covers the cost Gross vs. Net Reporting - CORRECT ANSWER - gross is BEST when the seller bears risk in inventory and credit, can choose supplier, and establishes price - if these conditions are NOT met, US GAAP suggests the company report net sales, much like sales commission Differences Between IFRS and GAAP - CORRECT ANSWER - under both IFRS and US GAAP, revenue is recognized when it is realizable - IFRS has different rules for the sale of a good and rendering of a service, the main difference being when a service is provided, the percentage of completion must be known US GAAP states four conditions that need to be met in order for revenue to be realizable: - there is an arrangement between buyer and seller - product has been delivered or service rendered - price is determined or determinable - seller is likely to collect the money from the buyer IFRS requires - seller transferred risk/rewards to ownership of goods of the buyer - the entity doesn't have managerial involvement to the degree associated with ownership or effective control of the goods sold - the amount of revenue can be measured reliably - it is probable that the economic benefits associated with the transaction will flow to the entity - the costs incurred for the transaction can be measured reliably Installment Method vs. Cost Recovery Method - CORRECT ANSWER Cost Recovery - all payments are matched with expenses for zero profits until the expenses have all been matched; only after that will profits be recognized (reasonable when there is doubt of receiving all payments) Installment Method - when proceeds from a good or service are paid over time *when profit needs to be deferred, two methods - installment method and cost recovery method - may be used according to US GAAP *under IFRS, a firm with an installment sale recognizes this prevent value as revenue today, and then recognizes the difference between this and the nominal payments as interest income over time Differences between IFRS and GAAP - CORRECT ANSWER Revenue Recognition - IFRS requires that it is probably that economic benefits flow to the seller; GAAP requires that the seller is reasonably sure of collecting the money Completed Contract Method - CORRECT ANSWER - used by US GAAP companies when the outcome of the long-term contract cannot be measured reliably - under this method the company will not recognize any revenue until the contract is substantially complete (any amounts remaining are insignificant) - not an option under IFRS; the revenue will be recognized to the extent of costs incurred *losses recognized immediately Income Statement Ratios - CORRECT ANSWER - used to measure the profitability of a company - net profit margin/gross profit margin are most common Barter Transactions - CORRECT ANSWER - when goods or services of one company are exchanged for goods or services from another company; no cash changes hands - under IFRS, revenue from barter transactions will be based on fair value from similar non-barter transactions - US GAAP allows fair value to be used if the company has historically received cash payments for similar services; carrying value of assets surrendered if no historical basis Revenue Recognition Accounting Standards Issued May 2014 - CORRECT ANSWER 5 steps: - identify contract - identify performance obligations - determine transaction price - allocate the transaction price to the performance obligations - recognize revenue as entity satisfies performance obligation - if changes are made, total revenue and costs must be recalculated to reflect the changes and a new percentage of completion calculated; cumulative catch-up adjustment is required - incremental costs of obtaining a contract and certain other costs now need to be capitalized and added to the building asset rather than expensing them when incurred - according to the newly converged accounting standards, revenue is recognized as good/services are transferred to customers in an amount that reflects the consideration the seller expects to receive General Principles - Matching Principle - CORRECT ANSWER - expenses should be recorded in the same period as the revenue they helped generate, thus matching expenses to the revenue - other expenses like rent, depreciation, are not directly tied to the product, but still need to be recorded against the revenue they helped generate - some expenses can be directly matched to the revenue they generate, like inventory, whereas other expenditures hold a periodic relationship Expense Recognition - IASB Framework - CORRECT ANSWER Expense Recognition - decrease of equity, other than owner equity transactions, recorded in the accounting period in which the cost was incurred Considerations - under IFRS, an expense is a reduction in equity not resulting from equity transactions with the company's owners - recognition is when a cost is recorded on the income statement as an expense - costs are recognizes as expenses i the period the cost is incurred - under IFRS, expenses and losses similarly decrease equity, although they arise from different types of transctions - finally, expense recognition issues arise because revenues are recognized when they are earned and expenses, when they are incurred, not when revenues are actually collected or expenses actually paid Doubtful Accounts and Warranties - CORRECT ANSWER - companies should estimate uncollectible accounts and warranty expenses to record an estimated expense at the time of sale - doing this allows gross profit to more accurately reflect activity, rather than violating the matching principle Depreciation and Amortization - CORRECT ANSWER - depreciation is the process of allocating costs of long-lived tangible assets over the time period during which the assets are expected to produce economic benefits - amortization is a similar process for intangible assets - the cost model allocates the purchase price minus the salvage value to accounting periods over time Different Depreciation Methods - CORRECT ANSWER - straight-line depreciation (or amortization) allocates the same depreciation (or amortization) expense each year of an asset's useful life - accelerated depreciation methods, such as double-declining balance, allows higher depreciation expense in the first year, which falls over time until the salvage value is reached Comprehensive Income - CORRECT ANSWER - IFRS and GAAP allow companies to choose between reporting total comprehensive income as a single statement, or reporting an income statement with other comprehensive income on the side; but needs to be somewhere - trading securities are on IS; available-for-sale securities are not; shown as other comprehensive income - IFRS allows for some valuation changes to long-lived assets, and you might find a couple of other things that serve as a sort of "garbage can" of items on other comprehensive income that allow equity balances to connect from one period to another - to understand how reported shareholders' equity in one period is connected to shareholders' equity in the next period, it is important to pay attention to items that are excluded from net income calculation, as these items known as OCI, represent changes in equity during a period from transactions other than those with owners - IFRS and GAAP would treat change in value of a derivative used as a hedge as OCI Components and Format of the Balance Sheet - CORRECT ANSWER - BS shows, at a specific point in time the assets, liabilities, and claims by the owner on the assets (equity) - BS amounts are listed at various measurements, including historical cost, historical cost less adjustments, and current value Current and Non-Current Classification of Assets and Liabilities - CORRECT ANSWER Operating Cycle - amount of time between acquiring merchandise inventory or raw materials and collecting cash from the sale of final goods to customers Current Assets - those that are expected to be converted to cash or consumed within one year or the operating cycle (whichever is longer); IFRS requires payables that are clearly part of the company's operating cycle to be classified as current even if they are to be settled more than one year after the BS date Investment Property and PPE - CORRECT ANSWER PPE - listed at historical cost (IFRS/GAAP); IFRS allows for revaluation of certain assets Recoverable Amount - IFRS calls the higher of two ideas (value in use and fair value less cost to sell) Investment Property - non-current asset used to earn rental income or capital appreciation (or both); recognized under IFRS but not GAAP PPE - tangible assets expected to generate cash flows for the company over a long time period - IFRS allows both the cost model and revaluation model, whereas US GAAP permits only the cost model; IFRS allows reversals of impairment losses while US GAAP does not Current Asses - Cash and Cash Equivalents - CORRECT ANSWER - measured at either amortized cost or fair value - Amortized Cost: historical cost of the asset adjusted for amortization (reducing an account over time as it is expensed) and impairment (when value is decreased below the original balance sheet amount) - Fair Value: amount at which an asset could be exchanged (or a liability settled) in an arm's-length transaction between knowledgeable and willing parties - highly liquid, short-term investments that are close to maturity and can be assured of their value in the short term - include T Bills, commercial paper, money market funds - marketable securities are NOT cash equivalents, but are current assets and easy to liquidate; include debt and equity securities like CDs, government bonds, and common stock Intangible Assets - CORRECT ANSWER - can be valued with cost model or revaluation model under IFRS, GAAP only allows cost model Regarding intangible assets: - identifiable nonmonetary assets with no physical existence - trademarks, copyrights, and patents are typical examples of intangible assets - there are special rules on the amortization and impairment of intangibles - under IFRS, companies recognize identifiable intangible assets on their balance sheet if they expect to receive future economic benefits and can reliably measure the cost of the assets - under both IFRS and GAAP, internally created identifiable intangibles are often not reported on the balance sheet, but when expensed instead; the exception is development phase costs when other conditions are met Financial Assets - CORRECT ANSWER - measured at either historical/amortized cost - held-to-maturity securities valued at historical or amortized cost, trading securities and available-for-sale securities and derivatives at fair value, some at current market value - available-for-sale are no longer included in IFRS, won't exist as a classification in the future Goodwill - CORRECT ANSWER - capitalized under GAAP and IFRS, not amortized; requires annual impairment test - total value of assets is then reduced by impairment charge Regarding goodwill: - if an acquirer pays more than fair value of the identifiable assets and liabilities of a target company, the excess is recognized on the balance sheet as an asset and is called goodwill - goodwill is NOT amortized like other intangible assets - goodwill is subject to annual impairment test Equity and It's Components - CORRECT ANSWER - equity is made up of: capital contributed by owners, preferred shares, treasury shares, retained earnings, accumulated other comprehensive income, noncontrolling interests Statement of Changes in Equity (2) - CORRECT ANSWER IFRS requires 4 items: - total comprehensive income for the period, which includes net income and OCI - the effects of any accounting changes that have been retrospectively applied to previous periods, which can definitely affect the values of some equity componenets - capital transactions with owners and distributions to owners, including stock repurchases and dividend payments - the reconciliation of the carrying amounts of each component of equity at the beginning and end of the year US GAAP - requires companies to provide an analysis of changes in each component of stockholders' equity that is shown on the balance sheet as specified by the SEC Current Assets - Inventories - CORRECT ANSWER - typically valued at cost, however when market price drops below cost, then the inventory should be written down to that lower amount - under GAAP, inventory can never be written back up, should current market price increase; IFRS does permit a reversal of the original write-down in such instances Standard Cost Valuation - uses normal levels of materials, labor, and overhead to calculate the typical inventory cost Retail Method Valuation - takes into account that sales less cost of goods equals gross margin; if a retailer knows the GM%, can apply it and deduct from sales to estimate cost - IFRS allows for FIFO, weighted average, and specific identification methods; GAAP allows for these and LIFO (GAAP ALLOWS ALL) - inventory is stated at the lower of cost vs. current market value Current Assets - Trade (AR) Receivables - CORRECT ANSWER - listed at net realizable value (fair value estimate taking into account probability of collection) - if receivables increasing at higher rate than credit sales, could be an indication receivables are slowing down Regarding trade receivables: - TR/AR are the amounts owed to a company from conducting sales on credit - they are listed at net realizable value, which is a fair value estimate taking into account the probability of collection -trade receivables are listed as GROSS amount of receivables, less an allowance account based on an estimate of the amount of receivables that will ultimately not be collected Current Assets - Other Current Assets - CORRECT ANSWER Regarding other current assets: - "other current assets" section of the BS accumulates the total items that are not material enough to warrant separate line item recognition - common current assets contained include prepaid expenses and deferred tax assets - these assets arise when expenses are paid in advance of the time period in which they will be "enjoyed" or incurred Accounting for Gains and Losses on Marketable Securities - CORRECT ANSWER - companies record gains and losses on financial assets in different ways based on accounting policy that classifies these assets as held-for-trading, available-for-sale, or held-to-maturity - balance sheet and income statements reflect these various treatments Trading securities - unrealized gains pass through income statement and land on balance sheet Available-for-sale - adjusted for market value changes, so there's an unrealized gain to show on the balance sheet now Held-to-maturity - nothing on income statement or balance sheet, effectively ignored Noncurrent Liabilities - CORRECT ANSWER - refer to all liabilities that are not classified as current; includes deferred revenue, long-term liabilities which are usually held at face value, and any premium or discount amortized over time - deferred tax liabilities arise from companies paying less than is expensed in taxes in the current period Current Liabilities - CORRECT ANSWER - obligations that are expected to be paid or settled within 12 months, or a normal operating cycle - includes accounts payable (payables to suppliers), accrued expenses (expenses on income statement that will be paid at a later time), deferred income (when the company has been paid for a good or service in advance Common-Size Analysis of Balance Sheet - CORRECT ANSWER - involves stating each balance sheet amount as a percentage of total assets - gives insight into the composition of the company - can help identify problems with liquidity (short-term debt) or solvency (long-term debt) Cross-Sectional Common-Size Analysis - CORRECT ANSWER - specific application of common-size balance sheet analysis where multiple companies are analyzed in regards to their competition - this analysis proves useful even if the companies are of different sizes Balance Sheet Ratios - CORRECT ANSWER liquidity ratios - "higher is better" - cash ratio, quick ratio, current ratio *cash ratio = most restrictive solvency ratios - "lower is better" - debt/equity ratio, total debt ratio, financial leverage ratio - these are useful as they allow for comparison with other firms and with the firm itself over time, although different accounting practices can make these ratios misleading Components of the Cash Flow Statement - CORRECT ANSWER - operating activities: day-to-day activities that generate an inflow or outflow of cash - investing activities: involve the purchase or sale of long-term assets, including some securities of other firms - financing activities: issuance of stock and bonds and their repurchase, as well as possibly the payment of dividends and interest - non-cash items, such as depreciation and gains/losses aren't on the cash flow statement IFRS vs. US GAAP Classifications - CORRECT ANSWER *if GAAP, no choice in how things are done US GAAP - interest received and paid, dividends received falls under operating activities; dividends paid is financing; taxes are operating; bank overdrafts are financing IFRS - receiving interest and dividends can be classified as operating or investing, and paying interest and dividends can be classified as operating or financing; taxes "go with it" (i.e. if sale of fixed asset in investing, tax goes in investing); bank overdrafts are cash equivalents - both encourage the direct method - IFRS allows choice as far as classifying interest and dividends as operating or investing/financing, depending on whether they are received or paid - there's choice within IFRS about classifying some tax payments as well - GAAP, there is no choice; these are all operating activities except for dividends paid (financing activity, as well as a few others Linking the CF Statement with Other Financial Statements - CORRECT ANSWER - cash flow statement is derived from changes in the statement of financial position from one year to the next - these changes include the income statement, as it is part of retained earnings - the cash flow statement is not created from any accounting entries Direct & Indirect Methods for Reporting CFO - CORRECT ANSWER - direct method of cash flow statement preparation is often preferred and recommended, as it shows each cash inflow and outflow - this is additional information beyond that of the indirect cash flow method, which starts with net income then adjusts to operating cash flow - the values are the same with either method; only presentation differs - cash flows for investing and financing activities are the same for both Overall Statement of Cash Flows under the Indirect Method - CORRECT ANSWER - add back non-cash expenses, subtract gains and add back losses from non-operating activities, consider changes in the current assets and current liability accounts (working capital accounts) - net income is the adjustment to net cash provided by operating activities through consideration of noncash revenues and expenses as well as through changes in current asset and current liability accounts Overall Statement of Cash Flows under the Direct Method - CORRECT ANSWER - direct method determines the amount of cash received and paid for the day-to-day activities of the company, shown in the operating section - the overall net change in cash will be seen on the bottom of the cash flow statement and on the comparative balance sheet Cash Received from Customers and Paid to Suppliers - CORRECT ANSWER - Cash Received from Customers is the first line on a direct statement; includes revenues and changes in AR; subtract increase (add decrease in AR) to revenues TO CALCULATE Cash Received From Customers: start with revenues from the income statement, subtract increases in AR, or add decrease in AR over the year Cash Paid to Suppliers: calculate the amount of inventory purchased, then determine how much of the purchase price was paid in cash Cash Paid for Income Taxes and Other Expenses - CORRECT ANSWER Cash Paid for Income Taxes - income tax expense, add net increase (subtract net decrease) in taxes receivable and deferred taxes and subtract net increase (add net decrease) in taxes payable - under GAAP, cash paid for income taxes is included as operating activity - under IFRS, cash paid for income taxes will normally be included as an operating activity, but can be classified as an investing or financing activity at times *cash paid for income taxes must be disclosed under both GAAP and IFRS Cash Paid for Other Operating Expenses -operating expenses from IS, add increase in prepaid expenses (subtract decrease in prepaid expenses), and subtract the net income in accrued liabilities (or add a net decrease in accrued liabilities) - income tax expense needs to be adjusted for the net change in taxes receivable, deferred taxes, and taxes payable to calculate cash paid for income taxes Adjustments to Net Income Using the Indirect Method - CORRECT ANSWER to adjust net income to cash flows provided/used by operating activities under the indirect method, there are three steps: 1) add back non-cash expenses 2) deduct gains and add back losses that result from investing activities 3) consider changes to non-cash current assets and liabilities (see below) For non-cash charges: Current Asset Decrease = + to NI Current Asset Increase = - to NI Current Liability Increase = + to NI Current Liability Decrease = - to NI Cash Paid for Employees and Interest - CORRECT ANSWER Cash Paid to Employees - salary/wage expense minus the increase in salary/wage payable Cash Paid for Interest - adding the net decrease in interest payable (subtract a net increase) to the interest expense on the income statement CPFI = interest expense + decrease in interest payables - GAAP requires cash paid for interest to be classified as operating activity; IFRS allows cash paid for interest to be operating for financing activity Investing and Financing Activities - CORRECT ANSWER - investing activities impact long-term assets; financing activities include LT liabilities and equity - amount of cash received from the issuance of common stock = common stock + additional paid-in capital Conversions of Cash Flows from the Indirect to the Direct Method - CORRECT ANSWER if an analyst wants to review trends in cash receipts and payments, but the operating activities were prepared using the indirect method, a three-step convergence can be done: 1) separate net income into total revenues and total expenses 2) remove all non-cash and non-operating items and separate the remaining items into relevant cash flow items 3) convert accrual amounts of revenues and expenses to cash receipts and payments by adjusting for increases/decreases in current assets and current liabiltiies Evaluation of Sources and Uses of Cash - CORRECT ANSWER - higher CFO than NI is generally a good sign - operating cash flows: indicate whether a company can generate positive cash flows from what they are in business to do - investing cash flows: tell users whether funds are being spent or generated from capital assets or LT investments - financing cash flows: disclose sources or uses of cash from LT debt or from share transactions Common-Size Cash Flow Statement - CORRECT ANSWER - each line item is expressed as either a percentage of total cash inflows/outflows or as a percentage of revenue - shows trends in cash flow instead of looking at total amounts Cash Flow Ratios - Performance - CORRECT ANSWER CF to Revenue = CFO / Net Revenue Cash Return on Assets = CFO / Avg Total Assets Cash Return on Equity = CFO / Average SE Equity *the higher the better Cash to Income = CFO / OI Cash Flow per Share = (CFO - P Dividends ) / # Common Shares Outstanding * need to be careful with this ratio with IFRS vs. GAAP, if dividends are paid to common shareholders in CFO, they need to be added back FCF to the Firm and FCF to Equity - CORRECT ANSWER FCF to Firm = cash available to creditors (excludes cash flow from financing activities) CF to Firm = CFO + After-Tax Interest Paid - Fixed Capital Investments FCF to Equity = cash available to shareholders, AFTER creditors are paid CF to Equity = CFO - Fixed Equipment Purchases + Fixed Equipment Sales - Debt Repayment Cash Flow Ratios - Coverage - CORRECT ANSWER Debt Coverage Ratio = CFO / Total Debt *closer to 1, the better Interest Coverage Ratio = (CFO + Interest Paid + Taxes Paid) / Interest Paid *the higher, the better *depending on how the company is reporting interest and taxes, an analyst might have to add one or both of these figures back to CFO Reinvestment Ratio - CFO available to pay for capital assets w/o borrowing Debt Payment Ratio = CFO / Cash Paid for LT Debt Repayment *higher result is better than a lower one Dividend Payment Ratio = CFO / Dividends Paid Investing/Financing Coverage Ratio = CFO / Cash Outflows for Investing and Financing Activities *lower ratio means lower coverage, and a reduced capacity to continue to make such cash outflows going forward Model Building and Forecasting - CORRECT ANSWER - analysts build models that forecast the future financial performance of a company by utilizing multiple techniques, including security analysis, scenario analysis, and simulation - analysts also create pro forma financial statements as part of an earnings model - executives and managers within the company may also create pro forma statements when considering a change that may have a financial impact Financial Statement Analysis Process and Framework - CORRECT ANSWER - the analyst should clarify the purpose and context of his work as well as the level of detail, data availability, and any limitations before choosing the set of techniques to be used Steps 1) articulate the purpose/context of analysis 2) collect input data 3) process data 4) analyze/interpret the processed data 5) develop and communicate conclusions and recommendations Distinguishing between Computations and Analysis - CORRECT ANSWER - an effective analysis includes both computations and interpretations; integrates data into meaningful whole - computations tell what happened; analysis can tell why it happed - analysis need to communicate their findings in a written report; which should indicate: how conclusions were reached, how recommendations were made, the appropriate past period data, analytics appropriate to the purpose of the report Common-Size Analysis of the Balance Sheet - CORRECT ANSWER - vertical common-size balance sheet divides each balance by total assets for comparability of balance sheet items across companies, eliminating currency and size differences - horizontal balance sheet shows all balances as a % of that balance in a starting year; better at showing trends Financial Ratios and Their Interpretation - CORRECT ANSWER Regarding financial ratios and interpretation: - # of different ratios is limitless - no universal list that is common to all analysts - there are some that are widely accepted and used, like return on assets or return on equity, but others are industry specific - care must be used so that the specific numbers used - year end or average, for example - best reflect the industry being examined Value, Limitations, and Sources of Ratios - CORRECT ANSWER Regarding ratio analysis: - financial ratios can be used to easily compare companies in similar industries, as well as to spot trends in the past of the same company - ratios can be used to compare companies that vary in size, but are not useful in comparing companies in different industries, due to different products and operating conditions - ratios can also be used by potential investors to discover potential risks - ratios may be calculated using data directly obtained from financial statements - another source are popular databases, such as Bloomberg, that may also include data taken from financial statements and presented in various forms Overview of Common Ratios Used including Categories - CORRECT ANSWER Activity Ratios - measure how well a business does its day-to-day things Profitability Ratios - measure how well a business uses the assets it has to make profits Liquidity Ratios - measure how well a business can meet its ST debts Solvency Ratios - measure how well a business can meet its LT debts Valuation Ratios - measure things that relate to what a company is worth; stockholders are interested in this Interpretation and Context of Financial Ratios - CORRECT ANSWER Financial ratios: - are best interpreted in the context of other information - can be compared to industry benchmarks or ratios from major competitors - in combination with general economic conditions can also provide context Activity Ratios and their Calculation - CORRECT ANSWER - activity ratios measure how efficiently a business handles its day-to-day tasks like generating revenues, inventory management, receivables, and payables - many activity ratios are a mix of income statement items and balance sheet items - balances must be averaged over the time period used for the activity Inventory Turnover and Days on Hand - CORRECT ANSWER Inventory Turnover = COGS / Average Inventory DOH = # Days in Period / Inventory Turnover Regarding inventory turnover/DOH: - both reflect the effectiveness of a company's inventory management - if inventory turnover is high, then DOH is likely low, as inventory would be leaving the company quickly - if revenue is growing along with high inventory turnover, the company has effective inventory management - if revenues are falling, then the company may be running out of stock - comparing these two ratios with revenue growth allows for a more complete assessment of inventory management Receivables Turnover and DSO - CORRECT ANSWER Receivables Turnover = Revenue / Average Receivables DSO = (AR/Total Credit Sales) x # of Days DSO = # of days in the period / AR Turnover Regarding receivables turnover and DSO: - a relatively high receivables turnover corresponds with a low DSO - this can indicate either efficiency in credit and collections or a overly stringent credit policy - comparison of sales growth relative to the industry can help with the determination - a lower turnover can indicate credit management problems - DSO is an activity ratio that shows how many days it takes a company to collect on credit sales - DSO calculation shows creditors and investors the company can collect from their customers efficienctly Activity Turnover Ratios - CORRECT ANSWER Working Capital Turnover = Revenue / Average WC - how efficiently a company is using its working capital Fixed Asset Turnover = Revenue / Average Fixed Assets - measures how well a company generates revenue from its fixed assets Total Asset Turnover = Revenue / Average Total Assets - measures the company's overall ability to generate revenue from a given level of assets Payables Turnover and Number of Days Payable - CORRECT ANSWER Payables Turnover = Purchases / Average Trade Payables - how many times each year a company theoretically pays off all its creditors - excessively lower turnover could indicate trouble in making payments on time or taking advantage of lenient terms Number of Days of Payables = # of Days in Period / Purchases Turnover *these move in opposite direction; a higher payables turnover will lower the days of payables Cross-Sectional Analysis - CORRECT ANSWER - compares specific metrics from one company with the same metrics for another company or groups of companies - this allows for comparison of different-sized businesses or between firms using different currencies Profitability Ratios and Their Calculaiton - CORRECT ANSWER Regarding profitability ratios: - profitability ratios, show the profitability of a company - in turn this shows how well a company is being managed, as well as their position in the market - as an investment analysts, calculating profitability ratios such as gross profit margin and rate of return on sales can help you determine which companies are the best investments Return on Assets - CORRECT ANSWER ROA = NI / Average Total Assets ROA (from operations) = (NI + Interest Expense(1 - Tax Rate)) / Average Total Assets - can be modified to net out interest expense to provide operating ROA Current, Quick, and Cash Ratios - CORRECT ANSWER Quick Ratio = (Cash + MKT Investments + Receivables) / Current Liabilities Cash Ratio = (Cash + ST Investments) / Current Liabilities Current Ratio = CA / CL Defensive Interval Ratio - CORRECT ANSWER DI Ratio = (Cash + ST MKT Investments + Receivables) / Daily Cash Expenditures - indicates how many days a firm can meet its expenditures without obtaining additional cash flow Return on Equity - CORRECT ANSWER ROE = NI / Average Total Equity Return on Common Equity = (NI - P Divs) / Average Common Equity *higher = better for shareholders Operating and Financial Leverage - CORRECT ANSWER Operating Leverage = Fixed Costs / Total Costs - greater use of fixed costs magnifies the impact that additional sales will have on operating income since variable costs will rise with volumes and fixed costs won't - the use of debt constitutes financial leverage because interest payments are a fixed financing cost - higher leverage increases the proportional returns of earnings to equity holders but also increases the risk of default on obligations Cash Conversion Cycle - CORRECT ANSWER - measures the length of time that it takes to convert cash paid for operations to cash received back from customers for the sale of products purchased CCC = DOH + DSO - # of Days in Payables *shorter conversion cycles = more liquidity Coverage Ratios - CORRECT ANSWER Interest Coverage Ratio = EBIT / Interest Payments - measures the number of times a company's earnings could pay the company's interest costs Fixed Charge Coverage Ratio = (EBIT + Lease Payments) / (Interest Payments + Lease Payments) - measures how many times the earnings could cover these fixed payments Debt Ratios - CORRECT ANSWER Financial Leverage Ratio = Total Assets / Total Equity DuPont Analysis and Decomposition of ROE - CORRECT ANSWER ROA = Tax Burden x Interest Burden x EBIT Margin x Total Asset Turnover x Leverage DuPont ROE = (NI / Revs) x (Revs / Average Total Assets) x (Average Total assets / SE) Valuation Ratios Using Share Price - CORRECT ANSWER - P/E, P/CF, P/S, P/BV are valuation ratios that have share price in the numerator and divide by performance metrics in the denominator Dividend-Related Quantities - CORRECT ANSWER 3 dividend-related quantities exist: - Dividend Payout Ratio = Common Dividends / NI Attributable to Common Shares - Retention Rate = 1 - Dividend Payout - Sustainable Growth Rate = ROE x Retention Rate Interpretation of EPS, Basic EPS, and Diluted EPS - CORRECT ANSWER Basic EPS = (NI - P Divs) / Weighted Average Common Shares Outstanding Diluted EPS = Adjusted Income Available to Common Shares Reflecting Conversions of Dilutive Securities / Weighted Average Number of Ordinary and Potential Shares - diluted and basic are not comparable from one company to another - accounting standards generally require that both be disclosed with explanations as to the numbers in the numerator and denominator Industry-Specific Ratios - CORRECT ANSWER - some ratios are industry specific, such as same-store sales in retail, occupancy rates in hotels, and capitalization ratios in banking - some ratios are designed for specific purposes, such as coefficients in variation in revenue, operating income, or net income designed to gauge business risk Segment Reporting Requirements - CORRECT ANSWER Considerations of segment reporting requirements: - accounting standards require data be reported - segment is defined as a component of the company engaging in activities that generate revenue and create expenses - the company must report segment data for those segments exceeding 10% of the company's total revenue, assets, or profit - in addition, the total revenue from reported segments must exceed 75% of total revenue for the company, if the segments with over 10% do not total at least 75% of revenue - additional segments are reported, even if they don't have 10%, so the total of all reported segments is at least 75% of revenue Credit Analysis - CORRECT ANSWER Regarding credit analysis: - its the evaluation of credit risk - approaches of credit analysis vary depending on the purpose for the analysis - credit analysis for specific financing often involves projecting cash flows to assess the likelihood of repayment - a general approach is used by credit rating agencies to assess and communicate the likelihood of default of debt obligations Credit Rating Process - CORRECT ANSWER Business Risk - includes things like cyclicality, capital intensity, competitive position *as a credit analyst, you would like to see firms with a high level of business risk have a lower level of financial risk Financial Risk - is measured by reviewing financial statements; often means examining capital structure, interest coverage, and profitability - the credit rating process involves both an analysis of the company's financial reports as well as a broad assessment of a company's operations Research on Ratios in Credit Analysis - CORRECT ANSWER - z-score is often considered; other variables include ROA, LT Debt to Assets, Interest Coverage, Cash Flow to Debt, Measure of Variability for Cash Flow and Assets Segment Ratios - CORRECT ANSWER These segment ratios measure segment aspects of profitability, efficiency, and solvency: - Segment Margin: segment profit/segment revenue - Segment Turnover: segment revenue/segment assets - Segment ROA: segment profit/segment assets - Segment Debt Ratio: segment liabilities/segment assets Cost of Inventories - CORRECT ANSWER costs to include in inventories are generally: - purchase costs - costs of manufacturing goods - any other costs to bring an item to a location or condition ready for resale - both GAAP/IFRS are similar when determining the costs to include in inventories and those that should be expensed as incurred related to inventory; both exclude storage costs as allowable to be capitalized as part of inventory Inventory Valuation Methods - CORRECT ANSWER IFRS allows for: specific identification, FIFO, weighted average cost GAAP allows for: LIFO Last-In, First-Out (LIFO) - CORRECT ANSWER LIFO method of inventory assumes the last goods manufactured or purchased are the first ones sold; Using LIFO: - ending inventory values are assigned using the beginning inventory values or the oldest purchased or manufactured - COGS is assigned using the values of the newest goods manufactured or purchased - the actual flow of goods may not match the costs being assigned - GAAP allows for LIFO to be used in financial reporting - companies reporting under IFRS are now allowed to use LIFO Specific Identification - CORRECT ANSWER The method of specific identification is most often used for inventory products that are: - uniquely identifiable - not ordinarily interchangeable - produced for a specific project - under SI, the actual cost of each item remains in inventory until that specific item is sold; the physical flow of units matches the cost flows when using specific identification Weighted Average Cost - CORRECT ANSWER The weighted average cost method: - uses an average cost of goods available for sale to assign costs to both ending inventory and goods sold - is calculated by taking the total costs of the units available for sale and dividing it by the total number of units for sale in the same period First-In, First-Out (FIFO) - CORRECT ANSWER The FIFO method of inventory assumes the first goods manufactured or purchased are the first ones sold; key points include: - ending inventory values are assigned using the most recent purchase or manufacturing costs - COGS is assigned using the values from beginning inventory or the oldest goods manufactured or purchased - the actual physical flow of goods may not match the costs being assigned - when pricing are rising, FIFO will result in higher costs being assigned to ending inventory - when prices are falling, ending inventory will be assigned lower costs than COGS Calculation of Cost of Sales, Gross Profit, and Ending Inventory - CORRECT ANSWER When prices are changing, the various inventory methods will result in different allocations to cost of sales and to inventory resulting in differences in: - gross profit, ending inventory, cost of sales Periodic vs. Perpetual Inventory Systems - CORRECT ANSWER Companies can record inventory using either a periodic or perpetual inventory system: - perpetual inventory will be continually updated as goods are received and sold - periodic inventory means goods will be recorded as purchases and adjustments made to the inventory account at regular intervals - really only affects LIFO; specific identification and FIFO go generally unaffected Measurement of Inventory Value under US GAAP - CORRECT ANSWER - requires inventory be valued at the lower of cost or market; market value CANT be lower than the net realizable value less a normal profit margin - inventory adjustments under GAAP reduce inventory balance and are reflected as an expense in the income statment in the period of adjustment - if the inventory value recovers in future periods, GAAP does NOT allow an increase in inventory US GAAP requires inventory is measured at the lower of cost or market value; GAAP and IFRS differ in some aspects of measurement; under US GAAP - market value determines replacement cost, with upper and lower limits allowed - write-downs reduce inventory directly - write-ups of previous write-downs are not allowed - special commodities are allowed a different measurement of value LIFO: The LIFO Reserve - CORRECT ANSWER - the difference between what is reported under LIFO for inventory and COGS, and what is reported under FIFO - this is a quick adjustment that can be made for a company using LIFO to make its financial information comparable to FIFO - is the US GAAP-required disclosure of LIFO's effects on inventory valuation - since this also affects COGS, it has implications for taxes and profits *if LIFO Reserve increases, should be subtracted from COGS Measurement of Inventory Value under IFRS - CORRECT ANSWER - requires inventories are measured at the lower of cost or net realizable value, which is the estimated selling price minus any costs to sell or make the item ready to sell - IFRS allows for reversals to be made up to the amount of the original write-down if inventory recovers in value - does NOT apply to producers or brokers of certain special commodities such as agricultural and forest products; these are reported at net realizable value LIFO: LIFO Liquidation - CORRECT ANSWER - when a number of units taken out of inventory exceeds the number of units added to it at current prices - occurs when sales are higher - full disclosure for any LIFO liquidations are required in the notes to the financial statements, and the impact/amounts on all items affected is required - one-time impact on the company's earnings Changes in Inventory Valuation Method - CORRECT ANSWER - GAAP: requirement is to explain why the change would be superior and preferable; requires retrospective reporting when changing from LIFO to any other method, with restatement, similar to IFRS; when changing from FIFO to LIFO, GAAP requires prospective reporting only - IFRS: all changes must be accounted for retrospectively, with historical information restarted for all years in the financial statements - reversals are allowed under IFRS, as long as they don't exceed the original write-down amount Inventory Adjustments - CORRECT ANSWER US GAAP and IFRS have different measures to account for the declines and recoveries in values for most inventories: - GAAP requires lower of cost or market - IFRS requires lower of cost or net realizable value - IFRS allows write-ups of previously written down inventory - GAAP prohibits write-ups - special commodities are accounted for in a similar way under both GAAP and IFRS *write-downs under IFRS in inventory allowance account, included in COGS for GAAP Bonds Payable - Basics - CORRECT ANSWER Face Value - amount of cash to be paid back to the bondholder in the future Maturity Date - when the company will have to pay back cash Coupon Rate - interest rate that the company will pay to the bondholder throughout the life of the bond, interest normally paid 2x a year Accounting for Bonds Issued at a Premium - CORRECT ANSWER - bonds issued at a premium occur when the bond's contract rate is higher than the market rate of interest - investors are willing to pay more than the face value of the bond now in order to earn a higher rate of return in the future Accounting for Bonds Issued at Face Value - CORRECT ANSWER Regarding accounting for bonds issued at face value: - when a bond is issued at face value the coupon of interest is equal to the market rate of interest - since the interest rates are the same the company will be able to sell the bond for full face value - in order to account for this bond the company must record the receipt of cash and the bond payable liability when the bond is issued - they will also have to account for the interest payments and the pay back of the bond Accounting for Bonds Issued at a Discount - CORRECT ANSWER Bonds issued at a discount rate require three main accounting entries: - the issuance of the bond including discount - the interest payments over the life of the bond - the repayment at maturity date *zero-coupon bonds are issued at a discount Debt Covenants - CORRECT ANSWER - included in borrowing agreements - offer benefits to both lenders and borrowers - benefits are reduced costs in the form of lower interest rates, and lower risk for lenders because borrowers are restricted or required to perform certain actions that protect the borrower's interests Amortizing Bond Premiums/Discounts with Straight-Line Method - CORRECT ANSWER - straight-line method is not allowed under IFRS, not preferred under GAAP - amortization amount is the premium/discount divided by the number of interest paymnets - amortized amount for a premium will decrease the interest expense, and it will increase the interest expense for a discount Differences between Accounting Profit and Taxable Income - CORRECT ANSWER Accounting Profit - pretax income doing things your way Taxable Income - determined using tax law - when accounting profit is lower than taxable income, leads to a Deferred Tax Asset - when accounting profit is higher than taxable income, leads to a Deferred Tax Liability Tax Loss Carry Forward - when a firm experiences a loss in one year, and can use that loss against profits next year Unused Tax Losses and Tax Credits - CORRECT ANSWER - unused tax losses and credits may be used to decrease future taxes - unused tax losses and credits are only recognized to the extent that they are likely to be used in the future - IFRS allows recording deferred tax assets up to this value, while GAAP allows recording the entire tax loss along with a valuation allowance account - if uncertain, may be best to record the credit when realized Current Tax Assets and Liabilities - CORRECT ANSWER Regarding current tax assets and liabilities: - the amount a company expects to get back from prepaid taxes is a TAX ASSET, the amount the company owes is a TAX LIABILITY; both calculated on current taxable income - if there is a difference between the taxable income and the accounting profit, then the current tax asset or liability may vary - differences in account profit and taxable income happen when different standards are applied Determining the Tax Base of an Asset - CORRECT ANSWER - the tax base of an asset is its value for tax purposes and can be calculated from the carrying amount of the asset plus or minus any temporary differences between accounting rules and tax authority standards Deferred Tax Assets and Liabilities - CORRECT ANSWER - deferred tax assets and liabilities are taxed paid or due that result from a difference between the accounting standards and the tax authority standards - when these deferred taxes are self-correcting over time, they are called temporary differences - a deferred tax must reverse in some future tax period Determining the Tax Base of a Liability - CORRECT ANSWER - tax base of a liability is its value for tax purposes, and can be calculated from the carrying amount of the liability and adjusted for any temporary differences between accounting rules and tax authority standards Temporary and Permanent Differences between Taxable and Accounting Profit - CORRECT ANSWER Taxable Temporary Difference - leads to a deferred tax liability - don't get to create deferred tax liabilities for goodwill for a merger under IFRS, GAAP offers no exemptions - only recognized deferred tax if goodwill is amortizable - if Temporary, the difference is either a taxable temporary difference or a deductible temporary difference - US GAAP does NOT allow for a deferred tax for non-amortized goodwill, and IFRS does not recognize deferred tax accounts for goodwill from business combinations - deductible temporary differences are allowable if there is a reasonable expectation of future profit for recovery Interest Payment vs. Interest Expense - CORRECT ANSWER - expense on IS, payment on CF - IFRS: operating or financing activity - GAAP: operating activity Amortizing Bond Premium/Discount with Effective Interest Rate Method - CORRECT ANSWER Regarding amortizing bond premiums or discounts with the effective interest rate method: - amortizing bond premiums/discounts using the effective interest method is required under IFRS and preferred under GAAP - the effective interest method allocates bond interest expense over the life of the bond at a constant interest rate - the market rate at the time the bond is issued - to calculate interest expense, multiply the carrying value of the bond (face value +/- premium/discount) by the market rate of interest Current Market Rates and Fair Value Reporting Option - CORRECT ANSWER Regarding fair value reporting: - reporting bonds at amortized historical cost reflects the market rate of interest at the time the bond is issued, but does not adjust for changing market rates - IFRS and GAAP now allow companies to report liabilities at fair value by showing the gain/loss received by the increase/decrease in interest rates - the gains/losses will be recognized as profits/losses Presentation and Disclosure - IFRS vs. GAAP - CORRECT ANSWER - both require disclosures related to the write-downs of inventory and the circumstances that created those write-downs during the period - IFRS requires that any write-ups of inventory and circumstances are also reported - GAAP does NOT require disclosure on write-ups, as write-ups are not allowed under GAAP Both require disclosures for: - accounting policies for measurement - amount and classification of inventory - special inventory items carried at NRV - cost of sales for period - inventory write-downs for the period and related circumstances - inventory amounts used as collateral Inventory Ratios - CORRECT ANSWER Inventory Turnover = Sales / Avg Inventory DOH = # Days in Accounting Period / Inventory Turnover GM% = Gross Profit / Sales Changes in Income Taxes - CORRECT ANSWER - high income tax rates increase both deferred tax assets, and deferred tax liabilities - if the income tax rate is increased, the deferred taxes increase, and if the income tax rate is decreased, deferred taxes decrease Recognition & Measurement of Current/Deferred Taxes - CORRECT ANSWER Regarding current and deferred tax: - shown on income statements - based on current applicable tax laws - deferred taxes are shown at the rates that will apply at the time recognized or paid - deferred taxes may be adjusted based on changes to tax rates but are not discounted to PV Regarding recognition of valuation allowance: - if there is doubt whether a DTA will be recovered, then the carrying amount should be reduced to the estimated recovery amount - GAAP uses a valuation allowance to reduced deferred tax assets - if things change and the tax asset valuation allowance is reduced, the reversal will increase the deferred tax asset and the operating income Business Combinations and Deferred Taxes - CORRECT ANSWER - deferred tax liability will be recognized when a temporary difference is created expect if the parent company is in control of the timing of the temporary difference reversal, and the temporary difference will probably not reverse in the future - deferred tax assets need to reverse in the future and have sufficient taxable profit to justify the tax asset Recognition of Current and Deferred Tax Charged Directly to Equity - CORRECT ANSWER - deferred tax liability is calculated as the difference between the carrying amount and the tax base, times the tax rate - the recognition of the current and deferred taxes is charged directly to equity in only specific types of situations, such as when taxes are related to long-term investments, revaluations, accounting policy changes, and translation differences arising from exchange rate differences IFRS vs. GAAP - Considerations & Applications - CORRECT ANSWER - both require provisions for deferred taxes when there is a temporary difference - there are minor differences in general treatment, as well as differences in specific applications such as deferred taxes from revaluations and currency translation differences (allowed only under IFRS) IFRS vs. GAAP - Business Combinations - CORRECT ANSWER GAAP and IFRS deal with acquisitions similarly when it comes to step-up of assets and liabilities as well as the way they deal with initial recognition. They differ on: - recognition of previously unrecognized tax losses (GAAP requires to be recorded against goodwill) - uncertain taxes (under IFRS, resolution that happens more than one year after acquisition will result in income or expense in IS) - subsequent recognition of income tax resolutions IFRS vs. GAAP - Measurement of Deferred Tax - CORRECT ANSWER GAAP and IFRs vary in the way they measure deferred taxes: - IFRS allows tax rates and tax laws that have been enacted or substantively enacted - GAAP only allows for tax rates and tax laws that have been fully enacted - GAAP allows for the recognition of deferred tax through a valuation allowance - IFRS does not permit valuation allowances Required Disclosures Relating to Deferred Tax Items - CORRECT ANSWER when temporary differences create deferred taxes, disclosures must be used to explain: - the reasons for the temporary difference - any adjustments made - the resolution of the difference if the deferred tax item affects financial analytics like ratios, then a disclosure must be used for explanation IFRS vs. GAAP - Presentation of Deferred Tax - CORRECT ANSWER - GAAP and IFRS have similar guidelines - IFRS always classifies deferred taxes as noncurrent whereas GAAP allows a choice based on the related non-tax asset - reconciliation of actual and expected taxes is required via a disclosure by IFRS but GAAP only requires it for publicly traded companies Reporting Financial Liabilities at Fair Value - CORRECT ANSWER - when a company selects to report financial liabilities at fair value, the increases/decreases in interest rates are reported as gains/losses on the income statement - the value will be adjusted and gains/losses recorded each time the financial statements are created Introduction to Pensions & Other Post-Employment Benefits - CORRECT ANSWER Regarding pensions and other post-employment benefits: - companies often offer difference benefits to employees after they retire, including medical insurance, health insurance, and pensions - pensions are the most common - most common types: defined-contribution plans and defined-benefit plans - the accounting for a defined-contribution plan is fairly simple, while the accounting for a defined-benefit plan is more complicated - often, defined-benefit plan contributions are placed in a trust fund, earnings interest until they are used - accounting procedures vary depending upon if there is a gain or a loss in the fund and where the company the employee worked Derecognition of Debt - CORRECT ANSWER - occurs when a bond reaches maturity, by calling the bond, or purchasing the bond in the open market Bond debt can be extinguished under three different circumstances: - when the bond reaches maturity - by calling the bond before maturity - by repurchasing the bond in the open market - GAAP: any issuance costs that have not been amortized will be written off when the debt is paid off and any gain/loss will also be recognized; disclosure of gain/loss due to debt extinguishment is required by GAAP - IFRS: issuance costs will be included in the carrying value of the debt, so there will not be a gain/loss Presentation and Disclosure of LT Debt - CORRECT ANSWER - disclosure of the terms of LT debt is required by GAAP and can appear in the notes to the financial statements as well as in the MD&A Disclosures of Complex Debt - CORRECT ANSWER - required for public companies - include interest rates, maturity dates, and debt covenants Leases and Advantages of Leasing - CORRECT ANSWER - leases can be an attractive option for both the lessor (owner of asset) and lessee (company using the asset) - lessor may be in better position to use the tax benefits, take on the risk of ownership, and service of the asset - lessee may benefit with better financing terms, which in the long run will be less expensive than buying the asset Finance (or Capital ) Leases vs. Operating Leases - CORRECT ANSWER Capital Lease - of such duration and total cost or ultimately transfers ownership to the lessee that is economically equivalent to a purchase Operating Lease - similar to a rental, allows lessee to use asset for a specified period of time *if PV of lease payments is more than 90%, agreement is a capital lease Defined Contribution Plans - CORRECT ANSWER - company contributes a set amount to a pension plan; considered a pension expense on IS - same amount of pension expense is a cash outflow as an operating activity - if the company does not make the agreed upon payments, it will have to record a liability on the balance sheet Accounting and Reporting Operating Leases - Lessee - CORRECT ANSWER - expense on IS, cash outflow in operating activities on SOCF - must disclose future contractual minimum lease payments for the next 5 years in a note to the financial statements *cheaper than capital lease in early years of lease Accounting and Reporting Capital Leases - CORRECT ANSWER Regarding accounting and reporting of capital leases: - capital/finance lease requires the lessee to account for the lease essentially as a purchase made with a loan - a least asset and liability are recorded on the BS - expenses are recorded for depreciation and interest - payments is comprised of interest expense and reduction of lease liability - interest portion of the payment is report as an operating activity cash flow under GAAP, and as either operating activities or financing activities under IFRS - payment portion reducing the lease liability must be reported under financing activities Defined Benefit Plans - CORRECT ANSWER Regarding defined benefit plans: - company agrees to make future payments to the employee during his/her retirement - in order to determine how much the company needs to invest in a pension fund now, there are several estimates to be made - company must estimate the employee's salary at retirement and the number of years the employee will live after retirement - future payments are then discounted back to PV amounts Accounting and Reporting by the Lessor - CORRECT ANSWER - if PV lease payments = carrying value of asset, then its a direct financing lease - if PV lease payments > carrying value of asset, then it's a sales-type lease - when a lessor follows GAAP, they must distinguish if the capital lease is a direct financing lease or a sales-type lease - if direct financing lease: lessor shows a lease receivable on their balance sheet, and the revenue is in the form of interest payments - if sales-type lease: it is treated as a sale of the asset with financing of the asset provided by lessor IFRS vs. GAAP Treatment of Net Pension Asset/Liability - CORRECT ANSWER Differences in treatment of net pension assets/liabilities between IFRS & GAAP: - accounting for pensions is similar under IFRS and GAAP - GAAP amortizes prior service costs, while IFRS recognizes it immediately - Actuarial gains and losses and variances between expected and actual returns on plan assets are recorded to other comprehensive income under both IFRS and GAAP - however, GAAP amortizes them to expense over time while IFRS leaves the amount in OCI - net pension asset or liability is recorded on the balance sheet the same under GAAP and IFRS Leverage Ratios in Evaluating Solvency - CORRECT ANSWER *higher the ratio, weaker the solvency Accounting & Reporting Rules under IFRS vs. GAAP - CORRECT ANSWER The accounting and reporting requirements for operating leases are identical under GAAP and IFRS and nearly so for finance/capital leases with some differences merely in technology: - there are minor differences in the criteria used to determine if a lease is an operating lease or a finance/capital lease - IFRS requires the lease liability to be recorded on the balance sheet under debt - GAAP requires interest to be shown as a cash flow from operating activities while IFRS allows the company to show it under either operating or financing activities *GAAP contains revenue-recognition criteria while IFRS DOES NOT PV of minimum lease payments > carrying value? sales-type lease under GAAP Coverage Ratios in Evaluating Solvency - CORRECT ANSWER Interest Coverage = EBIT / Interest Payments Fixed Charge Coverage = (EBIT + Lease Payments) / (Interest Payments + Lease Payments) GAAP Treatment of Net Pension Asset / Liability - CORRECT ANSWER Pension Obligation = PV of projected benefits - GAAP requires that only service cost, interest costs, and expected return on plan assets be recorded in pension expense each period - GAAP allows companies to amortize, or smooth, prior service costs and actuarial gains and losses since they are most volatile; recorded in OCI Considerations: - service cost, interest cost, return on plan assets, prior service costs, and actuarial gains/losses all impact the pension obligation - prior service costs and actuarial gains/losses are recorded to OCI and amortized to income/expense over time - any other change in the pension obligation is recognized as pension expense in the period as shown on the income statement - should the company contribute more to the plan's assets than pension expense, a net pension asset is created and shown on the balance sheet - a contribution to the plan assets that is less than the pension expense for the period results in a net pension liability on the BS - unamortized prior service costs and actuarial gains/losses will be reported in OCI in the equity section of BS IFRS and GAAP Criteria for Identifying Capital Leases - CORRECT ANSWER GAAP Criteria: - ownership of asset transfers to lessee at end of lease - option in lease for lessee to purchase asset cheaply - lease lasts for 75% or longer of useful life of asset - PV of lease payments is at least 90% of fair value of asset IFRS recognizes a lease as a capital lease if substantially all the risks and rewards are passed onto the lessee; lessee will show asset and lease obligation on their BS Effective Tax Rate Reconciliation - CORRECT ANSWER - IFRS: taxes are calculated by applying the tax rate to the accounting profit; requires a disclosure for any effective tax rate change; requires a reconciliation of actual and expected taxes based on creation of effective tax rate - GAAP: applies the tax rate to the pre-tax amount; only requires a disclosure on effective tax rate changes for publicly traded companies Assessing Credit Risk - CORRECT ANSWER - Moody's uses 5 ratios to assess tolerance to leverage: - debt/EBITDA, FCF/net debt, Retained Cash Flow/debt, Cash/debt, EBIT/Interest Capitalizing vs. Expensing in PPE - CORRECT ANSWER - PPE are long-lived assets that are capitalized on the statement of financial position - all costs that are require to make the asset usable in the business are included in the capitalized cost - long-lived assets that are either constructed or take a long period of time to place into use may incur interest charges on funds borrowed to acquire them - these interest charges are capitalized as part of the cost of the asset Depreciation and Amortization - Long-Lived Assets - CORRECT ANSWER - IFRS: cost model or revaluation model - GAAP: only allows cost model Revaluation Model - fair value of asset is adjusted at each reporting date Cost Model - historical cost does not change, but depreciation is accumulated, net amount is reported on BS Units-of-Production Method - CORRECT ANSWER (output / total capacity) x (cost - residual value) - uses the capacity of the asset to determine the annual depreciation - method is best used for machines that have an estimated useful life based on a unit of activity, such as kilowatt hours, or a number of units Capitalization of Interest Costs - CORRECT ANSWER - interest costs for construction of firm PPE can be capitalized with the real asset, and then will be included with its related depreciation expense over time - interest costs for inventory production can be capitalized by inclusion with inventory, and then included in COGS, which also affects cash flow classification Component Method and Reporting Differences - CORRECT ANSWER - under IFRS, long-lived assets are required to be depreciated using the component method - required under IFRS, allowed under GAAP - means assets that are comprised of different parts would be depreciated on a significant part-by-part basis rather than as a whole Amortization Methods and Calculation of Amortization Expense - CORRECT ANSWER - there are different methods to amortizing cost, but the key components are total cost, useful life, and salvage value - intangible assets have a finite life if there is an end to the period over which they contribute to future cash inflows - the end may be caused by a legal restriction, a contractual date, competitive advantage, and another economic event Revaluation Model - CORRECT ANSWER - IFRS allows, however, does not specify if the expense should be recorded as a loss on revaluation, or as part of depreciation expense - results in fair value being used for the carrying value rather than cost less accumulated depreciation under US GAAP - may not result in an annual depreciation amount and could result in an increase to net earnings, or an increase to OCI, as a result of fair value adjustments - will also DECREASE earnings if the fair value of the long-lived asset decreases upon subsequent revaluation - however, unlike the cost model, it could also increase earnings to the extent of a previous decrease Investment Property - Treatment under IFRS vs. GAAP - CORRECT ANSWER - investment property, defined under IFRS, consists of capital assets that generate cash flows independently from the ordinary assets used in the business - companies may value investment property, and requires the use of the cost model - GAAP does not define investment property, and requires the use of the cost model - investment property could cease to be investment property following certain changes, for instance if a rental building becomes owner occupied, or land becomes part of inventory; then any property accounted for using the fair value model is transferred at its fair value - reverse can also occur, which could give rise to the revaluation surpluses Capitalization of Internal Development Costs - CORRECT ANSWER - deciding feasibility requires judgement, and this can lead to challenges in comparability - adjusting capitalized costs back to expenses increases investing cash flow while decreasing operating cash flow, and will also typically increase P/E and P/CFO ratios Impairment of Assets - CORRECT ANSWER Recoverable Amount - IFRS: fair value less selling costs or value in use, whichever is higher - GAAP: fair value - when an asset's carrying value is GREATER than its value in the market, both IFRS/GAAP require the carrying value to be written down - this impairment may be later reversed under IFRS - aside from depreciation and amortization, long-lived assets may also suffer from impairment due to market forces such as obsolescence and loss of product demand; when this occurs, carrying value of the asset may need to be reduced Impairment of Intangibles and Reversals - CORRECT ANSWER - intangible assets with finite lives are amortized, tested for impairment with significant events, and impairments can be reversed - intangible assets with infinite lives are not amortized, but tested at least annually for impairment, which can be reversed - intangible assets held for sale cease to be depreciated or amortized, tested for impairment, and this implication can only be reversed under IFRS Derecognition, Gains, and Losses - CORRECT ANSWER Derecognition - term used to remove long-lived asset from the financial records - when LT assets no longer provide future economic benefits for the company/ the company will derecognize (remove from the books) the long-term asset by selling, exchanging, or abandoning them - a gain or loss on a sale of long-lived assets is determined by comparing the selling price (proceeds) to the book value (carrying value) - a long-lived asset distributed to owners in a spin-off needs to be removed from the books Presentation and Disclosures - CORRECT ANSWER - for every class of long-lived assets, certain information must be disclosed and presented in the financial statements, and notes under IFRS - GAAP also has required information, but it is is not as extensive - IFRS requires the disclosure of the measurement bases, the depreciation methods, the useful lives used, the gross carrying amount and accumulated depreciation at both the beginning and end of the period, a reconciliation of the carrying amount during the period, any restrictions on titles and pledges as security, contractual agreements to acquire long-lived assets, revaluation model used, date of revaluation, methods of determining fair market value, and revaluation surplus. US GAAP requires depreciation expense for the period, accumulated depreciation and carrying value of classes of depreciable assets, and a description of the depreciation methods used. Adjustments Related to PPE - CORRECT ANSWER - PPE divided by depreciation expense indicates useful life when the assets were purchased - looking at capex and asset disposal predicts growth asset base - capex/(PPE + Capex) gives the percentage of the assets being funded by new capital investment Adjustments Related to Goodwill - CORRECT ANSWER - goodwill is considered an intangible asset and value will be assessed every year for "impairment," or a decline in value; if there is a decline, goodwill will be reduced and a loss in value is written off - decline in value on BS, loss on IS IFRS vs. GAAP Disclosures - Intangible Assets - CORRECT ANSWER Both require enough disclosures about intangible assets to enable an analyst to assess a company's - level of investment - changes in intangible assets - impact on current and future performance IFS requires: any restrictions on the title of the asset, carrying amount GAAP requires: estimated amortization expense for next 5 fiscal years Leasing - Finance vs. Operating Leases - CORRECT ANSWER - lease that must be accounted for as a purchase is called a capital lease (GAAP) and finance lease (IFRS) - when the terms of a lease transfer significant incidents of ownership to the lessee, GAAP and IFRS require that the transaction be accounted for as if it were a purchase on credit - leases that are not classified as capital or finance leases are called operating leases IFRS vs. GAAP - Disclosures of Impairment Losses - CORRECT ANSWER - impairment losses occur when the fair value of an asset is lower than its carrying value - under IFRS and GAAP, disclosures are required concerning the cause of the impairment, the amount of loss, and where the loss is reported in the financial statements - with IFRS- since it allows for reversals of impairment losses - additional disclosures are required - GAAP does NOT permit reversals, requires to disclose how fair value was determined Accounting by the Lessee - CORRECT ANSWER - lessee records each lease payment under an operating lease as an expense incurred and as a cash flow out from operating activities - a less initially records a finance lease by capitalizing the leased asset and recording an equal lease liability - each lease payment is a combination of interest expense and a reduction of the lease liability - interest paid is a cash flow from operating activities, and the remainder of each lease payments is a cash flow from financing activities Accounting by the Lessor - CORRECT ANSWER - under an operating lease, the lessor retains the asset on the balance sheet, depreciates the asset, and recognizes the lease payment as rent revenue and a cash flow from operating activities - under a finance lease, the lessor derecognizes the asset, recognizes any profit on leasing under a sales-type lease, and records a lease liability at the lease inception High-Quality Financial Reports and Earnings - CORRECT ANSWER Highest level of the quality spectrum includes reports that: - include sustainable high-quality earnings - are useful for decisions - provide for adequate returns High-Quality Reporting - Useful Information but Not Sustainable - CORRECT ANSWER - second level of the quality spectrum includes reports that conform to GAAP and are useful for decisions, but may indicate that earnings are of a lower quality because they are: not sustainable in the future, unable to provide an adequate return on investment - difference between the highest level on the quality spectrum and the second level is related to the quality of earnings Biased Accounting Choices - CORRECT ANSWER - further down the quality spectrum of financial reporting are reports that are in conformance with GAAP but contain biased accounting choices - choosing methods that result in reports that do not accurately portray the company's economic position are biased choices - presenting information in a way that disguises poor performance or negative information is an aggressive and biased practice along with highlighting favorable information in an attempt to minimize negative information Context for Assessing Financial Reporting Quality - CORRECT ANSWER - important to consider motivations for issuing poor-quality reports, including hiding poor performance, meeting analysts' expectations or benchmarks, or fulfilling compensation arrangements - also important to look for conditions conducive to low-quality reports and mechanisms that discipline financial reporting Earnings Smoothin - CORRECT ANSWER - management method that uses biased accouting choices to increase/decrease expenses and revenues in an attempt to report less fluctuation in income from year to year May smooth earnings by: - using aggressive choices when the company is having financial difficulty - using conservative choices when the company is exceeding performance expectations Conservatism in Accounting Standards - CORRECT ANSWER - although it is often assumed that bias is only upward, conservative accounting policies may result in bias in the reports - conservatism results in expenses requiring less verification for recognition than revenues - several benefits: protection for contracting parties, reduced potential litigation, and protecting interests of regulators and politicians Reconciliation between GAAP and non-GAAP Earnings - CORRECT ANSWER - companies may include non-GAAP financial information such as pro forma earnings or other presentations using non-GAAP measures, but cannot place emphasis on the non-GAAP information - this non-GAAP measures must be disclosed and reconciled to GAAP for reporting purposes - the reconciliation shows important information as to what was included or excluded from the non-GAAP measurements Departures from GAAP - CORRECT ANSWER - near the bottom of the quality spectrum are financial reports that contain departures from GAAP - these financial reports are of low quality and do not provide adequate information to assess the quality of earnings there are 2 levels of reports that contain departures from GAAP - those that report actual information not in conformity with GAAP, those t hat include fictitious transactions or fraudulent information IFRS vs. GAAP - Conservatism - CORRECT ANSWER - both IFRS and GAAP have similar standards that require a conservative approach on some transactions, including: research costs, litigation costs, insurance recoverable, commodity inventories - for some transactions, such as the impairment of long-lived assets, the standards are different between IFRS and GAAP Private Contracting - CORRECT ANSWER - third parties who contract with companies also have a vested interest in whether the financial statements are of high quality - these contracts may include specific requirements that are legally binding on the company and that may promote high-quality reports to avoid contract violations - contracts may also result in manipulation of earnings in an effort to avoid violation of contract requirements Bias in the Application of Accounting Standards - CORRECT ANSWER - regardless of whether an accounting standard is biased or note, judgment is required in the application of standards that may result in bias - determining whether an aggressive or conservative approach has been used is based on the motivations for the use of a certain approach Cookie Jar Reserve Accounting - CORRECT ANSWER - GAAP requires that companies make estimates for expected future expenses - these estimates can be manipulated to result in "cookie jar" reserves, another method of using conservatism that will result in biased reports - overestimating expenses in the current period allows for reduction of expenses in a future period *goal is to smooth income over time Big Bath Accounting - CORRECT ANSWER - a method of applying conservatism that results in biased reports - companies may have the ability to report legitimate losses for restructuring, impairment or disposals of operations, but when the estimates used to record these losses are inflated substantially to avoid surprises later, it is considered big bath accounting Detection of Financial Reporting Quality Issues - CORRECT ANSWER - with many choices available in applying accounting standards, detection of low-quality financial reporting requires an understanding of the following: presentation choice, accounting choices and estimates, warning signs of low-quality reporting Critical Accounting Estimates - CORRECT ANSWER - due to the manipulation of financial statements using methods such as big bath accounting and cookie jar reserves, the SEC requires companies to present a section in the management's discussion and analysis for critical accounting estimates - this section is required to explain the estimates and the uncertainty surrounding them Accounting Choices and Estimates - CORRECT ANSWER - within GAAP, there are many principles that allow for choices between acceptable methods - the choice of method may impact the amounts reported in financial statements - additionally, GAAP requires that estimates be made in many circumstances - estimates are based on judgments that can inevitably produce different outcomes How Choices Affect the Cash Flow Statement - CORRECT ANSWER - the operating section of the statement of cash flows is most often used by investors to evaluate the earnings quality of businesses - businesses may be motivated to improve the operating section of the cash flow statement through: managing working capital accounts, classifying choices between the operating, investing, and financing sections Choices that Affect Financial Reporting - CORRECT ANSWER - GAAP allows for many choices that can cause various effects on the financial statements and within the financial reports - analysts must be aware of the impact of these choices in order to make assessments regarding the quality of the financial reporting and the earnings quality Related-Party Transactions - CORRECT ANSWER - businesses may conduct transactions with parties that are considered related for financial reporting purposes - the extent these transactions may cause concerns such as: are significant transactions conducted with related parties? do these transactions benefit members of management? Allowances for Doubtful Accounts - CORRECT ANSWER - allowances made for doubtful accounts or loan loss reserves require the use of subjective estimates, presenting an opportunity to adjust estimates to result in favorable reporting - areas of concern include: adjustments that are higher or lower than previous, changes from percentages used historically, circumstances that indicate earnings management Tax Asset Valuation Accounts - CORRECT ANSWER - deferred tax assets result from previous losses that can be used to offset expected future earnings - estimates of future earnings are subjective and may allow for manipulation - areas of concern related to tax asset valuations include: basis for estimates of future revenues, comparison of valuation and management outlook, timing of adjustments to the valuation outlook Effects of Interest Capitalization - CORRECT ANSWER - interest capitalization is an area that allows for many choices of classification - when portions of interest can be capitalized, choosing where to allocate the capitalized portion will impact operating cash flows - further, choices exist when interest expense includes noncash expense which allows for further choices in allocation between sections of the statement of cash flows Presentation Choices - CORRECT ANSWER - when preparing financial statements for presentation, companies have choices as to how to present required information along with choices about additional information the company wishes to present - common presentations may include: non-GAAP measurements in pro forma reports, EBITDA Use of EBITDA - CORRECT ANSWER - measurement that was developed to allow investors to make comparisons between companies on a consistent basis - eliminates the effects of different accounting choices for depreciation, as well as effects from financing choices that create interest epense - companies may create a modified version of EBITDA for use in reporting that excludes additional items Warnings Signs Regarding Choices Management makes to Achieve Desired Results - CORRECT ANSWER - accounting and reporting choices that result in low-quality reporting can be identified by looking for warning signs - warning signs generally fall into 1 of 2 ways that management has manipulated earnings: biased decisions in revenue and expense recognition Depreciation Methods and Useful Lives - CORRECT ANSWER - depreciation methods and estimates of useful lives allow for manipulation of earnings - warning signs: comparison of useful lives with others in the industry; comparison of policies with others in the industry How Accounting Choices and Estimates Affect Earnings and Balance Sheets - CORRECT ANSWER - the choices allowed within US GAAP that impact the income statement also affect accounts on the balance sheet - the differences may come from choosing different acceptable methods within US GAAP - other impacts may relate to the use of estimates based on judgments that are required by US GAAP Capitalization Policies and Deferred Costs - CORRECT ANSWER - capitalization policies can have an impact on earnings reported and may allow for manipulation - concerns that indicate warnings for manipulation include: long-term asset capitalization policies inconsistent with industry practices; capitalization of interest policies inconsistent with industry practices Warranty Reserves - CORRECT ANSWER - reserves for warranty expense are subject to estimates, allowing for manipulation of earnings - areas of concern include: reductions in reserves, actual costs compared to reserves, indications of poor quality Effects of Accounts Payable Management - CORRECT ANSWER - making changes in the accounts payable balance is one way of managing the reported amounts of operating cash flows - increasing AP is a result of expenses or assets purchased without the use of cash, and presents the appearance of higher cash flows from operations Introduction of the Pro Forma Reporting Method - CORRECT ANSWER - businesses used pro forma reporting to exclude charges from business combinations - other pro forma reports resulted from companies not having enough earnings to use traditional measurements - companies started finding creative ways to measure earnings using pro forma reporting in an attempt to justify their stock prices Effects of Acquisitions and Purchase Methods - CORRECT ANSWER - acquisitions result in recording purchased assets at fair value, which is not always easily measured - judgment is required in allocating the purchase price and can result in bias to reduce allocations for certain assets or increase allocations for others - goodwill results from the un-allocated purchase price and creates another area of potential manipulation Restructuring/Impairment Charges - CORRECT ANSWER - restructuring and impairment charges are often reported as a one-time, nonrecurring expense - analysts must carefully evaluate these changes as the events that preceded them may not reflect the real earnings trends - analysts may develop pro forma reports to allocate these changes to prior periods to establish earnings trends Non-Operating Income Included in Revenue - CORRECT ANSWER - analysts should look for warning signs that nonoperating income may be included in revenue - businesses may attempt to boost earnings by: including gains in operating revenue, including revenues from disposed segments or lines in continuing operations Out-of-Line Margins - CORRECT ANSWER - when analyzing financial statements, analysts should compare gross margins and operating margins with competitors' or industry averages - margins that are different may be an indication of superior management ability or the presence of earnings management Intangibles - Capitalization Policies - CORRECT ANSWER - intangible assets are subject to several estimates and valuations that allow the opportunity to impact earnings - areas of concern include: inappropriate capitalization of expenses; capitalization policies for intangibles; reasonableness of amortization policies Effects of Inventory Assumptions - CORRECT ANSWER - GAAP allows for several choices of inventory cost flow assumptions, each having a different impact on the financial statements - the choice of inventory cost flow assumptions will impact amounts reported for COGS and inventory balanced, impacting both the income statement and balance sheet Effects of Capitalization Practices - CORRECT ANSWER - capitalization practices will affect both earnings on the income statement and assets reported on the balance sheet - choosing to capitalize items rather than expense them will result in increased earnings and increased assets - management must make judgments on which items to capitalize or expense, and these judgments provide the potential for manipulation of earnings Related-Party Transactions (Self-Dealing) - CORRECT ANSWER - watch for: significant transactions with related parties, transactions that benefit members of management Fourth Quarter Surprises - CORRECT ANSWER - fourth quarter surprises should indicate a warning to analysts that management may be manipulating earnings 4th quarter surprises may indicate: - management is over-reporting in the fourth quarter to meet earnings expectations - management has over-reported earlier in the year and reports low earnings in the fourth quarter Inventory Signals - CORRECT ANSWER - inventory is an area that allows for manipulation of earnings - comparison with industry benchmarks and evaluation of ratios may provide warning signs, which include: inventories not market down due to obsolescence, the use of inventory valuation to artificially inflate revenues Revenue Recognition - CORRECT ANSWER = areas of concern: channel-stuffing practices, bill-and-hold transactions or multiple-deliverable arrangements, use of rebates Inventory Cost Methods - CORRECT ANSWER - concerns related to inventory valuation methods include: appropriateness for the business/industry, reserves for inventory and changes in reserves, LIFO liquidation Regulation of non-GAAP Measures - CORRECT ANSWER - companies must follow certain regulations when presenting non-GAAP financial information and also may not place emphasis on any non-GAAP measurements SEC disallows: - exclusion of charges or liabilities that require cash settlements from non-GAAP liquidity measurements - use of non-GAAP measurements for items that are labeled nonrecurring, but are likely to occur again Effects of Deferred Tax Assets - CORRECT ANSWER - occur when businesses report losses under tax-accounting rules that can be offset against future earnings - are not expected to be offset with future profits are reduced by valuation allowances - the judgment on whether a tax asset will be recognized allows for potential to overstate the asset - if future earnings are not expected, a valuation allowance is not used Motivation to Increase Operating Cash Flow - CORRECT ANSWER - operating cash flows are used to evaluate the performances of companies - higher operating cash flows may imply higher-quality earnings and will make the investment look more appealing - the use of cash flows as a performance measurement may motivate companies to managing accounts that will impact the reported cash flows Relationship of Cash Flow and Net Income - CORRECT ANSWER - analyzing the relationship of cash flows and net income can identify warning signs of earnings that have been manipulated - analysts can evaluate this relationship by: comparing net income to cash generated by operations, computing a ratio of net income to cash flows Effects of Accrual Accounting - CORRECT ANSWER - accrual accounting allows companies to recognize revenues before the cash is received and to record expenses before cash is paid - the purpose of accrual accounting is to better recognize the actual economic events of business transactions in the period in which they occur but are not necessarily paid, but accrual accounting also presents the potential to manipulate earnings with the use of estimates or other means Revenue Concerns / Manipulation - CORRECT ANSWER [Show More]

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