Financial Statemenet Analysis - Zell Education 2024

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Table of Contents
Introduction to Financial Statement Analysis ................................................................................ 5
Financial Statement Roles ................................................................................................................... 5
Analyzing Income Statements .................................................................................................... 16
Revenue Recognition......................................................................................................................... 16
Expense Recognition ......................................................................................................................... 22
EPS and Dilutive Securities ................................................................................................................ 30
Common-Size Income Statements .................................................................................................... 40
Understanding Balance Sheets ................................................................................................... 43
Balance Sheet Introduction ............................................................................................................... 43
Intangible Assets ............................................................................................................................... 44
Marketable Securities ....................................................................................................................... 46
Shareholders’ Equity and Ratios ....................................................................................................... 52
Analyzing Statements of Cash Flows I ......................................................................................... 59
Cash Flow Introduction ..................................................................................................................... 59
The Direct and Indirect Methods....................................................................................................... 65
Converting Indirect to Direct ............................................................................................................. 74
Analyzing Statements of Cash Flows II ........................................................................................ 78
Inventories ................................................................................................................................ 85
Cost Flow Methods............................................................................................................................ 85
Inventory Valuation........................................................................................................................... 86
Long-Lived Assets....................................................................................................................... 93
Impairment and Revaluation ............................................................................................................ 98
Topics in Long-term Liabilities and Equity ................................................................................. 109
Income Taxes ........................................................................................................................... 118
Tax Terms ........................................................................................................................................ 118
Deferred Tax Liabilities and Assets ................................................................................................. 120
Financial Reporting Quality ...................................................................................................... 131
Reporting Quality ............................................................................................................................ 131
Warning Signs ................................................................................................................................. 143
Financial Analysis Techniques ................................................................................................... 149
Introduction to Financial Ratios ...................................................................................................... 149
Financial Ratios, Part 1 ................................................................................................................... 154
Financial Ratios, Part 2 ................................................................................................................... 158
Dupont Analysis .............................................................................................................................. 168
More Financial Ratios ..................................................................................................................... 172
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Introduction to Financial Statement Modelling ......................................................................... 180

Formula ................................................................................................................................... 186
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Foreword
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With the aforementioned in context, we bring to you these notes, created by us, for you, to
truly help make the difference and turn your journey with us into a memorable one.
Authored by: Dhrumi Doshi, Prabhjyot Taluja, Esha Vora

Illustrated by: Aayush Shah & Rohan Shah
Introduction to Financial Statement Analysis 5
Introduction to Financial Statement Analysis

Exam Focus
• For applicants with no prior experience in financial statements

• Topics covered are nature of the audit report which is the information that is
contained in the footnotes to financial statements, proxy statements, Management’s
Discussion and Analysis, and the supplementary schedules.
• A useful framework enumerating the steps in financial statement analysis is
presented.
Financial Statement Roles
LOS 33a: Describe the steps in the financial statement analysis framework
Analysis of Financial statements is done by investors before investing in a company’s equity
shares as a basis for deciding whether the investment is attractive and to determine what an
appropriate price might be.
Financial Statement Analysis Framework
1) Articulate the purpose and context of the analysis: The first step is to clearly define the
objective of the analysis and the context in which it is performed. This includes understanding
the purpose of the analysis, such as evaluating a company's financial health, profitability, or
solvency.
2) Collect data: In this step, the analyst collects the necessary financial statements and related
disclosures, such as the income statement, balance sheet, and cash flow statement.
Additionally, he may need to obtain other relevant information, such as footnotes and
management's discussion and analysis.
3) Process Data: After collecting the data, the analyst uses appropriate analytical tools or a
combination of tools to process the data. This may include understanding any and all factors
that may affect comparability between companies such as differences in business models,
operating decisions etc.
4) Analyza and Interpret Data: This process entails analysing the financial statements using
various financial ratios and indicators. Profitability ratios (e.g., gross margin, operating
margin), liquidity ratios (e.g., current ratio, quick ratio), leverage ratios (e.g., debt-to-equity
ratio), and activity ratios (e.g., inventory turnover, accounts receivable turnover) are all
calculated. Vertical and horizontal analysis may also be used to find trends and patterns in
financial data.
5) Develop and Communicate Conclusions and Recommendations: The next stage is to
communicate the conclusion or advice in an acceptable format. The suitable format will differ
depending on the analytical job, the institution, or the audience. An equities analyst's report
for external distribution, for example.
The following components are often included: a summary and investment conclusion; an
industry overview and competitive analysis; a financial statement model, perhaps with
numerous scenarios; valuation; and investment risks.
6) Follow-Up: The report is not the end of the process. If an equity investment is made or a
credit rating is provided, projections and recommendations must be revised on a regular basis
based on new information. If an investment is denied, more investigations may be necessary
if the security price or business conditions change. Follow-up may entail repeating all
preceding phases in the procedure on a regular basis.
LOS 33b: Describe the roles of financial reporting and financial statement analysis.
Role of Financial reporting

It is the way companies portray their financial performance to investors, creditors, and other
interested parties.
They report this information by formulating and presenting financial statements.
Role of Financial statement analysis
It uses the information in a company’s financial statements, along with other relevant
information, to make economic decisions.
For e.g.: Decisions with regard to whether to invest in the company’s or recommend them for
bank loans etc. Past performance and current financial situation is analysed to form opinions
about the company’s ability to earn profits and generate cash flow in the future.
Note: Management too performs financial analysis in making everyday decisions. However,
they depend on internal financial information that is maintained in a different format and is
not available to external users.
LOS 33c: Describe the importance of regulatory filings, financial statement notes and
supplementary information, management’s commentary, and audit reports
Financial Regulatories:
Accounting and auditing professional organisations that produce financial reporting
standards are known as standard-setting bodies. Regulatory authorities are government
agencies having the legal jurisdiction to enforce financial reporting requirements compliance.
The Financial Accounting Standards Board (FASB) and the International Accounting
Standards Board (IASB) are the two principal standard-setting organisations. The FASB
establishes Generally Accepted Accounting Principles (GAAP) in the United States. The IASB
develops International Financial Reporting Standards (IFRS) for countries other than the
United States.
There are many more national standard-setting agencies. Some earlier IASB standards are
known as International Accounting Standards (IAS). National governments create regulatory
bodies such as the Securities and Exchange Commission (SEC) in the United States and the
Financial Conduct Authority in the United Kingdom.Explain the objective of audits of financial
statements, types of audit reports, and importance of effective internal controls.
Although, not a regulatoty authority itself, International Organisation of Ssecurities
Commission (IOSCO) regulates more than 95% of the world’s financial markets, its members
collaborate to make national legislation and enforcement more consistent throughout the
world.
Explain SEC and what are its reporting requirements?
The SEC responsibly imposes Sarbanes-Oxley Act of 2002.
The act includes;
• Promotion of independent audit: No external company auditor (to avoid any conflict
of interest) is allowed to provide certain additional paid services to the company.
• Fair presentation: The act requires a company’s executive management to certify that
the financial statements are presented fairly and to also include a statement about the
efficiency of the company’s internal controls of financial reporting.
The SEC required filing includes:

Form S-1.
Registration statement filed before sale of new securities to the public. The registration
statement includes audited financial statements, risk assessment, underwriter identification,
and the estimated amount and use of the offering proceeds.
Form 10-K.
Required annual filing that consist of information about the business and its management,
audited financial statements and disclosures, and disclosures about legal matters involving
the firm.
Information under this from is similar to annual report to shareholders. However, it is not a
replacement for the required 10-K filing.
In case foreign issuers in the U.S. markets
Similar forms are Form 40-F for Canadian companies and Form 20-F for other foreign issuers.
Form 10-Q.
U.S. companies are needed to file this form every quarter, with updated financial statements
(unlike Form 10-K, these need not be audited) and disclose about few events such as
significant legal proceedings or changes in accounting policy.
Non-U.S. companies are usually needed to file the Form 6-K semi-annually.
Form DEF-14A.
In case of a company that prepares a proxy statement for its shareholders before the annual
meeting or other shareholder vote, it also files the statement with the SEC as Form DEF-14A.
Form 8-K.
Companies must file this form to disclose material events including significant asset
acquisitions and disposals, changes in management or corporate Video covering this content
is available online. governance, or matters related to its accountants, its financial statements,
or the markets in which its securities trade.
Form 11-K requires companies to provide audited financial statements for the past two fiscal
years, an audited statement of income, and changes in plan equity for each of the latest three
fiscal years of the plan.
Form 144.
A company can issue securities to certain qualified buyers without registering the securities
with the SEC but must notify the SEC that it intends to do so.
Form 144 is notice of the proposed sale of restricted securities or securities held by an affiliate
of the issuer.
Forms 3, 4, and 5
These involve the beneficial ownership of securities by a company’s officers and directors.
Analysts could use these filings to learn about purchases and sales of company securities by
corporate insiders.
All economies in the EU are needed to report using IFRS.
The European Commission has also formed the European Securities Commission, which
advises the European Commission on securities regulation issues, and the European Securities
and Market Authority (ESMA), which manages within the EU.
Financial statement notes (footnotes)
These include disclosures that deliver more details with regard to the information
summarized in the financial statements.
Footnotes improves the assessments of the amount, timing, and uncertainty of the estimates.
Footnotes:
1. Discuss the basis of presentation like the fiscal period covered by the statements and
the inclusion of consolidated entities.
2. Provide information with regards to the accounting methods, assumptions, and
estimates used by management.
3. Provide extra information on components such as business acquisitions or disposals,
legal actions, employee benefit plans, contingencies and commitments, significant
customers, sales to related parties, and segments of the firm.
Business and Geogrpahic Segment Reporting
Many corporations are made up of multiple businesses. Although firms are not required to
submit disaggregated full financial statements for all of their businesses or subsidiaries, they
are required to present certain disaggregated information in the notes to financial statements
by operating segment under both IFRS and US GAAP.
An operating segment is defined as a component of a company that
1) engages in activities that may generate revenue and expenses, including a start-up
segment that has yet to earn revenues;
2) whose results are reviewed on a regular basis by the company's senior management;
3) for which discrete financial information is available.
Apart from these qualitative conditions, the company must disclose separate information
about any operating segment that meets any one of the following quantitative conditions:
the segments comprises of 10% or more of the companies

• revenue
• assets
• profits
Management’s commentary [also known as Management’s Discussion and Analysis (MD&A)]

IFRS guidance suggests that management commentary report the nature of the business,
management’s objectives, the company’s past performance, the performance measures
used, and the company’s key relationships, resources, and risks.
Some parts of management’s commentary might be unaudited.

In case of publicly held companies in the USA, the SEC requires that MD&A discuss trends and
identify significant events and uncertainties that affect the company’s liquidity, capital
resources, and results of operations.
MD&A should also disclose:
1. Effects of material inflation and changing prices.
2. Effects of off-balance-sheet obligations and contracts like purchase commitments.
3. Accounting practices that need significant judgment by management.
4. Futuristic expenditures and divestitures.
Auditor’s Report
What do you mean by audit?
Meaning: Audit is the independent review of an institution’s financial statements. It is an

important source of information for analysis.
Objective: Enabling an insight on the fairness and reliability of the financial statements.
Purpose: Public accountants conduct audit and evaluate the company’s financial reports and
supporting records (e.g.: MD&A, footnotes etc).The Board of Directors employs an
independent certified public accounting company that is responsible for supervising, that the
financial statements adhere to the applicable accounting standards. An auditor evaluates the
company’s accounting and internal control systems, verifies the assets and liabilities,
simultaneously checking for no material errors in the financial statements.
What is stated in the standard auditor’s opinion?
The standard auditor’s opinion contains 3 parts, and it states:

1. Despite the financial statements being prepared by management and are its
responsibility, the auditor has performed an independent review.
2. Generally accepted auditing standards were followed, thus providing reasonable
guarantee that the financial statements do not include any material errors.
3. The auditor is satisfied that the statements were prepared in accordance with
accepted accounting principles and that the principles chosen, and estimates made
are reasonable.
Note: An additional explanation must be included in the audit report in case of accounting
methods not being consistent between periods.
What do you understand by an unqualified opinion?
• Unqualified /unmodified /clean opinion indicates that the auditor believes the
statements are free from material omissions and errors.
• In case of any exceptions to the accounting principles, the auditor may publish a
qualified opinion and explain these exceptions in the audit report.
• A qualified opinion is an adverse opinion if the statements are not presented fairly or
are materially not in line with with accounting standards.
• In case of a scope limitation; disclaimer of their opinion is published.
• Any opinion besides unqualified is referred to as a modified opinion.
• In case of a probable loss that cannot be measured reasonably an explanatory
paragraph is included.
• Such disclosures concerning the future of the firm signal serious problems that needs
close examination by the analyst.
What do you understand by Internal control?
• Internal controls are the actions that ensure accurate financial statement
presentation.
• The management is responsible for Internal controls.
• The auditor must issue an opinion on the internal controls system of the company, in
case of publicly traded firms in the USA.
• This opinion may be issued separately or as the 4th element of the standard opinion.
• An audit report must also contain a section called Key Audit Matters (international
reports) or Critical Audit Matters (U.S.), which focusses on the accounting choices that
make the most sense to analysts. This includes accounting choices that need
maximum management judgments and estimates, For e.g.: how significant
transactions during a period were accounted for, or choices the auditor finds
challenging which have a great probability of being misstated.
LOS 33d: Describe implications for financial analysis of alternative financial reporting
systems and the importance of monitoring developments in financial reporting
standards
Most nations outside of the United States have adopted IFRS as the compulsory financial
reporting standard, advancing the objective of global convergence. Nonetheless, major
variations in financial reporting remain in the worldwide capital markets. The distinctions
between IFRS and US GAAP are perhaps the most important, given a considerable proportion
of the world's listed firms utilise one of these two reporting standards.
Differences between IFRS and US GAAP:
IFRS US GAAP
Inventory Valuation FIFO or weighted average FIFO or specific
cost identification methods
Research and Development Can be capitalized under Generally expensed
Costs certain criteria
Reversal for impairment Allowed for certain assets Not allowed
losses
Statement of Cash Flows Interest paid can be Interest paid is classified as
classified as operating or operating
financing
Because IFRS and US GAAP reconciliation disclosures are not required, an analyst evaluating
two firms that use different reporting standards must be aware of areas where accounting
standards have not converged. In many circumstances, a user of financial statements
prepared according to multiple accounting standards lacks sufficient information to make the
exact adjustments necessary for comparability. Instead, an analyst must exercise caution
when interpreting comparative financial measures produced under different accounting
standards, as significant changes in financial reporting standards can have significant
implications for comparing company performance and security valuation.
All these differences are further explained and discussed in the readings.
LOS 33e: Describe information sources that analysts use in financial statement
analysis besides annual and interim financial reports
In addition to annual and interim financial reports, financial analysts use various information
sources to conduct thorough financial statement analysis. These additional sources provide
valuable insights into a company's financial performance, industry dynamics, and market
conditions. Here are some common sources analysts rely on:
1. Press Releases and News Articles: Analysts keep an eye on press releases and news articles
related to the company they are analyzing. These sources provide updates on corporate
actions, strategic initiatives, mergers and acquisitions, product launches, legal issues, and
other significant events that may impact financial performance.
2. SEC Filings: In the United States, analysts refer to filings made with the Securities and
Exchange Commission (SEC), such as Form 10-K, Form 10-Q, and Form 8-K. These filings
provide detailed financial information, including footnotes and management discussion and
analysis (MD&A) sections, which offer insights into the company's operations, risks, and
future prospects.
3. Industry Reports and Market Research: Analysts often rely on industry reports and market
research conducted by research firms, industry associations, and financial institutions. These
reports provide an overview of industry trends, competitive dynamics, market size, growth
rates, and key success factors. They help analysts assess a company's positioning within its
industry and evaluate its performance relative to industry benchmarks.
4. Analyst Reports and Investment Research: Analysts review reports and research
publications from investment banks, brokerage firms, and independent research providers.
These reports often contain financial analysis, forecasts, target prices, and recommendations
for specific stocks. Analysts consider these insights while formulating their own assessments
and investment recommendations.
5. Company Presentations, Conference Calls & Earnings Calls: also known as conference
calls, provide analysts with insights into a company's financial performance, strategic
initiatives, and future outlook. These calls involve company executives discussing financial
results and answering questions from analysts and investors. Earnings calls offer valuable
qualitative information and help analysts gain a deeper understanding of the company's
operations and performance drivers.
6. Corporate Governance Information: Analysts analyze corporate governance-related

information, such as proxy statements, annual reports on Form 10-K, and corporate
governance ratings. This information helps assess the company's board structure, executive
compensation practices, shareholder rights, and adherence to ethical standards.
7. Economic Data and Macro Indicators: Analysts monitor economic data and macro
indicators, such as GDP growth rates, inflation rates, interest rates, and employment figures.
These indicators provide a broader context for analyzing a company's financial statements,
assessing market conditions, and identifying potential risks and opportunities.
1) Which of the following is most likely provided by Footnotes to the financial statement:
A. Effects of inflation and changing prices of materials.

B. Forward looking investments and divestitures.
C. Information about accounting methods and estimates used by the management.
2) The final step of financial statement analysis framework is
A. Analyze and interpret the data.

B. Gather data
C. Update the analysis
3) Which of the following most likely contains the information about elections of
members to a company’s Board of Directors:
A. A 10-Q filing
B. A proxy statement
C. Footnotes to the financial statements
4) Which of the following best describes unqualified opinion
A. The auditor believes the statements are free from material omission and errors.
B. The auditor believes the statements are not presented fairly.
C. The auditor is unable to express an opinion.
5) A company's interim financial reports are most likely to be:
A. Monthly
B. Qualified
C. Unaudited
6) An independent audit report is most likely to provide:
A. Complete confidence in the financial accounts' accuracy.

B. In terms of the financial statements' transparency, a qualified opinion is given.
C. Reasonable confidence in the accuracy of the financial statements.
7) Which of the following will most likely provide information on a company's objectives,
strategy, and key risks:
A. Auditor’s report.
B. Management commentary.
C. Notes to the financial statements.
8) Which of the following statements best expresses why financial statement notes are
required? The notes:
A. Allow for flexibility in the creation of financial statements.

B. Ensure that financial reporting is consistent across all businesses.
C. Provide the necessary information to comprehend the financial statements.
Answer
1. C is correct.
2. C is correct.
3. B is correct. Proxy statements are a good source of information about the election of
board members.
4. A is correct.
5. C is correct. Interim reports are typically provided semiannually or quarterly and present
the four basic financial statements and condensed notes. They are not audited.
Unqualified is a type of audit opinion
6. C is correct. The independent audit report gives reasonable assurance that the financial
statements are fairly presented, implying that the audited financial statements are devoid
of substantial errors, fraud, or illegal acts that have a direct impact on the financial
accounts.
7. B is correct. This is a part of the management comments.
8. C is correct. The notes contain information that is necessary to comprehend the primary
statements' material.
Analyzing Income Statements 16
Analyzing Income Statements

• Components of income statement
• General principles of recognition and accounting
• Operating vs Non-operating elements of the income statement
• Earnings per share – Simple and diluted
• Evaluation of a company – Financial Ratios
• Other Comprehensive Income
• Treatment of non-recurring items
Revenue Recognition
LOS 34a: Describe general principles of revenue recognition, specific revenue
recognition applications, and implications of revenue recognition choices for
financial analysis
Revenue is the top line in an income statement which is the money generated from normal
business operations, calculated as the average sales price times the number of units sold.
Explain general principles for revenue recognition.
In case of:
a. Goods sold for cash & no returns permitted: Revenue is realised directly at the time
of exchange. For e.g.: Ajay sells books to Radha for ₹ 5,000 cash, paid at the time of
transfer.
b. Goods sold on credit: Revenue is recorded at the time of sale, by creating an accounts
receivable a/c on the asset side of the balance sheet. For e.g.: Ajay sells books to
Radha for ₹ 5,000, amount to be paid by Radha in 3 months. Accounts receivable a/c
for the amount due is created on the balance sheet at the time of transfer.
c. Payment received prior to the transfer of goods: Payment is recorded on the liability
side of the balance sheet under unearned revenue, to offset the  in cash (advance
payment) on the asset side. For e.g.: Ajay sells books to Radha for ₹ 5,000. Ajay is
supposed to deliver the books in slots of 2 weeks, Radha has already paid the full
amount in advance. Thus, Ajay creates an unearned revenue a/c on the liability side,
which he deducts each time that he delivers the books.
Accounting Standards for Revenue Recognition

In May 2014, IASB and FASB released converged standards for recognising revenue. This
conversion came into effect from the start of 2018.
These new standards have a principles-based approach to revenue recognition problems. The
core principle similar to the accrual accounting principle states that, a company should realize
revenue when it has transferred a good or service to a customer.
The converged standards identify a 5-step process for recognizing revenue:
1. Identify the contract/s with a customer.
2. Identify the separate or distinct performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
Note: The obligations in a contract if “probable” can be treated differently under US GAAP &
IFRS. Under IFRS, probable means more likely than not, and under US GAAP, it means likely
to occur. As a result of this, economically similar contracts may be treated differently under
IFRS and US GAAP.
What do you understand by performance obligation?
• Promise to deliver a “distinct” good/service.

• A Distinct good/service is one that meets the following criteria:
a. Consumer satisfaction attained either by using the good individually or by
combining it with other resources,
b. Ability to differentiate between the promise of transferring one good, and
separating it from the promise of transferring other goods.
For e.g.:The resale of goods purchased by an entity

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

• Customer has the legal title
• Customer has physical possession
• Customer has significant risk and rewards of ownership
• Customer has accepted the asset
Home Security Equipment, Installation, And Monitoring
LSS has sold its standard package to a homeowner. The contract includes the following
promised goods and services:
a. Home security equipment, including motion sensor lights, door and window
detectors, and a touchscreen control panel
b. Equipment installation
c. Three years of 24/7 security monitoring
However, the contract mentions this LSS package to be a distinct service as:
Firstly, Home security equipment provides satisfaction of ease and automation when
installed.
Secondly, the company allows the equipment installation and monitoring services to be
performed separately by a third party thus, allowing one promise to be separated from the
other promises mentioned.
What do you mean by transaction price?
The sum that a company assumes to receive from a client in exchange of transferring a good
or service to the client. The price is mostly a fixed sum however it can vary. For e.g.: excess
shipping charges for early delivery.
When should a firm recognise revenue?
A firm must realise revenue only when they are certain of not reversing the transaction. For
example, a company realises a liability for a refund obligation (offsetting asset for returned
goods) if the revenue from sale is uncertain.
In case of long-term contracts, revenue is realised based on a company’s advancement
towards completing a performance obligation.
1. Advancement towards completion can be calculated from the input side using % of
completion costs expensed as of the report date.
2. Advancement can also be calculated from the output side, using engineering
milestones or % of the total output carried out to date.
3. Lastly, a prominent change to the standards for accounting for a long-term contract
is that the costs to safeguard the contract and certain other costs must be capitalized.
The effect of capitalizing these expenses is to  stated expenses on the income
statement and  recorded profitability during the contract tenure.
There are a substantial number of disclosures needed under the converged standards. They
include:
• Contracts with customers by category.

• Assets and liabilities related to contracts, including balances and changes.
• Outstanding performance obligations and the transaction prices allocated to them.
• Management judgments used to determine the amount and timing of revenue
recognition, including any changes to those judgments
Illustration (A)
For year 1
A builder decides to build a mall for ₹ 10,00,000.
Total cost of construction is estimated to be ₹ 8,00,000.
Cost in Year 1= ₹ 4,00,000.
Despite the presence of separate identifiable components (e.g.: flooring, roofs etc), the
performance obligation is that of a completed mall and no separate delivery of the
components.
For year 2
In Year2 cost incurred is ₹ 2,00,000
Bonus of ₹ 1,00,000 is added to the revenue (in either year) if the project is completed within
3 years.
Government regulations with regards to the number of floors in the mall, are merciful post
year 1. Calculate the appropriate revenue recognition for Year1 & Year2.
Solution
For Year 1
Cost in Year1 = ₹ 4,00,000
Total Cost = ₹ 8,00,000
 cost incurred in year1 is 50% of the total estimated cost,

This means that the project is advancing towards completion.
Hence, ₹ 5,00,000 (50% of total revenue of ₹ 10,00,000) is recognised as revenue for year 1.
Due to the presence of stringent government regulations the builder is uncertain about the
completion of the project in year 1 and revenue shall only be realised when there is certainty.
Thus, no bonus is recorded for the 1st year.
For Year 2
In Year2, due to the relaxation in government regulations the builder can foresee his project
getting completed in the given time frame.
Thus, the bonus of ₹ 1,00,000 is considered as a part of total revenue.
Cost incurred in Year2= ₹ 2,00,000
% Of total cost incurred until now= (₹ 4,00,000+₹ 2,00,000) ÷ ₹ 8,00,000
% Of total cost incurred until now = 75%
Total Revenue to be recognised until year2 = 75% X ₹ 11,00,000 (₹ 10,00,000 +₹ 1,00,000)
Total Revenue to be recognised until year2 = ₹ 8,25,000
Revenue recognised for Year2= ₹ 8,25,000 − ₹ 5,00,000 (for year1)

Revenue recognised for Year2= ₹ 3,25,000
Illustration (B)
Extending the above example, in year 2 a contract revision requires an installation of lifts in
the mall. The builder believes that this installation shall increase his costs by ₹ 2,00,000 to
₹ 10,00,000 and his total transaction value is increased to ₹ 14,00,000 (bonus included)
instead of
₹ 11,00,000.
Calculate the new revenue for Year2
Solution
% Of Costs up to year2 = (₹ 4,00,000+₹ 2,00,000) ÷ ₹ 10,00,000
% Of Costs up to year2 = 60%
Total Revenue to be recognised until year2 = 60% X ₹ 14,00,000 (new transaction value)
Total Revenue to be recognised until year2 = ₹ 8,40,000
Revenue recognised for Year2= ₹ 8,40,000 − ₹ 5,00,000 (for year1)

Revenue recognised for Year2= ₹ 3,40,000
Illustration
Ravi, a travel agent books first-class non-refundable tickets to Dubai for Maya. The tickets
costed ₹ 50,000 out of which Ravi charged his commission of ₹ 10,000. Calculate the revenue
that needs to be recognised for Ravi.
Solution
Since Ravi bears no risk and is simply the agent in the transaction, he must recognise revenue
equivalent to his commission of ₹ 10,000.
1) Which of the following is least likely a criteria for distinct good:
A. The customer can benefit from the product or service on its own or in
combination with other readily available resources.
B. The promise to deliver the good or service is indistinguishable from all other
commitments.
C. The promise to transfer the good or service can be identified separately from any
other promises.
2) The final step in the revenue recognition process is to:
A. Determine the transaction price.

B. Identify the contract with the customer.
C. Recognize revenue when the entity satisfies a performance obligation.
3) Are depreciation and interest expenses included or omitted from operating expenses
in the income statement for non-financial firms?
A. Both are included.

B. Depreciation expenses are excluded whereas interest expenses are included.
C. Depreciation expenses are included whereas interest expenses are excluded.
Anwsers
1. B is correct.
2. C is correct.
3. C is correct. Because interest is a finance cost, it is not included in operating

expenditures.
Expense Recognition
LOS 34b: Describe general principles of expense recognition, specific expense
recognition applications, implications of expense recognition choices for financial
analysis and contrast costs that are capitalized versus those that are expensed in the
period in which they are incurred
What do you understand by expense recognition?

Net income = Revenue – Expenses
Expenses  the economic benefits in the form of outflows, deterioration of assets and
occurrence of liabilities (that deplete the equity value).
Under the cash method of accounting the problem of revenue recognition & expense
recognition is resolved. Revenue is recognised when cash is received and expense is
recognised when cash is paid.
However, under accrual accounting, the matching principal states that expenses incurred to
generate revenue are recognised in the same period as the revenue.
Which are the different methods of Inventory Expense Recognition?
Special Identification First In First Out Last In First Out (LIFO) Weighted Average
(FIFO)
Goods bought first Popular in USA for its Easy to use method.
are sold first. tax benefits.
Companies that are Per unit cost =
capable of identifying COGS is calculated Goods bought last are COGS available ÷ total
between what using the earliest sold first. number of units
product is sold and goods price.
what is left in the COGS is calculated Average cost is used
inventory. Ending Inventory is using the current for calculating both
valued at the recent price. COGS and ending
(current) price. inventory.
Ending Inventory is
valued at the earliest Ending inventory
price.It is not values lie between
permitted under IFRS LIFO & FIFO.
Period costs are expenditures that are indirectly related to the manufacturing process. These
expenditures are expensed as incurred. Expenses like administrative, information technolofgy
(IT), Reasearch and Development (R&D) are a few examples of period costs.
Product costs are total costs involved in making a product and getting it ready for sale.
Expenses like product costs, manufacturing costs, cost of raw materials etc are examples of
product costs and these costs are capitalised i.e., added to the cost of asset.
Capitalizing and Expenses
Capitalizing like mentioned before, is adding costs like manufacturing, production and cost of
raw materials to the cost of the asset on the balance sheet. After this initial recognition, a
company expenses the capotalized amount over the asset’s useful life as depreciation or
amortization.
Expensed as incurred is when expenses are recognized on the income statement. These
expenses are not added to the cost of the asset.
Effect of capitalizing or expensed as incurred expenses
When expenditures are capitalized as assets on balance sheet, the typically appear as
investing cash outflow on the statement of cashflows. As they are they are then expensed
through depreciation or amprtisation, which are non-cash expenses and therefore apart from
their on taxable income and taxes payable, they have no impact on the cash flow statement.
When expenses are capitalised in the initial year, this results in a higher shareholder’s equity
as higher income will result in a higher retained earnings. It also increases the the reported
cash flow of operations. Explain depreciation recognition under the different methods of
depreciation.
Long-lived assets generally provide economic benefits for a long period of time. Thus, the
cost of an asset is allocated over its economic life. This is known as depreciation (tangible
assets), depletion (natural resources), or amortization (intangible assets).
The methods for depreciation include:
Straight-Line Depreciation (Sld) Accelerated Depreciation Method

Most preferred method. Assets that provide more benefit in their early life
Equal amount of depreciation Speedy & systematic recognition of expense in the
expense is recorded every year in early years of an asset
the income statement
 depreciation expense in the early  depreciation expense in the later years
years
 net income in early years  net income in later years
SLD = Cost – Residual Value ÷ Useful Declining balance method (DB), is a form of
Life accelerated depreciation.
It applies a constant rate of depreciation to the
assets book value
Total amount of depreciation is DB does not use the asset’s residual value in the
same for SLD & Accelerated calculations; however, depreciation stops once the
depreciation. projected residual value has been reached.
For e.g.: For e.g.: Double Declining Balance Method (DDM)

An equipment purchased for ₹ DDB depreciation = 2/useful life x (cost –
10,000 has a life of 10 years. accumulated depreciation)
Calculate the depreciation expense In case of:
under SLD. An equipment purchased for ₹ 10,000 has a life of 10
years. Calculate the depreciation expense under
SLD= Cost – Residual Value ÷ Useful DDB.
Life DDB = 2/10 x (₹ 10,000-0)
SLD= ₹ 10,000 – 0 ÷ 10 DDB= ₹ 2,000 for this year.
SLD= ₹ 1,000 every year.
What do you understand by amortization expense recognition?

Amortization Expense Recognition
• Allocation of cost over the useful life of an intangible asset (e.g.: copyrights, patents
etc)
• Straight line amortization which is similar to SLD is the preferred method of
depreciation
• Indefinite life assets like goodwill are not amortized but are tested for impairment
annually.
• If impaired, the loss is reported on the income statement
Why are bad debt expense and warranty expense recognised?
Bad Debt Expense and Warranty Expense Recognition
• If goods/services are sold on credit or a warranty is offered the company needs to

recognise a bad debt expense/warranty expense under the matching principal.
• Thus, recognising the expense in the period of sale rather than postponing it.
What are the implications for financial statements?
• Similar to revenue delayed expenses  net income in the current period, this is known
as aggressive accounting.
•  in the bad debt expense needs proper analysis. Whether the company reduced it
from the recovery of payments or reduced it to manipulate the public.
• Comparative analysis needs to be performed by the investors for the company & its
peers.
• Accounting policies and several other important decisions are clarified in the
footnotes and MD&A section of the statement.
LOS 34c: Describe the financial reporting treatment and analysis of non-recurring
items (including discontinued operations, unusual or infrequent items) and changes
in accounting policies.
• Under IFRS, a company should present additional line items, heading and subtotals
beyond those specified when such presentation is relevant to an understanding of the
entity’s financial performance. Some items from prior years clearly are not expected
to continue in future periods and are separately disclosed on a complanies income
statement. Under US GAAP, unusual and/ or infrequently occurring items, which are
marerial, are presented separately within income from continuing operations.
• Non-operating items are reported separately from operating items on the income
statement. Under both IFRS and US GAAP, the income statament reports separately
the effect of the disposal of a component operation as a “discountinued” operation.
• A discontinued operation is one that management has decided to let go of or has plans
of letting it go.
• The measurement date is the day a plan of letting go an operation is developed.
• The period between the measurement period and the actual disposal date is referred
to as the phaseout period.
• Any income or loss from discontinued operations is reported separately on the income
statement, net of tax, after income from continuing operations.
• Past income statements need to be restated
• Analytical implications: exclude discontinued operations income/loss in case of
estimations of future earnings.
Unusual or infrequent items.
• Events are either unusual or occur infrequently.

• For e.g.: profit/loss from the sale of assets, Impairments, write-offs, write-downs, and
restructuring costs.
• They are not a part of normal course of business.
• These items are included in income from continuing operations and are reported
before tax.
• Analytical implications: it is important to truly check its inclusion as few companies
have these “unusual or infrequent” losses every year or every few years.
Changes in Accounting Policies and Estimates
• Accounting changes include changes in accounting policies, changes in accounting

estimates, and prior-period adjustments. For e.g.: Change in inventory valuation
method from LIFO to FIFO.
• Changes can be made to the past/future statements.
• Changes in the past statements (retrospectively) improves the comparability of the
financial statements over time.
• In case of future application of a change (prospectively), past statements are not
restated, and the new policies are applied only to future financial statements.
• Analytical implications: generally, these changes do not affect the cash flow.
• Sometimes a change from an incorrect accounting method from one that is permitted
under GAAP or IFRS is needed.
• A rectification of an accounting error made in past statements is reported as a prior-
period adjustment. Prior-period results are restated.
• Disclosure of the nature of any important prior-period adjustment and its effect on
net income is also required.
• Analytical implications: No effect on the cash flow. Analysts must review adjustments
because errors may indicate weaknesses internally in a company.
1) If the warranty expense in proportion to sales of two identical companies is significantly

different, which of the following approaches is most likely to be used during the analysis?
A. Adjust the financials to decrease the warranty expense to a lower level.

B. Adjust the financials to increase the warranty expense to a higher level.
C. Review the trend of warranty claims received by the two companies and assess the need
for adjustments.
2) Which of the following is the most likely example of nature-based expenses?
A. Cost of goods sold

B. Depreciation.
C. Expenses
3) pCloud is a cloud data storage company that recently acquired a $2 million patent. Which of
the following methods is the best for allocating the patent's cost?
A. Double-declining balance method.

B. Straight-line amortization.
C. Straight-line depreciation
4) Entity A uses the straight-line method of depreciation, whereas entity Z uses the double-
declining method. Over the useful life of an asset, which entity will have the largest overall
depreciation expense?
A. Entity A will have a higher total depreciation expense.

B. Entity Z will have a higher total depreciation expense.
C. Both the entities will have the same total depreciation expense
5) At the beginning of 2019, a tyre manufacturing company paid $500,000 for a tyre-making
machine. The machines' salvage worth is $50,000 and has a 5-year functional life. The
depreciation figure for 2020, calculated using the straight-line technique, is closest to:
A. $90,000
B. $410,000
C. $450,000
6) A cement manufacturing company acquired a cement-making machine at the beginning of

2020 at $700,000. The machine has a residual value of $75,000 and a useful life of 5 years.
Using the double-declining method, the depreciation for 2021 is closest to:
A. 72,000.
B. 168,000.
C. 200,000
7) Which combination of depreciation methods and usable lifespan is the most conservative in
the year a depreciable item is acquired?
A. Balance depreciation is decreasing with an extended useful life

B. Declining balance depreciation with a short useful life
C. Depreciation on a straight line with a short useful life
8) Which inventory method is least likely to be used under IFRS?
A. First in, first out

B. Last in, first out
C. Weighted average
9) During 2010, Hamleys Plc., which began business in October of that year, purchased 10,000
units of a toy at a cost of £10 per unit in October. The toy sold well in October. In anticipation
of heavy December sales, Hamleys purchased 5,000 additional units in November at a cost of
£11 per unit. Hamleys sold 12,000 units at a cost of £15 a unit in 2010. What is Hamely's cost
of goods sold for 2010 using the first in, first out (FIFO) method?
A. £120,000
B. £122, 000
C. £124,000
Answers
1. C is correct. Two identical companies may have different warranty expenses due to a
substantial difference in warranty claims due to different product quality
2. B is correct. The grouping of depreciation on manufacturing equipment, depreciation on

administrative equipment, etc. into a single line item of depreciation is an example of grouping
by nature of expenses.
3. B is correct. The amortization method is used to allocate the cost of long-lived intangible
assets such as patents.
4. C is correct. The total depreciation expense will be the same under the straight-line method
and the double declining balance depreciation method. Only the depreciation schedule will
be different.
5. A is correct. Under the straight-line method of depreciation-
Historical cost of the asset − Estimated residual value

Estimated useful life
500, 000 − 50, 000

= 90000
5
6. B is correct. Under the double-declining method,
1
2 × × Beginning Value
Estimated Residual Life
1
For year 1, 2020: Depreciation= 2 × 5 × 700000 = 280000
Beginning Value in Year 2 = Historical Cost of the Asset - Depreciation Expenses in Year 1
1
For year 2, 2021: Depreciation = 2 × 5 × (700000 − 280000) = 168000
7. B is correct. In comparison to the other options, this would result in the highest amount of
depreciation in the first year and thus the lowest amount of net income.
8. B is correct. The last in, first out (LIFO) method is not permitted under IFRS
9. B is correct.Under the first in, first out (FIFO) method, the first 10,000 units sold came from
the October purchases at £10, and the next 2,000 units sold came from the November
purchases at £11.
EPS and Dilutive Securities

LOS 34d: Describe how earnings per share is calculated and calculate and interpret a
company’s basic and diluted earnings per share for companies with simple and
complex capital structures including those with antidilutive securities
Earnings Per Share (EPS)

A frequently used measurement of profitability, for publicly traded companies. Private
companies are not required to state their EPS. EPS is stated only for the common stock
/common shares, there is no EPS reported for components like preferred shares, authorised
stock capital.
A company’s capital is composed of equity and debt. In equity, some shares may have
preference over others, and some debt may be converted to equity.
Ordinary shares are those equity shares that are subordinate to all other types of equity
shares. These shareholders get the residual income of the company in the form if dividends.
Because different types and tranches of shares exist, a company may have either a simple or
complex capital structure
Simple Capital Structure Complex Capital Structure

NO potentially dilutive securities are Potentially dilutive securities are included in
included in the capital structure. the capital structure.
It includes only common stock, It includes warrants, convertible debt,
nonconvertible debt, and nonconvertible convertible preferred stock etc.
preferred stock.
Only Basic EPS is required to be reported as Basic & Dilutive EPS is required to be
for a company having simple capital reported
structure, Basic EPS = Diluted EPS.
Differentiate between basic and dilutive EPS?
Basic EPS Dilutive EPS

Effects of dilutive securities are not Effects of convertible debt, convertible
considered. preferred stock, warrants etc, under:
a. Dilutive securities:
When securities lead to a  in EPS, if
implemented or converted to common shares.
b. Anti-dilutive securities
When securities lead to an  in EPS, if
implemented or converted to common shares.
Basic EPS = Diluted EPS =

Adjusted income available for common
shareholders ÷
Net income – preference dividend ÷ weighted average number of potential + new

weighted average number of common common shares that would have been issued
shares outstanding at conversion
Preference dividend for the current year For numerator,

is deducted from the NI, since, EPS is Adjusted income includes:
earning per common share. net income – preferred dividends (similar to
basic EPS)
Dividend on common shares is not + dividends on convertible preferred shares
deducted because it is income (earning) + after-tax interest on convertible debt
for common shareholders
Dividends on convertible preference shares (if

dilutive) is added back because, post the
conversion of preference shares to common
stock the excess promised preference dividend
is now available to the common shareholders.
Dividends on convertible preference shares (if
dilutive)  the EPS
Similarly, after-tax interest on convertible debt

is added back because post the conversion of
debt to common stock there is no requirement
for the interest expense, hence the saved
interest expense of
Interest (1 – Tax Rate) is now available for the
common shareholders.
The savings are after tax because when the
conversion takes place the companies lose their
tax benefit on interest expense for debt.
The weighted average number of For denominator,
common shares = total number of The basic EPS denominator
common shares outstanding during that + the number of common shares that would be
year, weighted by the portion of the year created if the conversion of all outstanding
they were outstanding. dilutive securities would take place.
Dilutive securities include: convertible bonds,

convertible preferred shares, warrants, and
options
For a given year, if a dilutive security was

created, the increase in the weighted average
number of shares for diluted EPS is based only
on the portion of the year the dilutive security
was outstanding.
Dilutive stock options or warrants increase the

total number of outstanding common shares in
the denominator for diluted EPS.
No adjustment is required for the numerator.
Effects of stock dividend Thus, Dilutive EPS =

For a stock dividend the investor is
distributed additional shares in Net income – preference dividend
proportion to his current share + convertible preference dividend
investment. + convertible debt interest (1 – tax)
,
For e.g.: a stock dividend of 20% means weighted average common shares
that an investor with 10 shares shall + shares from conversion of conv. preference
receive 2 addition shares as dividend. shares
+ shares from conversion of conv. Debt
Thus, there is an  in the number of + shares issuable from stock options
shares owned by the investor.
Effects of stock split

For a stock split every “old” share is
divided into the “new” mentioned
number of shares.
For e.g.: a stock split of 5:1 it states that,

for every 1 share the investor now gets 5
shares.
Thus, there is an  in the number of

shares owned by the investor.
In case of either a stock split or a stock Each dilutive security is considered individually
dividend the proportionate ownership to determine if it is dilutive and if it, ’s the EPS.
of the investor remains unchanged in
the company.
The number of shares owned , but the
percentage ownership is constant.
What are the points to remember while calculating weighted average shares outstanding?
a. The weighting system = days outstanding / the number of days in a year, however,
for simplicity, the monthly estimation method is used.
b. Shares issued are considered into the computation since the date of its issuance.
c. Reacquired shares are not considered in the calculation since the date of
reacquisition.
d. Shares sold/issued in case of purchase of assets, are considered since the date of its
issuance.
e. A, stock split or stock dividend, is applied to all shares outstanding retrospectively
and to the beginning-of-period weighted average shares.
No prospective adjustment is needed in case of a stock split or stock dividend.
Illustration
ITC ltd has 1,00,000 shares outstanding as of 1st January,2019.
On 31st March 2019, ITC issues 50,000 new shares.
On 1st June 2019, ITC allocates a 20% stock dividend.
On 1st September 2019, ITC buys back 36,000 shares.
Further, the financial readings for ITC for 2019, included:
Net income = ₹ 10,00,000,
Dividend paid (preferred shareholders) = ₹ 1,00,000
Dividend paid (common shareholders) = ₹ 2,00,000
Calculate:
1. ITC’s weighted average number of shares outstanding for the year
2. basic earnings per share.
Assume the financial year to be January - December
Solution
For weighted average number of shares outstanding for the year
Since a stock dividend of 20% was announced in June, changes need to be made
retrospectively and not prospectively.
Date Calculations No of Shares (Nos)

January 1, NOS = 1,00,000 x 1.2 (stock dividend) x 12/12 (portion 1,20,000
2019 of the year)
March 1, NOS = 50,000 X 1.2 X 9/12 45,000
2019
September NOS = − 36,000 x 4/12 (12,000)
1, 2019
(buyback)
Total weighted average number of shares 1,53,000
outstanding for the year
For basic earnings per share

EPS = Net income – preference dividend ÷ weighted average number of common shares
outstanding
EPS = ₹ 10,00,000 - ₹ 1,00,000 ÷ 1,53,000 = ₹ 5.90
Illustration
Case 1
During 2020, Microsoft ltd recorded a net income of $4,000,000 and had 1,000,000 common
shares outstanding for the whole year.
Microsoft’s 10%, $2,000,000 par value preferred shares are convertible into common shares
at a conversion rate of 1:2, where par value = $100.
Calculate:
1. Basic EPS
2. Diluted EPS
Case 2
In 2019, Microsoft has issued 5,000, $1,000 par, 10% bonds for $5,000,000 (issued at par).
Every bond is convertible to 100 common shares.
The tax rate is 10%.
Calculate:
Diluted EPS for 2020
Solution
Case 1
For basic EPS
EPS = Net income – preference dividend ÷ weighted average number of common shares
outstanding
EPS = $4,000,000 – [10% ($2,000,000)] ÷ 1,000,000
EPS = $3.8
For diluted EPS
increase in number of shares = [($2,000,000 ÷ 100) x 1.2]
 in NOS = 24,000
Diluted EPS = Net income −preference dividend +convertible pref. dividend ÷ Weighted
average common shares + convertible preference shares
Diluted EPS = $4,000,000 - [10% ($2,000,000)] + [10% ($2,000,000)] ÷ 1,000,000 + 24,000
Diluted EPS = $3.91
Since, Diluted EPS ($3.91) > Basic EPS ($3.8), convertible preference shares must not be
included in the calculation and is known as antidilutive.
An easier way to check whether the security is dilutive or not = preference dividend ÷ new
shares that will be created in case of conversion
= 10% ($2,000,000) ÷ 24,000
= 8.33, which is > basic EPS, hence it should not be included in calculating dilutive EPS.
Case 2
For Diluted EPS
NOS for converted debt = 5000 x 100 = 50,000 shares
The increase in Income due to conversion = [($5,000,000 x 10%) (1-10%)] = $450,000
Diluted EPS = Net income − preference dividend +convertible interest (1-T) ÷ Weighted
average common shares + convertible debt shares
Diluted EPS = $4,000,000 - [10% ($2,000,000)] +$450,000 ÷ 1,000,000 + 50,000
Diluted EPS = $4.04
Since, Diluted EPS ($4.04) > Basic EPS ($3.8), convertible debt must not be included in the
calculation and is known as antidilutive.
An easier way to check whether the security is dilutive or not = convertible interest (1-T) ÷ 
in new shares, that will be created in case of conversion
= [($5,000,000 x 10%) (1-10%)] ÷ 50,000
= 9, which is > basic EPS, hence it should not be included in calculating dilutive EPS.
Diluted EPS and Basic EPS for Larsen & Toubro Limited from financial year 2018 to 2020
YEAR DILUTED EPS BASIC EPS

2018 ₹ 38.37 ₹ 38.46
2019 ₹ 53.34 ₹ 53.43
2020 ₹ 47.53 ₹ 47.59
As seen above for the year 2018, Basic EPS > Diluted EPS, hence the securities included are
dilutive.
However, for the year 2019 & 2020 Basic EPS < Diluted EPS, hence certain securities included
in the dilutive EPS are antidilutive. Thus, they must be excluded.
The earnings have  , since 2018-2020.

Explain the treasury stock method.
In case of Stock options and warrants, they are dilutive only when:
Exercise prices < the average market price.
Thus, investors need to use the treasury stock method If the options/warrants are dilutive; to
calculate the number of shares in the denominator.
Assumption:
Funds received by the company from the exercise of the options would be used to
hypothetically re purchase the common shares of the company at the average market price.
Therefore, the net increase in the NOS outstanding =
The NOS created by exercising the options - the NOS hypothetically repurchased
Illustration
In 2020, Reliance Ltd recorded income available to common shareholders as ₹ 10,00,000
NOS (common) outstanding = 100,000 shares for the whole year.
Reliance ltd has 10,000 stock options outstanding for the whole year.
Every option allows the holder to buy one share of common stock at ₹ 20 per share.
The average market price of the stock in 2020 is ₹ 25 per share.
Calculate the diluted EPS
Solution
The total number of common shares created if the stock option is exercised = 10,000 shares
Cash Inflow in case of options being exercised = ₹ 20 x 10,000 = ₹2,00,000
Hypothetical buyback = ₹2,00,000 / ₹ 25 = 8,000 shares
 net increase in the NOS = 10,000 shares − 8,000 shares = 2,000 shares
Diluted EPS = Net Income ÷ Average NOS + New shares if option exercise
Diluted EPS = ₹ 10,00,000 ÷ 100,000 + 2,000
Diluted EPS = ₹ 9.80
An easier way to check whether the net increase in the shares, in case of an option being
exercised =
[Average Market Price – Exercise Price ÷ Average Market Price] x NOS that warrants/stock
options
 Increase in the NOS = [₹ 25 – ₹ 20 ÷ ₹25] x 10,000 = 2000 shares

Use the following information to answer questions 1 & 2 –

Angel Products made a net income of $2,500,000 for the year ended December 31, 2018.
The corporation declared and paid $200,000 in preferred stock dividends. The following
information was also available for the company's common stock shares:
Diluted EPS: The If-Converted Method
Shares outstanding on 1 January 2018 = 1,000,000
Shares issued on 1 April 2018 = 200,000
Shares repurchased (treasury shares) on 1 October 2018 = (100,000)
Shares outstanding on 31 December 2018 = 1,100,000
1) What is the company's weighted average number of shares outstanding?
A. 600,000
B. 850,000
C. 1,125,000
2) What is the company's basic EPS?
A. $1.125
B. $2.04
C. $4.06
3) Loreal reported the following financial data for year-end 31 December Common
shares outstanding, 1 January 2,020,000 Common shares issued as stock dividend. 1
June 380,000 Warrants outstanding, 1 January 500,000 Net income $3,350,000
Preferred stock dividends paid $430,000 Common stock dividends paid $240,000
which statement about the calculation of Loreal’s EPS is most accurate?
A. Loreal's basic EPS is $1.12.

B. Loreal's diluted EPS is equal to or less than its basic EPS.
C. The weighted average number of shares outstanding is 2.210,000.
4) The net income of Shopify for the year ended December 31, 2018 was $1,950,000.
When the company filed for bankruptcy, it had 1,700,000 shares of common stock
outstanding, no preferred stock, and no convertible financial instruments. What is
Shopify's basic EPS?
A. $0.89
B. $1.15
C. $2.25
Answers
1. C is correct. The weighted average number of shares outstanding is determined by the
length of time each quantity of shares was outstanding: 1,000,000 < (3 months/12
months) = 250,000. 1,200,000 x (6 months/12 months) = 600,000. 1,100,000 x (3
months/12 months) 275,000. Weighted average number of shares outstanding 1,125,000
2. B is correct. - Basic EPS (Net income - Preferred dividends)/weighted average number of

2500000−2000000
shares = = 2.04
1125000
3. B is correct. Loreal has warrants in its capital structure; if the exercise price is less than
the weighted average market price during the year, the effect of their conversion is to
increase the weighted average number of common shares outstanding, causing diluted
EPS to be lower than basic EPS. If the exercise price is equal to the weighted average
market price, the number of shares issued equals the number of shares repurchased.
Therefore, the weighted average number of common shares outstanding is not affected
and diluted EPS equals basic EPS. If the exercise price is greater than the weighted average
market price, the effect of their conversion is anti-dilutive. As such, they are not included
in the calculation of basic EPS. Loreal's basic EPS is $1.22 [= ($3,350,000 -
$430,000)/2,400,000). Stock dividends are treated as having been issued retroactively to
the beginning of the period
4. B is correct. Shopify's basic EPS is $1.15 = $1,950,000/1,700,000 shares

Common-Size Income Statements

LOS 34e: Evaluate a company’s financial performance using common-size income
statements and financial ratios based on the income statement
In case of a vertical common-size income statement, every category of the income statement
is portrayed as a % of revenue. On the other hand, under the common-size format the
income statement is regulates by terminating the effects of size. This enables the comparison
of income statement components over time under time-series analysis and amongst firms
through cross-sectional analysis.
For e.g.:
Business 1 % Business 2 %
Revenue 48,077 100% 108,249 1005
Cost of sales 37,288 77.6% 64,431 59.5%
Gross margin 10,789 22.4% 43,818 40.5%
Research & development 1,909 4% 1,402 1.3%
Sales & marketing 6,216 12.9% 6,345 5.9%
General & administrative 658 1.4% 954 0.9%
Operating expense 8,783 18.3% 8,701 8.0%
Depreciation 1,000 2.1% 1,327 1.2%
Operating income 1,006 2.1% 33,790 31.2%
Finance cost 72 0.1% -415 -0.4%
Income before tac 934 1.9% 34,205 31.6%
Income expense 291 0.6% 8,283 7.7%
Net income 643 1.3% 25,922 23.9%
As seen above in case of Business 1 & Business 2,

The profitability margins, under both absolute values for the income statement and the
comparative values under the common size statement clearly indicate that
Business 2 > Business 1.
Further, common-size analysis can also be utilised to identify a company’s strategy. Business
2’s higher gross profit margin could be a result of technologically advanced products. Also as
seen above the research cost for Business 1 > Business 2, allowing Business 1 to levy a higher
price for its products.
Exception for common size statement is income tax expense. Tax expense makes more sense
when portrayed as a percentage of pre-tax income. This is known as the effective tax rate.
Another quick solution to quantify a company’s profitability is by calculating Income
statement ratios.
This includes:
a. Gross profit margin = ratio of gross profit (Sales – COGS) to revenue (sales)
Gross profit margin = Gross Profit / Revenue.
By either  prices or  COGS gross profit margin can be increased. An  in the price
is possible if a company’s product can be differentiated from its peers, based on
factors such as brand names, quality, technology, or patent protection. As seen above
in the example where the gross profit margin for Business 2 > Business 1. Anlysts
should keep in mind that gross profit margins do not reflect the expendutures of the
company.
b. Net Profit Margin = ratio of net income to revenue (sales)

Net profit margin = Net Profit / Revenue.
It measures the total gain after deducting all the expenses. Just like Gross Profit
Margin, it requires comparative analysis with it peers. Net income margin measures
the amount of income the company was able to generate for each dollar of revenue.
Net profit margin, the higher the better.
For e.g.:
IBM – COMMON SIZE INCOME STATEMENT

2010-12 2011-12 2012-12
Revenue 100% 100% 100%
Cost Of Revenue 53.93% 53.11% 51.87%
Gross Profit 46.07% 46.89% 48.13%
Operating Expenses
Research and 6.03% 5.85% 6.03%
Development
Sales, General and 21.87% 22.07% 22.54%
Administrative
Total Operating 27.90% 27.92% 28.57%
Expenses
Operating Income 18.17% 18.97% 19.56%
Interest Expense 0.37% 0.38% 0.44%
Other Income 1.94% 1.06% 1.83%
(Expense)
Income Before Taxes 19.75% 19.64% 20.96%
Provision For Income 4.90% 4.81% 5.07%
Taxes
Net Income 14.85% 14.83% 15.89%
As seen above, the gross profit margin for IBM has increased over the years and this was
possible via a cut down in the % of COGS. The net income has also risen consistently over the
tenure of 3 years, indicating some stability.
1) Which statement is most accurate regarding a common size income statement:

A. Allows an analyst to conduct cross-sectional analysis by removing the effect of
company size
B. Restates each line item of the income statement as a percentage of net income
C. Standardizes each line item of the income statement but fails to help an analyst
identify differences in companies' strategies
Answers
1. A is correct. - Common size income statements facilitate comparison across time periods
(time-series analysis) and across companies (cross-sectional analysis) by stating each line
item of the income statement as a percentage of revenue, The relative performance of
different companies can be more easily assessed because scaling the numbers removes
the effect of size. A common size income statement states each line item on the income
statement as a percentage of revenue. The standardization of each line item makes a
common size income statement useful for identifying differences in companies'
strategies.
Understanding Balance Sheets 43
Understanding Balance Sheets
Exam Focus
• Overview of the company’s holding of assets and liabilities.

• Understanding balance sheet accounts for financial analysis.
• Calculating and focusing on balance sheet valuation.
• Adjusting the variations in accounting methods and their impact on the balance
sheet components for comparative analysis.
• Focus on the impact on income statement and shareholders equity through changes
in accounting methods.
Balance Sheet Introduction

Describe the elements of the balance sheet: assets, liabilities, and equity.
Balance sheet
Also known as the statement of financial position of a company which tells the users of the
financial statements what an entity owns, owes and the owners’ interest in the net assets of
the company at a specific point in time.
Components of balance sheet includes:
a. Assets: Resources gathered from past occasions that are estimated to provide future
benefits.
b. Liabilities: Obligations gathered from past occasions that are estimated to lead to
future outflows.
c. Equity: Total Assets = Total Liabilities + Equity
 Equity/shareholder’s equity/owner’s equity = Residual asset value/net asset value
(Total Assets −Total Liabilities)
Note: Record values on the financial statements only if future benefits are probable (flowing
to / from the firm) and the value or cost is measurable.
Intangible Assets
LOS 35a: Explain the financial reporting and disclosures related to intangible assets
Intangible assets are assets that lack physical substance.
These are further divided into:
a. Identifiable assets: Assets like patents, trademarks, and copyrights that can be
possessed and sold separately.
b. Unidentifiable assets: Assets like goodwill that cannot be possessed or sold separately
and have an unlimited life.
Treatment for identifiable intangible assets:

For IFRS: Cost model or revaluation model can be used however, revaluation model
can be used only if there exists an active market for identifiable intangible assets.
For US GAAP: Only cost model is used
Treatment for internally created intangible assets: For instance, in case of research
and development costs
For IFRS: Research stage cost must be expensed however development cost can be
capitalized if certain conditions are met.
For US GAAP: Costs (both research and development) are expensed as incurred
For each intangible asset, a company assess whether the useful life of an asset is
definite or indefinite.
Principles for determining the same are as follows:
a. An intangible asset with a finite useful life is amortized on a systematic basis
over the useful life where the useful life is reviewed atleast annually.
b. Intangible assets with a finite life are impaired the same way as PP&E.
c. An intangible asset with indefinite useful life is not amortized. Instead, it is
checked for impairment at leats annually.
For both IFRS and U.S. GAAP

The costs given below must be expensed in the period of occurrence itself:
1. Start-up and training costs.
2. Administrative overhead.
3. Advertising and promotion costs.
4. Relocation and reorganization costs.
5. Termination and redundancy costs.
Value of each intangible asset to the company must be considered before deciding to
eliminate it for analytical purpose.
US GAAP prohibits the capitalization of most costs of internally developed intangibles like and
research and development. All such costs are expensed.
In contrast, acquired or purchased intangible assets are capitalized and reported separately
as identifiable intangible assets.
LOS 35b: Explain the financial reporting and disclosures related to goodwill
Goodwill is the excess of purchase price over the fair vaue of the identifiable net assets (assets
– liabilities) acquired in a business acquisition.
Goodwill= Purchase price – Fair value of identifiable assets (under acquisition)
Excess price is paid for:

a. The reputation or creditability of the company in the industry
b. Perceived synergies that may help in reducing duplicate costs e.g.: HR costs,
accounting etc
In case of purchase price < acquisition price, gain is reported in the acquirer’s income
statement.
Characteristics for goodwill:
1. Only created under acquisition (purchase)
2. Internally generated goodwill is expensed when in the same period of occurrence
3. Goodwill is tested for impairment annually; in case of an impairment loss, it is reported
in the income statement. Cash flow is not affected.
4. Management can manipulate the value of goodwill and thereby affect the asset value
since goodwill is not amortized.
For analytical purpose one must eliminate goodwill and its impairment charges for
calculating ratios.
Differentiate between accounting and economic goodwill.
Accounting Goodwill Economic Goodwill

Based on accounting standards and is Based on the economic performance of the
reported only incase of acquisations. equity.
Not necessarily reflected in the balance sheet
but in the stock price.
Under both IFRS and US GAAP, accounting goodwill arising from acquisitions is capitalized.
Goodwill is not amortized but is tested for impairment annually and because of this, firms can
manipulate net income upwards by allocationg more of the acquisition price to the internally
created goodwill and less to identifiable assets which are amortized. This results in less
amortization expense, resulting in higher net income.
If goodwill is impaired, the impairment loss is charged against income earned in the current
year, hence reducing profit of the company.
If goodwill is impaired, it also reduces total assets, so performance measures like return on
assets will increase in future periods as the denominator (total assets) will reduce by a greater
proportion than the numerator (Net income).
LOS 35c: Explain the financial reporting and disclosures related to financial
instruments.
Marketable Securities
• Financial instruments can be present on both the asset and liability side.
Financial securities like investment securities (stocks and bonds), derivatives, loans,
and receivables can simultaneously give rise to asset of one entity and liability/equity
of another entity. For e.g.: Issuing equity share capital (equity) for cash (asset).
Corresponding impact on the other entity as well.
• Financial instruments can be measured at historical cost, amortized cost, or fair value.
Historical cost method
a. Equity investments where there lacks an active market and fair value cannot be
reliably estimated
b. Loans to, and notes receivable from other entities.
Measurement under U.S. GAAP:
1) Amortized cost method
Debt securities undertaken with an intention to be held till maturity are classified as
held-to-maturity securities. These securities are measured at amortized cost.
Where,
Amortized cost = Original issue price - any principal payments + any amortized
discount - any amortized premium- any impairment losses.
Note: Successive variations in market value are ignored.
2) Fair Value Method

In case of financial assets like trading securities, available-for-sale securities, and
derivatives, they are measured at fair value and it is known as mark-to-market
accounting.
a. Trading securities /Held-for-trading securities
These are debt securities purchased with an intention to sell them over a short period. Trading
securities are recorded on the balance sheet at fair value. Unrealized gains and losses, that is
fluctuations in market value before any sale is recorded in the income statement.These
unrealized gains and losses are also known as holding period gains and losses.
Note: The treatment for derivative investments is the same as trading securities.
b. Available for sale securities
These debt securities are neither held till maturity nor traded in the near term. These
securities are recorded on the balance sheet at the fair value.
Unrealized gains and losses is recorded under the comprehensive income statement under
equity. Note: For all financial securities dividend, interest income and actual (realised) gains
or losses when the securities are sold are recorded in the income statement.
c. Held to maturity
These securities are bought with the intention of holding them to maturity. They are recorded
on the balance sheet usually as a non-current asset at amortized cost. Unlike held for trade
and available for sale securities, unrealised gains and losses do not appear on financial
statements.
Illustration
A ltd, a U.S. GAAP reporting company, in Jan 2020, bought a 5% bond, at par, for ₹1,000. In
March 2020, interest rates rose and the market value of the bond declined to ₹ 500. Calculate
the bond’s effect on A ltd.’s financial statements under:
A. Held to maturity security
B. Trading security
C. Available for sale security
Solution
For held to maturity security
Balance sheet = Bond recorded at ₹ 1,000.
Income statement =Interest income of ₹ 50 [₹ 1,000× 5%].
For trading security

Balance sheet = Bond recorded at ₹ 500
Income statement = ₹ 500 unrealized loss and ₹ 50 of interest income.
For available-for-sale security,
Balance sheet = Bond recorded at ₹ 500
Income statement = ₹ 50 of interest income.
Other comprehensive income= ₹ 500 unrealized loss.
For IFRS
a. Securities measured at amortized cost = the US GAAP held-to-maturity securities.
b. Securities measured at fair value though other comprehensive income = the US GAAP
available-for-sale securities.
c. Securities measured at fair value through profit and loss = the US GAAP treatment of
trading securities.
Financial asset classifications under IFRS
Measured at amortized Measured at fair value through Measured at fair value

cost other comprehensive income through profit and loss
Debt securities intended to Debt securities purchased with Debt securities purchased with
be held till maturity intention to collect interest intent to sell in short term
payments but sell before
maturity
Loan’s receivable Equity securities only if this Equity securities (exception
Note’s receivable method is chosen at time of fair value through OCI chosen
purchase at time of purchase)
Unlisted equity securities in
case of fair value that Derivatives
cannot be determined
reliably
Securities that are not
categorised under the other
two categories
Securities where this method is
chosen at time of purchase
LOS 35d: Explain the financial reporting and disclosures related to non-current
liabilities
What is included under non-current liabilities?

Non-Current Liabilities
a. Long-term financial liabilities.
• Financial liabilities include bank loans, notes payable, bonds payable and
derivatives.
• In case of financial liabilities not being issued at face value,
financial liabilities = recorded at amortized cost, on balance sheet.
• In certain cases, financial liabilities = recorded at fair value.
For e.g.: held-for trading liabilities such as a short position in a stock, derivative
liabilities, liabilities with exposures hedged by derivatives.
b. Deferred tax liabilities.

Deferred tax liabilities are future income taxes payable as a result of temporary
differences.
1. Deferred tax liabilities = income tax expense recognized in the income statement
> taxes payable.
For e.g.: A company that applies an accelerated depreciation method for tax
purposes and the straight-line method for financial reporting.
2. Deferred tax liabilities = revenues or gains are recorded in the income statement
before they are taxable.
For e.g.: A company that records earnings of a subsidiary before any dividends are
made.
Eventually, deferred tax liabilities shall reverse once the taxes are paid.
1) Which of the following is least likely a marketable security?
A. Mutual fund shares.

B. Promissory notes.
C. Treasury Bills
2) Which of the following is the least likely an identifiable intangible asset?
A. Copyrights
B. Goodwill
C. Patents
3) Queen Inc. paid $675 million for Wayne Corp.'s outstanding stock. The following table
lists some of Wayne Corp.'s financial accounts:
Account Amount ( in million)
Cash 200
Inventory 50
Property, Plant & Equipment 480
Short term liabilities 80
Long term liabilities 150
Common equity 500
If the fair value of the plant is $125 million higher than its book value, the amount of
goodwill that Queen Inc. paid is closest to:
A. $50 million
B. $125 million
C. $175 million
4) Spice Jet Co. bought a 5-year 7.5 percent bond with a $1,000 par value at the start of
the year. The bond's value has dropped by $135 due to a rise in interest rates. If Spice
Jet classifies the bond as an available-for-sale security, the bond's value on the balance
sheet will be closest to:
A. $75
B. $135
C. $865
Answers
1. B is correct. Promissory notes are financial assets that are not traded in a public market
and, hence, cannot be classified as marketable securities.
2. B is correct. Intangible assets are non-monetary assets that do not have physical
existence. Intangible assets can be identifiable intangible assets (Patents, copyrights) or
unidentifiable intangible assets (Goodwill).
3. A is correct. Goodwill is the excess of the purchase price of an acquired company over
the fair value of the identifiable net assets acquired. Since the fair value of the plant is
$125 million higher than its book value:
Net assets value (NAV) = Cash + Inventory + Plant − Short-term liabilities − Long-term
liabilities =
$200 million + $50 million + $605 million ($480 million + $125 million) − $80 million = $625
million
Goodwill paid on the purchase of Wayne stocks
= Price − Fair value of net assets = $675 million − $625 million = $50 million
4. C is correct. Financial assets recognized as available-for-sale securities are reported at
their fair value. Since the value of the bond has decreased by $135, the bond will be
reported at its fair value of $865, an interest income of $75 will be recognized in the
income statement, and a loss of $135 will be reported under changes in stockholder's
equity.
Shareholders’ Equity and Ratios

Describe the components of shareholders’ equity.
1. Owners’ equity: Asset – Liabilities = Owner’s equity.
Owners’ equity includes contributed capital, preferred stock, treasury stock, retained
earnings, non-controlling interest and accumulated other comprehensive income.
2. Contributed capital: It is also known as issued capital. It is the amount contributed by
equity shareholders.
3. Par value of common stock: It is a stated/legal value. Par value has nothing to do with
fair value. Sometimes common stock is even issued without a par value. In case of par
value, it is recorded separately in shareholders’ equity. Thus, Proceeds from issuing
equity = Par value of issued shares + “additional paid-in capital”
4. Authorized shares: These are the number of shares that may be sold under the firm’s
articles of incorporation.
5. Issued shares: The total number of shares that have actually been sold to the
shareholders.
Outstanding shares = the issued shares - shares that have been repurchased by the
company (i.e., treasury stock).
6. Preferred stock: These stockholders have rights and privileges that is not enjoyed by
the common shareholders. For instance, preferred shareholders are promised a
certain percentage of dividend every year, common shareholders are not guaranteed
any fixed dividend payment. It is a perfect blend of debt or equity, depending on the
terms.
For example, in case of:
a. Perpetual preferred stock that is non-redeemable is considered equity.
b. Preferred stock that asks for mandatory redemption in fixed amounts is
categorised as a financial liability.
7. Noncontrolling interest /minority interest: It is the minority shareholder’s pro-rata
share of equity of a subsidiary that is not completely owned by the parent.
8. Retained earnings: These are the undistributed earnings of the company since
beginning that have not been paid out to shareholders as dividends.
9. Treasury stock: The stock that has been repurchased by the issuing company but not
yet retired. Treasury stock reduces stockholder’s equity. This is not an investment in
the company. Treasury stock has no voting rights and does not receive dividends.
10. Accumulated other comprehensive income: It includes all changes in shareholders’
equity besides transactions recorded in the income statement (net income) and
transactions with shareholders, such as issuing stock, reacquiring stock and paying
dividends.
Comprehensive income = Net income + Other comprehensive income (OCI).
Note: Comprehensive income v/s accumulated comprehensive income

a. Comprehensive income is an income calculated over a period of time.
Comprehensive income = net income + other comprehensive income for the
period.
b. Accumulated other comprehensive income does not include net income but is a
part of common shareholder’s equity at a point in time.
Common Retained Accumulated Total

Stock Earnings (in Other
thousands) Comprehensive
Income (loss)
Beginning balance $49,234 $26,664 ($406) $75,492
Net income 6,994 6.994
1. Net unrealized loss (40) (40)
on available for
sale securities
2. Net unrealized loss (56) (56)
on cash flow
hedges
3. Minimum pension (26) (26)
liability
4. Cumulative 42 42
translation
adjustment
Comprehensive income 6.914
Issuance of common stock 1,282 1,282
Repurchase of common (6,200) (6,200)
stock
Dividends (2,360) (2,360)
Ending balance $44,316 $31,298 ($486) $75,128
The above statement of changes in stockholder’s equity depicts:

1. All transactions that increase or decrease the equity accounts for the period.
2. The statement includes transactions with shareholders and reconciles the beginning
and ending balance of each equity account, including common stock, additional paid-
in-capital, retained earnings and accumulated other comprehensive income. In
addition, the components of accumulated other comprehensive income are disclosed
(i.e., unrealized gains and losses from available-for-sale securities, cash flow hedging
derivatives, foreign currency translation and adjustments for minimum pension
liability).
LOS 35e: Calculate and interpret common-size balance sheets and related financial
ratios
In case of a vertical common-size balance sheet. Each component of the balance sheet is
presented as a percentage of total assets.
By converting the balance sheet to a common-size balance sheet it makes 2 companies of
different sizes comparable.
This allows for comparative analysis over time (time series analysis) and across the industry
(cross-sectional analysis).
From the above example of East v/s West, we get:
East’s investment in current assets of 25% > West’s current assets investment of 23%.
However, East’s current liabilities of 22% of total assets > West’s current liabilities of 7%.
Therefore, East is less liquid.
Further, West’s better working capital condition may not be an efficient use of resources. The
investment returns on working capital are usually lower than the returns on long-term assets.
Further, a closer look at current assets reveals those East records less cash as a percentage of
assets than West.
East does not even have enough cash to satisfy its current liabilities without selling more
inventory and collecting receivables.
East’s inventories of 12% of total assets are higher than West’s inventories of 6%.
Higher inventories indicates an inventory obsolescence.
Further analysis of inventory is mandatory.
Not only are East’s current liabilities higher than West’s, but East’s long-term debt of 58% of
total assets is a lot higher than West’s long-term debt of 33%.
Thus, East may have issues in satisfying its long-term obligations since its capital structure
consists of more debt.
Thus, East appears to be growing through acquisitions as it is recording goodwill. West is
growing internally since no goodwill is reported. It can be that East is financing the
acquisitions with debt.
The Balance sheet of a company helps analysts insight’s into the liquidity, solvency as well as
the economic resources held by the company.
1. Liquidity ratios
Measures company’s ability to meet short-term obligations as they near the due date.
Liquidity ratios comprises of the current ratio, the quick ratio and the cash ratio.
• Current ratio = current assets / current liabilities
• Quick ratio = cash + marketable securities + receivables / current liabilities

• Cash ratio = cash + marketable securities / current liabilities.
Although all three ratios measure the firm’s ability to pay current liabilities, they
should be considered collectively. For e.g.: If Firm A has a higher current ratio but a
lower quick ratio as compared to Firm B. This is the result of higher inventory as
compared to Firm B.
Note:
A. The quick ratio (also known as the acid-test ratio) is calculated by excluding
inventory from current assets.
B. The cash ratio is calculated by excluding inventory and receivables.
2. Solvency ratios
Measures company’s ability to meet its long-term obligations.
Solvency ratios comprises of long-term debt-to-equity ratio, total debt-to-equity
ratio, debt ratio and the financial leverage ratio.
➢ Long-term debt-to-equity = long-term debt /total equity
➢ Total debt-to-equity = total debt /total equity
➢ Debt ratio = total debt/ total asset
➢ Financial leverage = total asset/total equity
Just like liquidity ratios all four ratios measure solvency but they should be considered
collectively
Limitations of balance sheet ratio analysis include:
a. Cross sectional analysis is limited by differences in accounting standards and
estimates.
b. Lack of homogeneity as many firms operate in different industries.
c. Interpretation of ratios requires significant judgment.
d. Balance sheet data is measured at a single point in time only.
1) A corporation has £35 million in total liabilities and £55 million in total stockholders'
equity. On a vertical common size balance sheet, total liabilities are represented by the
percentage that is closest to:
A. 35%
B. 39%
C. 64%
2) The most comprehensive assessment of a company's liquidity is:
A. Cash ratio
B. Current Ratio
C. Quick ratio
3) An analyst would most likely be able to determine which of the following from a
common-size analysis of a company's balance sheet over several periods?
A. A more efficient or less efficient use of assets

B. An increase or decrease in financial leverage
C. An increase or decrease in sales
4) How are unrealized gains and losses reported in shareholders' equity for financial
assets defined as trading securities?
A. They are a component of accumulated other comprehensive income

B. They are not recognized
C. They flow through income into retained earnings
5) If total asset turnover is defined as revenue divided by average total assets, all else
equal, impairment write-downs of a company's long-lived assets will almost certainly
result in an increase in:
A. The debt-to-equity ratio but not the total asset turnover

B. The total asset turnover but not the debt-to-equity ratio
C. Both the debt-to-equity ratio and the total asset turnover
6) An investor concerned about a company's long-term survivability would look at its:
A. Current ratio
B. Debt-to-equity ratio
C. Return on equity
7) A vertical common-size balance sheet expresses each category of the balance sheet as a
percentage of:
A. Assets
B. Liabilities
C. Shareholders' equity
8) The World Bank is looking at Philips Corp's ability to repay a long-term loan that the
company just sought for. Which of the following analyses will be most useful in this
situation?
A. Liquidity analysis.
B. Profitability analysis
C. Solvency analysis
9) Seattle & Co. has total liabilities of $45 million and total stockholders’ equity of $75
million. Total liabilities are represented on a vertical common-size balance sheet by a
percentage closest to:
A. 38%
B. 63%
C. 60%
Answers
1. B is correct. Vertical common-size analysis involves stating each balance sheet item as a
percentage of total assets. Total assets are the sum of total liabilities (£35 million) and
total stockholders' equity (E55 million), or £90 million. Total liabilities are shown on a
vertical common-size balance sheet as (£35 million/£90 million) 39%.
2. A is correct. The cash ratio measures how much of a company's near-term commitments
may be satisfied with existing amounts of cash and marketable securities
3. B is correct. - Common size analysis (as presented in the reading) provides information
about composition of the balance sheet and changes over time. As a result, it can provide
information about an increase or decrease in a company's financial leverage.
4. C is correct. For financial assets classified as trading securities, unrealized gains and losses
are reported on the income statement and flow to shareholders equity as part of retained
earnings.
5. C is correct. Impairment write-downs reduce equity in the denominator of the debt-to-

equity ratio but do not affect debt, so the debt-to-equity ratio is expected to increase.
Impairment write-downs reduce total assets but do not affect revenue. Thus, total asset
turnover is expected to increase.
6. B is correct. The debt-to-equity ratio, a solvency ratio, is an indicator of financial risk.
7. A is correct. Each category in the common-size balance sheet are expressed as a

percentage of assets.
8. C is correct. The solvency analysis is used to measure the ability of a company to meet
its long-term obligations.
9. A is correct. Vertical common-size analysis involves stating each balance sheet item as a
percentage of total assets.
Total assets are the sum of total liabilities ($45 million) and total stockholders’ equity ($75
million), or $120 million. Total liabilities are shown on a vertical common-size balance
sheet as
( $45million ÷ $120 million) ≈ 38%
Analyzing Statements of Cash Flows I 59
Analyzing Statements of Cash Flows I

Exam Focus
• Understanding the importance of cash flows since net income may not represent cash
generated from operations (prepared under the accrual method)
• Understand difference between operating, financing, and investing cash flows
• Interpret both reported and common-size cash flow statement
• Calculate and analyse cashflow related ratios
Cash Flow Introduction

Cash flow statement:
• Information provided is beyond the scope of accrual accounting under income

statement.
• The cash flow statement offers information, with regards to the:
a. Firm’s cash earnings and cash expenditure, for a specific accounting period.
b. Firm’s operating, investing, and financing activities.
c. Influence of accrual accounting treatment on cash flows.
• From an analytical point of view, the cash flow statement delivers information with
regards to the company’s liquidity, solvency, and financial capabilities.
An analyst must assess the cash flows statement for evaluating, whether:
a. Sufficient cash is created through regular operations in order to sustain the
business.
b. Sufficient cash is created to pay off current debts once they mature.
c. Companies need additional financing.
d. Unanticipated requirements can be met.
e. The company can optimize their growth opportunities as they arise.
Compare cash flows from operating, investing, and financing activities and classify cash flow
items as relating to one of those three categories given a description of the items.
Differentiate between cash flow from operating, financing and investing.
CASH FLOW FROM CASH FLOW FROM INVESTING CASH FLOW FROM
OPERATING (CFO) (CFI) FINANCING (CFF)
Cash inflows/outflows Cash inflows/outflows resulting Cash inflows/outflows
resulting from transactions from acquisition/disposal of resulting from transactions
that directly affect a long-term assets and certain that impact the company’s
company’s net income. investments capital structure
Cash flows that affect the Cash transactions on non- Cash dealings in relation to
day to day working of a current assets that generate the purchasing or
company future profits. repayment of capital.
Explain the components of cash flow from operating, financing and investing (as per US
GAAP and IFRS).
For, Cash Flow from Operating (CFO)
INFLOWS (Cash Received) OUTFLOWS (Cash Paid)

Cash sales from clients Employee salaries
Dividend and interest Purchase of trading securities (excludes
securities bought for investment)
Sale of trading securities(excludes Interest on debt/leases
securities bought for investment)
Collection of accounts receivable Taxes
Royalty and commissions Other expenses
For, Cash Flow from Investing (CFI)

Sale of fixed assets(PPE) Purchase of fixed assets (PPE)
Sale of financial securities (debt/equity) Purchase of financial securities
(debt/equity)
Principal received from loans made to Loan given
others
Intangibles (receivable)
For, Cash Flow from Financing (CFF)

Principal on debt (issued) Principal paid on debt/leases
Fresh Issue of Stock Buyback of stock
Dividends paid to stockholders
Contrast cash flow statements prepared under International Financial Reporting Standards
(IFRS) and US generally accepted accounting principles (US GAAP).
What is the difference in the treatment of cash flow components under US GAAP & IFRS?
US GAAP IFRS
Dividend paid = CFF More options in treatment, as:
Interest paid = CFO Dividend/Interest received = CFO or CFI
Dividend/Interest received = CFO Dividend/Interest paid= CFO or CFF
All Taxes = CFO Taxes = CFO except taxes associated with an
investing or financing transaction.
Cash Flow Statements: Difference between IFRS and US GAAP
Topic IFRS US GAAP

Classification of cash Operating or investing Operating
flow:
Interest received Operating or investing Operating
Interest Paid Operating or investing Operating
Dividends received Operating or investing Operating
Dividends paid Operating or financing Financing
Bank overdraft Considered part of cash Not considered part of cash
equivalents and cash equivalents and
classified as financing
Taxes paid Generally operating, but a Operating
portion can be allocated to
investing or financing if it can be
specifically identified with these
categories
Format of statement Direct or indirect; direct is Direct or indirect; direct is
encouraged encouraged. A reconcilation
of net income to cash flow
from operating activities
must be provided regardless
of method used.
LOS 36a: Describe how the cash flow statement is linked to the income statement and the
balance sheet.
How is the cashflow statement related to the financial statements? Explain.
As seen below; in the course of an accounting period, the cash flow statements reconcile the
beginning and ending balance of cash.
Change in Cash Balance = Operating Cash Flow + Investing Cash Flow + Financing Cash Flow
And;
Change in Cash Balance + Beginning Cash Balance = Ending Cash Balance
Where (subject to few exceptions);
1. Operating Activities = Activities concerned with the current assets/liabilities of the
company.
2. Investing Activities = Activities concerned with the non- current assets of the
company.
3. Financing Activities= Activities concerned with the non- current liabilities & equity of
the company.
Relationship between cash flow and balance sheet accounts
The difference between the recognition of revenue / expenditure and receipt / payment of
cash due to a time lag is reflected in the balance sheet. For e.g.: In case of credit sales > cash
sales;
The balance sheet reflection =  in account receivable (asset).

Hence;
 credit sales leads to  account receivables,  cash collection leads to  account receivables
Thus, from the above correlation we get:
Beginning accounts receivable + Sales – Cash collections = Ending accounts receivable
Illustration
For the year 2018-19, the cash collections for Zee ltd were ₹ 10,000 and sales was ₹
30,000.Also, the ending balance sheet value for accounts receivable was ₹ 50,000. Calculate
the beginning balance sheet value of accounts receivable for Zee Ltd.
Solution
For Ending Balance sheet vale;
Beginning accounts receivable + Sales – Cash collections = Ending accounts receivable
Beginning accounts receivable + ₹ 30,000 - ₹ 10,000 = ₹ 50,000
 Beginning accounts receivable = ₹ 30,000
1) Which of the following is most likely to appear in the operations section of a cash flow
statement when using the indirect approach?
A. Cash paid to suppliers

B. Cash received from customers
C. Net income
2) On the cash flow statement, what type of activity would a cash sale of a property be
listed as?
A. Financing
B. Investing
C. Operating
3) A company's dividends could be classified into two categories under the IFRS
Framework. Which of these isn't a possible category for it to fall into?
A. Financing
B. Investing
C. Operating
4) On the last day of the fiscal year, capital collected from shareholders is used to
purchase machinery on the same day. Which of the statements below is the most
likely to be accurate?
A. The transaction impacts cash flows from investing and financing activities
B. The transaction impacts cash flows from investing and operating activities due to
additional depreciation
C. The transaction impacts cash flows from investing activities only.
5) For the year 2014, Neilson & Murdock LLC created a provision for doubtful debts.
When using the indirect approach to prepare operating cash flows, how should this
provision for doubtful debts be handled? Most probable, the doubtful debt is
A. Added to net income.

B. Deducted from net income.
C. Neither added nor deducted from net income.
Answers
1. C is correct. - Under the indirect method, the operating section would begin with net
income and adjust it to arrive at operating cash flow. The other two items would appear
in the operating section under the direct method
2. B is correct. Purchases and sales of long-term assets are considered investing activities.
3. B is correct. Under IFRS, a company could put the dividends it paid into operating activities
of financing activities. Note that using the US GAAP, you would have to put it into the
financing category only.
4. A is correct. Receipt of capital from shareholders increases the cash flows from financing
activities. Cash outflow due to the purchase of machinery reduces the cash flows from
investing activities.
5. A is correct. Under the indirect method, non-cash expenditures are added to net income
to calculate the cash flow from operating activities.
The Direct and Indirect Methods
LOS 36b: Describe the steps in the preparation of direct and indirect cash flow
statements, including how cash flows can be computed using income statement and
balance sheet data.
What are the steps in the preparation of direct and indirect cash flow statements? How can
cash flows be computed using income statement and balance sheet data?
Before we begin with the steps, here are few points to remember under both the methods:
• Despite CFO being calculated differently,

CFO (direct method) = CFO (indirect method).
• Under both the direct and indirect method, calculation of CFI and CFF is identical.
• There lies an inverse relationship between ’s in assets and ’s in cash flows.
• For e.g.: When credit sales > cash receipts;
  current cash collection leads to  future account receivables, and vice versa.
• There lies a direct relationship between ’s in liabilities and ’s in cash flows.
For e.g.: When credit purchases > cash payments;
  future cash payment leads to  current account payables, and vice versa.
• Thus,
 in liability account = source of cash (+ve adjustment), and
 in a liability = use of cash (-ve adjustment).
• Thus,
 in asset account = use of cash (-ve adjustment), and
 in asset account = source of cash (+ve adjustment).
CFO statement under the direct method:
The direct method of presenting a firm’s statement of cash flows shows only cash payments
and receipts over the period. The sum of these is the company’s CFO. This method gives more
information than the indirect method.
For CFO; the items generally involved under a direct method are:
• Cash collected from clients, typically the core item of CFO.

• Cash utilised in the production of output a.k.a cash input.
• Cash operating expenses.
• Cash paid for interest.
• Cash paid for taxes.
Note: Ignore depreciation expense (non-cash expense); when reporting cashflow under the
direct method. We consider the same as an adjustment (added back) under the Indirect
method since it has been subtracted from net income (the starting point).
CFO statement under the indirect method:
• While CFI & CFF is calculated similarly under both direct and indirect method; there
exists a difference in the calculation of CFO.
• Since, indirect method is a bottom-line approach, adjustments are made to the net
income.
• Adjustments involved in calculating CFO under the indirect method include:
1. Begin with net income.
2. Less any  in the operating asset accounts (uses of cash)
Add any  in the operating asset accounts (sources of cash)
For e.g.: An  in the Account receivable; indicates credit sales > cash sales.
This leads to a  in current year cash inflow thus, we  the net income.
3. Add  in the operating liability accounts (sources of cash),
Less  in the operating liability accounts (uses of cash).
For e.g.: An  in the Account payable; indicates credit purchases > cash sales.
This leads to a  in current year cash outflow thus, we  the net income.
4. Add back all noncash expenses such as depreciation and amortization, and less all
noncash components of revenue such as sale in exchange of a non-cash
consideration.
5. Less gains & Add losses that are a result of non-recurring financing/investing
activities (such as gains from sale of land that forms part of investing cash flows).
The treatment for CFI and CFF is identical under both direct and indirect method
For CFI
• It is calculated by evaluating the changes in the gross asset investments.

• Gross asset accounts include PP&E, intangible assets, and investment securities.
• Since, depreciation is a non-cash expense related accumulated
depreciation/amortization is ignored.
*Gross asset account = balance sheet value without subtracting accumulated
depreciation
Note:
a. Check if the old assets are sold in order to calculate the cash paid for the new assets.
If the old assets are sold in the period of purchase of new assets;
Cash paid for new asset = ending gross assets + gross cost of old assets sold −
beginning gross assets
For an easier understanding we can also write it as:
Beginning gross assets + cash paid for new assets − gross cost of assets sold = ending
gross assets.
b. Check for profit/loss on sale of an old asset; while calculating cashflow from an old
asset:
Cash from asset sold = book value of the asset + gain (or − loss) on sale
For CFF:
• It is calculated by measuring the cashflows between the company and the lenders of
capital.
• Where;
a. New borrowings = +ve CFF
b. Debt principal repayments = -ve CFF
c. Equity issue = +ve CFF
d. Share repurchase/cash dividend = -ve CFF
• Thus,
a. Net cash flows from creditors = new borrowings − principal amounts repaid
b. Net cash flows from shareholders = new equity issued − share repurchases − cash
dividends paid
Note:
a. Interest paid is a cash flow to lenders
 − CFF or −CFO under IFRS. However, under US GAAP interest paid = − CFO
b. Cash dividends paid = dividends declared + any ’s in dividends payable.
Thus,
Total cash flow = CFO + CFI + CFF.
If calculated properly,
Total cash flow = balance sheet cash value for year1 − balance sheet cash value for
year2
Illustration
From the following balance sheet and income statement prepare a statement of cash flows
under the indirect method.
Income Statement for 2018
Amount (₹)
Sales 1,00,000
COGS (45,000)
Salaries (10,000)
Depreciation (5,000)
Interest (2,000)
OPERATING INCOME 38,000
Profit from sale of land 30,000
EBT 68,000
Provision for taxes 20,000
NET INCOME 48,000
Common dividends declared 8,000
Balance sheet for the year 2017 and 2016
2017 2016
Amount (₹) Amount (₹)
Assets
Cash 2,50,000 1,20,000
Accounts receivable 15,000 12,000
Inventory 5,000 8,000
Total Current Assets 2,70,000 1,40,000
Land 50,000 60,000
Gross plant and equipment 50,000 25,000
Less: Accumulated depreciation (10,000) (5,000)
Net plant and equipment 40,000 20,000
Goodwill 20,000 20,000
Total Noncurrent Assets 1,10,000 100,000
TOTAL ASSETS 3,80,000 2,40,000
Liabilities
Accounts payable 10,000 5,000
Dividends payable 5,000 2,000
Taxes payable 6,000 5,000
Total Current Liabilities 21,000 12,000
Bonds 20,000 15,000
Deferred tax liability 25,000 20,000
Total Noncurrent Liabilities 45,000 35,000
Total Liabilities 66,000 47,000
Stockholders’ equity
Common stock 94,000 1,70,000
Retained earnings 2,20,000 23,000
Total equity 3,14,000 1,93,000
TOTAL LIABILITIES AND 3,80,000 2,40,000
STOCKHOLDERS’ EQUITY
Solution
For CFO
Income Statement for 2017

Amount (₹)
Net income 48,000
Less: Profit from sale of land (30,000)
Add: Depreciation 5,000
Subtotal 23,000
Changes in operating accounts
Increase in receivables (3,000)
Decrease in inventories 3,000
Increase in accounts payable 5,000
Increase in taxes payable 1,000
Increase in deferred taxes 5,000
CFO 34,000
For CFI
It consists of two components:
a. Sale of land
b. Gross PP&E
For sale of land
Ending land = beginning land + land purchased − gross cost of land sold
Ending land = ₹ 60,000 + ₹ 0 – ₹ 10,000 = ₹ 50,000
 cash from sale of land = decrease in asset + gain on sale
cash from sale of land = ₹ 10,000 + ₹ 30,000 = ₹40,000
For Gross PP&E
P&E purchased = ending gross P&E + gross cost of P&E sold − beginning gross P&E
P&E purchased = ₹ 50,000 + 0 - ₹25,000 = (₹25,000)
 CFI = ₹40,000 - ₹25,000
CFI = ₹15,000
For CFF
a. Cash inflow from bond issue
b. Cash to repurchase stock
c. Cash dividends
For cash inflow from bond issue

Ending bonds payable = beginning bonds payable + bonds issued – bonds repaid
Ending bonds payable = ₹ 15,000 + ₹ 5,000 - ₹0
Cash from bond issue = ending bonds payable + bonds repaid – beginning bonds payable
Cash from bond issue = ₹20,000 + ₹ 0 – ₹ 15,000 = ₹5,000
For cash to repurchase stock

Cash to repurchase stock = beginning common stock + stock issued − ending common stock
Cash to repurchase stock = ₹ 1,70,000 + ₹0 - ₹94,000 = (₹ 76,000)
Ending common stock = beginning common stock + stock issued − stock reacquired
Ending common stock = ₹1,70,000 + ₹ 0 - ₹ 76,000 = ₹94,000
For cash dividends
Cash dividends = −dividend declared + increase in dividends payable = - 8,000 + 3,000
Cash dividends= −₹ 8,000 + ₹ 3,000 = (₹ 5,000)
CFF = ₹5,000 - ₹76,000 - ₹5,000
CFF = -₹76,000
TOTAL CASHFLOW = CFO + CFI + CFF

TOTAL CASHFLOW = ₹ 34,000 + ₹15,000 -₹79,000
TOTAL CASHFLOW = -30,000.
Thus, the total cash flow of ₹ 30,000 is equivalent to the increase in the cash account.
Note: Both IFRS and U.S. GAAP encourages the use of cash flows in the direct format. Under
U.S. GAAP, statement of cash flow presented in direct method must include a footnote
disclosing the indirect method. Therefore, most companies report the statement of cash
flows using the indirect method, which requires no additional disclosures.
1) Consider a plant with a $500,000 starting gross value, a $700,000 ending gross value,
and a $175,000 gross cost. Calculate the plant's cash flow from investing operations.
A. $325,000
B. $375,000
C. $700,000
2) Assume for the purposes of this question that Lux recently switched from US GAAP to
IFRS and achieved $500,000 in net income in 2016. Interest costs are incurred as a
result of financing activity. Calculate the cash flow from operations using the indirect
method using the accounts shown in the following table after making the necessary
changes to net income.
2016 2017
Depreciation Exp. 100,000 80,000
Gain on Sale of Land 55,000
Interest Exp. 37,000 22,000
Plant 450,000 370,000
Accounts Receivable 170,000 135,000
Inventory 90,000 115,000
Wages Payable 87,000 69,000
Taxes Payable 85,000 63,000
A. $538,000
B. $590,000
C. $612,000
3) Jindal Steel is an Indian steel molding company that reports under US GAAP. An analyst
has gathered the following information regarding the company for the year 2016:
Net Income 400

Depreciation Expense 10
Decrease in Acc. Rec. 50
Increase in Inventory 35
Increase in Plant 120
Decrease in Land 40
Gain on Sale of Land 60
Share Repurchase 170
Issuance of Bond 210
Increase in Dividend Payables 45
Given that the information is accurate, the cash flow from investing activities for the
company is closest to:
A. -$20.
B. -$80.
C. $220
4) Missoni Inc. is a male fashion brand based in Italy. Carillio is an analyst working on the
cash flow statement of Missoni using the direct method
Sales 150
COGS 90
Interest Expenses 30
Dep. Expenses 25
Decrease in Acc. Rec. 10
Increase in Acc. Pay. 20
Increase in Int. Pay. 20
Using the financial data provided in the table above, the value of Missoni's Cash
Interest that should be used when calculating cash flow from operating activities is
closest to:
A. $10
B. $30
C. $70
5) When reporting operating cash flows, one advantage of utilising the direct approach
rather than the indirect technique is that the direct method:
A. Is easier and less costly

B. Mirrors a forecasting approach
C. Provides specific information on the sources of operating cash flows
Answers
1. B is correct. Cash flow from investing activities is calculated by determining the change in
gross assets. To correctly determine the change in gross assets, the following equation is
used: Cashflow from investing activities = Ending gross plant + Gross cost of old plant sold−
Beginning gross plant = $700, 000 + $175, 000 − $500, 000 = $375,000
2. C is correct. To calculate CFO using the indirect method, we need to adjust Net Income for
non-cash charges and non-operating activities and, since we are assuming that Alaska
reports under IFRS, we need to add back Interest expense related to financing activities
to the Net Income and subtract the same interest expense from cash flow from financing
activities. Net Income to be used for the calculation of CFO = $500,000 + $100,000 -
$55,000 + $37000 = $582,000. Then:
Net Income 500,000

Depreciation Expense 100,000
Gain on Sale of Land (55,000)
Interest Expenses 37,000
Increase in Accounts Receivable (35,000)
Decrease in Inventory 25,000
Increase in Wages Payable 18,000
Increases in Taxes Payable 22,000
Total CFO 612,000
3. A is correct. Cash flow from investing activities is calculated by determining the change in
gross assets accounts.
Step 1: Cash from the sale of Land = $40 (Decrease in land) + $60 (Gain on the sale of land)
= $100
Step 2: Cash paid for new plant = Increase in plant = $120 (Increase in Plant $120)
Total cash flow from investing activities = -$20 (Using the following table)
Decrease in Land 40
Gain on Sale of Land 60
Increase in Plant (120)
Cash Flow from Investing (20)
4. A is correct. Under the direct method of calculating cash flow from operations, we
calculate the cash interest.
Missoni's Cash interest = $30 (Interest expense) − $20 (Increase in interest payable) = $10
5. C is correct. - The primary argument in favor of the direct method is that it pro vides
information on the specific sources of operating cash receipts and payments. Arguments
for the indirect method include that it mirrors a forecasting approach and it is easier and
less costly.
Converting Indirect to Direct
LOS 36c : Demonstrate the conversion of cash flows from the indirect to direct
method
Additions:
Non-cash items
• Depreciation expense of tangible assets
• Amortization expense of intangible assets
• Depletion expense of natural resources
• Amortisation of bond discount
Non-operating losses
• Loss on sale or write-down of assets
• Loss on retirement of debt
• Loss on investments accounted for under the equity method
Increase in deferred income tax liability
Changes in working capital resulting from accruing higher amounts for expenses than the
amounts of cash payments or lower amounts for revenues than the amounts of cash
receipts
• Decrease in current operating assets (e.g., accounts receivable, inventory, and
prepaid expenses)
• Increase in current operating liabilities (e.g., accounts payable and accrued expense
liabilities)
Subtractions
Non-cash items (e.g., amortization of bond premium)
Non-operating items
• Gain on sale of assets
• Gain on the retirement of debt
• Income on investments accounted for under the equity method
Decrease in deferred income tax liability
Changes in working capital resulting from accruing lower amounts for expenses than for
cash payments or higher amounts for revenues than for cash receipts
• Increase in current operating assets (e.g., accounts receivable, inventory, and

prepaid expenses)
• Decrease in current operating liabilities (e.g., accounts payable and accrued expense
liabilities)
In order to convert cash flows to the direct method; we require:

a. Income statement, where;
Adjustments include: Modification to every item of the income statement for its
corresponding balance sheet accounts and to remove any non-cash and non-
operating dealings.
b. CFO calculated under the indirect method.
CFO under the direct method primarily includes cash collections (receipts) and cash
payments. Hence, the modifications involved in the income statement under cash
collections and cash payments are:
For cash collections
1. Starting point = Net sales
2. In case of credit sales > cash sales
Since, cash collections < net sales
Subtract any  in the accounts receivable as reported under indirect method from net
sales and vice-versa;
3. In case of advance cash (unearned revenue) received before the delivery of goods,
since unearned revenue received is not included in the income statement;
Add the  in unearned revenue to net sales and vice versa.
For cash payments

1. Starting point = COGS. (Since it is an outflow put a negative sign for COGS)
2. In case of depreciation included in the COGS;
It leads to  COGS   costs under indirect method;
Thus, add back these non-cash expenses to COGS, when calculating cash payments to
suppliers since these are not actual cash outflows.
3. The impact of credit and cash purchases can be interepreted as follows:
Credit purchases > cash purchases (+) Inflow of cash
(creditors ↑)
Credit purchases < cash purchases (-) Outflow of cash
(creditors ↓)
4. The impact of inventory can be seen as follows:

Purchase of inventory (-) Outflow of cash
(inventory ↑)
Sale of inventory (+) Inflow of cash
(inventory ↓)
5. In case of an inventory write-off, the ending inventory is reduced and thus the COGS
is increased. Since no cashflow is involved;
Subtract any write-offs for cash payments in the period of occurrence.
6. In case cash taxes paid,
Starting Point = income tax expense on the income statement. Adjustments are made
to deferred tax assets and liabilities, and income taxes payable.
7. In case of cash operating expense
Since, an increase in prepaid expenses is a cash outflow that is not included in SG&A
for the current period.
An  in prepaid expenses =  in cash outflows (payments).
Note: Points to remember
1. Source of cash = “+” sign
 net sales = “+” sign
2. Use of cash = “–” sign
 COGS and other expenses = “–” sign
Thus,
An  in assets and  in liabilities = use of cash = “-” sign, and
A  in assets and  in liabilities = source of cash = “+” sign.
Illustration
From the illustration given above calculate the cash flow under the direct statement using the
indirect cashflow statement and income statement for the year 2017. Since CFI & CFF is same
under both the methods, we calculate only CFO.
For CFO
a. Cash collections
Sales − increase in accounts receivable
= ₹ 1,00,000 − ₹ 3,000= ₹ 97,000
b. Cash paid to suppliers – COGS + decrease in inventory + increase in accounts payable
= −₹ 45,000 + ₹ 3,000 + ₹ 5,000 = (₹ 37,000)
c. Cash taxes
–Tax expense + increase in taxes payable + increase in deferred tax liability
= – ₹ 20,000 + ₹ 1,000 + ₹ 5,000 = (₹ 14,000)
d. Salaries paid
= (₹ 10,000)
e. Interest paid
= (₹ 2,000)
CFO = ₹ 97,000 - ₹ 37,000 - ₹ 14,000 - ₹ 10,000 - ₹ 2,000
CFO=₹ 34,000.
LOS 36d: Contrast cash flow statements prepared under International Financial
Reporting Standards (IFRS) and US generally accepted accounting principles (US
GAAP)
The key difference between statetments of cash flows prepared under IFRS and US GAAP is
that IFRS allows more flexibility in the reporting of items such as interest paid or received and
dividends paid or received and in how income tax expense is classified.
Cash Flow Statement differences between IFRS and US GAAP.
IFRS US GAAP
Interest Received Operating or Investing Operating
Interest Paid Operating or Financing Operating
Dividends Received Operating or Investing Operating
Dividends Paid Operating or Financing Financing
Another important difference relates to income taxes paid. Under U.S. GAAP, all taxes apid
are reported as operating activities, even if taxes are related to investing and financing
transactions. Under IFRS, income taxes are also reported as operating activity unless the
expense is associated with an investing or financing transaction.
Analyzing Statements of Cash Flows II 78
Analyzing Statements of Cash Flows II
As mentioned and explained above, an analysis of a company’s statement of cash flows

provides crucial information for evaluating a company’s financial position and for forecasting
its future cash flows.
LOS 37a: Analyze and interpret both reported and common-size cash flow
statements
Just like the above mentioned financial statements, common-size analysis can also be used to
analyse the cash flow statement. It can be converted to common-size format by stating each
line item as a percentage of revenue.
Major Sources of Cash
The cash flow analysis starts by conducting an examination of the firm's cash sources and uses
from operating, investing, and financing operations. Cash sources and uses vary as a company
progresses through its life cycle. It shifts from enduring negative cash flows in the early phases
of expansion, which is often supported by issuing debt or equity securities externally.
However, these sources of funding are not sustainable. Long-term success requires a firm's
ability to generate operational cash flows that surpass capital expenditures while also
providing a return to debt and equity investors.
Operating Cash Flow
The primary factors of operating cash flow should be identified by an analyst. Earnings-related
operations of the company might create positive operating cash flow. Increasing payables or
lowering noncash working capital might provide positive operational cash flow. However,
reducing noncash working capital is not sustainable since inventories and receivables cannot
be reduced to zero and creditors will not provide credit perpetually unless payments are
made on time.
Operating cash flow also indicates the quality of earnings. Earnings that greatly exceed
operational cash flow may indicate aggressive or even incorrect accounting decisions, such as
recognising revenue too fast or delaying cost recognition.
Investing Cash Flow
Increased capital expenditures, or the usage of cash, are typically indicative of growth. In
order to preserve or earn cash, a company may minimise capital expenditures or even sell
capital assets. As ageing assets are replaced or growth restarts, this may result in bigger cash
outflows in the future.
Financing Cash Flow
The cash flow statement's financing operations section shows whether the company
generates cash flow by issuing debt or stock. It also informs analysts if the company is utilising
cash to repay debt, repurchase stock, or pay dividends.
LOS 37b: Calculate and interpret free cash flow to the firm, free cash flow to equity,
and performance and coverage cash flow ratios
Free cash flow: measure of cash that is available for discretionary purposes. This is the cash
flow that is available once the firm has covered its capital expenditures.
Free cash flow can be divided in
a. Free cash flow to the firm (FCFF), and
b. Free cash flow to equity (FCFE).
These are fundamental cash flow measures used for valuation.
a. Free cash flow to the firm (FCFF)
It is the excess cashflow available to all investors, both equity and debt holders.
FCFF can be calculated by starting with either net income or operating cash flow.
For net income as starting point:
FCFF = NI + NCC + [Int × (1 − tax rate)] − FCInv − WCInv
Where:
NI = net income
NCC = noncash charges (like depreciation and amortization)
Int = cash interest paid
FCInv = fixed capital investment (net capital expenditures)
WCInv = working capital investment (CA-CL)
Note: Interest (1- Tax)], is added back to net income.
This is because FCFF is the cash flow available to all investors and interest is paid to
the debt holders, thus it must be included in FCFF.
For CFO as starting point
FCFF = CFO + [Int × (1 − tax rate)] − FCInv
Where:
1. It is not required to adjust for noncash charges and changes in working capital
when starting with CFO, since they are already reflected in the calculation of CFO.
2. For companies reporting under IFRS, it is not mandatory to adjust for interest
that is included as a part of financing activities.
3. Further, companies that follow IFRS can report dividends paid as operating activities.
Thus, in this case, dividends would be added back to CFO since these are available to
shareholders. Tax adjustments are not required since dividends paid are not tax deductible.
b. Free cash flow to equity (FCFE)

It is the cash flow that would be available for distribution to common shareholders.
FCFE = CFO − FCInv + net borrowing
Where:
Net borrowing = debt issued – debt repaid
If net borrowing is negative (debt repaid > debt issued), we would deduct net
borrowing in calculating FCFE.
To summarize,
Beginning with CFO Beginning with Net Profit
US GAAP IFRS IFRS
(Financing (Operating
activity) activity)
CFO CFO CFO Net Profit
Add: Dividend Add: Interest*(1-t)
paid
Add: Add: Interest*(1- Add: Depreciation
Interest*(1-t) t)
Add/Less: Working capital
adjustments
Less: Capex Less: Capex Less: Capex Less: Capex
FCFF
Beginning with CFO Beginning with Net

Profit
US GAAP IFRS IFRS
(Financing activity) (Operating activity)
CFO CFO CFO Net Profit
Add: Depreciation
Add: Interest*(1-t) Add: Dividend paid Add/Less: Working
capital adjustments
Less: Capex Less: Capex Less: Capex Less: Capex
Add/Less: Amount Add/Less: Amount Add/Less: Amount Add/Less: Amount
borrowed/repaid borrowed/repaid borrowed/repaid borrowed/repaid
FCFE
👩‍🏫 Illustration
In continuation from the above illustration, calculate the company’s FCFF & FCFE. Assume a
tax rate of 20%
Solution
FCFF = CFO + [interest paid × (1 – tax rate)] – fixed capital investment
FCFF= ₹ 34,000 + [2000 x (1-20%)] – ₹ 10,000
FCFF = ₹ 25,600.
FCFE= CFO – fixed capital investment + net borrowing
FCFE= ₹ 34,000 – ₹ 10,000 + ₹ 5,000
FCFE = ₹ 29,000
Other Cash Flow Ratios
The cash flow statement can be used for comparative analysis over time and amongst peers.
Cash flow ratios are classified as performance ratios and coverage ratios
I. Performance Ratios
a. Cash flow-to-revenue ratio
It measures the amount of CFO produced for every dollar of revenue.
Cash flow-to-revenue = CFO / Net Revenue.
b. Cash return-on-assets ratio

It measures the return of CFO allocated to all providers of capital.
Cash return-on-assets = CFO / average total assets.
c. Cash return-on-equity ratio

It measures the return of CFO allocated to all shareholders.
Cash return-on-equity = CFO / average total equity.
d. Cash-to-income ratio
It measures the ability to create cash from company operations.
Cash-to-income = CFO / operating income.
e. Cash flow per share

It is a substitute for basic EPS calculated by using CFO and not net income.
Cash flow per share = CFO – preferred dividend / weighted average number of common
shares.
Note: Under IFRS, in case of common dividends being classified as operating, they should be
added back to CFO.
II. Coverage Ratios

a. Debt coverage ratio
It measures financial risk and leverage.
Debt coverage = CFO / total debt
b. Interest coverage ratio

It measures the company’s capacity to meet its interest obligations.
Interest coverage = CFO + interest paid + taxes paid / interest paid
Note: Under IFRS, in case of interest paid being classified as a financing activity no interest
adjustment is required.
c. Reinvestment ratio
It measures the company’s ability to obtain long-term assets with CFO.
Reinvestment ratio = CFO / cash paid for long-term assets
d. Debt payment ratio

It measures the company’s ability to satisfy long-term debt with CFO.
Debt payment = CFO / cash long-term debt repayment
e. Dividend payment ratio

It measures the company’s ability to make dividend payments from CFO. Dividend payment
= CFO / dividends paid
f. Investing and financing ratio

It measures the company’s ability to buy assets, satisfy debts, and pay dividends. Investing
and financing = CFO/ cash outflows from investing and financing activities
1. Free cash flow for the firm (FCFF) is most likely available to:
A. Debt holders and equity holders.

B. Debt holders.
C. Equity holders
2. The reinvestment ratio measure's a firms ability to use its operating cash flow to:
A. Acquire long lived assets

B. Invest in working capital
C. Non-cash charges
3. The financial data of a hypothetical firm is provided below.
Net Income 700

Depreciation Expenses 57
Decrease in Accounts Receivable 49
Increase in inventory 36
Interest in expense 100
Increase in capital expenditure 180
Debt issued 450
Debt Repaid 330
Using the cash flow from operational activities equation and a 40% tax rate, the Free
Cash Flow for the Firm (FCFF) is closest to:
A. $650
B. $690
C. $770
4. Each cash flow in a common size cash flow statement is expressed as a percentage
of:
A. The change in cash

B. Total assets
C. Total revenues
5. Determine the cash flow debt coverage ratio of a company based on the information
provided below:
• Cash Flow Metrics From Investing Activities: $ 15 Million
• From Financing Activities: $ 13 Million
• From Operating Activities: $ 90 Million
• Total Cash Flows: $ 118 Million
• Total Debt: $ 270 Million
A. 0.333
B. 0.437
C. 0.356
84
Answers
1. A is correct. Free cash flow to the Firm (FCFF) is the cash available to both debt
holders and equity holders after the firm has covered its capital expenditures.
2. A is correct. Reinvestment ratio is CFO/ cash paid for long term assets.
3. A is correct. Cash flow from operating activities = $700 (Net income) + $57
(Depreciation) + $49 (Decrease in Acc. Rec − $36 (Increase in Inventory) = $770 FCFF = CFO +
Int. Exp × (1 − Tax rate) − Fixed Capital investment = $770 + $100 × (60%) − $180 = $650
4. C is correct. By expressing each line item as a percentage of revenue, the cash flow
statement can be converted to a common size format.
5. A is correct.
Cash Flow Debt Coverage Ratio = Cash Flow from Operating ActivitiesTotal Debt = 90270
=0.3333
85
Inventories
Exam Focus
• Studying different inventory cost flow methods like FIFO, LIFO & Weighted Average.
• Calculating COGS, gross profit, ending and beginning inventory for each method.
• Evaluating the effect of these methods on financial ratios like solvency, liquidity,
profitability and activity.
• Application of appropriate inventory valuation method as under
a) IFRS (lower of cost/ net realizable value)
b) US GAAP (lower of cost/ market)
• Calculation of inventory losses and reverses if permitted. Analysing the company’s

efficiency in managing inventory.
Cost Flow Methods

What are the balance sheet treatments of inventory for merchandising and manufacturing firms?
Merchandising Manufacturing
Businesses dealing in finished goods Companies that are involved in assembling the
(merchandising) such as wholesalers and finished goods report inventory on the balance
retailers buy inventory that is all set for sale & sheet under three separate accounts: raw
inventory is reported on Balance sheet under materials, work-in-process, and finished goods.
one account: finished goods.
How is COGS derived under inventory method?
• The relationship of COGS (COS for IFRS) can be explained using purchases, beginning & ending
balance inventory
• COGS = Beginning Inventory + Purchases – Ending Inventory
Which can further be rearranged as:
1. Purchases = Ending Inventory − Beginning Inventory + COGS
2. Beginning Inventory = COGS − Purchases + Ending Inventory
3. Ending Inventory = Beginning Inventory + Purchases – COGS (easiest to remember)
For e.g.: Calculate the cost of goods sold for J.C. Penney (NYSE: JCP) for the year ended 2016. Where,
Beginning inventory (2015) = $2.72 billion

Ending inventory (2016) = $2.85 billion
Purchases during 2016= $8.2 billion
Inventories 86
 COGS = $2.72 billion + $ 8.2 billion – $2.85 billion
COGS = $8.07 billion

Inventory Valuation
LOS 38a: Describe the measurement of inventory at the lower of cost and net
realisable value.
How would you describe inventory measurement at lower cost and net realisable value?
IFRS US GAAP
Inventory is recorded on the balance sheet Except in case of LIFO and Retail method,
at lower of: Inventory is recorded on the balance sheet at
a. Cost lower of:
b. Net Realisable Value a. Cost
b. Net Realisable Value
Net Realisable Value (NRV) = In case of LIFO / Retail Method, inventory is

Expected Revenue − Projected Selling Costs reported on the balance sheet at lower of:
– Completion Costs a. Cost
b. Market Value (MV)
Where generally,
Market value = Replacement Cost
The replacement cost is:
Capped by NRV, and
Floored by NRV – Profit Margin
Range = (NRV – Profit Margin) to NRV
If NRV (Inventory) < Balance sheet cost, B/S If Cost Value > Market value, inventory is
Inventory gets written down to MV on balance sheet.
Written down to NRV Loss is recorded on the income statement:
Loss is reported in the income statement Separately in case of a large change in value,
or
By  COGS in case of a small change in value
MV turn out to be the new cost value.
In case of a recovery, inventory can be In case of a recovery, inventory cannot be
written back up to the amount previously written back.
written down only.
Profit is recorded in the income statement

by  COGS by the amount of recovery
profit.
The write-ups/ downs (IFRS) are recorded NO write-ups are permitted under US GAAP.
on the balance sheet through a valuation
allowance account.
Inventories 87
It is a contra asset a/c that helps in

differentiating between the cost and
carrying value.
CONCLUSION
Inventory COGS Profit
WRITE DOWN ↓ ↑ ↓
WRITE UP ↑ ↓ ↑
Note:
• For LIFO, in case of inflation, inventory is valued at lower older costs.

Since, costs are the basis for impairment, LIFO firms generally don’t record a write-
down as the costs are already low (old).
• Effects on Inventory write up/down on ratios:
In case of:
a. Inventory write down,
Inventory turnover ratio 
Since loss →  COGS
Write downs → Average Inventory
b. Inventory write up,
Inventory turnover ratio 
Since gain →  COGS
Write up →  Average Inventory
• Valuation of inventory above cost is permitted under US GAAP & IFRS in case of
Natural Resources (e.g.: agriculture, forests, mineral ores etc).
Where, inventory is recorded on the Balance sheet at NRV,
Any unrealised gains/losses arising due to changing market prices are recorded on
the income statement.
Illustration
For 2020, SONY Ltd, sells LED television sets. The Per-unit cost of the inventory for SONY, is
mentioned below:
PARTICULARS AMT (₹)

Cost Value (2018) 20,000
Projected Selling Price 25,000
Projected Selling Costs 6,000
Replacement Cost 17,500
Normal Profit Margin 3,000
Inventories 88
i) Explain the inventory valuation under IFRS & US GAAP (LIFO)

ii) In case of a recovery of ₹ 1,500, what is the treatment of this recovery under IFRS & US
GAAP
Solution
i) For IFRS (inventory valuation)
Inventory is valued at, lower of:
a. Cost, or
b. NRV.
NRV = Expected Revenue − Projected Selling Costs – Completion Costs
NRV= ₹ 25,000 - ₹6,000
NRV = ₹19,000
Since, Cost Value > NRV (₹20,000 > ₹ 19,000)
Inventory is written down to NRV on the balance sheet at ₹19,000.
Loss = ₹20,000 - ₹19,000
Loss = ₹1,000, reported on the income statement.
For US GAAP (inventory valuation)

Inventory is valued at, lower of:
a. Cost
b. Market Value (MV)
For MV,
MV = Replacement cost (₹ 17,500), since
a. NRV (₹ 19,000) > Replacement cost (₹17,500), and,
b. NRV (₹ 19,000) −Normal profit margin (₹3,000) < Replacement Cost (₹ 17,500)
Thus, ₹ 16,000 < ₹ 17,500.
 MV = Replacement Cost = ₹ 17,500.
Loss = Cost Value – MV

Loss = ₹20,000 – ₹ 17,500
Loss = ₹ 2,500 reported in the income statement.
ii) For Recovery of losses
IFRS US GAAP
Recovery amount = ₹ 1,500 NO write-ups are allowed,
However, write up is limited to previously Gain is recorded at the time of sale of
recognised amount of loss = ₹ 1,000 inventory
Thus, ₹ 1000 is recorded as a reduction in the
income statement.
Inventories 89
Thus, balance sheet value (written up value)

= ₹ 20,000 since, carrying value cannot be
more than cost value.
LOS 38a: Implications of valuing inventory at net realisable value for financial
statements and ratios.
Explain the implications of inventory valuations on financial statements and ratios.

In case of a write-down of inventory,
It is assumed that inventory is reported at NRV on the balance sheet, and  COGS is recorded
in the income statement. This leads to (period of write-down):
1.  in Current Ratio (CA/CL)
Since, inventory is included in current assets, an inventory write-down ’s both

current and total assets.
2.  Quick Ratio (QA/QL)

Since, inventories are not included in quick assets.
3.  in Inventory Turnover (COGS/Average Inventory)

Since,  COGS &  in average inventory.
4.  Days’ Inventory on Hand and The Cash Conversion Cycle.
Since, days inventory on hand = 365 days ÷ inventory turnover
  Inventory turnover →  days’ inventory on hand
For, cash conversion cycle,
Cash conversion cycle = days inventory standing + days sales outstanding - days
payable outstanding
 days’ inventory on hand →  cash conversion cycle.
5.  Total Asset Turnover And  in the Debt-To Assets Ratio

Due to  in total assets.
6.  The Debt-To-Equity Ratio
Since, Equity  to balance the  in inventory (assets).
7.  Gross Margin, Operating Margin, And Net Margin.
Due to an  COGS
8. The % decrease in net income > the % decrease in assets or equity.
Accordingly, there is  in ROA and ROE
• For periods following a write-down of inventory,
Inventory is reported on the balance sheet at the NRV,
  COGS due lower inventory carrying values.
Inventories 90
Thus, profitability  .
Along with the  in assets and equity from the previous period write-down, an 
in net income from lower COGS leads to ’s ROA and ROE in the following
periods.
LOS 38b: Calculate and explain how inflation and deflation of inventory costs affect
the financial statements and ratios of companies that use different inventory
valuation methods.
INFLATION DEFLATION
Rising prices and stable or increasing Falling prices and stable or increasing
inventory quantities quantities
LIFO COGS > FIFO COGS,  LIFO COGS < FIFO COGS, 
LIFO PROFIT < FIFO PROFIT. LIFO PROFIT > FIFO PROFIT.
 ↑ Tax & Cash Flow for FIFO V/S LIFO   Tax &  Cash Flow for FIFO V/S LIFO
Due to ↑ recent prices which are used for LIFO Due to  recent prices which are used for LIFO
COGS calculations COGS calculations
LIFO ending inventory < FIFO ending inventory, LIFO ending inventory > FIFO ending inventory,
As LIFO Inventory is valued at  older costs. As LIFO Inventory is valued at ↑ older costs.
↑ current ratio and working capital for FIFO ↑ current ratio and working capital for LIFO v/s
v/s LIFO FIFO
Notes:
➢ In case of stable prices, LIFO, FIFO & Weighted Average shall produce the same
results for inventory, COGS, and gross profit.
➢ FIFO inventory is made up of the most recent purchases. These purchase costs can
be viewed as a better approximation of current cost, and thus a better
approximation of economic value for ending inventory.
➢ LIFO COGS is based on the most recent purchases, LIFO produces a better
approximation of current cost (COGS) in the income statement.
Inventories 91
LOS 38c: Describe the presentation and disclosures relating to inventories
Inventory disclosures
• Inventory disclosures are normally found in the footnotes of the financial statement.
• They are required for comparative analysis within an industry.
• Required disclosures are similar under U.S. GAAP and IFRS.
• Requirements include:
1. The cost flow method (LIFO, FIFO, etc.) applied.
2. Total carrying value of inventory with classification under raw materials, work-in-
process, and finished goods, if suitable.
3. Carrying value of inventories reported at fair value − selling costs.
4. The cost of inventory recognized as an expense (COGS) during the period.
5. Total of inventory write-downs during the period.

Reversals of inventory write-downs during the period, including a discussion of the
circumstances of reversal (only IFRS)
6. Carrying value of inventories guaranteed as security.
Inventory Changes
• Change in inventory cost flow method is not common

• The changes of the new method if applicable is made in all the prior- period financial
statements.
• The collective effect of the change is recorded as an adjustment to the beginning
retained earnings of the earliest year presented.
• Under IFRS, the company needs to prove that the change will enhance the reliability
and relevancy of the information.
• Under U.S. GAAP, the company needs to clarify the need for changes in the cost flow
method.
• An exception to retrospective application applies when a firm changes to LIFO from
another cost flow method. In this case, the change is applied prospectively; no
adjustments are made to the prior periods. With prospective application, the carrying
General Electric applies LIFO for its U.S. inventory and FIFO for international.
Inventories 92
value of inventory under the old method simply becomes the first layer of inventory
under LIFO in the period of the change.
LOS 38c: Explain issues that analysts should consider when examining a company’s
inventory disclosures and other sources of information.
What are the issues that analysts should consider when examining a company’s inventory
disclosures and other sources of information?
• Reporting of Inventory on The Balance Sheet

In case of ready to sale inventory it is reported under one account on the balance
sheet
In case of manufacturing firms’ inventory is reported under 3 accounts (raw materials,
work-in-progress and finished goods) on the balance sheet.
• Signal of a Company’s Future Revenues and Earnings
Data published in the Management Discussion Analysis, financial statement
disclosures, economic data in regards to the business etc can be used as an indication.
For e.g.: A sign of higher raw materials and work in progress goods on the balance
sheet may indicate a future increase in demand → increase in revenues and earnings
However, a sign of rising finished goods v/s diminishing raw materials and work in
progress goods indicate a future decrease in demand → potential inventory write
downs.
• Relationship Between Sales and Finished Goods
 finished goods growing faster than  sales, indicates a slowdown in the demand
and presence of obsolete inventory/extra inventory.
Obsolete inventory →  inventory write down resulting into  NI.
Extra inventory →  storage, insurance costs etc. and usage of cash which could
otherwise be used elsewhere.
•  inventory turnover and  days on hand inventory is preferable
However, extremely high inventory turnover indicates less inventory on hand to meet
the current demand, leading to loss if revenue.
Further, high inventory turnover maybe an indicator of inventory write downs owing
to poor management of inventory.
• High inventory turnover coupled with comparatively slower sales growth may indicate
inadequate inventory quantities.
Long-Lived Assets 93
Long-Lived Assets
Exam Focus
• Understanding concepts like tangible assets, intangible assets, and financial assets
• Focusing on the choices in accounting made by firms and their effect on profits, ratios
and cash flow classifications.
• Calculate depreciation expense
• Understanding and evaluating the effects and issues under capitalization and
immediate expensing
• For capitalized costs, familiarize with the different depreciation and amortization
methods and assess asset impairment
• Focusing and learning revaluation (fair value) model under IFRS and the disclosure
requirements
LOS 39a: Compare the financial reporting of the following types of intangible assets:
purchased, internally developed, acquired in a business combination
What do you mean by Intangible assets and what are its types?
Intangible assets
• Assets that lack physical existence.

• Further divided into
a. Intangible assets with Finite lives (amortized) e.g.: patents, copyrights, and
franchises.
b. Intangible assets with Indefinite lives (tested for impairment at least annually)
e.g.: Goodwill
• They are also categorized as either
a. Identifiable asset (Patents, Copyrights, And Franchises)
Under IFRS, an identifiable intangible asset is required to be:
o Ability of being separated from the firm / arise from a contractual / legal right.
o Controlled by the firm.
o Expected to deliver future economic benefits
There must be reliability in measuring the cost of these identifiable assets.
b. Unidentifiable asset (Goodwill)
Cannot be bought separately and it can have an indefinite life.
Goodwill = purchase price - fair value of the identifiable assets, acquired in a
business transaction.
• All intangible assets are not reported on the balance sheet. Accounting for an
intangible asset depends on whether the asset was created internally, purchased
externally, or obtained as part of a business combination.
What do you understand by the accounting treatment for intangible assets under asset
that is created internally, purchased externally, or obtained as part of a business
combination?
Created Internally Purchased Externally Obtained As Part of a

Business Combination
Costs expensed when Bought from another party Under IFRS and GAAP.
incurred. Recorded on the balance sheet Acquisition method is used
Exceptions at cost
1. Research and Cost = fair value at the time of
Development costs purchase. If the intangible
(under IFRS), asset is purchased as part of a
2. Software Development group, the total purchase price
costs. is allocated to each asset on
the basis of its fair value.
Research Cost = Finding Analysts are more interested in Goodwill = purchase price -
new scientific or technical the kind of asset instead of the fair value of the net
information and evaluating monetary value on the balance identifiable assets
its success sheet.
Development Costs = For e.g.: If a pharma
Implementation of research For e.g.: If a pharma company company acquires a
findings in the form of a acquires a patent from the laboratory for ₹ 100 and
plan or design for new target company, the profits of the net identifiable assets
product the acquirer company rise in cost ₹ 95
the future. The ₹ 5 is the target
company’s goodwill.
Under IFRS, Only goodwill acquired via a

Research costs are business combination is
expensed capitalized.
Development costs can be
capitalized if the company
can prove that it can
complete the asset
successfully and further use
it for its own purpose or sell
it.
Under US GAAP, Internally generated
R&D costs are both goodwill is expensed in the
expensed, period incurred.
Exception Software
Development Costs
The costs incurred to create

a software for sale to others
are expensed as incurred
until the company proves
that the product is
technologically feasible.
Costs incurred for
developing a saleable
product post establishment
of technological feasibility
are capitalized.
Illustration
Wipro ltd established a new gaming software project on 1st April, 2019. By 30th June, 2019 it
was established that the software will be successfully completed and shall be in use as
thought. The company occurs a cost of ₹ 1,00,000 per month till March 31st ,2020. Calculate
the costs under IFRS and US GAAP before and after 30th June, 2019.
Solution
IFRS: Costs are expensed until the project feasibility and successful completion is proved
Expensed (1st April – 30th June) ₹ 3,00,000

Capitalized (1st July – 31st March) ₹ 9,00,000
US GAAP: Entire cost is Capitalized
Capitalized (1st April – 31st March) ₹ 12,00,000

1) Which of the following is most likely accurate:
A. Capitalized interest is reported in the income statement as interest expense.

B. The cash flow statement shows capitalized interest as an inflow from investing
activities.
C. When determining interest coverage ratios, an analyst should use both capitalized
and expensed interest.
2) Identify which of the following statements regarding intangible assets are most likely
correct.
I. An intangible asset with a finite life is amortized over its useful life.
II. An intangible asset with an indefinite life is tested for impairment.
III. If an indefinite-lived intangible asset is impaired, the loss is recognized in the
income statement.
A. Statements I & II
B. Statements I & III
C. Statements II & III
3) Which of the following statements about the treatment of research and development
costs under IFRS is the least likely to be correct:
A. Both research and development costs are treated as expenses incurred.

B. Development expenditures may be capitalized under IFRS.
C. The cost of research are treated as expenses incurred.
4) If a firm buys an asset with extremely unknown future economic benefits, the
company should:
A. Expense the purchase

B. Use an accelerated depreciation method
C. Use straight-line depreciation
5) The Rand Company depreciates its development expenditures immediately, whereas

the Fisk Company capitalizes its development costs. If everything else is equal, Rand
Company will:
A. Report higher asset turnover than Fisk Company.

B. Report higher operating cash flow than Fisk Company.
C. Show smoother reported earnings than Fisk Company.
Answers
1. C is correct. For an analyst, both capitalized and expensed interest should be used when
calculating interest coverage ratios
2. A is correct. All three statements are correct. Intangible assets are long-lived assets that
lack a physical presence. These assets include patents, copyrights, brand names, etc.
Finite-lived intangible assets are amortized over their useful lives, while intangible assets
with indefinite lives are tested for impairment. If impaired, the loss is recognized in the
income statement.
3. A is correct. Under U.S. GAAP, both research and development costs are generally
expensed as incurred
4. A is correct. If the future economic benefits of a purchase are highly uncertain, a company
should expense the purchase in the period it is incurred.
5. A is correct. As compared to a firm that capitalizes its expenditures, a irm that immediately
expenses expenditures will report lower assets. Thus, asset turnover (revenue / average
assets) will be higher for the expensing firm (lower denominator).
Impairment and Revaluation

Explain and evaluate how impairment and derecognition of property, plant, and
equipment and intangible assets affect the financial statements and ratios
In contrast to depreciation and amortisation charges, which serve to allocate the depreciable
cost of a long-lived asset throughout its useful life, impairment costs reflect an unexpected
drop in the value of an asset.
An asset is considered to be impaired when its carrying value exceeds its recoverable amount.
Impairment of Property, Plant and Equipment
What do you understand by impairment of assets?
Impairment Of Assets
An unexpected  in the asset value where impairment charges occur due to

Fair value falling below carrying value (FV < CV)
Despite both IFRS and U.S. GAAP requiring firms to report an impairment loss in the income
statement there are differences present in relation to the application of standards. This
includes:
IFRS US GAAP
Annual assessment to check for impairment Assets tested only when situation indicates
loss. For e.g.: that the firm may not be able to recover the
Decline in market value carrying value through future use.
Physical depletion of asset
Asset is impaired if: The 2 steps involved for determining whether
CV > Recoverable Amount an impairment exists and calculating the
Where, impairment loss are:
Recoverable amount is greater of: Step 1:
1. Fair Value (FV) – Selling Costs or Asset is tested for impairment via a
2. Value in use recoverability test.
Value in Use = PV future cashflow stream Where, recoverability test indicates
(from continuous use of the asset) impairment if:
CV > Future “undiscounted” cash flow
stream.
Since, undiscounted cashflows are involved
impairment requires substantial
management discretion.
Step 2:
For Impairment Loss
Balance sheet asset = FV (written down
value)
Income Statement = CV – FV
Discounted value of future cash flows is used
if the fair value is not known
Thus, if the asset is impaired, For impairment test: undiscounted cash

Balance sheet = Recoverable Amount flows are used
Income Statement = CV - Recoverable For impairment loss: fair value or the
Amount discounted future cash flows are used.
An impairment loss on an identifiable long- Loss recoveries are typically not permitted
lived asset (e.g.: building, machinery) can be
reversed if the asset regains value in the
future.
However, the loss reversal is limited to the
original impairment loss.
For e.g.: For e.g.:
The CV of a machinery is $1000 and the The CV of a machinery is $1000 and the Fair
recoverable amount is $700, an impairment Value is $700, Step 1
loss of $300 is reported in the Income impairment exists an impairment loss of $300
Statement, is reported in the Income Statement.
2 years later the machinery is valued at Step 2

$1100, 2 years later the machinery is valued at
A loss reversal of only $300 is recorded in the $1100
income statement instead of $400 as $1100 > No loss reversal is reported.
$1000 (original value)
In 2015, Microsoft recorded an impairment loss on goodwill and few more intangible assets in relation to the
2013 acquirement of Nokia. Primarily, Microsoft recognized goodwill (Nokia) at the value of $5.5 billion. The
book value of this goodwill and the total assets, were deemed to be overstated when compared to the fair
value. Since Microsoft was unable to capitalize the possible profits from the cell phone business, the company
recognized an impairment loss.
Illustration
In case of an electric furnace owned by Jindal Steel:

Cost= ₹ 3,00,000
Accumulated Depreciation= ₹ 65,000
Future cash flow = ₹ 2,30,000
Fair value = ₹ 2,20,000
Value in use = ₹ 2,05,000
Selling costs = ₹ 40,000
Test the furnace for impairment under IFRS and U.S. GAAP. Discuss.
Solution
IFRS US GAAP
CV = ₹ 3,00,000 - ₹ 65,000 CV = ₹ 3,00,000 - ₹ 65,000
CV = ₹ 2,35,000 CV = ₹ 2,35,000
Recoverable Amount (RA) = ₹ 2,05,000 Since, CV > Future cash flow
(Higher of FV-Selling costs & Value in Use) (₹ 2,35,000 > ₹ 2,30,000), impairment
exists.
Impairment treatment: Impairment treatment:
Balance sheet = ₹ 2,20,000 (RA) Balance sheet = ₹ 2,20,000 (FV)
Income statement = Impairment Loss Income statement = Impairment Loss
Impairment Loss = CV – RA Impairment Loss = CV – FV
Loss = ₹ 2,35,000 - ₹ 2,05,000 Loss = ₹ 2,35,000 - ₹ 2,20,000
Impairment Loss = ₹ 20,000 Impairment Loss = ₹ 15,000
Impairment of Intangible assets with Finite Life
Intangible assets having a finite life are amortised, which means that their carrying value
diminishes over time and may become impaired. These assets are not assessed for
impairment on an annual basis, but only when substantial events indicate that testing is
required. A big decline in market price or a negative shift in legal or economic causes are
examples of such situations. Intangible asset impairment losses affect both the carrying value
of the asset on the balance sheet and the net income on the income statement. Because
impairment loss is a non-cash item, it has no effect on cash flow from operations.
Impairment of Intangibles with Indefinite Lives
Intangible assets that have an indefinite life cycle are not amortised. Instead, they are
recorded on the balance sheet at historical cost and are evaluated for impairment at least
yearly. When the carrying amount exceeds the fair value, there is impairment.
Impairment for Long-Lived Assets Held for Sale
• If a company has an intention to sell their asset and the sale is highlt probable then it
is reclassified from held for use to held for sale and the asset is no longer depreciated
/ amortized and is tested for impairment.
• Impairment occurs when,
CV > Net Realizable Value (FV – Selling costs)
• In case of an impairment loss:
Balance sheet: Net realizable value
Income Statement: Impairment Loss (CV – Net Realisable Value)
• Loss reversal is permitted under both IFRS and US GAAP. The loss reversal is limited
to the original impairment loss.
• For e.g.: Building, equipment, land etc.
An Impairment loss for goodwill

Quess Corp, India’s largest staffing company, in 2019-20 with almost 25 acquisitions in the past 13
years, eliminated Rs 1,335 crores in goodwill assets and Rs 278 crores in intangibles. A one-time write-
off wiped out 40% of its investment.
Explain the derecognition of property, plant, and equipment and intangible assets.
Derecognition of assets (exclusion from B/S) takes place when assets are sold, exchanged, or
abandoned.
SALE OF AN ASSET Abandonment of the Asset Exchanged Asset
A Gain / Loss (Income The accounting treatment is Gain / Loss = Comparing

Statement) =The sale proceeds - identical to the one in case the CV of old asset v/s FV
The CV of asset of a sale of an asset but of old asset
there are no sale proceeds. (Or the fair value of the
new asset if that value is
more apparent).
In case of CFO calculated through Thus, Thus,
indirect method: Balance Sheet: (-) CV of Balance Sheet: (-) CV of old
Adjust net income by: Asset Asset
(--) Gain On Sale of Asset / Income Statement: Balance Sheet: (+) FV of
+ Loss On Sale of Asset Impairment Loss = CV. new Asset
as the proceeds from selling a
long-lived asset are an investing
cash inflow.
LOS 39c: Analyze and interpret financial statement disclosures regarding property,
plant, and equipment and intangible assets
What is the presentation and disclosures required for assets under IFRS?
Under IFRS, the company is required to disclose the following for every long-lived asset:
• Basis for measurement (usually historical cost).

• Useful lives or depreciation rate.
• Gross CV and accumulated depreciation.
• Reconciliation of carrying amounts from the beginning of the period to the end of
the period.
The firm must also disclose:
• Title restrictions and assets pledged as collateral.

• Contracts to acquire PP&E in the future.
If the revaluation (fair value) model is used, the firm must disclose:
• The revaluation dates.

• How fair value is evaluated.
• CV using the historical cost model.
Under IFRS, the disclosure requirements for intangible assets are similar to those for long -
lived, except that the company is required to disclose if the useful lives are finite or
indefinite.
For impaired assets, the firm must disclose:
• Value of impairment losses and reversals by asset class.

• Losses and loss reversals in the income statement.
• Conditions that lead to the impairment loss or reversal.
What is the presentation and disclosures required for assets under US GAAP?
Under US GAAP, the company is required to disclose the following for every long-lived
asset:
• Depreciation expense through period.

• Balances of major classes of assets by nature and function, such as land,
improvements, buildings, machinery, and furniture.
• Accumulated depreciation by major classes or in total.
• General description of depreciation methods used.

Under U.S. GAAP, the disclosure requirements for intangible assets are similar to long lived
assets. In addition, the company must provide an approximation of amortization expense
for the next 5 years.
For impaired assets, the firm must disclose:
• Particulars of the impaired asset.

• Situations that lead to the impairment.
• How fair value is evaluated.
• The value of loss.
• Losses in the income statement.
What do you analyse and interpret from the above stated disclosures about assets?
• Analysis and interpretation from disclosures include:

Assessment of an asset’s average life. Average life is important for:
a. Evaluating the older assets
Older assets make companies less competitive as they are less efficient and
produce lower output
b. To learn about the timing of core capital expenditures + forthcoming financing
requirements of the company
For e.g.: A company that has a machinery with an average life of 15 years depicts
that the machinery has aged and the company may have to incur expenses in the
near future either for replacing the machinery or modifying it.
• The amount of information provided in the footnote disclosures regarding fixed

assets and depreciation differs across companies, due to grouping by useful lives.
• Thus, the following methods of average age estimation, economic life, and
remaining useful life of a company’s assets can highlight issues for further
investigation.
• However, these calculations lack accuracy.
Which are the three important methods of calculations for an analyst?
AVERAGE AGE TOTAL USEFUL LIFE REMAINING USEFUL LIFE

Average Age = Total useful life = Remaining Useful Life =
Accumulated Depreciation/ Historical cost / Annual Ending Net Asset / Annual
Annual Depreciation Expense Depreciation Expense Depreciation Expense
Or
Total useful life – Average
age
Higher accuracy for companies Historical cost = Net Asset = Original cost
using straight-line Gross Asset before (gross asset) - AD
depreciation. subtracting accumulated
The calculation can be depreciation
remarkably affected by the
mix of assets (e.g.: goodwill,
machinery, desktops etc)
For e.g.: For e.g.: For e.g.:
Calculate the average life of a Calculate the total use life of Calculate the remaining life of
car with a yearly depreciation a car with a cost (excluding ₹ a car with a cost (excluding ₹
expense of ₹ 10,000 and an AD 15,000 of AD) 15,000 AD)
of ₹ 15,000 of ₹50,000 and depreciation of ₹50,000 and depreciation
Average age = AD/ expense of ₹ 10,000 expense of ₹ 10,000
Depreciation expense Total useful life = Historical Net asset = ₹ 50,000 – ₹
Average age = 1.5 years cost / Annual Depreciation 15,000
Expense = ₹ 35,000
= ₹ 50,000/₹ 10,000 Remaining Useful Life =
 Total useful life= 5 years Ending Net Asset / Annual
Depreciation Expense
= ₹ 35,000/₹ 10,000
Remaining Useful Life= 3.5
years
Or
Total useful life – Average age
= 5 years – 1.5 years
Remaining Useful Life= 3.5
years
Note: The ratio of annual capital expenditures to depreciation expense is another well-
known system of measurement. It provides material about whether the company is replacing
its asset at the same rate as the assets are being depreciated.
Illustration
A company spends ₹ 5 lakhs on physical capital everywhere. The yearly depreciation expense
being ₹ 3 lakhs per year under Straight line depreciation. Calculate the annual capital
expenditures to depreciation expense.
Solution
The annual capital expenditures to depreciation expense ratio
= ₹ 5,00,000/₹ 3,00,000
= 1.67
This shows that for every ₹ 1 of depreciation expense the capital expenditure is ₹ 1.67.
This is usually the situation in the early stage of a start-up
Illustration
As of 31st March, 2018, DHFL ltd has a building valuing ₹ 25,00,000 (gross).
Accumulated depreciation of ₹ 15,00,000. During the year, depreciation expense was
₹ 1,00,000. Calculate the average age, total useful life, and remaining useful life of the
company’s building?
Solution
METHOD CALCULATION TOTAL

Average Age = Average Age = Average Age =
Accumulated Depreciation/ Annual ₹ 15,00,000 / ₹ 15 years
Depreciation Expense 1,00,000
Total useful life = Total useful life= Total useful life=
Historical cost / Annual Depreciation ₹ 25,00,000/₹ 1,00,000 25 years
Expense
Remaining Useful Life = Remaining Useful Life = Remaining Useful Life =
total useful life – Average age 25 years – 15 years 5 years
Interpret how disclosures are used in analysis.

Ratios used in analyzing fixed assers include fixed asset turnover ratio and several asset age
ratios. The fixed asset turnover ratio which reflects the relationship between total revenues
and investments in PPE. The higher this ratio, the hgher the sales the company is able to
generate within a given investment of fixed assets. A higher fixed asset turnover is often
interpreted as an indicator of greater efficiency.
Assets age and remaining useful life, are important indicators of a company’s need to reinvest
in productive capacity. These ratios help the analyst in estimating the timing of major capital
expenditures and a firm’s future financing requirements.
The useful information for analysts are:
Average Age:
𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
This calculation is more accurate for a firm that uses straight-line depreciation.
Total Useful Life:
𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐𝑎𝑙 𝐶𝑜𝑠𝑡
𝑇𝑜𝑡𝑎𝑙 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒 =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
Historical cost = Gross PP&E before deducting accumulated depreciation.
Remaining Useful Life:

𝐸𝑛𝑑𝑖𝑛𝑔 𝑛𝑒𝑡 𝑃𝑃&𝐸
𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒:
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
Net PP&E = Gross PP&E – accumulated depreciation
1) According to U.S. GAAP, an asset is impaired when:
A. Accumulated depreciation plus salvage value exceeds acquisition cost

B. The firm cannot fully recover the carrying amount of the asset through
operations
C. The present value of future cash flows from an asset exceeds its carrying value.
2) Ratatouille Diners Inc., a hypothetical firm, sells 450 used pizza ovens and declares a
$1.2 million profit on the sale as a result of overhauling its menus to focus on
healthier food products. The ovens had a carrying value of $1.9 million (original cost
of $5.1 million minus depreciation of $3.2 million). How much did Ratatouille charge
for the ovens?
A. $0.7 million
B. $3.1 million
C. $6.3 million
3) Intangible assets having finite useful lives are typically treated differently than
intangible assets with infinite useful lives in terms of accounting treatment of:
A. Amortization
B. Costs
C. Revaluation
4) Identify the least appropriate statement regarding the revaluation of long-lived

assets.
A. Any subsequent increase in the fair value of long-lived assets is recorded in net
income as a revaluation surplus.
B. IFRS allows long-lived assets to be revaluated at their fair value, but US GAAP
does not.
C. Long-lived assets are reported under US GAAP at either their depreciated cost or
their fair value.
5) A company recently suffered a $15,000 loss on the sale of machinery that was
employed in its manufacturing process. The machinery was purchased for $100,000
and had accumulated depreciation of $60,000 at the time of sale. What was the
profit on the sale for th company?
A. $25,000.
B. $45,000.
C. $85,000.
6) Identify the most appropriate impact of impairment
A. The Return on Asset and Return on Equity improve when an asset is impaired,
while profit margins decline.
B. The Return on Asset, Return on Equity, and Profit Margin all decline when an
asset is impaired.
C. The Return on Asset ratio and profit margins decline when an asset is impaired,
but the Return on Equity increases.
7) A company owns and rents out a warehouse. The firm may record the value of this
asset on its balance sheet using the following IFRS formula:
A. The cost model or the fair value model.

B. The cost model or the revaluation model.
C. The revaluation model or the fair value model
8) According to IFRS, all of the following information about intangible assets must be
stated in a company's financial statements and footnotes, except the value of
intangible assets:
A. Amortization rate
B. Fair value
C. Impairment loss
9) What information must be given for investment properties using the cost model of
valuation under IFRS?
A. Reconciliation between beginning and ending carrying amounts of investment

property
B. The method for determining fair value
C. Useful lives
Answers
1. B is correct. An asset is impaired when the firm cannot recover the carrying value. Under
U.S. GAAP, recoverability is tested based on undiscounted future cash flows.
2. B is correct. The ovens had a carrying amount of $1.9 million, and Ratatouille recognized
a gain of $1.2 million. Therefore, Ratatouille sold the ovens at a price of $3.1 million. The
gain on the sale of $1.2 million is the selling price of $3.1 million minus the carrying
amount of $1.9 million. Ignoring taxes, the cash flow from the sale is $3.1 million, which
would appear as a cash inflow from investing.
3. A is correct. Whereas an intangible asset with a finite useful life is amortized, an intangible
asset with an indefinite useful life is not.
4. A is correct. US GAAP only allows long-lived assets to be reported at their depreciated cost
(Original cost of the asset - Depreciation allowance). IFRS permits the reporting of assets
at their depreciated cost or the fair value of long-lived assets if the active market of the
asset exists.
5. A is correct. Gain or loss is equal to the sale proceeds minus the carrying value (cost minus
accumulated depreciation) at the time of sale. Given the loss of $15,000 and carrying
value of $40,000 ($100,000 – $60,000), we can solve for the proceeds of $25,000 (–15,000
+ 40,000).
6. B is correct. If an asset is impaired, the loss is recognized in the income statement which
decreases ROA, ROE, and Profit margins.
7. A is correct. Under IFRS, the warehouse is classified as investment property because it is

owned primarily for rental income. Investment property may be reported using either the
cost model or the fair value model.
8. B is correct. IFRS do not require fair value of intangible assets to be disclosed.
9. C is correct. Under IFRS, when using the cost model for its investment properties, a
company must disclose useful lives. The method for determining fair value, as well as
reconciliation between beginning and ending carrying amounts of investment property, is
a required disclosure when the fair value model is used
Topics in Long-term Liabilities and Equity 109
Topics in Long-term Liabilities and Equity
Los 40a: Explain the financial reporting of leases from the perspectives of lessors
and lessees
Firms often purchase the rights to use assets outright. A lease, on the other hand, is a contract
that grants the right to use an item for a specified tenor in exchange for payment. The lessee
is the person who uses the asset and pays the consideration, whereas the lessor is the party
who owns the asset, provides the right to use the asset, and gets payment.
For e.g.:
The Tata Steel Plant land in Jamshedpur is leased from the Jharkhand government for 30
years. Here the Jharkhand government is the lessor and Tata Steel Plant is the lessee.
Leasing allows users to get the advantages of an item without having to buy it completely.
From the standpoint of a lessee, it is a type of financing that is similar to acquiring an asset
with a note payable. A lease is a type of investment for a lessor and may also be an efficient
selling approach because clients like to pay in instalments.
Requirements for Lease Accounting
For a contract to be a lease or contain a lease, it must
• Identify a specific underlying asset

• Give the customer the right to obtain largely all of the economic benefits from the
asset over the contract term
• Give the customer, not the supplier, the ability to direct how and for what objective
the underlying asset is used.
What are the advantages of leasing?
• Less costly financing

 Interest on loan maybe more than the interest on lease payment
 Low down payment
 For e.g. The interest rate for machinery purchase is 6.85% and the lease
payment bears a 5% interest.
• Less restrictive provisions
o Covenants are liberal in nature v/s the bond/loan agreements
• Less risk of obsolescence
 Since the lessee returns back the asset after its tenure, he doesn’t bear the loss
in value.
 For e.g.: A xerox machine is leased to a newspaper company for 5 years.
 After 5 years in case of the low efficiency of the machine the obsolescence cost
is borne by the lessor and not the lessee.
Lease Classification as Finance or operating

Financial reporting standards require a lease to be classified as a finance lease if it meets any
of the following 5 conditions:
1. Ownership of the leased asset transfers to the lessee.
2. The lessee has an option to buy the asset and is expected to exercise it.
3. The lease is for most of the asset’s useful life.
4. The present value of the lease payments is greater than or equal to the asset’s fair
value.
5. The lessor has no other use for the asset.
Operating leases are leases that are not categorised as financial leases.
Explain the financial reporting of leases from a lessee’s perspective.
Use IFRS and GAAP to explain the financial reporting of leases from a lessee’s perspective.
For IFRS all leases, with the exception of those that are short-term (up to 12 months) or of
low value (up to $5,000), require the lessee to record a right-of-use asset and a lease liability
on the balance sheet (both equal to the present values of the lease payments).
The right-to-use asset is amortised over the lease term, and the amount of amortisation for
each period is recorded on the income statement.
The lease liability is reduced each period by the decrease in the principal portion outstanding
that results from each lease payment.
Therefore, while booth the lease asset and liability begin with the same value and reach zero
at the end of the lease, they can have different values during the tenor of the lease. s
BASE IFRS
Balance sheet (B/S)1 Assets/Liabilities= PV (Lease Payments)
Assets here is not the leased property but the right to use it
Depreciation1 Over the tenure of the lease
Periodic lease payment Interest expense = income statement
treatment1 Periodic Principal payment =
 outstanding B/S liability
Short-term leases/ No B/S adjustment.
Low-value assets Directly expensed in Income statement (as rent expense) and
classified as CFO.
Note 1: For long term leases

FOR US GAAP
Under U.S. GAAP, a lease is either classified as a finance lease or an operating lease
Finance Lease Operating Lease

Risk and benefits of ownership of Risk and benefits of ownership of leased asset borne
leased asset borne by the lessee. by the lessor.
Similar to IFRS, No B/S adjustment.
Interest expense = income Rent directly expensed in Income statement
statement
Periodic Principal payment =
 outstanding B/S liability
Interest expense= CFO/CFF. The entire lease payment is recorded as a lease
expense on the income statement; there is no
separate interest expense reported. However, the
principal portion of an operating lease payment is
used to reduce the balance sheet lease liability
For e.g.: For e.g.:
Gym equipment, vehicles in When lease tenure is < 75% of the useful life of the
transport companies etc asset
Lease Classification for Lessee and Lessor:

Lessee
Quality for lease IFRS US GAAP

accounting
exemption?
Finance Leases Operating Leases

All Leases
Fortunately, lessor accounting under both IFRS and US GAAP is substantially identical, and the
differences in treatment for lessees are modest.
Illustration
Reliance Chemicals leases a fluid transfer machine from A Ltd from January 2017 for a period
of 3 years paying ₹ 120 at the start of every year. The fair value of the machine is ₹ 350 and
the interest rate is 12%. Assume a straight-line depreciation. Show the working treating the
transaction as a financial and operating lease.
Find:
a. Lease liability at end of every year
b. Total expense for every year
For financial lease

Calculate the PV of lease payments
CF0 =₹120
CF1, CF2= 120
I = 12 %
NPV = ₹ 322.8, ₹ 322.8 > 90% of the fair value ₹ 350, hence it can be categorised as a
finance lease.
Year Lease Lease Interest Total Reduction Lease

Liability Payment @12% expense In Lease Liability
(JAN) (Jan) [1] [2] [1] + [2] Liability (Dec)
[1] - [2]
2017 322.8 120 0 120 120 202.8
2018 202.8 120 24.34 144.34 95.66 107.14
2019 107.14 120 12.86 132.86 107.14 0
Where,
Lease Liability (Jan) = Lease Liability (Dec) previous year
Lease payment= ₹ 120 (given)
Interest @12% = Lease Liability previous year *12%
In year0 the interest is 0 since inception of the lease is in 2017.
Lease Liability (Dec)= Lease Liability (Jan) – Reduction in liability
For operating lease

Since operating lease is directly expensed it is not reported on the balance sheet,
Year Expense
2017 107.33
2018 107.33
2019 107.33
Where,
Expense = Depreciation Expense
= 322.8/3 = 107.33
As seen above,
In case of financial lease v/s operational lease
Financial Lease =  Initial Expense  Balance Sheet Values
(∵  Liability =  Interest Expense)
Operational Lease =  Initial Expense   Net Income in Initial Years
Explain the financial reporting of leases from a lessor’s perspective.

Use IFRS and US GAAP to explain the financial reporting of leases from a lessor’s
perspective
For IFRS: The classifications for lessors are:
Finance Lease Operating Lease

(−) Lease Asset and Lease receipt = income
(+) Lease receivable = PV (Lease payments) + Costs (e.g.: Depreciation) = expense
PV (Residual value of asset)
In case of the lessor being a manufacturer:
Profit/loss = Revenue (value of leased asset)
– COGS (CV asset)
Interest = Income in income statement
For US GAAP
A lessor will categorise a lease as a
1. Sales-type lease if:
It meets the transfer of ownership criteria =
Lease term > 75% useful life of asset,
PV = > 90% of fair market value
and collection of payments is judged to be probable.
2. Direct financing lease if:

• The transfer of ownership criteria is not met.
• A third-party guarantees (e.g.: an AMC) the residual value of the asset at the end
of the lease.
• Assured lease payments + the asset’s residual value ≥ Fair value of the asset.
3. Other leases under U.S. GAAP are classified as operating leases.

What is the financial treatment for the leases mentioned above?
Sales-Type Lease (GAAP) Direct Financing Lease Operating Lease (IFRS

Finance Lease (IFRS) (US GAAP Only) or GAAP)
Income Over life of lease: Over lease term Throughout the asset’s
Statement Revenue = interest Revenue = interest life
portion of lease portion of lease payments Revenue = lease
payments payments,
Revenue = Value of lease Expense = depreciation
receivable
COGS = CV of leased asset
Balance (−) Lease Asset and (−) Lease Liability Asset Leased asset remains
sheet (+) Lease receivable and
(+) Lease receivable
Cash Flow If the lessor’s primary If the lessor’s primary Entire lease payment =
business is leasing then business is leasing then CFO inflow
Principal portion = CFO, Principal portion = CFO,
otherwise, CFI inflow. otherwise, CFI inflow,
Interest portion = CFO Interest portion = CFO
(US GAAP),
= CFO/ CFI inflow (IFRS)
In 1973, the first ever leasing company of India called First Leasing Company of India was set-up. Their
main objective was to lease movable and immovable properties and financing.
Illustration
Reliance Chemicals has leased a fluid transfer machine to A Ltd from January 2017 for a
period of 3 years receiving ₹ 120 at the start of every year. The fair value of the machine is ₹
350 and the interest rate is 12%. Assume a straight-line depreciation. Show the working for
Direct Financing Lease.
Find:
a. Lease receivable liability at end of every year
b. Total expense for every year
Solution
Year Lease Lease Interest Total Reduction Lease
Receivable Payment @12% expense In Lease Receivable
(JAN) Received [2] [1] + [2] Receivable (Dec)
(Jan) [1] [1] – [2]
2017 322.8 120 0 120 120 202.8
2018 202.8 120 24.34 144.34 95.66 107.14
2019 107.14 120 12.86 132.86 107.14 0
Thus, from the above example we understand that the amounts for Financial Lease (US
GAAP) for lessee = Direct Financial Lease (US GAAP) for lessor
The only change is that Lease payable is replaced with lease receivable
LOS 40b: Explain the financial reporting of defined contribution, defined benefit, and
stock-based compensation plans
Employee Compensations
These packages are structured to achieve various objectives, including satisfying employees’
needs for liquidity, retaining and motivating employees. Common components of employee
compensation are salary, bonuses, health and life insurance premiums, defined contribution
and benefit pension plans, and share-based compensation.
Deferred Compensation
These compensations vests over time and can provide valuable retirement savings and
financial upside to employees and often serve as an effective retention and stakeholder
alignment tool for employers. Pensions and other postemployment benefit plans are a
common type of deferred compensation. Two common types of pension plans are defined
contribution pension plans and defined benefit pension plans.
DEFINED CONTRIBUTION PLANS DEFINED BENEFIT PLANS

Firm contributes a certain amount The firm promises to make payments every year to
every period to the employee’s the employee after retirement.
retirement plan.
Contribution can be based on a number Contribution is generally based on factors like the
of factors employee’s compensation at or near retirement,
For e.g.: % Of employee’s contribution, years of service etc
profitability, employee age, employee For e.g.: Contribution = 2% x last drawn salary of
compensation etc. employee x total years of service
2% x ₹ 10,000 x 25 = ₹ 5,000 promised by the

company to the employee every year.
No commitment is given by the The company promises timely payments by bearing
employer to the employee regarding all the risks. Thus, the investment decisions are at the
the future value of the planned assets employer’s discretion.
Thus, the investment decisions are left Since the employer (company) bears all the risks, the
at the employees’ discretion who portfolio of the promised planned assets is handed
thereby bear all the investment risk. over to a separate legal entity, usually a Trust. This
entity generates income to meet the planned
payments when they are due.
Pension expense is = employer’s The employer must estimate the value of the future
contribution, reported in the income pension benefit obligation (PBO) to its employees
statement. based on variables such as future compensation
levels, employee turnover, average retirement age,
No asset/liability is reported on the mortality rates, and an appropriate discount rate.
balance sheet as there is no future
liable payments that are promised.
If fair value of planned assets > Estimated PBO =
Overfunded plan
If fair value of planned assets < Estimated PBO=

Underfunded plan
Net Pension Liability (underfunded plan)/ Asset
(overfunded plan) is recorded on the Balance sheet.
Change in Net Pension Liability/Asset is recorded on
the income statement/ Equity via Other
Comprehensive Income (OCI).
Under US GAAP, while costs that are reported in OCI

are amortized (expensed) to the income statement.
Under IFRS, these costs are not amortized

Pension expense does not appear separately on the
income statement for manufacturing companies
since it is allocated to inventory and cost of goods
sold for employees who provide direct labour to
production and to salary or administrative expense for
other employees.
For e.g.: In USA, the 401(k) plans, 403(b) plans which
includes employee stock ownership plans, profit-
sharing plans, stock bonus plans are examples of
Defined Benefit Plan, where the employer promises
periodic payments.
Share Based Compensation

Share-based compensation in intended to align with the employees’ interests with those of
the shareholders and is another common type of deferred compensations. Unlike defined
pension plans which are usually available to all employees of the company, share based
payments are concentrated among more senior-level employees.
Both IFRS and US GAAP require a company to disclose in their annual report key elements of
management compensation. These disclosure help analysts understand the nature and extent
of the compensation.
These payments, in addition to aligning the interests of the employees with shareholders, has
the advantage of initially not requiring no cash outlay. However, as this is an employee benefit
expense, a reduction of earnings is recorded even when there no cash changes hands. In
contrast, issuing shares to employees dilutes existing shareholdings. Additionally, share based
payments may have limited influence over the company’s market value so share-based
compensation does not necessarily provide the desired incentives and may improperly
reward or punish employee performance. Another disadvantage is that increased ownership
may lead to managers being risk averse or excessive risk taking.
For financial reporting of share-based compensation plans, under both IFRS and US GAAP,
companies generally estimate the fair value of the share-based compensation at the grant
date and recognize it as compensation expense proportionately over the plan’s vesting
schedule. Any changes in the employee’s stock price after the grant date does not affect the
financial reporting.
Income Taxes 118
Income Taxes
Exam Focus
Due to the difference in Tax reporting and financial reporting standards, understanding terms
related to each set of standards like taxes payable, taxes that are actually due to the
government, and income tax expense that is recorded on the income statement (taxes
payable + deferred income tax expense) is important.
Creation of deferred tax liabilities (future payments) and deferred tax assets (future benefits)
for companies, due to a difference in timing of recognition (of income and expenditure).
Focusing on the differences (temporary and permanent) between taxable and pre-tax
income.
Calculating the above and making adjustments as necessary for analysis.
Tax Terms
LOS 41a: Contrast accounting profit, taxable income, taxes payable, and income tax expense
and temporary versus permanent differences between accounting profit and taxable
income
Due to a difference in accounting and tax regulations, the sum of income tax expense
recorded in the income statement may vary from the actual taxes payable to the taxing
authorities in a country.
Before we jump into why the differneces occur, lets get familiar with the terminology used.
Tax Return Terminology Financial Reporting

Teminolgy
Income for Tax Taxable Income: refers to Accounting Profit: refers to
Computation the part of a person's or a a corporate entity's financial
business's income that is profit earned within a given
subject to government accounting period based on
taxation. It computes the accounting rules. It is
amount on which taxes are computed by deducting all
charged by taking into revenue-generating
account different expenditures from total
deductions, exemptions, revenue received.
and credits authorised
under the tax code.
Value of an asset / liability Tax Base: The net amount Carrying Value: Net value of
of an asset or liability used an asset or liability in the
in tax reporting. balance sheet of a company
Deductions Tax Loss Carryforward: Valuation allowance: is a
allows taxpayers to use contra-asset account
their current or past tax created to reduce the
Income Taxes 119
losses to reduce their future carrying value of an asset

taxable income, thereby when there is doubt about
lowering their tax liability. its recoverability or ability
to be utilized.
Taxes Payable: refers to the amount of taxes that a company or an individual owes to the
tax authorities based on the taxable income for a given period.
Income Tax Paid: refers to the actual cash outflow made by a company or an individual to
settle their income tax liability.
Income Tax Expense: Income statement expense that comprises taxes payable and changes
in deferred tax assets and liabilities (DTA and DTL). The income tax expense equation is as
follows:
Income tax expense = taxes payable + ΔDTL − ΔDTA
Deferred tax liabilities: is created when income tax expense (income statement) is greater
than taxes payable (tax return) due to temporary differences hence are expected to reverse
and result in future cash outflows when the taxes are paid.
Deferred tax assets: is created when taxes payable (tax return) is greater than incime tax
expense (income statement) due to temporary differences. Just like DTLs, these are expected
to reverse but provide future tax savings.
Post-employment benefits, warranty expenses and tax loss carryforwards are typically causes
of deffered tax assets.
Permanent Differences: are differences between tax laws and reporting and accounting
standards that will not be reversed at some future date because of which these differences
do not lead to deferred tax assets or liabilities.
Instances like income or expense items not allowed by tax legislations, such as penalties and
fines that are considered expenses for financial reporting purposes, but are not deductible
fornta purposes would lead to permaenent differences.
Because no deferred tax item is created for permanent differences, all permanent differences
result in a difference between the company’s tax rate and its statutory corporate income tax
rate.
Income Taxes 120
Deferred Tax Liabilities and Assets

LOS 41b: Explain how deferred tax liabilities and assets are created and the factors
that determine how a company’s deferred tax liabilities and assets should be treated
for the purposes of financial analysis.
Explain the circumstances under which the treatment of an accounting item for tax
reporting and for financial reporting is different.
The difference between taxation and accounting treatment occurs:
a. Due to a difference in timing of revenue and expense recognition,
b. When certain incomes and expenses are recorded on the income statement and never
under tax return, vice-versa.
c. When there exists a difference in carrying values and tax bases for assets/liabilities in
the balance sheet.
d. When profit or loss reporting in the income statement varies from the tax return.
e. When tax losses from previous times offset future taxable income.
f. When financial statement modifications have no effect on the tax return/ are
recorded in different times.
Differentiate between deferred tax assets (DTA) & deferred tax liabilities (DTL).
DEFERRED TAX ASSETS (DTA) DEFERRED TAX LIABILITIES (DTL)

A DTA is created based on a temporary A DTL is created based on a temporary
difference where, difference where,
Taxes Payable (Tax Return) > Income Tax Income Tax Expense (Income Statement) >
Expense (Income Statement) Taxes Payable (Tax Return).
DTA arises when; DTL arises when;
1. Income (or profits) are taxable before 1. Income (or profit) is recorded in the
they are recognized in the income income statement before it is recorded
statement. under tax return due to temporary
2. Expenditure (or losses) are recorded differences.
in the income statement before they 2. Expenditures (or losses) are tax
are tax deductible. deductible before they are recorded in
3. Tax loss carry forwards are present to the income statement.
decrease the future taxable income.
DTA’s are supposed to reverse (since they DTL’s are supposed to reverse (since they are a
are a result of temporary differences) and result of temporary differences) and lead to
lead to future tax savings. future cash outflows when the taxes are paid.
In case of a company where;

taxable losses > taxable income, companies
can carry forward those extra losses and
Income Taxes 121
apply them to decrease the taxable income

(and taxes) in subsequent periods.
A DTA is mostly created due to; A DTL is mostly created when;

Post-employment benefits, warranty accelerated depreciation method is applied on
expenses, and tax loss carry forwards. the tax return and straight-line depreciation is
applied on the income statement.
For e.g.: For e.g.:
Balance sheet components like “bad debts” Bonus / commission payable to employees in
saying that Provision for bad debts created in line with Section 43B of the Income Tax Act”
the income statement cannot be deducted in which is tax deductible on a payment basis for
the tax return unless the corresponding tax return but is accounted for on accrual basis
Account receivables are deemed worthless on the income statement
In USA, since 2018 taxpayers can carry forward their DTA’s indefinitely.
When or will the total deferred tax liability be reversed in the future?
a. Suppose if DTL’s are expected to reverse in future, they are categorised under
liabilities by an analyst.
b. However, if they are not expected to reverse in future and are categorised as equity
(DTL  =  Equity).
c. However, for the treatment of deferred taxes for analytical purposes an analyst must
choose the correct treatment based on a case-by-case evaluation.
DTA Reversal leading to a loss in earnings

A realty giant, DLF recorded a combined net loss of ₹1,857.76 crore in the 4th quarter of 2019-20. The
core reason was a reversal of DTA due to adaptation of a lower tax rate. As a result the total earnings
fell to ₹ 6,884.14 crore in 2019-20 from ₹ 9,029.41 crore in the past fiscal year.
Income Taxes 122
1) Unused tax losses that are anticipated to be used in the future will:
A. Have no impact on tax assets nor liabilities.

B. Increase deferred tax assets
C. Increase deferred tax liabilities.
2) Deferred tax liabilities that are expected to reverse should be treated as:
A. Equity
B. Liabilities
C. Neither liabilities nor equity
3) When an analyst compares a company to its competitors, he or she is doing it

objectively. Because of accelerated depreciation for tax reasons, the company has a
deferred tax liability. The company is projected to continue to expand in the near
future. In terms of analysis, how should the liability be handled?
A. It should be treated as equity at its full value.

B. It should be treated as a liability at its full value.
C. The present value should be treated as a liability with the remainder being
treated as equity.
4) This year, the publisher gave a $300,000 advance to the author of a new textbook.
When the advance was received, $90,000 in income taxes were paid. The textbook
will not be completed until the next year. Determine the advance's tax basis at the
end of the year.\
A. $0.
B. $90,000.
C. $100,000.
5) When some expenditures result in tax credits that decrease taxes immediately, the
corporation is likely to keep track of:
A. A deferred tax asset.

B. A deferred tax liability
C. No deferred tax asset or liability
Income Taxes 123
6) Which of the statements below is the most accurate? The difference between the
taxes payable for the period and the tax expense recorded in the financial
statements is due to the:
A. Difference between basic and diluted earnings

B. Difference between financial and tax accounting.
C. Difference in management control.
Answers
1. B is correct. Unused tax losses expected to be used in future periods will increase
deferred tax assets.
2. B is correct. If the liability is expected to reverse (and thus require a cash tax payment)
the deferred tax represents a future liability
3. A is correct. The DTL is not expected to reverse in the foreseeable future because a
growing irm is expected to continue to increase its investment in depreciable assets, and
accelerated depreciation for tax on the newly acquired assets delays the reversal of the
DTL. The liability should be treated as equity at its full value.
4. A is correct. For revenue received in advance, the tax base is equal to the carrying value
minus any amounts that will not be taxed in the future. Since the advance has already
been taxed, $300,000 will not be taxed in the future. Thus, the textbook advance liability
has a tax base of $0 ($300,000 carrying value – $300,000 revenue not taxed in the
future).
5. C is correct. Tax credits that directly reduce taxes are a permanent difference, and
permanent differences do not give rise to deferred tax.
6. B is correct. The difference between taxes payable for the period and the tax expense
recognized on the financial statements results from differences between financial and
tax accounting.
Income Taxes 124
LOS 41c: Calculate, interpret, and contrast an issuer’s effective tax rate, statutory
tax rate, and cash tax rate
Income raxes payable are primarily determined by the geographic composition of taxable
income and the tax rates in each jurisdiction but can also be influenced by the nature of the
business. Some companies benefit from special tax treatment – for example Real Estate
Investment Trusts (REITs) are exempted from paying taxes if they distributed around 90% of
their earnings.
Differences in tax rates can be an important driver of value. Generally, three types of tax rates
are relavant to analysts:
• The statutory tax rate, which is the corporate income tax rate in the country in which
the company is domiciled.
• The effective tax rate, which is calculated as the reported income tax expense amount
on the income statement divided by the pre-tax income.
• The cash tax rate, which is the tax paid in cash that period (cash tax) divided by pre-
tax income
In USA, 5 regular permanent differences are penalties and fines, meals and entertainment, life
insurance proceeds upon death of an employee, interest on municipal bonds, and the special
dividends received deduction.
Income Taxes 125
Describe the valuation allowance for deferred tax assets—when it is required and what
effect it has on financial statements.
How can you explain valuation allowance for DTA’s? When is it needed? What effect does
it have on financial statements?
a. Although deferred taxes arise as a result of temporary differences, which are expected
to reverse in the future, neither DTA’s nor DTL’s are recorded on the balance sheet at
their discounted present value.
b. However, DTA’s are evaluated at every balance sheet date to verify the possibility of
adequate future taxable earnings to retrieve the tax assets.
c. In the absence of future taxable income, a DTA is insignificant.
d. Under U.S. GAAP, if there is a probability of 50% (or more), that a part of or all of a
DTA shall not be realized (future taxable income is not sufficient to retrieve the tax
asset), then the DTA must be reduced by a valuation allowance.
Where; valuation allowance = contra account,
It decreases the net balance sheet value of the DTA.
By;  valuation allowance → ’s the net balance sheet DTA,
As a result, income tax expense  and net income  .
e. Under IFRS, a parallel adjustment similar to the US GAAP is made, however;
Net amount of the DTA is recorded on the balance sheet.
The valuation allowance total is not presented separately.
In case of a change in the situation, the net DTA can be increased by reducing the
valuation allowance. This leads to  earnings.
f. Thus, the management controls and defends the realization of all DTA’s.
g. If a company has order accumulation or current contracts that are expected to realise
future taxable income, a valuation allowance may not be required.
h. However, in case of cumulative losses over the past few years/ history of incapability
in utilising tax loss carry forwards, the company needs to use a valuation allowance to
reflect the possibility that a DTA shall never be realized.
i. Since, an  in the valuation allowance →  in incomes,
management could influence the income by altering the valuation allowance.
j. Thus, an analyst must evaluate the company’s financial performance to determine the
probability that the substantial deferred tax assets, will be realized.
k. Further, analysts must also examine the changes in the valuation allowance to identify
if the changes are economically acceptable.
Income Taxes 126
Note: A valuation allowance account is only needed for DTA’s. For U.S. GAAP, DTA’s and DTL’S
are recorded separately on the balance sheet, generally at the gross value. (i.e. not netted
off)
For e.g.: if a firm has a $10 million valuation allowance to offset $10 million in DTAs, and
management realizes it's going to miss earnings by $2 million, it can make few aggressive
assumptions to decrease $2 million from its valuation allowance, which passes on to net
income and allows the company to meet earnings.
LOS 41d: Analyse disclosures relating to deferred tax items and the effective tax rate
reconciliation and explain how information included in these disclosures affects a
company’s financial statements and financial ratios.
Evaluate disclosures relating to deferred tax items and the effective tax rate reconciliation.
Explain how information included in these affect a company’s financial statements and
financial ratios.
Corporations mandatorily need to reveal the details on the source of the temporary
differences that cause the DTA’s and DTL’s. Fluctuations in these balance sheet items are
reflected under income tax expense as a part of the income statement.
For e.g.:
a. A DTL created due to adapting the accelerated depreciation for tax purposes and
straight-line depreciation for the financial statements. The analyst must contemplate
the company’s growth rate and capital expenditure levels when evaluating the
possibility of a reversal of differences.
b. Impairments usually lead to DTA because the write-down is realised immediately in
the income statement. However, the tax return deduction is usually not permitted
until the asset is sold/disposed.
c. Restructuring produces a DTA since, the costs are realized under financial reporting
when restructuring is declared. On the other hand, they are not subtracted under tax
return until actually paid. Remember that restructuring generally leads to substantial
cash outflows (net of the tax savings) in the years succeeding restructuring costs.
d. In USA, businesses that report under LIFO for their financial statements are needed to
report the tax returns under LIFO as well.Thus, there is no room for temporary
differences. However, in case of economies where there is no such requirement,
temporary differences could arise from the choice of inventory cost-flow method.
Income Taxes 127
e. Post-employment benefits and deferred compensation are recorded for financial

reporting when earned by the employee. However; they aren’t subtracted for tax
purposes until the costs are paid. This leads to the creation of a DTA that shall be
reversed when the benefits/compensation are paid.
f. A deferred tax modification is made to shareholders’ equity to mirror the future tax
impact of unrealized gains/losses on available-for-sale marketable securities that are
considered directly under equity. No DTL is included in the balance sheet for the future
tax liability when gains/losses are realized.
Typically, the following deferred tax information is disclosed:
a. Deferred tax liabilities, deferred tax assets, any valuation allowance, and the net
change in the valuation allowance over the period.
b. Any unrecognized deferred tax liability for undistributed earnings of subsidiaries and
joint ventures.
c. Current-year tax effect of each type of temporary difference.
d. Components of income tax expense.
e. Reconciliation of reported income tax expense and the tax expense based on the
statutory rate.
f. Tax loss carry forwards and credits.
Illustration
For 2017 and 2018, Microsoft ltd.’s income tax expense is greater than taxes payable.
Microsoft ltd, released in its footnotes to its 2018 financial statements, the major items
recorded as DTA & DTL’s (in millions of dollars), as given below:
Deferred Tax Disclosures in the financial statements include:
2018 2017
Amount ($) Amount ($)
Employee Benefit 350 400
Global Tax Loss Carry forwards 100 90
Subtotal 450 490
Valuation Allowance (50) (80)
DTA 350 320
PP&E 450 350
Unrealized profit on Available for sale 70 45
securities
DTL 500 400
Deferred income taxes 150 80
Interpretate the table given above to explain why income tax expense > taxes payable over
the last two years. Further, explain the effect of the change in the valuation allowance on
Microsoft’s’ income for 2018.
Income Taxes 128
Solution
The corporate’s DTA balance outcomes are from the global tax loss carry forwards and
employee benefits; arising from pension and other post-retirement benefit that are nullified
by a valuation allowance.
The corporate’s DTL balance is an outcome from PP&E; most probably from applying
accelerated depreciation methods for tax purposes and straight-line on the financial
statements and unrealized gains on securities categorised as available-for-sale since,
unrealized gain is not taxable until realized.
Income tax expense = taxes payable + deferred income tax expense.
Since, DTL’s have been growing faster than DTA’s, deferred income tax expense has been
positive.
Thus, this has led to an income tax expense being higher than taxes payable.
Management reduced the valuation allowance by $30 million in 2018. This led to a  in
deferred income tax expense and an  in reported income for 2018.
How can you analyse the effective tax rate reconciliation?
Few companies reported income tax expense varies from the amount calculated as per the
statutory - income tax rate.
The differences are usually a result of:
a. Dissimilar tax rates in different tax dominions.
b. Permanent tax differences: tax credits, tax-exempt income, non-deductible expenses,
and tax differences between capital gains and operating income.
c. Variations in tax rates and laws.
d. Deferred taxes on the reinvested income of foreign and unconsolidated domestic
affiliates.
e. Tax holidays in few economies (look out for special norms such as termination dates
for the holiday or a requirement to pay the accumulated taxes at some point in the
future).
Studying the differences between reported income tax expense and the amount depending
on the statutory income tax rate allows the analyst to improve forecasts with regards to
upcoming earnings and cash flow.
When forecasting upcoming earnings and cash flows, an analyst must study each element of
the reconciliation, including its comparative impact, how it has fluctuated with time, and how
it is probable to change in the future.
In analysing patterns in tax rates, it is vital to only consider reconciliation components that
are constant in nature rather than those that are irregular. Components including different
rates in different countries, tax-exempt income, and non-deductible expenses tend to be
constant.
Income Taxes 129
Other items are almost always irregular, such as the occurrence of large asset sales and tax
holiday savings. The disclosures of every financial statement must be reviewed based on the
footnotes and MD&A.
Illustration
Apple ltd. Is a global company. The corporation’s reconciliation between effective and
statutory tax rates for 2 years is given below.
Interpretate the trend in effective tax rates over the two years given.
2019 2020
Statutory U.S. federal income tax rate 30% 30%
State income taxes, net of related 2% 2.2%
federal income tax benefit
Benefits and taxes related to foreign (7%) (6.8%)
operations
Tax rate changes 0% 0%
Capital gains on sale of assets 0% (2%)
Special items (2%) 4%
Other, net 0.6% 0.5%
Effective income tax rates 23.6% 27.9%
Solution
As seen above, the effective tax rate is upward trending over the 2-year horizon. Contributing
to the upward trend is a rise in the state income tax rate and the loss of benefits related to
taxes on foreign income.
In 2020, a loss in relation to the sale of assets was partially nullified by an increase in taxes
created by special items. In 2019, the special items and the other items also offset each other.
The special items and other items being so unpredictable over the 2-year period advocates
that it will be difficult for an analyst to forecast the effective tax rate for Apple ltd, for the
upcoming future without additional information. This volatility also reduces peer
comparability.
Income Taxes 130
1) The information in the table below was collected from Shield Company's financial
accounts. Determine the company's effective tax rate for the year 2017 using the
provided.
Financial Years 2017 Financial Years 2016
(Amount in $) (Amount in $)
Income before taxes 90,000 75,000
Tax Payable 15000 10000
Deferred Tax Assets 70,000 50,000
Deferred Tax Liabilities 30,000 20,000
A. 0.056
B. 0.0625
C. 0.1193
D.
2) At the end of the current period, a U.S. GAAP reporting firm reports an enhanced
valuation allowance. What impact will this have on the firm's current-period income
tax expense?
A. Decrease
B. Increase
C. No effect
Answers
1. A is correct.
Income Tax Expense
Effective Tax Rate = Pre−tax Income
Income tax expense = = Income tax payable + Change in DTL − Change in DTA
15000 + (30000 − 20000) − (70000 − 50000) = 5000
5000
Effective tax rate = 90000 = 0.056 = 5.56%
2. B is correct. Recognizing a greater valuation allowance reduces the net value of a

deferred tax asset, which increases income tax expense in the current period.
Financial Reporting Quality 131
Financial Reporting Quality
Exam Focus
• Focussing on the overall quality of the company’s financial reports. These reports are
determined by the quality of a company’s financial statements and quality of financial
reporting.
• Focusing on how accounting choices can affect reported earnings, financial position,
and categorisation of cash flows.
• Interpretating the additional disclosures required when non-GAAP events are
reported and analysing the warning signs of management manipulation.
Reporting Quality
LOS 42a: Compare financial reporting quality and quality of reported results (including
quality of earnings, cash flow, and balance sheet items).
Differentiate between the financial reporting quality and quality of reported results.
FINANCIAL REPORTING QUALITY
Relationships between Financial Reporting Quality and Earnings Quality
Financial Reporting Quality

Low High
HIGH financial reporting

quality enables assessment.
High HIGH earnings quality
Earnings LOW financial reporting increases company value.
(Results) quality impedes assessment
Quality of earnings quality and HIGH financial reporting
Low impedes valuation. quality enables assessment.
LOW earnings quality
decreases company value.
a. Financial reporting quality includes features of a company’s financial statements.

b. Basis for judging reporting quality;
It involves compliance to GAAP as per the country where the company operates.
However, this compliance does not necessarily indicate highest reporting quality by
itself (since the GAAP prescribes various choices of methods, estimates and specific
treatment of many items.
c. Basis for high reporting quality
It must be decision useful; which includes relevance and faithful representation
a. Relevance representation requires reporting to be:
Useful for users of financial statements

Material i.e.; relevant information can affect the decisions of users of financial
statements
b. Faithful representation requires reporting to be: Complete, neutral, and absence
of errors.
Quality Spectrum of Financial Reports
GAAP, decision useful,

Sustainable, and
adequate returns
GAAP, decision useful, but sustainable?

Low “earnings quality”
Within GAAP but biased choices
Within GAAP, but
“earnings management” (EM)
-Real EM
-Accounting EM
Non-compliant
Accounting
Fictitious
transactions
QUALITY OF EARNINGS
a. Quality of earnings includes the quality of reported earnings and not the quality of
earnings reports.
b. Basis for judging quality of earnings includes;
Sustainability of earnings, cashflows and level of earnings.
1. Sustainable earnings is earning that is recurring and consistent in the long-term.
➢ Earnings, as a result of better efficiency and larger market share are

sustainable in the long term.
Thus, profit through high quality of earnings is more valuable than an
equivalent profit through low quality of earnings.
 High probability of high quality of earnings in the future has a better impact
on the value of a company. Estimated earnings are calculated as the present
value of expected future earnings.
➢ Earnings, reported from either sale of assets or forex fluctuations is not
sustainable in the long term.
Thus, a onetime profit from such transactions has a smaller impact on the
company value and estimated future earnings.
2. Importance of sustainability in cash flows in order to determine the value of

balance sheet components.
➢ Insufficient accruals for liabilities (e.g.: accrued employee wages, accrued
interest payable etc), or
➢ Overstatement of assets (e.g., using straight line depreciation method instead
of accelerating method) can decrease the quality of earnings and affect the
sustainability as well.
3. Importance of high level of earning includes;

➢ Sustainability in company’s operations
➢ Survival of the company in the long-term
➢ Provide substantial return to the company’s investors; both equity and debt
holders.
As seen above financial reporting can be GAAP compliant but when combined with low
quality of earnings it can lead to issues in relation to sustainability.
LOS 42b: Describe a spectrum for assessing financial reporting quality.
Explain the range for assessing financial reporting quality

On one hand we have high compliance (GAAP) of financial reporting and high quality of
earnings (sustainable), and
On the other hand, we have financial reporting that is fictitious (fraudulent). In case of such
low financial reporting, the analysis for quality of reported earnings gets difficult. Thus, by
incorporating both financial reporting quality and quality of reported earnings we can
categorise the range for earnings from best to worst.
For instance; one of the possible ranges from best to worst includes:
1. Reporting is compliant with GAAP; earnings are sustainable.
For e.g.: earnings based on sustainable sources like larger market share and are GAAP
compliant.
2. Reporting is compliant with GAAP, but low earnings quality (lacks sustainability).
For e.g.: Financial reporting that is complaint with GAAP but lacks sustainability due
to the basis of sources like sale of assets.
3. Reporting is compliant with GAAP, but earnings quality is low and reporting choices
applied are biased For e.g., aggressive choices like acceleration method of
depreciation and conservative choices like straight line depreciation
4. Reporting is compliant with GAAP, but the amount of earnings is actively managed to
increase, decrease, or smooth reported earnings
For e.g.: deferring expenditures or changing accounting estimates etc.
5. Reporting is not compliant with GAAP, however; the reporting quality is based on the
company’s actual economic activities.
6. Reporting is not compliant with GAAP and quality of earnings is basically fictitious or
fraudulent. For e.g.: Off balance sheet accounts, substantial advances to
employees/CFO, no disclosure for related party dealings
Satyam Scam of 2009.

Satyam computer services was an IT firm based in Hyderabad, India. It was discovered by CBI that
the company back in 2009 had inflated the company revenue by $1.5 billion through falsified
margins, statements of cash flows and revenue.
revenues.
LOS 42c: Explain the difference between conservative and aggressive accounting.
What is the difference between conservative and aggressive accounting?

Conservative and aggressive accounting practices are used to smooth earnings over time.
➢ In case of higher-than-expected reported earnings for an accounting year;
conservatism approach can be applied to the accrued liabilities for this period.
➢ Accrued liabilities are adjusted upward to reduce the current period income.
➢ This way we defer the current period earnings for later years and smooth the current
period earnings.
➢ This is referred as putting the excess earnings in a “cookie jar” (future benefits).
CONSERVATIVE ACCOUNTING AGGRESSIVE ACCOUNTING

Meaning
These accounting practises tend to These accounting practises tend to
 the company’s earnings,  the company’s earnings,
 financial position (balance sheet values);  financial position (balance sheet values);
for the current period, and for the current period.
 company earnings and financial position  company earnings and financial position
in the later years. in the later years.
Few Management decisions to smooth earnings under conservative and aggressive

accounting include:
Expensing current costs
Capitalizing current costs
Accelerated depreciation; Straight-line depreciation;
Thus, a shorter estimation of useful lives Thus, a longer estimation of useful lives and
and lower amounts for salvage values larger estimated amounts for salvage
values.
Early recognition of impairment for assets Delayed recognition of impairment for
like goodwill and trademarks. assets like goodwill and trademarks
More provisions for bad debt, i.e.;
delaying the recognition of bad debt Less provisions for bad debt, i.e.; immediate
expense. recognition of bad debt expense.
Larger valuation allowances on DTA’s. Smaller valuation allowances on DTA’s.
Note: Bias is present in case of financial representation as well. Companies can either present
financial statements in a transparent manner or provide minimum disclosures only.
Neither conservatism or aggressive accounting is good/bad; they both lack faithful
representation.
Under conservatism, there is a reduction in current period tax liability through lower earnings.
What are the higher standards introduced by GAAP to introduce conservatism?
Under GAAP, sometimes conservatism is introduced by imposing higher standards for
verification of revenue and profit versus expenses or losses.
For e.g.:
a. Due to uncertainty about the benefits from research costs; these costs are generally
expensed in the period of occurrence, and revenue is not recognized until some future
period.
b. The procedure for accrual of liabilities is less strict (recorded when future payment
becomes “probable”) than for increasing the asset values.
c. Inventory write-downs are recorded when decrease in value is probable; however
upward valuation of inventory is not realised until actually sold.
For e.g.: In case of invention of android replacing NOKIA,
A write off in the inventory for NOKIA phones was recorded as the probability for NOKIA
failure increased with the rise in android phones.
However, an upward valuation in the inventory value may only be recorded if the market
value (when phones are actually sold) exceeds the carrying amount.
Describe motivations that might cause management to issue financial reports that are not
high quality.
What is the driving force that causes management to issue financial reports that are not
high quality?
Management prefer aggressive accounting:
To meet their targets of a specific EPS, and
Realising earnings greater than:
a. Initial earnings direction offered by management.
b. Analyst estimations.
c. Previous year earnings.
The cause for such preferences is;

a. Incentive based compensation (bonuses) that depends on investor returns,
b. Improving the image of the company in the market, and
c. To avoid debt covenants for debt driven companies.
Note: In case of reported earnings > benchmark levels, managers tend to make conservative
accounting choices in order to defer the benefits.
Thus, this deferral increases the probability of higher future period earnings versus the
benchmark.
LOS 42d: Describe motivations that might cause management to issue financial
reports that are not high quality and conditions that are conducive to issuing low-
quality, or even fraudulent, financial reports
Explain the conditions present to induce low-quality financial reports.

The 3 factors that promote fraudulent reports are:
1. As seen earlier, the causes for motivations are mentioned in the above LOS.
2. Opportunities include:
• Weak internal controls for a business.
• Insufficient attention provided by the board of directors.
• Accounting standards with a wide range of acceptable accounting treatment.
• Trivial fees in case of fraudulent accounting.
3. Rationalization includes:
Reasons for unethical doings.
For e.g.: “I need the bonus for paying back my debt”, “COVID has affected the company”
etc.
LOS 42e: Describe mechanisms that discipline financial reporting quality and the
potential limitations of those mechanisms.
Explain the systems that are in charge of disciplining financial reporting. Also describe their
limitations.
• In every economy there exists a regulatory body that not only overlooks the publicly
traded securities but also regulates the markets in which these securities trade.
• Few regulatory bodies include:
a. The Securities and Exchange Commission (SEC) in USA.
b. SEBI in India.
c. The International Organization of Securities Commissions (IOSCO) that manages
securities regulation on a global platform with over 200 individual regulatory
country members.
For e.g.: the European Securities and Markets Authority (ESMA), manages the
policies among the securities regulators of countries in the European Union.
• The requirements under securities regulations include:

a. A registration process in order to issue new publicly traded securities (e.g.:
prospectus in an IPO).
b. Detailed disclosures and reporting requirements that comprises periodic financial
statements and accompanying notes (e.g.: footnotes, manager’s discussion and
analysis, etc)
c. Adherence to accounting standards guaranteed by an independent audit body i.e.;
when board of directors have no influence on the auditing body.
d. A statement of financial condition (or management commentary) made by
management.
e. A signed statement by individuals in charge of fair reporting of statements.
f. Regular reviews after registration to keep in check if the rules are followed.
g. Disclosures in case of private financing, like those with lenders. It is needed to
calculate the value of loan covenants
h. Further in case of USA disclosures with regard to the efficiency of internal
management control is also needed.
• Imposition by securities regulators include fines, suspension of participation in
issuance and trading of securities, and public disclosure of the results of disciplinary
proceedings.
• Regulators can also move forward with criminal prosecution of fraudulent or
otherwise illegal activities.
Note: Unbiased audit opinion is not an assurance that no fraud has occurred, it only offers
reasonable assurance that the financial reports have been reported fairly with respect to their
jurisdiction’s GAAP.
The independent auditor is selected and paid by the audited company.
Nirav Modi scam: Money laundering via Punjab National Bank mixed with bureaucratic corruption.
Using the bank instrument letter of understanding (LOU’s), Nirav Modi was able to launder crores of
public money. In February 2018 Punjab National Bank (PNB) levied charges of criminal conspiracy
worth 280 crores.
LOS 42f: Describe presentation choices, including non-GAAP measures, that could be
used to influence an analyst’s opinion.
Which are the presentation choices that could influence an analyst’s opinion?
Companies shall sometimes report accounting measures which are not required by GAAP.
Non-GAAP measures involves; exclusion of some items in order to make the company’s
performance look better versus reporting under GAAP.
Certain components like different non-cash charges for different peer companies, non-
recurring components like gain from sale of land, etc are excluded since they are one-time or
nonoperating costs that shall not affect the operating earnings in future and for non-cash
charges, exclusion is necessary to improve comparability with companies that use different
accounting methods.
For USA, businesses that apply non-GAAP measures for their financial statements are
required:
a. Present the most comparable GAAP measure.
b. A management disclosure of why a non-GAAP measure better.
c. To reconcile the dissimilarities between the non-GAAP measure v/s comparable GAAP
measure.
d. Disclose other purposes of a company for presenting non-GAAP measure.
e. Remember to include in any non-GAAP measure, any items that are likely to re-occur
in the future, even those treated as nonrecurring, unusual, or infrequent in the
financial statements.
In case of businesses using non-IFRS measures in financial reports, requirements include:
a. Explain the relevance of such non-IFRS measures.
b. Reconcile the variations between the non-IFRS measures v/s comparable IFRS
measure.
Thus, companies apply the non-GAAP measures to diminish the barriers involved
under GAAP.
LOS 42g: Describe accounting methods (choices and estimates) that could be used to
manage earnings, cash flow, and balance sheet items.
Explain the accounting procedure that can be used for managing earnings, cash flow and
balance sheet components.
Accounting procedures include:
Revenue Recognition
For timing of revenue recognition:
a. In case of ownership title;
A firm may choose Inco-terms such as FOB (Shipping point)- recognising revenue when goods
are shipped or FOB (destination)- recognising revenue when goods reach the customer’s
location or destination.
Recognising revenue at the time of shipment (FOB- shipping point) indicates an early
recognition of revenue versus revenue recognised at the time of delivery (FOB- Destination).
Accelerating or delaying the recognition of revenue
For accelerating revenue,
In times of lower than estimated earnings; companies can offer discounts and other benefits
to increase orders in the current year, OR
Channel stuffing where more goods than would normally be sold are shipped to traders in a
certain distribution channel OR
Bill-and-hold where an invoice is drawn for the goods sold however, they are shipped at a
later date (if revenue recognition is based purely on billing)
Thus, income for current period rises (  orders and corresponding revenue) and
Income for later years falls (shipment  however no revenue is recorded)

For delaying revenue,
In times of higher than estimated earnings; companies may delay their recognition of high
earnings to the following period by delaying/holding shipments.
Thus, income for current period falls ( revenue recognition) and

Income for later years rises (actual recognition of revenue on shipment of goods).
Estimates of Credit Losses

For provision of bad-debts/credit losses,
In case of lower probability of bad debts,
As we know a provision for credit loss a/c offsets the account receivables a/c on the balance
sheet.
A  in the estimation of bad debt leads to;
 in the account receivable account,

 bad debt expense in the income statement and   net income.
Thus, an overestimation of losses leads to recording higher net income for the current
period.
The opposite effects occur in case of higher estimation for bad-debt.
An underestimation of losses leads to recognition of lower net income for the current period.
In case of higher/lower reported earnings
For higher-than-expected reported earnings management  the bad debt reserve, and
For lower-than-expected reported earnings management  the bad debt reserve.

Hence, management can modify reserves to smooth revenues.
Other reserves like warranty reserves too can be modified in a similar way to smooth
revenues.
Valuation Allowance
As we know valuation allowance reduces carrying value of DTA’s, based on the probability
that it shall not be recognised.
A  in the estimation of valuation allowance leads to;
 in the DTA,
  net income.
The opposite effects occur in case of lower estimation for valuation allowance.
Depreciation Methods and Estimates
For accelerating v/s straight line method
Under accelerating method of depreciation, for initial years of an asset;
 Depreciation expense →  net income,

Further carrying value of the asset decreases faster under accelerating depreciation versus
straight line depreciation.
For estimation of salvage value
 estimated salvage value slows down depreciation which leads to:

 carrying value of the asset,  depreciation expense and  net income.
The opposite effects occur in case of lower estimated salvage value.
For estimation of useful life:
 estimated useful life of an asset leads to:

 depreciation expense and  net income in the initial years of the asset’s life.
The opposite effects occur in case of shorter estimated useful life.
Amortization and Impairment
For amortization
Amortization of intangible assets is similar to the depreciation part stated above.
For impairment
Impairment of assets like goodwill can be recognised early (periods of  earnings)/delayed

(periods of  earnings) to smooth earnings
Inventory Method
Choice of Inventory
In case of FIFO versus weighed average method of inventory valuation;
In times of rising prices;
COGS (FIFO) < COGS (weighted average)
Gross profit, earnings & balance sheet value for FIFO is higher versus weighted average.
The opposite happens in times of falling prices;
COGS (FIFO) > COGS (weighted average)
Gross profit, earnings & balance sheet value for weighted average is higher versus FIFO.
In terms of relevance and accuracy,
For Balance sheet, FIFO will be preferred, since the reported inventory value is closest to the
current market prices.
For Income Statement, Weighted Average will be preferred, since COGS calculated is closest
to the current costs which reflects the economic reality of profit margins and earnings.
Related-Party Transactions
In case of a company that does business with a supplier company where the management has
some control, earnings can be manipulated by shifting the earnings between companies.
Capitalization
Expenses that appear on the balance sheet can be expensed in the net income over a long
period of time.
Other Cash Flow Effects
Manipulating cash flows for higher CFO
Stretching payables:
For achieving higher values of CFO, management delays payments to the creditors thereby
increasing their CFO for the current period and reducing the CFO for the subsequent periods.
No change is recorded in the income statement for the current period and it is constant in
nature.
Capitalization and cash flow.
When expenses are capitalized, the complete value is classified as a CFI thus, CFO increases
by that value.
Further under IFRS the freedom to allocate interest and dividend cashflow as CFI/CFO and
CFF/CFO, respectively leaves room for management manipulation of cash flows.
Case study on related party transactions
Back in early 2000’s, in Hong Kong, publicly listed infrastructural development companies had
a master services agreement in which associate companies used to provide all services from
construction to engineering to security to guarding, to one another.
However, these related party agreements lacked transparent disclosure and also these
agreements could negatively affect the value of minority shareholders.
For e.g.: A surplus cash investment by a listed company in an unlisted parent company for a
long tenure. This leads to a loss in value for minority shareholders. These are opportunities
missed by shareholders to earn higher returns via strategic investments.
Warning Signs
LOS 42h: Describe accounting warning signs and methods for detecting manipulation
of information in financial reports.
Explain the various accounting warning signs.

Presence of warning signs doesn’t indicate fraudulent accounting practises, however; 1 or
more warning signs indicate a requirement for further analysis.
In case of a negative analytical result, one must avoid investing in such companies.
The list for several warning signs includes:
Revenue Recognition
a. Variations in revenue recognition methods, e.g.: recognising revenue at the end of
project or via percentage of completion method.
b. Adapting bill-and-hold transactions.
c. Constant dealing in barter agreements, i.e., no cash flows involved.
d. Constant utilisation of discounting on goods that lead to an impact estimation needed
on net revenue. For e.g.: different percentages of discounts used on the same goods
all throughout the year.
e. Lack of transparency in relation to the revenue recognition of the different parts of a
customer order.
For e.g.: Absence of substantial disclosures in the footnotes, management discussions.
f. Revenue grows at a much faster pace as compared to the industry competitors.
g. Constant reduction in account receivable’s turnover and total asset turnover,
specifically in case of a company that is growing through acquisition of other
companies.
h. Inclusion of non-operating items or significant one-time sales in revenue. For e.g.:
Profit from sale of land.
Inventories
a. Constant fall in inventory turnover ratio.
For e.g.: Lower inventory ratio can lead to stock obsolesce, poor cash flow etc.
b. LIFO liquidations (US GAAP only)
It leads to lower levels of inventory on the balance and lower COGS (through costs of
old inventory) on the income statement, thus manipulating a higher net income.
Capitalization Policies
a. Firm capitalizes costs that are not typically capitalized by firms in their industry.
Relationship of Revenue and Cash Flow
a. The ratio of operating cash flow to net income is persistently less than one or declining
over time.
Other Warning Signs
a. Completely out of line with respect to depreciation methods, estimated useful asset
lives or salvage values with those of industry competitors.
b. Last -quarter earnings varies with that of the earnings of the industry
For e.g.: A company that has recorded a profit equivalent to the peers for 3 quarters
and records a lower profit in the last quarter, further analysis is required.
c. In case of a substantial related party transaction in the company.
For e.g.: transaction related to purchases or sales of goods, property and other assets.
Rendering or receiving of services, leases etc.
d. Expenses that are categorised as onetime but appear repeatedly in financial reports.
For e.g.: loss due to fire, write-off of a company’s division, etc.
e. Gross and operating margins for a company > industry competitors.
f. Lack of transparent management discussions and footnote disclosures.
g. Earnings manipulation through non-GAAP earnings measures and use of aggressive
practices.
For e.g.: Use of accelerating method of depreciation instead of straight line.
Growth via constant acquisitions leads to difficulty in comparable analysis of future
depreciation and amortization.
1) Financial reporting is most likely to be decision useful when management’s

accounting choices are:
A. Aggressive.
B. Conservative
C. Neutral
2) Which of the following would most likely indicate that a corporation is attempting to
transfer current spending to later periods through aggressive accrual accounting
policies? Over the last five years, the cash flow to net income ratio has:
A. Decreased each year

B. Fluctuated from year to year
C. Increased each year
3) Which of these is least likely a reason for a firm to overstate its net income?
A. To meet analysts' earnings expectations

B. To minimize incentive compensation
C. To remain in compliance with lending contracts.
4) Which of the following is a sign that a business is recognizing income too soon? In
comparison to its competitors, the firm's:
A. Asset turnover is decreasing

B. Day’s sales outstanding are increasing
C. Receivable’s turnover is increasing
5) With respect to conditions that may lead to low-quality financial reporting,

ineffective internal controls are best described as:
A. Motivation
B. Opportunity
C. Rationalization
6) Which of the following could be a red flag that financial statements have been
tampered with?
I. Non-recurring costs that are classified as excessive in the income statement.

II. A net profit of 3% in the first three quarters, followed by an 18% net profit in the
fourth quarter.
III. The number of outstanding sales days was 25. For the industry, the figure was 75
days. Customers usually pay once the company's design is authorized by the
customer's construction team, which usually takes 4-5 months.
A. I & II
B. I, II & III
C. III.
7) Bias in revenue recognition would least likely be suspected if
A. Revenue is recognized before goods are shipped to customers

B. Reported revenue is higher than the previous quarter
C. The firm engages in barter transactions
8) Inappropriate capitalization in the current period is most likely to:
A. Overstate revenues
B. Understate expenses
C. Understate liabilities
9) In the spectrum of financial reporting quality, which of the following financial reports
is considered to be of the lowest quality?
A. Reporting is compliant with GAAP, and earnings are sustainable but inadequate
B. Reporting is compliant with GAAP, but earnings quality is low
C. Reporting is not compliant with GAAP, but earnings are based on the firm's
actual economic activities.
10) This alternative is explored when earnings are raised by deferring research and
development (R&D) investments until the next reporting period:
A. Earnings management as a result of an accounting choice

B. Earnings management as a result of a real action
C. A non-compliant accounting
Answers
1. C is correct. Financial reporting is most likely to be decision useful when accounting
choices are neutral. Either aggressive or conservative accounting choices by management
may be viewed as biases.
2. A is correct. If the ratio of cash flow to net income for a company is consistently below 1
or has declined repeatedly over time; this may be a signal of manipulation of information
in financial reports through aggressive accrual accounting policies. When net income is
consistently higher than cash provided by operations, one possible explanation is that the
company may be using aggressive accrual accounting policies to shift current expenses to
later periods.
3. B is correct. To MAXIMIZE incentive compensation would be a reason a firm chooses to

overstate its net income.
4. B is correct. If a company's days sales outstanding (DSO) is increasing relative to

competitors, this may be a signal that revenues are being recorded prematurely or are
even fictitious. There are numerous analytical procedures that can be performed to
provide evidence of manipulation of information in financial reporting. These warning
signs are often linked to bias associated with revenue recognition and expense
recognition policies
5. B is correct. Ineffective internal controls are a condition that provides an opportunity for
low quality financial reporting.
6. B is correct. All three cases may have a considerable impact on the conclusion that the
analyst draws about the company. When looking at a company's financial statements,
analysts should pay close attention to revenue, inventories, capitalization policies and
deferred costs, and the relationship between cash flow and net income. Other potential
warnings signs may include a large difference between the depreciation method and
estimated useful life of the company, fourth-quarter surprises, and one-time sales
included in revenue.
7. B is correct. Bias in revenue recognition can lead to financial report information being
manipulated. To evaluate if there is bias in revenue recognition, it is not enough to ask
whether revenue is higher or lower than the preceding period. Additional analytical
techniques must be carried out in order to detect warning signs of accounting fraud.
Barter transactions are difficult to value correctly, which can lead to revenue recognition
bias. Policies that make it simpler to recognize revenue before goods are distributed to
customers, for example, could be a red flag for accounting fraud.
8. B is correct. Management may make inappropriate capitalization decisions to understate

expenses by creating balance sheet assets for items that should instead be recognized as
expenses in the current period, increasing net income in the current period. Revenues and
liabilities are unlikely to be affected by capitalization decisions.
9. C is correct. A quality spectrum provides a basis for evaluating quality reports and ranges
from reports of high financial reporting quality and reflect high and sustainable earnings
quality to reports that are not useful due to poor financial reporting quality. According to
the quality spectrum of financial reporting, a firm that does not comply with GAAP is of
the lowest quality. At the bottom level of the quality, spectrum is a company displaying
fictitious transactions. Right above it is financial reporting which departs from GAAP.
10. B is correct. - Deferring research and development (R&D) investments into the next
reporting period is an example of earnings management by taking a real action.
Financial Analysis Techniques 149
Financial Analysis Techniques

Exam Focus
⮚ Focusing on not just calculating but also understanding and interpretating the ratios like
whether a higher or lower value which is better.
⮚ Importance of understanding and differentiating between components like total liabilities,

total interest-bearing debt, long-term debt, creditor and trade debt.
⮚ Focus on understanding and interpretating the ratio correctly rather than focusing on the
calculation method.
⮚ The DuPont formula along with decomposing ROE etc is extremely Important analytical tool
and trick.
⮚ Understanding the tools and techniques used in financial analysis including their uses and
limitations.
Introduction to Financial Ratios

LOS 43a: Describe tools and techniques used in financial analysis, including their uses and
limitations.
Explain the tools and techniques and their uses and limitations used in financial analysis.
For financial analysis tools and techniques are used to convert financial statement data. Tools and
techniques include ratio analysis, common-size analysis, graphical analysis, and regression analysis.
A. Ratio Analysis
Ratios are required for analysing cross company and internal progress. Ratios are required to
identify questions rather than answering questions.
Uses of ratios include the following:
⮚ Estimate the future revenue and cash flow.
⮚ Measuring a company’s financial stability in case of an unforeseen circumstance.

For e.g.: Measuring the company’s capability to meet liabilities during Covid 19
⮚ Evaluate management’s performance. For e.g.: keeping a check on the internal

working of a company.
⮚ Over time measure the changes in the company and industry over time.
⮚ Cross company analysis within the industry.

Limitations for ratio analysis include:
⮚ Financial ratios are only useful when compared amongst companies or through its
historical performance. It has no value when evaluated on a standalone basis.
⮚ In case of companies using different accounting treatments comparing ratios gets

difficult, adjustments need to be made. For e.g.: Comparing US reporting firms v/s
non-US reporting firms.
⮚ Difficulty in finding a common ground for comparative analysis in case of companies
functioning in multiple industries. For e.g.: Reliance industries, Tata ltd etc
⮚ Analysis is incomplete until all ratios are taken into consideration; thus, relative
valuation is required.
⮚ Finding the correct range and value for comparison is difficult, requiring some severe
digging and individual analysis. For example: The correct debt level for every
company is different. Start-ups can be more debt driven versus mature companies.
Further, the correct definition of ratio varies across analysts just like the correct acceptable
value (e.g.: debt to equity level). For e.g.: Few analysts use all liabilities when calculating
leverage, while others only make use of interest-bearing liable components.
B. Common-Size Analysis
Much easier median to relatively compare performances of companies within the industry
and applicable for standalone analysis as well.
⮚ In case of a vertical common-size balance sheet all balance sheet components are
presented as a percentage of total assets.
⮚ In case of a vertical common-size income statement all income statement components

are presented as a percentage of sales.
Besides comparative and timely analysis, common-size analysis is needed for identifying
certain standalone financial ratios. For e.g., gross profit margin, operating profit margin, and
net profit margin.
Note: Vertical common-size income statement ratios are very useful for interpretating trends
in costs and profit margins.
a. Vertical common-size income statement ratios = income statement item/sales
b. Vertical common-size balance-sheet ratios = balance sheet item / sales.
For e.g.:
Pepsi Co, Inc

Income statement
Years ended December 25, 2010 and December 26, 2009
(dollars amounts are in millions)
2010 2009
Amount Percent Amount Percent
Net sales $57,838 100% $43,233 100%
Cost of goods sold $26,575 45.9% $20,099 46.5%
Gross margin $31,263 54.1% $23,133 53.5%
Selling & $22,814 39.4% $15,026 34.8%

administrative
expenses
Other operating $117 0.2% $63 0.1%

expenses
Operating income $8,332 14.4% $8,044 18.6%
Interest expense $903 1.6% $397 0.9%
Other income $785 1.4% $399 0.9%

(expenses; net)
Income before $8,214 14.2% $8,046 18.6%

taxes
Income tax $1,894 3.3% $2,100 4.9%

expense
Net income $6,320 10.9% $5,946 13.8%
As seen above,
From 2009 to 2010, the net gross margin for Pepsi company has risen from 53.5% to 54.1%,
however due to rising operating expense from 0.9% to 1.4% the net income for the company
has fallen from 13.8% to 10.9%.
Figure 24.1: Vertical Common Size Balance Sheet and Income Statement
Balance sheet 2016 2015 2014
Assets
Cash & cash equivalents 0.38% 0.29% 0.37%
Accounts receivable 5.46% 5.61% 6.20%
Inventories 5.92% 5.42% 5.84%
Defered income taxes 0.89% 0.84% 0.97%
Other current assets 0.41% 0.40% 0.36%
Total current assets 13.06% 12.56% 13.74%
Gross fixed assets 25.21% 23.79% 25.05%
Accumulated depreciation 8.57% 7.46% 6.98%
Net gross fixed assets 16.74% 16.32% 18.06%
Other long time assets 70.20% 71.12% 68.20%
Total assets 100% 100% 100%
Liabilities
Accounts payable 3.40% 3.40% 3.79%
Short term debt 1.00% 2.19% 1.65%
Other current liabilities 8.16% 10.32% 9.14%
Total current liabilities 12.56% 15.91% 14.58%
Long term debt 18.24% 14.58% 5.18%
Other long term liabilities 23.96% 27.44% 53.27%
Total liabilities 54.76% 57.92% 73.02%
Preferred equity 0.00% 0.00% 0.00%
Common equity 45.24% 42.08% 26.98%
Total liabilities & equity 100% 100% 100%

Figure 24.2: Horizontal Common - Size Balance Sheet Data
2014 2015 2016
Inventory 1.0 1.1 1.4
Cash and marketable 1.0 1.3 1.2

securities
Long term debt 1.0 1.6 1.8
Pp&e (net depreciation) 1.0 0.9 1.4
As seen above,
Trends can be identified from the horizontal common size balance sheet in order to
understand the historic value of the company. The first year is the base year and the value of
1 is denoted to it.
While the inventory values clearly depict a rising ratio the constant rise in the long-term debt
and the inconsistent cash and marketable value need to be analysed more significantly to
know where the company stands.
C. Graphical analysis
A visual representation of financial data comparisons combined with the representation of
company performance.
It is further divided into:
1. Stacked column graph /stacked bar graph

The changes in financial components are presented on an annual basis in graphical form.
2. Line graph
The same financial data is presented in a line format.
For e.g.:
As seen above,
In both the charts an increase in trade payables and decrease in cash are apparent. These
issues would warn the analyst to possible liquidity problems, thus leading to further detailed
analysis.
D. Regression analysis
Regression analysis could be used for identifying relationships between variables. The results
are many times used for forecasting. For e.g., The relationship between GDP and sales could
be used by analysts to prepare a sales forecast.
Financial Ratios, Part 1

LOS 43b: Classify, calculate, and interpret activity, liquidity, solvency, profitability, and
valuation ratios
Explain and mention the different categories of financial ratio?
Financial ratios include:
a. Activity ratios.
Activity ratios comprises asset utilization or turnover ratios like inventory turnover,
receivables turnover and total assets turnover. These ratios indicates the level of internal
management of certain assets.
b. Liquidity ratios.
Liquidity here is the capability to meet short-term obligations as and when they are due.
c. Solvency ratios.
These ratios indicate a company’s leverage position and its capability to meet long-term
obligations.
d. Profitability ratios.
These ratios indicate a company’s ability to generate exorbitant operating profits and net
profits from its sales.
e. Valuation ratios.
Ratios such as sales per share, earnings per share, and price to cash flow per share are used
for relative valuation of companies.
Note: There is no fixed category or criteria set for financial analysis.
For e.g.: In case of an activity ratio like payables turnover, it also provides data about the
liquidity of a company. Each analyst has his own method and way of interpretation.
While some ratios are more or less the same under every method some differ drastically.
Explain Activity Ratios?
Activity Ratio
It measures the efficiency of a company in managing its assets.
It includes:
a. Receivable’s turnover
Receivable’s turnover = annual sales ÷ average receivables
Desirable Value = close to industry average
Note: In case of such ratios where one component is from the income statement and the
other is from the balance sheet, balance sheet component is always averaged.
Average value = beginning + ending ÷ 2.
b. Days of sales outstanding

Days of sales outstanding/average collection period is the inverse of receivables turnover
times 365 days.
It measures the average number of days that the company debtors take to pay back the
company. Thus, average time it takes for credit sales to turn into cash sales.
Days of sales outstanding = 365 ÷ receivables turnover

Desirable value = close to the industry norm and company’s credit norms.
As compared to the industry;
A very high ratio indicates a very slow customer payback ratio which leads to excess money
getting blocked in assets.
A very low ratio indicates extremely fast customer paybacks and also indicates rigorous
company payback policy which further hampers the sales.
c. Inventory turnover
A measure of company’s efficiency in terms of managing and producing inventory.
Inventory turnover = cost of goods sold ÷ average inventory
d. Days of inventory on hand

Days of inventory on hand/average inventory processing period/number of days of inventory
= 365 ÷ inventory turnover.
Desirable value = close to industry norm

As compared to the industry,
A very high ratio indicates an extensive use of capital which signals the presence of obsolete
inventory. A very low ratio may signal an existence of inadequate stock which hampers the
sale.
e. Payable’s turnover
This ratio measures the total amount trade credit used by a company.
Payable’s turnover = purchases ÷ average trade payables
Note: In order to calculate purchases;
Purchases = ending inventory – beginning inventory + cost of goods sold.
f. Number of days payables

Also known as payables payment period is the inverse of payable’s turnover multiplied by 365
days. It calculates the average amount of time that the company takes to payback its bills to
the creditors.
Number of days payables = 365 ÷ payables turnover ratio
Note: In case of turnover ratios for a quarter instead of a year, the division value must be
number of days in the quarter in order to get “days” form of these ratios.
Total asset turnover

It measures the efficiency of a company in generating revenue by maximising the use of total
assets.
Total asset turnover = revenue ÷ average total assets

Desirable value: close to industry norm. For e.g.: capital intensive industries like
manufacturing units have turnover ratios nearing one while retail businesses have turnover
ratios as high as almost 10.
On the other hand, low turnover ratios indicate that too much capital is tied up in the asset
base.
Similarly, a very high ratio either indicates that the assets are obsolete or the assets base is
not sufficient for potential sales.
g. Fixed asset turnover

It measures the utilisation of fixed assets. Desirable value: close to industry norm.
Fixed asset turnover = Revenue/ average fixed assets
For e.g.: capital intensive industries like manufacturing units have turnover ratios nearing one
while retail businesses have turnover ratios as high as almost 10.
On the other hand, low turnover ratios indicate that too much capital is tied up in the asset
base. Similarly, a very high ratio either indicates that the assets are obsolete or that capital
expenditures are required in the future to meet growing revenues.
Note: In case of recently acquired firms, the fixed asset turnover ratios are low since “net” in
the given ratio refers to net of “accumulated depreciation”.
h. Working capital turnover ratio

Working capital turnover= revenue ÷ average working capital
Where,
Working capital/net working capital = current assets – current liabilities
This ratio gives us an insight on dollars of sales per dollar of working capital
In case of Low working capital due to; outstanding payables ≥ inventory and receivables,
It leads to very large working capital turnover and the information can be misleading.
Explain liquidity ratio.
These ratios aid in determining the company’s ability to pay back short-term liabilities.
a. Current ratio
Current ratio = current assets ÷ current liabilities
Desirable value = the higher the better, a ratio of < 1 indicates negative working capital and
probably the company is facing a liquidity crisis.
b. Quick ratio
It is a very rigid measure of liquidity.
It excludes inventories and other assets that may not be very liquid.
Quick ratio = cash + marketable securities + receivables ÷ current liabilities
Desirable value = the higher the better
For e.g.: Marketable securities are good credible short-term debt instruments.
c. Cash ratio
Most conservative ratio
Cash ratio = cash + marketable securities ÷ current liabilities
Desirable value = the higher the better
Note: The current, quick, and cash ratios only differ in the assumed liquidity by analysts to
calculate sufficient liquidity to pay off current liabilities
d. Defensive interval ratio

It is a measure of liquidity where the number of days of cash expenditures (average) that the
company could pay with its current liquid assets is calculated.
Defensive interval = cash+ marketable securities+ receivables ÷ average daily expenditures
Where;
Expenditures include cash expenses for COGS, SG&A, and research and development.
If these costs are included;
Similar to cash flows by the indirect method, noncash charges such as depreciation should be
added back.
e. Cash conversion cycle

It is the total time undergone to turn the company’s cash investment in inventory back into
cash, via collections from the sales of that inventory.
Cash conversion cycle = (days sales outstanding) + (days of inventory on hand) - (number of
days of payables)
High cash conversion cycles are not desirable. A high conversion cycle indicates that the
company has an excessive amount of capital investment in the sales process.
Financial Ratios, Part 2

What do you mean by solvency ratios?
Solvency ratios
Calculates the company’s financial leverage and capacity to meet its long-term obligations.
It includes:
Debt ratios: Based on balance sheet

Coverage ratios: Based on income statement
Thus, the ratios are:
a. Debt-to-equity
It includes fixed-cost financing sources of a company
Debt-to-equity = total debt ÷ total shareholders’ equity
Where;
Total debt = long-term debt + interest-bearing short-term debt.
Increases (decreases) in this ratio indicate a greater (lesser) reliance on debt as a source of
financing.
Note: Under total debt few analysts include the present value of lease obligations and/or non-
interest-bearing current liabilities, such as trade payables.
b. Debt to capital ratio
Debt-to-capital ratio= total debt ÷ total debt + total shareholders’ equity
Where;
Capital = all short-term and long-term debt + preferred stock and equity. Increases (decreases)
in this ratio indicate a greater (lesser) reliance on debt as a source of financing.
c. Debt-to-assets
Debt-to-assets ratio = total debt ÷ total assets
Increases (decreases) in this ratio indicate a greater (lesser) reliance on debt as a source of
financing.
d. Financial leverage ratio/leverage ratio
Financial leverage = average total assets ÷ average total equity
Where;
Average is average value at the beginning and at the end of the period.
 debt financing =  financial leverage =  risk to equity holders and bondholders alike.
Following are the remaining risk ratios that help in defining the company’s ability to payback its debt
obligations.
a. Interest coverage ratio

Interest coverage = earnings before interest and taxes ÷ interest payments
Desirable value = The higher the better.
b. Debt service coverge ratio

EBIT ÷ Interest + Debt to be repaid
c. Debt-to-EBITDA ratio
As depreciation and amortization are not cash expenses. We have other ratios which also
includes;
Debt-to-EBITDA ratio: total debt ÷ EBITDA
d. Fixed charge coverage ratio:

Fixed charge coverage = EBIT + lease payments ÷ interest payments + lease payments.
Where,
lease payments are added back as lease obligations will reduce this ratio drastically as
compared to the interest coverage ratio.
This ratio is more insightful for companies that lease a large portion of their assets e.g.:
airlines.
Note: In calculating these ratios consider the variability of a company’s cash flow, as generally
companies with stable cash flows able to carry more debt.
What do you understand by profitability ratios?

It measures the company’s overall performance relative to its revenues, assets, equity, and capital.
For instance;
In case of operating profitability ratios, it calculates the capability of management in turning their
efforts into profits. Operating ratios compare sales to profits.
The relation between sales and the different profitability’s can be seen below:
Net sales
- Cost of goods sold
Gross profit
- Operating expense
Operating profit (EBIT)
- Interest
Earnings before taxes (EBT)
- Taxes
Earnings after taxes (EAT)
+/- Below the line item adjusted for tax

Net income
- Preferred dividends
Income available to common
Few terms mentioned in profitability ratios include:
⮚ Gross profits = net sales – COGS

⮚ Operating profits = earnings before interest and taxes = EBIT
⮚ Net income = earnings after taxes but before dividends
⮚ Total capital = long-term debt + short-term debt + common and preferred equity
⮚ Total capital = total assets
Note: The difference between these two definitions of total capital is the working capital liabilities,
such as accounts payable; it depends on the analyst’s measurement method.
The ratios include:
a. Net profit margin

Net profit margin = net income ÷ revenue
A very low ratio is considered alarming.
Where;
Only net income from continuing operations must be considered as items such as
discontinued operations do not affect the company in the future.
b. Gross profit margin

It is the ratio of gross profit (Sales - COGS) to sales:
Gross profit margin = gross profit ÷ revenue
A very low ratio is considered alarming. Gross profit could be improved by raising sales prices
or reducing COGS. However, due to competition increasing price is limited.
c. Operating profit margin
It is the ratio of operating profit (gross profit – SG&A expenses) to sales. Operating profit is
also referred to as earnings before interest and taxes (EBIT)
Operating profit margin = operating profit/EBIT ÷ revenue
A very low ratio is considered alarming. EBIT includes some nonoperating items, such as gains
on investment.
Further, few analysts like to calculate the operating profit margin by adding back non-cash
expenses like depreciation and any amortization thus getting to EBITDA. Thus, an analyst must
be consistent in his calculation method and know how published ratios are calculated.
d. Pre-tax margin
It is calculated by subtracting interest from EBIT /operating income.
Pre-tax margin = EBT/ revenue
Further; profitability ratios that measure profitability relative to funds invested in the
company by common stockholders, preferred stockholders, and suppliers of debt financing
e. Return on assets (ROA)
Usually;
Return on assets (ROA) = net income ÷ average total assets.
However; it is a bit misleading, as Interest is excluded from net income but total assets include
debt and equity. Thus, interest expense that should be added back is gross interest expense,
Adjusted return on assets (ROA) = net income + interest expense (1 – tax rate) ÷ average total
asset.
f. Operating return on assets
It includes both taxes and interest in the numerator
Operating return on assets = operating income / EBIT ÷ average total asset
g. Return on total capital (ROTC)

Return on total capital =EBIT ÷ Average total capital
Where;
Total capital includes short- and long-term debt, preferred equity, and common equity.
A very low ratio is considered alarming. An alternative method for computing ROTC is to
include the present value of operating leases on the balance sheet as a fixed asset and as a
long-term liability. For that are dependent on operating leases as a major form of financing
this type of calculation is important.
h. Return on equity (ROE)
Return on equity = net income ÷ average total equity
A very low ratio is considered alarming. It is also called as return on total equity.
i. Return on common equity:
Return on common equity = net income – preference dividend / net income available to
common ÷ average common equity
A very low ratio is considered alarming. This ratio differs from the return on total equity in
that it only measures the ratio pertaining to common stockholders as a whole, instead of
common and preferred stockholders.
Thus, preferred dividends are deducted from net income in the numerator. Further; The
return on common equity is often more analysed more definitely using the DuPont
decomposition.
Illustration
For 2020, using the company information provided, calculate: current ratio, total asset turnover,
return on common equity, and total debt to equity.
A’s Company
Year 2020 (₹) 2019 (₹)
ASSETS
Cash and marketable securities 100 90
Receivables 200 190
Inventories 300 290
Total current assets 600 570
Gross property, plant, and 1000 800

equipment
Accumulated depreciation 300 200
Net property, plant, and 700 600

equipment
Total assets 1300 1170
LIABILITIES
Payables 100 90
Short-term debt 150 140
Current portion of long-term debt 300 250
Total current liabilities 550 510
Long-term debt 300 250
Deferred taxes 100 90
Retained earnings 150 120
Common shareholders’ equity 200 200
Total liabilities and equity 1300 1170

A Company’s Income Statement for 2020
Particulars Amount (₹)
Sales 1000
COGS 500
Gross profit 500
Operating expenses 100
Operating profit 400
Interest expense 50
Earnings before taxes 350
Taxes 50
Net income 300
Common dividends 100
Solution
A. Current ratio = current assets / current liabilities

Current ratio = 600/550
Current ratio = 1.01
B. Total asset turnover = revenue/average assets
Total asset turnover = 1000/ (1300 +1170÷2)
Total asset turnover = 0.809
C. Return on equity
Return on equity = net income/average common equity
Return on equity =300/ (200+200 ÷ 2)
Return on equity =150%
D. Debt to equity ratio
Debt to equity = total debt / total equity
Debt to equity = 300+150+300/200
Debt to equity =3.75
Illustration
From the table given below interpret the ratios and give a detailed analysis.
2020 2019 2018
Current ratio 2.00 1.75 1.01
Quick ratio 0.3 0.4 0.5
Days of inventory 70 40 30
Days’ sales outstanding 15 25 30
Solution
⮚ In case of current and quick ratio:

It has risen with the quick ratio simultaneously falling. Thus, this could be a result of either
the inventories increasing or current assets except inventories falling.
⮚ In case of days of inventory and days sales outstanding. The rise in days of inventory on one
hand indicates rising inventories depicting the opposing trends in the current and quick
ratios.
⮚ The fall in days’ sales outstanding shows that the company has been collecting cash from
clients faster than it had been in the past. Thus, combining these ratios, we get that the
company may be rushing its cash collections to compensate for the liquidity crunch arising
from poor inventory management.
1) An analyst is assessing Star Manufacturing's solvency and liquidity and has gathered the
following information (in million Euros):
FY3 FY2 FY1
Total debt 7000 5000 3000
Total equity 3000 3500 5000
Which of the following would be the analyst's most likely conclusion?
A. From FY1 to FY3, the company's debt-to-equity ratio increased from 0.6 to 2.33,
indicating that it is getting increasingly insolvent.
B. From FY1 to FY3, the company's debt-to-equity ratio increased from 0.6 to 2.33,
indicating that it is getting more liquid.
C. The debt-to-equity ratio increased from 0.33 to 0.36 from FY1 to FY3, indicating that the
corporation is becoming less liquid.
2) Which of the following statements is most likely correct?
A. The activity ratio is a metric for determining the amount of an asset or flow that is linked
to the ownership of a specific claim.
B. The activity ratio measures how well a corporation manages its day-to-day operations.
C. The activity ratio, which measures the efficiency of operations, is not important for
financial statement analysis.
3) An analyst gathered the following information for a small company reporting under IFRS:
Revenue $570,000
Cost of sales ($100,000)
Average inventory $75,000
Average trade receivables $95,000
The days of sales outstanding (DSO) is closest to: if the number of days in a year is believed
to be 360.
A. 26
B. 40
C. 60
4) Which of the following is the least likely reason for a decrease in inventory turnover ratio?
A. Change in fashion.
B. Increase in the number of distributors
C. Obsolescence of technology.
5) An analyst who is interested in a company's long term solvency would most likely examine
the:
A. Defensive interval ratio

B. Fixed charge coverage ratio
C. Return on total capital
6) Which of the following is the most likely explanation for a rise in receivables turnover?
A. Last year, the company implemented new credit criteria and began providing credit to
consumers with poor credit records.
B. The company had accrued a significant quantity of uncollectible accounts and had
written off a huge portion of its receivables due to complications with an inaccuracy in
its prior credit scoring system.
C. To match the terms set by its closest rival, the company established new payment terms
that now require net payment within 30 days, rather than the previous minimum of 15
days.
7) The working capital and fixed asset turnover ratios for a hypothetical corporation are 3 and
6, respectively. Furthermore, the company's revenue is predicted to be $123,000. The
company's average working capital is closest to:
A. $21,000
B. $33,000
C. $41,000
8) Which of the following statements about the defensive interval ratio is the most accurate?
A. The defensive interval ratio calculates the amount of time that current obligations can
cover daily cash needs.
B. The defensive interval ratio calculates the length of time that a period's daily cash
requirements may be met using anticipated liquid assets at the end of the period.
C. The defensive interval ratio determines how long a period's daily cash requirements may
be fulfilled with existing liquid assets.
9) A drop in which of the following ratios would most likely be considered good news by a
creditor?
A. Debt-to-total assets
B. Interest coverage (times interest earned)
C. Return on assets
10) Receivables turnover is twelve times, inventory turnover is six times, and payables turnover
is eight times at Dunder Mifflin. The cash conversion cycle of Dunder Mifflin is the most
similar to:
A. 10
B. 20
C. 30
Answers
1. A is correct. The amount of a company's debt and equity do not provide direct information
about the company's liquidity position Debt to equity:
FY5: 000/3,000 = 2.33
FY2: 5000/3,500 = 1.42
FY1: 3000/5,000 = 0.6
2. B is correct. The activity ratio indicates how efficiently a company performs its day-to-day
tasks such as collecting dues from customers and managing inventory.
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑

3. C is correct. DSO is given by: Days of Sales Outstanding =
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Where,
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 570000
Receivables Turnover = = =6
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 95000
360
DSO = = 60
6
4. B is correct. An increase in the number of distributors cannot be directly correlated with a

reduction in the inventory turnover ratio.
5. B is correct. Fixed charge coverage is a solvency ratio where as defensive interval ratio is a
liquidity measure and return on total capital is a measure of profitability.
6. B is correct. A write off of receivables would decrease the average amount of accounts
receivable (the denominator of the receivables turnover ratio), thus increasing this ratio.
Customers with weaker credit are more likely to make payments more slowly or to pose
collection difficulties, which would likely increase the average amount of accounts receivable
and thus decrease receivables turnover. Longer payment terms would likely increase the
average amount of accounts receivable and thus decrease receivables turnover.
7. C is correct. The working capital turnover is defined as:

𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Working capital turnover =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
In this case, we have,
123000
3=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
123000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = = 41,000
3
8. C is correct. The defensive interval ratio measures the number of days a company could
operate without using any long-term assets.
9. A is correct. In general, a creditor would view a lower debt-to-total-assets ratio as good

news. A higher degree of debt in a company's capital structure raises the chance of default
and, in general, will result in higher borrowing rates to compensate lenders for taking on
more credit risk. A drop in interest coverage or return on assets is likely to be regarded as
bad news.
10. A is correct.
Cash conversion cycle = 12 + 6 – 8 = 10
Dupont Analysis
LOS 43d: Demonstrate the application of DuPont analysis of return on equity and calculate
and interpret effects of changes in its components.
Explain the importance of DuPont analysis of return on equity. Calculate and explain the effects of
changes in its parts.
DuPont analysis
It helps in analysing the return on equity. This method of analysis breaks down the calculation in
various components. This breakdown enables in interpretating the components and ratio even better.
The two approaches involved are:
a. The original three-part approach

b. The extended five-part system.
The original three-part approach breakdown is shown below:
⮚ ROE = net income / average equity

Further, multiplying ROE by (revenue/revenue) we get;
⮚ ROE = (net income / revenue) (revenue/average equity)

Where;
the first bracket = profit margin, and
second bracket = equity turnover
⮚ Moving forward, by multiplying these terms by (assets/assets), we get:

ROE= (net income / revenue) (revenue/average total assets) (average total assets/average
equity)
Where;
The first bracket = profit margin, however,
The second term = asset turnover,
⮚ The third term = financial leverage ratio which increases with an increase in the use of debt
Thus,
ROE= (net profit margin) (asset turnover) (leverage ratio/equity multiplier)
In case of a low ROE;
The company either has a poor profit margin or a poor asset turnover or the company has too
little leverage.
Note: It is necessary to understand that DuPont method is a way to decompose ROE and
it enables in understanding what components actually drive the ROE.
Illustration
Reliance ltd has sustained a stable ROE of nearly 15% from 2018-2020.
Reliance ltd combined Balance sheet and Income Statement (₹, lakhs)
Year 2020 2019 2018
Net income 20 21 20.5
Revenue 300 310 350
Average equity 110 115 120
Average assets 200 250 300
From the statement given above use the traditional DuPont analysis to decompose the given ROE into
its three components and comment on trends in company performance.
Solution
ROE =Net income / Average equity
2020 20/110 18.18%
2019 21/115 18.26%
2018 20.5/120 17.08%
DuPont = (net income / revenue) (revenue/average total assets)

(average total assets/average equity)
2020 6.67% x 1.5 x 1.81
2019 6.77% x1.24 x2.17
2018 5.86% x 1.16 x 2.5
Concluding the analysis, we get:
On one hand while the traditional ROE has not dropped that drastically, On the other hand, both total
asset turnover and net profit margin have decreased.
However, this decrease has been offset by a substantial rise in leverage.
Thus, the analyst must be cautious regarding the fall in net margin and regulate the blend of industry
price and/or increasing expenses. Further, notice how the company risk has risen due to rising debt
financing.
Illustration
A ltd has a net profit margin of 5%, asset turnover of 3.0, and a debt-to-assets ratio of 40%. What is
the ROE?
Solution
Since, the debt-to-assets = 40%, equity to assets = 60%;

thus, the assets to equity (the leverage ratio) = 1 / 0.6 = 1.667
ROE = (net profit margin) (asset turnover) (leverage ratio)
ROE = 5% X 3.00 X 1.667
ROE= 25%
The extended (5 way) Dupont method breakdown includes:
⮚ ROE = (net income / EBT) (EBT/EBIT) (EBIT/revenue) (revenue/ average assets) (average
assets/average equity)
The net profit margin component is broken down into 3 parts:
1. Net income / EBT = tax burden = (1 – tax rate).
2. EBT/EBIT = interest burden.
3. EBIT/revenue = EBIT margin.
Thus, we have:
ROE = (tax burden) (interest burden) (EBIT margin) (asset turnover) (financial leverage)
Note:
a.  in interest expense as proportion of EBIT leads to  in interest burden, thus,  in the
interest burden ratio.
 in either tax burden /interest burden leads to  ROE.
b. EBIT margin can also be known as operating margin.
Thus, the interest burden part would then depict the effects of nonoperating income and
of interest expense.
c. Generally, high profit margins, leverage, and asset turnover lead to higher ROE. However,
the extended formula depicts that more leverage does not always lead to higher ROE.
Since, higher leverage leads to higher interest burden which offsets the positive effect.
d. Higher taxes leads to lower ROE.
Illustration
Using the information given below of two companies from the same industry, calculate the ROE for
both companies using the extended DuPont analysis. Explain the important factors that lead to a
difference in both the company’s ROE’s.
Selected Income and Balance Sheet
Firm A (₹) Firm B (₹)
Revenue 5000 9000

EBIT 350 1000
Interest expense 50 0
EBT 300 1000
Taxes 100 400
Net Income 200 600
Average assets 2500 3000
Total debt 1000 500
Average equity 1500 2500
Solution
A. EBIT margin = EBIT / revenue

For Company A:
EBIT margin = 350 / 5000 = 7.0%
For Company B:
EBIT margin = 100 / 900 = 11.1%
B. Asset turnover = revenue / average assets
For Company A:
Asset turnover = 5000 / 2500 = 2.0
For Company B:
Asset turnover = 9000 / 3000 = 3.0
C. Interest burden = EBT / EBIT
For Company A: interest burden = 300 / 350 = 85.7%
For Company B: interest burden = 1000 / 1000 = 1
D. Financial leverage = average assets / average equity
For Company A:
Financial leverage = 2500 / 1500 = 1.67
For Company B:
Financial leverage = 300 / 250 = 1.2
E. Tax burden = net income / EBT
For Company A:
Tax burden = 200 / 300 = 66.7%
For Company B:
Tax burden = 600 / 1000 = 60.0%
Thus,
For Company A:
ROE = 0.667 × 0.857 × 0.07 × 2.0 × 1.67 = 13.4%
For Company B:
ROE = 0.608 × 1.0 × 0.111 × 3.0 × 1.2 = 24%
Analysis:
As compared to Company A, Company B =
↑ tax burden,
↓ interest burden (lower the ratio higher the burden),
↑ EBIT margins,
↑ asset utilization (this includes proper current asset management or cost control for fixed assets
because of their age), and ↓ leverage.
Thus, the ↑ operating profit margins and ↑ asset turnover are the key factors driving the ROE
significantly above Company A. Further it attains this ROE with less leverage than Company A.
More Financial Ratios

LOS 43e: Calculate and interpret ratios used in equity analysis and credit analysis.
With regard to equity and credit analysis, calculate and interpret ratios.
For equity,
1. Valuation ratios
⮚ Ratios used for analysing the investment in common equity.
⮚ It includes;
Relative per share valuation ratios like;
⮚ Price-to-earnings (P/E) ratio,

P/E = current market price of a share ÷ company’s EPS.
It also includes Price-to-cash flow, the price-to-sales, and the price-to-book value ratios.
⮚ Basic EPS = net income (common shareholders) ÷ weighted average number of common
shares outstanding.
⮚ Diluted EPS is the lowest reported EPS, hypothetically assuming that all dilutive securities
had been converted. Dilutive securities includes convertible debt and convertible
preferred stock, options and warrants issued by a firm.
In case of dilutive securities,
The numerator (adjusted net income) ↑’s,
by the after-tax interest savings on any dilutive debt securities and by the dividends on
any dilutive convertible preferred stock.
Further;
The denominator ↑’s, by the higher common shares’ resultant from the conversion or
exchange of dilutive securities
⮚ Cash flow per share, EBIT per share, and EBITDA per share.
Note: Per share measures are not comparable since the number of outstanding shares
vary across companies.
2. ROE & Dividends

Neither EPS nor net income is reduced by the payment of common stock dividends.
Therefore, retained earnings = net income - dividends declared These earnings are used to
grow the company and are not distributed. It is important to determine the proportion of a
company’s net income that is retained to calculate the sustainable growth rate.
Thus;
The proportion of earnings reinvested is known as the retention rate (RR) and
Sustainable growth rate, which is how fast a company can grow without additional issue of
equity and holding leverage constant is:
g = RR × ROE
where;
Retention rate
= net income available to common – dividends declared ÷ net income available to common
= 1 – dividend pay-out ratio
And;
Dividend pay-out ratio = dividends declared ÷ net income available to common
Illustration
Given is the company’s EPS = ₹ 200, dividend per share = ₹ 100 and ROE = 15%. Calculate the
sustainable growth rate.
Solution
Retention rate = 1 – (dividends/earnings)

Retention rate = 1 – (100 / 200)
Retention rate (RR) = 0.5
Further;
g= RR x ROE
g= 0.5 x 15%
g=7.5%
1. Ratios with specific applications

⮚ Net income per employee and sales per employee used by service and consulting
companies.
⮚ Growth in same-store sales is used in the restaurant and retail industries to indicate
growth without the effects of new locations that have been opened. It measures how
well a company is doing by attracting and keeping existing customers
Furter in case of over-lapping markets, it may also show that new locations are taking
customers from existing ones. Sales per square foot is another ratio used in the retail
industry.
2. Business risk
⮚ Coefficient of variation (CV)
Since standard deviations of a company like revenue, operating income etc depend on
the size of a company, the coefficient of variation (CV) is used.
CV for a variable = standard deviation ÷ expected value.

Every industry has its own level of uncertainty about revenues, expenses, taxes, and
nonoperating items.
Thus, comparing CVs for a company across time, or among a company and its
competitors, can help the analyst in analysing both the relative and absolute degree of
risk that a company faces in generating income.
a. CV sales = standard deviation of sales ÷ mean sales

b. CV operating income = standard deviation of operating income ÷ mean operating
income
c. CV net income = Standard deviation of net income ÷ mean net income
⮚ Capital adequacy
It measures both operational and financial risk of a company to its equity capital.
Other measures of capital are also used.
A common measure of capital risk is value-at-risk (VAR), VAR is an estimate of the dollar
size of the loss that a firm will exceed only some specific percent of the time, over a
specific period of time.
⮚ Reserve requirements
Banks are subject to minimum reserve requirements.
For e.g.: CRR, SLR ratio and liquid asset requirement (liquid assets /certain liabilities).
⮚ Net interest margin

The performance of financial companies that give funds on credit is measured under the
net interest margin,
Net interest margin = interest income ÷company’s interest-earning assets.
⮚ For credit analysis,

In case of checking the company’s ability to repay debt
The ratios involved are interest coverage ratios (calculated with EBIT or EBITDA), return
on capital, debt-to-assets ratios and various measures of cash flow to total debt.
Ratios are used to analyse and predict firm bankruptcies.
For instance;
The Z-score is useful in forecasting bankruptcies (lower scores depict higher probability
of failure).
Explain the requirements for segment reporting and calculate and interpret segment ratios.
What are the requirements for segment reporting? Calculate and interpret segment ratios.
Segments include;
a. Business segment: It is a part of a larger company that accounts for >10% of the company’s
revenues, assets, or income. Further, it is differentiated from the company’s other lines of
business in terms of the risk and return characteristics of the segment.
b. Geographic segments: They are also identified when they meet the size criterion given
previously and the geographic unit has a business environment that is different from that of
other segments or the remainder of the company’s business. Under both U.S. GAAP and IFRS,
companies are needed to report segment data, but the required disclosure components are
only a part of the required disclosures for the company as a whole.
However, an analyst can yet prepare a more detailed analysis and forecast by inspecting the
performance of business or geographic segments separately. The performance ratios involved
are; segment profit margins, asset utilization (turnover), and return on assets for overall
operations. For forecasting ratios involved are, growth rates of segment revenues and profits
which can be utilised to predict future sales and profits.
LOS 43f: Describe how ratio analysis and other techniques can be used to model and
forecast earnings.
How can ratio analysis and other techniques be used to model and forecast earnings?
Ratio analysis is used to prepare pro forma financial statements. These statements give an estimate
of financial statement items for one or more future periods.
For e.g.:
a. For next period revenue, the most recent COGS, or an average of COGS, from a common-size
income statement is used.
Assuming that ratio of COGS/revenue wouldn’t change; a pro forma income statement for the
next period based on the estimate of sales can be made.
b. In case of no information indicating a change of direction in the statement components, an
analyst may choose to involve the operating profit margin from the prior period into a pro
forma income statement for the next period.
The 3 methods of examining the variability of financial outcomes are:
a. Sensitivity analysis, It is based on “what if” questions. For e.g.: What will be the effect on
COGS if revenue increases by 5% instead of the predicted 8%?
b. Scenario analysis, It is based on specific scenarios (a specific set of outcomes for main
variables). It also yields a range of values for financial statement items.
3. Simulation, Simulation is a technique in which probability distributions for key variables
are selected and a computer is used to generate a distribution of values for outcomes based
on repeated random selection of values for the key variables.
1) What is the most likely impact of a corporation tax interest rate hike from 25% to 27% on a
firm's return on equity ratio?
A. The Return on equity ratio will decrease

B. The Return on equity ratio will increase
C. The Return on equity ratio will remain unchanged
2) When developing forecasts, analysts should most likely:
A. Develop options solely based on the findings of a financial analysis.

B. Use the results of financial analysis, analysis of other information, and judgment
C. Using the results of financial analysis to build extremely precise forecasts.
3) Which of the following equations should be used to calculate the return on equity ratio?
A. Return on Equity = Gross Profit Margin × Return on Assets × Financial Leverage.

B. Return on Equity = Net Profit Margin × Asset Turnover × Financial Leverage.
C. Return on Equity = Net Profit Margin × Equity Turnover × Financial Leverage.
4) A research analyst at Shark Investment Management is performing a DuPont analysis for a

company whose financial information is listed in the table below:
Financial Data
Revenue 1550000
COGS 350000
Gross profit 1200000
SG&A 180000
Wages 120000
EBITDA 900000
Depreciation 330000
Operating profit 570000
Interest payment 170000
EBT 400000
Taxes 80000
Net income 320000
Total assets 2400000

Total debt 1000000
Considering that the data provided is accurate, the firm's return on equity using the
extended DuPont ratio is closest to:
A. 2%
B. 14%
C. 22%
5) Accounting standards demand segment reporting for a distinct section of a company that
includes at least
A. 10% of assets
B. 20% of earnings
C. 5% of revenues
6) Which of the following ratios can most likely be used to measure a firm's business risk?
A. Asset Turnover
B. Coefficient of Variation in Sales
C. No. of Days of Payables.
7) Which of the following credit analysis metrics is used to forecast a company's failure?
A. Altman's F-score.
B. Altman's t-score.
C. Altman's Z-score.
8) Which of the following risk metrics is most frequently used by banks to monitor and quantify
the level of financial risk within a company during a certain time period?
A. Liquid Asset Requirement.
B. Reserve Requirement.
C. Value at Risk (VaR)
9) If the above company’s dividend payout ratio is 38.5% and the ROE is 21%. The company’s
sustainable growth rate is most likely:
A. 0.081
B. 0.129
C. 0.211
10) A decomposition of ROE for Integra SA is as follows:

FY11 FY10
ROE 18.90% 18.90%
Tax burden 0.70 0.75
Interest burden 0.90 0.90
EBIT margin 10% 10%
Asset turnover 1.50 1.40
Leverage 2.00 2.00
Which of the following choices best describes reasonable conclusions an analyst might make
based on this ROE decomposition?
A. In fiscal year 2011, both profitability and liquidity improved.

B. In FY11, a higher average tax rate outweighed efficiency gains, keeping ROE constant.
C. The increase in profitability in FY11 was offset by a higher average tax rate, keeping ROE
unchanged.
Answers
1. A is correct. The increase in Taxes will decrease Net Income and decrease the Return on equity
ratio (Net Income/Avg. Total Equity). Note: The Return on equity ratio does not use Revenue.
2. B is correct. The results of an analyst's financial analysis are integral to the process of developing
forecasts, along with the analysis of other information and judgment of the analysts. Forecasts
are not limited to a single point estimate but should involve a range of possibilities.
3. B is correct.
4. C is correct. The extended DuPont approach has 5 components: Tax burden (N.I./ EBT), Interest
Burden (EBT/EBIT), EBIT Margin (EBIT/Revenue), Asset Turnover (Revenue/ Avg. Total Assets) &
Financial Leverage (Avg. Total Assets/Avg. Total Equity). Return on Equity = 0.22 or 22% (Using
the following table)
Tax burden 0.80
Interest burden 0.70
EBIT margin 0.36
Asset turnover 0.64
Financial leverage 1.72
ROE 0.22
5. A is correct. For segment reporting, a business segment is a distinguishable portion of the overall
company that produces more than 10% of its revenues or accounts for more than 10% of its
assets.
6. B is correct. The Coefficient of variation of sales measures the standard deviation in Sales.
Deviation in sales, EBIT, and Net Income, are indicators of Business Risk.
7. C is correct. Altman's Z-score formula may be used to predict the probability that a firm will go
into bankruptcy within two years. A low Z-Score predicts a high probability of bankruptcy.
8. C is correct. Value at Risk (VaR) is a statistical technique used to measure and quantify the level
of financial risk within a firm or investment portfolio over a specific time frame
9. B is correct. Sustainable growth rate = Retention ratio × Return on equity. To get the sustainable
growth rate, we first have to determine the retention ratio. Retention ratio = 1 − Dividend
payout ratio Retention ratio = 1 − 0.385 = 0.615
Sustainable Growth Rate = 0.615 × 21% = 12.915%
10. B is correct. The increase in the average tax rate in FY11, as indicated by the decrease in the
value of the tax burden (the tax burden equals one minus the average tax rate), offset the
improvement in efficiency indicated by higher asset turnover) leaving ROE unchanged. The EBIT
margin, measuring profitability, was unchanged in FY11 and no information is given on liquidity.
Introduction to Financial Statement Modelling 180
Introduction to Financial Statement Modelling
LOS 44a: Demonstrate the development of a sales-based pro forma company model
A sales-based pro forma company model entails forecasting future financial statements by projecting
a company's revenues, guided by an analyst's estimations. The summarized steps for constructing such
a model are outlined here, with further elaboration provided in our Equity Investments reading on
Company Analysis: Forecasting.
1. Estimate Revenue Growth: Determine future revenue by considering market growth, market
share, trend growth rate, or growth relative to GDP.
2. Estimate COGS: Assess Cost of Goods Sold (COGS) using a sales-based percentage or a more
detailed approach based on business strategy or competitive landscape.
3. Estimate SG&A: Forecast Selling, General, and Administrative (SG&A) expenses, considering fixed
costs, growth proportionate to revenue, or other estimation techniques.
4. Estimate Financing Costs: Calculate financing costs using interest rates, debt levels, and potential
significant changes in capital expenditures or financial structure.
5. Estimate Income Tax Expense: Predict income tax and cash tax expenses using historical effective
rates, trends, and segment data for various tax jurisdictions. Account for growth in different tax
segments and changes in deferred tax items.
6. Model Balance Sheet: Construct the balance sheet by incorporating elements derived from the
income statement, particularly working capital accounts.
7. Estimate Capital Expenditures: Utilize depreciation and capital expenditures (for maintenance and
growth) to project net Property, Plant, and Equipment (PP&E) for the balance sheet.
8. Construct Cash Flow Statement: Combine the completed pro forma income statement and balance
sheet to create a pro forma cash flow statement.
LOS 44b: Explain how behavioral factors affect analyst forecasts and recommend
remedial actions for analyst biases.
1.Overconfidence Bias: Analysts may exhibit overconfidence, underestimating the extent of their
forecasting errors and narrowing their confidence intervals. This bias can be reduced through sharing
forecasts, seeking critique, and learning from past errors. Scenario analysis can help identify potential
shortcomings.
2.Illusion of Control Bias: This bias involves overestimating control and attempting to control
uncontrollable factors. Seeking expert opinions solely for validation and increasing model complexity
can lead to poor out-of-sample performance. Mitigation involves focusing on relevant variables and
seeking external opinions from those with relevant perspectives.
3.Conservatism Bias: Also known as anchoring, this bias results in limited adjustments to prior
forecasts despite new information. Overcoming this bias requires periodic evaluation of errors and
using simpler models that are adaptable to changing assumptions.
4.Representativeness Bias: Analysts tend to rely on known classifications, overlooking subtle

differences in new information. Considering both the specific (inside view) and general (outside view)
perspectives can enhance forecasts.
5.Confirmation Bias: Confirmation bias leads analysts to favor data that supports existing beliefs and
ignore contradictory information. Mitigating this bias involves seeking diverse viewpoints, including
those opposing one's own, and being cautious of management's favorable representations.
In the financial industry, being aware of and addressing these behavioral biases is crucial to making
accurate and unbiased forecasts.
LOS 44c: Explain how the competitive position of a company based on a Porter’s five
forces analysis affects prices and costs.
A firm's competitive environment and its ability to thrive within it significantly shape its future
financial outcomes. While there are no fixed formulas, a firm's competitive success holds utmost
importance in determining its future revenue and profitability.
Analysts often employ Porter's Five Forces framework to assess a company's competitive standing, a
concept we briefly introduce here and explore further in our Equity Investments reading on Industry
and Competitive Analysis.
1. Pricing power is greater when substitute product threats are minimal and switching costs are high.
Conversely, pricing power diminishes when viable substitutes exist and customer switching is
convenient.
2. Pricing power is enhanced when industry rivalry is low, and weakened when competition is fierce.
Rivalry intensifies with more competitors, high fixed costs, exit barriers, sluggish industry growth, and
undifferentiated products.
3. Elevated supplier bargaining power may elevate cost pressures and hamper earnings growth.
Limited suppliers could exert greater control over value distribution.
4. Pricing power declines as customer bargaining power increases, especially if few customers drive
significant sales or switching costs are low.
5. Enhanced pricing power and earnings potential arise when new entrant threats are minimal. High
entry barriers deter new players from entering the industry, allowing existing companies greater
control.
LOS 44d: Explain how to forecast industry and company sales and costs when they
are subject to price inflation or deflation
Input costs hold significant weight across various industries, including examples like jet fuel in airlines,
grains for cereal makers, and coffee beans for cafes. Fluctuations in these costs wield substantial
influence over earnings.
To counter the impact of volatile input prices, companies employing commodity-type inputs can
adopt hedging strategies using derivatives or fixed-price contracts. Such measures mitigate short-
term price volatility, extending the period before prolonged cost and earnings alterations materialize.
Vertical integration, where a company is its own supplier, also cushions exposure to input cost risk.
For firms not employing hedging or vertical integration, analysts grapple with the speed and extent
at which cost hikes can be passed on to consumers, alongside the potential repercussions on sales
volume and revenue due to price adjustments. Close monitoring of production costs by product
category and geographic region is imperative, focusing on determinants like weather, regulations,
taxation, tariffs, and input market dynamics. Substituting inputs can sometimes mitigate price rise
effects, such as power generation firms switching from oil to natural gas amid escalating oil costs.
When forecasting the repercussions of rising input costs, analysts must factor in pricing strategies and
the impact on unit sales. Temporary cost hikes may prompt firms to trim non-essential expenditures
like advertising, preserving operating margins. However, this approach may not hold for prolonged
cost uptrends.
The effect of price hikes on a product hinge on its demand elasticity. Generally, product demand
shows elasticity, where the percentage dip in unit sales outweighs the percentage price hike, leading
to reduced overall revenue.
Elasticity of demand primarily hinges on substitute product availability. Competitive industry

dynamics shape market share in response to pricing decisions. Early price increases could lead to
steeper sales drops than those occurring after peers adjust prices. Timing matters—firms may delay
price hikes to gain market share when rivals raise prices. Premature hikes lead to falling sales, while
tardiness leads to declining margins.
In a hypothetical scenario where cost-per-unit increment is absorbed by product price without sales
decline (unlikely), operating profit remains steady. Nonetheless, gross, operating, and net margins
will decline.
Frays Inc, sells a specialized network component, The firm’s income statement for the past year
follows.
Frays Inc, Income statement for the year ended 20X1
Revenues 1,000 @ $100 $100,000
COGS 1,000 @ $40 $40,000
Gross profit $60,000
SG & A $30,000
Operating profit $30,000
For 20X2, the input costs (COGS) will increase by $5 per unit.
1. Calculate the gross margin and operating margin for Frays Inc., for 20X1.
2. Calculate the 20X2 gross margin and operating margin assuming the following:
a. The entire increase in input cost is passed on to the customers through an equal increase in
selling price. The number of units sold is not affected.
b . The selling price is increased by 5% and the number of units sold decreases by 5%.
c. The selling price is increased by 5% and the number of units sold decreases by 10%.
Answer:
1 . gross margin = gross profit / sales = $60,000 / $100,000 = 60%
operating margin = operating profit / sales = $30,000 / $100,000 = 30%
2. a. 20X2, given an increase in unit price by $5 and no change in units sold:
Revenues 1,000 units @ $105 $105,000
COGS 1,000 units @ $45 $45,000
SG & A $30,000
Gross margin $57%
Operating margin $29%
Gross margin = gross profit/sales = $60,000/$105,000 = 57%
Operating margin = operating profit/sales = $30,000/$105,000 = 29%
b. 20X2, given an increase in unit price by $5 and a decrease of 50 in units sold:
Revenues 950 units @ $105 $99,750
COGS 950 UNITS @ $45 $42,750
SG & A $30,000
Gross margin $57%
c. 20X2, given an increase in unit price by $5 and a decrease of 100 in units sold:
Revenues 900 units @ $105 $94,500
COGS 900 units @ $45 $40,500
SG & A $30,000
Gross margin $57%

LOS 44e: Explain considerations in the choice of an explicit forecast horizon and an
analyst’s choices in developing projections beyond the short-term forecast horizon.
Buy-side analysts often align their forecast horizon with the expected holding period for a stock. For
instance, a portfolio featuring 15% annual turnover, translating to an average holding duration of four
years, would suggest a suitable four-year forecast horizon.
However, gauging the forecast horizon for highly cyclical firms poses challenges. It must encompass a
span where current economic cycle effects don't overly impact earnings trends. Striking a balance, it
should encapsulate a business cycle's midpoint to incorporate sales and profit levels characteristic of
such a phase. Normalized earnings represent midcycle expectations, accounting for events or
cyclicality's transient influences on earnings.
Temporary events like acquisitions, mergers, or restructurings warrant a forecast horizon long enough
to realize perceived benefits, or lack thereof, arising from these events.
External factors, such as managerial directives, could also dictate the forecast horizon.
For long-term earnings projections, one approach entails extending the trend growth rate of revenue
from the previous cycle. Pro forma financial outcomes for each future period can be estimated based
on this revenue projection.
Typically, analysts value stocks using earnings or cash flow metrics within the forecast period,
alongside the stock's terminal value at the horizon's end. This terminal value is often derived through
relative valuation (using price multiples) or discounted cash flow methodologies.
In employing a multiples approach, an analyst must ensure congruence between the chosen multiple
and the projected growth rate and required rate of return for the company. For instance, using the
average P/E ratio over the past decade assumes that future earnings growth and required rate of
return will mirror the historical trend. Yet, this assumption might not hold true for the future.
When employing the discounted cash flow method to determine the terminal value, critical inputs
involve a cash flow or earnings metric and an anticipated future growth rate. This earnings or cash
flow projection should be normalized to a midcycle value, unaffected by transient events. Because the
terminal value is calculated as the present value of an everlasting cash flow, even slight shifts in the
projected perpetual growth rate of future earnings or cash flows can significantly impact terminal
values, thereby influencing the current stock valuation.
Presuming future profitability growth will mirror past average profitability growth might lack
justification. A challenging aspect of an analyst's role is identifying inflection points—instances when
the future diverges from the past. These points often involve shifts in the economic landscape, stages
of the business cycle, regulatory changes, or technological advancements.
1) An analyst continues to add independent variables to a forecasting model, even

when doing so does not improve its accuracy significantly. The analyst most likely
exhibits:
A. confirmation bias.
B. illusion of control bias.
C. representativeness bias.
2) Which of Porter’s five forces should an analyst focus on when evaluating risks to a
company’s input costs?
A. Threat of new entrants.
B. Intensity of industry rivalry.
C. Bargaining power of suppliers.
3) When analyzing a cyclical company, the forecast horizon should include:

A. a full business cycle.
B. the midpoint of a business cycle.
C. the next change in phase of a business cycle.
Answers:
1. B is correct as making a forecasting model overly complex, even when doing so brings no
significant improvement, most likely reflects illusion of control bias.
2. C is correct as of Porter’s five forces, bargaining power of suppliers has the most direct
influence on a company’s input costs. The other four forces more directly
affect a company’s pricing power.
3. B is correct as the forecast horizon for a cyclical company should include the midpoint of a
business cycle, at which the company is expected to produce normalized
earnings.
Formula 186
Formula
Activity ratios:
𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
• Receivables turnover = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑎𝑏𝑙𝑒𝑠
365
• Days of sales outstanding = 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

• Inventory turnover = average inventory
365
• Days of inventory on hand = 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
• Payables turnover = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
365
• Number of days payable = 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
𝑟𝑒𝑣𝑒𝑛𝑢𝑒
• Total assets turnover = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
• Fixed asset turnover = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡
• Working capital turnover = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
Liquidity ratios:
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
• Current ratio = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑐𝑎𝑠ℎ + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

• Quick ratio = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡𝑙 𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑐𝑎𝑠ℎ + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠

• Cash ratio = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑐𝑎𝑠ℎ + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

• Defensive interval = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠
• Cash conversion cycle = (𝑑𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔) +

(𝑑𝑎𝑦𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑜𝑛 ℎ𝑎𝑛𝑑) − (𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒)
Formula 187
Solvency ratios:
total debt
• Debt to equity = total shareholder′ s equity
total debt
• Debt to capital = total debt + total shareholder′ s equity
total debt
• Debt to asset ratio = total assets
average total assets

• Financial leverage ratio =
average total equity
EBIT
• Interest coverage ratio = interest payments
EBIT + lease payments

• Fixed charge coverage ratio = interest payments + lease payments
Profitability ratios:
gross profit
• Gross profit margin = revenue
operating income EBIT

• Operating profit margin = or
revenue revenue
EBIT
• Pretax margin = revenue
net income
• Net profit margin = revenue
operating income EBIT

• Operating ROA = or
average total assets average total assets
net income
• Return on assets (ROA) = average total assets
net income + interest expense (1−tax rate)

• Return on assets (ROA) = average total assets
EBIT
• Return on total capital = average total capital
net income
• Return on equity (ROE) = average total equity
net income − preferred dividends

• Return on common equity (ROCE) = average common equity
Formula 188
Free Cash flow to the Firm:
• FCFF = net income + noncash charges + [cash interest paid × (1 − tax rate)] −
fixed capital investment − working capital investment
• FCFF = cash flow from operations + [cash interest paid × (1 − tax rate)] −
fixed capital investment
Free Cash Flow to Equity:
• FCFE = cash flow from operations − fixed capital investments + net borrowings
income statement account

• Common size income statement ratios = sales
balance sheet accounts

• Common size balance sheet ratios = total assets
cash flow statement account

• Common size cash flow ratios = revenues
• Original DuPoint equation: ROE =
(net profit margin)(asset turnover)(leverage ratio)
• Extended DuPoint equation: ROE =
net income EBIT EBIT revenue total assets

( ) (EBIT) (revenue) (total assets) (total equity)
EBIT
et income − preferred dividends dividends

• Basic EPS = weighted average number of common shares outstanding
• Diluted EPS = [net income − preferred dividens] +

[convertible preferred dividends] + (convertible debt interest)(1 − t)/
(weighted average shares) +
(shares from conversion of convertible preference shares) +
(shares from conversion of convertible debt) +
(shares issuable from stock options)
Coefficient of Variations:
standard deviation of sales

• CV sale = mean sales
Formula 189
standard deviation of operating income

• CV operating incomes = mean operating income
standard deviation of net income

• CV net income = mean net income
Inventories:
• Ending inventory = beginning inventory + purchases − COGS
• FIFO COGS = LIFO COGS − (ending LIFO reserves − beginning LIFO reserves)
Deferred Taxes:
Income tax expense = taxes payable + ∆DTL − ∆DTA
Long Lived Assets:

cost − salvage value
• Straight line depreciation= useful life
2
• DDB depreciation= ( ) (cost − accumulated depreciation)
useful life
original cost − salvage value

• Units of production depreciation = ×
life in inputs
output units in the period
accumulated depreciation
• Average age = annual depreciation expense
historical cost
• Total useful age = annual depreciation expense
ending net PP&E

• Remaining useful life = annual depreciation expense
Debt Liabilities:
• Interest expense = (market rate at issue) ×

(balance sheet value of the liability at the beginning of the period)
Formula 190
Performance Ratios:
CFO
• Cash flow to revenue = net revenue
CFO
• Cash return on assets = average total assets
CFO
• Cash return on equity = average total equity
CFO
• Cash to income = operating income
CFO – preferred dividends

• Cash flow per share =
weighted average number of common shares
Coverage Ratios:
CFO
• Debt coverage =
total debt
CFO + interest paid + taxes

• Interest coverage = interest paid
CFO
• Reinvestment = cash paid for long term assets
CFO
• Debt payment =
cash long term debt repayment
CFO
• Dividend payment = dividends paid
CFO
• Investing and financing = cash outflows from investing and financing activities
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Introduction to Financial Statement Modelling ......................................................................... 180

Authored by: Dhrumi Doshi, Prabhjyot Taluja, Esha Vora

Introduction to Financial Statement Analysis

• For applicants with no prior experience in financial statements

Financial Statement Roles

Role of Financial reporting

The SEC required filing includes:

the segments comprises of 10% or more of the companies

Management’s commentary [also known as Management’s Discussion and Analysis (MD&A)]

Some parts of management’s commentary might be unaudited.

Meaning: Audit is the independent review of an institution’s financial statements. It is an

The standard auditor’s opinion contains 3 parts, and it states:

What do you understand by Internal control?

6. Corporate Governance Information: Analysts analyze corporate governance-related

A. Effects of inflation and changing prices of materials.

A. Analyze and interpret the data.

4) Which of the following best describes unqualified opinion

5) A company's interim financial reports are most likely to be:

6) An independent audit report is most likely to provide:

A. Complete confidence in the financial accounts' accuracy.

A. Allow for flexibility in the creation of financial statements.

7. B is correct. This is a part of the management comments.

Analyzing Income Statements

Accounting Standards for Revenue Recognition

• Promise to deliver a “distinct” good/service.

For e.g.:The resale of goods purchased by an entity

• Entity has a present right to payment

• Contracts with customers by category.

 cost incurred in year1 is 50% of the total estimated cost,

Revenue recognised for Year2= ₹ 8,25,000 − ₹ 5,00,000 (for year1)

Revenue recognised for Year2= ₹ 8,40,000 − ₹ 5,00,000 (for year1)

1) Which of the following is least likely a criteria for distinct good:

2) The final step in the revenue recognition process is to:

A. Determine the transaction price.

A. Both are included.

3. C is correct. Because interest is a finance cost, it is not included in operating

What do you understand by expense recognition?

Which are the different methods of Inventory Expense Recognition?

Straight-Line Depreciation (Sld) Accelerated Depreciation Method

For e.g.: For e.g.: Double Declining Balance Method (DDM)

What do you understand by amortization expense recognition?

• If goods/services are sold on credit or a warranty is offered the company needs to

What are the implications for financial statements?

Unusual or infrequent items.

• Events are either unusual or occur infrequently.

Changes in Accounting Policies and Estimates

• Accounting changes include changes in accounting policies, changes in accounting

1) If the warranty expense in proportion to sales of two identical companies is significantly

A. Adjust the financials to decrease the warranty expense to a lower level.

2) Which of the following is the most likely example of nature-based expenses?

A. Cost of goods sold

A. Double-declining balance method.

A. Entity A will have a higher total depreciation expense.

6) A cement manufacturing company acquired a cement-making machine at the beginning of

A. Balance depreciation is decreasing with an extended useful life

8) Which inventory method is least likely to be used under IFRS?

A. First in, first out

2. B is correct. The grouping of depreciation on manufacturing equipment, depreciation on